microsoft word 5 aslan_koksal_ocal pp paper[1].doc international journal of economics and financial issues vol. 1, no. 2, 2011, pp.74-77 issn: 2146-4138 www.econjournals.com competitive environment hypothesis in turkish banking system alper aslan nevsehir university, faculty of economics and administrative sciences, 50300, nevsehir, turkey. tel: 0090 384 228 11 10 / 1519 email: alperleo@gmail.com kemal koksal celal bayar university, institute of social sciences, 45030, manisa, turkey. email: koksal_kemal@hotmail.com oguz ocal erciyes university, institute of social sciences, kayseri, turkey. email: oguz_ocal@yahoo.com abstract: this paper investigates the persistence of profit in turkish banking system for the period of 2004:1 – 2009:4 by focusing net income after tax to total equity (roe) as profit measures by utilizing panel unit root tests. we found that competition among surviving banks is high in the turkish banking system for the period 2004:1 – 2009:4 which means that competitive environment hypothesis is valid for turkish banking system. keywords: persistence, roe, turkish banking system. 1. introduction much empirical research after second world war focus on a casual relationship exists between the structure of a market (the number and size distribution of firms, product differentiation, and entry and exit barriers) and conduct and performance of the firms operating in that market. the researches attempted to quantify relationships between structure variables such as profit or growth rates (bain 1956). in the theoretical literature, it has been shown that there exits close relationship between market structure and economic performance of the firms in the sector. competition leads to higher efficiency and productivity and hence contributes significantly to the rate of growth of the economy. understanding the nature and degree of competition has also important implications for national and international policy making. the argument that the lack of competition in emerging markets was the fundamental causes of the asian crisis seems to be a good example of it (kaplan and aslan, 2008). there is a fast growing empirical literature on persistence of profit (pp) in non-financial sector. starting with the seminal contributions by mueller (1977), geroski and jacquemin (1988), a vast number of empirical studies have been initiated in order to verify the basic idea that profits persist. cubbin and geroski (1987), goddard and wilson (1999), glen and singh (2001), maruyama and odagiri (2002), glen et al. (2003), yurtoglu (2004), bentzen et al. (2005), goddard et al. (2006), cuaresma and gschwandtner (2006), cable and mueller (2008), and aslan et al. (2010) are just some of the papers that searches evidence for pp for different economies and different time periods. since banking has a major role, as being an agent in the transfer of funds from savers to borrowers, evaluating borrowers, and providing liquidity in economies, understanding the intensity of competition in banking system is mainly important. despite the significance of persistent excess profits in evaluating the efficiency of a banking system, this question has received relatively little competitive environment hypothesis in turkish banking system 75 empirical attention. berger et al. (2000), isik and hassan (2002), goddard et al. (2004a and 2004b), agostino et al. (2005), bektas (2007), kaplan and celik (2008) can be counted as contributions on the persistence of profit rates in the banking industry. this article aims to examine profit persistence in turkish banking system by employing panel unit root methodology. the paper is organized as follows. section ii provides basic background on panel data unit root testing and data set. section iii brings some final comments. 2. data and methodology this study analyses profit persistency in turkish banking system (tbs). the sample consists of 13 banks1 which survive between from 2004:1 to 2009:4 in istanbul stock exchange (ise). the data is taken from balance sheet and income statements of related banks which are obtained from ise. net income after tax to total equity is calculated as roe. roe is employed as profit measures. the aim of this study is to examine the intensity of competition in the turkish banking sector with persistence of profit methodology. im, pesaran and shin (2003, ips hereafter) is based on the traditional augmented dickey fuller specification it p k kitikitiiiit vyyty i     1 1  (1) ips allows for a heterogeneous coefficient of 1ity and proposes a testing procedure based on averaging individual unit root test statistics and the null hypothesis is given by the existence of a unit root in all the units of the panel against the alternative of at least one stationary cross-section. to test the hypothesis, im et al. (2003) propose a standardized t-bar statistic given by:        1,0 00, 1 00, 1 , 1 1 n ptvar n pte n tbarn z nt iiit n i iiit n int tbar                 (2) the levin, lin and chu t-test (2002, hereafter llc) test is carried out by estimating the following equation:     il l tiltiltiikiti yyy 1 ,,1,,,  (3) the panel ols of the normalized residuals is run to obtain the  estimates. and llc show that under the null hypothesis 0: oh , the regression t-statistic ( t ) has a standard normal limiting distribution. when one considers both ips and llc test results with trend and without trend analysis, the results reject in all cases the existence of a unit root for roe which mean that there is convergence in profit rates among banks in table 1. results from ips and llc illustrate that persistence of profit tend to return to their trend path overtime. 3. conclusion the competitive environment hypothesis states that competitive environment will erode abnormal profits and therefore, profitability of competing firms will not be persistent and hence profit differentials across firms, will disappear in the long run. this will persist until the decrease of profitability on a competitive rate. this is very widely known as profit persistence. in this paper, profit persistence in the turkish banking sector is examined by using the data from 13 surviving banks for the period of 2004:1 to 2009:4. it is concluded that the profit rates follow a stationary process implying convergence in profit rates in the long-run which means that competition among surviving banks is high in the turkish banking system. this result confirm competitive environment hypothesis for turkey banking sector for the period from 2004:1 to 2009:4. 1 akbank, alternatifbank, denizbank, finansbank, fortisbank, garantibank, halkbank, i̇sbank, sekerbank, tekstilbank, teb, vakıfbank and yapi kredibank. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.74-77 76 table 1. unit root tests roe method augmented lag constant constant and trend llc 0 1 2 optimal lag -9.842 (0.000) -6.402 (0.000) -2.518 (0.005) -1.908 (0.028) -7.677 (0.000) -6.374 (0.000) -2.463 (0.006) -1.975 (0.024) ips 0 1 2 optimal lag -8.363 (0.000) -6.402 (0.000) -4.387 (0.000) -2.975 (0.001) -3.988 (0.000) -6.022 (0.000) -6.898 (0.000) -3.396 (0.000) note: probability values appear in parenthesis and schwarz information criterion (sic) is used to decide the optimal lag. references agostino, m., leonida l. and trivieri f. (2005) profits persistence and ownership: evidence from the italian banking sector, applied economics, 37(14), 1615 – 1621. aslan, a, f. kula and m. kaplan (2010) “new evidence on the persistence of profit in turkey with first and second generation panel unit root test” metu studies in development, 37(1), 2540. bain, j. (1956) barriers to new competition. harvard university press: cambridge. bektas, e. (2007) the persistence of profits in the turkish banking system, applied economics letters, 14(3), 187-190. berger, n. b., bonime, s. d., covitz, d. m. and hancock, d. (2000) why are bank profits so persistent? the roles of product market competition,informational opacity, and regional/macroeconomic shocks, journal of banking and finance, 24, 1203–35. bentzen, j., e. madsen, v. smith, and m. dilling-hansen (2005). “persistence in corporate performance? empirical evidence from panel unit root tests,” empirica, volume 32: pp. 217-230. cable, j. and jackson, r.h.g. (2008) the persistence of profits in the long run: a new approach, international journal of the economics of business, 15, 229-244. cuaresma c, j., and a. gschwandtner (2006). “on the determinant of profit persistence: evidence from a panel of us firms.” mimeo, university of vienna. cubbin, j. and geroski pa. (1987) the convergence of profits in the long run: inter-firm and interindustry comparisons, journal of industrial economics, 35: 427–442. geroski, p. and jacquemin a. (1988) the persistence of profits: a european comparison, economic journal, 98, 375-389. glen, j., lee, k. and singh, a. (2001) persistence of profitability and competition in emerging markets, economics letters, 72, 247–53. glen, j., lee, k. and singh, a. (2003) corporate profitability and the dynamics of competition in emerging markets: a time series analysis, the economic journal,113, 465–84. competitive environment hypothesis in turkish banking system 77 goddard, j. and wilson, j.o.s. (1999) the persistence of profit: a new empirical interpretation, international journal of industrial organization, 17, 663-87. goddard, j., mcmillan, d. and wilson, j.o.s. (2006). do firm sizes and profit rates converge? evidence on gibrat’s law and the persistence of profits in the long run. applied economics 38: 267-278. goddard, j., molyneux, p., and wilson, j.o.s. (2004a) the profitability of european banks: a crosssectional and dynamic panel analysis, manchester school, 72, 363-381. goddard, j., molyneux, p., and wilson, j.o.s. (2004b) dynamics of growth and profitability in banking, journal of money, credit and banking, 36, 1069-1090. im, k. s., pesaran, m. h. and shin, y. (2003) testing for unit roots heterogeneous panels, journal of econometrics, 115, 53–74. isik, i. and k. hassan, (2002), ‘technical, scale and allocative efficiencies of turkish banking industry’, journal of banking & finance, vol. 26, pp.719–766. kaplan m and aslan al (2008), “persistence of profitability and the dynamics of competition in turkey 19852004” the empirical economics letters, 7(9), 933–941. levin, a., lin, c. f. and chu, c. s. j. (2002), “unit root tests in panel data: asymptotic and finitesample properties”, journal of econometrics, 108, 1-24. marayuma, n. and odagiri, h. (2002) does the persistence of profits persist? a study of company profits in japan, 1964-1997, international journal of industrial organization, 20, 1513-1533. mueller, d. c. (1977) the persistence of profits above the norm, economica, 44, 369–80. yurtoglu, b. (2004) persistence of firm-level profitability in turkey, applied economics, 36, 615-625. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(6), 1-4. international journal of economics and financial issues | vol 10 • issue 6 • 2020 1 understating the impact of economic factors on stock yield: jordanian stock market case ade al-nimri1, yaseen altarawneh2* 1economic and financial researcher, the university of jordan, jordan, 2the university of jordan, jordan. *email: y.tarawneh@ju.edu.jo received: 10 july 2020 accepted: 05 october 2020 doi: https://doi.org/10.32479/ijefi.10415 abstract the study aimed to identify the most salient and critical factors influencing the stock yield and causing this sharp fluctuation, and clarifying which factors are more influential than others on the stock yield in the amman stock market – jordan. the study population consisted of all listed companies in the amman stock market. the sample of the study is random stratified and includes 30% of the original population. the study sample numbered 60 companies of the companies listed on the amman stock market. the main findings are the positive relationship between inflation rates, interest rate, number of employees and capital shares with income shares. the results also showed no relationship between the deficit and surplus of balance of payments and stock yield, as well as no relationship between the level of gross domestic product (gdp) and the stock yield in amman stock market in jordan. keyword: stock yield, inflation rate, interest rate, number of employees, balance of payment, gross domestic product jel classifications: e44, g10 1. introduction the stock market is the place where securities are exchanged between seller and buyer under the laws and provisions of dealing with securities stocks and bonds. the stock market has a significant impact on economic growth in the hashemite kingdom, and it has a secondary market that deals with shares (matar and tim, 2005; al-shibli and al-shibli, 2000). the objective of an investor is always to get the estimated yield as an estimated venture capital. there are several sectors in the market (banking, industry, services and insurance sectors). due to the potential profit and loss of these companies’ shares, there are external and internal factors that affect the earnings per share. external economic factors that have different effects on stock yield will be mentioned, including the interest rate, which is considered the main incentive of capital descriptions and its transfer between shares, bonds and banks; the rate of inflation that affects the interest rate and also affects securities and is accompanied by an increase or decrease in investment and balance payments and the imbalances that result in disturbances in the state economy and financial position among the outside world (yong and xingkai, 2016; farhan, 2002). in addition to the effect of budget on economic development (jamal, 2004). one of the most important factors affecting the productivity of companies, income of employees, and employment opportunities is gdp, which indirectly affects the stock market (levine et al., 2000; al-zubaidi, 2004). there are two common internal factors to companies listed on the amman stock market on stock yield, these factors are: 1. the number of employees in the company, which varies from one company to another depending on the business’ size, and affects the results of the projects outcome profit or loss. the capital of the company (the circulation amount), it aims to increase wealth. in this research, this journal is licensed under a creative commons attribution 4.0 international license independent variables dependent variable inflation interest rate balance of payments deficit or surplus deficit in the general budget gross domestic product number of employees in the company the company's capital stock yield figure 1: study model al-nimri and altarawneh: understating the impact of economic factors on stock yield: jordanian stock market case international journal of economics and financial issues | vol 10 • issue 6 • 20202 we will explain the effect of each factor on stock yield, which gives stockholders indications to the right time to invest in the appropriate companies. 2. the hypotheses hypothesis 1: there was no statistically significant relation between inflation rate and stock yield at (0.05 ≤α) level. hypothesis 2: there was no statistically significant relation between balance of payment surplus and deficit and the stock yield at (0.05 ≤α) level. hypothesis 3: there was no statistically significant relation between interest rates and stock yield at (0.05 ≤α) level. hypothesis 4: there was no statistically significant relation between the government budget deficit and stock yield at (0.05 ≤α) level. hypothesis 5: there was no statistically significant relation between the size of gdp and the stock yield at (0.05 ≤α) level. hypothesis 6: there was no statistically significant relation between the size of the capital of companies and stock yield at (0.05 ≤α) level. hypothesis 7: there was no statistically significant relation between the number of employees and the stock yield at (0.05 ≤α) level. 3. the model the model of the study is presented in figure 1. 4. literature review a study by (abu al-haijaa, 2004) entitled “allocation of profits policies and their impact on market value per share.” this study aimed at identifying the most important financing policies on which companies depend on providing needed liquidity for expansion and growth. the importance of this study emerges from it studying the retained earnings which is one of the most important financing policies in companies and they should be used optimally. the researcher studied all companies listed on the amman stock market and then chose a company from each sector. the study found a significant statistical relation between the market value per share and the book value of the share. the study also found that companies in jordan follow similar profit distribution policies, it turns out that companies in jordan have tried to maintain a stable yield for the share and within certain limits. a study by (king and levine, 1993) aimed to examine the nature of the relations between the ratio of book value and the market stock yield (be/me) and earnings per share to the market stock yield (e/p) and market share return (mrr). the study sample included 35 jordanian public shareholding companies listed on the amman stock market within the industrial and services sectors during the period between 1990 and 1991. the relationship was examined using simple and multiple linear regression analysis the results were similar to other studies (abdah, 2001; stephen, 2013) which indicated that there was a significant positive correlation between earnings per share and the market stock yield; while the relation between ratio of the book value of the market value of the share, and market stock yield was not statistically significant. the study also indicated that the ability to explain the variance in market stock yield is not very different when using a ratio of realized earnings per share and the book value of the market value of the shares together, than using ratio of earnings per share by itself. sheilla and odhiambo (2015) study aimed to investigate how this sector’s shares were affected by a number of factors. the study included estimating the relation between the returns of oil sector shares as a dependent variable and between some independent variables such as the interest rate, the exchange rate of the us and the canadian dollar, and the market returns and oil prices. using the generalize method the study found that the returns of this sector are positively correlated with the market returns of least square and oil prices. however, these returns are in line with interest rates as well as canadian currency exchange rates against the us dollar (hammad, 2000). al-nimri and altarawneh: understating the impact of economic factors on stock yield: jordanian stock market case international journal of economics and financial issues | vol 10 • issue 6 • 2020 3 5. the data, methodology and estimated results the study population consists of all the companies listed on the amman stock market, numbering 202 companies, which were divided into four categories and table 1 shows that: in order to verify the objectivity of the study results, kolmogorovsmirnov test was used to verify the absence of statistical problems in the study data that may adversely affect the results of testing the study hypothesis. this test requires normal distribution of the data. in contrast, if there were any statistical problems in the study data there will be a false correlation between the independent and dependent variables of the study, and therefore the correlation loses its ability to explain or predict the phenomenon under study, as shown in table 2. table 1: the random sample was adopted in selecting the number of companies per sector sector number of companies the study sample 1. banks 17 5 2. industry 83 25 3. services 77 23 4. insurance 25 7 total 220 60 table 2: normal distribution of the study variables result sig * kolmogorov smirnov variable n follow normal distribution 0.723 0.693 inflation 1 follow normal distribution 0.994 0.421 interest rate 2 follow normal distribution 0.848 0.468 balance of payments deficit or surplus 3 follow normal distribution 0.206 1.066 deficit in the general budget 4 follow normal distribution 0.974 0.482 gross domestic product 5 follow normal distribution 0.139 3.593 number of company employees 6 follow normal distribution 0.139 3.593 the company’s capital 7 follow normal distribution 0.087 2.503 stock yield 8 *the distribution is normal as between if the significance level is >0.05 table 3: the relation between the study variables and the stock yield individual level of significance f regression coefficient b illustration coefficient r2 correlation coefficient r variables ho1 accepted 0.002 6.66 0.194 0.708 0.841 inflation ho2 rejected 0.494 0.543 0.195 0.098 0.313 balance of payments deficit or surplus ho3 accepted 0.015 9.519 0.206 0.543 0.737 interest rates ho4 rejected 0.096 2.857 0.13 0.047 0.217 general budget deficit ho5 accepted 0.044 6.546 0.71 0.493 0.702 size of gross domestic product ho6 accepted 0.001 22.33 0.803 0.736 0.858 number of employees ho7 accepted 0.025 7.522 0.263 0.485 0.696 the size of companies capital looking at the table above and at the level of significance (0.05) and above, it is found that the distribution of all variables was normal. where the normal distribution rate for all responses was greater than (0.05), which is the level adopted in the statistical treatment of this study. table 3 shows the relation between the independent variables of the study and stock yield, in addition to the regression b below the level of 0.05≤α. table 3 shows that inflation had a strong correlation with stock yield. the coefficient of correlation is (0.841) and the value of the r2 (0.708) and the value of (f) were greater than the tabular value. therefore, the null hypothesis was rejected and the alternative hypothesis was accepted, which states that there is a relationship between inflation and stock yield. in the variable deficit or surplus of payment features, the relationship was (0.313). the coefficient of r2 (0.098) is weak and the test value of (f) is less than the tabular value. this results in the acceptance of the null hypothesis, ie, the absence of a relationship between deficit and surplus and the features of payments and stock yield. as for interest rates the results showed the strength of the relationship between the interest rates and the stock yield where the strength of the relation was (0.737) and coefficient of determination was (0.543) while the coefficient of regression was (20.631) and this is evidence of a strong relationship between interest rates and stock yield, and this is logical theoretically. the strength of the relationship between general budget deficit and stock yield were weak and unsettled. the correlation coefficient was (0.217) and the determination coefficient was (0.047). the coefficient of regression was negative, and this indicates that the relation between the two variables is weak. as for the size of the gdp, the results showed that there is a strong positive relationship with the value of correlation coefficient (0.702) and the coefficient of determination (0.436) and the value of the calculated f test was greater than the tabular value. therefore, the alternative hypothesis was accepted, which means there is a relationship between the two independent variables, the size of gross product and the stock yield. while the size of company’s capital was strongly correlated with the stock yield through the strength of the coefficient of correlation (0.696) and the coefficient of determination r2 (0.485) and its calculated result (f) which was greater than the tabular value, causing rejection of the null hypothesis and acceptance of the alternative hypothesis that states the presence of a relation between the size of the company capital al-nimri and altarawneh: understating the impact of economic factors on stock yield: jordanian stock market case international journal of economics and financial issues | vol 10 • issue 6 • 20204 and the stock yield. through the results presented in table 3, it is possible to determine the factors that are related to the stock yield and factors unrelated to the impact through the weakness of the relationship of stock yield. 6. conclusion the study reached the following main results. the results indicated a statistically significant relation between inflation and stock yield at significant level of (α ≤0.05) level. a statistical relationship is found to be logical because the high economic inflation is usually reflected in the purchasing power of the local currency. when purchasing power of the local currency decreases, it leads to higher values of real assets such as real estate and securities, including stocks. the results of the statistical analysis showed that there is no statistically significant relation between the balance of payments deficit or surplus and the stock yield at significant level of (α ≤0.05). although there is no statistical relation, but there is a theoretical relation between the balance of payments and the stock yield. the deficit of the balance of payments on the value of the currency increases the interest paid on loans and must be reflected in stock prices and returns, this contradict the statistical result. the results of the study showed a statistically significant relation between interest rates and stock yield at significant level of (α ≤0.05). this is logical because there is a close relation between the interest rate and inflation, as the raise of interest rate guides investors to deposit more and decrease usage of loans, unless there is a return on investment above the interest rate, thus leading to the interest rate, while if investors turn to deposits this will lead to lowering prices. and the results of the analysis indicate that there is no statistically significant relation between the state budget deficit and the stock yield at significant level of (α ≤0.05). although there is no statistical relation, theoretically, there is a relation from the researcher’s point of view. because deficit in the general budget means increasing the size of the gdp, and accordingly means the increase in goods in a given region, is evidence of the decline in the value of primary commodities, resulting in a lower stock yield. also, the results showed a significant statistical relationship between the number of employees and stock yield at significant level of (α ≤0.05) and there was a positive statistical relation between the numbers of employees leading to an increase in shares. this means that the greater number of workers leads to increased productivity, including increased investment, and therefore the stock increases. but this is not necessarily true for all companies, for there are some companies with a large number of employees and a lower stock yield than some other companies with small staff. the results of the analysis showed a statistically significant relation between the size of the companies’ capital and stock yield at significant level (α ≤0.05). this indicates that there is a positive statistical relation between the stock yield and the size of the companies’ capital. the increase in the size of the capital leads to an increase in stock yield. this gives the company an economic strength compared to other companies, which raises the stock yield, but this result does not necessarily apply to all companies, for many companies with large capital have less stock yield than companies whose capital size is smaller. references abdah, r.s. (2001), the relationship between the book value ratio of the market value of the share, and earnings per share and stock yield, unpublished master thesis. jordan: university of jordan. abu al-haijaa, a. (2004), allocation of profits policies and their impact on market value per share: a field study in the amman financial market, unpublished master thesis. jordan: al-bayt university. al-shibli, m., al-shibli, t. (2000), introduction to financial and monetary markets book. amman, jordan: dar wael publishing and distribution. al-zubaidi, h.m. (2004), advanced financial management book. amman, jordan: dar al-warraq publishing and distribution. farhan, o.f. (2002), the determinants of interest rate in the jordanian economy, unpublished master thesis. jordan: university of jordan. hammad, t. (2000), investor’s guide to the stock exchange book. amman, jordan: university house of books. jamal, a. (2004), fundamentals of state budget book. amman, jordan: dar al-fajr publishing and distribution. king, r.g., levine, r. (1993), finance and growth: schumpeter might be right. the quarterly journal of economics, 108(3), 717-737. levine, r., loayza, n., beck, t. (2000), financial intermediation and growth: causality and causes. journal of monetary economics, 46(1), 31-77. matar, m., tim, f. (2005), investment portfolio management book. amman, jordan: dar wael publishing and distribution. sheilla, n., odhiambo, n.m. (2015), economic growth and market-based financial systems: a review. studies in economics and finance, 32(2), 235-255. stephen, s. (2013), financial inclusion and social financialization: britain in a european context. international journal of sociology and social policy, 33(11), 658-676. yong, m., xingkai, l. (2016), financial development and the effectiveness of monetary policy. journal of banking and finance, 68(1), 1-11. . international journal of economics and financial issues | vol 10 • issue 3 • 2020 79 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(3), 79-82. the role of human resources in comprehensive regional sustainable development: the case of azerbaijan urkhan alakbarov*, ziyafat habibova, rajab rahimli academy of public administration under the president of the republic of azerbaijan, azerbaijan. *email: alakbarovuk@gmail.com received: 27 january 2020 accepted: 07 april 2020 doi: https://doi.org/10.32479/ijefi.9303 abstract the main objective of sustainable and comprehensive economic development is the successful implementation and integration of human resources into national programs and development policies. to attain such all-inclusive and maintainable levels of development, the fundamental elements of economic growth, inclusive societies and the environmental protection should be harmonized with each other. with the understanding that a strong correlation exists between human resources and sustainable economic development, states and governments should adopt policies that effectively address these interconnected elements in order to reach the goal of prosperity of individuals under the slogan “inclusive societies.” in accordance with this framework, the sustainable development goals, which are reflected in the sustainable development 2030 agenda, define the priorities for regional sustainable comprehensive development and relate the strategies necessary for implementation of human capital plans. countries in the caspian sea basin, such as the republic of azerbaijan, are currently in the process of further integrating their human resource capacities into the general development of the country. this paper analyzes further positive economic results along with effective human governance through the use of new principles and contemporary technologies. keywords: human resources, national programs, development policies, azerbaijan, caspian sea jel classifications: o15, p48, q01 1. introduction sustainable inclusive development has become a crucial priority in the twentieth century and it has now become a major priority to ensure the well-being of the present-day generations without jeopardizing the possibility of ongoing growth and development for future generations. these advancing processes and contemporary global challenges have made it vital to discuss the progress of development at both regional and global levels. in this sense, the sustainable development goals (sdgs) ask for jointly organized global efforts to build an inclusive, sustainable and solid future for humans and for the whole planet. in order to achieve such a comprehensive state of sustainable development, it is necessary to balance the following three central factors: (1) economic growth; (2) inclusive societies; and the (3) environmental protection (gupta and vegelin, 2016). with an understanding that there is a strong correlation between human resources and sustainable economic development, governments should adopt policies that promote the above three interrelated elements in the endeavor of reaching the goal of prosperity of individuals in line with the slogan “inclusive societies.” within this context, the sdgs, derived from the sustainable development 2030 agenda, describe the urgencies for addressing regional sustainable comprehensive development while linking the strategies to the execution of human capital plans. the government of the republic of azerbaijan, along with other governments of nations in the caspian sea basin, is presently taking significant steps to promote the further integration of human this journal is licensed under a creative commons attribution 4.0 international license alakbarov, et al.: the role of human resources in comprehensive regional sustainable development: the case of azerbaijan international journal of economics and financial issues | vol 10 • issue 3 • 202080 resources capabilities into the country’s overall development (alakbarov and lawrence, 2015). 2. literature review for the next 11 years, as reflected in the sustainable development 2030 agenda, countries plan to follow the principle guideline “leave no one behind” while mobilizing their efforts to put an end to all forms of poverty by taking direct action against inequality and the threat of rapid climate change. sdgs, also known as the “global goals,” are based on the results of the millennium development goals (mdgs). mdgs that covered the years 2000 – 2015, aimed at carrying out works on the global problems that would typically affect the countries (un general assembly, 2015). on the other hand, sdgs can be categorized into all sectors from national to global levels, and seek to promote progress whilst ensuring the protection of the local and global environment. in accordance with these objectives, the 2030 agenda provides an extensive array of solutions designed to further social developments ranging from the fields of education and employment to the climate change adaptation and protection of ecosystems (gupta and vegelin, 2016). the building and maintaining of an environmentally sustainable and socially inclusive society, depends largely upon the successful development of regional areas (alakbarov and lawrence, 2015). simultaneously, additional positive economic results could be achieved through the use of new principles, contemporary technologies and effective human governance. research activities aiming to study and make comparative analyses of the key indicators of the caspian region have been essential in the design of long-term sustainability strategies and policies. figure 1 shows levels of both inclusive development indexes (idi) and gross domestic product per capita (gdp) of azerbaijan in comparison to its neighboring countries in the caspian region. it can be clearly observed in figure 1 that although the economic potential (gdp per capita) of the republic of azerbaijan is low in comparison to neighboring countries in the region, azerbaijan’s inclusive development index is the highest in the region and equals 4.69 (the world bank, 2019b). to eventuate, it needs to be added the economic opportunities that are certainly valuable, omitting is not a warranty for the sustainable and inclusive growth. a more important aspiration, and arguably the key to the success of sustainable development, is the formation of human potential that is associated with innovation and proper public administration. in figure 2, it can be seen that the high potential of innovation in the republic of azerbaijan promotes its inclusive growth and development. one of the key necessities for sustainable and inclusive growth is energy efficiency, which would contribute to a higher degree of resilience of adaptation to the anticipated effects of climate change as the process intensifies (alakbarov, 2017). in this sense, energy efficiency means that a lower level of greenhouse gas emissions will be emitted from industrial activities into our planet’s atmosphere. indicators have connection with the both circumstances, whichever eminent in terms of the evaluation of inclusive development index. it is interesting to take note of the fact that the gross domestic product (gdp) is growing quickly in the country. it is a moral imperative that this anticipated quantitative economic increase be accompanied by a corresponding increases in qualitative outcomes. it is also noteworthy that the level of energy consumption for each unit of gdp has declined rapidly over the last decade. this represents a direct consequence of increasingly efficient consumption of both renewable and non-renewable resources. this is considered to be one of the most paramount indicators of sustainable development and the green economy movement (campo and sarmiento, 2013). some of the goals that have been suggested by the un and accepted throughout the world, that reflects the level of the sustainable development and diversification of the economy. in order to ensure international comparisons and to promote good practice, the energy equivalent of one kilogram of crude oil is taken as one unit of energy and the value of the product or service produced is estimated in the currency of us dollars with ppp. according to data computed by international organizations, the highest value in the region is held by azerbaijan. using the above information in figure 3, in conjunction with the official records, a product worth of $11.2 was composed or dispatched for each unit of energy consumed in the country in 2019 (the world bank, 2019a). the statistics determined and the figures presented were issued by the world bank in their official report of the caspian region. the dynamics of this indicator regarding the level of sustainable development in the republic of azerbaijan is even more pronounced. in order to more clearly clear illustrate the significance of this achievement, this figure has risen from $2.1 in 2003, $2.7 in 2005, and $7.0 in 2009 (alakbarov, 2017). the numbers from literature review signify that the country is confidently moving forward with sustainable development. between 2003 and 2019, energy usage efficiency levels expanded by 5.6 times (gabibova, 2018). in the upcoming years, the republic of azerbaijan has the opportunity to achieve further progress towards the implementation of energy efficiency principles as well as sustainable inclusive development. source: the world bank, 2019b (*idi for turkmenistan n/a) 4.69 4.26 4.2 4.08 18.01 27.83 27.14 21.01 19.27 0 5 10 15 20 25 30 azerbaijan kazakhstan russian fed. islamic republic of iran turkmenistan idi gdp figure 1: inclusive development index (idi) of the caspian countries and gdp per capita (us dollars with ppp) source: the world bank, 2019d. *n/a data on turkmenistan 72 67 63 44 0 20 40 60 80 azerbaijan kazakhstan russian fed. islamic rep. of iran figure 2: innovation capacity of caspian countries as a factor of sustainable inclusive growth (business dynamics) alakbarov, et al.: the role of human resources in comprehensive regional sustainable development: the case of azerbaijan international journal of economics and financial issues | vol 10 • issue 3 • 2020 81 3. data analysis a decrease in the overall levels of energy consumption could consequently result in lower greenhouse gas emission into the planet’s atmosphere. this would also significantly contribute to the process of reducing the negative effects associated with global climate events. environmental change is one of the most globally discussed topics and represents the main issue for many countries in the proper implementation of the sendai framework or the unfccc programs that contribute towards the goals of sustainable development (huseynov, 2019). the calculation of the inclusive development index takes into consideration the intensity of greenhouse gas emissions per unit of gdp. it is suggested that the major indicator of the effectiveness of reducing the severity of global climate change is the quantity of carbon dioxide emitted by distinctive countries being 1 usd ppp. table 1 below provides an important set of figures regarding the reduction of carbon dioxide emissions by selected countries in the caspian basin (8). based on the numbers in table 1, it can be recognized that the republic of azerbaijan has achieved first-rate outcomes by means of mechanisms that decrease levels of greenhouse gas emissions in the region. nonetheless, the demonstrated comparison shows that the economies of almost all of the countries in the caspian region are similar to each other. the production and export of hydrocarbons play an essential role in all of the economies of these states. sustainable development management is the most valuable tool available for governments to reduce emissions of greenhouse gases into the atmosphere (alakbarov and lawrence, 2017). it is also necessary to articulate the fact that inclusive development implies that a range of different social policies are effectively implemented. the gini index is used as an indicator to present the success of such policies for each country. the gini index describes the fair distribution of income across individuals or households within a given economy. the value of this coefficient can vary from 0 (full equality) to 100 (acute inequality) depending on specific economic circumstances. as shown in the figure 4, the world economic forum in davos, switzerland prepared a report that determined the value of the gini index in the republic of azerbaijan to be at a rate of 26.6 (the world bank, 2019d). this is a fairly high indicator for a country that only restored its independence three decades ago. azerbaijan, is the only country in the caspian basin that has a realistic opportunity to further reduce this figure and cross over into the ranks of the most advanced countries in the world in terms of revenue distribution. programs aimed at developing regions and the non-oil sector are likely to increase incomes through the development and diversification of the economy overall. the presence of economic opportunities is an essential component of promoting sustainable inclusive growth. nevertheless, the optimal management of resources is a key factor in ensuring the inclusive nature of sustainable development. high levels of achievement have historically been accomplished in very brief time periods. such successes were made possible merely by conditions of effective management of economic diversification and technological progress in management and production. as a consequence, this can solely be attained through the implementation of a policy that focuses on strengthening the effectiveness of current knowledge while developing the potential of human resources (gabibova, 2018). the results obtained are crucial in terms of long-term economic security and sustainable human development. they hold valuable significance in this subject because they demonstrate that the state is pursuing a policy that is strategically focused on the distant future. in modern times, the potential of humans has become the most meaningful and most beneficial form of capital amongst the nonrenewable and renewable natural resources. its role is widely considered to be of strategically paramount importance. the human factor has always been and remains a decisive factor in long-term sustainable development (rehimli, 2016). in recent years, the growth of countries, the welfare of the population, and their dependence on knowledge and skills have raised the importance of the human factor to prominence. the success achieved in management and production as well as the reputation and competitiveness of the country depend on the scientific approaches used and the contemporary technologies that are employed. the human is the actor who creates this knowledge and technology as well as being responsible for innovating and implementing them effectively (human development report, table 1: reduction of co2 emission country co2 emission, kg 1$ gdp while producing, 2000 co2 emission, kg 1$ gdp while producing, latest data for 2019 reduction rate, folds azerbaijan 1 0,2 5 russian fed. 1,6 0,5 3,2 islamic rep. iran 1,5 0,5 3 kazakhstan 1 0,6 1,6 turkmenistan 2 0,8 2,5 source: the world bank, 2019c source: the world bank, 2019b. 3.1 5.3 5.6 5.9 11.2 0 2 4 6 8 10 12 turkmenistan russian federation kazakhstan islamic republic of iran azerbaijan figure 3: the value of gdp (usd with ppp) generated by the use of one unit of the energy. source: the world bank, 2019d 26.6 27.5 37.7 40 0 10 20 30 40 50 azerbaijan kazakhstan russian fed. islamic rep. iran figure 4: gini index of the caspian countries alakbarov, et al.: the role of human resources in comprehensive regional sustainable development: the case of azerbaijan international journal of economics and financial issues | vol 10 • issue 3 • 202082 2016). human development will continue to be the most imperative task facing the country. 4. conclusion and suggestions the competitive advantage of the economy and the methods of its modernization are affected by the potential human of human capital, both as an accumulated and employed opportunity within the country, the experiences of educated and qualified human beings have a profound influence on the limits and opportunities for interchange and growth within a society. for the most part, human resources represent the most crucial engine of innovation in all areas of public life and the national economy in addition to playing an increasing significant role in managerial efficiency. the predominant responsibility of the state over the next decade will be to invest into the future, which, as a consequence, includes measures to improve the quality of human resources in azerbaijan. the following state activities are of particular substance: • it should remarkably have cited that to arrange trainings with the use of the revived educational technologies to build human resources that will protect the country’s global leadership within the province inclusive development to identify the newest one, preventive directions and scientific and methodological support in the indicated area. it is a prerequisite that the contents of scientific and methodological resources meet the requirements of the structural transition to project management, state programs and innovative development projects. • it is important to use detailed reliable assessment technology for specific tasks in the creation of a set of tools for measuring and evaluating the necessary competencies in civil service. • the introduction of new methods (project methodology, exchange of experience, training-based approach) along with the continuous education of civil servants. • the improvement of training organization mechanisms that envisage cooperation between state bodies and educational institutions to the study professional specifics and practical tasks of civil servants. • the improvement of information and methodological support for the implementation of measures promoting the continuous development of civil servants through the creation of a unified information resource that includes a continuously updated database of supplementary training programs for public employees as well as a system of methodological, analytical and informational materials related to self-study of public employees. • the formation of mechanisms that facilitate the professional development of civil servants who are in reserve or will be rotated. • increasing the quantity and range of modular structured programs aimed at developing specific competencies and work habits. • the establishment of rapid mechanisms aimed at amplifying the professional competence of civil servants. • expanding the practice of implementing e-learning and the distance learning technologies in the implementation of measures for the professional development of public employees. • the implementation of network training projects with the extensive use of regional platforms; • amending the system of scientific support for the improvement of public administration systems and expert-analytical support for the activities of state bodies. in conclusion, the analysis provided within this paper clearly demonstrates that the government of the republic of azerbaijan has made serious long-term commitments to promoting and facilitating investments into the country’s human capital potential in an endeavor to further advance indicators of high economic development. references alakbarov, u.k. (2017), formation of personnel potential for innovative management of sustainable development processes in the republic of azerbaijan: process and results. journal problems of the control, 4(66), 19-23. alakbarov, u.k., lawrence, j.e.s. (2015), towards ecological civilization: ideas from azerbaijan. journal of human resource and sustainability studies, 3(3), 93-100. alakbarov, u.k., lawrence, j.e.s. (2017), energy efficiency as indicator of sustainable development policy: the azerbaijan experience. journal of sustainable development, 10(3), 187-193. campo, j., sarmiento, v. (2013), the relationship between energy consumption and gdp: evidence from a panel of 10 latin american countries. latin american journal of economics, 50(2), 233-255. gabibova, z.z. (2018), human potential: from the ideology of growth to the ideology of development. moscow: science. p182. gupta, j., vegelin, c. (2016), sustainable development goals and inclusive development. international environmental agreements: politics, law and economics, springer, 16(3), 433-448. human development report. (2016), undp, new york. available from: http://www.hdr.undp.org/sites/default/files/2016_human_ development_report.pdf. [last accessed on 2020 jan 24]. huseynov, y. (2019), resilience of the republic of azerbaijan and implementation of the state program on the social and economic development of regions-2019-2023. economics and environment, 71(4), 163-175. rehimli, r. (2016), azerbaycan kamu personel yönetimi. turkey: anadolu universitesi. p275. the world bank. (2019a), gdp per unit of energy use (ppp $ per kg of oil equivalent). available from: https://www.data.worldbank.org/ indicator/eg.gdp.puse.ko.pp. [last accessed on 2020 jan 24]. the world bank. (2019b), energy use (kg of oil equivalent) per $1,000 gdp (constant 2011 ppp). available from: https://www. data.worldbank.org/indicator/eg.use.comm.gd.pp.kd. [last accessed on 2020 jan 24]. the world bank. (2019c), co2 emissions (kg per ppp $ of gdp). available from: https://www.data.worldbank.org/indicator/en.atm. co2e.pp.gd. [last accessed on 2020 jan 24]. the world bank. (2019d), gini index-russian federation, azerbaijan, kazakhstan, iran, islamic rep. available from: https://www.data. worldbank.org/indicator/si.pov.gini?locations=ru-az-kz-ir. [last accessed on 2020 jan 24]. un general assembly. (2015), transforming our world: the 2030 agenda for sustainable development, a/res/70/1. available from: https://www.refworld.org/docid/57b6e3e44.html. [last accessed on 2020 jan 24]. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(1), 127-131. international journal of economics and financial issues | vol 10 • issue 1 • 2020 127 is amman stock exchange an indicator of jordan’s economic performance? ahmed hussein alrefai* college of business and management, fahad bin sultan university, tabuk, saudi arabia. *email: aalrefai@fbsu.edu.sa received: 07 october 2019 accepted: 12 december 2019 doi: https://doi.org/10.32479/ijefi.9103 abstract there have been great debate in the literature on the impact of stock market on the economic performance, as some believe that higher stock prices increase the wealth of people and stimulate further investment leading to higher consumption and investment, consequently higher gdp. others cast doubts on the robustness of that view. in jordan, an emerging market, the amman stock exchange plays a crucial role in the economy as the share of market capitalization to gdp was more than 200% until 2008 but dropped drastically during the economic turbulences after the arab spring to reach only 57% in 2018. this study aims to test whether the stock prices in jordan are to be used as a leading economic indicator. the correlation between the former and the latter is measured through the statistical method used by granger (1969). we used quarterly data for real gdp for the period 2000q1 till 2018-q1 as a proxy for economic growth and the weighted average of amman stock exchange index as a proxy for stock prices. we found that the optimum time lag to be used was 4 lags and further the null hypothesis of no granger-causality between lagged stock prices and gdp was rejected at 5%. this means that lagged stock prices in jordan can cause economic performance. such findings offer indication on the plausible use of jordan lagged stock prices as causal factors to economic performance. as such, in an effort to revive the economy, jordanian government should incentivize investment and stimulus policies targeting amman’s stock exchange. keywords: amman stock exchange, granger-causality, economic performance jel classifications: o16, g00, n1 1. introduction the stock market has been traditionally viewed as a determinant of the economy, since as the stock prices are increasing, there are two effects: the wealth effect and the valuation effect. the wealth effect means as the stock prices increase, people believe the value of their financial assets go up, hence their wealth increases, which then reflects in more consumption on goods and services. as we know from the economic theory, consumption comprises the major component of the national income, therefore, when wealth increases the national income will improve. moreover, when stock prices boom, investors and businesses become more optimistic about the value and the profitability of their businesses (valuation effect), leading them to expand in their businesses and recruit more people, which in turn improves the real sector, hall (2018). however, there are others who are skeptics and question the validity of that view and believe that the stock prices are not determinant of the real economy. this view was supported by the strong economic growth that followed the 1987 stock market crash. moreover, in a question at quora (2017) as to “why indian people are pumping in huge amount of liquidity into the markets which keeps the market alive and kicking, nobody questioned when the gdp went up. why.” an answer by saravanan (2017) to that question was “i find this to be a short term disruption that is going on with our economy. a good estimate is to compare how they are going to grow in the future quarters.” this dispute of the causality or prediction of stock market to the real sector calls for further research in that topic. jordan, an emerging economy, has witnessed drastic changes in its economy since the ascension of king abdullah ii to the throne in the this journal is licensed under a creative commons attribution 4.0 international license alrefai: is amman stock exchange an indicator of jordan’s economic performance? international journal of economics and financial issues | vol 10 • issue 1 • 2020128 year 2000. the era could be divided into two periods 2000-2010 and 2010-2018. the first one was characterized by high rates of growth of 8% annually, huge influx of foreign investments, particularly from iraqis businesses, and foreign aid to stabilize the country. however, following the arab spring in 2011, jordan suffered from chronic economic crisis represented by high rates of unemployment reaching 18.5% in 2018, moderate economic growth of around 2%, poverty, huge debt of about $40 billion in 2018 and a debt to gdp ratio of about 95%, the world bank (2018). this economic slow down can be attributed to the influx of more than a million of refugees, rising public debt resulting in a removal of subsidies on major food items, regional instability causing massive reduction in tourist activity, decreased foreign investment, increased military spending and the collapse of trade with major trading neighbors syria and iraq. the stock market in jordan is considered a backbone to the economy as can be seen from table 1. it followed the same path as that of the economy since the number of listed companies in the amman stock exchange registered a record high of 277 company 2010. the value traded increased from jd16, 871 million in 2005 to jd20, 318 in 2008 when there was a boom in the stock market, but reduced drastically by more than 110% in 2009 to jd9, 665.3 million due to the market crash and continued deteriorating thereafter to reach only jd2319.3 by 2018. moreover, the market capitalization to gdp ratio went down from 326.6% in 2005 to 56.7 in 2018. therefore, the objective of this research is to investigate whether jordan stock market prices cause changes in the economy. furthermore, we need to test for that causality using the grangercausality test (1969). in other words, will changes in stock prices today in jordan cause changes on the future economy, or conversely would the economic performance today cause changes in the future value of stocks. in order to do that, we use quarterly data for real gross domestic product and weighted average stock prices index for the period of 2000q1-2018q1 with 72 total value of observations. the importance of this study stems from the fact that this is the first paper of its kind to tackle that issue in jordan as businesses fear from government policies and are reluctant to inject money in the market, leading to a further deterioration of the economy. the paper is organized in five sections as follows: section 1 is the introduction. in section 2, we review the literature that tackled the relationship between stock prices and economic growth. section 3 presents the methodology and the model that will be tested using quarterly data. section 4 presents analysis of the granger – causality test and discussion, whereas section 5 concludes the paper. 2. literature review the subject of the impact of the stock market on the real economy has been controversial. many believe that stock prices are a good determinant of the economy through its impact on the wealth and valuation of future values, others question that claim. wild and lebdaoi (2014) studied the relationship between morocco stock market development and economic growth using quarterly data from 2003 to 2014. they tested for cointegration and the dynamics of gdp growth and stock market development using vector error correction model and granger-causality tests. they found that there is a long run relation between stock market development and economic growth. also they found that there is evidence of the demand following hypothesis and there is a threshold level before a positive interaction between real and financial market takes place. chavda et al. (2018) investigated the growth rate in gdp and performance of indian stock market bse-sensex index for the period 2008-2017. their study shows that sensex index is significantly affect gdp growth rate and the correlation between both variables is significant and positive. they concluded that gdp is a predictable variable for indian stock market returns. another similar study was conducted by comincioli (1996) who used quarterly data for the us economy from 1970 to 1999. he found a “causal” relationship between the us stock market and the economy and that stock prices grangercaused economic activity, but not the reverse. further, he found that there is a lag length in the stock market turbulences and the changes in the real economy. the lag length impact is very crucial in such instances and the longest significant lag length was three quarters. however, the skeptics argue that there was a strong economic growth after the 1987 market crash, which contradicts the previous findings by doubting the stock market’s predictive ability. also peek and rosenberg (1988) found out that between 1955 and 1986 out of eleven cases in which the standard and poor’s composite index of 500 stocks (s&p 500) that were declined by more than 7% only six cases followed by recession. table 1: amman stock exchange: major indicators year # of listed companies mkt capitalization (jd million) value traded (jd million) mkt capitalization/gdp (%) 2005 201 # 16871.0 326.6 2006 227 # 14209.9 233.9 2007 245 # 12348.1 289.0 2008 262 # 20318.0 216.7 2009 272 # 9665.3 149.6 2010 277 # 6690.0 122.7 2011 247 # 2850.2 102.7 2012 243 19141.5 1978.8 93.5 2013 240 18233.5 3027.3 83.0 2014 236 18082.6 2263.4 75.8 2015 228 17984.7 3417.1 70.7 2016 224 17339.4 2329.5 65.0 2017 194 16962.6 2926.2 61.8 2018 195 16122.7 2319.3 56.7 source: key statistics of the ase, 2018 alrefai: is amman stock exchange an indicator of jordan’s economic performance? international journal of economics and financial issues | vol 10 • issue 1 • 2020 129 3. methodology in order to test whether the amman stock exchange market (ase) can cause the economic performance in jordan or the economic performance causes changes in stock prices, the quarterly data from the period of 2000-q1 till the year 2018-q1 was used making the total number of observations 72. we use the weighted average of ase price index as a proxy for the stock market performance and the real gdp as a proxy for economic performance. the data was obtained from the yearly official published reports of the central bank of jordan and the amman stock exchange, (cbj different issues and ase). in order to reveal the relationship between stock prices and gdp in jordan and whether stock prices cause gdp or the other way around, we will use the “granger-causality” test. a variable x “granger-causes y” if y can be better predicted using the histories of both variables (x and y) rather than using the historical values of only y. the following pair of models will be used in this study: k k i=1 i=1 dgpt=a0+ ai(gdp)t-i+ bi(sp)t-i+ut∑ ∑ (1) k k i=1 i=1 spt=c0+ ci(sp)t-i+ di(gdp)t-i+vt∑ ∑ (2) where: gdpt: real gross domestic product at time t. spt: weighted average stock price index at time t. bi, di: are ar coefficients. k: number of lags. ut, vt: are white noise. equation (1) above regresses current gross domestic product on the two independent variables: previous values of gdp and the previous values of the stock prices. whereas, equation (2) tests whether lagged values of gdp cause the stock market prices. the hypothesis that will be tested is the following: null hypothesis h0: bi =0. alternative h1: bi ≠0. where i = 1,2,3,…k. if the null hypothesis is accepted that means stock prices can not cause the real economy. on the contrary, if the null hypothesis is rejected then the stock market is a good cause (determinant) of the future economic performance. 4. statistical test for granger causality analysis in order to test whether the amman stock prices granger cause the real economy (equation 1), the first step in testing is to check whether the variables (gdp and sp) are stationary (mean and variance have to be constant) to be able to do forecasting of time series. as can be seen from figure 1, the variance of the two variables is not constant, indicating that they are not stationary and need to be converted into stationary by “first differencing.” after conversion to first difference, figure 2 appears to be stationary. hence, the stationary data/variables can be used to run various time series models such as regression, var and granger causality. we also used the augmented dickey fuller test (adf) (unit root test) for stationary. the results of the adf are shown in table 2. as can be seen from the results in table 2, both variables gdp and sp are stationary once we take the first difference and the t-test results are significant at 5% level. therefore, the model that will be tested is as follows: k k i=1 i=1 gdpt = a0 + ai( gdp)t i + bi( sp)t i + ut∆ ∆ ∆∑ ∑ (3) k k i=1 i=1 spt = c0 c1( sp)t i + di( gdp)t i + vt∆ ∆ ∆∑ ∑ (4) where ∆gdp and ∆sp are the first differences of gdp and sp simultaneously. the second step of conducting the granger causality test is to determine the optimum number of lags to be used in the model, as too many lags lead to loss of degrees of freedom and can cause multicollinearity, serial correlation in the error terms and misspecification errors. there are few ways to determine the optimal number of lags of the model such as akaike information criterion (aic), schwarz . 1000. 2000. 3000. 4000. 5000. 6000. 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 rgdp aseg_ind figure 1: non-stationary variables -1500.0 -1000.0 -500.0 0.0 500.0 1000.0 1500.0 1 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58 61 64 67 70 73 rgdp1 aseg_ind1 figure 2: stationary variables alrefai: is amman stock exchange an indicator of jordan’s economic performance? international journal of economics and financial issues | vol 10 • issue 1 • 2020130 information criterion (sic) and hannan-quinn information criterion (hqic). the lower the value of aic, or hqic or sic the better the model. after estimating the vector autoregressive (var), the results are shown in table 3. as can be seen from table 3, the results show that in all the different criterion of lags (aic, hqic and sic), lag 4 seems to be the optimum lag to be taken in the model as it has the lowest value. this means any changes in the stock prices today will be reflected in the real economy (gdp) four quarters later. in other words, if stock prices today increase, then through the wealth and the valuation effect the economy improves four quarters after. the third step in our test for granger causality is to check if the variables, i.e., ∆gdp and ∆sp are correlated, as if they are correlated then one can check for the causality. however, if it turns out that the variables are not correlated, then there is no use to check for causality. therefore, i run multiple linear regression for different models with different lags (1,2,3 and 4) as can be seen from table 4. the anova test results show that the best f-value is 4.694 (significant at 5%) when four lags are taken. the equation for the best model with four lags is as follows: ∆gdpt=2000+0.139 ∆spt-4. as the objective of this research paper was to check whether gdp granger-causes sp or sp granger-cause gdp, it is time to run the fourth and last step for granger-causality test. after running a regression for the above equations (3) and (4) in which the null hypothesis are h0: bi=0, di=0. versus the alternative h1: bi≠0,di≠0. the value of f-statistics is appointed. if the p-value is more than 5%, we cannot reject the null hypothesis. on the other hand, if the p-value is <5%, we reject the null hypothesis and accept the alternative. this means the stock prices in jordan granger cause the gdp (financial market do affect real economy). after we run the for granger-causality test for the above two equations (3) and (4), the results are shown in table 5. grangercausality waldtests equation excluded χ2 df prob. >χ2 d_aseg_inddrgdp 1.9158 4 0.751 d_aseg_indall 1.9158 4 0.751 drgdpd_aseg_ind 14.818 4 0.005 drgdp all 14.818 4 0.005 one can see that in the second model where we regress stock prices on its lagged values and lagged gdp values, the p-values are not significant at 5% level, indicating that the null hypothesis (di=0) is accepted and gdp does not granger-cause or predict stock prices. however, the first model in which gross domestic product gdp is the dependent variable and the lagged values of sp and gdp are the independent variables, the p-value is <5%, which means we can reject the null hypothesis that bi=0 and accept the alternative. therefore, the stock prices when we take 4 lags granger-cause the real economy. table 2: stationary test: adf test δgdp t score p-value (%) c.v stationary at 5% const only −2.4 17.9 −3.0 false const+trend −2.8 0.3 −1.6 true const+trend+trend^2 −2.9 0.2 −1.6 true δsp const only −4.1 0.5 −3.0 true const+trend −4.2 0.0 −1.6 true const+trend+trend^2 −4.5 0.0 −1.6 true table 3: var test for equation 3 lag ll lr df p aic hqic sic 0 −927.14 27.3279 27.3538 27.3932 1 −921.17 11.948 4 0.018 27.2698 27.3474 27.4657 2 −875.48 91.378 4 0.000 26.0437 26.173 26.3701 3 −826.63 97.697 4 0.000 24.7246 24.9057 25.1816 4 −780.75 91.759* 4 0.000 23.4929* 23.7257* 24.0804* table 4: anovae model sum of squares df mean square f sig. 1 regression 1588417.783 4 397104.446 1.604 0.185a residual 1.535e7 62 247559.546 total 1.694e7 66 2 regression 1527067.999 3 509022.666 2.081 0.112b residual 1.541e7 63 244603.835 total 1.694e7 66 3 regression 1476778.454 2 738389.227 3.057 0.054c residual 1.546e7 64 241567.675 total 1.694e7 66 4 regression 1140720.948 1 1140720.948 4.694 0.034d residual 1.580e7 65 243021.364 total 1.694e7 66 apredictors: (constant), xt4, xt1, xt2, xt3. bpredictors: (constant), xt4, xt1, xt3. cpredictors: (constant), xt4, xt1. dpredictors: (constant), xt4. edependent variable: rgdp alrefai: is amman stock exchange an indicator of jordan’s economic performance? international journal of economics and financial issues | vol 10 • issue 1 • 2020 131 5. conclusion the stock market in jordan is considered a backbone to the economy. it followed the same path as that of the economy since the number of listed companies in the amman stock exchange registered a record high of 277 company 2010. the value traded increased from jd16, 871 million in 2005 to jd20, 318 in 2008 when there was a boom in the stock market, but reduced drastically by more than 110% in 2009 to jd9, 665.3 million due to the market crash and continued deteriorating thereafter to reach only jd2319.3 by 2018. moreover, the market capitalization to gdp ratio reached a record high of 326.6% in 2005 but dropped drastically to 56.7 in 2018 due to the regional turbulences and the influx of thousands of syrian refugees to jordan. the objective of this study was to test the effectiveness of stock market as a leading economic indicator for the jordanian economy and explore the causal relationship between amman stock market and the real sector using quarterly data for the period of 2000-q1-2018q1. we tested for the granger-causality test. we used the values of real gdp as a proxy for the economic performance and the weighted average of amman stock price index as a proxy for the stock market performance. the results show that the optimum lag time to be used in our model was 4 lags. this was supported by aic, sic and hqic. furthermore, we found out that amman stock prices “granger-cause” the economy but not the other way around. the coefficient of lag 4 of stock prices was positive and significant in causing or predicting the economy at 5% significant level. this finding was supported by the effect of wealth and the forward looking nature of the stock market. the policy implication of such result is very important for policy makers in jordan since the stock market plays a crucial role in boosting the economic growth of the country. therefore, by fostering and facilitating the flow of foreign investments into the market, that will be reflected in a positive and significant impact on the economy, given the fact that more than 50% of the investments in the stock market belongs to non-jordanians. references amman stock exchange. (2018), key statistics of the ase. jordan: amman stock exchange. chavda, k.n, kumar s.t.m., shah, j.z., shree, c.j., vidhyadham, p. (2018), analysis of impact of gross domestic products (gdp) on stock market returns in india. international journal of creative research thoughts, 6(3), 678-683. comincioli, b. (1996), the stock market as a leading ındicator: an application of granger causality, the park place economist. illinois wesleyan university, 4(1), 155. granger, c.j. (1969), investigating causal relationships by econometric models and cross spectral methods. econometrica, 37, 425-435. hall, m. (2018), how does the stock market affect gdp, investopedia, website. peek, j., rosengren, e.s. (1988), the stock market and economic activity new england economic review. boston: federal reserve bank of boston. p39-50. saravanan, b. (2017), india’s gdp growth is slowing down, but the stock market is rising, quora, website. the world bank. (2018), jordan’s economic outlook. jordan: the world bank. wild, j., lebdaoui, h. (2014), stock market performance and economic growth in morocco. global advanced research journal of management and business studies, 3(5), 207-216. table 5: granger-causality test variable coef. std. err z p>|z| (95% conf. interval) d_aseg_ind d_aseg_ind l1 0.4426788 0.119881 3.69 0.000 0.2077164 0.6776 l2 −.173476 0.1321405 −1.31 0.189 −0.4324666 0.0855 l3 −.0096142 0.1308895 −0.07 0.941 −0.266153 0.2469 l4 −0.1497256 0.1201565 −1.25 0.213 −0.3852279 0.0857 drgdp l1 −0.6150656 0.8342855 −0.74 0.461 −2.250235 1.020 l2 −0.0861524 0.8301496 −0.10 0.917 −1.713216 1.540 l3 −0.5229836 0.8442969 −0.62 0.536 −2.177775 1.131 l4 −0.2533928 0.849088 −0.30 0.765 −1.917575 1.410 _cons 53.1045 83.29886 0.64 0.524 −110.1583 216.3 drgdp d_aseg_ind l1 0.0236518 0.0090722 2.61 0.009 0.0058707 0.041 l2 −0.0075701 0.0099999 −0.76 0.449 −0.0271697 0.0120 l3 −0.0214051 0.0099053 −2.16 0.031 −0.0408191 −0.0019 l4 0.0192772 0.009093 2.12 0.034 0.0014552 0.0370 drgdp l1 −0.1156866 0.0631359 −1.83 0.067 −0.2394308 0.0080 l2 −0.1590576 0.062823 −2.53 0.011 −0.2821883 −0.0359 l3 −0.1344018 0.0638936 −2.10 0.035 −0.2596309 −0.0091 l4 0.8705071 0.0642561 13.55 0.000 0.7445673 0.9964 _cons 12.25474 6.30378 1.94 0.052 −0.1004373 24.60 international journal of economics and financial issues vol. 1, no. 1, 2011, pp. 12-18 www.econjournals.com the stock market and macroeconomic variables in a brics country and policy implications yu hsing department of management & business administration, college of business, southeastern louisiana university, u.s.a. phone: 985-549-2086, e-mail: yhsing@selu.edu abstract: this paper examines the effects of selected macroeconomic variables on the stock market index in south africa. the exponential garch (nelson, 1991) model is applied. it finds that south africa’s stock market index is positively influenced by the growth rate of real gdp, the ratio of the money supply to gdp and the u.s. stock market index and negatively affected by the ratio of the government deficit to gdp, the domestic real interest rate, the nominal effective exchange rate, the domestic inflation rate, and the u.s. government bond yield. therefore, to maintain a robust stock market, the authorities are expected to pursue economic growth, fiscal prudence, a higher ratio of the money supply to gdp, a lower real interest rate, depreciation of the rand, and/or a lower inflation rate. keywords: stock market, monetary policy, fiscal policy, interest rates, exchange rates, inflation jel classification: e44, g15 1. introduction the global financial crisis had caused south africa to suffer a substantial decline in the value of financial assets including stocks. the johannesburg stock exchange (jse) index decreased 43.5% during may 2008 november 2008, which was better than the 56.8% decline of s&p 500 during its recent worst-performing period. by early may 2011, the jse index has bounced back and almost reached the pre-crisis high. the substantial decline in stock prices is expected to have negative impacts on household consumption spending through the wealth effect, business investment spending through tobin’s q theory and the balance-sheet effect, international capital flows, the demand for money, and other economic variables. the purpose of this paper is to examine the impacts of selected macroeconomic variables on the stock market for south africa with the following focuses. first, the paper presents theoretical analysis to find the possible relationship between the stock market index and the government budget deficit, the money supply or the exchange rate. second, this study incorporates the world stock market index and the world interest rate as the south african stock market is expected to be affected by the world stock market and as international investors compare the attractiveness of financial assets in different countries in order to increase the rate of return on their financial assets. third, the exponential garch (nelson, 1991) model is applied in empirical work in order to estimate the variance equation properly. 2. literature survey there are several recent studies examining the impacts of selected macroeconomic variables on the stock market index for south africa and related countries. jefferis and okeahalam (2000) study the relationship between stock prices and selected economic variables for south africa, zimbabwe and botswana. for south africa, they show that the stock market is positively affected by real gdp and the real exchange rate and negatively influenced by the long-term interest rate. alam and uddin (2009) examine the relationship between stock prices and interest rates for 15 countries. for south africa, they indicate that stock prices are significantly affected by interest rates mailto:yhsing@selu.edu international journal of economics and financial issues, vol. 1, no. 1, 2011, pp.12-18 and that a change in stock prices is significantly influenced by a change in interest rates. in addition, they also show lack of evidence of the random walk model or weak-form efficiency for all the countries. chinzara and aziakpono (2009) find that stock returns and volatility in south africa are linked to major world stock markets with australia, china and the u.s. having the most impacts and that volatility exhibits asymmetry and stability over time, and that there is lack of evidence of the riskpremium hypothesis. alagidede and panagiotidis (2010) investigate the relationship between the stock price and inflation for selected african stock markets. for south africa, they reveal that the elasticity of the stock price with respect to the consumer price is 2.264 and that the stock price shows a transitory negative response to the consumer price in the short run and a positive response in the long run. hence, stocks are a hedge against inflation in the long run. arjoon, botes, chesang and gupta (2010) analyze the relationship between stock prices and inflation for south africa. they find that real stock prices are not affected by a permanent change in the inflation rate in the long run and that any deviation in real stock prices in the short run will be adjusted toward real stock prices in the long run. gupta and modise (2011) estimate the predictive power of selected macroeconomic variables for south africa. they report that for in-sample forecasts, interest rates, the money supply and world oil production growth have some predictive power in the short run, that for out-of-sample forecasts, interest rates and the money supply exhibit short-run predictability, and that the inflation rate shows a strong out-of-sample predictive power. chinzara (2011) studies macroeconomic uncertainty and stock market volatility for south africa. he indicates that stock market volatility is significantly affected by macroeconomic uncertainty, that financial crises raise stock market volatility, and that volatilities in exchange rates and short-term interest rates are the most influential variables in affecting stock market volatility whereas volatilities in oil prices, gold prices and inflation play minor roles in affecting stock market volatility. 3. the model extending previous studies, we can express the south african stock market index as: ????? ),,,,,,,( ** +−+ = rsrmdyfs πε (1) where s = the stock market index in south africa, y = real output, d = the government deficit, m = the money supply, r = domestic real interest rate, ε = the nominal effective exchange rate (an increase means an appreciation of the south african rand.), π = the inflation rate, *s = the world stock market index, and *r = the world interest rate. we expect that in the long run, the south african stock market index has a positive relationship with real output and the world stock market index, a negative relationship with the domestic real interest rate, and an uncertain relationship with the government deficit, the money supply, the nominal effective exchange rate, the inflation rate or the world interest rate. more government deficit or debt would increase aggregate expenditures (ae) in the short run, the price level (p), the nominal interest rate (r), the demand for financial assets including stocks (e) due to the theoretic portfolio approach, and future tax liabilities (t) (brunner, 1961; cagan, 1972; barro, 1974; feldstein, 1982; hoelscher, 1986; darrat, 1990a, 1990b): dtdedrdpdae tsesrspsaesds ++++=∂∂ > or <0 (2) 13 the stock market and macroeconomic variables in a brics country and policy implications where .0,0,0,0,0 >>>>> ddddd terpae because the sign of the first and fourth terms is positive whereas the sign of the remaining terms is negative, the net impact of more government deficit is unclear. more money supply would change the nominal interest rate (r) and increase output, the demand for stocks (e) due to the portfolio adjustment, the price level and the expected inflation rate (bulmash and trivoli, 1991; abdullah and hayworth, 1993; dhakal, kandil and sharma, 1993; mukherjee and naka, 1995; cheung and lai, 1999; wongbangpo and sharma, 2002; chaudhuri and smiles, 2004; ratanapakorn and sharma, 2007; humpe and macmillan, 2009): e mmpmemymr espsesysrsms ππ++++=∂∂ >or <0 (3) where .0,0,0,0,0 >>>><> emmmmm peyorr π the sign in the first term may be negative or positive depending upon whether the liquidity effect would dominate other effects. the sign of the second and third terms is positive whereas the sign of the remaining terms is negative. therefore, the net effect is ambiguous. an appreciation of the south african rand would reduce exports (x), import costs (c) and domestic prices and increase international capital inflows (ci) to south africa (abdullah and hayworth, 1993; mukherjee and naka, 1995; choi, 1995; ajayi and mougoue, 1996; abdalla and murinde, 1997; nieh and lee, 2001; wongbangpo and sharma, 2002; kim, 2003): εεεεε cispscsxss cipcx +++=∂∂ > or <0 (4) where .0,0,0,0 ><<< εεεε cipcx since the sign of the first term is negative whereas the sign of the remaining terms is positive, the net impact is uncertain. a higher inflation rate may increase stock prices as stocks are a hedge against inflation or reduce stock prices due to the negative impact of a higher inflation rate on economic and business activities (fisher, 1930; fama, 1981). a higher world interest rate would cause the south african rand to depreciate and increase its exports but reduce international capital inflows to south africa and the demand for financial assets including stocks. 4. empirical results all the data were collected from the international financial statistics (ifs). s is represented by the share price index for south africa with 2005 as the base year. y is represented by real gdp measured in billion rands at the 2005 price. the percent change in real gdp is employed to reduce multicollineraity. d is measured by the government deficit as a percent of gdp. m is represented by the m3 money supply as a percent of gdp. r is measured by the difference between the lending rate and the inflation rate. ε is represented by the nominal effective exchange rate. an increase means an appreciation of the rand versus a basket of major foreign currencies. π is measured by the inflation rate derived from the consumer price index. *s is represented by the u.s. share price index with 2005 as the base year. *r is represented by the 10-year u.s. government bond yield. both the logarithmic form and the linear form will be considered in empirical work. because the growth rate of real gdp, the ratio of the government deficit to gdp, the domestic real interest rate and the inflation rate have potential negative values, the logarithmic scale is not used. the sample ranges from 1980.q2 to 2010.q3. the quarterly data for the growth rate of real gdp before 1980.q2 are not available. the adf unit root test shows that except for the ratio of the government deficit to gdp, the ratio of m3 to gdp and the u.s. stock market index, all other variables in level do not have unit roots and that all the variables in first difference are stationary at the 1% or 5% level. in order to determine 14 international journal of economics and financial issues, vol. 1, no. 1, 2011, pp.12-18 whether the regression may be spurious, the adf test on the regression residuals is performed. based on the aic, a lag length of 0 is selected. the critical value at the 1% significance level is -2.584, and the test statistic is -2.983. hence, these time series variables are cointegrated and have a long-term stable relationship. the exponential garch or egarch (nelson, 1991) model is applied in empirical work. the egarch (1,1) process is selected based on the significance of the coefficients in the variance equation. table 1 presents estimated parameters and related statistics. figures in the parenthesis are zstatistics. in version (a), the logarithmic form is considered. the value of adjusted r2 is 0.936, suggesting that 93.6% of the variation in the south african stock market index can be explained by the eight right-hand side variables. all the coefficients are significant at the 1% level. the south african stock market index is positively influenced by real gdp growth, the ratio of the m3 money supply to gdp and the u.s. stock market index and negatively associated with the government deficit/gdp ratio, the domestic real interest rate, the nominal effective exchange rate, the inflation rate, and the u.s. government bond yield. table i. estimated regressions of the south african stock market index: 1980.q2-2010.q3 (a) (b) (c) growth of real gdp 0.013* (3.168) 0.438* (4.772) 0.022* (3.431) government deficit/gdp ratio -0.010* (-2.159) -0.191* (-2.803) -0.017* (-2.559) log(m3/gdp ratio) m3/gdp ratio 0.597* (15.889) 1.328* (72.162) 1.927* (35.567) domestic real interest rate -0.017* (-11.475) -0.644* (-19.499) -0.041* (-25.572) log(nominal effective exchange rate) nominal effective exchange rate -0.074* (-2.712) -0.016* (-12.266) -0.156* (-5.978) inflation rate -0.023* (-2.797) -1.706* (-10.186) -0.138* (-20.182) log(u.s. stock market index) u.s. stock market index log(u.k. stock market index) 0.771* (34.881) 0.471* (61.897) 0.925* (35.817) log(u.s. government bond yield) u.s. government bond yield log(u.k. government bond yield) -0.183* (-5.302) -0.317* (-3.922) 0.201* (6.682) constant -0.923* (-3.413) -46.013* (-60.408) -6.924* (-81.713) adjusted r2 0.936 0.724 0.948 f-statistic 161.628 29.840 200.149 aic -1.045 6.630 -0.810 sc -0.769 6.906 -0.534 estimation method egarch egarch egarch notes: the dependent variable is log(s). * means that the coefficient is significant at the 1% level. the south african stock market index appears to be more sensitive to a percent change in the m3/gdp ratio or the u.s. stock market index than other variables. a 1% increase in the m3/gdp ratio 15 the stock market and macroeconomic variables in a brics country and policy implications will increase the south african stock market index by 0.597%. if the u.s. stock market index rises 1%, the south african stock market index will rise by 0.771%. the significant negative coefficient of the government deficit/gdp ratio suggests that negative impacts on higher prices, interest rates and future tax burdens outweigh positive impacts on increased aggregate expenditures and the demand for stocks. the significant negative coefficient of the nominal effective exchange rate indicates that the negative impact on reduced exports dominates the positive impacts on reduced import costs and domestic prices and increased international capital inflows. in version (b), the linear form is considered. the sign and significance of the coefficients remain unchanged. the value of adjusted r2 of 0.724 suggests that the log form in version i has a higher explanatory power than the linear form. in version (c), if the u.k. share price index replaces the u.s. share price index and if the u.k. government bond yield replaces the u.s. government bond yield, the positive coefficient of the u.k. share price index is significant at the 1% level, and the positive coefficient of the u.k. government bond yield is significant at the 1% level. the value of adjusted r2 is 0.948. other results are similar. 5. summary and conclusions this study has examined the relationship between the south african stock market index and selected macroeconomic variables. the egaech model is employed in estimating the variance equation. more real gdp growth, a lower ratio of the government deficit to gdp, a higher ratio of m3 to gdp, a lower domestic real interest rate, depreciation of the rand, a lower inflation rate, a higher u.s. stock price, or a lower u.s. government bond yield would help the south african stock market. in comparison, the findings in this study are consistent with jefferis and okeahalam (2000) in the relationship with real gdp, the interest rate and the exchange rate; alam and uddin (2009) in the relationship with the interest rate; chinzara and aziakpono (2009) in the relationship with the world stock markets; alagidede and panagiotidis (2010) in the negative relationship with the inflation rate in the short run; gupta and modise (2011) in the relationship with the interest rate, the money supply, and the inflation rate; and chinzara (2011) in the relationship with exchange rates and short-term interest rates. however, the results in this paper are different from alagidede and panagiotidis (2010) in the positive relationship with the inflation rate in the long run and arjoon, botes, chesang and gupta (2010) in the relationship with the inflation rate. different outcomes between this paper and some of the previous studies may be attributable to model specifications, variable definitions and measurements, methodologies used in empirical works, sample periods, etc. to help the stock market, the authorities are expected to pursue strong economic growth, fiscal discipline, a higher ratio of the m3 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(2010), effects of macroeconomic factors on share prices. journal of international finance & economics, 10, 113-123. 18 tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(5), 68-73. international journal of economics and financial issues | vol 11 • issue 5 • 202168 effect of volatility in the naira dollar exchange rate on the volume of imports to, and exports from nigeria mela yila dogo1*, osman nuri aras2 1director from the central bank of nigeria, phd dissertation in economics, nile university of nigeria, abuja, nigeria, 2professor of economics and vice chancellor, nile university of nigeria, abuja. *email: dogomy@yahoo.com received: 03 july 2021 accepted: 05 september 2021 doi: https://doi.org/10.32479/ijefi.11799 abstract we analyzed the effect of volatility in the naira-dollar exchange rate on the volume of imports to and exports from nigeria between 1990 and 2019. data for all variables, except volatility, were sourced from the central bank of nigeria (cbn), the national bureau of statistics (nbs), and the international financial statistics. the volatility of the naira exchange rate was calculated from the model. the study employed both the autoregressive distributed lagged (ardl) and exponential generalized autoregressive conditional heteroscedasticity (egarch) models to test for the short and long-run relationships between changes in the naira-dollar exchange rate and the volume of imports and exports. volatility in the naira-dollar exchange rate was found to be related to the volume of imports to and exports from nigeria in the long run with no short-run effects because of the pass-through effect to domestic inflation. the study recommends that government should sustain efforts at promoting exports and reducing imports to improve the trade balance. the study brings into perspective another way of looking at the long-run relationship between the naira-dollar exchange rate and nigeria’s trade balance. keywords: foreign exchange rate, foreign exchange market, imports, exports, the balance of trade, nigeria jel classifications: f14, f31, 024 1. introduction severe fluctuations in the foreign exchange market of countries have caused disruptive tendencies on activities in the real economy (obstfeld and rogoff, 1998), especially on the balance sheet of banks with foreign currency exposures. such disruptive tendencies have led to volatility in the exchange rate with corresponding repercussions on the balance of trade. in addition, the increasing globalization in banking and financial services is creating challenges of highfrequency volatility in the exchange rate, for which countries have responded variedly, depending on the peculiarities of their economies. the response of most of these countries including nigeria is to adopt policies that would both reduce the exchange rate volatility1 as well as achieve some form of internal and external balance in the 1 for a good discussion of the determinants of exchange rate volatility in nigeria, see ajao & igbekoyi (2013). macroeconomy. since a country’s international competitiveness is linked to its imports and exports, reducing the high-frequency volatility in the currency exchange rate help in minimizing the adverse balance of trade position, improving the efficacy of monetary policy outcomes, and promoting the efficient delivery of government policies and programs. following the introduction, section two contains the review of relevant literature, while section three describes the sources of data and the method of analysis. section four presents the empirical analysis and results and the discussion of policy implication, while section five concludes with key findings and recommendations. 2. theoretical framework studies on exchange rate volatility and international trade have attracted divergence attentions particularly in developing nations this journal is licensed under a creative commons attribution 4.0 international license dogo and aras: effect of volatility in the naira dollar exchange rate on the volume of imports to, and exports from nigeria international journal of economics and financial issues | vol 11 • issue 5 • 2021 69 because of the role of the local currency on the domestic economy and its implications on the external sector, especially like in the nigerian economy, where, where developments in oil exports seem to impact directly on government operations. here, frequent changes in the exchange rate are an issue of concern to the government, policymakers, producers, and consumers. the wide spectrum of interest in the subject has sustained a continued rise in studies, to better understand the phenomenon. we review, a few of the studies that tried to establish a relationship between exchange rate volatility and the volume of exports and imports and their conclusions. it is important to note that, while a number of these studies established empirical evidence on the existence of a strong relationship, others did not, with most of them citing differences in economic peculiarities of countries, as explanations for the divergence in results. asteriou et al. (2016) analyzed the effects of exchange rate volatility on international trade in mexico, indonesia, nigeria, and turkey and the methods of generalized autoregressive conditional heteroscedasticity (garch) and autoregressive distribution lag (ardl) models. they found no long-run relationship between exchange rate volatility and volume of international trade in those countries, except in turkey, where the amplitude of the volatility was quite minimal. they, however, noted that in the short run, there was a significant causality running from the exchange rate volatility to the volume of exports and imports demand in indonesia and mexico; that a unidirectional causality existed from exports demand from nigeria to the volatility of the naira-dollar exchange rate. safuan (2017), investigated the impact of exchange rate volatility on exports to the united states, japan, and china from 1996 to 2016 using unrelated regression and concluded that the volatility of the exchange rate had negative effects on the volume of exports. when they disaggregated the data, it revealed that the volatility of the exchange rate on exports was negative and varied among industries in the countries of study. also, alper (2017) examined the impact of exchange rate volatility on turkey’s trade with fifteen european countries from 1971q1 to 2015q4 using the garch model and the result revealed that the volatility of exchange rate reduced export flows in the short run but had mixed results on imports in the long run. he then concluded that exchange rate volatility did not affect the volume of trade between turkey and the european countries. bahmani-oskooee and gelan (2018), examined the long-run and short-run impacts of exchange rate risk on trade flow in twelve african countries from 1971q1 to 2015q4, using the ardl model. the results revealed the presence of a long-run relationship between exchange rate volatility and trade flows in all the selected countries. latief and lefen (2018) investigated the relationships between the volatility of exchange rate and international trade and foreign direct investment from 1995 to 2016 for seven developing countries of bangladesh, bhutan, india, maldives, nepal, pakistan, and sri lanka using the garch model. their findings revealed that volatility of exchange rate for bhutan, maldives, and nepal had positive effects on international trade flows, but negative effects for pakistan and sri lanka. however, with the tgarch model, the study found a significant positive impact of exchange rate volatility on international trade flows for bhutan, maldives, and nepal. that foreign direct investment and exchange rate volatility also had a significant positive relationship in india and pakistan but a negative relationship in bhutan and nepal. muhia and gachunga (2019) examined the effect of exchange rate volatility on exports and imports in kenya from 1980-2015 using a log-linear multiple regression model and found a significantly strong relationship between them. similarly, in a study on vietnam, thuy and thuy (2019) found that exchange rate volatility impacted negatively on the volume of exports in the long run, while a currency depreciation impacted exports negatively in the short run but positively in the long run, suggesting the presence of the j-curve effect in vietnam. in addition, that an increase in the real income of foreign currencies decreases vietnamese export volume. bostan and firtescu (2019) used ordinary least square (ols) to analyzed data on romania. the results revealed that exchange rate volatility was an important determinant of competitiveness but that the influence of uncertainty arising from volatility in the exchange rate seems to be weak on imports but strong on exports. ikechi and anthony (2020) examined the impact of exchange rate volatility on international trade in nigeria from 1996 to 2018 using the vector autoregression (var) model and established a negative relationship between exports, imports, and volatility in the real effective exchange rate (reer). the variance decomposition also revealed that the shocks partially explained fluctuations in exports, imports, and real effective exchange rates. in terms of causality, it revealed that imports granger-caused exports, but exports did not granger-cause imports. the garch results also confirm the presence of volatility in the real effective exchange rate (reer) on exports and imports in nigeria. in a related study on oil price shocks and exchange rate volatility in nigeria, tule and osude (2014) used monthly data for the period 2000 to 2013 and the garch and egarch methods to establish the existence of a strong relationship between volatilities in oil prices and the real exchange rate in nigeria yakubu et al. (2019) used both agarch and ardl models to test for the existence of a long-run relationship between exchange rate volatility and trade flows between 1997 and 2016. their results revealed that volatility in the exchange rate adversely affected trade flows in the short-run but not in the long-run. a result was worthy of further investigation. also, umaru et al. (2013) studied the effect of exchange rate volatility and exports from nigeria. using ordinary least squares (ols); the arch and garch models and concluded that a strong relationship existed between them. the studies revealed mixed results. that, while most found evidence of a long-run relationship between exchange rate volatility and trade balance, few like ozturk (2006) had mixed results extending explanations of peculiarities in the economies of countries. this paper offers an alternative approach to analyzing the effect of exchange rate volatility on the balance of trade in nigeria. 3. method of the study 3.1. data sources and variables in the model available data for most of the variables were sourced from the cbn statistical bulletin (2019) and nbs (2021) for the period 1990 to 2019. the data on the real effective exchange rate in dogo and aras: effect of volatility in the naira dollar exchange rate on the volume of imports to, and exports from nigeria international journal of economics and financial issues | vol 11 • issue 5 • 202170 nigeria was from the international financial statistics (2017; 2021), publications of the imf. the period covered was, largely based on data availability. the main variables used for the analysis includes total exports (expt) (free on board), total imports (impt) (free onboard), the naira -us dollar rate (exrv), the rate of inflation (infla), the balance of trade (bot) and the gross domestic product (gdp) 3.2. choice of model and estimation procedure the study used both statistical and econometric techniques to analyze the data. the summary statistics of the data were used to look at the nature of the data in terms of the description of one variable with other variables in the model. then we carried the adf unit root test to establish their stationarity or otherwise. we then estimated the general format of the model specified in equation (1) below using ols before applying the ardl technique. the study then employed the exponential generalized autoregressive conditional heteroscedastic (egarch) (1,1) model to generate the volatility series through the variance equation and the ardl bounds tests to establish long-run relationships. the egarch model was better than basic garch since the log (conditional variance) is modeled, then even if the parameters are negative, the log of conditional variance will be positive2. the eviews 11 software was used for the analysis. 3.3 model specification this study employs the exponential (egarch) method to model volatility in the exchange rate due to the shortcomings of garch. the model was originally developed by nelson (1991) to capture any asymmetric effect of the shock and to ensure that the variances were positive. kamal et al. (2012) emphasized that the effects of a shock on the volatility are asymmetric. that is, it could be good news or positive past residuals or bad news which could be a negative lagged residual, though bad news tends to exert more influence on volatility than good news. the natural logarithm of the conditional variance was used in the egarch. the garch (p, q) model is given as ( ) 21 11 1 1 2 0 1 2 ( ) t t t t t tlog log        − −− − −   + +    = + ψ ψ ϒ (1) where δt 2 is the conditional variance of exchange rate series for the study period, 1 1 t t   − −       is the arch term showing the magnitude of past shocks to volatility in the exchange rate and the degree of volatility clustering, 2 1t−δ is the garch term, 1 1 t t   − −       is the arch component showing leverage effect, α0 is the constant, and ѱ1 is the coefficient of asymmetry, ѱ2 is the coefficient of persistence, while ϒ is the leverage coefficient showing the leverage effect. where negative returns (shocks) are 2 this means that, there will be no need for us to artificially impose non-negative restrictions on the parameter coefficients of the model. expected to produce higher volatility than positive returns of the same magnitude which further confirms the role of asymmetry and μt is the error term that is uncorrelated with its past values. as earlier pointed out, the advantage of the egarch model is that since the log (conditional variance) is modeled, then even if with negative parameters, the log of conditional variance will be positive. this means no need for non-negative restrictions on parameter coefficients of the model. furthermore, to establish short and long-run relationships between exchange rate volatility and exports and imports, we follow after bahmani-oskooee and sami (2019), who had separate specifications for imports and exports. the dynamic autoregressive distributed lag (ardl) model of pesaran et al. (2001) are as shown in equations 2 and 3 below. 0 1 1 2 1 3 1 4 1 5 1 0 0 6 1 1 0 t t t t q q t t i i q t t t i expt expt exrv inf expt exrv inf ecm          − − − − − = = − − = δ = + + + + δ + δ + δ + + ∑ ∑ ∑ (2) 0 1 1 2 1 3 1 4 1 5 1 0 0 6 1 1 0 t t t t q q t t i i q t t t i impt impt exrv inf impt exrv inf ecm          − − − − − = = − − = δ = + + + + δ + δ + δ + + ∑ ∑ ∑ (3) were. expt = exports, impt = imports, exrv = exchange rate volatility, and inf = inflation rate β0 and α0 are the constant or intercept terms β1−β6 and α1−α6 are the parameter estimates. δ = difference operator, q = lag length and ɛt = serially uncorrelated error term. λ = speed of adjustment parameter and ecm = the error correction term. the coefficient of the lagged error correction term (λ) is expected to be negative and statistically significant to show that short-run disequilibrium will be corrected in the long run. 4. model results and discussions the study begins the analysis of the results with a discussion of the summary statistics followed by correlation analysis of the relationship among the variables, especially the correlation between the balance of trade (bot) and real effective exchange rate (reer) in nigeria. the summary statistics results in table 1 show that the mean score of bot is positive and the largest followed by expt, reer, and inf while that of impt is also large but negative. the standard deviation (also a proxy for volatility) for all the variables except dogo and aras: effect of volatility in the naira dollar exchange rate on the volume of imports to, and exports from nigeria international journal of economics and financial issues | vol 11 • issue 5 • 2021 71 inf, tends to be large, suggesting high volatility levels. the correlation matrix as reported in the lower part of table 1 indicates that, apart from the positive correlations between expt and bot and between impt and inf, all the other correlations had negative correlations. the positive correlations suggest that the higher the export, the higher is the balance of trade, and the higher the imports, the higher the level of inflation. more so, of particular importance is the balance of trade and the real effective exchange rate that are negatively related, suggesting that as the real effective exchange rate reduces, the balance of trade improves. the study generated an exchange rate volatility series using the garch approach and replaces the real effective exchange rate, to ascertain the actual impact of the exchange rate volatility on both exports and imports. precursory to the application of the cointegration and the ardl long-run and short-run analysis, we check for the unit root properties of the variables using the augmented dickey-fuller test and establish that all the variables (expt, impt, inf) except exrv are stationary at i(1) (table 2). the exrv is however stationary at a level i(0). the mixed order of integration of the results further buttresses the application of the ardl model in this study. the results of the bounds cointegration test in table 3 indicate the absence of cointegration or long-run relationship between exchange rate volatility and exports as shown in model 1 and between exchange rate volatility and imports as shown in model 2. these decisions are based on the fact that the value of the fstatistic of the models is less than the upper critical bounds. cointegration exists in a model when the value of the f-statistic is greater than the upper critical bounds of the ardl. hence, we conclude that there is no long-run relationship among the variables. to this effect, the study takes the difference of the series and estimates the short-run relationship and the results are presented in tables 4 and 5 respectively. tables 4 and 5 present short-run results of the relationship between exchange rate volatility on exports and imports respectively, given that no long-run relationship was found to exist among the variables for both models. the results indicate that exchange rate volatility has a positive but statistically insignificant effect on both exports and imports in the short run. the insignificance of the positive effect entails that, exchange rate volatility is not a strong determinant of both exports and imports in the short run. both exporters and importers are not guided by exchange rate volatility in making short-run decisions. this may be due to the pass-through price effect of increases in domestic prices arising from exchange rate volatility, that the producers pass onto the consumers. also evident from the results is that inflation has a negative but also statistically insignificant effect on both exports and imports. this also explains the fact that inflation is not a strong determinant of exports and imports in the table 1: (a) summary statistics and correlation analysis expt impt bot reer mean 6478.374 −4232.701 10711.08 107.7390 median 5924.655 −2407.900 8371.630 99.77986 maximum 18707.60 −39.77100 31160.60 272.9200 minimum 109.8860 −12453.00 149.6570 49.73297 std. dev. 5894.174 4171.878 9933.457 50.97531 skewness 0.446312 −0.572478 0.464526 1.851841 kurtosis 1.816639 1.711772 1.747381 6.108070 jarque-bera 2.746400 3.713071 3.040238 29.22171 probability 0.253295 0.156213 0.218686 0.000000 sum 194351.2 −126981.0 321332.3 3232.169 sum sq. dev. 1.01e+09 5.05e+08 2.86e+09 75355.99 observations 30 30 30 30 table 2: results of adf unit root test variable adf and level adf and 1st diff order of integration expt −1.73100 (0.1090) −5.6244(0.000) i(1) impt −0.30442 (0.9126) −5.7321(0.000) i(1) exrv −5.10690 (0.000) i(0) inf −2.02758 (0.2740) −4.35859 (0.0019) i(1) the values in the parentheses are the probability values (b): correlation matrix analysis correlation probability expt impt bot reer inf expt 1.000000 ---- impt −0.946079 1.000000 (0.0000) ---- bot 0.990702 −0.981353 1.000000 (0.0000) (0.0000) ---- reer −0.033254 −0.013019 −0.014264 1.000000 (0.8615) (0.9456) (0.9404) ---- inf −0.409663 0.374235 −0.400252 −0.019841 1.000000 (0.0246) (0.0416) (0.0284) (0.9171) ---- the values in the parentheses are the probability values. dogo and aras: effect of volatility in the naira dollar exchange rate on the volume of imports to, and exports from nigeria international journal of economics and financial issues | vol 11 • issue 5 • 202172 short run in nigeria. the coefficient of determination measured by r-squared in both results, although low, indicated that exchange rate volatility and inflation rate are weakly correlated with the volume of exports and imports in nigeria and therefore may not fully explain the effect of short-run volatility in the naira-us dollar exchange rate on variations in the volume of exports and imports in nigeria. this implies that, apart from exchange rate volatility, the volume of imports and exports in nigeria is also influenced by other factors, outside the exchange rate. 5. conclusion and recommendations the study investigated the effect of exchange rate volatility on exports and imports in nigeria during the period 1990 to 2020. summary statistics and correlation analysis of the data were carried out to determine the relational properties of the time series data. the analysis revealed a negative relationship between exchange rate volatility and the balance of trade in nigeria. also, the results of the ardl bounds test indicated the absence of cointegration for both the exports and imports models. that, there is no long-run relationship between exchange rate volatility and exports from, and between exchange rate volatility and imports to nigeria. to this effect, the study focused on the short-run analysis and found that exchange rate volatility is also not a strong determinant of both exports and imports given the insignificant nature of its parameter coefficient in both relationships. the study, therefore, concluded that, although there is no short-run relationship between the naira-us dollar exchange rate and the balance of trade in nigeria due to the pass-through effect of exchange rate volatility on domestic prices, there appeared to be indeed a long-run relationship between volatility in the exchange rate and the volume of imports and exports in nigeria during the period 1990 to 2020. this implies that government should sustain current efforts at increasing the volume of exports from nigeria and reducing the volume of imports to the country, to positively impact the balance of trade. that although exchange rate volatility did not appear to impact the trade balance directly, there was a pass-through effect on domestic prices. so government should support the currency exchange rate with complimentary monetary and fiscal policy measures, to minimize its volatility and improve the balance of trade. references alper, a.e. (2017), exchange rate volatility and trade flows. fiscaoeconomia, 1(3), 14-39. asteriou, d., masatci, k., pılbeam, k. (2016), exchange rate volatility and international trade: international evidence from the mint countries. economic modelling, 58, 133-140. bahmani-oskooee, m., gelan, a. (2018), exchange-rate volatility and international trade performance: evidence from 12 african countries. economic analysis and policy, 58, 14-21. bahmani-oskooee, n.r., sami, s. (2019), exchange-rate volatility and commodity trade between the u.s, and germany: asymmetry analysis. international economics and economic policy, https://doi. org/10.1007/s10368-019-00455-0. bostan, i., toderașcu, c., firtescu, b.n. (2018), exchange rate effects on international commercial trade competitiveness. journal of risk and financial management, 11(2), 19-29. central bank of nigeria cbn. (2006), foreign exchange manual. abuja, nigeria: central bank of nigeria. central bank of nigeria cbn. (2019), annual statistical bulletin. abuja, nigeria: central bank of nigeria. ikechi, k.s., anthony, n. (2020), exchange rate volatility and international trade in nigeria. international journal of management science and table 3: ardl bounds test f-statistic lower and upper critical values decision 1% 5% 10% i(0) i(1) i(0) i(1) i(0) i(1) model 1 expt f(exrv, inf) 0.79238 4.95 6.03 3.48 4.34 2.85 3.62 no cointegration model 2 impt f(exrv, inf) 0.71035 4.95 6.03 3.48 4.34 2.85 3.62 no cointegration i(0) and i(1) represent lower bounds and upper bounds respectively table 4: short-run estimates of the effect of exchange rate volatility on exports dependent variable: expt variable coefficient std. error t-statistic prob. exrv 0.002288 0.024813 0.092216 0.9272 inf −1.450873 36.56067 −0.039684 0.9686 c 423.3133 454.3825 0.931623 0.3601 r-squared 0.000410 mean dependent var 433.9384 adjusted r-squared −0.076482 s.d. dependent var 2277.649 s.e. of regression 2363.144 akaike info criterion 18.47107 sum squared resid 1.45e+08 schwarz criterion 18.61251 log likelihood −264.8305 hannan-quin criter. 18.51537 f-statistic 0.005330 durbin-watson stat 1.625570 prob(f-statistic) 0.994685 table 5: short-run estimates of the effect of exchange rate volatility on imports dependent variable: impt variable coefficient std. error t-statistic prob. exrv 0.003708 0.012015 0.308619 0.7601 inf −0.610146 17.70353 −0.034465 0.9728 c −369.8823 220.0226 −1.681110 0.1047 r-squared 0.003773 mean dependent var −352.4217 adjusted r-squared −0.072860 s.d. dependent var 1104.751 s.e. of regression 1144.289 akaike info criterion 17.02065 sum squared resid 34044337 schwarz criterion 17.16210 log-likelihood −243.7995 hannan-quinn criter. 17.06495 f-statistic 0.049238 durbin-watson stat 2.112373 prob(f-statistic) 0.952043 dogo and aras: effect of volatility in the naira dollar exchange rate on the volume of imports to, and exports from nigeria international journal of economics and financial issues | vol 11 • issue 5 • 2021 73 business administration, 6(5), 56-72. kamal, y., ui-hag, h., ghani, u., khan, m.m. (2012), modeling the exchange rate volatility, using generalized autoregressive conditionally heteroscedastic (garch) type models: evidence from pakistan. african journal of business management, 6(8), 2830-2838. latief, r., lefen, l. (2018), the effect of exchange rate volatility on international trade and foreign direct investment (fdi) in developing countries along “one belt and one road”. international journal of financial studies, 6(4), 86-97. muhia, j., gachunga, m.j. (2019), effect of exchange rates volatility on exports and imports in kenya. mediterranean journal of basic and applied sciences, 2(4), 102-108. national bureau of statistics nbs. (2021), reports. available from: https://nigerianstat.gov.ng/elibrary nelson, d.b. (1991), conditional heteroskedasticity in asset returns: a new approach. econometrica: journal of the econometric society, 59, 347-370. obstfeld, m., rogoff, k. (1998), risk and exchange rates. working paper, no. 6694, national bureau of economic research. ozturk, i. (2006), exchange rate volatility and trade: a literature survey. international journal of applied econometrics and quantitative studies, 3, 85-102. pesaran, m.h., shin, y., smith, r.j. (2001), bounds testing approaches to the analysis of level relationships. journal of applied econometrics, 16(3), 289-326. safuan, s. (2017), exchange rate volatility and export volume: the case of indonesia and its main trading partners. european research studies journal, 10(3a), 3-13. thuy, v.n.t., thuy, d.t.t. (2019), the impact of exchange rate volatility on exports in vietnam: a bounds testing approach. journal of risk and financial management, 12(1), 1-14. tule, m.k., osude, d. (2014), oil price shocks and real exchange rate movement in nigeria. economic and financial review, 52(1), 29-45. umaru, a., sa'idu, b.m., musa, s. (2013), an empirical analysis of exchange rate volatility on export trade in a developing economy. journal of emerging trends in economics and management sciences, 4(1), 42-53. yakubu, m.u., obiezue, t.o., aliyu, v.o. (2019), the volatility of exchange rate on trade flows in nigeria, economic and financial review, central bank of nigeria. economic and financial review, 57, 23-46. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1851-1857. international journal of economics and financial issues | vol 6 • issue 4 • 2016 1851 methods of standard rates of financial expenses calculation on landscaped areas maintenance (on the example of st. petersburg, russia) maria evgenievna skachkova1, olga jurjevna lepikhina2* 1saint-petersburg mining university, 2, 21st street v.o., saint petersburg, 199106, russia, 2saint-petersburg mining university, 2, 21st street v.o., saint petersburg, 199106, russia. *email: oljunchik@mail.ru abstract relevance of research is caused by need of optimization of the expenditure of budgetary funds of st. petersburg in the field of gardening. the article is devoted to development of system of indicators for identification of volumes of works per unit of measurement, necessary to form costs for works on maintenance of objects and the territories of green plantings of st. petersburg. main methods to research of the matter were natural and analytical methods which have allowed revealing the main problems of management of the territories and objects of green plantings of the megalopolis. also the method of the statistical analysis was applied to sample some 123 objects of green plantings of st. petersburg. the system of indicators to calculate objectively and reasonably standard rates of finance costs on maintenance of objects and the territories of green plantings of st. petersburg has been identified. to control results the method of the comparative analysis was used. problems of management of the territories and objects of green plantings of megalopolises are revealed; the unique system of indicators for the purposes of forming of standard rates of finance costs for works on maintenance of objects and the territories of green plantings of megalopolises is provided; recommendations about enhancement of system of certification of green plantings are proved. the developed system of indicators has been used by committee for economic policy and strategic planning of st. petersburg. keywords: green plantings, maintenance, finance costs, accounting, certification jel classifications: m41, q10 1. introduction st. petersburg one of the largest cities of russia. its sustainable development is a significant task of the national security of the russian federation (“on strategy of the national security of the russian federation,” 2015). the scenario of a sustainable development is the avowed strategic element of city planning. the triune concept which is the basis for sustainable development includes three aspects: social, economic and ecological (skachkova, 2014). all specified components are interconnected and require equivalent attention. however the ecological aspect is often immolating for economic or social benefits. green plantings of the large cities being the aggregate of wood, shrubby, grassy plants and flower-gardens (“on green plantings in st. petersburg,” 2010) are major factor of ecological wellbeing of the urbanized territories and quality of urban population life (loures and costa, 2010; deneva et al., 2008; husqvarna group, 2012). the most significant functions are carried out by them such as sanitary and hygienic, decorative and planning, esthetic, environmental and others (ilchenko, 2014). thereafter, carrying out competent policy in the field of maintenance and repair of green plantings is one of paramount tasks of municipal level. in that field many domestic and foreign scientists researched (moshchenikova, 2011; loures and costa, 2010; morita, 2012; skachkova, 2007, kovyazin, 2008, podgornaya, 2008, mensah, 2014). however the main problem-insufficient and inefficient financing of area of green plantings-is still not solved (etim et al., 2012). skachkova and lepikhina: methods of standard rates of financial expenses calculation on landscaped areas maintenance (on the example of st. petersburg, russia) international journal of economics and financial issues | vol 6 • issue 4 • 20161852 2. methods the problem of rational and effective management of areas and objects of green plantings of megalopolises remains actual. however, there is still a quantity of unresolved questions concerning st. petersburg, in particular: 1. uneven arrangement of the territories of green plantings within the borders of st. petersburg, owing to which the indicator of green plantings security, for example, for general use, may vary from 3.5 to 82.0 m2/capita depending on the administrative area. information about green plantings for general use (gugp) security is provided in table 1 (“on gugp,” 2007). changes in the problem of gugp are connected with annual modification of the law of st. petersburg (“on gugp,” 2007) in connection with refining of the areas or new objects of gugp identification. it is obvious that security of gugp satisfies to standard rates not everywhere. in the central districts of st. petersburg the gardening problem is particularly acute. the problem connected with planted trees and shrubs territory security applies not only for st. petersburg. it is also possible to add other numerous regions of the russian federation (dubinin, 2007). 2. low variety of wood and shrubby vegetation and unsatisfactory condition of green plantings due to inadequate organization, 1 increase in the area in comparison with 2014 has happened due to the yuntolovsky forest park inclusion in the list of gugp, and also increase in total area of parks and squares. technologies and qualities of their creation, maintenance and repair. according to moshchenikova (2011) the results of gugp inventory of st. petersburg in 2006 detected that only 18% of trees were not weak, the maximum percent was constituted weakened (46%) and strongly weakened (23%), 3% dead wood. further researches have shown a bigger decrease in stability of green plantings. 3. inefficient financing of green plantings management in st. petersburg. in the open memorandum of the center of examinations of the st. petersburg society of scientists (“principles of legislative regulation of protection of green plantings in st. petersburg,” n.d.) it was noted that one of the main threats is incompliance of financing with the norms, the underestimated standard rates of green construction and maintenance of green plantings financing that was a consequence of underestimation of their economic and social value. 4. unstable legal status of the planted lands which leads to numerous allotments of block green belts for construction and to destruction of local green plantings as a result of densification. according to data of the public cadastral map only 23% of such land parcels are registered in the state immovable cadastre and have accurate legal status. the provided list of problems is not complete and relates to inefficient green plantings management in st. petersburg. there are various facilities for management of real estate objects: inventory, accounting, monitoring, information resources, etc. in particular, financial mechanisms are also referred to them. if we table 1: indicators of the area and security of gugp on the administrative districts of st. petersburg administrative districts of st. petersburg population (“population of the russian federation on municipalities for january 1, 2015”, 2015) area, hectares area of gugp, hectares security of gugp, m2 per person in 2015 share of planted trees and shrubs territory, % 2014 2015 central (historical center) districts (gugp security for central districts must be over 12.8 m2 per person (“on the urban development plan of st. petersburg,” 2005) admiralteysky district 170,361 1382 94.56 94.56 5.6 6.8 vasileostrovsky district 211,132 2147 76.52 75.16 3.6 3.5 petrogradsky district 139,107 2400 225.47 225.47 16.2 9.4 tsentralny district 226,674 1712 79.09 3.5 4.6 in total (central districts) 747,274 7641 474.28 off-center districts (gugp security for off-center districts must be over 16 m2 per person (“on the urban development plan of st. petersburg,” 2005) vyborgsky district 482,450 11,550 609.87 611.59 12.7 5.3 kalininsky district 526,876 4012 439.26 8.2 10.7 kirovsky district 338,593 4700 239.78 239.78 7.1 5.1 kolpinsky district 186,973 10,560 227.08 227.08 12.1 2.2 krasnogvardeysky district 347,545 5680 162.24 178.03 5.1 3.1 krasnoselsky district 357,091 11,400 524.38 524.38 14.7 4.6 kronshtadsky district 44,074 1935 47.13 48.77 11.1 2.5 kurortny district 73,846 26,792 239.74 239.74 32.5 0.9 moskovsky district 332,596 7107 280.10 286.27 8.6 4.0 nevsky district 497,509 6177 251.26 5.1 4.1 petrodvortsovy district 133,668 10,900 1095.75 1095.75 82.0 10.1 primorsky district 544,032 10,987 277.28 530.601 9.8 4.8 pushkinsky district 171,593 24,033 590.85 590.40 34.4 2.5 frunzensky district 407,570 3747 240.85 240.85 5.9 6.4 total (off-center districts) 4,444,416 139,580 5503.76 grand total 5,191,690 147,221 http://wooordhunt.ru/word/historical http://wooordhunt.ru/word/center https://en.wikipedia.org/wiki/tsentralny_district,_minsk http://wooordhunt.ru/word/off-center http://wooordhunt.ru/word/off-center https://en.wikipedia.org/wiki/vyborgsky_district,_leningrad_oblast http://wooordhunt.ru/word/off-center skachkova and lepikhina: methods of standard rates of financial expenses calculation on landscaped areas maintenance (on the example of st. petersburg, russia) international journal of economics and financial issues | vol 6 • issue 4 • 2016 1853 consider activities for maintenance and repair of objects and the territories of green plantings, the implementation is impossible without financing from appropriate authority. in st. petersburg, these expenses are financed from budget funds of st. petersburg (“on green plantings in st. petersburg,” 2010). at the same time forming of expenses of the budget for the next financial year is performed in compliance with rules of calculation of the budget assignments of st. petersburg based on standard rates of the financial expenses approved by the government of st. petersburg (government of st. petersburg, 2014, committee on economic policy and strategic planning of st. petersburg, 2015). according to the technique (committee of economic development, industrial policy and trade of the government of st. petersburg, 2012) when calculating financial expenses for works on maintenance of the territories of green plantings and repair of green plantings located on them the “basic and index” method is applied. it is based on the system of current indexes of changing value of works in relation to direct costs on works and maintenance determined in basic price level. financial expenses on the specified work type are calculated by formula: c = (cbas 1 icur 1 + cmat 1) +… + (cbas n icur n + cmat n) + o + ep + ccont (1) where: cbas n costs for works on maintenance of the territories of green plantings and to repair of objects of green plantings as per regional unit prices (rup) determined in a basic level of the prices; icur n current index of work cost change; cmat n the amount of unaccounted tsq costs for materials, determined in the current price level; o standard rate of overheads; ep standard rate of estimate profit; ccont the costs of works (services) which are not considered in rup, considered in addition and determined by results of monitoring of the cost of accomplishment of the corresponding works (services) in the current financial year. for costs on maintenance of the territories of green plantings and repair of green plantings of calculation it is necessary to know volume of works per unit of measurement, and also frequency of accomplishment of a specific work type. complex of works is approved by the committee on improvement of st. petersburg within production schedules (committee on improvement of the government of st. petersburg, 2012). in the document, frequency of carrying out each work type is also specified. thus, identification of volume of works per unit of measurement and the system of the indicators needed to calculate costs of works on maintenance and repair of objects and territories of green plantings became an objective of research. in this article, the system of indicators within works on maintenance is offered. final indicators on repair will be provided in further publications of authors. objects of research are the territories and gugp, which require special attention and care (“on gugp,” 2007). except work types and their frequency, finance costs on works on maintenance and repair of objects and the territories of green plantings depend on the category of green planting. according to the production schedules (committee on improvement of the government of st. petersburg, 2012) and the order of the committee on improvement of the government of st. petersburg dated 8/12/2014 no. 134-r (2014) green plantings are divided into four categories depending on appointment, placement in urban development and intensity of handling. determination of volumes of works per unit of measurement was carried out within examination of production schedules (committee on improvement of the government of st. petersburg, 2012) according to the public contract dated 2/11/2015 no. 0172200002014000126_160837 of the committee on economic policy and strategic planning of st. petersburg. for identification of volumes of works per unit of measurement the analysis of plant types growing in st. petersburg was initially done. the database containing data on 123 objects of green plantings (gardens, parks, squares, boulevards) has been created. the analysis was done separately by trees, bushes and plants taking into account their quantity, age, and also the categories of objects of green plantings (committee on improvement of the government of st. petersburg, 2012). the total quantity of the considered trees has constituted 391,810 including 180,586 coniferous and 211,224 deciduous trees (table 2). the general ratio of shrubby breeds depending on category of green planting and age is presented in table 3. 740,768 units were analyzed, 511,984 of them are single bushes and bushes in groups, 228,784 bushes in green hedge. the plants growing in territories of green plantings of st. petersburg are presented by small-bulbous plants and perennial grassy plants (table 4). also, the analysis of characteristics of gugp objects has been made. 3. results based on the carried out analysis of objects and the territories of green plantings of st. petersburg the system of indicators has been developed to identify the volumes of works per unit of measurement, necessary for costs calculation of works on maintenance of objects and the territories of green plantings of st. petersburg. the provided volumes do not consider frequency of carrying out specific work types. for example, the following formula was applied to determine the total quantity of trees per 1 hectare of gugp ntr tot per 1 hectare (2): tr tr tot per 1 hectare gugp n n = s (2) skachkova and lepikhina: methods of standard rates of financial expenses calculation on landscaped areas maintenance (on the example of st. petersburg, russia) international journal of economics and financial issues | vol 6 • issue 4 • 20161854 where ntr total quantity of trees of gugp objects of each category; sgugp total area of gugp objects of each category, hectare. as a result, some 49 dependences were made, on which the final volume parameters have been calculated (table 5). the system includes several blocks depending on an accounting unit: 1. trees 2. bushes (single and in groups, and also in green hedges) 3. lawns 4. flower-gardens 5. paths and platforms. it has been revealed that for correct forming of standard rates of finance expenses on maintenance of objects and the territories of green plantings the additional data which are absent in passports of objects of green plantings are required. for example, according to production schedules (committee on improvement of the government of st. petersburg, 2012) one of work types is modeling cutting of crowns. when calculating standard rates of finance table 2: ratio of trees depending on the age and category age, years quantity of coniferous trees quantity of deciduous trees quantity of poplars quantity of willow total quantity of trees 1st category <10 731 1999 0 196 2730 from 10 to 20 302 6388 60 463 6690 more than 20 2034 17,149 695 1172 19,183 total 3067 25,536 755 1831 28,603 2nd category <10 1053 3953 172 386 5006 from 10 to 20 1443 5554 114 618 6997 more than 20 5888 36,986 2196 3066 42,874 total 8384 46,493 2482 4070 54,877 3rd category <10 413 1263 23 309 1676 from 10 to 20 1463 5001 979 861 6464 more than 20 12,063 13,414 2042 938 25,477 total 13,939 19,678 3044 2108 33,617 4th category <10 1287 3537 0 192 4824 from 10 to 20 6943 8615 1196 696 15,558 more than 20 146,966 107,365 718 647 254,331 total 155,196 119,517 1914 1535 274,713 grand total 180,586 211,224 8195 9544 391,810 table 3: ratio of bushes depending on the category of green planting type of gugp single bushes and bushes in groups bushes in green hedge in total % 1st category park 69,580 50,302 119,882 56 garden 14,870 13,270 28,140 13 square 23,417 14,470 37,887 18 boulevard 21,056 8183 29,239 14 total 128,923 (59.9%) 86,225 (40.1%) 215,148 (100%) 100 2nd category park 167,162 50,641 217,803 71 garden 15,753 9482 25,235 8 square 16,216 4805 21,021 7 boulevard 27,658 16,387 44,045 14 total 226,789 (73.6%) 81,315 (26.4%) 308,104 (100%) 100 3rd category park 33,092 42,042 75,134 80 garden 1695 1404 3099 3 square 2151 299 2450 3 boulevard 12,333 1217 13,550 14 total 49,271 (52.3%) 44,962 (47.7%) 94,233 (100%) 100 4th category park 102,181 16,282 118,463 96 garden 0 0 0 0 square 4820 0 4820 4 boulevard 0 0 0 0 total 107,001 (86.8%) 16,282 (13.2%) 123,283 (100%) 100 bushes of all categories, grand total 511,984 228,784 740,768 http://wooordhunt.ru/word/square http://wooordhunt.ru/word/square http://wooordhunt.ru/word/square http://wooordhunt.ru/word/square skachkova and lepikhina: methods of standard rates of financial expenses calculation on landscaped areas maintenance (on the example of st. petersburg, russia) international journal of economics and financial issues | vol 6 • issue 4 • 2016 1855 costs, this work type is divided into two categories depending on height of trees (under 5 m and over 5 m). for cutting of trees over 5 m specialized equipment is used and, respectively, it increases costs. therefore it is necessary to account differentiation of trees by height in the inventory of green plantings. thus, except the standard parameters specified in passports of green plantings it is necessary to determine the following indicators in addition: 1. tree height (meters) 2. diameter of tree caudex (cm) 3. availability of wounds, hollows, mechanical damages, etc. 4. age of tree (in current passports, trees are ranged as follows: under 10 years, 10-20 years, over 20 years. it has been revealed that more detailed differentiation with an interval of at least 5 years is necessary) 5. age at the time of inventory and the current age (for trees and bushes) 6. planned position of a tree on maps that are used for inventory 7. if some of these indicators are missing, volumes of works are calculated approximately through indirect parameters. table 4: ratio of green plantings depending on their category type of gugp small-bulbous plantings perennial grassy plantings in total % 1st category park 0 5896 5896 15 garden 2250 6890 9140 24 square 21,800 1534 23,334 61 boulevard 0 0 0 0 total 24,050 14,320 38,370 100 2nd category park 30,000 36,032 66,032 98 garden 0 644 644 1 square 0 415 415 1 boulevard 0 131 131 0 total 30,000 37,222 67,222 100 3rd category park 2038 6214 8252 99 garden 0 0 0 0 square 0 0 0 0 boulevard 0 125 125 1 total 2038 6339 8377 100 4th category park 0 11,399 11,399 100 garden 0 0 0 0 square 0 0 0 0 boulevard 0 0 0 0 total 0 11,399 11,399 100 grand total for all the categories 56,088 69,280 125,368 table 5: calculation of volumes of works on a unit of measure per 1 hectare of the area of gugp indicator measure unit according to rup volumes of works for categories i ii iii iv trees total quantity of trees per 1 hectare of gugp ntr tot per 1 hectare 1 tree 123.22 172.20 245.40 473.55 quantity of trees under 3 years per 1 hectare of gugp ntr<3 per 1 hectare 10 trees 3.53 4.71 0.04* 0.02* quantity of coniferous trees per 1 hectare of gugp ncon.tr.per 1 hectare 10 trees 13.21 26.31 1.02* 2.68* quantity of deciduous trees per 1 hectare of gugp ndec.tr.per 1 hectare 10 trees 110.01 145.89 1.44* 2.06* quantity of trees over 3 years per 1 hectare of gugp ntr>3 per 1 hectare 10 trees 119.70 167.49 2.42* 4.71* quantity of trees over 20 years per 1 hectare of gugp ntr>20 per 1 hectare 10 trees 82.64 134.53 1.86* 4.38* area of loosening of holes of trees under 3 years per 1 hectare of gugp shol.tr<3 per 1 hectare 1 m2 11.76 15.71 0.11* 0.08* quantity of trees from 3 to10 years per 1 hectare of gugp ntr. 3-10 per 1 hectare 1 tree 8.23 11.00 8.56 5.82 quantity of trees over 10 years per 1 hectare of gugp ntr.>10 per 1 hectare 1 tree 111.46 156.49 233.17 465.23 quantity of trees under 10 years per 1 hectare of gugp ntr.<10 per 1 hectare 1 tree 11.76 15.71 12.23 8.32 quantity of poplars over 20 years per 1 hectare of gugp npop.>20 per 1 hectare 1 tree 2.99 6.89 14.91 1.24 quantity of poplars and willow over 20 years per 1 hectare of gugp npop.+will.>20 per 1 hectare 100 trees 8.04 16.51 21.75 2.35 quantity of trees over 20 years except poplars and willows per 1 hectare of gugp ntr.−(pop.+will.)>20 per 1 hectare 100 trees 74.60 118.02 164.23 436.06 trees along street roads area per 1 hectare of gugp str.al.str.per 1 hectare m 6.47 10.86 19.69 719.59 green plantings area per 1 hectare of gugp sgp per 1 hectare m 2 8184.04 7769.28 8558.71 8982.18 *for iii and iv categories volumes of works are increased by additional coefficient (1%) as not in all territory the full complex of works is applied fully http://wooordhunt.ru/word/square http://wooordhunt.ru/word/square http://wooordhunt.ru/word/square http://wooordhunt.ru/word/square skachkova and lepikhina: methods of standard rates of financial expenses calculation on landscaped areas maintenance (on the example of st. petersburg, russia) international journal of economics and financial issues | vol 6 • issue 4 • 20161856 4. discussion and conclusion as a result, based on the analysis of modern domestic and foreign literature, practical experience in the field of landscape gardening economy the author’s system of the indicators necessary for forming of costs for works on maintenance of objects and the territories of green plantings has been offered. analogs of the provided system have not been revealed. also, recommendations about enhancement of certification of green plantings have been made. management of green plantings in megalopolises is a debatable and contradictory area, where various social, financial, town-planning and other interests meet. modern methods of management of green objects are inefficient; they require enhancement and increase of objectivity. the system of indicators developed by authors allows proving mathematically calculation of financial expenses on maintenance of objects and territories of green plantings, and, as a result, leads to more effective expenditure of budgetary funds. based on the conducted research it is possible to make the following conclusions: 1. one of the reasons of inefficient control over green plantings of megalopolises is understating of standard rates of financing in this sphere, and also underestimation of economic and social value of green plantings 2. calculation of standard rates of finance costs on maintenance of green plantings needs to be carried out based on the system of indicators including volumes of works per unit of measurement and also frequency of accomplishment of a specific work type 3. actual data of certification of objects of green plantings must be initial for identification of volumes of works per unit of measurement 4. existing indicators of certification of green plantings are not enough for reasonable and full calculation of standard rates of financial expenses. references deneva, m., bozhkov, l., naydenova, v. (2008), the green system of sofia. urban green spaces. a key for sustainable cities: international conference, sofia, bulgaria, april 17-18. ioer dresden, eva-maria tittle, jacqueline hoyer. p16-19. dubinin, v.p. (2007), level of municipal forestry. determining a factor of an ecological condition of city. the role of green plantings in strategy of development of khabarovsk. materials of the third city scientific and practical conference. on march 15, 2007, khabarovsk: tikhookean state university. p6-8. etim, j.d., umazi, u.a., ufot, i.n. (2012), awareness and perception of urban forestry among urban dwellers in sahel savannah region of nigeria. journal of biodiversity and ecological sciences, 2(4), 236-243. husqvarna group. (2012), global garden report: a closer look at urban green spaces around the globe. stockholm: kairos future. ilchenko, i.a. (2014), system of green plantings as environmental factor of city microclimate. bulletin of the taganrog institute of management and economy, 1, 37-42. kovyazin, v.f. (2008), biological bases of formation of steady ecosystems and rational use of soil and vegetable resources of megalopolises (on the example of st. petersburg). doctoral thesis. st. petersburg: agrophysical research institute. p40. loures, l., costa, l. (2012), the role of urban parks to enhance metropolitan sustainability: the case of oporto. international journal of energy and environment, 6(4), 453-461. memorandum “principles of legislative regulation of protection of green plantings in st. petersburg”. (n. d.), center of examinations of the st. petersburg society of scientists. available from: http://www. ecom.su/appeals/index.php?id=249. [last retrieved on 2016 jul]. mensah, a.c. 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[last retrieved on 2016 jul]. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(2), 242-247. international journal of economics and financial issues | vol 10 • issue 2 • 2020242 financial performance as mediator on the impact of investment and financial decisions on stock price and future profit: the case of the jordanian financial sector zaher abdel fattah al-slehat* faculty of business, tafila technical university, at-tafilah, p.o. box 179, tafila 66110, jordan. *email: zalabadi@yahoo.com received: 01 january 2020 accepted: 01 march 2020 doi: https://doi.org/10.32479/ijefi.9520 abstract the current study investigates the effect of investment and financial decisions on stock prices and future profits in the presence of financial performance as an intermediate variable. thus, the case of the jordanian banking and insurance sector is analysed. the sample includes 13 banks and 10 insurance companies from 2009 to 2018. a structural equation modeling analysis is conducted using the amos 23 software to test the hypotheses and validate the model. financial decision exhibits no effect on future profits and stock prices, whereas investment decision affects future profits and stock prices. financial performance is considered a mediator in the effect between financing decision and future profits. by contrast, financial performance fails to mediate the impact of financial decision and stock prices. in addition, it cannot mediate the effect of investment decision on future profits and stock prices. keywords: investment decision, financial decision, financial performance, stock price, future profit jel classifications: g1, g2, g11 1. introduction banking and insurance sectors are considered basic components in any economy because of their important role for achieving stability and increasing growth rates. the banking sector contributes to raising the level of savings and improving return, which is reflected in the increase in investment opportunities, while the insurance sector provides protection for any economic process. thus, losses are minimized. ayuba et al. (2019) and nurmet et al. (2019) indicated that the financial performance of companies depends on administrative decisions, which are implemented within the company, and is proven by the ability of managers to manage a business and maximize the owners’ wealth. investment decision refers to choosing the investment structure, that is, shortand long-term investments and the level of investment (investment size). financial decision refers to choosing the financing structure (debt or equity). the financial department should increase the operational, investment, and financial efficiency that maximize the value of the stock in the market and increase the expected future profits. hence, this paper mainly aims to examine the effect of the investment and financing decision on stock prices and future profits in the presence of financial performance as an intermediate variable. 2. theoretical framework and previous studies modigliani and miller (1963) indicated that investment and financial decisions are reflected in maximizing profits and wealth of owners provided that these decisions are ideal. their previous study (modigliani and miller, 1958) is considered one this journal is licensed under a creative commons attribution 4.0 international license al-slehat: financial performance as mediator on the impact of investment and financial decisions on stock price and future profit: the case of the jordanian financial sector international journal of economics and financial issues | vol 10 • issue 2 • 2020 243 of the most important studies on the link between investment and financial decision because it concluded that no relationship exists between investment and financial decisions if markets are extremely efficient. moreover, owners must make appropriate financial decisions to contribute to creating value for the company (chavez et al., 2015). investment decision aims to allocate money in long-term assets that will be profitable in the future (obara and eyo, 2000). such a decision determines the optimal mixture of projects that will be invested between shortand long-term investments. thus, investment decisions must be taken after the investment project is completely analyzed, because they aim to increase the value of investments, growth in sales, and profits and maximize the value of the company (virlice, 2013; vos and vos, 2000). gill et al. (2018) explained that investors create investment decisions on the basis of their rational viewpoints, experience, and available information. thus, all operational and financial aspects, liquidity and profitability, and the prospects for stock growth are considered while investment decisions are made. the adoption of the investment decision is affected by the following factors (saksonova, 2010; jiricek and dostalova, 2010; paramasivan and subramanian, 2009): 1. investment risks 2. worth of investment project 3. diversity of investment project 4. type of investment 5. restricted availability of financial resources. the company’s investment and financial decisions must be reflected in its financial performance in a timely and correct manner to become highly efficient. this efficiency proves the management’s ability to use its resources and thereby achieve and increase future profits. financial performance aims to inform stakeholders and thus encourage them to make decisions, which is a financial case for the company that includes the collection and use of funds and demonstrates the company’s ability to manage and control its resources. analyzing financial ratios during a specific time is the best way to assess the financial performance of companies (fatihudin et al., 2018; matar and eneizan, 2018; naz et al., 2016; aliona, 2016). fatihudin et al. (2018), erdemir (2019), ahmad et al. (2019), ayuba et al. (2019), and ullah et al. (2019) have indicated a set of ratios that is used to measure the financial performance of companies, such as return on investment, return on equity, and return on assets. numerous investors tend to invest in shares. therefore, they must be aware of stock price because it determines the expected future profits within an acceptable level of risk. furthermore, the investor must be aware of the factors that affect stock prices, including financial information, which can be obtained from financial data that cause stock prices to move (dang et al., 2018; cutler et al., 1988). the substantial amount of available data indicates increasing chances to study their prices (harris, 1991). gordon (1959) indicated that stock prices must have a specific relationship to earnings (harris, 1991). 2.1. previous studies balas (2013) intended to test the effect of financial and investment decisions on financial performance. the study was applied to 22 listed companies on the bucharest stock exchange from 2005 to 2010 and concluded a statistically significant effect of financial and investment decisions on financial performance. khanqah and ahmadnia (2013) examined the relationship between investment and financial decisions and determined the effect of growth, company size, dividend policy, accounting rate of return, and liquidity on financial decisions. a total of 50 companies listed on the tehran stock exchange from 2005 to 2010 were used as sample. they concluded that investment decisions exhibit a positive effect on financial decisions during the instance of uncertainty. matiin et al. (2018) investigated the influence of investment decisions, financial decisions, strategic risks, efficiency, financial performance, company value, and good governance as intermediate variables for the coal sector in mining companies. this study was applied to a sample of 18 companies listed on the indonesia stock exchange from 2012 to 2016. notably, investment decisions fail to affect efficiency, whereas investment decisions affect financial performance. in addition, investment decisions affect the value of the company, and financial decisions influence efficiency, financial performance, and the value of the company. ahmed (2008) analyzed the effect of the company’s financial policy, profit distribution policy, and structure on performance. the study was conducted form 1999 to 2002 for a sample of 100 indicators for companies listed on the kuala lumpur stock exchange. the study emphasized that the company’s debt policy (financial decision) affects corporate performance. makarim and noveria (2014) analyzed the financial performance of companies as one of the main tools for making an investment decision. five companies listed on the indonesian construction market from 2009 to 2013 were used as sample. they found that the fundamental analysis of investors can be used to investment decision-making. peterson and benesh (1983) emphasized the relationship between investment decisions and financial decisions among companies through a pilot study on all companies in the standard and poors index, which excludes utility and financing companies, from 1975 to 1979. the number of observations ranged from 534 to 538 companies. notably, financial decisions exhibit a major influence on investment decisions. muiruri and wepukhulu (2018) focused on the influence of financial decisions on the financial performance of companies listed on the nairobi stock exchange. the study targeted 66 companies from 2012 to 2016. findings reveal that capital structure has a positive and slight effect on return on assets, while it has a positive and significant effect on return on shareholders’ equity. liquidity decision exhibits a positive influence on the return on assets and return on equity. moreover, investment decision has a positive and considerable effect on return on assets and return on equity. al-slehat: financial performance as mediator on the impact of investment and financial decisions on stock price and future profit: the case of the jordanian financial sector international journal of economics and financial issues | vol 10 • issue 2 • 2020244 2.1.1. study contribution through a review of related literature, we find that previous studies aimed to examine the effect of investment and financial decisions on a set of dependent variables, including financial performance. different from them, the current study aims to investigate the effect of investment and financial decisions on stock prices and future profits in the existence of financial performance as an intermediate variable. furthermore, existing studies were applied in foreign environments, whereas the current study was applied in the jordanian market, particularly in two important sectors, namely, banking and insurance sectors. the interest in investment and financial decisions increased because of their importance for preventing risks of financial crisis, failure, or bankruptcy. therefore, the results of the current study may be generalized to the financial sector. 3. methodology the current study employs analytical method using structural equation modeling (sem). in particular, a model is developed to test the effect of investment and financial decisions on stock prices and future profits in the presence of financial performance as an intermediate variable. 3.1. research hypotheses h01: financial decision has no effect on the return on assets. h02: investment decision has no effect on the return on assets. h03: investment decision exhibits no effect on the return on equity. h04: financial decision exhibits no effect on the return on equity. h05: the return on assets has no effect on the return on equity. h06: the return on assets has no effect on future profit. h07: financial decision exhibits no effect on future profit. h08: the return on equity has no effect on future profit. h09: the return on equity has no effect on stock price. h10: investment decision exhibits no effect on stock price. h11: the return on assets has no effect on stock price. h12: investment decision has no effect on future profit. h13: financial decision has no effect on stock price. 3.2. population and sample study the study population consists of all companies operating in the banking and insurance sectors, while the study sample comprised 23 companies as shown in table 1. 3.3. data collection annual financial reports published on the amman stock exchange website, books, periodicals, and research, masters, and doctoral dissertations published on the internet are utilized for data collection. 3.4. model of study the following model reflects the study problem that is represented by the effect of investment and financial decisions on stock prices and future profits in the existence of financial performance as an intermediate variable. figure 1 illustrates the study model including a group of independent, dependent, and intermediate variables that are related to each other. sem is a method that solves systems of linear equations simultaneously and analyze the best relationships among variables through a graph. in addition to several techniques such as regression analysis, path analysis, and factor analysis, sem is also used to test the suitability of the assumed model (stein et al., 2012; hox and bechger, 2014) and the ability of this technique to measure direct and indirect relationships among variables (civelek, 2018). sem aims to evaluate the suitability of the assumed model to assess whether it provides a good fit of data through a set of indicators (hox and bechger, 2014). such a method is more statistically suitable for testing hypotheses than other methods (hoyle, 1995; karagoz, 2016). therefore, sem is used in this study to examine the extent of conformity of the default study model using the amos version 23 software to evaluate the suitability of this model through a set of indicators. table 2 indicates the sem analysis results. 3.5. study variables 3.5.1. independent variables independent variables: based on the review of previous literature, the following measures are adopted (gabow, 2017; alslehat and altahtamouni, 2014; lopez-gutierriz et al., 2015): • investment decision: this variable is measured according to the following formula: figure 1: the study model table 2: hypothesized model (goodness-of-fit indices) threshold values fit indices indicators name measures absolute fit level gfi >0.90 0.998 gfi rmsea <0.08 0.035 rmsea p-value <0.05 0.022 root mean square residual incremental fit level nfi >0.90 0.998 nfi tli >0.90 0.992 tli cfi >0.95 0.999 cfi agfi >0.90 0.961 agfi parsimonious fit index cmin/df <5 1.287 gfi: goodness of fit index, rmsea: root mean square error of approximation, tli: tucker lewis index, cfi: comparative fit index, agfi: adjusted goodness of fit index, nfi: normed fit index table 1: study sample number of companies sector 13 the banking sector 10 the insurance sector al-slehat: financial performance as mediator on the impact of investment and financial decisions on stock price and future profit: the case of the jordanian financial sector international journal of economics and financial issues | vol 10 • issue 2 • 2020 245 (total assets on the day (t)−total assets on the day (t−1))/ total assets on the day (t−1) • financing decision: this variable is measured through the debt ratio according to the following formula: debt ratio = total liabilities/total assets. 3.5.2. dependent variables dependent variables: the dependent variables are listed as follows:(https://www.ase.com.jo/en) • closing prices: it is the annual closing prices for the study sample companies • future profits: it is a net annual profit for the study sample companies. 3.5.3. intermediate variables intermediate variables: the intermediate variables are financial performance, which are measured by the following indicators (andrew, 2006; moldovan et al., 2016): • return on assets: it is the net profit after tax is divided by total assets. this variable is measured according to the following formula: return on assets net income after tax total asset = • return on equity: it is the net profit after taxes are divided by the total equity. this variable is calculated according to the following formula: net income return on equity = shareholders’ equity 4. statistical analysis 4.1. hypothesized model (goodness-of-fit indices) table 2 presents the results, which are specified as follows: 1. absolute fit level: this test indicates the suitability of the study model. among the tests used in the good conformity index, the following indices are obtained: the goodness of fit index, root mean square error of approximation, and root mean square residual reach 0.998, 0.035, and 0.022, respectively. therefore, indicates the suitability of the proposed study model. 2. incremental fit level: this analysis shows the incremental extent of the factor or framework, that is, the extent that the results are increasingly accepted. the most important indices in this analysis include: normed fit index, tucker lewis index, comparative fit index, adjusted goodness of fit index. this indices reach 0.998, 0.992, 0.999, and 0.961, respectively. thus, the study model is successful and accepted. 3. the parsimonious fit index: minimum value of the discrepancy function divided by degrees of freedom (cmin/df) value is <3. therefore, the model is fully accepted. 4.2. hypothesis testing of hypothesized model table 3 lists the hypotheses results and indicates the direct relationships between the variables of the study. 1. the first hypothesis, which states that financial decision has no effect on the rate of return on assets, is accepted. therefore, the banking and the insurance sectors do not depend on debt to increase the rate of return on assets, and several factors including working capital affect the return on assets 2. the second hypothesis is rejected, whereas the alternative hypothesis, which posits that investment decision affects the rate of return on assets, is accepted. this finding reinforces the first hypothesis given that the two sectors rely on their working capital investment and other areas of investment to increase the rate of return on assets 3. the third and fourth hypotheses, which indicate that investment and financing decisions exhibit no effect on the rate of return on equity, are accepted. the owners primarily aim to maximize the value of the company as a whole, thereby positively reflecting on the value of the stock and future total profits 4. the fifth and sixth hypotheses are rejected. thus, the alternative hypotheses for each of them are accepted. in particular, the rate of the return on assets affect the rate of the return on equity and future profits 5. the seventh hypothesis, is accepted, which states that financial decision has no effect on future profits. this result reinforces the result of the first, third, and fourth hypotheses because the two sectors do not rely on debt to achieve future profits 6. the eighth and ninth hypotheses are rejected, and their alternative hypotheses are accepted. in particular, the rate of return on equity affects future profits and stock prices, which is the owners’ goal in accordance with the third and fourth hypotheses 7. the tenth and twelfth hypotheses are rejected, whereas their alternative hypotheses are accepted. these hypotheses state that investment decision influences stock prices and future profits. therefore, investment decision exhibits a significant effect on investors in the banking and insurance sectors given that they are concerned with future profits and stock prices 8. the eleventh hypothesis is rejected, whereas the alternative hypothesis is accepted. in particular, the rate of return on assets influences share prices, thereby achieving the owners’ goal 9. the thirteenth hypothesis is accepted, which posits that financial decision exhibit no effect on stock prices. therefore, the banking and the insurance sectors prevent debt financing table 3: regression weights for hypotheses testing result hypothesis directionof influence estimate s.e. c.r. p support h01 roa←fd 0.002 0.005 0.310 0.757 accepted h02 roa←id 0.149 0.064 2.332 0.020 reject h03 roe←id 0.063 0.211 0.301 0.764 accepted h04 roe←fd 0.008 0.017 0.488 0.626 accepted h05 roe←roa 6.486 0.215 30.175 *** reject h06 fp←roa 0.481 0.214 2.246 0.025 reject h07 fp←fd −0.005 0.007 −0.666 0.505 accepted h08 fp←roe −0.069 0.030 −2.329 0.020 reject h09 sp←roe −0.409 0.091 −4.511 *** reject h10 sp←id 3.102 0.289 10.735 *** reject h11 sp←roa 3.004 0.658 4.567 *** reject h12 fp←id 0.555 0.094 5.898 *** reject h13 sp←fd 0.007 0.023 0.309 0.757 accepted al-slehat: financial performance as mediator on the impact of investment and financial decisions on stock price and future profit: the case of the jordanian financial sector international journal of economics and financial issues | vol 10 • issue 2 • 2020246 to increase stock prices in the market, because debt financing increases interest in the two sectors. 4.3. direct, indirect, and total effects of the hypothesized model given that financial performance is an intermediate variable, it is calculated in different manner that is called direct and indirect effect. table 4 reveals the strength of the intermediate variable (represented by financial performance through the measures of the rate of return on assets and the rate of return on equity) on the effect of investment and financial decisions on stock prices and future profits. 1. the direct effect between the financial decision and future profits is −0.041, whereas the indirect effect is −0.004. therefore, the indirect relationship is stronger and succeeds more than the direct relationship, and the intermediate variable represented by financial performance mediates the effect between the financial decision and future profits 2. the direct effect between the financial decision and stock prices reaches 0.016, whereas the indirect effect is −0.006. therefore, the direct relationship is stronger than the indirect relationship. in addition, financial performance fails to mediate the effect between financial decision and stock prices 3. the direct effect between investment decision and future profits reaches 0.365, whereas the indirect effect is 0.001. thus, the direct effect is stronger and more successful than the indirect effect. moreover, financial performance fails to mediate the effect between investment decision and future profits 4. the direct influence between investment decision and stock prices is 0.568, and the indirect effect is (0.005). consequently, the direct effect is stronger and more successful than the indirect effect. furthermore, financial performance fails to mediate the effect between the investment decision and stock prices. 5. conclusions and recommendations the study obtained a set of results as follows: 1. financing decision has no effect on the rate of return on assets, the rate of return on equity, future profits, and stock prices 2. investment decision affects the rate of return on assets, stock prices, and future profits. however, investment decision exhibits no affect on the rate of return on equity 3. the rate of return on assets influences the rate of return on equity, future profits, and stock prices 4. the rate of return on equity affects future profits and stock prices 5. financial performance mediates the effect between the financial decision and future profits, but it fails to mediate the effect between financial decidion 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(2000), investment decision criteria in small new zealand businesses. investment decision criteria in small new zealand businesses, 8(1), 44-55. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(6), 50-56. international journal of economics and financial issues | vol 10 • issue 6 • 202050 does service quality influence tax compliance behaviour of smes? a new perspective from ghana daniel susuawu1, kenneth ofori-boateng2, john kwaku amoh3* 1finance directorate, university of health and allied sciences, ho (uhas), ghana, west-africa, 2department of accounting and finance, ghana institute of management and public administration (gimpa), greenhill, accra, ghana, west africa, 3department of accounting, faculty of accounting and finance, university of professional studies, accra, ghana, west-africa. *email: john.amoh@upsamail.edu.gh received: 01 august 2020 accepted: 15 october 2020 doi: https://doi.org/10.32479/ijefi.10554 abstract while many factors influence tax compliance behaviour, this study aims to examine the effect of the quality of tax services on the compliance behaviour of small and medium-sized enterprises. the study used the survey to test five hypotheses with the aid of frequency tables, regression and correlation analyses. the study found statistically significant positive effects of reliability, responsiveness, assurance, and empathy on the tax compliance behaviour of smes. secondly, there are varying positive correlations amongst key tax service quality measures. the research has several implications for taxing authorities and policy makers due to its effect on tax revenue generation for economic growth and development. the novelty of this paper lies in its premier attempt to enrich the literature on the tax service qualitytax compliance behaviour nexus with the adoption of parasuraman et al. (1988)’s service quality indicators. in employing these tax service quality indicators, a better understanding is gained into tax non-compliance behaviour, which emanates from poor service quality. the findings provide some insights to taxing authorities and policy makers in drafting policies to enhance tax compliance by improving, digitising and modernising tax administration for maximum revenue mobilisation to drive economic growth. keywords: tax, service, quality, compliance, ghana, economic growth, smes jel classifications: h2, q2, q3 1. introduction many emerging economies, including ghana, are heavily dependent on taxation as a means of generating the required financial capital to meet their ever-increasing spending requirements to ensure economic growth and improve the quality of citizens’ lives. however, many of these economies do not collect much tax revenue due to a variety of inhibiting factors (amoh and adom, 2017; amoh and ali-nakyea, 2019) specifically, according to the institute of statistical social and economic research, isser (2019), ghana has had low levels of tax compliance in recent years, impacting the mobilization of tax revenue. according to okpeyo et al. (2019), tax non-compliance is a challenging issue for emerging economies like ghana which demands attention. al-ttaffi and abdul-jabbar (2016) have argued that to improve tax compliance, quality of service tax provision must be excellent. this is because one way of addressing tax non-compliance is a superior tax service quality provided by tax officials (al-ttaffi and abdul-jabbar, 2016). thus, it is expected that where tax service quality levels are high, a positive tax compliance behaviour among taxpayers is evoked. the implication is that taxpayers will normally collaborate with quality taxservice-providing taxing authorities, who also treat the taxpayers as partners in the revenue mobilisation agenda (ameyaw et al, 2016). satisfaction with the government and the tax authority’s this journal is licensed under a creative commons attribution 4.0 international license susuawu and amoh: does service quality influence tax compliance behaviour of smes? a new perspective from ghana international journal of economics and financial issues | vol 10 • issue 6 • 2020 51 service delivery also encourages taxpayers to comply with tax rules (vigoda-gadot, 2007). the motivation for this paper is the low level of tax compliance in ghana (isser, 2019) and other emerging economies which translates into low tax revenues and explains the rising debts levels to meet the increasing government expenditures (amoh and adom, 2017; amoh and ali-nakyea, 2019). secondly, the problem of tax non-compliance in emerging economies like ghana is mainly as a result of the large informal sector and the lack of proper systems and structures to enforce tax laws (ameyaw, et al., 2007). this large informal sector is dominated by a large pool of small and medium scale enterprises, smes (ghana living standards survey, glss 7, 2017). thirdly, though some studies have been conducted on how tax service quality influences tax compliance behaviour (alabede et al., 2011; osei-darko, 2012; hidayat et al., 2014; al-ttaffi and abdul-jabbar, 2016; awaluddin and tamburaka, 2017; wisudawaty et al., 2018), the results are mixed. while some of the studies posit a positive relationship, others report a negative association. in this light, this study was conducted by surveying some selected smes in the madina, makola, tema and kaneshie municipalities to assess the effects of tax service quality of ghana revenue authority (gra) on the compliance behaviour of smes in ghana to gain fresh insights into the phenomenon. relying on parasuraman et al. (1988)’s service quality indicators, the study examined the impact of reliability, responsiveness, empathy and assurance of taxing authorities on tax compliance behaviour of smes. accordingly, the hypotheses to be tested to achieve the study objectives are: h1: does the responsiveness of tax officials affect the tax compliance behaviour of smes? h2: does the reliability of tax officials affect the tax compliance behaviour of smes? h3: does the empathy of tax officials affect the tax compliance behaviour of smes? h4: does the assurance of tax officials affect the tax compliance behaviour of smes? h5: are there any correlations amongst the tax service variables? to test these hypotheses, nine hundred and sixty-eight (968) survey responses were analysed from one thousand and two hundred (1200) questionnaires administered to smes of four business enclaves. with the aid of frequency tables, multiple regression and correlation analyses the research hypotheses were addressed for policy decisions and implementation. the study is interesting, unique and a premier attempt in the area of tax service quality-compliance behaviour nexus literature because firstly, it focuses on the effects of the tax service quality indicators advocated for by parasuraman et al. (1988): responsiveness, reliability, empathy and assurance on tax compliance behaviour. according to parasuraman et al. (1988), the importance of these service indicators is that they represent an overall measurement of the ingredients of an excellent service delivery. second, the paper has empirically enhanced the quality of research in this under-researched area, particularly in countries south of the sahara. third, the results are representative because, with the selection of respondents from four different business enclaves from different locations, the distinctive features of small and medium-sized enterprises in emerging economies are being harnessed. the next chapter presents a succinct review of related relevant literature. chapter 2 discusses the methodology of the study. chapter 4 presents results and discussions. the conclusions and policy implications are discussed in chapter 5. 2. literature review this section reviews theories that establish relationships between tax service quality and tax compliance behaviour as well as relevant empirical literature. with respect to tax compliance, kirchler et al. (2008) posited that governments and tax authorities have primary interest and responsibility to ensure that citizens comply with this civic duty and behave in compliance with the provision of tax laws irrespective of their social status. according to brown and mazur (2003), tax compliance theoretically involves compliance with respect to payment, filing, and reporting. kirchler (2007) explains that tax compliance is the preparedness of taxpayers to honour his or her tax obligations. the main tax compliance theories underpinning this research are the psychology theory of tax compliance, comparative treatment theory, and the political legitimacy theory. these theories posit that taxpayers consider certain factors in taking tax compliance decisions. for example, when tax services provided by taxing authorities are excellent, positive tax compliance behaviour will be enhanced. 2.1. tax service quality indicators the issue of service quality is an important indicator for the success of any business organisation in today’s competitive environment. according to tjiptono and chandra (2011), service quality is an attempt to fulfil needs and desires of customers and deliver accuracy in balancing customer expectations. service quality for the taxing authorities in emerging economies and developing countries is even more critical because of poor level of tax revenue performance (amoh and ali-nakyea, 2019). parasuraman et al. (1988) submit that quality is a measure of overall assessment of the level of a good service, hence tax service quality encompasses the provision of all the best services to the maximum satisfaction of taxpayers in their tax compliance efforts. prior literature has documented some indicators of service quality. khudri and sultana (2015) argue that there are five determinants of service quality: personal interaction, appearance, reliability, policy, and problem solving. parasuraman et al. (1988) theorised that perceived service quality is a worldwide verdict or attitude which relates to the provision of superior service. accordingly, parasuraman et al. (1988) proposed five main indicators of service quality, capable of capturing susuawu and amoh: does service quality influence tax compliance behaviour of smes? a new perspective from ghana international journal of economics and financial issues | vol 10 • issue 6 • 202052 all the ramifications of the phenomenon: tangibles, reliability, responsiveness, assurance, and empathy. with respect to tax service quality proposed by parasuraman et al. (1988), responsiveness refers to the agility with which tax authorities respond to the enquiries and needs of taxpayers. reliability refers to the capability of the taxing authorities to deliver excellent service to taxpayers dependably and accurately. assurance involves the trust and confidence taxpayers repose in the tax authorities to deal faithfully with them. when tax authorities make the needs of taxpayers their priority and also empathize with them, then the quality of empathy is activated. tangibility refers to the physical image of the services provided by tax authorities to the taxpayers such as physical facilities, tools and machines. 2.2. tax service quality-tax compliance behaviour nexus a number of studies have tried to establish the relationship between tax service quality and tax compliance behaviour in different countries. this section reviews some to enable the researchers situate the current paper. alabede et al. (2011) analysed the effect that tax service quality has on tax compliance behaviour in nigeria. the study found that perceived tax service quality is positively and significantly related with tax compliance behaviour. further, the study concluded that taxpayers’ financial condition and risk preference jointly moderate the relationship between perceived tax service quality and compliance behaviour. hidayat et al. (2014) assessed the indicators and variables that form quality of tax services, regional tax regulations, taxpayer satisfaction level, taxpayer behaviour and their compliance in theory using confirmatory factor analysis (cfa) approach. the study found responsiveness to be the most significant tax service quality. al-ttaffi and abdul-jabbar (2016) analysed the impact of tax service quality on taxpayer behaviour of smes in yemeni. adopting a simple regression analysis, the study found that the perceived tax service quality has a significant negative influence on tax non-compliance behaviour. awaluddin and tamburaka (2017) examined the effect of service quality and taxpayer’s satisfaction to the compliance of paying motorized vehicle tax in the kendari office. the study found that service quality affects significantly the taxpayers’ compliance of motorized vehicle tax. wisudawaty et al. (2018) focused on investigating the effect of system quality, information quality, and service quality on the taxpayer compliance. the research showed that system quality, information quality and service quality all influence taxpayer compliance behaviour. the nature of the tax service quality-tax compliance behaviour phenomenon has many implications for public makers and governments because of its impact on tax revenue mobilisation especially in emerging economies. this necessitates more empirical work from different perspectives with different methodologies to draft policies to encourage tax compliance. hence, this paper contributes to literature by firstly, enhancing the quality of research papers in this under-researched area in countries south of the saharan. secondly, adopting the service quality measures of parasuraman et al. (1988) to study the relationship is not only unique but also a premiering attempt. 3. methodology this section discusses the sample size, research instrument and the model specified to test the hypotheses. 3.1. sample size and survey instrument the determination of an appropriate sample size for the nature of this research depends on the ability to get a good number of smes clustered in one area and hence the choice of the four main industry enclaves. also, the four municipalities have the ability to be representative of the smes in ghana. furthermore, tema is considered the industrial hub of ghana. 3.2. survey instrument this study employed the survey technique by administering questionnaires in the year 2019 to a sample of sme taxpayers in the makola, madina, tema and kaneshie business centres. this was done after an extensive review of literature on the research problem. the convenience sampling techniques were adopted to administer three hundred questionnaires to the smes of each of the four business and industrial centres. the questionnaires were personally administered by a team of eight final year accounting students from the university of professional studies, accra (upsa), ghana. the data collectors were briefed and trained for the questionnaire distribution. furthermore, the questionnaires were pre-tested to increase the validity of the questions and also to address potential challenges at the preliminary stages of questionnaire administration. the questionnaire has two sections: section a asked questions concerning the demographics of the respondents whilst section b consisted of fifteen statements on the tax service quality-tax compliance nexus. to test the hypotheses, the study used a fivepoint likert scale, where the respondents were asked to select the appropriate number, ranging from “strongly agree =1 to strongly disagree = 5.” for example, with a statement like this: gra staff keep taxpayers informed and updated on current laws and services, respondents were asked to select the appropriate number ranging from “strongly agree =1 to strongly disagree =5). selecting respondents from four different business enclaves ensures that the responses are encompassing of the several unique characteristics of smes in emerging economies. 3.3. model specification a correlation matrix was constructed to examine the association between selected pairs of tax service quality variables. to test the susuawu and amoh: does service quality influence tax compliance behaviour of smes? a new perspective from ghana international journal of economics and financial issues | vol 10 • issue 6 • 2020 53 tax service quality and tax compliance relationship, a multiple linear regression technique was adopted. following parasuraman et al. (1988), the study adopted the following the tax service indicators: responsiveness, reliability, assurance and empathy, for which structured questionnaires relating to each one of them in our study was designed. the model for the study was specified in the form, γ=α+β1x1+β2x2+β3x3+β4x4+β5x5 +…+e (1) as follows: comb=α+β1(reli)+β2(resp)+β3(empa)+β4(assu)+e (2) where: comb is the tax compliance behaviour of taxpayers (smes), reli is the reliability of the taxing authority, resp is the responsiveness of the taxing authority, empa is the reliability of the taxing authority, assu is reliability of the taxing authority, and e is the error term. 4. presentation and discussion of results this section presents the findings and discussions of the demographic data of the respondents and the research hypotheses. results were analysed for nine hundred and sixty-eight survey responses representing about eighty-one (80.66) per cent response rate. the survey responses were analysed and loaded into an econometric software to generate the regression and correlation results. 4.1. demographics of respondents table 1 reports the demographic characteristics of respondents. 82% of respondents are males, whiles 18% are females. regarding the age category, 2% of the respondents were within the 18-27 year group, 30% within 28-37 year category, 58% within 38-47 year category, 10% within the age category of 58 years and above. about the respondents’ educational level, 30% had completed the basic school level, 13% had a technical or post–secondary qualification, 10% also had a diploma qualification, 35% had a bachelor’s degree and 12% had master’s qualification. 4.2. testing the research hypotheses to test the hypotheses, frequency tables, regression and correlation analyses were employed. the results of the effect of the tax service quality measures being regressed on the tax compliance behaviour are presented in table 2 for discussion. the r-squared and adjusted r-squared are 59.19% and 49.59% respectively, which suggest that the tax service quality measures are capable of explaining any variations in tax compliance table 1: demographic information of respondents details frequency percentages total gender male 794 82 female 174 18 100 age (years) 18–27 19 2 28-37 290 30 38-47 562 58 58 and above 97 10 100 educational level primary/basic 290 30 technical/post-secondary 126 13 diploma 97 10 100 degree 339 35 masters 116 12 table 2: regression analysis variable coefficients standard error p-value c 2.8456 0.514 3.62e-05 reli 2.2024 0.1408 0.0136 resp 2.2838 0.0804 0.0113 empa 3.0987 0.1434 0.0452 assu 1.7217 0.1663 0.0315 r2 0.5919 adjusted r2 0.4959 f-statistic 0.00296 behaviour. the f-statistic which signifies the overall significance of the regression model is significant and hence the results could be analysed and inferences made therefrom for policy decision making. from the regression results all the tax service quality measures impact tax compliance behaviour of smes positively and significantly. in addition to the regression analysis, the survey responses were tallied and expressed in percentages for discussion to validate or disprove the regression output. 4.2.1. testing research hypothesis one (h1) the first research hypothesis seeks to examine the effect of responsiveness of tax officials in their service delivery on tax compliance behaviour. from table 3, 72% of the respondents believe that gra staff provide prompt services while with 28% had a contrary view. 44% of the respondents also affirmed that the employees of gra are always willing and ready to assist taxpayers, with 56% indicated that gra staff are not supportive of taxpayers. as to whether the tax authorities are reluctant in responding to taxpayers’ complaints, 100% reported in the affirmative. additionally, from table 2 on the regression, responsiveness of gra staff has a positive and significant impact on tax compliance behaviour. the study therefore concludes that the responsiveness of the taxing authorities has a positive and significant effect on the tax compliance behaviour of smes. the current study is consistent with the work of osei-darko (2012), who argued that customer satisfaction in service delivery is very critical to the operations and survival of organizations. susuawu and amoh: does service quality influence tax compliance behaviour of smes? a new perspective from ghana international journal of economics and financial issues | vol 10 • issue 6 • 202054 4.2.2. testing research hypothesis two (h2) the second research hypothesis seeks to ascertain the effect of the reliability of service provision of tax officials on tax compliance behaviour of smes. table 4 summarises the research findings. with the first statement, table 4 shows that 30.6% of the respondents fairly agreed that gra staffs are consistent and dependable in their service delivery to taxpayers with 69.4% disagreeing with that assertion. the second and third statements sought to find out whether gra staff perform transactions accurately and timely, respectively. from the results, 16.6% of the respondents fairy agree that gra staff are accurate in their delivery of services whilst 83.4% disagreed. also, on the timeliness of tax service provision, 38% fairly agreed with the timeliness assertion whiles 62% disagreed. finally, 46% of taxpayers agreed that gra staff keep them informed and updated on current laws and services with 56% disagreeing. from the regression analysis in table 2, reliability of service of gra staff is seen to impact positively and significantly on the behaviour of smes to comply with tax laws. the study therefore concludes that reliability of the taxing authorities has a positive and significant effect on the compliance behaviour of smes which is consistent with the findings of alabede et al. (2011) and wisudawaty et al. (2018), who found that system quality has an influence on taxpayer compliance, and hence tax service quality has an impact on the taxpayer compliance behaviour. 4.2.3. testing research hypothesis three (h3) the third research hypothesis examined how the assurance that smes have in the service delivery of gra staff affects their tax compliance behaviour. the results as displayed in table 5 reports that 56% of smes fairly agreed that the gra staff build trust and confidence whiles 44% disagreed. on the second statement, 78% of smes feel safe when transacting business with the gra staff with 22% disagreeing. 79% of smes agreed that gra staff are courteous and cheerful when serving them. however, 21% of smes had dissenting views. finally, 57% of respondents fairly agreed that gra staff provide in-depth answers in response to their complaints. 43% disagreed with the fourth statement. this current study found that the perceived assurance from gra staff in their service delivery has an effect on the compliance behaviour of smes. table 2 further reports that assurance as a tax quality service measure, drives compliance behaviour of taxpayers positively and significantly. this finding is consistent with alabede et al. (2011) and wisudawaty et al. (2018), who found that tax service quality has an impact on the taxpayer compliance. 4.2.4. testing research hypothesis four (h4) the fourth research hypothesis assessed the impact of empathy of the gra staff with respect to their service delivery on tax compliance behaviour of smes. from table 6, 18% of respondents fairly agreed that gra has the interest of taxpayers at heart with 82% disagreeing with that assertion. as to whether gra staff understand the needs and wants of taxpayers, 45% of respondents indicated that they agree while 65% disagreed. in the case of the third statement, whilst 65% of respondents disagreed with the assertion that gra staff give their undivided attention when serving taxpayers while 35% fairly agree. lastly, on the issue of whether gra conducts business within hours convenient to taxpayers, 28% of respondents fairly agreed and 72% disagreeing. table 3: the effect of responsiveness on tax compliance behaviour responsiveness strongly agree agree fairly agree disagree strongly disagree statement % % % % % gra staff provide services to tax payers promptly 70 2 14 14 the employees of gra are always supportive of taxpayers 32 12 20 36 gra staff are reluctant in responding to taxpayers’ complaints 8 82 10 table 4: the effect of reliability on tax compliance behaviour reliability strongly agree agree fairly agree disagree strongly disagree statement % % % % % gra staff are consistent and dependable in their service delivery to taxpayers 30.6 57.4 12 gra staff perform the tax transactions accurately 16.6 79.4 4 gra staff provide services timely 38 48 14 gra staff keep taxpayers informed and updated on current laws and services 46 34 20 table 5: the effect of assurance on tax compliance behaviour assurance strongly agree agree fairly agree disagree strongly agree statement % % % % % gra staff build trust and confidence in taxpayers 56 24 20 gra employees make taxpayers feel safe when dealing with them 78 8 14 gra staff are courteous and cheerful in serving taxpayers 79 21 gra staff provide in-depth answers in response to taxpayers’ complaints 57 11 32 susuawu and amoh: does service quality influence tax compliance behaviour of smes? a new perspective from ghana international journal of economics and financial issues | vol 10 • issue 6 • 2020 55 table 7: correlation amongst tax service quality measures variable reli resp assu empa reli 1.0000 resp 0.5041** 1.0000 assu 0.5276** 0.5242** 1.0000 empa 0.5362** 0.5389** 0.5037** 1.0000 **significant at 5% table 6: the effect of empathy on tax compliance behaviour empathy strongly agree agree fairly agree disagree strongly disagree statement % % % % % gra staff have taxpayers best interest at heart 18 66 16 gra employees understand the needs and wants of taxpayers 30 15 55 gra staff give taxpayers their undivided attention when serving taxpayers 35 45 20 gra conducts business within hours convenient to taxpayers 28 72 furthermore, table 2 shows that empathy as tax service quality measure has a positive and significant effect on the tax compliance behaviour of taxpayers. the study therefore, concludes that the empathy of the taxing authorities to taxpayers in their service delivery has positive and significant impact on their tax compliance behaviour. 4.2.5. testing research hypothesis five (h5) from table 7, there are positive correlations amongst tax service quality variables when pegged at 0.05 significance level. the implication is that pairs of tax service quality variables exhibit moderate correlations ranging from 0.5037 to 0.5389 within the the makola, madina,tema and kaneshie business centres. 5. conclusion and policy implications the aim of the paper was to examine the effects of tax service quality on tax compliance behaviour of smes in the the makola, madina, tema and kaneshie business enclaves. the study adopted a survey instrument using a convenience sampling technique to collect data to test five hypotheses. the results are summarised below: • responsiveness: gra staff provide prompt services to taxpayers but are always willing and ready to support taxpayers with their issues. in addition, gra staff are reluctant in responding to taxpayers’ complaints • reliability: gra staff are not consistent and dependable in their service delivery to taxpayers and also do not execute their jobs accurately. the gra staff do not perform their tax transactions timely and do not keep taxpayers informed on new tax laws and services • assurance: gra staff do not build trust and confidence in taxpayers and do not make taxpayers feel safe when dealing with them. however, the gra staff are courteous and cheerful when dealing with taxpayers • empathy: gra staff seem not to have the best interests of the taxpayers at heart and also do not give taxpayers their undivided attention when dealing with them. finally, gra do not conduct business within convenient time periods to taxpayers • there were statistically significant positive correlations amongst tax service quality measures • all the tax service quality variables (responsiveness, reliability, empathy and assurance) positively and significantly influence tax compliance behaviour of smes. the paper enriches the literature on tax service qualitytax compliance behaviour relationship by the adopting key measures of service quality by parasuraman et al. 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(2018), influence of system quality, information quality, and tax service quality to taxpayer compliance and risk as a moderating variable. journal of research in business and management, 6(6), 1-9. https://www.diva-portal.org/smash/get/diva2:831032/fulltext01.pdf https://www.diva-portal.org/smash/get/diva2:831032/fulltext01.pdf tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(3), 187-194. international journal of economics and financial issues | vol 10 • issue 3 • 2020 187 the impact of ownership structure on vietnamese commercial banks’ profitability van-thep nguyen*, day-yang liu graduate institute of finance, national taiwan university of science and technology, taiwan. *email: nvthep@ctu.edu.vn received: 10 april 2020 accepted: 10 may 2020 doi: https://doi.org/10.32479/ijefi.9760 abstract this study aims to check whether ownership structure affects vietnamese commercial banks’ profitability or not and identify factors influencing vietnamese commercial banks’ profitability as well. utilizing the bayesian model averaging (bma) model applying for 21 commercial banks in the period 2010-2017, the authors found that bank ownership is statistically significant and the sign of the correlation coefficient is negative, indicating that state-owned commercial banks are less efficient than other commercial banks. also, the empirical findings show that there are some factors affecting the profitability of commercial banks in vietnam such as credit risk, capital adequacy ratio, cost-income ratio, staff expenses, and asset growth rate, where credit risk and cost-income ratio have a negative relation to banks’ profitability. keywords: bank profitability, bayesian model averaging, commercial, ownership structure, vietnam jel classifications: g15, g21, g28 1. introduction financial intermediaries play a very important role in most economies through a variety of activities such as providing payment instruments, bridging for customers, as well as promoting transparency in the market, and managing risk. based on their functions, commercial banks are often seen as one of the most influential institutions in an economy. similar to other financial intermediaries, the ultimate goal of commercial banks is for profitability, as it is a prerequisite for any enterprises to survive, help withstands the economic shocks as well as the financial crisis. determining factors affecting commercial banks’ profitability, therefore, has become a matter of concern and implementation by researchers around the world (short, 1979; bourke, 1989; molyneux and thornton, 1992). these studies indicating that there are a plenty of factors affecting bank’s profitability, of which the remarkable variable is ownership structure, which is found with the conflict findings between previous studies. specifically, molyneux and thornton (1992) concluded that there is a statistically significant positive relationship between bank profitability and government ownership. meanwhile, previously, short (1979), and bourke (1989) suggested that state-owned banks generate less profit than their competitors. the vietnamese commercial banking system with the total assets as of the end of 2018 reached vnd 10,555 trillion, up 10.49% compared to the previous year, and the total profit after tax reached nearly vnd 100,000 billion, up about 25,31% compared to the previous year (state bank of vietnam, 2018). although there are more competitive advantages than other commercial banks due to the availability of cheaper funding thanks to the reputation of the state, the profitability of state-owned commercial banks is still at a low level in the rankings. previously, the leading banks in terms of profitability usually belonged to state-owned commercial banks such as vcb, ctg, and bid. however, there was a change in this ranking in 2018, the profitability of bid, ctg almost caught up by joint-stock commercial banks such as tcb, vpbank, and mbb. it is worth mentioning that agribank, a 100% stateowned commercial bank, had a lower profitability rate than other competitors. the question here is whether ownership structure this journal is licensed under a creative commons attribution 4.0 international license nguyen and liu: the impact of ownership structure on vietnamese commercial banks’ profitability international journal of economics and financial issues | vol 10 • issue 3 • 2020188 affects vietnamese commercial banks’ profitability or not, and in addition to the ownership structure, are there any other factors affecting vietnamese commercial banks’ profitability as well. to our knowledge, there are some studies on factors affecting of vietnamese commercial banks’ profitability. however, there have been no studies on the impact of ownership structure on vietnamese commercial banks’ profitability. derived from these problems, the authors carry out a study on the topic “the impact of ownership structure on vietnamese commercial banks’ profitability” in the period of 2010-2017 to have empirical support. the rest of the paper is structured as follows. section 2 provides a literature review on the determinants of bank profitability. section 3 describes research and methodology. section 4 shows empirical results and discussions. finally, section 5 offers some conclusions. 2. literature review molyneux and thornton (1992) studied factors affecting european bank profitability in the period of 1986-1989. they found that concentration, government ownership, and nominal interest rates affect banks’ profitability positively. however, short (1979), and bourke (1989) concluded that state-owned commercial banks create lower profitability than their competitors. kosmidou and pasiouras (2007) studied determinants of the commercial banks’ profitability in the european union between 1995 and 2001 and concluded that capital adequacy ratio, inflation rate, gdp, c5 concentration, and liquidity ratio affect banks’ profitability positively. in contrast, they found that the cost-income ratio and bank size affect banks’ profitability negatively. athanasoglou et al. (2008) studied the determinants of profitability in the greek banking industry covers the period 1985-2001 and concluded that capital adequacy ratio, productivity growth, business cycle, and inflation affect profitability positively, whereas, credit risk and operating expenses affect banks’ profitability negatively. in light of athanasoglou et al. (2008) contributions, dietrich and wanzenried (2011) found that the banks’ profitability and lagged banks’ profitability and business cycle in switzerland have a positive relationship, whereas, cost-income ratio, interest income, taxation affect banks’ profitability negatively when considering all years. furthermore, they suggested that bank ownership, car, and loan loss provisions affect banks’ profitability positively, whereas, the yearly growth of deposits and bank size affect banks’ profitability negatively. also, they found evidence that the market structure affects banks’ profitability positively, whereas, the funding costs affect banks’ profitability negatively before the crisis. in addition, djalilov and piesse (2016) analyzed determinants of bank profitability in transition countries in the period 2000-2013, emphasized that credit risk, government spending, monetary freedom, as well as squared terms of government spending and monetary freedom affect banks’ profitability negatively. moreover, they also found a piece of evidence shows that the capital adequacy ratio affect banks’ profitability positively in early transition countries. 3. research and methodology 3.1. data sources to estimate the impact of ownership structure on vietnamese commercial banks’ profitability, a panel data of 21 commercial banks with 168 observations covering the period 2010–2017 is employed1. 3.2. empirical models 3.2.1. dependent variable the dependent variable is the ratio of net profit after tax to average assets, denoted by roa. the roa of vietnamese commercial banks over the 2010-2017 period shown in table 1. 3.2.2. independent variables bank ownership, denoted by govt. it is a dummy variable, which is assigned value equals to 1 if a bank is the state-owned commercial bank (nationalized bank), equals to 0 if otherwise (private bank). according to the previous studies, only molyneux and thornton (1992) found evidence that the nationalized banks are more efficient than private banks, whereas, most authors found the opposite results (short, 1979; bourke, 1989; marriott and molyneux, 1991; barth et al., 2004; innotta et al., 2007; and dietrich and wanzenried, 2011), suggesting that the nationalized banks are less efficient than private banks. in addition to bank ownership (govt), the authors also employ some control variables related to bank characteristics to determine whether these variables affect vietnamese commercial banks’ profitability or not. these bank characteristics variables include credit risk (cred), bank size (size), capital adequacy ratio (car), liquidity ratio (ldr), staff expenses (se), deposit growth rate (dgr), asset growth rate (agr), and cost-income ratio (cir). cred is estimated by non-performing loans ratio, where the nonperforming loans is the sum of non-accrual loans and all loans that are past due for ninety days or more (stiroh and metli, 2003, lu and whidbee, 2013, ghosh, 2015, and tarchouna et al., 2017). according to athanasoglou et al. (2008), credit risk reduces banks’ returns, opposite to the study findings of djalilov and piesse (2016) on the early reforming countries’ findings. size, represents the bank size, estimated by using the logarithm of total assets (chaibi and ftiti, 2015). according to the previous 1 vietnam bank for agriculture and rural development (agribank), joint stock commercial bank for investment and development of vietnam (bid), vietnam joint stock commercial bank for industry and trade (ctg), bank for foreign trade of vietnam (vcb), joint-stock commercial banks: an binh commercial joint stock bank (abbank), asia commercial bank (acb), vietnam export import commercial joint stock bank (eib), housing development commercial joint stock bank (hdb), kien long commercial joint stock bank (klb), lien viet post joint stock commercial bank (lpb), military commercial joint stock bank (mbb), nam a commercial joint stock bank (namabank), national citizen commercial joint stock bank (ncb), petrolimex group commercial joint stock bank (pgbank), sai gon joint stock commercial bank (scb), saigon bank for industry and trade (sgb), saigon hanoi commercial joint stock bank (shb), sai gon thuong tin commercial joint stock bank (stb), vietnam technological and commercial joint stock bank (tcb), vietnam international commercial joint stock bank (vib), and vietnam prosperity joint stock commercial bank (vpb). nguyen and liu: the impact of ownership structure on vietnamese commercial banks’ profitability international journal of economics and financial issues | vol 10 • issue 3 • 2020 189 studies, the authors concluded that bank size effect on banks’ profitability negatively (kosmidou and pasiouras, 2007; dietrich and wanzenried, 2011), meaning that the bank has a large size is less profitable than the bank has a small size. also, the authors took the square of size as an independent variable to allow for non-linear effects. car, represents the capital adequacy ratio. this ratio is calculated by taking capital to divide total risk-weighted assets. dietrich and wanzenried (2011) found that car and banks’ profitability have a significantly negative relationship during the crisis. numerous existing studies, however, found a shred of evidence that car and banks’ profitability have a significantly positive relationship (bourke, 1989; goddard et al., 2004; kosmidou and pasiouras, 2007; athanasoglou et al., 2008). there are several studies on the impact of liquidity ratio (denoted by ldr) on banks’ profitability. according to molyneux and thornton (1992), they concluded that liquidity ratio affect banks’ profitability negatively, meaning that the more the bank holds liquidity assets, the more opportunity costs arise, resulting in lower profitability. conversely, bourke (1989), and kosmidou and pasiouras (2007) stated that liquidity ratio affect banks’ profitability positively. staff expenses, denoted by se. this variable is measured by taking staff expenses to divide total assets, according to bourke (1989), the lower the ratio, the higher the bank profitability. the yearly growth of deposits variable (dgr), according to dietrich and wanzenried (2011), they found that the deposit growth rate affects banks’ profitability negatively, suggesting that the more the deposit growth rate, the lower profitability the banks obtain. similar to dgr, the result also shows that the assets growth rate (agr) and banks’ profitability have a negative relationship (short, 1979). the final independent variable, cir, represents the cost-income ratio. according to kosmidou and pasiouras (2007), and dietrich and wanzenried (2011), the cost-income ratio has a negative relation to the banks’ profitability, indicating that the greater the cost-income ratio, the lower profitability the banks obtain. 3.2.3. model constructions the authors construct a multiple regression model to estimate the impact of ownership structure on vietnamese commercial banks’ profitability. this model arises as follows: bp govt xi t i t k n k ki t i i t, , , ,� � � � � � �� � � � �0 1 2 (1) where the subscripts i = 1,…, n denotes the cross sections; t = 1,…, t denotes the number of periods of the panel data; bp denotes bank profitability; β0 is the constant term; xk is the vector of bank characteristics variables, is the unobserved bank individual effects and εit is the error term. xk is the vector of bank characteristics variables shown in table 2. in addition, according to hoeting et al. (1999), to ignore the uncertainty in a model selection with over-confident inferences, the authors also utilise bayesian model averaging (bma) approach supported by the r statistical software. in this approach, the results will present a few optimal models. based on the bic value, the authors can choose the most optimal model (the lowest the bic value, the most optimal the model). 4. empirical result and discussion 4.1. unit root test to determine whether the variables are stationary or not, the authors use fisher-type panel unit root tests, and the results are shown in table 3. table 1: the ratio of net profit after tax to average assets (roa) bank 2017 (%) 2016 (%) 2015 (%) 2014 (%) 2013 (%) 2012 (%) 2011 (%) 2010 (%) agribank 0.36 0.32 0.29 0.24 0.26 0.42 0.42 0.26 bid 0.63 0.67 0.85 0.83 0.78 0.58 0.13 0.89 ctg 0.73 0.79 0.79 0.93 1.08 1.28 1.51 1.12 vcb 1.00 0.94 0.85 0.88 0.99 1.13 1.25 1.50 abbank 0.62 0.35 0.14 0.19 0.27 0.91 0.77 1.54 acb 0.82 0.61 0.54 0.55 0.48 0.34 1.32 1.25 eib 0.59 0.24 0.03 0.03 0.39 1.21 1.93 1.85 hdb 1.15 0.71 0.61 0.51 0.31 0.67 1.07 1.01 klb 0.60 0.43 0.68 0.79 1.57 1.93 2.59 1.95 lpb 0.57 0.90 0.85 0.34 0.52 0.78 1.42 2.14 mbb 1.22 1.21 1.19 1.31 1.28 1.48 1.54 1.95 namabank 0.49 0.08 0.53 0.57 0.60 1.03 1.43 1.09 ncb 0.03 0.02 0.02 0.02 0.07 0.01 0.78 0.81 pgbank 0.24 0.50 0.16 0.52 0.17 1.30 2.63 1.63 scb 0.03 0.02 0.03 0.04 0.03 0.06 0.58 0.49 sgb 0.27 0.76 0.26 1.19 1.17 1.97 1.89 5.57 shb 0.59 0.42 0.43 0.51 0.65 0.03 1.23 1.26 stb 0.34 0.03 0.27 1.26 1.42 0.68 1.36 1.49 tcb 2.55 1.47 0.83 0.65 0.39 0.42 1.91 1.71 vib 0.99 0.59 0.63 0.66 0.07 0.64 0.67 1.05 vpb 2.54 1.86 1.34 0.88 0.91 0.69 1.12 1.15 source: financial statement of commercial banks (2010-2017) nguyen and liu: the impact of ownership structure on vietnamese commercial banks’ profitability international journal of economics and financial issues | vol 10 • issue 3 • 2020190 based on table 3, we can see that all variables in the model are stationary in both augmented dickey-fuller and phillips-perron tests (p < 10% significance level). 4.2. the difference in bank ownership figure 1 shows the difference in bank ownership (state-owned commercial banks and other commercial banks) for eight indicators, (a) credit risk, (b) bank size, (c) capital adequacy ratio, (d) liquidity ratio, (e) staff expenses, (f) deposit growth rate, (g) assets growth rate and (h) cost-income ratio. figure 1 shows that only the mean of bank size and staff expenses are higher in state-owned commercial banks than in other commercial banks, whereas, the mean of credit risk, capital adequacy ratio, liquidity ratio, deposit growth rate, assets growth rate, and cost-income ratio are lower in state-owned commercial banks than in their competitors. also, table 4 shows that the differences in the mean of credit risk, staff expenses, and assets growth rate were statistically insignificant (p-value is greater than a 10% significance level), and the differences in the mean of remaining indicators were statistically significant (p < 10% significance level). before checking whether ownership structure affects vietnamese commercial banks’ profitability or not and identifying factors affecting vietnamese commercial banks’ profitability as well, the authors first analyze the correlation matrix, as well as the variance inflation factor (vif) of the independent variables included in the model, as shown in tables 5 and 6. tables 5 and 6 show that the correlation between independent variables is relatively low (smaller than 0.8, and vif < 10), meaning that there is no multicollinearity between independent variables. also, the authors conduct the breusch-pagan, and ramsey’s reset test to check heteroscedasticity, and omitted variables, and the results are shown in table 7. based on table 7, we can see that the model is no omit variable (p < 1% significance level) and there is no heteroscedasticity (p < 5% significance level). to check whether ownership structure affects vietnamese commercial banks’ profitability or not and identify factors affecting vietnamese commercial banks’ profitability as well, the authors perform multiple regression with the bma model as follows, and the results are shown in table 8. roa govt cred size size car i t i t i t i t i t i , , , , , , � � � � � � � � � � � � 0 1 2 3 4 2 5 tt i t i t i t i t i t i i t ldr se dgr agr cir � � � � � � � � � � � � � � 6 7 8 9 10 , , , , , , (5) table 8 shows that there are 05 best models selected based on the bma model approach. based on table 8, we can see the importance of the explanatory variables presented in the second table 2: definition of variables and previous empirical findings dependent variable definition roa the ratio of net profit after tax to average assets independent variables variables definition positive authors expected signnegative bank ownership govt it is a dummy variable, which is assigned value equals to 1 if the bank is state-owned commercial bank (nationalized bank), equals to 0 if otherwise (private bank) molyneux and thornton (1992) short, 1979; bourke, 1989; marriott and molyneux, 1991; barth et al., 2004; innotta et al., 2007; dietrich and wanzenried, 2011 ± bank-specific variables credit risk (cred) it is estimated by non-performing loans ratio, where the non-performing loans is the sum of non-accrual loans and all loans that are past due for ninety days or more djalilov and piesse (2016) athanasoglou et al. (2008) ± bank size (size) it is estimated by using the logarithm of total assets kosmidou and pasiouras (2007); dietrich and wanzenried (2011) u-shape capital adequacy ratio it is calculated by taking capital to divide total risk-weighted assets. bourke, 1989; goddard et al., 2004; kosmidou and pasiouras, 2007; athanasoglou et al., 2008 dietrich and wanzenried (2011) ± liquidity ratio cash, bank deposits, and investment securities to total assets bourke (1989); kosmidou and pasiouras (2007) molyneux and thornton (1992) ± staff expenses staff expenses to total assets bourke (1989) deposit growth rate the yearly growth of deposits dietrich and wanzenried (2011) asset growth rate the yearly growth of asset short, 1979 cost-income ratio cost to income kosmidou and pasiouras (2007); dietrich and wanzenried (2011) nguyen and liu: the impact of ownership structure on vietnamese commercial banks’ profitability international journal of economics and financial issues | vol 10 • issue 3 • 2020 191 column (p! = 0) representing the probability of occurrence of variables in the models. specifically, the probability of occurrence of se, agr, and cir in all models is almost 100%, the probability of occurrence of cred is 77.9%, the probability of occurrence of car is 74.1%, and the probability of occurrence of govt is 66.8%. in contrast, the probability of occurrence of variables such as ldr, size, size2, and dgr is at a very low level (<20%). in addition, looking at table 8, we can see that the optimal model is the model with statistically significant variables including govt, cred, car, se, agr, and cir, where se is the most influential variable and is positively correlated with the profitability of commercial banks in vietnam and the probability of this model is 26%. the second optimal model only includes table 4: the t-test for eight indicators indicators mean t p-value state-owned commercial banks (%) other commercial banks (%) credit risk 2.39 2.50 0.35 0.73 bank size 8.80 7.91 −19.56 0.00 capital adequacy ratio 9.96 14.51 8.25 0.00 liquidity ratio 29.84 36.94 4.36 0.00 staff expenses 0.91 0.84 −1.33 0.19 deposit growth rate 19.72 25.22 2.16 0.03 assets growth rate 17.88 22.15 1.63 0.11 cost income ratio 48.94 54.10 1.93 0.06 source: the authors’ calculation table 5: correlation matrix govt cred size car ldr se dgr agr cir govt 1.00 cred ‒0.02 1.00 size 0.68 ‒0.10 1.00 car ‒0.38 ‒0.01 ‒0.68 1.00 ldr ‒0.27 ‒0.19 ‒0.15 0.09 1.00 se 0.10 0.15 ‒0.03 0.15 ‒0.41 1.00 dgr ‒0.10 0.05 ‒0.09 ‒0.03 0.26 ‒0.42 1.00 agr ‒0.07 ‒0.07 ‒0.07 0.01 0.29 ‒0.43 0.63 1.00 cir ‒0.15 0.27 ‒0.10 ‒0.14 ‒0.23 0.11 0.00 ‒0.20 1.00 source: the authors’ calculation table 3: panel unit root tests (fisher-type unit root test) variables fisher-augmented dickey-fuller fisher-phillipsperron roa ‒7.9706*** ‒7.3954*** bank ownership ‒2.6087* ‒2.7299* credit risk ‒7.5851*** ‒6.3036*** bank size ‒3.3354** ‒3.3264** capital adequacy ratio ‒6.9811*** ‒7.1133*** liquidity ratio ‒6.0351*** ‒4.9799*** staff expenses ‒5.9403*** ‒5.9319*** deposit growth rate ‒6.6392*** ‒10.6985*** asset growth rate ‒10.8853*** ‒10.7565*** cost-income ratio ‒6.7714*** ‒6.2246*** reported unit root tests were conducted with one lag, where ***, **, and * denote for significant at 1%, 5%, and 10% level, respectively figure 1: bank ownership structure and eight indicators nguyen and liu: the impact of ownership structure on vietnamese commercial banks’ profitability international journal of economics and financial issues | vol 10 • issue 3 • 2020192 05 statistically significant variables, govt, cred, se, agr, and cir. however, the probability of this model is relatively low (only 10.4%). the other three models can also be good models for checking and analyzing the factors affecting the profitability of commercial banks in vietnam (probability of these models are less than 10%). to get a better overview of the models, we can look further at figure 2. based on figure 2, we can see that a total of 20 models have been selected, and se, agr, and cir are always statistically significant in all models. however, the correlation coefficients of these variables with the profitability of commercial banks in vietnam are contradictory (se and agr are positively correlated, whereas, cir is negatively correlated). the next important and statistically significant factors are cred, car, and govt. factors such as ldr, size, size2, and dgr, although these variables are likely to affect the profitability of commercial banks in vietnam, they are not as strong as these factors mentioned above. in conclusion, with the lowest bic value in the selected models, model 1 is considered the most optimal model. this model is modeled by 06 variables including govt, cred, car, se, agr, and cir, and these variables explain 69.5% of the change in the profitability of vietnamese commercial banks (r2 = 69.5%). the relationship between independent variables with statistical significance and dependent variables is explained as follows: first, the authors will rely on the govt variable to check if the ownership structure affects the profitability of vietnamese commercial banks. the result shows that this variable is statistically significant, and the sign of the correlation coefficient is negative. this result is similar to the studies of short (1979), bourke (1989), marriott and molyneux (1991), barth et al. (2004), innotta et al. (2007), and dietrich and wanzenried (2011), meaning that state-owned commercial banks are less efficient than other commercial banks. in fact, up to now, the number of state-owned commercial banks in vietnam is 07, of which 03 are taken over by the state bank of vietnam due to poor performance (oceanbank, gpbank, and vncb), 01 bank with 100% stakes owned by the state (agribank), and 03 commercial banks with more than 50% stakes owned by the state (vcb, ctg, and bid). however, in recent years, although there are more advantages thanks to the reputation of the state, these banks have not operated effectively. notably, agribank’s non-performing loans are always high compared to other banks (there are years with non-performing loans ratios of over 6%). besides, these banks also need to pay more attention to recruiting and training. a series of banker employees’ problems mostly belong to state-owned commercial banks. this is the reason why despite a large number of deposits from customers and good loans, the profitability of banks is still low compared to competitors. in addition to the ownership structure, the authors also identified a number of variables affecting the profitability of vietnamese commercial banks. factor has the greatest positively impact on the profitability of commercial banks in vietnam is se. to be specific, with a 1% increase staff expenses, the profitability of the bank is increased by about 0.84% and vice versa, holding other factors fixed. this result is contrary to the original expectation of the authors, as well as contrary to the study of bourke (1989) that the higher the ratio of staff expenses to total assets, the lower the profitability of the bank. it can be seen that to enhance competitiveness in integration, the personnel of commercial banks must not only meet the quantity requirements but also must ensure the quality. however, in order to have a quantity and quality table 6: the variance inflation factor (vif) of the independent variables variables vif 1/vif variables vif 1/vif govt 2.0802 0.4807 se 1.5119 0.6614 cred 1.1429 0.8750 dgr 1.8453 0.5419 size 3.1883 0.3136 agr 1.8790 0.5322 car 2.1167 0.4724 cir 1.3101 0.7633 ldr 1.4005 0.7140 mean vif 1.8305 source: the authors’ calculation table 7: breusch-pagan and ramsey’s reset test breusch-pagan test ramsey’s reset test breusch-pagan=18.268 p=0.03219 reset=56.722 p=0.0000 df=9 df1=2, df2=156 source: the authors’ calculation table 8: bma including year-fixed effect variables p!=0 model 1 model 2 model 3 model 4 model 5 intercept 100.0 0.018700 0.021930 0.016580 0.018300 0.013190 govt 66.8 ‒0.002328 ‒0.003338 ‒0.002302 cred 77.9 ‒0.049500 ‒0.051300 ‒0.048970 ‒0.043220 size 9.7 size2 9.9 car 74.1 0.019580 0.028280 0.020330 0.027130 ldr 16.2 0.006435 se 100.0 0.839700 0.912900 0.784100 0.796000 0.860900 dgr 2.5 agr 100.0 0.006109 0.006065 0.006338 0.006239 0.006187 cir 100.0 ‒0.031040 ‒0.032210 ‒0.029570 ‒0.033010 ‒0.029230 yearly-fixed effect yes yes yes yes yes r2 0.695 0.682 0.682 0.682 0.689 bic ‒163.8 ‒162.0 ‒161.8 ‒161.6 ‒160.2 post prob 0.260 0.104 0.096 0.087 0.043 source: the authors’ calculation nguyen and liu: the impact of ownership structure on vietnamese commercial banks’ profitability international journal of economics and financial issues | vol 10 • issue 3 • 2020 193 workforce, commercial banks need to develop a human resource development strategy in line with the development requirements of each bank. along with that, banks must also focus on training to improve their professional qualifications, career skills, foreign language knowledge, ability to apply modern technology, as well as executive management capacity. although these increases the bank’s operating expenses, it is very effective in generating profitability. although staff expenses have a positive effect, the cost-income ratio is negatively correlated with the profitability of vietnamese commercial banks. specifically, when the cost-income ratio increased by 1%, the profitability of vietnamese commercial banks decreased by about 0.03% and vice versa, holding other factors fixed. this result is similar to the studies of kosmidou and pasiouras (2007), and dietrich and wanzenried (2011). also, table 8 points out that cred is one of the most important factor affecting the bank profitability of commercial banks in vietnam negatively, suggesting that the higher the credit risk, the lower the probability of the bank. to be specific, with a 1% increase in credit risk, the profitability of the bank is decreased by about 0.05% and vice versa, holding other factors fixed. this shows that in order to improve profitability, vietnamese commercial banks need to control the cost-income ratio well. one of the costs is the provision for credit losses. these are expenses to prevent possible losses due to customers not fulfilling their committed obligations. the determination of the level of provision for credit losses is based on the debt classification of banks. currently, according to circular no. 09/2014/tt-nhnn of the sbv, the specific credit risk provision for each debt group is as follows: group 1: 0%, group 2: 5%, group 3: 20%, group 4: 50%, and group 5: 100%. the level of general provision for credit losses is determined by 0.75% of the total outstanding loans from group 1 to group 4. to minimize the cost of provisioning for credit losses, therefore, vietnamese commercial banks need to check and supervise loans well to limit credit risks. also, banks need to require borrowers to buy credit insurance. this is considered tool of a highly developed financial market to help banks prevent and hedge credit risk, share risks and create flexibility in managing the loan portfolio of each bank. the results also indicate that there is a significantly positive relationship between capital adequacy ratio and the profitability of commercial banks in vietnam. to be specific, with a 1% increase in capital adequacy ratio, the profitability of the bank is increased by about 0.02%, holding other factors fixed. this result is similar to the studies of bourke (1989), goddard et al. (2004), kosmidou and pasiouras (2007), and athanasoglou et al. (2008), indicating that the higher the capital adequacy ratio, the greater the profitability of commercial banks in vietnam. therefore, in addition to ensuring this ratio as prescribed by the sbv (according to circular no. 41/2016/tt-nhnn with a minimum of 8%), banks also need to improve this ratio. to accomplish this, besides raising capital, banks need to restructure their asset portfolios to reduce the proportion of high-risk assets. although the bank size variable is almost not statistically significant in the models, the asset growth rate has a positive effect on the profitability of vietnamese commercial banks. to be specific, with a 1% increase in asset growth rate, the profitability of the bank is increased by about 0.006%, holding other factors fixed. this result is contrary to the studies of short (1979), indicating that the higher the asset growth rate, the greater the profitability of commercial banks in vietnam. based on the characteristics of vietnamese commercial banks, outstanding loans are the item that accounts for the largest proportion of total assets, and this is also the item that brings the most income to banks. as a result, the asset growth rate is the same as that of outstanding loans. when the outstanding loans increase will increase the profitability of banks. however, banks also need to check and monitor outstanding loans so that the risks are at the lowest level. 5. conclusion similar to other financial intermediaries, the ultimate goal of commercial banks is for profitability, as it is a prerequisite for any enterprises to survive, help withstands the economic shocks, as well as the financial crisis. this study checks whether ownership structure affecting vietnamese commercial banks’ profitability or not and identifies factors affecting vietnamese commercial banks’ profitability as well. the results conclude that bank ownership is statistically significant and the sign of the correlation coefficient is negative, indicating that state-owned commercial banks are less efficient than other commercial banks. also, the empirical findings figure 2: models selected by bma including year-fixed effect nguyen and liu: the impact of ownership structure on vietnamese commercial banks’ profitability international journal of economics and financial issues | vol 10 • issue 3 • 2020194 show that there are some factors affecting the profitability of commercial banks in vietnam such as credit risk, capital adequacy ratio, cost-income ratio, staff expenses, and asset growth rate, where credit risk and cost-income ratio have a negative relation to banks’ profitability. references athanasoglou, p.p., brissimis, s.n., delis, m.d. (2008), bank-specific, industry-specific and macroeconomic determinants of bank profitability. journal of international financial markets institutions and money, 18, 121-136. barth, j., caprio, g., levine, r. (2004), bank regulation and supervision: what works best? journal of financial intermediation, 13, 205-248. bourke, p. (1989), concentration and other determinants of bank profitability in europe, north america and australia. journal of banking and finance, 13(1), 65-79. chaibi, h., ftiti, z. (2015), credit risk determinants: evidence from a cross-country study. research in international business and finance, 33, 1-16. dietrich, a., wanzenried, g. (2011), determinants of bank profitability before and during the crisis: evidence from switzerland. journal of international financial markets institutions and money, 21(3), 307-327. djalilov, k., piesse, j. (2016), determinants of bank profitability in transition countries: what matters most? research in international business and finance, 38(c), 69-82. ghosh, a. (2015), banking-industry specific and regional economic determinants of non-performing loans: evidence from us states. journal of financial stability, 20, 93-104. goddard, j., molyneux, p., wilson, j. (2004), the profitability of european banks: a cross-sectional and dynamic panel analysis. the manchester school, 72(3), 363-381. hoeting, j.a., madigan, d., raftery, a.e., volinsky, c.t. (1999), bayesian model averaging: a tutorial. statistical science, 14, 382-401. innotta, g., nocera, g., sironi, a. (2007), ownership structure, risk and performance in european banking industry. journal of banking and finance, 31, 2127-2149. kosmidou, m., pasiouras, f. (2007), factors influencing the profitability of domestic and foreign commercial banks in the european union. research in international business and finance, 21(2), 222-237. lu, w., whidbee, d.a. (2013), bank structure and failure during the financial crisis. journal of financial economic policy, 5, 281-299. marriott, a., molyneux, p. (1991), determinants of large bank profitability in europe. new york: mimeo, inc. pl-7. molyneux, p., thornton, j. (1992), the determinants of european bank profitability. journal of banking and finance, 16, 1173-1178. short, b. (1979), the relation between commercial bank profit rates and banking concentration in canada, western europe and japan. journal of banking and finance, 3(3), 209-219. stiroh, k.j., metli, c. (2003), now and then: the evolution of loan quality for us banks. united states: federal reserve bank of new york. tarchounaa, a., jarrayab, b., bouric, a. (2017), how to explain non-performing loans by many corporate governance variables simultaneously? a corporate governance index is built to us commercial banks. research in international business and finance, 42, 645-657. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(1), 259-265. international journal of economics and financial issues | vol 10 • issue 1 • 2020 259 rice consumption pattern of rural households in east oku and south oku regencies south sumatra province indonesia imam asngari1*, suhel suhel1, abdul bashir1, andi nurul a. arief2, era susanti3 1department of development economics, faculty of economics, universitas sriwijaya, palembang, indonseia, 2student at magister of economics, faculty of economics, universitas sriwijaya, palembang, indonesia, 3department of development economics (alumny), faculty of economics, universitas sriwijaya, indonesia. *email: imam.asngari@unsri.ac.id received: 11 november 2019 accepted: 06 january 2020 doi: https://doi.org/10.32479/ijefi.9094 abstract this study is to examine the pattern of rice consumption of rural households case study in east oku regency and south oku regency, south sumatra province indonesia. south oku regency is a paddy production center, and south oku regency is a coffee plantation center, not a rice producer. this study is field research by using household expenditure of 200 head of the family collected by using questionnaires. method of analyzing rice food consumption by using descriptive quantitative approaches and multiple logistic regression models. the results show that rural household spending was dominated by proportional rice food consumption. household rice food consumption has significantly influenced the price of wheat, family income, and the number of family members. factors the price of rice, working times, and total assets have different significance on influence rice consumption in east oku and south oku. keywords: household rice consumption, food price, income, work hour, numbers of family jel classifications: d11, d12, d16, q18, r22 1. introduction rice is a basic and strategic need for most people in indonesia, so the availability of rice food in south sumatra must be always guaranteed (adam et al., 2017). humans with all their abilities always try to meet their needs with a variety of businesses. first, business by utilizing nature as it is (natural) by planting various food plants. second, modify nature using technology to meet food production according to their needs. fulfillment of food needs is an obligation of the government and the community together as stated by law concerning food (law number 18 of 2012). the law states that food is the most important basic human need and its fulfillment is part of human rights, the state is also obliged to realize the availability, affordability, and fulfillment of consumption (ministry of agriculture, 2017). based on the level of welfare of the indonesian people as measured by the share of food expenditure, both in urban and rural areas is getting better. there is a change in the pattern of public expenditure from dominant in the grains group to the food and beverage group (central bureau statistic, 2014). while spending patterns for other food groups are relatively the same from year to year (ministry of trade, 2013). the issue of the world food crisis is closely related to the issue of global climate changes (fao, 2010). the economic crisis of developed countries since 2008 still leaves a weakening of their purchasing power of agricultural products and industrial raw materials (ejeta, 2009). weakening purchasing power of developed countries has affected the plummet of world primary commodities including food commodities from 2008 to 2016. the dynamics of the global economy have driven volatility in food and energy prices (ministry of agriculture, 2016). the impact of the decline in prices of primary agricultural commodities on world markets since the 2008 global crisis has been the decline in the welfare of rural populations. this journal is licensed under a creative commons attribution 4.0 international license asngari, et al.: rice consumption pattern of rural households in east oku and south oku regencies south sumatra province indonesia international journal of economics and financial issues | vol 10 • issue 1 • 2020260 table 1 confirms that the percentage of the population of the rich has decreased, shifted to the middle class, and from the lower middle class to the poor (using monthly per capita income of less than rp. 365,000). expenditures per capita of the population in east oku regency are concentrated in the expenditure intervals of rp. 750,000 to rp. 1,499,999 per month around 44.73% (2016), and decreased to around 41.90% (2017). whereas in south oku, the majority of monthly household expenditure at intervals of rp. 300,000 to rp. 749,999 was 60.34% (2016) and slightly decreased to around 49.93% (central bureau of statistic, 2018). this decline in expenditure groups occurred because part of the community’s income was reduced, as indicated by the increase in the population whose per capita spending was less than rp. 500,000 in east oku from 8.65%, up to 9.09% (central bureau of statistic, 2018). likewise in south oku, the number of residents whose expenditure is below the interval of rp. 300,000 per month increased from 15.44% (2016) to around 27.49% (2017). based on the data table 2 from the central bureau statistics (2018), the average growth in spending on household food consumption in 2017 decreased by 0.05%. the highest expenditure growth for food consumption was dominated by four food groups such as meat, tubers, processed food, and beverages, tobacco, and betel which grew around 0.23-0.5%. however, in 2017 was food groups, that had to grow negatively such as grains, nuts, fruits, oils and fats, beverage ingredients, and spices with an average decline of 0.16%. if the proportion of expenditure for the food group is calculated, the highest is dominated by grains (rice) by 15.6% in east oku and 12.9% in south oku. furthermore, the proportion of processed food and beverages is around 10.06-18.6%, tobacco and betel leaves around 9.79% to 15.97%, and vegetables around 7.43% to 9.59% (table 2). the data in table 2 can also provide information on the proportion of household expenditure per capita for each food group per month in the regency of east oku and south oku. the development of expenditure for food consumption has changed during 2016-2017, the change can be caused by rising food prices and household income, as well as the current pattern of household consumption that is changing. an interesting phenomenon shows that the proportion of consumption for grains is now smaller than the consumption of the food and beverage group, and the tobacco and betel groups, this indicates that households have reduced the demand for food consumption with more practical consumption of food and beverages. the phenomenon of the decline in the proportion of household spending on food such as grains also occurs in other provinces such as in east java (mayasari et al., 2018), which indicates an increase in prosperity in the region. therefore, what is interesting to study now is that investigating the response of households to rising food prices will provide policy advice to the government. the government can implement subsidized input prices and appropriate food prices. this study will also provide information about trends in changes in food consumption over time and become a guide for the development of food diversification in the future (ariani and purwati, 2015; rizov et al., 2015). rice food is a food commodity produced from processed agricultural products, namely rice. east oku regency is a rice production center and rice producer in south sumatra (asngari and sudiro, 2010), while south oku regency is a coffee plantation producer. nevertheless, the position of rice commodity for most of the population in the two regencies is the main food ingredient besides being an important source of nutrition in the food structure (firdaus and cahyono, 2017; kumar et al., 2017), so that the aspect of rice supply becomes very important considering the population in the province of south sumatra is getting bigger. the pattern of rice food consumption for rural households is interesting to study more deeply in order to obtain information on the response of household rice food demand to changes in income, food prices, a number of family members, hours worked and the number of assets. if household income does not change, while the price of rice food rises, households will respond by reducing the table 1: percentage of population by expenditure groups per capita for a month in east oku regency and south oku regency expenditure class (in rupiah) population in east oku (%) population in south oku (%) 2016 2017 2016 2017 <150,000 0.00 0.00 0.00 0.78 150,000-199,999 0.00 4.92 0.00 4.88 200,000-299,999 0.00 0.00 15.44 22.61 300,000-499,999 8.65 9.09 41.48 30.24 500,000-749,999 11.99 12.35 19.86 19.69 750,000-999,999 20.84 18.21 11.71 8.41 1,000,000-1,499,999 23.99 23.69 7.69 6.59 >1,500,000 34.53 31.74 3.82 6.79 jumlah/total 100.00 100.00 100.00 100.00 source: central bureau of statistics, 2018 table 2: average expenditure on food consumption in east oku and south oku regencies food group average spending per a month’s capita (rp) east oku south oku 2016 2017 2016 2017 grains 61,614 58,971 76,435 54,153 tubers 2493 2460 2434 3380 fish, shrimp, squid, mussels 30174 38163 27925 29942 meat 13.699 10472 10215 15423 eggs and milk 21672 25784 17766 21050 vegetables 41676 36644 40880 44828 nuts 12412 13325 8052 7208 fruits 13690 17978 10342 8031 oil and fat 13986 13306 10802 9401 beverage ingredients 15773 15757 20859 18616 spices 10273 8772 9246 8031 other consumption 7638 8553 8627 9622 food and beverage 84266 71055 45236 60690 tobacco and betel 65784 61043 77140 59060 total 395150 382283 365959 349435 source: central bureau of statistics, 2018 asngari, et al.: rice consumption pattern of rural households in east oku and south oku regencies south sumatra province indonesia international journal of economics and financial issues | vol 10 • issue 1 • 2020 261 demand for rice food and or replacing it with cheaper rice food such as low-quality rice or for some residents whose income level is low will turn to consumption other foods such as oyek or tiwul which are made from cassava. the response of households to the increase in rice food prices can be a guide for the government to implement rice food price policies, as well as adequate stock policies to anticipate trends in changes in rice food consumption over time and as a guide for the development of food diversification in the future (faharuddin et al., 2015). therefore, the role of the rice market policy will guarantee food security (azwardi et al., 2016; adam et al., 2017). 2. literature review demand is the desire of consumers to buy an item at various price levels over a certain period in a certain geographical area. the demand for an item is influenced by several factors such as (pindyck and rubinfeld, 2013): (a) the price of the it own good and services, (b) the price of other related goods, (c) the level of income per capita, (d) taste or habits, (e) total population. the demand for rice is determined, ceteris paribus, by factors such as own price, consumer income, population, gender, age, and the price of a substitute good (kouekam et al., 2018). demand for goods is determined by the price of the goods themselves, while other factors are considered constant unchanged (cateris paribus). the lower the price, the higher the demand, conversely the higher the price, the demand will decrease. the demand function is a request expressed in a mathematical relationship with the factors that influence it. consumption demand is determined by the same variables as the variables in demand theory, namely prices, income, prices of other goods, population, and other factors that can affect consumption patterns. function consumption demand is designed to determine the relationship between dependent variables and independent variables. suryani et al. (2009) conducted an exploratory study on the current conditions of consumption and food expenditure in singapore with implications for malaysia as an important agricultural exporting country to singapore. this research shows that singapore consumers are likely to demand high-quality poultry, pork, seafood, vegetables and fruits in the future, especially in response to revenue growth. meanwhile, malaysia appears to be rich in the production of these food commodities and is committed to exports due to oversupply. when facing competition from various countries, malaysia still has various competitive advantages compared to other countries. fransiska (2013) analyzed the diversification of rice and non-rice food consumption, it was found that the number of household members had a significant and positive effect on household food consumption. this is also supported by the results of research conducted by bangun (2014) showing that income and the number of family members have a significant effect on the level of rice consumption where the higher the income and the more family members the more rice consumed. according to husaini (1989) in the study of ampera et al. a person’s or family’s food consumption behavior is influenced by the level of education or knowledge about the food itself, in one family usually the mother is responsible for family food. the pattern of consumption of food rice in south ogan komering ulu was examined by hernanda (2016) conducted in sukamarga village, buay pematang ribu (bpr) central of ranau district. rice consumption is influenced by income, production, and area of paddy fields, number of family members, length of husband’s education and household expenses. 3. research method the scope of this study is focused on household rice food consumption in rural in the east ogan komering ulu regency and south oku regency. the study was conducted from october to december 2018. field data was taken from rural households in four villages namely sriwangi village and sumber jaya in east oku regency, and rantau panjang and banding agung villages in south oku regency. each village was taken a sample of 50 households, so the total sample of this study was 200 households. the analytical method used is a qualitative descriptive approach to investigate the proportion of rice food consumption, while the quantitative approach with multiple regression models (gujarati, 2004) to investigate the factors that influence household rice food consumption patterns in rural in the east oku and south oku regencies. the consumption pattern will be calculated in two ways. first, the proportion of household expenditure for rice and non-rice food to the total food expenditure and the total household expenditure in a month. second, the pattern of rice food consumption expenditure is estimated from the logistic multiple regression model as follows; lnqdb = σ+β1lnpb+β2lnpg+β3lny+β4lntw+β5lnpop+β6 lnasset+ei explanation: lnqdb = rice food consumption expenditure (rp) σ = constant ei = error of regression β1,…,β6 = regression coefficient of each variable lnpb = lon rice price (rp/kg) lnpg = lon wheat price (rp/kg) lntw = lon working time (hours) lnpop = lon number of family members (person) lnasset = lon asset (rp) 4. results and discussions 4.1. porportion of food expenditure based on table 3 on the distribution of food expenditure in the two regencies, it was found that the community tends to consume rice every month, with the remaining 24-26% for other commodities. based on a sample of 100 households in east oku regency, it is known that the allocation of household expenditure for rice is 27.80%, for fish consumption 13.37%, asngari, et al.: rice consumption pattern of rural households in east oku and south oku regencies south sumatra province indonesia international journal of economics and financial issues | vol 10 • issue 1 • 2020262 vegetables by 8%, chicken meat 7.7%, and 6, 3% for beef. in contrast to expenditures 100 households in south oku regency which is allocated for rice consumption by 20.63%, for fish by 16.65%, chicken meat by 10.86%, vegetables by 9.15% and beef 5.66%. the priority of community consumption in the two main regencies is for rice and fish, which is different in the third priority, if in east oku the preference is for vegetables, while in south oku it is more for chicken meat consumption. a fish product such as rice fields, swamps, and rivers that flow every day. the next food consumption which is relatively equally desirable is milk around 4%, tofu, and tempeh around 3.6% to 4.6% where east oku is slightly higher than south oku. 4.2. determinants of rice food consumption the demand for rice in east oku is significantly influenced by the price of rice, the level of income, and the number of family members at α = 1% level. other food commodities, which are proxy for wheat prices, are significant at α = 5%. while the length of work hours and the number of assets does not significantly affect rice consumption. the deterministic coefficient (r2) value is 0.7197, it means that the independent variable variation can explain the variation of rice demand in east oku by 71.97% and the rest is explained by other independent variables outside the model. based on the ols assumption test, the rice consumption model has fulfilled all classical assumptions, namely, there is no problem with autocorrelation, homoscedasticity, and no multicollinearity. based on the value of f-statistics = 26.10 with prob f = 0.0000 it means that all independent variables in the model have a significant effect on the level α = 1% (table 4). the value of the rice demand constant in east oku is ln (−9.433077) or rp. 800.3 if other variables are constant or zero. this constant figure is statistically significant. variable prices have a positive elasticity to the demand for rice of 1.27, meaning that changes in prices continue to encourage increased consumption of rice. wheat food prices have a positive and statistically significant effect, where the elasticity coefficient is 0.24890. every time the price of wheat increases, the demand for rice will increase by 1.2826. the average price of wheat is rp. 7,691 per kg. if there is an increase in wheat price by an average of rp. 1,000 a month it will reduce the demand for wheat, and will replace it by increasing the demand for rice by rp. 1,2826 per month. the average rice price in east oku regency is rp. 9,860 per kg, so an increase in the wheat price of rp. 1,000 per/kg will increase rice demand by 0.13 kg/month. the income variable has a significant and elastic effect on rice demand with an elasticity coefficient of 0.507758. the average income is rp. 3,251,127, with the income elasticity the change in demand for rice is rp. 1,662. if the average income rises by rp. 1000 per month, rice consumption in east oku will increase by rp. 1,662 per month. based on table 3, the proportion of rice expenditure in east oku is 27.8%, the average value of household expenditure for rice consumption is rp. 903,813 per month. a long time of working time per month is an average of 223 h or the equivalent of 55.75 h a month per person. high working hours have no real effect on rice consumption. this is due to the location of work generally near the place of residence, so there is no kitchen in the location they work. rural communities in east oku do not consume rice at rest, but they usually consume instant noodles or cakes made from wheat. both types of consumption are higher than south oku regency (table 2). the number of family members is inelastic at 0.658 and its effect on rice consumption is significant at α = 1%. the average family member is 4 people, meaning each additional 1 person, with the price of rice rp. 9860, each additional 1 family member will increase the demand for rice by 7.8 kg/month. this amount is table 3: distribution of primary food consumption expenditures in the rural of east oku and south oku regencies commodity east oku south oku value (rp) percent value (rp) percent rice 25,967,950 27.80 26,818,000 20.63 wheat 1,207,177 1.29 1,118,678 0.86 fish 12,487,000 13.37 21,642,250 16.65 beef 5,902,500 6.32 7,352,500 5.66 chicken meat 7,266,250 7.78 14,117,000 10.86 egg 3,087,177 3.30 6,089,000 4.68 vegetable oil 5,264,000 5.63 5,597,516 4.31 sugar 3,285,534 3.52 3,814,761 2.93 red chili pepper 3,788,250 4.06 6,747,250 5.19 cayenne pepper 2,863,500 3.07 3,488,500 2.68 salt 495,072 0.53 697 0.00 instant noodles 2,501,500 2.68 2,839,000 2.18 milk 4,082,484 4.37 5,728,000 4.41 tofu and tempe 4,306,000 4.61 4,498,500 3.46 meatball/bakso 2,588,991 2.77 4,693,000 3.61 coffe 1,321 0.00 3,573,000 2.75 tea 604 0.00 558 0.00 vegetables 8,323,000 8.91 11,897,000 9.15 amount 93,418,310 100.00 130,015,210 100 source: field research (processed by authors), 2018 table 4: determinants of demand for rice consumption in east oku regency dependent: demand rice consumption (lnqdb) variable east oku coefisien t-statistic prob. consnt −9.433077 −2.584050 0.0211 lnpb 1.271834 3.218236 0.0021 lnpgd 0.248901 2.336100 0.0228 lny 0.507758 7.671748 0.0000 lntw 0.032922 0.401944 0.4573 lnpop 0.658772 6.660809 0.0000 lnasset −0.035863 −0.920650 0.1317 r-sqared = 0.719738 f-statistik = 26.10888, prob. f = 0.0000 durbin-watson stat. = 1.367 source: field research (calculated by authors), 2018 asngari, et al.: rice consumption pattern of rural households in east oku and south oku regencies south sumatra province indonesia international journal of economics and financial issues | vol 10 • issue 1 • 2020 263 higher than the average rice consumption in indonesia, at 6.8 kg per capita per month (bps, 2017). the total value of assets has an elasticity of −0.035 and is not significant, meaning that the consumption of rice in east oku regency is not influenced by family assets. this is different from south oku because east oku is the center of rice production. the deterministic coefficient (r2) value is 0.4163 (table 5). it means that the variation of the independent variable can explain the variation of rice demand in east oku by 42% and the rest is explained by other independent variables outside the model. based on the classic assumption test has fulfilled all ols assumptions, namely, there is no autocorrelation problem, homos prevalence, and no multicollinearity. based on the f test the calculated f value = 11,737 with prob f = 0.0000 means that all independent variables in the model have a significant effect on the level of α = 1%. based on the classical assumption test, the demand regression model in berasi timur ok also fulfills all ols assumptions. then we can interpret the coefficient and the value of the statistical test. the constant model of rice demand in south oku is ln (−2.5565) or rp. 0.0776. even if other variables are constant or zero, then the community still consumes rice with autonomous consumption of rp. 0.0776. this constant is not statistically significant. the rice price variable is not significant but has a positive elasticity of 0.77. meaning that changes in rice prices do not cause changes in rice consumption. the price of rice is neutral. because rice is a normal item. south oku regency produces coffee and the price of rice does not significantly affect rice consumption. the people there will buy rice even though the price of rice is an average of rp. 10,057 per kg or higher compared to the east oku region as a rice producer. wheat food price has a positive elasticity of 0.0232 and has a significant effect on rice demand at α = 5%, with a coefficient of 1.023. that is, wheat becomes a food substitute for rice. wheat consumption per family is 2.51 kg/month, with an average wheat price of rp. 2,250 per kg. if the price of wheat rises by rp. 1,000 per kg to rp. 8,250 per kg, the demand for wheat will decrease, and demand for rice will increase by rp. 1,023. the average rice food consumption in the south oku regency of rp. 268,180 or 26.67 kg will increase by 2.72 kg to 29.39 kg. as a result of the increase in wheat prices the value of rice consumption to rp. 295,575. the income variables have inelastic and significant coefficients for rice demand. with the number 0.2386. the average income of rp. 3,251,127. the income elasticity will drive changes in rice consumption by rp. 1.2694. that means. if an increase in an average income of rp. 100,000 will affect the increase in demand for rice by rp. 126,947 per month and in south oku regency rice consumption will reach rp. 26,818,000 or an average rp. 268,180 per month will increase to rp. 395,127 per month. the increase in income caused rice consumption per capita to rise from 6.69 kg to 7.72 kg/month. the length of work time at south oku has a significant influence on rice food demand. working hours have a coefficient of 0.3899 which means an additional 1 working hour will increase rice consumption by 0.3899. the average work hours are 223 h a month, meaning that the coefficient of work time elasticity is 0.3899 which means there is an additional consumption equivalent to rp. 1,477 per hour or around 0.0015 kg/h. this means that if each family has an additional 10 h of work a month, the demand for rice food per family in 1 month will increase by rp. 14.77. this means, assuming 100 families have an additional 1000 h of work, it can increase rice consumption by 1.5 kg. increased rice consumption in line with the duration of work occurs because some respondents of the south oku regency are working in gardens that are located more than 1 km to 10 km from the house. this causes farmers to generally build huts and cook food, especially rice and side dishes while in the garden. the number of family members has an inelastic and significant influence on the level of α = 1% with an escalating rate of 0.4540. meaning each additional 1 family member will increase the increase in demand per capita of rice by rp. 1,575 or 0.0015 kg/month. assets have different effects in east oku regency and south oku regency. the value of assets is significant at α = 10% and influences the demand for rice in south oku. the higher the value of assets will encourage the increase in rice consumption. relatively wealthy residents are more able to hold social activities (parties) compared to poor groups. 5. conclusions the conclusion from the results of this study, found that the price of wheat, income, working hours and the number of family members each had a positive and significant effect on the consumption patterns of rice food demand in the two regencies. while rice prices have a significant effect on rice consumption in eastern oku but not significantly in south oku regency. working hours and assets are not significant in east oku regency, but have a significant effect on rice consumption in south oku regency. factors affecting rice demand in east oku regency are the price of rice, the price of wheat, the level of income and the number of family members. length of work and the value of assets does not table 5: determinants of demand for rice consumption in south oku regency demand rice consumption (lnqdb) variable south oku coefisien t-statistic prob. consnt −2.5565 −0.4597 0.6468 lnpb 0.7747 1.2859 0.2017 lnpgd 0.0233 2.0344 0.0448 lny 0.2387 3.4465 0.0009 lntw 0.3899 2.4813 0.0149 lnpop 0.4540 4.7266 0.0000 lnasset 0.0743 1.7126 0.0901 r-sqared = 0.4163 f-statistik = 11.05, prob. f = 0.0000 durbin-watson stat. =2.170 source: field research (calculated by authors), 2018 asngari, et al.: rice consumption pattern of rural households in east oku and south oku regencies south sumatra province indonesia international journal of economics and financial issues | vol 10 • issue 1 • 2020264 affect the consumption of rice. whereas the demand for rice in south oku regency is influenced by the price of wheat. income level. duration of work, number of family members, and value of assets. the duration of work has an affects consumption because in south oku the generally works in a garden which is relatively far from their home and makes a cottage for cooking. while in east oku it is relatively close to <0.5 km and is not used to cooking in rice fields. the proportion of expenditure on rice food consumption to total food in east oku is 27.80%. as for total expenditure, rice food expenditure is only around 12%. whereas in south oku the allocation of rice expenditure was 20.63% of the total food expenditure, and from household expenditure as a whole it was only around 5%. the proportion of rice expenditure in south oku is lower because for the same rice the price in south oku is higher than the price of rice in east oku. the price of rice consumed in east oku averages rp. 9,860 per kg, while in south oku it averages rp. 10,057 per kg. rice consumption per household in a month in east oku is around 26.34 kg, while in south oku it is around 26.67 kg. based on consumption patterns and factors affecting rice food demand. then it should be a concern of the government that the price of rice is not always the same effect on rural areas. if in east oku as a rice producer, then the price of rice will be responded to by households by choosing cheaper rice and selling better quality rice. whereas in south oku, prices do not significantly affect demand for rice, because the choice of rice quality is not as much as in east oku. even though the village community tends to choose quality iii rice. but in south oku the price does not affect the demand for rice. regardless of the price of rice will still be bought by people who generally work on plantations. there is a difference in the price of rice per kg of the same quality of rice, where the price of rice in south oku is slightly higher at around rp. 400 per kg. income has a significant influence on rice consumption, so that food consumption is maintained, the government must provide policies that can support the level of rice prices of farmers not to fall so that the added value generated is high (asngari and sudiro, 2010). the high value-added of rice increases their income so that they especially farmers are still able to buy rice food. the population has a significant effect on rice consumption, and the more the population increases the greater the level of consumption. food security policies should keep population growth below the rate of food productivity. 6. acknowledgment this research was supported by competitive research project grant. we thank our colleagues from university of sriwijaya who provided insight and expertise that greatly assisted the research, for comments that greatly improved the manuscript. references adam, m., taufiq, m., azwardi, a., husni, k.m.t., abdul, b. 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(2017), food consumption pattern and dietary diversity in nepal: implications for nutrition security. indian journal of human development, 10(3), 1-17. asngari, et al.: rice consumption pattern of rural households in east oku and south oku regencies south sumatra province indonesia international journal of economics and financial issues | vol 10 • issue 1 • 2020 265 law number 18. (2012), concerning food, promulgated in jakarta on 17 november 2012 by the minister of law and human rights of the republic of indonesia. mayasari, d., satria, d., noor, i. (2018), the pattern of food consumption based on hdi in east java. jurnal ekonomi dan pembangunan indonesia, 18(2), 191-213. ministry of agriculture. (2016), annual report on food security agency in 2015. jakarta: ministry of agriculture. ministry of agriculture. (2017), annual report on the food security agency in 2016. jakarta: ministry of agriculture. ministry of trade. 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(2009), food consumption and expenditures in singapore: implications to malaysia’s agricultural exports. international food research journal, 16, 119-126. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 42-48. international journal of economics and financial issues | vol 7 • issue 4 • 201742 middle income trap and infrastructure issues in indonesia: a strategic perspective sigit setiawan* fiscal policy agency, ministry of finance republic of indonesia. *email: ssetiawan@fiskal.depkeu.go.id; sigitstiawan@gmail.com abstract this study aims to analyze why (the urgency) and how (the process) indonesia has been struggling in formulating strategic policy framework and the implementation to fix its lack of infrastructure problem, as part of its effort to boost its economic growth and become a high income country. the scope of study is limited to infrastructure only, one of the critical concerns in leading the way to be a high income country. the study adopts qualitative descriptive analysis method. keywords: economic development, fiscal policy, infrastructure jel classifications: f63, e62, h54 1. introduction indonesia is a developing and emerging country with moslems as majority like turkey. indonesia situated in south east asia region is a member of asean community and has the biggest market in the asean community. indonesian economy once was devastated in 1998 after suffering severe monetary crisis, triggering a historical painful chaos and socio economic upheaval in the country. to recover the economic and political stability, the reigning military regime administration had to step down as a consequence, and since then indonesia embarked a new era ruled with democratic pillars and democratic government. not long after indonesia has made a remarkable comeback, it has almost doubled its gross domestic product (gdp) since 2001, maintaining an average growth rate of 5.3% which records a considerable growth among the countries in the world. with its gdp per capita us$3,347 and us$11,058 public private partnership (ppp) in 2015, indonesia is now classified into a low middle income country. indonesia similar with turkey is a member of g20 countries, a group consisting of several developed and emerging countries. currently an emerging economy, in the future indonesia is expected to be able to rise as a high income country, just like several fellow g20 members. nonetheless, the issue of middle income threat may loom and obstruct the expectation when the issue is not taken seriously. indonesia’s current and near future economic prospects will be marked by several factors which good policies can turn into robust drivers of growth: favorable demographics, urbanization trend, and rising middle class. demographics data shows that among 258 millions people (2015) living in indonesia, more than a half of its population are below 30. with average population growth 1.5%/year in the last decade, it is predicted other 15 million people will enter the labor market, totaling around 135 million, by 2020. in addition, indonesia has rapid urbanization rate with its urban population growing from 53% in 2015 to 60% by 20251. in line with its increasing gdp per capita, currently there are about 50 million people in the middle class. the figure is continuously growing more than 2 million every year, which creates strong demand for goods and services. with its abundant natural resources and its strategic position in the most economically dynamic region of the globe, all these factors have the potential to boost indonesia’s prosperity. 1 all data source related with indonesia is taken from bps statistics indonesia. setiawan: middle income trap and infrastructure issues in indonesia: a strategic perspective international journal of economics and financial issues | vol 7 • issue 4 • 2017 43 however, indonesia may risk slowdown in long-term growth due to external and internal sources. main risks due to external exposure may come from the ups and downs of primary exported commodity prices and global interest rates2. meanwhile, source of internal risks may come from inequality and unemployment. inclusive growth above 5% for indonesia is crucial and necessary to escape the threat of middle income trap. by reaching average growth of 9%, it would place indonesia to become a high-income country by the year 20303. learning the lessons from other countries, indonesia views that formulating right strategies are necessary to avoid the middle income trap. chinese taipei, hong kong-china, korea and singapore the 4 newly industrialised countries or nics have been successfully recognized in earning income convergence with highincome countries while latin american countries stay caught in the middle income trap. the nics adopted export-led growth strategy by picking particular strategic industries. the government then facilitated the industries to implement gradual diversification and improvement into new products that needed the same skills and inputs. the east asian nics notable success in the diversification and improvement of their export structure needs organized and integral policies covering the areas of infrastructure, education, innovation and financing4. successfully integrated policies covering the four areas created high nics’ industrial competitiveness, and boosted the nics economic growth to become high income countries. although indonesia has been copying export-led growth strategy5, indonesia has not successfully yet caught up with the nics. similar fact also has happened to other countries in asean region like malaysia, thailand, and the philippines. it is ironic since historically in 1960s all the forementioned countries and nics started from similarly low gdp per capita6. middle income trap which hit latin american countries might also hit indonesia if this issue is not taken seriously. indonesian government is fully aware of such risk and has taken immediate strategic policy responses to tackle this issue. this study aims to analyze why (the urgency) and how (the process) indonesia has been struggling in formulating strategic policy framework and the implementation to fix its lack of infrastructure problem, as part of its effort to boost its economic growth and become a high income country. the scope of study is limited to infrastructure only, one of the abovementioned critical concerns in leading the way to be a high income country. the study adopts qualitative descriptive analysis method. 2. industrial competitiveness and infrastructure in modern economic era, private and business sector not government sector understandably assume a role as the main driver of growth. thus, strengthening national industrial sector 2 foreign & commonwealth office (2014). 3 world bank (2014). 4 jankowska, et al. (2012). 5 furuoka (2007), kokko (2002), palley (2011), rahmaddi, r. and ichihashi, m. (2011). 6 see gdp comparison in www.worldbank.org to be internationally competitive is the only way for indonesia to escape from the middle income trap (basri and putra, 2016). in this regard, the role of president as the head of state is crucial to prepare the necessary fundamental economy and to drive effective industrial policies7. infrastructure has been long perceived as one of the main factors behind industrial competitiveness. almost all business players who run industrial sectors have perceived such a similar position on the the impact of infrastructure on their competitiveness. based on survey result in cbi (2015) in united kingdom, 94% of businesses perceived the infrastructure quality as a decisive factor when planning future investment8. the result reinforced another previous survey by cbi and kpmg (2012) which shows that almost half of respondents from large companies (48%) value the quality and reliability of transport infrastructure as ‘very significant’ in their investment decision making, whereas there is just over a quarter of smes (26%) who share similar views. in the context of the japanese manufacturing sector, kadokawa (2011) shows the evidence that infrastructure plays a significant role in directing the location of plants. after the availability of land, other factors i.e., highways, industrial zones, commuting convenience, and environmental restrictions are important reasons for businesses to decide an investment9. based on the above surveys and evidence, businesses have obvious views that infrastructure plays important role in supporting their competitiveness. domestic industrial competitiveness determines international country’s competitiveness; thus, government should be concerned about its country’s infrastructure gap10. infrastructure gap in broad sense may vary among countries, not only limited to connectivity or logistics sector (including rail, roads, ports, sea ports, digital network), industrial zones, and energy which are directly related with industries, but also watering and irrigation for farming, and public health and education facilities which support indirectly toward industrial competitiveness. in terms of connectivity or logistics sector, based on world bank logistics performance index 2016, the low logistics performance index that indonesia achieved (2.98) has been contributed by inadequate infrastructure, as shown by performance index for indonesian logistics infrastructure which is scored lower 2.65. the latter score of infrastructure index is lower than the average index score for 10 asean member countries (2.79). it implies that indonesian infrastructure quality (2.65) still lags behind average asean members. indonesian infrastructure quality exceeds that of lao pdr (1.76), myanmar (2.33), cambodia (2.36), philippines (2.55), and vietnam (2.70), yet inferior to brunei (2.75), thailand (3.12), malaysia (3.45), and singapore (4.20). the infrastructure issue in indonesia has been one of the primary concern driving higher logistics cost incurred by industries. logistics cost in indonesian industries is the second primary costs 7 basri and putra (2016). 8 cbi (2015). 9 kadokawa (2011). 10 luger, et al. (2013). setiawan: middle income trap and infrastructure issues in indonesia: a strategic perspective international journal of economics and financial issues | vol 7 • issue 4 • 201744 after labor and raw materials expenses11. thus, higher logistics cost will be transmitted into higher consumer price and the consumer eventually bear the burden. in comparison with other countries, indonesia’s logistics cost to gdp is still higher. indonesia logistics to gdp is 23.5% in 2014, and targeted 19.2% in 201912. just compare with rival asean countries such as thailand (16% in 2015 and declining to 14% in 2016), malaysia (14%), and singapore’s (8%); or indonesian main trade partners such as china (18%), india (14%), south korea (13%), japan (9%), and united states (8.5%)13. 3 . i n t e g r at e d i n f r a s t r u c t u r e development a particular attention on infrastructure development was first iniated in soesilo bambang yudhoyono second-term administration (2009-2014) and it has been continuing up to date in joko widodo administration (2014-2019). previous administrations since reform era began in 1998 had been absorbed to lay necessary fundamental aspects for a big reform, which was a transformation from authoritarian to democratic state system. structural reform has taken form in, among others bureaucracy reform, full support to transparency and accountability through the establishment of important institutions, including anti-corruption commission. in addition, power and authority to manage development is shared between central and local government through fiscal decentralization. to spur local development including in infrastructure, central government shares several fiscal authorities with local government. in the macro economy and state financial management, government of indonesia (goi) pushes budget reform to stabilize and strengthen economic fundamentals after economic crisis 1998 and toward subprime mortgage crisis in 2008. a comprehensive development concept the so called the master plan for the acceleration and expansion of indonesia’s economic development (mp3ei) was initiated in 2011, as the implementation of the law number 17 year 2007 on long-term national development plan year 2005-2025. mp3ei was formulated to support indonesian ambition to become a developed country in the future. in that regard, information and considerations that encompassed a variety of potentials owned by indonesia, particularly in natural resources, were taken into account. mp3ei was a very ambitious plan, obviously identified from the target set to achieve. by this plan indonesia will transform into a developed country by 2025 with expected per capita income of usd 14,250-usd 15,500 and total gdp of usd 4.0-4.5 trillion. about 82% or equivalent to usd 3.5 trillion is expected from six economic corridors: east sumatera northwest java, northern 11 mulyadi (2011). 12 stc group, logistics association indonesia, institute of technology in bandung, world bank jakarta office (2015). 13 see board of investment thailand (2016), goldsby, et al. (2014); open port (2016) see www.openport.com; roland berger (2016) see www. rolandberger.com. java, kalimantan, sulawesi, east java bali nusa tenggara and maluku islands and papua. to reach the above objectives, indonesia is targeted to acquire real economic growth of 6.47.5% with the decreasing rate of inflation to 6.5% during period of 2011-2014 to 3% in 2025. after the mp3ei implementation, it is expected there would be gradual increase in indonesian annual gdp growth around 12.7%, with regional growth within the corridor at 12.9%. the areas outside of the corridors would also benefit the spillover effects of economic development within the corridor areas and is expected to grow annually 12.1% as a result. historically, indonesian economy has been long dependent to commodity export, i.e., coal and natural gas, and low value-added products, i.e., palm oil and textile14. when launched in 2011, mp3ei was intended to transform indonesian economy, by managing indonesian abundant amount of natural resources carefully in order to able to deliver adequate added value to encourage high quality economic growth. the plan would be possible if there were adequate infrastructures. the investment offer would be attractive to investors if besides land availability suitable infrastructures are provided. the lack of infrastructures in indonesia, especially in eastern area has long been one of the main obstacles for manufacturers and inter region connectivity. indonesia is uniquely the largest archipelagic country in the world, with 17.504 islands scattering from the west to the east15. the vast sea separating the islands inevitably provide extra challenges for transport, logistics and product distribution compared to mainland area. addressing the obstacle is crucial since it will diminish the high transportation and logistics costs, support local industry competitiveness and accelerate the distribution of products, which in turn facilitating the product delivered to consumers in more affordable price. goi through state minister for national development planning/ national development planning agency estimated that idr 4,021 trillion investment and 90,000 mw electricity are needed to satisfy national infrastructure gap16. goi will contribute about 10% of the total estimated investment, in the form of basic infrastructures such as roads, seaports, airports, railroads and power plants. the remaining investment the biggest slice – is expected from the private sector, state owned enterprises (soes), and others. infrastructure provision mechanisms offered can be in the form of joint investment scheme between the goi and private sector through ppp. with regard to mp3ei implementation during 2011-2014, at the end of soesilo bambang yudhoyono second administration in 2014, goi had realized 208 infrastructure projects out of 1.048 scheduled projects, and 174 real sector projects out of 350 scheduled projects. all those realized projects value was estimated idr 854 trillion. in 2014, some other projects with total value idr 412 trillion had 14 central bureau statistics (2016), see www.bps.go.id. 15 ministry of home affairs (2004). see www.kemendagri.go.id. 16 infrastructure reform sector development program (irsdp) bappenas (2011). setiawan: middle income trap and infrastructure issues in indonesia: a strategic perspective international journal of economics and financial issues | vol 7 • issue 4 • 2017 45 been launched: the invested projects of soes amounted idr 157 trillion (38%), those of goi amounted idr 133 trillion (32%), those of corporate amounted idr 29 trillion (7%), and those of joint investment scheme amounted idr 93 trillion (23%)17. the presidential election 2014 resulted the new elected and current president joko widodo, replacing the former two-term president soesilo bambang yudhoyono. the new administration set nine priority development agenda (nawa cita), as a priority reform for indonesia to move forward to a country of political sovereignty, economic independence, with its own cultural character. infrastructure issue has also been a priority agenda for president joko widodo, head of current administration. it continues and improves infrastructure development agenda by the previous administration. the current administration has determined three development dimension: human development, main sector development, and territorial and equity dimension. human development dimension consists of education, health, housing, and mental/character building. main sector development dimension comprises 4 sectors: (1) food sovereignty; (2) energy and power sovereignty; (3) maritime and marine; (4) tourism and industry. meanwhile, territorial and equity dimension encompasses two sub dimensions: (1) among group of income; (2) among region. in each development dimension, infrastructure issues are always present and need to be resolved. the amount fund of fund needs to be raised for infrastructure investment project during joko widodo administration is rp4,796 trillion. this amount includes the project continuation previously launched by his predecessor. the sources of fund are various, from state budget allocation and local government budget (rp 1,979 trillion or 41%), soes (rp 1,066 trillion or 22%), and private participation (rp 1,752 trillion or 37%). not all project progress can be explained here. for illustration, in october 2016 some projects targeted for 2019 in food sovereignty have achieved certain progress: new farming irrigation development of 1 million hectare achieved 21% progress; whereas rehabilitated irrigation of 3 million hectare achieved 28% progress. out of 65 dams (49 new and 16 continuation) targeted for 2019, the progress has been 57%. part of projects for energy and power sovereignty are intended to enlarge electrification coverage to 96.6% in 2019. the progress achieved so far is 48%. in equity and territorial dimension, toll road development targeted 1,000 km long has progressed 27%, while for railroad project (incl. double track) targeted 3,258 km long has been around 21% accomplished. city transportation system development has been part of the dimension. the development (with each progress) includes the share of public transport use (30% out of 32%), city rail network (38% out of ten cities) and bus rapid transit system development (18% of 34 cities). out of that rp 4,796 trillion fund, goi still needs to invite other private sector fund for ppp scheme, which amounts rp 64 trillion 17 minister of national development planning (bappenas/national development planning agency) (2016). see www.bappenas.go.id for 2015-2016 period. the ppp scheme is allocated for fiber optic digital connectivity across indonesia, thermal power plant, and water treatment plant. other fund raising scheme is equity participation from soes, which is intended for fourteen toll roads projects of trans jawa with total 700 km long during 2015-2016. 4. strategic implementation in reaching the target indonesia has admittedly ambitious infrastructure development target, whereas the accomplishment is mainly constrained by time and financial resources. indonesia needs to optimize the utility of its limited internal financing source, set more realistic goals for accomplishment during 2015-2019, and expect the highest impact for high quality growth. thus, strategic plans are necessary related to priority infrastructure projects and financing aspect. priority projects are derived from the list of national strategy projects. goi has listed national strategic projects in mid-term national development plan 2015-2019. the list consists of 225 projects and 1 electricity program for acceleration. the projects are distributed over national projects (10 projects), and main islands: sumatra (46), java (89), kalimantan (24), bali and nusa tenggara (16), sulawesi (28), and maluku and papua (13). most of projects are dams (60), road construction (52), and economic zones (25). other strategic projects with high cost and value are railway (19), airport (17), and seaport (13). other strategic projects cover a variety of spectrum, covering housing, energy, fishery or maritime, water supply, communication, national border, smelter, and power. among the strategic projects, goi determined thirty priority projects, which will be provided additional project preparation. the thirty selected projects among others are those of four toll roads, six railway network, two sea port hub and one new sea port, nine power plants, three transmission lines, and three refineries. a special unit was then established to serve as the priority project management office which coordinate the additional preparation, both technically and financially. learning the lesson from several previous incomplete or long-delayed projects, goi devised another strategic approach. it then set up the so-called kppip unit to ensure the priority projects satisfy the required specifications and be successfully completed. under the presidential regulation, the kppip is set to have six main tasks: (1) to develop pre-feasibility study and quality standard; (2) to determine priority projects (thirty projects are selected as previously explained above); (3) to determine funding scheme and source; (4) to monitor and debottleneck, including high level issues in national strategic projects; (5) to determine strategy and policy; (6) to facilitate capacity and institutional building related to priority infrastructure delivery. by the existence of kppip, goi is able to show its commitment in setting up a robust project pipeline which boost infrastructure delivery. in this regard, goi sets selected infrastructure delivery milestones each year. in addition, goi also shows that it takes a pro-active perspective in constructing a conducive business climate and issuing policies which facilitate infrastructure investment. setiawan: middle income trap and infrastructure issues in indonesia: a strategic perspective international journal of economics and financial issues | vol 7 • issue 4 • 201746 based on its experience, goi has identified there are several major concerns that continuously hamper its infrastructure project execution and discourage potential investors to participate. the first major problem is long complicated licensing and bureaucracy procedures in central and local government, which triggers gratification and eventually high cost economy. the corrupt attitude and bad governance will also lead to poor project quality result, which goi then should incur the burden in the form of unnecessary annual maintenance cost. the second is very slow land acquisition process due to speculative practices related to acquired land price. as a consequence, investors have to incur big cost burden and uncertainty. the last is profit uncertainty amidst the big investment fund that an investor has to provide. investors expect goi or a reputable organization gets in to provide guarantee for project profit sustainability. to attract more investors, goi sets up new ppp supporting policies. with the existence of kppip and previously established agencies such as agencies dealing with anti-corruption and onestop administration service, goi targets the root problems can be identified and debottlenecked effectively. by the regulation, goi also provides more supports toward investors. first support is by easing land acquisition. in this regard, goi assumes the responsibility for land provision of an infrastructure project. the commonly found acquisition denial of speculative parties will be ineffective, since the land will still be acquired by goi while the money delivered for compensation based on professional appraisal will be administered in the court. goi has recently pushed forward the land acquisition facilitation by establishing land bank, a bank under ministry of finance that acquires and collect land for national strategic infrastructure projects. second, goi provides incentives for investors in (1) the certainty of return on investment with the payment by the user in the form of tariffs (user charge) or availability payment; (2) viability gap funding, which is a scheme of cash financing by goi on some private public partnership (ppp) project costs, in order to be able to provide public infrastructure services in reasonable prices; (3) goi guarantee in the financing scheme involving international financing institutions, or guarantee from a specific appointed soes for infrastructure. goi also improves other aspects in ppp project management. value for money principle is adopted in determining the priority and delivery mechanism to select ppp proposal. to gain more project ownership, goi increases budget allocation in related ministries/ institutions/local government for ppp projects. the capacity of human resources and institution involved is improved by setting up ppp focal points on related sector ministries and all provincial governments in indonesia. with regard to financing aspects for infrastructure, goi is prepared for several strategic financing steps. first source of financing is surely from internal source taken from its state buget. goi commitment to infrastructure is shown by the increasing trend of allocated budget for infrastructure since 2010. the allocated amount in year 2016 already reached approximately idr 314 trillion, historically the highest allocated budget ever. however, this amount is only 2.8% of indonesian gdp 2016 (current). on the other hand, goi will need infrastructure investment at minimum 5% of its gdp to accelerate its economic growth above 7%, the prerequisite to reach its ambition to be a high income country in 2030 or so. goi sees that fiscal constraints leave limited room for allocating public investment at the scale required. the reason is goi has to be selective and prioritize on non-commercially viable infrastructure projects. in addition, goi should also share its attention to other crucial work programs in diminishing interregional disparities and income inequality. therefore, finding external source of financing for infrastructure is a must. goi does not depend on a single external source of financing, yet it has various source to satisfy its budget needs. reflecting its needs, indonesian recent financing is dominated by infrastructure financing. bilateral financing is one of the sources. in december 2016, the total amount of indonesian debt to creditor countries is us$ 168 billion. the biggest five creditor countries are singapore (us$ 50.3 billion), japan (us$ 30.2 billion), china (us$ 14.8 billion), hongkong (us$ 11.7 billion), and the united states (us$ 10.5 billion)18. next financing source is international financing institution. until december 2016, goi is indebted to several international institutions with total us$ 30.2 billion. the biggest five creditors are international bank for reconstruction and development under world bank group (us$ 15.8 billion), asian development bank (adb) (us$ 9.3 billion), international monetary fund/imf (us$ 2.7 billion), international development association/ida which is also under world bank group (us$1.5 billion), and islamic development bank (us$ 700 million). goi through kppip is open for financing from other international organization and private sector. there are 102 national strategic projects (2016) at preparation stage and kppip is inviting international reputable organization and private sector to participate in project development facility. in 2016 kppip has calculated that those national strategic projects will need idr 2,818 trillion funding. some of the projects have strategic value as pilot projects, and international quality project preparation is therefore expected. other than the above-mentioned international financing organizations, a newly established international financing organization like the asian infrastructure investment bank (aiib) which is backed up by the reputable adb is also being explored to see the possibility of aiib to participate in the indonesian infrastructure portfolio fund. other various financing options from pure soes, pure private participation, equity participation from soes, and ppp are also invited. soes and private sector are important goi partners since they has more opportunity and flexibility than goi to attract overseas money and utilize fund inflow from the tax amnesty program which applies until march 2017. soes and private parties grouped into consortiums have come from either local or foreign financial entities. 18 external debt statistics of indonesia per december 2016. setiawan: middle income trap and infrastructure issues in indonesia: a strategic perspective international journal of economics and financial issues | vol 7 • issue 4 • 2017 47 however, all that would not be sustainable if goi has not established certain prerequisite: sound prudential macro economy and fiscal sustainability. such economic and fiscal reform have gradually been launched since reform era commenced in 1998. there are several economic and fiscal reforms important to note. the first is the issuance of financial system safety net laws and regulations which also includes the establishment of national coordinating committee in financial sector stability. the committee involves ministry of finance as the coordinator, central bank, deposit insurance, and the last joining financial services authority. in the beginning not long after 1998 economic crisis, the regulation was issued. recently in 2016, as the parliament agreed with goi, financial system safety net system includes the committee establishment was approved as the financial system safety net law. the second is prudent national debt management by a dedicated debt management unit under minister of finance. in cooperation with central bank, the unit has been effective in managing national debt. the unit is taken as a successful study case and has been visited by some developing countries (in asean and under south-south cooperation) who intend to learn how it works effectively. under management of the unit, cash financing risk through government bonds is strictly controlled. in year 2016 bond issuance amounting idr 600 trillion for illustration, the composition is 76% bonds are issued in local currency denomination and the rest in foreign currency. local currency denominated bonds is so dominant in order to curb foreign currency risk potential, the risk that triggered severe 1998 economic crisis in indonesia. prudent national debt management is also adopted by regulating maximum limit of debt to gdp ratio to 60% in the national laws. up to date, except in the beginning of reform era 1998, goi has always been conservative in practice by taking debt to gdp ratio below 30% in annual state budget. indonesian state budget deficit is also maintained conservative below 3% gdp. the last but not the least is a strategic decision by goi in december 2014 to remove subsidy on medium and high quality fuel for the medium class and the rich, and provide limited subsidy on low quality fuel for the poor. by reallocating the unproductive fuel subsidy to productive sector subsidy such as health, education, and infrastructure, goi has successfully tamed potentially malignant cancer cells in the indonesian economy history. fuel subsidy had previously been a main concern in indonesia from one administration term to another, since every international oil price hike would lead to rising burden fuel subsidy increase in the state budget. the situation had historically left a small fiscal space for goi to allocate in productive sectors. 5. conclusion lagging behind the nics today, indonesia is fully aware that it should not let itself to be caught in middle income trap as latin american countries have been. after intensive evaluation, as shown by several country comparison indicators, infrastructure has been one of indonesian main concerns other than education, innovation and financing. goi developed a comprehensive, ambitious, and inclusive infrastructure development agenda called mp3ei to bring indonesia closer to a developed country status in the future. the agenda was launched in 2011 and furthermore in 2014 it was refined into more focused infrastructure development agenda containing priority projects guided and monitored by a dedicated and specific taskforce. since 2011, the infrastructure development including for noncommercial public infrastructure has been massive and at a much faster pace than before. goi has adopted various strategies to expedite infrastructure development. goi encourages local government participation in infrastructure development by sharing budget allocation and authorities with local government. more infrastructure financing options are now prepared and included into the current financing portfolio: (1) state budget allocation and local government budget, (2) international institution financing, (3) bilateral financing, (4) pure soes, (4) pure private participation, (5) equity participation from soes, (6) ppp. to attract more investors, goi provides more supports toward investors. goi eases land acquisition by assuming the responsibility for land provision of an infrastructure project. goi also provides incentives for profit certainty and guarantee. goi also improves ppp project management in determining the priority and delivery mechanism to select ppp proposal. it also increases budget allocation to gain more project ownership and improve the capacity of human resources and institution involved in indonesia. the adopted financing strategies have so far been implemented effectively and the infrastructure development have run in a sustainable manner. such a condition is due to simultaneous efforts from previous state administrations in laying necessarily fundamental reforms in macro economy and fiscal sustainability, which successfully rebuilt the nation economy after devastating economic crisis in 1998. there are certainly various policy reforms issued by goi, but several main policies are worth to note: the issuance of financial system safety net laws and regulations, prudent national debt management, and strategic reallocation of fuel subsidy to productive sectors. yet, some challenges which need goi careful attention still remain. local government expenditure effectiveness toward productive sectors need improvement up to date. the gap between the rich and the poor and among regions and tax reform as well currently are still important issues to resolve. effective mix of fiscal policies need to be formulated, prepared and exist at the right time. references board of investment thailand. 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(2013), infrastructure and manufacturing: their evolving relationship. manchester business school and uk government’s foresight future of manufacturing project. october; 2013. ministry of finance. (2016), external debt statistics. indonesia: ministry of finance. mulyadi, d. (2011), pengembangan sistem logistik yang efisien dan efektif dengan pendekatan supply chain management. jurnal riset industri, 5(3), 275-282. palley, t.i. (2011), the rise and fall of export-led growth. working paper no. 675. levy economics institute. july; 2011. rahmaddi, r., ichihashi, m. (2011), export and economic growth in indonesia: a causality approach based on multi-variate ecm. journal of international development and cooperation, 17(2), 53-73. stc group, logistics association indonesia, institute of technology in bandung, world bank jakarta office. (2015), state of logistics indonesia 2015. jakarta: world bank office. world bank. (2014), indonesia 2014 development policy review. washington, dc: world bank. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(2), 101-107. international journal of economics and financial issues | vol 8 • issue 2 • 2018 101 education and economic growth in post-apartheid south africa: an autoregressive distributive lag approach luxolo malangeni1, andrew phiri2* 1department of economics, faculty of business and economic studies, nelson mandela metropolitan university, port elizabeth, south africa, 2department of economics, faculty of business and economic studies, nelson mandela metropolitan university, port elizabeth, south africa. *email: phiricandrew@gmail.com abstract using annual data collected between 1994 and 2014, this current study investigate the long-run and short-run cointegration relations between education and economic growth in south africa using the bounds approach to autoregressive distributive lag model. our empirical results obtained in the study point to an insignificant relationship between education and economic growth in south africa, a finding which goes contrary to both existing theoretical and empirical postulations. these obtained results hence imply that the issue with education may not so much with the quantity of existing education but rather the quality. therefore, our study advises policymakers to place much emphasis on quality of education is such education is likely to promote economic growth. keywords: education, economic growth, autoregressive distributive lag model, cointegration, south africa jel classifications: c32, c51, i25, o40 1. introduction achieving quality education is a problem for many developing countries in the world and south africa is no exception to this problem. the effects of apartheid in south africa had a great impact on the educational sector. according to jansen (2001) south african education system during the apartheid era was bureaucratically centralised, racially exclusive and politically authoritarian and this led to many unrest in state schools especially during the 1970s and 1980s. since the democratic elections of 1994, the south african government has been preoccupied with addressing the social imbalances inherited from the former apartheid rule. one of the pillars of government’s strategy has been on increasing public expenditure on domestic education. however, one of the biggest challenges to south africa’s education system was creating an environment that favours inclusive education as most of the people of south africa were racially marginalised due to years of neglect and inequality that the country had experienced (de wet and wolhuter, 2009). from an academic perspective, education has been long considered a fundamental factors of human capital, which in turn, is used in conjunction with accumulated capital as factors of production in creating output. henceforth many researchers have engaged in examining the empirical relationship between education and economic growth. a bulk majority of these studies have established a positive relationship between education and growth (barro (1991); fischer (1993); mankiw et al. (1992); levine and renelt (1992); easterly and levine (1997)) even though there exist exceptional cases studies which an insignificant relationship between the two variables hoeffler (2002). nevertheless, there appears to very little empirical research conducted on the south african economy, with most of the existing literature being attributed to panel studies (barro (1991); fischer (1993); mankiw et al. (1992); levine and renelt (1992); easterly and levine (1997); hoeffler (2002); gyimahbrempong et al. (2005); glewwe et al. (2012) and kocourek and nedomlelova (2018). one notable problem with these panel studies is that they generalize the obtained empirical results for a large number of countries with different economic characteristics. in this sense, country-specific studies present a more convenient alternative to investigating the education-growth relationship. in our study, we examine long-run and short-run cointegration relations between education and economic growth for the south malangeni and phiri: education and economic growth in post-apartheid south africa: an autoregressive distributive lag approach international journal of economics and financial issues | vol 8 • issue 2 • 2018102 african economy using the autoregressive distributive lag (ardl) model of pesaran et al. (2001) which is applied to empirical data spanning from 1994 to 2014. in realization of the lack of countryspecific studies on the subject matter for south africa, our study is thus presents a valuable contribution to the literature and bears important implications for policymakers. against this background, we structure the remainder of the manuscript as follows. the next section of the paper presents the associated theoretical and empirical review. section three outlines that methodology of the study whilst the empirical data and results are presented in section four of the paper. the paper is then concluded in section 5 in the form of policy recommendations. 2. literature review 2.1. theoretical review from a theoretical perspective, neoclassical and endogenous growth theorists are accredited for highlighting the importance the importance of human capital development contributions to steady-state dynamic economic growth. according to latif (2009) human capital via education plays an important role in the process of economic development because it is the key factor for increasing the long-term competitiveness of an economy. therefore, higher education attainment means more skilled and productive workers, which in turn, promotes growth and development. human capital theory particularly accounts for certain mechanisms through which education can influence economic development such as though skill formation; education and work experience enhance the individual’s skills and thereby raise their market value to employers, and contribute to economic growth and development. human capital investment will thus yield private returns in the form of greater employment opportunities and higher lifetime earnings because they increase the workers’ productivity in human capital investment (hoeffler, 2002). generally speaking, the theoretical growth literature emphasizes at least three mechanisms through which education may influence economic growth. first, education can increase the human capital inherent in the labour force, which increases labour productivity and thus transitional growth toward a higher equilibrium level of output as augmented in neoclassical growth theories (mankiw et al., 1992). second, education can increase the innovative capacity of the economy, and the new knowledge on new technologies, products, and processes promotes growth (as in theories of endogenous growth (lucas (1988) and romer (1990)). third, education can facilitate the diffusion and transmission of knowledge needed to understand and process new information and to successfully implement new technologies devised by others, which again promotes economic growth (benhabib and spiegel, 1994). however, pritchett (1996) argues that schooling may not be associated with higher growth rates because educated workers may be motivated to participate in socially unproductive activities such as “piracy.” a surplus of skilled labour has suppressed wages and dampened growth and poor quality of schooling has not translated into any increase in human capital. furthermore, glewwe et al. (2012) argue that an insignificant relationship between educational attainment and economic growth is plausible for less developed countries whose main concern is quality as opposed to quantity of educated persons. 2.2. empirical review the calibrations from dynamic growth theories has prompted many researchers to investigate the empirical relationship between education and growth. typically these studies estimate growth equation which are supplemented by school enrolment as a measure of education and are regressed with other growth determinants. this section of the paper presents a brief review of some of the associated literature. zivengwa (2006) investigates the cointegration relationship between education and economic growth in zimbabwe during the period 1980 to 2008 using a vector auto regression modelling process. the findings confirmed a positive relationship between education and economic growth with physical investment being a channel of transmission of these positive effects. for turkey, beskaya et al. (2010) conducted a study on the impact of education on economic growth in turkey using the ardl model applied to data spanning between 1923 and 2007, and the results suggested a significant long-run relationship between school enrolment and economic growth. on the other hand, afzal et al. (2010) investigated the short-run and long-run linkage between school education and economic growth in pakistan using annual data for the period 1970–71 to 2008–09. the study employed the ardl bounds testing approach to cointegration and found evidence of cointegration between school education and economic growth. the results of the study showed a direct relationship between school education and economic growth in pakistan, in both the shortand the long-run positive relationship between education and growth. also for pakistan data collected between 1981 and 2010, reza and valeecha (2012) investigate the education-growth relationship using a simple ols regression analysis. in differing from the results obtained in afzal et al. (2010), the authors are unable to establish any relationship between the two variables in the short-run but find a significant long-run relationship. pegkas and tsamadias (2014) apply the vector error correction model (vecm) to investigate the cointegration relationship between education and economic growth in greece over a period spanning from 1960 to 2009. the study examines a positive link between education attainment and economic growth for the data. using similar vecm modelling techniques, mariana (2015) investigate the relationship between education and economic growth for the romanian economy between 1980 and 2013. the empirical results indicate the education exerts a positive influence of long-term economic growth. shaihani et al. (2011) examined the impact of education level on economic growth in malaysia for the period 1978–2007 using the ardl modelling approach. the results of the study showed that primary and tertiary education showed a negatively significant malangeni and phiri: education and economic growth in post-apartheid south africa: an autoregressive distributive lag approach international journal of economics and financial issues | vol 8 • issue 2 • 2018 103 relationship with economic growth but secondary education had a positive significant effect on economic growth. nevertheless, in the long run, only tertiary education showed a positive and significant impact on economic growth. finally, nowak and dahal (2016) investigates the long run relationship between education and economic growth in nepal between 1995 and 2013 using ols and vecm estimation techniques. the results confirm that secondary and higher education contributes significantly to real per capita gdp. gyimah-brempong et al. (2005) used panel data for the period 1960–2000 to investigate the effect of higher education human capital on economic growth in african countries. the results of the study showed that all levels of education human capital, including higher education human capital, have a positive and statistically significant effect on the growth rate of per capita income in african counties. the estimated growth elasticity of higher education human capital was found to be about 0.09, which was twice as large as the growth impact of physical capital investment. although this result is seemingly an overestimate of the impact of higher education on growth, it is robust to different specifications and points to the need for african countries to use higher education human capital effectively in growth policies. 3. methodology 3.1. unit root testing procedures before estimating an ardl cointegration model, it is important that one test for unit roots. to recall, this is an important step since the ardl model can only be used if all the time series variables being modelled are not integrated of an order higher than i (2), hence meaning that a combination of i (0) and i (1) variables are desirable. the most commonly used unit root tests found in the literature is the adf test. the test regression is specified as follows: y d y y t t t j t j ej p t = + +− −= +∑β φ α1 1 (1) where, is a first difference operator, d is a deterministic trend and et is a well-behaved disturbance term. from regression (1), the unit root null hypothesis is formulated as h0: φ=0, and this null hypothesis is tested against the alternative of an otherwise stationary process. the second unit root test used in our study is the pp unit root test. according to phillips (1988), the pp test addresses the issue that the process generating data for time series might have a higher order of autocorrelation than is admitted in the test equation making thus invalidating the dickey–fuller test statistic. this is accomplished by making a non-parametric correction to the test statistic. therefore, the pp test statistic is more robust with respect to the unspecified autocorrelation and heteroscedasticity in the disturbance process of the test equation (phillips, 1988). pragmatically, the pp test regression may be formulated as: yt=βdt+ϕyt−1 (2) in similarity to the adf test, the null hypothesis of a unit root is tested as h0: φ=0, which is tested against the alternative of stationary process. 3.2. empirical specifications in investigating the debt-growth relationship the simplest estimation regression found in the literature involves estimating a bi-variate empirical regression between the time series. typically such regressions assume the following function form: gdpt=α+β1edut+et (3) where gdp is a measure of economic growth, edu is a measure of education and et is a normally distributed disturbance term. however, bi-variate regressions like that represented by equation 1 can be criticized on the premise of the omitted variable bias. therefore, multivariate regression specifications presented a more safer alternative in modelling the education-growth relationship. the multivariate regression may typically be specified as: gdpt=α+β1edut+β2xt+et (4) where, the vector xt represents a matrix of growth factors that are include in the mode to ensure robustness. in our study we include, investment, inflation, government size, terms of trade as plausible control variables which are all considered relevant variables in the south african context. for instance, inflation is an important variable since it is representative of monetary policy which is currently embarked on an inflation target programme to ensure price stability in the interest of promoting economic growth. similar, government size is another important variables in the south african context since, the new growth path and the new development plan, both which represent large-scale spending programmes aimed at improving long-term economic welfare through improved economic growth. by tradition, domestic investment has been considered the engine of growth is hence represents a standardized growth determinant in the empirical literature. finally, terms of trade as a measure of openness is assumed to be positively related with economic growth. therefore in including this group of growth determinants in equation 2, our final multivariate regression model can be specified as: gdpt=α+β1edut+β2govt+β3invt+β4inft+β5tott+et (5) where, gov is government size, inv is investment, inf is inflation and tot is terms of trade. 3.3. ardl models as mentioned earlier on, we employ the ardl model of pesaran et al. (2001) as our choice of econometric modelling. this study uses the ardl modelling approach as originally introduced by pesaran et al. (2001). the ardl cointegration approach has numerous advantages in comparison with other cointegration methods. unlike other cointegration techniques, the ardl does not impose a restrictive assumption that all the variables under study must be integrated of the same order. in other words, the ardl approach can be applied regardless of whether the underlying regressors are integrated of order i (1), order zero i (0) or are fractionally integrated. secondly, while other cointegration techniques are sensitive to the size of the sample, the ardl test is suitable even if the sample size is small. thirdly, the ardl technique generally provides unbiased estimates of the long-run malangeni and phiri: education and economic growth in post-apartheid south africa: an autoregressive distributive lag approach international journal of economics and financial issues | vol 8 • issue 2 • 2018104 model and valid t-statistics even when some of the regressors are endogenous. in formulating our ardl empirical specifications, we firstly re-specify the bi-variate as represented in equations 1 as the following ardl and ecm specifications: ∆ ∆ ∆gdp gdp edu gdp edu t t t i t i t i t ii n i n = + + + + = =∑ ∑φ φ β β ε 1 2 1 2 1 1 (6) and the associated error correction model (ecm) specifications is given as: ∆ ∆ ∆gdp gdp edu ect u t t t i t i t ii n i n = + + + = =∑ ∑φ φ γ 1 2 1 1 1 (7) whereas the multivariate regression (3) is re-specified as the following ardl specification: ∆ ∆ ∆ ∆ ∆ gdp gdp edu gov inv t t t i t i t ii n i n i n = + + + = = = ∑ ∑ ∑ φ φ φ φ 1 2 3 4 1 1 1 -i t i t i t i t i i n i n i n inf tot gdp edu + + + + + == = ∑∑ ∑ φ φ β β β 5 6 11 1 21 ∆ ∆ 33 4 5 6 gov inv inf tot t i t i t i t i t + + + +β β β ε (8) and the associated error correction model (ecm) specifications is given as: ∆ ∆ ∆ ∆ ∆ gdp gdp edu gov inv t t t i t i t ii n i n i n = + + + = = = ∑ ∑ ∑ φ φ φ φ 1 2 3 4 1 1 1 -i t i t i t i i n i n ti n inf tot ect u + + + + = == ∑ ∑∑ 1 111 5 6 φ φ γ∆ ∆ (9) where βi’s are the long-run regression coefficients, φi’s are the short-run coefficients and ect’s are the error correction terms which measure the speed of adjustment back to steady-state equilibrium in the face of external shocks to the economy. the error correction terms are assumed to lie within an interval (0, −1) although there are some exceptional cases where the coefficient can be allowed to be lie between −1 and −2. incidentally, significant negative error correction terms indicates long-run causality from the regressor to the regressand variable. however, prior to estimating our ardl models it is imperative that one tests for cointegration effects.to his end, the study uses the bounds test for cointegration effects which tests the joint null hypothesis as: h0: β1=β2=…=βi=0 (10) and this is tested against the alternative hypothesis of significant ardl cointegration effects i.e. h0: β1≠β2≠…≠βi≠0 (11) the test is tested with an f-statistics which is compared to the non-standard critical bounds values reported in pesaran et al. (2001). if the computed f statistic exceeds the critical upper bounds value, then the null hypothesis of no cointegration is rejected. if the computed φ-statistic falls below the critical lower bounds value, then the null hypothesis of no cointegration is not rejected. and if the computed f-statistic falls between the critical lower and upper bounds values, then the test are considered as being inconclusive. 4. methodology 4.1. data description and unit root tests the data used in our study has all been sourced from the world bank online database and consists of 6 variables collected on an annual frequency between 1994 and 2014. the dataset consist of the gdp growth rate (i.e., gdp), the secondary school enrolment (i.e., edu), the growth in government consumption expenditure (i.e., (gov), the cpi inflation rate (i.e., inf), the gross domestic fixed capital accumulation expressed as a share of gdp (i.e., inv) and the terms of trade (i.e., tot). the summary statistics and the correlation matrix of the time series has been respectively summarized in panel a and b of table 1. based on the summary statistics, it can be seen that the average growth rate over the sample period has been 1.38, a figure which is below the 6% growth target as envisioned by fiscal policymakers in their efforts to eradicate long-term unemployment and poverty. aloes note that the average inflation rate is 6.36%, which is a figure which slightly exceeds the upper bound of the current 3–6% range currently target by the reserve bank. we are also able to find that, on average, domestic investment have accounted for approximately 18% of total gdp. this latter figure highlights the low levels of domestic invest, an observation which may be a direct result of historically low savings rates. in turning our attention, to the correlation matrix as shown in panel b of table 1, we find that the reported figures produce a number of mixed results. for instance, whilst the positive correlation between government size and growth, the positive correlation between terms of trade and growth as well as the negative inflation-growth correlation are expected as they concur with standard growth theory, the negative education-growth and investment-growth correlation contradict contemporary economic theory. nevertheless, it is still to be confirmed whether our ardl estimates will support these preliminary correlations. as previously mentioned, the ardl methodology is only suitable for time series which are mixture of i (0) and i (1) variables hence testing for unit roots is an imperative step in our empirical analysis. henceforth, we perform the adf and pp unit root tests, with (i) a drift and (ii) an intercept, on the time series and report the empirical results of this exercise on table 2. as can be observed from the reported findings, in the levels of the time series variables, the results are mixed, with the adf test statics completely rejecting the unit root null hypothesis in favour of stationarity only for education, inflation and terms of trade whilst concerning the pp tests, stationarity in the levels of the variables is established for economic growth, inflation and terms of trade. however, in their first differences, all the time series manage to reject the unit root malangeni and phiri: education and economic growth in post-apartheid south africa: an autoregressive distributive lag approach international journal of economics and financial issues | vol 8 • issue 2 • 2018 105 null hypothesis at all critical levels regardless of whether the tests are performed with a drift or trend. 4.2. empirical results in light of the evidence of the time series being either stationary of first differences stationary variables, we conduct the bounds test for cointegration on our two empirical specifications, the first being the bi-variate education-growth model and the second being the multivariate specification which models economic growth and education alongside other growth determinants (i.e., inflation, government size, inflation, investment and terms of trade). the results of bounds test on both regressions are reported in table 3. the estimated f-statistics of 3.67 and 5.14 are obtained for the bi-variate and multivariate specifications, respectively, and both statistics manage to reject the joint null hypothesis of no cointegration since they exceed the upper critical bound albeit at different significance levels. this evidence permits us to proceed with estimating our empirical ardl models specifications. table 4 present our empirical estimates of both of our regression models. panel a presents the long-run estimates whereas panel b reported the short-run and error correction estimates of the estimate regressions. beginning with the long-run results reported in panel a, we firstly note that for both regression functions, the coefficient on education produces a negative and yet insignificant statistics on the variable. this implies that there is no distinct relationship between education and economic growth under the sample period. on the other hand, the coefficient on the government expenditure variable as being positive and statistically significant at a 10% critical level. we consider this finding as being credible since the positive relationship between government size and economic growth, finding which complies with wagner’s law and further advocated for in the works of odhiambo (2015) and phiri (2017). similarly, the negative coefficient and statically significant coefficient on the inflation variable is plausible since it adheres to traditional economic theory which hypothesis on a negative inflation-growth relationship. furthermore, such a negative inflation-growth relationship is empirical found in the study of hodge (2006) for similar south african data. in browsing through the short-run estimates shown in panel b of table 4, we note that government size is the only variables which produces a statistically significant coefficient estimate, which is positive at all critical levels. similarly, the error correction terms produce correct negative and statistically significant estimates of −0.74 to −0.89 for the f (gdp|edu) and f (gdp|edu, gov, inf, inv, tot) regressions, respectively. the latter result implies that between 74% and 89% of deviations from the steady-state are corrected in each period. 4.3. diagnostic results and stability analysis having estimated our empirical ardl models, the final stage of the empirical analysis involves performing diagnostic test on the estimated regressions. in particular, we perform the jarque-bera test for normality, the breusch-godrey test for serial correlation, the arch test for heteroscedasticity as well as ramsey’s reset test for functional form. based on the results reported in table 5, each of the test statics fail to reject the null hypotheses of diagnostic test, a result which offers support in notion of the absence of non-normality, serial correlation, heteroscedasticity and incorrect functional form within all estimated regressions. moreover, the cusum and cumsum square plots as depict in figures 1 and 2, for regressions f (gdp|edu) and f (gdp|edu, gov, inf, inv, tot) respectively. 5. conclusion following the democratic transition of the south african economy in 1994 much emphasis has been placed by policymakers in table 2: unit root test results levels adf pp drift trend drift trend gdp −4.10*** −4.15*** −2.07 −1.85 edu −2.18 −2.04 −4.14*** −4.17*** gov −3.14** −3.27* −4.87*** −4.95*** inv −2.69* −2.54 −3.06** −2.89 inf −1.69 −0.74 −1.35 −2.60 tot −0.08 −1.15 −0.24 −1.34 first differences gdp −8.25*** −5.29*** −6.57*** −9.69*** edu −5.66*** −5.71*** −7.47*** −7.15*** gov −7.65*** −7.84*** −7.14*** −6.84*** inv −3.89*** −3.91** −3.72*** −3.69** inf −4.51*** −5.65*** −8.27*** −7.90*** tot −4.03*** −4.04** −3.98*** −3.89** critical values (%) 1 −3.67 −4.30 −3.64 −4.26 5 −2.96 −3.57 −2.95 −3.55 10 −2.62 −3.22 −2.61 −3.20 table 1: summary statistics and correlation matrix of the variables variables gdp edu gov inv inf tot panel a: summary statistics mean±sd 1.38±1.61 89.33±4.04 2.78±2.81 18.15±2.26 6.36±1.39 83.44±12.53 j-b 1.74 1.09 16.59 1.48 0.16 2.28 prob. 0.42 0.58 0.00 0.48 0.92 0.32 panel b: correlation matrix gdp 1 edu −0.09 1 gov 0.39 0.17 1 inv −0.09 0.57 0.19 1 inf −0.28 −0.29 −0.22 0.24 1 tot 0.04 0.69 0.29 0.74 −0.21 1 malangeni and phiri: education and economic growth in post-apartheid south africa: an autoregressive distributive lag approach international journal of economics and financial issues | vol 8 • issue 2 • 2018106 attempts to correct social imbalances inherited the past apartheid regime. part-an-parcel of government’s efforts in designing policies which addresses these issues, is the specific focus on the role which education can play in improving the economy. in our study, we specifically examined the relationship between education and economic growth for south africa using annual post-democratic data spanning from 1994 to 2014. our mode of empirical investigation is the ardl model which is applied to two empirical specifications, the first being a bi-varaite education growth model and the second being a multivariate model consisting of education, economic growth and other control variable like government size, inflation, investment and terms of trade. our empirical results imply that education insignificantly impacts economic growth in both models whereas government size and inflation are the only variable which produce significant and theoretically correct coefficient estimates. the obtained empirical results in our study can provide some much needed advice to policymakers. for example the significant negative inflation-growth relationship implies that the reserve bank’s efforts in keeping inflation within a low target band is in the best interest of economic growth. our results further highlight the importance of government spending in improving economic growth, and as is well-known, a major part of government’s budget is dedicated towards education. however, the insignificant link between education and economic growth implies that an table 3: bounds test for cointegration regression function f-statistic significance (%) i (0) i (1) φ (gdp|edu) 3.67 10 2.2 3.09 φ (gdp|edu, gov, inf, inv, tot) 5.14 5 2.56 3.49 2.5 2.88 3.87 1 3.29 4.37 table 5: diagnostic test on estimated regressions test null hypothesis φ (gdp|edu) φ (gdp|edu, gov, inf, inv, tot) test statistic p-value test statistic p-value jarque–bera the regression is normal 4.02 0.13 1.06 0.59 breusch–godfrey there is no autocorrelation 0.39 0.72 0.11 0.90 arch there is no heteroscedasticity 0.01 0.98 0.42 0.53 ramsey resret test the mode is well-specified 1.66 0.12 1.78 0.12 figure 1: cusum and cumsumsq plots for φ (gdp|edu) figure 2: cusum and cumsumsq plots for φ (gdp|edu, gov, inf, inv, tot)inf, inv, tot) table 4: long-run and short-run ardl estimates variables φ (gdp|edu) φ (gdp|edu, gov, inf, inv, tot) coefficient estimate p-value coefficient estimate p-value panel a: long-run estimates edu −4.96 0.47 −4.11 0.68 gov 1.03 0.06* inf −0.47 0.05* inv 2.27 0.28 tot 0.16 0.92 panel b: short-run estimates ∆edu −11.51 0.10 −4.01 0.66 ∆gov 1.16 0.00*** ∆inf 0.01 0.98 ∆inv 0.10 0.97 ∆tot 6.06 0.16 ect (−1) −0.74 0.00*** −0.89 0.00*** “***”, “**” and “*” denote the 1%, 5% and 10% significance levels malangeni and phiri: education and economic growth in post-apartheid south africa: an autoregressive distributive lag approach international journal of economics and financial issues | vol 8 • issue 2 • 2018 107 increase in school enrolment numbers will not necessary benefit the economy in terms of improved growth. henceforth, our study implies that government should be rather concerned with deeper fundamental education issues such as improved quality of education. in suggesting direction for future research, we encourage academics to direct their efforts towards 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(2006), investigating the causal relationship between education and economic growth in zimbabwe. global journal of management and business research, 12(8), 1-13. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(3), 527-533. international journal of economics and financial issues | vol 7 • issue 3 • 2017 527 the effect of stock prices and exchange rates on economic growth in indonesia la saidi1*, pasrun adam2, rostin3, zainuddin saenong4, muh. yani balaka5, gamsir6, asmuddin7, salwiah8 1faculty of math and science, universitas halu oleo, kampus bumi tridhamma anduonohu 93232, kendari, indonesia, 2faculty of math and science, universitas halu oleo, kampus bumi tridhamma anduonohu 93232, kendari, indonesia, 3faculty of economics and business, universitas halu oleo, kampus bumi tridhamma anduonohu 93232, kendari, indonesia, 4faculty of economics and business, universitas halu oleo, kampus bumi tridhamma anduonohu 93232, kendari, indonesia, 5faculty of economics and business, universitas halu oleo, kampus bumi tridhamma anduonohu 93232, kendari, indonesia, 6faculty of economics and business, universitas halu oleo, kampus bumi tridhamma anduonohu 93232, kendari, indonesia, 7faculty of teacher training and education, universitas oleo, kampus bumi tridhamma anduonohu 93232, kendari, indonesia, 8faculty of teacher training and education, universitas oleo, kampus bumi tridhamma anduonohu 93232, kendari, indonesia. *email: lm.saidi@yahoo.co.id abstract this research aims to investigate the effect of stock prices and exchange rates on indonesia economic growth. the data were used the quarterly time series spanning in the period, 2004q1-2015q3. econometric model were used to analyze these data is the autoregressive distributed lag model. the result of stationary test showed that all of the time series of share prices, exchange rates, and economic growth are stationary at the first difference, or integrated of order one, i(1). the results of cointegration test showed that the third time series of stock prices, exchange rates, and economic growth are not cointegrated. the results of effect test showed that there is an effect of the stock prices and exchange rates on indonesia’s economic growth. furthermore, the amount of influence stock prices on economic growth is greater than the effect of exchange rates on economic growth. keywords: stock price, exchange rate, economic growth, autoregressive distributed lag model jel classifications: c44, f310, g120, o047 1. introduction foreign currency and share are instruments of investment in financial markets. investors will be motivated to invest in the stock market or in the foreign currency market, if investments in this market can give them a return or profit. if investors predicted that investment in the stock market and foreign exchange market can provide benefits in the future, then they will decide to buy the instrument in both markets, which in turn may lead to increase in demand for stocks and foreign currencies. furthermore, foreign currency becomes a tool in international trade transactions, both in the real sector and the financial sector. the high trading activity can lead to increase in demand for foreign currency. the increase in demand for shares and the foreign currency in the financial markets could cause a rise in prices of the two assets, which can ultimately affect a country’s macroeconomic conditions, among others: the stock price index and gross domestic product (gdp) or economic growth. factually in indonesia, it can be seen from the 3 time series trend of the stock price index, exchange rates, and economic growth in 2004q1-2015q3, where the stock price index, rupiah/euro exchange rate, and the indonesian gdp fluctuated and showed uptrend. stock price index rise from 735.68% in the first quarter of 2004 to be 4802.53% in the third quarter in 2015q3. rupiah/euro trend also rise from rp 10,541.55 in the first quarter of 2004q1 to be rp 16,575.67 in the third quarter of 2015q3. meanwhile, in the same period, indonesia gdp also saidi, et al.: the effect of stock prices and exchange rates on economic growth in indonesia international journal of economics and financial issues | vol 7 • issue 3 • 2017528 rise from us$ 536,605.3 in the first quarter of 2004q1 to be us$ 2,982,562 in the third quarter in 2015q3. in theory, the effect of stock prices on economic growth can be explained through the channels: the wealth effect and the theory of q-tobin. based on the wealth effect channels, increase in stock prices is a signal of impending increase in wealth for investors and households holding assets of shares. the increase in wealth can raise household spending (ludvigson and steindel, 1999; mehra, 2001; majumder and nag, 2015), which in turn can raise the gdp and economic growth (adam, 2015). furthermore, according to the q-tobin theory that if the stock price is high, then the value of the ratio between the market price of the company with capital replacement costs are high, ultimately increasing investment and aggregate output (duca, 2007). the increase in aggregate output may cause an increase in economic growth. exchange rate is also the price of foreign currency assets that can affect wealth. depreciation of the exchange rate of the domestic currency can increase the wealth of households holding foreign currency (sahadudheen, 2012). the increase in wealth could eventually raise consumption, gdp, and economic growth. furthermore, based on the channels of trade, the exchange rate is a tool in international trade transactions. the depreciation of the exchange rate may cause the price of domestic goods more competitive in the international market (mauro et al., 2008), then it can lead to increased purchase of domestic goods by other countries, so it can cause an increase in aggregate exports (ali et al., 2014; adam et al., 2017). this increase can raise the balance of trade, gdp (mauro et al., 2008; saidi, et al., 2015; saidi, 2016), and economic growth. empirical research on the effect of stock prices and exchange rates on economic growth has been done by researchers in economics and finance. there has been no consensus on the results of their research. some researchers found that the effect of stock prices on economic growth is positive, among others: chen (1991), hassapis and kalyvitis (2002), gallegati (2008), cole et al. (2008), madsen et al. (2013), and adam (2015). several other researchers found that the effect of stock prices on economic growth is negative, for example: dimson et al. (2002) and ritter (2005), and also there are researchers who found that stock prices do not affect economic growth, for example senturk et al. (2014). furthermore, some researchers found that the effect of exchange rates on economic growth is positive (rodrik, 2008). several other researchers found that the effect of exchange rates on economic growth is negative, among others: gyimah-brempong and gyapong (1993), omotor (2008), ndhlela (2012), papanikos (2015), and even some other researchers found that there was no effect of exchange rates on economic growth, among others: akpan and atan (2012), mukolu et al. (2013) and tang (2015). this difference could be due to the economic conditions of a country in a given time period in which the research is conducted, for example, anthony (2012) and akpan and atan (2012) conducted a study on the effect of exchange rates on economic growth in nigeria in different time periods, where anthony in his research found that there was an effect of exchange rate on the economic growth, while akpan and atan (2012) in their study did not find any effect of the exchange rate on economic growth. hossain and hossain (2015) also found that there was influence of stock prices on economic growth in the us and japan, but in the uk, the stock price did not affect the economic growth. thus, studies that use data at different time periods in one country can provide different findings. while studies on the effect of stock prices or exchange rates to economic growth have been conducted in various countries, and in different time periods by previous researchers, however, studies on the comparison of the influence between stock prices and exchange rates to economic growth is still rarely done by previous researchers. this research aims to investigate the effect of stock prices and exchange rates on economic growth, and we compare the effect between stock prices and exchange rates on economic growth in indonesia. the research data that we use is the quarterly time series data spanning from the first quarter of 2001 to the third quarter of 2015. furthermore, we use the autoregressive distributed lag (adl) model to analyze the data proposed by ender (2014) and koop (2006). 2. review of literature in theory, influence stock prices and exchange rates on economic growth has been stated in the introduction section. in this section, we just put forward some relevant empirical findings by previous researchers. ndhlela (2012) examined the relationship between exchange rate misalignment to economic growth in zimbabwe. the results showed that the exchange rate misalignment has a negative effect on economic growth. rapetti et al. (2012) examined the relationship between exchange rates and economic growth in developed countries (australia, austria, belgium, canada, denmark, finland, france, germany, greece, iceland, ireland, italy, japan, luxembourg, the netherlands, new zealand, norway, portugal, spain, sweden, switzerland, the united kingdom and the united states), and in developing countries (iraq, democtatic republic of korea, and laos), in the time period of 1950-2004. period of time, they divide into two subperiode, namely time periods of 1950-1979 and 1980-2004 time period. they found that there is an influence of the exchange rate on economic growth in each subperiode of time. this exchange rate effects in developing countries is stronger than in developed countries. kogid et al. (2012) investigated the effects of the real exchange rate and the nominal exchange rate to the enonomic growth of malaysian using annual data spanning 1971-2009. results of analysis using adl models, they found that the real exchange rate and the nominal exchange rate affected economic growth. aman et al. (2013) examined the relationship between exchange rates and economic growth in pakistan using data spanning in the period 1976-2010. their research results showed that there was a positive relationship between exchange rates and economic growth. missio et al. (2015) examined the relationship between exchange rates and output growth in latin america. the results saidi, et al.: the effect of stock prices and exchange rates on economic growth in indonesia international journal of economics and financial issues | vol 7 • issue 3 • 2017 529 of data analysis using quantile regression model showed that the exchange rate positively affected economic growth. some researchers also examined the effect of exchange rates and other macroeconomic variables to economic growth, which is as follows. wong (2013) examined the effect of interest rate differentials, productivity, real oil prices and exchange rates on economic growth. he used the adl model to analyze the data. he found that the rise in the real exchange rate misalignment reduced economic growth. koitsiwe and adachi (2015) examined the dynamics of the relationship between mining revenue, government spending, exchange rates, and economic growth in bosnia using quarterly data spanning the period 1994-2012. the test results using the var model, they found that the exchange rates and mining revenue affected economic growth. meanwhile, government expenditure was influenced by economic growth. omotor (2008) investigated the effect of exports, employment, imports, liberalization of economic policies, and exchange rate on nigeria’s economic growth using data in the period 19792005. the test results by using the error correction model (ecm) showed that exports, employment, and economgic liberalization policies affected positively on economic growth, while imports and exchange rate affected negatively on economic growth. research on the relationship between stock prices and economic growth is as follows. liu and sinklair (2008) investigated the relationship between the performance of the stock market and economic growth in greater china (china mailand, hong kong, and taiwan). the results of their analysis using the vecm show that in the short-run, stock prices affected economic growth. furthermore, they concluded that in the short-run, the stock price to become a leading indicator of future economic growth in greater china. mc-millan and wohar (2012) examined the long-run cointegration between the real output and stock prices in the united states using the data in the period 1801-2008. they found that in the long-run, there was a cointegration between stock prices and economic growth. zalgiryte et al. (2014) examined the effect of stock prices on economic activity in the united states and france in the period 200q2-2012q1. economic activity was proxied by gdp growth. they used cross-correlation to analyze the data, and they found that the stock market was a leading indicator of economic growth. guo (2015) examined the relationship between stock return and real economic growth in china, in the period of time before the suprime crisis and after the suprime crisis of the united states. he used the nonuniform cross-correlation weighting approach and the multivariate generalized autoregressive conditional heteroscedasticity model. based on the test results, he found that there was no relationship between stock returns and real economic growth before the subprime crisis. meanwhile, after the subprime crisis, there was a relationship between real economic growth and stock returns. senyuz et al. (2014) examined the dynamics of the relationship between economic growth and stock markets of turkey using data in the period 1988-2008. they found that the stock market affected economic growth. the researchers have also examined the effect of stock prices and other macroeconomic variables to economic growth. zhang and wu (2012) for example, examined the relationship between stock prices, household savings and economic growth in china. they use quarterly data in the period 1994-2005. economic growth was proxied by gdp. to analyze the data, they used the var model. the test results showed that the household savings positively affected gdp, while the relationship between stock prices and gdp was negative but insignificant. mauro (2003) examined the relationship between real interest rates, stock returns, money growth, and economic growth in emerging-market (among others: argentina, bangladesh, botswana, brazil, bulgaria, mexico, morocco), and in developed market (australia, austria, belgium, canada, denmark, france, germany, italy, japan, netherlands, norway, singapore, sweden, switzerland, united kingdom, usa, and spain) using annual data in the period 1971-1988. the test results using the panel regressions model showed that there was a positive and strong correlation between stock returns and economic growth. 3. data and methodology 3.1. data this study uses three types of time series data, namely: stock prices, exchange rates, and economic growth. the stock price is proxied by the stock price index of the indonesia stock exchange. exchange rate is proxied by idr/euro exchange rate (any subsequent written exchange rate) based on the consideration that some countries in europe, among others: finland, denmark, belgium, spain, italy, france, germany, sweden, slovakia, ukraine, azerbaijan, and the united kingdom are countries of trading partner of indonesia, and that the euro currency is an investment instrument and tool of trade transactions in indonesia. all types of time series data are quarterly data spanning in period 2004q1-2015q3. the data source of the stock price is fusion media limited (www.investing.com). the data source of the exchange rate is bank indonesia (www.bi.go.id). data source of indonesia’s economic growth is badan pusat statistik indonesia (www.bps.go.id). for purposes of analysis, time series data of stock prices is denoted by sto, the exchange rate is expressed by exc, and economic growth is expressed by gro. here, gro is the change in gdp from t-1 to t, so, gro gdp gdp gdp t t t t = − − − 1 1 3.2. methodology this study aimed to investigate the effect of stock prices and exchange rates on economic growth. therefore, this study used two independent variables, namely: stock price (sto) and exchange rate (exc), while the dependent variable is economic growth (gro). to test the effect, we used a model adl presented by ender (2015) and koop (2006). if sto, exc, and gro are stationary, then the formulation of the model is: saidi, et al.: the effect of stock prices and exchange rates on economic growth in indonesia international journal of economics and financial issues | vol 7 • issue 3 • 2017530 gro =a a gro b sto c exc ò t 0 i t i i=1 p j t j j=0 q k t k t k=0 r + + + + − − − ∑ ∑ ∑ (1) however, if all-time series data sto, exc, and gro is stationary at first difference or integrated of order one, i(1), and are not cointegrated, then the model (1) is expressed in the form of first differences, namely d gro =a + a d(gro b d(sto c d(exc t 0 i t i i=1 p j t j j=0 q k t k k ( ) + + + − − − ∑ ∑) ) ) ==0 r t∑  (2) where p, q, r are the length of time lag, et is white noise, ai (i = 1, 2,…, p), bj (j = 0, 1, 2,… q) and ck (k = 0, 1, 2,…, r) are regression parameters. d(grot) is the first difference form of grot where d(grot) = grot-grot−1 = gro-gro(−1). in the long-run, all variables gro, sto, and the exc are in equilibrium condition if, grot = grot−1 = grot−2 = ... = grot−p; sto = stot−1 = stot−2= ... = stot−p; and exct = exct−k = exct−2 = ... = exct−r, so the equation 2 becomes, d gro a a a a d(gro ) b t 0 i=1 n i j=1 p j i=1 n i t j=0 q j i=1 n ( ) = − + − + − ∑ ∑ ∑ ∑ ∑ 1 1 1 aa d(sto ) c a d(exc )+ i t j=0 r j i=1 n i t t + − ∑ ∑1  (3) where b b a j=1 q j i=1 n i = − ∑ ∑1 is long-run multiplier of stock prices on economic growth, and c c a j=0 r j i=1 n i = − ∑ ∑1 is a long-run multiplier of exchange rate on economic growth (heij et al., 2004; adam et al., 2015). a positive multiplier value means that the long-run effect of stock prices or exchange rates on economic growth is positive. koop (2006) states that the explanatory variables in the equation 1 and 2 can multicollinearity. to eliminate multicollinearity, he changed the form of equation 2 becomes, d d gro a d gro d sto d exc d(d(gro t t 1 t t i t i ( )( ) = + ( )+ ( )+ ( ) + − − 0 ρ θ γ τ ))) )) )) ( i=1 p j t j+1 j=0 q j t j j=0 q k d(d(sto d(d(sto d d( ∑ ∑ ∑ + + + − − + ω ω 1 φ eexc t k t k=0 r − + +∑ 1 ))  (4) where d(d(gro t)) = d(gro t)–d(gro t−1) = d(gro)d(gro(−1)) is the second difference form of grot. the long-run multiplier of stock prices on economic growth is, b= b a j=1 q j i=1 n i − = − ∑ ∑ θ ρ 1 and the long-run multiplier of exchange rate on economic growth is c c a j=0 r j i=1 n i = − = − ∑ ∑ τ ρ 1 . if each sto, exc, and gro is integrated of order one i(1), and they are cointegrated, then the equation 4 becomes, d d gro =a +e + d gro + d(sto ) + d(exc ) d(d(gro t 0 t t-1 t t i t ( )( ) ( ) + −1 ρ θ τ γ −− − + − + ∑ ∑ ∑ + + + i i=1 p j t j j=0 q k t k k=0 r t d(d(sto d(d(exc )) )) )) ω 1 1   (5) where et−1 is an error correction, and (5) is called an ecm. to test the effect of stock prices and exchange rates on economic growth, we do a three-step of test, namely: the unit root test, cointegration test, and test of the effect. we used the augmented dickey-fuller test to test a stationary time series data. according to this test, that if the absolute value of the test statistic is greater than the absolute value of it’s critics at the significance level of 1% or 5%, then the time series is stationary or integrated of order d, i(d). we used granger-two-step cointegration test to test cointegration among stock prices, exchange rates, and economic growth. in this test, we first build res time series from multiple regression equation, rest = grot−∝−βexct−γstot (6) where α, β, and γ are parameter estimation results of multiple regression. when rest is integrated of order zero, i(0), then sto, exc, and gro are cointegrated. to test the effect of stock prices and exchange rates on economic growth, first of all, we estimate all parameters of the adl model using the least squares method. while testing the significance of all these parameters, we used the p-value test of t-statistics and f-statistics on significance level α (1%, 5% or 10%). furthermore, the determination of lag length p, q, and r, we used the akaike table 1: the results of adf test variable adf statistic 1% critical value 5% critical value p* sto −0.852337 −3.581152 −2.926622 0.7943 d (sto) −5.286053 −3.584743 −2.928142 0.0001 exc −1.589670 −3.581152 −2.926622 0.4797 d (exc) −6.106235 −3.584743 −2.928142 0.0000 gro −2.224373 −3.600987 −2.935001 0.2011 d (gro) −4.802423 −3.615588 −2.941145 0.0004 *mackinnon (1996) one-sided p values saidi, et al.: the effect of stock prices and exchange rates on economic growth in indonesia international journal of economics and financial issues | vol 7 • issue 3 • 2017 531 information criterion (aic), namely that the values of p, q, and r is determined such that the value of aic reached the minimum value (koop, 2006). we also compare the statistical value of durbin watson (db) and r-square (r2) value to ensure that the results of model estimation are not a spurious regression model. 4. results and discussion 4.1. results results of the unit root test on time series of stock prices, exchange rates, and economic growth, both at the level and in first differences are summarized in table 1. based on the values of the statistics in table 1, all the time series of stock prices, exchange rates and economic growth are stationary at first difference, or integrated of order one, i(1). rest is a time series constructed from the equation 6. the results of the adf test on time series, we get the value of the test statistic is −1.287471. while the statistical value of it’s critics at the 5% significance level is −2.935001. by comparing the value of both these statistics, rest is unstasionary time series or is not integrated of order zero, i(0). so, the time series of stock prices, exchange rates, and economic growth are not cointegrated. the estimation results of all parameters of regression equation 4 are summarized in table 2. based on the p-value of f-statistics in table 2 show that all parameters of the adl model is significant 1%. this indicates that the stock prices and exchange rates jointly effect on economic growth. furthermore, based on the p-value of t-statistics, then each parameter of regression is significant (1%, 5%, or 10%). thus, partially, there is an effect of stock prices on economic growth, and there is an effect of exchange rates on economic growth. a long-run multiplier of independent variable d(sto) is 2.71993e-05. based on this multiplier number, then the effect of stock prices on economic growth is positive. the amount of influence stock prices on economic growth is relatively small, with each 1% rise in stock prices, economic growth rose by 2.71993e-05%. furthermore, the independent variable d(exc) has a long-run multiplier of 6.99048e-06, so that, the exchange rate also affects positively to economic growth, where each 1% increase in the exchange rate, economic growth rose by 6.99048e06%. based on the multiplier effect of stock prices and exchange rates, then we conclude that the contribution of stock price to economic growth is greater than the contribution of exchange rate to economic growth. 4.2. discussion the results of this study are consistent with results of previous studies mentioned in the introductory section and in the section of literature review; however, the results are not in line with the findings in the study by akpan and atan (2012), and tang (2015). the difference between our finding and the research results of akpan and atan (2012) and also tang (2015) could be caused by the economic conditions of the country where the study was conducted (hossain and hossain, 2015), where our study was conducted in indonesia, while akpan and atan (2012) in nigeria, and tang (2015) in china. in this study also found that economic growth is influenced by economic growth to the previous two quarters. the influence of stock prices and exchange rates on economic growth is relatively small, and the effect of economic growth in the past is still greater when seen from the coefficient of determination in table 2. thus, there are other factors that can affect the economic growth. other factors could be caused partly by: money growth (mauro, 2003), foreign direct investment (sylwester, 2005), export and import (omotor, 2008), interest rates and oil prices (wong, 2013), household saving (zhang and wu, 2012), and income distribution (molero-simarro, 2015). however, the effect of these factors need further research. 5. conclusion this research aims to investigate the influence of stock prices and the exchange rates on indonesia’s economic growth, and to compare the magnitude of the effect between stock prices and table 2: the estimation results of the adl model with dependent variable is d (d (gro) independent variable coefficient t-statistics p others statistics a0 −0.016552* −3.751093 0.0011 r 2: 0.970318 d (gro(−1)) −3.933924* −18.14962 0.0000 f-statistics: 44.94918 d (d (gro(−1))) 1.915941* 12.14940 0.0000 p (f-statistics): 0.000000 d (d (gro(−2))) 0.927774* 11.12662 0.0000 aic: −5.254963 d (sto) 0.000107* 3.949632 0.0007 dw statistic: 2.284653 d (d (sto)) −0.000119* −5.240784 0.0000 d (d (sto(−1))) −0.000102* −5.457940 0.0000 d (d (sto(−2))) −5.95e-05* −3.773651 0.0010 d (d (sto(−3))) −3.02e-05** −2.746150 0.0118 d (exc) 2.75e-05** 2.411121 0.0247 d (d (exc)) −3.09e-05* −3.023267 0.0062 d (d (exc(−1))) −2.42e-05** −2.611023 0.0160 d (d (exc(−2))) −2.25e-05** −2.669825 0.0140 d (d (exc(−3))) −1.52e-05** −2.155453 0.0423 d (d (exc(−4))) −1.10e-05*** −1.837731 0.0796 d (d (exc(−5))) −1.20e-05** −2.596310 0.0165 d (d (exc(−6))) −6.77e-06*** −1.900410 0.0706 *significant 1%, **significant 5%, ***significant 10%, adl: autoregressive distributed lag saidi, et al.: the effect of stock prices and exchange rates on economic growth in indonesia international journal of economics and financial issues | vol 7 • issue 3 • 2017532 exchange rates. time series data used in this study is the quarterly time series data spanning in the period 2004q1-2015q3. time series data consists of stock prices, exchange rates, and economic growth in indonesia. 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(2012), household savings, the stock market, and economic growth in china. emerging markets finance and trade, 48(2), 44-58. _goback . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 254-261. international journal of economics and financial issues | vol 7 • issue 4 • 2017254 analysis of the impact of economic growth on income inequality and poverty in south africa: the case of mpumalanga province ferdinand niyimbanira* school of development studies, university of mpumalanga, south africa. *email: f.niyimbanira@ump.ac.za abstract the aim of this article is to estimate the impact of economic growth on income inequality and poverty using data from the mpumalanga province in south africa. theoretically, it can be argued that there is a negative relationship between the gini coefficient and economic growth, but evidence shows that it is not always the case. the same argument can be reasoned for economic growth and poverty. the purpose of this paper is to establish whether there is empirical evidence of such relationships. furthermore, the paper examines the extent to which such nexuses are evident in south africa with particular reference to mpumalanga province. the gini coefficient is used as a proxy for income inequality. the method of analysis used is the fixed effect and pool regression models with secondary data from all 18 local municipalities in mpumalanga. the results have demonstrated that economic growth reduces poverty but not income inequality. the findings of this study have implication for policy makers to design strategies of reducing income inequality in south africa. the study concludes by proposing socio-economic measures that could enhance economic growth and improve human development in a knowledge-based economy. keywords: economic growth, income inequality, poverty, south africa jel classifications: i30, o110 1. introduction economic growth and the equitable distribution of income are two of five main macroeconomic objectives any country would like to achieve and are concerned with economic development. even though there is a belief that economic growth is the most powerful instrument for reducing poverty and improving the quality of life in developing countries, there is not enough debate amongst economists around the notion that a high level of economic growth is essential for poverty reduction. however, there is a lot of debate about economic growth and the gross domestic product and many questions have arisen on their impact on welfare. gumede (2016. p. 89) argues that “…the majority of those countries which managed to achieve higher growth levels suffer from high levels of socio-economic and political hardship, which is reflected in endemic poverty, struggles for daily existence, economic and social inequalities as well as various cleavages.” this shows that economic growth does not necessarily improve the lives of the poor. on the other hand, high economic growth advances human development which, in turn, promotes economic growth. rates of the economic growth can have different effects on poverty. the extent to which growth reduces poverty depends on the degree of poverty and to which extent the poor are involved in economic activities. thus, both the pace and pattern of growth matter in reducing poverty. the relationship between income inequality, poverty and economic growth has been an area of ongoing study for over five decades. the distribution of income in a country is assumed to fluctuate from relative equality to inequality and back to greater equality as the country develops. increased growth rates, effectively measured by rising per capita incomes, would appear to make this link clear and simple. this means that economic growth reduces poverty and inequality. yet it should also be noted that a higher inequality lowers human development by depriving lower-income households access to health and physical capital (aghion et al., 1999; galor and moav, 2004). the challenges of poverty and income inequality are commonly known globally. for example, about half of the world’s population lives on the equivalent of two usa dollars per day (hassoun, 2011). developing countries have been mostly characterized by impressive economic growth since early 1995. sometimes the niyimbanira: analysis of the impact of economic growth on income inequality and poverty in south africa: the case of mpumalanga province international journal of economics and financial issues | vol 7 • issue 4 • 2017 255 economic growth might come with challenges, which compound the socio-economic ills such as unemployment, poverty and inequality if the production process are technology and machinery based. in africa; economic growth has picked up remarkably but empirical evidence of its impact on poverty and inequality is mixed. in some countries that have achieved economic growth, there is evidence of low income inequality, unemployment and less poverty but in other countries there has been no reduction in those socio-economic ills despite the fast economic growth. in south africa, there has been a robust debate around the impact of economic growth on poverty and inequality in the post-apartheid era. according to gumede (2016. p. 115-116) “…there is a general consensus in south africa that poverty and inequality, particularly income inequality and income poverty, are persistent. these two development issues are primarily linked to the legacy of the apartheid system of governance as well as the structure of the economy.” this indicates that economic growth may have a positive impact in reducing income inequality and poverty but it might not always be the case. lewis (2008) describes this phenomenon as “growth without prosperity” in africa’s new democracies. for example, during the first decade of democracy in south africa, the economy has recorded one of its longest periods of positive economic growth in the country’s history. one of the more puzzling issues within the economic policy terrain in post-apartheid south africa though, has been the impact of this consistently positive growth performance on social welfare, specifically, income poverty and inequality (bhorat and van der westhuizen, 2012). many observers have highlighted the potential harmful consequences of persistently high levels of poverty and, particularly economic inequality, on the quality and sustainability of democracy (bermeo, 2009; kapstein and converse, 2008; well and krieckhaus, 2006). the primary objective of this article is to conduct an empirical investigation on the impact of economic growth on income inequality and poverty in the mpumalanga province. to achieve this, the study sought to determine whether a short-run and/or long-run relationship between income inequality, poverty and growth does exist. it also deals with the implications from the findings. first and foremost the study provided a reflections on recent theoretical and empirical studies and described data and methodology. thereafter, an econometric analysis of the results and findings with detailed implications is outlined. lastly, a conclusion and direction for future research are outlined. 2. reflections on recent theoretical and empirical studies the relationship between economic growth, poverty and income inequality can be positive or negative. in other words, there is no empirical consensus that the association between income inequality, poverty and economic growth is consistent. some recent research and development experiences suggest that sufficiently high and sustained growth is a prerequisite for meaningful, and hopefully irreversible, impact on poverty and income distribution. in addition; a careful analysis of historical growth processes across the world reveals that records of sustained and sufficiently deep economic growth which reduce both poverty and income inequality are an exception rather than a rule. thus, when economic growth takes place, its impact on poverty and income distribution is not automatic. the efficiency of growth in terms of poverty reductions, as well as its sustainability over time depends on the extent of inequality. indeed, while the empirical evidence suggests that practically no economic improvement takes place without growth, depending on the extent of initial inequality. growth spells may either collapse to a grinding halt, get completely reversed, or instead, could trigger a virtuous circle from growth to reduced poverty and to improved equality to further sustained growth in the future (hassan, 2008. p. 6). many different countries experience growth without both the reduction of poverty and widened income inequality, for example, china and india while others manage to reduce only one of these two socio-economic ills, and these are bangladesh and uganda (hassan, 2008). it is important to add that widening inequality and lack of poverty also have significant implications for growth and macroeconomic stability. according to claessens and perotti (2007) inequality might lead to political and decision making power in the hands of a few and/or to poor public policy choices. for example, it can lead to a backlash against growth-enhancing economic liberalization and fuel protectionist pressures against globalization and market-oriented reforms (claessens and perotti, 2007). in the south african political economy, this is known as radical economic transformation which recently has been topical and the policy direction the ruling party is taking. in their research on economic growth and inequality; panizza (2002) and frank (2002) studied the case of the united states of america (usa). the former reveals that an increase in per capita income equalizes income distribution in the usa. the results also showed that the relation between income inequality and growth is not robust. the latter study showed that there is a negative relationship between income inequality and economic growth but this negative link seems to be higher in low-income states of the usa. rangel et al. (2002) examine the impact on economic growth of income inequality pertaining to brazilian cities in minimum comparable areas. they check non-linear or inverted-u shaped phenomenon for these variables. several regressions are estimated using socio-economic variables to observe the attributed link between inequality and per capita income growth over a 10-year period, i.e., 1991-2001. the empirical evidence shows that the inverted-u shaped curve is the best functional specification to signify the relationship between inequality and economic growth. to verify the results, the akaike information criterion has been used to confirm their reliability and validity. marta and sanchez-robles (2005) and malinen (2008) examine the connection between income inequality and economic growth using latin american countries data. their results indicated mixed outcomes that the impact of income inequality on economic growth may be different at different stages of economic development and that the income inequality is negatively related to economic growth in south american countries. this was again found by wan et al. (2006) in their study on the nexus between income inequality and growth in post-reform using polynomial inverse lag framework for china. their results indicate that there is a non-linear and negative niyimbanira: analysis of the impact of economic growth on income inequality and poverty in south africa: the case of mpumalanga province international journal of economics and financial issues | vol 7 • issue 4 • 2017256 link between income inequality and economic growth irrespective of the time applied. nahum’s (2005) results, on the contrary, using sweden as a case study, aptly and positively indicated that income inequality is the necessary evil or an opportunity cost for economic growth. heyse (2006) extends the work on growth-inequality nexus for developing economies. the results reveal that developing countries with high income inequality are not connected with less economic growth as compared to those developing economies where income distribution is more equal (heyse, 2006). bahmani-oskooee and gelan (2007) found that economic growth for the usa favors income inequality for a short span of time but improves income distribution in the long run. cañadas (2008) analyzed inequality in argentina using partridge (2005) framework. it is revealed that the income growth of different quintiles has been related to economic growth for each province. the two models used were the spatial lag model and spatial error model. the results from the study indicated that income inequality in one province and inequality in other neighboring provinces was negatively related with the growth of all provinces in argentina. it is important to question the issue of celebrating high economic growth in developing countries especially if it has not translated into significant improvements in the wellbeing of the continent (gumede, 2016). research evidence suggests that the reduction of poverty in any country depends on the rate of average income growth, the initial level of inequality, and changes in the level of inequality (world bank, 2001; bourguignon, 2003; klasen, 2004). empirical evidence indicates that low inequality is positively associated with poverty reduction in countries with high economic growth (world bank, 2001; dollar and kraay, 2002; bourguignon, 2003). therefore, there is a pay-off in poverty reduction from growth, but also of lower initial inequality and reductions in inequality during the growth process. the aforementioned reflections have shaped this article as the following sections indicate. it is important to continue with pursuing all possible means to further economic growth ensuring that is sustainable and that it translates into the reduction of both poverty and income inequality. 3. data description and methodology income inequality can be measured using different indicators of which the most used ones are the lorenz curve, gini coefficient, quantile ratio and palma ratio. in addition, there are others which are less commonly used such as the theil index, robin hood index, atkinson index, coefficient of variation, generalised entropy index and sen poverty measure. each of these indices has some advantages and shortfalls. this paper adopted the commonly used indicator which is the gini coefficient. however, this choice does not indicate that it is the best or better index than others. according to gumede (2015) the gini coefficient is the most commonly used measure of inequality. it measures how much the distribution of income, or consumption expenditure, among individuals or households deviates from a perfectly equal distribution. graphically, the gini-coefficient can be easily represented by the area between the lorenz curve and the line of perfect equality (shahbaz, 2010). the lorenz curve plots the cumulative percentages of total income received against the cumulative number of recipients, starting with the poorest individual or household (mohr, 2012). the gini coefficient varies from 0 to 1, meaning that if the income is distributed perfectly the gini coefficient is zero. in this case the lorenz curve will be equal to the line of the prefect equality and the area of inequality will be equal to zero. in other words, the higher the gini coefficient is, the higher the level of inequality. a major advantage of the gini-coefficient is that it measures inequality by means of a ratio analysis that includes, and therefore represents, the total population and not just a part of the population (mohr, 2012). thus, for income inequality this study used gini coefficient data of all 18 local municipalities in the mpumalanga province of south africa. having discussed the measurement of income inequality, for poverty, this study used share below the lower poverty line as defined by statistics south africa. the poverty line is the level of income below which an individual or a household is regarded as poor (tucker, 2017). therefore, the paper used poverty rate as a percentage of the total population in each municipality of the mpumalanga province from 1996 to 2014. the same applies with economic growth which is the ability of an economy (national, provincial or municipal) to produce greater levels of output. this ability could be influenced by increase in resources such as capital or human and technology. tables 1-3 provide the gini coefficient, poverty and economic growth in the local municipal area of the mpumalanga province. the data was obtained from ihs global insight – rex, june 2015. among the 18 local municipal areas in 2014, referring to the table 1, dr js moroka (0.53) registered the lowest (best) gini-coefficient and govan mbeki, jointly with mbombela municipality, the highest (worst) at 0.62. with the exception of victor khanye, the income inequality deteriorated in all the municipal areas over the 18-year period under review. emalahleni and thaba chweu registered the highest deterioration in income distribution between 1996 and 2014. in terms of poverty level, in 1996 the municipality with the highest level was chief albert luthuli (75.5%) and the lowest was steve tshwete (31.6%); nkomazi local municipality had the highest level of poverty (50.1%); emalahleni and steve tshwete experienced the lowest poverty level (19.6%) in 2014. in order to empirically analyse the impact of the economic growth on income inequality and poverty in the mpumalanga province, econometric models are developed. this study performed a crosssectional time series data analysis which offers a better alternative to cross-country and time-series analyses (dawson, 2008; 2010; hassan et al., 2011; jaunky, 2013). for dawson (2008. p. 327) a cross-sectional time series data set consists of n individuals (local municipalities) over t time periods (years). according to stiglingh (2015. p. 46) “the use of cross-sectional time series data enables the study to address a broader range of variables and tackle more complex data that wouldn’t be possible with pure time series or pure cross-sectional data alone.” in addition, by using time niyimbanira: analysis of the impact of economic growth on income inequality and poverty in south africa: the case of mpumalanga province international journal of economics and financial issues | vol 7 • issue 4 • 2017 257 table 1: the gini coefficient of mpumalanga local municipalities: 1996‑2014 local municipality 1996 1999 2002 2005 2008 2011 2014 bushbuckridge 0.55 0.60 0.60 0.57 0.58 0.54 0.57 chief albert luthuli 0.55 0.60 0.62 0.60 0.58 0.56 0.58 dipaleseng 0.54 0.58 0.60 0.61 0.59 0.56 0.58 emakhazeni 0.51 0.56 0.59 0.60 0.59 0.57 0.70 emalahleni 0.54 0.59 0.61 0.62 0.61 0.60 0.60 govan mbeki 0.59 0.64 0.65 0.65 0.64 0.63 0.61 dr. j. s. moroka 0.52 0.57 0.58 0.55 0.53 0.52 0.53 lekwa 0.56 0.60 0.61 0.61 0.60 0.59 0.58 mbombela 0.59 0.63 0.63 0.63 0.63 0.63 0.62 mkhondo 0.57 0.61 0.62 0.61 0.60 0.59 0.59 msukaligwa 0.55 0.60 0.62 0.62 0.61 0.60 0.59 nkomazi 0.56 0.60 0.60 0.59 0.58 0.57 0.57 pixley ka isaka seme 0.59 0.62 0.64 0.64 0.63 0.62 0.61 steve tshwete 0.55 0.60 0.61 0.61 0.61 0.59 0.58 thaba chweu 0.54 0.59 0.61 0.62 0.62 0.60 0.60 thembisile hani 0.51 0.56 0.56 0.55 0.53 0.51 0.54 umjindi 0.55 0.59 0.61 0.61 0.61 0.60 0.58 victor khanye 0.59 0.63 0.63 0.62 0.61 0.61 0.59 source: ihs global insight – rex, june 2015 table 2: poverty in mpumalanga between 1996 and 2014: share below the lower poverty line (stats sa defined) in % local municipal area 1996 1999 2002 2005 2008 2011 2014 bushbuckridge 72.2 76.7 77.1 69.1 67.2 53.6 48.4 chief albert luthuli 75.5 77.1 75.7 65.5 61.8 46.5 42.8 dipaleseng 57.9 63.6 64.5 52.9 46.6 30.0 29.9 emakhazeni 51.1 54.3 54.9 46.4 42.7 27.9 28.2 emalahleni 31.7 38.6 41.2 35.2 30.9 18.6 19.6 govan mbeki 41.4 42.8 42.8 37.8 35.3 24.0 24.6 dr. j. s. moroka 71.0 73.6 73.0 64.9 62.6 47.7 45.8 lekwa 45.7 49.9 51.5 44.5 41.6 28.2 29.9 mbombela 55.4 57.3 57.1 49.6 46.9 33.1 33.1 mkhondo 65.8 71.9 73.7 66.3 64.1 50.0 49.8 msukaligwa 48.8 56.3 58.7 50.2 45.5 30.3 33.0 nkomazi 74.4 75.5 74.7 66.1 64.2 50.4 50.1 pixley ka isaka seme 64.5 70.5 72.1 63.5 60.1 45.7 43.8 steve tshwete 31.6 38.6 41.2 35.2 30.9 18.6 19.6 thaba chweu 43.6 45.8 46.0 37.6 34.2 21.3 21.2 thembisile hani 65.3 69.2 69.5 61.1 58.6 43.6 40.7 total 59.1 62.1 62.1 54.0 51.1 37.2 36.0 umjindi 47.7 48.6 48.7 42.1 40.7 28.4 30.9 victor khanye 52.3 57.3 58.2 49.2 44.8 29.8 30.5 source: ihs global insight – rex, june 2015 table 3: the economic growth by local municipalities (in %): 1996‑2014 local municipality 1996 1999 2002 2005 2008 2011 2014 bushbuckridge −1.8 −0.1 −2.9 1.6 −1.4 2.4 1.8 chief albert luthuli 1.1 3.1 7.4 −0.3 1 3.3 −0.6 dipaleseng −0.5 4.3 3.7 7.5 0.3 −4.4 −2.7 emakhazeni 2.4 0.6 1.8 −2.3 −1.9 0.6 0.1 emalahleni 6.2 4 10.5 2.6 −3.3 3.7 −1.7 govan mbeki 3.2 3.5 −1.4 12.3 −0.3 5.10 −1.5 dr. j. s. moroka −3.3 −8.1 −13 −3.2 −9.8 2.3 1.4 lekwa 2.9 3.8 3.5 0.3 −4.5 1.4 1.9 mbombela 2.6 2.6 −0.5 3.6 0 −1 0.4 mkhondo 1.6 3.3 3 1.7 0.4 1 1.1 msukaligwa 1.1 3.1 3.2 2.9 1.2 0.1 −1.3 nkomazi 1.1 1.3 −1.1 2 −0.1 −1 1.2 pixley ka isaka seme 1.4 3.4 13.7 3 −3.7 −3.3 −0.6 steve tshwete 2.7 2.9 2.5 5.6 −0.3 3.7 −1.7 thaba chweu 1.9 2.2 2.1 −0.8 −0.4 2.6 −1.9 thembisile hani 0.2 1.6 −0.8 1.5 −4.5 6.9 3 umjindi 0.1 3.3 1.9 6.6 −11.4 −1.6 −0.5 victor khanye 3.5 3.7 4.9 5.1 1.8 8.7 2.3 source: ihs global insight – rex, june 2015 niyimbanira: analysis of the impact of economic growth on income inequality and poverty in south africa: the case of mpumalanga province international journal of economics and financial issues | vol 7 • issue 4 • 2017258 series data it would frequently have a need for a long-run of data merely to get the necessary number of observations to be able to conduct a meaningful hypothesis testing. the models specified are as follows: ginit = α + βect + δpovt + εt (1) povt = α + βect + γginit + εt (2) where, gini represents income inequality, ec denotes the economic growth, pov represents the poverty level, t represents time, α is the slope coefficient. β, γ and δ are the coefficients of economic growth, income inequality and poverty, respectively, while ε is the error term. certain steps have to be followed in order to know when to use a normal panel regression which means that the data is integrated. but in a case where data is not integrated, the analysis would continue with a cointegration analysis. therefore, stationarity testing using unit root is employed because time series and cross-sectional information is combined, as a result of the increase in the sample size. thus, if variables are found to be nonstationary, the analysis continues with a cointegration analysis to find the fully modified ordinary least square (ols) model in order to show the long run relationship between variables. if the results from the unit root indicate that all variables are stationary; the experimental data is rather tested with a simple panel regression model which entails both time series and cross-sectional data in the design and would be used to continue with data analysis (stiglingh, 2015). in other words, the cross-sectional time series data which is found to be stationary results in, or leads to, running a fixed effects or random effects test. 4. results this section is the empirical analysis and results of the relationship between the gini coefficient, poverty and economic growth using the cross-sectional time series data from all 18 local municipalities of mpumalanga province from 1996 to 2014. the analysis started off with unit root test for each variable. recent studies have suggested that panel-based unit root tests have higher power than unit root tests based on individual time series. there is a number of panel unit root test, following five types of panel unit root tests namely: breitung (2000), levin et al. (2002), and im et al. (2003), fisher-type tests using augmented dickey-fuller and pp tests (maddala and wu, 1999; hadri, 2000; choi, 2001). after running the unit root test using e-views 8, the results from the unit root at level is presented in table 4. table 4 presents the results of the panel unit root tests at the levels for gini coefficient and economic growth at level while poverty is at first difference. the results indicate that all variables are i(0) in the constant of the panel root regression. therefore, there is no need for conducting a panel cointegration tests, which is supposed to be done only if the variables have a unit root or are i(1). in other words, there is no long-run relationships between variables. thus, the analysis proceeds with an estimation of the pooled regression model, fixed effect model (fem), random effect model (rem) and hausman test, to identify the model supported by the data. both table 5a and b analyzing the gini coefficient and poverty, respectively, present the pooled regression analysis or ols results. the results indicate that economic growth is positively related to income inequality and negatively with regard to poverty. in addition, the results of this paper showed that there is a negative relationship between the gini coefficient and poverty. all coefficients are statistically significant except the one for economic growth as illustrated in table 5b. considering the negative sign of the growth coefficient in table 5b, it indicates that the increase in economic growth does reduce poverty. as shown in table 5a, an increase in economic growth does not seem to decrease income inequality in the mpumalanga province. the results of this study are in line with the findings reported by van der berg (2010) which indicated that south africa consists of high levels of inequality, with especially large and persistent inequality in income distribution. therefore, the plausible explanation behind these findings could be that when the economy is growing, job creation takes place and those who are unemployed get some income which may reduce the level of poverty, but this growth does not reduce the level of income inequality. these results have to be compared with the ones from the fem which are presented in table 6a and b. table 6a and b show that all economic growth coefficients are positively related to income inequality and poverty, while both the gini and poverty coefficients are positive for both models. however, the coefficients of the constant in table 6b is negative. referring to table 6a, it is found that a unit increase in economic growth and poverty leads to 0.000199 and 0.045801 units increase in income inequality. furthermore, in table 6b, a unit increase in economic growth and the gini coefficient leads to 0.001532 and 1.178730 units increase in poverty level. in addition, the r2 from both tables indicates that approximately 64% of changes in income inequality and approximately 63% changes in poverty is caused by economic growth, using cross-sectional time series data from all 18 municipalities in the mpumalanga province. this implies that, 36% and 37% of balance is accounted for by the error term. furthermore, the results show that inequality hampers poverty reduction. this is in line with the argument of ravallion (2004). as a results, “…this is usually found in countries with high initial levels of inequality or in which the distributional pattern of growth favours the non-poor” (dabla-norris et al., 2015. p. 9). the next table 4: panel unit root for the gini coefficient, poverty and economic growth variables levin, lin and chu t* im, pesaran and shin w-statistics adf fisher chi-square pp fisher chi-square income inequality −5.50995*** −4.55959*** 85.8651*** 98.5115*** poverty (at 1st difference) −11.6920*** −8.01039*** 129.684*** 68.4366** economic growth −7.99790*** −6.53271*** 116.452*** 136.787*** *** and **indicate 1% and 5% significance levels respectively. source: estimated by author. adf: augmented dickey–fuller niyimbanira: analysis of the impact of economic growth on income inequality and poverty in south africa: the case of mpumalanga province international journal of economics and financial issues | vol 7 • issue 4 • 2017 259 step is to estimate the rem results and the correlated random effects-applying hausman test to select between fem and rem to identify which model is appropriate to accept. it should be noted that the null hypothesis is that random effect is appropriate or alternatively is that fixed effect is an appropriate model. the results of correlated random effects hausman test, in both table 7a and b, show the p values being 0.0012 and 0.0156, respectively, indicating that the null hypothesis should not be accepted and thus meaning that the fem is the appropriate one. hence, the fixed effects specification is preferred by the data. this is also confirmed by the variation difference between variables which is much smaller, meaning that the variables are now strongly correlated to one another and that the sample is a good fit for this specific model and data. however, the fixed effect in this case wouldn’t be the best either because there are no dummy variables in our panel of time series data. it also confirms that the economic growth does not reduce income inequality in the mpumalanga province rather it widens it. hence, this paper considers the results from the pooled regression to be the best. 5. policy implications from the above results, one may argue that a country or a province experiencing a high economic growth without reduction in income inequality implies that only few people reap the benefits of the economic growth and progress. this is also addressed by gumede (2016) when he aptly indicated that despite sustained growth levels in different phases of the lifecycle of the economy, african countries have not made a dent in improving human development; instead they have been bewildered by unsustainable poverty levels, joblessness, weak economic growth, and rising inequality. therefore, poverty reduction could be done through clear labor market policies. this could be done by making sure that the productive resources especially the unemployed youth get opportunities of contributing to the economy through sustainable job creation from economic growth. in other words, the creation of jobs would be one of the ways to translate high economic growth rates into the improvement of wellbeing in mpumalanga province, in particular, and south africa, in general. however, job creation on its own is not enough; it should be jobs which are permanent with decent incomes that improve workers’ lives. the policy of increasing the minimum wage in order to reduce poverty level in south africa should be implemented and well monitored. this could be done by paying higher wages to the lowest paid and this seems not to affect negatively the economic growth or employment rates in a country if the issue of productivity is well addressed as well. in addition, this article argues that to reduce income inequality the issues of maximum wage of skilled and well paid individuals also should be looked at. as indicated by the empirical findings of this article, economic growth is undeniably one of the powerful mechanisms for poverty reduction, but it does not reduce inequality. this implies that an increase of the gap between rich and poor needs to be addressed because it negatively impacts all the essence of life such as education; health, and social mobility. these findings show that economic growth does not address the problem of inequality. policies that provide durable redistributive measures that bring economic growth and reduce inequality should be prioritized. this could be done by expanding opportunities to those with disadvantaged backgrounds and to low-income households. this table 5a: pooled regression model (dependent variable: gini) variable coefficient standard error t-statistic p c 0.608225 0.005494 110.7091 0.0000 growth 0.001635 0.000408 4.004208 0.0001 poverty −0.034522 0.010339 −3.339080 0.0009 source: estimated by author table 5b: pooled regression model (dependent variable: poverty) variable coefficient standard error t-statistic p c 1.047720 0.163479 6.408878 0.0000 growth −0.000113 0.002159 −0.052506 0.9582 gini −0.922377 0.276237 −3.339080 0.0009 source: estimated by author table 6a: fem for gini variable coefficient standard error t-statistic p c 0.570890 0.005426 105.2158 0.0000 growth 0.000199 0.000299 0.666237 0.5057 poverty 0.045801 0.010684 4.286713 0.0000 r2=0.641951, n=342, p (f-statistic)=0.000000. source: estimated by author. fem: fixed effect model table 6b: fem for poverty variable coefficient standard error t-statistic p c −0.203847 0.163332 −1.248050 0.2129 growth 0.001532 0.001513 1.012161 0.3122 gini 1.178730 0.274973 4.286713 0.0000 r2=0.638814, n=342, p (f-statistic)=0.000000. source: estimated by author. fem: fixed effect model table 7a: hausman test for the gini and cross-section random effects test summary chi-square statistic chi-square df p cross-section random 13.487792 2 0.0012 cross-section random effects test comparisons variables fixed random var (difference) p growth 0.000199 0.000299 0.000000 0.0044 poverty 0.045801 0.037141 0.000007 0.0014 source: estimated by author table 7b: hausman test for poverty and cross-section random effects test summary chi-square statistic chi-square df p cross-section random 8.323594 2 0.0156 cross-section random effects test comparisons variable fixed random var (differnce) p growth 0.001532 0.001366 0.000000 0.2528 gini 1.178730 0.998872 0.003890 0.0039 source: estimated by author niyimbanira: analysis of the impact of economic growth on income inequality and poverty in south africa: the case of mpumalanga province international journal of economics and financial issues | vol 7 • issue 4 • 2017260 is to suggest that macroeconomic policies should go beyond its narrow objectives of stability because evidence has shown that where the stability is achieved it is at the expense of an increase in inequality and probably less improvement of the wellbeing of citizens. the emphasis on improving education outcomes and job creation is crucial for poverty reduction and could reduce the overall income inequality in the long-run. the low education and skills levels of those that are currently structurally unemployed would not assure them of high labor market earnings. consequently, even if they were employed, it would probably be at low wages, thus leaving the aggregate income inequality high. improving education and skills levels and at the same time improving labor market policies may bring positive outcomes in the long-run even if it may reduce the efficient functioning of the labor market in the short-run. considerable improvements in the education system and skills provision are necessary to remove the premium for skilled labor most effectively and thus improve the distribution of income through inclusive economic growth. for all these to take place, an improvement in the economic infrastructure is very crucial. high income inequality can be detrimental to achieving macroeconomic stability and this might be a result of a growing public demand for income redistribution (imf, 2014). this leads to another angle one could take into consideration: the impact of fiscal instruments on the gini coefficient. in other words, how government expenditure influences income inequality reduction. undeniably, addressing the challenge of income inequality would require a consistent fiscal sustainability and more efficient public services delivery (woolard et al., 2015). therefore; choices with regard to the level and composition of government spending are clearly one of the important ways of addressing income inequality. 6. conclusion the vital agenda for most countries especially developing ones is to address the challenge of poverty and inequality. this requires inclusive economic growth. the aim of the article was to assess the impacts of economic growth on income inequality and poverty in south africa. the panel regression analysis is applied using the mpumalanga province data. the results show, on the one hand, a negative relationship between economic growth and poverty, and on another hand, a positive relationship between growth and income inequality. in addition, the findings indicate that approximately 64% of changes in income inequality and approximately 63% changes in poverty are as a result of economic growth in mpumalanga province. this article revealed conflicting results with theory that economic growth is the solution to the poverty and income inequality. consistently, the findings of this article from the pooled regression and fems confirm that economic growth does not reduce income inequality. therefore, continuing with the current economic growth led policies may reduce poverty but on the cost of widening the income inequality 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(2001), attacking poverty: world development report, 2000/2001. new york: oxford university press. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(2), 454-460. international journal of economics and financial issues | vol 5 • issue 2 • 2015454 survey on financial market frictions and dynamic stochastic general equilibrium models1 mădălin viziniuc* doctoral school of finance, bucharest university of economic studies, 6 piata romana, 1st district, bucharest, 010374 romania. *email: madalinviziniuc@gmail.com abstract this survey reviews the research regarding the general frameworks used for the specification of financial market frictions in dynamic stochastic general equilibrium (dsge) models. within the related literature, financial frictions are considered to be the prime candidates for endogenous amplification of small transitory non-financial shocks. the latest financial crisis has changed a number of macroeconomic paradigms and dsge models were not left untouched. pre-crisis macroeconomic models neglected the financial markets due to the fact the most economists considered them to function perfectly. as economic events pointed out the contrary, numerous research papers that tackle this problem are available in literature, therefore, this rapidly growth of literature motivates this survey. keywords: dynamic stochastic general equilibrium models, financial market frictions, financial accelerator, collateral constraint, survey jel classifications: e21, e22, e32, e44, e59 1. introduction over the past few years important progress has been made in the specification and estimation of dynamic stochastic general equilibrium (hereafter dsge) models2. these models are complex by nature and call for state-of-the-art econometric techniques in order to be estimated. also these models are powerful tools for policy makers because are able to provide a micro-founded framework for policy discussion and analysis. in theory, due to the general equilibrium characteristics, a dsge model is able to account for inter-linkages between different sectors of the economy and can identify sources of fluctuations, answer questions about structural changes, assess the impact of policy changes, perform counterfactual scenarios and so on. due to these facts, dsge models caught the attention of central banks, but, so far 1 this work was cofinanced from the european social fund through sectoral operational programme human resources development 2007-2013, project number posdru/159/1.5/s/134197 “performance and excellence in doctoral and postdoctoral research in romanian economics science domain”. 2 see smets and wouters (2002, 2007), christiano et al. (2005), gali and monacelli (2005), adolfson et al. (2007), curdia and woodford (2009), etc. they have yet to become a standard tool for policy decisions and analysis. in general, the benchmark3 dsge model is used to assess the impact of a variety of shocks, as those arising from behavioural changes concerning households and firms’ decisions, increases in government spending, in the currency risk premium, tightening of monetary policy and so on. as for the general framework, these models include a variety of agents, such as households, producers, monetary and fiscal authorities. households consume, decide how much to invest and are monopolistic suppliers of labour. firms are monopolistic suppliers of differentiated goods and hire labour and capital from households in order to produce their output. both types of agents face a number of nominal rigidities like sticky wages and prices and partial indexation with inflation. the real frictions mostly refer to capital investment adjustment costs and variable capital utilization. the monetary policy is usually conducted using a standard taylor rule which assumes that there is some degree of interest rate smoothing and the central bank targets the deviation of inflation and output from the inflation 3 see for example smets and wouters (2002), christiano et al. (2005). viziniuc: survey on financial market frictions and dynamic stochastic general equilibrium models international journal of economics and financial issues | vol 5 • issue 2 • 2015 455 objective and from the potential growth, respectively. the common assumption for the fiscal policy is that the ricardian equivalence always holds and government consumption is modelled as first order autoregressive process. also it is common to introduce in these models a large variety of disturbances like monetary policy shock, households’ preference shocks, transitory and permanent productivity shocks, mark-up shocks for prices and wages, risk premium shock and so on. one can notice that the benchmark dsge model abstracts the financial markets. therefore, the model is unable to explain some of the regularities seen in the business cycle fluctuations. also it excludes some important areas in which a central bank may be interested, such as financial vulnerability, the feedback effect from the financial sector to the real economy, inter-linkages between domestic and international financial markets. the latest financial crisis highlighted the importance of the financial sector for the business cycle fluctuations. pre-crisis macroeconomic models relayed only on the specification of the real economy and neglected the financial sector which was considered to be almost irrelevant in the context of low inflation rates. moreover, the consensus among policy makers stated that price stability is enough to ensure macroeconomic stability and therefore embraced the general idea that the deterioration of financial markets is just a constant reflection of a declining economy, whereas, in reality it might be an important factor that affects the business cycle dynamics. even if pre-crisis operational macroeconomic models did not have a detailed specification of the financial sector, in the related literature there were attempts to tackle this problem. the most representative paper is the one written by bernanke et al. (1999), where the financial sector, thought the financial accelerator mechanism, interacts with the business cycle. moreover, another methods to introduce the credit frictions were available, such as the one proposed by kiyotaki and moore (1997), where the financial sector affects the business cycle thought the value of the collateral held the borrowers. although these mechanisms were appealing from theoretical perspective, they only answered to a fraction of the problem, namely the demand for credit. as shown recently, at the core of the financial crisis was the incapacity of credit institutions to supply credit to the economy. therefore, in this regard, extensive efforts were made in order to model the supply side of the credit channel. the main objective of this paper is to review the most important ways of introducing financial credit frictions in a dsge model. as we are focused on the flow of loans and deposits, we neglected the rest of models` frameworks. for a better understanding of these models we encourage the reader to see the original papers. the rest of the paper is structured as follows: in the second section we present the pre-crisis approaches to introduce financial cycles in a dsge model and in the third section we look at what has changed in this respect. finally we conclude with a discussion where we try to reiterate the story-line and we present the some new directions for dsge modelling. 2. demand side approaches as mention within the introduction, pre-crises models focused mainly on perturbations of the demand for credits. in the next two subsections we will briefly describe the frameworks of bernanke et al., (1999), hereafter bgg (1999) and kiyotaki and moore (1997), hereafter km (1997). 2.1. the bgg (1999) framework the model of bgg (1999) incorporates financial frictions via the financial accelerator mechanism. consider a frictionless case where the borrower, according to the modigliani–miller theorem, is indifferent to the source of the borrowed funds, either internal or external. in this case entrepreneurs can raise funds from financial markets in exchange for a share of expected profits. this is a standard handbook example where financial markets function perfectly, but in real world the barrower may face some restrictions when searching for external funds. in general these restrictions arise from the asymmetry of information between the borrower and the lender, which leads to an external finance premium in form of a higher interest rate. an external finance premium can be defined as the difference between the opportunity cost of raising internal funds and the cost for the external funds. also asymmetric information generally implies an additional cost, generally associated with monitoring costs. therefore, an external finance premium always has a positive value. the framework from bgg (1999) resides on a simple agency problem, which translates into an endogenous determined risk premium applied to the interest rate for credits. because the lender does not have full and unrestricted access to borrower investment decisions and therefore the realized return, he must pay a fix auditing cost. this cost can also be interpreted as a bankruptcy cost because it augments the capital that is seized by the bank in the case of barrower default. in the model entrepreneurs are assumed to be risk-neutral and have a finite horizon which allows us to abstract the investment reputation and also to prevent the entrepreneurs to accumulate wealth up to the point of financial independency. in this model the economy is populated by infinite-lived households, entrepreneurs and retailers. in order to be able to introduce price stickiness and the financial accelerator framework, bgg (1999) have considered that entrepreneurs are operating in a competitive environment and produce homogenous intermediate goods, which are sold to retailers in order to be differentiated. the policymakers are represented by a government that conducts both monetary and fiscal policies. in each period entrepreneurs must (re) purchase the entire capital which will be used in the next period production activity. also, the capital is homogeneous; therefore entrepreneurs are indifferent if the purchased capital is new or from the last period. this modelling strategy ensures that the leverage restrictions apply to the firm as a whole, not only on the marginal rate of investment. the return on the capital is sensitive to an idiosyncratic shock (besides the aggregate ones). the ex-post gross return on the capital is multiplied by the values of the idiosyncratic shock ωj which is independent and identically distributed across time and firms with viziniuc: survey on financial market frictions and dynamic stochastic general equilibrium models international journal of economics and financial issues | vol 5 • issue 2 • 2015456 a continuously once differentiable cumulative distribution function over a non-negative support. bgg (1999) define a hazard rate based on ω and impose the restriction that the first derivate of the hazard function with respect to ω to be positive, the distribution of choice being a log-normal one. suppose that there is a value of ω denoted with ω j that truncates the distribution in two parts. if the realization of ω is smaller than the threshold value ( )ω ω< j , the return on investment is so small that the entrepreneur can`t repay his debt, therefore enters in default. if ω is larger than the cut-off value ( )ω ω< j , the firm repays the lender the promised amount zj,t+1bj,t+1 and keeps the difference: ∆ = −+ + + + +j t j k t k t j t j t j tr q k z b, , , , , ,1 1 1 1 1ω (1) where ωj is the realized idiosyncratic shock, rk,t+1 in the return on capital and qk,tkj,t+1 is the value of firm capital which in this model corresponds to the firm value as a whole. moreover, the thresholds value of ω can be defined as: ω j j t j t k t k t j tz b r q k= + + + +, , , , ,/1 1 1 1 (2) ω j is the value that assures the zero profits for entrepreneurs. from equation (2) we clearly see why a value for the idiosyncratic shock smaller than the threshold value determines the entrepreneurs to default. when this occurs, the bankrupt entrepreneur cannot buy new capital and consumes his remaining wealth, eventually fading out of the scene. acquisition of new capital is financed from the entrepreneurs’ wealth (or net worth) and borrowed funds. the net worth is accumulated from two sources: profits from previous capital investments and from the supply of labour to the market. the net worth is of great importance for model dynamics, because the external finance premium is negatively correlated with it. consider that at the end of period t an entrepreneur (there are an infinity of entrepreneurs) has an available net worth nj,t+1 and in order to finance the difference between expenditures and net worth borrowers the amount of bj,t+1: b q k nj t k t j t j t, , , ,+ + += −1 1 1 (3) entrepreneurs borrow the necessary funds from financial intermediaries which are facing an opportunity costs equal to the economy risk-free interest rate rt+1. when there is aggregate uncertainty in the model, the threshold value, ω j, will depend on the realization of the return rate on capital, rk,t+1. under the assumption of risk-neutral entrepreneurs, the loan contract has a simple form because they are bearing all the aggregate risk and are only interested in the rate of return of their wealth. the values of ω j and zj,t+1 are determined by the restriction which states that a financial intermediary receive the interest rate which equals the opportunity cost of its funds. because there are a large number of entrepreneurs, the risk is perfectly diversifiable; therefore the opportunity cost equals the risk free interest rate. a loan contract must satisfy the following restrictions (from the perspective of the financial intermediary) 1 1 1 1 0 1 1 −  + − = + + + +∫f z b r q k f r j j t j t k t k t j t t j ( ) ( ) ( ) , , , , , ω µ ω ω ω d ++ +1 1bj t, (4) where in the left hand side are the expected aggregate returns on loans and in the right side is the opportunity cost of lending. after same manipulations, the above equation 4 can be written as a function of the cut-off value of the firm’s idiosyncratic shock: 1 1 0 1 1 1 −  + − = ∫ + + + f f r q k r q k j j k t k t j t t k t j j ( ) ( ) ( ) ( , , , , , ω ω µ ω ω ω d tt j tn+ +−1 1, ) (5) f j( )ω is the probability of default. equation (5) is conveniently express as a function of the cut-off productivity shock. a rise of the default thresholds increases the payments to the bank in the case of non-default but in the same time raises the default probability, which eventually shrinks the aggregate expected payoffs. an important characteristic of the financial accelerator is that it works in a pro-cyclical manner in the sense that mimics the business cycle dynamics. consider that the economy is in the boom period where the net worth of the entrepreneurs’ is increasing. this translates to a reduction of the default probability which eventually reduces the external finance premium (which is a function that depends on the monitoring costs µ, on the realization of the idiosyncratic shock w, the value of the firm qk,t−1kj,t and the net worth). in an alternative scenario, where the economy enters in a bust period, the net worth of the entrepreneur diminishes, which translates into a raise in the external finance premium. the lenders opportunity costs increases and if there isn’t a value of ω j that generate the required expected return (equation 5), then the borrower is rationed from the market. the mechanism described above shows how a temporary adverse shock on the economy, which reduces the entrepreneurs’ net worth, can generate an extended period of low lending activity, inducing a low growth of gross domestic product (gdp). 2.2. the km (1997) framework in the km (1997) framework, durable assets such as land, buildings and other production factors serve as collateral for loans. the borrower’s ability to take a loan is affected by the price of collateralized assets. in the model the transmission mechanism works in this way. consider an economy where the land (which doesn`t depreciate) is used for securing loans as well as for viziniuc: survey on financial market frictions and dynamic stochastic general equilibrium models international journal of economics and financial issues | vol 5 • issue 2 • 2015 457 producing output. the total supply of land is fixed. suppose that there are firms which are credit constrained and highly levered as a consequence of past borrowing activity. assuming that in the period t, a few firms experience a temporary productivity shock that reduces their net worth. because they cannot borrow more, the credit constraint forces them to cut the investment rate, affecting in this way the next period payoffs. moreover, this affects the price of capital, affecting the activity of all constrained firms (the value of their collateral reduces considerable). this mechanism affects the level of investment (therefore the level of the output) for a longer period. as we can see, at the origin of this persistent drop in output was just a temporary productivity shock, which propagated thought the next periods via the financial constraints of the firms. their basic model of km (1997) assumes that there are two types of farmers which are risk-neutral. they draw utility from the consumption of fruits at t+s. the main difference between these two types of farmers is their discount factor. assuming that β ' is the discount factor for impatient farmers and β the discount factor for patient farmers. in equilibrium impatient farmers do not postpone production, therefore β '<β which ensures that they borrow to finance their activities. also, there are further assumptions about farming. the first one states that the production is idiosyncratic, meaning that once a farmer has started the production in period t, only he has the necessary skills to harvest the land in t+1. the second one refers to the fact that each farmer can withdraw from the labour market between t and t+1, meaning that the output in t+1 will be the capital available in period t. these assumptions create the grounds for a renegotiation of the loan contract because if a farmer withdraws from the labour market the value of land without its fruits is smaller, therefore for the lenders are interested in letting the farmer to work his land by renegotiating the loan contract in order to reduce the debt burden. the financial constraint has the following form: rb q kt t t≤ +1 (6) where the r is the interest, bt is the total amount borrowed, qt+1 is the next period land price and kt is the land stock. this equation states that an impatient farmer can borrow as long as the repayments doesn`t exceed the value of collateral. the flow of funds for the impatient farmers is the following: q k k rb x ck ak bt t t t t t t t−( )+ + − = +− − − −1 1 1 1 (7) a farmer holds kt−1 land at the end of period t−1, and has a total debt of bt−1. at period t, he harvest akt−1 tradable fruits which together with new loans bt gives him the necessary funds to buy more land, to repay his last period debt and to buy addition goods for consumption. the framework of km (1997) was formerly introduced in an estimated dsge model by iacovellio (2005). he introduces two types of households, in line with km (1997) framework and entrepreneurs who act in a similar way as impatient households. therefore, in the model there are two types of agents that demand credit, namely impatient households and entrepreneurs. in the case of households the collateral is replaced with housing stock and for entrepreneurs with productive capital. the borrowing mechanism is similar for both agents, therefore we will present the problem faced by impatient households. impatient households discount future consumption more heavily that patient households. their variables of choice are consumption, housing stock, labour (and money). because their discount factor is smaller than the one from patient households, it guarantees that in the equilibrium the financial constraint holds and, therefore, they are borrowers4. in contrast with the framework of km (1997), the collateral depreciates over time and there are specialized agents that produce new housing stock. as in km (1997) framework, iacovellio (2005) assumes a limit on the obligation of impatient households. the lender can repossess the borrowers` assets by paying a proportional transaction costs (1−m) et(qt+1ht). therefore the maximum amount that can be borrowed is met(qt+1ht/rt), where m can be interpreted as loan-tovalue ratio. the latter formula is the financial constraint imposed on impatient households. the interpretation is similar with the one from km (1997). although this framework is quite easy to implement even when the loan-to-value ratio is variable thought time, it has a major drawback. the assumption that the borrowing constraints holds with equality every time, means that practically there is no default risk for the lender. recently pariès et al. (2010) and solomon (2010) have modified the framework of iacovellio (2005) to account for uncertainty regarding the repayment of loans. for explaining this approach, we will focus on entrepreneurs (the problem for impatient households is somewhat similar). in the framework of solomon (2010) each entrepreneur is risk adverse and combine labour and capital to produce final output. also, their discount factor is smaller than the one associated with the one for patient households. as in bgg (1999), entrepreneurs fixed capital is subject to common multiplicative idiosyncratic shocks ωt, which are independent and identical distributed across entrepreneurs with unit mean and lognormal pdf; the variance is unknown and is time-varying. regarding the participation of entrepreneurs in the financial markets, they receive a standard loan contract from the bank, where is specified the amount of the loan and the gross interest rate to be paid if the realized value of the idiosyncratic shock is large enough. entrepreneurs use debt contracts which depend on aggregate shocks, but not on idiosyncratic shocks. they are part of a large family that can diversify the idiosyncratic shock, but only after the loan contracts are settled. they cannot commit to share earnings from insurance with the bank. entrepreneurs who draw below ωt go bankrupt and the bank can seize a part of the capital ωt ta � with a cost proportional with the entrepreneurs’ capital 4 iacovellio (2005) has showed that a value for the discount factor associated with the impatient households near to 0.975 ensures that the financial constraint binds in steady state. the discount factor for patient households is set to match the economy’s interest rate on deposits (βpatient=1/steady state interest rate). viziniuc: survey on financial market frictions and dynamic stochastic general equilibrium models international journal of economics and financial issues | vol 5 • issue 2 • 2015458 � �µωt ta . entrepreneurs can use as collateral only a part of their capital, thus after an entrepreneur chooses to default, a bank can seize: ω ω δt t t t k k t ta m q k = − −( ) ,1 1 (8) mt reflects the ability to collateralize capital, δk is the capital depreciation rate, qk,t is the price of capital and kt is the capital stock. in order to solve the aggregation problems, entrepreneurs are allowed to insure their production and the payments from the insurance policy are conditional on the idiosyncratic shock. the insurer can fully diversify this risk across entrepreneurs and thus, on average his profit is zero. the insurance premium cannot be seized by the bank and ex-ante, is optimal for the borrower to repay his loan, they are not allays committing to do so. given these hypothesis, this framework generates a modified euler equation for the new loans in such a way that the external finance premium mimics the business cycle movements. also, another key fact of this framework is the ability to study the feedback effect from the household sector to the production sector. moreover, in comparison with the alternative framework of km (1997) where there is no uncertainty regarding the future value of the collateral, with this modelling approach we eliminate this potential model distortion and therefore we are able to provide a more accurate scenarios for policy makers. 3. supply side approaches in the aftermath of the financial crisis researchers have begun to look for new ways to improve the current macroeconomic models. as stated in the beginning of this paper, pre-crisis macroeconomic models used by central bankers neglected the financial sector even if there were research papers that highlight the importance of the financial sector in determining the fluctuations of the business cycle5. in the latter section we have presented the most prominent methodologies that can be used to introduce financial frictions in a dsge model. although these frameworks are important turning points in the related literature, one important weakness that each one shares is that in a case when an economy is perturbed by an adverse shocks, the supply of credit remains somewhat stable whereas the demand adjust accordingly to the shock. recently, new improvements were made to these methodologies in order to distinct two channels that affect credit dynamics, one aimed at the supply and another one to the demand for credit. therefore, in this section we will present what we think that are two of the most used methodologies in the literature for introducing perturbations to the supply of credit. first we will discuss the model of gertler and karadi (2011), hereafter gk (2011) and secondly the framework proposed by gerali et al. (2010), hereafter gnss (2010). 3.1. the gk (2011) framework gertler and karadi (2011) develop a quantitative dsge model with financial intermediaries that face endogenously determined 5 i am referring to the financial cycle literature, for more information’s see borio (2004, 2007) balance sheet constraints. the main purpose of their model is to capture the depreciation of banks’ balance sheets and the effects on real economy. in order to be able to do such a thing they introduce a simple agency problem between financial intermediaries and depositors. financial intermediaries finance their lending activity from deposits made by households and non-financial firms. also, they engage in maturity transformations, by holding long-term assets and financing them with short-term liabilities. using the original notations, where njt is the net worth of the financial intermediary, bjt the level of deposits that an intermediary receives, sj,t the financial claims on non-financial firms, then the balance sheet can be written as: qs n bt j t j t j t, , , �= + +1 (9) in each period a household makes a deposit and will receive in the next period a gross interest rate from the financial intermediary, therefore bj,t+1 can be seen as a debt for the financial intermediary and nj,t as his equity capital, the latter being remunerated over time. the balance sheet evolves over time as a difference between earning on assets and payments on liabilities. financial intermediaries are finite-lived agents and use a stochastic discount factor to evaluate future earnings. if the difference between risk adjusted return on assets and the paid interest on liabilities is positive, the banks will be inclined to expand their assets indefinitely by borrowing funds from households. to limit this ability, the authors introduce a moral hazard problem. at each period of time, a banker can choose to divert a fraction of available funds back to the household he is a member of. if depositors find out about this redirection of funds, they can force the intermediary to enter in default by recovering the remaining funds. however, the share of funds that was initially diverted to the household members of banker cannot be recovered (due to high costs), therefore is assumed to be a loss. this simple agency problem can be translated mathematically using the following restrictions: v qsj t t j t, ,≥ λ (10) where λqtsj,t is the fraction of diverted funds and the left hand side, vj,t, is the loss for the banker if he diverts funds. given the above assumptions the evolution of the net worth of a banker is: n r r r nj t k t t t t j t, , ,[( ) ]+ += − +1 1φ (11) where nj,t+1 is the net worth of a banker in the next period, which depends on the current period net worth on the differential between the gross interest rate on assets (rk,t) and the gross interest rate on liabilities (rt) on the ratio of privately intermediated assets to equity ft (leverage ratio) and the next period interest rate on liabilities rt+1. also the leverage ratio is introduced to restrict the incentive of a banker to divert funds to a point where the losses enquired by the banker balance the gains from diverting funds. as mention earlier there is a chance that a banker exits the financial markets in the next period, leaving the spot open for another entry. the newly entered banker receives a non-returnable fund viziniuc: survey on financial market frictions and dynamic stochastic general equilibrium models international journal of economics and financial issues | vol 5 • issue 2 • 2015 459 from its respective household in order to begin the operations – the probability of entering and exiting from the financial markets affects randomly the bankers and is modelled using an independent, identically distributed distribution. also in this framework a bank can be affected by a perturbation to the quality of its capital. this shock produces a decline on the net worth of a financial intermediary affecting his activities. on impact, the shock will decrease the asset value. next, due to a weakening in the balance sheet, a financial intermediary induces a drop in asset demand reducing its price. this reduction in assets price further shrinks the bank balance sheet affecting even more its capability of supplying new loans. with this mechanism embedded into the framework, such a shock will drastically affect the gdp and due to second rounds effects the recovery of the economy takes longer. also the authors show that unconventional monetary policy can be used to mitigate these effects, but this part is beyond the scope of this survey. 3.2. the gnss (2010) framework in their paper gnss (2010) study the role of credit-supply factors in business cycle dynamics. to this end, they specify an imperfectly competitive banking sector into a dsge model. in their model the only saving instrument is a bank deposit and the only way to borrow is via a bank loan. the flow of funds in the banking sector is: the impatient household makes a deposit at a retail deposit bank; these funds are then transferred to the wholesale bank. the wholesale bank uses these funds together with the bank capital to supply loans to the specialized retail banks, which at their end supply loans to the economy. because retailers are operating in the monopolistic environment, they put a mark-up over the policy interest rate for loans and under the policy rate in the case of deposits. from this banking activity they obtain profits which are transferred to the wholesale bank, where, only a fraction of profits remains in the banking sector, the rest being transferred to patient households in form of dividends. one of the key features of the model is the balance sheet identity: b d kt t t b= + (12) the balance sheet constraint states that the banking sector cannot give loans more than the total amount of deposits augmented with bank capital. from the perspective of equation (12) the two sources of financing are perfectly substitutable, but the level of bank capital is pinned down by the loans to capital ratio which is exogenously given. the banking sector is structured in two layers, wholesale and retail banks. the wholesale banks are operating in a competitive environment and are subject to capital requirements. any deviation of the bank from the targeted assets-to-capital ratio is costly; the cost is specified as being quadratic. the targeted ratio is fixed exogenously by the macroprudential authority and is assumed to be optimal. an arbitrary change of this value (which is set around 0.1) creates perturbations of bank ability to provide loans to real sector. at aggregate level the bank capital evolves accordingly to the following rule: k k jt b t b t b= −( ) +− −1 1 1δ ω (13) where δ is the depreciation rate of the bank capital due to costs related to their activity. jt b −1 is the aggregate bank profits and ω is the share that remains in the banking sector after the dividends are paid to the households. the share of profits that goes to households is exogenously fixed ensuring that the capital is predetermined. the second layer is composed of two types of retail banks one that receives deposits from the households and other two that supply loans to impatient households and entrepreneurs, respectively. all retail banks are monopolistic competitors and apply a mark-up over the interest rates that are financed. also gnss (2010) consider that a retail bank is subject to quadratic costs proportional to aggregate return on loans if they change the interest rate, introducing in this way interest rate stickiness. all this mechanisms ensure that the model is able to generate an imperfect passing thought of the monetary policy shocks, coming closely to empirical evidence in this matter. the main strong point of this framework is its relative simple setup and, therefore, can be transformed to accommodate numerous features like domestic and foreign interbank market, calvo type framework thought which the interest rates are set, a capital requirement rule, minimum requirements for the banking sector lending activity, etc. 4. conclusion in this paper we have presented different ways which are used in the literature to introduce financial market frictions into dgse models. pre-crisis dynamic models abstracted the financial markets affecting in this way their empirical performance, even if there were a few methodologies that could be used. the financial accelerator literature focuses on the value of external finance premium (which mimics the business cycle dynamics) to explain how a transitory shock can easily be translated into a prolonged period of slow economic growth. also the collateral constraint approach of km (1997) has some empirical advantages thought the fact that the financial constraint of households can influence the constraint of entrepreneurs. in this framework, there isn’t an endogenously determined financial premium but instead, the borrower is rationed from the financial market if it reaches his maximum borrowing capacity determined by an exogenously given loan-to-value ratio. as observed during the financial crises, the inability of a financial intermediary to provide loans to the economy can also affect the business cycle dynamics. this issue is generally modelled by using a principal-agent problem between depositors and lender, or by specifying targets for capital-to-assets ratio of the banks. also in these types of models there is an endogenously determined balance sheet constrains for the banking sector, which can further affect the ability of a financial intermediary to supply loans to the economy. viziniuc: survey on financial market frictions and dynamic stochastic general equilibrium models international journal of economics and financial issues | vol 5 • issue 2 • 2015460 the latest financial crisis has changed a few paradigms in the macroeconomics and the dsge models weren`t left untouched. pre-crisis macroeconomic models neglected the financial markets due to the fact the most economists considered them to function perfectly. as economic events pointed the contrary, important research groups were put together in order to find new ways to model the macroeconomic environment. an example is the research network created by the european central bank, called mars (macro-prudential research network) with the objective of developing new frameworks that will provide research support for the improvement of macro-prudential supervision across european union6. another one is the research task force organized by bis7 which has a similar set of objectives. although there is a great interest in this filed, there are many problems that have not been properly solved, like the problem of non-linearities and maturity transformations which are core features for the financial system, the small number of financial instruments modelled in dynamic models, the problem of crossborder contagion and so on. references adolfson, m., laseen, s., linde, j., villani, m. (2007), bayesian estimation of an open economy dsge model with incomplete pass-through. journal of international economics, 72(2), 481-511. basel committee on banking supervision. (2012), models and tools for macroprudential analysis, bis working paper, 21. 6 see the report of the macro-prudential research network. 7 research task force working group on the transmission channels between the financial and real sectors of the basel committee on banking supervision” and the most important findings are summarized in the bis working paper no. 21(2012) – “models and tools for macroprudential analysis”. bernanke, b., gertler, m., gilchrist, s. (1999), the financial accelerator in a quantitative business cycle framework, handbook of macroeconomics. north holland: elsevier science. p1341-1393. borio, c. (2004), market distress and vanishing liquidity: anatomy and policy options, bis working papers, no. 158. borio, c. (2007), monetary and prudential policies at a crossroads? new challenges in the new century. moneda y crédito, 224, 63-101. christiano, l., eichenbaum, m., evans, c. (2005), nominal rigidities and the dynamic effect of a shock to monetary policy. journal of political economy, 113(1), 1-44. curdia, v., woodford, m. (2009), credit frictions and optimal monetary policy, bis working paper, 278. gali, j., monacelli, t. (2005), monetary policy and exchange rate volatility in a small open economy. review of economic studies, 72, 707-734. gerali a., neri, s., sessa l., signoretti, f.m. (2010), credit and banking in a dsge model of the euro area. journal of money, credit and banking, 42, 107-141. gertler, m., karadi, p. (2011), a model of unconventional monetary policy. journal of monetary economics, 58(1), 17-34. iacovellio, m. (2005), house prices, borrowing constraints and monetary policy in the business cycle. american economic review, 95(3), 739-764. kiyotaki, n., moore, j. (1997), credit cycles. the journal of political economy, 105(2), 211-248. macro-prudential research network report. (2014), available from: https://www.ecb.europa.eu/events/pdf/conferences/140623/ mars_report.pdf. pariès, m.p., sørensen, c.k., palenzuela, d.r. (2010) macroeconomic propagation under different regulatory regimes. evidence from an estimated dsge model for the euro area, ecb working paper, 1251. smets, f., wouters r. (2002), an estimated stochastic dynamic general equilibrium model of the euro area, ecb working paper, 171. smets, f., wouters, r. (2007), shocks and frictions in us business cycles. a bayesian dsge approach, ecb working paper, 722. solomon, b.d. (2010), firm leverage, household leverage and the business cycle, mpra working paper, 26504. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(6), 24-31. international journal of economics and financial issues | vol 11 • issue 6 • 202124 production and sales risks in the manufacturing sector: the role of electricity supply, inflation and fuel price volatility thomas habanabakize1, zandri dickason-koekemoer2* 1school of economic sciences, trade research entity, north-west university, south africa, 2trade research director, north-west university, south africa. *email: zandri.dickason@nwu.ac.za received: 13 august 2021 accepted: 15 october 2021 doi: https://doi.org/10.32479/ijefi.12509 abstract the manufacturing sector occupies a critical position in the south african economy. however, in recent decades this sector experienced significant instability due to challenges within macroeconomic indicators. the sector’s challenges include the issue of electricity distribution, growing inflation rate and commodities price instability. this study aims to assess the effects of electricity supply, inflation and fuel prices on food and beverage production and sales in the manufacturing sector. to this end, the study applied different econometric approaches such as johansen test for cointegration, vector error correction model (vecm) and granger causality test on a monthly time series data ranging between january 2002 and december 2019. the study findings suggested the existence of a joint long-run relationship between electricity distribution, inflation rate, fuel price and production and sales of both food and beverage within the manufacturing sector. the result also indicated that both electricity supply and inflation highly impact the production of food and beverage sales compared to the effect of petrol price. granger causality results have shown that inflation rate can serve in predicting short term production and sales of food and beverage in the south african manufacturing sector. given the aforementioned findings, the study suggested that to increase production and sales of food and beverage in the manufacturing sector, policymakers should reduce tax on imported fuel. this would assist in lowering petrol prices that may have a repercussion on the inflation rate. additionally, besides the government support towards electricity production in the eskom, more effort and resources (financial) would also be allocated to generate and improve other sources of energy such as solar, wind, gas and biogas. keywords: inflation, eskom, electricity, fuel price, manufacturing, south africa jel classifications: l60, e31, l11 1. introduction since the second world war, the world experiences a significant increase in fuel prices that creates constraints in the production and sales of various products. a high price of fuel and other forms of energy impact negatively on the global economy in both developed and developing countries (cunado and perez de gracia 2005). in addition, fuel remains indispensable energy whose price oscillation influences most economic sectors (katircioglu et al., 2015). from world war ii till nowadays, the fuel price experiences drastic instability especially since the 2008 financial crisis. in december 2008, the price of the brent crude oil $40 per barrel and increased to $126 in 2012. however, this price drastically dropped to $30.5 per barrel in january 2016, risen again to $81 per barrel in 2018, and fall below $ 20 per barrel in april 2020 (macrotrends, 2018; the economic times, 2020). as a fuel importer, south africa economy is severely affected by this fuel price fluctuation were between 2017 and 2018, the fuel prices increased by more than 21 percent (sapia, 2018). as consequence, the country experienced a high inflation rate and low growth of below. despite the strong measures established by the south african reserve bank that include inflation targeting in 2002, the country continues to experience a growing inflation rate which negatively this journal is licensed under a creative commons attribution 4.0 international license http:////doi.org/10.32479/ijefi.12509 habanabakize and dickason-koekemoer: production and sales risks in the manufacturing sector: the role of electricity supply, inflation and fuel price volatility international journal of economics and financial issues | vol 11 • issue 6 • 2021 25 impacts both consumers and producers (khoza et al., 2016). high inflation increases the cost of production on the producers’ side and causes a reduction in consumers’ purchasing power (fedderke and liu, 2018). nonetheless owing to the increase of interest rate proposed by the monetary policy committee (mpc) in 2018, the south african inflation rate responded by declining from 5.09 percent to 4.06 percent. however, it was expected to rise again due to the increase in both fuel price and domestic electricity tariffs (industrial development corporation (idc), 2019). besides the role played by fuel price in the global economy, and particularly in south africa, an uninterrupted and secured electricity supply is essential to economic activities. however, due to population growth and the rapid speed of industrialisation, electricity demand outstrips its supply. thus, the shortage in supply and load shading (umar and kunda-wamuwi, 2019). the high electricity demand has put south africa’s public electricity provider (eskom) in a position where to reduce the imbalance between demand and supply of electricity it has touch its reserves (khobai et al., 2017). this leads to low supply commonly known as load-shedding. as most commercial and industrial sectors such manufacturing sector are energy and electricity reliant, their activities are mostly affected by load-shedding (adebola, 2011). additionally, electrical energy is considered as a core input to industrial production (isaksson, 2016). owing to this phenomenon of high fuel prices, high inflation, low electricity supply and their risk towards production and sales in the manufacturing sector; this paper investigates the role and magnitude of production of food and beverage and sales risks owing to fuel price, inflation rate and electricity volatilities within the south african manufacturing sector. the core objective is to indicate to which extent production and sales of manufactured food and beverage are affected by shocks in fuel price, inflation and electricity supply. additionally, it is important to highlight that the current paper is conducted based on production and consumer theories. 2. literature review 2.1. general review to maximise their profit and improve their revenues, firms have to produce and sell their products. the production process includes the use of both fixed and variables input factors. thus, the aggregate outputs and sales depend on the availability of factors of production (inputs) associated with production cost and risk management. the production theory suggests that lower cost of inputs leads to more outputs and sales, whilst the high cost of input causes a decline in output volume, increases selling and lessens the total sales (gans et al., 2011; sickles and zelenyuk, 2019). consequently, the firm’s output volume and total sales are more likely to depend on input costs, ceteris paribus. the manufacturing sector deserves specific attention compared to other economic sectors as it remains one of the core drivers for the south african economy (bhorat et al., 2018). this sector is known to have the largest economic and employment multipliers in south africa (department of trade and industry (dti) (dti, 2014). several studies were established to determine the role of the manufacturing section on the south african gdp and employment. the study of awolusi (2016) and tsoku et al. (2017) found a significant share of the manufacturing sector towards economic growth. additionally, the study of muzindutsi (2014) and mccamel (2018) revealed that the manufacturing sector plays an important role in creating jobs in south africa. irrespective of the contribution of the manufacturing sector towards employment and economic growth, this sector has been experiencing challenges in recent decades. since the 2000’s the south african manufacturing sector is experiencing a stagnant performance (bhorat et al., 2016) and a large number of manufacturing companies are experiencing economic challenges. these challenges result from, among others, a low level of domestic demand, poor supply of electricity from eskom and import penetration that leaves the south african manufacturing sector less competitive even within the domestic markets. due to the abovementioned constraints, the manufacturing sector accounted for a decline in its total production. hence, by the end of 2019, the south african manufacturing sect registered 10.6 percent loss of its annual income and experienced a decline in total production (south african market insights, 2020). table 1 displays changes in the volume of food and beverage produced between august 2019 and january 2020. the subsequent paragraphs discussed the linkage between electricity supply, inflation, fuel price and production and sales in the manufacturing sector. 2.2. electricity supply and production nexus the seventh un millennium sustainable development goal is access to sustainable, affordable and reliable energy for both social and economic activities (united nations, 2015). although there exist varieties of energies that are useful in the modern economies, attigah and mayer-tasch (2016) assert that electricity supply remains the indispensable form of energy needed within the industrial production process as it can assist in mass production and economy of scales attainment. therefore, electrical energy is considered one of the major inputs towards industrial production and an unreliable supply of electricity disrupts and impedes the table 1: volume of food and beverage manufacturing production (base: 2015=100) food and beverages weights aug-19 sep-19 oct-19 nov-19 dec-19 jan-20 meat, fish, fruit, etc. 6.69 104.1 102.8 114.1 112.0 106.7 92.5 dairy products 2.15 118.4 120.5 127.7 117.6 119.0 109.0 grain mill products 3.37 97.6 99.0 106.1 106.9 95.3 90.9 other food products 8.14 135.4 127.4 137.2 131.5 100.7 93.3 beverages 6.29 107.5 107.7 120.5 146.1 137.2 94.5 total 26.64 114.8 112.4 122.8 125.8 111.6 94.3 statistics south africa (statssa) (2020) habanabakize and dickason-koekemoer: production and sales risks in the manufacturing sector: the role of electricity supply, inflation and fuel price volatility international journal of economics and financial issues | vol 11 • issue 6 • 202126 production process (isaksson, 2016). the relationship between electricity supply and industrial production and sales was assessed by various researchers and their findings suggested the existence of a linear and positive relationship between electricity supply and industry’s output (abokyi et al., 2018; akinlo, 2008; mawejje and mawejje, 2016; khobai, 2013). a country’s economic growth and industrial production in most developing countries are dependent on the availability and affordability of electricity. electricity is not important only for production but also for the conservation and transportation of products (umar and kunda-wamuwi, 2019). despite the role of electricity in enhancing production and economic growth, the south african industrial sector has been undergoing severe shocks owing to the shortage of electricity supply (fedderke, 2014) which reduced the south african industries competitiveness. this energy shortage is the major cause of the high cost of production and high price of products. the issue of electricity supply is far from being solved as eskom issued a warning stipulation that due to high and growing electricity demand the electricity deficiency will remain a challenge until 2021 (ateba et al., 2019). owing to the inefficient electricity south african economy and industry lost billions and this is still to happen (oxford, 2015). although the cost of electricity may have an indirect effect on some of the food manufacturing industry by passing on the cost to customers, the purchasing power of later is directly affected resulting in low demand for matured food and beverages (deutsche securities, 2010). electricity is the most demanded form of energy in south africa. the significance of the role played by electrical energy within the south africa economy and particularly in the manufacturing sector, figure 1 indicates that in 2017, electricity counted 83 percent of the aggregate demand for energy within the commercial and public services sector. 2.3. the fuel price, manicuring food and beverages nexus apart from electricity, fuel is another type of energy that plays a significant role in most countries economies and particular in manufacturing food and beverage. fuel is also considered as an input during the production and selling of the manufactured food and beverages (green and zhang, 2013). the earlier studies evaluated the effect of fuel prices on food prices. analysing the asymmetric impacts of oil prices on food prices, meyer et al. (2018) found a linear relationship between fuel price and food price in developing countries. following the law of demand, the high is the price of goods or services, the lower quantity demanded (heakal, 2015). therefore, a rise in fuel price increases the cost of production resulting in a high price for both food and beverages. the high cost of manufacturing food and beverages is expected to reduce industries production and increase the selling price. on the customer’s side, a high price for goods and services implies less consumption (ncanywa and mgwangqa, 2018; simionescu et al., 2017). consequently, the manufacturing sector is seriously affected by fuel price volatility as south africa is a net petroleum products importer (kabini, 2019). 2.4. production, sales and inflation nexus as highlighted in the demand theory and the previous section, the quantity of food and beverages produced and sold, depends on consumers’ demand and purchasing power. the high is the consumer’s purchasing power, the more quantity is demand and the high is the quantity produced and sold. however, inflation is one of the major factors that impede consumers’ purchasing power (bagus et al., 2014). an increase in the inflation rate leads to a decline in productivity and aggregate production. different studies were conducted to analyse the impact of high inflation on manufacturing production. the study of bans-akutey et al. (2016) analysed the impact of inflation on the ghanaian manufacturing sector and findings revealed that inflation growth results in low productivity levels. a similar study was done in nigeria and the result indicated that an inverse relationship exists between manufacturing output and inflation levels (amaefule, 2019). contrary to these studies findings that suggested a negative relationship between manufacturing output and inflation, the study of ojeyinka and adegboye (2017) found a positive cointegration between inflation and manufacturing output. in the south african context, inflation fluctuation remains a crucial issue for policymakers and the country’s economy. despite the south african reserve bank introduced inflation targeting introduced in 2000 to fluctuate between 3% and 6%, the reality indicated that between 2000 and 2020 inflation rate has been above 3% and closer to 6% between 2000 and 2020 as the average annual inflation in 2020 is expected to be 5.4% (madito and odhiambo, 2018; south african reserve bank [sarb], 2019). this fluctuation is expected to have a significant impact on the production and sales of food and beverage in the manufacturing sector. the magnitude of this effect is determined by the study analysis presented after the methodology section. 2.5. production and sales risks in the manufacturing sector the aforementioned variables are some of the various determinants of production and sales in the manufacturing sector. the overall business activities in south africa’s manufacturing sector rely on electricity supply. shortage and/or interruption of electricity may result in low production, low sales and reduction in profitability (trace, 2020). additionally, long term electricity cuts may ruin some perishables goods creating losses to the industry. fuel price shocks is another economic variable that put the manufacturing sector’s production and sales at risk. fuel is the engine of source: doe energy balances, 2017 figure 1: energy demand in the commerce and public services sector, 2015 habanabakize and dickason-koekemoer: production and sales risks in the manufacturing sector: the role of electricity supply, inflation and fuel price volatility international journal of economics and financial issues | vol 11 • issue 6 • 2021 27 input procurement and output distribution. the high price of transportation causes an increase in both production cost and selling price. following, the law of demand and supply, high price leads to fewer sales resulting in low revenue and profitability of firms with the sector. the latter can also result from a high inflation rate. the lower is the purchasing power of money, the smaller is the quantity of the product demanded and sold (chakauya et al., 2009; gale, 1995. therefore, shocks in electricity supply, commodities price (especially fuel) and inflation rate are the major cause of production and sales risks in the manufacturing sector. 3. data, model specification and methodology 3.1. data the study is quantitative and it is built upon monthly time series data for the period starting from january 2002 to december 2019. the study variables include petrol price, consumer price index (cpi), electricity supply (stats sa), and production and sales of food and beverages. the entirety of the data was sourced from quantec easy data website. the dependent variable, production and sales of food and beverages, is measured in millions of rand, the electricity is measured in terms of gigawatt-hours, inflation rate (cpi) is calculated as a percentage change in the south african gdp deflator (cpi) index dec 2016 = 100, and the petrol price is measured in terms of cents per litre. for the sake of conformity and standardisation, all variables were transformed into a natural logarithm. 3.2. model specification to assess the effect of electricity supply, inflation and fuel price increase on food and beverage production and sales in the manufacturing sector, the following model was specified: lsalest = δ0+δ1 lcpit+δ2 lcpit+δ3 lelect+δ4 lpetpt+μt (1) where δ0 and δi are the constant and coefficients respectively, l denotes the natural logarithm, t represents the time factor and μ denotes the white noise. additionally, lsales represents total production and sales, lcpi is inflation, lelec denotes electricity supply and lpetp represents the petrol price. 3.3. methodology generally, time-series data is characterised by a non-stationarity aspect. however, if nonstationary data is analysed, the obtained results are more often considered to be spurious. in such cases, the regression outcomes give the impression of being statistically significant, while in reality, variables are serially correlated rather than being cointegrated (harris and sollis, 2003:32). any study based on spurious regression makes erroneous inferences and this can lead to inappropriate policies. spurious regression is evaded by firstly conducting unit root and stationarity test, before cointegration analysis. 3.3.1. unit root tests the literature provides several procedures that are useful in testing for unit root and stationarity of time series. these procedures and approaches include dickey-fuller (df) test, augmented dickey-fuller (adf) test, kahn and ogaki test, leybornemccabetest test, phillips-perron (pp) test, as well as, the kwiatkowski, phillips, schmidt and shin (kpss) test. owing to their simplicity and general nature, adf and pp are the most popular unit root tests employed by empirical studies (harris and sollis, 2003:42). this study employed also the adf test estimated as follows: 1 1 1 2 2 1 1ˆt t t t v t v ty y y y y uρ ρ ρ− − − − − +∆ ∆ ∆= + + + ∆+ + (2) 1 2ˆwhere ( ) 1vρ ρ ρ ρ= + + − 3.3.2. the johansen-juselius cointegration approach the literature represents several approaches and procedures useful to test the presence of cointegration between two or more variables. the presence of cointegration among variables implies the existence long-run relationship among the underlined variables. in other words, the existence of, at least, one cointegrating vector in the model suggests the existence of the long-run relationship. due to its popularity, the johansen test for cointegration which includes both trace and max-eigen statistics was selected for this study. using the unrestricted vector autoregression (var), the vector zt is expressed as follows: zt = a1 zt–1+… ak zt–k+ut (3) where zt denotes (n ×1) vector of series (variables); a1 denotes (n × n) parameters’ matrix and ut denotes the residuals or (n ×1) innovations vector. since the zt comprises of (n) endogenous variables, each variable presented in the model is regressed firstly on its lagged values and then on other variables in the model. under the vector error correction model (vecm) form, the var model is estimated as: ∆zt = γ1 zt–1+… γk–1 ∆zt–k+1+πzt–k+ut (4) where γi = – (i–a1–…–ai; (i = 1,…k–1) and π = –(i–a1–…–ak) according to harris and sollis (2003) both γi and π (in equation 4) denotes short-run and long-run adjustments towards changes in vector zt respectively. the vector represents a matrix of long-run coefficients and it expressed as a multiplier of two (n × r) vectors, (α) and (β), and these coefficients indicate the speed of adjustment towards long-run equilibrium and a long run coefficient matrix respectively. while analysing the relationship between variables г determine the number of cointegration in the model. if π = 0, that is (r=0), this implies no cointegration among variables. inversely, all variables are stationary if π possesses a full rank, that is(r = n). generally, π represents a reduced rank. in other words, r ≤(n–1) implies the existence of г cointegration vectors. in the current study, cointegration is assessed using both maximum eigenvalue and trace statistics. however, the unit root tests preceded the cointegration analysis. 4. empirical results and discussion 4.1. unit root tests the unit root test was used to determine the integration order for the underlined variables. table 2 represents the results from the adf tests. all variables in table 2 are stationary after the first habanabakize and dickason-koekemoer: production and sales risks in the manufacturing sector: the role of electricity supply, inflation and fuel price volatility international journal of economics and financial issues | vol 11 • issue 6 • 202128 difference. therefore, the johansen test for cointegration is a suitable model to determine the long-run relationship. 4.2. lag period selection in order to establish the accurate results from vecm, it is important to determine the optimum number of lags that should be included in the model. to this end, the study employed the akaike information criterion (aic), schwartz criterion (sc), hannam-quinn criterion (hqc) and final prediction error (fpe). as representing in table 3, the number of lags selected for this study is 2. all lag criteria reach the same conclusion that the optimum number of lags is two periods. 4.3. stability test additional to the selection the optimum number of lags to be included in the model is determined, it is also indispensable to ensure that the study model satisfies the stability condition. the result reported in table 4 infers that all inverse roots of characteristic polynomial remain within the unit circle. therefore, the vector error correction (vecm) is stable. before vecm establishment, it is essential to perform a cointegration test to ensure that a long-run relationship exists among variables. given that all variables are i (1), the cointegration was tested using the johansen procedures. 4.4. co-integration results following the johansen test for cointegration, eigenvalue and trace statistics were used to determine the long-run relationship among variables. the results from the test are exhibited in table 5. both trace and eigenvalue statistics reveal the presence of long-run relationships among variables and at most two cointegrating vectors. the presence of cointegration suggests, ipso facto, the specification of the vector error correction model (vecm) which is discussed further in the section after long-run relationships equilibrium. 4.5. long-run equilibrium relationships equation 5 below exhibits the long-run relationship for cointegrating vectors with their t-statistics provided in parentheses. l s a l e s = 2 . 9 6 3 6 0 2 + 1 . 6 4 8 0 9 3 l c p i + 0 . 7 3 5 2 8 8 [t-stat] [–13.5543] [4.13205] [0.43259] lelect–0.032261 lpetp (5) the individual coefficients represented in equation 5 suggest a positive relationship between inflation, electricity supply and production and sales of food and beverages in south africa. these results indicate that a 1 percent increased in the inflation rate would cause production and sales of food and beverages to increase approximately by 1.65 percent while a 1 percent increase in electricity supply would enhance the production and sales level by approximately 0.73 percent. in contrast, an increase of a 1 percent in the petrol price would cause production and sales of food and beverages to decline by 0.032 percent. considering the magnitude impact of the explanatory variables on the dependent variables, it can be inferred that the consumer price index (cpi) impact more on production and sales of food and beverages compared to other underlined variables. 4.6. vector error correction and short-run dynamics having established the cointegration among variables, the next step is to estimate the short-run dynamics of production and sales of food and beverages resulting from consumer price index (cpi), electricity supply, and petrol price fluctuations. these short term dynamics are presented in table 6. before discussing short-run results, it is important to have a close look at the error terms results. in determining whether the model is explosive or not, the rule of thumb suggests consideration of both sign and significant levels of the error correction term. the model is not explosive (adjusted towards long-run equilibrium) if the error term is negative and statistically significant. the sales equation is the only one that meets the aforementioned criteria. meaning that the short term shocks in the model are adjusted for long-run equilibrium. considering the short term coefficients, the electricity supply is the only variable that table 3: lag selection lag logl lr fpe aic sc hq 0 656.2524 na 2.65e-08 –6.095817 –6.03290 –6.070393 1 1869.352 2369.511 3.66e-13 –17.28366 –16.96908 –17.15654 2 1962.866 179.1630* 1.78e-13* –18.0081* –17.4418* –17.77928* *denotes lag order selected by the criterion table 2: adf unit root results variables level 1st difference without trend with trend without trend with trend lcpi 0.9569 0.7136 0.0000** 0.0000** lelec 0.5904 0.7593 0.0003** 0.0001** lpetp 0.6394 0.1614 0.0000** 0.0000** lsales 0.8980 0.0825 0.0032** 0.0177** ** denotes the rejection of null hypothesis at 5 percent level table 4: roots of the characteristic polynomial root modulus 0.999853 0.999853 0.875234 0.875234 0.680516–0.146417i 0.696089 0.680516+0.146417i 0.696089 –0.356791–0.137397i 0.382332 –0.356791+0.137397i 0.382332 0.364773–0.100597i 0.378390 0.364773+0.100597i 0.378390 habanabakize and dickason-koekemoer: production and sales risks in the manufacturing sector: the role of electricity supply, inflation and fuel price volatility international journal of economics and financial issues | vol 11 • issue 6 • 2021 29 possesses a significant effect on short term production and sales of food and beverages. changes in cpi and petrol price are not statistically significant to influence short term production and sales of food and beverages. 4.7. pairwise granger causality granger causality tests is another approach that is used to determine the short-run relationship between two or more variables. it can further be useful in predicting the behaviour of table 6: results of error correction terms and short-run dynamics error correction d (lsales) d (lcpi) d (lelect) d (lpetp) ecm –0.624696 0.018088 0.028946 –0.086428 s.e (0.08560) (0.00406) (0.04400) (0.04814) t-start. [–7.29753]** [4.45262]** [0.65789] [–1.79539] d (lnsales(-1)) –0.055307 –0.012522 0.040451 0.037071 s.e (0.07542) (0.00358) (0.03877) (0.04241) t-start. [–0.73330] [–3.49870] [1.04348] [ 0.87403] d (lnsales(–2)) –0.104377 –0.017348 –0.145839 –0.014712 s.e (0.06660) (0.00316) (0.03423) (0.03745) t-start. [–1.56721] [–5.48907]** [–4.26039]** [–0.39283] d (lncpi(–1)) 1.328864 0.375424 0.613904 1.146031 s.e (1.48761) (0.07059) (0.76460) (0.83655) t-start. [0.89329] [5.31813] [0.80291] [1.36995] d (lncpi(–2)) 2.172390 0.103461 –1.165734 –0.133883 s.e (1.48379) (0.07041) (0.76264) (0.83440) t-start. [1.46408] [1.46937] [–1.52855] [–0.16045] d (lnelect(–1)) –0.524832 0.016523 –0.404227 0.116348 s.e (0.16311) (0.00774) (0.08384) (0.09172) t-start. [–3.21765]** [2.13471]** [–4.82167]** [1.26845] d (lnelect(–2)) –0.115084 0.015118 0.174518 –0.023681 s.e (0.14831) (0.00704) (0.07623) (0.08340) t-start. [–0.77595] [2.14797]** [2.28935]** [–0.28394] d (lnpetp(–1)) 0.074622 0.004783 0.163463 0.407144 s.e (0.12679) (0.00602) (0.06517) (0.07130) t-start. [0.58854] [0.79495] [2.50830]** [5.71019]** d (lnpetp(–2)) –0.136238 –0.015000 0.097745 –0.354116 s.e (0.12548) (0.00595) (0.06449) (0.07056) t-start. [–1.08575] [–2.51911]** [1.51559] [–5.01851]** constant –0.005494 0.002414 0.001483 0.001968 s.e (0.00816) (0.00039) (0.00420) (0.00459) t-start. [–0.67298] [6.23185]** [0.35352] [0.42869] **denotes the significance of t-values at 5 percent level table 7: pairwise granger causality results null hypothesis f-statistic prob. causality direction lcpi does not granger cause lsales 26.4966 6.e-11** unidirectional lsales does not granger cause lcpi 1.12645 0.3261 lelect does not granger cause lsales 2.93990 0.0551 unidirectional lsales does not granger cause lelect 8.12742 0.0004** lpetp does not granger cause lsales 12.2631 9.e-06** unidirectional lsales does not granger cause lpetp 1.37552 0.2550 lelect does not granger cause lcpi 2.73951 0.0669 no causality lcpi does not granger cause lelect 2.71314 0.0687 lpetp does not granger cause lcpi 0.81965 0.4420 unidirectional lcpi does not granger cause lpetp 7.70634 0.0006** lpetp does not granger cause lelect 9.83252 8.e-05** unidirectional lelect does not granger cause lpetp 2.87747 0.0585 **denotes the significance of t-values at 5 percent level t-values at 5 percent level table 5: johansen cointegration test results h0 h1 trace maximum eigenvalue trace statistic t-critical value p-value max-eigen statistic t-critical value p-value r = 0 r > 0 119.0994 47.85613 0.000** 66.36082 27.58434 0.000** r ≤ 1 r > 1 52.73854 29.79707 0.000** 34.45673 21.13162 0.000** r ≤ 2 r > 2 18.28181 15.49471 0.018** 18.04025 14.26460 0.012** r ≤ 3 r > 3 0.241558 3.841466 0.6231 0.241558 3.841466 0.6231 r denotes the number of cointegrating vectors under the h0 of no cointegration. **, *suggests the rejection of the h0 of no cointegration at the 1% and 5% level of significance respectively habanabakize and dickason-koekemoer: production and sales risks in the manufacturing sector: the role of electricity supply, inflation and fuel price volatility international journal of economics and financial issues | vol 11 • issue 6 • 202130 one variable (y) based on past information of another variable (x). results in table 7 suggest that all three explanatory variables namely lcpi, lelect and lpetp can be used to predict the short term behaviour of production and sales of food and beverages. however, it is a one-way relationship, as the lsales does not ganger cause any of the independent variables. these results imply that the explanatory variables’ behaviour impacts the dependent variable, not vice versa. 4.8. results of diagnostic tests stability and residual test were conducted to assess if the employed model met the econometric assumptions. results in table 8 show that none of the null hypotheses is rejected. this confirms that none of the econometric assumptions was violated by the employed vecm. additionally, the plotted cusam result in figure 2 suggests that the study model is stable. 5. conclusion production and sales of food and beverages are major factors that sustain economic growth and social wellbeing. it also contributes to manufacturing employing capacity. however, the quantity of food and beverages produced and sold in the manufacturing sector depends on some other economic factors. these factors include purchasing power which depends on inflation level, interest rates, fuel price and production and supply of electricity. this study aimed to assess the impact of electricity supply, inflation rate and fuel price increase on food and beverage production and sales in the south african manufacturing sector. based on production theories and empirical analysis, the study employed a cointegration test, causality test and error correction model to establish the responsiveness production and sales of food and beverage towards changes in electricity supply, fuel price and inflation. the johansen test for cointegration findings revealed that a long-run relationship exists between the underlined variables. it was found that major changes in production and sales of food and beverage are caused by the inflation rate and electricity supply. although the fuel price negatively impacts on production and sales of food and beverages, its effect is manageable compared to the shocks caused by insufficient electricity supply and high inflation rate. the overall conclusion is that electricity supply level, fuel price and inflation rate play a major role in improving production and sales of food and beverage in the manufacturing sector. considering the effect of the inflation rate on the production and sales of food and beverage, the south african policymakers should create a conducive environment that strengthens the country’s currency and reduces the inflation rate. this would include wage, interest rate and money supply control. additionally, food and beverage production industries should increase their investments into other sources of energy such as wind and solar energy rather than relying on electricity supplied by eskom. references abokyi, e., appiah-konadu, p., sikayena, i., oteng-abayie, e. 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(2015), united nations resolution adopted by the general assembly on 25 2015: transforming our world: the 2030 agenda for sustainable development. available from: https://www. un.org/en/ga/search/view_doc.asp?symbol=a/res/70/1&lang=e [last accessed on 2017 sep 26]. tx_1~at/tx_2~at international journal of economics and financial issues | vol 10 • issue 4 • 2020 9 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(4), 9-17. the effect of financial sector development on poverty reduction in nigeria: an empirical investigation ishaq saidu*, abbas abdullahi marafa department of economics, baze university abuja-nigeria. *email: ishaq.saidu@bazeuniversity.edu.ng received: 03 march 2020 accepted: 10 june 2020 doi: https://doi.org/10.32479/ijefi.9532 abstract this paper examines whether financial services (mckinnon conduit) or provision of credit is more effective in reducing poverty in nigeria using data for the period 1980-2018. it employs autoregressive and distributed lag model (ardl) approach to estimate the parameters and cointegration analyses for income and consumption models. the results of the ardl bound test to cointegration indicate a long-run relationship among the variables in the two models. the study reveals that availability and improvement in financial services is more beneficial than credit growth. in addition, the study suggests that financial instability may hurt the poor and retards the beneficial effect of financial development particularly in the short run. the paper recommends intensification of effort towards second-generation reforms, such as, design and implementation of financial inclusion policies that involve improving access to financial services that foster inclusive-growth. furthermore, the study recommends guided deregulation in credit market as a way of precluding or subduing its susceptibility in triggering full-blown crises that is detrimental to the poor’s aggregate welfare. keywords: financial sector development, poverty reduction, ardl model, nigeria jel classifications: e51, e52, c52, e65 1. introduction a sound financial system is an indispensable ingredient to economic growth and development of any country. the last three decades have witnessed a growing research interest in finance-growth nexus, which was precipitated by financial crises and economic instability around the globe (levine, 2005; ang, 2005; fitzgerald, 2006; keho, 2017; mohieldin et al., 2019). debate on finance-growth nexus was confined to issue of direction of causality. the argument was whether financial development spurs economic growth or growth drives financial development. the issue of causality between finance and growth is to an extent over-romanticized, to the detriment of a more critical question that suffered a prolonged neglect, particularly, the role of financial development in poverty reduction. levine (2008) remarked that economic discipline has done stunningly inadequate job of examining how formal financial system affect the poor. conceptually, there are two broad channels in which financial development affect poverty: the direct and the indirect channels. while the direct channels include access to financial services, credit channels and financial crises channel and the indirect channel refers to the positive effect of finance on poverty through economic growth (holden and prokopenko, 2001; arestis and cancer, 2005; nnanna, 2004). conventional wisdom suggests that economic growth is a key element in the fight against poverty (dollar and kray, 2002; bourguingnon, 2003; inoue, 2019). the premise is that aggregate increase in economic activities will benefit both the poor and the rich. however, there is evolving evidence that significant poverty reduction is possible even where there is little or no economic growth. for instance, medvedev et al. (2013) demonstrated a case in jamaica where growth rate between 2003 and 2007 was stagnant at 1.1%, and poverty headcount reduced drastically from 21% to all time low of 9.9%. they attributed this development to changes in institutional structures that support income re-distribution and improved financial sector development. this journal is licensed under a creative commons attribution 4.0 international license ishaq and marafa: the effect of financial sector development on poverty reduction in nigeria: an empirical investigation international journal of economics and financial issues | vol 10 • issue 4 • 202010 the nigeria financial system has for the greater part of its history repressed, whereby excessive government interference create inefficiency in financial intermediation. the consequence is that financial repression fuels the emergence of fragmented financial market in which preferred borrowers obtained credit at subsidized rate, as directed by regulatory authorities, while less privileged but industrious borrowers with promising entrepreneurial capacity resort to informal and parallel market with exorbitant cost of borrowing. to move away from financial repression, nigeria embarked on financial liberalization reforms in 1986. however, despite this, access to financial services and credit remain a huge problem as only 32.5% of adults have access to basic financial services (efina, 2012). about 64.1% of adults do not have access to formal financial service (cbn, 2012). the private sector credit as percentage of gdp as at 2012 was 20.2 % compared to 246.2% in us and 190.4 in south africa. similarly, the ratio of commercial bank branches per 100,000 adults decreased from 6.4% to 5.8% between 2009 and 2012 compared to 35.6 % in us and 10.4 in south africa. paradoxically, despite the abundance of human and natural resources, the percentage of nigerian living below poverty line has been on the increase, from 28.1 % in 1980 to 44% in 1990, 74 % in 2000 and 70% in 2010 (nbs, 2013; 2019). there are few studies that explore the relationship between financial development and poverty in nigeria (saibu et al., 2011; fawowe and abidoye, 2013; goodness, 2013; keho, 2017). none of these studies examine the dichotomy of the channels of financial development on poverty reduction. in addition, the effect of financial instability on poverty was also not considered based on these channels. this study is an attempt to fill this vacuum. the objective of this study is to improve the existing literature by examining the transmission mechanism through which financial sector development and financial instability contributes to rising poverty incidences in nigeria. the curiosity is whether the high incidence of poverty is related to the shallowness and fragility of the financial system. the rest of the paper is structured as follows. section two presents the review of empirical literatures. section three outlines the methodology. section four presents the data analysis and empirical findings. section five contains conclusion and recommendation. 2. review of empirical literature there is scanty but growing body of empirical studies that address the finance poverty nexus. jeanneney and kpodar (2008) examined different channels in which finance exert positive influence on poverty. they isolated growth effects and examined whether credit or access to financial services is more beneficial to the poor. they employed dynamic panel generalized method (gmm), with sample size of 92 countries that generated 187 observations between 1955 and 2000. their study reveals that the effect of financial sector development in reducing poverty is stronger than economic growth, hence, concluded that the mckinnon conduit effect is more beneficial to the poor than the credit effect. honohan (2004) examines the influence of financial depth (measured as the ratio of private credit to gdp) on poverty (using $1 a day poverty headcount standards) for 45 countries. the findings reveal that doubling financial depth is associated with 10 percentage decline in poverty headcount and concluded that mainstream finance is associated with lower poverty, and added that expanding the concept of credit penetration to include the activities of development banks, may possibly be associated with lower poverty. kpodar and singh (2011) investigated the relevance of financial structure on poverty reduction in some selected developing countries and compared the efficacy of bank-based and market based financial system in poverty reductions. they adopted gmm developed by blundel and bond (1998).the results indicated that when institutions are weak, bank-based financial system is better at reducing poverty, and as institutions develop market-based financial system can turn out to be beneficial to the poor. this study collaborates the study of inoue (2019) that used india data between 1973 and 2004. mohieldin et al. (2019) examined the impact of financial development on economic growth in egypt using time series data between 1980 and 2016. they utilized ardl technique to analyze the new data set of financial development indexes released by imf. their analysis reveals a strong relationship between real growth per capita and financial development. surprising, their study indicates no causal relationship between access and uses of financial service and real per capita income. however, stock market indices have strong association with real per capita gross domestic product. the author suggest further reforms in banking and stock markets for their critical role in enhancing economic growth and welfare of egypt. singh and huang (2011) investigated two scenarios: determine the effect of financial sector development on poverty and investigate the effect of property right on poverty reduction in an efficient financial market environment in ssa and employed fgls method and the results show that the ratio of private sector credit to gdp increases, its marginal contribution to poverty reduction and inequality declines. they concluded that the poor may only benefit from financial deepening in countries with secured property right, which enhances the use of collateral for better access to credit facilities. in another study, akhter and dally (2009) investigate the impact of financial development on the poor in 54 developing countries using fixed effect vector decomposition method for the period 19932004. they concluded that on the average financial development is conducive for poverty reduction but cautioned that instability that accompany rapid financial deepening may erode the benefit of financial development. the result also indicates that access to saving and credit facilities are effective financial intermediation channels that contribute to alleviating poverty. in a similar study, khan, ahmad and jan (2012) examines the causal relationship between financial deepening and poverty alleviation for the period 1981-2010 using time series data from pakistan. broad money supply (m2/gdp), domestic credit to the private sector (dcp/gdp) and domestic money bank assets (dmba) are ishaq and marafa: the effect of financial sector development on poverty reduction in nigeria: an empirical investigation international journal of economics and financial issues | vol 10 • issue 4 • 2020 11 used as proxies for financial development and private per capita consumption as proxy for poverty reduction. using ardl, the result reveal that financial deepening (m2/gdp) have long-run relationship with poverty alleviation, dmba have no long-run relationship with poverty alleviation and a positive relation between dmba with per capita consumption. they concluded that financial deepening exerts positive effect on poverty reduction. quartey (2005) investigates the relationship between financial sector development, savings mobilization and poverty reduction in ghana from 1970 to 2001 using time series technique. the result of johansen co-integration test suggests long-run relationship between the variables and the granger-causality test points to unidirectional causality from financial development to poverty reduction. the effect of financial development on poverty in ghana is positive but insignificant, attributing it to the fact that financial intermediaries have not adequately channeled savings to the pro-poor sectors of the economy owing to government deficit financing, high default rate, lack of collateral and lack of proper business proposals etc. rewilak (2012) examine whether or not the incomes of the poor systematically grow with average incomes, and whether financial development enhances the incomes of the poorest quintile. the author build on dollar and kray (2002) data and he discovered that financial development aids the incomes of the poor in certain regions, whilst it may be detrimental in others and warned that adopting “one size fits all” may be detrimental to overall policy objective of poverty alleviation. saibu et al. (2011) examined the impact of financial development and financial volatility on poverty rate in nigeria. using bivariate and multivariate causality test on a data spanning from 1986 to 2010. specifying two different models: based on banking sector indices (private sector credit to gdp) and stock market indices (the ratio of trading volume to market capitalization). the co-integration result indicates a long run relationship between financial development, financial instability, and poverty. the authors also added that while financial development variable has net positive effect on poverty, financial instability had negative impact on poverty. aliero and ibrahim (2012) examined whether enhanced access to formal financial service reduces poverty in nigeria especially among rural dwellers in katsina state using multinomial logit regression model. they generated cross-sectional primary data from 384 respondents to capture average monthly income as poverty proxy and access to financial services like bank accounts, atm, loan, mobile banking, insurance, internet banking etc. they discovered that access to formal financial services especially credit facilities have a high probability of reducing poverty. fawowe and abidoye (2013) examined the effect of financial development on poverty and inequality in african countries. the results indicated that financial development has not had a significant effect on poverty and inequality. macroeconomic variables such as low inflation and trade openness were found to be statistically significant, implying that they can help reduce the level of poverty and inequality. our results confirm the deficiencies in african financial systems and highlight the fact that more efforts need to be done to improve access of poor households and small and medium scale enterprises to financial services. goodness (2013) investigates the role of financial development on economic growth in nigeria. using annual data spanning from 1961 to 2012. a bootstrap rolling window approach is used to account for potential time variation in the relationship. the results indicate no causality between the two series. the relevant var is unstable for the full sample which undermines the confidence in the bootstrap full sample granger causality tests. therefore, a bootstrap rolling window estimation was used to evaluate granger causality between financial deepening and economic growth over different time periods. these tests reveal periods where financial deepening has predictive power for economic growth, as well as periods where economic growth has predictive power for financial deepening. 3. methodology 3.1. variable definition, measurement and sources poverty reduction indicators (pv): household final consumption expenditure per person (hcep) is used as proxy for poverty. hcep is obtained as household final consumption expenditure divided by the population (ho and odhiambo, 2011). per capita income (pci): alternative proxy for poverty. it is gross domestic product divided by midyear population (world bank, 2005). financial development indicators (fd): a. private sector credit to gdp (pcgdp): this measures financial depth, it is the ratio of private sector credit to gross domestic product (demirguc-kunt and klapper, 2013). b. money supply (m2) to gdp (msgdp): this measures financial deepening, it is the ratio of money supply to gross domestic product (odhiambo, 2009; beck, demirguc-kunt, & levine, 2000). financial instability indicator (fi): measure financial instability of variable x as average absolute value the variable residuals (jeanneney and kpodar, 2008). this is obtained by regressing financial development variable fdt on it lagged values fdt-1 and a time trend (t). fi x of variable x is given as follow: 1 1  = = ∑ nx tt fi n . where εt represent the residuals derived from the ols estimation of the following equations: xt=a+bxt-1+ct+εt. thus, two financial development instability is iterated to access the effect of financial instability on poverty reduction in nigeria: financial instability emanating from credit market (finsc) and financial instability resulting from varies in money supply (finsm). control variables: a. inflation rate (inf): this is the growth rate of consumer price index and captures the macroeconomic environment or monetary instability ishaq and marafa: the effect of financial sector development on poverty reduction in nigeria: an empirical investigation international journal of economics and financial issues | vol 10 • issue 4 • 202012 b. real gdp (rgdp): this captures other indirect effect on poverty resulting from other macroeconomic policy including the financial sector. the real gdp per capita can be computed as real gross domestic product divided by the population c. trade openness (opn): measures the degree of trade liberalization of the economy. it is import plus export as ratio of gdp (essien and bawa, 2005). d. human capital development (hcd): is proxied as federal government capital expenditure on education, health and other social community services as percentage of total capital expenditure. all data are obtained from cbn statistical bulletin and world bank wdi (central bank of nigeria, 2019; world bank (2019)). 3.2. model specification the autoregresive and distributed lag (ardl) approach is adopted where two models the income and consumption models are estimated. the essence is to evaluate the impact of financial sector development and financial instability on poverty. the model is a modified version of jeanneney and kpodar (2008), goodness (2013) and saibu et al. (2011) as financial instability indicators is included as regressors in the model and additional control variables international trade openness indicator and inflation has been included to capture the impact of trade globalization and macroeconomic vagaries on domestic poverty. the poverty model has the following form: pvt=β0+β1fdi+β2fii+β3fe+β4cvi,t+φ+εt (1) the framework for equation (1) is: 1 1 21 1 3 4 11 1 2 3 4          − −= = − − −= = − − − ∆ = + ∆ + ∆ + ∆ + ∆ + + + + + ∑ ∑ ∑ ∑ p p t i t i i t ii i p p i t i i t i i t ii i i t i i t i i t i t pv pv fd fi cv pv fd fi cv ect (2) where pvt represent poverty indicators, fdi is financial development indicators, fii is financial instability indicator, while cvi,t represent control variables such as real gdp, inflation, trade openness, φ and εt represent time dummy and error term respectively. in equations (2), the terms with the summation signs represent the error correction dynamics while θ’s correspond to the long run relationship. the null hypotheses is that θ1= θ2 = θ3 = θ4 = θ5 = 0 which indicate the non-existence of the long run relationship. at equilibrium, the error term is expected to be zero. however, during disequilibrium this is non-zero, which is an indication of how far the system is away from equilibrium at time t. the value of ect is called the speed of adjustment as it shows how the dependent variable changes in response to disequilibrium. when this value tends to −1, it implies that economic agents remove a large percentage of the resulting disequilibrium in each period. however, a small value (tending to 0) implies that adjustment to the long-run steady state is slow which may be because of adjustment (pentti, 1992; pesaran & shin, 1999; pesaran, shin, & smith, 2001). 4. results and discussions 4.1. unit root test result table 1 reports the augmented dickey fuller (adf) and perron (pp) test results. the results indicate that none of the variables is stationary at levels except financial instability (finsm) and human capital development (hcd). all the variable becomes stationary after first difference. this implies that we can proceed with ardl approach. 4.2. regression result and analyses the over-parameterised model for model i and ii where the dependent variables and the regressors were fixed at two and three lags respectively, was first estimated (results not shown). most of the regressors in both models appear not to be significant even though they present near unity r squared. therefore, the size of the model was further reparemaetrized to remove poor performing lags and variables by imposing zero coefficient on lags that is insignificant. consequently, a more parsimonious and interpretable model were produced by setting the system to automatically select the optimum lags guided by akaike information criterion (aic). the result is presented in table 2. model i indicates that money supply to gdp, private sector credit to gdp, lagged value of financial instabilities, real gdp are all table 1: unit root test results variables test techniques i(0) adf t-statistics pp t-statistics levels 1st diff. levels 1st diff. hcep −3.4635*** −11.3249* −3.4311*** −11.2587* 1(1) hsgdp −3.263 −4.3650* −2.50819 −7.8894* 1(1) lpci −2.5051 −5.8535* −2.492 −5.9166* 1(1) pcgdp −3.3154*** −5.265* −2.4008 −8.9469* 1(1) inf −3.4186 −5.7469* −2.7634 −10.5522* 1(1) opn −2.0182 −7.0981* −2.0149 −8.0981* 1(1) insc −2.0224 −5.0919* −2.7983*** −6.0898* 1(1) ginsm −3.5132*** −5,8889* −3.5376** −9.0441* 1(0) rgdp −0.6495 −5.6624* −0.6503 −5.6640* 1(1) lhcd −4.095018** −11.2630* −4.19554*** −14.7336* 1(0) 4.03, 3.55 and 3.21 are the critical values of both adf and pp procedure at 1%, 5% and 10%, respectively. *, **, *** denote significance at 1%, 5% and 10% levels respectively. source: author’s computation with e-views 10 ishaq and marafa: the effect of financial sector development on poverty reduction in nigeria: an empirical investigation international journal of economics and financial issues | vol 10 • issue 4 • 2020 13 statistically significant (at 5%), while lagged value of per capita at 1% in influencing poverty reduction in nigeria. this is in line with the vicious circle of poverty hypothesis. the human capital development variable is barely significant at 10% while inflation rate is statistically not significant but properly signed. all variable except private sector credit to gdp confirm with the theoretical expectations. we tested whether payment system or credit is more beneficial to increasing the standard of living, and examined the channel of transmission of instabilities money or credit – impact to welfare. table 2 reveals that 1% increase in m2/gdp will translate to 0.6% increase per capita income. however, the financial instability indicator revealed that credit instability may induce reduction in income by 1.1% in subsequent year. hence, the hypothesis of a positive direct effect of financial development on the standard of living of the poor and the hypothesis that financial instability seems to significantly reduce the per capita income cannot be rejected. thus, confirming the mckinnon conduit channels that the depth of the financial sector has amplifying effect in reducing poverty (mckinnon, 1973). this result supports the findings of jeanneney and kpodar (2008). the coefficient of rgdp indicates that 10% increase in rgdp has the potential of reducing poverty by 2.9%. this connotes that the size and level of economic activity has a significant bearing in poverty reduction. this affirms the theoretical proposition that economic growth has indirect impact on poverty reduction. the negative coefficient of inflation (statistically insignificant) indicate that it erodes the value of income which is detrimental to the poor. human capital development is statistically significant and has positive infinitesimal impact on poverty reduction. this suggest paucity of funding to health, education and social sector that embodied human capital development. it may also imply that investment in human capital alone is not sufficient condition in the fight against poverty. this is in line with the findings of anyanwu and erjiakpor (2007) that other policy intervention such as sustaining democracy, upholding property right, acceleration national income, creating enabling environment for foreign direct investment among others will contribute in poverty reduction. model ii (consumption equation) indicate that financial instability and its lagged values, real gdp, and inflation have appropriate signs and statistically significant. a percentage point increase in financial instability will induce about 0.4% decrease in household consumption expenditures for the 1st year, and 1.8% the 2nd year. this shows that there is a negative relationship between financial instability and poverty reduction (consumption expenditure). the negative coefficient of inflation indicates that 1% increase in inflation will decrease household final consumption expenditure by 0.5%. this reinforces the fact that persistent rise in price hurt the poor and low-income earners with mainly fixed income. real gdp is statistic ally significant at 5% and with appropriate sign. the coefficient indicates that a 10% increase in real gdp will increase household consumption by 2.8%. this implies that growth conduit channel of poverty reduction is very strong. table 3 present ardl bound test approach to cointegration estimation result for model i and model ii respectively. the bound test f-statistics for model i is 8.99. this clearly exceeds 1% critical value for the upper bound. similarly, the bounds test f-statistics for model ii is 3.84. the f-value is higher than 5% critical value for the upper bound. all these suggests that we reject the null hypothesis of no long-run relationship. hence, there exists a long run relationship in both models. table 4 present the cointegrating form and the long run coefficient of the model. in model i, the error correction coefficient is properly signed with negative (−0.1602) and statistically significant at 5%. this means that about 16.02% disequilibrium is corrected annually because of converse adjustment in explanatory variables, indicating there is quick adjustment mechanism from disequilibrium. income equation indicate 1% increase in real gdp has a positive associating effect on per capita income by 6.4%. this result point table 2: parsimonious short run models model i (dep. variable=income) model ii (dep. variable=consumption) variables coefficient variable coefficient log(income(−1)) 0.5388 (6.826)* log(consuptn(−1)) 0.1449 (0.717) pcredit −0.0069 (−1.832)*** pcredit 0.0032 (0.247) moneys 0.0069 (2.098) pcredit(−1) −0.017 (−1.923)*** instabilityc 0.0001 (0.018) pcredit(−2) 0.0153 (1.698) instabilityc(−1) −0.0116 (−2.055)** moneys 0.0005 (0.051) instabilitym 0.0029 (0.595) instabilityc −0.0431 (−2.181)** instabilitym(−1) 0.0104 (2.233)** instabilityc(−1) −0.0180 (−1.022) inflation −0.0002 (−0.523) instabilityc(−2) 0.0470 (2.180)** log(realgdp) 0.2991 (6.483)* instabilitym 0.0681 (3.218)* log(humancap) 0.0027 (1.807)*** instabilitym(−1) −0.0101 (−0.596) c −3.6479 (−4.154)* instabilitym(−2) −0.0434 (−2.502)** inflation −0.0058 (−2.708)** log(realgdp) 0.2960 (2.121)** humancap 0.0002 (0.042) c 1.2943 (0.394) r2=0.99, adj. r2=0.97 dw=1.79, f–statistics=104.85 prob.*(f-statistics)=0.0000 r2=0.83, adj. r2=0.70 dw=2.56, f–statistics=6.38 prob.* (f-statistics)=0.000198 figures in parenthesis are t-statistics. *1% level of significance, ** 5% level of significance, ***10% level of significance source: author’s computation with e-view 9 ishaq and marafa: the effect of financial sector development on poverty reduction in nigeria: an empirical investigation international journal of economics and financial issues | vol 10 • issue 4 • 202014 to the significance of creating enabling environment for the real sector of the economy to thrive. the coefficient of money supply to gdp ratios (measure of financial deepening) has a positive and statistically significant effect in long –run on per capita income (poverty reduction). a unit improvement in financial services and monetization may translate to about i.5% reduction in poverty rate. this conform with the work of quartey (2005), odeniran, & udeaja (2010), odhiambo, (2009) and omotor (2007). the effect of human capital development is positive and statistically significant. however, the coefficient’s magnitude has infinitesimal impact in the long-run on poverty reduction. this suggest that except couple with institutional and development framework, investment in human capital alone might have a limited impact in tackling poverty menace in nigeria. financial instability does not have statistical significance in reducing poverty in the longrun. it will be recalled that the short-run equation indicate that financial instability is significant. this implies that rapid and untamed financial development may fuel financial crises in the short run but the long-run effect through economic growth has far-reaching impact that outweighs the short-term instability. in model ii (consumption model), the error correction coefficient is properly signed (−0.877) and statistically significant at 1% level. this implies that about 87.7% of the previous year ’s deviation from long-run equilibrium as a result of shock is corrected within the year. this implies that there is quick adjustment mechanism from disequilibrium. interestingly, financial instability coefficients are also not statistically significant in the long run equation. this reaffirms the earlier result in income equation and conforms to previous studies on this subject that financial instability is a short run phenomenon that usually herald financial liberalization policy but the effect fettered out in the long run. the result support the conclusions of rajan and zingales (2003), loayza and ranciere (2005) an jeanneney and kpodar (2008) that posit that financial development may precipitate financial crises in the short run but the long-run effect through economic growth has far reaching impact that outweighs the short term instability. similar to the findings of jeanneney and kpodar (2008), the result clearly indicates that credit growth does not benefit the poor. this seems to indicate that at rudimentary phase of financial sector development, improving access and expansion of financial services seems to be more effective in in poverty reduction than credit. this is peculiarly evidenced in developing countries where banks are disinclined to provide credit to the poor with prohibitive restrictions. nevertheless, as the financial market grows, saving accumulation may improve access to credit. real gdp coefficient indicates that a percent increase in real gdp will increase household consumption by 3.4%. this implies that growth conduit channel of poverty reduction is very crucial. inflation indicates a percentage increase in inflation will decrease household final consumption expenditure by 0.06% in the long run. this confirm the assertion that persistence inflation may harm the poor through its tendency of reducing the real value of wages and transfers, and eroding the value of financial asset that are liquid or near cash that dominate the poor preference and wallets (holden and prokopenko, 2001; easterly and fischer, 2001). 4.3. post-estimation diagnostic test to confirm statistical adequacy of the model, the two model were tested for normality, serial correlation, heteroscedasticity, specification error and stability test. the results is reported in table 5: the diagnostics indicate that the residuals are normally distributed, homoscedastic and serially uncorrelated. the ramsey’s reset test indicates that the functional form is correctly specified, which implies that the parameters estimate are stable. cusum and cusumsq further affirm this position. 4.4. parameter stability test the test confirms that the models are not varying or wandering over time and also eschews the problem of misspecifications which could lead to biased result and inferenced. the cumulative sum (cusum) and cumulative sum of square (cusumsq) graph at 5% significance level are presented in figures 1 and 2. the null hypothesis is that the regressions equation is correctly specified with stable parameter. table 4: long run coefficient model i and ii model i (dep. variable=income) model ii (dep. variable=consumption) variables coefficient variable coefficient pcredit −0.0151 (−1.972)*** pcredt 0.0009 (0.042) moneys 0.0151 (2.383)** moneys 0.0006 (0.052) instabiltyc −0.0250 (−1.575) instabilityc −0.0165 (−0.502) instabilitym 0.0291 (1.900)*** instabilitym 0.0171 (0.524) infaltion −0.0006 (−0.528) log(realgdp) 0.3462 (2.798)* log(realgdp) 0.6487 (9.774)* humancap 0.0002 (0.0423) humancap 0.0059 (1.828)** inflation −0.0068 (−2.672)* c −7.9109 (−3.816)* c 1.5139 (0.3874) figures in parenthesis are t-statistics. *1% level of significance, **5% level of significance, ***10% level of significance, source: author’s computation with e-view 9 table 3: ardl bound test approach to cointegration ([model i and ii]) statistics model i (income) model ii (consumption) f-statistics 8.99 3.84 significance i0 bound i1 bound 10% 2.2 3.09 5% 2.56 3.49 2.5% 2.88 3.87 1% 3.29 4.37 sources: author’s computation with e-view 10. ishaq and marafa: the effect of financial sector development on poverty reduction in nigeria: an empirical investigation international journal of economics and financial issues | vol 10 • issue 4 • 2020 15 both figure 1 and 2 indicate that the lines are well within the confidence bands, therefore the null hypotheses of stability are not rejected. 5. conclusion and recommendations this paper investigates the impact of financial sector development on poverty reduction. the study dichotomizes the channels of effect of finance sector development on poverty reduction. this study reveals that improvement in payment system and saving vehicle is likely to be more beneficial to the poor than credit facilities. this is premised on the fact that there is long–run relationship between improvement in payment system and saving function and reduction in poverty in nigeria. conversely, there is no relationship between credit growth and poverty reduction in the long-run. financial instability is a short run phenomenon. lending boom and uncontrolled rapid growth in credit activities may trigger instability, and this may hurt the poor disproportionately. growth effect on poverty reduction remain significant across the models. this reinforces the indirect channel of poverty reduction through economic growth. to ameliorate the downside of financial sector development, particularly, financial instability emanating from credit crunch, there is need to monitor the ease of credit arteries and credit growth to forestall the precipitated financial crises. there are several ways of checking and taming the excesses and recklessness in credit market. this includes prudential guidelines, sectoral credit regulation, strict compliance to code of corporate governance code, credit activities report rendition, loan-monitoring activities, etc. there is need to foster financial inclusion policies and implementation to reasonable level. this will encourage the expansion and improvement in financial services in the form of payment and saving vehicle affordable to the less privileged. this will ameliorate access and funding impediment, improve quality and productivity of human capital development, and compliment government fiscal effort towards these sectors. the government should create pro-business enabling environment that will foster job creation and enhance economic activities that support inclusive growth will go a long way in ameliorating the economic condition of the populace. it is useful to encourage microfinance activities, particularly, 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(2012), finance is good for the poor but it depends where you ishaq and marafa: the effect of financial sector development on poverty reduction in nigeria: an empirical investigation international journal of economics and financial issues | vol 10 • issue 4 • 2020 17 live. journal of banking and finance, 37(5), 1451-1459. saibu, m.o., nwosu, p.i., ajuwon, o.s. (2011), financial development, financial volatility, and poverty reduction: an empirical analysis. in: youth unemployment and poverty reduction in nigeria, nes, selected paper for 2012 conference. nigeria: nes. p389-341. singh, r.j., huang, y. (2011), financial deepening, property rights and poverty: evidence from sub-sahara africa, imf working paper wp/11/196. united states: international monetary fund. world bank. (2005), world development report 2006: equity and development. washington, dc: world bank group. world bank. (2019), world development indicator 2019: development data group. washington dc, world bank group. available from: https://www.datacatalog.worldbank.org/dataset/world-developmentindicators. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(5), 465-474. international journal of economics and financial issues | vol 7 • issue 5 • 2017 465 solving stock price-gross domestic product puzzle: evidence from sri lanka athambawa jahfer1*, tohru inoue2 1department of accountancy and finance, faculty of management and commerce, south eastern university of sri lanka, oluvil, sri lanka, 2graduate school of international social sciences, yokohama national university, 79-4 tokiwadai, hodogaya-ku, yokohama city, japan. *email: jahfer@seu.ac.lk abstract this paper investigates the macroeconomic factors influencing on stock market performances in the long run while solving “stock price-gross domestic product (gdp) puzzle” in the sri lankan market. the results show that money supply and inflation are positively related with stock market performances and exchange rate, gdp and interest rate are negatively related to the stock market performances. “stock pricegdp puzzle” was solved by adding the balance of trade in the model where it finds positive association between gdp and stock price indicator. this study contributes to the literature on the relationship between stock market performances and macro economic factors while solving “stock price-gdp puzzle”. keywords: all share price index, market capitalization, macro economic factors, sri lanka jel classifications: e44, f36, g00, o16 1. introducti̇on stock market is seen as a very significant component of a financial system in any country. it is playing a vital role in mobilization of capital within developing countries. the stock market is arguably the best place for an investor to invest in the shares of listed companies. it helps investors to sell their securities at a higher price. it is a known fact that most of the people invest in shares with the intention of selling the share at a higher price in future. if there is a well functioning share market, investors always invest their money in shares of different companies and it will help to increase the economy of a country and people’s income indirectly. many researchers like demirguc-kunt and levine (1996a), singh (1997), and levine and zervos (1998) found that stock market development plays an important role in economic growth. jahfer and inoue (2014) studied the relationship between stock market development and economic growth in sri lanka for the period from 1996 to 2011 and they concluded that stock market development does positively contribute to economic growth and stock market development is the key aspect of economic development in sri lanka. over the past few decades, the interaction of the capital market and the economic growth has been a subject of interest among financial economists and practitioners. it is often argued that stock market performances are determined by some fundamental macroeconomic variables such as gross domestic product (gdp), exchange rate, inflation, money supply, interest rate, balance of trade and etc. investors generally believe that monetary policy and macroeconomic events have a large influence on the volatility of the stock prices. this implies that macroeconomic variables could exert effect on share returns and influence investors’ investment decisions. in the past, many researchers (asprem,1989; yusof and majid, 2007; rahman et al., 2009; singh, 2010; hsing, 2011; 2014; eita, 2012; quadir, 2012; naik and padhi, 2012; jauhari and yadav, 2014; khan, 2014; pradhan and saraswari, 2010; bhatta, 2010 and regmi, 2012, investigated the relationships between stock market performances and macroeconomic variables and proved the relationship. the objective of this paper is to investigate the factors influencing the stock market performances in the long-run and to solve “stock price-gdp puzzle in the case of sri lanka. to the best our knowledge, there are no study attempted to solve “ stock price gdp puzzle” in an emerging market. jahfer and inoue: solving stock price-gross domestic product puzzle: evidence from sri lanka international journal of economics and financial issues | vol 7 • issue 5 • 2017466 the rest of paper is organized as follows: section 2 summaries the literature review. section 3 describes the data and methodology. section 4 presents empirical evidence of the study. section 5 concludes the research. 2. literature review there are number of empirical studies examining the relationship between financial market performances and macroeconomic factors and most of studies found that financial sector development contributes positively to economic growth. mookerjee and yu (1997) investigated the effect of macroeconomic variables on singapore stock market and found that stock prices are cointegrated with both measures of the money supply (m1 and m2) and aggregate foreign exchange reserves. but stock prices and exchange rates do not have a long-term relationship. ibrahim and aziz (2003) investigate the relationship between stock prices and industrial production, money supply, consumer price index, exchange rate in malaysia. stock prices are found a positive long-run relationships with industrial production and consumer price index. on the contrary, stock prices have a negative association with money supply and exchange rate. according to büyükşalvarcı, 2010; erdogan and ozlale, 2005, macroeconomic factors like inflation, industrial production, exchange rate, money supply, unemployment, risk premium, and rate of interest etc. have large influences on stock market operations. this is mainly because economic forces affect the discount rates, the ability of firms to generate cash flows and future dividend payments. arbitrage pricing theory introduced by ross (1976) suggest that an understanding of the macroeconomic context is essential for investors and policy makers in making effective investment decisions. liu and shrestha (2008) investigate the relationship between chinese stock market and a set of macroeconomic variables, i.e., money supply, industrial production, inflation, exchange rate and interest rate using heteroscedastic cointegration. and found stock performance is positively related to that of macro economy in the long term while inflation, exchange rate and interest rate have a negative relationship with the chinese stock market index. adam and tweneboah (2008) studied the impact of macroeconomic variables on stock prices in ghana using quarterly data from 1991 to 2007. they examined both the long-run and short-run dynamic relationships between the stock market index and the economic variables-inward foreign direct investment, treasury bill rate, consumer price index, average oil prices and exchange rates using cointegration test, vector error correction model (vecm). they found that there is a cointegration between macroeconomic variable and stock prices in ghana indicating long-run relationship. hasan and ahmad (2012) investigated the impact of macroeconomic factors on amman stock market returns of jordan employing monthly data from 1991 to 2010. they used six macroeconomic factors: real money supply, real gdp, consumer price index, real exchange rate, weighted average interest rates on loans and advances, and a dummy variable. they have applied normality test and unit root tests on the data. also, ols, arch/garch models are utilized. they show that real money supply, consumer price index, real exchange rate, weighted average interest rates and the dummy variable have a negative role on the on amman stock market returns and the real gdp has a positive impact. gunasekarage et al. (2004) examined the impacts of macroeconomic variables namely money supply, treasury bill rate (as a measure of interest rates), consumer price index (as a proxy for inflation) and exchange rate on stock market performance index using monthly data for the above variables. their results from estimating vecm model reveal that the rate of inflation, the money supply and the treasury bill rate have statically significant influence on the stock market index. guneratne (2011) analysed both short and long-run causal relationships between stock prices and macroeconomic variables for sri lanka. their results indicate that there are both short and long-run causal relationships between stock prices and macroeconomic variables. from the literature review, there are evidences that macro economic factors are negatively as well as positively associated with stock market performance based on economy. and also, less attention has been paid to study about the association between stock prices and gdp in emerging markets. however, we observed the existence of “stock price-gdp puzzle”. from our analyses in sri lanka. therefore, we are encouraged to solve “stock pricegdp puzzle” in the sri lankan market while identifying the macroeconomic factors influencing on stock market performances in the long run. 3. data and methodology 3.1. data quarterly time series data are used for the analyses during the period 1996 to 2014. ratanapakorn and sharma (2007), eita (2012), and kemboi and tarus (2012) also use quarterly data for examining the relationship between stock market performance macroeconomic factors. the data are collected from international financial statistics (ifs) published by the international monetary fund, colombo stock exchange (cse) data library 2015 and annual reports of central bank of sri lanka. all share price index (aspi) and market capitalization (msiz) are used to measure the stock market performance. the aspi indicates the price fluctuations of all the listed companies in the cse and covers all the traded companies during a market day. therefore, the best measure which reflects all the cse performance is the aspi and, it can be used to examine the effect on cse operations due to changes in selected variables of sri lankan economy. there are few literatures on msiz as a stock market performance indicator (e.g. levine and zervos [1998] used the stock msiz to gdp ratio as an indicator of market development). the assumption behind this measure is that overall market size is positively correlated with the ability to mobilize capital and diversify risk of an economy. macro economic factors such as gdp, money supply (m2), interest rate (interest), exchange rate (exr), inflation rate (inf) and balance of trade (bot) are used as independent variables. following common practice in the literature, economic growth is measured by the real gdp (constant 2005). money supply is one of the monetary policy tools which is measured by m2. maku and jahfer and inoue: solving stock price-gross domestic product puzzle: evidence from sri lanka international journal of economics and financial issues | vol 7 • issue 5 • 2017 467 atanda (2010) find that nse aspi is more responsive to changes in money supply. in the case of japan, the study shows that money supply is positively related to stock market. consistently, maysami and koh (2000) support the view of mukherjee and naka (1995) for both long run and short run dynamic interaction between money supply and stock returns for the case of singapore. the exchange rate is defined as domestic currency units (rs.) per unit of us dollar. adam and tweneboah (2008) find that the exchange rate demonstrates weak influence on price changes. in addition, ibbrahim (2000) suggest no long run relationship between stock market and exchange rate using three different exchange rates, in the case of malaysia. inflation is measured by consumer price index. marshall (1992) argued that the negative relationship between stock returns and inflation will be less pronounced during periods when inflation is generated primarily by monetary fluctuations, while mukherjee and naka (1995) and chen et al. (1986) show a negative relationship. interest rate is used for money market interest. liu and shrestha (2008) find negative impact on share prices. bulmash and trivoli (1991) also find a negative relationship between interest rate and stock prices for the usa. balance of trade is used as a proxy of the world wide business cycle or the business cycle of developed countries. table 1 provides the summary of descriptive statistics of the variables uses in this study. all the data except balance of trade are transferred to natural logarithms for conventional statistical reasons. figures 1-4 show the patterns of macroeconomic factors and indicators of stock market performance for the study period 1996-2014. it can be observed from the figures 1 and 2 that a significant development in the stock market performances after 20091. that is after the domestic war. there is also significant 1 the colombo stock exchange (cse) recorded a sharp growth in the first 9 months of 2014, with the all share price index (cseall) increasing by 22.6% to 7,252.1 points and the blue chip s&p sl 20 index growing by 23.7% to 4,038.3 points as of 30th september 2014. this continuous growth was on the back of 4.8% growth in cseall and 5.8% rise in the s&p sl 20 index during the year 2013. with this growth cse is continuing to be the best performing frontier market and also enjoys the pole position among all regional markets. while the fall in interest rates have helped to boost market activity many initiatives taken by the securities and exchange commission of sri lanka (sec) and the cse since 2013 were instrumental in increasing daily market liquidity. as of 26th september 2014 total market turnover surpassed the total annual turnover in 2013 of lkr 200.4 billion and was recorded at lkr 226.4 bn. foreign investor participation was at 29.7% while the balance was from local investors, which managed to increase the average daily turnover by 60% to lkr 1,322 million during the first nine months of the year. the initiatives taken by the sec and cse together with other market participants to organize overseas investor forums and attract foreign investors have no doubt contributed to the growth of the foreign investor contribution in 2014. further steps taken by the sec to increase market liquidity through introducing minimum public holding criteria for the listed companies has also positively affected the market performance. as of september 2014, a total of lkr 21.3 billion was raised through the capital market with lkr 13.9 billion raised as equity ipo’s, lkr. 2.7 billion as debt ipo’s and lkr 4.7 billion by way of rights issues. the proactive approach taken by the sec and other market intermediaries in further developing the capital market since 2013 has been validated by the market performance and the growth in ipo’s and rights issues witnessed thus far in 2014. improvement in the money supply and gdp after 2009. and also, we shall observe that there stock price of sri lanka was experienced a sharp fall after 2007 and then there is a sharp increase in the share price after 2009. this may be due to lehman shock2. figure 3 shows the trends of inflation rate, interest rate, treasury bill rate during the period 1996-2014 in sri lanka. it is clear from the figure that there is a significant decline of inflation rate, interest rate, treasury bill rate after 2009. it was the peak period in 2007 and 2008. figure 4 shows the trends of exchange rate between us$ and sri lanka rupees over the period 1996-2014 in sri lanka. exchange rate has been gradually increased from 1996. figure 5 shows the trend of export in sri lanka over the period 1996-2014. it shows a close relationship between stock prices and exports. figure 6 shows the balance of trade in sri lanka rupees over the period 1996-2014. it shows continuously increasing negative balance . 3.2. methodology at first, the co-integration tests were done among the variables using the johansen (1998) co-integration tests. since johansen co-integration is sensitive to the lag length, we used schwarz information criterion in the var to determine the appropriate number of lag. second, , we analyze the relationship using different methods in line with liu and shrestha (2008) methodology that is autoregressive conditional heteroskedasticity (arch) and ordinary least square (ols) method. since macroeconomic time series data contain unit root, variables used in the study are tested for stationary before analyses. for this purpose, unit roots are tested using augmented dickeyfuller (adf) (1979) test. after confirming that the variables are integrated of order one, then it is tested the existence of cointegration relationship between the variables. the following models are tested to examine the relationship between selected macro economic variables and stock market performance. model 1 aspi = β0 + β1 gdpt + β2 inft+ β3 m2t + β4 exrt + β5 irt+ ut 2 lehman shock refers to the shock 2008 filing of bankruptcy in of lehman brothers, one of the us and the world’s largest financial services firm. in the us alone, lehman’s bankruptcy was considered the biggest in financial history with assets of the organization reported to be around 600 billion us dollars. it was in september 25, 2008 when lehman brothers finally succumbed to the ongoing mortgage crisis in the us and eventually ended its reign as one of the world’s largest and soundest financial firm. this particular event in history eventually became known as lehman shock because it really shocked not only the us but also the whole world because it is such a large firm and not many people saw it’s fall to actually happen back in 2008. jahfer and inoue: solving stock price-gross domestic product puzzle: evidence from sri lanka international journal of economics and financial issues | vol 7 • issue 5 • 2017468 model 2 msiz = β0 + β1 gdpt + β2 inft+ β3 m2t + β4 exrt + β5 irt+ ut when tested the above two models, it was realized the existence of “stock price-gdp puzzle”. then to solve “stock price-gdp puzzle”, we estimated the following models models 3 and 4. model 3 aspi = β0 + β1 gdpt + β2 inft + β3 m2t + β4 exrt + β5 irt+ β6 bott+ ut model 4 msiz = β0 + β1 gdpt + β2 inft + β3 m2t + β4 exrt + β5 irt+ β6 bott+ ut where, aspi is all share price ındex; msiz is stock market capitalization; gdp is real gdp; inf is ınflation rate; m2 is money supply; exr is exchange rate; ir is ınterest rate; bot is the balance of trade and ut is error term of regression. further, if cointegration detected between variables, then it is known that there exists a long term equilibrium relationship between them, then we use standard generalized autoregressive conditional heteroskedasticity (garch) model as follows. table 1: descriptive statistics aspi msiz exr gdp inf m2 bot interest mean 3.2148 5.6354 1.9752 5.7827 0.9016 5.9681 −101916 0.9237 median 3.2143 5.6891 2.0077 5.7036 0.9415 5.9616 −66540 0.9583 maximum 3.8605 6.4866 2.1212 6.3976 1.4238 6.5207 9621 1.0923 minimum 2.6059 4.9054 1.7337 5.1954 0.0205 5.4350 −330600 0.6848 standard deviation 0.4122 0.5324 0.1113 0.3670 0.2745 0.3348 96727 0.1133 observations 75 75 75 75 75 75 75 75 aspi: all share price index, msiz: market capitalization, gdp: gross domestic product, m2-money supply; interest: interest rate, exr: exchange rate, inf: inflation rate, bot: balance of trade 1,000.0 2,000.0 3,000.0 4,000.0 5,000.0 6,000.0 7,000.0 8,000.0 19 96 -q 1 19 96 -q 4 19 97 -q 3 19 98 -q 2 19 99 -q 1 19 99 -q 4 20 00 -q 3 20 01 -q 2 20 02 -q 1 20 02 -q 4 20 03 -q 3 20 04 -q 2 20 05 -q 1 20 05 -q 4 20 06 -q 3 20 07 -q 2 20 08 -q 1 20 08 -q 4 20 09 -q 3 20 10 -q 2 20 11 -q 1 20 11 -q 4 20 12 -q 3 20 13 -q 2 20 14 -q 1 20 14 -q 4 aspi figure 1: all share price ındex 500,000.0 1,000,000.0 1,500,000.0 2,000,000.0 2,500,000.0 3,000,000.0 3,500,000.0 4,000,000.0 19 96 -q 1 19 97 -q 1 19 98 -q 1 19 99 -q 1 20 00 -q 1 20 01 -q 1 20 02 -q 1 20 03 -q 1 20 04 -q 1 20 05 -q 1 20 06 -q 1 20 07 -q 1 20 08 -q 1 20 09 -q 1 20 10 -q 1 20 11 -q 1 20 12 -q 1 20 13 -q 1 20 14 -q 1 market size( rs. mn) gdp (rs mn) money supply (rs.mn) figure 2: market capitalization, gross domestic product and money supply jahfer and inoue: solving stock price-gross domestic product puzzle: evidence from sri lanka international journal of economics and financial issues | vol 7 • issue 5 • 2017 469 5.0 10.0 15.0 20.0 25.0 30.0 19 96 -q 1 19 97 -q 1 19 98 -q 1 19 99 -q 1 20 00 -q 1 20 01 -q 1 20 02 -q 1 20 03 -q 1 20 04 -q 1 20 05 -q 1 20 06 -q 1 20 07 -q 1 20 08 -q 1 20 09 -q 1 20 10 -q 1 20 11 -q 1 20 12 -q 1 20 13 -q 1 20 14 -q 1 inflation rate interesrt rate(%) figure 3: inflation rate, ınterest rate 20.0 40.0 60.0 80.0 100.0 120.0 140.0 19 96 -q 1 19 97 -q 1 19 98 -q 1 19 99 -q 1 20 00 -q 1 20 01 -q 1 20 02 -q 1 20 03 -q 1 20 04 -q 1 20 05 -q 1 20 06 -q 1 20 07 -q 1 20 08 -q 1 20 09 -q 1 20 10 -q 1 20 11 -q 1 20 12 -q 1 20 13 -q 1 20 14 -q 1 exchange rate(1 us doller=rupees) figure 4: exchange rate figure 5: exports yt=α0 + α1x1t + + αkxkt+ εt, εt/ωt1n(o,ht), ht=w0+w1ht1+w2ε 2 t1 the autoregressive conditional heteroskedasticity (arch) model, introduced by engle (1982) has now become widely used in modeling the behavior of financial time series. one of the main advantages of arch models is its ability to capture the nonlinearity and volatility clustering in stock return data. this model was later extended by engle and bollerslev (1986) to the generalized autoregressive conditional heteroskedasticity (garch) model which incorporates the lagged values of jahfer and inoue: solving stock price-gross domestic product puzzle: evidence from sri lanka international journal of economics and financial issues | vol 7 • issue 5 • 2017470 conditional variance and therefore is able to capture the leptokurtosis, skewness, and volatility clustering in the time series data. the garch methodology also takes into account past variances in explaining future variances, and therefore when the data suffers from heteroscedasticity, the expected value of the error term is not constant. furthermore, all arch/garch models explain the importance of the degree of persistence of shocks to volatility in returns and macroeconomic variables. these models are also useful in examining the simultaneous interaction among stock market returns and variation in macroeconomic factors. 4. empi̇ri̇cal results 4.1. unit root test to check the stationarity of the variables, the adf test was employed. the test is conducted with intercept only and intercept and trend respectively on the level and first differences of the variables. it finds all variables are stationary on first differencing. the results of adf test are shown in table 2. 4.2. cointegration tests having confirmed that all variable are integrated of order (1), the cointegration tests were done among the variables using the johansen’s cointegration tests to investigate long-term equilibrium relationship among the variables. number of lags is selected using an optimal lag structure in the unrestricted var. johansen’s approach derives two likelihood estimators for the cointegration rank: a trace test and a maximum eigen value test. table 3 presents summarized cointegration results estimated using eviews software. cointegration results indicate the existence of long-run association between stock market performance and macro economic factors in sri lanka. 4.3. ordinary last square results table 4 reports the results under ols. r-squared value of this models are 95.52% and 97.02% respectively which are higher than 80%. it indicates the models are fitted nicely or data is fitted nicely. all macro economic variables are significant to explain both indicator of stock market performances. money supply and inflation are significantly positively associated with aspi and msiz while exchange rate, gdp and interest rate are significantly negatively associated. lagrange multiplier (lm) test for both aspi and msiz are highly significant. this indicates the presence of heteroscedastic in the long run cointegrating regression and it was estimated accordingly. 4.4. autoregressive conditional heteroskedasticity (garch) e s t i m a t e d r e s u l t s o f t h e a u t o r e g r e s s i v e c o n d i t i o n a l heteroskedasticity (garch) between stock market indicators and macroeconomic factors are presented in table 5. the unit root tests on the standardized residuals are highly significant for both indicators of stock market performances which indicates heteroscedastic relationship to be stationary. the results using heteroscedastic shows similar results like ols model. we could not find any different results from ols model. accordingly, money supply and inflation are positively related with stock market performances while the gdp, exchange rate and interest rate are negatively related to the stock market performances. the above analyses show a negative relationship between gdp and stock prices which doesn’t seems plausible in the long-run even though there are some preceding researches with negative coefficients of gdp. the reason for the negative coefficient of gdp may be the stock prices were affected by lehman shock . but it is surprising that gdp was not affected much.. at the same time, when we look at the relationship between stock price and export, it seems that stock prices and export are closely related. it is clear from regression results and the figures 3 and 5. it shows the existence of “stock price-gdp puzzle” in sri lanka. further, we regressed between stock market indicators and macro economic factors including export for the period 1996 to 2014 and -350000 -300000 -250000 -200000 -150000 -100000 -50000 0 50000 19 96 -q 1 19 96 -q 4 19 97 -q 3 19 98 -q 2 19 99 -q 1 19 99 -q 4 20 00 -q 3 20 01 -q 2 20 02 -q 1 20 02 -q 4 20 03 -q 3 20 04 -q 2 20 05 -q 1 20 05 -q 4 20 06 -q 3 20 07 -q 2 20 08 -q 1 20 08 -q 4 20 09 -q 3 20 10 -q 2 20 11 -q 1 20 11 -q 4 20 12 -q 3 20 13 -q 2 20 14 -q 1 20 14 -q 4 trade balance figure 6: balance of trade jahfer and inoue: solving stock price-gross domestic product puzzle: evidence from sri lanka international journal of economics and financial issues | vol 7 • issue 5 • 2017 471 before lehman shock that is from 1996 to 2008 and the results are presented in table 6. table indicates we can point out that the coefficients of gdp with export are positive and sometimes significant at 10% level. the coefficients of gdp before lehman are positive and sometimes significant. we solve the “stock price-gdp puzzle” by adding balance of trade as given in the models 3 and 4. the reason for adding the balance of trade is balance of trade or export is working as the proxy of the world wide business cycle or the business cycle of developed countries or big countries. the economy or the stock price are affected by the world wide business cycle. for the small economy or developing country in the early stage, the influence of the world economy may be large and independent from the domestic macro-economic variables. table 7 presents the estimated results with balance of trade. the unit root tests on the standardized residuals are highly significant for both indicators of stock market performances which indicates heteroscedastic relationship to be stationary. the results using heteroscedastic shows that gdp, money supply, balance of trade and inflation are positively related with stock market performances but exchange rate and interest rate are negatively related to the stock market performances. so, when we introduce the balance table 2: augmented dickey-fuller (adf) unit root test results variables level first difference number of observations (after adjustments) test with intercept test with trend and intercept lag length test with intercept test with trend and intercept lag length aspi −0.0960 −2.498 0 −8.159* −8.133* 0 74 msiz 0.055 −2.285 0 −8.182* −8.149* 0 74 gdp 0.331 −2.291 4 −3.608* −3.549** 3 74 inf −2.798 −2.969 0 −7.625* −7.580* 0 74 m2 0.039 −2.948 0 −8.456* −8.392* 1 73 exr −2.314 −2.135 2 −5.419* −5.783* 1 73 ir −2.927 −3.072 1 −3.320** −3.284** 0 74 bot −0.2209 −3.125 1 −11.345* −11.394* 0 74 *,**indicates significance at the 1%, and 5% level respectively. critical values with intercept and trend and intercept are for all tests are −3.522, −2.901, and −4.087, −3.472 at the 1%, and 5% levels of significance in that order. number of lags is selected automatic based schwarz information criterion (sic) table 3: johansen co-integration test results hypothesized no. of ce (s) trace test maximum eigenvalue test test statistic critical value 5% p** test statistic critical value 5% p** (i) aspi exr gdp inf ir m2 none* 144.8310 95.75366 0.000 50.40190 40.07757 0.002 at most 1* 94.42909 69.81889 0.000 40.82369 33.87687 0.006 at most 2* 53.60541 47.85613 0.013 26.27494 27.58434 0.072 at most 3 27.33046 29.79707 0.093 17.26346 21.13162 0.159 at most 4 10.06700 15.49471 0.275 9.461107 14.26460 0.249 at most 5 0.605892 3.841466 0.436 0.605892 3.841466 0.436 (ii) msiz exr gdp inf ir m2 none* 123.7690 95.75366 0.0002 48.64310 40.07757 0.004 at most 1* 75.12591 69.81889 0.0177 27.85222 33.87687 0.220 at most 2 47.27368 47.85613 0.0566 20.20768 27.58434 0.327 at most 3 27.06600 29.79707 0.1000 12.93907 21.13162 0.457 at most 4 14.12693 15.49471 0.0795 10.48758 14.26460 0.181 at most 5 3.639352 3.84146 0.0564 3.639352 3.841466 0.056 (iii) aspi exr gdp inf ir m2 bot none* 217.240 125.615 0.000 107.244 46.231 0.000 at most 1* 109.996 95.753 0.003 46.825 40.077 0.007 at most 2 63.170 69.818 0.151 25.659 33.877 0.341 at most 3 37.511 47.856 0.323 20.356 27.584 0.317 at most 4 17.154 29.797 0.628 7.870 21.131 0.911 at most 5 9.283 15.494 0.339 5.838 14.264 0.634 at most 6 3.445 3.841 0.063 3.445 3.841 0.063 (iv) msiz exr gdp inf ir m2 bot none* 217.000 125.615 0.000 111.335 46.231 0.000 at most 1* 105.665 95.753 0.008 41.721 40.077 0.032 at most 2 63.943 69.818 0.134 25.359 33.876 0.361 at most 3 38.583 47.856 0.277 20.146 27.584 0.331 at most 4 18.437 29.797 0.533 8.568 21.131 0.865 at most 5 9.868 15.494 0.291 6.524 14.264 0.546 at most 6 3.343 3.841 0.067 3.343 3.841 0.067 *denotes rejection of the hypothesis at the 0.05 level, **mackinnon-haug-michelis (1999) p values jahfer and inoue: solving stock price-gross domestic product puzzle: evidence from sri lanka international journal of economics and financial issues | vol 7 • issue 5 • 2017472 of trade in the model, the results are dramatically changed. that is gdp become positive association with stock prices. in addition, there is a structural change of stock price because the coefficients of gdp before lehman were positive and weakly table 4: ols results dependent variable aspi msiz variable coefficient t-statistic coefficient t-statistic c −3.67436 −7.706** −3.64119 −7.088** exr −2.62981 −7.817** −2.73725 −7.552** gdp −1.02772 −2.302** −1.16496 −2.423* inf 0.16100 3.460** 0.16511 3.294** m2 3.06739 5.392** 3.62810 5.919** ir −0.40198 −3.561** −0.36108 −2.969** r2 0.9572 0.9702 adjusted r2 0.9541 0.9681 breusch-godfrey serial correlation lm test 30.9774 30.9774 p-value 0.0000 0.0000 * and **denote the significance level at 5% and 1% level, respectively. aspi: all share price index, msiz: stock market capitalization, gdp: real gross domestic product, inf: inflation rate; m2: money supply, exr: exchange rate, ir: interest rate table 5: autoregressive conditional heteroskedasticity (garch) results dependent variable aspi msiz variable coefficient z-statistic coefficient z-statistic c −3.665354 −10.387** −3.088932 −5.824** exr −2.650003 −8.558** −2.741962 −7.702** gdp −1.027689 −3.208** −0.946212 −2.133* inf 0.147640 3.647** 0.138749 2.752** m2 3.065976 7.494** 3.352670 5.952** ir −0.346270 −16.663** −0.499760 −3.610** r2 0.9565 0.9685 adjusted r2 0.9512 0.9647 variance equation c 0.000238 0.413585 0.005586 1.603808 resid(-1)^2 −0.112841 −1.217509 0.404808 1.187925 garch(-1) 1.089772 7.907737 −0.048862 −0.116747 unit root −14.1809 p-value 0.0000 −14.4704 0.0000 * and **denote the significance level at 5% and 1% level, respectively. aspi: all share price index, msiz: stock market capitalization, gdp: real gross domestic product, inf:inflation rate; m2: money supply, exr: exchange rate, ir: interest rate table 6: autoregressive conditional heteroskedasticity (garch) results with export dependent variable 1996-2014 1996-2008 aspi msiz aspi msiz variable coefficient z-statistic coefficient z-statistic coefficient z-statistic coefficient z-statistic c −2.705 −13.262 −2.039 −11.112 −4.056 −20.100 −2.719 −5.217 exr −2.724 −24.508 −2.679 −15.368 −3.000 −17.888 −3.411 −9.126 gdp 0.166 3.808 0.316 6.636 0.136 1.798 0.211 0.972 inf 0.087 3.527 0.113 4.934 0.104 5.303 0.114 2.404 m2 2.070 18.986 2.575 31.318 2.355 31.906 2.864 11.322 ir −0.635 −13.052 −0.707 −13.331 −0.692 −15.111 −0.785 −5.958 exp −0.103 −0.667 −0.356 −3.640 −0.054 -0.489 −0.261 0.911 r2 0.96 0.98 0.87 0.95 adjusted r2 0.95 0.97 0.85 0.94 variance equation c 0.0073 4.881 0.0089 4.327 0.000 2.327 0.007 2.148 resid(−1)^2 0.4987 5.673 0.4080 4.550 1.275 5.320 0.554 1.682 garch(−1) −0.6247 −5.561 −0.697 −4.986 −0.025 −0.322 −0.617 −1.768 unit root −13.382 −13.53 −7.566 −8.386 p-value 0.000 0.000 0.000 0.000 * and **denote the significance level at 5% and 1% level, respectively. aspi: all share price index; msiz: stock market capitalization; gdp: real gross domestic product; inf: inflation rate; m2: money supply; exr: exchange rate; ir: interest rate; exp: export jahfer and inoue: solving stock price-gross domestic product puzzle: evidence from sri lanka international journal of economics and financial issues | vol 7 • issue 5 • 2017 473 significant without balance of trade. it may suggest that stock prices have come to depend more on balance of trade or export. this study contributes to the literature on the relationship between stock market performances and macro economic factors while “solving the stock price-gdp puzzle” using heteroskedastcity cointergration on an emerging economy sri lanka. 5. conclusi̇on the objective of this paper is to identify the macroeconomic factors influencing on stock market performances in the long run solve “stock price-gdp puzzle” using quarterly data of economic variables for the period 1996 to 2014 in the sri lankan market. the data are collected from ifs published by the international monetary fund, cse data library 2015 and annual reports of central bank of sri lanka. aspi and msiz are used to measure the stock market performance. the stationary of the data are tested using adf test. it was found that all variables are stationary on first differencing. the relationships between macro economic variables and indicators of stock market performance are investigated using johansen co-integration tests, and autoregressive conditional heteroskedasticity cointegration. cointegration results indicate the existence of long-run relationship between macro economic factors namely; gdp, money supply, interest rate, exchange rate, inflation rate balance of trade and stock market performance indicators such as aspi and msiz in the sri lankan market. analyses show that money supply and inflation are positively related with stock market performances and exchange rate, gdp and interest rate are negatively related to the stock market performances. and it was realized the existence of “stock price gdp puzzle” in sri lanka. this was solved by addition the balance of trade in the model where it finds positive association between gdp and stock price indicator. this study contributes to the literature on the relationship between stock market performances and macro economic factors while solving “stock price-gdp puzzle” using heteroskedastcity cointergration in an emerging economy sri lanka. references adam, a.m., tweneboah, g. 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(2007), macroeconomic variables and stock return in malaysia: an application of ardl bound testing approach. saving and investment, 31(4), 449-469. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(5), 92-101. international journal of economics and financial issues | vol 10 • issue 5 • 202092 the impact of credit ratings on firms’ capital structure rana abdelhafeez feda* department of finance, college of business administration, prince sultan university, riyadh, saudi arabia. *email: rfeda@psu.edu.sa received: 22 june 2020 accepted: 24 august 2020 doi: https://doi.org/10.32479/ijefi.10436 abstract in today’s financial markets, credit ratings play a significant role on the creditworthiness of firms as it represents the ability of a firm paying back debt and firm’s risk of default. the purpose of this study is to empirically evaluate the impact of credit ratings on firms leverage decisions. this paper examines firms leverage behavior with the discrete benefits of higher credit rating hypothesis presented by kisgen (2009). the empirical tests were designed based on the partial adjustment model by flannery and rangan (2006). firms that have faced a downgrade are more likely to reduce their financial leverage by reducing debts and issuing equity, with conscious of the costs of doing so. while firms that been upgraded from speculative grade to investment grade do little changes in their capital structure to maintain the discrete benefits attributable to higher credit ratings. the results of this paper are persisted with cr-cs hypothesis. keywords: financial markets, credit, debt management, firm performance, capital investment jel classifications: d53, e51, h63, l25, o16 1. introduction today, investors, financial managers, speculators and regulatory authorities largely depend on a firm’s credit ratings when making their financing and investment decisions. therefore, a company’s decision on its capital structure (cs) becomes one of its major financial decisions and one in which managers must devote substantial attention. there are a number of studies evaluate the factors that affect the capital structure decisions. the main two factors in the traditional studies are: a. external factors which reflect macroeconomic conditions such as inflation rate and interest rate. b. internal factors which are firm-specific such as company size, profitability, liquidity, non-debt tax shield and asset tangibility (serghiescu and vaidean, 2014; bandyopadhyay and barua, 2016). as explained by baghai et al. (2014), an entity’s cs entails the equity and debt combination, used to fund their projects or assets. a capital structure that is ideal comprises a superlative proportion of equity and debt of an entity, which arguments its value. designing such structure is, therefore, a critical role of every firm’s corporate fund unit especially in the current era of globalization, outside variables such as macroeconomic elements and credit ratings (crs) are major forces influencing the speculation and financing decisions of firms globally. according to manso (2013), the economy is recuperating gradually across regions and companies are considering refinancing risk via raising cash flows aimed at maintaining a strategic distance from future emergencies and, to expand valuations in securities exchange. comprehensively, these aspects of a firm have elevated the role of credit rating agencies in determining a firms’ financial constraints. 1.1. standard and poor’s credit rating definitions this table shows the classification of standard and poor’s long term issue credit ratings and its definition. aaa represents the highest (best) rating, while d refers to the lowest (worse) rating. some broad ratings (e.g. aa) have notches (+/non/−) that further divide the grade into subcategories to refer to the relative position within each category (standard and poor’s financial services llc, 2017). this journal is licensed under a creative commons attribution 4.0 international license feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 2020 93 classification rating definition investment grade aaa extremely strong capacity to meet its financial commitment aa (+/non/−) very strong capacity to meet its financial commitment a (+/non/−) strong capacity to meet its financial commitment bbb (+/non/−) adequate capacity to meet its financial commitment speculativegrade bb (+/non/−) less vulnerable to non-payment than other speculative issues major ongoing uncertainties b (+/non/−) adverse business, financial or economic conditions will likely impair the capacity or willingness to meet its financial commitment ccc (+/non/−) vulnerable to non-payment and dependent upon favourable business financial or economic conditions to meet its financial commitment cc, c currently highly vulnerable to non-payment c currently highly vulnerable to non-payment with lower recovery d in default or in breach of an imputed promise nr no rating has been requested, insufficient information for rating or s&p does not rate the particular obligation *source: standard and poor’s financial services llc (2017) is there a relationship between a firm’s credit ratings and its capital structure? do credit ratings determine the capital structure of a company? does the decision of a firm finance a project using debt or equity change due to its credit ratings? in this paper, we aim to shed light on these questions by determining whether there is a correlation between an entity’s capital structure and credit ratings. the findings of the study would help financial managers in understanding how changes in credit ratings impact on a firm’s costs of obtaining external financing and what are the necessary measures to implement to avoid low ratings and maintain high credit ratings to remain better positioned to acquire funding. the rest of the paper is organized as follows. section ii, discusses the related literature and prior work. section iii, explains the methodology, empirical design, and regression model specification used in this paper. section iv, describes the data and summary statistics, and section v contains main results and analysis. section vi concludes. 2. literature review credit ratings offer a general evaluation of firms’ creditworthiness and rank firms according to the possibility that they will not pay the debt back (rogers et al., 2016). a credit rating agency has access to different kinds of information like a firm’s dividend policy, capital expenditure an 64 business plan which is not given to investors. this information, comprehensively, assist the agencies in determining the financial constraints of a firm. as stated by baghai et al. (2014) credit ratings can solely influence a firm’s access to external funding, higher credit ratings are needed for various financial structures, for instance, commercial papers. the costs associated with external funding decreases extensively with the rise in credit ratings as a result of the exponential distribution of default probability relative to various categories of ratings. as such, credit rating is a critical aspect of a firm that must be taken into account while developing an optimal capital structure; baghai et al. (2014). while de jong et al. (2008) state that researchers have developed different models that aid in understanding a firm’s capital structure, including the trade-off theory (tot) and the pecking order theory (pot), as the most common. 2.1. the trade-off theory the tot (developed in 1973 by kraus and lichtenberger) posits that firms will seek to achieve an optimal leverage level or debt ratio. according to de jong et al. (2008), a company’s capital structure decisions are influenced by the trade-off theory. this is accomplished through balancing benefits and costs of debt financing. in addition, for an entity to obtain a capital structure that is optimal and one which maximizes its market value, it should have a debt level that balances the value of interest tax shields against the diverse costs of financial distress and bankruptcy. according to the theory, companies are partly financed through debt and equity. in light of this assertion, chang and dasgupta (2009) argue that firms seeking to maximize value tend to change their leverage to achieve the desired debt ratio systematically. as such, if the debt-level is adjusted lower than optimal level, an entity tends to issue more debt, however, when the debt-level is adjusted above the optimal level, a firm will issue more equity, hence impacting on the capital structure. 2.2. pecking oder theory on the contrary, the pecking order theory, in its simplest form, posits that financing needs that cannot be accomplished through internal funding should be sourced from external capital markets; de jong et al. (2008). more importantly, entities avoid issuing equity because of the related higher costs arising from information asymmetry. manso (2013) presented a review of kisgen (2006) cr-cs hypothesis which tested the implications of crs on capital structure decisions while integrating relating measures into the existing framework of trade-off theory and pecking order theory tests. the tests revealed that crs of a firm are material considerations in finance manager’s decision on a firm’s capital structure as a result of the discrete costs (benefits) relating to various levels of rating. kisgen (2009) termed this as the (cr-cs) hypothesis, which shows that entities close to a cr downgrade consider issuing less net debt relative to net equity. alternatively, a firm that is near a cr upgrade tends to take advantage of the upgrade through incurring lower costs of external capital (financing through debt), as they are better positioned for external financing (manso, 2013). sajjad and zakaria (2018) added to the literature stating that credit ratings are perceived as a proxy for the likelihood of defaults by firms. as such, credit ratings are relied on by individual and institutional investors when valuing a firm’s financial instruments, feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 202094 and accordingly allow the appropriate yield on the instruments with regard to the firm’s default risk level. crs downgrade (or upgrade) over a specific financial instrument, like the corporate bond, may add (or destroy) the asset’s value. as such, entities anticipating changes in their credit ratings consider issuing equity as opposed to bonds (debt) to prevent additional costs resulting from low-rating or later capitalization due to an upgrade. kisgen and strahan (2010) drew a concurrence with sajjad and zakaria (2018) by stating that a firm’s credit ratings impact on investors’ motivation to lend because crs often encompass non-public information given by entities to the credit rating agencies. kisgen and strahan (2010) asserted that such evidence influences investors’ decision to fund a company and equally affect the capital structure. moreover, in today’s financial markets, credit ratings enlighten market participants on the creditworthiness of firms. the credit rating agency create its own methodology that contain a mix of quantitative and qualitative tools and analysis them to be able to give proper rating (frost, 2007). the fitch ratings (fitch), standard& poor’s rating services as well as the moody’s investors services (moody’s) are the three most common credit rating agencies (cras) shaping today’s financial markets. according to baghai et al. (2014), such agencies base their credit ratings on the available qualitative and quantitative data about a company’s financial condition and use them to rate the creditworthiness of firms on an ordinal scale. beck et al. (2008) conducted a survey on the implication of crs on the capital structure of european firms, in their study they detailed that chief financial officers (cfos) of privately held and listed firms take into consideration the credit ratings of the firms while undertaking financial decisions, more so for debtbased financing decisions. similarly, individual investors use credit ratings to determine firm’s financial health. as such, highly rated firm’s benefit from positive market reputation and are better positioned to obtain less costly debt. conversely, low rated firms are perceived to have high default risks and thus experience high costs associated with raising external capital, minimal access to external funding as well as a negative corporate image to external investors. on the other hand, chen (2010) argue that a credit rating upgrade may not impact on subsequent managers’ decisions on the capital structure of their firm. in other words, cr upgrade enables a firm to easily access external funding coupled with minimal costs of capital but managers are forced to maintain desirable crs hence may not issue more debt regardless of the benefits. nonetheless, managers’ decisions on the capital structure may be affected asymmetrically by the preceding year’s changes in rating. an already existing downgrade gives external investors a negative signal and leads to adverse outcomes such as limited access to external funding and high costs of capital. following this, an entity tends to correct the downgrade to achieve higher raking to take advantage of external funding and the associated lower rates of interest by reducing their debt levels. conversely, the capital structure of an already upgraded firm may not require any adjustment in the following year since it may not gain from a possible downgrade. while testing the effect of changes in crs on an entity’s capital structure; de jong et al. (2008) detailed that a cr downgrade leads to a lower ratio of net debt relative to net equity issuances. conversely, a cr upgrade does not lead to a change in management’s decision on capital structure. notably, firm’s target minimal rating. in contrast, when a cr upgrades results to the material effect on management’s decision on capital structure (either increasing or decreasing leverage) a more proactive adjustment of the entity’s capital structure is required while measuring financial distress is of paramount importance. by incorporating the resultant rating levels, this study further analyzes any variation existing between a credit rating change that amounts to an investment grade rating level (ranging aaa to bbb-) or a speculative level of grade rating (ranging bb+ to ccc/c.) roberts and sufi, (2009) explain that an investment graded entity is better positioned to access external funds that have low rates of interests and reveal greater business development. furthermore, downgraded entities and whose resultant credit rating is speculative grade reveal the most distinctive patterns of adjustment in their capital structures. conversely, upgraded entities with investment grade are anticipated to demonstrate no subsequent adjustments in their capital structures, unless the entities target a minimum rating besides ratings being directly linked to concerns on financial distress. another set of studies examines does the decision of a firm to finance a project using debt or equity change due to the firm’s credit ratings. kisgen (2009) conducted a study on a firms’ leverage behavior following changes in their credit ratings. the study revealed that when firm managers are concerned with maintaining attractive credit ratings, they tend to change their capital structure to obtain upgrades and avoid downgrades and also lower leverage in case of downgrades. the study shows that companies respond asymmetrically to such rating changes, minimizing leverage following a downgrade but with little response upon an upgrade. as such, the decision of a firm to finance a project using debt or equity may change relative to changes in its credit ratings particularly when managers target achieving a specific minimum level of credit ratings. moreover, manso (2013) separately tested the probability of debt reductions, debt issuances, equity reductions and equity issuances for both upgraded and downgraded firms, in a case where decisions on capital structure reflected an aggregate measure. different implications were experienced for cr down and upgrades. when an entity targets a minimum rating, it tends to respond to a downgrade via undertaking financing decisions that foster an upgrade in the following years. precisely, a downgraded firm is likely to minimize debt, and less likely to use debt as well as reduce equity and is highly likely to use equity capital. further, under the assumption that changes in ratings are not associated with changes in the financial distress concerns, then a cr upgrade should not materially impact on the financing choices. in other words, the probability for changing their capital structure via external funding is zero since upgraded companies will avoid reversing the upgrade. on the other hand, if an upgrade affects the subsequent changes of an entity’s capital structure, it’s anticipated that the upgraded firm becomes more proactive and is less likely to minimize debt, has high chances of using debt, less likely to use equity capital and is highly likely to reduce equity. feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 2020 95 3. methodology 3.1. empirical design the research design was formulated to investigate the effect of credit rating changes on capital structure and related decisions using the empirical frameworks of the partial adjustment model done by flannery and rangan (2006). the study aims to test the following hypothesis, to determine whether there is empirical evidence that supports the formulated hypothesis or not. • h0: credit ratings do not determine a firm’s capital structure • h1: credit ratings determines a firm’s capital structure. this paper will also test the context of discrete benefits of higher credit rating hypothesis, a firm can exhibit a leverage behavior in four ways as presented by kisgen (2009). (1) downgraded firms have higher likelihood of reducing their financial leverage compared with other firms which have not encountered a downgrade in their credit ratings. (2) even after the control for changes in leverage behavior and other characteristics measuring distress of the firm, an upgrade in credit rating would not substantially lead to subsequent behavioral change in capital structure. (3) another implication is that downgrade of the credit ratings at which discrete costs are higher would lead to a higher possibility of leverage on capital market decisions. lastly, (4) firms that faced a downgraded in their credit ratings try to adjust the balance between their debt and equity levels until it reaches the target financial leverage level. 3.2. regression model specification the empirical framework of capital structure – the partial adjustment model – as it is being formulated in flannery and rangan (2006) helps in determining whether the target financial leverage levels of a firm is reached. these empirical tests used some notations that can be defined as follows: mdri,t firm’s target market debt ratio at time t that can be expressed as the book value of debt divided by the book value of debt plus the market capitalization of equity. xi,t firm characteristics vector (profitability, size, fixed assets, depreciation, r&d and m/b). λ speed of adjustment to the desired leverage levels (fast adjustment then λ equal to 1). downgradei,t dummy variable (rating fell in previous year then downgradei,t equal 1). upgradei,t dummy variable (rating raised in previous year then upgradei,t equal 1). netdissi,t (net debt issuance – net equity issuance) ÷ assets ki,t variables that show firm financial condition. in this model, the target leverage can be correlated linearly through a combination of different factors affecting capital structure as shown in equation (1). when constructing the partial adjustment model, it is significant to incorporate the possibility of the firm to adjust towards the target financial leverage, and this proposition is presented by equation (2). then by substituting (1) into (2) we will get equation (3). equation (3) below shows that the smaller the gap between firms’ actual debt ratio and firm’s target market debt ratio the better. mdr xi t i t, * ,� �1 � (1) ( ) * , 1 , , 1 , , 1 λ ε+ + +− = − +i t i t i t i t i tmdr mdr mdr mdr (2) , 1 , , , , 1 λ β λ ε+ +− = − +i t i t i t i t i tmdr mdr x mdr (3) moreover, equation (4) can be used to test the credit ratingcapital structure (cr-cs) hypothesis. upgrade or downgrade can be referred to as dummy variables that sum up to a value of 1 and are used to evaluate whether the firm was upgraded or downgraded in the previous year. since the data to be used in this empirical study is within the last 10 years, there is a higher likelihood of having lagged changes in the s&p’s credit rating of companies, but these changes would be significant in reducing the possibility of endogeneity issues in the time-series data. the implication of the discrete benefit of higher credit ratings presented in equation (4) is that the coefficient on is φ1 < 0 and this means that a downgrade compels a firm to reduce its financial leverage. additionally, cr-cs indicates that if a firm faced an upgrade, the speed of adjustment will remain the same and therefore, the coefficient φ2 = 0. , 1 , , , 1 , 2 , , 1 λ β λ ε + + − = − +φ + φ + i t i t i t i t i t i t i t mdr mdr x mdr downgrade upgrade (4) kisgen (2009) state that in equation (5) cr-cs implies λ1 is a positive number while λ2 is not significant. that means the adjustment speed will be affected only with firms’ downgrade, and will stay stable with an upgrade. an upgrade attracts little management’s interest in changing the financial leverage since they do not want to reverse the discrete benefits attributable to a higher credit rating and therefore, the speed of adjustment λ2 remains unaffected. ( ), 1 , 0 1 , 2 , * , 1 , , 1 ( ) λ λ λ ε + + + − = + + × − + i t i t i t i t i t i t i t mdr mdr downgrade upgrade mdr mdr (5) equation (6) can be developed in such a way that debt issuance in the bid to adjust towards achieving the desired level of leverage following changes in credit ratings. netdiss is used to measure the leverage-changing behavior of a firm at a given time t and it is defined as the net debt issuance of a firm minus net equity issuance and the result divided by the firm’s assets. the variables in k are sales, ebitda, m/b, and z-score. , 1 , 1 2 , 1 , 1 , 1 α β ε − − − + = + φ +φ + + i t i t i t i t i t netdiss downgrade upgrade k (6) in this study, a likert scale is proposed because it would transfer the qualitative value of credit rating to a corresponding quantitative value, based on the laid down procedure. there are 18 levels of credit ratings that were used in this study: aa+, aa, aa−, a+, a, a−, bbb+, bbb, bbb−, bb+, bb, bb−, b+, b, b−, ccc+, ccc, and ccc−. credit rating of “1” in likert scale represents an extremely low rate (ccc−), while “18” represents highest credit rating (aa+). feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 202096 4. data and summary statistics our focus is to study the correlation between credit ratings and firms’ capital structure from the beginning of 2008 to the end of 2017. the credit ratings used in this paper is standard and poor’s credit ratings at the beginning of a particular year. these ratings will show firm’s capability to pay its financial obligations in a 12 months period. the dataset is constructed of new york stock exchange (nyse) firms during the period 2008-2017. if a firm has missing data, it will be excluded from the tests. the main analysis in this paper is carried out using yearly data for both financial and nonfinancial firms. furthermore, the debt to total capitalization ratios will be used for the selected sample to observe the changes in the capital structure. tables 1 and 2 present summary statistics of firms with both credit ratings, and debt to equity ratio in our data. table 1 describes the dataset in terms of upgrade or downgrade movement for each rating category. out of a total of 750 downgrades, 335 were within investment grade and 415 were in the speculative grade. for upgrade, 376 were to investment grade of a total 768 firm-years. the table 1 shows the total number of firm-years for each rating category and the downgrade/upgrade activity. the sample includes both financial and nonfinancial bloomberg firms from 2008 to 2017 in nyse. the credit rating is standard and poor’s credit ratings for the year. table 2 provide summary of the number of firm-years in percentage form that firms have been engaged with issuance and reduction of debt and equity, as they adjust to the target financial leverage from previous’ year credit rating. from table 2, it can be seen that the percentage of the firms with downgrade are more likely to reduce debt or issue equity, while upgraded firms have higher percentage in issuing debt. additionally, the percentage of speculative downgrades of those firms likely to reduce debt (35.1%) is greater than those of downgraded ones (27.30%). on the other hand, the percentage of firms issue debt following an upgrade is 33.90%. the table 2 shows the impact of rating change on firms’ debt and equity decisions; computed by taking the previous year’s rating as the base to determine a downgrade, upgrade, or no change, with respect to speculative and investment grade. “downgrade to speculative” is a downgrade from an investment grade to a speculative grade rating, and “upgrade to investment grade” is the opposite. if a firm rating remains stable from 1 year to another, it will be added in no downgrade or no upgrade. figure 1 shows the response of the firms that had a change in the ratings in the previous year. the analysis has been separated into two graphs, showing the response of downgraded firms and upgraded firms separately. a total of 750 firm-years has been classified as downgraded and 768 for upgraded. in each year, the total is 100% and the chart shows how in each respective year have the firms either reduced, increased or not changed their levels of leverage. an increase or decrease in the level of leverage is defined only if the variable has increased or decreased by more than 5%. all the changes within the interval −5–+5% are classified as no change. it can be observed that for downgrade cases (graph a), each year is characterized by a higher probability of reduction in leverage, averaging about 73.2% debt reduction following a downgrade. 17.4% of the firms do not change any leverage and just 9.4% increase the leverage. graph b shows upgrade cases with the change in leverage level. table 2: capital activity with changes in rating ratings change (previous year) % of firms issue debt % of firms reduce debt % of firms issue equity % of firms reduce equity panel a: downgrades no downgrade 27.90 14.50 5.50 7.30 downgrade 13.60 27.30 5.20 3.30 downgrade to speculative 11.50 35.10 6.30 1.90 panel b: upgrades no upgrade 25.70 13.60 5.50 6.50 upgrade 33.90 13.30 7.50 6.50 upgrade to investment grade 27.20 8.70 6.60 6.60 table 1: summary statistics of corporate credit rating upgrades and downgrades rating change aa+ aa aa− a+ a a− bbb+ bbb bbb− #downgraded to 3 3 4 15 3 53 58 13 183 (% of firm-years) 5.60 16.70 4.00 6.30 0.50 8.80 7.20 1.10 17.30 #upgraded to 0 13 0 11 91 1 98 156 6 (% of firm-years) 0.00 72.20 0.00 4.60 16.70 0.20 12.20 12.70 0.60 total firm-years 54 18 100 237 546 605 803 1,224 1,059 rating change bb+ bb bb− b+ b b− ccc+ ccc ccc− #downgraded to 43 18 139 60 26 99 18 3 7 (% of firm-years) 7.00 2.60 20.30 11.80 6.90 64.70 50.00 42.90 175.00 #upgraded to 112 142 18 77 38 2 3 0 0 (% of firm-years) 18.30 20.20 2.60 15.20 10.10 1.30 8.30 0.00 0.00 total firm-years 612 704 686 508 375 153 36 7 4 feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 2020 97 figure 1: the response of firms after ratings change. graph a: downgraded firms’ response in the year following a rating change for 750 firmyears with leverage change, graph b: upgraded firms’ response in the year following a rating change for 768 firm-years with leverage change firms’ response to either an upgrade or downgrade in the previous year, in terms of increasing, decreasing or no change of the leverage factor in the next year. figure 2 presents the evolution of relationship between leverage, debt reduction, and downgraded firms debt reduction, in each year from 2008 to 2017. it can be observed that each spike in the leverage (measured by debt-equity ratio) is followed by a spike in the following year of the debt reduction in percentage. in each of the years, the reduction in leverage with downgraded firms is consistently higher than the reduction in the leverage. 5. main results and analysis to test the influence of credit ratings on firms’ debt and equity financing decisions we imply the partial adjustment model of flannery and rangan (2006) on the dataset. table 3 provides the results of cross-sectional regressions based on equation (4) and (5), where mdr is statistically correlated with x variables: ebit (profitability indicator), m/b, size of the firm (log of assets), fixed assets, depreciation (investment indicator), dummy value for missing r&d costs, and r&d costs. column 1 shows overall effects on the leverage caused by different variables figure 2: debt reduction and average leverage levels by year feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 202098 table 3: capital structure change based on credit rating changes variable all firms downgrade firms upgrade firms no change firms 1 2 3 4 5 6 7 downgradet−1 −0.015 −0.0193 −0.0321 (0.0044) (0.0032) (0.0048) upgradet−1 −0.0037 0.0039 0.0041 (0.0064) (0.0041) (0.0045) mdrt−1 −0.4401 −0.3754 −0.0483 −0.5285 −0.3991 −0.3613 (0.0208) (0.0201) (0.0115) (0.1180) (0.2004) (0.0313) ebitt−1 −0.0276 −0.0555 −0.005 0.2948 −0.0711 −0.1503 −0.0078 (0.0356) (0.0413) (0.0193) (0.0299) (0.1307) (0.1788) (0.0430) m/bt−1 −0.0035 −0.0039 0.0028 0.0289 −0.0584 −0.0187 −0.0041 (0.0046) (0.0042) (0.0024) (0.0410) (0.0350) (0.0087) (0.0041) depreciationt−1 −0.3442 −0.341 −0.1509 −0.1513 0.1556 1.0102 −0.4184 (0.1008) (0.1010) (0.0466) (0.1111) (0.5730) (0.4460) (0.0998) in (assets)t−1 0.0078 0.0064 −0.0019 −0.0038 0.0287 0.035 0.0005 (0.0052) (0.0048) (0.0015) (0.0032) (0.0199) (0.0164) (0.0040) fixed assetst−1 −0.0347 −0.0325 0.0063 −0.0151 −0.0638 −0.1545 −0.0201 (0.0268) (0.0239) (0.0068) (0.0212) (0.1613) (0.1250) (0.0296) r&d_dumt−1 −0.0012 −0.0007 0.0042 0.0028 −0.0068 0.0174 0.0034 (0.0070) (0.0073) (0.0041) (0.0058) (0.0460) (0.0314) (0.0060) r&dt−1 −0.09 −0.0952 −0.0832 0.0274 0.2101 1.953 −0.0902 (0.1384) (0.1501) (0.0491) (0.1575) (1.1711) (1.3520) (0.1540) fixed effects yes yes no yes yes yes yes ɸ1 > ɸ2 (p-value) n/a 0.0081 0.0077 0.0021 n/a n/a n/a n 7.436 7.436 7.666 7.436 750 768 5.916 r2 27 27.1 2.6 14.3 35.5 45.8 30.6 on the mdrt−1 before the event of upgrade or downgrade. in order to account for the presence of a particular firm, fixed effects have been included by including dummy variables, and to remove the bias, lagged values have been used in this case. columns 2 contains a dummy variable for both rating (downgrade-upgrade) as in equation (4). moreover, column 3 excludes firms fixed effects and column 4 removes the lagged leverage. from these columns, we can see that the premise of partial adjustment of capital structure posts a downgrade hold. columns 5 through 7 segregate the effects on downgraded, upgraded, and no change categories respectively by using equation (5). downgraded firms have a higher coefficient of mdr (52.9%), implying they adjusted faster than other firms in order to reach the desired level of leverage. the adjustment speeds of downgraded firms are significantly higher than that of upgraded or no change firms. the findings are also consistent with the crcs theory that implies an action of reduced leverage post a rating downgrade, but uncertain results in case of an upgrade. this table 3 shows the cross-section correlation analysis generated coefficients of each variable and standard errors of the regression model described in equation (4) and (5). columns 1, 2, 3, and 4 represent data for downgrade, upgrade, and no change variables, and dummy variables. columns 5, 6 and 7 present coefficients of each variable generated from the conditional tests of whether the firms downgraded, upgraded or experienced no change in their crediting ratings table 4 tests the results from equation (6) for relative leverage effects. the purpose of this test was to evaluate the effects of credit rating changes on the changes of market and book levels of financial leverage, with respect to assets and other control variables such as sales, ebitda, z-score, and m/b. table 4 presents two types of results with control variables and without control variables. the results without control variables have been documented in columns 1, 2. firms will issue 4.5% less debt if the firm has been downgraded in the previous year. on the other hand, upgraded firms will increase their debt by approximately 1.4%. columns 3 and 4 show the results including all control variables. downgraded firms reduce relative net debt by approx. 1.9%, and upgraded firms increase debt relative to equity by 0.7%. the regressions in these columns have higher r2 compared to columns 1 and 2. the specifications with fixed effects and industry effects could help reduce the hidden biases and the results are presented in columns 5 through 8. in columns 5 and 6, with the fixed effects, the reduction in debt level remains significantly negative at about 4%. columns 7and 8 show the same results with industry effects. even when these effects are taken into consideration the downgrade’s coefficient remains statistically significant. however, upgrade coefficients lose significance. this is consistence with the credit rating – capital structure theory that suggests that firms do not attempt to alter their capital structure post upgrades. this test uses market value of assets of the previous year with respect to credit rating, dummy variables, and explanatory variables used in equation (6). firms fixed effects and industry impacts have been included in the test as shown in columns 5 through 8. the table implies that firms that have experienced reduction in their credit ratings will issue less debt as they try to reach a target financial leverage in order to get discrete benefits attributable to higher credit ratings, while upgraded firms are the opposite. feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 2020 99 table 5 essentially presents the results using equation (6), but with logistic regression equations, assessing the impact of downgrade on reduction of debt or equity. an issuance or reduction is included only when the change in total asset is >5%. this analysis focuses on the downgraded cases and examines the capital structure reaction of a downgrade event. the table has four columns that report the change in the dependent variable. it shows that after a downgrade, firms are more likely to reduce debt, or issue equity and reduce debt. logistic regressions of dependent variables – debt issued/ debt reduced and equity issued/equity reduced have generated coefficients and their corresponding standard errors. the test focuses on downgraded firms with changes in firms’ capital structure with respect to adjusting their debt or equity to achieve a target financial leverage. section a and b below contains additional tests that shows the impact of credit rating downgrade on firms leverage level. 5.1. individual rating tests table 6 presents an individual rating test based on the partial adjustment model by adding a dummy variable for the change in rating in equation (6). results show that firms facing downgrade to a certain credit rating category tries to revert to their previous credit rating. according to below table, the targeting effect is the strongest around the cut-off between investment and speculative grade, or around the rating bbb to bbfor the reasons such as maintaining a lower cost of debt, expanding eligibility and ensuring compliance, as explained in the paper. this table presents each rating category coefficients and standard error of firms being downgraded in the previous year. units are measured in percentage. this test was done by using equation (6) on all firms that faced downgrade, then compare same rating category with firms capital structure activity. 5.2. individual years tests the firms with reduced financial leverage after credit rating downgrade could be caused by business cycle changes when many firms are downgraded during recession, such as the 2008 financial crisis and these firms are less likely to issue debt. table 7 present outcomes of regression equation (6) of mdr in a particular year. from table 7 we can see that the coefficient is negative across individual years and the leverage reduction is more than 1.8% in 7 out of 10 years. overall, the results of firm’s downgrade/upgrade are not due to business cycle effect. table 4: impact of credit rating change on capital structure behavior variable base specification firm fixed effects industry effect by year 1 2 3 4 5 6 7 8 downgradet−1 −0.0448 −0.0288 −0.0191 −0.0185 −0.041 −0.0361 −0.0174 −0.016 (0.0038) (0.0029) (0.0043) (0.0033) (0.0061) (0.0042) (0.0052) (0.0030) upgradet−1 0.0135 0.0075 0.0068 0.0067 0.0077 0.0093 0.0078 0.0058 (0.0037) (0.0035) (0.0050) (0.0038) (0.0042) (32.0000) (0.0054) (0.0044) leverage (bk) t−1 −0.0151 −0.0136 (0.0124) (0.0085) ∆leverage(bk)t−1 −0.0413 −0.1278 −0.0506 (0.0285) (0.0210) (0.0111) leverage (mkt)t−1 −0.0526 −0.0354 (0.0074) (0.0080) ∆leverage (mkt)t−1 −0.0032 0.0888 −0.0042 (0.0064) (0.0178) (0.0002) in (sales)t−1 −0.0062 −0.0037 −0.0066 −0.0051 (0.0018) (0.0009) (0.0035) (0.0007) ∆in (sales)t−1 0.0421 0.0416 0.0187 0.0212 0,0165 0.0204 (0.0212) (0.0095) (0.0065) (0.0065) (0.0069) (0.0042) ebitdat−1 0.2016 0.0872 0.1515 0.0613 (0.0550) (0.0276) (0.0256) (0.0150) ∆ebitdat−1 0.0187 −0.019 0.1001 0.0442 0.0505 0.0151 (0.0624) (0.0300) (0.0333) (0.0270) (0.0303) (0.0226) m/bt−1 0.0068 −0.0066 0.0049 −0.0044 (0.0045) (0.0010) (0.0035) (0.0022) ∆m/bt−1 −0.0038 0.0043 −0.0011 −0.0021 −0.0044 0.0038 (0.0018) (0.0009) (0.0011) (0.0015) (0.0014) (0.0007) z-scoret−1 0.0056 0.002 0.0115 0.0045 (0.0024) (0.0008) (0.0030) (0.0015) ∆z-scoret−1 0.0012 0.0066 0.0001 0.008 −0.0074 0.0024 (0.0156) (0.0080) (0.0002) (0.0033) (0.0091) (0.0026) rating levelt−1 −0.0102 −0.0008 −0.0046 −0.0019 (0.0088) (0.0007) (0.0011) (0.0006) intercept 0.0278 0.0186 0.0729 0.0918 0.1211 0.0717 (0.0021) (0.0016) (0.0236) (0.0192) (0.0213) (0.0215) ɸ1 > ɸ2 (p-value) 0.0001 0.0001 0.0056 0.0037 0.0045 0.0008 0.2153 0.0897 n 8.337 8.337 8.337 8.337 7.975 7.975 8.337 8.337 r2 0.7 1.1 3.8 3.9 27.4 27.4 27.4 21.1 feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 2020100 table 5: logistic tests: effects of credit rating downgrade on capital structure behavior variable dependent variable reduce debt issue debt reduce equity issue equity downgradet-1 0.6123 −0.4941 −0.3152 −0.6132 (0.0854) (0.0852) (0.1799) (0.1415) leverage (bk)t−1 0.6653 −0.0613 −0.4121 0.0758 (0.1455) (0.1212) (0.3316) (0.1920) ∆leverage (bk) t−1 0.2118 −0.1837 −2.1001 −0.6152 (0.2613) (0.2880) (0.3161) (0.3332) in (sales)t−1 −0.0515 −0.1463 0.0802 −0.2265 (0.0310) (0.0200) (0.0411) (0.4140) ∆in (sales)t−1 −0.5528 1.1123 −1.4225 −0.7141 (0.1785) (0.1211) (0.1818) (0.1068) ebtdat−1 −3.312 3.256 9.854 −2.664 (0.5514) (0.4117) (0.8181) (0.8557) ∆ebtdat−1 −1.5561 −0.7311 0.1845 −0.9812 (0.6102) (0.6565) (1.2506) (0.6153) m/bt−1 −0.2145 −0.0736 0.3378 0.1315 (0.0625) (0.0187) (0.0441) (0.0676) ∆m/bt−1 −0.0349 −0.0684 −0.3636 −0.0413 (0.0713) (0.0320) (0.0411) (0.0516) z-scoret−1 0.0352 0.0502 0.3636 −0.2311 (0.0324) (0.0116) (0.0564) (0.0643) ∆z-scoret−1 −0.048 −0.0613 0.78 0.0876 (0.0775) (0.0613) (0.1321) (0.0911) rating levelt−1 0.2369 0.0216 −0.0524 0.0977 (0.0256) (0.0095) (0.0192) (0.0284) intercept −3.2211 −0.7541 −3.4128 −3.1254 (0.3619) (0.2122) (0.4653) (0.2056) n 8.337 8.337 8.337 8.337 the table presents downgrade outcomes coefficient and standard error across individual years. it shows the cross-section correlational analysis for each year by using equation (6) with respect to the constant variables and dummy variables. 6. conclusion credit ratings influence firm’s capital structure in that both cfos and external investors since crs contain additional information table 6: individual rating tests: effects of credit rating downgrade on capital structure behavior panel a: investment grade rating aa+ aa aa− a+ a a− bbb+ bbb bbb− 2.75 2.11 −1.15 0.73 −1.32 −0.28 1.24 −1.91 −1.73 (1.30) (1.29) (0.81) (0.85) (0.77) (0.70) (0.76) (0.66) (0.96) panel b: speculative grade rating bb+ bb bbb+ b bccc+ ccc ccc−2.12 −5.22 −1.88 −1.56 −1.02 −4.78 −8.93 −6.66 −5.24 (0.91) (1.23) (2.01) (1.64) (1.42) (3.33) (3.21) (3.15) (3.78) table 7: tests at individual years: effect of rating changes on financial leverage variable 2008 2009 2010 2011 2012 downgradet-1 −0.0104 −0.0142 −0.0214 −0.0185 −0.0361 (0.0385) (0.0114) (0.0123) (0.0201) (0.0107) 2013 2014 2015 2016 2017 downgradet-1 −0.0214 −0.0147 −0.0216 −0.021 −0.0184 (0.0107) (0.0088) (0.0960) (0.0162) (0.0195) that may act as an indicator of a firm’s financial health. as earlier research finds, entities anticipating credit rating downgrade will issue less net debt relative to net equity. high credit ratings enable a firm to obtain debt at low rates of interests. this paper investigates whether credit ratings influence firms’ capital structure decision by using the partial adjustment model done by flannery and rangan (2006). the analysis was done by applying the empirical tests on the dataset, and from these tests we find the following; downgraded firms have higher likelihood of either reducing debt or reduce debt and issue equity. thus, the capital structure adjustments towards a target leverage are due to the discrete benefits associated with higher credit rating. on the other hand, firms are less likely to adjust their capital structure with the new credit rating upgrade because they do not want to reverse the discrete benefits of lowering the cost of debt. the effects of credit ratings on firms’ capital structure decisions will increase around the cut-off between investment and speculative grade. these findings are consistent with cr-cs hypothesis done by kisgen (2009). future research could apply the same empirical tests but with different international or local rating agencies and compare the results. another suggestion would be to investigate firms in different markets for example asian companies and see if the result match our findings. references baghai, r.p., servaes, h., tamayo, a. (2014), have rating agencies become more conservative? implications for capital structure and debt pricing. the journal of finance, 69(5), 1961-2005. bandyopadhyay, a., barua, n.m. (2016), factors determining capital structure and corporate performance in india: studying the business cycle effects. the quarterly review of economics and finance, 61, 160-172. beck, t., demirgüç-kunt, a., maksimovic, v. (2008), financing patterns around the world: are small firms different? journal of financial economics, 89(3), 467-487. chang, x., dasgupta, s. (2009), target behavior and financing: how conclusive is the evidence? the journal of finance, 64(4), 1767-1796. chen, h. (2010), macroeconomic conditions and the puzzles of credit spreads and capital structure. the journal of finance, 65(6), 21712212. de jong, a., kabir, r., nguyen, t.t. (2008), capital structure around the world: the roles of firm-and country-specific determinants. journal of banking and finance, 32(9), 1954-1969. flannery, m.j., rangan, k.p. (2006), partial adjustment toward target capital structures. journal of financial economics, 79(3), 469-506. frost, c.a. (2007), credit rating agencies in capital markets: a review of research evidence on selected criticisms of the agencies. journal of accounting, auditing and finance, 22(3), 469-492. kisgen, d.j. (2006), credit ratings and capital structure. the journal of finance, 61(3), 1035-1072. kisgen, d.j. (2009), do firms target credit ratings or leverage levels? journal of financial and quantitative analysis, 44(6), 1323-1344. kisgen, d.j., strahan, p.e. (2010), do regulations based on credit ratings affect a firm’s cost of capital? the review of financial studies, 23(12), 4324-4347. manso, g. (2013), feedback effects of credit ratings. journal of financial economics, 109(2), 535-548. roberts, m.r., sufi, a. (2009), control rights and capital structure: an empirical investigation. the journal of finance, 64(4), 1657-1695. feda: the impact of credit ratings on firms’ capital structure international journal of economics and financial issues | vol 10 • issue 5 • 2020 101 rogers, d., mendes-da-silva, w., rogers, p. (2016), credit rating change and capital structure in latin america. bar-brazilian administration review, 13(2), 1-22. s&p global ratings definitions. (2016), available from: https:// www.standardandpoors.com/en_us/web/guest/article/-/view/ sourceid/504352. [last accessed on 2020 feb 15]. sajjad, f., zakaria, m. (2018), credit rating as a mechanism for capital structure optimization: empirical evidence from panel data analysis. international journal of financial studies, 6(1), 13. serghiescu, l., vaidean, v.l. (2014), determinant factors of the capital structure of a firm-an empirical analysis. procedia economics and finance, 15(14), 1447-1457. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(1), 150-158. international journal of economics and financial issues | vol 10 • issue 1 • 2020150 impact of farmers’ cooperatives on socio-economic living conditions of rural households in north of burundi dismas manirakiza1*, fidèle mulumeoderhwa1,2, aristide maniriho1,3, patrice ndimanya4, philippe lebailly1 1economics and rural development unit, gembloux agro-bio tech, university of liege, belgium, 2faculty of economics and management sciences, evangelical university of africa, bukavu, democratic republic of congo, 3school of economics, university of rwanda, kigali, rwanda, 4rural economics unit, burundi national university, bujumbura, burundi. *email: dismasmanirakiza77@gmail.com received: 15 october 2019 accepted: 15 december 2019 doi: https://doi.org/10.32479/ijefi.8981 abstract the study aimed to assess the farmers’ cooperatives impact on the socio-economic living conditions of their members in north of burundi. a research survey was conducted on two farmers’ groups such as a sample of 90 farmers randomly chosen in three main cooperatives and a control sample of 60 non-members. data were analyzed with a comparative approach of descriptive statistics. among six main food crops considered by the study, results show a significant contribution of the cooperative only on bananas’ production (p = 0.075). moreover, members gain a cost reduction of 50%/kg in maize milling or rice dehulling. thanks to the multiple financial opportunities within the cooperative, members improve the quality of their houses (12%), subscribe supplementary health insurance (38%), pay easily the school fees for their children and equip themselves with household equipment. finally, the value of solidarity among members enhances the spirit of confidence and cohesion in the community. keywords: farmers’ cooperatives, impact, socio-economic living conditions, rural households jel classifications: o22, q12, q13 1. introduction the cooperative model is present in most countries and sectors of activity as a response to imperfections of the state and market abuse (birchall, 2004; gentil, 1984; giagnicavi, 2012; mertens, 2010). while the world suffered from economic crises during the 19th century, the cooperatives played a major role in solving common problems such as poverty, social exclusion, unemployment and exploitation of women (ilo, 2002; münkner and shah, 1993; porvali, 1993). since then, the co-operation appears throughout the world as the only possible means of defense enabling the most vulnerable to cope with the unfavorable social and economic conditions (braverman et al., 1991; ellis, 2000). the particularity of cooperative compared to conventional companies is that it allows individuals to be together and pool their resources to achieve a common goal that would be difficult for them to achieve individually (bm [banque mondiale], 2002). for example, a cooperator can produce, store and/or transform 10 kilos of a given agricultural product in the best conditions and taking advantage of economies of scale. in burundi, as in most african countries, where the agriculture dominates the rural economy, farmers’ cooperatives are associated in implementation of the national agricultural policies (develtere et al., 2007; scoones, 1998). in view of its importance, especially in rural community, the cooperative approach is often a major condition in the intervention methodology of the technical and financial partners. while the first burundian agricultural cooperatives date from the colonial period, their particular recognition begins in 21st century during the implementation of the millennium development goals. while the national agricultural budget has never exceeded the this journal is licensed under a creative commons attribution 4.0 international license manirakiza, et al.: impact of farmers’ cooperatives on socio-economic living conditions of rural households in north of burundi international journal of economics and financial issues | vol 10 • issue 1 • 2020 151 10% recommended by the maputo conference’s declaration, the farmers’ cooperatives have therefore seized new financial opportunities to help members get easily access to a wide range of services, including access to low-cost agricultural inputs, markets, agricultural micro-credits, natural resources, training and information. the report of the department of cooperatives commissioned by the ilo (minagri, 2012; develtere et al., 2007) established an overall quantitative evolution of agricultural cooperatives in the order of 16 cooperatives between 1952 and 1967; 21 cooperatives in 1970; 26 cooperatives in 1973 and only 15 cooperatives remained at the end of the 1980s. with their revival between 1990 and 2000, around 689 cooperative groups around food crops were registered in 1998; 1,500 in 2013 totalizing nearly 63,126 members and more than 157,285 households in 2016 (gpv01/région afrique, 2016). however, despite an increase of membership in agricultural food cooperatives in rural areas and a strong support from various stakeholders, it is clear that the living conditions of farming households have not been improved. indeed, the rate of monetary poverty, calculated with reference to the cost of basic needs, stood at 64.6% in 2014 without showing any difference with the ratio of non-monetary poverty (in living conditions), estimated at 68.8% (isteebu, 2015). this precariousness of living conditions strikes harder in rural areas than in urban areas, regardless of the dimensions considered. according the data on poverty, the non-satisfaction of basic needs affects 2.5 times more people in rural than in urban areas (isteebu, 2015). in terms of living conditions, there are 11 times more poor people in rural areas than in urban areas (71.1% against 6.6%). based on the aforementioned statements, the research question is formulated as following: do the agricultural food cooperatives improve the socio-economic living conditions of their members? the objective of our study is therefore to analyze their impact on the socioeconomic living conditions of rural households grouped into cooperatives. even if many research works have already been done to study the impact of development projects on rural development in africa (baker 2000; delarue and cochet, 2011; gertler et al., 2011), rare are the authors who introduced the notion of impact of an agricultural cooperative on the living conditions. this study tries to answer this question by considering the cooperative mechanism as a strategy or a development project whose impact corresponds to the changes obtained and actually attributable to the actions of the cooperative (figure 1). 2. materials and methods the realization of this study covering a period from 2011 to 2017 combines three methods such as the documentary exploitation, surveys and interviews with different actors of the cooperative movement of busiga and gashikanwa communes in ngozi province (6 representatives of cooperatives, 2 agricultural instructors, 1 representative of the louvain cooperation ngo and 1 provincial socio-economic adviser). the first survey was conducted on 90 members randomly selected in cooperatives of three main organizations present in each commune such as adisco (support to integral development and solidarity on hills), union for cooperation and development (ucode) and capad (collective of associations of agricultural producers for development). the cooperatives involved in our work are very active in supervising farmers around six main food crops widely present in households’ food in this province (beans, maize, cassava and potatoes) and in commercialization as bananas and rice. at different levels, they also have related activities (storage and processing) and others activities such as access to credit and health insurance. the second survey was carried out on a comparison group of 60 non-members, who were selected by using the purposive sampling technique in the same social group and geographical area as cooperatives’ members. the social group concept is approached according to filmer and pritchett (1998) conception, who define it as a class in which people with similar socio-economic characteristics are included. then, in order to establish the similarity of living conditions of samples’ farmers, before members joined cooperative, we have taken into account individual characteristics such as age, sex, marital status, educational level and socio-economic characteristics of the household (baker, 2000; ravallion, 2009; leeuw and vaessen, 2009). considering the latest characteristics, it is recognized that burundian rural households consider themselves in particular material goods as agricultural production, housing quality, possessed durable goods, animal wealth and land. my study area was selected according to the purposive sampling based on its accessibility and the level of cooperative dynamism established by a study of the agricultural advocacy group (cth, 2013) entitled “mapping of the intervention of farmers’ organizations and support organizations (ngos).” by coming in first position with a coverage rate in agricultural cooperatives of food products of 4.6%, the province of ngozi has in this context benefited from a strong support from the technical and financial partners for historical reasons of recurrence of food insecurity and increasing poverty. the choice of busiga commune for the criterion of strong cooperative presence and gashikanwa commune for a low presence is intended to exploit the completeness of the information. the location of the two municipalities in the same natural region reflects their similarity from geographical, cultural and socio-economic considerations. the analysis of results was carried out according to the descriptive and comparative approach of socio-economic variables based on their mean, frequencies and percentages calculated with excel and spss 16. indeed, the source: adapted from fao (2012) and ruette (2014) improvement of socio-economic living conditions economic impact social impact intermediate effects services offered by the cooperative figure 1: analytical framework of the study manirakiza, et al.: impact of farmers’ cooperatives on socio-economic living conditions of rural households in north of burundi international journal of economics and financial issues | vol 10 • issue 1 • 2020152 current situation of cooperators was compared with the reference situation reconstructed according to historical data obtained from the government gazettes, monographs and reports of various actors of co-operation, as well as the publications of specialized agencies. that approach is particularly appropriate in the absence of an ex-ante evaluation (durufle et al., 1988; pamies-sumner, 2014; pellerano, 2011; ravallion, 2008). in order to isolate the influence of exogenous factors, the situation of cooperators was also compared to that of the control group’s members by using the comparison tests of means and frequencies (t-student and chi-square) of the studied variables and the significance of their differences (p-value). the content analysis (verbal and textual) was used to confront many viewpoints of different actors of co-operation and to explain as much as possible the trend detected by the statistical tests. in this study, the variables used to analyze socio-economic living conditions are based on the indicators established in the report of the committee on the measurement of economic performance and social progress (or the stiglitz, sen and fitoussi report) which have been adapted to burundian rural area situation (olivier, 2010). it distinguished material socio-economic variables such as agricultural production, quality of housing, state of sanitation and access to safe water, possessed durable goods, wealth of animal livestock and immaterial aspects as mutual solidarity, initiative and entrepreneurial spirit, access to health care and children’s schooling. this way of exploring living conditions is inspired by mata (2002) conception that considers them as a set of material and immaterial means specific to a community and allowing it to exist and reproduce. 3. results and discussion 3.1. impact on food production according to secondary data, the levels of main food production in ngozi are ranked in the following order: banana (35%), cassava (27%), sweet potato (18%), beans (9%), potatoes (5%), corn (4%) and rice (2%). with regard to the figure below, the primary results indicate the same order of classification by also highlighting a positive evolution of production levels in the two groups of farmers. the upward trend of the quantities produced in the two groups of farmers does not, however, reveal any significant difference in their yields (in kg/ha), considering the two extreme years of the study period (2011 and 2016), exception of the 2016 banana yields (p = 0.075), whose significance of the difference is however slightly pronounced (graphs 1 and 2). despite the absence or weakness of significance, it is important to mention that the 2011 yield differences between the two groups have almost tripled in 2016 for beans, quadrupled for maize and sextupled for bananas. however, the difference in 2011 cassava yields (41.9 kg/ha) almost reversed in 2016 (−40.2 kg/ha), while the negative differences of rice yields (−95.5 kg/ha) and of potato yields (−129 kg/ha) were reduced by five and twice respectively (table 1). the absence of significant difference for majority of the main crops studied does not mean that the cooperative has no effect on the production level. the trend of productions evolution highlighted in the two groups is explained by the use of factors of production whose the cooperative is one of the providers. in burundian rural areas, the cooperatives often facilitate access to agricultural training, mineral fertilizers and improved seeds. firstly, although the government has mobilized farming trainers (one animator per administrative zone), the farmers say that they are rarely supported. according to the testimony of an agricultural instructor interviewed, the problem of technical means (means of travel, training manuals, lack of retraining, etc.) and financial means (delay of wages, logistical means) constitutes an obstacle on agricultural supervision. while 64% of non-members have never received agricultural supervision, more than 81% of cooperatives’ members benefited from the support of an endogenous animator. in 2017 and 2018, we found that the organization of supervision in cooperatives is based on a system of training by an agricultural coordinator attached to the cooperative. to boost learning, an individual farm improvement plan is developed by each cooperator based on a demonstrative model field. in addition, a group of farming leaders selected from the cooperators are charged to assist in the accompaniment of their colleagues. interviews graph 1: food production in group 1 source: author, survey, 2017 source: auteur, survey, 2018 graph 2: food production in group 2 manirakiza, et al.: impact of farmers’ cooperatives on socio-economic living conditions of rural households in north of burundi international journal of economics and financial issues | vol 10 • issue 1 • 2020 153 table 1: yield difference (kg/ha) and significance test (p‑v) between the two groups years gap/p-value bean maize cassava banana rice potato 2011 gap 25.2 7.7 41.9 87.5 (−95.5) (−129.4) p-value 0.146 0.22 0.11 0.103 0.49 0.75 2016 gap 82.4 31.8 (−40.2) 587.7 (−19.2) (−55.8) p-value 0.201 0.55 0.91 0.075* 0.107 0.116 *significant at 10% level (p<0.1). source: author, results of surveys of 2017 and 2018 with non-members show that the cultural methods learned by the co-operators also reach them. under the effect of a good neighborhood on the hills, the innovations are transmitted perfectly from house to house; so that neighbors copy the cultural model that seems the best (white and phillips, 2012). rousseau (2003) has explained this by indicating that the interactions between an individual and other individuals produce the externalities that may affect his economic situation. secondly, it is clear that the difficulty of chemical fertilizers supply is a great challenge that results in the problem of availability and access. with the establishment of pnseb (subsidy program for mineral fertilizers) by burundian government, the collective purchase through the cooperative seems to be one of the privileged channels for a wide public access to mineral fertilizers. according to the survey, the use of chemical fertilizers has increased compared to the national average of 8 kg/ha/year, but without showing a significant difference between the two groups. in fact, while the members consumed on average about 33 kg/ha of the main fertilizer used in burundi (dap), the non-members used it for 30 kg. moreover, there is no great difference between the proportions of the two group’s farmers using of chemical fertilizers. indeed, dap fertilizer is used by about 81% of the first group and 74% of the second ‘one, 55% and 53% for urea; 32% and 27% for kcl in the same order. with regard to preceding arguments, the testimonies of the peasants interviewed admit that the non-cooperators acquire fertilizers also informally from neighboring cooperators who sell them a part of their purchase or pass an excess order to supply them. this was also confirmed by niyonkuru (2018) in his book “dignité paysanne” published in the collection of “books grip” where the author shows the revelations of non-members who say that they have no reason to integrate these organizations for the only reason that they enjoyed practically the same services as the cooperators. third, the survey show that households using improved seeds are less numerous in both groups (42% of cooperators against 35% of non-cooperators) and show a small gap between them. this small supply gap between the two groups seems normal because the phenomenon of “free rider effect” is not so excluded in the acquisition of improved seeds. as an example, we can mention the case of “elite” maize variety promoted in 2015 via adisco agricultural co-operatives in gashikanwa by the usadf project, which has been widespread in non-co-operative households. the significant difference between banana productions is justified by the good banana management practices, from the selection of planting material to the harvest, taught to members of cooperatives, particularly ucode gashikanwa in 2016 and 2017. the nonmembers’ households are mostly confronted with the lack of improved and successful plant varieties. 3.2. transformation of production port-harvest management of production is necessary to value it or not waste it. the most widespread processing in our cooperatives is maize and cassava milling, as well as rice husking. according to the results analysis and the testimonies, cooperators gain on the price of the milling or dehulling at the mill of the cooperative. the tariff shows that milling of maize was relatively cheaper in cooperative (40 bif/kg) compared to the local private mill (60 bif/kg). while not being unfair competition, it has been found that the endowment of co-operatives in clean mills or in husking machines has made it possible to destabilize or regulate milling or dehulling prices in the study area. 3.3. habitat habitat is one of the units that determines family organization in rural areas and can be a telling sign of a household’s well-being (kalamou, 2014; virendra et al., 2015). in burundian rural area, habitat depends on the quality of housing (materials used), access to safe water and the state of sanitation. according to table 2, the statistical comparison test revealed a significant difference between the two groups with regard to wall construction materials at 10% level (p = 0.077). the group of non-members dominates for houses whose walls are built with wood covered of mud (18% of non-members against 4% of members). contrariwise, members dominate for houses with walls in burnt bricks; they represent 11% against 5% of non-members. although the difference is not significant for the flooring and roofing materials, non-members are numerous to have houses of earth floor (85% against 74% of members) and less numerous for a cemented floor (7% against 17%). households whose their houses are covered with clay tiles or new metal sheets are also more numerous in members’ group than in non-members’ one. knowing that decent housing is a determinant of hygiene and health of households by reducing the likelihood of exposure to disasters and diseases, that difference reveals the well-being of cooperators in terms of housing quality. according to the testimonies, the gap is justified by endogenous possibilities of access to small credits within the cooperative. indeed, out of a total budget of 17,850,000 bif (8,900 €) mobilized in 2016 by microfinance institutions partners (coopec, cecm, ucode) and internal solidarity funds (igg, muso and cem) in the form of small loans to farmers, about 6% of the beneficiaries have allocated their credit to the construction or improvement of their houses. according to table 3, the statistical analysis shows a significant difference between the two groups in terms of access to safe water (p = 0.080) and quality of sanitation (p = 0.092). that gap in access to safe water is related to the distance effect between the home and the source of water. while about 32% of households in each group manirakiza, et al.: impact of farmers’ cooperatives on socio-economic living conditions of rural households in north of burundi international journal of economics and financial issues | vol 10 • issue 1 • 2020154 live at more than 3 km from nearest source of safe water, bicycle becomes the most popular means often used in water supply in the study area. according to the survey results, a household of members’ group has on average 0.44 bike against 0.11 bike in non-members’ one. thus, it is obvious that co-operators are relatively more advantageous in water supply. wfp sees in bicycle as a productive good in ngozi province (pam, 2008); the non-possession can therefore be considered as a precarious index of households. indeed, the consequence of not having a bike implicates the inaccessibility to safe drinking water. for the quality of sanitation, the difference is related to the sensitization in cooperative about the techniques of latrines construction and the daily practices of keeping them always clean. it is worth important to note that the precarious hygienic conditions can lead to the fragility of health (velleman et al., 2013; who, 2004) and according to the previous arguments; many nonmembers are exposed to it. 3.4. access to health care decent health is one of the signs of a household or community’s standard of living that can be gained by the degree of financial and physical accessibility to health care (ekman, 2004; glouberman and millar, 2003). however, accessibility has a cost that can be felt differently among the population. firstly, physical (geographic) accessibility refers to the distance a patient travels to a health center, either private or public. secondly, financial accessibility requires paying the bill for health services (consultation, medical examination, medication, hospitalization and health insurance). in the national health insurance policy, burundi government has provided medical assistance through cam system (medical assistance card), which enables population of informal and rural area to benefit from basic health care reduced to 20% (kamwenubusa et al., 2009). in some of the cooperatives studied, supplementary health insurance ms (community health insurance) was introduced providing insured persons with additional coverage (consultations, medication, hospitalization and minor surgery) and extended coverage (private sector services). in both groups, the comparative study reveals disparities in financial access to health care (table 4). the households of members and non-members do not feel in the same way the cost of health care. the first are numerous (60%) to say that it is “easy” to access to basic care, while the latter do not exceed 43% for the same mention. contrary, fewer members (16%) experience “difficulties” in seeking treatment compared to 29% of non-members. the difficulties felt by the latter come from the significant costs they must endorse by buying medical services in private health centers or pharmacies. they are obliged to pay 100% for failing to find public structures nearby. generally, consultations or hospitalization and medication are relatively very expensive in private health sector. in rural areas, the cost of consultation at private health center varies from 2000 to 3000 bif (1 to 1.5 $) against 1000 to 1500 bif (0.5 to 0.7 $) in the public for a non-insured. in this situation, households are obliged to draw on the budget that is intended for other items of family expenses (rent, food, schooling of children, etc.) or to sell food crop or property at a low price. of course, the subscribing of the supplementary health insurance of an average amount of 22,000 bif (11 $) per household and per year confers to insureds an extended and complementary coverage even in private sector. in this regard, the first have indeed so many possibilities to be treated as well in the public health centers and in the private’s due table 2: housing quality components members (%) non-members (%) t/x2 dl p wall materials wood with mud 4 18 5.14 2 0.077* unburnt bricks 84 77 burnt bricks 11 5 roofing materials clay tile 58 48 8.75 6 0.188 reused sheet metal 26 38 new metal sheet 13 7 grass/thatch 3 7 flooring materials earth 74 85 4.84 5 0.236 cement 17 7 wood 2 2 bricks 4 5 clay tile 2 2 *significant at 10% level (p<0.1). source: author, results of surveys of 2017 and 2018 table 3: safe water access and sanitation quality components members (%) non-members (%) x2 dl p safe water unimproved source 36 45 4.25 2 0.080* public tap 23 19 protected spring 41 36 state of sanitation traditional pit toilet 78 83 4.76 2 0.092* pit with slab 22 15 open sanitation 0 2 *significant at 10% level (p<0.1). source: author, results of surveys of 2017 and 2018 manirakiza, et al.: impact of farmers’ cooperatives on socio-economic living conditions of rural households in north of burundi international journal of economics and financial issues | vol 10 • issue 1 • 2020 155 to the support of 60-80% by the mutual. the analysis based on the categories established according to the households’ income shows that as the peasants have money, as much they could easily buy the services of health company of choice. regardless of the category considered, the members are still ahead in access to health care. their advantage is the possibility of borrowing a small amount of money from microfinance institutions by intermediary of cooperative or from mutual solidarity funds to meet health needs. the guaranty is the group solidarity based on relationship and mutual confidence between cooperatives’ members. physical accessibility or geographical availability is understood as physical presence of drugs in the retail depot near the population for a period of time (lagarde and palmer, 2006; powell, 1995). the survey shows that the geographical availability of drugs depends on group and category of households (table 5). for members, the “permanently available” mention varies between 40% and 56% whereas it is 0-13% for non-members. this means that members have several nearby sources of supply that are favorable to their status. having a supplementary insurance in ms gives them the chance to access to the medical services in health centers either public, private or community. without supplementary health insurance, non-members benefit a little package of health care services. in this regard, having several alternatives of health structures consequently reduces geographical unavailability or physical inaccessibility (ekman, 2004). 3.5. possession of domestic animals in burundi, livestock farming is a major source of organic fertilizers and soil amendment for rural households. moreover, it is a source of household income from the sale of animal. traditionally, livestock is practiced for social integration and esteem to farmers. in the study area, the animals most breeded in the two groups are in this order: goats, cattle, rabbits and chickens (table 6). however, the level of animal ownership differs between the two groups with a significant difference for goats (p = 0.039) and cattle (p = 0.043). on average, a member household has 1.04 goats and 0.68 cattle while a non-member household has only 0.58 goats and 0.23 cattle. the average number of goats exceeds that found at provincial level of 0.9 goats and 0.2 cattle. goat farming is the animal whose meat is the most consumed in this province. according to the survey, about 48% of members have at least one goat against 37% for no-members. the level of cattle ownership is 34% in the first group and 26% in the second one. about 16% of members have no animals compared to 23% of non-members. this situation expresses a lack of opportunity for fertilization, wealth and social esteem, especially for non-members. the significant difference between the two groups for goats and cattle is justified by three reasons: the first reason is the sensitization campaign in cooperative to small income-generating activities and the use of credit (loan); this one is not easily accessible to non-members. thus, the rotating loan obtained in mutual solidarity groups requires a definition of a reasonable small project reasonable; a second reason is the price of cattle or goat that is not accessible to everyone if you have not borrowed money. indeed, a cow costs between 300,000 and 400,000 bif and a goat is bought at about 100,000 bif. last but not the least is the distribution of cattle to the selected cooperative’s members. about four members among ucode farmers have acquired cattle through the fao project “food support and environmental management” for the restocking of cattle livestock (ucode, 2015). table 4: financial accessibility to health care scale members (%) non-members (%) subgroup 1c (31) subgroup 1nc (41) cat. 1 cat. 2 cat. 3 average cat. 1 cat. 2 cat. 3 average never 0 0 0 0 0 0 0 0 difficult 20 12 11 14 46 36 29 37 a little easy 20 17 11 16 29 29 29 29 easy 60 71 78 70 25 36 43 34 1c: cooperators insured at cam and ms; 1nc: non-cooperators insured at cam. cat. 1: low-income households; cat. 2: middle-income households; cat. 3: high-income households. source: author, results of survey of 2017 and 2018 table 5: physical or geographical accessibility to health care scale members (%) non-members (%) sub-group 1c (31) sub-group 1nc (41) cat. 1 cat. 2 cat. 3 average cat. 1 cat. 2 cat. 3 average not available 0 0 0 0 17 17 33 22 sometimes available 20 18 11 16 37 67 67 57 often available 40 41 33 38 33 17 0 17 permanently available 40 41 56 46 13 0 0 4 source: author, results of survey of 2017 and 2018 table 6: average farm animals per household pet average per household comparison test members non-members t dl p cattle 0.63 0.23 −2.1 45 0.043* goat 1.04 0.58 −2.57 63 0.039* pigs 0.16 0.15 −1.65 10 0.302 sheep 0.2 0.11 0.066 12 0.243 rabbit 0.50 0.33 0.838 17 0.405 chicken 0.43 0.42 −1.75 29 0.384 *significant at the 5% level (p<0.05). source: author, results of survey of 2017 and 2018 manirakiza, et al.: impact of farmers’ cooperatives on socio-economic living conditions of rural households in north of burundi international journal of economics and financial issues | vol 10 • issue 1 • 2020156 3.6. schooling of children universal schooling is one of the priority actions of burundian government. since the 2005/2006 school year, schoolchildren are exempted from registration fees that may prevent them from not attending primary school. however, paying tuition fees is not the only way for parents to fund schools. schools charge them for operating, caretaking, maintenance or minor repairs. the comparison to be made between the two study groups focuses on the level of school dropout and its causes. in both groups, the results show that the major cause of defection of schoolchildren is poverty in households (graph 3). more than 27% and 33% of member’s households have children out of school due to poverty in 2015 and 2016 respectively. households of non-members are more affected with proportions of 44% and 44% for the same years. the parents told us that they do not bear the various expenses required by the school. this has been noted particularly in low-income households or households with more than four school-age children. secondary causes are unwanted pregnancies and security crisis. as previously mentioned, the dropout gap is mainly related to poverty. to understand it better, we pushed the study by asking respondents for the ability to accede to school fees. about 77% of members find “easy” to pay tuition fees compared to 52% of non-members. by contrary, more than 22% of non-members’ households find them “inaccessible” compared to 4% of members’ households. this proves that members’ households are better able to find school fees for children. the small endogenous structures of solidarity initiated in cooperatives allow members to solicit an advance to pay school fees. three members of cooperatives testified about loans from endogenous solidarity funds: (1) “it is within the igg that we can realize our dreams. there are people who can never have a pet at home or make money if they have not joined the self-help groups. for me, the igg allowed me to continue to pay the school fees of my children after the death of my husband” (2) “my family has six children. with muso, i took out a loan of 200.000 bif (120 $) which allowed me to buy three goats and five chickens. it helps me cope with everyday family emergencies and find school materials and school fees.” other opportunities arise when people are associated. the “ntunjujutane project” in local language or “does not become illiterate” initiated in 2012, 2013 and 2014 in ucode gashikanwa and busiga under the support of care international is an illustration of this. at the start of the school year, households receive an advance of 10,000 bif to pay for school materials. 3.7. the social effects of cooperatives in burundi, one of the defining elements of life in rural areas is the solidarity that has developed since the ancestral period. as mentioned above, solidarity is reflected in the systems of pooling health insurance (via community health insurance), solidarity financing (via the muso and igg solidarity funds) and in the practices of rotating aid in field plowing. in this respect, members learn to trust each other in a virtually neutral atmosphere. a member of testified that igg solidarity fund is a place of socialization and expression of mutual solidarity.” 4. conclusion according to the study results, agricultural cooperatives contribute in increasing of food production of either cooperatives’ members by easy access to agricultural training and chemical fertilizers or non-members due to the effect of positive externalities. through the credit obtained by intermediary of cooperative or from endogenous financial solidarity, the members have improved the housing quality (sustainable materials used) and hygienic conditions (drinking water and sanitation). they also have bought goats and cattle, which is for them a form of saving and a source of fertilizers. moreover, these financial opportunities allowed members to subscribe the community health insurance initiated in some cooperatives, which provides them with greater financial and physical access to health care than non-members can. the school dropouts, largely caused by poverty, are relatively less numerous in members’ households. this indicates a spirit of trust reinforced by mutual help in the happy or unhappy events. however, the strong mobilization of burundian government on promotion of cooperative movement since 2018, especially on the eve of elections (in 2020) could have a partisan stakes; which would compromise the autonomy advocated by the universal principles of rockdale. thus, it would be important to study in future research the extent of impact of that generalization of cooperative movement. source: author, results of survey of 2017 and 2018 graph 3: dropout rate and causes in the study area manirakiza, et 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[last accessed on 2019 nov 15]. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2022, 12(1), 28-36. international journal of economics and financial issues | vol 12 • issue 1 • 202228 does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment riadh el abed1*, zouheir mighri2, abderrazek ben hamouda3 1university of tunis el manar, faculté des sciences economiques et de gestion de tunis, laboratoire d’ingénierie financière et economique, 65 rue ibn sina, moknine 5050, tunisia, 2department of finance and insurance, saudi arabia, college of business, university of jeddah, saudi arabia, 3faculty of economics and management of tunis, university of tunis el manar, tunisia. *email: riadh.abed@gmail.com received: 03 september 2021 accepted: 23 december 2021 doi: https://doi.org/10.32479/ijefi.11973 abstract in this article, we estimate the links between nominal exchange rates (jpy/usd and cny/usd) and economic policy uncertainty (epu) in china and japan by employing monthly data during the period span from january 1997 to september 2020. the threshold cointegration approach focus in tar, m-tar, c-tar and c-mtar is used. results indicate the evidence of asymmetric effect in the adjustment process to equilibrium and the m-tar is the best model to detect threshold effect for the (cny/usd-cnyepu) pair and the c-tar is the best model to detect threshold effect for the (jpy/usd-jpyepu) pair. keywords: foreign exchange rate, economic policy uncertainty, nonlinear cointegration, asymmetric ecm jel classifications: f22, q56 1. introduction uncertainty in global economic policy results in sharp market fluctuations. global events and geopolitical issues are fundamentally the cause of market fluctuations. as markets collapse under fears of shrinking economic policy uncertainty (epu), the economic machine can also collapse. currency volatility can affect multinational companies, consumer behavior as well as small and medium-sized businesses. according to the international monetary fund (2020), uncertainty at the global level leads to a sharp reduction in trade between countries and large variations in the exchange rate. the world trade organization (2020) says that uncertainty represents an unprecedented upheaval around the world and that global trade has been sharply reduced. previous research has investigated the relationship between epu and exchange rate volatility. bartsch (2019) finds that uncertainty in economic policy amplifies short-term exchange rate volatility. chen et al. (2019) asserts that increasing uncertainty in economic policy causes increased levels of exchange rate volatility. nilavongse et al (2020) add that uncertainty in domestic economic policy affects the response to exchange rate volatility much more than uncertainty in foreign economic policy. on the contrary, abid and raul (2020) studied the relationship between policy uncertainty and the exchange rate in emerging markets using a panel var model. the results show that the effect of foreign epu on exchange rate volatility exceeds the contribution of local epu. specifically, baker et al. (2016) find that uncertainty in economic policy not only affects exchange rate volatility, but it has adverse effects on economic activity. arouri et al. (2016) show that the this journal is licensed under a creative commons attribution 4.0 international license el abed et al. does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment international journal of economics and financial issues | vol 12 • issue 1 • 2022 29 relationship between policy uncertainty and the exchange rate weighs negatively on financial markets. benigno et al. (2012) investigated the relationship between epu and the exchange rate using the autoregressive vector model (var). the results show that uncertainty in economic policy has an effect on short-term exchange rates. colombo (2013) studied the effect of the shock of us epu on the nominal euro-dollar exchange rate. the results indicate that the exchange rate reaction is more sensitive with an american uncertainty affected the european aggregates than with an uncertainty specific to the euro zone. sin (2015) studied the relationship between epu on exchange rate volatility for china using a structural vector autoregressive model (svar). the results indicate that the impact of an uncertainty shock has a significant effect on exchange rate volatility. krol (2014) finds that epu affects exchange rate volatility for ten industrial and emerging economies. therefore, the high volatility of the exchange rate will affect domestic production, consumer behavior and international trade. the main contribution of this paper is to study the nonlinear cointegration (threshold effect) and asymmetric adjustment between epu and foreign exchange market considering the china and japan economies. we employ four threshold models such as tar, m-tar, c-tar and c-mtar. the symmetric or asymmetric adjustment is analyses by the symmetric ecm or asymmetric ecm. in this paper, we study the impact of epu on exchange rates. we employed the nonlinear cointegration such as the threshold effect focus on tar model, consistent tar, momentum tar and consistent momentum tar. we examine the long-term relationship between foreign exchange rates and economic uncertainty on the china and japan. we use the enders and siklos (2001) asymmetric cointegration model to analyze the long-run asymmetric equilibrium relationship between variables. to be specific, the adjustment coefficient of the error correction term is different when the equilibrium error is positive from when it is negative. this paper is organized as follows. section 2 discusses the data and empirical methodology. section 3 presents the preliminary analysis. section 4 presents the empirical results and section 5 concludes the paper. 2. data and empirical methodology in this article, we use two variables, namely epu and nominal exchange rates (cny/usd and jpy/usd) from two asian countries such as china and japan at monthly frequency during the period span from january, 1997 to september, 2020. the main objective is to study the nonlinear cointegration and asymmetric adjustment between variables. the data for the epu is sourced from policyuncertainty.com and for exchange rates were collected from www.federalreserves.gov. the econometric methodology adopted in this research work focuses on three stages: the stationarity test is carried out to verify the presence or absence of unit root in the series studied. if the variables are stationary in the first difference, the linear and nonlinear cointegration methodology is adopted between epu and foreign exchange market. subsequently, the long-term asymmetric adjustment between variables is examined using the asymmetric error correction model (aecm). to study the non-linear interaction between foreign exchange rates and epu in china and japan, we have employed the threshold cointegration based on tar, m-tar, consistent-tar and consistent-mtar, which is developed by enders and siklos (2001). the two methods of cointegration are johansen and engle-granger two-step approaches. both of them assume symmetric relationship between variables. balke and fomby (1997) used a two-step approach for examining threshold cointegration on the basis of the approach developed by engle and granger (1987). enders and granger (1998) and enders and siklos (2001) further generalize the standard dickey-fuller test by allowing for the possibility of asymmetric movements in time-series data. this makes it possible to test for cointegration without maintaining the hypothesis of a symmetric adjustment to a long-term equilibrium. thereafter, the method has been widely applied to analyze asymmetric transmission. the conventional tests of cointegration such as engle and granger (1987) are a residual-based test that analyzes the validity of long-run relationship among epu and nominal exchange rate by estimating the following model: yt = β0 + β1xt + εt (1) where yt is the foreign exchange rates of china and japan at time t and x𝑡 is the epu in the two countries. is the residual in equation (1) and 𝛽0 and 𝛽1 are coefficients. in the next step, for the estimated error term ͡εt, we can estimate two regime threshold models explained by: ∆ ∆     ε ρ ε ρ ε ϕ ε εt t t t i p i t ti= + − + ∑ +− − = −1 1 2 1 1 11( )it (2) where, ρ1, ρ2 and φi are coefficients to be estimated, εt indicates the white noise error term εt and p is the best lag choosed by the aic. i if t if tt = − ≥ − <    1 1 0 1 ε τ ε τ (3) where τ is the parameter of threshold and it is the heaviside indicator. since the exact nature of the nonlinearity may not be known, enders and siklos (2001) consider another kind of asymmetric cointegration test methodology that allows the adjustment to be contingent on the change in εt-1 (i.e., δεt-1) instead of the level of εt-1. in this case, the heaviside indicator of eq. (3) becomes. i if t if tt = − ≥ − <    1 1 0 1 ∆ ∆ ε τ ε τ (4) equation (4) represents the momentum tar (m-tar), which captures more dynamics than the tar model if δεt-1 is el abed et al. does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment international journal of economics and financial issues | vol 12 • issue 1 • 202230 significantly different from zero. the speed of adjustment depends on the increase or decrease of εt. thompson (2006) stipulates that if |ρ1|<|ρ2|, then increase in εt tend to persist, whereas decreases revert back to the threshold quickly. considering the equation (2), asymmetric co-integration can be studied through the test of absence of co-integration h0: (ρ1 = ρ2 = 0). rejection of the null hypothesis indicates the evidence of cointegration according to the symmetrical (ρ1 = ρ2# 0) or asymmetrical context (ρ1 # ρ2). however, the acceptance of h0 allows evaluating the symmetrical adjustment following the long-term equilibrium and this using the test (h0: ρ1 = ρ2). in addition, the presence of threshold co-integration leads us to adopt the asymmetrical ecm model with a particular threshold value (tar or m-tar value). the asymmetric error correction mechanism can be estimated by the following equations: ∆ ∆ epu z z epu t epu epu t epu t j j epu j t j j j = + + + + + − + − − − = + − + = ∑ θ δ δ α 1 1 1 1 , ∑∑ ∑ ∑ − − − = + − + = − − − + + + α β β epu j t j j j er j t j j j er j t j e epu er er v , , , ∆ ∆ ∆ 1 1 ppu t, (5) and ∆ ∆ er z z er t er er t er t j j er j t j j j er j = + + + + + − + − − − = + − + = ∑ ∑ θ δ δ α α 1 1 1 1 , , −− − − = + − + = − − − + + + ∑ ∑ ∆ ∆ ∆ er epu epu v t j j j epu j t j j j epu j t j epu t 1 1 β β , , , (6) where er is the exchange rate, epu is the epu, zt tt− + −=1 1i and  z it tt− − −= −1 11( ) ,   + and − indicates the positive and negative speed of adjustment coefficient. in addition, the constant is θ . α and β represent the coefficients of the lagged difference of er and epu, respectively. also, j is the number of lag and vt denotes a white noise error term. in this context, many hypothesis can be used such as f-tests to detect the granger causality, distributed asymmetric lag effect, cumulative asymmetric effect, and equilibrium-adjustment path asymmetric effect between nominal exchange rates and epu. the granger causality test is tested from the two hypothesis: ( : : )h and h 01 02 0 0α α β β+ − + −= = = = . in the next step, we employ the hypothesis ( : )h 03  + −= to detect the presence of the distributed lag asymmetric effect of epu on its own. the hypothesis ( : )h 04  + −= can be adopted for each lag and both variables. for the cumulative asymmetric effect, we employed two hypothesis such as: ( h 05 : ( ) ( ) ∑ = ∑= + = − j j j j j j1 1  ) for epu and ( h 06 : ( ) ( ) ∑ = ∑= + = − j j j j j j1 1  ) for er. finally, we use the hypothesis (h 07 : ) + −= . 3. empirical results 3.1. preliminary analysis table 1 reports summary statistics of jpy/usd and cny/usd exchange rates and epu (jpyepu and cnyepu). the highest mean and standard deviation are observed for cnyepu during the period. asymmetry is measured by the values of skewness and kurtosis is a measurement for flatted distribution. we see that the two exchange rates have a negative skewness. however, epu is caracterisized by a positive skewness. the jarque-bera test statistics which rejects the null hypothesis of normality. table 1 shows the results of the stationarity test based on adf. the observation of the results indicates that all the series are stationary in first difference. we conclude that epu and exchange rates are integrated processes of order one i (1), or unit root processes. 3.2. results of the threshold cointegration analysis this work focuses on four threshold cointegration models: the tar, c-tar, m-tar and c-mtar models. table 2 reports the results of the estimates by focusing on the non-linear cointegration (threshold effect). considering the pair (cny/usd-cnyepu), the results indicate that the threshold value is zero for the tar and mtar models. however, the values of c-tar and c-mtar are 0.074 and -0.028 respectively. based on the reported results, the m-tar model is the best performed because it has the minimum information criterion (aic and sbic). l-jung-box’s statistics at order 4 show the absence of auto-correction problem. through the four nonlinear models, the results indicate the rejection of the null hypothesis of threshold cointegration (ρ1=ρ2=0) for the cny/usd-cnyepu pair by considering the m-tar model. this result confirms the evidence of a cointegrating relationship between exchange rate and epu. in this case we can examine whether their adjustment coefficients are different across positive and negative errors. this procedure serves to verify the evidence of an asymmetric cointegration through the hypothesis h0: ρ1=ρ2. if the two previous tests reject the null assumption, so asymmetry test makes sense. based on information criterion aic and sbic and l-jung box statistics, we observed that the m-tar is the most applicable model for variables’ adjustment to long-run equilibrium for the pair cny/usd-cnyepu. considering the cny/usd-cnyepu pair, we observe for the m-tar model that the f test relating to the null hypothesis of absence of cointegration admits a statistic of 2.582 which is significant at a level of 10%. this result indicates that epu and el abed et al. does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment international journal of economics and financial issues | vol 12 • issue 1 • 2022 31 ta bl e 1: d es cr ip ti ve s ta ti st ic s an d un it r oo t t es t st at is ti cs c n y /u sd c n y e p u jp y /u sd jp y e p u m ea n 1. 98 56 4. 77 78 4. 67 89 4. 66 15 m ed ia n 1. 94 87 4. 69 85 4. 69 76 4. 64 09 m ax im um 2. 11 93 6. 74 76 4. 97 45 5. 46 82 m in im um 1. 80 02 2. 12 17 4. 33 91 3. 88 29 st dde v 0. 11 52 0. 78 18 0. 13 20 0. 30 86 sk ew ne ss -0 .0 53 0 0. 18 32 -0 .8 82 0 0. 30 39 k ur to si s 1. 36 39 3. 37 18 3. 39 39 2. 92 28 ja rq ue -b er a 31 .9 17 9* ** 5. 22 53 * 38 .7 95 5* ** 4. 45 98 * pr ob 0. 00 00 0 .0 81 0 0. 00 00 0. 09 75 st at io na ri ty a d f ‑l ev el a d f ‑fi rs t di ff a d f ‑l ev el a d f ‑fi rs t di ff a d f ‑l ev el a d f ‑fi rs t d iff a d f ‑l ev el a d f ‑fi rs t d iff tst at is tic s −1 .2 40 3 −9 .4 84 4* ** −1 .9 37 5 –1 8. 11 49 ** * –2 .1 53 8 –1 2. 94 03 ** * –0 .0 33 2 –1 3. 70 32 ** * pr ob 0. 89 95 0. 00 00 0. 63 21 0. 00 00 0. 51 30 0. 00 00 0. 67 09 0. 00 00 *, * * an d ** *d en ot e th e si gn ifi ca nc e at 1 0% , 5 % a nd 1 % le ve ls ta bl e 2: e ng le ‑g ra ng er a nd th re sh ol d co in te gr at io n re su lt te st s p ai rs o f v ar ia bl es c n y /u sd ‑c n y e p u jp y /u sd ‑j p y e p u e ng le a nd g ra ng er ta r c ‑t a r m ‑t a r c ‑m ta r e ng le a nd g ra ng er ta r c ‑t a r m ‑t a r c ‑m ta r la gs (p ) 8 8 8 8 14 14 14 14 t hr es ho ld (τ ) 0 0. 07 4 0 –0 .0 28 0 –0 .0 7 0 0. 01 1 rh o1 –0 .0 33 –0 .0 56 0. 01 –0 .0 18 –0 .0 61 ** * –0 .0 66 ** * –0 .0 33 ** –0 .0 61 ** * (– 0. 99 1) (– 1. 53 1) (0 .3 39 ) (– 0. 76 8) (– 3. 09 8) (– 3. 36 8) (– 1. 99 6) (– 3. 15 8) rh o2 –0 .0 27 –0 .0 16 –0 .0 65 ** –0 .1 07 * –0 .0 19 –0 .0 17 –0 .0 31 ** –0 .0 17 (– 0. 96 6) (– 0. 61 5) (– 2. 22 4) (– 1. 91 5) (– 1. 40 2) (– 1. 21 5) (– 1. 98 2) (– 1. 22 2) to ta l o bs 28 5 28 5 28 5 28 5 28 5 28 5 28 5 28 5 co in t o bs 27 6 27 6 27 6 27 6 27 0 27 0 27 0 27 0 a ic –1 09 9. 47 6 –1 10 0. 31 7 –1 10 2. 90 8 –1 10 1. 81 3 –1 25 3. 59 8 –1 25 4. 95 9 –1 25 0. 06 7 –1 25 3. 82 9 b ic –1 05 9. 65 1 –1 06 0. 49 3 –1 06 3. 08 3 –1 06 1. 98 9 –1 19 2. 42 5 –1 19 3. 78 6 –1 18 8. 89 4 –1 19 2. 65 6 l b (4 ) 0. 87 0. 88 2 0. 80 9 0. 79 9 0. 99 6 0. 99 2 1 0. 98 7 n o c i 0. 90 6 1. 31 5 2. 58 2* 2. 04 5 5. 42 2* ** 6. 09 2* ** 3. 70 2 5. 53 6* ** h 0: 0. 40 53 0. 27 02 0. 07 75 0. 13 14 0. 00 49 0. 00 26 0. 02 60 ** 0. 00 44 n o a pt 0. 02 4 0. 83 6 3. 35 3* 2. 28 7 3. 34 6* * 4. 64 7* * 0. 00 3 3. 56 7* h 0: rh o 1= rh o2 0. 87 7 0. 36 1 0. 06 8 0. 13 2 0. 06 9 0. 03 2 0. 95 4 0. 06 n um be r i n pa re nt he se s ar e th e tva lu e. * , * * an d ** * de no te th e si gn ifi ca nc e at 1 0% , 5 % a nd 1 % le ve ls el abed et al. does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment international journal of economics and financial issues | vol 12 • issue 1 • 202232 exchange rate are cointegrated with an adjustment threshold. in addition, the f statistic for the null hypothesis of symmetric transmission has a value of 3.353 and it is significant at the 10% level. therefore, the adjustment process is asymmetric when exchange rate and epu adjust to achieve the long-term equilibrium. if we observe the pair (jpy/usd-jpyepu), the results indicate that the threshold value is zero for the tar and mtar models. however, the values of c-tar and c-mtar are –0.07 and 0.011 respectively. based on the reported results, the c-tar model is the best performed because it has the minimum information criterion (aic and sbic). l-jung-box’s statistics at order 4 show the absence of auto-correction problem. focused on four nonlinear models, the results indicate the rejection of the null hypothesis of threshold cointegration (ρ1=ρ2=0) for the jpy/usd-jpyepu pair. this result confirms the evidence of a cointegrating relationship between exchange rate and epu in japan. in this case we can examine whether their adjustment coefficients are different across positive and negative errors. this procedure serves to verify the evidence of an asymmetric cointegration through the hypothesis h0: ρ1=ρ2. if the two previous tests reject the null assumption, so asymmetry test makes sense. based on information criterion aic and sbic and l-jung box statistics, we observed that the c-tar is the most applicable model for variables’ adjustment to long-run equilibrium for the pair jpyy/usd-jpyepu. considering the jpy/usd-jpyepu pair, we observe for the c-tar model that the f test relating to the null hypothesis of absence of cointegration admits a statistic of 6.092 which is significant at a level of 1%. this result indicates that epu and japan exchange rate are cointegrated with an adjustment threshold. in addition, the f statistic for the null hypothesis of symmetric transmission has a value of 4.647 and it is significant at the 5% level. therefore, the adjustment process is asymmetric when exchange rate and epu in japan adjust to achieve the long-term equilibrium. figure 1 illustrate the variations of the sse for the m-tar model considering a lag of 8. by observing the cny/usd-cnyepu pair, we see that the lowest sse for the momentum-tar model is 0.389 at the threshold value of zero. the m-tar model is the best model characterized by the lowest aic statistic of –1102.908 and bic statistic of –1063.083. figure 2 illustrate the variations of the sse for the c-tar model considering a lag of 14. by observing the jpy/usd-jpyepu pair, we see that the lowest sse for the consistent-tar model is 0.183 at the threshold value of –0.066. the c-tar model is the best model characterized by the lowest aic statistic of –1254.959 and bic statistic of –1193.786. 3.3. results of the asymmetric error‑correction model in order to investigate the movement of the foreign exchange markets such as cny/usd and jpy/usd and epu series in a long-run equilibrium relationship, we analyze the asymmetric error correction model. empirical results justify the evidence of the long-run equilibrium relationship between epu and exchanges rates in the two countries with asymmetric behavior. the results of the m-tar model are reported in table 3 (cny/usd-cnyepu pair). based on aic, a maximum of up to three lags has selected for estimation of the asymmetric ecm. for regimes with positive and negative shocks (cnyepu is higher than cny/usd), which means that, in the next period, cnyepu figure 1: threshold value for m-tar (cny/usd-cnyepu) el abed et al. does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment international journal of economics and financial issues | vol 12 • issue 1 • 2022 33 ta bl e 3: r es ul ts o f t he a ‑e c m w it h th re sh ol d co in te gr at io n v ar ia bl e c oe ffi ci en ts c n y / u sd tst at is ti c m ‑t a r (l ag =3 ) c oe ffi ci en ts c n y e p u tst at is ti c c oe ffi ci en ts jp y / u sd tst at is ti c c ‑t a r (l ag =3 ) c oe ffi ci en ts jp y e p u tst at is ti c θ –0 .0 01 –0 .7 31 –0 .0 85 8 –1 .6 93 –0 .0 02 4 –0 .6 53 0. 06 94 ** 2. 30 7  1+ 0. 00 2 1. 04 7 –– 0. 29 86 ** –2 .5 14 0. 01 62 1. 21 4 –0 .2 99 2* * –2 .8 04  2+ 0. 00 1 0. 54 6 –0 .2 79 5* * –2 .3 89 –0 .0 29 4* * –2 .1 15 –0 .1 61 9 –1 .4 59  3+ 0. 00 1 0. 54 6 –0 .3 51 4* ** –3 .8 79 0. 01 30 0. 93 2 –0 .3 84 0* ** –3 .4 39  1− –0 .0 02 –1 .2 29 –0 .8 28 1* ** –8 .9 48 –0 .0 05 6 –0 .4 13 –0 .1 76 5 –1 .6 14  2− 0. 00 2 0. 94 0 –0 .3 85 4* ** –3 .3 17 0. 02 26 1. 68 0 –0 .1 03 5 –0 .9 63  3− 0. 00 1 0. 80 0 –0 .1 15 5 –0 .9 89 –0 .0 22 2 –1 .7 17 –0 .0 84 4 –0 .8 18  1 + 0. 56 1* ** 6. 37 1 9. 70 87 1. 71 6 0. 33 33 ** 2. 83 8 1. 02 53 1. 09 6  2+ –0 .1 72 –1 .7 69 –1 .4 38 2 –0 .2 30 –0 .0 07 5 –0 .0 63 –0 .1 31 3 –0 .1 38  3 + 0. 07 1 0. 80 7 4. 00 58 0. 70 4 0. 10 43 0. 90 2 –1 .3 57 0 –1 .4 72  1 − 0. 46 2* ** 4. 27 5 2. 57 82 0. 37 2 0. 26 17 ** 2. 52 8 0. 56 16 0. 68 1  2− 0. 21 9 1. 83 8 –4 .8 71 9 –0 .6 35 0. 07 91 0. 75 8 1. 62 35 1. 95 3  3 − –0 .1 71 –1 .5 71 –7 .1 12 4 –1 .0 15 –0 .1 19 9 –1 .1 45 0. 68 89 0. 82 6  + –0 .0 04 –0 .9 09 –0 .2 77 1 –1 .0 49 –0 .0 51 2* * –2 .7 69 –0 .0 49 6 –0 .3 37  − –0 .0 05 –0 .5 48 –0 .4 34 1 –0 .6 78 –0 .0 12 6 –0 .9 52 0. 06 11 0. 57 7 d ia gn os tic r -s qu ar ed 0. 27 56 0. 35 67 0. 13 71 0. 14 97 a dj us te d r -s qu ar ed 0. 23 75 0. 32 29 0. 09 16 0. 10 5 fst at 7. 23 10 .5 4 3. 01 8 3. 34 6 a ic –2 09 9. 95 8 23 9. 38 0 –1 30 5. 41 8 –1 39 .4 73 b ic –2 04 1. 74 4 29 7. 59 4 –1 24 7. 20 4 –8 1. 25 9 q (4 ) 0. 97 6 0. 41 5 0. 97 1 0. 70 3 (c on td ... ) el abed et al. does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment international journal of economics and financial issues | vol 12 • issue 1 • 202234 h yp ot he si s de sc ri pt io ns f -s ta ti st ic s c n y /u sd p‑ va lu e f -s ta ti st ic s c n y e p u p‑ va lu e f -s ta ti st ic s jp y /u sd p‑ va lu e f -s ta ti st ic s jp y e p u p‑ va lu e g ra ng er c au sa lit y te st h 0 1 :   yj yj + − = 0. 53 7 0. 78 0 19 .8 45 ** * 0. 00 0 1. 59 6 0. 14 8 5. 42 1* ** 0. 00 0 h 0 2 :   xj xj + − = 15 .8 39 ** * 0. 00 0 1. 04 4 0. 39 7 4. 87 0* ** 0. 00 0 1. 87 1* 0. 08 6 d is tr ib ut ed la g ay m m et ri c eff ec ts h 0 3 :   1 1 0 + − = = 1. 94 4 0. 16 4 9. 61 3* ** 0. 00 2 0. 94 7 0. 33 1 0. 46 7 0. 49 5 h 0 3 :   2 2 0 + − = = 0. 06 1 0. 80 4 0. 33 4 0. 56 4 5. 31 7* * 0. 02 2 0. 10 5 0. 74 6 h 0 3 :   3 3 0 + − = = 0. 29 0 0. 59 1 1. 92 8 0. 16 6 2. 47 0 0. 11 7 2. 80 5* 0. 09 5 h 0 4 :   1 1 0 + − = = 0. 42 5 0. 51 5 0. 53 2 0. 46 6 0. 15 1 0. 69 8 0. 09 9 0. 75 3 h 0 4 :   2 2 0 + − = = 5. 59 1* * 0. 01 9 0. 10 4 0. 74 7 0. 21 8 0. 64 1 1. 41 2 0. 23 6 h 0 4 :   3 3 0 + − = = 2. 53 1 0. 11 3 1. 28 6 0. 25 8 1. 48 1 0. 22 5 1. 94 4 0. 16 4 c um ul at iv e ay m m et ri c eff ec ts h : 0 5 σ σ ( ) ( ) jj j jj j = + = − = 1 1   0. 21 8 0. 64 1 3. 40 0* 0. 06 6 0. 02 0 0. 88 7 2. 86 7* 0. 09 2 h 0 6 : ) ( ) ( ) ∑ = = + = − jj j jj j 1 1    0. 07 5 0. 78 5 3. 40 3* 0. 06 6 0. 55 1 0. 45 9 2. 21 0 0. 13 8 e qu ili br um a dj us tm en t p at h as ym m et ry h 07 : δ + = δ– 0. 02 7 0. 87 1 0. 05 3 0. 81 8 2. 90 2* 0. 09 0 0. 37 8 0. 53 9 ** *, * *, * in di ca te s si gn ifi ca nt a t t he 1 % , 5 % , 1 0% le ve l, re sp ec tiv el y. n um be rs in b ra ck et s () a re p v al ue s ta bl e 3: (c on tin ue d) el abed et al. does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment international journal of economics and financial issues | vol 12 • issue 1 • 2022 35 will go up and the deviation will increase. the adjusted r-squared value is 0.2375for the cny/usd and 0.3229 for cnyepu. in the other hand, the statistic q of ljung-box indicates the absence of problem of autocorrelation. from causality analysis, we observe that the cny/usd cause the cnyepu in the short run (f-stat=15.839 and p = 0.0000) and cnyepu cause cny/usd in the long run (f-stat=19.845 and p = 0.0000). the null hypothesis of the absence of a distributed lag asymmetric effect from epu (cnyepu) to cny/usd is not rejected at the significance level. in addition, the study does not find evidence of a significant cumulative asymmetric effect from cny/usd to epu in china. the f-statistics of adjustment path asymmetric effect are respectively 0.027 for cny/usd (statistically not significant) and 0.053 for cnyepu (not significant). this result indicates that there is an absence of equilibrium adjustment path asymmetric effect between epu and cny/usd. the empirical results of the c-tar model are reported in table 3 (jpy/usd-jpyepu pair). based on aic, a maximum of up to three lags has selected for estimation of the asymmetric ecm. for regimes with positive and negative shocks (jpyepu is higher than jpy/usd), which means that, in the next period, jpyepu will go up and the deviation will increase. the adjusted r-squared value is 0.0916 for the jpy/usd and 0.105 for jpyepu. in the other hand, the statistic q of ljung-box indicates the absence of problem of autocorrelation. from causality analysis, we observe that the jpy/usd cause the jpyepu in the short run and jpyepu cause jpy/usd in the short and long. the f-statistics of adjustment path asymmetric effect are respectively 2.902 for jpy/usd (statistically significant) and 0.378 for jpyepu (not significant). this result indicates that there is a presence and absence of equilibrium adjustment path asymmetric effect between epu and jpy/usd. 4. conclusion in this article, we study the dynamic interaction between foreign exchange rate and epu by considering two asian countries such as china and japan. specifically, we focused on the linkages between variables in both the short-run and long-run horizons under the nonlinear threshold cointegration framework. we employ the methodology developed by enders and siklos (2001), focused on a nonlinear (threshold) cointegration model allowing for nonlinear adjustment to long-run equilibrium. from the nonlinear cointegration approaches, we can reject the null hypothesis of no cointegration for the pair (cny/usd-cnyepu) by considering the m-tar. from the pair (jpy/usd-jpyepu), we can reject the null hypothesis of no cointegration by considering four threshold models. in addition, we found evidence of asymmetry in the adjustment process to equilibrium. our finding indicates the presence of asymmetric effect between nominal exchange rate and epu. policymakers must pick sound economic policies to promote prosperity. the clarity in economic policy making, especially in the period of high volatility, can lead to more stable markets. additionally, our findings are also of great relevance for policymakers on managing exchange rate fluctuations and on prevention of potential risks that may arise due to significant dependence among different markets. they should further control over risks at markets of significant dependence and properly decide on the timing and extent of foreign exchange rate intervention. figure 2: threshold value for tar (jpy/usd-jpyepu) el abed et al. does economic policy uncertainty affect exchange rate in china and japan? evidence from threshold cointegration with asymmetric adjustment international journal of economics and financial issues | vol 12 • issue 1 • 202236 references abid, a., raul, c. 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(2020), export prohibitions and restrictions, information note. available from: https://www.wto.org/english/tratop_e/covid19_e/ export_prohibitions_report_e.pdf [last accessed on 2020 may 20]. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(3), 55-63. international journal of economics and financial issues | vol 11 • issue 3 • 2021 55 the impact of dollarization policy on zimbabwe exports: a gravity model approach lilian tomu1, knowledge mutodi2, tinashe chuchu3*, eugine tafadzwa maziriri4 1department of mba hospital and health care management, symbiosis institute of health science, symbiosis international university, pune, india, 2department of agricultural business development and economics, faculty of agriculture environment and food systems, university of zimbabwe. zimbabwe, 3school of business sciences, university of the witwatersrand, south africa, 4department of business management, faculty of economic and management sciences, university of the free state, south africa. *email: tinashe.chuchu@wits.ac.za received: 20 february 2021 accepted: 26 april 2021 doi: https://doi.org/10.32479/ijefi.11315 abstract this paper investigates the impact of dollarization policy on zimbabwe exports over a period of 20 years. the study used panel data for 50 zimbabwe potential historical trading partners. random effects model (rem) was applied to estimate the gravity model equation. panel feasible generalized least squares (fgls) regression technique corrected for heteroskedasticity and contemporaneous correlation across panels was applied to probe factors that drive zimbabwe export flows. the results provide insights on the impact of dollarization policy, gdp, bilateral exchange rate, sadc membership status and population on zimbabwe exports. if monetary authorities involuntarily re-dollarize the economy owing to monetary autonomy erosion, emphasis should be directed towards internal devaluation which could be attained by measures intended to exert downward pressure on domestic costs, wages and prices to recuperate export competitiveness. further, government has to create an environment that encourage foreign direct investment inflows to ease liquidity challenges probable to be experienced under dollarization regime. nevertheless, macroeconomic fundamentals ought to be addressed with action to spur economic growth. sufficient resources should be channelled towards increasing the country’s productive capacity, and this can enhance country‘s ability to supply export products to the international market, and curb import growth. keywords: dollarization policy, gravity model, zimbabwe jel classifications: f60, f63, 63 1. introduction the evolution of zimbabwe macroeconomic performance is highly related to the performance of the external sector. zimbabwe is primarily dependent on natural resource sector’s exports, particularly minerals and agriculture. zimbabwe’s the major export minerals are diamonds, platinum, nickel ores and gold (zimtrade, 2015). the agricultural export-based commodities are tobacco, cotton, sugar and horticulture. tobacco is the dominant cash crop in agriculture (researve bank of zimbabwe, 2015a). however, other sectors of the economy, such as manufacturing and tourism contributes to zimbabwe export earnings and overall economic growth. the liberal reforms of the 1990s soon got into conflict with the antimarket land expropriation programme introduced in 2000. the programme was meant to address the skewed land distribution between black and white farmers, but this quickly closed up the economy (buigut, 2015). soon major drops in agricultural production, productivity, and overall economic growth besieged the economy, culminating in hyperinflation of about 231 million witnessed by 2008 (koech, 2011). this general economic failure and loss of value of the zimbabwean dollar led to the dollarization of the zimbabwean economy in march 2009 (buigut, 2015). the united states dollar was adopted as the economy’s anchor currency (reserve bank of zimbabwe, 2015b). this journal is licensed under a creative commons attribution 4.0 international license tomu, et al.: the impact of dollarization policy on zimbabwe exports: a gravity model approach international journal of economics and financial issues | vol 11 • issue 3 • 202156 however, in 2014 the reserve bank of zimbabwe introduced bond coins to alleviate change shortages in an economy that was predominantly using the united states dollar as its anchor currency. these major structural shifts have caused major internal and external imbalances as reflected in uneven and sluggish economic performance since independence, deteriorating internal and external positions (reserve bank of zimbabwe, 2015b). zimbabwe’s current account deficit went up from an average of about 5% of gdp in the mid-2000s to an average of 22% in the past decade (world bank, 2016). the current account deficits have reflected a real overvalued zimbabwean dollar up until 2009, then an overvalued us dollar and then recently overvalued bond note (reserve bank of zimbabwe, 2017). overvalued currencies have caused loss of the country’s external competitiveness on the international markets. south africa remains zimbabwe’s major trading partner both in terms of imports and exports (reserve bank of zimbabwe, 2014). the rand/us$ exchange rate has become the key driver of the country’s external position. the us dollar has continued to appreciate against the south african rand negatively affecting exports which are priced in us dollars and encouraging imports (reserve bank of zimbabwe, 2015b). this has resulted in accumulating trade and current account deficits, and escalating debt building up (reserve bank of zimbabwe, 2015a). while the structure of the economy has greatly transformed as a result of the introduction of several micro and macroeconomic policy changes, zimbabwe is still confronted with series of economic challenges post-independence. maintaining internal and external balance has been a major challenge. the imbalances can be conceptualized as slow gdp growth, high inflation levels, overvalued zimbabwean dollar, foreign exchange shortages and balance of payments (bop) deficits (world bank, 2016). even after the introduction of dollarization regime to stop rampant inflation that had besieged the economy in 2008, internal imbalances have continued to show low gdp growth, liquidity problems and cash shortages among others. external imbalances have shown foreign exchange shortages, emergency of black market, trade and current account deficits and balance of payments deficits. further, post dollarization regime, the introduction of local currency in 2019 did little to solve the economic challenges affecting the economy. the exchange rate continues on a depreciating path reigniting debate among policy makers about specific policy interventions that need to be undertaken, to put back the economy on a recovery trajectory path. the high degree of currency substitution has imposed constraint on government’s capability to manage macroeconomic conditions. the real danger is the actual loss of monetary autonomy if the local currency is officially removed from the local financial system. thus, the study sort to examine the impact of dollarization policy on zimbabwe exports using a gravity model approach. and to test the hypothesis that dollarization negatively affect export flows. the rest of the paper is organized as follows. section 2 gives background on the origin of hyperinflation and the dollarization of the zimbabwe economy. section 3 reviews literature on economic causes, costs, benefits and impact of dollarization on trade. section 4 describes the empirical methodology and the data. section 5 presents and discusses results and policy implications, and section 6 concludes the study. 2. literature review 2.1. hyperinflation and dollarization of zimbabwean economy since 1980, the gap between exports and imports was very close, and even after the introduction of economic structural adjustment programme (sap) it remained unchanged. the introduction of land reform programme contributed to the widening gap between exports and imports from 2000 to 2008. the period of low negative and high positive growth rates has been replaced with persistent recessions since 2000 when the country embarked on the fast track land reform programme. this programme has faced several problems, among them resources to finance the programme (scoones, 2011). it has scared away investors, and strained relations with the western world and international institutions such as the world bank (wb) and international monetary fund (imf) (undp, 2009). it has become more difficult or impossible to raise new capital to stimulate economic growth. as a result, high unsustainable fiscal deficits stimulated inflation leading to hyper-inflation. agricultural production and economic growth both tumbled. a radical shift in the agrarian structure emerges as the large scale commercial farming declines replaced with the small holder farming sector characterized with low levels of capitalization (scoones, 2011). the land acquisition severely destabilized agricultural production affecting the overall economic performance. inflation went up by 4.8% on average from 2000 to 2005 and then further increased to 80% by 2008 as measured by gross domestic product deflator, which is the broadest measure of inflation (gstraunthaler, 2011). this shrinkage was induced by the decline in agricultural production which was a major source of raw materials in the manufacturing sector (saungweme, 2012). the quasi fiscal activities of the reserve bank of zimbabwe (rbz) also contributed to negative economic growth (world bank, 2016). they culminated to hyperinflation, high exchange rate volatility and currency crisis in 2008 (gstraunthaler, 2011). the nominal exchange rate was generally stable before the year 2000. however, in 2000-2008 the nominal exchange rate greatly depreciated escorted by high inflation levels. the harsh economic environment led to the full dollarization of the zimbabwean economy by march 2009. but before the introduction of dollarization in zimbabwe, however, they were major debates regarding this policy on whether to adopt it or not. it is defined by the reserve bank of zimbabwe (2015) as the official use of foreign currency (currencies) on all transactions, except the need for coins. the foldup of major agricultural activities post land reform programme in 2000, trade and current account deficits increased, and worsened by the year 2008 as the country was relying mainly on imports. zimbabwe unilaterally abandoned its local currency and adopted a basket of currencies in 2009. the currencies adopted initially were the us dollar, euro, uk sterling pound, south african rand and botswana pula. the introduction of dollarization regime anchored on the usd dramatically stabilized the economy with resumption of growth. the real average gross domestic product (gdp) growth rate was 8.5% during the 2009-2013. the recovery was temporary, so that by 2012 economic growth declined drastically due to tomu, et al.: the impact of dollarization policy on zimbabwe exports: a gravity model approach international journal of economics and financial issues | vol 11 • issue 3 • 2021 57 tight liquidity conditions which affected aggregate demand in the economy exacerbated by weak external sector competitiveness (rbz 2015a). the deficits of trade and current account remained very high in the year 2014 (adbg, 2014). the trade and current deficits went up from 24% of gdp in 2012, to 28% of gdp in 2013 and 25 % of gdp in 2014 (rbz, 2014; zeparu, 2015). the world economic forum’s global competitiveness index ranked zimbabwe number 124 out of 144 countries far below most of its regional competitors (rbz, 2015b). it indicated that zimbabwe’s exports were relatively uncompetitive in the world market. rbz attributed the weak international competitiveness on the overvalued exchange rate of the usd which was the dominant currency in both public and private sector transactions. the appreciation of the dollar created a strong appetite for imports causing chronic trade and current account deficits. in the recent past, there has been an increase in calls in some quarters to re-dollarize the economy as the exchange rate continues on a depreciating path. the high degree of currency substitution post dollarization regime has become the virus that threatens to obliterate the role of recently introduced local currency in the domestic financial system. the depreciation of the exchange rate and inflation upsurge led citizens to pursue alternative stores of value which in this case the us dollar. the high degree of currency substitution that has now occurred, has reflected market pressures and preferences at play. this have imposed constraint on government’s capacity to manage macroeconomic conditions. hence, the threat will be the actual loss of monetary autonomy if the local money is formally eliminated from the local financial system. 2.2. the economic causes, benefits and cost of dollarization dollarization is a common regularity in transitional and developing economies. the possible causes of dollarization is due to large exchange rate depreciation and persistent of high inflation levels. dollarization is a gradual process, as domestic inflation rate increases, economic agents do not expeditiously abandon local currency for foreign substitutes, but rather the use of foreign currency in domestic transactions gradually grow with the increase in domestic inflation rate. rational economic agents switch to an alternative currency with high degree of purchasing power strength against a background of high inflation and exchange rate devaluation expectations. evidence has shown that in some instances, countries that experience high inflation, the economy automatically dollarize as residents use foreign currency as the store of value. when the country’s monetary autonomy has been eroded due to failure by the monetary authorities to control high inflation and large exchange rate depreciations. the country will be forced to abandon its local currency and officially dollarize its economy. foreign currency will be allowed to be used as a unity of account and finally as the official medium of exchange. dollarization policy will then bring exchange rate stability and tame down the rampant inflation (berg and eduardo, 2000). official dollarization is when a country allow a foreign currency (currencies) to be a full legal tender and reduce its own currency if any to a secondary role and only issued in coins but having a small value. usually, under such arrangement there will be no risk of currency crisis. the adopted currency (currencies) will be used for both private and public transactions. however, full dollarization is relatively more difficult to reverse compared to currency board arrangements (makochekanwa, 2013). unofficial dollarization follows when domestic residents of any given country hold a large proportion of their financial wealth in foreign currency dominated assets. the foreign currency would not be a legal tender according to the country’s financial or monetary laws. under such circumstances the us dollar or any other foreign currency will be extensively used in private transactions as a medium of exchange, unit of account, store of value and standard of deferred payments. however, dollarizing an economy that has been under hyperinflation has benefits and costs to the dollarizing country (curutchet, 2001). if a country dollarize its economy it has the ability to stabilize inflation and this has been evidenced in zimbabwe when the country dollarize its economy post 2008 hyperinflation and financial crisis. the multicurrency regime managed to halt the high inflation level which was prevailing over that period. the dollarizing country’s inflation is closely linked to the anchor country’s inflation rate. this is because the dollarizing country will be relying on anchor country’s monetary policy (koech, 2011). dollarization reduce administrative expenses. the government of the dollarizing country will not bear the cost of maintaining an infrastructure devoted exclusively to the production and management of local currency for example printing money. these savings will be significant particularly to a country that has been facing economic challenges and such savings can be channeled to other productive sectors of the economy (cohen, 2000). dollarization supports the establishment of a sound financial sector. a sound financial sector would be created through financial integration with the anchor country. domestic financial institutions will be forced to improve in efficiency and service quality. dollarization can result in irreversible institutional change. where institutions will be committed to low inflation, fiscal responsibility, and transparency (cohen, 2000). it can result in lower interest rates. dollarization could result in interest rate drop for local borrowers. it lowers the level and volatility of domestic interest rates (real and nominal interest rates) through eliminating the risk of devaluation, thus eradicating the devaluationrisk premium in local currency interest rates. the government can achieve instant credibility without investing heavily in building market confidence using its own monetary policy (nkomazana and niyimbanira, 2014). dollarization can stimulate the development of domestic long-term capital markets through eradicating high inflation risk and currency devaluation. this is due to the fact that monetary policy is exogenously determined by the anchor country. thus, the dollarizing country cannot devalue the anchor currency it has adopted. the adopted currency (among other factors) brings confidence that motivates investors both locally and internationally to take part in the long term capital markets (berg and eduardo, 2000). further, dollarization can lower transaction costs. the use of the anchor currency which is highly traded and convertible such as the us dollar unlike the local currency, transaction costs in international trade and investments will be significantly reduced since there will be, if any, no need for currency conversions in international transactions. nevertheless, dollarization costs tomu, et al.: the impact of dollarization policy on zimbabwe exports: a gravity model approach international journal of economics and financial issues | vol 11 • issue 3 • 202158 counterbalances benefits that accrue to the dollarizing country. the dollarizing country will not be able to use its monetary policy since it will be exogenously determined by the anchor country. thus dollarization infers the forfeiture of autonomous monetary authority. the dollarizing country will not be able to unilaterally use its monetary policy to control the level of money supply in the economy or exchange rate. if the dollarizing country adopts the us dollar for instance as its anchor currency, the authority to use monetary policy is automatically relinquished to the us federal reserve. usually, when monetary decisions are made in the anchor country, the dollarizing country’s economic circumstances will not be taken into consideration. generally, when the country resolve to dollarize there is high likelihood that the country’s monetary autonomy will have been completely rendered useless. this is because there will be high degree of currency substitution before the decision to dollarize the economy is taken. further, dollarization result in seigniorage revenue loss. by dollarizing, the country forgo the capacity to create money otherwise known as seigniorage. seigniorage is the interest income earned by the central bank through issuing noninterest bearing money to buy interest-bearing assets. the interest is part of government revenue since a country’ central bank is part of its government. thus seigniorage can be considered as state alternative revenue source beyond what can be raised via taxation or through borrowing from financial markets at home or abroad (makochekanwa, 2013). with dollarization, the country will not be able to use inflation tax (revenue of last resort) through money printing in national emergency situations. usually, when government prints money it generate inflation in the process, hence it charges an implicit inflation tax to the citizens holding the local currency. due to inflation the real money value declines over time, thus inflation acts like a tax levied on those who hold the local currency. therefore, if the country dollarize, government can no longer print money and so it can no longer use inflation tax (cohen, 2000). the bank lender of last resort function vanish owing to dollarization. the dollarizing country domestic banks may become vulnerable to potential liquidity risks. the central bank will not be able to intervene during financial crisis. the central bank can ,however, avert domestic financial crisis given that dollarization usually reduce the overall need for international reserves, since external transactions that used to involve foreign currency is now considered as domestic transaction equivalent. thus the percentage of the central bank’s dollar assets could then be devoted to a public stabilization fund that will bail out domestic financial institutions under stress. an alternative channel is setting up of a contingency fund with foreign banks through using future tax revenue as collateral (klein, 2002). the dollarizing country will be unable to adjust exchange rate in precarious circumstances. the fact that the dollarizing country and the anchor country differ economically, necessitates that exchange rate policies have to be tailored to complement the dollarizing economic conditions. the loss of control over exchange rate policy could expose the country’s economy to external shocks given the highly integrated global markets (berg and eduardo, 2000). 2.3. the effect of dollarization on trade there have been studies conducted on the impact of dollarization on trade. a series of published papers regarding the effect of dollarization have come to different conclusions regarding the effect of dollarization policy on trade flows. the research on the effect of multicurrency arrangement on zimbabwe bilateral trade over a period from 2004 to 2012 using a total of 50 zimbabwe major trading partners, the results from the gravity model suggest that the multicurrency regime negatively affected bilateral trade by 15%. (buigut, 2015). according to makochekanwa and chimombe (2014) investigated the impact of dollarization on trade with countries that shared same currency during the dollarization policy regime. a gravity model approach was used for the study. however, the findings showed that dollarization had positive but insignificant impact on zimbabwe exports to countries it shared the same currency with. further (nkomazana and niyimbanira 2014) cited nakunyada and chikoko (2012) who tested the stationary of the current account deficit as well as examining the cointegration of exports and imports between 1990 and 2012. the results indicated that during the dollarization period the country’s current account deficit and external sector position has been unsustainable. thaver and bova (2014) applied the bounds testing approach to cointegration to estimate ecuador’s export demand function with the us between 1965 and 2011 with special focus on impact of dollarization on exports. the study results revealed that dollarization had a significant negative inelastic long and short run impact on ecuador’s exports to the us. edwards and magendzo (2003) analyzed the macroeconomic record of dollarized economies. they investigated whether dollarization is associated with lower inflation and faster growth. a matching estimator technique was applied to analyse the data. the results suggest that inflation has been very low in dollarized countries than non-dollarized countries. further, economic growth was lower in dollarized economies compared to non-dollarized economies. in case of high internal pressure to re-dollarize the economy as a result of inflation with government allowing the usd dollar to work along the local currency, insights from korab and heryan (1934) could help to understand how such a policy could affect the stability of local currency. they investigated the impact of nominal exchange rate volatility on banking deposits in two currencies in two parallel currency markets in south america, chile and argentina, where the national currency operates along with the us dollar. the use of garch model suggest that the increase in volatility of nominal exchange rate affects negatively deposits in national currency and positively deposits in the us dollar. this is because ‘’bad currency drives out the good one gresham’s law and could be the same situation that is unfolding in zimbabwe under the current economic conditions post dollarization policy. 2.4. the gravity model historical development and its specification the gravity model of international trade concept is centered on newton’s law of universal gravitation. the equation relates to the attraction force between two objects to their combined mass and to the distance separating them. the gravity model has been useful in estimating impact of several factors on international trade in many studies. application of gravity model tomu, et al.: the impact of dollarization policy on zimbabwe exports: a gravity model approach international journal of economics and financial issues | vol 11 • issue 3 • 2021 59 on international trade, however, was first proposed by james stewart in the 1940s. tinbergen (1962) first applied the model to international trade. the model predicts bilateral trade flows between countries as a function of their size and the distance between them. with economic size measured in terms of gross domestic product (gdp) or population/per capita income, distance is measured by means of distances separating capital cities of trading partner countries (anderson and wincoop, 2003). with regards to gravity model empirical work predated theories, several researchers have been able to prove beyond doubt that the gravity model fundamental assumptions can be derived from wide range of trade theories. the theoretical bases for gravity model application is a derivative of previous trade models such as ricardian and the factor proportions theory or heckscher-ohlin trade model. evidence from a series of published papers has shown that gravity model can be derived from both ricardian and ho models. adding to that, anderson (1979) as well specified that the gravity framework is consistent with a world trade model in which products are differentiated by the country of origin (muganyi and chen, 2016). though research on gravity model theoretical bases is still underway, its predictive power in international trade analysis has proved to be important. when natural logarithms of the equation derived from newtonian physics are taken, it results in the following basic form of gravity model equation. ln xij = β0+β1lngdpi+β2lngdpj+β3 ln dij+εij where: xij denotes the monetary value of trade between nation i and nation j. β0 is a regression constant. β1-3 are regression coefficients. gdpi symbolizes the gross domestic product of country i. gdpj symbolizes the gross domestic product of country j. dij is the distance in between country i and j. εij is an error term. from the above log linearized gravity model equation, it can be shown that countries with larger economic sizes in terms of gdp are likely to trade more whereas countries further apart in terms of distance are anticipated to trade less owing to indirect higher trade costs. current studies have shown that the model specification can be improved through addition of other variables that may possibly impact trade flows between countries. the variables include dummy variables such as common language, common borders and colonial ties among countries. further, the model can as well be used for evaluating policy effectiveness, for instance, impact of common currency or dollarization policy on trade flows between countries (glick and rose, 2001). 3. methodology to discover the impact of dollarization policy on zimbabwe trade flows, the study applied the gravity model approach. the model includes the multilateral resistance or country effects by cooperating dummy variables that capture effect of regional integration agreements, language and colonial ties among trading partner countries. 3.1. data sources this study uses panel data. the secondary data is collected for 20 years spanning from 2001 to 2020 with potential zimbabwe 50 historical trading partners. the uni-direction trade data in nominal us dollars was sourced from imf’s direction of trade statistics. the study has 50 countries and 20 years hence there are (2*n*n1*t) = 98, 000 bilateral trade data points since each trade flow is reported as import and export. and there were 1000 observations with 112 missing values in the data. the data for gdp and population were collected from world bank development indicators database. exchange rate data were sourced from the imf international financial statistics database. other variables that are expected to influence trade flows such as distance between trade partners, contiguity, common languages, and colonial relations are sourced from the institute of research on international economy (cepii) data base. distance is reported in kilometers and the variable is used to capture trade costs or barriers to trade in the model. the study covers africa, asia, western europe, eastern europe, north and south america and the countries are listed in the appendix 1. 3.2. empirical model the following specification of the gravity model expressed in natural logarithmic form is applied for this study: ln expijt = β0 + β1lngdpi +β2lngdpj +β3 ln nij + ln β4dij + ln β5exij+ + β6dollij+ β7sadcij + β8cij + β9 lij +εijt the variables in the above stated model denote the following: i: country 1 (zimbabwe) j: 2, 3, 4, 5,….50 (partner countries) t: 2000, 2006, 2007…2020. zim expijt: zimbabwe exports with country j in year t. gdpit: zimbabwe’s gdp in year t. gdpjt: gdp of partner j in year t. dollit: dummy variable for dollarization policy (1=dollarization period, 0 = otherwise). nit: population of country i (zimbabwe) in year t njt: population of partner j in year. t. dij: distance between capitals of zimbabwe and country j. exijt: exchange rate between zimbabwe and country j in year t. sadcij: dummy variable showing whether partner country is part of sadc. (1 = sadc, 0 = otherwise). cij: dummy variable for common colonizer (1 = trading partner has common colonizer with zimbabwe, 0 = different colonizer). lij: dummy variable for language (1 = trading partner shares a common language with zimbabwe, 0 = no common language). εijt : error term. zimbabwe gdp indicates the country’s production capacity and ability to supply export products on the international market. gdp of importing or receiving country indicates the purchasing power and absorption capacity. populations in trading countries are important factor enhancing trade flows. population represents the importer’s market size and absorption capacity. tomu, et al.: the impact of dollarization policy on zimbabwe exports: a gravity model approach international journal of economics and financial issues | vol 11 • issue 3 • 202160 3.3. estimation procedure in econometric analysis, the application of panel data has several advantages, in particular it becomes possible to analyze variables at various levels commonly referred to as hierarchical modeling. relevant to this study, panel data permits the control for variables that are difficult to observe or measured. nonetheless, the leading methods for analyzing panel data are pooled model, fixed effects model (fem) and random effects model (rem). entities respectively have their individual features which may affect explanatory variables called individual effects. for instance, infrastructure may not be included in the model but still affect trade flows of each country in the model. if individual effects are absent in the model, a pooled model will be more preferable. and if individual effects happen to exist in the model, then fem and rem will be chosen (nicita, 2013). fem controls for time invariant variances between two countries. applied primarily when the focus of the study is to evaluate the effect of predictor variables that vary over time. it controls for time invariant factors such as the political system of a particular country which may affect trade flows. the omission of time invariant factors presents bias to the fixed effects model principally on the slow changing variables. fem assumes that a certain factor within a country may affect or bias the predictor outcome. it as well omits the impact of time invariant characteristics as aforesaid, this is essentially to precisely evaluate the net impact of predictor variables on the principle or outcome variable. the principal challenge of fem is that time invariant variables cannot be estimated directly in this model (muganyi and chen, 2016). hence variables such as culture and distance between countries will not be supported in the fem. the quintessential insight in the fixed effect model is that if the unnoticed/undetected/unobserved variable does not vary over time, hence, any variation in the outcome variable must be owed to other effects than these fixed features. the important distinction between fixed and random effects is on whether unobserved individual variable impact expresses characteristics that are correlated with independent variables in the model not on whether the influences are stochastic or not. conversely, the rem assumes that the change across entities is random and uncorrelated with the outcome variable within the model. the rem allows the inclusion of time invariant variables, which are however absorbed in the intercept when fem is applied. in the rem there is need to specify individual features that may possibly or may not impact the predictor variables. the difficult with this is that some variables may not be obtainable thus leading to omitted variable bias in the model (oscar, 2007). centered on the above discussion, the rem is applied for this study using panel fgls regression method corrected for heteroskedasticity and contemporaneous correlation across panel. houseman test used to test for the presence of random effects in the model. further breuschpagan lm test was utilized to test for cross sectional correlation and an lr test was as well use to test for heteroscedasticity across panels. 4. result discussion and policy implications to find the best method to estimate the gravity model equation, the hausman test was conducted to test for cross section random effects. the null hypothesis is that random effect model is appropriate and the alternative hypothesis is that fixed effect model is appropriate. the probability of the housemen test was above 5% level of significance meaning that we accept the null hypothesis that the rem is most appropriate for the study (table a in appendix). thus, our estimation results are based on the random effect model. the sample size was big enough and so the impact of multicollinearity on estimated results was controlled. further, breusch-pagan lm test was utilized to test for the presence of heteroskedasticity and contemporaneous correlation. however, the test indicated that there was cross sectional dependence and heteroscedasticity across panels (table b and d in appendix). to correct for these a fgls specification was used for correcting heteroskedasticity and contemporaneous correlation across panels. the estimated results in table below indicates that zimbabwe exports are influenced by dollarization policy, sadc membership status, trading partner countries gdp, zimbabwe gdp, zimbabwe bilateral exchange rate, population of partner countries. 4.1. impact of dollarization policy on exports the period under dollarization policy was significant at 1% level with a negative coefficient of 1.028681. hence the period under assessment when zimbabwe adopted usd as the country’s anchor currency had a negative but big impact on exports of −64% i.e., 100(e−1.028681−1) between zimbabwe and its 50 historical major trading partners. it indicates that zimbabwe’s exports were relatively uncompetitive in the world market, which can be attributed to the weak international competitiveness on the overvalued exchange rate of the usd which was the dominant currency in both public and private sector transactions. higher prices of domestically produced goods are uncompetitive in the international market. thus, the appreciation of exchange rate reduces export volumes and increase the appetite for imports. the cost of a basket goods in zimbabwe over that period perhaps was very high compared to the cost of goods of its trading partners. these results confirm findings of other researchers on the impact of dollarization on trade. conferring to the research carried out on the effect of dollarization on ecuador exports. it has been found that dollarization negatively affected ecuador’s competitiveness as its exchange rate appreciated, making its goods more expensive than its trading partners (thaver and bova, 2014). however, some proponents of dollarization policy as well acknowledged that dollarization undesirably affect export growth. the recent internal pressures to re-dollarize the economy requires an understanding of what they ought to focus on in the event that de-dollarization process fails. policy makers ought to rely on internal devaluation, since under dollarization policy, monetary and exchange rate policies are exogenously determined, internal devaluation can be attained by measures designed to exert downward pressure on domestic costs, wages and prices. as well, government has to create an environment that encourage foreign direct investment inflows to address liquidity challenges likely to be experienced under dollarization regime. 4.2. impact of gdp zimbabwe gdp was positive with a coefficient of 2.527158 and significant at 1% level. a 10% increase in gdp could tomu, et al.: the impact of dollarization policy on zimbabwe exports: a gravity model approach international journal of economics and financial issues | vol 11 • issue 3 • 2021 61 i n c r e a s e e x p o r t s b y 2 5 0 % . i t i n d i c a t e s t h e c o u n t r y ’s production capacity and ability to supply export products to the international market. thus zimbabwe has to focus on addressing economic fundamentals affecting economic growth. the gdp of zimbabwe historical trading partners was positive with a coefficient of 0.359306 and significant at 1% level. a 10% increase in gdp of importing or receiving country surge the demand of zimbabwe exports by 35%. hence the rise in gdp of trading partners as well increase the purchasing power and absorption capacity of these countries. zimbabwe policy makers have to pay particular attention to trade cycles and take advantage during periods of high gdp growth rates in trading partner countries. 4.3. zimbabwe bilateral exchange rate exchange rate has a significant negative coefficient of −0.032718 at 1%. a decrease in the exchange rate suggests that the appreciation of the local currency makes the exportable goods expensive. this implied that appreciation of exchange rate has implication on zimbabwe export growth. a 10% appreciation of the exchange rate has a 3% negative effect on exports. the appreciation of the local currency may cause locally produced goods to be more expensive when compared to same basket of goods produced in other countries, making exports expensive. the findings concur with theoretical predictions that the exchange rate movements are positively related to export growth. 4.4. effect of sadc membership status the coefficient for regional integration was positive 3.362263 and significant at 1% level. the fact that zimbabwe is a sadc member country and the countries as well share the same continent, this had positive impact of 2896% i.e., 100(e3.4−1) on exports in the sadc region. this could be the result of geographic proximity and bilateral trade agreements signed in the region. however, since south africa is the major historical trading partner in the region both in terms of imports (43%) and export (19%) volumes, its economy is larger when compared to that of zimbabwe, hence it has the capacity to absorb zimbabwe exports. 4.5. impact of population, common language common colonizer and distance the population coefficient was positive 0.421688 and significant at 1% level, demonstrating that the greater the population in the partner countries has a positive impact on zimbabwe exports. a 10% increase in population may lead to 42% in demand for zimbabwe exports. if the population in trading partner countries is high it create the market and increase demand for zimbabwe exports. thus population in trading partner countries is an important factor that enhances trade flows. population represents the importer’s market size and absorption capacity. the coefficient of distance is negative but insignificant to explain variations in zimbabwe exports to its 50 trading partners. however, it confirms that the greater the distance between countries the lower their trade due to higher trade costs. the common language and colonizer variables were nevertheless not significant in the study. 5. conclusion the focus this paper was to examine the impact of dollarization regime on zimbabwe exports. several studies have been conducted in this area using the gravity model approach. nevertheless, few if none have focused on the impact of dollarization policy, which was put in place post 2008 hyperinflation. the conclusions of the study indicated that dollarization policy, gdp, bilateral exchange rate, sadc membership status and population explains most of the variation in zimbabwe exports. when zimbabwe adopted usd as the country’s economic anchor currency in 2009, the dollarization policy is found to have a negative impact on exports of 64% between zimbabwe and its 50 historical trading partners. still, post dollarization high inflation rate threatened to weaken the recently introduced bond notes. this have renewed calls to re-dollarize the economy. the unofficial economy re-dollarization in the recent past between year 2018 and 2020 have undermined the role of local currency in the domestic financial system. nonetheless, if government going forward is forced to re-dollarize the economy, focus should be directed on the real exchange rate devaluation. the devaluation of the real exchange rate is achieved by addressing cost drivers that make locally produced goods uncompetitive on the international market such as high electricity, water, borrowing and labour costs, poor infrastructures, high transportation, multiplicity of fees and charges, tariff policy and cumbersome regulations and procedures without lowering the nominal exchange rate value. this should improve competitiveness of tradable goods under dollarization policy. further, bilateral exchange rate was found to influence exports. a 10% appreciation of the exchange rate has a 3% negative effect on exports. monetary authorities ought to put in place exchange rate policies that favour export growth. there is also need to address economic fundamentals to stimulate gdp growth. it has been found that a 10% increase in gdp could increase exports by 250%. if enough resources are channelled towards increasing the country’s production capacity, this will enable the country to have the ability to supply export products to the international market, and curb import growth. also, attention should be paid to gdp growth rates of zimbabwe trading partners. because evidence from the study shows that a 10% increase in gdp of importing table 1: estimation results dependent variable zimbabwe exports variable coefficient std. error t-statistic prob. common colonizer −0.446518 0.531837 −0.839577 0.4014 common language −0.458985 0.503382 −0.911804 0.3621 dollarization policy −1.028681 0.171176 −6.009500 0.0000 sadc membership status 3.362263 1.053501 3.191513 0.0015 ln gdp of partner countries 0.359306 0.148732 2.415790 0.0159 ln zimbabwe bilateral exchange rate −0.032718 0.010892 −3.003732 0.0027 ln distance −0.091136 0.464524 −0.196193 0.8445 ln population of partner countries 0.421688 0.167250 2.521311 0.0119 ln zimbabwe gdp 2.527158 0.487964 5.178983 0.0000 constant −53.60932 11.77567 −4.552550 0.0000 source: researchers’ own estimation. significant at 1% level tomu, et al.: the impact of dollarization policy on zimbabwe exports: a gravity model approach international journal of economics and financial issues | vol 11 • issue 3 • 202162 or receiving country increase the demand of zimbabwe exports by 35%. zimbabwe could take advantage of boom cycles in the global economy, since demand will be at its pick. same applies to global population growth, population presents opportunity by creating market and demand for the country’ domestically produced goods. evidence from this study indicated that a 10% increase in partner country population may lead to 42% demand for zimbabwe exports. sadc membership status was found to have a positive impact on export growth of 2896%. thus countries in the sadc region should focus on lowering the barriers to trade and simultaneously taking full advantage of geographic proximity that permit the lowering of trade costs. this could be used as a route to improve trade and economic growth of the countries in the region. the above estimated results are not exclusively irrefutable due to a number of panel data econometric manipulation restrictions as well as the integral limitation of the gravity model application in trade enquiries. notwithstanding the aforesaid glitches, we powerfully accept as true that the study delivers great insights on the influence of dollarization policy, gdp, bilateral exchange rate, regional integration and population on zimbabwe exports. these are important insights particularly at a time when the monetary authorities are under pressure to re-dollarize the economy. references anderson, j.e. 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[last accessed on 2016 oct 20]. tomu, et al.: the impact of dollarization policy on zimbabwe exports: a gravity model approach international journal of economics and financial issues | vol 11 • issue 3 • 2021 63 table 1c: likelihood ratio test null hypothesis: homoscedastic likelihood ratio test model chi-sq prob. random effects 4712.204 0.43520 table 1a: correlated random effects hausman test correlated random effects hausman test test cross-section random effects test summary chi-sq. statistic chi-sq. d.f. prob. cross-section random 0.000000 6 1.0000 table 1b: residual cross section dependence test residual cross section dependence test null hypothesis: no cross section dependence (correlation) in residuals breusch pagan lm model chi-sq prob. random effects 5212.204 0.56560 table 1d: zimbabwe historical trading partners zimbabwe historical trading partners united states italy denmark russia israel united kingdom india philippines portugal sweden germany singapore egypt senegal malawi japan uganda hungary mexico namibia china poland australia turkey botswana france malaysia finland south korea zambia south africa canada kuwait brazil vietnam belgium mauritius indonesia burundi new zealand netherlands greece ireland united arab emirates mozambique kenya switzerland czech republic morocco nigeria appendix 1 tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(5), 211-219. international journal of economics and financial issues | vol 10 • issue 5 • 2020 211 business process life cycle affects company financial performance: micro, small, and medium business enterprises during the covid-19 period widarti*, desfitrina, zulfadhli faculty of economics and accounting, tamansiswa university, indonesia. *email: widartisuhaimi32@gmail.com received: 01 july 2020 accepted: 01 september 2020 doi: https://doi.org/10.32479/ijefi.10516 abstract the business process life cycle is a collection of structured work activities that are interconnected to solve a problem that results in an output (product/ output) or service that achieves goals and supports the achievement of strategic goals and objectives of an organization’s financial performance. business processes aim to achieve financial performance that is effective, efficient and increases the productivity of an organization. the life cycle of micro, small and medium enterprises aims to survive post-covid-19 in order to increase the productivity performance of the organization’s financial performance. to achieve this goal, an organization needs a good business process to support the organization’s financial performance and business ventures in designing activities to produce new products in order to develop management techniques so that they can survive the midst of the global covid-19 crisis. the product life cycle that can identify opportunities for environmental improvement is an important part of an organization that aims to minimize total costs, low prices and production results, improve the financial performance of micro, small, and medium business processes. techniques in producing using financial and non-financial information, to improve the company’s financial performance, and to contribute to the sustainability of business processes aim to provide physical information on material and energy use, as well as monetary information on costs, revenues and savings related to the company’s financial performance. this research was carried out on micro, small and medium enterprises in indonesia. this research method is descriptive and verification methods, the analysis tool is structural equation modeling (sem, lisrel). the results showed that the business process life cycle had an effect on the financial performance of the covid-19 small, and medium enterprises business companies. keywords: business process life cycle, corporate financial performance, micro, small and medium enterprises, covid-19 period jel classifications: e3, g2 1. introduction micro, small and medium enterprises are the sector most vulnerable to the impact of the corona virus pandemic. hertati and safkaur (2020) this sector can no longer be a buffer for the economy like during the 1998 and 2008 economic and financial crises. when indonesia experienced the 1998 monetary crisis, micro, small and medium enterprises became a buffer for the national economy. absorb labor, and move the economy (clemente, 2020). then hertati, et al. (2020) stated that during the global financial crisis, micro, small and medium enterprises remained strong to support the economy. the results of the study concluded that the covid-19 outbreak was concerning in the financial crisis and affected the financial sector of micro, small and medium enterprises (hertati et al., 2020). many micro, small and medium enterprises never got access to finance from the financial sector, the government. controlling the distribution chain of covid-19 so as not to have an impact on the economy strategies to strengthen micro, small and medium enterprises that can be done, such as digitizing sales or marketing, digitizing payments, and transferring sme businesses difficult financing, slow distribution, difficulty in raw materials, and slightly hampered production (ohlson, 1980). chan (2013) states that the success of a business process in a company is the employee who will carry out the business process. this journal is licensed under a creative commons attribution 4.0 international license widarti, et al.: business process life cycle affects company financial performance: micro, small, and medium business enterprises during the covid-19 period international journal of economics and financial issues | vol 10 • issue 5 • 2020212 braz et al. (2011) in carrying out a good business process, reliable employees are needed so that the business process can be carried out properly. in order for a company to want a good business process life cycle, human resources and personnel must be able to recruit employees who are brewer, (2001) and bourne, et al. (2000) and brintrup, et al. (2015) state that like humans, the products of micro, small and medium enterprises also have a life cycle. old products will be displaced by consumer demand for new things modern goods, further increase sales at launch. therefore, every company needs to know the different stages of the product life cycle and understand that all the products they sell have an age limit. the majority of companies will invest in new product development in order to ensure that business processes continue to grow. the phenomenon states that the business process of the covid-19 period that occurred in early 2020 experienced a collapse, as disclosed by santoso (2020), as chairman of the ojk board of commissioners to change the mindset and behavior of business as usual into creative actions in order to get breakthroughs (from a policy aspect and to monitor policy implementation so that micro, small and medium enterprises continue to grow healthily amid the corona outbreak that hits all over the world so that financial performance small and medium micro business companies can support the economy which is in an uncertain situation due to the devastation of covid-19. this is done so that ojk contribution in handling the economic aspects of the era of adaptation to new habits becomes more effective, efforts to move the economy are said to be able to take advantage of placement of state funds as stipulated in pmk no.70/2020. for the implementation of providing working capital credit to drive the real sector and especially msmes, ojk refers to pmk no.71/2020 concerning procedures for government guarantees through the guarantee business entity designated in the framework of implementing the economic recovery program national. the ojk is currently preparing various possibilities to issue a further relaxation policy regarding the restructuring period, the minimum credit limit, and support for the economic sector which will leverage the return of economic growth. ojk has issued various policies starting with the relaxation of credit restructuring. as of june 29, 2020, the overall realization of credit restructuring in the banking sector was recorded at idr740.79 trillion for 6.56 million debtors for micro, small and medium enterprises and nonmicro, small and medium enterprises. the restructuring realization for msmes amounted to idr317.29 trillion for 5.29 million debtors and idr423.5 trillion for nonmicro, small, and medium enterprises for 1.27 million debtors. research by gomes et al. (2004) found that the life cycle of business processes produced by micro, small and medium enterprises can help improve the company’s financial performance because of instructions from managers who are responsible for the company’s finances and try to make efforts to reduce expenses. research by gopal and thakkar (2012) and flynn (2010) found that by implementing a company’s business process life cycle can be done with cost savings so that financial performance increases. likewise with gopal and thakkar et al. (2012) who found that the application of business processes can increase profit growth through the use of information on reducing annual production costs. meanwhile, hertati and syafarudin (2018) stated that apart from reducing costs, the business process is useless, it can also be used to demonstrate the potential for investment in raw materials that are useful to generate significant financial benefits through avoiding useless costs. the company business process lifecycle is already part of an important decision-making tool in most companies in the developed world (price and sun 2017). the results of research by rajesh et al. (2011) and hertati et al. (2020) state that the main motivation for developing a business process life cycle is to provide a basis for improving the company’s financial performance. corporate finance generated by micro, small and medium enterprise accounting, especially cost information that is not value added, can help management control costs so as to produce cost savings which in turn will improve financial performance (padachi, 2006). the global business environment with high competition puts pressure on company management to increase productivity. various management tools have been used to address these challenges. one of the financial performance tools (syafarudin and hertati, 2020). ozturk et al. (2015) suggested that applying a business process life cycle approach is expected to aggregate company activities into strategic actions in relevant activities to understand cost behavior and potential sources of differentiation which can be an effective tool for optimizing resource use. some researchers have developed such research as brintrup, et al. (2016) to explain why business processes can be an important financial managerial tool. innovation in general is an important aspect of many businesses that can play a role in gaining business excellence (yang et al., 2017). business excellence can only be achieved by continuous improvement. the application of continuous improvement can be done by implementing a business strategy so that financial performance increases (yang, 2014). value chains are relationships with business processes that can meet targets of cost reduction, increase market efficiency, improve customer service, and ultimately improve financial and competitive position for organizations participating in value chain relationships. the research results show that companies that put more emphasis on business models based on innovation have experienced higher operating and sales growth rates (zhao, 2011). roodman (2009a) found that for manufacturing organizations, process innovation plays an important role in improving competitive advantage as a key factor in the successful implementation of business processes. this is supported by the results of research on the application of business processes to be part of the determinants of organizational success through innovation (roodman, 2009a). research conducted by (yang et al., 2017) concluded that after the application of business processes in the company, management is able to increase competitive advantage so that the company is widarti, et al.: business process life cycle affects company financial performance: micro, small, and medium business enterprises during the covid-19 period international journal of economics and financial issues | vol 10 • issue 5 • 2020 213 able to create competitive value for customers in order to improve the company’s financial performance. business processes are used with various purposes, namely to understand the behavior of the costs and the sources of differentiation (zhao et al., 2011; thompson et al., 1996) investigated the life cycle of business processes using various types of variations in order to improve financial performance. company including the life cycle of micro, small and medium enterprises. business processes provide a useful set of perspectives for companies to achieve a company competitive position (ozturk, 2001). yang et al. (2017) argue that there are two benefits that can be the objectives in implementing business processes, namely how to accept various products (product differentiation) and create cost leadership. companies that implement business processes have an impact on the company’s financial profit in two ways (yu et al., 2008). first, activity efficiency will have an impact on the company cost structure. second, with a mix of activities that apply business processes will provide a high level of satisfaction for consumers (yu et al., 2008). 2. literature review jensen, (1986) company owners and company management are the principals and agents, while management is the person who is authorized by the owner to run the company called the agent. eljelly (2004) defines an agency relationship as a contract, in which one or more people (employer or principal) employ another person (agent) to perform a number of services and delegate the authority to make decisions to the agent. the principal provides facilities and funds for company operations, the agent is obliged to manage the company with the aim of increasing the prosperity of the company owners (edwards and barron, 1994). the theory that underlies the company business processes that are used so far. the main principle of this theory states that there is a working relationship between the party giving the authority (principal), namely the investor, and the party receiving the authority (agency), namely the manager. the legitimacy given by the community to the company, and at the same time something that the company needs. legitimacy is the potential benefits, opportunities and resources needed in order to maintain the company going concern. folan (2005) states that companies need to maintain the values adopted by the surrounding community. this has led to a positive perception of investors, because the investment will be a going concern for companies that have going concern prospects, with a policy of paying attention to the surrounding community. legitimacy theory explains that the organization will continuously operate in accordance with the boundaries and values accepted by the community around the company in an effort to gain legitimacy (choi et al., 2005). the process of gaining legitimacy is related to the social contract made by the company and various parties in the community. the company’s performance is not only measured by the profit generated by the company, but other performance measures related to various interested parties. to gain legitimacy, the company has an incentive to carry out the social activities expected by the community around the company operational activities. 2.1. business process life cycle yu et al. (2008) explain that business processes are procedures and policies of people in the organization that are used to create value for stakeholders (customers, shareholders, vendors to name a few). argued that a business process is a set of relationships, coordinated, and structured activities and tasks performed by a person or by a computer or machine, and help achieve predetermined organizational goals. in line with this, stair and rost et al. (2017) explain that a business process is a set of coordinated and related activities that take one or more types of input and create outputs that have value to customers from that process (ozturk, 2001). defines a business process as a coordinated and standardized flow of activities carried out by people or machines, which can cross functional or departmental boundaries to achieve business goals that create value for internal or external customers. in line with this ozturk (2006) a business process is a series of tasks that are interconnected and involve data, organizational units, and logical time sequences. then said et al. (2003) say that a business process is a collection of activities and workflows in an organization that create value. in line with this, said (2013) explains that the functions that exist in business processes are: 1. production and manufacturing cycle includes assembling products, checking quality, generating bills for materials. 2. marketing and sales cycle includes customer determination, making customers aware of products, selling products 3. the accounting and financial cycle includes payment of creditors for purchases, making financial statements, managing cash accounts 4. the human resource cycle includes recruiting employees, evaluating employee performance, enrolling employees in a benefit plan/pension fund 5. the income cycle, in which goods and services are sold for cash or receivables 6. the expenditure cycle, where the company buys inventory for resale or raw materials to be used in producing the next product to issue cash or payment in the future. 2.2. financial performance of covid-19 micro, small, and medium enterprises business companies gepp et al. (2008) stated that financial performance is an indicator that is often used to measure the success of a company. fiss, (2007) states that measuring the financial performance of rost and ehrmann (2017) states that financial analysis is a business analysis that uses financial statements to analyze the performance and financial position of a company to assess financial position and performance, and to assess financial performance in the future. future (to come). the use of financial analysis as a measure of performance achievement, some of which still use contemporary financial performance indicators such as economic value added (eva) and market value added as well as measurement of profitability in the form of ratios such as return on investment (roi), return on assets (roa) and return on equity (roe) is still relevant to use because it is simpler, more comprehensive, and can be used by all companies (wang et al., 2008). widarti, et al.: business process life cycle affects company financial performance: micro, small, and medium business enterprises during the covid-19 period international journal of economics and financial issues | vol 10 • issue 5 • 2020214 ratios cannot describe good management, but can create better managers because they can help show this. matters that require further research in developing corporate strategy in the future (roodman 2009b). ratios cannot describe good management, but they can create better managers because they can help show things that require further research in developing corporate strategy in the future (gronum et al., 2017). other researchers such as hertati, et al. (2019) relate it to economic performance. economic performance is more general in nature and financial performance is included in it, however in various studies there has been a separation (gonenc and scholtens, 2017). then ozturk (2001) states that economic performance is more often associated with market-based measures with measures that are often used in the form of market portfolios, annual returns, stock prices, market returns, stock market responses, price-earning ratios, and so on. other. financial performance is linked to accounting-based measures, namely in the form of profitability of various sizes (franco et al., 2012). both accounting-based and market-based measures have their respective advantages and disadvantages as performance measures. however, market-based measures can only be used in public companies where the value of the company is measured by the value of its shares (ozturk et al., 2009). salazar et al. (2015) argue that accounting-based financial performance is a better predictor of measuring the success of environmental and social management, including its disclosure. roodman et al. (2008) stated that the company’s financial performance is ultimately reflected in the profit generated. roi, roa and roe are the most commonly used measures of profitability. roi and roa are often used interchangeably because they refer to the same thing, namely the ratio of profits to assets owned. 1. liquidity ratio: to measure the company ability to pay its debts, it can be seen in the company financial performance assessment used. 2. leverage ratio: to measure the extent to which the company’s assets are financed with debt, it can be seen in the measurement of the company’s financial performance appraisal used. 3. a c t i v i t y r a t i o : t o m e a s u r e h o w e f f e c t i v e t h e c o m p a n y i s i n u s i n g i t s f u n d i n g s o u r c e s . can be seen in the measurement of the company financial performance appraisal used. 4. profitability ratios: the final results of a number of policies and decisions that have been taken by company management can be seen in the measurement of the company financial performance appraisal. used. 2.3. business process life cycle on the financial performance of covid-19 micro, small, and medium enterprises business companies lazaridis, (2007) states that the success of a company’s financial performance can be measured in the business process life cycle in order to improve organizational structure and culture and increase customer and company business value. in line with this, rhou (2016 stated that the company’s financial performance is supported by business processes. while roodman (2008) argues that currently one of the things that will continue to influence the development of financial performance is business processes. 1998) states that the factors that need to be considered by the central organization when planning, implementing financial performance, one of which is the business process.this is supported by the research of saaty et al. (1998) which found that 11 important factors for the success of financial performance are: teamwork and composition; changing management programs and culture, support for planning management and business vision, business processes, reengineering with minimum customization; project management; performance monitoring and evaluation; effective communication; financial performance and proper business processes and it systems. estampe et al. (2013) stated that business process factors were found to be pe important for the success of financial performance and composition; business programs and processes, re-engineering with minimum customization; project management; performance monitoring and evaluation; effective communication; software development; testing and problem solving, appropriate business and financial performance. (christopher, 1998) research hypothesis: h1: the effect of the business process life cycle on the financial performance of covid-1 micro, small, and medium enterprises business companies next research conducted by rafuse (1996) found that the production process, customer service can improve business performance and implications for financial performance. finance and accounting, information processing and other processes can improve financial performance. in line with this, the results of a study conducted by roodman (2008) indicate that most cases in all areas of business processes are integrated into unique financial performance. meanwhile, a study conducted by panwala (2009) found that the design of financial performance again can be influenced by business processes. image: 2020 research framework. 3. methodology the review instrument was built using previous studies. the characteristics of the variable hypothesis were designed using sem-lisrel with five answers from 1 to 5. the measurement items widarti, et al.: business process life cycle affects company financial performance: micro, small, and medium business enterprises during the covid-19 period international journal of economics and financial issues | vol 10 • issue 5 • 2020 215 of the current study consisted of two business process life cycle variables on the financial performance of micro, small and medium enterprises business companies during the covid-19 period. the population contained in this study amounted to 250 regional work units and set precision or a significance level of 0.05 (fox, 2016). the research data was collected by using a questionnaire via google box directly and sending letters to micro, small and medium enterprises as many as 850 questionnaires. after sending the google box to micro, small and medium enterprises in indonesia. the process of selecting micro, small and medium enterprises in indonesia is very important for data collection for researchers, investigating product sales and the financial performance of msme business companies in the covid-19 period to respond. overall, the data collection process has been taken for 3 months and this research was conducted independently. (fox, 2016, 2016). states that to measure reliability in sem variance) composite reliability (internal consistency reliability) and variance extract measure (measure of variant extract) can be used. to determine the minimum sample required if the population is known, can use the slovin formula with the assumption that the tolerable sampling error rate is 5%. (fox, 2016). to calculate this relationship, the following formula is used: ( ) ( ) ( ) ( )2 22 2 . . − = − − ∑ ∑ ∑ ∑ ∑ ∑ ∑ n xy x y r n x x n y y information: r = correlation coefficient x = business process life cycle variable y = variable financial performance of micro, small and medium enterprises in the covid-19 period n = number of respondents to determine the effect of business process life cycle variables, the covid-19 coefficient of determination (r²) is used to determine the financial performance of micro, small and medium enterprises business companies. 4. data analysis the validity test was conducted which was used to determine the feasibility of the items in the questionnaire to determine the variables and the reliability test to measure the reliability of the object being measured. data analysis was carried out by descriptive analysis and verification. descriptive analysis was carried out with balanced categorization using quartile ranges (fox, 2016, 2016). the verification analysis used to test the hypothesis in this study is to use the structural component of the modeling equation (sem, lisrel) or variance based known as sem lisrel (arellano and bond, 1991) descriptive analysis of authorization, planning, supervision, allocation, distribution, stability of the statement. -the statement submitted on the questionnaire. based on the calculation of the percentage score for the craftsmen’s answer, the results are as shown in the following table (tables 1-6): testing carried out in the inner model in assessing the model with pls begins by looking at r2 for each dependent latent variable. changes in the value of r2 can be used to assess the effect of certain independent latent variables on the dependent latent variable whether it has a substantive effect. the ave results show that the indicators owned by each variable can measure the variable in question. discriminative validity is to compare the square root of average variance extracted (ave) value of each construct with the correlation between constructs and other constructs in the model. where the ave value must be> 0.50. this can be seen from the significance value of 0.026. therefore the hypothesis for a direct effect in this variable is accepted. the level of significance (p < 0.05) at a level below 0.05 indicates that the business process table 1: test results. results of square roots of ave no. dimension square roots of ave 1. 2. 3. 4. 5. 6 production cycle the marketing and sales cycle the accounting and financial cycle human resource cycle income cycle discharge cycle 0.829 0.749 0.612 0.752 0.601 0.851 source: uji. square roots of ave results, 2020 table 2: test results composite reliability no. dimension composite reliability cronbach alpha 1. 2. 3. 4. liquidity ratio leverage ratio activity ratio profitability ratio 0.846 0.820 0.860 0.821 0.852 0.836 0.841 0.852 source: composite reliability test, 2020 table 3: goodness of fit test results on the inner model measured using r square no. model r square 1. business process life cycle 0.126 source: goodness of fit test on the inner model is measured using r square, 2020 table 4: q square test results no. model q square 1. detect financial fraud 0.432 source: q square test results. spss data processing, 2020 table 5: direct effect testing results no. direct influence koefisien signifikansi information 1. the financial performance of micro, small, and medium enterprises in the covid-19 period −0.408 0.026 received source: results of direct effect testing spss data processing, 2020 table 6: goodness of fit (gof) results in the final model no. criteria value limit result conclusion 1. 2-chi square, significance probability p-value≥0,050 atau=0,000 0,000 fit 2. gfi > 0,90 0,734 fit 3. agfi > 0,60 0,647 fit 4. cfi > 0,92 0,953 fit 5. tli atau nfi > 0,81 0,771 fit 6. rmr ≤ 0,20 0,081 fit 7. rmsea ≤ 0,06 0,056 fit source: data processed in 2020 widarti, et al.: business process life cycle affects company financial performance: micro, small, and medium business enterprises during the covid-19 period international journal of economics and financial issues | vol 10 • issue 5 • 2020216 life cycle affects the financial performance of micro, small and medium enterprises in the covid-19 period. the reliability test was carried out by using the cronbach alpha test using spss. a construct is said to be reliable if it gives a cronbach alpha value > 0.60. structural equation model (sem) with partial least square (pls) method using warp pls 5.0 software. this method was first coined by wold as a general method for estimating the path model using a latent construct with multiple indicators. pls is an indeterminacy factor in a powerful analysis method because it does not assume that the data must be measured at a certain scale and a small number of samples (arellano and bond, 1991).) such as χ2, gfi, agfi, cfi, tli or nfi, rmr, and rmsea, so that the financial performance model of the covid-19 msme business company has met the criteria for a good measurement model (fit) and can be used as a manifest for the formation of a full model . the results of the goodness of fit suitability test for the final model of the financial performance of micro, small and medium enterprises business business companies in the covid-19 period obtained results such as in the recapitulation of the results of dimensions and detection indicators of financial performance in micro, small and medium enterprises in the covid-19 period. in sem analysis, an indicator is said to have good validity if it has a loading factor value greater than 0.70. while the loading factor of 0.50 to 0.60 can still be maintained for models that are still in the development stage (fox, 2016). evaluation of the construct reliability value is measured by composite reliability. each construct is said to be reliable if it has composite reliability greater than 0.70 and ave greater than 0.50 (arellano and bond, 1991). the final model of the cfa decline in the financial performance of the covid-19 umkm business companies that was formed had met several goodness of fit (gof) statistical criteria such as χ2, gfi, agfi, cfi, tli or nfi, rmr, and rmsea, so that the financial performance measurement model covid-19 msme business companies meet the criteria for a good measurement model (fit) and can be used as a manifest for the formation of a full model. the results of the goodness of fit suitability test in the final model of financial performance for micro, small and medium enterprises business enterprises in the covid-19 period are shown in the table. 5. discussion manita et al. (2018) stated that the success of a company solely depends on maximizing the welfare of the leadership (stockholders) is no longer relevant, because the existence of a corporate entity is basically a contract between the company and various other parties (maqbool, 2018). megginson (1994) and chenhall, (2005) state that a group of people who are in a company cannot run and maintain their operations as a going concern.” this group includes shareholders and investors, employees, customers and suppliers, as well as public stakeholders, namely management and consumer, where the company is bound by laws and regulations as well as on taxes and other obligations. the second group is secondary stakeholders, namely “a group of people who influence or are influenced by the company but are not very important for the company survival. nuss, (2016) explains that in developing the reach of company stakeholders, it is not only financial stakeholders such as investors and creditors but also non-financial stakeholders such as suppliers, customers, regulators, environmental groups, and the mass media. ohlson, (1980) developed a model for identifying stakeholders based on the level of power (power), legitimacy (legitimacy) and interests (urgency). al-fattah, (2013b) states that managers must focus their attention on stakeholders based on these three things, but the order does not have to be the same for every company. for example, companies that are prone to labor problems should pay more attention to workers or employees. meanwhile altman, (1968) states that companies that process natural resources or whose activities have an impact on the surrounding environment must pay more attention to consumer customers where the company processes products and designs and introduces these products to the public to be interested (altman and eberhart, 1994). the study results concluded that the application of the business process life cycle can improve the integrity of financial statements (lazaridis, 2007). researchers suggest holding a turnover of the audit team every three years and with high ethics applying gaap to improve financial reporting transparency. the results of a study conducted by hertati et al. (2020) related to the life cycle of business processes concluded that corporate, economic, social, cultural, legal and regulatory can be considered. one of the causes of the economic crisis is weak governance in the form of insecure segregation of functions within the company (lee and park 2010). the life cycle of business processes in a company will have an impact on the financial performance of company policies such as leverage, dividends, compensation and others. the manager (agent) will try to align with the principal objective, namely shareholder prosperity. in determining dividend and debt policies, inevitably it must be admitted that agency conflicts will also arise. opportunistic behavior of agents has the potential to direct policies that are only beneficial for themselves. however, this can be minimized if the company implements business processes (lee et al., 2013). by reducing opportunities for managers to behave deviantly and enriching themselves, it is expected that the company value will increase, which is marked by an increase in share prices and the prosperity of shareholders. abdulkadir et al. (2017) stated that effective business processes are expected to improve the company financial performance. the benefits of implementing a business process can be seen from the company stock price that investors are willing to pay. business processes can provide high protection for investors (denis, 2010) and can increase dividend payments (choy et al., 2011). the application of business processes will have an impact on high protection of investors, thereby reducing information asymmetry to a lower level (hertati et al., 2019). the application of business processes is also considered to reduce the risk of failure of the company’s business (saaty, 1996). research by megginson et al. (1994) proves that business processes are one of the factors that can explain the market value of a company. widarti, et al.: business process life cycle affects company financial performance: micro, small, and medium business enterprises during the covid-19 period international journal of economics and financial issues | vol 10 • issue 5 • 2020 217 6. conclusion this research focuses on how business processes, companies can control product costs that may previously have been difficult to control because they were hidden in overhead costs. the financial performance of micro, small and medium enterprises in the covid-19 period allows product prices to be identified, measured and allocated appropriately to related processes or products, making it easier for managers to control and save costs. with cost control based on the information provided by the business process, cost efficiency can be achieved so as to improve the company’s financial performance in order to support the economy in the midst of the covid19 pandemic. organizations that use the financial performance of micro, small and medium enterprises in the covid-19 period will design activities in producing cheap products that are of interest to the public and develop management techniques that do not endanger consumers. this allows the organization to use a product life cycle system that can identify opportunities for product improvement aimed at providing physical information on material and energy use so that products do not become obsolete, as well as monetary information on costs, income, and savings associated with consumers. in order to improve the financial performance of micro, small and medium enterprises in the covid-19 period. 7. acknowledgments this research was conducted by sending goole forms to micro, small and medium enterprises. we thank friends who have taken the time to fill out our very useful questionnaire form to complete this research in the covid-19 season even though they are not busy with all the interpretations/conclusions of this paper. references abdulkadir, a.r., ozturk, i. 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(2011), analyzing the resilience of complex supply network topologies against random and targeted disruptions. ieee systems journal, 5, 28-39. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(3), 768-778. international journal of economics and financial issues | vol 7 • issue 3 • 2017768 tax reforms and tax yield in nigeria bassey okon ebi1*, oluwafemi ayodele2 1department of economics, university of calabar, calabar, nigeria, 2department of economics, university of calabar, calabar, nigeria.*email: ukotebi@yahoo.co.uk abstract this study estimates elasticity and buoyancy of various tax components as well as the impact of tax reforms on tax components in nigeria between 1981 and 2014. error correction mechanism (ecm) technique was employed in analyzing the data. the results revealed that: all the tax components were inelastic, there was a general improvement in post-reformed tax elasticities ranging from 0.199 to 1.28 with petroleum profit tax and the total tax revenue having coefficients >1, values of tax buoyancies were all positive and <1, with post reform samples buoyancies being greater than that of common samples ranging from 0.13 to 0.93, tax reform was further confirms to improve tax revenues by positive and significant coefficients of the dummies. based on the findings, the study recommended that: government should diversify the economy for more development as well as strengthening tax reforms in order to increase overall tax revenue. keywords: tax reforms, tax elasticity, tax buoyancy jel classification: h250 1. introduction governments require revenue to augment the spending needs of maintaining adequate level of public investments and social services, and taxes constitute the main source of raising revenue in both developed and developing countries. tax reform is a process of changing the way taxes are collected or managed by the government in order to enhance tax yields-cum-revenue. accordingly, the governments of nigeria have carried out a number of tax reforms over the years. such notable reforms in nigeria include: establishment of federal inland revenue service (firs) in 1992 through the finance (miscellaneous taxation provisions) act no. 3 and decree no.104. with the passage of the firs (establishment) act, the firs was granted financial and administrative autonomy from civil service bureaucracy in terms of funding, personnel and material resource management (firs, 2014). other prominent tax reforms include the introduction of value added tax (vat) in 1992 which was prompted by the recommendation of the dr. sylvester ugoh led study group on indirect taxation, imposition of 10% and 2.5% levy on banks’ excess profits and on building and construction companies respectively (olajide and associates, 2013). the primary motivation for tax reforms-cum-revenue mobilization in nigeria has been the need for diversified tax base and increased revenues. the need to raise more revenue against the backdrop of high expenditure has taken added importance when compared to other sources of resource mobilization such as deficit financing and money creation; and the fact that nigeria federally collected revenue has been basically from oil. specifically, oil revenue constitute on average over 70% of the revenue between 1990 and 2014 (central bank of nigeria [cbn], 2014). the over dependence on oil revenue couple with its incessant fluctuations due to exogenous oil price shocks formed one of the reasons for the establishment of firs and the subsequent tax policies aimed at diversifying the revenue based away from oil. despite the major tax reform and restructuring in nigeria, nigeria’s fiscal deficit is still ever increasing and the revenue base highly skewed in favor of oil-revenue. in this regard, we augured strongly here that the knowledge of tax buoyancy and elasticity is indispensible for efficient tax reforms. tax revenue/ yield may change due to a variety of factors, such as changes in income, changes in tax rate and tax base, changes in efficiency of tax assessment and collection, among others. the responsiveness of tax revenue or yield to such changes can be explained with the ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017 769 help of tax elasticity and buoyancy (timsina, 2008; muibi and sinbo, 2013; mawia and nzomol, 2013; ebi and aladejare, 2016). tax elasticity may be defined as the ratio of a percentage change in adjusted tax revenue to a percentage change in income (nominal gross domestic product [gdp]). on the other hand, tax buoyancy refers to changes in actual tax revenues due to the changes in income as well as due to the changes in discretionary measures such as tax rates and tax bases (timsina, 2008). this distinction between the tax elasticity and buoyancy is very useful in analyzing and evaluating whether future revenues will be sufficient to meet the resource needs without changing the rates or bases of the existing tax. to measure the tax elasticity, historical tax series must be adjusted so as to eliminate the effects of tax revenues from discretionary changes. if there is no change in the tax rates and the tax base during the reference period, the buoyancy will be the same as elasticity. if the changes in the tax system are revenue enhancing, then buoyancy will exceed elasticity (timsina, 2008; and ebi and aladejare, 2016). alternatively, the buoyancy and the elasticity of tax revenues are also estimated by applying the partitioning approach. under this approach, tax elasticity and buoyancy coefficients are partitioned into tax to income and tax to base. in other words, tax elasticity and buoyancy are estimated with respect to the gdp as well as their respective proxy bases. the advantage of using such a partitioning approach is the ability to identify factors responsible for rapid or lagged revenue growth. factors that affect the tax to base elasticity such as tax rates exemptions and improvements in tax administration are within the control of the fiscal authorities, thereby making this measure important for related purposes. the tax to income elasticity, on the other hand, determined largely the way in which taxes responds to economic structure/growth (timsina, 2008). against this background, this study attempts to utilize the time series approach to empirically estimate the tax elasticity and buoyancy in nigeria for the period 1981-2014. the choice of this period is based on availability of data for most tax components as well as the desire to capture the impact of the establishment of firs in 1992 which marked the beginning of major tax reforms and tax policy administrations on tax yields. the major components of tax revenue such as personal income tax (pit), petroleum profit tax (ppt), vat, and excise duties (ed), etc., are employed and their buoyancy and elasticity estimated. 2. literature review a good tax system is expected to generate tax revenue that is responsive to changes in national income. there is substantial literature on the responsiveness of tax revenue to economic growth (gdp) and development. these literature provides support for the argument that economies with better/efficient tax system generates sufficient revenue for public expenditure without resulting to deficit financing, develop faster than their counterparts with insufficient tax revenue for public expenditure. the responsiveness of a tax system to changes in national income can result from two effects namely either elasticity (in-built flexibility) or the buoyancy of the tax. hence studies conducted by eminent scholars on this subject outside and within nigeria are reviewed in this section. mukariam (2001) carried out a study on the elasticity and buoyancy of major taxes in pakistan over the period 1981-2001. the study adopted chain indexing technique which was used for the adjustment of the tax yield series to subtract the revenue effect of the discretionary changes from the actual tax yield so as to represent the tax revenues that would have been obtained in each year if the rates applicable in the reference year had prevailed throughout the period. the study also employed the ordinary least squares econometric method for regression of the equations in the study. he found that, customs and ed appear to be relatively rigid. accordingly, the study projected that direct taxes and sales tax will be the pillar of pakistan’s future resource mobilization strategy. the results further showed that the buoyancy of all the taxes were higher than their corresponding elasticities and well above unity for direct taxes and sales taxes. muriithi and moyi (2003) analyzed the productivity of kenya’s tax structure in the context of the tax reforms. the findings suggest that tax reforms had a positive impact on the overall tax structure and on the individual tax handles, even though the impact of the reforms was not always uniform. the study confirms that the reforms had a bigger impact on direct taxes than on indirect taxes, suggesting that revenue leakage is still a major problem for indirect taxes. the study also submitted that the better responsiveness of direct taxes is attributed to the relative effectiveness of the reforms in direct taxes, which not only made the tax system simpler but also reduced avenues for evasion and corruption. in a related study conducted by samuel and isaac (2012) on the elasticity and buoyancy of tax components and tax systems in kenya using time series data, spanning from 1987 to 2011, the tax revenue model for estimating tax buoyancy and tax elasticity used by muriithi and moyi (2003) was adopted in the study; ordinary least square method was employed to estimate the parameters of the model. the findings of their study revealed that kenya tax system was neither income elastic nor buoyant. all major tax components in kenya are inelastic. income tax and ed had unity buoyancies over the study period. this was not in agreement with what muriithi and moyi (2003) found out that the two taxes were buoyant. according to the findings of the study import duties are the most buoyant tax component while the sales tax was least buoyant. the study was further examined in kenya by mawia and nzomol (2013); and omondi et al. (2014). mawia and nzomol (2013), utilized a time series approach to estimate tax buoyancy for kenya for the period 1999/2000-2010/2011. tax buoyancies were computed for income, import, excise, vat and total taxes. specifically, their paper examined the buoyancies of tax revenues to changes in economic growth (gdp) and proxy bases using quarterly data instead of annual data of gdp and tax revenues and their bases. they also analyzed the tax buoyancy of pay as you earn (paye), other income tax, as components of income tax and local and import vat as components of total vat, in order to ascertain the response of these specific taxes to their bases. their ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017770 results showed that the total tax was buoyant with a buoyancy value of 2.58 while the individual taxes were not buoyant except the excise duty which was buoyant with respect to the base. tax bases were found to respond well to economic changes with buoyancy values greater than unity, with an exception of excise duty base to income buoyancy coefficient being less than unity. based on their findings, they recommended a constant review of the tax system as the economic structure changes. omondi et al. (2014), conducted a study on the effects of tax reforms on buoyancy and elasticity of the tax system in kenya. annual time series data was used spanning from 1963 to 2010 to examine the effects of tax reforms on tax buoyancy and elasticity estimates and to determine the effect of tax modernization programme and revenue administration reforms on tax buoyancy and tax elasticity. the study employed regression analysis to regress tax revenue on income. the results showed that the elasticity for kenya’s overall tax system was 0.690 which means that the increase in national income brought about a less than proportionate increase in tax revenue. the results conformed to the findings of muriithi and moyi (2003); and wawire (2006) who found the overall tax system to be inelastic. timsina (2008) conducted a study on tax elasticity and buoyancy in nepal. annual time series data was applied from 1975 to 2005 to empirically measure the elasticity as well as buoyancy for the different taxes so as to ensure whether or not the tax system in nepal is elastic. partitioning approach was also applied to estimate the elasticity and buoyancy coefficients. in other words, tax elasticity and buoyancy were estimated through two ways: tax to base and base to income. the tax to base elasticity measured the progressiveness of the tax structure and/or a given trend in administrative efficiency while the base to income elasticity measured the responsiveness of tax base to income. the study revealed that the tax system in nepal is inelastic (less than unity) in the period 1975-2005 with a more than unitary buoyancy coefficient, thus reflecting that the bulk of revenue collection emanated from discretionary changes in the tax policy, rather than from automatic responses. it is also worthy of note that the product of the two coefficients of tax to base and tax base to income gave the same result of traditional income elasticity approach. choifor (2008) conducted a study on the indirect tax reforms and revenue mobilization in cameroon. annual time series data was used in the study spanning from 1980 to 2003 in order to investigate if the tax reforms did improve the initial tax revenue situation or rather helped to engineer the response of the tax system to changes in the tax bases for the purpose of raising sufficient revenue requirement for the economy; and to identify which indirect tax hurdles become more responsive (flexible) or remain rigid after the tax reform, as well as which of the indirect taxes responded to revenue increases depend on discretionary power influence than by natural response (elasticity). from the findings of the study, it was summarized that, cameroon tax system was inelastic. acharaya (2011) conducted a study on the measurement of tax elasticity in india. the study adopted the annual time series data approach for the period 1991-2010 in order to empirically estimate tax elasticities for india. findings of his regression analysis revealed that, the elasticity of direct tax was higher (1.62) compared to indirect tax with elasticity of <1. he explained that the result implies that government has been lenient or conservative with the tax collection in indirect tax area. in terms of tax buoyancy, he found that both direct tax and indirect tax shows nearly 1 as elasticity as expected and that the overall outlook was good for india as the elasticity calculated were high and more than 1 and thus shows that the tax revenue collections responds better to the changes in tax base and income. cotton (2012) conducted a study on the buoyancy and elasticity of non-oil tax revenues in trinidad and tobago. annual time series data was sourced for from the ministry of finance in the country and sub-divided into two main categories i.e., direct and indirect tax revenue and their components. the study revealed that the non-oil taxation system relatively response to changes in non-oil gdp and as such when growth recurs, revenue would increase and help to improve the fiscal position. ndedzu et al. (2013), conducted a study on the revenue, productivity of zimbabwe’s tax system. yearly time series data was used in the study spanning from 1975 to 2008 to evaluate the revenue productivity of zimbabwe’s overall tax system and of individual taxes on the basis of estimates of tax buoyancy. the study employed the multiplicative functional form of a tax revenue model by singer (1968). tax buoyancy measures percentage changes in tax revenue, including discretionary tax changes, due to a one percent increase in the base (gdp, in aggregate level). the findings of the study show that the tax system as a whole and the individual taxes with the exception of customs duty are both income inelastic and non-productive. buoyancy and elasticity coefficient, except for customs duty, were all less than unity. this implies that the tax system has failed to generate the necessary revenue. belinga et al. (2014), conducted a study on tax buoyancy in oecd countries to estimate short-run and long-run tax buoyancy in these countries between 1965 and 2012. the study used single error correction model. tax buoyancy was generally measured by regressing the log of tax revenue on the log of gdp, sometimes with controls for other factors influencing revenue performance. their findings showed that, long-run buoyancy was not significantly different from one in about half of the oecd countries. for 14 countries, long-run tax buoyancy exceeds one, implying that gdp growth has helped improve fiscal performance through the revenue side of the budget. in nigeria, a number of studies have been conducted on this subject over time. ariyo (1997) examined the productivity of the nigerian tax system for the period 1970-1990. the study adopted the double log form and the proportional adjustment methods. the findings of the study support a general acceptable tax productivity level, but with significant variations in the level of tax revenue by various tax sources which is related to the permissiveness in the administration of non-oil tax sources during the oil “glory day” period. ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017 771 temitayo and edu (1999), in a similar study for nigeria for the period 1970-1995 obtained a buoyancy of 1.6 with the base year as the denominator; while obtaining a buoyancy of 1.3, when the current year was adopted as the denominator, and a 1.4 buoyancy value when the mean of the base and current periods was adopted has the denominator. hence, their study deduced that, total government revenue was generally buoyant for the study period. meshak and jeff (2014) conducted a study on the productivity of the nigeria tax system using a time series data covering 30 years, from 1983 to 2012. the study adopted the tax elasticity and buoyancy approach and employed the regression in mintab statistical software. from the findings of the study, individual tax sources were all significant at 5% level of significance. the buoyancy result showed that ppt, custom ed (ced) and total tax revenue (ttr) were negative and less than unity. this result was synonymous to the one obtained by ariyo (1997). vat and company income tax (cit) exhibited a buoyancy excess of unity (1.85 and 1.13 respectively). the negative result of ttr indicates that the tax revenue collection was negatively responsive to changes in gdp. they concluded that the negative result of some of the tax bases to gdp can be attributable to poor tax effort, corruption, weak administrative structure, tax evasion, reoccurring tax exemption or incentives. the result of the analysis also revealed that two out of the four tax base have buoyancy above unity with vat as the most buoyant among all. this supports the thinking that vat will constitute a major source of revenue generation in both short and long run to meet government spending requirement. oriakhi and ahuru (2014) examined the impact of tax reforms on federal revenue generation in nigeria. the study employed annual time series data spanning the years (1981-2011). the study also employed the regression analysis. the total federally collected revenue was regressed on several tax revenues such as ppt, vat, and ced being used as proxy for tax reform. the study showed that by improving the tax system, reducing tax avoidance and evasion, reducing tax burden by scaling down the pit from 25% to 17.5% and cit from 30% to 20% improve the ability of the government to generate more revenue through taxation. this has the potential to improve both the quantity and quality of public expenditure, and de-link nigeria’s public expenditure from the happenings in the international oil market, thereby hedging the economy away from oil price volatility. the study recommended that in order to consolidate on the benefits from tax reforms, efforts should be made to achieve full autonomy for the firs, tackle the hydra-headed monster of multiple taxations and promote accountability and transparency in government business so as to restore the confidence of the tax payer in the tax system. ebi and aladejare (2016) examined how much economic growth has boosted government tax revenue in nigeria between 1980 and 2013. the study adopted the auto-regressive distributive lag approach to examine the short and long run buoyancy of government revenue sources which were decomposed into: ttr, oil revenue and non-oil revenue. results revealed very weak buoyancy of government revenue in both the short and long run periods. based on the findings, it was recommended that pervasive corruption at both the collection and remittance point of revenue should be tackled in the system, and that the development of the non-oil sector should not be taken lightly. these previous studies in nigeria as reviewed above followed a traditional approach to calculate elasticity and buoyancy of several taxes. again their period of studies did not take cognizance of any specific tax reforms in nigeria. hence this study differs from other works done nigeria on this subject in that, it focuses on elasticity and buoyancy of various taxes in nigeria from the period of establishment of firs in 1992-2014 using partitioning approach. an advantage of using such a partitioning approach is the ability to identify factors responsible for rapid or lagged revenue growth. in the partitioning approach, as discussed earlier, tax elasticity and buoyancy coefficients are partitioned into tax to base and base to income components (timsina, 2008). 3. data sources, measurement and method 3.1. data sources and measurement the data for this study was obtained from secondary sources such as the cbn statistical bulletin (cbn, various issues), national bureau of statistics, firs (appendix table a). the study followed the imf’s government finance statistics method to classify the tax revenue. “in this classification, tax revenues are classified with respect to their bases on which they are levied” (imf, 2006). the tax revenue can be classified on the basis of income, profit, consumption of goods and services, international trade, property etc. for example, income tax is levied on income of individuals and profits of business. in this study, for simplicity purpose, the non-agricultural income (nai) was taken as the proxy base for the income tax (as the agricultural income is not taxed in nigeria). the vat and ed are levied on private consumption and imports of goods and services respectively. the total tax is based on the gdp at current market price. the taxes and their proxy bases are presented in table 1. 3.2. model specification imf (2006) tax to base classification as well as works of timsina (2008) provides conceptual framework upon which this study is anchored. in the partitioning approach, as discussed earlier, tax elasticity and buoyancy coefficients are partitioned into tax to income, tax to base and base to gdp components respectively (timsina, 2008). accordingly, we specify that: pit = f(gdp, nai, dm, u1) (1) table 1: proxy tax bases tax revenue proxy bases pit nai vat pc ppt orev ed imps ttr nominal gdp source: imf’s government finance statistics (gfs) 2006, pit: personal income tax, nai: non-agricultural income, pc: private consumption, ppt: petroleum profit tax, orev: oil revenue, ed: excise duty, imps: imports and export of goods and services, ttr: total tax revenue ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017772 where, pit: personal income tax (a component of ttr). nai: non-agricultural income (a base for pit). dm: dummy variable used to proxy establishment of firs as a major tax reforms in 1992 (d = 0 for periods before the establishment of firs in 1992 and 1for periods starting from 1992). u: error term. the econometric model for pit is specified as: pit = α0+α1gdp+α2nai+α3dm+α4gdp*dm+α5nai*dm+u1 (2) where all the variables remained as previously defined. gdp*dm and nai*dm are differential of gdp and nai due to reforms. α1 and α2 are common elasticity and buoyancy of pit. α3: coefficient of tax reforms policy. α4 and α5: differentials elasticity and buoyancy of pit respectively. the common elasticity and buoyancy measure the impact of income and the base on the tax component (pit). on the other hand, the differentials elasticity and buoyancy measure the amount by which the impact of the corresponding income and base has change with tax reforms. we also specified that: ppt = f(gdp, orev, dm, u2) (3) where, ptt: petroleum profit tax (also a component of ttr). orev: oil revenue (a base for ppt). dm: dummy variable used to proxy establishment of firs as a major tax reforms in 1992. the econometric model for pit is specified as: ppt = b0+b1gdp+b2orev+b3dm+b4gdp*dm+b5orev*dm +u2 (4) where all the variables remained as previously defined. b1 and b2 are common elasticity and buoyancy of ppt. b3: coefficient of tax reforms policy in respect to ppt. b4 and b5: differentials elasticity and buoyancy of ppt respectively. we also specified that: ed = f (gdp, impgs, dm, u3) (5) where: ed: exercise duty tax (also a component of total tax). impgs: imports and export of goods and services (a base for ed). dm = dummy variable used to proxy establishment of firs as a major tax reforms in 1992. the econometric model for ed is specified as: ed = c0+c1gdp+c2impgs+c3dm+c4gdp*dm+c5impgs*dm +u3 (6) where all the variables remained as previously defined. c1 and c2 are common elasticity and buoyancy of ed. c3: coefficient of tax reforms policy in respect to ed. c4 and c5: differentials elasticity and buoyancy of ed respectively. we also specified that: vatt = f (gdp, pc, dm, u) (7) where, vatt: value added tax (also a component of total tax introduced in 1992). pc: private consumption (a base for vatt). other variables remained as previously defined. the econometric model for vatt is specified as: vatt = d0+d1gdp+c2pc+u4 (8) where all the variables remained as previously defined. d1 and d2 are elasticity and buoyancy of vatt. note, no differentials elasticity and buoyancy for vatt since it was introduced in 1992. we also specified that: ttr = f (gdp, dm, gdp*dm, u) (9) where, ttr: total tax revenue. gdp: gdp at current market price as base for ttr. other variables remained as previously defined. the econometric model for ttr is specified as: ttr = e0+e1gdp+e2dm+e3gdp*dm+u5 (10) where all the variables remained as previously defined. e1: common elasticity ttr. e2: coefficient of tax reforms policy in respect to ttr. e3: differentials elasticity of ttr. 3.3. estimation procedures several techniques are employed in this study to test and estimate the relevant equations. these include the unit root test, the cointegration test, and the error correction mechanism. 4. results 4.1. unit root result the test for unit root is invariably, the test for stationarity. the test was carried out on each variable in the model in order to ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017 773 avoid the estimation of a spurious relationship arising from using two or more non-stationary time series data to estimate long-run relationship. the augmented dickey fuller (adf) method was used to test for the unit root. the initial set of analysis involves the test on the data series in their level and if the variables are stationary at level, we difference it to make it stationary. the results of the unit root are presented in table 2. the result of the unit root using adf test reported in table 2 shows that all the variables are non-stationary at level. however, after first difference (cit, imports and export of goods and services [imps], orev, ppt, ttr and vat) were stationary at 1% level of significance and variables pc, pit, dm and ed) were also stationary at 5%, while variables gdp and nai attained stationarity at 10% level of significance. implying that all the variables are integrated of order one” i(1).” this result also made error correction mechanism (ecm) suitable for estimation. using the mackinnon critical values for rejection of hypothesis of a unit root, we therefore reject the null hypothesis that there is no unit root for all the variables in the model whose adf test statistic values are greater than the critical values at 10%, and accept that there is unit root for all in the variables. 4.2. cointegration test results given the unit-root properties of the variables, we proceeded to establish whether or not there is a long-run cointegrating relationship among the variables in the various equations using the johansen full information maximum likelihood method. the johansen cointegration tests revealed that the maximal eigen value statistics show existence of 3 cointegration equations for pit equation, 1 cointegration equation for ppt equation, 2 cointegration equations for ed equation, 2 cointegration equations for vatt equation, and 1 cointegration equation for ttr equation, all at 5% level of significance (table 3). the conclusion drawn from this result is that there exists a unique long-run relationship among the explanatory variables in our various models. hence, economic interpretation of the long-run relationship in the various models can be obtained by normalizing the estimates of the unconstrained cointegration equations. 4.3. result of taxes response to changes in gdp and gdp*dm (common and post reform tax elasticities) table 4a and b shows summary of coefficients of various taxes in respect to changes in gdp and gdp*dm from their various short-run estimates respectively (appendix table b). while the common-sampled coefficients of all the tax components were less than one (inelastic) as shown in table 4a, there was a general improvement in their post-tax elasticities with ppt and the total tax (ttr) having coefficients greater than on (elastic) as shown in table 4b the summary of the estimated values of tax elasticities over the post reform period shows that the estimated coefficients of elasticity are positive for all the tax variables. the coefficients of pit and ed were less than one (inelastic). that is, in every 1% change in post-tax reform gdp (that is gdp*dm), there is <1% increase in pit and ed. while a 1% increase in post-tax reform gdp) led to a more than 1% increase in ppt and ttr. again, only ed and ttr were statistically significant, while others were not statistically significant given their t-statistic values. the result also indicates that the ttr responded most to changes in gdp while the pit had the least response to changes in gdp. this table 2: unit root result variables adf test statistic 1st different remark level gdp 0.320853 −2.723637*** i (1) imps 1.252945 −4.131008* i (1) nai 4.206605 −2.900793*** i (1) orev −0.3162293 −5.948482* i (1) pc 0.114715 −2.997906** i (1) pit 1.326001 −3.283867** i (1) ppt −1.835385 −2.690734* i (1) ttr −1.848325 −3.690974* i (1) vat 1.6060956 −4.697178* i (1) ed 3.620211 −3.003260** i (1) dm −0.970780 −3.013274** 1 (1) source: author’s interpolation with e-views 8.0, critical values at level: 1% = −3.6496, 5% = −2.9558, 10% = −2.6164, *,**, and *** indicate statistical significance at 1%, 5% and 10% levels, adf: augmented dickey fuller, gdp: gross domestic product, imps: imports and export of goods and services, nai: non-agricultural income, pit: personal income tax, ppt: petroleum profit tax, ttr: total tax revenue, vat: valued added tax, ed: excise duties, orev: oil revenue table 3: cointegration test results equations eigen value 0.05 critical value hypothesized number of ce (s) pit 30.513 21.1316 at most 3* ppt 4.8044 3.8414 at most 1* ed 34.933 33.876 at most 2* vat 17.579 14.264 at most 2* ttr 28.266 27.584 at most 1* source: extracted from cointegration results on the appendix, *denotes rejection of the hypothesis at 5% level, pit: personal income tax, ppt: petroleum profit tax, ttr: total tax revenue, vat: valued added tax, ed: excise duties table 4a: response of taxes to d (gdp) (tax elasticities %) taxes coefficient standard error t-statistic p pit 0.171140 0.195290 0.876367 0.3889 ppt 0.922000 0.866000 0.106511 0.9160 ed 0.768300 0.011425 67.24850 0.0000 vat 0.722000 0.859000 0.840619 0.4116 ttr 0.986900 0.365100 2.702917 0.0115 source: author’s computation from the main result in the appendix, pit: personal income tax, ppt: petroleum profit tax, ttr: total tax revenue, vat: valued added tax, ed: excise duties, gdp: gross domestic product table 4b: response of taxes to d (gdp*dm) (post reform tax elasticities %) taxes coefficient standard error t-statistic p pit 0.199930 0.195550 1.022380 0.3160 ppt 1.009140 1.008660 0.105535 0.9168 ed 0.977509 0.411424 2.375910 0.0230 ttr 1.287500 0.365500 3.520930 0.0011 source: author’s computation from the main result in the appendix, ppt: petroleum profit tax, ttr: total tax revenue, ed: excise duties, gdp: gross domestic product, pit: personal income tax ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017774 is clearly shown by their coefficients of 0.98 and 0.17 for ttr and pit respectively. the findings of post-tax reform elasticities disagreed with ariyo (1997) and meshak and jeff [2014]) results, that all major tax components in nigeria are inelastic. our post reform ppt and ttr are elastic. the implication of these results is in tandem with oriakhi and ahuru (2014) that a tax reform improves tax elasticities. 4.4. result of taxes response to changes in their bases (tax bouyancy) table 5a and b shows the results of the responsiveness of various tax components to changes in their various common sampled bases and changes in their post-reform bases (post -reform tax buoyancies) respectively. from the result, the nai, oil revenue (orev), import of goods and services, and private consumption (pc) were used as bases for pit, ppt, ed and vat respectively, as it provides a more accurate estimation for these tax types. their respective post-reformed were captured by the various base interaction with dm (dummy representing reforms as stipulated earlier in table 1). the summary of the estimated values of tax buoyancies show that the coefficients are all positive and less than one for common sample base and post reform samples buoyancies were greater than that of common samples, except for ppt (0.018 against 0.017). also, pit and ppt were not statistically significant while ed and vat are statistically significant given their t-statistic values. the none buoyancy of all the taxes (less than unity) indicates the fact tax revenue grows less than proportionate to growth in their respective bases. in other words, an increase in the bases spurred a less than proportionate increase in tax revenue. this result agrees with ebi and aladejare (2016) that government tax revenues in nigeria exhibit weak buoyancy both the short and long run periods. the weak buoyancy of the ed can be attributed to the fact that policies are being put in place to discourage importation and encourage domestic production. this will inevitably lead to decline in the growth of excise commodities and reduction in collection. commodities such as beer, cigarette, and other alcoholic beverages which can generate over 80% of the excise revenue are price inelastic, hence the cause of the slow growth of the tax base. in addition, non-productivity of the vat may be attributed to numerous exemptions and tax evasions necessitated by multiple and complex rates assigned to vat, and the fact that vat which does not have a broader base and therefore captures less tax payers. this can be justified by the policy of the government to increase the vat to 10% from the current 5%. 4.5. response of taxes to reforms (dummies) dummies were assigned to pit, ppt, ttr and the ed in other to capture their response to tax reforms within the period of the study. the results as summarized in table 6 showed that the dummy coefficients are positively signed and statistically significant at 5% level. this further confirms the fact that tax reforms improve tax revenues. the positive impact of the reform could be associated with the organizational re-alignment achieved by the implementation of the pit act (pita). during the period of the reform, the buoyancy estimate was found to be 2.46. it therefore implies that the reforms improved tax buoyancy by about 2.46% over the reform period, thereby a boost in revenue collection through the pit. this positive impact can be attributed to objectives set by (pita) through a number of initiatives which included; a more equitable income tax structure as well as consolidated allowances percent of total evolvement introduced. ppt had a dummy coefficient of 2.44, also implies that the revenue administration reforms had a positive impact on the ppt. the positive impact of the reforms could be associated with the implementation of the ppt act (ppta). this positive impact can be attributed to objectives set by (ppta) through a number of initiatives which included; the nnpc to provide firs with comprehensive information on joint venture, sole risk and contract service in the upstream sub-sector of the oil industry for more effective taxation of the industry, as well as encouraging donations to tertiary and research institutions by making such donations tax deductible. the ttr response was very large 12.22. this conforms to the excess revenue in federated account over this period. although the t-statistic value of ed reflects its insignificance since it is <2, its coefficient of 4.122989 shows that the tax reforms improved revenue generated from ed by about 4.122%. table 5a: taxes response to common period bases (tax buoyancy %) taxes coefficient standard error t-statistic p pit/nai 0.253301 0.255601 0.991004 0.3308 ppt/orev 0.018153 0.042292 0.429240 0.6713 ed/impgs 0.032069 0.066878 0.479517 0.6356 source: author’s computation from the main result in the appendix, ppt: petroleum profit tax, ed: excise duties, pit: personal income tax, nai: non-agricultural income, impgs: imports and export of goods and services, orev: oil revenue table 5b: taxes response to post-reform period bases (post-reform tax buoyancies %) taxes coefficient standard error t-statistic p pit/nai*dm 0.283106 0.255805 1.106753 0.2785 ppt/orev*dm 0.017905 0.042292 0.423364 0.6755 ed/impgs*dm 0.931421 0.466874 1.995011 0.0584 vat/pc*dm 0.013950 0.001880 7.422152 0.0000 source: author’s computation from the main result in the appendix, impgs: imports and export of goods and services, ppt: petroleum profit tax, ed: excise duties, pit: personal income tax, nai: non-agricultural income, ed: excise duties, orev: oil revenue table 6: taxes response to reforms taxes coefficient standard error t-statistic p pit 2.466548 0.488827 5.045854 0.0000 ppt 2.447765 1.184605 2.066313 0.0489 ed 4.122989 4.997327 0.825039 0.4169 ttr 12.22739 3.607978 3.388987 0.0021 source: author’s computation, ppt: petroleum profit tax, pit: personal income tax, ed: excise duties, ttr: total tax revenue ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017 775 4.6. comparing the tax bouyancy and tax elasticity of various tax categories tax is revenue enhancing if its buoyancy exceed its elasticity. from the result presented in table 7, it can be observed that all the tax components except pit are not revenue enhancing. 5. conclusion and recommendations 5.1. conclusion the analysis of tax reforms and tax yield in nigeria shows that the coefficients of all the tax variables in both pre-reforms and post-reforms are positive during the period under study. while tax variables are inelastic in pre-reform period because they are less than unity (one) each, there was a general improvement in their post-reforms tax elasticities with ppt and ttr having coefficients >1 (elastic). a progressive tax system needs to have at least greater than unity value of the coefficient of elasticity, (timsina, 2008). and a higher degree of progressivity in the tax structure would result in elasticity >2, (timsina, 2008). from the findings using the partitioning approach, tax elasticities in the tax components to gdp in both the pre-reform and postreform shows that ttr responded most to changes in gdp while the pit had the least response to changes in gdp. the low responses of both pit and ed respectively can be attributed to the fact that not all self-employed people if any at all are incorporated into the tax net for proper deductions/payment of tax in the case of pit as it is obtainable in the advanced countries like the united state of america, great britain, etc., while that of ed can be attributed to the fact that policies are being implemented to discourage importation and encourage domestic production. this will inevitably lead to decline in the growth of excise commodities and reduction in collection. the revenue from tax is income elastic after the reforms in that the ppt and the ttr are >1 each which implies that gdp growth has helped in improving the fiscal performance through the revenue side of the budget. the tax buoyancy in the taxes to bases category are all positive but less than unity in both pre-reforms and postreforms respectively but there was general improvement in the interaction of the bases with dummy (representing reforms) after reforms except for ppt that slightly fell from 0.018 to 0.017. however, the taxes are not buoyant in that even after the reform, the coefficients are still less than unity indicating that an increase in the bases spurred a less than proportionate increase in tax revenue. the dummy results further confirm the fact that tax reforms improve tax revenues in nigeria with the least coefficient >2 indicating a higher degree of progressivity in nigerian tax structure. 6. recommendations based on the findings and conclusion, the study recommends as follows; a. ttr being elastic and responsive to economic growth, implies that economic growth and development increases overall tax revenue. hence, this study recommends that government should diversify the economy for more development in order to continue to increase overall tax revenue. diversification of the economy would also broaden and expand the base (tax base). by developing new and existing sectors in the economy, government will attract and generate income from the activities of these sectors. b. for the pit policy to have a more significant impact on the revenue base of nigeria, the government should ensure that self-employed individuals in nigeria register with the revenue authority and pay their taxes which can impact positively on increased revenue generation. public (civil) servants that constitute the chunk of labour force in nigeria with meager income pay pit (payee) more regularly than elective political office holders and appointees who receive huge allowances off the book without being taxed even as taxes are deducted from source. the introduction of progressive tax rates at source for elective political office holders and appointees with jumbo salaries/allowances may make nai base of the pit significant and buoyant. c. with respect to ed, introducing new goods in the tax net with low duties on locally manufactured goods will encourage more local potential manufacturers to produce even for exports, and thus broadening the tax net of ed. also, adoption of advalorem tax rates rather than specific tax rates are measures to be taken. d. for the ppt policy to have a more significant impact on the revenue base of nigeria, the government should minimize or find ways of eliminating totally the widespread corruption and leakages in the ppt administration. e. with regards to vat, there should be an upward review of the vat, from the current 5% to about 10% on luxury goods while the current rate of 5% may be maintained on necessities. also, developing a sound billing habit, increasing consumers’ consciousness on demanding bills, easing the tax reduction and vat refund process, discouraging the sellers’ trend of demanding huge amount of tax credit, developing cooperate and positive thinking of vat personnel to correct mistakes of the sellers on maintaining the account and relevant training for the vat personnel are some measures to be taken into consideration. references acharaya, h. (2011), the measurement of tax elasticity in india: a time series approach. available from: http://www.mpra.ub.unimuenchen. ariyo, a. (1997), productivity of the nigeria tax system: 1970-1990. african economic research consortium, nairobi kenya (aerc) research paper no. 67. belinga, v., benedek, d., mooij, r.d., norregaard, j. (2014), tax buoyancy in oecd countries. imf working paper. central bank of bank (cbn). (2014), cbn annual report and statement of accounts; 2014. table 7: comparison between tax bouyancy and tax elasticity taxes bouyancy elasticity difference pit 0.283106 0.199930 0.08317 ppt 0.017905 1.009140 −0.9912 ed 0.931421 0.977509 −0.0460 vat 0.013950 1.287500 −1.27355 source: author’s computation, ppt: petroleum profit tax, pit: personal income tax, ed: excise duties, vat: valued added tax ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017776 choifor, i.s. 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(2014), the productivity of the nigerian tax system. canadian open accounting and taxation journal, 1(1), 1-11. muibi, o.s., sinbo, o. (2013), macroeconomic determinants of tax revenue in nigeria. world applied sciences journal, 28(1), 27-35. mukariam, f. (2001), elasticity and buoyancy of major taxes in pakistan. pakistan economic and social review, 2(3), 75-86. muriithi, m.k., moyi, e.d. (2003), tax reforms and revenue mobilization in kenya. aerc research paper 131, nairobi. may; 2003. ndedzu, d., macheka, a., ithief, m.m., zivengwa, t. (2013), revenue productivity of zimbabwe’s tax system. asian journal of social sciences and humanities, 2(4), 32-39. olajide and associates. (2013), nigeria tax reform. available from: http://www.olajideassociates,com. omondi, o.v., wawire, n.h., manyasa, e.o., thuku, g.k. (2014), effects of tax reforms on buoyancy and elasticity of the tax system in kenya. international journal of economies and finance, 6(10), 97-111. oriakhi, d.e., ahuru, r.r. (2014), impact of tax reform on federal revenue generation in nigeria. journal of policy and development studies, 9(1), 157-9385. samuel, k.c., isaac, m.k. (2012), elasticity and buoyancy of tax components and tax systems in kenya. research journal of finance and accounting, 3(5), 116-125. singer, n.m. (1968), the use of dummy variables in estimating then income-elasticity of state income tax revenues. national tax journal, (21), 1. temitayo, o.g., edu, o.u. (1999), sources and structure of government revenue. in: oluranti s.k., hossein, j., mark, h., editors. fiscal policy and management in nigeria. ibadan: ncema. timsina, n. (2008), tax elasticity and buoyancy in nepal: a revisit. research department, nepal rastra bank. wawire, n.h.w. (2006), revenue productivity implications of kenya tax system. africa in transformation. political and economic issues, 1, 99-106. appendix a data 1 year gdp impgs nai vat pc cit 1981 94.32502 12.8396 74.82502 5.026 28.57486 4.03e+08 1982 101.0112 10.7705 78.45491 5.026 30.41138 5.5e+08 1983 110.064 8.9037 83.62717 5.026 35.21514 5.62e+08 1984 116.2722 7.1783 82.49495 5.026 42.85869 7.87e+08 1985 134.5856 7.0626 96.34105 5.026 49.30292 1e+09 1986 134.6033 5.9836 94.67025 5.026 51.53747 1.1e+09 1987 193.1262 17.8617 135.5467 5.026 75.98113 1.1e+09 1988 263.2945 21.4457 176.7099 5.026 106.6786 1.55e+09 1989 382.2615 30.8602 262.2013 5.026 126.1862 1.91e+09 1990 328.6061 45.7179 206.3755 5.026 177.2346 2.99e+09 1991 545.6724 89.4882 400.9689 5.026 206.8135 3.83e+09 1992 875.3425 143.1512 657.9229 5.026 373.5267 5.42e+09 1993 1089.68 165.6294 739.6326 5.026 502.7752 9.55e+09 1994 1399.703 162.7888 870.7515 5.026 610.3402 1.23e+10 1995 2907.358 755.1277 1967.053 6.2569 1387.446 2.19e+10 1996 4032.3 562.6266 2756.548 11.286 2124.271 2.31e+11 1997 4189.25 845.7166 2744.102 13.9053 2091.069 2.78e+11 1998 3989.45 837.4187 2388.874 16.2068 2371.328 3.33e+11 1999 4679.212 862.5157 2974.389 23.7505 2454.795 4.62e+11 2000 6713.575 985.0224 4912.092 30.6438 2478.777 5.33e+11 2001 6895.198 1358.18 4485.148 44.9129 3687.656 6.94e+11 2002 7795.758 1512.695 4948.644 52.632 5540.186 8.91e+11 2003 9913.518 2080.235 6682.075 65.8876 7044.545 1.15e+12 2004 11411.07 1987.045 7507.308 96.1956 8637.732 1.31e+12 2005 14610.88 2800.856 9857.903 87.4498 11075.06 1.7e+11 2006 18564.59 3108.519 12624.36 110.5668 11834.58 2.47e+11 2007 20657.32 3911.953 13899.45 144.3728 16243.72 3.32e+11 2008 24296.33 5593.18 16314.93 198.0653 16090.5 4.21e+11 2009 24794.24 5480.656 15607.93 229.3232 18980.96 6.01e+11 2010 33984.75 8163.975 23674.1 275.5746 22845.13 6.66e+11 2011 37409.86 10995.86 25816.43 318 22840.83 7.15e+11 2012 40544.1 9766.557 27130.26 347.6882 19536.05 8.47e+11 2013 42396.77 9439.425 27687.66 389.5263 19536.05 9.98e+11 2014 89043.62 10538.78 71025 388.85 19536.05 8.53e+11 firs: federal inland revenue service, cbn: central bank of nigeria, statistical bulletin, vat: valued added tax, impgs: imports and export of goods and services, nai: non-agricultural income, gdp: gross domestic product, cit: company income tax ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017 777 data 2 year ppt pit ttr orev dm 1981 6325.8 1997.3 6728.8 8.5644 0 1982 4840.4 732.5 5390.4 7.81 0 1983 3746.9 710.1 4308.4 7.25 0 1984 4761.4 580.9 5548.6 8.27 0 1985 6711 938.9 7715.3 10.92 0 1986 4811 433.7 5913.2 8.11 0 1987 12504 407.6 13606.5 19.03 0 1988 6814.4 540.5 8365.2 19.83 0 1989 10598.2 938 12512.4 39.13 0 1990 26909 1724 29901.3 71.89 0 1991 38615.9 3040.4 42443.8 82.67 0 1992 51476.7 4903.1 56893.9 164.08 0 1993 59207.6 5626.5 68761.7 162.1024 1 1994 42802.7 3888.2 62338.3 160.19 1 1995 42857.9 20436.4 85497.2 324.55 1 1996 47.6 3407 106.4 408.78 1 1997 64.3 8339.9 130.8 416.81 1 1998 24.6 11400 99.4 324.31 1 1999 71.1 20100 171.9 724.42 1 2000 334.5 38100 455.3 1591.676 1 2001 407.1 44400 586.6 1707.563 1 2002 224.4 68100 433.9 1230.851 1 2003 438 54200 703.1 2074.281 1 2004 878.6 58900 1194.8 3354.8 1 2005 1352.2 212100 1741.8 4762.4 1 2006 1352.5 33300 1866.2 5287.567 1 2007 1132 268700 1846.9 4462.91 1 2008 2060.9 178500 2972.2 6530.6 1 2009 939.4 227900 2197.6 3191.938 1 2010 1480.36 712000 2839.3 5396.091 1 2011 3070.59 806000 4628.46 8878.97 1 2012 3210.32 963200 5003.57 8025.971 1 2013 2666.36 963200 4805.65 6809.231 1 2014 2453.94 973200 4714.6 6793.724 1 firs: federal inland revenue service, cbn: central bank of nigeria, statistical bulletin, ppt: petroleum profit tax, pit: personal income tax, ttr: total tax revenue for ppt dependent variable: log (pit) method: least squares date: 07/23/16 time: 06:43 sample (adjusted): 1982 2014 included observations: 33 after adjustments variable coefficient standard error t-statistic p d (gdp) 0.171140 0.195290 0.876367 0.3889 d (nai) 0.253301 0.255601 0.991004 0.3308 d (gdp*dm) 0.199930 0.195550 1.022380 0.3160 d (nai*dm) 0.283106 0.255805 1.106753 0.2785 dm 2.466548 0.488827 5.045854 0.0000 ecm1(−1) −0.388106 0.132706 −2.924555 0.0168 c 6.743572 0.299842 22.49043 0.0000 r2 0.688850 mean dependent variable 9.729949 adjusted r2 0.663200 sd dependent variable 2.590782 se of regression 0.958239 akaike info criterion 2.938393 sum squared residuals 23.87377 schwarz criterion 3.255833 log likelihood −41.48348 hannan-quinn criterion 3.045202 f-statistic 34.65303 durbin-watson stat 1.798235 p (f-statistic) 0.000000 pit: personal income tax, nai: non-agricultural income, gdp: gross domestic product, ppt: petroleum profit tax for ppt dependent variable: log (ppt) method: least squares date: 07/23/16 time: 07:29 sample (adjusted): 1982 2014 included observations: 33 after adjustments variable coefficient standard error t-statistic p gdp 0.922000 0.866000 0.106511 0.9160 orev 0.018153 0.042292 0.429240 0.6713 dm 2.447765 1.184605 2.066313 0.0489 gdp*dm 1.009140 1.008660 0.105535 0.9168 orev*dm 0.017905 0.042292 0.423364 0.6755 ecm2(−1) −0.071805 0.021905 −3.284657 0.0029 c 8.753993 1.065408 8.216568 0.0000 r2 0.547660 mean dependent variable 7.713453 adjusted r2 0.443273 sd dependent variable 2.086458 se of regression 1.556792 akaike info criterion 3.908964 sum squared residuals 63.01366 schwarz criterion 4.226405 log likelihood −57.49790 hannan-quinn criterion 4.015773 f-statistic 5.246473 durbin-watson stat 1.856532 p (f-statistic) 0.001175 ppt: petroleum profit tax, gdp: gross domestic product, sd: standard deviation appendix b ebi and ayodele: tax reforms and tax yield in nigeria international journal of economics and financial issues | vol 7 • issue 3 • 2017778 result for ed dependent variable: log (ed) method: least squares date: 07/23/16 time: 08:17 sample (adjusted): 1982 2014 included observations: 33 after adjustments variable coefficient standard error t-statistic p d (gdp) 0.768300 0.011425 67.24850 0.0000 d (impgs) 0.032069 0.066878 0.479517 0.6356 d (dm) 4.122989 4.997327 0.825039 0.4169 d (gdp*dm) 0.977509 0.411424 2.375910 0.0230 d (imps*dm) 0.931421 0.466874 1.995011 0.0584 ecm3(−1) −0.499119 0.246208 −2.027228 0.0530 c 24.50357 0.401617 61.01220 0.0000 r2 0.766167 mean dependent variable 24.80229 adjusted r2 0.719897 sd dependent variable 2.162483 se of regression 1.909979 akaike info criterion 4.317893 sum squared residuals 94.84854 schwarz criterion 4.635334 log likelihood −64.24524 hannan-quinn criterion 4.424702 f-statistic 2.503374 durbin-watson stat 1.904695 p (f-statistic) 0.047864 gdp: gross domestic product, sd: standard deviation, impgs: imports and export of goods and services, ed: excise duties result for vat dependent variable: vat method: least squares date: 07/23/16 time: 08:40 sample (adjusted): 1993 2014 included observations: 22 after adjustments variable coefficient standard error t-statistic p d (gdp) 0.722000 0.859000 0.840619 0.4116 d (pc) 0.013950 0.001880 7.422152 0.0000 ecm5(−1) −0.105622 0.036313 −3.140601 0.0057 c −23.21895 9.743858 −2.382932 0.0284 r2 0.962276 mean dependent variable 130.0521 adjusted r2 0.955989 sd dependent variable 134.8514 se of regression 28.29022 akaike info criterion 9.685875 sum squared residual 14406.06 schwarz criterion 9.884246 log likelihood −102.5446 hannan-quinn criterion 9.732605 f-statistic 153.0509 durbin-watson stat 1.846373 p (f-statistic) 0.000000 vat: valued added tax, gdp: gross domestic product, sd: standard deviation for ttr dependent variable: log (ttr) method: least squares date: 07/23/16 time: 08:26 sample (adjusted): 1982 2014 included observations: 33 after adjustments variable coefficient standard error t-statistic p d (gdp) 0.986900 0.365100 2.702917 0.0115 d (dm) 12.22739 3.607978 3.388987 0.0021 d (gdp*dm) 1.287500 0.365500 3.520930 0.0011 ecm4(−1) −0.572705 0.165911 −3.451883 0.0018 c 7.761601 0.289821 26.78069 0.0000 r2 0.776496 mean dependent variable 8.127190 adjusted r2 0.701709 sd dependent variable 1.884921 se of regression 1.457972 akaike info criterion 3.730698 sum squared residuals 59.51915 schwarz criterion 3.957441 log likelihood −56.55651 hannan-quinn criterion 3.806990 f-statistic 6.371426 durbin-watson stat 1.919457 p (f-statistic) 0.000891 tx_1~at/tx_2~at international journal of economics and financial issues | vol 12 • issue 4 • 2022 1 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2022, 12(4), 1-12. subcentral taxation in spain asuncion arner guerre* departamento de economía aplicada. universidad de zaragoza, zaragoza, spain. email: aarner@unizar.es received: 22 march 2022 accepted: 24 june 2022 doi: https://doi.org/10.32479/ijefi.13131 abstract the latest reform of the financing system of the autonomous communities of the common regime (afs) has deepened spain’s fiscal co-responsibility and financial autonomy. in the personal income tax, the income transfer has been accompanied by a growing regulatory capacity, creating a regional personal income tax (rpit). subsequently, autonomous communities must approve yearly an autonomous rate. regional governments get the rpit income by monthly payments on account (poa) based on the budget forecast for the following year on fractional payments and withholdings. subsequently, there is the corresponding final settlement two years later. this work aims to study the rpit from the poa, considering the potential and current taxation to evaluate possible inefficiencies. the methodology consists of estimating a dynamic panel data of the fifteen autonomous communities for 2003-2019, using generalized estimator of moments (gmm). results show that there was some degree of tax base overlap between levels of government in the personal income tax. besides, there was some type of reaction of the tax rate in one region to the tax rate of others. consequently, the state transfers internalized vertical and horizontal externalities. in addition, efficiency concerns mainly were about taxation for entrepreneurs. keywords: fiscal decentralization, transfers, taxation, externalities jel classifications: h23, h24, h71 1. introduction according to keen (1997), federal structures raise the possibility of vertical tax externalities between state and federal governments arising from the concurrent taxation of the same tax base by both governments. concurrent taxation means that the tax rate set by one level of government is liable to affect the revenues of the other. to the extent that decision-makers do not internalize these effects, inefficiencies can arise. in addition, high taxes on the same bases at the local or state levels of government will lead to low taxes or possibly to subsidies on the same bases by the federal or state governments if they pursue coordinated policies (hoyt, 2001). moreover, both federal and state potential bases are dependent on the extent of activity of the private sector, which seems to make some degree of tax base overlap between levels of government and almost inevitable consequence of endowing both with real tax powers (boodway et al., 1998). besides, those authors point out that regional governments compete away regarding redistributive objectives, known as horizontal externalities. in spain, decentralization has its origin in a unitary state and was initially driven by spending needs. currently, spain is a leader in effective tax decentralization in the european union, with regional revenues on which subcentral governments can modify tax rates and deductions discretionally behind canada, switzerland, the us, and australia (lago-peñas and martínez vázquez, 2020). the latest reform of the financing system of the autonomous communities of common regime and cities with statute of autonomy (afs) has been to deepen the fiscal co-responsibility and financial autonomy1. to the taxes initially assigned (traditional resources), sharing in the central taxes of the state, namely, personal income tax, vat, and excise duties, have been added2. in the case of the personal income tax, the transfer 1 in spain, autonomous communities or regional governments refer to a subnational government. meanwhile, the state is used as a federal government. 2 traditional tax transferred are the tax on patrimonial transmissions (tpt); tax on heritage (th); taxes on gambling and taxes affected by the services transferred; tax on retail sales of certain hydrocarbons (trsch), and the special tax on transport registration (ttr). this journal is licensed under a creative commons attribution 4.0 international license arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 20222 has been accompanied by a growing regulatory capacity, creating a regional personal income tax (rpit). in 2001, by law 21/2001, of 27 december, the personal income tax was partially transferred to the regional governments, with the maximum limit of 33% of the total rate of the tax3. in this afs, the autonomous communities have the regulatory power to establish the rate with the only progressive requirement and having the same number of sections as the state. the current afs, approved in 2009, by law 22/2009, of 18 december, establishes the assignment of 50% of the personal income taxation, and the autonomous communities must approve an autonomous rate (rtr), which must only comply with the requirement of being progressive4. the tax base is the same for the state personal income tax (spit) and rpit; personal income taxation is the aggregate of the taxation for spit and rpit. regional governments get resources from rpit by monthly payments (poa) based on the budget forecast, for the following year t, on fractional payments (fp) of income of economic activities (iea) and withholdings (with), from employment income (ei), iea, and capital5. subsequently, there is the corresponding final settlement for the difference between the amount of the final values of rpit and poa. economics ministry mandates that the rpit collection corresponding t is on july 25 of t+1. consequently, in t should attend the collection of rpit, corresponding to the settlement of rpit in year t-1, namely crp, and monthly poa to the yield of rpit in t. after the 2001 afs reform, employment income (ei), the essential yield to the personal income tax, presents different taxation in each autonomous community. in 2003, ei increased up to 0.04%, being 79,89% of the tax base, with an average income of 17.624€6. besides, employment taxpayers increased up to 7.53%, being 89.02% of the personal income tax taxpayers. however, in 2009, the employment taxpayers decreased to -0.6%, although ei reached 80.5% of the base tax. this trend kept going until 2016. undoubtedly, this reduction is mainly attributable to the reduction in business income due to the great crisis that in 2008 affected the spanish economy. in 2018, employees were 82.8% of the personal income tax taxpayers, and the tax base from ei was 80.2% of the total, being the average income of 21.161€. withholdings from ei were 80% of total in 2002 and increased to 85.25% in 2018. 3 law 21/2001, of 27 december, regulating the fiscal and administrative measures of the new financing system of the autonomous communities of common regime and cities with statute of autonomy (b.o.e., of 31 december 2001, no. 313). 4 law 22/2009, of 18 december, regulates the financing system of the autonomous communities of common regime and cities with statute of autonomy (b.o.e., of 12 december 2009, no. 299). 5 law 35/2006, on personal income tax (b.o.e. of 29 november 2006, no. 285) establishes (article 99.7) the obligation to make fractional payments (fp) to the treasury for taxpayers who exercise economic activities. the quarterly fp of 20% of net yield is to personal income tax. besides, the effective rate of the fp is lower than the regulatory rate because taxpayers whose income has been subject to withholding or deposit on account of at least 70% in the previous year are excluded from this obligation. the payment for the first three quarters will be made between the 1st and 20th of april, july, and october. that of the fourth quarter, the 1st and 30th of january. in addition, the income of individual entrepreneurs and professionals constitutes iea in the personal income tax, which is taxed differently in each autonomous community; meanwhile, corporate taxation is uniform throughout the national territory at the tax rate of 25%6. the reform of the afs in 2001 meant a reduction of the iea declared in the personal income tax of 5.88%. in 2009, iea subject to taxation decreased by 12.7 % compared to 2008, and the cumulative reduction is 39% to 2002. besides, taxpayers decreased from 20% of the total in 2002 to 15.1% in 2018. meanwhile, the tax base per taxpayer increased from €9,393.39 in 2002 to €10.709 in 2018. this work aims to study the rpit, the leading tax with regulatory power transferred to regional governments in spain, from the poa. it is considering the potential and current tax power to evaluate possible inefficiencies. concerning individual effects on the behavior of the autonomous community, geography or institutional features are noted. the methodology estimates a dynamic panel data of the fifteen autonomous communities from 2003 to 2019 by the generalized estimator of moments (gmm). the transformation in first differences is applied to eliminate the individual fixed effects. results show that in the actual afs there were vertical and horizontal externalities because tax base is the same for the state and regional personal income taxation; also, rpit linked with private sector activity. besides, there was some type of reaction of the tax rate in one region to the tax rate of others. in addition, efficiency concerns mainly were about taxation for entrepreneurs. the work consists of the following sections, in addition to this introduction. section 2 refers to the review of economic literature. the rpit is shown in section 3. methods and data are addressed in section 4. the last section constitutes a discussion of the main conclusions of this work. 2. review of economic literature 2.1. economic features the study of fiscal decentralization, defined as the sharing of economic responsibilities between a country’s central government and regional and local governments, is carried out from the seminal works of tiebout (1961), olson (1956), and oates (1972). according to the allocation of taxes in conventional theory, subcentral governments have mainly transferred revenues. moreover, conventional theory considers the inefficiencies that arise since a local government ignores the effects of its decisions on the utility levels of nonresidents (gordon, 1983). inefficiencies are if nonresidents pay some taxes or receive some benefits, competition between local governments changes resource costs for public services; factor and output prices change to favor residents over nonresidents or because of spillovers. finally, inefficiencies are if distributed effects among nonresidents are ignored. 6 in 2019, of 3.197.935 economic activities, they were business activities, 43,26%; professional activities, 26,59%; artistic, sports, and others, 1,06%; and agricultural and livestock, 29,07%. the attributable effective rate, defined as the ratio between the total full share and the total taxable base, is 21.74% for business activities. the effective rate for professional and artistic activities is slightly higher than 24%. the effective rate for agricultural and livestock activities is 11% (aeat, 2022a). arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 2022 3 a vertical fiscal externality occurs in a federation when the taxes or expenditures of one level of government affect the budget constraint of another level of government (dahlby and wilson, 2003). transfers from the state to the federal government would eliminate that vertical externality by making the marginal cost of public funds to the state equal to its marginal social cost. the transfer direction depends on whether the state tax rate increases or decreases federal tax revenue. according to keen (1997), eliminating this externality is to allocate all tax powers to just one level of government and finance the other by a vertical transfer. in this view, vertical transfers aim to avoid inefficiencies from tax base overlap. besides, federal governments internalize fiscal externalities that may arise in horizontal relations between the states because of efficiency concerns. equalization grants to or from lower levels of governments are designed to equate social marginal costs of funds across jurisdictions (keen, 1997; dahlby and wilson, 2003). boadway et al. (1998) show that if one state increases its tax rate on a given base, its tax base will fall because of elasticity in the base supply and cross-border mobility. this loss in the tax base to neighboring states can be thought of as a horizontal fiscal externality. moreover, those authors point out that vertical externalities may induce states to undertake too much redistribution, perceiving part of the revenue cost to be passed to the federal governments and thereby to other states, and it induces the states to set a lower tax. consistent with zabalza (2020), essential features of fiscal decentralization processes in spain are the degree of tax autonomy allocated to sub-central governments and the adequacy of the resources of the financing system. the main drawbacks are that tax competition and the export of the tax burden can lead to less than optimal public spending and higher compliance costs by taxpayers of different tax systems simultaneously. transfers require a precise definition of fiscal effort and tax capacity of subcentral governments to avoid the resources received by subcentral administrations penalizing those who demand higher taxes (granell and fuenmayor, 2020). according to pérez garcía (2020), resources always reach regional governments as transfers from the central government and, consequently, it is challenging to differentiate vertical and horizontal imbalances. 2.2. applied studies fiscal decentralization applied studies are regarding public investment, efficiency, and economic growth; they also relate to income decentralization and fiscal inefficiencies. castells and solé ollé (2005) use a dynamic panel data to analyze the main determinants of public investment in spain (nuts3) in transport infrastructures from 1 987 to 1996. moreover, the effect of fiscal decentralization of public revenues on infrastructure investment at the sub-national level is studied by kappeler et al. (2013), estimating a panel of 20 european countries from 1990 to 2009. srithongrung and sánchez-juárez (2015) investigate the effects of taxes and public investment on the economic growth of 32 mexican states for the period 1993 to 2011, using an error correction model. according to the results, the taxing system at the subnational levels in mexico is unlikely to be optimal, and the taxes’ positive or negative net effect is likely the case. in turn, it depends on the pre-existing condition of the taxing system. if it is efficient in terms of having a broad base and being nondiscriminatory, then there is no incentive for economic agents to change their behavior in terms of labor supply or consumption demands to avoid increased taxes. in the case of a sub-optimal taxing system, some groups have an incentive to avoid a tax burden by withdrawing labor supply or substituting the highly taxed goods with lower-taxed. consistent with shahid and kalim (2020), fiscal decentralization is one of the significant policy variables to attain economic efficiency. this study examines the impact of decentralized taxes on the economic growth of pakistan from 1976 to 2018, addressed by an autoregressive distributive lag approach, after defining the problem of a unit root. the empirical results illustrate that income tax decentralization is growth-promoting in pakistan. also, the positive sign of interaction in tax decentralization and political institutions shows that these complement each other. in addition, suhuyanto et al. (2021) analyze the effect of intergovernmental transfer funds on district/municipality development performance in west java province by a panel data regression analysis for the period 2010 to 2016. it is based on regional autonomy and is intended to enhance the level of community involvement in the development process and the distribution of development outcomes relatively; in turn, transfer reaches most levels of government, achieving a fiscal balance. besides, general block grants have the most significant impact on regional performance. also, the the most significant indirect effect of transfer funds is education spending, followed by spending on goods and services. besides, priyady et al. (2021) analyze the efficiency of local income of cities in yogyakarta province. regional local income is considered an input in the local economic development that produces several outputs or public services and achieves prosperity and economic growth. based on the results of data analysis using data envelopment analysis on the level of efficiency of district/ city revenue, the achievement of the level of efficiency of 100% is with privileged funds, namely funds whose object is correct efficiency deviation. in the view of income taxation and inefficiencies produced by fiscal decentralization, hewett et al. (1983) point out that the tax policies of jurisdictions between which there is tax competition affect the collection of state tax. this work also suggests that the best results for studies of tax competition between jurisdictions should be carried out through the game theory approach. otherwise, panda (2016) examines the economic and political determinants of transfers from central government to states through a panel for 22 states of india, from 1980-81 to 2010-11. goodspeed (2000) analyzes the impact of local governments’ vertical and horizontal externalities of tax rates on a federation. the estimate is for 1975-1985 with a sample of 13 oecd countries. according to this work, an increase of 1% in the national income arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 20224 tax tax rate implies a fall of 0.17% in the tax rate of the local income tax, which corresponds to elasticity of -0.5. the work of hayashi and boadway (2000) confirms the existence of vertical and horizontal externalities in corporate taxes established by provincial governments and the federal government in canada. according to this work, while provincial tax rates respond negatively to the federal tax rate, at least some provinces increase their tax rates in response to increases in the tax rates of other provinces. however, esteller-moré and solé ollé (2001, 2002) found positive reactions of regional tax to increases in the federal tax rate, also between competing provinces. they analyzed 2001 vertical externalities in the design of tax policy in the personal income tax and the general sales tax in the united states in 1987-1996. the results show that the increase of 1% in the effective federal tax represents an increase of 0.10% in collecting the state income tax. this increase is 0.22% for the income tax and sales tax. in states where the deductibility of taxes at one level and another is reciprocal, the reaction is somewhat lower than the average. in 2002, those authors found, with data on canadian personal income taxation for the period 1982-1996, that an increase of around 0.20% follows a 1% increase in the federal tax burden in the regional tax rates and a 1% change in the tax rates of competing provinces forces a change in the tax rate of one province of 0.3%. 3. the regional personal income tax 3.1. the afs in 2009 the current afs is characterized by the significant increase in state tax assignments concerning state taxes and regulation over assigned taxes, detriment of vertical transfers (figure 1). article 8 of law 22/2009, of 18 december, defines tax capacity as the set of tax resources of each autonomous community in the base year. the collection by the regional government in 2007, without regulation, besides traditional tax transferred, are the rpit, corresponding to 50% of said yield; the transfer of the liquid collection of 50% of the value added tax (vat); the transfer of the liquid collection of 58% of the harmonized excise duties (tax on beer, wine, and fermented beverages; intermediate products, alcohol, and derived beverages; hydrocarbons and tobacco products); 100% of the liquid collection of the electricity tax, and the complete collection of the tax on deposits in credit institutions (idec). the basic financing of the afs since 2009, besides tax capacity, is constituted by the guarantee fund for fundamental public services (gffps) and the global sufficiency fund (gsf). the evolution of the basic financing of the afs in 2019 is shown in table 17. besides, other resources of the afs convergence funds (cf), which aim to promote convergence between autonomous communities in terms of per capita income, are the cooperation fund and, to adjust per capita financing, the competitiveness fund. the gffps is constituted by 75% of the theorist tax revenues of the autonomous communities, distributed each year in proportion to their spending needs (sn). the operation of the gffps generates horizontal flows of transfers between regions. the transfer of guarantee, which each community pays or receives, is the difference between its contribution to the gffps (75% of regional theorist collection for assigned taxes) and participation in the fund by the adjusted population8. consequently, also autonomous communities have 25% of the theorist regional tax revenues that are not integrated into the gffps. the gsf, or vertical core funding for each region in the base year, is the total net funding of the difference between actual and theorist collection for assigned taxes prior to the convergence funds and the global financing needs (gfns) for 2009. in the base year, the fs (fsi0) is established and evolves according to the so-called iten, defined as the state tax revenues corresponding to the no transferred tranches of personal income tax, vat, and excise duties9. different topics of the current afs are noted should be objected to reform. zabalza (2020) points out that the great recession of 2008 and the current mechanism of updating the model have generated significant levels of under-financing, with the consequent increase in the indebtedness of the communities. consistent with herrero (2021), the stock of public debt of the autonomous communities reached 23.7% of gdp in 2019, far exceeding the limit of 13% established in the budget stability law, highlighting the greater vulnerability of the autonomous communities to face the crisis of 2020, than that of 200810. moreover, according to lópez laborda and zabalza (2011), the horizontal equity of the model, based on the principle of equalization of fiscal capacity, is not maintained over time with the established updating mechanism. in addition, de la fuente (2021) proposed the creation of a complementary leveling fund financed entirely with state resources, which would be intended to supplement the income of those autonomous communities that are below the average in terms of financing per adjusted inhabitant. 3.2. the poa article 11 of law 22/2009, of 18 december, establishes that each year, the autonomous communities will receive the financing corresponding to the poa concerning the resources subject to liquidation, which are the rpit, the assigned percentage of vat, 7 last year for which final settlement data are available. 8 the adjusted population of each region considers demographic and geographical variables that affect the demand and unit costs of providing the essential public services of autonomous ownership. in addition, each exercise is applied with updated values of the population and the other distribution variables. 9 gitent is the variable’s cumulative gross growth rate of iten in the base year and t. 10 law 2/2012, of 27 april, of budgetary stability and financial sustainability. 51.86 40 8.13 63.49 16.96 19.53 0 10 20 30 40 50 60 70 tax with regulation (pitr, other tax) tax without regulation (vat, ed) transfers (gffps, gsf) 2003 2019 figure 1: afs resources evolution (%) own source arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 2022 5 and special duties, the transfer of the gffps and the gsf. the corresponding final settlement is for the difference between the final values and the poa perceived (table 2). the poa for the rpit, by article 12 of law 22/2009, determines based on the budgetary forecast of income from with, payments on account of no declarants (nd), and fp by the equation, poai (t) = bft (t) * ucrtri(t/ly) * 0.98 (1) being, poai (t): the annual amount of the state’s advance must pay to the autonomous community i in the concept of payment on account of the yield in year t of the rpit. bft (t): the amount of the personal income tax budget forecast for year t for with, nd, and fp. ucrtri (t/ly): the coefficient of update or expected increase for the autonomous rate of the tax of the autonomous community i, between the last year (ly) with final settlement practiced and year t. the update index, ucrtri(t/ly), is used to distribute the amount of bft (t) among the autonomous communities and is the result of applying three reasons. the first reason is defined as the ratio of the regional and state liquid quotas (plus nd) of the community i on the total of autonomous communities. the second reason measures the effect of the regulatory measures adopted by each autonomous community. the third reason weighs the discrepancy between the total liquid contributions (plus nd) and the net recognized rights for fp, with, and nd settled both last year. the amount of the poa is made effective for each autonomous community monthly. the final settlement is determined in t+2; it is for the difference between the final value of the rpit and the poa received. by article 26.2 of law 22/2009, of 18 december, the definitive settlement of the rpit is determined by the amount of the liquid quotas of the residents in the territory of the autonomous community (table 3). criticisms of the functioning of the poa (cerrfm, 2017, manzano, 2020) refer to the temporary gap between the time in which the regulatory decisions in the regional personal income tax are approved by the autonomous communities (t) and those that the economic effect is perceived by the regional finances and the citizens (t+2). in addition, they refer to the divergences between the estimates of the yield transferred and the final yield received by the autonomous communities. according to cuenca (2016), that system destabilized the income stream of the autonomous communities. 4. methods and results this work evaluates the rpit based on the poa. first, poa estimates are from potential income tax by considering the regional gdp (rgdp) and rtr. second, poa estimates are from current income tax in t using the variables fp, with, and crp. estimates in both models are by a dynamic panel data of table 1: the basic funding in 2019 (million euros) tax capacity [1] gffps [2] gsf [3] theorist core funding [4]=[1]+[2]+[3] cataluña 23.484 −1468 782 22.798 galicia 6256 1540 602 8398 andalucía 17.057 4842 506 22.405 asturias 2610 371 188 3169 cantabria 1603 61 495 2159 la rioja 813 88 215 1116 murcia 3156 773 −203 3726 valencia 12.334 1196 −1.459 12.072 aragón 3731 219 280 4230 c.-la mancha 4339 1292 80 5710 canarias 2316 2952 450 5243 extremadura 1985 914 −706 3350 baleares 3744 −364 −683 2673 madrid 24,242 −4344 −763 19.135 cast. y león 6105 1018 437 7560 total 2019 113.775 9090 979 123.844 total 2018 108.509 8972 947 118.248 variación % 7.61% 1.31% 3.37% 4.51% source: mh (2022b) table 2: tax resources subject to settlement in theorist terms in 2019 (million euros) rpit [1] vat [2] ed [3] [4]=[1]+[2]+[3] cataluña 10211,26 7109,44 2683,15 20003,85 galicia 2344,22 2108,84 923,66 5376,73 andalucía 5578,49 6135,36 2424,62 14138,48 asturias 1014,74 843,00 336,60 2194,34 cantabria 550,96 506,09 210,62 1267,67 la rioja 322,86 257,13 102,43 682,38 murcia 1029,13 1068,24 548,49 2645,96 valencia 4229,66 4100,53 1605,42 9955,61 aragón 1365,63 1144,80 549,60 3070,04 c.-la mancha 1381,24 1471,95 785,66 3638,86 canarias 1592,32 78,31 1670,63 extremadura 595,92 705,84 384,97 1686,73 baleares 1295,51 1410,90 447,62 3154,04 madrid 12300,32 6892,80 1683,19 20876,32 cast. y león 2160,20 2014,01 1007,92 5182,14 total 2019 46002,43 35768,96 13772,39 95543,78 source: mh (2022b) arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 20226 the fifteen autonomous communities for 2003-2019, using the estimator of instrumental variables (iv) and its generalization by the generalized estimator of moments (gmm). data are annual. the transformation in first differences is used to correct fixed effects. the definition of the variables used in gmm estimations and statistical sources are shown in table 4. one of the main advantages of panel data estimation is controlling individual, unobservable effects correlated with other variables in the specification of an equation. the individual study of each cross-section does not allow for identifying these individual effects (hausman and taylor, 1981). the inclusion of dynamic structures in a standard panel equation reinforces the persistence of this type of model since the unobservable individual effect, random or fixed in nature (ηi), is added to the inertia induced by the autoregressive mechanism of the equation (angulo and mur, 2004). the ls estimators’ inconsistency is because the orthogonality condition between the error term and the regressors is broken. the introduction of instrumental variables (iv), uncorrelated with the perturbation and highly correlated with the explanatory variables, constitutes a reasonable solution to this problem. the gmm estimator is consistent, although it cannot be guaranteed to be efficient. 4.1. unit roots and cointegration working with time series panel data, suppose that the endogeneity characteristic of the regressors, as well as correlation and heteroscedasticity of the residues, are joined with fixed and random effects. according to baltagi (2021), if variables are not stationary, panel data regression provides a consistent estimate of the parameters when n and t→∞. unit root tests assume the condition that n and t →∞. however, t increases faster than n, with n/t →0. table 5 presents the unit root test results, in first and second differences, considering an independent term and, therefore, the existence of individual effects for the variables poa, rgdp, rtr, fp, with, and crp. the number of individual sections is 15. the maximum number of delays is selected automatically by akaike information criterion (aic). the null hypothesis, ho, of a common unit root in the data panel considering cross-section are independent (levin statistic, lin & chu t-statistical) are accepted for all the variables in the panel, in first and second differences11. meanwhile, the existence of an individual unit root (im, pesaran, shin w-stat, adf-fisher, and pp-fisher) is rejected for all the variables, except for rgdp and fp in first differences. subsequently, estimates are consistent enough and not merely spurious. nevertheless, there are no definitive conclusions about cointegration between variables; meanwhile, variables are cointegrated consistent with the pedroni test, and that hypothesis is rejected according to the kao test (tables 6 and 11 if the ar(1) process is considered for a data panel, yit = pi yit-1 + xit δi+ꜫit , where i = 1,2,….,n and t = 1,2,….,ti. if |pi.<1|, yi is a weakly stationary process, if |pi.=1|, yi contains a unit root. the levin, lin, and chu test considers pi = p common to all individuals. this test is recommended when n and t are reduced. in the im, pesaran, shin w, fisher-adf, and fisherpp tests, pi varies between individuals. 7). it allows confirmation for -between dimensionof the pedroni cointegration test because the kao cointegration test considers common ar coefficients. 4.2. panel data estimation 4.2.1. the poa from potential income tax poa constitutes monthly payments on account of the yield of rpit in t and is first explained from potential regional income taxation considering rgdp and rtr. the econometric model defined is, poa i poa x vit it it it= + + +−η α β1 ' (2) v iidnit v~ ,0 2( ) being xit ' a 3 × 1 vector of observations of the explanatory variables (rgdp, rtr) in the individual i and time t and a white table 4: data definition and statistical sources variable definition statistical sources ei employment income aeat (2022b) iea income from economic activities aeat (2022b) etr the effective tax rate is defined as the rate between total fp and an average iea aeat (2021c) fp fractional payments by entrepreneurs aeat (2021c) rgdp gdp regional in market prices ine (2021) crp collection of rpit aeat (2022b) crpwr collection of rpit without regulation fedea (2021) poa monthly payments on account to rpit mh (2021b) rtr regional tax rate (marginal rate to the regional average of ie+iea) mh (2021c) str state tax rate (marginal rate to the average of ie+iea) personal income tax law with withholding on ei, iea, and capital aeat (2022c) table 3: final settlement of the rpit in 2019 (million euros) rpit [1] poa [2] final settlement [3]=[1]–[2] cataluña 10,573 9690 883 galicia 2368 2198 170 andalucía 5685 5204 481 asturias 1021 1012 9 cantabria 549 583 16 la rioja 315 302 13 murcia 1048 948 100 valencia 4315 3944 371 aragón 1427 1356 72 c.-la mancha 1372 1286 86 canarias 1508 1391 117 extremadura 625 604 21 baleares 1319 1166 153 madrid 11664 10604 1060 cast. y león 2077 1998 79 total 45867 42,236 3631 fuente: mh (2022b) arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 2022 7 noise error term, being i = 1, 2,…,15, the number of individuals considered in the period t = 1, 2,…,15. the term ηi is the term for individual fixed effects. the estimates of the dynamic panel data are for the period 2003-2019, being the endogenous variable the poa of the fifteen autonomous communities, using the iv estimator and its generalization by gmm. data are annual. the transformation in first differences is applied to eliminate the individual fixed effects. the weighting matrix used is a white period matrix. the estimated panel includes 225 standard observations. in addition, to the autoregressive of the endogenous variable, poa (-1), the variables rgdp and rtr are used. all variables are defined in logarithmic terms, l constituting the logarithmic notation. instruments: the autoregressive of the endogenous variable, lpoa (-2), lcrpwr, lei, lstr, and liea are considered potential instruments for gmm estimates. l constituting the logarithmic notation in estimates. in dynamic panel data estimates, lpoa (−2) constitutes an instrument for lpoa (−1) in the right hand of the equation. besides, because the rpit varies with the total regional income, the variable lrgdp should be correlated with the error term. consequently, the variable lcrpwr is used as an instrument because poa is payments on account considering such regulatory capacity. also, the primary sources of income, but individually considered; namely, lei and liea, are used as an instrument. however, the order of instruments is essential for estimates, and previously to liea, estimates used lstr. if the variable lrtr is correlated with the error term, it should be because lrtr is correlated between regions. moreover, using lstr as an instrument should be justified because, in the personal income tax, the base tax is the same for spit and rpit. subsequently, estimates consider the overlap in the base tax table 5: unit root test test first diferencies statistic probability second differences statistic probability poa ho: assumes common unit root process levin, lin & chu −18.8311 0.0000 −6.6302 0.0000 ho: assumes individual unit root process im, pesaran, shin w-st adf-fisher chi-square pp-fisher chi-square −19.8182 269.997 272.797 0.0000 0.0000 0.0000 −13.5859 249.257 268.048 0.0000 0.0000 0.0000 rgdp ho: assumes common unit root process levin, lin & chu −2.1294 0.0166 −13.7610 0.0000 ho: individual unit root im, pesaran, shin w-st adf-fisher chi-square pp-fisher chi-square −1.2154 30.9570 29.1778 0.1121 0.4175 0.5083 −9.7129 135.604 136.908 0.0000 0.0000 0.0000 rtr ho: common unit root levin, lin & chu −11.6588 0.0000 −21.8748 0.0000 ho: individual unit root im, pesaran, shin w-st adf-fisher chi-square pp-fisher chi-square −8.4427 110.329 110.430 0.0000 0.0000 0.0000 −16.8314 229.670 376.998 0.0000 0.0000 0.0000 fp ho: common unit root levin, lin & chu −5.8059 0.0000 −12.7347 0.0000 ho: individual unit root im, pesaran, shin w-st adf-fisher chi-square pp-fisher chi-square −2.4841 44.0608 41.7175 0.0000 0.0471 0.0757 −8.6861 126.375 203.313 0.0000 0.0000 0.0000 with ho: common unit root levin, lin & chu −6.8790 0.0000 −17.9431 0.0000 ho: individual unit root im, pesaran, shin w-st adf-fisher chi-square pp-fisher chi-square −5.5096 81.6647 79.2056 0.0000 0.0000 0.0000 −14.4377 195.133 256.298 0.0000 0.0000 0.0000 crp ho: common unit root levin, lin & chu −15.6071 0.0000 −14.2250 0.0000 ho: individual unit root im, pesaran, shin w-st adf-fisher chi-square pp-fisher chi-square −11.2536 157.753 229.757 0.0000 0.0000 0.0000 −11.2640 162.479 387.853 0.0000 0.0000 0.0000 arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 20228 in personal income tax; also, there is some type of response in the tax rate of one region to the others. according to arellano and bond (1991), in the estimation of gmm by iv, it is essential to contrast the validity of the instrumental variables; this is the null hypothesis of no correlation with the error term. the m2 statistic contrasts the absence of second-order serial correlation, ar (2), in the residues, from the equation in the first difference. it occurs if the error term in the level model is not correlated but also if the error term has a unit root. according to table 8, at the confidence level of 10%, the first-order statistic is significant and, therefore, the hypothesis of non-correlation in the first-order autoregressive ar(1) is accepted, while the m2 statistic is not significant. moreover, according to the results, the number of instruments (16) is greater than the number of estimated coefficients. therefore, the j statistic, or value of the objective function gmm in the value of the estimated parameters, is used to contrast the null hypothesis of over-identification of the restrictions or the sargan test. finally, the null hypothesis of overidentification of restrictions is rejected according to statistic j. subsequently, the equation to be estimated is, lpoait=ηi+αlpoait−1+β1 lrgdpit+β2 lrtrit+vit (3) v iidnit v~ ,0 2( ) being i the notation of the autonomous community i and t the year. the relationship between the variables lpoa and lpoa (−1) is expected to be direct because poa is calculated from the budget prevision, for the following year (t), on fp and with, and taking into account the update coefficient ucrtri (t/ly). the expected sign of the β1 coefficient is positive because lrgdp positively affects taxation, consequently, lpoa. besides, the expected sign of the β2 is positive because it is supposed to be a direct relationship between lrtr and lpoa. the results show that all the explanatory variables in the data panel are significant, according to the t-statistic at the significance level of 5% (table 8). in turn, the sign is expected regarding the coefficient table 6: cointegration test (poa, rgdp, rtr) pedroni cointegration test null: no cointegration no deterministic trend, automatic lag length based on aic with a max lag of 2 alternative hypothesis: common ar coefficients (within-dimension) statistic p-value weighted statistic p-value panel pp-statistic panel adf-statistic −13.6628 −13.8591 0.0000 0.000 −9.9712 −10.1893 0.0000 0.0000 alternative hypothesis: individual ar coefficients (between-dimension) statistic p-value group ppstatistic group adfstatistic −15.5167 −15.2202 0.0000 0.0000 kao cointegration test null hypothesis: no cointegration no deterministic trend, automatic lag length based on aic with a max lag of 3 hypothesis tstatistic p-value adf −2.7644 0.0029 table 7: cointegration test (poa, fp, with, crp) pedroni cointegration test null: no cointegration no deterministic trend, automatic lag length based on aic with a max lag of 3 alternative hypothesis: common ar coefficients (within-dimension) statistic p-value weighted statistic p-value panel pp-statistic panel adf-statistic −22.8357 −14.0774 0.0000 0.0000 −9.9712 −10.1893 0.0000 0.0000 alternative hypothesis: individual ar coefficients (between-dimension) statistic p-value group ppstatistic group adfstatistic −33.4924 −15.9285 0.0000 0.0000 kao cointegration test null hypothesis: no cointegration no deterministic trend, automatic lag length based on aic with a max lag of 3 hypothesis t-statistic p-value adf −9.9986 0.0000 arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 2022 9 of the autoregressive lpoa (−1). the sign of β1, as expected, is positive up to 1.09. consequently, the poa for the settlement of rpit is linked directly to the economic activity; a 1% increase in lrgdp suppose a 1.09% increase in lpoa. the sign of β2 is the expected positive; the elasticity of lpoa to lrtr is up to 0.5798. the results, consistent with boodway et al. (2001), show some degree of tax base overlap between levels of government, state and regional governments, which endow both with real tax power. in addition, regarding rtr, regional governments undertake too much redistribution, which induces them to set a lower tax. besides, possible inefficiencies will arise if vertical transfers do not internalize them. acording to keen (1997), state transfers should internalize fiscal externalities that arise in horizontal relations because of efficiency concerns. 4.2.2. the poa from income tax power subsequently, poa is explained considering current resources for the treasury from the personal income tax in t, that is, the payments on account to budget forecasting to determine poa, namely fp and with on ei, iea, and capital, which is the most important ei. besides, crp completes current income in t from rpit. moreover, being etr, the effective tax rate for fp, fp=iea*etr (4) if t is the taxation for the personal income tax, t = spit + rpit consequently, etr is an estimate of the t tax rate of the iea taxpayer, fp=iea*(str+rtr) (5) therefore, all fiscal variables, etr, rtr, and str, are considered to estimate poa from current taxation. the econometric model defined to explain poa from real is, poa i poa x vit it it it= + + +−η α β1 ' (8) v iidnit v~ ,0 2( ) being xit ' a 3 × 1 vector of observations of the explanatory variables (fp, with, and crp) in the individual i and time t and vit a white noise error term, being i = 1, 2,…,15, the number of individuals considered in the period t = 1, 2,…,15. the term ηi is the term for individual fixed effects. estimates use the iv estimator and its generalization by gmm for 2003-2019. data are annual. the transformation in first differences is applied to eliminate the individual fixed effects. the weighting matrix used is a white period matrix. the estimated panel includes 15 periods and 15 individual sections, with 225 standard observations. in addition, to the autoregressive of the endogenous variable, poa (-1), the variables fp, with and crp are used. all variables are defined in logarithmic terms, and l constitutes the logarithmic notation. subsequently, the equation to be estimated is, lpoait=ηi+αlpoait–1+β1 lfpit+β2 lwithit+β3 lcrpit+vit (6) v iidnit v~ ,0 2( ) being i the notation of the autonomous community i and t the time. the relationship between the variables lpoa and the autoregressive lpoa (−1) is expected to be direct because poa is calculated from the budget prevision, for the following year (t), on fp and with, and taking into account the update coefficient ucrtri (t/ly). the expected sign of the β1 is negative because is supposed lfp negatively affected poa, being a payment on account of the settlement of the personal income tax. however, the expected sign is positive for β2, considering lwith positively affects lpoa. the expected sign of the β3 is positive because it is supposed to be a direct relationship between lpoa and lcrp. instruments: the variables used as an instrument are lpoa (-2), liea, letr, lrtr, and lstr. l constituting the logarithmic notation in estimates. in the dynamic panel estimates, lpoa (−2) constitutes an instrument for lpoa (−1) in the right hand of the equation. lfp and lwith variables should be correlated with the error term because they are payments on account of budget forecasting to determine poa. the variables used as instruments for lfp are liea also letr. besides, lcrp should be correlated with the error term because lpoa (−1) is used on the right side of the equation. instruments for lwith, and lcrp, are all tax table 8: panel generalized method of moments (transformation: first differences) dependent variable: lpoait sample adjusted: 2005-2019 periods included: 15 cross-sections included: 15 total panel (unbalanced) observations: 225 white period-instrument weighting matrix white period (cross-section cluster) standard errors & covariance (d.f. corrected) instrument specification: @dyn lpoa (-2), lcrpwr, lei, lstr, liea constant added to instrumental list variable coefficient t-statistic p-value lpoa(−1) 0.4589 253.2860 0.0000 lrgdp 1.0918 77.8374 0.0000 lrtr 0.5798 6.9536 0.0000 effects specification cross‑section fixes (first diferences) instrument rank: 16 j-estadístico: 12.8781 p-value: 0.4572 arellano-bond serial correlación test test order m-statistic rho p-value ar (1) ar (2) −1.8329 0.8488 −4.4816 2.1565 0.0668 0.3960 arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 202210 rates applied in the personal income tax, namely, lrtr and lstr. using lstr as an instrument should be justified because, in the personal income tax, the base tax is the same for spit and rpit. subsequently, estimates consider the overlap in the base tax in personal income tax. also, using lrtr as an instrument is justified because there is some type of response in the tax rate of one region to the others. consistent with table 9, at the confidence level of 5%, the firstorder statistic is significant and, therefore, the hypothesis of noncorrelation in the first-order autoregressive ar(1) is accepted, while the m2 statistic is not significant. moreover, according to the results, the number of instruments (17) is greater than the number of estimated coefficients. therefore, the j-statistic or value of the objective function gmm in the value of the estimated parameters is used to contrast the null hypothesis of over-identification of the restrictions or sargan test. finally, the null hypothesis of overidentification of restrictions is rejected according to statistic j. the results show that all the explanatory variables in the data panel are significant, according to the t-statistic at the significance level of 5% (table 8). in addition, the sign is expected regarding the coefficient of the autoregressive lpoa (−1) up to 0.5602. the coefficient β1, negative at -0.1712, supposed that lfp negatively affects lpoa. agree with hoyt (2001), a coordinated policy pursued by different levels of government will lead to low taxes or possible subsidies. besides, the sign of β2 is the expected, positive up to 0.51; therefore, lwith positively affects lpoa. moreover, the sign of the β3, is the expected positive, up to 0.2365. otherwise, the net effect of lfp and lcrp on poa is 0.065. the results, consistent with boodway et al. (1998), show that state and regional bases are dependent on the extent of activity of the private sector, which seems to make some degree of tax base overlap between levels of government and almost inevitable consequence of endowing both with real tax powers. besides, as those authors point out, regional governments are competing away regarding redistributive objectives, known as horizontal externalities. 5. conclusions the reforms of the afs in 2001 and 2009, which established a regional rate of taxation for the personal income tax, is the leading tax with regulatory capacity assigned to the autonomous communities. the reform of the afs has meant that taxation for employment income is different through communities. besides, taxation of the iea is by a progressive tariff; it is also established by the sub-central government each year, unlike the corporate taxation that taxes with a proportional tax rate and equals throughout the national territory the companies’ income. the autonomous community gets regional personal income taxation through the monthly regional payments on account (poa). they are calculating from the budget prevision, for the following year (t), on fractional payments (fp) by entrepreneurs and withholdings on ei, iea, and capital (with) and taking into account the index of update ucrtri (t/ly). subsequently, in the year when all the outstanding values of the regional personal income taxation are known, regional governments receive the corresponding final settlement (t+2). the main drawbacks of this system are the time lag between the moment regional governments use their regulatory capacity in the personal income tax (rpit) and the moment in which governments and citizens notice these effects. moreover, the gap between the resources of the poa and the final settlement of the rpit. the study of the rpit is carried out by estimating a dynamic panel data of the poa of the fifteen autonomous communities, taking first differences to correct the fixed effects. first, it considers the potential taxation from gdp (lrgdp) and the regional tax (lrtr). the overall significance of the model makes it possible to affirm the existence of fixed effects in autonomous communities. the main results were that the poa is linked to the economic activity, the elasticity of lpoa to lrgdp, up to 1.09. also, the elasticity of lpoa to lrtr was 0.58. according to the results, there was some degree of tax base overlap between levels of government in the personal income tax. besides, there was some type of reaction of the tax rate in one region to the tax rate of others. consequently, state transfers internalized vertical and horizontal externalities. however, it should be noted that the null hypothesis of no correlation of instrumental variables with the error term is accepted at the confidence level of 10%. secondly, the lpoa is explained from tax power in t using lfp, lwith, and the collection of rpit in t (lcrp). the main results are lfp negatively affect lpoa, being the elasticity of lpoa to lfp negative up to -0.17; meanwhile, it is positive to lwith up to 0.51. finally, the elasticity of lpoa to lcrp is up to 0.2365. nevertheless, the net effect of lfp and lcrp is 0,06. consequently, real tax power is mainly from withholdings; negative efficiency concerns mainly concern taxation for entrepreneurs. in addition, there is some tax base overlap and the reaction of the tax rate in table 9: panel generalized method of moments (transformation: first differences) dependent variable: lpoa sample adjusted: 2005-2019 periods included: 15 cross-sections included: 15 total panel (unbalanced) observations: 225 white period-instrument weighting matrix white period (cross-section cluster) standard errors & covariance (d.f. corrected) instrument specification: @dyn (poa, -2), liea, letr, lrtr, lstr constant added to instrumental list variable coeficient t-statistc p-value lpoa (−1) 0.5602 53.5497 0.0000 lfp −0.1712 −9.6283 0.0000 lwith 0.5151 25.5767 0.0000 lcrp 0.2365 13.7968 0.0000 effects specification cross‑section fixes (first differences) instrument rank: 17 j-statistic: 15.6595 p-value: 0.2680 arellano-bond serial correlación test test order m-statistic rho p-value ar (1) ar (2) −2.1117 1.1843 −5.7234 2.5715 0.0347 0.2363 arner: subcentral taxation in spain international journal of economics and financial issues | vol 12 • issue 4 • 2022 11 one region to the tax rate of others. thar results are accepted being the null hypothesis of no correlation of instrumental variables with the error term accepted at the confidence level of 5%. in the current afs, the gffps and gsf internalize vertical and horizontal externalities; however, some weak points, indeed the increase of the indebtedness of regional governments or the poa, have been taken into account reform afs. references aeat. 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(2020), autonomía tributaria, suficiencia de recursos y descentralización. in: martínez-vázquez, j., lago peñas, s., editors. desafíos pendientes de la descentralización en españa: suficiencia y autonomía tributaria. spain: instituto de estudios fiscales, rifde. p89-127. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2022, 12(1), 13-23. international journal of economics and financial issues | vol 12 • issue 1 • 2022 13 investment risk tolerance amongst south african university students in the vaal triangle area antonios evangelou1, sune ferreira-schenk2*, lorainne ferreira3, elizabeth bothma4 1post graduate student, north west university, south africa, 2programme leader for risk management, school of economic sciences, north west university, south africa, 3senior lecturer, school of economic sciences, north west university, south africa, 4statistician, optentia research unit, north west university, south africa. *email: 23261048@nwu.ac.za received: 03 june 2021 accepted: 01 december 2021 doi: https://doi.org/10.32479/ijefi.11567 abstract analysing students risk tolerance during the investor life cycle is imperative to students and financial planners alike, to facilitate the implementation of suitable investments and investment strategies. students in universities do not have the required knowledge to invest and this is why an investment framework was created to assist, guide and inform students of what stage of the individual investor life cycle that they are in and suggest suitable investment strategies. the article implemented a quantitative approach, using secondary data analysis. the data used for the analysis is from a selfadministered questionnaire in 2017 that was distributed to a sample of 396 students from two higher education institutions in the vaal triangle region. two validated risk tolerance scales were used to analyse students risk tolerance levels. the objective of this paper was to determine the risk tolerance levels of students in the vaal triangle region. the two results from the 13-item scale and the single-item scale for measuring risk tolerance indicated that the students have a medium risk tolerance level. keywords: investing, students, demographic factors, south africa, risk tolerance jel classifications: d92, g11, j11 1. introduction risk tolerance is one of the most comprehensive concepts used in the financial industry and a fundamental factor that needs to be taken into consideration when planning an individual’s investment strategy (rutgers, 2014). risk is created from uncertainty and the inability to accurately predict market prices; however, risk that results from uncertainty can be managed (crouhy et al., 2014). an individual encounters risk daily. in general investment terms, risk can be explained as the uncertainty of future returns or potential losses (van den bergh, 2004). an individual’s life experiences, to some extent, are therefore linked with his/her understanding of the relationship between risk and return (crouhy et al., 2014). these life experiences will play an important role in an individual’s income, available capital, liquidity requirements, knowledge about investments, emotional resilience, as well as their attitude towards price volatility (fredman, 1996; hanna and chen, 1997). financial institutions and advisors should understand individual investors’ risk tolerance, in addition to their ability and willingness to take on risk as a fundamental component in the investment planning process (larkin et al., 2013). although risk tolerance is an important factor when determining an individual’s asset composition or asset portfolio, it is not an easy process due to risk tolerance being regarded as a multidimensional attitude, that is likely to be influenced by numerous predisposing factors (grable and joo, 2004). measuring financial risk tolerance and determining the factors that affect financial risk perception has been of interest to investors this journal is licensed under a creative commons attribution 4.0 international license evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 202214 and researchers alike for many years (adem, 2010). there are many variables that, once grouped and discussed, can interpret an individual’s risk tolerance level. these variables include age, sex, marital status, occupation and wealth. individual financial risk tolerance is assumed to be the primary determinant of choice behaviour in a situation that the individual is facing when investing (bailey and kinerson, 2005; grable and lytton, 2001). as such, investment managers, as well as researchers in the last decade, have renewed their interest in better comprehending risk tolerance associated with investors. one of the main reason for renewed interest is due to the advances in investment management models, as investment managers need a minimum of four factors as inputs when developing financial plans. these include the goals, time horizon, financial stability and the level of risk tolerance of the investor (garman and forgue, 1997; hallman and rosenbloom, 1987; trone et al., 996; van den bergh, 2018). risk tolerance is one of the factors that is often overlooked when potential investors or organisations are interested in investing. risk tolerance often enables a person or organisation to trade-off some level of investment returns for a better result over a period of time. it is therefore important to identify these factors for each individual, as a well-drafted portfolio could benefit the individual in times of need (kuhnen and knutson, 2011). according to mittra (1995), it is important for a financial planner to study investors risk tolerance levels using a subjective and objective measures to help identify what risk tolerance the individual investor is able to take. according to mclendon (2016), there are a few students that have the financial reserves to engage in financing investment opportunities. mclendon (2016) found that students follow either their peers or their own instinct when it comes to investing their money. this increases the likelihood that students could make a bad investment decision, which might lead to a negative investment experience (kuhnen and knutson, 2011). individuals’ perception of investments can be manipulated by individuals who have experienced financial losses, which can result in potential investors not investing and losing out on their potential earnings. there are nine countries with less than two-thirds (±62%) of the youth actually investing their money; these countries are singapore, philippines, indonesia, hong kong, taiwan, korea, india the united arab emirates and south africa. (charlett et al., 1995; baker and ricciardi, 2015). therefore, this study constructs an investment framework for students, established on their risk tolerance level. the study reviewed the current market-related investment products that might be suitable for students and analysed student risk tolerance levels. the study also proposes investment solutions based on the investor life cycle and the level and extent to which students are willing to take risk. the investment framework will serve as a benchmark framework for students, where they are able to choose the correct investment option according to their risk tolerance. 2. literature review the section focuses on investment decisions and how that is influenced by the investor life cycle theory. individual investor choices vary throughout the different phases of their life cycle since the investors will experience a change in their circumstances in each of the different phases. in order to construct an effective investment policy for the different needs and circumstances in an individual’s life, it is crucial to determine individual investors objectives and their constraints, which is called an investment portfolio (coronation fund managers, 2017:105). it is also important to determine an investors risk tolerance level before compiling an investment portfolio (goodall, 2005:4). this section will, therefore, establish the foundation for creating an investment framework for student investors. 2.1. investor life cycle theory according to bodie et al. (2010:698), the investor life cycle theory and what phase of the cycle the individual investor is in contributes as one of the main factors that influence the risk objectives of the investor. it is, therefore, imperative that the individual investor comprehends how essential it is to know where they are in the investor life cycle, as it can help manage the effectiveness of the investment portfolio to provide the best results (goodall, 2005:3; harty, 2014:1). the individual investor life cycle is defined as the several phases of owning an investment from the start of the transaction to the actual investment (harty, 2014). as seen in figure 1, during the different phases of the investor life cycle, each individual’s needs are different. as the individual investor’s life starts changing and net worth increases, the investment tactics are also altered to make sure that their goals and objectives have been met (reilly and brown, 2012). within the investor life cycle, the assignment table 1: assumed relationship between risk tolerance and demographics demographic low-risk tolerance high-risk tolerance gender female male age older younger marital status married single occupation workers and labourers professionals self-employment non-self employed self-employed income low high race non-whites whites education less more source: author’s own compilation figure 1: four phases of the investor life cycle source: (van den bergh, 2018) evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 2022 15 of assets shifts as the investor’s circumstances change. according to marx (2009:226), the investor life cycle theory is affected by demographics such as age and health of the investor as they become less risk-tolerant. 2.2. investor risk tolerance risk tolerance is an important factor that fundamentally influences an individual’s personal financial decisions (snelbecker et al., 1990:378). many determinants, once grouped and discussed can interpret an individual’s risk tolerance level. every investor’s level of risk tolerance is however different and is dependent on the demographic factors which are his/her age, gender, marital status, race, level of education, employment status and income. it is, therefore, imperative for investors that their financial planners, as well as researchers, understand what factors affect risk tolerance (grable, 2016:25). table 1 presents the conclusions from the literature about the relationship between risk tolerance and demographics. demographic characteristics are the most widely investigated determinant of financial risk tolerance. this is due to a consensus among investment managers and researchers that the demographics can be used to both differentiate among levels of investor risk tolerance and classify investors into risk tolerance categories. each investor has his/her risk tolerance level that depends on various demographic factors, such as age, gender, race, marital status, education, employment status and income. it was thought one of the most important demographic factors for risk tolerance is gender because it was found that men tend to be seen as ‘thrill-seekers’, more than what women are (roszkowski et al., 1993). a general agreement between investment managers is that the gender of an individual is both a differentiating and classifying factor because there is a strong belief that men need to take on more risks than what women do (slovic, 1966). other researchers have also verified this finding that females take fewer risks than their male counterparts, making males more risk-tolerant than females (higbee and lafferty, 1972; blume and friend, 1978; coet and mcdermott, 1979; rubin and paul, 1979; and yip (2000) slovic (1966), roszkowski et al. (1993), hawley and fuji (1993), sung and hanna (1996), sharma (2006), van den bergh, (2018) dickason and ferreira (2019) and lawrenson (2020). in addition, a study by dickason et al. (2017) found significant differences between the male and female perception of investment. their findings showed that male participants were more confident in investment decisions compared to female investors. furthermore, a study by bayyurt and coᶊkun (2013) found similar results. stating that males are more likely to invest in higher-risk investment option compared to females, who are more incline to invest in less risky alternatives. the demographic factor most frequently investigated is age, as it is believed to be linked to financial risk tolerance (grable et al., 2009:4). wallach and kogan (1961) were the first researchers to have studied the link between age and risk tolerance. their experiment used dilemmas of choice, indicating that individuals that were older had a lower risk tolerance than younger individuals. irwin (1993) explains that as individuals get older, it is believed that they would rather take less financial risk, because as investors grow older, they tend to have less time to recover from financial losses experienced from high-risk investments, compared to an individual who is younger and has more time to recover (grable and lytton, 1997:64; grable and roszkowski, 2008; gibson et al., 2013; dickason and ferreira, 2018). furthermore, cocco et al. (2005:526-527) supports this view and found that investors are more likely to refrain from more risky investments as they age. to determine how an investor with dubious income would react, the authors developed a quantitative model where the investor has a choice to either invest in a risky or riskless asset. the results showed that labour income – an implicit risk-free assest – becomes less important as the investor ages, and adjusts by increasing investments in risk-free assets. on the contrary, a study by gomes and michaelides (2005:897-898) investigated the low number of stock investments in america. the results, however, suggest that not all young investors have the majority of their portfolios invested in equities. the reason is that not all young investors accumulate enough wealth to enter the equities market during the accumulation phase due to risk-averse households with a low intertemporal substitution (eis). only if this barrier can be overcome, will you investors be able to invest in equities (michaelides and gomes, 2005). according to baker and haslem (1974), individuals that are single are also associated with higher levels of risk tolerance. the over-all consensus between researchers is that individuals who are single are believed to take on more risk than married individuals. this is because individuals who are single are presumed to have less worries than married individuals, particularly with relation to dependants. they are also considered to have less social risk when taking on higher-risk investments (roszkowski et al., 1993:225; sung and hanna, 1996:15; grable, 2000:38; grable and lytton, 2001:44; grable and joo, 2004:74; yao et al., 2004:259; yao and hanna, 2005:85; grable and roszkowski, 2007:797). financial investment managers, therefore, assume that individuals who are single do not have as much to lose as individuals that are married, who often have responsibilities towards themselves and their dependents. on the contrary, financial investment managers assume that individuals who are married are vulnerable to social risk if an investment choice results in an increase in loss (roszkowski et al., 1993). other important factors that determine an individual’s investment risk tolerance are income and wealth. this is because it is assumed that an individual’s risk tolerance level rises as his/her income rises. the reason for this is that individuals that have money or are wealthy are usually able to recover more easily from a financial loss due to a risky investment (grable and lytton, 1999). a study by maccrimmon and wehrung (1986) found that individuals that earn a higher salary usually take on more risk than lowerincome individuals. in addition, a study by irwin (1993) found that individuals wit predictable and stable income are inclined to be more risk-tolerant than individuals with unpredictable and unstable income. these results were confirmed in the south african context by van schalkwyk (2012); mabalane (2015:106); dickason (2017:217); van den bergh (2018:177); ferreira and dickason-koekemoer (2019:15). evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 202216 not many studies have been conducted pertaining to link between risk and race. the first researcher that explored risktaking differences between black and white adults was lefcourt (1965:765). the risk-taking experiment by lefcourt (1965:765), consisted of 30 african and 30 white participants, the results of which presented that the african participants take fewer risks, makes fewer bet shifts and opts to choose fewer low probability bets than the white demographic does. observational measures such as asset ownership and the proportion of overall wealth allocation to risky investment assets such as stocks or small business are used in most studies. in addition, a study by leigh (1986), found that non-white individuals, in comparison to white individuals, were more risktolerant. using a combination of econometric models, as well as correlation techniques, leigh concluded that there was a higher probability of non-white participants taking on more risk than white participants. in general, there is an acceptance by researchers and investment managers that there is a relationship between race and risk tolerance. subjective or objective measures of financial risk tolerance have been utilised by a number of studies. sung and hanna (1996:11), using the 1992 scf, studied factors relating to scf financial risk tolerance variable, coded as inclined to take a risk or reluctant to take any risk. they concluded that white individuals have higher financial risk tolerance than any other race. in south africa, a similar study was conducted between race and risk tolerance. in his study, metherell (2011) found, that a significant difference exists between the white and indian population groups. however, van schalkwyk (2012), on the other hand, concluded in his study on the relationship between race and risk tolerance, that african participants tend to take higher risks than white participants do, thus making the african participants more risk-tolerant. these results were confirmed by dickason and ferreira (2018b:5). another factor that encourages individuals to take financial risk is their level of education. the assumption is that there exists a correlation between higher education levels and increased risk tolerance. in a study by ramudzuli (2016), the results show a statistical difference in the risk tolerance level of students who study towards different degrees. students who study towards a business commerce in an accounting degree or an economics degree are considered to be more risk tolerant than those students who do not. furthermore, the study shows that students studying towards social sciences (humanities), law and education are more likely to be less risk tolerant. these findings are similar to previous international studies by barsky et al. (1997:570) and chang et al. (2004:60). 2.3. risk appetite according to lucarelli and brighetti (2010:2), financial risk tolerance can be explained as a risk appetite and risk capacity combined. the degree of risk tolerance that individual investors can tolerate is known as the investors’ risk appetite. this refers to the extent of risk an investor is willing to take. risk capacity, on the other hand, is the extent of risk an individual investor can afford to take. these concepts are graphically presented in figure 2 below. according to weber et al. (2002:222), the two components of risk tolerance are fundamentally diverse. risk appetite is referred to as a personality and psychological characteristic of an individual, whereas risk capacity refers to the financial capacity of the individual (lucarelli and brighetti, 2010:2). more specifically, botha et al. (2012:541) define risk capacity as the ability to take the risk and have the financial capacity to withstand market loss. risk appetite is defined as the total amount exposed that an investor wishes to undertake based on risk and return trade-offs for one or more desired outcomes (rims, 2012). 2.4. subjective and objective risk tolerance according to anbar and eker (2010:505), an investor’s subjective financial risk tolerance will change over time; hence, they will not have the same risk tolerance throughout their lifetime as their demographics, as well as the economic factors change. as such, risk tolerance will change. as this happens, it is imperative for investment managers to update the risk tolerance level of the client accordingly. subjective risk tolerance usually assesses an individual’s selfperceived risk tolerance level (chang et al., 2004:54) and is based on the economic theory of risk aversion. this refers to the unwillingness of an investor to accept a bargain that has an uncertain outcome, as opposed to one with high levels of certainty figure 2: risk appetite and tolerance of an individual source: (adapted from rims, 2012) evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 2022 17 and lower results (faff et al., 2011:2). as such, subjective risk tolerance is a measure of the emotional and financial ability of an individual investor to be able to incur losses (hanna et al., 2001:53). objective risk tolerance looks at an individual’s behaviour from past allocations of assets and is based on the notion of the financial situation of the household and the goals of the individual’s investment horizon (malkiel, 1996:401). malkiel (1996) asserts that the risk an individual can take is dependent on the individual’s financial condition, including his/her sources of income, excluding income received from investments. objective or subjective measures of risk tolerance would partially be suitable in measuring an individual’s risk tolerance levels, as it assists in gathering data. once data has been gathered and analysed, investors need to be classified to determine their portfolio implications and record their tolerance scores. 2.5. risk tolerance of students within the investor life cycle according to bodie et al. (2010:698), the most crucial factor that influences an investor’s objective depends on the stage of the investor life cycle the investor is currently in. investors should understand the importance of the stages of their life cycle and where they are in the individual phase of the life-cycle because it is an essential for the efficient management of an investment portfolio. this is no different for student investors. a study by masenya (2017) found that students between the ages of 18 and 24 are in the accumulation phase of investing. individuals in this stage of the lifecycle are gathering assets, planning for retirement and are satisfying their needs and long-term goals by purchasing or saving for houses, cars, furniture and children’s college (harty, 2014:1). individuals in this stage usually have large debts from car loans, house deposits and university debt that they are still paying off and have a small net worth. accordingly, harty (2014:1) states that it is essential for investors in this stage to begin to invest and save their money regularly. in addition, reilly and brown (2012:33) found that individuals in this phase are willing to take on more risk for higher returns, due to individual investor’s having a longer time horizon and greater future earning ability during this phase. furthermore, it is assumed that students invest because they are motivated to secure their future financial wellbeing. according to the findings of masenya (2017:153), students often invest in money market accounts, shares, bonds, funds and investment groups such as stokvel. his findings also show that students are high-risk investors, as they mostly invest in shares and derivatives. this is in line with the accumulation phase of investing as students can take on a high extent of risk when investing, as their time period to recover from any potential future losses is longer. according to these sources, university students have an advantage over other types of investors: time to invest. one of the biggest barriers for student investor is, however, the lack of investment knowledge, which could hinder the way and amount of time they take to recover from financial losses (masenya, 2017:153). with this in mind, the potential for student investors in the financial market is vast and they could, therefore, invest in sustainable investments. this is the trend seen among millenials as returns are earned while it is also environmentally conservative (the south african, 2019). investments such as stocks, bonds, mutual funds, real estate and commodities are other investment options, depending on the financial means of the student investor (masenya, 2017). finally, van deventer (2013:2) states that the generation of today is better positioned than the previous generations, as they could be the richest generation thus far. in addition, bevan-dye and surujlal (2011:49) found that the youth in south africa has the potential to accumulate higher future earnings, which makes the target market more lucrative for this generation than potential future investors. 3. methodology a quantitative research method approach was used in the article where a positivist paradigm was utilized. secondary data analysis was applied in this article. data that were collected and analysed previously are known as secondary data; it is also data that a researcher had no direct control over or had any involvement in (walliman, 2006:52). this type of analysis is valuable because it provides an opportunity for the data that has not been analysed fully to be used and to bring a different perception to the data that exists already and to be able to execute the research questions that the researcher collected with the primary data (ritchie and lewis, 2003:61). the secondary data used in this research paper was collected during 2017 from a study by masenya (2017). masenya (2017) used a mixed-methods design with a survey and interviews. the present study only utilised the raw quantitative data not fully utilized by the primary study. the primary study aimed to find out whether students invest and in what type of products. however, the survey allowed additional research opportunities. the present article proposes to investigate this opportunity for further research through focusing on the exploration of the levels of risk tolerance and subjective risk profile of vaal triangle students (gauteng province in south africa) by comparing these factors with the students’ demographics. 3.1. research sample the sample size is drawn from the target population where the sample size must be illustrative so the researcher can make conclusions from the statistics of the sample (maleske, 1995). it is essential to note that if the sample size is small it will lack the precision to give answers that are being investigated and that are reliable to the researcher. however, if the sample size is too big then time and resources could be wasted, usually at a minimal gain (chuan, 2006:72). the data were collected by means of a nonprobability convenience sample from the full-time undergraduate students that were registered in 2017 at two universities in the vaal triangle region (gauteng province in south africa). the sample size of 300 students that were enrolled full-time at two of south africa’s higher education institutions was considered statistically sufficient. previous studies of a similar nature had comparable sample sizes. shah et al. (2018), tested the influence of demographic variables on the risk tolerance profile of business students using a sample of 382 students. the study of cross-cultural differences in risk tolerance: a comparison between chinese and americans (zhong and xiao, 2009) had a sample evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 202218 of 470 participants. an empirical investigation for determining the relationship between personal financial risk tolerance and demographic characteristic (anbar et al., 2010) had a sample of 450 students. furthermore, a study concerning the financial risk tolerance and additional factors that affect risk-taking in everyday money matters (grable, 2000) had a sample of 600 participants. 3.2. measuring instruments since this article made use of secondary data, it is necessary to discuss the manner in which the data were collected previously. this article made use of selected sections of the original data set. the questionnaire in the primary study consisted of demographic information, the survey of consumer finances, the risk tolerance scale that was developed by grable and lytton, the wealth domain of the dospert scale and subjective financial knowledge. the following risk tolerance measures were used in this article: 3.2.1. survey of consumer finances (scf)(subjective self-report measure) as the risk profile of students to measure the participants’ risk tolerance and subjective approach, the scf single-item measure was included by utilising a single-question self-report. this scale is applied to collect data on assets, liabilities, financial attitudes as well as financial behaviours of individual groups. this scale was developed by the university of chicago and was sponsored by the board of the federal reserve and other governmental agencies (grable et al., 2001). the use of the scf financial risk-tolerance assessment has grown over the last couple of years because researchers, due to time constraints, needed a reliable method of assessment; the item has a long inclusion with the scf so it must also be valid (grable and lytton, 2001). the single risk tolerance self-report measure contained a single item: which of the following statements comes closest to the amount of financial risk that you and your (husband/wife/ partner) are willing to take when you save or make investments? 1. take substantial financial risks expecting to earn substantial returns. 2. take above-average financial risks expecting to earn aboveaverage returns. 3. take average financial risks expecting to earn average returns. 4. not willing to take any financial risks. 3.2.2. grable and lytton risk tolerance scale (objective risk tolerance scale) this is a scale consisting of 13 items. the 13 items are an assessment that measures financial risk tolerance and were created by grable and lytton (2001) to measure the objective risk-taking behaviour. the final version of the assessment gave a multidimensional scale, which was reliable and relatively easy to use. this risk tolerance scale also offered assistance for the construct validity of the tool (grable and lytton, 2001). two measures were used, namely the 13-item risk tolerance scale by grable and lytton (1999) and the scf single-item measure. to measure the risk tolerance from a multiple dimension, grable and lytton’s (1999) 13-item risk tolerance scale were included. the multidimensional scale has 13 items that comprise of questions that are multiple-choice and range from 1 to 47. the scale was split equally into three groups to determine low, medium and high-risk tolerance. ratings are assigned to the multiple-choice questions, although not all the scales have the same number of options for the multiple-choice or ratings allocated to them (grable and lytton, 1999:177). 3.3. statistical analysis the science of collecting, exploring and presenting large amounts of data is known as statistical analysis in order to find fundamental patterns and trends. statistical analysis is utilised in everyday scenarios – in governments, research as well as industry – to become more scientific about choices that need to be made (smith, 2019:1). ibm statistical package for the social sciences ™ (spss) version 26 (ibm corporation, 2020) was applied to analyse the data of this article. the following section shows the statistical methods that were applied during this article. 4. empirical results the two results from the 13-item scale and the single-item scale for measuring risk tolerance indicated that the majority of the participants have a medium (glr-ts), and average to above average (scf) risk tolerance level. since the 13-item risk tolerance scale and the scf scale have similar results and the 13-item risk tolerance measures risk tolerance from multidimensional levels, the results from both scales will be used throughout the rest of the article, similar to previous studies such as ferreira (2019) and ramudzuli (2016). this article states that participants have a medium risk tolerance level. as seen in table 2, the risk tolerance scale (gl-rts) recorded a mean of 11.36 and a standard deviation of 2.02. risk profile recorded a mean of 13.43 and a standard deviation of 4.48, which seems higher than that of the risk tolerance scale. table 2: descriptive statistics and reliability coefficients for risk tolerance and risk profile (scales adapted to 1‑20 for easy comparison) mean std. deviation reliability gl-rts 11.36 2.02 0.64 risk profile (scf) 13.43 4.48 table 3: demographics’ possible influence on level of risk tolerance and subjective risk profile risk tolerance (gl-rts) risk profile (scf) age 0.18 0.00 gender −0.12* −0.11* race −0.14** −0.13** marital status 0.10* −0.02 language −0.06 −0.16** qualification −0.09 0.02 year group 0.05 −0.04 situation −0.06 −0.11* monthly income 0.07 0.04 source of income −0.01 −0.06 number of dependents −0.06 −0.08 investment type −0.05 −0.10* *p<0.05, **p<0.01 evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 2022 19 reliability measures the extent to which an instrument yields the same results over multiple trials. if the reliability is 0.7 or higher, the instrument is considered reliable. it can be seen that risk tolerance reliability is 0.64, which is lower than the 0.7 reliability score. although this is due to the reason of unidemsionality which indicates that the gl-rts measured multiple factors rather than a single dimension. the total risk tolerance levels of the participants, which were measured using grable and lytton’s 13-item risk tolerance scale, indicated that the majority of the participants, 89.6%, had a medium risk tolerance, followed by high-risk tolerance, 9.1%, and low risk tolerance, 1.3%. as reported in table 3, correlations between the different demographic variables and the gl-rts and scf, respectively, were calculated and it was found that gender and race were the only two characteristics that had a possible significant influence on the levels of both measures. marital status could have a significant influence on participants’ risk tolerance level, with language and situation possibly influencing risk profile significantly. none of the other demographic characteristics was found to possibly influence either risk tolerance or the subjective risk profile level. 4.1. determining significant group mean differences the results of the t-tests for the characteristics of gender and marital status are reported in table 4. from the results, it is clear that the means for the levels of risk tolerance and risk profile, respectively, did not differ significantly when compared between single and married participants. with regards to males and females, both risk tolerance (p = 0.02*) and risk profile (p = 0.02*) showed significant differences between means. both t-statistics were positive, indicating the means for males were significantly higher than those for females, with a medium effect: risk tolerance = 0.23; risk profile = 0.25. the anova calculation indicates only whether or not significant differences exist, but do not provide information on exactly where those differences are. to determine where differences are located, tukey’s post hoc test is utilised. in addition to tukey’s post hoc test, homogenous subsets will be reported. possible homogenous subsets within the selected groups are identified to not only confirm tukey’s post hoc test results but also to indicate where similarities might be found. table 5 reports on the relevant groups identified through the anova process, table 6 contains tukey’s post hoc test results, and table 7 the possible homogenous subsets within these groups. table 5: significance of comparison of group means (anovas) variable risk tolerance (gl-rts) risk profile (scf) age 0.68 0.66 race 0.00** 0.00** language 0.57 0.05 qualification 0.00** 0.02* year group 0.35 0.41 situation 0.66 0.10 monthly income 0.30 0.92 source of income 0.71 0.47 number of dependents 0.56 0.05 investment type 0.03* 0.51 *p<0.05, **p<0.01 table 6: tukey’s post hoc test for race variable risk tolerance (gl-rts) risk profile (scf) mean difference mean difference african white 1.88* 0.46* coloured −1.03 0.16 indian 6.80 1.09 white coloured −2.91 0.62 indian 4.93 0.63 coloured indian 7.83* 1.25 *p < 0.05, **p < 0.01 table 7: tukey’s post hoc test for qualification variable risk tolerance (gl-rts) risk profile (scf) mean difference mean difference ba degree bcom degree −0.93 −0.17 bed degree 2.52* 0.35 bsc degree −0.29 −0.1 btech degree −0.36 −0.25 diploma 0.77 −0.08 other −4.26 −0.1 bcom degree bed degree 3.44* 0.51* bsc degree 0.63 0.07 btech degree 0.57 −0.08 diploma 1.70 0.08 other −3.33 0.07 bed degree bsc degree −2.81 −0.44 btech degree −2.87 −−0.59 diploma −1.74 −0.43* other −6.77 −0.44 bsc degree btech degree −0.06 −0.15 diploma 1.07 0.01 other −3.96 0.00 btech degree diploma 1.13 0.16 other −3.90 0.15 diploma other −5.03 −0.01 *p<0.05, **p<0.01 table 4: significance of comparison of group means (t‑test) risk tolerance (gl-rts) risk profile (scf) t-statistic p cohen’s d t-statistic p cohen’s d gender 2.29 0.02* 0.23 2.40 0.02* 0.25 marital status (without divorce) −1.06 0.29 0.09 0.93 *p<0.05, **p<0.01 evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 202220 the characteristics race and qualification were the only ones that indicated significant differences in group means for both measures, and investment type was shown to have significant mean differences with regards to only risk tolerance as seen in table 8. significant mean differences for both measures were found between african and white participants (gl-rts = 1.88*; scf = 0.46*) and for only risk tolerance between coloured and indian participants (gl-rts = 7.83*). it seems that african participants have both higher risk tolerance and risk profile scores when compared to white participants, and coloured participant has higher risk tolerance than indian participants, but do not necessarily have a higher risk profile. in table 9 two subsets within the race variable for both measures were indicated. for both measures, indian participants fell into one subset, and african, and coloured participants fell into a second subset. white participants were categorised in both subsets, which indicated that the group’s mean on risk tolerance and level of subjective risk tolerance profile were close enough to both subsets and could not be classified specifically. it was found that that there was no difference in the objective and subjective risk tolerance between the different racial groups. these results are not in accordance with previous studies that have been done (ferreira, 2019:6; masenya, 2017:102) that found that african investors risk tolerance level is lower than that of white individuals. bcom degree students and bed degree students showed significant differences between their means on both risk tolerance and risk profile levels (gl-rts = 3.44*; scf = 0.51*), with bcom degree students showing higher levels of both subjective risk tolerance and objective risk tolerance. a mean difference was found between ba degree and bed degree students in mean levels of risk tolerance (gl-rts = 2.52*), where ba degree students exhibited higher levels of risk tolerance. with regards to the subjective risk tolerance profile, students studying towards a diploma were willing to take higher risks than bed students (scf = −0.43*). when homogenous subsets for risk tolerance were identified, students studying towards a bed degree or a diploma were placed in the first subset, with students studying for unspecified qualifications placed in the second subset and for the intent of reporting/using these stats, the two homogenous groups could also be classified into one, this is because of the number of students studying “other”, which was ony four. if these students were left out of the calculation, only one subset would have been identified. there was only one significant difference between means found with regard to risk tolerance in the investment type group (the only significant difference indicated by anova), i.e., between participants that invest in clubs or groups like stokvels, and participants who did not invest that would also not consider investing (gl-rts = 7.67*). participants not investing who would also not consider investing have thus been shown to have lower risk tolerance. no other important differences in levels of risk tolerance or risk profiles were found, regardless of the type of investment. only one subset was identified for all types of investment. table 8: tukey’s post hoc test for investment type variable risk tolerance (gl-rts) mean difference money market account government bonds −3.60 derivatives (forex, etfs) −3.39 investment club/group (stokvel) −6.2 other types −1.6 multiple types −2.27 doesn’t invest, would consider −1.07 doesn’t invest, would not consider 1.47 government bonds derivatives (forex, etfs) 0.21 investment club/group (stokvel) −2.60 other types 2.00 multiple types 1.33 doesn’t invest, would consider 2.53 doesn’t invest, would not consider 5.07 derivatives (forex, etfs) investment club/group (stokvel) −2.81 other types 1.79 multiple types 1.12 doesn’t invest, would consider 2.32 doesn’t invest, would not consider 4.85 investment club/group (stokvel) other types 4.60 multiple types 3.93 doesn’t invest, would consider 5.13 doesn’t invest, would not consider 7.67* other types multiple types −0.67 doesn’t invest, would consider 0.53 doesn’t invest, would not consider 3.07 multiple types doesn’t invest, would consider 1.20 doesn’t invest, would not consider 3.73 doesn’t invest, would not consider 2.53 * p<0.05, ** p<0.01 table 9: homogenous subsets variable objective risk tolerance (gl-rts) subjective risk profile (scf) subset 1 subset 2 subset 1 subset 2 race indian 20.00 1.67 white 24.93 24.93 2.30 2.30 african 26.80 2.75 coloured 27.83 2.92 qualification bed degree 24.23 2.31 diploma 25.97 2.65 ba degree 26.74 26.74 2.74 bsc degree 27.04 27.04 2.75 btech degree 27.10 27.10 2.75 bcom degree 27.67 27.67 2.82 other 31.00 2.90 investment type doesn’t invest, would not consider 23.93 money market account 25.40 doesn’t invest, would consider 26.47 other types 27.00 multiple types 27.67 derivatives (forex, etfs) 28.79 government bonds 29.00 investment club/ group (stokvel) 31.60 evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 2022 21 5. conclusion based on the findings of the article, it can be concluded that risk tolerance is a pivotal factor that should be taken into consideration when planning individual investors’ investment strategies. it is also important for these individuals to know and understand how their demographics affect their risk tolerance level and how important it is to have basic financial knowledge before investing. students also have a lack of investment knowledge, which contributes to them not measuring their risk tolerance accordingly, which affects their investment strategies; therefore, the framework was created to guide students in investing. students must increase the knowledge that they have on investing to assist them in creating an investment portfolio before they start working to gain wealth from an earlier age than most individuals. if their risk tolerance and investment knowledge improve it could contribute to better investment decisions to assist in securing their financial well-being and to improve their quality of life. age, gender, race, marital status, nationality, home language, qualification, year of study, the study situation, monthly income, source of income, number of dependents along with the investments that they invest in were all taken into consideration. grable and lytton’s risk tolerance was measured in three different levels, these being low risk, medium risk and high-risk tolerance followed by the scf that measured risk tolerance in four different levels, namely no risk, average risk, above-average risk and substantial risk. the total grable and lytton risk tolerance found that most of the participants had a medium risk tolerance, followed by high-risk tolerance and low-risk tolerance. the investment risk of the participants was also measured, and it was found that most of the students have a medium investment risk tolerance level, followed by high-risk tolerance and low-risk tolerance. the outcomes for the remaining demographic characteristics (age group, race, language, qualification, year group, situation, monthly income, source of income, number of dependents and investment type) were provided. only race and qualification indicated significant differences in groups means for both measures, and investment type was shown to have significant mean differences with regards to only risk tolerance. tukey’s post hoc test was used to report for groups that had significant differences. significant mean differences for both measures were found between african and white participants (gl-rts = 1.88*; scf = 0.46*) and for only risk tolerance between coloured and indian participants (gl-rts = 7.83*). it seems that african participants have both higher risk tolerance and risk profile scores when compared to white participants, and coloured participant has higher risk tolerance than indian participants. bcom degree students and bed degree students showed significant differences between their means on both risk tolerance and risk profile levels (gl-rts = 3.44*; scf = 0.51*), with bcom degree students showing higher levels of both risk tolerance and risk profile. a mean difference was found between ba degree and bed degree students in mean levels of risk tolerance (gl-rts = 2.52*), where ba degree students exhibited higher levels of risk tolerance. with regards to risk profile levels, students studying towards a diploma were willing to take higher risks than bed students (scf = -0.43*). when homogenous subsets for risk tolerance were identified, students studying towards a bed degree or a diploma were placed in the first subset, with students studying for unspecified qualifications placed in the second subset. the other participant groups all had means too close to both subsets to be classified as part of either. all the qualification groups were classified together in one subset for risk profile levels. there was only one significant difference between means found in the investment type group, and only with regards to risk tolerance, i.e., between participants that invest in clubs or groups, like stokvels, and participants who did not invest that would also not consider investing (gl-rts = 7.67*). no other important differences in levels of risk tolerance or risk profiles were found, regardless of type of investment. only one subset was identified for all types of investment. 5.1. limitations • although the study achieved all the set objectives, there were certain limitations to the article. the first limitation that was encountered was that the sample size was only of 300 students within the vaal triangle district, which consisted of two universities, one traditional and one university of technology and also that studied specific courses. the sample size could have been more if more institutions were included in the article, such as colleges and/or all degrees that are offered at these universities. • secondly, the sample that was used did not have an equal distribution of students from the two universities, the best ratio would have been a 50 per cent ratio from each, however, it was split into a ratio of 70 per cent from a traditional university and 30 per cent from a university of technology. • future research could include more higher education institutions (hei) in the country, instead of just two from the vaal triangle region and by including more heis, a more accurate analysis could be done on students within south africa and students within the vaal triangle district. • the article could also be replicated in universities in other countries. this will assist researchers to determine the investment options for students as well as compare the results that they receive to students within south africa. this will also assist in measuring and to see if students in other countries are affected in the same way as south african students and to see if the investment options offered in other studies are similar to the investment options offered in this article. • the test of the empirical objectives of the article can be replicated using a wider variety of classifying factors, such as the behaviours, attitudes and any other socioeconomic characteristics. this could assist in contributing to determine the importance of other demographical factors in differentiation of the levels of risk tolerance. to increase risk tolerance levels, students are encouraged to learn more about different investment options and how their risk tolerance level affects their risk-taking decisions. students will be able to understand and be more aware of their risk tolerance levels, this will assist in making better investment decisions when it comes to investing and will assist them in adopting new investment behaviours evangelou, et al.: investment risk tolerance amongst south african university students in the vaal triangle area international journal of economics and financial issues | vol 12 • issue 1 • 202222 in terms of gender, both the objective risk tolerance scale and the 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(2009), determinants of family bond and stock holdings. journal of financial counseling and planning, 6, 1-10. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 35-45. international journal of economics and financial issues | vol 13 • issue 1 • 2023 35 effect of unemployment and inflation on economic growth in south africa dimakatso sekwati1, mbulaheni albert dagume2* 1department of economics, university of venda, south africa, 2university of venda, private bag x 5050, thohoyandou, south africa. *email: dagume@univen.ac.za received: 20 august 2022 accepted: 04 december 2022 doi: https://doi.org/10.32479/ijefi.13447 abstract the key macroeconomic objectives being pursued by any developing country are low unemployment, low inflation, and sustainable growth. the main aim of this study was to analyze the effect of unemployment and inflation on economic growth in south africa for the period of 1994 to 2018, using quarterly data. the results of the unit root test using the augmented dickey fuller and phillips perron tests showed that all the variables have a unit root in levels and became stationary after first differencing. the johansen co-integration test outcomes showed that there is a long-run relationship among variables, and the vector error correlation model confirmed that inflation and unemployment have a negative impact on economic growth. furthermore, the results of the tests for white heteroskedasticity, jarque -bera and serial correlation lm reveal that there is no problem of heteroskedasticity, data distribution or serial correlation respectively. the government should implement workable pricing regulations and enforce them to maintain stable price levels. the government should also through the department of higher education and training, establish a structure that connects the educational system with the industries in south africa, allowing for the development of skills at the tertiary level and increasing employment. keywords: economic growth, inflation, unemployment, south africa jel classifications: e24, e31 1. introduction regardless of the abundant natural resources that the south african economy has, per capita income is low, unemployment and inflation are high; this has resulted in the economy showing a downfall in growth, a situation which is very disturbing. the macroeconomic objective of the economy is to achieve price stability, full employment, and sustained growth, unfortunately the country is currently, unable to achieve that and government interventions have not been very successful. this kind of economic crises can lead to other economic problems such as high inflationary pressure, high exchange rate and debts affecting balance of payment (umaru, 2014). unemployment and inflation continue to be an issue of concern in south africa, because these two variables are regarded as macroeconomic indicators and determinants of economic growth (ademola and abdullahi, 2016). inflation and unemployment impact economic growth and development of any economy; these two factors are mainly used to examine the level of poverty in developing economies. countries, therefore, are encouraged to continually increase their level of produce because this will help to cushion the effect of inflation in the economy. also, increase in the level of goods and services will improve the standard of living, hence, create social harmony within the country (jelilov et al., 2016). according to pal (2018) cited in impin and kok (2021), a nation’s ability to withstand strong competition on the global market is determined by its economic growth, which is defined as the steady increase in national income or output, which largely entails an expansion of an economy’s flow of goods and services. a nation this journal is licensed under a creative commons attribution 4.0 international license sekwati and dagume: effect of unemployment and inflation on economic growth in south africa international journal of economics and financial issues | vol 13 • issue 1 • 202336 without a strong economy won’t be able to survive in the outside world. this is evident from the numerous financial crises that have struck several nations, including argentina in 2001-2002, asia in 1997-1998 and mexico in 1994, to name a few. the economic growth of the countries has been significantly impacted by these crises. one of the key areas of interest for researchers is to investigate what can help or hinder economic growth, although little agreement has been established thus far (impin and kok, 2021). the importance of economic growth has led booming of various studies on its determinants for effective policy formulation. economic growth provides advantages for the people living in a country. positive economic growth can lead to a reduction in poverty, improved health, longer lives, better living standard, more jobs creation, lower unemployment, provides political stability, etc. economists often associate slow economic growth with a high unemployment rate, and high poverty (impin and kok, 2021). the south african economy reveals the following growth figuresin the 1960s it was 5.8%; in the1970s it was 3.6% which decreased to 2.6% in the 1980s and 1.5% during the 1990s and in 2000s it was 4% (world bank, 2019). the growth rate between the period of 1994 and 2018 was recorded as follows: in 1994 it was 3.2% and in 2000 it was much better at 4.2%. its lowest performance was recorded during 2009 with −1.5% and the best performance was last recorded in 2006 at 5.6%. this trend shows that the south africa’s economy keeps on fluctuating (world bank, 2019). this trend from 1994 to 2018 does not show any improvement as unemployment and inflation continue to soar with adverse effects on the south african economy. the low economic growth in south africa is a concern which needs serious attention for when the per capita income is low, unemployment and inflation continue to rise drastically. for several decades, economic growth has not been impressive, therefore there is a need for better solutions and recommendations (umaru, 2014). from 1994 to 2018, similar fluctuating trends were seen in the country’s unemployment and inflation rates. average unemployment rates ranged from 29.9% between 1995 and 1997 to 29.9%, 31.3%, 30.3%, 25.7%, 24.3%, and 26.4% between 1997 and 1999, 2000-2002, 2003-2005, 2006-2008, 2009-2011, 2012-2014, and 2015-2018 respectively. regarding inflation, the highest rate was recoded 9.3% in 2009, while its lowest rate of 4.1% was witnessed in 2004 and 2010 respectively. the average inflation rate was 8.3% between 1994 and 1996, while 6.9%, 6.8%, 3 %, 6.5%, 5.5%. 5.9% and 5.2% have been recorded over the period 1997-1999, 2000-2002, 2003-2005, 2006-2008, 2009-2011, 2012-2014 and 2015-2018 respectively. it averaged 27.6% for unemployment rate and 6% for inflation rate in the period under study. these trends are reflections of how macroeconomic policy objectives did not translate into sustainable economic growth in the country (world bank, 2019). unemployment can largely contribute to poverty and increase income inequality, therefore, the urgency for a solution for that is within a government’s interest. there is a need for both pro-active and reactive policies for addressing inflation in the country. this can revive the economy and increase of jobs in the labor market. most developing and underdeveloped countries experience unemployment challenges and south africa is not an exception as is indicated by a fluctuation in the country. over the past years, the rate of job creation in south africa has not been congruent with growth in labor force absorption. if these trends continue, economic growth will remain unattainable (banda et al., 2016). to come up with better solutions, one must understand the relationship between unemployment and inflation that leads to shrinking of economic growth. the relationship between the two variables (inflation and unemployment) was first studied by phillips (1958), who found an inverse relationship between unemployment and inflation in the uk. in the short term the phillips curve happens to be a declining curve. the phillips curve in the long term is separate from the phillips curve in the short term. it has been observed in the literature that in the long run, unemployment and inflation are not related (anning et al., 2017). ademola and abdullahi (2016) state that inflation can be caused by high money circulation around the economy and suggest that when there is too much money supply, price of commodities goes up as well; this is known as inflation. researchers who have investigated the impact of unemployment and inflation on economic growth, came up with different views. this has been a controversial in both theory and empirical findings (majumder, 2016). mallik and chowdhury (2001); umaru and zubairu (2012) and muhammad et al. (2011) found a positive relationship between inflation and economic growth. on the other hand, mamo (2012) pointed out that, the relationship between inflation and economic growth is neither negative, positive or neutral. regarding the effects of unemployment on economic growth, banda et al. (2016) and akeju and olanipeun (2014), found a positive relationship between the two variables, while rafindadi (2012), li and liu (2012), hussain et al. (2010) and airi et al. (2016) found a negative relationship. against this background, there is a need for the current study to investigate the impact of unemployment and inflation on economic growth in south africa. this study examines the relationship between unemployment, inflation, and the overall growth of the economy. the examination additionally tries to recognize the impact of expansion on the south african economy as well as the reasons for joblessness in the south african economy. findings of this investigation will furnish policy makers with a superior comprehension of the relationship between unemployment and inflation on the growth of the economy. the examination could give a depiction of the circumstances and results of expansion and joblessness, therefore give a premise to basic leadership for different government departments. this will help researchers to diagnose the problem while adding to existing information and identifying possible solutions. in addition, the society is exposed to the current economic conditions and have an insight into how macroeconomic indicators can affect the economic growth of a country and thus can understand how the economy is working as a whole. this study will adopt economic growth as a dependent variable while using inflation and unemployment as independent variables to determine the relationship among them. the sections of the paper are structured as follows the second reviews the literature; the third outlines the study methods; the fourth gives the results and discussions and the fifth presents the conclusion and policy recommendations. sekwati and dagume: effect of unemployment and inflation on economic growth in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 37 2. literature review 2.1. conceptual literature on economic growth, unemployment, and inflation 2.1.1. the concept of economic growth economic growth is the expansion in estimation of definite goods delivered or produced by the economy after some time; for the most part it is estimated as the rate increment in gdp (afshan and sabeen, 2017). khan (2005) cited in imf (2012) classified growth rate into three categories, namely, high, moderate and low. high growth rate refers to an annual average growth in per capita gdp of 4% or more. the logic of this is that high growth rate should translate into an annual average growth in per capita personal consumption of 2.5-3% or more, which should provide a reasonable base of poverty. moderate growth refers to a minimum of 2.5% growth in per capita gdp which hopefully translates to a minimum of 1.5% annual growth in per capita personal consumption. lastly, low growth rate represents an annual growth in per capita income of 2.5% or less. economic growth is the increase in the number of final goods produced and sold within the boundaries of a country. it is conventionally measured as the percent rate of increase in real gross domestic product, or real gross domestic product (imf, 2012). 2.1.2. the concept of unemployment the international labour organization (2007) cited in michael et al., (2016) explain joblessness as the work power that is not working yet is accessible, willing, and ready to work, hence, is a situation where people are scanning for employments. unemployment represents the number of people in the work force who want to work but do not have jobs. it is generally stated as a percentage and calculated by dividing the number of people who are unemployed by the total work force. there are different types of unemployment cyclical, structural, frictional, and seasonal. mcgaughey (2018) maintains that the causes of unemployment are still open for debate, even today. unemployment is often defined by the classical economists as the excess supply of labour over the demand for labour which is cause by adjustment in real wage. the classical or real-wage unemployment occurs when real wages for job are set above the market clearing level, causing number of job-seekers to exceed the number of vacancies (ademola and badiru, 2016). cyclical unemployment takes place when the aggregate demand is not enough in the economy to provide jobs for everyone who is willing and able to work, therefore, few goods are produced. in this situation, the demand for those goods falls and few workers are required because there is not much to be produced, as a result unemployment takes over. in cyclical unemployment, jobs vacancies available is less than the number of people willing to work, so even if all the available job vacancies are occupied, others will remain unemployed. frictional unemployment is similar to structural unemployment which occurs when the skills of workers fail to correspond with what is required for that job (akeju and olanipeun, 2014). 2.1.3. the concept of inflation inflation refers to the long-term rise in the prices of goods and services caused by the devaluation of currency. inflation leads to reduced purchasing power of people especially when incomes are not increased accordingly. this results in the slowing or stagnation of the economy. excessive inflation can also wreak havoc on retirement savings as it reduces the purchasing power of the money that savers and investors have put away (richmond, 2018). 2.2. theoretical framework 2.2.1. keynesian theory of aggregate demand john maynard keynes is often referred to as the father of macroeconomics. his pioneering work “the general theory of employment, interest and money” published in 1936 provided a completely new approach to the modern study of macroeconomics. the notion “effective demand” and its influence on economic activity was the central theme in keynes’s theory of effective demand. refuting the classical theory which believed in strong general tendency of market mechanism to move output and employment towards full employment, keynes explained that, in some situations, no strong automatic mechanism moves output and employment towards full employment levels. keynes was the first economist to advocate the role of government, especially fiscal policy, as the primary means of stabilizing the economy. in his theory, the concept of aggregate demand (ad) refers to the total demand for goods and services in an economy. ad is related to the total expenditure flow in an economy in a given period. it consists of the following: • consumption demand by households (c) • investment demand, demand for capital goods (i) by the business firms • government expenditure (g) • net income from abroad minus net income from domestic goods (x-m). thus, symbolically, it can be written as equation (1) ad = c + i + g + (x–m) (1) according to keynes, full employment is not a normal situation as stated in the classical theory. he argued that economy’s equilibrium level of output and employment may not always correspond to the full employment level of income, therefore, it is possible to have macroeconomic equilibrium at less than full employment. if current level of aggregate demand (expenditure) is not adequate to purchase all the goods produced in the economy (that is, a situation of excess supply) then output will be cut back to match the level of aggregate demand. aggregate demand or what is called ‘aggregate demand price’ is the number of total receipts which all the firms expect to receive from the sale of output produced by a given number of workers employed, hence, aggregate demand increases with increase in the number of workers employed (suleiman et al., 2019). 2.2.2. the theory of inflation according to the classical theory, the key factor in inflation is the money supply because in accordance with the quantity theory of money, only an increase in the money supply can raise the sekwati and dagume: effect of unemployment and inflation on economic growth in south africa international journal of economics and financial issues | vol 13 • issue 1 • 202338 general price level. in modern income theory, however, demandpull is interpreted to mean an excess of aggregate money demand relative to the economy’s full employment output level. the theory assumes that prices of goods and services as well as for economic resources are responsive to supply and demand forces, and will, thus, move readily upward under the pressure of a high level of aggregate demand. economists like friedman, hawtrey, golden weiser, who regard inflation as a purely monetary phenomenon, strongly support this theory of inflation caused by excess money supply. the excess demand in the economy develops owing to large scale investment expenditure, either in the public or in the private sector, thereby exceeding the total output. as a result of this excess demand, prices will rise and excess demand inflation or demand-pull inflation comes to exist (suleiman et al., 2019). 2.3. empirical literature in this section, empirical literature on the relationship between economic growth, unemployment and inflation were reviewed. 2.3.1. effects of inflation on economic growth the effect of inflation on economic growth is still complicated. conclusion about the nature of these effect has not been made in previous empirical studies (xiao, 2009), however, mallik and chowdhury (2001) revealed that there is a positive impact between inflation and economic growth. mamo (2012) emphasized that these two variables are difficult to predict since the impact can either be negative, positive, or neutral. working with countries under transition, gillman and harris (2010) investigated the effect of inflation on economic growth from 1990 to 2003 using panel data evidence of 13 transitional countries with different equations growth, money, demand, and inflation. the results of the study revealed a strong effect between inflation and economic growth, therefore, gillman and harris suggested that monetary policy should intervene to stabilize inflation targeting and fiscal policies to control budget deficit. imoisi et al. (2017) examined the impact of inflation on economic growth using time series data for the period 1990 -2011 in tanzania. the study confirmed the negative impact of inflation on economic growth. the study also revealed that there was no cointegration between inflation and economic growth during the period of study, thus no long-run relationship between inflation and economic growth. in tanzania, kasidi and mwakanemela (2013) used correlation coefficient and cointegration technique to investigate the impact of inflation on economic growth for the period 1990-2011. the results of the study revealed that the effect between these variables are negative and co-integration does not exist between inflation and economic growth. in nigeria, osuala and onyeike (2013) investigated the impact of inflation on economic growth from the period 19702011. the techniques employed in the study was dickey fuller (adgf), philip-perron and error correlation model. the study confirmed that the link between inflation and economic growth and is statistically significant. hasanov (2010) investigated the threshold effect of inflation using annual data set of real gdps, consumer price index and real gross fixed capital formation from the period of 2001 to 2009. the results of the study revealed that the economic growth and inflation are nonlinear, it was 13% level of threshold inflation on gdp and if inflation level is lower than 13%, there is a significant positive effect on gdp, but if inflation level exceeds 13%, then the effect becomes negative. furthermore, khan and senhadji (2001) investigated threshold inflation level using nonlinear least squares on a panel of 140 countries at 1% for industrial countries and 11% for developing countries. the results of the study revealed that the effect of inflation on economic growth is positive even though it becomes statistically considerable for industrial countries, however, when the threshold level is above inflation, then the relationship becomes coheritor for both countries. espinoza et al. (2010) investigated the effect of inflation on economic growth using panel smooth transition regression of 165 countries to estimate inflation threshold at 10% in developing countries and 13% for countries exporting oil. the results of the study revealed that there is nonlinearity correlation among these variables. in nigeria, umaru and zubairu (2012) investigated the effect of inflation on economic growth from 1970 to 2010 using augmented dickey fuller and granger causality tests. the results of the study revealed that inflation and economic growth are positively related and concluded that if the country can encourage growth in productivity and level of output then economic growth can be achieved. bawa and abdullahi (2012) conducted a similar study in nigeria on the threshold effect of inflation on economic growth using a quarterly time series data for the period 1981-2009. they used threshold regression model developed by khan and senhadjie (2001) to estimate a threshold inflation level of 13%. below the threshold level, inflation has a mild effect on economic activities, while above it, the magnitude of the negative effect of inflation on growth was high. in turkey, karahan and colak (2020) investigated the relationship between inflation and economic growth using nonlinear autoregressive distributed lag (nardl) model for the quarterly data set between 2003 and 2017. a negative relationship between inflation and economic growth was found in the study. a study by ngoc (2020) investigated the asymmetric effect of inflation and money supply on economic growth using the nonlinear autoregressive distributed lag approach for vietnam over the period 19902017. the study confirmed the negative impact of inflation on economic growth and asymmetric in the long run. madurapperuma (2016) used the framework of johansen cointegration test and error correction model to investigate the impact of inflation on economic growth in sri lanka for the period 1988-2015. a long run negative and significant relationship between economic growth and inflation was found in the study. 2.3.2. effects of unemployment on economic growth in south africa, banda et al. (2016) researched about the effect of unemployment on economic growth from 1994 to 2012, using johansen cointegration. the results were that long-run unemployment and economic growth are positively correlated, however, rafindadi (2012) also investigated the impact between these two variables using ordinary least square and threshold model to investigate this relationship. the findings revealed that there is a negative nonlinear impact between output and unemployment. in nigeria, akeju and olanipeun (2014) investigated their effect by applying error correlation model and johansen cointegration test. the study revealed that there is positive effect among these variables. onwachukwu (2015) also investigated the effect of unemployment on economic growth from 1984 to 2010 using ordinary least square and augmented dickey-fuller methods. sekwati and dagume: effect of unemployment and inflation on economic growth in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 39 the results disclosed that unemployment does not have any impact on economic growth. in nigeria, airi et al. (2016) also confirmed a negative impact of unemployment on economic growth. in pakistan, hussain et al. (2010) investigated the impact of unemployment on economic growth using time series data from 1972 to 2006. the techniques employed in the study were augmented dickey fuller test and johansen cointegration test. the study confirmed the negative impact of unemployment on economic growth. in spain, villaverde and maza (2008) investigated the effect of unemployment on output from 1980 to 2004; a negative effect of unemployment on economic growth was found. in nigeria, yelwa et al. (2015) also investigated the relationship between unemployment and economic growth from 1987 to 2012. a negative relationship between unemployment and economic growth was found in this study. they reached a conclusion that, government should intervene so that the economic environment can be manageable. makaringe and khobai (2018) investigated the trends and impact of unemployment on economic growth in south africa using quarterly data over the period 1994q1 to 2016q4. they employed the auto regressive distribution lag (ardl) bounds test approach and the results from the ardl model suggest that there is a long run relationship between unemployment and economic growth. the empirical results obtained confirmed that there is a negative relationship between unemployment and economic growth both in the long and short run. mosikari (2013) also conducted a study on the effect of unemployment on gross domestic product in south africa. he employed augmented dickey-fuller (adf) stationary test, cointegration and granger causality test. the study revealed that the variables proved to be integrated of order one, and no causation between unemployment rate and gdp growth. using time series data from the period 1999 to 2017, iloabuchi (2019) examined the effect of unemployment on economic growth in nigeria. the central bank of nigeria’s database and the world bank’s data bank were used as sources for the data. ols, augmented dickeyfuller, philip-perron unit root tests, pair-wise granger causality, and ols were all used in the explanatory study. a unidirectional association between unemployment and nigeria’s economic growth is revealed using the granger causality test. the results of the model’s population increase component, which is also present, occur concurrently with economic expansion. hussain et al. (2010) researched on the impact of unemployment on economic growth based on data collected; the findings established a negative impact of unemployment on economic growth. additionally, shah et al. (2022) conducted research in pakistan on the effect of unemployment on economic growth, and the empirical results from the study reveal that unemployment has a negative relationship with economic growth that is statistically significant. 2.3.3. effects of unemployment and inflation on economic growth shahid (2014) explored the effect of rapid price increases and unemployment on economic growth in pakistan utilizing the time arrangement information for the time span of 1980 to 2010. the unit root adf and phillips perron illustrated that economic growth is stationary on level just as first distinction, yet unemployment and expansion are stationary on first contrast. the ardl result confirmed that there is a long-run connection between the variables. in nigeria from 1981 to 2016, gyang et al. (2018) investigated the relationship between unemployment, inflation, and economic growth. the analysis made use of the johansen co-integration test, the pairwise granger causality test, and the ordinary least squares (ols). the unit root test findings showed that at the first difference i, all the variables were stationary (1). since the estimation result suggested at least two co-integrating equations, the co-integration test provided evidence of a long-term equilibrium relationship between the variables. the pairwise granger causality test result showed that there was no causal connection between unemployment, inflation, and growth. additionally, the results of the ordinary least squares (ols) analysis show that the unemployment rate (unr) and inflation rate (infr) have a negative and insignificant impact on the contribution to the growth of nigerian domestic economy, while total government expenditure (tge) show a positive and significant relationship to the economic growth. ademola and bandiru (2016) used the ordinary least square (ols) method and several diagnostic test approaches to examine how unemployment and inflation affected economic growth in nigeria. the results of the unit root test indicate that all the model’s variables are stationary at the first difference, and those of the johansen cointegration show the existence of two cointegrating equations, indicating the existence of a long-term relationship between inflation, unemployment, and economic growth. the findings also showed that unemployment and inflation have a positive relationship with economic growth. suleiman et al. (2019) investigated the impact of inflation and unemployment on the nigeria monetary development (gdp) from 1985 to 2017. the techniques employed in the study was ols and granger causality test. the after-effects of ols from the model demonstrate that unemployment and inflation have an irrelevant association with gdp which infers that with increment in gdp, ceteris paribus inflation rate will increase, so also unemployment rate. the findings of the causality test, likewise, propose that lgdp does not cause inflation as showed in the probability esteem (0.0755); that linf additionally does not cause joblessness as demonstrated in the probability esteem (0.0593. using annual time series data covered the period 19862020, idris (2021) investigated how unemployment and inflation affected economic growth in nigeria. the ordinary least squares method is used to assess the model coefficient. according to findings, inflation has a positive impact whereas unemployment has a negative and significant impact on economic growth in nigeria. mohseni and jouzarjan (2016) conducted an empirical study concerning the effect of inflation and unemployment on economic growth in iran from 1996 to 2012. the study employed autoregressive distributed lag (ardl), microfit version 4.0 and eviews version 6 for model estimation. the study revealed a significant and negative effect of inflation and unemployment on economic growth in the long run. enejoh and tsauni (2019) examined the effect of inflation and unemployment on economic growth in nigeria from 1970 to 2016. the outcome was that the rate of inflation has a positive and an inconsequential effect on the monetary development while unemployment has a negative and an unimportant effect on the financial development in nigeria over the long run. umaru et al. (2013) investigated the effect of unemployment and inflation on economic growth in nigeria between 1986 and 2010. the techniques employed in the study sekwati and dagume: effect of unemployment and inflation on economic growth in south africa international journal of economics and financial issues | vol 13 • issue 1 • 202340 was johansen integration augmented dickey-fuller and granger causality test. the study confirmed the negative impact of two variables on economic growth and the results of causality suggest that unemployment and inflation cause economic growth, and not economic growth causing unemployment and inflation. thus, the result shows a one-way causation running from unemployment and inflation to economic growth. the relationship and effect of unemployment and inflation on economic growth are still unclear from the literature reviewed above, necessitating further study, which is why this study was undertaken. 2.4. limitations of the study and areas for further research the principal significant restriction was the inaccessibility of quarterly information on certain factors recommended by the hypothetical and observational writing with respect to how joblessness influences financial development. also, a portion of the auxiliary information utilized in this examination were gotten from fluctuated sources which may utilize diverse estimating systems; hence, the quality of the information cannot be ensured. based on this, the researcher suggests further research on how different macroeconomics factors, for example, genuine loan fees and cash supply may influence monetary development in south africa. 3. methods of the study 3.1. data sources and description the study employed ordinary least square and granger causality test for multiple regression method and data analysis. the data used for this study are basically time series quarterly data, secondary in nature, ranging from 1994 to 2018 and the data were sourced from world development bank. 3.2. model specification the study focuses on analyzing the relationship between inflation, unemployment and economic growth and adopt economic growth as dependent variable while unemployment and inflation as the independent variables. the study adopted the model of growth by aminu and anono (2012) to determine the impact of inflation and unemployment on economic growth of south african. mathematically, the model can be stated as follows: gdp= f (cpi, unempo) (2) where: gdp = gross domestic product cpi = inflation unempo = unemployment rate the econometric model that was used for this study to analyze the relationship between unemployment, inflation and economic growth is as follows gdpt = β0 + β1cpit + unempot + µt (3) the function above illustrates the relationship between economic growth which is the dependent variable and inflation and unemployment as the independent variables, where µt represent the error term which consists of variables that can affect the dependent variables but due to some reason have been analyzed in the study (interest rate, government expenditure and investment) the 𝛽0 and 𝛽1 are the parameters, the slope and intercept of the study, to estimate the changes of economic growth in respect of inflation and unemployment. the above function can also be presented in logarithm form as follows: log gdpt = β0 + β1 log cpit +β2 log unempot + µt (4) the above equation measures the responsiveness of south african gdp toward changes in inflation and unemployment rate. the apriori expectations are as follows: it is expected that: β1 > 0 and β2 > 0 4. empirical results and discussion this section presents the data analysis, results interpretation, and discussions. the first subsection covered the unit root test in which augmented dicky fuller and philip peron tests were used. subsequently, lag order selection criteria were presented in which the number of lags used in the study were identified. next, johansen co-integration test which checks if there is any co-integration equation was presented thereafter. having identified the cointegration equation, the vector error correction model was presented and ultimately, diagnostic tests in which serial correlation, heteroscedasticity and jargue-bera estimates were presented. 4.1. unit root test results the introductory stage of the johannsen procedure is to test for stationarity series, thus, results for unit root test are presented in table 1 below. augmented dicky fuller test is one of the main methods used to test whether time series are stationary or nonstationary. table 1 shows results for augmented dickey-fuller (adf) test and philip-perron (pp) results. the results on both adf and pp tests were carried out under the null hypothesis (ho) which assumes that the data has a unit root or is non-stationary against the alternative hypothesis (h1) which states that data do not have unit root, hence, is stationary. the calculated values of adf and pp were all equated to the critical values obtained. if the calculated statistic value is bigger than the calculated critical value, the null hypothesis is rejected, and it is concluded that the series data is stationary. similarly, if the calculated statistics values are less than the computed critical value, the null hypothesis is not rejected, and it can be concluded that the series has a unit root, hence, not stationary. in this regard, in table 1, results are presented under intercepts and trends as well as intercepts and none. as such, the results for gdp, cpi and unempo were found to be less than sekwati and dagume: effect of unemployment and inflation on economic growth in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 41 table 1: unit root test: augmented dickey‑fuller and phillip‑perron order of variables integration variables adf pp intercept trend and intercept none intercept trend and intercept none level lgdp 1.542900 1.919103 1.639540 1.542901 1.924850 1.084347 1st difference dgdp 13.1567 13.0851 13.2271 13.4694 13.4361 13.3790 8* 5* 0* 8* 2* 8* level lcpi 3.19928 3.25798 1.29900 2.23598 2.26621 1.61974 4 7 4 8 1st difference dcpi 4.682049* 4.661369* −4.69492* 5.998398* 5.750022* 6.029329* level lunemp o 2.349870 2.764531 0.321399 2.116062 2.628339 0.687268 1st difference dunemp o 11.05385* 10.99940* 11.06622* 11.63094* 11.59289* 11.38560* 1% critical values 4.43554 3.42121 2.12321 4.42123 3.4532 2.45121 5% 4.23134 3.21232 2.26543 4.21221 3.4215 1.2143 10% 4.12311 3.13113 2.31412 4.1143 3.1321 1.21321 values marked with a * represent stationary data at 1% and 5% level of significance, source: own computation table 2: trace results and maximum‑eigen results hypothesized no. of ce (s) trace results maximum‑eigen results eigen value trace statistic 0.05 critical value prob.** eigen value max‑ eigen statistic 0.05 critical value prob.** none* 0.2339 45.118 29.797 0.001 0.234 25.044 21.131 0.01933 at most 1 0.1500 20.074 21.495 0.383 0.145 15.268 17.264 0.09746 at most 2 0.0500 4.8053 6.8414 0.079 0.050 4.805 6.8414 0.32784 source: own computation the critical value at 1%, 5% and 10%. as shown in table 1, the calculated statistics display that all variables in levels, both for adf and pp tests were found to be not stationary in intercept, trend, and intercept, hence, contain a unit root. after first differencing, however, all computed values were greater than the critical values of 1%, 5% and 10% levels of significance respectively. gdp, cpi and unempo, thus became stationary at first difference. for the phillips-peron tests, the results confirm that all variables were not stationary in levels, intercept, trend, and intercept, however, after first differencing, all variables’ computed statistics values were greater than the critical value as show in table 1. the pp results, thus, confirmed that indeed the data became stationary after first differencing, and this supports the adf results as explained above. as such, it can be concluded that the series were integrated in the same order (1) since adf, and pp revealed that the data series were non-stationary in levels and became stationary after first being differenced. gdp, cpi and unempo are integrated of the same order; this necessitates the use of cointegration analysis, and the current study employed johansen approach as presented below. 4.2. cointegration test (johansen approach) johansen approach is a technique used to determine whether there is long-run association between given variables (gujarati, 2004). the current study tested the time series data to check if there is any long run association between the variables and the results are presented in table 2 below. to clearly demonstrate if there is any long-run association between the variables, it is imperative to know the number of lags to be used (asteriou and hall, 2011). as such, the akaike information criterion (aic) was used, and the results are presented in table 3. table 3 shows that the selected lag order for the study is 3 lags since the computed value of 1.54332 on lag 3 under aic is the lowest. gujarati (2004) stated that the lowest aic value computed may present a good model for cointegration analysis. as such, the study considered lag 3 and after identifying this number of lags, it necessitated the use of johansen cointegration test and the results are presented in table 2 below. results in table 2 show the johansen approach for cointegration which covered trace results and maximum-eigen results. the computed trace statistics was compared to the critical value at 5% level of significance. according to asteriou and hall (2011), if the computed test statistic is greater than the critical value at 5% level of significance it can be concluded that there is no cointegrating equation. as such, the computed trace statistic (45.118) was found to be greater than the critical value (29.797) and 5% level of significance. similarly, the computed max-eigen statistic (25.044) was greater than the critical value (21.131) at 5% level of significance. given these results, the current study failed to reject the null hypothesis at none* which states that there is no cointegrating equation. also, the corresponding p-value for trace results (0.001) and maximum-eigen results (0.019) show that the results are significant at none, hence, failed to reject the null hypothesis. considering at most 1 cointegrating equation, the computed trace statistic (20.074) is less than the critical value (21.495) and the corresponding p-value (0.383) is >5% hence, the null hypothesis was rejected. similarly, the max-eigen statistic value (15.268) is less than critical value (17.264) and the p-value (0.09736) is >5% and the null hypothesis was rejected; the current study concluded that at most, one equation is cointegrated, hence, there is a long run relationship between gdp, cpi and unempo. there is long relationship between gdp, cpi and unempo, thus, it is imperative to check for long run relationship between these variables. in this regard, error correction model (ecm) sekwati and dagume: effect of unemployment and inflation on economic growth in south africa international journal of economics and financial issues | vol 13 • issue 1 • 202342 and vector error correction model (vecm) is used check for short run and long run association respectively and the results are presented below. 4.3. error correction model (vcm) vector error correction model usually belongs to a category of multiple time series models which are commonly used for data, where the underlying variables have a longrun stochastic trend, thus, the current study first assessed the short run dynamics, and the results are presented in table 4. results in table 4 above show that at least one variable is statistically significant since the computed p-value is <5% level of significance. lncpi computed a p-value of 0.0416 which is <5% hence the results are not spurious. subsequently, the coefficient resid01 (−1) of 0.93 implies that approximately 93% of variation in the model is corrected in the first quarter and the model reverts to equilibrium condition. this indicates that there is a strong pressure on economic growth in re-establishing short-run equilibrium every time the economy experiences an external shock. the speed of adjustment is statistically significant at 5% since the computed p-value of 0.0120 is <5% and the corresponding t-statistic of 3.090821 is >3. in this regard, it is concluded that there is a negative relationship between economic growth and consumer price index in the short run. a unit increase in cpi in the short-run leads to a decrease in economic growth by 0.44575 units, thus, there is a negative association between cpi and economic growth in south africa. in terms of unemployment rate, the computed results show a negative association, but the results are insignificant since the computed p-value of 0.3422 is >5% and the corresponding t-statistics of 0.40138 is <3, hence the results are spurious. in this regard, the study further assessed the long run association between economic growth and the above-mentioned variables, and the results are presented below. 4.4. vector error correction model (vecm) the vector autoregression (var) is a technique used mainly in econometrics to establish the joint dynamic behaviour between dependent and independent variables (asteriou and hall, 2011). the structural behaviour identified by johannsen cointegration approach, necessitated the use of vecm. the vecm technique gives the long run impacts of independent variables on the dependent variable, thus, vecm was estimated, and the results are presented in table 5 below. the variables in the current study are cointegrated at the same order, hence there is a long run relationship between gdp and the given independent variables (consumer price index and aggregate unemployment) from 1994 quarter one to 2018 quarter four. the computed vecm is presented in equation 5 below. gdp = 2.568876-0.057579*unempo-0.0864647*cpi. (5) given the results in table 4 and equation 5, several conclusions may be derived. first, the computed r-squared value of 0.46 shows that at most 46% of the variation in equation 5 is explained by vecm model. from the results in table 5, it can be concluded that cpi and unempo are statistically significant since the corresponding t-statistics in absolute terms are >2. gujarati (2004) stated if the computed tstatistic is two and above, the results are considered significant, hence, it can be concluded that cpi and unempo results are statistically significant. furthermore, the computed p-values (unempo = 0.0079 and cpi = 0.0001) are <5% signifying significant results. in this situation, it can be concluded that in the long run, a unit increase in consumer price index (cpi) may lead to 0.05 unit decrease in gross domestic product in south africa. similarly, the results in table 4 show that a unit increase in unemployment may lead to 0.08 units decrease in gdp in south africa. the results showed a negative relationship between gdp and consumer price index and unemployment. based on this, the results support the findings of akeju and olanipeun (2014) and banda et a. (2016) who investigated the impact of inflation and unemployment on economic growth and revealed that imported inflation and structural unemployment have a negative effect on gdp, in developing nations. also, michael et al., (2016) stated table 3: lag order selection criteria lag log lr fpe aic sc hq 0 −135.760945 na 0.01432 6.231224 6.414574 8.30456 1 −36.454643 423.7633 4.34e-12 2.356256 2.565746* 2.85673* 2 −19.564764 44.54665 4.13e-12 2.187657 4.5657e8 3.206783 3 98.516754 72.25643* 2.55e-12* 1.545332* 6.949564 3.778667 source: own computation, *indicates lag order selected by the criterion, lr: sequentially modified lr test statistic (each test at 5% level) fpe: final prediction error, aic: akaike information criterion, sc: schwarz information criterion, hq: hannan-quinn information criterion table 4: error correction model results variable coefficient standard error t-statistic p-value lnunempo −0.21341 0.531269 −0.40138 0.3422 lncpi −0.44574 0.126231 −3.53114 0.0416 resid01(-1) 0.932193 0.309081 3.090821 0.0120 r-squared 0.45871; f-statistic 25.67583; dw stat 1.451671 source: own computation table 5: vector error correction model (vecm) variable coefficient standard error t-statistic prob. ct 2.568876 0.565716 4.50931 0.0000 y_gdp 1.000000 lnunempo −0.057579 0.021236 −2.711374 0.0079 lncpi −0.086464 0.021067 −4.104297 0.0001 r-squared f-statistic dw 0.46 9.580840 2.98889 source: own computation sekwati and dagume: effect of unemployment and inflation on economic growth in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 43 table 6: diagnostic test results diagnostic test corresponding null hypothesis t-statistic probability lagrange multiplier (lm) there is no serial correlation 0.975999 0.587098 white (ch-sq.) there is no conditional heteroscedasticity 0.799664 0.576780 jarque-bera (jb) the data is normal distribution 1.498091 0.324765 source: own computation that unemployment has a negative effect on economic growth since the unemployment population may devote their energies to unscrupulous activities which may lead to a deterioration in the aggregate output. considered as such, the study further assessed the validity of the parameters used to justify the worthiness of the results, using diagnostic tests. 4.5. diagnostic tests diagnostic tests which include lagrange multiplier (serial correlation), white noise chai square (heteroscedasticity) and jargue-bera (normal distribution) are presented in this section. these tests were carried out to test the goodness of fit of the model; the results are presented in table 6 below. results in table 6 revealed several conclusions regarding diagnostic checks. firs, the results on lm test computed a t-statistic of 0.975999 and a corresponding probability of 0.587098. as such, the computed t-statistics shows that the probability is >5%, hence the null hypothesis is not rejected; it is concluded that there is no serial correlation among the variables. second, white noise chi-square test computed a t-statistic 0.799664 and a probability of 0.576780, thus the t-statistic is <2 and the probability is >5%. in this regard, the null hypothesis which claims that there is no conditional heteroscedasticity is not rejected leading to the conclusion that the data does not suffer from white noise and there is no conditional heteroscedasticity. last, the computed t-statistic (1.498091) under jb tests is <2 and the probability is >5%, hence, the null hypothesis is not rejected, and it can be concluded that there are normal distribution residuals, and the model is good for long run forecasting. 5. conclusion and policy recommendations this study looked at the twin macroeconomic variables, confronting south african economy which have the propensity to be among the complex economic and social dimensions. the inability of government to find a listing solution to these problems has affected the economic life, economic activities, and political system of the country. this paper attempted to investigate the effect of unemployment and inflation on gdp in south africa through the application of ordinary least square and granger causality test of causation between unemployment, inflation, and gdp. consumer price index as a measure that inspects the weighted average of prices of a basket of consumer goods and services plays an important role in curbing inflation. considering the results in this study, inflation may lead to a decrease in aggregate economic growth, therefore, there is a need for strong institutional collaboration for dealing with these triple macroeconomic variables unemployment, inflation, and gdp-in south africa. policy options suggested by this study include the fact that the government should put practical price controls on the consumer price index and keep it in check to maintain price levels constant. this can be achieved by setting maximum and minimum price levels on consumer goods and services which are used daily. furthermore, for price indices which are calculated using national statistical measures, the government may use rent, wages, and salary control measures to regulate prices. the study thus recommends that the government should also put control measures on wages and salaries and relate them to price movements. once these statistical measures are kept in control, stable economic conditions may attract more investments leading to economic growth. also, if consumers are protected from income injection, this may discourage strikes which normally affect production in an economy. regarding unemployment, aggregate unemployment is defined as the overall state of an economy in which active job seekers are not employed and there are few jobs available in comparison to the demand for general jobs. from the outcome in the current study, the negative effect between unemployment and economic growth may be corrected, using the following policy recommendations-the government should encourage different skills development institutions to improve skills of its learners. skills’ development programmes may increase the chances of the unemployed work force being employed. one major reason for high unemployment rate is lack of necessary skills needed in the different industries, thus, investing in skills development programmes may help to reduce unemployment which in turn may improve economic growth. furthermore, the government through department of higher education and training should create a system which links the education system and the industries around south africa. this will enable skills development from tertiary level and employment can be increased. references ademola, a., badiru, a. 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(2015), analysis of the relationship between inflation, unemployment and economic growth in nigeria: 1987-2012. applied economics and finance, 2(3), 102-115. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(3), 1-12. international journal of economics and financial issues | vol 11 • issue 3 • 2021 1 spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries sessinou erick abel dedehouanou*, abou kane cheikh anta diop university of dakar, dakar, senegal. *email: erickdedehouanou@yahoo.fr received: 17 february 2021 accepted: 23 april 2021 doi: https://doi.org/10.32479/ijefi.11299 abstract for decades, the literature on the relationship between official development assistance (oda) and economic growth is characterized by ambiguity. this study removes such ambiguity for west african economic and monetary union (waemu) countries by considering gross domestic product (gdp) according to the production perspective and paying attention to spatial spillover effects. the results obtained by system generalized method of moments for the period 2000–2018 showed a link between economic growth and oda, which manifests itself through a positive and significant impact of the latter on the value added in the secondary and tertiary sectors. in addition, the value added in the secondary sector of a waemu country depends positively on the aid provided to other waemu countries that are geographically close to that country or located on the same road corridor. our results inform donors for an efficient allocation of development aid in the union. keywords: official development assistance, sectoral values added, spatial spillovers effects, west african economic and monetary union jel classifications: o1, o55, f351 1. introduction the contribution of official development assistance (oda) to the economic growth of recipient countries has been widely studied in the literature (amprou and chauvet, 2004), without a consensus being reached. there are three major schools of thought regarding the relationship between aid and economic growth. the first school highlights a negative effect of aid on growth, seen in the work of easterly et al. (2004). the second school of authors argues that there is a positive correlation between aid and economic growth; they do not necessarily show that aid is always effective, but that on average an increase in aid flows is associated with a gain in growth (radelet et al., 2006). finally, according to the third school, the correlation between aid and economic growth is conditional, either on the characteristics of the recipient country in particular good governance (isham et al., 1997) or on the behavior of donors with regard to aid allocation (berg, 2003). despite the diversity of the different econometric methods that are used, the common feature of these studies is that they take a “holistic” approach that masks large disparities in the effects of aid on economic growth. indeed, most studies consider the growth of the gross domestic product (gdp) as a homogeneous variable, when in fact the gdp results from the contributions of different sectors of the economy. thus, aid could have different effects depending on the three sectors of the economy (namely, primary, secondary, and tertiary). in addition, the aid received by a country could have an impact positive or negative on the economic growth not only of the this journal is licensed under a creative commons attribution 4.0 international license dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 20212 recipient country but also of other countries, through a spillover effect. indeed, according to the theory of spillover effects, initially devoted to foreign direct investments (fdi) (ortega and peri, 2014), geographical proximity along with commercial and cultural interactions could form the foundation of a spatial diffusion of the effect of aid on economic growth. in particular, aid provided to a recipient country may increase the effective demand for goods, services, and labor from neighboring countries, due to income effects (demir and duan, 2020). additionally, allocating aid to one country on the basis of structural reforms may lead other countries to adopt the same reforms that support economic growth (easterly and levine, 1998). however, aid can also have negative spillovers, such as the emigration of skilled workers from neighboring countries to the aid recipient country. the analyses of this study thus highlight a positive or negative spillover effect of aid on economic growth and consequently suggest that the spatial dimension be taken into account in studies of the relationship between development aid and economic growth. this study contributes to previous work on two points. first, the issue of the relationship between development aid and economic growth remains topical in the west african economic and monetary union (waemu), given the divergent results observed in the literature in general and the need for aid to achieve development goals. however, unlike most previous work, this study focuses on the components of production that comprise the value added of the primary, secondary, and tertiary sectors (rather than on gdp growth) to highlight the importance of oda. the aim is to highlight the economic sector that responds best to development aid. for example, rajan and subramanian (2005) have shown that aid provided to poor countries has a negative effect on the manufacturing industry (a branch of the secondary sector), while feeny and ouattara (2009) have demonstrated the effectiveness of foreign aid in promoting the growth of the agricultural industry (a branch of the primary sector) in developing countries. second, the literature on the spillover effects of aid on economic growth remains sparse in waemu countries: to our knowledge, only two studies have addressed this issue. askarov and doucouliagos (2015), examining the spatial relationship between aid and economic growth in economies transitioning to a market economy (in europe and central asia), have shown that while aid has a positive effect on the economic growth of the recipient country, it also seems to generate negative spillover effects on the economic growth of other countries. additionally, demir and duan (2020) have recently shown that multilateral aid provided by the world bank to countries in sub-saharan africa promotes economic growth in both recipient localities and those neighboring recipients. we add to the work of these authors by using spatial econometrics to determine the extent to which aid provided by donors generates spillover effects on the components of production (sectoral values added) in waemu countries. several forms of interactions between waemu countries could promote aid spillover effects. for one, an increase in development aid could stimulate economic growth in a given sector nationally but also in other waemu countries, such as through trade. in addition, as demir and duan (2020) have pointed out, aid flows can increase the demand for goods, services, and labor in a given sector in both the recipient country and in other countries in the union. the relative mobility of labor among waemu countries, due to their membership in the economic union, could facilitate this migration of employment from a given country to other countries receiving aid, thus contributing to the economic growth of the latter. senou (2017), focusing on the migration of workers in waemu countries, has effectively shown that immigrant labor positively affects the economic growth of countries (with the exception of senegal). in terms of economic policy implications, the analysis of the spillover effects of aid in waemu countries can inform an efficient allocation of development aid in the union. indeed, highlighting the (positive) spillover effects of aid on the value added of a sector of waemu economies indicates the need for an orientation of additional aid flows to this sector to promote the economic growth not only of the beneficiary country, but also of the other countries in the union. the rest of the study is organized as follows. section 2 reviews the literature on the link between development aid and economic growth. section 3 presents stylized facts about development aid and economic growth in waemu countries. the study methodology and the data are described in sections 4 and 5, respectively. section 6 presents and discusses the results obtained, while the conclusion and policy implications are presented in section 7. 2. literature review in contrast to the abundant and ambiguous literature on the relationship between aid and economic growth, research relating to the spillover effects of aid is scarce. like most studies of the relationship between aid and economic growth, these works look at economic growth holistically. this is the case in askarov and doucouliagos (2015), who examined the effects of development aid on economic growth in countries in transition (the countries of the former ussr, the former eastern bloc, and china). the authors used the tools of spatial econometrics to highlight the spatial effects of aid on geographically close countries. the results indicated that aid has a positive effect on the economic growth of countries in transition; however, negative effects of the aid received by one country were observed on the economic growth of other neighboring countries (i.e., negative spillover effects). in addition, positive spillover effects were observed with regard to the control of public spending and inflation. the authors explained these results with the fact that successful policies in one country are copied by other countries. demir and duan (2020) also studied the effectiveness of aid provided by the world bank to 48 countries in sub-saharan africa during the period 1995–2014. the results obtained from their instrumental variables approach revealed that aid at the local level promotes economic growth in both beneficiary localities and in neighboring localities. in contrast, aid flows at aggregate levels (nationally/by country) have the opposite effect and reduce economic growth. drawing on these results, the authors suggested dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 2021 3 that donors who prefer more visible megaprojects at the national level should instead focus their efforts on well-targeted local projects. all in all, the literature relating to the spillover effects of development aid on economic growth remains ambiguous, as is the literature relating to the direct effects of aid on economic growth. by emphasizing the spillover effects of aid on sectoral components of gdp, this study seeks to provide guidance for better allocation of development aid in waemu countries. 3. stylized facts 3.1. sector analysis of economic growth waemu member states have recorded sustained economic growth for several years. as seen in table 1 below, the average real gdp growth of these countries ranges from 2.08% (for togo) to 6.04% (for burkina faso) over the period 2005–2010. since 2011, economic growth has increased in all countries. this increase is explained by the implementation, for a period of 4 or 5 years (depending on the country), of the first phase of national development plans, one of the main strategic approaches through which vigorous and sustainable economic growth was promoted. it should be noted that at the end of this first phase, waemu countries have implemented new programs in order to consolidate the achievements of the previous ones. thus, all waemu countries were able to record economic growth greater than 5% during the period 2016–2019. the best performance was achieved by côte d’ivoire, with an average growth in production of 7.64%. however, this performance masks differences in economic growth within the waemu countries. benin, burkina faso, côte d’ivoire, and senegal recorded positive growth differentials compared to the average growth of the union. the other four waemu countries with negative economic growth differentials did not have the same profiles over the period considered. table 1 also presents data on the components of production (demand approach) i.e., sectoral value added. the primary sector includes the industries of agriculture, breeding, forestry, and fishing. the secondary sector includes manufacturing, electricity, gas, and water, as well as buildings and public works. the tertiary sector includes commerce, transport, warehouses and communications, banks, insurance, and other services. the value added of a sector is defined by the world bank as the value of the sector’s net output of intermediate consumption. across the board, an increase can be noted in sectoral values added in all waemu countries over the period 2005–2019. in particular, in recent years, economic expansion in all the countries has been driven by the service sector, with the exception of guinea-bissau, mali, and niger. in this last group of countries, the results of economic growth are generally attributable to the primary sector, in particular to booms in the production of main export crops (cotton for mali, cashews for guinea-bissau). in addition, despite the growth of value added in all sectors, the value added of the primary sector remains higher than that of the secondary sector in all countries. this situation results from the availability of abundant labor, to the detriment of other factors of production, particularly capital. indeed, data from the world bank indicate that workers in the primary sector on average represented approximately 50% of the total workforce of waemu countries in 2018, compared 36% in tertiary sector and only 14% in secondary sector. likewise, a weak increase can be noted in the value added of the secondary sector, which illustrates the insufficient development of this sector. this situation is characteristic of the weak structural transformation of waemu economies, with industry being more productive than agriculture (see graph 1) and the latter occupying a relatively large weight in production1. 3.2. official development assistance received by waemu countries graph 2 shows the dynamics of net oda flows received by waemu countries in the period 2002–2018. a relatively stable trend in development aid can be observed at 1-10% of gdp for the majority of countries. the exceptions are guinea-bissau and togo, where the level of aid received reached 20.48% and 10.75% of the respective gdps of these states. over the period 2002–2018, oda for all the countries in the union fluctuated, on average, around 4.61% of gdp. côte d’ivoire received the least aid, a situation that can be justified by its relatively high level of 1 structural transformation is defined as a reallocation of resources from sectors with low productivity to those with higher productivity (perspective economique en afrique de l’ocde et al., 2013). table 1: economic growth and sectoral values added in waemu countries (2005–2019) country 2005–2010 2011–2015 2016‑2019 % δgdp va (%gdp) % δgdp va (%gdp) % δgdp va (%gdp) vap vas vat vap vas vat vap vas vat benin 3.5 24.12 24.09 41.36 4.68 22.09 20.8 47.17 6.01 22.97 21.05 46.7 burkina 6.04 33.52 17.26 41.97 5.42 31.12 20.93 39.29 6.28 28.98 19.9 42.5 côte d’ivoire 2.14 22.6 23.58 53.82 6.56 22.73 25.47 44.17 7.64 21.26 25.05 43.9 guinea-bissau 3.45 44.26 13.66 40.07 3.41 44.79 13.41 39.42 5.28 47.66 12.6 34.6 mali 4.93 31.91 23.53 35.32 3.59 36.92 19.02 36.48 5.35 38.47 18.13 37.4 niger 5.6 38.71 13.99 41.55 6.25 37.05 19.14 36.6 5.66 39.21 16.11 38.1 senegal 3.91 14.31 21.49 52.99 4.02 13.64 23.35 53.14 6.55 15.67 24.97 51.1 togo 2.08 32.98 15.99 41.55 6.14 31.99 16.98 33.25 5.04 23.72 15.91 27.9 waemu 3.65 30.3 19.2 43.58 5.18 30.04 19.89 41.19 6.52 29.74 19.22 40.3 source: our calculations based on bceao and the world bank data. note: %δgdp=growth of real gross domestic product (gdp), va=sectoral value added, vap=value added of the primary sector; vas=value added of the secondary sector and vat=value added of the tertiary sector dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 20214 development compared to the other economies of the union (with the exception of senegal), meaning it requires less aid. countries like mali, niger, and burkina faso, which have an aid-to-gdp ratio of over 4%, face food and nutritional vulnerability due to their unfavorable sahelian geographic location as well as their security instability (due to the presence of armed terrorist groups in part of the territories). 4. methodology in order to analyze the direct effects of aid on sectoral value added, we must first consider the standard panel growth model: yit=yit–1 α+xit β+ϑt+μi+uit (1) where yit is the explained variable (sectorial value added); ϑt and μi represent the temporal and individual effects (country), respectively; uit is the error term identically and individually distributed according to a reduced centered normal distribution; and xit is the vector of explanatory variables, including development aid. a multitude of variables (other than aid) can affect sectoral values added. we retain only the variables of interest in addition to the net oda. thus, the value added of the primary sector is determined by rainfall (barrios et al., 2010), agricultural labor, export prices (mamingi, 1997), and the values added of other sectors of the economy (gemmell et al., 2000). for the value added of the secondary sector, the considered variables are inflation, the capital obtained from investment (mitra et al., 1998), the quality of institutions, and the values added of other sectors of the economy (sepehrdoust and hye, 2012). the value added of the tertiary sector is also explained by inflation and the quality of institutions, but also by credits to the economy, as well as other sectoral values added. next, the analysis of aid spillover effects requires the use of a spatial model. in the literature, several specifications are considered to account for spatial interactions or autocorrelations (kukenova and monteiro, 2009; elhorst, 2010; bouayad agha et al., 2018). the first is the spatial autoregressive model (sar), where spatial autocorrelation is observed at the level of the dependent variable. it is written as: y w y x uit ij jti j n it i it� � � ���� � � (2) graph 2: net official development assistance received by waemu countries (% of gdp) source: our calculations based on the world bank data graph 1: sectoral productivity (sectoral value added/sectoral employment) of waemu economies source: our calculations based on the world bank data dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 2021 5 the spatial dependence is modeled through a matrix of spatial interactions (or weights), also called the neighborhood matrix w, of which wij is an element of the matrix. this square matrix of dimension (n, n) summarizes the spatial links (neighborhood relations) among the countries in each year. in the literature, neighborhood relationships are most often defined by a binary matrix e.g., a geographic contiguity matrix. in this case, the elements of the matrix take the value 1 when the countries share a common border and 0 when they do not. the literature also distinguishes among other types of neighborly relations, such as those based on geographical distances between countries. wij yjt is called the endogenous spatially lagged variable, while ρ is the spatial autocorrelation coefficient, which measures the spatial spillover effect of y. in this study devoted to the spillover effects of aid on sectoral values added, the term wij yjt in equation (2) reflects the situation where the sectoral value added of a country depends on the same sectoral value added of the other countries in the union. the second specification is the autocorrelated error model or spatial error model (sem). here we have: yit=xit β+μi+uit (3) u w uit i j n ij jt it� ���� � (4) this model takes the spatial interrelationships into account at the error level. the sem model is consistent with the situation where the variables omitted in the modeling of sectoral value added are spatially self-correlated. the third specification is the spatial durbin model (sdm), based on the work of anselin (1988) and lesage and pace (2009). in this specification, some explanatory variables (e.g., development aid) are spatially lagged as follows: y w y x w x uit i j n ij jt it i j n ij jt i it� � � � �� �� �� � � � (5) in equation (5), a positive (or negative) coefficient means that the variation of the variable x for a given country positively (negatively) affects the variable y in the other countries. the direct effect of the variation of the variable x for a given country on the variable y for that same country remains β. from equation (5), the exogenous interaction model spatial lag x (slx) can be derived by considering ρ=0. in this last specification, spillover effects are measured only at the level of spatially lagged explanatory variables. other specifications are also used in spatial data econometrics for example, the spatial durbin errors model (sdem), which is composed of a spatially autocorrelated error term and spatially lagged explanatory variables, and the sarar model, simultaneously involving a spatial autoregressive process of the dependent variable and the error term (bouayad agha et al., 2018). in this study, we use the specification that best matches the research objective. in this regard, the sdm model (equation 5) which is also considered in the literature as the most robust model in terms of specification (floch & le saout, 2018) better accounts for the spillover effects of aid on sectoral economic growth in waemu countries. in addition, as specified, the sdm model makes it possible to take into account the interdependence of sectors in the production process. for instance, industry can use products from the agriculture sector, while the latter can benefit from transport services in order to transport agricultural inputs or export production. still, apart from these economic considerations, we implement several spatial autocorrelation tests based on statistical analyses to choose the appropriate spatial model. in particular, the literature distinguishes between moran’s spatial autocorrelation test (1950) and lagrange multiplier tests (burridge, 1980; anselin, 1988; anselin et al., 1996). moran’s (1950) spatial autocorrelation test is used to determine the existence of a spatial relationship between variables. this test is performed with the null hypothesis of an absence of autocorrelation of errors or of spatial dependence between variables. in contrast, the lagrange multiplier tests make it possible to determine whether the spatial correlation takes the form of a spatial autocorrelation of errors (equations 3 and 4) or of a spatially lagged endogenous variable (equation 2). the lagrange multiplier test for spatial error dependence (lmerr) and its robust version (r-lmerr) are used to test the null hypothesis of an absence of spatial autocorrelation of errors, while the lagrange multiplier test for spatial lag dependence (lmlag) and its robust version (r-lmlag) are used to test the null hypothesis of an absence of spatial autocorrelation of the spatially lagged endogenous variable. these different tests are based on the estimation of the non-spatial model by the ordinary least squares (ols) method (here, equation 1 without the autoregressive term). the model is chosen based on the significance of the statistics calculated: if lmerr (r-lmerr) is significant, then the spatial error model is preferred with its extension to the sdem model; if lmlag (rlmlag) is significant, then the sdm model is estimated. the different equations are estimated by the system generalized method of moments (gmm) estimator. this method is flexible enough to take into account the various econometric problems generated by our specifications, and this estimator has better properties for reduced data samples (blundell et al., 2000), as in the case of this study. in addition, the system gmm estimator enables taking into account the potential endogeneity of the sectoral values added described above, as well as that of certain explanatory variables such as capital, credits to the economy, and development aid. this last form of endogeneity has been widely discussed in the literature (hepp, 2008). in this study, two approaches were taken to deal with this equation. the first uses the lagged values of development aid as aid instruments in the various sectoral value added equations (a common assumption in the literature). the second approach follows the proposal by brückner (2013): the procedure consists of first estimating the effect of sectoral value added on aid using the method of instrumental variables (previous values of sectoral value added are used here as instruments): dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 20216 log(oda)it=α+log(va)it β+μi+uit (6) the elements of equation (6) are easily defined. then, the procedure involves obtaining a new round of aid ( )oda excluding the effect of the aid on sectoral value added: ( ) ˆlog( ) log log( ) β= − itit itoda oda va (7) β̂ corresponds to the estimated coefficient of the explanatory variable in equation (6) above. although the system gmm estimator appears to be suitable, we also use the instrumental variables panel data method to estimate equation 1. this enables us to assess the stability and robustness of the direct effect of the aid on sectoral values added. 5. data the data used in this study cover the period 2000–2018 from all eight waemu member states: benin, burkina faso, côte d’ivoire, guinea-bissau, mali, niger, senegal, and togo. several data sources were considered. data on aid flows were taken from the oecd database. sectoral values added and export prices were taken from the world bank’s world development indicators (wdi) database. the data, expressed in united states dollars, have been converted into west african cfa francs using the nominal exchange rate obtained from the same source. agricultural labor is measured by the product of jobs and working hours in the agricultural sector. these data are also taken from the world bank’s wdi database. data on rainfall (in mm) are taken from the bceao statistical yearbooks (2017 and 2018). inflation and loans to the economy (in west african cfa francs) come from the bceao database. the capital stock is obtained from penn world tables (pwt) and is estimated on the basis of the accumulation (previous capital stock added to current investment) and the depreciation (assuming a depreciation rate of 6%) of investments (inklaar and timmer, 2013). the variables are expressed in logarithm except for rainfall and inflation. institutional quality data involves political and economic institutions. in the equation of the value added of the secondary sector, we consider “the rule of law”, which captures the confidence in the laws and the rules of the company, especially the quality of the execution of the contracts, the property rights, the police, and the courts. this is an indicator from the world bank of the quality of political institutions (“worldwide governance indicators”). with regard to the value added of services (tertiary sector), we use a measure developed by the heritage foundation of the quality of economic institutions, especially the business freedom, which measures the various regulatory constraints to which businesses are subject. each of the variables reflecting the quality of institutions vary from 0 to 100, with the latter corresponding to a better score. in terms of spatial interactions, two weights matrices named w1 and w2 were considered. the first (w1) is a matrix of contiguity or geographic proximity; it is a binary matrix defined by the existence or nonexistence of a common border between the countries in the union. the gravity model suggests that two geographically close countries are more likely to influence each other than are two distant countries (tobler, 1979). we conjecture that the circumstance of sharing a common border within the waemu can be a vector of convergence of economies and can induce diffusion of the effects of aid and of sectoral values added. the second spatial weighting matrix (w2) is based on the eleven waemu inter-state road corridors2. this second matrix, also binary, takes the value 1 for states located on the same corridor and 0 otherwise. the idea behind the weighting matrix based on the corridors is that the spillover effect of aid or sectoral values added could occur along these corridors, given the efforts made by the waemu countries to facilitate free movement of people and goods (e.g., interconnection of customs it systems, establishment of juxtaposed control posts (pcj) that coordinate the control services of states in one location). thus, countries on the same corridor could also expect to see their economies converge. 6. results and discussion 6.1. baseline estimate: effect of aid on sectoral value added the analysis of the effect of aid on the sectoral values added is conducted with the estimations from the instrumental variables panel data method with fixed effect (iv-fe) and those of the system gmm estimator (gmm-sys). the estimates also take into account the sectoral heterogeneity across the waemu countries through country fixed effects. we consider the fact that sectoral growth may depend on the intrinsic characteristics of each country: for example, the growth of the primary sector could be limited in countries such as burkina faso, mali, and niger due to the sahelian climate, which is often unfavorable to agriculture, and coastal countries such as benin, côte d’ivoire, and senegal could experience a development of service activities. tables 2-4 present the results of the estimates for the values added of the primary, secondary, and tertiary sectors, respectively. in consideration of the validation criteria of the results obtained from the estimations of the different equations by the instrumental variables panel data method, the kleibergen-paap and cragg-donald f statistics show that the instruments used are relevant. hansen’s j statistics indicate that the equations are precisely identified. for the system gmm estimator, the arellano and bond autocorrelation test ar(2) results in not rejecting the hypothesis of the absence of second-order autocorrelation. the sargan test also allows us to accept the hypothesis of exogeneity of the instruments used in the gmm model. furthermore, the significance of the coefficients associated with the lagged variables (tables 2-4) justifies the use of the dynamic model. in the results of the regression of the value added of the primary sector presented in table 2, it emerges that the aid has no effect 2 according to the waemu commission (see decision “n° 39/2009/cm/ uemoa”), the corridors are roadways crossing at least two waemu member states with a sea port as a point of departure or arrival. they aim to ensure the fluidity of the traffic of people, goods, and services within the union. dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 2021 7 table 2: oda and value added of the primary sector variables log (va of the primary sector) iv‑fe gmm‑sys aid instrumented growth instrumented aid instrumented growth instrumented (1) (2) (3) (4) log (primary sector va lagged) 0.516*** (0.103) 0.511*** (0.103) log (net oda) 0.045 (0.077) –0.032 (0.028) –0.003 (0.013) –0.002 (0.013) log (agricultural labor) 0.278*** (0.052) 0.291*** (0.049) 0.167** (0.065) 0.169** (0.067) log (export price) 0.372*** (0.071) 0.380*** (0.069) 0.170* (0.077) 0.172* (0.079) rainfall 0.001*** (0.000) 0.001*** (0.000) 0.001** (0.000) 0.000** (0.000) log (tertiary sector va lagged) 0.491*** (0.088) 0.520*** (0.091) 0.269** (0.085) 0.274** (0.082) constant –3.387 (1.912) –3.456 (1.899) country fixed effect yes yes yes yes kleibergen–paap lm-stat. 7.102*** 35.240*** cragg-donald wald f stat. 8.787* 2535.360* hansen j stat. 0.000 0.000 ar (1) p–value 0.024 0.024 ar (2) p–value 0.101 0.102 sargan p–value 0.078 0.070 observations 144 144 144 144 r2 0.883 0.882 countries 8 8 8 8 source: our calculations. note: robust standard deviations are in parentheses, ***p < 0.01, **p < 0.05, *p < 0.1 denote respectively the significant coefficients at the 1%, 5% and 10% threshold. va: value added table 3: oda and value added of the secondary sector variables log (va of the secondary sector) iv‑fe gmm‑sys aid instrumented growth instrumented aid instrumented growth instrumented (1) (2) (3) (4) log (secondary sector va lagged) 0.693*** (0.052) 0.693*** (0.052) log (net oda) 0.072 (0.077) –0.007 (0.025) 0.020** (0.007) 0.020** (0.007) log (capital) 0.927*** (0.125) 0.932*** (0.119) 0.257** (0.076) 0.257** (0.076) inflation 0.004 (0.004) 0.005 (0.005) 0.007 (0.004) 0.007 (0.004) rule of law 0.013*** (0.002) 0.013*** (0.002) 0.006*** (0.001) 0.006*** (0.001) log (primary sector va lagged) 0.411*** (0.088) 0.442*** (0.080) 0.174*** (0.041) 0.174*** (0.041) constant 0.859* (0.405) 0.821* (0.386) country fixed effect yes yes yes yes kleibergen–paap lm-stat. 7.145*** 19.066*** cragg-donald wald f stat. 17.745* 8762.955* hansen j stat. 0.000 0.000 ar (1) p–value 0.043 0.043 ar (2) p–value 0.400 0.400 sargan p–value 0.180 0.180 observations 136 136 136 136 r2 0.898 0.899 countries 8 8 8 8 source: our calculations. note: robust standard deviations are in parentheses, ***p<0.01, **p<0.05, *p<0.1 denote respectively the significant coefficients at the 1%, 5% and 10% threshold. va: value added on the value added of this sector. this result contrasts with those obtained by kumi et al. (2017) for sub-saharan africa countries, who showed that development aid is an important determinant of sectoral growth, including for agriculture. however, these results are in line with the work of ighodaro and nwaogwugwu (2013) in nigeria. the insignificant effect obtained here could result from the low productivity of the primary sector or from dysfunctions in the orientation of donor aid toward the sector. with regard to the control variables, agricultural labor has a positive effect on the value added of the primary sector, regardless of the estimation method. as this sector has the largest share of the workforce, an increase in this workforce or in the hours worked allows production to increase. the same is true of rainfall and export prices, which remain favorable to the growth of the primary sector in waemu countries. furthermore, table 2 reveals the positive effect of the tertiary sector value added on that of the primary sector. thus, actors in the primary sector benefit from services (e.g., transport, telecommunications), which allow them to increase production and value added in this sector. with regard to the regression of the value added of the secondary sector (table 3), the effect of development aid is significantly positive dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 20218 in the gmm regressions. this result is in line with previous studies, in particular that of feeny and ouattara (2009) on developing countries. with regard to the control variables, capital has the expected positive effect, and the quality of institutions has a positive effect on the value added of the secondary sector, while the effect of inflation is insignificant. in addition, a positive relationship can be observed between the values added of the primary and secondary sectors. this situation confirms the argument that the primary sector provides inputs (raw materials) to the secondary sector, especially industry. table 4 shows that aid has a positive and significant effect on the value added of the tertiary sector. this positive effect of aid has also been reported by calì and te velde (2011) and by ferro et al. (2011). similarly, table 4 indicates that an improvement in the value added of the primary sector contributes to the value added of the tertiary sector. the other variables are significant, except for the business freedom. as for the effect of inflation, it is significantly positive but remains very weak. overall, the basic results highlight the heterogeneity of the effect of aid on different economic sectors. aid has a positive impact on economic growth, deriving from aid’s effect on the values added of the secondary and tertiary sectors. this result remains consistent, given the weight and contribution of the two sectors to economic growth in the waemu (table 1). 6.2. aid spillover effect on sectoral value added as mentioned earlier, we implement the diagnostic tests for spatial autocorrelation. the results of these various tests for the equations of value added in the secondary sector and of value added in the tertiary sector (given the above results) are presented in tables 5 and 6. it can be seen in the two tables that the lm lag statistic is higher than the lm error statistic. in addition, the probabilities show that the lm lag statistics are more significant than the lm error statistics. this suggests the rejection of the null hypothesis of the absence of spatial autocorrelation of endogenous variables, which are the values added of the secondary and tertiary sectors. therefore, for the estimation of the two equations, we consider the spatial autoregressive model to which we add spatially lagged explanatory variables (sdm model). however, the relative significance of the lm error statistic in the two sectoral value added equations leads us to include table 4: oda and value added of the tertiary sector variables log (va of the tertiary sector) iv‑fe gmm‑sys aid instrumented growth instrumented aid instrumented growth instrumented (1) (2) (3) (4) log (tertiary sector va lagged) 0.717*** (0.054) 0.717*** (0.054) log (net oda) 0.197* (0.104) 0.022 (0.029) 0.058*** (0.020) 0.058*** (0.020) log (credits to the economy) 0.184*** (0.050) 0.180*** (0.054) 0.053** (0.026) 0.053** (0.026) inflation 0.006 (0.005) 0.007 (0.005) 0.008** (0.003) 0.008** (0.003) business freedom 0.002 (0.002) –0.001 (0.002) 0.002 (0.001) 0.002 (0.001) log (primary sector va lagged) 0.436*** (0.134) 0.513*** (0.128) 0.135** (0.057) 0.135** (0.057) constant 0.731 (0.501) 0.822 (0.516) country fixed effect yes yes yes yes kleibergen–paap lm-stat. 7.249*** 33.720*** cragg-donald wald f stat. 7.927* 328.852* hansen j stat. 0.000 0.000 ar (1) p–value 0.000 0.000 ar (2) p–value 0.416 0.416 sargan p–value 0.262 0.262 observations 144 144 144 144 r2 0.837 0.850 countries 8 8 8 8 source: our calculations. note: robust standard deviations are in parentheses, ***p<0.01, **p<0.05, *p<0.1 denote respectively the significant coefficients at the 1%, 5% and 10% threshold. va: value added table 6: spatial panel autocorrelation tests for the tertiary sector value added equation diagnostic tests w1 w2 stat. prob. stat. prob. ho: error has no spatial autocorrelation moran mi error test –0.308 1.242 0.381 0.703 lm error (burridge) 2.797 0.094 0.000 0.992 lm error (robust) 39.765 0.000 19.267 0.000 ho: endogenous variable has no spatial autocorrelation lm lag (anselin) 30.589 0.000 31.195 0.000 lm lag (robust) 67.556 0.000 50.462 0.000 source: our calculations. note: w1=weights matrix based on the existence of a common border. w2=weights matrix based on belonging to the same waemu corridor table 5: spatial panel autocorrelation tests for the secondary sector value added equation diagnostic tests w1 w2 stat. prob. stat. prob. ho: error has no spatial autocorrelation moran mi error test 0.291 0.771 0.031 0.975 lm error (burridge) 0.010 0.921 1.627 0.202 lm error (robust) 3.599 0.058 22.997 0.000 ho: endogenous variable has no spatial autocorrelation lm lag (anselin) 9.368 0.002 18.357 0.000 lm lag (robust) 12.958 0.000 39.727 0.000 source: our calculations. note: w1 = weights matrix based on the existence of a common border. w2 = weights matrix based on belonging to the same waemu corridor dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 2021 9 a specification that takes into account the spatial interactions at the level of the error terms. as a result, the sdem model is also implemented so as to take into account the effect of a misspecification in our results. tables 7 and 8 provide the results of the estimation of the aid spillover effects from the gmm-sys estimator on the values added of the secondary and tertiary sectors, respectively. the estimates are obtained by treating the endogeneity of the aid as described above. the same procedure is used for the endogeneity of the spatially lagged aid variable. in tables 7 and 8, it can be noted that, whatever the specification, the direct effect of aid on the value added of the secondary sector and on that of the tertiary sector remains significant and positive. in addition, the control variables have the expected sign, except for inflation. with regard to the spatially lagged variables in table 7 the spatial interaction coefficient of the net oda variable is positive and significant in all specifications. thus, the value added of the secondary sector of a waemu country depends on the aid provided to other countries in the union. therefore, a spillover effect of aid can be seen on the growth of the secondary sector. the estimate of the sdem model (table a1 in the appendix) confirms the positive effect of development aid on the growth of this sector. this spatial diffusion effect of aid on the value added of the secondary sector could potentially be explained by the fact table 7: spillover effect of aid on the value added of the secondary sector, obtained by the system gmm estimator (sdm model) variables log (va of the secondary sector) w1 w2 aid instrumented growth instrumented aid instrumented growth instrumented (1) (2) (3) (4) log (secondary sector va lagged) 0.622*** (0.062) 0.634*** (0.091) 0.620*** (0.065) 0.632*** (0.079) log (net oda) 0.030* (0.018) 0.041** (0.016) 0.032* (0.019) 0.037* (0.022) log (capital) 0.351*** (0.119) 0.403* (0.198) 0.324** (0.127) 0.335** (0.167) inflation 0.006* (0.003) 0.005 (0.005) 0.007** (0.003) 0.006* (0.004) rule of law 0.006*** (0.001) 0.005** (0.001) 0.005*** (0.001) 0.005*** (0.002) log (primary sector va lagged) 0.174*** (0.059) 0.179* (0.088) 0.159*** (0.060) 0.194** (0.079) w*log (secondary sector va) –0.033 (0.029) –0.077 (0.050) –0.052* (0.027) –0.046 (0.030) w*log (net oda) 0.025** (0.012) 0.025* (0.011) 0.021** (0.009) 0.022** (0.009) w*log (primary sector va) 0.028 (0.034) 0.051 (0.049) 0.052* (0.029) 0.035 (0.032) constant 0.926 (0.666) 0.756 (0.525) 0.881 (0.679) 0.576 (0.866) country fixed effect yes yes yes yes ar (1) p–value 0.001 0.033 0.001 0.001 ar (2) p–value 0.120 0.147 0.199 0.171 sargan p–value 0.105 0.108 0.174 0.357 observations 128 128 128 128 countries 8 8 8 8 source: our calculations. note: standard deviations are in parentheses, w1=weights matrix based on the existence of a common border, w2=weights matrix based on belonging to the same waemu corridor, ***p<0.01, **p<0.05, *p<0.1 denote respectively the significant coefficients at the 1%, 5% and 10% threshold. va: value added table 8: aid spillover effect on the value added of the tertiary sector, obtained by the system gmm estimator (sdm model) variables log (va of the tertiary sector) w1 w2 aid instrumented growth instrumented aid instrumented growth instrumented (1) (2) (3) (4) log (tertiary sector va lagged) 0.496*** (0.081) 0.504*** (0.100) 0.583*** (0.076) 0.411*** (0.104) log (net oda) 0.058*** (0.020) 0.049** (0.024) 0.043** (0.021) 0.061*** (0.022) log (credits to the economy) 0.070*** (0.023) 0.084*** (0.028) 0.065** (0.025) 0.089*** (0.029) inflation 0.011*** (0.004) 0.009** (0.003) 0.009** (0.004) 0.007**(0.004) business freedom 0.002* (0.001) 0.002 (0.001) 0.002 (0.001) 0.002* (0.001) log (primary sector va lagged) 0.159** (0.067) 0.092 (0.089) 0.081 (0.072) 0.065 (0.084) w*log (tertiary sector va) –0.060 (0.037) –0.016 (0.039) –0.011 (0.032) 1 (0.033) w*log (net oda) –0.018 (0.013) –0.014 (0.014) –0.007 (0.010) –0.013 (0.009) w*log (primary sector va) 0.121*** (0.037) 0.093** (0.038) 0.051* (0.030) 0.047* (0.027) constant 2.478*** (0.714) 2.452*** (0.909) 1.976*** (0.688) 2.881*** (0.888) country fixed effect yes yes yes yes ar (1) p–value 0.000 0.000 0.000 0.000 ar (2) p–value 0.463 0.222 0.581 0.325 sargan p–value 0.598 0.309 0.368 0.608 observations 128 136 128 136 countries 8 8 8 8 source: our calculations. note: standard deviations are in parentheses, w1=weights matrix based on the existence of a common border, w2=weights matrix based on belonging to the same waemu corridor, ***p<0.01, **p<0.05, *p<0.1 denote respectively the significant coefficients at the 1%, 5% and 10% threshold. va: value added dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 202110 that waemu countries have adopted a common framework for industrial policy. thus, certain countries in the union could take advantage of the positive effects of aid on the secondary sector in other countries (e.g., through the formation of human capital in the field of manufacturing or energy industries). table 8 indicates the absence of an aid spillover effect on the value added of the tertiary sector. indeed, the coefficient related to the spatially lagged aid variables not significant. this result is robust in the choice of the spatial weighting matrix and the instruments, as well as in the specification (table a2 in the appendix for the results obtained for the sdem model). on the other hand, the value added of the tertiary sector in one country is positively affected by the value added of the primary sector in other countries. this result suggests a diffusion of growth at the sectoral level. for example, agricultural exports a branch of the primary sector of the three landlocked countries in the union (burkina, mali, and niger) pass through the ports of the five other countries with a sea front. therefore, an increase in the value added of services for the latter group of countries cannot be excluded when the value added of agriculture (particularly agricultural production) increases in the first group of countries. the implementation of regional economic cooperation policies, especially the construction or improvement of road and rail infrastructure among waemu member states, has promoted the effect of diffusing the value added of the primary sector. 7. conclusion and policy implications this study analyzed the spillover effect of official development aid on the sectoral values added of waemu countries. the analysis considers the gdp, which is defined according to the production approach. system generalized method of moments (gmm) was used to address the problem of endogeneity of aid. spatial links between countries are measured using two weighting matrices that are based on geographic proximity and countries’ membership in the same interstate road corridor. the results of the spatial model estimation showed that the aid provided to a waemu country has a direct effect on the value added of the secondary sector of the recipient country and on that of other countries in the union. in addition, the value added of the primary sector of one waemu country is positively affected by that of the tertiary sector of other countries in the union. thus, allocation of development aid in waemu countries should take into account the spillover effect in the other countries. to increase its effectiveness, part of the additional aid intended for waemu countries could be directed to the secondary sector, in order to stimulate the value added of the various branches in this sector for all countries. for example, several authors agree on the fact that the industrial revolution contributed to the emergence of what are currently called developed countries. although the economic model is different for waemu countries, targeted aid programs in industry (a branch of the secondary sector) could contribute to the acceleration of industrialization, which is an important step towards the structural transformation of waemu countries. therefore, beyond the exploitation of the extractive or mining industries, special attention should be paid to the manufacturing industry. the latter is characterized by the creation of competing production units and dependence on imported inputs; as a result, industry in the waemu has remained uncompetitive and weak in order to be able to fit into global value chains. under these conditions, aid could be used to deal with the obstacles encountered by industry through financing various regional integration projects in this sector, given the expected spillover effects. however, an industrial revolution cannot succeed without the development of other sectors of the economy. as our results showed, development aid has a positive effect on the value added of services. upstream, the tertiary sector is essential to the development of the value added of the primary sector, which in turn constitutes an important determinant of the growth of the secondary sector. downstream, the development of export activities particularly industrial products (secondary sector) to other waemu countries and to the rest of the world also requires commercial services (tertiary sector), such as transport, competitive warehousing, and telecommunications. consequently, aid intended for the primary and tertiary sectors should not be reduced, despite the lack of proof of a spillover effect 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(1979), cellular geography. in: gale, s., olsson, g., editors. philosophy in geography. dordrecht: reidel. p379-386. dedehouanou and kane: spillover effect of official development assistance on sectoral economic growth in west african economic and monetary union countries international journal of economics and financial issues | vol 11 • issue 3 • 202112 appendix table a2: aid spillover effect on the value added of the tertiary sector, obtained by the system gmm method (sdem model) variables log (va of the tertiary sector) w1 w2 aid instrumented growth instrumented aid instrumented growth instrumented (1) (2) (3) (4) log (tertiary sector va lagged) 0.392*** (0.097) 0.538*** (0.111) 0.572*** (0.082) 0.487*** (0.098) log (net oda) 0.048** (0.020) 0.020 (0.026) 0.046** (0.022) 0.037* (0.022) log (credits to the economy) 0.090*** (0.025) 0.073** (0.034) 0.066** (0.026) 0.082*** (0.029) inflation 0.009*** (0.003) 0.009*** (0.003) 0.009** (0.004) 0.008** (0.003) business freedom 0.002* (0.001) 0.002 (0.001) 0.003* (0.001) 0.003** (0.001) log (primary sector va lagged) 0.113* (0.068) 0.066 (0.097) 0.038 (0.074) 0.045 (0.089) w*log (net oda) –0.019 (0.013) –0.014 (0.014) –0.009 (0.010) –0.010 (0.009) w*log (primary sector va) 0.101*** (0.025) 0.088*** (0.031) 0.053*** (0.020) 0.066*** (0.023) w*u –0.147 (0.285) –0.153 (0.244) 0.160 (0.232) 0.115 (0.163) constant 3.918*** (0.865) 2.736** (1.063) 2.475*** (0.739) 2.835** (1.107) country fixed effect yes yes yes yes ar (1) p–value 0.000 0.000 0.000 0.000 ar (2) p–value 0.463 0.435 0.468 0.561 sargan p–value 0.647 0.824 0.453 0.802 observations 128 144 128 144 countries 8 8 8 8 source: our calculations. note: standard deviations are in parentheses, w1 = weights matrix based on the existence of a common border, w2 = weights matrix based on belonging to the same waemu corridor, ***p < 0.01, **p < 0.05, *p < 0.1 denote respectively the significant coefficients at the 1%, 5% and 10% threshold. va: value added table a1: aid spillover effect on the value added of the secondary sector, obtained by the system gmm method (sdem model) variables log (va of the secondary sector) w1 w2 aid instrumented growth instrumented aid instrumented growth instrumented (1) (2) (3) (4) log (secondary sector va lagged) 0.615*** (0.067) 0.681*** (0.114) 0.621*** (0.076) 0.676*** (0.084) log (net oda) 0.037* (0.019) 0.049** (0.018) 0.030 (0.022) 0.047** (0.023) log (capital) 0.375*** (0.133) 0.458* (0.223) 0.422** (0.176) 0.259 (0.168) inflation 0.004 (0.003) 0.002 (0.006) 0.006* (0.003) 0.004 (0.003) rule of law 0.005*** (0.001) 0.005*** (0.001) 0.005*** (0.002) 0.005*** (0.002) log (primary sector va lagged) 0.169*** (0.062) 0.116 (0.126) 0.165** (0.078) 0.142* (0.083) w*log (net oda) 0.026** (0.012) 0.030** (0.013) 0.019** (0.010) 0.021** (0.009) w*log (primary sector va) –0.010 (0.021) –0.036 (0.030) –0.012 (0.021) –0.002 (0.021) w*u –0.460** (0.184) –0.406* (0.180) –0.597* (0.281) –0.329** (0.147) constant 1.150 (0.715) 0.876 (0.705) 1.158 (0.823) 0.140 (0.847) country fixed effect yes yes yes yes ar (1) p–value 0.001 0.034 0.000 0.002 ar (2) p–value 0.137 0.210 0.501 0.231 sargan p–value 0.117 0.145 0.494 0.388 observations 128 128 128 128 countries 8 8 8 8 source: our calculations. note: standard deviations are in parentheses, w1 = weights matrix based on the existence of a common border, w2 = weights matrix based on belonging to the same waemu corridor, ***p < 0.01, **p < 0.05, *p < 0.1 denote respectively the significant coefficients at the 1%, 5% and 10% threshold. va: value added . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(3), 196-209. international journal of economics and financial issues | vol 7 • issue 3 • 2017196 financial development and economic growth: the empirical evidence of the southern mediterranean countries mohamed aydi1, abdelkader aguir2* 1faculty of economic sciences and management of sousse, tunisia, 2beta lab umr 7522 university of lorraine and ur mofid ur 13-es60, france. *email: abdelkader.aguir@univ-lorraine.fr abstract this paper analyzes empirically the links between financial development and the economic growth of the (squared multiple correlation). the study is based on a vector autoregression approach: the johansen tests for cointegration and vector error correction model models. the debate on the relation between the financial sphere and the real economic sphere was very ambiguous some studies have shown a positive association between these two spheres while others presented the opposing view perfectly. on the basis of the data relative to the psm, observed during period 1981-2014, we tried to show there is or not a positive relationship between the financial development and the economic growth. this relationship and increasingly intense for the role of the banking development and and refers to an innovation effort and modernization of the financial system. keywords: financial development, economic growth, southern mediterranean countries, vector autoregression approch jel classifications: g10, o47 1. introduction the theoretical debates on the sense of causality between the financial development and the economic growth, were marked by a significant advance progress. two currents of the literature come to intervene: one shows the favorable effect of the development of the banking sector and the financial market on the economic growth, while the other supports the opposite view perfectly. the actions of openings and revitalizing the financial system generally and the banking system in particular are causing financial instability and spread of banking crises which were translated by a decline of the economic growth which is due to the importance of the envisaged costs. the positive effect of financial development on economic growth was initially studied by the authors of the school of financial repression namely mckinnon (1973) and shaw (1973) and the authors of the liberal school namely keynes and hicks. these authors showed that an efficient financial system, dynamic and renovated is at the; origin of a capital accumulation, of a stimulation of the investment and then for economic development. the adverse effect of development of the banking system and the financial market on the economic growth was derived from recent banking and financial crises in the context of a financial liberalization policy. on the one hand, the strong information asymmetry characterizing the financial markets, may be the cause of a unsuccessful in coordinating the allocation of savings to investment. this information asymmetry companion can distort investors’ expectations who prefer to invest in less risky than in another universe uncertain and risky. this taking into account the investor’s degree of risk aversion, imperfect financial markets and high transaction costs. this dysfunction of the financial market and the inefficient intermediation can only slow economic growth. moreover, the recent crises of banking insolvency have plunged economies for the periods of recession. this experience gave us an example of the negative influence of the development of the banking sector onto the macroeconomic performance. these banking dysfunctions can be transformed into banking or financial crises generating huge costs for the whole economy. the absence of consensus regarding the effect of the development of banking and financial market on economic growth brings us aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017 197 to verify this relation for tunisia. to address this problem, a theoretical study and an empirical validation appear to be useful. to do this, we propose to use the time series methods based on unit root tests and cointegration johansen and the granger causality test. the advantage of cointegration test is the detection of a stable long-term relationship between financial development and economic growth. the rest of the article is organized as follows, section 2 reviews the literature. then, the section 3 describes the data and defines the variables used. then, the section 4 exposes the methodology, followed by the presentation of the results in the section 5. finally, the section 6 is reserved for the conclusion and for the implications of economic policy. 2. literature review several studies (cross-sectional data, panel data and time series) have focused on the nature of the relationship between financial development and economic growth. the results of these studies depend essentially on the nature of the selected sample. table 1 shows the chronological list of empirical studies on time series, which demonstrated the link between finance-growth. 2.1. summary of the main empirical research we are interested in the review of the empirical literature to work on time series because this article is based on a technique of time series of psm countries to study the impact of financial development on the economic growth. research on the time series are particularly relevant when we want to estimate the sense of the causality between the financial development and the economic growth. the first empirical works of time series reported to gupta (1984) and jung (1986) uses the granger causality tests and the var model “vector auto regressive” in level. by estimating the specification of a vector error correction, demetriades and hussein (1996) tests demetriades and hussein (1996) tests the link of long-term causality between the development of the financial intermediation and the growth of the real gross domestic product (gdp) per capita, respectively 16 and 10 developing countries. these authors support strongly the presence of a bidirectional causality and the existence of a reverse causality, very low, from the growth to the financial development, with results highly varied between economies. luintel and khan (1999) detects on the contrary a bidirectional connection between the financial development and the economic growth of all the countries of the sample. they explain the gap with the results of demetriades and hussein (1996) used longer time series and use a multivariate approach (rather than two variables). the presence of a bidirectional causality between the financial development and the growth, for developing economies, is questioned by xu (2000). xu (2000) on a sample of 41 developing countries between 1960 and 1993 demonstrated the presence of a positive effect of financial development in the long term, but short term is unfavorable, on the economic performance of most developing countries. it uses a multivariate approach var that allows the identification of longterm cumulative effects of financial development on gdp growth and the effects of the investment, by taking into account dynamic, short-term interactions, between variables. focusing on the case study of malaysia between 1960 and 2001, ang and mckibbin (2007) indicated that, contrary to the results (profits) obtained by xu (2000), this growth is at the origin of the development of the long-term banking sector, and not the opposite. similar conclusions are established by abu-bader and abu-qarn (2006) for a sample of five countries in the mena region, between 1960 and 2004. these authors show that the long-term relationship establishes between the financial development and the growth for the economies of these countries, is either bidirectional, or going from growth to the development of the financial system. ozturk (2008) reviewed the literature on finance-growth nexus and investigate the causality between financial development and economic growth in turkey for the period 1975-2004. the empirical findings in the paper show a two way causality (bidirectional) between financial development and economic growth. the existence of causality in both sensesd between the finance and the growth is rarely validated for the case of the developed countries. based on the error correction model rousseau and wachtel (1998) show that the dominant direction of the long-term causality in 5 industrialized countries studied, is the one part of the financial development to economic growth, not the reverse. through a vector error correction model (vecm) analysis arestis et al. (2001) obtain the same conclusion for the same group of countries (5 industrialized countries), after the integration of stock market development indicators. they show, besides, that it is the banks who contribute most (the most significant and the most important) to the process of growth in these countries compared to the stock market (for two of five studied countries, the effect of the development of the stock market on the growth is negative). neusser and kugler (1998) confirm these results by the application of granger and lin causality test (1995) for a sample of 13 countries of the oecd between 1970 and 1991. these authors estimate the relation finance growth by penetrating of two variables via, respectively, into the gdp of the financial system and into the made gdp. having analyzed the empirical work to defend the presence of a linear relationship between financial development and growth, we try to apply the techniques of time series on our samples. acaravci et al. (2009) review the literature on the finance-growth nexus and investigate the causality between financial development and economic growth in sub-saharan africa for the period 1975-2005. using panel cointegration and panel gmm estimation for causality, the results of the panel co-integration analysis provide evidence of no long-run relationship between financial development and economic growth. the empirical findings in the paper show a bi-directional causal relationship between the growth of real gdp per capita and the domestic credit provided by the banking sector for the panels of 24 sub-saharan african countries. the findings imply that african countries can accelerate their economic growth by improving their financial systems and vice versa. aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017198 authors number of the country(s) period methodology variables the empirical results studies on cross-sectional data goldsmith (1969) 35 countries annual data between 1949 and 1963 ols and graphical analysis the variables of financial development and economic growth the presence of a positive relationship albeit statistically weak between financial development and growth atje and jovanovic (1993) 94 countries annual data between 1960 and 1985 mco the variables of development of stock markets and economic activity significant positive effect of the development of stock markets on the level and the growth of the economic activity harris (1997) 39 countries annual data between 1980 and 1988 double least squares (dmc) the variables of the development of the stock market and the growth the hypothesis the stock-exchange activity allows the explanation of the growth is (partially) supported. the stock market development effects on growth is low in least developed countries. it is, however, significant for the developed countries levine and zervos (1998) 42 countries annual data between 1976 and 1993 mco and gmm the variables of the banking sector and the growth of the real gdp per capita the banking sector development contributes positively to the growth of real gdp per capita levine and zervos (1998b) 47 countries annual data between 1976 and 1993 mco the levels of market liquidity and the variables of the banking sector, the growth of the real gdp per capita, the productivity and the physical capital stock the initial levels of market liquidity and banking sector development are positively and significantly correlated to the future growth of the real gdp per capita, the productivity and the physical capital stock. no strong impact about the size of the stock markets on the sources of growth was detected table 1: financial development and growth: a selective review of the main empirical research (contd...) aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017 199 authors number of the country(s) period methodology variables the empirical results levine (1999) 49 countries annual data between 1960 and 1989 gmm the variables of the financial intermediation and the economic growth presence of a strong and significant positive correlation between the development of the financial intermediation explained and the growth ram (1999) 95 countries annual data between 1960 and 1989 mco the variables; ratio of the liquid liabilities and the economic growth the correlation between the financial development (ratio of the liquid liabilities) and the growth is weakly negative or negligible mccaig and stengos (2005) 71 countries annual data between 1960 and 1995 gmm the ratio of the liquid liabilities, the credit to the private sector and the economic growth rate positive effect of the finance on the growth when the financial development is measured by the ratio of the liquid liabilities or that of the credit to the private sector. the correlation between both variables is much lower when we describe the financial development by the asset ratio of commercial banks on the sum of this one with the asset of the central bank the panel data studies beck et al. (2000b) 77 countries the quinquennial average data between 1960 and 1995 gmm on dynamic panel the variables of financial intermediation, the growth of productivity and the real gdp per capita, the capital accumulation and the savings significantly positive and strong effect of the development of the financial intermediation on the growth of productivity and the real gdp per capita. although less robust positive effect of this one on the capital accumulation and the growth of the savings table 1: (continued...) (contd...) aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017200 authors number of the country(s) period methodology variables the empirical results levine et al. (2000) 74 countries the quinquennial average data between 1960 and 1995 gmm on dynamic panel the variables of the financial intermediation and the growth of the real gdp per capita the existence of a correlation significantly positive between the development of the financial intermediation and the growth of the real gdp per capita lopez and spiegel (2002) 101 countries the quinquennial average data between 1965 and 1990 gmm on dynamic panel the variables of the financial development and the economic growth significantly beneficial contribution of the financial development to the long-term growth. short-term ambiguous relation calderon and liu (2003) 109 countries data averaged over 5-10 years between 1960 and 1994 var models on panel, geweke’s decomposition and granger causality the variables of development of the financial intermediation and the economic growth bidirectional causality between the development of the financial intermediation and the growth. effect of the financial development on the growth stronger in developing countries, compared with the industrialized economies. the financial development affects the growth by acting essentially on the productivity growth beck and levine (2004) 40 countries the quinquennial average data between 1976 and 1998 gmm on dynamic panel the variables of development of the financial intermediation, the stock markets liquidity and the economic growth the development of the financial intermediation and the stock markets liquidity allow the promotion of the growth loayza and ranciere (2004) 75 countries annual data between 1960 and 2004 the pmg estimator (pmg) on dynamic panel the variables of the financial intermediation and the economic growth a relation significantly is positive in the long term, between the development of the financial intermediation and the growth, coexists with a short-term negative relationship in most countries in the sample table 1: (continued...) (contd...) aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017 201 authors number of the country(s) period methodology variables the empirical results stengos and liang (2005) 66 countries the quinquennial average data between 1961 and 1995 semi-parametric partially linear models the variables of financial development and economic growth non-linear relationship between financial development and growth. relation which depends on the financial development indicator used saci et al. (2009) 30 developing countries the quinquennial average data between 1988 and 2001 gmm on dynamic panel the variables of the banking development, the economic growth and the market capitalization no effect or significantly negative of the banking development on the growth when we control the development of the stock market. significantly positive effect of stock market development hassan et al. (2011) country with low or average income the quinquennial average data between 1980 and 2007 mco, weighted least squares, var model granger causality, fir and variance decomposition the development of financial intermediation and economic growth positive relationship between the development of the financial intermediation and the long-term growth al-malkawi and abdullah (2011) 13 countries of the mena region annual data between 1985 and 2005 pooled ols, fixed effects model, random effects model the variables of development of the financial intermediation and the growth positive relationship between the development of the financial intermediation and the growth kar et al. (2011) 15 countries of the mena region annual data between 1980 and 2007 vecm model, mmg, hurlin technique (2008) and approach of kónya (2006) the variables of financial development and the economic growth the direction of causality between financial development and growth varies according to the financial development indicator used, as well as between the countries of the studied sample time series studies gupta (1984) 14 developing countries quarterly data between 1961 and 1980 var model and granger causality tests the variables of the finance and the economic growth the results show a causality which goes of the finance towards the growth. they support, in certain cases, the presence of reverse causality. a mutual causality is proved however rarely table 1: (continued...) (contd...) aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017202 3. data and methodology 3.1. description of data to examine the empirical connections between financial development and economic growth, we collect data for the real gdp per capita, the internal credit supplies in the private sectors, the market capitalization, m2/gdp and the inflation as the control variables, for a period from 1981 to 2014 with 34 observations. the variables of economic growth and the inflation are obtained from the world bank database and the financial development variables of the database elaborated by beck, demirgüç-kunt and levine in 2013. the variable “gdp” design real gdp per capita. the gdp is the sum of gross value added generated by the productive sectors of an economy. it measures the efforts of economic output. its relative variation from 1 year to another reflects the economic growth rate. this variable is the dependent variable of the model. the variable “cisp” indicates the credit to the private sector report to gdp the amount of the credit assigned to the private sector by banks and other nonbank financial institutions. authors number of the country(s) period methodology variables the empirical results jung (1986) 56 countries annual data between 1950 and 1981 var model and granger causality tests the variables of the finance and the economic growth causality which goes of the financial development towards the growth in the least developed countries. a causality in the inverse sense for the developed countries arestis and demetriades and luintel (1997) germany and the united states quarterly data between 1979 and 1991 vecm model and johansen cointegration the financial development the real gdp causality goes from financial development to real gdp for germany, but in the opposite direction for the united states arestis et al. (2001) 5 industrialized countries quarterly data between 1972 and 1998 vecm model and johansen cointegration the variables of the intermediation of banks, stock markets and economic growth the financial development of banks and stock markets promotes growth. it is the banks who contribute in a more significant and more important way to the growth process, compared with stock markets thangavelu and ang (2004) australia quarterly data between 1960 and 1999 var model and granger causality the economic growth, the variables of the banking sector and the variables of development of the stock market the growth causes the development of the banking sector (according to granger), while the development of the stock market causes the growth ang and mckibbin (2007) malaysia annual data between 1960 and 2001 vecm, johansen cointegration, granger causality and acp the economic growth and the development of the banking sector a long-term relation which goes from the growth to the development of the banking sector and not the opposite source: established by the authors from the literature review. vecm: vector error correction model, var: vector autoregression, ols: ordinary least squares, gmm: generalized method of moment, gdp: gross domestic product, pmg: pooled mean group, fir: finite impulse response table 1: (continued...) aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017 203 this ratio allows the level of activity of banking and non-banking financial intermediaries in the exercise of their function of channeling savings. it reflects the way in which domestic assets are distributed between the public and private sectors. it is based on the assumption that the more developed financial systems are those who attribute the most credits to private firms. the variable “cb” means the ratio of market capitalization (market cap): this ratio measures the size of the stock market. it is equal to the total value of parts quoted in stock exchange reported to the gdp. the use of this indicator supposes the existence of a positive correlation between the size of the stock market and its development. however, this is not always obvious. a wide stock market is not necessarily effective in the performance of his duties. it can, moreover, be developed strongly despite a small size (this one being explained by the presence of taxes preventing an adequate quotation in stock exchange, rather than a low efficiency of the market in the exercise of his functions). the variable “liq” indicates the liquid liabilities in the gdp: it is the ratio of the liquid liabilities of the economy in the gdp. this indicator takes into account the money supply (m2) and the liquid liabilities of financial institutions. the liquid liabilities is a measure of the financial depth or the global size of the financial system. the variable “infl” indicates the inflation rate. it is the variable which represents the macroeconomic politics. it is introduced into the model to get the impact of the macroeconomic stabilization on the economy. the inflation is a factor of worsening of the growth because it has a negative it has a negative impact on the actual value of the portfolio and the purchasing power of household incomes and thus on the growth. we use the consumer price index as the indicator which measures the inflation rate. 3.2. methodology the main interest of this study is to analyze the impact of the financial development and the economic growth by using the models: vecm introduced by johansen (1988) and the var model is proposed by sims (1980). the advantage of the johansen and joselius cointegration procedure (1990) is that she allows on one hand testing the existence of one or several relations of cointegration between the various series. secondly, the method of johansen is a multivariate test which allows to determine the number of cointegration relationships between the selected series. thus, this approach avoids the two step test applied in engel-granger procedure which allows to have a one cointegration relationship. this approach also has the advantage of taking into account the problem of simultaneity. finally, the hypothesis of exogenous variables is not supported and it is not necessary to impose restrictions on the estimated coefficients to determine the short-term relationships. let us consider a vecm model based on annual data for pib = (cisp, cb, liq, infl) given by: ∆ ∆y y b b yt t i t i t i p = + + +− −=∑αβ ε' 1 0 1 (1) where δ is the first difference of the operator, b0 is a column vector of 4 dimensions of determinist constant terms and bi=i=1,…, p indicate matrices of order 4 of the short-term information parameters. αβ' is a matrix of order 4 of the longterm information parameters, where α represent the speed of adjustment of the balance and β contains the long term or equilibrium coefficients. εt denotes a four-dimensional vector of residuals where εt~iid(0,ω). the rank (αβ) = r is the number of cointegrating vectors which can vary according to the country and to the nature of the variable tested. if r = 0, the time-series variables are not cointegrated, in this case, the variables must first be differentiated and we have the var in the difference. in the first stage, we use the traditional unit root testing of augmented dickey-fuller (adf), phillips-perron (pp) and kwiatkowski-phillips-schmidt-shin (kpss) tests to verify the stationarity of all the variables. secondly, we apply other similar tests as endogenous break unit root tests of lee and strazicich breaks (2003; 2004) to avoid “spurious emissions” of conventional unit root tests. we proceed in the second stage to determine the length of delay of the var of the vecm models using the information criterion schwartez (cis), for variables growth rate of gdp per capita, internal credits supplies in the private sector, market capitalization, liquid liabilities and inflation rate contains a unit root. then we apply the johansen cointegration test to determine the number of cointegrating vectors (rang [αβ'] = r) using two different statistics: the trace statistic and the maximal eigenvalue statistic. in the third step, the estimated vecm between variables real gdp per capita, the domestic credit to private sector, market capitalization, examining the impulse response functions (irf) obtained by estimating the previous vecm. 4. empirical results 4.1. results of the unit root tests the adf unit root tests, pp and kpss variable on each level and in first difference has been made, and this for all countries in the sample. the test results are reported in table 2. the statistics of adf, pp and kpss suggest that all variables are integrated of order 1, i(1). except for the cases of egypt; liquid liabilities and variable inflation rates which are stationary in level i(0) at the 5% threshold and 10% respectively. the variable inflation rate seems to be integrated i(0) to the same tests in the case of jordan and lebanon. the history of the series, liquid liabilities and inflation rate in time, show that for every country the series are not really fixed trend in the level. the figure 1 indicates a presence of ruptures in all the series of variable liquid liabilities and inflation rate. the distribution of the series of variables presented by the figure 1 confirms the non-stationarity. it indicates in fact, the existence of a trend for the majority of the series. it also indicates the high probability existence of one or several structural rupture. this incites us to make the test of lee and strazicich (2003). which aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017204 will allow us to test the stationarity in the presence of structural rupture. the conventional unit root tests (adf, pp and kpss) are not able to reject the null hypothesis when the structural repture are present. these tests conduct their critical values are assuming no rupture under the null hypothesis. consequently, in the presence of a unit root with rupture, they tend to reject the null hypothesis suggesting that the time series is stationary around trend when it is non-stationary with a rupture. for this reason, we conduct tests for endogenous rupture in unit root. christiano (1992), perron and vogelsang (1992), zivot and andrews (1992) have developed methods to determine a repture point and to test the presence of a unitarian root when the process has a constant broken or trendy and demonstrated that their tests are robust and efficient than the conventional unit root tests. to avoid this problem and to examine the potential presence of rupture, we use in this paper the lm unit root test with two breaks endogenous proposed by lee and strazicich (2003; 2004). this result seems to be affected by ruptures under the null hypothesis. we find that significant structural ruptures provided for both series: liquid liabilities and inflation rate. concerning unit root tests adf, pp, kpss and lm, the results conclude in favor of the unit root i(1) for all series in all countries. 4.2. johansen cointegration test the study of the cointegration allows to test the existence of a longterm stable relationship between the variables integrated of order 1 i(1). there are several tests of cointegration, the most general being that of johansen. whatever the chosen test, it has meaning only on stationary series in first difference. consequently, the analysis of the cointegration allows to identify the true relationship between variables, by searching the existence of a cointegration vector and by eliminating its effect if necessary. two series x and y are called cointégrées if following both conditions are verified: they are affected by a stochastic trend of the same order of integration and a linear combination of these series and a linear combination of these series can be reduced to a series of order of integration lower. finally, the johansen cointegration test uses two statistics: statistics trace and the maximum eigenvalue whose order is d’exterminé by the schwarz criterion (sc). the unit root tests adf, pp, kpss and lm (lee and strazicich) prove that all variables contain a unit root, then we test cointegration in each vecm using both the trace and the maximum eigenvalue. results of the application of juselius (1990) and johansen approach are presented in table 3. the table 3 includes the ranks given in the first line, the number of cointegrating vectors in line 2, eigenvalue and track statistics for each selected country. the critical value is mentioned using asterisks. the null hypothesis is that the number of cointegrating relationship is equal to r, which is given in the “maximum rank” observed in the first row of table 3. the alternative is that there are more cointegration relationships r. we reject the null hypothesis if the trace statistic is greater than the critical value. we begin by testing h0: r 0. if the null hypothesis is rejected, we repeat for h0: r = 1. the process continues for t ab le 2 : s ta ti on ar it y te st a d f, p p an d k p ss (v ar ia bl es : g d p, c is p, l iq , c b a nd i n f ) c ou nt ry r ea l g d p pe r ca pi ta d om es ti c cr ed it to p ri va te se ct or m ar ke t c ap it al iz at io n l iq ui d lia bi lit ie s to g d p in fla ti on r at e a d f p p k p ss a d f p p k p ss a d f p p k p ss a d f p p k p ss a d f p p k p ss v ar ia bl es in le ve ls e gy pt −0 .7 14 −1 .3 83 0. 70 0* * −1 .7 35 −2 .0 56 0. 37 2* −1 .5 95 −1 .6 37 0. 48 4* * −3 .5 22 ** −3 .4 88 ** 0. 28 3 −2 .7 29 * −2 .6 56 * 0. 40 5* is ra el −0 .4 36 −0 .3 49 0. 69 5* * −1 .0 64 −0 .9 86 0. 52 7* * −2 .3 75 −2 .3 75 0. 55 3* * −0 .4 83 −0 .5 10 0. 63 4* * −1 .7 65 −1 .9 96 0. 46 2* * jo rd an −1 .2 83 −0 .4 2 0. 37 2* * −2 .2 88 −2 .0 39 0. 67 2* * −2 .0 19 −2 .1 01 0. 40 3* −2 .6 87 * −1 .7 13 0. 53 5* * −3 .6 85 ** * −3 .4 75 ** 0. 24 4 l eb an on −2 .2 86 −2 .3 35 0. 62 2* * −0 .9 87 −1 .0 98 0. 58 9* ** −2 .5 93 −2 .0 52 0. 16 −0 .9 05 −0 .7 60 0. 57 9* * −3 .3 46 ** −3 .3 35 ** 0. 22 7 m or oc co 1. 43 5 1. 3 34 0. 65 3* * 0. 01 3 0. 05 1 0. 64 7* * −1 .1 78 −1 .2 75 0. 64 5* * −0 .6 46 −0 .6 03 0. 65 8* * −2 .3 87 −2 .1 46 0. 66 3* * tu ni si a 1. 07 1. 15 9 0. 65 7* * −1 .2 55 −2 .5 49 0. 35 9* −2 .3 48 −1 .4 68 0. 51 2* * 0. 57 3 −0 .2 31 0. 64 1* * −1 .3 15 −1 .7 20 0. 44 8* tu rk ey −0 .4 16 −0 .1 94 0. 68 ** 4. 03 9 4. 08 1 0. 49 ** −0 .5 51 −2 .6 14 0. 73 0* ** 0. 25 8 0. 40 4 0. 68 8* * −2 .2 05 −2 .3 75 0. 39 9* v ar ia bl es in fi rs t di ff er en ce s e gy pt −4 .6 78 ** * −4 .6 88 ** * 0. 15 6 −3 .9 46 ** * −0 .3 96 7* ** 0. 29 1 −5 .4 18 ** * −5 .4 18 ** * 0. 11 5 −5 .8 32 ** * −5 .8 45 ** * 0. 27 6 −9 .5 09 ** * −9 .5 09 ** * 0. 22 2 is ra el −5 .1 36 ** * −6 .2 06 ** * 0. 15 5 −6 .4 25 ** * −6 .8 28 ** * 0. 37 3* −6 .2 53 ** * −6 .4 89 ** * 0. 11 0 −5 .1 15 ** * −5 .1 11 ** * 0. 10 4 −4 .8 68 ** * −8 .1 86 ** * 0. 5* * jo rd an −3 .4 46 *( b) −4 .3 28 ** * 0. 28 −5 .1 28 ** * −3 .7 34 ** * 0. 32 0 −6 .7 79 ** * −6 .7 45 ** * 0. 09 4 −2 .8 73 * −4 .8 88 ** * 0. 13 0 −6 .7 28 ** * −1 5. 36 7* ** 0. 5* * l eb an on −4 .8 02 ** * −4 .7 63 ** * 0. 08 6 −5 .6 53 ** * −5 .6 53 ** * 0. 18 6 −3 .2 69 ** −3 .2 69 ** 0. 07 −4 .3 05 ** * −4 .2 03 ** * 0. 17 4 −8 .6 38 ** * −1 0. 88 9* ** 0. 17 5 m or oc co −1 1 .4 28 ** * −1 0. 44 1* ** 0. 32 −6 .1 8* ** −6 .1 65 ** * 0. 11 9 −4 .9 02 ** * −4 .8 67 ** * 0. 06 7 −6 .7 30 ** * −6 .7 11 ** * 0. 04 2 −4 .5 69 ** * −1 3. 91 8* ** 0 .3 76 * tu ni si a −6 .6 89 ** * −5 .6 93 ** * 0. 37 * −1 .1 09 −5 .2 35 ** * 0. 08 8 −4 .2 36 ** * −6 .1 53 ** * 0. 29 6 −4 .2 63 ** * −5 .5 73 ** * 0. 18 1 −9 .1 69 ** * −9 .7 98 ** * 0. 5* tu rk ey −6 .3 64 ** * −7 .8 13 ** * 0. 11 9 −3 .6 97 ** (b ) −3 .6 57 ** (b ) 0. 45 5* −7 .0 12 ** * −1 5. 80 4* ** 0. 30 8 −4 .4 04 ** * −4 .2 66 ** * 0. 18 8 −7 .7 91 ** * −8 .3 07 ** * 0. 10 7 a d f: a ug m en te d d ic ke yfu lle r, pp : p hi lli ps -p er ro n, k ps s: k w ia tk ow sk iph ill ip ssc hm id tsh in , g d p: g ro ss d om es tic p ro du ct . * ,* * an d ** * in di ca te a n ac ce pt an ce o f t he h yp ot he si s at th e th re sh ol d of 1 0% , 5 % a nd 1 % re sp ec tiv el y. (b ) d en ot es th e st at io na ry w ith t re nd a nd in te rc ep t. th e le ng th o f d el ay in a ll th e te st s w as s el ec te d ac co rd in g to th e in fo rm at io n cr ite ri on s ch w ar te z aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017 205 figure 1: evolution of the series of variable by country. (a) variable interest: liquid liabilities (liq). (b) variable interest: inflation rate (inf) b a r = r = 2... 3 = 4 and r. the process ends when a test is not rejected. existing of one or several cointegration vectors explains that the variables have a long-term relationship and we should continue to use vecm. aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017206 the results of cointegration show that there are at least two cointegration vectors with an interception and/or trend in all the countries. therefore, we can conclude that there are at least two cointegrating vectors for all the selected countries. based on the results of johansen cointegration tests, we conclude that the vcem can be applied to all countries specifically for even the answers the impulse responses of the domestic credit provides private and market capitalization on economic growth sectors (table 4). table 3: the unit root test with two breaks of lee and strazicich series one-break two breaks model a model b model a model b t-stat break t-stat break t-stat break t-stat break liquid liabilities to gdp egypt −2.230 2004 −4.385 2005* −2.472 2004 2007 −5.674*** 1999 2010 israel −3.576** 2009 −17.25*** 2009 −3.587** 1995 2009 −17.911*** 1984 2009 jordan −4.239*** 1985 −6.082*** 1985 4.039** 1985 1996 −6.790*** 1984 1989 lebanon −3.993** 1989 −4.302* 2004 −4.224* 1988 2005 −5.852*** 1997 2007 morocco −4.249*** 2006 −4.809** 2000 −4.927*** 1997 2006 −6.421*** 1989 2004 tunisia −3.257* 1985 −2.750 1993 −3.384* 1985 2008 −17.114*** 1986 2010 turkey −1.855 1998 −5.812*** 2010 −1.994 1992 1998 −8.865*** 2004 2010 inflation rate egypt −4.103** 2005 −4.36 0* 2006 −5.329*** 1997 2007 −7.157*** 1995 2008 israel −5.190*** 2005 −5.014** 1990 −5.787*** 1987 2005 −7.396*** 2000 2009 jordan −3.367* 2010 −4. 188* 1987 −3.730** 1985 2010 −4.375* 1987 2001 lebanon −6.679*** 1991 −6.880*** 1992 −6.932*** 1992 1997 −8.530*** 1995 2000 morocco −4.847*** 1994 −4.887** 1991 −5.126*** 1994 2000 −5.916*** 1996 2002 tunisia −3.283* 1991 −5.015*** 1987 −4.188** 1988 1998 −6.053*** 1987 1998 turkey −4.471*** 2006 −7.282*** 2004 −6.644*** 2006 2009 −10.335*** 2004 2009 model a: change in the interception. model c: change in the constant and the trend. the critical values for the unit root test ls with a break are indicated in lee and strazicich (2004, table 1). the critical values for the unit root test ls with two breaks, which appear in lee and strazicich (2003, table 2), depend on the location of the rupture. *,**,*** indicate the level of signification respectively at 10%, 5% and 1%. gdp: gross domestic product table 4: results of johansen cointegration test (variables: gdp, cisp, liq, cb and inf) country r=0 r≤1 r≤2 r≤3 r≤4 1 2 1 2 1 2 1 2 1 2 egypt trace statistic 80.23644*** 106.5183*** 41.94786 60.36584* 20.04274 35.90485 6.920876 17.42934 1.515200 4.320857 max-eigen stat 38.28858** 46.15243*** 21.90512 24.46099 13.12186 18.47552 5.405675 13.10848 1.515200 4.320857 israel trace statistic 76.00426** 85.80266* 47.56137* 53.52832 20.79332 25.90573 5.938574 10.83198 0.333081 4.067754 max-eigen stat 28.44289 32.27434 26.76804* 27.62259 14.85475 15.07375 5.605492 6.764229 0.333081 4.067754 jordan trace statistic 95.67284*** 117.1330*** 56.47780*** 65.87977** 31.77948** 40.05070* 12.25967 20.46788 3.371765* 8.140777 max-eigen stat 39.19505* 51.25328*** 24.69832 25.82907 19.51981* 19.58282 8.887900 12.32711 3.371765* 8.140777 lebanon trace statistic 91.68223*** 130.8359*** 45.18321* 77.03425*** 21.06532 37.11210 7.825086 16.17432 0.310289 5.807031 max-eigen stat 46.49901*** 53.80161*** 24.11789 39.92215*** 13.24024 20.93778 7.514796 10.36729 0.310289 5.807031 morocco trace statistic 79.29406*** 103.5950*** 36.13360 53.67280 18.38017 28.59204 7.466910 16.18721 0.044629 5.616787 max-eigen stat 43.16046*** 49.92217*** 17.75343 25.08075 10.91326 12.40483 7.422281 10.57042 0.044629 5.616787 tunisia trace statistic 88.95627*** 101.9829*** 51.15970** 60.64219* 19.29113 26.31669 5.585769 12.52694 0.501403 2.813502 max-eigen stat 37.79658** 41.34072** 31.86856** 34.32550** 13.70536 13.78975 5.084366 9.713433 0.501403 2.813502 turkey trace statistic 84.34933*** 111.6427*** 47.10472* 74.25474*** 21.02951 39.46615 7.886801 19.48983 0.029780 7.612779 max-eigen stat 37.24461** 37.38793* 26.07521* 34.78860** 13.14270 19.97632 7.857021 11.87705 0.029780 7.612779 1: model with one interception, 2: model with an interception and a linear trend, r: number of cointegrating vector. ** and *** indicate the reject of the null hypothesis at the threshold of 10%, 5% and 1% respectively. the length of delay in all the tests was selected according to the information criterion schwartez. gdp: gross domestic product aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017 207 figure 2: domestic credit shock provided to the private sector and market capitalization aydi and aguir: financial development and economic growth: the empirical evidence of the southern mediterranean countries international journal of economics and financial issues | vol 7 • issue 3 • 2017208 5. the effect of the domestic credit shocks provided to the private sector and market capitalization on economic growth to evaluate the effect of the domestic credit shocks provided to the private sector and market capitalization on economic growth for egypt, israel, jordan, lebanon, morocco, tunisia and turkey. we use irf and analyze the impact of these shocks on the economic growth of countries in the region. the two columns of figure 2 respectively describe the impact of the domestic credit shocks provided to the private sector and market capitalization. 5.1. domestic credit shock (cisp) figure 2 shows that the domestic credit shock (cisp) (first column) have a significant negative effect on economic growth in egypt, israel, when they have a positive effect only to jordan. the effect of the shocks on the economic growth for morocco and tunisia, is however not significant. in fact the shape of the impulse response curve is volatile close to zero, sometimes positive and sometimes negative. for the case of lebanon and turkey the impact is mixed, what is positive in first period become negative for the second period for stabilizes in the sixth period in lebanon is still negative in turkey. 5.2. market capitalization shock (cb) the shocks on market capitalization (the second column) has a significantly positive effect on the economic growth for egypt, israel, lebanon and morocco, the shock is triggered in the first period to reach a maximum value in the second period and creates a peak, to gradually return to its equilibrium position from the third period. the effect of shocks on the economic growth for jordan and tunisia, is however not significant. indeed, the shape of the impulse response curve generally remains close to the abscissa axis of value zero order. for turkey, the triggering of the impulse response in half of the second period, has reached a significantly negative maximum value for created a peak in the third period and return to its equilibrium the end of the period. the main results for the impulse responses show that a shock on domestic credit provides private sectors and market capitalization influences positively or negatively the economic growth has short term, the answers are clearer for credits that essentially affects the economies of the region, as do not incur a great tradition of the stock change. 6. conclusion the released results of our estimate shows that there is a longterm relationship between financial development and economic growth. indeed functions of impulse responses shows that a shock on the domestic credit variable relating to the private sector has a significant effect on economic growth that a shock on the stock capitalization, but overall, the financial sector in the countries of the region psm continues to play a less important role than in other economies with similar income levels, but we notice considerable écarts between the countries of the region in terms of financial sector development level. the financial systems in the region remain dominated by banks, and financial intermediation is still in the development stage according to the international standards. however, the banking sector does not occupy an important place in the stimulation of economic development. in spite of the privatizations, the participation of states in bank’s capital continues to be higher than in the other countries of similar level. the countries of the region psm have to develop strategies to promote innovation, competition and the expansion of coverage of the financial sector. by considering the particular situation of each of the countries, such strategies could include opening bank markets to foreign and local new entrants and promoting better credit culture of the credit to facilitate the access to the finance, associated with more effective prudential supervision. in most of the countries, all this must be completed by legal and institutional reforms in the domains of the accounting, auditing, financial probity and corporate governance, in order to promote transparency and accountability. stock markets in the region are relatively new, and the market capitalization, the value of exchanges and companies quoted remain low compared with high income countries. globally issuing shares and bonds is still a little used method of fund-raising in the region, leaving the banking sector without competition. concerning policy implications, we must draw proposals based on the results. it is clear that improving the performance of the financial system in the region is absolutely essential in order to allow financial development as a growth stimulant. 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(1992), further evidence on the great crash, the oil-price shock and the unit root hypothesis. journal of business and economic statistics, 10, 251-270. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(4), 41-52. international journal of economics and financial issues | vol 11 • issue 4 • 2021 41 investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond faten al-jabsheh, sulayman al-qudsi, mohammed a. hajeeh* techno-economics division, kuwait institute for scientific research, safat 13109, kuwait. *email: mhajeeh@kisr.edu.kw received: 15 april 2021 accepted: 15 june 2021 doi: https://doi.org/10.32479/ijefi.11513 abstract endogenous economic growth theories have pointed to private investment as one of the determinants of long run, sustainable economic growth; a well-studied relationship in the development economics literature, both theoretically and empirically. one of the main reasons the kuwaiti economy has not achieved its aspired degree of economic diversification over decades, is the relatively low level of private investment, which has eventuated in a relatively small private sector, partly due to an unimproved investment ecosystem. like other economies, investment in kuwait is a robust growth driver especially as a policy tool to achieve a digital, knowledge-based economy that leapfrogs on innovative technological investments, as ambitiously strategized by the kuwait vision 2035. the eruption of the coronavirus pandemic and the deep recession it triggered is likely to become a major hurdle in the way of spurring sufficient quality investments. with contracted gdp and collapsed oil prices, export and fiscal revenues shrink substantially, reducing investment activity and hence negatively affecting investment. this paper focuses on the role of private investment as a function of sustainable economic growth. specifically, this paper aims to delineate the relationship between investment and economic growth in kuwait by outlining; the determinants and impediments of investment, investment trends and behavior, innovative models of investment in kuwait and applying a set of seven simulation-based scenarios of investment modelled as autoregressive distributed lags. by so doing, the paper elucidates the impact of critical variables including; non-oil gdp growth, interest rates management, attracting and fostering fdi inflows, as well as the recession plagued fiscal and trade balances, in order to estimate the magnitude and time-path of key policy variables on investment. the findings illustrate the rigidity of investment when recession drags gdp, fdi, exports and trade balances as well as fiscal revenues. keywords: oil surplus economy, kuwait vision 2035, diversification, coronavirus, simulation, autoregressive lag mode jel classifications: c1, c15, f, f01 1. introduction before the eruption of the coronavirus pandemic and the subsequent recession it triggered, policy makers and business leaders ascribed to put kuwait on a transformative digital economy path that is anchored on talent, innovation and technological knowledge. the eruption of the pandemic imposed an estimated 20% drop in demand for oil and hence a collapse in oil prices, which put many of the conventional and stylized economic facts under scrutiny, due to this shock. important and vital policy considerations became questionable regarding the role of future investments and the sufficiency of transforming kuwait into a digital knowledge-based economy that drifts away from dependence on oil as the sole engine of growth. this paper focuses on the role of investment as a function of sustainable economic growth, a dual challenge in kuwait. specifically this paper aims to delineate the relationship between investment and economic growth in kuwait by outlining; the determinants and impediments of investment, investment trends and behavior, innovative models of investment in kuwait and applying simulation-based scenarios of investments modelled as autoregressive distributed lags. by so doing, the paper elucidates the impact of critical variables including; non-oil gdp growth, this journal is licensed under a creative commons attribution 4.0 international license al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 202142 interest rates management, attracting and fostering fdi inflows, as well as the recession plagued fiscal and trade balances, in order to estimate and graphically visualize the magnitude and time-path of key policy variables on investment, which is considered a critical driver of kuwait’s future economic growth. one of the key determinants of an economy’s rate of economic growth is the rate of investment. economies that grow faster are essentially those that invest a considerable slice of their gdp back into their economies and the inverse being true; in that economies that do not successfully grow are those that fail to effectively invest, all else being equal (unctad, 2015). this conceptual framework is partly grounded in economic theory, the basic neoclassical growth model delineated by solow (1956) and swan (1956) which predicts that one of the key determinants of economic growth is the rate of investment. realizing that investment is integral to the economic growth equation, albeit not an exclusively identifiable factor that includes other equally critical components, such as institutional readiness, distribution of resources, trade and other factors. kuwait is a small, rich, and relatively open economy with proven crude oil reserves estimated at 10% of world reserves. crude oil production at a current rate of 2.3 million barrels per day accounts for nearly half of the country’s gdp, 95% of export revenues, and 90% of government income. gross fixed investment is at 8% of gdp, while public debt is at 29.6% of gdp. (al jabsheh et al., 2018) this over-reliance on oil revenues is unsustainable, nor can it propel economic growth. diversifying the sources of national income has been a long-sought strategic objective for the government, yet one that has not effectively materialized in spite of the authorities’ particularly intensive efforts to facilitate the growth of the private non-oil sectors in kuwait, using various tools such as subsidies and incentives. one of the main reasons the kuwaiti economy has not achieved the degree of diversification that policy and economic planners have aspired for is the low level of investment, particularly by the private sector, during the last four decades. in order to appreciate the implications of underinvestment in an economy, it is imperative to undertake an appreciation of “investment” itself. investment is the lifeblood of economic growth and sustainable development. in fact, it is one of the central and critical indicators that draw the long-term trajectory of economic performance. investment is defined in a number of ways that all reflect the same output. the keynesian definition of investment perceives it to be a flow concept where goods are designed to be utilized to produce others, rather than intrinsically consumed. alternatively, the financial dimension of investment focuses on the acquisition of financial assets, such as company shares. investors are the people or the entities that hold these assets. investment is the process of adding to stocks of real productive assets. this may mean acquiring fixed assets, such as buildings, plant, or equipment, or adding to stocks (gross fixed investment is spending on new capital equipment; net investment is gross investment minus capital consumption, an estimate of the loss of value of capital goods through wear and tear, the passage of time, or technical obsolescence). investments in the financial sense are often used to fund investment in the keynesian sense. investment is often considered in the context of savings, since savings are eventually allocated as funds to productive private sectors (tan and tang, 2016). understanding underinvestment and more specifically the peculiarities of underinvestment in kuwait is key to appreciating the country’s economic challenges and shortcomings. a longterm relationship exists between investment and kuwait’s gdp; expenditure-side investment is a critical component of gdp, alongside private consumption, expenditure, government spending, and net exports. there are two main types and directions of investment; namely, domestic investment funds which flow from within the economy to produce in its own economic sectors and foreign investment, where funds come from outside the country. the outflow of capital from kuwait has been substantial, although not expanding the productivity base of the economy even though economic returns are high (unctad, 2012) contrarily, increasing private investment in kuwait is a window of great opportunity. many barriers exist. disincentives and barriers that include bureaucratic red tape, which unnecessarily inflate the cost of licensing requirements; labor regulations that lack flexibility; and the labor market, which remains highly segmented, persist. this is in addition to the macro issues that include inflation and the government’s provision of an extensive subsidy program, in addition to the implementation of price controls through public utilities and enterprises, which have had a market distorting effect on the economy. at a time of persistent challenges, both social and environmental, employing and directing the process of economic growth for sustainable development is of primal importance. investment is a central and pivotal driver of such growth. utilizing investment and ensuring that it is directly relevant to the objectives of sustainable development is therefore a priority. many lessons were learned from resource-poor nations, likes the southeast asian economies, that relied on development through investment which was typically coupled with expedited knowledge and technology transfers, and hence, over time economic growth. the determinants of investment have typically included locational attractiveness, access to markets, sophisticated financial tools, political stability, and transparency. the prospects of relatively high financial returns and profitability, whether in the short or longterm are undoubtedly primary determinants for private investors (barro, 1995; carkovic and levine, 2002). more importantly, there was a clear recognition and a conviction on the part of policymakers in these countries that investment was critical to their economic development and growth (mohaddes et al., 2019 and fuinhas et al., 2019). this has not been the experience of resource-rich, oil surplus economies like kuwait, where to the contrary, investment has been looked at with an ambitious and entrepreneurial eye, especially if it is private. as a result, capital formation, partly a function of investment, has shown mixed performance in the gcc region, the lowest being in kuwait, over a past ten-year spread. one of the primary functions of increasing domestic investment flows in the private sector is to create new job opportunities. the downside is that the majority of these jobs went to foreign, unskilled workers, especially in the private sector, while the great majority of nationals al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 2021 43 remain employed in the public sector. in fact, the number of foreigners per one kuwaiti national was 63 to 1 in 2000, and has dropped to 44 to 1 in 2018. today, only 16% of the kuwaiti workforce is employed in the country’s private sector. (csb, 2019) the same trend resonates in the rest of the gcc, albeit, less amplified; for every omani working in the private sector, there are five foreign workers and in saudi arabia, the ratio is 9 to 1; (unstats, 2019). however, realizing kuwait’s dire need for economic diversification, the government has recognized that future economic growth will require the participation of a vital and dynamic private sector, and that foreign participation will encourage this. therefore, in 2001 the parliament enacted a law regulating direct foreign capital investment in kuwait, as a step to attract foreign investment by reducing or even eliminating foreign ownership limits. this law allowed foreigners to own up to 100% of businesses in certain sectors that include infrastructure projects (water, power, wastewater treatment, or communications); investment and exchange companies; insurance companies; information technology and software development; hospitals and pharmaceuticals; air, land and sea freight; tourism; hotels; entertainment; housing projects and urban development and logistic services and environmental activities. (eu-gcc invest report, 2018). 2. the role of private investment in economic growth in recent years, deliberation over the role that public and private investment play in the economic growth process of developing countries has taken center stage among policymaking and academic circles. the general consensus is that both components of investment, public, and private, have a differential and complementary impact on growth. public investment in infrastructure and human capital is fundamentally required and may increase private capital productivity. however, public investment may also crowd out private investment by utilizing scarce resources and adversely affecting growth. therefore, for policymakers and researchers concerned with growth in the developing world, it is not only the total level of investment that is important, but equally so is the ratio between the two. the relationship between domestic private investment (nongovernment) and economic growth is a well-studied relationship in the development economics literature, both theoretically and empirically (tawiri, 2010 and fakraoui, 2019). theoretically, the neoclassical framework highlights the role of savings and longterm growth performance. stimulation of private investment occurs mainly by engaging structural reforms, particularly in the financial sector, which will in turn facilitate the mobilization of savings and the allocation of funds to productive private sectors, ensuring stable macroeconomics. growth theory analyzes the disparity in economic growth rates between countries to identify the factors that affect output growth. determinants differ among countries and periods. additionally, the level of openness of an economic system also affects the impact ratio of these determinants. research findings indicate that there is a positive relationship between investment and economic growth. moreover, the prevalence of domestic investment is considered to be a primary driver of economic growth. causality tests indicated the existence of a causal relationship in the long and short terms of investment and growth (tan and tang, 2016). in fact, changes in investment helped explain correlative changes in economic growth. this is attributed to the underlying fundamental confirmation that increases in growth rates could lead to a notable revitalization of the economy, indicated primarily by the increase in employment opportunities. hence, domestic private investment is expected to play an important role in stimulating economic growth. studies have shown that private investment has a larger positive impact on growth than public investment (tawiri, 2010). in order to contribute to the discussion of what determines the desired capital stock for potential investments, a central motive and/or objective is to elucidate the main determinants of private investment decisions. noteworthy classical economic mainstays in the body of empirical literature on the determinants of investment behavior are divided into two pools; time series analyses for one or several countries, and microeconometric studies using firm level data. among the prominent in the former camp are; lougani and rush (1995), bloomstrom et al. (1996), everhart and sumlinski (2001), campos and nugent (2003), and krishna et al. (2003), while firm level analyses include among others chrinko and schaller (1995) and bloom et al. (2001). although the current tendency is toward microeconometric studies with panel data at the firm level, time series data analysis remains a mainstay for the same country analyses. the literature has proposed several hypotheses for evaluating the impact or the explanatory power of key macroeconomic variables as decisive factors in private investment behavior in a country. samuleson (1994) and irfan et al. (2004) elucidated the presence of a correlative relationship between investment and production, proposing the “accelerator” hypothesis; whereas, jorgenson (1963) highlighted that the level of demand had a positive impact on the value of the capital stock for a typical firm, maintaining that the output of the country’s gross domestic product (gdp) would be a good proxy for aggregate demand as a determinant of private investment (bloomstrom et al., 1996), as well as the rate of return on investment behavior, mainly as a function of the prevalent real interest rate as representative of the cost of capital. moreover, literature on the subject has also focused on alternate tangents of the investment framework that seemingly play a critical role in investment behavior as fisman (2001) suggests, “that in the long-run, economies with high rates of financial development will devote relatively more resources to industries with a “natural” reliance on outside finance due to a comparative advantage in these industries” (fisman, 2001), and that international technology transfer is increasingly playing a central role in investment decisions owing to the foreseen economic growth prospects, especially as countries progress along the development path (the world bank 2001 and the world bank 2016). the relatively small size of kuwait’s private sector is partially accountable for poor productivity. public sector investment in the1980’s was twice the size than that of the private sector, and this has continued to decline well into the 1990’s and 2000’s. kuwait al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 202144 private sector, as measured by its share in gdp, is about one third of the public sector and has not been increasing overtime. today the private sector accounts for still 31% of gdp, by constant 2010 prices (csb, 2019), the lowest in the gcc region. the bottom line is that increasing kuwait’s investment rate alone is not the key to raising economic growth rates if it is not accompanied by higher productivity. this coupling is very important. kuwait has constantly registered a negative productivity growth rate. studies that have investigated the determinants of tfp growth consistently show that investment growth to closely tied to improving the investment climate and institutions among other things, adopting open, outward policies, raising the quality of skilled human capital and avoiding an excessively large public sector. these are invariably the same factors that also increase per capita gdp growth rate. therefore, boosting the tfp growth rate should be combined with fostering a policy environment that provides the right incentives for encouraging investment. the following section delves into the empirical and applied perspective of the determinants of investment using a dynamic autoregressive distributed lag model that adds much value to our understanding. 3. investment determinants: a dynamic autoregressive distributed lag model this section provides empirical estimates of the response of investment to changes in two key parameters that are the focus of monetary and fiscal policy; namely gdp and interest rates. towards that objective, we deploy a dynamic autoregressive dynamic lag model and apply simulation techniques in order to arrive at estimates of the dynamic multiplier of investment with respect to non-oil gdp and interest rates. we opt to apply two specifications of the dynamic ardl model; one that is concisely capturing the interrelationships amongst critical variables of investment, income (gdp-non-oil) and real interest rates. since we aim to establish long run relationships or co-integration between these variables, we specify the first model as an error correction model which enables us to differentiate between the size of the elasticities, for example the investment elasticity with respect to income and the investment elasticity with respect to real interest rates. since the recession-triggered coronavirus pandemic has been deep and is likely to remain protracted over the next few quarters, our research here seeks to simulate the likely impact of key variables on the future path of domestic investment in kuwait. given that the kuwaiti economy as well as almost all global economies suffer from this complex and deep fall, due to the pandemic, the research here simulates the likely impact of the witnessed economic contraction on investment and the oil price collapses that characterize the current economy. accordingly, variants of the dynamic autoregressive and cointegration models for dynamically simulating, and for ease of evaluation the dynamic estimates, simulated over thousands of times, are then drawn up and graphed in a concise plot that combines alternative simulations of key variables such as gdp, interest rates, government expenditures, fdi and kuwait’s time variant trade balances. in the second specification of the investment function, key variables are included to income and real interest rates as additional regressors. deploying thousands of dynamic simulations, we graph the profound and deep impact on investment in the future years of the complex ramifications on the kuwaiti economy, represented by these regressors. the repercussions are in terms of both direction as well as order of magnitude and the length of the protracted time of the free-fall of these variables on kuwait’s future investment. simulated dynamic impact of the set of key variables are of enormous significance to policy makers and to the developmental trajectory that the economy is likely to follow. the underlying reason is that in the post coronavirus economy, kuwait will be relying more on innovative investment and fdi as drivers of the future digitized, and sustainable growth economy, (kuwait china ref, 2018). additional variables include government expenditure, which has traditionally been the main driver of growth in kuwait’s context as an oil economy. the government owns the physical hydrocarbon assets, the proceeds of which are used for the provision of “consumptive” products and a suite of social and infrastructure based assets such as capital and construction of physical buildings, schools, hospitals, government offices and the like. the second expanded specification includes a variable which connotes foreign direct investment inflows gauged relative to gdp. finally, the expanded specification incorporates trade balances as a regressor in order to test the direction and extent of influence it exerts on investment, in order to test the existence and magnitude of the causal relationship between external sector balances and domestic investment. in general terms, the autoregressive distributed lag model can be written as (jordan and philips, 2018) yt, ∆yt=α0+ δt +∑φpyt−p+∑θ1lx1,t−l1 +···+∑θklxt−lk+ p=1 l1=0 lk=0 (1) m q1 qk ∑ αm∆yt−m + ∑ β1q1∆x1,t−q1 +···+ ∑ βkqk∆xk,t−qk +εt m=1 q1=0 q1=0 all variables are gauged in logarithmic terms and the dependent variable is the log of investment regressed on the log of gdp-nonoil and real interest rates. since we are interested in ascertaining the existence of an integrated relationship, the dependent variable is the in first-differences (∆yt) while the dependent variables are gauged in level up to a maximum of 3 lags of the dependent variable, a series of lags for each of the k regressors—appearing either contemporaneously or with a lag—m lagged first-differences of the dependent variable, and contemporaneous and/or lagged first-differences of each of the regressors. in subsequent runs, using dynamic autoregressive lag model which runs thousands of simulations, we apply such combinations of contemporaneous, lagged, differences of each of the regressors (jordan and philips, 2018). al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 2021 45 yt =α0 +φ1yt−1 +θ1,0x1,t +···+θk,0xk,t +θ1,1x1,t−1 +···+θk,1xk,t−1 +εt (2) in addition to its non-stationary and cointegrating variant, which is commonly dubbed as an error-correction model ∆yt =α0+φ1yt−1+θ1,1x1,t−1+···+θk,1xk,t−1+β1∆x1,t+···+ βk∆xk,t +εt (3) in order to simplify visual appearance, the above formulation of the autoregressive distributed lag model leaves out first differences of the variables included as regressors, five in our expanded model. these can be simply inserted in the above equation but will crowd out the appearance of the equation. 3.1. empirical findings before estimating the determinants of investment utilizing the dynamic ardl model, we performed stationarity tests using two methods, pperron and the dfgls on the variables. table 1 displays the results of the tests of stationarity for key variables. in the case of (log) of investment, the hypothesis of unit root is rejected in favor of level stationarity, using a four year lag structure. similar tests were conducted on the other regressors which also indicated that the variables are level or first differences stationarity of i(0) or i(1). accordingly, we proceeded to estimate the determinants of investment utilizing the dynamic auto regressive distributed lag model. table 2 below summarizes the derived regression parameters of the error correction function. the estimates reveal the following interpretations and policy implications. first, investment in kuwait is highly responsive to changes in non-oil gdp with the long run income elasticity in the vicinity of 0.9 (exactly 0.895). this implies that if income increases by 1%, it triggers investment to increase by a smaller magnitude of 0.90%. while less than one, the estimated investment elasticity with respect to income, surrogated by non-oil gdp, is highly significant with the value of the t-statistic in excess of 13 and the parameter is accordingly highly significant at the 1% level. secondly, the estimated elasticity of investment with respect to changes in real interest rates is powerful at negative 0.40. therefore, relatively large changes in real interest rates bring about corresponding changes in investment but at smaller absolute magnitudes. hence, from a policy perspective the long run elasticity value of (−0.40) indicates that monetary authorities can effectively apply rates’ changes in order to bring about commensurately smaller changes in investment and accordingly large changes in real interest rates will be required in order to stimulate investment appreciably. finally, the elasticity of tradeable balances with respect to investment is positive and significant at the 5% level. the error correction term has the correct negative sign (−0.37). the value of the adjustment coefficient implies that investors adjust their expectations to the tune of 37% or alternatively, that 37% of their expectations are realized in any given period. table 2 also shows the derived estimates of the expanded model of investment determinants using the dynamic ardl model that can be summarized as follows: firstly, the size of the long run income elasticity is slightly higher at 0.95 in the expanded investment determinants model. secondly, the elasticity of investment with respect to real interest rates is markedly smaller at (−0.20). government spending has a positive impact on attracting investment. with an elasticity of 0.26, an increase in government spending by 1% is associated with an increase in investment by 0.26% signifying that government spending spurs investment in the context of the kuwaiti economy. historically, fdi has played an insignificant role in stimulating investment in kuwait due to the fact that kuwait is a capital-surplus oil economy. in fact, local investors considered fdi as a factor that competed for available business opportunities. whether this perspective remains unchanged in future as surplus funds shrink is an open question although one leans to think that such perspective will undergo changes and fdi will be looked upon more favorably in the postcoronavirus time recovery periods. finally, the elasticity of tradeable balances with respect to investment is positive and significant at the 5% level. an increase table 1: the p. perron and dicky-fuller tests of stationarity variables z p-value lags lninv −1.467 0.550 4.000 lngdpno −2.289 0. 175 4.000 lnrintrateus −2.107 0.242 4.000 dfuller test results z p-value lags lninv −0.104 0.949 4.000 lngdpno −1.563 0.502 4.000 lnrintrateus −1.507 0.530 4.000 table 2: regression results of the simple (1) and expanded investment (2) determinants (model: dynamic ardl) variables (1) lninv (2) lninv (1) lninv (2) lninv l.lninv −0.379*** (−3.79) −0.611*** (−5.054) sr:ld.lnfdiitgdp1 −0.611***(2.855) lr:lngdpnonoil 0.895*** (13.733) 0.944*** (4.639) sr:l2d.lnfdiitgdp1 −0.611*** (2.682) lr:lnrintrateus −0.404*** (−2.976) −0.202*** (−2.443) sr:d.lntradebal −0.065*** (−3.131) lr:lngovexp 0.261 (1.568) sr:ld.lntradebal −0.032*** (−1.763) lr:lnfdiitgdp1 0.206*** (−4.126) sr:l2d.lntradebalq −0.061*** (−3.122) lr:lntradebal 0.073*** (2.068) sr:_cons 0.147 (0.626) −2.345*** (-8.383) sr:d.lnrintrateus 0.040 (0.615) −0.000 (−0.004) sr:ld.lnrintrateus 0.272*** (4.344) 0.257*** (4.082) sr:l2d.lnrintrat~s 0.129*** (2.061) sr:d.lnfdiitgdp1 0.084*** (3.574) obs. 40 46 r-squared 0.556 0.474 t-values are in parenthesis. ***p<0.01, **p<0.05, *p<0.1 al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 202146 in tradeable balances of 1% will trigger long run increases in investment at 0.073 indicating that investment is inelastic with respect to tradeable balances. for most of the past 50 years kuwait has tended to realize annual surpluses in trade balances. should the historical trend be reversed in future times, the probable decline in trade balances is expected to trigger smaller yet appreciable declines in investment. judged by the value of the adjusted r-squared, the log-likelihood function, the model fits the data well. the value of the error correction parameter of 0.61 implies that each year investors adjust their investment by 61% towards their desired long-run equilibrium level. moreover, the requisite heteroscedasticity, durbin watson tests, serial correlation test and the ramsey diagnostic conducted in this study, all indicated the model variables are fit to deployment in the model (for space considerations, they are not shown but are available upon request). furthermore, the overall stability test was satisfied implying the model is stable as revealed in the outcome of the cumsum test of stability as shown in figure 1 below, indicating that recursive residuals lie within the 5% critical bounds. 3.2. dynamic scenario simulations findings as noted above, our dynamic ardl model of the determinants of investment in the context of kuwait have rather complex dynamic specifications, including multiple lags, first-differences, and lagged first-differences which renders interpretation of such complex specification tedious. this makes it more difficult to interpret the effects of changes, especially short and longer-run changes in the independent investment variable. in order to surmount this, recent literature has developed a flexible dynamic simulations based program that allows users to dynamically simulate a variety of ardl models, including the error-correction model which is deployed herein. such dynamic simulations offer an alternative to hypothesis testing of model coefficients by instead conveying the substantive significance of the results through meaningful counterfactual scenarios. therefore, here we test and graphically illustrate the dynamic impact on investment that result from time-specific changes in the values of each of the regressors. the selected dynamic scenarios have significant policy implications because they illustrate the damaging impact that the coronavirus triggered recession has had on one of the key policy variables, and associated instruments, that policy makers count on as transformative tools and bridges to achieving digitized, long-term sustainable economic growth. accordingly, the envisioned dynamic scenarios that are applied as shock triggers in the dynamic simulations are: 1. deep recession causes massive reduction in non-oil gdp that triggers investment to dip to substantially low levels. hence this scenario is dubbed “dynamic scenario of protracted recession and diminished investments” 2. foreign direct investment changes markedly under economic conditions dictated by the imperatives of coronavirus pandemic. the objective is to apply dynamic simulations to investment pursuant to major shocks in fdi inflows that have been retrenched massively on the heels of the pandemic 3. monetary authorities, i.e. kuwait central bank, effectuates real interest rates in order to mitigate the dynamic timeaggravated coronavirus lockdowns and oil price collapse on business activities in kuwait. accordingly, the third dynamic scenario shocks real interest rates downwards in order to dynamically simulate and track repercussions on investment in the context of kuwait 4. external trade balances are shocked quite heavily in the course of weak demand for oil and retrenched oil and other exports that reverses the long term trend of positive trade balances to substantially negative value and simulates and tracks the dynamic impact on investment; and finally 5. fiscal policy comes to the rescue: as the pandemic lockdown continues, kuwait government has offered a menu of supportive measures and provided cash to businesses, households, and individuals in order to mitigate the considerable economic repercussions on kuwait’s private sector businesses, smes and households and workers who lost their jobs or experienced wage and other income contractions as a result of the pandemic-inflicted recession. the magnitude of the fiscal support is articulated so as to maintain a necessary balance between the need to save the economy while maintaining fiscal sustainability. the left-hand side figure in figure 2 indicates that if the central bank lowers interest rates by 2 percentage points, the impact on investment will be significant over the course of time. in figure 2, the level of investment (in logarithmic terms) will rise from its level of 7.5 in the base year 5 to nearly 7.7 in year 14 and beyond. the right-hand-side figure illustrates the impact on investment of a positive shock to gdp by 2% added on top of historical growth mean level. since this is a sizeable increase in gdp growth, from figure 1: model 2 diagnostics stability tests al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 2021 47 say 3% to 5%, the impact on investment level is enormous where it rises from the base level of 7.5 to the vicinity of 9.4 in logarithmic scale, a tremendous push forward that would be much needed to achieve a leapfrogging growth pattern. turning to our five scenarios, we find that the 5000 simulations of each produced very illuminating impact on investment induced by the respective triggers, bearing in mind that the trigger of investment in each graph is indicated on the title of each of the seven respective graphs shown on figure 3 below. the dynamic simulations produce investment impacts that vary in terms of magnitude, perseverance or time-protraction and the associated confidence intervals of the estimates, ranging from 1%, to 5% and 10% respectively. these are discussed briefly below. figure 2: dynamic simulations of the five scenarios (model dynamic investment autoregressive distributed lag model 1) figure 3: model 2 dynamic simulations of the five scenarios (model dynamic investment autoregressive distributed lag model) al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 202148 in the first upper left graph, dubbed “non-oil shocked +2” a scenario is assumed whereby non-oil gdp is shocked up by 2% points above kuwait’s long run mean economic growth. the simulated graphical effect is in terms of a rise in investment that occurs fairly quickly leading to a rise from a logarithmic value of 7.4 to nearly 9.4 but the peak reverts to a lower level of about 8.2 in logarithmic scale, which remains higher than the initial investment level. therefore, this dynamic simulation attests to the powerful effect that income (non-oil gdp) growth exerts on investment. the second upper middle graph titled “non-oil gdp contraction-4” simulates the potential effect of a recession trap that causes contracts gdp in the non-oil sector by a powerful drop of its growth by 4% below its historical mean level. the initial level of investment at 7.4 is simulated to dynamically drop to a new level of <4 in logarithmic scale. however, the recession caused drop is v-shaped and investments trend upwards to slightly <6 logarithmic scale value and the new final level protracts throughout the time horizon under consideration which attest to the agony associated with a steep dive in incomes that protract over time. the third upper right graph titled, “shocking real interest rates by -3” illustrates the simulated dynamic impact of the cbk policy that seeks to stimulate the economy through the interest rates instrument. the upshot of dynamic simulations is in terms of a rise in investment from its initial level of 7.4 to nearly 7.5, which is mild. this indicates that changing interest rates while exerting a simulative effect does not last long, while lowering interest rates has a transitory effect on investment, which quickly reverts to initial levels or even inches downwards slightly. the fourth and fifth figures on the left-hand side and middle of the combined graphs picture elucidate the impact on investment by fdi inflows. they contrast and demonstrate the inverted impact of fdi inflows (as % of gdp) on domestic investments by businesses and other investors. the case of “shocking fdi -2” left-hand graph in the middle of the combined graphs illustrates the impact on investment of negative shocks, or decline in fdi, as also expected by al-shammari, n and halaq, s. (2016). conversely, the fdi shock in the middle graph which is positioned in the center of the page, titled “increasing fdi inflows to gdp by + 2” assumes declines in fdi by 2 percentage log scale -value points. clearly, negative fdi shocks trigger increased investment whereas positive fdi inflow shock of 2 is associated with a decline in domestic investment. the inverse patterns illustrate how kuwaiti business owners apparently prefer to go solo without foreign inflows. the sixth graph in the far-right center of the page elucidates the impact of retrenched trade balances on domestic investment. as shown graphically, the dynamic simulations vividly portray the negative effect of reduced balances on the size and the relative fixity of investment time at the destination point where in log scale, investment drops from the initial 7.4 log scale points to 7.2 at the destination point. lastly, the graph on the far left at the bottom of the page demonstrates the dynamic impact of an increase in fiscal spending that target to rescue the economy. as shown, an increase in fiscal expenditures by 2 log-scale points begets an immediate rise in investment from its initial status quo level of 7.4 to log-scale value that seems to exceed 8,5 log scale points. moreover, the fiscal rescue has a permanent effect on investment as it resonates at its destination level for the foreseeable time horizon of 25 years, ceteris paribus. accordingly, in kuwait’s context, increased fiscal spending for developmental (and social) purposes triggers a steady positive impact on investment. it is discernable that the seven dynamic simulations are associated with differential confidence intervals. in the case of gdp simulations, the timepath of the impact on investment has a relatively narrow range of confidence intervals (1%, 5% and 10%). in contrast, simulations of the fdi inflows in the center of the page are associated with a notable larger range of confidence interval. 4. general investment trends in kuwait the domestic private investment rate in kuwait has averaged 19% over the past decade (csb, 2010-2019), considered moderate at best according to international standards where the global average is 25%. moreover, regionally in the gcc the share of investment in gdp over a decade long average has been 29.5% in oman; 27.5% in the kingdom of saudi arabia, and 23.8% in the uae and growing (economy watch, 2019). while lagging behind levels in other countries, private investment in kuwait has been evolving discernibly over time. this paper suggests that its diffusion over the course of time has been crystallizing with sustained economic growth and has catalyzed particularly public investments that the government made in key sectors of the economy, notably in infrastructure and in human resources, especially health and education. such cumulative outlays have augmented the physical and human capital bases of the economy and in the process, expanded opportunities for further private investment particularly in niches that are lucrative such as banking, retail, and wholesale trade and increasingly in communications and information figure 4: trends in private and public investment. source: csb, 20 al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 2021 49 technology, the internet of things (iot). (nbk reports, 2019) drawn from the central statistical bureau (csb) publications on national income accounts, the demand side, investment in kuwait has been sizeable in absolute terms running at nearly kd 8,579 million in 2015. when gauged against kuwait’s gdp however, the total investment share in gdp is rather somewhat small at 15% averaged over the period 1983-2018. official csb data suggested that in 2014, the share of investment in gdp dipped in kuwait to 14.4% but recovered in the subsequent year, 2015, to 21.7% (csb, 2019). the research here suggests that private investors tend to be sector (and niche) selective. investors seem to favor such sectors as wholesale and retail trade, communications, banking and finance, recreation, hotels, restaurants and real estate sector. during the long-haul, 1985-2019, private investment has represented about 25% of total investment in kuwait and has managed to reach 45% to 50% during periods of high economic growth such as the period 2004-2008, and then retreated during times of slow growth. (csb, 2019) therefore, our analysis corroborates that private investment in kuwait tends to move pro-cyclically, that is increase during boom times and recede during times of slow economic growth and unfavorable business climate. moreover, business investments seem to increase with improved corporate governance and regulatory structure, by instituting favorable and easy-to-understand and implement rules and regulations. the policy implications of this profile should be in terms of measures that smooth out economic growth and minimize economic growth volatility. the data produced (al jabsheh et al, 2018) on the time-varying share of private investment displays the trend in private and public investment showing that the evolution and time-changing patterns of private, public and total investment in kuwait suggests that public investment has led the way and facilitated the penetration of private investment especially in sectors characterized by production and selling for the market as well as in the services sectors, notably financial, commercial and private housing, trade, restaurants and other related activities. over the period 19832015, private investments grew annually at an overall growth rate of 7.1% whereas public investment grew at a slower rate, or an average rate of 4.8%, implying that over time the share of private investment was rising. kuwait’s private investors seem less prone to invest domestically during times of high risks and uncertainty; that is they tend to be risk-averse. during much of the 1980s’ sluggish years in terms of economic growth; private investment was sluggish and annual growth rates were negative. by contrast, private investment grew at resilient rates during the buoyant years of the early 2000 to 2008, as shown in figure 4. the cyclical flip-flop annual growth rates of private investment meant high volatility of private investment relative to the volatility of public investment as shown in figure 5, which reinforces the contention that the standard deviation of the logarithm of private investment is 0.36, while the standard deviation for public investment is 0.15. that is to say, the volatility of private investment is fivefold the value of its mean (0.36 vs. 0.071). by contrast, the volatility of public investment was threefold the mean of the sector (0.15 vs. 0.048). the time-varying shares of public and private investment in kuwait shown graphically below clearly illustrate the rising tendency for private investment to partake larger shares subject to the state of the economy on the business cycle. noteworthy is the positive association between private investment and “good economic conditions” during the period of rising oil prices and robust economic growth, 2002 and 2009, the investment share of the private sector rose steadily to reach an all-time high of 56% in 2009 as shown in the figure 4. this is all in line with multi-country experiences suggesting that private investments increase during boom times and to locations that have favorable business environments, and conversely flatten out during periods of mediocre productivity and adverse economic times. noting these idiosyncrasies, countries vie to attract domestic investments by creating favorable business environments where fair, just, and efficient commercial laws prevail without intervention by opportunistic misbehavior. investment spurs growth, and rapid growth attracts investors that inherently infuse knowledge, know-how, and technological diffusion, hence, compounding the positive effects of investment itself. domestic investors internalize the benefits and expertise acquired, replicating this constructive experience across the board, horizontally and vertically across sectors. know-how is critical for up-skilling and re-skilling kuwait’s human resources at current times where the fourth industrial revolution and rapid technological innovations and discoveries are affecting total factor productivity. 5. determinants and impediments to investment in kuwait the lags of fdi and domestic investment in kuwait in comparison to the region and the gcc at large, has been studied and documented by the world bank (world bank report, 2018) and by economists for years (tawiri, 2010, wb report, 2010). the key and critical reasons for this shortfall have been clearly identified in a capstone as follows: excessive barriers to entry, restricted and limited ownership, legal implications, in addition to others, which in combination, produce an uninviting private sector for foreign investors seeking business-friendly opportunities. access to credit is one of the numerous factors that may impact and hence determine private investment. as a result, of the absence of future markets and long-term financing, the development of the size of credit that will eventually find its way to the private sector is potentially a good indicator of private investment behavior. real exchange rate can also affect the evolution of private investment and the rate of return. when a country’s currency depreciates in real terms, the price of assets falls and so does the nominal gain of investment. this is particularly poignant in sectors producing non-exportable goods. according to the world economic forum, infrastructure can make a substantial contribution to enhancing competitiveness of and gcc economies, where the challenge is dual-pronged, requiring infrastructure-based advances and institutional reforms, alongside a forward-looking economic reform agenda that serves the region’s development goals; also, broadening the economic base to create more jobs and reinvest oil income in sustainable development. al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 202150 furthermore, changes in the economic environment typically affect investment decisions of both companies and workers that operate in markets with different types of regulation, or of government groups whose decisions are made in normative environments outside of market mechanisms. here, public investment can also have differential impacts, that may include the “crowding in” or the “crowding out” effect; whereby, the state may act as a catalyst to exclude or crowd out the private sector when public investment increases in a country and competes for the appropriation of scarce (physical and financial) resources. in the case of the crowding in effect, through which, positive externalities such as investment in infrastructure and the complementarity that public investment has, occurs by propelling higher levels of private investment (everhart and sumlinski, 2001). in general, the investment climate encompasses fundamental factors that could have direct or indirect impact on stimulating investment. the investment climate or ecosystem defines the barriers and impediments; being political, structural, economical, institutional or social, that have been obstructing in the past and still impeding and hampering the enhancement of investment. economic factors essentially delineate unemployment, the availability of natural resources in addition to industrialization and overall production processes. whereas, a good legal system is one that is effective, efficient, and characterized by its stability and clarity, thereby reducing revenue risks, and facilitating investment operations and enhancing business. meanwhile, political factors encompass the political ecosystem the extent of its stability and flexibility of regime transition. investment typically blossoms in the presence of a stable and democratic government that provides fiscal incentives and lays out the proper legal framework for investing and investors. on the other hand, social factors incorporate social stability that comprises work ethics, crime levels, and staff workforce performance, among others. economic and financial factors may be characterized by several disorders that should be addressed with urgency. first, is the prevalence of a weak economic structure that lacks diversification and is solely dependent on a single source of income, which has in effect led to the pervasiveness of a high percentage of government-owned enterprises. the preponderance of a large and overwhelming public sector, embodied in state owned enterprises and their dominance over many economic activities, has limited the role of the private sector and has “crowded it out.” moreover, a monopolized private sector has created barriers to entry has compounded the problem. additional challenges include the prevalence of technically weak, uncompetitive industries that lack advanced manufacturing. a limited number of shareholders of privately owned companies; the small size of many of the financial and monetary markets; and the fact that the close relationship between banks and the government is often cited as a constraint on credit availability in addition to the fact that it lacks sufficient transparency. moreover, the main administrative factors that act as impediments to private investment in kuwait are lack of transparency, accountability and predictability of the public administration; red tape, bureaucracy, complicated and excessive procedures, and redundant regulations and transactions. this is in addition to favoritism in hiring, assigning, and promoting staff; limited investment opportunities and the fact that the project selection process is largely not based on sound economic feasibility studies. lastly and most importantly are the structural challenges that are broadly defined by the reality of a small nonoil manufacturing, industrial sector in kuwait that produces light manufactures at best, and a small, domestic market with limited capacity and investment opportunities. 6. sustainable development: innovative investment models in kuwait does innovation affect investment? the shortcut answer is in the affirmative. innovations present opportunities for differentiation of dynamic, originating, and transforming competitive enterprises and societies, and offers ways for distinction, and excellence and eventually prosperity at the enterprise and economy-wide levels. since the onset of the first industrial revolution, humanity has benefited from scientific and engineering advances that spur new products and processes. contemporaneously, the phenomenal growth that advances in machine learning, in computing machines and in artificial intelligence have achieved over the past few decades cause innovation to rise to the top of the agenda of policy makers at both the enterprise level as well as the overall macroeconomic level. entrepreneurs and policy makers are increasingly relying on emerging innovations as, “the unbounded hidden source” of productivity growth. from this perspective, figure 5: private investment’s share in total investment. source: csb, 2019 al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 2021 51 innovations are becoming synonymous with excellence and competitiveness. a long series of innovations in technologicalfrontier sectors such as the internet and communications, in transportation, energy, financial technology in banking and investment, in schooling and learning, as well as in healthcare and medical services are taking headwinds. they stand out as triggers for enabling complex interactions amongst capital markets, as they penetrate social fabrics, expedite cultural exchanges, and cross breeding of cultures and values. innovations advance the pace of economic development and enhance country innovating competitiveness enabling countries to reap the rewards in terms of market shares in global trade and enhanced efficiency. moreover, innovations impact investors and augment investments. anecdotal evidence suggests that countries that have high innovation efficiency tend to have high investment shares in gdp because innovative societies and economies explore and generate more opportunities for profit making which investors embrace. probing the innovation-investment nexus necessitates metrics on country differences with respect to innovation and its underlying drivers, exemplified by the global innovation index (gii). research conducted in this paper attests to the powerful effect of fiscal policy in supporting investment especially for the economy to break away from the protracted recession trap of the coronavirus pandemic. kuwait has a robust set of business leaders that are renowned in the region and globally. as well, tech-savvy kuwaiti youth are gradually making their way into the world of business startups dominated by innovative technology. often these startup need business leaders and financing that fosters their growth into world-class, creative technology-dominated business startups. likewise, the monetary authority, the kuwait central bank, has been and remains active by lowering interest rates in order to alleviate potential hardships on businesses, in order to spur future investments as the economy begins to recover from the recessionary trap. one objective that needs attention is to reconcile kuwait’s past heritage of doing without foreign direct investment, especially in the private sector of the economy. prospectively, kuwait’s authorities and businesses will have to attract large amounts of fdi; some are institutional, while others are strictly inflows through the venues of private corporations. our simulations above demonstrated that, in the historical context, reducing fdi inflows acted like a stimulus to private sector investment by kuwaiti entrepreneurs. 7. concluding remarks future business investment in kuwait’s post coronavirus era must be geared towards nurturing innovation, talent, and digital and innovative technologies. towards that, policy makers should encourage, support talented and tech-savvy kuwaitis, and help them set up innovative startups, through proper formula financing, in a rising set of niches and industries in modern high-tech import substituting and export promoting industries. escaping the trap of low investment especially under conditions of uncertainty requires concerted efforts by business leaders and economic gatekeepers including but not restricted to kuwait central bank, ministry of finance, the supreme council for planning and development, and the chamber of commerce and industry. kuwait’s historical investment evolution points to areas of malaise and suggest that concerted efforts are needed in order to break away from the trap of low investment rates. for instance, investment rates in kuwait during the late 80s and through the 90s were higher than they had been in the 1960s. nevertheless, in spite of the many attributes and advantages that kuwait enjoys, investment levels are considered relatively low, by regional and by global standards. while the investment rate does not change much over time for most countries in the world, the growth rate is highly volatile. if investment rates do not move much across decades but growth rates do, this means that investment must have not been an important determinant of growth. in fact, what matters for growth is not the overall level of investment but the quality and efficiency of investment and the level and aspect of innovation that it brings to the fabric of the enterprise. new determinants have come into the conceptual framework of analyzing benefits and efficacy of investment today, that were absent in the past, due to the technology revolution and the added aspect of innovation that have both enriched the production possibilities of firms today. in order to address the impediments to investment highlighted in this paper, kuwait should work on building a constructive and appealing investment environment and institute measures tailored to attract investors to invest domestically in kuwait. this can only be accomplished through genuine political will that embraces a strategy and an orchestrated package of policies and a set of actions to create desirable and innovative investment conditions. the investment environment could be enriched by enhancing the legislative, economic, financial, and administrative systems in the country, just as other emerging, developing economies like malaysia, uae and others have successfully done. learning from the experiences of others, investment opportunities in kuwait can be enhanced and directed by many means, highlighted by the following recommendations: improving the ‘ease of doing business’ index by removing administrative barriers and updating investment laws and procedures in addition to reducing bureaucracy and red tape. more so, creating an environment that encourages entrepreneurship; legislating clear, simple, and transparent investment laws and regulations that would produce a captivating investment climate and attract investors is another major transformational step. financially, assembling innovative financing schemes for investors in order to increase domestic production, reducing interest rates on loans and credit facilities especially for knowledge intensive and or technology intensive investments will have a multiplier value added economic and developmental impact, in addition to providing more equity-based incentives. privatizing publicly or state owned companies and services to increase productive efficiency and productivity, reduce unemployment and increase the skilled labor force is a warranted step that will eventually lead to applying international quality standards on local manufactures and produced goods. in a capstone, setting conditions for galvanizing the role of both the public and private sector in economic and social development processes and encouraging privatization and joint private public investments is the arch-objective and solution. by providing incentives and privileges to local investors, enhancing the performance of the investment supervisory bodies; developing al-jabsheh, et al.: investment and sustainable economic growth: empirical perspective on kuwait’s dual challenge during the covid-19 pandemic and beyond international journal of economics and financial issues | vol 11 • issue 4 • 202152 transparent, reliable, efficient, and strong legal and investment frameworks solutions to challenges are automatically unfolded. boosting domestic investment especially by encouraging more small-and-medium-sized entrepreneurship activity will eventually significantly contribute to diversifying the economy of kuwait and strengthening its sustainability. references al jabsheh, f., al qudsi, s., hajeeh, m. 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(2019), manual on statistics of international trade in services. new york: unstats. international journal of economics and financial issues vol. 1, no. 4, 2011, pp.153-162 issn: 2146-4138 www.econjournals.com testing the weak form efficiency of pakistani stock market (2000–2010) abdul haque department of management sciences, comsats lahore, pakistan. email: ahaque@ciitlahore.edu.pk , ahaque_257@yahoo.com hung-chun liu department of finance, minghsin university of science and technology, taiwan, roc. email: hungchun65@gmail.com fakhar-un-nisa department of management sciences, comsats lahore, pakistan. email: fakharunnisa@ciitlahore.edu.pk abstract: this empirical paper tests out the weak form efficiency of pakistani stock market by examining the weekly 100kse  index over the period 2000 2010 . return series has a leptokurtic and negatively skewed distribution, which is away from normal distribution as reflected by significant jarque-bera statistic. estimated results of adf (1979), pp (1988) and kpss (1992) tests, ljung-box q-statistic of autocorrelations and runs test of randomness reject the random walk hypothesis (rwh) for the returns series. moreover the results of variance ratio test (lo and mackinlay (1988)) also reject the rwh and prove the robustness of other estimated results. the rejection of rwh reveals that the pakistani stock prices are not weak form efficient. keywords: weak form efficiency, variance raito, random walk jel classification: c22, g12, g14 1. introduction in the last few decades a lot of research efforts were made on investigating the efficiency of stock markets and its significant role in challenging the financial resources. the term efficient market was introduced by an american economist eugene fama in early 60’s. he defined this term as the market which hastily tunes itself to new information. in generic terms market efficiency hypothesis predicates that security prices mull over all information backed by it. an obligatory thing for hypothesis is the information and the trading cost i.e. the cost of getting prices to reflect information are always zero (grossman and stieglitz, 1980). efficient market hypothesis (emh) opines that when investors are looking for alternative vogue in the stock market, each of the investors behaves in a very divergent manner. efficient market hypothesis leads the market toward perfect competition where none of the investors can exploit the market in the long run. in fact emh is the application of random walk theory (rwt), the central idea of which is that if the stream of available information is not restricted and in succession immediately reflected in stock prices, it simply means that rumors roaming around have no relationship with the current change in stock price. stock prices fluctuate in response to spontaneous information and since it enters the market randomly, so the price fluctuations also become random. there are three versions of efficient hypothesis i.e. i) weak form efficiency, ii) semi strong form efficiency, and iii) strong form efficiency. these versions have their respective impact on the market. in weak form efficiency (wfe), the investors can’t forecast the future prices despite having deep understanding of the past prices. even if they do, they can’t extend it for a longer period. most of the stock prices fluctuate randomly and thus are hard to predict. in semi strong form, share prices hastily tune themselves to new information available publicly but restrain the investors to earn excess international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.153-162 154 returns by trading on that news. in semi strong form efficiency, the adjustments must be of reasonable size and must be without delay. in order to test such efficiency in the market the consecutive upward and downward adjustment after the initial stage must be kept into account. in strong form efficiency, as the name itself signifies, the information obtained through public or private and even historical means pretends visible which forbids the investor to realize abnormal rate of return. strong form efficiency holds true in a market where the investors do not or cannot earn supernormal returns consecutively in long run. different research efforts persuaded on financial markets by various economists have enlightened this whole theory. in the case of developed countries the work done by hawawini and michel (1984), hudson, dempsey and keasey (1994), nicolaas (1997), sung and johnson (2006) and evans (2006) support that the changes in the stock prices show unsystematic pattern; thus it’s hard to predict the future prices. in emerging markets due to emaciated trade, the empirical studies confer mix outcomes. economists like omran and farrar (2006) used the random walk model to test the randomness in five different middle east countries like morocco, jordan, israel, turkey, and egypt. another worth seeking work done in much detail by covering twenty european markets is by worthington and higgs (2006). the results of unit root tests, autocorrelations, runs test and variance ratio (vr) test revealed that only five markets meet the purely rwh. with the above mentioned lighter tone of introduction it seems reasonable to further investigate the quest of wfe in the case of developing and emerging markets and we continued to this struggle by conducting an empirical study in the case of pakistan. our study investigated the wfe of pakistan’s stock market by analyzing the weekly data of 100kse  index over the period 2000 2010 . the results of unit root tests, autocorrelations, runs test, and variance ratio (vr) test strongly rejected the emh in the case of pakistan. there are obvious patterns and market directions which are of great help in predicting the future prices and thus benefit the investors to yield high volumes of abnormal returns. this phenomenon has made pakistan’s market inefficient. with reference to pakistan there are informational shortcomings in pakistani capital market which lead the market to be weak form inefficient. our results are updated since we have used the very recent data for the empirical analysis. the next section of this paper provides a detailed literature review, covering the research efforts done in the context of developed and emerging markets. 2. literature review this concept of efficient market didn’t earn much fame in the commencement but became conspicuous when the evident version of efficient market hypothesis was published. the influential work of fama (1970) provided some new insights in the efficient market hypothesis (emh) and laid down the basis of random walk model (rwm). in addition, the researchers did not focus on a specific technique or model rather developed numerous techniques. these various techniques, though apparently different in assumptions and execution but addressing the same motive of studying the market efficiency have been well appreciated and employed. although empirically different techniques, ranging from parametric to non-parametric tests, have been applied to diagnose the wfe of stock market but each of them focuses on the rwh. sometimes deviations in conclusions may appear because of the different time periods or the varying frequency of the data utilized in the study or perhaps driven by the macro or global financial conditions. nevertheless, the differences in estimated results may lead towards the rejection or questions the validity of these technique rather provide us with a wide range of options, which enable us to model any of the practical situations that could have not been modeled under the stringent assumptions of one specific technique and thus may be studied under different assumptions. the empirical findings on developing and emerging countries have somewhat mixed results and do not support the emh. barnes (1986) analyzed kuala lumpur stock exchange and found it to inefficient. dickinson and muragu (1994) supported the emh in the case of nairobi stock market. panas (1990) found the stock market of greece to be efficient but at the weak level. urrutia (1995) examined the four emerging markets of latin america including argentina, brazil, chile, and mexico by applying the runs test and vr test for testing rwh, the results of runs test of randomness supported the weak form efficiency but the vr test rejected the rwh. while for brazil and mexico, grieb and reyes (1999) supported the rwh in their equity prices. on the other hand, ojah and karemera (1999) accepted the rwh in the case of latin american countries and found these markets testing the weak form efficiency of pakistani stock market (2000 – 2010) 155 to be wfe. el-erian and kumar (1995) applied serial correlations and runs test on the stock markets of turkey and jordan. their findings suggested that these markets are inefficient. in the case of istnabul stock exchange, antoniou and ergul (1997) found the turkish stock market to be inefficient but efficiency was greatly improved soon after the liberalization. narayan and smith (2004) applied the zivot and adrews (za) (1992) and lumsdaine and papell (1997) structural break test on the south korean stock market, their findings reported the korean stock market to be wfe. mookerjee and yu (1999) examined the stock markets of china and found them to be weak form inefficient and similar findings were reported by groenewold et al. (2003). while, fawson et al (1996) and chang and ting (2000) found the stock market of taiwan to be wfe. whereas in the case of hong kong the studies of karemera et al. (1999) and lima and tabak (2004) reported the results in the favor of weak form efficiency hypothesis. awad and daraghma (2009) tested the wfe of palestinian securities by applying adf (1979) and pp (1988) unit root test, serial correlations and runs test. the market was reported to be inefficient on the basis of runs test and significant serial correlations. oskooe et al. (2010) studied the stock market of iran by employing the adf (1979), pp (1988) and kpss (1992) tests, estimated results reported the random walk in stock prices and supported the emh hypothesis in the case of iran. in addition to country specific studies some researchers have focused on the cross country analysis to envision the understanding in a larger matrix. campbell (1995) studied the twenty emerging stock markets covering the asia, africa, europe, latin america, and middle east. findings of the study suggested that in contrast to developed stock market the returns behavior of emerging stock market is more predictable of the future. abraham et al (2002) applied the vr and runs tests on the bahrain, kuwait, and saudi arabian stock markets. both of the tests rejected the rwh in the case of kuwaiti stock market. by applying the za (1992) structural break test on the seventeen emerging markets, chaudhuri and wu (2003) observed that for ten of the sampled stock markets the hypothesis of random walk was rejected. omran and farrar (2006) tested the rwh for the stock markets of egypt, isreal, jordan, morocco, and turkey and the hypothesis was rejected for all of the countries under study. marasdeh and shrestha (2008) tested the rwh over the securities markets of emirates and the results of adf (1979) and pp (1988) test supported the rwh. cooray and wickermaisgle (2005) studied the wfe of the south asian stock markets including bangladesh, india, pakistan, and sri lank by applying the unit root tests and elliot-rothenber-stock (ers) test. findings of the study revealed that the except bangladesh rest of the three stock markets were wfe. worthington and higgs (2006) applied the unit root tests (adf (1979), pp (1988) and kpss (1992)), serial correlation test, runs test of randomness, and variance ratio test on twenty seven emerging economies. the results of the unit root tests and serial correlations along with the runs test revealed that majority of the stock markets are inefficient and the same results were reported by the variance ratio test. with the above mentioned literature background and mixed results we assume more than one technique to be sure that the findings might not be related to a particular technique but rather prove the robustness of the results. 3. methodology after having an extensive literature review of the developed and emerging markets and having reviewed the different techniques applied to study the wfe of the stock market this study does not focus on one particular technique. the present study will be using the unit root testing, serial correlations, runs test, and famous variance ratio (vr) test for testing the wfe of pakistani stock market. the use of more than one technique provides the robustness of estimated results and thus adds to the rigor of the study. 3.1 unit root test an ultimate criterion to investigate the wfe of a stock market is a test of random walk hypothesis (rwh) in returns series. wide range of empirical literature investigating the wfe of stock markets emphasized on the randomness of stock prices. the randomness ensures that successive price movements are independent of each other and are stochastically determined. in other words, current price ( tp ) is independent of past prices ( 1 2, ,t tp p   ) and are not even helpful in predicting the future price ( 1tp ) movements. if the log price series ( tp ) follows a random walk and returns are independently and identically distributed, can be expressed as follows international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.153-162 156 1 1, 2, 3 ,t t tp p t n      (1) where tp and 1tp are the current and lagged values of the log of stock price, parameter  is mean or drift and t is the random error term. in econometric perspectives, a random walk series contains a unit root at the levels form and may become stationary at the differenced form. finally, a significant unit root test in returns series forms the basis of random walk and thus ensures the week form efficiency of the stock market. contrary to it, rejection of unit root at the levels forms implies that successive price movements are not independent of each other and this signals a deterministic or time trend. the study employed the widely used and largely accepted unit root tests, adf (1979), pp (1988), and kpss (1992). 3.1.1 augmented dickey and fuller (1979) unit root test for an ar (1) series of the form 1t t tp p     . where tp and 1tp are the current and lagged values of the log price,  is the mean or drift parameter and t is supposed to be white noise. a test of unit root calls for testing the modulus value of coefficient  of 1tp is greater than or equal to 1. under null hypothesis of 0 : 1h   , the series has a unit root and is non-stationary. acceptance of 0 : 1h   implies that the variance of the series is uncontrollable and various price fluctuations are independent and unpredictable, eventually supports the rwh. 1t t tp p     (2) 1 1 k t t i t i t i p p p          (3) 1 1 1 k t t i t i t i p p p            (4) 1 2 1 1 k t t i t i t i p t p p              (5) eq-3 is obtained by subtracting 1tp from both sides of eq-2 and adding the k lagged difference parameters 1 2, ,...... k   . the eq-4 and eq-5 are the simple extended form of equation-2, including a constant term 1 and a time trend parameter 2 . dickey and fuller (1979) used the t-statistic (as given by eq-6) for testing the null hypothesis 0 : 0h   of unit root against 1 : 0h   , which is exactly the same to test 0 : 1h   in eq-1 as 1   .  ˆ ˆ( )t se   (6) where ̂ is an estimate of  and ˆ( )se  is the standard error of ̂ . 3.1.2 the phillip-perron (pp) test pp (1988) is a nonparametric approach for testing unit root in a time series. unlike the adf (1979), which augment the k lagged differenced terms in the basic first differenced equation to control for the serial correlation in the series pp (1988) modify the t-statistic so that the asymptotic distribution of t is unchanged. modified t is as given below:   0 00 0 0 ˆ( ) 2 . t f se t t f f s       (7) where t is the test statistic given in eq-6, ˆ( )se  and s are the standard error of ̂ and test regression respectively. moreover, 0 is an estimator of random error term and 0f is an estimator of the residual spectrum. 3.1.3 the kwiatkowski, phillips, schmidt and shin (kpss) (1992) test testing the weak form efficiency of pakistani stock market (2000 – 2010) 157 this test differs from both adf (1979) and pp (1988) test in sense as both of these tests follow the null hypotheses of unit root against the alternative of stationarity while kpss (1992) test the null hypothesis of stationarity against the alternative of unit root in the series. so in case of kpss (1992) test, rejection of null indicates the presence of unit root and thus supports the random walk hypothesis (rwh). for a return series tp of the form (given in eq-8) to  21 1, 2, , ~ 0, t t t t t t t u p r t t n r r u u iid n           (8) be tested for stationarity. the tp series is decomposed into a random walk component tr , a deterministic trend component t along with an error term t . by assuming the series to be stationary (trend stationary) kpss test’s the null hypothesis 20 : 0uh   against the alternative of unit root 2 1 : 0uh   . under the 2 0 : uh  of statioanarity, 1 2, ,......, ne e e are the residuals obtained from eq-8 i.e ˆt te  . let  s t is the partial sum of the residuals such that   1 t j j s t e    and 2 is the variance of residuals 1 2, ,......, ne e e . a consistent estimator 2ˆ ( )p of 2 is obtained by applying newey and west (1987). finally the lm statistic of kpss is given by eq-9, the critical values of test statistic are provided by kpss (1992). 2 2 2 1 ˆ ( ) n t t kpss n s p    (9) runs test: famous “runs” test has been widely used in the empirical finance literature for testing the randomness of a financial series. by assuming the serial independence it tests for whether the successive occurrences of runs are independent of each other or not? a run is a sequence of successive positive or negative returns '' ''   or '' '' and the run length is a count of consecutive signs. being a non-parametric test it does not require a specific form of a probability distribution and the test statistic uses the run counts of both of the positive and negative runs. under the assumption of random walk, actual number of  runs r and the expected number of runs are same. let for a return series tr , n and n are the count of positive and negative runs and n n n   is the total count of runs. under 0h the successive runs are independent and for large sample sizes the test statistic follows the normal distribution and is given by:  ~ 0,1r r r z n     (10) where   2 1r n n n     and         2 2 2 1r n n n n n n n         are the sample mean and standard deviation respectively. 3.2. variance ratio test for testing the randomness of a series lo and mckanlay (1988) introduced a variance ratio (vr) test. for a return series , 0,1, 2, ,tr t nq  such that  1 0t t t tr r e      and   2 cov , 0t s t s t s        (11) international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.153-162 158 where,  is the drift parameter and t is the random error term. if tr follows a random walk then the variance of the first difference 1t tr r  is 1 q times the variance of t t qr r  or in other words the variance ratio  vr q of  var t t qr r q to  1var t tr r       1 var 1 var t t q t t r r q vr q r r       under 0h of a random walk. let    1 0 1 1 1 ˆ nq k k nq k r r r r nq nq        and   22 1 1 1 ˆ 1 nq a k k k r r nq         is the unbiased estimator of 1t tr r  and    22 1 ˆ 1 1 nq q k k q k q r r q q q nq q nq                is the unbiased estimator of t t qr r  . the vr test uses the  z q test statistic for testing the hypothesis of randomness. the  z q follows an asymptotic normal distribution and is given below in eq  2 1/ 2ˆ( ) ( ( ) 1).[ ( )] ~ 0,1z q vr q s q n  (12) where 2 2(2 1)( 1)ˆ ( ) 3 q q s q qt    for heteroskedastic error terms, the modified test statistic  z q  is given by  2 1/ 2ˆ( ) ( ( ) 1).[ ( )] 0,1z q vr q s q n     (13) where 21 2 1 2( )ˆ ˆ. q j j q j s q             and 2 2 2 2 1 1 1 1 1 ˆ ˆ ˆ ˆ( ) ( ) ( ) nq nq j k k k j k j k k k j k nq x x x x x x                                 4. data and descriptive statistics the study uses the weekly data of 100kse  index of karachi stock exchange (kse) over the period of 2000 2010 . the weekly observations of index were obtained from the kse website (http://www.kse.com.pk/). the continuous weekly returns tr are  1lnt t tr p p , where 1t tp and p are the log index at time t and 1t  . the basic descriptive statistics of the returns series for our sample period 2000 2010 are reported in the panel-a of table-1. over the sample time period, return series has an average of 0.0072 and standard deviation of 0.039. the returns are negatively skewed as the skewness is -0.2634. moreover, the return series exhibits a leptokurtic distribution as it has a positive kurtosis and a significant jarque-bera statistic. testing the weak form efficiency of pakistani stock market (2000 – 2010) 159 table 1. descriptive statistics, unit root tests, and autocorrelations for tp and tr series of kse-100 index for the period 2000-2010 panel-a: descriptive statistics of tp and tr for the sample period 2000-2010 series n min mean median s. d max skew kurto jarque-bera tp 571 7.03300 8.5418 0.0037 0.815 9.659 -0.4889 *** 1.7288*** 61.1931*** tr 570 -0.2009 0.0037 0.0072 0.039 0.257 -0.2634 *** 9.0299*** 871.6824*** panel-b: the results of unit root tests of tp and tr for the sample period 2000-2010 adf (1979) pp (1988) kpss (1992) series no trend trend no trend trend no trend trend tp -1.0232 -1.1831 -1.1103 -1.2434 2.6367 0.5607 tr -21.2727 -21.2689 -21.3962 -21.3917 0.1694 0.0976 panel-c: the autocorrelations of tr series up to lag-12 for the sample period 2000-2010 1 2 3 4 5 6 12 6q 12q ac 0.115 0.038 0.038 0.106 -0.043 -0.045 0.046 18.037*** 21.977*** p-val 0.006 0.015 0.026 0.003 0.005 0.006 0.038 0.006*** 0.038*** note: tp is the log of kse-100 index and tr is the returns (first difference of tp ), 6q and 12q are the ljung box statistics for the lag 6 and 12 respectively.***,**,* indicate the significant values at 1%, 5% and 10% level of significance. 4.1 estimations of unit root test in our pursuit of studying weak form efficiency of pakistani stock market we start our empirical investigation with the unit root tests. for this purpose the estimated results of unit root tests of adf (1979), pp (1988) and kpss (1992) applied to the log( )index and return series are reported in panel-b of table-1. all the three tests significantly reject the hypothesis of stationarity for the log price of 100kse  index. these significant results clearly reject the rwh in the case of 100kse  index series and which implies that the stock prices are not week form efficient. the above stated results suggest that the stock prices are predictable and the investors may follow the systematic pattern to earn the abnormal profits. the results of stationarity analysis for the return’s series do not turn to be significant which implies that the log price series is differenced stationary i.e (1)i . next we analyze the autocorrelation of returns series tr to further high light the debate of weak form efficiency. 4.2 autocorrelation tests after the rejection of rwh on the basis of the unit root tests we continue our pursuit for randomness by inspecting the autocorrelations and ljung box q-statistics for return series. under the null hypothesis q statistic assumes that the all the autocorrelations are equal to zero i.e different values are not correlated and thus are not helpful in predicting the future observations and ultimately the series is random or stochastic. the rejection of null hypothesis in the case of significant q-statistic implies that successive values are correlated to each and thus are predictive of future values and ultimately the series is not random and the stock prices are not weak form efficient. for our selected sample period as is evident from the panel-c of table-1, uptill 12lag  the autocorrelations of return’s series are significant. the significant autocorrelations (q-statistic) provide another evidence to reject the rwh and thus support to reject emh in the case of pakistan. further to check for the randomness of returns the study employees runs test and the next section provides the estimations of the runs test applied to our sample period. international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.153-162 160 table-2. estimated results of runs test and variance ratio test applied to the returns series of kse-100 index. panel-a: the results of runs test of randomness k mean k mean (0.0038) 0k  0.0000 cases k 251 cases k 220 cases k 320 cases k 351 total cases 571 total cases 571 no of runs 241 no of runs 237 z -3.514*** z -3.049*** panel-b: the results of variance ratio (vr) test 2j  4j  8j  16j  ( )vr j 0.5435 0.2507 0.1367 0.0705 ( )z j -10.898*** -9.5621*** -6.9676*** -5.0415*** * ( )z j -5.6394*** -5.4521*** -4.17628*** -3.2425*** note:. ( )vr j is the variance ratio statistic for 2, 4,8,16j  , ( )z j and * ( )z j are the z-statics under the assumption of homo/hetero skedastic increase. ***, **, * indicate the significant values at 1%, 5% and 10% level of significance. 4.3 runs test of randomness the runs test of randomness in not affected by the non-normality of the return’s series as the reported results of descriptive statistics in the panel-a of table-2 suggest. under the null of randomness the test assumes the sequence of positive (increasing) and negative (decreasing) runs to be independent of each other and don not follow any systematic pattern of occurrence and thus are not of any help in predicting the pattern of occurrences. the estimated results of runs test for both values of k , k mean and 0.0000k  of the returns series for our sample period 2000-2010 are reported in the panel-a of table-2. according the reported results the computed value of z-statistic is negative and significant at 1% of significance. the negative z-statistic value indicates, the actual number of runs is far less than the expected number. significant test statistic is indicative of the non randomness of the returns series. in other words there are obvious patterns (both positive and negative) in the return series of pakistani stock market which indicate that the market is not wfe. finally, to prove the robustness of earlier estimated results the study applies the variance ratio (vr) test of lo and mackinlay (1988) in the next section. 4.4 test of robustness: variance ratio (vr) test we apply the vr test of lo and mackinaly (1988) to prove the robustness of our finding that the pakistani stock prices are not weak form efficient. the estimated results of vr test of randomness for the returns series of 100kse  index are reported in the panel-b of table-2. the estimated variance ratio ( )vr j along with both ( )z j and * ( )z j are reported for 2, 4, 8 16j and . the estimated results are significant at 1% level of significance which clearly rejects the random walk hypothesis (rwh). these results further provide the robustness of our earlier results based on unit root tests, serial correlations and runs test that the pakistani stock market is not wfe. testing the weak form efficiency of pakistani stock market (2000 – 2010) 161 5. conclusion this research article adds to ongoing debate on weak form efficiency of developing stock markets by analyzing the returns behavior of pakistani stock market. for this purpose the study uses the latest weekly data of 100kse  over the sample period 2000 2010 . in order to test the weak form efficient hypothesis the study examines rwh in the returns series. instead of relying on a single test of rwh the study rather applied different econometric tests to test the robustness of the estimated results. descriptives reveal that returns distribution is non-normal, leptokurtic and negatively skewed. to test the rwh the study applied the adf (1979), pp (1988) and kpss (1992) unit root tests on the log of index. the estimated results of all these tests significantly rejected the hypothesis of stationarity and thus reveal that pakistani stock market is not weak form efficient. secondly the study applied the lung-box q-statistic for testing the autocorrelations of the returns series. estimated q-satistics are significant up to lag-12 which clearly rejected the joint hypothesis of zero auto correlations. the significant autocorrelations imply that the stock prices do not follow rw and are predictive of future prices. thirdly the study applied the runs test of randomness to test for the rwh; the estimated results significantly rejected the null hypothesis of randomness and provide third evidence in the support of rejection of the weak form efficient hypothesis in the case of pakistan. finally to test for the wfe hypothesis the study applied the most reliable vr test of lo and mackinlay (1988) to check the randomness of return series. in the line of earlier tests the results of vr test also rejected the hypothesis of randomness and thus provided the robustness of our estimated results. in the light of above mentioned facts based on the estimated results we conclude the weak form efficient hypothesis does not hold true in the case of pakistani stock market. thus the current stock prices are helpful in predicting the future prices. this predictive trend of stock prices may benefit the investors to yield some arbitrage benefits and abnormal profits. references abraham, a., fazal j. sayyed and alsakran, s. 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(1992), further evidence on the great crash, the oil price shock and the unit root hypothesis. journal of business and economics statistics, 10, 251-270. . international journal of economics and financial issues | vol 6 • special issue (s6) • 20166 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s6) 6-9. special issue for "ipn conferences, may 2016" retailer value-at-risk in interconnected power markets: an australian empirical analysis rangga handika1,2*, sigit triandaru3 1college of business administration, abu dhabi university, uae, 2fakultas ekonomi, universitas indonesia, indonesia, 3fakultas ekonomi, universitas atma jaya yogyakarta, indonesia. *email: rangga.handika@adu.ac.ae/rhandikapro@yahoo.com abstract this paper investigates value-at-risk in the australian interconnected power markets. we model the price change using seven different volatility models and perform the back testing from both investors’ (sellers’ side) and retailers’ (buyers’ side) perspectives. from investors’ perspective, we find that garch (1,1) model outperforms moving average (ma) and exponentially weighted ma models. on the other hand, the ma outperforms various garch (1,1) models from retailers’ perspective. our findings lead to a new insight to analyze carefully the position of modeling risk in power market since different position generates different result. keywords: back-testing, power markets, value-at-risk, volatility jel classifications: g17, g32, q40 1. introduction research works on risk measurement using value-at-risk (var) in power market are limited. the possible explanation is that var method historically came from industry practice and is normally used for standard financial instruments (like stocks and bonds). at that time, var in power market had not been applied yet. however, as financialization of commodity markets occurs, it is likely that power market will be treated like other financial instruments. therefore, the use of var in power market will emerge and this will explore new financial research area. another issue is that most papers investigating var in power market tend to take the position from generators’, the sellers’, perspective (for instance chan and gray, 2006; walls and zhang, 2006; frauendorfer and vinarski, 2007; herrera and gonzález, 2012; andriosopoulos and nomikos, 2012). this paper argues that analyzing var in power market from retailers’, the buyers’, perspective is also essential since the price spike, a stylized fact of power price, indeed generates market risks that must be managed carefully. therefore, a dramatic increase (i.e. huge positive “return”) is unfavorable while a dramatic decrease (i.e. huge negative “return”) is favorable for the retailers in power market. this new perspective changes the common var perspective by investigating right-tail side instead of left-tail side. 2. australian power market the australian power market has transformed over the last two decades. the market participants of australia were owned by government and monopolies before 1997. then, in the late 1990s, the australian government commenced significant structural reform by separating between power generation and power transmission. nowadays, the australian power market (national electricity market [nem]) is an interconnected power market among several regional networks between power suppliers and retailers. the price mechanism in the nem can be explained as follows. as the generators submit offers every 5 min, the submitted offers then become the basis in determining the number of generators that are required to produce electricity. then, the final price is constructed every half-hour for each of the regions by averaging the 5 min spot prices. therefore, there are 48 different half-hourly spot prices in a day for each region in the nem. handika and triandaru: retailer value-at-risk in interconnected power markets: an australian empirical analysis international journal of economics and financial issues | vol 6 • special issue (s6) • 2016 7 3. literature review there are a number of studies examining var in power market. the works tend to extend the standard var model, but cover only from the sellers’ perspective. chan and gray (2006) develop a model that incorporates autoregression and weekly seasonality in their egarch specification. walls and zhang (2006) use evt in their modified var model and demonstrate that the modified var is more accurate in the alberta power market. another extension of var in power market by adopting evt is proposed by herrera and gonzález (2012). frauendorfer and vinarski (2007) propose a quasi-sensitivity analysis of the var with respect to the risk factors price and volatility. andriosopoulos and nomikos (2012) extend a set of var models to capture the dynamics of energy prices. however, none of them performs var analysis from buyers’ side. the analysis from buyers’ side offers new insight to the retailer about how much the market risk exposure in the power market. 4. method instead of analyzing var from seller side, this paper offers new perspective by analyzing var from buyer side in the power market. we calculate common analytical var as explained in financial risk literature (such as hull, 2007; danielsson, 2011). however, we calculate the var value of the retailer by looking at the right-tail instead of the left-tail. in contrast to the previous research about var in power market, we propose various models of forecasting volatility so that the dynamic price change in the power market is captured by the dynamic volatility. we use seven different volatility models: 1. moving average (ma) the ma model is formulated (danielsson, 2011):  t w t k n n y k w 2 2 1 1 = − = ∑ (1) where σt denotes the volatility forecast for time t, yt denotes the realized return at time t, and nw denotes the number of estimation window. 2. exponentially weighted ma (ewma) ewma extends the ma by putting weight (λ) on recent observation. this paper formulates the ewma model that is close to hull (2007) and danielsson (2011): σ λ λσt t ty 2 1 2 1 21= − +− −( ) (2) where σt denotes the volatility forecast for time t and yt is the realized return at time t. 3. arch (1) arch (1) model formulates that the conditional variance depends on the recent squared return. according to engle (1982), arch (1) model can be written as follow: σ ω αt t zy2 1= + − (3) where σt denotes the volatility forecast for time t and yt is the realized return at time t. 4. garch (1,1) garch (1,1) generalizes the arch (1) model by also capturing previous conditional variance variable in the model. according to bollerslev (1986), garch (1,1) model can be written as follow: σ ω α βσt t ty 2 1 2 1 2= + +− − (4) where σt denotes the volatility forecast for time t and yt is the realized return at time t. 5. garch (1,1) – student t the model is similar with equation (4) but the conditional normal distribution is replaced with the student-t distribution. 6. egarch nelson (1991) modifies the garch model by designing exponential relationship. the model can be written as follow: ln y ln yt t t t t t ( ) | | ( )σ ω α σ π β σ γ σ 2 1 1 2 2 1 2 1 2 2 1 = + −         + + −− − − − (5) where σt denotes the volatility forecast for time t and yt is the realized return at time t. 7. gjr glosten et al. (1993) extends the garch model by adding an additional term for considering asymmetric response of volatility to recent positive and negative return. it is the gjr model and the model can be written as follow: σ ω α βσ γt t t t ty y i 2 1 2 1 2 1 2 1= + + +− − − − (6) it−1=1 if yt−1<0 and it−1=0 otherwise where σt denotes the volatility forecast for time t and yt is the realized return at time t. the estimated var is obtained from the value of estimated volatility from those seven different models. 5. data and empirical analysis we obtained the daily series of australian power market prices in four interconnected markets (nsw, qld, sa and vic) from the aemo website. then, we calculated the daily price for each region by averaging 48 half-hour power prices. we decomposed the sample period into in-sample and out-of-sample periods. the insample period is from 1 january 2000 to 31 december 2009 while the out-of-sample period is from 1 january 2010 to 31 december 2014. our choice about in-sample period is motivated by our focus on financialized commodity markets. commodity markets have entered financialization era and been identified to possess special properties since 2000s (rossi, 2012; tang and xiong, 2012). therefore, we start our in-sample period at january 1 2000. many finance empirical works use 10 years (ledoit and wolf, 2008). therefore, we decide to use 10 years data (until the end of 2009) for modeling basis (in-sample period). then, we forecasted various volatility models from in-sample period and used the estimated handika and triandaru: retailer value-at-risk in interconnected power markets: an australian empirical analysis international journal of economics and financial issues | vol 6 • special issue (s6) • 20168 volatility model to obtain var value. finally, we performed backtesting during out of sample period. table 1 reports the descriptive statistics of power price change in the four regions. we use “price change” instead of “return” because we emphasize the price risk from the retailers instead from the investors’ perspective. the descriptive statistics include the mean, standard deviation, minimum, maximum and the number of observation in the each region. panel a reports the descriptive statistics from january 1, 2000 to december 31, 2014 (all periods), panel b reports the descriptive statistics from january 1, 2000 to december 31, 2009 (in-sample period) and panel c reports the descriptive statistics from january 1, 2010 to december 31, 2014 (out-of-sample period). we find that average daily power price changes range from negative 0.07% in sa to 0.07% in vic during all sample period, range from negative 0.01% in qld to 0.13% in sa during insample period and range from negative 0.48% in sa to 0.03% in qld during out-of-sample period. overall, sa region tends to show the smallest price change while qld and vic regions tend to show the highest price change. we also find that the volatilities of power price change range from 35.2% in vic to 46.90% in sa during all sample period, range from 38.01% in vic to 48.15% in sa during in-sample period and range from 24.42% in nsw to 44.31% in sa during out-ofsample period. overall, sa region tends to be the most volatile of price change while nsw and vic regions tend to be the least volatile of price change. table 2 panel a reports the results of back-testing var in the four regions using seven different volatility models from investors’ perspective at 99%, 95%, and 90% confidence levels. the reported numbers are the number of var violations. a var violation from investors’ perspective occurs when a negative return is worse than var limit in the designated confidence level. the best volatility model implies the least var violation. we find that the power price volatilities are best captured by garch (1,1) model in four regions at 99% confidence level, by gacrh (1,1) model in nsw and qld regions and by arch (1) model in sa and vic regions at 95% confidence level, and by arch (1) model in nsw and sa regions, by egarch model in qld region and by ma model in vic region at 90% confidence level. overall, we can observe that garch (1,1) method tends to perform best in modeling power price change volatility from investors’ perspective. the situation is completely different when we perform similar analysis but from retailer perspective. as reported in the table 2 panel b, however, we find that the power price changes are best captured by ma model in nsw, qld and vic regions and by egarch model in sa region at 99%, 95% and 90% confidence table 1: the descriptive statistics of power price change in the four regions statistics descriptive panel a: all-sample period panel b: in-sample period panel c: out-of-sample period nsw % qld % sa % vic % nsw % qld % sa % vic % nsw % qld % sa % vic % mean 0.0183 0.0023 −0.0716 0.0692 0.0183 −0.0091 0.1334 0.1137 0.0183 0.0253 −0.4817 −0.0198 standard deviation 39.40 45.30 46.90 35.22 45.06 47.95 48.15 38.01 24.42 39.49 44.31 28.87% minimum −403.28 −415.47 −398.58 −399.29 −403.28 −414.45 −395.46 −368.41 −248.50 −415.47 −398.58 −399.29 maximum 406.45 426.88 439.62 381.15 406.45 426.88 439.62 381.15 239.78 415.77 352.82 361.77 number of observation 5479 5479 5479 5479 3653 3653 3653 3653 1826 1826 1826 1826 table 2: back-testing var results in the four regions using seven different volatility models from investors’ perspective (sellers’ side) in the panel a and from retailers’ perspective (buyers’ side) in the panel b panel a panel b moving average (ma) garch (1,1) normal moving average (ma) garch (1,1) normal cl nsw qld sa vic nsw qld sa vic nsw qld sa vic nsw qld sa vic n-99 15 22 28 17 1 6 13 4 12 19 30 16 17 31 39 16 n-95 16 34 55 25 9 16 47 26 16 39 50 20 32 48 59 33 n-90 18 56 77 35 26 34 85 51 19 52 74 28 44 62 96 56 ewma garch (1,1) t student ewma garch (1,1) t student n-99 32 41 43 30 1 8 13 3 50 48 54 44 22 38 30 16 n-95 71 70 86 75 11 16 37 20 95 77 89 87 38 52 54 35 n-90 117 101 122 124 30 41 57 47 143 119 131 128 73 72 83 57 arch (1) e-garch arch (1) e-garch n-99 3 10 15 7 14 12 43 25 15 24 31 16 15 10 38 18 n-95 6 19 35 14 18 21 64 34 22 41 55 25 17 19 65 25 n-90 10 31 53 40 18 30 91 49 26 61 76 41 25 28 92 46 gjr-garch gjr-garch n-99 19 49 65 26 25 55 57 21 n-95 31 69 86 41 43 87 90 41 n-90 54 93 118 62 60 111 120 62 cl: confidence level, n: number of var violations (a var violation occurs when a negative return is worse than var limit in the designated confidence level).” thus, “n-99” refers to the number of var violation during out-of-sample period at 99% confidence level, “n-95” refers to the number of var violation during out-of-sample period at 95% confidence level and “n-90” refers to the number of var violations during out-of-sample period at 90% confidence level handika and triandaru: retailer value-at-risk in interconnected power markets: an australian empirical analysis international journal of economics and financial issues | vol 6 • special issue (s6) • 2016 9 levels. overall, we can observe that ma method tends to perform best in modeling power price change volatility from retailers’ perspective. therefore, we should be careful when modeling risk in the power market. first, we have to understand our position whether we are from the buyer or seller side. different side will generate different result of which volatility model tends to be the best. second, we should note that price spike risk is indeed the risk faced by the retailers in the power markets. thus, an unexpected high positive return seems good in financial market (stocks) but is highly unfavorable in the power market, especially from the retailers’ perspective. while garch (1,1) model performs better than ma and ewma models from investors’ perspective, the ma performs better than various garch (1,1) models from retailers’ perspective in the power market. garch (1,1) model is expected to perform better for high frequency data (bollerslev, 1986; andersen and bollerslev, 1997). this theory works in power market when we discuss from the sellers’ side. from the buyers’ side, however, we provide an evidence that the theory does not work. 6. conclusion this paper investigates var in the power market using seven different volatility models from the retailers’ perspective. we model the volatility and perform the back testing var of price changes. we compare the back testing results from both investors’ (sellers’ side) and retailers’ (buyers’ side) perspectives. we find that the back testing results are substantially different from both sides in the power markets. garch (1,1) model tends to perform better than ma and ewma models from investors’ perspective. on the other hand, the ma performs better than various garch (1,1) models from retailers’ perspective. this implies a new perspective to consider our position (seller or buyer side) when we model the price change risk in the power market. references andersen, t.g., bollerslev, t. 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(2006), using extreme value theory to model electricity price risk with an application to the alberta power market. energy, exploration and exploitation, 23(5), 375-404. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(2), 262-267. international journal of economics and financial issues | vol 10 • issue 2 • 2020262 the effect of sovereign debt on economic growth: the case of oil-rich countries hussein salameh1*, ahmed alodadi2, khaled alzubi3 1researcher, amman, jordan, 2college of business, king khalid university, abha, saudi arabia, 3college of economics and administrative sciences, hashemite university, jordan. *email: salameh2272017@gmail.com received: 17 december 2019 accepted: 03 march 2020 doi: https://doi.org/10.32479/ijefi.9120 abstract key studies have identified the need to study the role of sovereign debt on economic growth, particularly in relation to countries with heavily oilbased status economies. this paper applies a panel vector autoregressive approach to examine the impact of sovereign debt on economic prosperity in several oil-rich countries between 2002 and 2017. the results show that in oil countries, like other developing countries, government debt has not had a positive impact on enhancing economic growth, resulting in a reluctance of such countries to invest debts in production, and a desire for the type of diversification of sources of income observable in most advanced countries. keywords: co-integration, sovereign debt, oil-rich countries jel classifications: a10, b22, b23, e23, e52, e62 1. introduction the greek budget deficits from the last decade transferred themselves by contagion across europe. as a result, market interest rates on sovereign debt started to rise. the impact of sovereign debt on economic growth has thus become one of the hottest topics globally. recently, oil-rich countries and the gulf cooperation council (gcc) created a special excess fund (yet to be employed) due to their dependence upon oil exports, with a view to removing the risk of debt-related financial failure. from another point of view, the lower cost of the debt feature encouraged them to use debt in their financing instead of using only their own capital. this topic is of importance to the oil-rich companies in their search for the nexus between debt and growth, as the debt crises in indebted nations affected their economic growth. in consequence, several questions were raised: does the growth in general gross government debt for oil-rich countries create significant shocks on economic growth – or vice versa? is there a relationship between gross debt and economic growth in the short and long run? through answering these questions, these countries will gain a greater insight into (and assistance in) their future fiscal policy. this paper makes several major contributions to existing literature on this topic. first, this is, to the authors’ knowledge, one of the few studies that illustrate a new overview and relevant information on the future effectiveness of sovereign debt for oilrich countries. the second contribution is that this work checks the standard deviation shocks of debt on growth, and vice versa. the results of empirical literature concerning the shortand longrun relationship between debt and growth and the impulse of debt shock on growth (or vice versa) are mixed. the authors hereby present the latest articles on this issue. lof and malinen (2014) revealed that sovereign debt produced no effect on economic growth; butsuch growth had a significant negative reverse effect on sovereign debt. by contrast, zouhaier and fatma (2014), szabó (2014), matei (2014) and pegkas (2018) found that debt/gdp had an adverse effect on growth. antonakakis (2014) found that non-sustainable debt-ratios > or <60% threshold affect short-run growth detrimentally, while sustainable debt-ratios <90% threshold influences short-run growth positively. in the long-run, both this journal is licensed under a creative commons attribution 4.0 international license salameh, et al.: the effect of sovereign debt on economic growth: the case of oil-rich countries international journal of economics and financial issues | vol 10 • issue 2 • 2020 263 non-sustainable ratios >90% or <60% threshold and sustainable debt-ratios >90% threshold compromised growth. furthermore, bakke (2016) found that elevated sovereign debt has a non-linear negative effect on gdp-per-capita growth, starting at a 90%-100% threshold. he also discovered that the negative growth effect of high government debt might be linear, starting at a 70%-80% threshold. moreover, baum et al. (2012) suggested that the short-run impact of debt on growth is positive and highly significant, but decreases to around zero and loses significance at debt/gdp <67% for dynamic and non-dynamic threshold models. for high debt/gdp >95% additional debt has a negative impact on economic activity. further, herndon et al. (2013) found that the average growth rate for countries with debt/gdp >90% is actually 2.2%, due to coding errors, selective exclusion of available data, and unconventional weighting of summary statistics, which contradicts reinhart and rogoff’s claim that debt/gdp >90% reduce gdp growth. in fact, there have been few studies on sovereign debt, and those that do exist have tended to focus on developed countries. this study is different. as far as the authors are aware, this article is the first study that analytically tests the impact of sovereign debt on economic growth on oil-rich countries and opens the door to future studies on the role of sovereign debt on economic growth. therefore, the main purpose of this paper is to consider the role of sovereign debt on the economic growth of several oil-rich countries and offer new insights. in an attempt to discuss all aspects of these two fields, the rest of the paper is organised as follows: the theoretical framework, followed by the method of study, the empirical results and, finally, the conclusion drawn there from. 2. methodology and data selection and collection in the current research’s data base, the aim was to construct data for the dependent variable real gross domestic product (rgdp) from the national statistical office while the main independent variable general gross government debt was collected from ministry of finance and treasury. the dataset consists of annual data on 7 oil-rich countries (the kingdom of saudi arabia, iran, united arab emirates, kuwait, qatar, oman and algeria) over the period 2002-2017 and includes 112 observations for each of the variables of the log model, plus 105 observations of the growth model. to analyse the relationship between the variables debt and gdp, the authors used panel vector autoregressive (pvar) (where debt is the dependent variable) and vecm (where growth is the dependent variable) and computed the impulse-response functions from estimated pvar when growth rate was used as one of the variables. 2.1. vector auto-regressions (vars) the var is commonly used for forecasting systems of interrelated time series and for analysing the dynamic impact of random disturbances on the system of variables. the var approach sidesteps the need for structural modelling by treating every endogenous variable in the system as a function of the lagged values of all of the endogenous variables in the system. the mathematical representation of a var is: 1 1 t t p t p t ty a y a y bx− −= +…………+ + + where yt is a k vector of endogenous variables, xt is a d vector of exogenous variables, a1,…., ap and b are matrices of coefficients to be estimated, and ϵt is a vector of innovations that may be contemporaneously correlated but are uncorrelated with their own lagged values and uncorrelated with all of the right-hand side variables. since only lagged values of the endogenous variables appear on the right-hand side of the equations, simultaneity is not an issue and ols yields consistent estimates. moreover, even though the innovations ϵt may be contemporaneously correlated, ols is efficient and equivalent to gls since all equations have identical regressors. as an example, let us suppose that real gross domestic product (rgdp) and general gross government debt (gggd) are jointly determined by a var, and let a constant be the only exogenous variable. assuming that the var contains two lagged values of the endogenous variables, it may be written as: 11 1 12 1 11 2 12 2 1 1 t t t t t t rgdp a rgdp a gggd b rgdp b gggd c − − − − = + + + + + 21 1 22 1 21 2 22 2 2 2 t t t t t t gggd a rgdp a gggd b rgdp b gggd c − − − − = + + + + + where aij, bij, ci are the parameters to be estimated. 2.2. vector error correction (vec) models a vec model is a restricted var designed for use with nonstationary series that are known to be co-integrated. co-integration may be tested using an estimated var object; the equation object may be estimated using non-stationary regression methods, or using a group object (see “co-integration testing”). the vec has co-integration relations built into the specification so that it restricts the long-run behaviour of the endogenous variables to converge to their co-integrating relationships while allowing for short-run adjustment dynamics. the co-integration term is known as the error correction term since the deviation from long-run equilibrium is corrected gradually through a series of partial shortrun adjustments. to take the simplest possible example, consider a two-variable system with one co-integrating equation and no lagged difference terms. the co-integrating equation is: 2, 1,t ty yβ= the corresponding vec model is: ( )1, 1 2, 1 1, 1 1,t t t ty y yα β− −∆ = − + ( )2, 2 2, 1 1, 1 2,t t t ty y yα β− −∆ = − + in this simple model, the only right-hand side variable is the error correction term. in the long-run equilibrium, this term is zero. however, if y1 and y2 deviate from the long-run equilibrium, the error correction term will be nonzero and each variable adjusts salameh, et al.: the effect of sovereign debt on economic growth: the case of oil-rich countries international journal of economics and financial issues | vol 10 • issue 2 • 2020264 to partially restore the equilibrium relation. the coefficient αi measures the speed of adjustment of the i-th endogenous variable towards the equilibrium. 2.3. impulse responses function a shock to the i-th variable not only directly affects the i-th variable but is also transmitted to all of the other endogenous variables through the dynamic (lag) structure of the var. an impulse response function traces the effect of a 1-time shock to one of the innovations on current and future values of the endogenous variables. if the innovations ϵt are contemporaneously uncorrelated, interpretation of the impulse response is straightforward. the i-th innovation ϵi,t is simply a shock to the i-th endogenous variable yi,t. innovations, however, are usually correlated, and may be viewed as having a common component which cannot be associated with a specific variable. in order to interpret the impulses, it is common to apply a transformation p to the innovations so that they become uncorrelated: (0, )t tp dευ = ≈ where d is a diagonal covariance matrix. as explained below, e-views provides several options for the choice of p. 3. results 3.1. panel unit root the results in table 1 show that the null hypothesis of the unit root for both variables (real gross domestic product and general gross government debt) haven’t been rejected under the panel unit root test/summary (in case none) at 1% significance level at the level i(0) (under the methods: levin, lin and chu t*, adf fisher chisquare, pp fisher chi-square), which means that this variable is not stationary under the three methods. from the other side, the null hypothesis of the unit root for both variables (real gross domestic product and general gross government debt) have been rejected under the panel unit root test/summary (in case none) at 1% significance level at the first difference i(1) (under the methods: levin, lin and chu t*, adf fisher chi-square, pp fisher chi-square), which means that the series is stationary at the first difference i(1) at 1% significance level for both variables (real gross demotic product and general gross government debt). to implement pvar test, the variables have to be stationary at i(1) and the unit root test shows that the variables are stationary at first difference i(1). 3.2. kao residual co-integration test the results in table 2 show that when the real gross domestic product is the dependent variable and general gross government debt is the independent variable, the null hypothesis that says there is no co-integration between the variables can be rejected. the pvar cannot therefore be used; instead, the vector error correction model (vecm) can be employed, which means that there is a long-run relationship between the variables. when the general gross government debt is the dependent variable and the real gross domestic product is the independent variable, the null hypothesis that says there is no co-integration between the variables can’t be rejected. the pvar model (var) is therefore used, which means that there isn’t a long-run relationship between the variables. 3.3. panel var fixed and random effects models dependent variable gggd table 4 below illustrates that the cross-section random effects model is appropriate. therefore, the results in table 3 show that the probability value of c, gggd (−1), gggd (−2) coefficients are <5% and significant, which means we can reject the null hypothesis and accept the alternative hypothesis. therefore, the intercept, general gross government debt lag 1 and lag 2 independent variables have an effect on the dependent variable general gross government debt. furthermore, table 3 shows that the probability value of rgdp (−1) and rgdp (−2) coefficients are more than 5% and are insignificant, which means the null hypothesis can’t be rejected: and has to be accepted. therefore, there is no effect of independent variables real gross domestic product lag 1 and lag 2 on the dependent variable general gross government debt. 3.4. hausman test table 4 shows that the probability value of chi-square is more than 5% and insignificant, which means the null hypothesis can’t be rejected; and it has to be accepted that the means random effect model is appropriate; therefore, the authors are going to depend on the random effect model in their analysis. 3.5. joint causality (wald test) table 5 shows that depending on the coefficient of rgdp (−1) and rgdp (−2): (c [4] and c [5]) in the cross-section random effects model, the authors found the probability of calculated f statistics and the probability value of chi-square for the independent variables (real gdp) is <5% and significant; this means the null hypothesis can be rejected for all independent variables and the alternative hypothesis has to be accepted. therefore, the table 1: panel unit root test/summary test (none) for stationary method variables real gross domestic product (rgdp) general gross government debt (gggd) level p value 1st diff. p value level p value 1st diff. p value levin, lin and chu t* 9.76303 1.0000 −4.50532*** 0.0000 1.10666 0.8658 −3.19066*** 0.0007 adf-fisher chi-square 1.23930 1.0000 43.3451*** 0.0001 10.5197 0.7233 29.9369*** 0.0078 pp-fisher chi-square 0.06132 1.0000 47.8523*** 0.0000 2.5983 0.9996 35.0208*** 0.0015 significance at 1%***, 5%**, 10%* table 2: kao residual co-integration test null hypothesis: no co-integration series: rgdp gggd series: gggd rgdp t-statistic prob. t-statistic prob. adf −2.3566*** 0.0092 adf −1.5697* 0.0582 significance at 1%***, 5%**, 10%* salameh, et al.: the effect of sovereign debt on economic growth: the case of oil-rich countries international journal of economics and financial issues | vol 10 • issue 2 • 2020 265 coefficients aren’t zero and the independent variable real gdp lag 1 and lag 2 can jointly cause short-run real gdp (there is a short-run causality running from real gdp to general gross government debt). 3.6. johansen fisher panel co-integration test the results in table 6 show that the probability value of none for both tests (trace test and max-eigen test) is <5% and significant, which means that we can reject the null hypothesis (none: number of co-integrated equations is zero or the variables are not cointegrated) and the alternative hypothesis has to be accepted, which means that at least one of the two variables are co-integrated. accordingly, as the second hypothesis is moved to, the probability value of at least one of the two variables in a co-integrated hypothesis for both tests (trace test and max-eigen test) is more than 5% and insignificant, which means that the null hypothesis can’t be rejected (at least one of the two variables are co-integrated) and has to be accepted, whilst the alternative hypothesis that there are more than two co-integrations must be rejected. this means that there is one co-integration between the variables and the vector error correction model (vecm) can be used. 3.7. discussing vector error correction model/ dependent variable rgdp the result in table 7 shows the results of the error correction model, which illustrate the coefficients and standard error and t statistic but not the p value. therefore, to get the p value we make a system and order by variable, and then we get two equations (these appear in the second and third row in table 8) with 12 coefficients. table 8 shows the results of ols regression for the two systems, but the authors are concerned with model one, where the dependent variable is d(rgdp). the p value of the coefficient of c(1) error correction term is insignificant because it is more than 5%, and the sign of c(1) coefficient is negative, which means that there is an insignificant long-run causality running from the independent variable general gross government debt to the dependent variable real gdp. the speed of adjustment towards long run equilibrium would be insignificant. 3.8. finally, joint causality (wald test) table 9 shows that the probability value of chi-square for the independent variable general gross government debt is more than 5% and insignificant, which means that the null hypothesis for the independent variables can’t be rejected, and it must therefore be accepted that the coefficients are zero and the independent variable general gross government debt lag 1 and lag 2 can’t jointly cause short-run real gdp. there is no short-run causality running from general gross government debt to real gdp). 3.9. discussing the impulse response function figure 1 shows the impulse response function derived from the estimated pvar equation. as shown in the graphs, the blue line is the impulse response function while the red lines are the 95% confidence intervals. the impulse response line must always lay between the 95% interval confidence red lines. also, the positive zone means that when a positive change happens in one variable the impact on the other variable is positive, while the negative zone means that the impact of one variable on the other variable is opposite. 3.10. interpretation of rgdp to sd shock gggd the right top graph shows the response of rgdp to a 1-time standard deviation shock (innovation) to gggd. the result shows that from period 1 to period 2 the response (reaction) of rgdp to gggd was positive, and the curve moving upward means that there is an increase in gdp. the curve starts moving downwards table 5: jointly causality (wald test) coefficients of rgdp (−1) with rgdp (−2) calculated f-statistic=4.734624** prob.=0.011 ho: c(4)=c(5)=0, h1: c(4)≠c(5)≠0 chisquare=9.469248*** prob.=0.0088 significance 1%***, 5%**, 10%* table 6: johansen fisher panel co-integration test series: rgdp gggd hypothesized no. of ce (s) fisher stat.* (from trace test) prob. fisher stat.* (from maxeigen test) prob. none (ho: r=0, ha: r≥1) 34.01*** 0.0021 30.17*** 0.007 at most 1 (ho: r≤1, ha: r>2) 14.83 0.3898 14.83 0.3898 significance 1% ***, 5% **, 10%* table 3: panel var fixed and random effects models/dependent variable: gggd variable fixed cross-section random effects coefficient t-statistic prob. coefficient t-statistic prob. c −1.0128** −2.2866 0.0246 −0.0995* −1.9655 0.0523 gggd (−1) 1.3440*** 13.7282 0.0000 1.4380*** 15.8307 0.0000 gggd (−2) −0.5081*** −5.2102 0.0000 −0.5507*** −6.1051 0.0000 rgdp (−1) 0.4124 0.5769 0.5655 0.1175 0.2028 0.8397 rgdp (−2) 0.0294 0.0441 0.9649 0.0020 0.0035 0.9972 r-squared 0.995987 0.995579 adjusted r-squared 0.995526 0.995388 f-statistic 2159.291*** 5235.231*** prob. (f-statistic) 0.0000 0.0000 significance at 1%***, 5%**, 10%*. the authors assume, when taking 2 lags, that the value of akaike info criterion is lowest and that this is optimal. there is no error correction term because the variables aren’t co-integrated table 4: correlated random effects hausman test test summary chi-sq. statistic chi-sq. d.f. prob. cross-section random 8.629129* 4 0.0711 significance 1%***, 5%**, 10%* salameh, et al.: the effect of sovereign debt on economic growth: the case of oil-rich countries international journal of economics and financial issues | vol 10 • issue 2 • 2020266 after period 2 until period 3 and enters the negative zone at 2.5 years, then from year 3 to year 4 the response of rgdp to gggd rises but is still in the negative zone. finally, from year 4 to year 8 the response has a tendency to increase but has no noticeable impact, and the curve moves upwards until it reaches zero at year 8 but stays in the negative zone. in other words, there is a very weak reaction in these years – it is stable and is almost at zero. 3.11. interpretation of gggd to sd shock rgdp staying with our analysis in figure 1, the bottom left graph shows the response of gggd to a 1-time standard deviation shock (innovation) to rgdp. the result shows that the response (reaction) of gggd to rgdp will be negative (negative zone) from period 1 to period 3, even though the curve is moving upward until it reaches zero, then from year 3 until year 8 it stays steady and is almost at zero at the x-axis line. 3.12. interpretation of rgdp to sd shock rgdp in observing the reaction to one sd shock (innovation) to rgdp with no shocks, a sharp fall can be seen until period 2. from period 2 until period 8 it declines but less sharply and stays in the positive zone. 3.13. interpretation of gggd to sd shock gggd the reaction of the gggd to one sd shock (innovation) was a sharp fall from period 1 to period 4 followed by stability; it was almost at zero at the x-axis line after period 8 but stayed in the positive zone. table 7: vector error correction model/dependent variable: rgdp variable coefficient s.t t-statistics variable coefficient s.t t-statistics cointeq1 −0.00438 (0.00643) [−0.68094] d(gggd(−1)) −0.001431 (0.01494) [−0.09580] d(rgdp(−1)) 0.394902 (0.10411) [3.79316] d(gggd(−2)) −0.007185 (0.01695) [−0.42402] d(rgdp(−2)) 0.174196 (0.09949) [1.75082] c 0.006336 (0.00292) [2.16657] r-squared 0.279287 adjusted r-squared 0.236892 f-statistic 6.587756 significance at 1%***, 5%**, 10%*. the authors assume when taking 2 lags that the value of akaike info criterion is lowest and that this is optimal s.t is standard error table 8: two equations system according to vecm ordinary least squares ols regression model (1): d(rgdp)=c(1)*(rgdp(−1)−0.936834665871*gggd(−1)−1.07833311315)+c(2)*d(rgdp(−1))+c(3)*d(rgdp(−2))+c(4)*d( gggd(−1))+c(5)*d(gggd(−2))+c(6) model (1): d(gggd)=c(7)*(rgdp(−1)−0.936834665871*gggd(−1)−1.07833311315)+c(8)*d(rgdp(−1))+c(9)*d(rgdp(−2))+c(10)* d(gggd(−1))+c(11)*d(gggd(−2))+c(12) variable coefficient t-statistic prob. variable coefficient t-statistic prob. c(1) −0.004381 −0.68094 0.4968 c(7) 0.129449*** 2.841952 0.005 c(2) 0.394902*** 3.793159 0.0002 c(8) −0.000993 −0.001347 0.9989 c(3) 0.174196* 1.750819 0.0818 c(9) 0.085858 0.121898 0.9031 c(4) −0.001431 −0.095797 0.9238 c(10) 0.544977*** 5.153265 0.0000 c(5) −0.007185 −0.424023 0.6721 c(11) 0.020438 0.170375 0.8649 c(6) 0.006336** 2.166567 0.0317 c(12) 0.026693 1.289323 0.199 r-squared 0.279287 r-squared 0.299293 adjusted r-squared 0.236892 adjusted r-squared 0.258075 significance at 1%***, 5%**, 10%* table 9: jointly causality (wald test) coefficients of gggd (−1) with gggd (−2) h0: c(4)=c(5)=0, h1: c(4)≠c(5)≠0 chi-square=0.274041 df=2 prob.=0.872 significance 1%***, 5%**, 10%* figure 1: response to cholesky one standard deviation. innovations±2 standard errors salameh, et al.: the effect of sovereign debt on economic growth: the case of oil-rich countries international journal of economics and financial issues | vol 10 • issue 2 • 2020 267 4. conclusion the results reflect the fact that sovereign debt does not affect the economic growth of several oil-rich countries in relation to their oil sectors. the analysis of the long-term relationship between these two variables found that sovereign debt does not have a strong influence on economic growth. therefore, oil-rich nations should re-direct their economic policies more and more towards promoting sovereign debt to achieve sustainable growth and development. it seems that oil-rich countries do not require the debt-based economic tools to achieve economic growth in the way that other developing countries do, and in fact the use of debt negatively affects their economic prosperity. on the other hand, experience shows that developed countries use government debt instruments for productive purposes, thereby promoting their growth and prosperity. us government debt, for example, currently accounts for about 104% of the us gdp, compared to 64% for china, which represents the optimal use of such debt to support economic growth. in general, the results of this study indicate that the exclusion of the sovereign debt variable and its impact on economic growth in oil countries, and a focus only on the role of exports (especially oil) may not reflect a new outlook of economic prosperity. hence, this paper has theoretical and practical implications. theoretically, by including the sovereign debt variable as a determinant of economic growth of oil-rich countries, the study has identified and highlighted the potential role of sovereign debt as a critical future factor that could change the view of these nations on economic growth. in practice, these results are directed at policy makers in oil-rich countries with regard to key future variables to focus on to ensure growth and sustainable development. highlighting sovereign debt as a future driver of growth means that policymakers must think about ways to exploit and improve this variable to ensure economic prosperity, and this can be done by investing in a variety of productive sectors. references antonakakis, n. (2014), sovereign debt and economic growth revisited: the role of (non) sustainable debt thresholds wirtschafts universitatwien (wu), working paper no. 187. available from: http://www.epub.wu.ac.at/id/eprint/4321. bakke, j. (2016), sovereign debt and economic growth in the european monetary union. the park place economist, 24(1), 8. baum, a., checherita-westphal, c., rother, p. (2012), debt and growth: new evidence for the euro area. journal of international money and finance, 32, 809-821. herndon, t., ash, m., pollin, r. (2014), does high public debt consistently stifle economic growth? a critique of reinhart and rogoff. cambridge journal of economics, 38(2), 257-279. lof, m., malinen, t. (2014), does sovereign debt weaken economic growth? a panel var analysis. economics letters, 122(3), 403-407. matei, i. (2014), sovereign debt crisis and economic growth: new evidence for the euro area, working paper. pegkas, p. (2018), the effect of government debt and other determinants on economic growth: the greek experience. economies, 6(10), 1-19. szabó, z. (2014), the effect of sovereign debt on economic growth and economic development. public finance quarterly, 58(3), 251-270. zouhaier, h., fatma, m. (2014), debt and economic growth. international journal of economics and financial issues, 4(2), 440-448. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(6), 94-98. international journal of economics and financial issues | vol 10 • issue 6 • 202094 the day of the week effect: unconditional and conditional market risk analysis olfa chaouachi*, imen dhaou faculty of economic sciences and management, university of tunis el manar, tunisia. *email: chaouachiolfa@yahoo.fr received: 12 september 2020 accepted: 02 november 2020 doi: https://doi.org/10.32479/ijefi.10610 abstract the objective of our investigation is to test empirically the existence of the day of the week effect on the canadian stock market between september 2009 and august 2019. our findings show that the day of the week effect is present. the highest and lowest mean daily returns of the s&p/tsx composite index are detected on tuesday and monday, respectively. moreover, we try to give an explanation of the day of the week effect by referring to the world market risk. using unconditional and conditional models, our results reveal that only the significant monday effect is still present after accounting for world market risk. then, we can deduce that the monday effect in returns of the s&p/tsx composite index is not explained by the risk-return relationship and that it is an anomaly of the canadian stock market. keywords: canadian stock market, day of the week anomaly, monday effect, world market risk jel classification: g14 1. introduction seasonal anomalies (effects) in equity market returns have been of considerable interest to academics and practitioners for several years. they are defined as phenomena that allow investors to realize profits by trading at particular times. there are many types of the seasonal effects which are investigated in literature. we can cite, for example, the day of the week anomaly, the month of the year anomaly, the semi-month anomaly and the ramadan anomaly. for academics, the study of seasonal anomalies in stock market returns may give important information about the level of market efficiency. founded on the efficient market hypothesis (emh), proposed by fama in 1970, on an efficient market asset prices completely mirror all available news at any point in time. if this is the case, it is impossible to make predictions on the evolution of the price. for practitioners, the study of calendar anomalies in equity market returns is also useful. it can help the investors to construct a beneficial investment strategy by observing the best moment to purchase and to sell securities. for example, the day of the week anomaly provides a favorable circumstance for investors to purchase securities on the day with lower returns and to sell them on the day with larger returns. to the best of our knowledge, there are many investigations exploring the day of the week anomaly in the canadian stock market like jaffe and westerfield (1985), kohers et al. (2004), baker et al. (2008) or zhang et al. (2017). the results of these studies are not similar. jaffe and westerfield (1985) and zhang et al. (2017) find strong statistical evidence for the day of the week anomaly in the canadian stock market. on the other hand, kohers et al. (2004) and baker et al. (2008) provide evidence of a weak day of the week effect in the canadian stock market. compared to these authors, our analysis gives another perspective by considering the impact of the global market risk on the daily evolution of the canadian equity market return. in other words, in the current investigation we examine empirically the existence of the day of the week anomaly on the canadian stock market between september 2009 and august 2019 employing both unconditional and conditional market risk analysis. this journal is licensed under a creative commons attribution 4.0 international license chaouachi and dhaou: the day of the week effect: unconditional and conditional market risk analysis international journal of economics and financial issues | vol 10 • issue 6 • 2020 95 the rest of our article follows: section 2 provides previous researches. section 3 describes the data and section 4 methodology. section 5 presents the findings and section 6 summarizes the conclusions. 2. literature review the day of the week anomaly has examined in developed stock markets. cross (1973) provides evidence of the day of the week anomaly in the american market between 1953 and 1970. he finds that the highest mean returns is detected on fridays, while the lowest mean returns detected on mondays. cho et al. (2007) also find strong statistical evidence for the monday effect in the us, japan and uk stock markets. zhang et al. (2017) investigate the day of the week anomaly in twelve developed markets. they provide evidence of the day of the week effect in all markets studied. however, in the uk market, gregoriou et al. (2004) report that once transaction costs are taken into account the day of the week effect fades away between january 1986 and december 1997. kohers et al. (2004) investigate the day of the week effect in eleven developed equity markets between january 1980 and june 2002. they provide evidence of the day of the week anomaly during the 1980’s in the majority of markets studied. however, starting the 1990’s the day of the week anomaly has disappeared. baker et al. (2008) examine the existence of the day of the week anomaly on the return and the volatility of returns in the canadian stock market between 1977 and 2002. they reveal that the day of the week effect both on the return and the volatility of returns is susceptible to the error distribution considered. the day of the week anomaly has been investigated not only in developed stock markets, but also in emerging and frontier markets. basher and sadorsky (2006) find that the day of the week anomalies detected on philippines and pakistan stocks markets persist even after adjusting for world market risk. alagidede (2008) examines seven african stock markets over the 2001-2006 period and also finds strong statistical evidence for the day of the week effect in south africa, zimbabwe and nigeria. he also reports that the day of the week anomaly do not fade away even after accounting for market risk. however, brooks and persand (2001) find that the day of the week effect, detected on thailand and malaysia stock markets over the 1989-1996 period, become less pronounced after taking into account the global market risk. tilica and oprea (2014) also find that the friday effect, observed on the romanian stock exchange from january 2005 to december 2011, is completely captured by the risk-return relationship. al-khazali et al. (2008) provide evidence of the day of the week anomaly in the greek stock market between january 1985 and december 2004. they document that the mean stock returns are low on tuesdays and high on friday. wang et al. (2013) examine the day of the week effect in the shanghai and shenzhen stock markets for the period january 2000 to december 2010. the findings show significantly higher mean returns on monday and lower on tuesday on both markets. chaouachi and ben mrad douagi (2014) report a friday effect in the tunisian stock market between january 1998 and december 2011. rita et al. (2018) investigate the existence of the day of the week effect in the indonesian stock market. they find evidence of the monday effect. gayaker et al. (2020) provide evidence of the day of the week anomaly in the istanbul stock market between january 1990 and october 2017. they document that the mean stock returns are low on mondays and high on friday. 3. data the data applied in our investigation consist of the daily closing prices of the s&p/tsx composite index and the dow jones global total stock market (dwg) index from september 2009 to august 2019. the s&p/tsx composite index is weighted by market capitalization and it includes stocks of the largest firms on the toronto stock exchange. dwg index represents 77 countries and covers more than 12000 equity securities. it gives near-complete coverage of developed, emerging and frontier markets. the daily closing prices of the s&p/tsx composite index and the dwg index were obtained respectively, from the www.investing.com and www.djindexs.com. s&p/tsx composite index is applied to calculate the return of canadian stock market and dwg index is used to compute the return of the world market portfolio. the daily returns for the s&p/tsx composite index and the dwg index are computed as the difference in the natural log of the closing index values between day t and t-1. table 1 displays the summary statistics for daily returns of the s&p/tsx composite index and the dwg index between september 2009 and august 2019. as shown in table 1, both s&p/ tsx composite and the dwg indexes have negative skewness coefficient and exhibit excess kurtosis. our findings indicate that return series for the s&p/tsx composite index and the dwg index are skewed to the left and are leptokurtic. the jarque-bera statistics also reveal that return series for the s&p/tsx composite index and the dwg index are non–normal at 1% level. the jarque bera test measures the normality of the distribution of the series. if the jarque bera statistic is significant, the null hypothesis of normal distribution is rejected. 4. methodology to explore the day of the week effect in returns, we implement the regression of the returns on five daily dummy variables by applying the ols technique. r dt it it ti= +=∑ α ε1 5 (1) table 1: summary statistics for daily returns of the s&p/ tsx composite index and the dwg index (%) september 2009 august 2019 description s&p/tsx composite index dwg index observation 2609 2609 mean 0.0076 0.0119 standard deviation 1.1842 1.0909 skewness -0.6766 -0.5913 kurtosis 13.4972 10.9724 jarque-bera 12177.72*** 7061.39*** ***significant at 1% level chaouachi and dhaou: the day of the week effect: unconditional and conditional market risk analysis international journal of economics and financial issues | vol 10 • issue 6 • 202096 where rt is the index return on day t; dit represent dummy variables such that d1t takes the value one if day t is a monday and zero otherwise and so forth; the parameters α1 to α5 indicate the average returns for monday through friday. εt is an error term. the presence of statistically significant αi coefficients would be indicative of day of the week effect and the market inefficiency. however, it is essential to mention that in model 1 we do not take into account the risk factors. brooks and persand (2001), basher and sadorsky (2006) and tilica and oprea (2014) argue that on specific days of the week, the world market risk is significantly higher or lower than the average and this could be the explanation for the day of the week effect. following the methodology employed by these authors, we introduce the world market risk as follows: r d rwmt it it t ti= + +=∑ α β ε1 5 (2) where the terminology of model 2 is identical to model 1; the parameter represents the sensitivity of return for the s&p/tsx composite index to a variation in the world market return and rwmt indicates the world market portfolio return. it is applied as a proxy for global market risk. the presence of insignificant αi coefficients indicates that the seasonality is completely attributed to the risk-return relationship. however, if the parameters αi are statistically significant, we can argue that the day of the week effect in returns may be explained by other risk factors. it is important to mention that in model 2 the world market risk do not vary across the days of the week. in model 3, we let the world market risk to vary across the days by multiplying world market risk by dummy variables. model 3 is written as follows: r d d rwmt it it i it t tii= +  +== ∑∑ α β ε1 5 1 5 (3) where the terminology of model 3 is identical to model 2 and βi represent the mean sensitivity parameters for each day of the week. models 1, 2 and 3 are unconditional models. these models suppose the existence of a symmetric relationship between stock market returns and world mark risk. an alternative approach is to employ a conditional model to examining for day of the week anomalies. this model supposes that market risk can have an asymmetric impact on stock returns. model 4 is a conditional model relating stock market returns to world market risk. r d d rwm d rwmt it it u ut t d dt t ti= + + +=∑ α β β ε1 5 (4) where dut (ddt) is a dummy variable takes the value one if rwmt are positive (negative) and zero otherwise. in model 5, we let the conditional risk to vary across the days by multiplying the conditional market risk ([dutrwmt] or [ddtrwmt]) by dummy variables (dit). model 5 is written as follows: r d d d rwm d d rwm t it it iu it ut tii id it dt t t = +   +  + == ∑∑ α β β ε 1 5 1 5 ii=∑ 1 5 (5) 5. findings estimation results for model 1 are reported in table 2. the coefficients for all dummy variables are statistically significant. the presence of statistically significant αi coefficients indicates the existence of day of the week effects. table 2 also reveals that the lowest mean returns are detected on monday. however the highest mean returns are observed on tuesday. our results indicate at a first sight, the presence of arbitrage opportunities, since market participants may construct beneficial investment strategies. for example, market participants could purchase stocks on monday and sell them on tuesday in order to take benefit of this anomaly. our findings are in line with jaffe and westerfield (1985), athanassakos and robinson (1994), baker et al. (2008) and zhang et al. (2017). these authors find strong statistical evidence for the monday anomaly in the canadian stock market. model 2 shows that the coefficients for all dummy variables, except monday are statistically insignificant. then, the significant day of the week effects, except monday effect, detected in table 2 disappear after adjusting for world market risk (table 3). from table 3 we can also say that only the monday effect is not explained by the risk-return relationship. it is important to mention that in model 2, the world market risk do not vary across the days of the week. moreover, the market coefficient (β) in model 2 is significantly positive and less than unity, implying that the canadian market is less risky than the world stock market. in model 3, we let the world stock market risk to vary across the days. we also find that the significant monday effect found in model 1 remains after adjusting for world market risk. then, we can also say that the monday effect is not explained by the risk-return relationship. further, model 3 reveals that the lowest mean interaction between the canadian market and the world market are detected on friday (0.77), followed by monday (0.78). however, the highest mean interaction are observed on thursday (0.85), followed by wednesday (0.84). models 4 and 5 are conditional models. these models suppose the existence of an asymmetric relationship between stock market returns and world market risk. the results from estimating model 4 show that the coefficients (βu and βd) are not statistically significant. then, the monday effect seen in tables 2-4 is still present. in model 5, we let the conditional risk to vary across the day. the estimation results from this model indicate that the coefficients (βiu and βid) are statistically significant at 1 % level. also, we note that the monday effect detected in table 6 remains. 6. conclusions the study of day of the week anomaly in equity market returns interests academics and practitioners. for academics, the chaouachi and dhaou: the day of the week effect: unconditional and conditional market risk analysis international journal of economics and financial issues | vol 10 • issue 6 • 2020 97 analysis of this anomaly gives insights about the level of market efficiency. practitioners utilize it to build their investment strategy. in this article, we investigate the day of the week effect in daily returns of s&p/tsx composite index in the canadian stock market between september 2009 and august 2019. our findings reveal the existence of the day of the week effect. the highest and lowest mean returns are detected on tuesday and monday, respectively. our findings are in line with jaffe and westerfield (1985), athanassakos and robinson (1994), baker et al. (2008) and zhang et al. (2017) in the canadian stock market. further, we try to explain the day of the week effect by referring to the world market risk. using unconditional and conditional models, our results show that only the significant monday effect remains after adjusting for world market risk. for this reason, the major conclusion of this article is that the monday effect in daily returns of the s&p/tsx composite index is not caused by the world market risk. an important extension of this paper would be to test empirically the day of the week effect in various stock markets in order to make a comparison between them about their reaction to the world market risk. references alagidede, p. (2008), day of the week seasonality in african stock markets. applied financial economics letters, 4(2), 115-120. al-khazali, o.m., koumanakos, e.p., pyun, c.s. (2008), calendar anomaly in the greek stock market: stochastic dominance analysis. international review of financial analysis, 17(3), 461-474. athanassakos, g., robinson, m.j. (1994), the day-of-the-week anomaly: the toronto stock exchange experience. journal of business finance and accounting, 21(6), 833-856. baker, h.k., rahman, a., saadi, s. (2008), the day-of-the-week effect and conditional volatility: sensitivity of error distributional assumptions. review of financial economics, 17(4), 280-295. basher, s.a., sadorsky, p. (2006), day-of-the-week effects in emerging stock markets. applied economics letters, 13(10), 621-628. brooks, c., persand, g. (2001), seasonality in southeast asian stock markets: some new evidence on the day-of-the-week effects. applied economics letters, 8(3), 155-158. chaouachi, o., ben mrad douagi, f.w. (2014), calendar effects in the tunisian stock exchange. international journal of behavioral accounting and finance, 4(4), 281-289. cho, y., linton, o., whang, y. (2007), are there monday effects in stock returns: a stochastic dominance approach. journal of empirical finance, 14(5), 736-755. cross, f. (1973), the behaviour of stock prices on mondays and fridays. financial analysts journal, 29(6), 67-69. fama, e. (1970), efficient capital markets: a review of theory and empirical work. journal of finance, 25(2), 383-417. gayaker, s., yalcin, y., berument, m.h. (2020), the day of the week effect and interest rates. borsa istanbul review, 20(1), 55-63. gregoriou, a., kontonikas, a., tsitsianis, n. (2004), does the day of the week effect exit once transaction costs have been accounted for? evidence from the uk. applied financial economics, 14(4), 215-220. jaffe, j., westerfield, r. (1985), the week-end effect in common stock returns: the international evidence. journal of finance, 40(2), 433-454. kohers, g., kohers, n., pandey, v., kohers, t. (2004), the disappearing table 2: estimation results for model 1 day mean t-stat. monday −0.1392*** −2.69 tuesday 0.2133*** 2.91 wednesday 0.1732** 2.36 thursday 0.1612** 2.20 friday 0.1864** 2.54 ***significant at 1% level. **significant at 5% level table 3: estimation results for model 2 mean t-stat. monday −0.1446*** −2.98 tuesday −0.0304 −0.62 wednesday −0.0553 −1.14 thursday −0.0488 −1.01 friday 0.0537 1.56 rwm 0.8127*** 57.78 ***significant at 1% level table 4: estimation results for model 3 mean t-stat. monday −0.1458*** −3.00 tuesday −0.0298 −0.61 wednesday −0.0564 −1.16 thursday −0.0494 −1.01 friday 0.0534 1.55 monday rwm 0.7870*** 29.08 tuesday rwm 0.8073*** 26.13 wednesday rwm 0.8450*** 25.85 thursday rwm 0.8573*** 26.42 friday rwm 0.7705*** 21.23 ***significant at 1% level table 5: estimation results for model 4 mean t-stat. monday −0.1639** −2.34 tuesday 0.0477 0.68 wednesday −0.0176 −0.25 thursday −0.0161 −0.23 friday −0.0054 −0.06 rwm down −0.0202 −0.59 rwm up 0.1286 1.01 **significant at 5% level table 6: estimation results for model 5 mean t-stat. monday −0.1159** −2.32 tuesday −0.0248 −0.49 wednesday −0.0361 −0.72 thursday −0.0493 −0.98 friday 0.0365 1.03 monday down −0.4129*** −10.29 tuesday down −0.3929*** −10.07 wednesday down −0.5397*** −11.77 thursday down −0.4247*** -8.39 friday down −0.2920*** −9.75 monday up 0.9805*** 7.55 tuesday up 1.4852*** 10.29 wednesday up 0.9025*** 7.52 thursday up 1.2399*** 10.91 friday up 0.8696*** 8.50 ***significant at 1% level. ** significant at 5% level chaouachi and dhaou: the day of the week effect: unconditional and conditional market risk analysis international journal of economics and financial issues | vol 10 • issue 6 • 202098 day-of-the-week effect in the world’s largest equity markets. applied economics letters, 11(3), 167-171. rita, m.r., wahyudi, s., muharam, h. (2018), bad friday, monday effect and politique issue: application of arch-garch model to analyse seasonal pattern of stock return. international journal of engineering and technology, 7(3), 38-47. tilica, e.v., oprea, d. (2014), seasonality in the romanian stock market: the day of the week effect. procedia economics and finance, 15, 704-710. wang, j.k., ojiako, v., wang, l. (2013), calendar effects of the chinese stock markets. international journal of business and emerging markets, 5(1), 67-82. zhang, j., lai, y., lin, j. (2017), the day of the week effects of stock markets in different countries. finance research letters, 20, 47-62. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(6), 129-138. international journal of economics and financial issues | vol 10 • issue 6 • 2020 129 the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia seyhak khon*, udomsak seenprachawong graduate school of development economics, national institute of development administration, bangkok, thailand. *email: khonseyhak@gmail.com received: 12 july 2020 accepted: 06 october 2020 doi: https://doi.org/10.32479/ijefi.10426 abstract our study estimates the willingness to pay (wtp) for the dengue fever vaccination program at a national level in cambodia. a double bounded format with an open-ended question was used in this study to estimate the wtp. the contingent valuation method (cvm) scenario was created as a two-year dengue fever vaccination program. two vaccine levels were used, one with 40% and another with 80% effectiveness, neither with any side effects. three doses were required for full protection. we used a 600-split sample survey in phnom penh, cambodia of those aged 20-60 years old and with cambodian nationality. subjects were asked how much they would be willing to pay for dengue fever vaccination via a 1-time income tax surcharge of either 50,000, 150,000, 200,000, 350,000, 500,000, or 600,000 riel, respectively. as shown by the tobit model, the mean of households’ willingness to pay to support the dengue fever vaccination program were 98,841 riel and 149,124 riel for the 40% and 80% levels, respectively. income, gender, marital status, and education were the key factors influencing households' wtp to support a dengue fever vaccination program. keywords: contingent valuation method, dengue fever vaccine, willingness to pay jel classifications: i11, i12, i13, i15, i18 1. background and rationale dengue fever is considered as an epidemic disease in cambodia, which is a nation with low health and economic indicators (asian development bank, 2009). the 2008 population estimation for cambodia was 14.6 million people (national institute of statistics, 1998). the first cambodian dengue infection case was discovered in 1963, after which dengue spread across the nation. the dengue fever infection rate has been reported as fast-rising over the years and has become one of the most significant public health issues. moreover, dengue fever infections drastically increased in 2008. and since 2008 there have been about 9000-38,000 cases (about 103 cases/100,000 population) and 3-179 deaths (about 1/100,000 population) every year. during 2008-2017, dengue fever infection cases in cambodia peaked 2012 with 37,675 cases and 179 deaths. in 2012, the mortality and morbidity levels were all high, at 2 and 262, respectively, per 100,000 population (ministry of health of cambodia, 2017). by 2017, there were 6372 reported cases, while in 2016 there were 12,483 cases. a large part of the reported cases occurred among children from ages of 5 through 10 (2434 cases or 38.2%), followed by children aged 10-15 (2,271 cases or 35.6%), children under 5 years of age (1305 cases or 10.7%), and children over 15 years (362 cases or 5.6%). it should be noted that among the child cases there is not much difference between males (3264 cases, 51.2%) and female (3108 cases, or 48.8%) (ministry of health of cambodia, 2017). in this study, we intend to derive a useful insight into the public demand from cambodian households (including both genders) as to how much they are willing to pay to support a 1-year dengue fever vaccine program. such a program aims to prevent the spread of dengue fever among the population, but to do so, individuals would have to pay a 1-time income tax surcharge of 50,000, 150,000, 200,000, 350,000, 500,000, or 600,000 riel, respectively. this paper examines the factors that influence this journal is licensed under a creative commons attribution 4.0 international license khon and seenprachawong: the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia international journal of economics and financial issues | vol 10 • issue 6 • 2020130 individuals regarding their household’s willingness to pay (wtp) for this vaccination program. estimating the wtp for a dengue fever vaccination program and thus a potential means of funding it can thus provide policy planners with an understanding of just how a dengue fever vaccination program can be most effective. our research questions are: (1) what are the key factors influencing how much a household is willing to pay to support a dengue fever vaccination program? and (2) how much would individuals actually be willing to pay to support such a program? 2. literature review previous research that has focused on estimating the private demand for dengue fever vaccine programs at a country level has been conducted in various countries, such as in metro manila, philippines (palanca-tan, 2008), indonesia (harapan et al., 2017), vietnam (nguyen et al., 2018), brazil (godoi et al., 2017), and south korea (amarasinghe et al., 2010b). however, none of these has evaluated a nation’s ability to financially subsidize a public dengue fever vaccination program nor examined how much the public is willing to pay for it. in addition, key factors influencing the number of vaccines that could be purchased for public use remain undetermined (hecht and suraratdecha, 2006). one study (agmapisarn, 2009) focused on public demand for a free hiv vaccination program and used the double bounded contingent valuation method (cvm) format. this was followed by an openended question to estimate the mean willingness to pay for the vaccination program. our study will follow this research design. dengue vaccine is a potentially effective method of preventing dengue fever in the long run. various public and private sectors have given assurances that a dengue fever vaccine was being developed and tested (deroeck et al., 2003). in 2007, one news report claimed that a dengue fever vaccine could be produced within the next 10 years. this news raised a lot of questions regarding policy implementation, such as to whom and how dengue fever vaccine could be supplied. for example, should a dengue vaccine be provided by the private or the public sector? in the case of the vaccine being provided by the private sector, the next question that arises is how much vaccine will be demanded by the market and at what price? and who will be able to receive the injections? on the other hand, if the public sector provides the vaccine, an evaluation of the estimated benefits of such a preventive measure needs to be made. willingness to pay (wtp) is the monetary valuation put on a vaccine by survey respondents and is derived from a contingent valuation survey. it is derived by assessing a household’s perceived benefit from preventing dengue disease. this wtp approach is more accurate and comprehensive than the cost of illness (coi) approach, comprised of treatment cost reduction and productivity gain that can occur place from illness prevention. this is the approach that is normally employed in the public health literature (palanca-tan, 2008). in vietnam, the escalation of dengue fever cases in recent years and the occurrence of a large-scale dengue fever outbreak in 2017 underlined the importance of dengue vaccines. given the potential benefits of dengue vaccines and the need for the private sector to pay for healthcare service coverage, nguyen et al. (2018) decided to evaluate the wtp for a dengue fever vaccination program for hospital patients in northern vietnam. cross-sectional data were collected from 330 inpatients and outpatients in bach mai hospital. the contingent valuation method was used to evaluate the wtp for dengue vaccines. results showed that around 95% of respondents were willing to pay an average of $67.4 usd for the vaccine. moreover, the study recommended that the government should subsidize the cost of the vaccine so as to increase the coverage of the population, especially the poor, in the future. in december 2015, the first dengue fever vaccine, developed by sanofi pasteur, was approved in brazil. however, given that the vaccine would potentially be paid for via the public health system, information was needed regarding consumers’ willingness to pay for the vaccine in order to discuss about the possible inclusion of this vaccine into the public health system in the first place needed to take place. godoi et al. (2017) addressed these issues using a cross-sectional data set with residents of greater belo horizonte, minas gerals to estimate their willingness to pay for dengue fever vaccine. after interviewing 507 respondents, they found that the maximum median value of consumers’ wtp was $33.61 usd. the study suggested that manufacturers in brazil should asses the possibility of lowering prices in order to reach more people. one study claimed that a dengue vaccine would be available in the next three to 5 years (amarasinghe et al., 2010a). the authors emphasized that such a vaccine was direly needed in both public and private markets for nations experiencing widespread dengue outbreaks. these estimations were based on population projections from 2015 to 2020 in asian and american endemic nations. moreover, it made an expectation for specific countries’ vaccination programs in the public, private, and traveler sectors. there were 54 countries that were categorized as dengue endemic, comprising a total population of 2.8 billion, among which were 54 million children aged 1-2 years old. in the following 5 years, it was estimated that 645 million doses would be needed for children to strengthen their immunity against the dengue fever virus and up to two billion doses for immunization catch-up, with 80% in the nations with dengue endemic for being in the public sector. also, it was estimated that for the traveler market, 59 to 89 million doses would be needed. recently, there have also been reports of dengue fever vaccine that has been produced and approved for use in some countries (lee et al., 2015). specifically, such vaccines have been deployed in countries in which a high risk of dengue has been reported. nevertheless, there might be an impediment toward dengue vaccine strategic adoption in some specific areas, especially in lowand middle-income nations (lee et al., 2015). such nations normally encounter difficulties in making decisions about how to allocate their limited budgets to cover vaccines, which are very expensive to produce. hence, they are faced with budget constraints (hadisoemarto and castro, 2013). thus, it is very important to fully understand the benefits of public dengue vaccination programs in terms of preventing the diseases and incurring even greater social and economic costs if vaccinations were not given. such an understanding is crucial before bringing proposals for a vaccination program to the public sector or to private markets (harapan et al., 2017). khon and seenprachawong: the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia international journal of economics and financial issues | vol 10 • issue 6 • 2020 131 among all five of the studies cited above, not one evaluates a nation’s ability to financially subsidize a public dengue vaccination program. nor do any examine how much the public would be willing to pay for such a program. however, there is a study of public demand of a free hiv vaccination program that used the double bounded cvm format followed by an open-ended question to estimate the mean willingness to pay for a vaccination program (agmapisarn, 2009). a 600-split sample survey was conducted by asking respondents aged 20-60 years old living and working in bangkok whether they were willing to pay (wtp) to support an hiv vaccination program using either a 30% or 70% effectiveness vaccine with an initial tax payment of either 500, 1500, 2000, 3500, 5000, or 6000 baht. the mean wtp values that were found were 2050 baht and 1746 baht for 70% and 30% effectiveness, respectively. the author recommended that, in addition to people using condoms to prevent hiv infection in the meantime, when a vaccine becomes available the thai government should use a progressive tax to fund such a program. as we have described above, most research so far has estimated private demand for a dengue fever vaccine at country level. however, none has evaluated a nation’s ability to subsidize a public dengue fever vaccination program nor examined how much the public is willing to pay for it. our objective here is to derive a useful insight into the demand among cambodian households (including both sexes) as to how much they are willing to pay to support a 1-year public dengue fever vaccination program. 3. methods 3.1. contingent valuation method (cvm) we employ a double-bounded approach with open questions at the end to derive an estimation of how much people surveyed would be willing to pay for dengue fever vaccine coverage as shown in figure 1. initial payment amount levels were 50,000, 150,000, 200,000, 350,000, 500,000, and 600,000 riel, respectively. when respondents gave a yes answer to the initial rate, we followed up by posing further questions for the respondents to answer, presenting them with a higher rate (hr) equal to one and a ½ times of initial rate. however, when respondents answered “no” to the initial rate (r), we gave them another question, offering them a lower rate (lr), equal to two-thirds of the initial rate as shown in table 1. in the last stage, we asked respondents to state the maximum amount they would be willing to pay to support a dengue fever vaccination program. if respondents stated that their maximum level of wtp was not zero, then we continued asking them more questions to identify the reason that they gave this amount for the program. moreover, if the respondents gave a zero amount for wtp for the program, then we asked them again the questions to find the reason why they were willing to give nothing at all for the program. this is a confirmation question to truly identify whether a zero amount of wtp for the program is valid or biased. if we found that respondents who gave a zero wtp for the program were biased, then the answers of those respondents were categorized as “non-response.” in addition, all respondents were advised to consider their budget constraints, and we also informed them that there were no right or wrong answers for this interview. moreover, in order to make sure that they told us the truth, we have talked with them using a cheap talk script before starting the interview to encourage them to answer truthfully. 3.2. survey sampling in this study, we randomly selected 600 samples and conducted interviews in phnom penh, the capital city of cambodia. the population in phnom penh accounts for 14% of the total population of the country. moreover, there is a vast inflow of migrants from across the nation. this has made phnom penh the nation’s largest city and one with fast economic growth. at the same time, this has increased social pressures and has aggravated problems such as slums and sanitation, resulting in phnom penh having the greatest number of dengue fever cases in the country. we used multistage sampling since a sampling frame was not needed in this method. moreover, multistage sampling is easier and less expensive than a single-stage random sampling when we use a cvm to survey a huge population (bateman et al., 2002). the defined targeted population was people aged 20-60 years old with cambodian nationality since these people are the taxpayers and the ones who have been living and working in phnom penh regardless of where they originally came from. we then used a multistage random sampling with three-stage sampling. first, we randomly selected a sample from 6 of the 12 districts or “khan” in phnom penh. after that we set a quota that took into account population density in order to select sample units in the second stage within each sample district. as a result, we selected the sample within a district by its proportion to the population density of each district. hence, we ended up with a total sample of 600 selected units. with regard to the sampling of 600 respondents, we randomly selected any person aged 20-60 years old in each sampling quota to form a final stage sample choice, as shown in table 2. randomly selected individuals had to be cambodian nationals and taxpayers who had a job in phnom penh, regardless of where they originally came from. table 2: multistage area sampling of 6 sampled districts conducted in the survey sampled district area (km2) population population density sampled quota chamkar mon 10.56 182,004.00 17,235 98 doun penh 7.44 126,550.00 17,009 96 prampir makara 2.21 91,895.00 41,581 235 tuol kork 7.99 171,200.00 21,427 121 dangkao 197.89 257,724.00 1,302 7 mean chey 43.79 327,801.00 7,486 42 total 269.88 1,157,174.00 106,040.98 600 source: (municipality of phnom penh, 2004) table 1: the wtp rate structure for respondent’s bid initial rate (r) higher rate (rh) lower rate (rl) 50,000 75,000 30,000 150,000 225,000 100,000 200,000 300,000 130,000 350,000 525,000 230,000 500,000 750,000 330000 600,000 900,000 400000 https://en.wikipedia.org/wiki/chamkar_mon_section https://en.wikipedia.org/wiki/doun_penh_section https://en.wikipedia.org/wiki/prampir_meakkakra_section https://en.wikipedia.org/wiki/tuol_kouk_section https://en.wikipedia.org/wiki/dangkao_section https://en.wikipedia.org/wiki/mean_chey_section khon and seenprachawong: the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia international journal of economics and financial issues | vol 10 • issue 6 • 2020132 3.3. research design the dengue fever vaccine program will be a 1-year program and it will be free to the public. the dengue fever vaccine itself will be separated into two different levels in terms of its effectiveness, namely, 40% and 80%, in order to protect our target group of cambodian citizens aged 20-60 years old. we also created different levels of 1-time income tax surcharge from which respondents were to choose: 50,000, 150,000, 200,000, 350,000, 500,000, 600,000 riel, respectively. this range of 1-time income tax surcharge payment was to be matched with the two different levels of effectiveness of the dengue fever vaccine. hence, there were 12 possible outcomes from combinations of tax payment rates and of dengue vaccine effectiveness (table 3). the sample size of 600 will be significantly depending on the sample of the fifty interviewed respondents per sampling point in every dengue fever vaccine effectiveness and range of tax payment rate combination. we also use the split sample approach to make an estimation on the wtp of respondents and testify the respondents’ answer consistency and reliability. (whittington, 1998; 2004). consequently, each sample in the survey was randomly given the question on their wtp for dengue fever vaccine program regarding to its level of effectiveness as well as the range of tax payment rate from 12 combinations (table 3). 3.4. contingent valuation scenario in order to make our respondents understand our scenario, we used illustrations in order to create a clear understanding about dengue fever vaccine’s effectiveness in the context of a contingent valuation scenario approach. the cv scenario is as follows: dengue fever is an epidemic disease caused by a mosquito-borne flavivirus that can spread to most tropical and subtropical regions. dengue fever viruses 1-4 are the main viruses that cause the illness. dengue fever vaccine is a protective method to prevent and control the spread of dengue fever infection, especially in cambodia. as mentioned previously, dengue fever vaccine in this study paper consists of two different levels of effectiveness (40% and 80%) and has no side effects on recipients. moreover, its effectiveness will last for 5 years or more, which can protect a household from getting infected by the four types of dengue fever virus. household members need to be injected with three doses of dengue fever vaccine 6 months apart. after receiving all three doses, recipients will be protected from dengue fever infection. in addition, figures 2 and 3 will also verify the precision and consistency of the explanation of our dengue fever vaccination program among the enumerators, who are the persons employed for taking a census of the population, when they explain and show the scenario illustration to the respondents. hence, this scenario will not just make things easier to understand for respondents. moreover, if respondents give a wrong response to the scenario or if that they do not understand our dengue fever vaccination program scenario, we will use the illustration in the study to prevent scenario misspecification problems. 3.5. the demand model our study aims to determine the public demand for dengue fever vaccination. the public demand for a dengue fever vaccine with regard to both vaccine effectiveness levels (40% effectiveness and 80% effectiveness) are as follows: pr (yes) =f (i, f, c, d, u, v) we wanted to determine whether respondents in public agreed to pay a 1-time income tax surcharge by using their annual income tax liability according to household monthly income (i); family composition or size (f) refers to the number of family members; household characteristics (c) include age, gender, occupation, education, marital status; the dengue fever variable (d) refers to awareness of dengue fever issues, general knowledge about dengue fever, and experience with dengue fever disease infection; vaccine effectiveness understanding variables (u) refer to understanding that dengue vaccine has two table 3: sampling of respondents distribution with regard to different vaccination effectiveness and range of tax payments target total sample=600 (n=600) vaccine effectiveness 40% (n=300) 80% (n=300) tax payment=r 50000 50 50 tax payment=r 1,50000 50 50 tax payment=r 2,00000 50 50 tax payment=r 3,50000 50 50 tax payment=r 5,00000 50 50 tax payment=r 6,00000 50 50 figure 1: the double-bounded format with open-ended following questions diagram. y y = yes/yes, y n = yes/no, n y = no/yes, n n = no/no figure 3: dengue fever vaccine with 40% level of effectiveness source: (do et al., 2006) khon and seenprachawong: the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia international journal of economics and financial issues | vol 10 • issue 6 • 2020 133 figure 2: dengue fever vaccine with 80% level of effectiveness levels of effectiveness (40% and 80%); and effectiveness level of the vaccine (v) refers to a vaccine whose effectiveness is either 40% or 80%, respectively. we also created the table of variables description in the public demand for dengue fever vaccination program with coefficients expected sign as shown in table 4. 4. results a total of 600 people aged 20-60 years were successfully interviewed during the period july 2019-february 2020. the response rate for interviewees was 95%. our study compensated for this by adding khon and seenprachawong: the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia international journal of economics and financial issues | vol 10 • issue 6 • 2020134 more survey interviews to obtain a total number of 600 survey interviews. we profiled respondents in terms of (1) sociodemographic characteristics, (2) knowledge, experiences, and awareness of dengue fever, and (3) understanding of vaccine effectiveness. 4.1. sociodemographic characteristics of the 600 people randomly selected in our survey in phnom penh, 57% were female with an average age of 31, and 60% were single. almost two-thirds (65.7%) had completed at least a university degree, and 78.7% were employed in the private sector. the average household size was 4.5 persons, and those with household members aged <9 years old living in the same household accounted for 51.2% (table 5). 4.2. knowledge, experience, and awareness of dengue fever of the 600 respondents in our survey, only 89.5% answered correctly all 5 questions regarding knowledge, experience, and awareness of dengue fever. as for the knowledge of dengue fever (table 6), more than 90% believed that the risk of dengue fever table 5: sociodemographic characteristics of respondents variable descriptive mean s.d tax payment rate tax payment rate (as in logarithm form, in riel) 12.356 0.840 monthly income household monthly income (continuous in logarithm form, riel) 14.255 0.431 household monthly income (continuous form, riel) 1,705,900.000 792,826.471 male gender=1 if male, 0 if otherwise (female as a base) 0.432 0.496 age age of respondents (continuous, years) 30.793 7.648 married marital status=1 if married, 0 otherwise 0.595 0.491 schooling the number of years in school of the respondents (continuous, years) 15.402 2.458 private occupation status=1 if private, 0 otherwise (public as a base) 0.787 0.410 household number of household members (continuous, persons) 4.532 1.322 children 1 if respondent has children aged <9 years living in the same household, 0 otherwise 0.512 0.500 table 6: knowledge, experience and awareness of dengue fever variable descriptive mean s.d mosquitohome 1 if respondent believes that risk of dengue fever transmission has been reduced by having reducing mosquito’s shelter, 0 otherwise 0.910 0.286 sleepingnet 1 if respondent believes that we reduce the risk of getting dengue fever infection by sleeping under a net, 0 otherwise 0.895 0.307 healthylook 1 if respondent believes that a healthy-looking person can get infected to dengue fever, 0 otherwise 0.902 0.298 mosquitobite 1 if respondent believes that a person can get dengue fever infection from mosquito bites, 0 otherwise 0.905 0.293 death 1 if respondent believes that a person can die by getting infected by the dengue fever virus, 0 otherwise 0.900 0.300 known 1 if respondent knows anyone who had got infected by dengue fever virus, 0 otherwise 0.977 0.151 curable 1 if respondent has heard that dengue fever is now curable, 0 otherwise 0.990 0.100 transmission 1 if respondent believes that mosquitos are the major cause of dengue fever spreading, 0 otherwise 0.922 0.269 children-infect 1 if respondent believes that children are more likely to get dengue fever, 0 otherwise 0.952 0.215 kidpriority 1 if respondent believes that the government should prioritize children as the first vaccinated group, 0 otherwise 0.908 0.289 prevention 1 if respondent believes that dengue fever vaccine is the most advanced method to prevent dengue fever diseases, 0 otherwise 0.910 0.286 table 4: variables descriptions in the public demand for dengue fever vaccination program with coefficients expected sign variables descriptions expected sign independent variables household income monthly income household monthly income (continuous in logarithm form, riel) positive socioeconomic and demographic variables gender male=1, 0 if otherwise (female gender as a base) n/a age respondents’ age (continuous, number of years) negative marital status married=1, 0 if otherwise (single/divorce/widow/separated as a base) n/a schooling the number of years in school of the respondents (continuous, years) positive private occupation status=1 if private, 0 otherwise (public as a base) n/a household number of household members (continuous, persons) negative children 1 if respondent has children aged <9 years living in the same household, 0 otherwise positive knowledge, experience, and awareness knowledge dengue fever knowledge=1 if respondent answered all 5 questions correctly, 0 otherwise positive known 1 if respondent has any family member has had dengue fever, 0 otherwise positive curable 1 if respondent has heard that dengue fever is now curable, 0 otherwise positive understanding of vaccine effectiveness understanding 1 if respondent passed all three questions on the understanding of vaccine effectiveness, 0 otherwise positive vaccine characteristic and program 80% effectiveness 1=vaccine is 80% effectiveness, 0 otherwise (40% vaccine effectiveness is a base) positive khon and seenprachawong: the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia international journal of economics and financial issues | vol 10 • issue 6 • 2020 135 found that respondents who were married tend to pay higher wtp compared to the base group which were single/divorce/widow/ separate, and this might because of married respondents tend think more about others, especially family members. in addition, our study results showed that people work in the public sector (base group) tend to pay higher wtp compared to people working in the private sectors. this might because of our respondents in the private sector that we randomly selected were mostly junior employees with low salary and small income, while respondents working in the public sector that we randomly selected were mostly senior officials with higher income lever. 4.4.2. the estimation of the tobit model our study was based on double-bounded format with the following open-ended question to make an estimation on households’ transmission would be reduced by reducing areas where mosquito shelter and breed and by sleeping under a mosquito net. they also believed that a healthy-looking person can get infected by dengue fever. more than 90% of respondents knew that a person can get infected by dengue from mosquito bites. surprisingly, almost 8.8% of respondents believed that a person cannot die from getting infected. regarding the experiences of dengue fever, 97.7% of respondents had known someone who had dengue fever, and almost 99% of the respondents believed that dengue fever is now curable. on the other hand, 2.03% of respondents had never known anyone who had contracted dengue fever, and 1% did not believe that dengue fever was currently curable (table 6). in terms of dengue fever awareness, more than 90% of respondents believed that mosquitos are the major cause of dengue fever spreading and that children are tend to get infected. in addition, 90.8% of respondents thought that the government should prioritize children and vaccinate them first if a dengue fever vaccine becomes available, and 91% of respondents believed that dengue fever vaccine is the most advanced method to prevent dengue fever diseases. 4.3. understanding of dengue fever vaccine effectiveness almost 100% of respondents demonstrated that they fully understand vaccine effectiveness of either the 40% or 80% variety by correctly answering all three questions regarding vaccine effectiveness. with the aid of our visual card, respondents had a better grasp of vaccine effectiveness during our explanation of either 40% or 80% effectiveness (table 7). 4.4. estimation of the demand model regarding the demand analysis, our study has divided it into two sections: (1) the result of analysis on factors influencing a household’s willingness to pay a certain amount to support a dengue fever vaccination program, and (2) the estimation of mean willingness to pay (wtp). our analysis of the demand for a free dengue fever vaccination program is discussed below. 4.4.1. the factors influencing a household’s willingness to pay a certain amount to support dengue fever vaccination program the study result shows that the factors influencing a household’s willingness to pay a certain amount to support dengue fever vaccination program are income, gender (male), occupation (private), marital status (married), and education (number of years spent in school). as shown in the table 8, income, occupation (private), and education (number of years spent in school) are all statistically significant with a 5% significance level. meanwhile, gender (male) and marital status (married) are also statistically significant, at a 10% significance level. moreover, based on results presented in table 8, income, and education (number of years spent in school) have positive coefficients. the results also showed that male respondents tend to pay more compare to the base group which was female respondents, and this might because of the culture of cambodian people which male are the family leader and have higher power in decision making. our study results also table 7: understanding of vaccine effectiveness variable descriptive mean s.d understanding 1 if respondent passed all three questions on the understanding of vaccine effectiveness, 0 otherwise. 0.992 0.091 table 8: factors influencing a household’s willingness to pay a certain amount to support a dengue fever vaccination program independent variable coefficient standard error p value mean constant −238,689.056 69,518.760 0.001 income 0.074*** 0.005 0.000 1,705,900. 000 number of family member 5451.413 5451.413 0.076 4.532 number of kids −13,706.251 10,738.729 0.202 0.512 age 840.281 631.211 0.183 30.793 male 17748.043* 7647.557 0.020 0.432 private -36492.592*** 9780.155 0.000 0.787 married 30898.091* 13,207.687 0.019 0.595 education 12703.760*** 1789.196 0.000 15.402 curable −21,959.155 12,659.904 0.083 0.910 known −33,305.952 23,952.136 0.164 0.977 knowledge 15,061.254 35,935.189 0.675 0.990 vaccine understanding 37,121.323 39,091.814 0.342 0.992 vaccine effectiveness −3806.640 7772.036 0.624 0.500 *p<0.05; **p<0.01; ***p<0.001 table 9: significant variables in the tobit model for vaccine with 40% effectiveness level independent variables coefficient standard error p value mean primary index equation for model constant −108,077.267 36,150.085 0.003 male 11,560.152 9904.934 0.243 0.350 private −38,478.587 17,217.118 0.025 0.920 education 6763.750 2044.935 0.001 14.957 income 0.079 0.007 0.000 1,529,000 .000 married 23,302.743 9114.046 0.011 0.537 disturbance standard deviation sigma | 78,061.8827 3186.86302 0.000 khon and seenprachawong: the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia international journal of economics and financial issues | vol 10 • issue 6 • 2020136 willingness to pay for a dengue fever vaccination program. therefore, in the open-ended question, we can use the tobit model to estimate the mean of households’ willingness to pay to support the dengue fever vaccination program by using the formula as below: ( ) )z )( (      = φ + −z z e wtp • e(wtp): is the mean of households’ willingness to pay to support the dengue fever vaccination program • φ: is the cdf of standard normal • ϕ: is the pdf of standard normal • z: is the mean of economic variables • β: is the coefficient of variable • σ: is the sigma value. table 8 presents results showing that the factors influencing a household’s willingness to pay to support dengue fever vaccination program are income, gender (male), occupation (private), marital status (married), and education (number of years spent in school). income, occupation (private), and education (number of years spent in school) are all statistically significant, at a 5% significance level. meanwhile, gender (male), and marital status (married) are all statistically significant at a 10% significance level. thus, we will take only these statistically significant independent variables to run in the tobit model to calculate the estimation of e(wtp) for both levels of vaccine effectiveness by using the limdep program as show in the table 9 for vaccine with 40% effectiveness and table 10 for vaccine with 80% effectiveness. from the calculation in the tobit model using the formula above, we found that the mean of households’ willingness to pay to support the dengue fever vaccination program is 98,841 riel and 149,124 riel for the 40% and 80% levels, respectively. 4.4.3. the estimation of the tobit model regarding our contingent valuation method (cvm), our study was based on a double-bounded format along with the following openended question to make an estimation of households’ willingness to pay for a dengue fever vaccination program. we used the logit and probit model to estimate the mean willing to pay for a dengue fever vaccination program by using the formula e(wtp) = α/β. from our calculation, we found an estimation of e(wtp) of dengue fever vaccination program for both models (table 11). since the logit model has the higher log likelihood function than in the probit model, our study will take the households’ mean willingness to pay to support the dengue fever vaccination program from the logit model, thus, 392,429 riel and 315,482 riel for the vaccine with 40% and 80% effectiveness, respectively. 4.4.4. mean willingness to pay regarding the split sample survey on two types vaccine effectiveness (40% and 80%), our results (table 12) show that respondents with 80% vaccine effectiveness were willing to pay more, compared to what they were willing to pay for 40% (lower) vaccine effectiveness. for instance, the yes/yes response to an initial tax payment of 50,000 riel, 50% of respondents supported the dengue fever vaccination program, whereas only 34% were willing to pay for the 40% effective vaccine. table 13 shows that the e(wtp) of the vaccine with 80% effectiveness is147,803 higher than the e(wtp) of the vaccine with 40% effectiveness, which is 100,109. this makes sense because households are willing to pay more for a vaccine with table 12: distribution of responses by various initial rate of tax payment in double-bounded format vaccine effectiveness y/y y/n n/y n/n 40% 80% 40% 80% 40% 80% 40% 80% n % n % n % n % n % n % n % n % initial rate=50,000 17 34 25 50 21 42 18 36 7 14 7 14 6 12 0 0 initial rate=150,000 0 0 6 12 22 44 26 52 2 4 8 16 26 52 11 22 initial rate=200,000 0 0 0 0 19 38 25 50 0 0 0 0 31 62 25 50 initial rate=350,000 0 0 0 0 12 24 13 26 4 8 4 8 34 68 33 66 initial rate=500,000 0 0 0 0 5 10 6 12 1 2 15 30 44 88 29 58 initial rate=600,000 0 0 0 0 1 2 1 2 0 0 2 4 50 100 47 94 n=number of respondents; %=percentage of respondents willing and able to pay for our dengue fever vaccination program with different rate of tax payment (in riel) and vaccine effectiveness (in percent); y/y=yes/yes; y/n=yes/no; n/y=no/yes; n/n=no/no; and total number of respondents per rate of tax payment and each vaccine effectiveness equal to 50 persons table 10: significant variables in the tobit model for vaccine with 80% effectiveness level independent variables coefficient standard error p value mean primary index equation for model constant −22,5741.823 46,824.792 0.000 male 33,621.401 11,205.478 0.003 0.513 private −35,920.446 13,061.816 0.006 0.653 education 14,270.850 2696.050 0.000 15.847 income 0.074 0.007 0.000 1,882,800. 000 married 19,820.906 12,388.565 0.110 0.653 disturbance standard deviation sigma | 94,789.9157 3869.78211 0.000 table 11: the result of mean willingness to pay for dengue fever vaccination program by using logit and probit model model vaccine effectiveness 40% 80% wtp log likelihood function wtp log likelihood function logit model 392,429 506.2477 315,482 490.0306 probit model 392,046 506.2299 320,772 489.8935 khon and seenprachawong: the public demand for a dengue fever vaccine: a contingent valuation survey in phnom penh, cambodia international journal of economics and financial issues | vol 10 • issue 6 • 2020 137 greater effectiveness. while for the logit model it doesn’t make sense because the e(wtp) of the vaccine with 40% effectiveness is higher than the e(wtp) of the vaccine with 80% effectiveness. therefore, our study chose the mean wtp from the tobit model to be the household’s mean willingness to pay for supporting the dengue fever vaccination program. compare our result to other research studies in a few countries such as vietnam (us$ 67.4 for three doses), indonesia (us$ 16.16 for three doses), philippines (us$ 81.3–96.9 for three doses), brazil (us$ 33.6 for three doses), and our study in cambodian (98,841149,124 riel or us$24 – us$36 for three doses; cambodian exchange rate us$1=4,106 riel). 4.5. cost-benefit analysis of dengue fever vaccination program the cost of illness of dengue fever includes direct medical cost and indirect cost. the direct cost of dengue fever are the cost of drug and the cost of hospitalization. meanwhile, the indirect cost of dengue fever is the productivity loss from being ill. from a study research in yogyakarta found that the direct cost of dengue fever in average was us$ 350 and indirect cost of dengue fever in average was us$ 142. therefore, the cost of illness of dengue fever in average was us$ 492 (supadmi, izzah, suwantika, perwitasari, & abdulah, 2019). the cost of dengue fever vaccine was around us$20–us$25 per dose. moreover, we need to inject three doses of dengue fever vaccine 6 months apart to get the full protection from dengue fever virus. therefore, the total cost of dengue fever vaccine for the full protection is around us$60–us$75. thus, the social cost of dengue fever vaccine is us$75 (pang & loh, 2017). our study result shows that household’s wtp for dengue fever vaccination program is 98,841-149,124 riel or us$24 – us$36 (cambodian exchange rate us$1=4,106 riel). thus, the social benefit that we can get from the dengue fever vaccination program is us$36. therefore, we found that this dengue fever vaccination program’s social benefit is less than its social cost. then, it is not worth to launch this dengue fever vaccination program. 5. discussion and conclusion the result showed that there was a potential-demand for dengue fever vaccination program. our study used logit, probit, and tobit model to calculate the mean wtp for dengue fever vaccination program, and we found that the result from tobit model is more reliable and makes sense accordance to household’s behavior. from tobit model, the mean of households’ willingness to pay to support the dengue fever vaccination program were 98,841 riel and 149,124 riel for 40% and 80% level, respectively. our study had two limitations. first, this study concluded survey of cambodian residents only in phnom penh metropolitan area which does not represent the whole country of cambodia. second, the question in our questionnaire might be too easy to answer since it was general questions about the knowledge, experience, and awareness of dengue fever. that might be the reasons that almost all respondents answer correctly for all questions which made no difference for our result. the study results would suggest some policy implications as follow. first, it recommends that policymakers should not provide a dengue fever vaccination program because this dengue fever vaccination program’s social benefit is less than its social cost. then, it is not worth to launch this dengue fever vaccination program. second, the government should use a combination of strategies to prevent dengue fever infection. cleaning up and treating areas where mosquitos proliferate and providing mosquito nets would be the most indispensable parts of this combined prevention strategy. the cambodian government should also launch a dengue fever prevention campaign along with access to information about dengue fever, especially for kids. last, the government should provide knowledge, skills, and promote the dengue fever awareness for behavior change nationwide, for example, by knowing how to detect one’s own dengue fever status, knowing about risks, knowing how to protect oneself from dengue fever, being careful about one’s health in general, and living in a clean environment. the government should employ a combination of all the above strategies to halt dengue fever. references agmapisarn, c. 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(2004), ethical issues with contingent valuation surveys in developing countries: a note on informed consent and other concerns. environmental and resource economics, 28(4), 507-515. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2022, 12(4), 28-33. international journal of economics and financial issues | vol 12 • issue 4 • 202228 a study on cryptocurrency investors’ purchase intentions: revisiting the brand personality theory jyothi chittineni* finance and accounting, ibs hyderabad, the icfai foundation for higher education, (declared as deemed-to-be university u/s 3 of the ugc act 1956), dontanapally campus, shanker pally road, hyderabad, india. *email: jyothi.kurra@gmail.com received: 14 march 2022 accepted: 20 june 2022 doi: https://doi.org/10.32479/ijefi.13102 abstract this paper aims to identify the factors affecting the investment decision of retail investors to add crypto assets to their portfolios. the personality theory and the innovation diffusion theory are used in this study to understand the characteristics that influence investors’ buying intentions. the study results show that the retail investors’ purchase intentions are influenced by familiarity with the asset, trust, risk and return profile of the asset class, and the perceived security of the investor. the study also examines the role of innovativeness as a moderating variable in the relationship between purchase intentions and the primary variables. the study confirms that innovativeness has a significant mediating role in the relationship between purchase intentions and trust and also in the relationship between purchase intentions and perceived security. the results indicate that innovativeness has no significant moderating impact on the relationship between purchase intentions and familiarity and also on the relationship between purchase intentions and risk and return consciousness. keywords: cryptocurrency, structural equation model, personality theory, innovative diffusion theory and purchase intention jel classifications: g11, g14 1. introduction since the introduction of the first cryptocurrency in 2008, the market has seen a boom in crypto assets. as of march 2nd, 2022 over 400 cryptocurrencies (https://coinmarketcap.com/all/views/ all/) were trading on crypto exchanges, with a market capitalization of usd 2.04 trillion (https://www.coingecko.com/. bitcoin (btc), ethereum (eth), tether (usdt), binance coin (bnb), u.s. dollar coin (usdc), xrp (xrp), terra (luna), cardano (ada), solana (sol), and avalanche (avax) are the top 10 cryptocurrencies according to the market capitalization as of march 1, 2022. the prices and the trading volumes are exponentially growing but there is no consistency among the different brands of these crypto-currencies. there exists a positive correlation among a few currency brands such as btc, eth, bnb, and usdc and there is a negative association among the other cryptocurrency brands such as xrp, luna, and usdt. despite the fact that there is no regulatory body, it is not a legal tender in many more countries, and there is no underlying asset to drive the price of these assets, still cryptocurrency market is growing with an annual compounding growth of 150%. the investor’s purchase intention is the driving factor for the growth of the cryptocurrency market. the bubble-like behavior exposes the need for research on determinants of investors’ purchase intentions for cryptocurrencies. banking is regulated by central banks, so people save their money at banks. because the stock market is regulated by sebi, people invest in it. a cryptocurrency market without a regulator or issuing authority is growing at a compounded annual growth of 150%. this journal is licensed under a creative commons attribution 4.0 international license chittineni: a study on crypto currency investors’ purchase intensions: revisiting the brand personality theory international journal of economics and financial issues | vol 12 • issue 4 • 2022 29 this study investigates the determinants of the investor’s investment intentions to invest in cryptocurrencies. the paper also examines the relationship between investors’ trust, product familiarity, returns consciousness, and perceived security in the purchase intentions. furthermore, this study aims to examine the role of investors’ innovativeness as a moderating variable in the relationship between trust, familiarity, risk and returns consciousness, and perceived security concerns. 2. review of literature this section presents the earlier research studies conducted on cryptocurrency. daniel et al. (2016), kaiser and stöckl (2020) investigated the investor’s herding behavior and technology acceptance theory in the cryptocurrency market. rubbaniy et al. (2021) conducted a study on 382 cryptocurrencies to understand the linkage between herding behavior and the investor’s mood. a study by telli and chen (2021) examines the relation between cryptocurrency market performance and the public interest and attention. rubbaniy et al. (2021), yarovaya et al. (2021) conducted a study by using 100 cryptocurrencies to understand the investors’ herd behavior during the covid19 lockdown period. the other set of literature aims to understand the impact of social media posts, google search engine search keywords, new events, purchase intention, and the cryptocurrency market performance (gurdgiev and o’loughlin, 2020; poongodi et al., 2021; tandon et al., 2021; al guindy, 2021; smales, 2022). chuffart (2021) investigates the role of social media and the google search engine on the dynamics of conditional correlation among the cryptocurrency prices. recent literature focused on the investor’s acceptance, sentiments, and buying intentions (sun et al., 2021), gaies et al. (2021), jonker (2019), alshamsi and andras (2019). flori (2019) bitcoin’s contribution to various portfolio construction strategies, along with other asset classes, others investigated the cryptocurrency price determinants. guizani and nafti (2019), the economic benefit of cryptocurrency (symitsi and chalvatzis, 2019), volatility spillovers among different cryptocurrencies, determinants for volatility and the other macro-economic factors (katsiampa, 2017). kumar and anandarao (2019), guizani and nafti (2019), policy uncertainty and its impact on bitcoin (wang et al., 2020). most studies have used secondary data such as social media posts, search engine keywords, or fear indexes but few studies have been conducted on primary data to understand the cryptocurrency investors’ purchase intentions. this present study aims to understand the purchase intention of cryptocurrency by employing personality theory, it is widely used in the marketing area to test purchase intentions. this study examines the brand personality theory and innovation diffusion theory in the context of cryptocurrency purchase intention. the key components used in this study to understand the purchase intention are brand familiarity, brand trust, price consciousness, investor’s awareness of the legal and regulatory compliances, and investor innovativeness. 3. theoretical foundations 3.1. familiarity familiarity defines the degree of association with a particular brand or product. a familiarity comes with the previous purchase/ usage experience or from the product promotional activity. earlier research suggests that brand familiarity and purchase intentions are positively associated dickinson and barker, 2007). investors who are more familiar with cryptocurrency brands, crypto exchanges, and trading processes will be more likely to purchase cryptocurrency. h1: familiarity positively affects the purchase intention 3.2. trust cryptocurrency is an electronic currency, and there is no regulatory body or issuing authority for it, hence trust is considered to be the most important aspect to buy, hold and transact it as an asset class. trust toward the cryptocurrency affect the purchase intention positively. h2: trust positively affects the purchase intention 3.3. risk return awareness risk return consciousness indicates the investor’s awareness of the risks associated with the asset class. minimum risk for the expected return is the objective for the optimal portfolio selection. so, investors’ awareness of expected returns and the associated risk is considered for the study. therefore the hypothesis could be. h3: risk and returns awareness positively affects the purchase intention. 3.4. perceived security fiat currency is issued and regulated by the central banks, but there is no regulator or issuing authority for cryptocurrencies. it is created, stored, and transacted on the digital platform called the blockchain. cryptocurrency has the properties of physical cash in a digital format, once lost, it is not easy to recover. as a result, security is foremost important for a service that is handling a significant amount of its customer’s monetary value. according to the earlier research (ganguly et al., 2011), consumer perception about technologies and their security influences their decision-making process. the following is the hypothesis for the same: h4: perceived security positively influences the purchase intension. 3.5. innovativeness innovativeness is the degree to which an individual is comparatively earlier in embracing new ideas than other members. individuals’ inclination to innovate influences the sources of information that they consider for the decision-making process. according to the earlier research innovativeness influences the decision-making process (dabholkar and bagozzi, 2002). chittineni: a study on crypto currency investors’ purchase intensions: revisiting the brand personality theory international journal of economics and financial issues | vol 12 • issue 4 • 202230 innovative people will have a more positive attitude toward accepting the technology and innovativeness acts as a moderating variable on brand familiarity, brand trust, and security concerns about the technology products such as cryptocurrency. the following are the hypotheses concerning the influence of innovativeness on purchasing intentions as a moderator. h5: innovativeness positively affects the purchase intention h6: innovativeness moderates the relationship between brand familiarity and purchase intention h7: innovativeness moderates the relationship between brand trust and purchase intention h8: innovativeness moderates the relationship between risk return consciousness and purchase intention h9: innovativeness moderates the relationship between perceived security and purchase intention. 4. methodology a structured questionnaire is used for data collection. the reliability of the measurement items’ is tested using cronbach’s α and construct validity is tested using barlett’s test of sphericity and the kaiser meyer-oklin (kmo) test is used to examine the validity of the constructs. the survey was conducted on cryptocurrency investors of the coindcx exchange. there were 1228 who participated in the survey, and 115 questionnaires were excluded from the analysis due to missing values. the results are based on data from 1113 participants. three items from dickinson and barker (2007) were used to measure familiarity. the statements are as follows: 1. “i am familiar with some of the cryptocurrency names” 2. “i know some of the cryptocurrency brand names” 3. “i can identify cryptocurrency logos” three constructs from reast (2005) were used to measure the trust. the statements are as follows: 1. “i know some trust worthy cryptocurrency brands” 2. “i trust cryptocurrencies because they are built on blockchain technologies” 3. “ i know some cryptocurrency brands keep promises” the following are the statements used to measure the risk and return consciousness. these items are taken from wakefield and inman (2003). 1. “i keep searching for some cryptocurrency brands with good returns to include them my portfolio” 2. “i follow news articles to understand the risk and returns of cryptocurrencies” 3. “the time and cost spend reading the news about cryptocurrencies is worth” to understand the effect of perceived security on purchase intension the following two statements are used: 1. “i believe that the blockchain technology is robust in all measures” 2. “i believe that my cryptocurrency transactions are safe” 3. “i belief that my crypto currency wallets is as safe as my physical wallet” three statements from san martín and herrero (2012) were used to test the effect of innovativeness. the following are the statements 1. “i like to try new things” 2. “i like to try out the new things” 3. “if there is any new investment avenue i would look for ways to experiment with it” these three statements were taken from sun, dedahanov, shin, kim, and trinidad segovia (2020) to test the purchase intention construct. listed below are the three statements used in the study. 1. “i am willing to purchase cryptocurrency” 2. “i plan to invest in cryptocurrency” the responses were recorded on a seven point likert scale, 1 representing strongly disagree and 7 representing strongly agree. the proposed model is presented in figure 1. 5. data analysis and results the partial least square technique is used because it facilitates the analysis of constructs using formative indicators when computing path coefficients that are significantly different from zero. this technique avoids using rigid distributional assumptions. therefore, pls is an appropriate strategy for this investigation. 5.1. results in this section, the survey results of 1113 participants are discussed. among 1113 participants, 81.04% were males and 18.96% were females. the majority of respondents were aged between 30 and 40 (51.12%). most of the respondents have a post-graduate degree (54.9%). the majority of the respondents have experience in trading activity and there are 40.43% of the respondents have more than 6 years of experience in equity trading. the proportion of cryptocurrency in the majority of the respondents’ portfolios is 5-10% of their total portfolio value. the majority of the respondents bought cryptocurrency for a speculative purpose (67.38%) and only a few of the respondents bought cryptocurrency for other reasons. the reliability of the measures is important to understand. the estimated cronbach’s alpha coefficient value was exceeded for all measures (0.68). the cronbach’s alpha coefficient values lie between 1 and 0. if the test value exceeds 0.6, then it is considered that the reliability of the measurement scales is sufficient. the composite reliability shows the internal consistency of variables and the results are presented in table1. a composite reliability coefficient value greater than 0.7 indicates good internal consistency of the measures. the composite reliability estimated coefficient is higher than 0.811 for all the constructs. the ave is a measure to understand how far the statistical sampling result differs from the predicted value. the test ave chittineni: a study on crypto currency investors’ purchase intensions: revisiting the brand personality theory international journal of economics and financial issues | vol 12 • issue 4 • 2022 31 table 2: discriminant validity, correlation matrix among the constructs and ave results familiarity trust risk and return consciousness perceived security innovativeness purchase intention familiarity 0.856 trust 0.568 0.915 risk and return consciousness 0.145 0.365 894 perceived security 0.384 0.452 0.156 0.912 innovativeness 0.651 0.495 0.254 0.451 0.861 purchase intention 0.154 0.511 0.412 0.511 0.485 0.901 square root of ave 0.856 0.915 894 0.912 0.861 0.901 table 3: structural model testing results hypotheses β coefficient t value result familiarity → purchase intention (h1) 0.286 (***) 2.148 significant risk and return consciousness → purchase intention (h2) 0.33 (***) 2.951 significant perceived security → purchase intention (h3) 0.389 (***) 3.478 significant trust → purchase intention (h4) 0.128 (***) 2.15 significant innovativeness → purchase intention (h5) 0.288 (***) 3.02 significant innovativeness*familiarity → purchase intention (h6) 0.051 1.548 not significant innovativeness*risk and return consciousnesss → purchase intention (h7) 0.012 1.294 not significant innovativeness*perceived security → purchase intention (h8) 0.225 (***) 0.254 significant innovativeness*trust → purchase intention (h9) 0.254 (***) 0.219 significant ***p<0.01 table 1: confirmatory factor analysis results variables items factor loadings ave composite reliability cronbach’s alpha familiarity familiarity-1 0.753 0.788 0.895 0.851 familiarity-2 0.851 familiarity-3 0.711 trust trust-1 0.862 0.845 0.912 0.789 trust-2 0.851 trust-3 0.786 risk and return consciousness r&r conciousness-1 0.854 0.712 0.855 0.812 r&r conciousness-2 0.954 r&r conciousness-3 0.912 perceived security perceived security-1 0.856 0.741 0.811 0.721 perceived security-2 0.874 perceived security-3 0.954 innovativeness innovatiness-1 0.712 0.798 0.891 0.819 innovatiness-2 0.847 innovatiness-3 0.765 purchase intention purchase intention-1 0.811 0.791 0.812 0.742 purchase intention-2 0.874 value exceeding 0.5 indicates a good convergent validity scale. in this study, all the ave scores were higher than 0.712. to test the discriminant validity, the square root value of the ave is estimated. the results are presented in table 2. if the estimated value is greater than the correlation coefficients between it and any other construct in the model, then it indicates that the discriminant validity is good for the selected model. the results (table 3) indicate that the model has good discriminant validity. 5.2. structural equation model the reliability and validation test results show that the items used in the model are valid and reliable, hence the constructs are valid to be used in the structural model. the results are presented in table 3. this shows that familiarity, trust, riskreturn consciousness, perceived security, and innovativeness are statistically significant and have a positive effect on purchase intention. the result supports hypotheses h1, h2, h3, h4, and h5. the moderating variable innovativeness has no significant effect in moderating the relationship between familiarity and purchase intention. the moderating effect of innovativeness between riskpurchase intention familiarity cognitive trust perceived security risk return consciousness innovativeness h1 h2 h3 h4 h5 h6 h7 h8 h9 figure 1: structural equation model chittineni: a study on crypto currency investors’ purchase intensions: revisiting the brand personality theory international journal of economics and financial issues | vol 12 • issue 4 • 202232 return consciousness and purchase intention is not confirmed statistically. hypotheses h6 and h8 are not supported by the path coefficients. the moderating role of innovativeness on trust and purchase intention is statistically significant. innovativeness moderately affects the relationship between perceived security and purchase intentions. the results also supported h7 and h9. 6. summary and implications this study investigates the psychological factors that influence the purchase intentions of cryptocurrencies. the constructs considered for the study are familiarity, trust, risk and return consciousness, and perceived security in the behavior of cryptocurrency investors’ intentions. the model also investigates the moderating impact of innovativeness on the relationship between the primary constructs and purchase intention. cryptocurrency, which is on a technology platform in a digital form, is getting more attention from researchers, investors, fund managers, financial advisors, and policymakers with the hope that it will achieve mainstream usage. the empirical test result confirms the impact of primary constructs like familiarity, trust, risk and return intention, and perceived security on purchase intention. the empirical results support the earlier studies. a study by andrew (2018) shows that price consciousness plays an important role in the decision-making process. daniel and lennon (2016) provided pieces of evidence on the role of trust in the cryptocurrency market; also, lou and li (2017) presented the role of innovativeness in accepting a new technology like blockchain. the model results partially confirm the moderating effect of innovativeness on the relationship between the primary constructs and purchase intention. the test result shows that innovativeness has a significant impact on the relationship between purchase intentions and trust. the study results also confirm that the moderating variable innovativeness impacts the relationship between purchase intention and perceived security. contrary to this, the moderating variable innovativeness shows no statistically significant impact on the relationship between purchase intentions and familiarity. innovativeness has no significant impact on the relationship between risk and returns consciousness and purchase intention. lack of moderating effect of innovativeness on the relationship between familiarity and purchase intention and also the lack of moderating effect of innovativeness on the relationship between risk and return consciousness and purchase intentions can be justified in many viewpoints. innovative investors always look for opportunities to get maximum returns by purchasing not so familiar but a potential brands. furthermore, innovative investors are ready to take more risks by investing in cryptocurrencies to maximize returns. innovative investors prefer to invest in initial coin offerings of crypto brands (ico) with the hope to receive higher returns even though cryptocurrency brands are unfamiliar. to conclude, the study results are important for cryptocurrency developers and crypto exchanges. they need to conduct interactive chatbots and video links on the risk and return profiles of the cryptocurrencies on their websites. using social media and digital platforms to make people aware of cryptocurrencies and their logos and brands makes investors familiar with the brands. creating knowledge-sharing social media blogs to address security concerns will boost brand trust. this study is no exception to the limitations. the study was conducted on retail investors and the analysis was limited to 1113 responses from india. the results may vary if the study is conducted in some other country. a cross-country survey is more appropriate to generalize the results and get more insights into the behavioral factors. further studies need to be conducted to consider the respondents from different nations and compare the differences in the behavioral factors between the emerging 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(2021), how can we predict the impact of the social media messages on the value of cryptocurrency? insights from big data analytics. international journal of information management data insights, 1(2), 100035. telli, ş., chen, h. (2021), multifractal behavior relationship between crypto markets and wikipedia-reddit online platforms. chaos, solitons and fractals, 152, 111331. wakefield, k.l., inman, j.j. (2003), situational price sensitivity: the role of consumption occasion, social context and income. journal of retailing, 79(4), 199-212. wang, p., li, x., shen, d., zhang, w. (2020), how does economic policy uncertainty affect the bitcoin market? research in international business and finance, 53, 101234. yarovaya, l., matkovskyy, r., jalan, a. (2021), the effects of a “black swan” event (covid-19) on herding behavior in cryptocurrency markets. journal of international financial markets, institutions and money, 75, 101321. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(3), 537-541. international journal of economics and financial issues | vol 7 • issue 3 • 2017 537 economic impact on financial ratios of food industry at istanbul stock exchange listed firms metin atmaca1*, engin demirel2 1faculty of economics and administrative sciences, canakkale onsekiz mart university, biga campus, canakkale, turkey, 2faculty of economics and administrative sciences, trakya university, balkan campus, edirne, turkey. *email: matmaca20@gmail.com abstract in this study, 22 food and beverage sector companies traded on the istanbul stock exchange were selected as scope for the period 2008-2015. this research aims to investigate the relation between firm’s financial ratios and selected macroeconomic indicators which are income, poverty, and gini coefficient value. time series of financial ratios are obtained from firm’s financial statements. we show that as an economic indicator poverty levels and minimum wage has a significant relation on firm’s financial ratios which are cash ratio, sales profitability ratio, and net working capital ratio. this research found that only poverty level and minimum wage has a positive impact on cash and working capital financial ratios and negative impact on sales profitability ratios of listed firms. keywords: financial ratio, panel data models, food industry, economic impact jel classifications: c23, l61, g30 1. introduction the ratio is a concept coming from latin origin and can be defined as a reasonable relationship between two amounts in the structure of an enterprise. for example, current ratio is expressed as the relationship between current assets and shortterm liabilities of an enterprise (durmuş and arat, 1997). ratio analysis is the analysis of financial statements by using financial ratios. this concept makes it possible to reveal the financial structure, efficiency, profitability, and liquidity position of an enterprise. this analysis allows us to interpret the current status of enterprises and make predictions about their futures (şamiloğlu and akgün, 2010). in this study, financial ratios are calculated by using financial data reported in the financial statements of food and beverage enterprises publicly traded in istanbul stock exchange (ise). in this study, the fact of whether or not there is a relationship between the financial ratios of a company and economic indicators such as net income, gini coefficient value, poverty level, poverty numbers, and minimum wage is analyzed. 2. literature review morrison and siegel (1998) examine the relationship between knowledge capital factors investments in r and d, high-tech and human capital-and cost structure in the u.s food and fiber processing industries from the 1960s through the 1980s. the analysis is made on the basis of the existence and extent of scale economies emanating from these factors. the results of the study imply that the mentioned factors decrease costs depending on the reduction of input use for all privately demanded factors and the effects on private capital are more than the others. ferdaus et al. (2005) examine the effects of financial structure change on the u.s. food manufacturing industry. the effects are evaluated on the basis of production, profitability and productivity growth. the empirical results of the study indicate that whereas the increased debt use of this industry has a negative effect on its output growth, input demand profitability, and total productivity growth, dividend payments have positive effect on production and performance. in addition, the results also imply that negative effect outweighs positive effect. guzmán and arcas (2008) examine the usefulness of accounting information in the measurement of atmaca and demirel: economic impact on financial ratios of food industry at ise listed firms international journal of economics and financial issues | vol 7 • issue 3 • 2017538 technical efficiency in agricultural cooperatives. in this context, they employed the data envelope analysis technique in this study. the results of the empirical study use the data of 247 observations for three accounting years from 2001 to 2003, indicate that the efficiency measures obtained by this technique are complementary to the traditional economic and financial ratio analysis. aydeniz (2009) examines the effects of macroeconomic indicators on the financial performance of the beverage and food firms, publicly traded in ise, by using linear regression analysis. the results of the study show that while profitability rates are affected mostly by consumer price index (cpi) and producer price index, ebit and ebitda are affected mostly by the rate of capacity utilization. moreover, interest rate is found to have a great influence on nopat. szczecińska (2011) demonstrates the results of the analysis of the liquidity strategies of two food companies for the period from 2005 to 2009. ratio analysis and residual profit calculation methods are used in this context. the positive value of the calculated residual profit of both companies confirms the strength of their liquidity strategies in the enhancement of the value of both companies. norvašiene and stankevičienė (2012) investigate the relationship between capital structure and the performance of companies. the results of the study verify the results of many previous studies that a significant negative relationship exists between capital structure and the efficiency of corporate performance. atmaca and kurt (2011) aimed to find out the effects of the global crisis of 2008 on the food companies publicly quoted in the ise. panel data analysis and ratio techniques are used in the analysis. the results of the study reveal that the liquidity structures and quality of the mentioned companies worsen during crisis times. furthermore, the problems related to the liquidity, financial structure and profitability influence profitability and performance levels. demirel et al. (2011) seek out the effects of financial and economic factors on the financial structure of tourism firms. the results of the study reveal that the debt ratio of firms is sensitive to macroeconomic and financial indicators. in this context, while debt coefficient, gnp and interest rate have positive effect on debt structure, account receivables and cash ratios have negative effects on debt structure. azhagaiah and deepa (2012) answer the question of which factors are the determinants of profitability of food industry in india in the context of size-wise analysis. the results indicate that the main determinants of the profitability of small size firms are volatility and growth. in addition, whereas growth is the main determinant of the profitability of medium size firms and capital intensity is the main determinant of the profitability of large size firms. demir and tuncay (2012) investigate the turkish food sector in terms of activity and profitability rates. the analysis is made on the basis of 11 firms publicly traded in ise from 2000 to 2008. the study conveys that the turkish food sector performs positively in terms of activity ratios. however, the situation is not the same in terms of profitability ratios. peeters and albers (2013) analyse empirically the effects of the world food prices on inflation and government subsidies for such north african countries as algeria, egypt, morocco and tunisia and such the middle east countries as israel, jordan, lebanon and the occupied palestinian territories from 2002 to 2011. the study reveals that there is a positive relationship between the rise in the world food prices and inflation and government subsidies. the rise in the world prices increases both inflations in terms of cpi and government food subsidies. fuchs et al. (2013) convey the issues related to the intensified financialization in the global agrifood system and the challenges involved in the definancializiation of it. in addition, the study emphasizes the importance of political developments at all political and societal levels and in different shapes and forms in the identification and assessment of the factors driving and facilitating financialization and its diffusion. epperson and escalante (2013) seek out the effect of eurozone crisis on the u.s. food companies. a system-of-equations approach in which stock prices of well-known u.s. food companies and the s and p index are regressed against such variables as accounting for profitability, the economic wellbeing of both the eurozone and the u.s. is used. the results of the study imply that the u.s. food companies are influenced mainly by the wellbeing of the u.s. economy in contradistinction to the european union food companies. topuz and akşit (2013) evaluate the effect of marketing expenses on stock returns within the context of ise food industry. a panel data regression analysis is used to analyse the effects of marketing, sales and distribution expenses on the stock returns of firms listed in ise food sectoral index. the results reveal the fact that marketing expenses have usually a positive effect on stock returns and a concave relationship exists between them. aydın (2013) analyzes the financial performances of food production firms by comparing turkish and british firms. the analysis covers the period from 2000 to 2012. the results of the study indicate that in spite of some differences in the financial indicators of the food companies in turkey and in the uk, food firms in both countries are in accord with the crisis. avcı et al. (2014) investigate the effects of the global financial crisis of 2008 on financial ratios in the turkish banking sector. in this context, the study tries to answer the question of how the profitability ratios of the banks, members of the ise, are affected pre-global financial crisis and post-2008 financial crisis of 2008 by using panel data analysis. the results of the study indicate that financial crisis usually affects the profitability ratios of the turkish banking sector except for a few exceptions. momcilovic et al. (2015) try to reveal a sustainable growth rate calculation methodology and find out sustainable growth rate for 60 enterprises in the agricultural and food sectors of serbia in 2011 and 2012. the results of the study imply that the opportunity for sustainable growth was rare and there was not a real sustainable growth in the mentioned sectors during that time. geylani (2015) analyses investment and capital adjustment patterns in the u.s. food manufacturing plants. in the beginning, the study both illustrates lumpy nature of investments and implies the necessity of large investments in the food manufacturing industry. the study also uses an investment hazard model to reveal the nature of capital atmaca and demirel: economic impact on financial ratios of food industry at ise listed firms international journal of economics and financial issues | vol 7 • issue 3 • 2017 539 adjustment costs. the results of the study reveal the existence both of convex and non-convex components of adjustment costs. ural et al. (2015) try to predict the financial distress of food and beverage and tobacco companies listed in borsa istanbul (bist) for the period of 2005-2012. the logistic regression model based on the data obtained from their financial reports is used for the empirical analysis. the results confirm that logistic regression model is an appropriate and important tool in the measurement of financial distress. kara and erdur (2015) investigate the determinants of capital structure of companies publicly traded in bist. a panel data analysis is used based on the data related to the financial reports of these companies and the period of analysis goes from 2006 to 2014. the results of the study show that the determinants having an effect on capital structure decisions differ for different industries. moreover, while the financial hierarch theory is valid for the automotive industry, the financial hierarch theory and trade-off theory are valid for food and drink and textile and leather industries. sengottaiyan and nandhini (2016) investigate the liquidity performances of selected food processing companies in india. the results of the study indicate that the liquidity performances are not promising and high fluctuations are common among the sample companies. 3. hypotheses this study aims to investigate the relation between food sector financial ratios and economic indicators related to income, poverty, and gini coefficient value. financial indicators are obtained from firm’s financial statements. turkish lira is used for economic and financial data as local currency. as an economic dependent indicator, we choose net income, gini coefficient value, poverty level, poverty numbers, and minimum wage. for financial ratios, we choose cash ratio, sales profitability ratio, and net working capital ratio. the research aim is that which economic indicator has a positive impact on financial ratios of the food sector. in order to analyse this impact, we test following five hypotheses: h1: net income purchasing power has a positive impact on financial ratios of food sector h2: gini coefficients has a positive impact on financial ratios of food sector h3: poverty level has a positive impact on financial ratios of food sector h4: poverty numbers has a positive impact on financial ratios of food sector h5: minimum wage has a positive impact on financial ratios of food sector. 4. research methodology table 1 represents the summary statistics of variables and table 2 shows the correlation matrix between variables. ise corporate data and public disclosure data are the main sources of financial variables (www.borsaistanbul.com/en/data) (www.kap.gov.tr). we calculate each firm cash ratio, sales profitability ratio, and net working capital ratio. sample period covers the years from 2008-2015. this sample period also covers 22 firms listed on ise. panel data is used to test this series. in order to test stationary, we analyse the unit root test. highest correlation is seen on between cash ratio and poverty level. and another correlation was seen on cash ratio and the minimum wage which both <20%. descriptions of variables on functions can be seen in table 3. economic indicators are year-end turkish lira. this research empirical analysis is based on the following general formula: yit = xitβ+ai+uit, i = 1,2,…,n t = 1,2,…,t, where i = 1,…n is the firm, t is the time period (year-end values), y is the dependent variable, x are independent variables and control variables. tested equations were estimated by using the standard panel data. the null hypothesis indicates selected economic indicators hasn’t a positive impact on firm’s financial ratios. alternative hypothesis indicates there is a positive impact on financial ratio from economic indicators. in order to test our hypothesis, we develop five equations. for each equation α, β, φ, γ, η, are the time constant factors. all equations and notations are as follows: nit = qit+α1csrit+α2spit+α3nwcit+mi+eit (1) ginit = qit+β1csrit+β2spit+β3nwcit+mi+eit (2) table 3: variables, descriptions and measures variable description and measure nit net income purchasing power year end values ginit gini coefficients values logplt poverty level (log values) logpnt poverty numbers (log values) logmwt minimum wage (log values) csrit cash ratio for i firm, t year spit sales profitability ratio for i firm, t year nwcit net working capital ratio for i firm, t year table 1: summary statistics variables minimum standard deviation median mean maximum nit 3.920 3.985 4.050 4.055 4.180 ginit 0.391 0.402 0.402 0.403 0.415 logplt 1.000 3.000 5.000 5.455 9.000 logpnt 3.820 3.830 3.855 3.850 3.870 logmwt 2.810 2.870 2.945 2.947 3.100 csrit 0.000 0.010 0.050 0.160 2.020 spit −11.540 −0.080 0.010 −0.080 1.090 nwcit 9.370 13.340 14.620 14.410 18.490 table 2: correlation matrix variables ni gini logpl logpn logmw csr sp nwc nit 1.00 ginit −0.66 1.00 logplt 0.96 −0.65 1.00 logpnt −0.73 0.68 −0.68 1.00 logmwt 0.99 −0.66 0.96 −0.72 1.00 csrit 0.18 −0.14 0.19 −0.14 0.18 1.00 spit −0.10 0.03 −0.11 0.10 −0.11 0.07 1.00 nwcit 0.13 −0.08 0.12 −0.10 0.13 0.04 0.13 1.00 atmaca and demirel: economic impact on financial ratios of food industry at ise listed firms international journal of economics and financial issues | vol 7 • issue 3 • 2017540 logplt = qit+φ1csrit+φ2spit+φ3nwcit+mi+ei (3) logpnt = qit+γ1csrit+γ2spit+γ3nwcit+mi+eit (4) logmwt = qit+η1csrit+η2spit+η3nwcit+ηi+eit (5) 5. research results we first test the stationary and unit root test. panel regression tests models are pooled ordinary last squares, fixed effects, and random effects. equations are analyzed according to pooled ols crosssection fixed effect and random effect model. fist equation results which net income as an economic indicator can be seen in table 4. equation 1 probability values are significant for p < 0.10 and cash ratio and net working capital ratio has positive coefficient value. sales profitability have negative coefficient value for net income data. for the second equation coefficient values are seen on table 5. as a dependent value, gini coefficient data equation are not significant for financial ratio. individual effect within model results of equation 3 can be seen on table 6. poverty level equation probability values are significant for p < 0.10. sales probability have negative coefficient value for poverty level. cash ratio and net working capital ratio has positive coefficient results. equation 4 model results and coefficient values are indicated on table 7. cash ratio and sales profitability have negative coefficient results for poverty levels as dependent value. for the equation 5 coefficient and estimated results indicated in table 8. equation 5 probability values are significant for p < 0.10 and just sales profitability have a negative coefficient value other financial ratios have positive coefficient value for minimum wage as the dependent variable. all equations, total sum of squares, the residual sum of squares, r-squared, adjusted r-squared, f statistics and probability values summarized in table 9. highest r-squared and adjusted r-squared results can be seen on equation 3 and equation 5. equation 2 and 3 has probability values higher than 0.05 level. all equations lagrange multiplier test, f tests and housman test results summarised in table 10. 6. conclusions this research aims to analyse positive relation on net income purchasing power, gini coefficient, poverty level and numbers, minimum wages on financial ratios of the food sector. we select 3 financial ratios which are cash ratio, sales profitability ratio, net working capital ratio. we found that there is a significant relation on poverty level (equation 3) and minimum wage (equation 5) on financial ratios which are cash ratio, sales profitability ratio, and net working capital ratio. in order to choose fixed and random effects model, we run hausman test where the null hypothesis is that the preferred model is random or alternatively fixed effect. we run the fixed effect and random effect model and perform hausman test. according to results equation 3 has a random effect and equation 5 has fixed effect model. both equations have 0.15 and 0.16 r-squared results. on the other hand, net income, gini coefficient and poverty numbers regression results are relatively low. these economic indicators positive impact on financial ratios r-squared ratios are 0.06, 0.02 and 0.09. as for the financial ratios, sales profitability has negative coefficient estimated results for both poverty level and minimum wage over the time. rather sales profitability has a negative coefficient, cash ratio and the net working capital ratio has positive coefficient estimated results. our analysis is focused on 22 food industry firms listed on ise on given time period years. this study focus on only selected ratio and economic indicator. we conclude that only minimum wage and poverty level has a positive impact on cash and working table 7: equation 4 pooling model results variable estimate standard error t-value p (>|t|) csr −0.0220927 0.0087884 −2.5138 0.01299* sp 0.0029150 0.0018785 1.5518 0.12281 nwc −0.0045582 0.0019018 −2.3967 0.01777* significant codes: *0.05 0.1+1 se: standard error table 8: equation 5 pooling model results variable estimate standard error t-value p (>|t|) csr 0.1467944 0.0420295 3.4927 0.0006276*** sp −0.0156987 0.0089836 −1.7475 0.0825839 nwc 0.0291925 0.0090953 3.2096 0.0016237** significant codes: ***0.001 **0.01, 0.1+1 se: standard error table 4: equation 1 one-way (individual) effect pooling model results variable estimate standard error t-value p (>|t|) (intercept) 3.9377693 0.0539234 73.0252 < 2e-16*** csr 0.0588800 0.0228087 2.5815 0.01067* sp −0.0131956 0.0073065 −1.8060 0.07267 nwc 0.0074060 0.0036979 2.0028 0.04677* significant codes: ***0.001 *0.05 0.1+1 se: standard error table 5: equation 2 pooling model results variable estimate standard error t-value p (>|t|) (intercept) 0.40740554 0.00387311 105.1882 < 2e-16*** csr −0.00311563 0.00163826 −1.9018 0.05887 sp 0.00036516 0.00052480 0.6958 0.48749+ nwc −0.00029503 0.00026561 −1.1108 0.26821+ significant codes: ***0.001, 0.1+1 se: standard error table 6: equation 3 pooling model results variable estimate standard error t-value p (>|t|) csr 3.62642 1.00975 3.5914 0.0004443*** sp −0.35991 0.21583 −1.6676 0.0974682 nwc 0.59828 0.21851 2.7379 0.0069258** significant codes: ***0.001 **0.01, 0.1+1 se: standard error atmaca and demirel: economic impact on financial ratios of food industry at ise listed firms international journal of economics and financial issues | vol 7 • issue 3 • 2017 541 capital ratio. just sales profitability has negative coefficient results over time. also, these results may comparable between emerging financial markets on same industry and it would be enlightening food and beverage industry capital structure related to economic indicator effects. references atmaca, m., kurt, s. (2011), the effect of 2008 global financial crisis on financial ratios of istanbul stock exchange food enterprises: panel data analysis. journal of money, investment and banking, 22, 59-69. avcı, p., demirel, e., atakişi, a. (2014), the effect of 2008 global financial crisis on financial ratios in turkish banking sector. international research journal of finance and economics, 128, 56-64. aydeniz, e.ş. (2009), makroekonomik göstergelerin firmalarin finansal performans ölçütleri üzerindeki etkisinin ölçülmesine yönelik bir araştirma: imkb’ye kote gida ve içecek işletmeleri üzerine bir uygulama. marmara university journal of economic and administrative science, 25(2), 263-277. aydın, s. (2013), an evaluation of the financial performances of food production enterprises: a case of turkey and england. international journal of business tourism and applied sciences, 1(2), 97-108. azhagaiah, r., deepa, r. (2012), determinants of profitability of food industry in india: a size-wise analysis. management, 7(2), 111-128. demir, m., tuncay, m. (2012), analysis of activity and profitability ratios for turkish food sector: a research on firms traded on the ise food sector. sulayman demirel university the journal of faculty of economics and administrative sciences, 17(2), 367-392. demirel, e., atakisi, a., atmaca, m. (2011), financial and economic factors affecting debt ratio and roe; ise tourism firms case. european journal of scientific research, 61(3), 458-466. durmuş, a.h., arat, m.e. (1997), i̇şletmelerde mali tablolar tahlili. 4th baskı. i̇stanbul: marmara üniversitesi nihat sayar eğitim vakfı yayınları. epperson, j.e., escalante, c.l. (2013), the effect of the eurozone crisis on u.s. food companies. journal of food distribution research, 44(1), 75-82. ferdaus, h., ruchi, j., ramu, g. (2005), financial structure, production, and productivity: evidence from the u.s. food manufacturing industry. agricultural economics, 3, 399-410. fuchs, d., meyer-eppler, r., hamenstädt, u. (2013), food for thought: the politics of financialization in the agrifood system. competition and change, 17(3), 219-233. geylani, p. (2015), lumpy investments and capital adjustment patterns in the food manufacturing industry. journal of economics and finance, 39(3), 501-517. guzmán, i., arcas, n. (2008), the usefulness of accounting information in the measurement of technical efficiency in agricultural cooperatives. annals of public and cooperative economics, 79(1), 107-131. kara, e.t., erdur, d.t.a. (2015), determinants of capital structure: a research on sectors that contribute to exports in turkey. istanbul university journal of the school of business, 44(2), 27-38. momcilovic, m., begovic, s.v., tomasevic, s., ercegovac, d. (2015), sustainable growth rate: evidence from agricultural and food enterprises. management journal for theory and practice of management, 20(76), 63-75. morrison, c.j., siegel, d. (1998), knowledge capital and cost structure in the u.s. food and fiber industries. american journal of agricultural economics, 80(1), 30-45. norvaišiene, r., stankevičienė, j. (2012), the relationship of corporate governance decision on capital structure and company’s performance: evidence from lithuanian food and beverages industry companies. economics and management, 17(2), 480-486. peeters, m., albers, r. (2013), food prices, government subsidies, and fiscal balances in south mediterranean countries. development policy review, 31(3), 273-290. şamiloğlu, f., akgün, a.i̇. (2010), finansal raporlama standartlarına uygun finansal tablolar analizi. bursa: ekin yayınevi. sengottaiyan, a., nandhini, a.s. (2016), liquidity analysis of selected food processing companies in india. international journal of scientific engineering and applied science, 2(5), 280-293. szczecińska, b. (2011), evaluation of the effectiveness of the financial liquidity strategy in the food economy enterprises. oeconomia, 10(2), 75-81. topuz, y.v., akşit, n. (2013), i̇şletmelerin pazarlama giderlerinin hisse senetleri getirileri üzerindeki etkisi: i̇mkb gida sektörü örneği. anadolu university journal of social sciences, 13(1), 53-60. ural, k., gürarda, ş., önemli, m.b. (2015), lojistik regresyon modeli ile finansal başarisizlik tahminlemesi: borsa istanbul’da faaliyet gösteren gida, içki ve tütün şirketlerinde uygulama. journal of accounting and finance, 67, 85-99. table 10: equation test lm, f and housman results equation lagrange multiplier test-(honda) f test for individual effects hausman test normal p value alternative hypothesis f p value alternative hypothesis χ2 p value alternative hypothesis 1 −2.5341 0.01127 significant effects 0.81366 0.6999 significant effects 29.302 1.935e-06 random effect 2 −3.0798 0.002072 significant effects 0.34277 0.997 significant effects 11.791 0.008135 fix effect 3 −2.398 0.01649 significant effects 0.75155 0.7732 significant effects 23.497 3.181e-05 fix effect 4 −2.9548 0.003129 significant effects 0.4349 0.9855 significant effects 4.0345 0.2578 random effect 5 −2.5198 0.01174 significant effects 0.8075 0.7074 significant effects 1.4828 0.6862 random effect table 9: equation results summary statistics equation 1 equation 2 equation 3 equation 4 equation 5 total sum of quares 1.3508 0.0066852 924 0.066 1.6269 residual sum of squares 1.2593 0.0064966 784.46 0.059424 1.3591 r2 0.067748 0.028212 0.15102 0.099633 0.16461 adjusted r2 0.066208 0.027571 0.12957 0.08548 0.14123 f statistic 4.1665 1.66443 8.95343 5.56977 9.91796 p value 0.0070451 0.17651 1.6984e-05 0.001189 5.2264e-06 tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(1), 83-89. international journal of economics and financial issues | vol 8 • issue 1 • 2018 83 the impact of enterprise management systems on management accounting in private companies of iran amir hosseinzadeh1*, behzad davari2 1the member of social security organization of iran and m.sc. graduated, department of accounting, islamic azad university, hamadan branch, hamadan, iran, 2m.sc. graduated, department of accounting, islamic azad university, hamadan branch, hamadan, iran.*email: amirhosseinzadeh_m@yahoo.com abstract the research aims to explore the impact of enterprise management system (erp) in management accounting activities. it includes a set of the developed hypotheses to evaluate how erp training and seller support affect applying erp systems and decision-making in five management accounting activities. the five management accounting activities include capital budgeting, budgeting, forecasting, activity-based costing and operational and reporting statements. the data collected using information questionnaire. the results show that erp system improves quality of management accounting process, like seller support, training affects application of erp system, but they have little impact on decision-making. due to the research results, it can be concluded that erp systems affect management accounting. therefore, ability of applying erp systems can be developed by proper training and seller support in an applied system. keywords: enterprise management system, accounting management, user training, seller support jel classifications: l32, m41 1. introduction va r i o u s c h a n g e s i n d y n a m i c w o r l d o f b u s i n e s s m a k e difficult contest to manual systems to survive. separate and unconsolidated (isolated) systems cannot exchange data within organization easily, whereas communication and information exchange is very important for growth and survival of any organization. it is very important for organizations that are faced with developing competitive market, global market changes, exchange rate fluctuations and frequent political changes regionally and globally. according these reasons, most organizations use it solutions such as enterprise management system (erp) systems, supply chain management systems, expert systems and artificial intelligence (ai) to survive and success in the market. an erp system is software that helps organizations to integrate their commercial activities through a common database, overall planning and wide optimizing organizational resources. compared with nonintegrated systems that are activity-based systems, erp system is process-based. originally, erp term refers to how planning a large organization to use wide organizational resources. today, erp systems can cover a wide range of activities and integrate them as a unified database. it includes various business sections such as finance, production, sales, value chain human resource (hr) management, customer relationship management, purchasing and inventory control. implementing an erp system is not always successful (bhatti, 2008). there are many situations that caused erp failure or success. this proves that preliminary assessments of budget, time and other resources are important in successful implementation of erp. the main reason for failure of erp systems is to consider it as an it solution, rather than a commercial solution. reducing duplicate data, improving efficiency of different processes and workflow, improving productivity and efficiency, reducing the fixed cost and improving customer satisfaction can be considered as benefits of erp systems. disadvantages of erp systems include their difficulty to be implemented according customer demand, time consuming, re-engineering process and worthless investment to implement erp. it is important for asian hosseinzadeh and davari: the impact of enterprise management systems on management accounting in private companies of iran international journal of economics and financial issues | vol 8 • issue 1 • 201884 countries, including iran because, as a developing country, there is raised a question that if it does not yield many benefits, will it be worth for massive investment in erp? after implementing erp system, lack of it knowledge and user reluctance to adopt new technologies are important issues in the country. 1.1. problem definition although most organizations apply financial sector of erp systems that are so vital for them, but there have not been conducted enough studies on the relationship between erp and accounting management in iran. therefore, the main purpose of present research is how the selected erp systems affect successful implementation of management accounting in private companies of iran. to facilitate the path, there are separately compared five management accounting activities with two factors, namely erp successful implementation with user training and seller support. management accounting activities include capital budgeting, budgeting, forecasting, activity-based costing (abc) and operational and reporting statements. 1.2. purpose of the research and its questions the exploratory research aims to determine whether erp has positive impact on management accounting activities. to achieve this objective, the following questions have been raised. all these questions focus on five main identified management accounting activities. 1. how organizations apply erp systems in management accounting? 2. how erp systems can be useful in decision process? 3. what is the effect of implementing erp systems on management accounting? in order to answer these questions, the research objectives are as follows: • determining the relationship between user training and seller support with erp application in five management accounting activities; • finding the relationship between user training and seller support with decision-making performance by focusing on financial sector; • determining the effect of erp systems on management accounting. 1.3. research importance although erp systems are widely used throughout the world and have been studied in recent several decades, but they have not properly discussed in iran and other developing countries. therefore, it is a new topic in the countries. as applying and developing erp systems require a huge investment, it is not effective for organizations, but will have indirect effects on countries in long-term. therefore, it is important measuring decisions to implement erp systems in iran. several studies have examined various factors affecting successful implementation of erp system (doan and davenport, 1998). one of them is user training and seller support that can be considered as an important factor in the country. by slow diffusion of technology and knowledge to general public in countries such as iran, most organizations have experienced extreme reluctance of their employees to change their normal work routine toward using it solutions. this can be due to fear of technology or fear of losing job. seller support is another important factor in iran. the present research examines two important factors in developing countries like iran. it also evaluates actual impact of erp systems on management accounting process. 1.4. research scope there are three main areas that will cover the research: 1. an area where is limited to five main management accounting activities, which can be classified as capital budgeting, budgeting, forecasting, abc and operational and reporting statements; 2. an area that contains companies that apply erp systems at least for 1 year; 3. the selected sample companies from manufacturer and service organizations only in private sector. 1.5. examining the research literature some researchers have examined various aspects of erp systems such as success factors, reasons for failure and their effects on various commercial activities. there have been conducted various studies in countries such as canada, australia, egypt, malaysia, india, romania and denmark in relation to different aspects of erp systems, accounting profession and its success factors. several studies have been summarized in the following. erp systems affect management accounting and methods of capital budgeting, but the impact has been on elementary level. erp allows performing methods with greater details and more accurately as well as more frequent reporting. after implementing erp, report of “good news” with time delay will be reduced dramatically (esteves et al., 2004). erp system affects process of transactions at operational level, but it has no influence decisionmaking and reporting (hope and fraser, 2003). erp facilitates accepting new accounting methods such as abc, product life-cycle costing and the balanced scorecard of performance. performance of erp systems is not changed dramatically. if erp system is combined with value chain management systems, it will lead to performance changes. erp systems have positive impact on collecting information of accounting management. seller support and user training affect successful implementation of erp system. therefore, response time for service, qualitative consultants and seller involvement are important. of course, factors such as seller long-term strategies, ability to sell future, financial efficiency, market feedback and product flexibility are long-term important factor that have been overlooked (rom and rohde, 2006). lack of user training and failure and inability to understand how business process has been changed using erp system have a negative effect on organizations. employees show reluctance to change their routine work. lack of it knowledge in accounting reduces applying controls and other facilitators of information systems. it will be increased for accountants and management as other staff members. hosseinzadeh and davari: the impact of enterprise management systems on management accounting in private companies of iran international journal of economics and financial issues | vol 8 • issue 1 • 2018 85 using erp systems, accountants can spend more time to analyze business decisions. erp system provides a richer structure for accountants so that they can use it to improve quality of their works. in short, there is disorganization in literature about erp potential (ability) on management accounting methods and public opinion to accept it. perception of accountants and other staff in financial sector is effective to apply erp systems and other information systems. 2. research design 2.1. research approach examining literature of past research suggests that there is significantly uncertainty about impact of erp systems on management accounting methods. there has not been conducted a similar research in iran. the present research is experimental. as erp is used in an organizational position, it is difficult to observe laboratory with the controlled variables. so this is a field study. the variables have high external validity (reliability) and this solution can be generalized and applied to other cases in the future. 2.2. theoretical bases the first objective of this research is to determine how erp success factors will affect applying erp systems on management accounting activities. for this purpose, there have been considered five management accounting activities, including capital budgeting, abc, forecasting and performance statement and reporting. two factors -user training and seller supporthave been selected as success factors for implementing erp, which they are discussed in this study (figure 1). the following h0 and alternative hypotheses were developed to test the relationship between user training and seller support on applying erp in management accounting activities. h0: there is no relationship between erp user training with the following cases: • erp applications in capital budgeting; • erp application in budgeting; • erp applications in abc; • erp application in performance statement and reporting; • erp application in forecasting. h0: there is no relationship between erp seller support with the following cases: • erp applications in capital budgeting; • erp application in budgeting; • erp applications in abc; • erp application in performance statement and reporting; • erp application in forecasting. 2.2.1. alternative hypothesis h1: there is a relationship between erp user training with the following cases: • erp applications in capital budgeting; • erp application in budgeting; figure 1: theoretical foundations and independent and dependent variables of the research hosseinzadeh and davari: the impact of enterprise management systems on management accounting in private companies of iran international journal of economics and financial issues | vol 8 • issue 1 • 201886 • erp applications in abc; • erp application in performance statement and reporting; • erp application in forecasting. h1: there is a relationship between erp seller support with the following cases: • erp applications in capital budgeting; • erp application in budgeting; • erp applications in abc; • erp application in performance statement and reporting; • erp application in forecasting. dependent and independent variables for the first objective can be summarized in the following table (table 1). the second aspect of this article is to find the relationship between two factors of erp success and enterprise decision performance in financial sector. decisions are made in different situations for different activities. in this paper, we only consider three important aspects of: profit, final cost and return on investment (roi). 2.2.2. the second hypothesis h0: there is no relationship between user training with the following cases: • performance of decision making related with profit; • performance of decision making related with roi; • performance of decision making related final cost. h0: there is no relationship between seller support with the following cases: • performance of decision making related with profit; • performance of decision making related with roi; • performance of decision making related final cost. 2.2.3.alternative hypothesis h1: there is a relationship between user training with the following cases: • performance of decision making related with profit; • performance of decision making related with roi; • performance of decision making related final cost. h1: there is a relationship between seller support with the following cases: • performance of decision making related with profit; • performance of decision making related with roi; • performance of decision making related final cost. dependent and independent variables for the second objective can be summarized in the following table (table 2). 2.3. methodology 2.3.1. population and sampling there are about 60 companies in iran that have applied erp systems in manufacturing and service activities on private sector of the country. the companies can be defined as the research population. there are responses from 32 organizations that will be considered as the research sample. this sample is approximately 53.33% of this population. the sample is chosen randomly that includes most of major industries such as garment, petrochemical, metal and nonmetal, pharmaceutical, investment and so on. 2.3.2. collecting data data was collected through interviews and questionnaires. the questionnaires consisted of closed and open ended questions. the closed-ended questionnaires were designed based on likert fivepoint scale. the questionnaires were answered by financial chief officers, management accountant, financial controller, financial managers and financial accountants. the answers were analyzed using interviews, questionnaires and statistical observations by tools such as chronbach’s alpha, correlation and anova. the data were analyzed using spss software. 3. results and discussion 3.1. tools’ validation the chronbach’s alpha has been used to determine reliability of the collected data. alpha value should be larger than 0.68; in this case, total data are considered as valid. according the calculations, values of chronbach’s alpha and reliability of the research were 0.803 and 80% respectively that show high internal consistency table 1: objective no. 1: dependent and independent variables dependent variable independent variable capital budgeting management accounting training it to user and process recognition success factors budgeting seller support forecasting abc performance statement and reporting abc: activity-based costing table 2: objective no. 2: dependent and independent variables dependent variable independent variable profit performance of decision in management accounting training it to user and process recognition success factors roi seller support final cost roi: return on investment hosseinzadeh and davari: the impact of enterprise management systems on management accounting in private companies of iran international journal of economics and financial issues | vol 8 • issue 1 • 2018 87 (internal validity) of the research. the values were obtained by analyzing data using anova and pearson correlation techniques (tables 3 and 4). pearson correlation approach has been used to determine the relationship between variables. if this value is close to +1, there will be a stronger positive correlation; and if it is closer to −1, the reverse relationship will be stronger. if anova significant is <0.05, there is a relationship between both variables. according table 3, there is a relationship between user training and five methods of management accounting, when significant level of anova is <0.05. in table 4, pearson correlation shows a positive relationship between user training and erp application in management accounting. according table 3, we can see the relationship between seller support and erp application in management accounting methods, except in budgeting. budgeting involves significant level of 0.325 that is >0.05. pearson correlation shows a positive relationship between seller support with erp application on abc, performance statement and reporting and forecasting. user training on erp system influences decision related to roi. this has been reflected using significance = 0.027 in anova table. however, pearson correlation shows a low relationship between two variables. decisions related to the final cost and benefit show significance level (significance) higher than 0.05. therefore, there is no correlation between the two variables. a similar situation can be considered for seller support, decision making related to profit and final cost. as significance level and pearson correlation values are 0.035 and 0.074 respectively, we can suppose that there is a relationship between seller support and decision related to roi. now we discuss on the impact of erp on five activities of management accounting. there is evidence that shows erp system is useful to improve efficiency, performance, accuracy of capital budgeting, forecasting, performance statement and reporting and abc. some organizations have applied abc after implementing erp system. in case of budgeting by erp systems, respondents have conflicting opinions so that some respondents have suggested that they do not apply directly erp system for budgeting, and others have expressed hope that budgeting is removed and move toward other budgeting techniques to prepare flexible and multi-faceted budgeting. the results show that there are held training sessions for staff in accounting process and management accounting activities. the sessions increase applying erp systems appropriately. according the provided responses by organizations, in initial stage of implementing erp system, there was reduced performance, but it will be increased in user training and enhancing their understanding of the system. finally, there is created a fixed level of performance. now, we suppose training management decisionmaking has a limited impact on decisions of changing business that are not understood by the system automatically. however, all respondents agree that erp system provides timely and reliable information that indirectly leads to higher accuracy of decisionmaking at all levels of finance department. at the same time, seller support has also affect operational level in management accounting so that his obligation on erp systems is an important and smooth (without problem) matter to guide business operations without any interruptions. ability to contact seller in a defective system and the spent time to fix a problem affect application of erp in accounting process. availability seller, when customer needs him, is vital for smooth management accounting activities. now we consider management decisions. given the fact that erp system does not directly facilitate decision-making, but information and techniques such as roi affect the automated system. mostly people are involved in process. as a result, seller support and availability has a limited impact on decision-making performance related to financial aspects. table 3: significant level between independent and dependent variables using anova variables anova significance level user training and capital budgeting 0.048 user training and budgeting 0.048 user training and abc 0.017 user training and performance statement and reporting 0.032 user training and forecasting 0.016 seller support and capital budgeting 0.012 seller support and budgeting 0.325 seller support and abc 0.044 seller support and performance statement and reporting 0.040 seller support and forecasting 0.019 user training and profit 0.598 user training and roi 0.027 user training and final price 0.189 seller support and profit 0.539 seller support and roi 0.035 seller support and final price 0.441 roi: return on investment, abc: activity-based costing table 4: correlation between user training and seller support correlation-seller support correlation-user training dependent variable capital budgeting 0.259 −0.267 budgeting 0.369 −0.064 abc 0.075 0.348 performance statement and reporting 0.280 0.410 forecasting 0.561 0.448 profit −0.120 −0.194 roi −0.091 0.074 final price 0.029 0.048 correlation at significance level of 1% roi: return on investment, abc: activity-based costing hosseinzadeh and davari: the impact of enterprise management systems on management accounting in private companies of iran international journal of economics and financial issues | vol 8 • issue 1 • 201888 most responses indicate that advantage of erp system in financial sector is related to the provided data and information by its reporting aspect. there is no direct suggestion that erp system has been applied in decision-making process on financial sector. erp system can be used as a facilitator in business and operational processes and provide suitable information for decision-making at various levels. it also has ability to sort data using different methods so that meets managers’ needs. most respondents have agreed with available controls in erp system that increases applying internal audit activities. using erp system, organizations can coordinate themselves with more advanced management accounting techniques such as abc, profitability indicators and techniques to measure non-financial performance. erp has a significant impact on abc (about 60%). it is a new technique of management accounting that has been supported by most erp models. some organizations, which do not use this technique, have created standard of cost centers and identify the associated cost for each customer or product using erp system. forecasting is another technique in management accounting system that has been strongly supported by erp system. the predictions are carried out based on past data that are available in these projects. most organizations have been suggested that apply their erp system for budgeting in range of 30–40%. more than 40–50% of erp system is applied in capital budgeting. most respondents agree that erp system increases accuracy of capital budgeting, but it cannot change budgeting way. now, if we consider all these factors, evidence indicates that erp system affects management accounting activities so that increases its reliability, accuracy and timely. however, this influence is not so high that change accounting management process. factors such as user training and seller support can improve application of erp system in management accounting activities. training erp system can be indirectly useful for decision-making process. 4. conclusion the present research offers new evidence regarding the impact of user training and seller vendor in management accounting process and decision-making performance. due to apply erp system, information will be provided for companies in real-time, largevolume and high reliability to make decisions. the research results suggest the relationship between user training and seller support with applying erp in operational level. the better and more prominent seller training, the more optimal potential of erp system. it requests that erp system need to renew its organizational business processes. therefore, cooperation between seller of erp system and enterprise as well as between user training and company can be considered as components of success of erp in any organization. in addition, accountants and financial employees require high it skills to apply their knowledge in the driven workplace by it. some participated organizations in the study agreed that it knowledge is not required among accountants and other staff of financial sector. organizations have spent high money and time for user training. erp enhances job promotion and financial benefits for employees on long-term. as a result, most iranian companies is now less reluctance of staff to implement erp face and demanded to obtain recognition of their advanced technology. seller support is important when we prove erp system: upgrading hardware, system and new versions; earning royalties; conducting user training; customer focus. quick access and seller support are important issues that increase applying erp in management accounting methods. due to different functional levels of erp system in budgeting, seller support has less effect on it, but other methods of management accounting can be improved by seller support. however, the impact of user training and seller support on performance of roi decisions, profit and final cost is very minor because of the lack of direct application erp system in decisionmaking. these results suggest that erp system tool is powerful for activities in operational level, but decision-making by erp system is not supported. these findings are consistent with all erp sellers such as sap and oracle. they stated that erp systems target management of operational level and strategic management systems can have a significant impact on decision-making process. erp system improves capacity and accuracy of the used data for budgeting and capital budgeting. this allows better tracking of projects and investments that seem more logical. increasing frequency of updating budget and range of information on many organizations are benefits of applying erp system for budgeting and capital budgeting. performance statement and reporting get the most benefits from erp system. as erp increases speed, accuracy and timely data and removes mistakes and repeated works, results of forecasts have focused on long-term courses. using erp within the specified time will increase number of forecasts. erp system increases levels of activities available for internal auditors, providers of non-financial indicators and analysts of company’s profitability. according to the study, some proposals are suggested as the following. 4.1. suggestions • do not let using very special software systems in training sessions. • training process usually happens at end of system implementation cycles, so intensive training after implementing the system has not enough good result. therefore, it is important to start training courses can lead to appropriate results, if it is held before system implementation. after implementing, it is better to hold sessions to solve problems. • however, business processes associated with change or changes on system caused by customer tastes. employees should be trained adequately for these changes. • improve it awareness of management and accountants in financial sector. • specify proper coordination and cooperation with seller and agreements necessary to support him. hosseinzadeh and davari: the impact of enterprise management systems on management accounting in private companies of iran international journal of economics and financial issues | vol 8 • issue 1 • 2018 89 • by studying resources and websites affiliated with clients and sellers, consider factors such as seller long-term strategy, seller support capabilities, financial capabilities, market feedback, production flexibility and achieve maximum benefits. • evaluate results of training sessions and user performance. • during education, just not educate how to use erp system, but why and how to use the system. • consider a long-term program to implement a support strategic planning system such as support decision systems, ai and enterprise strategic management systems for better long-term decisions. • avoid frequent changes in management accounting practices resulting in working and training deformation. 4.2. future research the future research can be conducted by focusing on similar subject areas and other accounting activities in public sector for small and medium size organizations in iran. researchers can also study other erp success factors such as top management support, oversight committees and staff resistance. as erp system includes lot of models such as production, sales, hr, inventory and so on, it allows you examine each section and its flexibility separately. references bhatti, t.r. (2008), critical success factors for the implementation of enterprise resource planning (erp): empirical validation. the second international conference on innovation in information technology (iit’05). doan, c., davenport, t.h. (1998), putting the enterprise into the enterprise system. harvard business review, 76(4), 121-131. esteves, j., pastor, j., casanovas, j. (2004), a goals/questions/metrics/ plan for monitoring user involvement and participation in erp implementation process. instituto de empresa business school working paper no. 04-31. available from: http://www.papers.ssrn. com/sol3/papers.cfm?abstract_id=1019991. h o p e , j . , f r a s e r, r . ( 2 0 0 3 ) , w h o n e e d s b u d g e t s ? h a r v a r d b u s i n e s s r e v i e w. o n l i n e . 1 9 . av a i l a b l e f r o m : h t t p : / / w w w . h a r v a r d b u s i n e s s o n l i n e . h b s p . h a r v a r d . e d u / b 0 1 / e n / c o m m o n / i t e m _ d e t a i l . j h t m l ; j s e s s i o n i d = h m s p u m d o u b o m 0 a k r g w d s e l q b k e 0 y i i s w ?id=r0302j&referral=8636&_requestid=6041. rom, a., rohde, c. (2006), enterprise resource planning systems, strategic enterprise management systems and management accounting. a danish study. journal of enterprise information management online, 19(1), 50-66. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(3), 35-46. international journal of economics and financial issues | vol 10 • issue 3 • 2020 35 the impact of psychological biases on the decision-making of the individual albanian investor blerina dervishaj1*, teftjola xhaferi2 1faculty of economy, university of vlora “ismail qemali”, albania, 2eae business school, madrid, master in financial management, spain. *email: blerina.dervishaj@univlora.edu.al received: 23 jaunury 2020 accepted: 01 april 2020 doi: https://doi.org/10.32479/ijefi.9488 abstract the study aims to measure the impact of psychological biases on financial decisions of the albanian individual investor. the paper uses primary data provided through structured interviews with 180 individual investors and one semi-structured interview with an expert of the financial market in albania. exploratory financial analysis, cronbach alpha test and descriptive analysis are used through r-software. the analysis and its results conclude a significant presence of psychological biases on the albanian individual investor behaviour. as there is too little research done on this field in albania, the study informs of the presence of these biases and tries to explain their impact not only on the previous crisis the country has experienced, but also on the current situation of the financial market in the country. keywords: psychological bias, individual investitor, financial decision-making, financial market jel classifications: g, g4, g41 1. introduction behavioral factors have not been for long considered as important variables relating to finance and investments and no sufficient attention has been paid to studying their impact on investor decision-making. what led to the emergence and evolution of behavioral finance was the inability of economists to explain the repeated occurrence of anomalies and financial crises in financial markets. instead of dictating the optimal and ideal behavior one should have, this new field of finance aims to explain the actual financial behavior by identifying the mistakes and psychological biases during investor’s financial decision-making. different studies in different countries have contributed in identifying these psychological bias and in measuring their quantitative impact on financial decision-making of investors. this will be as well the aim of the study for the albanian investor, although unlike the other more developed countries, albanian financial market is at its early stage of formation and still unproperly consolidated. during its transition the country has experienced two significant financial crisis urged also by the wrong decision-making of its individual investors. it is necessary to study and explain these important difficult past periods as well as the current country’s situation of the financial market from the perspective of financial behavior, by studying the impact of psychological biases on the albanian individual investor behavior. the research question the study aims to answer is: to what extent are the albanians affected by psychological biases while taking financial decisions? 2. literature review 2.1. main psychological biases psychological biases are one of the most important factors among the various behavioral variables affecting investor decisionthis journal is licensed under a creative commons attribution 4.0 international license dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 202036 making. we further present them according to the following classification: 2.1.1. heuristics biases representativeness: the tendency to be optimistic towards recent good investments and pessimistic towards bad ones. according to chen et al. (2007), investors tend to buy stocks that have recently had high returns as a benchmark for a good investment. availability: people tend to assess the likelihood of the occurrence of an event based on its frequency of occurrence, on the ease with which such events can be retrieved from memory or on emotions felt for previously experienced similar events. anchoring: this bias makes investors hold investments which have fallen in value because they “anchor” their valuation at the initial purchase price rather than at their intrinsic value. they continue to hold the investment hoping that the asset price will reach its initial purchase price. player’s fallacy: the investor believes that a random event is less likely to occur after a series of similar events. there are investors who think they should close a position, for example sell a stock that has been traded and overvalued for a long time, believing that the position will stop improving. overconfidence: people tend to be overconfident in their abilities and knowledge (glaser et al., 2010). brad and terrance (2001) show that overconfident investors believe that they have greater ability than others in choosing shares or the moment when to change a position. according to bloomfield et al. (1999), less literated investors show more overconfidence then the literated ones. 2.1.2. perspective theory biases regret aversion: investors who exhibit this bias take less risk to reduce the chances of bad results. the bias may explain investor’s reluctance to sell the resulting loss investments just to not admit the fact that decision-making has been bad. loss aversion: as the negative feeling for losses outweighs the positive feeling the same absolute amount earned causes, investors position themselves on very short-term investments. mental accounting: the bias happens unconsciously prompting the individual to group money into “different mental boxes” and afterwards decide about their separate use. 2.1.3. herding people need to feel accepted by the group rather than excluded, thus behaving as the group does, is the best way becoming part of it. the bias explains best bubbles and market crises. 2.2. summary of literature review on measuring the impact of psychological factors on investor decisionmaking table 1 presents a summary of the recent literature review about measuring the impact of psychological biases on investor behavior. 3. materials and methods the technique used is the judgemental sampling technique, a nonprobabilistic technique, where a specific group of individuals is selected to provide specific data. the interviewees are individuals who save and invest in different financial segments. the criteria used for selecting the sample are: 1. the investor earns medium or high income 2. the investor has invested also in other financial investment alternatives in the country other than bank deposits 3. the investor has a sufficient level of financial literacy. 3.1. research methods the mixed methods approach used in the study implies that both data collection (quantitative and qualitative) techniques, as well as the respective analysis procedures, are used in a single research model. quantitative research helps us identify and describe variables and also establish a relationship between them (garner et al., 2011). focusing on numbers and statistics, the quantitative study can lose the ability to distinguish individuals from institutions, being slightly superficial as it cannot directly link life to research (bryman and bell, 2007). for this reason, in order to better understand the result, in addition to the quantitative method, the qualitative one is also used. the paper concludes with interviewing the expert who helps us interpret and understand more about investor behavior and its impact in the market. according to bryman and bell (2007), when using mixed methods, researchers can start with either the quantitative method or the qualitative method. as the research question is based on theories of financial behavior, we first use the quantitative method, and after that we use the qualitative method. as behavioral finance is a complex field, the involvement of the financial expert is necessary to provide more detailed explanations of the results of the quantitative analysis. 3.2. techniques and procedures primary and secondary data for this study were obtained during the years 2016-2018. medium-income and “premium” clients of raiffeissen bank have been selected to be interviewed. they have invested at least in one of the following investment alternatives: treasury bills, government bonds, investment funds, pension funds, as well in time deposits. this is the only commercial bank in the country which offers alternatives of investment in three different types of investment funds. this institution represents the market “de facto” due to its high share in the albanian financial market, respectively in the investment funds market with around 80% of this market (figure 1). the sample consists of 180 investors who meet the criteria. instead of delivering self-administered questionnaires, we choose to use the structured interviews for collecting primary data. this technique gives us an almost twice as high response rate as well as higher reliability and accuracy. 3.3. structured interview it consists of 26 questions, grouped according to behavioral finance theories into three classifications: heuristics (a), perspective (b), dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 2020 37 and herding (c), (table 2; annex b). each question is measured on a likert scale from 1 (strongly disagree) to 5 (strongly agree). 3.4. steps of quantitative strategy the quantitative analysis explores the importance of psychological biases on individual investor decision making in financial assets in albania. the variables undergo the exploratory factor analysis, the cronbach’s alpha reliability test and the inferential analysis. 3.5. semi-structured interview semi-structured interviews are used to explore and explain issues arising from the use of a questionnaire (tashakkori and teddlie, 1998). the authors point out that semi-structured or in-depth interviews can be used as part of mixed methods research, to explain findings from analysing data gathered from questionnaires. 3.6. steps of qualitative strategy we contacted the financial market expert and submitted him the results of the statistical analysis. we sent the expert a basic summary literature on psychological factors by email in order to help him get acquainted with main theoretical concepts of the study. the expert then assigned us an appointment during which we conducted the semi-structured interview (annex a). 4. data analysis and results 4.1. exploratory factorial analysis it is a statistical method which determines the basic structure of a multivariable data matrix. it aims is to identify a set of basic dimensions, called factors, by studying the structure of the correlation between source: statistical report, collective investment ventures market, 30 june, 2018 raiffeisen prestigj 79.32% raiffeisen euro 18.61% credins premium 1.96% wvp top invest 0.12% figure 1: value of investment funds net assets in albania (june 2018) table 1: summary of literature review author finding data instrument method statistical analysis luong and ha (2011) heuristics, perspective, herding and the market impact investor decision-making in vietnam primary structured questionnarie quantitative descriptive analysis, factorial analysis, chronbach alpha test semi-structured interview qualitative subash (2012) new investors in india show the player’s fallacy, anchoring and retrospective bias more than the experienced investors primary structured questionnarie quantitative discriminant analysis, wighting scoring method, hi-square test, multicolinearity test chitra and jayashree (2014) representativeness and overconfidence, determinants of investor decision-making in india primary structured questionnarie quantitative descriptive analysis, factorial analysis anova prosad (2014) overconfidence, optimism and herding, affect stock market and investor decision-making in india secondary stock market data quantitative linear regression, times series regression, kernel pricing technique, garch primary structured questionnarie chronbach alpha, hi-square, t-test anastasia and suwitro (2015) emotions and psychological biases affect indonesians more when they invest in houses rather than when buying a house to live in primary structured questionnarie quantitative chronbach alpha test, discriminant analysis bakar and chuiyi (2016) overconfidence and availability affect decision-making and vary by investor gender in malaysia primary structured questionnarie quantitative multiple regression analysis sarwar and afaf (2016) psychological factors affect investment decision making in pakistan more than economic factors primary structured questionnarie quantitative descriptive analysis, factorial analysis, regression analysis, multikolinearity, t-test, anova kubilay and bayrakdaroglu (2016) turkish investor’s personality influences psychological biases and his risk tolerance primary structured questionnarie quantitative hi-square analysis, logistic regression analysis rasheed et al. (2018) representativeness and availability impact investor’s decision-making in pakistan primary structured questionnarie quantitative structured equation model, simple linear regression source: author summary based on literature review about behavioral finance dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 202038 variables. according to efa variables become part of homogeneous clusters with similar characteristics: factors (o’brien, 2007). analysis is based on a large number of variables aiming to group them into a smaller number of factors which undergo to further statistical analysis. to evaluate whether the data are appropriate enough to undergo this analysis, we need to focus on the magnitude of the choice as well as on the robustness of the correlation between the variables. a sample size of 150 cases is sufficient (tabachnick and fidell, 2007). the same authors suggest a factorial load >0.3. factorial load is defined as the correlation of each element with the factor to which it belongs. in this study the factors are nine, respectively: representativeness, overconfidence, anchoring, player’s fallacy, availability, loss aversion, regret aversion, mental accounting, herding. the corresponding responses to these nine factors are 26 in total. we specifically code them as: a1, a2, a3, a4, a5, a6, a7, a8, a9, a10, a11, a12, a13, a14, a15, b1, b2, b3, b4, b5, b6, c1, c2, c3, c4, c5. we install the r software, “psych” and “gparotation” packages so that we can perform efa. at first we need to confirm the number of factors which will be analysed. various methods such as “eigenvalue” or “parallel analysis” can be used for this. we specifically use the “fa.parallel” function, part of the “psych” package to perform the “parallel” analysis. this function makes it possible to determine the exact number of factors. by the “parallel analysis” method, we compare the set of observed data factors with a matrix generated from random data, which has the same dimensions as the original estimated matrix. this procedure can be performed for continuous, dichotomous and politomic data. “pearson,” “tetrachoric” and “polychoric” correlations can as well be used (revelle and rocklin, 1979; revelle, 2018). the corresponding result suggests a number of factors equal to 9. the mr1, mr2, mr3, mr4, mr5, mr6, mr7, mr8 and mr9 factors generated by the program correspond to the initial factors suggested by the relevant literature (tversky and kahneman, 1974; waweru et al., 2008). the rotation procedure which indicates which variables are “grouped” together is performed after the number of factors is defined. direct oblimin is the most commonly used technique for this (tabachnick and fidell, 2007). the program generates clusters according to table 3. only factors with values >0.3 are taken into table 2: structure of psychological biases with relevant questionnaire questions category psychological bias question heuristics heuristics of representativeness a1, a2, a3 overconfidence a4, a5, a6, a7 anchoring a8, a9 players’s fallacy a10, a11, a12 availability a13, a14, a15 perspective loss aversion b1, b2 regreet aversion b3, b4 mental accounting b5, b6 herding c1, c2, c3, c4, c5 source: author table 3: the results of factorial analysis for the 9 biases through r-software standardized loadings (pattern matrix) based upon correlation matrix mr1 mr2 mr3 mr4 mr5 mr6 mr7 mr8 mr9 a1 0.47 a2 0.63 a3 0.48 a4 0.71 a5 0.51 a6 0.63 a7 0.74 a8 0.87 a9 0.47 a10 0.69 a11 0.73 a12 0.84 a13 0.67 a14 0.57 a15 0.53 b1 0.54 b2 0.89 b3 0.46 b4 0.77 b5 0.85 b6 0.90 c1 0.66 c2 0.52 c3 0.87 c4 0.66 c5 0.62 tucker-lewis index of factoring reliability=0.907 the root mean square of the residuals (rmsr) is 0.02 rmsea index=0.001 and the 90% confidence intervals are 0 0.07 bic=‒150.64 fit based upon off diagonal values=0.91 dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 2020 39 consideration for further analysis. as the values of “loads” are in any case higher than 0.3, the question structure remains the same. the validity of the model is confirmed (table 3): • the rmsr (root mean square of residuals) is 0.02, an acceptable value as it should be around zero • the rmsea value is 0.001, a good fit of the model as it is lower than 0.05 • the tucker-lewis index is 0.907, an acceptable value as it is higher than the limit value of 0.9 (revelle, 2018). after the efa confirmed the logical value of the classification of variables according to nine psychological factors (representativeness a1, a2, a3; overconfidence a4, a5, a6, a; anchoring a8, a9; player’s fallacy a10, a11, a12; availability a13, a14, a15; loss aversion b1, b2; regret aversion b3, b4; mental accounting b5, b6; herding c1, c2, c3, c4, c5), the analysis continues with chronbach alpha test. 4.2. cronbach alpha test a valid questionnaire means that the data collected is consistent and coherent. foddy (1994) discusses validity and reliability in the context of meaningful questions and answers. it states that “the question must be understood by the respondent as it is intended by the researcher and the respondent answer must be understood by the researcher as intended by the respondent.” the test is commonly used in behavioral science studies to test the reliability of the internal consistency of the likert scale measurements (liu et al., 2010). as such, since the research is on behavioral finance and as we used the 5-point likert scale, the test is considered most appropriate for our study. in the paper, the cronbach alpha test will be conducted with r-software, to test the reliability of the measurements included in the factors formed after the efa. values of cronbach alpha >0.6 ensure that the measurements are reliable (field et al., 2012; kline, 1999). criteria for statistical indicators: • raw_alpha’: “cronbach α” valuevalues >0.6 or 0.7 show high reliability (field et al., 2012; kline, 1999) • “std.alpha”: this value is usually similar to “raw_alpha,” so we can rely on the first value • “g6”: guttman’s lambda (calculated by multiple correlation) • “average_r”: average correlation between variables (used to calculate “std.alpha”) • “mean”: the simple mathematical average of all individual means • “sd”: standard deviation. in the “reliability if an item is dropped” section, reliability is given if the relevant variable is eliminated. if the alpha value results in any case greater than the total alpha value, then the variable associated with it must be eliminated. the other columns include other statistics if the relevant variable is not considered. table 4: results for “representativeness” raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.7 0.7 0.67 0.44 2.4 0.039 2.8 0.64 0.48 lower alpha upper 95% confidence boundaries 0.62 0.7 0.78 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r a1 0.36 0.36 0.22 0.22 0.56 0.095 na 0.22 a2 0.65 0.65 0.48 0.48 1.86 0.052 na 0.48 a3 0.76 0.77 0.62 0.62 3.26 0.035 na 0.62 item statistics n raw.r std.r r.cor r.drop mean sd a1 180 0.88 0.88 0.83 0.70 2.8 0.82 a2 180 0.75 0.77 0.63 0.48 2.9 0.75 a3 180 0.74 0.72 0.49 0.40 2.6 0.85 table 5: results for “representativeness” excluding variable a3 raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.76 0.77 0.62 0.62 3.3 0.035 2.8 0.7 0.62 lower alpha upper 95% confidence boundaries 0.7 0.76 0.83 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r a1 0.62 0.62 0.38 0.62 0.56 na 0.62 0.62 a2 0.38 0.62 25 0.61 1.85 na 0.38 0.62 item statistics n raw.r std.r r.cor r.drop mean sd a1 180 0.91 0.9 0.71 0.62 2.8 0.82 a2 180 0.89 0.9 0.71 0.62 2.9 0.75 dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 202040 in the “item statistics” section: • “raw.r”: the correlation between the variable and the total of answers • “r.drop”: the correlation between the variable and the total of “corrected” responses by the variable itself. low values (approximately <0.3) indicate that the relevant variable is not sufficiently correlated with the total estimate. in this part of the analysis, we aim to eliminate the section variables (questions) from further analysis. first we need to have a total alpha value >0.6. second, we need to verify that all values of “raw_alpha” in the “reliability if an item is dropped” table, are smaller than the general alpha value. at last, in the “item statistics” section, values of “r.drop” must be (approximately) >0.3. table 6: results for “overconfidence” raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.79 0.78 0.76 0.47 3.6 0.024 3 0.6 0.5 lower alpha upper 95% confidence boundaries 0.74 0.79 0.84 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r a4 0.70 0.70 0.66 0.44 2.3 0.036 0.04335 0.40 a5 0.67 0.66 0.61 0.39 2.0 0.039 0.04164 0.31 a6 0.83 0.84 0.77 0.63 5.1 0.021 0.00095 0.63 a7 0.70 0.70 0.63 0.43 2.3 0.037 0.02244 0.40 item statistics n raw.r std.r r.cor r.drop mean sd a4 180 0.83 0.81 0.73 0.66 3.0 0.82 a5 180 0.86 0.85 0.81 0.72 3.1 0.77 a6 180 0.57 0.63 0.41 0.36 3.0 0.60 a7 180 0.84 0.82 0.76 0.67 3.1 0.84 table 7: results for “overconfidence” excluding variable a6 raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.83 0.84 0.77 0.63 5.1 0.021 3.1 0.7 0.63 lower alpha upper 95% confidence boundaries 0.79 0.83 0.88 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r a4 0.79 0.80 0.66 0.66 3.9 0.031 na 0.66 a5 0.77 0.77 0.63 0.63 3.4 0.034 na 0.63 a7 0.75 0.75 0.60 0.60 3.0 0.037 na 0.60 item statistics n raw.r std.r r.cor r.drop mean sd a4 180 0.86 0.86 0.73 0.67 3.0 0.82 a5 180 0.86 0.87 0.76 0.70 3.1 0.77 a7 180 0.88 0.88 0.79 0.72 3.1 0.84 table 8: results for “anchoring” raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.26 0.26 0.15 0.15 0.34 0.11 3.3 0.5 0.15 lower alpha upper 95% confidence boundaries 0.04 0.26 0.47 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r a8 0.146 0.15 0.021 0.15 na na 0.146 0.15 a9 0.021 0.15 na na na na 0.021 0.15 item statistics n raw.r std.r r.cor r.drop mean sd a8 180 0.76 0.76 0.29 0.15 3.3 0.66 a9 180 0.75 0.76 0.29 0.15 3.3 0.65 dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 2020 41 after the questions were converted according to literature guidelines (field et al., 2012; kline, 1999), the following analysis was performed. if the responses do not follow the trend of the corresponding characteristic, the r-software automatically converts the variable. the “output” of the calculation of “cronbach – α” for representativeness, overconfidence, anchoring, player’s fallacy, availability, loss aversion; regret aversion, mental accounting, herding, is presented in the following paragraphs. 4.2.1. representativeness the value of the total alpha is 0.70. we must prove that all values of “raw_alpha” in the “reliability if an item is dropped” table are greater (or equal) than the general alpha value. the variable a3 does not meet this condition. values of “r.drop” in the “item statistics” section must be (approximately) >0.3. in this case the variables meet the condition (table 4). r-software recalculates “cronbach’s α” excluding variable a2 (table 5). in this case all conditions are met. 4.2.2. overconfidence total alpha value must be >0.6. this value is 0.79. all values of “raw_alpha” in the “reliability if an item is dropped” are smaller (or equal) than the general alpha value. variable a6 does not meet this condition. values of “r.drop” must be >0.3 at the “item statistics.” in this case the variables meet the condition (table 6). table 9: results for player’s fallacy raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.46 0.45 0.39 0.22 0.83 0.07 3.4 0.51 0.12 lower alpha upper 95% confidence boundaries 0.32 0.46 0.59 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r a10 0.21 0.21 0.12 0.12 0.26 0.118 na 0.12 a11 0.21 0.21 0.12 0.12 0.27 0.117 na 0.12 a12 0.58 0.59 0.41 0.41 1.41 0.062 na 0.41 item statistics n raw.r std.r r.cor r.drop mean sd a10 180 0.74 0.74 0.55 0.37 3.4 0.72 a11 180 0.76 0.74 0.55 0.36 3.4 0.79 a12 180 0.58 0.60 0.20 0.14 3.3 0.71 table 10: results for “availibility” raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.69 0.69 0.6 0.43 2.3 0.04 3 0.64 0.42 lower alpha upper 95% confidence boundaries 0.62 0.69 0.77 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r a13 0.65 0.65 0.48 0.48 1.8 0.052 na 0.48 a14 0.57 0.57 0.39 0.39 1.3 0.065 na 0.39 a15 0.59 0.59 0.42 0.42 1.4 0.061 na 0.42 item statistics n raw.r std.r r.cor r.drop mean sd a13 180 0.77 0.77 0.56 0.47 2.9 0.83 a14 180 0.80 0.80 0.65 0.54 2.9 0.80 a15 180 0.79 0.79 0.63 0.52 3.1 0.81 table 11: results for “loss aversion” raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.71 0.71 0.55 0.55 2.4 0.044 4 0.69 0.55 lower alpha upper 95% confidence boundaries 0.62 0.71 0.79 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r b1 0.55 0.55 0.3 0.55 na na 0.55 0.55 b2 0.30 0.55 0.31 0.44 na na 0.30 0.55 item statistics n raw.r std.r r.cor r.drop mean sd b1 180 0.88 0.88 0.65 0.55 4 0.78 b2 180 0.88 0.88 0.65 0.55 4 0.79 dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 202042 r recalculates “cronbach’s α” excluding variable a6. finally, all conditions are met (table 7). 4.2.3. anchoring as the value of the total alpha is 0.26, this variable cannot be used for further analysis (table 8). 4.2.4. player’s fallacy the value of the general alpha should be >0.6. as its value in this case is 0.46, this variable cannot be used for further analysis (table 9). 4.2.5. availibility the value of the total alpha is 0.69. all “raw_alpha” values are smaller than the general alpha value. values of “r.drop” are >0.3. as the variables meet the conditions, all of them can be used for further analysis (table 10). 4.2.6. loss aversion the value of the total alpha is 0.71, >0.6. all values of “raw_alpha” are lower than general alpha value. values of “r.drop” are higher table 13: results for “mental accounting” raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.72 0.72 0.56 0.56 2.6 0.042 3.8 0.87 0.56 lower alpha upper 95% confidence boundaries 0.63 0.72 0.8 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r b5 0.56 0.56 0.32 0.56 na na 0.56 0.56 b6 0.32 0.56 0.33 0.54 na na 0.32 0.56 item statistics n raw.r std.r r.cor r.drop mean sd b5 180 0.90 0.88 0.66 0.56 3.7 1.05 b6 180 0.87 0.88 0.66 0.56 3.9 0.91 table 12: results for “regret aversion” raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.53 0.53 0.36 0.36 1.1 0.069 3.3 0.67 0.36 lower alpha upper 95% confidence boundaries 0.4 0.53 0.67 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r b3 0.36 0.36 0.13 0.36 na na 0.36 0.36 b4 0.13 0.36 na na na na 0.13 0.36 item statistics n raw.r std.r r.cor r.drop mean sd b3 180 0.83 0.83 0.5 0.36 3.1 0.83 b4 180 0.82 0.83 0.5 0.36 3.4 0.80 table 14: results for herding raw_alpha std.alpha g6(smc) average_r s/n ase mean sd median_r 0.92 0.92 0.91 0.69 11 0.0099 3.3 0.92 0.68 lower alpha upper 95% confidence boundaries 0.9 0.92 0.94 reliability if an item is dropped raw_alpha std.alpha g6(smc) average_r s/n alpha se var.r med.r c1 0.9 0.9 0.88 0.70 9.2 0.012 0.0017 0.70 c2 0.9 0.9 0.87 0.68 8.7 0.013 0.0020 0.67 c3 0.9 0.9 0.87 0.69 8.8 0.012 0.0022 0.67 c4 0.9 0.9 0.88 0.69 9.1 0.012 0.0028 0.68 c5 0.9 0.9 0.88 0.68 8.6 0.013 0.0028 0.66 item statistics n raw.r std.r r.cor r.drop mean sd c1 180 0.85 0.86 0.81 0.77 3.1 1.0 c2 180 0.87 0.87 0.84 0.80 3.4 1.0 c3 180 0.87 0.87 0.83 0.79 3.3 1.1 c4 180 0.86 0.86 0.81 0.78 3.2 1.1 c5 180 0.88 0.88 0.84 0.80 3.3 1.1 dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 2020 43 than 0.3. the variables meet the condition. all of these questions can be used for further analysis (table 11). 4.2.7. regret aversion as the total alpha value in this case is 0.53, <0.6, these questions cannot be used for further analysis (table 12). 4.2.8. mental accounting the value of the total alpha in this case is 0.72, >0.6. the values of “r.drop” are higher than 0.3, thus making it possible that these variables can be further used in the analysis (table 13). 4.2.9. herding the value of the total alpha is 0.92. this value is significantly higher than the standard value of 0.6, so this condition is met. we need to verify that all values of “raw_alpha” are smaller (or equal) than the general alpha value. variables meet this condition. the values of “r.drop” should be (approximately) >0.3. the variables finally meet the condition (table 14). factors which did not meet the criteria required are not reliable and those which met the criteria, influence decision-making. three factors were eliminated and there were left only six out of nine. 4.3. descriptive statistics it is used to determine the level of impact of psychological biases on individual investor decision-making. it consists in calculating the mean and standard deviation of the variables left after the efa and the cronbach’s alpha test. the following criteria are set to determine the level of the impact of the variables (luong and ha, 2011): • means in value smaller than 2, indicate very weak impact of the variable • means in value ≥2 and significantly smaller than 3, indicate relatively weak impact of the variable • means in value slightly smaller and >3, indicate moderate impact of the variable • means in value significantly >3 and slightly smaller than 4, indicate relatively strong impact of the variable • means in value ranging from 4 to 5, indicate very strong impact of the variable. table 15 summarizes the values of means and standard deviations of heuristics, perspective and herding which determine the level of the respective impact on albanian individual investor decisionmaking. 5. conclusions the results show that psychological biases affect individual investor decision-making while investing in financial assets in albania. the extent of this impact ranges from moderate to strong. a. although facts have shown (the case of pyramid schemes in 1997 in albania) “herding” has been actively present in albanians’ decision-making, the current situation shows another level of investor prudence. although at a completely different stage of the albanian financial system, the underdeveloped financial market in the country and the very low level of individual financial literacy makes investors imitate each other’s actions, believing that the others may be more informed then them b. usually investors in the financial market in albania exhibit a tendency of relatively overconfidence. these results are also strongly influenced by the fact that the interviewed investors are middle and high income investors, with an above average self-perceived level of financial literacy, which does not necessarily indicate a high level of it c. as they are affected by “representativeness,” investors in albania tend to join the investment fund when the quota price continues to rise, as they feel optimistic about its continued growth, but fear and withdraw their funds when the price of the quota declines as a result of its short-term fluctuations d. “loss aversion”: albanians are quite easily negatively affected by short-term volatility, what makes them leave the investment too early (whilst the prospectus of these funds strongly recommend not to do that). making future investment decisions based on previously suffered shortterm losses, may limit the chances of making new good investments and benefiting from long-term investments or diversification e. the ocurrence of the deposit crisis in 2002, showed that the the previous pyramid scheme crisis of 1997 had caused creation of strong psychological expectations into investors, thus implying the active presence of “availibility.” the current moderate impact, can be explained based on the slight indirect consequences the last 2008 global financial crisis had in our country f. “mental accounting”: individual investors in albania fail to conceive the entirety of their investments, but see them as separate and independent accounts, without considering possible links between them. a thorough and comprehensive look at investor’s portfolio can enhance the quality of his decisions. table 15: means for heuristics, perspective and herding statistics heuristics perspective herding representativeness overconfidence availability loss aversion mental accounting herding a1 a2 a4 a5 a7 a13 a14 a15 b1 b2 b5 b6 c1 c2 c3 c4 c5 mean1 2.85 3.06 2.97 4.01 3.93 3.28 standard deviation 0.81 0.78 0.81 0.83 0.97 1.05 impact moderate moderate moderate strong strong moderate 1mean is calculated as the simple average of the means of each variable dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual 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(2008), the effects of behavioural factors in investment decision-making: a survey of institutional investors operating at the nairobi stock exchange. international journal of business and emerging markets, 1(1), 24-41. dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 2020 45 annexes annex a semi-structured interview with the financial market expert, mr. elvin meka. 1. “representativeness” influences individual investment decision making on financial assets at a moderate level em: i agree with the conclusion that ‘representativeness’ affects decision-making of the albanian investor individual, and i even think that its impact may be even more than moderate. the “moderate” level belongs mainly to groups that having an above average level of financial literacy. let us consider the behavior of albanian investors towards investment funds: they tend to join the fund when the quota price continues to rise, as they feel optimistic about the continuation of its growth, but fear and withdraw their funds when the quota price falls, as a result of its short-term fluctuations. 2. “overconfidence” affects individual investment decisionmaking on financial assets at a moderate level em: it is an impressive finding, taking into consideration the very modest level of education and financial literacy of the albanian investor public. i personally believe that it is precisely because of this level of financial literacy that the average albanian investor tends to be overconfident. usually, a sophisticated investor exhibits this bias less, due to his objectivity deriving from the higher level of knowledge and experience with investments, which is not the case of the albanian individual investor. 3. “availibility” affects individual investment decision making on financial assets at a moderate level em: i believe this finding is within the expectations of the albanian investor. in the albanian context, we can mention the case of banking panic in 2002, where a significant role in its creation was played by the psychological expectations the masses had created in them. these psychological expectations originated from the previous pyramid schemes crisis of 1997. 4. “loss aversion” affects individual investment decision making on financial assets at high level em: this finding is correct, as in investment philosophy in general any investor is generally risk averse. this is especially true in the case of the not sophisticated investor. among the current investment options in the country, the investment funds market is typically characterized by the fast impact of short-term volatility. there is an early withdrawal of the albanian investor from the investment (which is strongly not recommended by the prospectus of these funds) thus losing the opportunity for the benefit of long-term returns and diversification. 5. “mental accounting” influences individual investment decision making on financial assets at high level em: i agree with this finding as well, as “mental accounting” is one of the most determinant psychological factors, which forces many investors to make bad choices or not leave in time from the wrong investments due to their lacking ability to overview a complete frame of the various individual investments of their portfolio. 6. “herding” influences individual investment decision making on financial assets at a moderate level. em: as in the case of the ‘representativeness’ conclusion, besides the fact that i fully agree with the conclusion that ‘herding’ influences the decision-making of the albanian individual investor, i think this factor should strongly influence the albanian investor. the case of pyramid schemes, the massive withdrawal of deposits in 2008 and their redepositing in march 2009 (following the adoption of regulatory changes about deposit insurance), indicates the presence of the impact of this bias. annex b psychological biases please enter a number from 1 to 5 next to each statement to indicate the degree to which you agree or disagree with it, where: dervishaj and xhaferi: the impact of psychological biases on the decision-making of the individual albanian investor international journal of economics and financial issues | vol 10 • issue 3 • 202046 a: heuristics 1. before i make an investment i consider its past performance 1 2 3 4 5 2. i choose to invest in recent succesful investments and to avoid investing in recent poor performing investments 1 2 3 4 5 3. ben likes opera and likes to visit arts gallery in his leisure time. as a child, he used to play chess with his friends and family. if i have to guess about his profession, i would say that he could rather be an instrumentist in a symphonic orchestra rather than a merchant 1 2 3 4 5 4. i have good knowledge of the albanian market 1 2 3 4 5 5. i am confident in my investing and better performing abilities than those of the others 1 2 3 4 5 6. i believe my investment performance will be better than that of the market 1 2 3 4 5 7. it is due to my knowledge and abilities that my last investment was succesful 1 2 3 4 5 8. to judge about the value of a real estate, i refer to the price set by the seller 1 2 3 4 5 9. i intend to sell my investment as soon as its price which has sharply fallen, rises at least the at the level of the purchasing price 1 2 3 4 5 10. if we toss a coin 6 times in a row, hthtth is more probable to happen rather than hhhhtt, where h-heads, ttails 1 2 3 4 5 11. while playing in a slotting machine, my hope that this machinery makes me a winner, increases after each subsequent loss 1 2 3 4 5 12. as up to now all the babies born during the day have been females, i believe the next baby will be a boy 1 2 3 4 5 13. because of the last month airplane crash, i am trying to avoid travelling by plane 1 2 3 4 5 14. analysts’ discussions and the information they offer in different media are an important source of to my investing decision makimg 1 2 3 4 5 15. i prefer to invest in albania rather than abroad due to my larger amount of information available to me 1 2 3 4 5 b: persepktiva 1. the more profit i make from my investments, the more risk i take in my future investments 1 2 3 4 5 2. after a loss-making investment, i am more cautious and take less risk in my future investments. 1 2 3 4 5 i bought an apartment in order to earn from reselling it 3. situation (1) price drops. i don’t sell the apartment if the price continues to fall, i will regret not having sold it sooner 4. situation (2) price increases. i sell the apartment if the price keeps going up, i will regret my hurry to sell it 1 2 3 4 5 1 2 3 4 5 5. i have 50,000 l (savings from work) in my wallet and i decide to play in a casino with some of it, where i win 30,000 l. i decide to try my luck a 2nd time. i no longer risk my savings but decide to play with the money earned from gambling 1 2 3 4 5 6. when i pay by credit or debit card, i am hesitate less and become more willing to pay more than when i pay in cash 1 2 3 4 5 c: herding 1. you have very little knowledge of a particular investment (e.g. investing in a private pension fund) and are unsure how to make it. other savers start investing in it. now you are considering investing in a private pension fund 1 2 3 4 5 2. the other savers are investing most of their money in a particular investment, for example in real estate. you are thinking of acting like them, as well 1 2 3 4 5 3. other savers are suddenly withdrawing their bank deposits. you are thinking to act like them, too 1 2 3 4 5 4. my disappointment after losing money on an investment is slightly reduced if others experience the same loss 1 2 3 4 5 5. i would be very disappointed if my friends imitating the actions of other investors are making profits while i am losing, as i am not following the trend 1 2 3 4 5 (1) disagree at all, (2) disagree, (3) not sure, (4) disagree, (5) completely agree international journal of economics and financial issues vol. 1, no. 3, 2011, pp.139-144 issn: 2146-4138 www.econjournals.com wage tendency in albania; the reaction to the global economic and financial crisis imelda sejdini department of business administration, faculty of economy, university “aleksander xhuvani”, elbasan, albania. email: sejdiniimelda@yahoo.com abstract: wage of both public and private sectors is a very important source of incomes for most of the population in albania. the importance of public sector wage policy exceeds the sector's actual share of total employment, because the level of wages in this sector is, to a certain extent, a point of reference for wages in the private sector, too. during the first transition years the wages of a great number of the employees, whose enterprises had stopped being operational, were practically a form of social support. the data for this paper are gathered from all the surveys done on wages during transition from the public sources and the institute of statistics. from these data results that the wages have increased recurrently, first of all to counter the inflationary effects and to provide a better remuneration to the employees in both sector, despite the global financial crisis. this is due to the lack of full integration in the global markets. in this paper we discuss about the wage tendency in albania as a country in further development, exposed to the risks of the global financial crisis, and the reaction to the difficulties encountered while the country is preparing for the eu integration. keywords: wage, financial crisis, income jel classifications: j31, g01, j33 1. wages during the first years of transition in albania under the communist system, albania's government had maintained one of the world's most egalitarian wage structures. the central authorities fixed the number of workers at an enterprise, assigned them to particular jobs, and set the wage fund, which for the nation as a whole translated in 1983 to a monthly pay of about l400 for a worker and about l900 for a manager. by 1988 average worker earnings grew to between l600 and l700 (us$89-us$104); and pay for top officials reached l1,500 (us$223). in the early 1990s, the regime modified the wage system, creating incentives for over fulfillment of plan targets, and allowing for a 10 percent pay cut for management if enterprises failed to attain plan targets. economic liberalization spawned a private sector without wage controls (brown, 1999). market-driven price hikes forced the government to raise wages for state workers twice in mid-1991. during the economic chaos, negotiators for albania's newly independent trade unions demanded that the government automatically increase wages to keep pace with price hikes. at state factories and farms idled by disruptions in deliveries of raw materials, workers' salaries were reduced only 20 percent, a move strongly criticized by the country's main opposition party as inherently inflationary. the opposition called for fixed wages for workers at state enterprises and an absolute limit on subsidies to money-losing enterprises, as two means of slowing the bidding-up of wages and inflation (burkhauser et al., 1996). in the chaos, the average monthly income for albanian workers plummeted to the equivalent of about us$10. during this long economic transition we note a radical change of wage structure conducted by the economic development, with its ups and downs during crisis. international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.139-144 140 2. the global financial crisis effect the global financial crisis that has spread around the world has caused a considerable slowdown in most developed countries and has already affected financial markets and growth prospects in developing countries (marone, 2009). the impact on the albanian economy, one of the poorest in europe, is yet to be determined and it expected that the full extent of the crisis will not be felt until a later moment due to the lack of full integration in the global markets. at first glance the albanian economy seems to have performed well in the past year; according to ebrd figures the average growth rate of the economies of south eastern europe at the beginning of the crisis was 6.5% with albania growing at 6.8%, 0.3% faster than the regional average. the albanian economy seems to have escaped relatively unharmed even in 2009, when the impact of the global crisis was felt in many developing countries. figures from the ebrd1 show that in 2009 the average growth rate of the south eastern european countries was -6.2%; whilst albania registered a positive growth rate of 3%. table 1. growth in the region in real gdp (%) 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 albania -10.9 8.6 13.2 6.5 7.9 4.2 5.8 5.7 5.7 5.4 6.0 6.8 3 southeastern europe average -0.2 0.1 -2.5 3.9 4.8 4.7 4.5 7.8 4.9 7.0 6.3 6.5 -6.2 source: acit, 2010 we can’t exclude the albanian economy from the negative effects of this crisis, although it is among the countries that still continue to have positive economic growth rhythms. in front of all the problematic world developments, the albanian economy has assigned positive economic growth during the first six months of 2009 at the time when internal inflation pressures have remained controlled (imf, 2009). according to data published by the albanian institute of statistics (instat), the annual gbp growth during the second trimester of 2009 was 5,3%, maintaining approximately the same rate of the first trimester. the economic activity in the sector of services had the main contribution in the gdp growth. the production sector had also its positive influence in the annual growth of gdp, mainly as a result of construction activities development, but at the same time the industrial activity accelerated the decreasing rhythms that established at the beginning of 2009 ( world bank, 2009). despite the influence of the global crisis, the government continues to have as an ambitious priority the continuing wage growth in order to contribute in improving the quality of life in the whole country. among differentiated wage growth in sectors like education, healthcare, etc. the government has been very careful in controlling the minimum wage in continuous increasing, in order to diminish the number of employees paid with the minimum wage. the policy combination of tax reduction and fiscal administration reinforcement has gained their effect in the income growth and the successful wage growth program application. 3. wage policies in albania during the economic global crisis according to instat the unemployment level during the last quarter of 2009 in albania reached 13.75%. this suggests that the albanian economy is experiencing the effects of the global recession with some delay, as the average unemployment level in the first three quarters of 2009 was 12.7%. according to official data the unemployment level in albania remained stable during 2008 and 2009; however it is interesting to note that according to instat the labor force in the last quarter of 2009 was almost 71 thousand workers less than in the third quarter of 2009. this sudden fall in the labor force is not explained by instat and at about 6.3% of the total labor force is by far the largest seen in the past two years. if these 70,962 are assumed to have lost their jobs, as has been alleged by a number of press articles and by the opposition parties, then the unemployment level in the last quarter of 2009 would jump to a staggering 20.55%. despite this, during the first six months of 2009 the 1 ebrd 2009 transition report wage tendency in albania; the reaction to the global economic and financial crisis 141 salaries in albania increased by about 5.6 %. this was mainly attributed to the public sector increases while in the private sector the wages remained almost unchanged. according to the bank of albania the private sector responded to the global crisis by freezing pay rises for its employees. the public sector on the other hand benefited from an increase in salaries in may 2009 a month before the general elections in albania. the national wage in the public and private sector is increased each year during the last years, according to the data published by instat. in the industrial sector, the average wage during 2007 is increased by 13% relative to the previous year 2006 and 22% relative to the year 2005. in the construction sector, the wage during 2007 is increased by 67% relative to the previous year 2006 and 85% relative to the year 2005. in the transport and telecommunication sector, which are the sectors with the biggest average wage, the wage during 2007 is increased by 16% relative to the previous year 2006 and 30% relative to the year 2005. in the trade sector, the wage during 2007 is increased by 32% relative to the previous year 2006 and 55% relative to the year 2005. in the sector of services, the wage during 2007 is increased by 19% relative to the previous year 2006 and 28% higher, relative to the year 2005. only in the public sector the average wage during 2007 was 12% higher relative to the previous year 2006 and 26% higher, relative to the year 2005. during 2008, the average wage in the public sector increased by 55% relative to the year 2005 and during 2009 it increased by 68% relative to the year 2005. according to the labor market evaluations, the same rhythms are noted in the private sector too. the government has adopted some measures in order to save the competitive abilities of businesses, according partial compensation for the training costs and sequential compensation for the social insurance contributions for the companies that hire unemployed job seekers and especially for the fason businesses (arango, c. and a. pachon, 2003). the fiscal charge on business is highly reduced related to the profit tax reduction from 20% to 10% and the decrease of social insurance payment from 38,5% during 2006 to 24,5% from may 2009. the reduction is mainly related to the employers part of contribution, which is almost half decreased (from 29% to 15%). during 2006 – 2009, the public administration wage growth is above the annual inflation rates declared by instat. at the same time, the differentiated wage growth policies in different sector like education, healthcare, public security, etc. has realized every year an annual wage growth higher than the annual price index (ceni, a., 2007). so the average monthly wage of doctors increased by 84% during 2008 related to 2005 and 100% during 2009, related to 2005. the average monthly wage of nurses increased by 89% during 2008 related to 2005 and 100% during 2009, related to the same year 2005. the average monthly wage of educators increased by 75% during 2008 related to 2005 and 100% during 2009, related to the same year 2005. this wage growth is due to two main reasons: first of all, these sectors were distinguished by low wages although the difficult work they do and secondly, considering them with priority in wage growth, the government has projected to fight the corruption. in the continuous attempt to protect the low income people, the albanian government has increased with significant rhythms the minimum wage. so during 2006, the minimum wage was increased by 18,6% and during 2008 was increased twice, by 6,2% and related to the same period of the previous year, the minimal wage was increased by 21,4%, while before 2006 it was increased by 7-9% (world bank, 2008). from may 2009, the minimum wage was 5,9% higher than during 2008 and 52,5% higher than during 2005. the last growth during july 2010 was by 5,6% related to the previous growth of may 2009. to realize the wage policies, it is negotiated with emplyees and amployers of both public and private sector in order to attein social consent, because the wage is an important factor for the economic activity encouragement and also an important factor for the poverty reduction (fields and kanbur, 2006). this process has been periodically realised in the moments of minimum wage revisions, wage indexation, etc. activating the wages commission of national labor council. in the conditions of the world economic crisis and the influence transmited in the economy of albania, in the preliminary meetings done by employers and employees , organizations in order to decide for the minimum wage changes, used a lot of attention in order to save the business from economic damage, and especially the fason businesses (fullani, 2009). in order to protect the employees from the wage discrimation, the state has approached the sindicates for including the minimum wage in all the collective bargains, as a factor of important priority, especially to the small international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.139-144 142 private enterprizes, securing the employees for the minimum floor of their incomes. the state has also the right to interfere by negotiating in all the divergences encountered from the way the employees are paid. the albanian government, according to the fouth article of europian social card, is trying to reach the parameters requested, by saving the rapport of 60% between minimal national wage and average national wage and this is another reason why we have continuous growth of the minimum wage. actually this rapport is 48%, although the considerable growth of the minimum wage and this is because of the influence in the average wage, the growth of wages in the education and healthcare sectors. related to this, it is very important to note the positive influence of the wage growth in the productivity growth, by 7 – 8% every year (bank of albania, 2009). table 2. minimum wage growth (1992 – 2010) period minimum wage (all) growth in % august 1992 675 1 january 1993 840 24 jun 1993 925 10 december 1993 2400 159 october 1994 2620 9 may 1995 3300 25.9 october 1995 3700 12 april 1996 4400 18.9 1997 4400 0 march 1998 5800 31.8 april 1999 6380 10 july 2000 7018 10 jun 2001 7580 8 jun 2002 9400 24 august 2003 10060 7 jun 2004 10800 7.4 may2005 11800 9.2 july 2006 14000 18.6 january 2008 16000 14.3 july 2008 17000 6.2 may 2009 18000 5.9 july 2010 19000 5.6 source: ministry of labor, social affairs and equal chances, 2010 wage tendency in albania; the reaction to the global economic and financial crisis 143 the wage growth perspective in our country for the four coming years, also according to the economic crisis predictions, is optimistic. the wage growth with low wages priority will continue for the next years with a predicted level of growth of 10%, and the minimum wage is planned to grow each year with higher rhythms related to the annual inflation index. wage growth will continue at the same time with the wages indexation in the same percentage of the annual inflation index2. 4. wages tendency and the future perspective during 1995 – 2007, we note a growing tendency in the average monthly wage for the public sector employees. we can not say the same for the real wage tendency, which is affected by the inflation fluctuations. during 1994 – 1996, as a result of price stability and wage growth in the public sector twice during a year, the wage growth has been bigger than the price growth. the economic crisis during 1997 was accompained by the real wage decrease, by 17% related to 1996. during 1999 the prices almost didn’t change but the real wage was changed by 17,7%. the year 2001marks a growth by 15,1% of the monthly average wage at the same time when the consume products prices are grown by 3,1%, resulting with the real wage growth by 11,6%. during 2003, the average monthly wage is increased by 8,5% when the consume products prices are grown by 2,4%, resulting with the real wage growth by 6%. during 2004 the average monthly wage is increased by 9,9% when the consume products prices are grown by 2,4%, resulting with the real wage growth by 7,3%. during 2005 the average monthly wage is increased by 9,9% and the real wage growth is 7,3%. during 2006 the average monthly wage is increased by 7,5% and the real wage growth is 4,9%. for the year 2007, the average monthly wage is increased by 17,1% when the consume products prices are grown by 2,9%, resulting with the real wage growth by 13,8%. for the year 2008, the average monthly wage is increased by 8,2% when the consume products prices are grown by 2,2%, resulting with the real wage growth by 4,7%3. the government has planned a wage growth for the future, by conserving the rapport not more than 1 to 5 of the lowest and higher wages. during 2005 – 2010, the minimum wage is increased by 61% related to the 2005 minimum wage. thir minimum wage gowth has been gradual each year during this five years period, resulting with more than double growth from the previous five years. the priority in the wage growth has resulted for the education and healthcare sections, when the wages are duplicated. the average wage for the public sector employees in general during the last five years 2005 – 2010 is increased by 79%, related to 36,4% of growth during 2002 – 2005. 5. conclusion wage policies can affect the buying power of employees and the growing tendency improves their quality of life. the tensions between the government and the social partners have been intensive and the wage regulations have encountered a lot of difficulties. the minimum wage still remains an important mean to maintain the consume of them at the end of the pay scale for the further improvement of the economy. the decisions for the minimum wage must be approached in a very careful survey of wage variations and other income sources for the most affected groups of population. all this can provide the base for the further decisions about conserving the buying force through the combination of the minimum wages with the other policies for the income generation and the tax reduction. the effective response to these policies needs a strong social dialogue and a careful survey of the impact of crisis to the week employees. at the same time there is not an universal system of wage decisions and the national regulations reflect the level of collective bargains and the role of state in the wage policies, at the meantime that the evidence tells that the social partners inclusion is very important. the social dialogue can lead to a better articulation of wages and negotiates related to this. the government must help the employees to be protected by the unfair competition, creating a climate that helps the job creation and the poverty reduction, and improves the competitive abilities of companies. this is a difficult challenge, but the wage growth obligates the employers to consider the 2 ministry of labor, social affairs and equal chances, 2010 3 this data is published by instat, 2009. international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.139-144 144 investments in the human capital and other complimentary factors in order to improve the labor productivity of employees. this argument can stimulate the employers to find ways for the efficiency improvement and to conserve the competitiveness in the global economy. references arango, c. and a. pachon (2003). distributive effects of minimum wages on household incomes. washington, dc: world bank, memo. brown, c. (1999). minimum wages, employment, and the distribution of income, in o. ashenfelter and r. layard (eds), handbook of labor economics. elsevier: north holland. burkhauser, r. v., k. a. couch, and d. c. wittenburg (1996). who gets what from minimum wage hikes: a re-estimation of card and krueger’s distributional analysis in myth and measurement: the new economics of the minimum wage," industrial and labor relations review, 49 (3): 547.52. ceni, a. (2007). menaxhimi i shperblimit, 471-508. ebrd (2009).transition report. fields, g. and r. kanbur (2006). minimum wages, poverty and income sharing. cornell university. bank of albania (2009). financial system stability in albania for the second half of the year 2008. bank of albania statement. fullani, a. (2009). recent economic and financial developments in albania. monetary policy statement for the second half of 2008, bis review 29/2009. imf (2009). the implications of the global financial crisis for low income countries. imf multimedia services division, 4-6. marone, h. (2009). some effects of the financial crisis on the developing world. office of development studies united nations development program, new york. world bank (2008). global financial crisis and implications for developing countries. washington dc. world bank (2009). the global economic crisis: assessing vulnerability with a poverty lens. washingtondc.(http://siteresources.worldbank.org/news/resources/wbgvulnerablecountri esbrief.pdf) . tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(5), 187-202. international journal of economics and financial issues | vol 10 • issue 5 • 2020 187 cost of educational deprivation: a case of pakistan nayar rafique1*, idrees khawaja2 1air university, a&ac, kamra, pakistan, 2 senior research economist, pakistan institute of development economics, islamabad, pakistan. *email: nayyar.rafique@aack.au.edu.pk received: 24 june 2020 accepted: 30 august 2020 doi: https://doi.org/10.32479/ijefi.10335 abstract being a developing country, with a hugely deprived educational profile, pakistan is facing huge cost of its millions of uneducated and out of school population. though we know that lack of education imposes costs on individuals and society, however no precise estimates of such costs are available. this research attempted to explain the cost associated with massive educationally deprived population in pakistan by using hies-pslm 2018-2019 dataset in the light of human capital theory and capability approach. the results showed gigantic loss of income for pakistan due to the current educational profile of labor force which includes enormous population with no education or lower level of education. given the results, we can say that if every individual in pakistan receives at least 10 year of schooling according to sdg goal 4, then pakistan could have thousands of billion more income which not only stimulate further economic growth but a wider development in every sphere of life at individual as well as collective level. keywords: pakistan, development, human capital, returns to education, cost, sdgs jel classifications: o1, o2, i2, i3 1. introduction a quick review of pre-ww-ii development discourses reveals the dominance of economic perspective emphasizing the availability and growth of economic resources as the key to societal development. this perspective with various interpretation remained dominant in the post-world-war two period till 1980s, when development experts across the globe felt stagnation, a socalled development impasse in the development thinking after recognizing failures of traditional development philosophy in generating efficient responses against various socio-economic problems such as poverty, inequality, unemployment, conflicts, market inefficiencies, lack of growth, and distribution of resources (booth, 1985). this very situation urged academia to re-assess the development thinking to move forward for a breakthrough for a sustainable, inclusive and holistic development of societies (schuurman, 1993). some important breakthroughs in the post 1980s development thinking then emerged which changed the dynamics of growth and development of societies. first, social as well as political parameters were recognized equally important for the sustainable development of a society in addition to its economic attributes. second, the missing link in development planning were identified, resulting the inclusion of development beneficiaries in development planning in an inclusive bottomup participatory development model contrary to the top-down development approach. third, a major shift in the thinking emerged as a realization of the importance of rule of games i.e. the role of social, economic, and political institutions to govern the development process in a nation state framework. fourth, a wider recognition of individuals, the fundamental unit of a society, as the “mean” as well as the “end” in the development process. this recognition highlighted the importance of individuals and their quality explained by a wider set of capabilities in defining the nature of institutions and hence shaping the path of development for a society. fifth and the most important breakthrough in post 1980s development thinking emerged as a greater recognition of education as an important factor determining the quality of individuals and hence quality of institutions as well as society this journal is licensed under a creative commons attribution 4.0 international license rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020188 (north, 1991; chambers, 1997; robinson and acemoglu, 2012; ostrom, 2015). education, thus, has been recognized to be the most important social commodity that provides the foundations for enlightened, developed, and civilized societies. supplied through public as well as private channels, education transforms the raw individuals into worthy human capital and hence influences the wellbeing of individual as well as societies through various channels. it enhances the capabilities of individuals and hence offer freedom to the individuals as well as societies to grow. the flipside is that deprivation of education defined by lack of education of masses, deprives the individual and society of freedom explained by limited set of capabilities and hence creates barriers for the wellbeing of individual as well as society. individuals with less education or no education are thus considered, poor-quality individuals with less freedom to enjoy wider set of functionings in social, economic, and political spheres. the path of development a society follows mainly depends upon the quality of individuals an economy has and quality of individuals mainly depends upon their capabilities, defining their freedom as well as operational domain to contribute effectively to their own as well as societal growth and development (sen, 1980). thus, by recognizing individuals as the means as well as end in the development process, the post 1980 development thinking emphasized the importance of individuals towards the wellbeing of societies. the capabilities and operational domain of an individual besides dependence on various societal conditions, equally relies heavily upon individuals’ personal worth, explained by level of education and hence access to resources. this development thinking seems miles away from its actual sense and application, when analysed in the context of pakistan. pakistan with an abysmal educational progress is immensely deprived of educated individuals. presence of a massive uneducated population on one hand is incapable of generating substantial national resources and hence hinder the speed of economic growth in pakistan but on other hand is creating huge anxiety in the society through various social, economic, political and security issues requiring huge efforts accompanying massive economic resources. presence of massive uneducated population in this way is costing pakistan in terms of lower contribution to the national income as well inefficient utilization of resources leading to fragile and inconsistent economic, social, and political development. though we know that lack of education imposes costs on individuals and society, however no precise estimates of such costs are available. this huge void in research makes societies like pakistan incapable of realizing the importance of education for a sustained, stable, and efficient growth and development. this study seeks to fill this gap by computing the cost of educational deprivation for pakistan by considering the district level data of pakistan social and living standard measurement survey hies-pslm 2018-2019. the study attempted to successfully achieve two main objectives: first, it estimated the returns to education for the case of pakistan based on latest dataset; second, by considering the labor force proportion in the age bracket 25-59 according to educational level, and returns to education estimates, the study has explained the cost associated with massive uneducated or less educated labor force, what we called, the cost of educational deprivation. this research in the light of earlier explained objectives has been extremely important for identifying and highlighting the value of education and the cost of educational deprivation in terms of lost incomes based on less productive and less efficient massive uneducated population. computing this income loss is extremely important because if saved or reduced by educating population, this income can put pakistan on the path of sustainable growth and development. thus, current situations and future growth perspective of pakistan become the core motivation for this analysis. this analysis can provide important policy insights by highlighting the losses and their sources associated with educational deprivation. on applied fronts, the research, by showing the significance of quantity as well as quality of education has provided valuable insights to supplement pakistan’s journey towards achieving various sustainable development goals. individuals, political leadership, policy makers and society can be induced to pay greater attention to imparting and seeking education if it can be shown that education is the key to growth and development in every domain of life and lack of education is imposing substantial costs for individuals as well as societal wellbeing. by discussing the case of rahim yar khan, this research has highlighted the importance of education for eradication of poverty and hunger; for improvements in health and wellbeing; for quality education; for innovation, infrastructure development, decent work, economic growth, peace, justice, equity and strong institutions. in this context, all the earlier mentioned data sets and estimations generated through this research will support the state towards achieving sdgs by providing the basis for productive, sustainable policies for a longterm sustainable growth and development of pakistan. attempting to achieve the explained objectives, this research is organized as follows. section 2 provided an overview of pakistan’s development, section 3 describes the framework, data and methodology of this research, section 4 provided the results and section 5 provides result discussion and conclusion of the whole research and suggested policy recommendations. 2. an overview of pakistan’s development as per sixth population census conducted in 2017, total population of pakistan stands at 207.78 million. when compared with the results of population census 1998, the total population grew at a rate of 2.40% from 1998 to 2017. the urban population rise by 4 percentage points from 32.5% in 1998 to 36.4% in 2017. the female population also depicts a growth of one percentage point from 48% to 49% causing a decline in the sex ration from 108.5 to 105.07. the age structure of population has also changed from 1998 to 2017 as percentage of population in under 15 years of age fell to 30.76% from 43.4%, the working age population on the other hand has risen to 64.5% in 2017 from 53.09% in 1998, and population in the age bracket of 65 and above has also risen to 4.56% from 3.5%. this change in age structure, with shift of population into working age rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020 189 bracket from youth dependent age bracket has changed the overall age dependency ratio from 88.34 to 65.3, with youth dependency ratio of 57.9% and elderly dependency ratio of 7.4. the literacy rate of pakistan also changed from 43.92% in 1998 to 59.13% in 2017 but still pakistan is ranked 147th out of 165 countries according to global literacy rate ranking, showing a poor state of education. pakistan, with a 51.5 million uneducated adults and 10 million uneducated youth, is the third amongst top ten states with more than 10 million uneducated adults, second amongst top ten states with 2 million uneducated youth (aepam, 2015). in addition, pakistan is second highest in the world with 22.84 million1 out of school children in the age bracket of 5-16, representing 44% of the total population (51.53 million) in this age bracket (nemis-aepam, 2018). according to the recently conducted household integrated economic survey (hies) 2018-2019, from 25,490 households across the four provinces in pakistan, 61% of the total population has ever attended schools. 30% of the children in the age bracket 5-16 are out of school with 23.56% never been to school and 6.57% attended but dropped out. overall literacy rate stands at 60% with males 71% and females 49%. youth literacy for the age bracket 15-24 is 72%. according to the survey, 14% of the households has computer, 95% has mobile phones and 34% has internet. 45% of the individuals own mobile phone with at least one connection, 8.25% has desktop, laptop, and tablet pc, 5 % has smart phones with 59% are able to use any of the ict technology for entertainment, 43% able to use social media, 47% are able to email, 17% use computers for presentations, 26% for spread sheet, 32% for file transfer among devices, whereas only 17% possess the advance skills to use ict for programming. this miserable state of education, on one hand depicts an inherited disability of the nation towards achieving higher growth and hence a sustainable development and on other hand is a major source of various social, economic, and political problems of pakistan. the situation is well evident from the performance of pakistan on various development indicators. a poor state of education depicts a great failure of pakistan towards prioritizing education in due course of history. many social, economic, political, and religious factors played a role behind this state of affairs and kept literacy rate below 60% which also includes a massive population which can only read or write. lack of resources and lack of will both played well towards poor growth of education in pakistan. deficiency of resources due to fragile and inconsistent economic growth, corruption, political instability, weak policies, strong feudal impacts, religious disharmony, regional disputes and a continuous state of war after independence in different forms are the major factors towards extremely slow progress in educating the nation (zaidi, 2015). due to slow pace of educational growth in pakistan, the country is facing challenges on all fronts at micro and macro level. the country has a huge mass of illiterate and unskilled population unable to contribute well in a productive manner for the development of state. its illiterate population is unable to pick the right political leadership, played in the hands of so-called 1 https://www.unicef.org/pakistan/education religious extremist forces, is ignorant or less enthusiastic towards environmental, health and gender issues. all these areas on one hand hinder the speed of economic growth in pakistan but on other hand create social, economic, political and security problems requiring huge efforts accompanying massive economic resources to cope with them. in this way presence of gigantic uneducated population is costing development of pakistan in every sphere (zaidi, 2005). this situation is evident from pakistan’s ranking on various global measures/indices covering political, economic, and social domains. politically pakistan’s ranking of 189 out of 195 states on global political stability index2, depicts it as the 7th most instable political landscape in the world. in addition to political instability, pakistan is ranked 120th out of 180 countries on the corruption perception index 2019, depicting the state of fair dealings. according to global prosperity index 20193 pakistan is ranked 140th out of 167 states with 156th place with reference to peace and security, 122nd for personal freedom, 120th for governance, 127th for enterprise conditions, 128th for market access and conditions, 138th for economics quality, 121st for living conditions, 127th for health, 133rd for education and worst for natural environment with 167th place. this situation is also verified by the poor performance of pakistan according to the recently published report of globally recognized human development index4. pakistan, with 67.1 years of life expectancy at birth, 8.5 expected years of schooling, 5.2 means year of schooling and $ 5109 gnp per capita (2011 ppp) is currently occupying 152nd place out of total 189 countries for overall human development and gender development. also ranked 136th according to gender inequality with maternal mortality rate of 178 deaths per 100 live births, adolescent birth rate of 38.8 births per 100 women aged 15-19, twenty percent share of seats in parliament 26.7 % female population with at least secondary education in comparison to 47.3 5 of males and 23.9% of labor force participation for females aged 15 and more in comparison to 81.5% of males. furthermore, it is a house of 38.3% poor population according to multidimensional poverty index 2019. pakistan due to unskilled labor force, inefficient and outdated technology, corruption, and poor governance ranked 110th out of 141 economies regarding global competitiveness according to recent report5. the report ranked pakistan 29th largest economy according to market size, 52nd dynamic business environment and 79th state with reference to innovative potential. despite this, the state is considered to be lacking a long-term view of competitiveness with mediocre ranking of pakistan for the rest of 9 out of 12 pillars of global competitiveness i.e. institutions (107), infrastructure (105), macroeconomic stability (116), ict adoption (131), health (115), skills (125), product market(126), labor market (120), financial system (99). in addition to pakistan’s poor global rankings, the average productive capacity of the work force is way behind the economies with higher proportion of educated population. it has been 2 https://www.theglobaleconomy.com/rankings/wb_political_stability/ 3 legatum prosperity index 2019 4 human development report 2019 5 global competitiveness report 2019 rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020190 comprehensively explained through schooling-wage relationship that productivity of an educated person on average is 40 to 50% more than an uneducated person. with this observation, an economy relying on uneducated or illiterate labor force bearing an economic loss of almost half of the total output as with educated labor force it can produce twice than with illiterate labor force. regarding the importance of education towards economic performance, it is explained that better education does not only lead to higher individual income but also is a necessary precondition for long-term economic growth (lutz et al., 2008). education is a longterm investment associated with near-term costs, but, in the long run, it is one of the best investments’ societies can make in their futures. a report titled ‘economic and social cost of illiteracy’ by world literacy foundation, summarized different types of social and economic costs related to illiteracy with reference to output, employability, business performance, technological skills, health, crime and welfare (cree et al., 2012). the report, which looks at the cost of illiteracy in emerging and developing countries, as well as the cost of functional illiteracy in the developed world, points out that illiteracy costs the global economy over usd 1.19 trillion a year. as per the parameters described by literacy foundation report, illiteracy costs pakistan an estimated usd 6 billion and india an estimated usd 53.56 billion. the losses to china are pegged higher at usd 135.60 billion. russia at usd 28.48 billion and brazil at usd 27.41 are placed at the third and fourth places, respectively. in conclusion, if we look at the socio-political and economic dynamics, pakistan is a state with massive illiterate population, 2nd highest in the south asia after afghanistan. with this huge mass of illiterate population pakistan is facing crisis in all domains. economically, pakistan’s productive efficiency, competitiveness, innovativeness, in all major industries including agriculture is lowest as compared to its productive potential. a key factor, among many, of this situation seems to be uneducated and poorly skilled labor force. we can calculate the economic loss due to uneducated population by comparing the current and potential production. socially, level of human rights violations, crimes, gender issues, terrorism, problems of extremism, and feudalism all are typically at a higher proportion in uneducated population and it directly or indirectly impacts economic development in the state. as per cree et al. (2012) 85% of the prisoners involved in different types of major or minor crimes in developing world have no education. one of the major causes of under development in rural pakistan is the hold of feudal system that only stands upon the exploitation of massive uneducated poor population, that restrict them to participate actively in the economic and development process for their own and overall social welfare (reference). politically, pakistan is ranked among top fragile states where democracy is only symbolic without any real fruits for the common man. one of the major reasons for this fruitless political system seems to be massive uneducated population, less able to take rational and effective political decision on merit. this state of affairs has the potential to lead to the election of inefficient, or incapable political leadership. this in turn hurts overall development through nepotism, corruption, bad governance, wrong policies, inefficient use of resources and authority. these practices at one end weaken the confidence of foreign investors due to inconsistencies in policies committing a heavy economic loss and push nation into depths of desperation and on the other hand invite non-political forces to occupy the state machinery which is evident from more than three decades of military rules in the overall history of pakistan. this indirectly cost nation in term of fragile political systems and also severely impacts state sovereignty (pildat, 2004). 3. framework, data and methodology recent advancements in the development thinking positioned individuals, the basic unit of every society, at the core of development. being end as well as mean in the development process, individuals are recognized to be the most important factor in the development of every society since heterogeneities in the development of states in the contemporary development map is explained by the differences of the quality of individuals they have. an overview of global development landscapes provides worthy insights that states who developed rapidly, invested heavily on their individuals to turn them into worthy human capital. these investments when makes individual to have more capabilities and hence access to a wider operational domain, at the same times provided state with the high-quality human capital to generate extra resources as well as strong institutions, and providing foundations for the sustainable development. a further review outlined some common policy traits of highly developed societies that they paid equal attention to the growth of individual parallel to the growth of infrastructure. when they build physical infrastructure, at the same time they focused equally on the quality of individuals to utilize their infrastructure and resources. quality of individuals in state when required good infrastructure, it also requires massive investments in education and health. these investments lead to an improved life expectancy, improvement in productivity and hence improved level of individuals as well as national earnings. thus, education stands out to be the most important and influential factors in societies transition from less developed to more developed, and that is only through turning poor quality individuals into high quality productive human resource. base on the study objectives, two main areas which this research has focused involves the estimation of returns to education and cost of educational deprivation. to estimate returns to education we have consulted mincerian earning function in the broader framework of human capital approach. to compute cost of educational deprivation, we have adopted a straightforward computational mechanism that involves the comparison of incomes to explain difference of income generation as the opportunity cost of lower educational profile. 3.1. the concept of capital and human capital in difference fields the term capital refers to different meaning: in accounting capital means financial assets to start and run a business enterprise, in economics it generally refers to tangible assets, technology or infrastructure to facilitate the production of want satisfying goods and services, in social sciences capital rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020 191 means the social infrastructure that provides the foundations of a stable society. whatever is the field of study or domain, the term capital refers to certain resources which may facilitate the creation of some goods or services. with this interpretation, capital may also include individuals without which it is hard to produce goods and services and which are the ultimate consumers of these goods and services. this perspective of seeing individual as capital can be found in the ever-progressing production theories which first assume individual as a factor of production to produce goods and services by utilizing capital and other resources. in the earlier parts of twentieth century, individual was described to be a special type of capital. walsh (1935) being pioneer in this respect, in his influential work “capital concept applied to man” argued that individuals has all the attributes which capital goods assume and hence can be treated as a special capital. this capital also requires investments with similar importance as are required for the physical capital to produce more goods and services. with investments made to human are equally important as investments made in physical capital for growth and development of a society. one of the important investments as explained by walsh (1935) is investments for educating individuals, this in addition to enhancing the technical skills, will improve the thinking abilities and visions to optimally respond in different social, economic, and political spheres. education at one end will directly impact the earning potential/lifetime earnings and on other hand it will provide handy tools and information for lowering costs and increasing benefits in different other areas such as physical, mental, and social health, urge for innovation, urge for better environment, and stable sociopolitical system. building on this principle (kendrick, 1961) explained four major types of capital as: tangible human capital which principally refers to quantity of labor force; intangible human capital which encompass the knowledge, expertise, experience, skills and other human attributes qualities which makes them able to produce more, intangible non-human capital that refers to process and procedures, techniques and technologies to facilitate production process; and tangible non-human capital which covers every physical assets, machinery, plants, structures, resources which can facilitate production process. human capital as explained by (becker, 1964), refers to the aggregate investment on humans which not only enhances their market capabilities earning potentials but also impact their general life through its wider spillover effects. the phenomenon refers to a combination of innate and acquired skills and abilities throughout the life span of an individual. innate abilities when depends upon the circumstances of individuals in which they born and grown, the acquired skills on the other hand requires some treatment to facilitate accumulation of knowledge, skills, and health against substantial costs, called investments in human capital. individuals at various stages of their life, utilizing both sets of skills and abilities to be more productive and hence enjoy better standards of living and wellbeing. despite simplicity in the meaning, the concept of human capital is a complex phenomenon and requires a greater grasp of some aspects which may influence its accumulation. generally, the concept is defined through some specific aspects with some basic’s differences from non-human capital. first, human capital consists of both the innate and acquired abilities and skills. innate human capital represents the trio of inborn physical, psychological, and intellectual strengths which an individual carry at the time of birth. acquired human capital on the other hand, represents the intellectual assets and knowledge, technical skills, good health and physical strengths, and capabilities which individuals attain throughout their lifetime through personal contacts and with some investments. second, non-human capital generally refers to a stock variable and a tradeable good. human capital on the other hand can be considered as a stock as well as a flow variable based on the components it encompasses which regularly changes with the scale of knowledge, experience, age etc. furthermore, human capital is a different kind of capital in comparison to physical capital with reference to its marketability and trade, accumulation, financing and returns. third, decision control regarding the quantity and quality of human capital stock an individual may have varies with the age. starting from the strict decisional control of parents and various socioeconomic institutions, individuals internalize these decisions in the later stages of their lives. individual, then take decisions based on the micro and macro environment and associated incentives with the level and kind of human capital. fourth, sources of human capital are both formal as well as informal. formal sources include the institutional mechanism to transfer essential skills and knowledge to the human in a regulated formal environment. informal sources of human capital on the other hand encompass the broader ecosystem where individuals live and work. this ecosystem helps individuals accumulate human capital through personal engagements and self-learning. fifth, human capital can further be categorized based on its domain of operations. the kind of human capital associated with some specific activities or involves some specific skills, knowledge, and training, is called specific human capital. whereas the kind of human capital that pertains a broader application in the social and economic environment is called as general human capital. sixth, the stock of specific and general human capital for individuals vary according the level of investments as well as the quality of investments individuals incur while accumulating human capital. furthermore, human capital involves both qualitative as well as quantitative aspects. knowledge is a qualitative face of human capital, but years of schooling an individual has quantitatively represents this human capital. similarly, same year of schooling from a good quality institution and a bad quality institution also reflects on the human capital of individuals. with this comes the influence of some external factors and quality of broader ecosystem where an individual acquires and apply human capital. for instance, the quality of educational system, the kind of working environment and the social conditions all influence the quantity as well as quality of human capital. in the light of these aspects, the stock of human capital may vary among individuals based on their circumstances and their investments. with reference to its uses, human capital corresponds to a set of marketable and non-market individual characteristics and skills. by marketable it means, those skills and individual attributes which increases the productivity of individual in labor market (becker, 1993). most of the literature on human capital address this use by considering knowledge and skills as an essential part of production function. rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020192 by non-market uses, it explains the spillover effects of knowledge, skills, training, and good health beyond market for the broader wellbeing of individuals. 3.2. education and human capital stock an important attribute that differentiates human from other livings species is the ability to learn and then utilize this learning to generate multiple benefits in the life. a key attribute in this context involves the retention and transmission of the learning/ knowledge and skills among people which stands out to be the key to contemporary growth and development on both academic as well as nonacademic fronts. a structure that facilitate this transmission of knowledge is generally referred to as schools and the process through which transmission took place is called schooling, generally called education. since human capital is the stock of knowledge, the education then corresponds to process of accumulating the stock of knowledge that requires certain investments. education thus is considered as a major form of investment in human capital. human capital approach consider education as a triggering force for many positive externalities for an individual as well as society’s growth and development in addition to its services for production. it emphasizes the investments in human resources today to generate some private as well as social returns at some future time. private returns are purely related to the individual’s cost and benefits of investment in education. it explains that: what direct cost as well opportunity cost individuals incur for their education; how this education add value into the life and productivity of individuals; and how this improves the earning prospect at some future times (walsh,1935; mincer, 1974; schultz, 1961; becker, 1964). individuals investment in formal education create positive signals regarding their abilities, skills, and set of information which makes them attractive to employers and raise their chances of employment (schultz, 1961). their skills gained through education when coupled with their work experience makes them more competitive in labor market to have more private return in terms of higher current earnings and to accumulate more life time wealth than those with less education (mincer, 1974). as far as social returns are concerned, these are explained by the investments plus opportunity costs incurred by the society towards educating an individual and the benefits associated with these investments. so, educating an individual by the society does not only create value for that individual, it is equally valuable for the whole society as it will enhance the productivity and earning potential of the whole society (riddell, 2006). contemporary research has recognized education as the key lever of individual, societal, and global growth, and development. linking human capital approach with the capability approach, education enable individuals to acquire essential skills and abilities to liberate himself from the economic limitations to enjoy greater economic freedom for his own as well as societal wellbeing. in line with observation we can build on the nexus of education, human capital, and individual quality. to analyse the association of education, the stock of human capital, and quality of individuals, we need to investigate the dynamics of individuals quality and its associated concepts. in the earlier mentioned aspects of human capital, an individual having substantial stock of human capital may well be called a good quality individual in comparison to the one with a poor stock of human capital. it is hard to exactly quantify or assess the quality of human capital stock and difficult to ensure the full utilization of all the skills, knowledge, and abilities representing the human capital stock. measuring the quality of individual in this context is a complex phenomenon. the quality of individuals is explained contextually as there is no universal definition or measure of individual quality based on the subjectivity and complexity the phenomenon entails. economic theory addressed this complexity through the marketability of human capital representing individual quality by viewing individuals with the lens of how they may impact their own as well as society’s economic wellbeing. general production theory explains this impact by considering individuals as one of the major factors of production i.e. labor, responsible for transforming the inputs into valuable outputs by utilizing the physical, technical, technological capital available for production. the extent to which labor contributes to the production process is explained by means of labor productivity, the incremental output associated with each labor unit. the market value of this incremental output provides the basis for the compensation (wages) of labor against their efforts. labor which contributes more to the production tends to achieve higher wages and enjoy more economic freedom and a wider operational domain. in the light of above, the wage of labor is an effective measure of labor productivity as more productive labor tends to earn more value against their incremental contribution. wages in this scenario may serve the purpose of a measure to assess the productivity of individuals which may vary greatly among individuals. an individual is called more productive if he or she is earning more in comparison to his peer under the similar circumstances. concluding on the discussion of human capital, we end up with the year of schooling as a representative measure of acquired human capital and the wages, an individual earn, represents the outcome of his/her stock of human capital and may well be a representative measure of quality of individuals. 3.3. returns to education according to the objective 1, this research has estimated the impact of education (human capital proxy) on the wages of individuals, the two key variables inferred from the previous discussion. the analysis followed returns to education approach as explained by jacob mincer, a leading economist representing the chicago school approach of seeing human capital. the lead scientists in this school such as becker, mincer, and schultz analysed the concept of human capital by considering year of schooling and job experience as the main variables having strong influence on the market wages of individuals. they introduced the idea of returns to education by addressing the linkages of education with wages. the analysis of returns to education occupies a substantial volume of socio-economic literature and significantly contributes towards highlighting the importance of education for individual as well as societal wellbeing. these studies investigated the returns to education by considering varying contexts and data sets and unanimously concluded a positive impact of schooling on wages and hence individual wellbeing. these findings have been at the fore front of policy decisions regarding public interventions in education sector for the holistic wellbeing of societies. the most prominent measure in this regard comes from the jacob mincer rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020 193 in the form of mincerian earning function on the principles of neoclassical theory of capital. he developed a very simple and parsimonious model to assess the returns to education in the broader framework of human capital approach (mincer, 1974). this model, renowned as mincerian earning function (mef) in literature, has enjoyed the most popular measure in the subject matter of returns to education. despite its simplistic structure and various methodological issues, hundreds of the studies on returns to education in varying contexts has used and are using mef as the foundation of their analysis. mef is thus globally enjoying the status of a reference framework to analyse the economic impact of education in term of its contribution towards earning potentials of individuals and how this earning potential changes with a change in the educational level? mincer (1974) explained this relationship by examining the impacts of schooling years on per hour wages, indicated by returns to education or returns to schooling. another approach which attempted to estimate the returns to education is called elaborate approach. this method by considering the age earnings profiles with reference to education level, attempts to finds the discount rate which equates the stream of educational benefits with the flow of educational investment at a given point in time. the annual stream of benefits according to elaborate method is the earning of particular educational level whereas stream of cost involves the foregone earning as well as investment on schooling. private rate of return in this approach reflects the behavior of people in seeking different levels and types of education, and as the distributive measures of the use of public resources. the greatest limitation for the elaborate method is the unavailability of detailed data which is required for the estimation of returns to education according to this method. since other methods involves detailed data sets or methodological complications, mincerian framework, the earning function method, on the other hand involves year of schooling, experience and wage earning and this is the most widely used approach in the world despite various limitations of the mincerian equation, if simplicity is considered for the estimating of the impact of work experience and schooling on wages, the mincerian equation is hard to beat (bjorklund and kjellstrom, 2002). the earning function method estimates the private returns of education by means of a log linear relationship of wages with the work experience with and without a square term for year of experience and year of schooling. the coefficient on schooling in this relationship corresponds to the returns to education contrary to the short-cut method which computed private returns to schooling as the proportion of years of schooling and earning. the equation presented by mincer has been widely accepted and referenced since the time of its inception in 1970 and has been used as a standardized method of calculation of returns to investment in education (psacharopoulos, 1981; card, 1999; heckman, et al, 2003; patrinos and psacharopoulos, 2010). based on the fundamental explained by becker (1964) towards estimation of returns to education in the framework of human capital theory, mincer (1974) proposed the following standard model based on cross sectional individual differentials to quantify the impact of schooling on individual earning. 2 i 1 i 2 i 3 i ilog (w) = + s + e + e +α β β β ε (1) the standard semi-logarithmic model written above, linearly explained variations in the hourly wages (w) through year of schooling (s) an individual has completed and his work experience (e). the model includes a quadratic experience term based on the curvi-linear behavior of wages against labor market experience. various other studies also consider a variety of other controlling factors such as gender, race, profession, age, location, ethnicity etc. in addition to schooling years and experience in the standard mincerian function to estimate returns to education (card and kruegerl, 1992). in contemporary literature, the application of mef comes with and without consideration of individual abilities or capabilities (behrman and birdsall, 1983; lang, 1993; behrman and rosenzweig, 1999; regan et al., 2006). most of the studies on returns to education does not account for the individual abilities as it appears in the above model, due to complexities involved in measuring abilities. these studies then evaluated the returns to education by considering abilities as unobserved. this approach of returns to education by assuming abilities as unobserved variable is followed in this research to estimate the returns to education for the case of pakistan due to unavailability of any observed measure of abilities in the dataset followed for analysis, as explained in the next section. 3.4. cost of educational deprivation finally, the framework to compute cost of educational deprivation follows a straightforward computational mechanism, developed solely for this research. the cost is explained in term of opportunity cost of staying with the current educational profile when it is compared with the incomes associated with some improved educational profiles. the difference of incomes is then explained as the income lost or cost of massive uneducated population. cost is computed by using the outcomes of wage function for the case of pakistan. the cost of educational deprivation, fundamentally, follows the concept of opportunity cost. the concept basically involves the potential and actual incomes associated with each level of education for the labor force in the reference age bracket of 25-59 years. the cost estimation further required the proportion of labor force according to education level. cost estimation for the case of pakistan follows a simple approach that involves five steps: first, wages rates for each year of schooling are determined by using the estimates of returns to education. the wage rates determined are multiplied with the total working hours available in a year to yield average annual income for each year of schooling. second, total, employed, and unemployed working population in the age bracket 25-59 is determined based on the labor force survey 2018-2019. furthermore, based on the education profile of the population in reference class, the proportion of population according to education level was determined. based on the education proportions number of persons with each level of education are determined for total, employed and unemployed labor force. third, multiplying the number of persons in each level of education for three classes of labor force (total, employed and unemployed) with average annual income to compute aggregate income of total and employed labor force as well as income loss of the unemployed labor force. this yielded the total and employed income for each level of education. summing income of all the educational level generated the total income of all the labor force if assumed employed (at full employment level), total income of all the actually employed persons and value of income loss due to unemployed labor force, all in the age bracket 25-59. fourth, six improved educational profiles are assumed for the rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020194 same working population but with a little improved educational profile from the original educational profile. for instance, profile of case 1 assumes a fifty percent decline in the uneducated population and an equivalent rise in the population with primary education. based on the six profiles as explained in the section 4, step two and three are repeated to compute the income of total and employed labor force for each of the six profiles. these incomes are then compared with the original profile to explain the difference of income as the cost associated with the current poor educational profile of labor force in pakistan. fifth, step one to four are repeated for the 9 years from 2009-2017 by discounting the labor force and average annual income with the average population growth rate and average income rise in the reference time 2009-2017. based on these estimates an aggregate loss of income is explained by not having an improved educational profile as of six cases. the whole procedure and estimation results are explained in the next section. 3.5. data the need for reliable and quality data is widely emphasized in social research to produce the good and reliable results for reliable and effective empirical analysis. thus, the pre-requisite for any empirical investigation is the availability of quality data as the method to be used for analysis ought to agree with the nature and quality of data at hand. the design of a study, in this way is defined by the nature of data which then study intends to investigate (olsen and george, 2004; wooldridge, 2010). based on the research objectives defined earlier, this research followed a cross-sectional study design with primary as well as secondary data. thus, whole analysis of returns to education for the case of pakistan is done based on well tested credible dataset of pakistan social and living standards measurement survey hies-pslm 2018-19 with data of 24809 households from all the districts in four provinces of pakistan covering urban as well as rural areas. the dataset provides comprehensive account of various indicators on education, health, population welfare, housing, water sanitation and hygiene, information communication and technology (ict), food insecurity experience scale (fies) and income and expenditure. in addition to household level indicators, the dataset provides a substantial individual level data of 175,691 individuals with variations according to gender, employment status, schooling, various earned as well as unearned incomes, working days, age, and various other attributes. we have used this individual level data of hiespslm 2018-2019 to estimate the returns to education and then cost of educational deprivation for the whole pakistan. all the individuals who are working and falls in the age bracket 25-59 were selected for this analysis. with this criterion, the data of 22,006 working individuals from all the districts of pakistan is used for the estimation of returns to education. further to this, the data regarding labor force statistics is extracted from the labor force survey 2018-2019. despite various issues and limitations, ols is one of the most widely used estimation technique for the returns to education analysis. this research also used ols for the estimation of earning function for pakistan. as discussed earlier, we rely on the data of hies-pslm 2018-19 which provides no appropriate instrument which can be used in the return to education analysis and hence makes it difficult for us to use other techniques such as 2sls or gmm. based on our data constraints we followed the traditional ols technique coherent with the analysis a lot of studies in domestic as well as global scale. 4. results to analyse the returns to education for the case of pakistan based on data of 22,006 individuals in the age bracket 25-59, we have used the traditional mef in the light of various studies (schultz, 1961; becker, 1964; mincer, 1974; griliche, 1977; blackburn and neumark, 1992; belzil, 2006). under the available data and research objectives the estimation of returns to education follows the following wage function: log (phw) = f (edu, exp) where phw represents per hour wages, edu represents the completed schooling years and exp is the work experience. per hour wages was calculated by using the available data regarding total annual income, working days in a month, and working hours in a day. thus, phw is determined by dividing the reported total annual income of individuals with the total annual working hours6 based on reported working days per month7, and average work hours per day. the data regarding work experience was also not available in the pslm dataset. work experience8 is then computed by means of age and schooling years. log of per hour wages is used in accordance with the conventional wisdom to look in the growth of wages against schooling (becker, 1993; belzil, 2006; griliche, 1977; mincer, 1974). the wage function was estimated under two assumptions related to the impact of education and experience in the light of literature. the effect of education on wage growth is widely explained to be positive. coherent with the academic evidence, we have assumed a positive impact of schooling and work experience on the wage growth (schultz, 1961; becker, 1964; griliche, 1977; blackburn and neumark, 1992; belzil, 2006). thus, based on our discussion in the previous section we started the estimation of returns to education by assuming: i i i i and log(phw) log(phw) > 0 > 0 edu exp ∂ ∂ ∂ ∂ (3) under these assumptions, we have estimated the three wage equations for whole pakistan i.e. for all areas, for urban areas, and for rural areas as shown in the appendices table 1. the estimates for all areas explained a 10.9% growth in hourly wages with each year increase of schooling or education. similarly, a 1.8% growth in hourly wages is explained by the work experience. when a dummy variable urban is introduced in the model to capture the variation based on regional differences, the growth in hourly wages is estimated to be 9.9% for urban area and 10.6% for rural areas. similarly, the effect of experience also varies with region. urban areas show on average 2.1% growth in hourly wages associated with each additional year of work experience in comparison to 1.5% growth for rural areas. the sign for both the education and work experience for all three models were according the assumptions. with these values the estimated wage rates for the 6 total annual working hours = 26*12*8 = 2496 7 reported average working days per month in pslm 2018-19 are 26 and average working hours per day are 8 8 work experience (exp) = age – education – 5. here, five represents the average schooling start age rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020 195 referenced education years are summarized in the appendices table 2. annual earning for each level of education is determined by multiplying annual working hours available with the estimated hourly wage rates. thus, annual income for each level of education was determined by using 2518 annual working hours per year. the estimates of income against each level are summarized in the appendices table 3. 4.1. income estimation with estimation of annual income for each level of education, the next step involves the computation of income of total and employed labor force as well as value of unemployed labor force in the age bracket 25-59. according to the 2017 population census, total population of pakistan is 207.9 million and 34% of this population (71.65 million) falls in the age bracket 25-59. 61% of the total population aged 25-59 is economically active with 96.3% employed and 3.7% unemployed. 38.21% of the total economically active population belongs to rural areas with 96.9% employed whereas 3.23% unemployed. 22.30% of the total economically active population in age bracket 25-59 belongs to urban areas with 95.3% employed and 4.7% unemployed. proportion of population with reference to education level was determined for the age group 25-59, these proportion are used to determine the total population for each education level as shown in the appendix’s tables 4-6. we have estimated the income of total and employed labor force as well as monetary worth of unemployed population by multiplying the education wise population proportions with respective average annual income of rural, urban and all areas. these incomes estimates are explained the following tables 1-3: according to our estimates in tables 1-3, the working population for all areas with the current education profiles has the potential to generate rs 8686 billion at full employment level but is generating rs 8365 billion with a loss of 321 billion due unemployment. similarly, rural areas with the current education profiles has the potential to generate rs 4041 billion at full employment level but is generating rs 3853 billion with a loss of 189 billion due unemployment. the urban areas on the other hand has the potential to generate rs 4458 billion but are generating 4318 billion with a loss of 140 billion due to unemployment. 4.2. cost estimation we have discussed six cases by assuming different and improved educational profiles for the reference labor force population of this research.to elaborate the cost of lack of education or lower level of education. we estimated potential and actual income as well as loss of unemployment with these six profiles under following assumptions: • proportion of total employed, and unemployed labor force remained unchanged for the reference age bracket 25-59 • average wage rate for each level of education also remained unchanged. thus, we assume wage rigidity for each education level. this assumption seems valid for the case of pakistan as wage rates depicts a rigid behavior and only changes with the announcement from the state. table 1: income estimates (all areas) education wise estimated average income (pkr billion) education potential income actual income unemployment loss 0 691 665 26 5 1962 1889 73 8 1886 1817 70 10 1941 1869 72 12 973 937 36 14 760 732 28 16 341 328 13 18 133 128 5 8686 8365 321 table 2: income estimates (urban) education wise estimated average income (rs billion) education potential income actual income unemployment loss 0 495 479 16 5 1300 1259 41 8 1037 1005 33 10 931 902 29 12 350 339 11 14 190 184 6 16 90 87 3 18 66 64 2 4458 4318 140 table 3: income estimates (rural) education wise estimated average income (rs billion) education potential income actual income unemployment loss 0 247 236 12 5 734 700 34 8 837 798 39 10 940 896 44 12 545 519 25 14 477 455 22 16 206 196 10 18 56 53 3 4041 3853 189 with these assumptions we consider the following six cases for our further analysis: cases description case 1 half of the population with 0 year of schooling is added to population with 5 years of education case 2 all the population with 0 year of schooling is added to population with 5 years of education case 3 all the population with 0 and 5 year of schooling is added to population with 8 years of education case 4 all the population with 0, 5 and 8 year of schooling is added to population with 10 years of education case 5 all the population with 0, 5 and 8 year of schooling is added to population with 10 years of education and 25% of the population with 10-year schooling is added to population with 12 years of schooling case 6 no one is below 10 years of schooling, 50% (10 years of schooling), 30% (12 years of schooling), 10% (14 years of schooling), 6% (16 years whereas 4% with 18 or more) rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020196 with this description the proportion of population according to six cases for the all, urban and rural areas is shown in the appendices tables 7-9. the income of total and employed labor force aged 25-59 for all, rural and urban areas with respect to six proposed educational profiles is computed according to new proportions as shown in the following tables 4 and 5: it shows a substantial difference of income when each proposed case is compared with the original case. this highlights the loss of income pakistan is facing by not having an improved education profile of its labor force in the age bracket 25-59. tables 6 and 7 shows the difference of income for each of the six cases with reference to original educational profile: as shown in the table 6, if pakistan currently had the education profile of case 1 as in the years 2017, then it could have an extra potential to generate rs 251 billion of more income with the same population in the age bracket 25-59. similarly, it could have more potential income of rs 501 billion, rs 1721 billion, rs 3245 billion, rs 3929 billion, and rs 5349 billion in 2017 it had the educational profile of case 2, case 3, case4,case 5, and case 6 respectively for same population in age bracket 25-59. similarly, as shown in the table 7, pakistan could have extra rs 242 billion, rs 483 billion, rs 1657 billion, rs 3125 billion, rs 3784 billion, and rs 5151 billion in 2017 with the same employed labor force in the age bracket 25-59, if it had the educational profile of case 1, case 2, case 3, case4,case 5, and case 6 respectively. this pattern prevails for both the urban as well as rural areas. amount of income lost by not having any of these educational profile for pakistan’s labor force is alarming in the wake of extreme resource scarcity pakistan is facing. if we consider the whole working population in the age bracket 15-65, then this difference of income may be more substantial showing the cost of lacking behind in educating the individuals, a worthy resource for production. 4.3. the cost estimate for the time 2009-2017 with an aim to further explain the income loss dues to uneducated as well as less educated individuals, the study has repeated the whole exercise of cost computation for the all areas from year 2009 to 2017. this was done to highlight the gigantic cost associated with the weak educational profile from 2009-2017. this computation was performed in the light of following assumptions: • first, we assume that the proportion of population in the age bracket 25-59 does not changed over the time 2009-2017 • second, the proportion of total, employed and unemployed labor force also remained same over the time 2009-2017 • third, the educational profile of population in age bracket 25-59 also remained same over the time 2009-2017. under above mentioned three assumptions, we have computed the income of total and employed labor force in the age bracket 25-59 from 2009-2017 by considering seven educational profiles9. to make this exercise accurate we have computed the average annual income for each year by considering the income of 2017 as base and then year by year discounting of this income. the discounting of income was done by considering the average wage increase rate of 10% announced by state for the budgetary statements in between 2009-2017. to adjust for the population numbers for each year we have again applied the year by year discounting of 2017 total population by assuming the average population growth rate of 2.1% as the population discount rate. with this treatment, the average annual income for each year of education and total population, and labor force proportions (total, employed) in the age bracket 25-59 for the period 2009-2017 were computed. these values are used to compute the income associated with total and employed labor force in the age bracket 25-59(all areas) for each year from 2009-2017 as shown in the following tables 8-9: to explain the cost associated with uneducated and lower educated individuals we have compared the present scenario (2017) of 9 original and six proposed profiles table 5: income of employed labor force as per six profile income of employed labor force aged 25-59 (rs billion) cases all areas rural areas urban areas original 8365 4318 3853 case 1 8606 4486 3928 case 2 8847 4644 4004 case 3 10,022 5417 4379 case 4 11,490 6325 4874 case 5 12,148 6687 5121 case 6 13,516 7612 5510 table 6: additional income of total labor force in comparison to original case additional income of total labor force aged 25-59 with proposed cases (rs billion) cases all areas rural areas urban areas case 1 251 173 79 case 2 501 337 158 case 3 1721 1135 553 case 4 3245 2071 1072 case 5 3929 2445 1331 case 6 5349 3400 1739 table 7: additional income of employed labor force in comparison to original case additional income of employed labor force aged 25-59 with proposed cases (rs billion) cases all areas rural areas urban areas case 1 242 168 76 case 2 483 326 151 case 3 1657 1099 527 case 4 3125 2006 1022 case 5 3784 2368 1269 case 6 5151 3293 1658 table 4: income of total labor force as per six profiles income of total labor force aged 25-59 (rs billion) cases all areas rural areas urban areas original 8686 4458 4041 case 1 8937 4632 4120 case 2 9187 4795 4199 case 3 10,407 5593 4594 case 4 11,931 6529 5113 case 5 12,615 6903 5372 case 6 14,035 7858 5780 rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020 197 table 11: additional income of employed labor force 2009-2017 addition income of employed labor force aged 25-59 with proposed cases 2009-2017 (rs billion) cases 2017 2016 2015 2014 2013 2012 2011 2010 2009 total case 1 242 215 192 171 152 135 120 107 95 1429 case 2 483 430 383 341 303 270 240 214 191 2854 case 3 1657 1475 1314 1170 1042 927 826 735 655 9800 case 4 3125 2783 2478 2206 1964 1749 1557 1387 1235 18484 case 5 3784 3369 3000 2671 2378 2117 1885 1679 1495 22377 case 6 5151 4587 4084 3636 3238 2883 2567 2285 2035 30466 table 9: income of employed labor force (25-59) for 2009-2017 income of employed labor force aged 25‑59 (all areas) with different 7 educational profiles (rs billion) cases 2017 2016 2015 2014 2013 2012 2011 2010 2009 original 8364.5 7447.7 6631.3 5904.5 5257.3 4681.1 4168.0 3711.2 3304.4 case 1 8606.0 7662.7 6822.9 6075.0 5409.2 4816.3 4288.4 3818.3 3399.8 case 2 8847.0 7877.3 7013.9 6245.1 5560.6 4951.1 4408.4 3925.2 3495.0 case 3 10021.5 8923.1 7945.0 7074.2 6298.8 5608.4 4993.7 4446.4 3959.0 case 4 11489.8 10230.4 9109.1 8110.6 7221.7 6430.1 5725.3 5097.8 4539.0 case 5 12148.0 10816.5 9630.9 8575.3 7635.4 6798.5 6053.3 5389.8 4799.1 case 6 13515.7 12034.2 10715.2 9540.7 8495.0 7563.9 6734.8 5996.6 5339.4 table 10: additional income of total labor force 2009-2017 additional income of total labor force aged 25-59 with proposed cases 2009-2017 (rs billion) cases 2017 2016 2015 2014 2013 2012 2011 2010 2009 total case 1 251 223 199 177 158 140 125 111 99 1484 case 2 501 446 397 354 315 280 250 222 198 2964 case 3 1721 1532 1364 1215 1082 963 858 764 680 10178 case 4 3246 2890 2573 2291 2040 1816 1617 1440 1282 19196 case 5 3929 3499 3115 2774 2470 2199 1958 1743 1552 23239 case 6 5350 4763 4241 3776 3362 2994 2666 2374 2113 31639 table 8: income of total labor force (25-59) for 2009-2017 income of total labor force aged 25‑59 (all areas) with different 7 educational profiles (rs billion) cases 2017 2016 2015 2014 2013 2012 2011 2010 2009 original 8686.6 7734.5 6886.7 6131.9 5459.8 4861.4 4328.5 3854.1 3431.6 case 1 8937.5 7957.9 7085.6 6309.0 5617.5 5001.8 4453.5 3965.4 3530.8 case 2 9187.7 8180.7 7284.0 6485.6 5774.7 5141.8 4578.2 4076.4 3629.6 case 3 10407.5 9266.7 8251.0 7346.7 6541.4 5824.4 5186.0 4617.6 4111.5 case 4 11932.3 10624.4 9459.9 8423.0 7499.8 6677.8 5945.8 5294.1 4713.8 case 5 12615.8 11233.0 10001.8 8905.5 7929.4 7060.3 6286.4 5597.4 4983.9 case 6 14036.2 12497.7 11127.9 9908.2 8822.2 7855.2 6994.2 6227.6 5545.0 income with the proposed/discussed six cases for income for total and employed labor force in the reference age bracket. the difference of incomes for each year were calculated to explain the total cost of educational deprivation for the time 2009-2017 as shown in the following tables 10 and 11: table 10 explains that total labor force aged 25-59 if all employed could have earned pkr 1484 billion more income from 2009-17 if it had educational profile of case 1 in year 2009. similarly, pakistan could have more income of pkr 2964 billion, pkr 10178 billion, pkr 19196 billion, pkr 23239 billion, pkr 31639 billion if it had educational profile of case 2, case 3, case 4, case 5, case 6 in 2009. table 11 explains that employed labor force aged 25-59 could have earned pkr 1429 billion more income from 2009-17 if it had educational profile of case 1 in year 2009. similarly, the employed labor force pakistan could have more income of pkr 2854 billion, pkr 9800 billion, pkr 18484 billion, pkr 22377 billion, pkr 30466 billion if it had educational profile of case 2, case 3, case 4, case5, case 6 in 2009. 5. discussion the return to education for the case of pakistan according to this study was estimated to be 8.6% when experience was not considered and 10.9% for all areas when experience is accounted for. when adjusted for the location, the returns to education estimated to be 9.9% for urban areas whereas 10.6% for rural areas. the estimates of returns to education are found closer to the 7.2% return to education for the case of pakistan (nasir and nazli, 2000) and on global level the estimates of the 9% return to education (borjas, 2004), south asian average return to schooling of 8.1% and world average return to schooling of 8.8% (psacharopoulos and patrinos, 2018). the average wage rate and average annual income for each level of education as shown in the rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020198 table 1, depicted a rising wage rate with schooling years. the lowest wage rate per hour was estimated for the population with no education which stand out to be pkr 35 for all areas, pkr 44 for urban areas and pkr 32 for rural areas. the highest estimated wage rate was estimated for the labor force with 18 years of education and that was pkr 276 for all areas, pkr 288 for urban areas and pkr 240 for rural areas. based on the pslm data, an average 2488 hours were available for work in a year. multiplying these available work hours with relevant wage rate per hour we have computed the average annual income for every level of education. the estimates again followed the same pattern as it appears for wage rates that total annual income appears to be lowest for individuals with no education whereas highest income is associated with highest level of education. the average income for urban areas is higher than rural areas as shown in the appendices table 3. to further proceed for the cost estimates, the proportion of labor force in age bracket 25-59 was determined with total labor force amounted to be 43.35 million. 41.75 million of this total labor force was employed whereas 1.6 million was unemployed according to the labor force survey 2018-19. the educational profile of this labor force was extracted from labor force survey which depicted more than 70% labor force with 8 or less years of education. according to the proportions, 18.30% labor force has no education, 30.14% has primary or less education, 20.90 % has education of 8 years or less but more than five, 17.29 % with 10 year of education, 9.97 % has intermediate or equivalent, 4.38% has 14 years, 1.58, and 0.44% has 18 years of education. the education wise situation is worse for the rural areas where 78% labor force has education 8 or less years of schooling in comparison to urban areas with 60% labor force in the same education profile. by using these proportions, the number of total labor force, employed labor force and unemployed labor force was determined as shown in the appendices tables 4-6. these number in conjunction to the average annual income estimates, provided the income of total labor force (full employment level), employed labor force(actual income) and income loss associated with the unemployed labor force as shown in the tables 1-3. the aggregate potential income10 for all areas estimated to be pkr 8686 billion for all areas, pkr 4458 billion for urban areas and pkr 4041 billion for rural areas. the income of employed labor force was estimated to be pkr 8365 billion for all areas, pkr 4318 billion for rural areas and pkr 3853 billion for urban areas. the income loss of unemployed labor force was estimated to be pkr 321 billion for all areas, pkr 140 billion for rural areas and pkr 189 billion for urban areas. income of total and employed labor force was again computed by considering six improved educational profiles as shown in the appendices tables 7-9. the income estimates based on six cases depicted a substantial change from the income estimates of original educational profile as shown in the tables 4 and 5. according to the estimates, if fifty percent of the labor force with no education had at least 5 years of education (case 1) then pakistan could have an extra potential of 251 billion income generation for all areas with 173 billion potential of income associated with rural areas and pkr 79 billion associated with urban areas. this extra potential rises to pkr 501 billion with case 2 that requires no one with less than 10 based on total labor force in the age bracket 25-59 primary education, pkr 1721 billion with case 3 that requires no one in labor force with less than 8 year of schooling and pkr 3245 billion with case 4 which is exactly a matching case of sdg 4 that requires no one with <10 year of education. similarly, our analysis depicts a much higher increase in potential as well as actual employed income with more improved cases 5-6 as shown in the tables 6 and 7. thus, the estimates of tables 6 and 7 indicates huge loss of income associated with the less attractive educational profile of labor force in the age bracket 25-59. this highlights the importance of having much improved educational profile of labor force to have greater income generational capability of individuals and hence overall pakistan. to further elaborate the loss of income in multiple years, the analysis of 9 year from 2009 to 2017 also depicted a horrendous loss of income due to not having an improved educational profile as of the six cases presented in this research. according the estimates of 2009-2017 presented in table 10, pakistan lost the potential of pkr 1484 billion by not having an educational profile of case 1 in year 2009. if pakistan had case 1 profile in 2009 then with the current proportion of employed labor force pakistan could have earned 1429 billion extra income and with case 4 pakistan could have earned pkr 19191 billion extra income from 2009 to 2017. if pakistan had the educational profile of case 6 then in 9 years pakistan could have an extra income of pkr 31639 billion from 2009 to 2017. this shows that being with the current educational profile if assumed same in the year 2009, costed pakistan loss of gigantic amount by not having improved educational profile as shown in the tables 10 and 11. 6. conclusions present study is conducted under some constraints or limitations which makes it hard to evaluate the concept in all respects as dataset of hies-psl 2018-2019 lacked various background and abilities related variable which can make this analysis more rigorous. so, given unavailability of data regarding background variables, proxy for individual abilities and some instruments for schooling or education, the present study by relying on available data and ols as estimation technique has comprehensively analysed the cost of education deprivation for the case of pakistan. furthermore, the complete educational profile of whole country covering different attribute such as gender, work status etc. was not available in the population census and labor force surveys which makes it difficult to analyse these dimensions in the light of this research with available dataset. under data, time, resources, and technique related constraints the present study has successfully highlighted the significance of education towards individual as well as aggregate level development by working out the massive cost of educational deprivation. the research shows that pakistan lost an income potential of pkr 251 billion by not having an educational profile of case 1 that requires promotion of 50% of the uneducated to at least primary level education. this loss is 10 times of the budgetary allocation for the health and higher education sector of pakistan according to the recent budget 2020-21. according to a prefeasibility study conducted by smeda11, a high school franchise with the student capacity of 500 needed pkr 10 million of infrastructure cost 11 pre-feasibility study for high school, 2015. http://www.commerce.gov.pk/ wp-content/uploads/pdf/high-school-franchise.pdf rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020 199 with additional pkr 5 million as annual running cost in 2015. by considering the future value of this amount in current year it amounts to be pkr 14 million for infrastructure and pkr 7 million for annual running cost. thus, we can build a middle or a high school with a capacity of 500 student and run it for 5 years in pkr 50 million. half of this amount may well be enough to construct and run a primary school. according to economic survey of pakistan 2019, pakistan has 172000 primary schools, 46700 middle school, 31400 secondary school, and 5800 higher secondary schools. the lost income potential of pkr 251 billion when considered in school infrastructure context, this is the amount through which state can double the existing stock of schools for primary, middle, secondary, and higher secondary education. similarly, this amount is enough to having ten more universities in the current stock of 211 with 5 years of operational expenditures. this amount is enough to feed 14 million poor people for 5 years according to the per capita monthly cost of food basket of pkr 2800 per month. as per our estimates pakistan lost pkr 501 billion by not having the labor force profile of case 2, that requires promotion of everyone in the labor force from no education to 5 years of education. with this amount in addition to the extra educational infrastructure, health and food spending, pakistan could have doubled the spending on ehsas program dealing with millions of poor and less privileged families. the loss of pkr 1721 billion is associated with the case 3 educational profile that requires promotion of labor force with no or primary education into middle education i.e. no one without 8 years of schooling. with this amount, in addition to the development spending as explained for the case 2, pakistan could have more than 1000 km of motorways or may well managed to construct main line 1 (ml1) railway project on its own basis which requires pkr 1340 billion. the loss of pkr 3245 billion associated with case 4 profile which is also goal 4 of sdgs, pakistan in addition to previously explained development spending could have resources to build diamir bhasha dam on its own. the potential loss associated with case 5 and case 6 may have more substantial development impacts. the loss of income potential in 9 years from 2009-17 reflects gigantic impact on development based on the opportunity cost of thousands of billion rupees associated with case 1 to case 6. as per our estimates, if we look at the case 4 only, pakistan has lost an income potential of pkr 19196 billion from 2009-2017 by not having the educational profile of at least 10 year of education for everyone in the labor force. this amount is more than the total foreign debt of pakistan $110 billion12 as per economic survey of pakistan. our estimates are based on the labor force in the age bracket 25-59, the amount and impacts may inflate to higher degree if we consider the whole working age population of 15-65. furthermore, apart from the impact of lost income potential, this income if earned by the labor force may have multiplier effects on the economy as well as society. individuals earning extra income means their ability to consume, save and invest also rises. a rise in consumption of goods and services lead to a rise in the demand for goods and services and hence production. this stimulates investments having positive impacts on employment, government revenue collection, exports, exchange rates and all other macroeconomic indicators. these developments motivate government spending on infrastructure and hence further stimulates the impacts. 12 pkr 18040 billion @ the current exchange rate of pkr 164 in addition to these, a rise in income at personal level lead to more affordability of goods and services. individuals with higher income can afford better quality health, education, and other necessities by their own rather than relying on state resources. this further provides quotient to the state to invest more rigorously on the development at broader level and hence further improve the general standard of living. as we have explained comprehensively the cost associated with the uneducated population. in the light of our analysis it is imperative to focus on education, this will not only speed up the journey of pakistan towards achieving goal#4 but it will also provide essential resources both human and economic to facilitate progress towards other sustainable development goals. as resource are the pre-requisite to end poverty and hunger(goal#1 and 2), to achieve sustainable health(goal#3), to have quality education (goal#4), to have better development infrastructure(goal#6,7,9,11), to promote innovation and economic growth (goal#8) and for a sustainable, healthier and responsible, peaceful and equitable living (goal #5, 12 and 16). these precious resources can only be generated by equally investing in human capital by providing them with essential quantity as well as quality of education. we have comprehensively highlighted the need for this investment by showing the opportunity costs of not investing for the education of uneducated. in addition to investments in education, state needs to provide necessary infrastructure and physical capital to consume the human capital as human capital without necessary avenues and opportunities may create burden rather than incentives for the state. we have shown this burden in term of monetary costs related to unemployment as a loss of massive income. this research highlighted the severity of issues related to educational deprivation and provide guidance to the policy makers to focus on the issues discussed in a more targeted manner based on the alarming estimates associated with the lack of education. to tackle with the deficiencies and to achieve all the sustainable development goals by the year 2030, in the light of our findings, the state needs to focus on certain areas with utmost importance such as: first, it needs to revamp the whole political landscapes of whole pakistan with a strong, influential, and independent inclusive local government system, which encourages participation from a wider part of society rather than a minor political elite. furthermore, state needs to eliminate the barrier to entry for well-educated and rational political class at provincial as well as national level. second, state need to provide opportunities, resources and expertise to facilitate growth and development in an inclusive participatory framework for which we have explained the need of a fully functional local government system which includes every segment of the society in each phase of the development process, from its planning to its post implementation evaluations and ownership. finally, state need to aggressively invest on the educational infrastructure to remove the impeding factors of retaining student at various levels of education as explained in the previous section. since we have shown the positive effect of rise in schooling years without any consideration of quality of education. this highlight the need for investments in schooling infrastructure as rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020200 if state increased the current infrastructure with current quality of education then it may still have substantial impact on the growth and development of pakistan in the future. and if quality is also improved with the numbers then these impacts may further be substantial in volume as well as intensity. investing on the infrastructure with the huge stress on resources is a great challenge for the state. to cope with this challenge, the state in a strictly resource deficient situation need to devise mechanism to engage various stakeholders such as private investors, donor agencies, highly qualified unemployed human resource and the common public in an all-inclusive framework to generate resources in a sustainable manner through rational planning and execution for building and running educational infrastructure keeping in mind the long-term future needs of the pakistan. one of the key resources in this regard may be the universities graduates at various levels which may be integrated in the current infrastructure to cope with the deficiencies of human resource. for example, there is a huge demand for university education, where every year thousands of students graduated at various levels. some these graduates got job opportunities and other remained unemployed or join further studies. those who failed to get a job or those who intends to join further studies can be utilized the system through a comprehensive internship programs and restructuring the admission criteria of universities. for example, if every university makes it mandatory for every undergraduate student to complete at least 1 year of service/internship at any primary, middle or secondary school before applying for the admissions of graduate programs and graduates to serve higher secondary schools or colleges before joining postgraduate studies. then, it will solve the problems of supply with highly qualified and updated younger human resource to educational institutes without much cost. with this model state only needs to invest on infrastructure and makes partnerships with universities to indulge their graduates in educational system. this on the other hand will also enhance the quality of university intake as now the student joining universities will have a reasonable experience which will benefits universities in their quality of education. references aepam. 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(1961), investments in human capital. the american economic review, 15(1), 1-17. rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020 201 appendices table 3: education wise estimated annual income estimated average annual income education overall urban rural 0 87,048 110,108 80,115 5 150,124 180,633 136,110 8 208,193 243,098 187,067 10 258,906 296,327 231,242 12 321,972 361,212 285,849 14 400,400 440,304 353,352 16 497,933 536,714 436,795 18 694,640 725,860 603,697 appendices table 2: education wise estimated wage rates estimated wage rates (pkr per hour) education overall urban rural 0 35 44 32 5 60 72 54 8 83 97 74 10 103 118 92 12 128 143 114 14 159 175 140 16 198 213 173 18 276 288 240 appendices table 6: education wise labor force (urban) labor force by level of education 25-59 years (urban) education level % age of population total employed unemployed 0 14.06 2,246,171 2,141,392 104,778 5 25.45 4,065,792 3,876,133 189,659 8 21.54 3,441,146 3,280,625 160,521 10 19.85 3,171,158 3,023,232 147,927 12 9.44 1,508,097 1,437,748 70,349 14 6.78 1,083,146 1,032,620 50,526 16 2.40 383,415 365,529 17,885 18 0.48 76,683 73,106 3577 15,975,608 15,230,386 745,223 appendices appendices table 5: education wise labor force (rural) labor force by level of education 25-59 years (rural) education level % age of population total employed unemployed 0 22.57 6,178,899 5,985,011 193,888 5 34.88 9,548,959 9,249,321 299,638 8 20.25 5,543,762 5,369,804 173,958 10 14.71 4,027,098 3,900,731 126,367 12 4.47 1,223,734 1,185,334 38,400 14 1.96 536,581 519,744 16,837 16 0.75 205,325 198,882 6443 18 0.40 109,506 106,070 3436 27,373,864 26,514,897 858,967 appendices table 4: education wise labor force (all areas) labor force by level of education 25-59 years (all areas) education % age of population total employed unemployed 0 18.30 7,933,454 7,639,872 293,583 5 30.14 13,066,356 12,582,827 483,529 8 20.90 9,060,612 8,725,318 335,294 10 17.29 7,495,597 7,218,218 277,379 12 6.97 3,021,649 2,909,831 111,818 14 4.38 1,898,827 1,828,560 70,267 16 1.58 684,965 659,617 25,348 18 0.44 190,750 183,691 7059 43,352,210 41,747,934 1,604,276 appendices table 8: education wise proportion (%) of labor force (urban) education wise proportion (%) of labor force (urban) education current profile case 1 case 2 case 3 case 4 case 5 case 6 0 14.06 7.03 0 0 0 0 0.00 5 25.45 32.48 39.51 0 0 0 0 8 21.54 21.54 21.54 61.05 0 0 0.00 10 19.85 19.85 19.85 19.85 80.9 55.9 50 12 9.44 9.44 9.44 9.44 9.44 34.44 30 14 6.78 6.78 6.78 6.78 6.78 6.78 10 16 2.40 2.40 2.40 2.40 2.40 2.40 6 18 0.48 0.48 0.48 0.48 0.48 0.48 4 appendices table 7: education wise proportion (%) of labor force (all areas) education wise proportion (%) of labor force (all areas) education current profile case 1 case 2 case 3 case 4 case 5 case 6 0 18.30 9.15 0.00 0.00 0.00 0.00 0.00 5 30.14 39.3 48.45 0 0 0 0 8 20.90 20.90 20.90 69.35 0.00 0.00 0.00 10 17.29 17.29 17.29 17.29 86.64 61.64 50 12 6.97 6.97 6.97 6.97 6.97 31.97 30 14 4.38 4.38 4.38 4.38 4.38 4.38 10 16 1.58 1.58 1.58 1.58 1.58 1.58 6 18 0.44 0.44 0.44 0.44 0.44 0.44 4 appendices table 1: returns to education estimated models variable model 1 model 2 model 3 (constant) 3.678*** (0.009) 3.039*** (0.022) 3.04*** (0.029) edu 0.086*** (0.001) 0.109*** (0.001) 0.106*** (0.002) exp 0.018*** (0.001) 0.015*** (0.001) urban 0.150*** (0.044) urban*edu –0.007** (0.003) urban*exp 0.006** (0.001) r2 0.236 0.268 0.290 f-stat 6788.592 4032.294 1794.417 f-sig 0000 0000 0000 observations 22,006 22,006 22,006 significance: *p≤0.10; **p≤0.05; ***p≤0.01 brackets (standard error) schuurman, f. (1993), beyond the impasse: new directions in development theory. london: zed books. sen, a. (1980), equality of what. in: mcmurrin, s., editor. tanner lectures on human values. cambridge: cambridge university press. wooldridge, j.m. (2010), econometric analysis of cross section and panel data. united states: the mit press. zaidi, s.a. (2015), issues in pakistan economy. united kingdom: oxford university press. rafique and khawaja: cost of educational deprivation: a case of pakistan international journal of economics and financial issues | vol 10 • issue 5 • 2020202 appendices table 9: education wise proportion (%) of labor force (rural) education wise proportion (%) of labor force (rural) education current profile case 1 case 2 case 3 case 4 case 5 case 6 0 22.57 11.3 0 0 0 0 0.00 5 34.88 46.18 57.21 0 0 0 0 8 20.25 20.25 20.25 77.46 0 0 0.00 10 14.71 14.71 14.71 14.71 92.17 67.17 50 12 4.47 4.47 4.47 4.47 4.47 29.47 30 14 1.96 1.96 1.96 1.96 1.96 1.96 10 16 0.75 0.75 0.75 0.75 0.75 0.75 6 18 0.40 0.40 0.40 0.40 0.40 0.40 4 . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 182-188. international journal of economics and financial issues | vol 7 • issue 4 • 2017182 financial literacy; strategies and concepts in understanding the financial planning with self-efficacy theory and goal setting theory of motivation approach muizzuddin1, taufik2, reza ghasarma1, leonita putri3, mohamad adam4* 1faculty of economics, sriwijaya university, south sumatera, indonesia, 2faculty of economics, sriwijaya university, south sumatera, indonesia, 3faculty of economics, sriwijaya university, south sumatera, indonesia, 4faculty of economics, sriwijaya university, south sumatera, indonesia. *email: mr_adam2406@yahoo.com abstract this article discusses the strategies and concepts in understanding the financial literacy with the approach of self-efficacy theory and goal setting theory of motivation. the discussion begins with the concept of behavioral finance that discusses links between financial concepts to the behavior, and then proceed with the concept and measurement of financial literacy of individuals altogether with some approaches and factors that may affect it. self-efficacy theory and goal setting theory of motivation is proposed to be a predictive factor of the level of financial literacy with relevant constructs, there are two propositions proposed to predict the level of financial literacy: (1) self-efficacy theory, in this case the motivational construct (manage finances, use credit cards less, and control debt), and (2) goal setting theory of motivation, in this case the goal commitment and goal specificity construct (financial planning). keywords: financial literacy, self-efficacy, goal setting jel classifications: g02, g3, l2 1. introducti̇on the development of the financial industry is one of the important determinants in the growth of the economy of a country that is constantly evolving dynamically. the development led to a wide variety of products and services, features and ease of access to services. many experts argued that it needs a comprehensive understanding, so that people can be successful and competitive in managing their finances, the understanding in this context is defined as financial literacy. chen and volpe (1998) defines financial literacy as the knowledge to manage finances in financial decision making. lack of financial literacy causes a person to be more likely to have problems with debt, more involved with higher credit costs and less likely to plan for the future (lusuardi, et al., 2010). hilgert et al. (2003) and cude et al. (2006) also stated that knowledge on how to manage finances and how is the technique in investing can not be ignored anymore as previous times. furthermore, to explain that the development of financial instruments is not accompanied by people’s desire to start investing, and the low level of financial literacy is supposed to be the factor. financial literacy helps to improve the efficiency and quality of financial services. financial literacy is a basic need for every individual to avoid financial problems. financial distress is not only a function of income (low income), financial distress can also arise from the errors in financial management (miss-management), moreover, in the research of garman et al. (1996), has founded that beside of giving negative impact to the individuals, poor financial decisions can affect the productivity in the workplace. survey of the world bank in 2010 showed that half of indonesia’s population has no access to formal financial services. this indicates that the financial system has not run optimally and there muizzuddin, et al.: financial literacy; strategies and concepts in understanding the financial planning with self-efficacy theory and goal setting theory of motivation approach international journal of economics and financial issues | vol 7 • issue 4 • 2017 183 is still room for improvement in order to improve people’s access to financial services (dpau-bi, 2014), moreover, based on the research result that is conducted in the framework of the national strategy for indonesian financial literacy, showed that the literacy level of the indonesian people to the financial products and services are still relatively low, amounting to 21.84% with the utility rate of 59.74% (snlki fsa, 2013). this article tries to discuss the strategies, concepts and constructs related to the improvement of financial literacy through the selfefficacy theory and goal setting theory of motivation approach. self-efficacy is known as the generative ability of an individual that includes the cognitive, social, and emotional, while goal setting theory of motivation explains that motivational mechanisms consist of: (a) goals for direct attention, (b) goals for increasing effort, (c) goals for increasing persistency, and (d) goals support strategies and plans of action. this approach is used because financial literacy is related to the ability and planning (goal setting), so that with the integration of both theories provide a strategy and concept in raising the level of financial literacy through a good understanding of the products and services of the financial industry. in general, the framework in this discussion is described through figure 1. 2. individual behavioral financial concepts and financial literacy behavioral finance is a relatively new field of economics and became a hot topic for professionals investor (fuller, 2000). behavioral finance is originated from the field of psychology that highlights that the individuals can not make decisions without being influenced by their psychological conditions, and individuals are assumed to have rationality limitation. later on, many empirical researchs result that are related to financialbased-psychology which reinforce doubts about the concept of traditional finance and the theories that had become the foundation of traditional finance. there are two psychological theories that underlie behavioral finance, those are heuristic theory and prospect theory. heuristic theory explains how investors make financial decisions under conditions of uncertainty. according to this theory, there are a lot of bias beliefs that affect how investors think and making decisions, while the prospect theory explains how investors make decisions under a certain risk. investor behavioral aspects in facing the risks described in this theory are loss aversion, mental accounting, myopic loss aversion, self-control, regret aversion. behavioral finance is a part of the financial discipline that examines the relationship between human behavior and the financial system as well as the behavioral dimension of the organization where the human and the financial system existed and acknowledged. shim and siegel (1991) said that a person’s behavior is a determining factor whether he will be successful or not in managing finances. furthermore, gitman (2004) said that the individual financial behavior is the way in which people manage sources of funds (money) to be used for funding, determination of working capital and the decision for retirement. related with the concept of behavioral finance, hilgert et al. (2003) argue that a person’s financial behavior can be observed on how good the person in managing savings and other expenses. related to the savings, it is whether they have regular savings or not, have an emergency fund or not, and many others. other expenses, will be shown from the ability to buy a house, having goals etc., behavioral finance is a important concept for the people, so that they can manage their finances properly. the central theory is the prospect theory that explains how investors evaluate the potential of loss and gain in the relation to the reference point. a healthy financial behavior is demonstrated by the good activity of financial planning, managing, and controlling. wisdom in the personal financial management is highly related to the people ability and knowledge of the concepts in financial literacy. thus, financial literacy affects almost all aspects related to planning and spending money, including the individual financial behavior. 3. individual financial literacy; evaluation and measurement orton (2007) argue that financial literacy had become inseparable thing in the life because of financial literacy is an useful tool in making informed financial decisions, but from the experiences in various countries, still show a relatively low figure. byrne (2007) also found that low financial knowledge will result in the creation of wrong financial plan, and lead to bias in the achievement of prosperity in the non productive age. the imporant mission of financial literacy is to give financial education to the indonesian community in order to manage their finances intelligently, so that lack of knowledge about the financial industry can be addressed and the public is not easily fooled on investment products that offer high profits in the short term without considering the risks. it needs communities’ understanding to the products and services offered by financial services institutions, the national financial literacy strategy program launches three main pillars. first, to feedback stage 1 personal financial literacy behavioral finance concept stage 2 evaluation of financial literacy stage 3 cause of financial literacy stage 4 strategies and concept outcome self-efficacy theory and goalsetting theory of motivation source: data processed, 2016 figure 1: relationship framework mu’izzuddin, et al.: financial literacy; strategies and concepts in understanding the financial planning with self-efficacy theory and goal setting theory of motivation approach international journal of economics and financial issues | vol 7 • issue 4 • 2017184 emphasize the education program and national campaign in financial literacy. second, in strengthening the infrastructure in the financial literacy. third, to talk about the development of the affordable financial products and services. the implementation of those three pillars is hoped to create the indonesian society which have high financial literacy level so the society can choose and utilize the financial products and services in improving their welfare (ojk, 2013). otoritas jasa keuangan indonesia (2013) defines financial literacy as the level of knowledge, skills and confidence related to the financial institution and it’s products and services, as outlined in the parameters or index measurement. disclosure of financial literacy index is particularly important in giving a view to the level of public knowledge of the features, benefits and risks, rights and obligations as users of financial products and services. financial literacy is a basic need for every individual to avoid financial problems. financial distress is not only a function of income (low income), financial distress can also arise from the errors in financial management (miss-management) such as the misuse of credit, and lack of financial planning. financial problems can cause stress, and low self-esteem. in recent years, financial literacy has received attention from various levels, including policy makers. in indonesia, the various studies on sustainable financial literacy are conducted by the competent institution like indonesian central bank as the monetary authority and the financial services authority. the realtively low level of society literacy rate towards the financial products and services becomes the reason for the publication of the national strategy for indonesia financial literacy (snlki) in 2014 by doing the following figure 2. the research conducted by the financial services authority in 2013 stated that only 21.84% of the indonesian population can be classified as well literate, 75.69% classified as sufficient literate, 2.06%, less literate and 0.41% not literate, if we see from the types of financial products and services, it is the banking products amounted to 21.8%, in insurance products amounted to 17.84%, in the pawnshop products amounted to 14.85%, the products of finance company amounted to 9.8%, the pension fund products amounted 7.13 % and the lowest, on capital market products, which is only 3.79%. this condition indicates that there is imbalance in the financial intelligence of the population of indonesia. indonesian population are more familiar with banking, insurance and pawnshop products, compared to financing, pension funds and capital markets products. the research on financial literacy by zait and bertea (2014) could be seen from various aspects, including the five dimensions, namely: (1) knowledge about financial concepts and products (financial knowledge variable), (2) communication about financial concepts (financial communication variable), (3) the ability to use that knowledge to make necessary financial decisions (financial ability variable), (4) the application/use of various financial instruments (behavioral finance variable), and (5) self-confidence on the previously taken decisions and actions (financial confidence variables). various studies earlier, for example, the discussion of financial knowledge, financial experience, ability to communicate about various financial concepts, the ability to use different financial concepts, the ability to make a good financial decisions, the attitude towards the use of financial instruments, public trust in the conducted financial activities, behavioral finance and several models of computation/planning. the measurement of the level of individual financial literacy is important to obtain the value that provides information in an integrative way. some of these measurements such as research conducted by zait and bertea (2014), chen and volpe (1998) and the financial services authority (2013), then, this article will propose a measurement framework that integrates those things as described as follows figure 3. 4. some determinants of financial literacy monticone (2010) stated that the factors that can determine financial literacy are: (1) demographic characteristics (gender, education and cognitive skills), (2) family background, (3) wealth, (4) time preferences. other researchers such as capuano and ramsay (2011) explains that the personal factor (intelligence and cognitive abilities), social and economic can determine the financial literacy and financial behavior of a person, although in the context of indonesia where personal finance education is still rare both in elementary school till college. figure 2: the national strategy of financial literacy source: otoritas jasa keuangan indonesia (2013) figure 3: integration of financial literacy measurement; proposed source: zaid and patrecia (2014), chen and volpe (1998) and otoritas jasa keuangan indonesia (2013) muizzuddin, et al.: financial literacy; strategies and concepts in understanding the financial planning with self-efficacy theory and goal setting theory of motivation approach international journal of economics and financial issues | vol 7 • issue 4 • 2017 185 behavioral decision model approach is used by stahl and hareell (1981) and harrel and stahl (1986) to test how the expectation theory towards the individual decision making. they found that the motivational decision-making processes are additive. this meant that the motivation could still significant despite the small hope of success if the value or utility result is big. motivation theory states that the measurement of financial literacy will relate to financial behaviour, although financial behavior appears to be positively related to financial literacy but the long-term impact of financial education still can not be sure that the relationship is certain. another approach is based on religious understanding, renneboog and spaenjers, (2009) examined the relationship between religion and financial decision making. the researchers found that those who have religions believe are more likely to save and invest only a small amount in risky assets. hilary and hui (2009) found a positive relationship between individual religiosity and risk aversion. researchers also found that the countries which have higher levels of religiosity have experienced low risk. 5. self-efficacy and financial knowledge concept bandura (1997) stated self-efficacy is an individual generative capabilities that includes cognitive, social, and emotional. in the context of financial literacy, this theory is related to how individuals manage their ability to understand financial products and services, to be well-literate to a variety of financial products and services that are always dynamic and fluctuative. self-efficacy is influenced by various factors, according to bandura (1997) it includes: mastery experience, vicarious experience or modeling, verbal persuasion, also physiological and affective state. the relation between these factors and this article is as follow: 1. mastery experience it is the experience of success, thus will provide authentic evidence of whether someone will be successful. success in the context of financial management is certainly a form of a good financial literacy (well-literate). the experience in improving self-efficacy will result in a strength and confidence in the use of financial products and services industry. 2. modeling individuals can not simply rely on the experience of success as a source of information about their capabilities. modelling on a person’s success in managing the finances will provide a motivation for individuals to prove that it can deliver good performance. 3. verbal persuasion verbal persuasion serves as a mean for strengthening confidence about the ability of the individual to achieve goals. in this context, education and socialization are important thing in improving the financial literacy of individuals. research chambliss and murray (1979) showed that the success of verbal persuasion have a positive impact on individuals in improving their confidence of their achievements (well-literate). 4. physiological and affective state information of individual ability are largely derived from the somatic that is continued to the physiological and affective. individual somatic indicators are highly relevant in physical health, health function, and coping with stress. stress certainly may reduce self-efficacy on the individual, if the individual stress level is low, the self-efficacy will be high and vice versa, if the stress is high, then the self-efficacy will be lower. in addition, bandura (1997) describes the psychological process of self-efficacy in affecting human functions, namely: (1) cognitive, allowing individuals to predict the current events that may affect the future, (2) motivational, optimistic thinking that appears to accomplish what had been planned, (3) afective, occured naturally and determine a person’s emotional experiences, and (4) selective, the ability to select behavior and the right environment. figure 4 describes the relationship of self-efficacy to human functions. 6. goal setting theory of motivation; context of motivation in financial literacy mitchel (1997) stated that motivation is a process that explains the intensity, direction, and persistence of an individual to achieve his goal. the three main elements in this definition are the intensity, direction, and persistence. motivation is the deciding factor for someone to do something, including in understanding the various aspects related to products and services of financial industry. there are many researchs conducted to see how is the relationship between motivation and output in an activity. those theories are: (1) the theory of needs, (2) the theory of need for achievement, (3) the theory of “erg;” (4) the theory of two factors, (5) the theory of justice, (6) the theory of expectations, (7) the theory of goal-setting, (8) the theory of reinforcement and behavioral modification, and (9) the theory of a link remuneration with the achievement. there are some studies discussing about the link between motivation and financial literacy, for example, hogarth and angelov (2003) that found an association between poor families with a low amount of savings resulting from the low motivation (willpower) in realizing anything, moreover, mandell and klein (2007) found that motivational variables significantly improve the financial literacy skills, further, it is explained that the motivations self-efficacy mastery experience modelling verbal persuasion physiological and affective state financial literacy cognitive motivational affective selective figure 4: self-efficacy and financial literacy source: data processed, 2016 mu’izzuddin, et al.: financial literacy; strategies and concepts in understanding the financial planning with self-efficacy theory and goal setting theory of motivation approach international journal of economics and financial issues | vol 7 • issue 4 • 2017186 are able to change the behavior of individuals in managing finances and ultimately improve the financial literacy (well-literate). context of this article, the motivational theory approach that is used to design the financial literacy strategies and concepts is goalsetting theory of motivation. locke et al. (1981) explained that the concept of motivation is used to describe the direction, magnitude (level of effort), and duration (or persistence) of behavior. when someones think about the purpose, then they are required to be able to consider the meaning of the achievements, especially when seems difficult. goal setting theory is a form of motivation theory which emphasizes the importance of the relationship between the goals set and the resulting performance. the basic concept is that a person who is able to understand the purpose that is expected by the organization, so that understanding will affect its behavior. goal setting is a cognitive process of practical purposes, one of the characteristics of behavior that has the goal, continues until it reaches its completion, once people start something then the individual will continue to pushed until it finished. goal setting consists of: (1) goal commitment, the level of effort made to achieve a goal, (2) the goal specificity, quantitative precision level/ clarity of these objectives, (3) goal acceptance, about the goalsetting process or determining how to achieve these goals, and (4) goal difficulty, skill level, or the level of achievement. from all the goal-setting processes, goal commitment and goal specificity are the most relevant to the context of financial behavior. heck (1984) in his research indicates that there are nine private financial behaviors. in the list, the first four are identified by researchers as “planning behaviours” and the rest five, as “implementing behaviours:” (1) set financial goals, (2) accurately estimate costs, (3) estimate the revenue appropriately, (4) the person’s planning and budgeting, (5) consider several alternatives when making financial decisions, (6) adjust to meet emergency financial situation, (7) meet the deadlines or bills on time, (8) managed to meet financial goals, and (9) successfully implement spending plans. goal setting is an important aspect of financial planning, there are some things you can do to achieve optimal results when doing a financial planning, such as: (1) establish measureable financial goals and have a term, (2) evaluate the financial condition periodically, (3) make financial planning as early as possible, (4) set the realistic financial goals, (5) gain understanding that achieving goals is a struggle, then planning is a process that requires time and continuously follow its development (figure 5). 7. integration of self-efficacy and goal setting theory of motivation on financial literacy strategy based on self-efficacy theory and goal setting theory of motivation, so the preposition proposed in this research are: (1) self-efficacy theory in this case the motivational construct (manage finances, use credit cards less, and control debt) can predict the level of individual financial literacy, (2) goal setting theory of motivation in this case the construct of goal commitment and goal specificity (financial planning) can predict the individual’s level of financial literacy (figure 6). self-efficacy is a belief about the abilities, someone can carry out his work successfully because he looks at the opportunity with some of his actions to obtain results. individuals with high selfefficacy will be diligent in doing something, have fewer doubts and doing activities as well as looking for new challenges (wood and bandura, 1989). individuals with high levels of self-efficacy have the confidence that they are able to manage and plan their financial successfully and better. the confidence motivates them for optimal performance. while goal setting is a process used to set the goal, in this case is financial planning. goal setting has a very big influence on the performance of the individual in planning financial targets. jack et al. (2004) defines the individual financial planning as a process to manage indiviuals finances to achieve personal economic satisfaction. this planning process can help individuals to control their financial condition. every individual, family has different conditions for planning figure 5: the financial planning process source: data processed, 2016 self-efficacy theory cognitive motivational afective selective goal setting theory of motivation manage finances use credit card less control debt goal commitment goal specificity goal acceptance goal diffuculty financial planning financial literacy figure 6: the concept in the determination of research propositions muizzuddin, et al.: financial literacy; strategies and concepts in understanding the financial planning with self-efficacy theory and goal setting theory of motivation approach international journal of economics and financial issues | vol 7 • issue 4 • 2017 187 financial to fulfill of needs and specific goals. further, it is explained that financial planning requires strategic measures, to provide optimal results, these measures include. first, determine the current financial condition of individuals. each individual needs to determine the current financial condition including income, expenses, debts and savings. by making individual statement of financial which consisting of current assets and liabilities, and cash flows consisted of cash flow generated and used during the period. second, make individual financial goals. individual financial goals can be short, medium or long term. financial goals of each individual is unique and not always the same. two people of the same age at the same time do not necessarily have the same financial goals. this is due to the differences in financial skills and lifestyle. third, make some choices to meet individual financial goals. making alternative choices is crucial in making decisions. there are many factors influence the making of alternative choices, some alternative choices can be categorized as follows: continue the situation that has been run, extending a situation that has been run, changing the situation that has been run, and create a new situation. fourth, the evaluation of every choice that has been made. in evaluating every possible choice, we need to consider the current financial situation, the current economic conditions and individual goals. every decision taken resulted in alternative options that others can not do. if someone makes a decision to invest in stocks may be at the same time can not be on vacation. opportunity cost is the cost that is sacrificed at the time of taking a decision. fifth, implement financial planning program. in the implementation phase of financial planning program includes an action plan that specifies the path to achieve financial goals. by making individual financial planning, we can understand how each financial decision that is taken will have an impact on various aspects of the overall financial situation. every financial decision that is taken must be seen any impact on the overall financial condition, including the purpose, these considerations include short-term and long-term. financial planning is very beneficial because financial planning can be used as a tool to achieve financial needs in the present and future. at its peak, individuals and families can achieve the goal of financial planning, which is financially free (financial freedom); free of debt, fixed income flows from investments, and most importantly, financially protected from any risk that might happen (well-literate). 8. conclusion financial literacy is an important thing to be understood and a basic need for every individual to avoid financial problems. a good understanding of financial literacy will make financial planning, management and control to be better. this article discusses the strategies and the concepts of financial literacy with the approach of self-efficacy theory and goal setting theory of motivation. the discussion of this article would have relevance with the concept of behavioral finance which is the part of the financial discipline that examines the relationship between human behavior and the financial system as well as the behavioral dimension of the organization where the human and the financial system was existed and acknowledged. a healthy financial behavior demonstrated by the good activity of financial planning, management and control. wisely or not the personal financial management is closely related to the ability and knowledge of the concepts in financial literacy. thus, financial literacy affects almost all aspects related to planning and spending money, including a person’s financial behavior. the process is of course closely related to the motivation and goals of the individual, then two theoretical approaches in the discussion of this theory are able to explain the process that takes place in an individual. self-efficacy is a belief about the abilities, individuals with a higher level of self-efficacy will have the belief that they are able to manage and plan their financial successfully and better, while goal setting is a process used to set the goal, in this case is financial planning as a major influence in the individual performance in planning financial targets. last, this article put forward two propositions that can be used in empirical studies on the relationship between the two theoretical approaches in this article towards financial literacy, the propositions include: (1) self-efficacy theory, in this case the motivational construct (manage finances, use credit cards less and control debt) can predict the level of individual financial literacy, (2) goal setting theory of motivation, in this case the construct of goal commitment and goal specificity (financial planning) can predict the level of individual financial literacy. references bandura, a. 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(2014), financial literacy conceptual definition and proposed approach for a measurement instrument. the journal of accounting and management, 3, 37-42. international journal of economics and financial issues vol. 3, no. 4, 2013, pp.923-931 issn: 2146-4138 www.econjournals.com 923 financial decision of tunisian firms in the context of market timing theory ramzi drissi carthage university & life research unit, tunisia. email: rdrissi@esg.fr tarek ghazouani faculty of economic sciences and management of tunis, el manar university, tunisia. email: ghaztarek@yahoo.com assaad ghazouani faculty of economic sciences and management of tunis, el manar university, tunisia. email: ghazouani_assaad@yahoo.fr abstract: this work focuses on the study of the determinants of capital structure in the context of the "market timing" theory in a sample of 20 tunisian firms listed on the tunis stock exchange during the period 2004-2010. the empirical analysis shows that the results are inconclusive regarding the relevance of certain variables from this theoretical framework due to various reasons including market inefficiency. we can also invoke the behavioral dimension of tunisian companies insofar as direct finance is not often the preferred alternative by the agents as well as to those in need financing capacity. keywords: capital structure; market timing theory; market to book ratio; panel data jel classifications: c33; g31; l25 1. introduction the theory of "trade-off"1 and the theory of "pecking order"2 have often been both theoretical frameworks of reference to study the behavior of financial firms. following the work of baker and wurgler (2002), several studies have focused on the study of the determinants of capital structure in the context of market timing. according to this "new" theoretical framework, firms issue equity when market conditions are favorable and bought otherwise. baker and wurgler (2002) suggest that firms rely less on debt during favorable periods marked by a good value on the market, especially when the mtb ratios are high. their results show that capital structure is the result of the willingness of successive 'timer' market (select the appropriate time). still in the work of baker and wurgler (2002) and those of welch (2004), kayhan and titman (2005), lemmon and zender (2003), alti (2003) and bruinshoofd and de haan (2012), the purpose of this article is to answer the question to what extent is the choice of corporate finance guided by considerations of timing? by adopting the methodology of hovakimian (2005) and frank and goyal (2004), empirical validation on a sample of 20 tunisian firms listed during the period 2004-2010. we'll see against the work of baker and wurgler (2002), if our results are conclusive to corroborate the thesis relevant variables from the theory of market timing for our sample of tunisian companies. 1 the trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. 2 the pecking order theory states that companies prioritize their sources of financing (from internal financing to equity) according to the cost of financing, preferring to raise equity as a financing means of last resort. hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued (myers and majluf, 1984). international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.923-931 924 2. theoretical framework there are two versions about the behavior of timing. according to the first one, economic agents are rational. assuming that the costs of adverse selection varies over time, several studies propose to explain the theory of market timing as a dynamic model of the hierarchical theory (lucas and mcdonald (1990), dierkens (1991), helwege and liang (1996) and de haan and hinloopen (2003). such work highlights the relevance of information asymmetry problems (and their variations over time) in the process of issuing shares. the second version of the theory of market timing implies that economic agents are irrational and that firms issue equity when stock prices are high and bought otherwise. baker and wurgler (2002) show that the structure of a company's financial results, not a conscious choice of a target ratio, but the accumulation of decisions made in the past in terms of market environment: issue of shares when valuations are high and / or the market environment is favorable; issuance of debt and redemption of shares when prices are low and / or exchange is depressed. the results show that 70% of the current financial structure is explained by the historical market to book (mtb) ratio. baker and wurgler (2002) conclude, then, that the capital structure is the result of mechanical control of successive "timer" in the market. a study based on a survey conducted by graham and harvey (2001) led to the same conclusions: the leaders seize the "window of opportunity" on the stock markets to achieve equity issues. according to the authors, the decision to issue equity is guided by the search for financial flexibility. it helps to have a debt capacity that can be used in case of poor market conditions. similarly, hovakimian et al. (2001) were able to show that firms issue equity after increasing their courses and conclude in favor of the theory of market timing. following the work of baker and wugler (2002), several studies have focused on the question: to what extent do considerations of market timing influence the decisions of corporate finance? (huang and ritter (2005), welch (2004). results obtained by these authors will be discussed in three parts: the relevance of theory market timing, persistence over time, and finally, through that affect proxies. according to the first aspect, huang and ritter (2005) examine the time-series models to test the determinants of financing during the period 1964-2001. according to the predictions of the theory of market timing, they conclude that u.s. firms finance a significant portion of their financing deficit by external equity when the cost of capital is low. those with low growth opportunities favor debt financing but when the cost of capital is low, they seize the opportunity and issue shares. frank and goyal (2004) show that high mtb ratio and have a negative impact on short-term debt. however, their results can not conclude in favor of the relationship overvalued-equity issues. in the long term, the authors believe that the behavior of financial firms is guided by considerations from the theory of trade-off. fama and french (2002) suggest that the variable measuring the behavior of timing namely the weighted average of the history of the mtb ratio is negatively correlated with debt ratio measured at market value. this result confirms the findings of baker and wurgler (2002). according to the second part, baker and wurgler (2002) raise the issue of persistence in time of the behavior of timing. they conclude that the impact of market timing on capital structure is significantly persistent, insofar as the will of successive "timer" the market held up to ten years. the impact of timing on capital structure raises an obvious question, namely: what is the persistence of the effect of timing on capital structure? in this context, alti (2003) suggests that "a question of research which has recently received considerable attention is the impact of long-term market timing on capital structure. the importance of this problem cannot be overstated. if this is true, the high persistence of the effects of market timing will result in loosening of the optimal debt, suggesting a minimal role for traditional determinants of capital structure. " the persistence of the effect of timing on capital structure has notably been raised to confront the explanatory power of the two theoretical frameworks of market timing and trade-off. indeed, if we assume that considerations timing persist over time, this implies that firms are not concerned with adjusting their debt ratios to target levels in subsequent years. as a result, capital structures observed are the cumulative result of past temptations of "timer" the stock market. this view is supported primarily by baker and wurgler (2002). financial decision of tunisian firms in the context of market timing theory 925 however, recent empirical work suggests the relevance of behavioral adjustment to target leverage levels (de bie and de hann, 2004; kayhan and titman (2007), hovakimian (2005), frank and goyal (2009) and leary and roberts (2005). frank and goyal (2009) use a vector autoregressive model (var) to examine the speed of adjustment of firms over the period 1950 to 2003. predictions of trade-off theory are compared to those of market timing theory and the theory of "inertia" welch (2004).the results argue that higher mtb ratios do not have a significant effect on the dynamics of capital structure. alti (2003), hovakimian (2005) and leary and roberts (2005) suggest the empirical behavior of rapid adjustment to the target debt despite the predictions of the theory of market timing. it’s relevant to note that these authors find that the financing by issuing shares coincides with favorable periods; however, they argue that the effect of the latter on the financing behavior of firms is significantly low and on the short term. the third part focuses on the biases affecting selected proxies. baker and wurgler (2002) hold as far as timing behavior of a variable that captures the interaction between mtb ratio and deficit financing (external finance weighted mtb: efwmtb). according to these authors, the funding gap will be filled by issuing shares when firms realize higher mtb ratios. too much criticism have been leveled at this position (lemmon and zender, 2003; kayhan and titman, 2005; de bie and de haan, 2004; hovakimian, 2005). indeed, the variation of market to book ratio may indicate that the values of shares on the market or that are high growth opportunities are important. similarly, hennessy and whited (2004) suggest that firms finance their growth opportunities through equity when the mtb ratios are high, and in order to avoid the risk of financial distress. in the same vein, hovakimian (2005) notes "the results show that the effect of efwamb remains significantly negative, implying that it is due to the presence of factors other than market timing, such as opportunities for growth". kayhan and titman (2005) and de haan and de bie (2004) decompose the measure of baker and wurgler (2002) into two entities. the first entity of the expression (the covariance between deficit financing and the market to book ratio divided by the average level of external funding) presents a measure of market timing behavior. but, the second entity represents the average level of market-tobook ratios during the study period represents no measurement timing. indeed, the latter is often associated with a significant level of growth opportunities (marsh 1982, myers 1977 and flannery and rangan (2006)). alti (2003) argues that the relationship between the decision to issue shares and evaluations of these is influenced by other factors that affect the funding policy. for example, companies with significant growth opportunities and higher ratios mtb can use relatively more equity financing in order to maintain financial flexibility. 3. empirical studies of the market timing theory working on a sample of u.s. firms for the period 1950-2000, frank and goyal (2004) explained the debt ratio by 39 explanatory factors from the theoretical frameworks of trade off of pecking order, market timing and agency theory. the main results are summarized as follows: firms with ratios market-to-book rates tend to reduce their debt levels. the most profitable firms have low debt ratios. large size firms have higher debt ratios. there is a positive relationship between debt and inflation. the results of alti (2003) over the period 1971-1999, show evidence of market timing theory. firms issue equity and reduce debt during periods of "high" (periods marked by a good valuation on the stock market, especially when the mtb ratios are high). however, the effect of timing becomes very small dice the second year following the ipo. chen and zhao (2005) worked on a sample of u.s. companies during the study period 19712002, conducted three tests. their results confirm the trade off theory and contradict the findings of baker and wurgler (2002). their findings are similar to those of leary and roberts (2005). welch (2004) follows the idea of baker and wurgler and concludes that the ratios of capital structure (at market value) are strongly influenced by past prices of shares. welch concludes that firms do not compensate for the effects of share prices on the capital structure. from his point of view, international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.923-931 926 changes in debt are not caused by the effects of market timing, but are the result of the reluctance of companies to counteract the effects of changes in share prices on the capital structure. according to the theory of inertia '' welch, the reasons for firms to issue shares remain a mystery. proxy variables such as the ratio market-to-book, profitability and market timing do not explain the market based on the capital structure dynamics. watching market movements based on ratios of capital structure, the effects of share price are key determinants and account for 40% of the ratio of capital structure dynamics. hovakimian (2003) notes the importance of the ratio of market-to-book regressions historical average debt is not due to increased synchronization of the award. he noted that only the issuance of shares may be "timer" conditions on the exchange, but they do not have significant lasting effects on capital structure. other transactions (purchases of equity, debt issuance and debt reduction) show timing models which are unlikely to induce a negative relationship between the ratio of market-tobook and debt. kayhan and titman (2005) have analytically divided measuring market timing bw into two components, a measure of short-term timing and other long-term. they confirm that the changes are driven by the debt market timing (next to the pecking-order and trade-off behavior). however, unlike bw, they do not support the long-term persistence of the effects of market timing. hovakimian (2005) examines the argument of baker and wurgler that market timing has a persistent impact on capital structure. while the results suggest that equity issues are "timées" periods ratios market-to-book levels, it also found that the effect of emissions actions on the debt is economically small and of short duration. he noted that the redemption of shares and their impact on the debt are even lower. it also notes that debt issues have a significant lasting effect on the capital structure, but their timing is unlikely to induce a negative relationship between the market-to-book and debt ratio. debt reduction also has a significant effect on the debt. in conclusion, o'brien et al. (2007) examine the conventional rule that a company can increase the intrinsic richness of long-term shareholders by issuing overvalued stocks and restricted debt outstanding, or redeem shares undervalued with the amount of new debt. they show that this may not work when the debt and equities are undervalued and the company should make a share exchange with debt while the shares are undervalued. 4. model specification 4.1. data source and sample our sample consists of 20 tunisian companies belonging particularly to industrial, commercial and service. financial institutions were excluded because their funding policies are very different from those of non-financial firms. the main data source for this study is the tunis stock exchange. the information used accounting data (comprising mainly the balance sheets and income statements) and exchanges. our study period runs from 2004 until 2010. 4.2. model like baker and wurgler (2002) and hovakimian (2005), our model aims to test the relevance of the theoretical predictions of the theory of market timing to explain the level of indebtedness of tunisian firms. it is as follows: df t = α 0 + α 1 rent t-1 + α 2 tang t-1 + α 3 size t-1 + α 4 mtb t-1 + α 5 efwmb t-1 + α 6 price t-1 + α 7 itunx t-1 + ξ t (1)  df: ratio of total financial liabilities measured at book value (dfvc) and market value (dfvm); table 1 presents dependent variables (debt ratio), and their measures adopted by the theory.  rent: the profitability of the firm measured by the ratio of ebit3 / total assets;  tang: the structure of the assets of the firm measured by the ratio of net tangible assets plus stocks / total assets; 3 earnings before interest and taxes. financial decision of tunisian firms in the context of market timing theory 927  size: the size of the firm measured by the log total assets;  mtb: market to book ratio measured by the ratio (market capitalization + debt) / total assets.  efwmb: weighted average of the past mtb ratios, starting with the first observation available in our sample, up to the mtb ratio (t-1). the weighting for each year is the funding deficit of the year (1) to (t-1). table 1. summary of dependent variables (debt ratio) dependent variable measures adopted authors reference debt ratio (book value) (dlt + bank loans) / total assets flannery and rangan (2006) debt ratio (market value) (+ dlt overdrafts) / book value of total debt + market capitalization grullon and kanatas (2001) this variable is measured by the following expression: s t s t r rr ss t mb de de efwamb           1 1 1 1 (2)  e: indicates equity = net change in shareholders own undistributed profits  d: change in debt accounting  price: the rate of change in the share price of the firm;  itunx: the index of the performance of the securities exchange tunis in year t is the tunindex  ξt: an error term 5. empirical results table 2 reports the pearson correlation coefficients between the dependent variable and the independent variables: size, rent, tang, mtb, price, itunx and efwmb. table 2. pearson correlation coefficient matrix e(v) size rent tang mtb price itunx efwmb size 1.0000 rent 0.0989 1.0000 tang 0.0850 0.1103 1.0000 mtb 0.1211 0.0413 -0.2876 1.0000 price 0.0275 -0.0321 0.1502 -0.4136 1.0000 itunx -0.1617 -0.0124 0.0536 0.0266 -0.4273 1.0000 efwmb 0.1570 -0.0103 0.0693 -0.0561 0.1911 -0.1542 1.0000 as it can be seen in table 2, the correlation coefficient matrix shows that the correlation between variables is generally low. the results of the regressions4 on the model (1) are summarized in table 3. as can be seen from table 3 (see r²), the explanatory power of the model tested varies between 0.12 and 0.11, depending on whether the regression of the debt ratio measured at book value 4 to perform the estimation of our model, we used stata version 9. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.923-931 928 or market value (see table 1 for more details on the measures adopted for the debt ratios), and depending on the model chosen (within). in comparison, our model is confused with the work of hovakimian (2005) (r2 = 0.176) and baker and wurgler (2002) (r2 = 0.20), as our relatively low r2 is equal to r2 of these authors. the tests carried lead to retain the fixed effects model (within)5. table 3. comparison fixed-effects model results variables dfvc dfvm fixed effects fixed effects const 0.311 (0.64) 0.468 (0.69) rent -0.02 (-0.27) -0.023 (-0.21) tang 0.312 (2.54)** 0.291 (1.72)* size 0.025 (0.40) 0.39 (3.64)** mtb 0.0344 (2.38)** -0.044 (-2.12)** price -0.03 (-0.48) -0.08 (-2.006)** efwmb -0.0023 (-0.28) -0.012 (-0.96) itunx -0.086 (-1.23) -0.121 (-1.75)* r² 0.1296 0.1145 n 120 120 t-values are in parentheses; ** significant at 5%, * significant at 10% an examination of the coefficients of variables efwmb, price and itunx, we can deduce that the results are inconclusive as to the relevance of variables from the market timing theory. contrary work of baker and wurgler (2002) who found a negative and significant coefficient at the 5% ratio between efwmb and debt level, the regressions shows that the coefficients of this variable are not significant (as it can be seen in table 3), although they have the expected sign (negative). these results are similar to those found by de bie and de haan (2004) in the dutch context. baker and wurgler (2002) explain this negative relationship that firms finance their deficit financing by issuing shares during favorable periods characterized by historic market to book ratio high. the coefficient of the variable (price), which measures the increase in action, is significant with a negative sign in the regression on merchant debt. this result is consistent with the approach of welch (2004) known as the "inertia theory" which predicts a negative relationship between the increase in share price and the debt ratio measured value. frank and goyal (2004) find that leverage is negatively related to changes in share prices. however, these authors argue that this variable is a simple measure of risk. according to the trade-off theory, firms reduce their indebtedness to minimize their risk. they add that the pecking order theory and the theory of market timing are silent regarding the risk-indebtedness. however, when debt is measured at book value, the coefficient of the variable (price) is no longer significant. such a finding confirms the relevance of market values compared to accounting measures (baker and wurgler (2002)). the coefficient of the variable (itunx) which measures the performance of the stock market is very small and insignificant in both regressions. the result contradicts the prediction of the theory of market timing, which according to frank and goyal (2003 and 2005) suggests a negative relationship between stock market performance and leverage. 5 we speak here of the hausman test. financial decision of tunisian firms in the context of market timing theory 929 the ratio market-to-book is negatively related to debt. this result is usually interpreted as resulting from growth opportunities. this interpretation is based on the trade-off theory (see table 1 in appendix for more details on the signs of the key variables in the capital structure). under the assumption of pecking order theory, more profitable firms use less debt. most profitable firms should also have a higher market value. according to the theory of market timing, good value on the market is interpreted by a low debt. in the regression where debt is measured in market value, the result confirms the evidence found theoretically and empirically. however, in the regression where debt is measured at book value, the coefficient of the mtb ratio changes sign and becomes positive. level control variables, the size and structure of the assets are statistically significant and carry the expected signs. on the one hand, the size variable is positively and significantly related to debt as it is expressed in value or market value (rajan and zingales (1995), hovakimian (2005) and huang and ritter (2005)). on the other hand, the coefficient associated with the variable structure of the business assets (tang) is positive and significant. this result supports the hypothesis that tangible assets are used as collateral for creditors (rajan and zingales (1995), kremp et al (1999) and ghazouani (2013)). finally, the negative coefficient associated with the variable (rent) measuring the profitability of the company supports the assumptions of the pecking order theory of myers and majluf (1984). this result confirms the empirical results obtained by titman and wessels (1988), rajan and zingales (1995) and hovakimian (2005) and ghazouani (2013). 6. conclusion this article is part of the work aimed at testing the empirical relevance of certain factors from the market timing theory as determinants of capital structure of firms (baker and wurgler, 2002; hovakimian, 2005; frank and goyal, 2004). in particular, we sought to explain the observed level of debt based on the valuation of the firm in the market, the stock market performance and rising share prices. the introduced control variables are those used by rajin and zingales (1995), namely the level of profitability of the firm size, growth opportunities and asset structure of the firm. contrary to the work of baker and wurgler (2002), our empirical results are inconclusive regarding the relevance of certain variables from the theoretical framework of the market timing. while the reasons are varied they are particularly apparent in the market inefficiency since the characteristics of an emerging market do not seem to allow stakeholders to identify windows of opportunity in the market. one can also invoke behavioral dimension insofar as direct finance is not often the preferred alternative by the agents as well as to those in need for financing capacity references alti, a. (2003), how persistent is the impact of market timing on capital structure? working paper from university of texas austin, 1-35. baker, m., wurgler, r. (2002), market timing and capital structure. journal of finance 57, 1-32. bayless, m.e., diltz, j.d. (1994), securities offerings and capital structure theory. journal of business finance and accounting, 21(1), 77-91. booth, l., aivazian, v., demirguc-kunt, a., maksimovic, v. (2001), capital structure in developing countries. journal of finance, 56, 87-130. bruinshoofd, a., de haan, l. (2012), market timing and corporate capital structure: a transatlantic comparison. applied economics, 44(28), 3691-3703. chen, l., zhao, x. (2005), firm financing decisions. working paper, michigan state university and kent state university. de haan, l., hinloopen, j. (2003), preference hierarchies for internal finance, bank loans, bond, and share issues: evidence for dutch firms. journal of empirical finance, 10(5), 661-681. de bie, t., de haan, l. (2004), does market timing drive capital structures? a panel data study for dutch firms, dnb working papers 016, netherlands central bank, research department. dierkens, n. (1991), information asymmetry and equity issues, journal of financial and quantitative analysis, 26, 181-199. fama, e.f., french, k.r. (2002), testing tradeoff and pecking order predictions about dividends and debt. review of financial studies, 15, 1-33. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.923-931 930 flannery, m. j., rangan, k.p. (2006), partial adjustment toward target capital structures. journal of financial economics, 79, 469–506. frank, m.z., goyal, v.k. (2009), capital structure decisions: which factors are reliably important? financial management, 38(1), 1–37. frank, m.z., goyal, v.k. (2005), tradeoff and pecking order theories of debt, chapter7 in b. espen eckbo ed.: handbook of empirical corporate finance. frank, m.z., goyal, v.k. (2004), the effect of market conditions on capital structure adjustment, finance research letters, 1, 47-55. frank, m.z., goyal, v.k. (2003), testing the pecking order theory of capital structure, journal of financial economics, 67, 217-248. ghazouani, t. (2013), the capital structure through the trade-off theory: evidence from tunisian firm. international journal of economics and financial issues vol. 3, no. 3, 625-636. graham, j.r. (2000), how big are the tax benefits of debt? journal of finance 55, 1901-1941. graham j.r., harvey, c.r. (2001), the theory and practices of corporate finance: evidence from the field, journal of financial economics 60, 187-243 grullon g., kanatas, g. (2001), managerial incentives, capital structure and firm value: evidence from dual-class stocks, working paper rice university, march. helwege, j., liang, n. (1996), is there a pecking order? evidence from a panel of ipo firms. financial journal of economics, 40, 429-458. hennessy, a., whited, m. (2004), debt dynamics, journal of finance, 60(3), 1129-1165. hesmati, a. (2001), the dynamics of capital structure: evidence from swedish. stockholm school of economics, working series in economics and finance no: 440. hovakimian, a. (2005), are observed capital structure determined by equity market timing? working paper from baruch college, pp. 1-45. hovakimian, a. (2003), are observed capital structures determined by equity market timing? working paper: baruch college. hovakimian, a., opler, t., titman, s. (2001), the debt-equity choice. journal of financial and quantitative analysis 36, 1-24 huang, r., ritter, j.r. (2005), testing the market timing theory of capital structure. working paper, university of florida. kayhan, a., titman, s. (2007), firms’ histories and their capital structure. working paper, univ. of texas at austin. kayhan, a., titman, s. (2005), firms’ histories and their capital structure. nber working paper, p. 151. kremp, e., stöß, e., gerdesmeier, d. (1999), estimation of a debt function: evidence from french and german firm panel data, in: sauvé, a., scheuer, m. (eds.), corporate finance in germany and france – a joint research project of the deutsche bundesbank and the banque de france. leary, m.t., roberts, m.r. (2005), do firms rebalance their capital structures? journal of finance, 6, 2575-2619. lemmon, m.l., zender, j.f. (2003), debt capacity and tests of capital structure theories, working paper, university of utah. lucas, d.j., mc donald, r.l. (1990), equity issues and stock price dynamics, the journal of finance, 45, 1019-1043 marsh, p. (1982), the choice between equity and debt: an empirical study. journal of finance 37, 121-144. myers, s.c. (1977), determinants of corporate borrowing. journal of financial economics, 5, 147175. myers, s.c., majluf, n.s. (1984), corporate financing and investment decisions when firms have information that investors do not have. journal of financial economics, 13, 187-221. o’brien, t.j., klein l.s., hilliard, j.i. (2007), capital structure swaps and shareholder wealth, european financial management, 13(5), 979-997. rajan, r.g., zingales, l. (1995), what do we know about capital structure? some evidence from international data. journal of finance, 50, 1421-60. financial decision of tunisian firms in the context of market timing theory 931 titman, s., wessels, r. (1988), the determinants of capital structure choice. journal of finance, 43, 1-19. warner, j.b. (1977), bankruptcy cost: some evidence. journal of finance 32, 337–347. welch, i. (2004), capital structure and stock returns. journal of political economy, 112(1), 106-131. appendix table 1. key predictors of capital structure notes: (+/-) signs of the independent variables of capital structure, predicted by the references theories. variables market timing pecking order trade off reference works profitability (rent) . + bayless and diltz (1994), graham (2000), booth et al. (2001) asset structure (struc) . + + frank and goyal (2003), kremp et al. (1999), and hovakimian et al. (2001) size . +/ + warner (1977), booth et al. (2001), titaman and wessels (1988), rajin and zingales (1995), and hesmati (2001). growth opportunities (mtb) . + booth et al. (2001), titaman and wessels (1988), rajin and zingales (1995), and garham (2000). changes in equity (price) . . welch (2004) perfermance stock market (itunx) . . frank and goyal (2003), frank and goyal (2005) tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(6), 1-8. international journal of economics and financial issues | vol 11 • issue 6 • 2021 1 the impact of the outward and inward fdi on global value chains hang su, yao fu* college of international economics and trade, dongbei university of finance and economics, dalian, china. *email: fylinda9441@163.com received: 16 august 2021 accepted: 17 october 2021 doi: https://doi.org/10.32479/ijefi.11950 abstract what kind of trade agreements should a country choose? regional trade agreements, multilateral trade agreements, or both? what’s the role of a country’s outward foreign direct investment (ofdi) and foreign direct investment (fdi) in its participation and position in global value chains (gvcs)? is a country’s research and development spending conducive to breaking the “low-end locking” of fdi? based on the world input-output tables (wiots) released in 2016, this paper computes the indicators of gvc participation and position and identifies the feature of the production division, providing a reference for promoting regional and multilateral trade agreements. this paper uses feasible generalized least squares (fgls) and system generalized method of moments (sys-gmm) to examine the impact of a country’s outward and inward fdi on its gvc participation and position. the empirical results imply that a country’s ofdi promotes its gvc participation and fosters its upgrading within industries in gvcs, while fdi inhibits the upgrading of gvcs, though it promotes a country’s gvc participation. in addition, a country’s research and development spending can be conducive to breaking the “low-end locking” effect of fdi. keywords: outward foreign direct investment, inward foreign direct investment, global value chains, world input-output tables, feasible generalized least squares jel classifications: c33, f21 1. introduction global value chains (gvcs) are a powerful driver of productivity growth, job creation, and increased living standards. gvcs give an impetus to development and growth (humphrey and schmitz, 2002). how countries engage with gvcs determines how much they benefit from them. with gvc-driven development, countries generate growth by moving to higher-value-added tasks and by embedding more technology and know-how in all their agriculture, manufacturing, and services production. in order to benefit from value chain participation, countries are also supposed to put in place the right kind of trade and investment policies and seize the opportunity to leap-frog their development process. the gvc position and participation of countries are increasingly linked to the ability to conduct more and better outward foreign direct investment (ofdi) and attract higher quality foreign direct investment (fdi) (amendolagine et al., 2019; martínez-galán et al., 2019). given the booming of integrated production systems spanning several countries and the application of advanced technology and sophisticated skills in international production, it is important for countries to conduct ofdi and attract high quality fdi, which contributes to the optimal allocation of production factors in global markets and the upgrading of gvcs. in fostering the upgrading of global value chains, fdi plays a positive role, while it can also play a negative role due to its “low-end locking” effect. this paper examines the effect of fdi on global value chains and introduces the interaction between fdi and research and development spending to figure out whether a country’s research and development spending is conducive to breaking the “low-end locking” effect of fdi and raising a country’s position in the global value chains. this paper also examines the effect of ofdi on global value chains and sheds this journal is licensed under a creative commons attribution 4.0 international license su and fu: the impact of the outward and inward fdi on global value chains international journal of economics and financial issues | vol 11 • issue 6 • 20212 lights on the ways a country promotes its global value chain participation and fosters its upgrading within industries in global value chains. the remaining part of the study is structured as follows: section 2 presents a review of the literature. the analytical framework and data sources are discussed in section 3. section 4 presents results and discussion, and the final section 5 concludes. 2. literature review there is considerable literature on the impact of a country’s ofdi on its industrial upgrading, and some suggest that as one of the determinants of ofdi, the technology-seeking objective enables enterprises conducting ofdi to seek the advanced technologies and strategic resources which can not be obtained in their domestic markets (deng, 2007), thus enhancing their technological strength and further promoting the domestic industrial upgrading (neven et al., 1996; wu and huang, 1997), while some analyze the reverse technology spillover effect of ofdi (branstetter, 2000; pottelsberghe and lichtenberg, 2001; zhao and liu, 2008). the notion of reverse technology spillovers of ofdi put forward by kogut and chang (1991) is different from the technologyseeking effect illustrated above, as reverse technology spillover emphasizes the potential and intangible influence of countries with technological advantages on the technology transfer in the investment, during which process the enterprises conducting ofdi often do not have to pay the cost of technology learning. kogut and chang put forward this notion by studying japanese companies’ investments in the united states. it argues that the reverse technology spillover effect of ofdi can also increase the total factor productivity, promote exports, improve the innovation of enterprises, and contribute to their technological progress (mao and xu, 2014). focusing on the role of direct investment in the upgrading of global value chains which can be quantified based on non-competitive input-output tables1, li and zhang (2017), and yang and li (2018) measure the gvcs and find that there is a positive effect of direct investment on a country’s position in the global value chains. compared with the export complexity index and the vertical specialization share (vss), the kpww2 based on non-competitive input-output tables further divides a country’s domestic valueadded into additional components that reveal the destination of a country’s exported value added, including its own value-added that returns home in its imports. however, ofdi also has a “crowding-out effect,” causing a decrease in the domestic investment and having a negative impact on domestic technological progress brought about by investments. 1 different from the competitive input-output table, the intermediate products of the non-competitive input-output tables are distinguished according to the source (export and domestic production). 2 koopman, r., powers, w., wang, z. (2010), give credit where credit is due-tracing value added in global production chains. national bureau of economic research. the kpww method is named using the capital letter of the authors’ names of the above mentioned paper. in addition, the technology gap between enterprises in some cases is too large to make a reverse technology spillover play a part. for these two reasons, the effect of the reverse technology spillover of ofdi on technology upgrading may not be obvious or significant. fdi can raise the position of a country’s manufacturing industry in global value chain by increasing the inflow of foreign intermediate products, but fdi may also hinder the upgrading of manufacturing in global value chain through the competitive effect of imported intermediate products and the low-end locking effect (tang and zhang, 2017). based on the literature above, the role of the outward and inward fdi in the upgrading of gvcs is a mixed one, and the evidence is not adequate on the impact of outward and inward fdi on the global value chain participation. this paper examines the effect of outward and inward fdi on global value chains and also presents whether a country’s research and development spending is conducive to breaking the “low-end locking” effect of fdi and raising a country’s position in the global value chains. 3. data and methodology 3.1. gvc indicators based on the decomposition of gross exports, koopman et al. (2010) constructs indicators that imply a country’s global value chain participation and position, namely the gvc participation index and the gvc position index. the gvc participation index is defined as follows: gvc_participation = (iv+fv)/e (1) where gvc_participation denotes a country’s participation in global value chain production networks. iv is the indirect domestic value added, fv is the foreign value added, and e denotes total exports. the indirect domestic value added in a country’s total exports can be defined as (i) in the table 1. gvc_position = ln(1+iv/e)−ln(1+fv/e) (2) where gvc_position denotes a country’s position in global value chain production networks. the gvc position index indicates the gap between a country’s indirect value-added exports and foreign value-added exports. the higher the index, the more intermediate goods the country exports to the rest of the world, indicating that the country is likely to be in the upstream of the global value chain. it can be noted that the gvc indicators computed above imply a country’s position and participation in gvcs, but they can’t tell whether the gvcs the countries participate in tend to be “regional” or “global.” the index constructed by los et al. (2015) indicates whether the value chain is featured by the regional production division or the global production division, based on which it can be implied that whether a country should promote regional or multilateral trade agreements in order to increase its welfare. if the value chain is dominated by the regional production division, regional trade agreements are a better choice to help improve welfare under the value chain trade. if the value chain is dominated by a global one, a multilateral trade su and fu: the impact of the outward and inward fdi on global value chains international journal of economics and financial issues | vol 11 • issue 6 • 2021 3 agreement is a better choice to help improve the welfare (los et al., 2015). los et al. (2015) expand the method of feenstra and gordon (1999) and the multinational division of production, and further examine the feature of a country’s participation in the value chain based on the distribution of final product valueadded among countries participated in the global production network which is represented typically by the asia factory, the north america factory, and the europe factory (baldwin and lopez-gonzales, 2013). the function is set as follows: fino i j va k i j, ,� � � � �� ��k (3) where fino(i,j) denotes the final output value of product (i,j), and va(k)(i,j) denotes the value added by country k in its production. fva i j va k i j fino i j va j i j, , , ,� � � � �� � � � � � � �� � �� �k j k (4) where fva(i,j) is defined as all value added outside the country-of completion of product (i,j). fvas i j fva(i,j) fino i j, / ,� � � � � (5) the importance of foreign value added is expressed as a share of all value added in production of (i,j), presented by fvas(i,j). it should also be noted that fva can be decomposed into regional foreign value added (rfva) and global foreign value added (gfva). rfva i,j = va(k)(i,j)-va(j)(i,j) keregionof j � � � (6) where rfva(i,j) in the value of product i with country j as country-of-completion is defined as the value added contribution of the region to which country j belongs minus the contribution of the country itself. the share of rfva in the value chain of (i,j) is defined as: rfvas i,j =rfva i,j /fino(i,j)� � � � (7) the global value added is defined as the value added contribution of all countries outside the region of country j: gfva i,j = va(k)(i,j) keoutsideregionof j � � � (8) the share of gfva in the value chain of (i,j) is defined by: gfvas i,j =gfva i,j fino i,j� � � � � �/ (9) 3.2. research model gvc_posit=β0+β1 ofdiit+γ xit+αi+ƛt+ɛit (10) where the subscript i denotes country and t denotes year. dependent variable gvc_posit represents global value chain position. ofdi (ofdiit) is employed as independent variable. xit represents control variables, including fdi (fdiit) market size (gdpit), natural resource abundance (resit), institutional quality (insit), technology and innovation capacity (tecit), and human resource endowment (hrit). αi is the fixed effect of the country, ƛt controls the time trend, and ɛit is the random error term. in order to examine the impact of ofdi technology reverse spillover and fdi technology spillover on the participation and the position of global value chains, this paper introduces interaction (odtecit) between ofdi (ofdiit) and technology and innovation capacity (tecit) on the basis of formula (10) and interaction (fdtecit) between fdi (fdiit) and technology and innovation capacity (tecit) on the basis of formula (10): gvc_posit=β0+β1 lnofdiit+β1 lnodtecit+γ xit+αi+ƛt+ɛit (11) gvc_posit=β0+β1 lnofdiit+β1 lnfdtecit+γ xit+αi+ƛt+ɛit (12) to examine the impact of ofdi on the global value chain participation, gvc_parit is adopted to represent the dependent variable: gvc_parit=β0+β1 lnofdiit+γ xit+αi+ƛt+ɛit (13) to examine the impact of ofdi technology reverse spillover and fdi technology spillover on the participation of global value chains, this paper introduces interaction item (odtecit) between table 1: gross exports decomposition gross exports (e) domestic value-added foreign value-added (fv) domestic value-added embodied in exports of final goods and services absorbed by the direct importer domestic value-added embodied in exports of intermediate inputs used by the direct importer to produce its domestically needed products domestic value-added embodied in intermediate exports used by the direct importer to produce goods for third countries (i) domestic value-added embodied in intermediate exports used by the direct importer to produce goods shipped back to source value-added from foreign countries embodied in exports of final goods value-added from foreign countries embodied intermediate in exports this table presents the gross exports decomposition. the decomposition method by koopman et al. (2010) and wang et al. (2015) is employed su and fu: the impact of the outward and inward fdi on global value chains international journal of economics and financial issues | vol 11 • issue 6 • 20214 ofdi (ofdiit) and technology and innovation capacity (tecit) on the basis of formula (13) and interaction item (fdtecit) between fdi (fdiit) and technology and innovation capacity (tecit) on the basis of formula (13): gvc par ofdi odtec x it it it i t it _ ln lnit � � � � � � � � � � � � � � � � � 0 1 2 (14) gvc par ofdi fdtec x it it it i t it _ ln lnit � � � � � � � � � � � � � � � � � 0 1 2 (15) 3.3. variables (1) global value chain position (pos) and global value chain participation (par): based on the gross export decomposition (koopman et al., 2010), and the methods of cen (2015) and wang et al. (2015), this paper calculates the gvc participation and position indices, which are adopted to represent a country’s global value chain participation and global value chain position, respectively. (2) outward foreign direct investment (ofdi): ofdi can be conducted to obtain strategic resources, break the “low-end locking,” and thus foster the upgrading of the value chain (li et al., 2017). strategic resources tend to be featured by the incompleteness of the external market, so alliance learning becomes the main way to obtain this resource (barney, 1991). compared to fdi, ofdi enables investors to have better access to strategic resources. this paper selects the stock of ofdi to measure ofdi, according to liu et al. (2017). (3) foreign direct investment (fdi): fdi can raise the position of a country’s manufacturing industry in global value chain by increasing the inflow of foreign intermediate products, but fdi may also hinder the upgrading of manufacturing in global value chain through the competitive effect of imported intermediate products and the low-end locking effect (tang and zhang, 2017). this paper takes the stock of foreign direct investment in various countries as the sample. (4) market size (gdp): this paper selects a country’s gdp level as an indicator to measure the country’s market size, according to wheeler et al. (1992). this paper uses the gdp based on the constant dollar price in 2015. (5) human resource endowment (hr): this paper uses the secondary school enrollment rate as a measure of human resource endowment with reference to li et al. (2018). (6) natural resource endowment (res): this paper measures a country’s natural resource endowment using the share of host country ore, fossil fuel and metal exports in total exports, according to buckley et al. (2007). (7) technology and innovation capacity (tec): this paper uses the share of r & d costs in gdp of home country as a measure of a country’s technology and innovation capacity with reference to chen et al. (2014). (8) institution quality (ins): this paper uses global governance indicators including voice and accountability (va), political stability and absence of violence (pv), government effectiveness (ge), regulatory quality (rq), rule of law (rl), and control of corruption (cc) to measure institution quality on a weighted average basis (kaufmann et al., 2012). 3.4. data global value chain participation and position indicators are computed based on the world input-output tables (wiots) released in 2016. the newly released wiots in 2016 covers data from 56 industries in 43 economies from 2000 to 2014. the database provides data on the world’s major economies and is adopted in studies of global value chains and trade value added. the data of ofdi and fdi are collected from the united nations conference on trade and development stat (unctad). market size (gdp) is collected from the united nations stats (un). natural resource endowment (res) is collected from the world bank databank (wb). technology and innovation capacity (tec) and human resource endowment (hr) are collected from the unesco institute for statistics (uis). institution quality (ins) is calculated based on the worldwide governance indicators (wgi). voice and accountability (va), political stability and absence of violence (pv), government effectiveness (ge), regulatory quality (rq), rule of law (rl) and control of corruption (cc) are collected from the worldwide governance indicators (wgi). 4. results and discussion 4.1. gvc indicators figure 1 presents the gvc position index in the year 2000 and 2014. in the year 2000, russia stands top in the gvc position 0 0.1 0.2 0.3 0.4 0.5 0.6 r us si an f ed er at io n t he r ep ub lic o f k or ea t he u ni te d s ta te s of a m er ic a c hi na b el gi um n et he rla nd s c an ad a ita ly g er m an y ja pa n fr an ce u ni te d k in gd om the gvc position index in 2000 the gvc position index in 2014 figure 1: the gvc position index the gvc position index is calculated based on the world input-output tables database (wiots) in 2000 and 2014. in this section, the ranking of twelve major exporting countries is presented. the twelve major exporting countries listed are collected based on the ranking in gross exports in 2013 from the united nations conference on trade and development (unctad) database su and fu: the impact of the outward and inward fdi on global value chains international journal of economics and financial issues | vol 11 • issue 6 • 2021 5 index, followed by south korea3, the united states, and china. it should be noted that, compared with other countries, the united states has witnessed a sharp increase in the gvc position index in 2014, making it stand at the top in the rankings in 2014. the top to low ranking of countries in gvc position index in 2000 is as follows (figure 1): russia, south korea, the united states, china, belgium, netherlands, canada, italy, germany, japan, france, and united kingdom. table 2 presents the changes in the ranking of countries in gvc position index over the period 2000-2014. countries such as china, germany, and netherlands have seen an increase in their gvc position indices, indicating that these countries have gained a higher gvc position in the global production network. the gvc position index of japan, france, united kingdom, and other countries are relatively stable, while countries including russia, italy, belgium and canada have seen declines in the gvc position. the top to low ranking of countries in gvc position index in 2014 is as follows (table 2): russia, south korea, the united states, china, belgium, netherlands, canada, italy, germany, japan, france, and united kingdom. the gvc indicators computed above imply a country’s position and participation in gvcs, but they can’t tell whether the gvcs the countries participate in are regionally or globally fragmenting. table 3 shows that belgium, italy, china, japan, south korea, and canada have seen an increase in their regional foreign value added shares in 2014, which means that the value chains of these countries are regionally fragmenting. while united kingdom, germany, france, netherlands, and the united states have witnessed a decrease in their regional foreign value added shares. it should also be noted that belgium, united kingdom, germany, france, netherlands, china, japan, germany, and the united states have had an increasing global share of foreign added value, which means that the value chains of these countries are globally fragmenting. this trend indicates that the shares of some countries such as belgium, china, japan, and germany are increasing in two ways, at both regional and global level, suggesting that it can be more complicated for these countries to decide whether to promote regional or multilateral trade agreements so as to increase their welfare. however, this feature of the gvcs of these countries can also mean that they have more opportunities and options to benefit from the production division network, although they have to take more factors into account. 4.2. empirical results this section discusses the empirical results. after computing gvc indicators, this paper proceeds to examine the impact of outward and inward fdi on the gvcs. table 4 presents the description, sources of data, and descriptive statistics of the key variables employed. as the data collected in this paper is long-panel data, the two-way fixed effect model is applied according to the long-panel data model assumption. in this paper, dummy variables are introduced to control individual effects and time trends. the basic regression 3 the republic of korea. is estimated using feasible generalized least squares (fgls). to solve auto-correlation of error terms, heteroskedasticity, and cross-sectional correlation problems, standard errors corrected by panels are used. table 5a reports results for model (10), (11), and (12). in model (10), (11), and (12), the effects of ofdi and fdi on gvc positions (pos) are investigated. the results presented in columns (1), (2), and (3) show that the coefficients of ofdi are positive and statistically significant, indicating that the impact of ofdi is positive. this is in line with the expectations in theories, in which ofdi can be conducted to obtain strategic resources, break the “low-end locking,” and thus foster the upgrading of the value chain (li and zhang, 2017). the coefficients of fdi are statistically significant and negative, indicating the negative impact of fdi. fdi can hinder the upgrading of manufacturing in global value chain through the competitive effect of imported intermediate products as well as the low-end locking effect, although it may also raise the position of a country’s manufacturing industry in global value chain by increasing the inflow of foreign intermediate products (tang and zhang, 2017). the results presented in table 5a also show that the coefficient of the interaction (odtec) between ofdi and tec is positive and statistically significant, indicating that the reverse technology spillover effect of ofdi is positive. column (3) shows that the coefficient of the interaction (fdtec) between fdi and tec is positive, which implies that a country’s high-tech innovation can be conducive to breaking the “low-end locking” effect of fdi, and raise a country’s global value chain position. however, this mediating effect of tec is offset by the negative effect of fdi. the coefficients of the control variables in table 5a are in line with expectations in theories. the impact of a country’s market size (gdp) is positive. with the expansion of a country’s economic scale, foreign exchange reserves increase, which attracts more foreign direct investment, and thus is conducive to fostering the upgrading of a country’s global value chain. the impact of natural resource endowment (res) is positive. a country with natural resource endowment has sufficient resource to promote table 2: the gvc position index year 2000 2010 2014 belgium 0.1287（5） 0.1343（5） 0.1288（6） canada 0.0889（7） 0.0663（9） 0.0799（8） china 0.1531（4） 0.2071（3） 0.2240（3） france 0.0421（11） 0.0286（11） 0.0318（11） germany 0.0681（9） 0.0948（7） 0.0918（7） italy 0.0724（8） 0.0815（8） 0.0716（9） japan 0.0558（10） 0.0397（10） 0.0392（10） netherlands 0.1140（6） 0.0951（6） 0.1467（5） the republic of korea 0.1641（2） 0.2196（2） 0.2287（2） russian federation 0.1955（1） 0.1723（4） 0.1675（4） united kingdom 0.0371（12） 0.0212（12） 0.0295（12） the united states of america 0.1613（3） 0.3518（1） 0.3601（1） the gvc position index is calculated based on the world input-output tables database (wiots) over the period 2000-2014. the figures in the parentheses are the ranking of countries in the gvc position su and fu: the impact of the outward and inward fdi on global value chains international journal of economics and financial issues | vol 11 • issue 6 • 20216 industrial development, which gives industrial development more opportunities to focus on the advancement of technology, and aim at technology rather than resources when conducting ofdi. this is conducive to raising the position in global value chains. the impact of a country’s ability of high-tech innovation (tec) is positive. the improvement of technology and innovation can table 3: regional and global shares of fvas (%) year belgium canada china france germany italy 2000 2014 2000 2014 2000 2014 2000 2014 2000 2014 2000 2014 fvas 46 54.4 52.4 50.6 52.2 55.4 46.7 46.1 48.2 50.7 48.7 50.5 rfvas 24 28.2 27.8 28.3 25.3 26.8 27.1 20.1 25.5 21.8 23.8 27.2 gfvas 22 26.2 24.6 22.3 26.9 28.6 19.6 26.1 22.7 28.9 24.9 23.3 japan netherlands united kingdom the united states of america south korea year 2000 2014 2000 2014 2000 2014 2000 2014 2000 2014 fvas 46.7 48.8 52.2 57 47.6 45.3 44 43 53.8 57.6 rfvas 24.1 25.7 28.8 27.6 27.8 22.1 25.3 23.2 25.7 29.3 gfvas 22.6 23.1 23.4 2 9.4 19.8 23.2 18.7 19.8 28.1 28.3 the index is calculated based on the world input-output tables database (wiots) in 2000 and 2014 table 4: description, sources of data, and descriptive statistics variable description source mean s.d. min max par global value chain participation wiots 0.7921 0.2408 0.6942 0.8457 pos global value chain position wiots 0.1354 0.1082 0.1109 0.3728 ofdi ofdi unctad 14.0987 1.3126 8.7918 15.7489 fdi fdi unctad 12.8978 1.0891 10.0984 16.9732 gdp market size un 17.3524 1.0972 14.9321 18.6140 res natural resource endowment wb 13.6446 16.9873 1.7631 32.1879 tec technology and innovation capacity uis 1.9821 0.6932 0.6137 3.9786 hr human resource endowment uis 1.7872 1.8318 0.4213 3.7341 ins institution quality wgi 0.6933 0.2571 0.5324 0.8907 va voice and accountability wgi 0.7781 0.2141 0.5229 0.9842 pv political stability and absence of violence wgi 0.6382 0.1627 0.4772 0.8760 ge government effectiveness wgi 0.7973 0.3214 0.3017 0.9971 rq regulatory quality wgi 0.7991 0.2179 0.5152 0.9816 rl rule of law wgi 0.7980 0.1057 0.4931 0.9074 cc corruption control wgi 0.6701 0.1844 0.5122 0.9891 the data are collected from the world input-output tables (wiots), the united nations conference on trade and development stat (unctad), the united nations stats (un), the world bank databank (wb), the unesco institute for statistics (uis), and the worldwide governance indicators (wgi) table 5a: basic regression results variables (1) (2) (3) pos pos pos ofdi 0.105*** 0.107*** 0.106*** (3.94) (4.41) (4.12) fdi −0.124*** −0.122*** −0.131*** (−4.71) (−4.95) (−4.92) gdp 0.296*** 0.301*** 0.270*** (5.81) (4.52) (5.77) res 0.314*** 0.320*** 0.311*** (5.98) (5.73) (5.78) tec 0.231*** 0.219*** 0.240*** (3.62) (2.76) (2.51) ins −0.113*** −0.108*** −0.117*** (−9.76) (−9.87) (−10.12) hr −0.041 −0.029 −0.031 (−2.01) (−1.96) (−1.83) odtec 0.067*** (2.26) fdtec 0.082*** (3.16) _cons 17.101*** 16.291*** 17.210*** (8.17) (7.90) (8.20) n 210 210 210 t statistics in parentheses. * p<0.05,**p<0.01,***p<0.001 table 5b: basic regression results variables (4) (5) (6) par par par ofdi 0.098*** 0.091*** 0.092*** (2.16) (1.97) (2.01) fdi 0.081*** 0.079*** 0.083*** (2.24) (2.31) (2.27) gdp −0.063*** −0.065*** −0.064*** (−2.51) (−2.47) (−2.53) res −0.030*** −0.027*** −0.029*** (−1.74) (−1.81) (−1.70) tec 0.014*** 0.016*** 0.013*** (1.34) (2.02) (1.41) ins 0.020 0.032 0.021 (1.03) (1.42) (1.06) hr −0.042 −0.038 −0.041 (−2.03) (−1.96) (−2.10) odtec 0.023*** (2.26) fdtec 0.031*** (1.91) _cons 2.327*** 2.218*** 2.384*** (11.57) (11.41) (12.31) n 210 210 210 t statistics in parentheses. * p<0.05,**p<0.01,***p<0.001 su and fu: the impact of the outward and inward fdi on global value chains international journal of economics and financial issues | vol 11 • issue 6 • 2021 7 increase the value added of its export products, and foster the upgrading of global value chains. in table 5b, columns (4), (5), and (6) report the results of the effects of ofdi and fdi on gvc participation (par). the results presented in table 5b show that the coefficients of ofdi and fdi are both significant and positive, which is in line with li et al. (2017). in columns (5) and (6), the coefficients of the interaction are significant and positive, which implies that the ability of technology and innovation of a country has a positive mediating effect on a country’s embedding in global value chain. it can be noted that the coefficient signs of the core variables remain the same when introducing control variables. 4.3. robustness test system generalized method of moments (sys-gmm) is applied to test the robustness which can be used to solve endogeneity. the ar(1) and ar(2) test and sargan test results all imply that the sys-gmm is effective. based on the basic regression model, the lagged variables are introduced. table 6a presents the results which imply that the coefficients of the core variables basically remain the same. table 6a reports robustness test results for model (1), (2), and (3), in which the effects of ofdi and fdi on gvc positions (pos) are investigated. the results presented in table 6a show that the coefficients of ofdi and fdi are statistically significant, indicating that the impact of ofdi is positive, while the impact of fdi is negative. the results presented in table 6a also show that the coefficients of odtec and fdtec are positive and statistically significant, indicating that the reverse technology spillover effect of ofdi and fdi is positive, which implies that a country’s hightech innovation can be conducive to raising a country’s global value chain position. in table 6b, columns (4), (5), and (6) report the results of the effects of ofdi and fdi on gvc participation (par), which indicate that the coefficients of ofdi and fdi are both significant and positive. it can be noted that the coefficients of odtec and fdtec are significant and positive, indicating that the mediating effect of the ability of technology and innovation of a country is positive. 5. conclusion a country’s ofdi not only promotes its global value chain participation but also fosters its upgrading within industries in global value chains, while fdi inhibits the upgrading of global value chains, although fdi can promote a country’s participation in the international fragmentation of production. the coefficient of interaction between a country’s fdi and its technology and innovation capacity is positive, which indicates that a country’s technology and innovation capacity has a positive mediating effect which is conducive to breaking the “low-end locking” effect of fdi and can raise a country’s position in the global value chains. the shares of fvas of some countries such as belgium, china, japan, and germany are increasing in two ways, at both regional and global level, suggesting that it can be more complicated for these countries to decide whether to promote regional or multilateral trade agreements so as to increase their welfare. however, this feature of the gvcs of these countries can also mean that they have more opportunities and options to benefit from the production division network, although they have to take more factors into account. table 6a: robustness test results variables (1) (2) (3) pos pos pos l.pos 0.812*** 0.811*** 0.814*** (5.32) (4.97) (5.96) ofdi 0.072*** 0.078*** 0.074*** (1.88) (2.21) (2.03) fdi −0.083*** −0.084*** −0.079*** (−1.93) (−1.81) (−2.72) gdp 0.086*** 0.081*** 0.085*** (2.26) (1.52) (1.81) res 0.051*** 0.053*** 0.046*** (1.23) (1.31) (1.21) tec 0.060*** 0.055*** 0.059*** (1.54) (1.47) (1.50) ins −0.026*** −0.021*** −0.024*** (−1.12) (−1.01) (−1.03) hr −0.027 −0.022 −0.034 (−1.21) (−1.32) (−1.47) odtec 0.057*** (1.71) fdtec 0.062*** (1.83) ar (2) test p values 0.281 0.279 0.296 sargan test p values 0.116 0.121 0.113 cons _ 3.247 3.441 3.423 (1.17) (1.61) (1.58) n 180 180 180 t statistics in parentheses. * p<0.05,**p<0.01,***p<0.001 table 6b: robustness test results variables (4) (5) (6) par par par l.par 0.863*** 0.858*** 0.861*** (5.58) (5.47) (5.63) ofdi 0.077*** 0.081*** 0.073*** (1.57) (1.72) (1.24) fdi 0.080*** 0.086*** 0.095*** (1.84) (1.91) (2.02) gdp −0.053*** −0.051*** −0.063*** (−1.31) (−2.01) (−2.16) res −0.061*** −0.072*** −0.069*** (−1.73) (−1.81) (−1.65) tec 0.044*** 0.050*** 0.047*** (1.33) (1.53) (1.51) ins 0.014*** 0.012*** 0.015*** (1.01) (1.44) (1.74) hr −0.103 −−0.051 −0.070 (−1.28) (−1.06) (−1.12) odtec 0.096*** (1.82) fdtec 0.089*** (1.74) ar (2) test p values 0.173 0.178 0.165 sargan test p values 0.216 0.232 0.224 _cons 1.782 1.931 2.109 (1.58) (1.72) (2.98) n 180 180 180 t statistics in parentheses. * p<0.05,**p<0.01,***p<0.001 su and fu: the impact of the outward and inward fdi on global value chains international journal of economics and financial issues | vol 11 • issue 6 • 20218 references amendolagine, v., presbitero, a., rabellotti, r., sanfilippo, m. 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(2008), outward direct investment and r&d spillovers: china’s case. in: conference proceeding of “emerging multinationals” outward foreign direct investment from emerging and developing economies. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 174-181. international journal of economics and financial issues | vol 7 • issue 4 • 2017174 effect of good corporate governance, kap reputation, its size and leverage on integrity of financial statements dade nurdiniah1*, endra pradika2 1faculity of economic, kalbis institute of technology and business, jl. pulomas selatan kav. 22, jakarta 1320, indonesia, 2indonesia college of economic, jl. kayujati raya no. 11 a rawamangun, jakarta 13220, indonesia. *email: dade.nurdiniah@kalbis.ac.id abstract this study aims to determine the effect of good corporate governance, the reputation of the firm, company size and leverage to the integrity of financial statements. the dependent variable in this study is the integrity of the financial statements is measured with conservative accounting model of beaver and ryan. independent variables used are independent directors, audit committee, institutional ownership, and the reputation of the firm, company size and leverage. data analysis method used is multiple linear regression analysis. the research proves that independent commissioners and the size of the company’s reputation kantor akuntun publik (kap) positive effect on the integrity of the financial statements of companies listed on the indonesian stock exchange (bei) in the period 2013-2015 while the audit committee, institutional ownership and leverage do not affect the integrity of the financial statements of companies listed on the indonesian stock exchange (bei) in the period 2013-2015. keywords: integrity financial statements, good corporate governance, reputation kap, company size, leverage jel classification: g3 1. introduction in the era of president ir. h joko widodo and vice president drs. h. muhammad jusuf kalla, indonesia is in full swing and the upgrading of infrastructure development in order to support the government’s program to improve the investment world. through the ministry of industry, the government tried to increase investment in the manufacturing industry. this is because the manufacturing industry is one sector that has a very important role in national development and the national economy. in the media industry in 2013 explained that in quarter iii/2013, the manufacturing sector continued to experience growth despite the slowdown in the national economy due to the global crisis. in that period, medium and large manufacturing sector grew by 6.83% compared with the same period the previous year. then the micro and small manufacturing sector also grew by 4.86%. some of the phenomenon of cheating scandal in the presentation of financial statements that has ever happened like enron, satyam (enron of asia), american international group inc., worldcom, tyco international and others have identical motifs are to continue to attract investors to the company’s existence in the business competition is maintained. in indonesia, the cheating scandal also never happened, such as state-owned pt. kimia farma tbk and pt. kereta api indonesia who manipulate financial statements to inflate profits. in addition, in mid-2015 again revealed cheating scandal in preparing the financial statements of the scandal toshiba. in the scandal toshiba presumably has magnified gains of up to us $ 1.2 billion over 5 years. since at the beginning of the scandal around april 2015, toshiba shares also declined by nearly 20%. based on this phenomenon, the researchers were motivated to examine the factors that affect the integrity of financial statements. researchers intend to reexamine the independent variables that have been used by the harrison (2012), nicolin (2013), gayatri and suputra (2013), saksakotama (2014), as well as fajaryani (2015). independent variables used are independent directors, audit committee, institutional ownership, firm size and leverage. then the researchers add the variable reputation of kap with the same theoretical basis with firm size and audit quality from previous research. differences researcher with the harrison (2012), nicolin nurdiniah and pradika: effect of good corporate governance, kap reputation, its size and leverage on integrity of financial statements international journal of economics and financial issues | vol 7 • issue 4 • 2017 175 (2013), gayatri and suputra (2013), as well as saksakotama (2014) is the study period, namely 2013, 2014 and 2015. as with fajaryani (2015), researchers used a manufacturing company. capital market supervisory agency (bapepam) issued regulations ix.i.6 numbers, attachment decisions chairman of bapepam number: kep-45/pm/2004, which is now replaced by the financial services authority regulation number 33/pojk.04/2014. the regulation explained that the board of directors of at least two members, one of whom is an independent commissioner. the existence of independent directors in the board of commissioners is expected to prevent the management company to commit fraud in the presentation of financial statements, so that it is presented not misleading information to the wearer. gayatri research results and suputra (2013), nicolin (2013) and saksakotama (2014) proved that independent commissioners positive effect on the integrity of financial statements. while the research conducted harrison (2012) proved that the independent commissioner does not affect the integrity of financial statements. the regulation also explained that the commissioners should establish an audit committee. it aims to aid effectiveness in the implementation of the tasks and responsibilities of the commissioner of the management company. in a number ix.i.5 regulations, bapepam chairman of the annex to decision number: kep-29/pm/2004 explained that the audit committee tasked with reviewing the financial information issued by the company and oversees companies’ compliance with laws and regulations relating to the activities of companies, results of research harrison (2012), nicolin (2013), as well as gayatri and suputra (2013) proved that the audit committee has positive influence on the integrity of financial statements. while saksakotama (2014) obtained results that the audit committee does not affect the integrity of financial statements. in addition to independent directors and audit committee, needs to be enabled monitoring through institutional investors. the company’s shares by institutions or other agencies be one of the mechanisms of supervision in a company. institutional investors are expected to monitor and encourage management to focus on efforts to improve corporate performance, thus reducing fraudulent behaviour of the management company that selfish. accordingly, the financial statements presented by management companies are expected to be free of material misstatement and the information is not misleading to the wearer. fajaryani research results (2015) obtained results that institutional ownership positively affects the integrity of the financial statements. while research harrison (2012), nicolin (2013), gayatri and suputra (2013) and saksakotama (2014) obtained results that institutional ownership does not affect the integrity of financial statements. efforts are to increase the confidence of users of financial reports on the integrity of the information that must be audited by an auditor or a public accountant. refer to rule number xk2, chairman of the annex to decision bapepam number: kep-346/bl/2011 and supported by the financial services authority regulation number 29/pojk.04/2015 stating that the issuer shall publish regular annual report accompanied by the audit report which comes from the independent external auditors of the financial statements. the external auditor who has a good reputation is assumed to be able to increase the credibility and integrity of the financial statements audited. lennox (2000), putra (2012) says that the reputation theory predicts a positive relationship between firm sizes with audit quality. results of research harrison (2012) proved that the quality audit positive effect on the integrity of financial statements. then saksakotama study (2014) showed that firm size positively affects the integrity of the financial statements. the size of the company is thought to be one of the factors that affect the company’s management in preparing the financial statements. large-scale companies will be faced with greater demands of stakeholders in preparing the financial statements in accordance with the actual financial condition than small enterprises. although the cheating scandal that is unfolding involving large-scale firms. this is because they get more attention from various parties. although to maintain the existence in the business world that they should not commit fraud that eventually destroyed the company. gayatri research results and suputra (2013), saksakotama (2014) and fajaryani (2015) proved that the size of the company’s positive effect on the integrity of financial statements. the high use of debt to finance the company’s assets alleged to be one of the factors that may affect the integrity of the financial statements. companies with high leverage level will be more extensive in providing information in an effort to lure investors compared with companies with lower leverage level. but the high degree of leverage does not rule out the possibility of companies to do window dressing on the financial statements. this is because of pressure from investors who want to earn big returns as results of the investment risks they face are also great. gayatri research results and suputra (2013) to get the result that leverage positive effect on the integrity of financial statements. these contrasts with research fajaryani (2015) who obtained results that leverage negatively affect the integrity of the financial statements. based on the above, the key problem in this research is formulated as follows: “do good corporate governance which is proxied by independent commissioners, audit committee and institutional ownership as well as the reputation of the firm, company size and leverage effect on the integrity of financial statements either partially or simultaneously.” 2. literature and development hypothesis 2.1. effect of independent commissioner against integrity reports finance independent commissioner must possess integrity and independence is strong so it is not easy to be influenced by the management and supervisory accomplishments can run effectively and efficiently. by having an independent commissioner is expected that the financial statements presented by the management of high integrity and be accountable so as not to mislead the users in the decision making process. this is consistent with research conducted by nurdiniah and pradika: effect of good corporate governance, kap reputation, its size and leverage on integrity of financial statements international journal of economics and financial issues | vol 7 • issue 4 • 2017176 gayatri and suputra (2013), nicolin (2013) and saksakotama (2014), which shows that independent commissioners positive effect on the integrity of financial statements. based on this, the development of the hypothesis in this study: h1: there is a positive influence of independent directors on the integrity of financial statements. 2.2. effect of audit committee against integrity financial statements the existence of the audit committee of a company is expected to be one way to reduce and prevent opportunistic behaviour and management are motivated to perform fraudulent practices in presenting the financial statements. the audit committee should have a strong independence property so as to oversee the actions of management to effectively and ensure that the company has been operating activities appropriate legislation, rules and norms. so that the financial statements presented by management have high integrity and does not provide misleading information to the wearer. this is consistent with research conducted by the harrison (2012), which indicates that the audit committee has positive influence on the integrity of financial statements. based on this, the development of the hypothesis in this study: h2: there is a positive effect of the audit committee of the integrity of financial statements. 2.3. effect of institutional ownership of integrity reports finance institutional ownership is ownership by institutions or other institutions that come from outside the company’s management. oversight of corporate governance by institutional investors is expected to encourage the management to focus more attention on the performance of companies, thus reducing behavioural management to commit fraud and ignoring the interests of other parties, especially those who come from outside the company. ownership of shares by institutions or other agencies from outside the company is one of the mechanisms of supervision in the management of the company. with the institutional investors are expected to reduce agency cost, so as to encourage the management to focus its attention on the company’s performance and management practices to prevent fraud. institutional ownership is assumed that it will be able to become an effective watchdog for the management in presenting financial statements, so that the information presented is free of misstatement material that may mislead users. this is consistent with research conducted by fajaryani (2015) which showed that institutional ownership positively affects the integrity of the financial statements. based on this, the development of the hypothesis in this study: h3: there is a positive effect of institutional ownership on the financial statements. 2.4. influence of kap reputation against integrity financial statements according agoes (2012. p. 4) auditing is an examination conducted to critically and systematically, by an independent party, the financial statements have been prepared by management, along with the copy of records and supporting evidence, in order to be able to give an opinion on fairness of the financial statements. then, arens et al. (2014. p. 4) defines an audit as the collection and evaluation of evidence about information to determine and report the degree of correspondence between the information with the criteria established, an audit should be performed by competent and independent. the financial statements published by the issuer or public company must be completed by an independent audit report issued by the office of public accountant (kap). this is to increase confidence in the financial statement users over the credibility of the financial statements presented by the management company. subramanyam and wild (2013. p. 86) says that the external auditor is an important mechanism to help ensure the quality and reliability of financial statements. so the financial statements must be audited by the auditors from outside the company and has a strong competence and independence. this is necessary in order to provide assurance that the financial statements are free of material misstatement ne and integrity that can be accounted for. lennox (2000), putra (2012) says that the reputation theory predicts a positive relationship between firm sizes with audit quality. later research harrison (2012) shows the positive effect on the quality audit financial statements integrity. based on this, the development of the hypothesis in this study: h4: there is a positive effect on the reputation of kap on the integrity of financial statements. 2.5. effect of company size of integrity report finance taures (2011) in saksakotama (2014) said that company size is a value that indicates the size of the company. mudoko and lana (2007) in fajaryani (2015) said that company size is the size of a company that can be seen from the total assets. the size of the company becomes one of the factors that is very important for management in presenting financial statements. small-scale firms assumed to be more likely to make earnings management practices compared with large-scale firms. this will make the financial condition of small companies will always look healthy and performing well. large companies will face demands for transparency of information more than a small company. therefore, the larger the company assumed the integrity of the information from the financial statements will be higher and the company does not need to rig the financial statement presentation only to maintain the existence of the company in the business competition. this is in line with research conducted by fajaryani (2015), saksakotama (2014) and gayatri and suputra (2013) who found that the size of the company’s positive effect on the integrity of financial statements. based on this, the development of the hypothesis in this study: h5: there is a positive influence on the size of the company on the integrity of financial statements. nurdiniah and pradika: effect of good corporate governance, kap reputation, its size and leverage on integrity of financial statements international journal of economics and financial issues | vol 7 • issue 4 • 2017 177 2.6. effect of leverage to integrity financial statements kashmir (2015. p. 113) says that the leverage ratio is a ratio used to measure the extent of the company’s assets is financed with debt. the use of debt is too high will harm the company because the company would fall into the category of extreme leverage (debt extreme), a company stuck in a high debt level and would be difficult to let go of the debt burden (fahmi, 2014. p. 127). companies that have a high leverage level will show that the company has the financial risk too high. this is because the company is experiencing financial difficulties that can be seen how much of the debt used to finance the company’s activities. this is what will make the company to disclose information more widely than the companies with low leverage levels. but the risks faced by investors will increase so that they will sue to get a great return on their investment. this condition is feared to trigger management to do window dressing on the financial statements so that the integrity of the weak. this is in line with research conducted by fajaryani (2015) which shows that leverage negatively affect the integrity of the financial statements. based on this, the development of the hypothesis in this study: h6: there is a negative effect of leverage on the integrity of financial statements. 2.7. effect of independent commissioners, the audit committee, institutional ownership, reputation kap, company size and leverage to integrity financial statements based on the relationship between each variable and the results of several previous studies it can be concluded that the independent directors, audit committee, institutional ownership as a supervisor behaviour management, reputation kap good, the size of a company as well as the high degree of leverage alleged influence on management in presenting the financial statements. thus it can be concluded that these factors have a simultaneous effect on the integrity of financial statements. h7: the influence of independent directors, audit committee, institutional ownership, the reputation of the firm, company size and leverage to the integrity of the financial statements simultaneously. based on the description that has been noted previously as well as the development of a hypothesis, and then the framework of this research can be seen in figure 1. 3. research methods 3.1. data and research samples data used hearts singer research is secondary data, i.e., the annual report and audited financial statements all manufacturing companies listed in indonesia stock exchange (bei) with timeframe 2013, 2014 and 2015. population research hearts singer manufacturing company is listed in indonesia stock exchange 2013-2015 period. in research singer, sampling using purposive sampling techniques i.e., based on the following criteria: (1) manufacturing companies listed in indonesia stock exchange (bei) in the period 2013 to 2015. (2) the company publishes audited financial statements and annual reports with fiscal year december 31 slow fence 30 april taxable incomes in the fiscal year the indonesian stock exchange. (3) manufacturing companies using currency solution yang rupiah (rp) hearts financial statements. (4) manufacturing companies the no deficiency of capital during the period 2013 until 2015. with singer to review avoid using variable the bias value total no. (5) manufacturing companies that is not experiencing disadvantage during the period 2013-2015. 3.2. the dependent variable the dependent variable is used hearts singer research integrity financial statements. integrity financial report is the extent to which information hearts financial statements presented honest and true operates well as meet the qualitative characteristics of financial statements. integrity financial statements the conservative accounting measured with never is used by reyad (2012), wistawan et al. (2015), fajaryani (2015) model namely beaver dan ryan. the high market the book then the high-level company conservatives. formula integrity financial statements are: cons stock market prices book value shares = information: cons: conservatives to measure the integrity of financial statements. book value shares: total equity/total number of shares outstanding. 3.3. independent variables independent variables used in this study as follows. 3.3.1. independent commissioner (koin) independent commissioner is a member of the board of directors who come from outside issuers and serves to monitor and assess good corporate governance independent commissioner (+) audit committee (+) integrity financial statements institutional ownership (+) reputation kap (+) company size (+) leverage ( ) figure 1: framework research nurdiniah and pradika: effect of good corporate governance, kap reputation, its size and leverage on integrity of financial statements international journal of economics and financial issues | vol 7 • issue 4 • 2017178 the company’s performance more broadly and comprehensively at the same time is expected to connect the asymmetry of information that occurs between the stakeholders with the company management. measurement of independent directors, namely comparing the number of independent directors with the total number of commissioners contained in company. koin number of independent directors the total number of co = mmmissioners 3.3.2. the audit committee (coma) the audit committee is a committee formed by the board of directors to assist them in conducting oversight of the board of directors or the management company as well as ensuring that the company is managed in a reasonable manner and without violating the rules that can harm various parties. bapepam regulation ix.i.5 numbers has required listed companies to have an audit committee; the audit committee of measurement is the number of audit committee members. koma = the number of audit committee members. 3.3.3. institutional ownership (inst) institutional ownership is ownership by the institution or institutions from outside the company. institutional investor is one of oversight mechanisms are expected to supervise effectively and encourage more focused management to improve company performance. measurement of institutional ownership is comparing the number of shares held institutionally by the number of shares outstanding. inst number of shares owned by institutional number of outs = ttanding shares 3.3.4. reputation kap kap good reputation is expected to increase the confidence of users of financial reports on the integrity of the financial statements audited. kap’s reputation is divided into two big four and kap non big four. kap’s reputation is measured by using dummy variables, where the number 1 is given if the firm auditing the company’s financial statements is a member of the big four accounting firm and 0 if it turns out the company audited by members of non big four accounting firm. 1 = kap big four 0 = kap non big four. 3.3.5. company size (size) the size of the company is a picture of the size of a company by looking at the total assets and sales are presented in the financial statements at the end of the period. the larger the company, the higher the demands on the disclosure of information that has high integrity compared to the size of the smaller company. firm size is calculated by using the natural: size = ln total assets. 3.3.6. leverage (levr) leverage is the ratio used to measure how much the company’s assets are financed by debt. the higher the level of leverage, then the investor will demand a larger return for the risks it faces. this is exactly what sparked concern the management company to do window dressing on the financial statements. measurement of leverage is comparing total debt by total assets. lever = total liabilities total assets 3.4. data analysis method the statistical method used to test the hypothesis in this study is multiple linear regression using spss for windows 22. it aims to examine whether there is influence of the independent variables more than one dependent variable. to test the hypothesis, the regression equations are used as follows: cons = α + β1koin + β2koma + β3inst + β4rkap + β5size + β5levr + ε information: cons: the integrity of the financial statements, α: contansta, β1−β2: coefficient of regression, koin: independent commissioner, koma: audit committee, inst: institutional ownership, cbp: reputation kap, size: company size, levr: leverage, ε: standard error. 4. data analysis and results 4.1. descriptive statistics test results descriptive statistical test result can be seen in table 1. 4.2. classical assumption test results before testing the hypothesis by using multiple linear regressions, performed classical assumption that consists of normality test, autocorrelation test, test multicollinearity and heteroskedasticity test. 4.2.1. normality test results normality test is done with a nonparametric statistical test of kolmogorov–smirnov. normality test results can be seen in table 2. based on table 2. the result of the test statistic has a value of 0.074 with a significance of 0.192. this shows that the significance value >0.05 (asymptomatic significance >0.05), it can be concluded that the data in this study residual normal distribution. 4.2.2. autocorrelation test results autocorrelation test results conducted by pierce and ljung box box, the result that all the lag exceeds the value significance. this shows that the significant value that is >0.05 (significance >0.05), it can be concluded residual bring the data in this study does not happen correlation between residual. nurdiniah and pradika: effect of good corporate governance, kap reputation, its size and leverage on integrity of financial statements international journal of economics and financial issues | vol 7 • issue 4 • 2017 179 4.2.3. test results multicollinearity multicollinearity test is done by looking at the amount of variance inflation factor (vif) and tolerance. multicollinearity test results can be seen in table 3. based on table 3, provides information that each independent variable has a value of tolerance of not less than 0.1 (>0.1) and the vif is not more than 10 (<10). where the variable independent commissioner (coin), the audit committee (koma), institutional ownership (inst), the reputation of kap (cbp), firm size (size) and leverage (levr) has a value of tolerance respectively 0.809, 0.794, 0.707, 0.520, 0.542 and 0.774. then have each vif value of 1.236, 1.259, 1.415, 1.923, 1.846 and 1.293. thus, it can be concluded that the regression model used for independent variables in this study there are no issues multicollinearity. 4.2.4. test results heteroskedasticity heteroskedasticityas test is done by looking at the graph plot. heteroskedasticity test results can be seen in figure 2. based on figure 2, scatterplot graph shows that the points seen spread at random and scattered above and below the number 0 on the y axis. it can be inferred that the regression model did not happen heteroskedastisitas, so that decent regression model used in this study. 4.3. hypothesis test results testing the hypothesis in this study was conducted using multiple linear regression models with spss for windows 22. hypothesis test results obtained as follows: 4.3.1. test results coefficient of determination (r2) determination coefficient test results are shown in table 4. based on table 4, the result that adjusted r2 of 0.349 or 34.9%. this suggests that the variation of variables independent commissioners, audit committee, institutional ownership, the reputation of the firm, company size and leverage can only explain 34.9% of the variation of the variable integrity of financial statements. this indicates amounted to 65.1% of other variables that may explain the variation of variables integrity of financial statements that are not included in this study regression model. 4.3.2. simultaneous significance test results (test statistic f) f statistical test result can be seen in table 5. based on table 5, the value of f obtained at 10.014 with a significance level of 0.000. this shows that the regression model is fit for use as a significance level of <0.05. then the hypothesis is accepted, it may be said that the independent directors, audit committee, institutional ownership, the reputation of the firm, company size and leverage together (simultaneously) affect the integrity of financial statements. 4.3.3. significant parameters individual test results (test statistic t) t statistical test results can be seen in table 6. the test results of the first hypothesis, namely koin against cons has a positive coefficient of 1.548. this suggests that each increase of one per cent variable independent directors will increase the integrity of financial statements amounting to 1.548%. the test results variables independent directors also have a significance level of 0.048, which means independent commissioners positive effect on the integrity of financial statements. the research result is consistent with studies that have been done by gayatri and suputra (2013), nicolin (2013) and saksakotama (2014), which proves that independent commissioners positive effect on the integrity of financial statements. the second hypothesis koma against cons has a negative coefficient of −0.325. this suggests that any increase in the number of audit committee members will degrade the integrity of the financial statements amounted to 0.325. the result of the audit committee variables has a significance value of 0.085 table 1: descriptive statistics test results descriptive statistics variables n minimum maximum mean±standard deviation cons 102 0.316 58.481 4.73071±9.119895 koin 102 0.250 0.800 0.40534±0.118213 koma 102 3.0 5.0 3.206±0.4943 inst 102 0.000 0.982 0.68514±0.240534 rkap 102 0.0 1.0 0.529±0.5016 size 102 25.634 33.134 28.80344±1.767017 levr 102 0.069 0.882 0.35312±0.176701 valid n (listwise) 102 source: spss 22, seconder data is processed in 2016 source: spss 22, seconder data is processed in 2016 figure 2: heteroskedasticity scatterplot test results table 2: test results normality ks one-sample ks test test result distribution unstandardized residual n 102 normal parameters mean±standard deviation 0.0000000±0.80175049 most extreme differences absolute 0.074 positive 0.047 negative −0.074 test statistic 0.074 asymptotic significance (two-tailed) 0.192 source: spss 22, seconder data is processed in 2016. ks: kolmogorov–smirnov nurdiniah and pradika: effect of good corporate governance, kap reputation, its size and leverage on integrity of financial statements international journal of economics and financial issues | vol 7 • issue 4 • 2017180 which means the audit committee does not affect the integrity of financial statements. the research result is consistent with studies that have been conducted by saksakotama (2014), which proves that the audit committee does not affect the integrity of financial statements. the third hypothesis inst against cons has a positive coefficient of 0.163. this suggests that each increase of one per cent institutional ownership variable will increase the integrity of financial statements amounting to 0.163%. the result of institutional ownership variable has a significance level of 0.689, which means institutional ownership does not affect the integrity of financial statements. the research result is consistent with research conducted by the harrison (2012), nicolin (2013), gayatri and suputra (2013) and saksakotama (2014), which proves that institutional ownership does not affect the integrity of financial statements. cons fourth hypothesis cbp is to have a positive coefficient of 0.712. this suggests that if the financial statements audited by the big four accounting firm will increase the integrity of financial statements amounting to 0.712. the test results variable kap’s reputation also has a significance level of 0.002, which means the reputation of kap positive effect on the integrity of financial statements. the research result is consistent with the study conducted by the harrison (2012), which proves that the quality of audit positive effect on the integrity of financial statements, as well as saksakotama (2014) which prove that firm size positively affects the integrity of the financial statements. cons size fifth hypothesis to have a positive coefficient of 0.161. this suggests that each increase of one per cent of the variable size of the company will increase the integrity of financial statements amounting to 0.161%. the result of variable size companies also has a significance level of 0.012, which means the size of the company’s positive effect on the integrity of financial statements. the research result is consistent with studies that have been done by gayatri and suputra (2013), saksakotama (2014) and fajaryani (2015) which proved that the size of the company’s positive effect on the integrity of financial statements. cons sixth hypothesis levr is to have a positive coefficient of 0.829. this suggests that each increase of 1% of the variable leverage will increase the integrity of financial statements amounting to 0.829%. the test results leverage variables have a significance level of 0.121, which means that the leverage does not affect the integrity of financial statements. the results of this study contradict the study conducted by fajaryani (2015) which proved that leverage negatively affect the integrity of the financial statements, as well as gayatri and suputra (2013) which proved that leverage positive effect on the integrity of financial statements. 5. conclusions, suggestions and limitations 5.1. conclusion this study aims to determine the influence of independent directors, audit committee, institutional ownership, and the reputation of the firm, company size and leverage to the integrity table 4: test results coefficient of determination (r2) dependent variable: cons model r r2 adjusted r2 standard error of the estimate 1 0.622a 0.387 0.349 0.826681312872919 apredictors: (constant), levr, koma, koin, rkap, inst, size. source: spss 22, seconder data is processed in 2016 table 6: test results statistics t coefficientsa model unstandardized coefficients standardized coefficients t significant b standard error beta 1 (constant) −4.112 1.768 −2.326 −0.022 koin 1.548 0.774 0.179 2.001 0.048 koma −0.325 0.187 −0.157 −1.741 0.085 inst 0.163 0.407 0.038 0.401 0.689 rkap 0.712 0.227 0.349 3.130 0.002 size 0.161 0.063 0.278 2.548 0.012 levr 0.829 0.529 0.143 1.566 0.121 adependent variable: cons. source: spss 22, seconder data is processed in 2016 table 3: test results multicollinearity coefficientsa model collinearity statistics tolerance vif 1 koin 0.809 1.236 koma 0.794 1.259 inst 0.707 1.415 rkap 0.520 1.923 size 0.542 1.846 levr 0.774 1.293 source: spss 22, seconder data is processed in 2016. vif: variance inflation factor table 5: test results statistics f anovaa model sum of squares df mean square f significant 1 regression 41.061 6 6.844 10.014 0.000b residual 64.923 95 0.683 total 105.985 101 adependent variable: cons. source: spss 22, seconder data is processed in 2016. bpredictors: (constant), levr, koma, koin, rkap, inst, size nurdiniah and pradika: effect of good corporate governance, kap reputation, its size and leverage on integrity of financial statements international journal of economics and financial issues | vol 7 • issue 4 • 2017 181 of financial statements. based on the results of tests performed using multiple linear regression model, it can be concluded that the independent commissioner, the reputation of the firm, and the size of the company’s positive effect on the integrity of financial statements. while the audit committee, institutional ownership, and leverage do not affect the integrity of financial statements. based on the results of the simultaneous test (f test) showed that the variables of independent commissioners, audit committee, institutional ownership, the reputation of the firm, company size and leverage simultaneously affect the integrity of financial statements. 5.2. suggestions based on the research results and conclusions, the researchers gave suggestions for further research, namely, (1) to use the research object such as mining, real estate and property, financial services and so on. (2) to add the study period and does not limit reporting until 30 april after the fiscal year, so it has observed that more and more. (3) to measure leverage using the debt to equity ratio, long term debt ratio, and so forth. (4) to test the managerial ownership variables, ceo duality, board size and so forth. (5) to examine the external factors such as auditor industry specialization, audit tenur, independence and so forth. 5.3. limitations of research and development of further research researchers realized that the outcome of this research is still far from perfection. this is due to the limitation in this research, this study uses only manufacturing companies listed in indonesia stock exchange as the research object, so that the study cannot explain the integrity of the financial statements on any type of companies operating in indonesia. this study only used for 3-year study period, namely 2013, 2014, 2015 and limit the reporting of the annual report and audited financial statements until 30 april after the fiscal year, so just get a sample of 34 for each period. variable leverage used in this study measured only by the debt to assets ratio, while a lot of ways to measure the leverage ratio. good corporate governance variables in this study is proxied by three variables, while there are many other proxies that can be used in addition to independent directors, audit committee and institutional ownership. external factors in this study only the reputation of kap, while many external factors that can be tested to determine the effect on the integrity of financial statements. references agoes, s. (2012), auditing: petunjuk praktik pemeriksaan oleh akuntan publik buku 1. jakarta: salemba empat. arens, a.a., elder, r.j., beasley, m.s., jusuf, a.a. (2014), jasa audit dan assurance pendekatan terpadu (adaptasi indonesia) buku 1. (diterjemahkan oleh: desti fitriyani). jakarta: salemba empat. fahmi, i. (2014), analisis laporan keuangan. bandung: alfabeta. fajaryani, a. (2015), analisis faktor-faktor yang mempengaruhi integritas laporan keuangan (studi empiris pada perusahaan pertambangan yang terdaftar di bursa efek indonesia periode 2008-2013). jurnal nominal, 4(1), 67-82. gayatri, i.a.s., suputra, i.d.g. (2013), pengaruh corporate governance, ukuran perusahaan dan leverage terhadap integritas laporan keuangan. e-jurnal akuntansi universitas udayana, 5(2), 345-360. harrison, w.t., horngren, c.t., thomas, c.w., suwardy, t. (2012), akuntansi keuangan international financial reporting standards edisi kedelapan jilid 1. (diterjemahkan oleh: gina gania). jakarta: erlangga. kasmir. (2015), analisis laporan keuangan. jakarta: rajawali pers. lennox, c.s. (2000), going concern opinion in failing companies: auditor dependence and opinion shopping. economic dept, university of bristol. nicolin, o. (2013), pengaruh struktur corporate governance, audit tenur, dan spesialiasi industri auditor terhadap integritas laporan keuangan. diponegoro journal of accounting, 1(3), 1-12. putra, d.s.f. (2012), pengaruh independensi, mekanisme corporate governance, kualitas audit dan manajemen laba terhadap integritas laporan keuangan. diponegoro journal of accounting, 1(2), 53-68. reyad, s.m.r. (2012), accounting conservatism and auditing quality: an applied on egyptian corporation. european journal of business and management, 4(21), 108-116. saksakotama, p.h. (2014), determinan integritas laporan keuangan perusahaan manufaktur di indonesia. diponegoro journal of accounting, 3(2), 1-13. subramanyam, k.r., wild, j.j. (2013), analisis laporan keuangan edisi 10 buku 1, dan buku 2. (diterjemahkan oleh: dewi yanti). jakarta: salemba empat. wistawan, i.m.a., subroto, b., ghofar, a. (2015), the characteristic board of directors, family ownership and accounting conservatism: evidence from family public firm in indonesia. research journal of finance and accounting, 6(22), 113-121. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(6), 222-231. international journal of economics and financial issues | vol 10 • issue 6 • 2020 222 the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study khawla k. abdo* department of finance and banking, al-balqa applied university, alsalt, jordan. *email: khawlaabdoo@bau.edu.jo received: 02 january 2020 accepted: 10 april 2020 doi: https://doi.org/10.32479/ijefi.9521 abstract the aim of this study is to explain the effect of the external variables on the financial performance of the islamic and conventional banks measured by the rates of return of assets and the rates of return on equity, in addition to the earnings per stock during the period (2001-2011). to achieve the objectives of the study, some statistical procedures and e-views program are used. the data of the annual financial reports from the sample of the study are collected. the findings of the study indicated a statistical significant effect of the external variables on the performance of the conventional banks. according to islamic banks, there was an effect of the external variables, on the financial performance. in addition, the findings showed that there were statistical significant differences in the rates of returns on assets between islamic and conventional banks, but there were no significant statistical differences with respect to rates of return on equity, and the earnings per stock between the two kinds of banks. in light of these findings, the study has come up with some recommendations. the islamic banks have to enhance their financial performance to be distinguished and to progress their activities. keywords: conventional banks, islamic banks, external variables, financial performance jel classifications: g2, g21 1. introduction islamic banks work in the banking sector in order to develop the society economically and socially. by exploiting its available resources in a legitimate manner consistent with the teachings of the islamic religion concerning the investment of funds and how to dispose them in the legitimate aspects. although the nature of islamic banking differs from that of conventional banking, islamic banks and conventional banks are among the most important financial and economic institutions. due to the complexity of its financial and banking relations with all other economic institutions, as well as the multiplicity of the size and type of customers benefiting from its services, so a large part of the activities of islamic banks are affected by a range of factors and variables (internal and external), this study came to examine a set of internal variables affecting the activity and business of banks in general, and affect the financial performance in particular. 1.1. the study problem financial institutions face many challenges as a result of the rapid developments in the world, and because the financial performance is of great importance in financial literature and thought and its importance in economic activity. islamic and conventional banks have not lost sight of their interest in improving their financial performance. by briefing the researcher on the previous studies related to the financial performance of jordanian banks and their follow-up to islamic and conventional banks, and the fact that these banks do not operate in an isolated environment, the researcher realized that there are many variables that are not taken into consideration by this journal is licensed under a creative commons attribution 4.0 international license abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020223 researchers and bank officials about their impact on their financial performance. these internal variables (current accounts, equity, bank size) play a pivotal role in the financial performance of banks. therefore, the purpose of this study is to demonstrate the impact of internal variables on the financial performance of islamic and conventional banks. 1.2. study hypotheses the first main hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (current accounts, equity, bank size) on the financial performance of jordanian islamic banks. the first hypothesis is subdivided into the following sub-hypotheses: the first sub-hypothesis: there is no statistically significant effect at the level (α ≤ 0.05) of the internal variables (current accounts, equity, bank size) on the rate of return on assets in jordanian islamic banks. the second sub-hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (current accounts, equity, bank size) on the rate of return on equity in jordanian islamic banks. third hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (current accounts, equity, bank size) on the share of net profit of the jordanian islamic banks. the second main hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (current accounts, equity, bank size) on the financial performance of jordanian conventional banks. the second hypothesis is subdivided into the following hypotheses: the first sub-hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (current accounts, equity, bank size) on the rate of return on assets in jordanian conventional banks. the second sub-hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (current accounts, equity, bank size) on the rate of return on equity in jordanian conventional banks. third sub-hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (current accounts, equity, bank size) on the share of net profits of jordanian conventional banks third main hypothesis: there are no statistically significant differences at the level (α ≤ 0.05) of the effect of internal variables (current accounts, equity, bank size) on the financial performance between conventional banks and financial performance of jordanian islamic banks. the third hypothesis is subdivided into the following hypotheses: the first sub-hypothesis: there are no statistically significant differences at the significance level (α ≤ 0.05) of the effect of internal variables (current accounts, equity, bank size) on the rate of return on assets between islamic banks and jordanian conventional banks. the second sub-hypothesis: there are no statistically significant differences at the significance level (α ≤ 0.05) of the effect of internal variables (current accounts, equity, bank size) on the rate of return on equity between islamic banks and jordanian conventional banks. third sub-hypothesis: there are no statistically significant differences at the level (α ≤ 0.05) of the effect of internal variables (current accounts, equity, bank size) on the average earnings per share between islamic banks and jordanian conventional banks. 1.3. the importance of studying this study draws its significance by addressing a relatively recent topic, which is of great interest to islamic banks operating in jordan namely: jordan islamic bank for investment and finance and arab islamic international bank, which they have experience in islamic banking, derived from the borrowing policy and interest rate, and will be through the measurement of the impact of internal variables on the financial performance of these banks, and to know how islamic banks are flexible in responding to those variables compared to the flexibility of conventional banks to those variables, and can maintain their financial position and competitiveness in the sector banking. 2. literature review 2.1. previous studies the study of al-yahya (2008) aimed to measure the efficiency of islamic banks compared to commercial banks in jordan, as well as compare the efficiency of the two islamic banks, namely jordan islamic investment bank and arab islamic international bank among them, using the analysis of financial ratios to measure the efficiency of banks. the results showed that commercial banks are more efficient than islamic banks by dividing the sample of the study into two groups containing the two islamic banks in addition to two commercial banks selected based on the convergence in the total assets of these banks with the two islamic banks. maria (2009), the study aimed to analyze profitability levels, asset quality, market value and liquidity ratio. the results showed that islamic banks outperformed their asset growth and net income from financing activities and had better liquidity compared to conventional banks. bushnaq (2011), the study aimed to evaluate the financial performance of islamic and conventional banks in palestine through comparison using several financial indicators such as liquidity, activity, profitability and market indicators. the study found the result: islamic banks maintain high abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020 224 liquidity compared to conventional banks. liquidity is less in islamic banks than conventional banks. kosmidou et al. (2005). the study investigates the impact of bank’s characteristics, macroeconomic conditions and financial market structure on the net interest margin and return on average assets of the uk commercial banking industry over the period 1995-2002. the result show a negative relation between the cost to income ratio and the bank profitability. liargovas, and skandalis, (2008) the study aimed to identify the factors affecting the financial performance of the greek industrial companies during the period (1997-2004). to achieve this, the researchers conducted a comprehensive analysis of the performance of greek industrial companies, based on the gradual regression equation, the researchers also used the questionnaire to collect information. the study also found that large companies, and inexperienced, exporting and involving a competitive management team are the most profitable, as these companies are characterized by the best indebtedness, and use their liquidity to finance their investments, the study recommends the integration of small companies so that they can stand and compete against large companies. almazari (2014) this paper investigated the internal factors that affecting profitability of banks. the main objective was to compare the profitability of the saudi and jordanian banks by using the internal factors for estimations. the necessary data was collected from secondary sources. however, the results indicated that there is a significant positive correlation between roa of saudi banks with tea, tia and lqr variables, as well as a negative correlation with nca, cdr, cir and sze variables. meanwhile, there is a significant positive correlation between roa of jordanian banks with lqr, nca, tea and cdr variables, also there is a negative correlation of return on assets with cir, tia and sze. it is recommended that empirical studies should be undertaken in the same field to find out what more internal factors could affect profitability of banks. 2.2. theoretical framework internal variables affecting the financial performance of banks: the financial performance of banks is influenced by many variables that may affect their profitability negatively or positively, among these variables, internal variables affected by government regulations and legislation represented by monetary and financial policy on the financial performance of banks, and internal variables include several factors including current accounts, equity, bank size. 2.2.1. current accounts (demand deposits) banks call accounts on certain types of deposits, such as current accounts. current accounts are considered one of the most important sources of external funds for conventional and islamic banks alike, where banks rely in financing the bulk of their operations on the funds of depositors, given the low cost of obtaining them compared to other sources. bankers defined the current account as a type of deposit account from which checks are drawn primarily by checks or any other withdrawal instrument withdrawn by the customer on the bank. 2.2.2. equity the internal sources of funds of banks include: equity (funds derived from the contributions of the owners of the bank, i.e., shareholders), funds arising from the results of its activities such as cash reserves held by the bank in compliance with the prevailing laws and part of the profits realized by the bank from its activities and not distributed to shareholders (retained earning). there are no differences in internal sources (equity) between islamic banks and conventional banks, except in one case that the islamic bank’s capital cannot contain preferred shares, because of its special nature, which includes predetermined fixed returns in addition to its share of profits. 2.2.3. bank size through the many applied studies that have introduced the size of the bank as one of the variables or as a basis for the classification of banks it turned out that there is no standard or standardized size of the bank. however, we can say that the size of the bank reflects the resources available to the bank so that these resources affect its economic activity and its ability to benefit from the environment more effectively. the size of the bank has a prominent value in many financial and economic studies, which addressed various topics including economic size, production, industrial concentration, profitability and technological change. however, there is no clear concept and standardized measure of the size of the bank, through the various experimental studies, but the most common and used measures of the size of the bank are (total assets, shareholders’ equity, number of employees and volume of deposits). in this study, one measure of the total assets will be taken. this measure is considered one of the most important measures to estimate the size of the bank, the total assets is the economic resources owned by the bank and is expected to be utilized in future operations. 3. methodology the study relied on the analytical approach in studying, analyzing and interpreting data related to jordanian conventional and islamic banks, and in studying and analyzing data based on financial ratios as a tool of analysis. the dependent variable which is financial performance, was measured by profitability ratios. the data was analyzed using the statistical package e-views. it is a modern and advanced program in the standard analysis and estimation of economic models. it is designed to handle (panel date) cross-sectional data and time series, i.e., data that examine a particular sector over time, and is an easy-to-use program for such a study. 3.1. how to calculate variables the variables that were concentrated during the study were divided into independent and dependent variables. the independent variables were calculated as follows: abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020225 economic growth is measured by (real gdp of current year real gdp of previous year/real gdp of previous year). inflation is measured by consumer price indices. the amman stock exchange index is measured by weighted indexes of market capitalization. then the dependent variable (financial performance) was calculated by the following equations: 1. rate of return on assets = net income total asset 2. rate of return on equity = net income total equity 3. earnings per share = net income number of shares outstanding the above indicators will be adopted separately to represent the dependent variable. 3.2. study population through reviewing the bulletins issued by the central bank of jordan and the association of jordanian banks. we find that the study population relates to licensed banks in jordan, which consist of three categories: conventional jordanian banks, foreign conventional banks, and islamic banks. the number of 26 banks according to the prospectus of the association of jordanian banks for 2016. the sample of the study is derived from the study population mentioned above. it will include 15 jordanian banks, 13 of which are conventional banks. as for islamic banks, jordan islamic bank for investment and finance and arab islamic international bank, but jordan dubai islamic bank and al rajhi bank have been excluded for lack of financial statements covering the study period. the following table 1 shows the sample of the study: 3.3. examine the first main hypothesis there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (inflation, economic growth, financial market index) on the financial performance of the jordanian islamic banks. this hypothesis was tested using the standard model of multiple linear regression test for cross-sectional time data. the first hypothesis is subdivided into the following hypotheses: first sub-hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (inflation, economic growth, financial market index) on the rate of return on assets in islamic banks. the relationship between the rate of return on assets in islamic banks as a dependent variable, inflation, economic growth and the financial market index can be represented as independent variables by the following general linear model: =a+β1inf+β2gdp+β3fmi+eroa the hypothesis can be formulated as follows: h0: β1=β2=β3=0 h1: β1≠β2≠β3≠0 to test the previous hypothesis, we estimate this model using panel egls. using e-views, we obtained the results shown in table 2. table 2 shows that the effect of inflation, economic growth, financial market index (inf, gdp, fmi) on the rate of return on assets is significant with a statistical significance level of 0.05. the calculated f value (5.567635) indicates a significant level of 0.05. on the fit of the proposed model to represent the relationship between variables (prob. = 0.002739). table 1: the names of the jordanian banks included in the study no. bank name date of establishment 1 arab bank 1930 2 jordan national bank 1956 3 bank of jordan 1960 4 cairo amman bank 1960 5 housing bank for trade and finance 1974 6 jordan kuwait bank 1977 7 commercial bank of jordan previously jordan gulf bank 1978 8 arab jordan investment bank 1978 9 jordan islamic bank for investment and finance 1979 10 arab banking corporation (jordan) 1989 11 investment bank 1989 12 union bank 1991 13 societe generale bank jordan 1993 14 jordan capital bank 1996 15 arab islamic international bank 1997 source: based on information from the 2016 report of the association of jordanian banks table 2: results of testing the impact of internal variables on the rate of return on assets in islamic banks for the period (2007-2016) dependent variable: roa variable coefficient standard error t-statistic prob. inflation 0.000180 0.000216 0.834643 0.4089 gdp 0.001409 0.000298 5.275862 0.0000 fmi 7.33e-07 1.92e-07 3.823295 0.0005 c 0.004171 0.001544 2.701246 0.0101 weighted statistics r-squared 0.294569 mean dependent var. 1.821899 adjusted r-squared 0.241661 sd dependent var. 1.239462 se of regression 1.041363 sum squared resid. 43.37746 f-statistic 5.567635 durbin-watson stat. 1.585408 prob. (f-statistic) 0.002739 c represents the linear equation constant, which is called in the case of two variables in the vertical segment abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020 226 the value of the coefficient of determination was (0.294569). this means that the previous independent variables combined explain (29.46%) of the variance in the dependent variable. moreover, the values of the regression coefficient showed that economic growth and the financial market index have a statistically significant effect on the rate of return on assets where the probability (p-value) at the values of my parameters <0.05, and therefore the null hypothesis will be rejected and accept the alternative hypothesis, that there is a statistically significant effect at the indicative level (α ≤ 0.05) of inflation, economic growth, and the financial market index (inf, gdp, fmi) on the rate of return on assets. second sub-hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (inflation, economic growth, financial market index) on the rate of return on equity in islamic banks. the relationship between the rate of return on equity in islamic banks as a dependent variable, inflation, economic growth and the financial market index can be represented as independent variables by the following general linear model: roe = a+β1inf+β2gdp+β3fmi+e the hypothesis can be formulated as follows: h0: β1=β2=β3=0 h1: β1≠β2≠β3≠0 to test the previous hypothesis, we estimate this model using panel egls. using e-views, we obtained the results shown in table 3. table 3 shows that the effect of inflation, economic growth, financial market index (inf, gdp, fmi) combined on the rate of return on equity is significant at a statistical significance level of 0.05. the calculated value of f (7.87969) indicates a significant level of 0.05. on the appropriateness of the proposed model to represent the relationship between variables (prob. = 0.000301). the value of the coefficient of determination was (0.371455), that is, the previous independent variables combined account for (37.15%) of the variance in the dependent variable. in addition, the coefficient parameters showed that economic growth and the stock market index have a statistically significant effect on the rate of return on equity where the probability (p-value) at the values of the regression parameters is <0.05, so the null hypothesis will be rejected. we reject the alternative hypothesis that there is a statistically significant effect at the significance level (α ≤ 0.05) of inflation, economic growth, and the financial market index (inf, gdp, fmi) on the rate of return on equity. third sub-hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (inflation, economic growth, financial market index) on the share of net profit in islamic banks. the relationship between the share of net profit in islamic banks as a dependent variable, inflation, economic growth and the financial market index can be represented as independent variables by the following general linear model: = a+β1inf+β2gdp+β3fmi+eeps the hypothesis can be formulated as follows: h0: β1=β2=β3=0 h1: β1≠β2≠β3≠0 to test the previous hypothesis, we estimate this model using panel egls. table 4 shows the impact of inflation, economic growth, and financial market index (inf, gdp, fmi) combined per share of net profits was significant with a statistical significance level of 0.05. the calculated f value (16.4938) indicates a significant level of 0.05. on the appropriateness of the proposed model to represent the relationship between variables (prob. = 0.00000). table 3: results of testing the effect of internal variables on the rate of return on equity in jordanian islamic banks for the period (2007-2016) dependent variable: roe variable coefficient standard error t-statistic prob. inflation 0.001354 0.002048 0.661180 0.5123 gdp 0.001409 0.000298 4.728188 0.0000 fmi 9.20e-06 1.89e-06 4.869718 0.0000 c 0.042251 0.016358 2.582868 0.0136 weighted statistics r-squared 0.371455 mean dependent var. 1.986363 adjusted r-squared 0.324314 sd dependent var. 1.429183 se of regression 1.048503 sum squared resid. 43.97437 f-statistic 7.879690 durbin-watson stat. 1.603326 prob. (f-statistic) 0.000301 table 4: results of the test of the impact of internal variables on the share of net profit in the jordanian islamic banks for the period (2007-2016) dependent variable: eps variable coefficient standard error t-statistic prob. inflation 0.003878 0.002393 1.620680 0.1129 gdp 0.012054 0.004850 2.485407 0.0172 fmi 2.11e-05 3.01e-06 7.003683 0.0000 c 0.112627 0.025317 4.448612 0.0001 weighted statistics r-squared 0.552979 mean dependent var. 2.177012 adjusted r-squared 0.519453 sd dependent var. 1.810461 se of regression 1.039755 sum squared resid. 43.24366 f-statistic 16.49378 durbin-watson stat. 1.759666 prob. (f-statistic) 0.000000 abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020227 the value of the coefficient of determination was (0.552979), which means that the previous independent variables combined explain (55.30%) of the variance in the dependent variable. in addition, the values of the coefficient parameters showed that economic growth and the stock market index have a statistically significant effect on the share of net profits where the probability (p-value) at the values of my parameters <0.05, and therefore will reject the null hypothesis we can not reject the hypothesis the alternative is that there is a statistically significant effect at the indicative level (α ≤ 0.05) of inflation, economic growth, and the financial market index (inf, gdp, fmi) on the share of net earnings. test the second main hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (inflation, economic growth, financial market index) on the financial performance of the traditional jordanian banks. this hypothesis was tested using the standard model of multiple linear regression test for cross-sectional time data. the second hypothesis is subdivided into the following hypotheses: first sub-hypothesis: there is no statistically significant effect at the significance level (α ≤ 0.05) of the internal variables (inflation, economic growth, financial market index) on the rate of return on assets in traditional jordanian banks. the relationship between the rate of return on assets in conventional banks as a dependent variable, inflation, economic growth and the financial market index can be represented as independent variables by the following general linear model: roa = a+β1inf+β2gdp+β3fmi+e the hypothesis can be formulated as follows: h0: β1=β2=β3=0 h1: β1≠β2≠β3≠0 to test the previous hypothesis, we estimate this model using panel egls. using e-views, we obtained the results shown in table 5. table 5 shows that the effect of inflation, economic growth, financial market index (inf, gdp, fmi) on the rate of return on assets is significant at a statistical significance level of 0.05. the calculated f value (67.34020) indicates a significant level of 0.05. on the appropriateness of the proposed model to represent the relationship between variables (prob. = 0.000000). the value of the coefficient of determination was (0.4174), that is, the previous independent variables combined account for (41.74%) of the variance in the dependent variable. in addition, the coefficient coefficient values showed that all internal variables have a statistically significant effect on the rate of return on assets where the probability (p-value) at all coefficients is <0.05. there is a statistically significant effect at the significance level (α ≤ 0.05) of inflation, economic growth and the financial market index (inf, gdp, fmi) on the rate of return on assets. second sub-hypothesis: there is no statistically significant effect at the level (α ≤ 0.05) of the internal variables (inflation, economic growth, financial market index) on the rate of return on equity in conventional banks. the relationship between the rate of return on equity in conventional banks as a dependent variable, inflation, economic growth and the stock market index can be represented as independent variables by the following general linear model: =a+β1inf+β2gdp+β3fmi+eroe the hypothesis can be formulated as follows: h0: β1=β2=β3=0 h1: β1≠β2≠β3≠0 to test the previous hypothesis, we estimate this model using panel egls. using e-views, we obtained the results shown in table 6. table 5: results of testing the impact of internal variables on the rate of return on assets in the traditional jordanian banks for the period (2007-2016) dependent variable: roa variable coefficient standard error t-statistic prob. inflation 0.000220 8.88e-05 2.477963 0.0138 gdp 0.000629 0.000115 5.471067 0.0000 fmi 1.33e-06 1.08e-07 12.26997 0.0000 c 0.001290 0.000817 1.578962 0.1155 weighted statistics r-squared 0.417380 mean dependent var. 0.708390 adjusted r-squared 0.411182 sd dependent var. 2.284083 se of regression 1.003391 sum squared resid. 283.9155 f-statistic 67.34020 durbin-watson stat 1.722182 prob. (f-statistic) 0.000000 table 6: results of testing the effect of internal variables on the rate of return on equity in the traditional jordanian banks for the period (2007-2016) dependent variable: roe variable coefficient standard error t-statistic prob. inflation 0.001409 0.000664 2.121988 0.0320 gdp 0.005834 0.000999 5.841519 0.0000 fmi 6.94e-06 8.63e-07 8.050228 0.0000 c 0.017967 0.006571 2.734266 0.0066 weighted statistics r-squared 0.266404 mean dependent var. 0.815761 adjusted r-squared 0.258599 sd dependent var. 2.000191 se of regression 1.002888 sum squared resid. 283.6312 f-statistic 34.13586 durbin-watson stat. 1.735645 prob. (f-statistic) 0.000000 abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020 228 table 6 shows that the effect of inflation, economic growth, financial market index (inf, gdp, fmi) combined on the rate of return on equity is significant at a statistical significance level of 0.05. the calculated value of f (34.13586) indicates a significant level of 0.05 for the suitability of the proposed model to represent the relationship between the variables (prob. = 0.000000). the value of the coefficient of determination was (0.2664), that is, the previous independent variables combined account for (26.64%) of the variance in the dependent variable. in addition, coefficient values showed that all internal variables have a statistically significant effect on the rate of return on equity where the probability (p-value) of all coefficients is <0.05. however, there is a statistically significant effect at the level (α ≤ 0.05) of inflation, economic growth and the financial market index (inf, gdp, fmi) on the rate of return on equity. third sub-hypothesis: there is no statistically significant effect at the level (α ≤ 0.05) of the internal variables (inflation, economic growth, financial market index) on the share of net profit in conventional banks. the relationship between net earnings per share in conventional banks as a dependent variable, inflation, economic growth and the stock market index can be represented as independent variables by the following general linear model: eps = a+β1inf+β2gdp+β3fmi+e the hypothesis can be formulated as follows: h0: β1=β2=β3=0 h1: β1≠β2≠β3≠0 to test the previous hypothesis, we estimate this model using panel egls. using e-views, we obtained the results shown in table 7. table 7 shows that the effect of inflation, economic growth, financial market index (inf, gdp, fmi) combined on the net earnings per share is significant with a statistical significance level of 0.05. the calculated f value (9.792046) indicates a significant level of 0.05. on the suitability of the proposed model to represent the relationship between variables (prob. = 0.000004). the value of the coefficient of determination was (0.0943), which means that the previous independent variables combined explain (9.43%) of the variance in the dependent variable. in addition, coefficient values showed that all internal variables have a statistically significant effect on the net earnings per share where the probability (p-value) at all coefficients is <0.05, therefore, the null hypothesis will be rejected and we cannot reject the alternative hypothesis which states that there is a statistically significant effect at the significance level (α ≤ 0.05) of inflation, economic growth, and the financial market index (inf, gdp, fmi) on the average earnings per share. the third main hypothesis: there are no statistically significant differences at the level (α ≤ 0.05) of the effect of internal variables (inflation, economic growth, financial market index) on the financial performance between islamic banks and traditional jordanian banks. the third hypothesis is subdivided into the following hypotheses: first sub-hypothesis: there are no statistically significant differences at the significance level (α ≤ 0.05) of the effect of internal variables (inflation, economic growth, financial market index) on the rate of return on assets between islamic banks and traditional jordanian banks. the bank is expressed as a dummy variant dummy variable, where the islamic bank takes the value of 1, while the commercial bank takes the value of 0, the results were as follows in table 8. table 7: results of the test of the impact of internal variables on the share of net profit in the traditional jordanian banks for the period (2007-2016) dependent variable: eps variable coefficient standard error t-statistic prob. inflation 0.005293 0.002193 2.413589 0.0296 gdp 0.007378 0.001983 3.720002 0.0002 fmi 7.87e-06 1.97e-06 4.004959 0.0001 c 0.096735 0.015316 6.315730 0.0000 weighted statistics r-squared 0.094343 mean dependent var. 1.165601 adjusted r-squared 0.084708 sd dependent var. 1.728491 se of regression 1.002557 sum squared resid. 283.4442 f-statistic 9.792046 durbin-watson stat. 1.838280 prob. (f-statistic) 0.000004 table 8: results of testing the effect of internal variables on the rate of return on assets between islamic banks and traditional jordanian banks for the period (2007-2016) dependent variable: roa variable coefficient standard error t-statistic prob. gdp 0.000393 0.000197 1.996313 0.0467 inflation −0.000180 0.000132 −1.364175 0.1735 fmi__p_ 1.31e-06 1.72e-07 7.607783 0.0000 bank −0.003110 0.001332 −2.334549 0.0202 c 0.002695 0.001271 2.119953 0.0348 r-squared 0.199586 mean dependent var. 0.009673 adjusted r-squared 0.189734 sd dependent var. 0.009139 se of regression 0.008227 akaike info criterion −6.747811 sum squared resid 0.021996 schwarz criterion −6.690249 log likelihood 1118.389 hannan-quinn criter. −6.724851 f-statistic 20.25993 durbin-watson stat 1.723928 prob. (f-statistic) 0.000000 abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020229 note that the value of the coefficient coefficient at the bank variable is (−0.003110), which is a statistically significant value where the value of (t-statistic = −2.334549) and a significant level (prob. = 0.0202) which is <0.05, which indicates that the classification of the bank islamic or commercial it significantly affects the rate of return on assets and indicates differences in the effect of internal variables on the rate of return on assets between islamic banks and conventional banks. second sub-hypothesis: there are no statistically significant differences at the significance level (α ≤ 0.05) of the effect of internal variables (inflation, economic growth, financial market index) on the rate of return on equity between islamic banks and traditional jordanian banks (table 9). note that the value of the coefficient at the bank variable is (−0.001869), a value that is not statistically significant, where the value (t-statistic = −0.180482) and the level of significance (prob. = 0.8569) which is >0.05, which indicates that the classification of the bank is islamic or tejari does not significantly affect the rate of return on equity, and indicates that there are no differences in the impact of internal variables on the rate of return on equity between islamic banks and conventional banks. third sub-hypothesis: there are no statistically significant differences at the significance level (α ≤ 0.05) of the effect of internal variables (inflation, economic growth, financial market index) on the average earnings per share between islamic banks and jordanian conventional banks (table 10). note that the value of the coefficient at the bank variable is (−0.026019), a value that is not statistically significant, where the value (t-statistic = −1.025753) and the level of significance (prob. = 0.3058) which is >0.05, which indicates that the classification of the bank islamic or tejari does not have a significant impact on the share of net profit, and indicates that there are no differences in the impact of internal variables on the share of net profit between islamic banks and conventional banks. 4. discussion of the findings and hypotheses discussion of the first main hypothesis: based on the results of the previous statistical tests, it was found that there was a significant statistically significant effect between the financial performance represented by (roa, roe, eps), and economic growth as measured by gdp in real prices. therefore, we believe that this result is in line with the expectations and economic studies and financial analysis. therefore, economic growth is an indicator of the health of the economies of the countries and institutions in which they operate. the banks often benefit from high economic growth rates to achieve high profits, which leads to increase domestic and foreign investment. increasing the appetite of individuals and sectors for bank financing, if islamic banks are efficient to manage their assets, using more than one islamic financing formula. the impact of inflation on the financial performance of islamic banks, shows the result of statistical tests that the impact is not significant, and this result is consistent with economic expectations, saying that high inflation rates and facilities have high interest rates, can positively affect the profitability of islamic banks, especially as a large proportion the profits of islamic banks come from investments and other traditional activities such as murabaha operations. as for the stock market index, there was a significant statistical impact on the financial performance. since the market index is a mirror to the image of the domestic economy of any country, any table 9: results of the test of the impact of internal variables on the rate of return on equity between islamic banks and traditional jordanian banks for the period (2007-2016) dependent variable: roe variable coefficient standard error t-statistic prob. gdp 0.004550 0.001529 2.975811 0.0031 inflation −0.001471 0.001024 −1.435967 0.1520 fmi__p_ 8.09e-06 1.34e-06 6.061506 0.0000 bank −0.001869 0.010355 −0.180482 0.8569 c 0.023550 0.009880 2.383660 0.0177 r-squared 0.149344 mean dependent var. 0.080233 adjusted r-squared 0.138874 sd dependent var. 0.068908 se of regression 0.063944 akaike info criterion −2.646577 sum squared resid. 1.328879 schwarz criterion −2.589015 log likelihood 441.6852 hannan-quinn criter. −2.623616 f-statistic 14.26452 durbin-watson stat. 1.775719 prob. (f-statistic) 0.000000 table 10: results of the test of the impact of internal variables on the share of net profit between islamic banks and jordanian traditional banks for the period (2007-2016) dependent variable: eps variable coefficient standard error t-statistic prob. gdp 0.003179 0.003746 0.848595 0.3967 inflation −0.001943 0.002509 −0.774462 0.4392 fmi__p_ 1.20e-05 3.27e-06 3.674802 0.0003 bank −0.026019 0.025366 −1.025753 0.3058 c 0.104287 0.024202 4.308995 0.0000 r-squared 0.052290 mean dependent var. 0.165209 adjusted r-squared 0.040625 sd dependent var. 0.159923 se of regression 0.156641 akaike info criterion −0.854691 sum squared resid. 7.974283 schwarz criterion −0.797129 log likelihood 146.0240 hannan-quinn criter. −0.831730 f-statistic 4.482938 durbin-watson stat. 1.842340 prob. (f-statistic) 0.001540 abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020 230 improvement in it reflects positively on the financial performance of islamic banks. discussion of the second main hypothesis: based on the results of the previous statistical tests, it was found that there is a significant statistical effect of economic growth as measured by gdp in real prices on the financial performance represented by roa, roe, eps., that the presence of growth in gdp means that the economic situation is improving, and the various economic sectors are growing well and these sectors traditional banks. this gives investors and individuals alike a state of future optimism, and leads to increased appetite for loans from conventional banks to finance their investments and spending, as well as the ability of companies and individuals to repay the installments of loans owed to them, and this result was consistent with the study (dawood, 2000), that the economic recession leads to projects faltered and the inability to pay and vice versa in the period of economic recovery. the effect of inflation on the financial performance of conventional banks was statistically significant, which is acceptable and consistent with the economic literature. increased demand for capital to finance the proposed projects, and increased demand for capital leads to higher interest rates, and consequently increase the profits of business enterprises, and this justifies the result consistent with the theoretical framework of the study, the lack of justice in the distribution of income among the layers of society the effect of inflation, where the first beneficiary of inflation are employers and professions, this result also corresponded with the results of the study (damotaran, 1999). the effect of the financial market index on the financial performance of conventional banks shows that there is a significant statistically significant effect, since any improvement in the performance of the financial market leads to a direct improvement in the financial performance of conventional banks as listed companies in that market. discussion of the third hypothesis: the existence of statistically significant differences on the effect of internal variables and internal variables on the rate of return on assets between islamic banks and conventional banks is attributed to the low financing and investment income of islamic banks compared to conventional banks that depend on the fixed interest rate to achieve their revenues. also, due to the low commission income of islamic banks and the lack of diversification of the areas of banking services provided by them, and this result is consistent with the study (alserogi) the results of a study conducted in the arab gulf states that conventional banks achieve higher profitability than islamic banks, within the measurement of financial performance index (roa). the rate of return on equity, which is a percentage of the profitability ratio, i.e., represents the return on shareholders’ investment from banks. this indicates better performance, due to the absence of statistically significant differences on the impact of internal variables on the rate of return on equity between islamic banks and conventional banks to use both types of banks for their own resources to make profits. earnings per share is an indicator measured by dividing the net profit after tax by the number of shares traded. this indicator is used to know the per share of net profit. it measures the share of earnings per share as a result of employing the economic resources of the bank and increasing this percentage indicates better financial performance of the bank. the absence of statistically significant differences is due to the impact of internal variables on the share of net profit between islamic banks and conventional banks due to the convergence between the share of net earnings per share of both islamic banks and conventional banks. especially after the global financial crisis (2008) and directed by them to acquire this stock because of the existence of religious motivation they have. 5. results of statistical analysis and conclusion 1. the study showed that the effect of inflation was significant on the financial performance of the traditional jordanian banks, due to their dealing with cash and interest rates, while islamic banks were not affected by inflation performance, because they deal with real commodities, and rely on the use of financing tools and forms of trade in goods islamic murabaha formula. 2. it is clear from the study that the stock market index, represented by the index of weighted indexes of stock prices, has a significant effect on the financial performance of islamic and conventional banks. 3. the study showed a significant impact of economic growth on the financial performance of the jordanian islamic and traditional banks, due to the increase in demand among individuals and increase production and therefore high economic growth rates. 4. the study shows that there are significant differences in the effect of internal variables on the rate of return on assets between islamic banks and conventional banks, due to the diversity of investments and financing methods in conventional banks. and their dependence on a fixed rate of interest. 5. the study found that there were no significant differences for the effect of internal variables on the share of net earnings per share between islamic banks and conventional banks. this is due to the convergence between the share of net profit in islamic banks and conventional banks, and thus good performance of those banks. 6. the study showed no significant differences for the effect of internal variables on the rate of return on equity between islamic banks and conventional banks, which means the ability of islamic banks to compete in the jordanian banking market, despite the small size of their total assets compared to conventional banks. in the light of the previous results, the study concluded with many recommendations, the most important of which are that islamic abdo: the impact of internal variables on the islamic banks and conventional banks financial performance in jordan: a comparative study international journal of economics and financial issues | vol 10 • issue 6 • 2020231 banks should improve their financial performance and strive for excellence and development in their activities. references almazari, a.a. (2014), impact of internal factors on bank profitability: comparative study between saudi arabia and jordan. journal of applied finance and banking, 4(1), 125-140. al-yahya, m. (2008), evaluating the performance of jordanian islamic banks compared to traditional banks. irbid, jordan: unpublished master thesis, yarmouk university. bushnaq, z.s. (2011), evaluation of the financial performance of islamic and traditional banks using financial indicators comparative study unpublished master thesis. gaza, palestine: gaza university. damotaran, a. (1999), applied corpoerate finance. new york: john wiley and sons inc. dawood, w. (2000), management of non-performing debts with traditional banks in jordan, unpublished master thesis. khartoum: al-neelain university. p10. islamic accounting and auditing organization. (2004), sharia standards, standard no. 27, bahrain, manama. p456. kosmidou, k., tanna, s., pasiouras, f. (2005), determinant’s of profitability of domestic uk commerial banks panel evidence from the period 1995-2002. coventry university business school. p1-20. maria, m.a. (2009), is islamic banks more immune than conventional banks in the face of the current global economic crisis. united arab emirates: unpublished master thesis, british university. moneim, (1985), macroeconomics, umm al-qura university, mecca, saudi arabia. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(3), 581-585. international journal of economics and financial issues | vol 7 • issue 3 • 2017 581 influence of country factors on entry mode through knowledge and transactional cost economics: market entry: evidence from construction firms kausar yasmeen1*, kuperan viswanathan2 1school of economics, finance and banking, universiti utara malaysia, malaysia, 2school of economics, finance and banking, universiti utara malaysia, malaysia. *email: eco.yasmeen@gmail.com abstract owing to the competition global level economy of world and pattern are promoting to the construction firms to increase into emerging economies. entry mode has become important for firms. the present paper aims to explore the entry modes which are preferred by construction firms in malaysia, for their international projects, on whether construction firms choose equity modes, non-equity modes or both modes. 19 questionnaires were filled by respondents by using cross-sectional data technique. this study found that country specific factors (cultural differences and target country risk) influence the entry mode of firms directly and through knowledge and transactional cost economics by applying the multinomial logistic regression. this study contributes theoretically and practically along with this; present study recommends that government should improve internal and external factors to enter the firms for economic development. keywords: entry mode, external factors, i̇nternal factors emerging economy jel classifications: m, m5, m21 1. introducti̇on infrastructural development creates a reduction in communication gap and time consumption along with a reduction in the cost of tariff barriers. likewise, other factors responsible for the globalization process results in the internationalization of the construction firms with many other opportunities. but the choice/selection of these firms regarding new entry in the market have made them risky i.e., it could lead to failure and results in financial loss to that firm by selection of the wrong choice. it could also lead to loss of opportunities and loss of market share in international markets as well. so the new entry of firm in the concerned market regarding choice has a significant effect on the company. and this situation has made the malaysian firms risky to start a business even by obtaining permits with respect to cultural differences (opanasopit, 2016). based on the resource-based view, when there is a situation of exploiting a competitive advantage, the firms have to take account the specific context knowledge, i.e., the especially the method of doing the investment that is typical of a specific country. so if a person has knowledge, he can enter the market the culture difference will not affect more (hussain and ishrat, 1999; kotler and armstrong, 2001; lundahl and skärvad, 1992; malik, 2010; madhok, 1997). so there is the probability that cultural differences affect entry mode of firms through knowledge. the cultural differences influence entry mode through transaction cost. as small culture differences lead to low cost and low cost will courage firm to enter the market (luo, 2001). additionally, if the construction firms do not have knowledge about the target country risk they can choose the wrong entry mode (brouthers, 2002). so country risk might influence entry mode through knowledge and transaction cost. if the firm feels that in host country thy have risk they need to spend more money in choosing the entry mode. as low risk leads to low cost and low cost will courage firm to enter the market (luo, 2001). however, the researcher failed to find the previous study that found the impact of cultural differences and country risk on firm’s entry mode through knowledge and transaction cost. yasmeen and viswanathan (2016) recommended that there is need to conduct a study on construction firms entry yasmeen and viswanathan: influence of country factors on entry mode through knowledge and transactional cost economics: market entry: evidence from construction firms international journal of economics and financial issues | vol 7 • issue 3 • 2017582 mode particularly in malaysia, so, this paper contributes to theoretically, practically and empirically, to conduct a study on the construction firms in an emerging economy of malaysia. the present study contributes to the literature by founding the impact of cultural differences and country risk on firm’s entry mode through knowledge and transaction cost. there are numerous studies that found that cultural differences and target country risk influence entry mode but few studies are available that theoretically say that cultural differences and target country risk influence entry mode through knowledge. so the present study contributes by conducting an empirical study on the influence of cultural differences and target country risk influence entry mode through knowledge. 2. theoreti̇cal background and li̇terature revi̇ew 2.1. country factors and entry modes as well as entry mode is concerned, each specific aspect of every destination should be termed as important. concluding from the past studies, in the host country, the distance among cultural and risk-targeted are the two variables with effect entry mode of the firm. the cultural distances are the differences of the culture of targeted host country in which business to be operated by new entry, and these differences are regarding the behavior of individuals to work with and start a business (hofstede, 1980). this can be further explained well under transaction cost economics in its application of investment on global level which is the internalization theory (anderson and gatignon, 1986; bradley, 2005; buckley and casson, 1976; rugman, 1981) that says cultural distance influence to the additional costs which is linked not only with communication but also with information collection methods to decode and code the information (pak and park, 2004). also, cultural distances results in difficulty of integration, adds up internationalization costs and firm then minimum resource of the organizational level of commitment (randoy and dibrell, 2002). owing to this; in the reference to contingency approach, contractual agreements are present to enhance and limit the cultural distances for the entry of new firms to become familiar with the host country (kim and hwang, 1992). also; resource dependency perspective states that to reduce risk regarding cultural distances, the firm took local support to help in the risk sharing aspects product characteristics and avoid mistakes (contractor and kundu, 1998; hennart and larimo, 1998; pak and park, 2004). h1: cultural distance will effect on entry modes of construction firms in emerging economy of malaysia. from above hypothesis, it can be derived sub-hypotheses based on the knowledge of host country regarding cultural distances which has already tested by empirically by previous studies (brown et al., 2003; hennart and larimo, 1998; hennart and larimo, 1998; kim and hwang, 1992; osborne, 1996; pak and park, 2004). this is reflected in the following hypothesis: h1a: cultural distance will effect on entry modes of construction firms in emerging economy of malaysia through knowledge. and furthermore, the second sub-hypothesis derived from the said main hypothesis is based on the degree of commitment in the host country based on the contracts agreed to support in order to coordinate accordingly by the cultural distances regarding new entry (aulakh and kotabe, 19 7; gatignon and anderson, 1988; hill et al. 1990;kim and hwang, 1992; luo, 2001; nakos et al., 2002; osborne, 1996). h1b: cultural distance will effect on entry modes of construction firms in emerging economy of malaysia through a degree of commitment. the next is the country risk that explains economically, political factor social and legal framework. the risk is involved because of the unexpected demand, political instability and uncertainty, variation in cost and in other sudden market behavior, however, in other situation, the alternative situation of argument as per maximum risk can be linked w with firms entry which can lead to lower resources commitment. based on the above discussion there is possibility of negative link between target country risk and the level of commitment supposed with firm entry type, this shows that the relationship has established the main empirical support (albaum et al., 2005; aulakh et al., 1998; axinn and matthyssens, 2002; azofra and martinez, 1999; brouthers, 2002; brouthers and brouthers, 2003; contractor and kundu, 1998; gatignon and anderson, 1988; kim and hwang, 1992; luo, 2001; nakos et al., 2002; osborne, 1996; pak and park, 2004; pla and leoin, 2002; ramon, 2002). h2: country risk will effect on equity entry modes. furthermore, bradley et al., (2006) the country risk of targeted location is linked with the transaction of costs which refers to political risk or the uncertainty associated with foreign ownership (pak and park, 2004; kotler and armstrong, 2001. if the firm feels that in host country they have a risk, then they need to spend more money in choosing the entry mode. as low risk leads to low cost and low cost will courage firm to enter the market (baek, 2003; brouthers and nakos 2004; czinkota and ronkainen, 2004; foster, 1998; hackett, 1976; luo, 2001). h2a: country risk will effect on equity entry modes through transaction cost economics. also, the target country risk is associated with the factor of knowledge. to overcome it, the firm will have to concern the local partner in the host country so that it could help the firm to familiarize accordingly (azofra and martinez, 1999; brouthers, 2002; deardorff, 1985; falvey, 1994). thus we can hypothesize that: h2b: cultural distance will effect on equity entry modes through knowledge. 3. research method malik (2010) employed the qualitative method while working out with a quantitative approach and applying multinomial logistic regression. hence, fig 1.1 shows the framework of the present study. yasmeen and viswanathan: influence of country factors on entry mode through knowledge and transactional cost economics: market entry: evidence from construction firms international journal of economics and financial issues | vol 7 • issue 3 • 2017 583 the population is unknown in this study because in malaysia the construction firm is not properly and formally. however, <200 construction firms of malaysia are formally registered as class a and grade 7 with cidb. the sample a random sampling technique is applied to collect the cross-sectional data and the sample size is determined by the rule of thumb sekaran and bougie, (2011) one hundred nineteen questionnaires were sent to the respondents, the response rate of construction companies was 53%. 4. measurement of variables three type of the firm have been selected in the present study, the respondents will be requested to chose eq (equity mode) neq (non-equity mode) or that chose both eq and neq. to collect the data the questionnaire is adapted from previous research of luo (2006) and datta, et al., (2009). in this paper, the dependent variable has three categories eq (equity mode) neq (non-equity mode) and both eq and neq. the nature of the dependent variable is nominal that is divided into three categories, so, the multinomial logit model suits to be applied to test the hypothesis. however, isa et al., (2014) used the same model to determine the influence of various variables on entry mode. hence, the econometric model of this study is as follows: em = β0+β1cdi+β2 tcri+β3 (cd*kn)iβ4 (cd*tc)i+β5 (cr*kn)iβ6 (cr*tc)i+ ei… (1) 0, j 1, j i1 2, j i2 3, j i3 4, j i4 5, j i5 6, j i6 i 4 0, j 1, j i1 2, j i2j 1 3, j i3 4, j i4 5, j i5 6, j exp( x x x x x x ) ws : pr (y j | x ) exp( x x x x x ) = β + β +β +β +β +β +β = = β + β +β +β +β +β +β ∑ (2) em represent to the entry mode of construction firms in malaysia, cd represent the cultural differences, cr represent to target country risk, kn represent to knowledge and finally, tc represent to transactional cost, where × β =×i represent to vector of characteristics particular jth respondents, and βj is a vector of coefficients respectively. the mnl model explain to each response probabilities once this study know the probabilities for j=0..j. as per the descriptive analysis, 54% firms are applying eq, neq is applied by 9% firms while 62% firms are applying both eq and neq in doing their international projects of construction in the asean. in the south asia, 27% malaysian are doing their construction projects and the rest were doing projects in other regions. 5. result and di̇scussi̇on according to the below table 1, the overall model is significant as the p > χ2 = 0.0000. in both cases (both and neq compare to eq) risk of the target country and cultural differences are in a negatively significant relationship. in the case of small cultural difference among both countries with low level of country risk, it can increase the entry of construction firms in the emerging economy of malaysia. particularly, if the construction firms feel that there is a low level of risk and cultural difference in the hosting country the firms will like to do business in the host country and because they will feel that their objectives can be achieved by completing their assignment in the peaceful and expected environment. betterment in the both factors (cultural difference and country risk) will push to the firms to perform in a way that is fit the preferred course for their construction firm.the findings of this study are in line with leo, 2001 and isa et al., 2014. the coefficient of the interaction term between knowledge, transactional cost and country-specific factors (culture differences and country risk) is significant, explaining that the influence of country-specific factors on the construction firm’s entry mode depends on the knowledge and transactional cost. the results of the present paper are in line with a previous study (aulakh and kotabe, 1997; brouthers, and moussetis, 2002; luo, 2001; madhok, 1997; pak and park, 2004). marginal effect to explain probabilities of choosing the category of firm entry mode, this study calculate the marginal effects. thus it is essential to evaluate all the outcomes, the marginal change in all (category) outcomes. for instance, using the predictors of x1,x2,x3, (the predictors) and pr (y=2): pr (y=1), pr (y=3): (pr (y=1) usually indicate to the base category, y=1. in multinomial logit, the marginal effects are applied to examine the effect of change as a result of a unit change: ( )ˆij ij j i i p p x   ∂ = − ∂ , where the probable table 1: results of multinomial logit estimation model 1 neq relative to eq both relative to eq coefficient se coefficient se cons 17.495 9.626 18.546 7.265 cd −0.538 0.242** −0.584 0.265** cd*kn 3.382 1.613** 0.55220 0.2652* cd*tc 2.590 1.292** 0.8609 0.3977** cr −5.256 2.6795** −4.5424 2.074* cr*kn 4.509 2.394*** 3.429 1.610** cr*tc 1.427 0.679*** 1.1622 0.5174** p>χ2: 0.000, log likelihood: −613.181 pseudo r2: 0.32, ***,** and * denote that the corresponding coefficient is significant at the 1%, 5%, and 10% level, respectively. this study considers significant value from 1% to 10%. eq is the base outcome, se: standard error figure 1.1: framework of the study yasmeen and viswanathan: influence of country factors on entry mode through knowledge and transactional cost economics: market entry: evidence from construction firms international journal of economics and financial issues | vol 7 • issue 3 • 2017584 ˆ ii ll l p = ∑ = is the probability of weighted average of βl awhen there is computation of a single factor the marginal effects will change owing to pij changes with the factors (xi), when the marginal effect is positive if βj>βi. according table 2 the marginal effect of cd, cr, kn and tc as per the probability of eq mode of the firm and both (eq and neq) are found statistically significant. hence, if a cd is are not bearable and as per expectations then the probability of eq and both is expected to decline by 0.001% and 0.026%, respectively. the probability of construction firms in the both case (eq and neq) is expected to decrease and are not supportive. the probability of the firm in the case of eq is expected to decrease and in the case of firms perceive property right system are not in support of construction firms. the marginal effect of cr on the probability of eq and both are statistically significant to enter into the malaysian economy. in the case of construction firm has cr the probability eq and both will increase by 0.224% and 0.08%, respectively. the marginal effect of the kn and tc determinants on the probability of eq, neq and both are statistically significant. hence, construction firm notices that they have kn and less tc factors, the construction firm’s probability eq, new and both will increase, respectively. 6. conclusi̇on present paper concludes that entry mode selection by construction firms in malaysia depends on country-specific factors, knowledge, and transactional cost economics. to test the hypothesis the crosssectional data was collected from construction firms working in malaysia; by applying multinomial logit model, this study found that country specific factors (cultural differences and target country risk) influence the entry mode of firms directly and through knowledge and transactional cost economics. the present paper contributes to both aspect theoretically and practically and also recommends that government of malaysia should amend the policies to minimize the cultural differences and transactional cost to enhance the number of construction firms and stay of construction firms in malaysia. this study recommends that the further studies should examine the direct impact of monitoring costs, bargaining costs, bonding cost and maladaptation costs on market entry of firms. references albaum, g., duerr, e., strandkov, j. 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(2003), case study research design and methods. 3rd ed. thousand oaks: sage publications inc. ole_link1 ole_link2 _goback . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(1), 67-72. international journal of economics and financial issues | vol 10 • issue 1 • 2020 67 five senses for effective and sustainable corporate social responsibility strategy muneer mohammed saeed al mubarak* management and marketing, ahlia university, manama, bahrain. *email: malmubarak@ahlia.edu.bh received: 18 october 2019 accepted: 10 december 2019 doi: https://doi.org/10.32479/ijefi.8990 abstract this study presents the five senses (sight, hearing, taste, touch and smell) concept that enhances the corporate social responsivity (csr) strategy. it sheds light on the true csr senses which are required by firms for better performance and sustainable development. the main approach for collecting information for discussion was the literature review focusing on topics such as csr strategy, csr activities, sustainability and sensemaking. a gap was found between what firms do and what are expected to deliver to the society in terms of csr activities and requirements. little was found on sensemaking and very little was found on csr five senses while searching the literature. when these five csr senses are incorporated in firms’ strategy and activities, a better performance is expected to achieve. when firms work effectively to meet different stakeholders’ needs and wants internally and externally, a better satisfaction level can be achieved, hence sustainable development is likely to be secured. these five csr senses have not been sufficiently considered in the research literature. this study contributes to the csr knowledge and practice in many venues by bridging the csr gap which might exist in strategy and practice. therefore, researchers and practitioners are expected to benefit from this study that can result in better csr control and sustainable development. keywords: five senses, corporate social responsibility, sustainability, sensemaking, stakeholders jel classification: m140 1. introduction corporate social responsibility (csr) covers economic, legal, ethical, and philanthropic activities and initiatives that the society expects from the firms (carroll, 1991). the philanthropic responsibility reflects unrestricted expectations that the society expects from businesses at a specific point of time (carroll, 2016). csr is developed when firms incorporate social and environmental concerns of the society in their activities and interact with stakeholders voluntarily. it goes beyond fulfilling legal expectations to investing into human capital, stakeholders’ relationships, and the environment. csr supports policies and practices that businesses need to help them interact with different stakeholders of the society (commission of the european communities, 2001). social responsibility was defined by iso (2010) as a firm’s responsibility towards the society and the environment through transparent and ethical behaviors that contribute to sustainable development by taking impactful decisions and conducting useful activities. it, therefore, reflects the well-being of the society and stakeholders’ expectations. büchner (2012) stated that csr could be described as management attitude that has sustainable business by supporting society-related activities. corporate sustainability, on the other hand, is a development in economic, social and ecological aspects, to meet the needs of present and future generations. it covers firm’s responsibility towards the community. for csr activities to work well, firms need to employ a sensesmaking perspective to decide what activities should be considered inside and outside the firms and to meet and manage different stakeholders’ s expectations (pater and lierop, 2006). cramer et al. (2006) stated that to adopt a sensemaking perspective of csr, firms need to set clear goals, focus on the public perception, set clear policy and procedures and institutionalize this journal is licensed under a creative commons attribution 4.0 international license al mubarak: five senses for effective and sustainable corporate social responsibility strategy international journal of economics and financial issues | vol 10 • issue 1 • 202068 csr concept in the caproate values and beliefs. the topic of csr is usually discussed and linked with other topics such as corporate governance, ethics, and performance, yet few researchers have focused on real deliverables of csr and its effectiveness to the different stakeholders within the society. “csr” is mentioned almost in all firms’ materials, websites and events. “csr” is used as a practice to protect environment, as a way of distinguishing business, and as a tool to promote the well-being of the society. among all of these views, csr, in practice, remains short of some senses as might be viewed by stakeholders. firms should engage in csr activities for many reasons including moral obligation where they balance their business with social practices, sustainability where such practices meet the need of current and future generations and improving corporate image. therefore, csr activities are important to strengthen firms’ reputation to stay in business and ultimately reap more profits. carroll (1991; 2016) and others discussed csr dimensions such as economic, legal, ethical, and philanthropic, but sustainability of these dimensions to firms remains a challenge. even if these are well laid in the corporate strategy the implementation mechanism is still not clear or not well controlled. for this reason, there is a need to activate csr dimensions and make them on the right track to seed what was planned for by employing what so called “five senses” of csr. this paper sheds light on the true csr senses as it tries to answer the question: how can csr strategy be effective and sustainable? these senses are much similar to human approaches of perception which are sight, hearing, taste, touch and smell. research to date has not sufficiently focused on this important area of collective senses that can improve firm’s contributions to the society and at the same time improve its performance. firms can only be effective and contributing well to the society, if they pass these basic but important criteria of senses. this paper contributes to the csr knowledge and practice by bridging the csr gap in strategy and practice for sustainable development. before embarking to the five csr senses, the following section presents general discussion on csr and sensemaking. 2. csr and sensemaking csr requires firms, in addition to making profits, to take care of environment and the wellbeing of people internally and externally. the issue of sensemaking of csr activities is very important. “csr” could have five sensemaking approaches. first, pragmatic sensemaking that focuses on clear goals to implement, second, external sensemaking that focuses on public perception by disseminating results for sustainability, third, procedural sensemaking, that focuses on a systematic way for csr implementation, fourth, policy-oriented sensemaking that focuses on putting csr sustainability aspects in firm’s policy, and fifth, values-driven sensemaking, that focuses on inclusion of csr in firm’s values and beliefs. change agents play a vital role in the process of csr sensemaking as they can stimulate people’s interest, organize csr activities well, and make effective communication with different stakeholders (cramer et al., 2006). csr improves firms’ competitive advantage, keeps business authorities engaged in corporate socially responsible practices, enhances organizational sense of community, and improves performance. “csr” was found to influence smes organizational commitment, and positively affects sustainability through organizational sense of community (d’aprile and talò, 2015). firms are agents that have relationships with different stakeholders, where such firms employ csr strategy that caters for and manages different groups’ interests. the emphasis on “csr” has increased by the community to protect itself against any environment disasters, or unfavorable practices by multinational corporations (estallo et al., 2007). firms responsibilities go beyond making profit to cover well-being of many stakeholders such as employees, customers, suppliers and people in the society. “csr” can to take the responsibility to create value to firms’ economic, social and environmental initiatives and to respond to stakeholders’ inquiries with full transparency (pater and lierop, 2006). different stakeholders can be managed by adopting two perspectives, an “inside–out” and an “outside–in,” where they can move on the continuum between these two perspectives. inside–out perspective works when a firm addresses issues such as its ambition and core competencies and then defines its social responsibilities. on the other hand, outside–in perspective of firm’s social responsibilities mainly views stakeholders’ claims. taking these two perspectives into account, and to be more effective, a firm can form a third perspective that considers the interests of various stakeholders and at the same time its internal characteristics by employing a collective sensemaking process. people make sense of their environment and share information with others to protect themselves against any unfavorable practices. sensemaking takes place when individuals and firms interact with others with the aim of sharing sense of reality. therefore, a sensemaking perspective has a broader and more balanced view of the firm’s social responsibilities and can be considered as a bridge between the “inside–out” and “outside–in” perspectives of csr (pater and lierop, 2006). “csr” is a form of corporate self-regulation where a firm considers the interests of different stakeholders and creates an impact on the environment, customers, employees, and community at large. firms, therefore, are expected to encourage community growth, and eliminate harmful practices. “csr” calls for the care of people and planet by the firm. hence, firms should keep the public interest in mind and not only focusing on generating profits as firms derive their profit from the society and not the other way around. for these reasons, youth in india asked firms to pay attention to public welfare, environmental protection, sustainable development and labor welfare (sharma and sharma, 2011). “csr” was found to have a significant impact on faculty job satisfaction, employee engagement, and organizational commitment in higher education institutions. “csr” is considered as a management strategy that improves workforce commitment, and efficiency (ahmad et al., 2017). it is important for the youth to understand csr concept and know its activities. taking it from a students’ perspective, they must be informed of the benefits of csr activities in order to make them interested to participate in such activities and go even beyond participating to planning and managing csr initiatives. al mubarak: five senses for effective and sustainable corporate social responsibility strategy international journal of economics and financial issues | vol 10 • issue 1 • 2020 69 if this value is well communicated to the younger generation, can undoubtedly have better impact on society in the long term (ahmad, 2012). benlemlih and bitar (2018) found a significant relationship between csr and investment efficiency, where csr dimensions such as employee relations, product characteristics and environment played a most important role in improving investment efficiency. high csr commitment helps increase investment efficiency for better financial performance. (das, 2009) focused on the importance of having a clear plan for csr activities by firms without neglecting making profits for all sizes of the businesses. devin and richards (2018) examined csr in the food supply chain and found that firms can be seen engaging in behaviors that are related to social responsibility, but in fact such firms plan to shift the problem of food waste somewhere else in the supply chain. the society expects firms to act responsibly when it comes to a food waste problem. managing such problem to meet current and future food security goals is important to cope with the increase in people who are food insecure, and global population growth. food donation is a favorable practice, but the problem still exists if the supply chain is not well managed as food retailers can move the problem elsewhere. therefore, the researchers called for a stronger government regulation that makes the supply chain system more socially responsible for sustainable development. if firms would like to use csr-related strategies as a source of competitive advantage, should first integrate csr strategies with their core business and production and second, work for better allocation and utilization of resources (hasan et al., 2018). hussain and attiq (2017) found that ethical leadership significantly influencing csr. on the other hand, csr was found to have a significant impact on trust and performance. therefore, csr activities reflect corporate culture, and if managed well, lead to better business efficiency and performance. jaworska (2018) discussed the climate change in the context of csr and environmental reporting in the oil industry and found that csr reporting simulated commitment to climate change. de jonge (2018) discussed the domestic violence issue and linked it to csr and warned of high business risk if firms ignore domestic violence in the workplace. domestic violence (or even family violence) exists when a partner abuses his/her power during or after the relationship is over. there has been a recognition for the need for the business to play a role as important social actors, rather than only economic actors. domestic violence is not a private issue anymore in the workplace. therefore, it is important, at work, for an employee to have full support if a domestic violence situation exists. businesses considering this issue are undoubtedly supporting the society and csr activities. small businesses show commitment to csr and integrate its activities with consistent value principles. they pay special attention to moral commitment to local community as part of social responsibility. moral responsibility of business owners undoubtedly influences their prime stakeholders such as customers and community, which can be further enhanced into a larger social and economic change over the long term (lange and fenwick, 2018). lee et al. (2018) studied the relationship between (csr)-related information and the value of stock recommendations developed by financial analysts and found that csr-related reports improve the information environment. furthermore, csr reporting that covers market prices is important as it contains rich information helpful for stakeholders. malik and kanwal (2018) studied the impact of csr disclosure on financial performance of listed pharmaceutical firms and found that the average rate of disclosure is increasing annually, which indicates that more information disclosure in firms’ annual reports is what the society expects. the willingness of firms to go beyond disclosing financial information to corporate social reporting makes such firms in the heart of the society. this responsiveness and proactiveness of firms are very important in the competitive world and make such firms to be different and unique as perceived by different stakeholders. firms that plan and operate ethically and socially, will undoubtedly develop loyal customers and happy society at large. on the other hand, developing country multinational enterprises were found to follow a code of conduct and csr initiatives more than their domestic counterparts. interestingly, country multinational enterprises from poorer countries which were characterized with lower governance guidelines found to be more committed to the society (preuss et al., 2016). the relationship between consumer perceptions of four csr aspects (economic, social, ecological and recycling) and buying behavior was examined by rodrigues and borges (2015) and found that recycling and environment mostly determined consumer buying decision. the purchase of the firm’s products and services is determined by customer knowledge of firm’s csr activities. therefore, csr strategy is used to improve firms’ image and brands that leads to attracting and retaining more customers. this is true when customers perceive and appreciate the value of social responsibilities practices. when customers are able to appreciate environmental aspects and put them as a priority of concern, firms can take this for their advantage by engaging in these aspects to positively influence the buying behavior. de roeck and maon (2018) stated that firms often engage in csr initiatives in an unfocused way without proper planning on how such initiatives affect different stakeholders’ perceptions and behaviors. this might hinder firm’s improvement in social and economic aspects. one of the solutions to make it better, firms to give high priority to their employees as they are the bridge between internal and external csr activities that positively influences economic and social performance. for this reason, firms around the globe should give a special attention to the best ways to develop and conduct csr activities that lead to improvements in economic and social value. in this modern era, customer has more information and access to information. the excessive information turned the business environment into an intense competition. business especially islamic banks are facing competition due to inevitable growth in islamic banking. it is essential for banks to retain customers and explore the tools to win customer loyalty (shabbir et al., 2018). firms are expected, in addition to making profits, to integrate al mubarak: five senses for effective and sustainable corporate social responsibility strategy international journal of economics and financial issues | vol 10 • issue 1 • 202070 society’s concerns into ongoing operations if they want to be good contributors in the society and at the same time create a good corporate reputation. “csr” was found to be an important driver of corporate reputation as csr affecting corporate reputation from the point of view of both important stakeholders and citizens. therefore, good corporate reputation comes from the integration of csr activities to strategies, programs and action plans, in a structural way that leads to better performance (vlastelica et al., 2018). firms use csr strategies to better interact with different stakeholders in the society with the aim of mutual understating and better environment. firms are called to integrate csr activities in their corporate vision, mission and practices, and make sure these are achieved (lindgreen et al., 2010). for csr activities to be effective (kemp, 2011) suggested that firms’ top management to be more aware of the importance of such activities when dealing with different stakeholders. firms, sometime, find resistance from the society if such firms do not fully consider the effect and voice of the society on their performance. therefore, firms should listen to the society and keep many issues into consideration. top management leadership is important in initiating corporate responsibility toward the society. this requires defining stakeholders’ key issues, developing and implementing policies and procedures, interacting with different stakeholders internally and externally, embedding firm’s values and commitment to corporate responsibility, and being transparent to build confidence. in this way, firms’ performance is determined, in addition to financial measure, based on social and environmental contributions. firms can be volatile if they neglect to meet their social responsibilities towards the expectations of staff, customers, society and environment. this negligence happens when firms focus only on shareholder value, devalue the importance of stakeholder dialogue, and regard csr as part of marketing or public relations only (büchner, 2012). “csr” has gained attention as a tool to enhance corporate image (shabbir et al., 2018). to have competitive edge, firms need to be seen as good employers from employees’ perspective, offer fair products from customers’ perspective, and be generous and environmentally sound from society’s perspective. therefore, firms’ decisions should be based on these stakeholders and not only shareholders (büchner, 2012). corporate social irresponsibility can exist with csr if managers’ decisions are described as immoral. corporate social irresponsibility can be overwhelming especially when it is related to the environment (popa and salanță, 2014). firms are said to work fairly well towards the society if they treat their employees well, respect consumers’ rights and interests, secure natural resources, ensure production processes are socially and ecologically sound, comply with labor standards, invest in education and training, promote cultural diversity, engage in fair competition, prevent corruption, and maintain transparency in corporate governance (büchner, 2012). “csr” is an instrument that brings competitive advantage to the firm in the short and long terms by interacting with the society. to make csr work well, an element of sustainability should be incorporated into firm’s strategies for better financial performance, better image and improved stakeholders’ relations (büchner, 2012). a study was conducted in the context of islamic banks and found that csr activities significantly increase customer loyalty and brand image. incorporating csr in business policy of islamic banks can enhance customer loyalty. this can be in two loyalty dimensions; attitudinal loyalty and behavioral loyalty. this shows the power of csr, if implemented correctly, on the loyalty of one of the main stakeholders, the customers (shabbir et al., 2018). stakeholders such as investors, customers, suppliers, employees, and community should drive the development of csr strategy. this will make the csr strategy more stakeholders’ oriented, and robust with a high success rate. for this reason, a stakeholder systems model was developed to include the identification of stakeholder groups, analysis of factors that influence board decisions, evaluation of stakeholder satisfaction, and assessments of csr. if firms adjust csr philosophy and practice according to different stakeholders’ feedback, they will definitely have better corporate social performance (mason and simmons, 2014). cruz and pedrozo (2009) studied challenges facing multinational companies when managing (csr) strategies. these challenges were represented by three main dimensions namely governance structure, corporate ethics and organizational learning. for governance structure, it was suggested that various departments of the firm to be involved in csr activities to produce better output, and to open an effective dialogue with stakeholders. with regards to corporate ethics, csr strategy to be developed with clearly defined csr objectives that integrate social and environmental issues in order to improve firm’s csr performance. organizational learning focuses on awareness-building and information exchange of csr initiatives internally and externally. awareness activities are encouraged to improve effectiveness of csr activities. büchner (2012) focused on the concept of corporate governance on reconciling the interests of all firm’s stakeholders to ensure transparency and good contributions to the society. 3. discussion from the above review, it has become clear how important csr and sensemaking approaches are to the society. this paper attempts to answer the following question: how can csr strategy be effective and sustainable? to tackle this question, we apply the five senses of csr, similar to the human senses which are sight, hearing, taste, touch and smell. being good by firms in these five senses criteria enable them to gently and effectively achieve csr strategy as these senses support the csr dimensions such as economic, legal, ethical, and philanthropic. the first sense is the “sight” or vision that makes the firm envision what society sees. to make this happens, csr should be envisioned and incorporated in the corporate strategy. stakeholders want a firm to envision its social responsibility toward the society, internally and externally. therefore, csr should be incorporated in the corporate strategy and be an integral part of it. all csr activities of the firm along with challenges that should be overcome to be mapped in the corporate strategy for the firm to contribute well in raising up the well-being of the society. al mubarak: five senses for effective and sustainable corporate social responsibility strategy international journal of economics and financial issues | vol 10 • issue 1 • 2020 71 the second sense is “hearing” or listening to what the society needs and wants. this requires having an effective channel of communication to hear stakeholders’ voice. different internal and external stakeholders want a firm to listen to their queries with regard to social responsibility activities. this is only possible when a firm establishes and maintains a good communication process to listen and respond to existing and potential enquires of the different stakeholders and work on meeting them. the third sense is “tasting” or testing where a firm develops a mechanism to detect consequences of its products offered. in other words, it tests the potential products and finds out their effect on the society. the ability to launch what the customers want brings competitive advantage to the firm. likewise, with different stakeholders, satisfying their needs and wants come from sensing and testing offerings that are acceptable to the stakeholders. the fourth sense is “touching” or feeling where the firm plans to touch the stakeholders’ true feelings by staying in touch with them. touching stakeholders’ desires requires firms to be close to them, balance what can be offered with what they want and working on achieving that. the fifth sense is “smelling” or detecting which shows the level of firm’s ability to detect what stakeholders’ like or dislike. the firm’s ability to detect harmful practices or stakeholders’ resentment and avoid them for better environment will matter to the society. ecological and environmental issues are the concern of the different stakeholders in the society and firms which take care of this dimension is better off in terms of acceptance by the society. if stakeholders in the society perceive that such a firm takes into consideration and honestly works on meeting these different senses, there is no reason not to deal, praise or accept its practices and offerings. therefore, passing these five csr senses can put a firm, be local or global, at a forefront as might be perceived by the society. these are illustrated in the conceptual model, figure 1. 4. conclusion and implications (csr) dimensions such as economic, legal, ethical, and philanthropic are very important for the firm and society. a sensemaking perspective of csr is crucial for firms to plan and implement csr activities internally and externally. it requires putting together all firm’s operational and strategic aspects including firm’s policy, procedures, goals and values in a way that leads to better competitive advantage. “csr” activities are more than pr practices if firms want to have a true and positive impact on the society. it also needs firm’s commitment to build good trust with the society. “csr” collective activities that are derived from caproate strategy and well implemented, will improve firm’s performance. for csr dimensions to work well and activities to be impactful, there is a need to incorporate the five senses to the csr strategy similar to the human senses concept. for this purpose, a conceptual model was developed that calls for the firm’s need to envision from the society perspective what social responsibility activities are to be conducted. hearing is the ability to listen to what society needs and wants so they can reach to mutual understanding and agreement. tasting is the ability to test firm’s offerings in a transparent way to avoid any damage or harm to the society. touching, is the ability for the firm to stay in touch with the society’s matters and concerns. smelling is the ability of the firm to detect what stakeholders’ likes and dislikes especially with the issues of ecology and environment. putting all these senses together will make the firm in a better shape in fulfilling the society’s needs and wants and ensuring the main csr dimensions of economic, legal, ethical, and philanthropic are in harmony with stakeholders’ expectations and requirements. such harmony between firm’s csr activities, when five csr senses are employed, with the society will lead to more acceptance by the society and also improve firm’s performance. these five csr senses have not been sufficiently considered in the research literature. this study contributes to the csr knowledge and practice in many venues by bridging the csr gap in strategy and practice for sustainable development. these senses, similar to human senses are working together, and if these are well functioned, will lead to better efficiency and effectiveness. by considering this concept, csr literature will be enhanced, and csr dimensions and approaches will be supported. in practice, firms which consider these five csr senses in their strategy and activities, are expected to achieve better performance by being the voice of society which ultimately leads to stakeholders’ satisfaction. this shows that csr is not only limited to one department, i.e., pr but goes beyond that to reflect the corporate philosophy in interacting and serving the community for better csr strategy sight/vision hear/listen taste/test touch/feel smell/detect performance figure 1: conceptual model al mubarak: five senses for effective and sustainable corporate social responsibility strategy international journal of economics and financial issues | vol 10 • issue 1 • 202072 today and tomorrow. only from these positive and favorable firm’s practices, supported by the five csr senses, sustainability can be achieved. references ahmad, j. 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(2018), how corporate social responsibility affects corporate reputation: evidence from an emerging market. journal of east european management studies, 23(1), 10-29. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(3), 149-157. international journal of economics and financial issues | vol 10 • issue 3 • 2020 149 analysis of the determinants of participation, strengths and weaknesses of vocational trainings of federally administered tribal area’s development authority sami ullah*, zilakat k. malik department of economics, university of peshawar, pakistan. *email: sami00212@yahoo.com received: 12 march 2020 accepted: 25 april 2020 doi: https://doi.org/10.32479/ijefi.9779 abstract modern economist emphasized human capital formation for socio-economic development. human capital theory considered education and training essential tools for human capital formation. this study was conducted to analyze what factors determines participation rate of youth in vocational trainings of federally administered tribal area’s development authority. study also focused strengths and weaknesses of the trainings delivered. data was collected on well-structured questioners from 400 respondents selected through disproportionate simple random sampling. the results revealed that age, marital status, father education, father profession, family size, family income and employment status before participation have significant effect on participation rate. short duration, poor linkages with industries, lack of tool kits, career counseling, internship facility and post training financial support were recorded potential issues that challenged the achievement of anticipated outcomes of the program. keywords: federally administered tribal areas, vocational training, human capital, technical and vocational education and training, determinants jel classifications: i21, j24 1. introduction modern economists emphasize a lot on investment in human capital consider as a pathway for socio-economic development of individuals and nations. due to its keen importance; human capital development remained a considerable subject in various well known conventions and international conferences (nafukho and bunyi, 2013). both technical education and vocational skills training are the key contributors to human capital development across the globe. human knowledge and skills is the engine for social and economic development of nations (goel, 2010). vocational skills training means the acquisition of practical skills related to different occupation i.e. engineering, construction, agriculture, carpentry, dress making, automobile and electronic etc. skills development has been the national development strategy for many countries. it increases the efficiency and productivity of workers, employability and self-employment. it makes the labor market entry convenient, make it easy for youth to attain employable skills and increase monthly earnings. it makes individual to earn them without looking to white collar jobs in government or in private sector. the reality of more than 95% employment of youth in germany and poland is due to its skilled worker. asian tigers i.e. thailand, malaysia, north korea, singapore and hong kong etc. saw the face of rapid development and industrialization due to its keen focus on human capital development. despite economic and labor market outcomes, development of vocational skills also breeds a lot of social benefits. labour market has become more specialized and demand high order technical and vocational skills. governments, national and international organizations are intensively investing in vocational and technical skills trainings (ullah et al., 2017). this journal is licensed under a creative commons attribution 4.0 international license international journal of economics and financial issues | vol 10 • issue 3 • 2020150 ullah and malik: analysis of the determinants of participation, strengths and weaknesses of vocational trainings of federally administered tribal area’s development authority the existing literature shows that participation of individuals in technical and vocational education and training (tvet) depends on individual personal characteristics, family background and quality parameters of the program. participation ratio in vocational training is less than participation in general education. participation ratio in tvet is higher for male than female (evertsson, 2004). according to ben-porath (2002), chances of participation of individuals in skills training decrease with increase in age. younger people participate more than their older counterpart. similarly probability of participation in vocational and technical trainings decrease when individual is married (pischke, 2001). probability of attainment of skills training is directly proportional to qualification of individuals. both are found complementary to each other. occupations also influence skills attainment decision of people. individual with occupation that requires higher skills are more likely to participate in skills training than others. similarly employees working in capital intensive industries participate more in skills trainings. the same effect is observed for full time workers (draca and green, 2004). efficient training delivery is required to achieve the core benefits and anticipated outputs of a vocational skills development program. according to hanushek (1995) and kremer (1995) quality of the skills training is important supply side factor expected to effect the demand. skill development depends on a number of factors including the inclusion of practical and theoretical components in appropriate proportion (wagner and tahir, 2005). in vocational training system, better equipment and learning material could enable the students to do better in their learning (makombe et al., 2016). vocational training system lacks internal and external efficiency because of shortage of training materials and equipments that further worsen employment rate and earning level of graduates (association of tanzania employers, 2011). strong collaboration of training institutes with relevant industries is strongly needed for upgrading the skills of graduates and other employees in line with technological advancements as well as the new ways of conducting business (khan et al., 2019). hujer et al. (2006) in a paper stated that the effect of vocational training on unemployment duration in eastern germany was significantly negative due to the hypothesis that the programmes offered were not compatible with market demand. according to brunello and rocco (2017) the wage and employment returns to vet are higher in countries where the relative supply of vet graduates was low with high demand. career counseling and guidance is the process of supporting vocational graduates to accept and develop an adequate picture of him and to make them aware of their role in practical world environment (ezeji, 2004). practical vocational guidance and career counseling programs are needed more than ever because of technological advancement in changing world (dokubo and dokubo, 2013). co-operation of the institute administration and program sponsoring agency play a positive role in successful delivery of technical and vocational skills training program. cooperation and persistence guidance from both side have significant impacts on outcome. furthermore demand for a certain trade and relevancy to local industries is very important. training the rural people open receive is inappropriate to the skills base needed for their local community and local industries (rosholm and skipper, 2009). fata is the home for 5,001,676 individuals and a sizeable pool of unemployed youth reside (pakistan bureau of statistics, 2017). an analysis report by national vocational technical training commission (navttc) in 2017 indicated drop out in tvet sector is 27% in fata which is much more than other parts of the country (navttc, 2017). the participation rate of youth in vocational skills training is far less than enrolment in general education. in order to improve the participation rate, it is important for policy makers and concerned organizations to understand the mechanism underlying participation decisions of youth. information on predictors of participation in vocational training enable policymakers to design and target appropriate strategies for policy-relevant subgroups. this paper addresses this knowledge gap by providing an overview of the determinants of participation in vocational skills training of fata youth. nevertheless, vocational skills training sponsored by fata-da have not yet achieved its anticipated targets. majority of fata youth do not foresee training as important. therefore, this study was conducted with the following two objectives; i. to analyze the determinants of participation in vocational trainings of fata-da. ii. to analyze the strengths and weaknesses of vocational trainings of fata-da. 2. literature review according to ben-porath (1967) age of the respondent is negatively related to skills training participation. agodini et al. (2004) in a study in us find out that participation rate of individual in vocational courses are positively related to their low academic performance. curtis (2008) showed in his study that students with low level literacy and numeracy abilities are more likely to participate in short term vocational certificates. on the other hand moenjak and worswick, (2003) conducted a study in thailand using probit model find out that academic performance has positive impact on enrolment in tvet for male only. blasco et al. (2013) confirmed in his study in france that aged individuals are more likely to participate in short term training and learning program. family income had a small but positive significant impact on decision of youth in attainment of tvet certificates/ diploma (behrman and knowles, 1999) (psacharapoulos, 1988). influence of parent’s education in tvet enrollment has not been focused as such however certain have showed a significant positive relationship among both (curtis, 2008; moenjak and worswick, 2003). fullarton (2002) concluded in australia that with increase in parents’ education, children are less likely to participate in secondary-level technical and vocational education. quality of the training being the supply side factor affects the demand for training participation (hanushek, 1995; kremer, 1995). according to the findings of (birdsall, 1985), (glewwe and jacoby, 2006), (tansel, 2002) a positive relationship exists between quality of training and enrolment. in labor market outcomes professional occupation growth rate is positively related to tvet enrolment (grubb, 1988). provision of equipments and instruments play a significant role in viability and sustainability of vocational training program. the adequacy of necessary equipments and material ensure the delivery of training adequate and provide easy way to the trainers ullah and malik: analysis of the determinants of participation, strengths and weaknesses of vocational trainings of federally administered tribal area’s development authority international journal of economics and financial issues | vol 10 • issue 3 • 2020 151 in explaining facts (khan et al., 2019). vocational skills training may be seriously hampered due to the lack of sufficient resources (hadda and sergio, 1990). vocational skills training accommodate a small fraction of school leavers and very few skills needed in rural areas are taught (owano, 2010). internship is the efficient way of technical skills delivery. it is estimated that 40% of skills are acquired through field internship program worldwide (world bank, 1994). parents’ involvement has a strong influence on enrolment and learning process of children. parents support and encouragement increase children confidence and expansion of positive attitude towards attainment of education and technical skills (moss and bloom, 2006). well established practical laboratories, workshops and proper space are needed in technical skills development training to maximize its output and outcome (greaney and kellaghan, 2005). individual’s characteristics like age, sex, education, parent’s education, parent’s occupation etc. also affect skills attainment (achieng, 2012) mature students adjust easily to the requirement of learning designed for younger people. elder individual join the institutes again after a long time for the acquisition of working skills (richardson and van den berg, 2005). indiscipline and lack of punctuality worstly affect the skills acquisition and results in poor performance of individuals (mukwa and too, 2002). indiscipline of the trainees had been the major cause of mass failure of skills development training and adult learning program (njoroge and nyabuto, 2014). he observed that in kenya 50% of the individual are not properly graduated in vocational training due to indiscipline. (njati, 2011) suggested that infrastructure facilities should be provided to youth polytechnic for efficient performance. (lawrence, 1975) argues that teaching methodology has significant impact on learner’s acquisition of skills and knowledge. subject matter, instructional material and objectives are the factors influence teaching methodology. volk et al. (2003) suggested the government of japan after observing the crucial importance of youth skills development in bringing economic prosperity that the concerned should focus to equip the institutes through sufficient training resources, ensuring attractive packages and engage in widespread campaign. aryeetey et al. (2011) studied that in ghana due to minimum allocation of funding, general negative perception of people and less trained instructors the vocational trainings had not been very successful. 3. federally administered tribal areas (fata) 3.1. demographic profile of fata fata is the home for 5,001,676 individuals (2.4% of pakistan population) living in 558,379 number of households (1.73% of household in pakistan) (pakistan bureau of statistics, 2017). in fata, 4,859,778 individual (97.1%) reside in rural areas and 141,898 individuals (2.9%) resides in urban areas. population growth rate was recorded as 2.41 % where it was little bit high in urban areas than rural area in fata. among them 2,556,292 (51.1%) are male, 2,445,357 (48.7%) are female and 27 (0.0005%) are transgender (pakistan bureau of statistics, 2017). detail of agency wise population is presented in the table 1 below as per 2017 population census (pakistan bureau of statistics, 2017). 3.2. technical vocational education and trainings (tvet) in fata fata is blessed with huge human resource in the form of youth but due to flaws in the quality and quantity of technical and vocational education and training; this resource pool is not so much productive. the situation of tvet is also not good all over the country but it is worse in terms of fata. an analysis report on tvet sector in pakistan by national vocational technical training commission (navttc) in 2017 indicated that drop out in tvet sector is 27% in fata which is much more than other parts of the country. as a whole, 09 technical 52 vocational institutes are imparting technical and vocational trainings to fata youth which is 2% of the total institutions in pakistan. among them 50% vocational and 80% technical are public sector institutes. in all public sector vocational institutes in fata, there is a capacity of 7248 instructors to be employed but only 341 instructors are presently imparting vocational trainings to fata’s youth. according to the survey “english speaking course” is the most popular course which is about 21% of the supply of vocational courses followed by tailoring which is 14% of the total supply (95-100% in the case of female). computer and it courses have 13% total supply in tvet sector in fata. the annual share of skilled workforce from fata is <1% in overall while its share in country population is 2.2%. intervention is needed in order to increase the share of fata in skilled workforce at least up to 2% (navttc, 2017). table 1: agency/fr wise population and households in fata (2017 population census) s. no. agency/fr area (sq. km) population households 1 fata (overall) 27,220 5,001,676 558,379 2 bajaur agency 1290 1,093,684 120,457 2 mohmand agency 2296 466,984 48,118 3 khyber agency 2576 986,973 111,558 4 kurram agency 3380 619,553 67,244 5 orakzai agency 1538 254,356 31,253 6 north waziristan agency 4707 543,254 59,003 7 south waziristan agency 6620 679,185 80,717 8 fr peshawar 261 64,691 7,065 9 fr kohat 446 118,578 14,339 10 fr bannu 877 43,114 4,188 11 fr lakki marwat 132 26,359 3,348 12 fr tank 3229 36,389 4,165 13 fr d.i. khan 2008 68,556 6,924 international journal of economics and financial issues | vol 10 • issue 3 • 2020152 ullah and malik: analysis of the determinants of participation, strengths and weaknesses of vocational trainings of federally administered tribal area’s development authority 3.3. technical and vocational training institutes table 2 below shows a list of institutes in which fata’s youth were imparted vocational trainings by fata development authority peshawar (fata-da annual report, 2017). 3.4. list of trades fata development authority (fata-da) imparted vocational trainings in more than 70 different market oriented trades to fata’s youth. detail of such trades is listed in the table 3 below (fata-da annual report, 2017). 4. research methodology 4.1. study area and target population fata was selected as a study area because of the reason that fata is the most marginalized community of the country. furthermore, fata da has imparted vocational training to more than 50 thousands youth of the area. 740,552 youth including 23,296 who participated in any vocational training of fata da was selected as target population. 4.2. sample size and sampling technique a sample size of 400 male in the age of 15-34 years was selected from total population. 200 male were selected from treatment group and 200 from control group. the sampling method applied was disproportionate random sampling procedure where samples were taken from uneven group of people. the following slovin’s formula was used while taking sample. sample size (ss) = n/1+(a)2 n= target population from which sample was drawn a = margin of error at 95% confidence level i.e. 100%-95% = 5%. 4.3. data collection and data analysis well-structured questioners were designed and self-administered for data collection from the respondents. data was collected in a total period of 4 months. at certain places indirect mode of data collection was also applied where it was not possible through direct interaction. data was sorted and analyzed in spss (statistical software for social sciences). binary logistic regression analysis was conducted to analyze the determinants of participation in vocational trainings of fata-da. binary logistic regression is normally used to avoid the shortcoming arise during linear regression analysis like probability of occurrence of an event may fall outside (0/1) interval. the model used was; 4.4. model specification pi= β0+β1age+ β2mst+β3fsz+β4fr+β5edu+β6fed+β7fp+β8fi +β9hh+β10sbt+...+ε (1) where, pi represent probability of participation, β0 = intercept term, age = respondent age, mst. = marital status, fsz = family size, fr = family residence, edu= respondent education, fe = father education, fp = father profession, fi = family income, hh= household head, sbt = employment status before participation in training, ɛ = error term. likert scale was used to analyze the strengths and weaknesses of vocational trainings of fata-da. in this case data was collected only from 200 respondents from treatment group (those who participated in vocational trainings. 5. results and discussion 5.1. determinants of participation the output of binary logistic regression analysis in the table 4 below shows that variable; age of the respondents, family size, father education, father profession, family income, employment status before training and marital status of the respondents have overall significant relationship with dependent variable i.e. probability of participation. certain other important variables like respondent education, family residence, and household head were found to have insignificant relation (p > 0.05) and were found individually not good predictor. it is evident from the results that increase in age of the respondents increase probability of participation in vocational training. the odd ratio age (3) shows that individuals fall in age group “26-30 years” are 1.164 times more likely to participate in vocational training of fata-da than other age groups. these findings are in line with the study of blasco et al. (2013) in france that individual with more education and age likely to participate more in short term employment training program. family size as a whole was observed to have significant positive relationship with dependent variable “p.” the probability of participation in vocational training increases with increase in family size. the higher impact was observed in case “fsiz (3),” and “fsiz (2).” the respondents belonging to families having more than 12 members and families having 9-12 members are 6.19 and 3.16 times respectively more likely to participate in the said program as compared to small size families. in large size families, due to availability of maximum number of young male, it is convenient for at least one young member to spare table 2: list of institutes construction technology training institute (ctti), islamabad pak emirates polytechnic trade, training and test centre, rawalpindi khyber institute of technical education (kite), peshawar national institute of sciences and technical education, islamabad waziristan institute of technical education (wite), swa national institute of cultural studies, islamabad agricultural light engineering program (alep), mardan wana institute of technical training, wana gems and gemological institute of pakistan (ggip), peshawar precision system training centre, pcsir peshawar swedish group of technical institute, wah cantt govt. technical and vocational center, peshawar dimension stone center, pcsir laboratory, peshawar pak german wood working center, peshawar govt. advance technical training institute, peshawar pakistan readymade garment training institute, lahore fan development institute, gujrat leather goods services center, bannu automotive training center, small industrial estate, peshawar national logistic cell, mandra pakistan knitwear training institute, lahore ensign communiqué, karachi ullah and malik: analysis of the determinants of participation, strengths and weaknesses of vocational trainings of federally administered tribal area’s development authority international journal of economics and financial issues | vol 10 • issue 3 • 2020 153 time and to avail the opportunity of participation in vocational training. father education was also found to have positive significant relationship (p < 0.05) with dependent variable “p.” the greater impact was observed in case “fedu (1),” where it is indicated that respondents who’s fathers were illiterate are 6.208 times more likely to participate as compared to others. high educated parents prefer general education on vocational for their children. father profession was also observed to have positive significant relationship with dependent variable “p.” the result shows that individuals whose fathers were in government service participated more than others. the odd ratio interprets that they are 3.19 times more likely to participate in vocational training. it is logical that parents in service know the benefits of training hence motivate their children too. family income also has positive significant relationship with dependent variable “p.” odd ratios of family income categories “fi (3) and fi (4)” indicated that individual belonging to families having monthly income 16,000-20,000 and more than 20,000 are 5.75 and 5.22 times respectively more likely to participate in the said program of fata-da. probability of participation increases with increase in family income. these findings are in line with most of other studies that were looking at the relationship between family incomes, educational quests and labor market outcomes. all of them observed family income have positive, although small, effect on enrollment decisions of individuals in labour market training programs (behrman and rosenzweig, 2005; behrman and knowles, 1999; psacharapoulos, 1997). the influence of marital status of the respondents on dependent variable was also investigated. the result indicated that unmarried individuals were 2.39 times more likely to participate than married individuals. married individual might be due to their heavy engagement in family matters and responsibilities would have less chance to spare time for participation in trainings. employment status before training also determines the decision of individual for his/her participation into labour markets program. the output indicated that employment status has positive significant relationship with dependent variable “p.” the odd ratio of variable sbt (1) in table 4 below shows that individuals who were unemployed before participation are 2.92 times more likely to participate in vocational training. it’s very understandable that unemployed individuals have more time to participate. unemployed individual readily participate in the sense they will acquired vocational skills and may get paid or self-employment. negelkerke r square (nrs) test value (0.372) indicates 37% of the variance in outcome or dependent variable predicted by predictors in the model. the nrs value (0.37) is logical considering the recommendation of minimum value of 0.15 (mitchell et al., 1989). in social science where human behavior is studied, this value typically lower than 0.2 i.e. 20% (becker and tomes, 1986). overall the model is significant, good enough fit to data and a good predictor. table 3: list of trades auto electrician auto mechanics basic electrician building painter carpet weaving office automation and management computer (hardware) cutting, carving, polishing of precious and semi-precious stones domestic electrician dress making and tailoring techniques electrician fabric and garments productions gemology and carving gemology and faceting general electrician heavy machinery operator industrial electrician laboratory assistant land surveying (with auto cad) marble and granite mining, cutting, polishing light engineering leather goods masonry material testing computer networking technician telecom technician control room operator advanced auto mechanic (efi/ cng) construction safety acuduct insulator tile mason plaster mason block mason fall ceiling scarf folder football stitching leather upper cutting stitching mobile phone repairing plumbing quantity surveyor refrigeration/air-conditioning repairing sheet metal works steel fixer surveyor civil turner machinist tv/ radio repairing wood technology x-ray machine operator call centre operator stitching machine operator training fan development and parts manufacturing conventional machinery operator course electrical equipment and electric fan testing course fan assembly course auto cad 2d, 3d cad/cam course computerized numerical control (cnc) mechanic-ii (engine) mechanic-ii (chasis) optical fiber cable jointing motor winding stitching machine operator training fan development and parts manufacturing conventional machinery operator course electrical equipment and electric fan testing course fan assembly course auto cad 2d, 3d cad/cam course machinery course mechanic-ii (engine) mechanic-ii (chasis) optical fiber cable jointing lasting computerized numerical control table 4: determinants of participation in vocational trainings of fata-da variable b s.e. wald sig. exp(b) age ----8.014 0.046 --age(3) 0.152 0.915 0.027 0.868 1.164 fsz ----25.596 0.000 --fsz(2) 1.150 0.485 5.616 0.018 3.158** fsz(3) 1.823 0.530 11.823 0.001 6.188* fed ----25.182 0.000 --fed(1) 1.826 0.687 7.069 0.008 6.208* fed(3) 1.292 0.703 3.376 0.066 3.639*** fpr ----7.017 0.071 --fpr(3) 1.160 0.657 3.119 0.077 3.190*** fi ----16.960 0.002 --fi(3) 1.750 0.683 6.569 0.010 5.755** fi(4) 1.654 0.662 6.251 0.012 5.228** sbt(1) 1.072 0.274 15.293 0.000 2.920* mst(1) 0.871 0.345 6.367 0.012 2.390 constant −4.652 1.446 10.346 0.001 0.010* model −2 log likelihood cox and snell r square negelkerke r square summary 423.825 0.279 0.372 *significant at 1% level, **significant at 5% level, ***significant at 10% level international journal of economics and financial issues | vol 10 • issue 3 • 2020154 ullah and malik: analysis of the determinants of participation, strengths and weaknesses of vocational trainings of federally administered tribal area’s development authority 5.2. strengths and weaknesses of vocational trainings of fata-da strengths and weaknesses of any vocational training program surely lead to either success or failure of the program. 76% training graduates were still looking for relevant jobs ((ullah and malik, 2019). data was collected from respondents on the below mentioned quality parameters using likert scale and result recorded in %. 5.2.1. the training was good and fruitful the quality of education and training is considered an important supply-side factor effecting the demand for education and training (hanushek, 1995; kremer, 1995). quality skills training ends in efficient output leads to better outcome (employability and increased earning) and long lasting impacts (socio-economic development). the respondents were asked about goodness of training and was observed that 57.5% were found agree and 19% strongly agree with the statement. only 17% of them was found either disagree or strongly disagree. 5.2.2. balance between theory and practical portion nübler et al. (2009) concurred that courses and standards offered in the tvet are considered to be insufficient, lacking quality learning materials and tools. wagner and tahir (2005) pointed out that skills training needs practical as well as theoretical components in appropriate proportion so individuals must demonstrate that they are able to perform all of the key functions in the business. the respondents were inquired for the same reason and recorded that balance between theory and practical portion was appropriate. 58% of the respondents were found agree and 12% strongly agree with the statement. only 17.5% were found disagree and strongly disagree. 5.2.3. instructors were well educated, trained and sincere institute standard, course curriculum and instructors expertise are equally important for efficient training delivery. trainers background knowledge of the course, technical skills, dedication and sincerity play a key role in vocational learning’s (oyebade et al., 2012). the respondents were asked the subject question and found that 56% of the respondents were agree and 18.5% strongly agree with the statement. 15% of the respondents were found either disagree or strongly disagree. 5.2.4. availability of well-equipped laboratories in vocational trainings, laboratories setup and equipments availability play an essential role. vocational training system lacks internal and external efficiency because of shortage of training materials and equipments that results in low employment rate and earning level of graduates [association of tanzania employers (ate), 2011]. makombe et al. (2016) in their study argued that with better equipment and learning materials, we could enable the students to do better in their learning. respondents were asked the same question and the result revealed 53% of the respondents were found agree and 15.5% strongly agree with the statement. 13.5% were found disagree and 8% strongly disagree with the statement. 5.2.5. training linkages with relevant industries a strong linkage of training with industries guarantees the success of vocational training program in term of gainful employment. the same is in practice in germany and in poland and they reached 95-100% youth employment. during survey, 36% of the respondents were found either agree or strongly agree with the statement that their training were linked with relevant industries while 48.5% of them were found either disagree or strongly disagree with the statement. according to researcher own observations, there is no such proper linkage of the vocational training program of fata-da with relevant industries. unesco (2011) and world bank (2012), argue that there is a general need to enhance collaboration with industry in the provision of in‐house training at work places with a view to upgrading the skills of graduates and other employees in line with technological advancements and new ways of conducting business. 5.2.6. market demand for the concerned trade/technology hujer et al. (2006) in a paper stated that the effect of vocational training on unemployment duration in eastern germany was significantly negative due to the hypothesis that the program offered were not compatible with market demand. according to brunello and rocco, (2017) the wage and employment returns to vet are higher in countries where the relative supply of vet graduates was low with high demand. the result revealed that 58.5% of the respondents were found either agree or strongly agree with the statement that their training were compatible with market demand. 30.5% of them were found either disagree or strongly disagree and 11% neutral. 5.2.7. career counseling and guidance career counseling and guidance is the process of supporting vocational graduates to accept and develop an adequate picture of them and to make them aware of their role in practical world environment (ezeji, 2001). vocational guidance and career counseling programs are needed more than ever because of technological advancement in changing world (dokubo and dokubo, 2013). students due to less understanding of job markets remain jobless after successful completion of vocational training courses. the result of the survey conducted so far revealed that 43.5% of the respondents were found either agree or strongly agree while 46% were found disagree or strongly disagree about the statement. the remaining 10.5% were neutral to the statement. 5.2.8. co-operation of institute administration and sponsoring agency co-operation of institute administration and program sponsoring agency play a significant role in successful delivery of training program. strong co-ordination and follow-up may identify issues timely during training. again it exposes the real face of progress towards goal and targets. the respondents were asked for the same reason and recorded that 50% of the trainees were found agree and 14.5% were found strongly agree with the statement. only 24% of them were found either disagree or strongly disagree. the remaining 11.5% were found neutral. 5.2.9. training duration according to rosholm and skipper (2009) often the training the rural people receive is inappropriate to the skills base needed for their local community and often short term, not geared to providing trainees with lifelong sustainable living and working skills. 90% ullah and malik: analysis of the determinants of participation, strengths and weaknesses of vocational trainings of federally administered tribal area’s development authority international journal of economics and financial issues | vol 10 • issue 3 • 2020 155 courses in which fata youth were imparted training were of short duration of 6 months. the respondents from treatment group were investigated whether the training duration was enough for efficient learning. the result revealed that 40% of the respondents were found agree and 11.5% strongly agree. 37.5% of the respondents were found disagree and 6.5% strongly disagree with the statement. 4.5% of the respondents remained neutral to the statement. 5.2.10. tool kits provision tool kits provision at the end of training give support to the poor graduates and enhance their chances of self-employment. most of the successful training graduates heal to poor families and are unable to start self-employment due to lack of essential tools and equipments. the respondents were asked whether they had provided tool kits after course completion by fata-da. the result showed a major chunk of the respondents (79%) were found either disagrees or strongly disagree with the statement. only 17% of the respondents were found agree and strongly agree. 5.2.11. provision of course completion certificates being a signal of one’s skills and abilities, course completion certificate in hand enhance the probability of finding a job. delay in provision of course completion certificates obviously delays paid employment. on respondents investigation it was recorded course completion certificates were provided on time. 63% of the respondents were found agree and 23.5% strongly agree with the statement. only a small segment (11%) of the respondents were found either disagree or strongly disagree with the statement. 5.2.12. financial support for self-employment self-employment generation among youth is considered the major outcome of vocational trainings. self-employed individual become employer of others and the process of development continue. most of the training graduates in fata failed to established entrepreneurships due to lack of financial resources. the respondents were asked if they were supported financially for self-employment after completion of training. the results revealed that respondents have not been supported financially for self-employment by any agency. maximum numbers of respondent (84.5%) were found either disagrees or strongly disagree with the statement of provision of financial support. 5.2.13. provision of internship facility provision of field internship of 6-12 months duration after completion of institute based training facilitates the first entry of youth into job market. competent graduates perform well when given internship or field sessions and they become innovative and entrepreneurs. the respondents were asked if they were offered any field internship facility after course completion. it was recorded that field internship facility was not provided as such. 81.5% of the respondents were found either disagree or strongly disagree with the statement while 19.5% were found agree and strongly agree. 6. conclusion the study concluded that age of the respondents (age), family size (fsiz), father education (fedu), family income (fi), marital status (mst.), and employment status before training (sbt) have significant relationship (p < 0.05) with dependent variable “p.” the odd ratio (exp (b)) for these variables shows that an individual fall in age group “26-30” years is 1.164 times more likely to participate in vocational training than individuals from other age groups. similarly a person belonging to families having family size 6-8 and 9-12 are 3.18 and 6.19 times respectively more likely to participate than others. the odd ratio for father profession indicates that individuals whose fathers were government servant are 3.2 times more likely to participate than others. individuals belonging to families having monthly income 16,000-20,000 and above 20,000 are 5.75 and 5.22 times respectively more likely to participate than individuals whose families’ income fall in less income categories. those individuals who were unmarried and who were not employed before participation were 2.4 and 2.4 times respectively more likely to participate in vocational skills training of fata-da as compared to married and employed individuals. during analysis of weaknesses and strengths, it was concluded that 77% respondents were found agree and strongly agree that training delivered to them was good and fruitful. 70% respondents were found agree and strongly agree that balance between theory and practical portion was kept appropriate. 75% of the respondents were found agree and strongly agree that their instructors were well educated, trained and sincere in imparting technical skills to them. 69% of the respondents were found agree and strongly agree that well equipped labs were available inside the institutes for practical portion of the training. 37% of the respondents were found agree and strongly agree that the training was linked to the relevant industry while 48% were found disagree and strongly disagree with the statement. 59% of the respondents were found agree and strongly about the trade in which they were offered training was having high market demand while 30% respondents were found disagree and strongly disagree. 44% of the respondents were found agree and strongly agree that they were given career counseling and professional guidance before, after or during the training while 45% were found either disagree or strongly disagree with the statement. 65% respondents were found agree and strongly agree with the statement that institutes administration and fata-da official were found cooperative during the course of study while 24% were found either disagree or strongly disagree. 52% of the respondents were found either agree or strongly agree that training duration of 6 months was enough for fruitful training delivery while 43% were found either disagree or strongly disagree. 79% of the respondents were found either disagree or strongly disagree that they were provided tool kits after course completion while only 17% were found either agree or strongly agree. 87% of the respondents were found agree and strongly agree that they were provided course completion certificates on time. only 10% were found either disagree or strongly disagree with the statement. 84% of the respondents were found either disagree or strongly disagree that they were financially supported after training for starting self-employment. only 12% were found either agree or strongly agree while 4% remained neutral. in case of provision of internship facility after ibt, 84% respondents were found disagree and strongly disagree while 12% either agree or strongly agree. the study suggested that fata-da may increase the participation rate of fata’s youth in the said training program by increasing the international journal of economics and financial issues | vol 10 • issue 3 • 2020156 ullah and malik: analysis of the determinants of participation, strengths and weaknesses of vocational trainings of federally administered tribal area’s development authority efficiency of the training program. incentives, pre and post training counseling and guidance sessions, financial support and provision of internship facilities would increase the efficiency of the training. references achieng, r.n. 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(1994), msettp transition from school to work; issues and policies. washington, dc: iiep. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(6), 18-24. international journal of economics and financial issues | vol 10 • issue 6 • 202018 does corporate governance affect the critical corporate policies such as dividend policy? dan lin1, lu lin2* 1department of banking and finance, takming university of science and technology, neihu, taipei, taiwan, 2department of public finance and taxation, takming university of science and technology, neihu, taipei, taiwan. *email: suzannelin@takming.edu.tw received: 31 july 2020 accepted: 15 october 2020 doi: https://doi.org/10.32479/ijefi.10546 abstract this study examines the influence of corporate governance on dividend policy based on a sample of canadian firms listed on the s&p/tsx composite index during 2009-2012. the results show that firms with better governance quality, measured by the governance index provided by the globe and mail, have larger payouts and have a higher propensity to pay dividends. in terms of four dimensions of corporate governance index, the shareholding and compensation index is the most important determinant of dividend payouts. our results support the complementary role of corporate governance and dividend policy of the firms. the implication from this study is that managers and board of directors should make dividend payout decisions in a big picture of corporate governance. keywords: dividend policy, corporate governance, agency problem jel classifications: g30, g34, g35 1. introduction dividend policy is one of the most important financing decisions in the company. it is about the decision to divide a company’s net earnings into dividends, which are to be distributed to shareholders, or retained earnings that may be used for investments in the future. the choice or the balance between these two options may reflect the liquidity status of the firm, its profitability level, future growth or investment opportunities, the preference of the investors, and even the corporate governance quality of the firm. the general framework of the agency theory suggests a link between governance quality and dividend payouts. as good corporate governance can mitigate the conflicts of interest between shareholders and managers, corporate governance must play a critical role in the dividend distribution decision (adjaoud and ben-amar, 2010). dividend payout is one way of returning cash directly to shareholders and act as a way of removing company’s cash from its coffers, where the cash may not be used in the best interest of shareholders. according to jensen’s (1986) agency costs of free cash flow hypothesis, when managers have excess cash after funding all positive npv projects, they have the incentives to waste the free cash flow on unprofitable investments. therefore, it is important to understand how corporate governance influence one of the most important corporate decisions; that is, the dividend policy. two theories propose a relationship between dividend policy and corporate governance. the first theory (i.e., the outcome model) argues that better corporate governance quality is associated with higher dividend payouts. the reason is that distributing available cash to shareholders can reduce the conflict of interests between managers and shareholders and thereby lower the agency costs. the second theory (i.e., the substitute model) proposes an inverse relationship between corporate governance quality and dividend payouts. the substitute model proposes that in firms with low governance quality, managers have greater opportunities to exploit this journal is licensed under a creative commons attribution 4.0 international license lin and lin: does corporate governance affect the critical corporate policies such as dividend policy? international journal of economics and financial issues | vol 10 • issue 6 • 2020 19 company resources in inefficient investments or to distribute them to shareholders. conversely, the substitute model suggests that when governance quality is high, managers are more likely to invest the cash flow in efficient projects and therefore, reduce the opportunity to distribute them to shareholders. the aim of this study is to analyze the implications of corporate governance for corporate payout decisions. this study will enrich the agency theory literature on dividend policy and contribute to the ongoing debate by providing additional evidence on the effect of corporate governance quality on a value-relevant firm decision; that is, the dividend policy. based on a sample of canadian firms listed on the s&p/tsx composite index between 2009 and 2012, this study obtains the following main findings. the results from panel data analyses show a positive relationship between governance quality and dividend payouts; that is, firms with higher governance quality have higher dividend payouts. also, among four dimensions of corporate governance index, including board composition index, shareholding and compensation index, shareholder rights index, and disclosure index, the shareholding and compensation index is a critical determinant of dividend policy. the additional test using the logit regression shows that firms with better governance quality are more likely to pay dividends. in sum, this study finds that better governance will contribute to protecting shareholders’ interests and therefore, is associated with larger dividends and a higher propensity of dividend payouts. this paper proceeds with the literature review and hypotheses development in section 2. section 3 presents the data sources and sample selection, defines variables, and specifies the model and data analysis techniques. the analysis and results are provided in section 4. section 5 conducts an additional test on the relationship between corporate governance quality and dividend policy. section 6 contains the conclusion and suggestions for future research. 2. literature review and hypothesis development the agency theory suggests that the corporate governance quality affects dividend policies. the outcome model predicts a positive relationship and suggests that firms with better governance quality are associated with higher dividend payouts because shareholders are in a better position to force managers to disgorge cash. in contrast, the substitute model predicts a negative relationship and suggests that firms with better governance quality are associated with lower dividend payouts because the existing good governance mechanisms in place reduce the role of dividends in controlling agency costs. previous studies have found evidence on the link between corporate governance and dividend policy. while mixed relations have been reported, most of the prior research findings support a positive relationship. for example, a recent study by tahir et al. (2020) examines the impact of different board attributes on dividend payout policy of malaysian non-financial firms during the period 2005-2018. the authors report that while the proportion of board independence, board tenure, board size and ceo duality have positive (but statistically mixed) relations with dividend payouts, board diversity and board member age have negative relations with dividend payouts. another study by rodrigues et al. (2020) who examine listed firms in continental european countries reports significant difference in board diversity and board tenure between dividend-paying and non-dividend-paying firms. the authors also adopt a tobit model and find the board size, board diversity, tenure, number of board meetings, network of board members, and remuneration of the ceo are important determinants of dividends. moreover, iqbal et al. (2020) investigate whether product market competition can lower the conflicts between majority and minority shareholders (that is, the principle-principle agency conflicts) and affect corporate dividend policy based on a sample of chinese-listed manufacturing firms during the period 20032016. the authors find that the industry-level competition has a significant impact on corporate dividend policy. specifically, intense competition can mitigate the principle-principle agency problems and is associated with larger dividend payouts and higher likelihood dividend payouts. furthermore, ganguli et al. (2020) examine the relationship between corporate governance and dividend policy from the perspective of minority shareholders rights based on a sample of ftse st companies of singapore. the authors find that in a civil law country with strong investor protection and good corporate governance code, minority shareholders can force firm managers to disgorge cash through dividends, which in turn lead to higher equity values of firms. their findings support the outcome model. the study by rohov et al. (2020) applies the interactive tree classification techniques to examine factors affecting the dividend policy of non-financial joint-stock companies in ukraine. rohov et al. (2020) find that ownership is the most important factor in dividend decisions. companies with controlling interests by individuals and institutional investors have a higher propensity to pay dividends. the results also provide support for the clientele theory that dividend decisions are strongly influenced by the clientele effect. dewasiri et al. (2019) study the determinants of dividend policy in an emerging market, sri lanka, during 2010-2016 and find that past year dividends, earnings, investment opportunities, profitability, free cash flow, corporate governance, state ownership, firm size, and industry influence are significant in explaining the likelihood of dividend payout. also, past dividends, investment opportunities, profitability and dividend premium are key determinants of dividend payouts. rajput and jhunjhunwala (2019) investigate the impact of ownership structure and corporate governance on dividend policy for 1,546 indian firms over the period 2006-2017. the authors find that corporate governance has a significantly positive effect on dividend payout decisions. however, family ownership has a negative effect on dividend payout decisions, suggesting that family-controlled firms tend to pay lower dividends. when considering the interaction effect of board independence and family ownership, the study finds that family-controlled firms with independent boards are likely to pay more dividends. lin and lin: does corporate governance affect the critical corporate policies such as dividend policy? international journal of economics and financial issues | vol 10 • issue 6 • 202020 awwad and hamdan (2018) use energy sectors in the gulf financial markets over a 10-year period between 2008 and 2017 and investigate the relationship between corporate governance (measured by managerial ownership, board size, independence of board of directors, and separation of the duties of board chairman and ceo) and dividend policy. the authors report a positive correlation between governance quality (in particular, the managerial ownership and separation of the duties of board chairman and ceo) and dividend payouts. chang et al. (2018) analyze a large sample of firms from 30 countries. however, they report mixed findings on the relationship between corporate governance and dividend payout policy. the authors find that after controlling for country-level governance, firms with better firm-level governance make more dividend payouts. however, this positive relationship between firm-level governance and dividend payout is pronounced only in countries with low shareholder rights. in countries with high shareholder rights, this positive relationship is not observed. there are studies that adopt governance indices rather than individual governance attributes when examining the relationship between corporate governance and dividend policy. for example, pahi and yadav (2019) examine how corporate governance affects dividend policy using six newly constructed governance indices, including board corporate governance index, board structure index, audit committee index, compensation index, nomination index and governance disclosure index, for listed indian companies between 2007 and 2017. pahi and yadav (2019) report a positive relationship between corporate governance and dividend payouts. firms are more likely to pay dividends as their internal corporate governance systems improve. when examining the corporate governance indices individually, pahi and yadav (2019) find that while these three indices, including board structure index, audit committee index and disclosure index, are significantly positively associated with the dividend policy, the other two indices, including compensation committee index and nomination committee index, have no significant relationship with dividend policy. the authors also test the interaction effects between corporate governance, growth opportunities and cash holdings on dividend payouts. they find that better-governed firms with more growth opportunities pay lower dividends while better-governed firms with more cash holdings pay more dividends. shamsabadi et al. (2016) also test the effect of corporate governance on dividend payouts using corporate governance indices. the authors examine a sample australian firms using three governance indices, including a self-constructed governance index, the corporate governance rating published in the whk horwath/university of newcastle corporate governance reports, and the index developed by aggarwal et al. (2011). based on tobit analyses, shamsabadi et al. (2016) report positive effects of governance on dividend payouts. moreover, jiraporn et al. (2011) use governance data from institutional services (iss-score) and show that the governance quality of firms has a significant impact on critical corporate decisions such as dividend policy. specifically, the better the governance quality of firms, the more likely the firms are to pay dividends, and the larger the payouts are. their results provide evidence consistent with the agency theory and suggest that managers of firms with better governance quality are under close scrutiny of shareholders and are forced to pay out more cash dividends to reduce agency problems. there are also studies that find a negative relationship between corporate governance quality and dividend payout. for example, ben-nasr (2015) examines newly privatized firms across 43 countries and finds that the government ownership is negatively associated with dividend payouts. the author also finds that such negative relationship is stronger in countries with weak law and order and a lower level of checks and balances. in addition, liu (2003) studies how external corporate governance environment affects dividend policies based on two models (that is, the outcome model and the substitute model) and finds support for the substitute model. the author shows that improvements in external corporate governance environment (including, better equity market discipline, accounting disclosure and insider trading law enactments) are related to lower cash dividend ratios and lower sensitivity of dividends to free cash flow. moreover, knyazeva (2007) examines the dynamic changes in firms’ dividend payout behavior and finds that governance quality is negatively related to changes in the dividend level. firms with weaker governance quality are more likely to engage in dividend smoothing, have lower dividend variability, make fewer dividend cuts and undertake more dividend increases. the author also studies the effect of corporate governance on the design of payout policy. when taking into account the agency costs of free cash flow, firms with better governance quality are found to pay lower dividends. the effect of corporate governance on dividend payout policy is strongest in firms with high cash flow and low growth opportunities. overall, most of prior studies support a positive relation between corporate governance and dividend policy. accordingly, this study expects firms with better governance quality to have larger dividend payouts in order to reduce the likelihood of expropriation by opportunistic managers. specifically, this study intends to test the following hypothesis: h1: firms with better governance quality pay larger dividends. 3. data and methods 3.1. sample selection the sample used in this study includes firms listed on the s&p/tsx composite index between 2009 and 2012. the data on corporate governance is collected from the globe and mail. the standard and poor’s compustat database is used to obtain the required accounting and financial data of sample firms. the final sample includes 532 firm-year observations. 3.2. model specification and data analysis technique to examine the impact of corporate governance quality on dividend payouts, a panel regression model with random effects is employed: lin and lin: does corporate governance affect the critical corporate policies such as dividend policy? international journal of economics and financial issues | vol 10 • issue 6 • 2020 21 payouti,t = β0+β1 govi,t+β2 payouti,t–1+β3sizei,t+β4 levi,t+β5 roei,t+ β6 capi,t+β7 mbvi,t+β8 taxi,t+β9 retaini,t +β10 liqi,t+β11fcfi,t+β12indi,t+ui,t (1) where payout is the dependent variable and represents dividend payouts, which is measured by the ratio of cash dividends to total assets. gov is the main variable of interest and is measured by the governance index provided by the globe and mail. this governance index considers four different dimensions of corporate governance, including (1) board compositions, (2) shareholding and compensation, (3) shareholder rights, and (4) disclosure. this study will perform six separate tests; the first test uses the overall governance index score (gov); the second test uses the board composition index score (gov1) independently; the third test uses the shareholding and compensation index score (gov2) independently; the fourth test uses the shareholder rights index score (gov3) independently; the fifth test uses the disclosure index score (gov4) independently; and the sixth test includes all four dimensions of governance in the test (that is, board compositions, shareholding and compensation, shareholder rights, and disclosure). payoutt-1 refers to previous year’s dividend payouts. size refers to firm size, measured by natural logarithm of total assets. lev is the leverage, measured by the ratio of total debt to total assets. roe is the return on equity, measured by the ratio of net income to shareholders’ equity. cap refers to capital expenditures, measured by the ratio of capital expenditures to total assets and proxies for growth opportunities. mbv is the market to book value ratio, calculated as the ratio of market value of equity plus the book value of debt to the book value of assets, and proxy for investment opportunities. tax refers to taxation, measured by the ratio of income tax to total assets. retain refers to retained earnings, measured by the ratio of retained earnings to total equity. liq refers to liquidity, calculated as the ratio of cash and marketable securities to net assets. fcf refers to free cash flow, which can be substituted for dividends, and is calculated as the ratio of free cash flow to book value of assets. ind is the industry dummy variable, which is based on the first-two digit sic codes. variable definitions are summarized in table 1. 4. analysis and results table 2 reports the mean, standard deviation and median of the main variables. the mean and median of dividend payouts, measured by the ratio of cash dividends to total assets, are 2.4% and 1.6% respectively. the average overall governance index score of sample firms is 69.0 out of a total score of 100. the average board composition index score is 20.7 out of a total score of 31. the average shareholding and compensation index score is 17.2 out of a total score of 24. the average shareholder rights index score is 22.3 out of a total score of 33. the average disclosure index score is 8.9 out of a total score of 12. the leverage, measured by the total debt ratio, has an average of 23.3%. the profitability of sample firms, proxied by roe, has a mean of 11.5%. the ratio of capital expenditures to total assets has an average of 6.9%, and the average market to book value ratio is 1.2. the average liquidity and free cash flow ratios are 9.7% and 0.3%, respectively. table 3 shows correlations of the main variables. dividend payouts are negatively associated with the overall governance index (gov), board composition index (gov1), shareholding and compensation index (gov2) and disclosure index (gov4), significant at the 5% level. dividend payouts are also negatively related to the shareholder rights index (gov3), though the result is not significant. the preliminary results from the correlation analysis show that corporate governance mechanisms substitute for corporate dividend policy. the substitute model suggests that when there are good corporate table 1: variable definitions variables variable definitions dependent variable payout ratio of cash dividends to total assets main explanatory variables gov overall governance index score, which considers four different dimensions of corporate governance, including (1) board compositions, (2) shareholding and compensation, (3) shareholder rights, and (4) disclosure, and is obtained from the globe and mail gov1 board composition index score provided the globe and mail gov2 shareholding and compensation index score provided the globe and mail gov3 shareholder rights index score provided the globe and mail gov4 disclosure index score provided the globe and mail control variables payoutt-1 previous year’s dividend payouts size natural logarithm of total assets lev ratio of total debt to total assets roe ratio of net income to shareholders’ equity cap ratio of capital expenditure to total assets mbv ratio of market value of equity plus the book value of debt to the book value of assets tax ratio of income tax to total assets retain ratio of retained earnings to total equity liq ratio of cash and marketable securities to net assets, which are total assets minus cash and short-term securities fcf ratio of free cash flow (calculated as net cash flow from operating activities minus cash dividends minus capital expenditures) to book value of assets ind industry dummy variables table 2: summary statistics variables obs mean std. dev. median payout 532 0.024 0.026 0.016 gov 532 68.953 15.562 69.000 gov1 532 20.665 5.036 21.000 gov2 532 17.154 5.044 18.000 gov3 532 22.252 6.622 24.000 gov4 532 8.882 2.885 10.000 payoutt-1 532 261.935 444.974 84.936 size 532 8.875 1.666 8.592 lev 532 23.311 16.006 21.014 roe 532 11.491 20.992 11.551 cap 532 0.069 0.062 0.057 mbv 532 1.196 0.769 1.060 tax 532 0.017 0.024 0.013 retain 532 0.249 1.110 0.473 liq 532 0.097 0.186 0.040 fcf 532 0.003 0.062 0.008 variable definitions are presented in table 1. the sample consists of firms listed on the s&p/tsx composite index between 2009 and 2012 lin and lin: does corporate governance affect the critical corporate policies such as dividend policy? international journal of economics and financial issues | vol 10 • issue 6 • 202022 table 3: correlations of main variables (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (1) payout 1.00 (2) gov –0.15 1.00 (3) gov1 –0.24 0.79 1.00 (4) gov2 –0.12 0.80 0.52 1.00 (5) gov3 –0.01 0.80 0.44 0.47 1.00 (6) gov4 –0.15 0.77 0.58 0.62 0.46 1.00 (7) size –0.45 0.40 0.28 0.37 0.33 0.28 1.00 (8) lev 0.08 0.06 0.03 0.10 –0.02 0.12 –0.07 1.00 (9) roe 0.13 0.00 –0.07 0.05 0.02 –0.03 0.02 –0.02 1.00 (10) cap 0.17 –0.08 –0.05 –0.14 –0.05 0.03 –0.27 0.00 –0.01 1.00 (11) mbv 0.56 –0.17 –0.20 –0.17 –0.04 –0.17 –0.57 –0.04 0.16 0.35 1.00 (12) tax 0.21 –0.23 –0.15 –0.25 –0.11 –0.24 –0.30 –0.25 0.20 0.24 0.43 1.00 (13) retain –0.20 0.06 0.14 0.06 –0.05 0.09 0.21 –0.29 0.07 0.00 –0.16 0.04 1.00 (14) liq 0.02 –0.19 –0.13 –0.17 –0.14 –0.17 –0.22 –0.28 0.03 –0.03 0.20 0.21 0.03 1.00 (15) fcf –0.12 –0.12 –0.05 –0.05 –0.15 –0.12 –0.07 –0.17 0.10 –0.49 0.09 0.27 0.04 0.24 1.00 variable definitions are presented in table 1. correlations are based on the sample of 532 firm-year observations. correlations significant at 5% level are in bold face table 4: corporate governance quality and dividend payouts model 1 model 2 model 3 model 4 model 5 model 6 intercept 0.094*** (7.772) 0.107*** (8.674) 0.101*** (8.536) 0.092*** (7.642) 0.100*** (8.441) 0.100*** (8.098) gov 0.000*** (3.120) gov1 0.000 (–1.334) –0.001*** (–2.604) gov2 0.000*** (2.848) 0.000 (1.578) gov3 0.001*** (4.340) 0.001*** (3.939) gov4 0.000* (1.830) 0.000 (0.254) payoutt–1 0.000*** (6.113)*** 0.000*** (6.315) 0.000*** (6.289) 0.000*** (5.858) 0.000*** (6.243) 0.000*** (6.016) size –0.012*** (–10.791) –0.011*** (–9.969) –0.012*** (–10.678) –0.012*** (–10.916) –0.012*** (–10.421) –0.012*** (–10.785) lev 0.000 (1.059) 0.000 (1.177) 0.000 (1.098) 0.000 (1.113) 0.000 (1.041) 0.000 (1.093) roe 0.000 (0.475) 0.000 (0.461) 0.000 (0.329) 0.000 (0.537) 0.000 (0.481) 0.000 (0.241) cap –0.007 (–0.392) –0.005 (–0.273) –0.008 (–0.454) –0.003 (–0.142) –0.008 (–0.456) –0.006 (–0.356) mbv 0.008*** (6.047) 0.008*** (5.991) 0.008*** (5.968) 0.008*** (5.850) 0.008*** (6.121) 0.008*** (5.690) tax 0.060** (2.169) 0.058** (2.057) 0.060** (2.147) 0.056** (1.995) 0.061** (2.172) 0.054* (1.934) retain 0.002*** (3.087) 0.002*** (2.985) 0.002*** (3.043) 0.002*** (3.327) 0.002*** (2.922) 0.002*** (3.470) liq –0.006 (–1.327) –0.008* (–1.777) –0.007 (–1.549) –0.006 (–1.420) –0.006 (–1.399) –0.007 (–1.532) fcf –0.041*** (–3.656) –0.041*** (–3.575) –0.041*** (–3.667) –0.037*** (–3.266) –0.043*** (–3.785) –0.037*** (–3.312) ind yes yes yes yes yes yes adj r2 0.290 0.286 0.289 0.300 0.285 0.307 variable definitions are presented in table 1. t-statistics are reported in parentheses. *, **, *** denote significance at the 10%, 5% and 1% levels, respectively governance mechanisms in place, shareholders worry less about expropriation of free cash by managers and are less likely to force managers to disgorge cash as dividends. the aim of this study is to examine how corporate governance quality affects firms’ corporate dividend decisions. the test results of panel regression models are reported in table 4. model 1 uses the overall governance index as the main explanatory variable and shows that firms with better governance quality have larger dividend payouts. model 2 uses the board composition index as the main explanatory variable and reports a positive but insignificant relationship between governance quality and firms’ dividend payouts. both model 3 (using the shareholding and compensation index as the main explanatory variable) and model 4 (using the shareholder rights index as the main explanatory variable) show a significant positive relationship between governance quality and payout policy at the 1% level. model 5 that uses the disclosure index also reports a significant positive relationship but the relationship lin and lin: does corporate governance affect the critical corporate policies such as dividend policy? international journal of economics and financial issues | vol 10 • issue 6 • 2020 23 is significant only at the 10% level. model 6 run the tests with all four dimensions of governance. some interesting results are found. firstly, the variable, gov1 (board composition index), becomes significant and the coefficient of gov1 turns negative. secondly, the coefficient of gov2 (shareholding and compensation index) remains positive but it becomes insignificant. thirdly, coefficient of gov4 (disclosure index) becomes insignificant. overall, the test results of multivariate analyses suggest that firms with higher governance quality have higher dividend payouts. the findings are consistent with prior evidence, including pahi and yadav (2019); shamsabadi et al. (2016); jiraporn et al. (2011), that reports a direct relationship between corporate governance and dividend policy. also, the results support the outcome model. that is, when there are good corporate governance mechanisms in place, the agency problems between shareholders and managers can be reduced by distributing earnings in the form of dividends to shareholders. shareholders can ensure that company earnings are not exploited for the self-interests of managers. in addition, we find that the shareholding and compensation index is a key determinant of dividend payouts. this result is consistent with the findings reported by rohov et al. (2020), rodrigues et al. (2020) and roark (2011). specifically, rohov et al. (2020) find that ownership is the most important factor in dividend decisions based on a sample of non-financial joint-stock ukrainian companies. the study by rodrigues et al. (2020) also shows that the remuneration of the ceo has an effect on dividend yields. in addition, rodrigues et al. (2020) report that corporate governance is important for stimulating dividends payouts even in the presence of controlling shareholders. moreover, roark (2011) examines the corporate governance of reits, which have a unique regulatory requirement of minimum dividend payments to shareholders. the author finds that excess dividends (measured by dividend payments in excess of the mandatory payments) can be partly explained by ceos’ share ownership and the compensation structure of reit ceos. in terms of control variables for corporate dividend policy, we find that previous year’s dividend decision, market to book value ratio (proxy for investment opportunities), tax, and retained earnings are significantly positively associated with dividend payouts. on the other hand, firm size and free cash flow are significantly negatively related to dividend payouts. the negative relationship between firm size and dividends can be explained from the signaling theory perspective, which suggests that as the financial positions of large companies are relatively transparent in the market due to disclosure requirements, large companies do not need to send signals in the form of dividends (rohov et al., 2020). in addition, as dividend payments decrease the free cash flow of a company, some companies may prefer to retain earnings for future investment opportunities rather to distribute them as dividends to shareholders. 5. additional test to enhance our understanding of the relationship between corporate governance quality and dividend policy, we conduct an additional test and examine if governance quality is related to the propensity to pay dividends. in this test, we adopt a logit regression model, where the dependent variable is a dummy variable that equals one if the firm pays a dividend and zero otherwise. the main explanatory variable in this model is the overall governance index (gov). the logit regression result is presented in table 5 and is consistent with the findings of former panel regression models. specifically, governance quality is positively associated with the propensity to pay dividends. therefore, firms with better governance quality are more likely to pay dividends. 6. conclusion the decision on whether to distribute the company’s earnings as dividends or to retain its earnings is one of the most critical decision in corporate finance. this study examines the relationship between dividend policy and corporate governance quality, measured by the governance index provided by the globe and mail that considers four different dimensions of corporate governance, including board compositions, shareholding and compensation, shareholder rights, and disclosure. the sample includes canadian firms listed on the s&p/tsx composite index during 2009-2012. this study attempts to shed light on the question as to whether firms’ governance quality matters to corporate dividend policies. the results show that firms with better governance quality have larger payouts. in terms of four dimensions of corporate governance index, the shareholding and compensation index is the most important determinant of dividend payouts. the result from the logit analysis shows that firms with better governance quality are more likely to distribute dividends to shareholders and further confirms our prior results. this study therefore supports the complementary role of corporate governance and dividend policy of the firms. the implication from our research findings is that managers and board of directors should make dividend payout decisions in a big picture of corporate governance. the results also show an important practical implication for firm managers. that is, table 5: corporate governance quality and propensity to pay dividends variables coefficient z-statistics intercept –8.234*** (–4.725) gov 0.046*** (4.226) payoutt–1 0.006** (2.557) size 0.305 (1.622) lev 0.051*** (3.906) roe 0.007 (1.139) cap –1.061 (–0.369) mbv 0.285 (1.562) tax 22.175*** (3.363) retain 0.375*** (3.295) liq –0.562 (–1.109) fcf 4.353* (1.937) ind 2.059*** (3.559) mcfadden r2 0.470 log likelihood –175.464 total obs 664 the dependent variable is a dummy variable that equals one if the firm pays a dividend and zero otherwise. variable definitions are presented in table 1. z-statistics are reported in parentheses. *, **, *** denote significance at the 10%, 5% and 1% levels, respectively lin and lin: does corporate governance affect the critical corporate policies such as dividend policy? international journal of economics and financial issues | vol 10 • issue 6 • 202024 as the agency problem between managers and shareholders is unavoidable in listed companies, policy makers and regulators could encourage companies to focus on the shareholding and compensation dimension of corporate governance in order to induce higher dividend payouts and protect shareholders. future research may explore the effect of corporate governance policy on dividend policy by comparing two different time periods, preand post-financial crisis of 2008. the oecd has pointed out that the financial crisis has revealed severe shortcomings in corporate governance. in addition, hilliard et al. (2019) find that firms with better corporate governance in 2007 react quickly to the worsening economic conditions by decreasing or eliminating dividends in 2008 and therefore have higher risk-adjusted returns in 2009. hence, there may be some major changes in firms’ governance practices after the financial crisis of 2008. further investigations on how financial crisis affect the relationship between corporate governance quality and dividend policy are needed. references adjaoud, f., ben-amar, w. (2010), corporate governance and dividend policy: shareholders’ protection or expropriation? journal of business finance and accounting, 37(5/6), 648-667. aggarwal, r., erel, i., ferreira, m., matos, p. (2011), does governance travel around the world? evidence from institutional investors. journal of financial economics, 100(1), 154-181. awwad, b.s.a., hamdan, a.m.m. (2018), gulf cooperation council energy sectors governance and dividend policy. international journal of economics and financial issues, 8(4), 163-171. ben-nasr, h. (2015), government ownership and dividend policy: evidence from newly privatised firms. journal of business finance and accounting, 42(5-6), 665. chang, b., dutta, s., saadi, s., zhu, p. (2018), corporate governance and dividend payout policy: beyond country-level governance. journal of financial research, 41(4), 445-484. dewasiri, n.j., koralalage, w.b.y., azeez, a.a., jayarathne, p., kuruppuarachchi, d., weerasinghe, v. (2019), determinants of dividend policy: evidence from an emerging and developing market. managerial finance, 46(3), 413-429. ganguli, s.k., dawar, v., arrawatia, r. (2020), corporate dividend policy, minority shareholders right and equity value of firm: evidence from singapore. journal of public affairs, 20(2), e2039. hilliard, j., jahera, j.s.j., zhang, h. (2019), the us financial crisis and corporate dividend reactions: for better or for worse? review of quantitative finance and accounting, 53(4), 1165-1193. iqbal, a., zhang, x., tauni, m.z., jebran, k. (2020), principal-principal agency conflicts, product market competition and corporate payout policy in china. journal of asia business studies, 14(3), 265-279. jensen, m.c. (1986), agency costs of free cash flow, corporate finance, and takeovers. american economic review, 76(2), 323-329. jiraporn, p., kim, j.c., kim, y.s. (2011), dividend payouts and corporate governance quality: an empirical investigation. financial review, 46(2), 251. knyazeva, a. (2007), essays in corporate finance. new york: new york university, graduate school of business administration, proquest dissertations publishing. liu, w. (2003), two essays on corporate dividend policy. united states: indiana university, proquest dissertations publishing. pahi, d., yadav, i.s. (2019), does corporate governance affect dividend policy in india? firm-level evidence from new indices. managerial finance, 45(9), 1219-1238. rajput, m., jhunjhunwala, s. (2019), corporate governance and payout policy: evidence from india. corporate governance, 19(5), 1117-1132. roark, r.s. (2011), three essays on corporate governance: insights from reits. united states: university of connecticut, proquest dissertations publishing. rodrigues, r., felício, j.a., matos, p.v. (2020), corporate governance and dividend policy in the presence of controlling shareholders. journal of risk and financial management, 13(8), 162. rohov, h., kolodiziev, o., krupka, m. (2020), factors affecting the dividend policy of non-financial joint-stock companies in ukraine. investment management and financial innovations, 17(3), 40-53. shamsabadi, h.a., min, b.s., chung, r. (2016), corporate governance and dividend strategy: lessons from australia. international journal of managerial finance, 12(5), 583-610. tahir, h., masri, r., rahman, m.m. (2020), impact of board attributes on the firm dividend payout policy: evidence from malaysia. corporate governance, 20(5), 919-937. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(1), 46-55. international journal of economics and financial issues | vol 7 • issue 1 • 201746 detecting asset price bubbles: a multifactor approach andré tomfort* department of international finance, berlin school of economics and law, badensche str. 50-51, 10825 berlin, germany. *email: tomfort@hwr-berlin.de abstract asset price bubbles and deep financial crises have occurred frequently over the past three decades. no wonder that decision makers are searching for ways to protect their economies. recognizing price bubbles in time could be very helpful in this regard to implement counter measures such as higher interest rates, taxes or capital buffers. in this paper a solution to this problem shall be proposed: a multifactor valuation approach based on a discounted cash flow and a cointegration model that links asset prices with selected variables to determine the valuation of a market. in addition, the gaps of credit and private fixed investments to gross domestic product are measured to assess whether the economy is facing overleveraging and overinvestment. if the four measures lead to a clear picture, policy makers are advised to take action. an exemplary analysis has been done for the former bubbles in japan, and in the us stock and housing market. keywords: asset price bubbles, cointegration, credit and investment expansion jel classifications: e44, g01, g 15, g 17 1. introduction throughout the past 30 years a high frequency of sharp asset price increases with a following deep financial crisis occurred. often these cases were regarded as asset price bubbles. such bubbles happened in japan in the late eighties, in several asian countries in the late nineties, in many stock markets before the millennium, and in the real estate market in the us and in parts of europe before 2007. all these bubbles have caused high social and financial costs and some of them have led to a long-lasting economic crisis. most researchers, central bankers and investors believe that a major asset price bubble is not predictable (issing, 2009). the policy conclusion is that countermeasures should only be taken after a burst of a bubble to limit the costs that have to be expected. this “laisser-faire” approach, however, is not without risks. governments are becoming more and more indebted after every crisis and world financial markets have been flooded with central bank money to save the financial system. this liquidity is now vagabonding between different financial markets and may facilitate excessive risk-taking as described by minsky (1986). under these circumstances, a new bubble may occur at any time somewhere in the world and particularly emerging markets with limited market liquidity are vulnerable. recognizing such price bubbles in an early stage could be very helpful to dampen them through effective countermeasures. in addition, a good timing is very important because countermeasures such as higher interest rates, taxes or capital buffers for banks and other financial institutions are costly and should only be raised if a crash and devastating crisis are looming. in this paper a solution to this problem shall be proposed: a multifactor approach that consists of a discounted cash flow (dcf) and a cointegration model that links asset prices with selected variables to determine the valuation of a market. in addition, the gaps of credit and private fixed investments to gross domestic product (gdp) are calculated to assess whether the economy is facing an overleveraging and overinvestment. if all four measures surpass their respective threshold value which is the 10-year average plus 50% of the standard deviation, policy makers are advised to take action. the 10-year time span was chosen because-from historical experience-we know that this often was the duration of a bubble formation process. a back-testing analysis will be presented for the housing bubble in japan in the eighties and the one in the us after the millennium as well as for the technology bubble in the us stock market (ussm). the reason for that choice was that all three bubbles were of major size, caused high economic and social costs and happened in different markets. in contrast to most other studies in the field which are based on a large sized tomfort: detecting asset price bubbles: an multifactor approach international journal of economics and financial issues | vol 7 • issue 1 • 2017 47 cross-sectional analysis, the chosen procedure is an inductive one. the advantage of that is two-fold: first, just major, “high-cost” bubbles will be included and not simple market overreactions to stress the strong speculative element in the bubble formation process, as well as the overleveraging and overinvestment in the economy that are typical for them. secondly, the individual bubble analysis avoids certain losses of information that may happen in the aggregation process of a cross-country analysis. the most innovative element of this paper is the autoregressive-distributedlag model for cointegration used as a valuation instrument. the main hypothesis is that large asset price bubbles can be detected in time to be able to take countermeasures. the paper starts with a background discussion and a literature review followed by an empirical analysis that consist of a dcf model and an autoregressive distributed lag (ardl) model to test for cointegration between asset prices and several macroeconomic or financial variables. out of the resulting longterm variation coefficients a fundamental value has been derived. the differences of market prices from the two independently calculated fundamental values can be regarded as a bubble component. in a second step, the credit and investment-to-gdp gap will be measured to assess whether the bubble building in financial markets is reflected in a leveraging and investment boom in the real economy. at the end of every investigated price bubble a conclusion for policy advices will be given. 2. background a first problem analysing asset price bubbles is that there is no commonly accepted view what an asset price bubble really is. some authors already define an asset price bubble as a 10% deviation from a long-term price trend (adalid and detken, 2007). the most accepted definitions however, do not refer to numbers but to the characteristics of a bubble formation process. according to them, asset price bubbles contain a strong speculative element, the fundamental value will be at least partially neglected by investors, and a strong market correction has to be expected once the bubble bursts. in addition, the process of the bubble formation seems to be explosive and non-linear (kindleberger, 2000 or shiller, 2000). of equal importance is that the bubble formation and risk-taking in financial markets is also reflected in the real economy in terms of leveraging and overinvestment. an asset price bubble that has not a strong impact on financing and investment decisions of corporations and private households should not be of major concern because its burst would cause only limited damage for the economy. in this paper, the focus shall be on major asset price bubbles that are of explosive nature and have the potential to cause high economic costs. an early recognition of asset price bubbles would be of great use to allow monetary and fiscal policy as well as financial regulators to intervene in time and avoid high economic costs for the society. in the past, the idea of interventions of central banks was rejected by central bankers and mainstream academics (bernanke and gertler, 2001). the argument was that a central bank which successfully stabilises output and inflation would also smooth prices in financial markets. empirical evidence, however, points into a different direction: in most of the major asset price bubbles inflation remained moderate until the final stage of the bubble. this was the case for the stock market bubble before the great depression, for japan in the eighties, for the technology bubble before the millennium or for the recent bubble in housing markets. another argument against central bank intervention is that central banks would not have the appropriate instruments available to fight asset price bubbles effectively. the effects of changes in interest rates and money supply on asset prices were too uncertain in terms of their impact and their time-lags (ceccehett et al., 2000). in addition, many researchers doubted the capability of central banks or governments to recognise a bubble better than the overall market (filardo, 2000). these concerns led to the so called jackson hole consensus which only favoured active central bank and governmental intervention once financial market prices have a strong and lasting impact on the inflation rate for goods and services (borio, 2008). this is usually the case if a burst of a price bubble alters consumption and investment expenditures in the real economy. according to this view, intervention should only take place in a crisis to dampen its economic costs but not in a pre-emptive way. the consequences of such a policy strategy can be severe. if central banks only intervene in downturns and let the upswings run, then-in the long run-central bank balance sheets balloon and a dangerous liquidity overhang may be the result (hoffmann, 2009). dangerous, because in combination with an insufficiently regulated financial sector the liquidity overhang could be the foundation for the next even bigger price bubble in asset markets (crotty, 2009 or schnabl and hoffmann, 2007). another dilemma for central banks is that financial markets get used to this liquidity overhang-particularly through a corresponding high valuation of asset prices. in this case it will become difficult for central banks to withdraw that liquidity without causing a collapse of asset prices and economic activity. the current difficulty of the federal reserve to raise interest rates is a good example. several authors confirm that the overall economic costs of an interventionist approach as proposed in this paper were significantly lower compared to the economic costs of a bursting bubble (blanchard, 2000). this is also a very important conclusion for emerging economies. in countries with less developed financial markets the incentive for local agents is high to borrow money abroad and market liquidity is limited. this makes these countries particularly vulnerable for a bubble contagion. apart from monetary or fiscal policy measures, some regulatory instruments can be used to prevent an asset price bubble. basel iii, for example, provides the pro-cyclical capital reserve in order to hedge better against the risks of strong credit expansion, and a “funding ratio,” which should reduce the risk of maturity transformation (claessens and kodres, 2014). the systemic risk that arises from asset price bubbles is also addressed by so called macro-prudential policies. countercyclical capital requirements and dynamic loan loss provisioning could be powerful additional tools in this context. both instruments require that that credit institutions must increasingly build up equity capital and provisions when their risks grow in line with their loan portfolio. the use of all these regulatory instruments has to be based upon a guideline. the proposed approach in this paper may be helpful in this respect. tomfort: detecting asset price bubbles: an multifactor approach international journal of economics and financial issues | vol 7 • issue 1 • 201748 3. literature review several empirical studies with regard to asset price bubbles gained broader attention. jones (2014) was proposing a twopillar-approach to bubble surveillance. the first one consists of a check whether risk premiums (rprs) in financial markets are extraordinary low which is taken as a warning signal. the second pillar is referring to the level of market quantities such as issuance, trading activity, fund flows, and return expectations provided by surveys. jones wants to provide an alternative approach to the ones that rely on monetary or credit data. alessi and detken (2009) researched for an early warning indicator with respect to asset price bubbles and financial crises using data for 18 organization for economic cooperation and development (oecd) countries between 1970 and 2007. they defined critical threshold levels and found that global measures for credit expansion are particularly useful in this respect. gerdesmeister et al. (2011) were defining a composite indicator to predict asset price bubbles based upon a probit approach. for their indicator they used variables such as credit aggregates, the investment-to-gdp ratio, an interest rate spread, a house price growth gap and stock market price growth. they did their analysis for 17 oecd countries for the time span between 1969 and 2010 and found that their indicator had enough predictive power to justify pre-emptive measures. detken and smets (2004) have analysed stock market and real estate price bubbles for 18 oecd countries between 1970 and 2003. they used a cross-sectional cointegration procedure for their analysis. according to their approach a bubble was identified when asset prices deviated by more than 10% from their long-term trend. the cross-sectional approach was used to draw general conclusions out of their big sample of “bubbles.” their major findings were that money and credit supply are relevant factors for the bubble formation. they got evidence that a financial accelerator process was at work and that monetary policy was generally too expansionary in comparison to the taylor rule during bubble phases. investment booms went often along with asset price bubbles but inflation remained remote. another important aspect of their study was that real estate market busts lead to significantly higher economic costs than stock market busts. adalid and detken (2007) investigated the impact of monetary shocks on asset price bubbles for oecd countries between 1970 and 2005. they used a specific var-technique to resolve the endogeneity problem of monetary policy. adalid and detken recognized 42 bubbles whereas again a difference of 10% of the actual price from the long-term trend was considered as a bubble. the analysis was done cross-sectional. the authors divided the whole bubble in a prosperity, boom and crises phase. for all of the phases the relationship between monetary variables, macroeconomic variables and asset prices were individually investigated. major findings of this study were that money supply had a bigger impact on the bubble formation than credit growth. they also found evidence that a financial accelerator effect played an important role, that monetary policy was too generous, that an investment boom in the real economy and asset price bubbles were closely linked, and that inflation remained relatively tame during the bubble periods. economic costs of real estate price busts were significantly higher than the ones of stock market busts. borio and lowe (2002) did an asset bubble study for 34 countries for the years 1960-1999. they found that asset price bubbles followed a strong credit expansion and a high financial leverage in the banking and/or corporate sector. they also found evidence that inflation did not accelerate dramatically in bubble situations. they explained that somewhat surprising phenomenon with high productivity gains and with central banks that were able to anchor inflation expectations due to their credibility to ensure price stability. in contrast to the two previously mentioned studies, borio and lowe showed that cumulative credit growth has a higher explanatory power than just credit growth. they also found strong evidence that a combination of rising asset prices, a strong cumulative credit and investment expansion is particularly dangerous for the stability of a financial system. one of their important conclusions was that the mentioned indications are able to forecast the formation and burst of a future asset price bubble. greiber and setzer (2007) analysed the recent housing price bubble in the usa and some european countries by running a cross-sectional cointegration analysis. they were focussing on the impact of money supply on housing prices. according to their findings, money supply had a significant impact on housing prices while inflation remained tame during the bubble. gurkaynak (2005) was investigating rational bubbles, detected by discounted dividend models. he came to the conclusion that these models were not successful to assess asset price bubbles. if time-varying discount rates or structural breaks were introduced, historical tests could not detect a bubble. 4. the dcf model the fundamental price of real estate or stocks can be assessed by discounting the future expected rents/dividends. p nts dividends ih s/ re / = (1) ph/s represents the fundamental price of a house or stock, and i the discount rate for which a typical mortgage rate (mgt) can be used. in the same way the fair value for the overall housing or stock market can be calculated as proceeded in this paper. in the academic discussion it remained doubtful whether cointegration based present value estimates work (campell and shiller, 1987). therefore, the simple dcf-model was used in this paper. its purpose was to indicate broadly the degree of a market overvaluation. despite its limitations and its openness for different kinds of interpretation, it is still considered as a useful guide to assess whether the market is entering a speculative phase. 5. ardl models and cointegration the ardl-model can be used to determine in a linear way the fair value of stock or housing prices if financial or macroeconomic variables can be found that are cointegrated. the resulting longterm equilibrium path can then be transmitted into a fundamental value for the asset markets. the cointegration methodology of engle and granger (1987) or johanson (1995) demand explanatory variables of the same integration order. this would exclude a lot of potential variables and restrain the quality of a model. this problem can be avoided by working with the ardl-methodology. it allows the use of variables with different orders of integration (pesaran tomfort: detecting asset price bubbles: an multifactor approach international journal of economics and financial issues | vol 7 • issue 1 • 2017 49 and shin, 1999). for the distribution of the f-statistics two kinds of critical values are calculated. for the first one the variables are taken to be of integration order one and for the second one they are taken as zero order variables. these two kinds of values define a range that captures all possible integration assessments of the variables. if the critical value of the f-statistic is higher than the one of the defined range, the estimation does not require an exact determination of the integration order of the variables. only if the critical value is located within the range, the order of integration has to be fixed in the model specification. the error-correction version of the ardl-model is suited to test the significance of the explanatory variables and the degree of cointegration. the derived long-run coefficients which are selected by the akaike information criterion or schwarz-bayes criterion can be used to calculate the fundamental value for housing and stock prices. for japanese housing market prices econometric pretesting delivered the results that the unemployment rate (ur), business failures (bfs), and business confidence (bc) could be cointegrated by assuming an integration order of one. the equation for japanese housing prices is as follows: jphp ur bf bco t= + + + +α α α α µ1 2 3 (2) the error correction model: ∆ ∆ ∆ ∆ jphp jphp ur bf t o i t i i n i t i i n i t i i n = + + + + − = − = − = ∑ ∑ ∑ α α α α α 1 1 1 1 1 1 33 1 4 1 5 1 6 1 6 1 i t i i n i t i t i t i t t bc jphp ur bf bc ∆ − = − − − − ∑ + + + + + α α α α µ (3) for ussm prices before the millennium, econometric pretesting delivered the results that corporate profits (cprs), the economic leading indicator (li), capacity utilisation (cu), and bank lending (bl) were significant variables that could be cointegrated with the s&p 500 assuming an integration order of one. the equation for stock market prices in the us takes looks like that: ussm cpr li cu blo t= + + + + +α α α α α µ1 2 3 4 (4) the error correction version: ∆ ∆ ∆ ∆ ussm cpr li cu t o i t i i n i t i i n i t i i n = + + + + − = − = − = ∑ ∑ ∑ α α α α α 1 1 2 1 3 1 4ii t i i n i t i t i t i t t bl cpr li cu bl ∆ − = − − − − ∑ + + + + + 1 5 1 6 1 7 1 8 1 α α α α µ (5) for us housing prices measured by the case-shiller index econometric pretesting delivered the results that the bc, the credit gap (cgap), the rpr, and mgts could be cointegrated with housing prices assuming an order of integration of one. the equation for housing prices in the us is as follows: 1 2 3 4o tcsi bc cgap rpr mgt     = + + + + + (6) the error correction version: ∆ ∆ ∆ ∆ csi bc cgap rpr t o i t i i n i t i i n i t i i n = + + + + − = − = − = ∑ ∑ ∑ α α α α α 1 1 2 1 3 1 44 1 5 1 6 1 4i t i t i t t bc cgap rpr − − − + + + α α µ (7) for all equation the null of no cointegration defined by h0 = α4i = α5i = α6i = 0 against h1 = α4i ≠ α5i ≠α6i ≠ 0 will be tested. 6. data for the japanese housing market monthly data from m1 1980 to m12 1992 was analysed, for the ussm monthly data from m1 1990 to m12 2000, and for the us housing market quarterly data from q1 1990 to q4 2009. in the first two cases, monthly data was used to densify the data before the burst of the bubble as much as possible. the ardl-model for the us housing market required quarterly data and was therefore estimated over a time horizon of 19 years to include the necessary degrees of freedom. for the assessment of the results of the two valuation models as well as for the two gap calculations a 10-year rolling window was used. the 10-year time span was selected since we know from historical experience that the formation process of a major asset price bubble-from its beginning to its burst-takes about that time. variables have been selected by proven financial or macroeconomic theories. all data was transformed into logarithms except interest rates. the augmented dickey–fuller test proved that the included variables had an integration order zero or one. the only exception was japanese housing prices were the results varied between order one and two. for the following analysis it was assumed that they were of integration order one. all variables entered the calculation with their assessed integration order. jphp (nominal housing prices) japan residential property prices, index 1995=100, month-on-month change, not seasonally adjusted (n.s.a), source: bank for international settlements rents japan, housing rent, index, 2005=100, n.s.a. source: statistics bureau, ministry of internal affairs and communication. to transfer that index into cash flows, rent figures in yen from the household living export were used. source: statistics bureau, ministry of internal affairs and communication mortgage rate japan, interest rate on building society mortgages, 10 years, source: oxford economics ur japan, unemployed rate, total, s.a., source: statistics bureau, ministry of internal affairs and communication bf japan, corporate bankruptcy, total cases, n.s.a., source: tokyo shoko research ltd. (contd...) tomfort: detecting asset price bubbles: an multifactor approach international journal of economics and financial issues | vol 7 • issue 1 • 201750 7. estimation results of the ardl model the following variables for japan turned out to be significant: the ur, the amount of bfs, and bc. the economic foundations for these variables are straight-forward. the level of unemployment is directly affecting the disposable income to finance housing. bfs were important because corporations were heavily invested in the real estate sector at that time so that a change of that figure had a significant impact on the demand for housing. in addition, the willingness of banks to finance housing activities of corporations was influenced by the overall amount of bfs. business sentiment was impacting the readiness of corporations to invest in the housing market. the ardl estimates were done for the time period from m1 1980 to m12 1991. the error correction version can be seen in table 1a. table 1a shows that all explanatory variables were significant as indicated by their t-ratios and had the theoretically expected sign. the error correction term had significant negative variation coefficient. it was −0.135 suggesting that 13.5% of its distance from equilibrium will be reduced after a month. one can conclude that the explanatory variables were cointegrated with housing prices. this conclusion was confirmed in table 1b by the f-statistic value of 5.479 which exceeded the critical 95% and 90% upper bound level. the r-squared showed a relatively high correlation, although it might have been somewhat distorted from the autocorrelation of residuals as indicated by the durbin–watson coefficient. the long run coefficients are shown in table 1c. the values in the first row are the long-term variation coefficients of the explanatory variables. in brackets the t-statistics can be seen. the explanatory variables had the expected sign and were significant. based upon these results the fundamental value for the housing market can be estimated. it will be shown in figure 1. in econometrical pretesting for the ussm before the millennium, the following variables were selected for the cointegration model: cprs, the li for the economy, the measured cu, and the amount of bl. theoretically, cprs impact stock prices because they represent the potential cash flows that a stock investor could receive from her investment. the li is showing the likely future course of the business cycle and is influencing rprs and expected cash flows alike. the degree of cu is having a direct impact on the efficiency of capital through the fixed cost effect and it represents indirectly the amount of sales. bank lending is important to finance investments and in economic boom times the amount of investments and corporate profitability are directly related to each other. the ardl was estimated for the time period from m1 1990 to m12 2000. the error correction results can be bc index japan, manufacturing, composite indicators, manufacturing industrial confidence indicator, s.a., source: economic indicators, oecd bank lending japan, loans and discounts, domestically licensed banks, yen, n.s.a., source bank of japan. this time series was deflated by the gdp deflator, source: cabinet office private fixed investment japan, expenditure approach, gross capital formation, 2005 chained prices, n.s.a., source: cabinet office s&p 500 us stock market capitalisation index, monthly average, source: s&p dow jones indices cpr us national income account, corporate profits, with inventory valuation adjustment and capital consumption adjustment, total, current prices, usd, s.a., source: department of commerce li us leading index, total, index, 2010=100, s.a., source: the conference board cu us capacity utilization, total index, s.a., source: us federal reserve bl us assets and liability of commercial banks, loans and leases in bank credit, usd, s.a., source: us federal reserve. the time series was deflated by the implicit price deflators for gross domestic product: index numbers, 2009=100, s.a., source: federal reserve bank of st. louis csi (house price index) united states, house prices, standard and poor’s case-shiller, national, index, 2000 m1=100, source: (www.econ.yale. edu/~shiller/data.htm) bc us bc measured by the purchasing manager index, source: ism institute cgap us assets and liability of commercial banks, loans and leases in bank credit, usd, calculated as actual deviation from 10 year trend, source: see bank lending rpr us risk premium, measured by the difference between the 3 months interbank rate and the treasury bill rate. interbank rate 3 month (london), source: reuters. treasury bill rate 3 month, source: market rates and yields 10 year bond yield us, long-term government bond yields, 10-year, source: main economic indicators, oecd rents us, city average, consumer prices, rent, primary residence, index, 1984=100, source: bureau of labor statistics. to transfer that index into cash flows, a rent from us market rent apartments (units), usd, current prices was taken, source: reis apartment, office, retail and industrial property trends mgt us mortgage lending rates, conventional mortgage points 15 year fixed rate mortgage, source: mba mortgage bankers association of america (contd...) private fixed investment real gross private domestic investment: fixed investment: residential, annual, n.s.a., source: us bureau of economic analysis ur: unemployment rate, bf: business failures, bc: business confidence, mgt: mortgage rate, rpr: risk premium, cgap: credit gap, bl: bank lending, li: leading indicator, cpr: corporate profits, cu: capacity utilisation tomfort: detecting asset price bubbles: an multifactor approach international journal of economics and financial issues | vol 7 • issue 1 • 2017 51 seen in table 2a. from table 2a it can be seen that all explanatory variables were significant as indicated by their t-ratios and had the theoretically expected sign. the error correction term had a significant negative variation coefficient. the explanatory variables were cointegrated with stock market prices. this conclusion was confirmed in table 2b by the f-statistic value of 4.651 which exceeded the critical 95% and 90% upper bound level. the r-squared showed a meaningful correlation. the autocorrelation of residuals did not seem to pose a problem. the long run coefficients are shown in table 2c. the values in the first row are the long-term variation coefficients of the explanatory variables. in brackets the t-statistics can be seen. the explanatory variables had the expected sign and were significant. however, some doubts have to be assessed with respect to the li. based upon these results, the fundamental value for the ussm before the millennium can be estimated. it will be shown in figure 2. econometrical pretesting for the us housing market showed that the following variables could be cointegrated: the bc index, the cgap, and the rpr. theoretically, bc and housing prices are linked through sentiment and the overall economic conditions. a rising cgap is indicating that financing houses becomes easier and credit conditions improve. it could also be an indication that a higher demand for housing is spurring credit growth. the level of the rpr is an indication for the risk perception in the banking sector and for the banks willingness to lend. the ardl was estimated for the time period from q1 1990 to q4 2009. according to their t-ratios in table 3a, the explanatory variables were significant and had the hypothesized sign. the error correction term was highly significant as well, proving the cointegration. its variation coefficient was −0.252 indicating that around 25% of the difference from equilibrium will be reduced after a quarter. from table 3b can be seen that the f-statistic had a value of 10.134 exceeding the upper bound levels. the r2 confirmed the explanatory power of the model. the diagnostics statistics did not reveal any distortions. the long run coefficients of the ardl model van be seen in table 3c. the values in the first row are the long-term variation coefficients of the explanatory variables. in brackets the t-statistics can be seen. the explanatory variables had again the expected sign and were significant. based upon these obtained results, the fundamental value for the us housing market can be estimated. it will be shown in the figure 3. 8. graphical results the dotted line in figure 1 represents the dcf model results, the slashed line the ardl-estimates, the continuous line the housing table 1c: long‑run coefficient estimates and diagnostics constant ur bf bc 0.01405 (3.72) −0.146 (−3.23) −0.496 (−3.20) 3.105 (2.39) figure 1: japanese housing market; autoregressive distributed lag and discounted cash flow -estimates table 1b: estimation and diagnostic statistics r-squared=0.447 r-bar-squared=0.422 f-statistics=17.63 (0.00) dw-statistics=1.726 f-statistic: 5.479 95% low. bound/ 3.3202 95% up. bound 4.433 90% low. bound 2.774 90% up. bound 3.830 table 1a: ardl (2,0,0,0) error correction estimation estimated variable 0.574* djphpt-1 −0.197* dur 0.067* dbf 0.419* dbc −0.135* ec1t-1 stde 0.0739 −0.0058 −0.0351 0.2071 0.0273 t-r. (7.76) (−3.39) (−2.52) (2.02) (−4.94) probit (0.00) (0.001) (0.013) (0.045) (0.00) table 2a: ardl (1,0,1,2,0) error correction model estimated variable 0.368* dcpr 1.957* dli 0.299* dcu 0.384* dcut−1 –0.433* dbl –0.221* ec1t−1 stde 0.0948 0.3585 0.1047 0.1033 0.221 0.0454 t-r. (3.88) (5.46) (2.86) (3.72) (1.96) (–4.88) probit (0.000) (0.000) (0.005) (0.000) (0.052) (0.000) ardl: autoregressive distributed lag tomfort: detecting asset price bubbles: an multifactor approach international journal of economics and financial issues | vol 7 • issue 1 • 201752 market. both fair value estimates show that the housing market was extraordinary overvalued by a level of around 100%. furthermore, the price bubble entered its final and explosive phase from 1988 onwards when market prices left the estimated values behind. the dcf results pointed towards a higher fair value than the ardlmodel. the advantage of an eclectic approach becomes visible at this point. estimates may deliver quite different results, depending on the methodology and variables involved. if, however, two largely independent approaches indicate a strongly overvalued market, the confidence in such an assessment can be high. it is important to state that housing prices in the large centres of japan such as in tokyo or osaka rose by a multiple of four in relation to the average countrywide housing price index used here. it can be fairly assumed that the degree of the asset price bubble was rather understated in this calculation. the risk that japan could run into a financial crisis was confirmed by the rising gaps of credit and investment relative to the gdp. the continuous line stands for gdp, the slashed line for credit expansion, and the dotted line for investments. credit demand started to accelerate sharply in the late seventies and was likely to spur investments in housing and business equipment. as interest rates were still at high levels of 6% or higher, the sharp rise of credit was driven by the deregulation of the financial sector that took place at that time. in the course of the eighties the gap of credits to gdp became smaller despite the fact that interest rates were falling. however, it was existent until the bubble burst and contributed to its development. usually one can expect that credit is expanding particularly fast in the last 3 years of the bubble formation when buying assets on margin seems very attractive. this was different in the japanese bubble but the high ratio in the first two-thirds of the eighties was enough to fuel the bubble in asset markets as well as the overinvestment in the economy. once a portion of the investment boom turns out to be loss-making in a recession, an operational and financial deleveraging will be forced in the private, corporate and banking sector alike. the more credit and investment rose in the boom phase, the deeper and longer the table 2c: long‑run coefficient estimates and diagnostics constant cpr li cu bl −0.0205 (−2.33) 1.663 (4.23) 0.477 (1.11) 0.238 (1.91) 1.953 (2.11) table 3c: long‑run coefficient estimates and diagnostics constant bc cgap rpr 0.0072 (1.09) 0.372 (2.86) 0.538 (2.95) −0.148 (−3.08) figure 4: credit and investment to gross domestic product gap in japan before 1990 figure 2: us stock market; autoregressive distributed lag and discounted cash flow-estimates before 2000 table 2b: estimation and diagnostic statistics r-squared=0.357 r-bar-squared=0.315 f-statistics=11.28 (0.00) dw-statistics=2.036 f-statistic: 4.651 95% low. bound 2.957 95% up. bound 4.113 90%low. bound 2.501 90% up. bound 3.577 table 3b: estimation and diagnostic statistics r-squared=0.759 r-bar-squared=0.742 f-statistics=45.35 (0.00) dw-statistics=1.92 f-statistic: 10.134 95% low. bound 3.412 95% up. bound 4.566 90% low. bound 2.847 90% up. bound 3.882 table 3a: ardl (1,0,1,0) error correction model estimated variable 0.0937* dbc 0.1356* dcgap −0.0104* drpr –0.2520* ec1t−1 stde 0.0262 0.0408 0.0046 0.0604 t-r (3.58) (3.32) (–2.23) (–4.17) probit (0.001) (0.001) (0.028) (0.000) figure 3: house price index, autoregressive distributed lag and discounted cash flow-estimates for the us housing market tomfort: detecting asset price bubbles: an multifactor approach international journal of economics and financial issues | vol 7 • issue 1 • 2017 53 deleveraging process will last as well as its negative impact on economic growth. japan suffered from two “lost” decades after the burst of the bubble (weingarten, 2010). it became clear that from august 1988 onwards all four indicators were above the threshold value of the 10 year average plus half the standard deviation as it was defined in this paper. the central bank and the government would have had about 2 years to prevent the worst if the appropriate countermeasures would have been taken. the dotted line in figure 4 represents again the dcf model results, the slashed line the ardl-estimate, and the continuous line the s&p 500. both fair value estimates show that the stock market was overvalued by a margin of around 50-100%. the stock market bubble entered its final and explosive phase from 1997 onwards when market prices surpassed the estimated values. the dcf-results pointed towards a higher fair value since it was spurred by booming cprs. however, a portion of these profits turned out to elusive and was rather a product of the stock market boom and not a reason. this was true for shares that led to rising asset values in corporations, and for investments that were only profitable as long as the economic upswing moved on. it can therefore be assumed that the dcf approach was overstating the fair value to some degree. the ardl estimate was rising continuously, also pushed by cprs and bl but held back by a relatively moderate cu, and a li that remained remote due to the asian crisis in 1997 and 1998 and rising interest rates afterwards. again, the eclectic approach allowed a more differentiated view on the valuation of the market and both approaches pointed towards a potential stock market bubble before the millennium. the risk of a potential asset price bubble was underlined by the rising gaps of credit and investment growth relative to the gdp as can be seen in figure 5. the continuous line stands for gdp, the slashed line for credit expansion, and the dotted line for investments. in the early nineties, the saving and loan crises in the us and a negative economic environment held back particularly credits and to a lesser extent also investment demands. from the mid-nineties onwards, credits and more so investment demand were outpacing gdp continuously. both time series were driven by high profit expectations while money supply and interest rates were not very supportive. credits and investments surpassed gdp growth in 1997 and from mid 1998 onwards, all four indicators left behind their threshold value of the 10-year average plus 50% of the standard deviation. the assessment that such a twin gap in combination with a highly overvalued financial market may lead to a severe financial crises was also confirmed for the ussm before the millennium. the central bank and the government had close to 2 years to slow down the bubble formation process and to avoid the at least some of the economic costs that followed. despite the fact that the divergence of credit and investment from gdp was even larger than in the japan, the economic damage in the years after the crash remained surprisingly remote. this was probably due to the aggressive delivering of us corporations, a more supportive reaction of the us central bank, and the fact, that private households remained less indebted than with a housing bubble. the dotted line represents the dcf model results, the slashed line the ardl-estimates, the continuous line the housing market. both fair value estimates clearly show that the housing market was overvalued by more than 100% according to both fair value measures. the price bubble entered its final and accelerating phase from 2003 onwards when market prices left the estimated values clearly behind. the dcf-results pushed upwards in that time because of falling interest rates in the aftermath of the recession in the years 2000-2003 and continuously rising rents. the ardl-estimate was influenced by an improving business climate, falling rprs and an expanding credit demand. it was figure 5: credit and investment to gross domestic product gap before the us stock bubble figure 6: credit and investment to gross domestic product gap before 2007 tomfort: detecting asset price bubbles: an multifactor approach international journal of economics and financial issues | vol 7 • issue 1 • 201754 assuring that the estimation approaches led to similar conclusions. after the burst of the bubble, however, the two valuation measures diverged. the dcf-estimates continued to rise due to falling interest rates while rents were hardly affected by the following economic crises. the ardl-estimate was dragged down because rprs increased sharply, business sentiment dropped and credit conditions tightened. also in the case of the us housing market, the looming asset price bubble came along with rising gaps of credit and investment growth relative to the gdp as can be seen in figure 6. the continuous line stands for gdp, the slashed line for credit expansion, and the dotted line for investments. credits and investment demand were outpacing gdp continuously. the credit as well as the investment gap was driven by high capital gain expectations in the real estate market and accommodative interest rates (taylor, 2008). the unavoidable delivering process after the burst happened in the financial sector and by private households. the economic costs were estimated to be three times the us gdp (atkinson and luttrell, 2013). overinvestments in housing have caused a sharp break-down of housing activity and even 7 years after the crises has started the sector has not reached pre-bubble construction activity levels. the threshold value of the 10-year average plus 50% of one standard deviation was surpassed by all four indicators from the second quarter 2005 onwards. the federal reserve as well as the us government had again about 2 years to dampen this development through monetary policy, fiscal or regulatory measures and thereby to reduce the economic costs of the deleveraging process. 9. summary and concluding remarks the aim of this paper was to test an eclectic approach with respect to its ability to predict major asset price bubbles and following financial crisis in advance. three of the major asset price bubbles in the more recent past were investigated. the approach included two largely independent valuation measures for the asset markets and a credit and investment gap calculation relative to gdp. the results show that in all cases the proposed approach was able to give a clear warning signal of about 2 years earlier before the burst of the bubble. this should be enough time for monetary, fiscal, and supervisory policies to take countermeasures to dampen the bubble and the corresponding boom in the real economy. the aim is to reduce economic and social costs once the unavoidable delivering process takes place. in academic literature the gap analysis of this paper is largely supported. the dcf model despite being somewhat controversial in this context was sending out reliable signals. the ardl model for cointegration was a truly innovative approach of this paper and provided accurate signals. as with every empirical investigation, the results are depending on the underlying time horizon. here the assumption was that the development of a major asset price bubble lasts 10 years and therefore the chosen time horizon for the measurement of the indicators was also 10 years. the author proposes a rolling 10 year analysis for all markets that shall be covered with this approach. overall, the impression is that the described approach has the potential to be a powerful detector of asset price bubbles and financial crises. clearly, this approach has to be tested for much more markets and time spans to increase the confidence in its reliability. the author has done that to some extent for the housing markets in spain, hong kong and shanghai and 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(2012), assessment of potential housing price bubbles in hong kong and shanghai – an ecletic approach. international review of business research papers, 8(6), 1-14. weingarten, b. (2010), the cause of japan`s boom and the reasons for its prolonged bust. lvm working paper. p1-15. international journal of economics and financial issues vol. 5, no. 1, 2015, pp.11-22 issn: 2146-4138 www.econjournals.com 11 fiscal policies and subnational economic growth in mexico arwiphawee srithongrung hugo wall school of public affairs wichita state university, usa. email: arwiphawee.srithongrung@wichita.edu isaac sánchez-juárez department of social sciences universidad autónoma de ciudad juárez, mexico. email: isaac.sanchez@uacj.mx abstract: this study investigates the effects of taxes and public investment on economic growth of mexican states. the subnational government finance data were drawn from 32 states during the period of 1993 to 2011. correcting for long-term trends and isolating cointegration effects between economic growth and public finance, the empirical results indicate that taxes have negative effect on growth and the effect can be seen in both transitory and permanent manners. as predicted by growth theory, the effects of public investment on subnational growth are statistically significant and positive in both short and long-runs. on the other hand, we find that educational accomplishment negatively relates to growth. foreign direct investment does not have any significant effect on subnational economic growth. in general, the results imply that an appropriate fiscal policy (equilibrium between public investment and taxes) is required to boost economic growth in this country. keywords: mexico, economic growth, taxes, public investment, states. jel classifications: o11, o23, o47, r11. 1. introduction the role of fiscal policies (i.e., taxes and spending) in subnational economic growth has been focused in numerous studies around the world, partly because there are mixed results for both impacts of taxing and spending on growth, depending on model specifications and estimation techniques. furthermore, given that subnational governments use both their own revenue sources and the resources from central government to finance public spending, it is necessary to understand in what way taxes and spending affect local growth. the purpose of this study is to: 1) to investigate the partial effects of taxes and public investment on subnational economic growth when the another side of fiscal policies is alternatively controlled for, and 2) to understand the partial effects of other exogenous variables in neoclassical growth model including education levels, population and foreign direct investment when fiscal policies are accounted in the model. the “partial effect of taxes” refers to the true effect of taxes themselves on economic growth, holding the partial effect of public spending constant. conventional beliefs and macroeconomic theory asserts that the true partial effect of taxes themselves should be negative, given that taxes distort economic agents’ production and consumption choices and, as a consequence, deadweight loss occurs in the private markets where taxes are levied. several empirical studies at the subnational levels in the united states found negative effects of taxes on growth; and hence; the empirical findings confirm conventional beliefs. in the case of mexico there are few studies that have addressed this issue and from here the originality of this paper. theoretically, public investment is expected to exhibit positive effects on growth given that public infrastructure such as road, bridges, water and sewerage systems and telecommunication infrastructure are important production factors (see for example, mankiw et al., 1992; barro and salai-martin, 2004). however, several empirical studies at the subnational levels both in the united states (for example; garcia-mila et al., 1996; holtz-eakin, 1993), and elsewhere (see for example, devarajan international journal of economics and financial issues, vol. 5, no. 1, 2015, pp.11-22 12 et al., 1996; sánchez and garcía, 2014) found either negative or insignificant effects of public infrastructure spending or public capital stocks on growth. the wrong and insignificant signs of public investment coefficients maybe due to several reasons including using inappropriate econometric approaches to analyze the panel data (kennedy, 2008). previous studies on the effects of public spending on growth, including those of helms (1985), mofidi and stone (1990); kneller et al. (1999); tomljanovich (2004) and bania et al. (2007) have addressed the issue of controlling another sides of fiscal policies as described above. however, to our knowledge, none of these papers has satisfactorily corrected econometric problems especially for integration problem that can be inherent characteristics of macroeconomic growth data. cointegration occurs when each of the time series data including taxes, spending, and economic growth levels contain strong unit roots and unfortunately all of the data series that have unit roots are simultaneously correlated; and hence, sharing the same or similar trends. several studies tried to correct unit roots but fails to address the cointegration problems (see for example reed, 2008). panel vector auto regression (pvar) method is recently used by several studies for subnational growth to control for cointegrated trends in macroeconomic data (see blanchard and perotti, 2002 and srithongrung and kriz, 2014). however, the underlying assumption for pvar method is that all variables in the model is endogenously determined by the rest of the variables in growth model. thus, the method is not appropriate for the model that incorporates some exogenously determined variables such as population growth and foreign investment. in this paper, we found that the standard panel data analyses controlling fixed or random effects are not enough to solve unit roots and cointegration problems in the subnational macroeconomic growth data. because we found strong trends in subnational public investment data and strong cointegrating trends between public spending and growth, we chose error correction model (ecm) suggested by kennedy (1998) to correct unit roots and cointegration while estimating the effects of taxes and public investment on growth. practically, we could use panel vector auto regression (pvar) method as mentioned above; however given that pvar assumes that all variables are endogenously determined by the other variables in the model; the method is not useful to analyze data in this study. in mexico, public spending by subnational governments is not completely financed by state’s own revenue sources; instead the spending is partially financed by mexico’s central government. furthermore, given that other socio-economic variables such as education, population and foreign direct investment are specified based on exogenous growth model, pvar is not chosen as appropriate method in this study. the results from ecm confirm theoretical hypotheses for the effects of taxes and public investment in both short-and long runs. the paper is organized as follows. the next section describes theoretical background and major hypotheses. the third section presents testing model and data. the following section provides results and discussion. the final section presents conclusion. 2. research background the effects of taxes on subnational economic growth previous empirical results indicated that tax has a negative effect on growth (holcombe and lacombe, 2004; mark et al., 2000; reed, 2008). theoretically, the negative effects may be either a direct effect of taxing, i.e., directly decreased citizens’ income, or an indirect effect, i.e., tax creates deadweight loss in private markets.1 however, some of the previous empirical results, especially for the studies that controlled for the effect of public spending in the same testing models, indicated that taxes had a positive effect on growth in the long-run (the growth-hills effect) (bania et al., 2007) and corporate taxes had a positive effect on per capita real gross state product (gsp) (tomljanovich, 2004). in the case of mexico, some studies have found negative impact of taxes over economic growth using an 1 deadweight loss is the sum of consumers’ and producers’ surplus that disappears after tax prices increase since taxpayers change their behavior by withdrawing their consumption (in the case of sales taxes), production (in the case of individual labor and corporate output taxes), and decisions to obtain personal properties (in the case of property taxes). christiansen (2007:25) argues that the appropriate way to determine the level of public goods provision is to evaluate the taxing regime: “taxes levied to finance public goods will inflict a loss of efficiency on society by inducing behavioral responses that are socially inefficient, even if privately rational. this is a social cost that must be added to the cost in terms of resources needed to produce the public goods”. fiscal policies and subnational economic growth in mexico 13 ols panel data model, but positive with fixed and random effects (samaniego, 2014 and caballero and lópez, 2012). canavire-bacarreza et al. (2013) using time series found that in mexico “a shock that increases collection of personal income tax by two standard deviations reduces economic growth in the short run, with a recovery and even a slight positive effect in the long run (more than 3 years).” as asserted by reed (2008), a part of these mixed results is relevant to different research methodologies. we add to this observation that another part of these mixed results is also relevant to the different underlying assumptions used in testing economic growth; namely, the “short-run” versus “long-run” growth. as discussed by diamond and moomau (2003), tax rate affects the investment demand function by changing after-tax return on capital and the supply function of investment by enhancing incentives to save more. while the first creates negative effects on growth, the latter creates positive effects on growth. according to these authors, the partial effect of tax itself is unfortunately still unclear as to whether the results will be positive or negative because the partial effect of taxes depends on the increasing level of saving and the decreasing level of investment. this opaque understanding for the roles of public finance on private investment and economic growth creates such arguments as whether public spending crowds out private investment (in mexico see for example calderón and roa, 2006). with this line of debating, we expect to choose an appropriate empirical economic growth model that allows testing of the two sides of government fiscal policies. this attempt is not new given that several studies, including those by helms (1985), mofidi and stone (1990), kneller et al. (1999), tomljanovich (2004), and bania et al. (2007) have addressed this issue. however, as mentioned above, these studies failed to control for cointegration that tends to create the wrong signs in econometric models (kennedy, 2008). furthermore, in addition to the relevancy to government spending, the net effects of taxes on growth might depend on the pre-existing condition of the taxing system. according to christiansen (2007), there are two cases of an initial taxing system: optimal and sub-optimal systems. the first asserts that the relationship between tax burden and government revenues is non-linear as portrayed by an inverted u shape. in this case, the taxing system is optimal in the pareto efficiency definition, given that it is impossible to increase the tax rate without making anyone worse off. under this optimal case, increasing the tax rate does not change the socially-aggregated utility, and thus, taxes have no significant impact on private markets. this is because the loss experienced by the group subject to a higher tax burden would be compensated by the benefits gained by the group receiving the benefits from public goods. as christiansen (2007) has pointed out, the key to understanding why aggregated social utility does not change when the tax system is efficient is to understand the consequences of having an efficient tax system at the initial point (or the term “self-selection constraints” defined by christiansen). if the taxing system is efficient or optimal in terms of having a broad base2 and being non-discriminatory,3 then there is no incentive for economic agents to change their behavior in terms of labor supply or consumption demands to avoid increased taxes. if the tax system is narrow and discriminatory, as in the latter case of the sub-optimal taxing system, there is incentive for some groups in the society to avoid a tax burden by withdrawing labor supply or substituting the highly taxed goods with lower taxed ones. this is where the deadweight loss mentioned previously occurs. in the suboptimal taxing system, the relationship between tax burden and government revenue is linear, given that changing the tax burden changes the socially aggregated utility according to the pareto inefficiency definition: it is possible to change tax rates to make someone better off without making anyone worse off (christiansen, 2007). according to christiansen (2007), under this suboptimal regime, increasing the tax rate alters the socially aggregated benefits in terms of net gain or net loss; also, there is a different cost in using taxes from different sources to fund the same public project. that is, some tax sources that have under-exploited since the beginning (or suboptimal according to the pareto efficiency definition) can exhibit a social net gain, while some tax sources that 2 a broad-base taxing system means that taxes are applied equally across all activities, goods, and services that are substitutable in the same classes. 3 a non-discriminatory taxing system means that taxes are applied unequally in terms of effective tax rate to different income classes in the society. international journal of economics and financial issues, vol. 5, no. 1, 2015, pp.11-22 14 have been over-taxed since the beginning can exhibit a social net loss when used to fund the same public project. it should be noted that the quality of the taxing system has nothing to do with the initial level of the tax burden; thus, non-linearity in terms of the initial level of the tax does not apply under this assumption. regarding the implications of the above concepts, if the coefficient of taxes is statistically significant, then the taxing system of a jurisdiction is inefficient at the beginning, thus exhibiting either positive or negative net effects depending on net-gain or net loss in using such a tax to fund different types of public spending. if the coefficients of the taxes are insignificant, then the taxing system of such jurisdiction is efficient since the beginning. empirically, reed (2008) has shown that under a robust estimation by using 5-year interval differenced data, tax burden exhibited negative effects through all estimation techniques, including pool ols with fixed state and time effects, fixed effects, random effects, general moment method, and dynamic panel data estimation. testing the long-run effects of taxes on personal income growth, bania et al. (2007) found that taxes exhibited positive effects on growth during the initial period, and then negative effects on growth during the later period. bania et al.’s (2007) full specification of government budget constraint omitted productive spending (which consists of all government spending except health and welfares and other transfers), used average data within five-year intervals (instead of differenced data which test short-run effects), and used leveled data of tax rate to personal income augmented by the squared term of tax rate to test “long-run growth hills.” bania et al. (2007) concluded that in the long-run, taxes used to fund productive expenditure which were omitted in the test have a positive net effect but later on exhibit negative net effects, depending on the taxing level during the beginning stage. unlike other studies, bania et al. (2007) used the barro-type endogenous growth model, which assumes non-linearity in estimating parameters (instead of variable values) as an underlying framework to test the endogenous effects of government fiscal policy. based on the previous empirical results, we assert that the taxing system at the subnational levels in mexico is unlikely to be optimal; thus, the positive or negative net effects of taxes are likely the case. as christiansen (2007) puts it, even with well-defined social objectives and well-established decision-making institutions, failure to achieve an optimal taxing system will occur due to asymmetric information in the decision-making process, let alone political, institutional, and administrative constraints. therefore, for this study, our first hypothesis is that taxing exhibits negative effects on economic growth both in short and long runs given that there is a social cost in producing public services and the cost paid by private sector affects saving and investment decisions. the effects of public investment spending on subnational economic growth regarding capital investment, which is one of the main focuses in this study, the studies in the u.s. during the early period (aschauer, 1990; munnell, 1990; costa et al., 1986) indicated significant and positive effects of public infrastructure spending or public infrastructure stocks on subnational growth. the models in these studies did not control for simultaneous effects between dependent and independent variables (aschauer, 1990), state and time fixed effects (aschauer, 1990; munnell, 1990), fixed time effects (costa et al., 1986), existing public capital stocks (munnell, 1990; costa et al., 1986), or public capital spending levels (aschauer, 1990). these studies obtained significant and large effects of public capital on growth (elasticity ranging from 0.15 to 1.96). furthermore, the adjusted rsquared in these models was extremely large (about 0.99), which signals autocorrelation due to uncontrolled unit roots in the time series data. when the flaws in these models were corrected, public capital stocks or spending exhibited significant but small effects on growth .01 for holtz-eakin and schwartz (1995), using the non-linear seemingly unrelated technique and .02 for lobo and rantisi (1999), using lsdv or insignificant impacts on growth for garcia-mila, mcguire, and porter (1996), using the general least square method and the two-stage least square method, and for moomaw et al. (2002) using lsdv. however, when a more recent method, such as the vector auto regression (var) technique which corrects simultaneous effects between dependent and independent variables due to co-integration and persistent trends in the lagged residuals, was used, pereira and andraz (2003) again found that public investment had significant and positive impacts on private output. for the types of capital spending, lobo and rantisi (1999) found that public capital stocks, total public transportation capital outlays, and total public capital outlays, excluding transportation, significantly and positively affected wage growth rates in 261 u.s. metropolitan areas during the period of 1977 to 1992. in the same study, lobo and rantisi (1999) found that total public sanitarian fiscal policies and subnational economic growth in mexico 15 outlays significantly but negatively affected the wage growth rate in the same areas and during the same time period. prior to the correction of endogeneity, garcia-mila and mcguire (1992) found that transportation systems, including highways and airports, have larger effects on state economic productivity relative to education than other types of infrastructure systems. although these studies had some empirical flaws, they imply that different funding across infrastructure service function types yields different effects on economic outputs. growth theories and empirical evidence (i.e. vijverberge et al., 1997; pinnoi, 1994) explain that public infrastructure increases productivity outputs by reducing private sector costs in the production process. this implies that different types of public spending that serve different functions for private production yield different social benefits for private outputs (for the case of mexico check the works of sánchez and garcía, 2014; caballero and lópez, 2012; hernández, 2010; nuñez, 2006). thus, the second hypothesis for this study is that when the negative effects of taxes and cointegration trends are isolated public investment spending is positively related to state economic growth in mexico given that public infrastructure reduces private production cost. the next section presents testing model and data. 3. methodology and data in their study on the role of government taxing and spending on growth, kneller et al. (1999) suggested that a government’s combined tax and service package is only one variable in the growth model; other non-fiscal variables, such as resource endowment, technological advancement in the local area, time period, and labor growth rates, are other inputs in the growth equation. thus, kneller et al.’s (1999:174) account of growth is: 1 1 k m i it j jt t i j a b y x u         (1) where; y represents non-fiscal variables, x is a government’s combined tax and spending policy, and u is error terms. using the growth account by kneller et al. (1999), equation (1) is rewritten: itit m j m j iitittiititittiitit tbsboexbntrbcbbkbnblba ,, 1 1 1 1 9,8,7,6,5,4,32,1, lnlnln         ………(2) where; it,ln is an annual growth rate of real gross domestic product (gdp) year t-1 to year t in state i ∆ itl ,ln is an annual change of labor quality measured by the changes in average level of educational accomplishment in year year t-1 to year t for state i, ∆ itn ,ln is an annual change in the number of population in year t-1 to year t for state i, ∆ itk ,ln is an annual change in private investment measured by the ratio of foreign direct investment to gdp in year t-1 to year t for state i, ∆ it , is annual change in tax burden measured by the ratio of total taxes (including income, sales, and property) to gdp in year t-1 to year t for state i,4 ∆ itc , is annual change in the ratio of public investment (i.e., government capital outlays) to real gdp in year t-1 to year t for state i, ∆ itntr , (omitted) is annual change in the ratio of total non-tax revenue including intergovernmental revenue and and other central government grants sent to state governments to gdp in year t-1 to year t for state i, ∆ itoex, (omitted) is annual change in the ratio of annual state government expenditure on operational spending to real gdp year t-1 to year t for state i,, 4 we followed reed (2008) in measuring percent of tax and spending to personal income by using the fiscal variables in year t and personal income variable in year t-1 given that the fiscal data were recorded according to fiscal year and the personal income data were recorded according to calendar year. international journal of economics and financial issues, vol. 5, no. 1, 2015, pp.11-22 16 as shown in the equation description above, we following kneller et al. (1999)’s budget constraint model by omitting a category in revenue and expenditure which are ∆ itntr , and ∆ itoex, , respectively to avoid perfect collinearity within taxing and spending categories. endogeneity, unit roots and cointegration problems in panel data endogeneity relationship between dependent variable (annual change in gdp growth) and independent variables (annual changes in the ratio of tax and public investment to gdp) may exist if the variables on the left and the right hand sides of the equation come from the same time period. to control for endogeneity, one-period lagged independent variables are specified to create an overlapped space between fiscal policies and compound growth of gdp in the subsequence periods. this is standard approach to deal with endogeneity (e.g. see garcia-milla and mcguire, 1992; tomljanovich, 2004; dye and feiock, 1995; bleaney et al., 2001). table 1 presents summary statistics for the data used in this study. empirical estimations were carried out using panel data for the period 1993 to 2011 for the 32 mexican states. all monetary data are in mexican pesos and in constant value based year 1993 to control for inflation effect. table 1. summary statistics variable total observations mean std. dev. min max gross domestic product (in million pesos, real value based year 1993) 608 46,700,000 59,400,000 5,859,721 376,000,000 average education level (year) 608 7.68 1.10 4.53 10.63 total population 608 3,127,930 2,675,375 353,348 15,200,000 foreign direct investment (pesos, real value based year 1993) 608 1,520,000,000 5,200,000,000 1,310,000,000 55,900,000,000 total taxes (pesos, real value based year 1993) 608 727,000,000 2,000,000,000 2,437,989 17,300,000,000 total public investment (pesos, real value based year 1993) 608 394,000,000 424,000,000 4,904,238 3,500,000,000 ratio of total public investment to total gdp (in million pesos) 608 0.00001 0.00001 0.00000 0.00006 ratio of total taxes to total gdp (in million pesos) 608 0.00002 0.00004 0.00000 0.00030 ratio of total foreign direct investment to total gdp (in million pesos) 608 0.00002 0.00003 -0.00002 0.00023 ratio of total public investment to total gdp 608 10.6 8.8 1.0 62.0 ratio of total taxes to total gdp 608 16.5 43.9 0.0 296.0 ratio of total foreign direct investment to total gdp 608 17.1 25.2 -23.0 232.0 table 2 presents unit root test and cointegration statistics. as presented in the table four of six variables including gdp, public investment, taxes and education contain unit roots. as presented in table 2, cointegration exists for the series of log gdp and public investment, the series of log gdp and taxes, and the series of gdp and education. to circumvent the unit root and cointegration problems, we used kennedy’s (2003) ecm technique, which relies on using differentiation to purge the serial correlation whereby data in the current year are explained by data in the previous year. to fiscal policies and subnational economic growth in mexico 17 control for cointegration, which is the relationship between the x variables and y (i.e., when the x values increase, y increases), the ecm model includes an error correction term. the error correction terms are the difference between dependent variable y and each independent variable x. these error correction terms catch the effects of cointegration between x’s and y so that the coefficients of the main variable take only the effects of unit change within that variable into account, rather than including the cointegration effects. table 2. levin-lin-chu unit root and cointegration test statistics ho: panels contain unit roots number of panels: 32 ha: panels are stationary number of periods: 19 autoregression parameter: common panel means: included time trend: not included adf regressions: 1 lag lr variance: bartlett kernel, 8 lags average (chosen by llc) unit root test t-statistics p-value log gdp 0.286 0.612 public investment 1.391 0.917 taxes 0.804 0.789 education 3.589 0.999 foreign direct investment -7.264 0.000 population -4.254 0.000 cointegration test t-statistics p-value log gdp ratio of public investment to gdp 13.328 1.000 log gdp ratio of taxes to gdp 8.438 1.000 log gdp log education 5.315 1.000 owing to use of the ecm technique, all variables in the model entered regression in difference values. the ratios of taxes and foreign direct investment, the mean of educational level, and total number of population are integrated at one level while real gdp value and the ratio of public investment are integrated two levels. the first difference in tax burden, capital stocks, education and population and the second difference of public investment and gdp growth are statistically determined by bayes information criterion (bic). bic chooses the length of the difference interval by judging from the magnitude of increasing r2 and the decreasing sum of squared residuals when one more lag is added to the regressing lagged dependent variable against the current-year dependent variable (stock and watson, 2007). due to unit root and cointegration correction, equation 2 is modified and re-written as shown in equation (3) below. ∆ , = + ∆ , + ∆ , + ∆ , + ∆ , ) + ∆ , + ( − 1 , − , + ( − 1) , − , + ( − 1) , − , + ∑ + , + , -------------(3) where; , is one period lagged residuals or autocorrelation in the model. equation 3 presents the final testing model for this study. in this ecm equation, there are two sets of the independent variables. the first set comprises the differenced independent variables (e.g. , − , ); the second set comprises the error correction terms (e.g. , − , ) that are added to restore equilibrium in the econometric model. in the ecm, when the error terms or the differenced values between dependent and independent variables in the previous period or series are added into the model, the unit roots of independent and dependent variables are canceled out (kennedy, 2003). meanwhile, the leveled data of these independent variables restore equilibrium lost due to the use of differenced independent values. the coefficient for the first set of independent variables, representing the difference between data for the previous and the current period, indicates international journal of economics and financial issues, vol. 5, no. 1, 2015, pp.11-22 18 the short-term effect of the independent variables on growth within the equilibrium model. the coefficients of the second set of independent variables, the error correction terms, were also derived from the regression models and are available on request. the coefficients of the error correction terms are significant at the 0.01 level. the significance of the error correction terms indicates that cointegration does exist in the testing models; however, this was controlled for by adding the error correction terms and residuals from unit root tests into the test equation. the regression results reported in the next section reflect the pure effects of fiscal policies on growth, because we control for unit roots in the time series data and for cointegration problems. 4. empirical results and discussion table 3 presents the results from the ecm model. column 1 of the table presents the results from the base model in which fiscal variables, taxes and public investment were omitted as the based case to see the effect of production inputs on gdp. in the short-run, population is significant and has negative effect on gdp growth; population effect is no longer significant when public investment was added in to the model as shown in columns 3 and 4. this implies that total number of population decreases available resources for production inputs; however when public investment is added, production inputs are increasing and hence the effect of population is diminished. like population, the average level of education accomplishment is significant and negatively affect gdp growth; however when public investment is added into the model, the effect of education becomes positive although insignificant in the short run, as shown in columns 3 and 4. in the long-run, it may be seen that educational accomplishment reduces gdp growth which is counter-intuitive finding given that educated workforce should help instead of hurt an economy. however, when considered that labor stock quantity and quality are substitutable by capital stock, the long-run negative effect of education on growth is possible. column 2 presents the partial effect of tax on real gdp growth when all production inputs are controlled for and public investment is omitted. as shown in the column, taxes exhibits negative effects on growth for both short and long-run. given that tax variable enters the regression model in a form of ratio of tax to total gdp while the dependent variable log gdp is entered the model in a form of million pesos value (i.e., lny * 1,000,000), the interpretation for the coefficient of tax is calculated by %.5 as seen in column two, for every percent increase in tax burden, the total gdp drops for 1.03% in the short-run and this effect is carried on as the coefficient of the long-term trend for taxes is statistically significant at 0.01 level. this result is consistent with the conventional belief and theory that government tax collection produces a negative effect on growth because the private resources are transferred through the public and there is a deadweight loss in the free market. column 3 presents the partial effect of public investment on real gdp growth when all production inputs are controlled for and tax variable is omitted. as shown in the column, public investment exhibits positive effect on growth for both short and long-run. given that public investment variable enters the regression model in a form of ratio of public investment to total gdp while the dependent variable log gdp is entered the model in a form of million pesos value (i.e. lny * 1,000,000), the interpretation for the coefficient of tax is calculated by %. as seen in column three, for every percent increase in public investment, the total gdp increase for 5.27% in the short-run and this effect is carried on as the coefficient of the long-term trend for taxes is statistically significant at 0.01 level. these findings correspond with the general belief that public capital outlay simply spurs the economy. 5 see stock and watson (2010:268-269). the coefficient b in log linear model is calculated such that 100 * b %. in this study, the ratio of tax to gdp was calculated by dividing total taxes to total gdp; while log gdp is entered regression model in a million pesos value. thus the interpretation for the coefficients b for the ratio of taxes and public investment is divided by 1,000,000 before converting into percentage term. fiscal policies and subnational economic growth in mexico 19 table 3. empirical results base model without fiscal variables taxes public investment taxes and public investment dependent variable: difference value of real gdp, ∆ , constant 3.848*** 5.012*** 0.457 2.948*** (0.687) (0.482) (0.874) (0.592) change in education level, ∆ , -1.18 -0.982 0.297 0.479 (1.142) (1.14) (0.990) (0.986) change in population level , ∆ , -4.489*** -14.51*** 4.111 3.781 (1.873) (1.861) (2.878) (2.844) change in foreign direct investment , ∆ , 23.581 34.131 -30.825 -22.133 (95.535) (95.33) (91.888) (91.694) change in taxes, ∆ , ---103.34** ---91.491** (45.302) (41.82) change in public investment, ∆ , ----527.96** 527.094** (238.52) (237.796) long-term trend for education level, -0.576*** -0.572*** -1.130*** -1.113*** , − , (0.094) (0.093) (0.136) (0.134) long-term trend for taxes ---0.446** ---0.69** , − , (0.090) (0.093) long-term trend for public investment ----1.045*** 1.029*** , − , (0.149) (0.148) model f-stats (4, 475) (6, 474) (6,474) (7,441) 71.21 60.39 27.53 24.64 prob > f 0.0000 0.0000 0.0000 0.0000 r-squared: within 0.428 0.433 0.304 0.031 between 0.081 0.081 0.023 0.024 overall 0.002 0.002 0.007 0.007 corr (u_i, xb) -0.99 -0.99 -0.98 -0.98 prob > f for the test that all u_i = 0 0.0000 0.0000 0.0000 0.0000 rho_ar , -0.449 -0.448 -0.321 -0.316 fixed effect included yes yes yes yes number of observation 512 512 480 480 number of groups 32 32 32 32 *note: ** refers to .05 statistical significance level and *** refers to .01 statistical significance level the last column of the table presents the net effect of taxes and public investment on real gdp growth when all production inputs and fiscal variables are controlled for. as shown in the column, public investment exhibits positive effect on growth for both short and long-run and tax exhibits negative effect on growth in both short and long-run. given that public investment and taxes variables enter the regression model in a form of ratio of public investment to total gdp and the ratio of taxes to gdp, respectively, while the dependent variable log gdp is entered the model in a form of million international journal of economics and financial issues, vol. 5, no. 1, 2015, pp.11-22 20 pesos value (i.e., lny * 1,000,000), the interpretation for the coefficient of tax and public investment is calculated by % and %, respectively. as seen in the last column of the table, for every percent increase in public investment ratio, the total gdp increase for 5.27% in the shortrun and for every percent increase in tax ratio, the total gdp drops for about 0.91 percent in the shortrun. the effects of public investment and taxes are carried on as the coefficients of tax and public investment variables in the long-term trends are statistically significant at 0.01 level. it should be noted that the effects of each of the public investment is positive in all cases no matter tax is included or not included in the models although the coefficient of tax drops slightly from 1.03% to 0.91% when public investment is included in the model. 5. conclusions this paper investigates the effect of taxes and public investment on state economic growth in mexico. this paper is different than the previous regional economic growth papers in that the estimation approach namely: error correction model (ecm) is used to correct unit roots and cointegration that tends to occur in macroeconomic panel data. the cointegration can generate spurious correlation between public spending and gdp and taxes and gdp and tends to produce the wrong signs. using budget constraint model as an underlying assumption for subnational economic growth model as suggested by kneller et al. (1999), the empirical results indicate that tax has negative impact on gdp growth in both short and long-run, while public investment has positive impacts on gdp growth in both short and long-runs. the effects of taxes range between -1.03 percent to -0.91% for every percent increase to total gdp, while the effect of public investment is at about 5.27% for every percent increase to total gdp. education accomplishment has negative impact on gdp in the long-run while has insignificant effect in the short-run. this result suggests that labor quality and quantity may be able to substitute for other production inputs such as public investment and the effect of input substitution can be seen only in the long-run. for policy makers and government practitioners, especially at the subnational level in mexico, the results in this study suggest that public finance can be used to stabilize regional growth while foreign direct investment is not useful in influencing growth. given that foreign direct investment depends on the economies outside the mexican states, it is difficult to intervene to enhance growth. instead of focusing on economic development incentives to attract foreign investment, it may be more worthwhile to spend regional economic development effort by re-allocating public resources, especially on public infrastructure, into the states where needs are the most to allow the underdeveloped states to catch up with developed states and hence the growth is even out across the country. for literature the results adds to subnational growth literature that public investment is another inputs in production function. furthermore, when the cointegration trend is controlled for, there is no evidence supporting the assumption that public investment crowds out private investment. references aschauer, d. 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(1997), public capital and private productivity. the review of economics and statistics, 79(2), 267-278. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(3), 64-71. international journal of economics and financial issues | vol 11 • issue 3 • 202164 analysis the effect of coconut production risk and price on the economic behavior of coconut farmers in seruyan district, central borneo province, indonesia rusdi1*, harianto2, sri hartoyo3, tanti novianti3 1departmen of accounting, faculty of economics, pamulang university, jl. surya kencana no.1, kota tangerang selatan, banten, indonesia, 2department of agribusiness, faculty of economics and management, ipb university, indonesia, 3department of economics, faculty of economics and management, ipb university, indonesia. *email: rusdi.msi@gmail.com received: 19 febraury 2021 accepted: 26 april 2021 doi: https://doi.org/10.32479/ijefi.11340 abstract coconut farmers are always faced with risks, including the risk of production and price risk. this production risk causes the productivity of the head to decline. in addition, the price risk faced by farmers will also have an impact on the income received so that in the end it will affect the farmer household decision making in allocating existing resources. the purpose of this study was to analyze the effect of changes in the level of production risk and price on farmer household behavior in coconut farming production decisions. this research was conducted in seruyan district, central borneo province with 200 farmers as respondents. the results showed that there was a risk that production would increase the use of herbicides, reduce the allocation of time to use male labor in the family on family farms and increase the use of male labor from outside the family and reduce spending on health, education and household savings. meanwhile, the price risk will result in reduced use of female labor from outside the family, reduced nonfood, education expenditure and reduced business investment. keywords: coconut farmer household economic behavior, production risk, price risk jel classifications: d10, d13, d14, q12 1. introduction coconut farmers are always faced with risks, including the risk of production and price risk. indications of the existence of production risk and prices are shown by the ups and downs of production and the prices received by coconut farmers every season. the existence of this production risk causes the productivity of the head to decrease. as for coconut production, as a whole, the production of coconut plantations in the district of seruyan in 2013 was 3360.2 tonnes/year and in 2014 it was 974.38 tonnes/year (bps seruyan, 2017). the main sources of risk that are generally felt by farmers include uncertainty of weather, pests and diseases and uncertainty of product prices (patrick et al., 1985). there are several risks faced by coconut farmers that often arise, namely the uncertainty of coconut prices. the risk of product prices causes the price obtained by coconut farmer households to fluctuate. the product price risk is largely determined by the strength of demand and coconut retention in the market. based on observations in the field of coconut prices in february 2019, it was 1500/coconut. even at the end of 2018 the price of coconut reached 800/coconut. this condition will result in a decrease in coconut peni household income. in addition to on-farm farming activities, coconut farmers allocate labor from their family members to activities outside of off-farm farming and outside non-farm farming, with these activities, coconut farmers household income will be used for daily consumption. with this production and price risk, it will affect the this journal is licensed under a creative commons attribution 4.0 international license rusdi, et al.: analysis the effect of coconut production risk and price on the economic behavior of coconut farmers in seruyan district, central borneo province, indonesia international journal of economics and financial issues | vol 11 • issue 3 • 2021 65 economic behavior of coconut farmer households both in making decisions on production, consumption and allocation of labor. nakajima (1986) states that one of the important aspects in assessing the agricultural sector in developing countries is the characteristics of the farm household as an interrelated economic unit. public policies directed at farmers or farms certainly need to pay attention to the behavior of these farmers’ decision-making, so that the policies taken can achieve their goals effectively and efficiently. various research results indicate that the existence of production and price risks will have an impact on decreasing production and household income. so that in the end it will affect the farmer household decision making in allocating existing resources (ellis, 1988; harwood et al., 1999 fariyanti et al., 2007; hartoyo et al., 2004; jufri et al., 2018). therefore, it is important to conduct research on household economic behavior due to the risk of production and prices in coconut farming. so that the purpose of this study is to analyze the effect of production risk and price on coconut farmer household economic performance and the factors that affect production, use of labor, and household expenditure. 2. literature review in the research of beach et al. (2008) formulated the elements of production risk and product price risk in the model of farmer household economic behavior. in which it assumes the present value of utility expectations with constraints of time, production function and budget. farm households have the following objective functions: ( )-rtmax e eu t dt∫ (1) if production and prices are stochastic, then household utility will depend on expectations and variance in the consumption level (c), the availability of leisure time (tl) and the characteristics of the farmer household (zh) as follows: eu=u(e (c), var (c), tl; zh) (2) assumed dan u u > 0 å £ (c) v 0 ar (c) ∂ ∂ ∂ ∂ . if the farmer household allocates labor resources in the family and the cultivated land it owns to manage the farm in producing a commodity by combining output for each period, the constraints are as follows: 1. time constraints: t=tf+to+tl, to≥0 (3) 2. production function: q=q(n, tf, lf, x, ε) (4) 3. budget constraints: pq q+wo to+y=px x+wh hf+pn n+pc c (5) where t is the total time for the household, tf is the time for the household to work on the farm, to is the time for the household to work outside the farm, tl is the time for the household to relax (leisure), q is the output, n is the area of land, lf is the labor rent, xi is the input of production, ε is the risk, pq is the price of output, pc is the price of consumer goods, wo is the wage of non-farm labor, px is the input price, wh is the wage of rented labor, pn is the price of land, y is income not from work, and c is a consumer good. production and prices are assumed to be sources of uncertainty, farmers often experience uncertainty in production prices when making decisions on production activities. the risk that is often faced by farmer households in cultivating farming is the risk of production, this appears due to weather, pests and plant diseases. if it is assumed that there is no joint product, the production function is as follows: qi=qi (ni, tfi, lfi, xi, εi) (6) in this research, the commodity under study is coconut, this commodity is the most dominant commodity cultivated by farmer households in the district of the district, the sub-district of the lower east, east borneo, central borneo. if it is assumed that the uncertainty of production is a multiplication, then the production function is as follows: qi=εi qi (ni, tfi, lfi, xi) (7) where are the expectations e(εi)=μ; variance var (εi)=σi 2 (8) furthermore, with the production function shown in equation (4), the current period profit function for coconut farming activities is written as follows: π=∑i (pqi εi qi (•)–wf tfi–wh lfi–px xi–pn n) (9) in this case wf shows the time value used by the farmer household in coconut farming. given the production risk and price defined as e (pi) = θi and the price variance as var (pi) = φi2, the expected profit can be written as follows: e(π)=∑[θi μi qi (•)–wf tfi–wh lfi–pxxi–pn n] (10) the expected profit variance can be written as follows ( )2 2 2 2 2 2 21 i i i i i ii q • (var( ) )= + +ϕ σ ϕ µ θ σπ ∑ (11) furthermore, the lagrangian function of the model can be written as follows: l ≡ u(e(c), var (c), tl; zh) λ [θi μi q(n, tf, lf, x)–px x–pn n–wh lf +wo to+v–pc c]+τ [t–tf–to–tl]+μto (12) when the conditions are optimal, the function of demand for input and supply of output can be derived by applying the kuhn tucker condition, which is as follows: rusdi, et al.: analysis the effect of coconut production risk and price on the economic behavior of coconut farmers in seruyan district, central borneo province, indonesia international journal of economics and financial issues | vol 11 • issue 3 • 202166 ni=ni (θi, φi 2, μi 2, σi 2, wh, px, wo, at–1, zh) (13) tfi=tfi (θi, φi 2, μi 2, σi 2, wh, px, wo, at–1, zh) (14) to=to (θi, φi 2, μi 2, σi 2, wh, px, wo, at–1, zh) (15) lf=lf (θi, φi 2, μi 2, σi 2, wh, px, wo, at–1, zh) (16) the function of input demand includes production for land area (ni), labor for coconut farming (tf), labor outside coconut farming (to), labor hired for coconut farming (lf) and other variable inputs such as fertilizers and pesticides. thus, the demand function on the expected goods consumed (c) is influenced by the variables mentioned above, non-work income (v) and the price of consumer goods (pc). 3. methods this research was conducted in seruyan regency, central borneo province purposively with the consideration that seruyan regency is one of the main coconut producing districts in central borneo province. the data used in this study are primary data and secondary data. primary data is cross section data for the 2019 planting season. data was obtained by conducting direct interviews with 200 coconut farmer households using a questionnaire prepared by the researcher. meanwhile, secondary data was obtained from several related agencies, such as the ministry of agriculture, the central bureau of statistics and other sources. this data is used to support the analysis in this study. coconut farmer household economic model 1. production prod=a0+a1*pugm+a2*hbsa+a3*jbkp+a4*tpdk+a5*t wdk+a6*ttlk+a7*lutk+a8*sdpk+e1 (17) 2. input usage pugm=b0+b1*jbkp+b2*hugm+b3*umpk+b4*tbuk+b5 *sdpk+b6*expk+e2 (18) hbsa=c0+c1*hhbs+c2*lhkp+c3*ttdk+c4*ttlk+c5*s dpk+c6*exhk+e3 (19) 3. use of labor tpdk=d0+d1*tbuk+d2*tpnp+d3*exhk+d4*expk+d5* sdpk+e4 (20) twdk=e0+e1*tbuk+e2*twnp+e3*exhk+e4*expk+e5* sdpk+e5 (21) ttdk=tpdk+twdk (22) tplk=f0+f1*jbkp+f2*utlk+f3*ptuk+f4*tpdk+f5*ex hk+f6*sdpk+e6 (23) twlk=g0+g1*lhkp+g2*tplk+g3*expk+g4*sdhk+e7 (24) ttlk=tplk+twlk (25) 4. spending kopg=h0+h1*jmak+h2*tprt+h3*expk+h4*umpk+h5* ttdk +e8 (26) knpg=i0+i1*kopg+i2*tbuk+i3*exhk+i4*sdhk+e9 (27) tkon=kopg+knpg (28) pkes=j0+j1*jmak+j2*tprt+j3*peis+j4*sdpk+j5*ppen +e10 ppen=k0+k1*jase+k2*pelk+k3*expk+k4*sdhk+k5*s dpk+k6*tprt+k7*jmak+k8*tkon+e11 (29) tran=tkon+pkes+ppen (30) tabp=l0+l1*tran+l2*tprt+l3*peis+l4*exhk+l5*sdpk +e12 (31) inves=m0+m1*tabp+m2*jpnp+m3*jput+m4*peis*m5* exhk+m6*expk+m7*sdhk+e1 (32) 3.1. variables description • prod = coconut productivity • exhk = coconut price expectations • expk = coconut production expectations • sdhk = coconut price risk • sdpk = coconut production risks • pugm = use of salt • hbsa = use of herbicides • tpdk = the use of male labor in the family in coconut farming • twdk = the use of female labor in the family in coconut farming • ttdk = total use of labor in the family in coconut farming • tplk = the use of male labor outside the family in coconut farming • twlk = the use of female labor outside the family in coconut farming • ttlk = the total use of labor outside the family in coconut farming • tpnp = the use of male labor in the family in non-agricultural activities • twnp = the use of female labor in the family in nonagricultural activities • ptuk = coconut farming income • tbuk = total cost of coconut farming • jput = total income from farming activities • jpnp = total income from non-agricultural activities • tprt = total household income • kopg = food consumption • knpg = non-food consumption • tkon = total consumption • pkes = health expenses • ppen = education expenditure • tran = total expenses • tabp = savings • inves = business investment • jbkp = number of productive coconut stems • lhkp = coconut land area • umpk = farmer’s age • peis = wife’s education • pelk = husband’s education • lutk = old coconut farming business • utlk = male labor wages for farming activities • hugm = price of salt • hhbs = herbicide prices • jase = number of school children • jmak= number of family members. rusdi, et al.: analysis the effect of coconut production risk and price on the economic behavior of coconut farmers in seruyan district, central borneo province, indonesia international journal of economics and financial issues | vol 11 • issue 3 • 2021 67 3.2. model identification the coconut farmer household economic model in this study consists of 17 equations (g) with details of 13 structural equations and 4 identity equations. the model consists of 17 endogenous variables and 25 exogenous variables so that the total variables are 42 variables (k). the maximum number of variables in the equation is 8 variables (m). if (k-m) is greater than (g-1), the excess identified equation is said to be over-identified and can be estimated using 2sls or 3sls (koutsoyiannis, 1977). it can be concluded that all structural equations are over identified. based on the terms of the order condition, the model is over-identified, so the method used is the two-stage least squares method (2sls). data processing used statistical analysis system/econometric time series (sas/ets) software version 9.3. 4. results and discussion the characteristics of respondents in this study consisted of age, education, experience in coconut farming, and coconut land area which are presented in table 1. based on the results of interviews with 200 farmers, the age of coconut farmers is mostly in the age group 41-50 years and 51-60 years. with each percentage of 31.00 percent. in addition, there are 10 percent of farmers who are under the age group of 30 years, this shows that coconut farming is still in demand by young people. furthermore, education for coconut farmers is mostly between 1 year and 6 years or equivalent to elementary school (33.00 percent). however, there are still farmers who do not get formal education (6.00 percent) and some have even educated up to tertiary education (2.00 percent). meanwhile, the experience of coconut farming shows that the majority of coconut farmers in seruyan regency have experience in farming coconuts between 11 and 20 years, amounting to 38.00 percent. in addition, there are 21.00 percent of farmers with less than 10 years of coconut farming experience. the last characteristic is the area of coconut land, where land is the most important natural resource in agricultural cultivation. based on the area of land tenure, in the research area the area of land cultivated for coconut farming is 2.8 hectares on average. where most coconut farmers (38.00 percent) cultivate land more than 2 hectares or classified as large land. 4.1. the influence of production risk and coconut price on economic behavior of coconut farmers household coconut farmer household economic behavior in this study is approached by simultaneous equations. the estimation results of the coconut farmer household economic model are presented in table 2. in terms of criteria economy, the estimated parameter sign in the two equations is in accordance with the proposed hypothesis. the coefficient of determination (r2) ranges from 0.08512 to 0.93499. this shows that the existence of exogenous variables in the equation behavior is able to explain endogenous variables well. based on table 2, it is known that the coconut productivity equation (prod) is significantly influenced by the use of herbicides (hbsa), the number of productive coconut stems (jbkp), the total labor outside the family (ttlk) and the length of coconut farming (lutk). the amount of herbicide use has a positive effect on coconut productivity, which means that the more herbicides used, the coconut productivity will increase. furthermore, the number of productive coconut stems also has a positive effect on coconut productivity. the results of research by muyengi et al. (2015), wulandari et al. (2018) show that the number of productive coconut stems will increase coconut production. the same thing is also shown by the effect of the total use of labor outside of work which also has a positive effect. increasing the number of workers will increase the maintenance of the coconut plantation area owned by farmers, so that the production results obtained are also more and more. the salt use equation (pugm) shows that the number of productive coconut stems (jbkp), age of coconut farmers (umpk), and coconut production expectations (expk) have a significant effect on the use of salt in coconut farming. the effect of changes in the number of productive coconut stems on the use of salt has a positive sign. this is in accordance with the production theory, where the need for salt will increase along with the increase in the number of productive coconut stems. in addition, production expectations also have a positive effect, where if coconut production expectations increase, it will increase the use of salt. and the characteristics of coconut business, namely the number of productive coconut stems. the use of herbicides (hbsa) by coconut farmer households shows farmer household demand for herbicides for coconut farming. the estimation results of the herbicide use equation show that the area of coconut land (lhkp), the total use of outside labor (ttlk) and the risk of coconut production (sdpk) significantly influence the use of herbicides with positive signs. coconut farmer household behavior in using herbicides is very much determined by farming characteristics such as the area of coconut land. increasing coconut land area will encourage farmer households to increase the use of herbicides. the average use of herbicides in coconut farmer households is 4.66 l/ha/ table 1: characteristics of coconut farmers in seruyan regency in 2020 no characteristics of farmers number of farmers percentage 1 age of farmer (year) ≤30 20 10.00 31-40 45 22.50 41-50 62 31.00 51-60 62 31.00 >60 11 5.50 2 level of education did not finish elementary school 12 6.00 elementary school 66 33.00 junior high school 57 28.50 senior high school 61 30.50 college 4 2.00 3 coconut farming experience (year) ≤10 42 21.00 11-20 76 38.00 21-30 44 22.00 31-40 27 13.50 41-50 11 5.50 4 coconut land area (ha) ≤1.0 60 30.00 1.01-2.0 64 32.00 >2.0 76 38.00 source: primary data processed, 2021 rusdi, et al.: analysis the effect of coconut production risk and price on the economic behavior of coconut farmers in seruyan district, central borneo province, indonesia international journal of economics and financial issues | vol 11 • issue 3 • 202168 year. the coconut production risk variable (sdpk) also has a positive effect on the use of herbicides. this shows that the behavior of coconut farmer households in using herbicides is also very much determined by the level of risk in coconut production faced by farmers. the risk of increasing coconut production will encourage farmer households to increase the use of herbicides. increased use of herbicides is a form of risk management carried out by farmers. by increasing the use of herbicides, it is hoped that it can reduce weeds that disturb coconut plants so that it will be able to increase coconut production. the similarity in the use of male labor in the family in coconut farming (tpdk) is significantly influenced by the use of male labor in the family for non-agricultural activities (tpnp) and the risk of coconut production (sdpk). the use of male labor in the family in coconut farming is very responsive to changes in the use of male labor in non-agricultural activities. coconut farmer household decision making in allocating male labor to coconut farming activities is largely determined by the use of male labor in non-agricultural activities. coconut farmer households will reduce the use of male labor in the family in coconut farming activities if the use of male labor in non-agricultural activities increases. this result is almost the same as the research result of nurhayati et al. (2012) stated that an increase in the outpouring of work outside of farming will reduce the time spent on farming activities. furthermore, the risk of coconut production (sdpk) which has a equation parameters estimate parameters t‑value pr>|t| pkes r2=0.08512 f value=3.61 d-w=1.8912 intercept 29.72724 3.56 0.0005 jmak 0.096584 0.06 0.9507 tprt 1.233e–7* 1.78 0.0765 peis 0.236364 0.40 0.6884 sdpk –0.00235** –2.20 0.0289 ppen –0.123050** –2.11 0.0364 ppend r2=0.15665 f value=4.43 d-w=2.009437 intercept –140.379 –3.16 0.0018 jase 2.830980 0.40 0.6922 pelk 1.571150 0.91 0.3664 expk 0.008371*** 2.71 0.0074 sdhk –0.03058 –0.60 0.5497 sdpk –0.00742* –1.80 0.0736 tprt 9.615e–8 0.39 0.6947 jmak 8.540021* 1.75 0.0822 tkon –0.415267** –2.49 0.0137 tabp r2=0.26058 f value=13.67 d-w=1.712227 intercept –144.751 –1.79 0.0743 tran 0.148523* 1.69 0.0929 tprt 1.309e– 6*** 4.98 <0.0001 peis 2.948420 1.39 0.1647 exhk 0.086809** 2.27 0.0244 sdpk –0.00321 –0.81 0.4161 inves r2=0.65672 f value=52.47 d-w=1.893637 intercept –183.877 –1.19 0.2340 tabp –1.10186* –1.70 0.0906 jpnp 0.691828*** 6.22 <0.0001 jput 7.994e– 6*** 6.44 <0.0001 peis 0.480156 0.12 0.9067 exhk 0.055406 0.68 0.4997 expk 0.001500 0.27 0.7849 sdhk –0.11600 –1.04 0.2986 source: primary data processed, 2021. ***significant α 1%. **significant α 5%. *significant α 10% table 2: (continued) equation parameters estimate parameters t‑value pr>|t| production prod r2=0.27606 f value=9.10 d-w=1.802844 intercept 6994.042** 2.58 0.0105 pugm –19.8174 –1.29 0.1977 hbsa –1165.15*** –4.21 <0.0001 jbkp 17.32798* 1.75 0.0818 tpdk 7.917620 0.88 0.3805 twdk 137.4638 1.58 0.1168 ttlk 68.79406*** 7.04 <.0001 lutk 64.13696* 1.66 0.0978 input usage hugm r2=0.87491 f value=224.98 d-w=1.958383 intercept –45.6304 –0.97 0.3345 jbkp 0.496588*** 12.71 <0.0001 hugm 0.002023 0.24 0.8078 umpk 0.718098* 1.82 0.0706 tbuk –1.12e–6 –1.29 0.1970 sdpk 0.003870 1.10 0.2716 expk 0.007205** 2.51 0.0131 hbsa r2=0.88228 f value=241.07 d-w=1.529866 intercept –1.54584 –0.48 0.6293 hhbs –0.00001 –0.84 0.3996 lhkp 3.295079*** 11.18 <0.0001 ttdk 0.008922 1.52 0.1291 ttlk 0.017245*** 2.86 0.0047 sdpk 0.000456** 2.46 0.0148 exhk 0.000826 0.54 0.5879 use of labors tpdk r2=0.38703 f value=24.50 d-w=1.945637 intercept 185.7037 4.61 <0.0001 tbuk –2.24e–7 –0.57 0.5672 tpnp –0.45607*** –10.56 <0.0001 exhk 0.007735 0.33 0.7399 expk 0.000804 0.33 0.7385 sdpk –0.00934*** –3.18 0.0017 twdk r2=0.23950 f value=12.22 d-w=1.947348 intercept 8.624100 1.16 0.2481 tbuk –1.57e–7** –2.25 0.0258 twnp –0.00368 –0.47 0.6362 exhk 0.005754 1.37 0.1720 expk 0.002264*** 5.20 <0.0001 sdpk 0.000737 1.36 0.1748 tplk r2=0.93499 f value=462.67 d-w=1.627376 intercept 21.55124 0.41 0.6818 jbkp 0.100554*** 7.59 <0.0001 utlk –0.00003 –0.07 0.9468 ptuk 1.96e–6*** 15.52 <0.0001 tpdk –0.06441 –1.35 0.1783 expk 0.002831** 2.34 0.0202 sdpk 0.007130*** 4.63 <0.0001 twlk r2=0.56327 f value=62.87 d-w=1.979295 intercept –1.72187 –0.83 0.4059 lhkp 3.216899*** 3.96 0.0001 tplk 0.017960 1.05 0.2969 expk 0.001314*** 3.13 0.0020 sdhk –0.01197* –1.74 0.0833 spending kopg r2=0.18555 f value=8.84 d-w=1.534995 intercept 178.6705 6.17 <0.0001 jmak 14.05849*** 4.11 <0.0001 tprt 4.061e–7** 2.26 0.0247 expk 0.000563 0.28 0.7812 umpk –0.97853** –2.62 0.0094 ttdk –0.18031* –1.84 0.0680 knpg r2=0.09621 f value=4.13 d-w=2.076586 intercept 80.64460 1.81 0.0712 kopg –0.62915*** –4.03 <0.0001 tbuk –3.72e–7 –1.54 0.1242 exhk 0.009876 0.47 0.6422 sdhk –0.030010 –0.90 0.3714 table 2: estimation results of coconut farmers household economic model (contd...) rusdi, et al.: analysis the effect of coconut production risk and price on the economic behavior of coconut farmers in seruyan district, central borneo province, indonesia international journal of economics and financial issues | vol 11 • issue 3 • 2021 69 negative effect on the use of male labor in the family in coconut farming (tpdk). this shows that if there is an increase in the risk of coconut production faced by the kelepa farmer household, it will cause a decrease in the number of male workers in the family used in coconut farming. the results of this study are the same as the results of research conducted by jufri et al. (2018) that an increase in the risk of production will reduce the outpouring of male labor in the family. the use of the results of the estimation of the equality of the use of female labor in the family in coconut farming (twdk) shows that the total cost of coconut farming (tbuk) has a negative effect on the use of female labor in the family in coconut farming activities and the real level is less than 5%. this shows that the increase in coconut farming costs causes the use of female labor in the family on potato farming to decrease. tzouvelekas (2011) states that an increase in production costs will reduce farm income so that it will increase farmers’ time spent working outside of agriculture. furthermore, coconut production expectations (expk) have a positive and real effect on the use of female labor in the family in coconut farming activities. coconut production expectations encourage coconut farmer households to increase coconut farming activities. so that the use of female labor in the family in coconut farming activities will increase. the use of female labor in the family in coconut farming activities is very responsive to changes in coconut production expectations. furthermore, tzouvelekas (2011) states that an increase in the price of an agricultural commodity will increase farmers’ incentives. so that it will increase the use of terja from within the family for farming activities. based on the estimation of the parameters of the equality of the use of male labor outside the family in coconut farming (tplk), it shows that the number of productive coconut stems (jbkp). coconut farming income (ptuk), coconut production expectations (expk) and the risk of coconut production (sdpk) have a significant effect on the use of male labor outside the family in coconut farming (tplk). the number of productive coconut stems which has a positive effect indicates an increase in the use of male labor outside the family which increases due to the increase in the number of productive coconut stems. this is due to the increasing need for male workers to care for productive coconut plants such as weeding coconut trees. fertilization. spraying as well as harvesting and gathering crops. this is in line with the results of research by asmarantaka et al. (2017) that an increase in land area will increase the use of labor from outside the family. furthermore, the coconut farming income variable (ptuk) has a positive effect because the increase in coconut farming income will increase the ability of farmers to pay workers who come from outside the family. this is in accordance with the results of research by adevia et al. (2017) which shows that an increase in income from coconut farming will increase the use of labor that comes from outside the family. in addition, the coconut production expectation variable (expk) also has a positive effect on tplk. the increase in production expectations causes an increase in the expectations of farmers to produce high products which will certainly have an impact on the income of coconut farming that will be received. so that if the price increases, the farmer’s ability to pay for the hired labor will be even greater. the results of this study are in line with the results of pamusu’s (2019) research that production expectations will increase the use of male labor from outside the family. the results of the estimation of the equation parameters for the use of female labor outside the family in coconut farming (twlk) are significantly influenced by the area of coconut land (lhkp) and coconut production expectations (expk) have a significant effect on the use of female labor outside the family in coconut farming (twlk). the increase in the use of female labor outside the family, which is getting higher due to the addition of coconut land area, is due to the increasing need for labor to care for coconut plants. in the research location, female workers in coconut farming are widely used in maintenance activities such as weeding coconut trees and fertilizing. the results of research by fariyanti et al. (2007) and pamusu (2019) show that the area of arable land has a significant effect on the use of female labor outside the family. the wider the land cultivated by farmers, the more female workers outside the family are used. according to kusnadi (2005) the use of labor outside the family is complementary to the area of land. the higher the land area of the farmers, the more use of labor outside the family. furthermore, the effect of changes in coconut production expectations (expk) also has a positive effect on twlk. the increase in production expected by farmers has a potential effect on expectations of income to be received. so that the increase in income will increase the use of female labor from outside the family. this is in line with the research of mariyanto et al. (2015) that income from farming will increase the use of labor from outside the family. furthermore, the price risk has a negative effect on the use of female labor outside the family. this is in accordance with tzouvelekas (2011) which states that an increase in price risk will reduce the use of labor from outside the family. this is because the increased risk of price will reduce the level of farm income. furthermore, in the expenditure block, the food consumption equation (kopg) is significantly influenced by the number of family members (jmak). total household income (tprt). age of coconut farmers (umpk). as well as the total use of labor in the family (ttdk). the number of family members has a positive influence on household food consumption of coconut farmers. this shows that there are more and more family members in coconut farmer households. it will increase household food needs so that expenditure for food consumption will increase. this is in accordance with the results of research by babatunde et al. (2019) and wantasen et al. (2012) stated that the more the number of household members, the greater the amount of expenditure for food consumption. asngari et al. (2020) states that the greater the number of family members, the more rice consumption will also increase. this is because rice is the staple food of the indonesian population. furthermore, total household income also has a positive effect on expenditure for food consumption. faharuddin et al. (2019). ningsih et al. (2021). achmad and diniyati (2018) state that an increase in household income will have an impact on increasing household expenditure for food consumption. furthermore, non-food consumption in coconut farmer households (npc) is significantly influenced by food consumption (kopg). rusdi, et al.: analysis the effect of coconut production risk and price on the economic behavior of coconut farmers in seruyan district, central borneo province, indonesia international journal of economics and financial issues | vol 11 • issue 3 • 202170 while other variables are like the total cost of coconut farming (tbuk). coconut price expectation (exhk) and coconut price risk (sdhk) have no significant effect. food consumption has a negative effect on non-food consumption in coconut households in seruyan regency. this shows the higher the expenditure for food consumption. coconut farmer households will reduce nonfood consumption expenditure. this condition shows that there is a trade off between spending on food consumption and non-food consumption. the health expenditure equation (pkes) of coconut farmer households shows that the total household income (tprt). the risk of coconut production (sdpk) and education expenditure have a significant effect on health spending. household income volume (tprt) has a positive effect on health expenditures. an increase in household income will have an impact on the level of awareness and attention of households towards the health of family members. this can be seen from the increasing use of health insurance with higher premiums and health care activities. this is supported by the results of the research by sen and rout (2007) that household income is very influential on the level of household health expenditure. the higher the household income, the greater the household health expenditure. furthermore, the coconut production risk variable (sdpk) has a negative effect on health expenditure. where the higher the production risk faced by coconut farmers, the health expenditure will decrease. the results of research by fariyanti et al. (2007b) support the results of this study. that the increased risk of cabbage production and the risk of potato production have a negative effect on household health expenditures. furthermore, the education expenditure variable (ppen) also has a negative effect on health expenditure. the higher the education expenditure. household will reduce health expenditures. this condition shows that there is a trade off between spending on health and education. education expenditure (ppen) is significantly influenced by coconut production expectations (expk). coconut production risk (sdpk). number of family members (jmak). and total consumption (tkon). the coconut production expectation variable (expk) has a positive effect on coconut household education expenditure. this means that increased production expectations will encourage coconut farmer households to allocate more education expenditures. the risk of coconut production (sdpk) has a negative effect on health spending. the higher the risk of coconut production faced by farmer households, the lower the health expenditure. the same thing also happens to total consumption (tkon) which has a negative effect on education expenditure. an increase in total consumption (food and nonfood consumption) by households will reduce the allocation for education expenditure. the estimation results on the household economic behavior of coconut farmers show that the coconut farmer household savings (tabp) is significantly influenced by the total household expenditure (tran). total household income (tprt) and coconut production expectations (expk). total household expenditure has a negative effect. this means that the greater the household expenditure (expenditure for food consumption, non-food consumption, health and education), the less income the household can use as savings. furthermore, the total household income variable has a positive effect on coconut farmer household savings. this illustrates that not all coconut farmer household income is spent on consumption. but also used for saving. savings used by coconut farmers in several forms. like cattle. routine social gathering. savings and loan cooperatives and bank accounts that can be used for time to meet daily needs as well as urgent needs such as the cost of children’s education. wedding party. and other necessities. the results of this study are supported by the research results of wantasen et al. (2012), nwibo and mbam (2013), abebe (2017) where the higher the household income, the greater the allocation for savings. the last equation is business investment (inves). where the variable that has a significant effect is savings (tabp). total income from non-agriculture (jpnp) and total income from coconut farming (jput). the savings variable has a negative effect on business investment. meaning there is a trade off between saving and investment. the greater the income used for savings, the smaller the amount of business investment will be. furthermore, the amount of income from non-agriculture (jpnp) and the amount of income from coconut farming (jput) have a positive effect on investment. increased income from coconut farming and nonagricultural activities will increase the household income surplus after it is used to meet daily needs. this is in line with the results of research by nwibo and mbam (2013). that the increase in income received by households will increase the surplus income that can be used for investment. 5. conclusion and recommendation the results showed that there was a simultaneous relationship between production, consumption, investment and savings in conditions of production risk and price faced by coconut farmer households. coconut farmer households will respond to an increase in production risk by increasing the use of input in the form of herbicides. on the labor use side, the increased risk of production will lead to a reduction in the allocation of time to use male labor in the family for coconut farming, but will increase the use of male labor from outside the family who is used to improve coconut tree care. meanwhile, on the consumption side, the response to increasing risk is by reducing the allocation of health expenditures to households, reducing spending on education, and reducing household savings. in addition, there is a risk that prices will reduce the use of female labor from outside the family. on the expenditure side, there is a risk that prices will have an impact on decreasing household income so that it is responded by reducing non-food consumption, education expenditure and decreasing business investment. the existence of production risks and prices faced by coconut farmer households will have an impact on the level of income received by farmer households. therefore it is necessary to diversify the land used for coconut farming. such as the use of between coconut plants with other farms that do not interfere with coconut growth. in addition, to reduce the level of price risk due to simultaneous harvests, it is necessary to do joint marketing, rusdi, et al.: analysis the effect of coconut production risk and price on the economic behavior of coconut farmers in seruyan district, central borneo province, indonesia international journal of economics and financial issues | vol 11 • issue 3 • 2021 71 to increase the bargaining position of farmers so that the price received is not too low. 6. acknowledgment this study a part of doctoral disertation at agricultural economics studies of ipb university. we gratefully ackhowledge the financial support provided by indonesian endowment fund for education (lpdp). references achmad, b., diniyati, d. 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(2018), analysis of factors affecting coconut productivity in district panjatan, regency of kulon progo. jurnal pertanian agros, 20(1), 29-38. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(2), 20-29. international journal of economics and financial issues | vol 10 • issue 2 • 202020 agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment emmanuel o. eyo*, merrian a. nwaogu, michael e. agenson department of agricultural economics, university of calabar, calabar, nigeria. *email: emaeyo@yahoo.com received: 12 december 2019 accepted: 05 february 2020 doi: https://doi.org/10.32479/ijefi.9101 abstract efforts to revitalize agricultural credit delivery became a reality in 1977 with the establishing of the agricultural credit guarantee scheme (acgs) fund. this study assesses the acgs under the nigerian macroeconomic environment. it assesses the real value of loans guaranteed overtime; analyzes agricultural output in agriculture credit guarantee scheme, analyses the effect of changes in interest rate and other variables on the volume of loans guaranteed. data obtained were analyzed using both descriptive and inferential statistics. this study suggests that the macroeconomic environment has not been friendly with acgs operations. credit guarantee contributes positively to increased agricultural output, but the number and value of loans guarantee as well as the performance of loans and agricultural sector output would be greatly enhance by policies that make interest rates, inflation, stock market capitalization, nominal exchange rates and other variables of the macroeconomic environment agricultural sector friendly and supportive. keywords: credit guarantee, agricultural sector, macroeconomic environment, nigeria jel classification: h 81 1. introduction the provision of institutional credit to farmers has been the policy thrust of successive governments in nigeria. to attain agricultural sector goals, several policies were formulated and implemented during the years following independence. over time, five main types of interventions have been tried, namely; lending requirements and quotas imposed on banks refinance schemes, loans at preferential interest rates, lending by development finance institutions and credit guarantees. these actions were intended to increase lending by reducing the costs and risks to lenders of making loans to preferred clients and sectors. in the agricultural sector, government introduced the agricultural credit guarantee fund scheme in to improve credit access of farmers, particularly the small farmers. like other public credit guarantee schemes, the purpose of the establishment of the agricultural credit guarantee scheme (acgs) was to serve as an inducement to banks (commercial and merchant) to increase and sustain lending to agriculture so as to reduce demand and supply gap in financing micro firms in agriculture. in nigeria, the scheme has achieved this feat. the increase in the number and nominal amount of loans guaranteed under the acgs fund (acgsf) scheme, overtime has been as a result of key changes made in the original design of the scheme. first, there was the waiving of tangible collateral security for small-scale farmers who borrow five thousand naira (5000.00) and below. second, there was the introduction of the self-help groups linkage with banks was introduced in 1991, in year 2000, loan limits to various categories of borrows were reviewed upwards, the interest drawback programme introduced in 2002 and the trust fund model introduced in 2009 (igben and eyo, 2002). credit guarantee is known to influence long term debt financing, allows greater debt capacity for firms, creates confidence among stake holders, overcome collateral constraints, provides stable finance, affect risk of lending, address the problem of information asymmetry, compensate for low profit, modify intrinsic characteristics of small business, induce learning as well as additionality (gudger, 1996; duarte and rodriguez, 2018). this journal is licensed under a creative commons attribution 4.0 international license eyo, et al.: agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment international journal of economics and financial issues | vol 10 • issue 2 • 2020 21 unfortunately, despite efforts to strengthen the scheme in nigeria, several author (gudger, 1996; nwosu et al., 2010; umoren et al., 2014), agree that loan default by famers is a persistent and major problems facing the acgs. in fact central bank of nigeria (cbn) (2000) agree that repayment performance between 1998 and december 2000 was unsatisfactory in number (77%) and value (70%) and in 2018, the cbn (2018) reports that as many as 240 number of loans were non performing. the acgs operates a loan guarantee ration of 75%. the persisting default problem point to the fact that the loan guarantee ration is not optimal. for effectiveness and sustainability of public credit guarantee schemes, there is need to specify an optimal credit guarantee ratio that will fulfill government goal of reducing nonperforming loans, among other benefits and this depend on government policies on the minimization of non performance of loans, bank behavior and the macroeconomic environment (yoshinco and taghizadeh-hesary, 2019). the macroeconomic environment is an important variable to consider in trying to specifying an optimal credit guarantee ratio. the macroeconomic environment is created by the macroeconomic policies, may be volatile or otherwise. high economic volatility has meant that the economic environment exerts pressure on government programmes, and complicates goal attainment. several variables like exchange rate, fiscal policy strategies and macroeconomic reforms can exert macroeconomic pressures on the performance of credit guarantees. this is particularly true for nigeria that has tried such exchange rate strategies as pegging of naira to the dollar, the dual exchange rate regime between 1995 and 1999 and allowing exchange rate to be determined by forces of demand and supply; such fiscal policy strategies as the value added tax, abolition of excise duties, regulation of custom and excise tariff, and the reforms of the structural adjustment program (sap). during sap special interest on agricultural loan was abolished and subsidy on agricultural inputs was deemphasized. the new policies of sap came with the introduction of microcredit programmes, government merged the nigerian agric cooperative bank, the family economic advancement programme to form the nigeria agric cooperative and rural development bank in the year 2000 to make it strong and more functional to address the credit needs of the famers. by 2004 there was bank consolidation. in fact, the experience of nigeria can be separated into two distinct periods. the 1970s witnessed very low interest rates that could not encourage the development of money or capital markets. no lender was willing to raise money from existing capital markets and lend under the prevailing low lending rates. inflation rates during those years were mostly in double digits per annum. before the introduction of the sap in 1986, agricultural lending rates were largely concessional or subsidized. although lending rates for agricultural purposes were deregulated in 1987, the high rates of inflation that accompanied the macroeconomic reforms, in excess of 40% per year in the earlyto mid-1990s contributed to negative real agricultural lending rates (cbn, 2010). in short, the concessional lending rates to agriculture before the introduction of sap and the prevailing high domestic inflation resulting from sap sent mixed market signals to creditors during this period. on the whole, some macroeconomic and sectoral policies implemented from 1970 to 1985 promoted economic distortions. for example, domestic prices and exchange rates were largely dictated by the government, generating large deviation between them and their market-determined equivalents. appreciation of exchange rates cheapened imports, hurt exports, implicitly taxed farmers’ incomes, and subsidized consumers. government also directly participated in the provision of many farm inputs and services, and in the production, processing, and marketing of farm commodities. after sap was introduced, there was general improvement in agricultural production and external trade from 1986 to 1989. thereafter, growth indices of agricultural production fluctuated between stagnation and decline, a situation blamed mainly on three policy reversals and inconsistencies. first, the devaluation of the naira which led to higher domestic prices of imported goods, including farm inputs (principally agrochemicals and fertilizers). second, neither the interest-rate nor the exchangerate liberalization was implemented to its logical conclusion such that agriculture could not sustainably derive the inflow of credit that it so badly needed. third, the agricultural trade reforms were interrupted by import and export restrictions or outright bans or both. all of these factors limited long-term private-investment decisions in agriculture. the 2004-2008 period, marked by a more successful phase of fiscal, monetary, and exchange rate policy coordination with limited aggregate demand pressures and falling inflation; and the 2008 and beyond where coordination of fiscal, monetary and exchange rate policy was challenged by the aftermath of the global financial crisis and oil price shock. the large default rate exerts pressure on the scheme to settle default claims. the ability of the scheme to settle claims is important for the success of the scheme. the acgs has a loan guarantee ratio of 75%. the inability of the scheme to overcome the problem of nonperforming loans implies that there is a considerable level of information asymmetry not resolved and these imply that the loan guarantee ratio of 75% is not optimal. the consequence of this is that the guarantee agency although able to increase (through their intervention) the number of firms that access the capital markets, bear excessive level risk and depress the efforts of both borrows and the lender to contain the risk in investment. the macro-economic environment affect production at the farm level, making it difficult for the guarantee scheme to minimize non performing loans. in nigeria, eyo (2008) reports that favorable exchange rate, low interest credit, low rate of inflation increased foreign private investment in agriculture where important variables that affected agricultural sector growth. elsewhere, zecchini and ventura (2006) observed that higher real gdp growth translates into more income which improves the debt servicing capacity of borrowers and when there is a slowdown in the economy unemployment increases, default risk is bound to increase with unemployment, borrowers have difficulty in paying their debt. also, yoshinco et al. (2015) asserts that loan default risk ratio depend in macroeconomic factors – stock prices, gdp and money supply. the public credit guarantee scheme is a tool to reduce the supply – demand gap in sme finance. optiomal credit guarantee ratio is needed for effectiveness and sustainability credit guarantee schemes, (yoshinco and taghizadeheyo, et al.: agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment international journal of economics and financial issues | vol 10 • issue 2 • 202022 hersary, 2016; 2019). in nigeria, available evidence suggest that the macroeconomic environment is hostile to the acgs, instead of being friendly. to ameliorate the problem an optimal guarantee ratio has to be specified for the acgs that presents a product suited to the macroeconomic environment. to specify an optimal credit guarantee ratio for the acgs, we must first analyse how the acgs has fared under the past macroeconomic environment. the general objective of the study is to evaluate the acgsf under the nigerian macroeconomic environment. specific objectives: 1. to assess the real value of loans guaranteed overtime 2. analyze the agricultural output in agriculture credit guarantee scheme 3. assess the effect of changes in interest rate and other variables on the volume of loans guaranteed. 1.1. theoretical issues and review of empirical studies option pricing theory of loan guarantees. this is a theory on how options are valued in a market. an option that gives the right to purchase (call option) and an option that gives the right to sell (put option). black and myron (1973) used the option pricing model to determine the fair price or theoretical value for a call or a put option based on volatility, type of option, underlying stock price, time, strike price and risk free rate and concludes that proper pricing of option eliminate the opportunity for any arbitrage. credit guarantee scheme provides third parties credit risk mitigation. they are like traders who buy sell and option. the guarantor will be compensated, the guaranteed pays a fee for the warranty, there is a risk reduction for the lender. fabio and calo (2015) used the option pricing theory to analysis security loan guarantees and interpretes them, as put option on the cash flow of secured debt, highlights that the value of guarantees are always. by acquiring the guarantee, the creditor acquires the right to overcome the debtors’ insolvency by recouping the residual credit on collateral or on the guarantor’s properties. fabio and calo (2015) analysed security loans based on the option pricing theory and interprets loan guarantees as a put option on the cash flow of secured debt, and argues that the value of guarantee are positive before loan before loan maturities, concluded that inefficiencies of the financial markets justifies their existence. sosin (1980) has also used the option pricing model to develop a theoretical option pricing model to value debt guarantees. credit guarantee is a form of protection of the creditor against default and to the lender a warrantee to recoup the asset from the guarantor in case of default. the intervention of the guarantee scheme gives the lenders the right to give credit and to the farmers the right to obtain credit. the existence and proliferation of loan guarantees is justified by the presence of market imperfections – information asymmetry, refusing to granting loans. if markets are not efficient those applying for funds could face huge difficulties in offering assets as collateral or finding 3rd parties to act as guarantees. from a theoretical point of view, it is believed that the intervention of a guarantor who has informational advantage compared to the lender may permit problems of asymmetric information to be mitigated and a better quality screening to be conducted. public guarantee does not lead to reduction of the risk that rest on the lender but rather transfers the risk to the guarantee agency. feintein et al. (2004) used the optimal pricing model to develop a theoretical value of the guarantee associated with loan guarantees and argues that credit guarantee is a contingent liability to the guarantor and a valuable asset to the borrower. credit guarantee scheme provides third parties credit risk mitigation. by acquiring the guarantee, the creditor acquires the right to overcome the debtors in solvency by recouping this residual credit on collateral or on the guarantors properties. sosin, 1980 used an option pricing model to develop a theoretical option pricing model to value debt guarantees. loan guarantee are important in many countries particularly government guarantee funds for firms in financial distress. several authors have analyzed loan guarantees in many countries sosin, 1980; phillip and mason (1980); selby et al. (1988). most of those work center on how to value credit guarantees and the properties of loan guarantees. credit guarantee are financial product that a farmer can acquire/ buy as a substitute for collateral. credit guarantee scheme are set up to distribute credit guarantees. it involves three parties namely, the borrower, guarantor and the lender. in italy, credit guarantee scheme is known. to ease sme financing difficulties and raises the amount of credit smes receive from the banking system and lower smes borrowing cost, (zecchini and ventura, 2006). this study benefits from the credit channel theory which suggest that policy may have an effect on credit supply and demand in an economy. dobrinsky and markov (2003) noted that the recently advanced “credit channel view” implies that monetary policy shocks affect real economic performance through the supply of credit by financial intermediaries due to shifts in the supply schedule of the latter. the literature makes a distinction between a “bank lending channel” and a “broad credit channel” which treats the supply of external funds to firms by all financial intermediaries. the credit channel view is also consistent with the assumption of the existence of market imperfections, in particular, information asymmetries between borrowers and lenders which give rise to the relevance of credit guarantees. one implication of the existence of a credit channel in the monetary transmission mechanism is that it induces a heterogeneous response both of the credit market and of the firms due to which the increase in the cost premium for external finance will not be uniformly distributed across firms. in particular, the credit channel view is consistent with the empirical finding that the effect of a monetary shock should be more severe for small firms (that are more likely to face information costs) than for large firms (oliner and rudebusch, 1996) or that the negative effect of a monetary contraction on investment is greater for highly leveraged firms (which are more likely to suffer a reduction in their collateralizable net worth due to the monetary shock) than for less leveraged firms (rondi et al., 1998; hu, 1999). it is worth eyo, et al.: agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment international journal of economics and financial issues | vol 10 • issue 2 • 2020 23 noting that nigerian agricultural sector is largely dominated by small-scale farms (or firms) and going by the foregoing empirical findings it would not be out of place to expect monetary policies having some effects on their collaterizable net worth and hence their credit requirements which banks tend to respond to when they supply credit to the agricultural sector. impact of acgsf on farm output: ammani (2012) investigated the relationship between agricultural production and formal credit supply in nigeria. data were obtained from secondary source and analysed using simple regression models. the study revealed that formal credit was positively and significantly related to the productivity of the crop, livestock and fishing sectors of nigerian agriculture. olagunju and adeyemo (2008) examined the impact of credit use on resource productivity of sweet potatoes farmers in osun-state, nigeria. a multistage sampling technique was used. data obtained were analyzed by marginal value product and multiple regression technique. results indicated that farmers that produced with credit use resources efficiently than those without credit. the study further revealed that sweet potato output, on the average, was smaller for farmers without credit than for those with credit. sial et al. (2011) assessed the role of institutional credit in agricultural production. times series data was used for the study and the data obtained was analysed using ordinary least square (ols) method. the study revealed that agricultural credit was positive and significantly related to agricultural production. the study concludes that agricultural credit is very important in agriculture production because availability of credit removes financial constraints relating to cash inputs, secondly technical efficiency of farmers will increase and thirdly agricultural credit will increase resource allocation and profitability. bashir et al. (2010) studied impact of agricultural credit on productivity of wheat crop. primary data were collected through a well structured questionnaire. multiple regression was used to analysis the data. the study showed that agricultural credit plays an important role in facilitating the transformation of agriculture and raising the participation of farmers in production process. kareem et al. (2013) examined the factors influencing agricultural output in nigeria: macro-economic perspectives. the study sort to determine the factors influencing agricultural production in nigeria, and also determine the causality between agricultural outputs and macro-economic variables. the study adopts regression analysis, descriptive statistics and the granger causality tests on macroeconomic variables (i.e. food import value, interest rate, commercial bank loans on agriculture, gdp growth rate and foreign direct investment) to find the significant relationship between the different variables chosen. the result showed fluctuations in the trend of variables considered (i.e. interest rate, commercial bank loans to agriculture, gdp growth rate and foreign direct investment) in relation to the period under review. the result further showed that foreign direct investment, commercial bank loan, interest rate and food import value have positive relationship with agricultural output. saheed (2014) reviewed the impact of acgsf on domestic food supply in nigeria. the study was carried out between the period 1988 and 2011. the study used secondary data which included: annual agricultural credits guarantee funds and the total domestic food output obtained from cbn’s statistical bulletin, the population data obtained from the nbs’s reports and the average annual rainfall for the country, calculated from the annual rainfall in each state of the federation obtained from the nigerian meteorological agency. the data were analyzed using ols method. the results show a robust adjusted r-square of about 86.3%. the value of t-statistics of each of the explanatory variables shows 3.0323 for acgsf, 6.8480 for rural population and 2.5418 for average annual rainfall, indicating that the explanatory variables are statistically significant in explaining domestic food supply in nigeria. the study observed that there has been an increase in trend of agricultural growth of 573.8% compared to the average growth of 59.25% in the domestic food supply in nigeria and the changes in the agricultural credit guarantee fund to the farmers has a significant impact on the domestic food supply. based on the findings, it was recommended that government should encourage agri-business and youths especially fresh graduates to go into scientific farming. this would greatly improve agricultural production and hence increase food supply in nigeria. obasi (2015) evaluated the performance of agricultural lending schemes in nigeria for the period 2009-2012. the study was carried out in benue, kwara, kaduna, abia, anambra, rivers and ogun states respectively. the method of proportionate random sampling technique was used in selecting 185 borrowers who were registered with their state development programmes. data collected were analyzed using frequencies, percentages, means, and multiple linear regression analysis. results of the analysis showed that during the period 2009-2012, a total of 27,987 farmers applied for bank loan in nigeria totaling n13, 704, 965, 000.00 while 21,490 farmers were granted loan facility during the same period totaling n7, 188, 575, 000.00 leaving a credit supply gap of n6, 516, 390, 000.00. the total amount of loan repaid by borrowers during the same period was n3, 523,018,005.00 giving a repayment rate of 49% and a default rate of 51%. the loan granted to borrowers increased national output by 20.33%, and impacted positively on the income of borrowers. it was recommended that the government should continue to encourage increased funding to the agricultural sector for accelerated food production in nigeria by small and medium scale farmers through the provision of institutional loans to these categories of farmers. obilor (2013) examined the impact of acgsf, agricultural product prices, government fund allocation and commercial banks’ credit to agricultural sector on agricultural productivity. the result revealed that acgsf and government fund allocation to agriculture produced a significant positive effect on agricultural productivity, while the other variables produced a significant negative effect. effect of interest rate, inflation and other variables: babalola et al. (2015) examined the effect of inflation and interest rate on economic growth and went further to determine the corrective measures to inflation and interest rate trend in nigeria between 1981 and 2014. secondary data sourced from world bank databank and cbn was used in the study. the study adopted ols method of analysis. the long-run relationship of the variables was analyzed using the johansen integrated test. however, the augmented eyo, et al.: agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment international journal of economics and financial issues | vol 10 • issue 2 • 202024 dickey fuller (adf) test performed showed that only inflation is not stationary at first difference. the direction of causality and trend analysis was also performed on variables. it was found out that inflation and interest rate has a negative effect on economic growth. the work concluded that policy makers should focus on maintaining inflation at a low rate (single digit) and ensuring interest rate stability. okoye and eze (2013) examined the impact of bank lending rate on the performance of nigerian deposit money banks between 2000 and 2010. they specifically determined the effects of lending rate and monetary policy rate (mpr) on the performance of nigerian deposit money banks and analysed how bank lending rate policy affected the performance of nigerian deposit money banks. the study utilized secondary data econometrics in a regression, where time-series and quantitative design were combined and estimated. the result confirmed that the lending rate and mpr had significant and positive effects on the performance of nigerian deposit money banks. thus, it was estimated from the result that increase in the bank lending rate by 1%, on the average, resulted to 1.31% increase in bank earning (be). should there be more and higher lending rate, bank performance will be enhanced. the computed coefficient of determination (0.856474) showed a high proportion of variation in the dependent variable (lr). thus, 85.65% of the total changes in the be was explained by lr. it was also found from the result that 1% increase in mpr, will bring about an approximate 0.30% increase in be. it was observed from the result that when government increases her mpr, bank performance will be enhanced and this will eventually lead to economic growth in nigeria. they therefore recommended that government should adopt policies that will help nigeria deposit money banks to improve on their performance and there is need to strengthen bank lending rate policy through effective and efficient regulation and supervisory framework. 2. research methodology 2.1. study area the study area is nigeria. nigeria has a total geographical area of 923,768 square kilometers, a north-south length of about 1450 km and west-east breath of about 800 km. its total boundary is 4047 km, while the coastline is 853 km and a population estimate of about 167 million (npc, 2006). nigeria is located 4°16i and 13053i north latitudes and 2°40i and 14°41i east longitudes. it comprises 36 states and the federal capital territory is located in abuja. nigeria is located in the tropics, which is characterized by high temperatures, high humidity and intense heat. its rainfall ranges between 2000 and 3000 mm. nigeria encompasses (6) major agro-ecological zones with rainfall diminishing along a south-north gradient. agriculture is the largest single sector of the economy, providing employment for a significant segment of the work force and constituting the main stay of nigeria’s large rural community which accounts for nearly two-third of the population. the population of the gdp attributed to agriculture hovers between 30 and 40%. nigeria is distinguished by the diversity of its ecosystems, an advantage for growing a broad range of crops. the main staple food crops produced are yam, cassava, rice, maize and beans. 2.2. sources and method data collection data for the study were obtained from secondary sources. secondary data were obtained from cbn statistical bulletin, cbn annual report, federal budget allocation report, annual reports and used for the study. 2.3. analytical techniques data were analyzed using descriptive and inferential statistics. 2.4. the empirical models the first empirical model hypothesises that agricultural output is a function of the number value of loans guaranteed as well as the number of participating commercial banks. consequently: agdpt = β0+β1nlt+β2alt+β3nct+εt (1) where, agdp = agricultural gross domestic product in naira nl = number of loans guarantted al = amount of loans guaranteed in naira ncbk = number of commercial banks εt = error term. the second empirical model hypothesizes the relationship between volume of credit guaranteed under the acgs and the macroeconomic environment as created by inflation, interest rate, exchange rate and other variables. the estimation of the long-run dynamic relationship between changes in interest rate and volume of credit sourced by farmers and other variables was executed through employment of the autoregressive distributed lag (ardl) bound approach. the ardl approach proposed by pesaran and shin (1995) and pesaran et al. (2001) has significant advantages. the approach can be employed even when the time series data are non-stationary and still, allow for conduct of inferences which is not possible under the alternative co-integration approach. this advantage offers a wide range of opportunities to conduct the estimation regardless of whether the time-series regressors are stationary at 1(0), 1(1) or both. further, ardl is associated with good small sample properties implying that ardl still provides quality results when the sample size is small and lastly, even if the series variables are fractionally integrated. the empirical application of the ardl methodology involves three steps: (i) identifying the order of integration of variables using the unit root tests; (ii) testing for the existence of a unique co-integrating relationship (long-run) using the bounds testing procedures; and (iii) estimation of an error correction model (ecm) to capture short-run dynamics of the system. table 1: summary characteristics on agricultural credit guarantee scheme by category of beneficiaries (1981‑2016) category portion of loans guaranteed (%) individual 93.00 informal groups 2.00 cooperative societies 3.00 agricultural companies 2.00 total 100 source: computed from central bank of nigeria statistical bulletin 2018 eyo, et al.: agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment international journal of economics and financial issues | vol 10 • issue 2 • 2020 25 the ardl co-integration model (onoja et al., 2011), is 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 t t t t t t t t lny lnx lnx lnx lnx lnx lnx lnx β β β β β β β β µ = + + + + + + + + (2) where, y = volume of loans guaranteed by the acgsf in millions of naira x1 = price deflator for agricultural commodities (index) x2 = interest rate (minimum lending rate in %) x3 = stock market capitalization (millions of naira) x4 = nominal exchange rate of naira to dollar (naira) x5 = value of agricultural output as share of total real gdp (millions of naira) x6 = volume of credit advanced to the core private sector (in millions of naira) x7 = value of immediate past loans guaranteed by acgsf (millions of naira). β1–β7 = coefficients of the respective variables t = period (year) β0 = intercept of the model u = stochastic error term. 2.5. unit root test a unit roots test analysis of each of the time series of the chosen variables were undertaken to ascertain the order of integration. here, the order of integration for all the variables must be known prior to co-integration analysis, at least to ensure that variable are not integrated of order greater than one (abbott et al., 2000). to determine the order of the series, two different unit root tests were conducted viz; adf test and phillips and perron. the test formula for the adf is shown in equations (3) δyt = α+∂yt−1+σγδyt−j+et (3) where: y = series to be tested δyt = first difference of yt ∂ = test difference coefficient j = lag length chosen for adf et = white noise t = time or trend variable. here the significance of ∂ would be tested against the null that ∂=0. thus if the hypothesis of non-stationarity cannot be rejected, the variables were differenced until they become stationary, that is until the existence of a unit root is rejected. we then proceed to test for co-integration. 2.6. co‑integration analysis: ardl bounds test the ardl co-integration test, otherwise called the bounds test developed by pesaran et al. (2001) was used to test for the co-integration relationships among the series in the model (equation 2). this will be performed by conducting a wald test (f-test version for bound-testing methodology) for table 3: unit root tests: impact of agricultural credit guarantee scheme fund on farm output variable l adf stat. critical v variable d adf stat. critical v decision agdp −1.4657 −3.5443 ∆agdp −5.4007 −3.5485** 1 (1) nl −2.0226 −3.5443 ∆nl −4.6275 −3.5485** 1 (1) al 2.8556 −3.5875 ∆al −0.1628 −3.595** 1 (1) ncbk −1.8599 −3.5443 ∆ncbk −5.4540 −3.5485** 1 (1) **denotes rejection of the null hypothesis at 5% table 2a: index real value of loans guaranteed 1978‑1994 year index of loans guaranteed growth rate (%) 1978 100.00 1979 267.65 62.64 1980 254.98 −4.97 1981 210.96 −20.87 1982 174.58 −24.65 1983 166.49 −4.86 1984 81.73 −03.71 1985 139.58 41.45 1986 196.04 28.80 1987 273.57 28.34 1988 206.51 −32.47 1989 149.58 −38.06 1990 105.98 −41.14 1991 78.28 −35.39 1992 60.55 −29.28 1993 33.92 −78.51 1994 35.49 4.42 source: computed from central bank of nigeria statistical bulletin 2016 table 2b: index of real value of loans guaranteed 1995‑2018 year index of loans guaranteed growth rate (%) 1995 100 1996 106.25 5.88 1997 103.03 −3.13 1998 86.49 −19.12 1999 89.53 3.40 2000 125.14 28.46 2001 212.15 41.01 2002 271.17 21.76 2003 260.38 −4.14 2004 409.98 36.49 2005 506.85 19.11 2006 647.01 21.66 2007 100.85 −7.68 2008 852.27 29.50 2009 970.67 12.20 2010 803.39 −17.23 2011 927.27 13.36 2012 768.87 −20.60 2013 702.05 −9.52 2014 875.41 19.80 2015 699.97 −25.06 2016 437.92 −59.84 2017 279.79 −56.52 2018 186.80 −49.78 source: computed from central bank of nigeria statistical bulletin 2018 eyo, et al.: agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment international journal of economics and financial issues | vol 10 • issue 2 • 202026 the joint significance of the lagged levels of the variables. once co-integration is established the conditional ardl (p, q1, q2, q3, q4), the long-run model for yt can be estimated. 3. results and discussion 3.1. the real value of loans guaranteed overtime under the acgs the acgs from inception guarantees loans to beneficiaries through partner banks who work hand in hand with the scheme to ensure that the scheme’s effort in the agricultural sector not only improve the agricultural sector by increasing agricultural productivity, but will also assist in improving the standard of living of these beneficiaries of the scheme. the acgs operate through commercial and merchant banks. the table 1 shows that between 1981 and 2016, the bulk of the loan (93%) went to individual while the rest went to company with cooperatives and informal groups receiving a negligible amount. table 2a shows the index of real value of loans guaranteed at 1985 prices. according to this table, the index of real value off loans guaranteed under the acgs of 210.96 in 1981 decline steadily to 81.73 in 1974 and increased steadily thereafter to 273.57 in 1987. this index declined again steadily to 33.92 in 1993 and 35.49 in 1994. there was no steady growth in the index of real value of loans in the period under review. in fact between 1981 and 1994 there was negative growth rate in the index of real value of loans guaranteed in ten out of the 14 years period. table 2b shows the index of real value of loans guaranteed at 2009 prices for 1995-2018. this table shows that the index of values of loans guaranteed decline steadily from 100 in 1995 to 86.49 in 1998 and then increased steadily to 647.01 in 2006, and the fluctuates to 186.80 in 2018. however, the real value of loan had negative growth rate in eleven out of the 23 year period. absence of steady growth in the index of real value of loans guaranteed points to the fact that inflation rates varied overtime creating shocks that distorted operations of the acgs. 3.2. analyses of agricultural output under agriculture credit guarantee scheme results on the impact of acgsf on farm output, analysed using the olss is presented in tables 3-5. table 3 shows the unit root test results, which confirm that all variables were stationary at first difference. table 4 presents the ols estimates. the choice of the ols multiple regression was due to the non co-integration of the data series. the result showed a coefficient of multiple determination of 93.15% and an f value of 159.6220. consequently, the total variation in the farm output (agdp) is accounted for by the explanatory variables while 6.85% of the total variation in agdp is attributable to influence of other variables which are not included in the regression model; and the f test show that the model is a good fit. the result of the ols shows that number of loans guaranteed, number of commercial banks and value of credit guarantee have significant effect on agricultural sector output. the number of commercial banks’ giving out acgs has a significant positive impact on farm output. this means that a 1% increase in number of commercial banks will increase agricultural sector output by 22.7%. also, the number of loans guaranteed is significant and positively related to the agricultural sector output. unfortunately, a 1% increase in number of loans guaranteed increase farm output by 0.07%. loan guaranteed the acgs was found to be significant (1%) and positive, but a 1% increase in amount of loan increase farm output by 0.00085%. on the whole the number and value of loans guaranteed contributes below 1% to the agricultural sector table 4: ols empirical result: impact of agricultural credit guarantee scheme fund on farm output variable coefficient std. error t-statistic prob. c 1664.347 635.8823 2.617381 0.0134** nc 22.76599 11.19038 2.034425 0.0503** nl 0.068791 0.024556 2.801411 0.0086** al 0.000845 0.000137 6.152752 0.0000*** r2 0.937361 durbin-watson stat 1.185814 adj. r2 0.931489 f-statistic 159.6220*** author’s computation from e-views 9.0. **significant at 5%, ***significant at 1% table 5: results of adf test variable adf (stat) variable (1st diff) adf (stat) order of integration y −3.3512* ∆y i (0) x1 −2.2981 ∆x1 −5.3887*** i (1) x2 −2.7899 ∆x2 −6.1282*** i (1) x3 −1.5139 ∆x3 −7.9042*** i (1) x4 −2.2799 ∆x4 −5.7140*** i (1) x5 −1.2169 ∆x5 −5.7057*** i (1) x6 −7.5745*** ∆x6 i (0) results are based on author’s calculations. *and ***is significant level at 10% and 1% table 6: results of bound test for co‑integration critical value (%) upper bound lower bound 5 3.28 2.27 1 3.99 2.88 computed f-statistic: 5.69, critical values at k=7-1=6 table 7: long-run estimate showing the effect of changes in interest rate and other variables on the volume of loan sourced by farmers regressor coefficient se z-ratio lnx1 0.8312 0.6660 1.2480 lnx2 −2.0270 0.9177 −2.2089** lnx3 0.2841 0.2876 0.9881 lnx4 0.2669 0.3342 0.7986 lnx5 2.2467 1.0139 2.2158** lnx6 −0.3625 0.3904 −0.9285 c 6.4973 3.1447 2.0661** r2 0.9448 adj. r2 0.9156 dw 2.4639 **denote the rejection of the null hypotheses at 5% level of significance. results were obtained from microfit 4.1 eyo, et al.: agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment international journal of economics and financial issues | vol 10 • issue 2 • 2020 27 output, with the worst contribution being from the value of loans guaranteed. 3.3. effect of changes in interest rate and other variables on the volume of loan guaranteed the first step in this analysis is to conduct a test for a unit root problem. table 5 explains the summary statistics of adf test. the results of the test indicate that some variables were stationary at level, while others were stationary at first difference. specifically, price deflator for agricultural commodities (x1), interest rate (x2), stock market capitalization (x3), nominal exchange rate (x4) and value of agricultural output (x5) were stationary at first difference while the volume of credit advanced to private sector (x6) and volume of loan guaranteed by acgsf (y) was stationary at level. the findings of the study provide the justification of ardl approach. 3.4. bounds test for co-integration table 6 interprets the findings of wald-test (f-statistics) for long-run relationship. as indicated on this table the calculated f-statistics (5.69) is significantly higher than the upper bound critical value at a 5 and 1% level of significance. this implies that the null hypothesis of no co-integration is rejected at 5 and 1% significance level. therefore a co-integrating relationship among the variables is confirmed. the long-run estimates showing the effect of changes in interest rate and other variables on the volume of agricultural loan guaranteed is presented in table 7. the result shows a good coefficient of multiple determination of about 91% and a durbin watson statistic that is plausible. however, the coefficient of price deflator of agricultural commodities (x1), stock market capitalization (x3), nominal exchange rate (x4) and value of agricultural output (x5) were positive but only the value of agricultural output (x5) had a significant effect on volume of loan guaranteed by the acgs at 5% level of significance. also, interest rate (x2) and volume of credit advanced to core private sector had a negative effect on the volume of loan sourced by farmers. this implies that the volume of loan guaranteed increases with output whereas high interest rate (x2) reduces the value of loans guaranteed under the acgs. the coefficient of interest rate, −2.0270 suggest that a unit increase in interest rate reduces the volume of loans guaranteed by about 2.07%. the other variables, price deflator of agricultural commodities, stock market capitalization and nominal exchange rate, although positively related to loans guaranteed under the scheme have not been supportive to the activities of the acgs. 3.5. short-run estimates of the effect of changes in interest rate and other variables on the volume of loan sourced by farmers table 8 shows the ardl-vecm model diagnostic tests which confirms the underlying ardl equation passes the diagnostic tests against, serial correlation, functional form misspecification, non-normal errors and heteroscedasticity. the result of the effect of changes in interest rate and other variables on the volume of loan guaranteed for farmers is presented in table 9. the regression for the underlying ardl equation fits very well at r2 = 95%. according to table 9, the coefficient of the error correction term (−1.1300) is negative and statistically significant at the 1% level. the negative and significant coefficient is an indication of co-integrating relationship between volume of loan guaranteed for farmers and its explanatory variables. the magnitude of the coefficient implies that more than 113% of the disequilibrium caused by previous year’s shocks converges back to the long-run equilibrium in the current year; implying that the adjustments is high, to correct to the long term equilibrium. however, the coefficient of price deflator of agricultural commodity (0.8312), previous year’s interest rate (1.2825), nominal exchange rate (0.2669) and value of agricultural output (2.2467) were all positive. both lag interest rate and value of agricultural output had a significant effect on volume of loan guaranteed. the coefficient for both variables was statistically significant at 5% level implying that a unit increase of lag interest rate and value of agricultural output will increase the volume of loan guaranteed by 1.2825 and 2.2467 respectively. similarly, current year’s interest rate (−0.8853), stock market capitalization (−0.4734) and volume of credit advanced to core private sector (−0.3625) all had a negative but not significant effect on volume of loan guaranteed. 4. conclusion efforts to revitalize agricultural credit delivery became a reality in 1977 with the establishing of the acgs. the scheme appears to have been bedeviled by the problem of nonperforming loans over time and several efforts to correct the mess appear futile. table 8: ardl‑vecm model diagnostic tests lm test statistic serial correlation χ2 (1)=1.8322 (0.176) normality χ2 (2)=1.0998 (0.577) functional form χ2 (1)=1.7641 (0.184) heteroscedasticity χ2 (1)=0.5346 (0.471) source: computed from microfit 4.1 result table 9: short -run estimates of the effect of changes in interest rate and other variables on the volume of loan sourced by farmers regressor coefficient se z-ratio ∆lnx1 0.8312 0.6660 1.2480 ∆lnx2 −0.8853 0.6059 −1.4612 ∆lnx2 (1) 1.2825 0.5385 2.3816** ∆lnx3 −0.4734 0.2765 −1.7120 ∆lnx4 0.2669 0.3342 0.7986 ∆lnx5 2.2467 1.0139 2.2158** ∆lnx6 −0.3625 0.3904 −0.9285 c 6.4973 3.1447 2.0661** ecm (−1) −1.1300 0.1876 −6.0235*** r2 0.7167 adj. r2 0.5667 dw 2.4639 **denote the rejection of the null hypotheses at 5% level of significance. ***denote the rejection of the null hypotheses at 1% level of significance results were obtained from microfit 4.1 eyo, et al.: agricultural credit guarantee in nigeria and the uncertainties of the macroeconomic environment international journal of economics and financial issues | vol 10 • issue 2 • 202028 this study assesses the acgs under the nigerian macroeconomic environment with a view to ascertaining if variables of macroeconomic decent could be responsible for nonperformance of loans guaranteed under the scheme. from the results it is clearly established that there was complete absence of steady growth in the index of real value of loans in the period under review. in fact between 1981 and 1994 there was negative growth rate in the index of real value of loans guaranteed in ten out of the fourteen (14) years period and between 1995 and 2018 the real value of loan had negative growth rate in eleven out of the 23 year period. absence of steady growth in the index of real value of loans guaranteed points to the fact that inflation rates varied overtime creating shocks that distorted operations of the acgs. the agricultural sector output did not do excellently well under the acgs. the result of the ols shows that number of loans guaranteed, number of commercial banks and value of credit guarantee have significant effect on agricultural sector output. unfortunately, a 1% increased in number of loans guaranteed increase farm output by only 0.07% and a 1% increase in amount of loan guaranteed increased farm output by only 0.00085%. on the whole the number and value of loans guaranteed contributes below 1% to the agricultural sector output, with the worst contribution being from the value of loans guaranteed. the result of this study suggests that the macroeconomic environment has not been friendly with acgs operations. in the long run, price deflator of agricultural commodities, stock market capitalization and nominal exchange rate, although positively related to loans guaranteed under the scheme have not been supportive to the activities of the acgs. in the short run, current year’s interest rate (−0.8853), stock market capitalization (−0.4734) and volume of credit advanced to core private sector (−0.3625) all had a negative but not significant effect on volume of loan guaranteed. finally, this study confirms the relevance of credit guarantee to increased agricultural output, but the number and value of loans guarantee as well as the performance of loans would be greatly enhance by policies that make interest rates, inflation, stock market capitalization, nominal exchange rates and other variables of the macroeconomic environment agricultural sector friendly and supportive. references abbott, a., darnell, a.c., evans, l. 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(2015), estimating dual deposit insurance premium rates and forecasting non performing loans: two new models. adbi working paper. asian dev bank institute. zecchini, s., ventura, m. (2006), public credit guarantees and sme finance, isae working papers. institutor di studie analisi economica. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(2), 108-116. international journal of economics and financial issues | vol 11 • issue 2 • 2021108 determinants of capital flight in post war sierra leone: an empirical analysis abu bakarr tarawalie1*, talatu jalloh2 1department of economics and commerce, university of sierra leone, sierra leone, 2department of economics, university of ghana, ghana. *email: tarawalieabu@yahoo.com received: 13 january 2021 accepted: 11 march 2021 doi: https://doi.org/10.32479/ijefi.11271 abstract the objective of this paper is to investigate the determinants of capital flight in sierra leone and the direction of causality between capital flight and key variables, within the context of the autoregressive distributed lag (ardl) estimation technique and the granger causality framework. the study utilizes quarterly data spanning the period 2000:q1 to 2019:q1. the bound test result confirms the existence of cointegration. the long run result reveals that real effective exchange rate, corruption and external debt are the main determinants of capital flight in sierra leone. specifically, the finding indicates that real effective exchange rate, high level of corruption and accumulation of external debt cause an increase in capital flight. furthermore, the result reveals that lagged capital flight, corruption, external debt and financial deepening are the main drivers of capital flight in the short run. whilst lagged capital flight, corruption and external debt accumulation increase capital flight, the result reveals that a well-developed financial system reduce capital flight. the finding asserts that any disequilibrium in the model is corrected at the 26% adjustment speed annually. the diagnostic test confirms that the coefficients are stable, given that the cusum and cusumsq lie within the critical band. the granger causality test results reveal that, external debt and capital flight exhibits bi-directional causality. however, both inflation and exchange rate demonstrate uni-directional causality, given that these variables granger cause capital flight, with no feedback effect. the study therefore urges the government to take measures to strengthen the anti-corruption commission and the judiciary with a view to intensify the fight against corruption, and reduce capital flight. also, government should put in place modalities to ensure strict capital controls, deepen the financial market and maintain broad macroeconomic stability as recipe to reduce capital flight. keywords: ardl, granger causality, capital flight, sierra leone, quarterly data jel classifications: c 32, f 21, f 40 1. introduction the issue of capital flight is an important concept in development and financial economics, and has been a major concern for developing countries, with limited resources for development. the discussion on capital flight is centred around the causes, magnitude and consequences of capital outflows and its spillover effect. capital flight has been defined in different ways in the literature. according to cuddington (1986), capital flight is defined as a short-term private capital outflow which occurs in response to political crisis and economic policy failure. thus, capital flight refers to the movement of capital out from a resource-scarce developing country to avoid social control. capital flight is also defined as the unrecorded movement of funds between a country and the rest of the world (world bank, 1985). it is also considered as the part of domestic savings that is sent abroad. capital flight is measured as net unrecorded capital outflow or the residual between officially recorded sources and recorded uses of funds (beja, 2006). the global interest on capital flight especially for developing economies, including sierra leone, derives largely from its adverse effects on macroeconomic stability and economic growth as scarce economic resources lost through capital flight do this journal is licensed under a creative commons attribution 4.0 international license tarawalie and jalloh: determinants of capital flight in post war sierra leone: an empirical analysis international journal of economics and financial issues | vol 11 • issue 2 • 2021 109 not contribute to enhance social welfare of residents (škare and sinković, 2013). capital flight has the tendency to undermine a country’s domestic resource mobilization strategy by eroding the tax base. also, it causes a decline in domestic investment, weaken the domestic currency, exacerbate external debt, increase interest rate on domestic debt, worsen the balance of payment position and subsequently result to slower economic growth. furthermore, capital flight heightens inequality between the rich and the poor, on account of the fact that wealthy people usually suffer smaller tax burden than poor people who do not have the opportunity to transfer their wealth abroad. the main channels of capital flight include unreported remittances, currency smuggling (concealing cash or cheques within suitcases), trade misinvoicing (including export misinvoicing and import misinvoicing), balance of payments leakages, and e-transfers from private banking services. the size and volume of capital flight in developing countries continues to pose serious challenges on macroeconomic stability and sustainable growth, with particular reference to africa. it is believed that developing countries are losing more resources through capital flight than debt servicing (ndikumana and boyce, 2003). estimate shows that africa is a net creditor to the rest of the world largely due to the fact that private asset held abroad far outweigh the external debt stock of africa. hence, the paradoxical situation of buildup of external debt and the simultaneous accumulation of external assets by residents in developing countries continues to draw interest on the issue of capital flight. the literature on capital flight is predicated on four theoretical paradigms: the portfolio choice theory, investment diversion thesis, the debt-driven thesis, and the tax-depressing theory. the portfolio choice theory posits that capital flight occurs as a result of agent desires to optimize yields on capital for a given level of risk` (collier et al., 2001). the theory also argues that, the occurrence of capital flight is due to the unstable macroeconomic and political environment in developing countries and the concurrent existence of better investment opportunities in advanced countries including high foreign interest rates (dim and ezenekwe, 2014). thus, a rational profit maximizing agent will invest abroad if the risk adjusted returns are higher abroad than in the domestic economy. in this regard, capital flight is considered as a response to changes in an investor’s portfolio bundle arising from factors such as the fear of political and economic uncertainty (mohamed and finnoff, 2004). the investment diversion theory postulates that individuals will transfer funds meant for the domestic economy to advance nations largely as a result of macroeconomic and political instability in developing economies. it is widely acknowledged that funds are transferred abroad in order to take advantage of better investment opportunities and high foreign interest rate coupled with political and macroeconomic stability. as a result, the asset and capital base of the home country is eroded, with negative spillover effects on investment, employment and economic growth. the debt-driven thesis, emphasizes that a country experiences capital flight in order to respond to changing economic conditions largely ascribed to external debt (boyce, 1992). the theory also posits that, the accumulation of external debt that would not generate sufficient foreign exchange for repayment may have adverse consequences on the exchange rate in the long-run. the tax depressing theory postulates that there is a significant loss of tax revenue due to capital flight predicated on the doctrine that, domestic government has little or no control over wealth held abroad by domestic residents, therefore such wealth cannot be taxed. the loss of revenue due to capital flight, limits the fiscal space for government to generate revenue and implement programs for economic growth and development. furthermore, it reduces government’s debt-serving capacity, and consequently increase the debt burden and its negative spillover effect on the domestic economy. the empirical literature has produced mixed results on the drivers of capital flight. some researchers hold the view that real gdp growth, interest rate differential, uncertainty and exchange rate are the main determinants of capital flight (ndikumana and boyce, 2003; fedderke and liu, 2002). others suggest that the main determinants of capital flight include high inflation, domestic tax, budget deficit and trade policies (henry, 1996; olopoenia, 2000; and cuddington, 1986). another line of literature postulates that corruption and institutional governance (including regime durability and rule of law) are the key drivers of capital flight (see osei-assibey et al., 2018; north, 1990). sierra leone, a small open economy in west africa, witnessed 10 years of civil conflict (1991-2000), which devasted the economic and social fabrics of the country. the country is endowed with natural resources including minerals like diamonds, gold, bauxite, and rutile; agricultural and marine resources; and considerable tourism potential. however, endowment in natural resources is considered as a recipe for theft, embezzlement, and trade misinvoicing due to the large volumes of transactions involved in the extraction and export of these resources. discussion on capital flight within the sierra leone context is relevant and timely taking into consideration the positive impact that external assets kept abroad can have on the domestic economy if such assets are left in sierra leone. thus, the paradox and severity on the issue of capital flight is that for a small open economy like sierra leone that is plagued with chronic poverty, heavy debt burden, exchange rate shortages, high inflation and sluggish economic growth, capital flight result to a greater proportion of the resources needed to leapfrog the economy and boost economic growth, create employment as well as promote broader macroeconomic stability. the country is considered as one of the poorest in the world. with a human development index of 0.452 in 2019, the country is in the bottom human development category, ranked 182 out of 189 countries. during the war period, sierra leone experienced severe exchange rate depreciation, high inflation, large trade deficit, depletion of foreign reserves, huge budget deficit and low economic growth. however, economic activities rebounded during the post-war era as the country witnessed positive economic growth, moderate inflation and lower budget deficit. notwithstanding the positive gains during the post war period, the country experienced huge capital flight between 2000 and 2019. figure 1 presents the capital flight estimates in sierra leone. for the period between 2000 and 2019, capital flight from sierra leone totaled us$ 19,867.7 million, largely due to macroeconomic instability, coupled with the dynamics of the political landscape, endemic corruption by political elites and tarawalie and jalloh: determinants of capital flight in post war sierra leone: an empirical analysis international journal of economics and financial issues | vol 11 • issue 2 • 2021110 the experience from the civil conflict. this situation is worrisome and pose serious challenge for a small open economy like sierra leone, with an average yearly nominal gdp of us$ 3,900 million. capital flight peaked in 2012, possibly due to the robust economic growth rate (15.2%) triggered by increased iron ore production. the country also experienced reversal in capital (capital inflow) in 2006 and 2007 amounting to us$ 1,343.4 million, due largely to relative macroeconomic stability. based on the ensuing discussion, the important question for policy makers and government is; why is the sierra leone economy experiencing significant level of capital flight, when such resources would have been used for domestic investment with a view to increase employment and boost economic growth. against this background, the main focus of this study is to investigate the determinants of capital flight and to establish the direction of causality between capital flight and key variables in sierra leone, using quarterly data for the period 2000:q1 to 2019:q1. this paper contributes to the existing literature in diverse ways. the study combines both the autoregressive distributed lag (ardl) model and the granger causality framework to identify the drivers of capital flight and the causal relationship between capital flight and key variables of interest. furthermore, despite the large volume of empirical literature on the issue of capital flight and its determinants, the authors are not aware of any country specific study on sierra leone, whose economy has been besieged with massive capital outflows during the past two decades. most of the studies involving sierra leone are based on panel data analysis with generalized inference drawn on the given set of countries (example ndikumana and boyce, 2003). thus, this study will provide a guiding framework for policymakers in formulating policies and initiatives with respect to capital flight in sierra leone. the rest of the paper is structured as follows: section 2 discusses the empirical literature on the determinants of capital flight, and section 3 addresses the methodology. section presents the empirical result and discussion, while section 5 concludes the paper and suggest some policy recommendations arising from the study. 2. literature review the empirical literature is replete with studies on the determinants of capital flight. while some researches focus on country specific studies (ljungwall and zijian, 2008; forson et al., 2017), others utilize panel data (kant, 1996; raheem, 2015; nyong, 2003). despite the large volume of empirical studies, the literature suggests that identifying the determinants of capital flight remains an unresolve issue, and the findings have produced mixed results. using the ordinary least squares (ols) technique, han et al. (2012), conducts a study to investigate the determinants of capital flight in hong kong. the empirical evidence reveals that, overvaluation of the currency, currency account deficit, and the dummy variable representing chinas open door policy of 1979 are the key determinants of capital flight in honk kong. employing similar methodology, kipyegon (2004) investigates the drivers of capital flight in kenya. using time series data for the period from 1971 to 2001, the findings indicate that external borrowing, inflation, real exchange rate, real economic growth, and financial development are the main determinants of capital flight. in a related study, aziz et al. (2014) examines the determinants of capital flight in bangladesh for the period 1972-2013. employing the ols method, the result reveals that foreign direct investment, external debt, and foreign reserves are the major causes of capital flight. also, al-basheer et al. (2016) employs the ols technique to investigate the causes of capital flight in jordan for the period 2000-2013. the finding shows that external public debt, economic openness, taxes, and the lagged capital are the main determinants of capital flight in jordan. uddin et al. (2017) investigates the determinants of capital flight in bangladesh spanning 1973-2013. using the ols technique, study confirms that, the main determinants of capital flight are foreign direct investment, external debt, interest rate differentials, foreign reserves, and current account surplus. utilizing a combination of the ols and the generalized method of moments (gmm) estimation techniques, salandy and henry (2018) examines the determinants of capital flight in trinidad and tobago for the period 1971 and 2011. the empirical finding indicates the key determinants of capital flight are the lagged external debt, lagged capital flight, external debt, gdp growth, interest rate differential, and excess liquidity. ljungwall and zijian (2008) investigate the causes of capital flight in china, using quarterly data for the periods 1993:q1-2003:q4. employing co-integration and innovation accounting techniques the result shows that external debt, real gdp growth and foreign investors’confidence are the main causes of capital flight. nyoni (2000) employs time series data spanning 1973-1992 to identify the determinants of capital flight in tanzania. the study confirms that lagged capital flight, real growth rates, interest rate and exchange rate differentials are the main determinants of capital flight in tanzania. using panel data, egbulonu and bhattarai (2020) examines the determinants of capital flight in 25 sub–saharan african countries (ssa) over the period 1986-2010. using dynamic panel data estimation method, the findings indicate that capital flight is largely driven by corruption, lag capital flight, external debt, foreign direct investment, and macroeconomic uncertainty. in a related study, brafu-insaidoo and biekpe (2014) conducted a study to examine the macroeconomic determinants of capital flight in sub-saharan african (ssa) countries during the period 1981-2015, and using the ardl approach. the results reveal that the main determinants of capital flight in ssa are economic figure 1: capital flight (us$ millions) source: authors’ computation tarawalie and jalloh: determinants of capital flight in post war sierra leone: an empirical analysis international journal of economics and financial issues | vol 11 • issue 2 • 2021 111 growth external debt. furthermore, kant (1998) carried out a study to investigate relationship between fdi and capital flight in developing countries, using time series data from 1974 to 1992. the study finds a negative relationship between fdi and capital flight in developing countries. the find also shows that, mismanagement by the government leads to capital flight. furthermore, antzoulatos and sampaniotis (2002) examines the determinants of capital flight in 17 eastern europe countries, using quarterly data from 1993 to 1999. their result reveals a positive relationship between fdi and capital flight. cuddington (1986) employs time series analysis from 1974 to 1984 to examine the relationship between capital flight and key macroeconomic variables latin american countries. the findings show that interest rate differentials, external debt flows, lagged capital flight, inflation and exchange rates are the main determinants of capital flight. ndikumana and boyce (2003) investigate the determinants of capital flight for 30 sub-saharan african countries, including 24 countries classified as severely indebted low-income countries, using data covering the period from 1970 to 1996. their findings show that external borrowing has a positive impact on capital flight. it also reveals that capital flight exhibits a high degree of persistent. al-fayoumi et al. (2012) examines the determinants of capital flight in seven middle east and north africa (mena) countries for the period 1981 to 2008. utilizing the ols, fixed effects, random effects, and seemingly unrelated regression models, the findings reveal that lag capital flight, external debt, foreign direct investment, real gdp growth rate and uncertainty are the main determinants of capital flight. osei-assibey et al. (2018) investigates the effect of corruption and institutional governance indicators on capital flight for 32 countries in subsaharan africa over the period 2000-2012. using the generalized method of moment and fixed effect regression within the portfolio choice framework, the findings reveal that corruption, regime durability and rule of law are the main variables that influence capital flights in ssa. employing the ardl model, forson et al (2017) investigates the long-run and short-run determinants of capital flight in ghana for the period 1986-2015. their findings show that higher domestic real interest rate in relation to foreign interest rate, good governance, financial development, real gdp growth rate, and strong property right, and ratio of external debt to gdp are the main determinants of capital flight in ghana. using similar methodology, liew et al. (2016) investigates the macroeconomic determinants of capital flight in malaysia. employing time series data spanning the period 1980-2010, within the ardl framework, the findings show that political risk and financial crisis positively influence capital flight in the long-run. in a similar context, using annual data for malaysia for the period 1992 and 2012, auzairy et al. (2017) investigates the dynamic relationship between capital flight and macroeconomic fundamentals in malaysia between 1992 and 2012. utilizing co-integration and vector autoregression methods of estimation, the study noted that consumer price index (cpi), gdp, interest rate and exchange rate constitute the macroeconomic fundamentals determining capital flight. alam and quazi (2003) investigate the determinants of capital flight in bangladesh using time series data from 1973 to1999. the study employs the ardl bound testing framework. the findings reveal that political instability is the most significant variable influencing capital flight. 3. methodology to investigate the determinants of capital flight in post-war sierra leone, the study utilizes the autoregressive distributed lag (ardl) estimation technique. also, the study employs the granger causality test to establish the direction of causality between capital flight and key variables. the model specification is largely informed by review of the empirical literature and theoretical foundation on capital flight. the model specified in this paper is akin to the empirical work of obeng (2017). however, a key variant of this current model is the inclusion of corruption and inflation as determinants of capital flight. the choice for including inflation is based on the fact that, the sierra leone economy is typified with high inflationary pressure, with inflation rate in double digit. the literature suggests that higher level of inflation reflects macroeconomic instability which can create investment risks, as well as risks for holding domestic financial assets (dooley, 1988). furthermore, the government can use the level of inflation to gauge how much to tax domestic assets (harrigan et al., 2002). also, corruption is included as an explanatory variable on account of the endemic corruption that continues to besiege the sierra leone economy during the post-war era. empirical evidence suggests that corruption reduces investment quality, which creates uncertainty and insecurity (tanzi and davoodi, 1997). besides, corruption-driven funds normally move out of a country in fear that the corrupt government will be unable to provide a conducive investment climate (osei-assibey et al., 2018). thus, the model is specified in the form of a multiple linear regression form as follows: cf inf er corr ed fd rgdp t t t t t t t t � � � � � � � � � � � � � � � � 0 1 2 3 4 5 6 (1) where: cf is capital flight, inf is inflation rate, er is real effective exchange rate, corr is corruption index, ed is external debt expressed as a percent of gdp, fd is financial development defined by broad money as a percent of gdp, and rgdp is real gdp growth rate. also, βiwith i=0…6 represent parameters to be estimated and ε is the error term, that is identically and independently distributed with zero mean and constant variance. capital flight, external debt and financial deepening are expressed in natural logs, whilst all other variables are expressed in levels. furthermore, this study uses the broad measure approach (indirect approach) to measure capital flight. the advantages of the broad measure approach over the hot money measure, is based on the fact that broad money measure covers a wide range of transactions; can be treated as a measure of resident capital outflows; it reduces the potential biases; and does not include in its computation elements that might not include in capital flight (schneider, 2003; osei-assibey et al., 2018; ndikumana and boyce, 2018). the broad-based method used in this study to calculate capital flight is given as follows: tarawalie and jalloh: determinants of capital flight in post war sierra leone: an empirical analysis international journal of economics and financial issues | vol 11 • issue 2 • 2021112 cf debt fdi oi ca nrt t t t t t� � � � �� �� � (2) where: ∆debt is change in debt stock, fdi is net foreign direct investment, oi is other investments, ca is current account and nr is net additions to reserves. in terms of the estimation technique, the autoregressive distributed lag (ardl) estimation framework is used in this study in order to estimate the capital flight model for the sierra leone economy. this approach has the advantage of performing better and being more robust for small sample data size, hence, suitable for this study. also, the ardl has the advantage of allowing variable relationships to be tested even when the variables are of i(1) or i(0) (pesaran et al., 2001). its popularity can be traced to the fact that a cointegration of non-stationary variables is equal to an error correction process. to proceed with the ardl estimation framework, this study specified an unrestricted ardl model for capital flight by transforming equation (1) as follows: 0 1 2 0 0 3 4 5 0 0 0 6 1 1 2 1 3 1 0 4 1 5 1 6 1 − − = = − − − = = = − − − − = − − − ∆ = + ∆ + ∆ + ∆ + ∆ + ∆ + + + + + + + + ∑ ∑ ∑ ∑ ∑ ∑ q q t ti t i ti t i i i q q q ti t i ti t i ti t i i i i q ti t i t t t i t t t t cf inf er corr ed fd rgdp inf er corr ed fd rgdp δ γ γ γ γ γ γ β β β β β β ε (3) where q represents the maximum lag of the independent variables; is the drift component; δ denotes the first difference operator; and t-1 is the level lag. the long-run relationship is captured by the βi’s, i=1…6, reflecting the long-run coefficients in the model, while the remaining component reflects the short-run dynamics of the model. following the specification of equation (3), the study proceeds to test for cointegration premised on the ardl bound testing technique. a pre-condition for conducting the cointegration test is to establish the optimal lag length using the sbc, aic, and the h-q statistics. testing for cointegration is predicated on setting up of the null and alternative hypothesis. the null hypothesis assumes there is no cointegration, which involves subjecting the coefficients of the long-run variables to zero. the alternative hypothesis asserts the existence of cointegration on grounds that the long run coefficients are not equal to zero. the null and alternative hypotheses are given as follows: 0 1 2 3 4 5 6 0 ( )= = = = = = =h no cointegrationα α α α α α 0 1 2 3 4 5 6 0 ( )≠ ≠ ≠ ≠ ≠ ≠ ≠h cointegrationα α α α α α the literature on the ardl cointegration framework gives two asymptotic critical values; the lower bound valuessuggests that the variables are stationary hence integrated of order zero, and the upper bound valuesassumes that the variables non-stationary, therefore integrated of order one. thus, in a situation where the computed f-statistic is larger than the upper critical value, we accept the alternative hypothesis that there is cointegration, thereby rejecting the null hypothesis. however, in a situation that the computed f-statistic is below the lower critical value, we accept the null hypothesis and conclude there is no cointegration. given that the study establishes the existence of cointegration, we then proceed to estimate a restricted short-run ardl error correction model of the form specified as follows: � � � �cf inf er corrt i q ti t i i q ti t i i q ti i � � � � � � � � � � � � � �� � � �0 0 1 0 2 0 3 00 4 0 5 0 6 1 q ti t i i q ti t i i q ti t i ted fd rgdp ect� � �� � � � � �� � � �� � � � �� � � tt (4) in equation 4, all the variables are in first difference, which illustrate the short run scenario. furthermore, the short run model includes the error correction term (ect) and the coefficient of the ect, δ is the speed of adjustment, which indicates the direction of change to the long run equilibrium. the study also employs the granger causality framework to test for any bivariate linear causality between capital flight and key variables. the literature suggests that granger causality is a probabilistic method that is used to investigate causality between two variables in a model. the method clearly and unambiguously measures the causal effect of stationary multivariate autoregressive. in line with granger (1969), a bivariate autoregressive model is defined as; cf a cf b x et j s j t j j s j t j t� � � � � � �� � 1 1 � � � � (5) x c cf d xi t j s j t j j s j t j t, � � �� � � � �� � 1 1 (6) where: et and ∈t are assumed to be two uncorrelated white-noise series. in equation (5) and (6), s is the maximum number of lagged observations in the model and x represents any explanatory variable that is tested against cf. by the definition of causality shown in equation (5) and (6), x is causing cf if bj is not equal to zero. similarly, cf is causing x if cj is not equal to zero. however, if both events occur, then a feedback relationship is said to exist between cf and x (granger, 1969). this test is conducted through the use of the f-test. thus, the granger causality tests in equations (5) and (6) are used to establish the causal relationship between capital flight and its determinants. the study utilizes quarterly data spanning the period 2000:q12019:q1. whilst capital flight, external debt and financial deepening are expressed in natural logs, all other variables are expressed in levels. data for the study were sourced from the united nations conference on trade and development (unctad), international financial statistics (imf) and the balance of payment and international investment position statistics (bop/iip), and world bank’s world development tarawalie and jalloh: determinants of capital flight in post war sierra leone: an empirical analysis international journal of economics and financial issues | vol 11 • issue 2 • 2021 113 indicators (wdi), world governance indicators (wgi) and international debt statistics (ids). 4. empirical results and discussions 4.1. unit root test all the variables were subjected to unit root test to ascertain the stationarity of the individual time series, using both the augmented-dickey fuller (adf) and philip-perron (pp) test. the results as presented in table 1 reveal that all the variables are non-stationary in levels, except capital flight and real effective exchange rate which are stationary in levels. however, when the variables are difference once and subjected to unit root test, the result indicate that all the variables became stationary in first difference. the conclusion of the unit root result shows that, while capital flight and real effective exchange rate ae integrated of order zero, i.e. i(0), all other variables are integrated of order one, i.e., i(1). the combination of both i(0) and i(1) series provide a strong justification for the application of the ardl bound testing technique. 4.2. the ardl bounds test for cointegration the study employs the ardl bound test to ascertain the existence of cointegration, that is, whether there is a long run relationship (nkoro and uko, 2016). to proceed with the bound test, we specified the null hypothesis of no cointegration, against the alternative hypothesis of cointegration. the rule of thumb is that, if the f-statistics is greater than the 1% and 5% upper limit, we accept the alternative hypothesis and conclude the existence of cointegration. results from the ardl bounds test for cointegration is reported in table 2. the outcome from the table confirms that, the f-statistics value of 6.14 is above the upper-bound at the 1%, 5% and 10% significance level, respectively. the result therefore establishes the existence of cointegration, hence there is a long-run relationship between the variables of interest. 4.3. the long-run ardl model the study proceeded to estimating the long-run ardl model having determined the existence of a long-run relationship. the results are presented in table 3. the result reveals that real effective exchange rate, corruption and external debt are the main determinants of capital flight in sierra leone. the result confirms a positive relationship between real effective exchange rate and capital flight. the result shows that a unit increase in exchange rate will increase capital flight by 0.05%. intuitively, an increase in real effective exchange rate indicates a loss in trade competitiveness as a consequence of an appreciation. this tends to increase the country’s vulnerability to financial crisis, as well as worsening the current account, thus increasing the risk of capital flight (pettinger, 2019). this result is consistent with the empirical findings by harrigan et al. (2002). therefore, the study concludes that higher real effective exchange rate is likely to induce capital flight from sierra leone. furthermore, the result reveals a positive relationship between corruption and capital flight. thus, if corruption increase by one unit, capital flight will increase by 0.17%. the literature posits that corruption creates business insecurity and uncertainty, which therefore leads to capital flight. also, corruption-driven funds normally move out of a country in fear that the corrupt government will be unable to provide a conducive investment climate. the findings concur with empirical work of osei-assibey et al. (2018) and tanzi and davoodi (1997). the empirical result also confirms a positive relationship between external debt and capital flight in sierra leone. the result shows that a one percentage point increase in external debt will cause capital flight to increase by 0.39%. this finding is consistent with the empirical work of makochekanwa (2007). generally, rising external debts creates expectation about the depreciation of the exchange rate and for taxation increase, thus, stimulating capital flight (harrigan et al., 2002; kipyegon, 2014). 4.4. short-run ardl model the ardl short-run result is presented in table 4. from the result, the speed of adjustment term was negative and highly significant which further reinforces the existence of a long-run relation among the variables. the result shows that any disequilibrium in the model is corrected at the 26% adjustment speed annually. the result presupposes a slow speed of adjustment. the results reveal that the lagged capital flight, corruption, external debt and financial deepening are the short-run determinants of capital flight in sierra leone. in the short-run, the lagged capital flight was found to have a positive impact on capital flight. the results show that for a one percentage point increase in the lagged capital flight, capital flight will increase by 0.53%. this suggests that the previous year’s capital flight can influence positively on current year’s capital flight. furthermore, the short run result confirms a positive relationship between corruption and capital flight, consistent with the long run findings. thus, a one unit increase in the level of corruption table 1: unit root test results variable augmented dickey-fuller philips-peron order of integration level first difference level first difference capital flight −3.032** −2.983** i (0) inflation −2.536 −4.870** −2.582 −5.934* i (1) real effective exchange rate −3.318** 3.047** i (0) corruption −0.462 −3.330** −0.858 −3.649** i (1) external debt −2.059 -2.919** −2.253 −3.054** i (1) financial deepening −1.750 −3.168** −0.804 −3.297** i (1) real gdp −1.902 −3.309** −1.357 −3.494** i (1) * and ** indicate significance at 1% and 5% levels, respectively tarawalie and jalloh: determinants of capital flight in post war sierra leone: an empirical analysis international journal of economics and financial issues | vol 11 • issue 2 • 2021114 would increase capital flight by 0.06% in the short-run. the finding is consistent with the work of osei-assibey et al. (2018). also, external debt was found to have a positive effect on capital flight in the short-run, a result similar to the long run finding. the results show that a one percentage point increase in external debt will cause capital flight to increase by 0.61%. the finding is in line with the empirical result of salandy and henry (2018) and anetor (2019). the result also confirms a negative relationship between financial deepening and capital flight with significant coefficient in the short run. the findings indicate that a one percentage point increase in financial deepening decrease capital flight by 0.13%. a result that corroborates with the findings by raheem (2015). intuitively the literature posits that with a well-developed financial system, the transaction and information cost of economic activity will be lower. as such, investors are encouraged to invest in the domestic economy thereby reducing capital flight. the diagnostic result posits that 75% of the variations in capital flight were explained by the explanatory variables. also, the durbin watson value (2.04) indicates the absence of any first-order serial correlation. 4.5. stability test the study carried out the stability test to ensure the stability of the parameters using both the cumulative sum (cusum) and the cumulative sum of square (cusumsq). as reported in figures 2 and 3, the results indicate that, the coefficients are stable, given that the cusum and cusumsq lie within the critical band. 4.6. granger causality test the granger causality test results are shown in table 5. critical analysis of the result indicate that only external debt and capital flight exhibits a bi-directional causality. however, both inflation and exchange rate demonstrate uni-directional causality, given that both variables granger cause capital flight, with no feedback effect. therefore, in this study causality was not observed for corruption, financial deepening and real gdp against capital flight. table 2: ardl bounds test result test statistics value significance i (0) i (1) f-statistic 6.135 k 4 1% 3.29 4.37 5% 2.56 3.49 10% 2.2 3.09 asymptotic: n=1000. source: authors’ computation using eviews 11 table 3: ardl long-run result variable coefficient std. error p-value er 0.047 0.009 0.002 inf −1.032 0.974 0.197 corr 0.173 0.058 0.028 ed 0.391 0.103 0.001 fd −0.205 0.185 0.268 rgdp −0.213 0.185 0.127 constant 10.321 4.973 0.041 source: authors’ computation using eviews 11 table 4: short run ardl (2, 0, 0,1, 1, 1,0) variable coefficient std. error (robust) p-value d (lncf_1) 0.527 0.169 0.002 d (corr) 0.064 0.019 0.001 d (lned) 0.605 0.238 0.032 d (lnfd) -0.134 0.042 0.000 ect(-1) -0.261 0.041 0.000 r-squared 0.751 adjusted r-squared 0.724 durbin watson statistic 2.043 source: authors’ computation using eviews 11 table 5: granger causality results null hypothesis obs f-statistic prob. inflation does not granger cause capital flight 75 3.300 0.047 capital flight does not granger cause inflation 75 0.315 0.731 real effective exchange rate does not granger cause capital flight 75 2.731 0.051 capital flight does not granger cause real effective exchange rate 75 1.104 0.337 corruption does not granger cause capital flight 75 2.163 0.123 capital flight does not granger cause corruption 75 0.295 0.745 external debt does not granger cause capital flight 75 2.593 0.082 capital flight does not granger cause external debt 75 4.954 0.010 financial deepening does not granger cause capital flight 75 2.042 0.138 capital flight does not granger cause financial deepening 75 0.520 0.597 real gdp does not granger cause capital flight 75 1.578 0.214 capital flight does not granger cause real gdp 75 0.370 0.692 source: authors’ compilation using eviews 11 figure 3: result of cusumsq test for stability figure 2: result of cusum test for stability source: eviews 11 output tarawalie and jalloh: determinants of capital flight in post war sierra leone: an empirical analysis international journal of economics and financial issues | vol 11 • issue 2 • 2021 115 5. conclusion the objective of this paper was to investigate the determinants of capital flight and establish the direction of causality between capital flight and its determinants in sierra leone. the ardl estimation technique and granger causality framework were employed, with quarterly data for the period 2000:q1-2019:q1. the result from the bound test confirmed the existence of cointegration. the long run results showed that real effective exchange rate, corruption and external debt were the main determinants of capital flight in sierra leone during the study period. specifically, the finding showed that real effective exchange rate, high level of corruption and accumulation of external debt increase capital flight. furthermore, the findings revealed that lagged capital flight, corruption, external debt and financial deepening were the main drivers of capital flight in the short run. whilst lagged capital flight, corruption and external debt accumulation cause capital flight, the result revealed that a well-developed financial system reduces capital flight. the result also showed that any disequilibrium in the model is corrected at the 26% adjustment speed annually. also, the findings confirmed that the coefficients are stable, given that the cusum and cusumsq lie within the critical band. results from the granger causality test indicated that only external debt and capital flight exhibits a bi-directional causality. however, both inflation and exchange rate demonstrate uni-directional causality, given that both variables granger cause capital flight, with no feedback effect. in line with the findings of the study, it is recommended that the government should strengthen the anti-corruption commission and the judiciary with a view to intensify the fight against corruption, ensure transparency and accountability in order to reduce capital flight. furthermore, government should reduce the level of 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(1985), world development report, washington dc: world bank. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(3), 28-34. international journal of economics and financial issues | vol 11 • issue 3 • 202128 potential agglomeration of small food industry in palembang, south sumatra indonesia mukhlis*, bernadette robiani, dirta pratama atiyatna department of economic, economic faculty, sriwijaya university, south sumatra, indonesia. *email: mukhlis6473@gmail.com received: 17 february 2021 accepted: 25 april 2021 doi: https://doi.org/10.32479/ijefi.11300 abstract the pattern of the spread of small food industries in palembang show has led to the establishment of concentration patterns or clusters. this is evident from the grouping type of food industries in certain regions of the city of palembang. the pattern of industrial activity concentration is spatially often identified with the agglomeration. it is, therefore, necessary to study the level of concentration and agglomeration force for small food industries. the population in this study was small food industries scattered throughout the districts in the city of palembang. the analytical tool used herfindahl index, locational gini index, and the agglomeration strength index. the results showed industrial concentration is highest in the district food ilir timur ii at 1.4177 with labor contribution of 4.75 percent. rated power at small industrial agglomeration in palembang foods obtained at 0.03042, with a specialization level of 0.03036. overall there are 488 units of small food industry businesses in palembang and 21.7 percent are in the district of east ilir ii predominantly small soft drink industry with a total production amounting to rp. 11,779,574. this suggests that small soft drink industry potential for development because it has a fairly wide market prospect and raw materials are relatively easy to obtain, although the potential for agglomeration is still relatively weak. therefore, developing soft drink industry needs to consider the use of a cluster-based industrial strategy which is based on industry specialization driven by the occurrence of agglomeration in an effort to develop a competitive advantage in the face of competition in the free market era. keywords: spatial concentration, agglomeration, herfindahl index, locational gini index, agglomeration strength index jel classification: l60; l66 1. introduction the development of small industries today is very important, because of its strategic socio-economic and political functions. the problem that arises for the development of this small industry is the development of economic globalization. globalization is characterized by the growth of cross-border market systems, increased openness and dependence of the national economy in the international economic network, the development of multinational companies, the increasing volume of investment and cross-border trade, as well as the increasing share of world production and trade by multinational companies. in the context of national development, the role and function of small industries has been widely understood. in almost every area, small industries are economic areas that involve the interests of many communities. small industries play a role in the procurement of various needs of products and services for the community and for large-scale economic activities. small industries are now a major force for economic development in each region. in the long run, the development of small industries is directed to serve as a dynamicator for other sectors and will lead all sectors of the economy to a higher level of growth. thus, small industries can truly become the backbone of the economy and encourage ongoing development. as in other areas, economic development in palembang has the main goal to increase the number and type of job opportunities this journal is licensed under a creative commons attribution 4.0 international license mukhlis, et al.: potential agglomeration of small food industry in palembang, south sumatra indonesia international journal of economics and financial issues | vol 11 • issue 3 • 2021 29 for the community. one effort that can be done is by encouraging the development of industrial activities as the main economic activity (prime mover) that can provide a multiplier effect on the growth of other sectors. the industrialization process that has been going on so far has had an impact on the reform of the economic structure, not only at the national level but also at the regional level, including the city of palembang as part of the administrative region of palembang city province. this change in economic structure is characterized by a greater contribution of industrial sector than other economic sectors in palembang. in 2020, the industry sector contributed 45.67 percent to the gross regional domestic product (gdp) of palembang city. the magnitude of this contribution shows the high intensity of industrial sector development in palembang. industrial activities in palembang are dominated by small industries, both from business units and absorbed labor. in 2020, there are 92.78 percent of business units came from small industries with a workforce absorption of 37.22 percent. this shows the large role of small industries in supporting development in palembang. one of the small industrial activities in palembang that has the potential to be developed is the food industry. in 2020, the small food industry made a significant contribution to the development of small industries in palembang, where the contribution of revenue amounted to 72.2 percent of the total revenue of the industrial sector. although the number of business units is still below the small industrial sub-sector of chemicals and building materials, and the small industrial sub-sector of metals and services, as seen in table 1. but small food industry subsectors are able to absorb more labor than other subsectors. subsector of small food industry in palembang is spread in several sub-districts. the most are in the district lir timur ii, with the number of business units as many as 106 units and labor absorbed by 821 people (table 2). the distribution pattern of small food industry subsectors in palembang implicitly reflects the existence of “concentration patterns” or “clusters” of small industrial activities, especially for small industries that are dominant in the region. fujita and thisse (1996), states that spatial concentration is a spatial grouping of each industry and economic activity, where the industry is located in a particular region. spatial concentration indicates the share of an area and the distribution of the location of an industry. if an industry’s spatial distribution is uneven and there is an area that dominates the industrial site, it shows that the industry is spatially concentrated in the region (aiginger and rossi-hansberg, 2003a). discussion of the pattern of concentration of industrial activities and economic activity spatially in various literature is often identified with agglomeration (kuncoro and wahyuni, 2009). agglomeration itself is a very important location factor, both in the form of industrial groupings, housing, the concentration of shops in shopping centers, are equally the main means to improve economic efficiency, because there is a concentration of human activities in a particular location. in line with what montgomery stated in kuncoro (2012), agglomeration is a spatial concentration of economic activity in a region due to savings due to adjacent locations that are often identified with spatial clusters of companies, workers and consumers. although the benefits obtained from industrial agglomeration are quite large, in reality the small industry in the city of palembang, especially the subsector of the small food industry does not seem to have formed an agglomeration. the new pattern is limited to the tendency and potential formation of industrial agglomeration (mukhlis et al., 2017). tight competition as a result of globalization and liberalization gives demands to small industries to be able to compete, including small food industries in the city of palembang. the condition that allows the small food industry in palembang city to survive the competition with large industries is to merge in an agglomeration. small food industries should be able to create efficient economies of scale, so that small food industries can move in an unfragmented market (kuncoro, 2013). given the benefits of agglomeration due to the existence of industrial sites in an area is very large, it is important to know about the existence of industrial agglomeration sites, especially small food industries in the city of palembang. through the agglomeration table 1: small industry in palembang, 2020 industrial branch business unit investation value (rp. 000) labor (person) food 537 21,075,458 5,308 clothing and leather 331 12,586,550 3,784 chemical and building materials 749 4,720 4,720 metals and services 677 20,644,949 3,768 craft and general 162 1,980,552 2,523 total 2,455 56,292,228 20,103 source: the central statistics agency of south sumatra province, 2020 table 2: food small industry distribution area in palembang city, 2020 district business unit investment value (rp. 000) labo (person) alang-alang lebar 4 9,035,195 33 bukit kecil 19 230,390 86 gandus 6 381,500 64 ilir barat i 42 1,091,895 368 ilir barat ii 20 450,312 143 ilit timur i 96 1,706,051 736 ilir timur ii 106 1,991,901 821 kalidoni 10 432,390 30 kemuning 18 773,699 133 kertapati 3 527,900 22 plaju 4 56,250 23 sako 31 859,362 325 seberang ulu i 38 706,532 273 seberang ulu ii 18 461,634 121 sukarame 73 2,250,158 705 sematang borang 0 0 0 total 488 20,955,169 3,883 source: the central statistics agency of palembang city, 2020 mukhlis, et al.: potential agglomeration of small food industry in palembang, south sumatra indonesia international journal of economics and financial issues | vol 11 • issue 3 • 202130 of small food industry is expected to provide spread effect to the surrounding area, thus giving a significant positive influence also to the surrounding area. in this study, the search about the location of small food industry agglomeration in palembang was conducted through literature studies and direct observations in the field. 2. theoretical framework 2.1. industry concept industry is a collection of companies that produce homogeny goods (haryadi et al., 2016). an industrial company produces certain products that have the company’s characteristics. products produced by each company must get legal protection and should not be separated from government supervision. based on this concept, industry has two meanings: (1) broad understanding, industry covers all businesses and activities in the field of economics is productive; (2) in a narrow sense, the industry only includes the processing industry which is an economic activity that conducts the activity of converting a basic mechanical, chemical, or by hand goods so that it becomes semi-finished goods and or finished goods, then goods that lack value into goods of more value and nature more to the final use. 2.2. industry classification by international standard of industrial classification (isic) industries can be classified by several commodity groups, based on business scale and by relationship between their products. the most universal classification is based on the international standard of industrial classification (isic). this isic classification is based on the approach of commodity groups, which are broadly differentiated to the nine groups listed below (central bureau statistics of south sumatra, 2021): 1. isic 31: food, beverage and tobacco industry 2. isic 32: textile, apparel and leather industries 3. isic 33: wood industry and wooden goods, including home furnishings 4. isic 34: paper industry and goods from paper, printing and publishing 5. isic 35: chemical industry and goods from chemical, petroleum, coal, rubber and plastics 6. isic 36: non-metal mining industry, except petroleum and coal 7. isic 37: basic metal industry 8. isic 38: industrial goods from metals, machinery and equipment 9. isic 39: other processing industries. the criteria used by the ministry of industry and trade in assessing small industries use the number of labor force, production and number of sales. this is based on the nature of small industries that are generally labor-intensive, so that with the increase in the labor force and the amount of production or sales means that small industries are able to survive in the environment. 2.3. spatial concentration rauch (1993) stated in the concentration of economic activity spatially, there are three things that are interrelated, namely the interaction between economies of scale, transportation costs, and demand. to gain and increase the power of economies of scale, companies tend to be located in areas with large local demand. however, large local demand tends to be located around concentrated economic activity. next, fujita and thisse (1999) explains that basically, the thinking about agglomeration is based on the importance of increased results due to economies of scale and transportation costs, as well as backward and forward inter-industry links. however, a large local demand tends to be located around the concentration of economic activity. furthermore, head and mayer (2004), explains that in essence, the idea of the agglomeration is based on increasing returns due to economies of scale and transport costs, as well as linkages backward and forward between industries. according to aiginger and rossi-hansberg (2003), the spatial concentration is regional share showing the locational distribution of an industry. meanwhile, industry specialization is defined as the industrial distribution of a region. spatial concentration indicates the level of activity and locational distribution of industries in the region. the approach is often used to analyze the spatial concentration is herfindahl index, denoted by hs, showing the location of the sub-sectors distribution in certain areas. hs values range between zero and one. the higher the hs the increasingly unequal distribution and industrial subsectors s tends to be concentrated in specific areas. ellison and glaeser (1994), analyze the spatial concentration using the labor-based index, known as locational gini index (geg). this index is used to analyze the spatial concentration of manufacturing industry in the united states. based on the analysis, it can be concluded that the spatial concentration occurs because of natural advantages and knowledge spillover. however, because it is difficult to measure the impulse of knowledge spillover towards spatial concentration, then ellison and glaeser argued about the contribution of natural advantages based on factor endowment that simultaneously influences and drive the company’s internal economies of scale. 2.4. agglomeration ellison et al. (2010), states that the agglomeration does not always happen in the industry. agglomeration can occur in several different industries and interrelated. more industrial agglomeration leads to an explanation of the formation or development of a cluster. agglomeration generates benefits for regional development through the movement of goods, human resources, and ease of information. the labor market becomes larger in an industrial area that is agglomerated for information on employment become more numerous. while other costs incurred is the cost of living, commuting and other costs will be cheaper. the natural advantage for the industrial sector occurred because of the availability of raw materials and means of supporting infrastructure. while the spillover of knowledge is supported by the increasing degree of education workers. companies tend to always group in specific locations. this indicates that the increased scale of returns can be achieved by mukhlis, et al.: potential agglomeration of small food industry in palembang, south sumatra indonesia international journal of economics and financial issues | vol 11 • issue 3 • 2021 31 companies in the group, if that is not achieved then the grouping is only temporary. according to mccann (2001), that there are three sources why the scale of increased returns is always achieved, namely: (1) information spillovers. if many companies in the industry are classified as similar, then by grouping at the same location then the workforce in a particular company will be relatively easy to relate to the labor of other local companies. thus, the exchange of information both between workers and between companies will be easier and take place at all times; (2) nontraded local inputs. the circumstances in which companies in similar industries are grouped somewhere then there are certain production inputs that become more efficient when used jointly by workers in those companies than if those inputs were purchased individually by those companies; and (3) availability of local skilled labor pool. the availability of skilled labor in the region will lead to lower labor costs for companies on the site. 3. literature review chollidah (2012), in her study of small food processing industry in semarang district, find from 19 districts in the district of semarang, the concentration of small food processing industry is concentrated in a single district, the district tuntang. the magnitude of the power of agglomeration occurs in small industrial processed foods, concentrated in semarang district amounted to 0.069856, with little industry specialization level of processed food amounted to 0.070254. policy planning and development are considered strategic for the development of small food processing industry is the cluster approach. tilaar (2010), in her study of the distribution of agglomeration locations in indonesia, found that the industrial sector plays an important role in the economy of a region. in indonesia, the industrial sector is the major sector in the economy because it contributes greatly to indonesia’s gross domestic product over the last 10 years. the concentration of industry that occurred in the region will benefit so-called agglomeration economies and provide a positive influence on economic development. lafourcade and mion (2007), in their study of the spatial concentration and size of companies (agro-industry), using the location quotient, found that the relative specialization in a region occur if industry specialization in an area larger than industry specialization in the main areas (aggregate). ellison and glaeser (1999), in their study of natural agglomeration advantages associated with the use of locational gini index ellison and glaeser index, found the spatial concentration of industries occur because of natural advantages and knowledge spillover. agglomeration research with geogarfic economic approach was conducted by (markusen, 1996). the goal is to look at the pattern of industrial clusters or industrial aglomeration in the united states. based on variable business structure and economies of scale, investment decisions, cooperation with suppliers, network of cooperation between entrepreneurs in clusters, network of cooperation with companies outside the cluster, market and labor migration, local cultural identity associations, the role of local governments, and the role of associations, the cluster pattern is distinguished into four districts, namely marshallian district, district hub and spoke, satellite district, and state-anchored district. kim (1995) in his study of industrial regional localization in the united states using variable resource intensity, economies of scale, and variable dummy found changes in resource use and economies of scale significantly explaining the tendency of regional localization in the united states. 3.1. flow of thought as seen in figure 1, the potential agglomeration of small food industry in palembang will be calculated using herfindhal index, locational gini index, and agglomeration strength index. through the size of each index, it will be seen whether the small food industry in the city of palembang has the potency to agglomerate. 4. material and methods research emphasis on small industrial agglomeration food in the city of palembang in 2020, due to the small industrial sector including the food industry subsectors little big contribution in the creation of employment and income from the industrial sector. primary data was collected through questionnaire by survey method. the sampling method used was convenient sampling, which comprised of 60 samples. the data used are secondary data and primary data, obtained from various agencies such as the central bureau of statistics of palembang, the ministry of industry, trade and cooperatives palembang. in addition, data obtained through the library of literature in the form of textbooks, scientific articles, and other sources that are relevant to the topic being studied. this study used a qualitative descriptive approach to provide an overview of the condition of the small industrial sector food in palembang. estimation tools used among others; 4.1. herfindahl index (hs) hs values range between zero and one, the higher hs the increasingly unequal distribution locations, and small businesses tend to be concentrated in specific areas (ellison et al., 2010); h ss i m ij� ��2 1 2 (1) and; s e e ij ij j � � (2) where: hs = the concentration ratio (percent); m = number of areas/regions; and si = share of small industrial employment subsector i at sub-district in palembang; eij = labor sector i in region j; σeij = total employment in the sector i and j. mukhlis, et al.: potential agglomeration of small food industry in palembang, south sumatra indonesia international journal of economics and financial issues | vol 11 • issue 3 • 202132 4.2. potential agglomeration the power of small industry agglomeration food in palembang calculated using locational gini index and agglomeration strength index (ellison et al., 2010); 4.2.1. locational gini index g s eeg i m ij ij� ��� 2 1 2 ( ) (3) and; eij je je ij ij � � �� � (4) 4.2.2. agglomeration strength index (ellison et al., 2010) g g eij eg eg i m � � ��1 1 2 ( ) (5) where: geg = force that drives concentration spatial agglomeration; geg = gini locational; si = share of small industrial employment subsector i at subdistrict in palembang; eij = share of small industrial employment subsector i in palembang. 5. results and discussion the spatial concentration provides the advantages of saving localization and urbanization that encourages agglomeration. localization savings associated with externalities in an industry has given rise to the phenomenon of industrial clusters, often called industrial clusters or industrial districts. the region has diverse small businesses, such as palembang rare phenomenon of an industrial district, is a cluster which occurs naturally. industry cluster that occurred in the city of palembang mostly industrial complex shaped clusters, which do not occur naturally and in need of investment and government intervention, as well as other related institutions in building a relationship with based on rationality. in this regard, it is necessary to do a study on the potential level of concentration and agglomeration of small food industries in the city of palembang in the development of the small industry. 5.1. spatial concentration of small food industries in palembang based on herfindahl index the spatial concentration level of small food industry in palembang city was analyzed using herfindahl index to show the distribution of subsector locations in palembang as seen in table 3. the highest index in the subsector of small industries in palembang is in ilir timur ii subdistrict of 1.4177, the second rank is in ilir timur i subdistrict of 1.2710. the lowest index is in sematang borang sub-district because there is no small food industry, and kertapati sub-district. the high index figures in ilir timur ii sub-district show that the dominance of labor distribution in the area is greater than other sub-districts in palembang. the high index figure is due to ilir timur ii subdistrict is the largest soft drink producing area in palembang with a production value of rp. 11,779,574. sub-district sematang borang has the lowest spatial concentration value because the area did not reveal any small food industry. in the realm of informal and based on field surveys, in the district of sematang borang have small food industries, but the food industry has not been registered yet. it is also the problem when calculating the distribution of small food industry workers in those locations. based on survey results, the distribution of the largest labor force in the district sematang borang found on clothing and leather industries, as well as metals and services. other distribution of the lowest labor contained in sub-kertapati, because in this area the greatest contributions come from the subsectors of clothing/textiles. to improve the low labor distribution in the region, the local government should give serious consideration to doing counseling and providing assistance to small industry players, especially mothers of households to be given the skills to create and manage an innovative food that has more value. moreover, the improvement of road infrastructure is also very influential on the development of small food industry. if the roads are good, then the main attraction for the investors to invest in the area. small industrial agglomeration (kuncoro, 2000); fujita et al 1999) potential agglomeration of small food industry (cholidah, 2012) herfindhal index (elison glaeser, 1999) gini location index (ellison glaeser, 1999) agglomeration strength index (ellison glaeser, 1999; krugman 1991) figure 1: schematic flow of thought mukhlis, et al.: potential agglomeration of small food industry in palembang, south sumatra indonesia international journal of economics and financial issues | vol 11 • issue 3 • 2021 33 5.2. strength of small food industry agglomeration in palembang based on locational gini index and agglomeration strength index based on calculations using the gini index locational and agglomeration strength, as seen in table 4, obtained the degree of specialization of small food industry subsector amounted to 0.03036. while the magnitude of an agglomeration that encourages spatial concentration on small food industries in palembang at 0.03042. the highest value is precisely located on a small industrial chemicals and building materials, with a specialization level of 0.05913 and the value of the power of agglomeration of 0.05935. this indicates that the level of specialization of the small food industry is still relatively low compared to the small industrial chemicals and building materials. saving urbanization occurs when the majority of small food industries are concentrated in the district of east ilir ii. saving urbanization gave rise to the phenomenon called by agglomeration. the development of small food industry subsectors are concentrated in the district of east ilir ii, palembang happens impulse potential agglomeration caused by externalities in the form of knowledge spillover and specialized labor. it is also driven by market access, population, and transportation facilities. the population is a potential demand for the small industrial output of food, thus supporting its development as the natural advantages the region an important role in the process of agglomeration. 5.3. spatial concentration suitability small industries food with potential locations in palembang development of small food industry sector in palembang consider the use of cluster-based industrial strategy. based on industry specialization driven by agglomeration in developing competitive advantages of the small industrial sector in the city of palembang in the face of competition in the free market era. based on the survey, the region has the potential for agglomeration is ilir timur sub-district ii, with the kind of small industries soft drink.it is based on the consideration that the soft drink industry has a fairly broad market prospects and does not require imported raw materials. planning the development of small industries with a soft drink on a cluster approach ii east ilir subdistrict in palembang is strategic because it not only raises the cost efficiency but also can increase bargaining power and have a positive influence on regional economic development. the cluster approach to stimulate innovation through the exchange of experience and knowledge among small food industry players in palembang in the upstream-downstream, and able to provide a framework to face the challenges of globalization. 6. conclusion small industrial food in palembang is concentrated in the district of east ilir ii with a value of 1.4177 with the amount of labor distribution of 821 workers of the total workforce in the city of palembang amounted to 17 273 workers. lowest spatial concentration in the sub-sematang borang and sub-kertapati, with each value of 0.0000 and 0.0380. type of small industry which potential to developed in palembang, especially in the district of east ilir ii is the soft drink industry, as the market outlook is quite wide, availability of raw materials, and mastery of technology manufacture of soft drinks are easily understood by the workforce. specialization level of small food industrial by using analytical tools localization gini index of 0.03036, and not more precious than a small chemicals and building materials industries that are equal to 0.05913. based on the number of agglomeration strength index of at 0.03042 show little food industry has great potential to agglomeration, although still at low level. references aiginger, k., rossi-hansberg, e. 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(2010), overview of distribution location of industrial agglomeration in indonesia. tekno, 7(52), 90-96. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2022, 12(5), 21-28. international journal of economics and financial issues | vol 12 • issue 5 • 2022 21 progress towards recognised professional status: the australian financial planning landscape in 2022 ben neilson* university of southern queensland, po box 8010, bargara, qld 4670, australia. *email: ben@neilsonwealth.com.au received: 03 june 2022 accepted: 09 august 2022 doi: https://doi.org/10.32479/ijefi.13377 abstract research seeks to measure the progress made towards achieving recognised professional status within the australian financial planning sector. it identifies four key professional attributes derived from literature and applies these within a financial context using a tool designed to measure progress. sample size consists of 1,093 useable responses recorded during a 4-month period in 2022. quantitative data collected using online survey and recorded using likert mean scale with anova analysis technique applied. results aim to evidence progress and further advance financial theory by bridging a knowledge gap and evidencing the professional progress within the australian financial planning sector. keywords: australia, financial, planning, profession, industry jel classifications: g15, n20, o19 1. introduction the australian financial planning sector is an emerging profession (robinson et al., 2022) originating in the 1970’s. it has developed to offer services in relation to wealth, taxation, superannuation, insurance, and investment advice addressing individual need. financial advice is important with respect to building individual levels of financial development (wang et al., 2022), understanding financial decision-making capabilities (sunderaraman et al., 2022) and fostering the evolution of financial resilience (lyons and kass-hanna, 2022), when addressing matters of personal finances (garcía mata, 2021). regional based australians have been identified as possessing lower levels of financial literacy (de zwaan and west, 2022) and struggle to mitigate these deficiencies. financial advice has shown (tahir et al., 2022) to contextualise direction, mediate impulsivity and increase individual life satisfaction due to addressing shortfalls in financial literacy. financial advisers have been linked to benefitting their surrounding social communities and contribute to the reduction in rates of consumer fraud and scam (mamonov, 2022). oh et al. (2022) have shown that removal to the access of financial advice will increase the potential susceptibility of consumers to fraud. (irving, 2012) found that financial advice has a direct effect on individual well-being and offers psychological benefits. the provision of financial advice offers the ability to empower individuals allowing the creation of their versions of financial freedom (cull, 2009). over the past decade research has indicated that levels of consumer trust in australian financial advisers experienced a steady decline (asic, 2019). due to several elements such as comprehension of complex advice documents, sector misconduct, excessive cost of services and low education barriers to entry (asic, 2019). in response, the australian government commenced a royal commission (hayne, 2019) and has since introduced a series of reforms aimed to increase regulation, professionalism and improve the quality of advice. this includes reforms relevant to this research such as future of financial advice (australian government, 2012), life insurance reforms (trowbridge, 2016), financial planners and advisers code of ethics 2019 (code of ethics, 2020) and the financial sector reform act 2021 (hayne, 2021). ap (2011) found that acceptance of recognised status would this journal is licensed under a creative commons attribution 4.0 international license neilson: progress towards recognised professional status: the australian financial planning landscape in 2022 international journal of economics and financial issues | vol 12 • issue 5 • 202222 contribute heavily towards restoring public trust and confidence in australian financial advisers. professionalism is a sought status often associated with an increasing perception within society. professional status is positioned to be an indicator of trust and expertise, based upon the proficient mastery over a complex body of theory, knowledge and skills, (cruess et al., 2004). an important milestone of achieving “professional recognition” is used to increase consumer trust, unify individual professional actions and adhere to professional authorities within the financial planning context (murphy and watts, 2009). this research uses attributes of professionalism derived from (abbott, 1998; dellaportas et al., 2005; huber and königkersting, 2022) allowing distinguishable factors between industry and professions. definitions are identified to isolate notable professional attributes later determined to measure progress. these attributes are applied in a financial context as a tool to measure progress towards professionalism. we define expected attributes of an “industry” and understand how these differ from those associated with a profession. the definition noted by dyckman (1974, p. 40) applies to workers in an industry: “(a group) of persons engaging in the same business or plying the same craft. primary function seeks to establish control over the trade by setting expected standards of workmanship.” industry groups aim to protect themselves from various avenues of competition by offering the purpose of continued economic security and status to members. for a “professional” we have sought the use of the definition from (lee, 1990 p.139), which argues that a professional is a person working within a group that is part of a: “self-regulating occupation, used as a vehicle for social control in providing professional skills to match uncertainties. controls body of knowledge, regulates members, and relies on client dependency for services. it is given authority to exercise such power. however, it needs to institutionalise and have its activities legitimated to achieve this state accordingly.” limitations present regarding definitions as they provide only partial explanation in respect to their primary application with the terms “industry” and ‘profession” defined within the financial context. this research uses existing findings captured by (murphy and watts, 2009) as a theoretical baseline. captures new data over a 4-month period in 2022. collects a sample size of 1,093 useable responses and seeks to identify progress made toward professional recognition defined by professional attributes using a likert mean scale. analysis technique adopted the analysis of variance (anova) tool used to determine group mean differences within each professional attribute. additionally, linear regressions are applied to categories of attributes using heteroskedastic-robust standard errors to minimise evidence of bias during analysis of results. research was designed to answer the research question of: how does progress of professional attributes contribute to the status of professional recognition. this paper argues that financial planning as practised in australia today, has made considerable professional progress since the original data was published in 2009. it outlines beneficial roles professional status may play in the financial planning sector and details how the unified progress towards professional recognition may benefit the financial planning sector, for both consumers and advisers, in future years. 2. review of literature financial planning will soon reflect a recognised profession, (ioannides, 2015). to contextualise we must define the requirements of a recognised profession and apply these in a financial context. 2.1. definition of profession historically, the term “profession” was associated with the sacred oath taken by monastic clergy (johnson, 2009). during early nineteenth century components of professionalism were developed to embrace four areas of specific endeavour: theology, law, education and medicine (kimball, 1996). cornerstone of a profession requires providing services to the community (abbott and meerabeau, 1998). ideology of professionalism surrounds that of a primary purpose in the spirit of public benefit and service (pound, 1953). professional recognition seeks acknowledgement of theoretical base and the inclusion of a regulatory body of professional authority to protect members of the public. professional authorities often advocate for members on issues such as regulatory reform, funding methodologies, expected ethical leadership (johnson, et al., 2001), and informing the public about their position and areas of oversight and involvement (cruess and cruess, 1997). professional authorities also assume responsibility for unity and alignment with respect to development, service and adherence with professional codes of ethics. professional organisations provide exposure, insight and direction as well as opportunities for continued education and professional development (brennan, 2008). attributes of formalised professions suggests the presence of a governing body including regulatory enforcement (oecd, 2015), membership to a professional organisation (greenwood, 1957), higher levels of mandatory education (surendar and sarma, 2017), and expectations of professional actions measured against standardised codes of conduct and ethics, (noordegraaf, 2007). larger literature searches are required focusing on that of professionals, attributes, recognised professions, and financial planning to define professional attributes accordingly. these will be positioned to establish a framework for subsequent measurement and discussion. (dellaportas et al., 2005) outlines the characteristics of professionalism as: educated individuals possessing competence neilson: progress towards recognised professional status: the australian financial planning landscape in 2022 international journal of economics and financial issues | vol 12 • issue 5 • 2022 23 and skills required to deliver their services to the public with professional authority. regarded as professionals holding a fiduciary relationship over those whom they provide service. (abbott, 1998) defines characteristics of professionalism as: high levels of education supported by a theoretical body, highly specialized knowledge, regulated ethical standards and professional membership. (huber and könig-kersting, 2022) outline characteristics of professionalism within the financial context as: increased ethical decision-making capabilities, high understanding of best interest, legal obligation to uphold public and ethical responsibilities. 2.2. attributes of professionalism drawn from literature review the research has been able to identify key professional attributes and applied these in a financial context. attributes included offering of a unique tool for measurement to be applied against existing data (murphy and watts, 2009) providing a baseline of which this research is able to measure progress since initial publication. attributes encapsulated under the terms: social responsibility, systematic body of theory, professional authority and ethical responsibility. social responsibility outlines an ethical framework in which individuals are expected to assist other individuals and members of the community, vaaland et al. (2008) applied in a financial context this attribute correlates to acting in the clients’ best interest (asic, 2021; commonwealth, 2001) and putting clients needs first, (code of ethics, 2020). systematic body of theory relates to available literature used to advance the profession, (callard, 1998). offers tacit knowledge (snider and nissen, 2003), academic developments and regulatory introduction (dorrell and gadawski, 2012). applied in a financial context positioned to increase financial knowledge and advance outcomes (lusardi and mitchell, 2014). offers access to knowledge providing the basis for professional authority (brennan, 2008). characterised by the evolution of accepted practice through enhanced theory. (morris et al., 2006, p. 710) summarises that “an essential element of a profession is the ownership of a body of knowledge group”. professional authority noted by (dellaportas, et al., 2005, p. 62) obtained through superior knowledge places the professional: “in a dominant position in their role/relationship with clients, the client has no choice but to trust or rely on the judgment and experience of the professional and because, the client cannot appraise the quality of service due to the knowledge differentiation, clients must therefore take it on faith that the professional is competent and committed to helping them.” (olive, 2005) claimed professional authority is based on fact that public has limited access to information and relied on professional guidance for appropriate recommendation and direction. applied in financial terms as access to products, quality of communication in professional relationship, hunt et al. (2011), and specialised knowledge (alhenawi, 2013). ethical responsibility supplies professionals with a minimum expected standard of ethical behaviour to resolve ethical dilemmas and act, respond and navigate accordingly, sekerka et al. (2009). encapsulated by (dellaportas et al., 2005) ethical responsibility tests whether professionals act in manners that are consistent with ethical codes and adhere to repetitively. applied in a financial context by removing ethical boundaries (smith, 2009), providing a framework for ethical decision making (cull and bowyer, 2017) and adhering to all twelve stages of the code of ethics (code of ethics, 2020). professional recognition is an important milestone for the financial planning sector to achieve to increase levels of consumer trust (collier, 2012), assist to increase sector perception (devlin et al., 2015) and encourage financial planning as an enticing career path for future generations (cull and melville, 2018). reviewed literature indicates that attributes may be related. literature review identified four major attributes which can distinguish an industry from a profession. attributes are detailed below: 2.3. industry social responsibility > self-interest. body of theory > acceptance. professional authority > sanctioned. ethical responsibility > minimal. 2.4. profession social responsibility > public interest. body of theory > created. professional authority > navigation through use of specialist knowledge. ethical responsibility > regulated. 3. methodology research is designed to acknowledge results of existing study (watts and murphy, 2009) as a baseline and determine progress towards professionalism using the results of current research in the period since. to achieve these aims data was requested from practicing financial advisers through a structured questionnaire administered through various social media platforms and collated online through a software offering named surveymonkey. leveraging the researchers’ available connections, the survey was made available and released on social media platforms namely linkedin and facebook. it was shared via member associations namely association of financial advisers (afa), financial planning association of australia (fpa) and through key centres of influence namely the “xy adviser” group to increase levels of participation. survey sent to contacts at the eight largest australian financial planning licensees namely, amp advice holdings, smsf advisers network, ioof holdings, easton investments, synchron, centrepoint alliance, capstone financial planning and infocus securities australia. data sought from practising financial advisers due to their interactions with regulators, product providers and clients daily. their unique exposure offered duality with its response as it neilson: progress towards recognised professional status: the australian financial planning landscape in 2022 international journal of economics and financial issues | vol 12 • issue 5 • 202224 combines ground level exposure applied in work-based practises and also reflects that of the emerging regulatory landscape. 3.1. response rate survey was available using an online survey tool for a period of four months. accompanied by an explanatory sentence identifying the objectives and purpose of the study. 1,127 responses received, thirty-four were incomplete thus ineligible for inclusion. researchers identified 1,093 complete responses recorded able to contribute to the study. attempts were made to promote a higher national response rate within the underrepresented states, which included seeking individual businesses to forward survey, offering incentives to complete, and making direct contact. most indicated their willingness to complete but failed to do so before the completion date. 3.2. design, collection and analysis identified attributes measuring progress guided the initial survey design. attributes were separated via categories and released through sets of associated questions. the first grouping of questions focused on social responsibility, the second considered body of theory, while the third investigated the professional authority. the final group of questions explored ethical responsibilities. responses were scored on each question using a five-point likert scale. values ranged from: strongly disagree to strongly agree. additional questions were sought to further understand the responders so potential correlations may be drawn. a pilot questionnaire was evaluated using twelve financial planners located in bundaberg, queensland, prior to being released. when determining data collection options researchers focused on that offering methods of familiarity and ease (joshi et al., 2015), ability to reflect options against questions, (nemoto and beglar, 2014) and the ability to apply statistical analysis to results, jebb et al. (2021). the adoptive use of the likert scale measures respondents’ level of agreement with various attitude statements (veal, 2005). researchers adopted the analysis of variance tool (anova) capturing its statistical benefits used to compare variances between means across attribute groups. 4. results and discussion results reflect responses relating to findings throughout the financial planning sector. below serves to provide data surrounding progress in professional members, perceived value in professional membership and obtaining higher levels of education. the table 1 outlines covariant changes in collected data. results indicated that 942 (86.27%) of the respondents are members of professional associations signalling a significant increase from the initial published findings of 31 (30.97%) reflecting a mean increase of +46.57%. 720 (65.94%) of respondents believed that membership to professional associations added value to levels of professionalism, but this reflected a decline from base of 60 (80.70%) reflecting a mean decrease of –14.76%. attaining higher levels of education reflected 887 (81.23%) supporting results, which reflected a +23.45% mean increase than previous data of 45 (57.70%) results. graph 1 shows the age bracket fluctuations of the respondents, with graph 2, 3, 4 and 5 reporting financial planning experience, national response rate, business size of and attained levels of education. the largest group comprised of 360 responses (32.93%) from the age bracket 40-49, 324 responses (29.64%) from the age bracket 30-39, 282 responses (25.80%) from the age bracket 50-59, 72 responses (6.58%) from the age bracket 60+ and 55 (5.05%) from the age bracket 20-29, indicating a diverse group of respondents. graph 2 identifies levels of held financial planning experience. the largest group comprised of 366 responses (33.48%) from the experience bracket 20 + years, 240 responses (21.95%) from the experience bracket 8-11 years, 174 responses (15.92%) from the experience bracket 12-15 years, 144 responses (13.18%) from the experience bracket 16-19 years, 84 responses (7.69%) from the experience bracket 4-7 years, 49 responses (4.49%) from the experience bracket 0-3 years and 36 (3.29%) from the experience bracket not directly working in financial planning, which represents a mature group of respondents. graph 3 represents the national response rate and reflects the vast majority of responses 425 (38.88%) were received from the location bracket of qld, 258 responses (23.60%) from the location bracket of vic, 240 responses (21.95%) from the location bracket of nsw, 78 responses (7.13%) from the location bracket of wa, 54 responses (4.95%) from the location bracket of sa, 22 responses (2.02%) from the location bracket of nt and 16 (1.47%) from the location bracket of act. despite efforts no responses received from tasmania; we discuss geographical limitations later in the research. graph 4 reflects the business environment of respondents which the researchers correlate to support enhanced ethical influence in later discussions. the largest group comprised of 392 responses (35.86%) from the staff bracket 2-5, 277 responses (25.34%) from the staff bracket sole practitioner, 259 responses (23.70%) from table 1: shift in professional landscape 2009-2022 yes, response in 2009 percent of 2009 respondents yes, response in 2022 percent of 2022 respondents correlation on professional progress are you a member a professional association? 31 39.70% 942 86.27% +46.57% do you believe that belonging to a professional association adds value to the professionalism of financial planning. 63 80.70% 720 65.94% –14.76% does obtaining higher levels of education and qualifications, along with completing the fasea examination, add value to financial planners? 45 57.70% 887 81.15% +23.45% neilson: progress towards recognised professional status: the australian financial planning landscape in 2022 international journal of economics and financial issues | vol 12 • issue 5 • 2022 25 graph 1: age bracket of survey respondents graph 2: experience levels of survey respondents graph 3: national response rate of survey respondents graph 4: survey respondents business size the staff bracket 10+ and 165 responses (15.10%) from the staff bracket 6-10. graph 5 reflects the level education throughout the respondents. 456 (41.72%) held a bachelors degree, 218 respondents (19.94%) held a masters degree, 216 respondents (19.77%) held a graduate diploma, 125 respondents (11.44%) were rg146 compliant, 72 respondents (6.59%) held a graduate certificate and 6 respondents (0.54%) held a phd. the next stage of results represents the hierarchy of importance that respondents expressed towards attitude sentences. respondents ranked each component from one: strongly disagree to five: strongly agree. each category of attribute contained six sentences designed to measure progress since original data collection. mean results are attached to attributes and compared against 2009 mean results to reflect correlated outcome on professionalism shown below in tables 2-5. anova analysis then applied to attribute categories, not individual statements, applied under the calculation of: f = msb/ msw f (k-1, n-k) msb = ssb/(k − 1). 4.1. social responsibility results indicate that financial advisers are extremely conscious of their social responsibilities. most means reflected considerable progress in all areas except one which remains unchanged. anova analysis attributed a 2009 mean result of 2.6333, std deviation of 0.7052 and sts error of 0.2879. anova analysis attributed a 2022 mean result of 3.565, std deviation of 1.0124 and std error of 0.4133. resulting in a f-statistic value = 3.42148 and p-value = 0.09409. 4.2. systematic body of theory survey results indicate that financial advisers are becoming more familiar with the value of accessing their body of theory. all acknowledged the increasing importance of theory, levels of education and continuing professional development reflecting that most believe a systematic body of theory is an imperative ingredient of professionalism. anova analysis attributed a 2009 mean of 2.6617, std deviation of 1.0815 and sts error of 0.4415. anova analysis attributed a 2022 mean of 3.995, std deviation of 0.4117 std error of 0.1681. resulting in a f-statistic value = 7.96492 and p = 0.01809. 4.3. professional authority results suggest financial advisers acknowledge they hold professional authority derived from a dependent relationship, industry knowledge and trust due to complexity. responses graph 5: levels of tertiary education neilson: progress towards recognised professional status: the australian financial planning landscape in 2022 international journal of economics and financial issues | vol 12 • issue 5 • 202226 table 4: progress of professional attribute “professional authority” question mean result 2009 mean result 2022 correlated outcome on professionalism a financial planner holds an inferred authority derived from a limited but often dependent client relationship 3.47 4.02 +11.00% clients have choice but often prefer to simply trust the financial planners’ judgments instead 3.10 4.34 +24.80% clients often place significant emphasis on the financial planners’ recommendations 3.93 4.42 +9.80% industry knowledge is the basis for professional authority 4.40 3.71 –13.80% theory, experience and industry knowledge provides increased professional authority 1.90 4.38 +49.60% improved standard practices evolves through improved theory, experience and input 3.30 4.23 +18.60% table 2: progress of professional attribute “social responsibility” question mean result 2009 mean result 2022 correlated outcome on professionalism the aim of financial planning is to support the spirit of public service 3.33 3.84 +10.20% the purpose of financial planning is to protect, guide and lead the public 2.97 4.40 +28.60% your primary responsibility is to yourself, your staff and your licensee/dealer group 2.13 2.02 -2.20% your primary responsibility is to your client 1.93 4.68 +54.00% your primary responsibility is to your firm and or business 1.97 2.73 +15.20% your primary responsibility is to the greater community 3.47 3.72 +5.00% table 3: progress of professional attribute “systematic body of theory” question mean result 2009 mean result 2022 correlated outcome on professionalism a systematic body of relevant theory is a defining characteristic of financial planning 1.13 3.55 +48.40% mastery of relevant theory is important within the financial planning sector 1.97 3.91 +38.80% a relevant degree is a necessary prerequisite to enter and practice financial planning 2.57 4.16 +31.80% an increasing knowledge base will add value to financial planning and the ability of financial planners 3.63 4.55 +18.40% the existing knowledge base provides sufficient information to practice financial planning 4.10 3.52 -11.60% yearly continuing professional development requirements allow financial planning to evolve with the changing needs of society and conform with updated or introduced rules, obligations and pieces of legislation 2.57 4.28 +34.20% table 5: progress of professional attribute “ethical responsibility” question mean result 2009 mean result 2022 correlated outcome on professionalism ethical education provides financial planners with standards, expectations and tools to resolve dilemmas and act ethically in situations 2.30 3.75 +29.00% my professional actions are consistent with the code of ethics 4.13 4.50 +7.40% my advice, responses and actions are client focused 100% of the time 2.73 4.58 +37.00% i declare all commissions, fees and benefits received to my clients in their advice documents 2.90 5.23 +46.60% i believe that existing regulating rules, explanations and guidelines provide sufficient ethical direction 2.23 3.79 +31.20% i believe that any conflicts of interest occurring within financial planning has significantly decreased in the last 2 years. 1.87 4.10 +44.60% indicate the view that professional authority is affected through theory, experience, and specialist knowledge. anova analysis attributed a 2009 mean of 3.35, std deviation of 0.851 and sts error of 0.3474. anova analysis attributed a 2022 mean of 4.1833, std deviation of 0.2728 and std error of 0.1114. resulting in a f-statistic value = 5.21691 and p-value = 0.04547 4.4. ethical responsibility responses to ethical attributes demonstrated the strongest recorded suggesting financial advisers now accept elevated levels of ethical progress. responses to education, client focus, remuneration, ethical direction and conflicts each showed significant mean increase. approach to ethical responsibility allow actions to align neilson: progress towards recognised professional status: the australian financial planning landscape in 2022 international journal of economics and financial issues | vol 12 • issue 5 • 2022 27 in accordance with their professional obligations and meet their ethical expectations. financial advisers now show significant confidence in their ability to navigate ethical areas and can rely on their code of ethics to determine conduct as a basis for navigation and decision making. anova analysis attributed a 2009 mean of 2.6933, std deviation of 0.7944 and sts error of 0.3243. anova analysis attributed a 2022 mean of 4.325, std deviation of 0.5625 and std error of 0.2296. resulting in a f-statistic value = 16.86021 p = 0.00212. results indicated mean professional progress in all four professional attribute categories. researchers noted that inclusion of wording “duty to staff” in graph seven may have contributed to negative mean results given business owners may have felt conflicted with answering this question. the “existing knowledge base was sufficient” presents as a challenging question due to introduction of additional regulation and compliance obstacles, further due to regulation being deciphered by licensees and individual methods of addressing being significant different across businesses. capabilities both professional and product based have been subject to significant amendments and may thus reduce the benefit of experience. finally, that the introduction of mandated ethical codes and legal requirements to “act in the clients best interest” have contributed significant progress towards professional recognition. researchers acknowledge that due to the mature group of established respondents’ higher levels of professional actions are expected and results stand to reflect difference if triangulated towards younger advisers, in smaller businesses yielding less experience. 5. conclusion recorded data suggests responses were received from a mature group of established financial advisers primarily located in the australian states of queensland, new south wales and victoria. majority of respondents operate as professionals supported by heightened levels of professional membership, ethical adherence, and levels of education. financial advisers demonstrate conformance with professional attributes supported by heightened mean outcomes recorded on each category of professional attributes. results outline an increasing value placed on accessing theoretical body of literature with a reliance on to navigate through regulatory reform. financial advisers have acknowledged that professional authority is enhanced by theory, knowledge, and social responsibility. positive correlations were found between demographics such as age, education, and business size, on that of increased mean results across professional attributes. positive correlations were identified including interdependent relationships found between each of the professional attributes. positive correlations were located between increased mean on professional attributes and professional progress. correlations between progress to professional recognition are evident but will require further research to determine the extent. combination of the above attributes when put into public practise suggest that financial planning is evolving into a recognised profession (breakey and sampford, 2017). as such financial advisers have been recently regulated to reflect their professional status like other conventional professionals such as qualified lawyers, doctors and international financial advisers. literature on the development of recognising professions (neal and morgan, 2000) suggest it is a challenging and ongoing process which is often reduced by the dubious acts of others. it is imperative that australian financial advisers, offering professional input, commit to being involved in shaping the professional policies, governance, processes, so that financial planning becomes a true profession run by advisers, like other established professions run theirs (mcinnes, 2020). to date, little systematic research exists on professional attributes and professional progress within the australian financial planning sector. this 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(2009), assessing professionalism: the case of financial planning. jassa, 2(3), 40-44. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(2), 238-242. international journal of economics and financial issues | vol 8 • issue 2 • 2018238 returns of islamic stocks in saudi arabia: segmentation and risk aversion abdullah m. al-awadhi1*, ahmad bash2, ahmad f. al-mutairi3, ahmad m. al-awadhi4 1college of business studies, the public authority for applied education and training, kuwait, 2college of business studies, public authority for applied education and training, kuwait, 3college of business studies, public authority for applied education and training, kuwait, 4kuwait consultancy group, kuwait. *email: am.alawadhi1@paaet.edu.kw abstract this study investigates whether religious-based trading practices affect market returns. we use data from saudi arabia, which has clear defined religious rules on investing in stock markets. using panel regression model, we find that non-islamic stocks in this market have lower returns compared to islamic stocks. these results conflict with merton’s market segmentation theory. keywords: returns, islamic stocks, risk-aversion, segmentation, investment jel classifications: c58, e44, g32\ 1. introduction following merton (1987) market segmentation theory, neglected stocks should outperform other stocks, compensating investors for limited risk-sharing. in this study, we use data with an islamic religious background to investigate returns difference between stocks that are neglected by investors because they conflict with islamic shariah (non-islamic stocks) and stocks that can be characterized as conforming with islamic shariah (islamic stocks). although a number of studies examine the effect of islamic shariah on stock returns, there is no clear understanding of this effect (merdad, 2012). in our study, we may expect that a significant portion of retail investors will follow islamic trading rules in this islamic society and neglect non-islamic stocks as the level of religiosity is very high. according to a gallup 2009 survey, the society of saudi arabia has a strong belief that religion is important in daily life. the survey shows that 93% of people in saudi arabia believe that religion is important in life. we use data from saudi arabia stock market, where recently they adapted friendly foreigner’s regulations to attract both foreign investors and firms (see, saudi arabia to give foreign investors full access to parallel stock market by thomson reuters). however, islamic investors in saudi arabia are considered to be bound by islamic laws that could limit their investments in to islamic stocks only. consequently, the market would be subject to significant segmentation in case the majority of investors trades just islamic stocks, which may be led to discouraging non-islamic firms from listing in this market. we use panel data regression model to mitigate the problems associated with estimation bias and multicollinearity, control for individual heterogeneity, as well as specifying the time-varying relation between dependent and independent variables (baltagi, 2008; hsiao, 2014). we find that non-islamic stocks have lower returns in comparison with islamic stocks. these results conflict with market segmentation theory. one possible reason for the higher returns of islamic stocks in saudi arabia is the high trading by retail investor, as cited by the saudi stock market report, 2015 (http://www.tadawul.com. sa). in the saudi arabia stock market, individual trading represents around 89% of the total trading value. previous research has shown that religiosity is, in general, positively related to risk-aversion (miller and hoffmann, 1995; hilary and hui, 2009; noussair et al., 2013). thus, it is possible that the “segmentation” effect of merton (1987) market segmentation theory in saudi arabia is al-awadhi, et al.: returns of islamic stocks in saudi arabia: segmentation and risk aversion international journal of economics and financial issues | vol 8 • issue 2 • 2018 239 offset by the higher risk-aversion of islamic religious retail traders who trade only islamic stocks and require higher returns, leading to higher returns for islamic stocks. the rest of this paper is organized as follows. the next section presents the literature review. section 3 is data and descriptive statistics. section 4 presents the empirical tests, while section 5 concludes. 2. literature review each society defines ethical investments in a different way. according to (fabozzi et al., 2008), what is perceived as ethical differs between societies and changes over time. islamic societies define ethical investments in an islamic religion context. the effect of religion on returns has been addressed in the context of islamic stocks from the perspectives of mutual funds (elfakhani et al., 2005; abdullah et al., 2007; hayat and kraeussl, 2011; bukhari and azam, 2015) and stock indexes (hakim and rashidian, 2002; hussein, 2004; hussein and omran, 2005; hashim, 2008; hassan and girard, 2010; abbes, 2012; lobe et al., 2012; walkshäusl and lobe, 2012a; walkshäusl and lobe, 2012b; al-khazali et al., 2014; canepa and ibnrubbian, 2014; ho et al., 2014; jawadi et al., 2014; kr and fu, 2014; ashraf, 2016). however, whereas some studies find that islamic investments outperform non-islamic investments, other studies either suggest the opposite or find that there is little or no difference (merdad et al., 2015). following merton (1987) market segmentation theory, neglected stocks should outperform other stocks componsating investors for limited risk-sharing. further, from the literature we have observed that ethically neglected stocks typically outperform the market (fabozzi et al., 2008; hong and kacperczyk, 2009; kim and venkatachalam, 2011; luo and balvers, 2014) and other acceptable portfolios (liston and soydemir, 2010). thus, neglected nonislamic stocks should outperform other stocks and islamic stocks, compensating investors for limited risk-sharing. this leads us to hypothesize that non-islamic stocks outperform islamic stocks. 3. data and descriptive statistics 3.1. data our study is based on stock markets in religious islamic societies that have both “islamic” and “non-islamic” stocks (mixed markets), specifically the listed firms in saudi arabia. the islamic screening strategy in this study divides the stocks into two categories: (i) the stocks of islamic companies and (ii) the stocks of conventional companies or non-islamic companies. we follow the list of the al-mashora and al-raya for islamic financial consultancy to identify the islamic-listed stocks in these stock markets. the data has been collected from thomson datastream. stock closing prices, shares outstanding, and trading volume are collected on a daily basis for the period 2004–2014. furthermore, we also obtained the monthly firm-specific variables, including firm size, firm age, and market-to-book ratio (table 1). this table presents the number of listed islamic firms in the saudi arabia stock market as the end of 2014 (based on the list of al-mashora and al-raya for the islamic financial consultancy). this table also reports the total market capitalization as the end of 2014 in us dollars as well as the average market capitalization for listed firms in us dollars (taken from thomson datastream). table 2 reports the industry concentration of islamic and nonislamic stocks in the saudi arabian stock market, showing that the majority of the islamic stocks are concentrated in the banking, insurance, and financial services industries. thus, we control for the systematic risk that is attached to the stock industry. table 1: saudi arabia stock markets descriptions number of listed firms islamic firms percentage of islamic firms (%) market cap in us$ (000,000’) average firm market cap in us$ (000,000’) 167 39 23 482,145 2,720 table 2: industry distribution of islamic and non-islamic stocks type of bank industrial utility transportation bank and loan insurance other financial islamic 48.3 0.0 0.0 13.8 34.5 3.4 non-islamic 70.9 4.3 3.4 6.8 11.1 3.4 table 3: summary statistics for return panel regression variables er (%) s (000’) mb rt (%) bt t (%) ag panel a: mean, median, and sd mean 0.60 14.93 1.03 0.54 0.95 131.13 8.69 median 0.88 14.92 1.00 1.01 0.92 79.48 8.69 sd 0.08 0.25 0.22 0.02 0.06 1.83 0.16 panel b: median equality test islamic 0.26 14.57 0.82 1.00 0.95 51.28 8.45 non-islamic 1.47 15.01 1.09 1.64 0.90 80.83 8.74 p (0.74) (0.00) (0.00) (0.41) (0.00) (0.00) (0.00) sd: standard deviation al-awadhi, et al.: returns of islamic stocks in saudi arabia: segmentation and risk aversion international journal of economics and financial issues | vol 8 • issue 2 • 2018240 this table presents the industry distribution percentages of the listed islamic and non-islamic stocks in the saudi arabia stock market of our study as the end of 2014. the sector classification is from worldscope’s general industry classification. the percentage of islamic stocks in each sector has been calculated as the number of islamic stocks in that sector divided by the total number of islamic stocks in the market; we calculated the percentage of non-islamic stocks in each sector in the same manner. 3.2. descriptive statistics table 3 reports our main variables of interest and their corresponding distribution statistics. panel a reports the overall market statistics for the return regression variables. we report the excess return (eri,t), firm size (si,t) beta of the stock (bti,t), monthly turnover (ti,t), market-to-book ratio (mbi,t), average monthly return for the previous 12 months (rti,t), and firm age (agi,t) as our main firm-level variables. panel a shows that saudi arabia has high trading activity with a monthly average turnover of around 131%. this table presents the summary statistics for the panel regression variables for 2007-2014. the mean is the time-series average of means, median is the time-series median of means, and standard deviations (sd) is the time-series average of sd. si,t is the monthly natural logarithm of the firm market capitalization in local currency in thousands, mbi,t is the monthly log of the stock market-to-book ratio, bti,t is the rolling beta for the industry to which firm i belongs (calculated at month t based on the previous 36 months), tit is stock i’s turnover ratio for the month t, rti,t is stock i’s average monthly return for the previous 12 months, and afi,t is the log of the firm’s age calculated on a monthly basis. panel a reports the mean, median, and sd of the panel regression variables for the overall market data. panel b reports the median equality test between islamic and non-islamic stocks for the panel regression variables. the p-values correspond to a wilcoxon-mann-whitney signed rank median test. panel b of table 3 reports the results of a median equality test for the return panel regression variables. this test allows for a determination of whether islamic stocks are inherently different from non-islamic stocks. we find that, at the median level, non-islamic stocks do not have significantly higher excess returns when compared to islamic stocks. in terms of trading activity in relation to the turnover ratio, we observe that the median level, non-islamic stocks are traded more table 4: return panel regression tests d s mb rt bt t ag panel a: baseline ols regression (1) 0.003 0.002*** (0.003) (0.001) (2) 0.002 0.002* 0.002** (0.003) (0.001) (0.001) (3) 0.003 0.002** 0.003*** −0.262*** (0.003) (0.001) (0.001) (0.031) (4) 0.003 0.002** 0.003** −0.261*** 0.017** (0.003) (0.001) (0.001) (0.031) (0.007) (5) 0.003 0.002** 0.003*** −0.261*** 0.017** 0.000 (0.003) (0.001) (0.001) (0.031) (0.007) (0.000) (6) 0.003 0.002** 0.003*** −0.261*** 0.017** 0.000 0.000 (0.003) (0.001) (0.001) (0.031) (0.007) (0.000) (0.002) panel b: panel regression including industry dummies and robust standard errors (1) 0.003* 0.005*** (0.002) (0.001) (2) 0.004 0.005*** 0.002* (0.002) (0.001) (0.001) (3) 0.004 0.006*** 0.003** −0.296*** (0.003) (0.001) (0.001) (0.042) (4) 0.004 0.006*** 0.003** −0.294*** 0.014 (0.003) (0.001) (0.001) (0.042) (0.010) (5) 0.004 0.006*** 0.003** −0.293*** 0.015 0.000* (0.003) (0.001) (0.001) (0.042) (0.010) (0.000) (6) 0.005 0.006*** 0.003*** −0.296*** 0.016 0.000 0.004** (0.003) (0.001) (0.001) (0.042) (0.010) (0.000) (0.002) panel c: panel regression including industry dummies, year dummies and robust standard errors (1) 0.003* 0.005*** (0.002) (0.001) (2) 0.004* 0.005*** 0.002* (0.002) (0.001) (0.001) (3) 0.004* 0.006*** 0.003** −0.296*** (0.003) (0.001) (0.001) (0.042) (4) 0.004* 0.006*** 0.003** −0.294*** 0.014 (0.003) (0.001) (0.001) (0.042) (0.010) (5) 0.004* 0.006*** 0.003** −0.293*** 0.015 0.000* (0.003) (0.001) (0.001) (0.042) (0.010) (0.000) (6) 0.005* 0.005*** 0.004*** 0.031*** −0.402*** 0.000 0.000 (0.003) (0.001) (0.001) (0.011) (0.047) (0.000) (0.002) ols: ordinary least squares al-awadhi, et al.: returns of islamic stocks in saudi arabia: segmentation and risk aversion international journal of economics and financial issues | vol 8 • issue 2 • 2018 241 frequently than are islamic stocks. the higher turnover of islamic stocks in some countries indicates that traders in saudi arabia may prefer to trade islamic stocks and neglect non-islamic stocks. 4. empirical tests to test the relative performance of islamic and non-islamic stocks, we apply a panel test, while controlling for firmspecific characteristics to determine whether non-islamic stocks outperform islamic stocks. thus, we estimate stock returns as: eri,t=α0+α1di,t−1+βxi,t−1+εi,t (1) where eri,t is the excess monthly return to the risk-free rate of stock i, regressed on the lagged previous monthly values of firm return predictors, which are di,t−1 as a dummy variable, equal to 1 if the stock is islamic and 0 if non-islamic; xi,t−1 as the monthly firm-specific characteristics; and εt is the error term. the monthly firm-specific characteristics variables, xi,t−1, are the log firm market capitalization, si,t; the industry rolling beta for stock i calculated from the previous 36 months, bti,t; the turnover ratio, ti,t, for stock i; the log of the stock market-to-book ratio, mbi,t; the average return for stock i in the 12 months, rti,t; and the log of the firm age, agi,t. 1 the coefficient α1 indicates whether islamic stocks have higher or lower returns than non-islamic stocks after controlling for firm-specific characteristics. the null hypothesis is that α1 equals zero, whereas our expectation is that it will be significantly <0. the results of the ordinary least squares (ols) tests are reported in panel a of table 4. the results suggest that there is no significant return difference between non-islamic and islamic stocks, after controlling for firm-specific factors. this table reports the coefficients of the panel regressions for 2007–2014. the dependent variable eri,t is the monthly return net of the risk-free rate for stock i in month t, and di,t is the dummy variable equal to 1 if the stock is islamic and 0 otherwise. si,t is the monthly natural logarithm for the market capitalization of firm i; mbi,t is the monthly log of the stock market-to-book ratio; rti,t is the stock i average monthly return for the previous 12 months; and bti,t is the rolling beta for the industry to which firm i belongs, calculated at month t based on the previous 36 months. ti,t is stock i’s turnover ratio for the month t, and agi,t is the log of the firm’s age. the standard errors are in parentheses. ***1%, **5%, and *10% denote levels of significance. to avoid the potentail autocorrelation and heteroskedasticity that may influence the ols results, we repeat the tests including industry dummies and use a cluster-robust variance and covariance estimators (arellano, 2003). panel b of table 4 reveal that we derive similar conclusion when we repeat the tests. 1 following previous studies to minimize the influence of the outliers, we take the natural logarithm of the firm market capitalization, the stock market-to-book ratio, and the firm age (galema et al., 2008; hong and kacperczyk, 2009). furthermore, we include yearly dummy variables to control for the potential effect of changes in market trends that may affect stock returns such as, the global financial crises (hui, 2005; 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(2012b), islamic investing. review of financial economics, 21(2), 53-62. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(4), 97-104. international journal of economics and financial issues | vol 11 • issue 4 • 2021 97 foreign direct investment and co2, ch4, n2o, greenhouse gas emissions: a cross country study sujan chandra paul1*, md. harun rosid1, md. jamil sharif2, anjuman ara rajonee3 1department of accounting and information systems, university of barishal, bangladesh, 2department of accounting and information systems, university of dhaka, bangladesh, 3department of soil and environmental sciences, university of barishal, bangladesh. *email: sujan9099@gmail.com received: 04 may 2021 accepted: 09 july 2021 doi: https://doi.org/10.32479/ijefi.11535 abstract to investigate the effects of foreign direct investment on co2, ch4, n2o, and other greenhouse gas emission the study was conducted. the panel data from 200 countries were collected for the period of 1990 to 2018. ordinary least square (ols), pooled ordinary least square (pols), driscoll-kraay (dk), second stage least square (2sls), generalized methods of moments (gmm) model has been performed. the findings showed that foreign direct investment has positive impact on co2 in all the models. the study also showed that fdi had negative impact on ch4 emission and positive impact on n2o emissions in all models except gmm model. finally, fdi had mixed impact on greenhouse gas emission but the results were statistically insignificant except ols model. keywords: co2, ch4, n2o, greenhouse gas emission, fdi jel classifications: f21, o44, q5 1. introduction the environmental impacts of fdi (foreign direct investment); sustainability of fdi and its effect on the environment; and cross-border environmental implications are the areas of debate in which the fdi-environment relationship considers its status for study. the literature has progressed to the point that no clear or conclusive consensus on the meaning has been reached (cole et al., 2017; pazienza, 2014), which is particularly true in the first vein of the sentence, for which it is commonly argued that further research is required (shao, 2018; zheng and sheng, 2017; seker et al., 2015; mcausland, 2010; oecd, 2002a). it has been noted that there has been a greater focus on the relationship between fdi and the atmosphere in this specific thematic area. the majority of the work has been completed, and continues to be done, using various aggregated fdi statistics (e.g. bakhsh et al., 2017; shahbaz et al., 2015, 2011; liang, 2006). according to marques and caetano (2020), the supply of goods and services would begin to rise as a result of globalization, which would inevitably encourage a nation’s economic growth. however, one aspect of globalization that has piqued economists’ interest is the flow of polluting industries between countries. this issue may be caused by inconsistencies in environmental regulations and the failure of instruments to control pollution. the panel on autoregressive distributed lag was used to calculate the impact of fdi on carbon dioxide and other significant greenhouse gas emissions with this viewpoint in mind. their data were collected from 21 countries with different income levels for a period of 2001 to 2017. this approach permitted the study of the resulting emission dynamics in the short and long term. a deeper understanding of the consequences of fdi flows requires the qualities of efficiency, imagination, and power. control continues to increase pollution in high-income countries, so it’s this journal is licensed under a creative commons attribution 4.0 international license paul, et al.: foreign direct investment and co2, ch4, n2o, greenhouse gas emissions: a cross country study international journal of economics and financial issues | vol 11 • issue 4 • 202198 worth debating more. the pollution haven theory states that fdi reduces emissions in high-income countries while increasing emissions in middle-income countries. however, middle-income countries’ willingness to absorb technology will become crucial in the long run. environmental policy has a major impact on trade in middle-income countries. our mission is to comprehend the transfer of emissions from polluting industries, which is why we conducted a thorough examination of the industrial sector’s total green house gas pollution. it has also been discovered that policymakers do not pay enough attention to how innovation contributes to environmental degradation. this paper has five sections. section two discusses the review of the literature. section three is the methods. section four is about the findings and discussion and finally section five of this paper give some recommendations and conclusion. 2. literature review while panel data analyses using aggregated data, such as those conducted by hoffmann et al. (2005), sadorsky (2010), pao and tsai (2011), and kim and adilov (2012), have been unable to confirm a near relationship between energy intensity and fdi or emission and fdi, firm level analyses conducted by blackman and wu (1999) and fisher-vanden et al. (2004) have shown that fdi has a reduced impact on energy intensity. furthermore, hoffmann et al. (2005) discover that the causal relationship transfers to country groups that were identified by the granger causality approach screen as having high per capita income. in addition, eskeland and harrison (2003), merican et al. (2007), lee (2009), tang (2009), and chang (2012) have identified a transformation in bilateral relations using time series analyses. panel data analyses produce more reliable and statistically powerful results than cross-section and time series analyses since the sample size is larger. there may be some variation in the estimated parameters for each particular panel, however (country). furthermore, the topic of heterogeneity will influence bias estimation. furthermore, cross-sectional dependence may lead to erroneous conclusions. the chosen panel data approach should then take into account variability and cross-sectional dependency concerns. adams (2009) revealed that fdi had an initial negative influence on di and subsequent positive effect in later periods for the panel of countries investigated. the sign and size of the present and delayed fdi coefficients imply a net crowding out impact. the study's findings and analysis of the literature show that the continent need a tailored strategy to fdi, increased absorption capacity of local companies, and government-mne cooperation to achieve mutual benefit. azomahou et al. (2005) used a panel of 100 nations to look at the empirical relationship between co2 emissions per capita and gdp per capita from 1960 to 1996. they discovered evidence of the relationship's structural integrity. they then design a countryspecific nonparametric panel data model. the findings of the estimation reveal that the connection is upward sloping. another concern in the literature is the conflicting findings on the relationship of fdi-energy power and fdi-pollution. for example, eskeland and harrison (2003) found that fdi helps mexico save electricity. cole and elliott’s (2005) findings supported the carbon haven hypothesis for the aforementioned countries. several studies, including blackman and wu (1999), hübler and keller (2010), sadorsky (2010), and herrerias et al. (2013), have assumed that if fdi had contributed to energy production, per capita emissions would have decreased. variations in processes, time intervals, or factors may have caused conflicting results in various experiments. as a consequence, the two lines of literature should be reviewed together in order to achieve reliable data. if there are contrary results, reducing emissions by energy savings enhanced by inward fdi cannot be obvious. muhammad and khan (2019) contributed to factors that help asian countries grow economically, with an emphasis on often-forgotten bilateral fdi, electricity use, co2 emissions, and a central position in the economy. in their study, they used the generalized approach of moments (gmm), ols regression, fixed effect and random effect estimates. between 2001 and 2012, data was gathered from 34 asian host countries and 115 source countries. the study found that oil use, fdi inflows and outflows, co2 emissions, and other services all play a significant role in asia’s economic growth. the current study shows that improved energy use strategies, such as the use of appropriate and innovative energy technologies, as well as attracting international investors both in and out of the countries, are being implemented in asian countries, resulting in increased economic growth as the global economy grows due to both inflows and outflows of fdi, oil use, and co2 emissions. fauzel (2017) looked at the longand short-term effects of fdi on co2 emissions in mauritius (disaggregated into manufacturing and non-manufacturing sectors). in this study, the bounds checking approach to co-integration is used. for time series data from 1980 to 2012, the autoregressive distributed lag (ardl) model is used. the study’s main findings show that foreign investment in the manufacturing industry is adverse to the environment, while fdi in non-manufacturing sectors is not. furthermore, an increase in demand is thought to result in an increase in co2 emissions. energy consumption in the world has already been found to result in an increase in co2 emissions. the results also affirm the stability of the model for the small island economy in mauritius. saini and sighania (2019) focused on long-term growth and carbon emissions, as well as their effect on the environment. they tried to gather all available information on the topic and discovered that, in the present scenario, the problem is gaining high priority due to the growing pace of development in developing countries. many of the study supported kuznets’ environmental curve theory, and they discovered a wide body of literature advocating for cleaner fdi as a way to reduce the negative environmental effects of economic growth. carbon pollution and foreign direct investment have a negative relationship, according to yüksel et al. (2020). as a result, a comparison analysis is conducted for all e7 and g7 countries. the analysis framework incorporates pedroni panel co-integration (ppc), kao panel co-integration (kpc), and dumitrescu hurlin panel causality (dhpc) analyses. gas emissions have a detrimental impact on foreign direct investment for all countries, according to the findings. this bond, on the other hand, is stronger paul, et al.: foreign direct investment and co2, ch4, n2o, greenhouse gas emissions: a cross country study international journal of economics and financial issues | vol 11 • issue 4 • 2021 99 with the g7 economies. there is also no evidence of a causal relationship between these factors. countries should follow ambitious policies to reduce carbon emissions, according to the experts. in this way, a new tax might be imposed on businesses that emit a lot of pollution. policymakers, on the other hand, may be willing to support policies that aim to reduce carbon emissions. in this scenario, lowering the tax rate and increasing the supply of technical assistance are examples. li and liu (2011) used absolute and comparative metrics representing the volume of co2 released from 30 chinese provinces from 2000 to 2008 to divide the entire county into eastern and western regions based on economic and geographical factors. the thesis investigates the effect of foreign direct investment on co2 emissions across a technical channel. according to the findings, fdi’s effect on co2 emissions in china is erratic. fdi in the east has a significant positive impact on local co2 emissions; the role of fdi in the central region is unclear; and fdi in the west of the country had a negative impact on co2 emissions. the effect of international trade and foreign direct investment (fdi) on co2 emissions in turkey was investigated by haug and ucal (2019). they looked at both linear and non-linear ardl models and discovered that exports, imports, and fdi have a significant asymmetrical effect on per capita co2 emissions. fdi, on the other hand, has no statistically significant long-term effects. the reduction in exports reduces per capita co2 emissions in the long run, but the increase in exports has no statistically meaningful effect. imports increase co2 emissions per capita, while reductions in imports have no long-term effects. exports and imports, on the other hand, have little effect on co2 power, which measures co2 emissions per unit of oil. instead, financial development and urbanization are aided. they also discovered that the kuznets environmental curve is current for both co2 indices, implying that increases in actual per capita gdp have led to lower co2 emissions for at least the last decade, after accounting for other competing causes. furthermore, in two of the four markets, the sectoral share of co2 emissions in total co2 emissions asymmetrically changes with foreign trade, with export growth leading to a lower share of co2 and imports having the opposite impact. fereidouni (2013) indicated that actual fdi states do not add to emissions of co2. consumption of energy, urbanization and economic growth has also been described as significant determinants of co2 emissions. mugableh (2013) and borhan et al. (2012) studied the association between co2 emissions and economic growth in malaysia in separate ways, but the results were similar: an increase in the economy causes co2 emissions. to re-analyse co2 pollution, mugableh (2013) used a self-regressive lag strategy. from 1971 to 2012, data was collected. the results show that economic development is dependent on energy demand, but that this can be harmful to the environment because it can result in co2 emissions. borhan et al. (2012) used fdi to conduct their research. from 1965 to 2010, they used a larger number of comments in the study. revenue, fdi, population, exports and imports were included as parts of their co2 feature. the non-linear model has been used and the findings suggest that a rise in fdi implies a rise of co2 in the atmosphere. for 15 years, maddison and rehdanz (2008) looked at the relationship between gdp and carbon emissions in 134 countries (1990 to 2005). when variability is ignored, co2 emissions in north america, asia, and oceania are not compared to gdp. han and lee (2013) used a hierarchical panel data model to study the directional relationship between pollution and economic growth in oecd countries from 1981 to 2009. the connection between economic growth and pollution implies the need for technological advancement in order to achieve economic growth with minimal pollution, which supports kuznets’ environmental curve hypothesis. 3. methods a analysis using a composite model was carried out. using stata 15, describe the relationship between fdi and emission-related variables. the ols (ordinary least squares) model was used. stata 15 was used to describe the relationship between fdi and emission variables using the pooled ordinary least squares (pols model). using stata 15, the drisc/kraay (dk) model was used to determine the relationship between fdi and emission variables. the two stage least square model (2sls) was used to describe the relationship between fdi and variables related to emissions using stata 15. finally, using stata 15, a generalized method of moments (gmm) model was used to define important explanatory variables that can describe the reasons for the interaction between fdi and emission variables. variables and description sl. no. variable description unit 1 lnfdi log normal of foreign direct investment, net inflows (bop, current) usd 2 lnco2ekt log normal of co2 emissions (kt) 3 lnco2emtpc log normal of co2 emissions (metric tons per capita) 4 lnch4e log normal of ch4 emissions (kt of co2 equivalent) 5 lnn2oe log normal of n2o emissions (thousand metric tons of co2 equivalent) 6 lntghge log normal of total greenhouse gas emissions (kt of co2 equivalent) hypotheses no. hypotheses h1 a significant positive relationship between fdi and co2 emissions (kt) of a country h2 a significant positive relationship between fdi and co2 emissions (metric ton per capita) of a country h3 a significant positive relationship between fdi and ch4 emissions of a country h4 a significant positive relationship between fdi and n2o emissions h5 a significant negative relationship between fdi and total greenhouse gas emissions paul, et al.: foreign direct investment and co2, ch4, n2o, greenhouse gas emissions: a cross country study international journal of economics and financial issues | vol 11 • issue 4 • 2021100 4. results and discussion 4.1. descriptive statistics the following table summarizes the informative data for all of the variables considered in this study’s models. for each element, the table shows the number of observations, mean value, standard deviations, minimum and maximum score. table 1 summarizes the data gathered over a 29-year period for 200 countries on six variables (appendix 1). the major dependent variable, fdi, shows an average of 17.276 billion dollars for the countries surveyed, with a very high standard deviation of 7.291 billion dollars, indicating that there is a significant difference in fdi among the world’s countries. the average lnco2ekt is 7.598, while the average lnco2emtpc is 0.554, according to the table. lnco2ekt and lnco2emtpc have standard deviations of 4.163 and 1.557, respectively. the average lnch4e, on the other hand, is 6.57, the average lnn2oe is 5.845, and the average lntghge is 7.458. lnch4e, lnn2oe, and lntghge have standard deviations of 4.212, 4.007, and 5.122, respectively. 4.2. pair wise correlation matrix first, we’ll look at the associations among the variables we found in the literature and see whether there’s a connection between fdi and different types of emissions. the variables are reported in a combined correlation matrix shown in table 2. table 2 indicates that the factors have no correlation, suggesting that endogeneity is unlikely. only the correlation coefficient matrices and collinearity test results are given due to the layout constraints. the findings, on the other hand, pass the correlation coefficient and vifs tests. furthermore, both of the variables display importance at the 0.10 mark. there is no correlation between any of the variables at the 0.90 mark. 4.3. econometric models multiple regression models have been run with the dependent (lnfdi) and independent variables (lnco2ekt, lnco2emtpc, lnch4e, lnn2oe and lntghge). in the following section the results of those models are presented and interpreted below. co2 emissions (both kt and metric ton per capita) have a strong positive association with fdi, as seen in table 3. the higher a country’s foreign direct investment, the higher its co2 emissions. on the contrary ch4 emissions has significant negative relationship with the fdi which indicates that a country having high more fdi does not significantly affect the ch4 emission of a country. n2o emissions and total greenhouse gas emissions have a substantial positive relationship with fdi, indicating that more fdi produces more n2o and total greenhouse gas emissions in a region. co2 emissions (both kt and metric ton per capita) and nitrous oxide emissions (both kt and metric ton per capita) have a strong positive relationship with fdi, as seen in table 4. the higher a country’s foreign direct investment, the higher its co2 and n2o emissions. on the contrary methane emissions has significant negative relationship with the fdi which indicates that a country having high more fdi does not significantly affect the ch4 emission of a country. total greenhouse gas emissions have a negative relationship with fdi, but the relationship is insignificant, even though the overall model is significant at the 10% stage. co2 emissions (kt) and nitrous oxide emissions (kt) have a significant beneficial association with fdi, as seen in table 5. the higher a country’s foreign direct investment, the higher its co2 and nitrous oxide emissions. methane emissions, on the other hand, have a substantial negative association with fdi, indicating that a nation with a high level of fdi has no impact on its ch4 emissions. co2 emissions (metric ton per capita and gross greenhouse gas emissions) have a favorable relationship with fdi, but the relationship is negligible, despite the overall model table 3: ordinary least squares model lnfdi coef. st. err. t-value p-value [95% conf interval] sig lnco2ekt 0.595 0.037 16.02 0 0.522 0.668 *** lnco2emtpc 0.282 0.067 4.21 0 0.151 0.413 *** lnch4e –1.715 0.123 –13.95 0 –1.956 –1.474 *** lnn2oe 1.592 0.12 13.25 0 1.357 1.828 *** lntghge 0.098 0.055 1.78 0.075 –0.01 0.206 * constant 13.825 0.192 72.07 0 13.449 14.201 *** mean dependent var 17.276 sd dependent var 7.291 r-squared 0.127 number of obs 5800.000 f-test 168.958 prob>f 0.000 akaike crit. (aic) 38726.869 bayesian crit. (bic) 38766.862 ***p<0.01, **p<0.05, *p<0.1 table 2: pairwise correlations matrix variables (1) (2) (3) (4) (5) (6) (1) lnfdi 1.000 (2) lnco2ekt 0.306 1.000 (3) lnco2emtpc 0.150 0.344 1.000 (4) lnch4e 0.188 0.745 0.018 1.000 (5) lnn2oe 0.214 0.727 –0.012 0.982 1.000 (6) lntghge 0.193 0.702 0.009 0.947 0.940 1.000 table 1: descriptive statistics variable obs mean std. dev. min max lnfdi 5800 17.276 7.291 0 27.879 lnco2ekt 5800 7.598 4.163 0 16.147 lnco2emtpc 5800 0.554 1.557 –4.773 4.249 lnch4e 5800 6.57 4.212 0 14.376 lnn2oe 5800 5.845 4.007 -4.155 13.283 lntghge 5800 7.458 5.122 0 16.338 paul, et al.: foreign direct investment and co2, ch4, n2o, greenhouse gas emissions: a cross country study international journal of economics and financial issues | vol 11 • issue 4 • 2021 101 being important at the 10% stage. the next model is presented to improve the findings’ robustness. co2 emissions (both kt and metric ton per capita) have a strong positive association with fdi, as seen in table 6. the higher a table 6: two stage least square model instrumental variables (2sls) regression lnfdi coef. st. err. t-value p-value 95% conf interval sig lnco2ekt 0.595 0.037 16.02 0 0.522 0.668 *** lnco2emtpc 0.282 0.067 4.21 0 0.151 0.413 *** lnch4e –1.715 0.123 –13.95 0 –1.956 –1.474 *** lnn2oe 1.592 0.12 13.25 0 1.357 1.828 *** lntghge 0.098 0.055 1.78 0.075 –0.01 0.206 * constant 13.825 0.192 72.07 0 13.449 14.201 *** mean dependent var 17.276 sd dependent var 7.291 r-squared 0.127 number of obs 5800.000 f-test 168.958 prob>f 0.000 ***p<0.01, **p<0.05, *p<0.1 table 4: pooled ordinary least squares model regression results lnfdi coef. st. err. t-value p-value 95% conf interval sig lnco2ekt 0.331 0.031 10.64 0 0.27 0.392 *** lnco2emtpc 0.817 0.112 7.29 0 0.598 1.037 *** lnch4e –0.853 0.155 –5.49 0 –1.157 –0.548 *** lnn2oe 0.622 0.16 3.89 0 0.308 0.936 *** lntghge –0.028 0.052 –0.53 0.595 –0.129 0.074 constant 16.48 0.305 54.06 0 15.883 17.078 *** mean dependent var 17.276 sd dependent var 7.291 overall r-squared 0.053 number of obs 5800.000 chi-square 282.463 prob>chi2 0.000 r-squared within 0.046 r-squared between 0.063 ***p<0.01, **p<0.05, *p<0.1 table 7: generalized method of moments model regression results of system gmm model lnfdi coef. st.err. t-value p-value 95% conf interval sig l.lnfdi 0.2 0.019 10.50 0 0.163 0.237 *** lnco2ekt 0.064 0.028 2.30 0.022 0.009 0.118 ** lnco2emtpc 0.969 0.182 5.34 0 0.613 1.326 *** lnch4e 0.83 0.27 3.07 0.002 0.299 1.36 *** lnn2oe –1.1 0.3 –3.67 0 –1.689 –0.512 *** lntghge 0.062 0.071 0.88 0.38 –0.077 0.201 constant 13.47 0.366 36.85 0 12.753 14.186 *** mean dependent var 17.438 sd dependent var 7.187 number of obs 5400.000 chi-square 184.165 ***p<0.01, **p<0.05, *p<0.1 table 5: driscoll-kraay pooled ols model regression with driscoll-kraay standard errors number of obs=5800 method: pooled ols number of groups=200 group variable (i): id f (5, 28)=53.59 maximum lag: 3 prob>f = 0.0000 r-squared=0.1273 root mse=6.8146 drisc/kraay lnfdi coef. std. err. t p>t 95% conf. interval lnco2ekt 0.595 0.290 2.050 0.050 0.001 1.190 lnco2emtpc 0.282 0.214 1.320 0.199 –0.157 0.720 lnch4e –1.715 0.448 –3.830 0.001 –2.632 –0.797 lnn2oe 1.592 0.450 3.540 0.001 0.670 2.514 lntghge 0.098 0.082 1.200 0.240 –0.069 0.265 _cons 13.825 2.583 5.350 0.000 8.534 19.117 paul, et al.: foreign direct investment and co2, ch4, n2o, greenhouse gas emissions: a cross country study international journal of economics and financial issues | vol 11 • issue 4 • 2021102 country’s foreign direct investment, the higher its co2 emissions. on the other hand, ch4 emissions have a major negative association with fdi, indicating that a nation with a high level of fdi has no impact on its ch4 emissions. n2o emissions and total greenhouse gas emissions have a significant beneficial association with fdi, implying that more fdi causes more n2o emissions and total greenhouse gas emissions. the next model is run to ensure that the findings are more reliable. table 7 reveals a significant positive association between co2 emissions (kt), co2 emissions (metric ton per capita), and ch4 emissions and fdi. the higher a country’s foreign direct investment, the higher its co2 and methane emissions. in the other hand, n2o emissions have a major negative association with fdi, indicating that a nation with a high level of fdi has no impact on its n2o emissions. total greenhouse gas emissions have a favorable relationship with fdi, but the relationship is negligible, despite the overall model being meaningful at the 10% stage. 5. conclusion to investigate the effects of foreign direct investment on co2, ch4, n2o and total greenhouse gas emission this study is conducted. panel data for 200 countries over a period of 29 years (19902018) has been used as the sources of information. ordinary least square (ols), pooled ordinary least square (pols), driscollkraay (dk), second stage least square (2sls), generalized methods of moments (gmm) models have been performed and the result shows that there is a positive relationship between fdi and different types of green house gas emission. with economical advancement the emission green house gases (co2, ch4, n2o and others) increase simultaneously. the findings are very important in case of formulating environmental policies. therefore, the developing country should find alternative sources of energy to ensure that there is no harmful effect on environment as there is an increase rate of energy consumption with economic growth. the use of natural gas, biomass, green technology etc. may be some important way to reduce co2 emission. data were collected only from 200 countries because there is a lack of data availability from remaining countries of the world. data more than 29 years would have led us to a better conclusion. data conversion during analysis may lead to some discrepancy. besides these emissions many other variables remained untouched in this research that may help us on 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(2017), the impact of foreign direct investment (fdi) on the environment: market perspectives and evidence from china. economies, 5(8), 2-15. appendix (contd...) appendix 1: list of countries 1 afghanistan 41 congo, dem. rep. 81 hong kong sar, china 2 albania 42 congo, rep. 82 hungary 3 algeria 43 costa rica 83 iceland 4 american samoa 44 cote d’ivoire 84 india 5 andorra 45 croatia 85 indonesia 6 angola 46 cuba 86 iran, islamic rep. 7 antigua and barbuda 47 cyprus 87 iraq 8 argentina 48 czech republic 88 ireland 9 armenia 49 denmark 89 isle of man 10 aruba 50 djibouti 90 israel 11 australia 51 dominica 91 italy 12 austria 52 dominican republic 92 jamaica 13 azerbaijan 53 ecuador 93 japan 14 bahamas, the 54 egypt, arab rep. 94 jordan 15 bahrain 55 el salvador 95 kazakhstan 16 bangladesh 56 equatorial guinea 96 kenya 17 barbados 57 eritrea 97 kiribati 18 belarus 58 estonia 98 korea, dem. people’s rep. 19 belgium 59 eswatini 99 korea, rep. 20 belize 60 ethiopia 100 kosovo 21 benin 61 euro area 101 kuwait 22 bermuda 62 fiji 102 kyrgyz republic 23 bhutan 63 finland 103 lao pdr 24 bolivia 64 france 104 latvia 25 bosnia and herzegovina 65 french polynesia 105 lebanon 26 botswana 66 gabon 106 lesotho 27 brazil 67 gambia, the 107 liberia 28 brunei darussalam 68 georgia 108 libya paul, et al.: foreign direct investment and co2, ch4, n2o, greenhouse gas emissions: a cross country study international journal of economics and financial issues | vol 11 • issue 4 • 2021104 29 bulgaria 69 germany 109 liechtenstein 30 burkina faso 70 ghana 110 lithuania 31 burundi 71 gibraltar 111 luxembourg 32 cabo verde 72 greece 112 macao sar, china 33 cambodia 73 greenland 113 madagascar 34 cameroon 74 grenada 114 malawi 35 canada 75 guatemala 115 malaysia 36 chad 76 guinea 116 maldives 37 chile 77 guinea-bissau 117 mali 38 china 78 guyana 118 malta 39 colombia 79 haiti 119 marshall islands 40 comoros 80 honduras 120 mauritania 121 mauritius 161 singapore 122 mexico 162 slovak republic 123 micronesia, fed. sts. 163 slovenia 124 moldova 164 solomon islands 125 mongolia 165 somalia 126 morocco 166 south africa 127 mozambique 167 south asia 128 myanmar 168 spain 129 namibia 169 sri lanka 130 nauru 170 st. kitts and nevis 131 nepal 171 st. lucia 132 netherlands 172 st. vincent and the grenadines 133 new caledonia 173 sudan 134 new zealand 174 suriname 135 nicaragua 175 sweden 136 niger 176 switzerland 137 nigeria 177 syrian arab republic 138 north america 178 tajikistan 139 north macedonia 179 tanzania 140 norway 180 thailand 141 oman 181 timor-leste 142 pakistan 182 togo 143 palau 183 tonga 144 panama 184 trinidad and tobago 145 papua new guinea 185 tunisia 146 paraguay 186 turkey 147 peru 187 turkmenistan 148 philippines 188 uganda 149 poland 189 ukraine 150 portugal 190 united arab emirates 151 qatar 191 united kingdom 152 romania 192 united states 153 russian federation 193 uruguay 154 rwanda 194 uzbekistan 155 samoa 195 vanuatu 156 sao tome and principe 196 venezuela, rb 157 saudi arabia 197 vietnam 158 senegal 198 yemen, rep. 159 seychelles 199 zambia 160 sierra leone 200 zimbabwe appendix 1: (continued) . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 283-291. international journal of economics and financial issues | vol 7 • issue 2 • 2017 283 the impact of creative accounting techniques on the reliability of financial reporting with particular reference to saudi auditors and academics ahmed yousif adam ismael* department of business administration, college of science humanitarian & studies, prince sattam bin abdul-aziz university, al-aflaj, ksa. *email: ahmed211120@yahoo.com abstract creative accounting plays a significant role in financial reporting but it has been negatively correlated that means more managers involved in it may decrease the value of financial information, this study aims to shed light on the impact of creative accounting ethics techniques on the reliability of financial reporting from auditors and academics point of view. the data has been collected through a well-structured questionnaire is designed and will be distributed to a randomly chosen sample of certified auditors and accounting instructors in some universities. descriptive and inferential statistics were used to generalize the results and conclude the findings. the result deduces that creative accounting techniques used by management negatively affect the reliability of financial reporting. the statutory auditor plays an important role in promoting creative accounting practice in such way that positively affect the reliability of financial reporting. keywords: creative accounting, reliability, financial reporting jel classifications: g2, m4 1. introduction in recent years there are many criticisms to accounting profession that it relies on some accounting methods which can provide unreliable and misleading information to the users of this information, which may cause collapse for some companies. the practices and techniques of creative accounting contribute to the breakdown of bigger companies such as arther anderson, enron, world com, parmalat, etc., (norri, 2013; ajibolade, 2008). financial accounting reports are produced to show the true and fair state of financial statements of an entity in order to help stakeholders in making appropriate decisions, however, current accounting practices allow different policies and professional judgments in determining the methods of measurement (beshiru and prince, 2014). accounting arose from the need to have a clear situation of everything happening economically and financially in a company, which offered at the beginning prestige and trust of users of accounting information, however over time, more and more scandals that erupted because of infringement of regulations (voinea, 2013). the phenomenon of creative accounting can be understood as the alteration of the economic reality of an entity through techniques, options, lack of restraints allowed by the legal norms (radu, 2013). the creative accounting is a tool to support the manager to promote and support the company’s image; however, the manager used that information to support his selfinterest (victoria, 2014). the techniques of creative accounting can be used in an unacceptable way in the preparation of the financial statements in order to meet management needs with regard to the performance of the company, and this leads to the misleading of financial statements (balacia, 2008). the widespread corruption in the society and the failure of organizations in every part of the world have once more increased the need for accounting professionals to adhere strictly to the codes of professional practice (ogbonna and appah, 2012). this corruption has brought to greater scrutiny the work of the accountant from both within the profession and from outside (aguolu, 2006). however, (revsine, 1991); offers some defense for the practice of creative accounting based on positive accounting theory and agency relationship between ismael: the impact of creative accounting techniques on the reliability of financial reporting with particular reference to saudi auditors and academics international journal of economics and financial issues | vol 7 • issue 2 • 2017284 managers and shareholders and argues that each can draw benefits for ‘loose’ accounting standards that tool up managers with latitude in timing the reporting of income. the positive side of the creative accounting refers to the application of the best options and the ultimate goal being that the information in the financial statements reflects the true and fair view of the financial position (victoria, 2014). every profession has a built in the code of ethics to compel ethical behavior on its members (mathews and perera, 1996). any organization that lacks ethical considerations may not survive for a protracted time to achieve its desired goals and objectives and that of its stakeholders (ogbonna, 2010). therefore accountants as professionals responsible for the preparation of financial reports need to adhere to the codes of ethical accounting standards to produce reliable, relevant, timely, accurate, understandable and comprehensive financial reports (ogbonna and appah, 2012). there are various shareholders need financial reports for decision making on the investment and financial aspect of the organization. so the financial reports generated by accountants should be based on reliable information in order to be understood by the users (nzotta, 2008). also, this idea confirmed by (alexander and britton, 2000); who noted that the fundamental objective of financial reports is to communicate economic datum about resources and performance of the reporting entity useful to those having reasonable rights to such information. 2. theoretical and emirical literature from management authority, accountants exercise a set of accounting techniques to influence financial reports which known as the creative accounting. according to (naser, 1993); creative accounting is the transformation of financial accounting figures from what they actually are, to what preparer’s desire by taking advantage of the existing rules. according to (oriol, 1999); the creative accounting is a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business. creative accounting refers to the use of accounting knowledge to influence the reported figures, while remaining within the jurisdiction of accounting rules and laws, so that instead of showing the actual performance of the company, they reflect what the management deficiency (ashok, 2015; algodah et al., 2015). management may use different types of creative accounting techniques to manipulate the result represented in the financial statements which complying with all applied accounting standards and other regulations. there are various methods used for creative accounting which can fall into four categories: different accounting policies, abuse of judgment, artificial transactions (substance over form), and the timing of genuine transactions (oriol, 1999; kevin, 2003; ashok, 2015). according to (gabar, 2015; adel and adarhaman, 2015; algray and aseeri, 2013; norri, 2013; gaara et al., 2015; vlora and albulena, 2014); the techniques that management used for creative accounting are: window dressing, off balance sheet finance, changes in accounting policies, profit smoothing, capitalizing expenses, contingent liabilities, changes in depreciation policy, etc. (nwagboso, 2008); a spell that accounting is a profession that rests heavily on the need to exhibit a high sense of accountability and skepticism, therefore all its members should be adherent by a professional code of conduct. the basic principles of ethical standards that accountants should adherent include integrity, objectivity, competence and due care, confidentiality and professional behavior (aguolu, 2006; okezie, 2008; nwagboso, 2008; nwanyanwu, 2010); (diana et al., 2014); show that more than half of the managers questioned answered that they had used accounting manipulation techniques to beautify the image of their companies even though they show a real life. (kassem, 2012); conclude that the ethical practices of creative accounting are there basically to support the external auditors to enhance their efficiency and accuracy in finding any fraud. (afolabi and oluseye, 2013); conducted research on manufacturing firms of nigeria and they concluded that financial reporting does have an effect on managerial and investment decision making. (yadav et al., 2014); find out ways that assist in reducing the effect of creative accounting on the statement of financial position, by display quite positive picture of creative accounting practices. (radu, 2013); explain that although there is a clear difference between creative accounting and deliberate breaking of the law, bought phenomena appear in times of economic distress and are based on the intent to deceive, consequently, even if the use of creative accounting is not always illegal it shows that managers which are under financial pressure look for solutions without obeying certain ethical standards. (dumitrescu, 2014); derive that companies proceed to smoothing results, which consists of the presentation the trend of profit growth, than to show volatile profits that successively increase or decrease, dramatically. as (gherai and balaciu, 2011); predict in their literature, they find that enterprise stake is at risk when it indulges in practices of creative accounting, because these practices give firm only short term benefits, at the end, the enterprise would be surrounded with scandals. (beshiru and prince, 2014); clarify that creative accounting practices have a significant effect on commercial banks distress in nigeria and by implication adversely affect users of accounting information. (gaara et al., 2015) light that the misuse of creative accounting techniques leads the users of accounting information care continuously concern about creative accounting. (gherai and balaciu, 2011); found that most techniques of creative accounting designed for misleading financial statements and condense on self-interest. (effiok and eton, 2012); show that the application of creative accounting techniques through the manipulation of financial statements affects the share price and assets value. (gabar, 2015); conclude that creative accounting techniques effect on the reliability of financial statements. (alomery and alameen, 2014); a spell that there is a negative effect of creative accounting techniques on the quality of financial reporting, especially with regard profit manipulation. (khamangy and sadeeg, 2015); conclude that the aim of financial information manipulation is to mislead the users of financial reporting through providing information that affects their decisions. according to (effiok and eton, 2012); manipulation of accounts may affect the share price and market share of company, so macro manipulation does increase the risk of investor which may cause loss. (osaze and henry, 2012); noted that the statistical evidence revealed that creative accounting positively affects firm’s value, this being the ismael: the impact of creative accounting techniques on the reliability of financial reporting with particular reference to saudi auditors and academics international journal of economics and financial issues | vol 7 • issue 2 • 2017 285 case, it implies that most investors are not able to see through the financial illusion of creative accounting. (algray and aseeri, 2013); find out that most of the creative accounting techniques do not comply with generally accepted accounting principles. the auditor responsibility is to audit the financial statements in accordance with relevant legal and regulatory requirements a n d i n t e r n a t i o n a l s t a n d a r d s o n a u d i t i n g , w h e r e a s t h e directors’(accountants) responsibility to prepare the annual report and the financial statements in accordance with applicable accounting standards. (kevin, 2003); stated that the auditor responsibility is to report on the accounts, to identify whether they have been properly prepared and to provide an opinion on whether they show a true and fair view. (al momani and obeidat, 2013); investigate that to what extent auditor is ethically capable of detecting creative accounting practices, and to what extent auditor’s ethics can affect the practices of creative accounting. (al momanil and obeidat, 2013; gaara, 2012); show that the independence and integrity of external auditor has a bigger effect for discovering the creative accounting techniques. indeed (mitchell and sikka, 1993); claim that audits are now used as loss leaders in order to attract other more lucrative business and there is growing concern that the pursuit of commercial objectives has had a detrimental impact on the quality of audit services. (ali, 2008); illustrate that the primary responsibility of auditor is to explain in his report to shareholders whether the financial statements give a true and fair view and not contained any creative accounting. however, (keith, 2010); argue that there is a strategic interaction between auditors and management and that allows management to pick out the economically irrational outcome of behaving ethically even when doing so defies their own financial self-interest. therefore, (ihsan, 2008); explain that the substantial reason for enron collapse that arthur anderson as an auditor does not take the absolute responsibility to prevent the company from creative accounting. corporate governance can control the practices of creative accounting because it works as an eye if companies can compound its number of outside directors, the social responsibility of company increases because it will be answerable to numerous of people (fizza and qaisar, 2015). (kevin, 2003) argue that the true safeguard for good corporate governance lies in the application of informed and independent judgment by the qualified executive and non-executive directors. (dumitrescu, 2014); draw that the connection between creative accounting and corporate governance has been much debated within the specialized literature as creative accounting emerged amid the deficiency of corporate governance. (yadav and cuzdriorean, 2013); finds that involvement of outsiders director may reduce the practices of creative accounting, and the involvement of professionals in financials decision that can build a trust of stakeholders on enterprise, so, qualified accountants can help companies about the use of creative accounting techniques. (yadav et al., 2014); also, find out the ways that help to minify the effect of creative accounting on the statement of financial position, they present quite a positive picture of creative accounting practices. according to (sorin et al., 2012); operation of corporate governance is depends on the structure of the corporation, directors, and their management participation. so, the well-designed structure of audit denies the practices of creative accounting. the primary objective of financial reporting is to communicate the economic events about the financial performance of the entity. according to (nzotta, 2008); financial reporting is a critical issue which affects the decision-making process of various individuals, corporate bodies, investors and policy makers. on that direction (nzotta, 2008); clarify that financial reporting assists the user in rectifying the past and present performance of the organization and its ability to maximize the wealth of the shareholders. (glautier and underdown, 2001); infer that the primary objective of financial reporting is to communicate economic information about resources held by an entity and its performances to those having the right to such information. in order to be meaningful and meet its objective, financial reporting should have higher quality. (abbas et al., 2006); stated that the qualitative characteristics of accounting information that affect the reliability reporting contain: relevance, reliability, understandability, and comparability (belkaoui, 2002; willekens, 2008; courtis, 2005; schipper and vincent, 2004; beuselinck, 2007; greg and mohamed, 2006; dak, 2005). based on literature review, the following hypotheses were generated: h1: there is a negative relationship between creative accounting techniques and the reliability of financial reports. h2: there is a positive relationship between the roles of statutory auditors in creative accounting practices and the reliability financial reports. h3: there is a positive relationship between the commitment to ethical standards and the reliability financial reports. h4: there is a positive relationship between the qualitative characteristic of accounting information and the reliability financial reports. 3. methdology this study based on quantitative research design. primary and secondary data has been used. the primary data were generated through a well-structured 100 questionnaires were distributed randomly to some practitioners of accounting and auditing profession in ksa environment; only 63 respondents have been returned, with response rate of 63% to evaluate the impact of creative accounting ethics techniques on the reliability of financial reporting from auditors and academics point of view. the questionnaire has been arbitrated by a qualified expert to give higher quality and to ensure the specificity and reliability of the questionnaire be realized. the result of the reliability test shows that the designed questionnaire is highly reliable. in order to obtain a reliable data, the chosen scale items were translated from english into the arabic language to reduce translation errors and reflect the real meaning and local acknowledge. the first part of the questionnaire contains questions on respondents’ characteristics and personal information. the second part of the questionnaire examined the creative accounting techniques, roles of statuary auditors the creative accounting practice, the commitment of ethical standards, and the qualitative ismael: the impact of creative accounting techniques on the reliability of financial reporting with particular reference to saudi auditors and academics international journal of economics and financial issues | vol 7 • issue 2 • 2017286 characteristic of accounting information. a five-point likert scale indicators were used, between 1 indicating strongly disagree and 5 indicating strongly agree. 4. analysis and result 4.1. goodness of measures the study used several statistical procedures. the descriptive statistics, correlations, chi-square test and cronbach’s alpha test were conducted to examine the relationships among variables by using the spss 24.0 version. the results of the statistics analyses are described as follows. 4.2. respondents demographic characteristics table 1 presents the respondents demographic characteristics. the table shows that: the respondents’ ages between (40 and <55 years) is the highest which represent (47.69%) followed by respondents’ those between (25 and <40 years) which represent (35.39%) then the respondents’ ages (55 years and more) which represent (10.77%) and lastly, the respondents ages (<25 years) which represent (6.15%). regarding the respondents job title, the majority of them were academics (61.54%), followed by practitioner (38.46%). concerning for the respondent’s educational level, the majority of them were post-graduate education level which represents (81.54%), followed by the level of graduate education (16.93%), and others (1.53%) as a lower ratio. as for the length of respondents’ working experiences. the table shows that respondents’ whom they have worked (<10 years) were the highest ratio which represents (44.62%) followed by those work (more than 20 years) which represent (29.23%), and those respondents from (10 <20 years) is a lower ratio which represents (26.15%). 4.3. tests for response bias a test of response bias has been conducted to confirm that there is no systematic response bias (armstrong and overton, 1977). to determine whether non-response bias was presented in the study, academics respondents were compared with practitioners respondents along all the descriptive response items in the survey. accordingly, 40 were considered as academics respondents and 25 respondents were considered as practitioners’ responses and to be proxies for non-respondents. to represent academics versus practitioners’ responses, a multivariate chi-square test was performed using the respondents’ characteristics in order to decide whether significant differences exist between the two groups. table 2 presents the result of the test. it is clear from the table that no significant differences exist between the academics and practitioners responses. for all the four characteristics of respondents (age, educational level, experiences) the chi-square tests show no significant difference exist between the practitioners and academics responses. it can be concluded that non-response bias is not a serious problem in this study. so, it is safety to join the responses as one sample. 4.4. reliability analysis to test reliability this study used cronbach’s alpha. according to hair et al. (2010), the lower limit for cronbach’s alpha is 0.70. the results of the reliability analysis summarized in table 3 confirmed that all the items display a satisfactory level of reliability (cronbach’s alpha exceed the minimum value of 0.70). therefore, it can be concluded that the measures have an acceptable level of reliability. it is worth mentioning that some items are deleted to increase the reliability to accepted level. the full items statements are displayed in appendix a. table 4 shows the means and standard deviations of the four components of creative accounting: techniques of creative accounting, the role of statutory auditors in creative accounting practice, the commitment of ethical standards, and the qualitative characteristic of accounting information. the table shows that the saudi arabia accounting and auditing profession emphasized more on the qualitative characteristic of accounting information (mean = 4.4308, standard deviation = 0.49115), followed by the commitment of ethical standards (mean = 4.2462, standard deviation = 0.52532), then the role of statutory auditors in creative accounting practice (mean = 4.4154, standard deviation = 0.50054), and the lowest components is the techniques of creative accounting (mean = 4.0744, standard deviation = 0.84678). therefore, those four dimensions were achieved average mean (mean = 4.2917, standard deviation = 0.40214). on the other hand also, table 4 presents the bivariate correlation matrix for the constructs operationalized in this study. the table shows that no correlations near 1.0 (or approaching 0.8 or 0.9) were detected, which indicate that multicollinearity is not a significant problem in this particular data set. also, the table shows that the average mean in the last column is positively and significantly correlated with the techniques of creative accounting (r = 0.625, p < 0.01), the role of statutory auditors in creative accounting practice (r = 0.680, p < 0.01), the commitment of ethical standards (r = 0.687, p < 0.01), the qualitative characteristic of accounting information (r = 0.770, p < 0.01) respectively. 4.5. hypotheses test the results in tables 5 and 6 for weighted mean and standard deviation show that items statement a1.2 and a1.3 which related to the techniques of creative accounting have weighted mean between (3.40 and 4.19) that means agree and item statement a1.1 has weighted mean between (4.20 and 5.00) that means strongly agree of the responses in the variable. therefore, it can be concluded table 1: respondents demographic characteristics variable particular frequency (%) age <25 years 4 (6.15) 25 and<40 years 22 (35.39) 40 and<55 years 30 (47.69) 55 years and more 7 (10.77) total 63 (100) job title academic 40 (61.54) professional/practitioner 23 (38.46) total 63 (100) educational level graduate 11 (16.93) post-graduate 53 (81.54) other 1 (1.53) total 65 (100) experience <10 years 29 (44.62) 10 and<20 17 (26.15) 20 years and more 19 (29.23) total 65 (100) ismael: the impact of creative accounting techniques on the reliability of financial reporting with particular reference to saudi auditors and academics international journal of economics and financial issues | vol 7 • issue 2 • 2017 287 that the h1 (there is a negative relationship between creative accounting techniques and the reliability of financial reports) full supported. also, the tables for weighted mean and standard deviation show that all items statement b2.1, b2.3, b2.4 and b2.5 which related to the role of statuary auditors in creative accounting practice have weighted mean (between 4.20 and 5.00) that affirms strongly agree of the responses in the variable. therefore, it can be concluded that the h2 (there is a positive relationship between the roles of statutory auditors in creative accounting practice and the reliability financial reports) full supported. the results in tables 5 and 6 for weighted mean and standard deviation show that items statement c3.5 and c3.6 which related to the commitment of ethical standards have weighted mean between (3.40 and 4.19) that means agree and item statement c3.2, c3.3, and c3.4 have weighted mean between (4.20 and 5.00) that assert strongly agree of the responses in the variable. therefore, it can be concluded that the h3 (there is a positive relationship between the commitment to ethical standards and the reliability financial reports) full supported. further, the tables for weighted mean and standard deviation show that all items statement d4.2, d4.3, d4.5 and d4.7 which related to the qualitative characteristic of accounting information have weighted mean (between 4.20 and 5.00) that confirm strongly agree of the responses in the variable. therefore, it can be concluded that the h4 (there is a positive table 2: chi-square test for academic and practitioners responses chi-square test for differences between practitioners, academics, and both responses categories academics practitioners total chi-square value significant age of the respondents <25 years 2 2 4 13.985 0.030 25 and<40 years 16 6 22 40 and<55 years 19 11 30 55 years and more 3 4 7 total 40 23 63 educational level graduate 3 8 11 19.625 0.033 post-graduate 37 13 50 other 0 1 1 total 40 22 62 experiences <10 years 17 9 26 22.082 0.005 10 and<20 11 6 17 20 years and more 10 8 18 non-response 2 0 2 total 40 23 63 table 3: item-total statistics and reliability statistics items scale mean if item deleted scale variance if item deleted corrected item-total correlation squared multiple correlation cronbach’s alpha if item deleted cronbach’s alpha based on standardized items cronbach’s alpha a1.1 7.9531 3.410 0.684 0.496 0.690 0.803 0.797 a1.2 8.2344 3.008 0.681 0.500 0.679 a1.3 8.3125 3.139 0.573 0.329 0.803 b2.1 13.2462 2.251 0.506 0.262 0.683 0.733 0.729 b2.3 13.1846 2.778 0.488 0.252 0.690 b2.4 13.2154 2.609 0.517 0.268 0.672 b2.5 13.3385 2.196 0.590 0.351 0.624 c3.2 16.6825 5.446 0.547 0.327 0.710 0.770 0.750 c3.3 17.0000 4.516 0.555 0.324 0.691 c3.4 16.9048 5.088 0.594 0.375 0.688 c3.5 17.2540 4.225 0.524 0.301 0.711 c3.6 17.2381 4.765 0.454 0.233 0.732 d4.2 13.3385 2.665 0.496 0.368 0.653 0.720 0.709 d4.3 13.1846 2.715 0.448 0.343 0.676 d4.5 13.1692 2.268 0.544 0.378 0.615 d4.7 13.4769 1.878 0.543 0.399 0.632 table 4: descriptive statistics and pearson’s correlation items mean±sd 1 2 3 4 5 1. techniques of creative accounting (as) 4.0744±0.84678 1 0.024 0.051 0.244* 0.625** 2. role of statutry auditors (bs) 4.4154±0.50054 1 0.577** 0.548** 0.680** 3. commitment of ethical standards (cs) 4.2462±0.52532 1 0.506** 0.687** 4. qualitative characteristic of accounting information (ds) 4.4308±0.49115 1 0.770** 4. average 4.2917±0.40214 1 **correlation is significant at the 0.01 level (two-tailed), *correlation is significant at the 0.05 level (two-tailed), all variables used a 5-point likert scale (1=strongly disagree, 5=strongly agree) ismael: the impact of creative accounting techniques on the reliability of financial reporting with particular reference to saudi auditors and academics international journal of economics and financial issues | vol 7 • issue 2 • 2017288 relationship between the qualitative characteristic of accounting information and the reliability financial reports) full supported. 5. discussion this part of study examines the discussion of relevant findings of the research. the creative accounting techniques used by management have a negative effect on the reliability of financial reporting. for the relationship between creative accounting techniques and reliability of financial reporting, inferential statistics shows that there is a significant negative interaction between predictor and the dependent variable, especially artificial treatment, off balance finance, and multiplicity of accounting policies (table 6). this result is emphasized by (fizza and qaisar, 2015; alomery and alameen, 2014); who conclude that there is a negative effect of creative accounting techniques on quality of financial reporting. however, (diana et al., 2014); show that more than half of the managers questioned answered that they had used accounting manipulation techniques to beautify the image of their companies even though they show a real life. also, (yadav et al., 2014) finds out the ways that helped to reduce the effect of creative accounting on the statement of financial position, by a presenting a quite positive picture of creative accounting practices. for the connection between the role of the statutory auditor and reliability of financial reporting, inferential statistics shows that there is a significant positive relationship between the role of the external auditor in promoting creative accounting practice (proper planning, qualification, independence, and competence) and reliability of financial reporting. this result is in line with a number of studies: (al momani and obeidat, 2013; osama, 2012; mohammed and mohammed, 2013); who are found that the independence and integrity of statutory auditor has a greater effect on the reliability of financial reporting. however, keith (2010) argue that there is a strategic interaction between auditors and management and that allows management to choose the economically irrational outcome of behaving ethically even when doing so defies their own financial self-interest. also, (fizza and qaisar, 2015) believe that corporate governance can control the practices of creative accounting because it acts as an eye, if companies can increase its number of outside directors, the social responsibility of company boosts because it will be answerable to many of people. for the relationship between the ethical standards and reliability of financial reporting, inferential statistics shows that there is a significant positive connection between the commitment to ethical standards in accounting profession (integrity, professional conduct, confidentiality, and objectivity) and reliability of financial reporting. this result is supported by. (kassem, 2012); who conclude that the ethical practices of creative accounting are there basically to help the external auditors and accountant in providing reliable financial accounts. for the connexion between the qualitative characteristics of accounting information and reliability of financial reporting, inferential statistics shows that there is a significant positive correlation between the quality of accounting information (fair presentation, accuracy, timing and consistency of accounting policies) and reliability of financial reporting. this result is confirmed by. (willekens, 2008; courtis, 2005); who conclude that the qualitative characteristics of accounting information effect reliability of financial reporting. 5.1. implications, limitations and suggestions for the study the results of this study have theoretical and practical implications that could be of interest for directors, auditors, accounting profession, regulators, and who in charge in governance. the first theoretical contribution to good corporate governance focuses on the positive relationship between the role of statuary auditor and the reliability of financial reporting. the second theoretical contribution is the study provide a framework for table 5: the weights of respondent’s answers opinion weight weighted mean level strongly disagree 1 from 1.00 to 1.79 strongly disagree disagree 2 from 1.80 to 2.59 disagree neutral 3 from 2.60 to 3.39 neutral agree 4 from 3.40 to 4.19 agree strongly agree 5 from 4.20 to 5.00 strongly agree table 6: the weighted means and directions item strongly disagree (%) disagree (%) neutral (%) agree (%) strongly agree (%) weighted mean standard deviation direction a1.1 1 (1.54) 3 (4.62) 5 (7.69) 24 (36.92) 32 (49.23) 4.28 0.91 strongly agree a1.2 2 (3.08) 5 (7.69) 6 (9.23) 29 (44.62) 23 (35.38) 4.02 1.02 agree a1.3 3 (4.69) 5 (7.81) 6 (9.38) 29 (45.31) 21 (32.81) 3.94 1.08 agree b2.1 1 (1.54) 0 (0.0) 5 (7.69) 24 (36.92) 35 (53.85) 4.41 0.78 strongly agree b2.3 0 (0.0) 0 (0.0) 2 (3.08) 30 (46.15) 33 (50.77) 4.48 0.56 strongly agree b2.4 0 (0.0) 1 (1.54) 1 (1.54) 31 (47.69) 32 (49.23) 4.45 0.61 strongly agree b2.5 0 (0.0) 2 (3.0) 4 (6.2) 30 (46.2) 29 (44.6) 4.32 0.73 strongly agree c3.2 0 (0.0) 0 (0.0) 1 (1.6) 24 (37.5) 39 (60.9) 4.59 0.53 strongly agree c3.3 0 (0.0) 3 (4.7) 5 (7.8) 27 (42.2) 29 (45.3) 4.28 0.81 strongly agree c3.4 0 (0.0) 0 (0.0) 4 (6.15 33 (50.77) 28 (43.08) 4.37 0.60 strongly agree c3.5 0 (0.0) 5 (7.7) 15 (23.1) 22 (33.8) 23 (35.4) 3.97 0.95 agree c3.6 0 (0.0) 2 (3.12) 14 (21.88) 28 (43.75) 20 (31.25) 4.03 0.82 agree d4.2 0 (0.0) 0 (0.0) 2 (3.1) 36 (55.4) 27 (41.5) 4.38 0.55 strongly agree d4.3 0 (0.0) 0 (0.0) 2 (3.1) 26 (40.0) 37 (56.9) 4.54 0.56 strongly agree d4.5 1 (1.54) 0 (0.0) 1 (1.54) 23 (35.38) 40 (61.54) 4.55 0.69 strongly agree d4.7 1 (1.54) 1 (1.54) 8 (12.31) 26 (40.0) 29 (44.61) 4.25 0.85 strongly agree ismael: the impact of creative accounting techniques on the reliability of financial reporting with particular reference to saudi auditors and academics international journal of economics and financial issues | vol 7 • issue 2 • 2017 289 creative accounting techniques that negatively affect the reliability of financial reporting. this study practically contributes to the accounting profession ethics literature by examining the importance and effect of exercising ethical standards on the reliability of financial reporting. in spite of it’s theoretical and practical implications and contributions to the management accounting and reporting literature, this study is subject to some limitations that need be considered. this study is based on participants’ responses to given scenarios and there is a risk that the respondents may not have answered the questionnaire honestly. the findings and discussion are limited to the propositions put forward in the questionnaire and such a survey instrument provides limited opportunity to solicit further meanings to participant’s responses. the major limitation of this study is that the scope of the research is bounded and sampling method used, thus limiting the generalizability of the results. the study only applied in ksa environment, this could result in an important limitation of the study. the study only considers the view of male gender. the more consideration of the study concentrates on academics view. the results of the current study open several avenues for additional research. one important area is an evaluation of the effectiveness of the code of professional conduct in constraining creative accounting. the findings of this report suggest that the most experienced members of the profession should be involved in this project. future research could map out the association of corporate governance features and creative accounting in the ksa environment since no study was been conducted so far in this respect. 6. conclusion this study explores the impact of creative accounting techniques on the reliability of financial reporting from auditors and academics point of view. creative accounting techniques have a positive and negative effects. this study only considers the negative effects of creative accounting techniques on the reliability of financial reporting. the negative effects of creative accounting techniques cannot be eliminated completely but it can be reduced to the lower level. therefore the study found that active corporate governance principles can be used to control the practices of creative accounting by using independent non-executive directors. also, the study concludes that the 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(2014), concept of creative accounting and its different tools. international journal of management and social sciences research (ijmssr), 3(2), 66-74. ismael: the impact of creative accounting techniques on the reliability of financial reporting with particular reference to saudi auditors and academics international journal of economics and financial issues | vol 7 • issue 2 • 2017 291 n the phrase strongly agree agree neutral disagre strongly disagree a. techniques of creative accounting 1 the artificial treatment of financial events have a negative impact on the credibility of financial reports 2 the off balance finance have a negative impact on the credibility of financial reports 3 the multiplicity of accounting policies and treatments have a negative impact on the credibility of financial reports b. the role of statutry auditor in creative accounting practices 1 proper planning for auditing helps in detecting the creative accounting practices 3 the professional qualification of auditor helps in detecting the creative accounting practices 4 when the auditor be up todate with accounting work helps in detecting the creative accounting practices 5 the independence of auditor helps in detecting the creative accounting practices c. ethical standards 2 the integrity contribute to the credibility of financial reports 3 the commitment of professional conduct contribute to the credibility of financial reports 4 the objectivity of accounting measurement contribute to the credibility of financial reports 5 maintaining the confidentiality of company information contributes to the credibility of financial reports 6 teaching ethics of creative accounting in educational institutions may increase the credibility of financial reports d. qualitative characteristics of accounting information 2 the fair presentation of accounting information have a positive impact on the credibility of financial reports 3 the aquaracy of accounting information have a positive impact on the credibility of financial reports 5 the timing of accounting information have a positive impact on the credibility of financial reports 7 the consistancy of accounting policies have a positive impact on the credibility of financial reports appendix a . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(1), 48-53. international journal of economics and financial issues | vol 8 • issue 1 • 201848 bilateral trade in european sports industry: linder versus hecksher-ohlin-samuelson görkemli kazar1*, altuğ kazar2, tamer sami sert3 1department of economics, feas, mersin university, mersin, turkey, 2department of economics, feas, munzur university, tunceli, turkey, 3mersin university, institute of social sciences, mersin, turkey. *email: gorkemli@mersin.edu.tr abstract in recent years, sports industry became one of the diverse industries in the world. its inter-industry and intra-industry trade potential revitalize the national economies, especially in europe. therefore, this paper examines the determinants of bilateral industrial sports sector trade in twenty-eight european countries. following the relative endowment-based gravity model, the econometric estimates of the panel datasets show that bilateral trade increases with the size of domestic markets and the similarity of the country size. however, the trade volume is negatively affected by the transportation costs. according to simulation results, the appreciation of the domestic currency has a negative effect on trade volume except the inland visegrad countries. the linder hypothesis is validated only for countries with large market shares. so, most of the european countries improve their bilateral trade through factor endowment differences. keywords: europe, endowment-based gravity model, sports industry trade jel classifications: f1, l83, o52 1. introduction according to 1992 european sports charter, sports includes organized or casual participation into physical activities. the cave paintings reveal the fact that origins of sports activities date back to prehistoric times. the social interest on sports started with the funeral games in bronze age which later formed the origins of the sport festivals organized by greeks. since then, national sports competitions such as olympic games motivate the national cohesion through national pride and social inclusiveness. the social reflections of sports also attracted the researchers in the field of economics such as rottenberg (1956). in economical perspective, sport is far more than the athletics. these activities create a composite industry by means of constant interaction with many industries. this relationship can be observed mainly in the apparel industry; the services sector and financial sector. furthermore, at both national and international level, the broadcasts of sport events through televisions, radios and newspapers attract the public attention. so, substantial amounts of money are spent to acquire sporting goods and equipment for a variety of sports. since the early 1990s, sports industry became one of the important branch of economic activities because of the advances in its revenues through advertising, sponsorship and broadcasting rights. today, the sports industry’s economic potential created many public and private sectors which contributed the high scale turnover of the industry. because of its dynamic structure many studies are conducted concerning the sports economics. the market structure is analyzed by preliminary studies of rottenberg (1956), topkis (1948), gregory (1956), neale (1964) and the first formal economic model of sports is introduced by el-hodiri and quirk (1971). after mid-1990s, consistent with the increasing revenue of the industry, the number of publications in the field of sport economics are expanded. in addition, by the establishment of the committee for the development of sport (cds) of the council of europe, more attention and support is given to the studies about sports and its implications. another vital step is taken with the macro econometric modelling of the sports economy by weber et al.. (1997). with the process of globalization and the expansion of sports in 1990s, the trade volume of the sporting goods of the multinational kazar, et al.: bilateral trade in european sports industry: linder versus hecksher-ohlin-samuelson international journal of economics and financial issues | vol 8 • issue 1 • 2018 49 corporations such as adidas, nike, reebok, and so on became more apparent in international trade. these corporations easily relocate their production to the low-cost countries of the south (hanzl and urban, 2000; lipsey, 2006; sage, 2000). this leads to a more polarized trade structure in sporting goods by forming major exporters such as china, south korea, india, the united states and france, and major importers such as the united states, japan, germany, france, united kingdom and italy (andreff and andreff, 2007). in addition, the international sports competitions also contribute to the development of the trade through advertisements which implies the success depending on the quality of the equipment used. international trade in sports is analyzed by harvey and saint-germain (2001), meek (1997) and andreff (1989; 1994). harvey et al. examine the trade of the 28 countries for the 1974-1994 period. the study shows the geographic concentration and the regionalization in the sporting goods trade of the developed countries. andreff (1994) report that some european countries have trade deficits related with the crowding out effect of the imported sporting goods. in his article meek (1997) reports the high growth rates in international trade of the sports goods. the limited literature about sporting goods trade is remained incapable of explaining the significance of the economic performances of the trading nations and the geographical gravity forces in action. the main purpose of this study is to analyze and figure out the major determinants of the european sports goods trade by using the endowment-based gravity model introduced by linder (1961). unlike the previous studies about sports economy, the sports industry’s trade structure will be reviewed by not only considering the geographical influences such as transportation costs, but also economic performances of the trading partners with relative factor endowments (rfe). the rest of the paper is organized as follows. section 2 provides a general overview of the sports industry. section 3 introduces the endowment-based gravity model. section 4 describes the data and the model. in section 5 empirical results are given and analyzed. section 6 provides conclusions. 2. overview of the sports industry the share of the sports industry in the world economy is increasing since the end of world war ii. today, large sports organizations are attracting massive amounts both as active and passive participants. as a result, the sport industry is expanding by incurring positive externalities. this also offers unique opportunities for companies operating in conjunction with the sports industry. by initiating the industrial revolution and hosting about 50% of the world sporting events, today’s dominating brands of sports industry are mainly originated from europe. in this section, first, sports market will be evaluated by separating the sources of the revenues and then the trade structure of european sports market will be examined. the figure 1 displays the revenue sources of the global sports market. the interaction of the sports industry with other markets increases gradually as the revenue increases through gate payments, media rights and sponsorships. according to figure 1, world sports market income increased by 35% between 2006 and 2015 and reached to a peak of $145 billion in 2015. from figure 1 it is perceived that the gate revenues show a steady trend throughout the period. since consumption habits of households exhibits consistent patterns over time, the financial crisis of 2008-2009 have very moderate effect on the gate revenues. the bankruptcy of the companies in 2008 crises leads to 3% decrease in sponsorship revenues. implications of precautionary measures by the governments to soften the effects of the crises cause 44% increase in sponsorship revenues over 6 years of time. although the revenues of media rights increase 45% on average, it displays a fluctuating pattern between 2006 and 2015 because of the periodic global games. in figure 1, with a decrease of 17%, merchandising revenues are the most responsive revenue item to the crises of 2008-2009. although, the merchandising revenues show 14% increase, the levels of revenues in 2009-2015 period are <2007 level. after 2013, global sports activities such as world cup and olympic games result in a slightly increasing trend. in figure 2, the sports goods exports, imports and total trade volumes for european countries are given. as can be seen from the figure, european countries’ sports goods trade increased by 79% between 2000 and 2015. after the enlargement of european union (eu) in 2004, when the process of harmonization with the eu has been completed, european brands have moved their production to new participant countries in which the wages are relatively low. as this harmonization process was completed in 2006, from this year imports started to fall whereas exports continued to increase. although total trade fell after the 2008 crisis due to unfavorable economic conditions around the world, the global sporting events has turned the trade back into its previous rising trend that has accelerated after 2013. figure 1: global sports market revenue (millions, us $) source: pwc (2016) source: eurostat database figure 2: the sports goods trade in european countries 2000-2015 (1000 euro) kazar, et al.: bilateral trade in european sports industry: linder versus hecksher-ohlin-samuelson international journal of economics and financial issues | vol 8 • issue 1 • 201850 in figure 3 percentage distributions of import volumes of sports industry are given. in the 2000s, developed countries have moved their production to places where raw materials and labor are cheaper due to global climate change and environmental concerns. so, they have to import the final sporting goods they need from the countries where they have shifted production. accordingly, at the beginning of the 2000s the share of imports from non-european countries was greater. with the enlargement of the eu in 2004, some of the production centers have moved to europe, and the import volume of sports goods within europe have increased. the closure of firms during 2008-2009 crisis has disturbed the economic structure of the new member states that reduces the share of intra-europe imports. in the post-crisis era, intra-european trade and non-european trade maintained their import shares which are very close to each other. the percentage distribution of exports of european sporting goods are displayed in figure 4. it is observed that about 60% of exports of sporting goods are made within europe. since the goods produced in europe are generally high-quality and expensive products for elite sports, the most important share of market demand is created by european countries. another reason for the high volume of exports in europe is the fact that sports competitions are mainly held in this continent. from the figures 1-4, not only the revenue but also the trade volume of the sports market has grown significantly in recent years. in addition, worldwide government regulations about health and the environment has led to an increase in sports activities and expenditures in both the world and europe. the export structure of european sporting goods mainly depends on the intra-eu trade. since sporting goods production shifted to the cost-efficient regions, the share of imports has remained largely stable between europe and other countries. 3. endowment-based gravity model in 1687, isaac newton introduced the law of universal gravitation, which states that the power of gravity between two objects is positively related with their masses, whereas negatively related with the distance between these objects. following newton, gravity equation gained the interest of many researchers and many studies are conducted to interpret the spatial influences on the variables. the gravity equation developed by newton’s law applied to trade flows as well as non-trade flows such as migration, population and education (glejser and dramais, 1969). linder (1961), tinbergen (1962), pöyhönen (1963) and linnemann (1966) were the pioneers of theoretical gravity model of international trade. according to model the trade flows are proportional to the size of the economies and distance have an adverse effect on trade volume: tfij = αgdpigdpj/dij (1) where tfij is the bilateral trade flow from country i to j, gross domestic product (gdpi) and gdpj are the gdp of country i and j, dij is the distance between countries i and j, α is a gravitational constant. the gravity models of trade are validated and improved technically by anderson (1979), bergstrand (1985), helpman and krugman (1985), helpman (1987), deardorff (1995), eaton and kortum (1997), and anderson and wincoop (2003) as they emphasized the role of the theoretical foundations of the trade theory. following these studies, gravity equation is used to examine bilateral trade based on common borders (mccallum,1995; wei, 1996; helliwell, 1997; nitsch, 2000; anderson and wincoop, 2003; coughlin and novy, 2012), international agreements (baier and bergstrand, 2007; grant and boys, 2011; rose, 2004; frazer and van biesebroeck, 2010; dutt et al.., 2013; subramanian and wei, 2007; tomz et al.., 2007; liu, 2009; herz and wagner, 2011), tariffs (cadot et al.., 2002; augier et al.., 2004) and non-tariff barriers (sunesen et al..,2009; kee et al.., 2009; bianco et al.., 2016). besides the literature given above, the theory of foreign trade is reconciled with demand and the endowment-based trade hypothesis was expressed by linder in 1961. the linder hypothesis suggests that international trade has been intensified between countries with similar levels of income and demand structures. the empirical studies express the linder variable by the difference between per capita incomes of foreign trade countries. as the income disparity of the countries decreases, the increasing trade intensity of the countries supports the linder hypothesis. linder has reached three conclusions concerning the trade of countries with similar income levels: (1) as the level figure 3: percentage distribution of sports goods imports in european countries source: eurostat database figure 4: percentage distribution of sports goods exports in european countries source: eurostat database kazar, et al.: bilateral trade in european sports industry: linder versus hecksher-ohlin-samuelson international journal of economics and financial issues | vol 8 • issue 1 • 2018 51 of income per capita increases, better quality products often take on lesser quality products, (2) demand for final goods in the short run is greater than unit elasticity. however, when the final goods are classified according to their qualities, the income elasticity of those with higher quality will be more than one. (3) export and import volume can be increased by applying an unbalanced income redistribution policy. such a policy will lead to different income levels and the demand for different qualified products will increase. following linder, gruber and vernon (1970) have shown the difference between the consumption patterns by adding the absolute difference between the income levels. accordingly, a negative coefficient supports the linder hypothesis by indicating the countries that have similar per capita income have identical consumption patterns and the trade within these countries is positively affected. in 1977, the endowmentbased theory of new trade gained significance with the work of dixit and stiglitz. according to helpman and krugman (1985), helpman (1987) and egger (2002) who follow this study, the magnitude of the bilateral trade is a function of factor incomes g, the similarity between the relative size of the countries sim and the variations in rfe. 4. data and the model in our study, the validity of the linder hypothesis for european countries’ sports industry will be searched by considering intraeu and extra-eu bilateral trade flows. the yearly data related with the bilateral trade flows for 2000-2014 are obtained from the sport statistics database of the eurostat. the income and real effective exchange rate data are taken from wdi, and the distance between the countries, are acquired from cepii (mayer and zignago, 2011) dataset. consistent with the endowment-based gravity model studies, the general form of the estimation specification of the study can be given as follows: ijt 0 1 ijt 2 ijt 3 ijt it 4 ijt 5 ijt jt lnbtf = + lng + lnsim + lnrfe rer + dist + ln +u rer β β β β β β (2) here, the hecksher-ohlin-samuelson (hos) determinants are defined as follows: ( )ijt it jtg = log gdp +gdp (3) 2 2 jtit ijt it jt it jt gdpgdp sim = log 1 gdp +gdp gdp +gdp              −   −  (4) jtit ijt it jt gdpgdp rfe = log log n n          − (5) where i denotes the european home country and j denotes the host country, btfijt measures the total trade between country i and country j in millions us dollars, gijt measures the total gdp of the trade partners converted to million dollars using purchasing power parity rates, simijt measures the economic similarity between the trading partners, rfeijt measures the differences in rfe, distijt measures the distance between country i and j, rerit/rerjt is the ratio of the real effective exchange rate and ut is the log-normally distributed disturbance term. along with the gravity approach, we expect to have positive income coefficient for trading countries and negative coefficients related with the distance between countries. since the rfe variable is used to understand the differences in relative factor contributions, obtaining a positive coefficient for rfeijt is consistent with the heckscher-ohlin-samuelson approach and shows that there is a inter-industry trade structure. on the other hand, if a negative coefficient is obtained for the rfeijt variable, the linder hypothesis is valid, since in this case the trade between the countries becomes lower as the countries diverge according to their rfe. the similarity measure simijt, that presents the contribution of intra-industry trade to total trade, is expected to have a positive coefficient contingent with the differentiated product trade theory. as home country’s currency depreciation increases the export inflows, we expect that the ratio of real effective exchange rates to have a negative sign. 5. empirical results table 1 shows the test results of the sports trade model for the european countries that has available data. according to test results, the trade volume of sport goods is positively affected by the increase in the income of the trading partners, as expected. in addition, consistent with the literature, the distancea proxy variable for transportation costsbetween the countries negatively related to the sports goods trade. the similarity measure explaining the trade structure, seems to have a positive value for all countries. accordingly, the trade volume of sport goods increases among the trade partners with similar economic conditions. real effective foreign exchange rates have negative coefficients in all countries except czech republic, hungary and slovakia. the increase in the ratio of effective exchange raterelative price of tradeleads to the appreciation of the domestic currency. this causes a significant decrease in the exports of the country, while imports will increase as foreign sport goods become cheaper. in general, the impact on total trade will be negative because the decrease in exports will be greater than the increase in imports. the trade volume of market driven, medium skill industry such as sports goods for inland visegrad countries (czech republic, hungary and slovenia) give a counter reaction to the appreciation of domestic currency. in these countries, an excessive change in sport goods imports end up with a positive coefficient. when the rfe are taken into consideration, the linder hypothesis is valid only in countries that have largest market share in sports industry such as france, italy, germany, spain, turkey and england. these countries have an intra-industry production based sports goods trade. when rfe are evaluated for other european countries, the test results show that they have a positive coefficient which indicates the validity of the heckscher-ohlin-samuelson hypothesis. the most important reason why these countries have positive coefficient of rfe is that there is inter-industry based free foreign trade in sport industry. kazar, et al.: bilateral trade in european sports industry: linder versus hecksher-ohlin-samuelson international journal of economics and financial issues | vol 8 • issue 1 • 201852 6. conclusion sport industry has significant economic contributions by having intense interaction with many industries. from the last decade of 20th century, the industry’s economic potential and the high scale of turnover caused extraordinary revenues. multinational companies polarized the trade structure by causing major trade partners in the industry. so, industry’s international trade structure is mainly shaped by not only the economic performances of the trading partners, but also the spatial forces. in addition, as europe hosts foremost sporting events throughout history, the support of the cds also reinforced her position as trade center of sporting goods. in this paper, we analyzed the sports industry’s trade patterns by using panel of bilateral sporting goods trade flows of the european countries over the period 2000-2014. we used the endowmentbased gravity approach, bilateral country size, rfe, similarity in country size, the distance between trade partners. to address the impact of the inflationary effects of the relative prices of goods on trade, we extended the model by the ratio of the effective exchange rate. consistent with the existing literature, our empirical results reveal the fact that bilateral trade flow is positively related to total income of the trading partners and similarity in country size, and is inversely related to transportation costs. the relative price of trade has negative influence on the sporting goods trade volume except the inland visegrad countries. according to test results, the new trade theory and linder’s hypothesis is validated for only the countries that have the largest market share in the industry. on the contrary, the trade volume of the rest of the european countries continue to expand, in accordance with hos theory. therefore, these countries have much gain from different factor-endowments. our outcomes also highlight the importance of reducing gaps in gdp of the trade partners to ensure the full benefit of the trade. references anderson, j.e. (1979), a theoretical foundation for the gravity equation. the american economic review, 69(1), 106-116. anderson, j.e., wincoop, v.e. (2003), gravity with gravitas: a solution to the border puzzle. american economic review, 93(1), 170-192. andreff, m., andreff, w. (2007), international specialization of major trading countries in global trade of sports goods no. 0715. andreff, w. (1989), l’internationalisation économique du sport. economie politique du sport. paris: dalloz. pp203-236. andreff, w. (1994), the economic i̇mportance of sport in europe: financing and economic i̇mpact. cdds 94(3). strasbourg: council of europe. augier, p., gasiorek, m., lai-tong, c. (2004), rules of origin and the eu-med partnership: the case of textiles. world economy, 27(9), 1449-1473. baier, s.l., bergstrand, j.h. (2007), do free trade agreement actually increase members’ international trade? journal of i̇nternational economics, 71(1), 72-95. bergstrand, j.h. (1985), the gravity equation in international trade: some microeconomic foundations and empirical evidence. the review of economics and statistics, 67(3), 474-481. table 1: endowment-based gravity model results variables lngij lnsimij lnrfeij lndistij ln (reri/ rerj) constant observed r-sq. austria 0.61*** (0.08) 0.19*** (0.02) 0. 0.97*** (0.19) −0.89*** (0.05) −0.12 (0.46) −1.57 (2.87) 584 0.56 belgium 0.74*** (0.11) 0.19*** (0.02) 0.87*** (0.25) −0.75*** (0.05) −3.24*** (0.58) −7.16*** (4.07) 584 0.59 bulgaria 0.26*** (0.02) 0.16*** (0.02) 1.63*** (0.16) −1.43*** (0.08) 0.34 (0.46) 12.86*** (0.82) 579 0.55 croatia 0.01 (0.03) 1.82*** (0.46) 3.32*** (0.19) −1.23*** (0.07) −1.58*** (0.57) 19.37*** (1.18) 575 0.58 cyprus 0.05* (0.03) −1.39 (0.85) 2.07*** (0.20) −0.52*** (0.12) −2.59*** (0.66) 11.52*** (1.28) 552 0.41 czech rep. 1.20*** (0.16) 0.14*** (0.03) 0.09 (0.32) −1.15*** (0.06) 0.88*** (0.43) −23.14*** (6.03) 584 0.58 denmark 0.40*** (0.08) 0.20*** (0.02) 1.34*** (0.19) −0.92*** (0.06) −2.23*** (0.48) 5.89** (3.09) 584 0.61 estonia 0.01 (0.02) 1.21* (0.71) 2.54*** (0.19) −1.38*** (0.08) 0.22 (0.57) 19.87*** (0.94) 575 0.55 finland 0.30** (0.14) 0.26*** (0.02) 1.74*** (0.28) −1.28*** (0.06) 0.41 (0.49) 12.51** (5.41) 583 0.60 france 1.09*** (0.12) 0.05*** (0.02) −0.91*** (0.15) −0.66*** (0.05) −0.93** (0.42) −20.67*** (4.59) 584 0.56 germany 0.34*** (0.06) 0.04*** (0.01) −1.16*** (0.13) −0.68*** (0.04) −0.74** (0.35) 9.87*** (2.31) 584 0.59 greece 0.51*** (0.14) 0.22*** (0.03) 1.59*** (0.29) −0.99*** (0.09) −2.09*** (0.62) 1.68 (5.22) 580 0.44 hungary 0.49*** (0.11) 0.24*** (0.02) 1.66*** (0.25) −1.21*** (0.07) 1.26** (0.54) 3.08 (4.02) 581 0.53 ireland −0.02 (0.14) 0.29*** (0.03) 2.37*** (0.29) −1.19*** (0.09) −2.49*** (0.62) 21.86*** (5.23) 566 0.56 italy 0.71*** (0.07) 0.05*** (0.01) −0.86*** (0.14) −0.69*** (0.05) −1.78*** (0.38) −5.07* (2.78) 584 0.49 lithuania 0.09** (0.04) −1.02 (0.87) 2.74*** (0.23) −1.98*** (0.10) 0.57 (0.73) 21.00*** (1.57) 540 0.47 luxembourg 0.05 (0.05) −1.37 (1.23) 2.72*** (0.29) −1.64*** (0.09) −4.49*** (0.99) 17.97*** (1.93) 491 0.52 netherlands 0.81*** (0.06) 0.16*** (0.02) 0.39** (0.17) −0.73*** (0.04) −0.99** (0.39) −10.08*** (2.34) 584 0.66 norway 0.53*** (0.09) 0.16*** (0.02) 1.38*** (0.22) −1.20*** (0.08) −0.21 (0.59) 3.46 (3.27) 584 0.46 poland 0.89*** (0.08) 0.14*** (0.02) 0.19 (0.24) −1.19*** (0.07) −1.39** (0.71) −11.05*** (2.81) 428 0.54 portugal 0.46*** (0.10) 0.29*** (0.02) 1.60*** (0.24) −1.59*** (0.09) −3.90*** (0.58) 8.21** (3.96) 579 0.67 romania 1.07*** (0.15) 0.20*** (0.03) 0.82** (0.34) −1.53*** (0.11) 0.19 (0.69) −16.64*** (5.78) 574 0.45 slovakia 0.18*** (0.03) 0.18*** (0.02) 1.86*** (0.18) −1.24*** (0.07) 3.34*** (0.55) 14.67*** (1.28 420 0.58 spain 1.54*** (0.10) 0.03 (0.02) −1.41*** (0.19) −0.99*** (0.07) −3.76*** (0.49) −36.57*** (3.81) 584 0.63 sweden 1.19*** (0.14) 0.14*** (0.03) 0.04 (0.28) −1.25*** (0.07) −0.30 (0.44) −21.35*** (5.32) 584 0.56 switzerland 1.37*** (0.15) 0.13*** (0.03) −0.26 (0.31) −0.87*** (0.07) −0.48 (0.54) −31.59*** (5.60) 583 0.57 turkey 1.67*** (0.11) 0.06*** (0.02) −0.63** (0.25) −0.54*** (0.09) −2.63*** (0.48) −47.72*** (4.21) 534 0.51 uk 0.65*** (0.09) 0.12*** (0.02) −0.60*** (0.17) −0.37*** (0.05) −0.60* (0.33) −5.34 (3.68) 584 0.51 robust, clustered standard errors are reported in parentheses. ***denotes p<0.01, **denotes p<0.05, *denotes p<0.1. trade flows are the total exports and imports between country i and country j. gijt is the total gdp of the trade partners, simijt is the economic similarity measure, rfeijt shows the relative factor endowments, distijt is the distance between country i and j. rerit/rerjt is the ratio of the real effective exchange rate. gdp: gross domestic product, rfe: relative factor endowments kazar, et al.: bilateral trade in european sports industry: linder versus hecksher-ohlin-samuelson international journal of economics and financial issues | vol 8 • issue 1 • 2018 53 bianco, a.d., boatto, v.l., caracciolo, f., santeramo, f.g. 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(1996), intra-national versus i̇nternational trade: how stubborn are nations in global i̇ntegration? national bureau of economic research. no. w5531. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 7-12. international journal of economics and financial issues | vol 13 • issue 1 • 2023 7 valuation of corporate debt and equity in uncertain markets frank ranganai matenda1*, justin chirima2, mabutho sibanda1 1school of accounting, economics and finance, university of kwazulu-natal, westville campus, university road, westville, private bag x54001, 4000, durban, south africa, 2department of mathematics and computer science, great zimbabwe university, p. o. box 1235, masvingo, zimbabwe. *email: frmatenda@gmail.com received: 20 september 2022 accepted: 13 december 2022 doi: https://doi.org/10.32479/ijefi.13706 abstract in practice, financial decisions are made in the context of indeterminacy. randomness, uncertainty, and fuzziness are three basic types of indeterminacy. a multiplicity of differential equations have been designed to depict various processes powered by different kinds of indeterminacy. among others, these differential equations include uncertain differential equations, stochastic differential equations, and fuzzy differential equations. in this study, we propose that the value of a firm can be described by an uncertain differential equation powered by a geometric canonical liu process. uncertain differential equations describe processes driven by uncertainty. implementing the uncertain liu option pricing theory, we develop and analyse a framework for valuing debt and equity for a levered firm in uncertain markets. numerical calculations are demonstrated. keywords: uncertainty theory, uncertain liu option pricing theory, uncertain markets, corporate debt, corporate equity jel classifications: g12, g13 1. introduction decisions, in reality, are executed in the context of indeterminacy (chen et al., 2022; huang and ning, 2021; matenda and chikodza, 2019). the indeterminacy of event outcomes is their quality or situation of being unpredictable in advance. randomness, uncertainty, and fuzziness are three rudimentary types of indeterminacy. matenda and chikodza (2019) opined that randomness is a feature of anything that probabilistic laws can explain, and uncertainty is a characteristic of anything that can be explained by belief degrees. fuzziness refers to any phenomenon that a credibility measure can quantify (matenda, 2016). kolmogorov (1933) introduced probability theory to describe randomness, and liu and liu (2002) introduced credibility theory to deal with fuzziness effectively. in 2007, liu (2007) suggested uncertainty theory to model uncertainty. probability theory is a subdivision of pure mathematics that deals with frequencies. it is implemented when the size of the sample is relatively large to determine the probability distribution from obtainable frequency (gao et al., 2022; zhou et al., 2022; huang and ning, 2021; liu et al., 2022; wang and ralescu, 2021; matenda and chikodza, 2019). the implementation of probability theory in finance theory resulted in the emergence of stochastic finance theory. that is to say, stochastic finance theory is founded on probability theory. stochastic processes (e.g., the brownian motion) and stochastic differential equations (des) are indispensable tools in probability theory and stochastic finance theory. a stochastic process is defined as a series of random variables indexed by space or time. stochastic des are des powered by the brownian motion. on the other hand, credibility theory is a unit of mathematics that deals with and examines the aspects of dynamic fuzzy phenomena. credibility theory deals with events or processes whose measurement is imperfect and dim (see, for instance, jiwo and chikodza, 2015). the application of fuzzy mathematics in finance theory resulted in fuzzy finance theory. that is to say, fuzzy finance theory is founded on fuzzy mathematics. fuzzy processes (e.g., the geometric liu process) this journal is licensed under a creative commons attribution 4.0 international license matenda, et al.: valuation of corporate debt and equity in uncertain markets international journal of economics and financial issues | vol 13 • issue 1 • 20238 and fuzzy des are essential tools in fuzzy calculus and fuzzy finance theory. a fuzzy process is defined as a series of fuzzy variables which change with time. fuzzy des are des powered by the liu process. derivative values depend on the values of the underlying assets. options are one prominent example of derivative instruments and are widely used in risk management. an option is defined as a contract that offers the holder of the contract the privilege but not the compulsion to sell or buy an underlying asset at a stated fixed price on a specific date or at any time before that date. options theory is a vital discipline in modern finance and it is essential in both the financial industry and academia (gao et al., 2022; huang and ning, 2021; hassanzadeh and mehrdoust, 2018). wang and ralescu (2021) and hassanzadeh and mehrdoust (2018) articulated that the valuation of options is a challenge in finance. in the same vein, rao and zhu (2022) postulated that the major challenge in stock option pricing is discovering an appropriate process to explain the stock price movement patterns better. in the theory of stochastic analysis, black and scholes (1973), premised on the geometric brownian motion, introduced the well-known black-scholes (b-s) model and proposed european option pricing formulae. since then, the b-s model has become an essential instrument in stochastic finance theory when pricing financial derivatives (wang and ralescu, 2021; peng and yao, 2011). the classical work of black and scholes (1973) has provided a strong footing for derivative instruments pricing. on the other hand, liu (2008) suggested a fuzzy stock model called liu’s stock model. the liu’s stock model is considered a fuzzy counterpart of the b-s model and has represented a significant advancement in fuzzy finance theory. after that, qin and li (2008) deduced the conforming european option pricing formulae. it is important to note that most studies on option pricing have been performed under the frameworks of fuzzy des and stochastic des. nonetheless, in some instances, some inexact quantities (e.g., stock prices and corporate values) denoted by human language do not act like fuzziness or randomness (rao and zhu, 2022; huang and ning, 2021; hassanzadeh and mehrdoust, 2018). to deal with such inexact quantities, domain specialists are summoned to examine their belief degrees of every event happening (gao et al., 2022; huang and ning, 2021; liu et al., 2022; wang and ralescu, 2021; matenda and chikodza, 2019; hassanzadeh and mehrdoust, 2018). the authors (matenda and chikodza, 2019) further articulated that credibility theory or probability theory cannot describe personal belief degrees because it leads to counterintuitive results. therefore, to rationally model personal belief degrees, liu (2007) developed the uncertainty theory that was further analysed by liu (2010). liu (2015) defined the uncertainty theory as the subdivision of pure mathematics that models belief degrees. the implementation of the uncertainty theory in finance theory led to the emergence of uncertain finance theory. that is to say, the uncertain finance theory is founded on uncertainty theory. uncertain processes (e.g., the canonical liu process) and uncertain des play critical roles in the uncertainty theory and uncertain finance theory (see, for instance, chen et al., 2022; wang and ralescu, 2021). an uncertain process refers to a series of uncertain variables indexed by space or time. uncertain des are des powered by the canonical liu process. under the supposition that stock prices obey the geometric canonical liu process, liu (2009) derived an uncertain stock model, i.e., the uncertain liu stock model, and developed the conforming european option pricing formulae. from that time, the uncertain liu stock model has emerged as an essential instrument in uncertain finance theory. the uncertain liu stock model is generally regarded as the uncertain equivalent of the b-s model and liu’s stock model. sun and chen (2015) and chen (2011) generated the asian option pricing formulae and american option pricing formulae, respectively, premised on the uncertain liu stock model. also, premised on the uncertain liu stock model, chen et al. (2013) and peng and yao (2011) designed a periodic-dividend stock model and a mean-reverting stock model, respectively. further, yao (2015) developed a sufficient and necessary noarbitrage condition for the uncertain liu stock model. the total market value of the corporate is given by the total market value of its outstanding equity plus the total market value of its outstanding debt and other external claims. conceptually, equity in a levered corporate resembles a call option on the corporate. the selling of pure discount bonds by shareholders to the bondholders is virtually the same as the selling of corporate’s assets to the bondholders for the bond issue’s proceeds and buying a call option to reacquire those corporate assets from the bondholders at a strike price equivalent to the issued bonds’ face value (see black and scholes, 1973). further, shareholders, as the owners of the corporate, are residual claimants. they claim the remaining cash flows after all financial claimants are paid. likewise, if an organisation is liquidated, equity-holders get the residual after all financial claimants are paid. in publicly traded organisations, the basic principle of limited liability protects shareholders. if the corporate value is lower than the outstanding debt value, losses incurred by the shareholders cannot exceed their total investment into the organisation. when the debt value exceeds the value of the assets, equity-holders can move away from the firm. on the contrary, when the value of the assets is more than the value of the debts, the equity-holders would continue operating the business. corporate liabilities have been widely priced under the framework of stochastic des (eissa and elsayed, 2022; yin et al., 2018; black and scholes, 1973). black and scholes (1973) illustrated how the b-s model can be used in the pricing of corporate liabilities. nevertheless, studies devoted to the valuation of corporate liabilities under the frameworks of fuzzy des and uncertain des are limited. in this study, we propose that the corporate value can be modelled by an uncertain differential equation powered by the geometric canonical liu process. the article implements the uncertain liu option pricing theory to develop and analyse a framework for valuing debt and equity for a levered firm in uncertain markets. numerical calculations are demonstrated. we indicate that market participants can apply this framework in practice to value a levered firm’s corporate debt and equity in uncertain markets. to the authors’ knowledge, no such study has been conducted before. matenda, et al.: valuation of corporate debt and equity in uncertain markets international journal of economics and financial issues | vol 13 • issue 1 • 2023 9 the remaining part of the study is categorised as below. section 2 describes the preliminaries, and section 3 gives an overview of the uncertain liu stock model. the uncertain liu option pricing model is presented in section 4 and the dynamics of valuing debt and equity for a levered firm in uncertain markets are illustrated in sections 5. section 6 concludes the study. 2. preliminaries here, we present some essential definitions in uncertainty theory. these definitions constitute the footing of this article. in this study, we take into account an uncertainty space (γ, ⱡ, ɱ) and a filtration, {ℱt}t≥0, produced by a one-dimensional canonical liu process, {ct}t≥0. definition 2.1 (liu, 2007) assume that γ is a non-empty set and ⱡ is a σ-algebra over γ. each element λ in ⱡ is considered to be an event. an uncertain measure refers to a set function ɱ: ⱡ → [0, 1] which meets the below-mentioned four axioms: • normality axiom: ɱ{γ} = 1; • monotonicity axiom: ɱ {λ1} ≤ ɱ {λ2} if λ1 ⸦ λ2; • duality axiom: ɱ {λ} + ɱ {λc} = 1 for every λ ∈ ⱡ; • sub-additivity axiom: for each countable event sequence {λ1, λ2,…}, ɱ{∪i λi} ≤ ʃi ɱ {λi}. definition 2.2 (liu, 2007) an uncertain variable is a measurable function ξ from an uncertainty space (γ, ⱡ, ɱ) to the set of real numbers such that for each borel set b, {ξ ∈ b} is an event. definition 2.3 (liu, 2013) assume that t is an index set and (γ, ⱡ, ɱ) refers to an uncertainty space. an uncertain process is a measurable function xt (γ) from t x (γ, ⱡ, ɱ) to the set of real numbers such that at any time t, for every borel set b, {xt ∈ b} is an event. definition 2.4 (liu, 2009) an uncertain process ct is defined as a canonical liu process if • c0 = 0 and almost all sample paths are lipschitz continuous, • ct has independent and stationary increments, • each increment cs+t cs is a normal uncertain variable with variance t2 and expected value 0, whose uncertainty distribution is given by ( ) 1x (1 exp ( )) , x . 3 x t  −−φ = + ∈ (1) definition 2.5 (haugh, 2010) a filtration, {ℱt}t≥0, describes the time evolution of information. a filtration on (γ, ⱡ, ɱ) is an index set, {ℱt}t≥0, of sub-σ-algebra of ℱ. definition 2.6 (liu, 2008) assume that ct is a canonical liu process, and that f and g are two functions. the equation dxt = f(t, xt)dt + g(t, xt)dct (2) is an uncertain de. a solution is an uncertain process xt that satisfies (2) identically in t. remark 2.1: an uncertain de (2) is considered to be equivalent to an uncertain integral equation s s t t t0s 0 0 f (t, x )dt x g(t, x )x dc .= + +∫ ∫ (3) 3. uncertain liu stock model liu (2009) proposed that the price of the stock can be described by an uncertain de driven by the geometric canonical liu process and derived an uncertain liu stock model in which the price of the bond dt and the price of stock yt are given by ddt = rdtdt (4) and dyt = µytdt + σytdct, (5) respectively, where r denotes the risk-free rate of interest, µ is the log-drift, σ represents the log-diffusion, and ct denotes the canonical liu process. the explicit price of the bond is described by dt = d0exp(rt), (6) and that of the stock is given by yt = y0 exp (µt + σct), (7) whose inverse uncertainty distribution is ( 1) 0 3 ( ) exp( ( ln ). 1t µ t y t σ α φ α π α − = + − (8) 4. uncertain liu option pricing model liu (2009) suggested the following formulae for the european put option premium, p, and the european call option premium, c. suppose the european call option for the uncertain liu stock model is associated with an exercise price k and expiration time t. the european call option premium is then described by ( ) 1 c 00 t 3 f exp rt y exp t ln k d . 1 +   σ α = − µ + − α    π − α   ∫ (9) assume that the european put option for the uncertain liu stock model is associated with an exercise price k and expiration time t. the european put option premium is then given by f exp rt k yexp t t �1n d p � � � � � � � � � � � � � �� � � �� � � �� � � �� � ( ) 0 0 3 1 � � � � � � 11 � . (10) 5. pricing corporate debt and equity in uncertain markets the total market value of the corporate is given by the total market value of outstanding equity plus the total market value of matenda, et al.: valuation of corporate debt and equity in uncertain markets international journal of economics and financial issues | vol 13 • issue 1 • 202310 outstanding debt and other external claims. since the equity in a levered corporation resembles a call option on the corporate, we will use the uncertain liu option pricing theory to price the debt and equity of a levered firm in uncertain markets. here, we assume the following: • pure discount bonds: the corporate of interest sells pure discount bonds, which forbid any coupon payments until after their maturity, and the residual is paid-off to equityholders. • capital structure cannot affect the total value of the firm. • investors have uniform anticipations concerning the dynamic behaviour of the corporate’s assets. in mathematical notation, from the balance sheet, the corporate’s value is given by v = e + d, (11) where v represents the total market value of the corporate, e denotes the total market value of equity outstanding, and d represents the total market value of the outstanding debt and other external claims. let’s say b is the face value, i.e., par value, of defaultable debt. therefore, the pay-offs of corporate debt and equity at debt maturity are given by total debt: d = min (b, v), and total equity: e* = max (v − b, 0). similarly, the value of the call option c, given an exercise price k, on an asset with a present-day value s, is described by c = max (s − k, 0), and its pay-off is given by c =exp(−rt) max (s − k, 0)+. the dynamics of equity and call option pay-offs are similar. this confirms that the equity of a firm resembles a call option. therefore, we propose that the uncertain liu option pricing model might offer a modelling mechanism that can be used in the valuation of equity and debt for a levered corporate. the total corporate value, vt, at time t is given by the following uncertain de powered by the geometric canonical liu process dvt = µvtdt + σvtdct, (12) where µ represents the log-drift, σ denotes the log-diffusion, and ct is the geometric canonical liu process. theorem 1. let e* be the equity value, b be the bond’s face value, v be the corporate’s value, µ be the log-drift, σ and be the logdiffusion. the value of the corporate equity is given by e exp rt v exp t t ln b d* = − + −         −       + ∫( ) 00 1 3 1 µ σ π α α α . (13) proof: the solution to equation (12) is an uncertain process given vt by vt = v0 exp(µt + σct) (14) and its inverse uncertainty distribution is described by 1 10 exp( )v tµ   − −= + φ (15) now the expected value of the pay-off for total equity e* is given by e* = exp(-rt) e(max (vt-b, 0+). (16) the uncertainty distribution of equation (16) is described by φ t * = ɱ {exp(-rt)(v0 exp(µt+σct)-k)≤x} = ɱ { ( )}exp µt c k xexp rt v t +( )( ) ≤ +σ 0 = ɱ { ( ) }c lnk xexp rt v µt t ≤ + − 1 0 σ σ = + + + ( ( ) )1 3 3 0 π σ π σ µ t ln v k xexp rt -1 whose inverse uncertainty distribution is 1 á 0 t 3 * exp( rt) v exp t ln b 1  −  σ α = − µ + −   π − α  applying the expected value of an uncertain variable definition to equation (16), we get e exp rt v exp t t ln b d * = − + −         −       + ∫( ) 00 1 3 1 µ σ π α α α which is similar to equation (13). thus, the proof is concluded. further, if v is the value of the firm and e* is the value of the outstanding equity, the value of the outstanding debt, d, is given by d = v–e*, i.e., d v exp rt v exp t t ln b d= − −( ) + −         −       + ∫( .00 1 3 1 µ σ π α α α (17) in general, the value of the debt can be presented by d = d (v, b, t, σ, r), where ∂ ∂ ∂ ∂ > d v d b , 0 and ∂ ∂ ∂ ∂ ∂ ∂ < d t d ã d r , , 0 . these partial effects have the following intuitive interpretations: • if the firm value increases, equity value and cover on the debt increase. consequently, the belief degree of default decreases while the debt value rises matenda, et al.: valuation of corporate debt and equity in uncertain markets international journal of economics and financial issues | vol 13 • issue 1 • 2023 11 • if the debt repayment amount increases, the claims of debtholders against the assets of the firm increase. hence, debt value increases, and the current equity value decreases. • the present debt value decreases and the equity market value increases when the debt repayment increases. • an increase in the riskless interest rate lowers the debt’s present value and amplifies the equity market value. • the dispersion of possible values of the corporate value at the debt maturity date increases when the time to maturity or the log-diffusion increases. • the debt-holders receive b as their maximum payment. when the dispersion of possible outcomes of b increases, the belief degree that the corporate assets’ value will be below b increases. thus, the belief degree of default increases, the debt value decreases, and the equity value increases. 5.1. numerical example: valuation of corporate debt and equity let the corporate value v be $100 million, the outstanding debt’s face value b be $80 million, the life of a zero-coupon debt t be 2 years, the log-diffusion σ be 0.32, the rate of treasury bond commensurate to the life of the option be 0.08, and the log-drift µ be 0.06. given the above variables, using the uncertain liu option pricing theory, the equity value e* = $50.764 million, and the value of outstanding debt d = $49.236 million. considering the above variables, let’s look at firm value dynamics and equity pay-off dynamics. figure 1 shows the relationship between the firm’s value, time, and log-diffusion. it is clear from figure 1 that if all other parameters are held constant, the firm value increases exponentially when time and log-diffusion increase. in figure 2, the firm value increases exponentially as the time and log-drift increase. from figures 1 and 2, we deduce that increases in the firm value due to rises in the value of the log-drift for a fixed value of logdiffusion are greater than those due to rises in the log-diffusion value for a fixed value of log-drift over the same time interval. the relationship between the equity pay-off, time, and the riskless interest rate is shown in figure 3, and it is clear that there is an exponential relationship between these parameters. the equity pay-off increases exponentially as time and the risk-less interest rate increase. figure 4 shows the relationship between the equity pay-off, debt’s face value, and time. the equity pay-off decreases linearly as the debt’s face value increases and increases exponentially as time increases. in this study, we proposed that the value of a firm can be described by an uncertain de powered by the geometric canonical liu process. applying the uncertain liu option figure 1: relationship between the value of the firm, time and log-diffusion figure 3: relationship between the equity pay-off, time, and risk-less interest rate figure 2: relationship between the value of the firm, time and log-drift pricing theory, we developed and analyse a framework for valuing debt and equity for a levered firm in uncertain markets. we provided numerical calculations for the designed model. numerical computations indicated that debt and equity for a levered firm can be priced in uncertain markets. this study could be extended by valuing (i) equity in a troubled corporate; (ii) the effect of a conflict between bondholders and shareholders on the corporate value; (iii) a corporate after stockholders pursued a project; (iv) equity after a conglomerate merger; and (v) a new corporate. matenda, et al.: valuation of corporate debt and equity in uncertain markets international journal of economics and financial issues | vol 13 • issue 1 • 202312 references black, f., scholes, m. 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(2022), uncertainty theory-based structural reliability analysis and design optimization under epistemic uncertainty. applied sciences, 12, 2846. figure 4: relationship between equity pay-off, time, and debt’s face value given a fixed value of log-diffusion tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2021, 11(5), 86-95. international journal of economics and financial issues | vol 11 • issue 5 • 202186 factors influencing poverty in south africa: time series analysis mbulaheni albert dagume* ph.d., senior lecturer, department of economics, faculty of management, commerce and law, university of venda, private bag x5050, thohoyandou, 0950, south africa. *email: mbulaheni.dagume@univen.ac.za received: 25 may 2021 accepted: 07 august 2021 doi: https://doi.org/10.32479/ijefi.11629 abstract poverty is an emerging issue that is being debated upon in both developed and developing countries, including south africa. this research investigates the factors that affect poverty in south africa, as well as the theoretical connections between poverty and the country’s key macroeconomic variables using annual time series data for 1996-2019. the stationarity test found that some variables were not stationary at the level but were after first differencing; the cointegration test demonstrated that the variables under investigation have a long-term relationship. the vecm findings revealed that the ratio of agriculture to gdp has a negative short-run relationship with poverty rates, while domestic credit to the private sector, foreign direct investment, growth rate, and gross enrollment ratio have a negative short-run relationship with poverty rate, but statistically significant. domestic credit to the private sector, foreign direct investment, growth rate, and gross enrollment ratio all have a negative long-run relationship with poverty rate, while agriculture to gdp and military spending have a positive but statistically insignificant long-run relationship with poverty rate. to encourage more private sector investment in economic development and poverty alleviation, the south african government must create an open business climate with attractive regulatory incentives. keywords: lower bound poverty line, foreign direct investment, economic growth, sa jel classifications: c22, c50, e60, e62 1. introduction poverty is an emerging issue that is being addressed and debated upon in a number of developed and developing countries, including south africa. it stifles growth and changes that are brought on by factors, such as social, political, educational, economic and cultural. one of the major unresolved issues is the lack of consistency in establishing levels of living standards across countries. poverty causes people to be pessimistic about the consequences of market-oriented and growth policies (akhtar et al., 2017; adriana, 2016). poverty victims also suffer from malnutrition, illness, crime, family disintegration, indignities, and even death, according to kammerman and kahn (1997, cited in seipel, 2003). adriana (2016) agrees, adding that hunger, malnutrition, disease, housing, illiteracy, and other poverty-related problems are obstacles that most developing countries strive to solve. in south africa, despite the robust implementation of many government poverty-alleviation policies and programs, poverty remains the country’s biggest problem (madikizela and ntshaka, 2010). poverty is described as a situation in which an individual lives below the poverty line and is unable to meet basic needs, such as food, shelter, and health. poor people’s voices are totally ignored in their countries, for example, in politics; they are powerless and have no say in crucial matters that affect them daily. poor people are the victims of any economic shocks that occur in the world; in reality, poor people pay more for their daily survival than rich people, but, ironically, rich people earn more (afandi et al., 2017). poverty is an conspicuous predictor of economic suffering that plagues most third-world nations, including south africa (rostitawati et al., 2019). for the purposes of this study, poverty this journal is licensed under a creative commons attribution 4.0 international license https://doi.org/10.32479/ijefi.11629 dagume: factors influencing poverty in south africa: time series analysis international journal of economics and financial issues | vol 11 • issue 5 • 2021 87 is described in monetary terms; it is not having enough money to meet one’s basic needs. poverty lines are used to differentiate various types of poverty. the three different categories of poverty lines used in south africa are the food poverty line (fpl), the lower bound poverty line (lbpl), and the upper-bound poverty line (ubpl). the fpl is the rand value below which people cannot afford to purchase or consume enough food to meet their daily energy needs for good health. individuals at the lbpl lack the financial means to purchase or consume adequate food and non-food products, and are therefore forced to sacrifice food in order to obtain necessary non-food items. individuals can buy enough food to feed themselves and their families at the ubpl (stats sa, 2020). south africa has three national poverty lines for official statistical purposes, however, the lower-bound poverty line has emerged as the chosen threshold for the country’s poverty-reduction objectives outlined in the medium-term strategic framework (mtsf), national development plan, and sustainable development goals (stats sa, 2017). as a result, one of the country’s goals is to reduce the proportion of the population living in poverty from 39% in 2009 to zero by 2030 (stats sa, 2017). in order for south africa to meet its 2030 goal, the proportion of people living below the poverty line (lbpl) must also decline by 2.67% points every year for the next 15 years (stats sa, 2017). in light of this, the current study uses the r840/person/month lower bound poverty line (at april 2020 prices). this is consistent with stats sa (2017), which reported that lbpl is the preferred measure of poverty since it is used to set national poverty reduction goals. using the national lower bound poverty line of r840/person/ month to assess poverty in south africa as the area of study, from 1996 to 2019, the proportion of people living below the lbpl increased from 55.7% to 57.2% to 57.3% and to 57.3% to 23.4 million, 24.5 million, 24.9 million and 25.2 million people in 1996, 1997, 1998 and 1999 respectively, and droped to 56.6% in 2000. the share of people living below the lower -bound poverty line increased between 2001 and 2003, indicating an upward trend. in 2001, the poverty rate rose from 55.5% to 55.9% in 2002 and 2003, respectively. this amounted to 25.1 million, 25.6 million, and 25.9 million people, respectively. in 2004 and 2005, the figures dropped to 52.4% and 49.3%, respectively, before rising to 49.8% in 2006. people living below the lowerbound poverty line were 48.4% in 2007, 49.2% in 2008, 46.5% in 2009, and 40.7% in 2010. from 2011 to 2019, the poverty rate as measured by the lbpl rose or increased, as shown by the following percentages: 35.4%, 36.6%, 37.3%, 38.5%, 39.0%, 41.8%, 43.2%, 43.6%, and 44.8%. this corresponds to 18.4 million, 19.4 million, 20 million, 21 million, 21.7 million, 23.5 million, 24.7 million, and 26.3 million people, respectively (world bank, 2020; his global insight, 2020). low and poor economic growth, continuing high unemployment levels, lower commodity prices, higher consumer prices, lower investment levels, greater household reliance on credit, policy uncertainty and global finacial crises are all contributing to this upward trend. the explanation for this is that from these economic strains, south african households’ standards of living are deteriorating, causing poverty among many families and individuals (stats sa, 2017). as previously noted, one alarming feature of south african poverty is its downward and upward trend or volatility, which appears to be on the rise rather than subsiding. it is widely assumed that poverty is multidimensional in nature, hence, it is critical to identify the key factors that affect it, even though, there is no agreement about how macroeconomic factors, such as inflation, unemployment, government spending, and economic growth impact on poverty indices (kashi and tash, 2014, imani et al., 2018). poverty is affected by many economic and social factors in a country, and there has been a lot of debate about how to address these factors. it is difficult to pinpoint the exact cause of income disparity, whether from price indices or shifts in investment opportunities, also, how to get the levels down (mansi et al., 2020). there are a number of studies that look at the fators that affect poverty. biyase and zwane (2018) determine the factors that influence poverty and household welfare in south africa. the results, from fixed effect and random effect probit, indicate that levels of education of the household head, provincal characteristics, race of the household head, dependency ratio, gender of the household head, employment status of the household head and marital status of the household head are statistically significant determinants of household welfare. they also found that, compared to traditional rural areas (used as reference category), households living in urban and farms are less likely to be poverty-stricken. baiyegunhi and fraser (2010) empirically assessed the dynamics of poverty and identified the determinants of households’ vulnerability to poverty in the amothole district municipality of the eastern cape province. they found that the number of vulnerable households is significantly larger than for the currently poor households; the vulnerability index was found to be 0.62 compared to 0.56 headcount index. the result of the probit model shows that the age, level of education and occupation of the household head, dependency ratio, exposure to eccentricity risks and access to credit are statistically significant in explaining a households’ vulnerability to poverty. all variables, thus, were found to be statistically significant in explaining a household’s vulnerability to poverty. garidzirai and sekhampu(2013) investigated the perceived causes of poverty in the south african township of kwakwatsi. the objective of the study was to investigate if participants pereceived causes of poverty in individualistic, structural or fatalistic terms and the impact of socioeconomic factors, from the residents’ perceptions, on the causes of poverty. they find age, marital staus, education, gender, employment staus and income of the participants were significant predictors of all the indices. they find that the variable, household size, had no significance in all the three indices. kgaphola (2015) investigated factors that influence poverty in south africa using annual data from 1996 to 2013. the main findings of the study were that there is a negative relationship between poverty and government expenditure on health, housing, energy, public order and safety, and access to credit in south africa. government expenditure on education is found not to reduce poverty in south africa, neither is unemployment found to increase poverty in south africa. this paper looks at the factors that influence poverty in south africa. it differs from that of kgaphola (2015) in that it uses the dagume: factors influencing poverty in south africa: time series analysis international journal of economics and financial issues | vol 11 • issue 5 • 202188 most recent data. the previous author used data from 1996 through 2013, while the current study used data from 1996 to 2018. another difference is that the macroeconomic variables incorporated in this study, include: agricultural ratio to gros domestic product, ratio of foreign direct investment to gdp, ratio of the primary education, ratio of the domestic credit to private sector and military expenditure as percentage of gdp, while kgaphola (2015) used health, housing, enegry, public order and safety, access to credit, education and unemployment. other studies, for example, those conducted by biyase and zwane (2018); baiyeguhi and fraser (2010) and garidzirai and sekhampu (2013) investigated the influence of demographic characteristics (age, education, gender, race, dependency ratio, employment status, marital status, occupation of the household head and income of the participant) on household poverty in south africa. most of these studies used a binary variable as dependent variable, while this paper used as a dependent variable, poverty headcount and lower-bound poverty line. these are some of the gaps in the literature that the current study attempts to fill. povery alleviation is at the top of developing countries’ agendas because a large portion of their population lives in poverty, a major impediment to these countries’ economic growth. being poor is a complex phenomenon with many determinants with macroeconomic varaibles having the greatest impact on poverty. macroeconomic variables have a greater impact since they influence policies, controlling the running of countries. variables, like gross domestic product (gdp) agricultural production, education, foreign direct investment,(fdi), domestic credit, inflation, and other macroeconomic variables are the most commonly identified included. it is, therefore, essential to comprehend how these influence poverty in a country. there is no systematic empirical study analyzing the macroeconomic determinants of poverty in south africa using the most recent data on macroeconomic variables and the lowerbound poverty line in south africa, hence, this study attempts to fill this information gap. developing countries’ governments, such as south africa’s, have adopted policies aimed at alleviating poverty. the aim of this research is to find out how certain macroeconomic variables affect poverty in south africa as the findings should be useful to government and policymakers in monitoring these variables. the rest of the paper is structured as follows: the second section reviews the literature; the third section outlines the study methods; the fourth section gives the results and discussion; and the fifth section presents the conclusion and policy implications. 2. literature review this section deals with the review of some related literatures on this topic by surveying the findings of some scholars, researchers and writers. 2.1. gdp and poverty tahir et al. (2014) investigated the impact of growth rate on poverty of pakistan using secondary data collected covering the period of 1980 2012. the results revealed the negative relation between the gdp growth rate on poverty. it was found that 1% increase in gdp growth rate has a significantly negative impact on 1.9% on poverty. the growth elasticity of poverty calculated was −0.00035205, which is highly less elastic, indicating that 296.50% increase in gdp growth rate decreases poverty by only 0.1043% while the relationship between gdp growth rate and poverty was found to be negative. the implication was that as gdp growth rate increases, poverty decreases and vice versa. in terms of head count ratio, the relationship between gdp and poverty was found to be deterministic because for each value of the independent variable (gdp growth rate) there is one and only one corresponding value of dependent variable (hcr). in nigeria, omoniyi (2018) examined the relationship between poverty and economic growth, the determinants of economic growth and poverty from 1980 to 2013 using an error correction model to analyse the time series data. the study revealed that economic growth has a negative and significat relationship with poverty. the coefficient of the variable −1.52e −06 indicates that 1% increases in economic growth may have led to about a 1.52% reduction in poverty in nigeria during the period of the study. similarly, the negative impact of economic growth on poverty was also supported by wijayi (2020) and kashi and tash (2014) in their studies conducted in banjarnegara and iran, respectively. 2.2. foreign direct investment and poverty anigbogu et al. (2016) investigated the effect of foreign direct investment on poverty reduction in nigeria using an econometric model of the ordinary least square (ols). findings revealed that foreign direct investment and trade openness are statistically significant in explaining poverty reduction in nigeria. this means that, foreign direct investment increase will bring about a decline in poverty. finding from a study by ogunniyi and igberi (2014) prove that fdi has a positive but insignificant impact on real per capita income and has the potential of reducing poverty in nigeria. israel (2014) investigated the relationship between fdi and poverty reduction in nigeria using cointegration and error correction model (ecm) and augmented dickey-fuller test with annual time series data covering the period between 1980 and 2009. the results from error correction model uncovered a short run relationship among the variables under study. the ecm results showed that poverty reduction is positively related to fdi; this means that fdi does have a positive relationship on poverty reduction. using a standard unit root test (the augmented dickeyfuller test), the study found that each variable is non-stationary in first differences, suggesting a possibility for co-integration. using standard co integration tests (englegranger and johansen-julius), the study found that the variables are co integrated, suggesting that there exists a short run relationship among them. ucal (2014) investigated the relationship between fdi and poverty by using econometric model on unbalanced panel data in selected 26 developing countries, from unctad, over a period of 24 years from 1990 to 2009. the findings revealed that there is a statistically significant relationship between fdi and poverty. pervez and rizvi (2014) explored the determinants of poverty in pakistan; they applied the ordinary least square and vecm for the sample period, from 1980 to 2010. the study concluded that fdi has negative but insignificant impact on poverty in pakistan. ogunniyi and igberi (2014) examined the influence of foreign direct investment (fdi) on poverty reduction in nigeria using secondary dagume: factors influencing poverty in south africa: time series analysis international journal of economics and financial issues | vol 11 • issue 5 • 2021 89 data over the period 1980-2015. the ordinary least squares (ols) regression method was applied for the data analysis with the aid of the e-views statistical package. the result of the analysis showed that fdi, although, it has an inverse relationship with the poverty rate, yet it was not statistically significant, however, the overall results as shown by the f-statistics confirmed that foreign direct investment exert enough influence on the poverty rate. 2.3. military expenditures and poverty olofin (2012) examined the relationship between the components of the military’s spending on poverty in nigeria for the period 1990-2010. the results show that military expenditure per soldier and military participation rate, were positively related to poverty indicator; both were found to be statistically significant. military expenditure, thus, was negatively related to poverty level. akhtar et al. (2017) found that military expenditure has positive and significant impact on poverty. henderson (1998) examined the extent to which military spending is associated with poverty in the united states for the period 1959 1992. the study revealed that increased military spending is associated with increasing poverty; however, there is an inverse relationship between wartime military spending and poverty and a direct relationship between peacetime military spending and poverty. similarly, kalim and hassan (2014) investigated the impact of public defence spending on poverty using ardl bounds testing approach for the period from 1976 to 2012, in pakistan. the study reveals that public defence spending has significant and accelerating impact on poverty in both lonrun and short-run in pakistan. 2.4. education and poverty garza rodriguez (2016) examined the determinnats or correlates of poverty in the mexican states bordering the united states. the data used came from the 2008 national survey of income and expenditures of households. a logistic regression model was estimated to determine which variables might be important in explaining poverty in the region. high educational level of the household head was found to be negatively correlated with the probability of being poor. this means that a strong inverse relationship between the level of education and poverty incidence was found. similarly, pervez (2014) investigated the impact of education on poverty reduction in pakistan; an augmented dickeyfuller, causality and johansen cointegration methodology with time series data was used in this study. the study revealed that literacy rate and gross enrolment have negative and significant impact on poverty in the long-run, while life expectancy has positive impact on poverty. pervez (2016) also conducted a study on the role of education in poverty elimination in pakistan with special reference to south punjab. the results of the study show that education has significant impact on poverty level of people, while another hypothesis depicted that education improves the employment status of people. the results of the study also show that people’s education has a direct and significant impact on the income of respondent; this improves the living standard of people and consequently, the eradication of poverty. chikelu (2016) examined the impact of human capital development on poverty reduction in the nigerian economy, from the period 1986 to 2012. the study used the ordinary least squares (ols), augmented dickey-fuller and johansen co-integration methods to estimate the model of one dependent variable (poverty rate) and four explanatory variables (primary school enrolment, secondary school enrolment, tertiary school enrolment and per capita income). the study revealed that there exists a relationship between human capital development and poverty reduction in nigeria. chaudhry (2009) investigated the factors affecting rural poverty using logit regression modeling based on primary source of data, in the project area of asian development bank. the study revealed that rural poverty can be alleviated by: lowering the household size, persons per room and dependency ratio, improving education, more female labor participation, higher household participation rate, as well as improving assets and households’ access to market, especially, in remote areas. malik (1996) investigated the reasons as to how some of the landless households managed to escape poverty, whereas some cultivating households failed to do so. the main factors responsible for this outcome were found to be favouarble/unfavourable distribution of land by size of landholds, household size, educational attainment, depending ratio, and age of the household head. the results suggest that poverty is most severe among the population with no educational attainment. it was found that both the level of intensity and the factors’ contribution to total poverty declined as the level of educational attainment increases. likewise, talukdar (2012) found that there is a negative relationship between educational attainment and poverty. the negative coefficient on secschenr (secondary school enrolment ration expressed as percentage of population) means that higher educational attainment reduces poverty and lower educational attainment would increase poverty. 2.5. private investment and poverty simon-oke and olayemi (2014) investigated the relationship between foreign private investment, capital formation and poverty reduction in nigeria, using co-integration and error correction mechanism (ecm), as well as granger causality tests with annual time series data covering the period, 1978 and 2008. the various tests demonstrated that the inflow of foreign private investment in nigeria has not significantly contributed to poverty alleviation in the country. the study also showed that government investment in health and education has not helped to reduce poverty in nigeria. the recommendations from the study were that the government, at all levels, should encourage the inflow of foreign private investment and intensify efforts at curbing capital flight. this would expand government spending on education and health sectors, coupled with the expectation that proper accountability and transparency on the part of the government would reduce poverty to the bearest minimum in nigeria. 2.6. agricultural growth and poverty viet cuong (2011) investigated the impact of production of crops, forestry, livestock and aquaculture on household welfare, poverty and inequality in rural vietnam, using fixed-effects regressions. data used in this were from vietnam household living standard surveys 2002 and 2004. the findings indicated that, impact estimates of the production of crops and forestry on per capita income and consumption expenditure are not statistically significant. impact estimates of the livestock production were positive and statistically significant for per capita income, but not statistically significant for per capita expenditure, however, dagume: factors influencing poverty in south africa: time series analysis international journal of economics and financial issues | vol 11 • issue 5 • 202190 agricultural production has positive and statistically significant impacts on both income and expenditure. ogundipe et al. (2016) examined the effect of agricultural productivity on poverty reduction in africa using the dynamic panel data approach estimate using the system-gmm technique for the period 1991-2015. the empirical results suggested that agricultural-value added, per worker, contributes significantly to reducing rural poverty in africa. on the other hand, food production index and gdp per capita were more important factors in curbing urban and dollar poverty, implying that the non-farm poor tends to have a large food marginal propensity to consume (mpc). the insignificance of gdp per capita in dwindling rural poverty reflects that reality growth in other sectors does not influence the livelihood of the rural-poor farmers due to farming’s subsistence nature. finally, domestic credit to private sectors and institutions were significant in reducing all categories of poverty, with the largest impact on rural poverty. similarly, in their study, fan et al. (2000) used a simultaneous equation model and time series (1978-1997), cross section (25 provinces) data to analyze the differential impact of different types of public investments on growth and poverty reduction in rural china. the results show that growth in agricultural production, higher agricultural wages, and increased non-agricultural employment opportunities have all contributed significantly to reducing rural poverty. 3. research methodology this section discusses the method and procedures employed in carrying out this, particularly, the procedures for collecting and analyzing data. the data for the study were collected from world development indicators and south african reserve bank for the period 1996-2019; this period was chosen because of the availability of secondary data for the analysis. 3.1. model specification the model for the study was based on the empirical work of akhtar et al. (2017) with modification. the variables which are under consideration in this study include: headcount index was replaced by the lower bound poverty line (lbpl) which was used as proxy for poverty and served as the dependent variable, while gross primary enrollment ratio, ratio of fdi to gdp and the ratio of agriculture gdp to total gdp, ratio of the domestic credit to private sector, ratio of the military expenditure as percentage of gdp were the indepent variables. in addition, gdp growth rate as the proxy for economic growth was also addeded in the model as a new variable. the model is specified in a functional form as follows: poverty=f(ger,dc,me,fdi,agri,rgdp) (1) the econometric form of the model can be expressed as: povertyt=ββ0+ββ1 gert+ββ2dct+ββ3met+ββ4fdit+ββ5agrt+β β6rg dpt+ μt� (2) where: poverty rate = lower boundpoverty line ger = gross enrollment ratio, primary education dc = domestic credit to private sector as percentage of gdp me = military expenditure as percentage of gdp fdi= ratio of fdi to gdp agri = ratio of agriculture gdp to gdp rgdp = proxy for economic growth β0 = constant term β1−β6 = parameters to be estimated µt = stochastic error term the study adopted the lower-boundpoverty line, as it is adopted by the authoritative national planning commission (npc) with regard to its poverty targets “as outlined in the [national development plan] ndp” (stats sa, 2014, p.14). according to stats sa (2017), the lower – bound poverty line has emerged as the preferred threshold in policy-making and monitoring. south africa’s poverty reduction targets are based on the lowerbound line in the mediu, term strategic framework, national development plan and sustainable developmenmt goals. 3.1. estimation techniques 3.1.1. unit root test according to ogunniyi and igberi (2014) and chebet (2016), regression of a nonstationary time series data on another nonstationary time series may cause a spurious regression or claptrap regression; they may indicate a relationship between variables which does not exist. in the econometrics insight, augmented dickey-fuller (adf) tests are used to assess whether time series variables are non-stationary or have a unit root (shrestha and bhatta, 2018). the null hypothesis under the adf test assumes that all variables have a unit root and the alternative hypothesis “no unit root (stationary)” (paparoditis and politis, 2016). 3.1.2. co-integration test co-integration tests are designed for non-stationary variables, in order to know the long-run relationship between variables. the method of co-integration was introduced by granger (1981) and the basic purpose was to protect the losses of long-run information of data which occurs due to time series. the linear combination of variable is, i(1) and also i(0), then variables are said to be cointegrated with each other and requires that time series data to be non-stationary, at the level and stationary at the first difference. the johnnes co-integration test is used in this regard. co-integration of two or more series suggests that there is a long run relationship between them (akhtar et al., 2017). 3.13. diagnostic tests residual diagnostic tests include normality test to check whether the error term was normally distributed; heteroskedasticity to check whether the variance of the residuals was constant and serial dagume: factors influencing poverty in south africa: time series analysis international journal of economics and financial issues | vol 11 • issue 5 • 2021 91 correlated; this is to check whether the error terms from different time periods were correlated (chebet, 2016). 4. results and discussion 4.1. unit root test in this study, like in any studies that use time series data, variables are first tested for stationary. an augmented dickey fuller test (adf) was used to check the stationary of variables at level and also at 1st difference and the results are presented in table 1 below. the results in table 1 show that all variable contained a unit root at levels. this is shown through the computed absolute t-values which are less than the critical values at 1% and 5% level of significance. for instance, the computed adf values lngri_ratio −0.785927 (gross enrolment ratio), lnd_credit −2.1652137 (domestic credit) and lnfdi −2.12111 (foreign direct investments) respectively are less than critical values at 1% and 5% as shown in table 1. similarly, the computed p-values for variables in levels are greater than a 5% level of significance. this means the null hypothesis of having a unit root is not rejected, however, after 1st differencing all computed adf values are greater than test critical statistics, for example, (lnagri-ratio – 4.597660, lnge_ratio – 4.483885 and lnmil_exp – 8.877489, respectively, are greater than the computed test critical values at 1% and 5% as shown in table 1. as such, the null hypothesis “presence of unit root” is rejected at 1st difference, hence the series become stationary after the first differencing. at this stage, it is important to determine the optimal number of lags before performing the cointegration test and vec modelling and the results are shown in table 2. 4.2. lag order selection lag order selection is usually done to suggest the lags that should be used to limit the autocorrelation challenges. the study made use of the akaike information criterion (aic) to determine the number of lags to be used and the results are shown in table 2. table 2 shows that results for lag order selection and in this regard, aic was considered. the value under aic determines the optimal lags to be used and as shown in table 2, two lags were chosen for this model. having determined the number of lags (1), it was fundamental to perform the johansen cointegration test to determine if there is at least one cointegrating equation in the model and the results are shown in table 3. 4.3. johansen cointegration test the johansen cointegration test is generally used to test cointegrating relationships between several time-series data (guirguis, 2018). this is done through comparing the tests to the engle-granger test, as the johansen test allows for more than one cointegrating relationship. if all variables included in the test are integrated of order one, the next step i is to test the existence of a co-integration relationship between the variables under consideration (akhtar et al., 2017). the results are presented in table 3. the results in table 3 under trace show that the computed critical value (125.6154) at a 5% level of significance is less than the trace statistic (264.6205) and the p-value of 0,0056 is less than 5%. this shows that the null hypothesis of no cointegrating equation is rejected at a 5% level of significance. analogous results are also noted under maximum eigen statistics where the computed critical value (46.23142) is less than the maximum eigenvalue (82.74929). the computed p-value of 0.0006 probability reveals that the null hypothesis of no cointegrating equation is rejected, however, the computed p-values under trace (0.4213) and maximum eigenvalue (0.5432) are >5%, hence, the null hypothesis of, at most, one cointegrating equation is not rejected. as such, the results indicate the long-run relationship between the poverty rate and other explanatory variables in the model. the next section presents the short and long-run dynamics between the endogenous and exogenous variables in the model. 4.4. vector error correction model (short-run dynamics) the error correction model (ecm) is regarded as a time series regression model that is grounded on the behavioural assumption that two or more-time series exhibit an equilibrium relationship that determines both short-run and long-run association (ararso, 2021). the results in table 1 show that the time-series data is stationary in levels after the first differencing necessitated by the ecm; the results are presented in table 4. results in table 4 above show that at least one variable is statistically significant since the computed probability are less than 5% and the corresponding t-statistic is >2, are statistically significant and were interpreted in the study. the ratio of agriculture to gdp (lnagri_ratio) has a negative short-run table 1: results of adf unit root test variable levels 1st difference critical values p-values critical values p-values lnagri_ratio 0.785927* 3.831511** 3.029970*** 0.8002 4.597660* 3.831511** 3.029970*** 0.0020 lnd_credit 2.1652137* 3.75294** 2.99806*** 0.2232 4.953441* 3.769597** 3.004861*** 0.0007 lnfdi 2.12111* 3.752946** 2.999053*** 0.34102 4.978759* 3.808546** 3.020686*** 0.0008 lngr_rate 0.213411* 3.788030** 3.012363*** 0.9825 6.009272* 3.788030** 3.012363*** 0.0001 lnge_ratio 1.731364* 3.769597** 3.004861*** 0.4025 4.483885* 3.769599** 3.004861*** 0.0020 lnlbpl 1.628170* 3.769597** 3.004861*** 0.4521 4.7058355* 3.769597** 3.004861*** 0.0089 lnmil_exp 0.747794* 3.769597** 3.004860*** 0.9904 8.877489* 3.769597** 3.004861*** 0.0000 source: author’s computation: e-views output (2021) (*denotes augmented dickey-fuller test statistics, ** denotes test critical values at 1% and *** denotes test critical values at 5%) dagume: factors influencing poverty in south africa: time series analysis international journal of economics and financial issues | vol 11 • issue 5 • 202192 relationship with the poverty rate (lnlbpl). the computed p-value of 0.0019 is <5% and the corresponding t-statistic of 3.6629 (in absolute terms) is >2, hence, statistically significant results. this means that holding other things constant, a unit increase in the ratio of agriculture to gdp increases by one unit and the poverty rate decreases by 0.78 units. in terms of growth rate, gross enrolment ratio, military expenditure, and foreign direct investment were found to have a negative short-run association with the poverty rate but the results are statistically insignificant as shown in table 4. furthermore, the coefficient r-squared of 0.75 (2dc) which measures the speed of adjustment shows approximately 75% of the error in the short run is corrected in the first quarter as the condition in the economy resorts to its equilibrium. this indicates a strong pressure on the poverty rate in re-establishing short-run equilibrium, every time there is a shock to the economy. the speed of adjustment is statistically significant at 5% with an absolute f-value of approximately 0.000234. in this regard, the study further checked for a long run association between poverty rate and other explanatory variables in the model. table 2: lag order selection lag logl lr fpe aic sc hq 0 21.63863 na 0.012492 1.563863 −1.265143 −1.505549 1 32.89726 14.63622* 0.004531 2.589726 −2.241220 −2.521694 2 35.76472 3.440959 0.003822* 2.776472* −2.378180* −2.698721* 3 35.95333 0.207462 0.004237 2.695333 −2.247253 −2.607863 4 35.95336 3.22e−05 0.004822 2.595336 −2.097470 −2.498147 source: eviews output (2021). * indicates lag order selected by the criterion. lr: sequential modified lr test statistic (each test at 5% level), fpe: final prediction error, aic: akaike information criterion, sc: schwarz information criterion, hq: hannan-quinn information criterion table 3: results of johansen test for co-integration (trace and maximum eigenvalue) unrestricted cointegration rank test (trace) hypothesized trace 0.05 prob.** no. of ce(s) eigenvalue statistic critical value none * 0.976747 264.6205 125.6154 0.0056 at most 1 * 0.943915 21.8712246190177 95.75366 0.4213 at most 2 * 0.898193 18.4918610580562 69.81889 0.6432 at most 3 * 0.805354 18.22897476003261 47.85613 0.5621 trace test indicates 2 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **mackinnon-haug-michelis (1999) p-values unrestricted cointegration rank test (maximum eigenvalue) hypothesized max-eigen 0.05 no. of ce(s) eigenvalue statistic critical value prob.** none * 0.976747 82.74929 46.23142 0.0006 at most 1 * 0.943915 23.379096 40.07757 0.5432 at most 2 * 0.898193 50.26289 33.87687 0.6759 at most 3 * 0.805354 18.4541112 27.58434 0.79828 max-eigenvalue test indicates 2 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **mackinnon-haug-michelis (1999) p-values table 4: vec model dependent variable: d(lnlbpl) method: least squares variable coefficient std. error t-statistic prob. d(lnmil_exp (−2)) −0.011426 0.044960 −0.254141 0.8024 d(lnge_ratio (−2)) −0.292489 1.022949 −0.285927 0.7784 d(lng_rate (−2)) −0.012498 0.027151 −0.460323 0.6511 d(lnfdi (−2)) −0.020412 0.026148 −0.780646 0.4457 d(lnd_credit (−2)) 0.074469 0.345780 0.215365 0.8320 d(lnagri_ratio (−2)) −0.781104 0.213247 −3.662915 0.0019 c 4.105503 4.602954 0.891928 0.3849 r-squared 0.749457 mean dependent var 3.854949 f-statistic 8.475428 durbin-watson stat 0.508819 prob(f-statistic) 0.000234 dagume: factors influencing poverty in south africa: time series analysis international journal of economics and financial issues | vol 11 • issue 5 • 2021 93 4.5. vector error correction model (vecm) the vector autoregressive (var) model is regarded as a general framework used to define the short-run dynamic interrelationship among stationary variables (bringmann et al., 2018). it is a technique that can be used by macroeconomists to characterize the joint dynamic behaviour of a collection of variables, without requiring strong restrictions of the kind needed to identify underlying structural parameters. the results from, at most, one cointegrating equation necessitated the use of vecm and the results are shown in table 5 below. the results in table 5 presents the vecm results of the model. the variables are cointegrated of the same order and it shows a long-term relationship among the variables in the model. the constant coefficient of 0.514824 shows that the previous year’s deviation from the long-run equilibrium is corrected in the current period at an adjustment speed of 51%. the long-run relationship between poverty rate and control variables for one cointegration vector is presented below: lnlbpl = −0.514824 +0.428782 lnagri_ratio −1.11536 lnd_ credit – 0.05300 lnfdi −0.06206 lng_rate + 0.071516 lnmil_ exp – 3.009853 lnge_ratio (3) equation 1 is expressed using var results in table 5 above. the results show that, domestic credit to private sector, foreign direct investment, economic growth (growth rate) and gross enrollment ratio, have a negative long-run relationship with the poverty rate. in terms of impact of domestic credit to private sector on poverty, the result conform to the findings by other studies, such as ogundipe et al. (2016) and akhtar et al. (2017). this is, however, contrary to the results from dilawar et al. (2012) that found a positive relationship between domestic credit and poverty in pakistan. with regard to foreign direct investment, this finding is similar to other studies, akhtar et al. (2017), ucal (2014) and ogunniyi and igberi (2014) that found a negative and significant relationship between forign direct investment and poverty. the negative and significant effect of economic growth rate on poverty is similar to the previous studies by tahir et al.(2014), kashi and tash (2014) and wijaya (2020) that prove that, as economic growth rate increases, poverty decreases. these are studies that also suggest a negative relationship between gross enrollment ratio of primary education and poverty, pervez (2014), garza rodriquez (2016), pervez (2016), chikelu (2016) and talukdar (2012). the ratio of agriculture to gdp and military expenditure has a positive association with the poverty rate in the long run. as such, a percentage increase in the ratio of agriculture to gdp leads to a 0.42% increase in the poverty rate. this is contrary to our hypothesis and inconsistent with the studies done by akhatar et al. (2017) and viet cuong (2011) who found a negative relationship. this implies that agricultural growth would stimulate economic growth in non-agricultural sectors, which in turn results in increased employment and reduced poverty. another interesting finding is the positive effect of military expenditure on poverty which is insignificant. this implies that a 1% increase in military expenditure results in a 0.07% increase in the poverty rate in south africa, holding other factors constant, although, in the long run, military expenditure is positively related to poverty rate. this finding is consistent with our hypothesis and with the studies done by olofin (2012), akhtar et al. (2017), henderson (1988) and hassan (2014). a unit increase in domestic credit to the private sector, foreign direct investment, growth rate and gross investment ratio, may result in a poverty rate decrease; for instance, a 1% increase in domestic credit to the private sector results in a 1.1% decrease in the poverty rate in south africa. the ratio of agriculture to total gdp and military expenditure results, however, are statistically insignificant since the computed t-statistic values of 0.86058 and 1.31230, respectively, are below two. eventually, domestic credit to private sector, foreign direct investment, economic growth (growth rate) and gross enrollment ratio are statistically significant since the computed t-statistics are >2 as shown in table 5. at this point, diagnostic checks for the model in consideration are presented below. 4.6. diagnostic analysis to check for the best fit of the model, lagrange multiplier (serial correlation), white noise (conditional heteroscedasticity) and jarque-bera (normal distribution) were used in this study. table 6 presents the diagnostic analysis tests results. first, the lagrange multiplier (lm test) was conducted under the null hypothesis of “no serial correlation”. the computed probability of 0.3226 is greater than a 5% significance level, hence, the null hypothesis of “no serial correlation” is not rejected. second, chi-square was employed and the null hypothesis states that conditional heteroscedasticity is not rejected since the computed p-value of 0.0888 is greater than a 5% level of significance. third, the jarque-bera (jb) test was employed and the null hypothesis that the series is normally distributed is not rejected, since the p-value of 0.2633 is greater than the 5% level of significance. as such, the results show that the series used does not suffer from no serial correlation, no conditional heteroscedasticity and is normally distributed. table 6: diagnostics analysis test null hypothesis t-statistic probability lagrange multiplier (lm) no serial correlation 39.34244 0.3226 white (ch-sq.) no conditional heteroscedasticity 10.98474 0.0888 jarque-bera (jb) there is a normal distribution 3.52000 0.2633 table 5: vecm ( long run dynamics ) variable coefficient standard error t-statistic constant −0.514824 lnlbpl 1.000000 lnagri_ratio 0.428782 0.49825 0.86058 lnd_credit −1.11536 0.07019 22.9583 lnfdi −0.05300 0.00474 −11.1834 lng_rate −0.06206 0.00546 −11.3678 lnmil_exp 0.071516 0.05450 1.312300 lnge_ratio −3.009853 0.14236 −21.1431 dagume: factors influencing poverty in south africa: time series analysis international journal of economics and financial issues | vol 11 • issue 5 • 202194 5. conclusion and policy implications using data from 1996 to 2019, this study shows how major macroeconomic variables influence poverty in south africa. multi diagnostic tests were used in conjunction with the johansen cointegration technique. agriculture’s gdp ratio, fdi, education enrollments, domestic credit to the private sector, military spending, and other macroeconomic variables were analyzed in this report, and the findings indicate that all of these variables, with the exception of agriculture and military expenditure, have a substantial impact on poverty in south africa; in relation to economic growth, a high rate of growth has a major negative effect on poverty. in addition, the study finds that gross primary school enrollment has a long-term effect on poverty. as a result of this observation, it can be concluded that schooling assists in the elimination of poverty and the development of individuals’ and society’s socioeconomic status. the population of the poor can be reduced by educating more people in the country. this research also found that the portion of domestic credit to the private sector has a major effect on poverty. in south africa, the private sector plays an important role in determining the country’s job situation; as a result of a rise in jobs, poverty rates are decreased, thus, there is a negative relationship between poverty and providing credit to the private sector. the study’s findings revealed that foreign direct investment has a substantial negative impact on poverty in south africa. in the receiving countries, fdi creates jobs, new technology is acquired, human capital is created, domestic investment is increased, tax revenue is increased, and foreign trade is integrated. many of these fdi gains are the key drivers of poverty reduction. defence spending has an important positive effect on poverty in south africa, as shown by this report. increased military spending has a trade-off impact on other productive sector spending, resulting in lower spending on productive sectors, such as education and development. as a result of these declines, the country’s poverty rate increases. some policy guidelines are suggested based on the results of this study and these are outlined in the discussions below. the government should establish quality institutions to improve the level of economic growth and macroeconomic factors such as low inflation, export orientation and low labor taxes should be encouraged. to support the fact that education is an engine of social stability and resilience, it must be provided in an inclusive, equitable, and meaningful manner across south africa. through policy implications and budget allocation, the south african government should make additional efforts to ensure the quality and coverage of education, thereby, the curse of poverty can be avoided by investing in high-quality education. the south african government should increase expenditure on education, because it is generally belived that increased government spending on education has by far the largest impact on poverty. domestic credit to private sectors has a significant and negative impact on poverty, therefore, the south african government should encourage private sectors to operate in the country by lowering the interest rate so that domestic credit to private sectors can be easily provided. the government should follow policies that enable banks to channel more funds into the private sector for investment. the negative effects of fdi on poverty in south africa, means that labor-intensive industries will eradicate poverty, more effectively. south africa, like other developing countries, has a competitive advantage in labor-intensive production, therefore, the south african government could promote more fdi in labor-intensive industries; incentives for international investors, the formulation of investment-friendly policies, and the management of the country’s law and order challenges should all be included in this strategy. the government must ensure an open business-operating environment with attractive legislative incentives to attract more investments from private sectors for economic development. the government must encourage entrepreneurship and investment by lowering the risks and costs of doing business, including removing barriers to formalization. the study recommends the provision of adequate infrastructure and policy framework that will be conducive for investors for doing business in south africa. an effective strategy for attracting foreign investment would also be to make the south african economy very attractive to domestic investors, first. despite the fact that there are several other variables that may have a greater impact on poverty in south africa, this paper was unable to consider a longer time series in the study due to a lack of data. in light of the data limitations, the focus was on four major influencing factors of poverty: agricultural gdp to total gdp ratio, education enrollment ratio, domestic credit-to-private-sector ratio, military expenditure, and foreign direct investment ratio (fdi). for another angle to the south africa’s poverty situation, this research could be performed on provincial levels. i also propose that a similar study be carried out in the future but at the regional level, with a longer time series and a larger number of variables. references adriana, m. 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(2020), world development indicators (wdi). available from: http://data.worldbank.org/data-catalog/world-developmentindicators [last accessed on 2021 mar 30]. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(5), 304-316. international journal of economics and financial issues | vol 10 • issue 5 • 2020304 linkages to budgetary control and budgetary absorption performance arwan gunawan1*, winwin yadiati2, harry suharman2, k. poppy sofia2 1department of accounting, state polytechnic, bandung, indonesia, 2department of accounting, faculty of economics and business, university padjadjaran, indonesia. *email: arwan.gunawan@polban.ac.id received: 01 july 2020 accepted: 01 september 2020 doi: https://doi.org/10.32479/ijefi.10515 abstract this study aims to examine the effect of budgetary control on the performance of budgetary absorption. the research method used was a survey of a population comprising 548 provincial/regency/city governments in indonesia with 231 samples. primary data consisting of 33 samples were collected using questionnaires, and analysed quantitayively testing method used partial least square-path modeling (pls-pm), whereas data processing methods used smartpls. the research method used was a survey of a population comprising 548 provincial/regency/city governments in indonesia with 231 samples. primary data consisting of 33 samples were collected using questionnaires, and analysed quantitayively testing method used plspm, whereas data processing methods used smartpls. the results of the study indicate that budgetary control has a significant positive effect on the performance of budgetary absorption. thus, budgetary control can be said to have a high thrust to increase the performance of budgetary absorption. this contributes to the acceleration of economic development of regional governments in a country. keywords: budgetary control, budgetary absorption performance, local government jel classifications: h61, h72 1. introduction the phenomenon that often happens is towards the end of the fiscal year where government agencies are trying to absorb the budget close to 100% so that not assessed absorption low budget (hertati et al., 2019). the world bank calls developing countries, including indonesia, has problems in budget absorption called slow back-loaded, which is low absorption in the early until the middle of the budget year and jumped into the year-end budget. this is due to not the technical issue of budget implementation but the habit factor that occurs repeatedly where it should be prevented. in carrying out budget control for the process of the budget absorption should involve stakeholders (stakeholders) into the form of deliberation planning development (musrenbang), where the legal foundation is established based on the decree of minister of commerce: 050-187/kep/bangda/2007. budget control issues and budget absorption performance in local governments (local government), as well as unresolved most of the following: in table 1 that the completion rate of the perkada for total local government (local government) which includes: (1) accounting policy is only reached 49.07% of 542 local government and (2) accounting system of local governments (sapd) is only reached 37.45% of 542 government. this indicates, among other things: (1) unresolved perkada indicates weak budget control and (2) unresolved perkada provides low absorption of local government budget in indonesia. based on the realization of the expenditure reporting as a form of budget absorption for apbd every semester i for several periods, shown as follows: thus, at the end of semester ii during the period, the absorption of the budget was forced to reach an average of this journal is licensed under a creative commons attribution 4.0 international license gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020 305 70.39% or at least attempted to close to 100%. this is what the world bank has called a slow back-loaded.it is stated that the local government in managing the budget at each stage of the budget absorption does not indicate a proportional absorption process. the budget process is a way to demonstrate compliance with needs, including budget allocation for growth; other than that the implementation of budget-based budgets will be more efficient, where there are eight dimensions for performance measurements one of them is efficiency and also one of the budget characteristics is the budget performance should be monitored continuous (natural and lawrence, 1994; pendlebury, 1994; brunsson, 1995; murphy et al., 1996). measure in the size of a number for a given period, having interactions between behaviors and organizations affecting budgets, where accounting roles in budget practices relate to the perception of accountability, similarly, management reform for the purpose of budget efficiency and accountability (anthony et al., 1998; goddard, 2004; brook and philip, 2007: hertati and sumantri, 2016). research by (abdul and abdulah, 2006; apostolache and mihai: 2013; bastida and bernardino, 2007; becker et al., 2014; bourdeaux, 2008; williams et al., 2010; victor, 2010; williams et al, 2012; yilmaz and gökhan, 2011), provide evidence of the relationship between local government agencies with budgets and accounting activities in recording every activity of local government accounting posts. 1.1. research purposes the purposes of this research are as follows: to know and get empirical evidence of research so that obtained answers to research issues regarding, the magnitude of influence of budget control over the budget absorption performance. the results of the study (van dijk, 2001; the asia foundation, usaid, performance and fitra, 2012; tangen, 2004; speklé and frank; 2014; spathis and sylvia, 2004; smith, 1999: skærbæk and jens, 2004), link the influence of social aspects in organizations as well as absorption of government budgets and management decisions in organizations. 1.2. scope of the study ● the observation of budget absorption performance in the study, especially in every semester i, is an integral part with the performance of budget absorption in some period of budget of local government in indonesia. ● the budget of local government in indonesia. 2. literature study 2.1. budget control and budget absorption performance research conducted by alt and alec (1981. p. 37), based on the results of data testing from the united kingdom and the united states and the results compared to evidence from other countries, showed that government spending grew in proportion to national income because politicians feel comfortable to plan for them. hertati (2015) state that however, budgets in the public sector serve many purposes with varying interests, which have to be supported by various supporting devices. it was revealed by aiden (1989. p. 58) that public budgeting serves many purposes, which must be supported, among others: (1) enforcement of honesty in transactions financial statement;(2) control and accountability maintenance; (3) planning and management of resources; (4) efficiency in resource allocation;(5) a fair spread in fiscal decision making; and (6) governmental management and government relations stakeholders. in another opinion, williams et al. (1990. p. 221) says characteristics of the behavior of a similar entity principal in the public and private sectors. characteristic entity principal budget behavior can be associated with a performance evaluation, where dunk (1992. p. 195) saying entities was can leverage dependence on budget control in evaluating performance. in research pettersen (1995. p. 207) said that discussion of results shows an interesting general topic for public management accounting and control, particularly in relation to budget controls. according to the institute of cost and management accountants (cima) in carter et al. (1997) that: “budgetary control defined as the establishment of the relating the responsibilities of executives to the requirements of a policy, and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy, or to provide a basis for its revision.” hertati (2015) state that budget control is defined as the establishment of budgets related to executive responsibilities in making policies, and comparing budget targets with their realizations, where policies and allow to be used as a basis for revising budgets. thus, it can be concluded that the budget control is the result of the executive agreement poured into its budget to be ready to be revised at any time and realized at every final stage of its activity. similarly, budget control can be said to be part of management control activities because the budget is also a management tool to achieve its objectives. table 1: development of settlement of governor/regent/mayor regulation the accrual-based accounting policy and systematic the development (sapd) governor/mayor regulation/regent about... province regency/city total province/mayor/regency total settlement of perkada % total settlement of perkada % total settlement of perkada % accounting policies 34 34 100 508 232 46 542 266 49.07 local government accounting system 34 34 100 508 169 33 542 203 37.45 source: directorate general of keuda, late november 2014 gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020306 when the budget control becomes a model of management control, equivalent to those expressed by marginson (hertati, 2015) the budget control process that operates in an organization including a model management control. thus, it can be concluded that the budget control is a form of executive responsibility that is poured into the target budget with realization, which can be used as a management control model in the organizational entity. van der stede (2000. p. 609), however, has the view that the entity that has a distinction or more proactive strategy has less stringent budget control, which increases the tendency to build looseness and the tendency of entity leaders to think long term. budget control has functions as well, as said by jones and thompson (2000. p. 205) that there are three very important functions in budget control: (1) allocate decision rights among agents in the organization; (2) measure and evaluate performance; and (3) reward and punish individuals for their performance; as well as the budgeting and accounting accountability system is the most widespread mechanism to perform these functions. further, van der stede (2001. p. 119) says that budget control seems stricter than merely monitoring budget deviations with a management base. budget control for lowering the intensity of budget deviations, associated also with performance measurements, as said by modell (2001. p. 437) that performance measurements in public sector organizations are important to do especially regarding budget control interactions with the organization’s budget absorption. hertati (2016) state that thus, the important budget control is done for performance measurements through how much the budget absorption process is in the perspective of the quality of the series, such as the development budget of a library building that corresponds to its specifications (is not a specification of a built office building), budget consumables for the needs of libraries but made a kind of budget for office administrative needs, and others. thus it can be said that budget control tends to lower the intensity of budget looseness that is expected to impact the increase in budget absorption performance in the context of its budgetary quality. furthermore, oreblyl and ugochukwu (2005. p. 69) argues that the control of budget is conducted to maintain and achieve a balanced budget and surplus and implement a pragmatic approach to controlling budget through an efficient monitoring system. while hertati (2015) has other views that budget control is related to the behavior that constitutes the organizational value. similarly, özer and emine (2011. p. 8902) says that budget control has a partial mediation effect on the relationship between environmental uncertainty and a tendency to create budget looseness. hertati (2015) state that thus, it can be concluded that the budget control is an efficient monitoring system that forms the value of the organization where the effect of environmental uncertainty and budget loosening allows it to be lowered intensity. because budget control affects the organizational value, it’s a broader perspective that covers other aspects. some of the budget characteristics to show a good budget, must be measurable and within a certain time limit, as said by anthony et al. (1998) that the understanding of the budget in general is a plan presented size (quantitatively) and are usually expressed in units for a given period. in addition, the sense of budget in general should be adaptable to the paradigm change of budget research influenced by various aspects within the scope of the organization, according to what hartmann and moers (1999. p. 291) that behavioral and organizational interactions that affect the budget, in which its interpretation and conclusion should help the research paradigm. things that cannot be ignored are the accounting roles in local governments (governments), which are apparently budget practices and interrelated accountability. matching is said by goddard (2004. p. 543) that from the study of the relationship between accounting, governance and accountability in the local government in the uk, it turns out the budget system as the most important organizational process in relation to accountability and budget practices relate to the perception of accountability. any budget-based, must be measurable in performance. these performance measurements can use different types of indicators. indicators for performance measurement in the budget process, should be used to measure the precise absorption rate of relative budgets. as in the research conducted by hajnal and ugros (2015) in mike and reply (winter 2015/2016:125-126) says that although the management-based performance of indicators exists in sporadic form in the public administration of eu member states, but eu funding regulations require an indicator-based performance scale and its quality far exceeds other practices. similarly hajnal & jenei 2007 in mike and reply (winter 2015/2016:126) says that in performance measurements are based on the administrative traditions that emphasize the legality of the level of efficiency. a overall need to be seen from various aspects, including budget behavior is observed within the framework, so that the reality of the organization can be seen from good budgeting and budgeting in organizational practice must be able to realize the expectations of society (davis et al., 1966; jonsson, 1982; covaleski and dirsmith, 1986; covaleski and dibsmith, 1988: hertati, 2015). these opinions affirm that the reality of a good organization can be seen from good budgeting, where it demands suitability between the disbursement planning and its realization. based on several studies above, it can be outlined below. that the budget of local government in indonesia is not separated from budget politics because in the legality of rapbd to be apbd by the council (legislative) is a little more definite political nuance. this happens because of many interests with different objectives that should be of concern. therefore, a local pemda in indonesia has accommodated many purposes. however, the budget behavior is a concern in the local government budget in indonesia, because the budget that has been compiled is in contact with its constituent behavior. this is what characterize the characteristics of budget behavior and the budget behavior must be controllable to give effect to its performance aspects. there by it can be said that the budget control can be used to evaluate gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020 307 the performance of budget absorption at local government in indonesia, where the control of this budget as a management tool in carrying out its functions. hertati et al. (2015) state that in addition , budget control can be used to detect budget looseness because this cannot be ignored by management in running the function, so it can be said that the budget control has been accommodate the function. similarly, budget control can impact the monitoring of budget deviations, which need to be supported by budget-based performance measurements. in another perspective that budget control provides an impact on efficient monitoring systems because the internal and external aspects become its attention, such as uncertainty environmental aspects and the tendency to create budget and attribute looseness or any other parameter. this perspective is also associated with the performance of budget absorption at local government in indonesia to accommodate incremental budgets (input based). a good budget reflects the reality of the organization and should be able to uncover the budgeting involved in the creation of social reality, where it certainly supports the budget information used in performance evaluation for the purpose transparency of public. local government officials in indonesia in carrying out their duties and functions are not only public interest oriented but need balance. therefore, the budget of local government in indonesia needs to use incentive-based compensation, with the main objective to encourage work motivation in realizing the budget that pro public services, where the current relative is not fully committed. hertati et al. (2020) empirical study indicates that the requirements of external authorities have been conducted regarding the budget of local government in indonesia, there proved to be budget authorization activity and budget validation that must be guided in the prevailing laws and regulations, in where budget control is associated with budget absorption performance that has been accommodating the incremental budget (input-based). similarly, budget absorption performance should be able to reveal efficiencies on all lines (inputs, processes, outputs). further that should be done research in order to help uncover the paradigm of overall budget research and research on the budget into its main topic, because so important absorption performance budget to detect budget efficiency at each stage (input, process, output).so that phenomena perkada settlement (accounting policy regulation & regional accounting system) related to the research of budget absorption performance be an evaluation material and attention to the importance of budget absorption performance impacts on the quality of financial reporting. in the end that research should be able to impact the advice of making planning and budgeting electronic based systems and incremental budgets as input-based budgets are still applied to the absorption-based performance budget, in which enam criteria related to absorption of budget applied to the local government in indonesia, so that it becomes one of the basis in p-size performance-based absorption budget. thus it can be concluded that in previous studies specifically on the aspect of budget control only, while being the state of the art in research that will be conducted by the researcher that is the aspect of control budget that is associated with the performance of regional government budget absorption in indonesia. similarly, budgeting is used for planning and controlling activities as well as budget information is used in performance evaluation, where such performance evaluation needs to be measured, such as difficulties budgetary goals and feedback are required for performance measurements and the use of incentive-based compensation can be used for performance measurements (welsch et al., 1988; briers and mark, 1990; hirst and steven, 1990; fatseas and mark, 1992). the budget process is a way to demonstrate compliance with needs, including budget allocation for growth; other than that, performance-based budget implementations will be more efficient, where there are eight dimensions for performance measurements one is the efficiency and also one of the budget characteristics is the budget performance should be monitored continuously (natural and lawrence, 1994; pendlebury, 1994; brunsson, 1995; murphy et al., 1996; carter et al., 1997). budget in numeric size for a specific period, having interactions between behaviors and organizations affecting budgets, where accounting roles in budget practices relate to the perception of accountability, as well as management reform for budget efficiency and accountability (anthony et al., 1998; hartmann and moers, 1999; goddard, 2004; brook and philip, 2007). in practice, the use of budgeting and accounting systems in a political organization, as the budget as a thorough and coordinated plan, needs to be conducted an accounting system reformation that implicates the allocation of budget, in which the state budget in the public sector organization including the scope of management accounting, is advised to be made public financial management system (smkp) for public accountability and internal control monitoring for budgeting and incremental-based budgets is still relevant for use (ezzamel et al., 2007; atkinson et al., 2012; erlina et al., 2012; muzividzi, 2013; jones et al., 2014). based on the experts’ opinion above, it can be summarized that good budgeting can reflect the reality of the organization, measurement of budget performance can be carried out from various aspects that one of them with the use of compensation an incentivebased without neglecting one of the dimensions for performance measurements , which is the efficiency, where accounting roles in budget practices relate to accountability perception; the use of budgeting in government should be monitored for internal control because it is related to public accountability. as revealed by mardiasmo (vice minister of finance, kementerian finance ri, 11/08/2015), gives six criteria that must be fulfilled for the implementation of a good budget, and also that expressed by mike and reply (winter 2015/2016:135),in research related to operational program extensive give empiricalas evidence a budget document dimension that includes the criteria:(1) the managed funds can be executed according to the existing regulations up to semester i; (2) timeliness in the completion of the bill; and (3) conformity between disbursement planning and its realisations; (4) gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020308 submission of contract data; (5) the revision of the budget, in the sense the fewer revisions are made, the better; and (6) the accuracy of the filling of paid warrants (sppd). the dimensions efficiency is a package that cannot be separated into the dimensions of the budget document because in the budget documents there are indicators of its achievements. thus, the dimensions efficiency to measure the performance of the budget absorption dimensions of budget documents. 2.2. influence of budget control over budget absorption performance management accounting is a control tool in an organization so that financial and non-financial performance in order to make this decision is expressed by (hansen and maryanne, 2006; horngren, 1994; horngren et al., 2015; hyndman and ciaran, 2011; jacobs, 1995; jaweng, 2014; kominis and dudau, 2012; likert, 1989; louise, 1997). the important control aspect is done by each organization. organizations must have a budget as its operational basis. to ensure the sustainability of the budget, there must be a strong support of the legitimacy of action for such control. the same thing is expressed by covaleski and dirsmith (1986. p. 193) that the power of legitimacy of action in the control of budgets supports budgeting that facilitates and enables rational technical decision making in the organization, and good budgeting reflects the reality of the organization in the context of organizational life force. the strength of the organizational life also concerns the behavior of the organization to demonstrate alignments in the public interest, as revealed by bailey (1993. p. 7) that local government reform in the context of budget control influence the fundamental revaluation considerations on the form of democracy and the way to secure, questioning the behavior characteristic of the local government in relation to the public interest, representing the public interest to the program employment in local government budgeting. reform of an organization is done in order to improve its performance. however, it is also necessary to anticipate any changes in developing the right mechanisms in each activity. whether it is controlling activity or the performance aspect. it is said by broadbent and laughlin (1998. p. 403) that changes in accounting and financial changes in the context of budget control in the public sector can anticipate the nature of activities and core values of the public sector organization, which gives the effect of this dominant stance is to develop the right budget absorption mechanisms so that the activity and core values remain unaffected. the budget absorption mechanism cannot be released by the evaluation aspect on how to provide the service efficiently by using the organizational budget capacity, as said by mullins and zorn (1999. p. 37) that cost-based activities in budget control can greatly improve the evaluation of how to provide services efficiently in the public sector, which in general activity-based costs do not face barriers to provide assistance to governments the area in the thorough evaluation of direct services and determine the candidate of vendors or privatization into the program of the estimated work. thorough evaluation of direct services, cannot be ignored also aspects of performance measurement, as said by modell (2001. p. 437) that performance measurements in public sector organizations are important to do specifically related to budget control interactions with the organization’s budget absorption. apostolache and mihai, (2013) stated that the introduction of the budgeting system was bestowed on the organization as a positive effect of the implementation of management accounting changes in the form of regional financial management. management accounting changes are associated with behaviors that make up the value of the organization, as said by william (2005) that budget controls related to behaviors that make up organizational value and organizational value are formed by one by budget absorption performance. the organizational value formed in larger organizations is decentralized due to the demands of changes to efficient service needs, supported by accounting data. it was said by noutomi and nakanishi (2007. p. 1393) that budget control on a relatively larger organization led to the outcome-oriented decentralization management characterized by performance measurements within the budget local governments. according to robson (2008. p. 343) that accounting data is indispensable in budget control to prevent low budget absorption. robson’s further (2008. p. 343) states that cost information in the context of budget control is used as the accounting data source for performance measurements in budget absorption. similarly, research conducted by seal and amanda (2011. p. 409) that reveals that control in public sector budgets plays a role to avoid cognitive problems based on data-immainstay and program planning work that can be applied to explain the volatility of public sector budgets. the research was reaffirmed able by hertati (2015) stating that the design of performance management systems in budget control will provide the sustainability benefits of the work program within the regional government budgeting. according to other views of van rinsum and verbeeten (2014. p. 131) stating that the scope of purpose clarity, the ability to choose undistorted performance metrics and the extent to which the organization’s leadership knows and controls the process transformations in budget control that can provide positive effects tend to improve performance in the performance measurement system. wickramasinghe (2015. p. 323) argues that the problem of cost saving in budget control has social relevance to the special issue of management accounting in the context of loosening the confinement of the old bureaucracy budget the post-colonial keynes. another opinion according to goddard and mkasiwa (2016. p. 340) that the budget changes imposed in the context of budget control that affects the organization’s perpetrators committed to central government reform adopt innovation to ensure various funding sources have been accommodated into its budget. according to the above statements it can be concluded that the budget control affects the performance of the ang sequestration (figure 1). budget control budget absorption performance a plan that describes the company's future activities:: 1. in the form of a plan, 2. includes all activities, 3. expressed in monetary units, and 4. shows the time period. figure 1: research gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020 309 a transparent government financial budget will determine a good organizational performance system as a result of research (cocca and alberti, 2010; decree of the minister of the interior no. 050-187 / kep / bangda, 2007; erlina and rasdianto, 2012; grifel, 1993; gryna et al., 2007; guilford and fruchter, 1956; bourdeaux, 2008; becker et al, 2014; bastida and bernardino, 2007; apostolache and mihai, 2013). 2.3. hypotheses based on the phenomena outlined earlier, which in general that the national budget absorption of local government is declared low, and the study of the literature and the above thought frame, the research hypothesis can be determined below: h1: budget control affects budget absorption performance. 3. methodology that the research method of a science can be developed by certain methods of using valid data conducted during the investigation to solving the problem. the research method uses a descriptive method to describe or describe the research variables. the descriptive method can also be said as a survey method. according to hair et al., (2006), that generally survey research is limited to research whose data is collected from samples over the population to represent the entire population. the verificative method or hypotheses testing is a method of study used in this study. according to zaman and george (2009), that the verificative research or also called hypotheses testing research is a research aimed at testing the truth of the theory or the results of pre-existing research, which formulated in the research hypothesis. thus, this study can be said as a descriptive verification study. according to hair et al (2006) that the operationalization of the variable is to embed the meaning of a construction or variable by assigning an activity or action that is necessary to measure the construct or variable. variable operationalization is done by formulating variables derived to each dimension until the determination of the indicators attached to the variables. these indicators are poured into the questioner list which serves as a research instrument. based on the above description then the operationalization of each of the research variables as follows: 3.1. budget control budget control cannot be ignored from the aspect of behaviour in the organization is not differentiated private sector or public with the same characteristics and cannot be ignored also behavior that raises the attitude of rational utility maximizer’s. budget related to behavioural behavior rational utility maximizer’s so created budgetary slack that would weaken budget control (abdulkadir and ozturk, 2017). dunk (1993) states that three dimensions have been proven to affect the occurrence of slack of budgeting namely: (1) organizational level; (2) environmental level; and (3) individual levels. the dimensions of budget control variables are outlined below: a. organisational levels occur in activities: participation in budgeting, asymmetric information, superior grading styles – concurrent influences of evaluation style and asymmetric information, superior ability to detect slack, realization-salary reduction plan and task obscurity (dunk, 1993). b. environmental level is a confusing situation (dunk, 1993); evaluating subordinates based on budget (bruns et al., 1975); and the budget explanation of the variance needed (andrew goddard, 2014). c. the individual level is related to the liking of risk (dunk, 1993); drafting a budget change (bruns and waterhouse, 1975); and a useful role for managerial roles (andrew goddard, 2014). 3.2. performance absorption budget according to jaweng (2014), that performance can be interpreted as “appearance,” “rally,” or “accomplishment.” also expressed performance as the record of outcomes produced on a specified job function or activity during a specified period. according to zaman and george (2009) that behavioral standards can be a management policy or a formal plan set in a budget. mike and reply (winter 2015/2016:135), in a research related extensive operational program giving empirical evidence to simplify process analysis into budget documents. thus, the budget document can be applied to six attribute that must be met as a good budget execution indicator which includes (mardiasmo, 2015): (1) how much funds managed by the government/ ministry/ institution can be executed in accordance with the regulations that exist until the first semester; (2) timeliness in the completion of the bill; (3) conformity between withdrawal planning and its realization; (4) submission of contract data through the treasury and state budget system (span); (5) revision of the implementation of budget (dipa) fields. in the sense, the fewer revisions are made, the better; and (6) the accuracy of filling the payment warrant (spm) (table 2). gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020310 according to sekaran and bougie (2010:121) that population is a whole group of people, events or interests that are investigated by researchers. similarly still according to sekaran and bougie (2010:248) that the unit of analysis is the level of data aggregation collected during the analysis of data. the population as an overall unit of analysis in this study covers all local governments (local government) in indonesia as many as 548 entities of the government organization. a regency in indonesia or indonesia is as much as 416 districts (data 2015-2016), the number of cities in indonesia or indonesia is as much as 98 cities (data 2015-2016), number provinces in indonesia or indonesia is as much as 34. thus, the number of local governments in indonesia is 548. according to hair et al., (2006) that samples are part of the population used to conclude or describe the population. the number of samples to be taken using the following slovin formula: n = n/(1 + (n × e²)) where: n = number of samples n = population number e = margin of error using margin of error 5% and confidence degree of 95%, the number of samples calculated as follows: n = n/(1 + (n × e ²)) so: n = 548/(1 + (548 × 0.05 ²)) n = 548/(1 + (548 × 0.0025)) n = 548/(1 + 1.37) n = 548/2.37 n = 231.2236 ≈ 231 thus it can be stated that the sample amount is 231. sample collection techniques using simple random sampling. the data collection method is the mail survey and the location of the local government, while the remote location is confirmed by telephone operator of local government offices in indonesia. but the number of samples accumulated as many as 33 respondents in indonesia. according to roscue, 1975 in sekaran (2013, p. 267) that samples larger than 30 and <500 are adequate sample sizes in the majority of research. thus, can be presented the number of samples in the following table 3: table 2: variable operationalization variable dimensions indicators scale no. item 1 2 3 4 5 budget control (x) bruns and waterhouse (1975), dunk (1993), william (2005), özer and emine (2011), williams et al. (1990) in goddard (2014) organizational level environmental level individual level 1. participation in budgeting 2. asymmetric information 3. superior ability to detect slack 4. a stressful situation 5. budget for subordinate evaluation 6. budget variance explanation 7. liking risks 8. revised budget 9. managerial roles are supported by the ordinal ordinal ordinal ordinal ordinal ordinal ordinal ordinal ordinal 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 budget absorption performance (y) carter et al. (1997), (mardiasmo, deputy minister of finance, ministry of finance ri, 11/08/2015), mike and reply (winter 2015/2016) budget documents 1. the amount of managed funds can be executed in accordance with the existing regulations up to semester i. 2. timeliness in billing settlement. 3. the suitability between planning the funds of the fund with its realization.. 4. submission of contract data. 5. budget revision. in the sense, the fewer revisions are made, the better. 6. precision filling spm/sppd. ordinal ordinal ordinal ordinal ordinal ordinal 2.10 2.11 2.12 2.13 2.14 4.47 source: variable operationalization table 3: list of local government samples in indonesia no. local government 1. kab. flat ground 2. city of payakumbuh 3. new pekan city 4. kab. eastern oku 5. kab. lebong 6. kab. west lampung 7. metro city 8. kep province the 9. kab. central bangka 10. province of dki jakarta 11. west jakarta 12. kab. sukabumi 13. kab. bandung 14. kab. sumedang 15. kab. west bandung 16. bandung 17. city of cimahi 18. city of banjar 19. kab. cilacap 20. kab. klaten 21. kab. jepara 22. kab. kendal 23. kab. pekalongan 24. kab. the 25. kab. gunung kidul 26. kab. tuban 27. kab. klungkung 28. kab. karangasem 29. mataram city 30. province of east nusa tenggara 31. kab. lembata 32. province of west kalimantan 33. city of bontang source: questionnaire propagation results figure 3: model estimation of budget control (x2) impact on budget absorption performance (y) source: smartpls 3.2.8 output result gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020 311 4. descriptive analysis of research data the data obtained from the survey results consist of research data (zaman and george 2009). the image of the research results can be used to enrich the discussion, through the overview of the respondent’s response data, which is known how respondents responded to each variable being researched. to make it easier to interpret the variables being researched, analysis categorization of the respondent’s response score was performed. the categorization principle of the number of respondent response scores in the adoption of arikunto (2008:353). from the respondent’s response, then drafted the assessment criteria for each question item by percentage with the following steps: 1. the cumulative value is the value of each question that is the answer of each respondent. 2. the percentage is the cumulative value of the item divided by the frequency value multiplied by 100%. 3. the number of respondents is 33 people, and the largest measuring scale value is 5, while the smallest measuring scale is 1. so the largest cumulative sum is obtained = 33 × 5 = 165. and the smallest number of kumulatrif = 33 × 1 = 33. the smallest percentage value is (33/165) × 100% = 20.00%, with the range value = 100%-20.00% = 80.00%. if divided by 5 categories, it can be a percentage interval value of 16.00%. 4.1. data testing model this stage relates to the formation of early models of the initial model of structural equations, prior to estimation. this initial model was formulated based on a previous theory or research (figure 2). through the drawing of the conceptual diagram above it can be noted that the line model consists of 1 (one) sub structure. in general, these models can be spelled out through the following equations: y = 1 x1 + ζ the process of estimating the above model is done using the help smartpls 3.2.8 program application. evaluation of the outer model the outer model specifications the relationship between the latent variables with the indicator or its manifest variables. outer model defines how each block of the indicator relates to its latent variables. in this study to formulate the latent variables and figure 2: conceptual diagram of the model of budget control impact (x2) on budget absorption performance source: smartpls 3.2.8 output result figure 4: result of reestimation of the model of budget control, influence on budget absorption performance source: smartpls 3.2.8 output result gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020312 the manifest variables were used reflective measuring models, where most of the measurements were developed from concept to indicator (figure 3). evaluation of the model can be done using convergent validity on the reflective model by looking at the value of loading factor. each observed variable is valid if the value of loading factor is above 0.50. based on the image above, it is known that almost the entire loading factor value of the observed variable is worth above the critical value of 0.50, except for the x2.1 measurement 0.1, x2.2.2, y3, y + 5, and a y6. indicators that have a loading factor value less than the critical value can be removed from the model. according to jaweng (2014), if there is a loading factor that is smaller than the critical value, so the corresponding observed variable can be abolished from the model. however, if the loading factor is still above 0.30, the corresponding variable can still be developed for removal. however, due to the fifth loading factor of the indicator table 4: evaluation linear validity measurement of variable control budget and budget absorption performance indicator x x1 x2 x3 y x1.2 0.643 0.946 0.369 0.147 0.525 x1.3 0.402 0.855 0.107 −0.003 0.200 x2.1 0.689 0.375 0.889 0.290 0.408 x2.3 0.422 0.010 0.663 0.263 0.204 x3.1 0.411 -0.143 0.100 0.745 0.433 x3.2 0.611 0.002 0.375 0.802 0.426 x3.3 0.644 0.281 0.256 0.705 0.657 i1 0.724 0.431 0.448 0.608 0.862 i2 0.559 0.264 0.293 0.551 0.807 i4 0.517 0.344 0.210 0.489 0.727 source: data processing results (2019) table 5: reliability evaluation measurement of budget control and budget absorption performance prove the truth indicator x composite reliability ave first order x1 0.781 0.897 0.813 x2 0.396 0.758 0.615 x3 0.623 0.795 0.565 second order the x2 0.616 0.752 0.312 first order y 0.721 0.842 0.641 source: data processing results (2019). ave=average variance extracted table 6: estimate result structural model effect of budget control on budget absorption performance variable path coefficient r square r square adjusted t statistic p value x -> y 0.761 0.579 0.565 6.465 0.000 source: data processing results (2019) still smaller than 0.30, the researcher decided to eliminate the five indicators from the research model and was not further analyzed. the result of the estimate after the issuance of five indicators that do not pass the validity of convergent is as follows (figure 4). based on the image above, it is known that the entire loading factor value of the observed variable has been worth above the critical value of 0.50. it can thus be concluded that the measuring model has had good convergent validity. further testing will be carried out the outer model including linear validity, composite reliability and cronbach’s alpha. the value of cross loadings presented through the table 4 also indicates the presence of a good linear validity, where the correlation value of the indicator with its construction is higher than the indicator’s correlation value with other construct (ghozali, 2014. p. 39). according to the table 5, it is known that almost all the construction has the value of cronbach’s alpha and composite reliability >0.70, except in the construction x2.2, x2.3, x2. the same looks at the ave value, not the entire construction has an ave value >0.50. taking into consideration the combined evaluation of the three criteria of the measurement’s reliability, it can be concluded that the reliability of the entire construction of the exogenous and endogenous measurements has been quite good. 4.2. evaluation of the inner model the structural model is a model that connects a latent variable exogenous with a latent variable endogenous or endogenous variable relationships with other endogenous variables (hair, 2014. p. 12; priest, 2006; natzir (2013). in this research the structural model is linked to the four research hypotheses that hinting causality relationships between latent variables. priest, (2006), gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics and financial issues | vol 10 • issue 5 • 2020 313 the structural model in the study involved one exogenous latent variable (budget control) and one endogenous latent variable (budget absorption performance). the result of standardized line coefficient calculation on structural model of budget control influence on budget absorption performance is shown in the following table 6. 4.3. test hypothesis h0 → there is no significant γ1 = 0 budget control (x2) influence on budget absorption performance (y); h1 → there is significant γ1 ≠ 0 (x2) budget control influence on budget absorption performance (y). test statistics: t stats at the equivalent of significance (α) = 5%. test criteria: reject h0 and thank h1 if t ≥ 1.96; accept h0 and reject h1 if t < 1.96. by using the help of application program smartpls 3.2.8 obtained the result of estimation of structural parameters as follows: based on the results of the estimation of structural parameters presented through the table 6, it was seen that budget control (x) proved significant impact on budget absorption performance (y), where the value of t statistic obtained is greater than the critical value at the level of significance set by 5% (6.465 > 1.96). with a line coefficient value of 0.761, the value of r2 obtained is 0, 579 and is included in the medium category (hair, 2014. p. 97, 175). this indicates that only 57.9% of the performance of the budget absorption (y) can be explained by a concession of budget control (x2), while the remaining 42.1% is explained by other construction that is not examined in the model of this research. the effect size of budget control over budget absorption performance is evaluated using the value of f2. riduwan and kuncoro, (2012), based on the results of the data processing, it is known that without a construction of budget control, the influence of exogenous construction on budget absorption performance is 0.000. so, the value of f2 for budget control variables can be calculated as follows: 2 2 2 2 0.579 0.000 1.373 1 0.5791 − − = = = −− included excluded included r r f r an f2 value of 1.373 worth more than 0.35 indicates that at the structural level, budget control provides a very strong influence over budget absorption performance. goodness of fit model (q2) to know how much the ability of the model (goodness of fit) in describing the variation of endogenous variables can be calculated as follows: r1 2 (budget absorption performance) = 0.579 q2 = 1−(1−r1 2) q2 = 1−(1−0.579) q2 = 0.579 = 57.9% model error = 100%−57.9% = 42.1%. it can be concluded that the capacity of the budget control in explaining the performance of the budget absorption is 57.9%, while the remaining 42.1% is influenced by other conduction that does not researched in this model of research. the value of q2 > 0 indicates that the model has a good predictive relevance (chin, 1998). 5. discussion the results of the research conclude that martha, (2011); melkers and katherine, (2005); musso et al., (2006); nafarin, (2009); nature and stewart, (1994); newberry and june, (2003), concludes that regional financial budgets are transferred from the central government to local governments in order to address the situation of local communities, through local governments. the results of the research otto, et al (2004); paul, (2012); peters, (2001); pina and lourdes, (2003); ramadan, (2009); ratna, et al (2017); richard, (1999); van der hoek, (2005); conclude that budgeting, quality management and target-based budgeting can be achieved if human resources can work with scientific competencies that can achieve the goals targeted by the government of a just and prosperous society. 6. conclusion and recommendation budget control affects budget absorption performance. the level of influence of organizational commitment to budget absorption performance in strong category. the results of this study are in line with what covaleski and dirsmith expressed (1986) that the power of legitimacy of action in the budget control supports budgeting that facilitates and enables rational technical decision making in the organization, and good budgeting reflects the reality of the organization in the context of the organizational life force. the magnitude of the influence of budget control on the budget absorption performance is 0.694 (69.4%). this means that the remainder amounted to 30.6%; budget absorption performance is influenced by other factors beyond the results of this research. some regional government officials in each stage evaluate their budgets and realizations in shorter periods as well as an evaluation material for their subordinate performance. evaluation of revenue realization carried out by presenting regional device organization (opd), evaluation of activities conducted each month by holding regular meetings between regional head and opd, thus development implementation regional revenue and expenditure budgets (apbd) can be known each month. that budget for subordinate evaluation should be a serious concern for local government organizations in indonesia because with the proper functioning of the budget as a tool to evaluate the subordinates, then the subordinates will be pleased where direct attention by superiors through the budget execution stages. therefore, local government in indonesia needs to create a formal policy foundation governing a subordinate performance evaluation that is based on budget execution stages. gunawan, et al.: linkages to budgetary control and budgetary absorption performance international journal of economics 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(2009), structural fund absorption: a new challenge for romania? romanian journal of economic forecasting, 1, 136-154. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 1-6. international journal of economics and financial issues | vol 13 • issue 1 • 2023 1 stock market liquidity during periods of distress and its implications: evidence from international financial markets samuel tabot enow* research associate, the iie vega school, south africa. *email: enowtabot@gmail.com received: 26 september 2022 accepted: 15 december 2022 doi: https://doi.org/10.32479/ijefi.13752 abstract traditional market pricing models assume frictionless markets with abundant liquidity. this traditional models also incorporate stock market liquidity as an exogenous cost. however, this paradigm has many shortcomings due to its inability to explain some of the problems associated with security market illiquidity. the aim of this study was to explore the concept of stock market liquidity during periods of financial distress. a markov switching garch model was used to investigate market liquidity in the cac 40, dax, jse, nasdaq index and the nikkei-225 during the 2007-2008 financial crisis and the covid-19 pandemic. the sample period was january 1, 2020-december 31, 2021 and december 1, 2007-june 30, 2009. from the findings, some financial markets where still liquid despite the financial crisis with the exception of the nasdaq index. conversely, all the financial markets under consideration displayed strong illiquidity during the covid-19 pandemic. in essence, the level of market depth has significantly decreased from the financial crisis to the covid-19 pandemic which may be attributed to increasing margin requirements and information asymmetry as well as price restrictions. there is an urgent need for regulatory authorities to review some of the trading regulations during financial distress. keywords: market liquidity, financial markets, markov switching model, financial distress jel classifications: g1, g2, g4 1. introduction market liquidity is a conspicuous aspect of stock market analysis when considering trading activities and the ability to exit the market. we have seen a couple of serious liquidity crises in financial markets ranging from black monday 1987: junk bond 1988: japanese bubble 1990: united states bond crash 1994: mexican crisis 1995: asian crises 1997: russian crisis 1998: long term capital management 1998: dotcom crash 2000: september 11 disruption 2001: argentina crisis 2002 to the credit crunch 2007 over the past few years. considering that these financial crises where linked to liquidity problems, it is therefore prudent to say that liquidity muddles are not a once-off scenario as it keeps resurfacing time and again. it will be reasonable and cautious to adjust our attitude towards stock market liquidity and to assume that there will always be a liquidity problem in the future. in finance literature, there are several definitions that are predominantly used to distinguish funding liquidity which relates to obtaining financing from market liquidity as a measure of market depth. as the term suggests, funding liquidity relates to the availability of credit in the market (tran, 2020). market liquidity on the other hand plays an important role in financial market analysis due to the perceived notion that fundamentals are usually based on liquidity drivers (warsh, 2007). prior literature also suggests that market liquidity plays an important role in determining the direction of the market in conjunction with earnings announcements (grossman and miller, 1988; amihud, 2002: amihud, mendelson & pedersen, 2005; bhattacharya et al., 2019). stock market liquidity arises from the willingness to trade on an index which ultimately increases the value and volume of trade (abudy, 2020). in essence, market participants can quickly execute or exit their positions because there is an accessible this journal is licensed under a creative commons attribution 4.0 international license enow: stock market liquidity during periods of distress and its implications: evidence from international financial markets international journal of economics and financial issues | vol 13 • issue 1 • 20232 and legible market in the index at all times (brunnermeier and pedersen, 2008). without this willingness, trading will be limited leading to illiquidity or liquidity crisis. liquidity crisis results from mainly two sources which are, the absence of partners or buyers and fire sales of assets below their fundamental values (boyson et al., 2011). during periods of financial distress, market participants move quickly to sell their assets to balance some of their losses due to slow economic growth. due to the congruent views among investors regarding the direction of the market during financial distresses, there is an uncurbed amount of sellers and limited buyers to facilitate trading leading to illiquidity. from a firm’s view point, balance sheets that are not aptly structured usually result in liquidity mismatch. this mismatch eventually drives sentiments in financial markets largely because of risk premia. there are basically three fault lines that exposes risk premia as a result of illiquidity which are maturity mismatch, credit risk and foreign exchange risk. it is also imperative to note that these fault lines are the crux that portrays sentiments in financial markets. in addition to the fault lines, stock market liquidity is also correlated to the structure of the financial market (næs et al., 2011). these includes the level of restriction, technological advancement and the market transparency. these idiosyncratic traits are significant because trading in financial markets have become intertemporal with increasing uncertainty. that notwithstanding, prior research has mainly focused on investigating stock market liquidity in a holistic manner (nguyen et al., 2021; umar et al., 2021; kunjal, 2021; tiwari et al., 2022; gofran et al., 2022). there still exists a gap in literature to empirically investigate and examine the trends in stock market liquidity during periods of financial distress. the ability to refinance loans and other financial instruments is substantially as a result of decreasing liquidity. hence, future refinancing in periods of distress will almost seem impossible if there is a decreasing trend in liquidity. therefore, this study makes a noteworthy contribution in formulating macroeconomics government policies in addition to the literature in market liquidity. 2. literature review as documented in prior literature (nguyen et al., 2021; umar et al., 2021; kunjal, 2021), there are multiple definitions of stock market liquidity. however, the quotidian aspect is the ability to trade quickly without significantly moving the price (bhattacharya et al., 2019). hence larger volumes can be traded without a notable change in market price leading to lower transaction cost. stock market liquidity is usually associated with market depth, resilience, immediacy and breath (olbrys and mursztyn, 2019). however, market depth and resilience are the most recurring themes of market liquidity. market depth and resilience connotes large order flow from both the buy side and sell side with insignificant change in price (enow et al., 2022). in this case, market participants expect to see low volatility in security prices. on a broader scale, market depth and resilience are a function of price impact and trading volume (kijima and ting, 2019). the characteristics of stock market liquidity varies considerably depending on the nature of the security market. this difference may be attributed to the market structure and the type of market. order driven markets where counterparties are unknown, display market prices and trading quantities on the exchange (wang et al., 2020). an important feature of these order driven markets are the level of transparency. the order books are readily available to all market participants and the exchange facilitates the process of matching the standardized supply and demand needs of traders which greatly improves liquidity (marcel and bruce, 1994). equity securities, futures and options on short term interest rates are traded on order driven markets. conversely quote driven markets are rather concluded on the basis of market quotes provided by markets makers. market makers in these type of market take considerable risk with regards to price fluctuations. to minimise this risk, brokers are often persuaded to actively participate in the market so as to enhance liquidity in terms of depth. the quote provided by the market maker is valid for a specific period which causes liquidity in this type of market to vary considerably. the four main factors conventional factors that impact stock market liquidity are; stable global monetary conditions, regulations in financial markets, growth in the size of the market and the performance of the banking sector (miranda-agrippino and rey, 2020). illiquidity is often accompanied by a wide trading spread gap as a result of large bid and offer mismatch. as seen in the past, liquidity crisis may lead to an entire market shut down as was the case in the hong kong 1987 crash where the market had closed for 4 days (malliaris and urrutia, 1992). the tables 1 and 2 summarize prior literature on stock market liquidity during financial distress. from tables 1 and 2, it is evident that financial distress is often associated with illiquidity. from prior literature summarised in the tables above, financial markets experienced liquidity shortages during the 2007-2008 financial crisis and covid-19 pandemic. the above studies directly imply that whenever there is a financial crisis markets experience liquidity shortages which might not be the case. also, stock market liquidity trends are not clearly defined in these prior literature hence the purpose of this paper to fill in the gap in literature. 3. methodology as alluded in the study of enow et al. (2022), liquidity is predominantly a function of market depth. therefore, to empirically investigate stock market liquidity, daily trading prices and trading volumes were used. these two variables are the conventional measures of liquidity (chordia et al., 2001; acharya and pedersen, 2005; hasbrouck, 2009; amidu, 2002; amidu et al., 2005; le and gregoriou, 2020). this study used the markov switching garch model which has an autoregressive property (bauwens et al., 2010). this model was used to investigate liquidity because of its interrogative property component in addition to the autoregressive table 1: stock market liquidity during the 2008-2009 financial crisis study model period country findings dang et al. (2014) regression analysis january 2003 december 2007 17,493 stocks across 41 countries the financial crisis had a negative impact on market liquidity enow: stock market liquidity during periods of distress and its implications: evidence from international financial markets international journal of economics and financial issues | vol 13 • issue 1 • 2023 3 table 2: stock market liquidity during the covid-19 pandemic study model period country findings nguyen et al. (2021) panel data regression january 30th, 2020-may 15th, 2021 vietnam negative relationship between the covid-19 pandemic and market liquidity umar et al. (2021) garch model december 31, 2019-july 10, 2020 china significant liquidity decline in the chinese stock market during the covid-19 pandemic kunjal (2021) t-statistics march 5, 2020-june 12, 2020 south africa the market liquidity of specific firms listed in the johannesburg stock exchange decreased significantly during the covid-19 pandemic tiwari et al. (2022) wavelet coherence december 2019-july 2020 china, australia and g7 nations countries that were affected by the covid-19 pandemic experienced lower liquidity gofran et al. (2022) multivariate regression analysis january 2020-may 2020 china, germany, spain, us and uk the pandemic caused short term liquidity problems but it will not be significant in the long run source: author table 3: stock market liquidity during the financial crisis for the cac 40 & dax variable coefficient cac 40 z-statistics p-value coefficient dax z-statistics p-value standard error standard error regime 1 regime 1 c 6246.026 55.33 112.88 0.000* 16164.5 106.63 151.5 0.000* volume 00000183 0.0000622 0.29 0.7687 −0.000065 00000139 −4.71 0.000* sigma 558 0.0559 99.87 0.000* 568 0.08 70.8 0.000* regime 2 regime 2 c 7137.94 39.36 181.32 0.000* 13238.94 147.40 89.8 0.000* volume −0.000018 0.000047 −3.94 0.0001* 0000032 00000167 1.9 0.055 sigma 5.02 0.0753 66.64 0.000* 656 0.0552 118.7 0.000* transition matrix parameters transition matrix parameters ρ11 5.64 1.18 4.75 0.000* 5.322259 1.33 3.99 0.0001* ρ21 −5.32 1.32 −4.01 0.0001* −5.670551 1.18 −4.78 0.000* table 4: stock market liquidity during the financial crisis for jse & nasdaq variable coefficient jse z-statistics p-value coefficient nasdaq z-statistics p-value standard error standard error regime 1 regime 1 c 10454.24 39.32 265.84 0.000* 2577.17 47.26 54.52 0.0000* volume 0.00163 0.00190 0.86 0.3892 −0.000091 0.0000002 −4.29 0.0000* sigma 5.5 0.0753 73.38 0.000* 4.86 0.0509 95.45 0.0000* regime 2 regime 2 c 11262.95 49.63 226.90 0.000* 1443.274 50.79 28.41 0.000* volume 0.000171 0.00015 1.10 0.2705 0.0000007 0.0000220 3.22 0.0013* sigma 5.78 0.00677 85.31 0.000* 4.94 0.0538 91.78 0.000* transition matrix parameters transition matrix parameters ρ11 3.47 0.53 6.50 0.000* 6.01 1.22 4.88 0.000* ρ21 −3.3 0.48 −6.92 0.000* -5.95 1.25 −4.73 0.000* *significant at 5% table 5: stock market liquidity during the financial crisis for nikkei-225 variable coefficient nikkei-225 z-statistics p-value standard error regime 1 c 28977.8 277.0191 104.60 0.000* volume −0.793 382 −2.07 0.3892 sigma 6.47 0.0684 94.65 0.000* regime 2 c 27969.99 317.79 88.01 0.000* volume −0.00017 0.00039 −4.26 0.000* sigma 6.30 0.0712 88.53 0.000* transition matrix parameters ρ11 3.44 0.54 6.36 0.000* ρ21 −3.47 0.538 −6.46 0.000* *significant at 5% and garch property (engle and russell, 1998). modelling liquidity using this method was suitable because the autoregressive component ensures that output variables depend linearly on the input variables and previous independent variables. in the context of this study, this blueprint models liquidity by using a conditional state of trading volumes (k) with variance (hk.) and its distributive parameters (εk) to investigate the effect on price distribution. the markov garch model is given by; haas (2004). where st = k is the conditional state, hk is the variance and εk is the distributive parameters. also, the markov switching garch model has regressive regime parameters that are used to explains the relationship between the dependent and independent variables. enow: stock market liquidity during periods of distress and its implications: evidence from international financial markets international journal of economics and financial issues | vol 13 • issue 1 • 20234 table 6: stock market liquidity during the pandemic for the cac 40 & dax variable coefficient cac 40 z-statistics p-value coefficient dax z-statistics p-value standard error standard error regime 1 regime 1 c 5311.36 46.25 114.8 0.000* 15920.75 63.19137 251.945 0.000* volume −0.0000356 0.000042 −8.4 0.000* −0.000618 0.0000094 −6.540587 0.000* sigma 5.95 0.0509 116.80 0.000* 0.000570 0.052 109.3836 0.000* regime 2 regime 2 c 6668.82 61.40 108.59 0.000* 14228.31 120.74 117.8 0.000* volume −0.000031 0.0000079 −3.92 0.0001* −0.000167 0.0000111 −14.9 0.000* sigma 5.96 0.047 125.9 0.0000* 6.88 0.0412 167.04 0.000* transition matrix parameters transition matrix parameters ρ11 5.21 0.83 6.27 0.000* 6.083287 1.289994 4.71 0.000* ρ21 −5.97 1.08 −5.5 0.000* −6.304316 1.203804 −5.23 0.000* *significant at 5% table 7: stock market liquidity during the pandemic for jse & nasdaq variable coefficient jse z-statistics p-value coefficient nasdaq z-statistics p-value standard error standard error regime 1 regime 1 c 10399.68 49.71 209.20 0.000* 7565.3 262.90 28.77 0.000* volume −0.000802 0.000163 −4.90 0.000* 0.0000718 0.00000551 13.01 0.000* sigma 6.02 0.0523 115.04 0.000* 7.29 0.00404 180.62 0.000* regime 2 regime 2 c 11224.53 37.2 301.41 0.000* 13815.77 338.2305 40.84 0.000* volume −0.00024 0.000104 −2.35 0.019* 0.0000192 0.0000734 2.61 0.009* sigma 5.81 0.044 130.89 0.000* 6.58 0.00527 124.9 0.000* transition matrix parameters transition matrix parameters ρ11 3.6 0.48 7.44 0.000* 6.35 1.20 5.25 0.000* ρ21 −3.9 0.46 −8.50 0.000* −6.14 1.32 −4.62 0.000* table 8: stock market liquidity during the pandemic for nikkei-225 variable coefficient nikkei-225 z-statistics p-value standard error regime 1 c 28365.94 214.53 132.21 0.000* volume 0.00066 0.0000303 2.20 0.0275* sigma 6.68 0.00461 145.11 0.000* regime 2 c 25917.2 341.09 75.98 0.000* volume −0.00041 0.0000401 −0.103 0.000* sigma 7.54 0.0000463 162.93 0.000* transition matrix parameters ρ11 6.19 1.23 5.02 0.000* ρ21 −6.17 1.23 −4.98 0.000* *significant at 5% the regime parameters are given by; 2 üüü i t t i th y h  − −≡ + + 2 , 1 , 1 k t k k t k k th y h  − −≡ + + haas (2004). the sample financial markets where order driven markets such as the french stock market index (cac 40), the german blue chip companies trading on the frankfurt stock exchange (dax), the johannesburg stock exchange (jse), nasdaq index and the nikkei stock average (nikkei-225). in line with the purpose of this study, the sample period was the financial crisis (december 1, 2007-june 30, 2009) and covid-19 pandemic (january 1, 2020-december 31, 2021). the financial markets under consideration will be deemed liquid if the p-values in one or more regime are insignificant and vice versa. the section below highlights the findings of the markov switching garch model. 4. results and discussion the tables 3-8 highlight the findings of markov model. 4.1. stock market liquidity during the financial crises the tables above present the findings from the markov switching model. during the 2007-2008 global recession, some markets were still portraying signs of strong liquidity. this is evident in the cac, the dax, nikkei-225 and jse where the index price and volume relationship were insignificant (p-values more than 5%) in either regime 1 or regime 2. however, the nasdaq index showed strong signs of illiquidity due to the significant price-volume relationship (p-values less than 5%). these findings are in accordance with the basel committee on banking supervision (bcbs) (2013) which indicated that some banks and other financial institutions where still showing signs of strong liquidity despite the 2007-2008 global meltdown. this study extends the bcbs (2013) findings by adding that some financial markets were also showing signs of strong liquidity. 4.2. liquidity during the covid-19 pandemic the tables above present the findings from the markov switching model. during the 2007-2008 global recession, some enow: stock market liquidity during periods of distress and its implications: evidence from international financial markets international journal of economics and financial issues | vol 13 • issue 1 • 2023 5 markets were still portraying signs of strong liquidity. this is evident in the cac, the dax, nikkei-225 and jse where the index price and volume relationship were insignificant (p-values more than 5%) in either regime 1 or regime 2. however, the nasdaq index showed strong signs of illiquidity due to the significant price-volume relationship (p < 5%). these findings are in accordance with the basel committee on banking supervision (bcbs) (2013) which indicated that some banks and other financial institutions where still showing signs of strong liquidity despite the 2007-2008 global meltdown. this study extends the bcbs (2013) findings by adding that some financial markets were also showing signs of strong liquidity. with regards to the market liquidity results for the covid-19 pandemic in tables 6-8, the findings indicate otherwise. from these results, all the markets under consideration portrayed strong signs of illiquidity. this is evident in the significant relationship between price and trading volume (p < 5%). in other words, the daily volumes moved the corresponding market prices significantly implying that the financial markets under consideration lack market depth. it can therefore be observed that liquidity during periods of financial distress have been altered. this may be due to the increasing margin requirements where the margin requirements for market participants have increased significantly in the past 10 years. also, the level of market asymmetry has greatly increased which may be a contribution factor for decreasing liquidity. the level of margin requirement and information asymmetry are amplified during periods of financial distress hence a possible shift in liquidity in the 2007-2008 global crisis and covid-19 pandemic. 5. conclusion the aim of this study was to empirically investigate market liquidity during periods of financial distress. more specially, the 2007-2008 financial crises and the recent covid-19 pandemic. this study made use of the markov switching model which is very useful in regression analysis because it takes into consideration structural breaks. the findings of this study indicated that some markets where liquid in the 2007-2008 financial crisis. however, all the financial markets under consideration in this study were illiquid. from this results it can be concluded that liquidity in financial markets is gradually fading especially during times of financial distress. this sentiment was also expressed by berner (2015) who is of the opinion that liquidity is gradually shrinking notably during economic turbulence. according to furse (2015), there is 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(2007), market liquidity: definitions and implications. at the institute of international bankers annual washington conference, washington, d.c. available from: https://www. federalreserve.gov/newsevents/speech/warsh20070305a.htm [last accessed on 2022 oct 24]. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 52-58. international journal of economics and financial issues | vol 7 • issue 2 • 201752 theoretical and empirical studies of economic growth processes of agricultural production in russian federation marina yegorovna anokhina1*, galina mikhailovna zinchuk2, aleksandr vladimirovich butov3 1plekhanov russian university of economics, 36, stremyanny lane, moscow, 117997, russian federation, 2plekhanov russian university of economics, 36, stremyanny lane, moscow, 117997, russian federation, 3plekhanov russian university of economics, 36, stremyanny lane, moscow, 117997, russian federation. *email: marina_anokhina@mail.ru abstract based on the analysis of the economic growth theories, economic cyclicality and industrial markets the article presents a concept of economic growth of industrial complexes. the concept focuses on factors, determinators and conditions of economic growth and their causal relationships, the latter being additional driving force of economic dynamics of an industrial complex. the practical aspects of the designed concept are shown on the example of the russian agro-industrial complex (aic). with account for the limitations of the present conditions which do not help provide for the essential functions of aic as a subsystem of national economy, the authors identified the causes of insufficient economic dynamics of aic. on the basis of the designed concept of economic growth of industrial complexes there were made conclusions about necessity to create growth conditions which, with appropriate balance of factors and growth determinators, will ensure quantitative, qualitative and reproductive dynamics of agro-industrial production. there have been devised strategic initiatives on managing economic growth of agro-industrial production at the stage of building-up sustainable dynamics and new quality of aic growth. keywords: economic growth, agro-industrial complex of russian federation, agro-industrial complex jel classifications: j47, o14, q01, q18 1. introduction the issue of economic growth is particularly important for russia today in the view of complicated global economic and political situation. sustainability and dynamics of national economy provide the foundation for maintaining national sovereignty, increasing competitiveness of the economy and reaching a new quality level, reducing current social tension. to ensure effectiveness in building environment for sustainable development in the long-term perspective and addressing insufficient economic dynamics there should be high level of scientific validity and applicability of underlying methodological concepts. this stipulates the necessity to formulate conceptual framework aimed at ensuring economic growth and to formulate the concept of economic growth. the aim of the presented study was to design conceptual basis for the model of economic growth of industrial complexes taking into account the impact of factors and conditions ensuring quantitative, qualitative and reproductive changes. 2. methodology and methods of research economic growth of an industrial complex is understood as the process of its socio-economic development with quantitative, qualitative and reproductive changes in volume and content of created public good taken together and in conjunction with present and future consumer values. in accordance with the indicated three components of economic growth the authors believe it necessary to consider the existing theories and concepts aimed at addressing problems of economic growth which analyze factors and conditions explaining economic dynamics through the aforementioned parameters. with regard to both, special features of an industrial complex as a business unit for managing economic anokhina, et al.: theoretical and empirical studies of economic growth processes of agricultural production in russian federation international journal of economics and financial issues | vol 7 • issue 2 • 2017 53 growth and cyclical pattern of economic dynamics process, there was carried out the analysis of relevant theoretical publications and identified three main groups of theories: theories of economic growth, theories of economic cyclicality and theories of industrial markets. the methodological analysis showed that theories of economic growth are fundamental in identifying common denominators and factors of economic dynamics for industrial complexes. in formulating the concepts of economic growth of industrial complexes the authors found of uppermost relevance the theories of economic cyclicality as their particular aspects reflect core features of economic dynamics. the theories of industrial markets help account for industrial features of a unit of management as regard to framework conditions of economic management, market structure and behavior of economic agents. the authors believe that conceptual basis for the theory of economic growth of industrial complexes can be found in the synergy of these three groups of theories. the analyzed publications indicate that economic theory on scientific fundamentals of economic growth with a multitude of development research and concepts demonstrates a mismatch between a formidable body of theoretical facts and a limited number of methodological approaches which can help address the issues of economic dynamics. research and analysis of economic growth by classical economists laid foundation for the majority of growth models along the two main directions of economic theory: neokeynesian, focusing on a special role of investment demand in achieving dynamic equilibrium, and neoclassical, introducing operational aspect with labour and capital taken as factors of growth. the development of the growth theory was along the lines of endogenzing technological progress and saving ratio as the factors of economic dynamics. there was built an optimization version of neoclassical model with endogenized saving ratio. the latter was calculated in the process of maximization by economic agents of discounted utility of consumption. if before early 60s technological changes were considered as external force which determined economic dynamics, arrow (1962) developed the model where practically all technological advances measured as gross volume of investments were narrowed down to accumulated experience of employees. the model also accounted for positive influence of educational level. however, a number of empirical studies in those days, for example “horndale effect1,” clearly identified it as already employed capital good. following neoclassical tradition and enriching it with research on intangible capital, shell (1967) designed a model on the 1 during 15 years there was no investment in steel-works in horndale (sweden). production methods did not change much. however, the productivity calculated as output per employee per hour annually increased by around 2%. in arrow’s opinion it showed improvement of workers’ skills due to acquired experience. basis of methodology of a two-sector approach uzawa (1963) (breakdown into production and innovational sectors) and identified knowledge as a separate specific factor of production, specifying that its accumulation is in direct relation to economic growth rates. current international and national approach to studying issues in economic growth is characterized by two main directions: endogenizing growth factors and in depth analysis of technological progress impact on economic dynamics. analysis of the modern international research publications renders possible to identify two dominating economic growth theories: evolutionary and endogenic. the most well-known evolutionary model is that of nelson-winter. the authors used computer modeling to present their understanding of economic evolution and “…what happens at macro level and at more aggregated level” (nelson and winter, 2002). the model of nelson and winter allowed generating time series of all main parameters: factors of production, pay rates, gross revenue, labour capital ratio. the proposed model is very important for the theory of economic growth in terms of studying meso-economic processes that take place at industry and structure levels, but it has practical limitations being analytically nontransparent and technically complicated as it uses computer simulation. the models of technological diffusion also focused on the necessity to account for technical change impact on economic dynamics. the model of soete аnd turner (1984) helps find correlations between technological diffusion at micro-level and the speed of technological progress at macro-level. the model of metcalfe and gibbons (1989) reveals the role of innovational competition in ensuring economic growth. it is based on treating technological differences between businesses as determining factors of continuous change in their performance. theoretical models of endogenic growth are targeted at identifying behavioral and institutional parameters which ensure sustainability of long-term economic growth. the goals of empirical research in this direction were to determine additionally to standard economic variables (investment, capital, labor, etc.) potentially important political, demographic, social and other variables to be treated as growth determinators. the latter can include a formidable body of parameters, such as educational level, different aspects of state policy, trade policy and others. one of the most important early endogenic growth studies was the model of romer (1986) which substantiated the importance of knowledge for economic growth. romer made conclusions that there can be an increase in knowledge and it can prompt corresponding economic growth without state interference, but in order to reach optimal results there should be introduced a sound fiscal policy. in the further development of endogenic growth studies, which were called “research and development,” romer (1990) showed the dependence of economic growth on technical change based on investment and aimed at profit maximization. there was made an important conclusion that human capital determines economic growth rate. anokhina, et al.: theoretical and empirical studies of economic growth processes of agricultural production in russian federation international journal of economics and financial issues | vol 7 • issue 2 • 201754 the novel prize winner lukas in his seminal article “on the mechanics of economic development” (1988) presents economic growth model in which on the basis of the revealed short comings of neoclassical model of solow2, he refuses from exogenous view of technological progress and introduces the complementary parameter of “human capital” as the growth driver for technical change. lukas (2013) shows the importance of the increase in accumulation of physical and human capital for economic growth, but indicates that “accumulation of physical capital plays considerable, but clearly a subordinate role.” the issue of measuring human capital is very complicated and still unsolved. realizing that it is impossible to measure human capital directly, lukas introduces externalities or external factors of human capital which include new knowledge dissemination, on-the-job training and exchange of ideas. in general the described theories of economic growth are focused on identifying the key factors, their features and power in influencing economic dynamics. among the variety of factors practically all theories to a certain extent in different forms and with different parameters considered natural resources, labour resources and capital as growth factors. other quantitative and qualitative factors more numerous in number were identified depending on aims and object of research, applied methodology, tools of theoretical and empirical studies. such factors included technological progress, technologies, investments, innovations, organizational policy, training etc. this group of factors is flexible in terms of their composition and content due to multivariance and speed of change in economic environment. such characteristics are confirmed by conclusions drawn from the evaluation of evolutionary development of the growth theory. economic growth theory incorporates the methodology of describing economic cycles. in this respect the theories of economic growth and economic dynamics are closely connected through methodology, given that growth is the function of economic cycle. cyclicality in economic system is a process, caused by a breakdown in its equilibrium which happens periodically and is accompanied either by considerable expansion or by contraction of business activity in most economy sectors. we believe that in developing theoretical concepts of economic growth of industrial complexes the theories of economic cyclicality bear significant relevance as these theories identify the most important conditions which ensure sustainability, balance and irrevocability of progressive changes in the economic system. the main focus in the system of economic cycle theories is innovational. one of the first to substantiate innovations as a driving force of economic development and identifying long wave fluctuations as one of the forms of economic dynamics 2 lukas thinks, that the model of solow “per se is not an example of good theory of economic development: it cannot explain the observed differences between countries and categorically though mistakenly forecasts that the practice of international trade will very soon lead to convergence in capital-labour ratio in different countries and in factor values” (translated from 8. p. 60). when applying the concept of kondratiev cycles was schumpeter (1982). according to his theory irregularity in economic growth of economic system is caused by the processes of introducing innovations and the following recovering of equilibrium at a new technical and economic level. this approach but at a global level was applied by glazyev (1993) when he substantiated the theory of technological modes. with regard to the differences in understanding the causes of breaking equilibrium in economic system as the methodological basis for economic cycle theories, there can be identified a range of research approaches. among them there are the following the theory of over accumulation of capital (forrester, 2006), social concept (freeman, 1982), price theory (rostow, 1980), keysian and neokeysian theories (hansen, 1951; fisher, 1933; hicks, 1992). the examined theories of economic cyclicality within the context of the designed concept of industrial complex economic growth give grounds to conclusion that cyclical iterations in economic system are an objective process, but it can be directed. it should be noted that the economic theory has not been treating one industry or industrial complexes growth issues as a separate direction of economic thought. the issue of economic growth of an industry is a part of industry economy research where the general theories of economic dynamics are applied with account for industry features. however, to better address particular features of an industry when formulating the concept of industrial complex economic growth as a structural part of national economic system where economic agents aim at having economically beneficial relations, production feasibility, social significance and act in keeping with consumer needs, the authors refer to theories of industrial markets. taking into account the methodological proximity of these theories to microeconomics it is necessary to focus on such important aspects as elements of industrial markets analysis and system of state regulation of an industrial structure, which have direct bearing to offering solutions for ensuring economic growth at industrial complex level. as a subset of economic knowledge system there exist a range of theories of industrial markets that look into relations between economic agents at meso-level of the economic system. their methodological and theoretical rationale took off at the onset of market relations and developed conducting studies on market regulation with the aim to ensure their maximum effectiveness. the main provisions of the industry markets theory were laid down by american and european researchers on the basis of historical experience of using market mechanisms and corresponding object of research in the form of industrial markets. in international practice this research direction was named “industrial organization.” there have been different methodological approaches to industrial markets analysis. the main ones are those of harvard and chicago schools of economics. the followers of harvard’s approach considered state intervention necessary as the market itself is not capable to regulate the economic system. chicago school’s paradigm of industrial markets applied microeconomic models basing on price theory and regularities in optimal solutions, but not on objective characteristics of the industries. anokhina, et al.: theoretical and empirical studies of economic growth processes of agricultural production in russian federation international journal of economics and financial issues | vol 7 • issue 2 • 2017 55 to account for industrial features when formulating the concept of industrial complex economic growth the authors believe it necessary to integrate these two approaches for conducting industrial analysis. combination of systemic and microeconomic approaches to market analysis at the industry level will rend it possible to identify the mechanism which makes productive activity of the economic agents of the industrial complex more fully correspond to demand in goods and service. this will in the end ensure positive economic dynamics for both, economic agents and for the complex at large. thus, economic growth of an industrial complex as the process of socio-economic dynamics of the volume and content of the created public good will take place if there exist particular factors and conditions ensuring quantitative, qualitative and reproductive changes in the economic system. the present study was conducted on the basis of differentiating between notions of factors and conditions for economic growth. growth factors serve as the primary cause for changes in volume and content of public good and lay the foundation for socioeconomic development of an industrial complex as an economic agent. growth conditions are understood as an environment which determines opportunities for growth factors to function and consequently, affect the features and intrinsic characteristics of economic dynamics of an industrial complex. 3. results and discussion taking into account the multitude and variety of factors, their relative importance and in many cases causal interrelations, the results of the conducted study give grounds for conclusion that it is possible to differentiate them into basic and determining growth factors. the basic and essential growth factors are natural resources, labour resources and capital. the determining factors or growth determinators are investment, innovation, technology, entrepreneurship, technological progress, education and training, organizational policy which provide for the reproduction and effectiveness of the basic factors. the more accessible, adequate and efficient the determinators are, the wider will be the opportunities for raising efficiency of growth factors ensuring quantitative, qualitative and reproductive dynamics of the economic system. the efficiency of both groups of growth factors depends on the existing environment or growth conditions, including economic, organizational, institutional, social, legal, cultural ones. close interaction and causal relations between basic growth factors, determinators and conditions indicate the necessity to specify them in conjunction with the features of a particular industrial complex. the present research was carried out on the analysis of the rf agro-industrial complex (aic) for which the causal relationships between the identified parameters of economic growth can be presented in the diagram (figure 1). the higher the extent of adequacy of the economic conditions to the characteristics, content and combination of the growth determinators, the more substantial will be the impact of the latter on growth factors, which in turn determine quantitative, qualitative and reproductive dynamics of the aic. at present the lack of balance between economic growth parameters is the reason for low economic dynamics of the russian aic which does not help maintain its core functions as a subsystem of national economy. having considerable potential in terms of basic growth factors the economic dynamics is negatively affected by inadequate growth determinators not corresponding to the present requirements of agro-industrial production. this misbalance is the result of existing growth conditions which do not allow reaching the appropriate level and correlation between growth factors and determinators for aic dynamics (table 1). the quantitative dynamics is characterized by the positive trend in the indicators which the existing agrarian policy considers the key ones. they include the following: agricultural output in monetary terms, availability of basic capital funds and grain production being the basis for export constituent of the economic policy. however, the indicators which determine the level of food security and are the basis for achieving it show negative dynamics. it can be seen that the number of employed in the agriculture has considerably lowered, there were reductions in the cattle population, no real positive dynamics in milk production and planted acreage. the qualitative dynamics shows the existing trends in agriculture. it is evident that there are no conditions for intensive development of agricultural production (reduced power supply capacity, increase in load per machinery), which causes decrease in dynamics or low rate of positive dynamics for indicators of grain yield, productivity and efficiency. the reproductive dynamics clearly shows that the existing approach and economic system cannot provide sustainable economic growth of agro-industrial production. lack of internal funds, insufficient budgetary funding, high level of liabilities of the agricultural producers cannot ensure required technical and technological level of production, or increase soil productivity, or maintain and develop strategic resources. increase in investment alone cannot be considered a sufficient condition for reproduction. it should be also noted that most investment funds are used for purchasing foreign machinery and technologies, while practically nothing is being done to create one’s own capital base for reproduction. in general, the assessment of the dynamics of even a limited part of the parameters shows the weakening of the reproductive component of economic growth, if compared to conduct with foreign countries (table 2) in which the development and support of agrarian sector is considered as a basis of national policy, the need to change the approach to the management of economic growth of aic of the russian federation even more becomes apparent. to evaluate the rate of change in the parameters of economic growth (figure 2) the set of statistical indicators of the aic performance over the period from 2005 to 2014 (official site of the federal state statistics service)was divided into three blocks(anokhina, 2016): • indicators of quantitative dynamics; • indicators of qualitative dynamics; • indicators of reproductive dynamics. anokhina, et al.: theoretical and empirical studies of economic growth processes of agricultural production in russian federation international journal of economics and financial issues | vol 7 • issue 2 • 201756 to estimate a complex index for each block there was done a calculation of relative indicators (normalization of data).  = ∈ ∈             f f if i m f f if i m u o o u , _ , _ 1 2 (1), where, fu value of the indicator included in the corresponding block; δ relative value; fo optimal (standard) value of i ed indicator. it should be noted that when standard value cannot be plotted, the received value of the indicator over the studied period is assumed. the optimal value is assumed to equal maximum value if the factor under study is characterized by the positive growth trend (м1 – stimulating agent). the optimal value is assumed to equal minimum value if for the factor under study the positive growth trend is characterized by decrease (м2 – de-stimulating agent). for stimulating agents there was used the following formula: ( ) ( ) min max min x x x x ij j j j − − (2) for de-stimulating agents there was used the following formula: 1− ( ) ( ) min max min x x x x ij j j j − − (3) where, x x i mj ij max max ( );= ≤ ≤1 x x i mj ij min min ( );= ≤ ≤1 the resulting complex indicator is the sum total of normalized values of the indicators included in the corresponding block. whilst analysing the received data one should account for the consistent pattern of nonequivalent impact of quantatitive, qualitative and reproductive changes on the overall economic figure 1: causal relations between parameters of agro-industrial complex economic growth figure 2: dynamics of the complex indicators of the rf aig economic growth anokhina, et al.: theoretical and empirical studies of economic growth processes of agricultural production in russian federation international journal of economics and financial issues | vol 7 • issue 2 • 2017 57 dynamics of the aig over the period. the quantatitive changes are more dependent on extensive growth factors, whereas qualitative and reproductive changes require more costly intensive activities. the results of the latter can be seen as a rule only with time. quite explicit is the link between the qualitative and reproductive changes and the social development pathway of the industrial complex, it being anintrinsic component of the balanced and sustainable growth. overall, over the recent decade the growth of reproductive changes has been more intensive. this positive dynamics stipulated the capability for the aic to function and to build a foundation for its moderate growth under present conditions. however, during the period from 2010 to 2014 the correlation between complex parameters of aig economic growth changed with quantitative growth of 53%, qualitativegrowth of 46.7%, reproductive growth of 48.5%. this will definitely not lead to building up thefoundation for aic development, it already poses a threat for addressing acute agrarian issues in the country. in order to reach tangible results in the agriculture it is necessary to shift the priorities in the agrarian policy and to change from micromanagement to systemic approach in managing aic economic growth. in accordance with basic managerial principles the process of managing aic economic growth must be well structured. the stages of the process should reflect the chosen priorities in the table 1: key indicators of aic economic dynamics indicators 2000 2005 2010 2012 2013 2014 2015 quantitative dynamics agricultural output in current prices, billion rubles 742.4 1500.9 2855.5 3561.5 3687.1 4319.1 5165.7 gross yield of grain, million tonnes 65.4 77.8 61 70.9 92.4 105.3 104.8 milk production, milliontonnes 32.3 31.1 31.8 31.8 30.5 30.8 30.8 annual average of those employed in agriculture, million people 8.4 6.7 6.1 5.9 5.8 5.6 5.4 planted acreage, thousand hectares 84,670 75,837 75,188 76,325 78,057 78,525 79,319 cattle population, million cattle 27.5 21.6 20 20 19.5 19.3 18.9 change in availability of capital funds (in comparable prices), % to the previous year 97.1 97.9 101.2 101.6 102.2 101.9 101.7 qualitative dynamics productivity rate (in percentages to the previous year), % n/a 101.8 88.3 98.2 106.0 102.9 103.8 profit per one employed in agriculture, in thousand rubles 3.1 8.21 18.08 27.05 22.87 46.85 61.23 loss per one employed in agriculture, in thousand rubles 2.37 3.36 7.05 4.96 12.37 14.52 9.36 crop yield of cereal and grain legume crops, in hundred kilograms per hectare 15.6 18.5 18.3 18.3 22.0 24.1 23.7 milk yield per cow, in kg 2502 3176 3776 3898 3893 4021 4134 ground load per tractor, in hectare 135 181 236 258 274 289 307 power capacity per hectare of planted acreage, in horsepower 3.29 2.7 2.27 2.11 2.01 2.01 1.97 reproductive dynamics volume of budgetary funds per hectare of planted acreage, in thousand rubles 0.14 0.25 1.79 1.8 2.26 2.00 2.8 liabilities of agricultural organizations per a ruble profit, in rubles 8.78 7.96 13.45 11.89 1557 8.36 7.64 fixed capital investments (in comparable prices), % to the previous year 104.9 110.6 88.8 101.7 106.6 94.8 90.4 applied mineral fertilizers per hectare of planted acreage, in kg 19 25 38 38 38 40 42 ratio of monthly average nominal wages in agriculture to national average, % 40.0 43.0 51.0 53.0 52.2 54.0 57.9 number of general educational institutions in rural areas, in thousands 45.4 40.7 30.6 27.4 26.4 26.1 26.0 putting into service motor roads for general use in rural areas, km 5626 1790 1482 1735 1995 1573 2047 source: official site of the federal state statistics service (http://www.gks.ru/wps/wcm/connect/rosstat_main/rosstat/ru/statistics/publications/catalog/). aic: agro-industrial complex table 2: comparison of parameters of economic dynamics agro-industrial complex of the russian federation and foreign countries indicators russian federation belarus germany france netherlands united states canada turkey the area of agricultural land per 100 people, ha 153↓ 92 21 45↓ 11 129↓ 180↓ 51↓ grain yield, с/ha 24.4↑ 37.2↑ 80.5↑ 58.29↓ 90.74↑ 76.4↑ 36.7↑ 31.2↑ the number of cattle, million goal 19.6↓ 4.4↑ 12.6↓ 19.1↓ 3.9↓ 92.7↓ 12.2↓ 14.1↑ milk yield per one cow, kg 3851↑ 4482↑ 7236↑ 6674↑ 7537↑ 9678↑ 8699↑ 2970↑ applied fertiliser per hectare, kg 15.2↓ 255.7↓ 203.5↑ 140.6↓ 231.1↓ 131.9↑ 88.3↑ 113.5↑ сombine harvesters per 1.000 ha of arable land and land under perennial crops 0.7↓ 2.02↓ 7.8↓ 4.07↓ 7.08↑ 2.11↓ 1.66↓ 4.13↑ agricultural machinery, tractors per 1.000ha of arable land 3.3↓ 8.38↓ 92.54↓ 59.89↓ 126.53↓ 26.69↑ 14.51↑ 67.96↑ agriculture value added per worker (constant 2010 us$) 11593↑ 15814↑ 43327↑ 95420↑ 78141↑ 78224↑ 82512↑ 9792↑ source: faostat. url: http://www.fao.org/countryprofiles/ru, world bank group. url: http://data.worldbank.org/indicator/ea.prd.agri.kd, official site of the federal state statistics service (http://www.gks.ru/wps/wcm/connect/rosstat_main/rosstat/ru/statistics/publications/catalog/). the arrow is a general trend in the changes over the last 5 years anokhina, et al.: theoretical and empirical studies of economic growth processes of agricultural production in russian federation international journal of economics and financial issues | vol 7 • issue 2 • 201758 agrarian policy, overall aims of the national economy and the availability of corresponding resources. with regard to both, the importance of ensuring aic economic growth for national economy under present conditions and with state commitment to develop industrial complex, there can be identified two stages: the first one–to ensure the reproductive growth; the second one–to reach a new quality level of growth for the agro-industrial production. at the first stage of ensuring reproductive growth the main objective is to achieve sustainable long-term dynamics of aic which entails achieving the following goals: to provide the country with food staples, to retain the core rural lifestyle pattern, to minimize disproportions in the structural industrial setup. the formation of reproductive economic growth of the aic can be done on the basis of the following strategic initiatives: 1. to design the system of agro-industrial production deployment. 2. to develop the aic social pathway. 3. to increase the level of agro-industrial production intensification. 4. to increase profitability levels of the agricultural producers. 5. to stimulate the internal market of food distribution channels. 6. to develop the infrastructure of agrarian markets. 7. to develop agrarian education and to reestablish agrarian science. the management of the aic economic growth at the stage of reaching its new quality level should be linked to the development of the agriculture as a strategic industry of the national economy, which ensures a considerable agro-export potential of the countryexporter of food products with high added value. this stage involves complete changeover to a new paradigm of production based on the advanced technologies, on cutting-edge informational and communication technologies, on creating attractive image of aic as an area of economic activity; on the development of educational and scientific model to sustain the demand for knowledge as the key to retain important positions on the world food markets. at the stage of reaching a new quality level of aic economic growth there should be implemented the following strategic initiatives: 1. to ensure that the rural lifestyle is perceived as the core system of the society which spurs the overall progress in the national economy. 2. to reach a high level of ecological safety for agro-industrial products. 3. to develop sustainable agrarian economy resistant to climatic changes. 4. to develop ecosystems interrelated with agriculture. 5. to transfer to highly technological pattern of agro-industrial production. implementation of strategic initiatives at the stage of ensuring reproductive growth of the agro-industrial production creates the foundation for building new quality of the economic growth and on condition of successful realization of the corresponding strategic initiatives leads to reaching such levels of economic dynamics that will make it possible for russia to become the world supplier of the high-level processed foods. putting into practice the proposed strategic initiatives requires the dominating role of the state in managing the processes of aic economic dynamics with the appropriate set of legal and administrative mechanisms. 4. acknowledgments the authors are expressing their gratitude to russian foundation for basic research (rfbr) for their financial support for the present research (grant № 16-02-00030). references anokhina, m.y. 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(1967), a model of inventive activity and capital accumulation. essays on the theory of optimal economic growth. cambridge, massachusetts: mit press. p67-85. available from: http://www. dklevine.com/archive/refs41409.pdf. soete, l., turner, r. (1984), technology diffusion and the rate of technical change. the economic journal, 94, 612-623. uzawa, h. (1963), on a two-sector model of economic growth ii. review of economic studies, 30, 105-118. . international journal of economics and financial issues | vol 6 • special issue (s7) • 201686 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s7) 86-91. special issue for "international soft science conference (issc 2016), 11-13 april 2016, universiti utara malaysia, malaysia” performance of youth entreprenuers in malaysia micro small and medium enterprises shazida jan mohd khan1*, nur syamilah md. noor2, abdul rahim anuar3 1school of economics, finance and banking, college of business, universiti utara malaysia, 06010 sintok, kedah, malaysia, 2school of international studies, universiti utara malaysia, 06010 sintok, kedah, malaysia, 3school of international studies, universiti utara malaysia, 06010 sintok, kedah, malaysia. *email: sjmohd@uum.edu.my abstract this study aim to look on the role of government policy, infrastructure, and business support facility towards the performance of youth entrepreneurs involved in micro small and medium enterprises (smes) in malaysia. entrepreneurship development calls for support from various quarters and primarily the need exists to initiate a youth entrepreneurship culture and drive amongst the youth in the society. the study adopts a quantitative approach whereby a questionnaire survey was used to gather data. seemingly unrelated regression was chosen as a method of analysis and the result of this study is expected to give insight into the existing government policy, infrastructure, and business support facility while assisting in formulation policies for the development of youth entrepreneur specifically involved in micro smes. keywords: youth entrepreneur, micro small and medium enterprises, infrastructure facility, business support facility, government policy jel classifications: l2, l26 1. youth entrepreneurship and micro small and medium enterprises (smes) youth entrepreneurship figures prominently in the development agendas of many developing countries including malaysia. youth constitute a resource of great potential and can contribute significantly to the development of the country. the ability to harness their potential will helps to determine malaysia strength and resilience in pursuing social, economic and political development. most government and local communities across the world have identified entrepreneurship as the key to build prosperity and stimulate regional growth especially among youth. youth entrepreneurship has become a topic of interest for research scholars and also a subject of major concern. recently malaysian governments encourage youth moving towards self-employment as part of the measure taken to overcome the issues of unemployment. current uncertainties in global market demand and economic crisis situations have led to the need for any society or its communities at large to find opportunities in self-employment, including by the youths (chigunta, 2002; schoof, 2006). as for the malaysia government, the importance of fostering the entrepreneurs especially among youth is clearly stated in the malaysia 10th and 11th plan. promoting youth entrepreneurship will not only help in reducing unemployment but more importantly make young people understand that they have alternatives to create their own destiny by starting their own companies and they need not keep waiting to get a job. in malaysia, the age for youth is defined as those between 15 and 40-year-old but the main focus of development programs in the country are for those aged of 18-25. table 1 show the definition of smes in malaysia. this study will only focus on the involvement of youth as entrepreneur in micro smes. according to institute of youth research malaysia, in 2014 youth population in malaysia for aged between 15 and 30 years are 9.1 million that represent 30% of the population. there is a khan, et al.: performance of youth entreprenuers in malaysia micro small and medium enterprises international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 87 significant demand of becoming entrepreneurs among youth. a study by the institute of youth development research malaysia on youth index scores of 4673 of malaysia youth, the youths are found to have a relatively high score of 68.6 in 2011 and have increased significantly from the score of 51.6 in 2006 to 63.3 in 2008. youth were currently resource of tremendous potential which can be expanded through developing youth entrepreneurs. definition of youth entrepreneurship demonstrates their capability where the practical application of enterprising qualities such as initiative, innovation, creativity, and risk-taking into the work environment (either self-employment or employment in small start-up firms), using the appropriate skills necessary for success in that environment and culture. these qualities are crucial for competitiveness because new entrepreneurial initiatives raise the productivity level, increase competitive pressure, and encourage innovation. malaysia has been able to nurture youth entrepreneurship through the smes programs. smes is one of the important contributor to the development in malaysia. the census of establishments and enterprises 2005 indicates that 99.2% or 518,996 of business establishments are smes, of which 411,849 are micro enterprises. most of these smes are in the services sector, particularly in retail, restaurant and wholesale businesses. total employment in the smes accounted for more than 3 million workers, and generated rm154 billion value-added in 2003. the economic census 2011 stated that profile of smes identify 97.3% (645,136) business establishments in the country are smes. these two studies have showed the significant changes in the numbers of smes development in malaysia which indicate the growing interest of these enterprises. at the same time, according to malaysia 11th plan, smes will be given a special focus as they made up 98.5% of total establishments and 59% of total employment in the economy in 2015. malaysia has increased the participation of providing programs and fund towards developing the smes. during the 10th plan, regional economic corridors also have provided several initiatives to uplift the lives of communities in surrounding areas. over the years, malaysia government has attributes to a number of supports programs to the smes sector. these includes the involvement of several government agencies, at both the federal and state levels, providing variety of programs to smes sector in achieving sustainable levels of growth and development. according to past literature these programs focuses mostly on financial and credit assistance, technical and training assistance, extension and advisory services, marketing and market research, and infrastructure supports (abdullah, 1999; daisy et al., 2011). these programs have assist smes through providing management expertise, land/building facilities, and information about the market and tax deduction (hashim et al., 2003). summary for the agencies that involved encouraging smes’s entrepreneurs is showed in table 2. 2. literature review on the whole, the past literatures have discussed similar problems facing smes, namely financing, human resources, information technology (it), managerial inefficiency, bureaucracy, market accessibility and competition. similar problems and challenges also been identified in other countries such as india and africa. the trade india newsletter (2007) reported among the challenges that smes in india faced were technological backwardness, poor financial conditions, and low levels of research and design, poor adaptability to changing trade trends, non-availability of technically trained human resources, lack of management skills, lack of access to technological information and lack of consultancy services. whereas in many firms in africa operate in an information-poor environment due to lack of adequate business support services and the poor information technological infrastructures (oshikoya and hussain, 2007). access to information has however not been given the same attention as other constraints to growth of smes like access to finance, markets, technology or training. 2.1. performance business performance can be explain in term of financial as return on investment (profit), return on assets (roas), net sales, net income and the present value of the firm. besides that, nonfinancial aspects of performance are about surviving in the market (competition) such as the number of new employees, the number of new store opened, and the number of new products introduced (blythe, 1992). according to business development of canada, bdc (2015), performance also will be recognized using efficiency ratio often measured over a 3-5 years period, these give additional insight into areas of your business such as collections, cash flow, and operational results. in other hand, according to ge capital, america (2015), performance was be measured by strategic planning team to develop more specific execution targets. for example, management might decide on a 1-year goal of raising table 1: smes definition in malaysia smes category micro small medium manufacturing sales turnover of less than rm300,000 or full-time employees<5 sales turnover from rm300,000 to less than rm15 million or full-time employees from 5 to<75 sales turnover from rm15 million to not exceeding rm50 million or full-time employees from 75 to not exceeding 200 services and other sectors sales turnover from rm300,000 to less than rm3 million or full-time employees from 5 to<3 sales turnover from rm3 million to not exceeding rm20 million or full-time employees from 30 to not exceeding 75 source: circular on new definition of smes, 2013. sme: small and medium enterprises khan, et al.: performance of youth entreprenuers in malaysia micro small and medium enterprises international journal of economics and financial issues | vol 6 • special issue (s7) • 201688 yearly sales growth from 3% to 5%. from that goal, the strategic planning team would develop more specific execution targets. in order to boost overall sales growth, a goal for one division might be to increase sales by 6% in the coming year. however, according to randoy and goel (2003) on their observations from several company of small medium enterprises during the period of 1996-1998, performance of the company is related to entrepreneur himself is positive as well as significant on company performance, which means that better monitoring by the managers will increases shareholders’ value. 2.2. business support program as an entrepreneur, they can’t express the support needed to meet support programme provided because the need is difference according to business field. therefore, policy makers and program administrators should ensuring that support programs meet the needs of entrepreneurs such as entrepreneur satisfaction; impact of the support to business performance and the support can be assist to measures of growth in sales, employment and profitability. a study by juita-elena (2010) on assistance programs found that it is important for who working to create an operating new business. however, entrepreneurs are many failing to avoid the risk and the difficulties in challenges of the start-up process. the reality of a new entrepreneurs and their start-up organizations need the right estimate capital and sources of capital, and the also need often look for external guidance and assistance to support their business. according to past study, support programme can positively impact the performance of smes as suggested (stevenson and sahlman, 1988; juita-elena, 2010). they also stated entrepreneurs who want to involve in support programs need to sacrifice money and other resource commitments for sponsors and service providers. in term of time, they need to spend the time to participate the training. therefore, the effectiveness of support programme can be measured by the performance after their received the support programme by the agency. 2.3. infrastructure facility through many government support programmes, smes have been allocated various information and communication technologies funds to assist them to adopt it. this is because information communication and technology (ict) is considered as important infrastructure facility to bring up the competitive level of smes in business arena. according to selamat et al. (2011), his study found ict are expected to contribute to a better theoretical understanding of the factors that promote ict usage among the smes and answer the objective of the study to examine the awareness level of ict and factors that may affect the adoption of ict among smes in malaysia. it is because is found to play an important role for any organization. the use of ict that range from mainframe to personal computers, from word processing to sophisticated application and systems can provide a wide variety of benefits to different organization. 2.4. government policy government support policies can be assumed as the lead for entrepreneurial development, it should provide the much needed resources according to its capabilities. the policy is about the support include provision of environment conducive to business that will highly promote entrepreneurship. the supports in the government policy such as aims at regulating and improving the conditions of smes in terms of supportive, implementation and funding policies by the government (nkem and mercy, 2014). in addition, the past study (mason and brown, 2011; nkem and mercy, 2014) also emphasize the importance of government policy as a support to entrepreneurs in their business performance. although most of these studies have discussed almost similar problems, they have only examined smes as a single unit of analysis. the study analyses the relationship of business support program, infrastructure facility and government policy with the performance of youth entrepreneurs that involved in micro smes within their 3 years table 2: support program by the agency agency support program aim • provide financial, guidance and training to the entrepreneurs of poor and low-income families. aim provides the capital financing, compulsory savings and welfare fund to achieve the objective mara • conducting entrepreneurship training to produce global entrepreneurs • develop technopreneurs in the fields of high technology through a strategic partnership of cooperation • provide business advisory services to strengthen and increase the capacity of entrepreneurs and businesses and meet the needs of global standards • providing integrated marketing program to penetrate the global market • establishing a strategic network for holistic entrepreneurship development tekun • providing microfinance and entrepreneurship development support punb • provide opportunities to bumiputera entrepreneurs achieving business success through the provisions of financial and corporate support mavcap • invest in small companies with the potential to succeed mtdc • provide opportunities for new generation of technopreneurs through comprehensive nurturing services that support them all the way from laboratory ideas to full commercialisation mdv • provide innovative, flexible financing solutions and specialized funding programs for smes • provide industry expertise and advisory services mdec • create an ideal and conducive platform to nurture malaysian smes in the ict sector, to become world-class businesses whilst attracting participation from global ict companies to invest in and develop cutting edge digital and creative solutions in malaysia source: gathered information by the author. aim: amanah ikhtiar malaysia, mara: majlis amanah rakyat, tekun: tabung ekonomi kumpulan usaha niaga, punb: perbadanan usahawan nasional berhad, mavcap: malaysia venture capital management berhad, mtdc: malaysia technology development corporation, mdv: malaysia debt ventures berhad, mdec: multimedia development corporation, ict: information communication and technology khan, et al.: performance of youth entreprenuers in malaysia micro small and medium enterprises international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 89 of operating the business. the analysis will employs seemingly unrelated regression (sur) model to estimate the impact focusing on their performance in sales, competition and their profit. 3. data and methodology the analyzed micro smes were obtained from malaysia department of statistics database that provides entrepreneur characteristics and their business profile. a random sample was distributed to 14 states as a sampling population that includes a micro-enterprise only inclusive of 438 respondents. 3.1. descriptive analysis table 3 describes the aspects of the entrepreneur characteristics include gender, age, ethnicity, and level of education. in malaysia, the age for youth is defined as those between 15 and 40-year-old but the main focus of development programs in the country are for those ages of 18-25. the youth entrepreneurs studied were mainly local malays. a majority (54.1%) of the selected entrepreneurs were of malay ethnicity while the remaining youths were of chinese ethnicity (39.5%) followed by the indians (2.5%) and others that represent the small group different ethnicity especially in the area in sabah and sarawak (3.9%). the level of education was low among the respondents for the study. their educations qualifications are only limited to secondary schools. the success of smes is closely connected to education level (staw, 1991; meng and liang, 1996) beside other factor such as age, political environment, government, infrastructure, technology, etc. several other factors (information, financing and institutional support) were also identified that have preventing smes to work at their full potential. however a number of program and support were given by the malaysian government agencies through the government business support services in providing guide to suit the current needs of the smes and business environment. among agencies involved are as discussed in table 2. the contributions of these agencies are well recognized and have great impacts on the smes growth. in terms of gender, 56.6% of the respondents were male and only 43.4% are women. table 4 provides their business profile. majority of the respondents (49.3%, n = 511) owned businesses that were <5 years and 49.3% of the operated more than 5 years (49.3%). the common types of the businesses were in the services sector (83.1%) with a business status of sole proprietorships (72.1%). 3.2. estimation methodology sur was chosen as the method of analysis. sur permits equation coefficients and variance to differ, and also allows for contemporaneous correlation between the errors (lukianchuk, 2015. p. 416). it is a very useful technique in this study as it allows to run three regressions with different independent variables: model of sales growth as a dependent variable: sg = β0 + β1 infrastucture facility + β2 business support facility + β3 government policy + age = gender + education + εsg (1) model of profit as a dependent variable: profit = β0 + β1 infrastucture facility + β2 business support facility + β3 government policy + age + gender + education + εprofit (2) model of competition as a dependent variable: compt = β0 + β1 infrastructure facility + β2 business support facility + β3 government policy + age = gender + education + εcompt (3) where, 1. the “profit within 3 years of business operation” is influenced by infrastructure facility (i.e., basic utility infrastructure such as electricity, water and it facility), business support facility (i.e., entrepreneurship program by government agencies, management expertise) and government policy (i.e., information about the market, rules and regulations information and tax information) 2. the “performance in sales” is influenced by infrastructure facility (i.e., basic utility infrastructure such as electricity, water and it facility), business support facility (i.e., entrepreneurship program by government agencies, management expertise) and table 3: entrepreneur characteristic characteristics category frequency n=438 (%) gender male 248 (56.6) female 190 (43.4) ethnicity malay 237 (54.1) chinese 173 (39.5) indian 11 (2.5) others 17 (3.9) education background off school 4 (0.9) primary/upsr 7 (1.6) pmr/srp or equivalent 12 (2.7) spm and equivalent 224 (51.1) stpm/and equivalent 29 (6.6) certification 27 (6.2) diploma 74 (16.9) bachelor 57 (13.0) postgraduate 2 (0.5) others 2 (0.5) spm: sijil pelajaran malaysia, stpm: sijil tinggi persekolahan malaysia, upsr: ujian penilaian sekolah rendah table 4: business profile characteristics category frequency n=438 (%) establishment less 5 years 222 (50.7) 5 years and above 216 (49.3) business sector by dos services 364 (83.1) manufacturing 49 (11.2) construction 15 (3.4) agriculture 9 (2.1) environment 1 (0.2) business status sole proprietorships 316 (72.15) partnership 38 (8.68) limited company 83 (18.95) others 1 (0.23) khan, et al.: performance of youth entreprenuers in malaysia micro small and medium enterprises international journal of economics and financial issues | vol 6 • special issue (s7) • 201690 government policy (i.e., information about the market, rules and regulations information and tax information) 3. the “competition” among entrepreneur of micro smes is influenced by infrastructure facility (i.e., basic utility infrastructure such as electricity, water and it facility), business support facility (i.e., entrepreneurship program by government agencies, management expertise) and government policy (i.e., information about the market, rules and regulations information and tax information). age, gender and education were treated as the control variables. 3.3. estimation results having performed collinearity diagnostics (table 5), they are all <10 and our mean variance inflation factor is only 1.15. hence, we may experience a certain degree of multicollinearity in our analysis but it will not bring serious noise to our results. the breusch–pagan tests of serial independence between the residuals for each sur regression are reported at the bottom of table 6. results show that the chi-square estimates are significant at 1% level for all set of equations. this demonstrates that the residuals within each sur system are not independent and therefore that sur is an appropriate technique. the results in table 7 shows that infrastructure facility, business support facility and government policy has a significant and positive affect on the performance of micro smes. basic utility infrastructure such as electricity, water, communication and it is importance in assuring the success of smes. the usage of infrastructure facility such as it in smes is crucial as this became part of their marketing strategy in promoting services and products. smes that take this advantage in it have made their business more mobile and transferable which allow for promoting technology, source and knowledge transfer. over the years, the government business support program have worked closely along the government policies and experienced a number of transformations to suit the current needs of the smes and business environment. this finding were supported by numbers of previous study that significantly showed the essentials of government support to smes (saleh and ndubisi, 2006; jianzhong and hong, 2009; schaper and volery, 2004) therefore, the contribution of the present study not only provides the insight into the performance of micro smes, but also divulges on how the government support program is perceived by micro smes and affect the performance. however, the limitation in the survey questions unable to identify how many people from the respondent received and utilized government support facility. the results indicate that the program has significantly have impact on their performance on sales and competition. this may reflect the program setup by the government in given courses on how to increase sales and to face competition in the market. the performance of micro smes is positive and significantly affect by the government policy which include dissemination of information about the market, rules and regulations information and taxation information. however the results unable to identify key challenges that occur since the study do not categorized the challenges individually. malaysian smes face many other challenges that have been highlighted by many previous literatures including lack of government policy (apec survey, 1994; smi development plan, 2001-2005 [smidec, 2002]; ting, 2004; and ups, 2005). infrastructure facility is also found to be significant in assuring the performance in sales and competition. it also shows significant towards profit. table 2 describes some of the effort by the malaysia government in providing support to smes. for example, the smidec/sme corporation malaysia (sme corp. malaysia) provides infrastructure facilities, financial assistance, advisory services, market access and other support programs. the final aim was to develop capable and resilient malaysian smes to become competitive in the global market. the overall results have confirmed that malaysia has provided impressive platform for micro smes to develop. however, in table 5: collinearity diagnostics variables vif square root vif tolerance (1/vif) r2 profit 1.17 1.08 0.85 0.15 infrastructure facility 1.31 1.15 0.76 0.24 business facility 1.12 1.06 0.89 0.11 government support 1.34 1.16 0.75 0.25 age 1.06 1.03 0.95 0.05 gender 1.03 1.01 0.97 0.03 education 1.03 1.01 0.97 0.03 mean vif 1.15 vif: variance inflation factor table 6: correlation matrix of residuals variables profit sales competition profit b44 1 sales b45 0.7721 1 competition bb46 0.6411 0.775 1 breusch–pagan test of independence: chi-square (3)=704.205, p=0.000 table 7: results of the estimation: sur variables profit sales competition infrastructure facility 0.253** (0.405) 0.333*** (0.477) 0.263** (0.421) business support program 0.044 (0.121) 0.0782* (0.151) 0.087* (0.168) government policy 0.412*** (0.565) 0.415*** (0.559) 0.403*** (0.561) age 0.026 (0.169) 0.025 (0.160) −0.065 (0.083) education background −0.028 (0.25) 0.017 (0.068) 0.018 (0.074) gender 0.059 (0.246) 0.143 (0.321) 0.066 (0.261) constant 1.005* (1.941) 0.115 (0.999) 0.735 (1.707) *p<0.05; **p<0.01; ***p<0.001; bracket ( ) show standard errors. sur: seemingly unrelated regression khan, et al.: performance of youth entreprenuers in malaysia micro small and medium enterprises international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 91 spite of all the effort, smes are still facing heaps of challenges and obstacles that deter them from further expanding their businesses and sustainable growth. this study provides the review of the current programs and allow for further study to be taken in the future to look on these other challenges, identify and provide solution. 4. conclusions micro smes has grown and play a vital role in malaysia economic development. concentration and attention of research on micro smes should be intensified as there is lack of literature in malaysia that concentrated on the study of micro smes especially involving the youth group. the finding clearly supported the argument that the performance of micro smes in malaysia is very much affected by the condition of infrastructure facility (i.e., basic utility infrastructure such as electricity, water and it facility), business support facility (i.e., entrepreneurship program by government agencies, management expertise) and government policy (i.e. information about the market, rules and regulations information and tax information). further research may look on the individual factor of each in order to enhance the existing program and supported program by the government. 5. acknowledgments the author likes to thank niche research grant scheme for providing funding to do the study on talent development and youth entrepreneurship. references abdullah, m.a. 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(2004), smes in malaysia: pivot points for change. available from: http://www.mca.org.my. united parcel services, ups, 2005. ups reveals asia business monitor survey findings. available from: http://www.ups.com. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 112-120. international journal of economics and financial issues | vol 13 • issue 1 • 2023112 analysing the factors affecting the long-term investment intention of investors suné ferreira-schenk, zandri dickason-koekemoer* north-west university, south africa. *email: 20800274@nwu.ac.za received: 22 september 2022 accepted: 11 december 2022 doi: https://doi.org/10.32479/ijefi.13640 abstract the intention of investors to invest over a long term is generally aimed toward stable returns and low liquidity. the framework of this article looks at the theoretical concepts, investor characteristics and investor bias in a risk profile that could influence investors’ intent to invest over the long term. based on traditional investment theory, investment companies acknowledge the impact of risk tolerance on the desired investment horizon of investors. however, traditional risk assessments are limited since they omit variables like personality measures and behavioural finance biases which could affect an investor’s long-term investment intentions. the unfavourable results might be less accurate investor profiles and an investment portfolio not meeting the required return objective. this study included a sample size of 593 private investors. the results indicated that personality traits (extraversion, openness to experience), risk tolerance, and behavioural biases (overconfidence bias) significantly influence long-term investment intentions. by incorporating the above-mentioned factors, financial planners and institutions can more accurately profile their clients and offer financial products that are more suitable for the investor’s needs. keywords: behavioural finance, portfolio management, investment intentions, personality traits; risk tolerance jel classification: a14, g11, g41 1. introduction baker and ricciardi (2015) emphasised that a traditional risk profile includes various subjective and objective factors which ultimately impact the decisions of clients regarding financial products and investment services. these traditional risk profiles include demographics, the lifecycle of the investor, liquidity needs, desired investment time horizon and risk tolerance levels. however, the question is what characteristics does a long-term investor have? according to pompian (2012) and praja et al. (2020), long-term investing is dependent on individual investor characteristics and investor bias. theory elucidates that, investor decision-making, primarily appertaining focuses on age, net worth and risk tolerance, as the investor’s circumstances and resources continuously change over time (goodall, 2005; harty, 2014; kellerman, 2019; van den berg, 2019). a heuristic belief associated with the investor life cycle is that investors become less willing to tolerate risks as they age (blitzstein, 2008). theory ascribes that as investors age, their investment time horizons contract, implying that they would have less disposable time to recover from potential losses if incurred on long-term investments (marx, 2009). investors who choose to invest over the long-term take on the additional risk of long-term exposure and forfeit some of their current consumption behaviour for future benefit (praja et al., 2020). the overriding function of any investment company is to assist individual investors with their financial and investment planning (forbes, 2019). to profile an investor, investment companies apply risk assessment tools to determine the risk profile of an investor and facilitate their investment and financial planning. according to marx et al., (2013) such risk assessment tools (risk tolerance questionnaires) of investment companies include variables like the investors’ personal investment objectives (capital accumulation, this journal is licensed under a creative commons attribution 4.0 international license ferreira-schenk and dickason-koekemoer: analysing the factors affecting the long-term investment intention of investors international journal of economics and financial issues | vol 13 • issue 1 • 2023 113 capital appreciation or current income), preferences (these could be very personal preferences, i.e not investing in non-sustainable companies) investment time horizon (long-term or short-term), individual risk tolerance (risk aggressive or risk-averse) and risk personality (extrovert or introvert) to establish a risk profile. nevertheless, some risk profiles are often very limited in the variables that it includes due to the type of risk assessment tools used. taking into account risk tolerance and behavioural finance biases in risk assessments with other constructs can be advantageous to financial institutions, financial planners and individual investors to incorporate. the result will enable portfolio managers to create an accurate profile of existing and potential clients by way of offering investment products more suitable based on their risk profile. a critical question for investment firms to ask is what variables may be contributing to changing investment decisions concerning the desired time horizon to invest. dickason and ferreira (2018) also previously found a relationship in investor behaviour between behavioural finance, risk tolerance and personality measures but omitted investment intentions over the short or long-term. other studies in financial and investment management omit personality traits, risk tolerance and behavioural biases on the desired time horizon of investors. general investment and financial planning do reflect the influence of risk tolerance on the behaviour of investors (van de venter et al., 2010; hanna et al., 2011). however, these risk assessments are limited. omitting these variables during investment may lead to a less accurate investor profile and desired investment horizon. therefore, this paper aims to answer whether the behavioural intention of private investors’ time horizon (over the long-term) is influenced by personality traits, subjective risk tolerance, and behavioural finance biases. 2. literature review the theoretical framework of this article looks at the theoretical concepts, investor characteristics and investor bias in a risk profile that could influence investors’ intent to invest over the long term. figure 1 indicates the conceptual model of the relationship between investors’ long-term investment intentions and personality traits (neuroticism, extraversion, openness to experience, agreeableness, conscientiousness), risk tolerance (subjective risk tolerance) and behavioural finance biases (representativeness, overconfidence, anchoring, gambler’s fallacy, availability, loss aversion, regret aversion, mental accounting, self-control). 2.1. theoretical and conceptual framework 2.1.1. risk tolerance and investment intentions based on traditional investment decision theories, grable (2000) and hallahan et al., (2015) have described risk tolerance as the level of risk that an investor will be willing to receive to attain the desired investment objective. it is therefore important to acknowledge the multidimensional risk attitude component inherent in risk tolerance. the investor’s willingness to take a certain amount of risk may often be related to but not limited to variables such as their demographics, comprehension of finances and investment, liquidity needs, portfolio size, investment horizon and perception of market volatility (sulaiman, 2012). the influence risk tolerance can have on a client’s investment decisionmaking process should be acknowledged when constructing a risk profile. the level of risk tolerance an investor is willing to take is a clear reflection of their decisions regarding accumulating capital, portfolio allocation, and estate planning (grable, 2000; hanna et al., 2001). risk tolerance can be measured by several techniques. these techniques can include several risk assessment tools, for example where behaviour towards risk is analysed using surveys. in these assessment tools, questions are structured in such a manner to estimate the respondents’ willingness to accept risk based on a set of risk scenarios (hanna and lindamood, 2004). grable and lytton (1999) shared that the continuous development and improvement of the survey can enhance the validity and reliability of the instrument which could ultimately lead to a financial risk tolerance assessment instrument for private and public entities. 2.1.2. behavioural finance biases and behavioural investment intentions behavioural finance is another contributing variable toward a deviation in investment decisions throughout financial and investment markets. a phenomenon contrary to the efficient market hypothesis leads to irrational investor behaviour (dickason, 2017). behavioural finance encompasses the reasoning for the financial decisions investors tend to make. the foremost behavioural finance biases under the heuristic theory are anchoring, mental accounting, gambler’s fallacy, overconfidence, representativeness bias, loss aversion, self-control, regret aversion, and availability bias (dickason, 2017; isidore and christie, 2019). these biases establish the manner various investors understand and react to available information in the market when making financial or investment decisions. however, the reality is contrary to theory, investors rarely behave rationally or predict quantitative models in an unbiased manner, but rather tend to overreact or underreact to market information. therefore, behavioural finance explains the behaviour of investors which results in market anomalies (jahanzeb, 2012). a previous research paper by ferreira-schenk et al. (2021) highlighted behavioural finance biases as another factor that can influence the investment decisions of clients. a study conducted by van den bergh-lindeque et al. (2020), and pak and mahmood (2015) confirmed that investors act irrationally whereby investment decisions are driven by behavioural finance biases. singh (2010) stated that behavioural finance biases account for the effect of psychological traits on investment decisions. moreover, mankuroane (2020) and muhammad (2009) highlighted that investor behaviour is not always rational due to investment decisions being influenced by cognitive and psychological factors. baker and ricciardi (2014) stated that generally, factors such as personal preference, beliefs and past events influence the investment decisions of investors. these personal preferences, beliefs and past events form behavioural finance biases grouped as the availability bias, regret aversion, overconfidence bias, loss aversion bias, anchoring bias, mental accounting, self-control bias, gambler’s fallacy and the representativeness bias. ferreira-schenk and dickason-koekemoer: analysing the factors affecting the long-term investment intention of investors international journal of economics and financial issues | vol 13 • issue 1 • 2023114 the overconfidence bias groups individuals that are likely overconfident in terms of their market and financial knowledge and skills and ignore risks related to investments (rehan and umer, 2017). these investors are identified as investors that tend to underreact to public information and overreact to private signals and trade excessively (kumar and goyal, 2015). the loss aversion bias groups investors together that prefer to make more risky financial decisions to minimise losses instead of accounting for possible positive investments (ainia and lutfi, 2019). thus, investors would take on more risks when possible losses may be realised. however, investors tend to be more risk-averse when they face the possibility of making a gain (kumar and babu, 2018). investor decisions are positively and significantly impacted by anchoring (rehan and umer, 2017). anchoring arises when the cognitive decision-making process is controlled by certain information (furnham and boo, 2011; costa et al., 2017). importantly, kannadhasan (2006) highlighted that investors expect historical earning trends to continue, which often leads to disappointment as trends change. the availability bias realises when investors make investment decisions and rely solely on new market information inflows to make decisions (shah et al., 2018). jain et al. (2015) stated that investors subject to this bias are more likely to concentrate on a certain piece of available information rather than on all available information. this bias results in investors overreacting to results in the market, either positive or negative (bakar and yi, 2016). in the regret aversion bias, previous investment losses experienced in the stock market, investors’ instincts prevent them from continuous investments (beach and rose, 2005). moreover, investors are convinced that by holding onto the initially parched stock, no loss occurs until the stock is sold (seiler et al., 2008). as a result, investors tend to hold onto non-performing stocks in the market to avoid the regret embedded in facing losses, even though bigger losses can be experienced in the future (etzioni, 2014). jordan and kaas (2002) explained the representativeness bias where investors base their judgments on stereotypes or similarities. investors take into account the social pressure or the opinions of experts when making decisions (shah et al., 2018). the mental accounting bias is prevalent when an investor views the investment worth differently when considered as a single asset as compared to when the investment is part of a whole portfolio (seiler et al., 2012). this bias serves as a reference point to provide gains and loss determination for decision-makers (ceren and akkaya, 2013). inheritance of personality traits that includes internal conflict among rational and emotional facets is known as self-control (sadiq et al., 2018). lucks (2016) highlighted that when an investor lacks self-control he/she may tend to make investment decisions that are contradictory to personal goals for example overspending, procrastinating and under-saving. another bias, the gambler’s fallacy, is explained by huber et al. (2010) as to where an outcome has remained unchanged but is believed by the investor that the outcome has changed. in an equal, statistically independent event, the fallacy assumes the outcome’s current occurrence diminishes the likelihood of possible recurrence (coleman, 2007; jayaraj, 2013). the disposition effect explained as when an investor sells winners too early and keeps losers too long, has comparable features to the gambler’s fallacy (huber et al., 2010). 2.1.3. personality traits and behavioural investment intention personality traits are becoming more acknowledged for their influence on economic outcomes such as employment status, income levels (heineck and anger, 2010) and wealth creation through investment (caliendo et al., 2012). these studies found that financial decision-making by investors can be affected by personality traits (brown and taylor, 2014). also, individual personality traits can influence how investments are managed by the investors themselves (krishnan and beena, 2009), their spending, as well as the risk tolerance of these investors (nga and ken yien, 2013). the general big five personality traits used by many researchers in the financial industry are a reliable measure when analysing financial behaviour (halama, 2005). this personality domain model comprises five personality traits figure 1: conceptual model of the factors influencing investors’ intention to invest in the long-term ferreira-schenk and dickason-koekemoer: analysing the factors affecting the long-term investment intention of investors international journal of economics and financial issues | vol 13 • issue 1 • 2023 115 namely; neuroticism, extraversion, openness to experience, conscientiousness, and agreeableness (isik and üzbe, 2015). neuroticism is a personality trait that shows discomfort, dissatisfaction and distress over time. moreover, neuroticism is typically recognised when an individual is in an emotional and negative state for a long period (wright et al., 2006). some common characteristics of neuroticism include anger, irritability, worry and anxiety (lahey, 2009). barlow et al. (2014) explained that this personality trait predicts treatment for health anxieties and mental disorders. the origin of neuroticism includes genetic factors which escalate over time and cause an individual to overreact to stress. this personality trait in terms of investors, oehler et al. (2018) explains that investors tend to deviate from investments in equities and debt securities. pak and mahood (2015) highlighted that investors overestimate the risk involved in market crashes and underestimate profits that prevail from favourable market positions. according to lathif (2019) short-and long-term investment intentions have been influenced by neuroticism. previous studies conducted by crysel et al. (2013) and pak and mahmood (2015) opined that the level of extraversion in a certain personality can likely influence how certain individuals make investment decisions. based on an investment perspective, due to the optimistic character of extraverted investors, they tend to overestimate a gain and underestimate a loss. therefore, extraverted investors can miss out on investment opportunities that can be profitable. results from the study conducted by lathif (2019) confirmed that short-term investment intentions are significantly influenced by extraversion, however, longterm investment intentions were not significantly influenced. on the other hand, individuals that are sensitive and act with their emotions are characterised by the openness to experience personality traits. taking into account the sensitivity aspect of these individuals, they are usually responsive to feedback obtained in a work environment (george and zhou, 2001). lathif (2019) indicated in their research results that individuals with openness to experience personality traits take higher risks which has a positive impact on short-and long-term investment intentions. moreover, these investors are known to have a preference for complexity, new developments and sensations. due to the openness of these investors, new market information and frequent adjustments in investment portfolios are accepted with ease (pak and mahmood, 2015). another personality trait, conscientiousness, is composed of two domains namely dependability and achievement. ajzen et al. (2012) explained dependability as interpersonal and found in dutifulness and responsibility traits. on the other hand, achievement is associated with hard work and enduring challenges. individuals who rank high on the conscientiousness spectrum are not scared to express their intentions freely and will be sure to be direct with an investment manager regarding their investment intentions. as a result, high conscientiousness can ultimately affect the final decision of an investor. conscientious investors are characterised by high confidence, are analytical, are selfdisciplined, and have well-formulated investment goals (pak and mahmood, 2015; husnain et al., 2019). the agreeableness personality trait is based on sustaining positive relationships with other individuals. this trait focuses on reducing negative impacts regarding conflicts between individuals and rather encourages outcomes that are beneficial for both parties. jensen-campbell and graziano (2001) confirmed that individuals that possess a high agreeable personality trait can cope well under conflict and are good negotiators. typical characteristics associated with agreeableness are forgiving, helpful, and generous (graziano et al., 2007). pak and mahmood (2015) and later lathif (2019) confirmed a relationship between investments and agreeableness. when an investor with an agreeable personality trait needs to make an investment decision, this investor relies heavily on the opinion of an analyst. 3. methodology this section represents the research design, sampling method and data collection, the research instrument, the applied hypothesis and the statistical analysis implemented. 3.1. research design a positivistic paradigm was implemented using a quantitative research approach to explain the personality traits of investors, the subject level of risk tolerance behaviour as well as the behavioural finance biases. therefore, secondary data analysis was used to answer the primary research question of this article which was to determine “which factors drive investors’ intention to invest in the long-term?” 3.2. sampling method and data collection the primary data was sourced from an online questionnaire distributed by a private investment company in south africa, having one of the largest private investor client bases in the country. the inclusion criteria required investors to be private investors and have invested more than 2 years at the private investment company. the secondary data from the private investment company were then employed in the study as this niche investor group is often difficult to reach by a single individual researcher. the study area and sample were collected from all nine provinces within south africa. the private investment firm granted the researchers’ gatekeeper permission to use the secondary data collected by the private investment firm to profile their investor client base. the investment company sent out 3000 online questionnaires and a final sample of 593 was collected for this paper. the sample was considered adequate for conducting structural equation modelling (sem) using statistical software, ibm spss® amos™, version 27. 3.3. research instrument the questionnaire sent out by the investment company included four sections. section 1 included the questions about the behavioural intention of investors to invest in the long term. section 2 used a single validated scale by grable and lytton (2001) to measure risk tolerance behaviour. it is acknowledged that the scf scale omitted some variables known to the financial market but is a comprehensive measure (includes a four-item scale) for measuring individual investment choices, investment behaviour and experience (grable and lytton, 2001). the third ferreira-schenk and dickason-koekemoer: analysing the factors affecting the long-term investment intention of investors international journal of economics and financial issues | vol 13 • issue 1 • 2023116 section included the personality traits or measures to profile investor personalities and match that with their investment term choices. a validated personality scale developed by mayfield et al. (2008) was used and comprised; extraversion, neuroticism, openness to experience, agreeableness and conscientiousness. section 4 included the behavioural finance biases that investors might consider when making decisions, where nine biases were included using a nine-item verified behavioural finance scale (using a six-point likert) constructed by ferreira (2018). when measuring human behaviour categorically, a cronbach value of α of 0.6 or more is deemed to be satisfactory (cronbach, 1951; malhotra, 2010), therefore the α-value for the personality traits section was larger than 0.6, and the behavioural finance bias scale was also found to be reliable with an α-value of 0.69. 3.4. data analysis due to the categorical questionnaire and the nature of the secondary data obtained, sem was considered the most suitable for the dataset. the sem, allowed for a multivariate statistical analysis which was able to demonstrate the multidimensional existing theoretical relationship of the variables. 4. results and discussion table 1 indicated that long-term investment intentions and age had a weak negative linear relationship (−0.129) with a p-value (0.002) that was significant at 1% significance level. also for the relationship between long-term investment intentions and the highest level of annual income had a weak positive linear relationship (0.089) with a significance value of 0.031 that is significant at 5% significance level. the results reveal that younger investors, with higher annual income and higher levels of education, are more likely to have intentions to invest in the long term. for age, the results are similar to traditional investment theory where older individuals are not willing to make long-term commitments due to their low-risk tolerance and the short life cycle of the investor. table 2 below indicates the correlation analysis between personality traits (five personality traits, risk tolerance behaviour (subjective risk tolerance) and behavioural finance biases (nine biases). a weak positive relationship (0.284) between extraversion and long-term investment intentions was found which was significant. therefore, there is a relationship between an extroverted investor personality and the intention to invest in the long term. the highest positive correlation (0.301) was found between openness to experience and long-term investment intention which was significant. for the personality trait of agreeableness, a weak positive and significant association was found (0.094) with long-term investment intentions. a significant weak positive linear association was found for conscientiousness. the results of this study are similar to the empirical results found by mayfield et al. (2008) who found a relationship between extraversion, openness to experience, and conscientiousness to invest in the long term. the correlation coefficient between risk tolerance indicated a significant positive linear association. representativeness bias showed a weak but significant positive linear relationship with investment intentions. furthermore, another significant positive relationship was found between overconfidence and the dependent variable. a small positive association was found for gambler’s fallacy indicating a relationship between the two variables. for the availability bias, a weak positive correlation was found which also proved to be significant. self-control indicated a significant positive correlation with investors’ long-term investment intentions. therefore, the correlation analysis indicated a significant relationship between the behavioural finance biases; availability, self-control bias; representativeness, overconfidence bias, gambler’s fallacy, and the behavioural intention for longterm investing. figure 2 indicates the behavioural intention of investors and the relationship between the latent variables and scales. the overall model proved to be significant were all the other fit indexes (cfi, tli, cmin/df) criteria were satisfactory based on the convention criteria stipulated for conducting sem. values ranging between 3.0 and 5.0 are acceptable as that would indicate that the data fit the model well (mueller, 1996). therefore, the cmin/df value of 3.333 represents a good model fit. the comparative fit index (cfi) value of 0.902 was obtained and indicated a good model fit since it was larger than 0.9 as suggested by mueller (1996), confirmed later by gefen et al. (2000) as well as malhotra et al. (2017). therefore, the high value of 0.902 indicates a good model fit. for the ifi and the tucker lewis index (tli) values of 0.90 and 0.86 were recorded also indicating a good model fit since values closer to 1.0 indicate a better (malhotra et al., 2017). lower values are required for a good model fit when looking at absolute badness-of-fit indices. the rmsea value of 0.063, [0.056; 0.070] was recorded which suggests a good model fit (rmsea <0.8) (schreiber et al., 2006). for the absolute badness-of-fit indices, both the cmin/df and rmsea indicated a good model fit. table 3 above, regarding the five personality traits, extraversion (0.173) and openness to experience (0.165) contributed meaningfully towards explaining the behavioural intention of investors to invest over a longer time horizon. these results are similar to previous researchers such as mayfield et al. (2008) and recently mankuroane (2020) who found similar results indicating that extraversion has a positive association with longterm investment and may influence their long-term investment decisions. the significantly meaningful coefficient for openness table 1: the relationship between long-term investment intentions and demographic variables items spearman’s correlation demographic factors age annual income highest level of education long-term investment intentions correlation coefficient −0.129*** 0.070 0.089** sig. (2-tailed) 0.002 0.088 0.031 n 593 593 593 ferreira-schenk and dickason-koekemoer: analysing the factors affecting the long-term investment intention of investors international journal of economics and financial issues | vol 13 • issue 1 • 2023 117 to experience suggests that sociable, active and energetic investors are more likely to invest in portfolios that provide the required return in the long term (lathif, 2019; mankuroane, 2020). considering the behavioural finance biases, the overconfidence bias (0.249) contributed significantly meaningful toward longterm investment intention. in theory, such investors are prone to underreact to new public information, which can cause these investors to invest over longer periods. although overconfident investors can be vulnerable to market manipulation, overconfidence will persevere in the financial behavioural intention (dittrich et al., 2005). gamblers’ fallacy contributed significantly towards explaining investors’ intention to invest over the long term. this behavioural finance bias assumes that the occurrence of the current event’s outcome will minimize the likelihood of the reoccurrence of the same event i.e. the same event with the same outcome cannot happen twice (coleman, 2007; jayaraj, 2013). hence, investors subject to this bias will likely invest in the long-term where they keep undesired investments for too long and sell good-performing investments too early (huber et al., 2010). table 2 indicates that risk tolerance also significantly contributed to the long-term investment intentions of investors (standardised regression coefficient = 0.246). this is consistent with ferreira-schenk et al., (2021) who found a positive correlation between investors’ behavioural intention to invest in the short run and long run and the gambler’s fallacy bias. figure 2 indicates the structural relationship between the dependant variable long-term investor intentions and investor personality (extraversion and openness to experience), risk tolerance and behavioural finance bias (overconfidence and gamblers fallacy). the last step in completing a sem includes the composition of significant recommendations for future research on the structured model for long-term investment intention. as mentioned earlier, many risk assessments when doing financial planning omit variables that could be explanatory and are limited by not including the influence of personality traits and behavioural biases on the investment intentions of investors. these current risk assessments are limited which can often lead to a less accurate investor profile, resulting in unfavourable returns. future models could expand on the demographic, socio-cultural and behavioural variables influencing financial behaviour. figure 2: structural model of long-term behavioural intention to invest in the long-term, investor personality traits, risk tolerance and investor behavioural finance biases table 2: the relationship between long-term investment intentions and independent variables influencing constructs long-term investment intention neuroticism p −0.068 t 0.098 extraversion p 0.284*** t 0.000 openness to experience p 0.301*** t 0.000 agreeableness p 0.094** t 0.021 conscientiousness p 0.108*** t 0.008 risk tolerance p 0.283*** t 0.000 representativeness p 0.177*** t 0.000 overconfidence p 0.345*** t 0.000 anchoring p 0.034 t 0.409 gambler’s fallacy p 0.249*** t 0.000 availability p 0.151*** t 0.000 loss aversion p 0.042 t 0.305 regret aversion p 0.072 t 0.081 mental accounting p 0.071 t 0.084 self-control p 0.185*** t 0.000 ***significant at 0.01 level, **significant at 0.05 ferreira-schenk and dickason-koekemoer: analysing the factors affecting the long-term investment intention of investors international journal of economics and financial issues | vol 13 • issue 1 • 2023118 5. conclusion the paper aimed to determine which factors influence the behavioural intention to invest in the long-term considering south african investors where a case of one private investment company was used. behavioural and physiological factors have previously been omitted from research studies as possible influencing variables on the behavioural intention of investors to invest long term investments. therefore, this article incorporated personality and behavioural variables such as risk tolerance, personality traits and behavioural finance biases. results indicated that extraversion and openness to experience contributed meaningfully toward the behavioural intention for long-term investing. this proved that investors who tend to be extroverts and who are very sociable, tend to invest in portfolios that provide the required return in the long term. risk tolerance also contributed to investors’ long-term investment intentions. investors who are high risk tolerant will be willing to take on the volatility that goes along with investing in long-term investments and portfolios. only two behavioural finance biases came out to be statistically meaningful where these included overconfidence and gambler’s fallacy. therefore, it can be suggested that overconfident investors are likely to omit new public information in their investment decisions, which can cause these investors to invest in the long-term and ignore short-term volatility. although overconfident investors can be vulnerable to market manipulation, their overconfidence will substitute uncertainty. gamblers’ fallacy bias investors might hold onto underperforming investments for too long in the long term and sell overperforming investments too fast. research in academia and industry in financial and investment planning is limited in terms of the various factors that could influence investment choices in the short-term and long-term. among these factors are several behavioural and psychological factors. the results from this article could contribute to the risk assessments of investors where the factors considered in financial and investment 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(2006), neuroanatomical correlates of extraversion and neuroticism. cerebral cortex, 16(12), 1809-1819. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(1), 358-364. international journal of economics and financial issues | vol 7 • issue 1 • 2017358 effect of fiscal policy and trade openness on economic growth in indonesia: 1990-2015 nursini nursini* department of economics, hasanuddin university, makassar south sulawesi, indonesia. *email: nini_mahmud@yahoo.com abstract this study examines empirically the effect of fiscal policy and trade openness on economic growth in indonesia for the period 1990-2015. fiscal policy includes government spending on infrastructures, human resources, and routine spending, while tax revenue and foreign loans is as source of financing. this study finds government spending on infrastructure and human resources have positive and significant effect on economic growth if they are financed by tax revenue and insignificant if they are financed by foreign loans. routine government spending has negative and insignificant effect on economic growth for both financed by taxes and foreign loans. trade openness has positive and significant effect on economic growth. the implication is the proportion of spending on infrastructure and human resources should be increased by taxes financing rather than foreign loans. competitiveness of domestic industries should be improved to achieve a positive impact of free trade. keywords: fiscal, trade openness, economic growth jel classifications: e62, f13, f41, h5, h6 1. introduction economic growth is a key indicator of the success of a country’s development. with high economic growth can overcome some macroeconomic problems such as unemployment, poverty and income inequality. the importance of economic growth has been debated both theoretically and empirically. the focus of the debate lies on the determinants of economic growth. in endogenous growth theory introduced by barro (1990), barro and sala-i-martin (1992), roomer (1990; 1996; 2001) emphasize that the endogenous technology is a decisive factor of economic growth of a country. similarly, in the new international trade theory also asserts that the transfer of technology through the flow of goods and services from abroad will encourage the acceleration of economic growth in home country (grossman and helpman, 1991b; krugman and obsfeld, 2000). both theories are equally emphasized the importance of technological progress to economic growth. macroeconomic instruments that play an important role to encourage technologies that can further stimulate economic growth are fiscal policy and trade policy. fiscal policy and trade openness are interesting and highly relevant to the conditions in indonesia for the period 1990-2015. during this period, the relationship between fiscal policy, trade openness, and economic growth is quite attractive to be estimated. in the period 1990-1997, economic growth is quite high on average 7.4% per year, but in that period is relatively less expansionary fiscal policy and the ratio of exports plus imports to gross domestic product (gdp) as proxy of trade openness has not significantly increase. in the period 1998-2015, in which the expansion of fiscal policy is quite large and rapidly growing trade volume, but economic growth is only an average of 3.96% per year which is relatively slower than the previous period. this condition rises the critical question how far fiscal policy and trade openness affects economic growth in indonesia during the period. which of fiscal policy instruments have impact on economic growth? empirical studies that have examined the effect of fiscal policy and trade openness on economic growth basically too much both in developed and developing countries include in indonesia1. the 1 ahmed and miller (2000), yasin (2001), bleaney et al. (2001), benos (2004; 2009), ali (2005), gray et al. (2007), abdullah et al. (2009), ismal (2011), cottarelli and jaramillo (2012), shijaku and gjokuta (2013), mercan et al. (2013), razmi and refaei (2013), attinasi and klemm (2014) and the latest paparas and ricther (2015), dao (2015). nursini: effect of fiscal policy and trade openness on economic growth in indonesia: 1990-2015 international journal of economics and financial issues | vol 7 • issue 1 • 2017 359 result of their finding are different, it depends on the instruments of fiscal policy, measurement trade openness, and model specification. however, in general, the results found that the fiscal policy and trade openness significantly influence economic growth especially in developing countries. the study is organized in the following sections. section 2 discusses literature survey. section 3 discusses the model specification. section 4 describes the results and discussion. 2. literature survey some previous studies have estimated the relationship between fiscal policy and economic growth using several fiscal policy instruments. fiscal policy instruments are grouped into three major groups: (i) fiscal policy focused on aggregate government spending, (ii) fiscal policy focused on disaggregate government spending, (iii) fiscal policy instruments include simultaneously government spending and tax revenue as financing sources. the same case for trade openness is measured differently by empirical studies. the instrument includes tarif, trade volume, export to gdp ratio, import to gdp ratio. at the aggregated level of fiscal policy effect on economic growth was estimated by barro and sala-i-martin (1992) using panel data on 75 countries. the size of fiscal policy is the ratio of total government expenditure to gdp and the ratio of consumption expenditure to gdp. they found that there are negative effect and not significant between fiscal policy and economic growth per capita. the same results were found by folster and henrekson (2000) analyzes the fiscal policy by focusing on aggregate expenditures, they found the negative effect of fiscal policy on economic growth in developed countries. several subsequent studies using ordinary least squares method and they found the same results, among others; kweka and dan morissey (2000) in tanzania, jung and thorbecke (2001) in tanzania and zambia, huart (2002) at emu state, dong et al. (2003) using vector auto regression methods in the united states, and koulovatianos and mirman (2004) in the case of developed countries, and ismal (2011) in indonesia. recently studies for nigeria by ismaila and imoughele (2015), osinowo (2015) reinforce the results of previous studies. the findings were different when government spending estimated at disaggregated level or per sector2. douglas and william (1997) examined government expenditure by sector for oecd countries and generally found a positive correlation and significant. the same thing was found by asante (2000) for the state of ghana. this finding is in line with barro (1990) for the developed countries. glomm and ravikumar (2001) conducted research focusing on infrastructure investments in taiwan, korea and japan, the results reported to positive effect. peretto (2000) only look at r and d expenditure in 12 european countries, 2 government spending will provide different policy implications when government spending was estimated on per sector such as government spending on productive sectors such as infrastructure spending, government spending of education, health, housing, spending on r and d. generally his finding has a positive effect. hermes and lensink (2001) analyzed fiscal policy included infrastructure spending, education and health as the independent variable simultaneously on 33 developing countries. the study found that infrastructure expenditure, education and health have a positive effect on economic growth in most countries. the same findings made by zang (1996), wolft (2000), bos et al. (2003), hadiwibowo (2010) in indonesia using vector error correlation, and recently was conducted by abdon et al. (2014) in developing asia, the results is consistent with the previous studies especially government spending on education. the study was contrast by devarajan et al., (1996) and agel and ohlsson (2003). fiscal policy instruments are quite interesting aside from government spending is tax revenue because the role of taxes can be positive or negative effect on economic growth. several studies analyzed the effects of taxes and government spending simultaneously on economic growth. hosoya (2003) examined the influence of government expenditure on health, where government expenditure is financed by taxes. his finding is the effect of government spending on health is positive. dong et al. (2003) empirically tested the relationship between fiscal policy and economic growth in the period 1983-2002 in the united states which the government spending financed by increased taxes and the results is positive and significant. in contrast to attinasi and klemm (2014) analyzed the impact of discretionary fiscal policy for a sample of 18 eu countries over the period 1998-2011 and using the revenue side. in general, the results indicate that indirect tax increases are found negative impact on growth. the effect of trade openness on economic growth depends on the size of trade openness definitions. several indicators of trade openness are used by empirical studies among other; the ratio of exports plus imports to gdp, the ratio of exports to gdp, the ratio of imports to gdp, import tariffs, import penetration, the ratio of foreign direct investment to gdp, import duties and dummy variables. yasin (2000) examined the effect of trade openness on economic growth for the case of sub-saharan african countries, morrisey et al. (2002), pernia and quising (2003) in four regions in the philippines. they found that trade openness has significantly positive effect of economic growth. walde and wood (2004) evaluated the empirical results the relationship of trade liberalization and economic growth, where low tariff rates and no tariff rates have a strong positive relationship with growth. jawaid et al. (2011) showed trade policy has insignificant effect on economic growth the case of pakistan. yusoff and febriana (2012) showed the positive relationship among economic growth, investment, and trade openness in indonesia. the same result was conducted by dao (2015) that trade liberalization has impact positive on economic growth. however, in contrast to simorangkir (2006) found the negative effect trade openness and economic growth in indonesia. this result is in line with benos (2004) in the case of oecd countries, however benos (2009) found the positive effect insignificant of trade openness and economic growth in eu countries. nursini: effect of fiscal policy and trade openness on economic growth in indonesia: 1990-2015 international journal of economics and financial issues | vol 7 • issue 1 • 2017360 3. specification model the effect of fiscal policy on economic growth was first introduced by barro (1990)3. this model is consistent with endogenous growth theory. trade openness accelerates economic growth through the development of r and d as the new international trade theory (grossman and helpmant, 1991b). thus, endogenous growth theory explicitly confirms that fiscal policy and trade openness can accelerate economic growth through technological progress. this study developed two estimation models to determine and analyze the effect of fiscal policy and trade openness on economic growth in indonesia for the period 1990-2015: (1) the effect of fiscal policy and trade openness on economic growth when government spending is financed by taxes, (2) the effect of fiscal policy and trade openness on economic growth when government spending is financed by foreign debt4. general form of estimation equation of the effects of fiscal policy and trade openness on economic growth that is; gr if op ub b m b= + + + = ∑α β α0 1 6 1 (1) where, gr is economic growth, ifb is instruments of fiscal policy. instruments of fiscal policy include the types of government expenditure (gi), taxes (t), and foreign debt (db). gi includes routine government expenditure (grt), infrastructure expenditure (ginfr), and expenditure on human resources (ghm). op is trade openness in term of the ratio of total export and import to gdp. the government maximizes its expenditure with budget constraint through taxes and non-taxes. in this study uses foreign loans variable as non-taxes which is followed by benos (2009). equation for budget constraint is: gi t debt s= ∑ = + 1 3 (2) to avoid perfect multicollinearity problems in the estimation equation, one of instruments fiscal policy should be excluded from the equation ahmed and miller (2000) and bleaney et al. (2001). thus, if ifm b b m = − = − ∑ 1 1 (3) where m is the number of fiscal policy instruments. while m−1 is the number of fiscal policy instruments minus one of the all fiscal policy instruments. b is the types of government expenditure (ginfr, grt, ghm), t, and foreign debt. variable excluded 3 barro stated output per capita was affected by the capital input per worker and expressed the government’s investment in the cobb-douglas production function y=f(k, g)=ak1-αgα where y is output per worker (y/l), k is capital per worker (k/l), g is the quantity of goods and public services provided to each household and firms. conceptually the government does not have output and capital. so the government only buys the output from the private sector. 4 in line with the endogenous growth model of fiscal policy and trade openness, the following empirical study is specified gr=f(if, op), where if is instrument fiscal policy and op is trade openness. from the estimation equation is assumed to compensate the budget constraint. hence, the equation 3 becomes: gr if op ub m b b m = + − + + = − ∑α β β α0 1 1 6 2 ( ) (4) equation 4 stresses that ifb coefficient should be interpreted as (βb−βm) not βb (bleaney et al., 2001; benos, 2004). in another word, the true explanation of each coefficient of the budget constraint is the effect of a unit change in fiscal policy instruments offset by a unit change in fiscal policy instruments are removed from the regression equation, which implicitly financed fiscal policy instrument variations (benos, 2009). for example, if tax revenue is removed from the regression equation it means the increased of government expenditure is implicitly financed by taxes. similarly, if the debt variable excluded from the regression equation, it means the increased of government expenditure is implicitly financed by foreign debt. to estimate the effect of fiscal policy and trade openness on economic growth, the equation 4 is divided by two estimation equation that is: if government expenditure is implicitly financed by foreign debt, the estimation equation is: gr ghm ginfr grt t op dm = + + + + + + + β β β β β β β µ 0 1 2 3 4 5 6 1 (5) where; α1>0; α2>0; α3<0, α4>0; α5>0; α6>0; ceteris paribus. dummy variable (dm) is added to the model to analyze how the impact of the economic crisis on economic growth where 0 is for the period before the crisis (1990-1997) and 1 after that period (1998-2015). if government expenditure is implicitly financed by taxes, the estimation equation is: gr ghm ginfr grt db op dm v = + + + + + + +        0 1 2 3 4 5 6 1 (6) where β1>0; β2>0; β3<0; β4<0; β5>0; β6>0 ceteris paribus. data for the all fiscal instruments (ghm, ginfr, grt, t, db) and trade openness (op) is a percentage of gdp. table 1: unit root test variables adf calculated value in level adf calculated value in 1st difference order of integration gr −3.438112* −6.178305** 1(0) ghm −2.386138 −6.042540** 1(1) ginfr −1.528151 −4.265820** 1(1) grt −3.104605* −5.599919** 1(0) t −2.781421 −6.632608** 1(1) db −2.1709691 −4.708598** 1(1) op −4.185017** −7.013090** 1(0) dm −1.494753 −4.898971** 1(1) mackinnon critical values for rejection of unit root hypothesis 1% critical value −3.724070 −3.737853 5% critical value −2.986225 −2.991878 *,**denotes statistical significance at 1% and 5% level respectively. source: computed by the author (2015) nursini: effect of fiscal policy and trade openness on economic growth in indonesia: 1990-2015 international journal of economics and financial issues | vol 7 • issue 1 • 2017 361 4. result and discussion 4.1. unit root test of stationary of variable this study developed two models to show the relationship between fiscal policy, trade openness, and growth. one is the types of government spending are implicitly financed by taxes and the other is the types of government expenditures are financed by foreign loans. there are nine variables for both models. to test whether time series data is stationary or not, this study used the augmented dickey fuller (adf) test. based on results adf test, there are two variables is stationary at level and remaining stationary on first different. however, all variables are stationary at first different and it means that each data series is integrated on the order of 1. 4.2. test for cointegration to determine the long-run relationship between fiscal policy instrument, trade openness, and economic growth, this study used johansen co-integration test. the results of the data series for the equations 5 and 6 can be seen in tables 2 and 3, respectively. tables 2 and 3 show that all the trace and maximum eigen value statistics are greater than critical value of 5% and that means they reject the null hypothesis of no cointegration. therefore there is a long run relationship between fiscal policy, trade openness, and growth either government expenditure is implicitly financed by taxes or foreign debt. 4.3. effect of fiscal policy and trade openness on economic growth table 4 shows the effect of fiscal policy on economic growth varies depending on the type of government expenditure and alternative sources of financing. government spending on infrastructure and human resources are positive and significant impact on economic growth if they are implicitly financed from taxes and insignificant if they are financed by foreign loans. this shows that tax revenue has been quite conducive in stimulating economic growth. this fact has been reinforced by a tax coefficient in equation 5 which is positive and significant, which means the role of taxes as a source of development financing is quite large. the findings of this study is in line with hosoya (2003), dong et al. (2003), and abdon et al. (2014). the results of this study are highly relevant to the current policy of the indonesian government. one of the successful policies is a tax amnesty program. tax amnesty program is expected to boost the ratio of tax revenue to gdp, which is still comparatively low with an average of 12% in the period 1990-2015. however, this study contradicts with attinasi and klemm (2014)5. positve and significant effect of government spending on infrastructure and human resources have strengthened some of the results of previous studies both the developed countries and other developing countries6 and studies in indonesia by hadiwibowo 5 gale (2014) suggests that not all tax changes will have the same impact on growth. reforms that improve incentives, reduce existing subsidies, avoid windfall gains, and avoid deficit financing will have more auspicious effects on the long-term size of the economy, but may also create trade-offs between equity and efficiency. 6 zang (1996), wolft (2000), asante (2000), glom (2001), hermes and lensink (2003), bos et al. (2003), and donghyun (2014). (2010). conversely, routine government spending has a negative and no significant effect on economic growth for both financed by taxes and foreign loans. even the effect of increased routine government spending without considering the source of financing is also negatively related to economic growth in this study. these findings support the results for ahmed and miller (2000), kweka and dan morissey (2000), jung and thorbecke (2001), mansouri (2000), and bose et al. (2003), and benos (2009)7. they support barro (1990), barro and sala-i-martin (1992) which asserts unproductive expenditure does not encourage economic growth. its quite interesting to be analyzed is the effect of government spending on infrastructure and human resources to economic growth if they are financed by foreign loans. the estimation results indicate a positive relationship but not significantly. this means that foreign loan has not been fully to encourage economic growth in the long run. the implication of this finding is to give attention to the indonesian government to be careful in raising foreign loans because based on the estimates that the foreign debt affects negative significantly to economic growth. this study is in line siddique (2015) at indebted poor countries and osinowo (2015) in nigeria, but contrary to kasidi and said (2013) for the case of tanzania. this study suggests that foreign loans should be reduced and managed properly. this is quite reasonable considering the withdrawal of foreign loans has exceeded principal repayments of foreign debt. in 2015, the withdrawal of foreign loans amounting to us $48 647, while principal repayments foreign debt amounted to usd 64183.2 billion. during the 1990-2015, the ratio of gross foreign debt to gdp is an average of 1.98% per year. based on data released by bank indonesia, total foreign debt (private and public) to a july 2015 reached rp. 4376.3 trillion. in general, the effect of fiscal policy in term of the government spending on infrastructure and human resources is quite effective on economic growth in the long run. the proportions of central government expenditure for the economy function (such as economic and social infrastructure) and education function reached an average of 10.29% per year and 11.11% per year respectively in the period 2010-2015. although this figure is still relatively small, but it indicates that during this period, the government’s attention to physical and human investments has been improved. in the coming years, the share of budget allocations for infrastructure and human resources are expected to increase quite dramatically in order to accelerate economic growth in the long run. trade openness shows a significant and positive sign, which means the results of the estimates in accordance with the theory. this indicates that the impact of economic openness has been a positive effect on the performance of the indonesian economy. the result is in line with previous studies8 and the recent empirical 7 benos, 2009 denotes that if routine expenditure is financed by nondistortionary tax. sebaliknya jika pen, it has neutral effect, but if it is financed by distortionary tax, it has negative effect. 8 for example cuadros et al. (2002) in argentina, brazil and mexico, choudhri and hakura (2000), yasin (2001) in sub saharan afrika, duncan and quang (2002) in some developed and developing countries, and anderson (2001) in swedia. nursini: effect of fiscal policy and trade openness on economic growth in indonesia: 1990-2015 international journal of economics and financial issues | vol 7 • issue 1 • 2017362 studies9. this result is not in line with simorangkir (2006) found the negative effects of trade openness and economic growth in indonesia. therefore, this study suggests that the quality of human resources should be increased in the future. improving the quality of human resources is expected to create new innovation through the transfer of technology from partner countries. the opportunities of the free trade of asean economic community (aec) can be utilized as much as possible and the threat can be reduced. this is very important for the indonesia because the data shows that in the last three years, there is a tendency of the value of imports exceeded the value of exports, which also affect the economic slowdown. 9 jawaid et al. (2011) showed trade policy has insignificant effect on economic growth the case of pakistan and yusoff and febriana, (2012). the economic crisis began in 1997 and continued global crisis in 2008 turned out to have an impact on the domestic economy. indonesia’s economic growth in the period before the crisis was in the range of 7-8%, but after the economic crisis, indonesia’s economic growth reached negative figures in 1998. since then, the various instruments of fiscal and monetary policies adopted by the government to restore the economy and the results are quite positive. this fact is reflected in economic performance is gradually growing at a rate 3-6% since 2000-2007. but the global economic crisis had a significant effect on economic growth in indonesia. economic growth in the last few years has slowed to only reach 4.8% in 2015. this condition is statistically proven by the results of estimation shown by equation 5 and 6 that the economic crisis shown by dummy variable has a negative impact to economic growth. table 2: co-integration test result for series data in equation 5 hypothesized number of ce(s) trace statistic 5% critical value hypothesized number of ce(s) max-eigen value statistic 5% critical value none* 254.6952 125.6154 none* 101.8427 46.23142 at most 1* 152.8525 95.75366 at most 1* 80.23908 40.07757 at most 2* 72.61342 69.81889 at most 2 31.94780 33.87687 at most 3 40.66562 47.85613 at most 3 20.72812 27.58434 at most 4 19.93750 29.79707 at most 4 14.36922 21.13162 at most 5 5.568283 15.49471 at most 5 4.048267 14.26460 at most 6 1.520015 3.841466 at most 6 1.520015 3.841466 trace test indicates 3 cointegrating equations at the 0.05 level. *denotes rejection of the hypothesis at the 0.05 level max-eigen value test indicates 2 cointegrating equations at the 0.05 level. *denotes rejection of the hypothesis at the 0.05 level source: computed by the author (2015) table 3: co-integration test result for series data in equation 6 hypothesized number of ce(s) trace statistic 5% critical value hypothesized number of ce(s) max-eigen value statistic 5% critical value none* 296.9969 125.6154 none* 108.5857 46.23142 at most 1* 188.4112 95.75366 at most 1* 76.50318 40.07757 at most 2* 111.9080 69.81889 at most 2* 58.24833 33.87687 at most 3* 53.65969 47.85613 at most 3* 34.18516 27.58434 at most 4 19.47453 29.79707 at most 4 12.18827 7.286261 at most 5 15.49471 21.13162 at most 5 5.318165 14.26460 at most 6 1.968095 3.841466 at most 6 1.968095 3.841466 trace test indicates 4 cointegrating equations at the 0.05 level. *denotes rejection of the hypothesis at the 0.05 level max-eigen value test indicates 4 cointegrating equations at the 0.05 level. *denotes rejection of the hypothesis at the 0.05 level source: computed by the author (2015) table 4: results estimation independent variables government expenditure is implicitly financed by external debt government expenditure is implicitly financed by taxes without tax and external debt constant −1.799767 −0.966068 −0.596142 ghm 0.113739ns 6.987693** 4.488378ns ginfr 2.794370ns 2.461393** 5.518430** grt −1.420906ns −0.493721ns −1.439564** t 1.076320** db −3.178220** op 0.194003*,** 0.181615** 0.211554** dm −0.914931ns −7.053137** 0.121677ns r2 0.517486 0.817684 0.404157 adjusted r2 0.365113 0.760110 0.255197 f-statistic 3.396183 14.20243 2.713183 *,**: denotes 10%, 5%, respectively. source: computed by the author (2015) nursini: effect of fiscal policy and trade openness on economic growth in indonesia: 1990-2015 international journal of economics and financial issues | vol 7 • issue 1 • 2017 363 5. concluding remarks and policy implications empirical studies on the effect of fiscal policy and trade openness to economic growth has been widely discussed in the literature. this study examines empirically the effect of fiscal policy and trade openness on economic growth in the period 1990-2015. fiscal policy includes government spending on infrastructure, human resources (education and health), and routine spending. tax revenue and foreign loans are used as a source of financing. this study develops two models, one is the model that examines the effect of government spending on infrastructure, human resources, and routine expenditures and trade openness on economic growth where the types of government spending are implicitly financed by tax revenues, and the second model is the types of government spending are financed by foreign loans. all variables in the model estimation are stationary and cointegrated in the first different so that there is long-run effects of fiscal policy and trade openness to economic growth in indonesia. the study found that government spending on infrastructure and human resources have positive and significant effect on economic growth if they are financed by tax revenue and insignificant effect when they are financed by foreign loans. while routine government spending has a negative and insignificant impact to economic growth. other findings are trade openness has a positive and significant effect on economic growth in the long-run. the implications of these findings affirm that fiscal policy, especially government spending on infrastructure and human resources should be prioritized and financed by taxes revenue. this statement is in line with the findings that the tax revenue has a positive and significant impact on economic growth. while the financing from foreign loans should be reduced considering the amount of principal repayments of foreign debt is large enough so that the effects of foreign debt can depress economic growth in the long-run. therefore, tax reform needs to be done in accordance with the circumstances and economic conditions. the forms of tax reform, among others a decline in the tax rate, the sustainability of the tax amnesty program, the improvement/simplification of tax administration and the extension of tax objects intensified. the proportion of spending for the development 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(1996), optimal public investments in education and endogenous growth. scandinavian journal of economics, 98(3), 387-404. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(4), 301-312. international journal of economics and financial issues | vol 8 • issue 4 • 2018 301 the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates akram masoud haddad* college of business administration, american university in the emirates, dubai, united arab emirates. *email: dr_akram2@yahoo.com abstract different studies conducted in past regarding the fdi policies in different countries and regions and its impacts on the recipient countries, most of these studies concentrated on the impact of fdi on the economic growth measured by the gross domestic product. in this study the impact of both the inflow and outflow fdi on the economic growth measured by hdi which is the proxy for the health, income and education in the countries, united arab emirates (uae) is the case where there are both cases of the fdi flows are clear and big. ordinary least square method is applied and both simple and multiple regressions is used, the results show that both inflow and outflow fdi have an impact on the hdi alone while considering both together only the inflow fdi has an impact on the hdi so that the impacts of the outflow is eliminated with the impact of the inflow fdi. the explanation of that is the inflow fdi brings with it many direct benefits to the people of the country while the outflow fdi brings indirect benefits to these people. however, country like uae should pay more attention for the both inflow and outflow investment so that the dependency on will be less. keywords: human development index, investment, foreign direct investment, united arab emirates, economic growth jel classifications: f21, f43, n15, o15, o47 1. introduction the united arab emirates (uae) is located in the middle east region of asia, at the tip of the arabian peninsula. the uae is the eighth largest oil producer and one of the six gulf cooperation countries consists of seven emirates namely; abu dhabi, dubai, sharjah, ras al khaimah, ajman, umm al quwain and fujairah. in 1971, the late president sheikh zayed bin sultan al nahyan unified the small, underdeveloped states into a federation and used the oil wealth to develop the uae into one of the world’s most open and successful economies. according to the constitution of the federation each emirate handles all authorities that are not assigned by the constitution, contribute to building and protecting the constitution as well as benefiting from its services. however, jointly conduct foreign affairs, defense, security and social services and adopt a common immigration policy, other administrative matters are left to the jurisdiction of the local government of each emirate. although it is small in size (86716 square kilometer), with total population of (9.6) millions at 2016, the uae has become an important player in regional and international affairs. uae maintains a free-market economy and is also one of the most politically stable and secure in the region. this ensures that the country has a robust competitive edge as the region’s premier commercial hub and second largest economy. the political and economic stability of the country attracting investors, according to the 2015 global investment report of unctad, the uae is the second largest fdi recipient in the west asia region, after turkey. the total fdi inflow is usd 13 billion (a 25% increase on 2014) which represent around (2.7% of the gross domestic product [gdp]). the main investors in uae are britain, japan and hong kong, in 2014 india, the united states, the united kingdom, germany, japan, kuwait, south korea, france, australia and singapore respectively are main countries investing in the uae, in terms of investment cost of the projects. the share of india, the haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018302 united states and the united kingdom accounted for around 40% of the total investment on the country. most of fdi is concentrated in the sectors of hydrocarbons, water and electricity production. arab and foreign investments incoming to the uae are concentrated in the real estate sector with a percentage of (22.7%) followed by the hotels and tourism sector, with (15.2%), (12.7%) in the oil and gas sector and 6.3% in the financial services sector (unctad, 2015). in addition, uae is considered one of the biggest investors outside the country, uae appear in the 33 and 10 positions of the investors among all countries and the developing countries. the total outflow investments are estimated to be (3 billion usd) which represent around (0.7% of the gdp). the uae is ranked 14th position in 2013 and 15th in 2012 and 11th position 2015 globally in the foreign direct investment (fdi) confidence index which is created by management consulting firm in 1998 (uae, 2016). the total outflow investment represents 9.2% of the arab total in 2014 (unctad, 2015). egypt, india, iraq, jordan, algeria, tunisia, saudi arabia, the united kingdom, morocco and syria respectively were on the list of the most important countries receiving emirati investments, in terms of investment cost of the projects. the share of egypt, india and iraq accounted for around 31% of the total in 2014. different studies conducted in past regarding the fdi policies in different countries and regions and its impacts on the recipient countries, such as haddad (2016) haddad (2018); sun and he (2014); alfaro et al. (2004) al-habees and rumman (2012) shaari et al. (2012) velnampy et al. (2013) dritsakis and stamatiou (2014) ball et al. (2013) mucuk and demirsel (2013) colen et al. (2009); perugini, pompei, signorelli (2005) al-shammari et al. (2016). al-shammri and al-sarhan, (2012); bilal 2011; abdullah (2013); akbar (2012); saleh (2015 ); afifi 2009; mokhtar et al. (2013) sharaf, 2006; ahmed 2009; rakha 2012, shaikh, (2010), anwar and sun (2011) el-wassal (2012) and many others studied on fdi giving an evidence that fdi has either positive or negative impact on the economic growth measured as (gdp), the unemployment, the population’s life expectancy and other factors for the country’s wellbeing in general separately. nevertheless, there is limited researches that investigates and analyzes the impact of the fdi on the human development measured as hdi, in additions these studies concentrated on the incoming investment to the counties and their impacts on the host countries and don’t considered the impact of the outwards investment going out of the country on the economics growth of the investor countries as well as they concentrate on the other variables to measure the development rather than the human development of the donate or investor countries. therefore, this study explores the impacts of the fdi both the inwards and outwards on the economy of the investor country and the impacts of these investments on the development measured by hdi in one of the one the most important country namely uae. thus, the purpose of this study is to determine the impacts of fdi in uae human development indicator. thus, study analyzes the effects of fdi on development measured by human development index (hdi) in uae compared to the impact of fdi on economic growth as measured by (gdp). to achieve this objective the study tries to answer the following research questions: 1. what extent fdi inflow influences the development of uae measured by hdi? 2. what extent fdi outward influences the development of uae measured by hdi? 3. what is the mutual and joint impact of the both types of fdi on development of uae measured by hdi? this paper is organized as follows: the 1st section is revision of literature and theoretical background of the subject. the 2nd section presents the methodology, data collections, and the models of the study, while the 3rd section present the results of the data analysis of the impact of investment on hdi in uae. finally, the paper ends up with concluding remarks. 2. review of literature and theoretical background fdi received the attentions of researchers, policy makers and economists all over the world, as mentioned in the introductions there are enormous studies done in the impacts of the fdi on the host countries, in additions there is a debate about the positive impacts on the host countries economies mainly in the developing countries. however, policy makers do their best to create enabling environment to attract investments to their countries to create development and solve socio-economic problems facing the economy of their countries. fdi can be defined as the investment which is invested by an investor in foreign countries with interest to gain more market share in the international context and enjoy the economies of scale (shaari et al., 2012). while international monetary fund and organization for economic co-operation development, defined the fdi as an international venture in which an investor residing in the home economy acquires a long-term ―influence in the management of an affiliate firm in the host economy. according to the definition, the existence of such long-term influence should be assumed when voting shares or rights controlled by the multinational firm amount to at least 10 percent of total voting shares of rights of the foreign firm. fdi flows can be observed from the perspective of the host economy, which records them as inward fdi along with other liabilities in the balance of payments, or from the perspective of the home economy which records them as outward fdi, a category of assets (contessi and weinberger, 2009). further, european union report on international trade and fdi, 2013 stated that, the globalization has the impact on the economy through the foreign trade in goods and services, financial flows and the movement of persons linked to cross – border economic activity. theoretical studies on fdi have led to a better understanding of the economic mechanism and the behavior of economic agents. there are many theories concerning the fdi and its role in economy, which can be categorized in to four; these are production cycle of the fdi theory, the exchange rates on imperfect capital markets, the internalization theory and the eclectic paradigm theory denisia (2010). haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018 303 fdi provides the basic infrastructure facilities to host countries especially developing countries such as capital, technology, managerial skills, entrepreneurial ability, brands, and access to markets. these are essential for developing countries to industrialize, create jobs and reduce the unemployment rate, enhance the entrepreneurial intention and reduce the poverty. (athukorala, 2003). investment can benefit the host country in several aspects, it is working to increase the national income as a key component of aggregate demand components, the level of skills, technology transfer to the host country and private foreign investment on modern technology transfer, it is working to increase local expertise and in particular managerial experiences through new ideas non-existent in the host country, which creates a quantum leap in national activities. fdi is also connected to the transmission quality and methods which drives efficient domestic market, also helps investment to reduce unemployment, especially if the laborintensive investments, making it easier optional saving process, through wages and salaries for employees, which leads to increased national income and that helps out the poverty cycle which drives the wheel of development in the country. ball et al. (2013) tested the validity of okun law using the data of the us and 20 developed countries found that okun law was strong and stable relationship in most of the countries, however there are sometimes deviations from okun law, but these deviations were generally small in size and short lived. on the same context, kitov (2011) investigate the relationship between unemployment and real gdp per capita in the developed countries (the us, france, australia, the united kingdom, canada and spain) during the period of 1985-2010, the results of the study confirm that okun law predicted the changes in unemployment rate substantially correct for the developed countries. furthermore, the findings of study done in japan on the impact of fdi on unemployment by shows that japan experienced considerably lower levels of inward fdi compared to other developed countries. furthermore, the rate of unemployment in japan was relatively low which is caused by a specific attitude of the active population of japan towards employment issues. the findings indicate clear existence of correlation between fdi and unemployment. lin and wang (2004) focused on the correlation between capital outflow and unemployment in g-7 countries and comprise the most capital outflow countries in the world (g-7 countries) using annual data from 1981 to 2002, results show that fdi is negatively correlate with the unemployment rate in all g-7 countries. sharma and gani (2004) examined the effect of fdi on human development, by measuring the hdi scores for middle and lowincome countries. they observed that fdi has a positive effect on human development through its economic contribution and infrastructure developments in the recipient countries, with consequent increase in human capital. blomström and kokko (2001) found that fdi creates a favorable atmosphere for the development of human capital in east asia and in latin america. in both regions local employees’ training has improved, and their education level increased as a result of fdi and they could utilize more advanced technology in the production process. thus, in parallel with human development, fdi is observed to support technological progress in the recipient country. majeed and ahmad (2008) argue that higher hdi scores may be one more factor attracting fdi. a positive relation between health expenditures and fdi inflows has been detected by the authors, mainly because work quality of the labor force and ability to learn are dependent on health of the employees. it may be implied that inflows of fdi that positively affect hdi will definitely attract further fdi in particular region. subbarao (2008) has analyzed the effect of fdi inflows on the host country’s human development from two viewpoints, first from the demand perspective and from the supply perspective. talking about demand, there is a demand and need for better prepared and trained workers who can adopt faster and easier to more innovative technology, which helps to develop employee’s efficiency. supply side means that foreign investors provide jobs and training for employees. sometimes foreign firms are supporting host country’s education system, so the efficiency of the workers can be increased. assadzadeh and pourqoly (2013) capital scarcity is known to be one of the main causes of many countries’ entrapment in vicious cycle of poverty and underdevelopment. in addition, the existence of appropriate institutional quality has an impact on the poverty rates in these countries. this paper examines the effects of fdi and institutional quality (rule of law) on reducing poverty. to do so, a random effect panel econometric technique is applied using mena countries’ data for 2000–2009. the hdi is used as an indicator of poverty reduction. the findings show that the fdi and appropriate institutional quality have significant positive effects on reducing poverty and increasing welfare. baghirzade, n (2012) examine the impact of fdi on hdi in commonwealth of independent for the period 1995-2009, the impact of fdi on people’s quality of life, on education, health, income and life expectancy is analyzed, the results shows that fdi inflows improve the education, health, income and life expectancy in all cis countries, except azerbaijan analyses the impacts of fdi on economic growth in the six (gcc) countries (kingdom of saudi arabia, uae, oman, qatar, kuwait and bahrain) and identify the determinants of fdi in these countries. results indicate a weak relationship between fdi and gdp in the panel of the gcc, which supports the endogenous growth hypothesis for this group of countries. el-wassal (2012) examines and investigates the relationship between fdi and economic growth in 16 arab countries for the peroid1970-2008 using a dynamic panel approach. the results of the analysis show that the impact of fdi on economic growth in arab countries is limited or negligible. the findings propose that financial development, trade openness, human capital and infrastructure quality are not significantly improving arab haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018304 countries’ capacity to obtain growth benefits from fdi. in addition, the preconditions should not be seen as of equal importance. however, sectoral composition of fdi plays a critical role in deriving fdi growth benefits which might make it a necessary precondition for fdi to promote economic growth, while other factors are sufficient preconditions for reaping fdi growth dividends. thuc (2010) investigate the impact of fdi on human development in developing countries using hdi as a proxy for human development using panel data for 92 developing countries over the period 1980-2009, shows a positive significant effect of fdi on hdi even after controlling for gdp and other relevant variables. mina (2013) finds that fdi is important in building a sustainable and diversified knowledge-based uae economy. the stock of fdi grew at an average annual growth rate of 45.3%t over the past decade reaching us$ 95 billion or nearly 27% of gdp in 2012. fdi flows have not recovered from the global financial crises. most fdi stock is concentrated in finance, construction, and real estate. recent green field fdi is concentrated in construction, while more than half of top m&a deals took place in finance, transportation, communications and utilities. the list of top oecd home countries for fdi flows to the uae include italy, germany, chile, united kingdom, luxembourg, france, united states, and belgium. though uae investment policy limits foreign investment and reduces competition, the government has undertaken reforms and contracted investment treaties that have encouraged investment. efforts are under way to speed up the ratification of a new foreign investment law, which removes several of the current legal barriers to fdi and offers foreign investors similar rights to those of uae nationals. the uae has high fdi potential with plenty of room for improving fdi performance and benefits. 3. methodology this study employs empirical analysis to examine the impact of fdi on development and the human development measured by the hdi in uae for the period 1990-2014. time serious data was collected from different resources such as untied nation development programme (undp), unctad, and the arab investment and export credit guarantee corporation. hdi is collected from annual reports of the human development issued by undp, while data of fdi is collected from both unctad and the arab investment and export credit guarantee corporation. single and multiple regressions using ordinary least square regressions method were used to analysis the annual data on fdi and the hdi. fdi (both inflow and outflow investment are used separately and together) are the independent variable and hdi is the dependent variable. the following models represent the econometrics models of the study: 1. the first model measures the impact of fdi outflow on hdi that is hdi is a function of fdi outflow represented in equation one hdit = β0 + β1 fdi (outflow) t + ε t (1) 2. the second model measures the impact of fdi inflow on hdi, that is hdi is a function of fdi represented in equation two hdit = β0 + β1 fdi (inflow) t + ε t (2) 3. the third model measures the impact of fdi inflow and outflow mutually on hdi, that is hdi is a function of fdi inflow and fdi outflow as in equation three hdit = β0 + β1 fdi (outflow) t + b2fdi (inflows) + ε t (3) where βo = intercept β1 = slope (measure the impact of the dependent variable on the independent variable) fdi(outflow) t = outflow fdi in period t (the investment of the country on other countries) fdi(inflow) t = inflow fdi in period t (incoming investment from other countries to the country) hdi t = hdi in period t εi = random error. based on the equations above, the positive sign of fdi coefficient represents a positive effect of fdi on economic growth and hdi. a rise in fdi will cause the economic growth and human development to decrease. 3.1. variables of the study 3.1.1. the hdi the hdi was created by undp since 1990 to emphasize that people and their capabilities should be the ultimate criteria for assessing the development of a country, not only the economic growth as done in most cases. and since that year undp annually published independent reports of human development (hdr) that include the hdi. there are many definitions of hdi; one of them is that hdi is tool for comparative estimation of poverty, literacy, education, average life expectancy and other indicators of the country. hdi is a summary measure of average achievement in key dimensions of human development, namely health, education and income, hdi is the geometric mean of normalized indices for each of the three dimensions. the health dimension is assessed by life expectancy at birth, the education dimension is measured by mean of years of schooling for adults aged 25 years and more and expected years of schooling for children of school entering age and the standard of living dimension is measured by gross national income per capita. the hdi uses the logarithm of income, to reflect the diminishing importance of income with increasing gni. the scores for the three hdi dimension indices are then aggregated into a composite index using geometric mean (undp, 2016)1. that is hdi is a composite index measuring average achievement in three basic dimensions of human development-a long and healthy life, knowledge and a decent standard of living. that is hdi composed from three indicators, these are life quality (life 1 refer to technical notes for more details. haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018 305 expectancy index, life expectancy at birth (in years)); education index (ei) measured by mean years of schooling (in years), and expected years of schooling (in years), and income index measured by per capita income (ppp $). although the hdi simplifies and captures only part of what human development entails and does not reflect other dimensions of human development such as inequalities, poverty, human security, empowerment, it still better measure of development than measuring economic growth as gdp inductor alone as it reflects more dimensions of the development in any country. 3.2. robust of the model using time series data is accomplished by many problems among and the most important is non-stationary which leads to spurious regression (gujarati, 2003; trung and vinh, 2011; shaari et al., 2012). therefore, the first step in constructing a time series data is to determine the non-stationary property of each variable. many statistical methods are used to test the non-stationary of the time series. in this study, augmented dickey fuller (adf) unit root test (adf –fisher chi square and adf choi z –stat) is applied which is the most popular test. if the test shows the significant level in terms of p value, it will be concluded that the variable series is stationary. it means that, the data are not in the position of unit root. in contrast, if the stationary test is not in the significant level in terms of p value, it will be statistically explained that the variable series is non-stationary and has a unit root test (gujarati, 2003; trung and vinh, 2011; shaari et al., 2012). table 1 presents the results of the adf unit root test for the three models used in the study. the information in the tables indicates the augmented dickey fuller statistics (adf –fisher chi square and adf choi z –stat) are significant at the level (p < 0.05). therefore, no unit root in the data series and the variable series is stationary and does not have a unit root test. 4. investment environment in uae the government of uae adopted numerous measures and initiatives, laws and regulations throughout the seven emirates of the uae aiming to develop a more conducive environment for foreign investment and motivate fdi. moreover, all seven emirates have adopted measures to create a more favorable environment for foreign investors in each emirate. for example, dubai, sharjah and abu dhabi have very flexible rules concerning the acquisition of real estate property by foreigners. nevertheless, the regulatory and legal framework in the uae continues to favor local over foreign investors. furthermore, the government of the uae has passed a new companies law recently to facilitate investment and beginning business in uae. there are currently 18 draft laws that are intended to address a range of issues obstruct foreign investment in the uae. these laws cover insolvency and arbitration laws, as well as a draft foreign investment law. uae excogitate to remove the obligation of holding 51% of company capital by an emirati national, and establishing banking and insurance services, but these issues have not yet been decided upon. easy access to oil resources, low energy costs, a willingness to diversify the economy and a high purchasing power consist the main strengths of the uae in attracting investment. in addition to the absence of direct business taxation (excluding banks, oil companies and telecommunications operators) and direct income taxation, and absence of exchange controls and of any limitations on the repatriation of capital, as well as the existence of a strong and profitable banking sector, the geographical situation of the country, making it a potential platform to influence the gulf, iran, asia and the middle-east; lastly, the country has a cheap foreign labor force, very good transport and production infrastructures (financed by hydrocarbon income) and an access to low-cost energy. however, the main weakness is the small size of its domestic market, legal obstacles to foreign investments. effectively, the interdiction (except for free zone) of more than 49% of shareholding of a local company for a foreign investor constitutes a significant hindrance. moreover, the obligation for recourse to a local service agent for the branches and representative offices of foreign companies represents a limit. uae signed more than 50 bilateral agreements on investment to protect fdi besides that uae signed the investment conventions and international controversies registered by unctad. the government of uae established in 2007 the investment authority (eia) which is the sovereign wealth fund of the federal government of the uae through federal decree law no. 4 of 2007 which is amended by federal decree law no. 13 of 2009. the eia has actively sought unique investment opportunities locally, regionally and internationally, focusing on investing in asset classes that will help strengthen and diversify the uae economy. its primary directive is to manage the sovereign wealth of the uae by investing in a diversified portfolio of assets in key economic sectors and industries with the aim of delivering sustained financial gains for the uae. as a custodian of the federal assets of the uae, the eia is mandated to strategically invest funds allocated by the federal government to create long-term value for the uae and contribute to the future prosperity of the country. in a short span of time, the eia has uniquely positioned itself to become an invaluable partner for significant world-class investment opportunities locally, regionally and internationally (eia, 2015). the main objectives of the eia are using practical and sound investment strategies in accordance with global best practice, the eia has highly diversified investment portfolio, spread across a variety of investments and instruments which are carefully and table 1: augmented dickey-fuller unit root test results method first model second model third model adf fisher chi-square statistic 21.94 20.11 20.91 p 0.0002 0.0006 0.0002 adf choi z-stat statistic −3.71 −3.35 −3.72 recourse: calculated from the data haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018306 thoroughly managed to ensure superior, risk-adjusted returns to deliver long-term financial value to the uae and to ensure that the risks involved in each of the underlying assets are within limits and the investment activities generate the desired financial goals (eia, 2015). however, at emirate level, in 1967, abu dhabi emirate created the financial investments board which operated within its department of finance and was responsible for managing the emirate’s excess oil revenues. in 1976, the abu dhabi investment authority (adia) which is a sovereign wealth fund owned by emirate of abu dhabi was established as an independent investment institution for the purpose of investing funds on behalf of the government of the emirate of abu dhabi and to sustain the long term prosperity of abu dhabi by prudently growing capital through a disciplined investment process. adia manages a diversified global investment portfolio across more than 24 asset classes and sub-categories. it directly invest in global financial markets, alongside trusted partners and through a network of carefully selected external managers. 5. description of the variables 5.1. fdi of uae 5.1.1. incoming fdi 5.1.1.1. trend of incoming investments the inflows investments to uae are very small before 1993 and reach only (401.3) and (399.9) millions of us$ in 1993 and 1994, these investments started to fluctuate during the period 1995-2003. the abnormal increase was happened 2003, 2003 and 2004 and after, were the investments reaches (1183.8) (4256) and (10003.5) respectively and reach the maximum of (14186.5) us$ in 2007 and then started to decrease till 2010 were it increase to be (5500.3) millions of us$, after that these investments stilled around 10 billion annually (table 2). although the position of uae in the international was 179 before 2000 in attracting investment, the uae start to occupy advanced position in attracting investment ranging 18-42 during 2003-2014 due to the efforts of the uae attract foreign investment especially in dubai. in addition, the uae became the first arabic country in attracting foreign investment in 2003-2004 and 2013-2014. however, the position of uae regress to the fifth in 2009 but still ranging 2-3th position among the arab countries during 2005-2014. that is uae the most attracting country to foreign investment among the arab countries. 5.2. origin of incoming investments the total incoming investment to uae during the period 20032015 is (142262) million us$. table 3 shows there are diversity of the investments coming to the uae, that is more than 30 countries invest in uae, five countries own around more than half of these investments. the first country that invest in uae is india with a percentage of (17.6%) of the total investment in uae followed by the united states, united kingdom, and japan with a percentage of (14.8, 8.2%, 5.4% and 5.2). the total investment of these five countries consist of half of the investments coming to uae. the arabic investment in uae are very small and amounted to (11%) of the total investments coming to uae, these investment mainly coming from kuwait (4.9%), which occupied the 6th countries that invest in uae followed by saudi arabia with percentage of (3%) and the 11th rank, other arabic countries invest in uae are bahrain, lebanon, jordan, egypt with percentage of (0.8%, 0.8%, 0.7%, 0.7%) respectively. the incoming investments to uae generate about (352.2) thousand jobs, united states of america, india and united kingdom investments generate about (15%) (10.9%) and (9.1%) of the total employments while (6.6%) (6%) and (4.9%) of the job opportunities are coming from the investments of germany, kuwait, and france. which amounted all to (52.9%) of the job created by investments in uae during the period 2003-2015. furthermore, the investments of south korea, saudi arabia, switzerland contribute by 12.3% divided equally between them. the average cost of one employment created during the 2003-2015 form the incoming investment in uae is (403.9) thousands of us$, while the maximum is (896.7) thousand us$ from the japanese investments and the minimum investment to create one job is 202.7 thousand us $ coming from the investments of malaysia. the arabic investments create around 14% of the total employments, with an average cost of 494 thousand us $, most of the arab investments are coming from the gulf countries mainly kuwait, saudi arabia and bahrain which counted for 9% of the total investment, and 11.5% of the total jobs and each job cost around (219) thousand us$ of the gcc. 5.3. the sectors of the investments the real estate sector is the first sector that attracts the investments in uae with a percentage of 22.7%m followed by the hotels and tourism, coal. oil, and natural gas sector and financial services, with percentages of (15.2%, 12.7%, and 6.3%) respectively, the other sectors ranging from 2.8 to 4.5% of the total investments (table 4). around 24.5 of the jobs are created in the real estate sectors followed by the hotels and tourism sector. the maximum investment needed to create one job is 2829.9 thousand us$ in coal, oil and natural gas sector followed the hotels and tourism sector, and financial services with (751) and (725.1) thousand us$ and while it is only (116.1) thousand us$ in consumer products sector. the cost of the job created in the real estate sector is (374.6) thousands of us$. 5.4. the outward investment of the uae table (5) shows that uae become one of the 42 investor countries in the world and in same years become 23 top investor countries in the world. the outward investments of the uae increase in the end of nineties of the last century, the year 1993 witness huge increase of the uae investments outside in which the amount of investment increase from 30.8 in 1993 million to 577 million in 1994 then deceased in the years 1995. however, anther abnormal increase is in2004, 2006, 2007, 2008 were the investments increase to reach 3750.3 (10891.8) (14567.7) and (15820.3) million us$ respectively, after that the investment ranging between two to haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018 307 table 2: the inflow fdi of uae trend and compared to the world, arab, developed and developing countries year value million us $ percentage of uae of arab countries world developed developing gdp 1990 (115.8) −9.05 −0.06 −0.07 −0.33 −0.23 1991 25.9 1.16 0.02 0.02 0.07 0.05 1992 129.7 3.35 0.08 0.12 0.24 0.24 1993 401.3 10.28 0.18 0.28 0.53 0.72 1994 62.5 1.76 0.02 0.04 0.06 0.11 1995 399.9 14.19 0.12 0.18 0.34 0.61 1996 300.5 6.09 0.08 0.13 0.20 0.41 1997 232.4 3.48 0.05 0.08 0.13 0.29 1998 257.7 5.04 0.04 0.05 0.15 0.34 1999 (985.3) −22.63 −0.09 −0.12 −0.46 −1.17 2000 (506.3) −8.54 −0.04 −0.04 −0.22 −0.49 2001 1,183.8 12.60 0.17 0.26 0.55 1.15 2002 95.3 1.31 0.02 0.02 0.06 0.09 2003 4,256.0 26.58 0.77 1.26 2.17 3.42 2004 10,003.5 39.61 1.47 2.57 3.79 6.77 2005 10,899.9 23.26 1.18 1.93 3.30 6.03 2006 12,806.0 18.31 0.92 1.38 3.17 5.77 2007 14,186.5 17.69 0.76 1.13 2.68 5.50 2008 13,723.6 14.12 0.92 1.74 2.34 4.35 2009 4,002.7 4.93 0.34 0.61 0.86 1.57 2010 5,500.3 8.24 0.41 0.82 0.95 1.91 2011 7,678.7 16.86 0.49 0.93 1.20 2.20 2012 9,601.9 18.00 0.68 1.41 1.50 2.50 2013 10,488.0 22.06 0.71 1.51 1.56 2.67 2014 10,065.8 22.93 0.82 2.02 1.48 2.48 recourse: calculated from the data of unctad data base. note in brackets means negative table 3: the sources of the fdi inflow to the uae rank hosting values percentages comp. projects jobs cost comp. projects jobs cost 1 india 273 339 38,257 25,065 8.5 8.7 10.9 17.6 2 united state 724 880 53,007 21,121 22.5 22.7 15.0 14.8 3 united kingdom 551 644 31,998 11,720 17.1 16.6 9.1 8.2 4 germany 193 243 23,172 7,691 6.0 6.3 6.6 5.4 5 japan 95 106 8,222 7,373 3.0 2.7 2.3 5.2 6 kuwait 44 62 21,138 7,039 1.4 1.6 6.0 4.9 7 south korea 30 41 14,137 6,480 0.9 1.1 4.0 4.6 8 france 166 215 17,089 6,051 5.2 5.5 4.9 4.3 9 australia 62 68 10,261 4,602 1.9 1.8 2.9 3.2 10 singapore 38 47 10,400 4,545 1.2 1.2 3.0 3.2 11 saudi arabia 55 61 14,491 4,293 1.7 1.6 4.1 3.0 12 switzerland 98 123 14,304 3,475 3.0 3.2 4.1 2.4 13 holland 64 81 6,487 3,017 2.0 2.1 1.8 2.1 14 canada 56 69 7,450 2,796 1.7 1.8 2.1 2.0 15 belgium 27 33 3,097 2,521 0.8 0.9 0.9 1.8 16 italia 84 100 9,703 2,425 2.6 2.6 2.8 1.7 17 spain 80 85 5,455 2,068 2.5 2.2 1.5 1.5 18 china 37 47 2,354 1,448 1.1 1.2 0.7 1.0 19 pakistan 14 18 6,420 1,354 0.4 0.5 1.8 1.0 20 bahrain 19 23 4,743 1,179 0.6 0.6 1.3 0.8 21 lebanon 20 25 3,297 1,169 0.6 0.6 0.9 0.8 22 hong kong 31 39 2,906 1,078 1.0 1.0 0.8 0.8 23 qatar 19 24 4,330 983 0.6 0.6 1.2 0.7 24 jordan 12 13 3,562 965 0.4 0.3 1.0 0.7 25 thailand 13 14 2,078 964 0.4 0.4 0.6 0.7 26 egypt 16 22 2,007 937 0.5 0.6 0.6 0.7 27 russia 28 32 3,155 883 0.9 0.8 0.9 0.6 28 turkey 18 22 1,791 810 0.6 0.6 0.5 0.6 29 malaysia 26 28 3,858 782 0.8 0.7 1.1 0.5 30 bahamas 2 2 2,788 665 0.1 0.1 0.8 0.5 others 324 374 20,252 6,766 10.1 9.6 5.7 4.8 total 3,219 3,880 352,209 142,262 100.0 100.0 100.0 100.0 resources: calculated from the data of arab investment organization annual reports haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018308 table 4: fdi inflow to the uae according to the sectors rank sector values percentage comp. projects jobs created cost (million $) comp. projects jobs created cost 1 real estate 120 150 86,178 32,284 3.7 3.9 24.5 22.7 2 hotels and tourism 114 176 28,751 21,591 3.5 4.5 8.2 15.2 3 coal, oil and natural gas 65 71 6,380 18,055 2.0 1.8 1.8 12.7 4 financial services 382 498 12,309 8,925 11.9 12.8 3.5 6.3 5 business services 598 677 19,382 6,378 18.6 17.4 5.5 4.5 6 chemicals 65 78 9,909 6,371 2.0 2.0 2.8 4.5 7 communications 182 210 11,790 5,309 5.7 5.4 3.3 3.7 8 leisure and entertainment 27 34 12,062 4,570 0.8 0.9 3.4 3.2 9 metals 96 105 18,958 3,967 3.0 2.7 5.4 2.8 10 consumer products 144 184 33,814 3,925 4.5 4.7 9.6 2.8 others 1,426 1,697 112,676 30,887 44.3 43.7 32.0 21.7 total 3,219 3,880 352,209 142,262 100.0 100.0 100.0 100.0 resources: calculated from the data of arab investment organization annual reports table 5: fdi outflow of the uae according to hosting countries rank hosting number of percentage of total companies projects jobs cost comp. projects jobs cost 1 egypt 64 99 44,827 32,378 5.5 4.0 7.8 10.9 2 india 135 354 101,083 29,692 11.6 14.4 17.7 10.0 3 iraq 33 48 17,445 29,135 2.8 2.0 3.0 9.8 4 jordan 39 59 22,490 15,447 3.3 2.4 3.9 5.2 5 uae 25 26 11,561 15,280 2.1 1.1 2.0 5.1 6 tunisia 14 16 4,295 14,839 1.2 0.7 0.8 5.0 7 saudi arabia 135 201 32,140 13,489 11.6 8.2 5.6 4.5 8 united kingdom 55 169 15,410 12,658 4.7 6.9 2.7 4.3 9 morocco 25 46 21,120 11,693 2.1 1.9 3.7 3.9 10 syria 17 21 22,388 9,275 1.5 0.9 3.9 3.1 11 china 42 66 18,484 9,074 3.6 2.7 3.2 3.1 12 qatar 100 135 21,609 7,897 8.6 5.5 3.8 2.7 13 indonesia 14 19 10,886 7,897 1.2 0.8 1.9 2.7 14 lebanon 44 53 18,509 7,308 3.8 2.2 3.2 2.5 15 pakistan 28 60 15,831 7,202 2.4 2.4 2.8 2.4 16 bahrain 71 104 16,353 6,582 6.1 4.2 2.9 2.2 17 united state 47 69 12,897 5,395 4.0 2.8 2.3 1.8 18 turkey 24 26 11,013 5,184 2.1 1.1 1.9 1.7 19 oman 81 127 19,013 3,036 6.9 5.2 3.3 1.0 20 nigeria 14 17 4,459 2,957 1.2 0.7 0.8 1.0 21 australia 15 33 4,303 2,754 1.3 1.3 0.8 0.9 22 kuwait 57 79 10,027 2,620 4.9 3.2 1.8 0.9 23 russia 14 18 7,851 2,204 1.2 0.7 1.4 0.7 24 malaysia 25 34 8,837 2,068 2.1 1.4 1.5 0.7 25 spain 14 22 3,594 1,943 1.2 0.9 0.6 0.7 26 germany 17 26 4,358 1,930 1.5 1.1 0.8 0.6 27 peru 1 2 3,836 1,850 0.1 0.1 0.7 0.6 28 senegal 5 7 4,814 1,743 0.4 0.3 0.8 0.6 29 djibouti 4 4 2,545 1,695 0.3 0.2 0.4 0.6 30 georgia 7 12 5,353 1,383 0.6 0.5 0.9 0.5 others 504 74,965 30,759 0.0 20.5 13.1 10.3 total 1166 2,456 572,296 297,365 100.0 100.0 100.0 100.0 resources: calculated from the data of arab investment organization annual reports first or the second one. 5.5. receiving countries the uae investment aboard is more diversified that is around 89.7% of these investments are located into 30 countries, the first six countries where the uae located are arabic countries counted for 40.5% of the total uae investments aboard and occupied the first seven position in addition to india. these countries, in order, are egypt, iraq, jordan, algeria, tunisia, and saudi arabia. the three billion annually as shown in (table 6). there are many reasons for these increases in the uae investments outside the country among them the efforts of the government to build strong resource of income to the country after establishing the uae investment authority in 2007. it is worth to mentioned that abu dubai investment authority (adia) which is a sovereign wealth fund owned by emirate of abu dhabi became the fourth in the world by (773) million us$ in 2014 and in some years the haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018 309 uae investments in india counted for (10%) and occupied the second country which receives the uae investments. the first european country is the united kingdom which receive only (4.3%) of the total uae investments and occupied the 8th position, followed by spain and germany receiving about 0.7 and 0.6% and occupied the 25th and 26th positions. the total investments in 11 arab countries received around (55%) of the uae investments in aboard that is five arab countries in addition to the first top arab countries receive about 14% of the total investments. these are morocco, syria, qatar, lebanon, bahrain, oman, kuwait and djibouti. the uae investments abroad create around (572.3) thousands job opportunities in the receiving countries (17.7%) of these jobs are in india, followed by egypt with 7.8% while the other jobs are distributed among other countries. each job opportunities need (519.6) thousands of us$, with maximum of (3454.9) thousands of us$ is needed to create one job in tunisia and only 159.7 thousand us$ to create one job in oman. 5.6. the impact of the investments on the gdp in order to explore and investigate the impact of fdi on the development of the uae, both fdi investments directions (outflow and inflow) are regressed on the hdi individual to observe the impact of each direction of investment on the local development on the uae as well as mutual effects of both types of investments. durbin-watson is used to test for autocorrelation, a statistic that indicates the likelihood that the deviation (error) values for the regression have a first-order auto regression component; the regression models assume that the error deviations are uncorrelated. the durbin-watson statistic is always between 0 and 4, a value of 2 means that there is no autocorrelation in the sample. values approaching 0 indicate positive autocorrelation and values toward 4 indicate negative autocorrelation. parameters of the model (β) of the independent variables measure the impact of the independent variable on the dependent variable that is the amount of the change in the independent variable resulted from one-unit change in the dependent variable and the values of (t) parameter indicates the significant of impact of the independent variables on the dependent variable. table 7 summarizes the results of the three model’s regressions. model (1) measures the impacts of the fdi outflow, model (2) measures the impact of inflow and the third model measures the mutual impacts of both type of investment fdi outflow and inflow together on the development on the uae. the figures on the table for model (1) shows that the overall significance in regression analysis of model (1), measured by f ratio which is equal to (24.8) with significant level of it which is (α = 0.000; <0.05) for the first model indicates that the model is suitable and can explore the relationship between the dependent variable (hdi) and the independent variable (fdi outflow), the value of the confirm that hdi respond to changes in fdi and the model can be easy estimate the impact of the fdi outflow on the hdi on the uae. table 6: trends and comparison of the uae fdi outflows year value in million us$ percentage of uae of arab countries world developing economies developed economies gdp 1990 (57.7) 7.05 −0.02 −0.44 −0.02 −0.114 1991 10.4 20.00 0.01 0.09 0.01 0.020 1992 15.2 −1.47 0.01 0.07 0.01 0.028 1993 30.8 9.10 0.01 0.09 0.02 0.055 1994 577.0 −351.05 0.20 1.26 0.24 0.973 1995 62.5 −10.33 0.02 0.12 0.02 0.095 1996 128.6 4.70 0.03 0.21 0.04 0.175 1997 231.1 75.81 0.05 0.35 0.06 0.293 1998 127.3 −11.58 0.02 0.30 0.02 0.168 1999 317.1 28.72 0.03 0.56 0.03 0.376 2000 423.7 18.26 0.04 0.48 0.04 0.406 2001 213.7 22.30 0.04 0.37 0.04 0.207 2002 441.1 14.23 0.09 1.20 0.10 0.402 2003 991.2 −59.11 0.19 2.52 0.21 0.797 2004 2,208.0 27.49 0.25 1.96 0.29 1.494 2005 3,750.3 32.04 0.47 3.42 0.56 2.076 2006 10,891.8 47.75 0.81 5.37 0.98 4.904 2007 14,567.7 38.77 0.68 5.40 0.80 5.648 2008 15,820.3 35.85 0.93 5.75 1.16 5.015 2009 2,722.9 14.32 0.25 1.16 0.33 1.069 2010 2,015.0 9.53 0.15 0.59 0.21 0.701 2011 2,178.0 6.92 0.14 0.61 0.19 0.625 2012 2,536.0 11.30 0.20 0.71 0.29 0.661 2013 2,951.7 7.55 0.23 0.78 0.35 0.741 2014 3,071.8 9.21 0.23 0.66 0.37 0.758 resources: calculated from the data of arab investment organization annual reports and recourse: calculated from the data of unctad data base. in brackets means negative haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018310 the value of durbin-watson test is (2.09) and it is close to 2.0 is consistent with no autocorrelation in the model, so that there is no autocorrelation between the variables which have been used in this model. the coefficient of determination (r2) value which is (0.508) means that the fdi outflow explain 50.8% of the variations in the dependent variable (hdi). that is the fdi outflow are responsible for 50.8% of the change in the hdi in uae while other variables are responsible for the rest of the variation in the hdi on uae which are not our concern in this study. the value of parameters (β = 0.00001) of the independent variables (fdi outflow) which is significant (α = 0.000; < 0.05) show that the impact of the independent variable (fdi outflow) on the dependent variable (hdi) is significant and that one-unit change in fdi outflow) can generate (0.00001) change in the in the independent variable (hdi). for the impact of the inflow on the development on the uae measured by the (hdi) model (2) is used, the  table (7) indicates that value of f ratio which is (77) means that overall significance in regression is significant level of it which is (α = 0.000; <0.05) that the model is suitable and can explore the relationship between the dependent variable (hdi) and the independent variable (fdi inflow), the value of the confirm that hdi respond to changes in fdi and the model can be easy estimate the impact of the fdi inflow on the hdi on the uae. the value of durbin-watson test is (2.06) and it is close to 2.0 is consistent with no autocorrelation in the model, consequently that there is no autocorrelation between the variables which have been used in this model. the coefficient of determination (r2) value which is (0.784) means that the fdi outflow explain 78.4% of the variations in the dependent variable (hdi). that is the fdi outflows are responsible for 78.4% of the change in the hdi in uae while other variables are responsible for the rest of the variation in the hdi on uae which are not our concern in this study. the value of parameters (β = 0.00001) of the independent variables (fdi inflow) which is significant (α = 0.000; <0.05) show that the impact of the independent variable (fdi inflow) on the dependent variable (hdi) is significant and that one-unit change in fdi inflow) can generate (0.00001) change in the in the independent variable (hdi). multiple regressions analysis is used to examine the relationship between the dependent variables in this study is fdi (fdi inflow and fdi outflow and independent variables in this model is the development measured in hdi on the uae. the figures on the table for model (3) illustrate that the value of f ratio which is equal to (36.8) with significant level of it which is (α=0.000; <0.05) indicates that the model is suitable and can explore the relationship between the dependent variable (hdi) and the independent variables (fdi outflow and fdi inflow), the value of the confirm that hdi respond to changes in fdi inflow and outflow and the model can be easy estimate the impact of the fdi outflow on the hdi on the uae. the value of durbin-watson test is (2.08) and it is close to 2.0 is consistent with no autocorrelation in the model, therefore that there is no autocorrelation between the variables which have been used in this model. the coefficient of determination (r2) value which is (0.773) means that the fdi outflow explain 77.3% of the variations in the dependent variable (hdi). that is the fdi outflow and fdi inflow are responsible for 77.3% of the change in the hdi in uae while other variables are responsible for the rest of the variation in the hdi on uae which are not our concern in this study. the value of parameters fdi inflow (β1 = 0.00001) of the independent variables (fdi inflow) which is significant (t = 4.91; α = 0.000; <0.05) show that the impact of the independent variable (fdi inflow) on the dependent variable (hdi) is significant and that one unit change in fdi inflow) can generate (0.00001) change in the in the independent variable (hdi). the value of parameters fdi outflow (β2 = 0.000001) of the independent variables (fdi outflow) which is insignificant (t = 0.30; α = 0.764; more than 0.05) show that there are no impact of the independent variable (fdi outflow) on the dependent variable (hdi) and this impact is eliminated when considering both the type of the fdi on development of the uae measured by the human development. 6. conclusion the concern of this study is the development of one of the big oil producers, investments which is the uae, although it is considered as developing country, but the country is one of the big investor in the world and in the meantime one of the big attracting and hosting the fdi investment to the country. the government of the table 7: the results of regression of fdi s on hdi for uae model parameter b t sig. r2 d-w f sig. model 1 (constant) 0.77966 97.39 0.000 0.508 2.09 24.8 0.000 fdi outflow 0.00001 4.98 0.000 model 2 (constant) 0.75752 107.93 0.000 0.784 2.06 77.0 0.000 fdi inflow 0.00001 8.78 0.000 model 3 (constant) 0.75792 103.78 0.000 0.773 2.08 36.8 0.000 fdi inflow 0.00001 4.91 0.000 fdi outflow 0.000001 0.30 0.764 resources calculated from the data of the study haddad: the impacts of the inwards and outwards fdi on the development measured by hdi: the case of united arab emirates international journal of economics and financial issues | vol 8 • issue 4 • 2018 311 uae pay attention for both types of investment; to attract fdi to the country the government of uae and the governments of each emirate provide the suitable environment for the foreign investors, however there are many steps should be taken to improve this 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(2006), foreign investment and its impact on the economy of the state. financial management, 35(1), 59-78. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(special issue) 183-189. 2nd afap international conference on entrepreneurship and business management (aicebm 2015), 10-11 january 2015, universiti teknologi malaysia, kuala lumpur, malaysia. international journal of economics and financial issues | vol 5 • special issue • 2015 183 determination of constructs and dimensions of employability skills based work performance prediction: a triangular approach normala rahmat1*, yahya buntat2, abdul rahman ayub3 1department of technical and engineering education, faculty of education, universiti teknologi malaysia, 81310 utm johor bahru, johor, malaysia, 2department of technical and engineering education, faculty of education, universiti teknologi malaysia, 81310 utm johor bahru, johor, malaysia, 3teacher training division, ministry of education malaysia, level 2, block e13, parcel e, federal government administration center, 62604 putrajaya, malaysia. *email: normala74@gmail.com abstract the level of the employability skills of the graduates as determined by job role and mapped to the employability skills, which correspond to the requirement of employers, will have significant impact on the graduates’ job performance. the main objective of this study was to identify the constructs and dimensions of employability skills, which can predict the work performance of electronic polytechnic graduate in electrical and electronics industry. a triangular qualitative approach was used in the early stages in the development of research constructs and dimensions employability skills based work performance prediction (eswpp) of document analysis and expert interview protocol from the electrical and electronics industry and the institutions perspective. document analysis was done by using frequency matrices tables while interview data involving experts from industry and institution were analyzed using fleiss kappa reliability. fleiss kappa reliability analysis is used to determine the overall dimensions of the approval index for each construct eswpp. the findings of the overall kappa coefficient value at 0.91 and 0.99 for the industry and the academia, which indicates the level of agreement, is very good. the results showed that the constructs and dimensions eswpp were communication skills, personal qualities, teamwork skills, critical thinking skills and problem solving, technology skills, organizational skills and learning skills. keywords: employability skills, graduate electronic polytechnic, job roles, construct, dimensions jel classifications: m001 1. introduction today’s market has a steady stream towards globalization, diversification changes in technologies and intense highly competition among companies and countries. employers nowadays are concerned about finding good employees not only with technical skills but they are also looking employees with high competitiveness and ability to adjust with rapid changes in the industry (shafie and nayan, 2010; johari et al., 2011; mohd sahandri et al., 2012; selvadurai et al., 2012; mohamad et al., 2012; yahya et al., 2013; fong et al., 2014). there are employability skills that employers like to see in an engineering graduate and these can vary according to type of role to coop with the job market scenario (raybould and sheedy, 2005). employability skill refers to work readiness that is possession of the attributes, skills and knowledge of the engineering graduate should possess to obtain a job; also to ensure they have the capability being effective in the workplace; could also assist to adjust themselves towards various changes suit with the working environmental needs and could eventually enhance careers through the acquisition of those skills (normala and yahya, 2013). study on employability requires sustained effort so that the institution can learn the employability skills necessary changes by employers to job performance in order to strengthen efforts to provide quality engineering graduates. many researcher have rahmat, et al.: determination of constructs and dimensions of employability skills based work performance prediction: a triangular approach international journal of economics and financial issues | vol 5 • special issue • 2015184 proven, there are contradict the importance of employability’ skills for employees (archer and davison, 2008; mustafa et al., 2008; lowden, 2009; shukla, 2012). however, although ample evidence, there are limitations in previous studies. most studies used adaption constructs and dimensions employability skills from secretary’s commission on achieving necessary skills (scans, 1991) and model employability skills 2000 + by the conference board of canada’s employability skills forum board of canada, along with the changes and because of different purpose or situation where the research will conducted so the objective of this study was to identify and confirm the constructs and dimensions of employability skills that can predict the work performance (eswpp) of electronic polytechnic graduate in electrical and electronics industry to fulfill research requirement. 2. problem statement employers nowadays stressed that graduates lack employability skills required by employers (fairuzza et al., 2011; ahn et al., 2012; abdul, 2012; ministry of higher education, 2012b). employers think that graduates are not ready to enter and confront the complexities and challenges of the world of work (freudenberg et al., 2011; tymon, 2011; marais and perkins, 2012) and the resulting unwillingness of graduates are not proficient in the implementation of work task (tetreault, 1997). employers believe that education institutions is the most responsible to equip graduates with employability skills. however, the skills, behaviors and attitudes required by the prospective employees are different from what is taught during the study. different perceptions result in a gap between the knowledge, skills and qualities required by employers with what was dominated by graduates (rohaizat et al., 2012) increase a unemployment rate. tracer study report 2011 issued by the ministry of higher education shows that the percentage of polytechnic engineering graduates who are still unemployed in 2011 was 63.8% (ministry of higher education, 2012a). the issue of unemployment in malaysia is not because of lack of employment opportunities, but is due to poor quality of graduates (zaliza and mohd, 2014; normala et al., 2014). yahya (2004) view that graduates good technical skills, without having employability skills are considered not to be quality. a review studies done by thangiah (2008) reveal that one of the factors contributing to the unemployed graduates in malaysia is a “skills mismatch” where graduates do not have the skills sought by potential employers. this is happen because there is no consensus on the exact inventory of employability skills needed by graduates for the industry electric and electronics because even though various companies in the same industry sector, they have their own specific employability skills need (pillai et al., 2012). industrial demand will not be satisfied as long as the clear specification of properties that need to be established or the characteristics of workers who may not be completed (ministry of higher education, 2012b). shweta (2012) mention that the gap in terms of ensuring that the industry will be met by the continued development of the skills of the workforce. therefore, this study aims to identify and confirm the constructs and dimensions of eswpp of electronic polytechnic graduate in electrical and electronics industry to provide exact inventory of employability skills needed by graduates for the industry electric and electronics. the findings will be used to further empower collaboration, industrial services and employment center function by providing training about employability skills to polytechnic engineering graduate that actually required by the employer and most significant effect on the job performance to reduce the unemployment rate among engineering graduates of the polytechnic. 3. research questions the research questions are as follows: 1. what is constructs and dimensions of employability skills required by employers electrical and electronics industry in malaysia based on analysis document. 2. what is constructs and dimensions of employability skills which can predict the performance of an employee in the electrical and electronics industry in malaysia from perspective employers and institutions. 4. methodology a triangular qualitative approach was used in the early stages in the development of research constructs and dimensions eswpp of document analysis and expert interview protocol from electrical and electronic industry and institution perspective. document analysis was analyzed using frequency matrices tables and interview data involving experts from industry and institution were analyzed using fleiss kappa reliability. fleiss kappa reliability analysis is used to determine the overall dimensions of the approval index for each construct eswpp. the findings of the overall kappa coefficient value at 0.91 and 0.99 for the industry and the academia, which indicates the level of agreement, is very good. the results showed that the constructs and dimensions eswpp is communication skills, personal qualities, teamwork skills, critical thinking skills and problem solving, technology skills, organizational skills and learning skills. scale fleiss kappa agreement are as follows (table 1a): 5. result and discussions 5.1. document analysis and expert interviews construct formation of eswpp based on the comments and literature citations are shown in table 1b, the researcher has a list of the main constructs table 1a: scale fleiss kappa agreement κ interpretation <0 poor agreement 0.01-0.20 slight agreement 0.21-0.40 fair agreement 0.41-0.60 moderate agreement 0.61-0.80 substantial agreement 0.81-1.00 almost perfect agreement source: landis and koch (1977) rahmat, et al.: determination of constructs and dimensions of employability skills based work performance prediction: a triangular approach international journal of economics and financial issues | vol 5 • special issue • 2015 185 that are frequently mentioned by among famous model of employability skills throughout country as a construct of eswpp are communication skills, personal qualities, teamwork skills, critical thinking and problem solving skills, technology skills, organizational skills and continuously learning skills. table 1c have shown a result from interview sessions with five electric and electronic human resources officer in malaysia regarding their opinion about which construct of employability skills that they were concerned and really need acquisition show up by graduate especially graduate electronic polytechnic during interview session. table 1d have shown a result from interview sessions with five content expert come from several university regarding their opinion about which construct of employability skills that our graduate especially graduate electronic polytechnic should possess for job hunting success. based on the findings of the analysis of documents and expert interview protocol, it can be stated that the constructs eswpp include communication skills, personal qualities, teamwork skills, critical thinking and problem solving skills, technology skills, organizational skills and continuously learning skills. therefore, the formation of these elements may be continued to establish the dimensions of the constructs eswpp. 5.2. findings document analysis creation construct dimensions of eswpp 5.2.1. expert insights interviews formation of construct dimensions of eswpp from a documents analysis shown in table 1e it shows the list of the 27 main dimensions that are frequently mentioned in famous model of employability skills throughout country and used as formation dimensions for development of the constructs for eswpp. suitable dimensions for communication skills construct are effective reading strategies, effective writing strategies, using numeracy effectively, effective listening skills, effective speaking skills and share information using a range of information and communications technology. dimensions for personal qualities construct are responsibility, self-esteem and self-management. mean while dimensions for teamwork skills are work independently and as part of a team, coaching and mentoring table 1b: document analysis comparison for constructs formation of eswpp employability skills construct summary the conference board of canada (2000) employability skills 2000+ scans (2001) european union (eu) (dest 2002) australian government department of education employment and workplace relations (2008) stemnet (2015) total score communication skills √ √ √ √ √ 5/5 personal qualities √ √ √ √ √ 5/5 teamwork skills √ √ √ √ √ 5/5 critical thinking and problem solving skills √ √ √ √ √ 5/5 technology skills √ √ √ √ 4/5 organizational skills √ √ √ √ √ 5/5 continuously learning skills √ √ √ √ 4/5 eswpp: employability skills based work performance prediction, scans: secretary’s commission on achieving necessary skills table 1c: table comparison of constructs of eswpp from the employer expert perspective employability skills construct summary company (1) company (2) company (3) company (4) company (5) total score communication skills √ √ √ √ √ 5/5 personal qualities √ √ √ √ √ 5/5 teamwork skills √ √ √ √ √ 5/5 critical thinking and problem solving skills √ √ √ √ √ 5/5 technology skills √ √ √ √ √ 5/5 organizational skills √ √ √ √ √ 5/5 continuously learning skills √ √ √ √ √ 5/5 eswpp: employability skills based work performance prediction table 1d: table comparison of constructs formation of eswpp from the institution expert perspective employability construct summary content expert (1) content expert (2) content expert (3) content expert (4) content expert (5) total score communication skills √ √ √ √ √ 5/5 personal qualities √ √ √ √ √ 5/5 teamwork skills √ √ √ √ √ 5/5 critical thinking and problem solving skills √ √ √ √ √ 5/5 technology skills √ √ √ √ √ 5/5 organizational skills √ √ √ √ √ 5/5 continuously learning skills √ √ √ √ √ 5/5 eswpp: employability skills based work performance prediction rahmat, et al.: determination of constructs and dimensions of employability skills based work performance prediction: a triangular approach international journal of economics and financial issues | vol 5 • special issue • 2015186 skills, serves clients or customers, exhibits leadership, flexibility and works with cultural diversity. applies creative, innovative and practical solutions, applies decision-making strategies and recognises and solves problem are formation for crictical thinking and problem solving skills. technology skills contruct consists of select technology and applies technology to task. dimensions for organisational skills construct are utilizing resources such as manages time, manages money, manages materials facilities, manage human resources. planning process, adapt to changing requirements and information and continuously monitor the success of project or task and identify ways to improve are also dimensions included in organisational skills construct. lastly dimensions for continuosly learning skills construct are having enthusiasm for ongoing learning, managing own learning and assess personal strengths and areas for development. table 1f have shown a result from interview sessions with five electrical and electronic human resources officer in malaysia regarding their opinion about dimensions construct of employability skills that polytechnic graduate should acquire in order to make sure they can do the work. almost the 27 dimensions are agreed by them to perform dimensions of the construct of eswpp. table 1g have shown a result from interview sessions with content expert from institution. majority of them agreed table 1e: comparison of document analysis creation construct dimensions of eswpp employability skills construct employability skills dimension comparative employ ability skills model by country that needed by employers of industry the conference board of canada (2000) employability skills 2000+ scans (2001) european union (eu) (dest 2002) australian government department of education employment and workplace relations (2008) stem net (2013) total score communication skills effective reading strategies √ √ √ 3/5 effective writing strategies √ √ √ √ √ 5/5 using numeracy effectively √ √ √ 3/5 effective listening skills √ √ √ √ 4/5 effective speaking skills √ √ √ 3/5 share information using a range of information and communications technologies √ √ √ 3/5 personal qualities responsibility √ √ √ 3/5 self-esteem √ √ √ √ 4/5 self-management √ √ √ √ 4/5 teamwork skills work independently or as part of a team √ √ √ √ 4/5 coaching and mentoring skills √ √ √ 3/5 serves clients @ customers √ √ √ √ 4/5 exhibits leadership √ √ √ 3/5 flexibility √ √ √ 3/5 works with cultural diversity √ √ √ √ 4/5 critical thinking and problem solving skills applies creative, innovative and practical solutions √ √ √ 3/5 applies decision-making strategies √ √ √ √ √ 5/5 recognizes and solves problems √ √ √ √ √ 5/5 technology skills selects technology √ √ √ √ 4/5 applies technology to task √ √ √ 3/5 organizational skills utilizing resources √ √ √ 3/5 manages time manages money manages materials/facilities manages human resources planning process √ √ √ 3/5 adapt to changing requirements and information √ √ √ 3/5 continuously monitor the success of a project or task and identify ways to improve √ √ 3/5 continuously learning skills having enthusiasm for ongoing; learning √ √ √ 3/5 managing own learning √ √ 3/5 assess personal strengths and areas for development √ √ 3/5 eswpp: employability skills based work performance prediction, scans: secretary’s commission on achieving necessary skills rahmat, et al.: determination of constructs and dimensions of employability skills based work performance prediction: a triangular approach international journal of economics and financial issues | vol 5 • special issue • 2015 187 with 27 dimensions of contruct for eswpp and suggested that the dimension coaching and mentoring for construct teamwork skills need to be split up into two dimension because it brings a different meaning and approach and because the number of the dimensions is now 28. based on the analyzes and opinion from the experts that were conducted as described above, researchers have identified a finding that led to the formation of 28 dimensions contained in the seven constructs. through the process of analyzing these data, the constructs of the eswpp required by the electrical and electronics industry in malaysia which can improve work performance can be recognized and confirmed as constructs for the eswpp. the elements and dimensions have been reviewed by five experts whereby the approval has been granted. it is also based on the fleiss qualitative research where the five people involved are specialized in the qualitative research methods and the content of the study. in this study, the equation obtained is k = (pa−pc)/(1−pc) k = kappa value pa = observed agreement pc = chance agreement the findings of fleiss kappa coefficient values as a whole is 0.91 and 0.99 for the industry and the academia indicating a very good level of agreement. table 1f: comparison of expert insight interviews for formation of construct dimensions of performance prediction based on employability skills from the industry perspective employability skills construct employability skills dimension comparative employability skills that needed by employers of electrical and electronic industry in malaysia company (1) company (2) company (3) company (4) company (5) total score communication skills effective reading strategies √ √ √ √ 4/5 effective writing strategies √ √ √ √ √ 5/5 using numeracy effectively √ √ √ √ 4/5 effective listening skills √ √ √ √ √ 5/5 effective speaking skills √ √ √ √ √ 5/5 share information using a range of information and communications technologies √ √ √ √ √ 5/5 personal qualities responsibility √ √ √ √ √ 5/5 self-esteem √ √ √ √ √ 5/5 self-management √ √ √ √ 4/5 teamwork skills work independently or as part of a team √ √ √ √ √ 5/5 coaching and mentoring skills √ √ √ √ 4/5 serves clients @ customers √ √ √ √ 4/5 exhibits leadership √ √ √ √ 4/5 flexibility √ √ √ √ √ 5/5 works with cultural diversity √ √ √ √ √ 5/5 critical thinking and problem solving skills applies creative, innovative and practical solutions √ √ √ √ √ 5/5 applies decision-making strategies √ √ √ √ √ 5/5 recognizes and solves problems √ √ √ √ √ 5/5 technology skills selects technology √ √ √ √ 4/5 applies technology to task √ √ √ √ 4/5 organizational skills utilizing resources √ √ √ √ √ 5/5 manages time manages money manages materials/facilities manages human resources planning process √ √ √ √ 4/5 adapt to changing requirements and information √ √ √ √ 4/5 continuously monitor the success of a project or task and identify ways to improve √ √ √ √ 4/5 continuously learning skills having enthusiasm for ongoing; learning √ √ √ √ 4/5 managing own learning √ √ √ √ 4/5 assess personal strengths and areas for development √ √ √ √ 4/5 rahmat, et al.: determination of constructs and dimensions of employability skills based work performance prediction: a triangular approach international journal of economics and financial issues | vol 5 • special issue • 2015188 6. conclusion it was shown in this study that the analysis and opinion from the experts led to the formation of 28 dimensions consisted in seven constructs. it was also further shown that through the process of analyzing those data, the constructs of the eswpp required by the electrical and electronics industry in malaysia which can potentially improve the work performance can be recognized and confirmed as constructs for the eswpp. the equation obtained in this study also shows that the equation obtained with the fleiss kappa coefficient values as a whole at 0.91 and 0.99 for the industry and the academia indicating a very good level of agreement. in overall, the findings from the tringular approach which involved the analysis of documents and the expert perspective garthered form the industry and institution interviews demonstrated that the construct protocols for the eswpp are communication skills, personal qualities, teamwork skills, critical thinking and problem solving skills, technology skills, organizational skills, and continuously learning skills. 7. acknowledgments the author also gratefully acknowledges the contribution of dr. yahya buntat, dr. abdul rahman ayub (ministry of education), tang chee kuan (ministry of education), dr. azman hasan (uthm), prof. dr. ramlee mustapha (upsi), dr. ahmad esa (uthm), dr. mohamad sattar rasul (ukm), dr. seri bunian (puo), suzalina chu (osram), jamaludin johar (st), zulkepli table 1g: comparison of expert insight interviews for formation of construct dimensions of performance prediction based on employability skills from the institution perspective employability skills construct employability skills dimension comparative employability skills that needed by employers of electrical and electronic industry in malaysia (academician expert perspective) content expert (1) content expert (2) content expert (3) content expert (4) content expert (5) total score communication skills effective reading strategies √ √ √ √ √ 5/5 effective writing strategies √ √ √ √ √ 5/5 using numeracy effectively √ √ √ √ √ 5/5 effective listening skills √ √ √ √ √ 5/5 effective speaking skills √ √ √ √ √ 5/5 share information using a range of information and communications technologies √ √ x √ √ 4/5 personal qualities responsibility √ √ √ √ √ 5/5 self-esteem √ √ √ √ √ 5/5 self-management √ √ √ √ √ 5/5 teamwork skills work independently or as part of a team √ √ √ √ √ 5/5 coaching and mentoring skills √ √ √ √ √ 5/5 serves clients @ customers √ √ √ √ √ 5/5 exhibits leadership √ √ √ √ √ 5/5 flexibility √ √ √ √ √ 5/5 works with cultural diversity √ √ √ √ √ 5/5 critical thinking and problem solving skills applies creative, innovative and practical solutions √ √ √ √ √ 5/5 applies decision-making strategies √ √ √ √ √ 5/5 recognizes and solves problems √ √ √ √ √ 5/5 technology skills selects technology √ √ √ √ √ 5/5 applies technology to task √ √ √ √ √ 5/5 organizational skills utilizing resources √ √ √ √ √ 5/5 manages time manages money manages materials/facilities manages human resources planning process √ √ √ √ √ 5/5 adapt to changing requirements and information √ √ √ √ √ 5/5 continuously monitor the success of a project or task and identify ways to improve √ √ √ √ √ 5/5 continuously learning skills having enthusiasm for ongoing; learning √ √ √ √ √ 5/5 managing own learning √ √ √ √ √ 5/5 assess personal strengths and areas for development √ √ √ √ √ 5/5 rahmat, et al.: determination of constructs and dimensions of employability skills based work performance prediction: a triangular approach international journal of economics and financial issues | vol 5 • special issue • 2015 189 md som (opto dominant), zulkifli yatim (sharp), rosita (pioneer), adenan che mat (sharp), asif azwan amdan (fujitsu), for completing this manuscript. references abdul, g. 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(2014), unemployment among malaysia graduates: graduates’attributes, lecturers’ competency and quality of education. procedia social and behavioral sciences, 112, 1056-1063. doi:10.1016/j.sbspro.2014.01.1269. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(3), 117-125. international journal of economics and financial issues | vol 13 • issue 3 • 2023 117 systemic risk: a comparative study between public and private banks aymen mselmi1,2*, imen mahmoud3 1college of business al kamil, university of jeddah, saudi arabia, 2higher institute of business administration of gafsa (isaeg), university of gafsa, tunisia, 3laboratory of research in innovative management risk, accounting and finance (larimraf) university of manouba, tunisia. *email: aemselmi@uj.edu.sa received: 22 september 2022 accepted: 01 april 2023 doi: https://doi.org/10.32479/ijefi.13622 abstract this paper aims to study the capital insufficiency in various tunisian banks which are on the list of the tunisian stock exchange market. basing our work on the various measures of systemic risk, we have modeled the shortfall capital of the tunisian banking sector in order to compare private banks and public ones in terms of exposure to systemic risk. we have also studied the effect of stock market shocks on the banks’ marginal expected shortfall. the results obtained show that the systemic risk for the period 2006 and 2013 is mainly conveyed by the three public banks. keywords: systemic risk, marginal expected shortfall, public bank, private bank jel classifications: g21 g30 g32 g33 1. introduction the subprime crisis has confirmed the fragility of banking systems. banks were unable to maintain the funds needed to deal with financial turmoil and under-funding. thus, the amplification of the size of banks assets accompanied by the problem of capital shortfall led to systemic crises in the banking sector, where the bankruptcy of an institution affects the entire sector. as a result, banks are required to build capital reserves to offset capital shortfall in times of financial distress. in order to determine the requisite amount for the recapitalization and financing of capital insufficiency, a set of systemic risk measures are made available. the financial investigations carried out by “attac and basta” (2015) show that the size of banks assets has increased dramatically in relation to the gdp of oecd countries for the period between 1995 and 2013. this difference is mainly due to the orientation of the banks’ main activity (i.e., the collection of deposits from individuals and companies as well as the funding of the economy) to more speculation and security of corporate debts. it might be also the consequence of the development of more complex derivatives. in this respect, kirkpatrick (2009) confirms the presence of the paradigm “too big to fail.” he postulates that banks with a high level of total assets are related with higher systemic risk, while mayordomo et al. (2014) do not obtain a significant relationship between total assets and systemic risk. cerutti et al. (2015) and alin and simona (2016) indicate that the increase in volatility of total assets increases the banks contribution to the total systemic risk of the financial sector. research has led to the development of new methods aimed at bringing the financial sphere closer to real life. in this respect, the basel iii agreement has taken into consideration the latter connection by pushing analyzes and research towards a more generalized world. it is for this reason that current research has shifted to new more complex system risk measurement methods. acharya and volpin. (2010) validate that the mes was a good this journal is licensed under a creative commons attribution 4.0 international license mselmi and mahmoud: systemic risk: a comparative study between public and private banks international journal of economics and financial issues | vol 13 • issue 3 • 2023118 predictor of the decline of the stock prices. idier et al. (2014) have tried to evaluate the mes method and its capabilities to estimate the contribution of systemic risk to the financial sector risk compared to other measures. through this research, we try to identify the tunisian systemic banks in order to classify them according to their contribution to the sector systemic risk. furthermore, we try to compare the public and private banks as a function of their contribution to the total systemic risk. according to the modern financial theory, there are three main methods of quantifying systemic risk, such as “the marginal expected shortfall (mes), acharya and volpin (2010),” “the systemic risk index (srisk), acharya et al. (2012)” and “the variation in conditional value-at-risk (δcovar), adrian and brunnermeier (2011).” 2. data 2.1. measures overview this section outlines the construction of systemic risk indicators. to study the systemic risk in the tunisian banking sector, on the one hand, and to rank banks according to their contribution to the systemic risk of financial sector, on the other hand, we decided to proceed by the measures conceived by acharya et al. (2012). these include the mes, the lrmes and the srisk. the financial data corresponding to the construction of the systemic risk indicators are collected manually from the tunis stock exchange website and the annual reports of the various banks listed on the bvmt1. formally, acharya et al. (2012) illustrate the marginal expected shortfall as the forecasted equity loss when market falls below a 2% in a single day. this measure has a more realistic predictive ability than other measures. it provides a more reasonable economic interpretation than the conditional var. in addition, the general index of systemic risk came into being with the work of acharya et al. (2012). the srisk is considered as the extension of the mes. this involves taking into consideration both the financial commitments and the size of the financial institution. it corresponds to the expected capital deficit of a financial institution, depending on a crisis affecting the entire financial system. it estimates the amount of capital that the institution would need to obtain, in equity, during a severe financial crisis. furthermore, the srisk of an institution, during a financial crisis, is calculated according to the mes. for example, companies with large sifis under-fund the financial market in the event of a crisis. as a result, they would be the most vulnerable to risk. therefore, the risk% index measures the share of the expected deficit of each bank related to the overall deficit of the banking sector. 2.2. methodology in order to quantify the systemic risk of tunisian banks, we first adopt the engle model (2002) “dcc-mgarch,” in order to 1 bvmt: tunis stock exchange calculate the conditional volatility and the conditional correlation peer (i.e., stock price performance of banks and the performance of the general index of the tunis stock exchange “tunindex”). after calculating the variances and conditional correlations of the various performance peers for the period between 2006 and 2013, we secondly use the methodology of acharya et al. (2012) to determine the level of systemic risk mes of each bank. finally, we study the dynamic relationship between stock price shocks of banks and the stock index level tunindex. 2.3. sample of the study our sample includes eleven tunisian banks (both public and private). our study covers the period between 2006 and 2013. this survey focuses on a daily frequency for calculating stock market returns and a half-yearly frequency for the calculation of the risk index. the chosen period is considered as representative since it encompasses the main facts observed, namely the fallout from the global sub-prime crisis, the european sovereign debt crisis, the political disturbances as well as the “tunisian revolution” triggered from december, 2010. 3. systemic risk modeling 3.1. volatility modeling and conditional correlation 3.1.1. the estimation of dcc-mgarch model in this sub-section, we first attempt to present the dcc-mgarch model proposed by engle (2002) in order to make estimates of the volatility and conditional correlation of tunisian banks daily yields of stock market prices between 2006 and 2013. the above model minimizes the number of parameters by making the correlation matrix dynamic over time. in this respect, we can model the conditional variances, on the one hand, and the conditional correlations of several series of returns, on the other hand. the stated model is as follows: h =d r d t t t t (1) with d diag h h ht t t nnt= ( )11 22, ,....., r diagq q diagqt t t t= ( ) ( ) -1 2 1 2 with: dtrtdt: the variance-co-variance matrix ( )itdiag h : the designation of the diagonal matrix of standard deviations that vary over time. rt: the representation of the conditional correlation coefficient matrix. qt: the representation of the co-variance matrix of standardized residuals, of the dimension (n*n). 3.1.2. preliminary empirical tests of modeling dcc-mgarch the estimation of the dcc-mgarch model consists in exploiting the presence of similar movements between the index of the tunis stock exchange (tunindex) and the various stock prices in tunisian banks. mselmi and mahmoud: systemic risk: a comparative study between public and private banks international journal of economics and financial issues | vol 13 • issue 3 • 2023 119 in fact, we try to examine the conditional correlations between tunisian banks stock market returns and the tunindex index returns. first of all, we must proceed by testing the heteroscedasticity of the errors to validate the existence of the arch effect. then we have to test the normality of stock market returns. the tests cited above inform us about the robustness of the estimation in order to decide on the law of distribution (i.e, gaussian or student) with which we have to begin our regressions. in order to study volatility and conditional correlation based on the engle model (2002), we first test the heteroscedasticity of errors. the test postulates that under the null hypothesis of homoscedasticity, the statistics associated with the chi-square test follow a chi-square law with (q) degrees of freedom. the results of the arch-lm test are shown in the following table: reading this table shows us that the probabilities associated with the test statistics (x2) are null. as a result, our series of stock market returns are heteroscedastic, hence we confirm the presence of the arch effect for all series. 3.1.3. model estimation results “dccmgarch” the relevance of this modeling lies in the use of the multivariate garch model from the garch family, retaining the hypothesis of the dynamic variation of the variances and correlations of the series over time. indeed, the modeling of these correlations takes into account all the financial information available, at a given moment. the results of the dcc-mgarch model are reproduced in the following table: [supplementary table 1]. we proceeded by the dynamic conditional correlation model developed by engle (2002) to explore the evolution of the dependence between stock market returns and the tunindex index returns. the estimation of the dcc-mgarch model for the period between 2006 and 2013 confirms the significance of all the parameters. therefore, we validate the adoption of the garch specification of the different variables. moreover, the persistence of the coefficient (α), in the short term, remains low and statistically significant for most of the conditional variance equations, with the exception of two series, that of the bte bank and the ubci bank. however, the sum of the two parameters (α+β) is very close to unity, which reveals the importance of the persistence of the conditional variance of the series of stock market returns2. however, we note that both banks, that is attijari bank and atb bank admit the highest conditional correlation coefficients, in terms of dependence between stock price performance and the tunindex index. on the other hand, amen bank and the bank of tunisia are the least market-dependent, with correlation coefficients equal to 0.0583 and −0.0066 respectively. 2 our structure of analysis of the different parameters of the estimation of the dcc-mgarch models is based on the work of rouabah (2007), “co-variation of sectoral growth rates in luxembourg: the contribution of dynamic conditional correlations”, working paper no. 25, central bank of luxembourg. at the same time, we notice the presence of two shocks. actually, the interconnection between the general index of the stock market (tunindex) and most tunisian banks stock exchange prices has amplified to reach spectacular levels. the first shock was recorded between 2008 and 2009. this reflects the impact of the global financial crisis “sub-prime” on the tunisian economy, while the second phase of interdependence began in 2011, reaching extreme levels in early 2012. in this respect, the strong correlation between the different stock market returns of the banks and the tunindex index returns, during the downward phases of the financial market, has had a negative impact on the diversification strategies which, therefore, would reduce investment gains. we present, below, the different dcc curves between the tunindex returns and banks stock market returns. from the graph above, the estimated dynamic conditional correlations seem important. in addition, we can see strong intensity between the banking sector and the tunisian securities market. even more, it appears that dynamic conditional correlations have increased during the crisis period and the period of political turmoil (2011) [supplementary figure 1]. 3.2. systemic risk modeling 3.2.1. the marginal expected shortfall we try, through the modeling of the mes, to quantify the probability of occurrence of the marginal expected shortfall of the banks stock market value, on the basis of the work of acharya et al. (2012). we try, through the model below to determine the expected marginal shortfall of the banks stock market value, based on the work of acharya et al. (2012). in this respect, the marginal expected shortfall mes is defined as follows: ( ) ( ) , , , , , , , , , , 2 , , , , , () 1σ σ σ ρ ε ε σ ρ ξ ε = < = < + < m t m t i t i t m t c i t i m t m t m t c i t i m t i t m t mes e r r c e e (2) if ξit( ) and εmt( ) are independent, we have: mes ei t i t i m t m t m t c m t, , , , , , ,= <( ) σ ρ ε ε σ where from mes e r ci t i t i m t m t m t, , , , , ,= <( ) σ ρ ε (3) with r p div pi t i t i t , , , ln( )= + −1 r p pm t m t m t , , , ln( )= −1 and ( pi m, ) represents the closing prices of the stocks and the tunindex index. mselmi and mahmoud: systemic risk: a comparative study between public and private banks international journal of economics and financial issues | vol 13 • issue 3 • 2023120 c varm t= , ( )α σi t, = conditional volatility of the securities (i) ρi m t, , = conditional correlation of peers (i and m) in order to model the systemic risk, it is necessary to determine certain variables such as the tunindex returns, the banks stock market returns, the dynamic conditional correlation between the banks stock market returns and the market index returns, the conditional volatility of the banks stock market returns and finally the historical var of the market index. after calculations, we obtained a historical var of the tunisian market index almost equal to that found by acharya et al. (2012). hence, the historical var of the tunindex for the period (20062013) is equal to: c varm t = = ≈ = , ( %) . % % α 1 1 98 2 (4) after setting the var, in a first time, and the mes of the different tunisian banks listed on the bvmt in a second time, we can then proceed to the classification of these institutions on the basis of the degree of risk assigned to each of them. the ranking of tunisian banks according to the mes for the period between 2006 and 2013 gave us the following results: the figure 1 ranks the banks by their exposure to the risk of marginal expected loss when the stock index falls by −2%, in a single day. therefore, ubci bank appears to be the riskiest bank with an average mes equal to 6.69%. however, bte bank appears to be the least exposed to risk, with an average mes equal to 0.11%. at the same time, we can see that the banks status (whether public or private) is not significant. in addition, the above rankings are, indeed, heterogeneous in terms of the banks status. 3.2.2. long-run marginal expected shortfall the long-run marginal expected shortfall appeared, for the first time, with the study of brownlees and engle in 2010. this risk measure is defined as the long-term mes calculated over a period of 6 months or more. this is the long-run mes calculated on the basis of 6 months. the lrmes forecasts provide insight into longterm financial risk. brownlees and engle (2011) show that lrmes can be estimated through two approaches, a direct approach and 0 .2 .4 .6 c _ b h * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc bh_tdx 0 .2 .4 .6 .8 c _ a t j* 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc attijeri-bq_tdx 0 .2 .4 .6 c _ b n a * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc bna_tdx -. 2 -. 1 0 .1 .2 c _ b t * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc bt_tdx -. 4 -. 2 0 .2 .4 c _ a m n * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc amn_tdx -. 2 0 .2 .4 .6 .8 c _ s t b * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc stb_tdx -. 4 -. 2 0 .2 .4 c _ u ib * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc uib_tdx 0 .2 .4 .6 .8 c _ a t b * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc atb_tdx 0 .0 5 .1 .1 5 .2 c _ b t e * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc bte_tdx 0 .2 .4 .6 .8 c _ b a t * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc biat_tdx -. 2 -. 1 0 .1 .2 c _ u b c * 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014 date dcc ubci_tdx figure 1: dynamic conditional correlation between the tunindex return and banks’ stock market return mselmi and mahmoud: systemic risk: a comparative study between public and private banks international journal of economics and financial issues | vol 13 • issue 3 • 2023 121 an indirect approach. the direct approach allows the lrmes to be calculated when the return of the tunindex index falls by −40%, in a single semester. this method is particularly difficult to estimate because, in reality, the most dynamic stock markets in the world such as the us stock exchange market, during the last century, had only three stock market crashes, where the index got deteriorated to more than -40%, in 1930, 2000 and 2008. thus, this method is estimated, according to monte carlo’s simulation, as follows: lrmes r i r c i r i t t t i t t t s m t t t s s s m t t t , : , : ( ) , : ( ) , : -+ + += + = ≤( )∑ 1 (( )s s s c≤( )=∑ 1 (5) ri t t t s , : ( ) + and rm t t t s , : ( ) + represent stock market returns (i) for a 6-month period (t: t) and the return of the tunindex index for the same semester. c = 40% brownlees and engle (2011) define a stock market crash as a rebound in the market index of −40%, in one semester. i (x) = (1) if true otherwise (0) the indirect approach is to determine the long-run marginal expected shortfall, without the market declining by −40%. in this case, the monte carlo simulation is not necessary because the lrmes is determined through the modeling of the mes. therefore, the lrmes is defined as follows: srmes e r ri t i t m t, , ,%= ≤  + + 1 1 2 (6) the srmes (short-run marginal expected shortfall) represents the mes. moreover, the final approximation of the lrmes proposed by brownlees and engle (2011) is defined as follows: lrmes k mesi t t t i t, : ,exp -+ ≈ ×( )1 (7) for the calculation of the long-run marginal expected returns of the stock market returns, we proceed with the indirect approach, since the index of the bvmt (tunindex) has not bounced below 40% during the study period 2006-2013. 3.2.3. systemic risk measure according to the (risk management center of the university of lausanne), the systemic risk index was first reported by acharya and volpin (2010). the srisk is defined as the capital that a company would need in the event of a subsequent financial crisis. depending on brownlees and engle (2011), the systemic risk of a financial institution is defined as follows: srisk csi t t t i t t t, : , :max ,+ += ( ) 0 (8) our objective is to validate the assumption that the capital requirement of financial institutions increases when the stock market performance decreases. acharya et al. (2017) show that it is possible to directly calculate the capital shortfall value using the following variables (the book value of debts for a period of 6 months, the market capitalization of the bank and the long-run marginal expected shortfall. in this regard, the srisk is calculated as follows: srisk kd k lrmes ei t i t i t i t, , , ,-= ( )( ) 1 1 (9) k =the prudential ratio, assumed equal to 8% di t, = the book value of the debts of the institution (i) for semester (t) ei t, = the market capitalization of the institution (i) for semester (t) thus, we can determine the sectoral systemic risk through the aggregation of the srisk of each bank listed on the bvmt. the following formula represents the sectoral srisk: sriskj t j j , ∈ ∑ (10) the space (j) refers to all the bank institutions whose systemic risk is positive for period (t). to assimilate the share of each bank in the sectoral systemic risk, we then calculate the contribution of each bank in the total deficit of the banking sector (in other words, the systemic risk as a percentage). according to acharya et al. (2012), the individual banking contribution (in percentage) in sectoral systemic risk is determined as follows: srisk srisk srisk j t j t j t j j (%) , , , = ∈ ∑ (11) the calculation of the individual contribution of each bank in the overall systemic risk illustrates the following results: according to this figure 2, we can see that the three public banks “stb, bna and bh” contribute to sector systemic risk, in a significant way. 3.3. the sensitivity coefficient beta in parallel with the work of brownlees and engle (2011), acharya et al. (2012), benoit et al. (2014), we first try to determine the sensitivity coefficient beta of the various banks stock market. secondly, we try to compare this coefficient of sensitivity with the different risk measures previously treated such as mes, lrmes and srisk. indeed, beta is considered as the sensitivity coefficient associated with the risk premium derived from the famous capital asset pricing model (capm). however, it is the ratio between the co-variance of the banks stock returns (i), the return of the tunindex index (m) as well as the variance (m). mathematically, beta is defined as follows: βi t i t m t m tr r r, , , ,cov , var= ( ) ( ) (12) mselmi and mahmoud: systemic risk: a comparative study between public and private banks international journal of economics and financial issues | vol 13 • issue 3 • 2023122 = ρ σ σ i t i t m t , , , in addition, the cross-sectional analysis revealed that the coefficient beta reached its highest level in times of political upheaval (2010-2011). the graph below describes the evolution of beta of different banks during the period between 2006 and 2013 [supplementary figure 2]. the coefficient beta recorded significant levels on two occasions and the effect of the (2007-2008) subprime crisis is clearly visible. while those of the year 2011 are dictated by a purely political upheaval. in addition, the coefficient beta associated with the performance of private banks was larger and more significant than that associated with public banks. a priori, we can see that the portfolio of private banks was riskier than that of public banks. we, then, analyze the average beta throughout the reference period between 2006 and 2013. this is illustrated through the supplementary figure 3. the analysis of the average beta shows that bt bank (public bank) is qualified as the riskiest bank with a coefficient equal to 0.26. however, amen bank ranks second with a coefficient equal to 0.22, followed by atb bank, attijari bank and ubci, with risk coefficients around 0.12. 3.4. comparing the different measures of systemic risk and beta after analyzing the different facets of systemic risk such as (mes, lrmes, srisk in value and srisk in %), we proceed to classify the different institutions according to the nature of the risk. the ranking of the different institutions is represented in the following table: the table above shows the classification of tunisian financial institutions (banks) according to their contribution to systemic risk (srisk) and this concerns the period between 2006 and 2013. the above lrmes and beta are calculated according to their average during the same period. in this respect, the classification of the various establishments has allowed us to note that public banks (stb, bna and bh) are the riskiest in terms of srsik. nevertheless, the ranking according to other systemic risk measures such as lrmes and beta did not lead to the same results. thus, the results we have obtained show that the banks ranking differs from one measure to another, since each measure deals with a particular aspect of systemic risk. therefore, the divergence in classifications of banks on the basis of systemic risk is due to the difference in the fundamentals of each measure and not to the instability of a particular measure. in addition, the ranking based on the srisk is mainly sensitive to the importance of the level of indebtedness of each bank. brownlees and engle (2011) show that the srisk can be considered as a “compromise between the two paradigms (too big to fail) and (too interconnected to go bankrupt)”. however, they have shown, through their empirical study, that the two measures (srisk and beta) differ in the definition of their contribution to systemic risk. in contrast, these two measures are qualitatively very similar in explaining crosssectional differences in contribution to systemic risks. in addition, they are closely related to certain financial variables such as var, size and financial leverage. afterwards, we try to illustrate the degree of agreement between the two measures of systemic risk lrmes and beta through the following graphical representation: from the figure 3, we note that both risk measures increase in times of economic downturn. this is explained by sylvain et al. (2013). they explain how these two measures (i.e., lrmes and beta) tend to increase in times of economic slowdown, which is the case for our study. apart from that, the measure beta seems to be more sensitive to periods of economic and political disturbances. in addition, we note that the two risk measures followed the same trend for the period between 2006 and 2013. 6.69% 1.94% 1.52% 1.18% 0.80% 0.79% 0.78% 0.58% 0.52% 0.41% 0.11% 0% 1% 2% 3% 4% 5% 6% 7% ubci stb biat bna amn bt atj uib bh atb bte figure 2: ranking of tunisian banks according to the mes for the period between 2006 and 2013 figure 3: individual contribution in % to systemic risk of banking sector mselmi and mahmoud: systemic risk: a comparative study between public and private banks international journal of economics and financial issues | vol 13 • issue 3 • 2023 123 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8 1.0 2006-1 2006-2 2007-1 2007-2 2008-1 2008-2 2009-1 2009-2 2010-1 2010-2 2011-1 2011-2 2012-1 2012-2 2013-1 2013-2 stb bna bh atb amen biat bt bte ubci uib atj figure 4: biannual beta of tunisian banks (2006-2013) that stock market returns fall by <2% in a single day. thus, the risk measurement lrmes is considered as more relevant than beta. unlike lrmes, the risk measure beta is based on the co-variance dependence of the average returns on the banks financial assets. finally, the weakness of the tunisian banking sector, in terms of capital deficiency, has not disrupted the tunisian real economy, unlike in the case of systemic multinational financial institutions (sifs) where the systemic risk holds an important place in the gdp. this can be explained by the absence of the paradigm tbtf in the tunisian banking system. afterwards, we try to study the effect of impulse shocks, in terms of the marginal expected shortfall of the stock market performance of the banking sector. 4. the study of impulse shocks to minimize the systemic risk, a government must act on the performance and governance variables in banking institutions in order to reduce the budget devoted to the recapitalization of the banking sector, in the event of a financial crisis. after identifying systemic institutions, a government could downplay the systemic risk by referring to more stringent regulations in terms of prudential ratios. in other words, by identifying the financial and economic variables that affect the measure of systemic risk, we could avoid the spread of this risk across the entire financial sector that could subsequently affect the real economy. the key assumption of acharya et al. (2010) table 1: arch effect presence test “arch-lm test” bank ab atb atj bh biat bna bt bte stb ubci uib probability 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 table 2 : the results of the estimation of the model dcc garch [1.1] bank the coefficients of the estimation of the dcc garch model conditional correlations adjustment dcc mgarch distributions arch (1) arch (1) garch (1) garch (1) m-garch m-garch α1.1 α2.1 β1.1 β2.1 ρ(i, j) dcc 1 dcc2 amn 0.2758 0.1407 0.4764 0.6994 0.0583 0.0367 0.7164 gaussienne (0.000) (0.000) (0.000) (0.008) (0.043) (0.068) (0.000) atb 0.2306 0.1850 0.5191 0.5955 0.4360 0.0218 0.8263 gaussienne (0.000) (0.000) (0.000) (0.003) (0.000) (0.011) (0.000) atj 0.2344 0.1941 0.5364 0.2647 0.4493 0.0190 0.9386 gaussienne (0.000) (0.000) (0.000) (0.056) (0.000) (0.006) (0.000) bh 0.2491 0.3064 0.5265 0.4844 0.2643 0.0066 0.9862 gaussienne (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) biat 0.5939 0.7547 0.5566 0.6566 0.4156 0.0700 0.2208 student (0.000) (0.000) (0.000) (0.000) (0.000) (0.171) (0.678) bna 0.4675 0.5969 0.6139 0.6805 0.2843 0.0139 0.9675 student (0.000) (0.000) (0.000) (0.000) (0.000) (0.065) (0.000) bt 0.2723 0.4984 0.4805 0.1494 -0.0066 0.0242 0.6813 gaussienne (0.000) (0.000) (0.000) (0.005) (0.809) (0.169) (0.006) bte 517.9314 250.6698 0.4096 0.2366 0.0795 0.0637 0.9346 student (0.690) (0.691) (0.000) (0.000) (0.003) (0.000) stb 0.2624 0.1923 0.5140 0.6807 0.3000 0.0572 0.5352 gaussienne (0.000) (0.000) (0.000) (0.000) (0.000) (0.014) (0.097) ubci -0.0373 0.0077 0.4860 student (0.155) (0.329) (0.264) uib 1.0291 1.0757 0.4594 0.5514 0.0928 0.0593 0.5150 student (0.002) (0.003) (0.000) (0.000) (0.001) (0.223) (0.144) the difference between the two measures stems from the fact that the systemic risk calculated according to the lrmes is based on the tail dependence rather than the average co-variance, acharya (2010). in other words, the systemic risk measurement lrmes calculated according to the mes, is modeled on the assumption mselmi and mahmoud: systemic risk: a comparative study between public and private banks international journal of economics and financial issues | vol 13 • issue 3 • 2023124 be absorbed by competitors when a country’s economy is in a recession. in other words, when the system is underfunded, it will no longer provide liquidity on a regular basis. this phenomenon can be analyzed by impulsive shocks in the tunisian banking sector. 4.1. approach to the study in order to study the impulse shocks on the tunisian banking sector, we looked at two variables such as the daily market index returns “tunindex” and the overall marginal expected shortfall of the banks stock exchange markets “global mes.” the analysis will cover the period from 2006 to 2013. 4.2. the pulse function yun and moon (2014) conducted an impulse study to investigate the impact of financial shocks on the real economy during periods of economic stability and instability. to do this, they proceeded by the structural threshold model var of balke (2000). in this respect, we adopt this same methodology, except that, instead of studying the effect of financial shocks on the real economy, we analyze the effect of stock market shocks on the mes. the graph below illustrates the impulse response of market index shocks “tunindex” to the overall marginal expected shortfall of the banking book (i.e., the aggregate mes). the blue curve represents the impact of the stock index returns “tunindex” shock on the marginal expected shortfall of the banking sector while the dashed lines represent the confidence interval (figure 4). we will be focused in the impacts of the impulse shock on a horizon of thirty trading days. this period represents the time needed for the two indicators to regain their long-term equilibrium. as a result, a positive stock market index shock lowers the overall “global mes” to a level of 0.00076 for four trading days. this impact, then, disappears gradually until it returns to a long-term equilibrium after a period of three trading weeks. in this regard, we can make a final judgment on the reaction of the sector mes in the face of the stock market index shock. indeed, the results obtained demonstrate that the absorption of the impulse shock is a gradual process that lasts three trading weeks. -.0008 -.0006 -.0004 -.0002 .0000 .0002 .0004 .0006 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 response of mesg to cholesky one s.d. td x innovation période (% ) figure 7: response of global mes to cholesky one s.d. tdx innovation 0% 5% 10% 15% 20% 25% 30% 35% 40% 20 06 -1 20 06 -2 20 07 -1 20 07 -2 20 08 -1 20 08 -2 20 09 -1 20 09 -2 20 10 -1 20 10 -2 20 11 -1 20 11 -2 20 12 -1 20 12 -2 20 13 -1 20 13 -2 bêta lrmes figure 6: concordance between lrems and beta 0.0 0.1 0.2 0.3 stb bna bh atb amen biat bt bte ubci uib atj figure 5: average beta of tunisian banks (2006-2013) table 3: ranking of banks by srisk %, srisk (one million tunisian dinars), lrmes and beta bank rank srisk in (%) srisk in (mdt) bank lrmes (%) bank β stb 1 43.57 3,401,361 biat 19.90 bt 0.270 bna 2 24.19 1,889,003 bna 17.70 amen 0.217 bh 3 14.96 1,167,810 atj 11.90 atb 0.138 atb 4 7.18 560,419 uib 8.50 atj 0.123 amen 5 3.47 270,970 bh 8.40 ubci 0.117 atj 6 1.99 154,987 bt 7.20 stb 0.115 bt 7 1.96 153,306 ubci 6.80 bna 0.107 biat 8 1.92 149,557 stb 6.70 bh 0.089 ubci 9 0.43 33,325 amen 5.60 bte 0.086 uib 10 0.34 26,757 bte 1.80 biat 0.074 bte 11 0.00 0 atb 1.20 uib 0.062 total 100 7,807,494 is that undervaluation of the capital of a financial institution imposes external costs on the real economy when it occurs during a period of financial distress. indeed, these costs are borne by taxpayers. however, it also includes externalities that are particularly severe. however, the bankruptcy of a financial institution cannot mselmi and mahmoud: systemic risk: a comparative study between public and private banks international journal of economics and financial issues | vol 13 • issue 3 • 2023 125 5. conclusion since the advent of the sub-prime crisis, academic and professional research on systemic risk management of financial institutions has proliferated. the failure of micro-prudential regulations prompted several questions about the reliability of rules and measures of systemic risk. some researchers describe this failure as the result of the sophistication of financial risk modeling techniques. others consider the weakness of the financial system as the consequence of the inefficient governance structures of banks. the study of the above-mentioned systemic risk measures highlights three periods of disruption in which the overall marginal expected shortfall “global mes” has reached extreme levels. in this regard, we note that the tunisian banking system has reached critical levels, in terms of the overall marginal expected shortfall for the period 2010 and 2011, when the latter measure exceeded 10%. in addition, the disturbances observed in 2008 represent the result of the fallout from the subprime crisis on the tunisian economy. thus, we can notice that lrmes recorded significant proportions during the study period. indeed, it has reached more than 25%. in fact, this is explained by the fallout from the tunisian political crisis triggered in december 2010. thus, we find that public and private banks were exposed to prudential risk in the same way. even more, cross-sectional analysis has found that public banks “stb, bna and bh” have contributed to the systemic risk of the banking sector in a more significant way than private banks. moreover, the systemic risk is mediocre for most private banks except the atb and amen bank. in addition, the examination of the overall systemic risk of the tunisian banks revealed two important phases for the period between 2006 and 2013. indeed, we note that the marginal expected shortfall of the sector increased between 2006 and 2010. the second episode of increase in srisk is caused by political turmoil from january 2011. the banking sector capital shortage widened between the period 2011 and 2013. finally, the results obtained show that the systemic risk for the period 2006 and 2013 is mainly conveyed by the three public banks. finally, the fallout from the subprime crisis (2007-2008), on the one hand, and the tunisian political events triggered at the end of 2010, on the other hand, have revealed the deficiency of the tunisian banking system. 6. acknowledgments special thanks to prof. dr. boutheina regaieg, dean of university of management, economic and law of jendouba, tunisia, for supervising this manuscript. references acharya, v.v., pedersen, l.h., philippon, t., richardson, m. 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(2014), measuring systemic risk in the korean banking sector via dynamic conditional correlation models. pacific-basin finance journal, 27, 94-114. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(special issue) 223-228. 2nd afap international conference on entrepreneurship and business management (aicebm 2015), 10-11 january 2015, universiti teknologi malaysia, kuala lumpur, malaysia. international journal of economics and financial issues | vol 5 • special issue • 2015 223 a review of commercialization tools: university incubators and technology parks farhan jamil1, kamariah ismail2*, nasir mahmood3 1faculty of management, universiti teknologi malaysia, skudai, johor, malaysia, 2utm technology entrepreneurship centre, universiti teknologi malaysia, skudai, johor, 81310, malaysia, 3school of management, northwestern polytechnical university, xian, p.r. china. *email: m-maria@utm.my abstract in recent years, commercialization has gained significant importance due to its active participation in knowledge transfer, economic growth, job creation and entrepreneurship. whereas the role of university incubators and technology parks to excel commercialization has also much evidence. this study reviews the roles, practices, functions, factors and dimensions of the commercialization, university incubators and technology parks. during review, it come to surface that property development, networking with local and international markets, research and development, proximity to university, firm’s clustering, provision of advanced equipments, managerial support, faculty and students, and institutional reputation are the most important elements of university incubators and technology parks to promote commercialization. however, various challenges such as lack of human expertise and insufficient financial capital are still exists which requires to be further studied to upraise the commercialization efficacy. keywords: commercialization, university incubators, technology parks, knowledge transfer, entrepreneurship jel classifications: m00 1. introduction recently, a rapid increase in establishment of incubators, technology parks and other property initiatives have become a source of revenue generation by most of the universities. link and siegel (2005) experienced this change in us and europe. many countries have supported these institutions as tool to commercialization in various ways; policies, funding and legislation. the motivation to review the university incubators and technology parks is their contribution in knowledge-based economies. universities have taken several initiatives including excel in r and d investment to promote commercialization (huggins and kitagawa, 2012). however, the role of intermediary to facilitate the knowledge transfer is much desired. recently, costantini and liberati (2014) also emphasized the importance of the identification of knowledge transfer approach. in view of the above, munkongsujarit (2013) analyzed technology parks and incubators as potential intermediaries between universities and industries to excel commercialization. hence, the existence of several stakeholders such as government, university and industry to achieve the strategic goal of developing technology parks and incubators is essential (sanni et al., 2010). grimaldi and grandi (2005); audretsch (2014) supported the presence of university to promote the commercialization by having some knowledge transfer mechanism. many of the researches tells the role, functioning, implications and contributions of technology parks and university incubators (abetti, 2004; bergek and norrman, 2008; chandra et al., 2012; dahlstrand and politis, 2013; link and scott, 2007; link and scott, 2006; lundqvist, 2014; phan et al., 2005; sofouli and vonortas, 2007; squicciarini, 2008; tamásy, 2007; wonglimpiyarat, 2010). however, the capabilities of universities are not fully capitalized and show less output in commercializing their products and services (huggins, 2008a). mueller (2005) brief the reasons of inefficiency in the commercialization process as; current jamil, et al.: a review of commercialization tools: university incubators and technology parks international journal of economics and financial issues | vol 5 • special issue • 2015224 knowledge not being fully commercialized, universities and higher education institutions are not commercializing their research and knowledge at the utmost level and existing entrepreneurs also not willing to share new knowledge whereby suggests to involve intermediary channels to foster the knowledge transfer scheme. 2. commercialization commercialization is a mechanism to tranform the knowledge into products, services and institutues by having competative advantage to achieve the regional economic growth (mueller, 2005). meanwhile, audretsch et al. (2006) analyzed universities as the backbone of knowledge based economy. according to bramwell and wolfe (2008); breznitz and feldman (2010), commercialization got more popularity in its participation in economic growth through university platform. university has evolved as an “entrepreneurial university” to support commercialization of researach and knowledge for a sustainable and progressive ecosystem (audretsch, 2014). whereas he further explained entrepreneurial university as a university focusing on establishment of new enterprises, promote entrepreneurial environment and commercialization to transfer knowledge from academicians to society. moreover, siegel et al. (2003) monitored a sharp rise in university commercialization to businesses. thus, commercialization and knowledge transfer to society becomes the third mission of universities apart from two previous of teaching and research (baycan and stough, 2012). the success of commercialiation depends on the involvement of multidimenstional parties having different missions and objectives such as government, academicians, business and community (markman et al., 2008). hence, the commercialization has various implementations for academicians, industry, government, students and researchers. the major changes in commercialization framework brought by bayh-dole act through legislative reforms (ibata-arens, 2008). siegel et al. (2003) explain a well integrated and complete process of commercialization. accordign to siegel et al. (2003), commercialization depends on research and development to take initiative and followed by disclosure, evaluation feedback, faculty input and patents, if required. after the patenting, marketing channels are located for licensing and spinoffs. finally, products or services are commercialiazed that contirute in wealth generation. researches have identified various commercialization channels and measurements (audretsch et al., 2006; carlsson et al., 2007; faria and barbosa, 2014; grimm and jaenicke, 2012; guerrero et al., 2014; markman et al., 2008; perkmann et al., 2013; swamidass, 2013). these can mainly be classified into patents, licensing, research contracts and formation of new businesses. 3. university incubators since the inception of first incubator on earth, batavia at usa, incubators were not much popular till 1970s. however, a rapid increase in incubators happened after 1980s and cross the figure of 7000 incubators around the world (national business incubation association, 2014a). incubators are seem as a mechanism to support and establish new businesses by providing resources and facilities (chen, 2009; grimaldi and grandi, 2005; national business incubation association, 2014b). meanwhile, incubators deliver assistance to new entrepreneurs in several ways. the main services discussed by several scholars (al-mubaraki and busler, 2010; chandra et al., 2012; colombo et al., 2012; özdemir and şehitoğlu, 2013; schwartz and hornych, 2010; tang et al., 2013) are provision of shared space, advanced equipments, managerial support, networking and access to national and international markets, patenting and ip protection. an intermediary to rationalize transaction cost, establishing university industry linkages, access to knowledge and financial capital, encouraging entrepreneurship and support in screening and selection program of incubates. there are mainly two types of incubators (allen and mccluskey, 1990). one is for profit incubators, mostly operated by private sector. the second one is non-profit incubators; mainly funded by government with support from rental income (chandra et al., 2012). non-profit incubators are mostly academic based initiatives (phillips, 2002). the universities are at central position in economic growth of a country by playing an active role in research and development, innovation, incubators and technology park, and commercialization (miner et al., 2001). henceforth, many economies have established university incubators to promote the ecosystem and new ventures (studdard, 2006). however, palumbo and dominici (2013 define university incubators simply as a university supported incubation system with shared space at campus and facilitate in formation of university spinoffs. university incubators have a successful history in provision of location, human and financial capital, innovation and commercialization (chandra et al., 2012; somsuk et al., 2012). moreover, university incubators are also considered as the most powerful incubators (salem, 2014). several dimensions providing the pillars and seems as successful factors of university incubators are identified by researchers (bøllingtoft and ulhøi, 2005; bruneel et al., 2012; culkin, 2013; grimaldi and grandi, 2005; gstraunthaler, 2010; lee and osteryoung, 2004; mcadam and marlow, 2011; ratinho and henriques, 2010; somsuk et al., 2012; todorovic and suntornpithug, 2008) are infrastructure, networking, human and technical support, faculty and institutional reputation. researchers have witnessed that commercialization is accelerated and influenced by incubators (al-mubaraki and busler, 2010; chandra et al., 2012; tamásy, 2007) in the shape of spinoffs (lee and osteryoung, 2004; mian, 1996; palumbo and dominici, 2013). oecd (2010) also supported the engagement of university and industry to excel commercialization from the platform of incubators. however, phillips (2002) thinks it differently as not found a strong interaction between commercialization and incubators. he further suggested to examine the incubator’s efficacy in commercialization. jamil, et al.: a review of commercialization tools: university incubators and technology parks international journal of economics and financial issues | vol 5 • special issue • 2015 225 4. technology park technology park is defined as an organization works to promote innovation, university industry linkages, developing knowledge institutes, commercialization of products and services, formation of new ventures and other facilities by having managerial, technical and physical capabilities (international association of science parks, 2014). however, different terms have been used in different regions for technology parks. research park is more common in usa, science park in europe and technology park in asia (link and scott, 2011). according to phan et al. (2005), the greatness of technology parks rely on the involvement of multiple stakeholders; academicians, government, industry and community. these multiple members contribute in the success of technology parks. even so, the role of university is critical in technology parks framework (malairaja and zawdie, 2008). history tells stanford technology park, owned by stanford university, established in 1950s at california, usa as the pioneer (phan et al., 2005). the stanford technology park later on becomes a well-known industry cluster called silicon valley. other early days famous technology parks established in 1960s are cornell business and technology park (cornell university) and research triangle park (affiliated with cambell, duke and other carolina research institutes) (link and scott, 2003). however, silicon valley acknowledged as role model for all other technology parks whether developed or in developing stage. the concept of technology parks has taken much popularity and spread across the world. there are around 365 technology parks only in europe, creating jobs for more than 750,000 employees by having heavy investments. the essence of technology parks identified by several researchers time by time are real estate development, technology park’s location, clustering nature, internationalization and promotion of r and d (abetti, 2004; appold, 2004; durão et al., 2005; fukugawa, 2006; henneberry, 1984; jongwanich et al., 2014; link and scott, 2003; malairaja and zawdie, 2008; porter, 1998; ratinho and henriques, 2010; salvador, 2011; westhead and batstone, 1999). researchers accepted technology parks as a tool to economic development, commercialization and social benefit to society. abetti (2004); durão et al. (2005); sanni et al. (2010) agreed that technology parks take an active part in new ventures formation, creating jobs and economic growth. however, the development of technology parks requires a strong academic business association apart from technology and knowledge management (wonglimpiyarat, 2010). the relation of technology parks and commercialization has been further illuminated by link and scott (2003), technology parks with university association magnify the patenting. similarly, huibing and nengli (2005) also extended that technology parks having university affiliation becomes a source of revenue generation and job creation by commercializing the products and services. in another study, the formation of new ventures is substantial at technology parks in contrast to off parks. moreover, link and scott (2011) also supported technology parks as a tool of commercialization for economic and social goals. however, researches are still lacking consensus on the measures of technology park’s performance (fikirkoca and saritas, 2012; phan et al., 2005) and that empirical studies regarding technology parks are nascent (link and scott, 2011). 5. methodology the purpose of this study is to make a direction for analyzing the knowledge transfer from university to society especially through commercialization and its mechanisms such as incubators and technology parks. a systematic approach is adopted to review the previous literature. the purpose of systematic literature review (slr) is to identify the areas having ambiguity or remained less focused by researchers and to further suggest the future prospects. a total of 197 articles or studies have been identified comprising of 85 articles from only three renowned journals (technovation, research policy, and journal of technology transfer). the answers of following research questions are located during the review; (1) what are the commercialization barriers and how universities can overcome them? (2) how universities collaborate with industry to promote commercialization? (3) what are the practices of incubators and technology parks? (4) how much incubators and technology parks are helpful in promoting commercialization? (5) where are the missing links in previous studies? the idea behind using slr is to select the variables that can contribute in commercialization. the databases used to identify the study are mainly emerald, sciencedirect, web of science, taylor and francis, and wiley online library that have mostly cited publications and consist of high ranked journals across the disciplines. subsequently, a filter is placed to restrict the publications for a specific period of last 10 years from 2004 to 2014. the journals having more articles relevant to commercialization, incubators and technology parks are journal of technology transfer, technovation, research policy, journal of business venture, strategic management journal, journal of small medium enterprise, procedia-social behavior science. 6. results and discussion the trend of publications relevant to commercialization, incubators at university and technology parks over the last 10 years depicts a positive attitude of researchers. the publications especially in last 5 years show the emergence of commercialization, incubators and technology parks as a dynamic research area. figure 1 elaborates the same: moreover, figure 2 depicts that the publications are mostly by highly renowned impact factor journals such as technovation, research policy and journal of technology transfer. the publications by these highly ranked journals also reflect the importance of commercialization, university incubators and technology parks in current era and also in forthcoming. as the objective of the study is to understand the importance of commercialization for local and regional socio economic development, job creation and new business formation; and how jamil, et al.: a review of commercialization tools: university incubators and technology parks international journal of economics and financial issues | vol 5 • special issue • 2015226 university incubators and technology parks as knowledge transfer mechanisms can contribute to achieve the commercialization output. moreover, researchers have highlighted the challenges; university incubators and technology parks have to face, are also discussed in this study. the literature reveals that commercialization is an effective means of knowledge transfer from university to industry and to achieve the economic growth, sustainability, wealth generation, job creation and establishment of new businesses. whereas, university incubators and technology parks are also used as the successful tools of commercialization and knowledge transfer to society. however, they have to face major challenges and constraints such as lack of human expertise and insufficient financial capital which needs to be addressed. 7. conclusion commercialization participates significantly in local and regional economic growth and sustainability tough it has to face several challenges and barriers to achieve this goal. commercialization would not be able to achieve the destination level until a well-defined mechanism is established. whereas, technology parks and university incubators are proved by researchers as successful commercialization institutes. therefore, technology parks and university incubators can be used as a valuable means of commercialization. however, these mechanisms are also struggling to fully support the commercialization due to several barriers. the human and financial constraints are the main hurdle in technology parks and university incubators functioning. although most developed economies have abundant supply of financial resources through various pipes, also struggling to tackle this problem. financial constraints remain the big filter in narrow down the knowledge transfer process (hsu, 2007; huggins, 2008b). additionally, ample financing along with other resources and capabilities is desired to magnify the commercialization output. a compatible financial model suitable for incubators and new business formation is much desired for economic and industrial sustainability. henceforth, a complete set of funding mechanism oriented to commercialization needs to be explored. moreover, a financial framework suitable for commercialization tools such as technology parks and university incubators needs to be institutionalized. the participation of various financial hubs should be recognized and triggered to enhance the efficacy of technology parks and university incubators for an expanded research commercialization. references abetti, p.a. 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(2010), commercialization strategies of technology: lessons from silicon valley. the journal of technology transfer, 35(2), 225-236. tx_1~at/tx_2~at international journal of economics and financial issues | vol 10 • issue 4 • 2020 39 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(4), 39-46. covid-19 an insight into various impacts on health, society and economy sampath kumar venkatachary1*, jagdish prasad2, ravi samikannu3, leo john baptist4, annamalai alagappan5, rohini ravi6 1grant thornton, aumen park, fair grounds, gaborone, botswana, 2coordinator, amity school of applied sciences, amity university rajasthan, jaipur, rajasthan, india, 3department of electrical, computers and telecommunication engineering, botswana international university of science and technology, palaype, botswana, 4department of software engineering, faculty of computing, botho university, botswana, 5department of network and infrastructure management, faculty of computing, botho university, botswana, 6department of computer science and engineering, vivekanandha college of engineering for women, tiruchengode, tamil nadu, india. *email: sampathkumaris123@gmail.com received: 03 april 2020 accepted: 15 june 2020 doi: https://doi.org/10.32479/ijefi.9925 abstract the declaration of covid 19 as pandemic has impacted the society at large. in what started with 17 cases in wuhan spread its tentacles and has now over 4 million cases across the globe. in this rapidly changing environment, it is extremely difficult to quantify the impacts that the virus has on many aspects of society. the paper highlights the various challenges and the impact on society, economy and general health. these are only initial levels impacts, and it goes on with greater implications on growth depends on many factors, including the social distancing norms and shutdown rules laid by countries. nonetheless, it is clear that the virus is here to stay and is likely to impact growth, health and society substantially. keywords: covid-19, health, economy, society jel classifications: e, i1, f6, f69 1. introduction the world has witnessed many health crises in the last 75 years or so but nothing like the present crisis which has been declared as a pandemic. as the crisis unfolded, it brought death, suffering, indicating it to be more than a health crisis. the current coronavirus pandemic is triggered by severe acute respiratory syndrome coronavirus 2 (sars-cov-2). the outbreak originated in wuhan, china, in december 2019. the covid-19 was declared a pandemic on march 11th, 2020. as of april 11th, 2020, more than 1.7 million people have been affected by the current pandemic. over 210 countries have reported infection with the world more than 102,000 deaths. the case fatality rate varied among countries and so did the recovery rate, effectively indicating that the countries which were successful with high recovery rates had carried out some effective government regulations. figure 1 shows a timeline of events on coronavirus. the pandemic, as it stands, can be compared to a natural hazard. though the impacts are not in a direct nature, it has left a clear mark with knock-on livelihoods, employment, governance, tourism, critical infrastructure services like health services, transportation, power systems, and so on. the ebola outbreak in 2014-2016 could be termed as a precursor for the current covid pandemic. with a mortality rate of over 70%, the virus had killed more than 11,000 people and left deep scars on the health systems in the african region. the economic aspects relating to ebola had its impact beyond heath, had killed many key workers, the front line defence against the pandemic. it had kept both parents and children alike this journal is licensed under a creative commons attribution 4.0 international license venkatachary, et al.: covid-19 an insight into various impacts on health, society and economy international journal of economics and financial issues | vol 10 • issue 4 • 202040 resulting impacting them in the form of job loss, denial to study etc. the current covid pandemic is showing its nature in the way of huge impacts, adversely affecting the population (kellet, 2020). the governments across the globe are stepping up their efforts to control by increasing and establishing mechanisms to manage through various technological means like usage of drones, surveillance systems, introducing ai-based robots, automating medical supplies and ensuring rapid laboratory testing procedures. the figure 2 shows the fatality rates in the last 50 years. as seen from the figure, marburg had the greatest impact in 1967 with a fatality rate of over 80%. the disease which traces its origin in uganda and spread in germany as a result of import of monkeys, killed 88% of people infected by the disease. as compared to other diseases, covid-19 has registered a far less fatality rate of 2.2%. against this backdrop, this paper aims to provide some insights into the impacts by employing a wide range of data sets. section 2 highlights the societal implications of the pandemic. 2. impacts of covid-19 the current pandemic is unique and differs from the past trigger factors that lead to downturns. the epidemic, by and large, has affected all sections of the society in numerous ways. functionally, the disease reduces labour supply, enforce quarantines, regional and domestic lockdowns, forcing societal regulations in the form of social distancing, mobility restrictions, which are critical measures for reducing the transmission of the disease. these measures are especially harsh on the industries and sectors which rely on social interactions as in the case of travel, hospitality, entertainment and mainly tourism. the pandemic has been harsh on numerous nations dependent on tourism. workplace closures also have ripple effects in the form of affecting the supply chain, impacting lower productivity, forced layoffs, income declines as uncertainty looms in the communities across the nations. the ripple effect of layoffs leads to lesser spending by people, triggering a further chain reaction in business closures and job losses leading to a de facto shutdown on portions of the economy. the pandemic has also lead to a sharp increase in healthcare spending. these domestic disruptions lead to spillover to trading partners adding to the macroeconomic effects (imf, 2020). 2.1. societal impacts the response to covid 19 pandemic by many governments were on war footing basis to control the pandemic. just as in war, measures addressing the nations were taken up in the form of policies, economic stimulus packages, health regulations, mitigation measures to control the virus, post-recovery measures, controlling of drug provisions and so on were announced by different ministries by respective governments. just as these policy measures, controls were announced, they started having an impact on society. 2.1.1. impacts on mental and physical health though the effects of covid 19 on the health aspects are not measured or registered, the impact on patients and the people surrounding them could have repercussions in the form of isolation, social stigma etc. some clear lessons need to be learnt from mers, sars, ebola outbreak treatments where patients had registered significant psychophysical and mental stress (kim et al., 2019). the governments across the globe must take into consideration these factors as they impose lockdowns and controls to isolate the vast population. the likeliness of neurological disorders during a lockdown could be as high figure 1: coronavirus timeline 88.00% 77.60% 57.00% 52.80% 40.40% 39.30% 34.40% 9.60% 0.02% 2.20% 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% 90.00% 100.00% marburg nipah hendra h5n1 bird flu ebola h7n9 bird flu mers sars h1n1 covid-19 figure 2: fatality rate of major outbreaks in the last 50 years. venkatachary, et al.: covid-19 an insight into various impacts on health, society and economy international journal of economics and financial issues | vol 10 • issue 4 • 2020 41 as 3-4% as noticed after boston bombings (guerriero et al., 2014). as governments across the globe embark on isolation to protect its people, these measures may be acceptable during the instance such as terrorist attacks, natural disasters etc. still, they could prove otherwise in the current scenario where the mental stress is already at stake (fagan et al., 2003). there is also a need for awareness among the health care workers on the patients neurological and psychological condition of the patient testing positive for covid 19 (jeong et al., 2016) (torales et al., 2020). the sars, mers, ebola outbreak also brought out the mental and psychiatric symptoms in the form of post-traumatic stress, anxiety, social stigma and social outrage as experienced by the health care workers during and after the epidemic who had either been in close contact with the patients or had been treating them. the number of reported incidents related to the outbreak also went up after quarantine measures like isolation, home quarantine. the research also indicated that the healthcare workers had to be provided with regular psychiatric counselling by psychiatrists to cope with the outbreak (lee et al., 2018) (shantanu and kearsley, 2020) (park et al., 2018). the emergency health care workers also reported on the mental stigma and the fear of isolation and transmission of the virus to nearest kin or relatives. doctors and health workers also highlighted that they experienced communication problems due to psychological distress (lee et al., 2018) (shigemura et al., 2020). bo et al. study the post-traumatic stress symptoms and discover that at the peak of the crisis in china, a staggering 96.2% of people report posttraumatic stress due to treatment, quarantine, social isolation, side effects of medicine etc. (bo et al., 2020). the current pandemic is also reported to have similar effects on the mental and physical state of the health workers treating the patients. healthcare workers from many nations have reported overwork, frustration, social discrimination, the negativity surrounding the pandemic, withdrawal symptoms, sleep deprivation, anxiety and anger, fear etc. it is also reported the lack of protection against contamination, availability of resources like masks, sanitisers in required quantity is adding to their owes (jones et al., 2017) (kang et al., 2020). lai et al. study the impacts of covid 19 and highlight that the health workers exhibit a high percentage of depression (50%), anxiety (45%), insomnia (34%) and distress (72%) and are more predominantly visible in the female staff than amongst the men. they also indicate that the groups who exhibited symptoms were considered as moderate to high risk (10-20%) (lai et al., 2020). 2.1.2. social impacts covid 19 also has left its mark in the form of forced social distancing, no handshakes, masking, and so on striking at the heart of societies. the covid-19 pandemic affects all segments of the populations. it is detrimental to members of social sections in most vulnerable situations like poverty-stricken communities, older people, the homeless, people with disabilities etc. the pandemic so far has been disproportionately affecting the segments. the epidemic also led to widespread panic across the communities, including panic buying, stocking up, and so on. though it is too early to comment on the social impacts, it is noticeable across the communities. the impact of social media on covid 19 pandemic has also contributed enormously negatively and impacted the public and the health workers alike. this is primarily due to the incomplete information dissemination from the government. with information flooding the social media groups in the form genuine, misleading, and fake messages, the stress levels and the anxiety levels, unjustified fear among the public, in general, is high. this flood of misleading information could lead to discrimination, stigmatisation, which in turn could lead to other problems in the form of social bullying etc. (purgato et al., 2018) (mowbray, 2020). 2.1.3. economical impacts the sars outbreak in 2003 had a huge impact, and the global economy had lost about usd 50 billion. similarly, the mers outbreak cost an estimated usd 8.5 billion (scott, 2020). as the coronavirus spread its tentacles, it is likely to have a far greater economic impact than its predecessors. with more than 1.8 million cases of covid-19 businesses are the worst impacted with having to cope with forced shutdowns of factories, manufacturing units, disrupted supply chains, restricted transportation of essential goods, commerce etc. the chain reaction that the virus has left has impacted in terms of job losses, unemployment, pay cuts, with more than 5.5 million americans alone filing for unemployment benefits. international monetary fund (imf) in their reports indicated that the pandemic had instigated a great depression and economic downturn which the world has not experienced since the great depression (scott, 2020). with china, which is considered to be manufacturing hub, shutting down as economic lockdown, its effects have already been field across the globe. the present covid-19 crisis is still in its initial phase and is unprecedented. table 1 indicates the global indicators. in percentage, variation is shown in table 2. figures 3 and 4 indicates the data plot and figure 5 shows the percentage change from november 19 to march 2020. as observed from the data indicates a clear slowdown in the nations due to the pandemic. the indicators suggest that there are uncertainty concerns on the lockdown measures implemented across the nations. the current estimates indicate that the future in 2020 is going to view the biggest slump in recent years across major economies. the slowdown can be seen across economies, and no country is immune from it. as predicted, the five major economies in asia china, india, indonesia, japan and korea are likely to be impacted by the change, and the percentage variation is expected to be in the region of −0.39%. figure 3: oecd leading indicators as of march 2020 venkatachary, et al.: covid-19 an insight into various impacts on health, society and economy international journal of economics and financial issues | vol 10 • issue 4 • 202042 table 1: oecd composite leading indicators (oecd, 2020) oecd leading indicators countries 2020-march 2020-february 2020-january 2019december 2019-november oecd area 98.8 99.6 99.5 99.5 99.4 euro area 98.2 99.4 99.4 99.4 99.3 major five asia 99 99.2 99.5 99.4 99.4 major seven 98.6 99.5 99.4 99.3 99.2 canada 97.8 99.4 99.3 99.1 99.1 france 98.8 99.4 99.4 99.5 99.6 japan 98.4 98.9 99 99.2 99.4 germany 97.5 99.4 99.3 99.2 99.1 italy 98.1 99.5 99.5 99.4 99.4 uk 98.2 100.1 99.9 99.7 99.5 us 98.9 99.5 99.4 99.2 99.1 brazil 100.8 101.8 102.6 103 103.1 china 98.8 99.1 99.4 99.3 99.2 india 99.5 99.6 99.6 99.7 99.8 russia 97.5 97.5 99.1 99.8 100 table 2: percentage change as observed from november 2019 to end march 2020 (oecd 2020) countries change march-2020 february-2020 janaury-2020 december-2019 novrmber-2019 remarks oecd area −0.067 −0.8 0.03 0.07 0.09 0.08 sharp slump; stable growth momentum and below-trend growth euro area −1.47 −1.16 −0.01 0.01 0.02 0.02 sharp slump; stable growth momentum and below-trend growth major five asia −0.39 −0.27 −0.24 0.01 0 0.01 sharp slump; signs of easing growth momentum major seven −0.93 −0.9 0.07 0.08 0.09 0.07 sharp slump; stable growth momentum and below-trend growth canada −1.45 −1.63 0.15 0.12 0.08 0.03 sharp slump; stable growth momentum and below-trend growth france −0.66 −0.54 −0.09 −0.08 −0.06 −0.04 sharp slump; stable growth momentum and below-trend growth japan −1.7 −0.49 −0.16 −0.17 −0.15 −0.14 sharp slump; signs of easing growth germany −2.25 −1.93 0.1 0.12 0.12 0.1 sharp slump; stable growth momentum and below-trend growth italy −1.54 −1.37 0.02 0.03 0.03 0.02 sharp slump; stable growth momentum and below-trend growth uk −0.77 −1.84 0.15 0.18 0.2 0.2 sharp slump; growth gaining momentum us −0.39 −0.59 0.14 0.16 0.16 0.13 sharp slump; growth gaining momentum brazil −1.26 −0.99 −0.77 −0.42 −0.12 0.07 sharp slump; growth gaining momentum china 0.12 −0.3 −0.33 0.12 0.07 0.07 sharp slump; signs of easing growth india −0.98 −0.09 −0.09 −0.09 −0.08 −0.08 slump; stable growth momentum russia −2.57 −1.59 −0.38 −0.29 −0.17 −0.08 sharp slump; stable growth momentum and below-trend growth when comparing the individual economies, it can be seen that india is going to experience a slowdown of −0.98%, but is likely to have a very stable growth as the indicators indicate stable momentum in the coming months. other major economies canada, germany, japan, united kingdom, usa, are likely to experience a drastic slowdown. the growth momentum for canada, france, venkatachary, et al.: covid-19 an insight into various impacts on health, society and economy international journal of economics and financial issues | vol 10 • issue 4 • 2020 43 94 95 96 97 98 99 100 101 102 103 104 mar-20 feb-20 jan-20 dec-19 nov-19 figure 4: oecd economic indicators from november 2019 to march 2020 -3 -2.5 -2 -1.5 -1 -0.5 0 0.5 o e c d a re a e ur o a re a m aj or f iv e a si a m aj or s ev en c an ad a fr an ce ja pa n g er m an y ita ly u k u s b ra zi l c hi na in di a r us si a change mar-20 feb-20 jan-20 dec-19 nov-19 figure 5: percentage change in gdp table 3: major economies from november’ 2019 to march’ 2020 (oecd, 2020) november-2019 december-2019 january-2020 february-2020 march-2020 100.0 100.0 100.0 99.9 99.6 99.1 99.1 99.3 99.4 97.8 99.6 99.5 99.4 99.4 98.8 99.1 99.2 99.3 99.4 97.5 99.6 99.7 99.7 99.6 99.0 99.4 99.4 99.5 99.5 98.1 99.4 99.2 99.0 98.9 98.4 99.5 99.7 99.9 100.1 98.2 99.1 99.2 99.4 99.5 98.9 103.1 103.0 102.6 101.8 100.8 99.2 99.3 99.4 99.1 98.8 99.8 99.7 99.7 99.6 99.5 99.7 99.6 99.4 99.1 .. 100.0 99.8 99.5 99.1 97.5 99.6 99.5 99.5 99.4 99.1 germany, italy is likely to be stable. it is, however interesting to see the growth gaining momentum in brazil, the uk and the us. india’s growth is expected to be stable. china is going to witness a considerable slump in the coming months. as seen from table 3, figures 6 and 7, the major economies are facing one of the most significant slowdowns and are heading into a recession. it is expected that the us economy is likely to shrink by 6%, europe by 6.6%, while china is likely to face the most significant slowdown shrinking up to 1.2% in 2020. the plausible reason for the shrink can be attributed to the second wave of infection, and the countries are experiencing. the covid-19 pandemic is perpetrating high, and rising human costs around the world and the essential assurance measures are seriously affecting venkatachary, et al.: covid-19 an insight into various impacts on health, society and economy international journal of economics and financial issues | vol 10 • issue 4 • 202044 the economy. because of the pandemic, the worldwide economy is anticipated to contract strongly by – 3% in 2020, much more terrible than during the 2008-2009 economic crisis. assuming that the pandemic subsides and the control measures in place are lifted in the second half of 2020, the economy is expected to grow up to 5.8% in early point 2021 based on governments financial efforts and policy supports. effective strategies and policies are necessary to instil the confidence measures of the investors and forestall the possible worse outcomes. it is also required for fiscal measures to reduce the contagion and ensure lives are protected for they are the most critical part of the investment. since the financial aftermath is intense in specific segments, policymakers should execute measures considerably focused on economic, monetary, and financial markets to help the needy families affected by the pandemic and businesses locally. also, universally, strong multilateral collaboration is fundamental to conquer the impacts of the pandemic, including to help monetarily compelled nations confronting both the epidemic and financial shocks, and for diverting aid to countries with weak healthcare systems. the fiscal response in affected countries has been phenomenal and swift in countries like india, australia, france, germany, uk, usa, china, indonesia, south africa announcing important fiscal measures to the impacted sectors and employees. it is also essential to ensure that these fiscal measures are scaled up depending on lifting curbs. it is also vital to provide necessary budgetary support to other emerging countries impacted by the pandemic. fiscal stimulus package can preempt investors confidence, ensure aggregate demand and avert a deep recession. figure 8 shows the impact on commodity prices. as seen, there has been a gradual decline since january 2020. the significant drop started from mid-january. the metal prices fell by about 15%, the crude oil more than 65% and the natural gas by 38%. the oil price drop is significant as it dropped to <$40 a barrel. the market trends indicate that the drop is going to be more or less stable and the price is likely to be around $45 through 2021, indicating that the weak demand. though numerous factors are influencing the prices, one of the major influential factors, in this case, is due to low demand. the demand slump can be attributed to the travel restrictions imposed by various countries. this drop is likely to impact the opec countries which rely heavily on oil for revenues. while it is likely to be heavy on the opec countries, the compounding problem of the contagion is expected to further lead to financial conditions due to weaker external demand. however, it is essential to note that lower prices will benefit the oil-importing countries like india and china (imf, 2020). 3. discussion and conclusion covid-19 pandemic has brought in events that are hard to comprehend by the present generation. the success or the pace of recovery be it economically or societal, will depend entirely on the policies taken to address the crisis by respective governments. the economic policies are likely to take a key outlook in the crisis. for example, if the policies are drafted include that the employers retain their workers, companies and businesses formulate policies that try to avoid bankruptcy, the likeliness of the economy bouncing back on the recovery track will be more or less smooth. unlike in an economic collapse, the present crisis is not driven by the demand and supply but rather due to an unprecedented turn of events which are unavoidable to curb the spread of the disease. therefore, the employers, government, stakeholders must take a holistic view and address the concerns rather empathetically than aggressively. the aggressiveness, in this case, should cover more or less key points 96.0 96.5 97.0 97.5 98.0 98.5 99.0 99.5 100.0 100.5 nov-2019 dec-2019 jan-2020 feb-2020 mar-2020 australia canada france germany israel italy japan united kingdom figure 6: major economies from november’ 2019 to march’ 2020 0.0 20.0 40.0 60.0 80.0 100.0 120.0 nov-2019 dec-2019 jan-2020 feb-2020 mar-2020 united states brazil china india indonesia russia south africa figure 7: major economies from november’ 2019 to march’ 2020 venkatachary, et al.: covid-19 an insight into various impacts on health, society and economy international journal of economics and financial issues | vol 10 • issue 4 • 2020 45 3.1. essential sectors the government must ensure and take stock of the functionality of the essential service and ensure the proper supply of the essential goods. it is vital to ensure that the patients get the best possible treatment with good health and care to avoid a relapse. any further deterioration could technically increase the chances of a further economic downturn. just as in wartime, efforts should ensure critical prioritisation of necessary contracts, goods and trade regulations. the policies should also ensure that the private industries are roped into manufacturing critically essential goods needed to combat the pandemic. 3.2. providing enough resources to the people household segments are the key to the success of combating the pandemic. take the instance of african and asian countries, most of them fall under the category of middleand low-income countries. the economy in these countries is mostly relying on sme sectors where most of the production income is centred. the closure of these industries technically hit the market hard and employers are now forced to layoff. this now essentially poses a bigger threat in the form of hunger and food crisis, which technically is a huge risk of the contagion. it is therefore essential that governments step up their efforts and ensure enough resources are provided to the household during these lockdown and closure or emergency period. 3.3. economic disruptions the policies laid by the governments need to ensure that they safeguard the relations of producers, employers, workers, consumers, lenders and borrowers. this is key to resuming the businesses post lockdown and emergency. the instance of closures of companies, factories etc. could turn out to be counterproductive and increase the risk of a financial meltdown and amplify economic crisis. therefore, governments need to ensure support to the private firms in the form of subsidies, equity investments, wage relaxations with appropriate policies, rules and conditions, loan guarantees, tax relaxations and numerous other benefits for the companies and factories to bounce back on track. it is also essential that the government ensures continued figure 8: commodity prices from 1 january’ 2020 to 4 april 2020. source data: imf (imf, 2020) 0.00 20.00 40.00 60.00 80.00 100.00 120.00 metal oil natural gas cooperation on the points above to both the domestic and international investors or companies. 3.4. societal counselling though limiting the movement of the people is key to controlling the pandemic, it is also likely to leave behind a scar and trauma on the people and society. therefore, it is essential to include post-traumatic programs to mitigate risk. the post-traumatic counselling is key in addressing the pandemic frontline fighters, especially the doctors, nurses and midwife professionals. while frontlines form the core, it is also essential to continue providing support to the patients in the form of regular counsel to the patients and quarantined people (aten, 2020). 4. conclusion thus to conclude, the current situation is extremely unpredictable and uncertainty around the global growth. this could lead to an economic fallout in the coming months due to factors influencing the pandemic, and it is hard to predict. the influential factors include the 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(2020), the outbreak of covid-19 coronavirus and its impact on global mental health. international journal of social psychiatry, 66(4), 317-320. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1784-1790. international journal of economics and financial issues | vol 6 • issue 4 • 20161784 corporate ownership and sustainability reporting: environmental agencies’ moderating effects alhassan haladu1*, basariah bt. salim2 1tunku puteri intan safinaz school of accountancy (tissa-uum), college of business, universiti utara, kedah, malaysia, 2tunku puteri intan safinaz school of accountancy (tissa-uum), college of business, universiti utara, kedah, malaysia. *email: kirikichichi@gmail.com abstract in third world economies like nigeria, the role of foreign ownership of businesses compared to local ownership on environmental issues has been given very little attention. foreign investors may assist in the fight against environmental degradation. this research determines the relationship between environmental information disclosure and ownership structure in combination with environmental agencies using the latest version of gri (g4). the study is a pioneer application of environmental agencies’ role in sustainability reporting and considers 81 companies in 6 environmentally sensitive industries of the economy. from a stratified random selected sample of 67 firms, the study tested for the relationship from 2009 to 2014. the outcome showed an inverse and significant relationship between environmental disclosure and ownership structure. this forced the recommendation that local ownership should be encouraged to grow at a faster rate so that a positive impact will be reflected on environmental information disclosure. keywords: corporate ownership structure, environmental disclosure, environmental agencies jel classifications: g31, h23, r11 1. introduction 1.1. background globalization has made the world interdependent. this interdependency have seen instant capital flow between countries which in turn has enable the manufacturing of products in many countries and sold to customers all over the world. although globalization encompasses political, social and economic integration, economic progress could be said to be its greatest objective. under globalization, advances in technology (internet) have generated more than the anticipated socio-cultural and economic interdependence. this has seen centralized economies become outdated and replaced by the more dynamic free market economics under which ownership and control of business organization were transferred to the private sector. with these developments, emerging as well as developing economies started to encourage the attraction of steady flow of foreign financial resources (al farooque et al., 2007), by reducing the cost of capital, taxes and investors’ risks. to this extent, many economies’ investment could now be divided into “foreign” and “indigenous” investments. this could be seen as just one of the classification of ownership. separation of ownership and control is also a common phenomenon (ali et al., 2008). this may give rise to managerial ownership. there are also group ownership, family ownership, shareholder ownership, etc. corporate ownership defines the contribution of residual claims and decision control that has consequences on firms’ behavior (delgado-garcia et al., 2010) and demarcate the relationship between shareholders and independent management. most importantly, it tries to show how much stock is owned by an individual investor (jensen and meckling, 1976). in short, it is about a shareholder’s interest in a company. ownership structure is a very important factor in environmental information disclosure. where ownership control is vested in local hands, environmental disclosure tend to be poor. in situation of foreign ownership especially by multinational corporations, compliance with sustainability standards is expected to be very high. this is because the level of recognition granted to environmental haladu and salim: corporate ownership and sustainability reporting: environmental agencies’ moderating effects international journal of economics and financial issues | vol 6 • issue 4 • 2016 1785 disclosure by developing nations is yet to attain international standards as most environmental disclosures are voluntary. with the high priority given to environmental matters in developed economies disclosures on environmental issues are mandatory. in fact, most new investments are geared towards non-fossil investments (beaudry, 2014). the aim of this paper is to investigate the association between ownership structure based on foreign and indigenous ownership, and environmental disclosure by quoted firms in the nigerian economy. emphasis was laid on the role of environmental agencies as it affects policy implementation in relation to this relationship. for simplicity purpose, we have five sections in this paper. while the general background of corporate ownership structure (cos) as it relates to disclosure and environmental policy execution was discussed in the first section, the second section is a critical review of empirical works on this relationship. the third part showed the designed and scope of the study. empirical results obtained from secondary sources were objectively analyzed in the fourth section. in the last section (section five), a general conclusion was drawn pointing out the basic findings and recommendations of the study. 2. review of relevant literature and conceptual framework 2.1. introduction in the early days ownership of businesses was a single venture dominated by sole proprietorship. as societies grew ownership changed from individual ownership to partnership. as societies became more developed and complex, business transactions advanced and became more competitive. partnerships was seen as insufficient as it lacks the capacity to meet the need for modern corporate finance. the large investments needed for modern businesses cannot be met by a single or few individuals, thus the concept of corporate finance based on limited liability companies emerged which saw ownership moved to shareholders. with limited liability came the separation between ownership and control. some control however, are in the hands of major shareholders. others are left exclusively in the hands of independent board of directors (bod). with the advent of globalization dominating businesses, most bod are now controlled by foreign ownership. 2.2. the concept of cos ownership structure according to delgado-garcia et al. (2010), is the contribution of residual claims and control that have consequences on firm behavior. in general terms ownership structure looks at the interest of shareholders in a company. this is dictated by the number of interest a board member or shareholder has which, may determine his/her influence and control over the business. jensen and meckling (1976), sees ownership as the distribution of equity to determine voting rights, capital invested and investors’ identity. different types of ownership could be identified with certain factors used as benchmark. relational and transactional ownerships views the concept from citizenship perspective by emphasizing on domestic and foreign investment. management, concentrated and institutional ownership are classified on managerial basis (alves, 2012). management ownership is based on ownership interest in the business. concentrated ownership vested control in the hands of large shareholders, while institutional ownership depicts ownership by institutions. this type of ownership showed the degree of efficiency, effectiveness and financial manipulation by owners. it should be noted that higher level of ownership concentration suggests stronger minority power (grenoble, 2010). in nigeria though different types of cos exists, it is much better to distinguish between indigenous (domestic or local) and foreign ownership structures. the government in recent times have open the economy and have tried as much as possible to attract foreign capital. in some exclusive sectors like natural gas, local investors lack the capital base to finance investment is such projects, foreign direct investment therefore offers the best option. in what is termed “dominant forms of ownership” connelly et al. (2010), distinguish between inside ownership and outside ownership. inside ownership is a situation in which interest holders to the business like managers and shareholders are in control of the organization. the advantage of this system is that it motivates the making of decisions that are consistent with owner’s interest. members of inside ownership includes executives, board members, employees, block holders, agent owners and private equity holders. the other type of ownership called outside ownership deals with equity holders outside the organization. this type of ownership helps greatly in monitoring more carefully the actions of managers. in extending the “control” approach block holders, agent owners and private equity holders operate from outside. ownership structure also have great impact on owners influence (connelly et al., 2010). owners outside the organization may dispose of their share if management’s decision did not favor them. in recent years the us and uk shareholders have applied sophisticated tactics than share disposal. pressure of business restructuring, activism and buy-and-hold strategy are just some of the modern influence that owners can exert on management (connelly et al., 2010). 2.3. environmental reporting and disclosure rahman et al. (2010) argued that friedman’s work in 1970 was the first to look at the association between business and society. his study have today led to the recognition of sustainability reporting as opposed to reports being restricted only to the financial performance of businesses. sustainability reporting is aimed at forcing organizations to take responsibility for their actions. environmental reporting concerns the presentation of financial and nonfinancial environmental information (firoz and ansari, 2010). in social/environmental reporting companies are expected to disclosure not only financial information but nonfinancial information regarding the effects of their operations on the immediate community as well. looking from a broader perspective that includes both corporate social and environmental information haider (2010), sees environmental reporting as consisting of information in relation with companies’ “operations, aspirations and public image” in its community. though a precise definition, it fails to specify whether the information should be economic or noneconomic. most importantly however, environmental reporting intends to communicate the socio-economic effects of organizations’ activities on society and the environment (gray, 2001; ismail and ibrahim, 2009). haladu and salim: corporate ownership and sustainability reporting: environmental agencies’ moderating effects international journal of economics and financial issues | vol 6 • issue 4 • 20161786 the aim of social disclosure is to communicate to stakeholders what is being done to the environment. this can determine a firm’s relationship with stakeholders. with the threat of investors moving from fossil to green investments, environmental reporting helps to attract foreign investments. all these have the advantage of assisting firms in defining their responsibilities to the community and assist management in doing proper environmental impact assessment. notwithstanding, environmental reporting faces major challenges like the lack of internationally acceptable or recognized reporting standard and guidelines. this coupled with the shortage of environmental experts and professionals makes it very expensive to report on environmental issues. 2.4. policy administrators policy administrators has a major influence on environmental reporting. in nigeria the major agencies in charge of environmental matters are the nigerian stock exchange (nse), department of petroleum resources (dpr) and national environmental standard and regulations enforcement agency (nesrea). as a member of the united nations sustainable stock exchange initiative (unssei), the nse through the sustainable stock exchange is well slated to perform a significant role in facilitating and promoting corporate performance on environmental issues to help meet the united nations development goals (sustainable stock exchange report, 2014). the dpr oversees environmental safety operations of firms in the petroleum industry to ensure that firms are prevented from improper disposal of industrial wastes (ikpe, 2011) by defining areas of effective regulatory control and monitoring (osu, 2011). nesrea is in charge of environmental matters for the non-oil and gas sector. 2.5. impact of ownership on environmental disclosure concentrated ownership, institutional ownership, family ownership, etc. all have different impact on voluntary disclosure (matoussi and chakroun, 2008). interest in firms may come in the form of large interest or small interest. where large interests are controlled by very few (matoussi and chakroun, 2008), there is no need for conflict between management and large interest holders. conflict in such situation is between large interest and small interest. institutional ownership also exert influence on voluntary disclosure. institutional investors have professional experience, influence, respect and protection to induce disclosure. the direct participation of family members in the bod under family ownership allows for direct access to all information of assurance about their investments. this however, have a negative impact on disclosure as asking for more information is low (matoussi and chakroun, 2008). 2.6. cos relationships cos is a concept that have enjoyed wide coverage in empirical research. alves (2012) related ownership structure with earnings management, al farooque (2012) did a comparison with emerging markets, and aslan and kumar (2012) looked at ownership structure with cost of debt, to name just few. prado-lorenzo et al. (2009) seem to be one of the few collections that have related ownership with capital structure. basing his study on firms on the portuguese economy, alves (2012) discovered an inverse relationship between ownership structure and earning management. it has also been discovered that the concentration of power in corporations boosts a company’s image. however, if such concentration is in the hands of multinationals david et al. (2010), suggested that more concern would be given to growth. firms’ financial performance is positively related to ownership (fauzi and locke, 2012), but with no effect on a company’s value even though tangible assets and investment opportunities relates positively with ownership (fauzi and locke, 2012). prado-lorenzo et al. (2009) posit that the ownership power on sustainability disclosure is limited. it is expected that firms that are foreign owned should disclose more in terms in sustainability (monteiro and aibar-guzman, 2010; freedman and jaggi, 2005). this is so because considering the national background, environmental attitudes, standards and guidelines existing in most developed economies have influence on their foreign investment even though the opposite was the case in the study of gray et al. (1996). in developed economies pressure from social groups like oxfam international, world wildlife fund and global justice now seem to force them to disclose more. this is entrenched and boosted by the desire for close monitoring by owners to attract more investments (andrikopoulos and kriklani, 2013; el-gazzar et al., 2006). andrikopoulos and kriklani (2013) and el-gazzar et al. (2006) studies gives a positive relationship between ownership and environmental disclosure. the work of li and zhang (2010) showed a two-way result: one for the public sector and another for the private sector. for the private sector the relationship between ownership and environmental disclosure was positive, while for the private sector an inverse relationship was discovered. 2.7. model relationship development 2.7.1. ownership structure there has been mixed results on the relationship between corporate ownership and disclosures. inverse relationship was discovered by al farooque (2010) and alves (2012). in their study of corporate ownership and firm performance, fauzi and locke (2012), lappalainen and nishanen (2009) and de jorge and laborda (2011) discovered a positive association between the two. it is expected that foreign owned firms should disclose more than their local counterpart (monteiro and aibar-guzman, 2010). the measurement of ownership structure differs a lot. the most popular measurements are expressed in percentage (klein et al., 2005; fauzi and locke, 2012; al-farooque, 2010). dummies has also been applied by monteiro and aibar-guzman (2010). in our context dummies of 0 and 1 was applied. where there is absolute control (more than 50%) the holder was scored 1 point. for non-control interest (below 50%) the score attracted 0 point. given the fact that the research looked at ownership structure from citizenship perspective, dummy of 1 was allotted for foreign ownership and 0 for indigenous ownership (prado-lorenzo et al., 2009; monteiro and aibar-guzman, 2010). whichever have more than 50% interest was score 1 and below 50% received 0 score. the following model explains the relationship between cos and environmental disclosure. thus: haladu and salim: corporate ownership and sustainability reporting: environmental agencies’ moderating effects international journal of economics and financial issues | vol 6 • issue 4 • 2016 1787 erit f(cos) erit = a + βcosit + ε (1) where: erit: environmental information disclosure, cos: corporate ownership structure, a: constant, ε: error term. 2.7.2. policy administrators hardly studies exists that tries to examine the relationship between environmental reporting and environmental agencies. in nigeria, the dpr, nesrea and nse are responsible for the implementation of environmental policies. with regard to the nse the increasing demand and interest by modern investors emphasize on environmental disclosure has forced the organization to encourage disclosure by listed firms in nigeria. this has seen it enlist as a member of the unssei. a mean value index (mvi) was used to measure the compliance by listed firms through the nse. the mvi is a ratio of total compliance score to expect score expressed in terms of 5. the same measure was used for dpr and nesrea who are responsible for the oil and gas and non-oil and gas sectors respectively. these agencies were related to disclosure in conjunction with ownership structure. the model that explains this relationship is given below: erit = a + βcosit padit + ε (2) where: pad: policy administrators. the study is built on the agency and institutional theories. in the context of the agency theory the manager (agent) acts on behalf of the shareholders (principal). rouf and abdullah-al-harun (2011) noted that this theory is very significant in situation where managers take advantage of insider information for their selfinterest. in such a situation a clear line of distinction should be drawn between the principal and the agent. shareholders role in management is therefore, necessary to serve as a check to such excesses. managers may be carried away and focus more on their personal interest rather than maximizing shareholders wealth (rouf and abdullah-al-harun, 2011). the institutional theory explains the control of companies operating in nigeria by external environmental institutions like the dpr, nesrea and nse. 3. methodology much attention of this work was focused on sectors whose operations impact adversely on the environment. going by our estimation six such sectors exists in the nigerian economy. each with multiples of industries and firms under them. our population therefore, comprises of companies that are listed in the nse under these sectors: agriculture, construction/real estate, healthcare, industrial goods, natural resources and oil and gas. the two biggest operators and environmentally sensitive of these sectors are the industrial goods and oil and gas sectors giving a total population of 81 companies. the sample technique applied was the stratified random sample technique. grouping the population into sectors and industries, selection was done pro rata based on the number of firms in a sector or an industry. collin’s and schultz’s sample selection technique as adopted by nyor (2008) was applied at the marginal error rate of 5% to give us a sample size of 67. the data used was purely secondary and they were selected from firms’ annual financial and sustainability statements. this was then analyzed using stata13 through content analysis, descriptive statistics and regression. analysis was based on panel data evaluation as a result of 67 firms being analyze for a period of 6 years (2009-2014). environmental reporting was measured with the latest version of gri (g4). 33 key disclosure items of g4 were grouped into 10 based on disclosure characteristics. the ten groups include: strategy and analysis, organizational profile, governance, economic issues, environmental issues, social issues, labour practices and decent work, human rights issues, product responsibility and ethical policies. for each of the 33 items a score of 1 mark was awarded. the average score then gives the simple average disclosure index (sadi) as applied by ahmad et al. (2003), sulaiman and mokhtar (2012), and monteiro and aibar-guzman (2010). the sadi was the instrument used to measure environmental disclosure. it ranges between 0 and 1 representing lowest and highest disclosure indices respectively. the role of policy administrators was determine using mvi as applied by hossain et al. (2006), enahoro (2009) and sulaiman and mokhtar (2012). mvi is a ratio of actual agency performance to the expected performance expressed as 5 or as percentage. it measures the effectiveness and efficiency of environmental agencies in implementing environmental policies. the measurement process constituted a likert scale questionnaire which, is expected to be completed by the agencies with regard to information on registered firms, environmental experts, environmental disclosure, standards compliance, degree of supervision, obstacles confronted, sanctions imposed, effects of policies, future prospects, etc. these were scored based on the firm’s record on these factors. the total score obtained was then related to the expected score and expressed to 5 to give the mvi. the result was then measured on a 5-point scale thus: unacceptable (0.00), very poor (0.01-1.00), poor (1.01-2.00), fair (2.01-3.00), good (3.01-4.00), and very good (4.01-5.00). 4. discussion of results 4.1. introduction this section is an analysis of results of the secondary data to see the outcome of the relationship between environmental disclosure and cos with the effects of policy administrators. the discussion was centered on the level and pattern of disclosure, the average ownership structure as affected by policy administrator, the type and degree of relationship that exists, and the significance or otherwise of the relationship. 4.2. descriptive statistics there were some 67 firms observed for a 6 years period (2009-2014) which, totaled 402 observations. results show that the level of disclosure was very high. it stood at 60.36%. for a developing haladu and salim: corporate ownership and sustainability reporting: environmental agencies’ moderating effects international journal of economics and financial issues | vol 6 • issue 4 • 20161788 economy and with disclosure being voluntary, this result is very encouraging. the deviation for the standard disclosure is 0.2564 which, show an irrelevant variation for the mean or standard. overall the least disclosure of environmental information was 6.06% while the highest disclosure in the distribution was 100% (table 1). these results are encouraging giving the fact that environmental disclosure in nigeria is voluntary and the standard guidelines used are not in effect “standard”. in nigeria, environmental standards and guidelines governing all sectors of the economy – environmental guidelines and standards for the petroleum industry in nigeria and nesr, have no provisions for the disclosure of environmental information. these guidelines concentrated more on preventive measure and penalties for safety and environmental violations. as a member of the united nations, nigeria depends more on united nations environmental program guidelines and standards like gri for environmental disclosure. disclosure on corporate ownership is represented by either 0 or 1. the total firms observed was 402 firms. of this total 162 firms (40.30%) are owned by indigenous investors while the remaining 240 firms (59.70%) are foreign owned (table 2). this gives an ownership ration of 2:3. that is, for every 2 locally owned firms in the environmentally sensitive economy there exists 3 foreign owned firms. this is reflected in the mean disclosure which gives 0.5970 result with an acceptable deviation from the standard of 0.4911 (table 1). the minimum disclosure was 0 and the maximum 1, depicting indigenous and foreign owned respectively. in short, more foreign owned firms (59.70%) are found in environmentally sensitive firms in nigeria than indigenous firms. it is therefore, not surprising that the rate of disclosure of environmental information is very high (60.36%). cos as is affected by policy implementation has an average disclosure of 5.35 with a standard deviation of 4.5391. with a minimum disclosure rate of 0 and a maximum of 11.56, the spread of the disclosure seem to fall within the range of the distribution. 4.3. correlation matrix a very good relationship exists between environmental disclosure and corporate ownership-policy administration. the correlation matrix result for this relationship is −0.0913 (table 3). though a weak relationship, it gives an acceptable range and is free from collinearity as the figure does not exceed 80%. moreover, the relationship is inverse. this implies that the more foreign firms there are in the sector/economy, the lesser the disclosure on environmental issues. similarly, fewer foreign investments indicate more environmental disclosure. of major importance is that the relationship is significant at 10% level of significance. 4.4. regression analysis the regression result show a total significant level of 7.74% and an r2 of 0.83% (table 4). while the r2 level could be regarded as too low, the significance is at an acceptable level of 10% level of significance. the rate of overall change however, between disclosures and ownership is very low. the coefficient of −0.0052 was recorded. this indicate that for every increase in foreign ownership, disclosure of environmental information will fall by 0.52%. this rate which is a fraction of 1% could be acceptable as the fall in disclosure rate is less than the increase in ownership rate. however, it should not be encourage to continue as this may have an adverse long-run effect. the biggest question is that how come foreign firms which, are expected to comply fully with environmental disclosure are having negative impact on disclosure in nigeria? this may be as a result of the voluntary nature of disclosure in the country. if it were mandatory there would have been a 100% compliance rate by these firms. in addition the high rate of local firms operation in these sectors offset the positive contribution made by foreign firms. because no matter the degree of compliance by foreign firms if 40% of firms in the sectors (local ownership) fail to comply, then definitely the impact on disclosure will be negative. in the light of these it could be seen that though disclosure rate is high the negative impact of ownership may have a long-run effect. 5. conclusion and recommendations 5.1. summary ownership structure depicts the interest of shareholders in business. it is dictated by how much interest a board member have to exercise control over decision being made by management. the increased concern over global warming have pushed the environmental issues to the extent that nations are out for solutions to the problem. however, much attention is being paid to the issue in developed economies than in the third world. this paper is an attempt to relate ownership structure and policy administrators to environmental information disclose in environmentally sensitive sectors in nigeria. with the sector dominated by foreign investments the question of whether or not these firms will have table 1: descriptive statistics variable mean±standard deviation min max sadi 0.603606±0.2564115 0.0606 1 co 0.5970149±0.491109 0 1 mco 5.352075±4.539084 0 11.5556 source: computed by research using stata13. sadi: simple average disclosure index table 2: cos ownership number of firms (%) indigenous firms 162 (40.30) foreign ownership 240 (59.70) total 402 (100) source: computed by research using excel. cos: corporate ownership structure table 3: correlation table variables sadi mco mco −0.0913 1.0000 0.0676 source: computed by research using stata13. sadi: simple average disclosure index table 4: regression result sadi coefficient p>|t| mco −0.005155 0.077 _cons 0.6311957 0.000 p>f 0.0774 r2 0.0083 source: computed by research using stata13. sadi: simple average disclosure index haladu and salim: corporate ownership and sustainability reporting: environmental agencies’ moderating effects international journal of economics and financial issues | vol 6 • issue 4 • 2016 1789 positive impact on environmental disclosure, especially where the disclosure is voluntary; is very important. previous scanty literature on the subject matter showed that institutional ownership exerts influence on voluntary disclosure. however, family ownership exerts negative impact on environment disclosure. other researches have yield mixed result. this study however, attempts to view this relationship from environmental institutional perspective jointly with policy administrators. to achieve our aim, a look at 67 firms in the economy closely associated with environmental issues for the period 2009-2014 was done. the result was analyzed using stata13 and excel13. 5.2. conclusion and findings the analysis were done by looking at the descriptive statistics, correlation matrix and regression. a summary of the outcome is outlined below: a. there is high level of foreign investment in the environmentally sensitive sector in nigeria. about 59.70% of foreign firms are listed under this sector as opposed to about 40.30% indigenous firms b. environmental information disclosure by environmentally sensitive firms in nigeria stood at 60.36% c. an inverse relationship exists between environmental disclosure and ownership structure with policy administrators in nigeria d. the relationship between environmental disclosure and ownership structure is significant at 10% level of significant e. the degree of change between disclosure and foreign firms in the nigerian economy is very low. 5.3. recommendations though most of the results are favorable there is need for rectification and improvements in certain areas. for instance, even though the relationship between environmental disclosure and foreign investment is negative this does not mean foreign investment should be discouraged as it has its positive contribution to the economy. the authorities should however, encourage more of local investment at a faster rate than foreign investment. in this regard the efforts on disclosure will be positive. environmental disclosure should be made mandatory in nigeria. if under the current voluntary 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(2011), ownership structure and voluntary disclosure in annual reports of bangladesh. pakistan journal of commerce and social sciences, 5(1), 129-139. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(3), 100-108. international journal of economics and financial issues | vol 13 • issue 3 • 2023100 firm-specific determinants of aggressive tax management among east african firms alfred james kimea1, msizi mkhize2, haruna maama3* 1school of accounting, economics and finance, university of kwazulu natal, south africa, 2college of law and management studies, university of kwazulu natal, south africa, 3department of financial accounting, durban university of technology, south africa. *email: harunam@dut.ac.za received: 15 august 2022 accepted: 13 march 2023 doi:https://doi.org/10.32479/ijefi.13476 abstract since tax represents an inflow of revenue to the government and an outflow of revenue to firms, factors that influence the tax planning activities of firms have gained considerable attention among management, shareholders, policymakers and researchers. following the impact of taxation on an economy and a firm, the study investigated the factors that influence aggressive tax management practices of firms listed in east african economies. data were collected from 99 firms for an 11-year period, from 2008 to 2018. both cash effective tax rate and accounting effective rate were used as measures of tax planning. multiple regression models were used for the estimation. the study results showed that smaller firms are more tax aggressive compared with larger firms, which is consistent with the political cost theory. this finding may alert policymakers and regulatory authorities (for example, revenue authorities) that small firms are most likely to avoid paying taxes compared with larger firms. this might be associated with fewer regulations and enforcements imposed on this category of business. the evidence further demonstrated that profitable firms are less tax aggressive. consistent with the political power theory, this study has confirmed the view that profitable firms have enough earnings to pay their taxes and thus are less tax aggressive. the study further found that older firms are less involved in tax avoidance. this study has policy implications as it will assist both policymakers and firm management in their decision-making. shareholders and firm management would benefit by understanding why some firms successfully reduce their tax burden compared to other firms. keywords: tax planning, tax management, cash effective tax rate, accounting effective tax rate jel classifications: h21, h25, h26 1. introduction following the involvements of several multinational corporations (mncs) in aggressive tax management, the issue of tax planning has attracted attention among academics, political bodies, investors and the public at large (huseynov et al., 2017; lee, 2020). for instance, recent evidence about tax management in companies, such as starbucks, apple and facebook (davis et al., 2015), and the unforgettable scandals involving firms, such as enron and worldcom (mcgill and outslay, 2004), have shown that tax planning has become more aggressive, which is notable in today’s businesses around the globe. supporting this claim, ogembo (2019) showed that tax planning/avoidance worldwide had reached $650 billion per year as of 2018. nevertheless, some companies promptly pay a substantial amount of taxes annually. tax management is a there are various strategies that firms can use to reduce the amount of taxes paid to the government by taking advantage of the differences in the corporate tax systems of various nations and shifting profits from countries with higher tax rates to those with lower ones. tax aggressive management is also known as tax planning. empirical findings indicate substantial differences in the amounts of taxes that firms pay (thomsen and watrin, 2018). the variation this journal is licensed under a creative commons attribution 4.0 international license kimea, et al.: firm-specific determinants of aggressive tax management among east african firms international journal of economics and financial issues | vol 13 • issue 3 • 2023 101 in the level of tax payment of firms has been evidenced in empirical studies that showed that different companies pay different amounts of corporate income taxes (mocanu et al., 2021; chen et al., 2019; jingga and lina, 2017; dyreng et al., 2017). this means that some companies seem to reduce their corporate income taxes successfully compared to their counterparts in the same economy or industry. in addition, thomsen and watrin (2018) showed that some companies pay very little taxes compared to other companies in the same country. thomsen and watrin (2018) noted that while more than half of the companies paid effective tax rate (etr) ranging from 30% to 40% of their profits, other companies paid as low as 20%. this considerable variation in corporate tax avoidance amongst firms has raised concerns among academics, researchers and policymakers. the central question of debate is, therefore, why do some companies aggressively reduce their taxes, whereas others pay substantial amounts of taxes with an etr that is equal to or above the statutory tax rate? this variation may be associated with the tax planning opportunities presented by loopholes in tax laws (dyreng et al., 2016; wang et al., 2020). some studies such as those of cooper and nguyen (2020), sianipar et al. (2020), nasution et al. (2020) and chyz et al. (2021) documented the level and trend of tax planning in some countries, which indicated that tax planning activities are carried out by firms and that there was a gradual increase in these activities. such practice is becoming common in east african countries (eacs) where kimea and mkhize (2021) reported that firms were increasingly adopting aggressive tax planning posture. nonetheless, these studies did not clearly reveal the determinants (factors) that may affect tax planning in these countries. some factors may explain the variations in the level of tax planning; however, their influence remains equivocal. this shortcoming meant a lack of clarity about tax planning activities in eacs. it is against this background that the study investigated the firm-specific determinants of tax planning in the east african context, and thus contributed to the existing literature on the topic by showing whether firm-specific factors influence tax planning. 2. literature review some studies have investigated the influence of firm-specific characteristics on corporate tax planning. for instance, firm attributes, such as firm size, profitability, leverage, capital intensity, and the age of firms have been constantly investigated to examine their influence on the trend and level of tax planning (ribeiro, 2015; wahab and holland, 2012). studies have documented conflicting results on the relationship between these specific characteristics and corporate tax planning. the mixed results might be due to different methods of measuring tax planning, different research timespans and the estimation techniques used in analysing the data (minnick and noga, 2010). the various studies on the influence of firm-specific characteristics on tax planning are that discussed below. these firm characteristics are size, profitability, leverage, capital intensity and age. 2.1. firm size and tax planning the influence of firm size on tax management has been researched in the literature, with studies using two competing views in their arguments based on the political power theory and the political cost theory. the political power theory maintains that larger firms pay lower taxes because they have substantial resources (such as financial capacity and manpower), which capacitate them to hire competent tax planners to organise their financial affairs for optimal tax saving. owing to their power, larger firms have political connections with high-level government officials, which allow them to manipulate political processes and minimise their taxes (wu et al., 2016). this view argues that political power possessed by larger firms allows them to negotiate with revenue authorities about their tax position. kraft’s (2014) study confirms this view by documenting that the larger firms are more tax aggressive than smaller firms. previous studies have documented a positive association between tax planning and firm size (increased firm size equates to increased tax aggressiveness), which they explain by way of the political power theory (hanlon and heitzman, 2010; hoi et al., 2013). these studies suggest that large firms have enough resources to manage their taxes, which is not the case with smaller companies. similar findings emanated from lanis’ and richardson (2018) study investigating the determinants of tax planning in listed firms in australia between 1997 and 2003. using ordinary least squares (ols) as an estimation technique, the authors found that larger firms have a smaller etr than smaller firms. in addition, their study concluded that larger companies appear to possess superior economic and political power compared to smaller firms and they are also able to reduce their tax burden. a number of studies also base their arguments on political cost theory, which was developed by jensen and meckling (1976). this theory proposes that large size companies are subjected to political pressure, which limits them from practising aggressive tax planning. according to this theory, firms may opt not to avoid taxes to protect their reputation and thus lessen their level of tax management to avoid being seen as unpatriotic corporations that do not pay their fair share of taxes to support the social and economic wellbeing of the country. studies that have found that the size of a firm is negatively associated with tax planning have explained their result in terms of the political cost theory. in other words, large-sized firms are less tax aggressive compared to small-sized firms. zimmerman (1983) finds that companies that are relatively large have higher etrs. additionally, the literature suggests that as the size of a firm increases and become more visible, it attracts the government’s attention and thus is closely monitored to meet revenue collection targets (kraft, 2014). therefore, successful businesses are subjected to stringent scrutiny, are less tax aggressive (halioui et al., 2016; blaufus et al., 2022) and transfer more wealth to the government. according to halioui et al. (2016), larger and more prosperous firms become more exposed to strict government regulations (parisi, 2016). jingga and lina (2017) also hold the view that governments and other regulatory authorities closely supervise and investigate larger firms, as opposed to smaller firms. larger firms represent the interests of the public, who are shareholders, and those to whom the corporations offer employment opportunities. they also pay a substantial amount of taxes to governments. therefore, their strategic role makes it logical that they are subjected to many kimea, et al.: firm-specific determinants of aggressive tax management among east african firms international journal of economics and financial issues | vol 13 • issue 3 • 2023102 regulations because any wrongdoings could affect the interests of the public. the literature argues that this close supervision limits tax avoidance in larger firms. thus, large firms endure higher political costs because of their size, as found by irianto et al. (2017), who conducted a study to determine the firm attributes that affect tax avoidance practices. the study found a positive link between firm size and tax avoidance that was explained by the political cost theory. however, several studies have suggested that firm size significantly influence tax planning. askenberg and isaksson (2018) conducted a study to investigate the relationship between two proxies (revenue and total assets) of firm size and the etr. this study showed that large firms are most likely to avoid more taxes compared to small firms, which is consistent with the political power theory. surprisingly, when revenue was used as a measure of firm size, the results showed a positive relationship, in line with the political cost theory. according to askenberg and isaksson (2018), jaffari et al. (2021) and fernández-rodríguez et al. (2021) the relationship between a firm’s size and tax planning is amongst the most interesting research topics, owing to its inconsistent results in previous studies, and thus is recommended for further research. studies based on the political power theory argue that large firms are more tax aggressive compared to small firms. however, other studies believe that small firms have an advantage in tax planning over large firms because of the political cost theory. to the best of the researcher’s knowledge, studies that have investigated the influence of firm size on tax aggressiveness are limited in developing nations, and those that are available provide mixed results. thus, the researcher was motivated to investigate the influence of firm size on tax planning in the east african context and formulated the following hypothesis: hypothesis one (h1): firm size positively and significantly influences the effective tax rate. 2.2. profitability and tax planning according to the political cost theory, profitability influences tax planning (graham et al., fernández-rodríguez et al., 2019; jingga and lina, 2017). this theory holds that large and more profitable firms are more exposed to government regulations than smaller firms. this limits their tax management, and thus they pay their taxes according to the law to avoid reputation loss. furthermore, fernández-rodríguez et al. (2019) suggest that more profitable firms have higher corporate etrs and are less tax aggressive than less profitable firms. however, the findings of derashid and zhang (2003) reveal that profitable firms have lower etrs and are more tax aggressive than less profitable firms. thus, the findings of the studies support the political power theory that presumes that profitable firms have resources, such as financial and competitive human resources and tax planning instruments at their disposal, which allow them to minimise their tax burden. the current study included the firm profitability variable as a possible determinant of the level of tax planning in eacs. based on the explanation above, this study formulated the following hypothesis: hypothesis (h2): profitability has a positive influence on the effective tax rate. 2.3. leverage and tax planning leverage is the ratio of debt finance to equity finance. firms can use the debt from external sources as an alternative to equity finance from the shareholders. debt finance results in interest expenses that the firm has to pay to debt owners. the interest on debt finance is a tax-deductible expense in most countries. as a result, firms with more debt finance than equity finance will have a smaller net profit compared to those firms with more equity finance. this argument is logical since the cost of equity (dividend) is not a tax-deductible expenditure, while the cost of debt finance (interest expenses) is an allowable expenditure when computing taxable income (parisi, 2016). according to parisi (2016), a firm’s decisions about capital structure affect its etr. this study argues that tax laws exhibit differential treatment of capital structure (debt and equity). consequently, firms use finance decisions as a tax planning decision to reduce their tax burden (lanis and richardson, 2018). the view suggests that the leverage ratio significantly and positively affects tax planning. in line with the argument that companies use debt as a tax planning strategy, ozkan and ozkan (2004) posits that firms with higher tax liabilities may choose to acquire more loans to get tax deductions. swingly and sukartha (2015) investigated the determinants of tax avoidance in indonesia, using a sample of 41 manufacturing firms listed on the indonesia stock exchange (idx) between 2011 and 2013. the results of this study indicated that leverage has a positive effect on aggressive tax planning. in this context, arora and sharma (2016) suggest that a high leverage ratio lowers the etr. this means that firms with high leverage ratios are more tax aggressive. this study maintains that companies deliberately use debt finance to reduce their tax burden. conversely, irianto et al. (2017) argue that leverage does not influence the level of tax planning. the authors investigated the factors that affect a firm’s tax planning. amongst other results, this study found that the leverage ratio does not significantly influence tax planning. conversely, fernández-rodríguez (2021) and mocanu et al. (2021) claims that leverage does not have any effect on the level of a firm’s tax planning. in conclusion, previous studies about the influence of leverage on tax planning document mixed empirical results. a few studies revealed a near consensus that high debt financing results in low etrs, although other studies found that leverage does not significantly affect the level of tax planning. however, the current study expects that firms with high leverage ratios might have a lower etr. therefore, based on the above discussion, the current study proposed the following hypothesis: hypothesis (h3): there is a negative and significant relationship between leverage and the effective tax rate. 2.4. capital intensity and tax planning the capital intensity ratio measures a firm’s investment in capital assets (fixed assets). the study proposes a link between tax planning and capital intensity because ribeiro (2015), argues that firms invest in fixed assets as a tax planning strategy, although kimea, et al.: firm-specific determinants of aggressive tax management among east african firms international journal of economics and financial issues | vol 13 • issue 3 • 2023 103 they may depreciate over time. some studies have investigated the influence of capital intensity on tax planning (parisi, 2016; ribeiro, 2015). these studies show that capital intensity significantly influences the etr. richardson and lanis (2007) maintain that there is a negative and significant relationship between capital intensity and etr and that corporate taxpayers are permitted to write off the cost of a fixed asset (depreciable asset) in a shorter period than the asset’s economic life. therefore, companies that are relatively more capital intensive are likely to have a lower etr. however, irianto et al. (2017) claim that capital intensity does not significantly influence tax planning. due to the mixed results from previous studies relating to capital expenditure, the current study included this variable as a possible factors that influence tax planning in eacs. hence, the researchers formulated the following hypotheses: hypothesis (h4): capital intensity has a negative impact on the effective tax rate. 2.5. age of company and tax planning age is the length of the period that a company’s stock has been traded in the securities market. the relationship between the length of time that firms trade on the capital market and their involvement in tax planning has been debated in the literature. some studies argue that firms that have been longer in the capital market are under pressure to maintain their performance and to meet future performance expectations, which leads them engaging in aggressive tax planning activities. supporting this claim, lanis and richardson (2018) and mocanu et al. (2021) presented evidence to show that older firms are more tax aggressive compared to the new firms in the public capital market. however, halioui et al. (2016) and irianto et al. (2017) as well as askenberg and isaksson (2018) used political cost theory to connect firm age and tax planning. they avow that older firms with well-established businesses are prone to reputational risk and choose not to practise tax planning that may harm their reputation. therefore, the current study predicted that older firms are less tax aggressive with the following hypothesis: hypothesis five (h5): age is positively associated with the effective tax rate. 3. methodology 3.1. data the study used a sample of listed firms from east african countries comprising kenya, tanzania and uganda. the dataset included financial and taxation information. this information was archival, as companies were required to publish it publicly through their annual reports (audited annual reports and accounts). consequently, the data were obtained from bloomberg, mcgregor, financial stock markets and particular company websites. data were collected on the variables of interest for an 11-year period, from 2008 to 2018. the starting date 2008 reflected the year when the eacs adopted their code of corporate governance, while the cut-off date, 2018, reflected the most currently available data. although 1089 firm-year observations were targeted, those of some firms were not available, resulting in a shortage of 68. as a result, 1021 firmyear observations were used for the study. 3.2. model specification and estimation method the study used a panel data estimating technique. with this type of data, the individual behaviours of entities are observed across time. one significant advantage of panel data is that it can control for individual heterogeneity and allow identifying and measuring effects that are not detectable using other data models (khan et al., 2018). in addition, it has the benefit of reducing collinearity and allowing more degrees of freedom while being more efficient. in this sense, a panel data structure controls for unobservable effects in cross-section and time dimensions. to test the hypotheses about the influence of a firm’s specific characteristics on the level of tax planning, the study presented two regression models. these two models only differed in the dependent variables, the cash effective tax rate (cetr) and accounting effective tax rate (aetr). these models are stated as follows: cetrit = β0 + β1sizeit + β2roait + β3levit + β4cntit + β5ageit + ԑit (1) aetrit = β0 + β1sizeit + β2roait + β3levit + β4cntit + β5ageit + ԑit (2) where cetr cash effective tax rate age years of existence of the firms aetr accounting effective tax rate β0 constant of the equation size size of the firms at a time β1 to β5 coefficients of the variables roa return on assets ԑit the stochastic error term lev leverage i firms cnt capital intensity t time (the year 2007 to 2018) 3.3. definition and measurement of variables 3.3.1. dependent variable the study used tax planning measured by the effective tax rate (etr) as the dependent variable. following recent studies (armstrong et al., 2019; chen et al., 2010; dyreng et al., 2016; lennox et al., 2013), this study used a cash effective tax rate (cetr), together with an accounting effective tax rate (aetr), to measure tax planning. an etr is computed as the tax expense divided by a firm’s pre-tax accounting income (hanlon and heitzman, 2010). therefore, an etr measures the ability of a company to minimise its tax, compared with its pre-tax accounting income, and is an indication of its tax burden relative to other firms. firms with lower etrs are said to be more tax aggressive compared to the firms with higher etrs tax rates. cetr is computed as cash taxes paid divided by pre-tax accounting income (dyreng et al., 2017; chen et al., 2010), while aetr is computed as total tax expense divided by pre-tax accounting income (chen et al., 2010; mcguire et al., 2012). the use of more than one measure helps to capture the broad range of activities that are symptomatic of tax planning. in addition, the use of multiple measures improves the robustness of the results. kimea, et al.: firm-specific determinants of aggressive tax management among east african firms international journal of economics and financial issues | vol 13 • issue 3 • 2023104 3.3.2. independent variables to examine the influence of firm-specific characteristics on tax planning, the study used five firm-specific factors, comprsing size, profitability, financing decisions, investments decision and age. 3.3.2.1. size to investigate the influence of size on a firm’s tax planning, the study used the variable of firm size (size), which was computed as the natural logarithm of total assets. this variable is largely used in previous papers related to tax planning (armstrong et al., 2012). 3.3.2.2. profitability following armstrong et al. (2012) and kraft (2014), the study included the profitability of a firm as another possible factor affecting the firms’ level of tax planning. a firm’s profitability is commonly argued to have the explanatory power of its etr. the study measured profitability using return on assets (roa). roa was measured as the ratio of pre-tax income to total assets. roa has been used in previous tax planning studies, such as those conducted by armstrong et al. (2012) and kraft (2014). 3.3.2.3. financing decisions to evaluate the influence of financing decisions on the level of tax planning, the study included leverage, which was the ratio of long-term debt to shareholder equity, as computed by chen et al. (2010). chen et al. (2010) and armstrong et al. (2012) are some of the authors who used leverage in their studies. 3.3.2.4. investment decisions to investigate the influence of investment decisions on the level of tax planning, the study used capital intensity to represent the asset mix of the firms, which was the ratio of fixed assets to total assets. asset mix has been used to investigate its power on tax planning variation (richardson and lanis, 2007; minick and noga, 2010). 3.3.2.5. age in addition, the study included the variable of age to investigate the influence of a firm’s experience in business on its level of tax planning. the age variable was measured as the number of years a corporation’s stock had been traded on the stock market (maama et al., 2019). 4. results and discussion this section presents the results of the variables that influenced the tax-planning practices of firms in eacs. the summary of the descriptive statistics for the variables is presented in table 1. for the dependent variables, the results showed that the mean value of the accounting effective tax rate (aetr) was 0.263 (26.3%) while that of the cash effective tax rate (cetr) was 0.195 (19.5%). this showed that, on average, the tax liabilities of the firms in the eacs represented 26.3%. however, the firms paid 19.5% as tax, suggesting tax-planning activities. this is because the statutory tax rate for all three eacs (kenya, tanzania, and uganda) had been 30% over the past 12 years. therefore, the mean value of less than 30% indicated the presence of tax planning in eacs. the standard deviation (sd) of aetr and cetr were 0.139 and 0.107, respectively. this suggested a small degree of dispersion of aetr and cetr amongst the firms in the eacs. furthermore, the mean value of the firm-specific variables, such as firm size, return on assets, leverage, capital intensity and age were 48.67, 0.086, 0.578, 0.599 and 19.992, respectively. the average firm size of 48.67 indicated that the average total assets of the firms amounted to $48.67 million. this shows that the firms in the eacs had relatively large assets. a standard deviation of 27.01, suggested wide variations amongst the asset size of the firms. in addition, the average roa of 0.086 indicated that the average roa of the firms was 8.6%, suggesting that they were profitable, albeit small. in addition, the results showed that the average leverage of the firms was 0.578. this showed that, on average, the debt of firms in eacs represented 57.8%. concerning the capital intensity of the firms, the mean value was 0.599, suggesting that the percentage of fixed assets to total assets of the firms was relatively low. 4.1. multicollinearity tests the pearson correlation matrix, together with the variance inflation factor (vif), were performed to check the possibility of multicollinearity amongst the independent variables used in the model. table 2 below provides the results of the pearson correlations matrix and vif. the results of the vif and correlation matrix showed that all variables were far from being highly correlated. the estimation indicated that the vif of all variables was less than two, which was far from the threshold of 10, which is suggested by literature ( marcoulides and raykov, 2019). these outcomes suggested that no variables used in this analysis suffered from multicollinearity. similarly, the correlation matrix results suggested no strong correlation among the variables used in the analysis. all the correlation coefficients were <0.5, suggesting that the variables were not highly correlated. these results showed that the use of these variables in the regression would not produce any spurious results. 4.2. regression results of the impact of firm-specific characteristics on tax planning this section presents the results and discussion of the influence of firm-specific characteristics on the level of tax planning. after establishing that the panel data estimation models were appropriate techniques, the study explored the type of panel data estimation model to be adopted, either fixed effect (fe) or random effect (re) model. the hausman test was used to decide whether fe or re was the appropriate technique in equations 1 and 2. the results of the hausman tests are reported in table 3. the results showed that the two equations, each obtained a p < 0.05. these results were significant. therefore, h0 was rejected in the research models, implying that the models had to be estimated using the fixed effect table 1: descriptive statistics variables obs mean sd max min aetr 1021 0.263 0.139 0.30 0.000 cetr 1021 0.195 0.107 0.30 0.000 size ($m) 1021 48.67 27.01 203.85 13.59 roa 1021 0.086 0.151 0.692 -0.557 lev 1021 0.578 0.252 0.995 0.007 cnt 1021 0.599 0.212 0.983 0.009 age 1021 27.000 12.947 67.00 14.00 kimea, et al.: firm-specific determinants of aggressive tax management among east african firms international journal of economics and financial issues | vol 13 • issue 3 • 2023 105 estimation method. table 3 below presents the regression results of models 1 and 2, which analysed the impact of the firms’ specific characteristics on tax planning, using the cash effective tax rate (model 1) and the accounting effective tax rate (model 2). the study analysed the influence of firm-specific characteristics on the firms’ level of tax aggressiveness in model 1 and model 2, using the fixed effects model. model 1 and 2 included different tax planning measures as dependent variables and firm-specific characteristics as independent variables. table 3 presents the estimation results for models 1 and 2. as explained above, the two models had the same independent variables, and the only difference was the measure of the dependent variable, which was the tax planning variable. model 1 used cetr, which was the main measure of tax planning of the study, while model 2 used the accounting effective tax rate (aetr) as the alternative measure of tax planning. the cash effective tax rate was expected to be a more reliable measure of tax planning because the literature shows that it can control for the effects of tax reductions through other factors, which are not necessarily tax-planning activities (zimmerman, 1983). therefore, our discussion is based on model 1, although model 2 is also discussed to support model 1’s results. hypothesis 1 (h1) predicted a significant positive relationship between firm size and level of tax planning, measured by cetr and aetr. the results in table 3 shows that the size of the firms has a significant positive association with cetr (p < 0.01) and aetr (p < 0.05). this finding supports h1 that firm size influences the level of tax planning. this finding suggested that large companies report higher effective tax rates, that is, a low level of tax planning than small firms, which implies that larger firms do not engage in tax planning activities as much as smaller firms. this finding also suggested that an increase in the size of a firm would result in a decrease in its tax planning activities. a possible explanation of these results is that large firms are exposed to effective and efficient scrutiny by various regulatory agencies, stakeholders and, particularly, the tax authority. they would have little or no chance to minimise tax expenses aggressively. another explanation is that larger firms are concerned about their reputation and would like to protect it, hence their decision not to engage in tax planning activities. in other words, the community may view big firms that pay less tax as socially irresponsible, which damages their reputation. this explanation is consistent with the legitimacy theory, which explains that firms may want the public to perceive them as responsible, which may force them to pay higher taxes and will enhance their public image and acceptance. the results also support the political cost theory, which postulates that big companies prevent a negative reputation by avoiding aggressive tax planning. moreover, the results conform with the findings of several other studies, such as those of askenberg and isaksson (2018), kraft (2014), minnick and noga (2010) and ribeiro (2015). these studies found that an increase in a firm’s size increases the etr (less tax avoidance). hypothesis 2 (h2) predicted that a firm’s profitability has a significant and positive relationship with the etr. this hypothesis postulated that more profitable firms report higher etrs (less tax planning) than less profitable firms. the results in table 3 above showed that roa has a positive and statistically significant association with cetr well below (p < 0.01) and aetr at the level of (p < 0.05), which is consistent with h2. this finding affirms that more profitable firms are less tax aggressive than those that are less profitable. the results are not surprising because it is expected that tax rates are progressive according to income. therefore, profitable firms are expected to pay more taxes than the less profitable ones. similarly, these results suggest that profitable firms have higher earnings that would allow them to pay their taxes. in addition, these results were consistent with political cost theory, suggesting that large and more profitable firms are exposed to government regulations that reduce their chance of tax avoidance. the finding of a positive relationship between etrs and roe is consistent with that of richardson and lanis (2007), minick and noga (2010) and armstrong et al. (2012). however, these results contradict the conclusions of derashid and zhang (2003) as well as kraft (2014), who documented a negative association between effective tax rates and firm profitability. with this finding, the study accepts the second hypothesis that there is an association between tax planning and roa. table 2: pearson correlation matrix together with the vif variables cetr aetr size roa lev cnt age vif cetr 1.000 1.39 aetr 0.893*** 1.000 1.92 size 0.155 0.064 1.000 1.06 roa 0.241** 0.203** −0.104 1.000 1.29 lev 0.096 0.022** 0.068 −0.422* 1.000 1.62 cnt −0.269* −0.156 0.097** −0.189 0.013* 1.000 1.83 age −0.047 0.015 −0.004 −0.065 −0.104** 0.119 1.000 1.47 ***significance at 0.01; **at 0.05 and *at 0.1, and *at 0.1. vif: variance inflation factor table 3: regression results: the influence of firm-specific factors on tax planning variable model 1 model 2 size 1.1668*** (7.486) 0.0674** (2.0705) return on assets 0.1493*** (4.662) 0.3754*** (3.2989) leverage 0.0499 (0.542) 0.1286 (1.496) capital intensity −0.0716 (−1.028) −0.0528 (−0.756) age 0.4012*** (3.382) 1.1703*** (7.701) c −0.3901** (−2.322) −1.6225*** (−2.679) r-squared 0.8525 0.8576 adjusted r-squared 0.4836 0.8502 f-statistic 5.0725 5.1927 prob (f-statistic) 0.0000 0.0000 prob. of hausman test 0.0000 0.0000 durbin-watson stat 2.2554 2.2785 ***significance at 0.01; **at 0.05 and *at 0.1, and *at 0.1 kimea, et al.: firm-specific determinants of aggressive tax management among east african firms international journal of economics and financial issues | vol 13 • issue 3 • 2023106 hypothesis 3 (h3) envisaged a negative and statistically significant relationship between leverage and level of tax planning. this hypothesis predicted that firms with a high leverage ratio have a low etr (more tax aggressive). as anticipated, the results in table 3 shows that leverage has a positive but statistically insignificant association with cetr and aetr (p > 0.1). this result is inconsistent with h3, which predicted a positive and statistically significant relationship between leverage and etr. the study predicted a negative association between etr and leverage because a higher leverage ratio implies that a firm uses more debts than equity as its tax planning strategy. leverage reduces taxable income because the use of debts accumulates interests, which are tax-deductible expenses. contrary to the expectation of the study that there is a negative relationship between leverage and etr, the results reveal a positive and statistically insignificant association. these finding is aligned with minnick and noga (2010). thus, as well as. thus, the research showed that managers might view debt as a burden for a company and therefore they choose to remove it, rather than use it as a tax avoidance tool. hypothesis 4 (h4) predicted a negative and significant relationship between capital intensity and the etr. it suggested that firms with a high capital intensity ratio have a lower etr than firms with a low capital intensity ratio. the results from models 1 and 2 showed that capital intensity has a negative and insignificant relationship with cetr and aetr (p > 0.1). these results indicated that firms with high capital intensity (more fixed assets) have a lower effective tax rate. furthermore, the results confirmed h4. this finding was accepted because firms with higher capital intensity exhibit a lower etr due to the deductibility of depreciation and amortisation expenses. big investments in physical assets, for example, tend to use higher values of depreciation expense to reduce their assessable income, and therefore pay lower income tax expenses. this evidence is in line with the findings of other studies such as those of gupta and newberry (1997) and richardson and lanis (2007). however, the insignificant results might have been because firms in emerging economies are relatively incapable financially of having massive investments in physical assets. hypothesis 5 (h5) envisaged a positive relationship between age and tax planning (etr). this hypothesis predicted that older firms have a higher etr (less tax aggressive) than new firms. table 3 above shows that age is positive and statistically significant with cetr (p < 0.01) and aetr at 0.05. this result is consistent with h5, which predicted a positive relationship between age and the etr in eacs. this finding indicates that older firms are less tax aggressive than new firms. one might expect that the old firms with experiences and connections have the advantage to reduce taxes. however, this result is aligned with the political cost theory which postulates that older and big companies may be under close government monitoring, which could limit their possibilities of averting tax. these results show that the older firms in eacs tried to be good citizens by paying their fair taxes to the government. these firms likely tried to avoid reputation loss due to their long history of good reputations and goodwill. the high involvement in tax planning by the more recently listed firms might have been facilitated by pressure from the firms’ owners and stakeholders to compel management to meet earning expectations. furthermore, the adequacy of the independent variables in explaining the dependent variables was tested. the general results showed that, in models 1 and 2, all the variables had an influence, except leverage and capital intensity. moreover, the results indicated that the models were robust and justified by the high coefficients of r2 and adjusted r2. the results show that r2 was 85.24% for model 1 and 85.56% for model 2. this meant that the two models showed that firm-specific characteristics could explain about 85% variations in the level of tax planning. this result showed that the findings related to the first regression were more robust concerning the influence of firms’ characteristics on the etr tax rate. on the whole, the finding of the estimations indicated that the firm-specific characteristics influence the level of corporate tax planning measured by the etr. 5. conclusion and recommendations understanding the factors that influence the tax planning activities of firms has gained considerable attention among management, shareholders, policymakers and researchers. this justifies the importance of studies that examine the determinants of tax planning in selected emerging economies. following the significance of tax planning to an economy and a firm, the study investigated the influence of firm-specific characteristics on tax planning. firms listed in east african economies were used for the study. both cash effective tax rate and accounting effective rate were used as measures of tax planning. multiple regression models were used for the estimation. the study results showed that smaller firms are more tax aggressive compared with larger firms, which is consistent with the political cost theory. this finding may alert policymakers and regulatory authorities (for example, revenue authorities) that small firms are most likely to avoid paying taxes compared with larger firms. this might be associated with fewer regulations and enforcements imposed on this category of business. furthermore, the results revealed that profitable firms are less tax aggressive. this result confirmed the view that profitable firms have enough earnings to pay their taxes and thus are less tax aggressive. given this, the researcher recommends that emerging economies should revisit their policies to make their economies more conducive in order to attract profitable investments. moreover, the evidence showed that older firms are less involved in tax avoidance. this is possible because old firms are affected by political pressure to pay fair taxes to avoid reputation loss. however, results of the examination of leverage and capital intensity found no influence on the level of tax planning. thus, the study has contributed to existing literature that explores 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(1983), taxes and firm size. journal of accounting and economics, 5, 119-149. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(2), 414-419. international journal of economics and financial issues | vol 6 • issue 2 • 2016414 determinants of corporate trade credit: an empirical study on korean firms woo sung kim* department of business administration, college of business administration, konkuk university, 120, neungdong-ro gwangjin-gu, seoul 05029, korea. *email: ab1212@konkuk.ac.kr abstract this study is designed to determine the motives for trade credit in korean firms. based on data collected from 14,660 firm-year observations running from 1992 to 2011 on the korean stock exchange, this paper finds strong evidence on determinants of trade credit based on financial characteristics. the principal result is that older firms with larger size, lower growth, and higher profits tend to extend accounts receivable. this evidence, while consistent with the access to financing hypothesis, is difficult to reconcile with the growth hypothesis and price discrimination hypothesis. second, this paper provides evidence that firms with larger size and greater leverage, as well as young firms, appear to use accounts payable. this finding, while consistent with the financial constraint hypothesis, is difficult to harmonize with the financing and growth hypothesis. the paper contributes to the argument about trade credit motives. it may help managers in making financial policy concerning improving firm value in the korean market. keywords: trade credit, accounts receivable, accounts payable jel classifications: 30, 32 1. introduction trade credit is a very important corporate finance issue. in general, trade credit is measured by accounts receivable (ar) and accounts payable (ap). trade credit research has garnered little attention in corporate finance literature. according to nadri (1969), one reason for this neglect is that trade credit is buried in the firm’s distribution activity. trade credit, like other working capital components, is related to short-term external finance. moreover, trade credit makes up a large share of total assets in manufacturing companies. mian and smith (1992) document that ar are 21.0% of total assets in us manufacturing corporations, a substantial fraction of corporate assets. likewise, ar are approximately 19% of total assets in korea manufacturing companies. specifically, trade credit management, such as ar, is one of the most important and time-consuming activities for a financial manager. why do firms then extend or use trade credit? prior literature has many theoretical explanations for trade credit determinants. interestingly, it is mixed with both financial and non-financial descriptions. first, the non-financial explanation suggests that trade credit arises from price discrimination and acts as a warranty for product quality, and the persistence of long-term relationships with customers (long et al., 1993; shin and soenen, 1998; wilson and summers, 2002; deloof, 2003; barine, 2012; hill et al., 2012). meanwhile, financial explanations highlight cost, monitoring, and informational advantages over banks (biais and gollier, 1997; burkart and ellingsen, 2004). furthermore, prior studies empirically examine the determinants of trade credit concentrating on the preferences and expectations of both suppliers and buyers (deloof and jegers, 1996; petersen and rajan, 1997; love et al., 2007; giannetti et al. 2008; bougheas et al., 2009; molina and preve, 2009; garcía-teruel, and martínez-solano, 2010). more specifically, ferrando and mulier (2011) noted that companies that are more likely to be financially constrained are more dependent on the trade credit channel to finance growth. the goal of this paper is to examine determinants of corporate trade credit in korea. empirical trade credit research has been applied mainly to developed countries. as with most emerging countries, for korean companies, trade credit is an important source of kim: determinants of corporate trade credit: an empirical study on korean firms international journal of economics and financial issues | vol 6 • issue 2 • 2016 415 financing. however, empirically little attempt has been made to verify the effect of trade credit on the motives behind trade credit. this paper tests our hypotheses using a sample of 14,660 firmyear data points across non-financial korean companies for the period from 1992 to 2011. methodologically, this paper adopts a large panel data set of trade credit for these firms, considering the fixed effects for each firm and each year (to consider unobserved relationships). this study groups corporate trade credit hypotheses into two categories: account receivables and account payables. our main results are as follows. first, this paper finds that firm size and age have a significantly positive impact on ar, whereas growth and profitability have a significantly negative effect on ar. second, the results demonstrate that firm size and leverage are significantly positively related to ap, whereas firm age has a significantly negative effect on ap. the paper contributes to the growing literature on corporate trade credit motives. the sample includes firms from emerging countries that prior literature has not widely studied. moreover, the paper explains trade credit motives. it also may help managers, such as the chief financial officer, to make effective financial policy to improve firm performance on the korean market. the paper is organized as follows. in section 2, this paper suggests the hypotheses to be tested. in section 3, data description and methodologies are presented. section 4 presents empirical results on reasons why firms extend trade credit. section 5 summarizes and concludes the paper. 2. hypothesis 2.1. determinants of ar 2.1.1. access to financing hypothesis in a capital system, larger firms are more creditworthy than other firms (petersen and rajan, 1997). large established firms have better reputations on the capital markets (diamond, 1991). specifically, older firms may have more access to financial markets than younger firms. well-established firms with better access to financial markets extend more trade credit than other firms (niskanen and niskanen, 2006; baños-caballero et al., 2010). thus, firm size and age are positively related to the level of ar. this study tests the following hypotheses: h1.1: firm size is positively related with ar. h1.2: firm age is positively related with ar. 2.1.2. growth hypothesis a firm willing to grow may choose a strategy of extending trade credit with longer re-payment periods than its competitors (niskanen and niskanen, 2006). in general, firms may perform a growth strategy using trade credit terms, such as the credit period, which is the total length of time credit extended to the customer. for instance, a way to beat competitors may be to grant credit if the customer is expected to be a repeat customer. therefore, this study tests the following hypothesis: h.1.3: firm growth is positively related with ar. 2.1.3. price discrimination hypothesis trade credit may be offered even if the supplier does not have a financing advantage over financial institutions, because trade credit may be used for price discrimination (mian and smith, 1992; petersen and rajan, 1997). in particular, since firms with low credit quality have bad credit terms, trade credit lowers the effective price of goods and services. thus, firms with larger operating margins have a larger incentive to generate additional cash flows by financing the sales of additional units to their poorer customers by extending trade credit (niskanen and niskanen, 2006). for example, wealthy customers pay early and get a discount. monopolists can use trade credit as a price discrimination tool. therefore, this study tests the following hypothesis: h1.4: profitability is positively related with ar. 2.2. determinants of ap 2.2.1. financing hypothesis large and old firms may have more collateral assets than small and young firms (barclay et al., 2003). these firms are inclined to have more stable cash flows. moreover, large and old firms may have a high incentive for ap, because of low information asymmetry compared with small and young firms. hence, larger firms and older firms are positively related to the level of ap. therefore, this study tests the following hypotheses: h2.1: firm size is positively related with ap. h2.2: firm age is positively related with ap. 2.2.2. growth hypothesis suppliers appear to have some advantage in financing growing firms. that is, firms with high growth opportunity may be a source of future business to a supplier, and suppliers are more willing to provide credit in anticipation of capturing this future business. theoretically, it may be argued that rapidly growing firms have better investment opportunities than other firms do, and are thus willing to use more trade credit as a partial financing source for their new investments (niskanen and niskanen, 2006). therefore, firms with high growth have a greater possibility to increase ap (howorth and reber, 2003; cunat, 2006). therefore, this study tests the following hypothesis: h.2.3: firm growth is positively related with ap. 2.2.3. financial constraint hypothesis in general, firms facing financial distress have difficulty acquiring financing on the capital market. in other words, financially constrained firms have less access to capital and face more costly external financing, since they have a higher default risk and tighter monetary conditions. firms under financial distress use a significantly larger amount of trade credit to substitute for alternative financing sources (molina and preve, 2012). this suggests a positive effect relative to equity and financial debt when firms are in financial distress. accordingly, firms experiencing kim: determinants of corporate trade credit: an empirical study on korean firms international journal of economics and financial issues | vol 6 • issue 2 • 2016416 financial distress may extend ap to avoid high equity costs of issuing stock and high debt costs. therefore, this study tests the following hypothesis: h2.4: leverage is positively related with ap. 3. data and methodology this paper is based on data collected from 763 non-financial firms listed on the korean stock exchange for the period from 1992 to 2011. the panel data set is based on 14,660 firm-year data points across listed korean non-financial firms. sample data has been collected from the data analysis, retrieval and transfer system supplied by the financial supervisory service and financial data obtained from kisvalue, supplied by national information and credit evaluation. we exclude issues offered by financial companies from our sample. this study performs a t-test to analyze firm specifics and industry characteristics for trade credit. furthermore, the study uses the panel regression model to test the hypotheses. the advantage of panel data methodology allows us to control for unobservable heterogeneity. to model trade credit determinants, the estimated equations take the following form. trade creditit = β0 + β1lnsaleit + β2lnageit + β3assetgrit + β4profitit + β5leverageit + ui + λt + eit (1) where, trade credit is accounts receivable and accounts payable for each firm. ar is defined as ar divided by the book value of total assets (kestens et al., 2012). ap is defined as ap divided by the book value of total assets. lnsale is measured as the natural logarithm of the book value of total sales. lnage is measured as the natural logarithm of the difference between year 2011 and the year when the firm was first established. trade credit may be particularly important for firms with financial market imperfections, such as young or small firms. asset growth rate (assetgr) is measured by subtracting total assets in year t−1 from total assets in year t divided by total assets in year t−1 ([total assets in year t − total assets in year t−1]/total assets in year t−1). profit is earnings before interest and tax divided by total assets, which is the profitability of assets-in-place. leverage is measured by total debt divided by total assets. the study includes the fixed effects for each firm and each year to consider unobserved relationships. the parameter ui is the firm’s unobservable individual effects, so we can control for the unique characteristics of each firm. the parameter λt is a time dummy variable that aims to capture the influence of economic factors that may also affect corporate trade credit determinants and firm performance, but which firms cannot control. furthermore, the parameter eit is random disturbance. table 1 presents a description of the variables. 4. empirical results 4.1. descriptive of statistics table 2 provides descriptive statistics for sample data. the mean of ar is 0.181 (18.1%), indicating that ar is relatively higher than reported for а related u.s. study presented by petersen and rajan (1997) where the mean value is 11.6%. additionally, the mean of ap is 0.115 (11.5%), suggesting that ap is slightly lower than reported in the previously mentioned work of petersen and rajan (1997) where it is documented as 18.5%. the mean of assetgr is 0.126 (12.6%), which implies a relatively high firm performance of korean companies. the means of the ratio of lnsale and lnage are 25.473 and 3.283, respectively. the means of leverage and profit are 0.558 (55.8%) and 0.056 (5.6%). 4.2. firm and industry characteristics for trade credit table 3 illustrates firm and industry characteristics for trade credit. the current study performs the t-tests to establish if there are differences in the mean values of comparing samples. in panel a of table 3, this paper have compared financial characteristics of firms ranging from large to small ones. the results show that there are significant differences in the mean values between the two groups for all the variables except assetgr at 1% significant level. more precisely, the mean values of ar and ap are significantly higher for small firms than for large firms, indicating that trade credit plays a more important role for small firms than it does for large ones in short-term financing. on the other hand, the mean values of leverage and lnsale and profit and lnage are significantly lower for small firms than they are for large ones at 1% significant level. in panel b of table 3, the study compares financial characteristics of firms with high leverage to those of firms with low leverage. the results indicate that there are significant differences in mean values between the two groups for all variables except ar at 1% significant level. moreover, the ap of firms with high financial distress is slightly higher than the ap of low-financial-distress companies. the mean value of profit is significantly higher for firms with high leverage than it is for firms with low leverage. on the contrary, the mean values of lnsale and assetgr and lnage table 1: description of variable variable name description expected sign coefficient ar ap ar account receivable divided by the book value of total assets ap account payable divided by the book value of total assets lnsale the natural logarithm of the book value of total sales + + lnage natural logarithm of the difference between year 2011 and the year when the firm had first been established + + assetgr subtracting total assets in year t−1 from total assets in year t divided by total assets in year t−1 ([total assets in year t−total assets in year t−1)/total assets in year t−1 + + profit ebit divided by total assets which is the profitability of assets-in-place + leverage total debt divided by total assets + ebit: earnings before interest and tax kim: determinants of corporate trade credit: an empirical study on korean firms international journal of economics and financial issues | vol 6 • issue 2 • 2016 417 table 2: descriptive statistics variable observations mean median maximum minimum sd ar 14,639 0.181 0.159 0.802 0.000 0.121 ap 14,639 0.115 0.086 1.334 0.000 0.101 assetgr 13,927 0.126 0.081 31.212 −1.000 0.420 lnsale 14,635 25.473 25.329 32.425 17.263 1.582 lnage 14,644 3.283 3.367 4.745 0.000 0.517 leverage 14,660 0.558 0.557 26.477 0.000 0.417 profit 14,639 0.056 0.055 0.550 −2.753 0.083 the sample consists of 14,660 firms-year observations from1992 to 2011 excluding financial and regulated firms. all market and accounting data are for the end of the fiscal year to the issue, unless otherwise indicated. ar is defined as account receivable divided by the book value of total assets. and ap is defined as account payable divided by the book value of total assets. leverage is measured by total debt divided by total assets. lnsale is measured as the natural logarithm of the book value of total sales. profit is measured by ebit divided by total assets which is the profitability of assets-in-place. assetgr is measured by subtracting total assets in year t−1 from total assets in year t divided by total assets in year t−1 ([total assets in year t−total assets in year t−1]/total assets in year t−1. lnage is measured by natural logarithm of the difference between year 2011 and the year when the firm had first been established. sd: standard deviation table 3: firm and industry characteristics of trade credit panel a: large firms versus small firms variables large firm small firm difference (mean) t value significant levelobservations mean observations mean ar 1725 0.120 7157 0.186 −0.066*** −21.846 0.000 ap 1725 0.097 7157 0.104 −0.007*** −3.010 0.003 leverage 1725 0.561 7157 0.487 0.074*** 5.749 0.000 lnsale 1725 28.076 7157 25.237 2.839*** 95.331 0.000 profit 1725 0.056 7157 0.042 0.014*** 5.991 0.000 assetgr 1725 0.105 7157 0.094 0.011 1.340 0.180 lnage 1725 3.637 7157 3.405 0.232*** −7.578 0.000 panel b. high leverage firms vs. low leverage firms variables high‑leverage firm low leverage firm difference (mean) t value significant levelobservations mean observations mean ar 7316 0.182 7323 0.18 0.002 0.748 0.455 ap 7316 0.144 7323 0.087 0.057*** 35.297 0.000 lnsale 7316 0.05 7323 0.062 −0.012*** −8.597 0.000 profit 7316 0.971 7344 0.922 0.049*** 4.305 0.000 assetgr 7302 3.178 7342 3.388 −0.21*** −25.12 0.000 lnage 4935 31.511 6233 37.000 −5.489*** −14.73 0.000 panel c: high‑tech firms versus low‑tech firms variables high‑tech firms low‑tech firms difference (mean) t value significant levelobservations mean observations mean ar 8001 0.202 6638 0.155 0.047*** 23.648 0.000 ap 8001 0.118 6638 0.112 0.006*** 3.767 0.000 leverage 8020 0.542 6640 0.577 −0.035*** −5.080 0.000 lnsale 7998 25.233 6637 25.762 −0.529*** −20.436 0.000 profit 8001 0.059 6638 0.052 0.007*** 5.278 0.000 assetgr 7619 0.135 6308 0.116 0.020*** 2.828 0.005 lnage 8013 3.221 6631 3.358 −0.136*** −16.012 0.000 panel d: manufacturing firms versus service firms variables manufacturing firms service firms difference (mean) t value significant levelobservations mean observations mean ar 10,760 0.192 3879 0.151 0.040*** 17.940 0.000 ap 10,760 0.110 3879 0.131 −0.021*** −10.904 0.000 leverage 10,780 0.541 3880 0.604 −0.062*** −7.999 0.000 lnsale 10,759 25.282 3876 26.002 −0.720*** −24.794 0.000 profit 10,760 0.058 3879 0.049 0.009*** 5.909 0.000 assetgr 10,241 0.125 3686 0.129 −0.004 −0.521 0.602 lnage 10,764 3.277 3880 3.300 −0.022** −2.314 0.021 the sample consists of 14,660 firm-year observations from1992 to 2011 excluding financial and regulated firms. all market and accounting data are for the end of the fiscal year to the issue, unless otherwise indicated. ar is defined as account receivable divided by the book value of total assets. and ap is defined as account payable divided by the book value of total assets. leverage is measured by total debt divided by total assets. lnsale is measured as the natural logarithm of the book value of total sales. profit is measured by ebit divided by total assets which is the profitability of assets-in-place. assetgr is measured by subtracting total assets in year t−1 from total assets in year t divided by total assets in year t−1 ([total assets in year t−total assets in year t−1]/total assets in year t−1. lnage is measured by natural logarithm of the difference between year 2011 and the year when the firm had first been established. ***,** and * represent 1%, 5% and 10% significance levels, respectively kim: determinants of corporate trade credit: an empirical study on korean firms international journal of economics and financial issues | vol 6 • issue 2 • 2016418 are significantly higher for firms with low leverage than those of firms with high leverage. in panel c of table 3, the study correlates the industry characteristics of high-tech firms to those of low-tech ones. the results reveal that there are significant differences in mean values between the two groups for all variables. this is especially valid for the mean values of ar and ap, which are substantially higher for high-tech firms than the ones of low-tech ones. the mean values of leverage and lnsale and lnage are considerably higher for low-tech firms than those for high-tech firms. additionally, the mean values of profit and assetgr are way higher for high-tech firms than those of low-tech ones. finally, in panel d of table 3, the paper compares the industry characteristics of manufacturing firms to those of service firms. the results demonstrate significant distinction between the mean values of the two groups for all variables except assetgr at 1% and 5% significance level. more specifically, the mean values of ar are quite higher for manufacturing firms than those for service firms; the mean values of ap are much higher for service firms than those for manufacturing firms. the mean values of leverage and lnsale and lnage are substantially higher for service firms than those for manufacturing ones. also, the mean values of profit are significantly lower for service firms than those of manufacturing ones. 4.3. determinants of corporate trade credit the current study uses panel regressions to examine determinants of corporate trade credit. table 3 shows the results of panel regression for the dependent variables ar and ap. column (2) of table 4 presents the results of the determinants of corporate trade credit dependent variable ar. the coefficient (0.024, 19.022 [t-statistics]) of lnsale is positive and statistically significant at 1% level, indicating that large firms tend to extend ar. this outcome strongly supports h1.1. the coefficient (0.028, 19.022 [t-statistics]) of lnage is positive and statistically significant at 1% level, suggesting that older firms tend to increase their ar as this paper implied in h1.2. meanwhile, the coefficient (−0.007, −3.581 [t-statistics]) of assetgr is negative and statistically significant at 1% level, indicating that firms with growth are inclined to reduce their trade credit receivable. this result is inconsistent with h1.3. the coefficient of profitability (−0.057, −6.184 [t-statistics]) is negative and statistically significant at 1% level, which means that firms with high operating margin are likely to decrease their ar. this outcome is inconsistent with h1.4. column (3) of table 4 presents the results for the dependent variable ap. the coefficient (0.022, 33.923 [t-statistics]) of lnsale is positive and statistically significant at 1% level, which is a sign that large firms tend to use ap. this result strongly supports h2.1. the coefficient (−0.071, −8.922 [t-statistics]) of lnage is positive and statistically significant at 1% level, indicating that older firms are likely to decrease their ap as this paper hypothesized in h2.2. meanwhile, the coefficient (0.00009, 0.627 [t-statistics]) of assetgr is positive and statistically insignificant. this result is inconsistent with h2.3. the coefficient (0.054, 42.309 [t-statistics]) of leverage is positive and statistically significant at 1% level, supporting the notion that firms with high financial stress are inclined to increase their ap. this result is consistent with h2.4. in short, hypotheses h1.1, h1.2, h2.1, and h2.4 are strongly supported by the panel regression results. 5. conclusion the general state of the determinants of corporate trade credit is still unresolved. the current paper examines the determinants of corporate trade credit in the korea stock exchange market. based on a panel data set from 14,660 firms in korea, this study provides strong evidence that financial characteristics affect trade credit policy. more specifically, it compares industry characteristics of high-tech firms to those of low-tech ones. the results indicate that ar and ap are higher for high-tech firms than those of low-tech firms, proving that firms requiring more time to observe product quality extend more trade credit that those where product quality is easy to observe (long et al., 1993). this evidence implies that trade credit can reduce information asymmetry concerning product quality by allowing buyers to assess the quality of goods before remitting payment. it also correlates industry characteristics of manufacturing firms to those of service firms. the outcome shows that ar are higher for manufacturing firms than those for service firms, while the ap are higher for service firms compared to those for manufacturing firms. first, the main results show that firms with larger size, lower growth, lower profit and longer corporate presence tend to extend ar. this evidence, while consistent with the access to financing hypothesis, is difficult to reconcile with the growth hypothesis and price discrimination hypothesis. second, this paper provides evidence that firms with larger size, higher leverage and shorter table 4: panel regression estimating determinants of corporate trade credit independent variable dependent variable ar ap intercept −0.537*** −0.263*** (−12.146) (−7.491) lnsale 0.024*** 0.022*** (19.022) (33.923) lnage 0.028*** −0.071*** (19.022) (−8.922) assetgr −0.007*** 0.00009 (−3.581) (0.627) profit −0.057*** (−6.184) leverage 0.054*** (42.309) fixed effects firm and time firm and time adjusted r2 0.694 0.676 f value 34.397*** 32.711*** the sample consists of 14,660 firm-year observations from 1992 to 2011 excluding financial and regulated firms. all market and accounting data are for the end of the fiscal year to the issue, unless otherwise indicated. ar is defined as account receivable divided by the book value of total assets. and ap is defined as account payable divided by the book value of total assets. leverage is measured by total debt divided by total assets. lnsale is measured as the natural logarithm of the book value of total sales. profit is measured by ebit divided by total assets which is the profitability of assets-in-place. assetgr is measured by subtracting total assets in year t−1 from total assets in year t divided by total assets in year t−1 ([total assets in year t total assets in year t−1]/total assets in year t−1). lnage is measured by natural logarithm of the difference between year 2011 and the year when the firm had first been established. ***,** and * represent 1%, 5% and 10% significance levels, respectively kim: determinants of corporate trade credit: an empirical study on korean firms international journal of economics and financial issues | vol 6 • issue 2 • 2016 419 market presence appear to use ap. this finding, while consistent with the financial constraint hypothesis, does not correspond to the financing and growth hypothesis. before all else, this finding suggests that trade credits do not act as an effective financial policy to firm growth in korea. moreover, these results indicate that trade credit is used as an alternative source of financing as well as an operational vehicle for marketing. the paper contributes to the growing literature on motives of corporate trade credit. additionally, the sample includes firms from emerging countries that prior literature has not studied thoroughly. it may also be useful to managers such as chief financial officers in developing financial policies toward improving firm performance in the korean market. references baños-caballero, s., garcía-teruel, p.j., martínez-solano, p. 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(1991), monitoring and reputation: the choice between bank loans and directly placed debt. journal of political economy, 99(4), 689-721. deloof, m. (2003), does working capital management affect profitability of belgian firms? journal of business finance and accounting, 30, 573-588. deloof, m.m., jegers, m. (1996), trade credit, product quality, and intra group trade: some european evidence. financial management, 25, 33-43. ferrando, a., mulier, k. (2013), do firms use the trade credit channel to finance growth?. journal of banking and finance, 37, 3035-3046. garcía-teruel, p.j., martínez-solano, p. (2010), determinants of trade credit: a comparative study of european smes. international small business journal, 28(3), 215-233. giannetti, m., burkart, m., ellingsen, t. (2011), what you sell is what you lend? explaining trade credit contracts. review of financial studies, 24(4), 1261-1298. hill, m.g., wayne, k., lockhart, g.b. (2012), shareholder returns from supplying trade credit. financial management, 41, 255-280. howorth, c., reber, b. (2003), habitual late payment of trade credit: an empirical examination of uk small firms. managerial and decision economics, 24(6-7), 471-482. kestens, k., cauwenberge, p.v., bauwhede, h.v. (2012), trade credit and company performance during the 2008 financial crisis. accounting and finance, 52(4), 1125-1151. long, m.s., malitz, i.b., ravid, s.a. (1993), trade credit, quality guarantees, and product marketability. financial management, 22(4), 117-127. love, i., preve, l.a., sarria-allenda, v. (2007), trade credit and bank credit: evidence from recent financial crises. journal of financial economics, 83(2), 453-469. mian, s.l., smith, c.w. (1992), accounts receivable management policy: theory and evidence. the journal of finance, 47(1), 169-200. molina, c., preve, l. (2009), trade receivables policy of distressed firms and its effect on the costs of financial distress. financial management, 38, 663-686. molina, c., preve, l. (2012), an empirical analysis of the effect of financial distress on trade credit. financial management spring, 41, 187-205. nadiri, m.i. (1969), the determinants of trade credit in the us total manufacturing sector. econometrica: journal of the econometric society, 37(3), 408-423. niskanen, j., niskanen, m. (2006), the determinants of corporate trade credit policies in a bank-dominated financial environment: the case of finnish small firms. european financial management, 12, 81-102. petersen, m., rajan, r. (1997), trade credit: theories and evidence. review of financial studies, 10, 661-691. shin, h.h., soenen, l. (1998), efficiency of working capital management and corporate profitability. financial practice and education, 8, 37-45. wilson, n., summers, b. (2002), trade credit terms offered by small firms: survey evidence and empirical analysis. journal of business finance & accounting, 29(34), 317-351. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 172-183. international journal of economics and financial issues | vol 13 • issue 1 • 2023172 effects of government expenditure on foreign exchange reserves: evidence for namibia victoria manuel*, daisy mbazima-lando, erwin naimhwaka bank of namibia, research and financial sector development department, windhoek, namibia. *email: victoria.manuel@bon.com.na received: 15 september 2022 accepted: 30 december 2022 doi: https://doi.org/10.32479/ijefi.13525 abstract the study empirically investigated the effects of government expenditure on fx reserves in namibia. using quarterly data, the study applied the autoregressive distributed lag (ardl) cointegration technique to examine the relationship between fx reserves and government expenditure, the exchange rate, external borrowing, current account balance and m2 over the period ranging from 2002 to 2020. the results show that an increase in government expenditure reduces fx reserves. furthermore, increase in foreign debt, current account balance and m2 increases the level of fx reserves, while an appreciation of the effective exchange rate reduces fx reserves. the study, therefore, concludes that high government expenditure and increase in foreign borrowing impacts fx reserves. these findings suggest that developments in government expenditure may hinder monetary policy effectiveness. based on these findings, the study recommends the continuation of fiscal consolidation to reduce fiscal deficits and government debt. similarly, it is important to ensure macroeconomic balance and appropriate coordination between fiscal and monetary policies. keywords: foreign exchange reserves, government expenditure, namibia jel classifications: c2, c4, e5, h72 1. introduction foreign exchange (fx) reserves are defined as external stock of assets, which is available to the country’s monetary authorities to cover external payment imbalances or to influence the exchange rate of the domestic currency through intervention in the exchange market, or for other purposes (international monetary funds-imf, 2021). the level of fx reserves in any country can be one of the useful macroeconomic indicators of financial soundness and in many developing economies, fx reserves are held with the main purpose of supporting monetary and foreign exchange rate policies. for namibia and many other export-based economies, having adequate fx reserves becomes beneficial in meeting the international financial obligations, that is a foreign payment of goods and services as well as to maintain the peg to the south african rand. moreover, fx reserves act as a financing option for excessive government expenditures in times of crisis (akpan, 2016). according to osigwe et al. (2015), fx reserves provide a cushion at a time when access to the international capital market is difficult or not possible, and an adequate level of fx reserves improves a country’s credit worthiness. additionally, it improves the country’s reputation by enabling a regular servicing of the external debt and avoiding payment default penalties and charges. hence, maintaining a good and adequate holding of fx reserves is of utmost importance to the central bank in order to maintain the exchange rate policy and to meet the countries international payment needs. the macroeconomic effect of fiscal policy on fx reserves generally arises through persistent government budget deficits due to increase in government expenditure. gupta and singh (2016) defined the fiscal deficit as ‘an economic phenomenon where the government’s total expenditure surpasses the revenue generated’. it measures the level of government indebtedness and the extent to which the government exceeds its financial means. there is a view that a fiscal deficit is not necessarily a bad economic phenomenon, this journal is licensed under a creative commons attribution 4.0 international license manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023 173 as it can be a very important tool to accelerate economic growth in many developing countries, as noted by abayomi et al. (2014). a fiscal deficit is normally beneficial to an economy if the deficit is recorded due to expenditure on investment, particularly capital projects that are envisaged to contribute to employment creation, economic growth and improve the social welfare of a country. however, persistent and high fiscal deficits over time can result in macroeconomic imbalances and may become unsustainable, these may include depletion of fx reserves. additionally, the macroeconomic effects of fiscal deficits on foreign exchange reserve are dependent on how the fiscal deficit is financed. according to alagidede (2016), in addition to the fiscal consolidation in expenditures and strategy to increase fiscal revenues, there are several ways in which the government can finance a high budget deficit, and these can take a number of forms. theoretically, the government can use the traditional method of printing money, however, this method is not so common and is discouraged as it can be inflationary. the government can in contrast opt for domestic borrowing, foreign borrowing and can also use fx reserves to finance deficit. the use of fx reserve to finance a deficit can consequently have a significant impact on a central bank’s fx reserves management and monetary policy objectives. although external debt denominated in foreign currency increases fx reserves temporarily, repayment and debt servicing of external loans can become very costly in the long-run and may result in a significant decline in the stock of fx reserves, (baksay et al., 2012). drawing down on fx reserves to finance a budget deficit can result in imbalances in the balance of payments. running down fx reserves instead of printing money, the government may put off the inflationary effects of a deficit, however, financing a fiscal deficit with reserves has limitations. according to fischer and easterly (1990), ‘the private sector’s expectations that the limit is about to be reached can provoke capital flights and may heighten a balance of payments crisis, since exhaustion of fx reserves will be associated with a currency devaluation. moreover, public debt dynamics in which foreign debt dominates the domestic debt may have long term negative effects on the government budget and central bank’s fx reserves. a high share of foreign currency denominated debt may temporarily build-up fx reserves, however, it reduces it overtime through repayments of external debt and may affect the central bank’s reserve adequacy targets. on the other hand, a high share of domestic borrowing compared to foreign debt puts pressure on interest rates and can also crowd-out private investment, resulting in low credit extension to the private sector, decreasing investment, economic activity and output, (baksay et al., 2012). although foreign debt minimises the crowding out effect and increases the flow of fx reserves, it has a long-term negative effect on government expenditure. a high foreign debt stock increases government expenditure through interest payments and debt servicing payments. the long-term effect of high government foreign borrowing may lead to a persistent record of negative budget balances over the years and this process may become recurring and might instigate a debt crisis if not solved. a government debt dominated with a high share of foreign debt may also expose the country to external vulnerability as perceived by external investors and various credit rating agencies. in addition, foreign borrowing can further have implications on the level of fx reserve through exchange rate, as a depreciation of a local currency may worsen debt servicing costs and ultimately fx reserves may be drawn down in the absence of adequate fiscal space. one of the current macroeconomic challenges in namibia is the persistent increase in government expenditure and the level of debt, this continue to be a subject of concern to the namibian fiscus. the persistent growth in expenditure and fiscal deficit has resulted in an increase in government borrowing to finance the deficit. in this regard, total government debt relative to gdp has increased and exceeded the national threshold of 35% set by the namibian government and has further gone beyond the southern african development community (sadc) threshold of 60% (figure 1). despite efforts and reforms such as fiscal consolidation to help reduce spending, government expenditure remains high and continues to register a budget deficit. consequently, high expenditure and rising debt continues to remain a hurdle for namibian policy makers. despite namibia’s fx reserves historically meeting the international benchmark of 3 months of import cover as well as the common monetary area (cma) benchmark of 4 months over the study period, there were times when fx reserves were below the 3 months import cover benchmark. with regard to regional comparison, namibia’s fx reserves are comparatively low in southern african development community (sadc), given the regional benchmark of 6 months import cover. it remained low relative to some selected countries, such as mauritius, angola and botswana, that held relatively high fx reserves above 10 months of import cover. 2. research objective the connection between fiscal and monetary policy is one of the complex topics and their effect on various macroeconomic variables are some of the most researched topics by economic scholars. although the role of each policy is different, the effectiveness of these policies in achieving their respective mandates are highly dependent on proper coordination of the two policies. to date, no empirical study has examined how government spending affects international of reserves in namibia. this study, therefore, seeks to bridge this gap. the study, therefore, aims to empirically investigate the effect of government expenditure on fx reserves in namibia. the study uses variables such as government expenditure, change in external debt, the current account balance as a share of gdp, money aggregates (m2) and exchange rate as other determinants of fx reserves in namibia. this study also provides an opportunity to contribute further and enrich the existing literature on the relationship of fiscal policy and fx reserves, by providing evidence from a small developing economy. the rest of the paper is organised as follows: following the introduction and research objective, the second section of the paper reviews the namibian fiscal expenditure and fx reserves, manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023174 followed by the review of relevant literature in the third section. the fourth section briefly discusses the study’s methodology, while the results of the study are presented in section five. the study then concludes with specific policy implications and suggests some policy recommendations. 3. trend analysis of government expenditure and fx reserves in namibia namibia has been recording negative budget balances for the past 20 years, except for the period 2006/07-2009/10 fiscal years. the deficit reached its highest level of 8.3% of gdp recorded in 2015/16, from the lowest of 0.1% in the 2005/06 and 2012/13 fiscal years. the rise in the fiscal deficit was mainly attributed to increases in public expenditure compared to revenue, which prompted government to undertake fiscal consolidation initiatives since late 2016. during these periods, government expenditure as percentage of gdp rose from 27.4% of gdp in 2000/01 to 30.7% in the 2008/09 fiscal year, reaching a peak of 43.4% in 2015/16 fiscal year. government expenditure has remained above 30% of gdp since then. the increase in the fiscal deficit in 2015/16 was in line with the trend in government expenditures and government debt level. the persistent negative government budget balance resulted in the escalation of government borrowing from both domestic and foreign sources to finance the deficit. the increase in government expenditure is mainly due to high current expenditure and policy implementation over the study period (figure 1). this is attributed to high operational government expenditure as a result of high personnel spending. this is mainly due to high wage bill as a result of recruitment of teachers and police officers, as well as civil servants’ salary grade restructuring, coupled with subsidies and other current transfers during the study period. in addition, government expenditure from 2009/10 was also accelerated by spending on policy implementations such as the national development plans (ndps), targeted intervention programme for employment and economic growth (tipeeg), harambe prosperity plans (hhp) and free education among others. moreover, interest and borrowing related charges, are some of the general additional contributing factors to high expenditure by government. the increase in spending since 2020/21 fiscal year was due to the expansion in fiscal spending related to covid-19 pandemic. additionally, government expenditure is estimated to increase further beyond 2020/21 fiscal year, as a result of the pandemic. total debt as a percentage of gdp had been relatively low and remained within the limit of 35% of gdp, since 2000/01 to 2014/15 fiscal periods. in the 2015/16 fiscal year, the government total debt as a percentage of gdp reached 41.5% before increasing further to 43.2% in 2016/17, reaching 52.9% in the 2019/20 fiscal year (figure 2). the increase was due to rapid increases in government borrowing to finance the fiscal budget related finances. public debt as a ratio of gdp rose further to its current and highest-level of 62.0% in 2020/21 fiscal year (figure 2), was attributed to high spending directed to reduce the impact of the covid-19 pandemic. this level is estimated to increase further to a level above 70.0%, as fiscal expenditures related to addressing externalities posed by the covid-19 pandemic expands. furthermore, the government debt level has exceeded both the namibian government debt-to-gdp ratio thresholds of 35% and the sadc benchmark of 60%. this development, however, is not exclusive to namibia as the pandemic has exacerbated debt levels of many developing countries. growth in foreign borrowing by government is observed to be followed by an increase in the growth of fx reserves. this is mainly evident in 2011/12 when an increase in foreign borrowing by 150%, led to a growth in fx reserves by 20% (figure 3). a similar trend is observed in the years through to 2015/16 up to 2017/18 fiscal years, when growth in external debt resulted in an increase in fx reserves following the same trend. the increase in foreign debt during these periods was largely attributed to the issuance of the eurobond and jse listed bonds in 2011/12, 2012/13 and 2015/16 fiscal years, respectively. in addition, the increase was partly due to the depreciation of the namibia dollar against the us dollar. these developments resulted in an increase in fx reserves during these periods. moreover, the increase in fx reserves was further complemented by sacu receipts and the introduction figure 1: total government expenditure, current and capital expenditure source: bank of namibia (2021) manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023 175 of an asset swap arrangement by the bank of namibia with the government institution pension fund (gipf). on the contrary, namibia observed a marginal decline in fx reserves in 2018 and 2019 (figure 3). the reduction in fx reserves was also partly driven by higher government foreign payments during 2019, coupled with net sales of rand to commercial banks by the bank of namibia. the observed increase in foreign exchange reserves in 2020 was mainly due to foreign debt inflows such as the afdb loan, higher sacu receipts and the depreciation of the of the local currency against major international currencies. furthermore, the higher level of foreign exchange reserve in 2020 was due to a decline in the level of imports as a result of subdued demand, caused by the impact of global economic lockdowns as a result of the covid-19 pandemic. these trends demonstrate the extent to which fiscal policy such as external deficit financing and high government expenditure can affect the fx reserves level. from 2000/01 to 2005/06 fiscal years, both fx reservess and sacu receipts were relatively below 10.0% of gdp (figure 4). however, as sacu receipts started increasing from 2006/07 fiscal year, the fx reserves started picking up. both fx reserves and sacu receipts increased to a level above 10% of gdp between 2006/7 and 2009/10 fiscal years. an increase in sacu receipts prompted an increase in government expenditure during the same period and as a result, imports picked-up during the same period (figure 5). a sudden pickup in the level of imports in 2008/09 and 2009/10 fiscal year, as well as a reduction in sacu receipts during these periods, placed pressure on fx reserves. these developments resulted in a sharp decline in the growth of fx reserves between 2009 and 2014/15 fiscal year. an upward trend of foreign exchange reserve from 2014/15 fiscal years is associated to an increase in foreign debt acquired during the same period. there is a high association between fx reserves, government expenditure and external debt. similarly, growth in government expenditure seems to trigger growth in imports of goods. this is because, an increase in expenditure begins with an increase in sacu receipts, and an increase in expenditure of government results in an increase in imports, which theoretically is supposed to reduce reserves as imports are paid in foreign currency. as sacu receipts increased by 72.1% in 2006/07 fiscal year, for example, reserves also increased by about 60% and government expenditure increased by 14% and imports increased by 19.2%. the trends above indicates that a persistent fiscal deficit, high government expenditure, in an import-dependent country such as namibia, can result in a drastic decline of fx reserves. given that namibia is an import dependent country, a persistent increase in the fiscal deficit due to increase in government expenditure as depicted above, can result in a decline of fx reserves, as fx reserves are used to pay for imports. this maybe a cause of concern, especially when imports of consumable goods are higher compared to capital related imports. this is the case for namibia, whose imports share of consumable goods has been more than 20% over the study. in the long-run, this may result in namibia not being able to meet its foreign financial obligations. to this end, the crucial question is whether the level of fx reserves is affected by fiscal developments, hence, the objective of this study. 4. literature review the study’s review of literature follows two approaches, the first discusses the theoretical framework which relies on a model of foreign exchange reserve determinants and secondly the empirical review, which assesses the connection between fiscal policy, represented by fiscal expenditure, fiscal deficit and external debt and how it relates to fx reserves. source: bank of namibia (2021) figure 2: total government debt, overall fiscal balance, and expenditure (% of gdp) source: bank of namibia (2021) figure 3: growth rates of foreign debt and fx reserves manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023176 4.1. theoretical framework the theoretical explanation of the foreign exchange reserve model is described by two approaches (huang and shen, 1999, as cited in khomo et al., 2018). the first approach assumes that fx reserves fluctuations respond to discrepancies between the desired reserves and actual reserves held by a country. the demand for international reserves or buffer stock model states that reserves are there to finance international transactions and thus serve as a buffer stock against fluctuations in international accounts. the alternative approach explains the reserve holdings in terms of the monetary approach to balance of payments. according to this approach a change in reserve holdings is related to the disequilibrium in the domestic money market. fx reserves will increase when there is an excess demand for money, given that domestic credit is constant; and conversely fx reserves will decrease if there is an excess supply of money, (prabheesh et al., 2007). with the assistance of the imf (2003) study guidelines, prabheesh et al. (2007) as well as khomo et al. (2018), identified the empirical determinants of the fx reserves model. these determinants can be grouped into five major categories, namely, economic size, current account vulnerability, capital account vulnerability, exchange rate flexibility and opportunity cost (table 1). khomo et al. (2018), however, further emphasised that the choice of potential variables entering the model for each country may be different based on the underlying economic structure, exchange rate policy and external sector. the fx reserves model should follow these theoretical grouping, however, the uniqueness of the underlying factors of the economy that may affect the fx reserves, may result in some minor alterations of the theoretical model of fx reserves. in addition, the theoretical link between government expenditure and fx reserves is mainly through financing of the fiscal deficit. according to abayomi et al. (2014), the fiscal deficit may be financed in two ways: • firstly, a fiscal deficit can be financed through external net claims, which can be indirectly done through an increase in foreign borrowing or reduction of foreign international reserves • secondly, fiscal deficit could also be financed domestically, by an increase in government debt held by the private economic sector. source: bank of namibia (2021) figure 4: trends in external debt, sacu receipts and fx reserves (% of gdp) source: bank of namibia (2021) figure 5: growth rates of imports, sacu receipts and fx reserves manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023 177 the financing of the fiscal deficit through domestic and foreign borrowing is expressed as follows: g-t = δdcg -δnfag (1) where g-t represents fiscal deficit given as government consumption (expenditure) less tax, δdc represent domestic credit extended to government and δnfa represents a change in fx reserves (as net foreign assets). hence, persistent record of fiscal deficit or increase ingovernment expenditure affects δnfa. 4.2. empirical literature review the empirical literature on fiscal policy and exchange reserves in namibia is non-existent, however, the topic is widely debated on a global and regional level. the empirical studies discussed below established that there are various macro-economic variables that affect fx reserves in advanced, emerging and developing economies. in their study, annicchiarico et al. (2007) investigated currency and financial crises of the 1990’s using an optimising general equilibrium model for the emerging markets. the study focused on some latin american and asian countries (argentina, brazil, mexico, venezuela, chile, colombia, peru, uruguay, bolivia, honduras, indonesia, korea, malaysia, philippines, thailand, turkey, singapore, china (p. r. mainland), india, pakistan and sri lanka), using data from 1990 through 2000. the results showed that a rise in current and expected future of government budget deficits which is a result of high government expenditure, may generate a real exchange rate appreciation and a decumulation of external assets, leading up to a currency crisis when fx reserves approximate a critical level. likewise, chaudhary and shabbir (2005) found evidence that an increase in the government budget deficit (expenditure) led to fx reserves outflows in pakistan. they investigated the impact of the government budget deficit on money supply, domestic price level, output, balance of payments and international reserves in pakistan over the period 1965-99. their empirical evidence led to a conclusion that fiscal and monetary variables are important determinants of economic stability in the external sector of pakistan. it further concluded that money supply was positively related to fx reserves, bank credit and borrowing of the public sector to finance the deficit. the increase in the government budget deficit, financed through excessive expansion in domestic credit, created excessive supply of money over demand and led to fx reserves outflows. it was also established that india’s fx reserves accumulation was highly sensitive to capital account vulnerability. this was evidenced by prabheesh et al. (2007), who estimated the demand for fx reserves for india using a vector error correction cointegration approach, over the period 1983-2005. the study established that the ratio of imports to gdp, the ratio of broad money to gdp, exchange rate flexibility and interest rate differential determine india’s long-run reserves demand function. the study empirically concluded that reserves accumulation in india was highly sensitive to capital account vulnerability and less sensitive to its opportunity cost. further empirical evidence on fiscal policy and fx reserve showed that, developing countries with low political risk, countercyclical (procyclical) fiscal policies have higher (lower) fx reserves holdings in economic recessions. zhou (2009) investigated the link between the pattern of fiscal policy and the demand for fx reserves in developing countries, and how this relationship is associated with political risk and conditional access to global capital markets. the study results indicate that for developing countries with low political risks, fx reserves and fiscal policy have the following relationship: during economic downturns, countercyclical fiscal policies are associated with higher fx reserve holdings, while procyclical fiscal policies are associated with lower fx reserve holdings. this relationship is stronger when the countries with low political risk rely heavily on external financing. the results for developing countries with high political risk, however, did not indicate a clear-cut link between reserve holdings and fiscal policy pattern. according to baksay et al. (2012), the size and structure of foreign currency-denominated public debt, influenced the optimal level of fx reserves in hungary. the study analysed the interactions between public debt policy and fx reserves management in the emerging marketsfor hungary. the study applied the guidottigreenspan rule, which states that reserves should cover a country’s short-term foreign debt, with the period of analysis ranging from 1990 to 2011. the study found that foreign currency debt issuance contributed significantly to the growth of fx reserves. however, the positive contribution was temporary and could cause serious difficulties in the assessment of fx reserves adequacy, especially during crisis periods when it’s difficult to refinance maturing debt at a time when, for various reasons, the reserve requirement may still be rising. moreover, it could affect the profit-loss of the central bank and may affect the public deficit and debt as well. in addition, chowdhury et al. (2014) concluded that the exchange rate, remittances, home interest rate, broad money, export and import, as well as per capita gdp have significant long-run effect on fx reserve in bangladesh. the study conducted an engle granger residual-based co-integration analysis of the determinants of fx reserves using annual data for the period of 1972-2011 for variables including remittances (% of gdp), the exchange rate, inflation rate differential, unit price index of imports and export, foreign aid (% of gdp) and per capita gdp. the empirical table 1: empirical determinants fx reserves determinants explanatory variables economic size population and per capita gdp current account vulnerability ratio of imports to gdp, ratio of trade to gdp and ratio of the current account deficit to gdp capital account vulnerability ratio of the capital account deficit to gdp, ratio of short-term external debt to gdp and ratio of broad money to gdp exchange rate flexibility standard deviation of exchange rate opportunity cost of holding reserve interest rate differential source: khomo et al. (2018) manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023178 results confirmed that there exists a strong relationship among fx reserves, exchange rate, remittance, home interest rate, broad money, unit price index of export and import, and per capita gdp. the paper concluded that the exchange rate, a strong remittance related policy, quality items of exports, and sustainable gdp can play a substantial and feasible role with retaining a healthy amount of fx reserves for bangladesh. the study, however, did not include any fiscal variables in their study. likewise, bosnjak et al. (2020) found the exchange rate and money supply (m2) as significant determinants of fx reserves in north macedonia and serbia. their study applied a quantile regression approach to explore the determinants and properties of fx reserves in serbia and north macedonia, using quarterly data for the period 2005q1–2019q1. the results revealed quantile-dependent determinants of fx reserves and enabled a comparison between the two countries, showing co-movements between monetary policy and economic fluctuations. the study concluded that for north macedonia, the fx reserves were significantly determined by the real effective exchange rate, monetary aggregates m2/gdp, and the level of gdp. in serbia the level of real exchange rate and monetary aggregate m2/gdp are significant determinants of fx reserves. moreover, andriyani et al. (2020) analysed the factors that affect fx reserves in indonesia. using variables such as external debt, exchange rate, inflation, and exports as explanatory factors, the study employed the ardl cointegration approach to do the analysis. the findings from this research revealed that that foreign debt, exchange rates, inflation, and exports significantly affected the simultaneous fluctuation of fx reserves in indonesia. partially, foreign debt had a significant and positive effect on fx reserves. the exchange rate had a significant and negative effect on fx reserves, while inflation did not significantly affect fx reserves in indonesia. exports had a significant and positive effect on fx reserves. in africa, it was determined that fiscal deficits which are a result of high government spending tend to affect fx reserves. this was confirmed by fasoranti and amasoma (2013), who found evidence that running a fiscal deficit led to a long-run deterioration in external reserves accumulation and the exchange rate. their study examined the effects of and the causation between fiscal deficits and the external sector performance in nigeria between 1961 and 2011. they employed a bi-variate granger causality technique and the error correction modeling techniques to examine the causation effects. the study confirmed the existence of a long-run relationship among the variables. there also existed a bi-directional causality between budget deficits and external sector performance in the long-run while a one-way causation existed from the external sector performance to budget deficits in the shortrun with no feedback on the fiscal deficit. further, the results also showed that fiscal deficit did not significantly affect external sector performance in the short-run. the cross-correlation coefficient indicated that fiscal deficits lead to a long-run deterioration in external reserves accumulation and the exchange rate. similarly, abayomi et al. (2014), examined the effect of fiscal deficits on external reserves in nigeria over the period 19812012. employing a cointegration and error correction econometric technique, the study examined the relationship between capital expenditure, recurrent expenditure, and external reserves. the study found a long-run relationship among the variables and evidence that capital and recurrent expenditures significantly affect the level of fx reserves in nigeria. these findings implied that fx reserves can be determined, in the long-run, by recurrent and capital expenditures. in addition to government expenditure, exchange rate, exports, external debt, and inflation were also found to be additional macroeconomic determinants of fx reserves in nigeria. this was established by osigwe et al. (2015), who evaluated the other macroeconomic determinants of fx reserves in the nigerian economy, using cointegration econometric methodology over the period 1970-2013. exchange rate and inflation were found to be negative determinants of fx reserves while oil exports and fdi were positive determinants of reserves in nigeria. osigwe et al. (2015), concluded that exchange rate, exports, external debt and inflation were found to be the main macroeconomic determinants of fx reserves in nigeria. sanusi et al. (2019), found import, export, exchange rate, inflation and capital inflows as the determinants of fx reserves in ten southern african countries. they applied the ardl approach within a panel econometric framework using annual data sets over the period from 1990 to 2015. the fx reserve model included variables such as capital inflows, exports, inflation, exchange rate and imports. they found a long-run relationship among variables, with exports, inflation rate, exchange rate and imports being the significant determinants of foreign reserve holdings. all variables have positive effect on reserve in the long run apart from import demand. on the contrary, capital inflows were found to be a non-significant determinant of reserve holdings in the long-run. the short-run findings showed that all the independent variables, except for exchange rate, did not significantly determine reserve holdings. the study concluded that the “fear of floating” rather than “fear of capital” is a significant driver or determinant of fx reserves in southern african countries. no fiscal variables such as government expenditure nor external debt or fiscal deficit was included in this study. in the cma, eswatini found evidence that government expenditure, current account, exchange rate and per capita income have significant effect on fx reserves. using the ardl bounds testing cointegration methodology, khomo et al. (2018) investigated the behaviour of eswatini’s fx reserves over the period 1990-2014. the study concluded that fx reserves in eswatini were driven by gdp per capita, developments in the current account, government expenditure and movements in the exchange rate. the study recommended the need for policy makers to increase efforts to build reserves and support confidence in the currency peg between eswatini and south africa and hence maintain financial stability. evidence by mushendami et al. (2017), show that fiscal balance has a significant impact on the level of reserve in namibia. this was established by examining the possibility of the monetary approach to balance of payment, by employing the vector error correction model (vecm) with quarterly data ranging from 1991 to 2015. the study found that, an increase in domestic credit had a negative effect on the net foreign assets (nfa) and improvement in government budget manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023 179 balance improved the nfa in the short-run. other macroeconomic variables such as interest rate, exchange rate, gdp and cpi were found to be insignificant. furthermore, evidence of uni-directional causality from gdp, fiscal balance, exchange rate and domestic credit to nfa was also established in the study. the study, therefore, concluded that, monetary variables were not the only factors causing variations in nfa in namibia, as fiscal balance, had significant contributions to changes in the nfa. empirical literature above concludes that that there are various factors affecting fx reserves and evidence shows that government expenditure and fiscal balance variables are among the determinants. although the reviewed literature above included developing economies, countries in a fixed exchange rate, southern africa and even the cma, no evidence is available for namibia on the link between government expenditure and fx reserves. research studies on the fiscal policy and its relation to fx reserves has received little attention in the namibian economy. to our knowledge, no research has come close to investigating fiscal policy and fx reserves namibia. this study is the first attempt to assess and therefore contribute to the empirical literature between fiscal policy and fx reserves in namibia. 5. methodology to examine the impact of the fiscal deficit financing on fx reserves, a cointegration methodology was employed to analyse the long-run relationship between these variables. the autoregressive distributed lag (ardl) method by pesaran et al. (2001) was adopted to establish cointegration relationships among the variables. several steps and procedures were conducted as required by the methodology. the f-test was used to test for cointegration, which tests for the presence of a long-run relationship among the variables. the f-statistic value is used to compare with the critical value in the lower bound and upper bound (pesaran and shin, 1999). the ardl bound cointegration equation is specified as follows: � � � � lnres gx lnm ca i t pi n i t pi n ii n t p i � � � � � �� �� � � � � � � � � � 0 1 1 2 1 3 1 2 �� � � � � � � �� � � � � 1 4 5 1 1 1 2 1 3 1 4 2 n i ii n t p t t t reer ed res gx m ca � � � � � � � � tt t t treer ed� � �� � �1 5 1 6 1� � � (2) where lnres is the log of fx reserves, gx is government expenditure as a share of gdp, lnm2 is the log of aggregate money demand, ca is current account as a share of gdp, ed is change in external debt, whereas reer is real effective exchange rate. δ0 represents the intercept; μi are short-run parameters, γi are long-run coefficients and ∆ is first difference operator and εt is an error term. equation (1) null and alternative hypotheses are derived as follow: h0: γ1 = γ2 = γ3 = γ4 = γ5 = γ6 = 0 hα: γ1 ≠ γ2 ≠ γ3 ≠ γ4 ≠ γ5 + γ6 ≠ 0 the conditions are that the null hypothesis of no co-integration would be rejected if the estimated f-statistics are greater than the upper bound value and vice versa if the f-statistic value is lower than critical bound value. this indicates the existence of long-run relationship among the variables. failure to reject the null hypothesis implies that there is no cointegration, the opposite indicates that the variables in equation (1) have a longrun relationship. the error correction model is then developed to derive the error correction term (ect) which corrects for any deviations and adjusts it back to the long-run equilibrium in the model. this methodology is preferred over other methodologies due to its several comparative advantages. firstly, the ardl method works well with a small sample size which is the case for this study. secondly, it is more preferred because of its flexibility to work well with the mixed order of cointegration associated with economic variables. thirdly, a dynamic unrestricted error correction model (uecm) can be derived from the ardl bound testing through a simple linear transformation. the uecm integrates the shortrun dynamics with the long-run equilibrium without losing any information for the long-run. to study the impact of government expenditure on fx reserves in namibia, the study adopts a similar theoretical model by khomo et al. (2018). in addition to the variables applied by khomo et al. (2018), this study incorporated fiscal variables which include government expenditure and government foreign debt. hence the model in this study includes the following variables: external debt, current account, government expenditure and the exchange rate. given the above theoretical understanding of both fiscal expenditure and fx reserves, the model in this study is then specified as follows: res f ed ca gx reer= ( , , , m2 (3) re-specifying equation. (3) in a regression form, will obtain equation (4) as follows: res ed ca m gx reert t t t t t� � � � � � �� � � � � � �1 2 3 4 5 72� ) (4) the coefficients β2 to β6 can be estimated to get the effects of each variable on fx reserves. β1 is a constant and εt is an error term. 6. data, variables, and prior expectations the analysis in this study covers the period between 2002q1 and 2020q4 and is conducted using quarterly time series with secondary data sourced from the bank of namibia. data on fx reserves, m2 and changes in external debt are expressed in natural logs, government expenditure and current account are expressed as ratios to gdp, while real effective exchange rate is an index. • fx reserves: it is the dependent variable. manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023180 • m2: like khomo et al. (2018)1, this study included broad money (m2) variable in the model, due to the fact that namibia is in a fixed exchange rate with south africa through the cma, together with eswatini and lesotho. since the bilateral arrangement under cma requires that currency in circulation must be fully backed by fx reserves, it was imperative to include this variable in the reserve model. others such as prabheesh (2007), chaudhary and shabbir (2005), chowdhury et al. (2014), bosnjak et al. (2020) and others, have also included the broad money supply (m32) as a variable that introduces capital account vulnerability. based on the above, the study expects a positive relationship between m2 and fx reserves, as fx reserves holdings will increase as the demand for money increases. • external debt: represents borrowing by the government from the external market. it is expected that; change in external borrowing will increase fx reserves in the short-run and reduce it in the long-run due to debt servicing and repayments of foreign denominated loans. • government expenditure: refers to government expenditure on goods and services in a given period. it is expected that an increase in expenditure will reduce fx reserves. this is because an increase in expenditure will result in higher imports which will be paid using fx reserves. additionally, namibia who is a member of the southern african customs union (sacu), receives payments from sacu. sacu inflows increase fx reserves and from experience, this increases government expenditure, which later reduces fx reserves (khomo et al., 2018). • real effective exchange rate: the weighted average of the namibia dollar in relation to an index of other major trading countries’ currencies. an appreciation of the namibia dollar will result in a decline of competitiveness. exports will decline and imports will increase. hence, an appreciation will reduce fx reserves, while a depreciation will increase fx reserves. • current account balance: according to the imf bpm63 definition, an account of the balance of payment (bop) which shows the flows of goods, services, primary income and secondary income between resident and non-resident units. an increase in current account is theoretically expected to have a positive effect on fx reserves, while a decrease in current account means imports are higher than exports and will reduce fx reserves. 7. results 7.1. unit root test as per the methodological requirements, it is necessary to test the order of cointegration of the data used in the model, as data which is cointegrated of order 2 contradicts or violates the ardl methodology. hence, performing such tests at the beginning of any analysis is necessary as results may be spurious and misleading 1 included broad money supply in the foreign exchange reserve model for eswatini due to the economy being in a fixed pegged exchange rate policy to the south african rand. 2 namibia does not currently compile m3. 3 balance of payments and international investment position manual if variables integrated of order i (2) and more are included in the regression. the study applied the phillips-perron unit root test, to evaluate the order of cointegration and whether the data is stationary to conform with the cointegration ardl method. the results of the unit root test presented in table 2 indicate that all variables are i (1), as they only became stationary after taking first difference. the current account is, however, stationary in levels, which implies that it is an i (0) variable. the order of integration of the variables used in the study conform with the ardl methodology requirements, which tolerates the use of i (0) and i (1) cointegration combination. 7.2. ardl cointegration test the null hypothesis of no co-integration is rejected at all levels of significance, which implies that there is a long-run relationship among these variables. this is because the estimated f-statistics value is greater than the upper critical bounds value at all levels of significance based on pesaran et al. (2001) (table 3). a confirmation of cointegration in this study proves that there is a long-run relationship between fx reserves, external debt, exchange rate, government expenditure and the current account. furthermore, the existence of cointegration relationships in the model means that, a short-run error correction model (ecm) of foreign exchange rate can be further investigated. as prior expected, the coefficient of government expenditure exhibits a negative effect on fx reserves. this means that a percentage increase in government expenditure will reduce fx reserves by 0.15%. this finding is consistent with the findings of khomo et al. (2018) who also found a negative effect of government expenditure on fx reserves, in eswatini. moreover, the results show that growth in foreign debt is positively related to fx reserves, this is reflected by a positive coefficient which is statistically significant. all other things being equal, a percentage increase in government foreign debt will increase fx reserves by 0.52%. this is theoretically true and in line with prior expectation that, growth in government external debt instantly increases fx reserves. this is mainly attributed to the effects of external debt reserve shocks, which often increases the level of fx reserves as a result of foreign debt transfer through to the central bank. in general, however, high external debt, has a long-term negative effect on fx reserves, as it puts pressure on government expenditure due to increased repayments and foreign debt servicing thereof. these results conform to the theory of capital flows, which explains that borrowing money from other countries will lead to a temporary increase in foreign capital flow, increasing fx reserves (andriyani et al., 2020). the result further shows that an exchange rate appreciation has an inverse relationship with the level of fx reserves, as the coefficient of exchange rate on fx reserves came out negative and statistically significant. moreover, a depreciation of local exchange rate against foreign currency results in higher levels of fx reserves when expressed in namibia dollar. the result implies that an increase in exchange rate (appreciation) by one index point reduces foreign reserve by 3.88% and vice versa. this is also linked to the theoretical expectation of the link between exchange rate manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023 181 and trade. as the exchange rate appreciates, export will decline while import increase which ultimately reduces foreign exchange receipts, however as the exchange rate depreciates it will increase fx reserves through increase in export receipts. the exchange rate result is in line with the result of current account, whose coefficient came out positive and statistically significant. these confirm that an increase in current account which is an improvement in export earnings increases fx reserves, while a decline in current account reduces fx reserves. the long-run results of capital account vulnerability variable proxied by m2, showed that it has a positive relationship with fx reserves. meaning, a one percent increase in the broad money supply will result in fx reserves holdings to increase by 2.94% in the longrun. this is true for namibia and other cma members in which the money circulation in the economy should be backed by the equivalent amount of fx reserves. lnres reer m ca � � � � � �� � �� � � �4 51 3 88 2 94 2 0 11 0. . . . . . . . 1 4 315 965 293�� � �� � � �� �0 15 0 52. .. .gx ed481 264 (5) moreover, the lagged ect of the ardl cointegration exhibits a negative coefficient of 0.43 and was statistically significant (annex 1). this result implies that the selected ardl model has a strong convergence back to long-run equilibrium level as it adjusts all the short-run error (shocks) back to its long-run equilibrium at an adjustment speed of 43 percent. all short-run disequilibrium in the fx reserves model is corrected back to its long-run equilibrium every quarter. in the short-run, current account foreign debt, government expenditure and exchange rate have effects on fx reserves in namibia, except for broad money (m2). these are supported by the significant coefficients, while broad money is insignificant. the autoregressive conditional heteroscedasticity (arch) test, breusch-godfrey serial correlation lm and the jarque-bera tests were used to test for heteroscedasticity, serial correlation, and normality of the series in the model, respectively. the results displayed in table 4 shows that the residuals are normally distributed and there is no autocorrelation. it further shows that the model does not suffer from heteroscedasticity, this means that the estimated model is well specified. the study conclude that the residuals are stable based on the recursive cusum test. cusum test, is based on the residuals from the recursive estimates, that also helps detect the systematic changes and sudden changes in regression coefficient. both the cusum and the cusum of squares test showed in figures 6 and 7 (annex) reveal that, the estimated model is stable as the fitted line lies within the 5% critical region. all diagnostic tests, prove that the estimated model results are fit and reliable and can be referenced for policy use. 8. conclusion and policy implications the study examined the effect of government expenditure on fx reserves in namibia, by empirically testing the long-run relationship between fx reserves, foreign debt, government table 4: diagnostics tests tests results breusch-godfrey serial correlation lm test obs*r-squared 0.403632 prob.chi-square (4) (0.9395) heteroskedasticity test: arch obs*r-squared 0.254379 prob.chi-square (3) (0.9684) normality test) jarque-bera (5.50) probability (0.06364) durbin-watson stat 2.083288 table 3: cointegration test (bound test) significance levels lower bound (i0) upper bound (i1) f-statistics critical value bound 10% 2.08 3.00 3.83 5% 2.39 3.38 2.5% 2.70 3.73 figure 6: cusum test of stability table 2: phillips-perron unit root test phillips-perron unit root test variable level first difference conclusion intercept intercept and trend intercept intercept and trend phillips-perron test statistics and probability gx 0.066855 (0.9611) −2.74319 (0.2225) −9.856144*** (0.0087) −9.833125*** 0.0293 i (1) current account −3.775559** (0.0047) −4.593313*** (0.0022) i (0) reserve −0.737929 (0.8301) −1.893365 (0.6481) −9.500039*** (0.0000) −9.886955 *** (0.0000) i (1) external debt −1.258332 0.6448 −0.137273 0.9933 −3.567196** 0.0088 −3.722321*** 0.0269 i (1) m2 −0.549648 (0.8742) −1.553676 (0.8012) −9.235417*** (0.0000) −9.243699*** (0.0001) i (1) reer −0.216244 0.9309 −3.035911 (0.1296) −6.798416*** (0.0000) −6.927683*** (0.0000) i (1) *; **; *** denotes significance at 10%, 5% and 1% respectively. values in parentheses represent the probability manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023182 figure 7: cusum of square test of stability expenditure, exchange rate, current account vulnerability and broad money supply. the long-run relationship was tested using the ardl bound test for the period 2002: q1 to 2020: q4. empirical test results revealed that there is a long-run relationship between fx reserves and foreign debt, government expenditure, exchange rate, current account, and broad money supply. the study found that an increase in government expenditure reduces fx reserves, while foreign debt accumulates reserves. the study also confirmed that, an appreciation of exchange rate reduces fx reserves in namibia, while both current account and broad money supply was found to have positive relationship with fx reserves holdings. moreover, the conclusion of this study is consistent with the findings of khomo et al. (2018) and aboyomi et al. (2014), who also found evidence that fx reserves in eswatini and nigeria, was determined by changes in government expenditure. similarly, the findings regarding the effect of government external debt on reserve, is also in agreement with baksay et al. (2012), fasoranti and amasoma (2013) who both concluded that the size and structure of foreign currency denominated public debt have an impact on the level of fx reserves. these results trigger necessary policy changes toward a reduction of government expenditure and therefore the fiscal deficit. the review of literature and the empirical results from the study both confirmed that, government expenditure which results in persistent fiscal deficits, usually results in high government borrowing, which impact fx reserves. persistent fiscal deficits can, therefore, be seen to gradually erode the function of the central bank of safeguarding fx reserves, to maintain the one-to-one link between the namibia dollar and the south african rand and hence compromise its credibility in the long-run. annicchiarico et al. (2007), reiterate this concern by asserting that a deterioration in fx reserves because of a persistent fiscal deficit may hinder monetary policy effectiveness and may result in a currency crisis. 8.1. policy recommendations • based on the findings, the study recommends the continuation of fiscal consolidation. while there is a dire need government expenditure in order to cushion the effect of covid-19 on the economy, the study stresses the need for the fiscal authority to continue with consolidation policy measures adopted before covid-19. the reduction and prioritisation of government targeted expenditure to reduce the fiscal deficit will facilitate the attainment of sustainable debt levels going forward. • effort should be put in place to reduce spending, while simultaneously, expanding revenue generation measures under namra. in the wake of the highlighted challenges associated with the persistent negative budget balance, government under the new revenue collection agency (namra), is encouraged to prioritise and implement measures that will widen tax base, especially to economic agents in the informal sector that may qualify and contribute towards expanding tax revenue. this must be complemented by the privatization, outsourcing and if necessary, the liquidation of non-performing state-owned enterprises (soe’s). this will reduce expenditure burden on transfers to soes and contribute to the rebuilding of fiscal buffers. • facilitation of private sector led growth and development. in order to ensure that debt is brought under a sustainable trajectory over a reasonable time, and ultimately reduce the pressure on reserves, government needs to rededicate its commitment to ensure a conducive environment for private sector led growth and investment. • the study further recommends that policy makers develop or enhance the existing strategies of fx reserves accumulation and management. doing this will help namibia increase its fx reserves buffers and manage it effectively, so as to maintain the fixed exchange rate peg to the south african rand. this will also allow namibia to meet the regional requirements of at least a minimum of six months of import cover. • continued coordination of monetary and fiscal policies is encouraged. as empirically proven by this study and by many other scholars on this topic, the operation of fiscal and monetary policies cannot operate independently. while the role of each policy is different, the effectiveness of achieving the overall objective of macroeconomic stability requires the continued coordination of both policies. references abayomi, a., ezie, o., jonathan, o.o. (2014), fiscal deficits and foreign reserves evidence from nigeria. international journal of economics, commerce and management, 2(10), 1-16. akpan, u. (2016), foreign reserves accumulation and macroeconomic environment: the nigerian experience (2004-2014). international journal of economics and finance studies, 8(1), 1309-8055. alagidede, p. (2016), central bank deficit financing in a constrained fiscal space. international growth center (igc). working paper, no. s-33306-gha-1. south africa: university of the witwatersrand. andriyani, k., marwa, t., adnan, n., muizzuddin, m. (2020), the determinants of foreign exchange reserves: evidence from indonesia. journal of asian finance, economics and business, 7(11), 629-636. annicchiarico, b., marini, g., piersanti, g. (2007), budget deficits and exchange rate crises. international economic journal, 25(2), 285-303. baksay, g., karvalits, f., kuti, z. (2012), the impact of public debt on foreign exchange reserves and central bank profitability: the case of hungary. bis papers no 67. bošnjak, m., bilas, v., kordić, g. (2020), determinants of foreign exchange reserves in serbia and north macedonia. economic annals, 65(226), 103-120. chaudhary, m.a., shabbir, g. (2005), macroeconomic impacts of budget deficit on pakistan’s foreign sector. pakistan economic and social review, 43(2), 185-198. chowdhury, n.m., uddin, m.j., islam, m.s. (2014), an econometric manuel, et al.: effects of government expenditure on foreign exchange reserves: evidence for namibia international journal of economics and financial issues | vol 13 • issue 1 • 2023 183 analysis of the determinants of foreign exchange reserves in bangladesh. journal of world economic research, 3(6), 72-82. fasoranti, m.m., amasima, d. (2013), analysis of the relationship between fiscal deficits and external sector performance in nigeria. journal of economics and sustainable development, 4(11), 80-87. fischer, s., easterly, w. (1990), the economics of the government budget constraint. the world bank research observer, 5(2), pp.127-142. gupta, s., singh, k. (2016), fiscal deficit and its trends in india. international journal of business and management invention, 5(11), 63-75. huang, t., shen, c. (1999), applying the seasonal error correction model to the demand for international reserves in taiwan. journal of international money and finance, 18, 107-131. international monetary fund (imf). (2003), guidelines for foreign reserves management, approved by the executive board. united states: international monetary fund. international monetary fund (imf). (2021), revised guidelines for foreign exchange reserve management. available from: https:// www.guidelines for foreign exchange reserve management (imf. org) [last accessed on 2022 jul 13]. khomo, m., mamba, n., matsebula, l. (2018), determinants of foreign exchange reserves in eswatini. african review of economics and finance, 10(2), 134-150. annex 1: ardl error correction regression (1, 1, 3, 0, 2, 3) variable coefficient t-statistic prob. lnres(−1) 0.566016 3.501539 0.0009 lnm2 0.898223 3.690506 0.0005 lnm2(−1) 0.379323 1.051043 0.2977 gx −0.076862 −2.316745 0.0241 gx(−1) 0.103412 1.826355 0.0730 gx(−2) −0.051666 −1.092097 0.2794 gx(−3) −0.037977 −1.345808 0.1837 ca 0.045981 2.199191 0.0319 lnreer −2.352901 −2.691688 0.0093 lnreer(−1) 2.388218 2.512303 0.0148 lnreer(−2) −1.717117 −2.712060 0.0088 lnext_debt −0.037075 −0.160069 0.8734 lned(−1) 0.361270 1.157243 0.2520 lned(−2) −0.407665 −1.480601 0.1442 lned(−3) 0.307046 1.363573 0.1781 c −1.958560 −0.927988 0.3573 cointeq(−1)* -0.433984 5.445822 0.0000 mushendami, p., manuel, v., shifotoka, h., nakusera, f. (2017), empirical analysis of the monetary approach to the balance of payment in namibia. international review of research in emerging markets and the global economy (irrem), 3(1), 2311-3200. osigwe, a.c., okechukwu, a.i., onoja, t.c. (2015), modeling the determinant of foreign reserves in nigeria. international knowledge sharing platform, 5(19), 72-77. pesaran, m.h., shin, y. (1999), an autoregressive distributed lag modelling approach to cointegration. in: econometrics and economic theory in the 20th century: the ragnar frisch centennial symposium. ch. 4. cambridge, united kingdom: cambridge university press. pp371-413. pesaran, m.h., shin, y., smith, r.j. (2001), bounds testing approaches to the analysis of level relationships. journal of applied econometrics. 16, 289-326. prabheesh, k.p., malathy, d., madhumathi, r. (2007), demand for foreign exchange reserves in india: a co-integration approach. south asian journal of management, 14(2), 36-46. sanusi, k.a., meyer, d.f., hassan, a.s. (2019), an investigation of the determinants of foreign exchange reserves in southern african countries. journal of international studies, 12(2), 201-212. zhou, y. (2009), international reserves and fiscal policy in developing countries. review of international economics, 17(5), 942-960. annex . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(1), 73-79. international journal of economics and financial issues | vol 6 • issue 1 • 2016 73 impact of financial literacy and investment experience on risk tolerance and investment decisions: empirical evidence from pakistan mustabsar awais1, m. fahad laber2, nilofer rasheed3, aisha khursheed4* 1alfalah institute of banking and finance, baha-ud-din zakariya university, multan, pakistan, 2alfalah institute of banking and finance, baha-ud-din zakariya university, multan, pakistan, 3alfalah institute of banking and finance, baha-ud-din zakariya university, multan, pakistan, 4department of management sciences, university of education lahore, multan campus, multan, pakistan. *email: aisha.khursheed@ue.edu.pk abstract investment decision making is a very crucial process which is influenced by many factors. an important thing which is necessary to understand is the degree to which an investor can absorb the risk. this intensity of risk which can be of minimal, maximum or mediocre level, defines the strategies regarding the decisions of investment. a determinant of investment decisions needs special consideration to be understood by investors. this paper helps to determine those variables by constructing a theoretical model. after studying the past researches and theories certain conclusions are drawn whether which are the factors that impacts the decision making process. this paper is structured as follows. the first part describes relevant literature and devises hypotheses. section 2 describes the model, methodology, data source and the variables measurement. section 3 is based on a discussion and concludes and provide with future implications. keywords: risk tolerance, investment decision making, investment experience, financial literacy jel classifications: g02, g11, g110 1. introduction investment decision making process is a critical process which depends upon various factors that may vary among individuals. while making any types of decisions in life people use to behave differently. some make decision based on judgment while others consider many other factors that direct them to act upon such appropriate decision. the process of decision making becomes easy when all the confounding variables are well recognized by investors. the variables which direct them to make the right decision so that the losses can be avoided or reduced in the future. during the period of investment decision making, investors’ encounter highly complex factors such as risk, ambiguity, and choice overload. these are challenging for financial professionals, experienced investors, and especially the ordinary private households. investors have to chase risks in their financial decisions. this can lead them to earn profits. on the other hand any decision made by investors on the basis of poor or misleading information or on the basis of poorly analyzed information may leads towards imperfect outcomes. investment as expense made now can make profits in future. a company may be dealing with foreign institutions like world bank, european commission, european bank for reconstruction and development and others. these are the institutions which formulate some specific processes to handle investment decisions. the investment expenses are made to attain gains and they can be achieved through two ways. the first way is investments in fix assets like buildings, machinery or plants. while the second may be investments in terms of money such as stocks, bonds etc. both forms of investment can make a corporation flourish. financial literacy is valuable. information has a criticality on the decision to the clue. a positive signal can make an investor make a good decision. the investor should decide regarding his investment risk based on the clues he receives. information can be significant awais, et al.: impact of financial literacy and investment experience on risk tolerance and investment decisions: empirical evidence from pakistan international journal of economics and financial issues | vol 6 • issue 1 • 201674 if some of the clues will change the decision, or information can be worthless. the value of the information is coming from the way it is utilized by the decision maker regarding the investment. an informed decision maker can always act like a non-informed one by ignoring the coming information. a good investment decision can be made by an experienced investor by building confidence or by utilization of experience or by managing risk appropriately. doing the good investment is challenging for people with minimal or without having know how and experience about investing. severe losses can be the result of not making right decisions because investment is related with risk and it is an important element that depicts the investor’s decision to invest. risky investment generates magnified outcomes either in form of gain or loss. in other hand less risk associated with investment will leads towards minimal gain to neutralize for the low risk related with the investment. information regarding different variables and investment experience has major impact on risk perception and in turn on investment decisions. so the financial literacy and investment experience are supposed to be the important factors having impact on risk tolerance and investment decisions. as the information used to make financial decisions is being collected from different sources. the sources were categorized as: secondary sources, medium, and the world wide web, friends, family and professional financial services providers or many others to gain information regarding diversification, interest rates and inflation and many other economic indicators as well. investor’s subjective knowledge and wealth were supposed to impact their decisions of whether to use which sources of information. previous studies depict that seminars, written communications and website information are good methods in conveying financial education. so this paper will reveal that whether the financial literacy and investment experience helps to define the risk tolerance which leads towards making investment choices and decision. 2. problem statement we are trying to discover the factors having impact on risk tolerance and investment decisions; there are many factors that affect an investor decision making process like demographics, income level, qualification, financial knowledge and previous experience with investment. many studies are supposed to be done on finding the factors that affects the ability to take risk and make investment decisions accordingly but here we will consider the influence of financial literacy and investment experience on risk perception and investment decisions. 3. research gap making decisions regarding investment is a sensitive process because an investor is not only investing his/her money but a good worth of time as well. risk is always associated with that in every aspect, coping up in that situation they have to consider all factors related with that. as in pakistan where economy is not strong and political instability is there, put the investors in precautionary zone to which extent they can chase risk and make risky investment. income level is also the determinant of decisions but economic and political circumstances make them conscious to invest or not because economic conditions are usually influenced by political circumstances. researchers are always in a surge to determine indicators and factors that impact the investment decision process in many countries of asia and other continents but pakistan as varying in many ways from other countries having its own determinants. it is important to explore those variables that help pakistani investors in decision making process like demographics, income level, qualification, financial knowledge and previous experience with investment but their effect yet not find with special reference to pakistan. the previous studies lack the focus in pakistani context; most of the researchers have only covered other asian countries like china and have explored many psychological factors and some materialistic factors. in this research we start up with important factors like financial literacy and investment experience and then we will discuss how these factors impact the risk tolerance level and investment decisions. it is necessary to learn how much the literacy of finances impact the investment decisions, this will help institutions to equip themselves with such sources which are supposed to fascinate with financial education especially to investors in different dimensions like how they can utilize their knowledge to manage their risk bearing capacity and to end with healthy investment. investment experience proves to be a best tool to deal with risky investments because it enhances the confidence level of investor. experienced investors have a portfolio of good and bad experience. a wise investor learns from past experience to tackle risky situations and to handle it properly, when he learn a lot, so s/he can jump into risky investment to earn high returns by managing it efficiently. our research proves to be valuable to explore those impacts as well. this study proves to be a milestone for future researchers while incorporating risk and other factors that affect the investor’s decision making process in pakistan. on the other hand it will help investors as well on how much knowledge they should have to cope up with risky situation and how investment experience helps to handle risky investments. little attention has been given in pakistan to determine factors that affect decision making process. financial literacy proves to be an important determinant, while further research is required to explore more dimensions which can influence investment decisions. 4. literature review 4.1. financial literacy, risk tolerance and decision making it is evident from literature that financial literacy can be taken as of mathematical capability and the knowhow of financial wording. according to this financial literacy is high for people having age of 50 and 60 years, professionals, business and owners of farm, and university or college graduates (worthington, 2001)† literacy of financial education can also described as the capability of individuals to go for financial decisions by keeping in view their own best short term and long-term interests (mandell, 2008). it is evident that financial experience leads towards financial knowledge creating awareness for self-education or make the awais, et al.: impact of financial literacy and investment experience on risk tolerance and investment decisions: empirical evidence from pakistan international journal of economics and financial issues | vol 6 • issue 1 • 2016 75 financial literacy programs more significant. even the stock market games provide the opportunity to gain effective exposure and experience (frijns et al., 2014). hence literacy can also be enhanced by the people who have enough resources and utilize these resources to obtain financial information for implying better outcomes from investment decisions. wealthier households can spend more money to get access to financial information. by using this information they are usually less uncertain about the risky assets as they are aware of all the information about the financial market. as the wealth of investor increases, his absolute risk tolerance will also increase because he can have every type of information by using his money, but on the other hand less wealthy individuals are uncertain because they can’t purchase that much information (makarov and schornick, 2010). there is a significant relationship among financialeducation and monetary accumulations because individuals having knowledge about how to take benefit of the stock premium on equity investment. financial literacy is positively related with planning of retired income behavior (lusardi, et al., 2007; lusardi and mitchell, 2009; 2011a). empirical results suggest that respondents with more confidence in their financial knowledge show a higher degree to plan. financial illiteracy is very high among specific age, gender, income and qualification (lusardi and mitchell, 2007b; 2008) evidence of less education and less financial sophistication is also shown in less age respondents. financial illiteracy has important consequences; those who lack literacy will not be able to makeplan for retirement (lusardi and mitchell, 2006; 2007a; 2007c), will have less wealth near to retirement thus will be having less ability to invest in stocks (vaan rooij, et al., 2007; kimball and shumway, 2006; yoong, 2007), and will borrow at high interest rate (lusardi and tufano, 2009). present studies shows that less knowhow of financial education is very common and people don’t have knowledge of even basic dimensions which are related to economics. so to achieve potential results financial know how seems to be important (chan and stevens, 2008). (bernheim and garrett, 2003) said that those people save more who got qualification in high school or in the workplace. competition gets enhanced by the people having financial knowhow. this helps to innovate and therefore boosts growth economically (oecd, 2005). (chan and stevens, 2008) presented that individual running homes making pension and retirement saving decisions on basis of limited and oftentimes pension knowledge which is not right. it can also improve performance health of company as joo (1998) described that financial knowledge enhances workers performance and decreases turnover to cope with personal financial issues which can arise due to absence from work. some people encounter maximum risks of having insufficient financial qualification and skills to face the challenges in good manner imposed by the reformed system of pension. while an enhanced level of financial knowledge can be good generally. after retirement people use to go for investment plans it is evident that when they obtain economic and organization based qualification their financial knowhow get improved. financial knowhow is an important variable of planning about retirement. it is also demonstrated that a negative impact of participation in capital market caused by less education of financial knowledge and it will lead to loss in the long term (cocco et al., 2005). to invest successfully, financial literacy should be enhanced (agnew and szykman, 2005). in the questionnaire certain variables used to measure the extent of financial literacy which refers to the knowhow of variables such as inflation, compound interest and diversification of risk. it is the demand of more complex markets to be equipped with financial literacy education. (braunstein and welch, 2002; lusardi, 2008). financial literacy is also having an impact on portfolio decisions. while making decisions with regards to whether to go for risky or riskless security, this will also refers to further quest for financial advice that helps in decision making. calcagno and monticone (2015) argued that financial literacy is a necessary element of financial decision making, and many low age people having desire of getting financial qualification. major proportion of college students said they required more education on managing finances, many would like to get information about financial management topics in high school, and less proportion would desire to get such information as college (mae, 2009). fewer studies have considered the impact of financial literacy at work place on nonpublic savings or contributions to pension funds. results show that there is a significant influence of financial education on the decisions made for savings and pensions. these results also show that the type of education used for decision making does matter. as, (bernheim and garrett, 2003) and (bayer, et al., 1996) found that opportunities that are contingent on print media (newsletters, plan description, etc.) have no impact on contributions or pension participations, in spite of the fact that the quality of financial information do matter (clark and schieber, 1998). in opposite, conferences on retirement are considered worthwhile, but these seminars appear to impact only specific features of attitude, like participation of pension and the volume of contributions, but it does not effect the level of total savings (bernheim and garrett 2003; mccarthy and turner, 1996). according to findings of clark and schieber (1998) people with less financial education have more saving habits (gustman and steinmeier, 1999). reported that most of people are not properly equipped about the outcomes of their pension and the benefits of social security and are usually not aware of the forms of pension plan available to them and the paybacks related with that plan. benefits of financial knowledge are that it decreases the costs of obtaining and processing information and minimizes the obstacles to invest in the equity market (haliassos and bertaut, 1995; vissing-jorgensen, 2004). yong age people were not only less in education, but also have a minimal knowledge of basic economics dimensions such as interest rate compounding (lusardi and mitchell, awais, et al.: impact of financial literacy and investment experience on risk tolerance and investment decisions: empirical evidence from pakistan international journal of economics and financial issues | vol 6 • issue 1 • 201676 2007a). financial illiteracy can have many long run financial outcomes or may end up in deficits (lusardi, 2008). as, people who undermine the strength of compounding the interest rate will come up with large number of debt (lusardi and tufano, 2009). individuals who cannot refinance the returns successfully or to incorrectly forecast the amount by which interest rates can vary will pay very much in the form of mortgage interest (campbell, 2006). financial literacy is related with a broader range of financial decisions, such as equity market participation, diversification of portfolio and the ability to avoid extreme indebtedness (kimball and shumway, 2007; guiso and japelli, 2008; lusardi and tufano, 2008; van rooij et al., 2011). those people who possess financial literacy commonly believe that many consumers can’t go for critical financial decisions in their best benefits because they lack the financial education required to go for those decisions (perry, 2008; braunstein and welch, 2002). financial literacy has significant effect on individual financial behaviors as it will give favorable results (hilgert et al., 2003). by integrating the factors we can hypothesize that: h1: financial literacy is positively related with investment decisions due to risk tolerance 4.2. investment experience risk tolerance and investment decisions in fact, without being knowledgeable about how the users of financial reports consider risk, this will prove difficult for people managing and regulating to understand either risk related informationis working as expected or they operate in unexpected manner (gomes et al., 2004). that’s why people who managing and regulating utilize this findings of financial risk judgments to make more effective decisions. small and medium investors are more attracted towards higher rate of return (ji, 2011). (kahneman and tversky, 1979) gives the definition financial risk tolerance as a psychological element of decision making under financial ambiguity a situation in which a person estimate the probability of possible outcomes and their chances of occurrence. another approach to get people know about risk related with investment is to give them complete knowledge of financial markets by providing brochures or booklets. in german booklet of more than 150 pages with ‘‘fundamental information’’ about economic associations, chances and risks of instruments is given to every single investor who wants to invest in stocks or funds (bank, 2005). different risks related to investment can be categorized as issuer risk, exchange risk, and inflation risk. many single investors may be bombarded by this broader value of information and by its unclear form. moreover, this vide variety of information does not seem to be helping when going for specific investment decision, because this kind of general information ignore many experience levels and financial education of the customers. through that vary perspective there is a chance that degree of decision quality effected by this large amount of information is called excess information (hwang and lin, 1999). studies done by customer protection organizations reveal that adaptability of information to the individual requirements of the customer is minimal. demographical characteristics of the customer also impact the way information is analyzed or perceived. moreover previous investment patterns also reflect how financial reports users think about risk management and regulation. research shows that individual investment decision making is directly influenced by the risk perceptions of the individuals (coombs, 1975; march and shapira, 1987). from a theory view, the primary focus of financialstudies on risk is the role of decision theory factors, results in risk perception and probabilities (libby and fishburn, 1977; lipe, 1998). so far a trimpop (1994) study reflects that risk seekers are psychologically elastic. they are normally having good knowledge about risk, having successful history of risk tolerance, tolerate unclearity, obtain novel experience, and give rapid response to stimulus. we can also associate knowledge with experience as well. as agarwal et al., (2007) found that mostly financial blunders are made by individuals, who are exposed to lowest amount of financial knowledge. to some extent, poor financial decisions are the reason of failure to appreciate economic vulnerability. education can solve that issue by providing knowledge and financial decision doing skills. (bernheim and garrett, 1994) to understand the basic features of their retirement plans, retirementage adults must be financial literate (lusardi and mitchell, 2009). moreover (bernheim et al., 2001) considers middle age individuals save high proportion of their incomes because in high school they took a personal financial management course. many households don’t invest equity market because they have less knowledge of shares, the working of the stock market, and pricing process of asset. (grable and lytton, 1998) suggest that in a financial planning perspective, tolerance related to financial risk has a critical part in directing individuals toward a psychologically satisfactory and suitable investment. xiao and anderson (1997) predict a significant relationship between one demographic element like age and risk tolerance and base their description on the assumption that, other things being equal, age is a proxy for wealth. a research was done on the hardships that a single person may face in making decisions for pensions and for the savings along with the way they tackle the complications of making plans of saving, those hardships are true and should be taken under consideration while making saving and decisions of investment. financial counseling impacts financial decision making towards good saving and investment decisions (lusardi and mitchell, 2005). lack of experience sometimes leads towards lack of innovation in decisions and high level of risk exposure. as study suggests people don’t save enough for retirement and outcome they gather more debt, and of not taking benefit of financial breakthrough (lusardi and mitchell, 2007b; campbell, 2006). people with less literacy are most likely to depend on family and friends as their main source of financial counseling. the financial condition of today’s youthis showing big levels of debt. the heavy impacts of gathering more levels of liabilities include bankruptcy (roberts and jones, awais, et al.: impact of financial literacy and investment experience on risk tolerance and investment decisions: empirical evidence from pakistan international journal of economics and financial issues | vol 6 • issue 1 • 2016 77 2001). a mismatch normally found among what individual think to know and how concisely measured financial knowledge (agnew and szykman, 2005). (chou et al., 2010) emphasize that behavior of investor is influenced by past experience. an experienced investor has more tendency of selecting risky portfolio, because he gone through experiences how to tackle it properly. good or not better experience of investor will impact the risk tolerance degree of investor and investment decisions. successful past investment experience promising towards high risk tolerances which generate high returns evidently. so the past investment behavior is positively related with risk tolerance which in face effect investment decisions it has been revealed by the work of (corter and chen, 2006) that here is a relationship between investment experience and risk tolerance during investment decision process. but they take the sample of 63 graduate students and conclude that an experienced investor sow he attitude of high risk tolerance by choosing risky portfolio of investment. (roszkowski and davey, 2010) also support this finding that experienced investors having more ability to hold risky investment than investor having no experience. an experienced investor is confident about the skills and past experience he has which make him known with the condition. with enough financial qualification, information and also experience investor will help manage to manage pool investment according to desired objectives and in accordance with time match with bigger degree of risk tolerance. as an outcome risk tolerance and experience with investment having significant correlation, where higher investment experience it lead the investor towards high risk tolerance. on the basis of above empirical analysis we can formulate following hypothesis. h2: investment experience is positively related with investment decisions mediated by risk tolerance. 5. methodology 5.1. empirical model on the basis of above hypothesis we can formulate a general model showing the mediating relationship of risk tolerance between financial literacy, investment experiences and investment decisions. risk tolerance investment decisions investment experience financial literacy 5.2. variables 1. financial literacy (iv) 2. investment experience (iv) 3. risk tolerance (mediating) 4. investment decisions (dv). the model gives the demonstration of variables and the relationship among them. hypothesis are devised on the basis of model which after testing concludes that financial literacy and investment experience in the presence of risk tolerance leads towards better investment decisions. 6. conclusion and future implications this paper tries to construct a theoretical model that proves to be useful for the investors while making the investment or designing portfolio. the process of decision making becomes easy when all the confounding variables are well recognized by investors that direct them to make the right decision and hence losses can be avoided or reduced in the future. during the period of investment decision making, investors’ encounter to highly complex factors such as risk, ambiguity, and choice overload. these are challenging for financial professionals, experienced investors, and especially the ordinary private household. investors have to chase risks in their financial decisions. higher investment experiences and financial literacy will lead to greater risk tolerance and investor then have to choice risky investment securities to match with their high level of risk tolerance experienced investors have a portfolio of good and bad experience. a wise investor learns from past experience to tackle risky situations and handle it properly. by the increased level of knowledge about financial information and the increased ability of analyzing that information, investor can improve the capacity jump into risky investments for earning high returns by managing investment efficiently. our research proves to be valuable as it has explored this impact as well. financial literacy which is also related with the knowhow of factors such as inflation, compounding interest and diversification of risk, as the analysis of these factors also helps to go for appropriate decisions. this study proves to be a milestone for future researchers while incorporating risk and other factors that affect the investor decision making process in pakistan. moreover for investors this research is helpful while acquiring financial information they would be aware that how much knowledge they must have to cope up with risky situation and how investment experience would help them to handle risky investments. little attention has been given in pakistan to determine factors that affect decision making process. financial literacy proves to be an important determinant while further research is required to explore further dimensions like influence of investment experience. area of investment experience with its own dimensions either positive or negative need to be explored more. as in previous studies only questionnaires were used as instrument, there must be the usage of other research tools to make the data more authentic. because of the economic and political instability of pakistan the results might vary in context of other economies having different economic and political conditions. qualitative awais, et al.: impact of financial literacy and investment experience on risk tolerance and investment decisions: empirical evidence from pakistan international journal of economics and financial issues | vol 6 • issue 1 • 201678 studies like interviewing the investors to get insight about how these factors are impacting and many other factors that influence the investment decision making can be explored. references agarwal, s., driscoll, j.c., gabaix, x., laibson, d. 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(2007), essays in development economics and finance. stanford: stanford university press. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 922-928. international journal of economics and financial issues | vol 5 • issue 4 • 2015922 portfolio diversification benefits using real estate investment trusts – an experiment with us common stocks, equity real estate investment trusts, and mortgage real estate investment trusts rafiq bhuyan1*, james kuhle2, talla mohammed al-deehani3, munir mahmood4 1department of finance, college of business and economics, american university of kuwait, safat 13034, kuwait, 2department of finance, college of business administration, california state university sacramento, ca, usa, 3department of finance and financial institutions, college of business administration, kuwait university, kuwait, 4department of mathematics and natural sciences, gulf university for science and technology, hawally 32093, kuwait. *e-mail rbhuyan@auk.edu.kw abstract using recent data (2002-2012) from the us financial markets, we study the magnitude and benefits of real estate investment trust (reit) and common stock in portfolio diversification. in particular, we examine the effects of risk-reduction benefits through diversifying among common stocks via equity reits (ereits) and mortgage reits (mreits). in addition, overall performance measures are calculated and compared among reit, common stock and mixed-asset portfolios. we observe that investors can benefit from diversification using ereits but not mreits. in fact, mreits turn out to be the worst asset class to be in diversifying portfolio. this conclusion is in contrast with kuhle (1987) who claims improvement of portfolio risk reduction with mreits. our finding, however, is consistent with hartzell et al. (1986) and chen et al. (2005). finally, even though our data period consists one of the historic collapses of real estate market in the us, it still indicates the ereits still offers diversification benefits. it provides evidence that small investors can use ereits to diversify their risks. it also offers an opportunity to earn return on real estate investments without investing in real estate properties which may be beyond investor’s capacity. keywords: portfolio diversification, risk, equity real estate investment trusts, mortgage real estate investment trusts jel classifications: d53, g11, r30 1. introduction financial engineering and securitization have made the financial market endowed with large numbers of financial instruments for the investor to consider both at retail and institutional levels. in addition to common stocks and stock mutual funds, now investors have an array of alternative securities such as exchange traded funds, equity real estate investment trusts (ereits) and mortgage reits (mreits) to trade and invest. nowadays, investors can include real estate based investments in their portfolio allocation along with stock portfolio to diversify their portfolio risk. with this increased “securitization” of real estate markets beginning from early 1980s, the application of traditional portfolio theory has become potentially more viable. existing research findings indicate that risk reduction is possible with portfolio holdings of reits with stocks (kuhle, 1987; grissom et al., 1987; chen et al., 2005; among others). global financial crisis in 2007-08 that has noted a historic turmoil in financial markets around the world especially with the bubble burst in the housing sector makes us curious if the potential of the mortgage and real estate related assets’ role in portfolio risk reduction is still in place. the purpose of this research, hence, is to investigate with recent data whether the diversification benefit in reducing risks exists in portfolio formation with stocks and the two types of reits. literature seems to be very little regarding the role of reits in risk management and we intend to fill this gap in the current literature considering different reits of us. this research examines the effects of diversification on the reduction of total bhuyan, et al.: portfolio diversification benefits using real estate investment trusts – an experiment with us common stocks, equity real estate investment trusts, and mortgage real estate investment trusts international journal of economics and financial issues | vol 5 • issue 4 • 2015 923 portfolio risk combining three asset classes namely, common stock portfolio, ereits and mreits. we examine the effect of risk on portfolio diversification with each asset class separately and with mixed asset portfolios to understand the power of these reits in risk reduction. a full set of markowitz (1952) analysis is employed to examine the risk and return potential of portfolios comprised of reits only and reits combined with common stocks. the level of risk is calculated to determine if significant differences exist between the various classified common stock and reits portfolios. the overall performance of portfolios is calculated by a return/risk ratio and then those various ratios are tested for each portfolio category to determine if pairwise significant difference exists. 2. literature review chen et al. (2011) find that ereits return are sensitive to changes in monetary policy across/with different ereits return. during bull markets, changes in monetary policy have a significant negative impact on ereits when investors have lower expectations of real estate price increases, but are not effective when investors have higher expectations of real estate price increases. to the contrary, during volatile and bear markets, ereits return are not sensitive to changes in monetary policy stance. results also show that ereits return respond positively to stock returns in various states and conditions. schmidt (2004) investigates risk return characteristics and diversification benefits when private equity is used as a portfolio component. schmidt finds that private equity outperforms stock investment. he observes that high average portfolio returns are generated solely by the ability to select a few extremely well performing companies. he observes that there is a high marginal diversifiable risk reduction of about 80% when the portfolio size is increased to include 15 investments. he also observes that an actual average portfolio size between 20 and 28 investments seems to be well balance selection for the purpose of investment. chen et al. (2005) investigate whether investors can improve their investment opportunity sets by adding a reit portfolio to benchmark portfolios. they find that ereits appear to be non-redundant financial assets, which helps to enhance the completeness/competence of the financial market. mreits provide no diversification benefits in the sample period. georgiev et al. (2003) find that real estate investment represents a significant part of many institutional portfolios as the benefits increase with real estate investments as part of an investor’s overall asset portfolio. alcock et al. (2013) investigate whether reit managers actively manipulate performance measures in spite of the strict regulation under a reit regime. their findings suggest that the existing reit regulation may fail to mitigate a substantial agency conflict and investors benefit from evaluating return information carefully in order to avoid potentially manipulative funds. fei et al. (2010) examine the dynamics of the correlation and volatility of reits, stocks, and direct real estate returns. they find a strong relationship between correlations and reit returns and that the patterns are distinguishable for different types of reits. interestingly, when the correlation between reits and the standard and poor’s 500 (s and p 500) is at its lowest, the future performance of reits is at its highest. results suggest that it has economic implications regarding the time-dependent diversification benefits of reits in a mixed-asset portfolio and the unique risk and return characteristics of reits. lee (2014) demonstrates his analysis of the volatility spillovers and asymmetry between reits and stock prices for nine countries (australia, belgium, germany, italy, japan, the netherlands, singapore, the united kingdom, and the united states) using eight different multivariate generalized autoregressive conditional heteroskedasticity models utilizing the optimal weights, hedging effectiveness, and hedge ratios for reit-stock portfolio holdings. horrigan et al. (2009) using reit return data, bond data, and property holding data, construct property market segment-specific indices of asset returns. they show that pure-play indices can be employed to make pure, targeted investments in the commercial real estate market while retaining the liquidity, transparency, and pricing efficiency benefits of the well-developed public market in reits. francis and ibbotson (2009) study the annual returns of us real estate over the 31-year period starting in 1978. they find that ereits substantially outperform physical real estate over the sample period, and mreits and hybrid reits suffered badly from the subprime mortgage crisis. fisher and goetzman (2005) examine actual cash flows from commercial properties over 1977-2004 and provide insight into the benefits of diversification by property sector versus location. kaiser (2005) observes that private real estate returns cannot be explained adequately by alpha and beta alone. lee and kien (2009) studies on the malaysian securitized real estate market and find that property shares offer little diversification benefits or portfolio return enhancement, whereas the equally weighted reits portfolio does provide some diversification benefits and return enhancements under the mean-variance and downside risk frameworks. the results also reveal that the equally and value-weighted reit portfolios do behave differently. garcia-feijoo et al. (2012) evaluate the effectiveness of several asset classes in the hedging of portfolio risk over the 1970-2010 period. of the alternative assets examined, commodities offer the greatest diversification potential due to their very low correlation with stock and bond returns. furthermore, while the diversification benefits of many asset classes diminish during periods of extreme market movements, the benefits of commodities remain strong. overall, they find robust support for the hedging potential of commodities. grissom et al. (1987) show that significant diversification benefits can be obtained by using real estate assets along with common stocks to create well-diversified portfolios. kuhle (1987) examines the effects of diversification on the reduction of total portfolio risk in reits and mixed-asset portfolios. when overall performance measures are calculated and compared among reits, common stock, and mixed-asset portfolios, he observes that the improvement of portfolio risk reduction with mreits. kuhle (1987) further maintains that risk reduction takes place with common stock and ereits portfolio. this risk reduction and performance analysis also support that ereits, not mreits combined with common stock offers efficient portfolio, in a markowitz sense, than of only common stocks. in our research we focus closely the findings of kuhle (1987). using different and more recent time periods, we examine whether the risk reduction findings are similar or whether recent phenomena offer different results. our results confirm some of the findings of kuhle (1987), differ on others (hartzel et al., 1986, burns and epley, 1982, clayton et al. 2009, bhuyan, et al.: portfolio diversification benefits using real estate investment trusts – an experiment with us common stocks, equity real estate investment trusts, and mortgage real estate investment trusts international journal of economics and financial issues | vol 5 • issue 4 • 2015924 and chen et.al., 2005) and lend support to the findings of chen et al. (2005). 3. the data and methodology the sample for this research consists of ex post prices and dividends for a total of 82 firms -26 ereits, 16 mreits, and 42 common stocks listed on various stock exchanges. reits are classified as either ereits or mreits by the percentage of each reit’s total assets invested in equity asset ownership or mortgage asset ownership. any reit that is not clearly (60% or more) invested in the equity or mortgage position is excluded from the sample. the 42 common stocks used are randomly selected from the s and p 500 that are most expensive and large common stocks. it is designed that way to make a comparable sample for reits as reits are combinations of various assets. the time period chosen for the research is from july 2002 through july 2012. we could not review the earlier period as many of the reits do not have enough time series data. earliest time is chosen to be july 2002 due to the availability of data for all securities. all firms included in the sample had their monthly returns calculated using: ( ]i ioi i io[ )– /p p dr p+= (1) where, ri = monthly return for asset i, where, i = 1,2,…,42 in case of common stock, i = 1,2,…,26 in case of ereits, and i = 1,2,…,16 in case of mreits. pi1 = asset price at the end of the month, pi0 = asset price at the beginning of the month, di1 = dividend paid at the end of the month for asset i. the monthly return values are then used to create portfolio of various size within five portfolio categories: (i) ereits, (ii) mreits, (iii) common stock portfolios, (iv) mixed portfolios of ereits and common stock, and (v) mixed portfolios of mreits and common stock. return of the portfolio is estimated as follows: r xr p i i n i = = ∑ 1 (2) where, xi = proportion of total portfolio invested in security i, and i=1,2,…,n. there are “n” number of securities in the portfolio where, n = 2,3,…12 with ri has the meaning of equation (1). within each category a total of 600 portfolios are created containing various levels of assets. that is, 50 random portfolios are created that contained 1,2,…,12 assets each. each asset in each portfolio is equally weighed, therefore, no attempt is made to solve for optimal asset proportions and or minimum variance asset allocations. once returns are estimated, the standard deviation for each of the randomly created portfolios is calculated from: σ σ p i j j n ij i n = == ∑∑ x x 11 (3) where, σp = portfolio standard deviation, xi = proportion of total portfolio invested in security i, xj = proportion of total portfolio invested in security j, σij = correlation between securities i and j, n = total number of securities in the portfolio. the portfolios are calculated on the basis of equal asset proportions; therefore xi = xj. equally weighed assets usually result in the highest portfolio risk. but the rationale for equal weights is that the investor has no information about the future information on returns and variances or covariance. therefore, if we can show reduced risk level on any combination, we expect that this result should hold for similar experiment on minimum variance portfolio risk reduction and optimal portfolio risk reduction as well. once these portfolio risks are estimated, an average of the risk is calculated and used for our experiment via, σ σ p pi i= = ∑ 1 50 50 (4) 3.1. research hypotheses and test criteria four general research hypotheses are tested in this research: 1. the portfolio risk level for ereits and mreits portfolios is not significantly lower than the risk level for common stock portfolios 2. the risk level for mixed reit and common stock portfolios is not significantly lower than the risk level for common stock portfolios 3. the reward/risk level for ereits and mreits portfolios, measured by the ratio of returns to standard deviations, is significantly greater than the reward/risk level of common stock portfolios 4. the reward/risk level for mixed reit and common stock portfolios is significantly greater than the reward/risk level of common stock portfolios. the z-test is used to determine the statistical difference between various portfolio categories for each hypothesis. a 95% confidence level is selected in calculating the critical z-value of 1.64. equation (4) is used in determining the calculated z-value for each portfolio comparison made. z x x s n s n = − + 1 2 1 2 1 2 2 2 (5) hence, any calculated z > 1.64 would indicate a significant statistical difference in the two means tested. for example, consider hypotheses one. the z-test would measure the statistical difference between ereits or mreits and common stock portfolios with asset levels ranging from 1 to 16. finally, as we all know that standard deviation is not a perfect measure of risk and sometimes difficult to compare among assets, a modified version of sharp ratio is designed to offer the performance test. in sharp ratio, we measure the risk to reward ratio by taking the difference of the return with respect to the risk free asset and then divide that by the risk. in this analysis, we drop the risk free rate in order to find the ratio of return over risk. it is estimated as follows for each type of portfolios: bhuyan, et al.: portfolio diversification benefits using real estate investment trusts – an experiment with us common stocks, equity real estate investment trusts, and mortgage real estate investment trusts international journal of economics and financial issues | vol 5 • issue 4 • 2015 925 s r = p pσ (6) where, rp and σ p are the average of the 50 portfolio values, and s is the modified sharp ratio. we drop the risk free ratio as it is not constant and fixed either as we have seen in last two decades. in late 1990s, risk free rate has been as high as 6.5% and then it has dropped to as little as 0.25% in early 2000s and still it is that low. however, it is left for future research to investigate whether the results we draw can have any impact if we incorporate dynamic risk free rate. 4. results and analysis table 1 presents summary statistics of all three categories of securities risk and returns. in our descriptive statistics, we observe that common stocks offer an average monthly return of 1.45% with 9.25% standard deviation. during the same time period, ereits offer an average return of 0.65% with 10.20% standard deviation. finally, mreits offer an average of.8% return with 16.08% standard deviation. it is very interesting to note that during the period of july 2002 to july 2012, randomly chosen 52 common stocks perform better than two categories of reits and it gives rise to the question whether portfolio mix of common stock with two types of reits would offer better risk adjusted return. 4.1. differences in portfolio risk levels: non-mixedasset portfolios the effects of diversification on risk in portfolio setting are first analyzed for our hypothesis 1 for non-mixed-asset portfolio case. exhibit 1 shows the amount of portfolio risk level for 5 different asset classes for various combination portfolios. each of the number in the exhibit is an average of the risk of 50 random portfolios for that class. the result of the monthly risk level is calculated by taking average of risk from 50 portfolio created randomly out of available securities in class. for example, a threestock common stock portfolio’s risk number shown in the exhibit is an average of the 50 three-stock common stock portfolio’s risks. once using variance of the portfolio of three stocks are calculated and repeated for 50 times using random selection with equal weights, we then take square root of the variances to find standard deviation and then averaged on 50 portfolios. portfolios are created using a range of one asset to 16 assets from the same class of assets. as it is observed, common stocks portfolio does exhibit lower risk level than mreits and ereits. for example, a 7 stock portfolio has 6.03% portfolio risk, whereas, a 7 ereits portfolio has a risk level of 6.55% and that of mreits of 9.48%. it is not surprising as during the chosen period there has been a collapse in mortgage and real estate markets in the us. it is also observed from this exhibit that mix of common stock and ereits do show an improvement in risk reduction as opposed to the mix of common stock and mreits. for example, a 12 asset combination of common stock and ereits has a standard deviation of 5.15% compared to 6.39% for a 12 asset common stocks and mreits portfolio. the mixture of common stock and ereits also show an improvement in risk reduction compared to common stock only. from the combination of five assets portfolio and onward, mix of common stock and ereits exhibits lower trending risk than common stock only portfolios. our results show that as we increase number of stocks in portfolios, risk level on average is reduced in each of the five asset classes. notable result is the risk level of mreits which is substantially higher compared to other asset classes. ereits follow that of exhibit 1: average portfolio risk levels (monthly standard deviations) for the five portfolio categories number of assests in portfolio common stocks ereits mreits ereits+common stocks mreits+common stocks 1 0.09014449 0.09356149 0.11667340 0.11286919 0.19480562 2 0.07339119 0.09875972 0.12989906 0.07501094 0.09600176 3 0.06800259 0.08090223 0.11934539 0.06097817 0.08373499 4 0.06369339 0.07137199 0.10542039 0.06660787 0.09100867 5 0.05987907 0.06766036 0.11868970 0.05763449 0.09255665 6 0.06015175 0.07164919 0.09445273 0.05494328 0.06620053 7 0.06029581 0.06554437 0.09479827 0.05368553 0.07737244 8 0.05927917 0.06976110 0.08968564 0.05214839 0.06826420 9 0.05573255 0.06310134 0.09738588 0.05150260 0.07027697 10 0.05638244 0.06506779 0.09020443 0.05181440 0.06717805 11 0.05680601 0.06341733 0.08763746 0.05129149 0.06229943 12 0.05556790 0.06507813 0.08719880 0.05154605 0.06385254 13 0.05517407 0.06320726 0.08147692 0.04990176 0.06637302 14 0.05477303 0.06404460 0.08409202 0.04942903 0.05876460 15 0.05389162 0.06292353 0.08321987 0.04829395 0.06345760 16 0.05522372 0.06021358 0.08066065 0.04769629 0.05687532 ereits: equity real estate investment trusts, mreits: mortgage real estate investment trusts table 1: descriptive statistics of randomly chosen 52 common stocks, 36 ereits, and 16 mreits return standard common stocks ereits mreits average minimum maximum average minimum maximum average minimum maximum return std 0.014476 0.0926 −0.00385 0.04839 0.04379 0.16222 0.00065 0.10195 −0.00547 0.04664 0.01947 0.27149 0.00798 0.16079 −0.00375 0.05835 0.0748 0.74738 ereits: equity real estate investment trusts, mreits: mortgage real estate investment trusts bhuyan, et al.: portfolio diversification benefits using real estate investment trusts – an experiment with us common stocks, equity real estate investment trusts, and mortgage real estate investment trusts international journal of economics and financial issues | vol 5 • issue 4 • 2015926 mreits which is also not surprising as our sample is taken from one of the historic housing bubble period of 2002-2012. with the collapse of housing and mortgage markets, it is no surprise that during this time periods, larger common stocks performed much better than reits of both categories. one more interesting observation is the combination of common stock with ereits. column five shows the five-asset portfolio risks from both. common stock with ereits portfolio risk (0.05763449) tends to reduce more than common stock portfolio risk (0.05987907) with five asset combination portfolios. it is also true when compared with mreits plus common stock. one clear distinction that we claim is the process of calculation. we differ from kuhle (1987) in calculating portfolios of mix asset with reits. kuhle (1987) uses 11 stocks and an ereits to calculate one asset portfolio of ereits and common stock, whereas, we estimate the same portfolio by taking one asset from each class of assets. similar process is used in calculating portfolios for the other mix assets as well. however, the findings from the results seem to match with kuhle (1987) that mix of ereits with common stock compares better than mreits with common stock. exhibit 2 summarizes the z-score results for the test between mean standard deviation values of common stock and those of ereits and mreits portfolios. it is a test of findings for the nonmixed assets. among the three asset classes, we explore if any of them has better risk reduction than the others. here, we take the standard deviation numbers of each asset class from exhibit 1 in order to perform the test. respective numbers are taken from the asset class based on how many assets are included in portfolio. for example, the test result in column 2 row 5 (2.71575487) is calculated by taking the difference of the risks of five-assets portfolio of common stock and five asset portfolio of ereits to apply in the numerator of equation (3). the denominator numbers are estimated from the 50 random five asset respective portfolio’s variance (variance of variances). we know that at the alpha level of 0.05, the hypothesis should be rejected if the z-score registers above 1.64. the calculated z-scores as shown in exhibit 2 are all higher than 1.64. the implication, under the assumptions of normal distribution, is that the risk level of mreits is higher than ereits and common stock portfolio. also, the risk level of ereits is higher than the common stock portfolio. this result though counter intuitive and yet not surprising given the sample period. this result suggests that investors would be better off avoiding mreits from their portfolio and select common stock and some ereits to form a balanced portfolio. 4.2. differences in performance ratios: mixed-asset portfolios exhibit 3 displays the z-score results for mixed-asset portfolios. these results establish our view that mreits are highly volatile asset class compared to ereits. investors can benefit from combination of common stock and ereits portfolio rather than common stock only portfolio for all assets combination except for one asset portfolio. when common stock and mreits are combined, it is observed that diversification does not benefit investors until eight-assets portfolio. diversification does not benefit at all when compared with common stock with ereits and common stock with mreits as all the z-score values are smaller than 1.64 except for two cases. we should point out that the results in column 2 of exhibit 3 are for common stock with ereits versus common stocks not viz. and same is the case for results in column 3. in these two columns we test the significance of mix with common stock against common stock portfolio itself. findings are clearly suggesting benefits combination of common stock and ereits but not with mreits. the second part of the finding contradicts with kuhle (1987). the last column shows the result of significance of common stock exhibit 2: average z-scores between various non-mixed-asset portfolio categories difference between mean monthly standard deviations number of assets in portfolio common stocks versus ereits common stocks versus mreits ereits versus mreits 1 0.56800657 1.77085102 1.51984764 2 4.43831032 3.93243520 2.05352401 3 3.28615878 4.65085292 3.37415643 4 2.76434831 5.18225472 4.10769487 5 2.71575487 8.36080526 6.90001559 6 4.16589432 5.98253160 3.71206815 7 2.76485872 7.15673339 5.85971120 8 4.82407450 7.70412623 4.66931598 9 3.57376355 13.71966429 9.89186833 10 4.68241623 12.30765604 8.28304276 11 4.53010235 12.69960262 9.33035145 12 6.47391904 15.14892826 9.83636239 13 5.75019643 13.13993652 8.47542836 14 6.61760848 25.04792097 12.89681895 15 6.91176194 37.77628744 17.95119063 16 4.66495266 47.03467420 22.15614786 ereits: equity real estate investment trusts, mreits: mortgage real estate investment trusts exhibit 3: average z-scores between various mixed-asset portfolio categories difference between mean monthly standard deviations number of assets in portfolio common stocks versus common stocks+ereits common stocks versus common stocks+mreits common stocks+ereits versus common stocks+mreits 1 1.32055680 0.83280702 0.81928427 2 2.19261615 1.70830324 0.70669137 3 3.16201448 2.30256933 0.98856683 4 2.83194895 1.27442314 1.24866467 5 3.25995246 1.08984681 1.54432022 6 3.16715222 2.28372518 0.50942484 7 3.69666475 1.45380887 1.53291614 8 4.31703378 2.42264666 1.46565664 9 4.00369641 2.25765071 1.04573445 10 3.86017586 2.12492258 1.64687867 11 4.55835964 3.09730367 0.32385152 12 3.78231793 2.55405097 1.03073348 13 4.23594553 2.57735337 1.53153228 14 4.22618967 2.67665448 1.45713216 15 4.50369398 2.82299999 1.77069694 16 4.70907239 3.19210051 1.28207471 ereits: equity real estate investment trusts, mreits: mortgage real estate investment trusts bhuyan, et al.: portfolio diversification benefits using real estate investment trusts – an experiment with us common stocks, equity real estate investment trusts, and mortgage real estate investment trusts international journal of economics and financial issues | vol 5 • issue 4 • 2015 927 plus mreits against common stock with ereits and it is clear that mreits combination does not add value for the investors in terms of risk reduction. 4.3. differences in performance ratios: non-mixedasset portfolios in previous section, we present the empirical test results for the difference between the risk levels of various portfolio categories for hypothesis one and two. it is clear that if we rank the assets based on lowest risk to highest risk, common stock portfolio comes first and mreits portfolio comes last. as it is well known that the standard deviation is not a perfect measure of risk and sometimes difficult to compare among assets, in this section first we combine the risk and return based performance and then compare the three assets classes. a modified version of sharpe ratio is designed to offer the performance test. in sharp ratio, we measure the risk to reward ratio by taking the difference of the return with respect to the risk free asset and then divide that by the risk. in this analysis, we drop the risk free rate in order to find the ratio of return over risk. to give details of our process, we first estimate return and risk for each combination. then we generate 50 returns and 50 risks for that combination. once we find them, we then take average of those numbers to generate return and risk to find their ratios. this process is followed for each of the asset combination for all 16 portfolio cases. exhibit 4 provides results for three non-mixed-asset categories portfolios’ performance ratios. it is calculated by first using modified version of the sharp ratio to calculate performance ratio of each category and then using z-score for the performance comparison. the modified performance ratio expresses, as discussed, the return of a portfolio in relation to its risk or standard deviation. it represents the magnitude of financial rewards per unit of risk. if the performance ratio is high, it is an indication of higher performing asset overall. the return/risk ratio is calculated for each of the random 50 portfolios of each asset class. then average of the 50 portfolio for each class and each size such as 1 2 16, ,..., assets is calculated. these samples are then used for statistical test of significance between various categories of portfolios. not surprisingly, common stock only portfolio performed better than both ereits and mreits. ereits also did better than mreits. results shown in the exhibit 4 are clearly suggesting that mean performance ratio of the stock portfolio is superior to both ereits and mreits. the results also show the ereits also outperformed mreits. 4.4. differences in performance ratios: mixed-asset portfolios exhibit 5 compares the z-scores of common stock portfolios with mixed portfolios of common stock and ereits, common stock portfolio with mixed portfolios of common stock and mreits, and mixed portfolios of common stock and ereits with mixed portfolios of common stock and mreits. results, again, are similar to those found in exhibit 4. common stock portfolio stands out to be superior to any mix. column 2 and 3 are holding results for that conclusion. investors can expect enhanced portfolio performance holding as many common stocks in their portfolio than holding some ereits and common stock or mreits and common stock. results in column 4 is also supporting similar conclusion found in exhibit 4. the mix of common stock and ereits is superior to mix of common stock and mreits. these results confirm the economic reality of the mortgage market during the housing bubble that has crashed financial wealth of investors in this category in last decade. 5. conclusions the main purpose of the research is to explore the role of two types of reits in portfolio choice to determine if it helps in diversifying exhibit 4: average z-scores between various non-mixed-asset portfolio categories difference between mean performance ratios number of assets in portfolio ereits versus common stocks mreits versus common stocks mreits versus ereits 1 7.09652683 6.74776028 4.61594833 2 11.06299866 8.25681180 3.23341050 3 13.74437055 9.62745547 3.51013559 4 16.62581708 11.41446708 4.00079918 5 15.66057221 11.82171331 4.62450437 6 16.70428561 13.62723156 5.39018621 7 19.43666915 14.23729134 5.19151610 8 19.64240521 16.42395331 5.44517137 9 19.99948777 17.69512101 4.27148573 10 20.51948246 18.35208229 5.30128618 11 23.64619845 20.15944166 6.01356775 12 23.35042485 21.02361189 5.74488026 13 23.74297746 21.68352774 6.94597552 14 23.38778016 25.90721990 4.97652494 15 24.79149757 34.04536670 6.66570497 16 26.55459523 45.41948480 9.51508553 ereits: equity real estate investment trusts, mreits: mortgage real estate investment trusts exhibit 5: average z-scores between various mixed-asset portfolio categories difference between mean performance ratios number of assets in portfolio common stocks versus common stocks+ereits common stocks versus common stocks+mreits common stocks+ereits versus common stocks+mreits 1 9.07751202 4.23255758 1.53230286 2 12.03141551 9.71401348 4.38914595 3 20.93132870 14.97127573 7.20713193 4 25.77629936 12.40216268 3.17980448 5 29.40209353 13.40779006 4.94182801 6 23.82387699 18.32240435 7.86804125 7 31.22869817 12.93883175 4.37514806 8 46.36014185 23.21988804 5.87562933 9 45.07938062 23.87665116 9.02739894 10 41.25271343 24.96014712 7.16103237 11 57.43116537 34.70421513 11.75217759 12 38.18776231 31.50654629 13.17056818 13 46.93220641 35.73779176 14.74642483 14 44.41166877 30.53029763 9.69134152 15 53.65612257 40.99688629 14.17102562 16 44.54012873 36.46092594 14.75235812 ereits: equity real estate investment trusts, mreits: mortgage real estate investment trusts bhuyan, et al.: portfolio diversification benefits using real estate investment trusts – an experiment with us common stocks, equity real estate investment trusts, and mortgage real estate investment trusts international journal of economics and financial issues | vol 5 • issue 4 • 2015928 risk enough to include in individual investor’s portfolio holdings. the secondary objective is to examine the overall performance between various classes of common stock and reits portfolios. the conclusion to our first objective is that mreits seem to be out of class and too risky compared to ereits. investors can benefit from diversification using ereits. our observation, however, has research time period that could be biased as it included in the analysis one of the decades when there are two collapses around the world especially in the united states, namely, housing bubble burst and systemic financial collapse. at this time, mreits turn out to be the worst asset class to be in diversifying portfolio. this conclusion is in contrast of kuhle (1987) who claims improvement of portfolio risk reduction with mreits, and is consistent with hartzell et al. (1986). like kuhle (1987), however, we also observe that risk reduction takes place with common stock and ereits portfolio. this risk reduction and performance analysis also support ereits in contrast to mreits combined with common stock offers efficient portfolio, in a markowitz sense, than of only common stocks. finally, even though our data period consists one of the historic collapse of real estate market, it is indicative that the ereits continue to offer diversification benefits. it would be interesting to test this model with new data on different countries to further expand the knowledge in this field during those two major shocks during (2002-2012) which may or may not have affected directly or indirectly to those countries. it provides evidence that small investors can use eriets to diversify their risks. it also offers an opportunity to earn return on real estate investments without investing in real estate properties which may be beyond investor’s capacity. reits as alternative investments in property instead of buying home should be a future topic of research focus. references alcock, j., glascock, j., steiner, e. (2013), manipulation in u.s. reit investment performance evaluation: empirical evidence. journal of portfolio management, 47, 434-465. burns, w.l., epley, d.r. (1982), the performance of portfolios of reits and stocks. journal of portfolio management, 12, 37-42. chen, m.c., pengy, s., sheu, m., zeng, j. (2011), market states and the effect on equity reit returns due to changes in monetary policy stance. journal of real estate finance and economics, 14, 23-45. chen, h.c., ho, k.y., lu, c., wu, c.h. (2005), real estate investment trusts. journal of portfolio management, 31, 46-54. clayton, j., giliberto, s.m., gordon, j., hudson-wilson, s., fabozzi, f., liang, y. (2009), real estate’s evolution as an asset class. journal of portfolio management, 35(5), 10-22. fei, p., ding, l., deng, y. (2010), correlation and volatility dynamics in reit return: performance and portfolio considerations. journal of portfolio management, 36, 113-125. garcia-feijoo, l., jensen, g.r., johnson, r.r. (2012), the effectiveness of asset classes in hedging risk. journal of portfolio management, 38(3), 40-55. fisher, j., goetzmann, w. (2005), performance of real estate portfolios. journal of portfolio management, 35, 32-45. francis, j., ibbotson, r. (2009), contrasting real estate with comparable investments, 1978 to 2008. journal of portfolio management, 36, 141-155. grissom, t.v., kuhle, j.l., walther, c.h. (1987), diversification works in real estate, too. journal of portfolio management, 12, 66-71. georgiev, g., gupta, b., kunkel, t. (2003), benefits of real estate investment. journal of portfolio management, 29, 28-33. hartzell, d., hekman, j., miles, m. (1986), diversification categories in investment real estate. areuea journal, 14(2), 230-254. horrigan, h., case, b., geltner, d., pollakowski, h. (2009), reit-based property return indices: a new way to track and trade commercial real estate. journal of portfolio management, 35, 80-91. kaiser, r. (2005), analyzing real estate portfolio returns. journal of portfolio management, 31, 134-142. kuhle, j.l. (1987) portfolio diversification and return benefits-common stocks vs. real estate investment trusts (reits). the journal of real estate research, 2(2), 1-9. lee, y. (2014), an international analysis of reits and stock portfolio management based on dynamic conditional correlation models. journal of portfolio management, 28, 165-180. lee, c.l., kien, h.t. (2009), the role of malaysian securitised real estate in a mixed‐asset portfolio. journal of financial management of property and construction, 14(3), 208-230. markowitz, h.m. (1952), portfolio selection. journal of finance, 32, 34-58. schmidt, d. (2004), private equity-, stockand mixed asset-portfolios: a bootstrap approach to determine performance characteristics, diversification benefits and optimal portfolio allocations. working paper series, center for financial studies, germany. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(5), 243-255. international journal of economics and financial issues | vol 10 • issue 5 • 2020 243 asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange unbreen arif*, muhammad tayyab sohail national college of business administration and economics, pakistan. *email: unbreen@hotmail.com received: 28 april 2020 accepted: 18 june 2020 doi: https://doi.org/10.32479/ijefi.10351 abstract the development of asset pricing model is attributed to markowitz (1952) which initiated towards modern portfolio theory (mpt). the whole concept of mpt based on normality of returns assumption but in emerging economies volatility of returns is an important issue and sometimes markets only behave in either bullish or bearish patterns. moreover, the volatility cannot be attributed and explained by variance rather it can be a result of extreme events (profits / losses) referred to as none elliptical distributions of returns. the objective of this study is to incorporate additional dimensions of risk in markowitz mean-variance framework through inclusions of skewness kurtosis and coherent risk measure cvar to obtain optimal portfolio with pgp approach. the study analyzes the portfolio returns of mean-variance (mv), mean variance skewness (mvs), mean variance skewness kurtosis (mvsk) and mean cvar skewness kurtosis (mcvarsk) models by using selected stocks of kse-100 index over the time period of 20092018. the empirical findings suggest that portfolio returns impacted through inclusion of higher moments and cvar and generated higher returns over the benchmark portfolio. the results of study are immensely useful for the fund managers and investors for stocks selection and construction of alternative portfolios. keywords: portfolio optimization, mean cvar skewness kurtosis, multi objective optimization, pakistan jel classifications: c61, g10, g11 1. introduction the stock market in any country plays a significant role in economic development through saving mobilization. the developed liquid and efficient stock market mobilized savings easily which ultimately result in economic growth (levine and zervos, 1999). the stock exchange provide platform to investors, to get optimize returns through diversification of investment. the investors and wealth managers always looked for those securities investment to which leads towards maximum returns therefore portfolio formation and the optimization has always been of major concern to them as the idiosyncratic risk may be reduced through creation of well diversified portfolio. portfolio is defined as pool of securities that is created by individual or institutional investors with a motive to earn returns/ profit on investment. in order to optimal allocation of funds in stocks diversification is key, for the investors it is all about “don’t put all your eggs in one basket” the objective of diversification is to optimally select asset for the construction of portfolio aiming at possible reduction in risk to get maximum return. in the world of investment and finance this whole idea is attributed to the markowitz (1952) “mean variance frame work” which leads towards modern portfolio theory based on fundamental concept of tradeoff between risk and return. in existence of phenomena of normative theory investors are risk aversive and there only preference is to maximize expected returns, whereby the risk is measured through variance covariance of assets. over the years this model is widely used in investment industry for optimal allocation of assets and construction of portfolios. one of the most important assumption of markowitz mean variance frame work is the normality of returns which emphasizes that only mean and this journal is licensed under a creative commons attribution 4.0 international license arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020244 variance are sufficient indicators of portfolio optimization many studies theoretically and empirically rejected these assumptions and have reported the non-normality of returns (fama, 1965; kon, 1984; harvey and siddique, 2000). the normality of return is an ideal phenomena which does not exist in case of emerging markets as they showed great volatility of returns and in presence of extreme events the returns might deviate from their average such markets are attributed to low liquidity, increased volatility and asymmetric information (luciano and marena, 2002; ghysels and valkanov, 2016; sharif, 2018). for construction of portfolio according to investors decision the higher moments are relevant (samuelson, 1958), the idea motivated many researcher to develop asset pricing model to address the issue as in the presence of extreme events i.e. skewness and kurtosis the results obtained through mv model are inappropriate as probability of extreme events are underestimated (jones, 2010). in 1976, kraus and litzenberger highlighted the use of higher order co moments and co skewness in order to explain the expected returns. another view of higher order co moment presented in research of friend and westerfield (1980) that in addition to covariance, co-skewness required to be assed for asset pricing of individual assets moreover the presence of kurtosis indicates the higher probability of extreme events. many academic researchers supported for inclusion of higher moments in construction of portfolios (konno and suzuki, 1992; scott and horvath, 1980; lai et al., 2006; saranya and prasanna, 2014). in portfolio optimization the only risk left after diversification is systematic risk with the evolution of financial market financial regulatory body basel committee on banking supervision (bcbs) make var as supplement to credit risk measure (tian, cai, & fang, 2018). var is attributed as easy and practical approach to measure risk for portfolio managers (miskolczi, 2016) but its non-convexity and subadditivity property ignores fat tail risk (luciano and marena, 2002). to overcome such issues cvar or expected shortfall is efficient measure than var when the returns are non-normalized (uryasev, 2000). pakistan is an emerging economy and its stock market showed a semi strong form of efficiency and the returns are highly volatile (asghar et al., 2011; snoussi and el-aroui, 2012). therefore use of mpt will provide suboptimal results (chen, 2016). the current study is proposed due to the inability of mv theory to obtain optimize portfolios in cases of extreme events and fat tail risks moreover there is also need to incorporate coherent risk measure of cvar for construction of optimal portfolio. further, very few studies initiated to incorporate higher moments in mean variance frame work and as per observation so far no study has been witnessed which incorporate more accepted risk measure i.e. cvar in mvsk framework in context of pakistan. the polynomial goal programming (pgp) approach is used to solve the problem of investors decisions based on the multiple objectives to construct optimal portfolio. the pgp model developed by (lai, 1991) is attributed as best approach to solve multiple conflicting criteria. empirical findings indicate that the inclusion of higher moments and cvar have strong influence on portfolio returns as compare to mean variance portfolio and benchmark portfolio. the results confirm the tradeoff between risk and return and contribute to the literature of portfolio optimization and these findings would also be useful for fund managers and investors to form optimal portfolios when the returns are non-normal. the objective of this research is that most of the model so far only focused on the 2nd or third co moments model while very few studies in developing economy is available to account for the fourth moment. moreover so far no study incorporated the higher order co moment in mean cvar portfolio optimization model. the objectives are listed as under:• to compare the efficacy of portfolio optimization results obtained through different models i.e. from mv. mvs, mvsk, mcvarsk for the stock returns of psx. • to develop a unifying portfolio optimization model that may overcome the deficiency of markowitz mpt through analyzing higher co moments through inclusion of more efficient and widely accepted risk measure i.e. cvar. • to empirically investigate the results by analyzing stock returns and through portfolio construction from psx by using polynomial goal programming technique. • to better understand the psx behavior that will help fund managers and practitioners to opt for alternative models for portfolio selection. the remainder of the paper is organized as follows; section 2 incorporates brief literature review, section 3; describes the research model data and methodology. section 4; presents the empirical findings and results and section 5; consists of conclusions. 2. literature review investment management is mainly attributed to the security selection and asset allocation (ross, 1976). in the world of finance the markowitz (1952) first served the idea of risk and return which ensued to mean variance theory known as modern portfolio theory. this normative theory addressed the investor sentiment of risk and reward and remained widely used tool for investors for selection of stocks with an objective of portfolio optimization. markowitz normative theory had certain limitations i.e. normality of returns and asset distribution is explained by its mean/expected value and variance, leading towards the issue that optimization result through mpt will be suboptimal when the returns are non-normal. (copeland et al., 2013). this ideal phenomena of normal returns does not hold true in case of emerging markets due to presence of extreme events, low liquidity and asymmetric information (luciano and marena, 2002; sharif, 2018). several empirical investigation revealed the non-normality of returns (baumol, 1963; nazir et al., 2010). the non-normality of return motivated many researchers to develop asset pricing model for the construction of optimal portfolio. to elaborate risk and return relationship time to time different models were proposed. samuelson (1958) reported that for construction of portfolio according to investor’s decision the higher moments are relevant. mirza and reddy (2017) highlighted the use of higher order co moments i.e. co-skewness arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 245 in order to explain the expected returns in empirical investigation conducted by bollerslev et al. (1988) showed emerging markets exhibited great volatility of returns and have idiosyncratic and positive skewness. the efficacy of second moment i.e. variance covariance as a risk determinant was questioned and investigated by researchers in absence of normality of returns (aggarwal et al., 1989; tang and choi, 1998; lux and marchesi, 2000). another view of higher order co moment presented by in research of (kraus and litzenberger, 1976) whereby he incorporated the third moment in asset pricing model he presented that with addition to covariance, systematic skewness required to be incorporated for pricing of individual assets. moreover the presence of kurtosis indicates the higher probability of extreme events. this portfolio selection problem was extended by (davies et al., 2009) to hedge fund indexes. jondeau and rockinger (2006) study confirmed that in case of non-normality the first and second order moment model is ineffective and third moment or four moment can served as good approximation. several academic researchers through empirical investigation of data have supported for inclusion of higher moments in construction of portfolios (konno and suzuki, 1992; scott and horvath, 1980; lai et al., 2006; saranya and prasanna, 2014). in portfolio optimization the only risk left after diversification is systematic risk with the evolution of financial market financial regulatory body basel committee on banking supervision (bcbs) make var as supplement to credit risk measure. var is defined as the maximum loss over the given confidence level (1−α). the concept of value at risk was introduced by baumol (1963). linsmeier and pearson (2000) research reported that var as an acceptable risk measure for financial institutes, fund managers and regulators. bali and cakici (2004) attributed var as determinant of return in normal distribution further, chabi-yo et al., (2017) reported var reported same results as negative coskewness. now a days var and conditional value-at-risk (cvar) are widely popular risk management tool (guo et al., 2018). further mckey and keefer (1996) reported var inability to predict optimal position. despite of the popularity of var it is reported by (guo et al., 2018) that var is coherent risk measure when it is based on sd of normal distribution, further (artzner et al., 1999) reported var inability to predict optimal position. conditional value at risk (cvar) also referred to as tail var reports losses exceeding var, it is reported better performance measure than var (uryasev, 2000). cvar being possessing superior mathematical properties has an ability to measure and manage risk more efficiently (artzner et al., 1999). cvar considered as better technique for portfolio optimization and to evaluate risk (uryasev, 2000). in order to address the inconsistencies in the mean variance frame work (rockafeller and uryasev, 2000) merge mean-cvar in mean variance framework. being the popular risk measure and its reported efficiency to optimize portfolio another motive of the proposed study is to incorporate the cvar in higher co moment model. portfolio optimization is a process of return optimization by selecting the best portfolio (asset allocation) (agarwalla et al., 2017) within certain constraints it can be define as multifunctional, non-linear approach comprising varying objectives of investors. so for the multifunctional objectives polynomial goal programming is widely acceptable approach in literature in existence of varying objective of maximizing returns and minimizing variance and kurtosis. for non-linear optimization of portfolio the pgp approach proved to be the efficient technique (roman et al., 2007). in order to manage bank balance sheet with conflicting objectives pgp was first introduced by (kemalbay et al., 2005) for the portfolio construction with skewness this technique of portfolio optimization was used by (tayi and leonard, 1988) another dimensions mean-variance-skewness-kurtosis was added by lai et al. (2006) and škrinjarić (2013), subsequently pgp used for higher order comoments portfolio optimization by lai (1991) and also used for optimization of hedge funds by mhiri and prigent (2010). so based on the phenomena and after review of literature the research question arises:• whether higher co-moments along with cvar can be key indicator of gain or loss in developing economy like pakistan? • what is the degree and direction of these indicators have an impact on stock returns of psx? • cvar measure in higher co moments frame work enhance the optimization of portfolio of stocks in psx? • how to optimize portfolio in presence of multipurpose objective? 3. data and methodology psx is the only representative market of stocks trading in pakistan in 2016 the three stock exchanges (lahore, karachi and islamabad) merged together and form single psx (economist, 2018). the performance of psx is often measured with kse-100 index which was declared as asia’s best in 2016. in 2017 the number of listed companies in psx is 559 with market capitalization pkr 8.5 trillion. the importance of psx is also accelerated with the initiative of obor in 2014 and in context of cpec the 40% shares of psx is transferred to the chinese consortium for the purpose of strategic alliance after the competitive bidding process. on a positive note, so far, the market witnessed higher liquidity, less excessive volatility, and better returns for investors in the post-merger period compared to pre-merger period (ceic, 2018). the resultant of the strategic alliance is that psx is now listed to emerging market index of morgan stanley capital market index (sharif, 2018) which is served as catalyst to motivate new investor to invest in psx and calls for research to identify the risks which may cause any suboptimal investment decisions if may ignored. for the purpose of analysis at first stage kse-100 index companies stocks were selected. the data were obtained from website of psx, sbp and standard capital securities (pvt) ltd, brokerage firm. the time span of stocks selected for valuation 10 years i.e. from 2009 to 2018. as most of the mutual funds in pakistan report their performance on monthly basis and further, the monthly returns eliminate the element of noise which may distort the ability to draw real inferences about the investment strategy. therefore monthly stock returns of 100 index companies were analyzed who constantly remain part of index. psx is not efficient however a semi strong form of efficiency were observed by many studies (ali and mustafa, 2001; hussain, 2017; shamshair et al., 2018). arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020246 the returns of the stocks are mainly linked with the cash flows earned through its trade in market and also through the dividend receipts. in pakistan the dividend payment are considered as one of the influential factor for investors as supported by the studies and results (nazir et al., 2010; hunjra et al., 2014). another study conducted in context of pakistan concluded that to form diversified portfolio 10 stocks should be selected (ahuja, 2015). therefore 10 stocks were selected for the construction of portfolio and for validity of higher co moment model with an additional and more acceptable risk measure of cvar. the monthly returns of selected stocks are calculated by following the methodology of (biglova et al., 2004). returns p p it it =       − ln 1 returns are used in the portfolio optimization of higher order co moment and cvar detailed as under: 3.1. model formulation for portfolio optimization let wk is weight of k assets in portfolio, w t is transpose vector of weights assign to portfolios. let x is distribution of stock returns the variables of the study are return/mean = m = (m1, m2, m3,……….mn) t, v = variance covariance, cvar = conditional value at risk s = skewness co-skewness, k = kurtosis co-kurtosis the measure of above mentioned variables are m w x xp t= ( ) = − e x e ( ) wmi ii n =∑ 1 (1) v w x x x xp t= ( ) = − −v x e [ ( )( )] e [ ]( )w x xt − 2 wwi j ijj n i n σ � == ∑∑ 11 where i ≠ j (2) s =s x e p tw x x x x x x( ) = − − −[ ( )( )( )] = − e[ ]( )w x xt 3 = === ∑∑∑ ww w si j k ijkk n j n i n 111 (3) k w x x x x x x x xp t =e [ ]( )( )( )( )− − − − =e [ ]( )w x xt − 4 = ==== ∑∑∑∑ l n i j k ijklk n j n i n lww w w s1111 (4) further s x xi iiii =e [ ]− 3 (skewness coefficient for individual stock) (5) s x x x xi i j jijj =e [ ]( )( )− − 2 (skewness coefficient for two stock portfolio) (6) s x x x x x xi i j j k kijk =e [ ]( )( )( )− − − (skewness coefficient for three stock portfolio (7) kurtosis co-kurtosis coefficients will be calculated as follows:k x xi iiiii =e [ ]− 4 (8) k x x x xi i j jiijj =e [ ]( ) ( )− − 2 2 (9) k x x x xi i j jijjj =e [ ]( ) ( )− − 3 (10) k x x x x x x x xi i j j k k l lijkl =e [ ]( )( )( )( )− − − − (11) value at risk or var is defined as the value of maximum that will not exceed from the given level of confidence (guo et al., 2018). let x’ random variable of loss then for given parameter 0< α <1 the varα for x’ is defined as:varα = min {a: p (x’ ≤ a) ≥ α} i.e. the minimum loss not exceeded with α (12) conditional value at risk or cvar which may also be referred to as conditional tail expectation or expected short fall may calculated as;cvar x x varα α α= ≥ < < e [ where 1| | ] ' ' 0 for discrete probability distribution for event yj ' with probabilities pj cvar x p f x y j f x y var x jα α α ( , ..,) , ' : , ( ) ' ' ' ' ' = − ( ) = …( ( )≥ ∑ 1 1 for j 1 n)) (13) for continuous probability distribution. let ϕ (.) be the standard normal cumulative distribution function and φ (.) is the standard normal density function then for any confidence level t ϵ (0.5, 1) φ −( ) = −zt t( )1 ϕ x dx t zt ( ) = − −∞ − ∫ 1 by using definition of var we can write it as v [t, xw] = zt σ(xw) −e(x) cvar is defined as the expected loss at confidence level by holding it over investment period where loss is ≥var, therefore cvar at 100% confidence level t is arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 247 y [t, xw] = −e[xw\xw ≤−v [t, xw]] if the min –cvar exist then it will be mean variance efficient therefore cvar is y [t, xw] = jt σxw−e(xw) where ( ) [ , ] [ , ] & 1 zt t t t w w x x dx j j z xy t v t x t ϕ− −∞ = >− > −∫ polynomial goal programming (pgp) will be used to get optimize portfolio with multiple objectives. multi-objective optimization will be performed in two stages being considering following motives:( ) ( ) ( ) ' : ( ) : ( ) : : : 1 *1 1 0 p p p p p t i max m x min v x min cvar x max s x min k x subject tow i where i n vector of w α              = = ≥ (14) step ii: let γ1, γ2, γ3, γ4 and γ5 be the investor preferences over the given portfolio and let d1, d2, d3, d4, and d5 non negative deviation from the parameter of optimized portfolio i.e. m’’, v’, cvarα’, s’ and k’ also called aspired value (richta’rik, 2015). by forming polynomial goal programming model multipurpose portfolio optimization converted to unifying model of portfolio optimization with an objective to minimize the deviations from the aspired values. so by implementing minkowski distance (lai et al., 2006) 3 5 1 2 4 * 3 51 2 4 ' ' ' ' ' : d dd d d min z m v cvar s k γ γγ γ γ α = + + + + (15) subject to:( ) ( ) ' 1 2 ' 2 ' 3 3 ' 4 4 ' 5 [ ( ) ] 1 0 0 t t t t t i i w m d m e w x x d v cvar d cvar e w x x d s e w x x d k for w i w d α α + = − − = − =  − + =        − − =           =  ≥ ≥      by solving above equations the best value of w will be obtained for corresponding γi (i=1,….5) values. the r programming is used for t ab le 1 : r an ki ng o f s to ck s ba se d on c oe ffi ci en t o f v ar ia ti on , s ke w ne ss , k ur to si s an d c v ar st oc ks m ea n st d. d ev v ar ia nc e sk ew ne ss k ur to si s c v v ar c v ar r an ks c .v r an k sk ew ne ss r an k ku rt os is r an k c v ar a b o t t 0. 01 91 97 1 0. 08 22 35 0. 00 67 62 6 0. 93 03 07 2 6. 19 76 67 4. 28 37 25 −0 .0 92 93 3 −0 .1 27 36 61 3 6 6 3 a pl 0. 00 97 68 6 0. 06 57 10 9 0. 00 43 17 9 0. 33 73 87 7 5. 68 29 08 6. 72 67 53 −0 .0 89 55 80 6 −0 .1 39 25 02 7 10 4 6 b a ta 0. 01 31 95 6 0. 11 26 28 1 0. 01 26 85 1 1. 39 15 14 1 6. 39 18 03 8. 53 52 52 −0 .1 23 34 56 −0 .1 63 67 05 9 2 7 9 e n g r o 0. 01 14 87 0. 08 14 46 4 0. 00 66 33 5 0. 37 14 69 6 3. 63 52 63 7. 09 02 86 −0 .0 91 80 31 6 −0 .1 51 36 86 8 8 1 7 in d u 0. 02 66 73 2 0. 09 77 31 0. 00 95 51 4 1. 30 58 72 1 12 .2 03 93 5 3. 66 40 13 −0 .1 20 67 09 −0 .1 74 32 85 2 3 9 10 l u c k 0. 02 69 38 6 0. 08 61 93 0. 00 74 29 2 0. 90 51 6. 71 67 82 3. 19 96 07 −0 .1 07 28 52 0. 13 47 51 1 7 8 5 m c b 0. 00 80 54 8 0. 07 26 27 6 0. 00 52 74 8 1. 19 31 48 6 5. 45 63 73 9. 01 66 49 −0 .0 78 28 30 3 −0 .1 15 84 74 10 5 3 1 pk g s 0. 01 42 37 8 0. 08 64 69 2 0. 00 74 76 9 1. 30 43 58 5 5. 92 81 26 6. 07 31 96 −0 .0 97 75 04 9 −0 .1 18 68 38 6 4 5 2 po l 0. 01 57 86 5 0. 07 32 11 2 0. 00 53 59 9 0. 36 79 38 7 4. 04 55 53 4. 63 75 83 −0 .0 89 00 56 9 −0 .1 30 47 24 4 9 2 4 t h a l l 0. 02 03 39 0. 10 56 59 6 0. 01 11 64 2. 62 32 75 18 .4 30 00 7 5. 19 49 39 −0 .0 99 61 95 −0 .1 51 67 63 5 1 10 8 so ur ce : a ut ho r’ s es tim at io n an d ca lc ul at io n. arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020248 the solving the equations and to estimate weights for construction of optimal portfolio under investors preferences. 4. empirical results and findings the first step is to test the stock returns normality with jarquebera test being identified as the best for testing of normality and the identification of non-normal returns of stocks. the hypothesis formulated for testing of normality as under:h0 = the stocks returns are normally distributed. h1 = the stocks returns are not normally distributed the rejection of null hypothesis is made on the basis of p-value related to jb test. the acceptance of alternative hypothesis is determined by the value of p at 5% level of significance. the test results showed that 82% of the stocks are non-normal which gives an importance of inclusion of higher order moments in pakistan stock exchange. for the purpose of portfolio construction 10 stocks were selected to determine the impact of the model on portfolio optimization to get optimal weight for each stock. polynomial goal programming (pgp) is used to solve multipurpose motives to construct optimized portfolio. descriptive statistics of selected stocks and the ranking were made on the basis of coefficient of variation, higher moments and cvar indicates the significant impact of selection of stocks for the purpose of optimal portfolio. table 1 presents the descriptive statistics of each selected stock of kse-100 index and the ranks according to the desirable criteria of selection. coefficient of variation measure the ratio of risk to table 2: optimal solution for individual criterion criteria mean variance cvar coskewness cokurtosis optimal scores 0.02441 0.0026 0.0752 0.0009055 0.000026 source: author’s own estimation and calculation figure 1: radar graphs of 10 selected stocks evaluated on each objective source: author’s estimation and calculations table 3: optimal weight allocation under individual objective stocks mean variance cvar skewness kurtosis abott 0.05 0.01674 0.2756 0.05 0.254 apl 0.05 0.2105 0.05 0.076 0.166 bata 0.05 0.05 0.05 0.052 0.05 engro 0.05 0.1681 0.2255 0.05 0.166 indu 0.2 0.05 0.05 0.064 0.05 luck 0.5 0.05 0.05 0.066 0.05 mcb 0.05 0.05 0.05 0.056 0.05 pkgs 0.05 0.05 0.05 0.05 0.05 pol 0.05 0.1441 0.0786 0.05 0.104 thall 0.05 0.05 0.1103 0.494 0.05 source: author’s own estimation and calculation return, it is indicated from the result of the table 1 that luck being highest due to lower risk to expected return but in terms of skewness and kurtosis it is ranked at 7 and 8 respectively, while mcb is ranked at the lowest in terms of risk per unit of return but varying ranks in respect of skewness kurtosis and cvar. these variations in results motivated to investigate for inclusion of higher moment along with cvar in mean-variance asset pricing model. the figure 1 represents the 10 individual stocks behavior evaluated on the individual criteria of return and risk. arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 249 to solve the multipurpose objective of investment preference criteria table 2 give the results of aspired values of each criteria. the weights corresponding to the aspired levels of each stock is represented in table 3. the proposed model is solved by substituting the aspired levels in the in equation (15). the model is evaluated to solve for multi objective criteria according to the investor preference. the result of the model is compared with the equally weighted model which is used as the bench mark test. the r programming used by utilizing multiple packages to solve the optimization problem of portfolio (detail out puts are placed as annexure-a and b). through changing the investor preferences for the selected portfolio 18 portfolios were evaluated accordingly. the optimal values of objective as per the investor preferences criteria are presented in the table 4 detailed as under:table 4 results clearly indicates that the higher preference for the expected return increase the value of mean and vice versa. further, the findings also indicate the presence of higher moments and the inclusion of cvar in the mean variance optimized model have significant impact on the portfolio returns. the results of the model have evident impact on the returns with the additional dimensions of risk. if we compare the mean variance table 4: optimal value of objectives and trade off in objective criteria investor preferences 1 2 3 4 5 6 7 8 9 γ1 1 3 3 3 1 1 0 0 0 γ2 1 1 1 1 3 0 1 0 0 γ3 0 2 1 2 1 0 0 1 0 γ4 0 1 0 2 0 0 0 0 1 γ5 0 0 0 1 0 0 0 0 0 mean 0.024390 0.019590 0.015875 0.019700 0.017350 0.024410 00.02130 0.016460 0.018450 variance 0.005200 0.004161 0.002910 0.004217 0.003295 0.005300 0.002590 0.002980 0.005270 cvar 0.112600 0.088000 0.090400 0.087400 0.088040 0.112000 0.094500 0.075200 0.089280 coskewness 0.000560 0.004200 0.000085 0.000473 0.000198 0.000512 0.000890 0.000104 0.000906 cokurtosis 0.000302 0.000179 0.000040 0.000212 0.000081 0.000280 0.000447 0.004012 0.000440 investor preferences 10 11 12 13 14 15 16 17 18 γ1 0 1 1 1 1 1 1 1 1 γ2 0 0 1 1 1 0 1 0 0 γ3 0 1 0 0 1 1 0 1 1 γ4 0 0 1 0 1 1 1 0 1 γ5 1 0 0 1 1 0 1 1 1 mean 0.015500 0.023900 0.017100 0.017470 0.019740 0.023260 0.016530 0.021810 0.020720 variance 0.002650 0.004950 0.002849 0.002865 0.004200 0.005500 0.002800 0.004614 0.004130 cvar 0.085200 0.094300 0.091900 0.081000 0.041260 0.043750 0.091100 0.041350 0.039950 coskewness 0.000046 0.000481 0.000074 0.000109 0.000344 0.000704 0.000071 0.000527 0.000436 cokurtosis 0.000026 0.000254 0.000035 0.000047 0.000155 0.000400 0.000034 0.000269 0.000208 table 5: assets allocation as per investors preference for construction of optimal portfolio portfolio 1 2 3 4 5 6 7 8 9 γi (1,1,0,0,0) (3,1,2,1,0) (3,1,1,0,0) (3,1,2,2,1) (1,3,1,0,0) (1,0,0,0,0) (0,1,0,0,0) (0,0,1,0,0) (0,0,0,1,0) abott 0.05 0.08 0.13 0.11 0.11 0.05 0.17 0.28 0.05 apl 0.05 0 0.14 0.01 0.08 0.05 0.21 0.05 0.076 bata 0.05 0.1 0.02 0.1 0.08 0.05 0.05 0.05 0.052 engro 0.05 0.01 0.11 0.02 0.08 0.2 0.17 0.23 0.05 indu 0.27 0.13 0.06 0.17 0.11 0.5 0.05 0.05 0.064 luck 0.43 0.1 0.11 0.15 0.12 0.05 0.05 0.05 0.066 mcb 0.05 0.07 0.14 0.06 0.11 0.05 0.05 0.05 0.056 pkgs 0.05 0.1 0.11 0.1 0.11 0.05 0.05 0.05 0.05 pol 0.05 0.24 0.04 0.05 0.09 0.05 0.14 0.08 0.05 thall 0.05 0.23 0.05 0.23 0.12 0.05 0.05 0.11 0.494 10 11 12 13 14 15 16 17 18 (0,0,0,0,1) (1,0,1,0,0,0) (1,1,0,1,0) (1,1,0,0,1) (1,1,1,1,1) (1,0,1,1,0) (1,1,0,1,1) (1,0,1,0,1) (1,0,1,1,1) abott 0.254 0.073 0.21 0.174 0.064 0.05 0.22 0.062 0.078 apl 0.166 0.05 0.06 0.068 0.08 0.05 0.056 0.05 0.052 bata 0.05 0.05 0.06 0.056 0.07 0.05 0.05 0.068 0.064 engro 0.166 0.05 0.06 0.124 0.054 0.054 0.108 0.05 0.05 indu 0.05 0.2331 0.08 0.116 0.24 0.496 0.068 0.374 0.314 luck 0.05 0.4123 0.08 0.116 0.2 0.102 0.072 0.166 0.178 mcb 0.05 0.05 0.05 0.05 0.062 0.05 0.074 0.06 0.082 pkgs 0.05 0.05 0.06 0.05 0.05 0.08 0.106 0.068 0.054 pol 0.104 0.0745 0.28 0.182 0.078 0.062 0.176 0.054 0.052 thall 0.0571 0.0571 0.05 0.054 0.096 0.1 0.06 0.094 0.092 source: author’s estimation and calculations arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020250 portfolio (portfolio1) with mean-cvar portfolio it is evident that the highest expected return is achieved in both of these portfolio but with the mean-cvar optimization the additional risk dimensions value is lower with the same level of return as compare to the only mean-variance criteria. as for choosing only mean-variance criteria investor opted to choose for extreme events. the optimal combination of stocks which satisfies the investor criteria is presented in table 5. table 5 indicates the optimal allocation of stocks as per investor’s preference criteria. for the performance evaluation of portfolios under higher moment preference and cvar the portfolio cumulative returns has been calculated and compared with the benchmark . the figures 2-5 represents cumulative return comparison of models mean-variance, mean-cvar, mcvars, mcvark, mvs and mvk, mvcvarsk, mvsk with the bench mark portfolio over the research time frame of 2009-2018. in figure 2 both the portfolios i.e., mean-variance and mean-cvar outperform as compared to the bench mark portfolio. the figure 3 presents the model comparison of portfolio formed under mean-cvar, mean-cvar-skewness, mean-cvar-kurtosis vs benchmark the cumulative return performance of alternative model formed with higher co moments along with more coherent risk measure of cvar yield higher returns as compared to the bench mark. further, from figure 4 the risk return tradeoff is clearly evident as if investor wants to minimize additional dimensions of risk then he has to forego additional returns associated with higher risk. the comparison of graph 3 and 5 demonstrate that the higher order comoments models i.e. mean-cvar-skewness, mean-cvar-kurtosis yield higher cumulative returns over the benchmark but for mvcvarsk the results are close to and for mvsk models the mix trend is observed in performance comparison to benchmark portfolio. the results strongly recommend the higher dimensions of risk should be incorporated in case of non-normal return behavior of stock market and to determine the true optimization process which ultimately will be beneficial for investor exposure to high volatile periods and to protect against extra ordinary losses in emerging markets where the returns are non-normal. figure 2: comparison of cumulative returns for portfolio of mean-variance and mean-cvar, with benchmark figure 3: cumulative returns for the portfolio models mcvar, mcvars, mcvark vs benchmark arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 251 5. conclusion in this study we expand the markowitz theory of portfolio optimization through inclusion of higher order co-moments and more sophisticated risk measure of cvar. the markowitz theory is criticized due to its assumptions of normality of stocks which is not held true in practical world. emerging markets like pakistan which are not efficient showed the behavior of non-normality of returns. the presence of such phenomena search for inclusion of higher order comoments and more sophisticated risk measure to avoid high volatility of returns. the empirical findings of this study indicate the inclusion of higher dimensions of risk will have an impact on returns of portfolio. in order to get an optimized return in emerging market like psx investor needs to incorporate higher dimensions of risk in order avoid extreme volatility. to have stable consistent returns there is a strong need to consider these multidimensional risk instead of forming portfolio based on mean-variance criteria. so, the study concluded that ignoring higher dimensions of risk will lead towards mispricing which ultimately have an impact on sustainable returns. refrences agarwalla, s.k., jacob, j., varma, j.r. 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(2000), conditional value at risk: optimization algorithms and applications. financial engineering news. p1-5. arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 253 annexure-a stocks mean st. dev variance skewness kurtosis cv p-value abl 0.0132490 0.0684599 0.0046868 1.0404605 5.088675 5.167172 5.72494e−10 abott 0.0191971 0.082235 0.0067626 0.9303072 6.197667 4.283725 2.22045e−15 acpl 0.0152765 0.0978478 0.0095742 0.5385335 4.118813 6.405097 0.002720356 aicl 0.0011868 0.0994497 0.0098902 0.244262 8.459326 83.794646 0 apl 0.0097686 0.0657109 0.0043179 0.3373877 5.682908 6.726753 5.91682e−09 atlh 0.0116856 0.0937027 0.0087802 0.0125565 5.463582 8.018656 2.91516e−07 atrl 0.0157917 0.114399 0.0130871 1.5904872 8.986616 7.24424 0 baf 0.0124939 0.0696305 0.0048484 0.0564588 2.626702 5.573141 0.686402 bahl 0.0095237 0.0581736 0.0033842 −0.1938788 3.520002 6.1083 0.3556675 bata 0.0131956 0.1126281 0.0126851 1.3915141 6.391803 8.535252 0 bnwm 0.0081143 0.1351684 0.0182705 0.3552532 5.260212 16.657954 9.32837e−07 bop 0.0083749 0.1188198 0.0141182 1.3211184 5.304217 14.187585 9.02611e−14 bwcl 0.0212822 0.1510597 0.022819 1.4929462 7.188005 7.097929 0 byco 0.0094793 0.1168321 0.0136497 1.3863993 5.990078 12.325016 0 chcc 0.0200870 0.11266 0.0126923 0.8198316 4.436603 5.608606 9.03646e−06 cppl 0.0213287 0.134509 0.0180927 1.1882017 5.690443 6.306495 1.89848e−14 dawh 0.0075672 0.1208359 0.0146013 −1.1896743 11.902864 15.968329 0 djkc 0.0186727 0.1011919 0.0102398 0.6488998 3.942549 5.419242 0.001886303 efug 0.0054123 0.0924185 0.0085412 1.1174289 8.157586 17.075729 0 engro 0.0114870 0.0814464 0.0066335 0.3714696 3.635263 7.090286 0.09686022 fabl 0.0096511 0.0882839 0.007794 0.7654514 3.899505 9.147555 0.000466533 fccl 0.0165151 0.0934915 0.0087407 0.168559 2.68277 5.660959 0.592052 ffbl 0.0101181 0.06663 0.0044396 0.2677728 3.259853 6.585237 0.4229188 gadt 0.0238194 0.1257337 0.015809 −0.0257125 3.84189 5.278628 0.1714316 ghgl 0.0030057 0.0863794 0.0074614 −0.1128659 6.051556 28.738194 8.32537e−11 glaxo 0.0060694 0.0822851 0.0067708 1.6080962 9.959318 13.557465 0 hbl 0.008887 0.0794016 0.0063046 0.9794826 5.927871 8.934561 5.51781e−14 hcar 0.0309188 0.1315333 0.017301 0.9053408 4.401018 4.254149 2.78847e−06 hmb 0.005458 0.0675408 0.0045618 0.3110622 3.128357 12.374605 0.3767184 hubc 0.0161201 0.0583456 0.0034042 1.172332 6.795398 3.619428 0 humnl −0.0034459 0.1333675 0.0177869 −1.6213181 13.923737 −38.70292 0 ibfl 0.0096277 0.0979634 0.0095968 1.085166 6.094566 10.175141 5.55112e−16 ici 0.0266152 0.105779 0.0111892 2.4295189 14.465737 3.974381 0 indu 0.0266732 0.097731 0.0095514 1.3058721 12.203935 3.664013 0 inil 0.014834 0.1004213 0.0100844 0.4868312 2.82543 6.76966 0.09378377 jdws 0.020386 0.0867598 0.0075273 1.1259308 6.353972 4.255854 0 jgicl −0.000665 0.0756632 0.0057249 0.1888686 7.247467 −113.77258 0 jlicl 0.0267217 0.0870202 0.0075725 1.389514 10.543068 3.256539 0 jscl 0.0052808 0.1703259 0.0290109 2.1750501 10.995278 32.253616 0 kapco 0.0039217 0.0497851 0.0024786 0.075372 4.170727 12.694758 0.03165467 kel 0.0138202 0.1198242 0.0143578 1.8860013 7.853089 8.670214 0 kohc 0.0252254 0.1333188 0.0177739 1.3210785 6.583232 5.285108 0 descriptive statistics and normality test results (contd...) arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020254 stocks mean st. dev variance skewness kurtosis cv p-value ktml 0.0269588 0.1416213 0.0200566 1.5097217 7.680061 5.253251 0 luck 0.0269386 0.086193 0.0074292 0.9051 6.716782 3.199607 0 mari 0.0313516 0.1372763 0.0188448 1.0396643 7.429576 4.378611 0 mcb 0.0080548 0.0726276 0.0052748 1.1931486 5.456373 9.016649 3.36176e−13 mebl 0.016474 0.0599336 0.003592 0.4227311 3.070468 3.638075 0.1755405 mlcf 0.0280955 0.140134 0.0196375 1.6813687 8.856107 4.987778 0 mtl 0.0176176 0.0778218 0.0060562 −0.2965133 3.481092 4.417265 0.2408071 mureb 0.0259865 0.1302678 0.0169697 2.0461208 10.509455 5.012897 0 natf 0.0176728 0.1244824 0.0154959 0.528806 7.328598 7.04374 0 nbp 0.0015016 0.0772281 0.0059642 −0.0510279 3.906418 51.431256 0.1271944 ncl 0.0203414 0.1069232 0.0114326 0.4757667 3.859941 5.256426 0.01792444 nestle 0.0205733 0.0850316 0.0072304 0.6769748 4.120329 4.133107 0.00053023 nrl 0.0121948 0.0942501 0.0088831 0.7454379 5.874556 7.728719 5.89173e−12 ogdc 0.0111942 0.0676015 0.00457 0.5698864 3.987516 6.038964 0.003859068 olpl 0.0127581 0.0954599 0.0091126 0.1931386 4.936221 7.482282 6.41112e−05 pael 0.0130202 0.136915 0.0187457 0.7155574 3.530691 10.515571 0.003524119 pakt 0.0366319 0.1216899 0.0148084 1.659154 6.150523 3.321969 0 pmpk 0.0280412 0.1347536 0.0181585 1.0759546 5.665124 4.805559 3.10418e−13 pict 0.0211536 0.1131466 0.0128021 2.1148829 9.146733 5.348803 0 pioc 0.0183629 0.1464737 0.0214545 1.0644758 7.385358 7.976627 0 pkgs 0.0142378 0.0864692 0.0074769 1.3043585 5.928126 6.073196 0 pol 0.0157865 0.0732112 0.0053599 0.3679388 4.045553 4.637583 0 poml 0.0225542 0.1131676 0.0128069 1.3848949 7.138461 5.017589 0 ppl 0.0033394 0.0596033 0.0035526 0.0407968 3.166014 17.848475 0.9190471 psmc 0.0156965 0.0986564 0.0097331 0.6032087 3.635517 6.28526 0.01090135 pso 0.0095799 0.0840597 0.007066 0.4643415 4.303332 8.774601 0.0018442 ptc −0.0004927 0.0748886 0.0056083 1.2566113 5.699875 −151.98558 3.33067e−15 scbpl 0.0099828 0.0658683 0.0043386 0.8046955 4.137681 6.598157 7.72248e−05 shel 0.0049221 0.078997 0.0062405 0.2195452 3.5606 16.049509 0.2879114 shfa 0.0241239 0.0977624 0.0095575 1.3596463 6.723966 4.052519 0 sml 0.0296827 0.1462997 0.0214036 1.3491014 5.40606 4.928779 1.33227e−14 snbl 0.0037692 0.0905135 0.0081927 1.2498947 5.878234 24.014139 3.33067e−16 sngp 0.0136899 0.1032841 0.0106676 0.2792946 2.69595 7.544573 0.3740753 ssgc 0.0089943 0.0951877 0.0090607 0.1735969 3.104158 10.58306 0.7274347 thall 0.020339 0.1056596 0.011164 2.623275 18.430007 5.194939 0 trg 0.0326925 0.1670759 0.0279144 1.395618 6.261428 5.110528 0 source: author’s estimation and calculations continued arif and sohail: asset pricing with higher co-moments and cvar: evidence from pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 255 annexure-b figure 1: stock performance over each individual criteria of preference for construction of portfolio figure 2: mean variance optimized portfolio returns with benchmark portfolio figure 3: mean-cvar portfolio comparion with benchmark portfolio . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1446-1453. international journal of economics and financial issues | vol 6 • issue 4 • 20161446 the nexus of regional poverty and education in egypt: a micro analysis heba nassar1, marwa biltagy2* 1professor of economics, faculty of economics and political science, cairo university, egypt, 2associate professor of economics, faculty of economics and political science, cairo university, egypt. *email: bilmarwa@feps.edu.eg abstract the poverty pattern has changed from an urban/rural pattern to a geographical/regional pattern. these changes may be explained by several aspects. the employment aspect is one of the main determinants for socioeconomic status. the inability of household members to participate in income-generating activities is considered an important explanation of poverty trends and the relationship between poverty and employment can be explained by the loss of earnings or the decline in real incomes. this can be related to several aspects, pattern of jobs and its regularity, human resource development indicators and investment indicators. the objective of this paper is to understand the changes in poverty levels in egypt in total and by region by studying their relationship to regional composition and trends of employment and educational characteristics. the study starts a theoretical review about poverty and employment, which will constitute the basis for the micro level analysis in order to propose a framework for a pro-poor employment strategy. keywords: regional poverty, education, egypt, investment in schooling jel classifications: h75, i20, i32 1. introduction the objective of this paper is to understand the regional changes in poverty levels by studying their relationship to regional composition and trends of employment in order to draw a propoor employment growth oriented policies. the study starts with a literature review about poverty and employment to be able to establish a theoretical framework, then the profile of poverty in egypt is presented in the second part of the study, which will constitute the basis for the micro level analysis. finally the conclusion proposes a framework for a pro-poor employment strategy. the traditional dichotomy of urban rural divide was justified by the hypothesis of labor market segmentation, fragmentation and lack of access of the poor to employment opportunities, so that both unemployment and poverty will stem from the weak laborabsorption capacity of the modern sector in the metropolitan cities. hence, in spite of relatively higher productivity and growth rates in metropolitan cities, poverty also exists (squire, 1981). moreover in the case of rural migration to urban areas, migrants may be discriminated against, because of lower educational characteristics, different work attitudes, relatively less contacts, if compared with natives, which may reduce their chances of finding suitable employment in urban cities. 2. the relationship between poverty and the labor market: theoretical framework and literature review the existing pattern of differences in regional poverty and employment requires a different explanation. regional divergences may be justified by the relationship between regional employment characteristics and growth pattern on one hand and poverty on the other hand. employment characteristics may be a significant determinant of poverty in labor markets. lack of skills or assets and educational characteristics required for job access may lead to variations in earned income, labor productivity and rewards. entrance in the labor market will be through low-income points and will include nassar and biltagy: the nexus of regional poverty and education in egypt: a micro analysis international journal of economics and financial issues | vol 6 • issue 4 • 2016 1447 horizontal shifts rather than vertical movement on the occupational ladder (oberai and singh, 1983). in this respect the theoretical framework of human capital formation may be a relevant hypothesis for regional variations in poverty. human capital formation hypothesis explains the variations in poverty levels through geographical differences in the accessibility to social services. these divergences have an impact on the qualitative dimension of human capital formation addressing issues of education, training, nourishment, equal employment opportunities, improved health, knowledge and skills formation (briggs, 1987). these variations affect the return to employment by region and may lead to differences in the living standards. on the other hand, poverty might arise from differences in economic growth affecting employment opportunities as well as from labor market characteristics. differences in the overall levels of economic growth and investment lead to limited possibilities for employment generation. as indicated from numerous statistical and theoretical studies, there is a strong association between economic growth and poverty, showing that growth is as good for the poor as for the overall population. moreover, it was found that poverty reduction could in fact be also necessary to implement stable macroeconomic policies to achieve higher growth rates. on the other hand macroeconomic instability, such as inflation, has generally been associated with growth in poverty levels, as the poor tend to hold most of their financial assets in the form of cash, rather than in interest-bearing assets. the sectorial composition of growth also can affect poverty levels. growth in agricultural and tertiary activities reduces poverty, because it generates incomes for poor farmers and increases the demand for goods and services, which can easily be produced by them (ames et al., 2001). finally, labor market characteristics, such as lack of protection through legal regulations or collective organizations as well as irregularity and insecurity in work conditions may lead also to poverty. the egyptian labor market is characterized by structural distortions intensified by the inability of the rate, as well as the pattern, of economic growth to generate sufficient, productive and decent job opportunities. in fact, the growing mismatch between the population growth and the labor supply, on the one hand, and the labor demand, on the other, will remain the main obstacle against eradicating unemployment and is intensified by the gender and the geographic disparities (nassar, 2009). the egyptian economy has a large and growing informal sector that has been a major source of job creation for some time. however, the jobs created in this sector are not decent enough in terms of wage, sustainability and work conditions. moreover, a lot of jobs in the formal sector lack stability due to the absence of social security coverage and work contracts, as employers refuse to enter into binding work contracts and complain of the high cost of the social security system. informal employment can be measured using labor force sample survey (lfss) data, in which case, it will be defined as the number of private sector workers employed outside establishments (including agriculture). under this definition, informal employment reached 10.8 million in 2008, representing 48.1% of total employment and it reached 11.3 million in 2013 representing 47% of total employment (capmas, lfss 2008; 2013). capmas, lfss (2013) ascertains that 13% of total labor force is illiterate or just reading and writing, however graduates of technical intermediate education represent 41% of total egyptian labor force and university education graduate reach 31% of all graduates, both categories are facing the highest unemployment rate as will be indicated in the unemployment analysis. the sectoral distribution of employment indicates that 27.1% of the labor force in 2012 is working in agriculture and hunting characterized by low value-added and productivity. the manufacturing sector, characterized by its forward and backward linkages, employs only 11.2% of total workers. the financial and insurance activities employ 0.8%, the construction sector is absorbing 11.8% of employment, while the public administration, defense and compulsory social solidarity absorbs 8% of total labor force (authors’ calculations based on data from capmas, lfss, 2001, 2012). the literature review shows that the implementation of the policy framework in support of an employment intensive growth strategy for poverty reduction requires a concerted and coordinated program of action to contribute to capacity building in egypt (undp, 1997). ali and elbadawi (2000), indicates that the main labor market linkages to poverty are reflected on three main aspects; first, rising unemployment, especially among asset-less school graduates, contributes directly to the spread of poverty. second, the emergence of the informal sector as a major source of employment with relatively low productivity and low wages and incomes. finally, the decline in real wages in the formal sector. moreover, wahba (2002), aimed at providing an overview of the labor force dynamics during the period from 1988 to 1998, a period of significant economic reform and structural adjustment. she showed that the net inflow to informal employment was twice as much as that into formal employment. this might be an indication for increasing vulnerability and instability in the region. with the decline in the construction boom, rural to urban migration has not picked up in the 1990s, which might have led to deterioration in living standards of workers in some regions such as upper egypt. nevertheless, the orientation of the paper on “employment intensive program, ilo, 1998” in tackling poverty, concentrates also on the situation of the informal sector, indicating that in many regions of the world, millions of aspiring new entrants to the labor force face bleak job prospects and poverty. el-ehwany and el-laithy (2001) questioned directly, what has egypt done in the context of poverty, unemployment and employment? however each aspect was investigated separately, without drawing interrelationship. in this study it was indicated that causes of poverty are: insufficient formal employment opportunities, low earning per working hour and high prices of basic goods and services. the main findings can be summarized as follows: the labor market in egypt has been increasingly suffering nassar and biltagy: the nexus of regional poverty and education in egypt: a micro analysis international journal of economics and financial issues | vol 6 • issue 4 • 20161448 from many distortions and disequilibria during the period 19802000, the problems of the labor market are a natural outcome of the complete divorce between macro-economic policies and employment policies, the main challenge facing policy makers in both medium and long terms lies in the creation of sufficient, productive and permanent jobs to reduce unemployment and to enhance labor competitiveness. the objective of the study by assaad et al. (1999) was to understand the factors that sort individuals into various employment states. the evidence presented in this paper show that the egyptian labor market is moving to a stage, where unemployment is increasingly concentrated among specific groups, whose access to the private sector is limited. casual workers are highly vulnerable to underemployment rather than to unemployment. this is especially true in rural areas and even more for females. nassar and el-laithy (2000) tackled directly the relationship between urban poverty and the labor market by studying employment as a determinant for poverty. the paper revealed that the classification of individuals as poor is related to individuals with higher dependency ratio, illiterate and unpaid workers in construction, manufacturing or in agricultural activities. the findings of this study concentrate on the following: access-ability of the poor to the labor market is limited due to the selectivity of the labor market in metropolitans with respect to skilled workers, significant wage differences exist among the different welfare groups, in addition there is an increasingly concentration of the poor in the informal sector, where wages are low and formal working regulations are missing. 3. the profile of poverty in egypt poverty can be defined as an absence or a shortage of the needs required for human survival. nevertheless, there is no agreement about what basic human requirements are or how they can be identified. moreover, the definition of poverty can be extended to include other types of deprivation, such as non-material deficiency and social differentiation (wratten, 1995). in egypt, poverty declined in 1999/2000 for the first time since the early 1980s to less than 17% of the population (world bank report, 2002). however, the report shows also that the poverty pattern has changed from an urban/rural pattern to a geographical/ regional pattern as poverty has declined in the metropolitan cities and increased in upper egypt and was at intermediate levels in lower egypt. the incidence of poverty increased substantially from 10.82% to 19.27% in urban upper egypt and from 29.32% to 34.15% in rural upper egypt over the period 1995/96-1999/2000. on the other hand, poverty declined over the same period from 13.1% to 5.06% in metropolitan cities and from 8.34% to 6.17% in urban lower egypt and from 21.53% to 11.83% in rural lower egypt. the panel household income, expenditure, and consumption survey (hiecs survey) 2005-2008 which is conducted by capmas to trace household consumption and living standards over 2005-2008 demonstrates that due to rapid economic growth, egypt has achieved impressive poverty reduction, reversing the trend of worsening poverty outcomes over 2000-2005. the number of poor was reduced by 1.8 million. real consumption has increased even despite accelerating inflation and rapidly growing food prices. however, the economic growth has not resulted in immediate and universal improvement of living conditions for all. while egypt experienced high gross domestic product (gdp) growth rate over the period 2005-2008 poverty remained a major challenge in egypt. in 2004/2005, it was estimated that about 19.6% were living in absolute poverty, and 21% were near poor. the global economic slowdown that began in 2008 had adversely affected growth and employment and investment in egypt. growth has been threatened by inflation, particularly rising food prices, which have worsened the situation of the poor. since the events of 2011, egypt has experienced political disturbance, which severely affected the egyptian economy and people’s livelihoods. at the present time, growth rate remains stationary, at 4.3% in the fourth quarter of 2014. however, the most dangerous situation is the growing income inequality coupled with a continued persistence of rural/urban disparities. the unemployment rate, which was around 9% in 2010, has increased to 12.9% in the fourth quarter of 2014. unemployment rates are highest among young people and particularly among individuals in the rural areas. moreover, egypt’s poverty rate increased over time and reached 26.3% in 2013/2014 (capmas statistical yearbook, different issues). most of the country’s poor people live in rural upper egypt, where there are higher rates of illiteracy, infant mortality and low rates of educational attainment and health care. around 51% of the population living in rural areas in upper egypt is poor. most individuals in upper egypt depend on agriculture for their living; however, agriculture does not provide them with sufficient food security and income. most people have limited access to water, in terms of both quality and quantity. in addition, they have very small land holdings compared to those in lower egypt. moreover, alternative employment opportunities are limited in upper egypt because of the insufficient other non-farm economic activities. it can be said that, out of the 1000 poorest villages in egypt, 941 are located in upper egypt and the remaining 59 villages are scattered across the lower egypt. the increasing incidence of income poverty in recent times is compounded by the prevalence of poor living conditions and inadequate access to education and health services resulting in extreme multidimensional poverty amongst11.9% of the population in 2011. upper egypt shows the highest prevalence rate (18%) compared to all other regions, much higher than lower egypt and urban governorates (8.7% and 6.8% respectively) (egypt network for integrated development, 2015). hiecs 2010-2011, ascertains that the population of rural upper egypt is dramatically worse off than rural lower egypt, and qena governorate suffers most severely from among all upper egypt. the proportion of poor and near poor households is as high as78% for qena, which is above the average for rural upper egypt (75%). the incidence of poverty is also widely variable across governorates. governorates that demonstrate the highest income poverty rates are also those with the highest rates of extreme multi-dimensional poverty; mostly menia, assuit, sohag, bani nassar and biltagy: the nexus of regional poverty and education in egypt: a micro analysis international journal of economics and financial issues | vol 6 • issue 4 • 2016 1449 suef, fayoum and qena in upper egypt. the prevalence of income poverty is critically high in assuit (69.5%), sohag (58.6%) and aswan (54.4%) in upper egypt, moderate in most governorates of lower egypt and negligible in suez and damietta (3.2%)1. hence, there is strong evidence that justifies targeting of rural egypt and especially rural upper egypt for social protection and economic development. biasness in public spending in favor of the south is not only vital for differentials in poverty levels and deprivation but also can be justified in terms of comparative advantage for job creation. the percentage of the poor in 2013/2012 is the highest since 2000 since it reached 26.3%. the percentage increased from 16.7% in 1999/2000 to 21.6% in 2008/2009 to 25.2% in 2010/2011 and then it reached 26.3% in 2012/2013 (capmas, indicators of poverty, hiecs 2010/2011, 2012/2013). table 1 demonstrates that, while urban areas have seen a rise in the indicators of poverty between 2011 and 2013, the rural areas have not experienced any change statistically significant. the urban governorates have seen the biggest rise in the poverty indicators (becoming more deteriorated). moreover, the poverty rate has fallen in upper egypt, whether in urban or rural areas, and the difference was statistically significant. about half of the population in rural upper egypt (49.44%) cannot meet their basic needs in 2012/2013. this percentage decreased to 26.70% in the urban upper egypt, while that percentage reached the lowest level in the urban lower egypt (11.71%). hiecs, 2012/2013 ascertains that the poorest governorates were asyout (61.7%), qena (59.8%), suhag (55.8%), north sinai (47.7%), aswan (44.3%), luxor (43%) and bani sweif (38.5%). 4. the micro analysis the main question in this part addresses employment and education as two important factors among others affecting the average incomes of workers. the data used in the analysis is egypt labor market panel survey 2012 (elmps 2012). the size of the total sample is 9723 individuals. the sample contains waged workers whose ages range from 15 to 64 years. the empirical model specifies the different factors affecting the average income of workers, including employment and job stability. table 2 presents the regression results of estimating the earnings function of the total sample. it is estimated that, the private rate of return to education is 3.6%. moreover, the rate of return to the number of years of experience is 2.6%. moreover, at 5% significance level, the individual who lives in urban areas gains more earnings than the one who lives in rural areas by 11.2%. 1 hiecs 2012/2013, which is a new hiecs panel survey conducted by capmas illustrates that the average poverty line is 3920 egyptian pounds per individual per year, or 327 pounds per person per month and the average abject poverty line is 2750 egyptian pounds per individual per year. gender has a significant effect on the earnings of an individual i.e., males get more monthly earnings than females by 24.8% on average. there is a negative relationship between the household size and the earnings of an individual. the married individual gets more earnings than the single by 4.9%. in addition, working in government or public sectors guarantees more earnings (by 5.3%) if compared to private, investment or international sectors. if the work is permanent then, the earnings will be higher by 11.1% compared to casual, seasonal or temporary work. the variable of the number of hours per day is insignificant while working for long hours per day is associated with higher levels of earnings for an individual. the estimation results prove the importance of human capital formation factors in determining the earnings function of workers. as seen from tables 2-6, education and experience table 1: the development of the poverty rate in urban and rural areas, 2010/2011-2012/2013 region 2010/2011 2012/2013 the difference total 25.18 26.29 1.11 urban 15.27 17.59 2.32 rural 32.35 32.38 0.04 urban governorates 9.58 15.68 6.10 urban lower egypt 10.32 11.71 1.39 rural lower egypt 16.99 17.41 0.42 urban upper egypt 29.41 26.70 −2.72 rural upper egypt 51.48 49.44 −2.04 source: el-laithy, poverty and inequality metrics , unpublished memo, 2014 table 2: the regression results of estimating the earnings function (the total sample) lnw coefficient standard error t p>t educlvl 0.03,51,668 0.00,15,062 23.35 0.000 calculatedexp 0.02,59,615 0.00,19,467 13.34 0.000 expsquared −0.00,03,135 0.00,00,381 −8.23 0.000 urban 0.10,57,918 0.01,22,855 8.61 0.000 sex 0.22,17,201 0.01,68,013 13.20 0.000 hhsize −0.00,726 0.00,30,234 −2.40 0.016 marital 0.04,79,905 0.01,59,628 3.01 0.003 ussectrp 0.05,17,714 0.00,72,898 7.10 0.000 usstablp 0.10,54,888 0.01,45,555 7.25 0.000 ushrsday 0.0,00,978 0.0,02,608 0.37 0.708 usnumdys 0.01,18,318 0.00,57,548 2.06 0.040 _cons 5.6,74,954 0.05,16,849 109.80 0.000 source: authors’ calculations based on elmps 2012 table 3: the regression results of estimating the earnings function (rural lower) lnw coefficient standard error t p>t educlvl 0.02,15,366 0.00,26,962 7.99 0.000 calculatedexp 0.02,59,015 0.00,35,293 7.34 0.000 expsquared −0.0,00,388 0.00,00,673 −5.76 0.000 sex 0.21,67,997 0.03,15,521 6.87 0.000 hhsize −0.01,29,127 0.00,61,205 −2.11 0.035 marital 0.04,03,514 0.03,13,135 1.29 0.198 ussectrp 0.01,35,711 0.01,33,485 1.02 0.309 usstablp 0.09,38,667 0.02,57,319 3.65 0.000 ushrsday 0.00,14,724 0.00,41,254 0.36 0.721 usnumdys 0.02,23,404 0.00,95,622 2.34 0.020 _cons 5.8,35,065 0.08,99,274 64.89 0.000 source: authors’ calculations based on elmps 2012 http://www.erfdataportal.com/index.php/catalog/67 nassar and biltagy: the nexus of regional poverty and education in egypt: a micro analysis international journal of economics and financial issues | vol 6 • issue 4 • 20161450 variables are playing the most important role in increasing earnings for all regions. however, despite the fact that the educational variable increases earnings, higher levels of education are the main determinant of a significant increase in the income levels. the low educational attainment levels of the labor force in upper egypt (especially in rural areas) in comparison to other regions, can explain the concentration of workers in upper egypt in primary activities and in the work status self-employed without hiring others, which do not need high educational characteristics. these results suggest a reallocation of social spending to deprived areas such as upper egypt. geographical variations in per capita expenditure on education and training explain differences in educational attainment and the concentration of labor in low earning activities in upper egypt. regarding rural lower sample, the results show that the marital status, the economic sector of employment and the number of working hours per day are insignificant variables at 5% significance level. according to the sample of urban lower region, the results ascertain that the household size, marital status, the number of working hours per day and the sector of employment are insignificant variables at 5% significance level. in rural upper egypt, the results ascertain that the household size variable is not significant and this result is consistent with the culture of this region. moreover, the job stability variable is insignificant at 5% significance level. working in private, investment or international sectors guarantees more earnings (by 5.4%) if compared to the government or public sectors. it can be said that, in rural upper egypt, the rate of absorption of workers in the private sector is higher than in other regions; however most workers are in the informal sector. according to the sample of urban upper region, the results demonstrate that the household size, the marital status and the number of working hours per day variables are insignificant at 5% significance level. working in private, investment or international sectors guarantees more earnings (by 6.6%), if compared to the government or public sectors2. to sum up, the estimation results prove the importance of human capital resources in determining the earnings function of workers i.e., education and experience variables are playing the most important role in increasing earnings for all regions. moreover, characteristics of the labor market have a significant effect on the earnings function. the results show that in upper egypt (rural and urban) and rural lower egypt, the probability of being non poor decreases with the increase in the number of working days per week. this might be explained by the fact that those who are working more days are those, who do not have permanent jobs in regions with large rural areas and for whom the probability to be poor is higher. alternatively, this fact is not valid in urban governorates and in urban lower egypt3 because permanent work is concentrated more in these regions. job stability4 is important as a factor reducing the probability of being poor. this variable is significant in the total sample, urban governorates, lower egypt (rural and urban) and urban upper egypt. furthermore, the estimation results show that rural upper egypt has the highest ratio of unstable work. over the period 1996/1997-2000/2001, investment policies in egypt tend to be biased against upper egypt especially in rural 2 tadele (2004) studied the causes of poverty in urban areas in ethiopia. kedir (2005) confirmed that, the study by tadele (2004) dealt more with methods for data collection than with the techniques of poverty analysis. the reasons of poverty as mentioned by tadele (2004), include urban displacement, unemployment, high food prices, bad health services, hiv/ aids and discrimination against women in employment opportunities. 3 the estimation results ascertain that the variable of the number of working days per week is not significant in urban governorates and urban lower egypt. 4 the categories of this variable include: permanent, temporary, seasonal and casual work. table 4: the regression results of estimating the earnings function (urban lower) lnw coefficient standard error t p>t educlvl 0.03,27,382 0.00,40,267 8.13 0.000 calculatedexp 0.02,75,731 0.00,51,333 5.37 0.000 expsquared −0.00,03,308 0.00,01,041 −3.18 0.002 sex 0.25,76,658 0.03,93,698 6.54 0.000 hhsize −0.00,37,001 0.01,00,795 −0.37 0.714 marital 0.06,00,585 0.04,05,863 1.48 0.139 uzssectrp 0.00,71,136 0.02,00,689 0.35 0.723 usstablp 0.20,33,283 0.04,07,791 4.99 0.000 ushrsday 0.01,15,137 0.00,76,441 1.51 0.132 usnumdys 0.00,86,118 0.01,66,392 0.52 0.605 _cons 5.5,42,955 0.14,26,049 38.87 0.000 source: authors’ calculations based on elmps 2012 table 5: the regression results of estimating the earnings function (rural upper) lnw coefficient standard error t p>t educlvl 0.02,38,262 0.00,29,753 8.01 0.000 calculatedexp 0.01,97,793 0.00,40,848 4.84 0.000 expsquared −0.00,02,642 0.00,00,738 −3.58 0.000 sex 0.17,13,541 0.05,14,604 3.33 0.001 hhsize −0.00,06,141 0.00,47,368 −0.13 0.897 marital 0.02,38,913 0.0,34,321 0.70 0.486 ussectrp 0.0,52,849 0.01,75,633 3.01 0.003 usstablp −0.03,11,784 0.03,17,379 −0.98 0.326 ushrsday −0.00,28,927 0.00,54,955 −0.53 0.599 usnumdys 0.05,35,009 0.01,05,699 5.06 0.000 _cons 5.8,07,341 0.10,61,467 54.71 0.000 source: authors’ calculations based on elmps 2012 table 6: the regression results of estimating the earnings function (urban upper) lnw coefficient standard error t p>t educlvl 0.0449447 0.00,44,235 10.16 0.000 calculatedexp 0.02,73,504 0.00,53,192 5.14 0.000 expsquared −0.00,03,016 0.0,00,111 −2.72 0.007 sex 0.22,44,871 0.04,13,708 5.43 0.000 hhsize −0.00,54,914 0.00,81,724 −0.67 0.502 marital 0.05,13,865 0.04,33,714 1.18 0.236 ussectrp 0.0,64,218 0.02,00,839 3.20 0.001 usstablp 0.14,94,897 0.04,12,557 3.62 0.000 ushrsday −0.00,44,858 0.00,75,894 −0.59 0.555 usnumdys −0.03,44,196 0.01,60,964 −2.14 0.033 _cons 5.8,07,934 0.14,65,615 39.63 0.000 source: authors’ calculations based on elmps 2012 nassar and biltagy: the nexus of regional poverty and education in egypt: a micro analysis international journal of economics and financial issues | vol 6 • issue 4 • 2016 1451 areas, while the distribution of public investments by region in 2012/13 shows an opposite case, in which investment was higher in upper egypt especially in the southern areas (ministry of planning, 2012). actually, this trend of investment can explain the situation of poverty by region in egypt over years. over the period 1995/96-1999/2000, poverty has declined in the metropolitan cities and increased in upper egypt and was at intermediate levels in lower egypt. the incidence of poverty increased substantially from 10.82% to 19.27% in urban upper egypt and from 29.32% to 34.15% in rural upper egypt. on the contrary, over the period 2010/11-2012/13, the urban governorates have seen the biggest rise in the poverty indicators (becoming more deteriorated). moreover, the poverty rate has fallen in upper egypt, whether in urban or rural areas, and the difference was statistically significant. one of the main findings of the micro analysis is that improving educational levels in all regions will reduce the probability of being poor because of the positive relationship between the number of years of schooling and the earnings of an individual. accordingly, it is important to present a general outlook on the public expenditure on education in egypt. the percentage of public expenditure on education to the total public expenditure was 11.7% in 2010/11 and 2013/14. however, the percentage of public expenditure on pre-university education to the total expenditure on education has increased from 66.4% in 2010/11 to 68.1% in 2013/14, while the percentage of public expenditure on university education to the total expenditure on education has remained constant in 2011/12-2012/13 (21.4%) and reached 22.4% in 2013/14. as a percentage of gdp, the public expenditure on education was 3.4% in 2010/11 and 4.1% in 2013/14 (capmas, egypt in figures, 2012, 2013, 2014 and 2015). regarding regional expenditure on education, it can be said that, the lowest allocations directed to the educational directorates located in upper egypt especially, assiut, el-minya, suhag and qena while the highest allocations directed to educational directorates in the lower egypt, for example, damietta and dakahlia (ministry of finance, administrative machinery budget, 2014). as mentioned above, low level of education is one of the most crucial factors linked to poverty in egypt, where the indicators of poverty decrease with higher levels of education. regarding the percentage of the poor according to the educational status in 2012/2013, it can be said that, an individual is more likely to be poor if he is illiterate. figure 1 illustrates that 37% of illiterate individuals are poor, compared to 9% for those with university education in the same year. despite the high unemployment rates among the university and post university education, just 4% of post university education counted as poor over the same period. table 7 illustrates the regional distribution of investments directed to the education sector in egypt. the data shows that the total investments directed to the education sector in lower egypt in the fiscal year 2013/2014 was 6,023 million egyptian pounds; while the total investments directed to the education sector in upper egypt in the same fiscal year was 2,074 million egyptian pounds. in turn, this explains the reasons of achieving very low levels of education in upper egypt (table 8). table 8 ascertains that, the highest percentage of illiterates (39.6%) live in upper egypt. moreover, 35.1% of the total individuals who can only read and write are located also in upper egypt. consequently, this explains the nexus among poverty, employment, investment and education i.e., individuals live in upper egypt (the poorest areas) are severely educationally deprived since the total investments directed to the education sector in upper egypt are very low compared to lower egypt. furthermore, the low educational attainment levels of the labor force in upper egypt in comparison to other regions, can explain the concentration of workers in primary activities and in the work status self-employed. again, improving educational levels in upper egypt region will reduce the probability of being poor because of the positive relationship between the number of years of schooling and the earnings of an individual. 5. conclusion the previous analysis at the micro level shows that differences in human capital indicators and employment characteristics may explain the variations in geographical poverty. as these factors are implemented at the sectoral level and affecting the micro level, suggested poverty reduction strategy can be divided into two sets of policies: sectoral as well as micro level policies. the main objective of this strategy is to improve the living standard of inhabitants in upper egypt through expansion of productive employment opportunities. implementation of such a strategy should be implemented by governmental, non-governmental agencies and supported by donor agencies. the private sector can play an effective role, if it believes in the benefits, it can enjoy from a more balanced regional growth. a. sectoral policies table 7: regional distribution of investments directed to the education sector (in million egyptian pounds) region total investments investments directed to the education sector urban governorates 19.088 1.405 lower egypt 25.028 6.023 upper egypt 15.082 2.074 total 59.198 9.502 source: authors’ calculations based on data of ministry of planning and follow-up and administrative reform 2013/2014 source: drawn by the authors based on capmas, indicators of poverty, hiecs 2012/2013 figure 1: the percentage of the poor according to the educational status in 2012/2013 nassar and biltagy: the nexus of regional poverty and education in egypt: a micro analysis international journal of economics and financial issues | vol 6 • issue 4 • 20161452 sector-specific policies should focus on removing distortions that impede growth in different sectors given the large productivity differentials between agriculture and other sectors as well as formal and informal sectors in upper egypt (hassan and kandil, 2014). 1. the development of an extensive system for employment and income generation schemes in rural upper egypt. the expansion of farm and non-farm activities in upper egypt is important to increase living standards in rural areas. this means: • the adoption of several measures to facilitate access of the poor in rural areas to productive employment through provision of credits and institutional help. self employment may not be a mean for alleviation poverty, if not achieving sustainability and outreach. the lack of assets is to a large extent a constraint against productive employment for the poor. meanwhile it is important to enhance the private sector to improve the contract system. • in general there is a need to establish at a decentralized level a transparent and efficient tendering and bidding system to improve the living conditions workers in rural areas. 2. increasing output and employment in formal (sme’s) this can be achieved by shifting the structure of investments and the pattern of modern sector growth to concentrate more heavily than in the past, on more labor absorbing sectors, specifically modern smalland medium-scale enterprises. a wide range of policies is needed to stimulate and support the expansion of modern smalland medium-scale enterprise such as: a. support entrepreneurship development programs. b. improve access to finance for the poor as well as nonfinancial services such as improvement of production methods, introduction of new technologies, skills training, business management training, and expansion of marketing channels. c. encourage linkages between enterprises of different sizes and across different sectors. 3. upgrading the in formal economy with the relatively high share of informal sector in rural upper egypt it is important to adopt several measures by the government as well as by the business sector (formal small and medium sector) for upgrading this sector. the following are the main policies suggested to improve the status of workers in this sector: a. strengthening the informal information base b. providing social protection (health and social) for informal workers through ngos c. increasing access to financial services and better marketing opportunities through strengthening the financial intermediaries and micro finance in upper egypt d. promoting industrial and manufacturing activities and encouraging the use of improved technologies as informal activities are mainly concentrated in trade and services e. increasing linkages with formal economy in upper egypt and cairo through subcontracting and franchising system, and with the rural economy especially through rural nonfarm activities in upper egypt f. improving infrastructure in poor rural upper egypt to support informal economy (undp, ilo, 1997). 4. employment intensive approaches for public investment programs in order to introduce employment objectives into investment programs and to absorb seasonal and temporary workers in upper egypt, regional labor-based approaches are recommended. cost-effectiveness, technical feasibility and quality standards, alongside economic and social sustainability, have become the criteria for the choice and application of labor-based methods. b. micro level • non-governmental organizations can play an important role in increasing available employment opportunities for the poor, improving returns to their returns, and enhancing the conditions of their employment. this requires multifaceted strategies, emphasizing self-employment and micro finance through financial and non financial support. • ngos can also play an important role in improving the educational skills of workers in upper egypt through different kinds of formal and informal training. • improving entrepreneurship skills to improve the status of self-employed by achieving accessibility and outreach to their activities through micro level support. • income maintenance payment by the ministry of social affairs as well as non-governmental organizations for workers in agriculture can be an immediate solution for those, who lost their occasional or temporary jobs. in addition the provision of unemployment benefits as a component of an employment promotion program by providing unemployed in agriculture activities with vocational training through contracting between ministry of social affairs and the social fund for development can be a solution to increase incomes of the unemployed in the long run. references ali, a., elbadawi, i. (2000), labor market and poverty in the arab world: some preliminary results, the seventh annual conference of the economic research forum for the arab countries, iran and turkey 9erf): jordan, 26-29 october. 2000. p. 1-19. ames, w., brown, w., devarajan, s., izquierdo, a. (2001), macroeconomic policy and poverty reduction. washington, dc: imf world bank. table 8: the percentage distribution of educational status by region region illiterate reads and writes intermediate university education greater cairo 17.6 18.3 21.7 31.9 alexandria 4 5.6 6.35 9.11 delta region 36.96 2.98 3.5 3.2 canal region 1.9 38.1 38.05 30.9 upper egypt 39.6 35.1 30.4 24.9 source: authors’ calculations based on the population distribution (age 10+) according to educational status in governorates, census 2006 nassar and biltagy: the nexus of regional poverty and education in egypt: a micro analysis international journal of economics and financial issues | vol 6 • issue 4 • 2016 1453 assaad, r., el hamidi, f., ahmed, a.u. (1999), the determinants of employment status of egypt. international food policy research institute, discussion paper briefs, discussion paper, 88. p1-2. briggs, v. (1987), human resource development and the formulation of a national policy. journal of economic issues, 21, 1207-1240. capmas. central agency for public mobilization and statistics. (2012, 2013, 2014 and 2015), egypt in figures, arab republic of egypt. capmas. central agency for public mobilization and statistics. (different issues). statistical yearbook, arab republic of egypt. capmas. indicators of poverty, the panel household income, expenditure, and consumption survey (hiecs survey), 2005-2008, 2010/2011, 2012/2013. capmas. labor force sample survey, (lfss), 2001, 2008, 2012, 2013. census. (2006), population distribution (age 10+) according to educational status in governorates. capmas. central agency for public mobilization and statistics. egypt network for integrated development. (2015), a profile of poverty accross egypt and recommendations, policy brief; 2015. p1-9. el-ehwany, n., el-laithy, h. (2001), poverty-employment and policy – making in egypt, ilo, towards decent work in north africa, no. 1, area office in cairo north africa multi-disciplinary advisory team, a country profile. p1-66. el-laithy, h. (2014), poverty and inequality metrics. unpublished memo. p1-31. elmps. (2012), egypt labor market panel survey. economic research forum. hassan, m., kandil, m. (2014), employment fluctuations and sectoral shifts in egypt: testing the public/private sectoral shifts hypothesis. international journal of development issues, 13(2), 129-154. ilo. (1998), employment intensive program. geneva: international labour office. kedir, a. (2005), understanding urban chronic poverty: crossing the qualitative and quantitative divide. environment and urbanization, 17(2), 43-54. ministry of finance, administrative machinery budget, 2014. ministry of planning and follow-up and administrative reform, 2013/2014. ministry of planning. (2012), socio-economic plan for the fiscal year 2012/2013. nassar, h. (2009), growth, economic policies and employment linkages. research country paper, p1-43. nassar, h., el-laithy, h. (2000), labor market, urban poverty and propoor employment policies, working paper no. 2036. faculty of economics and political sciences, cairo university. oberai, a., singh, h. (1983), causes and consequences of internal migration: a study in indian punjab. new delhi: oxford university press. squire, l. (1981), employment policy in developing countries: a survey of issues and evidence. new york: a world bank research publication, oxford university press. tadele, f. (2004), urban poverty studies in ethiopia – reflection on the methodological approaches”, paper prepared for the chronic urban poverty workshop, 16-18 august 2004, addis ababa, ethiopia. undp, ilo. (1997), job creation and poverty alleviation in egypt strategy and programs. geneva: undp, ilo. wahba, j. (2002), labor mobility in egypt: are the 1990s any different from the 1980s? in: assaad, r., editor. the egyptian labor market in an era of reform. cairo: an economic research forum edition. 2002. p. 257-286. world bank, are. (2002), poverty reduction in egypt, diagnosis and strategy. washington, dc: world bank. wratten, e. (1995), conceptualizing urban poverty. environment and urbanization, 7(1), 11-38. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(1), 403-413. international journal of economics and financial issues | vol 7 • issue 1 • 2017 403 transaction costs and prospects for public-private partnership in the russian mineral resourse sector irina glazyrina1*, sergey lavlinskii2 1department for ecological economics, institute of natural resources, ecology and cryology of the siberian branch of the russian academy of sciences, transbaikal state university, chita, 672014 russia, 2institute of mathematics of the siberian branch of the russian academy of sciences, transbaikal state university, novosibirsk, 630090, russia. *email: iglazyrina@bk.ru abstract an analysis is presented for the current development level of the institution of public-private partnership (ppp) in the mineral resources complex of russia. the main focus is on the two ppp models that are most widely used in russia. the first model is production sharing agreement (psa). an analysis is conducted of the psa concept. the sakhalin 2 project is used as an example to show how an inadequate preparation of psa terms and high transaction costs (tc) can lead to a breach of contract. the second model is applied in production infrastructure development projects financed by the investment fund of russia. this is a russia-specific model; thus, authors use a special toolkit for its assessment in the paper. analysis shows that important factor of the project efficiency is an institutional environment. weakness of institutions and lack of low cost instruments of conflict resolution might be the cause of high tc and environmental damage. the technique applied in the efficiency analysis of concrete partnership arrangements is presented using the examples of the ppp models practiced in krasnoyarsk krai and transbaikal region in siberia. it can be applied in designing a raw-material base development program involving ppp arrangements. the problem solution generates a cost-sharing arrangement between the state and the private investor, making it possible to optimize the majority of russian ppp models. keywords: mineral resources, public-private partnership, production sharing agreement, transaction costs jel classifications: q32, o13, c63 1. introduction high inflation, natural-resource orientation and technological backlog–these are the characteristic features of the russian economy of recent years. these circumstances largely define the strategy of natural resource use on most of the vast and lowdeveloped territories of russia. the major challenge here is to design a mechanism to coordinate the long-term interests of the state and the private investor. such a mechanism should ensure the investment appeal of the region, the inflow of government money, and the observance of environmental constraints in territorial socioeconomic development. public-private partnerships (ppps) are widely used throughout the world and are an effective way to achieve a compromise of interests in various spheres of economy. there are diverse forms of ppp arrangements whereby a private company builds a state-owned object and transfers it to the state either directly upon the completion of the works or after a certain period of operation. world experience shows that ppps can be a successful means, primarily, of creating new and maintaining the existing public sector infrastructure. in the mineral complex, ppps help to considerably expand project financing and encourage subsoil users to develop new fields in remote areas. how broadly is the ppp institution implemented in the mineral resources complex of russia? it is quite often that the investor cannot implement an investment project due to a lack of the necessary infrastructure, and the state officials are unwilling to invest in infrastructure until they are sure it is used efficiently. what steps are taken to break this vicious circle? what economic and mathematical tools for designing an efficient ppp model can be used in the russian context? these questions are the focus of this paper. the authors propose a ppp model-building methodology based on finding of a compromise of economic interests. this approach would ensure long-term efficiency for the state as well as the private investor. glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017404 2. history of russian ppps the original form of the ppp model is traditionally termed bot (built, own, transfer) and is known worldwide as concession. its core idea is the transfer of activities from the state to the private sector. this ppp model was broadly used in europe since the 19th century in the development of transport infrastructure (reznichenko, 2010). the next step in the development of ppps— the boot model (built, own, operate, transfer)—was taken in australia (quiggin, 2004). in this model, the private investor builds, finances, manages, and operates an infrastructure object. in this case, the ownership of the created object belongs to a private partner until the end of the contract, after which it passes to the state (grimsey and levis, 2004). this model played a dominant role in the implementation of infrastructure projects in the 1990s. the next stage in the development of ppps is associated with the dbfo (design, built, finance, operate) model (mayston, 1999) and the adoption of a new strategy for government projects in the uk, i.e., the private finance initiative (groute, 1997; owen and merna, 1997). in this model, the private investor sets up a management company for a long term (30-60 years) to build, finance, and manage the object and provide the services specified in the government contract (broadbent and laughlin, 2003; bennett and iossa, 2006). this is a general outline of the twocenturies long evolution of the ppp institution in the world. as a result, now the state is changing the strategies and formats of its participation in infrastructure development. the state is anxious about the search for an optimum proportion between directive and market management, heading toward large-scale attraction of private resources to development of industries that used to be in state ownership and constituted a state monopoly. attracting private capital on a partnership basis, the state divests itself of a substantial part of its administrative and economic functions to release resources for other socially important functions (varnavsky, 2009). the history of the ppp institution in russia is much less eventful. in 1836, the emperor nicholas i granted a concession to build a railway line from st. petersburg to tsarskoe selo. the state provided land for free and gave guarantees for the project (westwood, 1964). further on, there were attempts at using ppps in russia, but those were isolated instances of an experimental nature. the situation has changed only in the last decades. private capital began to flow to the infrastructure sector, but on a lower scale compared with developed nations. a particularly complex situation is observed in the mineral resource sector, which has traditionally been in focus of the state. here the state is most interested in the development of ppp tools capable of attracting the resources of the various financial and credit institutions to the implementation of major investment programs. historically, two ppp models have been most widely used in the russian mineral resources complex. the first one is production sharing agreement (psa), which is commonly used for oil and gas projects. the second model is applied in production infrastructure development projects financed by the investment fund of russia. both of the models are based on international experience, but their original form has undergone serious change in the process of adaptation to the russian conditions. 2.1. psa in a transition economy, the main challenge for an investor evaluating a field is the uncertainty of the project’s external conditions in terms of tax burden. the use of a special psa regime is an effective way to solve this problem. developing a field under a standard license agreement, the investor pays, in addition to royalties, a full spectrum of general (labor, property, value-added, and profit) taxes, whose rates are formed outside the natural resource sector and reflect the general tendencies in the economy. in a transition economy, such a tax environment puts a mineral resource project on a par with regular goods and services, the investment horizon of which is an order of magnitude smaller, leading to an adverse effect on the project economics. the economic nature of a large-scale mineral resource production project—a long period of capital investments, high specific transportation costs, and fluctuating prices—leads to a high investor’s discount in russia. the current tax system ignores the key role of the internal rate of return (irr) in the investor’s value system: the investor is “stunned” by a sizable tax burden as soon as the first item is produced. the project costs cannot be compensated within a reasonably short period to achieve a satisfactory performance. that is why in many cases a license agreement does not give the investor an irr that would justify the risks associated with the implementation of a serious project in russia. the psa contractual mechanism, which was designed specifically for unstable economies, is more sensitive to the costs in the initial project period; tax payments begin to grow gradually only when the investor has reached a certain profitability level. this scheme pulls the investor beyond their discount threshold while ensuring that the state receives the larger part of the rent in the form of taxes. that is why psa helps harmonize a ppp and achieve a compromise between the interests of the ppp participants. unfortunately, the psa model that has proven effective in the global economy has undergone serious change in russia. in this context, noteworthy is the example of the sakhalin 2 project on the development of the lunskoe and piltun-astokhskoe fields on the sakhalin shelf with the total geological reserves of 600 million tons of oil and condensate and 700 billion cubic meters of gas. the sakhalin 2 psa includes both value-added and labor taxes, showing the inertia of the fiscal approach and the failure to understand that the psa ideology is based on the concept of a “protective dome” covering the investor. this dome guarantees the existence of unchanging “rules of the game” for the investor to minimize political and economic risks regardless of the situation outside the field. the sakhalin 2 psa, which was signed in the 1990s, was beneficial to the russian government because the domestic oil companies had neither the technology nor sufficient working capital to develop the field. the economic conditions have changed seriously over time: the national economy has stabilized; the role of the oil-and-gas glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017 405 sector has increased dramatically, and so has the financial capacity of russian companies. the terms under which the foreign party concluded the psa began to seem unprofitable for russia, and the government decided to change the terms of the agreement, undermining the very foundations of the ppp institution. russian state-owned companies became part of the sakhalin 2 project; the strategic investor’s protective dome was destroyed. 2.2. ppp projects financed by the investment fund of russia the production infrastructure projects financed by the investment fund use a non-classical ppp model evolved due to the specific features of the russian economy. (varnavsky, 2009) methodologically, investment projects become ppp projects only when a private company finances the construction and (or) operation of state-owned objects (groute, 1997). within russian projects, production infrastructure is built under the principle that each participant finances their own objects only. in practice this means that the government finances only public properties such as roads, bridges, power lines, etc., whereas businesses build their own objects, i.e., plants, factories, etc. in this situation, the main problem is to share the project costs between the participants. here we can draw a historical parallel. during the great depression, in france the classical model of concession was modernized. two systems appeared: a ppp-based concession system and a system whereby the infrastructure was created directly by the government. at that time, in france a large number of infrastructure objects were developed under concession agreements between the government and a public corporation specifically created for the construction and operation of infrastructure facilities (grimsey and levis, 2005). however, the outwardly similar ppp types had evolved under different circumstances. in france the government struggled with the economic crisis and pursued a proactive industrial policy. in russia the government is looking for effective partnership arrangements for the economic development of lowdeveloped areas with a promising mineral resource base; however, russian businesses do not trust the government and do not work unless they own the assets. they do not understand how and on what terms they can finance properties owned by the state. the best that they have agreed to is the participation in large production infrastructure projects whereby private companies build private properties and the government builds public facilities. the major infrastructure projects supported by the investment fund are implemented according to the above scheme. the federal investment project on the integrated development of the lower angara region includes infrastructure projects and the construction of the boguchansk hydroelectric power plant (hpp), an aluminum smelter, and a pulp and paper plant. the support of the investment fund is to come in the form of co-financing of the investment project on negotiated terms through construction of the hpp and infrastructure facilities that will become the property of the russian federation (where the state unreasonably took a lion share of environmental costs connected with the construction of the reservoir). another such project is the one to create the transport infrastructure for the development of mineral resources in the southeast of the transbaikal region in siberia. in this project, the government builds the naryn–lugokan railway line to provide access to a cluster of prospective fields to be developed by a private investor (oao norilsk nickel). both of these projects are being implemented at different pace and with different degrees of success. in the lower angara region, the hpp construction is almost complete, but the projects financed by the private investor lag behind the planned schedule (aluminum smelter and pulp and paper plant). in transbaikal, 3 years after the project was launched, the private investor—oao norilsk nickel—declared its intention not to fulfill its obligations under the project statement. so, both the company’s competence and the need for further budget funding of the railway construction were called into question. indeed, why build a road if there is nothing to carry? as a result, the government builds only a part of the railway up to the station gazimursky zavod (223 km instead of 425). this infrastructure provides access to two fields only (bystrinskoe and bugdainskoe polymetallic deposits) out of those originally planned under the project. 3. decision-making tools the above examples suggest that the first experience of russian ppps in the production infrastructure sector with the support of the investment fund was not very successful. this result is due not only to the transition nature of the economy and the lack of the necessary market institutions. specific transaction costs (tc), (wallis and north, 1986) incurred in: 1. identification and establishment of property rights on constructed facilities; 2. finding compromise solutions acceptable to both parties: the investor and the state; 3. unforeseen challenges due to inadequately developed and often ineffective institutions regulating the relations between private and public interests; 4. unforeseen challenges due to uncertainty. how can be taken into account costs this kind of? practical experience suggests that for this decision-making process, a comprehensive evaluation of the ppp project and used schemes of project financing. in the international practice, there are tools allowing enterprises created within ppp arrangements to raise finance and take out loans for major investment programs. these tools use sophisticated schemes of financing, cross-guarantees, and risk redistribution. world experience shows that the project financing scheme is the most effective form of long-term funding of major ppp projects. the most important feature of project funding is that the project itself, its working capital, (lavlinskii, 2010) and investment is guaranteed only by the economic effect of the project. that is why commercial banks have recently started to withdraw from net lending for infrastructure projects and prefer project financing schemes, which allow them to share risks with other institutional investors. the government performs various functions glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017406 in ppp projects, which often determine the project success. the government itself finances them in part, provides an organizational framework, and reduces the risks by guaranteeing the repayment of loans, procurement, and supplies at negotiated prices. how to create an effective ppp arrangement? the involvement of a large number of stakeholders in the development of a ppp project places high demands on project organization and management. it is already at the project development stage that an a priori assessment is required for the ppp model by forecasting the implications of the project. this assessment is not possible without a comprehensive analysis of all the details of project financing and interactions between the government, banks, and private investors. an analysis of the feasibility studies submitted to the investment fund for the ppp projects in the lower angara region and transbaikal reveals insufficient project preparation (lavlinskii, 2010; glazyrina et al., 2013; glazyrina et al., 2014). in these materials the main focus is on the subprojects implemented by private investors. there are independent economic assessments for these subprojects, but no comprehensive assessment for the entire project, which would take into account the contribution of the investment fund to the infrastructure development. the quality of preparation of psa projects is roughly the same. although in the 1990s a psa support department was established within the russian economic ministry, the quality of the sakhalin-2 psa leaves much to be desired. an analysis of the main psa parameters forming the ratio between “cost oil” and “profit oil” suggests that no comprehensive expert assessment of the project implications was carried out at the time of signing the agreement. however, a psa, like any fiscal scheme, is a fairly complex algorithm with a set of parameters whose roles and effective ranges depend primarily on the features of the economic environment. the psa efficiency indicators fundamentally depend on a specific combination of key parameters, i.e., the project financing scheme, costs eligible for recovery, depreciation, bonus program, and royalty and uplift rates. however, the materials on the sakhalin 2 psa contain no economic and mathematical analysis. neither there are any forecasts regarding the project outcomes at a particular combination of the psa parameters. the above excursion to the modern history of the russian ppp models in the mineral resource sector indicates that political arguments tend to dominate in the decision-making process. the socioeconomic and environmental implications of this approach initially fade into the background; however, it is these implications that eventually lead to the breach of partnership relations and project suspension. the available experience shows that designing an efficient ppp model for the russian mineral resource sector would require specialized economic and mathematical tools for the development, assessment, and support of ppp projects. it is only these tools that can provide a comprehensive socioeconomic and environmental assessment of a ppp project and its funding scheme. for the first of the above ppp models, i.e., psa, the problem has largely been solved. there is a series of works on economic and mathematical modeling of psa projects (david, 1996; johnston, 1994). the russia-specific modeling tools and techniques to develop the terms of psas for oil and gas projects are described in (lavlinskii, 2007). this is sufficient to support the decisionmaking process in designing and evaluating a specific psa model. for the second form of the ppp (russian industrial and infrastructure projects financed from the investment fund of the russian federation) modern world experiences are virtually absent. it is difficult to find international counterparts for the production infrastructure ppp projects financed by the investment fund of russia. this circumstance necessitates the creation of special modeling tools for decision-making in the development, assessment, and support of these projects the subsequent sections of this paper are devoted mainly to the description of one of the possible approaches to this problem. this approach, which has been tested in real-life conditions, may provide ex ante evaluation of tc and therefore be useful for natural resource-based regions that consider the use of ppp mechanisms in designing a program for the development of their raw material base. 4. ppp model assessment 4.1. general concept in the majority of natural resource-based regions of russia, most of the economic potential is concentrated in the natural resource sector. industrial development can be achieved by dealing with the “infrastructure bottlenecks,” i.e., electricity shortage and the lack of roads and transport communications. the project economics of a private investor is, as a rule, very sensitive to the availability of roads, bridges, power lines, etc. in the region and, in some cases, cannot allow for extra costs other than those planned at the beginning. so, here comes the government, which helps the private investor out by taking responsibility for a part of the general-purpose infrastructure projects. the thus created infrastructure can be used not only during the implementation of the private investor’s projects but also in the future. it facilitates economic development through new investment projects that will come to the region in the future as a result of its serious competitive advantages over the other areas, primarily in terms of infrastructure development and reduced project costs. large investment projects in the natural resource sector, which are most typical of the siberian and eastern regions of russia, should take into account not only the global economic efficiency considerations but also the environmental impacts of the project activities. that is why the search for a long-term compromise between economy and environment should be used as a way of managing large-scale projects with the participation of private investors and the state. being part of a partnership, the state can take over a part of the costs related to the environmental losses caused by the implementation of investment projects. this is the general idea underlying the coordination of interests within the conceptual ppp model, which should be transformed into economic and mathematical tools of regional planning. these tools are essentially a forecasting model used to assess glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017 407 the consequences of a regional development program based on a particular ppp model. the procedure for an assessment of a ppp model is as follows. considering a mineral resource base development program as a set of long-term investment projects, the state seeks to achieve a compromise between the interests of all the stakeholders. the assessment of a field in terms of economic rent plays an important role in the selection of projects by the investor. it characterizes the project profitability and is based on the net present value npv of the project: npv= ( ) / ( )d r et t t t t = ∑ − + 1 1 , (1) where, dt and rt are the sales revenues and the technological costs of the project (capital investment, operational costs, and labor remuneration) in comparable prices in year t; e is the discount rate; and t is the field development period. the investor’s tax payments are not included into the technological costs rt, since they are considered as part of the project’s positive cash flow. npv reflects the general efficiency of the project and corresponds to the discounted cash flow of the state and the investor taken together whereby the state plays a passive role of resource owner and recipient of fiscal revenues according to a particular tax system. a proactive position of the state, which is associated with the use of ppps, has a profound effect on the situation. being part of a ppp, the state is involved in the financing of capital investment by building a part of the infrastructure needed for the technological project and implementing a range of environmental activities. in this case, a relationship similar to (1) may also be constructed for the state (npvst). it uses a longer time horizon ts and a discount rate est that is considerably smaller than that of the investor: npv vdi r tax est st t st t t st t t ts = − + += ∑ ( )11 (2) here the costs of the state tstr are the capital investments in the infrastructure and environmental activities; the state revenues include not only the tax payments taxt arising from the project but also the non-project revenues vdst t generated by the development of local infrastructure. the key efficiency indicator for the investor is npvinv, an analog of (1), which is characterized by reduced capital costs due to the state participation and by additional costs, i.e., tax payments: npv d r r tax einv t t st t t inv t t t = − − += ∑ ( ) ( )11 , (3) the investor is interested in a project if npvinv ≥ 0. the state implements the raw-material base development program as an integrated project consisting of a set of investment subprojects within a ppp model. within this project, the state builds infrastructure facilities and finances environmental activities. it receives tax revenues from all the investment subprojects and non-project revenues as a result of the development of local infrastructure. for such an integrated project, we can derive the state’s integral npvst int , which is defined by the selected ppp model (cost-sharing arrangement) and is similar to (2). a compromise between the interests of all the stakeholders (the state and investors) is achieved if {for each investor npvinv ≥ 0} and { npvst int ≥ 0}. (4) thus, to choose of an effective raw-material base development strategy, one needs to take the following steps: 1. conduct an efficiency assessment of the projects. 2. define the range of objects with npv ≥ 0. 3. develop a state infrastructure and environmental construction program implementing the selected ppp model and ensuring the fulfillment of condition (4). 4.2. tools for ppp model assessment the key role in designing the tools to assess a raw-material base development program using a specific ppp mechanism is played by a model describing the implementation of an investment project. this model makes it possible to assess the profitability of a project and its implications for the region within a given scenario of external conditions, a part of which are determined by the chosen ppp model and project financing scheme. the core idea is to use a computer model describing the operation of an enterprise created by the investor to implement the project. the model helps generate a forecast for the trajectory of the key economic indicators depending on a variety of factors. the formal scheme of the model is given by a system of recurrence equations: x(t)=f(x(t-1),p,e(t),pppm), на t=1.,t, (5) where, p is the original technological project; e(t) is the forecast for the external operational conditions; and x(t) is the vector describing the state of the enterprise at the end of year t. the components of x(t) determine the production capacity and output, the mining of ore, oil, and gas, the results of their processing, the loans and interest paid under the chosen project financing scheme, tax payments by category, and financial and economic indicators showing the performance of the enterprise in year t. the applied ppp model pppm directly affects the project configuration because a part of the production infrastructure and necessary environmental projects are implemented by the state. the system’s operator f is formalized as a set of simulation algorithms describing the functioning of individual units within the investor’s enterprise. the model describes the interactions between the units and the decision-making routines to generate a forecast for the dynamics of the resulting material and financial flows of all kinds. an example showing the interactions for a typical mineral resource project such as the development of a polymetallic ore field can be found in (lavlinskii, 2008). once a ppp model pppm is chosen (exogenously) by an expert and the initial state of the investor’s enterprise x(0) is described, glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017408 the recurrence equations in model (5) are used to derive the enterprise development trajectory {x(t), t = 0,…, t} for each scenario {e(t), t = 1,…, t}. for field development projects that are most typical of the natural resource sector, model (5) allows the construction of annual charts of revenues and expenses for the state and the investor and the assessment of the economic rent from the field npv and the corresponding npvinv and npvst. the rent sharing proportions between the participants are analyzed to determine the degree of compromise between their interests and evaluate of the chosen ppp model. in a mineral resource region, the state generally deals with a set of fields and a group of potential investors, each of which having a specific technological project that can be implemented under specific conditions. in this context, the ppp mechanism is a basic element in a raw-material base development program. the development of such a program involves the use of special tools based on territorial planning and forecasting models with a strong emphasis on the issues related to raw-material base development. thus, the decision-maker cannot do without field development models, which are the core of the procedures to assess a specific partnership mechanism as part of the overall development strategy. how can such an assessment be made? the proposed technology is based on understanding the regional development process as a set of investment projects and a particular ppp model used to harmonize the participants’ intentions. hence, a raw-material base development program can be treated as a bunch of investment projects (bip), i.e. a set of projects “bundled” by a given ppp model. a general scheme of the model is shown in figure 1. the basic element of the bunch model is the investment project model (5) within a given ppp mechanism. for field development projects, one can use the standard models for an oil-and-gas complex and a mining factory (lavlinskii, 2008). the road, power line, hpp, etc. construction projects are standard infrastructure projects (figure 1). an hpp is the most complex object in the group; it requires a special model with a dedicated environmental block describing the preparation, construction, and operation processes. in the general case, the environmental block contains a set of environmental project models to implement a range of compensatory actions such as resettlement from the flooding zone, protection from flash flooding, protective measures against ice weakening, etc. the road and power line models describe the construction and operation (maintenance and service) processes. they use the general investment project model (5) supplemented by a detailed project financing scheme. the input data of the bip model are as follows: 1. a set of investment projects implemented by the private investor; the investor’s choice depends on what the state offers in terms of infrastructure construction. 2. a set of infrastructure projects implemented by the state; the state’s choice depends on efficiency estimates based on the long-term prospects of regional development. 3. a list of environmental projects necessary to offset the environmental losses caused by the implementation of the investment projects; the sharing of commitments for environmental projects between the private investor and the state is not specified and has to be derived from the ppp costsharing arrangement. 4. the cost-sharing arrangement defining the ppp model. the output of the bip model is a forecast of the revenues and expenses of the private investor and the state during the implementation of the entire set of projects within the assessed cost-sharing arrangement. these data allow one to assess the efficiency of the selected ppp model and the degree of compromise of interests provided by positive npvst int and npvinv. thus, the core of the proposed ppp assessment technology is a forecasting model allowing the expert to evaluate the ppp mechanism and uncover its internal imbalances (negative npv of some of the participants). a “manual” adjustment of the cost-sharing arrangement and repeated application of the model procedure make it possible to find a partnership mechanism ensuring a compromise of interests1. 4.3. examples of ppp model assessment the possibilities of the proposed approach are illustrated using the above described infrastructure projects implemented with the participation of the investment fund of russia. the central object of the lower angara development program is the boguchansk hpp investment project. the planned capital investment in construction is 70 billion rubles, most of which is to be covered by debt financing. the 10-year construction period is planned to provide 3000 mw of capacity by 2016. financing the infrastructure projects and, in part, the hpp construction, the state needs to know the long-term efficiency of the projects. in this case, environmental considerations and adequate tc evaluation play a major role; it is here that the problem of finding an efficient ppp mechanism comes to the fore. thus, the hpp construction and operation entails costs due to the population resettlement from the flooding zone, compensation for agricultural production losses, implementation of socioeconomic programs, etc. these costs are estimated to be at least 18 billion rubles, but are beyond the scope of the activities financed by the investor within the hpp construction project. who has to cover these costs? figure 2 shows estimates for the implications of the various strategies for sharing the above-mentioned environmental costs for the boguchansk hpp project from the standpoint of the participants’ return on investment. the estimates were derived using the bip model; they show that positive estimates overlooking the environmental costs change substantially as soon as the costs of compensatory measures are factored in. if the private investor bears all the environmental costs, the investor’s economic incentives for implementing the project are undermined. in this case, the state is required to provide partnership assistance, e.g., through an equal cost-sharing strategy. 1 the basic mathematical models described in (lavlinskii, 2008; glazyrina et al, 2014). glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017 409 figure 1: general scheme of the bunch of investment projects model glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017410 this would adversely affect the state’s efficiency indicators both for the hpp project and the lower angara program as a whole, but would provide a positive npv for the private investor. within the third scenario, the ppp model whereby the state finances a part of the construction of the boguchansk hpp and half of the environmental costs yields a satisfactory compromise between the participants’ interests. thus, with a reasonable distribution of costs, it was possible to find an economically viable solution. in reality, however, during the construction of the hpp the investor and the state was made not all environmental and social obligations. the construction of the reservoir was constructed with significant environmental violations. accumulated damage (glazyrina et al., 2006) had not been taken into account. property losses of the population was not fully refunded. although the russian laws provide for the rights of citizens in such conflicts, the relevant institutions in russia are weak and inefficient. so the public tc for these purposes are extremely high. rural residents could not afford such costs. as a result, their interests were sacrificed to the interests of the owner of hpp. another case illustrating the ppp practices in russia is that of transbaikal region. here, construction works are being completed on the naryn–lugokan railway line (up to the gazimursky zavod station) for a total cost of about 32 billion rubles; the project is financed by the investment fund of russia. this opens up prospects for launching the first phase of the project to create the transport infrastructure for the development of mineral resources in the southeast of the transbaikal region and develop the bystrinskoe and bugdainskoe fields. the chosen ppp model allowed oao norilsk nickel to build the key transport infrastructure element mainly through the federal budget and create an economic background to launch the field development projects. environmental issues associated with the project would involve substantial additional costs (zabelina and klevakina, 2012). how good was the choice of a ppp model for the bugdainskoe and bystrinskoe fields? this question can be answered by applying the bip model, which allows one to assess the two projects from the point of view of the investor as well as the regional and federal budgets under different ppp arrangements. in the model experiments, the state’s participates in the infrastructure project by sharing with the investor the construction costs of the railway line. the state’s participation in these costs can range from 0 to 100%. the zero level corresponds to a situation whereby the investor independently finances the infrastructure project (the target object of the ppp). the 100% level means that the construction is financed from the federal budget. in the subsequent numerical experiments, we consider 11 levels of state participation with a step of 10%. we consider three product price scenarios: optimistic (market 1), inertial (market 2), and pessimistic (market 3). the scenarios are based on a retrospective analysis and retain the general upward trends in the raw materials sector, which have been observed for the last decade. our calculations show that the minimum number of process stages in the field development projects predetermines the maximum level of sensitivity of performance indicators to a change in the market conditions. an analysis of figure 3 suggests that the irr for the federal budget financing of the railway construction falls sharply with the increase in the main ppp parameter, i.e., the state’s share in the capital investments for this infrastructure. the state is in general much less sensitive; nevertheless, its irr becomes less than the modeled 5% discount for adverse market conditions if the state participation is more than 75%. but this irr is enough to provide positive npv2. within scenarios (market 1) and (market 2). for adverse market conditions when the level of state costs exceeds 75%, state’s npv becomes negative and leads to a violation of conditions of balance of interests (4). the calculations show that even under the most favorable price conditions, at least 80% state participation is required for an investor with a discount of 15% to invest in the bystrinskoe and bugdainskoe fields. any other market situation pushes the investor into the domain of negative npvs (figure 4). any other situation puts the investor in negative npv; inertial scenario of market prices does not provide the required level of profitability (figure 4), and in pessimistic scenarios the irr does not even exist. any other situation puts the investor in negative npv – inertial scenario of market prices does not provide the required level of profitability 2 5% adopted in russia the discount rate of the state. figure 2: environmental cost sharing strategies for the boguchansk hydroelectric power plant project and the participants’ return: environmental costs are paid by the investor (ppp1); environmental costs are shared equally between (ppp2); and environmental costs paid by the state (ppp3) glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017 411 (figure 4), and in pessimistic scenarios, realized in practice, the irr does not even exist. thus, the evaluated fragment of the transbaikal mineral resource base development program using a ppp whereby the state builds the naryn–gazimursky zavod railway line ensures a positive return for the state in a wide range of market conditions. within the initial technological projects for the development of the bystrinskoe and bugdainskoe fields, the chosen ppp gives a sufficient return for the investor under favorable market conditions only. to achieve greater price stability for the field development projects, they should plan a greater number of technological process stages. how the project has been implemented in practice? the decision, which was adopted in the construction of the railway line, was the fact that 75% of the costs would be provided by the state. the calculations show that in this case, under favorable market conditions, the investor’s irr for both projects is greater than 15%, which can be considered acceptable. under conditions of the inertial scenario of market prices, the ppp project becomes marginally profitable for the state and for the investor. under the most adverse conditions of the pessimistic scenario, realized in practice, the investor loses interest in the project, and the state still may consider the level of irr is acceptable because it is the beneficiary of the project not only in connection with mining. new railways can significantly improve business conditions and quality of life of the local population. the decision to launch the project was made in 2007 and by 2012 the railway was built. however, the global crisis of 2008-2009 and figure 3: state’s internal rate of return for the public-private partnership project in the construction of the railway line naryn – gazimursky zavod figure 4: investor’s internal rate of return for the bystrinskoe and bugdainskoe fields glazyrina and lavlinskii: transaction costs and prospects for public-private partnership in the russian mineral resourse sector international journal of economics and financial issues | vol 7 • issue 1 • 2017412 subsequent fall in metal prices has made changes in the plans of the investor. the timing of construction of enterprises was postponed for a few years. built road was unclaimed. the current situation is an apparent result of underestimation of tc. in the design and construction of the road basic tc has been paid from the investment fund of russia. but after construction it was necessary to determine ownership rights to the constructed object and the right to use it. however, the costs for this purpose was not provided for in the project budget, and the railroad more than 2 years was “no one’s object.” state institutions in russia are not aimed at achieving long-term goals, so no one government agency was interested in spending the budget until the start of field development. the cost of maintaining the railroad was not needed and the investor company, as the construction of mining and processing has not started yet. local people were interested in the work of the road but they did not have to her any rights3. as a result, the railroad became a focus for local criminal groups, which have destroyed it in order to sell the metal on the black market. such a market exists in the border regions for more than 20 years. its stability is related to the ability to export the metal in neighboring china. the high level of corruption makes the process of legalization of this product is relatively simple, and tc that legalization is insignificant compared with criminal income. the decision about transfer of rights on the use of the railway to the investor company was adopted only in 2015. according to expert estimates, the additional costs in connection with the need to restore damaged areas are roughly 16% of the total expenses of the investor on the construction of the road. 5. conclusion it can be concluded from the retrospective analysis of the development of the ppp institution in russia that it is only beginning to shape. although the government pays much attention to the development of the mineral resources complex, its attempts to stimulate the use of the various ppp models are not reinforced by economically sound administrative decisions. the political losses due to the failure of the psa and ppp projects financed by the investment fund of russia are big enough for the government to become seriously concerned about decisionmaking in this sphere. the proposed approach to the development of economic and mathematical tools to design and evaluate ppp models (with all relevant tc) may address a substantial part of these issues. the bip model takes into account all the features of the mineral resources complex and project financing details when evaluating a particular ppp arrangement. having been tested in real-life contexts, the model can be used already at the decision-making stage to predict situations involving the risk of partnership termination and project suspension. 3 financial resources for the railway construction were provided from the federal state budget. there is a “budget trichotomy” in russia: strict division between budget levels (federal, regional and local). the assessment of the institutional environment at all stages of implementation of projects and related tc deserves a special attention. our examples show that the quality of institutions can have a significant impact on the overall result: in the context of economic efficiency and in terms of implications for the welfare of the local population. existing russian institutions of environmental control was powerless under the pressure of large economic agent who performs the project development of the lower angara region, with the state support. social and environmental rights of local residents are protected by the constitution of the russian federation, but in the absence of low cost instruments of conflict resolution (ostrom, 1999; 2009) the level necessary for the judicial protection of the rights of tc is irresistible to relatively poor rural population. only a few people of the thousands appealed to the court. an important factor was the distrust of the judiciary because of the reputation of the courts. people don’t want to waste time, money, health, understanding that win in court against the powerful companies and the state is unlikely. in the case of the mineral cluster in the south-east of the transbaikal region in siberia institutional gap was the reason for the untimely specifications of the rights of ownership and management, which led to additional costs and an overall efficiency reduction of the project. the results of the analysis of the development of the ppp institute in the russian mineral complex say about the important role of tc. we offer modeling tools that allow to analyze the expected results of the project under various exogenous scenarios (macroeconomic and market conditions, external shocks etc.), for practical purposes needs to be supplemented with the forecast estimates dynamics of the institutional environment. the transformation of institutions is necessary for decreasing tc, although it is not always feasible in the short term (mccann, 2013). however, changes at the level of legal rules and management practices, that is, the second and third level in williamson’s classification (williamson, 1998), can be implemented in a reasonable period of time and require relatively little tc. overcoming “budget trichotomy in russia” is one of priorities for institutional development. it is important that the necessity of these institutional reforms to be recognized, and the corresponding tc to be provided in the budget: “institutions do not come for free” (marshall, 2013). 6. acknowledgments the article presents the research results in the framework of the russian scientific foundation project #16-18-00073. references bennett, j., iossa, e. 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(1964), a history of russian railways. london: g. allen and unvin. williamson, o.e. (1998), transaction cost economics: how it works; where it is headed. the economist, 146(3), 23-58. zabelina, i., klevakina, e. (2012), environmental and economic aspects of natural resource use and problems of cross-border cooperation in regions of siberia. problems of economic transition, 55(7), 39-48. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(3), 1262-1269. international journal of economics and financial issues | vol 6 • issue 3 • 20161262 the influence of sustainability report disclosure as moderating variable towards the impact of intellectual capital on company’s performance anak agung gde satia utama1*, reza renaldi mirhard2 1fakultas ekonomi dan bisnis, universitas airlangga, surabaya, indonesia, 2fakultas ekonomi dan bisnis, universitas airlangga, surabaya, indonesia. *email: gde.agung@feb.unair.ac.id abstract the purpose of this paper is to examine the influence of sustainability report (sr) disclosure as moderating variable towards the impact of intellectual capital (ic) on company’s performance based on 21 companies listed in indonesia stock exchange and listed in national center for sr chapter indonesia for the period 2010-2013. this research used pulic’s model of value added intellectual coefficient (vaic) to determine the ic of companies. company’s performance is presented as return on assets (roa), return on equity (roe), and revenue growth (rg). the required data to calculate the ic and company’s performance was obtained from the annual reports while sr disclosure was obtained from sr. results from linear regression analysis show that vaic has positive effects on roa and roe. it means high roa and roe companies are associated with more vaic. aside from that, vaic does not have effect to rg. result from moderated regression analysis also show that sr disclosure has positive effects on roa and roe, but does not have any influence on rg. sr disclosure becomes pure moderator on roa while become quasi moderator on roe. it means sr disclosure is only as moderating variable on roa while it can be both independent and moderating variable on roe. keywords: intellectual capital, company’s performance, sustainability report, value added intellectual coefficient, moderating variable jel classifications: g32, m41 1. introduction in calculating the value of a company, analysts used the traditional measurement to capture the value which was only relying on the measurable things. they measured the company value based on stock price, size, net assets, etc., there were many argues came to the surface when discussing about this traditional measurement, because this measurement did not include the intangible resources that cannot be measured. their system to measure the company value was not wrong, but it was inadequate enough to represent the real value of the company. we all know that in financial statement, we can find the value of intangible assets down there, but it is not enough to determine the value of intangible resources. according to cordazzo (2005. p. 442), the traditional system to value a company do not consider about the dematerialization of economic activity, the knowledge society, the service-based economy, the technological advances, and such other macro and micro events. intellectual capital (ic) can help a company to disclose its intangible resources. oliveira et al. (2010. p. 575) stated that to improve transparency, legitimize status, and enhance reputation, a company needs to disclose its ic. the ic disclosures can be found in annual report, sustainability report (sr), and company website. ic could also straighten the information gap between the management and the shareholders. abhayawansa and guthrie (2010. p. 217) stated that there is a connection between the ic with the market value of equity and company’s performance. to add deeper understanding about ic, veltri and silvestri (2011. p. 241) stated that the level of knowledge mainly in competence and skills, high degree of technological innovation, and a high degree of interaction between personnel and clients are the major trigger for a good company’s performance based on the level of service and assistance provided to the clients. utama and mirhard: the influence of sustainability report disclosure as moderating variable towards the impact of intellectual capital on company’s performance international journal of economics and financial issues | vol 6 • issue 3 • 2016 1263 widiyaningrum (2004. p. 24) concluded that the awareness of the importance of the ic in indonesia is really low. it is understandable seeing that there are many industries in indonesia are being dominated by the physical investment industries. that’s why the point of seeing the potential company needs to be changed, the shareholders and investors must consider about the ic of a company. ic disclosures can be found in the sr in which the stakeholders are the common readers, some of additional information of ic might be found in annual report and company website. ic disclosures would be a very good motivation to satisfy the stakeholders. according to global reporting index or known as global reporting initiative (gri), a sr is a report published by a company that consists about the economic, environmental, and social impacts caused by its activities. a sr also consists about the organization’s values and governance model, and demonstrates the relation between its strategy and its commitment to a sustainable global economy. it is very unfortunate to stakeholders because the rule of the disclosing sr is still voluntary. the increasing number of companies is happening because they want to make their operations sustainable and contribute to sustainable-related development. based on gri-3 guidelines, sr can help a company to measure, learn, and deliver their three key areas: economic, environmental, and social. those three key areas are included in the ic disclosure index based on the methods by bukh et al. (2005) and oliveira et al. (2010). that’s why the sr disclosure supports the resources of ic. as stated by wang (2008), in assessing the real value of a company, a company will have many advantages on changing tangible assets into ic. the innovation capabilities, skills, knowledge, and human resources of a company would be the great benefit for the company in the long term. by doing that, the leaders and managers also need to change the way of thinking and understanding the marketplace landscape. as a result, the investors would like to invest more their money in the high ic companies. there are some studies about the impact of the ic on company’s performance that have been done in domestic and abroad with different results. joshi et al. (2013. p. 267) explained that to measure ic, most of researchers use value added ic (vaic). vaic produce comparative analysis between companies in many different sectors to obtain the valid measurement of ic, because vaic has been robustly tested and been used internationally. for the studies of the relation between the sr disclosure with ic, oliveira et al. (2010) stated that there is a significant effect of the sr disclosure with the ic. it appears that gri guidelines have helped improved the ic in a company. they also stated that companies can acquire an important intangible element a good reputation to stakeholders by building positive image in sr. 2. literature review 2.1. ic the research of ic is growing from year to year, most of the experts say that ic is very important to company and can create the competitive advantage. managing the intellectual resource properly will support the company to achieve its goals. while ic is important, the term of ic itself has been defined differently by many researchers (mondal and ghosh, 2012. p. 516). generally, the term of ic is commonly used to explain the intangible assets or intangible resources of the company. although ic are not generally counted and listed in the balance sheet, they can support the company to success and deal a great impact on its performance. mondal and ghosh (2012. p. 517) explained that “researchers categorized all non-physical assets and resources of an organization into several components. popular components include human capital (hc), structural capital (sc), and relation or customer capital (table 1).” according to joshi et al. (2013. p. 267), hc is defined as the knowledge, qualification, and skills of employees which can be enhanced with the training. ghosh and mondal (2009. p. 372) recognized hc as the most important and the largest intangible assets in a company. hc can be improved if the company can manage and develop the knowledge, competence, and the skills of the employee efficiently. by improving the hc, it means that the company performance will also be improved. joshi et al. (2013. p. 267) defined sc as the knowledge created by the company and cannot be separated from the company. it includes the database, procedures, routine, systems, company’s structures, cultures, and others. sc supports the hc to do their job, hence that’s why the sc and hc are related each other. mondal and ghosh (2012. p. 517) defined relation capital as the resources that are acquired by doing the external relationship, such as relationship with customers, suppliers, or other stakeholders. in other words, relation capital is the knowledge that is attached in the external relationship that need to be maintained and can affect the company’s performance. 2.2. vaic vaic was developed by pulic (1998) in order to measure the ic of a company. it has been used in the investigation of the instruments table 1: list of intellectual items on sustainability report n ic items hc 1. employees characteristics 2. employees training 3. employees skills 4. employees wellness oc 5. intellectual property 6. information systems 7. corporate culture and management philosophy 8. management processes 9. research and development rc 10. distribution channels 11. business collaborations 12. university and research centre collaborations 13. company reputation 14. customers 15. suppliers 16. financial relations source: cinquini et al. (2012, p. 543), hc: human capital, oc: organizational capital, rc: relational capital utama and mirhard: the influence of sustainability report disclosure as moderating variable towards the impact of intellectual capital on company’s performance international journal of economics and financial issues | vol 6 • issue 3 • 20161264 of ic relationship. it offers the measurement of the company’s efficiency to manage their ic by looking at their all resources, such as physical, financial, and ic. the advantage of using vaic according to clarke et al. (2011. p. 507) is all instruments of vaic can be relatively easily obtained from the annual report and it is quantifiable. chan (2009. p. 10) explained the advantages of vaic are following: 1. vaic instruments can be acquired in annual report and those are quantifiable. as a result, the quantitative method can be done without any involvement of subjective valuation like the scoring or scaling. it also helps the computation and analysis of a large sample size. 2. it allows the stakeholders and shareholders to capture and compare the ic instruments in order to value the company’s performance by providing the relevant, useful, and informative indicators. 3. by using the financially oriented measurement, any indicators, connections, or ratios calculated can be used to compare with the traditional financial indicators. it could provide the advance analysis about the financial measurement. 4. it uses the relatively simple and easy index and coefficients computation procedure, hence can be easily to understand by people who already know how to read the traditional accounting information. 5. it creates a way to make the measurement of ic become standardized. the indicators of ic can be used for the comparison across nation. 6. it allows gathering the indicators from the public financial statement so it is reliable and available. 7. it delivers the measurement of ic that is getting along with the theory of stakeholder and resource based by using a value added (va) approach. 8. it values employees and hc as the key source of ic, hence congruent with the definition of ic in the most literatures. 9. it is already used by most researchers in many countries, like hongkong, taiwan, malaysia, and singapore. by looking from that, ic research by using vaic is already proven its credibility. 2.3. sr disclosure sr is a voluntary report issued by a company separately from the annual report and support a company to disclose its information that integrate social, economic, and environmental impacts on business. gri defines sr as a practice of measuring and disclosing the company’s activities as, responsibility to both internal and external stakeholders in order to achieve sustainable development. beside as the support of sustainable development, this report can disclose everything that cannot be disclosed in annual report. sr can be the media for both internal and external stakeholders to provide information about the accomplishment of company to be responsible of its activities. sr can enhance the information about the company that cannot be disclosed in annual report. it can contain what the company needs to report so the stakeholders can know what’s going on inside. we can find some parts of ic can be received from the sr. 3. research methodology 3.1. development of hypotheses 3.1.1. the relationship between ic and company’s performance resource-based theory explains that resources can create the advantages for the company. wernerfelt (1984. p. 172) stated that resources could be anything and could be from both tangible and intangible assets. anything here means that not only tangible and intangible assets, but also the intangible resources that appear to have potential to create va for the company. those intangible resources can be said as ic of company. hypothesis 1: vaic is positively related to return on assets (roa). hypothesis 2: vaic is positively related to roe. hypothesis 3: vaic is positively related to revenue growth (rg). 3.1.2. the relationship between sr disclosure and ic one of main purposes of companies in issuing sr is to disclose the additional information. that additional information will help company to build their transparency to their stakeholders hence will result in increasing reputation-related ic. according to ic definition, ic consists of three instruments; those are hc, sc, and relation or customer capital. the information about those instruments can be found in both annual report and sr. while annual report shows the amount of them, sr shows the explanatory details. gri provides the guidelines how to compile good sr. gri guidelines have the similar instruments like the ic instruments. oliveira et al. (2010. p. 590) stated that publicly listed companies were found to use sr to deliver ic information to stakeholders. those companies tried to improve relationship with external stakeholders by disclosing ic in sr. hypothesis 4: sr disclosure is positively related to the impact of vaic on roa. hypothesis 5: sr disclosure is positively related to the impact of vaic on roe. hypothesis 6: sr disclosure is positively related to the impact of vaic on rg. 3.2. dependent variables 3.2.1. roa financial performance in this research will use roa as one of its indicators. roa is one of the profitability ratios that can be used to measure the company performance in generating the profit from the total assets used. needles et al. (2010. p. 204) stated that roa reflects the benefit of both the profit margin and asset turnover. profit margin doesn’t calculate the total assets, while total assets turnover doesn’t calculate the sales profitability. the formulation of roa (clarke et al. 2011): roa = profit before tax/average total assets (1) 3.2.2. roe roe is a ratio to measure the company’s efficiency in generating the profit from shareholders equity. needles et al. (2010. p. 204) stated that roe can help investors to know how much they have earned in the business. the formulation of roe (clarke et al. 2011): utama and mirhard: the influence of sustainability report disclosure as moderating variable towards the impact of intellectual capital on company’s performance international journal of economics and financial issues | vol 6 • issue 3 • 2016 1265 roe = profit before tax/average common stock equity (2) 3.2.3. rg rg is a calculation of company’’s current year revenue compared to prior year revenue. the increasing value of rg can be a good signal for a company to grow even bigger. the formulation of rg (clarke et al. 2011): rg = (current year revenue/prior year revenue) 1 (3) 3.3. independent variable in this research, researcher uses vaic as an independent variable. pulic (as cited in mondal and ghosh, 2012) created the measurement basis for the independent variable in the present study. management, shareholders, and other relevant stakeholder can monitor and evaluate the efficiency of va by looking from a firm’s total resources and each major resource component by using vaic. a company with a higher vaic means that they can manage their all available resources to create a higher value creation. in order to calculate vaic, the va of a company need to be calculated first. this following algebraic equation is used by firer and williams (2003), ghosh and mondal (2009), mondal and ghosh (2012), and clarke et al. (2011): va = ni+t+dp+i+w (4) where: ni=net income after tax t=taxes dp=depreciation i=interest expense w=total employee expenses otherwise, as stated by pulic (as cited in mondal and ghosh, 2012), va can be calculated by sum up the operating revenues then deduct it by operating expenses (materials, maintenance, other external costs). vaic consist of three efficiency measurements, the first one is hc efficiency (hce). hc represents the value of the employees. it consists of their skills, experiences, productivity, and knowledge (clarke et al., 2011). pulic (as cited in mondal and ghosh 2012) calculates hce as following equation: hce = va/hc (5) where: va=value added hc=hc (total employee expenses) the second efficiency measurement is sc efficiency (sce). sc in ic consists of the company strategy, brand names, organizational networks, customers’ database, and patents. pulic (as cited in clarke et al., 2011) calculates sc and sce as: sc = va-hc (6) ce = sc/va (7) where: sc=structural capital va=value added hc=human capital pulic (as cited in mondal and ghosh, 2012) argues there is an inverse relationship between sc and hc in the value creation process. whenever sc contributes less in value creation process, hc will contribute more. the third efficiency measurement is capital employed efficiency (cee). clarke et al. (2011) defines cee as the efficiency of ic that hce and sce fail to capture. cee shows how much the creation of va by spending the money on ce. mondal and ghosh (2012. p. 517) defined ce or relation capital as the resources that are acquired by doing the external relationship, such as relationship with customers, suppliers, or other stakeholders. in other words, relation capital is the knowledge that is attached in the external relationship that need to be maintained and can affect the company’s performance. pulic (as cited in firer and williams, 2003) calculates the cee as following equation: cee = va/ce (8) where: va=value added ce=capital employed (book value of a company’s net assets) together, all the efficiency measurements (hce, sce, and cee) bring the vaic as one. vaic can be calculated by compiling all the equations above to become a final equation: vaic = hce+sce+cee (9) 3.4. moderating variable moderating variable in this research is the sr disclosure. sr provides the non-quantified ic which really helps the company to add more value creation process. cinquini et al. (2012) defines the ic items that stated in sr that can help the companies to deliver the information of their ic. the formulation of sr index as following: sri = ∑x (10) where: x=dummy variables: 1=disclosed; 0=not disclosed. 3.5. sample the population for the study is all companies that listed in indonesia stock exchange and issued sr listed on national center for sr chapter indonesia consecutively for 4 years, which are approximately 40 companies. the documenting period is 4 years, which is derived from 2010 until 2013. several screening operation were performed on these files. the technique for sample taken is conducted with purposive sampling in order to obtain representative sample according to the set of criteria, which leave 21 companies to be the final sample of the present study. utama and mirhard: the influence of sustainability report disclosure as moderating variable towards the impact of intellectual capital on company’s performance international journal of economics and financial issues | vol 6 • issue 3 • 20161266 3.6. regression models the regression models for this research are: roa = α0+α1vaic+e (1) roe = α2+α3vaic+e (2) rg = α4+α5vaic+e (3) roa = α6+α7vaic+α8sri+e (4) roe = α9+α10vaic+α11sri+e (5) rg = α12+α13vaic+α14sri+e (6) roa = α15+α16vaic+α17sri+α18vaic.sri+e (7) roe= α19+α20vaic+α21sri+α22vaic.sri+e (8) rg = α23+α24vaic+α25sri+α26vaic.sri+e (9) 4. findings research hypotheses are tested by comparing the equation of the regression model with α significance value of α. if the value is smaller than the level of significance (5%) then there is a positive relation of each independent variable on dependent variable. equation regression models are also tested together. if the value is smaller than the level of significance (5%) then there is a positive relation of all independent variables on dependent variable. 4.1. normality test the residual notmality assumption has been fulfilled, because under the kolmogorov test stated a significance value of 0.200 which is >0.05 (α=5%). 4.2. autocorrelation test the run test result a significance value 0.272 which is >0.05 (α=5%), it can be concluded that there is no residual autocorrelation in the regression model. 4.3. heteroscedasticity test based on scatterplot output, there is no particular pattern for irregular spread points and below the axis 0 on the y axis. it means no symptoms heteroscedasticity. 4.4. regression test taken from regression test, in the future the effect of intellectual capital on companies’ financial performance will vary depending on type of industry. 4.5. discussion of results all of the data have passed the classic assumption testing, based on tables 2-4. it makes the present study can be regressed in order to know the result of the proposed models. 4.5.1. the impact of ic on roa the first hypothesis stated that the ic, identified using vaic, is positively related to roa. ic is the key of company’s performance. based on the resources based theory, ic can create something intangible resource that can trigger to the greater value of roa. based on table 5, the significance value of vaic is 0.002, which is <0.05. as a conclusion we accept the first hypothesis at significance level of 5%. it shows that ic give significant impact to the company’s roa which is one of the proxies of company’s performance. specifically, ic has positive relation with the company’s roa. so, our first hypothesis is accepted which means that the greater the degree of ic owned by companies, they will have greater roa. the result of this research is consistent with chen et al. (2005) who stated that ic is positively related to the roa. they stated that their empirical study could prove that investors would like to invest in companies that have high value of ic. in addition, companies with high value of ic could lead to better roa. although the instruments of ic are being restrained to be disclosed in annual report, investors still tend to invest in companies that have high ic in order to take the advantages of invisible value from ic. 4.5.2. the impact of ic on roe the second hypothesis stated that the ic, identified using vaic, is positively related to roe. based on table 5, the significance value of vaic is 0.008, which is <0.05. as a conclusion we accept the second hypothesis at significance level of 5%. it shows that ic give significant impact to the company’s roe which is one of the proxies of company’s performance. specifically, ic has positive relation with the company’s roe. so, our second hypothesis is accepted which means that the greater the degree of ic owned by companies, they will have greater roe. the result of this research is consistent with fathi et al. (2013) who stated that ic is positively related to the roe. they suggested table 2: one‑sample kolmogorov smirnov test model test roa roe rg vaic sri vaic. sri kolmogorov smirnov z 1.059 1.07 0.924 1.146 1.335 1.283 asymptotic significant (two-tailed) 0.212 0.203 0.361 0.144 0.057 0.074 distribution result normal normal normal normal normal normal roa: return on assets, roe: return on equity, rg: revenue growth, vaic.sri: value added intellectual coefficient table 3: durbin watson test model du durbin watson 4–du conclusion 1 1.67 2.098 2.33 no autocorrelation 2 1.67 2.096 2.33 no autocorrelation 3 1.67 2.145 2.33 no autocorrelation 4 1.7 2.218 2.3 no autocorrelation 5 1.7 2.255 2.3 no autocorrelation 6 1.7 2.16 2.3 no autocorrelation 7 1.72 2.253 2.28 no autocorrelation 8 1.72 2.273 2.28 no autocorrelation 9 1.72 2.16 2.28 no autocorrelation utama and mirhard: the influence of sustainability report disclosure as moderating variable towards the impact of intellectual capital on company’s performance international journal of economics and financial issues | vol 6 • issue 3 • 2016 1267 business might move their treatment from a whole of tangible assets to some of intangible assets. this research is also congruent with ifada and hapsari (2012) which investigated the relationship between ic and companies’ financial performance in indonesia. the results of this study were there was a positive effect of ic on companies’ roe. they also stated that in the future, the effect of ic on companies’ financial performance will vary depending on type of industry. 4.5.3. the impact of ic on rg the third hypothesis stated that the ic, identified using vaic, is positively related to rg. based on table 5, the significance value of vaic is 0.445, which is more than 0.05. as a conclusion we reject the third hypothesis at significance level of 5%. it shows that ic don’t have any impact to the company’s rg which is one of the proxies of company’s performance. so, our third hypothesis is rejected which means that the greater the degree of ic owned by companies, they will have no effect on rg. the result of this research is consistent with maditinos et al. (2011) who proved that ic does not have anything to do with the rg. they stated although ic mostly could show a growing acceptance among academics, this result would begin to raise some various arguments and critics about the usage of the ic which will lead to further research on the subject. 4.5.4. the impact of ic on roa with sr disclosure as moderating variable the fourth hypothesis stated that sr disclosure is positively related to the impact of vaic on roa. ic is the key of company’s performance. based on the resources based theory, ic can create something intangible resource that can trigger to the greater value of roa. but the impact of vaic on roa with complete disclosure of sr will result greater than the incomplete disclosure of sr. based on table 5, the significance value of vaic is 0.002 and vaic.sri is 0.049, which are <0.05. as a conclusion we accept the fourth hypothesis at significance level of 5%. it shows that ic and sr disclosure give significant impact to the company’s roa which is one of the proxies of company’s performance. specifically, ic and sr disclosure has positive relation with the company’s roa. so, our fourth hypothesis is accepted which means that the greater the degree of ic owned by companies, they will have greater roa. the result will even greater when the sr is completely disclosed. the significance value of sr is more than 0.05. as conclusion, we accept that sr disclosure in this model research’s role is as pure moderating variable. 4.5.5. the impact of ic on roe with sr disclosure as moderating variable the fifth hypothesis stated that sr disclosure is positively related to the impact of vaic on roe. ic is the key of company’s performance. based on the resources based theory, ic can create something intangible resource that can trigger to the greater value of roe. but the impact of vaic on roe with complete disclosure of sr will result greater than the incomplete disclosure of sr. based on table 5, the significance value of vaic is 0.007 and vaic.sri is 0.027, which are <0.05. as a conclusion we accept the fifth hypothesis at significance level of 5%. it shows that ic and sr disclosure give significant impact to the company’s roe which is one of the proxies of company’s performance. specifically, ic and sr disclosure has positive relation with the company’s roe. so, our fifth hypothesis is accepted which means that the greater the degree of ic owned by companies, they will have greater roe. the result will even greater when the sr is completely disclosed. the significance value of sr is <0.05. as conclusion, we accept that sr disclosure in this model research’s role is as quasi moderating variable. table 4: glejser test model variable significant model variable significant model variable significant 1 vaic 0.16 4 vaic 0.093 7 vaic 0.12 sri 0.917 sri 0.29 vaic.sri 0.06 2 vaic 0.66 5 vaic 0.176 8 vaic 0.28 sri 0.271 sri 0.99 vaic.sri 0.06 3 vaic 0.38 6 vaic 0.369 9 vaic 0.37 sri 0.542 sri 0.57 vaic.sri 0.86 vaic.sri: value added intellectual coefficient table 5: regression test model variable significant model variable significant model variable significant 1 vaic 0.002 4 vaic 0.002 7 vaic 0.002 sri 0.039 sri 0.075 vaic.sri 0.049 2 vaic 0.008 5 vaic 0.008 8 vaic 0.007 sri 0.019 sri 0.041 vaic.sri 0.027 3 vaic 0.445 6 vaic 0.459 9 vaic 0.462 sri 0.561 sri 0.568 vaic.sri 0.999 vaic.sri: value added intellectual coefficient utama and mirhard: the influence of sustainability report disclosure as moderating variable towards the impact of intellectual capital on company’s performance international journal of economics and financial issues | vol 6 • issue 3 • 20161268 4.5.6. the impact of ic on rg with sr disclosure as moderating variable the sixth hypothesis stated that sr disclosure is positively related to the impact of vaic on rg. ic is the key of company’s performance. based on the resources based theory, ic can create something intangible resource that can trigger to the greater value of rg. but the impact of vaic on rg with complete disclosure of sr will result greater than the incomplete disclosure of sr. based on table 5, the significance value of vaic is 0.462 and vaic.sri is 0.999, which are more than 0.05. as a conclusion we reject the fifth hypothesis at significance level of 5%. it shows that ic and sr disclosure do not give any impact to the company’s roe which is one of the proxies of company’s performance. our sixth hypothesis is rejected which means that the greater the degree of ic owned by companies, they will don’t have anything to do with the rg. 5. conclusions the present study attempted to investigate the influence of sr disclosure as moderating variable towards the impact of ic on company’s performance of public listed companies in indonesia, period 2010-2014. the main idea was only the impact of ic on company’s performance, but researcher wanted to add sr disclosure as moderating variable because sr disclosure, according to oliveira et al. (2010), has significant effect to the value of ic itself. the methodology used for vaic is adopted from pulic’s model and for sr disclosure is adopted from cinquini et al. (2012) model. the conclusion is the ic will be more intensive in giving positive effect to roa and roe if the sr is disclosed more completely. sr disclosure acts like a catalyst. whenever the ic is high the effect will be also high to the both roa and roe, vice versa. sr help companies to deliver the information of ic of companies which have been issued in annual report. annual and sr are helping each other to create higher value of roa and roe. sr contain useful information for the reader which are not attached in annual report hence can create something valuable for the companies. therefore, fourth and fifth hypothesis are accepted. ic doesn’t give any effect to rg as well as the sr disclosure. companies with higher ic and sr will have nothing to do with rg. rg somehow can’t truly express the company performance since rg model only calculates between current year revenue over prior year revenue. a company might have better revenue in prior year but their real performance might be better in the current year. that can be happened if we consider about the other possibilities. therefore, sixth hypothesis is rejected. overall, the empirical findings suggest that the indonesian companies should be more concerned about the value of ic and the sr disclosure one. although one of the dependent variable, rg, is failed to proof the usage of ic and sr, but other dependent variables, roa and roe, have significant effect of them. companies should intensify the disclosure of sr because of the intangible advantages that they will get, as the same as this findings of this study. as well as sr, companies should be more concerned about the ic parts (human capital, sc, and relation capital or capital employed) because they can lead to better company’s performance. 6. limitations and future studies 1. because researcher cannot find either the annual report or sr from companies that might be potentially used for the samples in this research, it is expected that the future studies can include samples that couldn’t be found by the researcher. 2. there are a lot of companies that didn’t publish sr continuously each year in indonesia. some companies already started to publish it in earlier but also stopped earlier. there are also some companies just started to publish it in recent years. it takes efforts by companies to create and publish sr, since it’s not mandatory. researcher hopes that there will be more companies that will publish sr continuously. references abhayawansa, s., james, g. 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(2010), intellectual capital reporting in sustainability reports. journal of intellectual capital, 11(4), 575-594. pulic, a. (1998), measuring the performance of intellectual potential in knowledge economy. the second mcmaster world congress on measuring and managing intellectual capital. veltri, s., silvestri, a. (2011), direct and indirect effects of human capital on firm value: evidence from italian companies. journal of human resource costing and accounting, 15(3), 232-254. wang, j.c. (2008), investigating market value and intellectual capital for s & p 500. journal of intellectual capital, 9(4), 546-563. wernerfelt, b. (1984), a resource-based view of the firm. strategic management journal, 5, 171-180. widiyaningrum, a. (2004), modal intelektual. jurnal akuntansi dan keuangan indonesia, 1, 16-25. international journal of economics and financial issues vol. 1, no. 3, 2011, pp.88-98 issn: 2146-4138 www.econjournals.com governance mechanisms and buyer supplier relationship: static and dynamic panel data evidence from tunisian exporting smes bellouma meryem faculty of economics and management of nabeultunisia 12 avenue doha 2083 cité la gazelletunisia e-mail: mbellouma@yahoo.fr abstract: this study seeks to understand the effect of transactional and relational governance mechanisms on opportunism induced by the buyer supplier relationship. using panel data of 386 tunisian export companies between 2003 and 2008, the analysis shows that transactional as well as relational governance mechanisms are negatively related to the opportunistic behavior of the customer. in order to focus on internal corporate characteristics, the level of debt and the size of the buyer are controlled. this study supports the role of contracts as formal governance tool in reducing inter-firm opportunism which corroborates transaction cost economics. it also confirms some main notions in social exchange theory. the role of trust as relational mechanism in governing the buyer-supplier relationship has been verified. finally, the findings of this paper sustain the complementarity view toward relational and transactional governance mechanisms. the paper offers insights to executives of companies to govern the buyer-supplier relationship in order to dispel opportunism by using simultaneously transactional and relational mechanisms. keywords: governance, transactional governance mechanisms, relational governance mechanisms, opportunism, buyer supplier relationship. jel classification: g32, g34, l14 1. introduction as stressed by heide (1994, p. 72), governance is “a multidimensional phenomenon which encompasses the initiation, termination, and ongoing relationship maintenance between a set of parties”. in this sense, governance mechanisms are tools used to arrange any exchange ties. specially, the relationship between buyers and suppliers must rely on these tools which entail both transactional and relational mechanisms (poppo and zenger, 2002). transactional mechanisms emphasize legal conditions and incentive systems. however, relational mechanisms are those that govern exchanges through moral control and trust (jap and anderson, 2003). during the 1960’s and 1970’s, the relationship between the buyer and the seller was short term with formal transactional negotiations in western economies (morrissey, 2006). those characteristics imply a high probability of supplier’s switch or threat by the buyer and a lack of trust between the two parties (saunders, 1997). since the 1990’s, a change in the form of the buyer-supplier relationship from the traditional type towards the collaboration one is observed (hines, 1994; schmitz, 1995; holmlund and kock, 1996; saunders, 1997). this shift in the trade interaction generates many modifications in the practices of companies by considering social values and trust (morrissey and pittaway, 2004). thus, the company may have other incentives like building its social capital by adopting a trust behavior. transactional governance mechanisms are important in restraining opportunism in any repeated economic exchange. however, the relative effectiveness of relational mechanisms in enhancing buyer supplier relationship has yet to be addressed. academic literature considers trade credit as an external financing source for small and medium companies in countries with less developed financial markets (biais and gollier, 1997; bougheas et al., 2009, bellouma, 2011). in fact, most part of company’s sales and purchases in emerging market are done on credit. particularly, this is the case of small and medium tunisian companies. in 2008, the part of accounts payable in total liability is 40 percent and accounts receivable governance mechanisms and buyer supplier relationship: static and dynamic panel data evidence from tunisian exporting smes 89 represent 60 percent of total assets1. thus, trade credit is a central component of corporate assetliability management and tunisian smes have to look for new ways to use trade credit efficiently in order to survive and to restrain opportunism (bellouma, 2011). similarly to the information acquired by banks, trade creditors can use private information that facilitates the grant of credit to their customers. then, they act like banks which base their decisions on the relationship establishment (paul, 2007). this relationship lending view of trade credit is confirmed by many authors like jain (2001) and paul and wilson (2007) but it was difficult to validate empirically because of a lack of data about the buyer-supplier relationship. mainly due to this cause, petersen and rajan (1997) use data base of small u.s. companies to test some trade credit theories’. the information used is just about either the firm is the provider or the recipient of trade credit and covers only one year. besides, several empirical studies have been conducted to observe the effect of enhancing trade credit decision on corporate profitability (deloof, 2003, lazaridis and tryfonidis, 2006 and uyar, 2009). this study is the first research who aims to understand the impact of relational and transactional governance mechanisms on reducing opportunism between buyers and suppliers. specially, an empirical study is conducted to observe these link on the basis of tunisian export smes since trade credit decision is crucial for them. indeed, they have to establish relationship with foreign customers with different culture and habit. moreover, governance tools have variable efficiency when cultures and risk preferences differ. so, managers have to structure their relationships with their partners by enhancing their coordination mechanisms. in addition to this contribution, this paper tries to explain if governance mechanisms created in developed markets, such as the united states and western europe, can be used in emerging market like tunisia. although emerging markets are subject to increasing research attention in the field of governance mechanisms, existing studies remain limited. thus, this paper contributes to governance literature by clarifying the efficiency of governance mechanisms in emerging markets by testing both transactional and relational governance mechanisms. finally, it should be noted that it is the first paper dealing with governance mechanisms and their impact on opportunism using two kinds of panel data: static and dynamic. the paper is organized as follows. section two briefly provides the literature review and presents the hypotheses. section three describes the methodology adopted. section four exposes the findings. finally, section five concerns the conclusion. 2. literature review and derivation of hypotheses governance mechanisms are essential to ensure the stability of buyer– supplier relationships (benton and maloni, 2005). opportunistic behaviors, objectives divergences, operational routines differences and unpredicted market changes are considered as factors implying conflict between buyers and suppliers and as reasons of control (jap and anderson, 2003). the relationship development between supply chain members can be realized through transactional and relational governance tools. in this section, theoretical and empirical researches on transactional mechanisms are first exposed. then, existing literature of relational mechanisms is presented. on the basis of this overview, testable hypotheses are derived. transactional mechanisms: the formal governance tools in the buyer-supplier dyads according to transaction costs analysis, a contract between the buyer and its customer clarifies the transactions, the price, the agreements and safeguards. this theory presumes that the contract terms (quantity, quality, and duration) are well specified (williamson, 1999). the system guiding the transactions between the buyer and the supplier is monitoring which incites both parties to reduce the information asymmetry and the opportunistic behaviors. consequently, the absence of information asymmetry may mitigate conflicts between the buyer and the supplier, prevent opportunism and prompt mutual trust. transactional mechanisms are considered by liu et al. (2010) as an ex ante governance tool used in monitoring buyer–supplier relationship through contractual clauses and bilateral transactionspecific investments (luo, 2007).specially, contractual guidance implies a legal framework to enhance relationship performance perceived by the partners involved. 1 statistics from the tunisian consulting group “synergia”. international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.88-98 90 as argued by williamson (1985), a well-specified contract states the rights and obligations of each party and how to face future situations such trading practices or penalties. thus, contracts make the relationship explicit and clear. they prevent opportunism through behavioral boundaries and legal forces (liu et al., 2010). otherwise, some psychology theorists argue that contracts accentuate control and may indicate mistrust between the two parties. in other words, in uncertain situations, contracts may induce opportunism. given the asymmetric information, contracts tend to be incomplete (grossman and hart, 1980) and cannot restrain opportunism. thus, transaction-specific investment can be used as an incentive instrument in monitoring relationships. the transaction specific investment can be tangible (specific tool or equipment) or intangible (specific knowledge or capability) (jap and anderson, 2003).this investment increases partners’ interdependence on each other. it has considerable value when bilateral relationship between buyer and seller is not interrupted since it is difficult to redeploy outside a particular relationship (lohtia et al., 1994). transaction specific investment reduces the opportunistic behavior of each party and provides incentives to continue the partnership and to promote party’s accountability (kotabe and al., 2003). in the same way, it is likely to serve the firm’s competitive advantages since it creates value for the partners in the form of cost saving and profit enhancement. based on the above discussion, i hypothesize: hypothesis1. the use of transactional mechanisms (contract or transaction-specific investments) reduces opportunism in buyer–supplier dyads. relational mechanisms: an informal governance mechanism tool in the buyer supplier dyads in addition to the transactional governance mechanisms, relational ones have been recently considered as useful to inhibit opportunism and to enhance cooperation in buyer –supplier exchanges (kim, 2000, liu et al. 2010). according to social exchange theory, opportunistic incentive of one partner is restrained by the ostracism by the other (levinthal and fichman, 1988). thus, relational governance mechanisms generate norms of social connections embedding authoritative bonds in limiting opportunism2. these social links increase the commitment of the parties and imply a cooperative relationship through shared norms and values (seabright et al., 1992). increasing harmony between the buyer and the seller changes self-centered behavior to solidarity behavior. relational mechanisms cover relational norms and trust that govern buyer supplier relationship by creating a social environment (luo, 2007). as the relationship lasts, relational norms and trust encourage the development of relationship-specific opportunities. consequently, the buyer and the customer can reduce transaction cost and opportunism. relational norms refer to behavioral anticipations shared by a group in order to reach a collective goal, to solve problems and to accomplish performance objectives. the fulfillment of these norms appears from the exchange of useful information between the buyer and the supplier, the solvency of conflicts and problems, the discussion through joint consultations… (poppo and zenger, 2002). mian and smith (1992) suggest that trade creditors accumulate private information over time about their customers. the authors note that trade creditors are relationship lenders. the collection of non-public information allows suppliers to better appreciate the buyer’s risk profile and moderate adverse selection and moral hazard problems in the trade credit process. this type of information characterized by berger and udell (2002) and bellouma et al. (2009) as soft information is acquired by the seller about the buyer through direct contact. thus, information exchange reduces asymmetric information and supports the harmonization of interests. socialization improves exchange outputs through the use of this private information flows rather than resorting to contracts. companies can support their relationships with customers through many socialization plans, such as enhancing technical efficiency and increasing assistance. the socialization efforts boost the trust between the channel partners and reduce possible conflict. thus, trust ameliorates the cooperative atmosphere between the buyer and the supplier through developing honesty. besides, the exchange partners are assured that the other doesn’t behave opportunistically such lying, cheating or not fully revealing information (dyer and chu, 2003). 2 opportunism (cheating, violating an agreement, hiding information…) increases transaction costs and limits the development of trust (john, 1984). governance mechanisms and buyer supplier relationship: static and dynamic panel data evidence from tunisian exporting smes 91 therefore, relational governance mechanisms can be efficient when the buyer and the supplier respect each other rights, benefits and responsibilities. in light of the above, i propose: hypothesis2. the use of relational mechanisms (relational norms or trust) reduces opportunism in buyer–supplier dyads. relative importance of transactional and relational mechanisms liu et al. (2010) argued that transactional mechanisms are more effective than relational ones. in fact, relational mechanisms have limits on curtailing opportunism due to the lack of formal guidance of buyer supplier relationship. for instance, too much trust will either reduce the commitment of one party to monitor the other or increase the opportunism of one partner (jeffries and reed, 2000). besides, transaction specific investment may be more efficient in governing repeated exchange (williamson, 1983). indeed, in the case of buyer supplier relationship, the partner will loose the advantage of transaction specific investment if he seeks only its own gain (luo, 2007). the high number of contracts terms and transaction specific investment reflect the importance of the exchange relationship for the two parties (child and tse, 2001). they also reveal, in an ex ante perspective, the capacity of the buyer and supplier to solve problems (luo, 2002). however, highly stipulated contracts may handicap the commitment of the buyer and the supplier for gaining new opportunities (bernheim and whinston, 1998). particularly, unanticipated eventualities may occur after the contract is signed. according to social exchange theory, opportunism can be reduced by trust since transactional governance mechanisms can be costly in the case of socially embedded economic activities. thus, the flexibility of relational mechanisms will support the buyer and the supplier to enhance their exchange relationship beyond the specification of the contracts. with efficient relational mechanisms, partners are able to respond to the environment uncertainty and to deal with unpredicted problems (paulraj et al., 2008). under the governance of relational mechanisms, the buyer and the supplier improve communication, information share and solidarity. this is even more perceptible in emerging markets where economic and institutional environments are changing rapidly that no contracts can practically specify all eventualities (luo, 2007). i finally expect that: hypothesis3. relational mechanisms (relational norms or trust) are more effective than contractual mechanisms (contracts or transaction-specific investments) in reducing opportunism. 3. methodology the purpose of this study is to identify the impact of transactional and relational mechanisms on reducing opportunism between the buyer and the supplier with reference to tunisia. in this section, we present the data collected, the variables used, the hypothesis tested and the statistical techniques applied in the investigation. data collection and sample characteristics the data were obtained from tunisian export promotion center (cepex)3. the choice of export companies can be explained by the importance of trade credit for them and the competitive environment in which they operate. the data gathered are based on financial statements of 410 export companies dressed by the cepex. the information coming from the annual financial statements isn’t sufficient.in order to scrutinize seriously the impact of relational and transactional mechanisms on reducing the opportunism between the buyer and the supplier; i designed a questionnaire to describe their relationship along the period 2003-2008. with three reminders (calls, emails and re-mailing), i received 394 returned questionnaires of which 386 were complete. specifically, 136 companies work at the food industry, 96 product construction materials, 104 run textile business, 24 operate in metal industry and 22 have a service activity. the panel is mainly composed of limited liability companies (67.8%). the limited corporations represent only 32.2%. 20.2% of companies in the sample export over 50% of their products towards four foreign markets 3 the cepex is a governmental organism which offers assistance for export tunisian companies. international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.88-98 92 (u.s, asia, europe and arabic maghreb union). 53.2% employ less than 50 workers. thus, they are considered as small and medium-sized companies4. variables of the analysis the dependant variable of the study is: days of sales outstanding it: days of sales outstanding reflects the average number of days conceding by the supplier to its customer in order to collect revenue from sale. it designs the length of trade credit maturity. it’s measured as accounts receivable x 365/sales (deloof, 2003). a low number of days of sales outstanding shows that the company collects its accounts receivable in fewer days. however, a high number indicates that a company grants its customer a credit and takes longer time to gather money. besides, a high dso may be a sign of the opportunism of the customer who aims to maximize its own benefits. the independent variables included in the study are divided into three categories: variables relating to transactional governance mechanisms contract it: contract is a dummy variable which takes 1 if the respondent affirms that his relationship with the customers is governed by formal contracts and 0 otherwise. transaction specific investment it: transaction specific investment is a dummy variable which takes 1 if the respondent affirms that the company has made significant investment for its customer such as providing specific products or facilities in distribution and 0 otherwise. variables relating to relational governance mechanisms social contact it: the social contact is the first relational governance mechanism. it is a dummy variable which takes 1 if the respondent replied “high” to the question: “how do you consider social contact with your customer in deciding trade credit conditions?” and 0 otherwise. turnover it: the turnover of the export company’s credit manager addresses directly his role in the production of soft information. it is a dummy variable which takes 1 if the respondent replied “high” to the question: “is the number of credit managers dealing with your customers is high or low?” and 0 otherwise. control variables sizeit: the size of the company is measured by the natural logarithm of sales in million tunisian dinars (tnd) (1usd = 1,4386tnd). financial and organizational restrictions of the companies may limit the period of trade credit for suppliers. debt ratio it: the debt ratio (short term loans /total assets). it indicates the proportion of company’s short term debt relatively to its assets. it gives an idea about the company’s ability to cover its short term assets and specially its accounts receivable. data analysis and results table 1 reports the average, the standard deviation, the minimum and maximum values of the variables included in the study. in the panel used, companies collect their cash from receivables after an average of 97.943 days with standard deviation of 40.608 days and a minimum of 15.546 days. the mean value of the company size is 0.891 with a standard deviation of 0.492. the minimum value is -0.36 and the maximum is 2.336. the average of debt ratio is 38.1 % with a standard deviation of 13.5%. the minimum level of debt is 10% which may explain the incapacity of the companies of the study to access to external financing. 80% of the companies find that the social contact between them and their customer is important to obtain specific information. the turnover of credit manager is not important in our sample. in fact, 23.4% of the companies have a high turnover of their credit managers in the period of the study. 57.51% of the companies find that their relationship with their customers is based on trust. however, 72.62% of the companies govern their relationship with their customers by using explicit contracts. finally, only 5.31% of the companies use transaction specific investment as formal governance mechanisms to develop their relationship with the buyers. in order to capture the impact of relational and contractual governance mechanisms on reducing opportunism between buyers and suppliers, i use static and dynamic panel data regressions to identify micro-level information imperceptible in cross section or time series data. the static model with panel data is presented as follows: 4 “a wide consensus among national officials seems to exist on a non-official definition of smes as those enterprises employing between 10 and 100 workers. this definition, however, is not stated clearly, nor it appears in any official document” di tommasso et al. (2001: 44). governance mechanisms and buyer supplier relationship: static and dynamic panel data evidence from tunisian exporting smes 93 yi,t = αi + β xk,i,t + δt + εit (1) where the subscripts i and t represent respectively firm and time period respectively, yi,t is the vector of dependant variable, xk,i,t is the vector of explanatory variables, β is the vector of parameters to be estimated, αi is the individual effect which is constant for firm i over t, δt is the time effect which is constant for the period t over i and εit the term error is (iid). table 1: descriptive statistics variables mean standard deviation minimum maximum days of sales outstanding 97.493 40.608 15.546 199.485 debt ratio 0.381 0.135 0.1 0.93 size 0.891 0.492 -0.36 2.336 frequency percentage social contact=0 social contact=1 462 1854 20 80 turnover= 0 turnover 1774 542 76.6 23.4 trust=0 trust= 1 984 1332 42.48 57.51 contract=0 contract=1 634 1682 27.38 72.62 transaction specific investment =0 transaction specific investment=1 2193 123 94.70 5.31 to estimate the model (1), the fixed effects model and the random effects model are used. in a fixed effects specification, αi corresponds to the individual cross-sectional unit. the chow test is performed to confirm the fixed effects model (hsiao, 1986). in other words, the hypothesis that the individual coefficients αi are not all equal will to be proved. this corresponds to test the null hypothesis h0: αi = ... = αn =α. to validate the existence of significant heterogeneity across firms, the alternative hypothesis must be accepted. conversely, in a random effects model, αi doesn’t represent an individual cross-sectional unit and the stochastic error term εit becomes iti   . the generally accepted strategy of choosing between fixed and random effects is running a hausman test (1978) under the null hypothesis e (αi/xit) =0. if the null hypothesis is rejected, the effects are considered fixed. however, if it is accepted, the effects are random. besides, the buyer-supplier relationship should be modeled by taking into account its dynamic nature. the general form of the model is: yit = i yit-1 + β’ xit + ui + νit (2) where the subscripts i and t represent firm and time period respectively, yi,t is the vector of dependant variable, yi,t-1 is the vector of the lagged dependant variable, xk,i,t is the vector of explanatory variables, β’ is the vector of parameters to be estimated, αi is the individual effect which is constant for firm i over t, ui are firm-specific random effects and vit the overall errors. the independent variables and the lagged dependent variable are correlated. therefore, the estimators provided by the pooled ordinary least squares (ols) are inconsistent and biased. to obtain consistent estimators, the generalized method of moments technique (gmm) in first-differences is used as arellano and bond (1991). they proceed by first differencing the equation (1) to remove ui. all the lagged variables are used as instruments in the first-differenced equation. yit yit-1= i (yit-1 yit-2) + β’ (xit xit-1) + (ui-ui) + (vit vit-1 ) (3) as noted by the authors, the new error term (vit -vit-1) is correlated with the lagged dependent variable (yit-1 yit-2). the one-step estimator supposes homoskedastic errors while the two-step estimator constructs heteroskedasticity-consistent standard errors by using the first-step errors. according to arellano and bond (1991), although the homoskedasticity of the error terms, the twostep estimators are more proficient than the one-step when the number of firms is important. the efficiency of the gmm estimator depends on the effectiveness of the instruments and the uncorrelation of the error terms. thus, the sargan test of over-identifying restrictions is done. international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.88-98 94 4. empirical results in this subsection, the results presented in table 2 are discussed. the chow test is significant at 1% and proves the firm-specific effects. the hausman test shows that the fixed effect model is more suitable than the random effect model. only the size of tunisian companies has a negative effect on days of sales outstanding. this result entails that larger companies give fewer days for their customer to pay their purchases. accordingly, the small sized companies are more likely to be subject to the opportunistic behavior of their customers. table 2: static panel data versus dynamic panel data variables static panel data fixed effect random effect dynamic panel data one step two step days of sales outstanding -1 contract transaction specific investment debt ratio size social contact turnover constant -0.007 (-0.31) -0.089 (-0.44) -0.125 (-0.07) -42.090 (-1.86)* 0.867 (-0.72) 0.052 (0.05) 97.201 (44.27)*** -0.011 (-0.62) -0.017 (-0.51) -0.438 (-0.12) -0.449 (-0.44) -0.880 (-0.74) 0.058 (0.05) 97.650 (33.70)*** 0.273 (3.00)*** -0.089 (-3.75) -0.056 (-0.62) -57.718 (-1.25)* -30.714 (-1.60) 45.156 (2.21) -8.030 (-0.31) 162.948 (3.54)*** 0.300 (2.65)*** -32.101 (-11.86)** -0.023 (-0.34) -120.373 (-2.05)** -43.625 (-1.78)* -75.388 (3.00)*** -6.240 (-0.88 ) 236.860 (3.71)*** chow test f (5, 1920) hausman test chi2 (5) sargan test 27.35*** 62.34 (0.0000) 13.56 (0.3486) serial correlation test 16.03 (0.655) 21.56 (0.4537) regarding the generalized moment method (gmm), the sargan test implies that the gmm (two-step) is retained and the gmm (one-step) is rejected. the last days of sales outstanding is significant and positively affects the current one. this reflects that tunisian managers do not follow stable trade credit policies. besides, the constant term is always significant and positive which reveals the incapacity of the companies included in the sample to reduce their days of sales outstanding and to eliminate totally the opportunism generated. regarding to the formal governance mechanisms, significant negative relationships were found between contracts and opportunism. this result lends support to the first hypothesis and corroborates transaction cost theory. contract has a control effect for partners involved in a buyer-supplier relationship and facing intensifying competition due to the export uncertainty. thus, tunisian export companies need to adjust their corporate strategies to 4.89 *** tstudent in parenthesis z-value in parenthesis governance mechanisms and buyer supplier relationship: static and dynamic panel data evidence from tunisian exporting smes 95 respond to changes in the foreign environment. similarly, social contact as a relational governance mechanism exerts a significant and negative effect on days of sales outstanding. this result supports the second hypothesis and demonstrates the social exchange theory’s relevance in explicating the buyer supplier governance. a high level of social contact is related with an important production of private information and an atmosphere of trust. thus, rich mutual information exchanges between the foreign customer and the tunisian buyer could increase the latter’s capacity to react rapidly to eventual changes. once trust is established, the customers may be reluctant to behave opportunistically by delaying reimbursement. overall, transactional and relational governance mechanisms are efficient tools for restraining opportunism in a supply chain. thus, this finding supports that the formal and informal governance systems function as complements. this complementarity is harmonious with the economic sociology view. in fact, when economic actions are implanted in social structure, relational and transactional governance mechanisms reciprocally remedy each other’s insufficiency. more precisely, transactional mechanisms offer an institutional support for relational mechanisms, whereas relational mechanisms provide incentives for performing transactional mechanisms. thus, additional advantages are induced by a suitable arrangement between contractual and relational governance mechanisms. besides, relational governance mechanisms emerge if there are guarantees that each party behaves in the interest of the other. turning to the debt ratio, the statistically significant coefficient suggests that the financial condition of the seller has negative effect on the number of days granted to its customer. more precisely, when the supplier has a large leverage, he limits the customers’ opportunism by restricting the number of days of sales outstanding in order to collect liquidity quickly. finally, the size is negatively correlated to the dependant variable as explained for the fixed effect model. to further test the relative importance of transactional and relational governance mechanisms on opportunism, the semipartial correlation is performed. table 3: semi-partial correlation days of sales outstanding part correlation square part correlation transactional governance mechanisms  contract  transaction specific investment relational governance mechanisms  social contract  turnover -0.306 0.094 -0.111 0.012 -0.487 0.237 -0.209 0.044 as reported in table 3, the sum of the contribution of contracts and transaction-specific investments to anti-opportunism equals to 0.106 (0.094+0.012). similarly, the contribution of relational governance mechanisms to anti-opportunism equals to 0.281 (0.237+0.044). therefore, the effect of relational governance mechanisms on opportunism is stronger than that of transactional governance mechanisms. the third hypothesis of the analysis is supported. trust habitually occurs when the buyer supplier relationship is sustained for long. currently, tunisia is characterized by an economic and social transformation and export tunisian companies still use primary business habits in managing informally relationships with their partners. however, cultural divergence and foreign challenges give incites to tunisian export companies to effectively manage channel relationships on the basis of transactional mechanisms. 5. conclusion the main objective of this paper was the study of transactional and relational governance mechanisms effects’ on opportunism induced through the buyer and the supplier partnership. as companies look for more advantages to face competitive environment, the improvement of the international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.88-98 96 relationship between buyers and suppliers is progressively more vital. besides, trade practices in emerging economies are mainly marked by inter-firm relationships and necessitate a critical development. superior relationships between the buyer and the supplier allow companies to grow in a dynamic marketplace and to generate considerable returns for the two parties. nevertheless, buyer– supplier dyads imply opportunism and conflict. thus, governing such relationships on the basis of formal and informal mechanisms is a crucial task for managers to improve the exchange process. through the analysis of 386 companies, over a six-year period from 2003 to 2008, the transactional governance mechanisms (contracts) and relational governance mechanisms (social contact) appear both important in curtailing opportunism of the foreign customer. this work confirms that the two governance mechanisms are complementary. however, relational aspects have more significant effect on opportunism than the contracting process. in managerial terms, there is evidence that transactional governance mechanisms are crucial but not sufficient to curtain opportunistic behavior in the foreign market. another lesson learned from this paper, is relevant to buyer supplier operations in emerging and developing economies. as many of these economies, like tunisia, have exchange relationships with foreign customers. thus, the issue of managing these ties is important to both academics and practitioners. finally, the paper shows that the exchange relationship between the two parties does not always operate the 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(1999), strategy research: governance and competence perspectives. strategic management journal, 20 (12):1087–1168. . international journal of economics and financial issues | vol 6 • special issue (s6) • 2016130 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s6) 130-134. special issue for "ipn conferences, may 2016" e-commerce strategic business environment analysis in indonesia dwitya aribawa* department of management, universitas atma jaya yogyakarta, indonesia. *email: dwitya_aribawa@mail.uajy.ac.id abstract this research is aim to identified important factors in external business environment that tend to influence company capabilities to achieve objective. it conducts to several e-commerce in indonesia. those companies operate several industries, such as grocery and household retail, fashion retail, electronic and gadget retail and travel agency booking provider. we conduct thematic analysis with quad helix stakeholders approach. it found that the firm faces several external environment factors that affect the business activities. this research concludes that e-commerce in indonesia needs to establish strategic action plan to take advantage from opportunities of demographic bonus, arising middle income and broaden the scope of business. to minimizing external limitation, quad helix stakeholders are demanding to covers urgency issues on establishing efficiency in transportation, educating small and medium enterprises to engage with e-commerce and demanding of alternatives source of funding. this research recommend that firms in this industry focus on integrating channels of ordering, improving warehousing and delivering process, expanding marketing strategy that focus in knowledge sharing and integrating global supply chain. keywords: business environment, industry analysis, e-commerce jel classifications: m10, m30, f23 1. introduction according to saroja (2012), today’s retailers faces some of the toughest issues ever experienced in the history of the industry from a fundamental change in the way consumers shop to greatly increased expectations for service and price. retail is last channels that engage to end customers. this also means they should aware about customers very well. information technology plays a vital role in how well the customers are satisfied to achieve revolutionary excellence in marketing, customer service, and associate effectiveness and supply chain efficiency. retailers has concern to take a look at how to transform operations through the creative deployment of today’s information technologies to increase sales, improve customer retention rates and reduce costs for a significant competitive advantage. the transformation of the retail industry is accelerating rapidly due to the formation of new businesses not bound by the limitations of traditional organizational and structural models. e-commerce are an excellent approach to be applied in this growing environment of technology (ibm, 2006). advanced tacit and explicit knowledge approach can be used to unify insights to specific offers, and execution capabilities are recommended to support organization wide sharing of objective at scale and across multiple channels to meet satisfaction and repurchase intention of customers (accenture, 2012). the major players have always used scale to maximize their buying power, but that scale also considering characterize of behaviors and preferences of customers. with access to more detailed, real time information about potential customers and more ways to reach them, retailers can improve on how they managing customers. further, it also will help organization to shortening behind the desk expenses and logistics, overall costs and in the end will effect to the uplift of margin by efficiency in operational (mercier et al., 2012). e-commerce refers to all of commercial transaction that related to organization and individual that based on digital processing aribawa: e-commerce strategic business environment analysis in indonesia international journal of economics and financial issues | vol 6 • special issue (s6) • 2016 131 based on internet. in indonesia e-commerce as a one of activity in economics pattern that supported by internet infrastructure has a wide segmentation and implementation. outlined by indonesia ministry of communication and information technology (2012), activity of e-commerce will be maximize implemented in indonesia when supported by the infrastructure, connectivity, tendency of changing in people behavior and the ease of using e-commerce facilitated by enterprise. with its stable economic growth, young population and growing middle class, producers of consumer goods have a positive point of view to indonesia market as the next big leap of emerging market. with base of consumers that was bigger than the united states and europe, emerging markets are being a huge opportunity since millions of people moving out of subsistence poverty and entering the middle class, with growing disposable income. analyst has claimed that indonesian consumers were characteristic in six areas: willingness to pay more for brands, homogenous in what they buy, strong brand loyalty, preference for small packs, high purchase frequency and influenced by social media (suwastoyo, 2013). the arise of awareness of people using internet or e-banking technology, growing infrastructure of internet, increasing the number of middle class, improvement of education and expansion of gadget users in indonesia bring positive impact for the demand of e-commerce industry (forst & sullivan consulting, 2012). starting from 2012, some of indonesian e-commerce has established by foreign direct investment (fdi) from of multinational companies. this is an insight of e-commerce business in indonesia entering rapid leap of growth. considering the study background above, the problem statement of this research paper that guiding readers to understand clearly is “there are several external environment factors which create opportunities, threats and business implication which that will influencing e-commerce in indonesia.” 2. literature review 2.1. indonesia e-commerce industry according to veritrans and daily social research (2012) about e-commerce survey in indonesia. the research found the 2011 data which counted $0.9 billion total of indonesia e-commerce market share, this amount is only 0.7% of the retail industry market share ($137 billion). the researcher analyze about future growth of indonesia e-commerce industry that will be growing rapidly from 2011 to 2015 regarding the trend moves of youngsters and internet penetration that driving indonesian customers to more preferably purchasing by e-commerce. figure 1 will explain about the potential growth of indonesia e-commerce in term of internet users, middle class population, broadband (internet) penetration and e-commerce market size. indonesia has huge opportunity as one giant in e-commerce industry that derived global development. according to tumiwa (2015), indonesian digital buyers is just 2% from the population, in thailand it counted around 21%, in malaysia it counted around 53% and in singapore it counted around 58%. the other fact that considering in is about the trends and behaviors of online customers in indonesia. fashion product and travel booking are most popular goods and services that prefer to buy according to the surveys. in the other hands books and grocery product are not yet common in e-commerce transaction in indonesia. veritrans and daily social (2012) also discover about the preferred place doing online transaction is and how to paid the transaction. facebook (social media), kaskus (online forum) and olx relative more attractive to in indonesia customers rather than the e-commerce company official website such as sukamart.com, bhinneka.com, blibli.com or tokopedia.com. this trend is arising possibility of fraud in term of online transaction. 2.2. indonesia e-commerce stakeholders indonesian e-commerce following the regulation and direction from three government bodies, which are ministry of trade and commerce, ministry of communication and informatics and indonesian agency for creative economy. some of regulations also including control from indonesia central bank and indonesia financial service authority. indonesia e-commerce association or known as idea is an official entity for e-commerce business in indonesia. idea facilitating, connecting and providing their members with specific approach of e-commerce development plan in order to compete to global marketplace. the association also takes in charge to prepare the appropriate regulation and direction to e-commerce in indonesia (tumiwa, 2015). 3. research design this research using gathering expert view from focus group discussion to quad helix stakeholders, which are consists of academia, e-commerce players, government (key person from indonesian agency for creative economy) and civil society (key person from indonesia e-commerce association). secondary data obtained from the company available sources, literature review from articles and books that related to strategy and business topic and also news and statistic data that supported the business environment issue for the subject of research. this paper using the qualitative analysis (thematic-analysis) and literature review methods to collecting, structuring and analyzing the data that has found. 4. empirical results and analysis according to downey (2007), political, economic, social and technological (pest) analysis is a scan of the external macroenvironment in which an organization exists. it is a useful tool for understanding the political, economic, socio-cultural and technological environment that an organization operates in. 4.1. political factors creative industry, especially it based business has been put in the front of the next developing industry that has high growth rate to stimulate economic growth and absorbing employees. according to ministry of communication and information technology (2012), there are several amount of budget allocation that focus aribawa: e-commerce strategic business environment analysis in indonesia international journal of economics and financial issues | vol 6 • special issue (s6) • 2016132 to develop the environment of it business in indonesia and empowering business with attention to small medium enterprise and new developed business. decentralization arise good chance to set business centers in outside java island, especially for sub-warehousing system. public (government)–private company partnership need to assess as an opportunity to engaging business expand. in democracy era there will arise election dilemma for business, in fact the successfulness of election will influence positively to business flow and create better climate of competition (world bank and the international finance corporation, 2013). imt-gt collaboration appearing positive insight for indonesian e-commerce that may has plan to expand business chain to asean countries start from indonesia. imt-gt that empower outside java island growth is the positive issue to decrease the gap between java island economic growth and other island in indonesia. the long term relation of indonesia and country around (especially asean and east asia) will be escalate the as well known, smt own related business in retails and distribution that will incline the opportunity to get benefit from the strong value chain of holding company (imt-gt, 2013). the implementation of acfta in 2010 and aec in 2015 bring challenge to local e-commerce providers because in term of efficiency is difficult to compete. moreover, some of indonesian e-commerce just distribute imported product from china, asean countries or japan. in order to compete, indonesian e-commerce needs to provide typically needed goods and services using the local knowledge that only known by local e-commerce providers. 4.2. economic factors the growing demand e-commerce business seems look as future potential sector that will bring positive insight to indonesia economic growth. lot of fdi in ict industry also makes an impact to gross domestic product (gdp) of indonesia. improvement awareness and education of using ict around indonesia has a positive impact to income per capita in the future (forst & sullivan consulting, 2012; veritrans and daily social, 2012). the number of target market of indonesian e-commerce should be broaden, not only focus on certain local market but also expand to around indonesia and may going to global market for the future. in term of economic of scale, indonesian e-commerce (especially small and medium enterprises) faced difficulty to compete to big company (local and foreign). e-commerce industry is an industry with technology-incentive characteristic. as a part of ict creative industry, this industry planned by government to greatly contributes to economic development. ict industry will be prioritizing as an industry that has high growth rate or called future industry for indonesia. further, it also suggest by experties that stated the needs of changes to paradigm of indonesia industry driving from mass rapid product to creative-value added (kim, 2004; lucci, 2012). some policy that supports the industry development should be decided by government, collaboration of ministry of industry as a supportive part to gain competitiveness in industry development to support economic growth (ministry of communication and information technology, 2012). government instructed to support ict business in term of empowering new business, bank funding and developing business infrastructure. plus a tax allowance for communication products (e-business infrastructure) plan to accelerate ict industry will be prioritize as an industry that has high growth rate or called future industry for indonesia according to white book of ict from ministry of communication and information. in the same time, there is demanding to indonesian employee that needs to develop in order to meet the needs of rapid development of e-commerce industry. safety of transaction still is an issue in this industry, need of clear regulation and education of doing transaction will be essential in order to create well climate in e-commerce industry. monetary and fiscal policy can be implementing simultaneously to prevent some extraordinary conditions of global environment or internal country situation (laurens and piedra, 1998). every figure 1: potency of indonesia e-commerce source: tumiwa (2015) aribawa: e-commerce strategic business environment analysis in indonesia international journal of economics and financial issues | vol 6 • special issue (s6) • 2016 133 country needs to determine the right combination of monetary and fiscal policies in the right conditions (right pills on the right disease) of global environment and country itself (adiningsih, 2013). this is the right time for local e-commerce business to provide indonesia products to indonesia market and also global market. increasing the amount of local consumption will also derive to hold indonesia gdp growth in positive. amount of vat that will grant to e-commerce business will increase consumers tendency index and business tendency index in general, trust of consumers will build up and climate of industry will be much better after implement this policy. consumer tendency index aims to get a picture of a business situation and general economic consumer opinion, based on consumer purchasing power and also on perceptions about business conditions and economic climate. business tendency index provides information about state of business and the economy in the short-term. 4.3. social factors there is inequality of income (higher gini ratio) between urban and rural area. futher, found much of tendency to enter middle class trap, since middle class people not build human capital. e-commerce faced difficulty to broaden market outside java island, lack of the logistic ability and infrastructure being barriers to reach other island faster and easier. inequality infrastructure between java and outside java make problem for distribute (bowie, 2008). y generations demanding a new way to shop and tendency of live individually (especially in big cities), they think about time efficiency, shopping activity will not be an entertainment activity. indonesian people has a strongly tendency doing orientated community (based on ethnic, interest and other relative factors), it will be a proper new market segmentation for indonesian e-commerce to serve group or community needs. growing of middle class (higher level of social class) people in indonesia that demanding more healthy and easy to reach products (ancok, 2013). questioning to serve rural area in the future, e-commerce business can be the proper solution of disparity of distribution between west and east part of indonesia. moreover, personalization of goods and services needs for specific demographic of buyer, business needs to develop new way of approach regarding this issue in order to create barrier to entry and keep in touch to niche customers in order to anticipate big players in retail industry that take a part in retail e-commerce competition. indonesian people have a low tendency of using e-payment system, that is why government and business should facilitate a comprehensive infrastructure and education related to the payment system that makes users more comfortable (verra and fitriani, 2012; susilastuti, 2013). businesses in indonesia are well advised to develop a genuine awareness of their surrounding community. demonstrating a business contributes to community welfare helps ensure the community has an interest in protecting the business. unless a venture seeks local community involvement, providing employment and investment will not ensure good relations or security. the concept of traditional land ownership remains strong across indonesia, and irrespective of contractual rights the government may award, local communities will act to protect their environment. hence, mining companies adopting consensus based approaches to secure their rights are more likely to receive local community support than those relying on legal solutions. 4.4. technological factors based on asean e-commerce database project (2010), indonesia has only contribute 24.4% in internet penetration of asean or only 12% indonesia people can accessed internet (20% is an average of asean penetration to internet), that proportion is look small when compared to indonesian population to asean. where only 47% indonesian decide to purchase in online store and the most of that transaction using bank transfer (46%) as a payment method besides using e-money (8%) or credit card (34%). the arise of awareness of people using internet or e-banking technology (as safe payment system online), growing infrastructure of internet, increasing the number of middle class, improvement of education and expansion of smart phone and gadget in indonesia bring positive impact for the demand of new development of e-commerce industry in indonesia (forst & sullivan consulting, 2012) (figure 2). in order to create customers engagement, indonesian e-commerce needs to leverage the local knowledge that only known by local players and centralized to into specific customer database management. customer database management approach will help business through allowing clear understanding to the customer needs and wants. advanced tacit and explicit knowledge approach can be used to unify insights to specific offers, and execution capabilities are recommended to support organization wide sharing of objective at scale and across multiple channels to meet satisfaction and repurchase intention. figure 2: indonesia ict outlook source: forst & sullivan consulting (2012) aribawa: e-commerce strategic business environment analysis in indonesia international journal of economics and financial issues | vol 6 • special issue (s6) • 2016134 5. concluding remarks this research try to elaborate expert views and secondary sources information regarding to pest elements as external environment factors that will arises opportunities, threats and business implication to indonesian e-commerce, which those are describing in previous part as factors that affect the business. according to wheelen et al. (2015), the external business environmental scanning must be carried out prior to the strategy formulation process of a company since it provides the management with a tool for avoiding strategic surprise and provides a higher probability to meet sustainability growth of company. the external strategic factors analysis summary (efas) is tool for summarizing and evaluating the relative influence of individual environmental issues, as shown on table 1. considering on efas analysis, overall it can be conclude that indonesian e-commerce has proper responds to strategic external factors appears. indonesian e-commerce able to take advantage from opportunities and minimizing the effects of threats those come from business external factors in order to compete to global marketplace. according to quad helix discussion synthesization, the future outlooks for sustainable development of indonesian e-commerce industry are: 1. provide excellent quality of services and provide reliable center of information to meet customers’ engagement and in the end will be satisfied and retain repurchase intention 2. develop mobile access to ordering process and also provide the today shipping system 3. build the technology based integrating system of ordering, warehousing and delivering process to meet the fast moving consumers in indonesia 4. expanding marketing strategy and offerings products based on local knowledge 5. integrating global supply chain of corporation to meet the efficiency goal. references accenture. (2012), customer-infused retailing. interactive point of view series. chicago: accenture consulting. adiningsih, s. (2013), monetary and fiscal policies. module of general business environment. yogyakarta: universitas gadjah mada. ancok, d. (2013), social environment analysis. module of general business environment. yogyakarta: universitas gadjah mada. andaya, d.b., juban, a.m. (2010), the asean e-commerce database project. asean project report. superius corporation. bowie, a. (2008), the effect of culture on business relationship. the neumann business review: the journal of the division of business and information management, 3(1), 1-19. downey, j. (2007), strategic analysis tools. topic gateway series of 34. london: the chartered institute of management accountants. forst & sullivan research. (2012), the big leap ahead. periodical research of indonesia ict outlook. jakarta: forst & sullivan research group. ibm global services. (2006), e-business momentum and evolution in the retail industry. periodic analysis. somers, new york: ibm group. imt-gt. (2013), a statistical information brief. brief statistical brochure. putrajaya: imt-gt group. kim, y.h. (2002), financing information technology diffusion in low– income asian developing countries. development centre seminars technology and poverty reductionin asia and the pacific, 115-133. laurens, b., piedra, e. g. (1998), coordination of monetary and fiscal policies. international monetary fund working paper. washington, dc: imf monetary and affairs department. lucci, p. (2012), post 2015 mdgs: what role for business? research report. overseas development institute. mercier, p., jacobsen, r., veitch, a. (2012), retail 2020: competing in a changing industry. industry report. london: boston consulting group. ministry of communication and information technology. (2012), white book of indonesia communication and information. periodic booklet. jakarta: indonesia it policy research group. saroja, s. (2012), information technology – key success factor in retail. gian jyoti e-journal, 2(1), 221-233. susilastuti, d.h. (2013), demographic environment for business analysis. module of general business environment. yogyakarta: universitas gadjah mada. suwastoyo, b. (2013), retailers eye indonesia as next big market. jakarta globe magazine. jakarta: the jakarta globe media group. tumiwa, d. (2015), how e-commerce shape the culture in indonesia. e-commerce indonesia report. indonesia e-commerce association. veritrans and daily social. (2012), e-commerce in indonesia. periodical research. jakarta: e-commerce joint research group. verra and fitriani. (2012), indonesia’s rising middle class: tweeting to be heard. rsis commentaries. singapore: nanyang technological university. wheelen, t.l., hunger, j.d., hoffman, a.n., bamford, c.e. (2015), strategic management and business policy: globalization, innovation and sustainability: global edition. new delhi: pearson higher ed. world bank and the international finance corporation. (2013), doing business 2014 economy profile: indonesia. doing business report. washington, dc: the world bank. table 1: indonesian e-commerce efas external factors (opportunities and threats) weight rating weighted score governmental environment 0.025 2 0.05 domestic politic 0.050 3 0.15 international politic 0.050 2 0.1 economic development 0.025 3 0.075 industry arid sectoral policies 0.100 4 0.4 regional economy 0.050 4 0.2 monetary and fiscal policies 0.050 2 0.1 social environment 0.150 4 0.6 cultural environment 0.025 2 0.05 demographical environment 0.100 5 0.5 natural environment 0.025 3 0.075 processing technology 0.200 5 1 information technology 0.150 4 0.6 total 1 3.90 source: focus group discussion. efas: external strategic factors analysis summary . international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 77 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s7) 77-80. special issue for "international soft science conference (issc 2016), 11-13 april 2016, universiti utara malaysia, malaysia” the association between corporate governance and auditor switching decision shamharir abidin1*, ishaku vandi ishaya2, mohamad naimi m-nor3 1tissa-uum, universiti utara malaysia, 06010 uum sintok, kedah, malaysia, 2bekaji estate, jimeta yola, nigeria. 3tissauum, universiti utara malaysia, 06010 uum sintok, kedah, malaysia. *email: sham1202@uum.edu.my abstract the purpose of this study is to examine the association between corporate governance and the propensity of auditor switching. in particular, the study seeks to investigate whether board independence and chairman chief executive officer (ceo) duality, influence the auditor-client realignment exercise. understanding the reasons why companies switch auditor is very important as auditor switching could inhibit the flow of capital in the securities markets, and subsequently, increase the capital costs. based on the analysis of 712 non-financial companies listed on bursa malaysia during the period from 31st december, 2009 to 2011, the results suggest that the companies with higher non-executive directors than the sample median tend to switch auditor. the chairman-ceo duality, however, has no effect on the decision. the results also suggest that the provision of non-audit service, changes in key management, company size and big 4 are significant determinants of auditor switch decision. the outcome of the study indicates the importance of sound governance on auditor switch decision and might provide insightful knowledge which helps shareholders to realize the importance of having balance bods. keywords: auditor switch, audit market, auditor change, corporate governance, malaysia jel classifications: m41, m43, m49 1. introduction in the middle of year 2002, andersen, one of the top five audit firms in the world, was convicted of obstruction of justice for shredding documents related to the failed us energy giant, enron. andersen ceased its business in august 2002, and its business was acquired by other firms. the demise of andersen and the collapse of enron have ignited intense debate regarding audit market competition and audit quality. although the us supreme court reversed andersen’s conviction in 2005, the audit market environment and structure had already changed. new legislation and corporate governance codes were proposed and introduced worldwide. the main focus was on improving corporate governance, which also includes the issue of auditor choice. the issue of auditor choice is not straightforward. according to abdel-khalik (2002), the biggest fallacy in corporate governance today is the premise that shareholders elect and appoint the auditor, when, in fact, shareholders (through proxy votes) have effectively handed over the control of auditor-related decisions (hiring, retention and compensation) to management. therefore, the real motivation for auditor-client re-alignment might be known only to management. generally, evidence suggests that auditor switches could diminish users’ confidence in the audited financial statements which further could inhibit the flow of capital in the securities markets and subsequently increased capital costs (knapp and elikai, 1988). despite the importance of understanding the motivations for, or determinants of, auditor switch, little has been done to investigate the issue, particularly in emerging market such as malaysia. in malaysia, studies on auditor switch can be considered scarce. the most recent studies; nazri et al. (2012a) and nazri et al. (2012b) recommended that a study should be conducted on corporate governance characteristics such as board independence abidin, et al.: the association between corporate governance and auditor switching decision international journal of economics and financial issues | vol 6 • special issue (s7) • 201678 and chief executive officer (ceo) duality, so as to shed more light on this particular subject. other prior malaysian’s studies (e.g. ismail et al., 2008; joher et al., 2000) also do not address whether the auditor-client realignment decision is a function of company’s corporate governance practices. the present study extends the auditor switch studies by examining the possible influence of internal corporate governance mechanisms on auditor switch decision. thus, the purpose of this study is to provide an answer to this research question: what is the association between corporate governance and auditor switching decision? given how important corporate governance is in recent years and the recent reforms in the corporate governance code, the study hopes that more valuable findings could be revealed to help enrich the level of corporate governance agenda. the paper is organized as follows. the next section discusses prior relevant studies and outlines the development of hypotheses. section 3 outlines the research methods and section 4 presents the results of the study. section 5 concludes the study. 2. prior studies and hypotheses most prior studies on the auditor switch or change decision in malaysia have examined auditor switch determinants such as change in management, audit opinion, client size (nazri et al. 2012a; ismail et al., 2008). however, studies on corporate governance characteristics such as board independence, ceo duality, are still lacking. nazri et al. (2012a), investigated auditor choice issues, covering 18 years dataset period (1990-2008). the authors recommended that a study should be conducted on corporate governance characteristics so as to shed more light on this particular subject, and to include other variables that could affect the auditor choice decision such as audit opinion, audit fees and client firm size. similarly, nazri et al. (2012b) investigate the factors influencing auditor switch. however, despite the findings providing invaluable evidence on the issue of auditor switch in the country, they still recommended a replication of their study with other determinants of auditor switch such as: audit tenure, non-audit services, board independence, auditor-client relationship and ceo duality. ismail et al. (2008) cover the period from 1997 to 1998. the study examined major determinants of auditor switch; however, corporate governance variables were not examined in the study as determinants of auditor switch. joher et al. (2000) cover a relatively old dataset (1986-1996). while providing invaluable evidence about the auditor switch issue, the study focuses mainly on how the switch could trigger market reaction. 2.1. hypothesis 1: board independence the distribution of power among corporate managers, shareholders and directors is set when shareholders nominate a board of directors to represent and protect their interest (o’neill et al., 1998). a major role of a company’s board is its control function, which includes monitoring top management actions to ensure that executives fulfill their responsibilities to the company (fama and jensen, 1983). it is believed that the effectiveness of the board in monitoring the decisions of managers is often associated with its composition. board composition refers to the distribution of members according to their primary allegiance, which may be either to the shareholders (outside) or to the managers (inside). outside directors generally are viewed as professional referees who unbiasedly protect the shareholders’ interests, helping to prevent or detect any management opportunistic behavior (fama and jensen, 1983). non-executive directors (neds) who are independent from management could limit the opportunity of the board to become “an instrument of top management” by serving to limit top management’s discretionary decisions (beasley and petroni, 2001). thus, the larger the proportion of independent neds on the board, the more effective it will be in monitoring managerial opportunism (fama and jensen, 1983). empirical studies (e.g., dechow et al., 1996) have shown that when boards of directors are more independent, they tend to act in the best interests of shareholders. neds are expected to place a greater emphasis (than executive directors) on the extent and quality of the audit rather than on its cost, thereby seeking to reduce informational asymmetries between themselves and inside (executive) directors (beasley and petroni, 2001). the presence of neds is expected to increase auditor independence since the external auditor is able to discuss matters arising from the audit process with neds free from managerial influence. the development of audit committees has further enhanced the role of neds in this respect. in light of the above arguments, it is expected that, in the event of auditor change, companies with a greater proportion of neds on the board would provide a better monitoring on the management action. given the bad effects of auditor change on users’ perception, the company with better directors’ independence will be less likely to change auditor. h1: board of directors’ independence is negatively associated with auditor switch. 2.2. hypothesis 2: the existence of a dominant personality (duality) besides the composition of outside directors on the board, the separation of the roles of the chairman of the board and the ceo can also affect the independence of the board. the cadbury report and the combined code in the uk suggest that the roles of the chairman and ceo should be separated. a separate chairman, who is more likely to monitor the interests of the shareholders, can countervail ceo power. whenever the same person acts as both chairman and ceo (i.e., duality), the ceo will have greater stature and political influence over board members and this has the potential to undermine the independence of the board (jubb, 2000). as the duality implies influence by an insider on the board, then it can be expected that auditor change would be more likely in the presence of chairman and ceo duality than in its absence. in light of the above discussion, it is expected that the presence of a dual chairman/ceo is positively associated with the propensity to switch auditor. h2: the presence of a dual chairman/ceo is positively associated with auditor switch. abidin, et al.: the association between corporate governance and auditor switching decision international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 79 3. methods 3.1. sample selection initial annual listings of all companies were obtained from the official list of companies listed on bursa malaysia, as on 31st december of 2007-2011. this source contains comprehensive entries of all companies and securities listed on the main market or ace market (prior to 2010, the list includes second board and mesdaq market). as extracted from datastream on 2nd september, 2015, 763 companies were continuously listed on bursa malaysia from the period of 2007 to 2011. 25 companies were excluded from the total population due to incomplete data (annual report not available). furthermore, 26 companies were similarly excluded since the said companies changed auditor more than once during that period. the total sample size became 712 companies, which included 191 auditor-changed companies, and 521 non-auditor changed companies. 3.2. model estimation the logistic model to estimate the auditor switch was developed to include potential determinant variables. the estimation is as below. p (audswch=1)=f (nedbod, dual, nas, nasaudfee, mgtchg, levtdta, sizeasset, growth, lgaud fee, opinion and big4). where; audswch=the estimated conditional probability of auditor switch and the dependable variables are: nedbod=a proxy for bods independence. equal “1” if the ratio of ned on bods equal or higher than the sample median, “0” otherwise dual=equals ‘1’ if the chairman is also the md/ceo during the year preceding auditor switch or ‘0’ otherwise. nas=equal ‘1’ if nas provided to client is higher the sample median or ‘0’ otherwise. nasaudfee=a proxy auditor independence as measured by the ratio of non-audit services fee paid to the auditor to the total audit fee during the year of auditor switch. mgtchg=equals ‘1’ if the company had change managing director or ceo during the year of auditor switch or ‘0’ otherwise. levtdta=total debt/total assets. lgsizeasset=natural log of total assets. growth=percentage change in sales. lgaud fee=natural log of audit fee paid to auditor fee during the year of auditor change. opinion=a qualified opinion indicator variable, coded ‘1’ if the company was issued with qualified audit opinion during the year of auditor switch or ‘0’ otherwise. big4=equals ‘1’ if the company’s auditor was a big4 during the year preceding auditor switch or ‘0’ otherwise. 4. results 4.1. descriptive analysis table 1 presents descriptive statistics of variables that influenced auditor switch decision in malaysia. the result is presented in terms of mean, median, standard deviation, minimum and maximum values of each construct. as can be seen from the table 1, auditor change switch has a mean value of 0.2683, indicating 26.83% of the sample had switched auditor during the period. with regards to nedbod, 44.04% of the companies were found to have number of neds more than the sample median. for duality, 1 is labeled if the chairman is also the ceo during the preceding year of auditor change, then 0 otherwise. the statistics suggests that 17.13% of the companies were run by the ceos, who was also the chairman. in respect to nas, the mean, median and standard deviation value is 0.5183, 1 and 0.5000. minimum value is 0 while the maximum value is 1. in terms of nasaudfee, the mean value indicates 0.8572; median value indicates 0.09, while standard deviation value is 15.8386. it shows a minimum value of −0.24 while the maximum value indicates 422.68. for management change (mgtchg) variable, it equals 1 if the company had changed managing director or ceo during the year preceding auditor change or 0 if otherwise. the mean value indicates close to 9% of companies had changed their ceo. leverage (levtdta) has a mean value of 57.0734, median value of 31.575 and a standard deviation value of 264.3675. meanwhile, the assets mean, median and standard deviation value, after transformation, is 5.5402, 5.46 and 0.7390 respectively. the minimum value reports 3.41 while the maximum value is 8.53. growth indicates a mean value of 37.67014, median value of 6.87 and standard deviation value of 721.904. for audit fee, the mean, median and standard deviation value are 2.1230, 2.05 and 0.4476 respectively; while the minimum value is 0.6 and maximum value is 4.2. the table 1 also reports that 2.5% of the sample companies were issued with qualified audit opinion during the year of auditor switch. the results also suggest that 55% of the companies were audited by big 4, i.e., pwc, ey, kpmg and deloitte. 4.2. model estimation table 2 presents the results for the auditor switch model. based on the results of this study, board independence is significant at the p = 0.072. the finding is contradicted to h1. this suggests that the greater the percentage of independent board members, the more likely a company will change auditor. this is possibly due to demand by independent directors for the company to change table 1: results of descriptive statistics variables mean median standard deviation min max audswch 0.2683 0.00 0.4434 0 1 nedbod 0.4404 0.43 0.1248 0 1 dual 0.1713 0.00 0.3771 0 1 nas 0.5183 1.00 0.5000 0 1 nasaudfee 0.8572 0.09 15.8386 −0.24 422.68 mgtchg 0.0899 0.00 0.2862 0 1 levtdta 57.0734 31.575 264.3675 −3441.55 5146.49 lgsizeasset 5.5402 5.46 0.7390 3.41 8.53 growth 37.6701 6.87 721.9040 −100 19210.54 lgaud_fee 2.1230 2.05 0.4476 0.60 4.20 opinion 0.0253 0.00 0.1571 0 1 big4 0.5548 1.00 0.4973 0 1 abidin, et al.: the association between corporate governance and auditor switching decision international journal of economics and financial issues | vol 6 • special issue (s7) • 201680 to a higher quality auditor. another explanation is that the change was initiated to avoid auditor’s familiarity threat. however, ceo duality was found to be not significant. this finding does not support h2 which stated that the presence of dual chairman/ceo is positively associated with auditor change. the result supports the findings of o’sullivan (2000), which revealed that there is no significant relationship between the two variables. hence, in respect to the above assertion, a company that is being run by a chairman who is also the ceo does not seem to influence auditor change decision. other significant determinants include a change in management, size and brand name auditor. the findings document a p = 0.077, indicating that management changes could influence auditor switch decision. the result is consistent with the findings of nazri et al. (2012a). the study also documents a strong association between size and auditor change decision. this finding is supported by prior studies such as nazri et al. (2012b), ismail et al. (2008), hudaib and cooke (2005) and huson et al. (2000). additionally, the brand name auditor (i.e., big 4) was also found to be a significant determinant, indicating a negative association between the two variables. a company seems less likely to switch auditor if its current auditor is one of the big 4. 5. summary and conclusion the research objective of the study is to investigate the impact of corporate governance on auditor switch decision. in particular, the study investigates the association between board independence, duality and the propensity to switch auditor. based on a sample size of 712 non-financial companies, the results suggest board independence as one of the determinant factors of auditor switch. other significant determinants include the provision of non-audit service, changes in management, size and big 4. the outcome of the study indicates the impact of sound governance on auditor switch decision and might provide insightful knowledge which helps shareholders to realize the importance of having balance bods. the study recommends that future studies should include additional corporate governance variables such as the effectiveness of audit committee, management ownership and ownership concentration. lastly, a longer period of years could be covered to have a true reflection on the issue. 6. acknowledgement this paper is financially supported by the universiti utara malaysia’s pibt research grant. references abdel-khalik, a.r. 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(2000), audit switch decisions of malaysian listed firms: test of determinants of wealth effect. capital market review, 8(2), 1-24. ismail, s., aliahmed, h.j., nassir, a.m., hamid, m.a.a. (2008), why malaysian second board companies switch auditors: evidence of bursa malaysia. international research journal of finance and economics, 13(13), 123-130. joher, h., ali, m., ramidili, s.m., nassir, a.m. (2000), auditor switch decision of malaysian listed finns: tests of determinants and wealth effect. pertanika journal of social sciences and humanities, 8(2), 77-90. jubb, p.b. (2000), auditors as whistleblowers. international journal of auditing, 4(2), 153-167. knapp, m.c., elikai, f. (1988), auditor changes: a note on the policy implications of recent analytical and empirical research. journal of accounting, auditing and finance, 3(1), 78-86. nazri, s.n.f., smith, m., ismail, z. (2012a), factors influencing auditor change: evidence from malaysia. asian review of accounting, 20(3), 222-240. nazri, s.n.f., smith, m., ismail, z. (2012b), the impact of ethnicity on auditor choice: malaysian evidence. asian review of accounting, 20(3), 198-221. o’sullivan, n. (2000), the impact of board composition and ownership on audit quality: evidence from large uk companies. the british accounting review, 32(4), 397-414. o’neill, h.m., pounder, r.w., buchholtz, a.k. (1998), patterns in the diffusion of strategies across organizations: insights from the innovation diffusion literature. academy of management review, 23(1), 98-114. table 2: results of auditor switch model variables coefficient standard error z p>z nedbod 1.3275 0.7390 1.8000 0.0720* dual −0.2977 0.2471 −1.2100 0.2280 nas −0.3945 0.1990 −1.9800 0.0470** nasaudfee −0.0077 0.0422 −0.1800 0.8550 mgtchg 0.5336 0.3017 1.7700 0.0770* levtdta 0.0003 0.0003 0.8200 0.4110 lgsizeasset −0.4884 0.2016 −2.4200 0.0150** growth 0.0001 0.0002 0.6200 0.5350 lgaud_fee 0.4928 0.3060 1.6100 0.1070 opinion 0.2785 0.5268 0.5300 0.5970 big4 −1.1852 0.2056 −5.7600 0.0000*** cons 0.7607 0.8666 0.8800 0.3800 number of obs 712 lr chi-square (11) 89.57 p>chi-square 0.0000 pseudo r2 0.1082 log likelihood −369.25745 the dependent variable (audswch) is 1 for auditor-changed companies. the p values are based on two-tailed tests. *, **, ***denotes significance at 10%, 5% and 1% level, respectively . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(2), 450-455. international journal of economics and financial issues | vol 6 • issue 2 • 2016450 agricultural trade and its determinants: evidence from bounds testing approach for turkey kamil sertoglu1*, nezahat dogan2 1department of economics, faculty of business and economics, eastern mediterranean university, famagusta, north cyprus, 2department of business, faculty of economics and administrative sciences, british university of nicosia, kyrenia, north cyprus. *email: kamil.sertoglu@emu.edu.tr abstract this paper empirically analyses the long run relationship between agricultural trade performance and real exchange rate in turkey by using quarterly data covering 1994:q1-2012:q3. the other factors that are expected to effect agricultural trade balance such as ratio of export and import prices of agricultural goods, producer prices, real income of the country are also added to the model. for this purpose, bounds test approach for co-integration and autoregressive distributed lag method are used to show the existence of long-term relationship between agricultural trade balance and its determinants in turkey. the results show that real exchange rate, real gross domestic product, and agricultural producer prices are highly significant and have negative impact on determining agricultural trade balances in turkey. consequently, findings suggest that the policies or reforms that reducing producer prices and using new technologies to increase productivity may help to create trade surplus in agricultural trade of turkey. keywords: agricultural trade, turkey, bound test approach jel classifications: q17, q18, f14 1. introduction agriculture sector and its development are very important for both developed and developing countries, like seen in turkey with its climate, ecological and geographical conditions. according to the ministry of food agriculture and livestock of turkey (2013), turkey is in top five with 30 products in world agricultural product and with 20 products in exports in 2012, and the government defined the agriculture as a competitive and strategic economic sector rather than a social sector. another report written by organization for economics cooperation and development (oecd) (2011) defined turkey’s agriculture as 7th biggest agricultural power of the world and mentioned that the recent reforms made by the government have been affected the sector positively in terms of agricultural exports. however, too see the big picture, it would be better to look at both agricultural export and agricultural import together. as it can be seen from figure 1, turkey was a net exporter from 1994:q1 to 2000:q1 period. especially until 2001, the government has supported agricultural sector with direct intervention on agricultural input and output prices such as providing subsidies or lower cost bank credits to prevent the farmers from unexpected climate and natural effects and buyers of agricultural goods from fluctuations in the market as well. however, after 2001 turkey’s figure 1: agricultural trade volume of turkey sertoglu and dogan: agricultural trade and its determinants: evidence from bounds testing approach for turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016 451 agricultural exports and imports increased together, and the gap between exports and imports has started to narrow in last years. the position of turkey changes from net exporter to net importer nowadays. the rapid increase in agricultural imports of turkey may be associated with changes in some macroeconomic variables such as economic growth, real exchange rate, export and import prices, and producer prices. in this study, instead of using price indices, volume indices are preferred to use to consider demand changes rather than changes in price. because, the reason of increased import may be explained not only by cheaper import prices but also increased in domestic demand as well. in addition to changes in these variables, another reason of increasing imports can be explained by turkey’s agricultural import policy options on agreements of world trade organization and integration to the european union (eu) with two chapters (chapter 11-12) directly related to agriculture in negotiations with eu; agriculture and rural development, food safety, veterinary and plant health. in this paper, determinants of turkish agricultural trade will be estimated. in next section literature about agricultural trade studies will be presented, then data and methodology will be discussed and in last part empirical results and conclusion will be discussed and finalized. 2. literature review in the literature, most of the studies use the elasticity approach to explain trade balance of countries. in these studies, the results may vary depending on the different period of time, variables, and countries used in the studies. elasticity approach focuses on changes in real exchange rate of countries. this can be explained by using marshall-lerner (ml) condition. according to ml condition, when absolute value of summation of domestic demand elasticity of imports and foreign demand elasticity of exports is >1, a rise in exchange rate (depreciation of domestic currency) improves the trade balance of countries in long run. however, in this study it was aimed that were determine the factors effecting turkish agricultural trade. therefore, this part includes some examples from turkish agricultural market. yazici and islam (2012) investigated the short run and long run impact of exchange rate on agricultural trade balance of turkey with european union based on the data 1988:q1 2008:q4 period and concludes that depreciation of domestic currency (rise in exchange rate) has significant negative impact on agricultural trade of turkey. yazici (2008) studied the effect of exchange rate on three sector of turkey, including agriculture, by using the almon lag technique and found that a rise in exchange rate first improves the agricultural trade, then worsens, then improves, and finally in the long run it has negative effect on agricultural trade balance. yanikkaya et al. (2013) analyzed the selected agricultural commodities export flow of turkey by using panel data set for the years from 1971 to 2010 and found that depreciation in turkish lira leads higher exports for grape and hazelnut. another study by fidan (2006) concluded that real effective exchange rate (reer) does not have significant effect on agricultural exports and imports of turkey. on the other hand, erdem et al. (2010) examined the impact of exchange rate uncertainty on agricultural trade in turkey by using panel cointegration method for the years 1980-2005, and found that import trade volumes are more sensitive than export volumes to the negative impacts of exchange rate uncertainty. erdal et al. (2012) used the data from 1995 to 2007 and claimed that exchange rate volatility has positive significant impact on agricultural exports of turkey, but negative significant impact on agricultural imports of turkey. another study conducted by uzunoz and akcay (2009), analyzed the import demand for wheat during the period 1984-2006 for turkey by using double log-linear function and they found that turkey’s import demand for wheat negatively affected by amount of production and positively affected by exchange rate, domestic price, and income per capita. in turkey, the studies about the international trade generally concerned general economic sector rather focusing on sub sectors such as agriculture or mining etc. table 1 shows some examples from the literature regarding studies turkey’s trade balance, exports, and imports in different time periods and their conclusions. as it can be understood from this table 1, there is not much study regarding agricultural trade more specifically. the studies about the agricultural sector were mentioned above and their number is very limited and mainly focusing on exchange rate as a variable. however, this paper considers more than one variable including country specific and sector specific factors such as agricultural export and import price ratio and agricultural producer prices rather than using only exchange rate as a determinant of turkey’s agricultural trade. and also, it uses the recent dataset and agricultural trade balance volume to consider demand changes rather than focusing on only import or export side and their prices. and finally, this study tries to look at general picture of turkish agricultural trade instead of focusing on only one product as did in previous studies. it will provide to see big picture and recent trends in agricultural trade of turkey. 3. data and methodology in this paper, quarterly data covering 1994:q1 2012:q3 is used and agricultural trade volume balance (balance), reer, the ratio of agricultural export price to import price (pr), real gdp per capita of turkey (rgdp), and agricultural goods producer price index (ppi) for turkey are the variables used in the study. balance, reer and pr data were obtained from statistics of international trade of oecd, and also, rgdp and ppi data were obtained from turkish statistical institute. the logarithmic forms of the variables were used in the analyses. series that have significant seasonality are also corrected by using x-12 method in the e-views 8-software package. to investigate the long run relationship between the variables, bound test for co-integration with autoregressive distributed lag (ardl) modeling approach was adopted in this study. this model is recently developed by pesaran et al. (2001) and provides some advantages in application; first, it can be applied even if the variables have different order of integration; second, it is good to prefer in small samples; and finally, it gives both short run estimation with error correction model (ecm) and long run estimations simultaneously. however, sertoglu and dogan: agricultural trade and its determinants: evidence from bounds testing approach for turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016452 the main focus in this paper is to analyze the long run estimates for turkish agricultural trade balance. ardl approach has two stages. fist of all, long run relationship among variables should be determined by using bound test developed by pesaran and shin (1999). in the case of having any information on direction of relationship between variables, unrestricted conditional rcm (uecm) is estimated in the bound test approach. while doing this, each variable is taken as dependent variable and uecm is defined as: ∆ ∆ ∆ y t y v y v d t t i it j t j j p i ij it j t = + + + + + + − − − == − ∑∑µ µ λ θ γ ω ψ 0 1 1 1 1 11 4 ' ++ == ∑∑ εt j p i 01 4 in this equation, vt is the vector defined as vt=(lpr, lreer, lrgdp, lppi), dt is the vector including exogenous variables such as structural break dummies. here, according to the wald test, null hypothesis asserts that there is no co-integration (h0: λ1 = θ1 = θ2 = θ3 = θ4 = 0), while the alternative hypothesis asserts long run relationship between variables (h0: λ1 ≠ θ1 ≠ θ2 ≠ θ3 ≠ θ4 ≠ 0). while testing the null hypothesis, critical values provided by pesaran et al. (2001) is used. they provide three different scenarios in their paper about the conclusions of test results. when calculated f statistics exceeds the upper bound critical value in given significance, null hypothesis is rejected and we can conclude that variables have long run relationship (cointegrated). in the light of the results, ardl approach to the estimation of level relations is adopted as below. y y v d ut j t j j p ij it j t t j q i i i = + + + +− = − == ∑ ∑∑µ β φ ψ0 1 01 4 ' here, all variables are defines as above. then, the next step in ardl procedure, conditional ecm is defined as; ∆ ∆ ∆y y v ecm dt j t j ij it j t t t j p ij p = + + + + +− − − === ∑∑∑µ γ ω ϑ ψ ε1 01 4 1 ' in this equation, whilst γj and ωij are short-term parameters, shows the speed of adjustment through the long run equilibrium. error correction term (ecmt) is defined in following format; ecm y lpr lreer lrgdp lppit t= − − − − −β β β β β ^ ^ ^ ^ ^ 0 1 2 3 4 4. empirical results correlations among the variables are given in table 2. according to the results, highest correlation among variables is between balance and lppi with 78%. it simply means that there table 1: some studies in the literature about turkey’s trade balance, export, and import authors (date of study) covered period of time findings of studies berberoğlu and oktay (1987) 1980-1987 significant relationship between trade balance of turkey and exchange rate abuşoğlu (1990) 1980-1988 insignificant relationship between real effective exchange rate and turkey’s export egeli (1992) after 1980 conclude that the export credits are better as a policy instrument rather than exchange rate policies ulusoy and zengin (1995) 1970-1992 insignificant relationship between real exchange rate and export zengin and terzi (1995) 1950-1994 no long run relationship and causality between exchange rate, trade balance, export and import terzi and zengin (1999) 1989-1996 insignificant relationship between exchange rate and trade balance zengin (2000) 1993:01-2000:08 found that the exchange rate is ineffective tool to improve trade balance sivri and usta (2001) 1994:01-2000:06 no causality from real exchange rate to import and export akbostancı (2002) 1987:01-2000:04 positive shock in real exchange rate first improves the trade balance, then decreases, then improves again gürbüz and çekerol (2002) 1995:01-2002:01 no long run relationship between exchange rate and trade balance yamak and korkmaz (2005) 1995:01-2004:04 in the short run, the relationship between real exchange rate and trade balance is determined by capital goods barışık and demircioğlu (2006) by using only exchange rate as a policy tool to improve trade balance will not give effective results doğanlar (2002) 1980-1996 negative relationship between exchange rate uncertainty and export bügük et al. (2003) no relationship between exchange rate uncertainty and agricultural export demirel and erdem (2004) 1990:01-2001:04 significant impact of exchange rate uncertainty on exports to germany, england, italy, and usa i̇rhan et al., (2011) 1990:q1-2007:q3 real exchange rate depreciation improves the trade balance and no significant effect of crude oil prices azgun (2011) 1989:q1-2009:q3 exchange rate shocks explain 21%, public and private consumption expenditure explain 30%, and interest rates explain 10% of the estimation error variance of the foreign trade balance yazici and islam (2012) 1988:q1-2008:q4 depreciation of turkish lira improves the trade balance in short run, but has negative impact on trade balance in long run source: adopted from hepaktan et al.(2011) sertoglu and dogan: agricultural trade and its determinants: evidence from bounds testing approach for turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016 453 is almost 80% negative correlation between trade balances in agricultural goods with the ppi as an indicator of cost of production in agricultural goods. the augmented dickey fuller (adf) and phillips-perron (pp) unit roots tests are also employed and the results are given in table 3. according to the unit root test results, all variables are stationary at their first differences, which means integrated of order 1. agricultural trade balance (balance) is nonstationary in adf, and pp test suggest that balance is integrated of order zero only at 10% significant level. however, some can conclude that adf can be taken into consideration as an alternative to pp. now, considering the stationary of variables in first differences for turkey, table 4 gives the bound test results for co-integration between lpr, lrgdp, lreer, lppi and balance under three different scenarios suggested by pesaran et al. (2001). maximum lag order (p) is determined as 2 according to both akaike information criteria results and schwartz information criteria results. therefore, maximum lag length is set to 2. since k=4 (number of independent variables), the 0.05 critical value bounds are (2.86, 4.01), (–2.86, –3.99), (3.05, 3.97), (3.47, 4.57) (–3.41, –4.36) for fiii, tiii, fiv, fv, and tv, respectively. for p=2, tests lie outside the 0.05 critical value bounds and reject the null hypothesis that there exists no level equation in both cases without or with deterministic trend. overall, the test results supports the existence of level equation (long run relationship) when a sufficiently high lag order is selected. table 5 shows the results of level equation (long run estimation) results for turkish agricultural trade balance. coefficients of all variables in the equation, except lpr even though it has the expected sign, are highly significant. according to the price theory, we are expecting higher quantity of supply, which is agricultural exports of turkey in this study, in the case of increasing in price. therefore, lpr has the correct sign but seems insignificant in the long run. another important determinant of the turkish agricultural trade balance is the real exchange rate, which is defined as the price of domestic currency in terms of foreign currency. any increase in real exchange rates (depreciation of domestic currency) is expected to increase trade balance through making the exports cheaper for foreigners and imports more expensive for domestic consumers, which lead positive coefficient in the model. however, for the agricultural trade of turkey, although it is highly significant, it negatively affects agricultural trade balance of turkey interestingly. on the other hand, this result shouldn’t be surprise for agricultural goods. the coefficient of reer (–0.610) shows us that turkish agricultural trade balance is inelastic with respect to reer, exactly similar with inelastic demand of agricultural goods in general. and also, in the literature, there are some studies shows that exchange rate rises is known to have negative effects on exports for developing countries (hall et al., 2010). similar findings are observed for turkey as well (rey, 2006; balcilar et al., 2013). according to the arndt and huemer (2004) and freund et al. (2012), although the sign of the reer is expected to be positive under normal conditions, increase in the share of imported inputs in exports and assembly can be eliminated the positive effect of reer on supply of exports and the its estimated parameter may be negative or insignificant. other important variable that determines the agricultural trade balance is real income per capita (rgdp) of turkey. as far as the expected, it shows a negative impact on agricultural trade balances. it means that increase in real domestic income in turkey will lead higher demand for goods and services including foreign agricultural goods as well. therefore, it will affect agricultural trade balance of turkey as negatively through increasing the imports from abroad even if keeping the exports constant. finally, lppi, as an indicator of cost of agricultural production including fuel oil, fertilizer, machinery, seed, labor etc., has table 2: pearson correlation coefficients variables balance lpr lreer16 lrgdp lppi balance 1.000000 lpr –0.362275 1.000000 lreer16 –0.011387 0.324258 1.000000 lrgdp –0.769904 0.290381 –0.270362 1.000000 lppi –0.785039 0.486418 –0.154358 0.841046 1.000000 table 3: unit root test results tests & variables level first differences intercept intercept and trend intercept intercept and trend adf balance –1.616451 (9) –4.338385*** (0) –9.190612*** (0) –9.168434** *(5) lpr –2.606185*(1) –2.664800 (1) –6.721317*** (1) –4.907961*** (0) lreer16 –2.662229* (1) –3.066627 (1) –10.67072*** (0) –10.59971*** (0) lrgdp –0.536196 (0) –2.325624 (0) –9.280125*** (0) –9.203514*** (0) lppi –2.568524 (4) –1.912647 (4) –1.590427 (7) –2.563372 (3) pp balance –3.099295* –4.411564*** –9.190612*** –9.168434*** lpr –2.363764 –2.518332 –6.640386*** –6.580352*** lreer13 –3.831026*** ––3.849697** –11.93171*** –12.81643*** lrgdp –0.536196 –2.531930 –9.150631*** –9.081660*** lppi –2.519750 –2.460247 –9.602171*** –15.14926*** *,**,***: ??? sertoglu and dogan: agricultural trade and its determinants: evidence from bounds testing approach for turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016454 negative sign and highly significant as expected for turkey. this result indicates that in the long run, increased in the agricultural producer prices affects turkish agricultural trade balance negatively. 5. conclusion and policy implications this paper has empirically analyzed the long run relationship between turkish agricultural trade balance, real exchange rate, real income, agricultural goods trade prices, and producer prices by using the bound test and ardl approach based on the quarterly data covering 1994:q1 2012:q3 period. the result of bound test confirm the co-integration between the variables. the main contribution of the paper is to analyze the turkish agricultural sector by using the up to date sectorial data rather than focusing on only one variable related to international trade in general such as real exchange rate. the focus of this paper is to see the main country specific reason of worsen agricultural trade balance in recent years. results indicate that in long run real an increase in exchange rate, real income and producer prices effects turkish agricultural trade balance negatively. this finding suggests that to improve the turkish agricultural trade balance through exchange rate policy, domestic currency should be appreciated with respect to other currencies. and last and may be the most important finding is to improve turkish agricultural trade balance by decreasing producer prices (cost of production) through supporting farmers (producers) via different channels such as using new technologies to lower production costs. government has a central role especially in developing countries in this respect. government can provide some lower cost credits to the farmers and financial incentives for supporting them as well. when we consider the fuel oil prices in turkey as an input (cost) of agricultural production like other sectors of economy, developing countries like turkey can try to use some other technologies rather that fuel oil due to its highest cost. if government wants to increase agricultural goods production in turkey, they may reduce the taxes and duties of imported agricultural machinery to decrease the cost of production. especially after the process in eu integration new policy environment is required to increase the agricultural production, and in turn, it is expected to improve agricultural trade balance. in this respect decision makers can describe some additional domestic policy tools such as infrastructural development, using r&d approach, insurance and credit markets etc. it should be reminded that the results obtained from this study recommends to decrease cost of production in agriculture to have comparative advantage among other countries and it depends on using new technologies in this sector to get more efficient allocation of resources and more production. primarily, the structure of the agricultural sector should be competitive. this is provided by diversification of rural economy and development in human resources to improve the capacity. we can also define the agricultural sector priorities as strengthening of agricultural marketing infrastructure and agro industries integration. in this context, establishment of market information systems, dissemination of licensed warehousing system, establishment of commodity exchanges and provision of liquidity to the agricultural sector should be provided. on the other hand, some of the farmers have been confronted with new technology but have not been informed in use of these tools and machines to overcome the problems encountered in reducing production costs and achieve more gain. therefore, agricultural extension activities should be expanded by creating relevant units to support and assist to farmers at the stage of transition to controlled and equipped production. and finally, supports for production should be well planned to reach an adequate level in turkey. references abuşoğlu, ö. 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(1995), türkiye’de kur politikası, i̇thalat, i̇hracat ve dış ticaret dengesi i̇lişkisinin ekonometrik analizi. gazi university journal of economics and administrative sciences, 11(1-2), 247-266. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(3), 861-871. international journal of economics and financial issues | vol 6 • issue 3 • 2016 861 cost efficiency of the egyptian banking sector: a panel data analysis hassan ismail hassan1, ammar jreisat2* 1department of banking and finance, college of business administrative, al ain university of science and technology, uae, 2department of banking and finance, college of business administrative, al ain university of science and technology, uae. *email: ammar.jreisat@aau.ac.ae abstract based on a two stage method this paper investigates the determinants of the cost efficiency (ce) of egyptian banking sector. employing data envelopment analysis (dea). we compare the ce of large, medium and small banks and the ce of foreign and domestic banks using a balanced panel which cover 14 banks operating in egypt from 1997 to 2013. in the first stage, ce scores are computed using an input-oriented dea. at the second stage, ce scores are regressed on a set of potential explanatory variables in a logit model. while the ce scores show large improvements in the early and third phases of financial deregulation. over the entire sample period, ce has declined at the rate of 0.963% per annum. our finding indicates that age, loan to net interest margin, return on equity and good management practices positively affects banks ce and number of bank branches negatively affects bank ce. keywords: cost efficiency, two-stage data envelopment analysis, egyptian banks jel classifications: d22, d24, d61, g21 1. introduction measuring banks’ performance have recently received great attention especially after the banking and financial crisis which started in 2007. two basic questions in banking are whether banks outperform or underperform their benchmarks and whether superior performance persists? with the egyptian economy’s slowdown, bank efficiency has become a concern for policymakers and egyptian banks have had to find creative ways to optimize their cost structures. there is a large body of literature dealing with the measurement of banking efficiency in the developed economies, but studies on banking efficiency relating to middle eastern economies are few. up to our knowledge, there is a no research related directly to the cost efficiency (ce) of banks in egypt. one of the reasons for the lack of this research is that most middle eastern countries including egypt did not introduce financial and banking sector reforms until the 1990s. until then, financial systems tended to be heavily regulated and dominated by the public sector (united nations, 2005). however, over the past two decades, the majority of middle east countries have gradually moved towards more liberalized financial systems. this has created interest among policy makers, managers and economists in assessing the efficiency performance of banks in middle eastern countries over time. in specific, the banking efficiency is essential for the survival of banks in egypt as the egyptian government accrue unprecedented outstanding loans during the last few decades. however, the ultimate ramifications of the high, yet debt-backed growth were uncontrollable inflation and enormous outstanding debts. evaluating ce of banks is significant for many reasons. first, to investigate weather banks are successful in their field of both individual banks and banking industry as a whole. second, efficiency is considered to be a vital factor for financial institutions wishing to maintain and monitor their business successfully, given the increasing global competition in financial markets. third, in a rapidly changing and more globalized financial marketplace, governments, regulators, managers and investors are concerned about how efficiently banks transform their expensive inputs into various financial products and services. finally, it may be noted that efficiency measures are critical aspects of banking industry that enable us to distinguish hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016862 banks that will survive and prosper from those that will fail and have problems with competitiveness. the efficiency of banks and other financial institutions is assessed based on summary measures which are technical in nature. these measures are quite crucial to understand and compare the efficiency estimates of banks of different sizes and over time. the aim of this research is to fill the gap to the existing literature on banking efficiency in egypt. the era of our sample is very rich with many aspects that influenced the egyptian banking system, starting with 2003 when the egyptian government decided to fully liberalize the currency exchange rate where the rate is set according to the market forces. the egyptian government believed that floating the egyptian pound against the us dollar will help the economy to be more competitive. in 2004, the central bank of egypt (cbe) started a new program to restructure the banking sector and deal with non-performing loans by encouraging a wave of mergers and acquisitions which enabled large and strong banks to acquire many small banks. the number of banks decreased from 65 banks in 1997 to only 39 banks in 2013. however, the global financial crises and the egyptian revolution in 2011 brought about great changes in practices of egyptian banks from 2009 to 2013. this research will provide a new perspective to the field of banking efficiency in egypt. the primary objective of this research is to undertake in-depth evaluation and examination the ce of banks operating in egypt for a balanced panel which covers 14 banks operating in egypt (3 large, 5 medium, 3 small and 3 foreign) for the period 1997-2013, by estimating a non-parametric approach data envelopment analysis (dea). the study compares the ce levels between the foreign banks and domestic banks, between large banks, medium and small banks during the sample period. the empirical results are obtained by running an input-oriented dea model using the software package, deap version 2.1 (coelli, 1996). the paper is organized as follows. section 2 provide overview on the financial reforms and banking sector in egypt. section 3 provide a review of literature on the egyptian banking efficiency. the concept of ce and its estimation based on dea approach discusses providing the dea results in section 4. section 5 provide the data as well as input and output variables. determinants of banks efficiency and the related estimation results are presented in section 5. section 6 presents some conclusions. 2. financial reforms and banking sector in egypt the egyptian banking industry has important achievements at the local and global levels in the last two decades. it played a great role in developing the egyptian economy through the activation of financial system, providing funds for mega projects in infrastructure and social services and inventing new services and products to move surpluses to sectors which has deficits. the egyptian economy has changed greatly in the last two decades. the egyptian government has altered its attitude towards a fully market-oriented economy. the government embarked upon a major program of economic reform that stimulated banking industry. this new program aimed generally at expanding the private sector’s ownership base, integrating into the global economy, and accelerating the pace of privatization of the public sector (central bank of egypt, 1996). consequently, the government issued public enterprise companies law no. 203/1991 to facilitate the implementation of the privatization program. additionally, in 1992, the government developed the legislations and legal regulations of the egyptian stock exchanges through the passage of capital market law no.95/1992. in specific, this program designed with help of international monetary fund and the world bank to decrease the government’s role in the financial sector, to encourage private sector investments, to introduce market-oriented banking mechanisms, to promote foreign direct investment in egypt and to enhance competition in the banking sector. however, there was a weak economic growth as a consequence of several economic and political shocks. consequently, several banking laws had been relaxed which was the first step to be taken by the egyptian government to remove many barriers toward market-oriented mechanisms. for example, interest rate ceilings have been removed, public companies permitted to deal with private and foreign banks and restrictions on banking fees and commissions have been eradicated. these new laws enabled both foreign and private banks to operate in parallel with public banks. it also obliged state-owned banks to face sever outside competition and to improve the quality of their credit. in 1996, the government issued new laws that permit 100% foreign ownership of banks and allow banks to do business in both foreign and local currencies (central bank of egypt, 2001). these new laws enabled both private and foreign banks to operate in a competitive environment. in 2003, the cbe started its comprehensive reform plan to promote the banking sector by consolidating and enhancing the overbanked and under-branched banking sector. the government seeks to enhance banking competition, diminish nonperforming loans, raise capital adequacy and ensure devotion to prudential regulations through specific banking restructuring programs (reda, 2013). as a result, a non-performing loans (npl) monitoring unit was established by the cbe in 2004 to restructure the state owned banks, consolidate banking systems through mergers and acquisitions of small and weak banks, privatize some state-owned banks, divest public sector shares in joint venture banks, resolve non-performing loans and strengthen the supervisory authority of the cbe (central bank of egypt, 2010). the cbe required the big four public banks which own more than 50% of the banking sector’ assets to sell their stakes in joint-venture banks and to raise paid up capital requirements to a minimum of usd 50 million for branches of foreign banks (central bank of egypt, 2005). it also refrained from issuing new banking licenses which effectively direct foreign banks to form a partnership with a local bank. this program helped the egyptian banks to comply with the guidelines of basel accord ii (central bank of egypt, 2010). moreover, the government started to privatize state-owned banks to decrease the oligopolistic appearance of these banks, to prevent further market fragmentation and to improve know-how through the participation of foreign banks. as a result, the number of banks operating in egypt plunged from 65 in 2003 to 40 in 2014 (central bank of egypt, 2014). hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016 863 3. a review of literature on the egyptian banking efficiency the last few decades have witnessed an ever-growing volume of various studies in the field banking efficiency worldwide. however, this study is by no means the first to focus on the ce of the egyptian banking sector. there have been a number of papers concerned with the ce in developed and developing countries. ferrier and lovell (1990) apply parametric stochastic frontier analysis (sfa) and non-parametric dea on a sample of 575 us banks to estimate ce. their results suggest both similarities and differences between the approaches. both techniques broadly agree on the average value of ce: 74% with sfa and 79% with dea. however, they observe a very different decomposition of cost inefficiencies between technical and allocative inefficiencies: technical inefficiencies dominate with dea, while allocative inefficiencies are stronger with sfa. gulati (2015) investigates the trends of ce of indian banking sector in response to financial deregulations in the beginning of 1990s. gulati finds that deregulation programme affected positively on ce and the increase of cost was due to improvements in technical efficiency. he also finds that public and foreign banks are better than private banks. he concluded that the size of banks and off-balance sheet activities are the key drivers of ce. jaffry et al. (2012) examine the trends in the efficiency levels of indian and pakistani commercial banks from 1985 to 2003 after a significant change in regulations in both countries. they find that the efficiency levels has decreased post reform period and then increased gradually. they concluded that banks need a period of initial adjustment after regulations followed by a subsequent correction period. in addition, chen et al. (2004) examined the cost, technical and allocative efficiency (ae) of 43 chinese banks covering the deregulation era from 1993 till 2000 by running input oriented dea approach. they employed the intermediation approach for choosing three inputs prices (price of labor, price of deposits and price of capital) with three outputs (loans, deposits and non-interest income). the study investigated the change in the efficiency of chinese banks’ after the initiation of a program of deregulation in 1995. it was found that large state-owned banks and smaller banks were more efficient than medium sized chinese banks. moreover, chinese banks during the financial deregulation of 1995 were recorded improvement in ce levels including both technical and ae. hassan et al. (2004) investigated efficiency of the banking sector in bahrain based on data for a panel of 31 banks in 1998 and 2000. their study estimated allocative and technical efficiencies, scale efficiency and overall ce. the model used three inputs, namely, labor, capital, and loanable funds and two outputs, namely, short term loan and long term loans. the input prices were: price of labor, price of capital, and interest rate on loanable funds. their result indicated that the average ae was about 73%, whereas the average technical efficiency was about 56%. recently, jreisat et al. (2015) examined the ce levels of jordanian banks during the reform period from 1996 to 2007. they suggest that both the domestic and foreign banks have shown slight improvements over the years of deregulation era and this led to improvement in the efficiency of the jordanian banking sector. they also investigated whether ownership structure, size, number of branches and atm, bad loan and age of the bank significantly affect the ce levels of jordanian banks. interestingly, their finding on the effect of number of atm on the ce is a statistically significant with positive impact on ce in jordanian banks. in addition, the results reveal that the relationship between bad loan (credit risk) and ce seems to be very strong, in which bad loan is significantly negatively related to ce. alkhathlan and malik (2010) investigated both technical and scale efficiencies of saudi commercial banks for the period, 2003-2008. their sample covered ten out of twelve commercial banks. they employed the dea intermediation approach. the result indicated that the majority of saudi banks operated at higher levels of efficiency and managed their financial resources adequately. jreisat et al. (2015), this paper aims to measure and evaluate the ce for 17 jordanian banks (2 large, 8 medium, 4 small and 3 foreign) for the period 1996-2007 covering the deregulation era, by employing a parametric estimation approach also known as a sfa. in addition, this paper analyze the sources of the ce method developed by papke and wooldridge (1996). the empirical result for the ce are obtained by running an input-oriented sfa model using the computer program, frontier version 4.1., developed by coelli (1996). the paper findings suggest that both the domestic and foreign banks have shown over the years of deregulation era slight improvements and this led to improvement in the efficiency of the jordanian banking sector. in addition, this paper investigates whether ownership structure, size, number of branches and atm, bad loan and age of the bank significantly affect the ce levels of jordanian banks. results show that differences in ownership structure significantly affect jordanian banks‟ performance in terms of ce. another study done by jreisat and paul (2010), provided a review of banking efficiency in the middle east economies with a special emphasis on measuring the efficiency of banking sector in jordan, they find that majority of studies have used dea approach; only few have used sfa methodology to compute efficiency estimates. these studies have revealed that banks have achieved some levels of efficiency. also, they presented a detailed analysis of banking efficiency in jordan using data for the period 1996-2007. the input oriented dea methodology is applied to obtain estimates of technical efficiency decomposed into pure technical and scale efficiency. an attempt is also made to check whether banks are operating at most efficient scale size. their analysis reveals that the arab bank which is one of the large banks has performed at the highest level of technical efficiency during the sample period. the small banks are found to be more efficient than the medium sized banks. the foreign banks have shown the lowest technical efficiency indicating a large scope for cost reduction. 4. the ce: concept and measurement a bank is considered cost efficient if it can find a combination of inputs that enables it to produce the desired (given) outputs at the minimum cost. the ce is the product of technical and allocative efficiencies. a firm/bank is considered technically efficient if it is not possible to reduce the level of inputs to produce a given level of output. to put in other words, the existence of technical inefficiency would mean that some inputs can be reduced without hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016864 affecting the level of output. the ae refers to the selection of inputs to produce a certain level of outputs at given input prices such that the cost of production is minimum. ce is defined as the ratio of minimum (optimum) cost to the observed cost for producing a level of output by a firm. if the ce score for a firm is 0.75, then it would mean that the bank could have achieved the same level of output with 75% of its costs. in other words, the firm wastes 25% of its costs relative to the best-practice firm (berger and mester, 1997). figure 1, reproduced from coelli et al. (2005. p. 52), explains how ce can be conceptualized and measured using input-oriented measures1. the working of this is explained by farrell (1957), who used a simple example of a firm requiring two inputs x1 and x2 for producing one output q, assuming constant return to scale. let w refer to input price vector and x to the observed vector of inputs used associated with point p; and let x̂ and x* refer to the input vectors associated with the technically efficient point q and the cost minimizing input vector at ′q respectively. thus, ce can be defined as the ratio of input costs associated with input vectors x and x ∗ associated with points p q and ′ . ce or op= ′ ′ = w x w x * / (1) as shown in figure 1, the slope of the isocost line aa′ represents the proportion of input prices. ae and te can be calculated as follows: *w x ˆw x ′ = = ′ or ae oq (2) ˆw x w x ′ = = ′ oq te op (3) thus, if the firm sets its inputs at the point q on the isoquant curve ss′ , then it can be said that this firm is technically efficient but allocatively inefficient. if the firm wishes to be technically and allocatively efficient it should reduce the production cost represented by the distance rq, which would occur at the allocatively (and technically) efficient point ′q , instead of at the technically efficient but allocatively inefficient point q. it follows from this that ce can be expressed as the product of technical and ae measures: te×ae=(oq/op)×(or/oq)=(or/op)=ce (4) dea efficiency scores assign numerical values (between 0 and 1 or 0 and 100%) to the ce level of a dmu relative to others. ce of one represents a fully cost efficient bank; (1−ce) represents the amount by which the bank could reduce its costs and still produce at least the same amount of output. to measure ce, two sets of linear programs are required, one to measure technical efficiency and the other to measure ce. the ce is often called economic efficiency or overall efficiency. the details of linear programming required to estimate ce is provided in coelli et al. (2005. p. 184) and hence is not repeated here. 1 coelli et al. (2005) discussed input-oriented and output-oriented measures, for more details see p51-57. 4.1. choice of variable for dea model the intermediation approach is quite popular in empirical research particularly based on cross-section data (colwell and davis, 1992; favero and papi, 1995). in the dea approach, the number of inputs and outputs is always determined by the number of dmus (banks in the present context) in the sample. the ability of dea to distinguish between efficient dmus and inefficient dmus depends on a number of inputs and outputs incorporated in the dea model. it is widely recognized that product of the number of inputs and outputs should not exceed the number of dmus in the sample (cooper et al. 2000). this study uses the intermediation approach originally suggested by sealey and lindley (1977), in which banks are viewed as intermediaries. in other word, intermediation approach views financial institutions as intermediaries that convert and transfer financial assets from surplus units to deficit units. the estimation of ce requires data not only on real values of inputs and outputs but also on input prices. the inputs and outputs variables used in this paper are listed in table 1. the input prices for each bank for each year are calculated as follows. 4.2. data sources the data used in this study covers 1997-2013 period and are taken from, auditing annual report of individual banks cbe. the data were collected from 14 banks operating in egypt, 11 domestic banks, and 3 foreign banks. assets of these banks are given in table 2. 4.3. empirical results on ce the ce scores of banks are obtained by running an inputoriented dea model using the software package, deap version table 1: variable definitions banks’ input prices and outputs for egypt variables description outputs total loan: y1 total customers’ loan other investments: y2 investments in bonds and securities, shares, treasury bills, and investment in affiliate and subsidiary companies inputs labour: x1 number of employee total deposit: x2 total customers deposit input prices price of labour: pl wages and personal expenses and benefit of the banks staff divided by number of staff price of fund: pf interest expense divided by total deposits figure 1: cost, technical and allocative efficiencies hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016 865 2.1 (coelli, 1996). while the bank specific yearly scores are presented in appendix table a1, the sample period mean estimates of cost, allocative and technical efficiencies for the banking sector as a whole as well as for each bank category are presented in table 3. the ce score of banks is 51.7%, which implies that the banking sector could have reduced the cost of production by 41.7% without affecting the level of output. in other words, banks have wasted 41.7% of resources in producing their levels of output. the ae is quite high (91.1%). this is consistent with the estimates reported for banks in most of the countries. the group of large banks is found to be least efficient in terms of ce as well as in terms of technical efficiency. the ce of foreign banks is found to be the most efficient for the entire groups (64.4%). the time series estimates of the ce by bank categories presented in table 4 also reveal that the group of foreign banks has performed better than domestic banks in terms of ce and te in each year of the sample period. the gap in their efficiency levels has widened, especially from 2008 onwards. the ae of domestic banks is higher than the foreign banks. this implies that in terms of input use in response to input prices, the domestic banks are more efficient than their foreign counterparts. the group of small banks has outperformed all other domestic bank categories in terms of ce in almost all the sample years. the annual efficiency scores for the banking sector as a whole. the latter are the weighted geometric mean of bank-specific scores where their shares in total output serve as weights. the ce score was low (53.9%) in the beginning of the sample period. the efficiency scores show an improvement trend with some fluctuations till 2000 and a declining thereafter until 2005, the reason for declining the cost and technical efficiency for the period (2000-2005) may be due to firstly, the egyptian economy faced a serious currency liquidity crisis in 1999 prior to bank privatization. secondly, in 2003 the egyptian government decided to float the egyptian pound against the us$ which increased the banks’ foreign exchange losses, particularly, those that have significant proportion of their investment portfolio in foreign currency. the ce for the whole banking sector showing improvement from 2005 till 2010. however, the ce declined again from 2011 till 2013 and may be due the revaluation in egypt in 2011. the highest ce score of 65.1% in the year (2000) of the sample period. while the bank timeline of major financial reforms in egyptian banks from 1991 to 2013 are presented in appendix table a2. to understand how efficiency has changed over the sub-periods of financial reforms and how changes in allocative and technical efficiencies have contributed to it, we decompose the growth of ce as the sum of the growth of allocative and technical efficiencies using the relationship ae × te = ce (see equation 5). the decomposition estimates for broad categories of banks for the full period under study as well as four sub-periods 1997-2000, 2001-05, 2006-2010 and 2011-13, are presented in table 5. these sub-periods represent the phases of financial deregulation/reform in egyptian economy. ln ln ( ) ( ) ( ) ( ) ce ce ae ae crs t crs t vrs t vrs t− −         =         + 1 1 lln ( ) ( ) te te t t−         1 (5) the banking sector as a whole has experienced a decline in ce at the rate of 7.41% and 4.23% per annum respectively in the second and fourth phases of financial deregulation due to the decision of the egyptian government to float the egyptian pound against the us$ which increased the banks’ foreign exchange losses, particularly, those that have significant proportion of their investment portfolio in foreign currency in 2003, and due the revaluation in egypt in 2011. in the early and middle phases, ce has increased at the rate of 6.31% and 3.08% per annum respectively, two thirds of this improvement from an improvement in technical efficiency. table 2: assets of domestic and foreign banks in egypt, (1997‑2013) bank category bank name short name total assets (us millions) domestic large national bank of egypt nbe 15905295 banque misr bm 14758047.9 bank du caire bdc 8446256.8 medium commercial international bank cib 4011017.1 suez canal bank scb 2180494 faisal islamic bank fib 1838888 housing and development bank hdb 1590305 misr iran development bank midb 1160970 small export development bank of egypt edb 691101.18 al baraka bank egypt abe 461254.73 societe arabe internationale de banque saib 401020 foreign national societe generale bank nsgb 1164457 arab african international bank aaib 997995 hsbc egypt hsbc 636343.2 source: annual report for each bank 1997 table 3: sample period mean ce, ae and te in egypt (1997‑2013) bank categories ce ae te large 0.457 0.927 0.488 medium 0.548 0.852 0.636 small 0.641 0.879 0.722 foreign banks 0.644 0.862 0.744 domestic banks 0.490 0.907 0.537 all banks 0.517 0.911 0.570 ce: cost efficiency; ae: allocative efficiency; te: technical efficiency hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016866 5. determinants of ce in this section, we identify a set of variables that may affect the ce level of a bank. the potential variables of interest are drawn from a number of recent international studies on banking efficiency (e.g., cavallo and rossi, 2002; hermes and nhung, 2010; pasiouras et al. 2009; casu and girardone, 2004; and vu and turnell, 2011). our choices of variables may effects on the ce of the banks as follow: ltd: it is the ratio of loans to deposits. it assesses a bank’s ability to transform deposits into loans. the higher this ratio, the more efficient the process of financial intermediation provided by the bank. for example, vu and turnell (2011) found a positive and statistically significant relationship between ltd and ce. nieta: it is the ratio of non-interest expense to total assets. nieta measures the magnitude of administrative expenses. banks that employ good management practices should be able to achieve lower administrative costs. thus, it is expected that the higher the nieta, the lower the ce of a bank. roe: it is the return on equity. the higher the return on equity will lead the bank to be more efficient. nim: net interest margin. this variable is defined as the difference between interest income and interest expenses divided by total assets. this variable is expected to have a positive effect on efficiency, that is, the higher the nim, the higher the nim, the bank will be efficient. branches: number of branches for each bank refers to network density. a high network density leads to higher structural overheads and thus may lower ce. the increase in the number of table 4: estimates of ce by category of banks and ownership, 1997‑2013 banks eff 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 mean domestic banks large ce 0.484 0.504 0.579 0.622 0.579 0.542 0.457 0.419 0.402 0.405 0.395 0.392 0.397 0.414 0.410 0.452 0.412 0.457 ae 0.961 0.964 0.985 0.991 0.984 0.966 0.922 0.891 0.913 0.916 0.895 0.876 0.908 0.906 0.887 0.896 0.913 0.927 te 0.503 0.523 0.588 0.627 0.587 0.558 0.492 0.470 0.439 0.441 0.435 0.436 0.424 0.446 0.452 0.498 0.447 0.488 medium ce 0.649 0.751 0.767 0.686 0.642 0.575 0.490 0.442 0.458 0.471 0.494 0.430 0.479 0.555 0.575 0.568 0.448 0.548 ae 0.950 0.929 0.923 0.881 0.893 0.847 0.802 0.795 0.803 0.830 0.830 0.765 0.796 0.883 0.849 0.864 0.871 0.852 te 0.678 0.808 0.830 0.772 0.713 0.668 0.598 0.553 0.567 0.567 0.592 0.551 0.593 0.622 0.659 0.642 0.508 0.636 small ce 0.746 0.695 0.884 0.899 0.851 0.738 0.514 0.500 0.538 0.590 0.587 0.631 0.697 0.699 0.553 0.463 0.540 0.641 ae 0.941 0.941 0.950 0.957 0.920 0.908 0.885 0.885 0.835 0.871 0.875 0.867 0.909 0.911 0.810 0.773 0.742 0.879 te 0.779 0.730 0.913 0.926 0.909 0.802 0.576 0.568 0.657 0.681 0.663 0.709 0.752 0.753 0.677 0.584 0.723 0.722 foreign banks ce 0.737 0.749 0.700 0.730 0.670 0.593 0.496 0.447 0.554 0.546 0.651 0.791 0.720 0.727 0.663 0.675 0.618 0.644 ae 0.891 0.896 0.914 0.864 0.894 0.835 0.816 0.817 0.834 0.882 0.872 0.882 0.862 0.867 0.837 0.846 0.853 0.862 te 0.830 0.837 0.763 0.834 0.742 0.705 0.605 0.551 0.664 0.622 0.746 0.887 0.831 0.831 0.790 0.794 0.719 0.744 domestic banks ce 0.528 0.564 0.630 0.647 0.605 0.558 0.467 0.428 0.420 0.428 0.425 0.416 0.442 0.476 0.465 0.487 0.435 0.490 ae 0.958 0.956 0.971 0.968 0.962 0.937 0.894 0.868 0.884 0.895 0.880 0.851 0.878 0.900 0.871 0.877 0.884 0.907 te 0.550 0.592 0.651 0.669 0.628 0.594 0.519 0.494 0.478 0.481 0.479 0.479 0.494 0.519 0.524 0.547 0.490 0.537 all banks ce 0.539 0.574 0.634 0.651 0.608 0.560 0.469 0.450 0.449 0.454 0.469 0.487 0.499 0.524 0.508 0.521 0.462 0.517 ae 0.955 0.953 0.968 0.963 0.959 0.932 0.890 0.907 0.913 0.917 0.898 0.865 0.880 0.888 0.864 0.871 0.880 0.911 te 0.564 0.605 0.656 0.676 0.634 0.600 0.524 0.522 0.514 0.510 0.531 0.557 0.564 0.580 0.582 0.592 0.524 0.570 ce: cost efficiency; ae: allocative efficiency; te: technical efficiency table 5: average annual growth rates of ce by bank category in sub periods bank type period growth of ce growth of ae growth of te domestic banks large banks 1997-2000 8.385 1.026 7.309 2001-2005 −8.746 −1.644 −7.138 2006-2010 0.614 −0.141 0.324 2011-2013 −0.221 0.241 0.058 1997-2013 −1.010 −0.320 −0.748 medium banks 1997-2000 1.837 −2.509 4.327 2001-2005 −8.103 −1.853 −6.171 2006-2010 3.856 1.885 1.860 2011-2013 −7.140 −0.459 −6.728 1997-2013 −2.321 −0.546 −1.797 small banks 1997-2000 6.213 0.547 5.764 2001-2005 −10.277 −2.710 −6.860 2006-2010 5.239 1.731 2.708 2011-2013 −8.620 −6.852 −1.362 1997-2013 −2.025 −1.488 −0.471 foreign banks 1997-2000 −0.304 −1.003 0.187 2001-2005 −5.502 −0.718 −4.568 2006-2010 5.412 0.779 4.483 2011-2013 −5.392 −0.556 −4.805 1997-2013 −1.096 −0.273 −0.892 domestic banks 1997-2000 6.803 0.340 6.540 2001-2005 −8.627 −1.804 −6.739 2006-2010 2.460 0.353 1.654 2011-2013 −2.953 −0.600 −1.867 1997-2013 −1.205 −0.502 −0.712 all banks 1997-2000 6.313 0.305 6.032 2001-2005 −7.410 −1.064 −5.498 2006-2010 3.084 −0.565 2.421 2011-2013 −4.238 −0.318 −3.395 1997-2013 −0.963 −0.511 −0.467 ce: cost efficiency; ae: allocative efficiency; te: technical efficiency over the entire sample period, ce has decreased at the rate of 0.96% per annum. hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016 867 branches also enables the banks to use their branch network as a barrier against the entry of new banks, which may lead to higher profit. thus the effect of this variable on efficiency could be in either direction depending on the effectiveness of service provided to the consumers. in their dataset, for medium sized bank maudos et al. (2002) find a negative and significant relationship between number of branches and ce. at the same time, for all other bank categories, they find that the number of branches does not have any significant effect on ce. also there is a correlation between total assets (proxy for bank size) and number of branches. in other word, size of the bank can be known from the number of branches. age: the age of the bank is used to reflect the maturity of bank. we expect that ceteris paribus, more mature banks would be more efficient than the younger or newly opened banks. 5.1. the model and estimation strategy consider a random sample of i=1,…, n banks observed over a duration of t consecutive years with time index t=1,…, t years and let ce be represented by ce, the fractional variable of interest, 0≤ce≤1, and x= (lta, ltd, nieta, roe, nim, branches) be a vector of six covariates discussed above. let β be the vector of parameters to be estimated and f ce x( | , )β denote the conditional density of ce. many applied economists assume a linear conditional mean model for ce: e ce x x( / ) = β (6) however, given that the dependent variable ce is strictly bounded from above and below, it is not reasonable to assume that the effect of any explanatory variable is constant throughout its entire range. further, the linear specification does not automatically guarantee that the predicted values of ce lie between 0 and 1 without severe constraints on the range of x or arbitrary modifications to fitted values outside the unit interval. in order to tackle this problem empirical economist use logistic relationship: e ce x e e x x ( / ) = + β β 1 (7) since it ensures that 0 < e ce x( / ) <1. however equation (7) is not directly estimated but it is transformed into log-odds model, e ce ce x xln 1−       = β (8) and then the estimation is done using ols. there are two major shortcomings of the above model; (i) recovering e ce x( / ) from (8) is not straight foreword (see papke and wooldridge, 1996 on p. 620 for details) and (ii) equation (8) is not well defined for boundary values 0 and 1 of ce. since the dea based frontier estimator always classifies at least one firm to be fully efficient (with ce=1), equation (8) cannot be used in this case. some authors use two-limit tobit model in order to restrict the predicted efficiency scores to be between 0 and 1. however, this model can only be applied if observations are available for both limits, which is often not the case2 in most efficiency studies. furthermore, the tobit model imposes restrictive assumptions on the dependent variable. that is, it assumes normality and homoskedasticity of the dependent variable, prior to censoring. for fractional dependent variables, papke and wooldridge (1996) have developed a simple estimation methodology. their methodology does not require manipulating the dependent variable, when it takes the extreme value of zero or one. the conditional expectation of dependent variable given the independent variables can be estimated in a straightforward manner. furthermore, the predicted values of the dependent variable always lie between zero and one. papke and wooldridge (1996) use the following bernoulli loglikelihood function: l ce g x ce g xit it it it it( ) log logβ β β≡ ( )  + −( ) − ( ) 1 1 (9) where 0 < g(.) < 1 is a logit function. the estimates3 for the parameter β can be obtained by maximizing the log-likelihood for the entire sample of 14 egyptian banks covering the deregulation period 1996-2007. in other word, the maximization problem can be written as: max ( ) β βlit it == ∑∑ 1 17 1 12 (10) the estimated variance-covariance matrix is given by 1 1ˆ ˆˆ ˆ− −=v a ba where a and b are given by 1 2 ' 1 1 1 ˆ ˆ ˆˆ( ) [ (1 )]− − = = = × −∑∑ n t it it it it it i t a n t g x x g g and 1 2 2 ' 2 1 1 ˆ ˆˆ ˆ ˆ( ) [ (1 )]− − = = = × −∑∑ n t it it it it it it i t b n t u g x x g g respectively, where ˆ ˆ( )β=it itg g x , ˆˆ ( )β=it itg g x , g x g x x( ) ( )β β β= ∂ ∂ and u ce ceit it it= − ^ . 5.2. results the regression estimates obtained using method developed by papke and wooldridge (1996). presented in table 6 are the regression coefficients obtained from ols and quasi-maximum likelihood estimator based on equation (9). the coefficient of age is estimated to be positive and significant, indicating that more mature banks would be more efficient than the younger or newly opened banks. the negative and significant coefficient of nieta implies that higher administrative cost leads to a decrease in ce. 2 in the efficiency studies where dea estimator is used to compute the efficiency scores, at least one would be classified to be fully efficient. however, in most dea based efficiency studies, one rarely comes across a firm whose estimated efficiency score is 0. 3 the stata comm and for this estimator can be downloaded from the following link: https://www.msu.edu/~ec/faculty/papke/flogitinstructions. pdf. hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016868 the positive and significant sign of roe suggests that banks which are more profitable are more cost efficient. at the first instance this result means that higher the roe, the more cost efficient the bank is. roe indicates how well bank management is using the investors’ capital. however, it turns out, that a bank can grow earnings faster than its current roe without raising additional cash. that is, a bank that now has a 5% roe can increase its earnings faster than 5% annually without borrowing funds or selling more shares. further, as expected the positive and significant sign of nim indicates that banks which are more profitable are more cost efficient. finally, a negative and significant coefficient on branches suggests banks with a bigger network of branches are relatively cost inefficient possibly due to higher structural overloads. 6. conclusions our research adopt two-stage approaches, in which ce scores are estimated in the first stage using input oriented dea, and in the second stage we study the potential determinants of ce. we estimate the level of ce in 14 egyptian banks using annual data for 1997-2013. the ce is decomposed into allocative and technical efficiency levels. the ce score was (53.9%) in the beginning phase of the sample period. the efficiency scores show an improvement trend with some fluctuations till 2000 and a declining thereafter until 2005, the reason for declining the cost and technical efficiency for the period (2000-2005) due to the serious currency liquidity crisis faced by egyptian economy in 1999 prior to bank privatization, in the other hand, the egyptian government decided to float the egyptian pound against the us$ in 2003 which increased the banks’ foreign exchange losses, particularly, those that have significant proportion of their investment portfolio in foreign currency. the ce for the whole banking sector showing improvement from 2005 till 2010. however, the ce declined again from 2011 till 2013 and may be due the revaluation in egypt in 2011. the highest ce score of 65.1% in the year (2000) of the sample period. while the bank timeline of major financial reforms in egyptian banks from 1991 to 2013. in the second stage we further analyze the factors rolling critically in shaping the ce of egyptian banks. the results reveal that net interest margins and bank branches are the main determinants cost efficiencies of egyptian banks. thus, the policy implications for the banking sector to improve ce are: (a) to minimize administrative and the overhead cost, (b) to develop an understanding of the forces affecting the net interest margin in order to avoid major surprises. references jreisat, a., barghouthi, s. 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(2000), data envelopment analysis: a comprehensive text with models, applications, table 6: estimates of regression model variables coefficient (ols) coefficient (qmle) constant 0.5889549 (0.0659131)*** 0.3659191 (0.2709631)*** age 0.0032742 (0.0012548)*** 0.0139137 (0.0038142)*** ltd 0.0360087 (0.0355351) 0.1498649 (0.1137172) nieta −15.47607 (2.734173)*** −65.26083 (11.30865)*** roe 0.1969922 (0.1167623)* 0.8418186 (0.4150223)*** nim 5.689282 (1.465611)*** 23.931 (5.490801)*** branches −0.0010105 (0.0002143)*** −0.0042571 (0.0006776)*** no of observation r2 238 238 log pseudo-likelihood 0.2667 −110.8870283 ***,**,*indicate 1%, 5% and 10% significance levels, respectively. asymptotic standard errors in parentheses, qmle: quasi-maximum likelihood estimator hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016 869 references and dea-solver software. boston: kluwer academic publishers. farrell, m.j. 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(2013), the effect of mergers and acquisitions on bank efficiency: evidence from bank consolidation in egypt. working paper 770, the egyptian center for economics studies. united nations. (2005), economic trends and impacts, banking sector lending behaviour and efficiency in selected. paper presented at the escwa, new york. p3. vu, h., turnell, s. (2011), cost and profit efficiencies of australian banks and the impact of the global financial crisis. economic record, 87, 525-536. hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016870 table a1: dea estimates of cost efficiency for domestic and foreign banks of egypt, 1997‑2013 bank eff 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 mean large nbe te 0.559 0.59 0.714 0.768 0.71 0.652 0.575 0.547 0.515 0.553 0.575 0.57 0.49 0.50 0.489 0.529 0.465 0.571 ae 0.992 0.992 0.992 0.999 0.999 0.998 0.974 0.896 0.944 0.926 0.934 0.941 0.996 0.984 0.988 0.963 0.992 0.971 ce 0.554 0.585 0.708 0.767 0.709 0.65 0.56 0.49 0.486 0.512 0.537 0.536 0.488 0.492 0.483 0.51 0.462 0.554 bm te 0.385 0.414 0.478 0.499 0.47 0.455 0.413 0.379 0.328 0.279 0.28 0.255 0.233 0.256 0.306 0.365 0.35 0.352 ae 0.951 0.964 0.993 0.978 0.97 0.942 0.885 0.90 0.898 0.91 0.848 0.798 0.737 0.732 0.633 0.732 0.736 0.852 ce 0.366 0.40 0.474 0.488 0.455 0.429 0.365 0.341 0.294 0.254 0.237 0.203 0.172 0.187 0.193 0.267 0.257 0.300 bdc te 0.61 0.587 0.508 0.529 0.464 0.496 0.449 0.462 0.463 0.495 0.445 0.54 0.575 0.579 0.507 0.529 0.494 0.511 ae 0.913 0.905 0.955 0.997 0.969 0.918 0.864 0.85 0.861 0.886 0.912 0.877 0.831 0.84 0.771 0.788 0.778 0.875 ce 0.557 0.531 0.485 0.527 0.45 0.456 0.388 0.393 0.399 0.438 0.406 0.473 0.478 0.486 0.391 0.417 0.384 0.447 medium cib te 0.851 1.00 1.00 0.94 0.797 0.698 0.651 0.637 0.64 0.649 0.639 0.521 0.594 0.676 0.703 0.707 0.501 0.704 ae 0.997 0.942 0.924 0.885 0.888 0.839 0.795 0.766 0.77 0.805 0.791 0.675 0.745 0.851 0.866 0.891 0.793 0.833 ce 0.849 0.942 0.924 0.831 0.707 0.586 0.517 0.488 0.492 0.522 0.506 0.352 0.442 0.575 0.609 0.63 0.397 0.586 scb te 0.749 0.781 0.853 0.867 0.899 0.899 0.805 0.683 0.677 0.706 0.551 0.56 0.609 0.524 0.544 0.474 0.436 0.667 ae 0.99 0.977 0.989 0.98 0.972 0.952 0.945 0.924 0.93 0.866 0.798 0.818 0.811 0.831 0.745 0.807 0.795 0.886 ce 0.741 0.763 0.844 0.85 0.873 0.856 0.761 0.631 0.63 0.611 0.44 0.458 0.494 0.436 0.405 0.382 0.346 0.591 fib te 0.49 0.69 0.692 0.568 0.53 0.493 0.389 0.371 0.39 0.367 0.518 0.496 0.539 0.548 0.611 0.576 0.508 0.507 ae 0.89 0.907 0.875 0.753 0.819 0.759 0.701 0.752 0.725 0.822 0.794 0.72 0.856 0.974 0.955 0.876 0.909 0.825 ce 0.436 0.626 0.606 0.428 0.434 0.374 0.273 0.279 0.282 0.302 0.411 0.357 0.461 0.534 0.583 0.504 0.462 0.418 hdb te 0.442 0.469 0.528 0.557 0.509 0.514 0.486 0.455 0.447 0.523 0.61 0.569 0.38 0.327 0.302 0.278 0.27 0.438 ae 0.995 0.988 0.99 0.993 0.968 0.942 0.907 0.876 0.938 0.911 0.986 0.975 0.676 0.723 0.579 0.585 0.59 0.844 ce 0.439 0.463 0.523 0.553 0.492 0.484 0.441 0.399 0.419 0.477 0.601 0.554 0.257 0.236 0.175 0.163 0.16 0.370 midb te 0.639 0.698 0.678 0.633 0.543 0.635 0.613 0.668 0.78 0.68 0.711 0.868 1.00 1.00 0.988 0.994 0.885 0.751 ae 0.355 0.388 0.444 0.436 0.427 0.382 0.416 0.571 0.757 0.802 0.995 0.996 0.953 1.00 0.999 0.999 0.985 0.645 ce 0.227 0.271 0.301 0.276 0.232 0.242 0.255 0.381 0.591 0.545 0.708 0.864 0.953 1.00 0.987 0.993 0.871 0.485 small edb te 0.874 0.738 1.00 1.00 1.00 0.851 0.537 0.463 0.494 0.541 0.547 0.58 0.593 0.59 0.604 0.539 0.521 0.652 ae 0.982 0.985 1.00 1.00 0.952 0.956 0.986 1.00 0.973 0.998 0.764 0.685 0.789 0.784 0.695 0.71 0.708 0.871 ce 0.858 0.726 1.00 1.00 0.952 0.813 0.529 0.463 0.48 0.54 0.418 0.397 0.468 0.463 0.42 0.383 0.369 0.567 abe te 0.868 0.89 0.892 0.919 0.902 0.917 0.843 0.853 0.868 0.92 0.982 1.00 0.995 1.00 0.745 0.404 0.911 0.862 ae 0.964 0.973 0.983 0.991 0.994 0.935 0.881 0.875 0.882 0.917 0.936 1.00 0.995 0.997 0.749 0.714 0.735 0.908 ce 0.836 0.866 0.877 0.91 0.897 0.858 0.743 0.746 0.766 0.843 0.919 1.00 0.99 0.997 0.558 0.288 0.669 0.783 saib te 0.384 0.503 0.576 0.604 0.535 0.573 0.464 0.497 0.71 0.651 0.532 0.631 0.745 0.753 0.712 0.769 0.83 0.604 ae 0.794 0.775 0.71 0.722 0.718 0.746 0.553 0.643 0.598 0.669 0.945 0.991 0.978 0.992 0.981 0.891 0.782 0.781 ce 0.305 0.39 0.409 0.436 0.384 0.428 0.257 0.32 0.425 0.435 0.502 0.625 0.729 0.746 0.699 0.685 0.649 0.471 foreign nsgb te 0.813 0.81 0.751 0.781 0.668 0.602 0.522 0.529 0.606 0.577 0.626 0.767 0.713 0.718 0.758 0.767 0.674 0.681 ae 0.985 0.984 0.988 0.901 0.979 0.842 0.718 0.66 0.83 0.89 0.892 0.792 0.823 0.803 0.746 0.741 0.76 0.837 ce 0.801 0.797 0.742 0.704 0.655 0.508 0.375 0.349 0.503 0.513 0.559 0.608 0.587 0.577 0.565 0.568 0.512 0.570 aaib te 0.859 0.85 0.723 0.756 0.654 0.691 0.543 0.484 0.722 0.637 0.899 1.00 0.918 0.928 0.829 0.817 0.771 0.757 ae 0.769 0.757 0.708 0.69 0.602 0.721 0.921 0.983 0.878 0.934 0.912 1.00 0.969 0.981 0.998 0.981 0.948 0.858 ce 0.661 0.644 0.512 0.522 0.394 0.498 0.50 0.476 0.635 0.595 0.82 1.00 0.89 0.911 0.828 0.802 0.731 0.649 hsbc te 0.796 0.863 0.816 1.00 0.888 0.845 0.773 0.667 0.69 0.725 0.763 0.923 0.931 0.914 0.805 0.834 0.778 0.820 ae 0.972 0.955 0.999 0.986 0.971 0.918 0.841 0.803 0.778 0.768 0.759 0.846 0.796 0.848 0.84 0.944 0.989 0.879 ce 0.774 0.824 0.815 0.986 0.862 0.776 0.651 0.536 0.536 0.556 0.578 0.78 0.741 0.775 0.676 0.788 0.769 0.720 ce: cost efficiency; ae: allocative efficiency; te: technical efficiency, nbe: national bank of egypt, bm: banque misr, bdd: bank du caire, cib: commercial international bank, scb: suez canal bank, fib: faisal islamic bank, hdb: housing and development bank, midb: misr iran development bank, abe: al baraka bank egypt, saib: societe arabe internationale de banque, nsgb: national societe generale bank, aaib: arab african international bank, hsbc: hsbc egypt appendix hassan and jreisat: cost efficiency of the egyptian banking sector: a panel data analysis international journal of economics and financial issues | vol 6 • issue 3 • 2016 871 table a2: timeline of major financial reforms in egypt from 1994 to 2013 timeline major financial reforms 1994-1998 first stage of privatization program started (108 state-owned companies) and none of the public banks included in this stage 1996 the government issued new laws that permit 100% foreign ownership of banks and allow banks to do business in both foreign and local currencies the government advised the four public banks to reduce their majority stakes in joint venture banks to maximum of 20% ownership 1998 the passage of law no. 155/1998 allows the privatization of state-owned banks the passage of law 5/1998 to close a double tax 100% loophole which, for banks, led to almost no tax liability by investing in t-bills 1999 cbe introduced restrictions on credit facilities for certain imports that reduced the volume of lcs which represent, on average, 22% of banks off balance-sheet positions the egyptian economy faced a serious currency liquidity crisis in 1999 prior to bank privatization 2002 the cbe raised the minimum capital adequacy ratio from 8% to 10% which created a problem for undercapitalized banks that have to raise their capital or merge with another capitalized bank 2003 the egyptian government decided to float the egyptian pound against the us$ which increased the banks’ foreign exchange losses, particularly, those that have significant proportion of their investment portfolio in foreign currency the cbe started its comprehensive reform plan to promote the banking sector by consolidating and enhancing the overbanked and under-branched banking sector 2004 a npl monitoring unit was established by the cbe to restructure the state owned banks, consolidate banking systems through mergers and acquisitions of small and weak banks, privatize some state-owned banks, divest public sector shares in joint venture banks, resolve non-performing loans and strengthen the supervisory authority of the central bank of egypt 2005 the cbe required the big four public banks which own more than 50% of the banking sector’ assets to sell their stakes in joint-venture banks and to raise paid up capital requirements to a minimum of usd 50 million for branches of foreign banks the egyptian minister of finance affirmed a revamp of egypt’s income tax structure, on the personal and corporate levels, with the later constituting a unification of the taxation rate at 20% down from a 42% levy on service entities. the banking sector is considered a main beneficiary of this new law and also some banks exempted from another 10% of the listed entities paid-in capital in the egyptian stock exchange 2008 the credit crunch crisis 2011 the egyptian revolution i 2013 the egyptian revolution ii cbe: central bank of egypt, npl: non-performing loans . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(2), 427-434. international journal of economics and financial issues | vol 6 • issue 2 • 2016 427 the effect of credit and market risk on bank performance: evidence from turkey aykut ekinci* economist, department of risk monitoring, development bank of turkey, ankara 06440, turkey. *email: aykutekinci@gmail.com abstract there is a strong connection between bank performance and economic growth. therefore, understanding on the effects of credit and market risk on bank performance could contribute to the better functioning of the banking system. this study investigates the effects of credit and market risk, i.e., interest rate and foreign exchange (fx) rate risk, on the bank performance for the turkish banking sector in a time-varying framework employing the generalized autoregressive conditional heteroscedastic approach for the 18.01.2002-30.10.2015 period by using weekly data. the results suggest two main findings: (i) credit risk has a negative and fx rate has a positive effect, but interest rate has insignificant effect on banking sector profitability, (ii) credit and market risk have a positive and significant effect on conditional bank stock return volatility. keywords: bank lending channel, bank performance, credit risk, interest rate risk, currency risk jel classifications: c32, e43, e44 1. introduction bank performance is vital in order to achieve sustainable economic growth especially in emerging countries like turkey, where the banking sector loans to gross domestic product ratio is over 70% and banks serve as the main financing source for corporations due to shallow financial markets. therefore, the efficiency of credit channel plays a significant role to provide uninterrupted and low cost of funding for corporations. however, banks deal with different types of risks such as credit risk, market risk and operational risk when meeting their intermediation function. therefore, better understanding on the effects of these risks on bank performance could contribute to the better functioning of the banking sector. in the history of turkish banking system, the 1990s were identified as the years of a high volatile environment because of 1994 currency, 1999 economic, and 2001 financial crises. the 90s could be characterized by high government debt, sudden-stop problems and determining exchange rates by the central bank of turkey with fixed-rate, which in turn created devaluation problems in the crisis period. banks were increasingly investing in government bonds as well as taking huge currency mismatches and interest rate risk in these years. credit channel could not function well because of high government demand on money market. finally, eleven banks were transferred to the savings deposit insurance fund (sdif) during the 1994-1999 period and 10 banks were transferred to the sdif because of the negative effects of 2001 financial crisis. on the other hand, the operating losses of publicly-financed banks were indemnified, their capital structures were consolidated and their operations were restructured (brsa, 2009). eventually, turkey took significant lessons from the crisis, especially after the 2001 financial crisis and proceeded to enact new laws and regulations concerning the banking sector. turkish banking sector started a strong and relatively healthy growth period after the 2001 crisis and became one of the least affected banking sectors in the world from the 2008 global crisis. after the establishment of banking regulation and supervision agency (brsa)1, banks defined their risk management procedures 1 brsa was established in june 1999 according to banks act nr. 4389 and began to operate in august 2000. before brsa, the regulation and supervision of banking system had a fragmented structure. the under secretariat of treasury was responsible for issuing banking regulations, carrying out on-site supervision and enforcement, central bank of turkey was responsible for off-site supervision and sdif gave insurance to saving deposits. ekinci: the effect of credit and market risk on bank performance: evidence from turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016428 and have taken necessary precautions in order to avoid risks, in compliance with basel accords2. the minimum capital adequacy ratio (car)3 in turkey was determined as 12%, which was over the 8% international target set by brsa. as of september 2015, the banking sector car ratio was 14.65% and the share of credit, market and operational risk in risk weighted assets were about 90%, 3% and 7% respectively. today, the turkish banking sector is the second largest banking system in emerging europe after russia, with an asset size of usd 795 billion as of december 2014. there are 49 banks in total, 32 of them being deposit, 13 development and investment and 4 of them participation banks. credit risk is the most important risk exposure for banks due to strong connection with bank profitability and economic growth. for banks, a proper investment decision means the greatest return on investment at the lowest credit risk. each loan without repayment decreases banks’ profit and equity, which in turn may result in bank failure if the bank cannot pay off its liabilities. the effects of credit risk on output have been mostly examined in the literature in terms of the bank lending channel, one of the nonneoclassical monetary transmission channels (boivin et al., 2010). there is a growing literature on the importance of credit risk for monetary policy, especially after the 2008 global financial crisis (ciccarelli et al., 2010; hempell and kok, 2010; gilchrist et al., 2009; gilchrist and mojon, 2014). most of the studies focusing on the effect of the credit risk on bank performance employed time series or panel data and used the monthly data since the credit risk variable is observed monthly. generally, return on assets and return on equity are used as bank performance indicators and diffusion indexes, stress tests, default spreads, expected default frequencies, loan loss provisions, loss given default, and nonperforming loans are used as credit risk indicators in these papers. the inverse relationship between bank performance and credit risk emerges as one of the main findings of the studies (bourke, 1989; molyneux and thornton, 1992; demirguc and huizinga, 1999; abreu and mendes, 2002; goddard et al., 2004; naceur and goaied, 2001; 2005; and pasiouras and kosmidou, 2007; mileris, 2012; romanova, 2012). market risk is the risk of losses in liquid portfolio arising from the movements in market prices and consisting of interest rate, currency, equity and commodity risks. interest rate and currency risk are the main parts of the market risk in the turkish banking sector. as i mentioned before, the share of market risk in riskweighted assets are only about 3% as of september 2015, but market risk exposure is more volatile than credit risk exposure due to rapid changes in market conditions. after the 2001 financial crisis, the economic structure of turkey has shifted to a new paradigm. the central bank of the republic of turkey (cbrt) has become independent, passed to a floating foreign exchange (fx) rate regime from fixed fx rate regime and adopted inflation targeting at the beginning of 2002. to achieve low inflation target 2 it is provided with legal amendments, “regulation on bank’s internal control and risk management systems” published in official gazette, issue no. 24312, on 8 february 2001. 3 car, also called capital to risk (weighted) assets ratio, is a ratio of a bank’s capital to its risk and is formulated as following: car = equity/risk weighted assets (credit risk + market risk + operational risk). under the new monetary policy, the cbrt uses the short term interest rates as an instrument of monetary policy instead of fx rates. while inflation decreased from over 30% to under 10% from 2002 to 2004, public debt and spending rates have improved significantly because of tight fiscal policy and strong economic growth. as a result, loans to assets ratio in the turkish banking sector has risen from 23% in december 2002 to 62% in september 2015. on the other hand, fx liabilities to total liabilities ratio has fluctuated between 25% and 40% during the period of 2002-2015. so the sensitivity of balance sheet to changes in fx rate is high in turkey. interest rate is also another important risk exposure for turkish banking sector when considering the average duration for deposits is very short, i.e., around 3 months and deposits to liabilities ratio is 53% as of september 2015. the existing literature offers little consensus regarding the effects of changes in interest rates on bank performance. if banks borrow short-term and lend long-term, and if their interest rates are not fully flexible, banks will be exposed to repricing and yield curve risk4. in such a case, the negative relationship between shortterm interest rates and bank profitability has mostly been offered by the literature (lloyd and shick, 1977; flannery, 1981; 1983; and flannery and james, 1984; hancock, 1985; den haan et al., 2007; kasman et al., 2011). on the other hand, banks generally can protect their balance sheet against interest rate changes using risk techniques. banks may hedge their interest rate risk exposure through using interest rate derivatives (flannery, 1981; gorton and rosen, 1995; purnanandam, 2007). moreover, banks may change the size and composition of non-interest income/expense in response to movements in interest rates. however, such changes in risk mitigation techniques are open to discussion due to their own risks (smith et al., 2003; stiroh, 2004; stiroh and rumble, 2006; and lepetit et al., 2008). on the other hand, demirguc and huizinga (1999) found a positive relationship with interest rates and profits, particularly in emerging market economies and albertazzi and gambacorta (2009) concluded that short-term interest rates have no significant impact on income margins for a group of oecd countries. the fluctuations in the fx rates can affect the bank profits directly by changing the value of net foreign currency position. if a bank has a long position, the increase in fx rate, i.e., loss in local currency value, results in a gain for a bank. however, especially for developing countries such as turkey, the changing value of local currency has important effects on inflation, import and export and interest rates. similar to interest rate risk, banks might mitigate the foreign currency exposure by using different hedging techniques. most of the studies on the effect of fx rates on bank performance have no clear conclusion; results are sensitive in regards to country, period or methodology. aharony et al. (1985) and grammatikos et al. (1986) concluded that the effect of the fx rate risk on bank stock returns is statistically significant because banks have imperfectly hedged their foreign currency positions. chamberlain et al. (1997) found that the exchange rate sensitivity of the stock returns of us banks was stronger than that of japanese banks. moreover, several studies have examined the effect of both 4 see for more information bis, 2004. ekinci: the effect of credit and market risk on bank performance: evidence from turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016 429 interest rate and exchange rate changes on financial sector returns (for example, choi et al., 1992; wetmore and brick, 1994; choi and elysiani, 1997; koch and saporoschenko, 2001; and joseph, 2003). some other studies focusing on the joint interaction of credit, interest and fx rate risks are madura and zarruk (1995), adjaoud and rahman (1996), prasad and rajan (1995), choi et al. (1998), tai (2000), atindéhou and gueyie (2001) and rahman (2010). as can be seen above, there is vast literature on the effects of credit and market risk on banking performance for developed countries. few studies focus on emerging countries, such as turkey. kasman et al. (2011), for instance, investigated the effects of interest rate and fx rate changes on turkish banks’ stock returns using the ordinary least squares and generalized autoregressive conditional heteroscedastic (garch) estimation models. the results suggest that changes in interest rate and fx rate have a negative and significant effect on the conditional bank stock return. moreover, bank stock return sensitivities are found to be stronger for market return than interest rates and exchange rates, implying that market return plays an important role in determining the dynamics of conditional return of bank stocks. the results further indicate that interest rate and exchange rate volatility are the major determinants of the conditional bank stock return volatility. this paper follows the kasman et al. (2011) and reinvestigates the same question with some extensions, namely the addition of credit risk besides interest and fx rate risk, use of different variables for interest rate such as 3 months deposits interest rate, commercial loan interest rate and spread, and selection of the different time period based on monetary policy in turkey. the remainder of the paper is organized as follows. section 2 discusses the data, section 3 explains the methodology, section 4 presents the empirical results and section 5 focuses on some different measurements of interest rate as a robustness check. the paper ends with some brief concluding remarks. 2. data i employed weekly data beginning on 18 january 2002 and ending on 30 october 2015 with 716 observations. the return of the bank index, industrial index and bank stocks5 listed on istanbul stock exchange (ise) are calculated as rt = 100* (ln pt − ln pt−1). where pt 5 the selection of banks is depending on data period and asset size of the banks, selected ones are the major banks in turkish banking system and marked as a, b, c, d banks. is the stock price at time t and pt−1 is the stock price at time t−1. the return of bank index and bank stocks indicates the performance of banking sector and banks respectively, and the industrial index, which consists of the stocks of industrial companies traded in the ise, indicates the credit risk. the banks consider low credit risk when the return of the industrial companies is high. the high stock return for industrial companies means high profit for companies and sends good signals to banks about the financial condition of companies6. the market risk consists of interest rate risk and fx rate risk. interest rate and fx rate data are gathered from the cbrt electronic data delivery system weekly. 3 months deposit interest rate7 is used for understanding the effect of changes in interest rate and interest rate risk on bank performance since the average duration of deposits is around 3 months in turkey and deposits are the main financing sources for banks. furthermore, commercial loan interest rate and spread, the difference between, 3 months deposit interest rate and commercial loan interest rate is taken as other proxies for interest rate. the first differences of 3 months deposit and commercial loan interest rate are used to provide stationary condition δit = it−it−1, and spread variable is already stationary in level. the fx rate is based on a simple basket of equally weighted two major currencies, the us dollar and the euro. the continuously-compounded returns for the fx rate are computed the same as stock returns. the descriptive statistics of the variables is presented in table 1. the return distribution is negatively skewed for all variables except for bank index and basket. negative skewness means an asymmetrical distribution with a long tail to the left, or to put it differently, big losses in the crisis periods. all data have big kurtosis values indicating a leptokurtic distribution which is more peaked around the mean than a gaussian distribution. as expected, the normality has been rejected at 1% significance level by jarguebera tests. augmented dickey-fuller statistics indicates that all data have proven stationary condition by rejecting the unit root at 1% and 5% significance levels. 6 kasman et al. (2011) use the return of ise 100 index as market risk, which reflects economy-wide factors. in this study, the return of industrial index is preferred to use because it is a narrower index to focus on the relationship between bank performance and corporation performance and excludes the effects of banks on overall ise 100 index. 7 weighted average interest rates of the banking sector are calculated by weighting each bank’s weighted and compounded average interest rates relating to its weekly amounts. table 1: descriptive statistics variable mean maximum minimum sd skewness kurtosis jarque-bera adf bank index 0.2468 36.555 −20.586 5.3131 0.2923 6.8403 450.18* −27.755* a −0.3542 21.706 −23.211 5.8106 −0.0088 4.6267 78.954* −28.982* b −0.3992 20.022 −31.365 6.1483 −0.1716 4.7467 94.539* −28.792* c −0.2329 25.757 −42.845 6.0033 −0.4083 7.8188 712.65* −27.282* d 0.1213 54.935 −44.183 6.8393 0.0628 12.689 2801.1* −16.524* industrial 0.2669 15.005 −16.278 3.0218 −0.8649 6.7344 505.33* −22.068* interest −0.0685 2.9700 −3.89 0.5452 −1.6962 14.575 4340.6* −8.753* commercial −0.0713 8.0500 −16.39 1.9029 −1.7165 18.307 7331.6* −6.288* spread 1.9275 9.8900 −12.68 2.6677 −1.3237 7.2540 749.01* −2.935** basket 0.1165 9.0825 −6.5566 1.4655 0.8891 7.0044 572.74* −19.838* *indicates the significance level at 1%, **ındicates the significance level at 5%. adf: augmented dickey-fuller, sd: standard deviation ekinci: the effect of credit and market risk on bank performance: evidence from turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016430 3. methodology i follow the same modeling methodology by kasman et al. (2011), with some extensions. they use the return of the istanbul stock price index 100 as market risk, but i use the return of industrial index as credit risk as i explained in the data section. instead of using the 2 years turkish government bond, the 3 months deposit interest rate is used in this paper due to its strong relationship with liabilities as explained in the data section. while the data is daily and starts from 1999 and finishes in 2009 in kasman et al. (2011); i use the period of 2002-2015 and exclude before 2002 because of the different monetary policy framework whose details are provided in the introduction section. moreover, weekly data are employed as interest rate data are gathered only on a weekly basis. kasman et al. (2011) employed the garch (1, 1) model to understand the effect of changes in interest rate and fx rate on bank return. instead of market risk, the credit risk variable is used in the model and it is estimated following the garch (1, 1) model8: rt = γ0+ γ1crt+ γ2intt+ γ3fxt+εt (1) σ ω αε βσt t t 2 1 2 1 2= + +− − (2) the mean equation given in (1) is written as a function of exogenous variables with an error term. where rt is the return of bank index or bank stocks, crt is the credit risk defined as the return of the industrial stocks at time t. intt refers to the first difference of the 3 months deposit interest rate at time t, fxt stands for the return of the basket fx rate, and εt is the error term which is normally distributed with zero mean and a variance of  t 2 . the sensitivity of banking sector or bank performance at time t to the credit risk, interest rate and fx rate are measured by the parameters γ1, γ2, and γ3, respectively. the conditional variance  t 2 is given by equation (2), and is ω is the time-invariant component of risk. furthermore, α is the arch parameter, which indicates the news about volatility from the previous period and measured as the lag of the squared residual from the mean equation, and β is the garch parameter, which is measured as the last period’s forecast variance. the second model focuses on the effect of credit, interest and fx rate risk on the bank index and bank stock returns volatility. the model is specified as follows: rt = γ0 + εt (3) σ ω αε βσ φ φ φt t t t t tcr int fx 2 1 2 1 2 1 2 2 3 2= + + + + +− − (4) the return of the bank index or bank stocks rt is written as a function of the constant term and an error term. the variance model given in equation (4) is the traditional garch (1, 1) model, plus credit risk, interest rate risk measured as intt 2 and the fx rate measured as fxt 2 . the return of the industrial index is used as credit risk indicator as did in equation (1) without 8 each return series have own dummy variables, which is identified over ±30% returns, in the mean equation such as equations (1) and (3). square function due to the first degree relationship between return and risk. 4. empirical evidence the estimated coefficients from the mean given in equation (1) and variance equation given in (2) are presented in table 2. the results indicate that the return of industrial index γ1 has a positive and significant relation with the return of the bank index and bank stocks. hence, greater credit risk means lower profitability for banks and banking sector. this main finding is in line with the literature (bourke, 1989; molyneux and thornton, 1992; demirguc and huizinga, 1999, abreu and mendes, 2002; goddard et al., 2004; naceur and goaied, 2001; 2005; and pasiouras and kosmidou, 2007; mileris, 2012; romanova, 2012). while the returns of bank index and d bank are affected the most, c bank is the least affected bank by credit risk. the response of conditional return to changes in interest rates is negative but insignificant for some cases. the effect of changes in 3 months deposit interest rate, γ2, is negative but insignificant for bank index and d bank, and negative and significant for a bank, b bank and c bank. in the overall banking sector and d bank may hedge their interest risk exposure through the use of interest rate derivatives (flannery, 1981; gorton and rosen, 1995; purnanandam, 2007) or change the size and composition of non-interest income/expense. on the other hand, a bank, b bank and c bank have been affected by interest rates negatively, which is consistent with the main expectation in the literature (lloyd and shick, 1977; flannery, 1981; 1983; and flannery and james, 1984; hancock, 1985; den haan et al., 2007; kasman et al., 2011). an increase in 3 months deposit interest rate may make the cost of funding higher than before for banks and may affect the value of securities portfolio negatively. as a result, net interest margin and profit decreases. c bank is the most sensitive bank to the changes in interest rate. the profitability of banking sector and all other banks has been affected by the increase of the fx rate positively, except for a bank. the coefficient γ3 is negative and insignificant for a bank (table 2). the increase in fx rate and weaker local currency, may affect bank profitability in a positive way if a bank has a long position. for instance, the net foreign currency position is generally positive when facing a hike in fx rate, such as banking sector, b bank, c bank and d bank. on the other hand, insignificant result for a bank may be interpreted as a balanced fx position in general and successful fx risk management. the returns of bank index and d bank are the most sensitive to the changes in fx rate as the same with credit risk; however, the bank index and d bank are insensitive to the interest rate changes. in contrast with the finding from this study, kasman et al. (2011) found the negative and significant effect for bank index, a bank, b bank and insignificant coefficients for nine banks. this opposite effect may be explained by the difference of net currency position and the exchange rate policy between these two studies. the banking sector had large, short position till ekinci: the effect of credit and market risk on bank performance: evidence from turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016 431 december 2002, and generally small and long position after that time9. the increase in fx rate resulted in big losses for the banks which aimed at having large short positions before 2003. in addition to this, the behavior of fx rates was different before and after february 2001 due to different fx rate policies as explained in the introduction section. the conditional  t 2 variance follows the process described in equation (2) and determined by the time-invariant component of risk ω, arch parameter α and garch parameter β. both the arch parameters and garch parameters are significant, satisfy the non-negativity condition, and the sum of the α and β parameters is less than one to secure the covariance stationary for the conditional variance for all cases. the garch parameters, the past behaviour of the variance  t 2 , are stronger than the arch parameters, past squared error terms t −1 2 . in other words, the volatility of each stock return and bank index return are more sensitive to own lagged values than the news from the previous period. the sum of the arch and garch parameters are close to one, which indicates that shocks have highly persistent effects on bank and index return, and the effect of shocks on conditional volatility decays at a slower rate. table 3 reports the estimated coefficients given in equation (2) and (4) to improve our understanding of the effect of credit, interest and fx rate risk on bank return volatility. after the inclusion of credit, interest and fx rate risk into the variance equation, the variance of the bank index or bank stock returns are sensitive to the garch parameter for all cases but sensitive to the arch parameter for only a bank with 10% significance level. credit risk φ1 has a significant effect on bank index and bank returns volatility for all cases, except b bank, which is still negative but insignificant. a decrease in credit risk, i.e., an increase in profitability of industrial sector, leads to less volatility for banking sector, a bank, c bank and d bank. on the other hand, when considering the mean equation in table 2, a decrease in credit 9 the net foreign exchange position for banking sector is −13,2 billion usd in 1999, −17,3 billion usd in 2000, −8,7 billion usd in 2001 and −5,3 billion usd in 2002; on the contrary, 0,150 billion usd in 2003, −0,074 billion in 2004, −0,086 billion usd in 2005, 0,198 billion in 2006, 0,204 billion usd in 2007, −0,93 billion usd in 2008, 0,605 billion usd in 2009, −0,813 billion in 2010, 0,602 billion usd in 2011, 3,9 billion usd in 2012, −1,2 billion usd in 2012 and −6,0 billion in 2014. see the banks association of turkey statistics for additional data. risk also supports the profitability of banking sector and banks. to put it in another way, less credit risk means stronger and more stable growth for banks and vice versa. the effect of credit risk on the return volatility is stronger for c bank than other banks and bank index. the interest rate risk φ2 has a statistically significant and positive effect on the volatility of bank profitability for all cases, which indicates that an increase in volatility of the 3 months interest rate rises up the volatility in bank returns. these findings on the effect of interest rate on average bank returns and volatility of bank returns are in accordance with kasman et al. (2011). moreover, the interest rate risk is explicitly the leading risk type affecting the volatility of returns among the credit and fx rate risk when the size of coefficients is compared. the effect of fx risk on bank return volatility φ3 is significant and positive for all cases, except for d bank, whose impact on bank return volatility is positive but insignificant. a possible explanation of the positive relationship between currency risk and bank return volatility is that turkish banks may not hedge their fx risk exposure well by using financial instruments known as derivatives, the two most common of which are options and futures. 5. different proxies for interest rate as a robustness check, the alternative measures of interest rate have been used to see how the results are sensitive to the measurement. the estimates of the coefficients from the equation (1) and (2) are reestimated with the new proxies, commercial loan interest rate and spread, and the results are presented in tables 4 and 5. as shown in table 4, the interest rate variable γ2 is insignificant for all cases after the inclusion of the commercial interest rate. the coefficient of the interest rate is negative and significant for a bank, b bank and c bank and negative but insignificant for bank index and d bank as the first case (table 2), where the interest rate is used as 3 months deposit interest rate. this result may be expected when considering the different roles of the commercial and deposit rates into the banks’ balance sheet. while 3 months deposit interest rate is related with the cost of funding for banks, the commercial loan rate depends mostly on the deposit interest rate and related with the table 2: estimates of the mean model given in equation 1 and variance equation given in 2 variable γ0 γ1 γ2 γ3 ω α β bank index −0.0562 (0.1514) 1.0417* (0.0585) −0.1288 (0.2990) 0.4133* (0.1294) 1.1509** (0.5270) 0.0935* (0.0278) 0.8405* (0.0484) a bank −0.4773* (0.2033) 0.2168* (0.0814) −0.8075** (0.3993) −0.0070 (0.1597) 0.7450** (0.3827) 0.0466* (0.0123) 0.9287* (0.0196) b bank −0.6013* (0.2075) 0.2728* (0.0829) −0.6874*** (0.4010) 0.2916*** (0.1567) 0.7899*** (0.4903) 0.0643* (0.0177) 0.9119* (0.0248) c bank −0.3992** (0.2005) 0.1494*** (0.0895) −1.0301** (0.4580) 0.2712*** (0.1546) 0.4564 (0.2970) 0.0534* (0.0129) 0.9314* (0.0174) d bank −0.1733 (0.1827) 1.1090* (0.0678) −0.3568 (0.4275) 0.4074* (0.1471) 1.2507* (0.3675) 0.1814* (0.0272) 0.7974* (0.0218) numbers in parenthesis indicate the standard errors. *indicates the significance level at 1%, **indicates the significance level at 5%, ***indicates the significance level at 10% ekinci: the effect of credit and market risk on bank performance: evidence from turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016432 return of assets. when the fact that the average duration of loans are longer than deposits in turkey is considered, it may be expected that the banks have been more sensitive to changes in deposit interest rates than the commercial loan rates. on the other hand, there is no significant change on the effect of credit and fx rate on bank return when the two results are compared. the only considerable change is evident in c bank because the fx rate coefficient for c bank γ3 turns to insignificant in this new definition. the results are very similar with the previous one when using spread as a proxy for interest rate, except for the fact that the interest rate coefficient of bank index γ2 is significant and positive at the 10% significance level (table 5). the spread indicates the basic profit for loans; therefore, an increase in spread leads to an increase in banking sector profitability. the first effect of the rising in deposit rate is less spread for banking sector. hence, the inverse relationship between deposit rate and spread is expected, which explains the reason of significant but different sign coefficient for bank index. on the other hand, the spread coefficients for individual banks are insignificant, which may indicate better management for interest risk exposure in respond to changes in spread at the bank level. 6. conclusion there is a strong connection between bank performance and sustainable economic growth. therefore, better understanding on table 3: estimates of the mean model given in equation 3 and variance equation given in 4 variables γ0 ω α β φ1 φ2 φ3 bank index 0.5475* (0.1895) 4.9309* (1.2683) 0.0396 (0.0289) 0.6978* (0.0724) −1.0561* (0.3231) 2.2149*** (1.2187) 0.6476** (0.3245) a bank −0.2901 (0.2029) 2.7944* (1.0857) 0.0334*** (0.0183) 0.8459* (0.0532) −0.4974** (0.2444) 1.4754*** (0.8375) 0.3875** (0.1972) b bank −0.4018** (0.2073) 5.1068* (2.1237) 0.0394 (0.0293) 0.7484* (0.0893) −0.5311 (0.3610) 3.7552*** (2.0297) 0.6559** (0.3197) c bank −0.2175 (0.2184) 18.502* (3.9518) 0.0103 (0.0191) 0.3884* (0.1288) −2.1955* (0.5023) 3.0242*** (1.7318) 0.6319*** (0.3823) d bank 0.3495 (0.2208) 3.5527* (1.0528) 0.0344 (0.0223) 0.8046* (0.0512) −0.7278* (0.2751) 12.553* (4.9301) 0.1493 (0.2482) numbers in parenthesis indicate the standard errors. *indicates the significance level at 1%, **indicates the significance level at 5%, ***indicates the significance level at 10% table 4: estimates of the mean model given in equation 1 and variance equation given in 2 by the commercial interest rate instead of 3 months deposit rate variables γ0 γ1 γ2 γ3 ω α β bank index −0.0484 (0.1506) 1.0442* (0.0576) 0.0051 (0.0933) 0.4156* (0.1304) 1.0521** (0.4777) 0.0914* (0.0261) 0.8477* (0.0443) a bank −0.4344** (0.2015) 0.2274* (0.0816) 0.0693 (0.1426) −0.0121 (0.1648) 0.7316** (0.3305) 0.0447* (0.0112) 0.9306* (0.0163) b bank −0.5784* (0.2078) 0.2781* (0.0829) 0.0631 (0.1277) 0.2712*** (0.1601) 0.9099*** (0.5197) 0.0663* (0.0183) 0.9062* (0.0259) c bank −0.3623*** (0.2004) 0.1621*** (0.0886) −0.0240 (0.1228) 0.2503 (0.1589) 0.4763*** (0.2911) 0.0539* (0.0127) 0.9299* (0.0168) d bank −0.1468 (0.1843) 1.1032* (0.0686) 0.0778 (0.1267) 0.3884* (0.1501) 1.3395* (0.3873) 0.1783* (0.0287) 0.7958* (0.0247) numbers in parenthesis indicate the standard errors. *indicates the significance level at 1%, **indicates the significance level at 5%, ***indicates the significance level at 10% table 5: estimates of the mean model given in equation 1 and variance equation given in 2 by the spread instead of the 3 months deposit rate variables γ0 γ1 γ2 γ3 ω α β bank index −0.2898 (0.1901) 1.0360* (0.0574) 0.1137*** (0.0605) 0.3975* (0.1293) 1.0774** (0.4983) 0.0956* (0.0280) 0.8429* (0.0464) a bank −0.4169 (0.2667) 0.2293* (0.0807) −0.0099 (0.0848) −0.0132 (0.1598) 0.7087** (0.3445) 0.0445* (0.0117) 0.9320* (0.0176) b bank −0.4894*** (0.2646) 0.2811* (0.0818) −0.0343 (0.0798) 0.2759*** (0.1584) 0.7611*** (0.4616) 0.0621* (0.0168) 0.9149* (0.0231) c bank −0.2139 (0.2457) 0.1649** (0.0871) −0.0606 (0.0757) 0.2552*** (0.1557) 0.4539 (0.2947) 0.0535* (0.0130) 0.9313* (0.0176) d bank −0.3145 (0.2646) 1.1028* (0.0696) 0.0641 (0.0877) 0.3878* (0.1477) 1.3162* (0.3722) 0.1855* (0.0286) 0.7922* (0.0236) numbers in parenthesis indicate the standard errors. *indicates the significance level at 1%, **indicates the significance level at 5%, ***indicates the significance level at 10% ekinci: the effect of credit and market risk on bank performance: evidence from turkey international journal of economics and financial issues | vol 6 • issue 2 • 2016 433 the effects of credit and market risk on bank performance could contribute to the better functioning of the banking system and help to understand the effects of monetary policy on it. following the same modeling methodology by kasman et al. (2011), this study provides strong empirical evidence on the effects of credit and market risk, which consist of interest rate and fx rate risk, on the bank performance for the turkish banking sector for the period of 18.01.2002-30.10.2015 by using weekly data. unlike to kasman et al. (2011), credit risk variable has added besides interest and and fx rate risk into the model, different variables for interest rate such as 3 months deposits interest rate, commercial loan interest rate and spread has used and different time period based on monetary policy has chosen. the paper has two main findings. (i) credit risk and fx rate have a positive and significant effect, but interest rate has insignificant effect on banking sector profitability, (ii) credit and market risk have a positive and significant effect on the conditional bank stock return volatility. credit risk, measured as return of industrial index, has a strong negative relationship with bank performance, measured as the return of bank index and bank stocks, i.e., a bank, b bank, c bank and d bank. this effect is also valid under the alternative measures of interest rate. credit risk is the most influential risk exposure on the bank profitability for the turkish banking sector but it changes at the bank level, that is some banks may effected by changes in interest rate or fx rate more than others. credit risk also has significant negative effect on return volatility. therefore less credit risk means high profit with less volatility for banks, in other words, less credit risk means stronger and stable growth for banks and vice versa. the effect of interest rate on bank profitability is not clear as literature suggested. the effect is insignificant for bank index and d bank but negative and significant for all other banks, i.e., a bank, b bank and c bank at 10% level. on the other hand, the effect is insignificant for all cases when the commercial interest rate instead of 3 months deposit rate is used, and only significant for bank index at 10% level when the spread, which is defined as difference of these two rates is considered. however, interest rate risk has a significant and positive effect on return volatility for banking sector and every bank. the fx rate and fx rate risk have a positive and significant effect on return10 and return volatility11 respectively. this finding supports the imperfect hedging in banking sector against the fluctuations in fx rate. the inference about the effects of credit and interest rate risk on bank returns is mainly in line with the kasman et al. 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(2004), diversifcation in banking: is noninterest income the answer? journal of money, credit and banking, 36(5), 853-882. stiroh, k., rumble, a. (2006), the dark side of diversifcation: the case of us financial holding companies. journal of banking and finance, 30(8), 2131-2161. tai, c.s. (2000), time-varying market, interest rate, and exchange rate risk premia in the us commercial bank stock returns. journal of multinational financial management, 10, 397-420. wetmore, j.l., brick, j.r. (1994), commercial bank risk: market, interest rate, and foreign exchange. journal of financial research, 17, 585-596. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2022, 12(6), 15-21. international journal of economics and financial issues | vol 12 • issue 6 • 2022 15 effect of speed of adjustments on capital structure decision: a conceptual analysis emmanuel kukah damina*, taiwo muritala, abbas umar ibrahim department of business administration, faculty of management, nile university of nigeria, nigeria. *email: dekukah@hotmail.com received: 25 july 2022 accepted: 18 october 2022 doi: https://doi.org/10.32479/ijefi.13469 abstract this study conceptually examines the effect of speed of adjustments on capital structure decisions. the study provides a conceptual and theoretical underpinning focused on the review of several studies on the effect of speed of adjustments on capital structure decisions. the study discovered firm size, assets, growth, profitability, and other factors that influence the speed of adjustments. the findings from a prior study showed that estimators of the speed of adjustments include the regression analysis, generalized methods of moments (gmm) and stochastic frontier analysis (sfa) models without a predictive model. the study recommends for a generalized predictive model that determines the speed of adjustments to the optimum capital structure of firms. keywords: speed of adjustment, capital structure decision, generalized predictive model jel classifications: g34 1. introduction a growing body of knowledge recognises that the speed of adjustments influences the optimum capital structure decision of firms under financing decisions in developed and developing countries. speed of adjustments shows how quickly a company can change its capital structure based on its desired goal and expectations within a given period. factors like growth opportunities influence the pace of change, age and size of the firm, profitability, macroeconomic factors, and distance to the target (haron et al., 2013; lemma and negash, 2014; ezeani, 2019; arief et al., 2020; bolarinwa and adeghoye, 2020; warmana et al., 2020). however, it has been observed that the result of the pace of adjustments is inconsistent when the capital structure target is observed under different models, industry or firm level parameters, and country-specific factors. one way to achieve and attain the optimum speed of adjustments is to determine a generalised predictor and aggregated factors that influence it (gan and chen, 2021; giovanni et al., 2021; cardoso and pinheiro, 2020; ezeani, 2019). for example, haron et al. (2013) argued that the speed of adjustment relies on the firm’s size and period due to the adjustment costs incurred by the firms. more recently, ezeani (2019) established that the legal, political, and regulatory environment on firms’ capital structure, which, when added to firm-level determinants, may give a better understanding of factors influencing the financing behaviour, especially in nigerian firms. while bolarinwe and adegboye (2020) re-examined the determinants of capital structure in nigeria using a combination of models like difference generalised method of moments (gmm), system gmm and stochastic frontier analysis (sfa). however, some studies which concentrated on developed countries found contrasting results, while fewer studies were on developing countries (bajaj et al., 2020; cardoso and pinheiro, 2020; goel, 2019; ganiyu et al., 2018). the limited study in developing countries like nigeria may create a misleading assumption that the theory and estimators applied in developed countries can be sustained and generalised in developing countries. this journal is licensed under a creative commons attribution 4.0 international license damina, et al.: effect of speed of adjustments on capital structure decision: a conceptual analysis international journal of economics and financial issues | vol 12 • issue 6 • 202216 besides, the variations in the results, industries, and estimators used for the speed of adjustments between and within the developed and developing countries, are creating contradicting results (haron et al., 2013; ezeani, 2019; bolarinwa and adegboye, 2020). the consequence of not establishing and standardising the model that fits into the reality of nigeria’s peculiar nature may result in managers selecting estimators that pander to biases when making capital structure decisions. furthermore, there is a need to understand the effect of intervening variables that may determine the optimisation level and influence the speed of adjustments. these include economic cycle and macroeconomics variables (gan and chen, 2021; giovanni et al., 2021; cardoso and pinheiro, 2020), efficiencies of cost and production (bolarinwa and adegboye, 2020), corruption (ezeani, 2019), and assets maturity along with an inconsistent measure for growth opportunities (warmana et al., 2020; arief et al., 2020). ignoring any controllable factor during the study may reduce the validity of the work, especially when the variables are determining factors that lead economic risk to override business risks. this study examines the factors that influence the speed of adjustments and how it influences the capital structure decision. based on these factors, there is a need for a generalised predictor that will aid in the determination of the speed of adjustments of capital structure decisions, especially in developing countries. this study conceptualises the factors influencing the rate of adjustments on the capital structure decision and justification for a generalised predictor. the study is organised into four sections as follows. section one has discussed the introduction of the study. section two will discuss the literature review, conceptualisation, theoretical framework, and review of prior studies. section three presents the discussion and implication of the study findings. section 4 concludes with the recommendation. 2. literature review 2.1. conceptualisation of the speed of adjustments and capital structure decisions capital structure has been defined as the permutation of equity and debt, which is used to derive the cost of capital (oino and ukaegbu, 2015; ayabe, 2015). using a more extended inclusive definition, giovanni et al. (2020) define capital structure as a fundamental aspect of corporate financial decisions that maximise firm value and minimise capital costs by determining the appropriate proportion of debt and equity that can minimise the company’s financial difficulties. furthermore, shahar and manja (2018) defines capital structure as the financial decisions regarding raising funds from several sources comprising internal (retained earnings) and external financing (debt and equity). wrong capital structure decisions will harm the company. ma and xu (2020) sees capital structure as the ratio between all liabilities and owner’s equity, which reflects the relationship between total liabilities and assets, total liabilities and total equity, different liabilities and different rights and interests. that capital structure optimisation theory establishes the model that describes the corporate characteristics and dynamic adjustment of capital structure recognised for its role in the development of enterprises. the speed of adjustments to a capital structure is defined as how fast a company can change its capital structure to meet its target within a period (warmana et al., 2020; arief et al., 2020). it entails the extent to which a firm can quickly change its target of debt or equity within a defined period. arief et al. (2020) stated that the change in the capital structure might be determined by factors like marginal benefit and the firm’s marginal cost. on the contrary, oino and ukaegbu (2015) recognised the internal financing approach as the best influence on the speed of capital structure adjustments. a firm can decide to vary or maintain its optimal capital structure at any time depending on the optimal target influenced by factors linked to the firm’s strategy. several studies have postulated a convergence for factors that determine the speed of adjustments, such as information asymmetry, cost of distress, profitability, solid financial needs, macroeconomic needs, distance form, and growth opportunities (haron et al., 2013; lemma and dagash, 2014). arief et al. (2020) stated that changes within the marginal benefits and marginal cost also affect the speed of adjustments, with the extent of their influence determined differently (bolarinwa and akingboye, 2020; ezeani, 2019). in addition, oino and ukaegbu (2015); oztekin and flannery (2012) identified that transaction costs, including legal, financial environment and investment bank fees, may prevent firms from adjusting their target leverage continuously, especially if these costs are prohibitively high. traditionally, it has been argued that growth, size, targetability, profitability, debt ratio, and expected inflation determine capital structure decisions, including speed of adjustments (frank and goyal, 2009; elsas and florysiak, 2008). kisgen (2006) included ratings of external rating agencies. elsas and florysiak (2008) argue that potential rating changes through financing decisions can alter the target debt level or the marginal benefit of debt over equity, rendering the corporate rating a potentially important determinant with competition, regulatory changes, and behavioural corporate finance are other factors that also determine the speed of adjustments. the review revealed that though the speed of adjustments has been influenced by several factors highlighted, country level, industry and firm-specific variables create different responses. 2.2. theoretical review since the emergence of modigliani and miller’s (1958, 1963) theory on capital structure, several other approaches have been developed. theories like the trade-off theory, the pecking order theory, market timing theory, and other theories like the signalling theory and agency theory. while some theories posit the relationship between capital structure and firm performance, others explain the rationale behind an optimum capital structure and rank which form can best create value for the firm. the modigliani and miller theories (1958; 1963) made the prepositions that capital structure does not affect the firm’s value. damina, et al.: effect of speed of adjustments on capital structure decision: a conceptual analysis international journal of economics and financial issues | vol 12 • issue 6 • 2022 17 they argued that, in a frictionless world, no difference exists between debt and equity. this has resulted in several empirical criticisms of the theory, with stitgis (1963) and luigi and sorin (2009) noting that the assumptions are unreal and impractical to be tested in a practical situation. further to this, eze and uzochukwu (2020), ejem and ogbonna (2019), onyinyechi (2019), ezirim and ezirim (2017), and cline (2015) tested the theory with modification of some of the assumptions yet found the result inconsistent with the claim by miller and modigliani. despite the shortcomings, ezeani (2019) and ardalan (2017) argued that modigliani and miller’s (1958) theorem is recognised as the first theory of capital structure, with its contributions acknowledged as the cornerstone of contemporary finance research. however, the idea only remains as far as a reference point to the historical, theoretical underpinning of capital structure. in trying to remedy the gap in the modigliani and miller theory, especially the inability of the authors to limit the firm’s debt capacity, the trade-off theory (kraus and litzenberger 1973; myers, 1984) suggests that profitability, asset tangibility and firm size will be positively related to leverage while business risk and strong growth will show a negative relationship with leverage. the theory recognised that debt is related to cost and benefits (arief, 2020); however, the bigger the debt, the more risk may occur. in addition, it assumes that a firm will adjust its target capital structure consisting of debt and equity composition to the optimal level to lower its capital cost and bankruptcy risk (kane et al., 1984). according to arief (2020), this movement is called the speed of adjustments. though the theory suggests that the ideal debt-to-equity ratio will involve the identification of a trade-off point, which may be unique for each firm, the theories pay attention to the efficiency of firms in capital structure decisions (bolarinwa and adegogboye, 2020). the emphasis is on the debt tax shield while ignoring other tax shields (ezeani, 2019), making it unattractive to a liquid and profitable firm. the pecking order, as postulated by myers and majluf (1984) and myers (1984), acknowledges the roles of information asymmetry in the agency relationship and hence notes that firms follow an order of hierarchy financing (khemiri and noubbigh, 2018). that the managers adopt a financial hierarchy while acting in the interest of the shareholders, starting with the retained earnings, debt, and issue of new equity. myers and majluf (1984) emphasised that firms prefer debt to equity if they need external funds, as further explained by oino and ukaegbu (2015). they noted that investors expect a higher return on equity despite equity being riskier than debt. notwithstanding this position, the pecking order theory ignored the criteria for adjustments to the capital structure. still, it relied more on the ranking and preferences of managers’ internal financing and debt in the first instance before equity. goyal and frank (2009) stated that in its current form, the pecking order theory does not help organise many of the prevalent features in how firms are financed. although, it is credited for correctly predicting the effect of profits (shyam-sunder and myers, 1999). the market-timing theory states that firms issue equity when market prices are irrationally overpriced, using the corresponding “window of opportunity” (baker and wurgler, 2002). baker and wurgler argued that capital structure is best understood as the cumulative effect of past attempts to time the market by considering the current conditions in debt and equity markets. if financing arises, managers use whichever market conditions look more favourable. frank and goyal (2009) see market timing theory in terms of predictions for the market-to-book assets ratio and the effect of expected inflation but weak for not making any predictions for many of the patterns in the data that are accounted for by the trade-off theory. on the weakness of the approach, frank and goyal recommended that the market timing theory needs considerable theoretical development to explain all empirical regularities observed. also, the dynamic trade-off theory recognises that firms have a targeted debt ratio in their capital structure decision which is adjusted for the firm to maintain a targeted debt level influenced by both exogenous and endogenous factors (oztekin and flannery, 2012). previous methods of adopting the debt ratio by firms are weakened by the noise created by the bias associated with the firm-specific models and optimal dynamic behaviour (fisher et al., 1989). the theory generates predictions about firms’ capital structure decisions that are not based on static leverage ratios. hence, the empirical tests are not subject to the problems strictly stated by the static and previous theories. therefore, a classicalist view of the factors that influence the adjustments, the speed of adjustments and not entirely the pursuit of optimality of the capital structure will suffice to explain this study better. this study argues that the theories underpinning the capital structure model have revealed inconsistent results (bajaj et al., 2020). the combination of two theories to explain any of the capital structure phenomena will demonstrate the level of influence each of the factors has on the speed of adjustments. though the dynamic model is an extension of the static trade-off theory, it recognised the dynamism created by the changes attributed to some factors that influence the capital structure. 2.3. review of prior literature several studies have reviewed the speed of adjustment in developed countries (fischer et al., 1989; flannery and rangan, 2006; huang and ritter, 2009; ma and xu, 2020; gan and chen, 2021) and developing countries (haron et al., 2013; lemma and negash, 2014; oino and ukaegbu, 2015; ezeani, 2019; warmana et al., 2020; bolarinwa and adegboye, 2020). however, most studies rely on different theories, factors, models, and inconsistent results. warmana et al. (2020) evaluated the influence of some variables like growth potential, profitability, company size, the ratio between capital structure and its target, short-term loan, asset maturity, growth of gdp and inflation rate towards capital structure soa in nigeria using the generalised method of moment (gmm). the results showed the existence of a partial adjustment model estimation with target leverage with soa of 64.73% per year on manufacturing companies in indonesia. however, ma and xu (2020) analyse capital structure’s characteristics and present its simplified mathematical model using a comprehensive panel data analysis by selecting from listed companies with continuous damina, et al.: effect of speed of adjustments on capital structure decision: a conceptual analysis international journal of economics and financial issues | vol 12 • issue 6 • 202218 financial data of a-shares in shenzhen and shanghai. the findings showed that the optimisation approach could improve the statistics result of capital structure adjustment. empirical analysis shows that equity financing is preferable for the listed companies. furthermore, a capital structure optimisation problem with uncertainty under equity financing constraints is studied and formulated as a two-stage stochastic optimisation problem. in the same vein, gan and chen (2021) extend the demazro and he (2019) model of capital structure dynamics by introducing macroeconomic conditions. the study analysed how business cycle risks impacting a firm’s capital structure adjustment speed. gan and chen attempt to theoretically link macroeconomic conditions to capital structure adjustment speed using the demarzo and he (2019) model of capital structure dynamics. the model estimated that capital structure adjustment is slower in the presence of macroeconomic risk. by contrast, huang and ritter (2009) examined time-series patterns of external financing decisions using the system gmm estimator. the findings show that publicly traded u.s. firms fund a much more significant proportion of their financing deficit with external equity than the cost of equity capital. further investigation by giovanni et al. (2020) on the implementation of pecking order theory and trade of theory on the speed of adjustments (soa) used the panel regression model analysis with the result showing that soa performed faster with the economic and business risks positively influencing the soa. contrary to the findings of bolarinwa and adeboye (2020), who adopted the static model to estimate the determinant of the capital structure in nigeria. bolarinwa and adeboye argue that static models of random and fixed effects are robust and account for persistence and dynamism in the modelling of determinants of capital structure. also, lemma and negash (2014) examine industry and firmspecific characteristics of the adjustment speed of corporate capital structure in developing countries. the model parameters were estimated using the generalised system method of moments (sys-gmm) estimator, which found that some firms in developing countries deviate from their target capital structures due to the gap between observed and target leverage ratios, unlike daniela et al. (2020) who examined the effect of growth opportunities using fixed and random regression model and find out that growth opportunities have a significant relationship with debt ratio and demand yield. in addition, haron et al. (2013) focus on the dynamic aspect of capital structure by employing panel data of 790 non-financial listed firms in malaysia for the period 2000–2009. the study was conducted using the dynamic partial adjustment model and estimated based on the generalised method of moments to determine the existence of target capital structure, speed of adjustment and factors affecting the speed of adjustment. the study finds strong evidence of the relationship between speed of adjustment and distance from target leverage. therefore, this study did not confirm the commonly held argument on the nonexistence of any relationship between growth opportunity and speed of adjustment. in developing country-level studies, bolanrinwe and adeboye (2020) examined the determinants of capital structures and speed of adjustments in nigeria using deference gmm, system gmm and stochastic frontier analysis (sfa). the results showed that firms’ efficiency affects capital structure while short-term debt has a higher speed of adjustments in nigeria. likewise, ezeani (2019) examined the capital structure determinants and speed of adjustment (soa) of nigeria’s non-financial firms and the impact of the financial crisis on the soa. the study uses dynamic capital models and the two-step gmm system estimation. the result shows 63% soa for listed nonfinancial firms in nigeria, with soa being faster after the financial crisis compared to the pre-crisis situation. similarly, oino and ukaegbu (2015) investigated the impacts of capital structure on the performance of nigerian-listed nonfinancial firms. the study used the pool ols and gmm to determine the speed of adjustment to the target capital structure. the descriptive statistics show that 63% of the capital structure of nigerian firms is leveraged, with short-term leverage dominating. the study observed that profitability and asset structure were negatively related to leverage, while the firm’s size and nondebt tax shield were positively associated with leverage. the adjustment speed of nigerian firms is stated at 47% compared to most developed countries. besides, most of the studies above used estimators of regression analysis, systems and differential gmm and the sfa models to determine the appropriate models deprived of any form of biases. the review further showed that scholars focused less on the predictive relevance of the dynamic factors that influence the speed of adjustment. 3. discussion of findings and implications 3.2. factors that influence speed of adjustments (soa) several studies identified factors that influence the speed of capital structure decisions. though the findings of most studies reviewed (lemma and negash, 2014; oino and ukaegbu, 2015; oztekin and flannery, 2012) may have been divergent in some instances, they showed the relevance of some of the factors that have influenced the speed of adjustments. 3.2.1. size of firm the firm’s size depends on whether a firm is big or small. prior studies have argued about its influence on the speed of adjustments (flannery and hankins, 2007; haron et al., 2013; lemma and dagash, 2014; ezeani, 2019). the results of previous studies, according to ezeani (2019), showed that soa for large and small firms are 50% and 58%, respectively, indicating a slower leverage adjustment process for both types of firms, with a slightly higher soa for small firms which may be attributed to a higher proportion of short-term leverage used by smaller firms when compared to larger firms. the firm’s size is measured using a log of assets and damina, et al.: effect of speed of adjustments on capital structure decision: a conceptual analysis international journal of economics and financial issues | vol 12 • issue 6 • 2022 19 a mature firm (goyal and frank, 2009; bolarinwa and akingboye, 2020). the results revealed that in determining the factors that influence the soa, the firm’s size is considered the main factor influencing the speed of adjustments. 3.2.2. profitability profitability involves the gains that accrue to a firm during the business. in the dynamic trade-off model, leverage can appear to be negatively related to profitability in the data due to various frictions (elsas and florysiak, 2008). therefore, profitability has been theoretically and empirically supported as a determinant that influences the speed of adjustments. 3.2.3. growth opportunities thus, the trade-off theory predicts that growth reduces leverage. by contrast, the pecking order theory implies that firms with more investments—holding profitability fixed—should accumulate more debt over time. thus, growth opportunities and leverage are positively related under the pecking order theory. 3.2.4. tangible assets tangible assets like property, plants and equipment are internal factors that determine the extent to which a firm can access capital structure and the volume it may require. while it is easier to measure tangible asset because it is visible, it is not easy with intangible assets. 3.2.5. taxes the accessibility of the debt market is another disturbing factor that influences the speed of adjustments. while the debt market is highly effective in developed countries like the usa, it cannot be stated as the same in developing countries as it is very restrictive. the h high-interest rates are discouraging factors in developing countries like nigeria compared to developed countries like the usa. 3.2.6. stock market condition welch (2004) argues that firms do not rebalance capital structure changes caused by stock price shocks. therefore, stock returns are considerably more important in explaining debt-equity ratios than all previously identified proxies. market timing theories make similar predictions, but the effects come from managers actively timing equity markets to take advantage of mispricing. the arguments indicate that the stock market condition is critical to the speed of adjustments. 3.2.7. macroeconomic conditions during expansions, stock prices go up, expected bankruptcy costs go down, taxable income goes up, and cash increases. if pecking order theory holds, leverage should decline since internal funds increase during expansions, all else equal. in nigeria, growth in gdp would adequately spur the speed of adjustments. conclusively, the factors discussed in this study influence the speed of adjustments to the capital structure decision, country models and level of development, making it difficult for the effect to remain consistent; however, in a broader application, the existence of these variables have remained constant and can be used to tests the estimates of the speed and develop a predictive instrument. 3.3. deployment of a generalised predictor the findings from the review indicate that most scholars concentrated on determining the speed of adjustments to capital structure decision estimates. though understanding the speed of adjustments will explain how fast the capital structure targets can be attained, a predictive model can further strengthen financial decisions. appendix table 1 shows the models adopted by several studies on estimating the speed of adjustment. table 1 shows that most scholars discussed estimating the speed of adjustments using either the regression model, gmm or citation analysis. though ayala and balzsek (2020) used the harvey and chargrity (2008) model in their estimation, which is an extended regression model, some studies adopted the pooled ols regression model, difference gmm, and systems gmm (ezeani, 2019; bolarinwa and adegboye, 2020). however, most studies relied on the regression model as a tool for analysis. the analysis revealed that none of the studies used the estimator as a predictive model to establish whether the existence of some of the controlled factors that influence the speed of adjustments, whether combined or controlled, may give the theoretical underpinnings of the targeted adjusted trade-off theory combined with the pecking order theory would provide an explained prediction that may be generalised. 4. conclusion and recommendation the study explored the speed of adjustments in the capital structure decision of non-financial firms in nigeria, a conceptualisation analysis. the study identified key factors of the size of firms, profitability, assets, growth, and economic factors, amongst others, as determinants of the speed of adjustments relying on the pecking order theory and dynamic trade of theory as theoretical underpinnings explaining the effect on the capital structure. in addition, this study noted that regression analysis, systems and differential gmm and the sfa models were used as estimators of the speed of capital structure adjustments. but none of the reviewed studies did not argue for using a predictor that can be adopted as a generalised model. this study recommended empirical research that combines factors of firm, industry, or country-specific characteristics in determining the speed of adjustments of capital structure in nigeria. it is also recommended that further study on the capital structure should attempt the use of a generalised model that can sufficiently predict the optimum target capital structure by firms. the predictive model would ensure that firms determine the most appropriate capital structure and financing mix. references apanisile, o.t. olayiwola, j.a. 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(2012), institutional determinants of capital structure adjustment speeds. journal of financial economics, 103(1), 88-112. shyam-sunder, l., myers, s.c. (1999), testing static trade-off against pecking order models of capital structure. journal of financial economics, 51, 219-244. stiglitz, j.e. (1969), a re-examination of the modigliani-miller theorem. the american economic review, 59(5), 784-793. shahar, w.s., manja, s.i. (2018), determinants of capital structure. report on economics and finance, 4(3), 139-149. warmana, g.o., rahyuda, i.k., purbawangsa, i.b.a., artini, n.l.g. (2020), investigating capital structure speed of adjustment (soa) of indonesian companies for corporate value. global journal of flexible systems management, 21, 215-231. appendix table 1: analysis of models for estimation of the speed of adjustments of capital structure s/n author models 1. gan and chen (2021); daniela et al. (2020); giovanni et al. (2020); hussain et al. (2020); ayala and blazsek (2020); ma and xu (2020); cardoso and pinheiro (2020); dao and ta (2020); arief et al. (2020); goel (2019); li et al. (2019); ezeani (2019); apanisile and olayiwola (2019); karpavičius and yu (2019); oino and ukaegbu (2015); haron et al. (2013); chekanskiy (2009); huang and ritter (2009) regression analysis: various variants of regression analysis like fixed and random effect regression models; dynamic partial equilibrium model developed; dynamic partial adjustment 2 bajaj et al. (2020). citation analysis 3 bolarinwa and adegboye (2020); warmana et al. (2020); ezeani (2019); ganiyu et al. (2018); oino and ukaegbu (2015). lemma and negash (2014) difference gmm, system gmm and stochastic frontier source: author’s compilation, 2021 appendix 1 . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(2), 588-595. international journal of economics and financial issues | vol 6 • issue 2 • 2016588 wealth effects from banks mergers and acquisitions in eastern europe georgios kyriazopoulos* department of accounting and finance, technological educational institute of western macedonia, 50100, koila, kozani, greece. *email: kyriazopoulosg@yahoo.com/kyriazog@teiwm.gr abstract the main objective of the current study is the examination of the wealth effects emanating from the announcement of mergers and acquisitions (m&as) in eastern europe that took place between 1995 and 2015. in specific, the main objective of the paper is the examination of the stock price reaction of both bidders and targets to the announcement of m&as. the method of payment is another aspect that is considered when assessing the wealth effects of m&as. to gauge market reaction, we use both the standard event study methodology and regression analysis. the results show that targets gain significant abnormal returns around event periods, while acquirers seem to earn trivial excess returns. moreover, cash disbursements in bank m&as boost price appreciations around event dates. the results from regression analysis reveal that the determinants of abnormal returns are the market competitiveness, method of payment, and relative size. keywords: mergers, acquisitions, wealth effects, abnormal returns, eastern europe jel classifications: g11, g14, g21, g34 1. introduction the european financial sector has witnessed dramatic changes in the last two decades as a result of the enactment of the second banking directive, the introduction of euro as the common european currency and the adoption of the capital requirements regulation and directive. furthermore, market de-regulation and harmonization of banking systems have resulted into banking concentration in all important banking markets, including the european one. however, the pace of changes in eastern european countries was a little bit more dramatic after the collapse of the communist regimes which led to the opening of these markets and offered new opportunities for european banks. the influx of western european banks into the financial sector of the central and eastern european countries (cee) was notable in an attempt to gain attractive new business in these markets. this trend increased when the first countries from eastern europe applied for membership and finally joined the european union (eu) in 2004 (fritsch et al., 2007). the immediate consequence of the above structural changes was the increase of investment interest in cee countries through a wave of mergers and acquisitions (m&as). in a nutshell, the opening of the banking sector in eastern europe was the new el dorado for m&a activities. though the announcement effects of m&as are one of the most extensively topics in banking and finance literature, the majority of prior studies have showed a preference to western europe leaving under-researched the wealth effects emanating from bank m&as in eastern europe. eastern europe presents many idiocyncrancies not observed in the western europe such as the newly developed economic system, the transition from a centrally planned economy to capitalism, the different legal and institutional environment and the degree of competition in the market for corporate control. therefore, eastern europe’s bank industry could be considered a good laboratory to gauge market reaction to bank m&a announcements that could provide useful to academics and practitioners alike. a key issue in any m&a transaction is whether the transaction is likely to create value for the shareholders of the acquiring firm. what matters is whether the stock market reacts positively to the transaction in the short-run and, more importantly, whether the kyriazopoulos: wealth effects from banks m&as in eastern europe international journal of economics and financial issues | vol 6 • issue 2 • 2016 589 acquirer’s stock outperforms its peers in the long-run. based on the above, the main objective of the current study is to assess the short-run market reaction to the announcement of bank m&as. for this purpose, an up-to-date sample of 69 bank m&a deals is considered for a period spanning from 1995 to 2015 in eastern europe. employing the classical event study methodology, we compute excess returns surrounding m&a deals for both bidding and target banks. our results aim at contributing to the pertinent literature by bringing new evidence from a market that has recently opened and is still under structural changes. moreover, this is the first study that analyzes market reaction to bank m&as in easter europe by taking into account the method of payment. in line with prior evidence, target shareholders seem to benefit, at least in the short-run, from the announcement of m&as especially when m&a deals are paid by cash. in contrast, bidding banks seem to reap marginal gains surrounding m&a dates. these results could be useful to bank managers who intend to get a toehold in a market that is relatively new and presents some market characteristics such as high ownership concentration, state intervention, market underdevelopment, high cost of capital, etc. the remainder of the paper is as follows: section 2 presents the pertinent literature review, while section 3 describes data and methodology. section 4 presents the empirical results of the study, while section 5 summarizes the most important results. 2. literature the pertinent literature has identified several factors which construe acquisitions in the banking sector (beltratti and paladino, 2013). these include: (i) economies of scale associated with centralizing functions like it and cash management, (ii) economies of information associated with better screening of borrowers (panetta et al., 2009), (iii) market power (focarelli et al., 2002; hankir et al., 2011), (iv) geographic, portfolio and activity diversification bringing benefits in terms of risk reduction (hughes et al., 1999; emmons et al., 2004; van lelyveld and knot, 2009), (v) implicit subsidies connected with a too-big-to-fail status (demirgüç-kunt and huizinga, 2010), (vi) empire-building on the part of the managers. however, some of these factors have never been tested in eastern europe’s bank m&as. there is a bulk of studies in banking and finance literature regarding m&as that analyze the impact of m&a’s on shareholders wealth and company’s performance, motives for m&a’s or variables that influence the success of m&as as well as the impact of m&a’s on society and economy (depamphilis, 2010). however, the m&a success is relevant and can be viewed from different perspectives. with the regard to the fact that m&as influence a wide spectrum of stakeholders (i.e., shareholders, managers, employees, clients, suppliers, lenders, etc.) and that interests of those stakeholders diverge, m&a transactions can, at the same time, positively influence one part, and negatively influence the other part of stakeholders. looking at the announcement effects of bank m&as, there is an overwhelming literature employing data from us banks. the prevailing view is that while the target shareholders generally fare pretty well, most acquisitions fail to create value for acquirers (hazelkorn et al., 2004). in specific, most of the studies report slightly negative value effects for bidders (e.g. wall and gup, 1989; hawawini and swary, 1990; houston and ryngaert, 1994; madura and wiant, 1994; hudgins and seifert, 1996; pilloff, 1996; kane, 2000; delong, 2001; amihud et al., 2002; cornett et al., 2003; knapp et al., 2005), while some other studies report positive, though non-significant, abnormal returns (for example kiymaz, 2004, delong and deyoung, 2007; williams and liao, 2008; goddard et al., 2012). the combined effect in most studies is slightly positive but not significantly different from zero. specifically, the combined excess returns of acquirers and targets are insignificant in houston and ryngaert (1994), hudgins and seifert (1996) and pilloff (1996). despite the high level of m&a activity in the european banking sector, relatively little research has been conducted so far. the first three studies are those of tourani-rad and van beek (1999), cybo-ottone and murgia (2000) and beitel et al. (2004) which probe into the announcement effects of european bank m&as. in particular, tourani-rad and van beek (1999) analyze a sample of 58 different bidding banks in acquisitions between 1989 and 1996 in europe and find non-significant difference in cross-border activity compared to domestic transactions. the shareholders of the acquiring bank do not experience a significant abnormal return. cybo-ottone and murgia (2000) make use of 54 european m&a deals between 1988 and 1997 and find insignificant results regarding the returns for the acquiring bank’s shareholders. beitel et al. (2004) analyze 98 european m&a transactions that occurred between 1987 and 2000. employing regression analyses, they test different potential value drivers regarding their influence on the cumulative average abnormal return (caar). their results indicate that cross border m&a deals increase the caar of the target bank, while bidders enjoy price appreciations in domestic transactions. for the combined entity the geographic focus, however, is not an important value driver. a new wave of european evidence points towards zero returns or marginal profits in the short-term for acquirer shareholders in the event of an m&a announcement for european samples of banking institutions. campa and herrando (2006) examine the financial industry in europe during 1998-2002 and find that abnormal returns for bidders are zero, while target banks experiencing low operating performance are positively affected by the transaction in the long-run. hagendorff et al. (2008) show positive short-term abnormal returns for bidder banks, while lensink and maslennikova (2008) find evidence of marginal or zero profits for bidders. clearly positive value creation is reported in cybo-ottone and murgia (2000), where after analyzing 54 large european bank mergers during the period 1989-1997. evidence of value creation from cross-border m&as is also found in schmautzer (2006). beitel et al. (2004) find a significant positive effect for combined entities and ekkayokkaya et al. (2009) show positive abnormal returns resulting from mergers especially for the period before the introduction of the common currency in europe. kyriazopoulos: wealth effects from banks m&as in eastern europe international journal of economics and financial issues | vol 6 • issue 2 • 2016590 more recently, tsangarakis et al. (2013) examine the european financial sector during the period 2000-2006 and assert that targets gain more through small cross-border deals. they also conclude that prior targets’ performance impacts negatively on abnormal returns derived from the transaction announcement. beltratti and paladino (2013) examine a sample of acquirers during 2007-2010 and find that bidders’ returns are positively affected by bank profitability and efficiency. finally, kyriazopoulos and drymbetas (2014) explore the short-term stock price reaction of cross-border bank m&as in western europe for the period 1998-2009. consistent with prior literature, they demonstrate that targets significantly benefit from m&as, while bidders undergo price losses during the m&a announcement dates. overall the existing literature on eu bank m&a activity is in line with the u.s. evidence with respect to target banks’ performance. the vast majority of the pertinent literature reports that targets experience positive abnormal returns to the m&a announcements. nonetheless, there exist noteworthy differences with respect to acquirers. the european evidence for bidders is mixed; there is a significant body of research which shows marginal profits to be earned by bidder banks. this represents a remarkable deviation from the commonly held view that bidders are usually losers in the short-run. note that similar finding of marginal or zero profits for bidders is scarcely found in the u.s. financial sector. europe, therefore, seems to provide a more favorable ground for bidder bank shareholders. however, the current study attempts to investigate whether this favorable environment for bidding banks holds in eastern europe, a market that has recently opened and deregulated. 3. research design 3.1. sample data regarding deal type, announcement dates, method of payment, deal status, country of origin, percentage acquired, announced total value of each deal, stock prices and market indices were culled from bloomberg. the focus of the current study is the wealth effects of bank m&as that occurred between 1995 and 2015 in eastern europe. to form our sample of m&a transactions we set the following criteria: i. the announcement date of the merger or acquisition was set between january 01, 1995 and december 31, 2015 ii. both acquirers and targets should be banks having the same two-digit sic code iii. m&as had been completed and not pending or withdrawn iv. the acquiring and the acquired bank were located in eastern europe v. both acquirers and targets were listed banks vi. multiple m&as within the same calendar year from the same bidder were excluded from the sample. the reason behind this decision is that the conveyed information content of the first m&a announcement is mitigated in the subsequent m&a announcements. the above criteria rendered a final sample of 69 bank m&a transactions of which 8 are cross-border and 61 domestic ones. table 1 presents the sample distribution by year. as it can be seen, the sample distribution is scattered across all years with the number of m&as peaked in 1999 (11 deals). it is worth mentioning that the number of deals continued in the crisis period (2008 onwards) proving that the financial turmoil did not affect severely bank m&as in eastern europe. table 2 presents the sample distribution of m&as by the country of origin of both targets and acquirers. russia and poland are the two countries that host most of the m&a deals. in specific, table 1: distribution of m&as by year year n (%) 1995 3 (4) 1996 2 (3) 1997 4 (6) 1998 3 (4) 1999 11 (16) 2000 3 (4) 2001 3 (4) 2002 0 (0) 2003 0 (0) 2004 0 (0) 2005 3 (4) 2006 1 (1) 2007 5 (7) 2008 5 (7) 2009 2 (3) 2010 9 (13) 2011 1 (1) 2012 5 (7) 2013 2 (3) 2014 2 (3) 2015 5 (7) total 69 (100) m&as: mergers and acquisitions table 2: distribution of m&as by country target n (%) acquirer n (%) bosnia 1 (1) bosnia 0 (0) bulgaria 1 (1) bulgaria 2 (3) croatia 3 (4) croatia 4 (6) czech republic 2 (3) czech republic 2 (3) estonia 3 (4) estonia 5 (7) former yugoslav republic of macedonia 1 (1) former yugoslav republic of macedonia 0 (0) hungary 1 (1) hungary 1 (1) latvia 3 (4) latvia 0 (0) lithuania 4 (6) lithuania 5 (7) poland 15 (22) poland 16 (23) russian federation 21 (30) russian federation 23 (33) slovenia 3 (4) slovenia 3 (4) turkey 3 (4) turkey 2 (3) ukraine 8 (12) ukraine 6 (9) total 69 (100) total 69 (100) cross-border 8 (12) domestic 61 (88) m&as: mergers and acquisitions kyriazopoulos: wealth effects from banks m&as in eastern europe international journal of economics and financial issues | vol 6 • issue 2 • 2016 591 21 targets and 23 acquirers are russian banks, while 15 targets and 16 bidders are polish banks. ukrainian banks hold the third position in the number of targets and bidders. table 3 reports some descriptive statistics for the examined m&a transactions. the mean percentage acquired is 38.64%, while that owned after the m&a deal is 62.79%. these two figures demonstrate that the deals under examination lead to the acquisition of major stake holdings (>50% of voting rights after the transaction) in target banks. finally, the mean enterprise value at the m&a announcement is 2454.96 million dollars, while that of equity value is 1038.60 million dollars. 3.2. event study methodology to calculate abnormal returns around m&as, daily closing prices 250 days before and 10 days after the announcement date of the m&a deals were collected both for banks’ equities and for their corresponding stock market indices. to estimate the market reaction to m&a announcements, we employ the standard event methodology and calculate aars and caars for the 21-day period (−10, +10) surrounding the merger or acquisition date. to compute both aars and caars we use the market model. based on the market model, the abnormal return achieved by firm i at time t is estimated as follows: rit = ai + βirmt + εit (1) where, rit is the observed return of bank i at time t; rmt is the observed return on the benchmark at time t and εit is the residual. we estimate parameters αi and βi, using ordinary least squares. based on these estimated parameters for the period t = −250 to −11, we use the market model to calculate abnormal returns arit at time t, for each bank i as follows: ar r a rit it i i mt= − +[ ] ^ ^  (2) the event window is t = (10, +10) days, where t = 0 is the announcement day of a transaction. within the event windows several periods such as (−1, +1), (−10, +1), etc. are studied. calculated abnormal returns then are averaged as follows: aar n art it i n = = ∑1 1 (3) where, n = number of analyzed stocks, and t = point of time to analyze, t ∈ t. caars for any interval [t1; t2] during the event window t are calculated as follows: caar aart t t t t 1 2 1 2 ; [ ; ] [ ] = ∑ (4) caars are computed for every bank over several event windows to capture the market reaction before as well as after the announcement of the deal. more specifically, we set out our calculations for event windows of 2-days, (t = −1 to t = 0), 3-days (t = −1 to t = +1), 5-days (t = −5 to t = −1 as well as t = +1 to t = +5), 11-days (t = −5 to t = +5 as well as t = −10 to t = −1 and t = +1 to t = +10) and 21-days (t = −10 to t = +10). the reason for estimating caars for various event windows is to detect possible sluggish market reaction or information leakages around the m&a announcement date. to test for significance of aars and caars t-statistics are employed as suggested by dodd and warner (1983), which were also applied by delong (2001), hudgins and seifert (1996) and fritsch et al. (2007). the test statistic furthermore is adjusted to reflect cross-sectional independence (brown and warner, 1985; dodd and warner, 1983). 3.3. regression model to identify the determinants of abnormal behavior surrounding m&a deals, we perform a regression analysis using aars or caars as dependent variable against a set of control variables. controlling for year and country effects, our model takes the following form: aari = b0 + b1*compi + b2*cashi + b3*sizei + b4*rsi + b5*domi + b6*roei + ei (5) where, compi measures banking competition based on the percentage of listed banks within a country in a specific year, cashi is a dummy variable taking a value of 1 if the acquisition was paid by cash and 0 otherwise, sizei is the bank size as measured by the natural logarithm of bank’s equity market value 1 month prior to the m&a announcement date, rsi is the relative size of the target in relation to the bidder 1 month prior the m&a announcement date, domi is a dummy variable taking a value of 1 for domestic m&as and 0 otherwise, roei, which measures profitability of target bank, is the return on equity of the target bank 1 month prior the m&a announcement date. 4. empirical results 4.1. event study results table 4 reports the market reaction of acquirers to m&a deals. in line with prior studies exploring bank m&as, we find positive, however, non-significant aars for the bidding banks on days −1, 0 and +1. moreover, the caar of 3 days (−1, +1) is 1.35% statistically non-significant at any conventional level. looking at table 3: descriptive statistics of m&a deals variables mean median standard deviation max min percentage of shares acquired 38.64 20.00 36.31 100.00 2.40 percentage owned after transaction 62.79 73.48 36.83 100.00 2.40 enterprise value at announcement ($mil) 2454.96 289.38 3926.60 17,687.91 3.88 equity value at announcement ($mil) 1038.60 214.48 1676.42 7569.22 3.88 m&as: mergers and acquisitions kyriazopoulos: wealth effects from banks m&as in eastern europe international journal of economics and financial issues | vol 6 • issue 2 • 2016592 the various event windows prior and post-m&a date, we do not detect any statistically significant stock price reaction suggesting that the market does not assess the announced m&a deals as valueadded corporate events for bidding banks. this result is in line with tsangarakis et al. (2013) who also derive marginally positive and non-significant returns during the same event windows. with the exception of the (−1, 0) event window, caars are marginally negative (positive) in the examined periods preceding (following) the announcement, but the absence of statistical significance does not allow us to make inferences of information leakage or retard market reaction. instead, we can assert that the market reacts in an efficient manner lending support for the efficient market hypothesis. panel a of table 5 displays the results for targets. similar to prior studies, we observe significant wealth effects for target shareholders. in specific, the aar on day 0 is 5.237%, statistically significant at the 1% level. however, the upward trend of stock prices commences 2 days before the actual announcement date and holds up to day +1. on day −2, the aar is 3.593%, on day −1 is 4.284% and on day +1 is 3.113%, all statistically significant. collectively, over the 3-day and 2-day event windows caars amount to 12.634% and 9.521%, respectively (panel b). the positive abnormal behavior persists in all pre-event windows such as (−10, −1) and (−5, −1). beltratti and paladino (2013) claim that event windows prior to the announcement of the deal serve solely the purpose of determining the forces of information dissemination prior to the event, and we verify that the pre-announced excess returns divulge the positive information content conveyed by the upcoming m&as for target banks. another task of the current study is the examination of the wealth effects surrounding m&a announcements taking into account the method of payment. in specific, we explore the market response to m&a deals paid by cash or through stock swap. for this purpose, we split the full sample of target banks1 based on the method of payment. table 6 presents the results from cash m&as. compared to the full sample of targets, the stock price response is stronger on magnitude and persistence. in particular, the stock price appreciation commences on day −3 and persists to day +1. moreover, the excess returns are higher in all these days viz. to the full sample of targets. for instance, on day 0 the aar is 8.379% as compared to 5.237% of the full sample of targets. turning to caars, the stronger market reaction is more than evident in all event windows. specifically, the 3-day caar is 20.214% and that of 2-days is 15.234%, both statistically significant at the 1% level. 1 the sample of bidders is not split since the market reaction to m&a announcements is statistically non-significant. table 5: aars and caars for target banks in eastern europe panel a: aars for targets (n=69) days aar% t-student −10 0.663 0.95 −9 0.106 0.16 −8 0.607 0.25 −7 0.979 0.65 −6 0.655 0.37 −5 0.589 0.56 −4 0.692 0.37 −3 1.662 1.23 −2 3.593 1.91* −1 4.284 2.64** 0 5.237 3.84*** 1 3.113 1.98** 2 0.224 0.38 3 0.185 0.29 4 0.036 0.11 5 −0.317 −0.44 6 −0.043 −0.04 7 0.085 0.05 8 −0.228 −0.25 9 0.176 0.26 10 −0.277 −0.35 panel b: caars for targets event period caar % t-student caar (−10, +10) 22.021 2.48** caar (−10, −1) 13.83 2.32** caar (+1, +10) 2.954 0.69 caar (−5, +5) 19.298 2.33** caar (−5, −1) −0.866 −0.68 caar (+1, +5) 3.241 0.77 caar (−1, +1) 12.634 3.47*** caar (−1, 0) 9.521 2.63***` *, **, *** denote statistical significance at the 10%, 5% and 1% level, respectively. caar: cumulative average abnormal return, aar: average abnormal return table 4: aars and caars for bidding banks in eastern europe panel a: aars for bidders (n=69) days aar% t-student −10 0.000 0.00 −9 −0.547 −0.51 −8 −0.623 −0.86 −7 −0.238 −0.23 −6 −0.213 −0.01 −5 −0.065 −0.12 −4 −0.228 −0.16 −3 0.289 0.20 −2 −0.284 −0.06 −1 0.614 0.08 0 0.623 0.97 1 0.113 0.12 2 0.124 0.24 3 0.088 0.09 4 0.236 0.31 5 −0.217 −0.44 6 0.043 0.04 7 0.485 0.40 8 −0.728 −0.25 9 0.276 0.36 10 −0.047 −0.05 panel b: caars for bidders event period caar % t-student caar (−10, +10) −0.299 −0.48 caar (−10, −1) −1.295 −1.32 caar (+1, +10) 0.373 0.69 caar (−5, +5) 1.293 0.33 caar (−5, −1) −0.866 −0.68 caar (+1, +5) 0.344 0.77 caar (−1, +1) 1.350 1.47 caar (−1, 0) 1.237 1.53 *, **, *** denote statistical significance at the 10%, 5% and 1% level, respectively. caar: cumulative average abnormal return, aar: average abnormal return kyriazopoulos: wealth effects from banks m&as in eastern europe international journal of economics and financial issues | vol 6 • issue 2 • 2016 593 these results suggest that the market applauds bank m&as that are paid through cash in countries that have underdeveloped banking sector and stock markets with more asymmetric information. in such environments, shareholders of the target banks are more willing to accept cash payments even if these deals lead to the loss of corporate control and management. table 7 reports the results from the wealth effects emanating from the stock payment or mixed payment (both are considered as stock swap). in contrast with the market reaction to m&as paid by cash, m&as paid with stock swap produce much less stock price response on day 0 and around it. in particular, the 3-day caar is 4.935%, statistically significant at the 5% level. however, the 2-day caar is 3.719%, statistically non-significant. these results reveal a market reaction that is almost four times less than that of the sample of cash payments. untabulated two-tailed statistics verify the statistical differences between the two sub-samples of targets for the two aforementioned event periods. collectively, the above results confirm prior evidence which shows that m&as paid for with stock are negatively valued by target shareholders because they prefer to avoid the risk of wealth expropriation as a result of becoming minority shareholders after the deal. overall, the current study supports prior evidence that bank m&as bring about non-significant abnormal returns for bidding banks and significantly positive abnormal returns for targets around the deal announcement. as the market for corporate control of public companies is excessively competitive, acquirers tend to bid more aggressively and offer hefty premiums to targets, which, as a result, capture most of the acquisition benefit and enjoy significant price appreciation. at the same time, the acquisitions may fail because of decrease in productivity, drop in employee satisfaction and increase in management attrition rates. finally, our results suggest that the method of payment really affects the market reaction of target banks, favoring those deals that involve cash disbursement. 4.2. regression results we attempt to investigate the factors that explain market reaction for targets, which display positive and significant abnormal returns around m&a event dates. in specific, we regress abnormal returns of target banks against a gamut of control variables such as bank competition in a target country, the method of payment (cash vs. stock), the type of the m&a (domestic vs. cross-border), the target bank size and the relative size of the target in relation to the bidder. in all regressions we control for year and country effects. in model 1 of table 8 the dependent variable is the aar of day 0. the results show that market competitiveness (comp) is positive and statistically significant at the 1% level, demonstrating that target banks earn higher abnormal returns as the market table 6: aars and caars for target banks get acquired by cash panel a: aars for targets (n=48) days aar% t-student −10 1.061 1.52 −9 0.169 0.26 −8 0.971 0.40 −7 1.566 1.04 −6 1.048 0.59 −5 0.942 0.90 −4 1.107 0.59 −3 2.659 1.97** −2 5.749 3.06*** −1 6.854 4.22*** 0 8.379 6.14*** 1 4.981 3.17*** 2 0.358 0.61 3 0.296 0.46 4 0.058 0.18 5 −0.507 −0.70 6 −0.069 −0.06 7 0.136 0.08 8 −0.365 −0.40 9 0.282 0.42 10 −0.443 −0.56 panel b: caars for targets event period caar % t-student caar (−10, +10) 35.234 5.48** caar (−10, −1) 22.128 −2.62** caar (+1, +10) 4.726 0.99 caar (−5, +5) 30.877 4.33** caar (−5, −1) −0.866 −0.88 caar (+1, +5) 5.186 1.57 caar (−1, +1) 20.214 4.56*** caar (−1, 0) 15.234 3.38*** *, **, *** denote statistical significance at the 10%, 5% and 1% level, respectively. caar: cumulative average abnormal return, aar: average abnormal return table 7: aars and caars for target banks get acquired through stock swap panel a: aars for targets (n=21) days aar% t-student −10 0.259 0.59 −9 0.041 0.10 −8 0.237 0.16 −7 0.382 0.41 −6 0.256 0.23 −5 0.230 0.35 −4 0.270 0.23 −3 0.649 0.77 −2 1.404 1.19 −1 1.673 1.65 0 2.046 2.40** 1 1.216 1.24 2 0.088 0.24 3 0.072 0.18 4 0.014 0.07 5 −0.124 −0.28 6 −0.017 −0.03 7 0.033 0.03 8 −0.089 −0.16 9 0.069 0.16 10 −0.108 −0.22 panel b: caars for targets event period caar % t-student caar (−10, +10) 8.602 2.28** caar (−10, −1) 5.402 −1.62 caar (+1, +10) 1.154 0.49 caar (−5, +5) 7.538 4.33** caar (−5, −1) −0.866 −0.59 caar (+1, +5) 1.266 0.57 caar (−1, +1) 4.935 2.17** caar (−1, 0) 3.719 1.62 *, **, *** denote statistical significance at the 10%, 5% and 1% level, respectively. caar: cumulative average abnormal return, aar: average abnormal return kyriazopoulos: wealth effects from banks m&as in eastern europe international journal of economics and financial issues | vol 6 • issue 2 • 2016594 competition is more intense. this result is in line with the notion that if competition for listed targets is a key determinant of gains to acquisitions, then abnormal returns to target firms should systematically increase with the time-varying competition measure. moreover, the coefficient of the method of payment (cash) is statistically significant corroborating our earlier evidence that the market reaction is stronger when m&a deals are financed by cash. finally, relative size demonstrates a positive and statistically significant coefficient suggesting that the higher the target size in comparison to bidder’s, the stronger the market reaction to m&a deals. qualitatively similar results are obtained when we regress caars of 3-days (−1, +1) against the same set of control variables. again, the level of competition, the method of payment and the relative size are the variables that exert statistical influence on caars of target banks. 5. conclusions banks decide to be involved in an m&a deal intending to create synergies which are expected to decrease operating expenses, rationalize operations, receive tax benefits or increase market share and profit margins. however, the key question is how these synergies are distributed between shareholders of target and bidding banks. many papers have attempted to answer the above question, but there is mixed evidence regarding who benefits and loses from an m&a transaction. the current study is another academic endeavor to answer the question whether shareholders of bidders and target benefit from a bank m&a transaction. in specific, this paper empirically addresses the factors that influence announcement effects of bank m&as in eastern europe employing a dataset of 69 transactions between 1995 and 2015. the main contribution of our study is the examination of an updated dataset of m&as from a market that has been largely ignored by researchers. moreover, the results from the method of payment of m&as allow us to make the appropriate inferences regarding the factors that drive market reaction surrounding m&a deals. the results from the event study shows that, on average, bidding banks do not exhibit statistically significant abnormal returns on the actual announcement date and the days around it. this result is in line with the prevalent view that bidders earn marginal or trivial abnormal returns in europe. on the other hand, the apparent winner of the m&a deal is target banks which greatly benefit from the announcement of a merger or acquisition. in specific, one investor, purchasing bank stocks 10 days before the announcement of the m&a deal and selling them 10 days after, can earn an excess return that exceeds 22%. moreover, this excess return amounts to 35% when the deal is going to be financed by cash rather than with stock or combination of cash and stock. similar to fritsch et al. (2007), standard factors explaining m&a success in developed markets, such as profitability, type of acquisition and size of the target are not the main explanatory variables in bank m&a in eastern europe. instead, the value drivers of target stocks seem to be the level of competition, the method of payment or the relative size of target viz., to bidders. our empirical results have several managerial implications for financial institutions planning to expand in eastern europe. summarizing our results, we see that m&a announcements produce economically significant benefits for target shareholders who have invested their money in a bank domiciled in eastern europe. second, we find that target banks gains are positively associated with the level of competition within their markets. third, we assert that m&as financed purely with cash are associated with higher excess returns for targets making the method of payment significant instrument of value enhancement. this work is a solid step towards analyzing the impact of bank m&as in eastern europe. however, taking into account the dynamic features of the region and the banking sector alike, future research could be directed to analyze deal-specific factors such as takeover premium, change of management, subsequent m&as and equity injections or business strategy divergence. moreover, the post-m&a performance (either stock or financial) of merged or acquired banks could be another interesting aspect of m&as that merits investigation. references amihud, y., delong, g.l., saunders, a. (2002), the effects of crossborder bank mergers on bank risk and value. journal of international money and finance, 21, 857-877. beitel, p., schiereck, d., wahrenburg, m. (2004), explaining the m&a table 8: regression results variable model 1 model 2 intercept 0.439 (0.38) 0.764 (0.47) comp 0.089* (1.85) 0.109** (2.52) cash 0.266*** (2.75) 0.276*** (2.99) size −0.045 (−0.35) −0.068 (−0.76) rs 0.030* (1.69) 0.034* (1.70) dom 0.163 (0.52) 0.232 (0.92) roe 0.015 (0.76) 0.020 (0.85) year effects yes yes country effects yes yes number of observations 69 69 f-statistic 5.78*** 4.78*** r2 (%) 37.82 35.39 in model 1, the dependent variable is aar of day 0 and in model is the 3-day caar (−1, +1). compi measures banking competition based on the percentage of listed banks within a target country in a specific year, cashi is a dummy variable taking a value of 1 if the acquisition was paid by cash and 0 otherwise, sizei is the bank size as measured by the natural logarithm of bank’s equity market value 1 month prior to the m&a announcement date, rsi is the relative size of the target in relation to the bidder 1 month prior the m&a announcement date, domi is a dummy variable taking a value of 1 for domestic m&as and 0 otherwise, roe is the return on equity of the target bank 1 month prior the m&a announcement date. t-statistics are in parentheses. *, **, *** denote statistical significance at the 10%, 5% and 1% level, respectively. caar: cumulative average abnormal return, aar: average abnormal return, m&as: mergers and acquisitions kyriazopoulos: wealth effects from banks m&as in eastern europe international journal of economics and financial issues | vol 6 • issue 2 • 2016 595 success in european bank mergers and acquisitions. european financial management, 10, 109-134. beltratti, a., paladino, g. 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(2008), the search for value: cross-border bank m&a in emerging markets. comparative economic studies, 50, 274-296. van lelyveld, i., knot, k. (2009), do financial conglomerates create or destroy value? evidence for the eu. journal of banking and finance, 33, 2312-2321. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 697-700. international journal of economics and financial issues | vol 7 • issue 2 • 2017 697 credit default swap and liquidity khaldoun maddallah al-qaisi1*, rafat mohd soudki al-batayneh2 1faculty of business, amman arab university, jordan, 2department of finance, faculty of business, amman arab university, jordan. *email: khaldoun_21@yahoo.com abstract the recent global economic downturn that erupted in the mid 2007 saw an increase of the credit default swaps (cds) by hundred basis points and severe liquidity crunch in the financial sector of the united states. the recession phase highlighted the importance of the liquidity for the investors and underlined the importance of understanding the connection between the liquidity of the market and the credit markets. in depth, this study tries to understand the relation between the liquidity risk in the cds market and the credit risk. along the same line of this study, a study conducted on the different swiss and german companies revealed that credit risk is not the direct originator of the liquidity risk, but it created by a negative credit shock. in addition, this paper focuses on the causes that intensified the global crisis of (2007) as well as the macro-prudential policies are highlighted that will prevent a similar type of crisis in the future. keywords: credit risk, liquidity, financial crisis jel classifications: g31, g33 1. introduction in the year 1998, long-term capital management hedge fund collapsed in the russian crisis and a decade later. in the year 2007, the global economic crisis erupted and emphasized on the importance of the liquidity for the investors. this period seen an increase in the spread of credit default swaps (cds) by hundred basis point (bp) and one bp is hundredth of a percentage point (hertrich, 2014). this created severe illiquidity in the market and many investor as well as hedge funds had to close their trading positions, which triggered a fire sale. fire sale stands for a position, in which securities, mostly unwanted ones, have very less financial values sold to the known clients who just have no idea about what those securities are. this incidence emphasized on the values of the liquidity in the credit market and the risk models in the turmoil phase. for investors, policy makers and the researcher in the field of financial market research, it is very important to know the importance of the cds spreads and the size of the cds market for measuring the financial health, stability and health of the sector. it is important to understand the intensifying factors that played a major role in the recent crisis. cifuentes et al. (2005) in their article relates to the relationship between credit risk and liquidity. they add that the recent crisis felt the perfect need to put an importance to the restricted use of the cds and importance of having a liquid position in the market. moreover, the article focuses on the rationality of treating the liquidity as a weak exogenous in the time series sense when compared to credit risk or the vice versa. finally, they reveal that around 39% of the swiss and german companies felt that credit risk is a weak endogenous for liquidity while around 4.5% of the companies suggested that the vice-versa is true. the trading scenario was changing just before the global crisis and the market for the derivatives expanded rapidly. the liquidity of the markets dealing with derivatives assumes to have a higher value than the liquidity of the underlying assets and likely corporate bonds. underlying assets mean the value of the securities depends on the underlying assets. if the underlying asset is corporate bonds then the amount that the investor will get is the value underlying holds at the date of the maturity. the global crisis made people knowledgeable about the actual scenario leading to the value of the underlying assets. to gauge the liquidity of the assets and other securities different models, both advanced financial and statistical used to deal with the issue of liquidity. al-qaisi and al-batayneh: credit default swap and liquidity international journal of economics and financial issues | vol 7 • issue 2 • 2017698 this study focuses on the non-us markets and conducted very recently, just after the market crash of (chen, lesmond and wei 2007). in addition, it is the first one to focus on the reasons of the changes in the bid ask spread, the impact of the financial markets in general and cds market in particular as well as the liquidity related to it (hamilton, 1994). section 2.1 of the study covers the literature review, and section 2.2 discusses in detail the risk measures required. section 3 is the methodology used to determine the co-relation between both risks. while section 4 presents the samples and the subsamples used and section 5 is the empirical section divided in three parts. in this study, different financial jargons are used such as cds, bid-ask price, trade volume, quotations and others. 2. literature review and theory 2.1. liquidity and liquidity risk the term liquidity means the ease at which particular assets can convert into cash. assuming a situation where the investors prefer more liquid assets and those assets priced at a higher price, and the trading costs associated with it lowered and bid – ask spreads of the assets has to split up. liquidity itself has a risk associated with it and liquidity risk related to the probability that the asset cannot trade when liquidity is stochastic (cont and wagalath, 2013). liquidity risk tends to be high when the probability of the tradability of the assets becomes less. this becomes at an alarming position when the probability reaches one and the market becomes illiquid. so, when the market is liquid and the liquidity risk is low then the bid ask spread found to be small and stable. 2.1.1. literature review and theoretical background the risk component, which is the same for all the market makers, is only dependent on the market structure called exogenous liquidity risk. on the other hand, the liquidity risk which varies with the size of the trading position is within the control of the market maker is called endogenous risk. the exogenous liquidity risk often cited as the bid-ask spread. in this study, both risks cited exclusively and used interchangeably. the bond market scenario has changed a lot, and the current trend has used the credit derivatives market from where the investors can take positions regarding various securities and shed off the risky positions. this helped in the emergence of the new problem in the fixed income analysis of the bonds that spread of the corporate bonds into credit risk and liquidity component. in the recent financial risk, the lack of liquidity of the investors made the events take a serious turn, and it literally shook the world (cifuentes et al., 2005). the spread of the corporate bond is determined as the gap between the duty free interest rate given in the default free interest rate and the yield to maturity rate of the bonds. 2.1.2. the relationship between liquidity risk and credit risk the loss which triggered by the default of a debtor is called credit risk, and the risk is maximum when the probability becomes one. no such empirical theories clearly states how the risk factors interact dynamically with each other. in the merton model, corporate bond uses as an underlying and a relation draws between the credit and liquidity risk. whenever the credit risk increases, the liquidity risk also increases at the same time. in the recession, the liquidity shortages accompany by the rising cds spreads, and the similarity between the bonds and cds have made a positive relation between liquidity and illiquidity risk. whereas another model states that in the case of short selling, the illiquid assets may often make higher prices than liquid assets depending upon the investment horizon and risk-taking capacity of the short seller. liquidity itself finds to be a multi-dimensional concept and cannot observe directly, so it measures by a variable associated with the bid-ask spread. the cost incurred relates to the taxes and fees associate with the trading as well as the associated costs relate to it. the absolute bid price is determined as the difference between the highest and the lowest of the bid prices. upon comparing different liquidity measures of the us treasury securities, it is found that the bid ask spread is found to be the best proxy as per the liquidity risks. on the other hand, another model shows that alternative liquidity measures and bid ask price are highly co-related and alternative liquidity measures include the effective spread of the trading volume. bonds, which have a rating of say aaa, known to be default free, and they often trade at a positive spread, which remains quite high as compared to the yield on treasury bonds. this paper discusses thoroughly how the difference in the value of the spread can take a significant turn and affect the liquidity position of the entire market (bongaerts, de jong and driessen 2012). 2.2. risk measures credit risk or the cds mid-rate considered to have several advantages and calculated as the mean value of the risk and the bid price of the each company. midt=ac+bc/2 (1) the cds mid-rate midt(ac+bc) is the corresponding of cds risk (highest) and cds bid prices of an organization at a given time. cds spreads normally trades on the standardized items and provide a pure pricing of the risk of the underlying assets. on the other hand, the bond spreads severely affected by the gap of chosen risk free benchmark and contractual agreements (breitenfellner and wagner 2012). another merit of cds spreads is that they are effective indicator of assessing the credit risk and respond quickly to the changes in the credit run than credit spreads as a result of the short sale restrictions and the funding issues associated with it. the researcher shows that about one-quarter of the corporate credit spread could define as a default prone or risky in nature due to the difference in the market spread against other different bonds (hertrich, 2014). the data of the study has a senior single of 5-year cds risk and bid prices quoted in bps and determined in euros, which figured out on august 24, 2007 to 2010, 01 june. this period marks the entire tenure of the financial crisis from the collapse of the lehman brothers to the end of the financial crisis. in addition, this paper consists of 5-year maturity cds only as the cds contracts thought to be the most liquid of all the contracts (bolton and oehmke, 2013). the focus here is on the short-term relationship al-qaisi and al-batayneh: credit default swap and liquidity international journal of economics and financial issues | vol 7 • issue 2 • 2017 699 between the liquidity risk and the credit risk, and the imbalances are present in the liquidity risk supply and demand impact liquidity. on the other hand, in the cross sectional regression analysis, there is a tremendous amount of positive co relation between the default and liquidity components of the bond yield spread of the securities. 3. data and methodology the collected data is from the database of the credit market analytics, which holds the maximum number of credible data of the most active and the largest buy side investors: asset managers, hedge funds and the global investment banks. even if the cds markets operates as an over the counter market, the using data from the large number of investors and majority of being blue chip companies makes the data more credible and helps to mitigate the problem. one can observe that daily the cds risk and bid prices are comparatively stable over the sampling period. around spring 2008, just after the global investment bank bear stearns signed a deal with j p morgan for a merger agreement. on march 16, 2008 just after lehman brothers filed for bankruptcy, the bidrisk prices exhibited large amount of spikes. these incidences were one-off incidence and the prices showed volatility in those cases whereas in normal cases the bid-risk prices were low and stable (hertrich, 2014). this study is made to identify whether at the time of time series the credit risk changes are weakly exogenous with the liquidity risk changes. various finance models are used, namely vector autoregression (var) model. the stationary test of kwiatkowski shortened as kpss model, which tests whether the mid-rate and the bid risk spread are stationary. this particular method is helpful in case of examining the causality in the stochastically trending variables. in a while, the researcher has moved forward from kpss model to the granger causality analysis in a bivariate var. it is assumed in the relative models that the mid-rate and bid ask spread are to be weakly stationary. the var allows only for a maximum of seven lags as this removes any sort of serial correlations. the optimal number of lags calculates by lowering the value of the akaike criterion of information. before calculating the granger causality test, the properties and the model assumptions are checked, which helps to test the residuals for conditional heteroscedasticity, auto co relation and the non-normality method by using the related multivariate test statistics. other methods for calculating the multivariate tests like autoregressive conditional heteroscedastic-lm models and multivariate jarque–bera test used exclusively to reach at the desired conclusions (hertrich, 2014). 4. empirical findings different advanced time series properties like bid ask spread stationarity, mid-rate stationarity, bid ask spread and mid-rate auto co relation used in the study. bid ask spread stationarity looks for a time trend in the mid-rate and bid ask spread. it is found that as per the kpss test, the bid ask spread are non-stationary whereas the changes are highly stationary. as such and until date, it is found to be no agreement on the fact that cds bid ask spread be stationary or not. another hypothesis also comes into play that mid-rate and bid ask spread both bounded from zero, and the traditional unit root is rejecting the null hypothesis of the unit root. the mid-rate stationarity helps in determining the difference between the mid-rate levels of the kpss tests and a null hypothesis is included as an intercept. the findings of these test helps in according with the time series properties of the cds spreads, and the data presented in the study is taken from 9th august 2007 to 29th march 2010 included german and swiss companies (hamilton, 1994). the companies that taken in the study are, abb, roche, swiss re and many others across different sectors namely; insurance, chemicals, electric, healthcare and others. the ratings of the bonds vary as per the companies are holding the bonds and normally they are in the range of ccc to aaa. in the mid-rate segment, the average is around 93% of the bonds has a default risk component and 65% has a risk to the total bond spread whereas 35% of the total of the corporate bonds known to have a liquidity risk component. bid risk spread analyzes the changes in the mid-rate and the bid risk spread taking into consideration a very large lags and the null hypothesis serially rejected in the co related time series. the ccf determines the direction, and the co relation of the two time series observed (campbell and taksler, 2003). even the ccf is helpful in making important lags and leads of the mid-rate changes or the bid risk spread changes, and the stationary difference exhibits largely in the stationary difference. it is found in the study that the time difference is responsible for the change in the mid-rate changes and the bid risk price changes. this particular theory thoroughly used in the study and deductions have been made based on the above models. also from the study, it is observed that in case of the companies from switzerland, a major co relation co efficient found among them but not at all a healthy sign of operations. although the epicenter of the global financial crisis was in the united states, but the repercussions stroked throughout the world and switzerland is not an exception. switzerland also felt the severity of the crash, which affected all of the companies (hertrich, 2014). other studies are focused mainly on the economy and companies of us, but this study focuses exclusively on the non-us operations. table 1: granger causality test for swiss companies company δbas grc ⇏ δmid δmid grc ⇏ δbas abb 0.330 1.006 cs 1.192 2.228 holcium 1.159 3.061 swissre 2.022 2.517 ubs 1.410 1.187 (source: ang, goetzmann and schaefer 2010) aq1 table 2: granger causality test for german companies company δbas grc ⇏ δmid δmid grc ⇏ δbas basf 0.615 2.084 dialmer 0.330 1.379 dbank 0.500 1.184 lufthansa 1.065 1.802 (source: corò, dufour and varotto 2013) aq1 al-qaisi and al-batayneh: credit default swap and liquidity international journal of economics and financial issues | vol 7 • issue 2 • 2017700 in addition, the timing of the study took place during 2007-2010, in the turmoil phases. another finding in this study is that a liquidity enhanced capital asset pricing model or a value at risk model. this inculcates the fact that liquidity should be treating as an endogenous and the control for the interaction among the liquidity with the credit risk as against the standard price method that used until date. different models applied taking the real life scenario and the data of the study took from the recession period when the economy was showing sign of recession in mid-2007 to the end of 2010 where the economy was showing signs of improvement (hull, 2006). the recession began with the collapse of the century old investment bank lehman brothers and many business houses and hedge funds close down their operations. bear sterns is one such investment bank that acquired by another big giant company called j p morgan and ultimately the two companies merged. 5. conclusion many economists cited the collapse of the markets caused by the illiquid market and the cds factors. this study has thoroughly researched to the cause of particularly the bonds and the effect it presented on the overall market. illiquid market is always a matter of concern to particularly the investors and the governments as well. the investors do not get their return at the right time and the government is unable to pay off the dues and spend on the public. the findings of the study show that how the policies the government regulatory body takes should align with the risk taking ability of the entire market. in addition, solution is providing as to how a further 2007 like incidence can avert from coming. different views are discussing as regards to the mathematical and financial models with their application in the corporate bonds. so, the effects of applying standard testing procedures over time series analysis and the alternative methods of the application in the alternative casualty tests in the discrete time series are discussing. this study will be helpful in averting another 2007 like scenario and the government regulatory body investors will be extra cautious in investing in a particular bond. references bolton, p., oehmke, m. (2013), strategic conduct in credit derivative markets. international journal of industrial organization, 31(5), 652-658. bongaerts, d., de jong, f., driessen, j. (2012), an asset pricing approach to liquidity effects in corporate bond markets. breitenfellner, b., wagner, n. (2012), explaining aggregate credit default swap spreads. international review of financial analysis, 22, 18-29. campbell, j.y., taksler, g.b. (2003), equity volatility and corporate bond yields. the journal of finance, 58(6), 2321-2350. cifuentes, r., ferrucci, g., shin, h.s. (2005), liquidity risk and contagion. journal of the european economic association, 3(2-3), 556-566. cont, r., wagalath, l. (2013), running for the exit: distressed selling and endogenous correlation in financial markets. mathematical finance, 23(4), 718-741. hamilton, j.d. (1994), time series analysis. vol. 2. princeton: princeton university press. hertrich, m. (2014), does credit risk impact liquidity risk? evidence from credit default swap markets. international journal of applied economics, 12(2), pp. 1-46. hull, j.c. (2006), options, futures, and other derivatives. upper saddle river, nj: pearson education india. author queries??? aq1: kindly cite tables 1 and 2 in text part . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(1), 143-152. international journal of economics and financial issues | vol 8 • issue 1 • 2018 143 does audit quality mediate the effect of auditor tenure, abnormal audit fee and auditor’s reputation on giving going concern opinion? dody hapsoro1*, tiara rani santoso2 1stie yogyakarta, 55281, indonesia, 2stie ykpn yogyakarta, 55281, indonesia. *email: dodyhapsoro@gmail.com abstract the increased fraud of financial statements shows the low role of external auditors in providing a quality audit report. the purpose of this paper is to analyze the effect of the length of the audit firm-client relationship, abnormal audit fees (abfe) and auditor reputation on giving of going concern opinion mediated by audit quality. the sample consists of 185 firm years. sample companies listed on the indonesian stock exchange from 2012 to 2016. data analysis techniques using structural equation modeling based partial least square. the result of the indirect effect test shows that auditor tenure and auditor reputation have a positive effect on audit quality while abfe has a negative effect to audit quality and audit quality has a negative effect on giving of going concern opinion. the results of this study also show that the company’s financial condition does not moderate the effect of audit quality on giving going concern opinion. keywords: audit quality, auditor tenure, abnormal audit fee, auditor’s reputation, going concern opinion jel classifcation: m42 1. introduction responsibility for the reliability of any information presented in the financial statements is very important because the value of information contained in the financial statements associated with the purpose of making investment decisions to be taken. the information generated by the financial statements may mislead the users if the information presented is unreliable even though the information is relevant. the business world was thrown with the accounting scandal that happened to some big companies like enron, worldcom and citigroup around 2001. another case was experienced by lehman brothers who dragged the famous public accounting firm (kap) ernst and young, who was considered negligent in examining the financial statements, thereby issuing false audit results to lehman brothers’ financial statements. the lehman brothers bankruptcy case is one example of the failure of the auditor to assess the company’s ability to maintain its business continuity. the association of certified fraud examiners (acfe) in report to nation 2016 revealed that asia-pacific ranks third of nine research areas after the united states and africa in fraud cases, which is about 221 cases or 10.4%. the fraud can be divided into three, namely asset misappropriation, corruption, and financial statement fraud. the case of fraudulent presentation of financial statements in 2016 amounted to 9.8% increased by 0.8% when compared to the year 2014 which is only 9%. the biggest losses incurred in the case of fraud in the presentation of financial statements amounted to us $ 975,000. acfe states that fraud in many countries can be detected because tips. while tips are consistently the top detection method in every region. for the asia-pacific region, almost 45.20% of fraud were detected because of tips, 15.80% of fraud detected by internal auditors while external auditors only able to uncover fraud by 5.9%. the results of this study indicate the low of external auditor role in the disclosure of fraud. the other cases involving auditor roles in the conduct of the audit took place in the toshiba company. recently, the japanese electronics giant (toshiba) stated that the losses experienced in hapsoro and santoso: does audit quality mediate the effect of auditor tenure, abnormal audit fee and auditor's reputation on giving going concern opinion? international journal of economics and financial issues | vol 8 • issue 1 • 2018144 2016 are greater than previous predictions. this stems from the unfolding of the accounting scandal in 2015, leaving the ceo and some toshiba senior managers to resign. in the scandal, toshiba proved to inflate earnings in the last 7 years of 1.2 billion us dollars (kompas, june 26, 2017). this indicates that ernst and young as toshiba’s external auditor was unable to find any accounting fraud practices performed by toshiba’s management. this shows that reputed kap are unable to provide high audit quality to maintain their reputation. in 2017, ernst and young’s affiliate kap in indonesia, kap purwantono, suherman & surja has agreed to pay a fine of $1 million after the u.s. audit regulator labeled lapses in its checks of a client’s books “audit failure.” the agreement was announced by public company accounting oversight board (pcaob) on february 9, 2017. they found that the audit results of one telecommunication company in indonesia are not supported with accurate data for the accounting of over 4,000 leases for space in its cellular towers. however, the affiliate ernst and young in indonesia released an audit report with unqualified status (reuters, feb. 10, 2017). two months before the ernst and young case erupted, kap deloitte and touche through its affiliates in brazil agree to pay a pcaob fine $ 8 million to settle civil charges that it issued and tried to cover up false audit reports. this case is the latest incident that hit the kap, raising concerns that kap can run its business practices, according to the code of conduct (reuters, feb. 10, 2017). aaa financial standard committee (2001) states that audit quality is determined by competent (expertise) and independence. auditor independence is the cornerstone of the audit profession (mohamed and habib, 2013). blandon and bosch (2013); mgbame et al. (2012) and al-thuneibat et al. (2011) states that one way to improve audit quality is to make a change of auditors. the close relationship to management leads the auditor to better identify with management interests than with the public interest (giri, 2010; blandon and bosch, 2013). however, jackson et al. (2008) concluded that the change of auditors performed would result in unnecessary costs (the cost of introducing new auditors with clients), both for kap and for companies with minimal benefits. furthermore, the auditor’s knowledge of the company’s performance will be better when the involvement occurs over a long period of time. in indonesia, the provisions concerning the audit work are regulated in peraturan menteri keuangan republik indonesia nomor 17/pmk.01/2008. problems can occur if the auditor is required to make decisions contrary to his or her independence. an auditor is required to always be independent of the client, but at the same time the auditor must also be able to fulfill the decision desired by the client because their economic needs depend on the fee paid by the client. this is evidenced by research fitriany and anggraita (2016); kraub et al. (2015) and choi et al. (2010) stating that positive abnormal audit fees (abfe) negatively affect audit quality. however, on the other hand eshleman and guo (2014) revealed that high audit fees will increase the quality of the audit. audit quality is often associated with the reputation of the audit firm. however, boone et al. (2010) shows that kap big 4 and kap two tier both show the same efficiency and audit quality. craswell et al. (1995) argue that the auditor’s reputation is less valuable when an industry, there is also a specialist auditor because industry specialist auditors have superior knowledge and more experience in a particular industry, so as to better detect earnings management compared to auditor industry non-specialization and may improve earnings quality (kanagaretnam et al., 2010). meza (2013) shows that there is no difference in the quality of audits produced by auditor industry specialization and auditor industry non-secialization. auditors are considered to have the ability to provide a signal to the market. the ability to provide this signal is obtained from the auditor’s authority to access company information and the auditor’s ability to assess going concern issues. over the past two decades, the auditor’s responsibility to assess the viability of going concerns in the client’s financial statements has been the subject of much debate in the audit and research profession by academics (vanstraelen, 2002). o’reilly (2009) and chen and church (1996) argue that going concern opinion is useful for investors because it is an early warning about the survival of the company. on the one hand, the auditor’s consideration in providing a going concern audit opinion can accelerate the bankruptcy process of the company (gallizo and saladrigues, 2016). generally, research on audit quality that focuses on the impact of giving going concern opinion still shows result which is not unidirectional. barbadillo et al. (2004) revealed that the quality of audit affects the probability of companies experiencing financial difficulties will receive a going concern opinion. however, vanstraelen’s (2002) study shows that auditors in belgium are significantly less likely to issue a going concern opinion for clients who pay higher audit fees and audit quality does not affect the giving of going concern opinion. this is likely due to the use of different audit quality proxies. in this study audit quality will be proxied with discretionary accruals. previous research on the influence of audit tenure, audit fees and auditor reputation on audit quality and its impact on giving of going concern opinion still shows unrelated results. in addition, previous studies only conducted partial testing of each variable. this research is done by integrating the variables that have been studied before into a path analysis. in addition, prior research on abfe largely focuses on audit markets in the united states (us), china and germany. there is little research on abfe performed in developing countries such as indonesia. 2. literature review and hypotheses development 2.1. agency theory jensen and meckling (1976) disclose that agency relationship are a contract by one or more principals that involve agents to carry out some activities by delegating decision-making powers to agents. eisenhardt (1989) explains that the problem that can occur in an hapsoro and santoso: does audit quality mediate the effect of auditor tenure, abnormal audit fee and auditor's reputation on giving going concern opinion? international journal of economics and financial issues | vol 8 • issue 1 • 2018 145 agency relationship is that there is a conflicting interest between the principal and the agent so that the principal cannot verify that the agent has performed his or her duties properly. conflicts over differences in importance and asymmetric information create a shared need to audit financial statements by a competent and independent third party (al-thuneibat et al., 2011). in other words, the auditor is a party that is considered capable of being an independent party for the interests of the stakeholders (principal) with the manager (agent) in managing corporate finance. according to committee reports (1972), the main criterion of auditing focuses on oversight and or bias disclosure in accounting information to be communicated to interested parties. auditing is based on four criteria used in evaluating potential accounting information, namely: relevance, verifiability, freedom from bias and quantifiability. deangelo (1981) defines audit quality as an auditor’s probability of finding mistakes in the client’s accounting system and reporting errors. audit quality is one of the important issues facing the audit profession (vanstraelen, 2000). audit quality is used to improve the credibility of financial statements so as to reduce the risk of non-credible information for users of financial statements, especially investors (mgbame et al., 2012). auditors are considered to have the ability to provide a signal to the market. the ability to provide this signal is derived from the auditor’s authority to access company information and the auditor’s ability to assess going concern issues (o’reilly, 2009). the auditor is responsible for evaluating whether there is any substantial doubt about the entity’s ability to maintain its viability within a reasonable period of time, not later than 1 year from the date of the audited financial statements (then the specified period will be called a reasonable period of time) (sa seksi 341 no. 02). 2.2. the effect of audit tenure on audit quality the assignment period is defined as the number of years the auditor is maintained by the company (myers et al., 2003). in indonesia, the audit tenure provisions have been regulated in peraturan menteri keuangan republik indonesia nomor 17/pmk.01/2008. in article 3 explained that the general audit service of an entity’s financial statement shall be executed by the kap for a maximum of six consecutive years and for the auditor three consecutive years for the longest. jackson et al. (2008) concluded that the change of auditors performed would result in unnecessary costs (the cost of introducing new auditors with clients), both for kap and for companies with minimal benefits. furthermore, the auditor’s knowledge of the company’s performance will improve when engagement occurs over a considerable period of time. thus, the quality of audit reporting will increase as the auditor’s competency increases over the client’s performance. therefore, hypotheses can be formulated as follows: h1: auditor tenure has a positive effect on audit quality 2.3. the effect of abfe on audit quality choi et al. (2010) revealed that audit fees can be divided into two components, namely the component of normal fee (supposed) and abnormal fee components. normal fees are mainly determined by factors that are common across different clients, such as client size, client complexity and client-specific risk, while abnormal fees are determined by factors that are idiosyncratic to a specific auditor-client relationship. in indonesia, the determination of the fees has been set in peraturan pengurus nomor 2 tahun 2016 tentang penentuan imbalan jasa audit laporan keuangan issued by indonesia public accountant institute (iapi). hoitash et al. (2007) said that high audit fees can improve the efforts made by auditors, thereby improving audit quality. on the other hand, the existence of financial dependence (economic ties between auditors and clients) may cause auditors to be reluctant to make appropriate inquiries during the audit process because they are afraid of losing beneficial audit fees received from clients. choi et al. (2010) found in the sample with negative abfe, there was no correlation between abfe and audit quality, but in the sample with a positive abnormal audit fee, the abfe had a negative effect on audit quality. therefore, hypotheses can be formulated as follows: h2: abfe have a negative effect on audit quality 2.4. the effect of auditor reputation on audit quality mayhew (2001) states that reputation serves as an endogenous mechanism that results in high audit efforts and high audit quality when demand for auditor services depends on reputation to support high quality audit reporting. choi et al. (2010) states that large kap produce better audit quality than small kap. large kap tend to be independent in disclosing and reporting fraud committed by clients. kanagaretnam et al. (2010) argue that firms audited by large kap will result in lower discretionary accruals compared to small kap, so large kap can increase reported credibility of accruals and thereby increase the value of discretionary accrual information. o’reilly and reisch (2002) explain that kap with specific knowledge about a particular industry will produce high audit quality so that it will improve audit effectiveness. auditors with good industry knowledge will easily detect problems that exist within the client industry, thereby limiting the practice of earnings management (kanagaretnam et al., 2010). in this study, the auditor reputation is divided into two, such as size of auditor and auditor industry specialization. therefore, hypotheses can be formulated as follows: h3a: auditor size has a positive effect on audit quality h3b: auditor industry specialization has a positive effect on audit quality. 2.5. the effect of audit quality on giving going concern opinion audit quality is used to improve the credibility of financial statements so as to reduce the risk of non-credible information for users of financial statements, especially investors (mgbame et al., 2012). auditors are considered to have the ability to provide a signal to the market. the ability to provide this signal is derived from the auditor’s authority to access company information and the ability of auditors to assess going-concern issues (o’reilly, 2009). hapsoro and santoso: does audit quality mediate the effect of auditor tenure, abnormal audit fee and auditor's reputation on giving going concern opinion? international journal of economics and financial issues | vol 8 • issue 1 • 2018146 mutchler (1985) stated that smaller firms would be more at risk of receiving going concern audit opinion than larger companies. this is possible because the auditor believes that a larger company can solve the financial difficulties it faces than smaller companies. francis and yu (2009) argue that kap big 4 will provide a high quality audit that reflects the quality of auditors in giving a going concern opinion. therefore, hypotheses can be formulated as follows: h4: audit quality has a positive effect on giving going concern opinion 2.6. audit quality mediating impact of audit tenure, abfe and auditor reputation on giving opinion going concern the auditor’s knowledge of the company’s performance will be better when the auditor has a long-term engagement (jackson et al., 2008). on the other hand, the existence of financial dependence (economic ties between auditors and clients) may cause auditors to be reluctant to make appropriate inquiries during the audit process because they are afraid of losing the favorable audit fees received from clients (hoitash et al., 2007). choi et al. (2010) suggests that large kap produce better audit quality compared to small kap. large kap tend to be more independent in disclosing and reporting fraud committed by clients. o’reilly and reisch (2002) explain that kap with specific knowledge about a particular industry will produce high audit quality so that it will improve audit effectiveness. francis and yu (2009) argue that kap big 4 will provide a high quality audit that reflects the quality of auditors in giving going concern opinion. however, blay et al. (2016) found that non-big 4 auditors in countries with relatively high rates of going concerns in the previous year were 6% more likely to issue going concerns. therefore, hypotheses can be formulated as follows: h5: audit quality mediates the effect of auditor tenure, abfe and auditor reputation on giving going concern opinion. 2.7. financial condition moderating impact of audit quality on giving opinion going concern platt and platt (2002) define financial distress as a condition of decreased performance of companies that will lead the company into bankruptcy or liquidation. financial distress conditions of a company are also associated with fiscal crisis issues, fiscal distress, financial risk or fiscal strain (cohen et al., 2017). geiger et al. (2014) stated that the increasing tendency of auditors to issue going-concern opinion occurs because of the financial crisis of the company. koh (1991) states that the use of bankruptcy prediction models will assist auditors in providing a going concern assessment. setyarno et al. (2006) indicates that the financial condition has a significant effect on the acceptance of going concern. therefore, hypotheses can be formulated as follows: h6: financial conditions moderate the effect of audit quality on giving going concern opinion. 3. study design and methodology 3.1. population and sample the population in this study are all companies listed in indonesia stock exchange (idx) period 2012–2015. this research used purposive sampling method or sampling based on certain considerations: (1) a non-financial company listed on the idx (bei) and publishes an annual report within the study period, (2) the company includes audited financial statements by an independent auditor, (3) the company discloses audit fees, (4) the company has experienced loss of at least 2 consecutive years or has negative retained earnings, (5) the company has completed data used in research for 5 years. based on the criteria set, then obtained the final sample of 185 sample companies. the analytical method used in this research is by using partial least square analysis model (pls) following the pattern of structural equation modeling model based on variance which can simultaneously perform testing of measurement model as well as testing of structural model (ghozali and latan, 2015). 3.2. dependent variables 3.2.1. going concern opinion (gcop) this variable is measured using the dummy variable. the going concern (gcop) is coded 1, whereas non-going concern opinion is coded 0. 3.3. independent variables 3.3.1. audit tenure (tena) audit tenure is the period of assignment of auditors in a company. according to al-thuneibat et al. (2011), the calculation of audit tenure variables by counting the number of years the auditor performs an audit of a company’s financial statements in sequence. 3.3.2. abfe abfe calculation uses the residual value of the normal ols fee audit regression (eshleman and guo, 2014). normal audit fee calculations into: (1) client size, (2) client complexity, (3) specific risks to audit engagement such as client and auditor risk (fitriany and anggraita, 2016; eshleman and guo, 2014; choi et al., 2010). abfe = β0+β1lnta+β2employ+β3nbs+β4ngs+β5invrec +β6qualβ7losslag+β8leve+β9liquid+β10roa+β11big4 +β12short_ten+β13btm+β14chgsale abfe = natural logarithm for factual audit fees lnta = natural logarithm of total assets employ = the square root of the employee nbs = natural logarithm above 1 plus number of business segments ngs = natural top logarithm 1 plus number of geographical segments hapsoro and santoso: does audit quality mediate the effect of auditor tenure, abnormal audit fee and auditor's reputation on giving going concern opinion? international journal of economics and financial issues | vol 8 • issue 1 • 2018 147 invrec = inventories and receivables divided by assets qual = 1 if the opinion is going concern, 0 others. losslag = 1 if net income period t−1 is negative, 0 others lev = leverage (total liabilities divided by total assets) roa = return on assets (net income divided by average total assets) liquid = current assets divided by current liabilities big4 = 1 if the auditors deloitte and touche, ernst and young, kpmg, and price waterhouse coopers, 0 others short_ten = 1 if the engagement period at the beginning of the year, 0 others btm = book to market ratio chgsale = changes in sales for the current year divided by total assets. 3.4. auditor reputation auditor reputation is divided into two aspects, such as auditor size and auditor industry specialization. 3.5. auditor size (big4) in this study the auditor size measures using dummy variables, the value of 1 if the company is audited by kap big 4 and 0 if audited by kap non-big 4. 3.6. auditor industry specialization (spec) according to rusmin (2010), auditor industry specialization is auditors who have a market share of at least 20% of the total number of clients received in certain groups. the amount of market share is determined by the part of the audit fee received by the firm in a particular industry compared to the total audit fees that all kap in certain industries receive. 3.7. mediating variables 3.8. audit quality (kuad) this study uses an accrual discretionary (da) as a proxy for audit quality. kasznik (1999) states that non-discretionary accruals are a function of income changes adjusted for changes in accounts receivable, ppe and cfo. ta a = 0 1 a + rev rec a ppe it it 1 it 1 it it it 1 i − − −             + α α ∆ α 1 2 ∆ tt it 1 it it 1 it a cfo a− −      +      +α3 ∆ e tait/ait−1 = total accrual of the firm i in period t δrev = change of income from year t−1 to year t (revt-revt−1) δrec = change of net of receivable value from year t−1 to year t (rect-rect−1) ppe = fixed asset value in year t δcfo = changes in operating cash flow from year t−1 to year t (cfot-cfot−1). 3.9. moderating variables 3.9.1. financial condition (zscr) the revised model of altman (1993) is as follows: z-score = 0.717z1+0.874z2+3.107z3+0.420z4+0.998z5 z1 = working capital/total asset z2 = retained earnings/total asset z3 = earnings before interest and taxes/total asset z4 = market value of equity/book value of debt z5 = sales/total asset. 3.10. control variables 3.10.1. client size (lnta) according to al-thuneibat et al. (2011), large companies tend to act cautiously in managing companies and tend to manage earnings efficiently. the client size is calculated using the natural log of total assets. 3.10.2. leverage (leve) researchers control the leverage of firms to be studied because high levels of financial leverage can increase the risk that companies will face (al-thuneibat et al., 2011). leverage is the ratio between total debt and total assets showing the amount of assets used to guarantee debt. 3.10.3. company growth (grwt) rusmin (2010) states that companies that have high growth companies are likely to be motivated to take profit management action. company growth is calculated as follows: growth sales sales sales t t t = − − − 1 1 3.10.4. liquidity (liku) liquidity ratio is a ratio that describes the ability of the company in meeting short-term liabilities (debt). if the company is unable to meet its short-term debt, it can be assumed that the company is facing a problem that could disrupt its business continuity. liquidity is the ratio between current assets and current debt. 4. results and discussions the magnitude of the suitability of the model can be determined by looking at the average r-squared (ars) calculation. average path table 1: value of goodness of fit model result p value criteria explanation ars=0.243 p<0.001 p<0.05 accepted apc=0.145 p=0.004 p<0.05 accepted avif=1.386 avif<5 accepted source: output pls. ars: average r-squared, apc: average path coefficient, avif: average variance inflation factor, pls: partial least square hapsoro and santoso: does audit quality mediate the effect of auditor tenure, abnormal audit fee and auditor's reputation on giving going concern opinion? international journal of economics and financial issues | vol 8 • issue 1 • 2018148 coefficient (apc) shows the interrelationship between variables. average variance inflation factor (avif) shows correlation or multicolinearity among independent variables. table 1 shows that all goodness of fit criteria in warppls is accepted. ars calculation shows that ars value is significant and the influence of the independent variable to dependent variable is 24.3% and the rest equal to 75.7% influenced by other independent variable. apc value of 0.145 and significant. it indicates that there is a causal relationship either directly or indirectly. in addition, this research model also shows the absence of multicolinearity as indicated by the avif value <5. the result of hypothesis testing using warppls 4.0 is shown in figure 1. the path coefficient is positive if beta (β) is negative because the audit quality calculated using discretionary accruals indicates that if the discretionary accrual value is high, then the quality of the audit report is low. thus, the value of a discretionary accrual has an inverse relationship with audit quality. test results can be seen in tables 2 and 3. 4.1. the effect of audit tenure on audit quality the result of h1 test shows that the auditor has a positive effect on audit quality. this can be seen in table 2 which shows a significance value of 0.028 and the beta coefficient (β) of 0.116 (positive). this indicates that the auditor engagement period increases, the better the audit quality will be. good audit quality is assessed with small discretionary accruals. h1 is accepted if the auditor’s coefficient of positive marker and significant to audit quality. based on this it can be concluded that h1 accepted. this study supports the research of jackson et al. (2008) which concluded that auditor turnover would lead to unnecessary costs (the cost of introducing new auditors with clients), both for kap and for companies with minimal benefits. furthermore, the auditor’s knowledge of the company’s performance will improve when engagement occurs over a considerable period of time. thus, the quality of audit reporting will increase as the auditor’s understanding of client performance improves. 4.2. the effect of abfe on audit quality the result of h2 test shows that abfe negatively affect audit quality. this can be seen in table 2 which shows the significance value of 0.001 and the beta coefficient (β) of −0.185 (negative). this indicates that the greater the audit fees received by the auditor during the assignment period, the quality of the audit will be worse. good audit quality is assessed with small discretionary accruals. h2 accepted if the coefficient of abnormal audit fee marked negative and significantly to audit quality. based on this it can be concluded that h2 accepted. this research supports the results of fitriany’s research (2016); kraub et al. (2015) and choi et al. (2010) stating that audit fees above normal causes bonding auditors to be stronger, thus decreasing auditor independence and degrading audit quality. 4.3. the effect of auditor reputation on audit quality the auditor reputation is divided into two aspects, namely auditor size and auditor industry specialization. 4.4. the effect of auditor size on audit quality the h3a test result shows that the auditor size has a positive effect on audit quality. this can be seen in table 2 which shows a significance value of 0.015 and the beta coefficient (β) of 0.131 (positive). this shows that big 4 kap will provide better audit quality than non-big kap 4. good audit quality is assessed with small discretionary accrual value. h3a is accepted if the kap-size coefficient is positive and significant to audit quality. based on this it can be concluded that h3a accepted. this study supports the research of choi et al. (2010) and kanagaretnam et al. (2010) stating that large kap produce better audit quality than small kap. large kap tend to be independent figure 1: output results hypothesis test hapsoro and santoso: does audit quality mediate the effect of auditor tenure, abnormal audit fee and auditor's reputation on giving going concern opinion? international journal of economics and financial issues | vol 8 • issue 1 • 2018 149 in disclosing and reporting fraud committed by clients. in addition, investors assume that larger kap are more able to meet the lawsuits that occur than small kap (skinner and srinivasan, 2012). 4.5. the effect auditor industry specialization on audit quality the h3b test result shows that auditor industry specialization has positive effects to audit quality. this can be seen in table 2 which shows the significance value of 0.008 and the beta coefficient (β) of 0.146 (positive). this suggests that auditor industry specialization will provide better audit quality than auditor industry non-specialization. good audit quality is assessed with small discretionary accruals. h3b is accepted if the coefficient auditor industry specialization is marked positive and significant to audit quality. based on this it can be concluded that h3b accepted. this research supports kanagaretnam et al. (2010) research which states that auditor industry specialization will limit earnings management practices. furthermore, o’reilly and reisch (2002) explain that kap with specific knowledge about a particular industry will result in high audit quality, thereby enhancing the effectiveness of the audit. 4.6. the effect of audit quality on giving opinion of going concern h4 test result shows that audit quality has a negative effect on giving going concern opinion. this can be seen in table 2 which shows the significance value of 0.029 and the beta coefficient (β) of −0.114 (negative). this indicates that the greater the reported discretionary accruals, the lower the audit quality, so that the auditor is more likely to giving going concern opinion. good audit quality is assessed with small discretionary accruals. h4 accepted if the audit quality coefficient marked positive and significant to the giving going concern opinion. based on this it can be concluded that h4 rejected. the results of this study indicate that high discretionary accruals indicate high management practices that can create auditor doubt, thus allowing auditors to provide a going concern opinion. muramiya and takada (2010) in his research found that the practice of earnings management is an indicator of the beginning for the auditor to issue a going concern opinion. high discretionary accruals indicate the number of management interventions on the company’s financial statements. the existence of management intervention indicates that management wants to achieve certain goals. management interventions can be management plans that have been implemented. companies experiencing poor financial conditions tend to conduct management planning in order to convince the auditors that the company is still capable of running its operations. sa section 341 discloses that if the auditor has doubts about the entity’s ability to maintain its survival and the auditor concludes that the management plan can be effectively implemented, the auditor will provide an unqualified opinion with an explanatory paragraph of the business unit’s ability to maintain its viability. furthermore, sa seksi 341 discloses that the management plan may be an asset sale plan, a debt withdrawal plan or a debt restructuring, a plan to reduce or postpone spending and a plan to raise ownership. the results of this study do not support the research of barbadillo et al. (2004) indicating that audit quality (measured by the level of independence and knowledge of auditors) affects the probability that a company experiencing financial difficulties will receive a going concern opinion. it happens because of different audit quality measurement proxies. 4.7. audit quality mediating impact of audit tenure, abfe and auditor reputation on giving opinion going concern h5 tested the effect of mediation variables. the test results show that audit quality is able to mediate the influence of audit tenure, abfe and auditor reputation on giving going concern opinion. this can be seen in table 3 which shows a significance value of 0.210 for audit tenure, 0.262 for abfe, <0.001 for auditor size and 0.014 for auditor industry specialization. h5 is accepted if p value for direct testing is significant value, which means partial mediated audit quality or p value for direct testing is insignificant, which means the quality of the audit is fully mediated. based on this it can be concluded that h5 accepted. this study supports the read and yezegel (2016) studies which provide evidence that the length of the auditor’s length is not associated with type ii errors. this shows that audit tenure and table 2: hypothesis testing results h1 to h4 and h6 hypothesis prediction variable effect*) path coef+) (β) p value significance result h1 + tenad→kuad +0.116 0.028 significant accepted h2 feab→kuad −0.185 0.001 significant accepted h3a + big4→kuad +0.131 0.015 significant accepted h3b + spec→kuad +0.146 0.008 significant accepted h4 + kuad→gcop −0.114 0.029 significant not accepted h6 moderating kuad*zscr→gcop +0.007 0.452 not significant not accepted source: data processed, warppls 4.0. *indirect effect, +path coefficient (β) discretionary accrual to audit quality table 3: hypothesis testing result h5 (mediating effect) hypothesis variable effect **) path coef (β) p value significance result mediating h5 tena→gcop −0.049 0.210 not significant not accepted fully feab→gcop −0.038 0.262 not significant not accepted fully big4→gcop −0.190 <0.001 significant accepted partially spec→gcop +0.111 0.014 significant accepted partially source: data processed, warppls 4.0. *indirect effect look at table 2, **direct effect hapsoro and santoso: does audit quality mediate the effect of auditor tenure, abnormal audit fee and auditor's reputation on giving going concern opinion? international journal of economics and financial issues | vol 8 • issue 1 • 2018150 abfe affect the audit quality, so that will impact on decision of giving going concern opinion or not. blay et al. (2016) found that non-big 4 auditors residing in countries with relatively high rates of going concerns in the previous year were six percent more likely to issue going concern opinions. auditor industry specialization will provide a higher level of check guarantee than the audits performed by auditor industry non-specialization (craswell et al., 1995). the guarantee of the examination is related to the giving going concern opinion. 4.8. financial condition moderating effects of audit quality on giving going concern opinion h6 tested the effect of moderating variables. the test results show that the financial condition is not able to moderate the influence of audit quality on giving going-concern opinion. this can be seen in table 2 which shows the interaction value of 0.452 and the beta coefficient (β) of 0.007. h6 accepted if p value significant moderation variable interaction value. based on this it can be concluded that h6 rejected. it means that the company’s financial condition does not moderate the effect of audit quality on giving going concern opinion. this can happen because the giving going concern opinion is not only based on the company’s financial condition, but also internal and external issues of the company (sa seksi 341). sa seksi 341 mentions that internal company problems may include work strikes or labor difficulties, substantial reliance on certain projects, noneconomic long-term commitments and resource requirements to significantly improve operations. examples of external problems that have occurred are complaints of court suits, the release of laws or other matters which may jeopardize the entity’s ability to operate; loss of franchise, license or patent; loss of major customers or suppliers; and losses due to major disasters such as earthquakes, floods, uninsured or insured droughts but with an inadequate amount of coverage. blay et al. (2016) stated that giving going concern opinion, besides caused by economic factor also caused by a behavioral psychological factor of auditor. the giving going concern opinion is based on the auditor’s belief about the presence or absence of things that may disrupt the entity’s ability to maintain its survival within 1 year (tanzil, 2016). 5. closing 5.1. conclusion based on the results obtained through statistical testing and the discussion described in the previous chapter, it can be concluded things as follows: 1. audit tenure and auditor reputation positively affect audit quality, while abfe negatively affect audit quality. this suggests that the quality of audits will increase as the auditor’s understanding of client performance improves. in addition, firms audited by reputable firms tend to be independent in disclosing and reporting fraud committed by clients, resulting in high audit quality. 2. audit quality negatively affects giving going concern opinion. this proves that companies experiencing poor financial conditions tend to conduct management planning in order to convince the auditors that the company is still capable of running its operations. high discretional accruals indicate high management practices that can create auditor doubt. 3. from the results of direct and indirect testing indicates that the audit quality can fully mediate the influence of audit tenure and abfe on giving going concern opinion. this indicates that auditor tenure and abfe have no significant effect on giving going concern opinion. while the reputation of auditors can significantly influence the giving of going concern opinion. this shows that audit quality mediates the partial influence of auditor reputation on giving going concern opinion. 4. financial condition does not moderate the influence of audit quality on giving going concern opinion. this is caused by the giving going concern not only based on the company’s financial condition, but also internal and external issues of the company (sa seksi 341). 6. limitations and recommendations this study has the limitations, at least the company that explicitly disclosed its audit fees. it has an impact on the number of samples used too few companies. this study only focuses on the company’s financial condition only, while other factors are not included in determining the giving going concern opinion. in addition, this study does not explain the impact of giving going concern opinion to the company and the market. further researcher can add other variables such as management strategy because in this study the financial condition has not moderate the effect of audit quality on giving going concern opinion. in addition, there necessary to evidence of the impact of going concern opinion on market players and companies, enabling the company to get the same opinion in the next year. 7. implications the results of this study indicate that abfe have a negative effect on audit quality. therefore, researchers advise governments and associations to periodically review the quality of kap in relation to documentation related to the audit engagement, so it can produce a good quality audit. in addition, the auditor should be able to be professional in accordance with applicable standards in order not to be given written sanctions related to significant audit quality degradation because the fee received is too high or too low (iapi, peraturan pengurus nomor 2 tahun, 2016). this study shows that the length of audit engagement provides high audit quality. this indicates that regulator should evaluate the rules regarding the duration of the engagement. regulators should not only look at their independence, but also the time it takes the auditor to understand the client’s business in order to create the proper audit procedures. references aaa financial accounting standards committee. 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(2002), auditor economic incentives and going-concern opinions in a limited litigious continental european business environment: empirical evidence from belgium. accounting and business research, 32(3), 171-186. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(1), 539-546. international journal of economics and financial issues | vol 7 • issue 1 • 2017 539 can optimal digital innovation and financial inclusion drive poverty reduction in the niger delta region of nigeria? eugene okoi ifere1*, napoleon david okosu2 1department of economics, federal university lafia, nasarawa state, nigeria, 2department of financial policy and regulation, central bank of nigeria, nigeria. *email: eugeoifere@gmail.com abstract poverty has remained a stubborn challenge in the niger delta region of nigeria amidst abundant natural resources. the sheer complexity of the niger delta with coastal waterways, creeks and islands creates unique challenges that cannot be underestimated. the study surveyed the extent of poverty using monthly income distribution, and degree of financial inclusion using access and usage of products and services. findings revealed that women are more financially excluded. findings also showed that majority of the population are unbanked and highly discouraged using financial products and services especially automated teller machine for fear of debiting without payment, long queues, high interest rates on loans and difficulty in accessing credit from financial institutions. the study suggests that the provisions of optimal digital financial services and products in this rural community with adequate education and advocacy for all the population will broaden financial inclusion, thereby contributing to poverty reduction. keywords: financial inclusion, poverty, digital innovation jel classifications: g21, o4 1. introduction poverty and widespread hunger are seriously and increasingly concentrated in the sub saharan africa and fast becoming a humanitarian issue. even though the urban poor are increasing in numbers, the rural population (mostly women) is the most vulnerable group experiencing extreme poverty. more than half of adult nigerians do not have formal bank accounts and so are financially excluded. the concept financial inclusion according to sarma (2008), is the process that ensures the ease of access, availability, and usage of formal financial system for all members of an economy. it is the extent to which financial services and products reach the poor households (deficit) units timely, and easily from surplus units (banks, multinationals, grant in aids, government etc.) to aid them in alleviating poverty without incurring additional cost. khan (2011) sees the pursuit of financial inclusion as a compulsory and not just a policy option. on the other hand (agrawal, 2008) as defined by rangarajan’s committee is the process of ensuring access to financial services and timely, and adequate credit where needed by vulnerable groups such as weaker sections and low income groups at an affordable cost.” amidžić et al. (2014) defined financial inclusion as an economic state where individuals and firms are not denied access to basic financial services. it can be voluntary or involuntary. the world bank (2014) defines voluntary exclusion as a condition where a particular population chooses not to use financial services either because they have no need for them or due to cultural or religious reasons; involuntary exclusion arises from insufficient income and high risk profile or due to discrimination and market failures and imperfections. according to empirical findings from enhancing financial innovation and access (eflna) survey report (2012), 42.7% of the total adult female population and 35.8% of the total adult male population are financially excluded in nigeria. it is also reported that 47.8% of rural and 24.8% of urban adult population are financially excluded. in africa, apart from south africa with 67% of banked adult, nigeria ranked second with 36% after kenya 30% and tanzania 29%, but on the contrary in terms of financial inclusion kenya and tanzania has a higher percentage of formally included adults mainly due to the high uptake of mobile money than nigeria. in the same (eflna) survey report (2014), 55.9% of ifere and okosu: can optimal digital innovation and financial inclusion drive poverty reduction in the niger delta region of nigeria? international journal of economics and financial issues | vol 7 • issue 1 • 2017540 adult males, 70.6% of adult females, and 75.0% of rural population are unbanked, with direct bank branches of 46.3% as the most frequently used channels of banking transaction and automated teller machine (atms) 53.0% leaving a very low gap in the use of e-payment channels. according to mbutor and uba (2013), an empirical picture of the position of nigeria in terms of financial inclusion shows that between 2008 and 2010, the percentage of financial exclusion fell from 53% to 46%. while those served by the informal sector fell from 24% to 17%. they further assert that in terms of access to savings products, nigeria has 461 savings accounts per 1000 that is considered to be poor compared with 2,063 savings account in malaysia. for credit penetration as an index of financial inclusion, nigeria was rated low compared to other peer countries. in comparison with south africa, nigeria has 2% access to formal product against south africa with 32%. in terms of insurance penetration, nigeria records only 1% while south africa records as high as 30%. to subbarao (2009), financial inclusion is necessary condition for sustainable and equitable growth. that only very few countries have taken off successfully from a primitive agrarian state to a postindustrial economy without first having the foundation of a broad based financial inclusion strategy. sarma and pais (2010) in a similar vein, asserts that financial inclusion process promotes ease of access, availability and usage of the formal financial system to all the segments of the economy. they further assert that an inclusive financial system can help reduce prevalence of informal financial institutions that are seen to be core capitalist and exploitative. according to them, an allinclusive financial system enhances efficiency and welfare by providing avenues for secure and safe financial practices. according to hariharan and marktanner (2012) financial inclusion is the access to formal financial services such as credit, savings and insurance opportunities. that lack of financial inclusion can be viewed as a multifaceted socio-economic phenomenon that results from various factors including geographic, cultural, historical, religion, socioeconomic, structure of the economy and policy. they noted financial inclusion to be a huge source of economic growth and development with the ability to create capital and total factor productivity of a country. while mahendra (2006) sees financial inclusion to be the availability of banking services at an affordable rate to the large segment of the vulnerable and low income groups. that although credit is taken to be the most significant component of financial services, such as savings, insurance payments and remittance facilities issued by financial institutions to those perceived to be financially excluded. this financial exclusion may be as a result of market failure, distance to banking facilities, products or services, fees and education. it has also been observed that within the different regions and communities that make up nigeria, disparities exist in access and usage of financial services. in terms of geo-political zones the north east is ranked the highest financially excluded zone with 68.4%, followed by north west 56.0%, while north central and south south (niger delta) share 32.7% each and south east, south west have 25.4% and 24.8% respectively. a great number of population in the rural communities are confronted with the huddles/challenge of ineffective and unaffordable financial inclusion tools necessary for saving, borrowing, making and receiving payments of money with ease. transforming the lives of these vulnerable groups using innovative financial inclusion strategy on the unbanked and under banked could be priceless. a clear understanding of the link between financial inclusion and poverty at the rural level is key to optimal design, innovation and implement of financial services necessary for reduction of poverty. insecurity, environmental degradation, health failure, marginalization, financial and state failures can be considered as possible elements that drive poverty and extreme hunger in these areas. a sizeable number of this group have no access to basic financial services which are taken for granted in developed economies and so could not save, borrow nor invest. this condition makes the rural poor to be extremely vulnerable to cash theft starched under pillows and cracks. studies have shown that poverty reduction, entrepreneurship, investment and economic growth potentials are common amongst a population with the ability to save and borrow. it is unarguably that innovation in mobile and electronic banking has facilitated formal credit and savings products to the hitherto financially excluded populations. despite strides in financial innovations, the african continent nay nigeria and niger delta region still confronted with great challenges and lags behind in, widespread adoption of effective and secure services. the sheer complexity of the niger delta with coastal waterways, creeks and islands creates unique challenges that cannot be underestimated. finance is the core of the modern economy, in the economic operation; it plays an important role in guiding the flow of resources in the region and among regions through special funds flow, which gets scarce resources in the region (luo and zhou, 2009). this can as well promote the reform of the corporate governance. both cross and country specific studies have reached the conclusions that income inequality is lower in countries with deeper and more accessible financial markets. jahan and mcdonald (2011) use the gini coefficient to measure inequality and find that a more developed financial system tends to have less income inequality although with much variations. their results of cross-country analysis shows that: gini coefficients fall more rapidly in countries with more developed financial intermediaries (such as banks or insurance companies); with better developed financial intermediaries, the income of the poorest 20% of the population grows faster than the national average; and the percentage of the population living on less than one or two dollars a day falls more rapidly with higher levels of financial development (beck et al., 2007). for country-specific (burgess and pande, 2005) in their impact study of bank branches in rural india found that output increased and poverty decline with greater access to finance. while (beck et al., 2010) conclude in their study that greater access to bank branches lowered income inequality in the united states. ifere and okosu: can optimal digital innovation and financial inclusion drive poverty reduction in the niger delta region of nigeria? international journal of economics and financial issues | vol 7 • issue 1 • 2017 541 the benefits of financial development extend beyond income equality to other poverty indicators. countries with welldeveloped financial system seem to have a lower incidence of poverty than others at the same level of national income (jahan and mcdonald, 2011). evidence abound that financial development improves societal health, education, and gender equality and reduce child labour. to buttress further, honohan (2007) in a study concludes that a 10% increase in the private credit-to-gross domestic product (gdp) ratio reduces the population of poverty by 2.5-3%. in the same argument, claessens and feijen (2007) submit that a 1% increase in private credit to gdp ratio reduces the prevalence of undernourishment by 0.2-2.5%. according to mbutor and uba (2013), the financial action task force reiterates the need for a broad based financial inclusion in 2011 when it noted that financial exclusion is a risk to financial integrity. the motivation was based on the premise that extending formal financial services to all the segments of the society will improve law enforcement by ensuring that more transactions are subject to the anti-money laundering and combating financing of terrorism controls and monitoring. the untold poverty in the niger delta region of nigeria is a true representation of shallow financial depth amidst wealth. this means that the range of financial assets available in the niger delta region is narrow. this is evidenced by the scanty number of commercial bank branches and atm points and other financial assets within the states that make up the niger delta in respect to the population (table 1). the stock market presence; the number of credit facilities accessed by indigenes of the area which is quite worrisome as well as the number of educated population and indigenes who have awareness to operate bank accounts with commercial banks in the area. this study seeks to empirically evaluate the impact of financial inclusion on the overall wellbeing of the people of the niger delta by looking at a wide range of financial assets. this can be specifically achieved by determining the appropriate measure of financial inclusion in the region. policy direction aimed at promoting financial development to alleviate poverty and foster growth, are also articulated in order to stem youth restiveness to its barest minimum. this study is divided into four sections. section one is the introduction; section two is a brief x-ray of the niger delta region of nigeria. section three discusses the impact and relationship between financial, inclusion and poverty in the niger delta; section four presents data and methodology for the study, while section five presents the results of the analysis and finally the concluding statement and policy direction and recommendations. 2. the niger delta region of nigeria the niger delta region is one of the largest wetlands in the world. this geo-political zone is occupied mainly by the minorities of southern nigeria which currently comprises the nine states of akwa ibom, bayelsa, cross river, delta, edo and rivers, redefined to encompass the contiguous three other oil-producing states; abia, imo and ondo, in addition to the original six. the region covers an area of 70,000 km2, with sandy coastal ridge barriers, brackish or saline mangroves, permanent and seasonal swamp forests as well as low land rain forest with the entire area crisscrossed by a large number of rivers rivulets, streams, canals and creeks (nnpc, 2005). in terms of mineral resources, it is one of the richest deltas in the world with huge oil and gas reserves, ranking as the worlds’ sixth largest exporters of crude oil and second largest producer of palm oil, after malaysia, which even obtained its palm seedlings from nigeria (petters, 2011). the niger delta states are rich in petroleum and gas resources, and at present produce the biggest proportion of crude petroleum and gas in nigeria. these states are endowed with many rivers and waterways. as a major wetland in the world, it houses one of the largest ecosystems that play a significant role in the world economy in terms of trade, given its ports and access routes. these access routes which include, ports and rivers have served as a lucrative trade routes right from the colonial to present era for trade in slaves, export commodities such as groundnuts, palm produce, timber, rubber, and cotton as well as other imports from abroad. the indigenous people of the oil fields of the niger delta region of nigeria are ethnically made up of those in rivers and bayelsa states (kalabari, ikwerre, ijaw, okrika, ibani, nembe, ogoni, ekpeye, ogba, engenni, epie-atissa); akwa ibom state (ibibio, anang, oron); cross river state (efik, ejagham, bekwarra, yakurr); ondo state (yoruba, ijo, illaje); edo state(edo, etsakos, yoruba, igbirra, okpameri); and the igbos in abia and imo states. agriculture is the most dominant economic activity in the niger delta states with crop farming and fishing activities accounting for about 80% of all forms of agricultural activity (mep, 2008). however, environmental degradation, which is caused by total dependence of the teeming rural population on unsustainable agriculture, fishing, forestry and wildlife exploration, has been a serious threat to the niger delta, relegating the population to poverty state amidst wealth and rich natural resources. the people are poverty stricken, depending on un-sustained agriculture and fishing which has been extinct and destroyed. a high financial inclusion in the niger delta is likelihood to generate positive employment, improved productivity and economic growth and alleviate poverty to its barest minimum; without necessary feeling the impact from the much destroyed ecosystem. financial inclusion can be a solution to cushion the effect of the much destroyed ecosystem. table 1: distribution of microfinance banks in nigeria distribution of microfinance banks by geopolitical zone geographical zone national mfb state mfb unit mfb total % of mfbs north central 13 162 175 18 north east 7 43 50 5 north west 1 2 126 129 13 south east 20 153 173 18 south south 1 21 85 107 11% south west 5 35 301 341 35 grand total 7 98 870 975 100 source: cbn, 2014 ifere and okosu: can optimal digital innovation and financial inclusion drive poverty reduction in the niger delta region of nigeria? international journal of economics and financial issues | vol 7 • issue 1 • 2017542 3. relationship between financial inclusion and poverty a sound financial system can promote economic growth and stability. some theories have suggested that the creation and promotion of efficient financial markets (institutions) are necessary for a genuine and enduring economic growth process; that financial markets can ameliorate risk, improve corporate governance, mobilize savings, reduce transaction and information costs, and promote specialization (bencivenga and smith, 1992; levine, 1997); while other models show that financial development reduces poverty and income inequality directly, by disproportionately relaxing credit constraints on the poor, and indirectly, by improving the allocation of capital and accelerating growth (jahan and mcdonald, 2011). however, in the niger delta, the benefits of financial inclusion have not extended beyond financing investment in the oil exploration by oil multinationals. financial development in the niger delta does not reduce inequality because; the benefits accrue primarily to the rich at the expense of the middle and low income citizens. according to imf (2007) financial globalization that concerns foreign direct investment has been associated with widening income disparities. in such situations, there is a risk that small groups of elites may capture the process of financial liberalization directing it in ways that narrow rather than broaden access (claessens and perotti, 2007). the relationship between financial inclusion and poverty could be viewed from two perspectives; the direct and indirect links. the direct link could present when the benefits of financial inclusion transcends to reducing poverty and income inequality while the indirect link on the other hand presents when financial inclusion exerts a positive effect on economic growth and how such gains from growth are channeled to the benefit of the poor. right from the discovery of finance as a pivot to economic growth, studies have shown that the development of financial inclusion can ease the credit constraints hitherto faced by the poverty stricken class, which has hindered their ability to undertake productive investments. whenever, access to credit is increased and made easy, the very low income (poor) would improve their welfare by spending more on consumption. the ease of accessing credit will also enable them the opportunity to raise capital from financial intermediaries for productive investment, which ordinarily were left to those in the rich income strata. in the works of greenwood and javanovic (1990), they submit that the relationship between income inequality and financial development takes on an inverted-u-shaped curve; that in the early stages of development, the poor will not be able to afford the initial setup costs associated with accessing financial intermediaries and thus the benefits of enhanced financial intermediation will be felt only by the rich. this would result in a widening of income inequality. in a similar situation, when the lending rates are fixed very high, it will limit the number of poor households obtaining credit because when the poor take out credit at high rates, there will be increase in default of nonperformance in loans; hence financial fragility. 3.1. financial literacy, technology diffusion and flexibility of financial services the idea of financial inclusion as it affects the rural poor in the niger delta region of nigeria poses a challenge to different groups of individuals in ameliorating this economic quagmire. first is the issue of financial literacy, which emphasizes the degree to which financial products and services are made, known to target populations and vulnerable groups (women and youths) who have been hitherto financially excluded. in this wise, creation of awareness by financial institutions on the availability of products, services and requisite technologies for the mobilization of savings or facilitation of financial services will bring about a tremendous transformation in the accessibility of these products. secondly, the idea of technology diffusion on the part of the target population is highly instrumental in determining the degree of assimilation of products and services. in this connection, the following questions must be answered; • what is the percentage of adults (particularly women) and youths in the rural areas have and operate bank accounts with functional atm cards? • how many of these people own or have access to multimedia phones with required software packages for carrying out financial transactions? • how many of these people have point of sale (pos) terminals in their business? or how many can understand or appreciate the idea of using a pos terminal instead of moving physical cash? • what is the percentage of people that can operate a computer and do internet banking with tokens? these and some other it related skill-set are required to ensure a greater amount of people in these rural areas become financially included. to this end, they must become technology savvy and adaptable to innovations in banking operations. more important is the degree of flexibility on the part of financial institutions in their operations and dealings with clients in the rural communities; there is need to design programmes that will be tailored to meet the financial needs of these people. the primary objective of this programme should be to mobilize funds in the rural communities, ensure adequate spread of mobile banks and atms. this will enhance banking operations among the rural poor. secondly, the innovations in the banking operations must be flexible so much so that it can be easily adaptable by all classes of people in the rural areas. example, the development of e-banking software that will work in multimedia and non-multimedia phones will significantly increase the number of users of this product. also, the ease with which financial product are accessed should be of great concern. 4. methodology the study adopts both quantitative and qualitative methods. this was intended to break through and identify the financial needs of the adult population, thereby creating opportunity for optimal use and development of innovative products by financial service providers. ifere and okosu: can optimal digital innovation and financial inclusion drive poverty reduction in the niger delta region of nigeria? international journal of economics and financial issues | vol 7 • issue 1 • 2017 543 first, the qualitative study adopts a survey design. carefully structured questionnaires and field observations were used to form part of primary data. this helped to gain in-depth knowledge of the study. open and close ended questionnaires were used to ascertain facts and solicit recommendations from respondents. samples were drawn from the population comprising adult community dwellers in each of the three niger delta states where research was conducted. these include cross river state, akwa ibom state and bayelsa state. a total of 450 questionnaires were administered in the 3 states out of the 9 states that make up the niger delta. out of this, 150 rural adults from three local governments each excluding state capitals (in each state) were sampled using purposive random sampling on the basis of its contribution of information rich cases. input from the civil society group will also form part of primary data for this study. the study put into consideration a non-response rate of 5%. out of the 450 sampled, 429 were returned. five of the returned questionnaires were rejected because they were not satisfactorily filled. only 424 questionnaires amounting to 94.2% fully completed and used for the analysis the questionnaire were divided into three parts to capture information relating to extent of poverty, awareness acceptability and workability of financial inclusion products and its importance to investment potential and sustainable economic development. the instruments and results obtained from the field were subjected to rigorous scrutiny and validation through triangulation of data and comparative analysis of responses. 5. presentation and analysis of survey result the survey on financial inclusion in the niger delta region of nigeria was conducted from november 2015 to february 2016 in three niger delta states. the states are akwa ibom, bayelsa and cross river states. the survey was based on adult population within two local governments each of these three states excluding the urban and state capitals. the result of the survey is presented as follows. from the survey, out of a total of 424 respondents, the gender distribution shows that 165 (39%) are adult males, while 259 representing 61% are female adults in the rural communities. this shows that there are more female adults than males financially excluded (figure 1). from the survey, the monthly income distribution, which depicts the extent of poverty and inequality as presented in figure 2 shows that majority of respondents 35.85% are living with no steady income and sustainable means. a greater percentage 54.24% earn between n4, 000 and n8, 000. this is quite small to sustain a household for a month while only 7.54% and negligible 2.35% earn between n21, 000 and above n40, 000 respectively. it can therefore be inferred from the survey that majority of people in the niger delta of about 90.09% are living below poverty level. in terms of the extent of financial access by the rural dwellers of the niger delta region of nigeria; survey results in figure 3 shows that a very small percentage of about 16.04% i.e., 68 out of a total of 424 respondents have access to or use deposit money banks and traditional banking product, such as atm/credit card, overdraft, loan from bank, fixed deposit, savings and current accounts. the survey also shows that 40.57% of the population sampled informally included i.e., they do not have any formal bank accounts or make use of any formal bank products. these percentages of respondents only use or have access to informal services and products such as local money lenders, esusu, ajo and other remittances like sending via transport services mobile phones and recharge cards whenever the need arises. the survey further reveals that a great majority of the respondents sampled 43.40% are financially excluded. this means that they do not bank nor have access to loans and gifts of any sort through any financial institutions. out of the percentage of adults who are financially excluded, i.e., who do not bank nor have access to loans and gifts of any sort through any financial institutions and had never use any; the women folk are the most affected. from the survey as much as 65% of women have never used nor had access to finance against 35% of men. it can be inferred that the female population are in serious need of financial access and products in the niger delta. this can be further proved that the female population are living source: field survey 2015/2016 figure 1: distribution of respondents by gender figure 2: distribution of monthly income source: field survey 2015/2016 figure 3: respondents financial access source: field survey 2015/2016 ifere and okosu: can optimal digital innovation and financial inclusion drive poverty reduction in the niger delta region of nigeria? international journal of economics and financial issues | vol 7 • issue 1 • 2017544 far below poverty level and do not have the means to sustainable investment to strengthen their economic power (figure 4). the distribution of livelihood profile from the survey as presented in figure 5 shows that out of 424 population sampled, 47 respondents representing 11.08% are involve in fishing activities, 104 representing 24.53% are involved in various trading activities within the region. trade in this region is made possible and easy due to its ports and access routes which include, ports and rivers that served as a lucrative trade routes right from the colonial to present era for trade in slaves, export commodities such as groundnuts, palm produce, timber, rubber, and cotton as well as other imports from abroad. out of this total population sampled, 183 respondents representing 43.16% are involved in subsistence and commercial farming activities. this is connected with the fact that agriculture is the most dominant economic activity in the niger delta region due to its fertile soil for crop cultivation. however, environmental degradation caused by oil and gas spillage as a result of oil exploration has caused total dependence of the teeming rural population on unsustainable agriculture. this has remained a serious threat to the niger delta, relegating the population to poverty state amidst wealth and rich natural resources. due to environmental degradation, poverty level is made worse by increasing the defendants to as high as 21.23% of respondents sampled for the survey. result from the survey in figure 6 shows that majority of the people in the niger delta are aware of e-banking even when a handful have never used the products. this is represented by 56% of the sampled population. although a sizeable number of 44% have no knowledge of e-banking because the products have not been brought to the rural area. the survey result shows that majority of the population in the niger delta region own and operates telephones. even though the telephones are not all smart phones that can be used for fund transfer, withdrawal of money, making of payments, paying of bills, buying of airtime and managing account, but a reasonable percentage of about 75.71% of respondents still own and can operate hand phones. the survey also shows that about 98 respondents sampled representing 23.11% do not own or operate telephones. this may be connected with their low income status. out of the total of 424 populations sampled, 24 representing 5.66% respondents do not own any telephone, but are eager and desperate to own one (figure 7). survey result on the extent to which rural dwellers of the niger delta use bank products is presented in figure 8. according to this result, the population in the niger delta is not use to new bank products probably because of the types of phones they use or the knowledge of new innovation in the banking products and services. the most widely used bank products are conventional bank branches with 49.29% which are easy to operate. there are few atm machines in these rural communities. for example in cross river state, only one atm machine owned by unical microfinance bank is functional and servicing two local government areas of bakassi and akpabuyo in the southern senatorial district where the survey was carried out. the percentage of respondents using atm is about 43.63% which shows that majority of the figure 4: distribution of gender that are financially excluded source: field survey 2015/2016 figure 5: livelihood profile of respondents source: field survey 2015/2016 figure 6: respondents awareness of e-banking source: field survey 2015/2016 figure 7: ownership and operation of telephones source: field survey 2015/2016 figure 8: usage of bank products source: field survey 2015/2016 ifere and okosu: can optimal digital innovation and financial inclusion drive poverty reduction in the niger delta region of nigeria? international journal of economics and financial issues | vol 7 • issue 1 • 2017 545 population knows how to use this bank product. however, the population in the niger delta does not know and use other bank products. only 1.18% uses internet, 3.54% can use their mobile phones to carry out transaction, while 2.36% know how to use pos machine. the nonuse of pos machine is its unavailability in the rural communities. to ascertain the fear and complaints the rural population have towards nonuse of new bank products, it was established from mutually inclusive result from the survey that the new bank products have their disadvantages. about 201 respondents do not know how to use the new bank products. 378 respondents do not use atm because the atm point is far from them while 199 don’t use atm because they are told that the machine can cease ones card. 176 respondents are afraid of being debited without payment. 208 respondents say they cannot stand the long queues experienced in banks while carrying out transaction (figure 9). 6. conclusion and policy recommendations to test whether optimal digital financial inclusion can helps reduce poverty in the niger delta region of nigeria, we carried out a qualitative survey in 3 states out of the 9 states that made up the niger delta. well-structured questionnaires were administered to adult population to find out the extent of financial inclusion in the region. also, our finding showed that exclusion was not based on cultural and religious belief, this may be due to the fact that the culture and religion practice in the region does not ban persons from banking services. next we tested which factors significantly influence financial inclusion and whether or not optimal financial inclusion in the region can help reduce poverty and income inequality. our findings clearly show that an optimal digital financial inclusion in the niger delta could significantly reduce poverty in the region. this can be possible if majority of the population are financially included with easy access to finance, credits and product, which indirectly triggers investment thereby alleviating poverty. based on our empirical results, we offer several policy implications. first, to reduce poverty rates in the region, the central bank and policymakers must implement policies that will address impediments to financial inclusion. in this regard, promoting an optimal digital financial inclusion amongst the population by financial institution and internet network providers is key to poverty reduction. complement efforts to reduce poverty. the role of microfinance in promoting credit allocation to rural dwellers in the niger delta at a very low interest rate without many constraints should be emphasized. second, availability of credit at lower interest rates with no collateral to lower income groups should be emphasized. in this context, financial packages should be developed by financial institutions that permit easy access to credit using phones by the rural population. this will further improve access to financial services and products, which in turn triggers investment in productive activities and reduce poverty. thirdly, to further reduce poverty, more optimal digital financial measures must be put in place to educate the use of financial services and products that can further address financial exclusion of low-income groups. in this wise a dedicated network must be used by all financial institutions for their data plan. pos, atm s and other financial products must be brought close to the rural communities with proper education and advocacy on use and functions. non smart phones should be designed to be compatible to make use of financial products. fourthly, atms should be upgraded to stop debiting without payment and constantly having network to function effectively without long ques. this can encourage 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[last retrieved on 2016 may 21]. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(5), 16-22. international journal of economics and financial issues | vol 10 • issue 5 • 202016 the stability of money demand function: evidence from south africa farhan abdi omar1*, abdishakur mohamed hussein2 1department of research and development, egalle minds, hargeisa, somaliland, 2faculty of business and economics, beder international university, hargeisa, somaliland. *email: farhan.omar@egalleminds.com received: 18 april 2020 accepted: 23 july 2020 doi: https://doi.org/10.32479/ijefi.9799 abstract the main purpose of this paper is to assess whether the money demand function is stable in south africa by employing the johansen co-integration and the vector error correction model. the results indicate unstable money demand function among its determinant including real income, interest rate, stock price, and real exchange rate. more importantly, the m3 has a significant long-run relationship among its determinant except the interest rate. furthermore, the short term dynamics show that unidirectional causality runs from determinants to the broader money except interest rate and exchange rate. this paper provides crucial evidence for policy-makers to consider the importance of the stock market activity to avoid misspecification of the money demand function. keywords: money demand, johansen, vector error correction model, stock price jel classifications: e5, e41 1. introduction many macroeconomists acknowledged the importance of behavior of money demand function when formulating an efficient monetary policy. the stability of the money demand function among its determinant including income and interest rate is a crucial component for the success of monetary intermediate targeting or direct approaches. this paper shows new evidence about the stability and relationship of the money demand function among its determinants in south africa by including stock market activity in the function using the johansen co-integration and vector error correction model (vecm). the literature over the past two decades indicates that financial reforms and switching between monetary policies have increased uncertainty about the stability of the money demand function (kumar et al., 2013; maki and kitasaka, 2006; nchor and adamec, 2016). south africa has experienced several different financial reforms and monetary regimes since the 1960s. a liquid asset ratio, cash reserve-based system, monetary targets regime, and inflation targeting were the main systems that the south africa reserve bank (sarb) adopted (table 1) (aron and muellbauer, 2002; 2007). in 2000, sarb implemented an inflation targeting system. the inflation targeting policy is that the central bank (sarb) forecasts the future rate of inflation and compares it with a predetermined inflation rate (3-6% in the case of sa). the approach proposed that the monetary policy is being directly forward-looked that employing inflation forecasting for guidance. the inflation rate is directly affected by policy instruments (interest rate, for example). hence, it is argued that monetary aggregates have no role under this approach (baltensperger et al., 2001). however, baltensperger et al. (2001) investigated the nexus between broader money (m3) and inflation where they proposed that monetary aggregates are still effective in the process of forecasting and targeting inflation. the fact is that m3 provides useful information about the movements of the price. besides, stable monetary this journal is licensed under a creative commons attribution 4.0 international license omar and hussein: the stability of money demand function: evidence from south africa international journal of economics and financial issues | vol 10 • issue 5 • 2020 17 aggregates is a useful instrument to stabilize the inflation rate (kumar et al., 2013; nell, 2003). the above argument emphasizes that stable money demand function is powerful under inflation targeting regime but the question is whether the money demand function is stable in south africa?. in the south african context, a few papers examined the relationship between money demand and its determinant. the results show stable money demand before implementing the inflation targeting regime (tavlas, 1989) (hurn and muscatelli, 1992) (jonsson, 2001)(bahmani-oskooee and gelan, 2009)1. however, most of the empirical literature conducted after the regime indicates that stable money demand function (m3) does not exist (nell, 2003) (tlelima and turner, 2004) (kapingura, 2014). the core variables were income and interest rate, but stock price and other financial variables are omitted. earlier studies such as friedman (1988) carried out empirical literature analyzing the nexus between stock market activity and money demand function in the us using data from 1961 to 1986. friedman proposed stock market affects money demand in different channels: (1) through income effect (positive): an increase of stock price reveals a rise of wealth that can result in higher money demand. (2) substitution effect (negative) an increase in the price of assets reveals that the investment market is more attractive than holding money where the people tend to invest and as a result, it reduces the demand for money. finally, friedman concluded that the impact of the stock market on money demand function is ambiguous (baharumshah et al., 2009). following the seminal work of friedman (1988), empirical literature highlighted inserting stock price in the money demand function improves the functional form. kia (2006), baharumshah et al., (2009) and others showed that the stock price is an important determinant in both developed and developing countries. furthermore, the omission of such an important variable could result in instability in the money demand function. in this regard, whereas the previous literature on south africa neglected (to our knowledge) the impact of the stock price on monetary aggregate, our study includes this crucial variable in the model. this study aims to address the stability and determinant of the money demand function by including the stock market 1 bahmani-oskooee used m2 instead of m3 and they found that m2 demand function is stable using a data between 1971q1 and 2001q3. activity. our objective is to shed light on the co-integration analysis of broader money, real income, stock price index and real exchange rate by using the most recent data. we examine broader money rather than m0, m1 or m2 because m3 is an important indicator of inflation targeting which south africa is adopting currently. in brief, we find that real income has a positive and significant relationship on m3. in contrast, both interest rates and exchange rates are negatively related to broader money. additionally, the stock price has a significant positive influence on the money demand function. for the period of investigation, the short term dynamics show all determinant have unidirectional causality except interest rate and exchange rate. the rest of the paper is planned as follows: section 2 provides a review of existing literature. the methodology is discussed in section 3. section 4 provides results and discussions. finally, policy recommendation is found in section 5. 2. literature review keynes (1936) developed the liquidity preference theory in order to analyze the money demand function. keynes started with the question of why money is held by people. three motives are underlined (1) transaction motive (2) precautionary motive (3) speculative motive. keynes asserted the reason that people hold cash balance is to fill up the gap between receipts and payment as same as for precautionary propose. keynes determined that both of the first two motives are a function of income (nchor and adamec, 2016). subsequently, some other researchers followed keynes’s proposal whereby the income is determinant of money demand, this researches including adekunle (1968) and sowa (1993). baumol, 1952 and tobin, 1956 latter argued the interest rate is one of the crucial explanatory variables that affect all money demand motives. besides, interest estimates the opportunity cost of holding money. for instance, if the interest rate increases, the opportunity cost of holding money will rise. hence, people desire to decrease their holding quantities of money (mishkin, 2007; nchor and adamec, 2016). after these different theories are carried out, the literature turns to investigate money demand function empirically. baharumshah et al., 2009; bahmani-oskooee and bohl, 2000; bahmani-oskooee and shabsigh, 1996; bahmani-oskooee* and rehman, 2005; bhaskara and singh, 2006; cheong, 2007; dreger and wolters, 2010; hamdi et al., 2015; hamori and hamori, 2008; kjosevski, 2013; knell and stix, 2005; mall, 2013; samreth, 2008 are consider both determinant of demand function and its stability. in the african continent, a sufficient number of empirical evidence ware published in particular (darrat, 1986; kapingura, 2014; kumar et al., 2013; nchor and adamec, 2016; tlelima and turner, 2004). table 2 indicates how the elasticity of income and interest rate differ across countries in africa. table 1: summary of monetary policy regimes in south africa duration monetary policy adopted 1960-1980 liquid asset ratio based system 1980-1985 cost of the cash reserve mid 1985-1999 monetary targeting 2000-current inflation targeting source: (aron and muellbauer, 2007) omar and hussein: the stability of money demand function: evidence from south africa international journal of economics and financial issues | vol 10 • issue 5 • 202018 3. methodology 3.1. data and model specification the study considers quarterly time series data from 2000q1 through 2017q2 (70 observations) where all data was collected from imf international financial statistics (ifs) database except broader money (m3) and stock price index. the former is obtained from south africa reserve bank (sarb) whereas the latter is collected from fred economic data. all variables are in natural log form excluding interest rate. following (sriram, 2000) and base on the friedman (1988) seminal, the broader money demand function is specified as: ( ),3 = f scalem p oc (1) where the demand for real broader money (m3/p) is a function of scale variable represent economic activity and opportunity cost which stands for the cost of holding money. we extend equation (1) into the econometric equation. 0 1 2 3 43 ε= ω +ω + ω + ω + ω +t t t t ttlrm ly r lsp lex (2) where lrm32 is a log of real demand for broader money. ly is the proxy of the scale variable. in fact, the appropriate scale variable has been strongly debated in the existing literature (kjosevski, 2013). some authors emphasize that using gdp as a proxy of scale variable could cause an overload of the level of the transaction in the economy. consequently, following kjosevski (2013), payne (2003), pelipas (2006) and others, the industrial production index (ipi, 2010=100) is used as a scale variable in this paper. following nell (2003), the (r) in the equation represents government bonds rate to estimate opportunity cost for holding money. lsp is the log of the stock price index3 (2015=100). finally, lex is the real exchange rate (domestic/foreign) which is used to capture the cost of holding domestic money against foreign currency. besides, the expectation of parameters is ω1>0; ω2<0. however, the expected sign of ω3 and ω4 are ambiguous. the former is discussed in the introduction section and the latter is due to different possible effects of the real exchange rate. for 2 south africa reserve bank (sarb) defines m3 as “m2 plus all long term deposit with monetary banking institutions”. 3 johannesburg stock exchange (jse) provides the index and it contains all share prices of 150 companies listed in the market. instance, if the real exchange rate depreciates, the domestic residents benefiting from increasing the value of the foreign asset, therefore, if the wealth follows and goes up the demand for money increases. on the other hand, if further depreciation expected, it leads to a decline in money demand (bahmanioskooee and malixi, 1991) (kia, 2006) (tang, 2007) 3.2. johansen co-integration specification it has been reported in the literature that most macroeconomic data have unit root and conventional thinking was to convert data into stationary before testing (johansen, 1991; ramachandran, 2004). however, engle and granger (1987) first proposed that if such a linear combination between two or more non-stationary variables is stationary, the variables are co-integrated. afterward, (johansen, 1991) and (johansen and juselius, 1990) developed a useful model to test long-run co-integration to analyze multivariate time series. in order to investigate the existence of co-integration among variables, first, we consider vector autoregressive model (var) with a vector variable yt is (n×1), a0 is (n×1) constant matrix term, ai is (n×n) matrices coefficient and ε1t is vector of error term. 0 1 1 2 2 1 ε− −= + + +t t t ty a a y a y (3) 1 0 1 ε − − − = ∆ = + π + +∑ k t t k i t i t i y a y ay (4) the vector variable δyt and yt–i have a unit root. therefore, the rank π (r) matrix determines the long-run relationship. if rank = 0, the var with kth lags will proceed and there is no cointegration among variables in the long run. despite that, if 0 <r<n, express into r×n matrix in such that rank with cointegration determined by ' π = αβ (5) where α is a strength parameter that measures the quality of co-integration and β’ vector of co-integration. hence, β’ yt is stationary at i(0). equation (5) implies that there is a long run linear combination among variables where r < n. 3.3. vector error correction (vecm) specification subsequently, the second step after confirming the existence of linear combination among variables is to employ vector error correction (vecm) to conduct the long-run coefficients, error correction model that indicates the speed of adjustments towards long-run equilibrium and granger causality test. the vecm model is specified as the following: table 2: summary of income and interest rate elasticity in africa author country monetary aggregates: period methodology income interest rate stability nchor and adamec (2016) ghana m1; 1990-2014 ecm 2.43 (0.574)*** ‒0.81 (0.66)*** stable kapingura (2014) south africa m3; 1995q1-2012q4 jml &vecm 5.013(1.090) 0.073(0.024) not stable kumar et al. (2013) nigeria m1; 1960-2008 ecm 0.90 (4.52)*** ‒0.19 ((3.16) *** stable herve and shen, (2011) côte d’ivoire m1; 1980-2007 jml 5.31 (6.16)** ‒0.19 (0.24)** not stable akinlo, (2006) nigeria m2; 1970q1-2004q4 jml 1.09 (43.8)*** ‒0.09(1.91)* stable nell (2003) south africa m3; 1965-1997 jml 1.27 (6.5)*** ‒0.006 (-2.6)*** not stable darrat (1986) kenya m1; 1969q1-1978q4 ols 1.843 (8.91)* −0.169(3.40)* stable ***, ** and * represents 1%, 5% and 10% significant of level respectively. (…) the number in parenthesis shows t-value. ols, ecm, ardl, jml are ordinary least square, autoregressive distribute lag, johansen maximum likelihood respectively omar and hussein: the stability of money demand function: evidence from south africa international journal of economics and financial issues | vol 10 • issue 5 • 2020 19 11 12 13 14 1 1 1 15 16 11 1, 1 1 1 1 3 3 ϕ τ τ τ τ τ ψ ε − − − = = = − − − = = = + ∆ + ∆ + ∆ + ∆ + ∆ − + ∑ ∑ ∑ ∑ ∑ k k k t t i t i i t i i t i i i i k k i t i i t i t t i i lrm lm ly r lsp lex ecm (6) 21 22 23 24 1 1 1 25 26 21 2, 1 2 1 1 3 ϕ τ τ τ τ τ ψ ε − − − = = = − − − = = = + ∆ + ∆ + ∆ + ∆ + ∆ − + ∑ ∑ ∑ ∑ ∑ k k k t t i t i i t i i t i i i i k k i t i i t i t t i i ly lm ly r lsp lex ecm (7) 31 32 33 34 1 1 1 35 36 31 3, 1 3 1 1 3 ϕ τ τ τ τ τ ψ ε − − − = = = − − − = = = + ∆ + ∆ + ∆ + ∆ + ∆ − + ∑ ∑ ∑ ∑ ∑ k k k t t i t i i t i i t i i i i k k i t i i t i t t i i lr lm ly r lsp lex ecm (8) 41 42 43 44 1 1 1 45 46 41 4, 1 1 1 1 3 ϕ τ τ τ τ τ ψ ε − − − = = = − − − = = = + ∆ + ∆ + ∆ + ∆ + ∆ − + ∑ ∑ ∑ ∑ ∑ k k k t t i t i i t i i t i i i i k k i t i i t i t t i i lsp lm ly r lsp lex ecm (9) 51 52 53 54 1 1 1 55 56 51 5, 1 5 1 1 3 ϕ τ τ τ τ τ ψ ε − − − = = = − − − = = = + ∆ + ∆ + ∆ + ∆ + ∆ − + ∑ ∑ ∑ ∑ ∑ k k k t t i t i i t i i t i i i i k k i t i i t i t t i i lex lm ly r lsp lex ecm (10) where φ11…φ51 is a constant term, τ12i… τ56i represent long-run elasticity, ∆ is designed to shows the operator of the first difference, ψ11…ψ51 reveals the parameter of the error correction model (ecm) which is specified as 1, 1 1 0 1 2 3 4 3 ρ ρ ρ ρ ρ− −= − − − − −t tecm lrm ly r lsp lex (11) ρ0 is constant of long term, ρ1…, ρ4 is long term elasticity and finally k is the optimal lag length chosen by using akaike information criterion (aic) conducted from var lag selection (wang and wang 2017). the third step is to calculate the granger causality test in order to investigate the direction of the relationship among variables. the vecm granger causality is estimated. the granger causality hypothesis should be detailed as: h0: ρ11k=0, ρ12k=0, ρ13k=0, ρ14k=ρ15k=0 (the lagged variable does not cause to lrm3). ha: ρ11k≠0, ρ12k≠0, ρ13k≠0, ρ14k≠ρ15k≠0 (the lagged variable does cause to lrm). by computing the wald test, if the p < 0.10 we reject the null hypothesis and conclude that the lagged value does granger cause to the dependent variable and vice-versa (bah and azam, 2017, p. 8). 3.4. test stability of the model and robustness check in this study, we performed cumulative sum of recursive residuals (cusum) and cumulative sum of recursive residuals square (cusumsq) developed by brown et al. (1975) to test the stability of parameters in the long run. subsequently, it is used to test the robustness of the model is to obtain the co-integration among variables. the study applied several diagnostic tests including the breusch–godfrey lm test and arch heteroskedasticity test to test the existence of autocorrelation and heteroskedasticity respectively. 4. results and discussions this section reports our empirical findings, including the results of the unit root test, co-integration test, long-run elasticity, granger causality, robustness, and stability check. 4.1. unit root test our aim in this paper is to investigate broader money demand function (m3) in south africa using johansen maximum likelihood (jml) co-integration test and vector error correction model (vecm). conducting the unit root test is necessary to check the validity of the jml assumption which assumes all variables are stationary at first deference i(1). an augmented dickey-fuller test (adf) is employed. the null hypothesis of adf shows the existence of a unit root. a maximum of 4 lags was chosen using the schwartz information criterion (sic). table 3 presents the results of the test. the result reveals that all variables are non-stationary at the level and therefore, they are stationary at the first difference i(1). 4.2. lag order selection since all variables are stationary at the first difference i(1), it is reasonable to proceed and obtain the number of appropriate lags for the jml test by formulating the var lag order selection method. consider that we have quarterly short term observation data (only 70), we selected a maximum of 6 lags. base on the table 3: adf unit root test level first difference conclusion constant constant with trend constant constant with trend lm3 ‒2.00 ‒1.75 ‒9.03*** 9.26*** i(1) ly ‒2.32 ‒2.60 ‒4.06*** ‒3.62*** i(1) r ‒2.18 ‒2.95 ‒4.08*** ‒7.36*** i(1) lsp ‒0.91 ‒2.43 ‒6.01*** ‒5.97*** i(1) lex ‒0.94 ‒1.56 ‒7.37*** ‒7.34*** i(1) ***, ** and * denotes significant at 1%, 5% and 10% significance level, respectively. the optimum lag length selected based on schwarz info criterion table 4: var lag order selection lag lr fpe aic sc hq 1 na 2.04e-10 ‒8.13 ‒7.28* ‒7.80 2 58.31 1.53e-10 ‒8.42 ‒6.74 ‒7.76 3 39.40 1.54e-10 ‒8.45 ‒5.92 ‒7.45 4 65.97 8.02e-11 ‒9.17 ‒5.80 ‒7.84 5 47.24* 5.83e-11* ‒9.60* ‒5.38 ‒7.93* 6 16.18 9.46e-11 ‒9.29 ‒4.23 ‒7.30 *indicates lag order selected by the criterion (each test at 5% level). lr: sequential modified lr test statistic. fpe: final prediction error. aic: akaike information criterion. sc: schwarz information criterion. hq: hannan-quinn information criteria omar and hussein: the stability of money demand function: evidence from south africa international journal of economics and financial issues | vol 10 • issue 5 • 202020 results presented in table 4, lr, fpe, aic and hq suggested 5 lags. hence, 5 lags are included in the model. another important diagnostic before investigating co-integration is to ensure that no significant lag was left. correlogram of residuals is taken into the account where no significant lag left. 4.3. johansen co-integration test subsequently, equation (3) (5) is employed to test the number of co-integration equations in the model. as panel a in table 5 reveals the results of the jml test where both trace and maximum eigen value statistics confirm that at least two co-integration equations exist in the model. however, we tasted only one co-integration equation since our interest is only to assess the relationship of broader money (m3) among its determinants. panel b in table 5 shows normalised long-run elasticity. the result indicates that signs of income and interest rate are consistent with the prediction of theoretical signs. moreover, the result shows that the stock market price has positively and significantly related to m3. the positive relationship reflects income effect is large than the substitution effect of stock market activity. the positive elasticity of stock price consistent with (baharumshah et al., 2009). on the other hand, the depreciation of the exchange rate causes a decrease of m3 which possibly comes from the expectation of the people that the domestic money depreciation can be deeper in the future and thereby holding it causes loss of its value. kapingura (2014) found that elasticity of exchange rate is 0.945 in south africa, which is greater than our elasticity. 4.4. short-run dynamics afterwards, the short term relationship was tested. the vecm is required in order to check the validity and convergence of the long term relationship. to determine the existence of a short term relationship at least one of the ecm coefficients should be significant. the results presented panel a in table 6 indicate that the error correct model (ecm) is negative as expected and significant. therefore, the ecm emphasized the existence of the long-run co-integration among variables. additionally, the ecm shows the departure of the dependent variable from the independent variable is corrected 94% each period. in other words, the disequilibrium of long-run relationship is corrected 94% each period where the convergence to the long-run equilibrium takes approximately a quarter and 2 months. the short term dynamics also explained the causality between variable which is when a variable past behaviour predicts the future value of another variable. the granger causality is tested to detect this dynamic behaviour within vecm. the results as illustrated in table 6 indicate the presence of this dynamic behaviour and it is directions are are ∆ly→∆lrm3, ∆lsp→∆lrm3, ∆lsp→∆ly, ∆lsp→∆lr, ∆lsp→∆lex. in other words, results in table 6 panel a show significant unidirectional causality runs from real income and stock price to the broad money. the result reveals interest rate and the real exchange rate does not granger causes broader money. in contrast, the results highlight that there is no causality running from rm3 to determinant variables. 4.5. robustness check and stability test in panel b of table 6, we turn to check several diagnostic checks including model stability, autocorrelation, and heteroskedasticity test. first, the breusch–godfrey lm test is calculated to capture the existence of serial correlation in the residuals. the x2 is reported in table 6 panel b. the p-value of the χ2 is 0.07 which is >0.05 level of conventional significance. this implies that the model is fit and free from serial correlation problems. next, we turn to estimate arch heteroskedasticity. the same procedure has been followed where it is concluded that heteroscedasticity is not present. finally, the cumulative sum of recursive residuals (cusum) and cumulative sum of recursive residuals square (cusumsq) are estimated to test the model stability. the results are presented in figure 1. the results show that the two tests lead to different conclusions. the former indicates a stable long-run relationship, whereas the latter shows a deviation of the money demand function. therefore, to ensure the existence of a structural break, the chow test is calculated. the results of the chow test indicate that there is structural break 2010q2 through 2011q1 where f-statistics rejected. the result of the chow test is not reported in order to save some space.table 5: johansen maximum likelihood result of the rm3 demand function panel a: jml trace statistics and maximum eigen value results null alternative trace statistics 95% critical value λmax statistics 95% critical value r=0a r=1 97.42* 69.82 34.29* 33.88 r≤3 r=2 63.14* 47.86 28.08* 27.58 r≤2 r=3 35.06* 29.80 18.14 21.13 r≤2 r=4 16.92* 15.49 8.67 14.26 r≤1 r=5 8.25* 3.84 8.25* 3.84 panel b: normalized co-integration coefficients lrm3=0.95ly–0.012r+0.45 lsp–0.40lex (0.48) (0.02) (0.07) (1.33) [–1.96] [–0.49] [-6.50] [-5.65] (a) indicate the rank of the co-integration equation. (*) shows the significance of t-statistics at 5%. trace and maximum eigen-value statistics are obtained including intercept with no trend. p-values is base on (mackinnon et al., 1999). (…) the number in parentheses represents standard error and […] the number in brackets indicates t-statistics table 6: panel a: granger causality test results dependent variable δlrm3 δly δr δlsp δlex ecm δlrm3 1.89 0.60 1.13 2.17 –0.95*** δly 19.75*** 0.62 4.21 4.86 0.054 δr 2.83 3.91 3.33 3.22 –0.11 δlsp 15.15*** 20.60*** 10.57* 10.81* -0.07 δlex 10.08* 2.61 3.10 5.32 –0.29 *** and ** denotes significant at 1% and 5% significance level, respectively panel b: robustness check test value r-square 0.71 autocorrelation lm test 5.27a arch heteroskedasticity test 0.64a ***and *indicates the level of significance 1% and 5% respectively. (a) represents χ2 value omar and hussein: the stability of money demand function: evidence from south africa international journal of economics and financial issues | vol 10 • issue 5 • 2020 21 5. conclusion the importance of money demand stability has been underlined to attain long term objectives of monetary policy. the previous research has shown that financial reforms and changing monetary policies could affect the stability of money demand function. furthermore, the current literature in south africa indicates that money demand is unstable since sarb adopted the inflation target policy in 2000. the purpose of this paper was to investigate the stability of money demand function in south africa. the paper included a new variable (our best knowledge) in the money demand function in south africa. the stock market activity is included following by friedman’s (1988) seminal work. the long-run cointegration of real broader money (rm3), income, interest rate, stock price, and real exchange rate is confirmed by the johansen co-integration model test. the vecm supported the existence of a long-run relationship. cusum and cusumsq are also tested to investigate the stability of the money demand function. the money demand function is found unstable according to cusumsq. and, chow test confirmed the existence of a structural break in 2010q2. for the policy-makers, the results suggest the importance of stock price and foreign activity to generate long term effective money demand function. although the money demand function still unstable when the two variables are included, however, the exclusion of them could delay the recovery of the stability. furthermore, both variables showed their influence in the long run. another important point is that income elasticity is approximately unitary which suggests to the policy-makers should allow the money supply to grow the same rate with income growth to avoid mismatching between money demand and money supply. finally, the study suggests further research on money demand stability by taking a structural break into the account. references adekunle, j. 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(2017), imported technology and co2 emission in china: collecting evidence through bound testing and vecm approach. renewable and sustainable energy reviews, 82, 4204-4214. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1918-1929. international journal of economics and financial issues | vol 6 • issue 4 • 20161918 kou jump diffusion model: an application to the standard and poor 500, nasdaq 100 and russell 2000 index options wajih abbasi1, petr hájek2*, diana ismailova3, saira yessimzhanova4, zouhaier ben khelifa5, kholnazar amonov6 1college of business and economics, qassim university, saudi arabia, 2unicorn college and central bohemia university, prague, the czech republic, 3kokshetau university named after abai myrzakhmetov, kazakhstan, 4narxoz university, kazakhstan, 5ecstra center of research on economics and finance, hec carthage, tunisia, 6central bohemia university, prague, the czech republic. *email: hajekp@gmail.com abstract this research focuses on the empirical comparative analysis of three models of option pricing: (a) the implied volatility daily calibrated black–scholes model, (b) the cox and ross univariate model with the volatility which is a deterministic and inverse function of the underlying asset price and (c) the kou jump diffusion model. to conduct the empirical analysis, we use a diversified sample with options written on three us indexes during 2007: large cap (standard and poor 500 [sp 500]), hi-tech cap (nasdaq 100) and small cap (russell 2000). for the estimation of models parameters, we opted for the data-fitting technique using the trust region reflective algorithm on option prices, rather than the more common maximum likelihood or generalized method of moments on the history of the underlying asset. the analysis that we conducted clearly shows the supremacy of kou model. we also notice that it provided better results for the nasdaq 100 and russell 2000 index options than for the sp 500 ones. actually, this supremacy comes from the ability of this model to be as close as possible of market participant’s behavior thanks to its double exponential distribution characterized by three main properties: (a) leptokurtic feature, (b) psychological specificity of investors and (c) memory-less feature. keywords: jump-diffusion, kou model, leptokurtic feature, trust-region-reflective algorithm, us index options jel classifications: c3, c8, g12, g13 1. introduction theoretical models that are interested in evaluating options are generally based on two key elements: the process of the underlying asset and the market price of the risk factor. the black–scholes (bs) model (1973) is based on the assumption of a lognormal diffusion process with a constant instantaneous volatility. being the benchmark for derivative assets valuation, this model has been, during the last 30 years, the target of several empirical studies that have revealed a number of limitations. on the one hand, the assumption of log normality of the underlying asset has been widely rejected by the autoregressive conditional heteroskedasticity literature. on the other hand, the assumption of a diffusion process was also rejected by the existence of heavy tails of the distribution of returns. finally, the effect of debt raised (black, 1976), and the existence of a possible correlation between the process and the volatility of the underlying asset (heston, 1993), nandi (2000) indicated a complex relationship between asset returns and volatility. these empirical limits pushed theorists to develop alternate models. research undertaken thereafter considered three approaches: the univariate models: these are models that have maintained the no-arbitrage assumption of the bs model, but gave up the assumption of geometric brownian motion. included are the constant elasticity variance model (cev) of cox and ross (1975) and cox (1996) and more recently the trinomial or implied binomial tree models of derman and kani (1994) and dupire (1994). • the stochastic volatility models: these models are based on the assumption of a volatility of the underlying asset evolving in a stochastic manner by following a diffusion process, abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 2016 1919 heston (1993), hull and white (1987), wiggins (1987), and the hybrid jump-diffusion process of duffie et al. (2000) • the jump diffusion models: that has replaced the underlying asset classical diffusion process. out of which the merton model (1976) remains the most popular. very recent studies have attempted to combine these three approaches, such as studies by jones (2003) and skiadopoulos (2000) who have respectively proposed a stochastic generalization of the cev process and the binomial tree model. although alternative models have started to appear few years after the original bs model, their empirical investigation was hampered by several factors. first, market data for options were and still remain difficult to collect. then, the new models are generally much more complicated than the bs model and validating them empirically needed advanced programming works. finally, the introduction of the concept of risk for certain jump processes or of the stochastic volatility models raised the problem of the evaluation of this variable. it is only by the 90s that we began to witness the appearance of serious empirical research on this level with the development of computers and the progress in mathematical and econometric research such as the fourier inversion technique used by heston (1993), or the non-linear squares technique used by bakshi et al. (1997), bates (1996a; 1996b), dumas et al. (1998). this paper proposes to compare the empirical performance of three alternatives to the bs model that belong to three different classes. first, the ad-hoc bs model that is praised by practitioners for its simplicity and effectiveness. it is simply the bs classical model with a daily implied volatility calibration from option pricing. although such procedure seems unorthodox and inconsistent with the assumptions of the bs classical model, it provides quite suitable results in the evaluation of options, where in his paper entitled “how to get the right option price with the wrong model?” berkowitz (2001) showed that, thanks to the daily volatility calibration, the ad-hoc bs model arrived to provide close performances to those of stochastic volatility models in terms of evaluation “in sample.” the second model is the cev model developed by cox and ross (1975) better known by the abbreviation cev model that belongs to the class of univariate models. by opting for a non-stationary process of the underlying asset volatility that is negatively correlated to the price of the asset, the cev model adjusts for some empirical realities: (a) the change in volatility over time, (b) the inverse relationship between volatility and the price of the underlying asset. the third alternative is the jump-diffusion model of kou (2002) which proposes a hybrid process for the underlying asset, consisting of a first “diffusion” component the same as in the bs model and a second “jump” component following a double exponential process. such a model allows us to understand two major empirical phenomena: the kou model leads to a probability distribution with heavy tails (a frequently observed phenomenon of the underlying assets distributions) which simply means a greater probability for extreme values. then the kou model is able to integrate the phenomenon of negative skewness (more probability for negative outcomes) through the jump signs, by proposing negative jumps for the underlying asset return, the model affects more probability for negative achievements. the empirical approach will be structured as follows: we begin by presenting the structure of the database used in this study. options traded on the chicago board options exchange (cboe) during the year 2007 for the three stock indexes standard and poor 500 (sp 500), nasdaq 100 and russell 2000 for a total of 26, 968 call options (the reason is to check whether technology and or small stocks behave in a different manner than those stocks that represent best the us economy). then we conduct a comparative analysis between the ad-hoc bs, the cev model and the jump-diffusion kou model. this analysis aims to verify the validity of the assumptions made by each of these models by comparing the model prices to market options prices. the comparative analysis will also detect any structural bias that would affect the performance of each of the three theoretical models. 2. cev model of cox and ross cox and ross (1975) developed a pricing model of calls that verifies the negative relationship between return volatility of the underlying asset and its price. in this model, the variance of returns is a deterministic function of the underlying asset price and its elasticity with respect to price is constant. specifically, the model assumes that the instantaneous rate of return of the underlying asset evolves according to the following process: 1 . . . ds dt s dz s   −= + (1) µ is the drift rate of the underlying asset return, δ.sθ−1 is the instantaneous standard deviation of the underlying asset return with δ a strictly positive constant, dz is a standard wiener process which follows a normal distribution with expectation e(dz)=0 and variance var(dz)=dt. the major difference with the bs model is that the volatility of returns of the underlying asset δ.sθ−1 is based on the price of the asset. however, if θ = 1, the cev model coincides with the bs model. whereas, when θ deviates from 1, the process that characterizes the underlying asset becomes non-stationary. the negative correlation between asset prices and volatility, as evidenced by several empirical studies will be checked only if θ < 1.hs, the variance elasticity of the underlying asset returns is given by, ( ) ( ) 2 2 22 2 2 2 2 . . . 2 1 . s ss s h s s s       − − ∂ ∂   = = = −    ∂ ∂  (2) we notice that the elasticity is negative only if θ < 1. considering an underlying asset that pays no dividend, a price that follows the process described in equation (1), and a constant riskfree rate r, using the cev model of cox, the price of a european abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 20161920 call under the risk-neutral probability is equal to the present value of the cash-flow expected at maturity: ( ). * . 0,ˆ rv tc e e max s k−  = −  (3) cv is the theoretical price calculated using the cev model, of a european call with exercise price k and maturing in τ years, ˆ te is the expectation operator under the risk-neutral probability, s* is the expected price of the underlying asset at the call maturity. once we identify the distribution of s*, the underlying asset price at maturity following the cev diffusion process as shown by equation (1), we can determine the theoretical price of the call. cox’s equation for evaluating options under the cev assumption is defined as follows: ( ) ( ) 0 1 . . , 1 . . . , 1 .r rv n c s g s n g k e n k e       − − =   = + + − −  ∑ ( ) 0 1 . , 1 . . . , 1r n g s n g k e n      − =    + − +     ∑ (4) ∅=2θ−2 ( )1 2 2 . . . r r e    −= ( ) 1 0 . . v nn e v dv ∞ − −γ = ∫ : the gamma function, ( ) ( ) 1 1, . . x ng x n e x n − −= γ : the gamma density function, ( ) ( ) 0 , , . g a n g x n dx ∞ = ∫ : the gamma complementary distribution function. however, this model continues to consider the parameters δ and θ as constants, which does not seem to be a very realistic assumption especially when it comes to evaluating options on stock indexes. indeed, if one refers to the idea of a constant negative elasticity, we could end up in a vicious circle, since any decline in the stock index will increase volatility. this latter increases market fears and causes a further decline in the index. with such a mechanism, we may end up with a volatility that tends to infinity along with a stock index which tends to zero. such a situation is unlikely. one solution to this problem would be to recalibrate the cev model on a periodic basis to update its δ and θ structural parameters like the ad-hoc bs model, we proceed to the daily calculation of the structural parameters of the cev model from option prices. for the remainder of this article, we will denote model with calibration by cev. 3. kou jump-diffusion model the model is quite simple in its logic. the logarithm of the underlying asset price is assumed to follow a hybrid jumpdiffusion process. the first component of the process is similar to that of bs geometric brownian motion. the second component corresponds to a “poisson” process jumps with amplitudes distributed according to the double exponential distribution. the model assumes that the underlying asset price volves according to the following process: ( ) ( ) ( ) ( ) ( ) 1 . . 1 n t ii ds t dt dw t d v s t   =  = + + − − ∑ (5) w(t) is a standard brownian motion, n(t) is a poisson process with a frequency λ. vi is a sequence of positive random variables independently and identically distributed such that y = log(v) follows a distribution with an asymmetric double exponential density function: ( ) { } { }1 2 . . 1 20 0. . . . y y y y yf y p e q e   − −≥ <= + (6) η1 > 1; η2 > 0 where, q > 0; p + q = 1, represent the probabilities of upward and downward jumps. the drift μ and the volatility σ are assumed to be constants and the brownian motion and jumps are assumed to be one dimensional. in other words, ( ) ( )( ) with probability with probability p log v y q   + −  =    (7) where ξ+ and ξ− are two exponential random variables with means 1 2 1 1and ,   respectively, and the notation ≜ means equal in distribution. y is the random variable representing the jumps that may affect the underlying asset rate of returns. ξ+ and ξ− are respectively the amplitudes of the upward and downward jumps. ( ) 1 2 p q e y   = − is the average amplitude of the jump. ( ) 2 2 2 1 2 1 2 1 1 . . p q var y p q        = + + +      is part of the volatility of the underlying asset due to jump risk. this will provide: var(s) = σ2 + var(y) (8) there are three interesting properties of the double exponential distribution which are fundamental to the model. first, the distribution has the leptokurtic feature. this feature that governs the jump size distribution is consistent with the empirical distribution that characterizes the underlying asset rate of return. then, the double exponential distribution has the memory less property. in other words, the current achievements depend, in one way or another, on the past achievements. finally, this distribution has a psychological and economic justification. indeed, it has been demonstrated through several empirical studies that markets tend to have an overreaction and under-reaction towards various good or bad news (fama, 1998; barberis et al., 1998). we can then interpret the jumps as a market response to new external market abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 2016 1921 information. thus, in the absence of external information, the price of the underlying asset should move according to a brownian motion. good or bad news occur according to a poisson process and the price of the underlying asset changes in response to this news, according to the distribution that governs the size of the jump. this distribution can be used to model the overreaction (through heavier tails) and the under-reaction (through a larger peak). therefore, the diffusion model with double exponential jumps can be interpreted as an attempt to build a simple model within the traditional framework of random walk and market efficiency that takes into account investor’s attitudes towards risk as well. the european call valuation formula, according to the kou jumpdiffusion model, is given by: ( ) ( )  2 1 2 2 1 2 1 0 0 . . . , , , , , , log , 2 1 . . . . , , , , , , log , 2 c rt k s x r p t s k k e x r p t s             −    = + −        − − −      (9) x: the probability function of the kou jump-diffusion model.   ( ) 1 2 1 1 2 1 1 1 2 2 . . 1 , . , 1 1 1 1 1 , 1 , . 1 p q p p                = + − = − + + − = − = + = +   the price of the corresponding put ψp(0), can be inferred through the call-put parity: ψp(0)−ψc(0)=k.e −r.t−s(0) (10) the kou model also presents analytical solutions for the evaluation of american options, look back options, and other exotic options. 4. overview of the database the final sample used concerns call options on three u.s. indexes, the nasdaq 100, sp 500 and russell 2000. the final sample that combines all categories of options includes 26,968 call options traded on the cboe during 2007and distributed as follows: 7151 options for the nasdaq 100 index; 12,499 options for the sp 500 and finally 7138 options for the russell 2000 index. we then compiled abstract tables which show the main properties for each of the three groups identified. the final sample is obtained by applying five filters. first, all the options with an average price <50 cents were removed. then the options with a spread which is the difference between the ask price and bid price divided by the mid-price of this option, where that spread represents more than 50% of the average call price are removed. these first two filters are meant to eliminate calls with a large spread in relation to bid-ask quotations reported by the database. we also removed options with a moneyness which deviates from the range (−10%, 10%). indeed, the options that are deep out-of-the-money (otm) or deep-in-the-money (itm) are illiquid and have a low time value which substantially affects the predictive power of the estimated parameters value. next, we eliminated options with <6 days or over 100 days to expiration. the former have almost zero time premiums while the latter are illiquid. finally, all options that do not meet the noarbitrage assumption are eliminated. the majority of observations eliminated correspond to deep itm calls. table 1 describes the properties of the final sample of sp 500 calls to be used for our empirical study. the sample is dominated by at-the-money (atm) options with 5599 observations (44.8% of the final sample) followed by itm options with 3970 observations (31.7% of the sample) and finally otm options with 2930 comments (23.5% of the sample). referring to the criterion of time to expiration, we realize that the sample is dominated by options of short and medium term maturities with respectively 4792 (38.3% of the sample) and 4496 observations (36% of the sample). the long-term options represent only 25.7% of the final sample with 3211 observations. the average price of sp 500 calls varies from $ 89.13 (long term deep itm options) to $ 0.67 (short term deep otm calls). the spread ranges from 2.2% of the call mid-price (long term itm calls) to 48.2% (short term deep otm calls). similarly, the properties of the final sample for nasdaq 100 and russell 2000 are respectively summarized in tables 2 and 3. table 1: properties of the final sample of the sp500 calls moneyness (%) time-to-expiration (days) sub-total 6-30 31-60 61-100 otm −10, −6 $0.67 $1.1 $2.31 0.482 0.408 0.305 33 363 599 995 −6, −3 $1.3 $3.72 $7.84 0.317 0.194 0.136 571 843 521 1935 atm −3, 0 $5.75 $12.74 $20.11 0.149 0.103 0.083 1221 1089 581 2891 0, 3 $22.94 $29.6 $37.31 0.073 0.064 0.053 1147 1012 549 2708 itm 3, 6 $82.34 $84.58 $89.13 0.024 0.024 0.022 693 730 502 1925 6, 10 $49.68 $53.88 $59.95 0.039 0.037 0.033 831 755 459 2045 sub-total 4496 4792 3211 12,499 prices reported in the table respectively represent the calls mid-price, the effective spread (defined as the difference between the bid and ask price of the option divided by its average price) and finally the total number of observations for each sample subcategory moneyness/time-to-expiration. the sample period is spread over the whole of 2007 for a total of 12,499 observations. the moneyness equals (s−k.e−r.t)/k.e−r.t. s means the spot level of the sp 500. k stands for the strike price, (r) for the risk-free interest rate which corresponds to the maturity of the call and (t) the call time-to-expiration. otm, atm and itm calls denote the out-of-the-money, at-the-money and in-the-money options. source: authors abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 20161922 5. parameters estimation and performance models in order to have a clearer view of the limits of the bs model, we represented the evolution of the implied volatility as a function of moneyness and time-to-maturity for 2 days arbitrarily chosen in our sample. we then obtained two surfaces of the implied volatility that highlight the dual structural bias plaguing the bs model (figure 1a and b). the surface traces the evolution of volatility across different levels of moneyness and time-toexpiration. each point on the surface corresponds to an implied volatility obtained through reversing of the bs formula. indeed, referring to these surfaces, we realize that the implied volatility generated from the bs model is not unique in space or constant in time, which is inconsistent with the hypothesis of log normality of the price of the underlying asset on which is based the bs model. figure 1 the shows two surfaces of the implied volatility for 2 separate days in the sample. the surface traces the evolution of volatility across different levels of moneyness and time-toexpiration. each point on the surface corresponds to an implied volatility obtained from the sp500 call mid-price, through reversing of the bs formula. the most dramatic change in the volatility is recorded for short term options with a volatility smile where otm and itm options show significantly different volatilities than atm options. any theoretical model, which presents itself as a serious alternative to the bs model, should provide a significant improvement mainly to short term options. as the time-to-expiration increases, the change in implied volatility becomes more moderate with a decreasing pace, commonly called the sneer where the most itm options show the highest volatility. as both phenomena smile and sneer are synonymous with a probability distribution with negative skewness and excess kurtosis, any acceptable alternative model to bs should propose a distribution that integrates these two aspects. thus, one can moderate the effect of the time-to-expiration and the moneyness as two generating sources of estimation bias. 5.1. alternate models parameter estimation: trust-region-reflective (trr) algorithm a solution to the parameters estimation problem would be to use the maximum likelihood or generalized method of moments to identify these estimates from the history of the underlying asset. maekawa et al. (2008) have used this technique to estimate the parameters of the kou model in the japanese market with more than 1, 000 observations out of nikkei 225 from june 1, 1992 to december 31, 2002. then they used the market prices of european call options for nikkei 225 from september 10, 1999 to december 12, 2002 to evaluate the empirical performance of the kou model. such a solution can be binding as it requires the collection of a large volume of historical data that eventually leads to low predictive power estimates. in order to address this gap, practitioners and researchers have chosen to derive the estimates table 2: properties of the final sample of the nasdaq 100 calls moneyness (%) time-to-expiration (days) sub-total 6-30 31-60 61-100 otm −10, −6 $1.72 $5.92 $14.03 26.5% 18.2% 12.8% 213 712 755 1680 −6, −3 $5.18 $16.71 $29.09 16.9% 11.5% 12.4% 339 486 416 1241 atm −3, 0 $16.36 $36.06 $49.44 10.6% 11.3% 11.9% 356 455 401 1, 212 0, 3 $39.9 $58.16 $72.51 9.8% 9.5% 8.8% 336 439 377 1152 itm 3, 6 $71.77 $86.46 $100.04 7.3% 6.9% 6.6% 276 382 258 916 6, 10 $111.57 $121.26 $133.81 4.9% 5% 5% 274 422 254 950 sub-total 1794 2896 2461 7151 prices reported in the table respectively represent the calls mid-price, the effective spread (defined as the difference between the bid and ask price of the option divided by its average price) and finally the total number of observations for each sample subcategory moneyness/time-to-expiration. the sample period is spread over the whole of 2007 for a total of 7, 151 observations. the moneyness equals (s−k.e−r.t)/k.e−r.t. s means the spot level of the nasdaq 100. k stands for the strike price, (r) for the risk-free interest rate which corresponds to the maturity of the call and (t) the call time to expiration. otm, atm and itm calls denote the out-of-the-money, at-the-money and in-the-money. source: authors table 3: properties of the final sample of russell 2000 calls moneyness (%) time-to-expiration (days) sub-total 6-30 31-60 61-100 otm −10, −6 $1.17 $2.69 $5.72 29.7% 17.2% 9.6% 122 541 568 1231 −6, −3 $2.35 $6.25 $10.89 19.6% 8.8% 6.9% 284 470 484 1238 atm −3, 0 $5.98 $12.36 $17.7 9.8% 5.9% 4.7% 350 457 463 1270 0, 3 $14.7 $21.4 $26.68 5.2% 3.9% 3.4% 330 441 466 1237 itm 3, 6 $27.24 $32.59 $37.51 3.1% 2.6% 2.4% 290 411 423 1124 6, 10 $43.13 $47.72 $51.03 1.9% 1.8% 1.8% 257 497 464 1218 sub-total 1633 2817 2868 7318 prices reported in the table respectively represent the calls mid-price, the effective spread (defined as the difference between the bid and ask price of the option divided by its average price) and finally the total number of observations for each sample subcategory moneyness/time-to-expiration. the sample period is spread over the whole of 2007 for a total of 7, 318 observations. the moneyness equals (s−k.e−r.t)/k.e−r.t. s means the spot level of the russell 2000. k stands for the strike price, (r) for the risk-free interest rate which corresponds to the maturity of the call and (t) the call time to expiration. otm, atm and itm calls denote the out-of-the-money, at-the-money and in-the-money options. source: authors abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 2016 1923 of the structural parameters from observed option prices. this solution has introduced the concept of the implied volatility for the bs model. however, the application of such a technique is more complicated with models that involve several structural parameters at the same time and using much more developed mathematical tools than for the case of the bs model. for this study, we chose to derive the estimates of the structural parameters of the kou model from instant cross sectional price of options for each day of the sample solving nonlinear curve-fitting (data-fitting) problems in least-squares sense means to find a set of parameters β that solve the least squares minimization problem. ( ) ( )( ) 2min min , i i i f f xdata ydata   = − ∑ (11) the optimization algorithm used for the least squares minimization is the trr. the basic idea behind the trr approach is as follows: suppose you are at a point β in n-space and you want to move to a point with a lower function value f. first, we have to approximate f (β) with a simpler function q which is defined by the first two terms of the taylor approximation to f at β. this approximation should reasonably reflect the behavior of f in a neighborhood n around the point βi. a trial step si is computed by minimizing (or approximately minimizing) over n. this n is called the trust region and the improved point βi+1 should also be in this region. n is usually spherical or ellipsoidal in shape. the trial step si = βi+1−βi is found by approximately solving the equation. ( )( )min , iq s s n ∈ (12) where, ( ) 1 2 t t i sq s s g s h= + such that ||dis|| ≤ δi (13) where, g is the gradient of f at the current point β, h is the hessian matrix, d is a diagonal scaling matrix, δi is a positive scalar corresponding to the trust region size. the trust region is adjusted from iteration to iteration. if the computations show that the approximate function qi at the current point βi fit the original problem well, the trust region can be enlarged. otherwise, it must be shrunk, byrd et al. (2000). the approximation approach followed is to restrict the trust-region sub problem to a twodimensional subspace v. in our algorithm, we choose v as the linear space spanned by v1 and v2, where v1 is in the direction of the gradient g, and v2 is either an approximate newton direction, i.e., a solution to, h.v2 = −g (14) in summary, the trr algorithm involves the following steps: 1. formulate the two-dimensional trust-region subproblem 2. solve (12) to determine the trial step si. 3. if f(βi + si) < f(βi), then βi + 1 becomes the current point; otherwise βi + 1 = βi 4. update δi 5. if the gradient is below a chosen tolerance, the algorithm ends; otherwise, repeat and increment i. such a technique can significantly reduce the number of observations required to estimate and leads to a significant improvement in the performance of the evaluation models, bates (1996a; 1996b), dumas et al. (1998), bakshi et al. (1997). the estimation procedure is as follows: step 1: for a well-defined sample, we collect m options, such as m is greater than or equal to (n + 1) where n is the number of parameters to estimate. in the case of the kou model, n = 4. cimarket is the market price of the ith call. cikou is the theoretical price of the ith call calculated using the kou model. the difference between these two prices will depend on the vector ϕ = {σ, λ, η1, η2}. for each option (i), we define: ( ) ( ) ( ), , , , market koui i i i i i i c t k c t k   = − (15) step 2: we find the vector of parameters that minimizes the sum of squared errors between the observed prices and the theoretical prices of options. ( ) 2 1 min n ii sse   =≡ ∑ (16) these two steps are repeated for each option and for each day in our sample. the objective function sse is defined as the sum of squared errors, in dollars, of call options prices. the use of nonlinear least squares should provide a fair comparison between figure 1: (a) standard and poor (sp 500) calls implied volatility surface, june 8, 2007, (b) sp 500 calls implied volatility surface, december 10, 2007 source: authors ba abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 20161924 the three models. we obtain structural parameters estimated through option prices for the ad-hoc bs model (implied volatility), cev(0, δ) and kou’s jump-diffusion {σ, λ, η1, η2}. 5.2. results of the estimation estimates of the structural parameters of the cev and the kou jump-diffusion models are included in table 4 (sp 500), table 5 (nasdaq 100) and table 6 (russell 2000). for the cev model, estimates show a poor negative correlation between the level of the sp 500 index and its volatility. indeed, as θ tends to 1, the cev model tends to the bs model. such a result is quite logical since the sp 500 index representing the u.s. equity market has strongly rebounded after the technology bubble and volatility indices have stabilized afterwards. this may explain the poor negative correlation generated by the nonlinear least squares, which only reflect the renewed confidence of market participants. for the kou jump-diffusion model, estimates are quite reasonable for a fairly diversified stock index, such as the sp 500, especially during stable times. according to the estimation results, the market participants anticipate to achieve an average of 3.514 jumps per year with average amplitude of −3.51% per jump. the overall average volatility that is measured by the variance represents 1.44% (being a standard deviation of 11.98%), distributed between 1.05% to the “diffusion” component (or standard deviation 10.24%) and 0.39% for the “jumps” component (being a standard deviation of 6.23%). in other words, the diffusion process contributes to 73% in the overall risk of the underlying asset against only 23% for the “jumps” component. the same procedure was repeated for options on nasdaq 100 and russell 2000. for the nasdaq 100 options, daily estimates are close to each other as shown by the standard deviation of the estimated parameters, equal to 0.0216, with an average of 0.9509. the same observation is valid for δ with a standard deviation of 0.0528 and an average of 0.2252 estimates. however, the daily calibration of the structural parameters of the model using nonlinear least squares remains useful given the sensitivity of the option price to forecast volatility parameters used in the calculation of theoretical prices. estimates of kou model implicit parameters from nasdaq 100 options show that there is an average of 5.796 jumps per year. the average amplitude of the jump is equal to −3.925%, where the average amplitude is calculated using the following formula: e y p q( ) = −  1 2 . y is the amplitude of the jump on the index return. p and q are respectively the probabilities of upward and downward jumps. p = q = 0.5. the nasdaq 100 has an overall instantaneous variance equal to 3.68% (an overall standard deviation of 19.18%). jumps contribute to 14.4% on the actual index volatility against 85.6% for the component “diffusion” process. however, it is worth noting that compared to the sp 500 options, the estimated parameters for the nasdaq 100 options show a significantly higher overall volatility and negative amplitude of jumps three times larger than the sp 500 options. such a result stems from the different characteristics of the two indexes. while the sp 500 contains the 500 largest market capitalization of the u.s. economy, the nasdaq 100 is limited to the 100 most highly capitalized technology companies naturally belonging to one of the riskiest sectors of the american economy. table 4: estimation of structural parameters for cev and kou models – sp 500 options parameters mean±standard deviation cev kou θ 0.8963±0.0429 δ 0.2036±0.0481 σ 0.1024±0.011 λ 3.514±1.174 η1 379.179±180.957 η2 13.746±3.112 for each day of the sample, the structural parameters of the cev cox and jump-diffusion kou models are estimated by minimizing the sum of squared errors between the observed option price and its theoretical price determined by each of the two models. these estimates will be realized for each day of the sample using the technique of nonlinear least squares. the table brings forward the estimates and the corresponding standard deviation for each parameter. cev refers to cox’s cev model (1976) whereas kou refers to the kou’s jump-diffusion model (2002). θ and δ are the structural parameters of the cev model and correspond to the elasticity of volatility and to a positive scalar. σ, λ, η1, η2 are the structural parameters to be estimated for the model of kou. σ designates the portion of the volatility generated by the diffusion process component. λ refers to the average number of jumps per year. η1 and η2 respectively control the amplitude of upward jumps (η1) and downward jumps (η2). the average amplitude is equal to p/η1−q/η2. p and q denote the probabilities of an upward or a downward jumps. p=q = 0.5. source: authors. cev: constant elasticity variance, sp 500: standard and poor 500 table 5: estimation of structural parameters for cev and kou models – nasdaq 100 options mean±standard deviation parameters cev kou θ 0.9509±0.0216 δ 0.2252±0.0528 σ 0.1776±0.3313 λ 5.7906±1.9921 η1 243.3514±91.365 η2 12.104±3.001 for each day of the sample, the structural parameters of the cev cox and jump-diffusion kou models are estimated by minimizing the sum of squared errors between the observed option price and its theoretical price determined by each of the two models. these estimates will be realized for each day of the sample using the technique of nonlinear least squares. the table brings forward the estimates and the corresponding standard deviation for each parameter. cev refers to cox’s cev model (1976) whereas kou refers to the kou’s jump-diffusion model (2002). θ and δ are the structural parameters of the cev model and correspond to the elasticity of volatility and to a positive scalar. σ, λ, η1, η2 are the structural parameters to be estimated for the model of kou. σ designates the portion of the volatility generated by the diffusion process component. λ refers to the average number of jumps per year. η1 and η2 respectively control the amplitude of upward jumps (η1) and downward jumps (η2). the average amplitude is equal to p/η1−q/η2. p and q denote the probabilities of an upward or a downward jumps. p=q = 0.5. source: authors. cev: constant elasticity variance table 6: estimation of structural parameters for cev and kou models – russell 2000 options mean±standard deviation parameters cev kou θ 0.9555±0.0214 δ 0.1982±0.0334 σ 0.1654±0.0233 λ 6.221±2.66 η1 153.6922±86.0209 η2 15.6833±4.0418 cev: constant elasticity variance abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 2016 1925 compared to sp 500 and nasdaq 100 options, the estimated parameters for the russell 2000 options show a global volatility that is much higher than that of sp 500 options but lower than that nasdaq 100 options. although the russell 2000 is the most diversified index grouping 2000 american firms, the “size” effect still works in favor of the sp 500 index. whereas, the nasdaq 100 index continues to be penalized by both low diversification and more volatile stocks even though it contains firms with significantly larger market capitalization than those of the russell 2000. for each day of the sample, the structural parameters of the cev cox and jump-diffusion kou models are estimated by minimizing the sum of squared errors between the observed option price and its theoretical price determined by each of the two models. these estimates will be realized for each day of the sample using the technique of nonlinear least squares. the table brings forward the estimates and the corresponding standard deviation for each parameter. cev refers to cox’s cev model (1976) whereas kou refers to the kou’s jump-diffusion model (2002). θ and δ are the structural parameters of the η2are the structural parameters to be estimated for the model of kou. σ designates the portion of the volatility generated by the diffusion process component. λ refers to the average number of jumps per year. η1 and η2 respectively control the amplitude of upward jumps (η1) and downward jumps (η2). the average amplitude is equal to p/η1−q/η2. p and q denote the probabilities of an upward or a downward jumps. p=q=0.5. daily estimates of the two parameters θ and δ release respective averages of 0.9555 for the parameter θ, and 0.1982 for the parameter δ. these estimates show an almost zero correlation between the level of the russell 2000 index and its volatility, as evidenced by the estimate of θ which is much closer to 1, the threshold for which the cev model coincides with the bs model. for the kou jump-diffusion model, estimates show that there is an average of 6.22 jumps per year the highest number of jumps compared to sp 500 and nasdaq 100 indexes. the average amplitude of the jump, equal to −3.925%, is identical to that of the options on nasdaq 100. the russell 2000 index has an instantaneous variance equal 3.065% (being a total standard deviation of 17.51%). jumps contribute to 10.73% on the actual volatility of the index against 89.27% for the component “diffusion” process. 5.3. performance models three criteria were used to conduct a comparative analysis between the three models: • the mean squared errors: this is the average of the squared differences between the observed price of the option and its theoretical price calculated using each of the three models. this measure gives more weight to itm calls compared to other options in the sample. • the mean absolute error: at first, the absolute value of the difference is calculated for each option between the observed mid-price of the option and its theoretical price. then, the average difference was reported at the observed mid-price. this will calculate the percentage of the estimation error for each model. such a measure tends to give greater weight to evaluation errors related to the calls otm at the expense of other options. • the frequency: this is the number of times where each model has led to the estimation error (mean absolute error) that is lowest compared to the other two models. this comparative analysis will be conducted by sub-sample “moneyness/time-to-expiration” instead of testing the performance of the three models for the entire sample as a single compact component. such an approach should allow a better understanding of the elements that may represent sources of estimation bias for our theoretical models. the results are summarized in tables 7-9 respectively for the sp 500, nasdaq 100 and russell 2000 indexes. table 7 summarizes these criteria divided into nine sub-samples that are usually based on the moneyness and time-to-expiration. the jump-diffusion model of kou largely outperforms the cev and ad-hoc bs models for all subcategories of the table. the superiority of the model becomes more evident as one moves away from the atm calls and notably for itm ones where the average relative error records its lowest level throughout the sample. this result was predictable since the kou model was the only one of the three models studied to take into account the aspect of the leptokurtic distribution of the underlying asset. thus, excess kurtosis can be integrated via the amplitude and frequency of jumps while the negative skewness was present throughout the anticipated jump sign (negative jumps). we also note that the performance of the model does not seem to suffer a lot from moneyness or time-to-expiration changes. the performance of the kou model can be explained by several factors. first, the choice of a double exponential distribution, which characterizes the jumps, has improved the quality of estimates since it is more likely to reflect the extreme. then, the technique of the structural parameters estimation of the model based on the nonlinear least squares has identified estimates based on option prices rather than time series of returns of the sp 500 index, as bates (2000) showed that only sporadic jumps with large amplitude are able to achieve results that deviate significantly from the bs model. but such jumps are difficult to detect from the time series of the underlying asset. once we examine the performance of the cev model, we note that even though we have applied the same method to estimate the kou model (the estimate of the model structural parameters is made with nonlinear least squares technique using cross sectional sp 500 options prices) and have made a daily calibration of the structural parameters, the performance of the cev model remains widely below those of the kou model. the cev model provides the worst results for itm options where he concedes the second position to the ad-hoc bs model for both short-term options, medium and long-term options. we can explain this result by the poor negative correlation between the index level and its volatility especially that we know that 2007 was a relatively “quiet” year. the inverse relationship between the price abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 20161926 table 7: in-sample performance evaluation models for sp 500 options moneyness (%) time-to-expiration (days) 6-30 31-60 61-100 kou cev bs kou cev bs kou cev bs otm −10, −6 0.101 0.339 0.451 0.045 0.568 4.654 0.09 1.22 14.189 46.5% 88.1% 71.3% 18.8% 70.1% 146.8% 11.04% 55.2% 142.3% (15) (0) (18) (322) (4) (37) (556) (31) (12) −6, −3 0.058 0.332 3.856 0.095 0.646 12.731 0.147 1.236 26.815 18.6% 46.2% 129.8% 8.87% 24.5% 103.4% 3.83% 14.9% 55.4% (456) (66) (49) (642) (189) (12) (431) (88) (2) atm −3, 0 0.123 2.731 8.254 0.114 3.668 18.894 0.188 3.297 26.268 6.52% 26.3% 62.7% 2.45% 14.1% 30.5% 1.72% 7.6% 17.6% (1102) (108) (11) (1040) (42) (7) (493) (50) (38) 0, 3 0.169 2.231 5.09 0.096 2.032 13.89 0.232 1.862 24.173 1.57% 6.6% 8.3% 0.82% 4.6% 7.9% 0.97% 3.1% 7.1% (881) (148) (118) (824) (68) (106) (380) (78) (91) itm 3, 6 0.191 2.669 1.573 0.14 8.489 5.785 0.255 16.318 14.107 0.55% 2.8% 1.9% 0.49% 5.1% 2.8% 0.64% 6.4% 3.9% (630) (94) (107) (644) (4) (107) (401) (0) (58) 6, 10 0.311 1.167 0.921 0.309 5.116 2.884 0.2 19.862 7.501 0.47% 1% 0.9% 0.5% 2.4% 1.5% 0.39% 4.7% 2.3% (449) (118) (113) (530) (75) (125) (464) (4) (34) table 7 shows the three criteria used to assess the quality of the estimate of each of the three valuation models. these three criteria are, in order of appearance in the table, the mean squared errors, the mean absolute error and the frequency (in parentheses). the mean squared error is calculated from the squared deviations and calculated for each of the options in the sample using the theoretical price and the observed price. the mean absolute error is the average of the absolute values of differences between the theoretical option price and observed price, divided by the observed prices. frequency reports the number of calls for which each of the three theoretical models released the lowest mean absolute error compared to the two other models. these three criteria are calculated for each moneyness/time-to-expiration sub-sample. the moneyness is equal to (s−k.e−r.t)/k.e−r.t. s means the spot level of the sp 500 index. k stands for the strike price while (r) stands for the risk-free interest rate corresponding to the maturity of the call and (t) the time-to-expiration. otm, atm and itm calls denote the out-of -the-money, at-the-money and in-the-money. source: authors. cev: constant elasticity variance, bs: black–scholes, sp 500: standard and poor 500 table 8: in-sample performance evaluation models for nasdaq 100 options moneyness (%) time-to-expiration (days) 6-30 31-60 61-100 kou cev bs kou cev bs kou cev bs otm −10, −6 0.155 0.504 5.058 0.386 2.06 11.906 0.43 6.6 11.793 18.8% 47.6% 129.4% 12% 27.7% 78.7% 2.9% 20.1% 28.8% (176) (23) (12) (520) (139) (6) (644) (35) (17) −6, −3 0.399 2.836 9.295 0.883 5.913 11.121 1.471 5.362 4.772 11.3% 27.4% 73.4% 4.2% 12.2% 23.5% 1.9% 5.8% 7.3% (276) (58) (5) (403) (74) (9) (302) (60) (54) atm −3, 0 1.216 23.685 7.791 1.451 21.17 3.52 2.641 10.917 4.389 5% 33.5% 22.3% 1.9% 14% 5.3% 1.5% 6% 3.5% (330) (4) (22) (375) (1) (79) (315) (43) (43) 0, 3 2.492 12.797 1.984 3.468 9.06 5.395 4.072 5.007 21.202 2.2% 9.4% 3% 1.4% 4.6% 3.2% 1.2% 2.4% 5.7% (224) (19) (93) (322) (51) (66) (289) (79) (9) itm 3, 6 1.086 6.988 9.138 3.226 16.31 19.484 3.519 30.643 48.983 1% 2.7% 3.8% 0.9% 3.9% 4.8% 0.7% 5.1% 6.6% (192) (59) (25) (340) (32) (10) (251) (3) (4) 6, 10 1.419 16.446 20.176 3.858 38.755 35.235 5.164 79.557 73.52 0.7% 2.9% 3.7% 0.8% 4.4% 4.6% 0.6% 6.4% 6.2% (216) (29) (27) (372) (31) (15) (247) (1) (4) table 8 shows the three criteria used to assess the quality of the estimate of each of the three valuation models. these three criteria are, in order of appearance in the table, the mean squared errors, the mean absolute error and the frequency (in parentheses). the mean squared error is calculated from the squared deviations and calculated for each of the options in the sample using the theoretical price and the observed price. the mean absolute error is the average of the absolute values of differences between the theoretical option price and observed price, divided by the observed prices. frequency reports the number of calls for which each of the three theoretical models released the lowest mean absolute error compared to the two other models. these three criteria are calculated for each moneyness/time-to-expiration sub-sample. the moneyness is equal to (s−k.e−r.t)/k.e−r.t. s means the spot level of the nasdaq 100 index. k stands for the strike price while (r) stands for the risk-free interest rate corresponding to the maturity of the call and (t) the time-to-expiration. otm, atm and itm calls denote the out-of-the-money, at-the-money and in-the-money. source: authors, cev: constant elasticity variance, bs: black–scholes, sp 500: standard and poor 500 abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 2016 1927 of the underlying asset and its volatility was first introduced to the options with the argument of the leverage effect. in the absence of such an effect for indexes, the only plausible argument to explain this inverse relationship would be the panic effect in the presence of downside market movements. this could be explained by the inability of the cev model to figure kurtosis excess that has always characterized the performance of indexes. finally, the ad-hoc bs model has usually a good performance for at-the-short term options. for itm options it provides the best performance ahead of the cev model and rivaling with the kou model which is another less expected result. once more, this result confirms that the short term itm options are less sensitive to the choice of models and structural parameters. however, as one moves towards otm options, the generated results are deteriorating in a spectacular way including a time-to-expiration above 30 days. unfortunately, the daily calibration of volatilities was not able to offset these biases due to the unrealistic assumption of the lognormal asset price. such a hypothesis is unable to integrate the phenomena that are empirically proved of high kurtosis and non-zero skewness. the results for the nasdaq 100 options in table 8 confirm those already presented in table 7 for the sp 500 options. the main conclusions are maintained for russell 2000 options in table 9 except for the cev model which was less efficient than it was for the sp 500 and nasdaq 100 options. also, the ad-hoc bs model was outperformed in most sub-samples, especially for atm and itm options. this result was expected as long as the estimation of the structural parameters of the cox model showed a θ = 0.9555 against 0.8963 for the sp500 and θ = 0.9509 options for nasdaq100 options. nonetheless, let’s remember that the more θ is close to 1, the greater the cev model coincides with the bs model. 5.4. estimation errors and regression we conduct a regression analysis to identify the factors responsible of the estimation errors for all the three models. by estimation error, we mean the mean absolute error ϑi(t) which is a function of moneynessi(t) the degree of moneyness, τi(t) the time to expiration, and of spreadi(t) the spread relative to the i th call observed at date (t). this regression performed using the technique of ordinary least squares will be applied to each of our three indexes. it will cover all 12,499 sp 500 calls, the 7151 nasdaq 100 calls and the 7318 russell 2000 calls. the regression equation is of the following form: ϑi(t) = β0 + β1moneynessi(t)+β2∙τi(t) + β3∙spreadi(t) + εi(t) (17) regression for sp 500 options (table 10) shows that, regardless of valuation models, all variables have a significant explanatory power at the confidence level of 1% estimation errors. in other words, the estimation errors of the three valuation models are, in part, due to moneyness, time-to-expiration or spread bias. the magnitude of this bias differs, however, from one model to the other. the moneyness bias is the highest for the ad-hoc bs model. the percentage of the estimation error for this model is expected to increase by 5.347 points every time the moneyness table 9: in-sample evaluation performance models for russell 2000 options moneyness (%) time-to-expiration (days) 6-30 31-60 61-100 kou cev bs kou cev bs kou cev bs otm −10 0.027 0.53 0.133 0.035 0.129 0.314 0.14 1.722 0.468 −6 0.118 0.64 0.327 0.054 0.462 0.24 0.033 0.266 0.122 (94) (2) (26) (495) (0) (46) (516) (17) (35) −6, 0.061 0.198 0.555 0.043 0.353 0.491 0.08 0.489 0.278 −3 0.107 0.233 0.425 0.025 0.104 0.132 0.013 0.058 0.041 (211) (64) (9) (376) (69) (25) (347) (57) (79) atm −3, 0.103 2.025 1.167 0.057 1.923 0.409 0.1 1.799 0.241 0 0.051 0.256 0.244 0.012 0.114 0.048 0.011 0.074 0.015 (326) (17) (7) (385) (0) (72) (286) (2) (175) 0, 0.164 2.147 0.933 0.056 1.282 0.509 0.136 0.975 0.810 3 0.018 0.114 0.068 0.007 0.054 0.018 0.009 0.035 0.024 (289) (14) (27) (321) (27) (92) (372) (54) (39) itm 3, 0.237 0.666 0.892 0.066 1.053 0.793 0.125 1.63 1.651 6 0.011 0.024 0.025 0.005 0.026 0.016 0.006 0.03 0.03 (204) (60) (26) (323) (30) (58) (388) (26) (9) 6, 0.356 1.204 0.904 0.172 2.722 0.972 0.124 6.052 1.992 10 0.009 0.022 0.176 0.006 0.031 0.135 0.004 0.048 0.024 (193) (30) (33) (348) (41) (108) (440) (2) (22) table 9 shows the three criteria used to assess the quality of the estimate of each of the three valuation models. these three criteria are, in order of appearance in the table, the mean squared errors, the mean absolute error and the frequency (in parentheses). the mean squared error is calculated from the squared deviations and calculated for each of the options in the sample using the theoretical price and the observed price. the mean absolute error is the average of the absolute values of differences between the theoretical option price and observed price, divided by the observed prices. frequency reports the number of calls for which each of the three theoretical models released the lowest mean absolute error compared to the two other models. these three criteria are calculated for each moneyness/time-to-expiration sub-sample. the moneyness is equal to (s−k.e−r.t)/k.e− r.t. s means the spot level of the russell 2000 index. k stands for the strike price while (r) stands for the risk-free interest rate corresponding to the maturity of the call and (t) the time-to-expiration. otm, atm and itm calls denote the out-of-the-money, at-the-money and in-the-money. source: authors. cev: constant elasticity variance, bs: black–scholes, sp 500: standard and poor 500 abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 20161928 decreases by one point. yet, the bias of the moneyness decreases with the cev model. hence, the error estimation should increase by 1.517 points every time the moneyness decreases by one point. that is to say that the cev model offers a better diffusion process than the ad-hoc bs model. finally, the bias of moneyness is lower for the kou jumpdiffusion model. the error estimation of this model should increase by only 0.319 points every time the moneyness decreases by one point. this improvement is due to a better process modeling of the underlying asset, thus a better volatility estimate thanks to the introduction of jumps in addition to the diffusion process. the bias of the residual time is much more discreet than the moneyness for all of the three models. this is due to the daily calibration which allows updating the structural parameters. such a result is consistent with other studies that have shown that with such a calibration, the bs model was able to mimic, in an acceptable manner, the stochastic volatility models, bakshi et al. (1997), bates (2003), berkowitz (2001). the same observation is valid for the cev model that has been able best to mitigate the time-to-expiration bias factor. this performance is due to two factors. first, the daily calibration of the model parameters has been updated daily. then, using the process proposed by the cev model, the volatility does not change in a purely stochastic manner but is inversely related to the price of the underlying asset, as demonstrated by several empirical studies, heston and nandi (2000), jones (2003), nandi (1998). regression releases the same trends for nasdaq 100 options as shown in table 11. unlike the sp 500 and nasdaq 100 options, the ad-hoc bs model for russell 2000 options no longer suffers from the moneyness bias with an estimated coefficient close to zero (−0.01) and in addition insignificant at the 1% and 5% levels. this result is surprising when compared to estimates for the sp 500 (−5.347) and nasdaq 100 (−1.778) moneyness coefficients. also, the coefficient on the bias of the residual time (−0.292) is significantly lower, in absolute value, than the estimates found for the nasdaq100 options (−1.208). these results give an idea of the progress made by the ad-hoc bs and clearly visible in table 12 where the model has claimed the second place to cev model of cox. the kou jump-diffusion model continues meanwhile to outperform the ad-hoc bs and cev models with estimated coefficients very close to zero. 6. conclusion the present work was interested in empirically validating three evaluation options models, the ad-hoc bs model, the cox cev model and the kou jump-diffusion model using call options, negotiated during the year 2007, on the sp 500 index, the nasdaq 100 index and the russell 2000 index. the cev model uses a diffusion process with the volatility which is a deterministic and inverse function of the underlying asset price. the kou model offers meanwhile a hybrid model with a hybrid jump-diffusion process where volatility evolves in a stochastic manner. in order to perform these calculations, we must first estimate the structural parameters for all of the three models. to do so, we choose the nonlinear least squares econometric technique on cross sectional option prices. a comparative analysis between the three models, based on the evaluation of the theoretical price of 12, 499 options on the sp 500; 7, 151 options on the nasdaq 100 and 7, 318 options on the russell 2000, shows a clear superiority of the kou jump-diffusion model which vastly outperforms the two other models for the entire sample. this result shows that the implied distribution over the underlying asset is generally different from the objective distribution. the first is determined by the mood of market participants and their expectations for the future, while the second is simply based on the history of the underlying asset price without considering the psychological aspect of market participants. table 10: regression results for the sp 500 options models parameters r2adjusted constant moneyness time spread ad-hoc bs 0.233*** −5.347*** −0.207** 1.879*** 0.306 (0.023) (0.272) (0.098) (0.155) cev 0.085*** −1.517*** −0.113*** 0.848*** 0.604 (0.004) (0.055) (0.019) (0.027) kou 0.023*** −0.319*** −0.128*** 0.325*** 0.438 (0.002) (0.025) (0.009) (0.015) table 10 shows the regression results for equation (17). the endogenous variable, designated by ϑi(t), is the mean absolute error calculated at date (t) equal to the absolute value of the difference between the theoretical and observed prices of the ith option price divided by the observed price. moneynessi(t), τi(t), spreadi(t) are respectively the degree of moneyness, time-to-expiration and the spread relative to the ith call observed at the date (t). the moneyness is equal to (s−k.e−r.t)/k.e−r.t. the spread will be equal to the difference between the bid and ask price of the option divided by its mid-price. ε is the residual term. ad0hoc bs is the black-scholes model with a daily implied volatility calibration. cev model is the cox cev with a daily calibration of elasticity. kou is the jump-diffusion model of kou. the regression is performed for each of the 3 models using all 12,499 sp 500 calls which constitute our sample. the sample period spans 2007. the coefficient estimates appear in the first line for all three models. figures in parentheses are standard deviations of the estimates. ***to mean that the estimate is significant to the 1% error. **to indicate that it is significant to the 5% error. source: authors. cev: constant elasticity variance, bs: black–scholes, sp 500: standard and poor 500 table 11: regression results for the nasdaq 100 options models parameters r2adjusted constant moneyness time spread ad-hoc bs 0.0357** −1.778*** −1.208*** 3.162*** 0.522 (0.0169) (0.107) (0.053) (0.137) cev 0.131*** −1.124*** −0.658*** 0.774*** 0.419 (0.008) (0.048) (0.028) (0.056) kou 0.016*** −0.220*** −0.232*** 0.469*** 0.269 (0.004) (0.025) (0.013) (0.034) table 11 shows the regression results for equation (17). the endogenous variable, designated by ϑi(t), is the mean absolute error calculated at date (t) equal to the absolute value of the difference between the theoretical and observed prices of the ith option price divided by the observed price. moneynessi(t), τi(t), spreadi(t) are respectively the degree of moneyness, time-to-expiration and the spread relative to the ith call observed at the date (t). the moneyness is equal to (s−k.e−r.t)/k.e−r.t. the spread will be equal to the difference between the bid and ask price of the option divided by its mid-price. ε is the residual term. ad-hoc bs is the black-scholes model with a daily implied volatility calibration. cev model is the cox cev with a daily calibration of elasticity. kou is the jump-diffusion model of kou. the regression is performed for each of the three models using all 7, 151 nasdaq 100 calls which constitute our sample. the sample period spans 2007. the coefficient estimates appear in the first line for all three models. figures in parentheses are standard deviations of the estimates. ***to mean that the estimate is significant to the 1% error. **to indicate that it is significant to the 5% error. source: authors. cev: constant elasticity variance, bs: black–scholes, sp 500: standard and poor 500 abbasi, et al.: kou jump diffusion model: an application to the sp 500, nasdaq 100 and russell 2000 index options international journal of economics and financial issues | vol 6 • issue 4 • 2016 1929 we also notice that the kou model provided better results for the nasdaq 100 and russell 2000 index options than for the sp 500 ones, despite the fact that empirical analysis has focused on the same period. this improvement has its origin in the very nature of each of the three indexes. thus the nasdaq 100 is much less diversified than the sp 500 while the russell 2000 is composed of small cap stocks. these effects of both “diversification” and “size” mean that the nasdaq 100 and russell 2000 have a much more unstable volatility than that of the sp 500. in other words, these two indexes have a greater probability for the realization of extreme values that is consistent with the assumptions of jumpdiffusion models. references bakshi, g., cao, c., chen, z. (1997), empirical performance of alternative option pricing models. journal of finance, 52, 2003-2049. barberis, n., shleifer, a., vishny, r. (1998), a model of investor sentiment. journal of financial economics, 49, 307-343. bates, d.s. (1996a), dollar jump fears, 1984-1992: distributional abnormalities implied in currency futures options. journal of international money and finance, 15, 65-93. bates, d.s. (1996b), jumps and stochastic volatility: exchange rate process implicit in phlx deutshemark options. review of financial studies, 9, 69-107. bates, d.s. (2000), post-’87 crash fears in the s&p 500 futures option market. journal of econometrics, 94, 181-238. bates, d.s. (2003), empirical option pricing: a retrospection. journal of econometrics, 116, 387-404. berkowitz, j. (2001), getting the right option price with the wrong model. university of california (irvine) working paper. black, f. (1976), studies of stock price volatility changes. proceedings of the 1976 meetings of the american statistical association. p177-181. black, f., scholes, m. (1973), the pricing of options and corporate liabilities. journal of political economy, 81, 637-659. byrd, r.h., gilbert, j.c., nocedal, j. (2000), a trust region method based on interior point techniques for nonlinear programming. mathematical programming, 89, 149-185. cox, j.c. (1996), the constant elasticity of variance option pricing model. the journal of portfolio management, 23, 15-17. cox, j.c., ross, s.a. (1975), the valuation of options for alternative stochastic processes. journal of financial economics, 3, 145-166. derman, e., kani, i. (1994), the volatility smile and its implied tree. quantitaive strategies research notes goldman sachs. duffie, d., pan, j., singleton, k.j. (2000), transform analysis and asset pricing for affine jump-diffusions. econometrica, 68, 1343-1376. dumas, b., fleming, j., whaley, r.e. (1998), implied volatility functions: empirical tests. journal of finance, 53, 2059-2106. dupire, b. (1994), pricing with a smile. risk, 7, 18-20. fama, e. (1998), market efficiency, long-term returns, and behavioral finance. journal of financial economics, 49, 283-306. heston, s. (1993), a closed-form solution for options with stochastic volatility with applications to bond and currency options. the review of financial studies, 6, 327-343. heston, s., nandi, s. (2000), a closed-form garch option valuation model. the review of financial studies, 13, 585-625. hull, j., white, a. (1987), the pricing of options on assets with stochastic volatilities. the journal of finance, 42, 281-300. jones, c.s. (2003), the dynamics of stochastic volatility. journal of econometrics, 116, 181-224. kou, s.g. (2002), a jump-diffusion model for option pricing. management science, 48, 1086-1101. maekawa, k., lee, s., morimoto, t., kawai, k. (2008), jump diffusion model with application to the japanese stock market. mathematics and computers in simulation, 78, 223-236. merton, r.c. (1976), option pricing when underlying stock returns are discontinuous. journal of financial economics, 3, 125-144. nandi, s. (1998), how important is the correlation between returns and volatility in a stochastic volatility model? empirical evidence from pricing and hedging in the s&p 500 index options. journal of banking and finance, 22, 589-610. nandi, s. (2000), asymmetric information about volatility: how does it affect implied volatility, option prices and market liquidity? review of derivatives research, 3, 215-236. skiadopoulos, g. (2000), volatility smile consistent option models: a survey. international journal of theoretical and applied finance, 4, 403-437. wiggins, j. (1987), option values under stochastic volatility: theory and empirical estimates. journal of financial economics, 19, 351-372. table 12: regression results for the russell 2000 options models parameters r2adjusted constant moneyness time spread ad-hoc bs 0.029*** −0.01 −0.292*** 1.472*** 0.575 (0.004) (0.028) (0.018) (0.023) cev 0.053*** −0.734*** −0.154*** 1.418*** 0.634 (0.004) (0.03) (0.018) (0.024) kou 0 0.039*** −0.047*** 0.436*** 0.327 (0.003) (0.013) (0.008) (0.01) the table shows the regression results for equation (17). the endogenous variable, designated by ϑi(t), is the mean absolute error calculated at date (t) equal to the absolute value of the difference between the theoretical and observed prices of the ith option price divided by the observed price. moneynessi(t), τi(t), spreadi(t) are respectively the degree of moneyness, time-to-expiration and the spread relative to the ith call observed at the date (t). the moneyness is equal to (s−k.er.t)/k.e−r.t. the spread will be equal to the difference between the bid and ask price of the option divided by its mid-price. ε is the residual term. ad-hoc bs is the black-scholes model with a daily implied volatility calibration. cev model is the cox cev with a daily calibration of elasticity. kou is the jump-diffusion model of kou. the regression is performed for each of the 3 models using all 7, 318 russell 2000 calls which constitute our sample. the sample period spans 2007. the coefficient estimates appear in the first line for all three models. figures in parentheses are standard deviations of the estimates, where ***to mean that the estimate is significant to the 1% error and **to indicate that it is significant to the 5% error. source: authors. cev: constant elasticity variance, bs: black–scholes, sp 500: standard and poor 500 tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 199-205. international journal of economics and financial issues | vol 13 • issue 1 • 2023 199 how did covid-19 affect the structural relationship between exchange rates and money supply? evidence from malawi fredrick m. banda1*, abdi-khalil edriss2 1department of business administration, malawi university of business and applied sciences (mubas), blantyre 3, malawi, 2department of agricultural and applied economics, lilongwe university of agriculture and natural resources (luanar), lilongwe, malawi. *email: fmbanda@mubas.ac.mw received: 29 september 2022 accepted: 30 december 2022 doi: https://doi.org/10.32479/ijefi.13679 abstract for countries that participate in international trade, exchange rate management is crucial as the exchange rate affects the competitiveness of the country in international trade. this affects the country’s balance of payments (bop) position and economic growth. this paper, therefore, set out to find out how covid-19 containment measures have affected the malawi kwacha-us dollar exchange rate, as well as money supply. previous studies have assessed the short-term impacts of covid-19 on the malawian economy in general, without considering how they have affected the exchange rate and money supply. this study adds to the literature by analyzing how the covid-19 containment measures have affected the exchange rate, and consequently, the money supply in malawi. the study employs the dummy variables approach and the vector error correction (vec) model to find out if there is a structural change in the exchange rate regression over time and whether that structural change in the exchange rates affects the money supply. regression results indicate that there is a structural break in the regression over time and that the malawi kwacha appreciated following the breakout of the pandemic. additionally, the results from the error correction model have indicated that the appreciation of the malawi kwacha, positively, affected the money supply in malawi. as a policy implication arising from this study, policymakers are encouraged to take advantage of the prevailing donor goodwill and ensure that the various donations received are put to good use so that the malawi kwacha should continue being relatively strong against the united states dollar. if this is not done, the malawi kwacha could, greatly, depreciate, a thing that can make the economy experience inflation thereby making people experience a lot of hardships caused by the covid-19 pandemic. keywords: endogenous, error correction model, monetarism, post-keynesian, money supply jel classification: g0 1. introduction ever since its breakout, covid-19 has brought about unspeakable illnesses and fatalities globally. covid-19 first appeared in the hubei province of china in december 2019 and has been spreading rapidly to asia, europe, and the rest of the world. it is a respiratory disease caused by the sars-cov-2 virus, a zoonotic pathogen kind of virus that is transmitted between animals and people. as an airborne infection, symptoms of covid-19 include fever, coughing, and shortness of breath. it is responsible for high death rates among people, the world over, mainly those with underlying health conditions such as diabetes, heart disease, chronic lung diseases, cardiovascular disease, and obesity. this made the world health organization (who) declare covid-19 as a pandemic on 11th march 2020. despite its breakout in december 2019, malawi recorded its first case of covid-19 on 2 april 2020, an indication that the disease took some time before reaching malawi. nevertheless, the government had already put in place some measures aimed at containing the disease even before registering the first confirmed case. for example, it declared the country a state of disaster this journal is licensed under a creative commons attribution 4.0 international license banda and edriss: how did covid-19 affect the structural relationship between exchange rates and money supply? evidence from malawi international journal of economics and financial issues | vol 13 • issue 1 • 2023200 on 21 march 2020 and immediately introduced containment measures such as banning street vending across the country, banning public gatherings such as religious gatherings, and wedding ceremonies, and closure of all schools as well as colleges. further virus containment measures included mandatory use of face masks in public places, washing hands with soap and water or use of hand sanitizers, and reporting to the nearest hospitals if one has any unusual symptoms. also, all visitors arriving in malawi from high-risk countries were asked to self-quarantine for 14 days. furthermore, the government closed its land borders and suspended all international flights except for flights involved in the transportation of goods and services deemed essential to the country. policy-wise, the government enacted some policies aimed at cushioning malawians from the effect of covid-19. for example, the governor of financial institutions agreed with the bankers association of malawi to introduce some monetary measures aimed at mitigating the impact of covid-19 on malawians as follows: (1) a 3-month moratorium on interests and principal repayments for loans by borrowers on a case by case basis, (2) restructuring, refinancing or renegotiation of loans for small and medium scale enterprises, corporate and other borrowers affected by covid-19 on a case by case basis, (3) a reduction by 40% of the fees and charges related to internet banking or mobile payments to encourage the use of electronic payment transactions, and (4) deferment of all payments of bonuses and dividends until the risk of covid-19 is under control. furthermore, the registrar of financial institutions undertook the following actions: (1) reduced the liquidity reserve requirement (lrr)1 on domestic currency deposits, thereby releasing 12 billion kwacha as additional liquidity availed to banks to directly support borrowers deemed to be distressed as a result of covid-19, (2) reduced lombard rate2 margin by 50% so as to reduce the cost of accessing funds from the central bank and enable banks to pass on the benefits to borrowers, (3) activated the emergency liquidity assistance facility and made it available to banks, (4) approved the recapitalization plan in the unlikely event of a bank breaching the capital requirement direction as a result of covid-19, and (5) granted relief to banks on the provision of restructured loans and loans on moratorium impacted by covid-19. however, much as these covid-19, containment measures sound good for the control of the negative effects of the pandemic, their effect on malawi’s macroeconomic variables, particularly exchange rates, is not known. the study focuses on the exchange rates3 because they play a very important role in an economy as they affect the relative price of domestic goods and foreign goods. for example, subject to the holding of the marshal-lerner condition4, when a country’s currency appreciates, its exports become expensive and, hence, less competitive on the international 1 this refers to the amount of funds that a commercial bank holds in reserve to ensure that it is able to meet liabilities in case of sudden withdraws. 2 this is the interest rate charged by central banks when extending short-term loans to commercial banks. 3 an exchange rate is the price of one currency expressed in terms of another currency. 4 the marshall-lerner condition states that currency devaluation will improve the trade balance if the devaluing nation’s demand elasticity for imports plus the foreign demand elasticity for the nation’s exports exceed 1. market because foreign goods become cheaper. on the other hand, when a country’s currency depreciates, its goods abroad become cheaper while foreign goods become more expensive (ogundipe et al., 2013). moreover, as pointed out by asif (2015), there is a statistically significant positive relationship between currency devaluation and money supply growth in the short run and long run. thus, since malawi actively engages in international trade, the exchange rate is a very important economic variable. movements in the exchange rate influence the decisions of individuals, businesses, and the government. consequently, this collectively affects the country’s level of economic activity, inflation, and the balance of payments. it is for this reason that management of the exchange rate is one of the key functions played by central banks of most countries. hence, there is a need to find out how covid-19 containment measures affected the exchange rates movement in malawi. however, there is scanty literature on how the containment measures of covid-19 have affected the exchange rates in malawi. it is only the international food policy institute (2020) that carried out an empirical estimation of the short-term impacts of covid-19 on the malawian economy even though it did not focus on how covid-19 affected the exchange rates in malawi. this paper, therefore, bridges this knowledge gap by, empirically, determining if there was a structural change in parameter values of money supply and exchange rates in malawi following the break out of the covid-19 pandemic. it thus poses the question: what is the effect of covid-19 containment measures on the structural relationship between money supply and exchange rate in malawi? the paper tests the following null hypotheses: (1) containment measures of covid-19 have not led to currency appreciation in malawi, and (2) containment measures of covid-19 have not led to an increase in money supply in malawi. the results from this study give a clear picture of how covid-19 containment measures have affected the relationship between some macroeconomic variables in malawi. furthermore, the study generates new knowledge that policymakers can use to further contain the disease and its economic effects in malawi as well as globally. 2. methodology 2.1. conceptual framework: a literature survey according to world bank (2020), there are four main channels of transmission of the effect of covid-19 on economic activity in sub-saharan african countries, namely: (1) disruption in trade and value chains, (2) disruption in foreign financing flows, (3) disruption of economic activity due to the wider spread of the virus leading to an increase in the number of both infected people and the fatalities, and (4) the disruptions caused by containment and mitigation measures imposed by governments and the response of the citizens. containment measures to slow the spread of the covid-19 virus have had a negative impact on various sectors of the economy globally. for instance, they have slowed global trade by reducing international travel and disrupting global value chains (world bank, 2020). official quarantines interrupted the free flow of people and goods, while precautionary behaviors (such as flight banda and edriss: how did covid-19 affect the structural relationship between exchange rates and money supply? evidence from malawi international journal of economics and financial issues | vol 13 • issue 1 • 2023 201 cancellations) by consumers and firms, and restrictions imposed by governments have reduced travel and tourism (world bank, 2020). furthermore, tighter border controls and production delays also disrupted the tightly-linked system of global value chains such that factories around the world slowed or halted production due to shortages of intermediate inputs from china and elsewhere (atkenson, 2020). in malawi, the estimated short-term impacts of covid-19 on the economy included the decline of gdp by around 11.6% between april and may, and between 4% and 5.2% over the 2020 calendar year thereby making around 1.1 million people fall into poverty temporarily (international food policy research institute, 2020). similarly, in their study, benzid and chebbi (2020) found that due to the plummeting commodity prices, exchange rates of key emerging market economies such as brazil, mexico, and south africa dropped substantially due to the emergence of covid-19. furthermore, the study found as the emerging market economies were experiencing currency depreciation, the currencies of advanced economies, particularly the united states dollar, had generally strengthened over the same period (oecd, 2020). eichenbaum et al., (2020) found that in an effort to reduce the chances of being infected by covid-19, people cut back on consumption and work. furthermore, they found that even though the decisions to reduce consumption and work tend to minimize the severity of the pandemic, they tend to exacerbate the size of the associated recession. 2.2. theoretical framework and empirical strategy the analysis of the relationship between money supply and exchange rates is based on two theories of the determination of money supply, namely monetarism and post-keynesian (nayan et al., 2013). monetarism theory is premised on the fact that money supply equals the money multiplier times the monetary base. since the central bank can change the monetary base, it can also control the supply of money in the economy. thus, according to the monetarist theory, the money supply is determined exogenously by the central bank (nayan et al., 2013). this means that the money supply is not determined by other variables existing in the economy implying that the money supply curve is vertical at a given level of national output, hence, perfectly inelastic (niggle, 1991). on the other hand, the post-keynesian view holds that money supply is determined, endogenously, by changes in the level of economic activity which affects people’s desire to hold currency relative to deposits, and the rate of interest (nayan et al., 2013). this, in particular, works through the monetary base which is the amount of cash, made up of currency in circulation and central bank reserves, circulating in an economy. key variables that can determine the monetary base are the market interest rates, excess reserve ratio, the required reserve ratio, and the exchange rates (mishkin, 2004). according to mishkin (2004), the relationship between money supply and exchange rates emanates from the fact that when central banks intervene in the foreign exchange market, they acquire or sell off international reserves thereby affecting their monetary base. however, there are different views regarding the effect of currency appreciation on the money supply, namely the traditional view and the new structuralism. the traditional view posits that, if the marshal-lerner condition holds, the depreciation of domestic currency encourages exports and discourages imports thereby increasing an economy’s competitiveness, a thing that leads to an increase in exports and a decrease in imports of the country. after some time period, the competitiveness of the economy leads to the emergence of a trade surplus which leads to an increase in foreign exchange reserves (auer, 2015; ogundipe et al., 2013). consequently, the domestic economy experiences a rise in the stock of money which causes an increase in the aggregate demand and in the price level. on the other hand, the new structuralism school stresses that currency depreciation can only lead to an increase in the money supply in the economy if and only if the marshal-lerner condition is satisfied. this means that if the marshall-lerner condition is not satisfied, a country’s currency devaluation can lead to a reduction in money supply, and hence become contractionary (krugman, 1978). currency depreciation negatively affects the monetary base thereby leading to a decline in money growth (mishkin, 2004). thus, the effect of exchange rate movement on money supply growth is not clear-cut. it depends on the existence of the marshall-lerner condition. this paper, firstly, determines if following the outbreak of covid-19, there has been a depreciation of the kwacha-dollar exchange rate, and, secondly, how that depreciation has affected the money supply in malawi. it focuses on the kwacha-us dollar exchange rate because the us dollar is a very important currency used widely in international trade so much so that it is referred to as the vehicle currency. by definition, currency depreciation is a decrease in the value of a country’s currency relative to other currencies. if for example, the kwacha-us dollar exchange rate is given by 744.44, it means that one us dollar is valued at 744.44 kwacha. if the exchange rate rises to 750.43, it implies that the kwacha has depreciated while the dollar has appreciated. thus, as one currency depreciates the other currency appreciates. the following model was used: er t dumt t� � � �� � � �0 1 2 t (1) where: ert = exchange rate at time t; β0= constant; β1 and β2 = slope coefficients; t = time period in months dumt = dummy variable which is equal to 1 for time period after december 20195, and 0 otherwise, εt = the error term. after finding out what happened to the kwacha-dollar exchange rate following the outbreak of the pandemic, the study now explored how the pandemic has affected the relationship between money supply and exchange rate. to achieve the foregoing, the study used the vector error correction (vec) model to determine if there exists a dynamic interrelationship between money supply and the kwacha-dollar exchange rate in malawi. 5 the covid-19 was discovered in december 2019. the study therefore expects a structural break in the money supply-exchange rate relationship following the outbreak of the disease in december, 2019. banda and edriss: how did covid-19 affect the structural relationship between exchange rates and money supply? evidence from malawi international journal of economics and financial issues | vol 13 • issue 1 • 2023202 2.3. data and estimation methods this study used quantitative data collected from various issues of the monthly economic reviews published by the reserve bank of malawi (rbm) covering the period january 2018 to september 2020. it, firstly, employs the dummy variable approach to determine if there has been a structural change in the exchange rate following the outbreak of the pandemic. secondly, it uses engle-granger test of cointegration and the vec to establish if there exists a relationship between exchange rate and money supply. table 1 presents the definition and measurement of the variables used in the regression analyses. 2.3.1. estimation of the structural change of the exchange rate since covid-19 emerged in december 2019, the study finds out if the values of the model remained the same through the entire period or there was a change in the values following the emergence of the disease. literature suggests that the structural stability of a regression model can be examined by using either the chow test or the dummy variable approach (gujarati, 2004). however, the dummy variable approach is superior to the chow test in the sense that it is able to show whether the difference in the two regressions was because of the differences in the intercept terms, or the slope coefficients, or both, something that the chow test cannot show (gujarati, 2004). it is due to the foregoing reason that this study employed the dummy variable approach. furthermore, the study used the durbin-watson d statistic to test for the presence of autocorrelation in the regression model, and it found a durbin-watson d statistic of 1.0251 < 2 suggesting the presence of positive autocorrelation. as a remedy for this, the generalized least squares (gls) method was applied. the advantage of the gls method is that, in addition to correcting for autocorrelation, it also corrects for the presence of heteroscedasticity in the regression model (gujarati, 2004). 2.3.2. empirical estimation of the relationship between money supply and exchange rate literature provides a number of methods for testing the relationship and causality between variables. this study, however, employed the vector error correction (vec) model to test the existence of causality between money supply and the exchange rate. as a prerequisite to testing for cointegration6 and causality, there is need to establish the stationarity properties of the variables of interest. to do this, the study adopted the augmented dickey fuller (adf) and phillips-perron (pp) tests for unit root. 2.3.3. model specifications 2.3.3.1. augmented dickey fuller test (adf) the adf test for a variable yt, involves estimating the following regression equation: � � � � � � �� � ��y t y yt t i m i t i t� � � � �1 2 1 1 (2) where: ∆yt shows the lagged differences of the variable of interest, εt is a pure white noise error term which is iidn (0, σ 2) 6 cointegration refers to the co-movement of two or more time series data so that in the long-run there is a constant linear combination between or among the series. 2.3.3.2. engle-granger causality (eg) and vec model the engle-granger causality test applies the adf test to the residuals obtained from the following regression assuming two variables x and y: y xt t t� � �� � �0 1 (3) where: α’ s are the parameter coefficients to be estimated, and if stationarity is established in the residuals from equation (3), the two variables will be deemed cointegrated. thus, the variables could still be in disequilibrium in the short run even if they are cointegrated in the long run (gujarati, 2004). 3. empirical results 3.1. descriptive statistics descriptive statistics for the variables used in the study are presented in table 2. as shown in table 2, the mean money supply is mk1218.315 billion and its median is mk 1215.6 billion. on the other hand, the mean and median for exchange rate are 733.4553 and 733.159, respectively. regarding standard deviation, money supply has a standard deviation of mk111.0864 billion while exchange rate has a standard deviation of 9.4467. this implies that money supply has a larger dispersion relative to its mean than exchange rate. furthermore, the table shows that the minimum and maximum values for money supply are mk1021 billion and mk1400 billion, respectively. on the other hand, the minimum value for exchange rate is 723.425 while its maximum is 763.998. the correlation between the two variables are presented in table 3. table 2: descriptive statistics variable mean median standard deviation minimum maximum ms (mk’ billion) 1218.315 1215.6 111.0864 1021 1400 er 733.4553 733.159 9.4467 723.425 763.998 table 3: correlation between the variables variable money supply exchange rate money supply 1.0000 exchange rate 0.6502 (0.0000)*** 1.0000 ***significant at 1% level of significance table 1: definition and measurement of the variables no variable definition and measurement 1 money supply (ms) (mk’ billion) based on m1; a measure of money that includes currency, traveler’s checks, and demand deposits 2 exchange rate (er) the price of one country’s currency in terms of another’s. here, we use the kwacha-us dollar exchange rate banda and edriss: how did covid-19 affect the structural relationship between exchange rates and money supply? evidence from malawi international journal of economics and financial issues | vol 13 • issue 1 • 2023 203 as shown in table 3, there is a positive significant correlation between exchange rate and money supply (p = 0.0000 < 0.01). regression results are presented in table 4. table 4 shows that the constant is positive and statistically significant (p = 0.000 < 0.01). similarly, the coefficient of the time variable is positive and statistically significant (p = 0.000 < 0.01). furthermore, the coefficient of dummy variable is negative and statistically significant (p = 0.088 < 0.1). therefore, using table 4, the regression output can be presented as follows: the general equation: er t dumt t� � �� � �0 1 2 (4a) the expected values for the two periods is given by: for the pre-covid-19 period: e( / )er dum tt t � � �0 0 1� � (4b) for the post-covid-19 period: e( / )er dum t dumt t t� � � �1 0 1 2� � � (4c) thus, using the values from table 4, the regression output is presented as follows: for the pre-covid-19 period: er tt � � �720 403 0 8893. . (5a) for the post-covid-19 period: er tt � � �712 8309 0 88093. . (5b) equation (5b) indicates that as time progresses, the us dollar has been depreciating while the malawi kwacha has been appreciating. since the coefficient of the dummy variable is negative and statistically significant it suggests that there has been a structural change in the exchange rate following the outbreak of covid-19 which was reflected in the appreciation of the malawi kwacha-us dollar exchange rate. having found that following the advent of covid-19 pandemic the malawi kwacha has appreciated against the united states dollar, the study then used the vec to estimate how that appreciation has affected the supply of money in the economy, keeping other things constant. 3.2. results of the unit root tests before conducting the vec regression analysis the study carried out unit root tests using both the adf and pp tests for stationarity whose results are presented in table 5. table 5 indicates that using both the adf and pp tests, money supply is non-stationary in levels (p = 0.8043 > 0.1) and (p = 0.1541 > 0.1), respectively. the study, therefore, fails to reject the null hypothesis of non-stationarity. however, after taking the first differences, money supply becomes stationary. this is confirmed by the p-values for both adf and the pp, which are 0.0000 < 0.01 in both cases. hence, the study rejects the null hypothesis of non-stationarity. furthermore, table 5 shows that the exchange rate is nonstationary, in levels, using both the adf test and the pp test as the p-values are 0.1541 > 0.1 and 0.2193 > 0.1, respectively. on the other hand, after first differencing, both the adf and pp tests indicate that the kwacha-dollar exchange rate becomes stationary. this is evidenced by the p-values of 0.0000 < 0.001 for both adf and pp test statistics. the study, therefore, rejects the null hypothesis of non-stationarity. therefore, the variables are now stationary and integrated of order 1. after finding that both money supply and exchange rate are integrated of order 1, the study then proceeded to test if there exists cointegration between money supply and exchange rate. the cointegrating equation, estimated by using ols, is given by: mst=ert + εt (6) table 4: regression output on the effect of covid-19 on the structural change of the kwacha-dollar exchange rate dependent variable: exchange rate variable coefficient standard error z-statistic p-value constant 720.403 2.9886 4.28 0.000*** t 0.8893 0.2079 −1.70 0.000*** dumt −7.5721 4.4447 −1.73 0.088* log likelihood = −110.5407. *significant at 10% level of significance. *** significant at 1% level of significance table 5: results for the adf and pp unit root tests variable augmented dickey fuller (adf) test phillips-peron test (pp test) money supply significance level critical values critical values level first differences level first differences 1% −3.709 −3.716 −3.702 −3.709 5% −2.983 −2.986 −2.980 −2.983 10% −2.623 −2.624 −2.622 −2.623 test statistic −0.849 −4.731 −0.683 −5.717 mackinnon p value for z (t) 0.8043 0.0001 0.8511 0.0000 exchange rate critical values critical values significance level level first differences level first differences 1% −3.709 −3.716 −3.702 −3.709 5% −2.983 −2.986 −2.980 −2.983 10% −2.623 −2.624 −2.622 −2.623 test statistic −2.357 −5.363 −2.165 −5.072 mackinnon p-value for z (t) 0.1541 0.0000 0.2193 0.0000 banda and edriss: how did covid-19 affect the structural relationship between exchange rates and money supply? evidence from malawi international journal of economics and financial issues | vol 13 • issue 1 • 2023204 results are presented in table 6. table 6, shows that exchange rate is significantly influencing money supply in malawi (p = 0.000 < 0.01). this, therefore, implies that the error term in equation 6 can be treated as an equilibrium error which is used to tie the short-run behaviour of money supply to its long-run value. consequently, using the granger-representation theorem7, the study employed the error correction model (ecm) to estimate the relationship between money supply and exchange rate. the following regression equations were used: � � � � � � � � � � � � � � � �� �ms er ms ectt i k i t i j k j t j t t� � � � �0 1 1 1 1 1 1 1 (7a) � � � � � � � � � � � � � � � �� �er er ms ectt i k i t i j k j t j t t� � � � �0 1 1 1 1 2 1 2 (7b) where: k-1= the lag length reduced by 1, βi and δj = short-run dynamic coefficients of the model’s adjustment to long-run equilibrium, λi = speed of adjustment parameter. to ensure convergence to longrun equilibrium, λi must always be negative, ectt-1 = the error correction term. it is the lagged value of the residuals obtained from the cointegrating regression of the dependent variable on the regressors. it contains long-run information derived from the long-run cointegrating relationship. the results of the long-run equation, also known as the johansen normalization restriction, are presented in table 7. as indicated in table 7, the error correction term is statistically significant at one percent level of significance as its chi-squared statistic has a p-value of 0.000 < 0.01. this, therefore, suggests that there exists a long run relationship between money supply and the exchange rate in malawi. furthermore, coefficient of exchange rate is negative and statistically significant at one percent level of significance (p-value = 0.000 < 0.01). this indicates that exchange rate has a positive8 effect on money supply in malawi. this, therefore, implies that following the outbreak of covid-19, the malawi kwacha appreciated which, as a result, endogenously led to the increase in money supply in malawi. this finding conforms to the post-keynesian view which posits that money supply is determined, endogenously, by the changes in the level of economic activity (nayan et al., 2013). 3.3. discussion of results this study has found that there was a structural break in the money supply-exchange rate relationship in malawi following the outbreak of the covid-19 pandemic. this structural change is in such a way that both the intercept term and the slope coefficients 7 according to the granger-representation theorem, if two variables are cointegrated, then their relationship can be expressed as error correction model (gujarati, 2004). 8 when interpreting results from the error correction term the signs are reversed. of the regression model changed. also, the study found that the malawi kwacha weakly appreciated against the us dollar amidst the pandemic. a possible explanation for this currency appreciation could be the fact that the country did receive foreign aid aimed at easing people’s suffering due to the covid-19 pandemic. for instance, from among its various donors, malawi received a donation of us$37 million as support for covid-19 response. the imf donated us$91 million under the rapid credit facility to help malawi meet the urgent balance of payment (bop) needs stemming from the covid-19 pandemic. additionally, on 25 april, 2020, malawi alongside other 25 countries, received an immediate debt relief from the imf which enabled the country save around k7.2 billion meant for debt servicing. and, again, in april, 2020, the world bank donated us$37 million as support for covid-19 response (world bank, 2020). cumulatively, these interventions had an effect of making currency appreciate since foreign aid leads to domestic currency appreciation in developing countries (paldam, 1997; rajan and subramanian, 2009). furthermore, the study has found that the currency appreciation positively affected money supply since money supply responds to changes in exchange rate in malawi. implications arising from this study is that policy makers in malawi needed to take advantage of the prevailing donor goodwill to ensure that the donations were put to good use so as to continue insulating the economy from negative shocks resulting from the covid-19 pandemic and its containment measures. for example, there is a possibility that following the appreciation of the malawi kwacha, there can be an increase in money supply which can lead to inflation. 4. conclusion this study set out to investigate whether covid-19 pandemic has brought about a structural change in the money supply-exchange rate relationship in malawi using the dummy variable approach and the vec model. the findings have revealed that there has been a structural change in the money supply-exchange rate relationship following the outbreak of covid-19 pandemic. furthermore, it has shown that the kwacha did appreciate following the outbreak of the pandemic, a thing that positively affected money supply in malawi. one possible explanation for kwacha appreciation table 6: results of cointegrating equation dependent variable: money supply variable coefficient standard error t-statistic p-value exchange rate 1.6620 0.0241 -68.94 0.000*** f-statistic=4752.92 r-squared=0.9933 prob>f = 0.0000 adj. r-squared=0.9931 ***significant at 1% level of significance table 7: results of the error correction model error correction term parms chi2 p>chi2 ectt-1 1 23.328 0.000 dependent variable: money supply variable coefficient standard error z-statistic p-value exchange rate −17.8279 3.6911 −4.83 0.000 banda and edriss: how did covid-19 affect the structural relationship between exchange rates and money supply? evidence from malawi international journal of economics and financial issues | vol 13 • issue 1 • 2023 205 lies in the fact that the country received foreign aid aimed at cushioning people from the effects of the pandemic. it is possible that it is the foreign aid which made the kwacha undergo currency appreciation. policy makers are therefore encouraged to take advantage of the donor goodwill to ensure that the funds received are put to good use so as to continue insulating people from the devastating effects of the covid-19 pandemic. references asif, m. (2015), devaluation and its impact on money supply growth. journal of social and organizational analysis. 1(2), 60-64. atkeson, a. (2020), what will be the economic impact of covid-19 in the us? rough estimates of disease scenarios. massachusetts: national bureau of economic research. working paper 26867. auer, a. (2015), exchange rate pass-through, domestic competition, and inflation: evidence from the 2005-08 revaluation of the renminbi. journal of money credit and banking, 47(8), 1617-1650. benzid, l., chebbi, k. (2020), the impact of covid-19 on exchange rate volatility: evidence through garch model. ssrn electronic journal. available at ssrn: https://ssrn.com/abstract=3612141 eichenbaum, m.s., rebelo, s., trabandt, m. (2020), the macroeconomics of epidemics. massachusetts: national bureau of economic research, working paper 26882. gujarati, d. (2004), basic econometrics. new york: mcgraw-hill companies. international food policy research institute. (2020), short-term impacts of covid-19 on the malawian economy: initial results. available from:  https:// doi.org/10.2499/p15738coll2.133788 [last accessed on 2023 jan 12]. krugman, p. (1978), contractionary effects of devaluation. journal of international economics, 8(3), 445-456. mishkin, f.s. (2004), economics of money, banking, and financial markets. united states of america: pearson addison. nayan, s., kadir, n., abdullah, m., ahmad, m. (2013), post keynesian endogeneity of money supply: panel evidence. germany: university library of munich, mpra paper 48716. niggle, c. (1991), the endogenous money supply theory: an institutionalist appraisal. journal of economic issues, 25(1), 137-151. oecd. (2020), covid-19 and global capital flows. available from: https://www.oecd.org/coronavirus/policy-responses/covid-19-andglobal-capital-flows-2dc69002 [last accessed on 2022 jan 12]. ogundipe, a.a., ojeaga, p., ogundipe, o.m. (2013), estimating the long run effects of exchange rate devaluation on the trade balance of nigeria. european journal of scientific research, 9(25), 233-249. paldam, m. (1997), the micro efficiency of danish development aid. working paper 1997-13, available from: https://ssrn.com/ abstract=64412. rajan, r., subramanian, a. (2011), aid, dutch disease, and manufacturing growth. the journal of development economics, 94(1), 106-118. world bank. (2020), assessing the economic impact of covid-19 and policy responses in sub-saharan africa. in: africa’s pulse. united states: world bank. p21. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(special issue) 207-214. 2nd afap international conference on entrepreneurship and business management (aicebm 2015), 10-11 january 2015, universiti teknologi malaysia, kuala lumpur, malaysia. international journal of economics and financial issues | vol 5 • special issue • 2015 207 a new business process and outcome oriented corporate social responsibility index for islamic banking abdullah rajeh ali alamer1*, hussin bin salamon2, muhammad imran qureshi3, amran md. rasli4 1faculty of management, universiti teknologi malaysia, skudai 81310, johor, malaysia, 2faculty of islamic civilization, universiti teknologi malaysia, skudai 81310, johor, malaysia, 3faculty of management, universiti teknologi malaysia, skudai 81310, johor, malaysia, 4faculty of management, universiti teknologi malaysia, skudai 81310, johor, malaysia. *email: raaabdullah2@live.utm.my abstract this article has answered on two questions; what the process-outcome weight ratio for oriented outcome should be? the second question is: what are the items would be reflected elements under dimensions of both sides? in logic thinking, the used corporate social responsibility (csr) dimensions of islamic banks (ibs) have different impacts on the society as result for that these dimensions should be different. there still is very lack in using appropriate weights of dimensions to measure of csr in ib. by redistribution of the dimensions to two types; business process dimensions (bpds) and oriented outcome dimensions (oods) then give each type specific weight to suit their consequence on the csr’s level in ibs. from 115 items, 23 sub-dimensions, and 7 dimensions that have taken from 18 articles since 2005 until 2013, this article has selected 16 items, 9 sub-dimensions, and 5 dimensions. only mohammed et al. (2008) built an index has different weights of the csr’s dimensions based on several academic experts in ib. the dimensions’ weights has been calculated based on weights of mohammed et al (2008) in which ratio of bpds and oods has been 54 and 46 respectively. keywords: corporate social responsibility, business process, oriented outcome dimensions jel classifications: k40 1. introduction 1.1. index development illustrated the discussion of the previous units gives us the understanding that, from an islamic argument of view, how ethically and responsibly an organization performs its corporate functions is more important than how it employs its earning. this being so, corporate social responsibility (csr) measures relating to essential business practices warrant more weight than the outcome-oriented measures or the measures not related to the essential processes. while it is conceptually justified that more weight be given to the process measures, at least two important questions need answers for illustrating the index development. the first question is: how much more? should the process-outcome weight ratio be 80/20, 70/30, 60/40, or something else? how is it decided? the second question is: what are the elements would be reflected items under dimensions of business process? before continuing to addressing these questions, we need to clarify that what follows is an illustration of how we do to develop a differentially weighted csr index for islamic banks (ibs). 1.2. weights ratio of processes and outcomes dimensions although in a span of almost one decade (2005-2013), many researchers studied social responsibility of ibs using many measures, effort to assign different weights to dimension and items of csr measures is originate only in one case. out of 18 sources listed, 11 sources used accounting and auditing organization for islamic financial institutions (aaoifi’s) index, the ethical identity index (eii), or variants of these, where all items of measurement established equal weight. based on literature review and in-depth expert interviews, yusuf and bahari (2011) and alamer, et al.: a new business process and outcome oriented corporate social responsibility index for islamic banking international journal of economics and financial issues | vol 5 • special issue • 2015208 nazir et al. (2014) recognized 34 csr measurement items under six basic criteria. it looks their items have different weights, but actually they do not. items were rated on a 10-point scale from five experts and an average score was calculated for each item to decide whether the item was important enough to be included under a particular standard for csr measurement. based on maqasid framework, mohammed et al. (2008) and rasli et al. (2014) developed performance measures of ibs. their maqasid index is created on 10 elements under three objectives that were allocated differential weights as shown in table 1. the distribution of weights to 3 objectives and 10 elements suggest us significant clues to ascertaining a preliminary process-outcome weights ratio of 54:46. the table 2 shows how we arrived at this preliminary ratio. the calculation in it shows a process-outcome ratio of 53.85:46.15 that has been rounded to 54:46. 1.3. items selection and their weights allocation as mentioned earlier, the second question for the development of the index is what items are to be included in the index. for this purpose, from the 18 articles stated, a compilation of 110 items belonging to 9 dimensions and 28 sub-dimensions has been made (all measurements of csr in ibs from related published literature are attached in appendix a). as a technique of illustration, nine items have been chosen under business process dimensions (bpds) which fall under three dimensions and four sub-dimensions. similarly, seven items have been selected under oriented outcome dimensions (oods) that belong to two dimensions and five subdimensions. all these selections are shown in table 3. the notes below table 3 temporarily describe how actual selection will be made and various weights will be allocated. 2. discussion some authors (e.g., sairally, 2005; farook et al. 2011) recognized expectations of the stakeholders of ibs based on the experience of the conventional literature of csr, in spite of wood’s (2010) recommendation of deliberate incorporation of research and delving into other domains of csr literature. others (mohammed et al., 2008; yusuf and bahari, 2011) have collected csr dimensions from ibs’ literature through studying islamic principles and law without paying more attention to the source of action. the csr actions come from the core business of ibs or from external activities. usmani (2002) stated that, according to islamic principles, business transactions could never be separated from the moral targets of a society. woermann (2013) argued that increasing emphasis on entering csr into the core business approach is a tool for companies to meet their csr obligations. as a result, this paper is relevant and a worthy contribution because it uses dimensions divided into two parts, that is, dimensions from core business transactions and from oriented activities. the structure of the index is like the structure of a real business, in which there are two parts: the business process and the oriented outcomes. table 1: average weights for three objectives/10 elements given by shari’ah experts objectives average weight (out of 100%) elements average weight (out of 100%) o1. education (tahdhib al-fard) 30 e1. education grants/donations 24 e2. research 27 e3. training 26 e4. publicity 23 total 100 o2. justice (al-adl) 41 e5. fair returns 30 e6. fair price 32 e7. interest-free product 38 total 100 o3. welfare (al-maslahah) 29 e8. bank’s profit ratios 33 e9. personal income transfers 30 e10. investment ratios in real sector 37 total 100 total 100 source: mohammed et al. (2008) table 2: ascertaining preliminary weights ratio for process measures/outcome measures objectives (average weights) elements classified process-based calculation of weights* output-oriented calculation of weights* o1. education (30) e1. education grants/donations 30×0.24=7.2 e2. research 30×0.27=8.1 e3. training 30×0.26=7.8 e4. publicity 30×0.23=6.9 o2. justice (41) e5. fair returns 41×0.30=12.3 e6. fair price 41×0.32=13.12 e7. interest-free product 41×0.38=15.58 o3. welfare (29) e8. bank’s profit ratios 29×0.33=9.57 e9. personal income transfers 29×0.30=8.7 e10. investment ratios in real sector 29×0.37=10.73 process total 53.85 outcome total 46.15 *weight of objective ×% weight of element alamer, et al.: a new business process and outcome oriented corporate social responsibility index for islamic banking international journal of economics and financial issues | vol 5 • special issue • 2015 209 this structure of the measures index is considered a contribution to csr and the ib field. one should see to the long-term impacts through ib products and investments by using macroeconomic and ms, and incorporate that in measuring csr in ibs. siddiqi (2006) argued that ibs should not look at the microeconomic targets of their investments to arrive at current targeted profits. instead, they must look at the long-term benefits and the positive consequences for the community and economy. farook et al. (2011) and yusof et al. (2010) stated that equity finance is in line with goals of islam maqasid shari’ah, specifically justice, good economic impacts and social equality. however, farook et al. (2011) and yusof et al. (2010) argued that using debt as an investment tool has failed and is one of the major causes of the global financial crisis. they and other researchers stated that ibs should increase their share in equity finance. malik et al. (2011) concluded that it is crucial to remember that the purpose of islamic finance practitioners is not to “replicate” conventional finance products in an islamic way at all times, but rather to create new financial ideas or products which appeal to ibs and investors, even if this means slower growth than islamisation. musharakah financing and equity investment are included as new measurements in the index to measure csr in ibs (table 3). the major contribution of this paper is its use of different weights based on the impact and importance of every dimension. indexes are used to measure the csr disclosure in ibs, including aaoifi’s index, the eii (haniffa and hudaib, 2007; hassan and harahap, 2010; zubairu et al., 2012; rashid et al., 2013; and kamla and rammal, 2013). maali et al. (2006); aribi and gao (2010); abbasi et al. (2012); and farook et al. (2011) used a disclosure index approach. 3. conclusion the paper attempted to explain the need for having an ib csr measurement index, which allocates more weight to the processbased measures than to outcome-oriented measures. references abbasi, t.h., kausar, a., ashiq, h., inam, h., nasar, h., amjad, r. (2012), corporate social responsibility disclosure: a comparison between islamic and conventional financial institutions in bahawalpur region. research journal of finance and accounting, 3(3), 51-62. aribi, z.a., gao, s. (2010), corporate social responsibility disclosure: a comparison between islamic and conventional financial institutions. journal of financial reporting and accounting, 8(2), 72-91. dusuki, a.w., dar, h. (2005), stakeholders’ perceptions of corporate social responsibility of islamic banks: evidence from malaysian economy. paper presented at the 6th international conference on islamic economics and finance, islamic economics and banking in the 21st century, jakarta, indonesia. el mousaid, f., boutti, r. (2012), relationship between corporate social responsibility and financial performance in islamic banking. research journal of finance and accounting, 3(10), 93-103. farook, s., hassan, m.k., lanis, r. (2011), determinants of corporate social responsibility disclosure: the case of islamic banks. journal of islamic accounting and business research, 2(2), 114-141. haniffa, r., hudaib, m. (2007), exploring the ethical identity of islamic banks via communication in annual reports. journal of business ethics, 76(1), 97-116. hassan, a., harahap, s.s. (2010), exploring corporate social responsibility disclosure: the case of islamic banks. international journal of islamic and middle eastern finance and management, 3(3), 203-227. kamla, r., rammal, h.g. (2013), social reporting by islamic banks: table 3: developed index for differentiated dimensions to measure csr of ibs weights dimensions** weights* sub-dimension weights* measurements items** weights* process (54) investment 50 empowerment of communities 100 m1: equity investment/total investment 20 m2: musharakah investment/total investment 20 m3: financing to poor families and small businesses 20 m4: investment in deprived areas 20 m5: selecting companies that represent industries of the future 20 r&d 25 advancement of knowledge 100 m6: research expense/total expense 100 hr 25 investing in education and training 50 m7: educational grant/total income ratio 50 m8: training expense/total expense 50 justice 50 m9: fairness in terms of wages, working hours 100 process total 100 outcome (46) social activities and sharing 70 supporting charities 50 m10: zakat/net income 50 m11: amount of sadaqah 50 playing the role of welfare without looking for profitability 25 m12: amount of qardh hassan 50 m13: interest-free income/total income 50 fair returns 25 m14: net profit/total asset 100 environment 30 in work place 50 m15: energy conservation 100 protecting the environment 50 m16: undertake initiative to promote environmental responsibility 100 outcome total overall *these weights are arbitrarily assigned for illustrative purposes. for actual development of the index, preliminary weights will be decided and justified based on literature review, which will then be validated through a panel of experts using online delphi techniques. **measurement items and dimensions will be judiciously selected to reflect and capture the notion of process and outcome and the selection will be subsequently validated by the same procedure as mentioned above. csr: corporate social responsibility, ib: islamic bank alamer, et al.: a new business process and outcome oriented corporate social responsibility index for islamic banking international journal of economics and financial issues | vol 5 • special issue • 2015210 does social justice matter? accounting, auditing and accountability journal, 26(6), 911-945. maali, b., casson, p., napier, c. (2006), social reporting by islamic banks. abacus, 42(2), 266-289. malik, m.s., malik, a., mustafa, w. (2011), controversies that make islamic banking controversial: an analysis of issues and challenges. american journal of social and management sciences, 2(1), 41-46. mohammed, m.o., abdul razak, d., taib, f.m. (2008), the performance measures of islamic banking based on the maqasid framework. paper presented at the iv iium international accounting conference (intac iv), putrajaya, malaysia. musa, m. (2011), islamic business ethics and finance: an exploratory study of islamic banks in malaysia. in 8th international conference on islamic economics and finance. p1-27. nazir, s., khan, s., jamil, r.a., mehmood, q.s. (2014), impact of customer relationship management on customer satisfaction in hoteling industry. journal of management info, 3(1), 84-98. nor, s., asutay, m. (2011), re-considering csr and sustainability identity of islamic banks in malaysia: an empirical analysis. international conference on islamic economics and finance, p1-17. rahman, a., hashim, m., bakar, f. (2010), corporate social reporting: a preliminary study of bank islam malaysia berhad (bimb). issues in social and environmental accounting, 4(1), 18-39. rashid, m., abdeljawad, i., ngalim, s.m., hassan, m.k. (2013), customer-centric corporate social responsibility: a framework for islamic banks on ethical efficiency. management research review, 36(4), 359-378. rasli, a.m., norhalim, n., kowang, t.o., qureshi, m.i. (2014), applying managerial competencies to overcome business constraints and create values evidence from small technology-based firms in malaysia. journal of management info, 3(1), 99-121. sairally, s. (2005), evaluating the “social responsibility” of islamic finance: learning from the experiences of socially responsible investment funds. in the 6th international conference on islamic economics and finance, islamic economics and banking in the 21st century, jakarta, indonesia. samina, q.s. (2012), practice of corporate social responsibility in islamic banks of bangladesh. world journal of social sciences, 2(6), 1-13. siddiqi, m.n. (2006), islamic banking and finance in theory and practice: a survey of state of the art. islamic economic studies, 13(2), 1-47. usmani, m.t. (2002), an introduction to islamic finance. the hague: kluwer law international. p111-116. woermann, m. (2013), reconsidering the meaning of corporate social responsibility. netherlands: springer. p89-123. wood, d.j. (2010), measuring corporate social performance. international journal of management reviews, 274, 50-84. yusof, e.f.e., kamal, a.a., kashoogie, j. (2010), islamic finance: debt versus equity financing in the light of maqasid al-shari’ah. banking, no. 20722. p1-19. yusuf, m.y., bahari, z. (2011), islamic corporate social responsibility in islamic banking: towards poverty alleviation. paper presented at the 8th international conference on islamic economics and finance, doha, qatar. zubairu, u.m., sakariyau, o.b., dauda, c.k. (2012), evaluation of social reporting practices of islamic banks in saudi arabia. electronic journal of business ethics and organization studies, 17(1), 41-50. alamer, et al.: a new business process and outcome oriented corporate social responsibility index for islamic banking international journal of economics and financial issues | vol 5 • special issue • 2015 211 appendix a: all measurements of csr in ibs are from the related published literature (18 articles) no. dimension no. sub-dimension no. measurements sources author/s 1 human resource 1 protecting health and safety 1 insurance and welfare for employees interviews/ respondents yusuf and bahari (2011) and musa (2011) 2 remuneration and benefits/reward for ethical behavior annual reports/ respondents rahman et al. (2010) and musa (2011) 3 place of work safe and comfortable interviews/annual reports yusuf and bahari (2011); nor and asutay (2011) 4 the standards include provisions for health and safety regulations. adhere to outlined procedures respondents dusuki and dar (2005) and musa (2011) 5 work does not exceed limits and time interviews yusuf and bahari, 2011 2 investing in education and training 6 training expense/total expense annual reports mohammed et al., 2008 7 education grant/total income annual reports mohammed et al., 2008 8 policy on education and training of employees. trained on shari’ah principles for islamic banking annual reports farook et al., 2011; maali et al., (2006) rahman et al. (2010) and musa (2011) 9 appropriately trained respondents musa (2011) 10 facilities for personal shari’ah obligations respondents musa (2011) 11 disclosure of employee including number of employees and training: shariah awareness annual reports the ethical identity index (eii). (1) 3 responsible in work 12 fulfill every contract demand interviews/ respondents yusuf and bahari, (2011) and musa (2011) 13 employee appreciation annual reports (1) + aribi and gao (2010) 14 optimal for using time and expertise interviews yusuf and bahari, 2011 15 free will interviews yusuf and bahari, 2011 16 fair competition interview yusuf and bahari, 2011 17 integrity in the work. gifts in return for favor is normal interview/ respondents yusuf and bahari (2011) and musa (2011) 18 transparency. advise one another respondents/ interviews sairally (2005); yusuf and bahari (2011) and musa (2011) 19 working in accordance with the limitations and responsibilities. avoid hurting each other interviews/ respondents yusuf and bahari (2011) and musa (2011) 20 accountability interviews yusuf and bahari (2011) 21 trust interviews/ respondents yusuf and bahari, 2011; musa (2011) 4 justice 22 the existence values of brotherhood and religious motivation interviews/ respondents yusuf and bahari (2011) and musa (2011) 23 fair in terms of wages, working hours respondents dusuki and dar (2005) and musa (2011) 24 eligible for wages interviews yusuf and bahari, 2011 25 promoting human rights. false expenses claims are normal respondents (dusuki and dar, 2005; abbasi et al., 2012) and musa (2011). 26 ensuring that the operation respects human rights respondents dusuki and dar (2005) 27 equal opportunity annual reports aribi and gao, (2010) 28 emphasize on ethical values and moral behavior respondents nor and asutay (2011); musa (2011) 29 improve the socio-economic condition of employees annual reports and other publications samina (2012) 2 good governance 5 vision and mission statement 30 commitments in operating, serving the needs of community annual reports the ethical identity index (eii). (1) 31 csr should be embedded in islamic banks’ policy respondents nor and asutay (2011) (contd...) alamer, et al.: a new business process and outcome oriented corporate social responsibility index for islamic banking international journal of economics and financial issues | vol 5 • special issue • 2015212 appendix a: (continued...) no. dimension no. sub-dimension no. measurements sources author/s 32 csr relevant to islamic banking concept respondents nor and asutay (2011) 33 engage only in permissible investment within shariah principles annual reports/ respondents the ethical identity index (eii) (1) and nor and asutay (2011) 34 regulations essential to avoid exploitation respondents musa (2011) 35 whistle-blowers not victimized and encouragement to report breach respondents musa (2011) 36 csr upholds the social justice dimension of islamic economics respondents nor and asutay (2011) 6 board members and top management 37 disclosure of names, positions websites farook et al., 2011 38 limited multiple directorships and shareholdings website the ethical identity index (eii). (1) 39 balanced board, no role duality annual reports the ethical identity index (eii). (1) 7 fair dealings 40 building long-lasting relationships with customers annual reports hassan and harahap (2010) 41 to give due importance to the ssb’s opinions annual reports hassan and harahap (2010) 42 having an audit committee annual reports the ethical identity index (eii). (1) 43 reducing the adverse impact of the investment interviews yusuf and bahari, 2011 44 bank’s assets often used for personal gain respondents musa (2011) 45 to maintain good relations with employees annual reports/ respondents hassan and harahap (2010); sairally (2005) 46 good relations with shareholders annual reports hassan and harahap (2010) 47 code of ethical conduct clearly communicated respondents musa (2011) 3 ssb: shariah supervisory board 8 ssb members and their role 48 names websites the ethical identity index (eii). (1) 49 remuneration annual reports rashid et al., 2013 50 number of meetings held annual reports the ethical identity index (eii). (1) 51 basis of examination of the documents annual reports the ethical identity index (eii). (1) 52 attestation that profits is gained lawfully annual reports the ethical identity index (eii). (1) 53 their recommendations to rectify the defects products and the actions taken by management annual reports and websites the ethical identity index (eii). (1) 54 doctorate qualification of ssb member website farook et al., 2011 55 reputable scholars and background websites farook et al., 2011 56 shariah supervisory council annual reports rahman et al., (2010) 57 number of ssb members websites farook et al. 2011 9 compliance with shari’ah 58 instrument selection/industry selection interviews/annual reports and other publications yusuf and bahari, (2011), samina (2012) 59 ex-ante and ex-post approved for new products annual reports maali et al. (2006); mosaid and boutti (2012) 60 ibi’s investment in halal products interviews/annual reports yusuf and bahari (2011); rahman et al. (2010) 61 not investing in impermissible activities respondents sairally (2005) & aaoifi 62 avoiding profit from non-halal interviews yusuf and bahari, 2011 (contd...) alamer, et al.: a new business process and outcome oriented corporate social responsibility index for islamic banking international journal of economics and financial issues | vol 5 • special issue • 2015 213 63 calculation of zakat annual reports maali et al. (2006); hassan and harahap (2010); mosaid and boutti 2012 64 revenues annual reports maali et al. (2006); hassan and harahap (2010) 65 operations annual reports rashid et al., 2013; musa (2011) 66 distribution of profit-loss, method of allocating pls with (iah) annual reports hassan and harahap (2010); mosaid and boutti (2012); aaoifi 67 selections of customers according to shariah interviews yusuf and bahari, 2011 68 unusual supervisory restrictions annual reports rahman et al. (2010) 69 screening clients and contractors annual reports and other publications samina (2012) 4 environment 10 investment and finance 70 no investment in any projects that may harm the environment use of all sources all authors except mohammed et al., 2008 11 in work place 71 educating employees to care for and treat the environment interviews yusuf and bahari, 2011 72 the use of recycled materials annual reports yusuf and bahari, 2011 73 good waste and recycle policy respondents dusuki and dar (2005) 74 energy conservation respondents: annual reports dusuki and dar (2005); mosaid and boutti (2012); nor and asutay (2011) 12 protecting the environment 75 undertake initiatives to promote environmental responsibility respondents/ annual reports, websites and other publications dusuki and dar (2005); samina (2012); rahman et al. (2010) 5 r & d 13 advancement of knowledge 76 research expense/total expense annual reports mohammed et al., 2008 77 supporting the r&d, training conducted by academics, changes in restricted investment annual reports or websites hassan and harahap (2010); aaoifi 14 innovative 78 introduce new products based on r&d of islamic concepts annual reports hassan and harahap (2010); aribi and gao, (2010); rahman et al. (2010) 6 investment 15 affordable products and services 79 bad debt/total investment annual reports mohammed et al., 2008 16 empowerment of communities 80 iah funds/shareholder funds annual reports farook et al., 2011 81 amount of financing to poor families and small businesses interviews yusuf and bahari, (2011), samina (2012) 82 financing housing construction respondents sairally (2005) 83 financing of health services respondents sairally (2005) 84 selecting companies that represent industries of the future respondents/ annual reports and other publications sairally (2005); samina (2012) 7 social activities and sharing 17 alleviate social problems 85 disclosure of debtors including amount of debts written off annual reports (1) and musa (2011) 86 without ulterior motive respondents musa (2011) 87 help solve social problems respondents dusuki and dar (2005) 18 support and help fund welfare 88 participating in social activities websites/ annual reports/ respondents all authors except mohammed et al., 2008 and yusuf and bahari, 2011 89 alliance and support with charitable organizations respondents nor and asutay (2011) and musa (2011) 90 waqf management: annual reports and other publications samina (2012) appendix a: (continued...) no. dimension no. sub-dimension no. measurements sources author/s (contd...) alamer, et al.: a new business process and outcome oriented corporate social responsibility index for islamic banking international journal of economics and financial issues | vol 5 • special issue • 2015214 appendix a: (continued...) no. dimension no. sub-dimension no. measurements sources author/s 91 the selection of investors to support the activities for social welfare interviews/annual reports and other publications yusuf and bahari (2011), samina (2012) 92 education, social donations interviews yusuf and bahari (2011) 93 sponsoring islamic educational and social events annual reports/ respondents the ethical identity index (eii). (1), nor and asutay (2011) and musa (2011) 19 supporting charities 94 sources of zakat funds annual reports/ respondents maali et al., 2006; mosaid and boutti (2012); nor and asutay (2011) 95 amount of zakat use all sources all authors except samina (2012) 96 zakat/net income annual reports mohammed et al., 2008 97 amount of sadaqah annual reports (2) 98 zakat obligation annual reports rahman et al. (2010) 99 the uses of the zakat fund annual reports/ respondents maali et al., 2006; mosaid and boutti 2012; nor and asutay (2011) 20 playing the role of welfare without looking solely for profitability 100 interest free income/total income annual reports mohammed et al., 2008 101 prevalence of ethics over profits respondents musa (2011) 102 participate in management of public affairs and participates in government social activities respondents dusuki and dar (2005) and musa (2011) 103 play a role in society, goes beyond profit maximization respondents dusuki and dar, 2005 104 policy of qardh hassan annual reports (1) 105 amount of qardh hassan: its source and use use all sources all authors 21 fair returns 106 net profit/total asset annual reports mohammed, 2008 22 achieve economic and social goals 107 numbers of female branches annual reports (1) 108 creating job opportunities annual reports (1) 109 the existence values of brotherhood interview yusuf and bahari, 2011 110 have the same opportunity interview yusuf and bahari, 2011 111 refrain lending to oppressive regime or companies violating human rights respondents dusuki and dar, 2005 112 providing grant for educational purposes or scholarship to students annual reports sairally, 2005 113 services excellent interview yusuf and bahari (2011), samina (2012) 114 avoid discrimination interview yusuf and bahari, 2011 23 make awareness of ibs 115 public expense/total expense annual reports mohammed et al., 2008 (1) six articles: (haniffa and hudaib, 2007; hassan and harahap, 2010; zubairu et al. 2012; rashid et al. 2013; and kamla and rammal, 2013; mosaid and boutti 2012). (2) eight articles (dusuki and dar 2005; yusuf and bahari 2011; farook et al. 2011; sairally, 2005; maali et al. 2006; abbasi et al. 2012; and aribi and gao 2010; samina, 2012). iah: investment account holders, ib: islamic bank, csr: corporate social responsibility, aaoifi: accounting and auditing organization for islamic financial institutions tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(3), 56-73. international journal of economics and financial issues | vol 13 • issue 3 • 202356 public policy and economic misery nexus: a comparative analysis of developed and developing world marc audi1,2,3, amjad ali2,1,4* 1abu dhabi school of management (adsm), uae, 2the european school of leadership and management (eslm), belgium, 3university paris 1 pantheon sorbonne, france, 4lahore school of accountancy and finance, university of lahore, pakistan. *email: chanamjadali@yahoo.com received: 13 october 2022 accepted: 01 april 2023 doi: https://doi.org/10.32479/ijefi.13720 abstract minimizing the level of economic misery is one of the prime objectives of all economies for the last couple of decades. it is not individuals who can themselves control it, some public policy options provide roots to minimize economic misery. this article has examined the role of public policy in determining the level of economic misery among developed and developing countries from 1987 to 2019. the empirical findings of the article show level of domestic investment, foreign debt, and government revenue are discouraging economic misery among developing countries. whereas economic development and the level of the population are encouraging economic misery among developing countries. the level of domestic investment is promoting economic misery in developed countries, but government revenue and economic development are reducing economic misery among developed countries. in the case of the whole sample analysis, the level of domestic investment and government revenues decreases the level of economic misery, but the level of population, foreign debt, and economic development depresses the economic misery. thus, it is concluded that public policy plays important role in determining economic misery both in developed and developing countries. developing countries should raise the level of domestic investment and government revenue to depress economic misery. developed countries should raise government revenue and economic development to depress economic misery. so, for the reduction of economic misery in developed and developing countries, public policy must be strengthened. keywords: public policy, economic misery, economic development jel classifications: e24, f63, j18, p24 1. introduction the literature of the last century is full of economic development theories and their implications, as the level of economic development determines the nature and conditions of economic issues related to the corporate body, business firms, trade unions, households, and individual and other decision-making bodies. economic development theories have presented a fairly adequate framework for how a government can impact different economic issues following the nature of developing and developed countries. dalton (1935) describes that public policies are a necessary part of the socioeconomic development of any economy. richardo (1821), and wicksell (1893) mention that revenue and spending by the public authorities and their adjustment need special attention from the policymakers. pigou (1929) highlights the importance of public policies while explaining the theory of taxation. keynes (1937) revolutionizes the concept, definition, and interpretation of public policies and the role of government. this is the period that was considered the emergence point of public finance, afterward, public policies have become an important tool for economic development. presently, undoubtedly, public policies have become an important determinant of the income and employment status of an economy. following the ideology established by keynes (1937), it is the this journal is licensed under a creative commons attribution 4.0 international license audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 2023 57 government that can diminish the strength of depression and raises the level of employment. when effective demand diminishes the production remains unsold which causes loss for the entrepreneurs. thus, an investor will decrease the level of investment, and as a result, the level of unemployment increases this situation set the roots of depression in the economy. during the depression, the economy needs some iron hands of the government (higgs, 2006; haberler and salerno, 2017). with the help of public policies, the government can raise the level of investment in specific and public welfare in general. so, full employment and stable inflation are impossible without the help of the government (wray, 1997). public policies have a direct and indirect impact on the macroeconomic situation of an economy. different indicators can be used to present the macroeconomic environment, but following extensive literature (cohen et al., 2014; shahbaz et al., 2016; melnyk et al., 2018; khan et al., 2019) economic misery is one of the main indicators to present the macroeconomic environment of the economy. this concept is introduced by okun (1960), he measured economic misery with the help of inflation and unemployment. inflation and unemployment are two crucial indicators for an economy, in the present era, every economy is caught in the trap of high inflation and unemployment (leduc, 2003; jones, 2007; carlin and soskice, 2018). thus, the economic misery index has great importance from its measurement to its implications. during the depression, the government uses effective fiscal policy and enhances public expenditure rather than public revenue (tanzi and schuknecht, 2000; spilimbergo et al., 2009). the deficiency can be covered by deficit financing, i.e., by printing new currency notes and foreign debt (mosler, 1995; bell, 2000). the purchasing power of the people could be increased by deficit financing and subsidies. as a result, an increase in the aggregate demand for goods and services leads to a rise in the demand and supplies operationalize, the economy’s depression situation tends to disappear and the economy moves towards a full-employment level (farmer, 2017; wray et al., 2018). on the other hand, whenever, there is a higher effective demand for goods and services the supply of money also increased, that will because of inflation in the country. for this reason, some economist prefers to have less role in the government (stiglitz, 2002; hausman and mcpherson, 2008). the conventional economic framework favors the public welfare foremost, inflation and unemployment are the main indicators to disturb public welfare (scharpf, 1991; starke et al., 2013). public policy focuses on the government under which it allocates resources to an economy (annabi et al., 2011). every government has its aims to provide necessities to the masses at affordable prices. for this reason, public policies should be designed in such a way that can generate employment opportunities for the public (chapin, 1995; jaumotte and pain, 2005). moreover, government should adopt such a policy that will help to control the inflation rate. in this study, we have to examine the role of public policies in determining the level of economic misery among developed and developing countries. we have also provided a comparative analysis of the developed world and developing world. 2. literature review economic growth and stability have been the top priority of developing and developed countries. in the present era without the government, the completion of this task is impossible. so, it is the responsibility of the government to develop such efficient public policy which maintained the mentioned targets. an efficient financial policy could support long-term economic growth and could be used as a tool to control inflation and unemployment in the country. forstater (1999) argues that government should use its powers to fill its two great responsibilities regarding the economy, first the prevention of depression, and second the stability in the value of money. the existing literature does not analyze the direct relationship between public policy and economic misery. in the past, economists have used these two major variables separately and tried to link them with different indicators of public policy. szarowská (2016) examines that public finance has a direct impact on the economic growth of the country. king and rebelo (1990) have also investigated the link between public policies and economic growth in the case of america. another study by chlichlia (1997) analyzed the link between unemployment and public finance in european countries.  phelps (2017) has examined the role of public policy to determine the level of inflation. in this study, he finds the component of tax as a public finance and its impact on inflation. rendahl (2016) found that equilibrium unemployment dynamics significantly affect fiscal policy. short-time increases in spending by the government can decrease the unemployment rate. onodugo et al. (2017) also investigate the impact of government spending and private investment on unemployment. vieira and kawashita (2013) investigate the relationship between budget deficit and inflation. the study finds that budget deficit is an important component of public finance and inflation. in another study, hamburger and zwick (1981) analyze the relationship between fiscal deficit and inflation. the empirical results reveal a strong relationship between the fiscal deficit and inflation and conclude that the budget deficit has an inflationary impact. landau (1986) examines the relationship between government expenditure and economic growth in the economy of less-developed countries. the result show government expenditure excluded (military and educational expenditure) has a significant cause of a decrease in economic growth. while military expenditure has not had a significant impact on economic growth this outcome was against the anticipation, government expenditure on education has a significant correlation with economic development. balassa (1993) analyzes the effects of the budget deficit, size of the government, private investment, and government investment on economic growth in the case of developed and developing countries. the empirical analysis notifies the negative correlation between capital expenditure (government expenditure to the gdp) and economic growth. barro (1995) examines the impact of inflation on economic growth. the result describes the adverse impact of inflation on economic growth in the short run. metin (1998) examines the relationship between inflation and budget deficit. the empirical result reveals that the budget deficit has an immediate positive relationship with inflation. real income audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 202358 growth is shown by the result hurting inflation for the short term but it became positive at the second lag with inflation. odedokun (2001) examines the effect of government expenditure, government revenue, and budget deficits on economic growth. the results of the empirical analysis show that an increase in capital expenditure harms economic growth in mineral exporting and highincome countries. de mello and barenstein (2002) investigate the effect of government spending on economic growth. the empirical analysis found a negative relationship between the population of municipalities and government expenditure. government spending at the municipal level is affected by the size of the population of the municipality. abu-bader and abu-qarn (2003) investigate the relationship between government expenditure and economic growth. empirical results show a bidirectional causal relationship between government expenditure and the economic growth of the country. loizides and vamvoukas (2005) examine the causal relationship between the size of the government and the growth of the economy. the empirical results found that the public expenditure of the country causes the growth in the gnp of the countries in the long run and short run in both cases. braşoveanu et al. (2008) examine the interconnection between fiscal policy and economic growth. the empirical result reveals that distortionary and non-distortionary revenues hurt the real growth rate of the economy, also be found a negative causality between economic growth and all type of fiscal revenues. doménech and garcía (2008) examine the relationship between unemployment, taxation, and unemployment. the empirical results reveal that the unemployment level in any country depends upon the efficiency of the government expenditure it further found that labor taxes also affect the level of unemployment in the country. young (2008) examines the role of public policy on unemployment and structural reforms of the product market. the statistical results support that fiscal expansion and sound public finance help to foster reforms. benos (2009) investigates the relationship between public policy and economic growth. the results reveal that government expenditure incurred on economic affairs, infrastructure, general public services, defense and military, property right protection, public safety, and law in order have a positive effect on economic growth. saad and kalakech (2009) investigate the impact of government expenditure and its growth on the economy of lebanon. the result reveals a positive and significant impact of education expenditure on economic growth, but in the short run, the impact of educational expenditure was found negative on economic growth. nurudeen and usman (2010) examine the impact of government expenditure on the economic growth of the country. the empirical results show that government capital expenditure, total government recurrent expenditures, and government expenditure on education harm economic growth. presbitero (2012) examines the effect of public debts on the economic growth of developing countries. the empirical result reveals that in lowand middle-income countries total public debts negatively impact economic growth accordant with the threshold of ninety percent of gdp, after which the effects become irrelevant. lin and chu (2013) examine the relationship between fiscal deficit and inflation. the empirical results reveal that inflation is strongly associated with the fiscal deficit in the country. mehrotra (2013) study the causal relationship between government recurrent expenditure and the growth of the economy. the result shows that there is an instant and unidirectional causal relationship between economic growth to government expenditure. in light of the analysis and results, it is to be revealed that the government expenditures need to reallocate so that they can play a significant role in the enhancement of economic growth in the economy of iran. fedeli and forte (2012) investigate the long-term relationship between unemployment and public deficit. the empirical results show an overall increase in public expenditure causes an increase in the rate of unemployment. khieu (2014) investigates the relationship between budget deficit, money supply, and inflation. the result shows that increase in the money supply has a positive relationship with inflation, but a budget deficit has no impact on the money supply. nastansky and strohe (2015) examine the relationship between government debts and inflation. the empirical analysis shows that after german reunification, in the long case a significant positive relationship was found between inflation and public debt. on the opposite, the change in inflation has a restraining impact on public debt growth for a short period. it is also observed that inflation causes government profits in the short run but long and medium term the mutual relationship is perceived. van bon (2015) investigates the relationship between public debts and inflation. the empirical result shows that developing countries of all-region like asia, africa, and latin america do not surrender from borrowing to finance their financial debts which makes the debts a significant determinant of inflation in the economy. effect inflation has a significant positive impact on economic growth but it has also an adverse effect if the inflation has larger than the threshold. canale and liotti (2015) examine the effects of structural budget adjustment on unemployment in the eurozone. the empirical result shows that there is a positive relationship between unemployment and fiscal balance restructuring balance and also between the change in unemployment and adjustment in fiscal balance restructuring. it is also be concluded that tightness in the fiscal policy and cut down in public expenditure increased unemployment in the first phase of the eurozone. szarowská (2016) examines the impact of public finance on economic growth. the results describe that financial variables of public finance have partly an impact on growth but growth is greatly influenced by the expenditure on human capital and trade openness. on the other hand, the government size, public debts, and budget deficit are not shown as statically significant. veiga and rodrigues, (2016) analyze the impact of public debt on economic growth and inflation. the overall result reveals that the restriction on public debts has negatively affected economic growth before a given level of debt, an inverse u behavior regarding the relationship between economic growth and public debt found in the empirical analysis. okunevičiūtė-neverauskienė et al. (2017) examine the impact of taxation on labor; in the study, the relationship is to be analyzed between the taxation and unemployment rate in the context of lithuania economy. unemployment trap high taxation on lowaudi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 2023 59 level wages earner and other social benefits to unemployed have a significant influence on the rate of unemployment, people elect to receive social benefits of the unemployed trap rather than do the job due to little difference between the low wage and the benefit that the perceived. the empirical result supports the significant co-relationship between the in-active population at age of (twenty to sixty-four) and the unemployment trap indicator. a decrease in the tax on labor or an increase in the benefit level can boost the motivation of people to take a job. lucifora and moriconi (2017) investigated the relationship between taxation on income and unemployment. the empirical results show that there is a negative relationship between the tax burden and labor market performance. wang et al. (2018) examine the relationship between government taxation and inflation. the analysis reveals that the tax increase directly affects inflation in the country. in simple words, more taxes by the government lead increase in inflation in the chinese economy, and a reduction in the taxes causes control of prices in the country. dadgar and nazari (2018) analyze the relationship between the misery index and economic growth in iran. the result shows that governance has a significant association with the misery index in the iranian economy and also reveals by the result that the growth of the economy has a negative relationship with economic misery. obioha (2018) examines the effect of the budget deficit on unemployment in the economy of nigeria. the empirical result shows that the annual budget deficit in nigeria has a significant and positive impact on unemployment. 3. theoretical links ricardo (1821) presents the famous theory, the ricardian theory of equivalence. this theory is based on the intervention of the government that may have no impact on economic growth. the inefficient fiscal policy of the government may not disturb the aggregate demand of the economy. this establishes the roots of the endogenous growth model theory which examines whether the public policy has an impact on the unemployment and inflation level or not (romer, 1990; grossman and helpman, 1991; howitt and aghion, 1998). this theory mentions that public policy is an important determinant of economic growth. the government collects taxes to meet its expenditure, as taxation is considered a primary source of income for any state (ballard et al., 1985; worlu and nkoro, 2012). government levy tax directly or indirectly on goods and services (trotman-dickenson, 1996; jain, 2013; hassija, 2017). any change in public policy has a significant impact on unemployment (garside, 2002; thane, 2016). okunevičiūtė-neverauskienė et al., (2017), canale and liotti (2015), and fedeli and forte (2012) mention that public policy has a positive impact on the level of employment. but unnecessarily burden of taxes forces the manufacturers and employers to cut their costs down by reducing employment or less supply and production (leibfritz et al., 1997; joumard, 2001). one of the main tools of public policy is foreign debt. foreign debts are mostly taken by the government to meet the budget deficit (beaugrand et al., 2002; singh, 2013). for the redemption of debts, the government levy more direct or indirect taxes (lucas and stokey, 1983; fritschy, 2008). if the level of debt increases from a certain level, it harms economic growth (zagler and dürnecker, 2003; abbas et al., 2021). metin (1998), nastansky et al., (2014), ahmed and henry (2012), van bon (2015); cassimon and vancampenhout (2007) find that a rising budget deficit raises the amount of foreign debt which further increases the inflation rate in the economy. some other studies examine the inverse relationship between foreign debt and the budget deficit (atique and malik, 2012; lee and ng, 2015). keynes (1939) mentions that a lack of demand in production causes an increase in unemployment. thus, the government has to play its role to boost the economy and decrease the unemployment level. kaya and yilmaz (2013) state that fiscal policy has a direct impact on the level of employment rate in the economy. on the other hand, slavin (2008) states that fiscal policy can play important role in countering recession and depression. but the government that takes the loan to stabilize the economy may stuck in poverty and an inflationary trap (friedman, 1977; krugman et al., 1998; eggertsson and krugman, 2012). thus, theoretical and empirical literature suggests a strong association between public policies, inflation, and unemployment. following the existing studies (phelps, 1969; metin, 1998; ali, 2015; van bon, 2015; ali et al., 2015; canale and liotti, 2015; ali and rehman, 2015; ali et al., 2016; arshad and ali, 2016; okunevičiūtė-neverauskienė et al., 2017; lucifora and moriconi, 2017; ali and naeem, 2017; smith and larimer, 2018; obioha, 2018; ali and audi, 2018; wang et al., 2018; junankar, 2019; roussel et al., 2021; abbas et al., 2021; ahmad et al., 2022), the model of our study becomes as: miseryit=f(niit, popit, fdebtit, grevit, developit) (1) misery = economic misery index has been constructed with the help of principle component analysis (pca) with help of inflation and unemployment. ni = level of domestic investment pop = population of a country fdebt =foreign debts g rev = government revenue develop = economic development t = time period (1987-2016) i= countries (31 developed and 35 developing countries) it is necessary to extract the econometrical model from its functional form to get empirical analysis and make a forecast: miseryit= α + β1niit + β2popit + β3fdebtit + β4grevit + β5developit + µit (2) µit = white nose error for this purpose, 66 developed and developing countries have been selected, among them, 35 are developing countries and 31 are developed countries. data from 1987 to 2019 has been used. the source of data is world bank and imf, world economic annual report april 2020. 3.1. measurement of economic misery firstly, the economic misery index has been introduced by the american economist okun (1960). this index is the composite index of unemployment and inflation in a country. after that there audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 202360 is an extensive amount of literature is available to use this index as a measure of economic misery i.e., cavanaugh (2002), kohnert (2008), bentley (2018), ali et al. (2015), shahbaz et al. (2016), lorde et al. (2016). based on the methodology by okun (1960), we have constructed the economic misery index with the help of principle component analysis. 3.2. measurement of public policy public policy plays important role in determining the socioeconomic development of a nation. a vast amount of literature is available to measure public policy. sadka (1976), parikh et al. (1990), balassa (1993), chlichlia et al. (1997), odedokun (2001), rosen (2004), sapiei and abdullah (2008), and rendahl (2016) measure public policy with government revenue. balassa (1993) has measured public policy with the help of government expenditure, budget deficit, and government investment. odedokun (2001) has measured public policy by government expenditure, government revenue, and budget deficit. while rosen (2004) has measured public policy by government expenditure and government revenue. szarowská (2016) has also used government expenditure, government revenue, fiscal deficit, and government size to measure public policy. we have used government revenue, foreign debt, and level of domestic investment in the case of developed and developing countries. 4. econometric methodology presently, applied econometrics has become the part and parcel of empirical analysis. this part of the study provides detailed information about the econometric methodologies used for empirical analysis. nelson and ploser (1982) mention that the stationarity of the variables is one of the main issues of time series and panel data. to determine the stationary of the variables, we have applied levin, lin and chu t*, im, pesaran, and shin w-stat, adf fisher chi-square, and pp fisher chi-square. levin et al. (2002) have offered a unit root test for panel data series, there are some unique properties of this test. llc unit root test has also used homogeneity of the panel as compared to other tests. the methodology of the llc unit root test is like the methodology of adf. the methodology follows as: � �y py y ui t i it i i t j i t i pi , , ,� � �� � � � �� �0 1 1 1 (3) “γ0i is the constant parameter in the eq. (3), this has exceptional properties for the cross-sectional units and p is the same for all the coefficients of autoregressive, however, γi presents the selected order of lags for the model, μi,t is the disturbance term, it is normally considered to be autonomous for all of the selected across of panel units. this eq. (3) is based on the autoregressive moving average (arma) stationary procedure for respective cross-sections, then eq. can be presented as: u yi t i i t j i t j , , ,� �� � � �� �1 0 � (4) based on eq. (4), null and alternative hypotheses would be tested as: h0: pi = p = 0 ha: pi = p < 0 for all i the t-test can be utilized for the llc model, where p is supposed to be fixed for the across and units, by following, the null and alternative hypothesis. t p se p p � � � ( ) (5) throughout this process, it has been assumed that the error series is following all properties of white-noise error. moreover, the panel eq. for regression has tp test statistics, it shows the convergence of all selected standard normally distributed series, for example, n and t � � n t → 0 . on the opposite sideways, if some units of the section are not independent of each other, then the residual of the selected series would be corrected, as this raises the chances of auto-correlation. because of such conditions llc test assumes an alternative test statistic: t t nt s p p p n m m � � � �� � � � 2 ( )u * * (6) where um * and σ m * are supposed to be augmented by the residual series, and its standard deviation, the coefficients of these estimates can be calculated with the support of monte carlo simulation, our unit test llc (2002) also followed this value. im et al. (2003) introduced another panel stationary test, under such conditions when the panel data have heterogeneity. this method has followed the procedures of adf unit root, but this method had used a modest mean of all series, the main eq. of this test can be written as: � �y w py y vi t i it i i t j i t i pi , , ,� � � � � � � � �1 1 1 � (7) the ips test permits the unit root process when we have heterogeneity in vi values, then the ips unit root test eq. would be written as: t n tt i i i n� � � �1 1 1 , (p ) (8) where ti,t is the test statistic for adf, lag order can be presented by pi. the main procedures for the analysis would be followed as: a n t t var t t t t � � � � ( )[ e(t )] (t ) (9) 4.1. panel autoregressive distributive lag model after the stationarity of the data has been established and each of the series is integrated into equal order either level or first difference and so on, the subsequent phase is to observe whether all of the selected series can be combined in a sole series, but for it, non-stationarity is also compulsory condition, which is identified audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 2023 61 as co-integration. co-integrated series follows the identical course for the long-run equilibrium, this kind of integration method has been developed and announced by granger (1981) and further prolonged and augmented by engle and granger (1987). to control the issues that emerged in traditional methods, different scholars present the concept of panel co-integration, which makes the pools of both cross-sectional and time series data, when the connection amid the non-stationary variables i(1). additional cointegration tests for panel data such as westerlund (2007). nevertheless, this test becomes invalid for our data set, as westerlund himself confirmed that this test provides biased outcomes when the sample size is less than 100. thus, following the weakness of traditional methods, this study has applied panel ardl. the test is can have the following procedures: panel-v-statistic: z lv i i t t t i n � � � � � � � � � � � � � � � �� � �� 11 2 1 2 11 1  , (10) the panel t statistic: z l lp i i t t t i n i i t i � � � � � � � � � � � � � � � � �� � � � � � �� 11 2 1 2 11 1 11 2 1    , , ,tt i t t i n � � �� � � � � � � � � � � � �� � 11 (11) 3 the panel t statistic (non-parametric): z l li n t i i t t t i n i i � � � � � � � � � � � � � � � �� � � � ��� ∼ � � , , \ , 2 11 2 1 2 11 1 2 11 2 tt i t i t t i n � � � � �� � � � � � � � � � � � � �� 1 11 � , � (12) the panel t statistic (parametric): z s l l t n t i i t t t i n i � � � � � � � �� � � � � � � � � � � � � � � � ��, , \ 2 11 2 1 2 11 1 2 11 ∼ � �� � �� �� �� � � � � � � � � � � � �� 2 1 11 � � i t i t t t i n , , (13) the group t statistic (parametric): z tn p i n i tt t i t i t ∼ � � �� � � � � � � � � � � � � � � � � � � � � � � � � � � � 1 2 1 1 2 1 1 1 \ , , , �� i t t � � � � � � � � � � � � � 1 (14) the group t statistic (non-parametric): z n t i n i i tt t i t � � � � � � � � � � � � � � � � � � � � � � � � � � � � � 1 2 1 2 1 2 1 1 2 1 \ , \ , �   ��  i t i t t , � � � � � � � � � � � � � � � � 1 (15) the group t statistic (parametric): z n s t i n i i tt t i ∼ � � � � �� �� � � � � � � � � � � � � � � � � � � � � � � � � � 1 2 1 2 2 1 1 1 2 \ , \ ,, ,t i t t t � �� �� � � � � � � � � � � � � � 1 1 � (16) where λ ̂ i presents a steady estimator, which is based on long-run variance. 2 2 , 11 111 2 , , , ,1 2 2 2 2 2 , ,1 111 1 2 1 1 1 2 , 1 1 η η η σ λ η σ σ η ∧ ∧ − = ∧ ∧ ∧ ∧ ∧ − = ∧ ∧ ∧∗ ∧− ∼∗ = =   = + −  +  = + = = = ∑ ∑ ∑ ∑ ∑ ∑ t ki i tt s t i i i ii t i t s itt n t n t i i i tt t s l t t k s s t l s s n t (17) and the residuals ŋ^ i, t, and ŋ ^* i, t and ŋ ^ i, t are measured with the help of the following regression: , , , , 1 ,t k , , 1 , ,1 , ,1 , ,γ η γ γ η γ η ∧ ∧ ∧ ∧ ∧ ∧∗ ∧∗ ∧ − − − = ∧ ∧ − = + + ∆ + = + ∑ ∑       mi t ki i t i t i i t i i t i ti i k i tk n i t mi i tm b x (18) hence, the null hypothesis of no co-integration would be accepted when residuals are non-stationary. but, when the errors are stationary, there exists co-integration. to analyze ardl regression for the panel dataset, the pooled mean group (pmg) method has been utilized. this method is recommended by pesaran et al. (1997, 1999), it combines the pooling and the averaging of coefficients. this technique enables the constants, short-run estimates, and residual variances to vary independently crossways different sets. along with this, pmg estimator constraints based on the likelihood procedure make the long-run estimates identical for all selected groups. because of this estimates become consistent even in the presence of homogeneity restriction. as we have a small sample size, in this situation pgm estimator is lesser sensitive to all types of outliers and the issue of serial autocorrelation. furthermore, this method is solving the issue of endogenous regressors with the help of appropriate lag order for explanatory and explained variables. the panel ecm procedure can be applied to check the short-term relationship of the variables for different panels. primarily, it has provided a baseline for all selected samples. it also gives a general platform to study the connection between the standards of human well-being and institutions. 4.2. pairwise dumitrescuhurlin panel causality granger (1969) establishes theoretical roots for examining the causal relationship among variables. based on granger’s (1969) audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 202362 methodology, we have applied pairwise dumitrescuhurlin panel causality to examine the causality of the variables. this test is based on individual heterogeneity of the variables, whic. is the main issue of the traditional panel granger causality test. this can also enhance the accuracy of the regression estimation. the granger causality test also can the duration of the factor and its outcome without aggregating bias. to empirically test the causality between the variables it can be written in the following form: y a yit k xt i k k ik k k ik i t k i t� � � � �� � � �� � 1 1 1 1� � , , (5) with ἰ = 1,…….,n and t= 1,…., t where xi,t and yi,t used for the observations of stationary variables for individual i in period t. coefficients are allowed to differ across individuals (note the i subscripts attached to coefficients) but are assumed time-invariant. the lag order k is assumed to be identical for all individuals and the panel must be balanced. 5. results and discussion this article has examined the role of public policy in determining the level of economic misery, for this purpose, three types of empirical analysis have been done: whole sample analysis of developed and developing countries. the intertemporal properties of the data have been checked with the help of des descriptive statistics. the descriptive statistic of the selected variables has been given in appendix tables 1-3. the descriptive statistic provides information about the kurtosis, skewness, standard deviation, minimum, maximum, median, and mean values of the variables. the estimated results reveal that the data of selected variables fulfill the requirements of the intertemporal properties of the variables. moreover, data also fulfill all the requirements of the balanced panel data analysis. to examine the degree of association between the selected variables, we applied a correlation matrix. the results of the correlation matrix have been given in appendix tables 4-6. the estimated results describe that most of the variables have significant correlations with each other, but all explanatory have not very strong correlations, which generates the issue of multicollinearity among the explanatory variables. this show that the panel regression model meets the basic requirements of ols and other advanced forms of panel ols for empirical analysis. to check the stationarity of the variables, panel unit root tests i.e., ip and s, pp-fc, adf-fc, and llc have been applied. the estimated results of unit root tests have been given in appendix tables 7-9. the outcomes of unit root tests describe that all three types of empirical models have mixed order of integration among the selected variables. in this situation is best to apply panel ardl for examining the long run and short relationship. lag length is very important for empirical analysis, there are famous lag length criterions i.e., sequential modified lr test statistic, final prediction error, akaike information criterion, schwarz information criterion, and hannan-quinn information criterion. the results of the var length criterion have been given in appendix tables 10-12. following the estimated outcomes of lr, fpe, aic, and hq maximum of 3 lags are allowed for all types of empirical analysis. the long-run outcomes of ardl for whole sample analysis, developed countries analysis, and developing countries analysis have been given in table 1. the level of domestic investment has a negative and significant on economic misery. this shows that rising levels of domestic investment depress the economic misery in the case of the whole sample and developing countries. this means that rising investment enhances employment opportunities, moreover, rising investment also stable the inflation rate (anyanwu, 2013; shahbaz, 2013; khan and sattar, 2014). in the case of developed countries, the level of domestic investment has a positive and significant impact on economic misery. developed countries have a minimum level of unemployment, which is near the natural rate of unemployment, and a stable inflation rate. so, as compared to the whole sample and developing countries, the developed countries have a positive relationship between the level of domestic investment and economic misery. these results support the results of de long and summers (1991) balassa (1993), ditta and hassan (2017), wang et al. (2019), and naeem (2021). the results show that the population of the country has a positive and significant impact on economic misery in the case of the whole sample analysis and developing countries. following the basic economic theories, a rising population will increase the unemployed portion of the population in the economy (altman, 2003; stuckler et al. 2009; zemtsov, 2020). the rising population increases the demand for goods and services and following the philips curve rule, this rising demand creates demand-pull inflation in the economy (totonchi, 2011; sasongko et al., 2021; purnomo, 2021). this further added to the overall economic misery of the country. the results show that the population of developed countries has a negative and insignificant impact on economic misery. the empirics show that most of the developed countries have population growth very close to the replacement rate, so the population has an insignificant impact on economic misery. our results are consistent with the findings of kuznets (1967), daily et al. (1998), alam et al. (2016), nwani and osuji (2020), and dakila (2020). the estimated outcomes of the long-run results show that foreign debt has a positive and significant impact on economic misery in the case of whole sample analysis and developed countries analysis. the rising foreign debt decreases the purchasing power table 1: ardl long run results variables whole sample developed countries developing countries dependent variable: misery ni −0.158142*** 0.135709*** −0.112032*** pop 0.010650** −0.011750 0.011041** fdebt 0.010119** 0.006684** −0.013238 grev −0.016309*** −0.074896** −0.016244*** dev 0.789336*** −2.177365*** 0.993302** c 18.72004 14.07626*** 38.69836 ***,**,* present significance level 1%, 5% and 10% respectively audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 2023 63 of the government as in the long run debt payments affect the employment schemes of the government as well as devalue the currency which becomes the cause of inflation in the economy (obstfeld, 1988; schwartz, 1998; ito, 2010; palley, 2015; tatliyer, 2017). so, rising foreign debt impact positively economic misery of the economy. the estimated outcomes of the long-run results show that foreign debt has a negative and insignificant impact on economic misery in developing countries. these outcomes are contradictory to the whole sample analysis and developed countries’ analysis. the estimated results of the study show that government revenue has a negative and significant impact on economic misery in the case of all types of empirical analysis. this shows that if a government has a higher amount of revenues, it has higher resources for development expenditures (bahl and nath, 1986; lin and ali, 2009; fisher, 2018). this also explains that if a government has enough resources, it can create new employment opportunities which lower the level of unemployment in the economy (sherif, 2013; kayode et al. 2014; akai and sakata, 2002). moreover, with higher revenues, a government can easily stable inflation (friedman, 1971). so, rising government revenues have an inverse relationship with economic misery (cardoso, 1993; clements et al., 2003; agénor and montiel, 2015). the results show that economic development has a positive and significant impact on economic misery in the case of the whole sample and developing countries’ analysis. following the stages, and theories, most of the world is in the transition phase (korotayev et al., 2015), so with high economic development, the economies face high unemployment with higher inflation (kaldor, 1976; epstein and yeldan, 2008; heintz and ndikumana, 2011; balakrishnan et al., 2016). moreover, 70 percent population of the world belongs to developing countries (national research council and committee on population, 2005), so higher economic development is attached to higher economic misery. the results show that economic development has a negative and significant impact on economic misery in the case of developed countries. the developed countries have achieved a higher growth stage of development (ruttan, 1965), so, with more economic development, economic misery comes down. these outcomes are contradictory to the whole sample analysis and developing countries’ analysis. the overall long-run results explain that population, foreign debt, and economic development are encouraging economic misery in the world, whereas the level of investment and government revenues are depressing economic misery in the whole sample case. after estimating the long-run coefficients of the model of whole sample analysis. now by using ect, panel short-run dynamic can be estimated. the short-run estimates of the whole sample analysis, developed countries analysis, and developing countries analysis have been given in table 2. the short-run outcomes show most of the explanatory variables have an insignificant short-run impact on economic misery in the case of whole sample analysis, developed countries analysis, and developing countries analysis over the selected period. the value and sign of ect are the most concerning thing in short-run outcomes. the error correction term gives information that how the short-run converges in the long-run equilibrium path. the findings of ect reveal that it is theoretically correct. this shows that the models of whole sample analysis, developed countries analysis, and developing countries analysis has a correct long-run relationship. ect coefficient shows that 41 percent, 37 percent, and 47 percent short-run deviation are moving towards a long equilibrium path every year respectively for whole sample analysis, developed countries analysis, and developing countries analysis. pairwise dumitrescu hurlin panel causality test has been used for examining the causality among the variables. the estimated results of the pairwise dumitrescu hurlin panel causality test of whole sample analysis, developed countries analysis, and developing countries analysis have been given in table 3. the results of the whole sample analysis and developed countries analysis show that bidirectional causality is running between the level of domestic investment and economic misery. but outcomes of developing countries’ analysis show that unidirectional causality is running from the level of domestic investment and economic misery. the results of all three models show that bidirectional causality is running between the level of population and economic misery, between the level of population and level of domestic investment, between government revenues and level of domestic investment, between economic development and level of domestic investment, between foreign debts and level of population, between government revenue and level of population, table 2: short run results variables whole sample developed countries developing countries dependent variable: misery d (ni) 2.292108 −0.994624 3.643008 d (pop) −79.18237 44.63524* −120.1328 d (fdebt) 1.347314 −0.463448 2.003826 d (grev) −2.079070 0.565798 −3.396131 d (dev) 49.10526 −4.051746 88.22123 ect −0.415089*** −0.373940*** −0.474170*** ***,**,* present significance level 1%, 5% and 10% respectively table 3: panel granger causality whole sample developed countries developing countries ni↔misery ni↔misery ni↔misery pop↔misery pop↔misery pop↔misery fdebt↔misery fdebt↔misery fdebt↔misery grev↔misery grev↔misery grev↔misery dev↔misery dev↔misery dev↔misery pop↔ni pop↔ni pop↔ni fdebt↔ni fdebt↔ni fdebt↔ni grev↔ni grev↔ni grev↔ni dev↔ni dev↔ni dev↔ni fdebt↔pop fdebt↔pop fdebt↔pop grev↔pop grev↔pop grev↔pop dev↔pop dev↔pop dev↔pop fdebt↔grev fdebt↔grev fdebt↔grev fdebt↔dev fdebt↔dev fdebt↔dev grev↔dev grev↔dev grev↔dev audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 202364 between economic development and level of population, between foreign debt and government revenue, between foreign debt and economic development, between government revenue and economic development. the results of the whole sample analysis and developed countries analysis show that bidirectional causality is running between foreign debt and the level of domestic investment. the results of the whole sample show that bidirectional causality is existed foreign debt and economic misery, whereas unidirectional causality is running from government revenue to economic misery, from economic development to economic misery. the results of developed countries’ analysis show that bidirectional causality is existed between government revenue and economic misery, between economic development and economic misery, whereas unidirectional causality is running from economic misery to foreign debt. the results of developing countries’ analysis show that unidirectional causality is running from foreign debt to economic misery, from foreign debt to the level of domestic investment, whereas no causality has existed between government revenue and economic misery. the overall results of the causality test show that most of the selected variables have a bidirectional causal relationship in the whole sample analysis, developed countries, and developing countries analysis. 6. conclusion this article has examined the impact of public policy on economic misery for the set of panel countries from 1987 to 2019. a panel of 66 countries has been selected for empirical analysis, among selected countries 31 are developed countries and 35 are developing countries. this article is based on three types of analysis, whole sample analysis, the developed countries analysis, and the developing countries analysis. the results of the whole sample analysis show that level of domestic investment and government revenue are depressing economic misery. the results show that level of population, foreign debt, and economic development are encouraging economic misery in the case of the whole sample analysis. the estimated outcomes show that level of domestic investment, and foreign debt has a positive and significant impact on economic misery in the case of developed countries. the results explain that government revenue and economic development have a negative and significant impact on economic misery in developed countries. the outcomes of developing countries explain that level of domestic investment, foreign debt, and government revenue have a negative and significant impact on economic misery. the results of developing countries also explain that level of population and economic development have a positive and significant impact on economic misery. the results of causality tests show that most of the variables have a causal relationship with each other. the overall results conclude that public policy is playing important role in deciding economic misery among developed and developing countries. the results of the three models show that level of investment hurts economic misery in the case of the whole sample analysis and developing countries analysis, whereas the level of investment has a positive impact on economic misery in the case of developed countries. so, the governments of the developing country should use investment as a tool to overcome economic misery. the population has a positive and significant impact on economic misery in the case of the whole sample analysis and developing countries but the population has an insignificant relationship between population and economic misery in the developed countries analysis. so, the governments of the developing country should start family planning schemes and awareness programs, especially in asian countries which are facing an explosive increment in population day by day. foreign debt has a positive and significant impact on economic misery in the case of the whole sample so due to extra burden of debts and its 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(2020), new technologies, potential unemployment and ‘nescience economy’ during and after the 2020 economic crisis. regional science policy and practice, 12(4), 723-743. audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 2023 69 appendix appendix table 2: descriptive statistic of developed countries misery ni pop fdebt grev develop mean 12.29542 23.45145 30.15563 64.52124 39.79278 10.05309 median 6.518775 22.85150 8.231500 54.12850 40.44150 10.17370 maximum 1068.092 42.28800 323.2250 450.3900 62.25600 11.69899 minimum 0.643868 −1.500000 0.244000 0.059000 12.52100 6.957402 sd 53.82016 4.912955 54.92458 57.37602 9.842113 0.792530 skewness 16.12346 0.468266 3.463454 3.128124 −0.440055 −1.138198 kurtosis 290.7065 5.151260 16.16451 16.37261 2.864381 4.906477 jarque-bera 3247827 213.3192 8574.852 8446.235 30.72825 341.6446 sum 11434.74 21809.84 28044.74 60004.75 37007.28 9349.375 sumsq. dev. 2690951 22423.39 2802523 3058276 89989.61 583.5084 appendix table 1: descriptive statistic of whole sample misery ni pop fdebt grev develop mean −11.23609 23.24144 72.80691 57.76624 31.90872 8.812725 median 1.593014 22.48800 12.30550 51.36900 29.45600 8.924482 maximum 20.61700 53.94900 1382.710 450.3900 261.7830 11.69899 minimum −5286.656 −1.500000 0.244000 0.059000 5.538000 5.405853 sd 155.5366 7.093978 202.0355 45.03578 19.23182 1.490224 skewness −24.06972 0.601568 5.006941 3.406212 5.640652 −0.267696 kurtosis 722.9166 4.701792 28.44352 22.48587 59.51957 1.996537 jarque-bera 42949280 358.3495 61681.19 35153.92 274042.7 106.7205 sum −22247.45 46018.05 144157.7 114377.2 63179.27 17449.19 sum sq. dev. 47875262 99592.22 80779473 4013850. 731958.8 4394.898 appendix table 3: descriptive statistic of developing countries misery ni pop fdebt grev develop mean −19.45038 23.05544 110.5838 51.78324 24.92571 7.714114 median 0.018936 21.89500 20.54050 46.75000 20.79700 7.729467 maximum 20.61700 53.94900 1382.710 170.1630 261.7830 9.755813 minimum −5286.656 0.693000 0.258000 3.879000 5.538000 5.405853 sd 207.3871 8.572658 267.0081 28.89038 22.54032 1.030186 skewness −18.82160 0.608925 3.660473 0.816763 7.388009 −0.097085 kurtosis 427.9925 3.710561 15.38984 4.036116 67.92396 2.221198 jarque-bera 7956473 86.97738 9060.816 163.7099 193963.5 28.18525 sum −20403.45 24208.21 116112.9 54372.40 26171.99 8099.820 sumsq. dev. 45073851 77091.49 74786714 875552.0 532961.3 1113.286 appendix table 4: correlation matrix of whole sample variables misery ni pop fdebt grev develop misery 1.000000 ni 0.053487** 1.000000 pop −0.002648 0.307424*** 1.000000 fdebt 0.018115 −0.213823*** −0.029367 1.000000 grev 0.028484 0.017108 −0.160258*** 0.099522*** 1.000000 develop 0.079032*** 0.096352*** −0.238744*** 0.089466*** 0.45724*** 1.000000 ***,**,* present significance level 1%, 5% and 10% respectively appendix table 5: correlation matrix of developed countries variables misery ni pop fdebt grev develop misery 1.000000 ni −0.183739*** 1.000000 pop −0.039622 −0.049823 1.000000 fdebt −0.058923* −0.214654*** 0.119012*** 1.000000 grev −0.072441** −0.316568*** −0.219878*** 0.200941*** 1.000000 develop −0.298656*** −0.130510*** 0.132129*** 0.141045*** 0.15661*** 1.000000 ***,**,* present significance level 1%, 5% and 10% respectively audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 202370 appendix table 6: correlation matrix of developing countries variables misery ni pop fdebt grev develop misery 1.000000 ni 0.043022 1.000000 pop 0.007325 0.374745*** 1.000000 fdebt −0.013674 −0.314227*** −0.046069 1.000000 grev −0.001235 0.078053** −0.08448*** −0.041446 1.000000 develop 0.024540 0.217653*** −0.19077*** −0.281569*** 0.313709*** 1.000000 ***,**,* present significance level 1%, 5% and 10% respectively appendix table 7: unit root results of whole sample variables test statistic prob** cross-section miseryi (0) levin, lin and chu t* −8.32691 0.0000 66 im, pesaran and shin w-stat −9.59733 0.0000 66 adf fisher chi-square 339.500 0.0000 66 pp fisher chi-square 351.620 0.0000 66 ni i (0) levin, lin and chu t* −3.58274 0.0002 66 im, pesaran and shin w-stat −5.52622 0.0000 66 adf fisher chi-square 232.114 0.0000 66 pp fisher chi-square 196.709 0.0002 66 popi (0) levin, lin and chu t* 1.45598 0.9273 66 im, pesaran and shin w-stat 11.2875 1.0000 66 adf fisher chi-square 87.6070 0.9989 66 pp fisher chi-square 237.232 0.0000 66 fdebti (0) levin, lin and chu t* 1.40352 0.9198 66 im, pesaran and shin w-stat 3.48863 0.9998 66 adf fisher chi-square 110.113 0.9174 66 pp fisher chi-square 89.9731 0.9980 66 grev i (0) levin, lin and chu t* −3.82980 0.0001 66 im, pesaran and shin w-stat −4.90723 0.0000 66 adf fisher chi-square 238.462 0.0000 66 pp fisher chi-square 245.067 0.0000 66 developi (0) levin, lin and chu t* −2.79030 0.0026 66 im, pesaran and shin w-stat 3.12931 0.9991 66 adf fisher chi-square 95.8471 0.9924 66 pp fisher chi-square 135.340 0.4033 66 miseryi (1) levin, lin and chu t* −25.2144 0.0000 66 im, pesaran and shin w-stat −28.1726 0.0000 66 adf fisher chi-square 931.807 0.0000 66 pp fisher chi-square 1380.85 0.0000 66 ni i (1) levin, lin and chu t* −20.3069 0.0000 66 im, pesaran and shin w-stat −24.2427 0.0000 66 adf fisher chi-square 799.135 0.0000 66 pp fisher chi-square 1236.13 0.0000 66 popi (1) levin, lin and chu t* 4.40407 0.0097 66 im, pesaran and shin w-stat −8.13769 0.0000 66 adf fisher chi-square 390.028 0.0000 66 pp fisher chi-square 446.006 0.0000 66 fdebti (1) levin, lin and chu t* −25.4784 0.0000 66 im, pesaran and shin w-stat −22.4042 0.0000 66 adf fisher chi-square 657.192 0.0000 66 pp fisher chi-square 710.928 0.0000 66 grev i (1) levin, lin and chu t* −38.5353 0.0000 66 im, pesaran and shin w-stat −36.8440 0.0000 66 adf fisher chi-square 1170.96 0.0000 66 pp fisher chi-square 1300.57 0.0000 66 developi (1) levin, lin and chu t* −23.4857 0.0000 66 im, pesaran and shin w-stat −22.1080 0.0000 66 adf fisher chi-square 709.867 0.0000 66 pp fisher chi-square 854.266 0.0000 66 audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 2023 71 appendix table 8: unit root results of developed countries variables test statistic prob** cross-section misery (0) levin, lin and chu t* −2.13197 0.0165 31 im, pesaran and shin w-stat −3.47784 0.0003 31 adf fisher chi-square 103.016 0.0008 31 pp fisher chi-square 123.441 0.0000 31 ni (0) levin, lin and chu t* −4.24028 0.0000 31 im, pesaran and shin w-stat −4.46726 0.0000 31 adf fisher chi-square 118.820 0.0000 31 pp fisher chi-square 75.2297 0.1207 31 pop (0) levin, lin and chu t* −2.29469 0.0109 31 im, pesaran and shin w-stat 6.40098 1.0000 31 adf fisher chi-square 52.8262 0.7904 31 pp fisher chi-square 69.3611 0.2432 31 fdebt (0) levin, lin and chu t* −0.17983 0.4286 31 im, pesaran and shin w-stat 1.90604 0.9717 31 adf fisher chi-square 43.1388 0.9673 31 pp fisher chi-square 43.5199 0.9640 31 grev (0) levin, lin and chu t* −2.70551 0.0034 31 im, pesaran and shin w-stat −2.37619 0.0087 31 adf fisher chi-square 91.4531 0.0089 31 pp fisher chi-square 103.122 0.0008 31 develop (0) levin, lin and chu t* −4.14662 0.0000 31 im, pesaran and shin w-stat 0.69582 0.7567 31 adf fisher chi-square 39.8420 0.9872 31 pp fisher chi-square 74.4548 0.1334 31 misery (1) levin, lin and chu t* −12.9396 0.0000 31 im, pesaran and shin w-stat −17.7698 0.0000 31 adf fisher chi-square 400.521 0.0000 31 pp fisher chi-square 631.556 0.0000 31 ni (1) levin, lin and chu t* −13.6881 0.0000 31 im, pesaran and shin w-stat −16.0838 0.0000 31 adf fisher chi-square 363.413 0.0000 31 pp fisher chi-square 549.283 0.0000 31 pop (1) levin, lin and chu t* 7.40905 0.0000 31 im, pesaran and shin w-stat −3.58141 0.0002 31 adf fisher chi-square 120.425 0.0000 31 pp fisher chi-square 127.011 0.0000 31 fdebt (1) levin, lin and chu t* −4.39142 0.0000 31 im, pesaran and shin w-stat −8.86112 0.0000 31 adf fisher chi-square 196.104 0.0000 31 pp fisher chi-square 321.625 0.0000 31 grev (1) levin, lin and chu t* −9.74439 0.0000 31 im, pesaran and shin w-stat −14.7055 0.0000 31 adf fisher chi-square 327.077 0.0000 31 pp fisher chi-square 549.887 0.0000 31 develop (1) levin, lin and chu t* −10.9655 0.0000 31 im, pesaran and shin w-stat −11.8370 0.0000 31 adf fisher chi-square 256.148 0.0000 31 pp fisher chi-square 400.913 0.0000 31 audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 202372 appendix table 9: unit root results of developing countries variables test statistic prob** cross-section misery (0) levin, lin and chu t* −7.95123 0.0000 35 im, pesaran and shin w-stat −7.95738 0.0000 35 adf fisher chi-square 194.343 0.0000 35 pp fisher chi-square 223.041 0.0000 35 ni (0) levin, lin and chu t* −1.83336 0.0334 35 im, pesaran and shin w-stat −3.38443 0.0004 35 adf fisher chi-square 113.295 0.0008 35 pp fisher chi-square 121.480 0.0001 35 pop (0) levin, lin and chu t* 2.45102 0.9929 35 im, pesaran and shin w-stat 9.47599 1.0000 35 adf fisher chi-square 34.7808 0.9999 35 pp fisher chi-square 167.871 0.0000 35 fdebt (0) levin, lin and chu t* −1.07024 0.1423 35 im, pesaran and shin w-stat 1.29173 0.9018 35 adf fisher chi-square 61.7059 0.7498 35 pp fisher chi-square 49.9465 0.9666 35 grev (0) levin, lin and chu t* −2.59386 0.0047 35 im, pesaran and shin w-stat −3.37359 0.0004 35 adf fisher chi-square 118.692 0.0003 35 pp fisher chi-square 141.945 0.0000 35 develop (0) levin, lin and chu t* 0.00010 0.5000 35 im, pesaran and shin w-stat 4.19153 1.0000 35 adf fisher chi-square 44.3063 0.9930 35 pp fisher chi-square 60.8853 0.7732 35 misery (1) levin, lin and chu t* −23.3242 0.0000 35 im, pesaran and shin w-stat −24.1173 0.0000 35 adf fisher chi-square 585.801 0.0000 35 pp fisher chi-square 826.323 0.0000 35 ni (1) levin, lin and chu t* −15.0124 0.0000 35 im, pesaran and shin w-stat −18.1535 0.0000 35 adf fisher chi-square 435.722 0.0000 35 pp fisher chi-square 686.842 0.0000 35 pop (1) levin, lin and chu t* 4.02658 0.0077 35 im, pesaran and shin w-stat −5.81530 0.0000 35 adf fisher chi-square 196.608 0.0000 35 pp fisher chi-square 335.581 0.0000 35 fdebt (1) levin, lin and chu t* −6.38263 0.0000 35 im, pesaran and shin w-stat −9.19953 0.0000 35 adf fisher chi-square 222.412 0.0000 35 pp fisher chi-square 389.303 0.0000 35 grev (1) levin, lin and chu t* −13.9484 0.0000 35 im, pesaran and shin w-stat −17.4516 0.0000 35 adf fisher chi-square 418.344 0.0000 35 pp fisher chi-square 750.679 0.0000 35 develop (1) levin, lin and chu t* −8.76763 0.0000 35 im, pesaran and shin w-stat −11.6630 0.0000 35 adf fisher chi-square 271.551 0.0000 35 pp fisher chi-square 453.353 0.0000 35 appendix table 10: var lag order selection criteria of whole sample lag logl lr fpe aic sc hq 0 −49454.76 na 5.17e+16 55.51152 55.52999 55.51834 1 −27212.72 44309.35 775796.4 30.58891 30.71820 30.63666 2 −24406.28 5571.930 34623.50 27.47955 27.71965 27.56823 3 −24252.00 305.2570* 30319.58* 27.34681* 27.69773* 27.47641* *indicates lag order selected by the criterion, lr: sequential modified lr test statistic (each test at 5% level), fpe: final prediction error, aic: akaike information criterion, sc: schwarz information criterion, hq: hannan-quinn information criterion audi and ali: public policy and economic misery nexus: a comparative analysis of developed and developing world international journal of economics and financial issues | vol 13 • issue 3 • 2023 73 appendix table 11: var lag order selection criteria of developed countries lag logl lr fpe aic sc hq 0 −19844.38 na 1.60e+13 47.43222 47.46612 47.44521 1 −9238.818 21033.74 172.2812 22.17639 22.41373 22.26737 2 −8131.501 2180.239 13.31966 19.61649 20.05726 19.78545 3 −7985.235 285.8906* 10.23482* 19.35301* 19.99722* 19.59996* *indicates lag order selected by the criterion, lr: sequential modified lr test statistic (each test at 5% level), fpe: final prediction error, aic: akaike information criterion, sc: schwarz information criterion, hq: hannan-quinn information criterion appendix table 12: var lag order selection criteria of developing countries lag logl lr fpe aic sc hq 0 −26255.94 na 5.88e+16 55.63970 55.67053 55.65145 1 −15556.23 21240.74 9064165. 33.04710 33.26289 33.12934 2 −14092.24 2887.651 439966.1 30.02170 30.42246* 30.17444 3 −13979.13 221.6749* 373658.6* 29.85833* 30.44404 30.08156* *indicates lag order selected by the criterion, lr: sequential modified lr test statistic (each test at 5% level), fpe: final prediction error, aic: akaike information criterion, sc: schwarz information criterion, hq: hannan-quinn information criterion tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 13-28. international journal of economics and financial issues | vol 13 • issue 1 • 2023 13 viewpoints in global value chains: evidence from sub-saharan africa eric mokwaro bosire* college of human resource and development (school of business), jomo kenyatta university of agriculture and technology, nairobi, kenya. email: rcbosire1000@gmail.com received: 02 october 2022 accepted: 17 december 2022 doi: https://doi.org/10.32479/ijefi.13797 abstract the aim of this paper is interrogate various perspective such as investments, infrastructure, governance and macroeconomic factors and how they influence global value chains in sub saharan africa. data was derived from 37 sub saharan africa countries for the period 2003-2018. panel corrected standard errors estimation model was adopted in analysis. both the direct relationships and controlled relationships were tested. macro-economic factors such as gdp growth rate, exchange rate, inflation rate and interest rates were used as controlling factors. the paper established a significant influence of investments on global value chains and that it can explain up to 45% of the variation. similarly, infrastructure has a significant influence on global value chains in sub saharan africa and that it can explain up to 67% of the variations. governance also has a significant influence on global value chains and it can explain up to 10% of the variations. the overall model was significant with a 76% explanation of the variation in global value chains in sub saharan africa. therefore, the paper recommends for a promotion of value added manufacturing, and an integration in global value chains. further, the paper recommends for enhanced resource allocation to infrastructure development to aid in the reduction of the production cost and to stream line governance. keywords: global value chains, investments, infrastructure development, governance, macro-economic variables, sub-saharan africa jel classifications: f13, e22, o12, o18 1. introduction over the past four decades, the world economy has observed a substantial revolution in the organization of international trade (antras and chor, 2021; pansera and owen, 2018; heeks et al. 2020). production of goods and services has increasingly been globalized and firms structured their production in a rather complex and interlinked systems of cross-border and national movements of goods, services and factors of production. these networks are referred to as global value chains (shepherd, 2016; adarov and stehrer, 2019). global value chains have been hailed as one of the surest means to industrialization and poverty eradication (world bank, 2020). when gvcs are effective, products are designed in one country, parts and components of the said products are produced by several other countries and then assembly done in yet another county. they are built upon speed of movement, cost effectiveness and reliability (world bank, 2020). as a consequence, gvcs boost international trade and investment flows significantly. they help in creating better employment opportunities, boosting economic growth and ultimately helping in reducing poverty levels (oecd, 2013). gvcs comprise of two elements that reflect the upstream and the downstream linkages in the entire international production and trade chains. some economies import inputs from foreign partners to enable the produce goods and service that they will export. this is commonly referred to as backward gvc participation (asian development bank, 2021). others export domestically produced inputs to other economies for further processing and export. this is also referred to as forward gvc participation (world bank, 2020). this journal is licensed under a creative commons attribution 4.0 international license bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 202314 a couple of factors have been cited as reasons behind the revolution in the global economy, comprising the transformations in the information and communication technology (adalov, 2021; rodrik, 2018), enactments of preferential trade agreements (world bank, 2017) which have reduced man-made trade barriers remarkably and developments in the political arena enhancing the portion of world populace taking part in the capitalist system (antras, 2016). this revolution made it possible for firms to enhance their usage of parts and components produced abroad in their production processes and also producers of intermediate inputs selling their outputs globally (johnson and noguera, 2012). however, the international fragmentation of the production process and the scattering of tasks and activities has led to a significant level of double counting in international trade. for instance, raw materials mined in one country may be exported to a second country for processing before they are exported to a manufacturing plant in yet another country. after manufacturing, the final product may again be exported to a forth country for consumption or as an input to another process. the raw material is counted once as a gdp contributor in the originating country but is counted a number of times in the subsequent exports (united nations, 2013). but advancements in trade statistics has been geared towards identification of double counting in gross trade figures and establishment of value creation in the entire international production process. the value creation statistics will then lead to the formulation of imperative policy intuitions (aslam et al., 2017). globally, gvcs continued on a promising upward trajectory from the year 1990 up and until the 2008 global financial crisis in a state referred to as hyper globalization (friedman, 2005; baldwin, 2016). due to its succeeding recession and a slowed pace of policy reforms the expansion had a sharp decrease and its growth has since stagnated. the stagnation was referred to as slowbalization (world bank, 2020) further, fragmentations in some of the sectors and regions has matured hence impeding new developments in gvcs. similarly, trade conflicts reported in some countries such as the united states of america and the peoples republic of china catalyzed a rise in protectionism policies which hinders gvcs (bellora and fontagne, 2020). it is estimated that if these trade conflicts continue, investor confidence will go down, hence reducing the global income by a whopping $ 1.4 trillion and pushing about 30.7 million people into poverty (world bank, 2020). in addition, the covid-19 pandemic led to closure of borders which as a consequence exposed vulnerabilities in some supply chains (asian development bank, 2021). however, it cannot be ignored that the pandemic opened new doors to multinational partnerships in the production of crucial vaccines (irwin, 2021). notably, over the past few years, globalization has faced outright opposition across the globe and protectionism finding favor (krugman, 2019; de bolle and zettelmeyer, 2019; bown et al., 2020). protectionism policies can easily prompt reshoring of existing global value chains or shifting them to different locations. this suggests that globalization and indeed global value chains has a dim future if corrective steps are not taken on time. today, gvc accounts for about 50% of international trade. its expansion has led to unprecedented growth of poor countries and a sharp decrease in poverty levels. (united nations, 2013). it is estimated that a 1% increase in gvc participation, leads to a more than 1% increase in per capita income. this increase is twice as much as that of conventional trade. similarly, though gvcs in sub-saharan africa appear to be minimal (figure 1), they have followed the behavior of the global gvcs. the expansion was steady and promising from 1990 up to the global financial meltdown of 2008 when it recorded a sharp decrease. since then the growth has been slow. notably, africa remains to be a minor actor in the world economy, accounting for just about 3% of the international trade. it has joined the ranks of gvcs in automotive, food, apparel and service industries. african exports are dominated by agricultural produce and natural resources and they join gvcs at its beginning point, as inputs to other countries exports. largely, some sub-saharan africa countries such as kenya, ethiopia, tanzania and south africa recorded a growth of 10% or more over the past few years. africa accounts for 14% of foreign value added in exports globally. to a large extent it is integrated to the supply chains in europe and central asia which accounts for about 42% of its foreign value added. followed by east asia and pacific which accounts for about 23% and other regions follow as illustrated in figure 2. indeed, there is rich literature on gvcs but only a few tend to interrogate what really drives the growth of gvcs or otherwise. for instance, infrastructure and institutional development, investment policies, liberal trade policies and human capital development have been identified as some of the factors that foster the development of gvcs (timmer et al., 2014, 2015; unctad, 2013; dollar and kidder, 2017; taglioni et al. 2014; oecd, 2013; adarov and stehrer 2021). in this regard, this study is proposing to have a deeper look at global value chains from different perspectives that influence its behavior in sub-saharan africa. but, this interrogation will be limited to such perspectives like investments, infrastructure development, governance and macro-economic variables. figure 1: global gvc verses ssa gvc. unctad-eora gvc database, 2018 bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 15 2. literature review 2.1. theoretical orientation this section briefly looks into abstract ideas that have been generated around the area of global value chains and international trade and try to relate them to the current study. in a nut shell the theory of absolute advantage as postulated by smith (1776) is explained. 2.1.1. theory of absolute advantage this theory was postulated by smith (1776) in his inquiry into the wealth of nations in which he argued against mercantilism. smith was dissatisfied with the idea and felt that nations do not get rich simultaneously by applying mercantilism due to the fact that one nation’s export is another nation’s import. smith further stated that nations would benefit if they embraced free trade and specialization in production according to their absolute advantage. that specialization and division of labor leads to improvements labor productivity hence increased output, growth and development (bloomfield and arthur, 1975; staley and charles 1989; myith, 1977). he also said, wealth of nations is influenced by the goods and services accessible to the citizens rather than their gold reserves. the gains brought about by trade with absolute advantage such as knowledge and technology transfer are beneficial to all individuals and nations but not in equal measure (schumacher, 2012) hence the idea of comparative advantage by david ricardo. this theory is based on the following assumptions; that there is trade between two nations, on a two country, two commodities framework. that one country must have an advantage in the production of one commodity at the lowest cost possible. that labor is mobile within a country but not mobile between countries. that there are no costs in transportation. and that the cost of commodities is calculated by the cost of labor required in the production process. nevertheless, this theory has been criticized on different horizons. for example, the idea that one country must have an absolute cost advantage in the production one commodity does not hold water when a certain country lacks a commodity in which it possesses production superiority over other countries at a given amount of capital and labor. apparently, most of the developing nations lack superior machinery they can install in the production hence not possible to have an absolute cost advantage. it has also been argued that most of the developed nations embraced protectionism policies which enabled them to protect and grow their infant industries (chang, 2007). empirical literature has proved that trade liberalization was responsible for the worsening of both the economic and social problems of most countries (stiglitz, 2002; shaikh, 2007). 2.2. conceptual framework 2.2.1. global value chains unctad defines global value chains as a location of different phases of the production process across various countries. it’s a production fragmentation the enables intermediate goods to cross borders many times along the value chain. global value chains is measured by weighting the share of each country’s gross exports in total regional gross exports (aslam et al., 2017). this makes the dependent variable. 2.2.2. investments investment is defined as a commitment of financial resources with an expectation of higher gains in the future period. for the purposes of this paper, investment is an independent variable and the following factors explain investments; • foreign direct investments; foreign direct investment, net inflows (bop, current us$) as measured by the world bank world development indicators • gross capital formation; gross capital formation (% of gdp) as measured by the world bank world development indicators • portfolio investments; portfolio investment, net (bop, current us$) as measured by the world bank world development indicators. 2.2.3. governance the world bank, (2017) defines governance as the process through which the government and other non-government players join hands to make and implement requisite policies that regulate power both formally and informally. good governance means stability in the public service, credibility and transparency in policy making process, effectiveness within the justice system and stability in the political arena (hossain and rahman, 2017). for the purposes of this study, governance will be measured by the world wide governance indicators generated by the world bank. they have identified 6 aggregate indicators which include; • government effectiveness: basically the perceptions about the quality and effectiveness of the public service, its ability to act independently from the influence of politics, the authenticity of the policy making process and the ability of the government to efficiently implement such policies (kaufmann et al., 2010) • regulatory quality: perceptions on the ability of government players to formulate and implement good policies which encourage the growth of the private sector (kaufmann et al., 2010) • political stability and absence of violence/terrorism: perceptions on the stability of a country from politically instigated violence which include ethnic tension and terrorism (kaufmann et al., 2010) • control of corruption: perceptions on the ability of the government to control people from gaining personal interests figure 2: ssa share of fva in exports. world development report, 2020 bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 202316 from state resources through corruption and state capture (kaufmann et al., 2010) • rule of law: perceptions on the ability of citizens to live harmoniously following the common instructions and rules of the society. this includes enforcement of contracts, the workings of the police service and the judicial system (kaufmann et al., 2010) • voice and accountability: perceptions on the ability of the people to voice their dissatisfaction and how the government protects basic fundamental rights and freedoms. it also entails the ability of people to choose their government democratically (kaufmann et al., 2010). 2.2.4. infrastructure development a well-developed infrastructure is essential for economic development. it aids businesses in ease to markets and reduction of transactional costs and also facilitates efficiency of other factors of production. infrastructure is also very necessary for aiding a country’s participation in the global value chains (luo and xu, 2018). the africa development bank (afdb) has developed an africa infrastructure development index (aidi) which will be the basis for analyzing this variable. the index is standardized to fall in between 0 and 100 with a higher value indicating the readiness of a country to meet its infrastructural needs (afdb, 2018). the index has 4 indicators and a composite aidi indicator through which infrastructure is measured and monitored. they include; • the transport composite index (tci): which is basically measured by the road networks in kilometers (per km2 of exploitable land area) and the total paved roads (kms per 10, 000) inhabitants) (afdb, 2013) • the electricity composite index (eci): this indicator is measured by the generation in kwh per inhabitants (afdb, 2013) • ict composite index (ici): it is measured by a conglomeration of sub indicators such as fixed line telephone subscriptions per 100 inhabitants, fixed line telephone subscriptions as a percentage of the population, mobile cellular subscriptions as a percentage of the population, number of internet users per 100 inhabitants, fixed (wired broadband internet subscribers per 100 inhabitants and international internet bandwidth (mbps) (afdb, 2013) • water supply and sanitation composite index: this one is measured by improved water sources as a percentage of population with access and improved sanitation facilities as a percentage of population with access (afdb, 2013). 2.2.5. macro-economic factors macroeconomic factors can be defined as fiscal or monetary factors that influence the national or regional economy. for purposes of this paper this paper macro-economic factors have been selected as controlling variables because they have an ability of influencing the behavior of any other factors within the economy. they include; • gdp growth rate: measured by gross domestic product annual growth rate as measured by the world bank world development indicators • exchange rate: measured by official exchange rate (lcu per us$, period average) as measured by the world bank world development indicators • interest rate: measured by real interest rate (%) as measured by the world bank world development indicators • inflation rate: measured by inflation, consumer prices (annual %) as measured by the world bank world development indicators the study will assume both a direct and a controlled relationship between global value chains as a dependent variable and investments, governance, infrastructure and macro-economic factors as independent variables. further a controlling effect will be added by macro-economic factors. 2.3. empirical literature review de marchi and alford (2021) conducted a study on state policies and upgrading in global value chains and made a conclusion that state policies are a very important component in developing global value chains. that means that for nations to increase their participation in gvcs, and at the same time be able to retain a substantial share of the value created, most often they adopt strategies such as infrastructure development in its broader sense and setting up of incentives which facilitate gvcs. on the other hand, nations that are sensitive to environmental and social outcomes tend to embrace regulatory measures which foster service delivery and economic growth. the study used a systematic review of both academic and policy literature. to achieve this, the study used a step wise approach to gather 418 relevant literature following the prisma method as describe by liberati et al., (2009). then screening of the said literature was done which excluded a total of 232 literatures, remaining with 186 elements. these then were taken through eligibility tests which excluded a total of 122 elements, remaining with 64 elements which were taken through analysis. kolesa (2018) investigated government policies that enhance the role of smes in gvcs in slovenia and established that a wholesome approach which brings on board all stakeholders in formulation and implementation of policies related to gvcs. to this extent, firms have been encouraged to differentiate their products, embrace creativity and innovation and acquire more knowledge based assets. further, the study recommends for a possibility of enhancing institutional frameworks which spearhead the development of gvcs and a focus on adopting a clear monitoring and evaluation frameworks. the study used a case study of slovenia and relied on time series data from the period 1995 to 2011. mouanda-mouanda (2019) studied global value chains participation for african countries with a focus on uibe gvc index system. the study found out that african countries tend to absorb more of foreign inputs in complex gvcs as compared to their domestic value added to products exported in simple gvcs. south africa and north africa countries were identified to be more responsive in exports and imports in simple gvcs whereas west africa tend to consume more of foreign intermediate products imported through complex gvcs. the study relied bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 17 upon descriptive statistics in analyzing data obtained from the university of international business and economics global value chain indexes. luo and xu, (2018) investigated infrastructure, value chains and economic upgrades and established that infrastructure development is a catalyst to economic upgrade. good infrastructure can aid a country to effectively participate in global value chains hence boosting international trade and hence economic growth. the study surveyed already available literature in gvcs, infrastructure and economic growth. however, the paper does not explain fully the procedure followed in literature review and thus is scanty on the methodology. pahl et al., (2022), looked at jobs and productivity growth in gvcs and found gvc jobs to be more productive than non gvc jobs. further, the study established that gvc jobs have a smaller share in the total labour force, especially for low income countries and that expansions in gvcs is correlate with labor proactivity in a positively. the study used data from 25 low and middle income countries for the period 2000 through 2014. adalov and stehrer (2019), studied foreign direct investments capital formation and global value chains and established that foreign direct investments and capital formations influence global value chains in a significant way. they further found out that inward fdi enhances the formation of backward linkages whereas forward gvc participation is facilitated by outward fdi. capital accumulation was found to facilitate both downstream and upstream integration. the study used wiod country level and sector level panel dataset for 43 countries spanning the period 2000 through 2014. the paper used fractional probit with standard errors which was clustered by country. to estimate robustness, the paper used fractional logit, panel fixed and random effects and pooled ols with a logistic transformation. yang, (2018) investigated infrastructure and value chain position in china and came up with a conclusion that proximity of cities to domestic markets enhances their participation in gvcs whereas proximity of cities to foreign markets minimizes their participation in gvcs. further the paper established that enhancing a country’s transport network enhances aggregate welfare by 11 percentages, spatial inequalities by 13% and participation in local value chains to aid foreign markets by about 2%. the paper used data from china for the period 2000 through 2006 and a regression model in analysis. 3. methodology 3.1. introduction this section explores the strategy employed in the investigations into various perspectives of global value chains in sub saharan africa. in a nut shell, it’s simply a road map to the findings of this study. 3.2. target population this study sought to interrogate data from 48 sub-saharan africa counties as stipulated in appendix 1. data from the year 2003 through the year 2018 was relied upon in the study. this period was selected due the fact that data is recent and available. in total, the study intended to consider a total population of 768 observations. however, 11 countries were excluded from the sample due to inadequacy of data (appendix 1) leaving 37 countries and a total of 592 observations. 3.3. sampling technique global value chains are a very important aspect in the economy and therefore deserves requisite attention. due to the fact that 592 observations are considered few, the study adopted a census method that interrogated all the available elements from the population. 3.4. data sources this study will rely upon secondary data that has already been collected and stored by various institutions on their institutional databases. the sources are tabulated in table 1. 3.5. data diagnostic tests with a view to ascertaining that basic regression models are met, the following tests were conducted both before and after estimation. to ascertain for data normality, this study opted for a shapiro-wilk test (1965). for data stationarity, a levin et al. (2002) test was conducted, and for multi collinearity, the study used a variance inflation factors (vif) test (theil 1971). to test for heteroscedasticity, the study used whites (1980) general test and woodridge (2002) test to check for auto correlation. and to determine the direction and the extent of association amongst variables, this study employed a pearson’s pair wise (1896) correlation analysis. 3.6. model specification the study made use of panel corrected standard errors model to establish the relationship between investments, infrastructure, governance, macro-economic factors and global value chains as shown by the following equations. a. investments gvc fdi gcf piit it it� � � � �� � � � �1 2 3 0 (1) b. infrastructure gvc tci eci icti wssiit it it it� � � � � �� � � � � �1 2 3 4 0 (2) c. governance gvc coc ge ps rq rl va it it it it it it � � � � � � � � � � � � � � � � 1 2 3 4 5 6 0 (3) d. macroeconomic factors gvc grr exr inf inrit it it it� � � � � �� � � � � �1 2 3 4 0 (4) e. overall model gvc fdi gcf pi tci eci icti ws it it it it it it � � � � � � � � � � � � � � � � 1 2 3 4 5 6 7 ssi coc ge ps rq rl va it it it it it it it � � � � � � � � � � � � � � 8 9 10 11 12 13 0 (5) bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 202318 f. overall model – controlled by macroeconomic factors gvc fdi gcf pi tci eci icti ws it it it it it it � � � � � � � � � � � � � � � � 1 2 3 4 5 6 7 ssi coc ge ps rq rl va gr it it it it it it it � � � � � � � � � � � � � � 8 9 10 11 12 13 14 rr exr inf inr it it it it � � � �� � � � 15 16 17 0 (6) 4. analysis and findings 4.1. descriptive statistics the study comprised of 37 countries from sub saharan africa from the year 2003-2018 making a total of 592 observations. means indicate arithmetic averages and the standard deviation the extent of variations from the mean (table 2). 4.2. normality test h0: sample data was not drawn from a normally distributed population it is assumed that the population from which the sample data for this study is found, follows a gaussian distribution. otherwise, if this assumption is violated, inferences therefrom may not be accurate and cannot be relied upon (ghasem and zahediasl, 2012). using shapiro-wilk (1965) test the study tested whether the sample data was drawn from a normally distributed population. from the test results presented in table 3, we fail to reject the null hypothesis and conclude that the sample data used in this study is significantly different from a normal population. 4.3. stationarity test h0: panels contain unit root ha: panels are stationary panel data is prone to many errors due to its ability to combine both time series and cross sectional properties. one of the errors is stationarity, i.e. mean and variance remaining constant for some time. non stationarity may produce spurious regression results, hence need to deal with it before estimation. this study made use of levin et al. (2002) test to establish whether sample data was stationary. test results presented in table 5 indicate that all variables were stationary at level with a trend apart from the variable explaining infrastructure (icti) which was found to contain a unit root. this necessitated differencing of the variables. they then turned out to be stationary. therefore, we reject the null hypothesis and conclude that panels were stationary at 1st differencing with a trend. 4.4. test for multi-collinearity the study made use of variance inflation factors (vif) as proposed by farrar and glauber (1967). vifs above 10 and those less than 1 indicate the possibility of collinearity. hence vifs should range between 1 and 10, (myles, 1990). test results presented in table 3 indicate that the variables ge, rq and rl were found to be collinear with vifs of (17.27, 10.07 and 18.76 respectively). this necessitated differencing of the variables (ge, rq and rl) which brought back the vifs to the acceptable limit. hence conclude that the sample data was void of collinearity problems. table 1: sources of data variables sub-variables variable description data source global value chains gvc weighted by the share of each country’s gross exports in total regional gross exports. unctad-eora database investments fdi foreign direct investment, net inflows (bop, current us$) world bank, world development indicatorsportfolio investments (net) portfolio investment, net (bop, current us$) gross capital formations gross capital formation (% of gdp) infrastructure development transport composite index road networks in kilometers (per km2 of exploitable land area) and the total paved roads (kms per 10, 000) inhabitants) africa development bank, africa infrastructure development index database electricity composite index generation in kwh per inhabitants information and communication technology index fixed line telephone subscriptions per 100 inhabitants, fixed line telephone subscriptions as a percentage of the population, mobile cellular subscriptions as a percentage of the population, number of internet users per 100 inhabitants, fixed (wired broadband internet subscribers per 100 inhabitants and international internet bandwidth (mbps) water supply and sewerage index improved water sources as a percentage of population with access and improved sanitation facilities as a percentage of population with access. governance government effectiveness government effectiveness: estimate world bank, world governance index databasecontrol of corruption control of corruption: estimate political stability political stability and absence of violence/terrorism: estimate regulatory quality regulatory quality: estimate rule of law rule of law: estimate voice and accountability voice and accountability: estimate macro-economic variables gdp growth rates gdp growth (annual %) world bank, world development indicators database inflation rates inflation, consumer prices (annual %). interest rates real interest rate (%) exchange rates official exchange rate (lcu per us$, period average) author compilation, 2022 bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 19 4.5. test for heteroscedasticity h0: homoscedasticity ha: unrestricted heteroscedasticity according to klein et al., (2016) regression models assume homoscedasticity, i.e. errors should be independently and identically distributed. this study employed the proposition of white (1980) to test for heteroscedasticity. according to the test results presented in table 4, [χ2 (252) = 589.27, p ≤ 0.01] which is significant at 0.05 alpha level. hence reject the null hypothesis and conclude that data contains unrestricted heteroscedasticity. statistically, heteroscedasticity is an error that should be dealt with before estimation. otherwise, estimations may be inefficient and biased standard errors. therefore, to deal with this problem, the study adopted to use a panel corrected standard errors estimation method which has the ability to correct for cross sectional dependence, heteroscedasticity and serial correlation. 4.6. correlation analysis correlation analysis is an important tool in measurement of the association between two variables. it shows the direction of the association and at the same time shows the strength of such a relationship (gogtay and thatte, 2017). the study employed a table 2: descriptive statistics variable obs mean sd min max country 592 19 10.68611 1 37 year 592 2010.5 4.613671 2003 2018 gvc 592 2511331 8791129 14305.37 6.75e+07 fdi 592 6.89e+08 1.54e+09 −7400000000 1.00e+10 gcf 592 23.50761 8.689429 4.703723 53.98797 pi 592 −4.38e+08 3.19e+09 −19600000000 1.43e+10 tci 592 9.080836 10.45616 0.0029003 53.30856 eci 592 7.830051 15.67298 0 82.37559 icti 592 4.92325 9.148061 0.0000097 63.4445 wssi 592 53.5098 20.61087 2.906174 99.78813 coc 592 −0.5667068 0.6588314 −1.868714 1.216737 ge 592 −0.7091467 0.6765023 −2.475142 1.056674 ps 592 −0.5096633 0.9679339 −3.314937 1.200234 rq 592 −0.5953336 0.6074625 −2.645041 1.12727 rl 592 −0.6208049 0.6824088 −2.606445 1.07713 va 592 −0.46712 0.7156903 −2.196764 0.9791626 grr 592 4.430425 4.483707 −36.39198 33.62937 exr 592 1010.802 3362.644 0.8667643 31558.91 inf 592 8.477103 18.94697 −8.97474 379.9996 inr 592 7.817907 11.47169 −34.46203 61.8826 author compilation using stata software, 2022 table 3: data normality test and multi collinearity test results shapiro wilk test for normality vif test for multi collinearity variable obs w v z prob>z level differenced gvc 592 0.27535 283.915 13.681 0.00000 vif 1/vif vif 1/vif grr 592 0.80656 75.791 10.482 0.00000 1.14 0.878514 1.13 0.882973 exr 592 0.28128 281.589 13.661 0.00000 1.63 0.612255 1.62 0.61634 inf 592 0.26045 289.754 13.730 0.00000 1.1 0.907832 1.08 0.922502 inr 592 0.92268 30.293 8.261 0.00000 1.12 0.895029 1.11 0.902751 fdi 592 0.59155 160.029 12.292 0.00000 1.43 0.697107 1.45 0.690404 gcf 592 0.95701 16.845 6.840 0.00000 1.37 0.732206 1.36 0.734204 pi 592 0.47138 207.112 12.917 0.00000 1.59 0.630641 1.61 0.620377 tci 592 0.71117 113.163 11.453 0.00000 3.93 0.254187 3.75 0.266865 eci 592 0.50109 195.470 12.777 0.00000 3.01 0.331985 2.86 0.34977 icti 592 0.58906 161.003 12.307 0.00000 1.7 0.587218 1.78 0.562762 wssi 592 0.98615 5.426 4.096 0.00002 2.72 0.367907 2.76 0.362461 coc 592 0.96627 13.214 6.252 0.00000 6.59 0.15177 6.23 0.160406 ge 592 0.98819 4.629 3.711 0.00010 17.27 0.057917 1.13 0.882732 ps 592 0.96551 13.511 6.306 0.00000 4.45 0.22455 4.38 0.22856 rq 592 0.97534 9.660 5.493 0.00000 10.07 0.099261 1.14 0.878014 rl 592 0.99332 2.618 2.331 0.00989 18.76 0.053299 9.83 0.101726 va 592 0.97951 8.029 5.045 0.00000 3.79 0.263976 3.69 0.270778 mean vif 4.8 2.76 author compilation using stata software, 2022 table 4: heteroscedasticity test results heteroscedasticity test auto-correlation test source χ2 df p f (1 ,36) 662.400 heteroscedasticity 589.27 252 0.0000 prob>f 0.0000 author compilation using stata software, 2022 bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 202320 table 5: data stationarity test variable at level 1st differencing no trend with trend no trend with trend unadj t adj t p-value unadj t adj t p-value unadj t adj t p-value unadj t adj t p-value gvc −11.8753 −8.2351 0.0000 −11.2518 −4.1286 0.0000 −22.0427 13.4448 0.0000 −27.8874 −14.162 0.0000 grr −14.4389 −6.3758 0.0000 −19.6598 −7.9246 0.0000 −26.6868 −15.4749 0.0000 −29.5423 −15.5028 0.0000 exr −2.3412 3.6831 0.9999 −11.5189 −4.1185 0.0000 −15.9119 −7.7361 0.0000 −20.9972 −8.8136 0.0000 inf −17.3309 −8.9587 0.0000 −23.989 −13.4375 0.0000 −29.6727 −21.0729 0.0000 −32.3326 −20.0212 0.0000 inr −28.1657 −24.8211 0.0000 −33.1027 −25.3875 0.0000 −27.891 −18.2146 0.0000 −27.808 −13.1622 0.0000 fdi −9.9641 −4.0059 0.0000 −13.327 −4.7603 0.0000 −19.2391 −9.7492 0.0000 −21.5261 −8.467 0.0000 gcf −11.4358 −4.8446 0.0000 −13.1047 −3.6949 0.0001 −20.2119 −11.118 0.0000 −23.4412 −11.0465 0.0000 pi −11.2084 −2.6076 0.0046 −16.9229 −4.8401 0.0000 −25.2712 −13.3803 0.0000 −26.6844 −10.9349 0.0000 tci −5.3157 −2.9606 0.0015 −20.1146 −10.0848 0.0000 −21.7238 −13.3639 0.0000 −21.7557 −9.32 0.0000 eci −4.3203 −0.9883 0.1615 −12.7039 −4.2279 0.0000 −19.9736 −10.4856 0.0000 −23.6627 −10.0302 0.0000 icti 7.7185 16.9912 1.0000 −4.7281 −0.4974 0.3095 −6.5451 −0.2634 0.3961 −16.4698 −3.6396 0.0000 wssi 2.0122 2.5716 0.9949 −8.2988 −3.2097 0.0007 −9.2348 −3.0475 0.0012 −14.4385 −2.844 0.0022 coc −9.7597 −3.7077 0.0001 −14.7006 −5.5467 0.0000 −19.6853 −9.6547 0.0000 −23.2813 −10.4548 0.0000 ge −9.5759 −4.007 0.0000 −16.393 −6.8803 0.0000 −22.1246 −12.3317 0.0000 −24.73 −11.3401 0.0000 ps −9.827 −3.6548 0.0001 −14.0276 −5.2896 0.0000 −20.8577 −10.5652 0.0000 −24.7926 −11.1487 0.0000 rq −10.1044 −4.8235 0.0000 −14.7658 −5.7336 0.0000 −21.487 −11.6653 0.0000 −24.8257 −11.3609 0.0000 rl −8.0499 −2.7067 0.0034 −14.6851 −5.4137 0.0000 −20.5537 −10.9463 0.0000 −23.2304 −10.5977 0.0000 va −12.3037 −6.6864 0.0000 −18.3509 −10.5693 0.0000 −18.5352 −10.0759 0.0000 −20.2718 −8.1441 0.0000 author compilation using stata software, 2022 table 6: pcse estimation results variables investments infrastructure governance macroeconomic overall model 1 2 3 4 5 6 7 8 9 fdi 0.00250045 0.0023433 0.000945 0.0008723 (0.000) (0.000) (0.000) (0.000) gcf −87996 −92967.15 −86099.52 −76993.74 (0.000) (0.000) (0.000) (0.002) pi −0.0010249 −0.0013368 −0.0004197 −0.0005504 (0.000) (0.000) (0.000) (0.001) tci −536815.8 −551270.9 −483506.7 −468043.5 (0.000) (0.000) (0.000) (0.000) eci 538467.6 543264.8 458704.8 451920.8 (0.000) (0.000) (0.000) (0.000) icti 27498.39 25348.9 7746.215 6293.563 (0.481) (0.515) (0.823) (0.861) wssi 65436.59 72528.29 54200.99 58336.1 (0.000) (0.000) (0.000) (0.000) coc −873202.5 −750680.8 909536.8 1004992 (0.406) (0.504) (0.245) (0.209) ge −1698.451 −66834.04 527002.2 941521.7 (0.999) (0.978) (0.718) (0.506) ps −3261965 −3262152 −1537135 −1590307 (0.000) (0.000) (0.000) (0.000) rq −3258912 −2508970 −336040.6 −94717.33 (0.124) (0.221) (0.889) (0.967) rl 2270403 1892239 914930.3 267955.8 (0.009) (0.037) (0.158) (0.649) va 4748809 4925166 1777885 1714098 (0.000) (0.000) (0.000) (0.000) grr −114664.1 49820.63 −162565.5 −128813.6 27525.02 (0.020) (0.215) (0.003) (0.002) (0.568) exr −684.6255 −60.58618 −76.64624 −187.6412 −279.8256 (0.000) (0.000) (0.023) (0.000) (0.001) inf −10086.78 4893.404 333.7315 −6473.775 3747.874 (0.232) (0.378) (0.952) (0.348) (0.413) inr −49062.51 45156.13 −59444.87 −43349.74 22655.94 (0.001) (0.010) (0.000) (0.000) (0.145) _cons 2404577 4165158 −467042.1 −1296228 4064249 5244652 3665482 2710225 1741882 (0.000) (0.000) (0.073) (0.019) (0.000) (0.000) (0.000) (0.002) (0.093) r2 0.3937 0.4592 0.6666 0.6711 0.0948 0.1071 0.0132 0.7535 0.7613 wald χ2 95.39 115.03 325.44 385.90 417.24 580.56 115.12 1433.25 1540.95 prob>χ2 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 obs 592 592 592 592 555 555 592 555 555 bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 21 pearson’ s (1896) pairwise correlation at a 0.05 significance level. according to the results presented in table 7, the study established a positive and significant relationship between gvc and fdi, eci, icti, wssi, coc, rl, and va (0.4957, p ≤ 0.01; 0.6809, p ≤ 0.01; 0.3743, p ≤ 0.01; 0.2626, p ≤ 0.01; 0.0996, p = 0.0154; 0.1281, p = 0.0018; and 0.2178, p ≤ 0.01). on the other hand, pi was found to have a negative but significant association with gvc. the strongest significant association was that of eci at 68% whereas the lowest significant association was that of coc at 9%. 4.7. test for auto correlation h0: no first order auto correlation in the presence of errors of auto correlation, the regression models become inefficient and also makes the estimation of standard errors problematic. this study made use of woodridge (2002) test for auto correction to check for its presence. according to test results presented in table 4, [f (1, 36) = 662.400, p ≤ 0.01] we reject the null hypothesis and conclude that variables are serially correlated. to correct this error, the study chose to use a panel corrected standard errors estimation model which has the ability to correct for serial correlation, cross sectional dependence and heteroscedasticity. 4.8. regression analysis panel data is vulnerable to complex error structures which may affect the efficiency of coefficient estimations and biased estimation of the standard errors. some of these errors include serial correlation, heteroscedasticity and cross sectional dependence (reed and ye, 2011). two of the best estimation methods to reduce some of the errors include feasible generalized least squares (fgls) and panel corrected standard errors (pcse). however, fgls is most effective when the number of time periods (t) is greater than or equal to the number of cross sections (n) (parks, 1967). therefore, due to the presence of serial correlation in the sample data, and the fact that (n) is greater than (t), this study opted to use pcse, which has the ability to correct for heteroscedasticity, cross sectional dependence and serial correlation. 4.8.1. relationships between investments and global value chains in sub-saharan africa this relationship is explained by both model 1 and model 2 in table 6. model 1 which is a composite model indicates a significant relationship between investments and global value chain at a 0.05 alpha significance level (wald χ2 (3) = 95.39, p ≤ 0.01). the coefficient of determination (r2 = 0.3937) indicating that investments can explain up to 39% of the variations in global value chains in sub saharan africa. the coefficient of fdi (0.003, p ≤ 0.01) is positive and significant at 0.05 alpha level, where s that of gcf (−87996, p ≤ 0.01) and pi (−0.001, p ≤ 0.01) are negative but significant at 0.05 level. thus, conclude that investments have a significant influence of global value chains in sub saharan africa. and fit equation 7. gvc fdi gcf pi sig � � � � � � � � 2404577 0 003 87996 0 001 0 0 0 0 0 . . ( . ) ( . ) (1 1 .. )01 (7) r2 = 0.3937 wald χ2 (3) = 95.39, p ≤ 0.01 where: gvc = global value chains fdi = foreign direct investments gcf = gross capital formation pi = portfolio investment model 2, which is controlled by macro-economic factors also indicates a significant relationship between investments and gvc (wald χ2 (7) = 115.03, p ≤ 0.01). the coefficient of determination (r2 = 0.4592) shows that investments can explain up to 45% of the variations in global value chains in sub saharan africa. the coefficients of fdi (0.002, p ≤ 0.01) show a positive and a significant relationship where as that of gcf, pi, grr, exr and inr (−92967.15, p ≤ 0.01; −0.001, p ≤ 0.01; −114664.1, p = 0.002; −684.63, p ≤ 0.01 and −49062.51, p = 0.001 respectively) show a negative but significant relationship at 0.05 alpha level. on the other hand, that of inf (−10086.78, p = 0.232) indicate a negative and non-significant relationship. thus, the study concludes that investments have a significant influence on global value chains even after controlling the relationship with macro-economic factors and fit equation 8. gvc fdi gcf pi sig � � � � � � � 4165158 0 002 92967 15 0 001 0 0 0 0 . . . ( . ) ( . )1 1 (( . ) . . . . ( . � � � � � � 0 0 114664 1 684 63 10086 78 49062 51 0 1 grr exr inf inr 00 0 0 0 23 0 0011 1) ( . ) . .� � � � � (8) r2 = 0.4592 wald χ2 (7) = 115.03, p ≤ 0.01 where: gvc = global value chains fdi = foreign direct investments gcf = gross capital formation pi = portfolio investment grr = gdp growth rate exr = exchange rate inf = inflation rate inr = interest rate the direct relationship model with 3 variables has a (wald χ2 (3) = 95.39, p ≤ 0.01) where as that of a controlled relationship with 7 variables has a (wald χ2 (7) = 115.03, p ≤ 0.01). since model 2 with 7 variables has a higher chi square value than model 1 with 3 variables, we conclude that model 2 presents a better fit. 4.8.2. relationships between infrastructure development and global value chains in sub saharan africa the relationship between infrastructure and global value chains (gvc) is presented by both model 3 and 4 in table 6. results from model 3, which represents a direct relationship indicate a significant relationship (wald χ2 (4) = 325.44, p ≤ 0.01) between infrastructure development and gvc. and the coefficient for determination (r2 = 0.6666) indicating a 66% possibility of infrastructure development explaining the variations in gvc in sub saharan africa. the coefficients of tci (−536815.8, p ≤ 0.01) show a negative but significant relationship. whereas bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 202322 ta bl e 7: p ea rs on ’s p ai rw is e co rr el at io n re su lt s g v c f d i g c f p i t c i e c i ic t i w ss i c o c g e p s r q r l va g r r e x r in f in r g v c 1. 00 00 fd i 0. 49 57 * 1. 00 00 (0 .0 00 0) g c f −0 .0 73 7 0. 10 56 * 1. 00 00 (0 .7 31 ) (0 .0 10 1) pi −0 .4 58 7* −0 .1 81 8* 0. 08 86 * 1. 00 00 (0 .0 00 0) (0 .0 00 0) (0 .0 31 1) tc i 0. 05 97 −0 .0 28 8 0. 28 21 * 0. 03 79 1. 00 00 (0 .1 47 1) (0 .4 83 6) (0 .0 00 0) (0 .3 57 5) ec i 0. 68 09 * 0. 30 01 * 0. 13 51 * −0 .2 77 7* 0. 60 02 * 1. 00 00 (0 .0 00 0) (0 .0 00 0) (0 .0 01 0) (0 .0 00 0) (0 .0 00 0) ic ti 0. 37 43 * 0. 12 12 * 0. 14 82 * −0 .1 51 6* 0. 43 87 * 0. 56 81 1. 00 00 (0 .0 00 0) (0 .0 03 1) (0 .0 00 3) (0 .0 00 2) (0 .0 00 0) (0 .0 00 0) w ss i 0. 26 26 * 0. 06 89 0. 11 90 * −0 .0 69 2 0. 71 33 * 0. 57 26 * 0. 52 41 * 1. 00 00 (0 .0 00 0) (0 .0 93 8) (0 .0 03 7) (0 .0 92 7) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) c o c 0. 09 96 * 0. 01 92 0. 37 23 * 0. 06 76 0. 70 99 * 0. 44 80 * 0. 32 76 * 0. 57 30 * 1. 00 00 (0 .0 15 4) (0 .6 41 6) (0 .0 00 0) (0 .1 00 4) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) g e −0 .0 06 2 0. 03 24 0. 04 12 0. 01 87 0. 07 35 0. 01 57 0. 05 71 0. 08 22 0. 06 89 (0 .8 83 7) (0 .4 46 7) (0 .3 32 5) (0 .6 59 9) (0 .0 83 8) (0 .7 11 8) (0 .1 78 9) (0 .0 52 8) (0 .1 04 7) ps 0. 01 39 −0 .0 73 7 0. 39 42 * 0. 17 20 * 0. 56 77 * 0. 37 16 * 0. 23 57 * 0. 46 13 * 0. 79 83 * 0. 04 37 1. 00 00 (0 .7 36 0) (0 .0 73 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .3 03 8) r q −0 .0 35 6 0. 00 71 −0 .0 31 5 0. 03 62 0. 01 78 −0 .0 36 4 −0 .0 13 4 0. 01 70 0. 03 74 0. 31 13 * 0. 00 40 1. 00 00 (0 .4 02 8) (0 .8 67 3) (0 .4 59 2) (0 .3 94 7) (0 .6 75 8) (0 .3 92 0) (0 .7 52 5) (0 .6 90 3) (0 .3 78 9) (0 .0 00 0) (0 .9 24 2) r l 0. 12 81 * 0. 05 31 0. 34 66 * 0. 12 15 * 0. 65 63 * 0. 44 56 * 0. 33 33 * 0. 57 36 * 0. 89 46 * 0. 05 66 0. 85 27 * 0. 01 63 1. 00 00 (0 .0 01 8) (0 .1 96 9) (0 .0 00 0) (0 .0 03 1) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .1 83 3) (0 .0 00 0) (0 .7 00 8) va 0. 21 78 * 0. 15 48 * 0. 34 40 * 0. 03 82 0. 57 47 * 0. 44 82 * 0. 34 09 * 0. 45 93 * 0. 76 99 * 0. 04 50 0. 71 95 * 0. 02 04 0. 83 95 * 1. 00 00 (0 .0 00 0) (0 .0 00 2) (0 .0 00 0) (0 .3 52 9) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .0 00 0) (0 .2 89 6) (0 .0 00 0) (0 .6 31 9) (0 .0 00 0) g r r −0 .0 62 4 0. 07 07 0. 18 03 * 0. 05 56 −0 .0 03 9 −0 .0 70 5 −0 .1 06 7* −0 .1 15 0* 0. 05 82 0. 08 30 0. 11 08 * 0. 13 83 * 0. 08 80 * 0. 10 37 * 1. 00 00 (0 .1 29 7) (0 .0 85 6) (0 .0 00 0) (0 .1 77 0) (0 .9 25 2) (0 .0 86 6) (0 .0 09 4) (0 .0 05 1) (0 .1 57 4) (0 .0 50 7) (0 .0 07 0) (0 .0 01 1) (0 .0 32 4) (0 .0 11 6) ex r −0 .0 73 5 −0 .0 64 1 −0 .0 95 7* −0 .4 30 4* −0 .1 51 2* −0 .1 28 2* −0 .0 79 7 −0 .1 54 5* −0 .3 08 1* 0. 02 65 −0 .3 73 1* 0. 03 39 −0 .4 09 7 −0 .3 33 3* −0 .0 33 9 1. 00 00 (0 .0 74 0) (0 .1 19 5) (0 .0 19 8) (0 .0 00 0) (0 .0 00 2) (0 .0 01 8) (0 .0 52 5) (0 .0 00 2) (0 .0 00 0) (0 .5 33 5) (0 .0 00 0) (0 .4 25 6) (0 .0 00 0) (0 .0 00 0) (0 .4 11 0) in f −0 .0 15 5 −0 .0 06 3 −0 .1 26 7* −0 .0 19 8 −0 .0 80 6 −0 .0 68 0 −0 .0 76 8 −0 .0 79 8 −0 .1 68 8* 0. 06 99 −0 .1 62 1* −0 .0 42 3 −0 .1 84 4 −0 .1 51 8* −0 .1 29 4* 0. 04 77 1. 00 00 (0 .7 06 2) (0 .8 79 1) (0 .0 02 0) (0 .6 31 2) (0 .0 50 1) (0 .0 98 5) (0 .0 61 8) (0 .0 52 2) (0 .0 00 0) (0 .0 99 8) (0 .0 00 1) (0 .3 20 3) (0 .0 00 0) (0 .0 00 2) (0 .0 01 6) (0 .2 46 6) in r −0 .0 63 4 0. 07 27 −0 .0 09 8 0. 02 35 −0 .0 23 3 −0 .1 17 9* −0 .0 36 0 −0 .1 34 1* 0. 00 41 −0 .0 71 1 −0 .0 22 5 0. 02 74 −0 .0 05 3 0. 02 24 0. 01 57 0. 05 79 0. 11 75 * 1. 00 00 (0 .1 23 4) (0 .0 77 0) (0 .8 11 2) (0 .5 67 5) (0 .5 71 0) (0 .0 04 1) (0 .3 82 1) (0 .0 01 1) (0 .9 19 8) (0 .0 94 1) (0 .5 85 4) (0 .5 20 1) (0 .8 97 9) (0 .5 86 6) (0 .7 02 7) (0 .1 59 3) (0 .0 04 2) bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 23 that of eci and wssi (538467.6, p ≤ 0.01 and 65436.59, p ≤ 0.01 respectively) show a positive and significant relationship. that of icti (27498.39, p = 0.481) show a positive but nonsignificant relationship. therefore, conclude that infrastructure development has a significant relationship with gvc and fit equation 9. gvc tci eci sig � � � � � � � � 467042 1 536815 8 538467 6 0 0 0 0 27 . . . ( . ) ( . )1 1 4498 39 65436 59 0 481 0 0 . . . ( . ) icti wssi� � � � 1 (9) r2 = 0.6666 wald χ2 (4) = 325.44, p ≤ 0.01 where: gvc = global value chains tci = transport composite index eci = electricity composite index icti = information, communication and technology index wssi= water, sewerage and sanitation index on the other hand, model 4 which is controlled by macroeconomic factors indicate a significant relationship (wald χ2 (8) = 385.90, p ≤ 0.01) between infrastructure development and gvc. its coefficient of determination (r2 = 0.6711) indicating that infrastructure development can explain up to 67% of the variations in gvc in sub saharan africa. the coefficients of tci and exr (−551270.9, p ≤ 0.01 and −60.59, p ≤ 0.01 respectively) indicate a negative but significant relationship. whereas that of eci, wssi and inr (543264.8, p ≤ 0.01; 72528.29, p ≤ 0.01 and 45156.13, p = 0.01) indicate a positive and significant relationship. that of icti, grr and inf (25348.9, p = 0.515; 49820.63, p = 0.215 and 4893.404, p = 0.378) indicate a positive but non-significant relationship. hence, conclude that infrastructure development has a significant relationship with gvc under controlled circumstances. equation 10 fits. gvc tci eci sig � � � � � � � � 1296228 551270 9 543264 8 0 0 0 0 253 . . ( . ) ( . )1 1 448 9 72528 29 49820 63 0 515 0 0 0 215 60 . . . . ( . ) . icti wssi grr� � � � � � � � 1 .. . . ( . ) . . 59 4893 404 45156 13 0 0 0 378 0 01 exr inf inr� � � � � � �1 (10) r2 = 0.6711 wald χ2 (8) = 385.90, p ≤ 0.01 where: gvc = global value chains tci = transport composite index eci = electricity composite index icti = information, communication and technology index wssi= water, sewerage and sanitation index grr = gdp growth rate exr = exchange rate inf = inflation rate inr = interest rate the direct relationship model with 4 variables has a (wald χ2 (4) = 325.44, p ≤ 0.01) where as that of a controlled relationship with 8 variables has a (wald χ2 (8) = 385.90, p ≤ 0.01). since model 4 with 8 variables has a higher chi square value than model 3 with 4 variables, we conclude that model 4 presents a better fit. 4.8.3. relationships between governance structures and global value chains in subsaharan africa the relationship between governance and global value chains is represented by model 5 and 6 in table 3. according to the results from model 5 which is a direct relationship (wald χ2 (6) = 417.24, p ≤ 0.01), governance has a significant relationship with gvc. its coefficient of determination (r2 = 0.095) indicating that governance can explain up to 9% of the variations in gvc in sub saharan africa. the coefficients of rl and va (2270403, p = 0.009 and 4748809, p ≤ 0.01 respectively) have a positive and significant relationship. whereas that of ps (−3261965, p ≤ 0.01) is negative but significant. those of coc, ge and rq (−873202.5, p = 0.406; −1698.451, p = 0.999 and −3258912, p = 0.124 respectively) are negative and non-significant. therefore, conclude that governance has a significant influence on gvc in sub saharan africa under a direct relationship. and fit equation 11. gvc coc ge ps sig � � � � � � � 4064249 873202 5 1698 45 3261965 0 406 0 99 . . . . 99 0 0 3258912 2270403 4748809 0 124 0 009 0 � � � � � � � � � � � ( . ) . . ( 1 rq rl va .. )01 (11) r2 = 0.0948 wald χ2 (6) = 417.24, p ≤ 0.01 where; gvc = global value chains coc = control of corruption ge = government effectiveness ps = political stability rq = regulatory quality rl = rule of law va = voice and accountability on the other hand, model 6 is controlled by macro-economic factors and presents a significant relationship (wald χ2 (10) = 580.56, p ≤ 0.01) between governance and gvc. its coefficient of determination (r2 = 0.1071) indicate that under a controlled environment, governance can explain up to 10 percent of the variations in gvc in sub saharan africa. the coefficients of rl and va (1892239, p = 0.037 and 4925166, p ≤ 0.01) are positive and significant. whereas those of ps, grr, exr and inr (−3262152, p ≤ 0.01; −162565.5, p = 0.003; −76.65, p = 0.023 and −59444.87, p ≤ 0.01 respectively) are negative but significant. those of coc, ge and rq (−750680.8, p = 0.504; −66834.04, p = 0.978 and −2508970, p = 0.221 respectively) are negative and non-significant. the coefficients of inf (333.73, p = 0.952) is positive but non-significant. thus conclude that under a controlled environment, governance still has a significant influence on gvc in sub-saharan africa. and fit equation 12. bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 202324 gvc coc ge ps sig � � � � � � � 5244652 750680 8 66834 04 3262152 0 504 0 9 . . . . 778 0 0 2508970 1892239 4925166 162565 5 0 22 � � � � � � � ( . ) . . 1 rq rl va grr 11 0 037 0 0 0 003 76 65 333 75 59444 87 0 � � � � � � � � � � . ( . ) . . . . . 1 exr inf inr 0023 0 952 0 0� � � � �. ( . )1 (12) r2 = 0.1071 wald χ2 (10) = 580.56, p ≤ 0.01 where; coc = control of corruption ge = government effectiveness ps = political stability rq = regulatory quality rl = rule of law va = voice and accountability grr = gdp growth rate exr = exchange rate inf = inflation rate inr = interest rate model 6 with 10 predictors has a higher chi square (wald χ2 (10) = 580.56, p ≤ 0.01) than model 5 (wald χ2 (6) = 417.24, p ≤ 0.01) with 6 predictors. hence conclude that model 6 with 10 variables are a better fit. 4.8.4. relationships between macroeconomic factors and global value chains in subsaharan africa macro-economic factors were selected as controlling variables in this study. however, the researcher opted to test their direct relationship with gvc in sub-saharan africa, hence this section. according to the results from model 7 in table 6, macro-economic factors have a significant relationship with gvc (wald χ2 (4) = 115.12, p ≤ 0.01). however, its low (r2 = 0.0132) indicate that they can only explain about 1% of the variations in gvc in sub saharan africa. the coefficients of grr, exr and inr (−128813.6, p = 0.002; −187.65, p ≤ 0.01 and −43349.74, p ≤ 0.01) indicate a negative but significant relationship. and those of inf (−6473.78, p = 0.348) indicate a negative but non-significant relationship. hence conclude that macro-economic factors have a significant influence on gvc in sub saharan africa. and fit equation 13. gvc grr exr sig � � � � � � � � 3665482 128813 6 187 65 0 002 0 0 6473 7 . . . ( . ) . 1 88 43349 74 0 348 0 0 inf inr� � � � . . ( . )1 (13) r2 = 0.0132 wald χ2 (4) = 115.12, p ≤ 0.01 where: gvc = global value chains grr = gdp growth rate exr = exchange rate inf = inflation rate inr = interest rate 4.8.5. overall relationship between all variables and gvc in sub saharan africa the overall relationship is represented by model 8 and 9 in table 6. model 8 is a direct relationship whereas model 9 is a controlled relationship. the controlling effect is added by macro-economic factors. according to the results from model 8, there is a significant relationship (wald χ2 (13) = 1433.25, p ≤ 0.01) between the predictors and gvc in sub saharan africa. the coefficient of determination (r2 = 0.7535) indicating that the overall model can explain up to 75 percent of the variations in gvc in sub saharan africa. the coefficients of fdi, eci, wssi and va (0.00095, p ≤ 0.01; 458704.8, p ≤ 0.01, 54200.99, p ≤ 0.01 and 1777885, p ≤ 0.01 respectively). those of icti, coc, ge and rl (7746.2, p = 0.823; 909536.8, p = 0.245; 527002.2, p = 0.718 and 914930.3, p = 0.158) are positive but non-significant. the coefficients of gcf, pi, tci and ps (−86099.52, p ≤ 0.01; −0.0004, p ≤ 0.01; −483506.7, p ≤ 0.01and −1537135, p ≤ 0.01) are negative and significant. those of rq (−336040.6, p = 0.889) is negative and non-significant. therefore, conclude that the overall model of investments, infrastructure and governance has a significant influence on global value chains in sub saharan africa. and fit model 14. gvc fdi gcf pi sig � � � � � � � 2710225 0 000945 86099 52 0 0004 0 0 0 . . . ( . ) (1 .. ) ( . ) . . . ( . ) ( 0 0 0 483506 7 458704 8 7746 21 0 0 0 1 1 1 � � � � � � tci eci icti .. ) . . . . ( . ) . 0 0 823 54200 9 909536 8 527002 2 0 0 0 24 1 1 � � � � � � wssi coc ge 55 0 718 1537135 336040 6 914930 3 1777885 0 0 � � � � � � � � � . . . ( . ps rq rl va 11 1) . . ( . )0 889 0 158 0 0� � � � � (14) r2 = 0.7535 wald χ2 (13) = 1433.25, p ≤ 0.01 where: gvc = global value chains fdi = foreign direct investments gcf = gross capital formation pi = portfolio investment tci = transport composite index eci = electricity composite index icti = information, communication and technology index wssi= water, sewerage and sanitation index coc = control of corruption ge = government effectiveness ps = political stability rq = regulatory quality rl = rule of law va = voice and accountability on the other hand, when a controlling effect of macro-economic factors is added to the overall relationship, the model is still significant (wald χ2 (17) = 1540.95, p ≤ 0.01). the coefficient of determination (r2 = 0.7613) indicates that the overall model can explain up to 76% of the variations in gvc in sub saharan africa. the coefficients of fdi, eci, wssi and va (0.0009, p ≤ 0.01; bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 25 451920.8, p ≤ 0.01; 58336.1, p ≤ 0.01 and 1714098, p ≤ 0.01 respectively). those of icti, coc, ge, rl, grr, inf and inr (6293.56, p = 0.861; 1004992, p = 0.209; 941521.7, p = 0.506; 267955.8, p = 0.649; 27525.02, p = 0.568; 3747.87, p = 0.413 and 22655.94, p = 0.145). the coefficients of gcf, pi, tci, ps and exr (−76993.74, p = 0.002; −0.00055, p = 0.001; −468043.5, p ≤ 0.01; −1590307, p ≤ 0.01; and −279.83, p = 0.001 respectively). and those of rq (−94717.33, p = 0.967) is negative and insignificant. thus conclude that the overall model with a controlling effect of macroeconomic factors has a significant influence on global value chains in sub saharan africa. and fit equation 15. gvc fdi gcf pi sig � � � � � � 1741882 0 00087 76993 74 0 00055 0 0 0 0 . . . ( . ) .1 002 0 001 468043 5 451920 8 6293 56 0 0 0 � � � � � � � � � . . . . ( . ) ( tci eci icti 1 .. ) . . . ( . ) . 0 0 861 58336 1 1004992 941521 7 0 0 0 209 1 1 � � � � � � wssi coc ge �� � � � � � � � � 0 506 1590307 94717 33 267955 8 1714098 0 0 . . . ( . ps rq rl va 1)) . . ( . ) . . . 0 967 0 649 0 0 27525 02 279 83 3747 87 2 � � � � � � � � � 1 grr exr inf 22655 94 0 568 0 001 0 413 0 145 . . . . . inr � � � � � � � � (15) r2 = 0.7613 wald χ2 (17) = 1540.95, p ≤ 0.01 where: gvc = global value chains fdi = foreign direct investments gcf = gross capital formation pi = portfolio investment tci = transport composite index eci = electricity composite index icti = information, communication and technology index wssi= water, sewerage and sanitation index coc = control of corruption ge = government effectiveness ps = political stability rq = regulatory quality rl = rule of law va = voice and accountability grr = gdp growth rate exr = exchange rate inf = inflation rate inr = interest rate model 9 with 17 predictors has a higher chi2 (wald χ2 (17) = 1540.95, p ≤ 0.01) than model 8 with 13 predictors (wald χ2 (13) = 1433.25, p ≤ 0.01). therefore, conclude that model 9 presents a better fit. 5. conclusions and policy implications 5.1. introduction based on the findings from chapter 4, this study makes the following conclusion and possible policy implications. 5.2. conclusions the main aim of this study was to look into global value chains from different perspectives such as investments, infrastructure development, governance and macro-economic factors and establish their relationships. panel data was used from 37 sub saharan africa countries from the year 2003-2018. the paper tested for both direct and controlled relationships using panel corrected standard errors estimation model. from both the direct models and controlled models, it was established that all the variables under study (investments, infrastructure, governance and macro-economic factors are significant in explaining the behavior of global value chains in sub saharan africa. however, controlled models were found to be a better fit than direct relationship models. the controlling effect was added using macro-economic factors. therefore, supports the proposition by smith (1776) on the theory of absolute advantage. liberalizing trade, embracing specialization and division of labor in production according to a countries core productive competencies leads to increased output and reduction of fixed overheads hence absolute advantage. 5.3. policy implications the world is experiencing a substantial change due to increased innovations in technology, international trade and investments. to remain competitive and harness the potential of industrialization, sub saharan africa should promote value added manufacturing, and integrate more into global value chains. sub saharan africa countries should also consider minimizing on protectionism policies to enable expansion of international trade and thus global value chains. infrastructure development is a significant factor in the variations of global value chains in sub saharan africa. effective and efficient infrastructure network enables a reduction in production cost hence possibilities in exploiting the benefits of absolute advantage. therefore, there is need for countries to deliberately channel resources to infrastructure development. governance can explain up to 10% of the variation in global value chains in sub saharan africa. it is indeed a significant factor in influencing global value chains. therefore, there is need to streamline governance especially as relates to manufacturing, international trade and business regulation. references adalov, a. 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(2018), infrastructure and global value chain position: evidence from china. department of economics and business. barcelona: universitat popmeu fabra. bosire: viewpoints in global value chains: evidence from sub-saharan africa international journal of economics and financial issues | vol 13 • issue 1 • 202328 appendix 1: sub-saharan africa countries sampled countries excluded countries no. country no. country no. country 1. angola 25. liberia 1. benin 2. benin 26. madagascar 2. burkina faso 3. botswana 27. malawi 3. comoros 4. burkina faso 28. mali 4. congo republic 5. burundi 29. mauritania 5. equatorial guinea 6. cameroon 30. mauritius 6. eritrea 7. cape verde 31. mozambique 7. ethiopia 8. central africa republic 32. namibia 8. guinea 9. chad 33. niger 9. guinea bissau 10. comoros 34. nigeria 10. sudan 11. republic of the congo 35. rwanda 11. zimbabwe 12. cote d’ivoire 36. sao tome principe 13. democratic republic of the congo 37. senegal 14. equatorial guinea 38. seychelles 15. eritrea 39. sierra leone 16. eswatini (formerly swaziland) 40. somalia 17. ethiopia 41. south africa 18. gabon 42. south sudan 19. gambia, the 43. sudan 20. ghana 44. tanzania 21. guinea 45. togo 22. guinea-bissau 46. uganda 23. kenya 47. zambia 24. lesotho 48. zimbabwe author compilation, 2022 nb: these countries were excluded due of inadequacies in data compilation appendix tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 46-55. international journal of economics and financial issues | vol 13 • issue 1 • 202346 a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period ruschelle sgammini* school of economic sciences, north-west university, south africa. *email: 22794107@nwu.ac.za received: 22 september 2022 accepted: 22 december 2022 doi: https://doi.org/10.32479/ijefi.13717 abstract socially responsible investing is a growing investment philosophy that has gained profound interest in both the local and international context. socially conscious investors are seeking alternative ways to make more responsible investment choices, especially since the covid-19 pandemic. although financial markets experienced a significant decrease owing to the pandemic, a more positive outcome was eminent by an increased demand in sri products during this period. the aim of this study was to evaluate the performance of local sri funds before, during and after the covid-19 period. comparatively evaluating the performance relative to the ftse/jse responsible investment index and all share index, will assist investors (those with a heightened desire to invest responsibly) to establish if sri funds were able to provide higher risk-adjusted returns than the comparable sri and general equity markets. the results indicated that although larger returns were produced by sri funds during the covid-19 period and that significant differences were found relative to the two indices, sri funds were not able to consistently outperform either index. thus, socially conscious investors are likely to achieve higher risk-adjusted returns from the sri index, although not receiving diversification benefits from investing in funds. keywords: south african sri funds, sri strategies, risk-adjusted performance, covid-19 jel classifications: g11, g23 1. introduction the generation of socially responsible (or ethical) investors have evolved and progressed, both locally and internationally. these investors have created and promoted an evolving trend of investing in a wide range of investment products that promote a greener, more sustainable, and socially responsible future (viviers, 2007:1; woods price, 2021; o’shea and benson, 2022). although the covid-19 pandemic led to financial markets experiencing downturns with a promised struggling recovery as the world learns how to deal with the consequences thereof, one positive outcome was eminent by an increased demand in socially responsible investment (sri) products during this period (madjarova, 2021). according to woods price (2021), the covid-19 pandemic drew the attention of the world to the various existing social, economic and environmental issues and inequalities, highlighted by the united nations sustainable developments goals (sdgs) that were developed in 2012. sris have been described by a number of researchers as ethical investing, sustainable investing, green investing, targeted investing, environmental investing, responsible investing or social investing (white, 1995; cowton, 1998; herringer et al., 2009; giamporcaro and pretorius, 2012). however, giamporcaro and pretorius (2012:3) clarified that, fundamentally, sri includes sustainable and responsible investments directed toward relating ethical, environmental, social and corporate governance (esg) investment objectives and conventional financial investment objectives. furthermore, during the investment decision-making process, investors select sris based on their perception toward esg factors as well as financial investment objectives (adam and shauki, 2014:226). therefore, the definition of socially responsible investing as the act taken to consider both financial investment objectives and the commitment towards esg investment objectives during the investment decision-making process, as provided by oh et al. (2013:705), is adopted for the purpose of this study. this journal is licensed under a creative commons attribution 4.0 international license sgammini: a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period international journal of economics and financial issues | vol 13 • issue 1 • 2023 47 as stated by viviers et al. (2009:9), the variety of definitions relating to socially responsible investing renders establishing the exact size of the south african sri market relatively difficult. the market was valued at approximately r18 billion and consisted of 35 active funds on 31 march 2006 (viviers, 2007). in 2009, the market grew with three funds to a total of 38 funds, with an approximate value of r23.28 billion (giamporcaro et al., 2010). in june 2015, the south african sri market grew substantially to a market value of r71.38 billion while consisting of 42 funds (du plessis, 2015:26). the study performed by du plessis (2015:27) found that the majority of sri funds (33%) followed a negative (or exclusionary) screening strategy in 2014, which predominantly focused on islamic shari’ah principles. furthermore, a positive (or inclusionary) strategy was employed by approximately 24% of the funds by placing focus on sectors or companies that promote esg factors (such as renewable energy), while cause-based investing was employed by only 19%. south african sri funds largely concentrate on the promotion of development, infrastructure (such as building roads, educational and medical centres) and broad based black economic empowerment (bbbee) (du plessis, 2015:29). as the positive screening strategy concentrates on the promotion of esg factors, the strategy often is combined with the cause-based investing strategy due to its mutual concentration on the promotion of infrastructure development and bbbee (viviers et al., 2009:11; giamporcaro et al., 2010:11). as reported by du plessis (2015:29) 12% of sri funds reported to employ a combination of positive screening and cause-based investing, in 2014. similar to the research of giamporcaro et al. (2010) it was found that the best-of-sector screening strategy (which is a hybrid form of positive and negative screening) is not employed by south african sri funds (du plessis, 2015:30). giamporcaro et al. (2010:13) identified that this contrasts with the french sri market in which the best-of-sector screening strategy is pervasive. viviers (2007) found that local sri funds underperformed relative to the (then) ftse/jse sri index between 1992 and 2002, while delivering equal risk-adjusted performance to that of the ftse/ jse all share index during the same period. furthermore, during the period between 2002 and 2006, viviers (2007) reported outperformance of sri funds relative both comparable indices. the study performed by du plessis (2015) incorporated a similar methodological approach to compare the performance of local sri funds against the aforementioned indices, as by viviers (2007). du plessis (2015), however found that during the period of 2004 to 2014, local sri funds did not outnor underperform against the relative indices but did however indicate improved risk-adjusted performance since the start of the research period. naidoo (2019) contrarily found that during 2009 to 2013, sri funds indicated significant underperformance, while during 2014 to 2018 indicated improved performance. this study will evaluate the performance of local sri funds before, during and after the covid-19 period to establish if the pandemic, a period in which financial markets experienced downturns, influenced sri fund performance. the risk-adjusted performance will be evaluated by employing the treynor ratio, sharpe ratio, jensen’s alpha, sortino ratio, calmar ratio and omega ratio. additionally, by evaluating sri fund performance against that of the ri top 30 index and alsh, it is possible to establish if sri funds outperformed the respective sri and general equity markets in south africa. given that the majority of local sri funds invest in equities (either locally or internationally), it is assumed that the analysis may indicate a relatively strong correlation to that of the two indices and may lead to certain traditional risk-adjusted performance measures to indicate biased results. 2. literature review 2.1. the history of socially responsible investment the history of sri dates back hundreds of years where following religious and moral standards (or principles) were regarded as compulsory. the 18th century quakers of the united states of america were the first group of investors to apply religious (or ethical) screening to traditional investments (kinder and domini, 1997:12; viviers, 2007:7; herringer et al., 2009:11). bauer et al. (2005:1752) noted that the quakers applied religious (or ethical) screens based on the promotion of human equality and nonviolence. following the religious screening introduced by the quakers, mutual funds in the united states of america adopted sri principles in the 1920s, which was, however, a result of the consequences of world war i (viviers, 2007:7). in the aftermath of world war i, social awareness amplified through which the first sri funds were created based on evading to invest in companies associated with alcohol, gambling, tobacco and weaponry production and transactions (viviers, 2007:7). interestingly and ironically, as proposed by heese (2005:730), the south african sri market grew at a much later stage than international sri markets. in the early 1970s, the apartheid era of south africa drove the growth of international sri markets through which, predominantly in the united states of america, a number of faith-based groups and pension funds retracted investment from south africa (beabout and schmiesing, 2003:67; ethical partnership, 2022). although the struggling circumstances of apartheid in south africa spurred the growth of international sri markets, south africa itself was not aware of this new social investment philosophy. the divestment from south africa brought about by the united states of america soon followed to the united kingdom and australia in the 1980s (giamporcaro and pretorius, 2012:1; oh et al., 2013:705). giamporcaro and pretorius (2012:1) noted that in 2000, sustainable development formed the basis and prompted the progression of the belgium, european, french, german and switzerland sri markets. directing or withholding investment from companies that did or did not focus on esg concerns was the ultimate manner in which socially responsible investing was practiced since 2000 (giamporcaro and pretorius, 2012:1). the south african sri market struggled to develop and grow as rapidly as the international sri sector (viviers, 2007:9). although the first two south african sri funds (the community growth sgammini: a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period international journal of economics and financial issues | vol 13 • issue 1 • 202348 equity fund and the futuregrowth albaraka equity fund1) were launched in 1992, the south african sri market did not receive as much attention given that various individual investors, financial institutions and financial managers were convinced that sri was associated with financial sacrifice followed by large-scale losses (viviers et al., 2008:39; viviers et al., 2009:3). however, since the establishment of the financial times stock exchange/johannesburg stock exchange (ftse/jse) sri index in may 2004, the south african sri market has received remarkable interest (viviers et al., 2009:3). as identified by the johannesburg stock exchange (jse) (2022), the ftse/jse sri index has developed substantially in order to encourage sustainable development and good corporate citizenship, measuring the companies listed on the ftse/jse all share index (alsh) against a number of esg concerns as well as the latest inclusion of climate change. in june 2015, the jse announced that they formed a partnership with the ftse russell (the global index provider) regarding aligning the jse’s esg approach with that of the ftse russell (jse, 2022). while the new partnered esg approach will replace the then current sri index, jse-listed companies, as well as social investors, will be provided with new opportunities to incorporate esg considerations into the investment decisionmaking process (london stock exchange group [lseg], 2022). the new ftse/jse responsible investment (ri) index series, which comprises of the ftse/jse ri index and the ftse/jse ri top 30 index, replaces the ftse/jse sri index (le roux, 2015). granting that sri received amplified interest since 2004 in south africa, the south african sri market remains comparatively smaller than international counterparts (viviers and fifer, 2013:218), although the largest in africa (viviers and els, 2017:124). as sparkes and cowton (2004:45) noted that sri started as an investment philosophy followed by a small amount of investors and investment funds (for example unit trust funds and mutual funds), larger investment institutions (for example pension funds and insurance companies) have adopted this style of investment over the years. the shift of sri from margin to mainstream, as asserted by sparkes and cowton (2004:49), has been evident by large pension funds and insurance companies, predominantly based in the united kingdom, united states of america, australia and canada, following this relatively new investment philosophy. in this regard, the development of sri has contributed to the growth of the developing economies, such as the south african economy, which can be noted through multiple businesses, institutions and retirement funds addressing esg concerns (de jongh et al., 2007:3; woods price, 2021). 2.2. socially responsible investment strategies sri is characterised by incorporating financial return with esg concerns into the investment decision-making process (viviers et al., 2009:1). during the investment decision-making process, socially responsible investors follow the mainstream approach of constructing a portfolio of investments, combined with one or more of the three noticeable sri strategies. screening, shareholder 1 the futuregrowth albaraka equity fund has changed its name to the old mutual albaraka equity fund. activism and cause-based investing are identified as the three sri strategies employed by socially responsible investors (heese, 2005:730; viviers, 2007:4; renneboog et al., 2008:1725; viviers et al., 2009:4; giamporcaro et al., 2010:3; oh et al., 2013:705). the first sri strategy, as noted by viviers (2007:71) as well as ballestero et al. (2012:488), comprises three types of screening, specifically negative, positive, and best-of-sector. negative (or exclusionary) screening involves evading to invest in companies that are deemed as morally and ethically undesirable (viviers, 2007:71). investors (or fund managers) who invest in companies that are considered to be good corporate citizens, as these companies generally pursue policies supportive of ethical and social concerns, employ a positive (or inclusionary) screening approach. a social investor may decide to combine positive and negative screening to form a best-of-sector (or hybrid) screening approach. the second sri strategy, namely shareholder activism (or shareholder engagement), as stated by viviers et al. (2009:7), entails actively participating in accordance with the companies’ management regarding esg concerns. viviers (2007:85) identified that investors can employ this strategy by engaging with management boards through dialogues, utilising voting rights, filing resolutions, or by ridding investments from those companies that do not conform to transformation. concerns regarding the environment, employees, socio-economic climate, and community can be addressed by means of shareholder activism. finally, socially responsible investors can employ a cause-based (or targeted) investing approach that comprises of directing finances towards particular social or ethical causes or projects. viviers et al. (2009:7) noted that cause-based investors would accept lower returns on investments as supporting a particular cause receives higher objective, although market rate returns, generally, are sought after. however, investors may also direct returns earned on conventional investment (non-sri) funds toward social causes in order to obtain a combination of traditional investment and ethical investment portfolios (statman, 2008:40). according to kinder (2005:11) and supported by oh et al. (2013:704), value-based investors, value-seeking investors, and value-enhancing investors are classified as the three types of investors seeking social returns. kinder (2005:12) further recognised that the three social investors each implement a different sri strategy to its advantage. both value-based and value-seeking investors invest in accordance with esg concerns, however, in differing ways, while value-enhancing investors pursue improving the value of investments in accordance with shareholder activism (kinder, 2005:30; viviers, 2007:85). 3. research design and methodology 3.1. data collection method and process the research period for this study extended from 21 february 2018 to 05 october 2022 to include a period in which financial markets experienced significant volatility due to the global covid-19 sgammini: a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period international journal of economics and financial issues | vol 13 • issue 1 • 2023 49 pandemic. the research period was divided into three subsequent periods (figure 1): • period 1: 21 february 2018 to 15 march 2020 – defined as the pre-covid-19 period; • period 2: 16 march 2020 to 04 april 20222 – defined as the period during covid-19; and • period 3: 05 april 2022 to 05 october 2022 – defined as the post-covid-19 period. the sample selected for the statistical analysis consisted of 14 local sri unit trust funds. the sample was selected based on the specification that the sri funds had to be active during the research period. furthermore, due to data availability, nondisclosure agreements (ndas) and confidentiality clauses, the sample was limited to the inclusion of unit trust funds only. secondary quantitative data were sourced and collected from the iress expert inet bfa (2022) financial database. to compare the risk-adjusted performance of the sri funds to that of two ftse/jse indices, namely the ri top 30 index and alsh, daily data were collected over the research period. furthermore, data for the risk-free rate (selected as the short-term (91 day) treasury bill rate of south africa) were collected from the south african reserve bank (sarb, 2022). 3.2. risk-adjusted performance measures performance measures are extensively employed to analyse the risk-adjusted performance of investments (including investment portfolios and funds) during the investment decisionmaking process. various performance measures utilise similar representations of excess return, however, each with a different representation of risk. the treynor ratio, sharpe ratio, jensen’s alpha, sortino ratio, calmar ratio and omega ratio were the riskadjusted performance measures selected for the statistical analysis. the treynor ratio, as presented by equation 1, indicates a funds’ excess return above the risk-free rate of return (the risk premium) 2 the start date of the covid-19 period was selected as 16 march 2022, the date on which south africa was declared to be in a national state of disaster; while the end date was selected as the date on which the national state of disaster was terminated. per unit of risk. the treynor ratio explicitly assumes that a funds’ inherent risk (market or systematic risk) can be measured by beta (βi) and, therefore, assumes that a fund is fully diversified. a high and positive treynor ratio is preferred as it is indicative of superior risk-adjusted performance (dzikevičius, 2005; kanellakos, 2005:49). treynor ratio r ri f i = � � (1) where ri is the expected return of fund i, rf is the risk-free rate of return, and βi is the funds’ beta. as one of the most widely employed measures, the sharpe ratio (lien, 2002:484), on the other hand, measures the risk-adjusted return per unit of total risk and, therefore, estimates both diversification and performance (marx et al., 2010:285; reilly and brown, 2012:939). the standard deviation, which is used by the sharpe ratio as a gauge of total risk, is used to measure the volatility of a fund’s returns as in equation 2 (sharpe, 2000:16): sortino ratio r dr i� � � �� (2) where σi represents the standard deviation of the fund as measure of total risk. as with the treynor ratio, a high sharpe ratio is indicative of greater risk-adjusted performance. as reported by van heerden et al. (2014), the results of the treynor ratio and the sharpe ratio will not always be the same, which may be assumed given that these ratios are very comparable. the jensen’s alpha, however, considers the correlation between the returns of a fund and the returns of a relative market benchmark or index (as denoted by rm in equation 3), which is calculated by the beta (βi) factor (eling and schuhmacher, 2007:2633). excess return is indicated by a statistically significant positive alpha (jensen, 1968:394), based on the assumptions of the capital asset pricing model (capm) (lintner, 1969; sharpe, 1964; black, 1972) that an investor is risk-averse, rational and that their investment decision relies on their risk-return utility function (elbannan, 2015:216). 30,000 40,000 50,000 60,000 70,000 80,000 f eb -2 01 8 ju l-2 01 8 d ec -2 01 8 m ay -2 01 9 o ct -2 01 9 m ar -2 02 0 a ug -2 02 0 ja n20 21 ju n20 21 n ov -2 02 1 a pr -2 02 2 s ep -2 02 2 f t s /j s e a ll s ha re in de x va lu e pre-covid-19 during covid-19 post covid-19 figure 1: research period as shown by the ftse/jse all share index sgammini: a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period international journal of economics and financial issues | vol 13 • issue 1 • 202350 jensen s alpha r r r ri f i m f , = � � �� ��� ��� (3) it may be evident, in cases where the above performance ratios deliver the same results, that the portfolio or fund under investigation is classified as a well-diversified investment since its total risk (as measure by the sharpe ratio) is reduced to its inherent market risk (as measured by the treynor ratio and jensen’s alpha) (verma and hirpara, 2016:383). contrarily, outperformance can be indicated by the treynor ratio and jensen’s alpha, while underperformance is indicated by the sharpe ratio, in cases where the unique risk (unsystematic risk) of the investment is very large and thus less diversified (deb, 2012:7; verma and hirpara, 2016:383). developed as an alteration to the sharpe ratio, the sortino ratio evaluates the risk-adjusted performance of a fund by using the downside deviation (or semi-variance) as representation of risk (rollinger and hoffman, 2013:41). a minimum acceptance return (mar) threshold is selected to capture exactly what investors regard as risky, which can be specified as zero, the risk-free rate or a relative benchmark or index. sortino ratio r dr i� � � �� (4) where ri denotes the average return of the fund, τ (tau) represents the mar threshold, and dr denotes the downside risk of the fund. for this study the mar threshold value was selected as the risk-free rate of return (per respective period analysed). mathematically, downside risk is expressed as the following (adapted from reilly and brown, 2012): downside risk dr n ri( ) ( )� �� 1 2� (5) where n is the number of fund returns that fall below the mar threshold. similar to the excess return captured by the treynor and sharpe ratios, and the focus on downside risk by the sortino ratio, the calmar ratio measures the excess return over the risk-free rate per unit of maximum drawdown [represented by e (mdd)]. the maximum drawdown of a fund captures the distance between the fund’s peak and trough, as the maximum cumulative decline that can be expected by the fund as in equation 6 (almahdi and yang, 2019:147). calmar ratio r r e mdd i f � � � � (6) while the traditional risk-adjusted performance measures do not take the entire return distribution into account, keating and shadwick (2002) introduced the omega ratio which addresses this limitation. the omega ratio expresses the upside deviation of a fund as a ratio of the downside deviation (each with a shared return threshold), while considering all moments of the return distribution (such as mean, variance, skewness and kurtosis) (bergh and van rensburg, 2008:105). ( )( ) ( ) 1 ( ))omega ratio ( b r r a f x dx r f x dx − = ∫ ∫ ω (7) where f (x) represents the cumulative distribution function of the return distribution, r is the return threshold (selected as the riskfree rate of return per respective period), b is the highest observed return in the return distribution (upper bound), and a is the lowest observed return in the return distribution (lower bound). 3.3. wilcoxon signed rank test the wilcoxon signed rank test was employed to establish if the sri funds outor underperformed against the three ftse/jse indices, pre-covid-19, during covid-19 and post-covid-19; as well as to establish if the difference in performance was statistically significant at a 95% confidence level. rather than testing the difference of the actual values of the respective risk-adjusted performance measures, the wilcoxon signed rank test includes using the ranks (or order) of the values as a non-parametric test (du plessis, 2015:88). the mathematical test statistic is expressed in equation 8 (adapted from du plessis, 2015:88). wilcoxon test statistic rii n = ( / ) ' � � �� 1 (8) where rii n ( / ) ' � � �� 1 is the addition of the positive (or negative) ranked differences between two paired values. the addition will be positive (or negative) if the majority of the differences are positive (or negative) (du plessis, 2015:88). to test the significance of the difference of the risk-adjusted performance, the following null and alternative hypotheses were defined, per comparative ftse/jse index and period: • h1,0: there was no statistically significant difference between the risk-adjusted performance of the sri funds and the ftse/jse index; and • h1,a: there was a statistically significant difference between the risk-adjusted performance of the sri funds and the ftse/jse index. 4. results and findings the statistical analysis included to firstly analyse the unadjusted annualised returns of sri funds and the ftse/jse indices and to determine to extent of the correlation, before, during and after covid-19. secondly, the evaluation of various risk-adjusted performance measures of the sri funds and ftse/jse indices, pre-covid-19, during covid-19 and post-covid-19, was performed. lastly, to establish if the difference in the risk-adjusted performance between the sri funds and the ftse/jse indices were statistically significant, the wilcoxon signed ranks test was performed. the analysed period extended from 21 february 2018 to 05 october 2022 which included a period of the covid-19 sgammini: a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period international journal of economics and financial issues | vol 13 • issue 1 • 2023 51 pandemic, a period in which financial markets around the world experienced significant downturns. as seen in figure 1, relatively stable index values were recorded by the alsh during the pre-covid-19 period (21 february 2018 to 15 march 2020), with a distinguished decline that extended into the start of the covid-19 period (16 march 2020). this decline can be ascribed to the impact of an anticipated national state of disaster declaration. during the covid-19 period, the alsh exhibited a bullish trend although reporting the lowest value of 37 963.01 (a decrease of 35.44% from the peak value recorded in the pre-covid-19 period) during the period under investigation. the highest index value of 77 536.12 was similarly recorded towards the end of the covid-19 period, which indicated the start of a bearish trend as reported during the post-covid-19 period. since the downturn was experienced at the onset of the pandemic, the index value was restored to pre-covid-19 levels after approximately 283 days. equities benefit from an expanding economy, evident by high economic activity, high inflation and thus high interest rates, which resulted from the contractionary pressures experienced due to the impact of the covid-19 pandemic. it is thus expected and evident (as in figure 1 in the post-covid-19 period) that the economy, and likewise the equity market, will reach a period of decline as the higher interest rates have started to take effect. the return distributions of the sri funds and the two ftse/ jse indices were analysed as presented in table 1 by the descriptive statistics. the descriptive statistics focussed on the mean (average), variance (standard deviation around the mean), skewness (indication of extreme returns to the left or right of the mean) and kurtosis (indication of thin or fat tails) as the first four moments of distribution (bacon, 2021). given that most of the risk-adjusted performance measures employ these moments of distribution in their design, van heerden et al. (2014:175) noted that it is essential to analyse the underlying return distributions to establish ability limitations of certain traditional risk-adjusted performance measures. risk-adjusted performance measures such as the sharpe ratio and jensen’s alpha rely on normally distributed returns and may limit the ability of these measures to effectively rank investment alternatives (kat, 2003). 4.1. descriptive statistics the descriptive statistics reported in table 1 indicate that sri funds are leptokurtic and negatively skewed throughout the research period. the sri fund return distribution indicates similarities to the characteristics of sri funds in france, the eurozone and europe as found by (le sourd, 2011) as well as of united states and european hedge funds as found by van heerden et al. (2014:178). the ri top 30 index exhibited inconsistent results between the three periods with a negatively skewed leptokurtic distribution in the pre-covid-19 period, a positively skewed leptokurtic distribution during the covid-19 period, and a negatively skewed platykurtic distribution during the post-covid-19 period. the general equity market indicated a negatively skewed leptokurtic distribution in the pre-covid-19 period, a positively skewed leptokurtic distribution during the covid-19 period as well as a positively skewed platykurtic distribution in the post-covid-19 period. given that the jarque-bera goodness-of-fit test indicated non-normality based on skewness and kurtosis for all return distributions, except for the two ftse/jse indices in the post-covid-19 period, the results of the traditional risk-adjusted performance measures may be biased (van heerden et al., 2014:177). the average compound returns of sri funds as well as the sri and general equity market increased from negative pre-covid-19 returns, to positive returns during the covid-19 period. accompanied with a higher average return, the standard deviation (risk/volatility) of sri funds and the ftse/jse indices likewise increased into the period during covid-19. however, in the post-covid-19 period, average returns exhibited a moderate decrease, reaching the low and negative returns exhibited in the period before covid-19, although combined with similar risk levels as during the covid-19 period, especially noted for sri funds and the alsh. furthermore, the correlation between the sri funds and the three ftse/jse indices was evaluated, as in table 2. according to van heerden et al. (2014:177), a biased risk-adjusted performance rank, by the sharpe ratio, results from the existence of correlation. the results in table 2 indicate similar results when comparing the sri table 1: descriptive statistics of the returns of sri funds and ftse/jse indices average pre-covid-19 period min. max. mean median std. dev. skewness kurtosis jarque-bera sri funds −3.576% 1.487% −0.011% 0.025% 0.526% −1.394 7.693 1957.129* ri top 30 −9.995% 2.786% −0.030% 0.015% 1.111% −2.008 14.697 4971.628* alsh −9.721% 3.254% −0.049% 0.027% 1.107% −1.885 13.338 4114.155* average during covid-19 period min. max. mean median std. dev. skewness kurtosis jarque-bera sri funds −3.273% 2.786% 0.069% 0.075% 0.625% −0.373 5.472 1929.678* ri top 30 −7.154% 8.613% 0.171% 0.175% 1.617% 0.189 4.495 435.834* alsh −7.154% 7.532% 0.131% 0.131% 1.350% 0.174 4.596 455.010* average post-covid-19 period min. max. mean median std. dev. skewness kurtosis jarque-bera sri funds −1.914% 1.770% −0.029% −0.016% 0.657% −0.591 3.215 643.937* ri top 30 −3.565% 3.615% −0.101% −0.196% 1.397% −0.005 −0.163 0.140 alsh −3.479% 3.274% −0.100% −0.156% 1.399% 0.173 −0.197 0.827 *reject the null hypothesis of normality at the 5% level of significance sgammini: a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period international journal of economics and financial issues | vol 13 • issue 1 • 202352 funds with firstly the ri top 30 index, and secondly the alsh, where a strong positive correlation is present for all three periods accompanied with an increase noted from period to period. thus, a biased performance ranking by the sharpe ratio may be expected based on the presence of correlation between the sri funds and the two ftse/jse indices. for this reason, other (than traditional) risk-adjusted performance ratios were implemented (such as the omega ratio) to evaluate these funds. given the increasing positive correlation between sri funds and the sri and general equity market, a clear dependence on equities was illustrated. given that the alsh indicated a bullish trend during the covid-19 period, and that there is an increasing positive strong correlation with sri funds, it may indicate the ability of sri funds to outperform the general equity market, which will be discussed in the following section. the strong correlation may similarly lead to sri funds experiencing a bearish trend in the post-covid-19 period following the trend by the alsh (figure 1). 4.2. risk-adjusted performance measures the risk-adjusted performance of the sri funds was compared to that of the two ftse/jse indices in the pre-, during, and post-covid-19 periods. as presented in table 3, the risk-adjusted performance measures calculated included the treynor ratio, sharpe ratio, jensen’s alpha, sortino ratio, calmar ratio and omega ratio. for the evaluation against the performance of the sri market, the ri top 30 index was utilised as the market portfolio for the treynor ratio and jensen’s alpha. likewise, for the evaluation against the general equity market, the alsh was employed as the market portfolio for both the treynor ratio and jensen’s alpha. as seen in table 3, across all risk-adjusted performance measures employed, on average, sri funds performed poorly both before and after the covid-19 period, indicated by negative ratio values; except for the omega ratio, and the treynor ratio with the ri top 30 index as market portfolio specifically pre-covid-19. this indicated that sri funds were not able to produce excess returns above the risk-free rate per unit of either total risk, market risk, downside risk or maximum drawdown. however, the evaluation further indicated that these funds were able to produce higher returns than the sri market and exhibited greater upside deviation opportunities. however, contrary to the assumption based on the results found by du plessis (2015) that on average, sri funds’ performance can be influenced by hazardous market events (such as the global financial crises of 2007/08, and hence the covid-19 pandemic), the risk-adjusted performance of the average sri funds was higher (and positive) during the covid-19 period. this indicated that during this period, sri funds were able to provide investors with excess returns per unit of specific risk measured. although the average market risk for both the sri and general equity markets was significantly high in the pre-covid-19 period and the period during covid-19 (22.60% and 24.17% before, 28.47% and 22.50% during, respectively), the average compound annual returns of sri funds produced were −2.92% before and 18.62% during covid-19, leading to the significantly higher risk-adjusted performance ratios. furthermore, as presented in table 4, sri funds produced significant differences relative to the ri top 30 index during the pre-covid-19 period, with only the treynor ratio indicative of outperformance. although the average sri funds’ risk-adjusted performance measures were higher and positive during the covid-19 period, underperformance was noted relative to the ri top 30 index across most performance measures, except for the treynor ratio (significantly) and omega ratio indicating outperformance. this indicates that the average excess returns produced by these funds were higher than that produced by the index and that the returns were more concentrated on the positive table 2: the average correlation between sri funds and the ftse/jse indices average correlation sri funds ri top 30 alsh pre-covid-19 period 0.600 0.559 during covid-19 period 0.703 0.742 post-covid-19 period 0.749 0.755 table 3: the average risk-adjusted performance of the sri funds and the ftse/jse indices pre-covid-19 period averages treynor ratio sharpe ratio jensen’s alpha sortino ratio calmar ratio omega ratiosri index equity index sri index equity index sri funds 0.052 −0.042 −1.252 −0.062 −0.055 −1.091 −0.872 1.185 ri top 30 index −0.157 −0.892 0.000 −0.787 −0.568 0.994 alsh −0.199 −1.136 0.000 −0.98 −0.748 0.946 covid-19 period averages treynor ratio sharpe ratio jensen’s alpha sortino ratio calmar ratio omega ratiosri funds sri index equity index sri index equity index 0.560 0.498 1.149 0.047 0.057 1.216 1.993 1.444 ri top 30 index 0.446 1.745 0.000 1.824 2.957 1.400 alsh 0.318 1.490 0.000 1.556 2.712 1.361 post-covid-19 period averages treynor ratio sharpe ratio jensen’s alpha sortino ratio calmar ratio omega ratiosri funds sri index equity index sri index equity index −0.608 −1.217 −1.249 −0.036 −0.036 −1.160 −1.700 1.082 ri top 30 index −0.294 −1.330 0.000 −1.316 −1.538 0.866 alsh −0.292 −1.322 0.000 −1.315 −1.831 0.868 sgammini: a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period international journal of economics and financial issues | vol 13 • issue 1 • 2023 53 side (upside) of the risk-free rate threshold selected. during the post-covid-19 period, sri funds underperformed the index as reported by the treynor ratio, jensen’s alpha and calmar ratio as a result of lower compound returns produced, greater maximum drawdowns experienced and exposure to greater market risk, compared to during covid-19. relative to the alsh, on average, the difference exhibited in performance was similar to that relative to the ri top 30 index, except for the calmar ratio during the post-covid-19 period. significant differences were found, however, in terms of fewer performance measures’ comparisons. pre-covid-19 exhibited that only according to the omega ratio, sri funds significantly outperformed the alsh. during the covid-19 period, no significant difference was found between the sri funds and the alsh. in the post-covid-19 period, significant underperformance against the alsh was recorded by the treynor ratio and jensen’s alpha, while significant outperformance was recorded by both the calmar ratio and omega ratio. 5. conclusion and recommendations the purpose of this study was to analyse the risk-adjusted performance of local sri funds before, during and after the covid-19 period. the risk-adjusted performance was further evaluated relative to the ftse/jse ri top 30 index and the ftse/jse alsh. the research period extended from 21 february 2018 to 05 october 2022 and was divided into three periods. period 1 served to represent a period before covid-19, period 2 represented a period during the covid-19 pandemic, and period 3 represented a post-covid-19 period. although financial markets experienced downturns as a result of the onset of the covid-19 pandemic, the period brought about an increase in the demand for investments that are more socially responsible. the results of this study indicated that sri funds are strongly correlated to both the ri top 30 index and the alsh, indicative of great dependence on equities, evident by a larger asset allocation toward the equity market of all analysed funds. furthermore, sri funds performed, on average, poorly in the pre-covid-19 and in the post-covid-19 period, according to treynor ratio, sharpe ratio, jensen’s alpha, sortino ratio and the calmar ratio. however, during both these periods, the omega ratio indicated greater upside potential exhibited by these funds. during the covid-19 period, contrary to the assumption that sri funds would similarly experience significant decreased performance due to the volatile period, these funds exhibited a higher risk-adjusted performance as measured across all performance measures employed in the study. relative to the ri top 30 index, sri funds underperformed significantly during the period before covid-19. the treynor ratio indicated significant outperformance in both the period before and during covid-19. during the period after covid-19, only the omega ratio indicated significant outperformance. therefore, during the analysed periods, on average, sri funds were not able to consistently outperform the ri top 30 index. the results relative to the alsh were similar with only the omega ratio indicating significant outperformance in the pre-covid-19 period. no significant difference was found in the period during covid-19 between sri funds and the alsh. however, in the period after covid-19, both the omega ratio and calmar ratio indicated significant outromance, while the treynor ratio and the jensen’s alpha indicated significant underperformance. therefore, similar to the evaluation relative to the ri top 30 index, sri funds were not able to consistently outperform the general equity market during the period under investigation. although the local sri market is still relatively small as compared to international counterparts, a number of recommendations for future research were identified. firstly, given the current and foreseeable increase in the demand for sri funds that spurred as a result of the covid-19 pandemic, it is suggested that the local sri market might grow to a size, which may be comparable to more multifaceted, sophisticated and advanced international sri markets, such as the sri market of the united states of america and the united kingdom. secondly, it is suggested that an event study methodology be conducted in order to analyse the impact of specific market events (be it hazardous or non-hazardous) on the long-term riskadjusted performance of local sri funds. it is suggested further that the results of the event study methodology be compared to the ftse/jse ri index, the general equity market and local nonsri funds. lastly, as a number of sri products, including funds, composites, unlisted investments and various other securities are available locally, it is suggested that future research focus on not only the performance, but rather the social impact of all available local table 4: the average difference in the risk‑adjusted performance between sri funds and the ftse/jse indices risk-adjusted performance of sri funds relative to the ftse/jse ri top 30 index average difference treynor ratio sharpe ratio jensen’s alpha sortino ratio calmar ratio omega ratio pre-covid-19 period 0.208* −0.360* −0.062* −0.303* −0.304* 0.191 during covid-19 period 0.114* −0.596 0.047 −0.608 −0.964 0.044 post-covid-19 period −0.314 0.081 −0.036 0.156 −0.163 0.215* risk-adjusted performance of sri funds relative to the ftse/jse alsh average difference treynor ratio sharpe ratio jensen’s alpha sortino ratio calmar ratio omega ratio pre-covid-19 period 0.157 −0.116 −0.055 −0.111 −0.124 0.239* during covid-19 period 0.180 −0.341 0.057 −0.340 −0.719 0.083 post-covid-19 period −0.925* 0.073 −0.036* 0.155 0.131* 0.214* *reject the null hypothesis at the 5% level of significance sgammini: a comparative risk-adjusted performance evaluation of south african sri funds and the ftse/jse over the covid-19 period international journal of economics and financial issues | vol 13 • issue 1 • 202354 sri products in order to provide a holistic view of the level and stance of 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(2017), responsible investing in south africa: past, present and future. african review of economics and finance, 9(1), 122-155. viviers, s., fifer, c. (2013), responsible investing in south africa-a retail perspective. journal of economic and financial sciences, 6(1), 217-242. white, m.a. (1995), the performance of environmental mutual funds in the united states and germany: is there economic hope for green investors? research in corporate social performance and policy, 1, 323-324. woods price, j. (2021), covid-19: impact investing’s inflection point. available from: https://www.gsb.uct.ac.za/ideas-exchange/ entrepreneurship-and-innovation/covid-19-impact-investinginflection-point [last accessed on 2022 oct 03]. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 29-34. international journal of economics and financial issues | vol 13 • issue 1 • 2023 29 country risk effects and government domestic debt nexus in south africa thomas habanabakize, zandri dickason-koekemoer* north-west university (nwu), south africa. *email: zandri.dickason@nwu.ac.za received: 29 august 2022 accepted: 04 december 2022 doi: https://doi.org/10.32479/ijefi.13484 abstract country risk rating is one of the factors that determine the stability of a given country’s economy and the government’s access to both domestic and foreign loans. this paper aimed at assessing the relationship that exists between country risk rating and the south african government’s access to domestic debts or loans. monthly data from january 2008 to december 2019 was investigated using the ardl bounds testing approach and the error correction model (ecm). the findings of this paper indicated that all country risk components (economic, financial and political) have a significant long-run effect on government domestic debt. while economic and financial risk scores have a positive effect on government debts, an inverse relationship was found between political risk and government debt. these results imply that in order to be independent of foreign debt which comes with terms and conditions; policymakers and the south african government leaders should strive to sustain the stability of the economy and the country’s financial conditions. keywords: government debt, economic risk, financial risk, political risk, country risk, south africa jel classifications: d81; e42; o55 1. introduction government borrowing creates government debt which can either be internal debt or external debt. government debt which in some cases is considered public debt is a concept had more attention in recent decades. since the 2008/2009 financial global crisis many countries, especially developed countries, increases their sovereign debt with the expectation of increasing country productivity and economic growth. nonetheless, it has been argued that public or government debt may only have a short-term significant effect on the economy while creating long-term economic challenges such as high government liabilities, low private investment and economic deterioration (calderón and fuentes, 2013). prior to further discussion, it is substantial to indicate that the aggregate government debt refers to the difference between government revenue and government expenditure (budget review, 2019). domestic or internal government debt refers to all resources generated by a given government from local individuals or institutions while external debt denotes all monetary resources used by a government which are not acquired from internal sources (okeke et al., 2020). the debt market is one of the largest markets in south africa and it also plays a significant role in the global liquid evolving bond markets (liu, 2013). it is in this same market where the government sells its securities and bonds. besides the revenue acquired from taxpayers, the government has to sell bonds and other securities to finance its infrastructures and other economic and development activities. half of the south african government aggregate debt is acquired through government-issued bonds. some of those bonds are currency bonds, inflation-linked, fixedrate and zero-coupon bonds (johannesburg stock exchange [jse], 2017). the cost of government debt is established by measuring the yield spread on sovereign bonds (rowland and torres, 2004). these sovereign yield spreads represent major determinants of risk associated with the government’s ability to pay or default this journal is licensed under a creative commons attribution 4.0 international license habanabakize and dickason-koekemoer: country risk effects and government domestic debt nexus in south africa international journal of economics and financial issues | vol 13 • issue 1 • 202330 the debt. due to power economic performance, the south african government debt, in 2019, has increased by r15.3 billion and the debt rate was expected to increase in 2020 (budget review, 2019) even before the covid-19 outbreak. domestic debt is described by adofu and abula (2010) as financial resources acquired internally by the government through selling financial securities in debt markets. buyers of those securities can either be the reserve bank, financial institutions, commercial banks, non-governmental organisations or private individuals. generally, a government borrows either to improve its economic performance or to solve a given national concern. thus, the effect of government debt depends on the amount of funds acquired and the purpose of those funds. given that the government debt is measured as the gross domestic product (gdp) ratio, reinhart et al. (2015) assert that the debt-gdp ratio should not be more than 90%. the economy will grow if the debt ratio is lower than 90% otherwise it will impede economic growth (karadam, 2018). in other words, low government debt is beneficial to a country’s economy while high country debt results in economic growth encumbrance. the ability of the government to acquire debt, internally or externally, depend on the country’s economic, financial and political stability. when a country is not stable, in any of the aforementioned dimensions, debt financing becomes a critical issue (abbas and christensen 2010; kourtellos, et al., 2013). courtiers with different economic situations, different political leaders and different income levels have also different debt-paying capacities. political, financial and economic instabilities are the major component of country risk and therefore, following abbas and christensen (2010) and kourtellos, et al., (2013) country risk has a significant impact on government access to debt. if countries differ in abilities to pay their debt owing to their country risk rating, a relationship between government debt and county risk should rather be asymmetric instead of a linear relationship (chiu and lee, 2017). various researchers conducted studies in different economic areas to determine the effect of country risk on government debt. ramzan and ahmad (2014) conducted a study in pakistan to assess the relationship between economic risk and government debt. the findings suggested that economic distortion reduces the country’s access to debt and creates inefficient debt capital flow within the country. concerning political risk, poor institutions, inadequate laws and other political unrest may cause moneylenders to become reluctant to lend their money to the government as they have no surety that their money will be paid back. besides, political instability is another bottleneck for economic development which hinders corporates and individuals’ ability to have money that they may lend to the government (roe and siegel, 2011). in addition to economic and political instabilities, financial instability or financial risk is another component of country risk that may influence domestic government debt. a mutual causality exists between financial risk and government debt. if financial institutions are well doing and individuals are financially secured, it will be easier for the government to borrow locally and increase its debt. however, on the other hand, poor debt management on the government side will make it insolvency and default on the borrowed money resulting in an unstable financial system and a reduction in moneylenders’ willingness to lend (chiu and lee, 2017). in the south african context, country risk components namely economic, and financial risks, plays a significant role in financial markets (bloomberg, 2017). according to papendorp and packirisamy (2015), political risk factors such as political instability, high rate of crime and corruption, protest action and other allegations against the country in 2016, and unnecessary cabinet reshuffle in both 2015 and 2017 caused south africa to be listed among junk status. other factors such as the stagnant economy (economic risk) and weak local currency against the ud dollar (financial risk) increased the government borrowing and rose the likelihood of the country’s downgrade. although some studies were conducted to determine the effect of country risk on equity market, debt and bond markets (kaminsky and schmukler, 2001; codogno et al., 2003; nhlapho and muzindutsi, 2020), none of these studies focused on the implications of country risk on government domestic debt in south africa. this highlight the importance of the current study to fill up that gap. 2. data and methods the study focuses on a quantitative to analyze the long and short-run effects of country risk components (economic risk, financial risk and political risk) on government domestic debt in south africa. the analysed data is a monthly time series of 300 observations for a period ranging between january 2008 and december 2019. government domestic debt is measured in million and was acquired from the south african reserve bank (sarb) website (sarb, 2022). the data of country risk is measured by a combination of the south african economic, financial and political risk ratings. this data was retrieved from the international country risk guide (icrg). the latter is an investment risk company that offers country risk components (economic, financial and political) for 140 countries (prs group, 2022). while economic risk. economic risk emphasises the probable strengths or weaknesses of a country by rating economic growth features such as gdp growth, budget balance and inflation; financial risk focuses on the country’s aptitude to pay its foreign debt and the country’s liquidity level. further, political risk rating considers government instabilities and other political uncertainties that could impact investment levels (meyer and habanabakize, 2018). when rating a country’s risk, each economic risk and financial risk has a score of 50, while the political risk has a score of 100 (prs group, 2018). these scores are considered indicators that serve in making the comparison between high and low-risk countries. thus, a high score suggests that country has low risk while a high-risk country has a low score rating. the study employed the autoregressive distributed lag (ardl) model to determine the relationship that exists among variables in both the short and long run. this model was introduced by pesaran and shin (1998) and revised by pesaran et al. (2001). contrary to rational models such as engle and granger (1987) and johansen (1988) that analyse variables with the same integration order; the ardl model allows a regression between variables habanabakize and dickason-koekemoer: country risk effects and government domestic debt nexus in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 31 of diverse integration order such as i(0), i(1) or a combination of both. additionally, this model provides short and long-run results simultaneously. nonetheless, the ardl model does not apply to variables that are stationary at the second difference i(2) (pesaran et al., 2001). to ascertain the stationarity level of the study variables and the appropriateness of model selection, the augmented dickey-fuller (adf) test was used for the unit root test. the analysis variables cointegration and their short-run relationship, the subsequent ardl model was estimated: 1 0 4 0 1 2 3 1 0 λ β δ λ λ η ψ λ − −= = − −= = = + ∆ + ∆ + ∆ + + + + ∝ + + ∆ ∑ ∑ ∑ ∑ k k i t i i t ii i k k i t i i t ii t t t t t i t lgdt linv ler lgdt ler lfr lpr lfr l r e p (1) where ∆lgdt denotes changes in the natural log of government domestic debt, ∆ler denotes changes in the natural log of economic risk ∆lfr denotes changes in the natural log of financial risk and ∆lpr denotes changes in natural log of political risk. short-run coefficients are represented by βi, δi, ηi and ψi while λ1 to λ4 represent the long-run coefficients. additionally, ∝0 and et represent the intercept and error term, whereas t symbolises the time period of the data. the test for cointegration or long-run relationship among variables is built on the subsequent hypotheses: h0: λ1=λ2=λ3=λ4=0 for no cointegration h0: λ1≠λ2≠λ3≠λ4≠0 for cointegration using the bound test for cointegration, the h0 was tested against h1 and the computed f-statistics were compared to i(0) and i(1) critical values from pesaran et al. (2001) table. the null hypothesis for no cointegration is rejected if the value of the computed f-statistic is greater than the upper bound critical values. there is no longrun relationship between variables if the if the value of computed f-statistic is smaller than the lower bounds critical values. in case the null hypothesis is rejected, suggesting the existence of cointegration, the subsequent error correction model is estimated: 1 0 10 1 0 β δ η ψ ϑ − −= = − − −= = = + ∆ + ∆ + ∆ ∆ ∝ + + + ∑ ∑ ∑ ∑ k k i t i i t ii i k k i t i i t i t ti i t lgdt ler lfr lpr ect lgd e t (2) where the speed of adjustment towards long-run equilibrium is measured by the ect. it is important to note that the reliable ardl model was chosen following the optimal lag length selected using the akaike information criteria (aic). additionally, before the discussion of the findings, and the accuracy of obtained results, the model was assessed for heteroscedasticity, parameter stability and serial correlation. 3. results and discussion 3.1. descriptive statistics the summary statistics in table 1 suggest that variables under the study namely government domestic debt, economic, financial and political risk have average or mean of 11.98680, 3.496539, 3.645441 and 4.177162 respectively. the results in the table indicate also, from a high standard deviation, that the domestic government debt has been volatile over the period under investigation. the political fluctuations, over the sample period, were lower compared to changes experienced within the economic and financial risk index. based on both skewness and kurtosis, as suggested by hair et al. (2010) and bryne (2010), economic risk is the only variable that is normally distributed. 3.2. correlation analysis the correlation coefficient (r) is one of the statistical tools employed to measure the relationship that exists between a pair of variables. its value varies between −1 and +1. thus, its mathematical representation can be written as follows: −1≤ r ≤ 1. the magnitude of the relationship between two variables of interest depends on how the value of the coefficient (r) is closer to zero. if the value of r is closer to zero, a small relationship exists between the variables of interest (ahlgren et al., 2003). considering the results in table 2, a weak correlation exists between government debt and country risk components. while a weak and positive correlation exists between government debt and economic risk, a weak and negative correlation exists between financial risk, political risk and government debt. 3.3. stationarity test the presence or absence of a unit root within the study variables was established using the augmented dickey-fuller test (adf) test where the null hypothesis suggests that the series under consideration has a unit root and the alternative suggests that the series has no unit root. the outcome of the test is presented in table 3. these results indicate a mixture of stationarity among variables. that is, economic risk and financial risk are stationary at levels i (1) while government debt and political risk are stationary at the first difference. consequently, the ardl model is the appropriate approach to estimating the relationship among variables. 3.4. bound testing for cointegration to establish the cointegration between variables, the f-statistics were computed and compared to the critical values of both lower table 1: summary statistics lgdt ler lfr lpr mean 11.98680 3.496539 3.645441 4.177162 median 12.11924 3.496508 3.650658 4.182050 maximum 12.65555 3.540959 3.737670 4.255613 minimum 10.83267 3.367296 3.511545 4.119037 sd 0.477773 0.033377 0.044508 0.029271 skewness −0.845062 −1.689195 −0.383917 −0.059396 kurtosis 2.920266 7.587139 2.927392 2.487513 table 2: correlation coefficients lgdt ler lfr lpr ldt 1 ler 0.183517** 1 lfr −0.0899*** −0.053429 1 lpr −0.6018* 0.133459 0.244245 1 *, **, ***indicates significant at the 10%, 5% and 1% level of significance respectively habanabakize and dickason-koekemoer: country risk effects and government domestic debt nexus in south africa international journal of economics and financial issues | vol 13 • issue 1 • 202332 table 4: f-bounds test null hypothesis: no level of relationship test statistic value sig. i (0) i (1) f-statistic 8.258340 10% 2.37 3.2 k 3 5% 2.79 3.67 1% 3.65 4.66 table 6: diagnostic tests test hypothesis (h0) probability so what? white no heteroscedasticity 0.2975 reject h0 lm no serial correlation 0.4895 reject h0 jb there is normality 0.31472 reject h0 ramsey error variances are all equal 0.6303 regression is correctly specified table 5: ardl regression outcome variable coefficient se t-statistic prob. long-run results ler 6.138472 3.732635 1.644541 0.1028 lfr 14.84378 6.249885 2.375048 0.0192** lpr −4.622738 4.783394 −0.966414 0.3358 short run dynamics d (ler) 0.100157 0.058914 1.700047 0.0917* d (lfr) 0.085162 0.071979 1.183153 0.2391 d (lpr) 0.075351 0.193115 0.390186 0.6971 d (lpr(-1)) 0.492973 0.269962 1.826084 0.0703* d (lpr(-2)) −0.518255 0.197946 −2.618158 0.0100** cointeq(-1) −0.018206 0.005331 −3.415123 0.0009*** *, **, and ***indicate significance at 10%, 5% and 1% respectively table 3: unit root results series levels first difference integration status intercept intercept and trend intercept intercept and trend lgdt 0.1378 0.7746 0.0000** ----------i (1) ler 0.0325* ------------------------------i (0) lfr 0.0044** ------------------------------i (0) lpr 0.2613 0.4159 0.0000** ----------i (1) *, **denotes the rejection of the null hypothesis at 5% and 1% significant level respectively and upper bounds. used critical values that were obtained from the table of pesaran et al., (2001). as discussed previously, if the computed f-statistic value is higher than the upper bound critical value the null hypothesis is rejected otherwise it is not rejected meaning the absence of cointegration. the f-bounds test results in table 4 suggest the rejection of the null hypothesis at all significant levels (10%, 5% and 1%) as the value of the computed f-statistics of 8.2583 is higher than the upper bounds critical values of 3.2; 3.67 and 4.66 at 10%, 5% and 1% respectively. consequently, a long-run relationship exists between government debt and country risk components. 3.5. regression findings for the ardl (4, 0, 1, 3) the model estimated parameters for both long-run and short-run relationships are reported in table 5. however, before the result interpretation, it is important to note that a high score in country risk components is awarded to the positive rating component (muzindutsi and manaliyo, 2016). thus high score for political risk indicates political stability while a high score for both economic and financial risk implies improvement in both countries’ economies and financial stability or certainty. the long-run estimates suggest a rating of economic risk and financial risk that increase the possibility of government debt. however, a negative long-run relationship exists between political risk and government debt. the long-run findings indicate that if the south african economic risk rating were to increase 1%, the government would increase its debt by approximately 6.14%; while a 1% increase in financial rating would allow the government to increase its debt by 14.84%. nonetheless, a low rating of political stability would reduce the government’s access to borrowing. in other words, a 1% decline in political risk rating would reduce the government’s ability to acquire debts by about 4.62%. these findings make more sense as the considered government debt is sourced domestically not from external foreign creditors. if the country’s economy is doing well and the finances of domestic companies and businesses are successful, then the latter can lend to the government and the government would acquire a date quickly at a reasonable interest rate. however, the political situation is not good as few companies are willing to lend their money to the government and the risk of losing their money is high. considering the short-run estimation, the coefficient of economic risk and lagged political risk are significant and bear positive and negative signs respectively. this implies that similar to the longrun results, economic risk has a positive impact on government domestic debt while political risk has a negative impact on government debt in the short run. it is also important to highlight that the model error correction term is negative and significant at 1% level. therefore, any shocks or deviation from the long-run equilibrium will be adjusted each month at a low speed of 1.8%. in other words, changes in country risk components will have a significant effect on government domestic debt after 54.93 months (1/0. 018206); that is approximately 4 years. 3.6. diagnostic tests discussion table 6 displays the diagnostic results from the study model. the results indicate the failure to reject null hypotheses for all conducted tests (normality test, homoscedasticity, serial correlation and parameters stability). failure to reject the null hypothesis for normality implies that the model residuals are normally distributed, and the failure to reject the homoscedasticity and serial correlation suggest that the used model is homoscedastic and free of serial correlation. additionally, the probability value of 0.6303 from the ramsey test indicates that the error variances are all equal meaning that the asymmetric combinations of the fitted values assist to elucidate the dependent variable. lastly, the cusum in figure 1, test result confirms the stability of the model coefficients. in other words, within the 95% level of confidence, the estimated model parameters are stable. habanabakize and dickason-koekemoer: country risk effects and government domestic debt nexus in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 33 -40 -30 -20 -10 0 10 20 30 40 10 11 12 13 14 15 16 17 18 19 cusum 5% significance figure 1: cusum test results 4. conclusion this study aimed at determining the effect of country risk on the south african government’s domestic debt. to this end, monthly data from january 2008 to december 2019 was assessed and using the autoregressive distributed lag (ardl) bounds testing method, a regression model was estimated. the results from the assessment suggested that a long-run relationship exists between the country risk components (economic risk, financial risk, and political risk) and government domestic debt. both economic and financial risk high scores infer a long-run increase in government debt while a high score in political risk is associated with a decline in the south african domestic debt. besides having positive effects, both economic and financial risk scores were found to have a large effect compared to political risk. these results possess policy inferences. development and improvement of both economic and financial stability assist the government in acquiring needed funds from domestic businesses and companies instead of borrowing from foreign creditors who would charge a high rate of interest. and since the money borrowed by the government is spent within the country, aside from the interest rate on loaned funds, households and domestic businesses will also benefit from government debt and the late may be used to improve infrastructures and sustain institutions which are useful for economic and financial stabilities. thus, an interaction exists between the usefulness of government debt and country risk. irrespective of the significance of this study, some limitations can be considered for further research. due to data availability, the study sample was limited to the period between 2008 and 2019. further, studies should extend the scope and also consider including the effect of covid-19 on the south african debt, in their analysis. references abbas, s.m.a., christensen, j.e. 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(2004), determinants of spread and creditworthiness for emerging market sovereign debt: a panel data study. borradores de economia, 295. banco de la republica de colombia. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 83-88. international journal of economics and financial issues | vol 13 • issue 1 • 2023 83 does external debt affect economic growth: evidence from south asian countries sonia afrin ale1, md shafiqul islam1, hazera-tun-nessa2* 1department of economics, noakhali science and technology university, bangladesh, 2department of international business, university of dhaka, bangladesh. *email: hazeratunnessa@du.ac.bd received: 20 september 2022 accepted: 30 december 2022 doi: https://doi.org/10.32479/ijefi.13527 abstract time series econometric methods are frequently used in studies examining how external debt affects economic growth. for the period of 1980-2020, this study creates a panel dataset of five south asian nations and examines the link between external debt and economic growth. the findings of cross-sectionally augmented panel unit root test by pesaran’s (2007) confirms that all variables are integrated in order i (1). to understand the error correction mechanism that determines the short-run dynamic nature of external debt and economic growth, the study uses the cross-sectional dependence autoregressive distributed lag (cs-ardl) technique. a significant negative association between external debt and economic growth is found to exist in south asia both in the long run and in the short run. since rising foreign debt is associated with slower economic growth, the study recommends that south asian nations should promote domestic savings and investment to lessen their reliance on external debt. keywords: external debt, economic growth, panel data model jel classifications: f34; o47; c23 1. introduction when a nation lacks adequate domestic savings, it often takes on external debt to supplement its domestic resources and achieve growth and other goals. external debts significantly diminish a country‘s capacity to repay debts if they are not invested in productive and income-boosting activities. high debt levels make it harder to maintain economic growth and fight poverty (berensmann, 2004; maghyereh and hashemite, 2003). researchers and policymakers have focused a lot of attention on the connection between external debt and economic growth in the wake of the global debt crisis of the 1980s, which was caused by the accumulated foreign debt stock and the associated sustainability problem, particularly in highly indebted poor countries (gunter, 2002; easterly, 2002). according to economic theory, both developing and developed countries should be able to increase their economic growth with a manageable amount of debt. the debt overhang theory and the liquidity constraint hypothesis have been used to understand better how debt affects economic growth (krugman 1988; saches 1989; and cohen 1995). according to these views, rising government internal borrowing prevents economic growth as debt levels rise. due to the crowding effect, when interest rates rise due to an increase in borrowing, borrowing becomes more expensive for both investment and consumption. furthermore, due to poor management, borrowing has a detrimental effect on the financial sustainability and economic progress of developing nations. so, it is essential to finance profitable investments that will produce additional income with external financing (kharusi and ada, 2018). the situation concerning south asian nations‘ external debt has changed throughout time. the trend of external debt (as a percentage of gni) of five south asian countries for the period of 1980 to 2020 is shown in figure 1. this journal is licensed under a creative commons attribution 4.0 international license ale, et al.: does external debt affect economic growth: evidence from south asian countries international journal of economics and financial issues | vol 13 • issue 1 • 202384 it is observed that bhutan is experiencing a rising external debt. before 2001, bhutan‘s external debt was lower than sri lanka and pakistan, but after 2001, it had the highest external debt among other south asian countries with a rising trend. although sri lanka has experienced lower volatility, it has higher external debt than the other four countries before 2001, and after 2001, it still has higher external debt than bangladesh, india, and pakistan but lower than bhutan. pakistan‘s external debt is lower than sri lanka‘s, but it has followed the same trend as sri lanka. india has experienced comparatively lower debt than other south asian countries. after 1984, india‘s external debt increased, which declined after 1995, and from 2012 to 2020, its external debt was slightly higher than bangladesh‘s. after 1995, bangladesh experienced a declining trend in external debt until 2012, when it remained almost flat until 2020. but after 2012, the other three countries also showed a rising trend in their external debt. over the period, all countries experienced frequent ups and downs in their gdp growth rate. in figure 2, the trend of gdp growth rate (%) over the sample period is represented. like external debt, bhutan’s gdp growth rate fluctuated a lot, with a major upward trend starting in 1985, which reached a peak of 28.70% around 1987, then began to fall sharply to 4.96% in 1988. this situation might occur due to rapid forced migration, which started in the late 1980s and increased further between the period of 1988 and 1933, which led to violent ethnic unrest and anti-government protest. after that, the country experienced several fluctuations in its gdp growth rates until 2019, with another major fluctuation between the period of 2006 and 2008. beyond 2019, a notable declining trend appeared, perhaps due to the start of the covid-19 pandemic. all other countries had several up-and-down fluctuating gdp growth figure 2: gdp growth rate (%) figure 1: external debt (% of gni) ale, et al.: does external debt affect economic growth: evidence from south asian countries international journal of economics and financial issues | vol 13 • issue 1 • 2023 85 rates with a declining trend after 2019, but unlike bhutan, no major fluctuations are notable. sri lanka experienced the lowest growth rate (−1.55%) during 2001 and recovered in the next year. bangladesh had a lower growth rate than india and pakistan for some years, but again higher than those countries for other periods. but after 2016, the gdp growth rate of bangladesh remains higher than other countries, with a declining trend after 2019. 2. review of literature considerable research has investigated the link between external debt and economic growth. some discovered beneficial effects, while others concluded that foreign debts had detrimental effects on economic growth. geiger (1990), for instance, examines the effect of public debt on economic growth for nine latin american nations over 12 years (1974-1986) and discovers an inverse and statistically significant association between debt burden and economic growth. the main factors influencing pakistan‘s economic growth are identified by iqbal and zahid (1998). to discover the negative impact of foreign debt on economic growth, they use annual data ranging from 1959-1960 to 1996-1997 and the ols approach. using data from 1980 to 1990, fosu (1999) evaluates the effect of external debt on economic growth in 35 sub-saharan african nations. the study discovers that net outstanding loans have a negative impact on economic growth, holding the amounts of production inputs constant. using data for 55 low-income countries from 1970 to 1999, clements et al. (2003) investigate the ways in which external debt influences economic growth. they argue that larger foreign debt levels hinder economic growth by skewing resource allocation rather than by lowering private investment. furthermore, it has been discovered that public investment, a form of indirect external debt, influences growth. mohamed (2005) looks into how sudan‘s external debt affects economic growth and uses time series data from 1978 to 2002 for the study. to describe the impact of the export promotion plan and to account for the inflationary impact of macroeconomic policy, the study considers the growth rate of real export earnings. the findings suggest that external debt inhibits economic growth. ali and mustafa (2012) examine the effects of pakistan‘s external debt on economic growth over the long and short terms, focusing on the years 1970 to 2010. their findings demonstrate that debt negatively and severely shortterm influences growth. this adverse effect is substantially less strong in the long run. shabbir (2013) examines how external debt affects economic growth in 70 emerging nations. he discusses the period from 1976 to 2011. the analysis uses estimation for both fixed and random effects. external debt and economic growth are found to be negatively correlated. they also discover that debt can reduce the resources available to support private investment in these nations. ramzan and ahmad (2014) use the ardl technique to assess the effect of pakistan‘s external debt on economic growth from 1970 to 2009. the results show that external debt negatively influences growth and that this negative impact can be reduced or even eliminated by using the right macroeconomic policies. additionally, they say that the negative effects of external debt are caused by the bilateral component rather than the multilateral component. siddique et al. (2016) investigate how foreign debt affects economic growth in highly indebted impoverished nations (hipcs). according to the findings, debt can boost short-term economic growth to a certain extent, which aligns with standard keynesian prescriptions. adamu and rasiah (2016) discover that foreign debt slows growth over time by applying an ardl bound test approach to nigeria between 1970 and 2013. moreover, in both the long and short terms, the authors’ index measuring the sustainability of external debt had a favorable impact on growth. the empirical studies, which use panel data analysis, evaluate how much economic growth depends on external debt from various angles, such as sub-saharan africa or deeply indebted impoverished countries. these prior studies predicted external debt elasticities have many signs and magnitudes. furthermore, most of these publications do not consider slope and cross-sectional dependence. to create an effective foreign debt policy considering cross-sectional dependence for south asian countries, a separate study is necessary. in this article, we analyze the impact of external debt on economic growth in south asian countries using crosssectional dependence (csd) on panel data. the following is how the paper is organized: the empirical model and data sources are presented in section 3, the results are presented and analyzed in section 4, and the conclusions are discussed in section 5. 3. data and model for estimation this study explores the relationships between population growth, foreign direct investment, gross capital formation, external debt, and economic growth. all the variables‘ data is used annually and spans the years 1980-2020. the readily available data determines the selection of nations for the years 1980-2020. all variables‘ data is taken from the world development indicators (wdi) report, which the world bank releases as shown in table 1. the following econometric model is considered for empirical analysis, table 1: description of variables and sources symbol variables source rgdp real gdp wdi, world bank ed external debt as a percentage of gross national income wdi, world bank k capital formation as a percentage of gdp wdi, world bank fdi foreign direct investment as a percentage of gdp wdi, world bank pop population growth rate wdi, world bank ale, et al.: does external debt affect economic growth: evidence from south asian countries international journal of economics and financial issues | vol 13 • issue 1 • 202386 eg ed k fdi popit it it it it it= + + + + +β β β β β ε0 1 2 3 4 � (1) where, eg, ed, k, fdi, and pop denote economic growth rate as an annual percentage gross domestic product (gdp), external debt as a percentage of gross national income, capital formation as a percentage of gdp, foreign direct investment as a percentage of gdp and population growth rate, respectively. here, i stands for countries and t stands for time. finally, an idiosyncratic error term is presented by εit. 4. empirical results to determine whether cross-sectional dependence exists, friedman (1937), frees (1995), and pesaran (2004) are used. table 2’s findings from the three cross-sectional dependence tests under estimations for random and fixed effects demonstrate that, in all models, the null hypothesis of no cross-sectional reliance is rejected at least at a 5% significance level. as a result, crosssectional dependence is taken into account in this study‘s unit root and cointegration tests. using the adjusted delta tilde test proposed by pesaran and yamagata (2008) and blomquist and westerlund (2013), we study the cointegrating coefficients‘ slope homogeneity. pesaran and yamagata’s (2008), and blomquist and westerlund’s (2013) test for homogeneous slopes of the coefficients are comfortably rejected. for this reason, we consider heterogeneous panel cointegration tests to estimate the model. in table 3, the outcomes are displayed. we use a cross-sectionally augmented panel unit root test created by pesaran (2007) to identify the unit root issue in the panel data. results of the unit root test are shown in table 4. it demonstrates that all variables—aside from external debt (ed) and capital formation (k)—are stationary at a level, except those two variables becoming stationary at the first difference. each variable is therefore integrated in the order i (1). in table 5, the estimated results about the impacts of external debts on economic growth both in short run and long run for selected the five selected south asian countries are represented. the economic growth of selected south asian countries is found to be significantly negatively affected by external debt. an increased share of external debt in a country‘s national income significantly negatively affects the economic growth of that country. this negative effect is found to persist both in the short run and in the long run across all baseline and extended models with a similar magnitude of effects. this means that external debt is hampering the economic growth of bangladesh, india, pakistan, bhutan, and sri lanka in both the short run and the long run. the higher the external debt in a country, the lower its economic growth will be. these findings are consistent with the theoretical predictions of classical and neoclassical views that external debt hampers economic growth in the long run by discouraging investment. the short-run findings are similar to keynesian predictions. considering the short-run impact of external debt, keynesian economists have focused on developing policies to reduce the adverse effects of debt. but we cannot be as neutral as the ricardian view—that external debt is a future tax, and therefore we are neutral regarding the debt-growth relationship (barro, 1990). the debt overhang dilemma is a channel through which external debt accumulation hampers economic growth by hampering investment over time. a debt overhang dilemma could be a significant factor in this inverse effect of external debt on economic growth. several studies have provided evidence regarding this, like cordella et al. (2005), daka et al. (2017), matuka and asafo (2018), noreddine and chkiriba, 2019, etc. disregarding the methodologies, the findings of current studies are also similar to the findings by geiger (1990) in the case of 9 latin american countries, by iqbal and zahid (1998) in the case of pakistan, etc. but as opposed to the findings of ali and mustafa (2012), who stated a strong negative effect in the short run and a weaker negative in the long run for pakistan, and siddique et al. (2016), who found a positive effect in the short run but a negative effect in the long run for nigeria, this study concluded the persistent of significant negative effects both in the short run and in the long run. in contrast, some studies provide evidence that external debt stimulates economic growth, including siddiqui and malik (2001), talreja et al. (2016), lau and kon (2014), chaudhry et al. (2017), etc. among other control variables, foreign direct investment affects economic growth negatively. the higher the percentage of foreign direct investment in a country‘s gdp, the lower the country‘s economic growth will be both in the short and long run. the effects table 2: results of cross-sectional dependence (cd) panel data model freidman (1937) frees (1995) pesaran (2004) fixed effect estimation 82.911*** 0.395*** 5.143*** random effect estimation 89.245*** 0.489*** 5.678*** ***, ** and * are significant at 1%, 5% and 10% respectively table 3: results of homogeneity tests test pesaran and yamagata (2008) blomquist and westerlund (2013) delta 1.921* 2.564*** delta (small sample adjusted) 2.080** 2.776*** ***, ** and * are significant at 1%, 5% and 10% respectively table 4: results of cross-sectionally augmented panel unit root test of pesaran (2007) variable cips (level) cips (1st difference) without trend with trend without trend with trend rgdp −4.859*** −4.481*** −9.001*** −8.486*** ed 1.385 1.305 −6.056*** −5.276*** k −0.892 −1.091 −6.361*** −5.677*** fdi −2.569** −3.657*** −8.305*** −7.386*** pop −0.433 −1.512* −2.897*** −1.818*** *** indicates 1% significance level. optimum lag length is chosen by the schwarz information criterion (sic) ale, et al.: does external debt affect economic growth: evidence from south asian countries international journal of economics and financial issues | vol 13 • issue 1 • 2023 87 of capital formation (k) and population growth rate on economic growth in south asian countries are found to be insignificant. the results remain the same in the short run and the long run. these insignificant effects imply that population growth rate and capital formation (percentage of gdp) do not contribute to the economic growth of bangladesh, india, pakistan, bhutan, and sri lanka during the concerned sample period. the general view of the economic growth increasing effects of fdi could be confronted by the possibility that a part of fdi may have detrimental effects on economic growth. in the case of south asian countries, chaudhury et al. (2020) find that the composition of fdi is crucial to determining whether the effects of fdi are growth enhancing or not. they estimated that while overall fdi increases economic growth significantly, fdi in secondary sectors hampers economic growth. thus, fdi should attract targeted sectors to ensure enough domestic investment. the analysis finds no evidence of a relationship between gross capital formation and economic growth. our results are in line with research by yasmeen et al. (2021), who used data from pakistan, and hartwig (2010), who used data from oecd countries, both of which conclude that capital formation does not affect economic growth. our results, however, differ from those of dash (2021) and meyer and sanusi’s (2019) investigations, which suggest that capital formation contributes positively to economic growth. according to dash (2021), financial sector growth, financial aid, trade openness, and gross capital accumulation are necessary for south asian countries sustained economic advancement. the study also reveals an insignificant impact of population growth on economic growth in south asian countries. this contrasts the general belief and malthusian theoretical predictions that population growth negatively effects per capita income and human development (johnson, 1999; schultz, 2003). but our results are similar to the findings of thornton (2001), who also found an insignificant long-run relationship between population growth and economic growth for seven latin american countries. therefore, in line with thornton (2001), it could be explained that due to inflationary pressure, population growth does not affect economic growth. this study establishes a long-run relationship between economic growth, external debt, and other variables through the highly significant negative error correction coefficients. these ensure that any short-run economic shocks will be adjusted in the long run. in the baseline model, the error correction coefficient is found to be-1.244, implying that per year, economic shocks in the short run revert to the long run equilibrium by 124.4 percent. the disequilibrium adjustment rates remain almost similar in the extended models with additional control variables. 5. conclusion for a long time, the relationship between external debt and economic growth has attracted the attention of researchers and policymakers. it has become crucial, particularly after the 1980‘s global debt crisis. previous studies conducted to understand the relationship have found both positive and negative effects of external debt on economic growth. findings varied due to the use of several countries, different techniques, different periods, and applying different techniques. most studies examined the relationship at the country level, mainly using time series data and techniques. this study contributes to the existing literature by examining the relationship between five south asian countries, i.e., bangladesh, india, pakistan, bhutan, and sri lanka, from 1980-2020. the application of advanced panel econometrics techniques, namely the panel autoregressive distributed lag (ardl) approach, reveals the effects of external debt on economic growth both in the short run and in the long run. the estimated negative error correction coefficients, which are highly significant, confirm a long-run relationship between economic growth and external debt, and other variables are established. it is found that external debt significantly negatively affects countries‘ economic growth in the short and long run. among other control variables, only foreign direct investment affects economic growth significantly, but the effect is negative. moreover, the effects of capital formation (k) and population growth rate on economic growth in south asian countries are found to be insignificant both in the short and long run. hence, south asian countries should be very conscious of the use of external debt. they should reduce the use of external debt by encouraging domestic savings and investment. while it is not possible to restrict the use of external debt, countries should look table 5: results of cross-sectional dependence autoregressive distributed lag model (cs-ardl) rgdp cs-ardl cs-ardl cs-ardl cs-ardl short-run estimate error correction −1.244***(0.00) −1.241***(0.00) −1.234***(0.00) −1.268***(0.00) ∆ed −0.011***(0.00) −0.008**(0.02) −0.009**(0.01) −0.009**(0.01) ∆k −0.004 (0.47) −0.003 (0.53) −0.004 (0.44) ∆fdi −0.005** (0.02) −0.005** (0.02) ∆pop −0.123 (0.87) long-run estimate ed −0.009*** (0.00) -0.007** (0.03) −0.008** (0.01) −0.008** (0.01) k −0.004 (0.396) −0.004 (0.57) −0.004 (0.39) fdi −0.004** (0.01) −0.004** (0.02) pop 0.008 (0.99) constant −0.24*** (0.00) −0.24*** (0.00) −0.23*** (0.00) −0.27*** (0.00) observations 194 194 194 194 country 5 5 5 5 p-values are represented in the parenthesis. ***, ** and * represents that coefficient are significant at 1%, 5% and 10% respectively ale, et al.: does external debt affect economic growth: evidence from south asian countries international journal of economics and financial issues | vol 13 • issue 1 • 202388 for appropriate ways to mitigate the negative effects of external debt on economic growth; to identify possible channels to convert the deteriorating effects of external debt into a beneficial one. references adamu, i.m., rasiah, r. 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(2021), discovering the relationship between natural resources, energy consumption, gross capital formation with economic growth: can lower financial openness change the curse into blessing. resources policy, 71, 102013. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1835-1841. international journal of economics and financial issues | vol 6 • issue 4 • 2016 1835 comparative study on performance of islamic banks and conventional banks: evidence from oman zaroug osman bilal1*, omar mohammad durrah2, tariq mohamed atiya3 1department of accounting and finance, college of commerce and business administration, dhofar university, salalah, oman, 2department of management and marketing, college of commerce and business administration, dhofar university, salalah, oman, 3department of management and marketing, college of commerce and business administration, dhofar university, salalah, oman. *email: zosman@du.edu.om abstract this research aims to examine and compare the performance for islamic banks (ibs) and conventional banks (cbs) in oman during 2013-2015. financial ratio analyses are employed to measure profitability, solvency and capital adequacy of seven cbs and two ibs. independen samples t-test was used to determine the whether there is a difference in the performance for ibs and cbs. the finding of the research establishes that cbs are more profitable and significantly different from ibs in terms of return on assets, return on equity and net profit margin. while, ibs were performing better in term of efficiency ratio, debt to assets ratio. debt to equity ratio and credit to deposits ratio total credit to total debit. the difference is statistical significant. keywords: islamic banks, conventional banks, performance, oman jel classifications: g35, g38, m41 1. introduction the importance of banking sector comes from its role in achieving the financial balance and economic development and growth. islamic banking (ib) is growing at a rapid speed and has showed unprecedented growth and expansion in last two decades in spite of mismatching of existing financial framework and business practices. it is estimated that the size of the ib industry at the global level was close to us$820 billion at end-2008 (islamic financial services board et al., 2010). middle east is the centre of ib with contribution of approximately 80% while 20% share is contributed by rest of the world (hanif, 2011). the gcc countries account for 40% of the $1.1 trillion global islamic finance industry with islamic finance expanding at a compounded average growth rate of 26.4% since 2006. islamic finance remains concentrated in the middle east, including iran, with a share of 35.7% in total islamic finance assets, saudi arabia with 13.9%, united arab emirates with 8.7%, kuwait with 7.3%, bahrain 5.3%, and qatar with 4.8% (oic outlook series, 2012). according to the world ib competitiveness report published by ernst and young (2012), ib assets with commercial banks globally grew to $1.3 trillion in 2011, suggesting an average annual growth of 19% over past 4 years. the ib growth story continues to be positive, growing 50% faster than the overall banking sector. the sultanate of oman is last gcc country initiated ibs. the first ib was established in 2011. the beginning of ib in the sultanate was an important milestone in the process of financial inclusion. ib is expected to assume an important role in the financial sector of oman by complementing the current conventional banking (cb) and thereby diversifying banking services. there were two full-fledged locally incorporated ib, namely, bank nizwa and al izz ib. six out of the seven locally incorporated conventional commercial banks were also offering ib services through dedicated windows. the ibs and windows operated with 29 branches have been started and provide their services to customers at the begging of january 2013. central bank of oman annual report (2015). ibs is based on the risk-sharing concept between the investor and entrepreneur, profit maximization theory based on shariah restrictions, and entering into partnership form of business is the main operation of the ibs. bilal, et al.: comparative study on performance of islamic banks and conventional banks: evidence from oman international journal of economics and financial issues | vol 6 • issue 4 • 20161836 on the other hand, in cb, there is no risk sharing concept between the buyer and seller but assurance of fixed interest rate, profit maximization theory without any restriction, and lending and receiving money is the main operation of the cb. the study of the comparative performance of ibs and cb is still considered as an important issue in the field of finance and investment. many studies were undertaken on cb and ib across the world including awan (2009), hanif (2011) and alkassim (2005) most of the studies focused on comparing cb with ib. some results reveal that ibs performed better rather than cb, while other results conclude that cb performed better than ibs. for example, dridi and hasan (2010) indicated that comparing the performance of ibs to cbs globally would suggest that ibs performed better, given the large losses incurred by cbs in europe and the us as a result of the international financial crisis moin (2008) conducted a study to analyze the effectiveness of the pioneering bank in ib sector in pakistan: meezan bank limited (mbl). the study examined mbl in contrast with five traditional banks in pakistan. study analyzed following aspects: profitability, risk, liquidity and efficiency for 2003-2007. the researched concluded that mbl was more solvent, less profitable, and less efficient as compared to the median of 5 traditional banks. however, there was no major distinction in liquidity between both streams of banks. this research too is another attempt to look at a comparative performance evaluation between for ibs and cb in oman during 2013-2015, we discuss the extent to which cbs and ibs satisfy its various performance indicators. we compare efficiency and effectiveness of operations of both bank-groups in terms of its return on equity (roe), return on assets (roa), and other performance indicators derived from the income statement and balance sheet of both ibs and cb. this research aims to provide both ibs and cb managers in oman a basic understanding of the comparative performance and this will be of immense help in formulating their future decisions and competitive financial position. also, this research may be useful in identifying its strengths and weaknesses. the main objective of the research is to conduct a comparative analysis of the performance for ibs and cb in oman during 20132015, to find out whether the ibs and cbs are operating efficiently. the research analyzed the data of seven cb and two ibs for the period 2013 to 2015. the organization of the research is as follows; section (2) discusses and review literature concerning the theoretical and empirical studies of cb and ibs (3) provides a brief about the cb and ibs in oman. section (4) illustrates the data collection and methodology used in the research, section (5) deals with the empirical findings and finally, in section (6) the conclusion of the research is discussed. 2. literature review although islamic commercial banks have many products similar to those offered by cbs, the two entities differ conceptually. one key difference is that cbs earn their money by charging interest and fees for services, whereas ibs earn their money by profit and loss sharing (pls), trading, leasing, charging fees for services rendered, and using other sharia contracts of exchange. 2.1. origins of the cb and ibs the establishment of first cb was nearly 424 years ago. as it has been stated in the book of sudin haron and wan nursofiza that modern cb came into existence nearly 420 years ago with establishment if banco della pizza at rialto in venice in 1587 (homoud, 1985). however, ibs officially was established in 1963 which was mit ghamr saving bank in egypt and its transactions were based on shariyah principles and rules. faizulayev (2011). according to metwally (1997) “ib was introduced in 1963 in a wee town of egypt.” this was done on an a study of performance. experimental basis to validate its feasibility in a live environment. this experiment was a success as the deposits surged in 3 years. 2.2. concept and the basis of transactions between ibs and cb ib attributes to a banking system or enterprise that is persistent with islamic laws and principles (sharia) in which interest rate is probated. lewis, 2008 on operation of ib briefed the essence of islamic finance. ib focused on the principle that loans should be advanced free of interest for charitable bodies and on a pls basis. the basic purpose for establishing an ib is to promote and encourage islamic principles. cbs are profit-making organizations that generally are not based on religious principles. that said, earning money is also a primary function of an islamic commercial bank. although the bank has a specific religious purpose, it can’t serve that purpose unless it also meets the objective of earning money. jamaldeen (2012), he goes on to illustrates that ibs operate based on islamic business law (called fiqh-u-muamalat) for their basic transactions, and they also follow the financial laws and regulations of the countries in which they operate. cbs likewise operate based on a country’s financial laws and regulations, but they don’t have contact with any religious body. the main difference between ibs and cbs are that, interest rate and speculative transactions, investment in alcohol, in tobacco and in pig made products are prohibited in accordance with islamic principles. generally, cb principles are man-made, whereas in ibs principles and rules are based on shariyah who set up the principles, simply to say transactions of ibs are based on pls faizulayev (2011). 2.3. previous studies profitability generally measures objective of private organization or firm as indicated by return on sales, assets, and owners equity. profitability ratio can be simply defined as the ability of a business to earn a profit which is left of the revenue a business generates after it pays all expenses directly related to the generation of the revenue, such as producing a product, and other expenses related to the conduct of the business’ activities ali et al. (2012). bilal, et al.: comparative study on performance of islamic banks and conventional banks: evidence from oman international journal of economics and financial issues | vol 6 • issue 4 • 2016 1837 in addition, (siraj and pillai, 2012) argued argued that ibs, unlike other form of business is evaluated not only based on its profitability, but also criteria’s such as quality of assets, liquidity management, risk management, etc., most of the comparative studies also stressed the relevance of these performance indicators to compare cb and ib. the studies provide three different viewpoints. many studies have been conducted to examine and compare the ibs and cb performance for example, abdus and hassan (1997) assessed the differences of performance measures of bank islam malaysia berhad (bimb) and eight cbs in terms of profitability, liquidity, risk and solvency. they come up with output of empirical results stating that bimb relatively is more liquid and less risky compared to the group of eight cbs. in addition, ibs showed significant progress on roa and roe during 1984-1997. however, samad and hassan (2000) found that comparison of bimb with group of 8 banks showed that difference in performance measures are statistically insignificant. they also found that the risk in bimb increased and it is statistically significant. in addition, moin (2008) conducted a study to analyze the effectiveness of the pioneering bank in ib sector in pakistan: mbl. the study examined mbl in contrast with five traditional banks in pakistan. study analyzed following aspects: profitability, risk, liquidity and efficiency for 2003 to 2007. the researched concluded that mbl was more solvent, less profitable, and less efficient as compared to the median of 5 traditional banks. however, there was no major distinction in liquidity between both streams of banks. according to study of alkassim (2005) who aimed to identify profitability of determinants of ibs and cbs. the profitability indicators roe, roa, and net interest margin (nim) of two different types of banks are compared. as independent variable he used: logarithmic of total assets, equity to assets, deposit to assets, total loans to assets and etc. he used cross country bank level data for gulf cooperation council gcc countries to conduct ordinary least square. he found the results which are consistent with hassan and bashir (2004) for ibs, and he also found in his analysis relationships between banks characteristics and profitability indicators for cbs. the result of variables showed their reflection towards profitability indicators differently. the logarithmic total assets ta have negative relationship with performance measure in cb system, but positive in ib system. the capital ratio or equity ratio has got negative association with performance measure of cbs and positive connection with ibs profitability indicators. he also found that lending improves the profitability of both ib and cbs, in other words total loans are positively related to determinant of profitability of both banks. in the same view, siraj and pillai (2012) conducted a study to review and compare performance of cbs and ibs operating in gcc region during 2005-10. the study selected six ibs and six cbs. a comparative study is undertaken based performance indicators such as oer, npr, roa, roe, eoa, operating expense, profit, assets, operating income, deposits and total equity. inferences based on analysis revealed better performance of ib during the study period. our analysis revealed that ibs are more equity financed than cbs. recent studies carried out by khamis and senhadji (2010), rashwan (2012), and merchant (2012) to empirically contrast performance of ibs and cbs pre and post the global financial crisis argue that performance of ibs during the 2008 financial crisis was more efficient than their counterpart cbs. on the other hand, moin (2008) measured the performance of first ib in pakistan with comparison of 5 cbs. the performance measure of this study was in the field of profitability, liquidity, risk and efficiency by using financial ratios. he found that cbs are more profitable and significantly different from first ib in terms of roe. his findings showed that ibs are getting closer with conventional ones in terms of profitability. he found also positive relationship of net profits with profitability indicator, roe. however, he did not find any difference between ib and cbs in term of liquidity, loan to deposit ratio. cbs are more risky and less solvent than ib due to high profitability. another study has been conducted by kakakhel et al. (2011) examined and evaluated the performance of the two ib (meezan and dubai islamic) and two cbs (mcb and hbl) in pakistan for the year 2008 to 2010. the result indicates that cbs are more profitable than ibs in pakistan for year 2008 to 2010. ibs in pakistan have better current, cash, debt to asset and asset turnover ratio while cbs have good performance in other remaining ratios. although in some ratios performance of ibs are also good but according to overall results cbs of pakistan are more efficient than ibs. it is obvious from the above discussion that there are different pictures concerning the performance of ibs and cb, some researchers are indicate that ibs are more efficient than cb; other studies show that cb are more profitable than ibs. as we mentioned before, in many countries numerous studies have been conducted to evaluate the performance for ibs and cb, however, no studies have been done before in the omani context to establish the relationship between jbs and cb performance this becauseibs have been established in oman recently (in 2012). 3. cb and ib in oman the sultanate of oman has already identified the potential demand and opportunities offered by the islamic finance industry and the royal decree announced in may 2011 has paved the way for the adoption of a dual financial system where conventional and shariah compliant products have been available to the people of oman. two ibs -bank nizwa and alizz ib and window operations of cbs have launched innovative products to attract omani customers, besides opening several branches in different parts of the country. ali hamdan al raisi, vice president, central bank of oman, told the times of oman: ibs grew very well last year, and the trend is continuing this year. he said that there is still space for ibs to grow further, although there are challenges ahead (time of oman, 2016) (table 1). the locally incorporated conventional commercial banks were bank muscat (bm), national bank of oman (nbo), hsbc bank oman, oman arab bank (oab), bank dhofar (bd), bank sohar (bs) and al ahli bank (ab). there were also two full-fledged locally incorporated ibs, namely, bank nizwa and al izz ib. six bilal, et al.: comparative study on performance of islamic banks and conventional banks: evidence from oman international journal of economics and financial issues | vol 6 • issue 4 • 20161838 out of the seven locally incorporated conventional commercial banks offered ib services through dedicated windows. central bank of oman annual report (2015). according to oxford business group (2016) total assets held by ibs and the ib windows of conventional lenders in march 2016 amounted to or2.5bn ($6.5 billion), compared to or 1.5 billion ($3.9 billion) 1 year earlier, according to the cbo. this took the ibs market share from 5.1% of the financial system’s overall assets in 2015 to 7.8% by march 2016. 4. data and research methodology as we illustrated before, the main objective of this paper is to examine and evaluate the comparative performance for ibs and cb in oman. to achieve research objectives, the data was collected from seven cbs namely bm, nbo, bd, hsbc oman, oab, ab, and bs. and two islamic al izz and nazwa banks during the period of 2013-2015. in order to study the performance comparison between islamic and cb in oman, a comparative research is conducted. the data were collected from the balance sheet and income statements of the ibs, cb and central bank of oman reports and other published reports. the researchers analyzed the data by using descriptive statistical analysis, independent t-test is to determine the difference in the performance between ibs and cb. many authors had used financial ratio analysis mentioned in the literature review. according to samad and hassan (2000) “i̇nter-temporal and interbank profitability of bimb” has been evaluated by using financial ratio analysis tool. saleh and rami (2006) also used the financial ratios to evaluate the jordanian exposure with ib. to find out whether there is any difference in the performance for ibs and cb this research was relying on the following financial indicators. 4.1. profitability performance the most common measure of bank performance is profitability. profitability is measured using the following criteria. 4.1.1. roa net profit/total assets shows the ability of management to acquire deposits at a reasonable cost and invest them in profitable investments (ahmed, 2009). this ratio indicates how much net income is generated per £ of assets. the higher the roa, the more the profitable the bank. 4.1.2. roe net profit/total equity. roe is the most important indicator of a bank’s profitability and growth potential. it is the rate of return to shareholders or the percentage return on each of equity invested in the bank. 4.1.3. efficiency ratio (efr) total cost/total income. it is measures the income generated per o.r cost. that is how expensive it is for the bank to produce a unit of output. the lower the efr ratio, the better the performance of the bank. 4.1.4. net margin it is the ratio of net profits to revenues for a company or business segment that shows how much of each dollar earned by the company is translated into profit. 4.2. solvency ratios van horne and wachowicz (2005), defined these ratios as “a measures the degree to which the business relies on debt financing.” the following criteria are used to measure this ratio. 4.2.1. debt to assets ratio (dar) the dar is an indicator of financial leverage. it tells you the percentage of total assets that were financed by creditors, liabilities, debt. the dar is calculated by dividing a corporation’s total liabilities by its total assets. 4.2.2. debt to equity ratio (der) der=total debt/total equity. it is also shows the extent to which shareholders’ equity can fulfill a company’s obligations to creditors in the event of liquidation. 4.3. capital adequacy ratio. this ratio is used to protect depositors and enhance the stability and efficiency of the banks keeping in view their risk exposures. this ratio is used to protect depositors and enhance the stability and efficiency of the banks keeping in view their risk exposures. in this research we used credit to deposit ratio (cdr) indicator which it can be used for both ibs and cb. cdr refers to total credits divided by total loans. to conduct a comparative analysis of the performance for ibs and cb in oman during 2013-2015, to find out whether the ib and cbs are operating efficiently. the following hypotheses were formulated and tested: h0: there exists no significant difference in performance among ibs and cb. h1: there is no significant difference among ibs and cb in terms (roa). h2: there is no significant difference among ibs and cb in terms (roe). h3: there is no significant difference among ib and cb in terms of efr. h4: there is no significant difference among ibs and cb in terms of net profit margin (npm). h5: there is no significant difference among ibs and cb in terms dar. h6: there is no significant difference among ibs and cb in terms (der). h7: there is no significant difference among ibs and cb in terms total credit to total debit (tctd). 5. the findings in this section the results of the difference in the performance between ibs and cb is presented. descriptive statistical analysis, independent samples t-test is used to determine the means between two groups are the same on the seven variables and to examine whether the difference in financial performance between ibs and cb in oman is statistically different during 2013-2015. bilal, et al.: comparative study on performance of islamic banks and conventional banks: evidence from oman international journal of economics and financial issues | vol 6 • issue 4 • 2016 1839 5.1. profitability four indicators are used to measure the efficiency of omani banks’ performance: roa (usually abbreviated as roa), roe and cost to income ratio (c/i). h1: there is no significant difference among ibs and cbs in terms of roa. h2: there is no significant difference among ibs and cbs in terms of roe. the results from tables 2 and 3 show that the mean for roa was 0.04576 in the ibs compared to 0.00243 for foreign banks. the mean difference between two group is 0.04576 and this difference is statistically significant at 0.05%. this implies that the cb used their assets more efficiently than ibs. this may be attributed to limited experience of ibs in this regards. also, roe shows a similar trend to roa, cb have a positive significant performance concerning roe than ibs, the mean for cb is.03286 compared to −0.05500 for ibs. accordingly, h1 and h2 can be accepted. h3: there is no significant difference among ibs and cbs in terms of efr. the results from table 4 reveal the different trend, to roa and roe. the mean for efr was 3.45000 for ibs compared to 0.06381 for cb, this difference is statistically significant at 0.05%. this implies that the ibs were run their activities with low cost compared to domestic banks, this may attribute to higher numbers of employees who are recruited by cb and high other costs for these banks (cb). accordingly, h3 can be accepted. h4: there is no significant difference among ibs and cbs in terms of of npm. the results from table 5 show that for npm the cb are managing its assets better than ibs, the mean was 0.03667 for the cb compared to the −1.53333 for ibs and it’s statistically significant at 0.05%. also, this indicates that that the cb were able to make an optimal decision and control for their expenses. accordingly, h4 can be accepted. we conclude from the above results that the profitability ratios for roa, roe, efr and nim reveals that cb have better performance than ibs in all these measures, the difference is statistically significant. this can be indicated that the cb were successfully in minimizing their cost and using their recourses more efficiently compared to ibs and the difference is statistical significant. this results are consistent with kakakhel et al. (2011) who examined and evaluated the profitability of the two ibs and two cbs in pakistan for the year 2008-2010. the result indicates that table 2: independent samples t‑test for roa variable mean mean difference t significant conventional banks islamic banks 0.04576 15.580 0.000 roa 0.00243 −0.04333 roa: return on assets table 3: independent samples t‑test for roe variable mean mean difference t significant conventional banks islamic banks 0.08786 8.555 0.000 roe 0.03286 −0.05500 roe: return on equity table 4: independent samples t‑test for efr variable mean mean difference t significant conventional banks islamic banks −03.38619 −27.642 0.000 efr 0.06381 3.45000 efr: efficiency ratio table 5: independent samples t‑test for npm variable mean mean difference t significant conventional banks islamic banks 1.570000 3.052 0.019 nim 0.03667 −1.53333 nim: net interest margin table 1: banking sector in oman type date of establishment branch network local banks nbo 1973 63 oab 1973 58 bank muscut 1981 137 bd 1990 64 al ahli 1997 12 sohar bank 2006 24 hsbc bank oman (merged 2012 with oib) 70 islamic banks nazwa bank 2012 10 al iz 2013 4 source: central bank of oman annual report (2015). oab: oman arab bank, bd: bank dhofar, nbo: national bank of oman bilal, et al.: comparative study on performance of islamic banks and conventional banks: evidence from oman international journal of economics and financial issues | vol 6 • issue 4 • 20161840 cbs are more profitable than ibs. also, the results are consistent with moin (2008). 5.2. solvency ratios h5: there is no significant difference among ibs and cbs in terms of dar. h6: there is no significant difference among ibs and cbs in terms of der. the results from tables 6 and 7 show that for dar the cb are relying on debt finance compared with the cb. the mean for ibs was 0.29333, while the mean for cb is 0.09143. the difference is statistically significant 0.05%. also, der shows a similar trend to dar, cb have a positive significant performance concerning roe than ibs, the mean for cb is 0.03286 compared to 0.68167 for ibs. accordingly, h5 and h6 can be accepted. this implies that cb are more risky and less solvent than rather than ibs the results are consistent with abdus and hassan (1997) who concluded that ibs are less risky compared to cb. 5.3. capital adequacy this ratio is used to protect depositors and enhance the stability and efficiency of the banks keeping in view their risk exposures. h7: there is no significant difference among ib and cbs in terms of tctd. the results from table 8 reveal that the ibs are more stability and protect depositors rather than cb. the mean for ibs was the 0.74333 compared with 17667 for cb. the difference is statistical significant at 0.05%. this revealed that ibs are more equity financed than cbs. accordingly, h7 can be accepted. this result is consistent with siraj and pillai (2012). 6. conclusions the main objective of this research is to examine where there is any significant difference in the performance for ibs and cb in oman. the data used are collected from annual financial reports (balance sheet and income statement) of seven cb and two ibs in oman, between 2013 and 2015. seven standards were adopted to compare performance between ibs and cb. the results show that that cbs are more profitable and significantly different from ibs in terms of roa, roe and npm. while, ibs were performing better in term of efr, dar. der and credit to deposits ratio tctd. the difference is statistical significant. this research expects to fill in the void in literature on the comparison of performance for ibs and cb in oman in particular and middle east in general. both the ibs and cb in oman should be able to understand that the dividend policy adopted by them will impact the stakeholder and can affect the investment decision and the investment climate in the country. the study concentrated on focused attention financial performance during 2013-2015 the period has been covered is limited this because ibs have been started only before 3 years, moreover, only seven measures have been used compare the performance for ibs and cb. in future researches attempts should be made to include more pertinent determinants so as to be able to explore the impact of those variables. references abdus, s., hassan, m.k. (1997), the performance of malaysian islamic bank during 1984-1997: an exploratory study. international journal of islamic financial, services, 1(3), 1-14. ali, s.a., shafique, a., razi, a. (2012), determinants of profitability of islamic banks, a case study of pakistan. interdisciplinary journal of contemporary research in business, 3(11), 86-99. alkassim, f.a. (2005), the profitability of islamic and conventional banking in the gcc countries: a comparative study of dubai, banking companies ordinance (1962). islamabad: state bank of pakistan. awan, a.g. (2009), comparison of islamic and conventional banking in pakistan, proceedings 2nd cbrc, lahore, (erf). central bank of oman report. (2015). available from: http://www. cbo-oman.org/. dridi, j., hasan, m. (2010), have islamic banks been impacted table 6: independent samples t‑test for dar variable mean mean difference t significant conventional banks islamic banks −0.20190 −13.188 0.000 dar 0.09143 0.29333 dar: debt to assets ratio table 7: independent samples t‑test for (der) variable mean mean difference t significant conventional banks islamic banks −0.43881 −5.803 0.001 der 0.24286 0.68167 der: debt to equity ratio table 8: independent samples t‑test for tctd variable mean mean difference t significant conventional banks islamic banks −0.56666 0−5.096 0.001 tctd 0.17667 0.74333 tctd: total credit to total debit bilal, et al.: comparative study on performance of islamic banks and conventional banks: evidence from oman international journal of economics and financial issues | vol 6 • issue 4 • 2016 1841 differently than conventional banks during the recent global crisis? imf working paper (forthcoming). ernst and young. (2012), world islamic banking competitiveness report (2012-2013). growing beyond dna of successful transformation. avbailable from: http://www.ey.com/publication/vwluassets/ theworld_islamicbankingcompetitivness._report/$file/ world%20islamic%20banking%20competitiveness%20report%20 201213.pdf. [last accessed on 2013 nov 18]. faizulayev, a. (2011), comparative analysis between islamic banking and conventional banking firms in terms of profitability, 2006-2009. submitted to the institute of graduate studies and research in partial fulfilment of the requirements for the degree of master of science in banking and finance, eastern mediterranean university may 2011 gazimağusa, north cyprus. hanif, m. (2011), differences and similarities in islamic and conventional banking. international journal of business and social science, 2(2), 166-175. hassan, m., bashir, a. (2003), determinants of islamic banking profitability. cairo: economic research forum. homoud, s.h. 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(2012), how did listed islamic and traditional banks perform: pre and post 2008 financial crisis? journal of applied finance and banking, 2(2), 149-175. saleh, a.s., rami, z. (2005), development of islamic banking in lebanon: prospects and future challenges. review of islamic economics, 9(2), 72-91. samad, a., hassan, m.k. (2000), the performance of malaysian islamic bank during 1984-1997: an exploratory study. thoughts on economics, 10(1-2), 7-26. siraj, k.k., pillai, p.s. (2012), comparative study on performance of islamic banks and conventional banks in gcc region. journal of applied finance and banking, 2(3), 123-161. time of oman. (2016), islamic banks to sustain robust growth in oman, says cbo official-edition news paper january 24, 2016. available from: http://www.timesofoman.com/article/76062/ business/banking/islamic-banks-in-oman-to-continue-growthsays-cbo-official. van horne, j., wachowicz, j. (2005), fundamentals of financial management. 12th ed. new york: pearson education limited. . international journal of economics and financial issues | vol 6 • special issue (s6) • 2016 135 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s6) 135-137. special issue for "ipn conferences, may 2016" board characteristics and earnings per share of malaysian islamic banks isah shittu1*, ayoib che ahmad2, zuaini ishak3 1school of accountancy, college of business, universiti utara malaysia 06010, sintok, kedah, malaysia, 2school of accountancy, college of business, universiti utara malaysia 06010, sintok, kedah, malaysia, 3school of accountancy, college of business, universiti utara malaysia 06010, sintok, kedahs, malaysia. *email: isahshittu15@yahoo.com abstract board characteristics of the corporate organization represent an important aspect of corporate monitoring. this study examined the effects of board size (bs), the size of shariah supervisory board ssb and shariah board members meeting on the earnings per share of the malaysian islamic banks. the study used data from sixteen (16) full-pledged islamic banks in malaysia for 6 year period (2010-2015). the study used pool ordinary least square to estimate the regression after satisfying post estimation tests. the results reveal significance positive relationship between bs, shariah board meeting and eps at 1% level of significance. on the other hand, a negative relationship was found between shariah bs and eps. the negative relationship between ssb size and eps could be due to non-disclosure of the minimum number of shariah board members by some banks. keywords: board characteristics, islamic banks, malaysia jel classifications: m40, m41, m48 1. introduction earnings per share (eps) refer to the percentage of a firms profit apportioned to each of the outstanding shares of common stock. the eps serve as an important indicator for the profitability of a company. eps is the most important measure of performance indicator reported by company managements to the shareholders, market and other interested parties (jorgensen, et al. 2014). the high quarterly eps encourage top executives management’s results to huge stock repurchases to helped them manage stock prices of their respective companies (lazonick, 2014). generally, eps is the amount of money every share of common stock would get if all of the company profits were shared to the shares outstanding at the year end. the question here is whether corporate governance variables measured by board size (bs), sbs and shariah board meetings impact on the eps of islamic banks in malaysia. corporate governance variables are regarded as global issues that attracted arguments among researchers, portfolio analysts and other actors in corporate administrations. the financial scandals in the recent period are largely credited to the failure of those organizations in their governances practices and that have upset the hope of the investing public (strier, 2005). corporate governance cg involves all those process and procedures whether structured or unstructured; principle or rule based that guides how a corporate entity is administered and control. cg variables also involve both internal and external governance mechanisms that guide the direction of the company for maximum shareholders benefit. the board of directors represents an important mechanism for corporate control and responsible for the overall monitoring of the management. in addition to the board of directors, islamic financial institutions ifis including islamic banks are mandated to have shariah supervisory board ssb to ensure that, the operations of the company are in conformity with principles of shariah (islamic law). similarly, the ssb are required to conduct meetings regularly to review bank operations and to approve a new product that may be introduced by the bank. however, there is a little theoretical effort on the relationship between these governance variables and performance of islamic shittu, et al.: board characteristics and earnings per share of malaysian islamic banks international journal of economics and financial issues | vol 6 • special issue (s6) • 2016136 banks, more importantly, earnings to shareholders. this study filled a gap in the literature by empirically examining the effect of bs, sbs and ssb meetings on eps of malaysian islamic banks. 2. literature and hypotheses there is large empirical literature on the relationship between bs and board meetings on the performance of conventional corporate organizations. some of the studies established a significant positive relationship between the variables and firm value while others reported a negative relationship. for example, linck et al. (2008) reported that average increase in the number of bs is positively and significantly related to firm value amongst sample firms in the us. firm bs has positive and significant relationship with subsequent firm value (alimehmeti and paletta, 2014). similarly, johl et al. (2015) tested board characteristics and firm performance amongst listed firms in malaysian firms. the study findings showed that bs is associated with firm performance and board diligence also frequency of members meetings has a significant influence on the firm performance. in addition, hoque et al. (2013) studied the frequency of company board meetings on the financial performance of firms in australia. the findings of the study revealed a positive and significant relationship between the board frequencies of meetings and performance measured by return on asset and return on equity. on the contrary, guest (2009) established that bs has significant negative impact on the tobin’s q and share return of the uk firms. bs has no significant association with the firm value measured by eps (gherghina, 2015). the theoretical background of this study is the agency theory; the theory explains the relationships which exist between principals (capital providers) and agents (managements). the theory designed to provide answers to the principal-agent problem. to achieve the objective of the study, the following hypotheses are tested. h1: bs has a positive relationship with eps of malaysian islamic banks h2: shariah supervisory bs has a positive relationship with eps of malaysian islamic banks h3: shariah supervisory board meetings has a positive relationship with eps of malaysian islamic banks. 3. methodology the study used secondary data from the published annual reports of the sixteen (16) islamic banks in malaysia. the data are collected on the individual bank basis for the period of six (6) years (2010-2015). the research utilized pool ordinary least square to estimate the regression and the post estimation test of normality, homoscedasticity, specification test and multicollinearity are satisfied. 3.1. model specification epsit = β0+β1bsit+β2sbsit+β3sbmit+β4ltait+εit where eps = earnings per share of banks over the period, bs = board size, sbs = shariah bs, sbm = shariah board meetings and lta = natural log of total asset and ε is the error term for variables not captured in the model (table 1). 4. results and discussions of findings the descriptive statistic results revealed a mean and standard deviation sd values of 3.3,80,454 and 1.1,47,723 for eps, 8.1,26,582 and 2.1,50,534 for bsize, 4.75,641 and 1.7,66,837 for sbsize, 8.7,54,098 and 4.6,49,931 for sbmeet and 3.3,79,871 and 0.94,65,095 for a log of total assets respectively. the minimum bsize is 3 and a maximum of 13, sbsize has a minimum of 0 and maximum of 9 due some banks under the sample failure to disclose their shariah board. the sd values clustered around the mean suggesting the normality of the data set (table 2). the correlation matrix table revealed a positive correlation of 0.2505 for bsize, the negative correlation of 0.3462 for sbsize, positive correlation of 0.0179 for sbmeet and positive correlation of 0.0034 for ltasset and eps malaysian islamic banks. the variable with the highest correlation is sbmeet and sbsize with a value of 0.5545 suggesting absence of multicollinearity in the model (table 3). the regression result presents a positive coefficient of 0.21,40,623 between bs and eps of malaysian islamic banks (table 4). this means that for every increase in bs from an average of 8 the eps will increase by 0.2140623 malaysian ringgit (myr). table 1: variable definition and measurement evm variables measurements eps net profit less preference dividend divide by common stock bs total number of board members serving in the bank sbs total number of number of shariah supervisory board members in the bank shariah board members meeting (sbm) total number of meetings held by shariah committee members in the year total asset natural log of total asset sbs: shariah board size, bs: board size, eps: earnings per share table 2: descriptive statistics variable mean±sd minimum maximum eps 3.3,80,454±1.1,47,723 −0.94,16,085 5.6,53,541 bsize 8.1,26,582±2.1,50,534 3 13 sbsize 4.75641±1.7,66,837 0 9 sbmeet 8.7,54,098±4.6,49,931 0 21 ltasset 3.3,79,871±0.94,65,095 1.2,32,333 4.3,69,448 eps: earnings per share, bs: board size, ssbs: shariah supervisory board size, sbm: shariah board meetings, lta: natural log of total asset, ε: error term for variables not captured in the model table 3: correlation matrix results variable eps bsize sbsize sbmeet ltasset eps 1.0000 bsize 0.2505*** 1.0000 sbsize −0.3462*** 0.0361 1.0000 sbmeet 0.0179*** −0.2509 0.5545 1.0000 ltasset 0.0034 −0.2039 −0.3083 −0.1084 1.0000 ***significant at 1% level of significance shittu, et al.: board characteristics and earnings per share of malaysian islamic banks international journal of economics and financial issues | vol 6 • special issue (s6) • 2016 137 the probability of bs to eps is 0.00 indicating a positive and significant relationship between the variables. the interpretation is that bs impacts positively to the eps of the shareholders at the 1% level of significance. this provides a convincing evidence of accepting the study hypothesis which predicts a positive relationship bs and eps of malaysian islamic banks. the result conforms to study of johl et al. (2015) and contradicts gherghina, 2015. similarly, the result shows a negative coefficient of -.4302993 between ssb size and eps of malaysian islamic banks. this suggests that an increase in sbs from an average of 4 the eps will decrease by 0.2140623 myr. the probability of ssb to eps is 0.00 indicating a negative and significant relationship between the variables. the interpretation is that ssb size impacts negatively to eps of shareholders at 1% level of significance. this provides a convincing evidence of rejecting the hypothesis which predicts a positive relationship ssb size and eps of malaysian islamic banks. the possible reason why the negative relationship was found between ssb size and eps may be due to violation of some banks under the sample to disclose minimum sbs of three (3) in their annual report. in fact, some of the banks did not disclose their ssb members. on the shariah board meeting the result reveals a positive coefficient of 0.10,73,845 between ssb meetings and eps of malaysian islamic banks. this means that for every increase in board meeting from an average of 8 the eps of islamic banks will increase by 0.10,73,845 myr. the probability of ssb meeting to eps is 0.01 indicating a positive and significant relationship between the explained and the explanatory variables. the interpretation is that ssb meetings impact positively to the eps of the shareholders at the 1% level of significance. this provides a substantial evidence for accepting the hypothesis of the study which predicts a positive association between ssb meetings and eps of malaysian islamic banks. the findings supported hoque et al. (2013). on the overall, the r2 is 31% suggesting that 31% of the variation in the eps is explained by the 3 cg variables and 69% by other factors not captured in the model. the combined probability is statistically significant at 1% level of significance. 5. concluding remark this study empirically examined the influence of bs, shariah supervisory board and shariah board meetings on the eps of malaysian islamic banks. the study established a positive and significant relationship between bs and shariah board meetings of islamic banks and eps. however, the sbs was negatively related to eps of the banks. this could be due to failure of some banks to comply with disclosure of minimum number of shariah board members as required by bank negara malaysia. the study, therefore, recommends more vigilance to islamic banks to ensure adherence to the regulatory guidelines. the 3 cg variables explained 31% of the variation in the eps of malaysian islamic banks while the remaining 69% are explained by other factors. references alimehmeti, g., paletta, a. (2014), corporate governance indexes: the confounding effects of using different measures. journal of applied economics and business research, 4(1), 64-79. gherghina, ş.c. (2015), corporate governance ratings and firm value : empirical evidence from the bucharest stock exchange. international journal of economics and financial issues, 5(1), 97-110. guest, p.m. (2009), the impact of board size on firm performance: evidence from the uk. the european journal of finance, 15(4), 385-404. hoque, m.z., islam, m.r., azam, m.n. (2013), board committee meetings and firm financial performance: an investigation of australian companies. international review of finance, 13(4), 503-528. johl, s.k., kaur, s., cooper, b.j. (2015), board characteristics and firm performance: evidence from malaysian public listed firms. journal of economics, business and management, 3(2), 239-243. jorgensen, b.n., lee, y.g., rock, s. (2014), the shapes of scaled earnings histograms are not due to scaling and sample selection: evidence from distributions of reported earnings per share. contemporary accounting research, 31(2), 498-521. lazonick, w. (2014), profits without prosperity: stock buybacks manipulate the market and leave most americans worse off. harvard business review, 5, 1-11. linck, j., netter, j., yang, t. (2008), the determinants of board structure. journal of financial economics, 87, 308-328. strier, f. (2005), conflicts of interest in corporate governance. journal of corporate citizenship, 19, 79-90. table 4: regression results variable coefficient t-value p bsize 0.21,40,623 3.12*** 0.00 sbsize −0.43,02,993 −4.33*** 0.00 sbmeet 0.10,73,845 2.91*** 0.00 ltasset −0.05,80,726 −0.28 0.783 cons 3.1,53,489 2.71 0.009 r2 0.3099 adjusted r2 0.2472 p-chi 0.00 ***significance at 1% . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1507-1514. international journal of economics and financial issues | vol 6 • issue 4 • 2016 1507 human capital, institutions and innovation in sub-saharan africa stephen oluwatobi1, oluyomi ola-david2, isaiah olurinola3, philip alege4, adeyemi ogundipe5* 1department of economics and development studies, covenant university, nigeria, 2department of economics and development studies, covenant university, nigeria, 3department of economics and development studies, covenant university, nigeria, 4department of economics and development studies, covenant university, nigeria, 5department of economics and development studies, covenant university, nigeria. *email: ade.ogundipe@covenantuniversity.edu.ng abstract this study examined the impact of human capital and institutions on innovation in sub-saharan africa (ssa) and clearly highlighted the relevance of the human factor in determining innovation outcomes in the sub-saharan african region. using the system generalized method of moments, coupled with some descriptive analyses, it was found out that human capital, as well as an enabling institutional environment, affects innovation outcomes in ssa. on the contrary, innovation outcomes in the region did not benefit from foreign investment. the study, therefore, recommends that human capital capacity be cultivated and given the enabling environment to contribute to innovation outcomes. this is expected to attract innovation-centred investments into the region. keywords: human capital, institutions, innovation, sub-saharan africa jel classifications: i25, o15, o31, o32, o43, o55 1. introduction the quality of human capital has been adjudged a crucial determinant of innovation in countries world over. in turn, innovation significantly impacts on the varying levels of growth and development (romer, 1990; romer, 1994; tebaldi and elmslie, 2013). developed countries, which are at the frontier of technological advancement and innovation are characterized by a highly skilled labour force, which drive their production and innovation processes. on the other hand, countries with low human development indices usually lag behind in development and capacity to innovate due to human and physical capital deficits. brain drain which connotes the movement of highly skilled labour and professionals from developing to developed countries also contributes to africa’s human capital deficits. however, it is theoretical propositions as well as empirical indications posit that latecomer countries have greater chance of achieving higher rates of innovation growth as a result of lower effective costs of education, which enable them catch up (ang et al., 2011). notably, african countries have been experiencing the highest levels of growth in the history of their development path (the economist, 2013). however, this rapid growth rate is not accompanied by structural transformation which entails a significant shift of labour skills from low-productivity agricultural sectors to sectors with higher productivity potentials. much of africa’s growth is driven by resource booms and windfalls from resource-seeking foreign direct investment. the capital-intensive nature of resource seeking fdi provides meager opportunity for local capacity building, which efficiency-seeking and costsaving fdi have as advantage. nevertheless, given the extent globalization and the proliferation of a knowledge economy, africa could catch up with frontier economies by leapfrogging major channels of technology transfer trade, investment and knowledge flows. countries’ absorptive capacity, indicated by human capital and innovation capacity, however determine the extent of learning and leapfrogging that may occur. sub-saharan africa (ssa) has been termed the region with the least innovative output (oluwatobi et al., 2014). as a latecomer oluwatobi, et al.: human capital, institutions and innovation in sub-saharan africa international journal of economics and financial issues | vol 6 • issue 4 • 20161508 in development, ssa demonstrates potential for accelerated economic growth and development. however, since innovation is not an end in itself, it cannot drive growth. the human capital component is essential in determining innovation outcomes, since even physical investments tend to accrue to regions with larger stock of human capital hence greater growth (chi, 2008). even though, ssa region has 60% of the fastest growing economies in the world, the dismal level of innovation and competiveness leaves much to be desired and raises a cause for concern for development experts. most of the existing studies on the relationship between human capital and innovation have been based on non-african economies. related regional studies focused on the human capital, institutions, economic nexus, while most others are countryspecific studies (oluwatobi and ogunrinola, 2011). going forward, it is pertinent to investigate the impact of human capital on innovation outcomes in ssa in order to ascertain the possibility of achieving innovation-driven growth in the region. also, the study by oyelaran-oyeyinka and barclay (2004), which is the closest to this study on ssa, examined human capital and the systems of innovation in the development of africa. however, we highlight the shortcomings of the study in an attempt to carry on a current and more robust analysis. firstly, the study by oyelaran-oyeyinka and barclay (2004) did not capture innovation; rather it related human capital variables with growth and development. secondly, the study adopted simple descriptive statistics and ordinary least squares as estimation techniques; these are incapable of addressing endogeneity and heterogeneity problems associated with cross country studies on the subject. thirdly, the study spans the period 1960-2000; hence, its findings may no longer be current and useful for drawing meaningful conclusions. in addition to these, most studies on this subject looked at the relationship between human capital and innovation with little attention to institutions, which defines the environment that enables innovation. besides, most of the studies have been on non-ssa countries (chi, 2008; ang et al., 2011; kato et al., 2015). this study, thus, fills these gaps by considering institutions in the relationship between human capital and innovation as well as paying attention to ssa in isolation of other regions. this is necessary to capture results that are distinct to the region given its peculiarity. in addition, the study employs the system generalized method of moments (sgmm) estimation technique, which has the capacity to address endogeneity and heterogeneity problems. next to this introductory section we present a brief overview of existing literature. section three is a presentation of some stylized facts on human capital, institutions and innovation in ssa as well as in relation to other regions of the world. section four describes the methodology employed for the study. the results from data analyses and estimations are presented i section five. the paper is concluded in section five with a summary of findings, their implications and policy recommendations. 2. literature review the theoretical background behind the relationship between human capital and innovation has been established by the proponents of endogenous growth theory (romer, 1990; aghion and howitt 1992; romer, 1994; aghion and howitt, 1997). this theory emphasized the predetermination of innovation as against the neoclassical idea that suggested that innovation was exogenous and could not be explained (solow, 1957). this foundation sets the pace for examining the impact of certain variables, such as human capital and institutions, on innovation. tebaldi and elmslie (2008, 2013) developed the baseline model to advance this theory specifically to establish the relationship among human capital, institutions and innovation. several studies in literature have examined this relationship. however, most of them have been in advanced and emerging economies. particularly, most of the studies are non-african studies. some of them are reviewed in this section. kato et al. (2015) embarked on a study aimed at investigating how the human capital of founders affect the innovation outcome of their organizations. their study is based on the premise that the value of human capital determines the level of investments made in r and d for innovation. they discovered that founders with greater human capital positively affects the innovation outcomes of their organization using probit model. they were able to pinpoint that it is the human capital as a result of training and experience that directly affects innovation while human capital as a result of educational background indirectly affects innovation outcomes through investment in r and d. some studies have validated that human capital is a major driver of innovation. mariz-perez et al. (2012) is one of such studies. their goal was to find out the impact human capital has on the capacity for innovation since human capital is the potential for vale creation. thus, they asserted that human capital is relevant for any economy to achieve competitive advantage sustainably. their argument was based on the fact that human capital manifests knowledge and capacity as main features for developing innovation and commercializing it. some other studies distinguished themselves by examining the composition of human capital and investigating which component is responsible for innovation (chi, 2008; ang et al., 2011; zhang and zhuang, 2011). their results confirmed that human capital with tertiary education play more significant role in affecting innovation that human capital with primary and secondary education. this suggests that higher levels of human capital are required to improve innovation outcomes. this does not mean that primary education and secondary education are irrelevant in the innovation process; it may, however, be an evidence of low level of development of an economy. ang et al. (2011) used a sample of 87 countries over a period of 35 years to find out whether the composition of human capital affects innovation using the sgmm technique. they discovered that a higher intensity of human capital with primary and secondary education translates in imitation while a higher intensity of human capital with tertiary education facilitates innovation. they posited that developing economies characterized by more of human capital with only primary and secondary education, which translates in imitation instead of innovation. thus, such economies imitate what advanced economies are doing as against generating new oluwatobi, et al.: human capital, institutions and innovation in sub-saharan africa international journal of economics and financial issues | vol 6 • issue 4 • 2016 1509 ideas, processes and products. this suggests that the composition of human capital has a direct impact on innovation growth. zhang and zhuang (2011) also examined the impact of human capital composition on innovation; however, unlike ang et al. (2011), who examined 87 countries, they examined china specifically using difference gmm. they found out that more developed provinces in china have more capacity to absorb human capital with tertiary education unlike less developed provinces that depend on primary and secondary education. this result is a validation of the result of ang et al. (2011). their findings suggest that economic growth is enhanced when innovation is enhanced; and innovation is enhanced when human capital is enhanced. chi (2008) embarked on a similar study on the same scope. however, she used different methodology. though she used gmm technique for estimation, it was for robustness purposes as the main technique used was two-stage least squares. there is, therefore, an established relationship between human capital and innovation; but, this relationship is expected to translate in growth and development. fleisher et al. (2010), therefore, tried to provide evidence from their investigation that variances in regional patterns of growth are as a result of variances in innovation, human capital and foreign investment. using fixed effect, they discovered that the direct effect of human capital was traceable to innovation activities while its indirect effect was traceable to spillover effects from foreign investments. their study revealed that the human capital investment not only leads to innovation growth, but also leads to a decline in inequality. this indicates the effect the relationship has on economic development. the findings of basu and mehra (2014) buttressed this. they posited that innovation reflects the capacity of human capital and discovered that wage inequality increases as a result of diversification of human capital in terms of skilled and unskilled human capital. human capital investments will, therefore, improve the innovation capacity of unskilled human capital in order to reduce the level of inequality. developing economies can, therefore, address their development challenges by investing in human capital development in order cultivate the innovation capacity required to drive economic development. teixeira and fortuna (2010) conducted a study on the portugese economy to examine this using cointegration technique. they discovered that investing in human capital capacity building activities develops the economy’s ability to identify, assimilate and value knowledge developed by more advanced economies. this gives developing economies the opportunity of learning fast to bridge the technology gap, address the challenge of inequality and promote domestic innovation. these studies, therefore, validate that there is a relationship between human capital and innovation and innovation growth can be achieved by the enhancement of human capital. these have been the expience in advanced, emerging and non-african developing economies. this study therefore seeks to investigate whether similar outcomes are valid in ssa. though there are related studies in ssa, they examined majorly the relationships between human capital, innovation and economic growth in africa (oyelaran-oyeyinka and barclay, 2004) while some others were country-specific (oluwatobi and ogunrinola, 2011). 3. some stylized facts human capital capacity in ssa has been the lowest when compared with other regions of the world within the time period of this study. table 1 shows that the region has the least human capital capacity through the period. europe and central asia (eca) topped the list. this was followed by latin america and the caribbean (lac) after which middle east and north africa (mena) and east asia and the pacific (eap) followed. the trend clearly shows that advanced economies invest substantially in cultivating their human capital capacity. eca, which topped the list, has experienced an increasing trend in its human capital capacity. ssa also experienced an increasing trend in its human capital capacity though its performance is low compared to the others. nevertheless, the trend is an indication that the region is experiencing growth in its human capital capacity to contribute to the development process. assessing the trend of human capital in ssa, however, is not sufficient; for it is imperative to assess the trend of the enabling factors that allow the optimization of this capacity. table 2, therefore, presents the trend of institutional quality in ssa in comparison with other regions of the world. virtually all the regions have been almost on a downward trend in their ability to control corruption except lac and eca. government effectiveness and regulatory quality were also on a downward trend for all the regions except lac and eca. ssa performance of institutional quality, thus, have been poor, which is an indication that human capital in the region lacks the enabling institutional environment to contribute to innovation outcomes and the development process. this conclusion was reinforced by assessing the trend of innovation outcomes in the region in comparison with those of other regions of the world. this is presented in table 3. it was observed that regions with the largest human capital capacity, as shown in table 1, had the largest innovation output as shown in table 3. moreover, the region with the best performing institutional quality had the largest innovation output. this is a signal of the direct relationships among the variables. ssa, which had the least human capital capacity, has the least innovation output throughout the period of study as shown in table 3. table 1: human capital with tertiary education: ssa and the world region 1996 2001 2006 2007 2008 2009 2010 2011 ssa 3.71 4.63 5.87 6.10 6.43 6.71 7.21 7.56 eap 11.25 17.24 24.37 25.24 26.08 27.72 29.11 30.11 eca 38.52 47.23 55.95 56.82 57.50 58.49 60.04 60.32 mena 17.24 21.09 24.43 25.95 27.91 28.66 30.48 31.34 sa 5.59 8.33 10.13 11.50 13.02 14.17 15.67 15.88 lac 18.09 24.43 32.42 35.52 38.52 39.60 41.17 42.32 source: oluwatobi et al. (2014). ssa: sub saharan africa, eap: east asia and the pacific, eca: europe and central asia, mena: middle east and north africa, sa: south asia, lac: latin america and the caribbean oluwatobi, et al.: human capital, institutions and innovation in sub-saharan africa international journal of economics and financial issues | vol 6 • issue 4 • 20161510 these trends reveal clear patterns that not only show the relationship that exists among human capital, institutions and innovation in ssa but also indicate the performance of the region in comparison to other regions of the world. the result of the low performance of the region in terms of its innovation output, is buttressed by the performance of selected countries in ssa for this study. the global innovation index 2014, presented in table 4, showed that none of the countries scored up to average. on the other hand, the global competitiveness report, shows that the ssa region has potentials to improve its innovation performance given its level of competitiveness. though not among the top ranking most competitive economies, selected countries in ssa are improving the level of competitiveness to catch up with advanced economies. from table 5, 18 countries out of 32 countries studied, scored above average. 4. methodology the foundation on which this study is conducted is based on the theoretical and empirical model developed by tebaldi and elmslie (2008, 2013) consistent with romer (1990),…. on the interelationship among human capital, institutions, innovation and economic growth. their model relates human capital and innovation as follows: a=δahaq[t(a)] (1) where a is a measure of innovation, ha is a measure of human capital and q is a measure of institution in relation to institutional quality and technical knowledge. this model, thus, is augmented to suit this study and capture two other variables; namely economic growth and spillovers from foreign investments. it is expected that innovation will be enhanced as the economy grows. it is also expected that spillovers from foreign investments improve innovation. the model for this study is therefore presented as follows: innovation =ah e y si,t i,t ins i,t i,t i,t 2 3 i,t 4 5 α α α α ε (2) table 2: institutions: ssa and the world region control of corruption government effectiveness regulatory quality 1996 2000 2005 2008 1996 2000 2005 2008 1996 2000 2005 2008 eap −0.43 −0.6 −0.53 −0.57 −0.3 −0.48 −0.46 −0.53 −0.35 −0.61 −0.56 −0.69 eca −0.7 −0.62 −0.52 −0.48 −0.58 −0.51 −0.37 −0.31 −0.59 −0.49 −0.32 −0.1 lac −0.35 −0.18 −0.16 −0.12 −0.34 −0.15 −0.14 −0.1 −0.22 −0.07 −0.07 −0.12 mena −0.46 −0.57 −0.55 −0.62 −0.45 −0.63 −0.63 −0.61 −0.64 −0.78 −0.73 −0.63 ssa −0.63 −0.58 −0.68 −0.62 −0.66 −0.72 −0.78 −0.78 −0.65 −0.64 −0.75 −0.7 world −0.03 −0.02 −0.02 −0.02 −0.04 −0.01 −0.01 −0.01 −0.05 −0.03 −0.02 −0.01 source: oluwatobi et al. (2014), ssa: sub saharan africa, eap: east asia and the pacific, eca: europe and central asia, mena: middle east and north africa, lac: latin america and the caribbean table 3: innovation: ssa and the world region 1996 2001 2006 2007 2008 2009 ssa 3908.6 3860 4615.6 4952.4 5074.4 5080.1 eap 89930.6 117690 161522.7 169109.4 182046.1 190578.9 eca 240081.3 255860.3 282648.5 287422.2 291637 290424.4 mena 9500.4 11452.6 15206.1 16628.2 17920.1 19167 sa 10266.1 11380.8 17784.2 19385.6 20372.6 21432.3 lac 10503.8 16074 21729.6 23337 24743.1 24032.6 source: oluwatobi, efobi, olurinola and alege (2014), ssa: sub saharan africa, eap: east asia and the pacific, eca: europe and central asia, mena: middle east and north africa, sa: south asia, lac: latin america and the caribbean table 4: global innovation index 2014 countries score (0-100) global rank (out of 143) ssa rank benin 24.21 132 28 botswana 30.87 92 6 burkina faso 28.18 109 14 burundi 22.43 138 30 cabo verde 30.09 97 8 cameroon 27.52 114 17 cote d’ivoire 27.02 116 18 ethiopia 25.36 126 24 gambia, the 29.03 104 11 ghana 30.26 96 7 guinea 20.25 139 31 kenya 31.85 85 4 lesotho 27.01 117 19 madagascar 25.5 124 23 malawi 27.61 113 16 mali 26.18 119 20 mauritius 40.94 40 1 mozambique 28.52 107 12 namibia 28.47 108 13 niger 24.27 131 27 nigeria 27.79 110 15 rwanda 29.31 102 10 sao tome and principe senegal 30.06 98 9 south africa 38.25 53 3 swaziland 25.33 127 25 tanzania 25.6 123 22 togo 17.65 142 32 uganda 31.14 91 5 zimbabwe 24.31 130 26 oluwatobi, et al.: human capital, institutions and innovation in sub-saharan africa international journal of economics and financial issues | vol 6 • issue 4 • 2016 1511 where a captures technical knowledge, hit measures human capital, insit measures institutions, yit measures economic growth, sit measures knowledge spillovers from foreign investments and εit represents the stochastic error term. i and t represent the country and time identifiers respectively. the formulation of the model is consistent with theoretical and empirical postulations framed on the logic that human capital cultivation is significant to absorption of knowledge, creation of ideas, enhanced r and d output and innovation growth. the model presented in equation 2 is re-presented in equation 3 as a linear function for the purpose of estimation. the transformation into a linear function for estimation is done using logarithm. lninnovationi,t=α0+α1lninnovationi,t-1+α2 lnhit+α3insit+α4lnyit+ α5lnsit+φi,t (3) where α0=lna, φi,t=lnεi,t and lninnovationi,t-1 is a signification that it is a dynamic panel model. the sgmm is the estimation technique employed for this study. some of the reasons responsible for the choice of this technique is that it helps to cater for unobserved heterogeneity and endogeneity biases associated with estimating dynamic panel models. it has proven to be more efficient than instrumental variables estimator in the presence of heteroskedasticity and can exploit stationarity restrictions. 5. results and discussion the results for this study are presented in tables 6 and 7. the two tables indicate the relationship between human capital and institutions and innovation in ssa. human capital, in table 6, is indicated by secondary school enrolment, thus, capturing human capital with secondary education; while human capital in table 7 is indicated tertiary school enrolment, hence, capturing human capital with tertiary education. it is pertinent to examine what kind of human capital has the most significant impact in affecting the innovation outcomes of ssa. the six indicators measuring institutional quality were each used independently. this was pertinent since they were highly correlated with each other from the multicollinearity test as indicated in the correlation matrix in the appendix (see table a1). the relationship between human capital and innovation was therefore examined in the presence of each of these institutional variables. the probability values of the sargan test in each of the six models in table 6 showed that there is no over-identifying restriction. hence, the roodman (2009) concern of too many instruments has been addressed. the hansen test results as indicated by the probability values, further corroborates this. the ar(1) and ar(2) results for each of the models in the table also indicates that there is no autocorrelation. these results strengthen the validity of the results of this study. hence, the results are useful for drawing conclusions. from table 6, human capital had a significant relationship with innovation in all the models except for where control of corruption was the indicator for institutional quality. only regulatory quality, political stability and rule of law were statistically significant for all the indicators of institutional quality. from model 1, a change in human capital with secondary education by 1 percent leads to a contemporaneous change in innovation by 0.541%. this is a clear indication of the relevance of human capital in driving innovation in ssa. regulatory quality had a much more significant impact on innovation in the model compared to human capital. the result showed that a unit change in regulatory quality will translate in a change in innovation by 0.586%. the result from model 4 validates the human capital has a significant effect on innovation in ssa. specifically, a change in human capital with secondary education by one percent leads to a change in innovation by 0.514%. this reflects a greater impact of human capital on innovation that political stability. the result shows that innovation outcome is altered by 0.499% as a result of a unit change in political stability. this means that… the result from model 5 corroborates previous results indicating the impact of human capital with secondary education on innovation outcomes in ssa. it showed that a change in human capital with secondary education by 1% translates into a change in innovation by 0.652%. institutional quality, as indicated by rule of law, was responsible for 62% of the variations in innovation, thus, validating the relevant role institutions have in affecting the amount and quality of innovation in the ssa region. table 5: global competitiveness index 2014/2015 countrie score (1-7) rank 2014/15 (out of 144) ssa rank benin botswana 4.15 74 4 burkina faso 3.21 135 23 burundi 3.09 139 24 cabo verde 3.68 114 10 cameroon 3.66 116 12 central african republic comoros cote d’ivoire 3.67 115 11 ethiopia 3.6 118 13 gambia, the 3.53 125 18 ghana 3.71 111 8 guinea 2.79 144 25 kenya 3.93 90 6 lesotho 3.73 107 7 madagascar malawi 3.25 132 21 mali 3.43 128 20 mauritius 4.52 39 1 mozambique 3.24 133 22 namibia 3.96 88 5 niger nigeria 3.44 127 19 rwanda 4.27 62 3 sao tome and principe senegal 3.7 112 9 south africa 4.35 56 2 swaziland 3.55 123 16 tanzania 3.57 121 14 togo uganda 3.56 122 15 zimbabwe 3.54 124 17 source: world economic forum (2014), ssa: sub saharan africa oluwatobi, et al.: human capital, institutions and innovation in sub-saharan africa international journal of economics and financial issues | vol 6 • issue 4 • 20161512 the result shows that economic growth has a significant relationship with innovation. the variable was statistically significant at 1% level of significance for all the six models. moreover, the result shows that innovation is highly sensitive to economic growth in ssa as indicated by the coefficients, which reflect that a change in economic growth leads to a more than proportionate change in innovation in ssa. this means that innovation thrives as the economies in the region grow. fdi spillover, measured by net fdi inflows as a percentage of gdp, did not show a statistically significant relationship with innovation except in model 4, which indicates vary little impact of the variable on innovation. this means that the ssa region hardly benefits from knowledge spillovers from foreign investments in the region. this is not farfetched given that most fdi in the region are targeted at extracting available raw materials as well as taking advantage of the large market for their products and services. these results are clear indications of the significant impact human capital with secondary education has on innovation in ssa. it was, hence, necessary to validate this result by examining the relationship between higher levels of human capital and the effect on innovation. the impact of human capital with tertiary education on innovation outcomes in ssa was therefore examined. the results of the investigation are presented in table 7. human capital with tertiary education was statistically significant for all the six models in the table, thus, indicating that there is a significant relationship between highly skilled human capital and innovation in ssa. this validates the idea that highly-skilled human capital is relevant to innovation outcomes and will enable developing economies improve on their capacity to innovate and catch up with advanced economies. hence, a 1% change in tertiary human capital will cause a contemporaneous change in innovation. the coefficient of institutional quality indicated statistical significance for regulatory quality, political stability, rule of law and voice and accountability. a unit change in regulatory quality translate in a change in innovation by 0.506% while a unit change in political stability leads to a change in innovation by 0.406%. the coefficient of rule of law indicates that it is affects changes in innovation by 0.377% as it changes by a unit while a change in voice and accountability by one unit leads to a contemporaneous change in innovation by 0.613%. the results showing the relationship between economic growth and innovation are consistent with those in table 6. it was statistically significant at 1% level of significance and the coefficients show that a change in economic growth by 1% leads to more than proportionate changes in innovation, thus, validating that magnanimous impact the variable has on innovation in ssa and table 6: sgmm estimation (human capital measured by secondary school enrolment) variables dependent variable: innovation 1 2 3 4 5 6 lag of innovation 0.207 (0.142) 0.172 (0.154) 0.225 (0.175) 0.278 (0.183) 0.300* (0.169) 0.393 (0.395) human capital (secondary) −0.541** (0.239) −0.178 (0.201) −0.428* (0.224) −0.514*** (0.194) −0.652** (0.255) −0.970* (0.510) regulatory quality 0.586* (0.355) corruption of control −0.345 (0.263) government effectiveness 0.264 (0.220) political stability 0.499** (0.228) rule of law 0.617** (0.274) voice and accountability 1.088 (0.760) economic growth 1.521*** (0.186) 1.540*** (0.192) 1.611*** (0.234) 1.758*** (0.270) 1.708*** (0.232) 1.604*** (0.357) fdi spillover −0.0216 (0.0308) 0.0179 (0.0421) −0.0109 (0.0279) −0.0753* (0.0395) −0.0249 (0.0323) −0.0618 (0.0521) year −0.0151 (0.0172) 0.00329 (0.0296) −0.0107 (0.0200) −0.0223 (0.0177) −0.00895 (0.0169) −0.0100 (0.0381) constant −1.161 (33.58) −36.79 (60.12) −11.43 (40.32) 7.820 (32.50) −17.72 (33.89) −13.98 (71.50) sargan p 0.188 0.133 0.168 0.488 0.469 0.241 hansen p 0.235 0.212 0.221 0.458 0.404 0.114 ar (1) p 0.045 0.048 0.058 0.045 0.048 0.219 ar (2) p 0.165 0.239 0.132 0.148 0.123 0.217 observations 253 253 253 253 253 253 number of year 13 13 13 13 13 13 source: computed by authors using stata 12.1. standard errors are in parentheses. ***,**,*denotes p<0.01, p<0.05 and p<0.1 respectively, sgmm: system generalized method of moments oluwatobi, et al.: human capital, institutions and innovation in sub-saharan africa international journal of economics and financial issues | vol 6 • issue 4 • 2016 1513 indicating that innovation advances in the region as the economies in the region grow. this indicates the direct relation economic growth has with innovation in ssa. the results show that fdi spillover did have any significant relationship with innovation in ssa, thus, buttressing the idea that foreign investments in the region are not impactful on innovation in the region. 6. conclusion this study examined the impact of human capital and institutional quality on innovation in ssa. the study ascertains that human capital capacity at the secondary and tertiary levels are relevant to drive innovation in the region. moreover, the quality of institutions affects the output of innovation. these results, thus, validate the idea that human capital capacity, coupled with the enabling institutional environment, are requirements to facilitate innovation. the implication for ssa is that it can catch up with advanced economies and close the technology gap by investing in human capital capacity development and providing the enabling institutional environment that facilitates free enterprise and supports innovation. the study, therefore, recommends to policy makers that efforts be made to catch up by cultivating the human capital capacity at the secondary and tertiary levels as well as provide the enabling environment for such capacities to be engaged to enhance innovation outcomes. the human capital capacity generated, coupled with the enabling environment should translate in competent human capital pool that attracts foreign investments that are innovation-centred. based on the results, this study recommends that part of the enabling environment should be to redefine terms with foreign investors to direct their investments in such a way that ssa benefits from knowledge spillovers that contributes to innovation outcomes in the region. references aghion, p., howitt, p. (1992), a model of growth through creative destruction. econometrica, 60(2), 323-351. aghion, p., howitt, p.w. (1997), endogenous growth theory. cambridge, ma: mit press. ang, j.b., madsen, j.b., islam, r. (2011), the effects of human capital composition on technological convergence. journal of macroeconomics, 33, 465-476. basu, s., mehra, m.k. (2014), endogenous human capital formation, distance to frontier and growth. research in economics, 68, 117-132. chi, w. (2008), the role of human capital in china’s economic development: review and new evidence. china economic review, 19, 421-436. table 7: sgmm estimation (human capital measured by tertiary school enrolment) variables dependent variable: innovation 1 2 3 4 5 6 lag of innovation −0.0530 (0.0793) −0.0765 (0.104) −0.0274 (0.0703) −0.0860 (0.0751) −0.0268 (0.0782) 0.0869 (0.0804) human capital (tertiary) −0.413*** (0.106) −0.360** (0.144) −0.341*** (0.0929) −0.394*** (0.105) −0.467*** (0.0802) −0.478*** (0.110) regulatory quality 0.506* (0.260) corruption of control 0.319 (0.284) government effectiveness 0.213 (0.192) political stability 0.406*** (0.139) rule of law 0.377* (0.203) voice and accountability 0.613*** (0.177) economic growth 1.234*** (0.184) 1.328*** (0.233) 1.340*** (0.153) 1.242*** (0.187) 1.365*** (0.196) 1.481*** (0.145) fdi spillover −0.0383 (0.0559) −0.00809 (0.0693) −0.0293 (0.0553) −0.0180 (0.0546) −0.0397 (0.0477) −0.0580 (0.0485) year 0.0809** (0.0411) 0.0575 (0.0389) 0.0676** (0.0323) 0.0554** (0.0279) 0.0781** (0.0318) 0.0808 (0.0516) constant −187.4** (83.23) −142.0* (79.43) −162.5** (65.04) −136.3** (56.16) −184.4*** (62.84) −193.4* (105.5) sargan p 0.444 0.130 0.290 0.228 0.282 0.115 hansen p 0.248 0.133 0.276 0.311 0.175 0.423 ar (1) p 0.182 0.213 0.283 0.078 0.171 0.140 ar (2) p 0.444 0.232 0.347 0.657 0.505 0.346 observations 191 191 191 191 191 191 number of year 13 13 13 13 13 13 source: computed by authors using stata 12.1. standard errors are in parentheses. ***,**,*denotes p<0.01, p<0.05 and p<0.1 respectively, sgmm: system generalized method of moments oluwatobi, et al.: human capital, institutions and innovation in sub-saharan africa international journal of economics and financial issues | vol 6 • issue 4 • 20161514 fleisher, b., li, h., zhao, m.q. 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(2011), the composition of human capital and economic growth: evidence from china using dynamic panel data analysis. china economic review, 22, 165-171. appendix appendix table table a1: correlation matrix indicators control of corruption government effectiveness political stability regulatory quality rule of law voice and accountability control of corruption 1.0000 government effectiveness 0.8322 1.0000 political stability 0.6925 0.6178 1.0000 regulatory quality 0.7548 0.8575 0.5791 1.0000 rule of law 0.8526 0.8644 0.7820 0.8244 1.0000 voice and accountability 0.7104 0.7409 0.7148 0.7078 0.8097 1.0000 . international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 81 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s7) 81-85. special issue for "international soft science conference (issc 2016), 11-13 april 2016, universiti utara malaysia, malaysia” relationship engagement in mergers and acquisitions through collegial leadership mohd haniff jedin1*, norsafinas md saad2 1school of international studies, international business department, sintok 06010 kedah, malaysia, 2school of international studies, international business department, sintok 06010 kedah, malaysia. *email: mdhaniff@uum.edu.my abstract many research in m&a focused on the deal processes, little has been said about how acquirer and the target firm engage in their relationship building processes. existing researches did not clearly demonstrate the importance of the relationship among m&a players in the amalgamation processes between an acquirer and the acquired firm. thus, this paper attempts to highlight the influence of collegial leadership in initiating relationship engagement in the post m&a integration. result shows that collegial leadership significantly influence the relationship engagement in m&a. keywords: mergers and acquisitions, relationship engagement, collegiality jel classification: g34 1. introduction mergers and acquisitions (m&as) is a business phenomenon that is very commonly used as corporate development strategies. this is not a new phenomenon but as an organizational growth approach which has been used extensively as a means to international expansion by many multinational corporations. m&a offers value-creation opportunities through combining complimentary assets and liabilities from firms with different backgrounds. m&a also has disadvantages that are attributed to hubris, managerial incompetency in achieving projected economies of scale and the firms being strategically mismatched (sinkovics et al., 2015). lack of communication between top management and other managerial positions is also believed to add more hurdles to the amalgamation process (sirower and lipin, 2003). in fact, previous studies have confirmed that almost 50-70% of m&a failed to create value for the acquiring firm’s shareholders, although at first glance the strategy would seem to be the most perfect way to improve a firm’s value and enhance its capabilities through better access to resources (tetenbaum, 1999). this may be due to the nature of m&as that is likely to bring about complex events and many drawbacks compared to the advantage in organizational environments, especially postintegration (larsson and finkelstein, 1999). one of the major challenges of the m&as integration process is the coordination and information flow in the merged difficulty involved in developing and exploiting skills and acquiring knowledge (meschi and metais, 2006). furthermore, lack of compelling strategic rationale and unrealistic expectations of the possible synergies also create significant challenges. one of the ways to generate a better communication bridge is developing an integration infrastructure that has clear roles, responsibilities and expectations (galpin and herndon, 2007). by adapting the resource-based view and social capital theory as the framework foundation, this paper attempts to raise this issue on how to develop better relationship engagement among the acquirer and the acquired firms. hence, this research seeks to initiate this line of enquiry by investigating how the managers of the acquirer and the acquired firms can work together in harmonies by adapting the collegiality leadership styles. jedin and saad: relationship engagement in mergers and acquisitions through collegial leadership international journal of economics and financial issues | vol 6 • special issue (s7) • 201682 2. literature review 2.1. collegiality leadership in m&a although, collegiality concept is familiar in academic world but there are unknown interpretations in applying this concept in an organization. in organization, collegiality approach seems to be co-existing but more in competition wise which is rather different from the academic world (singh, 2013). however, the competitive environments is controllable if the organization is equip with strong believe in a particular vision and objective. according to freedman (2009), collegiality approach works in many ways from cooperative to governance committee activities which highlight a concept of shared power and authority among colleagues. in fact, collegiality in m&a is an ideal initiative in order to develop sense of engagement among the staff and superior of the acquired firm and the acquirer. most likely, the acquirer will appoint their managers to head the position in the acquired firm. in this situation, a role of collegiate and empathy would be advantage in order for both staff to improve their relationships and at the same time enhance the productivity of the combined firms. by applying the concept of collegiality engagement in m&a integration, the staff would be able to be more lateral rather than high in hierarchical which improve in the decision making process in an organization. in addition, this concept could avoid conflict and the feeling of foreignness among the staff that attached with acquired and acquirer firms. therefore we propose the following hypothesis which considers collegiality as one of the factors that could facilitate relationship effectiveness among the staff in the m&a integration initiatives. figure 1 shows the conceptual framework of collegiality leadership and relationship engagement in m&a. h1 (+): the higher the initiative of collegial leadership, the better the relationship engagement between acquirer and the acquired firm. 2.2. effectiveness in relationship engagement another important outcome is the close relationships between the staff and managers of both firms (acquiring and acquired). the relationships between the managers are essential to avoid misunderstandings in communications and above all to ensure that the m&a integration activities are kept on track in order to allow an outstanding m&a performance (saunders et al., 2009). additionally, this outcome would hopefully retain staff rather than encouraging them to move to other organizations. losing these valuable managers are not the only a main concern but to lose the thinkers and hardworking managers would be a potential risk of losing key customers attached to those managers. even though the acquirer and the target firm have combined, relationship gaps between them will still exist. staff attached to the target firm will always be vulnerable to any decisions made by the new owner of the combined firm. therefore, quick action is needed to bridge this gap by enhancing good relationships in order to avoid the loss of dedicated staff and, more importantly, to eradicate feelings of discrimination amongst the staff. the acquirer needs to develop good flows of communication by having a lot of informal discussions and disseminating new information to all staff including those from the acquired firm. this is important to avoid irrational rumors which could cause the collapse of the newlybuilt firm. this can be addressed by improving the commitment to business relationships so that associates are ultimately made to feel important. relationship gaps among the managers of the acquired and the acquirer firm, particularly in m&as are not tangible, but need long term attention as relationships take time to develop. therefore, we hypothesize: h2 (+): the greater the staff relationship engagement, the better the m&a performance. 2.3. m&a performance various studies that focus on m&a performance in the integration phase consider the perspectives of financial performance after the m&a (homburg and bucerius, 2006; zollo and meier, 2008). another striking study by colombo et al. (2007) highlights five components of m&a performance, namely market share, profitability, competitive positioning, market coverage and customer satisfaction. this study that looks at m&a performance. hence, the present study attempts to highlight the role of collegiality leadership that could rejuvenate the relationship engagement in m&a integration thereby improving the m&a performance. 3. research methodologies 3.1. sample and measurement scales a survey methodology was used in this study. we look at m&a transactions undertaken by the malaysian firms, within the period of seven years (2006-2013). this period was also applied by sinkovics et al. (2011) in the m&a studies. however, the scope of this study was limited to malaysian contexts. the m&a cases were gathered from the bursa malaysia database. the minimum value for a cross border transaction was taken to be us$ 1 million, which is lower than the range proposed by kogut and singh (1988) of us$10 million. the rationale behind this was that the currency of countries such as malaysia, and the size of firms involved in m&as in those countries, and thus most of the transaction values, tend to be lower than those in developed countries. this is also in line with information reported by the bursa malaysia, which stated that cases with a value less than us$1 million are usually acquisitions by internal shareholders and are not likely to involve departmental integration, particularly in m&as. furthermore, if we had adopted a minimum value of us$ 10 million, the number of m&a cases in malaysia would be less and we would also be less likely to obtain a good response rate. we only choose firms acting as acquirers in m&as. we do not restrict the sample to any specific sector or industry. figure 1: conceptual framework of collegial leadership jedin and saad: relationship engagement in mergers and acquisitions through collegial leadership international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 83 out of the 428 m&a cases listed in bursa malaysia from the period of january 2006 until disember 2013, we identified 385 cases of malaysian firms involved in m&as with a transaction value of above us$1 million. from this sample, we managed to collect 72 responses which is 18.7 % response rates. all of the items in the questionnaire were measured using 7-point likert scales (1=strongly disagree/very infrequent/very low, 7=strongly agree/very frequent/very high, respectively. the measurement of the collegial leadership were adapted from singh (2013). next, we introduce one further variable in the effectiveness of the relationship engagement between the staff in the acquired and acquiring firm. this measurement was taken from jedin and saad (2012). the final measurement is performance outcomes, which were adapted from sinkovics et al. (2015). 3.2. reliability test table 1 depicts the results of the cronbach’s coefficient alpha on each construct. based on the recommendation for minimal acceptable reliability, the range of 0.6 and above is acceptable (churchill and peter, 1984; nunnally, 1978). the result shows a positive response as all of the variables yielded scores 0.9 and above. 4. findings and analysis 4.1. industry profile overall, 16 groups were identified in the questionnaire along with a separate group titled “other industry.” “other industry” is crucial as quite a few of the respondents who were not related to the above 15 named groups used this option. the industries involved in the survey, including those marked “other industry” are presented in table 2. out of 385 selected responses, we received 72 useable questionnaires. majority of these firms are believed to engage in banking and financial institutions, telecommunications, software and other services. 4.2. respondents profile table 3 indicate majority of the respondents (70%) were at the level of top management: director and senior management levels. meanwhile, 29% represented at the middle range of managers. in terms of number of years for the establishment, most of the firms were in the category of “30 years and above.” this was followed by firms established for “21-30 years” (22%). the remaining firms were in the category “21-30 years” (21.1%) and “<10 years” (14.7%). hence, it can be concluded that most of the malaysian firms that were involved in this study were established and matured to penetrate local and overseas markets through the cross-border m&a penetration strategy. as for the number of employees, on average the sample firms employ 1500 staff. half of the firms were in the range of “1,001-10,000” staff. 4.3. data analysis the data were analyzed using the partial least squares method (pls), applied using the smartpls 2.0 m3 software package (ringle et al., 2005). pls was employed to analyze the path coefficient by looking at the multiple correlation coefficients (r² statistics) for all endogenous constructs (henseler et al., 2009). pls has been designed to cope with problems in data analysis related to small data samples and missing values (hoyle, 1999). pls path modeling methods have not only been applied previously in marketing and management but also recently to m&a (cording et al., 2008). item reliabilities were assessed by examining the outer loadings of each item (table 4). most of the outer loadings are above the recommended threshold of 0.7 (henseler et al., 2009). however, some of the outer loadings are lower than the threshold. in pls, convergent validity is assessed through internal consistency and discriminant validity (fornell and larcker 1981). in terms of discriminant validity, fornell and larcker (1981) suggest the use of average variance extracted (ave), which should be greater than each of the variances shared between the constructs from the correlation matrix. table 5 shows that all the diagonal elements in the correlation matrix (ave) are table 1: reliability test construct item measure mean±sd n (72) cronbach’s alpha collegial relationships (six items) cl communicating to each other 5.8194±1.32502 72 0.970 responsive to each other 5.7222±1.34502 72 concern for colleagues 5.4444±1.35198 72 dynamic relationships 5.5278±1.22155 72 motivating to each other 5.2361±1.35826 72 passionate about your colleagues 5.0139±1.44858 72 willing to share ideas 5.5417±1.36286 72 willing to share skills 5.6111±1.28431 72 effective relationship engagement rl we have spent our time and effort in developing and maintaining our relationship 5.8750±0.96323 72 0.927 we have productively develop our relationship 5.9167±0.91544 72 we have been satisfied with our relationship 5.5000±0.94943 72 we have carried out our responsibilities and commitments 5.6250±0.82969 72 m&a performance map market share 5.9444±0.96252 72 0.904 profitability (return on investment) 5.8611±1.05224 72 competitive position 5.9583±1.08040 72 market coverage 6.0000±0.97865 72 customer satisfaction 5.9028±0.90631 72 m&a: mergers and acquisitions, sd: standard deviation jedin and saad: relationship engagement in mergers and acquisitions through collegial leadership international journal of economics and financial issues | vol 6 • special issue (s7) • 201684 greater than the off-diagonal elements in the corresponding rows and columns (variances shared). figure 2 confirms the relationship between the collegial leadership and the relationship engagement. similarly, the relationship also supported between relationship engagement and m&a performance. hence hypothesis h1 and h2 were supported. collegial leadership was found to have positive and significant influence on the effective relationship engagement (b = 0.795, p < 0.001). another path that found to be significant and positively influence is relationship engagement between m&a performance (b = 0.614, p < 0.001). 5. discussions this study indicates that the collegial leadership has a highly significant, positive influence on the relationship engagement. in table 2: industry profile valid frequency percent valid percent cumulative percent clothing 1 1.4 1.4 1.4 electronics 1 1.4 1.4 2.8 automotive 1 1.4 1.4 4.2 telecommunication 4 5.6 5.6 9.7 software 4 5.6 5.6 15.3 engineering 2 2.8 2.8 18.1 household and consumers 2 2.8 2.8 20.8 retail banking 8 11.1 11.1 31.9 investment banking 2 2.8 2.8 34.7 construction 3 4.2 4.2 38.9 food/beverages 4 5.6 5.6 44.4 chemicals 1 1.4 1.4 45.8 oil and gas 1 1.4 1.4 47.2 transport and logistics 1 1.4 1.4 48.6 plantation and agribusiness 1 1.4 1.4 50.0 utilities and infrastructure 2 2.8 2.8 52.8 other industry 34 47.2 47.2 100.0 total 72 100.0 100.0 table 3: respondents background characteristics of respondents frequency (%) designation ceo/director level 26 (36.1) senior general manager/head of division 25 (34.7) middle-level manager/senior executive 21 (29.2) industry experiences in m&a <10 years 11 (15.3) 11-20 years 18 (25) 21-30 years 21 (29.2) 31 years and above 22 (30.5) number of employees <100 employees 5 (6.9) 101-1000 employees 21 (29.2) 1001-10000 employees 36 (50) 10001 employees and more 10 (13.9) m&a: mergers and acquisitions, n=72 (number of respondent) table 4: internal consistency and outer loadings of items internal consistency outer loading construct: collegial relationship composite reliability 0.979670 cronbach’s alpha 0.970 ave 0.857700 communicating to each other 0.943469 responsive to each other 0.923444 concern for colleagues 0.937260 dynamic relationships 0.965504 motivating to each other 0.914749 passionate about your colleagues 0.884830 willing to share ideas 0.935568 willing to share skills 0.901715 construct: relationship effectiveness composite reliability 0.930466 cronbach’s alpha 0.927 ave 0.770366 we have spent our time and effort in developing and maintaining our relationship 0.912799 we have productively develop our relationship 0.928472 we have been satisfied with our relationship 0.850867 we have carried out our responsibilities and commitments 0.813773 construct: mergers and acquisitions performance composite reliability 0.928835 cronbach’s alpha 0.904 ave 0.725675 market share 0.838345 profitability (return on investment) 0.872657 competitive position 0.916657 market coverage 0.940020 customer satisfaction 0.663421 ave: average variance extracted table 5: correlations and discriminant validity latent variables 1 2 3 1. collegial relationships 0.926121 2. m&a performance 0.650114 0.851866 3. relationship engagement 0.613631 0.509588 0.877705 *bold diagonal figures represent the square root of ave. ave: average variance extracted, m&a: mergers and acquisitions other words, it appears that, if both the acquirer and the target firm work together to improve their relationship by enabling to share important position and decision making processes in the combined firms, they will be able to enhance m&a performance. it is not necessarily that important position is controlled by the leaders from the acquirer but some positions in the combined firm need the existing leaders from the acquired firm. this is due to the nature of the position and additionally the leaders who managed that position have huge knowledge and experiences in that particular position. thus, managers and leaders need to cultivate sharing and apply a rotation basis on their responsibilities in order to figure 2: path coefficient results jedin and saad: relationship engagement in mergers and acquisitions through collegial leadership international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 85 initiate healthy relationships which at the same time developing successful m&a integration. furthermore, this could generate a fair agreement among the managers and highlight to those who have perform better in a particular position in improving the new combined firm. a strong relationship among the leaders enables the combined firms to rejuvenate quick liquidity. more importantly both of the combined firms could develop sustain business environment with dynamic and passionate colleagues. in addition, the rotation basis on position approaches give more opportunity to both acquirer and acquired staff to maintain their personal developments and reduce feeling of retrenchment and uncertainty in the amalgamation (king et al., 2004). in fact, according to meyer (2001), both firms need to develop sharing environment and fostering relationships through balance power among the decision makers. thus, clearly, a leader in the amalgamation processes needs to play a pivotal role to develop a collegial relationship among the managers to cultivate a sustainable integration environment. 6. conclusions as predicted, the relationship engagement is significant and positively associated with the m&a performance. as mentioned earlier, relationship engagement is very important to all levels of staff in the combined firms as this is the one that manage the motivations and social supports at the workplace. furthermore, a high motivated staff could perform their task at maximum levels. relationship engagement in m&a is not only between the acquirer and the target firm but it also involves the customers, suppliers and stakeholders. thus, relationship engagement is a must to ensure a better m&a performance. thus, with these results we have achieved our main objective, demonstrating that the collegial leadership could cultivate better relationship engagement in m&a. references churchill, g.a.jr., peter, j.p. 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(1999), beating the odds of merger & acquisition failure: seven key practices that improve the chance for expected integration and synergies. organizational dynamics, 28(2), 22-35. zollo, m., meier, d. (2008), what is m&a performance? academy of management perspectives, 22(3), 55-77. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 164-171. international journal of economics and financial issues | vol 13 • issue 1 • 2023164 do payment technology innovations affect currency demand in tunisia? nadia mbazia* faculty of economic sciences and management of tunis, university of tunis el manar, tunis, tunisia. *email: nadia7mbazia@gmail.com received: 17 october 2022 accepted: 04 january 2023 doi: https://doi.org/10.32479/ijefi.13888 abstract this study investigates the impact of non-cash payment technologies on demand for currency in tunisia using the autoregressive distributed lag (ardl) cointegration approach from 2010m12 to 2018m7. in this context, our findings indicate a negative influence of eft-pos terminals on currency demand. we have also shown that the demand for currency is positively influenced by the increase in the number of atms and the volume of transactions made by bank cards in circulation, reflecting the frequent use of cards to receive cash in tunisia. whereas, the impact of increase in check payments on demand for currency is negative and not significant. the empirical evidence shows that there is preference for cash in payment habits by tunisian consumers. so, it should be noted that despite the development of payment systems, cash still attractive and an easier substitute for non-cash payments in tunisia. keywords: currency demand, atm, pos, ardl, tunisia jel classifications: e41, e42, e44, g21, o33 1. introduction recent developments in payment technologies have added new words to current literature about money demand and particularly about cash demand. in this context, new payment instruments, based on electronic transfer of funds, were broadly accepted by economic activists in different countries, caused more than ever the expansion of e-commerce in various forms. the central bank of tunisia involve strategies to promote the financial inclusion through the development of payment systems and means. the idea was to increase the use of non-cash payment instruments generated in the framework of the less cash society in order to encourage the creation of a secure payment system with the rapid use of non-cash payment instruments based cards. in tunisia, the payments’ motives are not changing: notes and coins are still more and more diffused for everyday purchases, in particular for low-value expenses, at the detriment of paper-based or card-based payments. in other words, cash is still the preferred and more used payment instrument by tunisian consumers. research studies on the demand for currency has found that the option of the payment systems, changes the demand for cash reflecting changes in the volume of cash transactions via changes in the consumer behaviors. there are several empirical studies started to model the demand for money against payment instruments development investigating the relationship between new payment instruments and cash usage. amromin and chakravorti (2007) estimated a study on the impact of the rise use of debit card to the circulation of cash. the findings showed that increasing debit cards may decrease low denomination currency, but high denomination currency is less affected. yilmazkuday (2007) examines the effects of credit and debit cards on the demand for currency using gmm estimation. he found the usage both credit and debit cards had a negative effect on currency demand. rinaldi (2001) estimated a this journal is licensed under a creative commons attribution 4.0 international license mbazia: do payment technology innovations affect currency demand in tunisia? international journal of economics and financial issues | vol 13 • issue 1 • 2023 165 currency demand equation for belgium to determine the imapct of alternative means of payment on cash usage. the findings shows that pos merchant acceptance and the number of atms had a negative impact on currency in circulation while there is a weak positive effect was found for the number of credit and debit cards. snellman et al. (2000) estimated a money demand equation using panel data for ten european countries and found that the number of debit and credit cards had an insignificant effect on demand for cash. stix (2004) found that debit cards affects cash demand significantly. also, anderson-reid (2008) found that demand for currency is positively affected by the volume of atm transactions in the previous two periods and negatively affected by electronic funds transfer point of sale systems (eftpos) transactions in the prior period in jamaica. moreover, tehranchian et al. (2012) examines the impact of modern technology including credit cards, automatic teller machines (atm) and electronic funds of transfer at the point-of-sale (pos) on money demand for iran using seasonal data for iran 2001-2008. they found a positive impact of the number atms and credit cards on the demand for currency in both short and long runs and a negative impact of the number of pos on cash usage. further, reddy and raj (2017) examines the impact of credit cards and debit cards on currency demand and seigniorage in india employing auto-regressive distributed lag (ardl) model for monthly data. he found that credit cards decrease currency demand. also, he found that wider usage of electronic cards may not a threat to the central bank autonomy in near future as seigniorage revenue is not affected by use of cards. adil and al (2020) estimates money demand for india from 1996:q2 to 2016:q3 with the linear ardl approach. they found that financial innovation plays a very significant role in the money demand specification and its stability. to the best of our knowledge, this paper represents the first attempts to examine the impact of non-cash payments developments on currency demand in tunisia using ardl approach. the purpose of this study is to understand if the modern payment instruments have an influence on currency demand in tunisia by a special focus on the more advanced means of payments as a main variable of interest. we particularly concentrate, for the 1st time, on the evolution of non-cash payments infrastructure that has increased in recent years in tunisia highlighting its impact on currency usage. in view of the fast changing external factors in the payment systems, we focus on the most used means of payment in tunisia like checks and pos and bank cards. this article is organized as follows. section 2 presents the payment technologies dynamic in tunisia. in section 3, we focus on the data and the empirical methodology. we present the empirical findings and the interpretation in section 4. we offer some concluding remarks in section 5. 2. the payment technologies dynamic in tunisia developments in information technology and telecommunications increased the payment technologies infrastructure. in tunisia, payment systems and the use of noncash payment instruments have undergone significant changes for over the last years. the central bank of tunisia adopt strategies to promote the financial inclusion and to support the development of payment systems in tunisia including the move toward the increasing reliance on the use of newly developed payment technologies to enable both e-commerce and e-payments. despite that, tunisian consumers required preference for cash. 2.1. the cash holdings in tunisia the question we ask is: why do tunisians use currency? why currency still be an important means of transaction in tunisia? to answer for this questions, we have to investigate the reasons for currency usage in tunisia which are essential to understand and design the behavior of the tunisian economic agents towards cash: 2.1.1. the motives for which currency is demanded: the motives behind holding cash must have gained in importance against other means of payment: the transaction motive: cash is a medium of exchange function. demanding currency arises from the fact that most transactions involve an exchange of cash. so, cash must be available as a mean of payment for consumption expenditures for both small and large transactions. cash is the most preferred and the most dominant mean of payment for tunisian consumers for the different nature of transactions particularly the extraordinary household expenses for the summer season, the month of ramadan, the religious holidays and the end of year celebration, respectively. in tunisia, most retail purchases are normally made with cash because of its specific benefits: 1. cash is completely anonymous which afford the most important characteristic relative to e-money and the other payment products. in this context, anonymity preserve a certain measure of privacy for users. almost, the payer and payee may not prefer to reveal their identities or the type of the transactions 2. cash is secure and provide confidence for the payer and the payee 3. cash is preferred for its high degree of liquidity 4. cash is the quickest mean of payment for transactions 5. cash is mostly used for legal and illegal transactions 6. cash can be used without the further involvement of any intermediate as a computer or a mobile or service providers 7. cash is the cheapest mean of payment in tunisia. the precautionary motive: cash is a store of value. tunisian consumers reserve cash for precautionary reasons. they have a monetary habit which to store an amount of currency in their houses or in their wallet. this form of cash hoarding has gained in importance against uncertainty and unforeseen expenses that may the payment must be done with cash. this reflects the urgent needs for liquidity and a secure mean of payment. 2.1.2. the expansion of the informal economy in tunisia in tunisia, the expansion of the informal sector can be a determinant factor for the higher demand for cash. indeed, the mbazia: do payment technology innovations affect currency demand in tunisia? international journal of economics and financial issues | vol 13 • issue 1 • 2023166 informal economy needs more cash than the modern means of payment. moreover, abid and ben salha (2013) found that the informal gdp is found to range between 14% and 29% of the formal gdp in tunisia during the period between 1980 and 2009 and represent 54% of the formal gdp in 2018. the informal economy plays an important role in tunisia that explains the use of cash as the most preferred means of payment for tunisian consumers. a higher share of currency issued by the monetary system is captured by the informal sector away from banks and does not serve the transparent financing of the economy. 2.1.3. low digital and financial inclusion in tunisia: despite the strategies involved by the central bank of tunisia to promote the financial inclusion particularly with supporting the development of payment systems and means, the tunisian consumers required preference for cash. according to annual report of the central bank of tunisia, only 17% of tunisians use payment means other than cash at least once per month and 3% of tunisians have already used a financial service via mobile phone in 2018. the central bank of tunisia create a new professional body namely the payment institution, exclusively devoted to the payment service. the aim is to boost financial inclusion and make the payment market more competitive to help consumers have access to proximity payment services at affordable prices. however, there are only 5 149 872 tunisians that have current accounts in 2018 relative to 4 153 000 people of the total labor force, indicating that about 124% of tunisians have a more than an account relative to the labor force (the number of the current accounts and check accounts held by tunisians in 2018 including banks and the national post office). nevertheless, digital inclusion must be developed because it is not enough to have a client accounts. it must be used by means of card payment and, increasingly, by mobile phone. in this context, the central bank was committed, over 2018, to implementing the decashing plan which will serve as an example to acquire new habits in terms of payment, characterized by more transparency and security. however, tunisian consumers have an “eternal” trust for cash, and even the retailers, the traders and the merchants are reluctant to adopt the bank cards since the number of eftposs sill insufficient due in particular to high commissions. this observation is confirmed by the statistics concerning electronic banking where the number of affiliated merchants increased from 13 958in december 2013 to 19,228in december 2018, an increase of only 37.7%. cash is the currency in circulation stocks required for settlement of transactions. thus, development in payment system have encouraged the use of many noncash instruments in transaction payments. according to table 1, the share of cash in m1 in tunisia has revealed a trend increase to 40.1% of m1 balances in 2018 from 35.3% in 1998. the cash usage still persistent in spite of a small drop in the ratio of cash to m1 which has fallen from 35.4% in 2008 to 34.4% in 2015, showing that cash still the most important means of payment in this country. the second column of the table shows the indicator of cash use: currency in circulation to gdp between 1998 and 2018. the statistics shows that cash to gdp ratios have increased in tunisia indicating that circulation of coins and banknotes grew faster than nominal gdp, which reflect an increase in cash holdings, and therefore, the frequent use of cash as a competitive means of payment. as illustrated in table 1, cash holdings per person increases between 1998 and 2018 which explain the importance of the currency demand in the settlement of the daily transactions in tunisia in spite of various innovations in the payment technologies. 2.2. the noncash payments infrastructure in tunisia the frequent use of cash by tunisian households in daily financial transactions is overriding in all socio-demographic categories. for tunisians, cash is the perfect mean of payment. moreover, there is no strong influence of the payment technologies innovations on the demand for cash in tunisia in spite of the development of payment media and the creation of various technical innovations for settling payments. the tunisian consumers have a high preference for cash usage particularly in small retail payment. the increased use of atm between 2016 and 2018 to withdraw cash may explain the higher demand for currency to settle payment transactions, particularly those of low-value transactions. since cash is most often used for everyday small value retail purchases, bank cards are its closest substitute in modern payment systems. as shown in figure 1, bank cards are used more frequently for withdrawals more than for payments in tunisia. the number of cash withdrawals transactions from atm machines increased from 47.4 million in 2016 to around 53 million operations in 2018. however, the number of cash withdrawal transactions at table 1: indicators of cash use in tunisia year cash to m1* ratio (%) cash to gdp** ratio (%) value of cash holding per capita 1998 35.3 7.9 190.7 2003 38 8.87 285.1 2008 35.4 8.39 446.6 2013 34.7 10.5 692.33 2015 34.4 9.94 779.4 2018 40.1 11.19 1073.1 source: ifs. *m1 includes the currency in circulation (coins and banknotes) plus demand deposits other than those in central banks. **gdp at current prices 0 10 20 30 40 50 60 70 2016 2017 2018 tr an sa ct io ns n um be r (m ill io n) atms withdrawals bank counters withdrawals payment transactions via eftpos figure 1: pos payments and cash withdrawls transaction in tinisia source: central bank of tunisia mbazia: do payment technology innovations affect currency demand in tunisia? international journal of economics and financial issues | vol 13 • issue 1 • 2023 167 bank counters decreased from 7.1 million in 2016 to 4.4 million in 2018. tunisian consumers withdraw cash more frequently from atms than from their bank counters that reflects their preferences of withdrawal options. it is quite common in tunisia, to see people, especially those having salary from public or private sectors, line up in queue in front of atm machines in order to withdraw money at the time right after the payday of each month. in this context, it’s clear that the atms have a determinant role in cash withdrawals in tunisia and are an important source of cash more than the bank counter. in accordance with this results, it’s important to note that the bank counter withdrawals are substituted by atm withdrawals in tunisia in the last 3 years moreover, the number of payment transactions via eftpos increased from 11.5 million operations in 2016 to 17.2 million in 2018, its reflects the development in the noncash payment habits using bank cards in tunisia which partially replaced cash. although growth in eftpos payment transactions has recently increased, this noncash payment instrument is likely to become increasingly important as the pos terminals network increases. overall, there is a link between the number of pos terminals and the number of payment transactions. this depends on the density of the eftpos network. at the same way, the expansion of atms could affect the withdrawal frequencies and therefore the currency circulation. as illustrated in table 2, the use of bank cards has been strongly supported by the diffusion of eft-pos terminals and atm machines. the number of atms and eft-pos terminals grew at a slower pace. indeed, atms are usually available 24 h a day even in the weekend and are widely dispersed in different regions in tunisia. the number of atms increased at a slowly rate from 2070 to 2694 during the years 2014-2018, representing the fluctuation growth between 8.6% in 2015 and 3.5% in 2018. in a similar way, the number of point-of-sales (pos) increased from 12655 to 21622. this points to the increase of around 2 times during the same period. noticeably, the expansion of payment cards in tunisia has been reinforced by the rapid increase in the number of eftpos terminals reflecting the new technology strategy adopted by the commercial banks. for bank cards, its growth reached the highest value in 2018 at 27%. during 2014 and 2018, bank cards growth fluctuated between 12.7% and 27% reaching the lowest value in 2016 at 3.8%. a closer look to the number of bank cards and the number of bank current accounts provides many interesting things. first, it indicates that the expansion of bank cards in tunisia has been reinforced by the rapid increase in the number of bank current accounts over the years 2014-2018. in terms of number noncash payment instruments, the number of bank cards (such as the payment cards and the withdrawals cards) progressed from around 3.1 million in 2014 to around 4.6 million in 2018. second, the number of bank current accounts grew at a slower pace over the period under review. however, it’s logical to find that the number of the bank cards is higher than the number of bank current accounts since every customer’s bank can hold both types of cards including withdrawal and payment functions. as seen in table 3, check payments have a major share of the total volume of transactions between 2008 and 2018 in tunisia. the share of check payments has fallen only a little from 68.7% to 54.5% during the same period. these statistics show that check is a competitive payment product and is mainly used for small and large value retail payments. moreover, the share of bank cards payments increased significantly from around 0.5% in december 2008 to around 7% in december 2018. this suggests that card payments have partially replaced checks in low value retail payments in tunisia that have historically strongly used checks. according to this, the diminishing share of checks in noncash transactions has mainly benefited bank cards and transfers payments, while the share of debits transactions in the total volume of payment transactions has been relatively stable. the share of commercial papers payments is decreased at a slower pace from around 14.2% in december 2008 to around 13% in december 2018. whereas, the share of the electronic payments is negligible. technological innovation has largely influenced the volume of electronic transactions, the volume of these transactions remain to be modest increasing from 0.03% to 0.08% during the period between 2008 and 2018. 3. data, model specification and estimation method 3.1. data and model specification in this section, we analyze the degree to which some forms of noncash payment instruments would substitute cash usage in tunisia. to this end, to more clearly identify the various effects on the demand for cash, we specify and estimate the following money demand equation using monthly data over the period 2010m12-2018m7 in tunisia considering the model of tehranchian et al. (2012): mc y r atm eftpos checks it i it it it it it it it it it i = + + + + + ρ α α α α α 1 2 3 4 5 tt it it itcards+ +α ε6 (1) table 2: the number and growth of payment instrument in tunisia year number of atm annual change % number of eftpos annual change % number of bank cards* annual change% number of bank current account** annual change% 2014 2070 * 12 655 * 2721166 * 2614705 * 2015 2249 8.6 12 991 2.65 3066792 12.7 2857676 9,29 2016 2385 6.04 13 510 3.99 3185 935 3.8 2974429 4,08 2017 2602 9.09 18 919 4 3655 026 14.7 3108370 4.5 2018 2694 3.53 21622 14.28 4640 237 26.9 3279143 5.4 source: central bank of tunisia. *number of payment cards and the withdrawals cards. **number of the current accounts and the checking accounts at the banks mbazia: do payment technology innovations affect currency demand in tunisia? international journal of economics and financial issues | vol 13 • issue 1 • 2023168 where mcis the real money holdings defined by currency (banknotes and coins) in circulation outside the banking sector, yis the real income represented by the index of industrial production as a proxy for performance of the economy since monthly data on gdp is not available, r is the nominal short-term rate of interest which is presented by 3 months money market rate, atm is the the number of automatic teller machines, eftpos is the number of electronic funds transfer per point of sale, checks is the volume of transactions made by checks, cards is the volume of transactions made by national bank cards in circulation (payment cards and atm cards), ε it is the error term and αi is the estimated constant. the consumer price index is used as the price variable. while the other variables typically enter in logarithms, the interest rate variable is used in levels. the demand for currency is expected to be positively influenced by the real income and negatively influenced by the opportunity cost variable, the monetary market rate. the demand for cash is expected to decline as transaction technology improves thereby reducing the need for cash. in this regard, the number eftpos terminals is expected to be negatively related to currency demand while the number of atms may be positively or negatively related to the demand for currency. the relationship between cash usage and atms is theoretically ambiguous: greater number of atms strongly increases the demand for cash since it can be easily accessed. on the other hand, more atms could reduce the currency demand since individuals can minimize the opportunity cost of transfers between currency and other bank deposits as reported in drehmann et al. (2002). the volume of transactions made by checks and bank cards in circulation are expected to be negative. all the data used in this study are collected from the international financial statistics (ifs) database, the tunisian central bank, the national institute of statistics and the tunisia’s professional association of banks. the choice of sample countries is based on data availability covering the period of study. 3.2. estimation method to examine shortand long-run effects of payment technology innovations on the demand for cash, method of auto regressive distributed lag (ardl) is employed. the ardl cointegration approach developed by pesaran and pesaran (1997) and pesaran et al., (2001) has several advantages has several advantages over the well-known residual-based approach proposed by engle and granger (1987) and the maximum likelihood-based approach proposed by johansen and julius (1990) and johansen (1992). the ardl approach provides unbiased estimates of long-run model and valid t-statistics, even when some of the regressors are endogenous. in addition, a dynamic error correction model can be derived through a simple linear transformation in the ardl model. moreover, it does not depend on pre-testing the order of integration of the variables, hence it is free from unit-root pretesting and can be applied regardless of whether variables are i(0) or i(1) or mutually cointegrated. ardl method simultaneously estimates the short-run and long-run patterns in model, and eliminates the problems of endogenity and autocorrelation that why the estimations using ardl approach are unbiased and efficient (siddiki, 2000). the short-and long-run parameters with appropriate asymptotic inferences can be obtained by applying ols to ardl with an appropriate lag length. for example, equation (1) can be re-written as an ardl model depicted below in equation (2): ∆ ∆ ∆ ∆ ∆ mc mc y r a t i t ii n i t ii n i t ii n i ( ) = + + + +−= −= −=∑ ∑ ∑α α α α α 0 11 21 31 4 ttm eftpos checks card t ii n i t ii n i t ii n i −= −= −= + + +∑ ∑ ∑ 1 51 61 7 α α α ∆ ∆ ∆ ss mc y r atm eftpos ch t ii n t t t t t −= − − − − − + + + + + + ∑ 1 1 1 2 1 3 1 4 1 5 1 6 β β β β β β eecks cardst t t− −+ +1 7 1β µ (2) where, δ is the first difference operator, β is the drift component, and µthe error term. the coefficients (β1 β7) represent the long-run relationship whereas the remaining expressions with summation sign (α1 α7) represent the short-run dynamics of the model. the bounds test used to determine the presence of cointegration among the variables is based on the wald test or the f-statistic test and follows a non-standard distribution (pesaran et al., 2001). under this, the null hypothesis of no cointegration is tested against the alternative of cointegration regardless of whether the regressors are i(1) or i(0) as follows: h0: β1 = β2 = β3 = β4 = β5 = β6 = β7 = 0 h1:β1≠β2≠β3≠β4≠β5≠β6≠β7≠ 0 pesaran et al. (2001) provide the two sets of critical values in which lower critical bound assumes that all the variables in the ardl model are i(0), and the upper critical bound assumes i(1). for this purpose, we first carried out the unit root tests to see the degree of integration of the selected variables. if the calculated f-statistics is greater than the appropriate upper bound critical values, the null hypothesis is rejected implying the existence of cointegration between the variables. if such statistics is below the lower bound, the null cannot be rejected, indicating the lack of cointegration. after establishing the evidence of the existence of the cointegration between variables, the lag orders of the variables are chosen by using the appropriate akaike information criteria (aic) or schwarz bayesian criteria (sbc). if cointegration is established, then long run results and short run results can be generated. the short run results include the error correction term that shows how much disequilibrium is eliminated table 3: percentage shares of the total volume of the payment transactions in tunisia (% of the volume of transactions) payment instruments december 2008 (%) december 2018 (%) check payments 68.7 54.5 commercial papers 14.2 13 transfers 12.2 19.6 debits 4 5.7 bank cards payments 0.5 7 electronic payments 0.03 0.08 source: central bank of tunisia mbazia: do payment technology innovations affect currency demand in tunisia? international journal of economics and financial issues | vol 13 • issue 1 • 2023 169 in each short run period. for cointegration to exist, the error correction term is expected to be negative and significant. thus, the error correction version of the ardl model pertaining to the equation (2) can be expressed as: ∆ ∆ ∆ ∆ ∆ mc mc y r a t i t ii n i t ii n i t ii n i ( ) = + + + +−= −= −=∑ ∑ ∑α α α α α 0 11 21 31 4 ttm eftpos checks card t ii n i t ii n i t ii n i −= −= −= + + +∑ ∑ ∑ 1 51 61 7 α α α ∆ ∆ ∆ ss ect ii n t t−= − + +∑ 1 1 λ µ (3) where λ measures the speed of adjustment parameter and ec is the residuals that are obtained from the estimated cointegration model of equation (2). 4. empirical results and discussion we initially tested the order of integration of the variables using the unit root tests: the augmented dickey–fuller (adf) by dickey and fuller (1981) and the phillips–perron (pp) by phillips and perron (1988). in all cases, the two unit root tests have been applied for both levels and their first differences. the computed test statistics for the levels and first differences of the variables are illustrated in table 4. all variables were found to have a unit root at the levels but not in their first differences, i.e. (i(1)). the ardl approach to cointegration, therefore, may be the most appropriate method for this analysis since the variables are i (1). after testing for the order of the integration of the variables, the next step is to perform the ardl bounds test to test the existence of only one long run relationship between the dependent variable and the exogenous variables (pesaran et al., 2001). in this context, two conditions must be fulfilled. first, there should be a longrun relationship among the variables, which is assumed by the f-statistics. second, the error correction model ecm should be significant. the first step and before the estimation of cointegration, the appropriate lag length is required. to this end, we use the schwartz-bayesian criterion to justify lag order of each variable in the system. the maximum lag order is set to 4. after setting up the appropriate lag length, the ardl method is estimated. table 5 presents the results of cointegration of estimating money demand function in tunisia using ardl approach for equation (2) where the dependant variable is the real money holdings defined by currency (banknotes and coins) in circulation outside the banking sector lnmc. panel a shows the diagnostics tests of the short run model. most short run coefficients of the variables under study have significant and reasonable impact on the demand for cash. the coefficient of real income is positive and significant, it has the expected sign as per economic theory. the coefficient of the interest rate being negative and significant shows the currency substitution effect in tunisia in the short run under the study period. importantly, focussing on the issue of new payment instruments in the short run, the coefficients of the number of automatic teller machines and bank cards are positive and increase the demand for cash. however, the coefficient of point-of-sale terminals and cheks, as expected, are negative and reduces the demand for currency. the results of the long-run normalized coefficients are presented in panel b. as shown in table 5, we found that there is a positive and a significant effect of the demand of currency on the income variable in tunisia (1.025). this may reflects the importance of economic activities in influencing the currency demand. the demand for cash is significantly, and positively affected by interest rate. the estimated coefficient on interest rate is around 0,488. this may reflect that a predominant share of cash in circulation is held for transaction rather than a store of value purpose. also, the coefficient of atms is positive and statistically significant (0.15), increasing weakly the needs for currency. this confirms the direction towards the atms to withdraw cash which led to a growing demand for currency to settle payment transactions, particularly those of low-value, or for unexpected defenses. this evidence appears to remain a fairly positive interaction between the number of atms and the demand for cash in tunisia. in this context, findings of such, positive impact of atm terminals on cash demand explained by the increased ease of receiving cash have been further reported in hataiseree and banchuen (2010) and tehranchian et al. (2012). in tunisia, the atm transactions have generally increased in step with atm expansion strategies that encourage benefits of holding bank cards which enhances their use reflecting the attractiveness of cash as a mean of payment. interestingly, we also find a significant and negative influence of eft-pos terminals on currency demand (−0,04). it should be noted, that a rise in the density of eft-pos terminals decreases the cash usage in tunisia reflecting the substitution wave of credit and debit cards payments for cash. this results show that tunisian consumers consider cash usage as an inexpensive instrument to pay, compared to paying with banking cards. this finding partly explains the low usage of electronic payment cards in point-of-sale (pos) because the no availability of these machines everywhere in many areas in tunisia and also for the strong preference for cash payment in the retail stores and other outlets. thus, in long run too, our findings support the results of snellman et al. (2000), drehmann et al. (2002), rinaldi (2011) and tehranchian et al. (2012). the coefficient of bank cards is positive and statistically significative table 4: unit root test results variables adf test statistics pp test statistics levels first difference levels first difference mc −1.426 −4.700*** −1.45122 −4.87052*** y −1.507 −4.648*** −1.21939 −5.12834*** i −1.176 −6.398*** −1.33075 −7.70353*** atm −1.883 −4.073*** −2.18240 −4.56724*** eftpos −1.558 −4.833*** −1.56587 −6.47155*** checks −0.219 −5.111*** −3.27215 −4.97547*** bank cards −1,456 −6.975*** −1.444674 −7.75639*** source: calculated by author. h0 is that the variable has a unit root. *** ** and * denote rejection of the null hypothesis at the 1%, 5% and 10% significance level mbazia: do payment technology innovations affect currency demand in tunisia? international journal of economics and financial issues | vol 13 • issue 1 • 2023170 (0.108) reflecting the frequent use of atm cards to receive cash in tunisia. these results may be explained by the dominance of the atm cards usage than the use of the cards payments in tunisia. in this regards, the electronic transfer of funds is made more by atms, which have been installed more for receiving cash in the banks, than the eft-pos terminals usage. however, the checks payment has a negative sign, although it is not statistically significant. as presented in panel c, the results indicates that the value of the f-statistic, is equal to 4.441, for joint significance of lagged level variables is higher than its critical upperbound at 5% significance level. this implies the existence of cointegration among the currency demand and its determinants. besides, the speed of adjustment is 17.6% per month. the error correction coefficient is negative and significant showing that short-run fluctuations are attributed to the long-run equilibrium values and improve the hypothesis of presence of cointegration. the various diagnostic tests presented in the table shows the robustness of the model since there is no diagnostic problem with the model. the bg-lm test indicates that there is no serial correlation problem. also, there is no heteroscedasticity, no functional form misspecification and the residuals are normally distributed. 5. conclusion and policy implications this study has examined the relationship between cash use and the development of electronic payment methods in tunisia. evidences so far tend to suggest that technological more advanced means of payments has shown a promising development in tunisia, although the pace of the new payment instruments usage have yet to quicken since cash still the more used instrument retail ’s payment. in this study, the ardl approach was used to estimate the short-run and long-run impact of currency demand on non cash payment instrument in tunisia over the period 2010m12-2018m7. apart from standard macroeconomic variables like real income and interest rates, some proxy variables related to methods of electronic transfer, such as atms (automated teller machines), eftpos terminals (electronic funds transfer at the point of sale), electronic bank cards and check, which are also incorporated into the model to analyse this sort of possible interaction of cashnoncash instruments substitution in tunisia. on our evidence, we found that modern payment technologies have little impact on currency usage in tunisia. the results showed that the number of atms and the volume of bank cards transactions tend to increase the demand for currency while both the number of eftpos and the volume of check transactions negatively influence the demand for cash, though neither effect is highly significant. in this context, the electronic tranfer of funds are increasing as the number of atms and pos terminals rises. however, checks still a popular cashless method of transfer for tunisians in volume terms despite it is not statistically significant. furthermore, according to the findings of this study, the demand for cash as a means of payment has been strong in tunisia. therefore, it should be noted in this regards that despite the development of payment systems, cash remains an important means of carrying out transactions. subsequently, as thus confirmed by drehmann et al. (2002), our results confirm that new payment technologies do not pose a threat to the use of cash in tunisia. although the new electronic payment technologies have many advantages, several elements hinder their development in tunisia. indeed, electronic payments raise issues of security and privacy protection and freedoms, as well as hackers who try to penetrate the bank accounts of electronic payment systems and to carry out thefts there by transfers to other accounts from electronic traces to find personal data. in this context, the tunisian government’s digital project held in 2020 aims to develop more the digital finance to enable users to pay for services electronically and to insure the table 5: the impact of noncash payment on currency demand in tunisia using linear ardl method (dependant variable mc) panel a: short‑run coefficient estimates lag order δlnm δlny δi δlnatm δlneftpos δlnchecks δlncards 0 0.03275 (0.07293) −0.04285 (0.02111) 0.09124 (0.1131) −0.38352 (0.0830) −0.12527 (0.06608) 0.29134 (0.1158) 1 0.05408 (0.0834) 0.10331 (0.06258) −0.00208 (0.02166) 0.01853 (0.0064) 0.18792 (0.0972) 2 −0.0295 (0.0845) 0.09925 (0.06425) −0.03882 (0.02109) 0.07602 (0.1267) 3 0.00547 (0.0953) 0.06717 (0.06308) −0.29134 (0.11587) 4 0.19983 (0.0750) panel b: long‑run coefficient estimates lny li lnatm lneftpos lnchecks lncards c 1.0252 (0.00) 0.48830 (0.1249) 0.15226 (0.0989) −0.04584 (0.0507) −0.49617 (0.4009) 0.10831 (0.0084) 15.9858 (0.000) panel c: diagnostic statistics f ecm r2 bg lm bpg reset jb test 4.441 −0.176 (0.06) 0.99 3.774 (0.15) 17.696 (0.65) 1.383 (0.33) 2.399 (0.12) source: calculated by author. selected model: ardl (4,3,3,2,1,0,0), values in parentheses are probability values; ln stands for natural logarithm; δ stands for the first difference operator. f is the bounds test, the lower and upper critical bounds values of the f statisticat the 5% level of significance are 2.431and 3.518, respectively. critical values are obtained from narayan (2005) (unrestricted intercept and no trend). bg–lm is the breusch godfrey serial correlation lagrange multiplier test; reset is ramsey’s regression specification error test; jb is the jarque–berra test; and bpg is the breusch–pagan–godfrey test for heteroscedasticity mbazia: do payment technology innovations affect currency demand in tunisia? international journal of economics and financial issues | vol 13 • issue 1 • 2023 171 security of the payment systems. the strongest advantages of cash over other means of payment, cashless or electronic, is that it is safe as a medium of exchange, cheaper, safer and more anonymous. our findings suggest that currency will not be completly replaced by more advanced electronic transfers and e-moneys of assorted varieties in tunisia due to infrastructure of tunisian’s economy and the payment consumers’s choices which prefers frequently cash usage. this finding may be explained by the expansion of the size and the forms of informal economy (grey or parallel economy) that are ever-growing in tunisia, it needs the anonymity for the holder or the user who is engaged in activities in this type of markets to satisfy the ordinary consumption expenditure transaction needs. so cash still the most anonymous means of payment demanded in this type of markets which tunisian’s consumer can never won’t give up on him. references abid, m., ben salha, o. (2013), the informal economy in tunisia: measurement and linkage with the formal economy. international journal of economics and business research, 6(2), 194-209. amromin, g., chakravorti, s. (2007), debit card and cash usage: a cross-country analysis. illinois: federal reserve bank of chicago’s working paper series 04. anderson-reid, k. (2008), estimating the impact of the alternative means of payment on currency demand in jamaica, bank of jamaica. available from: http://boj.org.jm/uploads/pdf/papers_pamphlets/ papers_pamphlets_estimating_the_impact_of_the_alternative_ means_of_payment_on_currency_demand_in_jamaica.pdf dickey, d.a., fuller, w.a. (1981), likelihood ratio statistics for autoregressive time series with a unit root. econometrica, 49, 1057-1072. drehmann, m., goodhart, c., krueger, m. (2002), the challenges facing currency usage: will the traditional transaction medium be able to resist competition from the new technologies? economic policy, 34, 193-227. engle, r.f., granger, c.w.j. (1987), cointegration and error-correction: representation, estimation, and testing. econometrica, 55, 251-276. hataiseree, r., banchuen, w. (2010), the effects of e-payment instruments on cash usage: thailand’s recent evidence and policy implications, working paper 2010-01, payment systems department. thailand: thammasat university. johansen, s. (1992), testing weak exogeneity and the order of cointegration in uk money demand data. journal of policy modeling, 14(3), 313-334. johansen, s., juselius, k. (1990), maximum likelihood estimation and inference on co-integration with application to the demand for money. oxford bulletin of economics and statistics, 52, 169-210. narayan, p.k. (2005), the saving and investment nexus in china: evidence from cointegration tests. applied economics, 37, 19791990. pesaran, m.h., pesaran, b. (1997), working with microfit 4.0: interactive econometric analysis; [windows version]. oxford: oxford university press. pesaran, m.h., shin, y., smith, r.j. (2001), bounds testing approaches to the analysis of level relationships. journal of applied econometrics, 16, 289-326. phillips, p.c., perron, p. (1988), testing for a unit root in time series regression. biometrika, 75(2), 335-346. reddy, k., raj, d. (2017), impact of credit cards and debit cards on currency demand and seigniorage: evidence from india. academy of accounting and financial studies journal, 21(3), 1-15. rinaldi, l. (2001), payment cards and money demand in belgium. center for economic studies, discussion paper. belgium: katholieke universiteit leuven. siddiki, j.u. (2000), demand for money in bangladesh: a cointegration analysis. applied economics, 32(15), 1977-1984. snellman, j, vesala, j., humphery d. (2000), substitution of non cash payment instrument for cash in europe. helsinki: bank of finland discussion paper. p.39-1. stix, h. (2004), how do debit cards affect cash demand? survey data evidence. empirica, 31, 93-115. tehranchian, a.m., samimi, a.j, yazdandoust, a. (2012), the impact of modern technology on demand for money in iran, iranian economic review, 16, 1-16 yilmazkuday, h. (2007), the effects of credit and debit cards on the currency demand. vanderbilt: vanderbilt university paper. http://boj.org.jm/uploads/pdf/papers_pamphlets/papers_pamphlets_estimating_the_impact_of_the_alternative_means_of_payment_on_currency_demand_in_jamaica.pdf http://boj.org.jm/uploads/pdf/papers_pamphlets/papers_pamphlets_estimating_the_impact_of_the_alternative_means_of_payment_on_currency_demand_in_jamaica.pdf http://boj.org.jm/uploads/pdf/papers_pamphlets/papers_pamphlets_estimating_the_impact_of_the_alternative_means_of_payment_on_currency_demand_in_jamaica.pdf tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 65-72. international journal of economics and financial issues | vol 13 • issue 1 • 2023 65 the realities and expectations of calculating government service costs: an analysis of jordanian hospitals obiedah mohammad alqudah*, safrul izani mohd salleh department of accounting, faculty of business and management, universiti sultan zainal abidin terengganu, malaysia, *email: obaidah2@hotmail.com received: 30 september 2022 accepted: 16 december 2022 doi: https://doi.org/10.32479/ijefi.13774 abstract the goal of this study is to look at how government service expenses are calculated and analysed in jordanian hospitals to direct health spending in the hospitals of the ministry of health of jordan for 2021. abc systems encourage hospitals to use, improve, and evolve in order to save government spending. the theoretical analysis’s most significant conclusions were that the process of computing service costs was wrong and did not rely on the cost accounting system of activities or others. furthermore, the calculation technique has resulted in a significant disparity in the cost of calculating each service from one hospital to the next, proving the inadequacies of the calculation approach. the study indicates that the health activity-based costing system (abc) be activated to monitor expenditures, especially medical and healthcare disposables, in order to decrease waste costs; that pay-outs on the system be linked to high involvement files; and that an inventory is conducted at the close of every year to guarantee that the stock fits actual spending. keywords: government service costs, realities, expectations, hospitals, jordan jel classifications:  h38, m41 1. introduction jordan’s government has moved in recent years to try to limit public spending, particularly spending on education and health services. the service sector provides a considerable portion of jordan’s public sector spending (al omari and khersiat, 2020). there is little research and statistics available on these services, their costs, and how to try to decrease them (hammad et al., 2022; alqudah et al., 2021; alsharari, 2018). to assist jordan’s government in its attempts to reduce government spending on services (al-fawwaz, 2016). the king abdullah ii bin al hussein center for excellence has introduced a number of institutional excellence categories focused on service efficiency and financial efficiency. one of these categories is the outstanding government service award, which has been created independently in 2019 and includes service efficiency and financial efficiency standards. the standards emphasize the leadership team’s involvement in service development planning, including service delivery channels, digital transformation, defining services, establishing service delivery procedures, and enhancing them to lower the expenses of highercost operations (kc, 2022). the jordanian ministry of health has striven to improve the efficiency of government services in accordance with jordanian government instructions. the king abdullah ii center for excellence examined all jordanian government institutions’ services and gave reports on the degree of progress in services for each government institution in light of the continual competitive criteria imposed on all government institutions. in addition to satisfying the jordanian government’s present and vital requirements relating to the large growth in public debt caused by excessive public spending and low income, a huge increase in the this journal is licensed under a creative commons attribution 4.0 international license alqudah and salleh: the realities and expectations of calculating government service costs: an analysis of jordanian hospitals international journal of economics and financial issues | vol 13 • issue 1 • 202366 number of patients attending government hospitals, which totals around 28 (kc, 2022). in 2021, the cost of these hospitals was over 400 million jordanian dinars (575 million usd), putting a great strain on the resources available for health services in these facilities (moj, 2022). however, the jordanian ministry of health and a research team carried it out. analytical research was created to illustrate the overall expenditures on hospitals, comprehensive components of these expenses, the cost of admission service for each hospital, as well as the cost of patient review for emergencies and clinics for all moh hospitals. an annual report on the study’s findings was released, with the goal of shedding light on direct expenditure in hospitals associated with the ministry of health for the year 2021 in order to provide certain indicators and suggestions. this will be the foundation for deciding the level of future government expenditure on these hospitals, as well as analyzing disparities in prices for the same health services from one hospital to another in order to rectify these inequalities. consequently, the hospital provides a comprehensive range of services to meet the requirements of its patients. this increases demand for its resources, resulting in an increase in price. the issue with the research is that it does not focus on estimating the cost of delivering these treatments, i.e., it does not determine the cost of health care (al-halabi, and shaqqour, 2018; bataineh, 2018; huang, 2018; mahal, and hossain, 2015). the issue also resides in the accurate computation of healthcare expenses and their involvement in resolving the substantial disparities in the cost of the same service from one hospital to the next. failure to assess the cost of health services in jordanian hospitals in an acceptable manner, allowing decision makers to use cost data to improve health care efficiency while lowering prices. therefore, the purpose of this study is to shed light on the significance of health services and to identify the method of realistically calculating the costs of health services in jordanian hospitals, as well as the significance of calculating the cost of health services by using the activity cost accounting system. the technique of this study is a critical and analytical analysis of a jordanian ministry of health economic report for the year 2021, which reveals the overall expenses and costs of health services delivered in 28 government hospitals. this study examines the significance of quantifying the costs of government services. this study aims to shed light on jordanian government hospitals’ health services and the volume of money spent on them, as well as to identify the cost accounting system of activities, its requirements, and the difference between them and the calculation mechanism used in the ministry of health of jordan’s report. it is necessary to draw stakeholders’ attention to the necessity of correctly assessing the price of health services and their involvement in resolving the substantial disparities in the cost of the same service from one hospital to another. furthermore, the significance of this study stems from the significance of the problem addressed, as it emphasizes the importance of accurately determining and calculating the cost of health services in jordanian hospitals and enabling decision-makers to use cost data to improve the efficiency of health services while lowering their costs. the remainder of this paper is organized as follows: section 2 examines the literature; section 3 presents research data, population, model, and methodologies; section 4 discusses the findings, and section 5 concludes the study. 2. literature review the section discusses the numerous empirical and theoretical research that has been conducted on the reality and expectations of determining government service costs. furthermore, it gives a detailed empirical analysis, which is an important stage in any type of study, both in scientific and social research. hospital activity is distinguished by certain characteristics that have a major influence on estimating the cost of health services. furthermore, assessing the cost of the impending health service using suitable cost data serves both the hospital administration and its clients by precisely determining the cost of the upcoming health service. the usage of cost systems also results in more precise information about the various units of exchange being provided (vassall et al., 2017). accounting for resource consumption helps to reduce health-care costs by regulating cost aspects and making managerial choices. the findings of a study conducted on ten iraqi hospitals emphasized the importance of accounting for resource consumption in determining and reducing the cost of health services as well as determining the actual full capacity available, which is reflected in cost reduction and enables managers to make sound decisions (shaswar and mustafa, 2022). the purpose of cost calculation in non-commercial public organizations is to offer information to diverse consumers so that they may make decisions to increase the efficiency of government. specifically, public companies that carry out manufacturing operations. second, to the bodies in charge of organizing and supervising budgetary and management procedures. finally, the highest government officials, on the other hand, the end beneficiary population of public production was able to learn about the costs of the specified items as well as the actions taken to lower them without compromising the quality of goods and services produced (hasyim and jabid, 2019). tran and tran (2022) used a quantitative method and a logistic regression model to investigate several aspects affecting the adoption of an activity-based cost accounting system for the efficiency of government in a transitional state. it comprised a sample of 71 vietnam-listed generic pharmaceutical businesses in 2017. besides, the use of an activity-based cost accounting system is critical in assessing elements such as indirect costs incurred, setting pricing, and diversifying various areas of the organization. it helps to analyze how it influences the decisionmaking process in a certain firm. among other things, it includes some useful data that may be utilized for public decision-making. therefore, it has a substantial influence on administrative practice and public policy management. time-driven activity-based costing (tdabc) is one of the new techniques. appropriate information on the activities required to give a good service and accurate information that may properly estimate the cost of services supplied to patients and their alqudah and salleh: the realities and expectations of calculating government service costs: an analysis of jordanian hospitals international journal of economics and financial issues | vol 13 • issue 1 • 2023 67 usage in hospitals can result in a more accurate cost estimate furthermore, it assists hospital administrators in making suitable decisions on capacity use, capital budgeting, cost control, and so on (ostadi et al., 2019). consequently, the abc system has grown into a key tool for enhancing competitiveness in corporate organizations as attempts are made to adopt new techniques of distributing overhead charges when calculating the costs of goods or other cost items. the abc system is not a novel accounting idea. accountants are well versed in the abc method (bozorgmehriana et al, 2012). many hospitals have successfully used the abc strategy to modify their price structure or better manage their resources. the benefits of a well-structured abc system extend beyond increased cost control. because the abc strategy focuses largely on the operations required to fulfill company goals, it encourages managers to boost activity organization and eliminate or minimize activities that do not give value (nielsen, 2022). abc distribution/ management distribution (mahal, and hossain, 2015). the abc system data has been utilized for product pricing, procurement, development of new products and profitability analysis analysis (lu et al, 2017). product combination selection (baki and cheng, 2021; homburg et al, 2018). analysis of customer profitability (bataineh, 2018). the cost of high-quality analysis (tran and tran, 2022). judgment on shared goods (mowen et al, 2022). environmental administration (viranda et al., 2020). management of projects (kusuma and bima, 2022), software development (lee et al., 2022), and so on. demdoum et al. (2021) investigated the usage of the abc accounting system and its applicability in the environmental accounting approach, which is geared toward the green economy, namely in the areas of digital strategy, governance, and organizational restructuring. similarly, danish and antonides (2013) found a strong direct link between the abc accounting system and the green economy and accountability, which is cause for worry. the researchers did remark, however, that certain critical criteria are difficult and impossible to achieve, limiting their usefulness and maybe restricting some degree of efficiency in hospital management of public services and patients (loayza and pennings, 2020; igalla et al., 2020). tran and tran (2022) to examine the influences on government efficiency of an activity-based costing accounting information system in a transition phase used a comparative study and a sample of 71 publicly traded pharmaceutical companies in vietnam in 2017. according to tran and tran (2022), the application of an abc is significant in determining factors such as indirect costs incurred, price fixation, and diversification of various aspects in the firm, as well as whether they have a positive impact on the decisionmaking of the given firm since they do provide some relevant information that can be used for overall decision-making, among other necessary factors. made et al. (2020) investigated the variables that influence the adoption of an abc in government training and educational institutions in south africa by comparing methods and data from diverse institutions. vetchagool et al. (2021) evaluated the impact of the abc accounting system on the overall performance of the business in providing services based on the degree of quality management and excellence in firms that employed bac and non-abc accounting systems. according to sedevich-fonts (2018), iso 9000 and the activity-based costing accounting technique have certain advantages. they said that the same has some impact on the overall performance of government and commercial companies in terms of service delivery, which is an important factor, as well as having some favorable design for overall performance improvement. 3. study methodology the section focuses on the different methodological techniques used by the research in examining the general calculation of government service costs and the analysis applied to direct health spending in the hospitals of the ministry of health of jordan for 2021. furthermore, the methodology of theoretical analysis serves as an overview of what the research aim is to conduct in the whole study, which is also an important component (sybing, 2022). among the important aspects considered by the study were research design, sample and sampling procedure, data methodologies, and ethical considerations, among others. the study employed quantitative data acquired by a report analysis; hence, it used a theoretical analysis research design. the primary goal of doing a quantitative study was to assess the significance of the link that exists between calculating government service expenses and performing an analysis of direct health spending in the hospitals of the ministry of health of jordan for 2021. furthermore, the study employed the general positivist research philosophy in establishing the cause-and-effect link and improving the establishment of the supplied objectivity, dependability, and general results used for decision-making and general forecasting, among other critical elements (lehtonen, 2021). the sampling strategy is an important aspect of the whole investigation. the study used the purposive sampling technique, which is a non-probabilistic sampling technique that allows the researcher to rely on objective factors and general conclusions when deciding which members of the population to consider for participation in the survey to avoid some biased and spurious results that are insignificant (kulkarni, 2020). the hospitals selected for the survey were chosen to have some specific results that are significant towards the general enhancement of the key factors and the general ability to decide on the key factors to be undertaken for the general achievement of the objective results and to be able to have some significant results in general. this study’s population was drawn from jordan’s government hospitals. as a result, 28 jordanian hospital surveys were distributed because of this. in this study, a convenient sample strategy was adopted, which refers to the gathering of information from the annual report 2021 that is readily available for submission (moj, 2022). the poll used data from the annual report of jordan’s government hospitals for 2021 to assess the cost of government services as a general component. the primary data used allowed for some of the important outcomes as well as definitive and substantial conclusions that are useful in policy and decision-making in general. alqudah and salleh: the realities and expectations of calculating government service costs: an analysis of jordanian hospitals international journal of economics and financial issues | vol 13 • issue 1 • 202368 4. analysis, findings, and discussion the purpose of this study is to provide light on direct health spending at hospitals linked with the ministry of health in 2021. data on hospital expenditures and the number of employees per job were gathered individually for each hospital, and these expenses were detailed according to the accounts map categorization established by the general budget department. analyze the data in tables prepared to meet the research’s objectives and develop some indicators and suggestions that will serve as the foundation for assessing the magnitude of hospital costs on an annual basis and using the approach used in this study. during the year 2021, the volume of spending on secondary healthcare services at hospitals linked with the ministry of health accounted for approximately 71% of the ministry’s total operating general expenditure, both current and capital. it is obvious that the expenses having the biggest influence are personnel salaries, pharmaceuticals, and medical consumables, which accounted for 53.2% and 24.5% of total hospital expenditures, respectively. this necessitates analytical research to determine ways to regulate and eliminate these expenditures, as well as waste. furthermore, the number of employees in hospitals affiliated with the ministry of health accounted for approximately 56% of the total employees in the ministry, with the majority concentrated in the positions of (nursing and midwifery) and (administrative and support functions), accounting for 45% and 27%, respectively. according to table 1, the volume of very direct spending at hospitals affiliated with the ministry of health’s budget for 2021 was about 212.6 million dinars, or 71% of the ministry’s total operating general expenditure, both current and capital. it should be mentioned that prince hamza hospital was left out because its budget is self-sufficient. for 2021, the yearly cost of the remuneration package for staff in hospitals associated with the ministry of health was about 21.2 million dinars, or 53% of the overall cost of direct hospital spending. it should be mentioned that the overall number of employees at these institutions was around 17 thousand, accounting for 52% of the total number of employees in the ministry of health. according to table 1 and figure 1, ruwaish hospital in mafraq governorate spent the most on this category, accounting for almost 68% of total hospital costs in 2021. while al-bashir hospital had the lowest percentage of cost, accounting for 42% of overall hospital expenses, it should be mentioned that the overall expenditure on workers’ compensation at the level of all hospitals associated with the ministry of health budget amounted to 53% of total expenditure. the value of hospitals’ demands for medications and medical consumables in 2021 was around 97.9 million dinars, or 24.5% of total hospital direct spending. medicines (67.6 million dinars) and medical consumables (30.3) million dinars according to table 1, al bashir hospital had the greatest amount of spending in this table 1: spending in government hospitals and allocated allocations within the ministry of health budget for 2021 spending in government hospitals allocated within the ministry of health budget for 2021 # the hospital name total expenses employee compensation ratio pharmaceuticals and medical supplies ratio average emergencies cost average entry cost 1 princess basma hospital 29,269,713 52.6% 30.8% 42 1439 2 princess raya hospital 6,784,798 63.3% 15.3% 36 1016 3 princess rahma hospital 9,751,573 55.3% 28.2% 60 643 4 princess badia hospital 5,932,380 62.8% 10.6% 89 476 5 ramtha government hospital 9,441,626 50.2% 23.9% 35 1225 6 yarmouk government hospital 7,112,239 62.1% 15.3% 42 1392 7 moaz bin jabal hospital 5,021,957 66.0% 13.0% 36 1288 8 abu obeida hospital 5,054,328 61.5% 14.4% 28 1350 9 jerash state hospital 11,195,857 58.4% 15.3% 42 961 10 faith hospital 8,501,790 64.3% 15.3% 44 1375 11 al hussein hospital 26,858,262 51.5% 19.5% 74 1364 12 princess iman hospital 5,525,318 62.4% 18.6% 46 1700 13 prince hussein hospital 10,141,301 58.2% 14.8% 48 1262 14 southern barn hospital 6,172,105 55.6% 19.0% 59 1449 15 zarqa government hospital 30,120,495 49.9% 23.6% 51 765 16 prince faisal hospital 12,741,212 58.1% 20.2% 36 838 17 al nadeem hospital 9,510,539 59.9% 17.0% 45 830 18 princess salma hospital 5,031,801 60.3% 12.6% 71 1434 19 mafraq hospital 8,248,987 56.9% 21.1% 65 1788 20 ruwaished hospital 2,270,088 67.9% 9.1% 46 3343 21 northern badia hospital 7,735,049 63.4% 10.4% 76 1892 22 women's and children's hospital mafraq 5,462,878 62.0% 9.9% 110 748 23 ma'an hospital 8,930,265 63.2% 14.9% 33 801 24 queen rania al abdullah hospital 6,834,991 60.5% 18.1% 80 1420 25 karak hospital 20,195,440 62.0% 17.5% 130 1126 26 gore safi hospital 6,319,120 62.6% 13.3% 60 1292 27 al bashir hospital 107,215,758 41.5% 39.3% 90 1172 28 jamil al-tautnji hospital 12,176,480 63.3% 17.8% 56 709 total 389556350 59.1% 17.8% 58.8 1253.5 alqudah and salleh: the realities and expectations of calculating government service costs: an analysis of jordanian hospitals international journal of economics and financial issues | vol 13 • issue 1 • 2023 69 category, accounting for almost 39% of overall hospital expenses in 2021. the women’s and children’s hospitals and mafraq had the lowest percentage of spending, accounting for 10% of overall hospital expenses. it should be mentioned that at the level of all hospitals associated with the ministry of health budget, total expenditure on medications and medical consumables stood at 25% of total expenditure. it should also be highlighted that the costs of patient admission and evaluation at al bashir hospital are much greater. this is because of the conditions surrounding the covid-19 epidemic and the protocols for using the hospital to accept covid-19 injuries. as a result, the number of emergency visitors and clinics decreased, as did the admission of regular patients who were not infected with covid-19. the ratio of the remuneration package for personnel in the governorate’s hospitals to the overall cost of direct expenditure in hospitals has risen to 59.2% on average. there has been an imbalance in employees’ beds. princess basma hospital had 4.2 employees per bed, whereas princess rahma hospital had 2.8 employees per bed. other expenditures are deducted from the number of employees. the cost of admission per patient at princess badia hospital was around 476 jd, making it the lowest cost of admission per patient at the ministry’s facilities. while the average cost of admission per patient in irbid governorate hospitals was (1443) dinars. the cost of evaluating patients in emergency departments has decreased, with jd (28) at abu obeida hospital having the lowest cost of reviewing emergency departments and clinics/patients. while the average cost of examining these departments in the irbid hospitals was around 46 dinars. the remuneration package for personnel in the governorate’s hospitals was 62.3% of the total cost of direct hospital spending on average. there has been an imbalance of employees to beds. gour al-safi hospital had a staff/bed ratio of 5.1, whereas karak hospital had a staff/bed ratio of 3.0. in karak hospitals, the average cost of patient admission is roughly 1209 dinars per admission. admission per patient costs around (1,262) dinars at karak hospital and (1292) dinars at ghor al-safi hospital. furthermore, the cost of patients’ visits to emergency departments and clinics at karak hospital was 130 dinars per patient, compared to 60 dinars in ghor al-safi hospital, and the highest cost of patients’ visits to emergency departments in jordan, as shown in figure 2. the economic report produced by jordan’s ministry of health, which was compiled by a committee appointed to determine and calculate the expenses of health services supplied by jordan’s ministry of health, has been evaluated. the overall costs, their particular components, and the technique for determining the average cost of services in general were analyzed, and the most notable results were identified. the report’s most important findings in the process of calculating the costs of services were incorrect and did not rely on the cost accounting system of activities or others. furthermore, the calculation system has resulted in a considerable discrepancy in the cost of calculating each service from one hospital to the next, confirming the calculation method’s inadequacy. the calculation technique does not assist the ministry’s services development team or the operations improvement team in identifying highercost centers and high-cost activities in order to enhance their delivery processes, which is the purpose of assessing service costs. consequently, the existing calculating process does not allow decision-makers to make reasonable decisions on healthcare pricing, whether to establish the amount of the sector’s expenditures or to submit them to the public or for the sake of outsourcing health-care services to the private sector. the availability of a group of essential discussions that, through their work, may establish the sound fundamental rules that allow the team to compute the costs of services, particularly the cost accounting department, to do their job with great precision. as a result, a good accounting system is constructed using best practices and is founded on accepted accounting principles and international accounting standards (ab-bader, 2021; aljabr, 2020; okaily, 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% princess basma hospital princess raya hospital princess rahma hospital princess badia hospital ramtha government hospital yarmouk government hospital moaz bin jabal hospital abu obeida hospital jerash state hospital faith hospital al hussein hospital princess iman hospital prince hussein hospital southern barn hospital zarqa government hospital prince faisal hospital al nadeem hospital princess salma hospital mafraq hospital ruwaished hospital northern badia hospital women's and children's hospital mafraq ma'an hospital queen rania al abdullah hospital karak hospital gore safi hospital al bashir hospital jamil al-tautnji hospital figure 1: employee compensation ratio for all jordan’s government hospitals alqudah and salleh: the realities and expectations of calculating government service costs: an analysis of jordanian hospitals international journal of economics and financial issues | vol 13 • issue 1 • 202370 2021). to ensure the availability of an accurate and unambiguous classification of the accounts tree (accounts directory), highlighting all cost centers (accounts directory, cost centers) (asfahani, 2021). a clear automated process system that identifies the major and supporting processes, details them, identifies activities and tasks, and connects them all to the accounting system, specifically each process and its elements with the cost center directly related to it (operations manual) (attanayake and aktan, 2015). a list of the government services supplied by the body in question (ministry, department, or institution). so that these services have a sound structure and are classified based on sound principles, such as the services classification guide or others, to ensure the grouping of each similar category or group of sub-services within one main service and then determine the processes for providing each service based on the approved operations guide (services guide) (cosgrove and loucks, 2015). members of the cost accounting department, members of other accounting departments, members of the operations department, members of the services department, members of the information technology department, and others as needed, comprise a qualified human cadre capable of performing the calculation process (human resources) (crouch, jacobs, and speight, 2021). finally, consider the coherence and clarity of the link between the regulations and the preceding things. so that all team members are usually aware of the principles of services, calculating their charges and the calculation process needs (haroun, 2015). 5. conclusion according to jordan’s planning commission projection for 2021, 2.7 million people, or 24% of the overall population, are poor, according to the report of the minister of planning last june. making research into the complexities of the cost of public healthcare service providers vital and relevant. currently, the majority of jordan’s public hospitals employ traditional costing methods, which frequently produce erroneous and misleading cost information. the current costing method is also incapable of establishing a strong management control model in a hospital setting since it is unable to answer a few critical management issues that necessitate cost analysis at the micro level of the organization. as a result, in this paper, we propose that the jordanian ministry of health establish a computerized system that calculates the actual costs of each hospital and health center separately and provides a database through which stakeholders can study and analyze the data systematically in order to improve the level of health services provided to citizens. this will allow the jordanian ministry of health to select a budget for each hospital separately from its central budget in the future. improving jordan’s ministry of health is standing among donor nations in order to acquire future grants and loans. furthermore, activate the health activitybased costing system (abc) to control expenses, particularly medicine and medical consumables, in order to reduce waste; link disbursements on the system with commitment documents; and conduct an inventory at the end of each year to ensure that the inventory matches actual spending. the investigation of the barriers that hinder the incorporation of the expense of healthrelated activities into all hospitals and health centers of all types. conducting economic feasibility studies prior to the development of any new hospital, as well as working with the royal jordanian medical services, in order to provide integrated services at the lowest feasible cost and assure access to a well-distributed network of hospital locations. furthermore, agreements established with universities are examined on a yearly basis in order to improve hospital medical services. furthermore, determining the basis and criteria for the disbursement of financial dues to doctors in a way that leads to the best use of their expertise; reviewing the granting of overtime allowance to doctors and pharmacists who are appointed beginning in 2023. furthermore, we should continue to make efforts to guarantee that all people have access to health insurance, taking into consideration the payment of the required contribution as a proportion of the treatment value, and enhance the quality of use of health care expenses and the method of access to them. 0 20 40 60 80 100 120 140 princess basma hospital princess raya hospital princess rahma hospital princess badia hospital ramtha government hospital yarmouk government hospital moaz bin jabal hospital abu obeida hospital jerash state hospital faith hospital al hussein hospital princess iman hospital prince hussein hospital southern barn hospital zarqa government hospital prince faisal hospital al nadeem hospital princess salma hospital mafraq hospital ruwaished hospital northern badia hospital women's and children's hospital mafraq ma'an hospital queen rania al abdullah hospital karak hospital gore safi hospital al bashir hospital jamil al-tautnji hospital figure 2: average emergencies cost for all jordan’s government hospitals alqudah and salleh: the realities and expectations of calculating government service costs: an analysis of jordanian hospitals international journal of economics and financial issues | vol 13 • issue 1 • 2023 71 adopting a defined approach within the ministry of health’s strategic plan to distribute health and administrative cadres to hospitals based on the real needs of the institution leads to improved medical service quality, which leads to the activation and rationalization of operational expenditures. the ministry should transfer as many medical and health cadres as possible from administrative positions in the jordanian ministry of health and its directorates to work in hospitals, strengthen their cadres, and benefit from their expertise, which will reduce the high cost of workers’ compensation and stop appointments except for urgent and necessary needs, thus lowering total costs. likewise, performing additional research and conducting studies on the issue of health and care economics would conducting economic analyses on the cost of health-care services offered to jordanians. acknowledgements the authors wish to thank zeyad safi, eman massad, and the participants for preparing the report on direct health expenditure in hospitals affiliated with the ministry of health in jordan for 2021. therefore, the report on analysis versions of this paper was used. references abu-bader, s.h. 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(2020), a mixed activity-based costing and resource constraint optimal decision model for iot-oriented intelligent building management system portfolios. sustainable cities and society, 60, 102142. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 889-896. international journal of economics and financial issues | vol 5 • issue 4 • 2015 889 liberalization of financial services and performance of commercial banks in algeria: an empirical study (1998 – 2012) rachida benahmed-daho1, abdelnacer bouteldja1, ali bendob2* 1faculty of economic sciences, management, and commercial sciences, university of tlemcenm, tlemcen 13000, algeria, 2department of economic science, institute of economic sciences, management, and commercial sciences, university of ain temouchent, bp 284, 46000, algeria. *e-mail: bendobali4@gmail.com abstract the banking system is facing deep and varied challenges due to financial openness and bank liberalization (lib) which both call for the removal of all restrictions and barriers on banking activities, as well as for a competition between foreign and local banks, which has increased in recent years. the aim of this paper is to investigate the impact of financial lib on banking efficiency in algeria. using three varieties of a panel data regression model on a sample of 10 algerian commercial banks (public and private) for the period during 1998-2012. our results show a negative and significant impact of financial lib on algerian banking performance during the period studied. keywords: financial liberalization, performance, commercial banks, algerian, panel data jel classifications: g21, g23, l25 1. introduction recently, the global financial sector has gone through a number of significant radical transformations which emerged from the financial globalization. these transformations called for the need to stay updated and adequately adapted to new situations, because they have significant effects on the financial and banking sectors, particularly on the liberalization (lib) of trade in financial and banking services, technological developments, implementation of economic reform programs, banking conglomerates, as well as on the acute competitive pressures between actors in the banking market. this would lead to a variety of high quality and low cost banking services. mc kinnon (1973) and shaw (1973) noted that financial repressions have repercussions that push the government to intervene energetically in the economic and financial sectors. this intervention appears in the legislation and laws related to banking which aim at limiting the freedom of the banking system. according to kinget and levine (1993), the financial repression leads to the reduction or scaling of the financial services offered by the financial system to savers, contractors, producers, beside new restrictions on economic activities and slower growth rates gheris (2005). however, chatelain and amable (1995) concluded that the financial repression is a policy that aims to keep the interest rates below the balance levels specified by the supply and demand law boujelbene et chtioui (2006). due to the negative results arising from this policy, many economists in developing countries advised to follow are form policy based on an increasingly limited intervention of the government in the financial activity, as well as freeing this activity from all restrictions imposed on it, i.e., following a financial liberalization (lib) policy in order to stimulate savings and improve the distribution of loans in the economy and raise the pace of economic growth. mc kinnon (1973) suggested to some countries to liberalize their financial systems in order to get rid of the negative effects generated by the financial repression which is seen in the scarcity of the financial resources required for investment. this is mainly due to the weak interest rates that discourage savings as well as to the ineffectiveness of the financial intermediation as a result of the massive intervention of the government, the poor distribution benahmed-daho, et al.: liberalization of financial services and performance of commercial banks in algeria: an empirical study (1998 – 2012) international journal of economics and financial issues | vol 5 • issue 4 • 2015890 of the financial savings in the economy (loans), on account of the policy of directing loans by the monetary authorities. all these facts led to weak growth rates in these countries. several studies have contributed to the promotion of the policy of financial lib bouzid (2003). in his work, kapur (1976) supported the view of mc kinnon and shaw, but showed a preference for raising the nominal interest rates on deposits as a solution to reduce the inflation rate, rather than cutting the money supply. he considers that raising the nominal interest rate al lows stimulating the savings and, at the same time, reducing the inflation rate. as for vogel and buser (1976), they both support the idea of complementary currency and capital; they are in favor of finished and semi-finished goods which are considered a refuge against inflation venet (1994). the pair (return/risk) is a new dimension in financial lib. galbis (1977) added a new point to the financial lib model. indeed, he considered that the economy is divided into two sectors: a traditional sector based on self-financing for the completion of projects, and a modern sector that depends on self-financing in addition to bank loans to realize new projects. furthermore, he considers that increasing the interest rate on deposits allows for increased productivity, and helps transferring savings from the traditional sector to the modern sector. fry (1977) studied the relationship between the real interest rate and savings, in a number of developing countries. he found that there is a strong positive relationship between these two variables (ary, 2002). mathieson (1979) expressed the necessity to reduce the money supply during the application of the financial lib policy. he justifies that by the fact that high nominal interest rates lead to increased funding from abroad under an open economy, and the high borrowing costs from the inside pushes the local institutions to borrow from countries where these costs are lower venet (1993). such a situation allows for significant financial flows into the economy, causing high inflation rate. likewise, moubini and sala-i-martin in 1992 showed the existence of a strong and positive relationship between the real interest rate and the savings rate (ary, 2002). similarly, both boujelbene and et chtioui (2006) supported the firm and positive relationship between the real interest rate and savings rate in nine african countries. finally, arestis and demetriades (1999) investigated the impact of financial lib on the gross domestic product (gdp) in south korea and concluded that a strong positive relationship exists between these two factors donadieu (2004). one of the objectives of the financial lib program is to make commercial banks more efficient by creating a flexible banking and financial sector, capable to compete. in such a program, the banks must have more control over the use of their own resources; they ought to determine the financial services required by the public. these services are established on the basis of efficiency and competitive prices. therefore, by the late eighties and early nineties, algeria and many other developing countries started adopting a package of reforms to keep pace with the global trend. so, the algerian economy witnessed a transitional phase from a socialist planned economy to a liberal economy based on the foundations and principles of the market economy. this occurred after the 1986 crisis, which clearly showed he fragility of the economic structure in algeria. this situation required, at first, to carry out some selfreforms without resorting to foreign parties, such as the international monetary institutions for example. however, self-reliance may result in worse monetary, economic and even social situations. considering the sensitive position the banking system occupies in the economic life, every state has to take care of its own system which has a significant impact on the development of the economy. the algerian banking system, just like other banking systems, has seen several reforms which began in 1971. their objectives were to conduct and monitor the financial operations of public institutions (banks), and impose strict control on cash flows. however, a radical reform was introduced on the banking function on august 19, 1986 (act 86-12), to establish the general principles of public banks and unify the legal framework which runs the banking institutions. act 01-88, issued on december 1, 1988, aimed at guiding the public institutions; the banks became more independent in managing their financial resources and granting loans. therefore, banks turned into economic institutions whose objective is to make profit and profitability. other financial reforms came later. the most important one was issued on february 14, 1990 (act 90-10), and it represented the turning point in the algerian banking system; it included new ideas related to the performance of banks, i.e., liberalizing banks from the restrictions imposed on them, limiting the monetary authority to one party which is the central bank and the council of money and credit, all owing the establishment of private banks, and encouraging the entry of foreign banks. the banking system is facing deep and varied challenges due to financial openness and bank lib which both call for the removal of all restrictions and barriers on banking activities, as well as for a competition between foreign and local banks, which has increased in recent years. so the banking variables made it extremely necessary for the algerian banking administration to adopt suitable strategies to face these challenges in order to ensure their survival and growth in the banking market. on this basis, the present research paper seeks to clarify that the lib of financial services allows commercial banks to expand and improve performance. the first part of this study concerns the foundations of financial lib and a reform to the banking system in algeria, as required by the financial globalization. the second part deals with the most important studies which involved both bank performance and lib of banking services. finally, an empirical study on all algerian banks (private and public) for the period extending from 1998 to 2012, using the panel regression technique to show the resulting effects of applying lib on the performance of the algerian banking system. 2. previous studies the services sector has not received any interest worth mentioning from the early economists, like adam smith and david ricardo, who considered that the services sector is a non-productive sector. during the last two decades (in the twentieth century), trade in services has gained increasing importance in the economies of the countries, and especially the developed ones, which led to put trade benahmed-daho, et al.: liberalization of financial services and performance of commercial banks in algeria: an empirical study (1998 – 2012) international journal of economics and financial issues | vol 5 • issue 4 • 2015 891 in services on the agenda of the uruguay roundtable, in september 20, 1986. an independent agreement on liberalizing trade in services was later reached and signed. developed countries, and particularly the united states, pushed in the direction of liberalizing trade in services and included them in the multilateral negotiations, because this is growing-fast sector which plays an important role in the world economy as well as in the development of international trade in the sector of services. banking services are among the most important services that have been liberalized. therefore, the banking field has become so important that it is now required to assess the banking system’s performance in order to determine the impacts of financial lib. a number of studies have analyzed the impacts and the relationship between the financial lib of services and the performance of the banking system: cevdet (2007) demonstrated the performance of banks before and after lib, using the data envelopment analysis (dea) on turkish banks. it appeared that the macroeconomic instability led to the reduction of the turkish banking system performance. lensink et al. (2008) used the dea technique in 26 developing countries, and confirmed that financial lib had a positive impact on the banking performance, for the period 1991-2000, in the short term. abid (2008) worked on a sample of 93 developing countries, between 1988 and 2006, using panel data and found that foreign banks have a positive impact on local banks, from a competitive point of view. however, al-fayoumi and abuzayed (2009) found that foreign banks have a negative short-term effect on local banks, unlike the long-term, we used the camels and swot techniques to analyze six jordanian banks; they found out that lib of financial services had various effects on the performance of every jordanian bank in the year 2007. hakkimi (2011) studied nine tunisian banks, during the period 1980-2009. he used the panel technique and found a negative relationship between financial lib and the profitability of banks. but in 2012, capraru (2012) carried out studies on 17 countries in central and eastern europe, for the period 2004-2008, and found out that financial lib and financial openness have a positive effect on the performance of banks in european union member states, according to the performance indicators and the determinants of bank performance. onu (2013) presented a research paper to evaluate the performance of 24 nigerian banks, for the period from 2001 to 2010. he showed that the comprehensiveness of banks affects the banking performance. on the other side, rekiba (2014) focused on the reforms undertaken by algeria to keep pace with the financial lib. the emergence of private banks, such as khalifa bank, had a negative impact on public banks, such as the algerian popular credit bank. this showed that the experience of failure of khalifa bank urged the banking system authorities to think about reformulating the banking reforms. khalifa crisis that contributed to the growth of the banking panic in algeria according the study of bendob (2015) on profitability of commercial banks in algeria. 3. research methodology several theoretical and experimental studies have highlighted the impact of financial lib on the performance of the banking system. some of them confirmed the existence of a positive relationship between financial lib and the performance of banks, but others developed some justifications for the existence of a negative effect of the financial lib on the profitability of commercial banks. we therefore proposed the following hypotheses: h0: the existence of a statistically significant positive relationship between the lib of financial services and the performance of commercial banks. h1: the existence of a statistically significant negative relationship between the lib of financial services and the performance of commercial banks. in light of this study, we used the bank scope database. the budgets, reports and accounts of 10 algerian commercial banks were used, for the period from 1998 to 2012, (table 1). besides, some statistical variables specific to the macroeconomics of the financial statements of the international monetary fund could be obtained. 3.1. model to test the relationship between financial lib and the performance of banks in algeria, the unbalanced panel data analysis (bendob, 2015) was used to study the multiple linear regression model, based on the least squares method. perf i, t = α0 + β 1 libi, t + β 2 riski, t + β 3 liq i, t + β 4 gdp t + β 4 iflt + ε i, t (1) perf = banking performance measure lib = financial lib measure risk = risk measure (loans) liq = liquidity measure gdp = cross domestic product (annual growth rate) ifl = inflation rate α = constant b1 = coefficient of estimation εi, t = error. 3.2. interpretation of variables 3.2.1. the financial lib variable introducing this variable in the bank’s performance modeling is of great importance. it takes the value 0 before lib and the value table 1: list of algerian commercial banks studied name of bank nature bea public bna public cpa public badr public bdl public bnp private sga private bmaic private tba private baraka private baraka: algerian al baraka bank, tba: trust bank algeria, bmaic: maghreb bank for investment and foreign trade, sga: société générale algeria, bnp: bnp paribas algeria, bdl: bank of local development, badr: bank of agriculture and rural development, cpa: algerian popular credit, bna: algerian national bank, bea: algerian foreign bank benahmed-daho, et al.: liberalization of financial services and performance of commercial banks in algeria: an empirical study (1998 – 2012) international journal of economics and financial issues | vol 5 • issue 4 • 2015892 1 during the period that follows the application of the financial lib policy. this variable involves a set of indicators (fray, 1997), as follows: • lib of interest rates • reduction of restrictions and barriers to foreign investment • reduction of compulsory reserve requirements • reduction of control on loans • privatization • rules of caution and care. to study the effects of financial lib on the profitability of commercial banks in algeria, we tried to build a financial lib index on the basis of the reforms implemented for openness on foreign financial exchanges. each variable takes a value between 0 and 3 to create the ultimate indicator, representative of the financial lib, knowing that0indicates the total financial repression, 1 the partial financial repression, 2 the partial financial lib, and 3 the total financial lib. they are as follows1: • credit lib and reduction of compulsory reserve requirements • lib of interest rates • lib of the banking sector • lib of capital • monitoring and supervision of the banking sector. 3.2.2. performance variable this factor represents the dependent variable (the interpreter) in the study model; it includes a set of indicators such as return on assets, return on average assets (roa or roaa) (demirgüç-knut and huizinga, 1999). we used the average return on assets to mitigate the changes in assets during the year. we also used return on equity, return on average equity (roe or roae) to carry out aempirical study to mitigate the urgency on equity changes during the year. they can be calculated as follows: net interest margin (nim) = (interest obtained interest granted by the bank)/total assets roa = net profit/total assets roe = net profit/total net capital 3.2.3. the risk variable this variable represents one the most important supports in the study of our standard model. this variable can be measured as follows: risk index = total loans/total assets (bourke, 1989). 3.2.4. the liquidity variable this has a statistical significance with the banks’ profitability. it determines the level of capital funds, and indicates the existence of surplus funds from financial lib that leads to the risk of insufficient liquidity. it is measured as follows: liquidity index (liq) = total loans/total deposits’ (liu and wilson, 2010). 1 financial sectors reforms in algeria, morocco and tunisia: a preliminary assessment, middle east department; imf, 2004, p26. 3.2.5. summary of independent variables used in the model eta capital equity/total assets llpni asset quality loan loss provision/net int rev niraa administration performance net intrev/avgassets latdb liquidity liquid assets/totdep and bor source: ben naceur and goaied (2001) 3.2.6. external factors there is an interdependent relationship between the internal and external factors for the banking sector. the most important are the gdp and the inflation index. they both show a significant impact on the performance of commercial banks, particularly the banking services (molyneux and thornton, 1992). 4. results and comments to study the impact of financial lib on banking profitability in algeria we will try to build with a synthetic index of financial lib starting from the reforms of financial lib. the reforms which we retained are as follows: credit control: this variable measures the liberation of all: the level of interest rates, statutory reserve and bank competition. the higher reserve requirement ratio fell and dropped restrictions on loans and banking generally increased the value of this variable. int rate control: this variable degree of lib of interest rates on loans and deposit rates, the more have been abandoned to direct loans and roofing for certain sectors of interest rate policies increased the value of this variable. entry barriers: this variable abolition of barriers and constraints to create a new, whether domestic or foreign, and open the banking sector to private investors in the banking sector banks. and the greater openness of the financial sector increased the value of this variable. intl capital: this variable eshml abolition of all restrictions on foreign financial exchanges, any lib of capital movement and the abolition of censorship applied to the current account and the capital account exchange rate. security market: this variable creation of financial markets, and policies that help the development of these markets, and the openness of domestic financial markets to foreign investors, like the abolition of the restrictions that prevent foreigners from acquiring shares issued by local institutions. banking superv: this variable is based on the extent of the application of one of the basel convention, which recommends banks to respect the proportion cook, also measures the extent of the independence of the central bank this variable and provided oversight of government interference. in the table 2 we present the index of financial lib in algeria based on the reforms applied to the algerian financial sector. table 3 highlights the results of estimation of the regression equation, using the pooled ordinary least squares (pols) method, benahmed-daho, et al.: liberalization of financial services and performance of commercial banks in algeria: an empirical study (1998 – 2012) international journal of economics and financial issues | vol 5 • issue 4 • 2015 893 where it appears that the fisher statistics is randomly different from zero for the level of 1% of the studied models. this means that this is a statistically acceptable model. the explanatory power reached the highest value with the model nim, where r2 = 94%. this rate of changes in the profitability of banks, expressed by nim, is explained by the selected variables. the remaining 6% reflect the errors and other factors, while the explanatory power of the two models roaa and roae appeared to be 61%. the first model nim, with 24%, remains the best, as it recorded the lowest value for both akaike and shwartz information criteria. it is also easily noted, from the results in the table 4, that there is a direct correlation, with a statistical significance, between nim and each one of eta (risk) and niraa (management efficiency) and gdp (gross domestic product) at the levels of 10%, 1% and 5%, respectively, where the flexibility of nim is very high compared to niraa whose coefficient is1.53. furthermore, the variable related to financial lib has a positive relationship with a statistical significance with nim. therefore, hypothesis h0 can be accepted, as it is in favor of the idea of the positive effects with statistical significance on the profitability of banks nim, using the pooled least squares technique. the use of this method means ignoring the characteristics of banks and considering them completely similar. the question remains as to whether the results obtained change if the characteristics of each bank are taken into consideration. this is going to be discussed in the next stage. table 3 highlights the results of estimation of the regression equation, using the pols as well as the fixed effects (fe); it appears that the fisher statistics f is randomly different from zero at the level of 1% for the studied models. this means that the model is statistically acceptable. we also added the dummy variable (0.1) to each bank in order to know the effect of the different characteristics of each bank. the explanatory power reached the highest value for the model nim where r2 = 96%. this ratio of changes in the profitability of banks is represented by nim, and is explained by the selected variables. the remaining 4% are explained by the errors and other factors. however, the explanatory power of the two models roaa and roae appeared to be 70% and 37%, respectively. this leaves the first model nim to be the best, as it recorded the lowest value for the akaike and schwarz information criteria. under the fe model, it appears that the variables nim and roae are distinguished by the presence of one independent variable with a statistical significance. these are the liquidity (latdb) in roae and the administration performance (niraa) in nim. it is easy to note that the roaa model is better, as it includes three table 2: extension represent show lib of financial services index account years crédit control intrate control entry barriers intlcapital sécurity market banking superv index of financial “lib” 1998 2.25 3 3 1 1 0 10.25 1999 2.25 3 3 1 1 1 11.25 2000 2.25 3 3 1 1 1 11.25 2001 2.25 3 3 1 1 1 11.25 2002 2.25 3 3 1 1 1 11.25 2003 2.25 3 3 1 1 1 11.25 2004 2.25 3 3 1 1 1 11.25 2005 2.25 3 3 1 1 1 11.25 2006 2.25 3 3 1 1 1 11.25 2007 2.25 3 3 1 1 1 11.25 2008 2.25 3 3 1 1 1 11.25 2009 1.5 3 1 1 1 1 8.5 2010 1.5 3 1 1 1 1 8.5 2011 1.5 3 1 1 1 1 8.5 2012 0.75 3 1 1 1 1 7.75 source: abiad, et al. (2008) with new database of financial reforms in algeria table 3: estimated regression equation using data panel study the model on pooled least squares dependent variable nim? roaa? roae? variable coefficient t-statistic coefficient t-statistic coefficient t-statistic c –1.427724ns –1.519534 –0.058225ns –0.059016 13.77934ns 1.267874 eta? 0.023516*** 1.923681 0.053251* 2.686992 –0.432710* –4.513817 llpni? –0.000189ns –0.511751 –0.000948ns –1.592794 0.012585ns 1.328147 niraa? 1.532350* 27.26297 0.509507* 7.038243 3.865974* 5.371110 latdb? 0.002943ns 1.031016 0.009899** 2.181057 0.125808* 2.845403 gdp 0.091405*** 1.887573 0.069013ns 1.236597 0.310863ns 0.488301 inf –0.058063ns –1.129346 –0.038755ns –0.671750 –0.554477ns –0.912117 lib 0.065668ns 0.831493 –0.101186ns –1.196888 –0.957936ns –1.103956 r2 0.937014 0.609695 0.243424 f-statistic 180.6445 18.96834 3.906899 akaike infocriterion 2.068947 2.771450 7.586081 schwarz criterion 2.286805 2.989308 7.803939 hannan-quinn criter 2.156912 2.859415 7.674046 source: authors, *significant at 1% level, **significant at 5% level, ***significant at 10% level. ns: not significant, lib: liberalization benahmed-daho, et al.: liberalization of financial services and performance of commercial banks in algeria: an empirical study (1998 – 2012) international journal of economics and financial issues | vol 5 • issue 4 • 2015894 independent variables with a statistical significance, though it has a lower explanatory power compared to that of the model nim. therefore, a positive relationship with a statistical significance appears between roaa and both of latdb and niraa at the level of 5%, as well as a negative relationship with a statistical significance between the same dependent variable and the variable related to financial lib at the level of 10%. based on that, hypothesis h1 which supports the negative relationship with the existence of a statistical significance between the financial lib and the performance of commercial banks, using the fe, is accepted. the use of fe takes into account the characteristics of each bank; it gave results different from those reported in table 2. therefore, the following question is asked: would the results be different in the case where the random effects are used? this will be dealt with in the following table. table 5 displays the results of estimating the regression equation using the pols and the random effects, where it appears that the fisher statistics f is randomly different from zero at the level of 1% of the models studied. this means that the model is statistically acceptable. the explanatory power reached the highest value with the model nim, as r2 = 87%. this ratio of changes in the profitability of banks is represented by nim, and is explained by the selected variables. the remaining 13% are due to error sand other factors. however, the explanatory power of the two models roaa and roae appeared to be 42% and 23%, respectively. therefore, the model nim turns out to be the best. under the random effects model “re,” the nim model shows a positive relationship with a statistical significance with niraa (management efficiency) at a level of 1%, unlike roaa which has a positive relationship with a statistical significance with niraa and eta at the level 1% and with latdb (liquidity) at 10%. as for the model roae, the results indicate that there is a positive relationship with a statistical significance between it and the same independent variables which are related to roaa at the level of 1%. to choose the best method to be used to interpret the study model, we applied hausman test, where the results showed that the probability has no statistical significance under the model “re.” hence, the best technique in pols is the fe model which aims at explaining the relationship between the financial lib of banking services and the performance (profitability) of banks, while diagnosing each bank separately, according to its characteristics in the studied sample. 5. conclusion the past years have witnessed a significant increase in the number of studies to analyze the relationship between the banking sector performance and the lib of financial services. these studies gave different views about the subject. however, our study was able to support the results of the most common investigations. the present research paper included the effects of financial openness on the performance of the banking sector, using internal and external variables on a sample of 10 algerian public and private commercial banks, during the period from 1998 to 2012. indicators representing the performance of banks and the financial lib variable showed that the algerian banking sector displays negative effects as a result of its entry in the financial openness table 4: estimated regression equation using data panel study the model on pooled least squares and fixed effects (cross) dependent variable nim? roaa? roae? variable coefficient t-statistic coefficient t-statistic coefficient t-statistic c 0.776498ns 0.813754 1.621080ns 1.045165 15.79190ns 1.101645 eta? –0.035299ns –1.393169 0.026151ns 0.515479 –0.254630ns –0.861723 llpni? –0.000160ns –0.549906 –0.000914ns –1.373152 0.012993ns 1.287384 niraa? 1.361142* 15.96662 0.298706** 2.423379 1.627789ns 1.539571 latdb? 0.005354ns 1.651790 0.011376** 2.420193 1.168968* 2.888870 gdp 0.035334ns 0.825397 0.021360ns 0.319998 –0.148315ns –0.212108 inf –0.055451ns –1.341117 –0.020340ns –0.344805 –0.522777ns –0.826653 lib –0.035617ns –0.534903 –0.178774*** –1.749428 –0.794656ns –0.742695 fixed effects (cross) bea-c –0.688215 –0.351653 –2.698333 bna-c –0.553191 –0.128535 6.290358 cpa-c –0.464156 –0.233833 –4.003432 badr-c –0.322175 –0.692268 –5.446082 bdl-c –0.351647 –0.416472 –1.419313 bnp-c 0.348365 1.016883 7.883896 sga-c 0.176494 –0.176553 0.323114 bmaic-c –0.072754 –1.015705 –17.83753 tba-c 2.126875 1.334384 0.262521 baraka-c 0.565207 0.469504 4 .871580 r2 0.957821 0.703009 0.366185 f-statistic 107.8649 11.24377 2.744301 akaike infocriterion 1.861513 2.691770 7.602584 schwarz criterion 2.324461 3.154719 8.065532 hannan–quinn criter 2.048438 2.878695 7.789509 source: authors, *significant at 1% level, **significant at 5% level, ***significant at 10% level, ns: not significant, lib: liberalization benahmed-daho, et al.: liberalization of financial services and performance of commercial banks in algeria: an empirical study (1998 – 2012) international journal of economics and financial issues | vol 5 • issue 4 • 2015 895 loop. the performance of the banking sector will still deteriorate because algeria has liberalized the financial and banking services, as the profitability of local banks cannot compete with foreign banks. therefore, the problem of stability and survival of the algerian local banks is urgent, despite the implementation of reforms imposed by the code of money and loan 90-10. hence, it is vital to reschedule and restructure the banking sector in order to cope efficiently with the lib policy in all areas, including the banking services. references abiad, a., detragiache, e., tressel, t. 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(1999), financial structure and bank profitability, world bank policy research working paper, n 2430, august. donadieu, j. (2003), financial liberalization: a breakdown of coherence thai and malaysian development models, the revue tiers monde, 44(173), 171-194. fray, m.j. (1997), in favor of financial liberalization. economic journal, 107, 754-770. galbis, v. (1977), financial ıntermediation and economic growth in lessdeveloped countries: a theorical approach. journal of development studies, 13(2), 58-72. gheris m., (2005), housing funding in morocco: illegal practices but effective : the case of pseudo-mortgage, 11th codesria general assembly, maputo, december 2005, quaddi ayyad university, marrakech, morocco. hakkimi, a. (2011), financial liberalization and banking profitability panel data analysis for tunisian banks. international journal of economics and financial, 1, 19-32. table 5: estimated regression equation using data panel study the model on pooled least squares and random effects (cross) dependent variable nim? roaa? roae? variable coefficient t-statistic coefficient t-statistic coefficient t-statistic c −0.477445ns −0.560347 0.473062ns 0.389487 13.96598ns 1.041592 eta? 0.000380ns 0.030140 0.048353* 3.140892 −0.425506* −3.134371 llpni? −0.000151ns −0.274258 −0.000989ns −1.206292 0.012335ns 1.341198 niraa? 1.448967* 23.02671 0.441018* 5.110835 3.745668* 4.450433 latdb? 0.004726ns 1.470735 0.008864*** 1.977814 0.124130* 2.709596 gdp 0.062881ns 1.493938 0.055587ns 0.884091 0.286318ns 0.398921 inf −0.059395ns −1.424242 −0.23869ns −0.379723 −0.530576ns −0.729668 lib 0.023223ns 0.356709 −0.127859ns −1.324818 −0.948948ns −0.866649 random effects (cross) bea-c −0.350558 −0.021471 −0.161138 bna-c −0.409236 −0.101131 0.613884 cpa-c −0.300139 −0.048866 −0.315973 badr-c −0.026401 −0.258659 −0.507255 bdl-c −0.079998 −0.116069 −0.117938 bnp-c 0.253432 0.671589 0.988884 sga-c 0.045974 −0.225040 −0.361012 bmaic-c −0.347639 −0.383425 −0.319552 tba-c 0.891527 0.342584 0.040159 baraka-c 0.323038 0.139488 0.139941 sd 0.460941 0.565500 0.409956 0.856487 1.298945 9.979078 rho 0.3992 0.6008 0.1864 0.8136 0.0167 0.9833 r2 0.870454 0.424086 0.226782 f-statistic 81.59086 8.941656 3.561457 hausman test chi-square statistic 11.301105 9.121083 11.370967 probility 0.1260 0.2441 0.1232 source: authors, *significant at 1% level, **significant at 5% level, ***significant at10% level, ns: not significant, roae: return on average equity, roaa: return on average assets, nim: net interest margin benahmed-daho, et al.: liberalization of financial services and performance of commercial banks in algeria: an empirical study (1998 – 2012) international journal of economics and financial issues | vol 5 • issue 4 • 2015896 imf. 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(1992), the determinants of european bank profitability. journal of banking and finance, 16, 1173-1178. onu, a.j.c. (2013), assessment of the ımpact of universal banking on bank performance in nigeria. european journal of business and management, 5(17), 42-45. rekiba s., (2014), the algerian banking system has the good fortune of joining a wto, review of the university of biskr n34/35. p 26-31. shaw, e.s. (1973), financial deepening in economic activity. new york: oxford university press. venet b. (1994), financial liberalization and economic development: an critical review of literature. journal of financial economics, 29, 87-111. vogel, r., buser, s. (1976), inflation. in: mckinnon, r.l., editor. financial repression, and capital formation in latin america. new york: marcel/dekker. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 884-888. international journal of economics and financial issues | vol 5 • issue 4 • 2015884 causal relationship among foreign reserves, exchange rate and foreign direct investment: evidence from nigeria augustine c. osigwe1*, maria chinecherem uzonwanne2 1department of economics and development studies, federal university, ndufu-alike, ikwo, nigeria, 2department of economics, nnamdi azikiwe university, awka, nigeria. *email: onyi2amaka@yahoo.com abstract this study scrutinized the granger causality of foreign reserves, exchange rate (exr) and foreign direct investment (fdi) in nigeria. the results of the augmented dicky–fuller and philip–perron unit root test for stationary of the variables showed that all the variables were non-stationary at levels, but become stationary after first differences. the johansen co-integration test revealed long-run relationship among the variables. the results of the granger causality test indicated unidirectional causality from exr to foreign reserves. consistently from lag one to lag two; unidirectional causality existed from fdi to foreign reserves. at lag three, bidirectional causality was discovered between foreign reserves and fdi. evidence of unidirectional causality running from exr to fdi in lags one and three, was revealed. no causality existed between the duos at lag two. based on the findings it is recommended that the policy makers establish the optimum exr level that positively promotes foreign reserves and fdi. keywords: foreign reserves, exchange rate, foreign direct investment jel classifications: c0, c32, f0 1. introduction the central bank of nigeria (cbn) act 1991 vests the custody and management of the country’s foreign reserves in the cbn. nigeria’s foreign reserves are mainly from the proceeds of crude oil production and sales. this includes direct sales (nigerian national petroleum corporation), petroleum profit tax (oil companies), royalties, penalty for gas flaring and rentals; and the reserve comprises of the federation, the federal government and the cbn portions. cbn (2015) noted that nigeria has taken numerous policy initiatives and measures in the management of its foreign reserves. although very little was achieved because the structure in place then could not support efficient reserves management, enduring lessons could be distilled from the nation’s past experience. it continued to note with nostalgia that since the 1970s, nigerian economy has persistently depended on oil as the main source of foreign exchange earnings with the attendant cycles of economic booms and bursts. however, one of the key challenges for nigeria over the last 8 years, especially under a civilian administration was how to manage the phenomenal growth in foreign exchange reserves (forex) resulting from the sustained high international oil prices. according to cbn (2015), foreign reserves in nigeria averaged 774483.82 million naira from 2000 until 2015, reaching an all-time high of 4166778.95 million naira in december of 2014 and a record low of 88,635 million naira in march of 2000. exchange rate (exr) price of a nation’s currency in terms of another currency. it is also regarded as the value of one country’s currency in terms of another currency. thus, exr has two components, namely; the domestic currency and a foreign currency, and can be quoted either directly or indirectly. in an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency whereas in a direct quotation, the converse holds. exrs are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers where currency trading is continuous. a market-based exr changes if the values of either of the two component currencies change. a currency will tend to become more valuable when demand for it is greater than the available supply and become less valuable each time demand is less than available supply. goldberg and charles (2015) observed that exrs can influence both the total amount of foreign direct investment (fdi) that takes place and the allocation of this osigwe and uzonwanne: causal relationship between foreign reserves, exchange rate and foreign direct investment: evidence from nigeria international journal of economics and financial issues | vol 5 • issue 4 • 2015 885 investment spending across a range of countries. when a currency depreciates, meaning that its value declines relative to the value of another currency, this exr movement has two potential implications for fdi. first, it reduces that country’s wages and production costs relative to those of its foreign counterparts. all else equal, the country experiencing real currency depreciation has enhanced “locational advantage” or attractiveness as a location for receiving productive capacity investments. by this “relative wage” channel, the exr depreciation improves the overall rate of return to foreigners contemplating an overseas investment project in this country. the reasons behind fdi and multinational corporations were explained by neoclassical economics based on macro-economic principles. these principles were based on the classical theory of trade in which the motive behind trade was a result of the difference in the costs of production of goods between two countries, focusing on the low cost of production as a motive for a firm’s foreign activity (ietto-gillies, 2012). global fdi inflows rose by 11% in 2013, to us$1.46 trillion. fdi flows to developed countries remained at a historically low share of global total fdi flows (39%) for the 2nd consecutive year. they increased by 12% to us$576 billion, but only to 44% of their peak value in 2007. fdi to the european union increased, while flows to the united states continued their decline. fdi flows to developing economies reached a new high of us$759 billion, accounting for 52% of global fdi inflows in 2013. at the regional level, flows to latin america and the caribbean, and africa were up; developing asia, with its flows at a level similar to 2012, remained the largest host region in the world (unctad, 2014). nigeria slumped from its number one position in 2012 to achieve $5.61 billion in fdi inflows in 2013, coming third behind mozambique and south africa (unctad, 2013). most scholars believe that fdi inflow has a direct impact on foreign exchange reserve, while others hold that fdi is mainly invested in the form of physical capital and technology, and therefore does not directly contribute to foreign exchanges reserve accumulation. hence the need for this study. a peep into the literature indicates that studies that have examined causality among foreign reserves exr and fdi remains mixed as their method of analysis varied. also, in the context of the dwindling revenue obtained from the main foreign exchange earner (crude oil) of nigeria, it becomes apt to re-examine the form of causality that runs among the three variables. the remainder of this paper is structured as follows. section 2 centers on literature review while section 3 briefly describes the theoretical framework and methodology adopted in the study. section 4 presents and discusses the empirical results while the study is concluded in section 5. 2. review of literature existing literature on relationship among foreign reserves, exr and fdi stands on divergent strands as evidenced by empirical outcomes. for instance, wenkai and song (2009) decomposed the possible effects fdi could have on forex into direct effects and indirect effects and mainly estimated the real effect of fdi on the growth of forex. according to them the study helped to correctly understand the role of fdi in raising forex. results from their empirical analysis revealed that fdi is an important factor that contributes to the growth of china’s forex. they asserted that during the rapid growth of the reserves in recent years, and contrary to the “decreasing contribution” as stated in the nominal effects, fdi’s real effect increased. this finding provides a basis to further analyze the possible causality that runs between fdi and forex and implications for policy makers. abdullateef and waheed (2010) extended the study on the determinant of foreign reserves by investigating the impact of change in external reserve (extr) positions of nigeria on domestic investment, inflation rate, and exr from 1986 to 2006. using the ordinary least square and vector error correction (vec) estimation methods, they found that change in extrs in the country only influences fdi and exrs, and no influence was found on domestic investment and inflation rates. the results further suggested that there is the need for broader reserve management strategies that will aim at maximizing the gains from oil export revenue by utilizing more of these resources to boost domestic investment. yasir et al. (2012) empirically investigated the relationship among the broad macro variables such as forex, fdi and nominal exr in pakistan by testing annual data set the period of 1980-2010. in order to investigate the stationarity of data at level or at first difference, they carried out augmented dicky–fuller (adf) unit root test and concluded that exr, fdi and forex are stationary at first difference. for the investigation of long-run relationship, johnson co-integration test was applied and the results showed that longrun relationship exist among the variables. they then proceeded to vec method to examine the short-run association of the variables. the obtained results suggested that nominal exr have a significant positive impact on forex while fdi have insignificant impact on forex. similarly, osuji and ebiringa (2012) focused on the longrun relationship between some selected macroeconomic variables and extr management factors in nigeria. the result of their vector auto regression (var) model indicated that exchange (extr) is significant in the current year but tends to converge in the previous years. on the other hand, the value of the joint significance indicates that the current values of gross domestic product (gdp), capital goods (cpg), non-cpg and excr are most influencing factors that determine the current values of extr. irefin and yaaba (2012) on the other hand, employed an autoregressive distributed lag approach to run a slightly modified econometrics “buffer stock model” of frenkel and jovanovic (1981) to estimate the determinants of foreign reserves in nigeria over the period of 1999-2011, with focus on income, monetary policy rate, imports and exr. the results debunked the existence of buffer stock model for reserves accumulation and provided strong evidence in support of income as the major determinant of reserves holdings in nigeria. using a time series data of between 1980 and 2010, gokhale and ramana (2013) establish a causal relationship between exr and forex in the indian context. they laid emphasis on understanding the impact of forex on the exr. according to them, india has accumulated unprecedented forex and synchronously has been experiencing a large depreciation in its osigwe and uzonwanne: causal relationship between foreign reserves, exchange rate and foreign direct investment: evidence from nigeria international journal of economics and financial issues | vol 5 • issue 4 • 2015886 rupee viz., us dollar. this trend prompted their study undertook to establish some association between the two trends. their employed unit root test, johansson co-integration test and var in the analysis of their data. on the basis of empirical findings, they concluded that there is no long-and short-term association between exr and forex in the indian context. chowdhury et al. (2014) recently undertook an econometric analysis of the determinants of forex in bangladesh, using the adf unit root test to examine stationarity, engle granger residual based co-integration approach to show the co-integrating relationship among the variables, and some diagnostic tests for better modeling. the empirical results of their study confirmed the existence of strong relationship among forex, exr, remittance, home interest rate, broad money, upi of export and import, and per capita gdp. the study suggested that exr, strong remittance related policies, quality items of exports and sustainable gdp can keep a substantial and feasible role to make up a healthy amount of forex for the host country like bangladesh. 3. theoretical framework and methodology 3.1. theoretical framework the core objective of this paper is to examine the casual relationship among foreign reserve, exr and fdi. in the light of this and leaning on the reviewed literature, the model of this study which is recursive in nature, mimics the empirical studies of yasir et al. (2012) for pakistan and osuji and ebiringa for nigeria (2012) and gokhale and ramana (2013) for india. 3.2. methodology two methods of unit root test (adf and philip–perron [pp]) were adopted to test for the stationarity of the variables. the causality among the variables is traced with the johansen cointegration technique and the granger causality test (gct). long-run relationship (co-integration) between two variables indicates that causality runs in at least one direction. it is one of the major thrust of this study to determine not only the longrun relationship among the variables but also to determine the causal relationship (if any) among them. to this effect, the pairwise gct was adopted. when a time series x granger causes another time series y, it follows that the pattern in x is approximately repeated in y after some time lags. alternatively expressed, a time series x is said to granger cause a time series y if and only if it can be clearly shown through series of t-tests and f-tests on the lagged values of x (with lagged values of y inclusive) that all the lagged x values provide statistically significant information about the future values of y. the null hypothesis underlying the gct is that the variable under study (say x) does not granger-cause the other (say y). originally, the gct is based on estimating a pair of regression models in the following generic fashion: y y x vt i n i t j n i t j t= + + = − − −∑ ∑ 1 1 1 1α β (1) x y x vt i n i t j n i t j t= + + = − − −∑ ∑ 1 1 1 2δ λ (2) where, it is assumed that v1t and v2t are uncorrelated. in the above specification, according to granger (1969), x is said to grangercause y if βi is not equal to zero and y will also granger-cause x if λi is not equal to zero. if these two situations simultaneously exist, then there is bi-directional causality. the first two scenarios represent unidirectional causality and if none of them prevails, then it is concluded that there is independence between the two variables x and y. this situation represents the simplest form of granger causality specification which involves only two variables (x and y), dealing with bilateral causality. however, in this study, the situation is more complex, involving three variables, thus, making it multivariable causality through the technique of var. thus, the gct is based on estimating the following var model: lfres lfres lexch fdi t i n i t i j n j t j k n k t k t = ∑ + ∑ + ∑ += − = − = −1 1 1 1α β δ ξ (3) lexch lfres lexch fdi t i n i t i j 1 n j t j k n k t k t = ∑ + ∑ + ∑ += − = − = −1 1 2γ θ η ξ (4) lfdi lfres lexch fdi t i n i t i j n j t j k n k t k t = ∑ + ∑ + ∑ += − = − = −1 1 1 3ϑ ς ϖ ξ (5) where, it is assumed that ξ1t, ξ2t and ξ3t are uncorrelated. the hypothesis of no causality between variables is rejected if the f-statistic for the restricted and unrestricted residual sum of squares is significant at the conventional 1% or 5% level of significance. given that the interest of this study is in testing for causality, one need not present the estimated coefficients of the var model explicitly (gujarati and porter, 2009). data for this study which ranged from 1970 to 2013 were sourced from wdi (2013). 4. empirical results the results of the adf and pp unit root test for stationary of the variables are presented in table 1. the results show that all our variables were non-stationary at levels, but become stationary after first differences. in other words, they are integrated of table 1: adf and pp unit root results variable adf statistic order of integration pp statistic order of integration lresv −3.600987** i (1) −6.291427** i (1) lexch −5.747095** i (1) −5.747095** i (1) lfdi −12.11608** i (1) −12.11608** i (1) **(*) implies significant at 1% (5%) level of significance. adf: augmented dickyfuller, pp: philip-perron table 2: results of johansen’s co-integration test (intercept, no trend) hypothesized number of ce(s) eigen value trace statistic 5% critical value p none* 0.562364 44.51718 29.79707 0.0005 at most 1* 0.198414 9.809721 15.49471 0.0257 at most 2 0.012325 0.520863 3.84146 0.4705 *denotes rejection of the hypothesis at the 0.05 level osigwe and uzonwanne: causal relationship between foreign reserves, exchange rate and foreign direct investment: evidence from nigeria international journal of economics and financial issues | vol 5 • issue 4 • 2015 887 the same order, that is order one, i(1). thus, null hypothesis of non-stationarity was rejected for all the variables. given that the variables were i(1), we proceeded to test for co-integration using the johansen co-integration test (table 2). table 2 shows that the null hypothesis of no co-integration relationships was rejected against the alternative of two cointegrating relationships at the 5% level. this implies that there is long-run relationship among fres, exch and fdi. evidence of co-integration suggest causality, at least, in one direction. the error correction model results would then be required to ascertain the direction of causation and in detecting the differences between the long-run and short-run granger causality. 4.1. gct results the optimal lag length was three for aic lag selection criteria and one for the schwarz information criterion. it was noted that the granger causality is sensitive to lags. thus, the empirical findings are guided by the optimal lags. the results of the gct indicate unidirectional causality runs consistently from exr to foreign reserves from lag one to lag three. the results also showed that, consistently from lag one to lag two, unidirectional causality from fdi to foreign reserves. at lag three, we discovered bidirectional granger causality between foreign reserves and fdi. evidence of unidirectional causality running from exr to fdi in lags one and three, was discovered. no causality existed between the duos at lag two (table 3). 5. conclusion this study examined the granger causality of foreign reserves, exr and fdi. the results of the adf and pp unit root test for stationary of the variables showed that all our variables were non-stationary at levels, but become stationary after first differences. the johansen co-integration technique revealed that the null hypothesis of no co-integration relationships was rejected against the alternative of two co-integrating relationships at the 5% level implying that there is long-run relationship among foreign reserves, exr and fdi. the results of the gct indicated that unidirectional causality runs from exr to foreign reserves from lag one to lag three. unidirectional causality from fdi to foreign reserves was found from lag one to lag two. at lag three, we discovered bidirectional granger causality between foreign reserves and fdi. evidence of unidirectional causality running from exr to fdi in lags one and three, was discovered. no causality existed between the duos at lag two. references abdullateef, u., waheed, i. (2010), external reserve holdings in nigeria: implications for investment, inflation and exchange rate. journal of economics and international finance, 2(9), 183-189. cbn. (2015), reserve management. abuja: central bank of nigeria. available from: http://www.cenbank.org/intops/reservemgmt.asp. [last retrieved on 15 aug 08]. chowdhury, m.n.m., uddin, m.j., islam, m.s. (2014), an econometric analysis of the determinants of foreign exchange reserves in bangladesh. journal of world economic research, 3(6), 72-82. frenkel, j., and jovanovic, b., (1981), optimal international reserves: a stochastic framework”, economic journal, 91, 507-514. gokhale, m.s., ramana, j.v. (2013), causality between exchange rate and foreign exchange reserves in the indian context. global journal of management and business research finance, 13(7), 449-456. granger, c.w. (1969), investigating causal relations by econometric models and cross-spectral methods. econometrica journal of the econometric society, 37(3), 424-438. goldberg, l., charles, k. (2005), foreign direct investment, exchange rate variability and demand uncertainty. international economic review, 36(4), 855-873. gujarati, d.n., porter, d.c. (2009), basic econometrics. 5th ed. new york: mcgraw-hill. ietto-gillies, g. (2012), transactional corporations and international table 3: gct results null hypothesis lag order f-statistic (p) decision exch does not granger cause resv resv does not granger cause exch 1 8.99949** (0.0046) 0.16444 (0.6873) reject accept exch does not granger cause resv resv does not granger cause exch 2 7.71877** (0.0016) 0.57628 (0.5669) reject accept exch does not granger cause resv resv does not granger cause exch 3 6.51409** (0.0013) 0.96533 (0.4203) reject accept fdi does not granger cause resv resv does not granger cause fdi 1 16.7412** (0.0002) 0.12195 (0.7288) reject accept fdi does not granger cause resv resv does not granger cause fdi 2 8.67701** (0.0008) 0.02294 (0.2117) reject accept fdi does not granger cause resv resv does not granger cause fdi 3 7.12448** (0.0008) 3.27594* (0.0327) reject reject fdi does not granger cause exch exch does not granger cause fdi 1 0.20955 (0.6496) 15.7645** (0.0003) accept reject fdi does not granger cause exch exch does not granger cause fdi 2 0.79345 (0.4598) 1.49252 (0.2384) accept accept fdi does not granger cause exch exch does not granger cause fdi 3 0.50195 (0.6835) 6.51336** (0.0013) accept reject **(*) denote rejection of the null hypothesis at 1%(5%) level; p values in parenthesis. gct: granger causality test. source: authors’ compilation using eviews, fdi: foreign direct investment osigwe and uzonwanne: causal relationship between foreign reserves, exchange rate and foreign direct investment: evidence from nigeria international journal of economics and financial issues | vol 5 • issue 4 • 2015888 production: concepts, theories and effects. 2nd ed. cheltenham, uk: edward elgar. irefin, d., yaaba, b.n. (2012), determinants of foreign reserves in nigeria: an autoregressive distributed lag approach. cbn journal of applied statistics, 2(2), 63-81. osuji, c.c., ebiringa, o.t. (2012), analysis of effect of external reserves management on macroeconomic stability of nigeria. international journal of business management and economic research, 3(6), 646-654. unctad. (2013), world investment report. geneva, switzerland: united nations conference on trade and development. unctad. (2014), global investment trends monitor. geneva, switzerland: united nations conference on trade and development. wdi. (2013), world bank database. washington, dc: world development indicator. wenkai, s., song, m. (2009), fdi’s real impact on foreign exchange reserves: evidence from china. china economist 1, 1-12. yasir, m., shehzad, f., ahmed, k., sehrish, s., saleem, f. (2012), relationship among exchange rate, fdi and foreign exchange reserves: an empirical investigation in case of pakistan. interdisciplinary journal of contemporary research in business, 4(5), 225-232. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(1), 340-350. international journal of economics and financial issues | vol 7 • issue 1 • 2017340 kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange patrick mumo muinde1*, james mwangi karanja2 1central university of finance and economics, beijing, china and kenya school of government, kenya, 2university of nairobi, kenya. *email: pmmumo@yahoo.com abstract the profitability of commercial banks in kenya has been a subject of intense policy debate over the past two decades. this paper explores and adduces evidence that the perceived abnormal profitability in the industry is reflected in stock returns. the study utilizes time series data obtained from the nse and five macroeconomic variables for the period 1996: 2015. we regress portfolio monthly excess returns, predict and graph these returns to determine if the banking sector outperforms other sectors of the economy. the empirical evidence presented here suggests that the banking industry outperforms other sectors of the economy in kenya. keywords: commercial banks, evidence, portfolio returns jel classifications: a23, c22, e44 1. introduction ever since the early 1990s, it has been argued that the kenyan banking sector is the most profitable within the kenyan economy, recording what is obviously considered as “abnormal profits” based on reported nominal before tax profits. kamau and were (2013) report that the industry profits have grown by about 400% over the period between 1997 and 2013, despite the economy performing very poorly in certain years over the period, the 2008/2009 global economic crises and the post-election violence after the 2007 general elections. from their statistics, nominal before tax profits grew from kenya shilling (kes) 18.8 billion (us$ 0.188 billion under current exchange rates [exr]) in 1997 to kes 89.2 billion (us$ 0.892 billion) in 2011, representing a 2.7% (from 0.3% to 3.0%) growth in share of gross domestic product (gdp). similarly, the industry asset and deposits bases grew phenomenally over the period to cross the psychological kes 1 trillion and stand at 67% and 49% of the gdp respectively by end of 2011. these unusually high profit returns have been the subject of heated debates among policy makers, politicians, economist and other professionals, civil society groups and the consumer federation in kenya. the big question at the center of the debate has been on how to explain the mind boggling numbers emanating from the financial reports of the commercial banks, especially the so called “the big 5” (kcb bank, barclays bank, standard and chatered bank, equity bank and cooperative bank) when contextualized within the economic environment in which they operate and nominal profitability as reported by other sectors of the economy. a more fundamental question is whether these sentiments of abnormal profitability in the banking sector is reflected on the stock returns for the listed commercial banks at the nse. this study tests whether an industry portfolio return for all listed commercial banks outperforms other industry portfolio returns for the period april 1996: december 2015. a single portfolio is created for each industry/sector based on the nse current classifications to form a total of 10 portfolios. daily trading data has been obtained from the nse for the period 1995:2015, while the monthly nse 20 share index weighted values and monthly consumer price index (cpi) values have been obtained from monthly economic indicator reports available at the kenya national bureau of muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017 341 statistics (knbs) website. other macroeconomic data series including money supply (ms), exr, 91 day average treasury bill rates (atb) short term interest rates, commercial banks weighted lending rates and interbank rates are obtained from the central bank of kenya (cbk) website. the interbank rates (proxy for short term interest rates) are subtracted from the commercial bank lending rates (proxy for long term interest rates) to compute the credit spreads (cs). a simple weighted average method is used to compute the portfolio return for each industry. the portfolio excess returns are first regressed under the capital asset pricing model (capm) to determine its validity in the emerging market of kenya. a multifactor model then extends the capm model by adding 5 macroeconomic variables to the regression. after regression, the excess returns for each portfolio are predicted and plotted against that of the banking sector to determine if the banking industry outperforms the other industries on average. the portfolio weighted average returns indicates that telecommunications and technology industry has the highest average return at 2.12%, followed by investment and services and manufacturing and allied with 1.45% and 1.28% respectively. the banking industry is fourth with a return of 1.08% while energy and petroleum has the least average returns at −0.02%. however, from the capm regression, the banking portfolio has the highest beta (β) for the market factor at 1.03, followed by telecommunications and technology and insurance sectors at 1.018 and 1.007 respectively. the agriculture sector has the lowest β at 0.823. the capm regressions results indicate that the constants are insignificant from zero for seven out of the ten portfolios. it’s only weakly significant for agriculture, banking and telecommunications and technology industries. this suggests that we cannot reject its validity in the emerging market of kenya. from the multifactor model, the βs for the market factor are all significant at the 1% confidence level for the 10 portfolios. the banking sector β remains the highest at 1.023 with the insurance following at 1.007. the agriculture sector β remains the least at 0.816. the βs for the macro-variables are largely insignificant across most of the portfolios. the predicted portfolio excess returns graphed against that of the banking sector indicates that the banking sector portfolio outperforms all other sectors except for the insurance sector that seems to move together. thus, the study concludes that the abnormal profits sentiments, for the banking sector has been priced in their stock returns at the nse. the fact that these public sentiments have been priced in the stock market could suggest the nse is at least in the semi-strong form of market efficiency. this study makes three key contributions to the body of knowledge. first, it has validated the ever growing belief that commercial banks in kenya earn “abnormal returns” with evidence from the stock market. if it’s true that the banking industry enjoys superior returns compared to other sectors of the economy, then we would expect rational wealth maximizing investors to use this information to earn superior returns from the stock markets. based on the efficiency market hypothesis, stock market can be taken as good predictors of investor beliefs as they would seek to exploit available information to grow their wealth. the study findings adduces objective evidence to this superior performance of the banking industry in kenya and could inform policy debate henceforth. secondly, the study proffers more insights into the scanty literature available from stock markets in less developed and developing countries. while a lot of literature exists about developed and emerging markets of the western, east and other asian economies, little is known and/or documented from less developed and developing markets, especially from sub-saharan africa. the fact that very little literature exists about these markets does not mean that such markets do not exist or do not provide opportunities for wealth seeking investors. in fact, i would hypothesize that such markets offer unique opportunities for risk diversification since these markets are not fully/tightly linked with well known and developed international markets. a ray of evidence of the existing potential in these markets, and sub-saharan africa in particular, could be traced to the recent successful sovereign bond issues by ghana (2012) and kenya in 2014 at the international markets. in each of both cases, the two countries raised us$1 billion from the international market, the bonds being over-subscribed by over 100%. kenyan tapped the international market for an additional us$ 750 million in the 2nd quarter of the 2014/15 financial year, and again the bond tap was over-subscribed by over 100%. finally, this study will contribute to the existing academic literature and body of knowledge. it is hoped that the study findings shades more light about sub-saharan africa capital markets and open the region for further studies in the coming years. this provides students of finance and economics with more information about an otherwise little known part of the global financial/capital markets. it creates a window of opportunity for further studies. the rest of the paper is organized as follows: part 2 discusses the relevant literature and part 3 describes the sources of data. part 4 discusses the identification strategy with the main results presented and discussed in part 5. in part 6 we conclude and proffer a limitation of the study. 2. relevant literature 2.1. background information over the years, the superior profitability debate of the kenyan banking sector has narrowed to their interest incomes, which constitute the major source of revenue for the banking industry. it’s without a doubt that kenya has one of the highest interest rates spreads among its economic peers. for instance, data from a presentation by the institute of economic affairs (iea) at a public forum in february 18, 2014, indicate that commercial banks weighted lending interest rates averaged at 22% to 17% for the period between april 2012 and december 2013, with weighted interest rates on savings remaining at about 8-6%. over this period, the interbank interest rates, 91 day treasury bill rates and central muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017342 bank rate (cbr) averaged 9.67, 9.62 and 11.45 respectively (computed from cbk data). the cbr was introduced in june 2006, and acts as the bench mark risk free rate. however, it has now been replaced by the kenya banks reference rate (kbrr), to be computed as an average between cbr and the weighted 2 month moving average of the 91 day treasury bill rates. the rate is set by the monetary policy committee and came into effect on july 1, 2014. it was initially set at 9.13% (ojiambo, 2014), and reviewed downwards to 8.54% in january 2015. however, due to macro-economic instability in the country for most part of 2015 the rate was reviewed upwards by 1.33 basis points to 9.87% in july 2015, in an effort to tighten ms and stabilize the kes against the us$. in july 25, 2016, it was adjusted downwards to the current rate of 8.90%. kbrr is an outcome of a consultative process led by industry stake holders, the cbk and the national treasury with the main objective as to tackle the problems of high interest rates in kenya, by bringing stability and predictability to the base rate. 2.2. the macroeconomic environment vs. banking profitability in kenya ndung’u and ngugi (2000) argue that the banking sector interest rate spread (irs) is among the most controversial post liberalization macroeconomic phenomenon in kenya. while they appreciate that many factors including market structure (internal organization) of the sector, management and regulatory framework play a key role in determining irs, they conclude that the absence of macroeconomic stability is an important trigger factor of a chain of variables that can explain the spreads in the kenyan case. one of these variables has been the consistently high budget deficits that the government often and largely finances with short term domestic borrowing, sometimes at very high interest rates. this offers the kenyan commercial banks a safe investment opportunity with a high return at the risk free rates. iea (2000) opines that the government is trapped in a debt cycle, often borrowing short term at high interest rates to repay maturing obligations. as a consequence, treasury bill rates that for a long period have served as the risk free/base rate (and currently still a key component in determination of the base rates) has remained unacceptably high. the high risk free government borrowing rates provides safe havens for banks to lend at no (or very low) risk, crowds out credit seeking private sector organization and individual borrowers. furthermore, high government borrowing increases demand for available credit reserves from surplus spending units, with the obvious consequence being an increase in the price for money given the simple economic logic of the forces of demand and supply. another unintended consequence of the high borrowing rates by the government is the fact that the upward pressure on the cost of credit keeps away potential high credit worth borrowers. assuming diligent and high credit worth borrowers (mainly the corporate sector) are rational, they will obviously keep away from borrowing from the commercial banks if they perceive the cost of debt to be unjustifiably high. that leaves the market littered with high risk borrowers (mainly individual borrowers). obliviously therefore, faced with a large pool of high risk borrowers, whose credit worthiness cannot be reliably determined and considering the high unit cost of collecting credit information for individual borrowers, the banks will of necessity set a high general minimum interest rates for this class of borrowers. the net cumulative effect is a general high interest rate regime and wide spreads. based on an analysis of ndung’u and ngugi (2000) report, iea concludes that the high interest spreads in kenya cannot be attributed entirely to the bank’s avarice, but are symbolic of a wider problem of failure on the part the regulatory authorities. kamau and were (2013) using structure conduct process analysis find that the superior performance in the kenyan banking sector is not as a result of improved efficiency or leverage on recent technologies heavily employed by the commercial banks in their operations, but it’s as a result of structure/collusive power. they argue that high concentration/market power explains the abnormal profitability in the banking sector. this implies that collusion among the big banks that control a significant portion of the market allows them power to control/dictate interest rates, ignoring policy signals to reduce their lending rates, and in the process reap huge profits despite glaring inefficiencies in their operations. the political class, often picking cue from the consumer federation, civil society groups and the media in every financial reporting cycle, have attempted to control interest rates through legislation. the first boldest attempt was in 2000, with the introduction of the central bank (amendment) act 2000 (famously referred to as the donde bill, after the member of parliament behind it). the bill had proposed to cap irs at 6% (lending rates to be pegged at 3% above the average previous months t. bill rates and interest on savings at 3% below the average previous t. bill rates). however, at the passing of the amendments on november 29, 2000, a compromise was arrived at that increased the peg to 4% on either side, thus increasing the spread to 8%. the amendments were, however, challenged in court by the banking sector and never came into effect. this position was strengthened by external pressure from the international monetary fund arguing against interest rates control, and terming them as retrogressive and likely to erode the gains achieved in liberalizing the kenyan financial sector. if we contextualize the high cost of credit in the country within the wider national long term economic development blue print (the vision 2030), then it would be clearer why the government is particularly concerned. under the vision 2030, it is projected that if the country is to attain the middle income country status, the overarching goal of the 25 year plan, the economy must, as of necessity grow at a sustained rate of 10% from the year 2012. this growth rate has not been achieved, with the economy growing at a paltry 4.6% in 2013, 5.3% in 2014 and 5.5% in 2015 as shown in figure 1. it is projected to remain at below 7% through 2017. the attempts to regulated interest rates in kenya succeeded in july 2016 with the passing of the central bank (amendment) act 2016 and signed by the president in august 2016. the new regulation caps lending interest rates at 4% above the base rate and savings rates at 70% of the base rate. since the coming into effect of the new regulations, there has been divided opinion muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017 343 on their implications to the economy. the banks have argued that this would lead to crowding out of low income earners who cannot borrow within the caps (due to their higher risk profile). some analysts argue that this is good news to the middle class and small and medium enterprises in kenya that can now access credit at affordable rates to invest back into the economy. however, what is in no doubt is that the new interest rate regime will eat into the high profitability currently enjoyed by the banking industry. while it requires no rocket science to understand that high interest rates spreads stifles investments, discourages savings, slows down economic growth and ultimately negatively impact on people’s welfare, the ultimate impact of this regulations remain uncertain. first, the government continues to run a very high budget deficit, with domestic debt accounting for about 55% of the national debt estimated at kes. 3.3 trillion in march 2016. this makes the government a key consumer in the local credit market, still borrowing at an attractive over 8% interest rate for the 91 day t. bills and between 10% and 15% for medium and long term bonds. this continues to crowd out the private sector and individual borrowers as the banks can still earn a decent return from the safe government securities. secondly, the high uncertainty/volatility of the exr remains a constant threat to stable interest rates regime in the country. for instance, the cbk had to increase the t. bill rates to over 11.45% in june 1999, peaking at 20.3% in january 2000 to stabilize the kes against the us$. they remained in the range of 10-15% for most of 2000, 2001 up to june 2002 when they dropped to about 8% and below. the cycle was repeated again in the period between august 2011 to august 2012, with the rates peaking at 20.56% in january 2012, when the kes entered into a free fall, loosing grounds of up to 26% (dropped from kes 85/us$ to kes 107/ us$) against the us$ in the 2nd quarter of 2011/2012 financial year. this has been repeated again for most part of 2015 with the t. bill rates peaking at 22.5% in october 2015 to stabilize the kes after depreciating by 21% (kes 87/us$ to kes 106/us$) between october 2014 to september 2015. thirdly, the banking sector remains highly concentrated, with the 5 big banks controlling a sizeable share of the market. kamau and were (2013) finds that there still exists high inefficiencies in the banking sector, since their model tests reject the hypothesis that the high profits in the kenyan banking sector are due to improved efficiency. as a policy recommendation, they argue that improved efficiency would be a key driver to increase competition in the industry, and thereby help reduce the ownership concentration in the sector. but of course, and as is expected, it’s unlikely that the smaller banks will grow as fast to increase competitive pressure in the industry. obviously, the “big boys” have no immediate and urgent incentive to improve efficiency as long as the potential for high and abnormal profits continue to exist. after all, they benefit most from the inefficiencies in the industry that support the continued concentration power. 2.3. empirical evidence mainly, available studies have focused on internal measures of bank performance as opposed to relating their profitability to stock returns. samad and hassan (1999) use ratio analysis to evaluate inter-temporal and interbank performance of islamic banks in malaysia. grigorian and manole (2002) and kablan (2007) use the data envelopment analysis to assess the determinants of commercial bank performance in transition and measure the efficiency of banks in the west african economic monetary union respectively. de young (1997) explores the challenges and misconceptions of measuring cost efficiency at financial institutions by demonstrating the pitfalls of accounting-based expense ratios while afroze (2007) adduces empirical evidence on the correlation between irs and deposit rates for commercial banks in bangladesh. kamau and were (2013) use scp analysis to assess the performance of the banking sector in kenya. this study departs from the internal focus of bank performance to evaluate if the perceived superior figure 1: economic growth in kenya 2010-2015 source: kenya national bureau of statistics muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017344 performance (profitability) of commercial banks in kenya is reflected on stock market. to assess this, we construct an industry portfolio for listed commercial banks in the nse and compare its return with portfolio returns for other sectors of the economy. from the foregoing therefore, if indeed the banking sector has exhibited superior performance above other sectors in the country, then we should expect the banks portfolio to outperform other portfolios based on investor rationality concept and wealth maximization goals. the efficient markets concept hypothesizes that security prices will adjust to reflect all historical information if in the weak form, all publicly available information if in the semistrong form, and all private and professional analyzed information if in the strong form of efficiency (brealey et al., 2011). if the nse is at least in the semi-strong form of efficiency, these “abnormal profitability” sentiments in the kenyan public domain ought to be reflected in the bank’s stock returns. 3. data sources and description of variables1 the study utilizes a time series data. daily trading data has been obtained from the nse for the period april 1996: december 2015. further data has been obtained from the websites of the knbs, the cbk and the 5 year nse handbooks from 1994: 2015. specifically, the monthly value weighted nse 20 share values (proxy for market 1 ms2 includes m1, quasi money in banks and quasi money in non-bank financial institutions (nbfi’s). m1 includes m0 (currency in circulation –cash in bank tills –commerative coins) + other deposits at cbk + demand deposits in banks. return) and monthly cpi changes data are obtained from the monthly key economic indicator’s reports and statistical abstracts from 1996 to december 2015, available on the knbs website (www. knbs.or.ke/). average monthly ms, the 91 day t. bill rates, exr, interbank rates and weighted average commercial bank lending rates were downloaded from the cbk website (www.centralbank.go.ke/). for the purpose of data analysis, the log values for the average monthly ms, average monthly exr and average national monthly cpi are used. the cpi has 2009 as the base year. cs is computed as the difference between weighted average commercial bank lending rates and interbank rates while short term interest rates (proxy for risk free rate) is the average monthly 91 day t. bill rates. accounting data, including pre-tax profits and number of issued shares for the each of the listed firms is obtained from the summary financial statements presented in the 5 year nse handbooks (1994:2015). the variables used are defined and described in table 1. 4. identification strategy 4.1. industry/sector classification all firms listed in the nse are grouped into 10 industries/sectors. for ease of data analysis and presentation, the sectors have been defined and classified in table 2. 4.2. unit root test in ols regressions, non-stationary time series pose a risk of spurious results that could be misleading during interpretation. it is thus important to confirm first if the data series are stationary table 1: definition and description of the variables acronyms construction of variables data source market premium monthly % return ((vt-vt−1)/vt−1 *100) of the weighted average market value of the nse 20 share index month-end closing prices (proxy for market return [rm]) minus atb knbs/cbk incpi natural logarithm for monthly average consumer price index (measure of monthly inflation) knbs inms natural logarithm of the monthly average of broad money supply (m21) cbk inexr natural logarithm of the average monthly exchange rate for the kes against the us$ (us dollar) cbk cs credit spread is the difference between commercial banks weighted average monthly lending rates and the monthly average of interbank (overnight) borrowing rates (proxy for long term and short term interest rates respectively) cbk atb average monthly 91 day treasury bill rates (measure of risk free rate) cbk nb: knbs: kenya national bureau of statistics monthly economic indicators reports, cbk: central bank of kenya. all data are available online from the two institutions websites, atb: average treasury bill, cs: credit spreads, cpi: consumer price index, kes: kenya shilling table 2: industry classification and description industry classification description number of listed firms* minimum** maximum*** a agriculture 6 6 8 b commercial and services 9 5 10 c banking 11 9 11 d insurance 6 2 6 e investment and services 5 2 5 f manufacturing and allied 10 7 8 g construction and allied 8 4 5 h energy and petroleum 5 3 5 i telecommunication and technology 1 1 2 j automobiles 3 3 5 *number of firms listed as of december 2015, **minimum number of firms in the portfolio during the period, ***maximum number of firms in the portfolio during the period under consideration muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017 345 or non-stationary, and if non-stationary to determine the order of integration. the presence of a unit root indicates that the data series is non-stationary. this study utilizes three common and widely used procedures to test for unit root namely the augmented dickey fuller (adf), phillips-perron (pp), and kwiatkowski-phillipsschmidt-shin (kpss) to test for unit roots in the time series. both the adf and the pp-test the null hypothesis (h0) that the data set being tested has a unit root. however, both procedures have again been criticized as having low power if the process is stationary but with a root close to the non-stationary boundary. kpss-tests the alternative hypothesis to adf and pp, that is, the data set is level stationary 1(0), around which the two earlier tests are criticized as being weak. kpss-tests whether we have a deterministic trend versus a stochastic trend, and thus offers a robust check for stationary. 4.3. study methodology 4.3.1. portfolio returns ratio analysis would have been a good approach to provide an insight into how the banking sector performance has fared compared to the other sectors of the economy. however, this approach is not feasible in this study given the difference in financial reporting requirements/regulations for the commercial banks, asset structure and composition of liabilities and nature of source of revenues. for instance, it would be practically misleading to compare asset based ratios for a commercial bank with those of a manufacturing enterprise given the differences in their asset structure. for a manufacturing entity, physical assets (machinery and equipment) constitute the largest investment in assets, while for commercial bank it would be loans advanced to customers and/ or investments in technology to improve operational efficiency. in this study, only a simple graphical analysis/presentation of the average before tax profits for each industry has been done to establish trends and demonstrate the perceived high profitability in the banking sector. this is because the reported high before tax profits has been the source of political and policy agitation to control interest rates in the banking industry. in order to compare stock average returns, monthly portfolios are constructed for all listed firms in every sector/industry as grouped by the nse assuming a buy and hold investment strategy. a simple value weighted average of the closing stock prices on the last trading day of each month is used to construct the portfolios. the closing price of the last day each stock was traded for every month is the opening price for the next period the stock is traded. for instance, if stock x is traded last on the 10th trading day of period t, and again on the 7th trading day of period t+1, then the closing price for period t is the stock price on the 10th trading day as well as opening price for period t+1 (7th trading day). similarly, if the stock is not traded in period t+1, that stock is not included in that period’s portfolio and the closing price on the 10th trading day at period t becomes the opening price on the first day the stock is traded in period t+2. portfolio excess returns are computed monthly for the entire period totaling 237 months. new listings in each sector are added to the portfolio based on the market price of their stocks at the end of the first trading month, with delisted or suspended firms being removed from the portfolio in the month of delisting. the monthly portfolio returns are computed as follows: [(p n )+(p n )+(p n )]-[(p n ) +(p n )+(p xt x yt y zt z xt-1 x yt-1 y zt-1 × × × × × ×× × × × × n )] [(p n )+(p n )+(p n )] z xt-1 x yt-1 y zt-1 z 100 where: pxt, pyt…pzt = are closing prices of stocks x, y and z at period t. pxt−1, pyt−1…pzt−1 = are closing prices of stocks x, y and z at period t-1. nx, ny…nz = number of listed shares for firms x, y and z. portfolio excess returns are then computed as follows: ri,t-rf,t where: ri,t and rf,t are returns of portfolio i at period t and rft the risk free rate (atb) respectively. a total of 10 portfolios are constructed for the following sectors: agriculture, commercial and services, banking, insurance, investment and services, manufacturing and allied, construction and allied, energy and petroleum, telecommunication and technology and automobiles. growth enterprise market is ignored in this study since it is fairly recent and lack long enough series to compare with other segments. the commercial banks portfolio excess return is then compared to the portfolio excess returns from other industries to determine if they outperform them on average over the period. 4.3.2. regression models-capm this study, being exploratory partly seeks to establish if the available data from the nse can explain the perceived higher profitability of the banking sector in kenya. possible problems that might arise are the few number of listed firms and problems of illiquidity that characterize many emerging markets. while the nse has a long history dating back to the mid 1940s, the market remains fairly small in the global stage, partly due to low growth of the kenyan economy over the past 50 years of post-colonial error. however, despite its comparative small size, the market has evolved with the evolutions in stock markets around the world, has kept the pace of technological advancement, best business practice and norms, and today is ranked among the top 5 best stock markets in africa. this implied efficiency offers the incentive to explore and test if the perceived superior performance of commercial banks has been priced in the market. first, we test the capm alphas by regressing monthly portfolio excess returns based on the following time series: ri,t-rf,t=αi+βi(rm,t-rf,t)+εi,t where ri,t-rf,t is the return of portfolio i in excess of the risk-free interest rate (the 1 month treasury bill rate) at time t; and rm,t-rf,t is the value -weighted market return of the nse 20 share index return (proxy for market return) minus the risk-free rate at time t. however, the ability of capm to explain stock return variability has been brought into question based on empirical evidence from the most advanced markets like the usa over the recent past. while muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017346 capm has been found to hold with data from 1926 to 1968 (black et al., 1972; fama and macbeth, 1973), it has been found not to hold with data from 1960s to 2000s (reinganum, 1981; lakonishok and shapiro, 1986; fama and french, 1993). if capm fails to hold in the most efficient markets, then it’s only fair to first test if it will hold in the less efficient emerging markets like that of kenya. borys (2007) using the fmb procedure tests if capm holds for the emerging markets of visegrad countries (hungary, poland, czech republic and the slovak republic). she finds that they could not reject the classical capm in hungary and slovakia because the constant terms were not statistically significant from zero, even though the slope coefficients for the excess market returns were also not significant. this implied that the local markets alone could not explain the variation in stock returns. however, for czech republic and poland they could reject capm since the terms were significantly different from zero, implying the presence of pricing errors in the model specification. 4.3.3. multifactor model given the possible limitations of the classical capm in the foregoing literature, this paper will also use the multi factor model to test if an all bank stock portfolio outperforms other market segment portfolios of the nse. in addition to the market premium, macroeconomic factors including cpi, broad ms, exr, short term interest rates and cs are added into the regression equation. from existing literature, macroeconomic factors including spreads between long and short term interest rates, expected and unexpected inflation, industrial productivity, credit risk spread between high and low grade bonds, term structure, country credit rating, market segmentation and momentum have been found to be priced in emerging markets (chen et al., 1986; erb et al., 1995;1996; harvey, 1995; de jong and de roon, 2001; borys, 2007; ericsson and karlsson, 2004). the regression equation is as follows: ri,t-rf,t= αi+βm(rm,t-rf,t)+β1dlncpit+β2dlnmst+β3dlnexrt+β4cs t+β5datbt+εi,t where: ri,t-rf,t = portfolio i excess return αi = constant βm(rm,t-rf,t) = market premium (market factor) β1dlncpit = first difference of the natural log of cpi β2dlnmst = first difference of the natural log of broad ms (ms2) β3dlnexrt = first difference of the natural log of exr β4cst = credit spread (weighted commercial bank rates interbank rates) β5datbt = average 91 day atb rates (short term interest rates) εi,t = error terms 5. main results and discussions 5.1. descriptive statistics this study set out to examine if banking industry outperforms other sectors of the economy at the nse market. the study utilizes time series data to regress the excess returns for 10 portfolios constructed for each sector. the descriptive statistics are presented in table 3. the mean for the market premium is −10.17% with a standard deviation of 9.36, a minimum of −34.86 and a maximum of 24.86. the average for inflation is 4.34%, a standard deviation of 0.45, a minimum of 3.57 and a maximum of 5.1%. ms has a mean of 13.3%, a standard deviation of 0.68, a minimum of 12.42 and a maximum of 14.62. the mean for exr is 4.33% with a standard deviation of 0.14, a minimum of 3.98 and a maximum of 4.66%. the cs has a mean of 9.12%, a standard deviation of 4.16, a minimum of −10.39 and a maximum of 17.45. short term interest rate has a mean of 10.49%, a standard deviation of 6.29, a minimum of 0.83 and a maximum of 27.15. finally, the nse 20 share index return has a mean of 0.31 with a standard deviation of 6.18, a minimum of −22.63 and a maximum of 32.52%. from the summary of the industry portfolio weighted returns, telecommunications and technology sector (industry i) has the highest average return at 2.12% followed by the investment and services sector (industry e). the banking sector (industry c) has a mean weighted return of 1.08 with the energy and petroleum sector (industry h) giving the lowest average return of −0.02%. on the return variability, investment and services has the largest standard deviation of 12.66% followed by automobiles sector (industry j). the banking sector has a standard deviation of 8.21 with commercial and services sector (industry b) showing the least variability in returns at 7.48%. however, for comparative analysis of the various sectors, we shall drop the telecommunication and technology sector due to short data series and the fact that the industry largely constitutes of one listed firm, safaricom kenya ltd., presumably the largest table 3: descriptive statistics summary statistics variable mean±sd minimum maximum observe market premium −10.17±9.36 −34.86 24.86 237 incpi 4.34±0.45 3.57 5.1 237 inms 13.3±0.68 12.42 14.62 237 inexr 4.33±0.14 3.98 4.66 237 cs 9.12±4.16 −10.39 17.45 237 atb 10.49±6.29 0.83 27.15 237 nse return 0.31±6.18 −22.63 32.52 237 industry weighted returns industry a 0.42±9.4 −41.16 62.04 237 industry b 0.44±7.48 −25.82 31.33 237 industry c 1.08±8.21 −24.98 37.39 237 industry d 0.98±9.59 −25.28 52.53 237 industry e 1.45±12.66 −43.01 76.98 237 industry f 1.28±7.77 −23.48 56.77 237 industry g 1±8.47 −21.37 33.88 237 industry h −0.02±9.49 −35.45 45.03 237 industry i 2.12±9.64 −30.65 28.85 103 industry j 0.39±10.08 −32.89 47.4 237 atb: average treasury bill, cs: credit spreads, cpi: consumer price index, sd: standard deviation muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017 347 and most profitable company in the eastern and central african region. this may preclude a fair comparison of the performance of the various sectors in the kenyan stock market. 5.2. unit root test results regression with non stationary time series data can result into spurious results. to check if the time series is stationary, three approaches including the adf, pp, and kpss procedures are conducted to test for unit roots in the data. adf and pp-test the null (h0) that the series in non stationary while the kpss-test the null (h0) that the series is stationary. if the estimated t-statistics (absolute values) are larger than the asymptotic critical values at the 1%, 5% or 10% confidence levels, then we reject the null, and accept the alternative hypothesis. the unit root tests are presented in table 4. from these tests, inflation, ms, exr and short term interest rates are assumed to have trends while market premium, cs and excess returns are random walks with no trends. the adf test fails to reject the null for ms, exr and short term interest rates but rejects the null for market premium, inflation and cs. it rejects the null at the first difference for ms, exr and short term interest rates and inflation. this implies market premium and cs are stationary at level 1(0) while ms, exr and short term interest rates have unit roots and are integrated at order 1(1). inflation has mixed results. the pp-test is theoretically a robust test of unit roots to adf. the test confirms the adf results except for inflation that it now finds non stationary at level but integrated of order 1(1). all the other variables are consistent with the adf tests under the pptest. finally, the kpss-test that the data set is level stationary 1(0), around which the two earlier tests are criticized as being weak. thus, it tests whether we have a deterministic trend versus a stochastic trend, and thus offers a robust check for stationary. the kpss-tests are consistent for all the variables except that it contradicts adf and pp for market premium and cs by rejecting the null at 1% and 10% confidence levels respectively. this could be explained by the fact that kpss assumes trend stationary by default while we assumed them as non-trending. to solve the unit root problem in the non-stationary data series, the first difference is used for these variables in the regression equations. 5.3. industry profitability analysis due to the difference in the asset structure and regulation requirements for the banking and other financial sectors, no attempt has been done to conduct ratio analysis which could have been a good indicator of the performance of the banking sector vis a vis other sectors of the economy. however, we compute the average before tax profits for each of the sectors for the period 1994:2014 from the published financial statements of the listed firms to ascertain the perceived above normal profits for the banking industry. industry i (telecommunication and technology) is dropped from this analysis as it constitutes only one company (safaricom kenya ltd). in addition, the industry has a fairly short data series with the only 2 firms in it (access kenya and safaricom kenya ltd.) first listing in june 2007 and june 2008 respectively, and access kenya delisting in may 2013. the results are presented in figure 2. from the trends evident on the graph, the banking industry (c) is dominant in terms of reported before tax profits for virtually the entire 21 year period. the gap with other industries particularly widens from 2007, increasing at an increasing rate to peak at an average of kes 10 billion (us$ 0.1 billion) in 2014, while all the other sectors remained stagnant or declined at below an average of kes 4 billion (us$ 0.04 billion). this clearly confirms the perceived above normal profitability of the banking industry in kenya in comparison to other sectors of the economy. 5.4. capm regression results with recent evidence on the failure of capm with data from the mid 1960’s for advanced markets, this paper first tests if it holds for the emerging market of kenya. technically, for capm to be said to hold, the constant from the regression equations should table 4: unit root test results unit root test for stationary variable adf-test pp-test kpss-test order of integration ho: variable is non stationary ho: variable is non stationary ho: variable is stationary market premium −8.128*** −8.245*** 1.9*** 1 (0) incpi −3.451** −2.801 2.33*** ∆incpi −4.946*** −9.448*** 0.0544 1 (1) inms −2.657 −1.251 5.63*** ∆inms −3.29* −17.277*** 0.137 1 (1) inexr −2.14 −2.028 1.88*** ∆inexr −4.851*** −11.842*** 0.0893 1 (1) cs −4.021*** −5.114*** 0.121* 1 (0) atb −1.853 −2.511 3.47*** ∆atb −5.001*** −11.28*** 0.0305 1 (1) asymptotic critical values 1% −3.999 −3.995 0.216 5% −3.433 −3.432 0.146 10% −3.133 −3.132 0.119 *** implies significant at 1% level, ** implies significant at 5% level, * implies significant at 10% level. ∆ represents first difference, atb: average treasury bill, cs: credit spreads, cpi: consumer price index, adf: augmented dickey fuller, pp: phillips-perron, kpss: kwiatkowski-phillips-schmidt-shin muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017348 not be significant from zero. if significant, it implies other factors other than the market premium might explain the variability in stock returns. the capm regression results are presented in table 5. the results for each of the 10 portfolios indicate the market premium β are all significant at the 1% degree confidence level. the banking industry has the highest β at 1.03 followed by telecommunications and technology industry with 1.018. third is the investment and services sector at 1.007, followed by insurance and energy and petroleum industries at 0.996. commercial and services and automobiles industries take the sixth and seventh position with 0.904 and 0.898 respectively. the others are construction and allied 0.858, manufacturing and allied 0.849 with agriculture having the least β at 0.823. the constant terms are insignificant for seven of the 10 portfolios with agriculture, banking and telecommunication and technology indicating significance at the 5% confidence levels. theoretically, these results imply capm could explain stock return variability for most of the sectors of the kenyan economy. implicitly therefore, we cannot reject the validity of capm for the emerging market of kenya. 5.5. multifactor model results while we may fail to entirely reject the validity of capm in the kenyan case, the significant constant terms for 3 of the 10 portfolios points to the possibility of other variables that could explain stock return variability. due to limitation of data that could allow us to perform the fama and french 3 factor model, we extent the regression model to factor in 5 macro variables (inflation, ms, exr, cs and short term interest rate) in addition to the market factor. these results are presented in table 6. the market factor βs from the multifactor model results indicate a marginal decline for all the portfolios and remain significant at the 1% degree confidence level. again, the banking sector β remains the highest at 1.023 but now followed by insurance industry at 1.007 as opposed to telecommunication and technology in the capm results. agriculture retains the lowest β at 0.816. not surprisingly, the macroeconomic variables are largely statistically insignificant across most of the portfolios. figure 2: industry profitability analysis table 6: multifactor model outputs multifactor model regression results industry a b c d e f g h i j market premium (β) 0.816*** (12.93) 0.907*** (21.16) 1.023*** (25.56) 1.007*** (16.88) 0.965*** (12.02) 0.852*** (17.91) 0.831*** (15.26) 0.986*** (18.44) 0.985*** (8.22) 0.870*** (13.83) incpi 27.776 (0.51) −0.875 (−0.84) −17.312 (−0.50) −12.427 (−0.24) 2.137 (0.03) −30.44 (−0.75) 54.951 (1.18) 0.01 (0.00) 154.415 (1.61) 167.53*** (3.10) inms2 53.699 (1.25) −58.08** (−1.99) −4.323 (−0.16) −38.152 (−0.94) 93.198* (1.71) −48.113 (−1.49) 9.28 (0.25) 48.256 (1.33) 118.945** (2.20) 64.755 (1.51) inexrate 7.25 (0.29) −23.954 (−1.40) 0.621 (0.04) −2.971 (−0.12) 26.081 (0.81) 3.182 (0.17) 47.259** (2.17) −7.388 (−0.35) −71.663** (−2.48) −23.11 (−0.92) atb 0.501 (1.22) −0.361 (−1.29) −0.079 (0.30) −0.151 (−0.39) −0.403 (−0.77) −0.706** (−2.28) −0.424 (−1.20) 0.388 (1.11) 0.213 (0.50) 0.355 (0.87) cs −0.015 (−0.10) 0.07 (0.68) 0.081 (0.85) −0.075 (−0.53) 0.258 (1.35) 0.022 (0.19) 0.156 (1.21) 0.022 (0.17) −0.038 (−0.19) 0.056 (0.38) r2 0.4445 0.6761 0.7530 0.5628 0.4334 0.6014 0.5395 0.6171 0.5684 0.501 adjusted r2 0.430 0.6676 0.7465 0.5513 0.4185 0.591 0.5275 0.6071 0.5414 0.488 ***means significant at 1% confidence level, ** means significant at 5% confidence level, * means significant at 10% confidence level, atb: avarage treasury bill, cs: credit spreads, cpi: consumer price index table 5: capm regression outputs capm regression results industry a b c d e f g h i j market premium (β) 0.823*** (13.55) 0.904*** (21.69) 1.030*** (26.85) 0.996*** (17.43) 1.007*** (12.9) 0.849*** (18.34) 0.858*** (15.99) 0.996*** (19.37) 1.018*** (10.08) 0.898*** (14.46) constant −1.687** −0.843 1.08** 0.636 1.212 −0.559 −0.752 −0.374 2.30** −0.96 r2 0.4387 0.6669 0.7541 0.5638 0.4147 0.5888 0.5212 0.6148 0.5013 0.471 adjusted r2 0.4363 0.6654 0.7531 0.5619 0.4122 0.587 0.5192 0.6132 0.4964 0.4687 *** means significant at 1% confidence level, ** means significant at 5% confidence level, capm: capital asset pricing model muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017 349 however, inflation has a positive and statistically significant effect for automobile industry and ms indicates a negative effect for commercial and services industry and a positive effect for both investment and services and telecommunication and technology industries. these effects are statistically significant at the 5% confidence level. exr indicates a positive and statistically significant effect for the construction and allied industry and a negative and statistically significant effect for the telecommunication and technology industry. short term interest rates only indicate a negative and statistically significant effect for the manufacturing and allied industry. while statistical significance is not necessarily an indicator of economic significance and neither is statistical insignificance an indicator of the absence of economic effects from the various macro variables, it would appear the macro variables indicate mixed effects for the various industries. since the focus of this study is to establish if there is empirical evidence that the banking sector outperforms other sectors in the kenya economy, we predict and graph the excess returns from the multifactor model regression results. for purpose of clarity, we plot the predicted values of the banking sector against predicted values of 2 other industries at a time. the results are presented in figure 3. the graphs clearly indicate that the banking portfolio predicted excess returns outperform all other sectors of the economy except for the insurance industry which seems to move together. this close movements with the insurance sector wouldn’t be surprising given both industries belong to the wider financial sector, and often both industries offer complementary products. for instance, from the early 2000s, the banking sector in kenya opened credit to salaried employees under unsecured loan facilities payable through a check-off system deductible to the employee by the employer. this credit facility has an insurance component that extends income benefits to the insurance industry. not surprisingly also, most banks in kenya have opened an insurance agency product under the brand name of “bancassurance.” these results suggest that the above normal profits (evidenced by the high average pre-tax profits) enjoyed by the banking sector in kenya eventually get priced in the stock market. this could also perhaps imply that the nse is at least in the semi strong form of market efficiency since the publicly available sentiments of high profitability of the banking sector seems to be reflected in the stock prices, assuming investor rationality and objectivity to make optimal decisions. 6. conclusion these study set out to establish if an all banking sector investment portfolio outperforms other sector investment portfolios at the nse market. the empirical evidence adduced in this study suggests that on average, the banking sector portfolio outperforms other figure 3: (a-d) visual comparative of portfolio predicted excess return dc ba muinde and karanja: kenya commercial banks are star performers: myth or truth? exploratory empirical evidence from nairobi securities exchange international journal of economics and financial issues | vol 7 • issue 1 • 2017350 sectors from the predicted excess returns. the pre-tax profitability analysis supports the perceived “above normal profits” for the banking sector within the kenyan economy. the predicted excess returns suggests this high profitability sentiments for the banking sector have indeed been priced in the stock market, and could imply that the nse market has characteristics of at least the semi-strong form of efficiency. portfolio regression results from capm seem to suggest that we cannot reject its validity in the emerging market of kenya. however, the data limitation of this study cannot be overlooked that could have allowed us to apply more recent empirical approaches like the now widely popular fama and french 3 factor model. references afroze, r. 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(1986), systematic risk, total risk, and size as determinants of stock market returns. journal of banking and finance, 10, 115-132. ndung’u, s.n., ngugi, r.w. (2000), banking sector interest rate spread in kenya. published by kenya institute of public policy research and analysis (kippra), discussion paper no. 5/2000. ojiambo, e. (2014), why the new interest regime in kenya should be treated with caution. article published by the star newspaper, july 25, 2014. reinganum, m. (1981), misspecification of capital asset pricing: empirical anomalies. journal of financial economics, 9, 19-46. samad, a., hassan, m.k. (1999), the performance of malaysian islamic bank during 1984-1997: an exploratory study. international journal of islamic financial services, 1(3), 1-14. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2022, 12(6), 75-85. international journal of economics and financial issues | vol 12 • issue 6 • 2022 75 macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach elizabeth baloi*, mbulaheni albert dagume department of economics, university of venda, thohoyandou, south africa. *email: elizabethlizabaloi@gmail.com received: 01 september 2022 accepted: 03 november 2022 doi: https://doi.org/10.32479/ijefi.13626 abstract priorities of developing countries include, obtaining sustained and positive economic growth. before this can be achieved, however, determinants of positive economic growth need to be identified so that policy makers can make right decisions when allocating funds. the aim of this study was to analyse macroeconomic determinants of economic growth in south africa for the period 1994-2016, using the cointegration approach. the study utilized both the augmented dickey fuller and the phillips perron unit root tests to ensure that all variables involved were stationary; after the tests, all the variables were found to be stationary at first difference i(1). the study then employed the johansen cointegration approach, which suggested that there is cointegration and a long-run relationship between real gdp per capita and the dependent variables. the vector autoregressive (var) was also estimated; results showed that the residuals were robust and well behaved. the vector error correction model proved existence of a short-run relationship among the variables and that physical capital and inflation have positive impact on economic growth; labour force, government expenditure and fdi have negative impact on economic growth in south africa. findings should help in understanding the macroeconomic determinants of economic growth in south africa. keywords: economic growth, real gdp per capita, johansen cointegration, south africa jel classifications: e52, e62, f43 1. introduction the transition from the apartheid era to a democracy in 1994 brought tremendous economic, social and political challenges to south africa. the challenge was not only in the transition of political power, but the country was also faced with challenges in improving social conditions which would impact significantly on people’s livelihoods and alleviate poverty. when the african national congress came into power, the government designed an initial expansionary policy-the reconstruction and development program (rdp)-that was aimed at improving the country’s economic and social standing. the rdp was aimed at improving people’s living standards by building houses, road construction, sewage, and water (anc, 1994). the growth, employment and redistribution program (gear) which was established in 1996, due to the rand crisis, was established to help reduce inflation and government deficits as well as improve the country’s economic growth (south african national treasury, 1996). when the new government (anc) came into power in 1994, the growth rates were sustainable, however between 1995 and 2004, south africa’s real economic growth rate averaged 3.1% (1.1% in terms of per capita). this was a significant improvement above the 0.8% average growth rate (–1.3% in terms of per capita) seen in the 10 years between 1985 and 1994. even though this was a muchneeded improvement, south africa’s growth performance was still somewhat low by international standards (du plessis and smit, 2007). the gdp growth rate for south africa was 2.74% between 1994 and 1998, and it grew to 3.19% and 4.8% between 1999 and 2003 and 2004 to 2008, respectively. it subsequently began to show a downward trend from 2009 to 2013; 2014 to 2018; and 2019 to 2021, with respective values of 1.91%, 1.21%, and –0.47. this journal is licensed under a creative commons attribution 4.0 international license baloi and dagume: macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach international journal of economics and financial issues | vol 12 • issue 6 • 202276 worrisome is the declining trend over the previous three periods. as a result, from 1994 to 2019 the overall gdp growth rate was 2.67%, and from 1994 to 2021 it was 2.42% (world bank, 2022). the country’s total manufacturing output decreased by 6.8% in the first quarter of 2009 as compared to the last quarter of 2008. there was also a huge decrease in mining production by 12% in the first quarter of 2009 ( (sarb , 2007-2009). the real per capita gdp of south africa’s economy improved from the negative growth rate of –2.9% encountered in 2009 to a positive growth rate of 1.6 in 2010. the economy expanded by a growth rate of 1.8 in 2011, however, the growth rate started to dwindle from 2012 to 2016 when the real gdp growth rate was 0.7% and –1.3%, respectively (world bank, 2017). poor economic growth rates experienced in south africa were mainly caused by depending on foreign investments that are unreliable, insufficient fixed capital and the inability of the state to initiate structural economic reform projects. theoretical and empirical literature have identified and analysed different factors that have a relationship with economic growth. hatmanu et al. (2020) proved that exchange rate has a positive relationship with economic growth; a relationship was also proven by recent studies conducted by hatoongo (2020) and mekonnen (2021) who discovered a positive relationship between exchange rate and economic growth. levine and renelt (1992) proved that capital has a relationship with economic growth; a relationship was also proven by recent studies conducted by zafar and zahid (2013) who discovered a positive correlation between physical capital and economic growth, contrary to pomi et al. (2021) who found that physical capital investment has a negative impact on economic growth in the short-run. solow (1956) determined that labour force is positively correlated with economic growth; this has also been proven by studies havi et al. (2013) and agdew (2019). according to uwakaeme (2022) together with the studies by chang and mendy (2012); babalola et al. (2019) and adam (2021), fdi is also one of the factors that affect economic growth. onifade et al. (2020) and barro (1991) also determined that government expenditure influences economic growth and agdew (2019) and antwi (2013) also confirmed that there is negative relationship between the two factors. fischer (1993) discovered that inflation rate has an impact on the growth rate of the country. ibrahim and morad (2020) and odo et al. (2016) found a positive relationship between economic growth and inflation, while sendi et al. (2022); ismaila and imoughele (2015) and thaddeus et al. (2021) found a negative relationship. it is, therefore, necessary to undertake the current study because the earlier empirical findings discussed above were not conclusive. 2. literature review the macroeconomic determinants of economic growth have been investigated by different studies, which include mukit (2020) who analyzed the macroeconomic determinants impact of gross domestic in bangladesh using the cointegration and the vector autoregressive model (var) test annual secondary data for the period 1982-2019. the results obtained concluded that the series was present, and that the regression model was significant. based on the results, exports had a positive but not significant relationship to gdp. imports, on the other hand, had an insignificant and negative relationship to gdp. inflation is a significant and positive relationship to gdp. using multiple regression analysis model, hasan et al. (2022) investigated the impact of macroeconomic factors to gross domestic product in bangladesh. the study found that import and export are positively associated with gdp, while inflation rate is a negatively associated factor pourshahabi et al. (2011) who made use of the panel data approach in conducting research on the relationship between fdi, economic freedom and economic growth in oecd countries from 1997 to 2007. they developed two models-one was used to find out which factors have positive impact on fdi, and the other to find the factors that contribute to economic growth in oecd countries. when researching on factors that stimulate fdi, the results were that human capital, the market size, inflation, and political stability are positively related to fdi showing a huge impact. economic freedom has been found to have a positive impact on fdi, however, the impact is not significant. when they investigated on the growth factors using the second model, they found that fdi, government expenditure, economic freedom, human capital, and public investment are positively related to economic growth, while inflation and external debt are negatively related. pooled mean group (pmg) estimator on the panel data was used by oyebowale and algarhi (2020) to explore the macroeconomic factors influencing economic growth across 21 african economies. the study’s findings showed that, at levels of 1%, 5%, and 1% respectively, the growth rates of exports, government spending, and gross capital formation have statistically significant positive long-run relationships on economic growth, whereas broad money is not statistically significant across the countries. the dumitrescu-hurlin granger causality test indicates that there is a two-way causal relationship between economic growth in african countries and increases in gross capital formation, but not between general money growth, export growth, or increases in government spending. however, the evidence for heterogeneous causality varies amongst the nations (lesotho, algeria, camerron, and benin). jacob et al. (2021) analyzed the impact of key macroeconomic factors on economic growth of bangladesh from the period of 1990 to 2020 using auto regressive distributed lag (ardl) model. the result of the ardl model shows that inflation rate, exchange rate and trade openness have positive and significant impact on bangladesh economic growth while foreign direct investment has insignificant impact on economic growth of bangladesh. antwi et al. (2013) used the error correction model to study the effect of macroeconomic factors on economic growth in ghana; their study was based on the years 1980 to 2010. they found that physical capital, foreign direct investment, government expenditure and inflation had an impact on economic growth. they also made recommendations that for economic growth to be balanced in the country, the government should make positive changes on the budget balance and that foreign aid should be directed to public capital-intensive projects. ullah and rauf (2013) studied the effect of macroeconomic factors on economic growth. their investigation was based on certain selected asian countries, from the year 1990 to 2010. they discovered that foreign direct investment and savings rate have a positive relationship baloi and dagume: macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach international journal of economics and financial issues | vol 12 • issue 6 • 2022 77 with economic growth; the exports have a negative impact on economic growth while labour force, and tax rate have no effect on economic growth. sharma et al. (2018) assessed the impact of foreign aid, government consumption expenditure, foreign direct investment, trade openness, exchange rate, human capital development, and inflation on economic growth in india by using yearly data and autoregressive distributed lag (ardl) model for the period of 46 years, that is, from 1971 to 2016. the outcomes of the study find that in the long run, foreign aid, the government’s final consumption expenditure and foreign direct investment have a positive and significant impact on economic growth, whereas economic growth has been negatively influenced by exchange rate and human capital development. contrary to the long run, foreign aid has a negative and significant impact on economic growth in the short run. the short-run outcomes show that all the selected macroeconomic determinants have either negative or positive influence on economic growth. smith (2021) used annual data from 1987 to 2019 to investigate the causal relationship between inflation and economic growth in bangladesh. vector error correction model and vector auto-regression model concluded that inflation negatively affects the gdp in the short run and a positive association in the long run. granger causality test was also performed to calculate the bidirectional relationship and revealed that inflation does not granger cause gdp growth. however, it also shows that gdp growth does not cause granger to cause inflation as well. in bangladesh, chowdhury et al. (2019) investigated the impact of macroeconomic variables on economic growth using correlation and multiple regression analysis for the period of 1987-2015.in correlation analysis, it was found that gdp has positive correlation with all the variables except int. furthermore, it was observed that the independent variables explained 75.60% of the variability of gdp and the relationship is also found statistically significant at 95% confidence level. therefore, this study has concluded that macroeconomic variables have significant effect on the economic growth of bangladesh. urgaia (2019) investigated determinants of economic growth in east africa using econometric panel data and wavelet time scaling analysis. the results of the study indicate that financial sector development (fsd), human capital resources (hcr) and foreign direct investment (fdi) have positively significant effects on the gdp growth. the var short term transmission mechanism-channels reveal that there is an important contribution of hcr to the development of physical capital stock through gross national income gni. the gni has also a positive impact on the accumulation of physical stock via hcr. zafar and zahid (2013) used the multiple regression framework to study macroeconomic variables which affect economic growth. in their study, they used data from 1959 to 1960 and 1996 to 1997. their collected data showed that human capital, in the form of education, is a necessary determinant for economic growth. they also found that openness to trade and increase in physical capital have a positive effect on economic growth, while external debt and budget deficit have a negative impact. they concluded that a country should try to rely more on domestic savings and resources in increasing growth in the country. bhaskara-rao and hassan (2011) conducted a study on the macroeconomic variables which determined economic growth in bangladesh from 1970 to 2007 using the autoregressive distribution lag method. the results of the study show that foreign direct investment, money supply and openness to trade have a positive impact on economic growth, however, government expenditure and inflation had a negative relationship with economic growth. in nigeria, babalola et al. (2019) examined the impact of foreign direct investment, foreign aid and foreign trade on economic growth using autoregressive distributed lag (ardl) model bounds test and error correction model (ecm) and the annual time series data for the period 1980-2015. the evidence from the study indicates that the variables are cointegrated. it also reveals that foreign direct investment, foreign aid and foreign trade have positive long-run impacts on economic growth in nigeria. in the short-run, only foreign aid has positive impact on economic growth. the granger causality results provide evidence of both short-run and long-run causality running from foreign aid and foreign trade to economic growth. fiaz and khurshid (2022) assessed the impact of macroeconomic variables on pakistan’s economic growth using the markov regime switching (ms) model and monthly data for 1981-2020. each regime’s mean and variance are highly significant and show a high growth regime with high volatility and a low growth regime with low volatility. furthermore, the results show that inflation, interest rate, and trade openness negatively impact while real effective exchange rates positively affect development in both regimes. the negative effect of interest rate, exchange rate, inflation, and trade openness become more pronounced in low growth regimes. chang and mendy (2012) examined how openness to trade affects economic growth in thirty-six african countries, from 1980 to 2009. they applied a panel fixed-effects regression model to examine the relationship. the results were that openness to trade, foreign aid, exports, and imports have a significant positive impact on economic growth, but national savings rate, foreign direct investment, and domestic savings affect economic growth negatively. with regards to foreign aid, the study showed that it affects countries differently because it has had a positive impact on economic growth in middle and north african countries while it has had a negative impact on west and east african countries. ibrahim and morad (2020) investigated the determinants of economic growth in a sample of six countries from the middle east and north africa region. two of which are from high-income countries, bahrain and saudi arabia, and two of the highest middle-income countries, jordan and lebanon, and two from lower middle income, egypt and morocco using panel data for the period 2001-2017. the results showed that the employment rate, foreign direct investment, gross national income, government expenditure, and inflation were among the most important in determining economic growth in the region during that period. all of them had a significant and positive impact on economic growth, except for the rate of growth in gross national income, which negatively affected the rate of economic growth. the pairwise granger causality showed that unidirectional causality is running from foreign direct investment gross domestic product growth rates, from both gross capital formation growth rates and imports growth rates to employment ratio. unidirectional causality also runs from both of exports growth rates, gross baloi and dagume: macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach international journal of economics and financial issues | vol 12 • issue 6 • 202278 capital formation growth rates, imports growth rates to foreign direct investment as a percent of gross domestic product. there is also unidirectional causality from foreign direct investment and imports to unemployment. thaddeus et al. (2021) investigated the impact of macroeconomic determinants on economic growth in cameroon using the autoregressive distributed lag (ardl) bounds model and time series data from 1970 to 2018. the results show that government expenditure, trade openness, gross capital formation and exchange rate positively and significantly impact economic growth in the short and long runs, while human capital development, foreign aid, money supply, inflation and foreign direct investment negatively and significantly affected economic growth in the short and long-runs. anyanwu (2014) studied macroeconomic variables which have an impact on economic growth in africa and china. for the african countries, cross country panel data was used from the years 1996 to 2010, while for china, time series data were used for the period, 1984-2010. from the results for the african countries, it was determined that domestic investment, net official aid, secondary school enrolment, metal price index, government effectiveness and urban population have a positive impact on economic growth. the results for china were that domestic investment and trade openness have a positive impact on economic growth, while official development aid, population growth, inflation, credit to the private sector, agricultural material price, and oil price have a negative impact on economic growth. sakyi and egyir (2017) examined the effects of trade and fdi on economic growth in africa. their focus was on testing the bhagwati hypothesis by researching if trade exports and fdi have an impact on economic growth in 45 african countries between 1990 and 1994. to conduct this test, they estimated an augmented endogenous growth model using the generalised method of momentum estimation method. they concluded that exports and fdi have a positive impact on economic growth in africa. acikgoz and mert (2014) collected data on the impact of investment on real gdp per capita in three asian countries, namely, hong kong, taiwan, and republic of korea. the autoregressive distributed lag and the fully modified ordinary least squares method were used for the period 1951-2007 for taiwan, 1953-2007 for republic of korea, and 1960-2007 for hong kong. from the results, it was concluded that in the three countries investment has a positive impact on economic growth. prochniak (2011) employed the ordinary least squares estimation to analyse the determinants of economic growth in ten eastern and central european countries from the year 1993 to 2009. the results showed that the investment rate, human capital, population, economic freedom, communication, technology, and the financial sector have a positive effect on economic growth. it also showed that interest rate, public debt, budget deficit and inflation have a negative relationship with economic growth. fetahi-vehapi et al. (2015) analysed how openness to trade affects economic growth in ten south eastern european countries, from the years 1996 to 2012 using a fixed-effects panel regression estimation method. the outcome demonstrated that human capital, trade openness, fdi and capital formation affect economic growth, positively while population size has a negative impact. assefa and mollick (2017) used the static and dynamic panel data methods to study the effects of financial development in fifteen african countries for the period, 1995 to 2010. the results of the study were that flows of portfolio capital and foreign direct investment have a positive impact on the growth of all the fifteen countries. salahuddin and gow (2016) researched on how financial development, internet usage and openness to trade had affected economic growth in south africa from the year 1991 to 2013. the structural unit root test and johansen and ardl cointegration were employed to analyse the relationship. the ardl results revealed that financial development and internet usage are positively correlated with economic growth in south africa and the granger causality test also proved the same point. tafirenyika (2017) employed the autoregressive distributed lag model to analyse the impact of fdi and economic growth in south africa in the long run, then used the vecm to analyse the short run dynamics and lastly applied the granger causality to examine the direction of causality. the results were that fdi, and exports have a positive relationship with economic growth, however the vecm granger causality test showed that there was a unidirectional causality between economic growth and fdi but a bidirectional causality between economic growth and exports. ismaila and imoughele (2015) investigated the impact of macroeconomic determinants on economic growth in nigeria using the adf test for the unit root test and the johansen cointegration test to analyse the short and long-run impact on economic growth in data from 1986 to 2012. from the results, it was concluded that foreign direct investment, capital formation and government expenditure are factors that affect growth positively, while inflation was proved to have a negative effect on the country’s growth. havi et al. (2013) made use of the johansen method of cointegration and the vector error correction method to examine the macroeconomic determinants of economic growth in ghana from 1970 to 2011. physical capital and fdi affect economic growth positively while labour, consumer price index, military rule, foreign aid, and government expenditure affect economic growth negatively were proven to effect economic growth. parviz (2011) examined factors of economic growth to determine if there were any time series support for fdi-led growth hypothesis in canada for a period of 33 (33) years. the beach-mackinnon technique was used to estimate the model for the study. findings were that factor productivity and domestic investment have a positive impact on economic growth and that there was no time-series support for fdi-led growth hypothesis in canada. fedderke and simkins (2012) analysed the economic growth of the south african economy by making use of the modern growth theory to structure a historical record. they concluded that financial deepening as well as the monetary and fiscal policies have a positive impact on economic growth. they concluded that political instability has affected economic growth negatively and that the country also needed to increase its human capital and technological progress. doku (2017) investigated the quantitative effect and direction of chinese foreign direct investment (fdi) on economic growth in africa using a sample of 20 african countries from 2003 to 2012; data was obtained from the united nations conference on trade and development and the world bank. the study used panel least squares regression, specifically the fixed-effect model to examine these effects in africa. the study also applied the granger causality baloi and dagume: macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach international journal of economics and financial issues | vol 12 • issue 6 • 2022 79 test to examine whether a causal relationship exists between economic growth and china’s fdi in africa. the study established that a 1 per cent increase in china’s fdi stock in africa significantly increases africa’s gross domestic product (gdp) growth by 0.607 per cent, all things being equal. furthermore, the study found that a causal link exists between gdp growth in africa, china’s fdi and the nature of causality is unidirectional. esso (2010) established a relationship between fdi and economic growth in 10 african countries, including south africa; the time series data used in the study was for the period 1970-2007. the results showed that there is a long run relationship in south africa, kenya, liberia, cote d’ivoire, angola, and senegal and the causality relationship in which fdi caused economic growth was found in angola, kenya, and cote d’ivoire. mazenda (2014) applied the johansen cointegration test and the vecm to study the effect of fdi on economic growth in south africa, during the period 1980-2010 with the outcome that fdi was significant only in the short run, but not in the long run. the results also revealed that fdi crowded out domestic investment although domestic investment has a positive impact on economic growth. ndambiri et al. (2012) examined the determinants of economic growth in sub-saharan africa. they applied a panel data approach and the gmm for the period 19822000. the outcomes were that physical capital formation exports and human capital formation have a significant positive impact on economic growth while government expenditure, nominal discount rate and foreign aid affect economic growth negatively. kumo (2012) investigated the impact of infrastructure investment and employment on economic growth in south africa for the period 1960-2009. the bivariate vector auto regression and vecm were employed to analyse this relationship and the granger causality test was also applied to test for causation between the variables of interest. the outcome showed that there exists both short and longrun relationship between the variables and that economic growth and infrastructure investment have bidirectional causality. chirwa and odhiambo (2016) in their study on the long run determinants of economic growth in south africa made use of the ardl bounds test approach for the period 1970-2013. the collected data from the study showed that investment, human capital, and international trade have a positive impact on economic growth and that population, government expenditure and inflation affect economic growth negatively. odo et al. (2016) employed the causality approach to analyse the long run effect of public expenditure on economic growth in south africa for the period 1980-2014; they also applied the cointegration test and vecm to estimate the variables. the results were that there is a positive relationship between inflation and economic growth while there is a negative relationship between government expenditure and economic growth. 3. methodology 3.1. sample period and variable description secondary data were collected to conduct this study as they are more reliable, enhanced, easy to access and convenient to use. the time series data on real gdp per capita, government expenditure, inflation, labour force, physical capital and foreign direct investment were obtained from world development indicators (2017). annual data series from 1994 to 2016 were used to analyse the relationship between real per capita gdp growth and the selected determinants for this study. the sampling size of the study was 23. the study period (i.e., 1994-2016) was chosen due to the availability of data. the following factors were taken into consideration when selecting the period of the study: democracy, political stability, economic liberisation and availability of the data needed to conduct the study. this study used the augmented dickey fuller test developed by dickey (1979) to test for stationarity of both exogenous and endogenous variables of the model. it was necessary to perform the test because it helped to prevent spurious regression which has a high possibility of occurring in an estimation of a regression line where the data follows a time trend. the equation required by the adf test is: ∆ ∆y b b y b t a y z h b h bt t i p t t= + + + + = >− = −∑0 1 1 2 1 1 1 0 1 1 1 0 0; : ; : (1) yt represents the vector for the time series variables included in the study t represents the time δ represents the first difference operator the study also applied the phillips-perron (pp) unit root test developed by phillips (1988). the error term in a pp test has to be statistically independent and should contain a constant variance (asteriou, 2011). the test was however modified in order to correct standard errors and also for it to be in line with its proposed assumptions. the advantage of this test is that, it can be applied to a wide number of problems. the johansen cointegration estimation method was employed to study the data and determine the factors which have a relationship with economic growth in south africa. for this study, real gdp per capita is the dependent variable and the explanatory variables are-foreign direct investment, inflation, government expenditure, physical capital, and labour force. the time series properties of all the variables included in this study were explored to eliminate trends that could lead to spurious parameter estimates. the johansen maximum likelihood cointegration test was used to determine long-term relationships between the variables. the error correction model integrates short-run dynamics in the following long-run growth function: ∆ ∆ ∆ ∆rpcgdpg b rpcgdp c k d lt i p i t i i p i t i i p i t=∝ + + + = − = − = −∑ ∑ ∑1 1 2 0 3 0 4 ii i p i t i i p i t i i p i t i t ie fdi f ge g i ecm+ + + + + = − = − = − −∑ ∑ ∑ 0 5 0 6 0 7 9 ∆ ∆∆ λ ε 22t (2) ecmt-i represents the error correction model in which the residuals are found from equation 2. the ecm is the result that shows the amount of disequilibrium being corrected. it also shows how stable baloi and dagume: macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach international journal of economics and financial issues | vol 12 • issue 6 • 202280 a relationship is in the long run through its statistical significance (bannerjee, 1998). 3.2. model specification many theories of economic growth, such as-classical, endogenous, keynesian, and neoclassical have tried to explain the variables which affect or determine economic growth in different countries. these variables include-the savings rate, technological progress, human capital, foreign direct investment, physical capital, natural resources, government expenditure, geographical areas, openness to trade and other variables; some of these are included in this study. real gdp per capita is a function of foreign direct investment, inflation, government expenditure, labour force and physical capital. following the approach employed by lucas (1988) as adopted by havi et al., (2013), south africa’s economic growth (gdp) function is mathematically expressed as follows: rpcgdp= f (k, l, fdi, ge, i) (3) thus, the function of economic growth becomes, rpcgdp k l fdi ge i t= + + + + + +β β β β β β ε0 1 2 3 4 5 (4) where: rpcgdp represents real gdp per capita growth rate, k represents physical capital measured as gross fixed capital formation as a % of gdp, l represents labour force measured as a % of total population aged 15–64, fdi represents foreign direct investment measured as foreign direct investment as a % of gdp, ge represents government expenditure measured as government expenditure as % of gdp, i represents inflation measured by consumer price index, εt represents the error term which is assumed to be normally and independently distributed with zero mean and constant variance. β1, β2, β3, β4 and β5 are the partial elasticity of real gdp per capita. 4. analysis and interpretation unit root theory is the cornerstone to the methodology used for testing the stationarity or nonstationarity of a time series (abdullah, 2022). the augmented dickey fuller (adf) and phillips-perron (pp) tests were used to test the stationarity of each variable, and the results are shown in tables 1 and 2, respectively. because the null hypothesis of non-stationarity is rejected at the first difference, the adf unit root test findings demonstrate that the variables are integrated of the first order i(1). the phillipsperron (pp) test results shown in table 2, which demonstrate that the variables are integrated of the first order i(1) because the null hypothesis of non-stationarity is rejected at first difference, also confirm the findings of the augmented dickey fuller test. 4.1. the vector autoregressive (var) lag order selection criteria table 3 above presents the lag lengths selected by different information criteria. akaike, schwarz and hannan-quinn information criteria are used for the selection of the optimal number of lags in the study. the optimal lag length is important because var and vecm are sensitive to the lag length. the akaike information criterion (aic) measures the quality of the models on a particular set of data. the aic measures the data for all the models individually, also provides the model selection. the schwarz criterion (sc) which is also known as bayesian information criterion (bic) is based on a finite set of models and it prefers the model with the lowest bic. the var determines the optimal lag length for the johansen cointegration test based on the aic. from table 3, the optimal lag length recommended for this study, by the akaike information criterion (aic) is 1, where aic (13.47291) is less than sc (15.55581). 4.2. the johansen cointegration approach tables 4 and 5 show trace and maximum-eigen results. the johansen’s maximum likelihood approach was employed to test for cointegration. this cointegration test analyses the short and long-run relationship between the variables of the study. all the variables have to be integrated of the same order, in this case all the variables differenced and were found to be integrated of order i(1). in table 4, the trace test is conducted to determine and analyse if there is a cointegration relationship between rpcgdp, k, l, fdi, ge and i in south africa. the results of the cointegration test showed that there are 6 cointegrating equations in the trace statistic, therefore this study rejects the null hypothesis that states that there is no cointegration. the null hypothesis is rejected at 179.63 because it is >95.75 at 5%, therefore, the results prove the existence of short and long-run relationship. in table 5, the max-eigen test is conducted to determine and analyse if there is a cointegration relationship between rpcgdp, k, l, fdi, ge and i in south africa. the max-eigen test results showed that there is one cointegrating equation, therefore the null hypothesis that states that there is no cointegration, is rejected. table 1: augmented dickey fuller test (adf) variable none constant constant and trend conclusion level 1st difference level 1st difference level 1st difference rpcgdp –1.972646* –5.229486** –2.472180 –5.114421** –2.599054 –5.105937** i (1) k 0.434500 –3.248848** –1.826032 –3.164758** –2.599054 –3.080972* i (1) l 2.679504 –1.722327* 0.136149 –2.799892* –6.180242** –3.883182** i (1) fdi –0.560861 –6.131947** –4.821864** –5.923021** –4.671096** –5.823688** i (1) ge 0.454114 –4.064745** –1.593213 –3.990784** –2.155552 –4.236270** i (1) i –0.790683 –5.002743** –3.922508** –4.884500** –3.911116** –4.906650** i (1) *significant at 10% **significant at 5% baloi and dagume: macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach international journal of economics and financial issues | vol 12 • issue 6 • 2022 81 the null hypothesis is rejected at 88.32 because it is >40.07 at 5% level, therefore, the results prove the existence of short and long-run relationship. 4.3. the vector error correction model (vecm) the existence of cointegration means that vecm can be used. vecm techniques allow long run and short run impacts of variables to establish the macroeconomic determinants of economic growth. using the results from the cointegration test, the vecm was specified. thew vecm results are presented in tables 6 and 7, below. real per capita gdp, as denoted by rpcgp, represents the economic growth rate proxy and it is normalised to unity as an endogenous variable of the regression model. table 6 shows the long-run and normalised coefficients for the model generated from the cointegrating vector. the equation is as follows: rpcgdp k l fdi ge − + + + − 0 570649 0 664542 0 128570 2 014495 0 172637 . . . . . ii (5) the long run equation is derived to make rpcgdp the endogenous variable. the derived equation is as follows: rpcgdp k l fdi ge = − − − + 0 570649 0 664542 0 128570 2 014495 0 172637 . . . . . ii (6) equation 6 shows that k and i have a positive impact on economic growth while l, fdi and ge have a negative impact. according to the results, capital, as denoted by k, has a positive impact on economic growth. the coefficient of k is 0.570649, therefore a 1% increase in capital will result in a 0.570649% increase in economic growth (rpcgdp). the result of this relationship is inconsistent with the results gathered by zafar and zahid (2013), who found that physical capital has a positive impact on economic growth. the results for labour force, as denoted by l, showed that labour force has a negative impact on economic growth in south africa. the coefficient of l suggests that a 1% increase in l will result in a 0.664542 decrease in economic growth (rpcgdp). the results of this relationship are similar to those found by havi et al. (2013), who also found a negative relationship between labour force and economic growth. foreign direct investment, as represented by fdi, has a negative impact on economic growth. according to the results, a 1% increase in foreign direct investment will lead to a 0.0128570% increase in economic growth as denoted by rpcgdp. the negative relationship outcome is similar to the results found by mazenda (2014). the results also show that government expenditure as denoted by ge has a negative impact on economic growth. given the coefficient of ge as –2.014495, this means that a 1% increase in government expenditure will result in 2.014495 decrease in economic growth (rpcpgdp). the negative relationship between government expenditure and economic growth is consistent with the relationship found by table 4: trace test hypothesized no. of ce (s) eigenvalue trace statistic 0.05 critical value prob.** none* 0.985087 179.6302 95.75366 0.0000 at most 1* 0.790242 91.31447 69.81889 0.0004 at most 2* 0.736793 58.51662 47.85613 0.0037 at most 3* 0.492238 30.48552 29.79707 0.0416 at most 4* 0.399781 16.25296 15.49471 0.0384 at most 5* 0.231635 5.533303 3.841466 0.0187 *standard error in parentheses. trace test indicates 6 cointegrating eqn (s) at the 0.05 level, *denotes rejection of the hypothesis at the 0.05 level, **mackinnon-haug-michelis (1999) p-values table 2: phillips perron test (pp) variable none constant constant and trend conclusion level 1st difference level 1st difference level 1st difference rpcgdp –1.972646** –5.229486** –2.472180 –5.114421** –2.599059 –5.105937** i (1) k 0.336498 –3.248848** –1.624609 –3.164758** –2.019675 –3.080972* i (1) l 7.353923 –1.758323* 0.611921 –3.077182** –1.551508 –3.367552* i (1) fdi –2.365456** –7.467049** –4.821864 –7.271314** –4.671096** –7.170641** i (1) ge 0.150963 –5.469948** –1.705722 –5.514651** –3.191243 –5.245024** i (1) i –1.097281 –4.422419** –3.140049** –4.316816** –3.112827 –4.234469** i (1) *significant at 10% **significant at 5% table 3: the vector autoregressive lag order selection criteria lag logl lr fpe aic sc hq 0 –215.8774 na 23.19158 20.17068 20.46823 2024077 1 –106.2020 149.5574 0.032809* 13.47291* 15.55581* 13.96358* *indicates lag order selected by the criterion table 5: max-eigen test hypothesized no. of ce (s) eigenvalue max-eigen statistic 0.05 critical value prob.** none* 0.985087 88.31572 40.07757 0.0000 at most 1 0.790242 32.79785 33.87687 0.0668 at most 2* 0.736793 28.03108 27.58434 0.0438 at most 3 0.492238 14.23258 21.13162 0.3463 at most 4 0.399781 10.71966 14.26460 0.1688 at most 5* 0.231635 5.533303 3.841466 0.0187 max-eigenvalue test indicates 1 cointegrating eqn (s) at the 0.05 level. *denotes rejection of the hypothesis at the 0.05 level. **mackinnon-haug-michelis (1999) p-values table 6: normalized cointegrating equation normalised cointegrating coefficients rpcgdp k l fdi ge i 1 –0.570649 0.664542 0.128570 2.014495 –0.172637 (0.07711) (0.13479) (0.10160) (0.14442) (0.06405) *standard error in parentheses baloi and dagume: macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach international journal of economics and financial issues | vol 12 • issue 6 • 202282 odo and chukwu (2016). according to these results, consumer price index or inflation, as denoted by i, has a positive effect on economic growth and since the coefficient of i is 0.172637, it means that a 1% increase in consumer price index will lead to a 0.0172637 increase in economic growth (rpcgdp). the positive relationship between inflation and economic growth is similar to the results found by odo and chukwu (2016). the vector error correction model estimates the short-run effects of the coefficients of the model. the short run effect is denoted by the speed of adjustment and for the model is-0.060414 as shown in table 7 below and it is significant at 5%. the system must converge to equilibrium, therefore the negative sign of the speed of adjustment is justified. the results suggest that 6.0414% disequilibria in economic growth of previous years are corrected in the current year. the significance of the results also confirms that there is a long-run equilibrium relationship between all the variables and economic growth. r squared indicates that 78.2687% of the total variations in south africa’s economic growth are explained by the independent variables of the model, therefore, the model represents a good measure of fit. 4.4. diagnostic test diagnostic tests were carried out to test for normality, serial correlation autocorrelation and heteroskedasticity in the model. the diagnostic test results presented in table 8 are at 5% level of significance. the first diagnostic test is the jarque-bera test for normality; the results show that the residuals of the regression are normally distributed as the p-value of 0.363220 is >0.05 (5%) level of significance. the breusch-godfrey test is for serial correlation; the results show that there is no serial correlation because the p = 0.9961 is >5% level of significance. the autocorrelation test was performed by ljung-box q; the results show that there is no autocorrelation in the model because the p = 0.881 is >5% level of significance. the breusch pagan godfrey is one of the tests used to test for heteroskedasticity; the result for this test proved that there is no heteroskedasticity in the model because the p = 0.3883 is >5% level of significance. the harvey test was also used to test for heteroskedasticity; the test shows that there is no heteroskedasticity because the p = 0.4961 is >5% level of significance. the glejser test was also used to test for heteroskedasticity; the test indicates that there is no heteroskedasticity in the model because the p = 0.4060 is >5% level of significance. the arch test also indicated that there is no heteroskedasticity in the model because the p = 0.9074 was >5% level of significance. the white test was also conducted to check for heteroskedasticity in the model; the results indicate that there is no heteroskedasticity since the p = 0.2940 is >5% level of significance. 4.5. stability test figure 1 above show that the model is stable throughout the period of the study because the cumulative sums move within the 5% critical lines, and this suggests that the model is stable and suitable for analysis. the cumulative sums line in figure 2 above moves within the 5% critical lines; this indicates that the model is stable and suitable to be used for analysis. table 9 shows the ramsey reset test results. the ramsey reset test is performed to check the stability of the model as to whether the model is correctly specified or not. the results table 8: diagnostic test results test null hypothesis test statistic p-values conclusion jarque-bera residuals are normally distributed 2.025493 0.363220 do not reject ho pv>los at 5% the residuals are normally distributed breusch-godfrey no serial correlation 2.39e-05 0.9961 do not reject ho pv>los at 5% there is no serial correlation ljung-box q no autocorrelation 5.1514 0.881 do not reject ho pv>los at 5% there is no autocorrelation breusch pagan godfrey no heteroskedasticity 5.231607 0.3883 do not reject ho pv>los at 5% there is no heteroskedasticity harvey no heteroskedasticity 4.380257 0.4961 do not reject ho pv>los at 5% there is no heteroskedasticity glejser no heteroskedasticity 5.081915 0.4060 do not reject ho pv>los at 5% there is no heteroskedasticity arch no heteroskedasticity 0.013527 0.9074 do not reject ho pv>los at 5% there is no heteroskedasticity white no heteroskedasticity 22.89448 0.2940 do not reject ho pv>los at 5% there is no heteroskedasticity *l.o.s means “level of significance”, *pv means “probability value” table 7: error correction results variables d (rpcgdp) d (k) d (l) d (fdi) d (ge) d (i) ect coefficients –0.060414 0.176340 0.023856 0.012134 –0.165482 0.522481 standard errors 0.13835 0.13635 0.01109 0.22887 0.06782 0.25345 t-statistics –0.43667 1.29326 2.15030 0.05302 –2.43991 2.06148 r2=0.782687 baloi and dagume: macroeconomic determinants of economic growth in south africa (1994-2016): cointegration approach international journal of economics and financial issues | vol 12 • issue 6 • 2022 83 indicate that the model is correctly specified, therefore the null hypothesis is not rejected because the probability value of 0.6036 is >5% level of significance. 5. conclusion and policy recommendations this study was aimed at determining and analysing macroeconomic determinants of economic growth in south africa for the period 1994-2016. the study focused on five determinants of economic growth-physical capital, labour force, foreign direct investment, government expenditure and inflation. the study analysed how these factors affect real gdp per capita growth rate in south africa. the rationale for conducting this study was because south africa has been experiencing low economic growth rates, hence, the need to find out how economic growth rate can be stimulated. the study made use of both adf unit root test and phillips-peron unit root test for stationarity of all the variables. the variables were not stationary at level, they were found to be stationary at first difference. the johansen cointegration test was applied to check for cointegration amongst the variables. the results showed that there is cointegration and proved that a long-run relationship exists among the variables. following the cointegration results, the vecm was applied for short and long-run estimates. this data indicated that physical capital and inflation have a positive relationship with economic growth, while labour force, fdi and government expenditure have a negative relationship with economic growth. the diagnostic tests showed that the model is stable and correctly specified, also that there is no serial correlation, auto correlation nor heteroskedasticity. the study found that physical capital has a positive impact on economic growth; this implies that investments in the construction of roads and buildings, machinery, plants, and other physical capital stock should be a priority for the government. physical capital investment increases production in a country, which has a positive impact on economic growth. labour force was found to have a negative impact on economic growth; this may be caused by high increasing population growth rate or a mismatch between jobs available and skills acquired. educational institutions and companies, therefore, should educate people on the skills that are mostly needed, in the workplace, to reduce the mismatch between skills acquired and jobs available. the results also showed that fdi has a negative impact on economic growth. the government, therefore, should depend less on foreign direct investment as this leads to volatility of investment funds; they should rather encourage domestic savings through taxation, compulsory lending to the government and a finance-credit mechanism to also collect savings from different sources. government expenditure was found to have a negative relationship with economic growth; hence, the government should try not to exceed its expenditure budget at any given period. the government should also try to spend on expenses that will have higher benefits for the economy, such as agriculture, health, physical capital, and education. according to the results, inflation has a positive impact on economic growth and even though the inflation rate has been higher than the 6% target, it has always been below 10% with the exception of 2008 (world bank, 2017). inflation rates lower than 10% affect economic growth positively, therefore the government should keep inflation at a lower rate so that the commercial banks’ lending rate can be lower, consequently, attract more investors. references abdullah, l.t. 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(2013), macroeconomic determinants of economic growth in pakistan. the pakistan development review, 37(2), 125-148. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(3), 265-269. international journal of economics and financial issues | vol 7 • issue 3 • 2017 265 the importance of green supply chain management and its role in marketing management moujan shahriarpour1*, akbar alam tabriz2 1master of industrial management, kar university, ghazvin branch, ghazvin, iran, 2industrial management, faculty of management and accounting, shahid beheshit university, tehran, iran. *email: mozhan_obtry@yahoo.com abstract supply chain is a network of organizations that in connection with those upstream to downstream are involved in the processes and activities and they produce value to the final customer in the goods and provided services. this subject on its own figured new challenges out for them. the chain management is offering a complex of methods used in integrating the providers, producers, barns and stores in order to produce and offer the intended products on a specified amount, in a certain time and in a specified place. this caused the whole chain expenses be decreased, in addition the customers’ needs be met with high service level. in this study, first of all the history of the emergence of supply chain and continue to components and elements and how the evolution of the green supply chain management will be discussed. the aim of this issues and literature related to green supply chain and understand its importance in the production of goods for all researchers, manufacturers and marketing. keywords: supply chain, green supply chain management, marketing jel classifications: m31, r41 1. introduction in the 1980s with the increasing diversity in desired patterns of customers, manufacturing organizations became increasingly interested in rising the flexibility in production line, the production improvement and the exiting processes and the new productions’ development in order to satisfy the customers’ needs. this subject in its turn figured new challenges out for them. in the 1990s, parallel to improvements in production capabilities, industry executives realized that the materials and services from different suppliers have considerable influence on the organization’s capacity to deal with customers’ requirements that this matter in turn raised the organization’s focus on sourcing strategies and supply resource bases. moreover, managers found that just producing a qualitative product is not enough. in fact, providing products with high quality standards and cost to their customers created new challenges. in such circumstances as a result of these changes, organizations found that these changes in long-term is not enough for their organization management. they must manage their organization’s network of all the factories and companiesdirectly or indirectlyprovided, also, the companies’ network related to the customer’s product delivery and aftersales services were involved. with such an approach, “supply chain” and “supply chain management” came into existence (ghazanfari et al., 2001). however, the term supply chain management was introduced and was considered later by a group of consultants for the first time in 1980 (chen and paularja, 2004). different definitions of supply chain have been presented, that some of them are listed below: supply chain is a network of organizations that related to those upstream to downstream are involved in the processes and activities and they produce value to the final customer in the goods and provided services (christopher, 1998; lysons, 2000). shahriarpour and tabriz: the importance of green supply chain management and its role in marketing management international journal of economics and financial issues | vol 7 • issue 3 • 2017266 supply chain includes all activities associated with the flow and transformation of goods from the stage of raw material (mining) to delivery to the final customer, as well as the information flows associated with them (ghazanfari et al., 2001). supply chain is a set of attitudes and thoughts that its task is to create synergies in the company’s performance (zhang, 2003). the supply chain is a network of steps and activities that its task is developing new products, supplying the raw materials from the sellers, transporting the materials between the units, manufacturing and distributing the finished products to the customers and finally after-sales services (mabert and vakataramanan, 1998). supply chain is a network of infrastructures that includes the material purchase task, transformation of these materials to the intermediate and final products and distribution of these final products to the customers and this is in both manufacturing and servicing organizations (kiahara, 2003). the supply chain is something more than physical goods move from beginning to the end of the chain and consists of two other flows: 1. information flow between the components: the communication between the components to run and maintain the supply chain is necessary. 2. the final flow that it’s the primary goal of every companies in the supply chain. as it can be seen that the physical goods flow is from the beginning to the end of the chain and the data and financial flow is vice versa. supply chain management is asset of procedures that is used the effective integration of suppliers, barns and stores in order to produce and offer the intended products on a specified amount, in a certain time and in a specified place. this causes the whole chain expenses be decreased, in addition the customers’ needs will be met with high service level (mir and seyed, 2003). in general supply chain management is a set of attitudes that is used to integrate the suppliers’, manufacturers’ and barns’ performance so that goods are produced and distributed at proper sizes, in the right place at the right time in order to decrease the costs throughout the system, despite the fact that service needs are provided (simchi et al., 2000). 2. supply chain components 2.1. upstream supply chain this includes primary providers that each of their suppliers can have other suppliers. in this case the supply chain will be longer. the main activities in this part are the purchase and transportation. 2.2. internal supply chain this section includes all the activities that an organization does on the inputs from the upstream supply chain from when the materials are entered to the final product and are become ready to be distributed outside of the organization. the main activities of this part include material handling, inventory management, manufacturing and quality control. 2.3. downstream supply chain all activities related to the products’ transportation and distribution to the final customers’ are taken in this chain. this part includes distributors, retailers and the final customers. it should be mentioned that each customer can have his/her own customers which in this case the supply chain will be longer. the main activities of this supply section are packaging, storage and transportation. 2.4. supply chain management goals the main goals of supply chain management include the emphasis on making the customers’ demands come true effectively, the profitability of the supply chain, and also the secondary objectives of supply chain management that include creating the ability to develop new products, minimizing the amount of time that a product passes through the supply chain and arrives the final customer and moreover maximizing the supply chain flexibility at responding the changes in customers’ needs (mir and seyed, 2003). 3. the supply chain models the most important supply chain models include. 3.1. the production-distribution model, lee and kim the main activity in the supply chain is the production planning and distribution (lee and kim, 2000). there are 2 distinct models: the production models and the distribution models that in production models-the distribution of these models are joined together and it’s considered as a production-distribution model in the supply chain. these models are relevant in operation and closely linked to each other. in this model, the first production model factory produces n different products that are used in m different products at the second production model factory. the distribution model includes stored buffers of all product types in which all the manufactured products are temporarily stored and the source of the demand are the intermediate barns that store a variety of products and the retailers. products are stored in a unique amount of buffers to both the barns and the retailers and directly transferred from the barns to the retailers in order to satisfy the demands. 3.2. chandra and fisher model this model is a harmonic multi-period planning in production and distribution in which several products that are produced over time in a factory are considered. a vehicle loads them in a factory then distribute them to some of the retailers. the demand for each retailer is specified. shahriarpour and tabriz: the importance of green supply chain management and its role in marketing management international journal of economics and financial issues | vol 7 • issue 3 • 2017 267 the matter of production and distribution scheduling is to minimize the total cost at the launch of production, distribution and inventory (chandra and marshal, 2003). 3.3. arntzen, brown, harrison and trafnon model arntzen and his colleagues present a model as global supply chain model that the coordinated production network, distribution and purchase in equipment digital company are studied. the presented model by them includes a type of supply chain that consists of products, technologies, customers, suppliers, multiple production and distribution centers that are spread over several countries (arntzen et al., 1995). 3.4. pike and cohen model pike and cohen, by providing an integrated model of production/ distribution of probability kind, try to reduce the supply chain expenses (mir and seyed, 2003). several products which are produced with independent and probable demands in a factory will be stored in a final products barn and then are sent to a retailer to meet the customers’ needs. the final products’ barn sends a batch production request to the factory when there is a reduction of product supply and reaching the reorder point. 3.5. zhou, cheng and heva model zhou et al. have tried for industries with continuous processes in order to optimize the entire supply chain from the purchase of raw materials to distribution by providing a model of goal programming. there are 4 goals in their model which are: 1. economic goal that is optimizing profits of entire chain and it will be obtained from differences of chain costs and contains the cost of purchasing, energy sales, management, transportation, stock, salaries, depreciation and taxes. 2. social purpose that is satisfying the needs of customers. 3. goal that relates to resource which includes 3 sub goals: • minimizing the consumption of raw materials • minimizing energy consumption • maximize the capacity of production, distribution and warehouses centers. 4. goal that relates to environment and it includes waste minimization of production, and distribution and discover progression for turning them to usable raw materials or energy. 4. porter supply chain and marketing supply chain concept has become common by michael porter’s book that its name is “competitive advantage: creating and maintaining superior performance” in 1985. organization goal is favorably optimizing each factor of supply chain in the analysis of different factors such as inland transportation (raw material supply, control and check, timely delivery) exterritorial transportation (the formation of order, transportation). marketing and sales (product development, pricing, sales promotion, distribution) services (on-site and off-site, spare parts, customer care) organizations are not only aware of their abilities but they look at competitors capabilities. porter had considered distinction between main activities and support activities. main activities are directly related to goods delivery, or services delivery these activities are including. inland transport, operations, exterritorial transportation, marketing, sales and service and support activities to improve the efficiency of main activities. these activities are determining infrastructure, human resources management, technology development and supplying (malekakhlagh and forouzanfar, 2014). 5. supply chain role in marketing 1. supply chain reflects organizational capabilities to carry out effective marketing activities. 2. it is used to assess the cost. 3. it can be evaluated in comparison with the supply chain competitors. 4. target market can affect condition of supply chain. 5. the decisions made by organization outside sources depends on supply chain weaknesses. 6. improves strategic decision making and cooperation for entering in new markets or access to special abilities to meet consumer needs. 7. supply chain, enables value-added analysis from the perspective of customers (doroudchi and nikmehr, 2007). 6. green supply chain management with increasing the concerns about environment in the last decade, should also consider environmental pollutants alongside the development of industry and in scm operational process. all solution of this issue are better to be compound into a comprehensive supply chain procedure (fallah and mohajeri, 2014). supply chain management is an important factor and it is directly linked to productivity and competitive position. making green the supply chain is a new concept. according this concept buyer will use his buying power to demand better environmental performance than superior supplier at supply chain this means that buyer (which is mostly a big firm) it has facilitator’s role for suppliers (this supplier are usually small and medium-sized companies) and helps them in turning to an environmentally friendly organizations. 7. making green supply chain making green the supply chain is the process of taking into account environmental criteria or environmental considerations in organizational purchasing decisions and long-term relationships with suppliers, making green the supply chain is greatly depends on organization nature. making green the supply chain activities are usually divided into two categories: shahriarpour and tabriz: the importance of green supply chain management and its role in marketing management international journal of economics and financial issues | vol 7 • issue 3 • 2017268 1. those cause to improve coordination with suppliers in the field of environmental efforts to facilitate the development of greener and more environmentally friendly products. 2. demands of improving the environmental performance of suppliers such as getting certification of iso 14000 or achieving a performance standard. the major differences between these two types of activities are that the firs one is focusing on supplier role in helping customer (with product design and solving environmental problems of customers) and the second one focuses on internal performance of supplier in combination with customer demand (to reduce risk or cost by using better environmental management supply chain). 8. the benefits of green supply chain at the individual level, it cause to certain competitive advantages such as lower prices, greener products, and better integration with suppliers and at the gsc national level it can create markets for green products and it can cause to better adoption of supplier with environmental issues. making green the supply chain can cause to improve the company’s competitive position by reducing costs. for industrial firms at their private section with lower profit margins, supply chain costs can improve their market situation. making green the supply chain can also make new market for companies. a case study shows that governments of taiwan, indonesia, the united states and canada have plans to buy eco products. at national level, green supply chain are also important for government to achieve international competition at their industrial sector of the country. while economics are seeking for solving sustainability challenges, the main issue is in the maintenance of market situation which is the ability of a nation’s industry in designing and production of green products that minimizes demanding for resources (ansari et al., 2014). 9. evolution process from supply chain management to green supply chain management scm complexity revolves around three crucial factors which are: 1. products 2. suppliers 3. raw materials. due to the global green projects, new methods have been emerged to take methods and standards for analyzing sustainable development at pioneer companies of developed countries. these ways are usually focusing on 3 aspects of a company that are: 1. product design 2. manufacturing process 3. the organization itself. 10. necessity of green supply chain making green the supply chain will create a good opportunity for those who are worried about sustainable consumption issues and environmental business operations. companies should reconsider about their product design and production techniques (to make products more environmentally whether during production or consuming time). some author claim that products should be recycled and reused after their end of life (as a strategy to reduce demand of raw materials, and solving problems related to the problem of lesions) this change has many applications for companies and organization’s long-term success depends on its ability to manage and coordinate relationships with suppliers and above all to making green its supply chain. at macro view, it is important to pay attention to green issues even as a mechanism for increasing the ability to design green products or as a means to create markets for eco-green products. making green the supply chain requires a series of new entries and it create an opportunity for company in return to invest for designing and production of greener products and to eliminate sustainability requirements, it’s not only for consumer goods but also inputs from suppliers it is causing them to get involved in to creation of green markets (mir and seyed, 2003). 11. conclusion in the 1990s, parallel to improving production capabilities, industrial executives realized that materials and services that are received from different suppliers has significant impact on increasing organization capacity in order to dealing with customer requirements. this in turn had a great impact on organizational focuses on supply base and sourcing strategies, managers have also found that simply producing a qualitative product is not enough. supply chain includes all related tasks, the flow and converting products from the stage of raw material (extraction) to delivering to end consumer and also data flow that are related to them. generally supply chain management to minimize costs at all over the system while supply services requirements are being supported, is a collection of opinions that are used for efficient integration of suppliers, manufacturers and warehouses in a way that products in suitable size, in suitable place and in suitable time will be produced and distributed. the main objectives of supply chain management include emphasis on effectively satisfying the customer demands, profitability of supply chain and also secondary objectives of supply chain management include creating the ability of developing new products, maximizing supply chain flexibility in responding to changes that arise at customer requirements. supply chain reflects organizational capabilities to carry out effective marketing activities. decision making to have strategy and cooperation for entering in new markets or achieving to special abilities, will improve supplying consumer needs. making green the supply chain is the process of taking into account the environmental criteria or environmental considerations in organizational purchasing decisions and long-term relationships with suppliers. the value of making green supply chain largely depend on the nature of organization. making green the supply chain creates a great opportunity for those are worried about shahriarpour and tabriz: the importance of green supply chain management and its role in marketing management international journal of economics and financial issues | vol 7 • issue 3 • 2017 269 sustainable consumption and environmental business operations issues. references ansari, i., sadeghi, m., mohammad, r. (2014), identify and explain the relationships and dynamics of green supply chain management approach to modeling structural interpretation. journal of scientific and research studies industrial management, 12(35), 14-21. arntzen, b.c., brown, g.g., harrison, t.p., trufton, l.l. (1995), global supply chain management and digital equipment coordination. interfaces, 25, 69-93. chandra, p.k., marshal, l.f. (2003), coordination of production and distribution planning. canada: faculty of management, mc gill university. chen, i.j., paularja, a. (2004), towards a theory of supply chain management, the constructs and measurement end. journal of operations management, 22, 119-150. christopher, m. (1998), logistics and supply chain management: strategies for reducing cost and improving services. 2nd ed. londen: financial times, prentice hall. doroudchi, m., nikmehr, n. (2007), the study importance of it in supply chain management. the first international conference on supply chain management and information systems. strategic management society of iran. fallah, m., mohajeri, a. (2014), the first series. the translation of green supply chain management. tehran: publishing of ettehad. ghazanfari, m., riazi, a., kazemi, m. (2001), supply chain management. strategy no. 117, november, 2001. kiahara, t. (2003), multi agent based supply chain modeling with dynamic environment. international journal of production economics, 85, 263-269. lee, y.h., kim, s.h. (2000), optimal production distribution planning in supply chain management using a hybrid simulation analytic approach. in: proceeding of the 2000 winder simulation conference, department of industrial engineering, hunyung university. lysons, k. (2000), purchasing and supply chain management. 5th ed. britain: prentice hall. mabert, v.a., vakataramanan, m.a. (1998), special research focus on supply chain linkage: challenges for design and management in 21st century. decision sciences, 23(3), 537-552. malekakhlagh, e., forouzanfar, e. (2014), modern marketing. new delhi: publishing speedroud. mir, g., seyed, h. (2003), designed mathematical model of tire industry supply chain, phd thesis. tarbiat modarres university. simchi-levi, d., kaminsky, p., simchi-levi, e. (2000), designing and managing the supply chain: concepts and case studies. singapore: mc-graw-hill international edition. zhang, q., vonderembse, m.a., lim, j.s. (2003), manufacturing flexibility: defining and analyzing relationships among competence, capability, and customer satisfaction, journal of operations management, 21(2), 173-191. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(2), 607-616. international journal of economics and financial issues | vol 6 • issue 2 • 2016 607 the political economy of financial regulation policies following the global crisis hale balseven* department of public finance, faculty of economics and administrative science, akdeniz university, antalya, turkey. *email: halebalseven@akdeniz.edu.tr abstract this paper analyses the efficiency of financial regulation reforms that are being supported in a variety of theoretical approaches after the 2007/2008 global crisis. the main challenges that prevent the efficiency of the reforms are; (i) maintaining the basel approach that is argued to have led to the financial crisis, (ii) its limited content, (iii) its lack of global and national financial infrastructure, (iv) not being designed in a framework that comprises the macro policies. due to the reasons mentioned above, this paper argues that the regulation policy can neither fulfill its stability role nor its distributive role and that in this way, it restructures forthcoming crisis, not the financial sector. in order to prevent crises, a critical approach is required on the mode of regulation of the economy and a reorganization of capitalism is necessary on a larger scale. keywords: government policy and regulation, financial crises, crisis management jel classifications: g18, g01, h12 1. introduction the 2007/2008 global crisis has indicated a big decline in the world economy with regards to many economic indicators such as economic growth, the increase of unemployment and public debts. while growth rates were 4% and 2.6% for developed countries before the global crisis in the year 2007, these ratios have fallen respectively to −2.2% and −3.8% (unctad, 2013. p. 2). while the unemployment rate was lower than 5% in the unites states of america (usa) in the year 2007, it has reach its peak level with 10% at the end of the year 2009 and could only fall back to 7.6% by mid-2013. as to the european union, the unemployment rate that was 7.2% in the year 2009 reached 11% in the year 2013 (unctad, 2013. p. 11). the bailout policies of states devoted to private financial institutions have increased the monetary base as well as the debt burden of states. the results of these policies might be observed in the financial statements of central banks. between august 2007 which marks the beginning of the crisis and the end of 2012, the financial statement of the federal reserve bank of the usa grew by 221% while the financial statement of the european central bank grew by 241% (unctad, 2013. p. 113). during the post-crisis period, regulations concerning the financial system have become a current issue since the global crisis, which had led to the related economic problems, had derived from the financial sector to a large extent. although the tools and methods used were differing, regulations had been supported by a large academia, in order to prevent a similar situation in the future (caprio, 2013; daripa et al., 2013; epstein, 2010; baker, 2010; davis and karim, 2010; wade, 2009; persaud, 2008). financial regulation means the establishment of institutions and rules concerning financial markets by public authorities, with the purpose of orienting sources in the direction of certain objectives, due to the regulatory function of state. together with globalization, nowadays the related institutions and rules are being established under the financial governance structure of international governance institutions such as the international monetary fund (imf) the world bank (wb), the world trade organization (wto) and the financial stability board (fsb), besides national states. thus, financial regulations shall be examined within their financial governance structure. this situation requires comprehensive political transformations on national as well as global levels. balseven: the political economy of financial regulation policies following the global crisis international journal of economics and financial issues | vol 6 • issue 2 • 2016608 although the necessity to strengthen the financial system with financial regulations is being accepted by a large academia after the global crisis, studies shall be conducted to understand how much progress has been made in this field, what have been the impacts of these practices on the financial sector since the crisis, what shall be the characteristics of financial regulations to prevent the repetition of similar crises? in order to answer these questions, the development of theoretical approaches on financial regulation has first been addressed in this paper. then, policy implementation topics during the period following the global crisis have been examined. when the variety of financial market institutions and instruments is considered, financial regulation policies have to be addressed on a comprehensive scale. during the post-crisis period, academicians and policy makers have started to focus on a large discussion which also comprises the basel standards and policy proposals have come to the agenda in this field. this paper does not address in detail all the regulation proposals and their theoretical basis. in accordance with the objective of the paper, particular importance has been attached to the implemented regulation policies and their efficiency as well as their impacts on the financial sector. the practices in the usa and england have been basically explained, while a limited focus has been given to the differences in policy implementations among countries, in order to keep the dimensions of the paper at a certain level. 2. financial regulations in the historical and theoretical framework as a practice of the interventionist role of the state in the economy after the second world war, financial regulations have been widely used, the capital controls being in the first place. however, in the 1970s the monetarist approach has been accepted as the effective economic theory and in this respect, the role of the state has been defined as just providing the continuity of the system and strengthening competitive markets (friedman, 1988). in this framework, the decrease of state interventions in financial markets have been brought to the agenda with financial liberalization policies and this process led to the gradual elimination of financial regulations. the theory of practices aimed at eliminating financial regulations is based on the financial repression analysis. the analysis argues that financial markets and financial market structures play important roles in economic growth and development. increasing the interest rates to their balance level with financial liberalization would orientate the savings from non-productive actives to the banking sector and make it possible to use them in more productive fields. according to this theory, during this process the increasing savings provide a more efficient use of sources for investment purposes. furthermore, the liberalization of credit markets which were being held under pressure would enable the development of financial markets and the diversification of market instruments. a financial deepening to be realized in this way and the monetarization of the economy would ensure the economic growth and the development of the financial system (mckinnon, 1973). after the crises experienced in the 1990s, new-keynesians have started to bring the first comprehensive criticisms on the financial liberalization theory. according to these theoreticians, crises might be explained with fundamental market failures of the system, not with market disruptions and deficiencies defended by liberal economists. according to stiglitz, financial markets are commonly defined with market failures. according to this approach, markets are encompassed with uncertainty, lack of information and risks and therefore the efficient markets hypothesis1 of the neo-classical theory which suggests that the existing information are reflected on the prices is not valid (stiglitz, 1985). as to stiglitz, this market failure is due to the fact that the social risk is not equal to the private risk in these markets. in other words, the market cannot price efficiently the private risk. in this case, if the market is left to its own devices, it would accumulate more risks than it is socially effective. according to stiglitz, market participants that focus much on short time periods and tend to a large extent towards the way other market participants would act can be cited as examples to those situations which are an indicator of market irrationality. as to stiglitz, the systemic risk that emerges as a result of financial decisions made under the influence of these speculative structures and the blockage this risk causes are the most important justifications of interventions such as taxes or regulations aimed at capital flows (stiglitz, 1998). besides stability, the keynesian approach also focuses on the income distribution impacts of financial regulation. although the market ensures the efficient resource allocation that is possible under the ideal conditions, the income distribution ensured by the market might not be efficient. therefore, according to stiglitz “one of the most important objectives of state interventions to financial markets is to restore misallocations” (stiglitz and uy, 1996. p. 250). following the global crisis, it might be observed that a consensus has been reached on the recognition of a market failure in the financial sector which necessitates the state intervention, although its degree might vary from one country to another. however, as pointed out by picciotto (2009), the spreading of formal regulation has a national focus but these regulations have been developed as an international process through regulators and experts that develop the principles and standards. at the same time, some of these rules have been developed by international governance institutions such as the imf, the wb, the wto and the fsb. thus, the crisis has opened a new door for many researchers into the analysis of the objectives, functions and contradictions of these institutions and their economic governance rules. these rules and institutions are commonly related with politics and power relations. especially, the old discussion on power relations in finance, which dates back to kindleberger (1988) has become even more vital in today’s world where money and trade get globalized increasingly. in this framework, it has been argued that the failure of the financial governance system in regulating the power of the financial sector has been another characteristic of the financial crisis. the arbitrage power of big banks, investment institutions and hedge funds, 1 the efficient market hypothesis assumes that financial markets would continually establish equilibrium asset prices based on the available information concerning the main economic indicators. balseven: the political economy of financial regulation policies following the global crisis international journal of economics and financial issues | vol 6 • issue 2 • 2016 609 necessitates that these enterprises undertake an extreme risk on the existing liquidity (dimsky, 2010). these risks are the risks of each economy and even more, the risks of the global system. the approaches that are based on this framework argue that the reason of the financial crisis is not just a financial market failure. according to these approaches, failure is at the centre of the economic mechanism. the state has implemented free market policies and transferred its auditing and regulation power to the banking lobby and organized business environments. transferring the regulative function of the state to these groups-which are denominated as the predictor class by galbraith has led to the uncontrolled growth of financial derivatives, tax heavens, investment strategies (carry trade) which benefit from the regulative arbitrage and the interest rate difference which is used in the foreign exchange (fx) market (galbraith, 2009). another approach which has become prominent with its crisis theories during the post-global crisis period is the marxist approach. this approach analyses the nature of the capitalist system, which is prone to crises, and the role of the state in this system. it brings up to the agenda a perspective suggesting that the global crisis is not just a regulation crisis, but that it is the global crisis of the capitalist system (bonefeld and holloway, 1995). according to this approach, the capital has to be re-allocated continuously to productive investments in order to maintain its level and widen. the widening of the capital is the descriptive phase of the global accumulation phase, during which the capital is in search of new areas in order to realize the surplus value or the profit (sawaya, 2010). if the capital cannot find ways to continue its valuation process in the real production area, fictive valuation mechanisms shall be created. at this phase, the role of the state in reshaping capitalist social relations as a whole becomes prominent. in this sense; “a regular intervention of state managers, the establishment of international regimes and institutions” (burnham, 2001) gain importance. consequently, according to this approach, approaches that focus on the circularity of the financial system that is targeted by the speculation or regulation policy based on imperfect knowledge have to rely on the criticism of the capitalist system. 3. financial regulation reforms the fact that the model implemented in the world starting from the 1970s with the gradual deregulation of markets has commonly led to crises in developing country groups has been attributed to the inadequacy of institutions in the related countries and their failures in policy implementation. on the other hand, it has been commonly argued that the reason of the 2007/2008 global crisis experienced in the developed economies where these problems are assumed as non-existing has arisen from formal regulation policies that are based on the basel model. since 130 years, this model has caused a bank panic in western countries for the first time. the theoretical framework and practices on which this approach is based are to a large extent, the different forms of micro-prudential regulations that lean on the efficient market hypothesis. however, during the 2007/2008 crisis, it has been observed that even though financial agents act in accordance with the micro-prudential approach, they cannot guarantee the stability of the system as a whole (baker, 2010). the global crisis has established an increasing consensus on the fact that the regulations related to the auditing and monitoring of each bank based on basel model are necessary but not sufficient for financial stability at the micro level (davis and karim, 2010) and macro-prudential regulations have been brought to the agenda. macro-prudential instruments are designed according to the risk contribution each institution makes at a certain time at the system-scale or according to how to total risk evolves in time (borio, 2009). instruments of the first type include instruments such as capital requirements, insurance premiums. instruments of the second type concern the establishment of counter-cyclical capital buffers for banks and financial institutions. they have for objective to bring a restriction on extreme risk taking and herding. they are devoted to decrease the immanent circularity of the financial system. following the global crisis, the basel committee on banking supervision has put into practice a higher capital requirements (increasing the quality and level of capital) and leverage ratio (constraining leverage) in the framework of basel iii (table 1). also, the committee has put into practice some rules having for objective to strengthen the liquidity supports (mitigate of systemic risk) of financial institutions that are active at the international scale. to this end, it has brought two instruments to measure the liquidity risk (the liquidity coverage ratio and the net stable funding ratio). especially, net stable funding ratio would encourage banks to use long-term sources which are more stable than short term funding instruments (saidenberg, 2011). a macro prudential element of the basel iii capital framework is the requirement that in good times, banks should build up buffers – a capital conservation buffer and a countercyclical buffer that can be drawn down in periods of stress (the bank for international settlements [bis], 2011. p. 112). the global crisis has contributed to the inclusion of swap and derivative markets to the regulation basin in the usa for the first time. with new regulations in the framework of the consumer protection act, swap dealers or swap market participants have become subject to new regulations and reporting requirements. this law has also included over the counter derivatives within the regulative framework. in order to resolve the insufficiency of auditing in financial markets following the crisis, some regulations have been made in order to improve the financial infrastructure. broad reforms on the financial infrastructure have been realized in the uk. following the global crisis, the uk has been one of the countries that was at the centre of criticisms concerning the inadequacies and failures of the financial stability authority (fsa) which is its own financial monitoring and auditing institution. the fsa has been abolished since it was being criticized for not being able to prevent the credit inflation and the boom that followed it and the risky transactions of banks. instead, two regulative authorities have been established. these institutions are the financial conduct authority (fca) which balseven: the political economy of financial regulation policies following the global crisis international journal of economics and financial issues | vol 6 • issue 2 • 2016610 has been established in april 2013 as an independent board and the prudential regulation authority (pra) that would function as a department of the central bank. the fca is responsible for protecting the investor, improving market integration and encouraging efficient competition. the pra is principally responsible for monitoring financial service companies (banks, insurance companies, big investment companies) and ensuring the stability of the english financial system. pra is composed of the financial policy committee (fpc) and the special resolution unit (sru). the fpc, which has been established in the year 2014, has for main objective to define, monitor and decrease the systemic risk. it has two powers; giving orders and recommendations to the pra and fca for establishing the macroprudential instruments. these instruments are the counter-cyclical capital buffers, sectoral capital requirements, the time-varying leverage ratios. on the other hand, the sru is a special resolution regime that has been brought for bankrupt banks with the banking law in the year 2009 (dariels and thornton, 2015). the sru has brought to the system a safety net that might decrease the costs that financial institution bankrupts would impose on the public sector. the interventions made by the states in the bankrupt of important financial institutions during the global crisis have resulted in big losses for tax payers. as in the uk, it is expected that an efficient authority (the resolution authority) might prevent these losses within the dispute resolution regime. thanks to these regulations, the central bank has acquired more control on the functioning of the financial system in england. furthermore, together with the new institutions, the authority responsible for the auditing of the financial service sector has been clearly defined (bank of england, 2009). 4. evaluation of financial regulation reforms 4.1. basic principles of financial regulations as seen in global crisis, intense competition among mega-banks forced bank management into extending leveraged activities, through financial innovation and the use of off-balance sheet trades leading to continuous expansion of available credit. especially, financial institutions in the usa and uk developed strategies so as to increase their profits by carrying out high leveraged financial transaction. provided the financial sources through securitization and financial derivatives are excluded from balance sheet, the firms’ leverage ratio will not reflect the truth (uzun and yıldıran, 2013). however, basel iii leverage ratio of 3% of non-weighted assets is widely seen as very weak constraint on bank risk seeking. furthermore, the leverage ratio is consigned to being a mere monitoring benchmark rather than as a frontline regulatory requirement (avgouleas and cullen, 2014). at the same time, the approach based on basel standards has been frequently criticized due to its complexity. according to caprio table 1: financial regulations on financial sector financial sector regulation theoretical base policy actor banks prudential regulation microprudential market failures moral hazard, too big to fail, incomplete contracts, information frictions, co-ordinations problem, failure of risk management basel i (capital ratios) and basel ii (capital requirement) basel iii (higher capital requirement: the minimum requirement of common equity increases from 2% to 4.5% of risk-weighted assets. leverage ratio: non-risk-based leverage ratio. likidity supervisory standard: a lcr and a net stable funding ratio) macroprudential regulation regime systemic risks capital conservation buffer (at 2.5% of common equity) countercyclical buffer (at 0-2.5% of common equity) investment banks, insurance companies, hedge fuds, money market funds markets failures markets capital flows otc markets swaps and derivatives capital controls improve transpareny monitor over-the-counter and swaps boom-boost cycle information failures speculative motive bis consumer protection act (us) financial infrastructure fsb fca versus pra (fpc, sru) resolution authority fpc financial research office coordination systemic risks information failures global level uk capital buffers, capital requirements, time varying leverage ratios (uk) collecting data on financial system, consumer protection act (us) esa systemic risks european financial markets (eu) sources: author. lcr: likidity coverage ratio, otc: over the counter, fsb: financial stability board, fca: financial conduct authority, pra: prudential regulation authority, fpc: financial policy committee, sru: special resolution unit balseven: the political economy of financial regulation policies following the global crisis international journal of economics and financial issues | vol 6 • issue 2 • 2016 611 (2013) who perceives crises partly as a direct consequence of the basel standards’ approach, although capital ratios that are risk weighted are especially the main source of complexity in this approach, this topic has not been discussed during reforms. according to caprio (2013. p. 32), giving a priority to simple rules might make a difference. restrictions on the debt-to-income ratio and the loan-to-value ratio and upper limits on credit expansion and fx debts might be efficient for restricting price inflations during the expansionary phase of the economy. a well-designed “contingent convertible debt requirement” might provide a continuous support to tax payers who deposit funds in the bank. more importantly, this requirement might serve to control banks that attempt to increase their risks even at high capital levels. what is even more important is how capital ratios based only on equities would isolate the economy from banking crises. macroprudential regulations are fictionalized on the banking system. however, the sources of the risk treated by macro-prudential regulations and their transmission mechanisms have to cover all the elements of the financial system, including intermediaries, markets and the infrastructure (hartman, 2010). although reducing the risks posed by financial institutions that are systemic in a global context is seen as a high priority by the international regulatory community, basel iii does not fully address the externalities or spillover effects that these financial institutions generate (bis, 2011). basel approach, which does not regulate big financial institutions other than banks, creates an asymmetric structure. it is indicated that especially together with the new regulations, important financial institutions are still not dissuaded from the risks they bring to the financial system and that the consumer protection law that has been prepared after the global crisis in the usa has created some adverse incentives in this respect. this law is being criticized since it does not establish a regulative structure by predicting to regulate investment banks, insurance companies, pension funds and money market funds as banks. however, these institutions have played important roles during the crisis by creating credit (richardson, 2011). the financial crisis might be characterized as an example of the final stage of the boom and bust pattern may have had its origin at least in large part-in the development of new financial product (colander et al., 263) by these institutions. this issue has a vital importance on the ground massive failure of risk management. stulz (2009) presents the detail analyses on how world’s largest financial institutions has failed to carry out its responsibilities on risk management since the collapse of long-term capital management. however, according to stulz (2009. p. 60) effective risk management does not provide a guarantee against failure. “even in companies with the best risk management people and systems, large losses can and will occur as long as taking risk of large losses increases expected profits sufficiently for top management to be willing to take risk.” in the meantime, insurance companies and hedge funds are the firms for which regulatory instruments and objectives differ sharply from those appropriate to banks. for instance, insurance companies tend to have very different risk characteristics from those of banks, particularly regarding likidity (bis, 2011. p. 78). in order to make an important progress on this topic, a model has been suggested to measure the contribution of a financial institution to the systemic risk. then these measurements might be used in the model for determining dissuasive mechanisms such as taxes to be implemented to these institutions (acharya, 2010). imf supports the view that co-risk models can help policy makers to better regulate institutions. also, imf accepts that in the fact of cross-market and cross-country linkage more attention should be paid to the systemic implication. imf proposed a risk-based regulation. this approach based on instituting “systemic-riskbased capital surcharges,” applying levies that are related to institutions’ contribution to systemic risk, or even limiting the size of certain business activities (imf, 2010. p. 63). the main problem of monitoring global systemic linkages is non-existency of relevant data2. imf admits of priority in such agreements in with gathering of relevant data. this might possible for a country by itself to undertake effective surveillance of potentially crossborder systemic linkage (imf, 2009. p. 105). as a tool for systemic risks, capital controls came to the agenda for the first time after the crises experienced in the 1990s following the financial liberalization, in what concerns the capital flows that have been canalized to developing countries (epstein et al., 2008). financial governance institutions have emphasized the negative aspects of capital controls but it has been observed that this approach has been moderated during the global crisis. imf’s new “institutional approach” with the global crisis recognizes the need to regulate capital flows. according to this approach, it has been suggested to re-use counter-cyclical regulations against capital inflows and outflows. this approach change has not been reflected on recommendations at the national level. it has been argued that financial deepening is more efficient than regulative interventions against the dangers of cross-border financial activity (gabor, 2015. p. 3). capital controls that have not been brought to the agenda due to their possibility to weaken financial integration might be functional for a steady growing financial sector and financial stability. actually, it is necessary to create a good balance between financial integration and financial stability. thus, taxes or regulations aimed at capital flows should be design according to the dynamics of risk in the market. 4.2. functioning of the financial system; openness, transparency, accountability according to a report studying the main issues concerning the efficient implementation of macro-prudential regulations entitled “a progressive program for economic recovery and financial reconstruction” (2008. p. 17); “for any serious regulatory reform to work, however, at least two conditions must be met. first, financial institutions must come under much more significant regulatory oversight that demands absolute transparency in operations to avoid fraud and other forms of financial malpractice. 2 an initiative has just started for harmonization of key otc derivatives data (bis, harmonization of key otc derivatives data elements, consultative report, september 2015). balseven: the political economy of financial regulation policies following the global crisis international journal of economics and financial issues | vol 6 • issue 2 • 2016612 second, the financial regulatory institutions must have the capacity, authority and desire to implement and enforce these.” absolute openness and transparency in the financial system operations is the most important obstacle in the implementation of regulative reforms. nowadays it is possible to avoid many regulations brought to the banking system by keeping the accounts off-shore. it is possible to abstain from financial regulations by tending towards other markets where these regulations are inadequate and making some short-term loaning/borrowing or offbalance sheet transactions. large banks typically draw substantial income from shadow banking activities. some of the risks of these activities are still not being addressed because of call for a high degree of coordination across regulatory agencies, both within and across national boundaries (bis, 2011. p. 79). the global crisis, during which all these mechanisms were operative, showed that the system based on formal monitoring and auditing was inefficient. the basel committee focuses on the information of the regulator or auditor. when the dynamic structure of finance tends towards unofficial operations, the regulator shall use the discretionary power given to it and go beyond the static regulation rules and catch them. such a discretionary power shall be designed together with accountability. another important focal point of regulation shall be to increase openness in the banking system. the basic functions of the regulator shall be to ensure that banks give more information, to have them guarantee the accuracy of this information and to apply penalty rules in case of inadequate and wrong information (caprio, 2013. p. 35). as in the uk, the establishment of new institutions holding more auditing power and responsibility in the financial infrastructure would secure the attainability of information and enforce the auditing structure. nevertheless, in order to ensure openness and take into consideration national discrepancies, it seems necessary to shape the global infrastructure together with national practices. especially developing countries shall have the elasticity to start different practices that are convenient to their own economic and financial structures. 4.3. financial infrastructure after the 2007-08 crises the most important change in the governance of international financial standards has been the transformation of the financial stability forum (fsf) into the fsb, so as to comprise the g20 countries. in addition to g7 countries, the fsf included the representatives of institutions such as the imf, the wb, bis. although the fsb has become more inclusivist under its new organization after global crisis in order to coordinate the international regulations, it still excludes many developing countries from the decision making process. besides, two important problems concerning the efficiency of the institution in financial regulation are indicated; 1. while the new organization of the fsb can prevent direct capture against the criticisms concerning the regulatory capture area where the regulation loses its efficiency under the pressure of powerful actors, the problem continues since members are not represented equally 2. the fsb does not bring a more efficient and effective mechanism for financial monitoring and auditing. the main objective in the establishment of the fsb is to prevent that crises decrease efforts aimed at encouraging international financial standards and that international financial regulations get even more divided (helleiner, 2010). moreover, the rules of the global financial system as well as the rules of international financial governance institutions that are not easy to handle and shape the functioning dynamics are forming an obstacle to the regulation policy. especially, the rules that have been put into force by economic governance institutions after bretton woods seem to have restricted the policy space of national authorities. this situation reveals that regulations have to be designed within the global financial governance structure. for example, the rules of international governance institutions concerning financial infrastructure have restricted to a large extent a possible division in financial regulations. the wto financial services agreement reached in december 1997 (gatt), restricts national policy preferences by bringing comprehensive and binding obligations to liberalize international economic flows (picciotto, 2007). according to the rules taking place in the general agreement on trade in services annex covering financial services, if a country has committed to give permission to certain activities of foreign financial institutions, it cannot impose any prudential regulation (ghosh, 2010; gallagher and stanley, 2013). similarly, the trade in services agreement puts countries into a position precluding financial regulation, although some financial market failures exist. this agreement is assumed to be kept as confidential and classified information for 5 years after its entry into force. the financial services in the draft agreement have been defined in the most comprehensive manner. in this respect, the agreement comprises stock market operations, asset management, brokering, derivative market activities, financial information supply and consultancy services and similar activities, besides banking activities. with regards to the functioning of the global system, the most ideal situation would be to make regulations under an approach on which an agreement has been reached at the international level in order to minimize the regulative arbitrage opportunities and maintain the national market share. this situation is the most important justification forming the inconvenience of applying in a single country specifically regulations and generally capital controls. the regulated actors have the capability to tend towards prohibited activities in non-regulated areas. in order to decrease the interests in tending towards the other side of the financial system or other locations, it is more efficient to consider capital controls continually as a variable rather than to perform capital controls and abolish them (caprio, 2013. p. 37). nevertheless, global regulations shall be designed so as to include national discrepancies. since no progress could be made in counter-cyclical regulations after the crisis, it is expected that boom-bust cycles, which are the main source of the problem, get repeated in the future (persaud, 2008). these regulations, especially controls on capital inflows and outflows, are of vital importance in developing countries which are more subject to balseven: the political economy of financial regulation policies following the global crisis international journal of economics and financial issues | vol 6 • issue 2 • 2016 613 capital inflows and outflows. in these countries, the banking system does not incorporate toxic assets and shadow banking transactions compared to countries where the financial sector is developed. global regulations have to take into consideration such national discrepancies. here the essential point is that even though developing countries have an adequate accounting, monitoring and auditing system as well as a legal infrastructure, basel standards do not constitute an appropriate capital standard as a prudential instrument against the volatility of capital flows for those countries. one of the most important inadequacies of these standards is that they misevaluate the risk characteristics of developing countries. standards do create some incentives for the banks of those countries towards taking extreme risks. the fact that those countries do not have a competitive capital market is another factor that suppresses the benefit of a capital standard for banks. therefore, it has been argued that deposit requirements might be beneficial in those countries (rojas-suarez, 2008. p. 252). similarly, caprio (2013. p. 29) advocates that not making any change in basel standards approach would bring more severe crises in the future. according to him, priority shall be given to increase the role of asian and developing countries in the basel committee for making a change in the regulation approach. a new group (the bali committee) responsible for the macro-prudential regulations shall be formed with these countries. this group shall remove risk weighting and adapt simple, un-weighted capital and leverage ratios. in this framework, it is possible to argue that designing together capital controls and prudential domestic regulations under the umbrella of global governance, by making distinctions according to the structural characteristics of countries might increase the efficiency of both policy instruments and decrease application costs. 4.4. the necessity of a broader perspective although there is a general consensus in bringing back the regulation policy after the global crisis, in order to control speculations with micro and macro instruments, reforms have been terminated with moderate revisions and the finance sector continued to expand following the crisis (ghosh, 2014). as seen from the table 2, the magnitude of global capital markets sustained to grow during 2000s after a moderate decline in global table 2: main indicators on global financial system (2000-2013) (billion dollars and in percent of gdp) year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 global capital markets1 150,437 130,341 152,327 165,130 194,462 241,089 221,494 242,264 256,900 259,212 273,768 286,584 world gdp 33,291 33,123 32,163 36,319 41,257 44,595 48,434 54,840 61,218 57,920 63,074 70,220 72,105 75,470 global capital markets (in percent of gdp) 467.7 358.9 369.2 370.3 401.5 439.6 361.8 418.3 407.3 369.1 397.7 379.7 banks banks assets 47,834 57,315 74,435 95,768 104,712 103,755 107,774 113,735 121,946 126,744 bank profitability (in percent) return on assets uk2 0.9 0.6 0.7 0.5 0.7 0.8 0.5 0.4 −0.4 0.0 0.3 0.3 0.2 0.2 usa 1.22 1.12 1.42 1.43 1.33 1.33 1.33 1.13 0.33 0.23 0.93 1.23 1.43 1.63 return on equity uk2 14.0 9.2 10.9 19.0 10.97 11.8 8.98 6.2 −10.3 −0.1 6.9 6.1 3.4 4.2 usa 14.02 12.92 15.02 15.83 13.23 12.73 12.33 10.53 3.33 1.73 6.93 9.63 11.63 13.23 capital adequacy (in percent) regulatory capital to risk-weighted assets uk2 11.8 12.2 12.5 12.4 12.7 12.8 12.9 12.6 12.9 13.3 15.94 15.7 17.1 19.6 usa 11.75 12.45 12.55 12.75 13.23 13.03 13.03 12.83 12.53 13.93 14.83 14.73 14.53 14.43 bank capital to assets uk2 6.5 6.6 6.7 6.8 7.0 6.1 6.1 5.5 4.4 5.4 5.4 5.1 5.5 6.3 usa 8.25 8.95 9.05 9.05 10.33 10.33 10.53 10.53 10.53 9.63 12.7 12.2 12.0 11.8 world export9 6.0 2.4 −13.3 14.0 5.2 1.8 uk export of financial services 20 19 20 28 37 42 51 74 72 58 53 62 59 62 usa export of financial services 22 21 24 27 36 39 47 61 63 64 72 78 76 83 sources; imf, global financial stability report 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015. datas for the export of financial services; http:// unctadstat.unctad.org/wds/tableviewer/tableview.aspx.; data for bank capital to assets ratio between 2010 and 2013; datawordbank.org april. [last retrieved on 2015 dec 19]. 1sum of the stock market capitalization, debt securities (bond and equities) and bank assets, 2june, 3september, 4december, 5march, 6november, 7includes mortgage banks and building society, 8before tax, 9unctad, trade and development report, annual percentage change. imf: international monetary fund, gdp: gross domestic product balseven: the political economy of financial regulation policies following the global crisis international journal of economics and financial issues | vol 6 • issue 2 • 2016614 crisis. the global capital markets grew faster than world gross domestic product (gdp), as a result of this, the ratio of gdp remained high levels, and reached at highest level in 2002 as 467.7 in percent of gdp. the global capital markets held assets that are worth almost 4 times more than world gdp (table 2). the growth of global capital markets from 2002 to 2013 is also shown in figure 1. the risks that rapid growth of capital markets and expansion of lending were further exarcerbated by the nature of financial institutions lending and investment strategies. the growth of fx and financial derivatives has changed widely of institutional peculiarities of world economy. for example, while the volume of the daily fx transaction was only 82 billions dollars in 1980, has reached to 5345 billion dollars in 2013. this extraordinary growth of the fx transaction is nearly nothing to the with the growth of the financing in trade. the ratio of the export in fx transaction which shows the part of fx transaction using financing of the exports is only 2.4 in 2001 and even drops more after and the level is only 1.7 in 2013 (table 3). the growth of over-the-counter derivatives in between 2001 and 2013 is nearly 7 times and almost unaffected by the crisis. table 3 shows a rapid rate of growth to a value of almost 693 trillion dollars in 2013. related to this growth, according to bryan and rafferty (2011), there is a momentum in accumulation that exists beyond bubbles and lax regulation. they noted in bryan and rafferty (2011. p. 213-214). in financial markets where institutions are looking for yield and to diversify asset portfolios, derivatives were especially attractive. with exchange rates and interest rates volatile, cash itself being necessarily denominated in a particular currency embodies significant risks. with interest rates on us trasury bonds pushed to low levels, their rate of return was not compensating for the risk of a volatile dollar. trading in derivatives and securities became the predictable response and investment in household income streams provided a new site for investment opportunities. the acquisition of derivatives as part of the strategy of diversification itself generated an innate search for yield. the effect of the global crises on especially us and uk bank profitability is spectacular during the global crisis, but short-lived. related to bank profitability, both return on assets and return on equity declined considerably in the uk and usa. especially in the uk, the rates declined in between 2007 and 2008 from 0.4 to −0.4 and from 6.2 to −10.3 respectively. in the uk and the us, the ratio of return on equity has recovered rapidly since 2010. while the return on assets in the us has reached at pre-crisis level since 2011, the rates in the uk has not reached pre-crisis levet yet (table 2). the evidences on the impacts of regulation policies on banks shows that roughly half of the drop in cross-border claims of bank can be attributed to regulatory changes (imf, 2015. p. 67). at the same time, banks in the us have strengthened of their capital ratios following the publication of the us stress tests in early 2009 as shown in the table 2. on the other hand, global indicators on bank assets indicate a growing trend in uk and us since 2010. figure 1: global capital markets and world gross domestic product (billion dollars) 0 50 100 150 200 250 300 350 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 20 12 20 13 global capital markets world gdp table 3: main indicators on capital flows, global fx markets and derivatives (2000‑2014) (billion dollars and in percent of gdp) year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 fdi net inflows uk 122.1 53.8 25.5 27.6 57.3 252.6 203.6 209.5 253.4 14.5 66.7 27.0 46.7 35.0 fdi net inflows us 321.2 167.0 84.3 63.7 145.9 138.3 294.2 340.0 322.7 153.7 259.3 257.4 232.0 287.1 portfolio equity net inflows/uk 191.7 22.5 2.3 32.6 3.5 12.4 −18.2 −20.1 71.7 72.8 −10.8 −13.9 −11.7 48.0 portfolio equity net inflows/us 193.6 121.4 54.0 33.9 61.7 89.2 145.4 275.6 126.8 219.3 178.9 123.3 239.0 −67.4 otc derivative1 99,755 127,564 169,678 220,058 281,493 369,906 516,407 683,725 604,622 582,655 647,547 639,396 692,908 fx turnover/daily 1239 1934 3324 3971 5345 fx turnover/annual2 307,500 483,500 831,000 992,750 1,336,250 world export4 7885 7614 7994 9323 11,310 12,870 14,849 17,307 19,747 15,783 18,713 22,178 22,446 23,114 world export/fx turnover 2.4 2.3 2.0 1.8 1.7 world export3 −1.0 5.0 6.0 11.0 5.0 8.0 6.0 2.4 −13.3 14.0 5.1 2.0 2.6 world output growth3 4.0 1.5 1.8 2.5 4.1 3.4 4.0 4.0 1.5 −2.1 4.1 2.8 2.2 2.4 sources: unctad, world investment report, 2001, 2006, 2010, 2014; for porfolio equity net inflows and fdi net inflows: worldbankdata.org; for fx and derivatives: bis triennial survey 2013, april. 1global otc derivatives markets consist of fx contracts, interest rate contracts, equity-linked contracts, commodity contracts, credit derivatives and other derivatives; data shows an amounts outstanding, the end of june, 2daily fx turnover multiply by 250, 3unctad, trade and development report, annual percentage change, 4imf, world economic outlook, goods and services. fx: foreign exchange, imf: international monetary fund, gdp: gross domestic product, fdi: foreign direct investment, otc: over-the-counter balseven: the political economy of financial regulation policies following the global crisis international journal of economics and financial issues | vol 6 • issue 2 • 2016 615 moreover, the cross-border financial services are the biggest source of foreign currency and profitability in developed central capitalist countries within the global governance structure. the export of financial services in both uk and us grows almost continual after slight decline in 2009 (table 2). this situation necessitates to explain the post-fordism developments in the structural dynamics of economies and to understand the new accumulation strategies of the capital. the usa and england have been the countries where the established financial institutions have taken the highest advantage from cancelling the restrictions on capital inflows and outflows and transactions. the financial institutions of these countries have successfully colonized new international markets and they have sent profits to their own countries. the growth of derivative markets and especially securitization have turned money forms into commodities and rendered possible their sales. thus, finance has become a new process of value creation (christophers, 2013. p. 236). in those countries, an important part of the growth in the profits of the financial sector has been based on the demand arising from overseas countries (christophers, 2013. p. 264). according to caprio (2013), in spite of the role played by international capital flows and macro policies during the crisis, regulators of the international financial system would not be able to take a significant result unless an improvement is made in those areas. the basic structure which guarantees the stability of the global system in the short-term might be ensured in the mid-term with an inclusivist regulation where the real and financial sectors take place together. at this stage, indirect suggestions such as the tobin tax which restrains directly the cross-border mobility of finance or slows down the financial sector and creates some time and policy space for nation states, is an efficient instrument in global regulation. such instruments are also crucial for distribution purposes (balseven and ve erdoğdu, 2005; erdoğdu and balseven, 2006). in spite of the international framework settled on bank, basel iii indirectly canalize to the systematic risk born by internationally active banks. there should be restraint on excessive bank competition and tightening of prudential regulation and also a curb on financial product which are deemed difficult to evaluate and monitor. many developing countries less sophisticated financial systems escaped the contagion effects from the crisis in more elaborate financial systems of the west. unlike usa, developing countries do not have shadow banking systems of any size nor did their bank hold complex toxic assets. this could be partly resistance of them from crisis and creates self-restraint (chowdhury, 2015). this opens up policy agendas about strategies to identification and being held in limited size of financial products that prevent extending leveraged activities in developed countries through financial innovations. lastly, the most frequently mentioned issue in both literature and policy implementation is power relation in finance hard to find solution in the future (balseven, 2010). the institutional foundations of becoming dominant of finance can be find in the policies implemented since 1980s in uk and usa. these policies have been reshaped of economies in the framework of post-bretton woods rules, as already suggested. 5. conclusion the 2007/2008 global crisis seems to be the most striking evidence of our century, exposing the unrealistic nature of the auto-regulative financial market model. the instability and crisis caused by non-regulated financial markets or financial markets that have not been sufficiently regulated have demonstrated that the financial regulation issue is not inherent to developing countries. the financial reforms made in the financial sector following the global crisis have been shaped so as to strengthen financial standards with a comprehensive practice, without making any division in the international financial system. on the other hand, what has been less discussed is whether the related standards are efficient or not. especially, the new basel standards, which are one of the most important novelties of regulation reforms, are being criticized for having rendered even more complex a structure that was already complex. reforms that continued the approach based on basel standards have made moderate changes and new additions in the institutional structure. basel standards shall involve a simpler and more efficient approach. furthermore, in order to be efficient, the regulation policy shall comprise all the instruments and markets and shall regulate the national and global infrastructures together. another topic which was less prominent in discussions concerning financial regulation theories and practices following the crisis is capital flows and macro-economic policies. the problem is not just a regulation issue. no matter how well financial regulations are designed, an efficient implementation is only possible when consistent macro-economic policies accompany it. references a progressive program for economic recovery and financial reconstruction. 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(2000), entering the 21st century, world development report 1999/2000. washington, dc: wb. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 868-874. international journal of economics and financial issues | vol 5 • issue 4 • 2015868 a comparative study of financial performance between conventional and islamic banking in united arab emirates mukdad ibrahim* department of accounting and finance, american university of ras al khaimah, united arab emirates, p o box 10021, ras al khaimah. *email: mukdad.ibrahim@aurak.ae abstract the purpose of this study is to compare the financial performance of two uae based islamic and conventional banks between the years 2002 and 2006. quantitative analysis was undertaken by looking at various sets of financial ratios that are routinely used to measure bank performance. the main ratios that were employed put a particular focus on the banks liquidity, profitability, management capacity, capital structure and share performance as reliable indicators of a bank performance. descriptive statistical analysis was used to rank the performance, measuring the dispersion and the stability-variability of the indicators. the research goes one step further and measures the financial stability of the two banks. conclusions were then drawn from the computation of the relevant ratios that allowed the author to make an effective comparison of said banks. subsequently, each bank’s performance was then ranked via the use of descriptive statistical analysis. this type of analysis was used to summarize the performance of each bank based on three criteria, mean, coefficient of variation and the overall stability of each banks performance. the findings showed that both banks performed reasonably well during the period studied. while the bank of sharjah benefitted by having an overall higher degree of liquidity, profitability, management capacity and capital structure, dubai islamic bank was better off in relation to share indicators performance and in terms of overall stability. keywords: banking, financial analysis, performance measurement, financial ratios, united arab emirates jel classifications: e44, g21, m40 1. introduction a commercial bank’s performance is evaluated for several reasons depending on personal objectives. an entity like a bank regulator, for example, may need to identify and call attention to banks that are experiencing chronic financial problems in order that they may fix them before they get out of control. such is the case with so called “bank runs.” shareholders, on the other hand need to assess which banks they can deem suitable to financially invest in. unsurprisingly, commercial banks evaluate their own performance over a given period so that they may determine the efficacy and long term viability of management decisions or goals so that they can alter the course and make changes whenever it is appropriate. with a constant and routine monitoring of performance, underlying problems may remain invisible and lead to financial failures further down the line. the overall objectives of this research is to measure the performance of two leading private sector commercial banks using five groups of financial ratios that will indicates the performance developments over the period 2002-2006. moreover, the study will make comparative assessment of the performance between two banks, conventional bank and islamic bank. furthermore, the research is going to measure the overall stability of each bank. to measure the financial performance and make a comparison between dubai islamic bank and bank of sharjah, the research is going to use five main groups of parameters. in each group, different ratios are going to employee to measure the performance. these ratios are going to be ranked for comparison purpose. the data for this research was obtained from abu dhabi financial service company. the descriptive measurements are going to be used to measure the performance and the stability-variability of these ratios over the years 2002-2006. moreover, z-score indicator is going to be used to measure the overall stability of each bank. ibrahim: a comparative study of financial performance between conventional and islamic banking in united arab emirates international journal of economics and financial issues | vol 5 • issue 4 • 2015 869 2. literature review 2.1. conventional banks misra and apa (2013) analyzed the financial position and performance of the state bank group using camel model. they tested their hypothesis on six banks on the basis that there is no significant difference in performance using twenty financial ratios. their findings showed that different banks obtained different ranks with respect to camel ratios. their study also depicted that thought ranking of ratios is different for different banks in state group. but there is no statistically significant difference between banks the camel ratios. it signifies that overall performance of state group is same. kumbrai et al. (2010) investigated the performance of south africa’s commercial banking sector for the period 2005-2009. they use financial ratios to measure the profitability, liquidity and credit quality performance of five large south african based commercial banks. the results showed an improvement in the bank performance in terms of profitability, liquidity, and credit quality from 2005 to 2007. they also found significant differences in profitability performance for the period 2005-2006 and the period 2008-2009. tuna (2013) tried to measure the financial health of two banks in indonesia for the period of 2008-2012, using five assessment aspects of the camel model (capital, asset, management, earnings, and liquidity). the t-test has been used to assess the differences between the two banks. the results in this research found no significant differences about bank soundness between the two banks. gupta (2014) evaluated the performance of public sector banks in india. he used camel approach for a 5-year period 2009-2013. the results showed that there is a statistically significant difference between the camel ratios of all the public sector banks in india. therefore, the overall performance of public sector banks is different. to identify selected determinants of profitability in six major european banking sectors, goddard et al., (2004) used crosssectional, pooled cross-sectional time series and dynamic panel models. they analyzed data on 665 banks from six european countries for the period 1992-1998. the results of the empirical analysis suggest that, despite the growth in competition in european financial markets, there is still significant persistence of profit from 1 year to the next. al tamimi (2010) investigated some influential factors in uae’s islamic and conventional national banks during the period 19962008. two dependents variables were used separately against five independent variables which are the financial development indicator, liquidity, concentration, cost, and branch number in using regression analysis. his analysis showed that liquidity is most influential factor for conventional banks. for islamic banks, his results stated that the influential factors are the cost and the branch number. tarawneh (2006) analyzed the financial statement of five omani banks for the financial period 1999-2003. in addition, he used simple regression to estimate the impact of asset management, operation efficiency, and bank size on the financial performance of these banks. the results showed that financial performance of the banks was strongly and positively influenced by the operational efficiency, asset management, and bank size. jha and hui (2012) compared the financial performance of different structured banks in nepal using camel framework. the study covered the years 2005-2010 to assess the financial performance of the eighteen commercial banks in nepal. the analysis was based mainly on the descriptive financial analysis to describe, measure, compare, and classify the financial situations. the authors then used multivariate regression model to test the significance of the variables used. they found that return on assets (roa) of public sector banks were higher than those of joint venture and domestic public banks. moreover, the values determined for the financial ratios revealed that joint venture and domestic public banks were also not so strong in nepal to manage the possible large-scale shock to their balance sheet. ferrouhi (2014) analyzed the performance of major moroccan financial institutions for the period 2001-2011 using camel approach. he used one financial ratio for each of capital adequacy, assets quality, management quality, earning ability, and liquidity position measures. the testing of the above measurements on six moroccan institutions revealed that all the six banks did well over the period of study. his findings were based on ranking the average of each ratio, showed that some banks are better off than others. ibrahim (2014) analyzed the financial performance of two uae based banks between the years 2004 and 2009, by looking at various set of ratios that are used to measure the bank performance. the analysis revealed that both banks did well over the above period, each bank scored high level of performance in one area than another. 2.2. islamic banks ahmed (2010) investigated the performance of islamic banks in pakistan. in this study, ahmed applied non-financial measures based on an eight item scale to sasses the performance of the islamic banks. he selected six full-fledged islamic banks and measured their performance by using modified version of an eightitem research instrument developed by quinn and rohrbaugh (1983). the responses were recorded regarding bank performance by considering different aspects. every respondent was asked to rank a number of aspects regarding his/her bank. these responses were recorded from 432 bankers through simple random sampling technique. the results show that bankers consider product quality, profitability, and productivity as more important indicators of performance with increasing evolution towards these items. the personnel voluntary rotation and personnel absenteeism are ranked low due to decreasing evolution among bankers. abduh et al. (2013) investigated the efficiency and performance of five islamic banks in bangladesh. their data were collected through the published annual reports of the five banks from the year ibrahim: a comparative study of financial performance between conventional and islamic banking in united arab emirates international journal of economics and financial issues | vol 5 • issue 4 • 2015870 of 2006 to 2010. to measure the efficiency and performance, the researchers used ratio analysis for measuring the performance and data envelopment analysis with malmquist index to measure the efficiency of the islamic bank. the result concludes that shajalal islamic bank has performed better than other islamic banks in terms of ratio analyzed. the result of data envelopment analysis reveals that the trend of all islamic banks was on the rising stage during year 2006 to year 2010, suggesting that the islamic banks have improved their efficiency over the study period. ibrahim et al. (2014) have used financial data obtained from the annual reports of the sample banks the study has evaluated the performance of six islamic banks listed at both dhaka stock exchange and chittagong stock exchange. their objectives were to evaluate the performance of these banks, and to make a comparison among different islamic banks from different variables. the results show that some banks are better off than others using different ratios. the overall performance of all islamic banks is satisfactory. the researchers believe that the future of islamic banking system in bangladesh is very bright. but for exploring the market opportunity the islamic banks must develop market driven strategy. yudistira (2004) used data envelopment analysis technique to create a frontier set by efficient banks and compare it with inefficient banks to produce efficiency scores. the researcher found that the overall efficiency across 18 islamic banks is small at just over 10%, which is quite low compared to many conventional counterparts. islamic banks in the sample suffered from the global crisis in 1998-1999, but performed very well after the difficult periods. moreover, the findings indicate that there are diseconomies of scale for small-to-medium islamic banks. sanwari and zakaria (2013) studied the islamic bank performance in relation to the effect of both internal conditions and the external factors on islamic banks performance. global islamic banks’ data were obtained from the annual report on islamic banking from bank scope database. panel data of 74 islamic banks from around the world was examined for the period 2000-2009. their findings revealed that the performance of these banks depends more on bank specific characteristics such as capital, assets quality and liquidity, while macroeconomic factors do not significantly influence islamic banks’ profit. akhter et al. (2011) measured the efficiency of islamic bank in relation to two conventional banks in pakistan. they used the financial ratios to measure profitability, liquidity risk and credit risk for the years 2006-2010. trend analysis was also used to check the trends of the balance sheet and income statement numbers. their findings conclude that no significant difference is observed between the two types of banks in respect of profitability and a divergence in liquidity and credit performance. the trend analysis showed a good trend of balance sheet of the islamic bank while in income statement, there was no meaningful difference. miniaoui and gohou (2011) examined the performance of the main islamic banks. they used the balance sheets data for 37 banks of the uae. their main purpose was to assess the magnitude of the gap between the conventional and the islamic banking systems using conditional and unconditional methodology. they analyzed two sets of indicators related to profitability and productivity. they found that conventional banks in the uae performed better than the islamic one. cihak and hesse (2010) assessed the relative financial strength of islamic banks. using z-score as a measure of stability on individual islamic and commercial banks in 19 banking systems, their findings were as follows: 1. small islamic banks tend to be financially stronger than small commercial banks 2. large commercial banks tend to be financially stronger than large islamic banks 3. small islamic banks tend to be stronger than large islamic banks. husein (2014) analyzed the data of 102 individual islamic banks in indonesia over the period 2010-2012. his objective was to investigate whether the bank size has significant effect on risk using the z-score as a measure of stability. the research findings were as follows: 1. the banks size has significant difference in terms of its stability 2. overall, islamic bank stability is affected by the assets and income diversity 3. large islamic banks tend to be financially stronger than small islamic banks 4. small banks tend to be more stable than medium islamic banks. ibrahim (2015) measured the financial performance of two islamic banks in united arab emirates for the period of 2003-2007. different groups of financial ratios have been used to measure the performance and make a comparison between these two banks. although, the results showed that both banks did well, it appears that each bank has its focus on some area such as liquidity, profitability, capital structure and stability. 2.3. comparative studies olson and zoubi (2008) distinguished between conventional and islamic banks in the gulf cooperation council region on the basis of financial characteristics alone. they put 26 financial ratios into logit, neural network and k-means nearest neighbor classification models to determine whether these ratios distinguish between the two types of banks. their results indicated that measures of bank characteristics such as profitability ratios, efficiency ratios, assetsquality indicators and cash/liability ratios are good discriminators between islamic and conventional banks in the gcc region. abdul-hamid and azmi (2011) compared the financial performance between one islamic bank eight conventional commercial banks for the period 2000-2009. the financial measurements used in this research are based on the criteria such as profitability, risk and solvency, and community involvement. the study evaluated inter-temporal and interbank performance of the pioneer of islamic banking in malaysia using. t-tests have been used in determining their significance. they used data for one islamic bank for the ibrahim: a comparative study of financial performance between conventional and islamic banking in united arab emirates international journal of economics and financial issues | vol 5 • issue 4 • 2015 871 period of 2000-2009 while the data used for eight conventional banks is from 2005 to 2009. the study found that while there is no significant difference in profitability during these two periods, islamic bank is relatively more liquid and less risky as compared to conventional banks. masruki et al. (2011) analyzed and measured the performance of both islamic and conventional banks in malaysia over 5 years, 2004-2008. their results should that islamic banks have less level of profitability than its rival banks. moreover, the results also indicated that conventional banks encountered high credit risk than islamic banks. 3. liquidity analysis 3.1. cash and deposits to total assets based on mean measure, the below tables 1 and 2, show that bank of sharjah has higher level of liquidity with a mean of 38% than dubai islamic bank with a mean ratio of 6.99% over the years of study, as a percentage of its total assets. in addition, the standard deviation and the coefficient of variation of sharjah bank indicate the higher stability level of this ratio over the time in sharjah bank than in dubai islamic bank. 3.2. customers deposits to total assets this ratio shows the ability of a bank to use the customers deposit to finance the bank activities. based on the mean measure, tables 1 and 2 show that dubai islamic bank depends more on customers deposits in financing its activities with a mean ratio of 81.44% thank sharjah bank with 67.51%. on the other hand, and based on standard deviation and coefficient of variation, these tables indicate a high dispersion and instability levels of this ratio in sharjah bank than dubai islamic bank. 3.3. shareholders’ equity to total assets this ratio shows bank money as a percentage of total assets. the high ratio shows the ability of a bank to use its own money and indicates more liquidity. based on the mean measure, the tables 1 and 2 demonstrate that sharjah bank is more able to use its own money with a mean percentage of 27.88% than dubai islamic bank with 9.5%. thus, this bank enjoys a higher level of liquidity than its rival bank. based on both standard deviation and the coefficient of variation, the analysis also shows that sharjah bank has higher level of stability than the dubai islamic bank. 4. profitability analysis 4.1. return on total income return on total income ratio shows the profitability percentage generated from the activities of a bank operations. it is calculated by dividing net profit by the total income. the comparison between the two means reveals that sharjah bank did enjoy high profitability with mean of 75.54% than dubai islamic bank which has a percentage mean of 29.44. this has been associated with high dispersion, and less variability level as it shown in tables 3 and 4. 4.2. return on shareholders’ equity this ratio shows the profitability in relation to the shareholders equity. the high ratio indicates an increase in the profitability of shareholders and presumably leads to increase the dividend level. dubai islamic bank higher level of profitability with a mean percentage of 17.34% comparing with sharjah bank with 16.62%, and it may attract more investors to invest their money in this bank, especially it is associated with more stability level based on the coefficient of variation in tables 3 and 4. table 1: liquidity analysis: bank of sharjah indicators % 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation cash and deposits to total assets 35.44 44.35 36.97 43.30 30.00 38.01 5.92 15.57 customers’ deposits to total assets 79.20 66.77 68.86 64.72 58.01 67.51 7.70 11.40 shareholder’s equity to total assets 18.91 31.96 30.03 33.43 25.10 27.88 5.92 21.23 table 2: liquidity analysis: dubai islamic bank indicators % 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation cash and deposits to total assets 6.63 6.07 7.50 9.30 5.46 6.99 1.49 21.31 customers’ deposits to total assets 86.68 87.29 81.47 77.66 74.08 81.44 5.70 6.10 shareholder’s equity to total assets 8 7.5 9.8 8.9 13.3 9.5 2.3 24.21 table 3: profitability analysis: bank of sharjah indicators % 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation return on total income 59.21 67.00 74.40 88.40 88.69 75.54 13.03 17.25 return on shareholder’s equity 14.07 9.05 13.35 31.37 15.27 16.62 8.57 51.56 return on total assets 2.66 2.89 4.01 10.49 3.83 4.77 3.25 68.13 table 4: profitability analysis: dubai islamic bank indicators % 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation return on total income 18.12 22.88 31.36 40.40 34.48 29.44 8.95 30.40 return on shareholders’ equity 10.15 13.81 15.44 28.83 18.48 17.34 7.09 40.88 return on total assets 0.82 1.03 1.51 2.57 2.45 1.67 0.80 47.90 ibrahim: a comparative study of financial performance between conventional and islamic banking in united arab emirates international journal of economics and financial issues | vol 5 • issue 4 • 2015872 4.3. roa roa ratio shows the profitability of using the assets. the high ratio indicates the efficient use of assets to generate more profit. the low ratio may indicate that a bank has invested too much money on its assets. based on the analysis in tables 3 and 4, bank of sharjah captured high level of profitability with a mean percentage of 4.77% against dubai islamic bank with 1.67%. but this high profitability ratio has associated with high level of variability during the year of study. 5. management capacity 5.1. total expenses to operating income this ratio shows the ability of the management in creating the revenues with certain level of expenses. it is calculated by dividing the total expenses to the income generated by a bank. the increases of this ratio from one period to another indicates that the expenses have increased at higher rate than the income did. based on tables 5 and 6, it is sharjah bank managed to reduce this ratio over the years with a mean percentage of 24.46% and high level of variability with a coefficient of variation 53.27% against a mean percentage of 28.23% and 8.50% coefficient of variation for dubai islamic bank. 5.2. investment to total assets this ratio shows the ability of bank management to allocate the appropriate amounts for investment. it is calculated by dividing the total amount invested by total assets. the high ratio will presumably create high income. the analysis in tables 5 and 6 shows that a similar level of investment accrued, with a mean percentage of 7.66 for bank of sharjah and 7.63 for dubai islamic bank. the standard deviation and the coefficient of variance clearly indicate that bank of sharjah has a high dispersion and variability levels in this ratio comparing the dubai islamic bank. 6. capital structure indicators 6.1. total liabilities to total assets this ratio shows the portion of money financed the total assets by outsources. the higher the ratio, the more of a firm’s assets are provided by creditors relative to owners. creditors prefer a low or moderate ratio, because it provides more protection in case a firm experience financial problems. the high ratio indicates the weak financial structure. the mean percent measure in tables 7 and 8 indicates that bank of sharjah is structurally stronger than dhabi islamic bank as it has less level of ratio. on average, this ratio is 70.37% for bank of sharjah and 90.51% for dubai islamic bank. but the later bank has managed to control its liabilities over the years as it has less standard deviation and coefficient of variation. out of the above ratios, customer deposits to total assets ratio formed 67.51% for bank of sharjah and 81.51% for dubai islamic. therefore, customers’ deposits is a major components of the banks’ liabilities and both banks depends largely on this type of finance to run their activities. 6.2. total liability to total equity this ratio the structures the relation between two types of finances, outsource finance represented by total liabilities and inside finance represented by shareholder’s equity. the high ratio indicates the weak financial structure. tables 7 and 8 demonstrate that the dubai islamic bank of has high ratio than bank of sharjah, as it has a mean of 10.07 comparing with bank of sharjah with a mean of 2.67. on average, dubai islamic bank’s creditors provided 10.07 dirhams in financing for every dirham contributed by owners, comparing to 2.67 dirhams for bank of sharjah. on the other hand, dubai islamic bank of has managed to control this ratio better than its rival bank as the coefficient of variation indicated. 7. share performance indicators 7.1. market value tables 9 and 10 below show the developments of share prices over the years 2002-2006. the mean of the prices is aed 14.88 for bank of sharjah, while it is aed 40.56 for dubai islamic bank which. this means that the public were more willing to invest in dubai islamic bank. moreover, the stock prices of both banks were moving randomly over the years of study as reflected in high standard deviation and high coefficient of variation. the main reason behind this random walk of the prices is the shift of investments to other high profitability sectors based on new available information to the investors. 7.2. price earnings ratio this ratio relates the share price to the earnings per share. this ratio expresses the multiple that the market places on a firm’s earnings per share. a high p/e multiple often reflects the market’s perception of the firm’s growth prospects. thus, if investors believe that a firm’s future earnings potential is good, they may be willing to pay a higher price for the stock and thus boost its p/e multiple. the mean measurement in tables 9 and 10 is slightly different between the two banks. on average, investors are willing to buy a share of bank of sharjah at price of 17 times more than its earnings per share, while the case of dubai islamic bank is 24 times. the table 5: management capacity analysis: bank of sharjah indicators % 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation total expenses to operating income 40.78 33.00 25.60 11.60 11.31 24.46 13.03 53.27 investment to total assets 3.10 2.32 2.65 12.11 18.12 7.66 7.13 93.08 table 6: management capacity analysis: dubai islamic bank indicators % 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation total expenses to operating revenues 30.89 26.32 30.76 26.07 27.11 28.23 2.40 8.50 investment to total assets 8.42 6.60 8.19 6.63 8.32 7.63 0.93 12.18 ibrahim: a comparative study of financial performance between conventional and islamic banking in united arab emirates international journal of economics and financial issues | vol 5 • issue 4 • 2015 873 standard deviation and the coefficient of variation show high dispersion and more instability of this ratio for both banks. 7.3. market value to book value this ratio structures the relation of share price to book value. this ratio is a blend of historical accounting and market indicators. it expresses the differential between the book value of the net assets of a firm and the market value of it. a high ratio means an increase in the stock price of the book value per share, and the company is doing well, since the market is willing to pay more than the equity per share. tables 9 and 10 below, state that the mean of this ratio for the dubai islamic bank is 4.62, nearly doubled than the mean for bank of sharjah. moreover, the fluctuation around the mean and the coefficient of variation are also high for the same bank. this ratio is affected by both inside and outside finance and economic factors. 7.4. earnings per share this ratio measures the profitability of the shareholder’s equity. the ratio provides a measure of overall performance and is an indicator of the possible amount of dividends that may be expected. the analysis in tables 9 and 10, below shows that dubai islamic bank enjoys high profitability per share with a mean of 1.66 dirhams comparing to bank of sharjah with 0.91 dirhams. the high ratio of earnings per share for dubai islamic bank is associated with high level of instability of this ratio as the coefficient of variation indicated. 7.5. bank stability this research focuses on measuring the financial performance of two banks using five types of parameters. however, it is possible to conduct a deeper investigation and measure the stability of the two banks by using the z-score measurement. z-score is the inverse of the probability of insolvency. it actually indicates the number of standard deviation that a bank’s roa has to drop its expected value before equity is depleted and the bank is insolvent (boyd et al., 1993). thus a higher z-score indicates that a bank incurs fewer risks and is more stable. the z-score can be computed as follows: z score roa+car sdroa − = where roa is the roa and car is the ratio of total equity over total assets of the bank. sdroa is each bank’s standard deviation of the roa. z-score in table 11 below indicates that both banks are stable, but the level of stability is by and large higher in dubai islamic bank than in bank of sharjah for individual years and for the whole period 2002-2006. 8. conclusion the central objective of the paper has been to conduct a comparative performance of two banks in united arab emirates for the period of 2002-2006. five groups of parameters have been table 7: capital structure analysis: bank of sharjah details 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation total liabilities to total assets % 81.09 68.04 69.97 66.57 66.20 70.37 6.17 8.76 total liabilities to equity (times) 4.29 2.13 2.33 1.99 2.64 2.67 0.93 34.83 table 8: capital structure analysis: dubai islamic bank indicators % 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation total liabilities to total assets 91.97 92.54 90.24 91.07 86.75 90.51 2.28 2.52 total liabilities to equity (times) 11.45 12.41 9.76 10.20 6.55 10.07 2.23 22.14 table 9: share performance analysis: bank of sharjah indicators 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation market value 27 34 4.61 6.05 2.74 14.88 14.52 97.58 price earnings ratio (times) 10.96 29.16 25.23 12.35 10.15 17.57 8.93 50.82 market value to book value (times) 1.54 2.64 3.37 3.15 1.63 2.46 0.85 34.55 earnings per share 2.46 1.17 0.18 0.49 0.27 0.91 0.95 104 table 10: share performance indicators: dubai islamic bank indicators 2002 2003 2004 2005 2006 mean standard deviation coefficient of variation market value 25.80 46.75 93.05 29.15 8.08 40.56 32.39 79.85 price earnings ratio (times) 16.15 19.94 30.27 39.51 14.34 24.04 10.62 42.42 market value to book value (times) 1.64 2.75 4.67 11.39 2.65 4.62 3.94 85.28 earnings per share 1.60 2.34 3.07 0.74 0.56 1.66 1.06 63.85 table 11: z-score measurement year bank of sharjah dubai islamic bank 2002 6.74 10.60 2003 10.87 10.24 2004 10.46 13.61 2005 13.50 13.85 2006 8.89 19.04 z-score: 2002-2006 10.06 13.47 ibrahim: a comparative study of financial performance between conventional and islamic banking in united arab emirates international journal of economics and financial issues | vol 5 • issue 4 • 2015874 used to measure liquidity level, profitability level, management capacity, capital structure and share performance. the findings show that both banks are financially viable as both have used the appropriate financial tools and policies to manage their organization and to adapt to their dynamic environment, resulting in a modest maximization of their profits. the liquidity level in dubai islamic bank is lower than that of its rival bank. the research findings also show that bank of sharjah possesses high level of profitability but cautions that this is accompanied with a high level of instability as well. as far as management capacity ratios, the analysis declared that bank of sharjah managed its operations with a lower level of expenditure than its rival bank. in addition, the analysis showed that bank of sharjah has a stronger financial structure than its competitor. finally, the analysis of the share performance and the z-scores showed that dubai islamic bank is in a stronger position than the bank of sharjah in terms of overall stability. references abduh, m., hasan, s., pananjung, a. (2013), efficiency and performance of islamic banks in bangladesh. journal of islamic banking and finance, 30(2), 94-106. abdul-hamid, m., azmi, s. (2011), the performance of banking during 2000-2009. international journal of economics and management sciences, 1(1), 9-19. ahmed, a. (2010), application of non-financial measures for assessment of performance of islamic banks in pakistan. interdisciplinary journal of contemporary research in business, 2(7), 173-181. akhter, w., raza, a., akram, m. (2011), efficiency and performance of islamic banking: the case of pakistan. far east journal of psychology and business, 2(2), 54-71. al tamimi, h.h. (2010), factors influencing performance of the uae islamic and conventional national banks. global journal of business research, 4(2), 1-9. boyd, j.h., graham, s.l., hewitt, r.s. (1993), bank holding company mergers with nonbank financial firms. journal of banking and finance, 17, 43-63. cihak, m., hesse, h. (2010), islamic banks and financial stability. journal of financial services research, 38(2-3), 95-113. ferrouhi, e.m. (2014), moroccan banks analysis using camel model. international journal of economics and financial issues, 4(3), 622-627. goddard, j., molyneux, p., wilson, j. (2004), the profitability of european banks. the manchester business journal, 72(3), 363-381. gupta, c.a.r. (2014), an analysis of indian public sector banks using camel approach, iosr journal of business and management, 16(1), 94-102. husein, m.f. (2014), the stability of islamic banks in indonesia, paper presented at the 2nd ibea – international conference on business, economics, and accounting, hong kong, 26-28. march, 2014. ibrahim, m. (2014), a comparative performance of two banks in united arab emirates, research journal of finance and accounting, 5(21), 24-29. ibrahim, m. (2015), measuring the financial performance of islamic banks. journal of applied finance and banking, 5(3), 93-104. ibrahim, m.d., mohammad, k., hoque, n., khan, m. (2014), investigation the performance of islamic banks in bangladesh. asian social science, 10(22), 165-174. jha, s., hui, x. (2012), a comparison of financial performance of commercial banks: a case study of nepal. african journal of business management, 6(25), 7601-7611. kumbrai, m., webb, r. (2010), a financial ratio analysis of commercial bank performance in south africa. african review of economics and finance, 2(1), 30-53. masruki, r., ibrahim, n., osman, e., abdul-wahab, h. (2011), financial performance of malaysian founder islamic banks versus conventional banks. journal of business and policy research, 6(2), 67-79. miniaoui, h., gohou, g. (2011), did the islamic banking perform better during the financial crisis? paper presented at international conference on management, economics, and social sciences, bangkok. december, 2011. misra, s.k., apa, p.k. (2013), a camel model analysis of state bank group. world journal of social science, 3(4), 36-55. olson, d., zoubi, r. (2008), using accounting ratios to distinguish between islamic and conventional banks in the gcc region. the international journal of accounting, 43, 45-65. sanwari, s., zakaria, r. (2013), the performance of islamic banks and macroeconomic condition. isra international journal of islamic finance, 5(2), 83-98. tarawneh, m. (2006), a comparison of financial performance in the banking sector: some evidence from omani commercial banks. international research journal of finance and economics, 3, 101-112. tuna, v.v. 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(2004), efficiency in islamic banking. islamic economic studies, 12(1), 1-19. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 645-649. international journal of economics and financial issues | vol 7 • issue 4 • 2017 645 functional forms and oligopolistic models: an empirical analysis david bouras1*, troy frank2, eric burgess3 1school of business, lincoln university, usa, 2school of business, lincoln university, usa, 3school of business, lincoln university, usa. *email: bourasd@lincolnu.edu abstract this paper attempts to empirically test the sensitivity of the new empirical industrial organization (neio) approach to the assumed demand and cost functional forms. such an approach relies upon oligopolistic models to infer the degree of competition in a market. unlike prior studies (genesove and mullin, 1998; clay and troesken, 2003), this paper focuses on the effect of the assumed cost function on the assessment of market power. using data from the us catfish industry, the empirical results reveal that the neio approach is fairly robust to the assumed demand and cost functional forms. keywords: demand, cost, new empirical industrial organization, market power jel classifications: c51, d24, d40 1. introduction the bulwark of the “new empirical industrial organization” method (neio, hereafter) is the relation linking the equilibrium price to marginal cost (e.g., bresnahan, 1982; genesove and mullin, 1998); that is, p mc q dp dq =       -θ ’ (1) where, p, q, and mc, are, respectively, output price, industry output, and marginal cost; and θ is an index of market power capturing various market structures. these include, among others, perfect competition when θ is equal to zero; monopoly power when θ is equal to one; and oligopoly power when θ lies between zero and one. inferring the degree of competition using equation (1) can be problematic, however. cost information and demand parameters are not readily available. hence, empirical estimations appear to be the only way of obtaining the needed cost and demand information. the empirical estimations of the parameters of the cost and demand functions, however, require the selection of functional forms. such a task can be tedious due to lack of theoretical and empirical foundations regarding the choice of appropriate functional forms. this, in turn, prompted economists to question the robustness of neio technique to the choice of the demand functional form. in that context, two studies attempted to evaluate empirically the robustness of the neio method: one in the sugar industry by genesove and mullin (1998), and the other in the whisky industry by clay and troesken (2003). these two studies used the adjusted lerner index (ali) as a benchmark and found that the neio approach is robust to the assumed demand functional form, especially for small values of the conduct parameter1. whether the neio technique is robust to the assumed cost functional form is an open question that needs to be addressed. in that setting, this paper fills the gap in the extant literature by testing empirically the sensitivity of the neio approach to the assumed cost functional form. it also contributes to the existing literature that examined competition in the us catfish industry in two different ways2. first, it addresses the sensitivity of the neio methodology to the selection of the cost and demand functional forms. second, one of the pitfalls of the research papers that investigated competition in the us catfish industry is their assumption that catfish processors sell a homogeneous product. in reality, however, catfish processing plants sell different forms 1 the ali is given by: θ η= p mc p       , where η is the elasticity of demand; and θ is the ali or the conduct parameter. 2 a substantial body of literature looked at competition in the us catfish industry (e.g., kinnucan and sullivan, 1986; kouka, 1995; bouras and engle, 2007; bouras et al., 2010). these studies, however, relied upon a simple functional form for the demand and cost functions. bouras, et al.: functional forms and oligopolistic models: an empirical analysis international journal of economics and financial issues | vol 7 • issue 4 • 2017646 of processed catfish, including primarily fresh and frozen whole catfish, fillet, nuggets, and steak. to address this issue, we focus exclusively on fresh whole dressed catfish. the paper is organized as follows: the first section provides the conceptual model; the second section contains data and the estimation of the econometric models; the third section reports comparative analyses; the last section concludes the paper. 2. conceptual model the starting point of our conceptual model is a catfish processor that converts live catfish into, among others, fresh whole dressed catfish. in that setting, the profit of producing and selling fresh whole dressed catfish can be formulated as: πi = p(q) × qi – tc (2) where, πi is the profit of the i th processor; p and qi are, respectively, the price and quantity sold of fresh whole dressed catfish; and tc is the total cost of producing fresh whole dressed catfish, which includes the processing cost and the cost of live catfish. the firstorder condition can be expressed as: i + i i i d dp dq= 0 ==> p q mc = 0 dq dq dq  (3) after a few algebraic manipulations, equation (3) can be rewritten as: p = mc q dp dq ¸ (4) where  = dq dq q i i q      is a measure of market power (iwata, 1974; bresnahan, 1982; lau, 1982). inferring θ from equation (4) requires the estimation of the parameters of the cost and demand functions. to this end, on the demand side, we use the following demand functional form (e.g., genesove and mullin, 1998): q(p) = β(α−p)γ (5) where, q is the quantity sold of fresh whole dressed catfish; and p is the price of fresh whole dressed catfish. we choose the above functional form because it encompasses several forms, including, among others, the log-linear form (α = 0 and γ < 0) and the linear form (γ = 1). for empirical application, we focus on the most commonly used functional forms, that is, the linear and log-linear forms. these functional forms are, respectively, given by: linear: q = β(α−p) + µ, (6) log-linear: ln(q) = ln(−β) + γln(p) + µ (7) using the demand function given in equation (5), equation (4), after a few algebraic manipulations, takes the following final form: + + + p = mcγ γ αθ γ     θ       θ . (8) equation (8) is termed the generalized pricing rule function (for example, genesove and mullin, 1998). on the cost side, we decompose marginal cost into two major components: marginal processing cost and the cost of live catfish. it is known that live catfish is converted in fixed and known proportions into fresh whole dressed catfish. hence, marginal cost can be formally expressed as: mc = mpc + k × w (9) where, mpc is marginal processing cost; k is the conversion factor; and w is the price of live catfish. the estimation of marginal cost as given in equation (9) requires knowledge of mpc and k. while the value of the conversion factor, k, can be obtained from extraneous information, the estimation of marginal processing cost, mpc, can be tedious. in the existing neio literature, the estimation of marginal processing cost is based on the selection and estimation of a specific functional form. in this paper, and in order to test the sensitivity of neio methodology to the selection of the cost functional form, we use three different methods. these methods include: the generalized leontief form, the linear form, and the genoseve and mullin’s technique (1998). the generalized leontief marginal processing cost (e.g., appelbaum, 1982) is given by: ( )1/2ij i j i=1 j=1 mpc = p pδ∑∑ , (10) where, p is a vector of input prices. as in bouras and engle (2007), we use three input prices: labor (pl), capital (pk), and energy (pe). marginal processing cost as given in equation (10) becomes mpc = δeepe + δkkpk + δllpl + 2δek(pepk) ½ + 2δel(pepl) ½ + 2δkl(pepl) ½ (11) the linear marginal processing cost (e.g., corts, 1999), on the other hand, can be formulated as: mpc = p 0 i i=1 i +ϕ ϕ∑ . (12) using the input prices, as previously defined, the linear marginal processing cost becomes: mpc = φ0 + φepe + φkpk + φlpl (13) finally, the genesove and mullin’s technique (1998) consists of treating marginal processing cost as a parameter and then estimating it along with other model’s parameters. specifically, marginal cost can be expressed as: mc = mpc + k × w (14) where, mc is marginal cost; mpc is a parameter representing marginal processing cost; k is the conversion factor; and w is the price of live catfish. 3. data and estimation procedure the econometric models include two different demand functional forms, including the log-linear and linear forms; and three bouras, et al.: functional forms and oligopolistic models: an empirical analysis international journal of economics and financial issues | vol 7 • issue 4 • 2017 647 generalized pricing rule functions. these pricing rule functions are obtained by using three different cost functions, including the linear and generalized leontief forms, and the genesove and mullin’s technique. to empirically estimate the econometric models, we use quarterly data ranging from 1992:ii to 2004:iv. the data were collected from various sources. the price of live catfish, and the quantity sold and price of fresh whole dressed catfish were collected from the united states department of agriculture; hourly minimum wage was obtained from the united states department of labor; average retail electricity price was taken from the united states department of energy; and the bank loan rates were compiled from the federal reserve bank of st. louis. summary statistics are reported in the table 1. to estimate the demand functions, we use the non-linear least squares method. heteroskedasticity and autocorrelation-consistent standard errors are computed using the newey and west’s technique (1987). table 2 contains the estimates of the parameters of the log-linear and linear demand functions. also reported in table 2 are the estimates for the demand elasticities (η) for the log-linear and linear demand functions3. having estimated the parameters of the demand functions, the next step is to use them along with an estimate of k, the conversion factor, to estimate the parameters of the generalized pricing rule functions. our estimate of k is taken from silva and dean’s study (2001). according to that study, one pound of live catfish yields 0.62 pounds of fresh whole dressed catfish; that is, for every pound of fresh whole dressed catfish produced 1.61 pounds of live catfish will be required. so, the value of k is 1.61. the estimates of the parameters of the generalized pricing rule functions are presented in table 3. of paramount relevance is the index of market power, θ. a casual look at the results shows that 3 the elasticity of demand for the linear form is computed at the mean values for the quantity and price of fresh whole dressed catfish. the point estimates of θ are close to zero. more importantly, and in most cases, the null hypothesis that θ is equal to zero cannot be rejected, implying that the market for fresh whole dressed catfish is competitive. the empirical results, therefore, suggest that the neio methodology is fairly robust to the assumed demand and cost functional forms. 4. comparative analyses in this section, we compare our estimate for market power; i.e. θ, obtained previously using the neio technique with a benchmark for market power. our benchmark for market power is obtained by using the ali. this index is given by: ali= p-mc p η    , (15) where, p is the price of fresh whole dressed catfish; η is the elasticity of demand for fresh whole dressed catfish; and mc is marginal cost. substituting (14) into (15) results in: ali= p mpc k w p ×    , (16) where, mpc is marginal processing cost; k is the conversion factor; and w is the price of live catfish. to compute the ali, we use our previous estimates for the elasticities of demand for fresh whole dressed catfish, η, for the log-linear and linear demand functions; the price of live catfish; the price of fresh whole dressed catfish; and an estimate for marginal processing cost (mpc). our proxy for marginal processing cost comes from a study by lazur (1997). following that study, the cost of processing one pound of live catfish into fresh whole dressed catfish is $0.44. so, the value of mpc is 0.44. yearly estimates of adjusted lerner indices are provided in table 4 and figure 1. the average values of the adjusted lerner indices are 0.040 and 0.046 for the log-linear and linear demand functional forms, respectively. these estimates are close to zero suggesting, once again, that the market for fresh whole dressed catfish is competitive. in addition, the estimates of the adjusted lerner indices are, to a greater extent, similar to those of the index of market power, θ, obtained previously using the neio methodology. it is also interesting to compare our proxy for marginal processing cost with the estimates for marginal processing cost obtained previously using the genesove and mullin’s technique (1998). table 5 contains the 99% confidence interval for marginal processing cost estimated using the genesove and mullin’s table 1: summary statistics variable minimum maximum mean±sd price of live catfish ($/lb) 0.55 0.80 0.70±0.08 price of fresh whole dressed catfish ($/lb) 1.43 1.89 1.72±0.14 quantity sold of fresh whole dressed catfish (1000 lbs) 5851.00 9955.00 7520.14±855.17 bank loan rate (%) 4.00 9.50 6.98±1.78 electricity price (ȼ/kwh) 4.26 5.56 4.77±0.31 hourly minimum wage ($/h) 4.25 5.15 4.80±0.42 sd: standard deviation table 2: nonlinear estimates of demand functions parameter demand functional form linear log-linear α or ln(−β) 5.03* (1.602) 9.17* (0.134) β or γ 2268.74* (1118.571) −0.47** (0.232) demand elasticity (η) −0.52* (0.256) −0.47** (0.232) r2 (%) 13.80 12.60 log-likelihood −412.39 42.88 number of observations 51 51 standard errors are between parentheses. *,**, and *** represent 1%, 5%, and 10% significance level, respectively bouras, et al.: functional forms and oligopolistic models: an empirical analysis international journal of economics and financial issues | vol 7 • issue 4 • 2017648 technique (1998) along with the direct measure of marginal processing cost taken from lazur’s study (1997). the estimates of marginal processing cost using the genesove and mullin’s technique (1998) range from $0.42/lb to $0.66/lb for the loglinear demand function; and range from $0.45/lb to $0.92/lb for the linear demand function. it should be pointed out that the genesove and mullin’s technique (1998) performed relatively well, especially when using the parameters taken from the loglinear demand function. 5. conclusion this paper attempts to empirically test the sensitivity of the neio technique to the assumed demand and cost functional forms. the focus of the paper is, however, on the effect of the assumed cost function on the estimation of market power. using data from the us catfish industry, our empirical results reveal that the new empirical industrial organization approach is fairly robust to the assumed demand and cost functional forms. in addition, the empirical results indicate that the genesove and mullin’s technique for estimating marginal processing cost performed relatively well particularly when using the parameters taken from the log-linear demand function. table 3: nonlinear estimates of generalized pricing rule functions parameter demand specification linear form log-linear form cost specification cost specification glf lf gmt glf lf gmt estimate estimate φ0 or mpc −0.02 0.69* −0.58* 0.54* (0.391) (0.088) (0.164) (0.046) θ −0.10* −0.11 −0.03 0.01 0.05 0.01 (0.037) (0.093) (0.026) (0.021) (0.044) (0.012) φe or δee −0.61 0.10* −0.10 0.10* (0.423) (0.019) (0.424) (0.019) φk or δkk 0.08 0.01** 0.13* 0.01** (0.063) (0.006) (0.044) (0.006) φl or δll −0.46 0.09* −1.14** 0.09* (0.380) (0.021) (0.512) (0.021) δek 0.02 −0.13** (0.061) (0.049) δel 0.67*** 1.19** (0.372) (0.446) δkl −010* 0.003 (0.031) (0.065) r2 (%) 95.14 93.84 82.86 93.88 93.84 82.86 log-likelihood 105.55 99.47 73.38 99.63 99.47 73.38 number of observations 51 51 51 51 51 51 standard errors are between parentheses. these are computed using the newey and west’s technique (1987); glf: generalized leontief form, lf: linear form, gmt: genesove and mullin’s technique, *,**, and *** represent 1%, 5%, and 10% significance level, respectively table 4: yearly estimates of ali year ali mean±sd linear demand log-linear demand 1992 0.013±0.009 0.017±0.011 1993 0.014±0.006 0.014±0.005 1994 0.038±0.010 0.033±0.006 1995 0.042±0.005 0.035±0.004 1996 0.050±0.012 0.041±0.006 1997 0.048±0.004 0.042±0.004 1998 0.043±0.009 0.038±0.006 1999 0.046±0.011 0.040±0.008 2000 0.070±0.022 0.055±0.014 2001 0.069±0.005 0.063±0.004 2002 0.034±0.002 0.037±0.005 2003 0.051±0.016 0.049±0.009 2004 0.081±0.013 0.058±0.006 average 0.046±0.010 0.040±0.007 sd: standard deviation, ali: adjusted lerner index table 5: marginal processing cost: direct measure versus genesove and mullin’s technique direct measure 99% confidence interval for marginal processing cost/genesove and mullin’s technique linear demand log-linear demand lower bound upper bound lower bound upper bound 0.44 0.45 0.92 0.42 0.66 figure 1: yearly estimates of adjusted lerner indices bouras, et al.: functional forms and oligopolistic models: an empirical analysis international journal of economics and financial issues | vol 7 • issue 4 • 2017 649 references appelbaum, e. 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(2001), processed catfish: product forms, packaging, yields and product mix, southern regional aquaculture center publication, no. 184. u.s. department of agriculture, catfish and trout production. national agricultural statistics service. (1992-2004). u.s. department of energy, energy information administration. monthly energy review. (1992-2004). u.s. department of labor, bureau of labor statistics, employment and earnings. (1992-2004). . international journal of economics and financial issues | vol 6 • special issue (s8) • 2016234 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s8) 234-239. special issue for “fundamental and applied research in economics and management: new perspectives” features of social and economic support of the territorial subjects of the russian federation denis a. klyuchnikov1*, rustem a. shichiyakh2, eugeny p. kolpak3, vitaly a. tupchienko4, viktor m. volodin5, albert k. isaev6 1far eastern federal university, vladivostok, russian federation, 2kuban state agrarian university, krasnodar, russian federation, 3saint petersburg state university, saint petersburg, russian federation, 4national research nuclear university mephi (moscow engineering physics institute), moscow, russian federation, 5penza state university, penza, russian federation. 6polytechnic institute (branch) of the don state technical university, taganrog, russian federation.*email: klyuchnikov_da@mail.ru abstract the political, social and economic reforms of the 90s of the last century, along with the activation of such social phenomena as alcoholism, drug addiction, depopulation, etc., gave rise to some processes fundamentally new for russia poverty, unemployment, child neglect, forced migration characterized by steady growth of population in need of social support. all these phenomena have identified urgent need to develop a system of measures on social support of the population of russia, mitigation of negative social consequences of economic reforms. however, the relaxation role the state’s role, formation of market mechanisms in the absence of the effective system of social process management in the situation of economic slack, realistic lack of consistency of social policy measures not only failed to alleviate the existing social risks, but often contributed to their increase. the most significant social problems today, despite some improvement in the standard of living of the past few years, are increasing polarization of incomes, the natural decline in population and its marginalization. the social support system existing in contemporary russia largely corresponds to the socialist mode of management; it is not adapted to the current social and economic factors and conditions of development of russia. keywords: economical good, social and economic support, country population jel classifications: h50, h53, l81, l84, m31 1. introduction social and economic support is in-kind and cash aid provided to citizens (families) in need of additional support due to difficult real-life situation. in cases when the citizens have no funds in the amount of living minimum wage, they are given social assistance: monetary payment (pensions, allowances, subsidies and a variety of compensations), free or partially paid (beneficial) services (at home, in the hospital, etc.), in-kind aid (fuel, food, clothing, footwear, medicines, etc.). the state of socio-economic support is aimed at maintaining the standard of living of the population category whose average income through no fault of their reasons is below the living minimum wage established in the territorial subjects of the russian federation. the source of funding of social assistance is the federal budget and the budgets of other levels, the basic principle of which is the principle of targeted and efficient use of funds. targeted social assistance can be provided on a nonrecurring basis for a period not <3 months. types of assistance: social allowance, subsidies, compensation. socio-economic policy of the russian government is aimed at in improving the standard of the population living based on the increase of real available income of citizens. within the framework klyuchnikov, et al.: features of social and economic support of the territorial subjects of the russian federation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 235 of improvement of population incomes policy, the strategic target of the state is to restore reproductive and stimulating function of wages, the amount of which should be sufficient not only to meet the current needs of food, clothing, housing, but also the needs in annual proper holiday, as well as to generate savings. social assistance only to those citizens whose actual consumption is below the living minimum wage has become the main method of support of the most vulnerable categories of the population (annemans, 2012). the concept of “targeting” in this context means the restriction of the circle of recipients of social assistance to a specific target group. the principle of social assistance targeting, enshrined in the laws is often understood as targeting related to a certain category of the population, and not on the basis of need. providing targeted assistance solely on the basis of income below the subsistence level leads to the fact that it will be received not only the citizens unable to work, but also quite able-bodied. therefore, the system of targeted social assistance should be sufficiently flexible and well thought-out to be effective. the assistance should be given to those who cannot cope with difficult life situations on their own. the realization of the principle of targeting shall allow directing the assistance to those who really needs it. of great importance in this case is the mechanism for providing targeted social assistance (intergovernmental fiscal relations in the conditions of development of federalism in russia: textbook, 2011). regional laws and the programs of targeted social assistance are distinguished by one common feature (bogoviz and mezhov, 2015): they combine the principle of categorical and targeting principle. laws on targeted assistance are aimed at specific categories of the population (as a rule, pensioners, the disabled, single-parent and large families) and those in need are selected out of these categories. the adoption of normative legal acts of targeted assistance, establishing the principle of targeting for child allowance payment before the adoption of the corresponding federal law, was due to lack of funds for the payment of allowances in full and the increase of debt on them. unfortunately, for the realization of the principle of targeting, the assistance is often provided in kind, based on the belief that only those in need will apply for obtaining in-kind assistance. of course, the accumulation of debts in payment of benefits, their issuance in-kind does not contribute to transparency of payments mechanism (annemans, 2012). all the regional laws and the programs of targeted social assistance are distinguished by one common feature: they combine the principle of categorical and targeting principle. laws on targeted assistance are aimed at specific categories of the population (as a rule, pensioners, the disabled, single-parent and large families) and those in need are selected out of these categories. to define the concept of targeted social assistance of the population, russia has yet only limited by the declaration of social state (zakharov et al., 2016; kunelbayev et al., 2016). many social guarantees of right and freedom enshrined in the constitution of the rf are either not provided, or act in a truncated version. targeted social assistance of the population takes an important place in the structure of social management in general and in local government structure in particular. organization of optimal targeted social assistance of the population implies not only the study of laws and other normative acts that establish its criteria within the framework of relations “state-person-law-social security,” but also the ability to define locally the admissible action boundaries in relationships with other subjects and to develop their own variants of targeted social assistance models. despite numerous attempts to introduce the principle of targeted social assistance at the regional and municipal levels, the degree of targeting of social benefits for the whole in the russian federation has not much been improved (okushko, 2011). 2. the problems of rendering the targeted social assistance to the population in our view, the problem of rendering the targeted social assistance was due to the following reasons: 1. the law does not contain specific information on the sources of funding for targeted payments. in the consideration stage in the state duma, some provisions were omitted which would allow the authorities of subjects of the federation and local authorities to reallocate for the purposes of targeted social assistance funds by a corresponding reduction in the costs for providing the categorical payments and benefits, which degree of targeting remains low. law “on state social assistance” becomes financially unsecured and impractical. thus, the country-wide transition to targeted principles of social assistance in the form in which it is provided by federal law, in practice is not feasible due to lack of funds. 2. regions with low levels of socio-economic infrastructure. with the current state of the federal and regional budgets in russia, the realization of targeted social assistance cannot set the task to overcome the poverty completely, which is actually implied in the laws “on the subsistence minimum in the russian federation” and “on state social assistance.” even with the severe restrictions on the provision of targeted assistance, potential costs would exceed the actual financial possibilities of the budget. the possible solution lies in creation of the set of measures for the development of industrial production in the regions on the basis of “dominant local employers” as well as the agricultural sector. in connection, there will be lead to decline in unemployment, therefore, the decline in those in need of social assistance, thereby increasing the budget of regions. thus, one can conclude that if the economic growth becomes stable, the level of financing the social sphere can be restored in a short time to the maximum level (ponomarenko, 2013). 3. evaluation of need. klyuchnikov, et al.: features of social and economic support of the territorial subjects of the russian federation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016236 when selecting the population in need of targeted assistance, the recipient shall be accurately and reliably determined. the most important parameter when evaluating any methodology of targeting provision is how accurately it identifies the recipients of assistance, i.e., how effectively it defines the poor and nonpoor (mindlin et al., 2016). all the assistance will be distributed exclusively within the target group in the ideal targeted program, and at the same time, the maximum assistance will be provided to the poorest representatives of the target group. however, the ideal targeted mechanism does not exist. often it is difficult to identify the poor, and the indicators used in the framework of a methodology for targeting provision do not reflect the actual characteristics of the poor. it should also be borne in mind that the law “on state social assistance” provides only one type of the citizens’ means test-selective direct control over the validity of the information about the income and property declared by the citizens, which can be used for the purposes of deriving income (zaviyalova et al., 2014; kirillov et al., 2016). however, even the most effective method based on the direct-mean test, does not allow to estimate with high confidence the level of consumption of poor families, who tend to understate the declared income. moreover, the restrictions imposed as a condition of receiving aid, often push people to provision of under-reporting of income of their households or false information with a view to get into the category of citizens in need. validation check of such information is often associated with certain administrative difficulties and is too expensive. however, it should be noted that administrative costs represent only a small portion of the total spending on social programs. solution of the accumulated targeted social problems implies deep structural reforms in the social sphere, which would ensure the redistribution of social spending in favor of the most vulnerable groups of population. 3. the evaluation of the economic enforceability of “cost-utility” method and its use in education and health care sectors currently, the results of rendering many medical services cannot be expressed in monetary terms. it is impossible, for example, to evaluate in rubles the role of psycho-therapeutic procedures during treatment, or the role of advanced professional training of personnel in improving the quality of rendering the medical aids, or the effect of acute pain control acute pain when applying block anesthesia (khabriev et al., 2012). the pharmacoeconomic studies more frequently use the analysis of “cost-utility,” which essence is to determine the ratio of the costs incurred and the utility obtained in comparable therapies (savchenko et al., 2009). in this case, as the uniform indicator for different types of results in practice there used the method reflecting the result, expressed in a summary not monetary indicator-such as quality adjusted life year (qaly) or disability-adjusted life year (daly). methodology of “costs-utility” is based on the choice of conditional indicator optimal in the patient’s point of view (silnov and tarakanov, 2015), which is a decision-making model for the patient on the ratio of the most suitable for him of the length and quality of life which is achieved due to the applied method of treatment with a given initial state of health. at that as a criterion for the usefulness of treatment used is the indicator qaly. the basis of the method “costs-utility” is to calculation of the “life expectancy indicator correlated with its quality” (qaly). to determine the meaning of condition utility there identified are the two groups of methods: • methods of direct assessment; • methods of assessments using questionnaires of the overall quality of life. to assess the utility the questionnaires are often used, since it is the most visible and convenient method of getting the information for the patient and the investigator. there can be several types of questionnaires: • depending on the area of application: • general (for adults and children); • specific. they are specific to the population (e.g., adolescents, the elderly), for the state (e.g., depression, restriction of mobility) for the problem (e.g., pain), for the disease (e.g., arthritis, asthma, osteoporosis), for the type of treatment (e.g., chemotherapy or radio-therapy). at that, it is possible to use both single questionnaire and a set of questionnaires for different functions and problems depending on the structure: • profile (multiple digital values that represent the profile formed by the values of several scales); • index numbers (uniform digital value) (ponomarenko, 2013). all the presented methods are hypothetical. the values of obtaining the results of any of these methods lie in the range from 0.00 to 1.00. the described methods provide identical results only if the function describing the utility of states is linear with time, which is rare. when comparing the results of the methods may differ. after determining by the patient of the preference value of the his state, qaly utility indicator is calculated taking into account the time period for which the calculation is made, and the quantitative value of assessing the state of health of the patient obtained on the first stage. qaly indicator is a numerical value measured in a state of uncertainty, which is a standard unit corresponding to 1 year of extended life to its absolute quality (1.00) and reflects the changes klyuchnikov, et al.: features of social and economic support of the territorial subjects of the russian federation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 237 in life expectancy and its quality that can be achieved using this method of treatment. qaly is a prognostic indicator of health status multiplied by the time interval for which the calculation is performed. in order to estimate the numerical value of qaly, each status during any kind of disease obtains utility ratios from 0 (death) to 1 (completely healthy). next, the years won are multiplied by the factor of utility, which ultimately gives the numerical value of qaly. for example, if the expected duration of life in the region as a result of the reforms in health care is increased by 5 years with an average coefficient of quality of added years of life equal to 0.7, then the result of realized reforms is estimated as 0.7 multiplied by 5 = 3.5 qaly (the rf law “on the basis of social service of the population of the russian federation,” 2016). another example of qaly calculation is provided by s. r. gilyarevsky “for example, after establishing the diagnosis of a particular disease the patient’s life expectancy without treatment will be equal to 1 year, but the quality of life in the course of this year will be good (utility indicator of life quality will be equal to 1.0)” (khabriev et al., 2012; androsova et al., 2016). treatment of this disease will prolong the life of the patient up to 4 years, but due to the side effects of therapy, the quality of life will decline to 0.6 for the remainder of life. based on these data, qaly calculation is as follows. 4 years of life after treatment with the utility value of life quality 0.6 give: 0.6 × 4 = 2.4; the loss in quality of life within 1 year from 1.0 (without treatment) to gives 0.6: 1.0-0.6 = 0.4; qaly indicator obtained as a result of treatment is equal to 2.4-0.4 = 2.0. qaly value, equal to 1.0, is assigned to lifespan of 1 year at the quality of life, corresponding to an absolute health. therefore, 1 year of life with a worse quality of life less than the absolute health is assigned a lesser qaly value 1.0. upon obtaining qaly indicator for this method of treatment, at the next stage of analysis it is combined with the economic evaluation of treatment effectiveness (cost-utility analysis [cua]). qaly indicator is used as a measure of “utility” when carrying out “cua”. this is a special case of cea analysis (“cost-effectiveness analysis”), in which the measure of effectiveness is utility. with this method of pharmaco-economic analysis there taken into account not only the achievement of various clinical effects as the patient preferences of certain interventions results. cua analysis implies comparing the value in monetary terms and the results of usage of alternative therapies or medicines in terms of utility or qaly (khabriev et al., 2012; mamycheva et al., 2016). the purpose of the analysis is to determine which of the alternative treatment regimens or the medicines will be the most preferable for the patient with respect to a unit cost. cua is done according to the following formula: cua = dc*ic/ut, where, cua “cost-utility” ratio; dc direct costs; ic indirect costs; ut utility. advantages of сuа method: 1. it takes into account the patient’s preferences in the selection of the results of certain interventions. 2. it combines both the quantity and quality of results in economic evaluation. disadvantages of сuа method: 1. difficult to measure utility. 2. subjective in advantage assessment. cua method is the most complex and costly. it is appropriate in the following situations: • when quality of life is an important indicator of the disease, such as asthma; • when the quality of life is the most important result. for example, when comparing interventions that are not expected to impact on mortality, but they have a very large impact on the patient’s vital functions and its well-being (e.g. treatment of arthritis); when the quality of life is an important indicator of treatment result; • when intervention affects both mortality and disease incidence, and the presence of the combines unit of result is preferred. for example, evaluation of therapy (for example, the use of estrogens by women in menopause), which can improve the quality of life, reduce the mortality rate due to specific conditions (e.g., heart disease), but may increase the mortality due to other conditions (such as cervical cancer); • when the compared interventions have a wide range of results and it is required to have one unit for comparison; when the target is to compare the interference with the others that have already been evaluated in qaly category (yagudina, 2011). 4. daly indicator along with the qaly many medical care quality assessment studies use calculations daly indicator-the loss of years of healthy life due to disability or premature death (annemans, 2012). this method gives an unequal value to age and introduces the concept of equivalent years of life. the method of calculating daly reflects population effects both due to the use of medical technologies, and as a result of the impact of the economic, social, environmental, urban and other adverse factors on the population. therefore, this criterion can be used for global economic calculations, such as differentiation and equalization of health care resources in the territories, having significant differences in this indicator, but is not suitable for routine pharmacoeconomic studies. this method involves comparison of spending options, aimed at achieving a common target and differing not only in costs, but also in the degree of achievement of final result. it is important that, using the method of “cost-effectiveness,” it is possible to compare klyuchnikov, et al.: features of social and economic support of the territorial subjects of the russian federation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016238 very different health programs aimed at the same target. thus, it is possible to compare programs aimed at treatment of heart disease, prevention of tuberculosis, kidney dialysis in case of kidneys fail, etc. the main thing is that these programs set the uniform target (e.g., extension of population life) (yakobson, 2014). development budgets are always connected with competition of sectors for public resources. for legislative and executive authorities it is important to determine funding priorities under the clear, transparent targets and with a view to achieving certain (measurable) results (savchenko et al., 2009; ragulina and kamaev, 2013) when introducing the budgeting methods. at macro level and at the industry-specific level, the method of “costeffectiveness” shall find widespread use in the near future, because it is very difficult to move from cost planning to the planning of results in the course of development of regional and local budgets without it (to performance-based budgeting). next, let’s consider the method of such analysis at the regional level and the municipality. with regard to efficiency in healthcare the analysis as per the “cost-effectiveness” method involves the evaluation of results related to the increase the life span of the population, reduction of incidence on a particular disease, improving the quality of medical services, etc. an illustrative example of using the method of “cost-effectiveness” can serve the following situation: the territory of the vologda region, there are two special programs “preventive vaccination” and “prevention of hiv-aids.” in the first case we are talking about prevention of common diseases (hepatitis b and rubella), covering thousands of people (malyshkov and ragulina, 2014). the situation with the incidence of the citizens of vologda region by aids today is characterized by a de facto termination of the growth of this indicator. this fact allows us to restrict preventive measures to prevent the spread of aids in the region through the creation of special conditions for a limited number of patients and implement the redistribution of the financial resources from the program “hiv-aids” to the program “preventive vaccination” (intergovernmental fiscal relations in the conditions of development of federalism in russia: textbook, 2011). until 2005, the same amount of money was spent on the development of the both regional programs each year 13 million rubles. the above described stabilization of the incidence of aids among the population on the background of complication of situation with the spread of hepatitis b and rubella within the region allowed to reduce the planned budget for the program “hivaids” by 4.5 million rubles in 2005 and thus to expand the budget of the program “preventive vaccination” by the same amount. as a result, a significant positive result in the economic and demographic aspects of health has been achieved-namely, reduction of the incidence of hepatitis b by 2 times and rubella by 22 times, while the incidence of aids has not increased. cost savings as a result of the redistribution of financial resources in favor of vaccination was around 350,000 rubles (khabriev et al., 2012). to evaluate the effectiveness of health care by the method of “costs-effectiveness” along with the above indicators of volumes of medical services (bed days per 1000 people according to profiles and levels of health care, the number of treated patients, the number of visits per 1000 people, the number of “emergency” calls per 1000 people, the number of days spent in day patient departments per 1000 people), the group of following indicators can be used for measuring the performance of health system and its institutions: • morbidity of the population (the number of cases registered at patients with first established diagnosis, per 1000 people), including the major classes of diseases; • the aggregate of all patients with this disease, who applied for help to; • to out-patient clinics both in current and in previous periods, and registered at the end of the reporting period; • morbidity of the population with temporary disability is characterized by a number of temporary disability days; • primary disability-the number of persons recognized as disabled for the first time in the current year; • mortality; • the number of public complaints about the quality of medical services rendered. 5. conclusion the refocusing of social programs and their resolution by the methods and means specific for the market economy system, puts on the agenda of the necessity to address to the following issues on a priority basis: self-sufficiency of society members at the expense of the own labor; compensation of reduction of life level and quality; targeted social assistance. these and other aspects of social character have long been widely publicized and used in developed countries, while we were limited to arguments about the general economic stability and support from the state. awareness of the causes of the urgent need to reform the social assistance system in conjunction with the idea of the experience of such reforms, both abroad and in some regions of the country, requires its radical reformation in russia, and this acquires a particular relevance today, in a new burst of economic crisis, which social consequences has already affected the society. it is referred to creating a system which in the long-term, would constitute an adequate level of social assistance, promote the effective labor and social and economic development of the country on the whole. references androsova, i.v., melnichuk, a.v., bondaletov, v.v., vinichenko, m.v., duplij, e.v. 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(2014), visualization of working versions of balanced scorecard strategy maps in managing regional competitiveness. life science journal, 11, 547-549. international journal of economics and financial issues vol. 1, no. 3, 2011, pp.78-87 issn: 2146-4138 www.econjournals.com perspectives of corporate governance in croatian banking sector tea golja department of economics and tourism “dr,mijo mirković” juraj dobrila university of pula, preradovićeva 1/1, 52100 pula tel: +385 52 377 086, e-mail: tgolja@efpu.hr marinela krstinic nizic faculty of tourism and hospitality management university of rijeka, primorska 42, 51410 opatija tel: +385 51 294 189, e-mail: marikn@fthm.hr morena paulišić department of economics and tourism “dr,mijo mirković” juraj dobrila university of pula, preradovićeva 1/1, 52100 pula tel: +385 52 377 055, e-mail: mpauli@unipu.hr abstarct: financial market of any country firstly has to be “secure”, but although financial market is regulated and monitored, we were witnesses of bad examples (island). so, globally all aspects of corporate governance became interesting: ownership; nature of activities; liquidity ratios, etc. the goal of this paper is to give perspectives of corporate governance in croatian banking sector. the results of the research conducted in october 2010 are presented. the situation regarding corporate governance issues in banks is highlighted. according to the research in croatian banks in the future corporate governance should give more attention to responsiveness; equity; efficiency and effectiveness; and on accountability. mentioned principles are not clearly defined and recognizable. these will assure differentiation on market and trust of all stakeholders. keywords: corporate governance, banking sector, the republic of croatia jel classification: d22, k23, m14 1. introduction the well functioning financial system is a key issue for healthy development and growth of the national economy. the last financial and economic crisis has revealed many holes and malfunctions of the financial markets and misconduct of its institutions and key participants like: the greed of managers, the company’s engagement in manipulative deals, corruption, the lack of state intervention on the market, the little focus placed on moral, ethics and losing of the human values as well as social responsibility of corporations. thus, special focus should be put on the governance system. precisely, the focus should be on encouraging and supporting effective implementation of already agreed standards, primarily as an issues for companies, their boards and their shareholders, but also as an important role for supervisory, regulatory and enforcement authorities (oecd steering group on corporate governance, 2010,6). crowther and aras (2009) stated that good governance is not simply a matter of adopting a set of rules, but a continuous process of implementing tailored strategic initiatives to maximize long-term value and furthermore has to be considered as an environment of trust, ethics, moral values and confidence – as a synergic effort of all the constituents of society – that is the stakeholders, including government; the general public etc; professional/service providers – and the corporate sector. any confidence in management is more important in financial organization than other business (aras, 2009, 91). corporate governance arrangements, as well as legal and regulatory systems, vary widely between countries (basel committee on banking supervision, 2006). financial market with stocks exchange, multinational corporations, unique currency (europe, usa), etc. needs global governance. global governance perspectives of corporate governance in croatian banking sector 79 (crowther, aras ,2009) can be considered to be the complex of formal and informal institutions, mechanisms, relationships, and processes between and among states, markets, citizens and organizations, both interand non-governmental, through which collective interests on the global plane are articulated, rights and obligations are established, and differences are mediated. nowadays, global governance tries to find solutions for threats of the european financial markets i.e. greece, portugal, and ireland etc. in the republic of croatia economy is still facing the recession problems while banking sector is relatively stable due to responsible risk management, high capitalization and active monetary policy. this stability has enabled the support of all economic activities and enhanced the economic recovery. from the above, it is notable the important role banks have for croatian economy, especially their healthiness and good business practice. as such, banks have to conduct their business responsibly in order to retain their reputation and support the economy. governance system in the banks and its way of functioning should be transparent, credible, ethically motivated and responsibility-oriented. this paper presents the research results of desk and field research. field research was carried out in october 2010 on sample of seven (7): six big and one medium-sized from thirty-four (34) existing banks (6 large, 3 medium-sized, and 25 small banks); selection criteria was report to croatian national bank on the consolidated basis (banks bulletin, no.20, 2010). the banks were: erste & steiermarkische bank, hrvatska poštanska banka, hypo-alpe – adria bank, privredna banka zagreb, raiffeisenbank austria, societe generale – splitska banka, and zagrebačka banka. the research tool was on-line questionnaire, created in a way to explore a manager’s perception of (1) corporate governance; (2) ethics and corporate social responsibility and (3) corporate communication and reputation. respondents’ were equally divided: male 50%; female 50%. average number of years on the managerial position was 7 years. the average age of respondents is as follows: 37, 5% of managers have between: 31-35 years; 37, 5% of managers have between: 41-45 years. 75% of the respondents have a bachelor degree; none of them has finished a mba, nor have attained the scientific master or doctoral degree. majority of the respondents were senior executives four (4), two(2) hold a position of a middle manager and one (1) low level management. in corporate governance system, it is inevitable to emphasize the gender structure, namely, in the analyzed banks 66, 7% of women is in supervisory board as well as in the board of directors. the average number of women employed (in general) in analyzed banks is 83, 3%. the paper provides a contribution in the field of banking sector in croatia, as well as it opens new questions to be posed in this direction. this paper will supplement researches (borozan and hadrović, 2003, kowalski et.al. 2003, koričan and ćorić, 2009, sever, 2009 ) also mainly focused on the csr and corporate governance. the goal of this paper is to give perspective (holistic picture) of corporate governance in croatian banking sector. in our future work except corporate governance we will analyzed the values of social responsibility and communication in croatian banking sector. 2. corporate governance expectation corporate governance usually represents strategic orientation throw set of processes, customs, polices, laws and institutions affecting the way any corporation is directed, administered and controlled. corporate governance is reliant on external factors (law, institutions, market, global situation, etc.), but internal factors (employees, strategies, knowledge, etc.) can give opportunity to differentiate from competitor on global market. also, corporate governance help businesses to meet global challenges while improving organizational competitiveness and safeguarding the interests of all stakeholders (aras, 2009, 87). corporate governance is very important because of its influence on: reputation; rights and treatments of shareholders, relations with stakeholders; transparency and openness of company, etc. corporate governance is nowadays used as managerial tool. good corporate governance should contribute to better company performance by helping a board discharge its duties in the best interests of shareholders; if it is ignored; the consequence may well be vulnerability or poor performance (frc, financial reporting councile, 2008). governance needs to assure expected behavior, ethical standards, culture, and to monitor institutional changes, community and media environments. but crisis has opened the old debate about the costs and benefits of regulation as opposed to market mechanisms (oecd steering group on corporate governance, 2010, 6). good corporate governance requires appropriate and effective legal, regulatory and institutional foundations (basel committee on banking supervision, 2006). furthermore we can recognize eight principles of international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.78-87 80 governance which underpin every system of governance (crowther and aras, 2009, 26-30): (1) transparency; (2) rule of law; (3) participation; (4) responsiveness; (5) equity; (6) efficiency and effectiveness; (7) sustainability and (8) accountability. in financial markets, there are various areas in which problems related to corporate governance arise like agency problems and the subsequent ethical problems that may lead to; the problems concerning insider trading; manipulation; reporting for general public; and providing information to investors (aras, 2009, 87). the banking sector is not necessarily totally corporate. some part of it is, of course, but a segment of banks is mostly government owned as statutory corporations or run as cooperatives (leeladhar, 2009). although government ownership of a bank has the potential to alter the strategies and objectives of the bank, a state-owned bank may face many of the same risks associated with weak corporate governance that are faced by banks that are not stateowned (basel committee on banking supervision , 2006). a good banking system is the backbone of a sustainable economy – and the banks’ vested involvement in influencing the market is not good for the economy (maharjan, 2011). since the market control is not sufficient to ensure proper governance in banks, the government does see reason in regulating and controlling the nature of activities, the structure of bonds, the ownership pattern, capital adequacy norms, liquidity ratios, etc. (leeladhar, 2009). but it is important for jurisdictions to regularly review whether their supervisory, regulatory and enforcement authorities are sufficiently resourced, independent and empowered to deal with corporate governance weaknesses that have become apparent (oecd steering group on corporate governance, 2010, 6). from banking industry perspective, corporate governance involves the manner in which the business and affairs of banks are governed by their boards of directors and senior management, which affects how, they (basel committee on banking supervision, 2006):  set corporate objectives;  operate the bank’s business on a day – to – day basis;  meet the obligation of accountability to their shareholders and take into account the interests of other recognized stakeholders;  align corporate activities and behavior with the expectation that banks will operate in a safe and sound manner, and in compliance with applicable laws and regulations, and  protect the interests of depositors. banking as a sector has been unique and the interests of other stakeholders appear more important to it than in the case of non-banking and non-finance organizations the involvement of government is discernibly higher in banks due to importance of stability of financial system and the larger interests of the public (leeladhar,2009). so, effective corporate governance practices are essential to achieving and maintaining public trust and confidence in the banking system, which are critical to the proper functioning of the banking sector and economy as a whole (basel committee on banking supervision, 2006). on other side, poor corporate governance may contribute to bank failures, which can pose significant public costs and consequence due to their potential impact on any applicable deposit insurance systems and the possibility of broader macroeconomic implications, such as contagion risk and impact on payment systems consequently all market can lose confidence (basel committee on banking supervision, 2006). a variety of factors, including the system of business laws and accounting standards, can affect market integrity and overall economic performance but such factors are often outside the scope of banking supervision (basel committee on banking supervision, 2006). there are four important forms of oversight that should be included in the organizational structure of any bank in order to ensure appropriate checks and balances (basel committee on banking supervision, 2006): (1) oversight by the board of directors or supervisory board; (2) oversight by individuals not involved in the day – to-day running of the various business areas; (3) direct line supervision of different business area and (4) independent risk management, compliance and audit functions. in addition, it is important that key personnel are fit and proper for their jobs. at the end, we should highlight that the corporate governance of banks in developing economies is important because (arun and turner, 2004): (1) banks have dominant position in financial system and they are important engine of economic growth; (2) financial market is usually undeveloped and banks represent main source of finance for the majority of firms; (3) banks in developing country are usually the main depository for the economies saving’s; (4) developing economies have recently “liberalized” banking system through privatization/disinvestments and reducing the role of economic regulation. perspectives of corporate governance in croatian banking sector 81 3. some insights into croatian banking sector the republic of croatia covers an area of 56 594 km2 and according to the 2009 mid-year population estimate, this area was populated by 4.4 million inhabitants. real gdp has decreased for 5, 8% in 2009 compared with 2008, and for 1, 4% in 2010 compared with the previous year due to the negative movements of domestic demand (negative trends on the labor market, low level of consumer optimism have influenced the household demand and all this was further supplemented with the decrease of investments) (croatian bureau of statistics, 2011). the structure of the gross added value in 2009 (current prices) was the following: public sector and defense (18%), agriculture (6, 7%), industry (19, 1%), construction (8%), hotels and restaurants (4,4%), trade (10,9%), transport and storage (8,3%), and financial services and real estate (24,4%) (croatian national bank, 2011a). the registered unemployment rate for march 2011 was 19, 3%. the average monthly paid off net earnings per person in paid employment in legal entities of the republic of croatia for february 2011 amounted to 5 242 hrk1 (croatian bureau of statistics, 2011). the inflation rate in february 2011 was 2, 2% due to the increase in prices of un-manufactured and manufactured alimentary goods. at the end of 2010 the gross foreign debt was 45, 8 billion euros or 99, 7% of gdp. due to the negative movements in the real sector and the high price of foreign borrowing the croatian national bank has continued to conduct politics of high hrk liquidity in the banking sector in order to enhance and improve domestic financing conditions and stronger credit activity recovery. at the beginning of march 2011, croatian national bank has decreased the rate of minimal coverage of the total foreign currency liability for liquid foreign currency receivables from 20% to 17%. (croatian national bank, 2011b). the discount rate of the croatian national bank is 9% the same as the interest rate for lombard credit, whilst the reserve requirement is 13% (croatian national bank, 2011c). the croatian national bank, as stipulated by the constitution of the republic of croatia, is the central bank of the republic of croatia. the status, tasks, objectives and capital ownership of the central bank, its powers, organization and relations with the bodies of the republic of croatia, banks and international institutions and organizations are regulated by the act on the croatian national bank (official gazette 75 of 1 july 2008). according to the credit institutions act (official gazette 117 of 26 september 2008) credit institutions in the republic of croatia are divided into three main groups: banks, savings banks and housing savings bank and their initial capital shall not be less than hrk 40 million (for the banks), less than hrk 8 million (for savings bank) and less than hrk 20 million (for savings housing bank). “credit institution” means a legal person authorized by the competent authority, whose business is: (1) to receive deposits and other repayable funds from the public and to grant credits for its own account; or (2) to issue means of payment in the form of electronic money. a credit institution is a joint-stock company. according to the banks bulletin (croatian national bank, 2010a and 2010b) we can distinguish small banks dispose of less than hrk1.0bn of total assets of all banks, medium size banks dispose of assets in size of hrk a 1.0-10.0bn and large banks dispose of assets exceeding hrk10.0bn. thus in statistic analysis of financial reports submitted by banks to the croatian national bank takes into account different bank peer groups. the number of large banks, their order by assets, and their total market shares, show no considerable variations in the last five years. by the end of the 2009 and in the first half of 2010 most of the market, i.e. 82.7% and i.e. 82.2% respectively, of total bank assets still belonged to the group of large banks. the bank ownership structure at the end of the first half of 2010 was: nineteen (19) banks were under majority ownership of domestic shareholders and 15 banks were under majority ownership of foreign shareholders. bank assets under majority ownership of foreign shareholders amounted to 90.6% of total asset of all banks (table 1), slightly lower share than by the end of 2009, as a consequence of the unchanged level in foreign ownership of overall bank assets and the simultaneous growth in domestically owned private bank assets by 5.1%, and in domestic state ownership of bank assets by 1.4%. the greatest impact in domestic ownership of bank asset share growth occurred in small banks, prevailingly owned by domestic shareholders. 1 the exchange rate for the croatian kuna on february 26th, 2011, according to the croatian national bank exchange rate list (middle reate) was 1eur = 7, 414 hrk international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.78-87 82 table 1. ownership structure of banks and their asset share in total bank assets, end of period 2007 2008 2009 2010 no.of banks share no.of banks share no.of banks share no.of banks share domestic ownership 17 9,6 18 9,4 19 9,1 19 9,4 domestic private ownership 15 4,9 16 4,9 17 4,9 17 5,2 domestic state ownership 2 4,7 2 4,5 2 4,2 2 4,2 foreign ownership 16 90,4 16 90,6 15 90,9 15 90,6 total 33 100 34 100 34 100 34 100 source: banks bulletin, no.21, year 10, croatian national bank, zagreb, december 2010, p. 20 the ownership structure according to the headquarters of the corporations is presented in the following table (table 2). table 2. the ownership structure according to the headquarters of corporations year austria italy france other domestic 2007 59,1 20,1 7,5 3,8 9,6 2008 59,7 19,7 7,4 93,8 9,4 2009 60,4 19,4 7,3 3,7 9,1 source: croatian national bank annual report, 2009, p. 64 it can be noted from the above that the greatest share in terms of ownership belongs to the austrian corporations, followed by italian and french corporations (country of residence of the owners). the analysis of asset concentration, net credit and deposits over the longer period showed that the bulk of the sum of all stated items remains concentrated in the top ten banks, viewed by their asset size (table 3). considerable amount of 41.5% in total bank assets in 2010 are further shown in the first two banks. first five banks had together a share of 75,4% at the end of 2009 and 75.1% at the end of 2010 of total bank assets, with the share of 92,5% at the end of 2009 and 92.1% at the end of 2010 in total bank assets held by the first ten banks. compared to the end of 2009, the shares in total net credits of all banks decreased only in the first two banks, which, after the decrease by 1.8 percentage points, amounted to 42.3% at the end 2010. table 3. biggest banks in the republic of croatia no. name total assets ‘000 hrk share in total assets in % asset growth 1 zagrebačka banka d.d. 92.814.083 24,10 3,83 2 privredna banka zagreb d.d. 65.061.033 16,89 1,04 3 erste&steiermarkische bank d.d. 49.142.273 12,76 7,47 4 raiffeisenbank austria d.d. 39.501.232 10,26 -2,17 5 hypo alpe-adria bank d.d. 38.764.907 10,07 46,23 6 societe generale splitska banka 27.702.201 7,19 0,75 7 hrvatska poštanska banka d.d. 13.985.623 3,63 -4,46 8 otp banka hrvatska d.d. 12.629.864 3,28 -1,90 9 volksbank d.d. 7.664.000 1,99 -0,18 10 međimurska banka d.d. 2.838.241 0,74 -0,80 source: croatian national bank, audited data on banks, 31st of december 2009 perspectives of corporate governance in croatian banking sector 83 the share of net credit in the top five and top ten banks increased slightly from 76,4% at the end of 2009 to 76.8% at the end of 2010 and from 92% at the end of 2009 to 92.9% at the end of 2010 respectively. unlike the reduction in assets and net credits in the first two banks, increase in concentration of deposits was shown in this group only and amounted to 43.3%. the share in total bank deposits decreased in the first five banks from 76,6% at the end of 2009 to 75.8% at the end of 2010, and in the first ten banks from 93,1% at the end of 2009 to 91.4% at the end of 2010. the following table presents the biggest banks in the republic of croatia. decrease in profits for the first semester of 2010 led to the further fall in bank profitability, and to lower values in return on average assets (roaa) and return on average equity (roae) regarding the same period of 2009. roaa decreased from 1.5%, to which it amounted at the end of the first half of 2009, to 1.2% at the end of the first half of 2010. it decreased both in large and small banks, while the increase in medium-size bank indicators represent the consequence of profits obtained by the bank which had operated with a loss in the same period of the previous year. the lowest value indicator was still stated in small banks (0.2%), in medium-size banks it amounted to 0.7%, and in large banks to 1.3%. after providing the short introduction of the situation in the banking sector in croatia, the research results are provided. corporate governance in practice – the evidence of croatian banks research results are presenting all major banks in croatia six (6) large banks and one (1) medium-sized bank which report to croatian national bank on the consolidated basis. all banks are: (1) listed in zagreb stock exchange and they are publishing price sensitive information; (2) registered as brokers on the zagreb stock exchange meaning they perform, on the basis of authorization issued by the croatian financial services supervisory agency the activities covered by the investment services referred to in the croatian capital market act (official gazette 88/08) and (3) members of the exchange. research results showed that corporate governance in croatian banks is mainly recognized in the processes of: strategic planning (66, 7%), financial reporting (66, 7%) and security of the business system (66, 7%); public relations (33, 3%) and controlling (16, 7%). further, corporate governance (graph 1) has very strong impact on the definition and implementation of the systems, rules, processes and conditions for managing the bank; strongly impact on (1) the strengthening of the relationship with stakeholders; (2) ensuring desirable environment for the employees; and (3) on the improvement of the communication with the local community and medium impact managers gave to the contentment of the global expectations, what should be change in future because of new demand of society – global governance especially at financial market. it is also important that managers have emphasized the importance the local community as important stakeholder, where main banks activities take place. different elements have been influencing the bank’s business behavior. research results pointed out that according to managers’ perspective the extremely important impact on their bank has notably (1) customer satisfaction and (2) gaining profits, while employee satisfaction and community benefits are perceived as important factors influencing the bank. it is evident that gaining profits is not considered as the starting point but it guides banks management towards it. although managers put customers and making profits on the top of their interests, employees are also perceived as important factor. employees are assets of the company, if recognized, they can foster greater productivity, assure customer loyalty, raise working atmosphere, raise credibility, etc. customers should be treated well and banks have to consider their interest in order to fulfill their needs. social responsibility and ethical behavior within it are valued for the benefits they bring to the company in terms of gaining greater profits. for all corporations good cooperation with stakeholders is needed, so participation as a principle of corporate governance is recognized. for managers in banks stakeholder participation means: (1) way of understanding stakeholders, learning and improving the organization within stakeholders’ expectations (66,7%) and identification, development and implementation of appropriate strategy, plans and ways of stakeholder engagement (66,7%); (2) identification and understanding of different stakeholders, their engagement possibilities, their expectations (33,3%) and defining ways of stakeholder inclusion in decision process which improves the sustainability of the international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.78-87 84 organization (33,3%) and (3) defining the conflict and dilemmas between different expectations of stakeholders (16,7%). graph 1: the influence of corporate governance on their bank source: authors’ analysis the following graph (graph 2) presents precise results of their cooperation with different stakeholders whether on a very frequent basis, rarely, often, sometimes or there is no cooperation at all. graph 2: cooperation with different stakeholders source: authors’ analysis it could be noted from the above that the banks always cooperate with (1) employees and trade unions, (2) financial institutions and (3) customers. that is in order with factors that influence on corporate governance. furthermore, they often cooperate with educational institutions, media, business organizations, regional and local community, suppliers and other stakeholders. they sometimes cooperate with nongovernmental organizations (ngos), competition, professional organizations, international institutions, and shareholders/owners. what is surprising is the point that their level of cooperation with shareholders on the not so frequent basis. it means that the shareholders/owners – managers in the banks relationship is built on trust and transparency as some of key elements of perspectives of corporate governance in croatian banking sector 85 corporate governance. on the other side, bearing in mind these are publicly traded companies, shareholders/owners do believe in the institutional framework and requirements. as all of the banks are listing their shares on the zagreb stock exchange, they have the obligation to comply with the defined code of corporate governance issued by zagreb stock exchange. the main scope of the code of corporate governance is to establish high corporate governance standards and to enhance transparency of the corporations (banks) in order to facilitate the access to capital with lower costs. the main principles of the code of corporate governance are: (1) transparency of the business conduct, (2) clearly defined procedures for the activities performed by the supervisory board, board of directors and other organs and structures that are included in the decision-making process, (3) avoidance of the conflict of interests, (4) effective internal control and (5) effective system of responsibilities (zagreb stock exchange and croatian financial services supervisory agency, 2011).survey showed that 50% of banks have accepted the internal code of conduct as a set of principles which define the behavior of the corporation and guidelines for improved accountability, enhanced conduct and better performance which is good because they use external and internal factor in strategic orientation. also managers of the banks think that code of conduct is really applied into practice and that it provides clear indications to the bank. the formal policy of corporate governance covers the following elements: statement of compliance of the formal policy with current legislation (33,3%), the remuneration framework and performance evaluation of the members of board of directors/supervisory board, ceo and senior executives (0%), independency statement of board of directors/supervisory board (16,7%), attendance of board of directors/supervisory board (0%), biographies, cvs of the members of board of directors/supervisory board disclosed (33,3%), and 50% does not know. in 50% of the banks the formal policy of corporate governance exists, whilst 16, 7% it does not and in other banks there is no such policy. in the majority of the banks (66,7%) the remuneration/compensation of the board members, members of the supervisory board and executive managers is not externally communicated, whilst in 33,3% of the banks, the remuneration is communicated on aggregated level for the board of directors/supervisory board, while in 16,7% the remuneration is communicated on individual level for each member of the board. the transparency requirements on the regular market on zagreb stock exchange are: financial reports, auditors’ reports, acquisition of own shares, corporate governance code, ga notice and decisions, other price sensitive information. for the official market, the requirements are: regular market requirements plus supervisory board meeting, acquisition of share from management, reporting in english, besides croatian. on the prime market the requirements are: official market requirements plus annual report presenting, corporate actions calendar and other requirements. the survey companies are listed on zagreb stock exchange and have to publish annual, semi-annual and quarterly financial and business reports depending on the type of the security, so rule of law as principle of corporate governance is also in use. except this law has lots of impact in other fields on banks because of their role in society. all of the reports have to be delivered electronically using intranet (zagreb stock exchange, 2011) so transparency as a principle of corporate governance is guaranteed. but trust is a base of all reports, activities etc. so banks need “environmental” trust and any misconduct can destroy reputation and trust in bank. although, in only 40% of the banks, integrated reports are publicly available. integrated reports cover, apart from financial date, the nonfinancial performances of the banks (their social and environmental performances). maybe we can say that responsible business practices was firstly recognized in banks activities. so, principle of responsibility is very accurate in banks sector. survey results showed that managers are linking responsible business practice with: the fight against corruption (80%); the environmental protection (60%); the protection of human rights (60%); the way of thinking (managing risks, taking care of local community) (60%), the economic benefits for all (60%) and philanthropic giving (40%). responsible business practice is closely connected with csr practice. survey showed that 80% of banks are very strongly and moderately engaged in csr activities. but only 20% of cooperation’s have a person in charge for csr activitieswho is either member of the board or senior manager. some of the corporations are clearly not engaged in csr activities. the main reasons for the lack of engagement are: the lack of financial resources (50%) and the lack of technical support (50%). for 80% csr is ethical responsibility; for 40% of the respondents’ social responsibility is perceived as corporation’s strategic commitment; for 40% as economic responsibility and for 20% the voluntary international journal of economics and financial issues, vol. 1, no. 3, 2011, pp.78-87 86 responsibility. and main reasons for engagement in csr are: enforcing reputation (100%), market enlargement, employees’ expectations (50%) and management requirement, customer requirement and attraction of best employees (25%). according to the research in croatian banks corporate governance in future should give more attention to responsiveness; equity; efficiency and effectiveness; and on accountability. stated principles are not clearly defined and recognizable and will assure differentiation on market and trust of all stakeholders. 4. conclusion in this turbulent time when many different factors affect each sector of the economy, financial sector which significantly influence on economic stability and in croatia has grate impact on gross added value has to be closely monitored. croatian economic situation is not good – small country on the entrance in european union; registered unemployment rate around 20 %, gross foreign debt 99, 7% of gdp, high credit rate; etc. head of the croatian national bank, željko rohatinski (rohatinski, 2010) introduced to the public some stimulation that can enhance economic recovery: (1) timeliness – fast action, (2) efficiency – differentiations of multiplier effects, (3) focus on long-term problems, (4) focus on investments, (5) social fairness, (6) bearing in mind the difficulties of the most vulnerable and (7) focus on areas with the highest rate of unemployment. accordingly, banks should follow at least some of the mentioned impulses, because role of institutions goes beyond the legal framework (schwab, 2011). the most problematic factors for doing business in croatia except well known: inefficient government bureaucracy (18, 8), tax rates (13, 8), tax regulation (13, 5), corruption (13, 2) is also access to financing (10, 9) (schwab, 2011, 136) which discourage new investments. banks as part of financial market have great influence on financing but corporate governance of banks is still focused on “obligatory” and “seen” principles: participation (employees, financial institutions, local community etc.); legal obligations (code of conduct, etc.) connected with transparency (annual report, integrated report, etc.) and social responsibility (fight against corruption, environmental protection, etc.). although, survey showed that corporate governance system is recognized primary as the process of strategic planning, corporate governance has strongest impact on the definition and implementation of the systems, rules, processes and conditions for managing the bank. banks are putting customers and making profits on the top of their interests, but global competitiveness (schwab, 2011) highlight access to financing as problematic factor to do business in croatia (high credit rate; etc.) which is not corresponding with the expectation of costumers. croatian banks in future should place more attention in corporate governance initiatives on responsiveness; equity; efficiency and effectiveness; and on accountability, principles that will assure differentiation on market and trust of all stakeholders. trust in banking sector will surely rise if banks put an effort and try to decrease credit rate etc. references aras, g. 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(2010) monetary policy in the period of crises, the opatija conference on croatian money markets speech, 12th of april 2010, available at: http://www.hnb.hr/govoriintervjui/govori/hgovor-rohatinski-12-04-2010.pdf schwab, k. (2011) the global competitiveness report 2010-2011, world economic forum, geneva, switzerland sever, s. (2009) position and perspectives of financial reporting and auditing in croatian publicly quoted companies, collection of papers of the zagreb faculty of economics and business, 7(2), 75 – 87. zagreb stock exchange and croatian financial services supervisory agency (2011) code of corporate governance, available at: http://www.zse.hr/default.aspx?id=33485 zagreb stock exchange, duties of issuers, manual, available at: http://www.zse.hr/userdocsimages/listing/obveze_izdavatelja.pdf international journal of economics and financial issues vol. 1, no. 4, 2011, pp.220-228 issn: 2146-4138 www.econjournals.com the relationship between interest rate, exchange rate and stock price: a wavelet analysis mohamed essaied hamrita computational mathematics laboratory university of monastir, monastir, tunisia email: mhamrita@gmail.com abdelkader trifi institut supérieur des etudes technologiques, ksar-hellal, tunisia email: abdelkadertrifi2005@yahoo.fr abstract: this paper examines the multi-scale relationship between the interest rate, exchange rate and stock price using a wavelet transform. in particular, we apply the maximum overlap discrete wavelet transform (modwt) to the interest rate, exchange rate and stock price in us over the period from january 1990 to december 2008 and using the definitions of wavelet variance, wavelet correlation and cross-correlations to analyze the association as well as the lead/lag relationship between these series at the different time scales. our results show that the relationship between interest rate and exchange rate is not significantly different from zero at all scales. on the other hand, the relationship between interest rate returns and stock index returns is significantly different from zero only at the highest scales. the exchange rate returns and stock index returns have a bidirectional relationship in this period at longer horizons. keywords: wavelet analysis, interest rate, stock price, wavelet cross-correlation, granger causality jel classification: c02, c22 1. introduction the stock markets are becoming an integral part of the economies of many countries. with the introduction of free and open economic policies and advanced technologies, investors are finding easy access to stock markets around the world. the fact that stock market indices have become an indication of the health of the economy of a country indicates the importance of stock markets. this increasing importance of the stock market has motivated the formulation of many theories to describe the working of the stock markets. one piece of information which is linked to the stock markets is interest rates and stock price fluctuations. in theory, the interest rates and the stock price have a negative correlation. this is because a rise in the interest rate reduces the present value of future dividend’s income, which should depress stock prices. conversely, low interest rates result in a lower opportunity cost of borrowing. lower interest rates stimulate investments and economic activities, which would cause prices to rise. on the other hand, according to the parity conditions, the interest rates and the exchange prices should be related with a negative coefficient. hence, we would expect a relationship between exchange price and stock price with a positive coefficient. however, the empirical studies carried out in the various markets had revealed conflicting results on causality between stock prices and the above economic variables. mok (1993), verified the causality of daily interest rate, exchange rate and stock prices in hong kong for the period from 1986 to 1991. the results indicate that the hibor (hong kong inter bank offered rate) and the price indices are independent series. as a further extension to the study the relationship between exchange rate and stock price was examined, the research concluded that those series are also independent. hashemzadeh and taylor (1988) have found bi-directional causality present in regression models between money supply and stock returns using stock indexes to estimate market returns. as regards, the interest rates of the results are not as conclusive. the direction of causality seems to be mostly the relationship between interest rate, exchange rate and stock price: a wavelet analysis 221 running from interest’s rate to stock price but not the other way. solnik (1987) found a weak positive relation between real stock return deferential and the changes in the real exchange rate, and that a real growth on the stock market has also a positive influence on the exchange rate. in this paper, we examine the relationship between interest rate, exchange rate and stock price. we adopt the time-series technique based in wavelet analysis. we apply the wavelet cross-correlation between these series based upon the maximum overlap discrete wavelet transform modwt [percival, and mofjeld (1997) and daubechies (1992)] families of wavelets. the decomposition of a time series on a scale-by-scale basis can unveil the structure at deferent time horizons. for example, the wavelet transform produces an alternative, known as the wavelet variance to the periodogram. this variance decomposition may be easily generalized for multivariate time series. standard time-domain measures of association for multivariate time series (e.g., cross-covariance and cross-correlation) may be defined using the coefficients from the application of the wavelet transform to each series, thus producing the wavelet cross-covariance and wavelet cross-correlation. the remainder of the paper is organized as follows. the main properties of the wavelets and the analytical deference’s with other filtering methods are dealt with in section 2, where we present the statistical properties of the wavelet variance, correlation and cross-correlation. in section 3, we describe the data used in the study and the basic statistics. section 4 discusses the empirical finding. finally, section 5 concludes and highlights some relevant remarks. 2. wavelet analysis the series were filtered using wavelet analysis that is a relatively new (at least for economists) statistical tool that, roughly speaking, decomposes a given series in orthogonal components, as in the fourier approach, but according to scale (time components) instead of frequencies. the comparison with the fourier analysis is useful first because wavelets use a similar strategy: find some orthogonal objects (wavelets functions instead of sines and cosines) and use them to decompose the series. second, since the fourier analysis is a common tool in economics, it may be useful in understanding the methodology and also the interpretation of results. we have to stress the main deference between the two tools. wavelet analysis does not need stationary assumption in order to decompose the series. this is because the fourier approach decomposes in frequencies space that may be interpreted as events of time-period t (where t is the number of observations). put differently, spectral decomposition methods perform a global analysis whereas, wavelets methods act locally in time and so do not need stationary cyclical components. recently, to relax the stationary frequencies assumption a windowing fourier decomposition that essentially use, for frequencies estimation, a time-period m (the window) event less than the number of observations t. the problem with this approach is the right choice of the window and, more important, its constancy over time. coming back to wavelets and going into some mathematical detail we may note that there are two basic wavelet functions: the father wavelet  and mother wavelets  such that: 0(t) and 1)( r    r dtt (1) using wavelets, any function in l2 (r) can be written as a linear combination of the type )()()()( ,,,,,,     j k k jj k kjkjkjkjkjkj tdtsttf  (2) where )(),( and )(),( ,,,, ttfdttfs kjkjkjkj   are the wavelet coefficients and where , ,, kjkj  the so-called scaling are and wavelet functions, respectively. the formal definition of the father wavelets is the function )2(2)( 2/, ktt jj kj    (3) defined as non-zero over a finite time length support that corresponds to given mother wavelets )2(2)( 2/, ktt jj kj    (4) international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.220-228 222 the former integrates to 1 and reconstructs the longest time-scale component of the series (trend), while the latter integrates to 0 (similarly to sine and cosine) and is used to describe all deviations from trend. the mother wavelets play a role similar to sins and cosines in the fourier decomposition. 2.1. the discrete wavelet transform let h1 = (h1,0 , . . . , h1,l-1 ,0, . . . , 0)t denote the wavelet filter coefficients of a daubechies compactly supported wavelet for unit scale daubechies (1992), zero padded to length n by defining h1,l =0 for l > l. a wavelet filter must satisfy the following three basic properties: 1 ; 0 1 0 2 ,1 1 0 ,1       l l l l l l hh (5)      1 0 2,1,1 0 l l nll hh for all non zero integers n. (6) that is, a wavelet filter must sum to zero (have zero mean), must have unit energy, and must be orthogonal to its even shifts. let g1 = (g1,0 , . . . , g1,l-1 ,0, . . . , 0)t be the zero padded scaling filter coefficients, defined via 1,1 1 ,1 )1(   ll l l hg and let x0, . . ., xn-1 be a time series. for scales that n  lj, where 1)1)(12(  ll jj , we can filter the time series using hj to obtain the wavelet coefficients   , 1 2 2 1 12 , ~ 2 1)1(2, 2/ ,                   jjtjj j tj n tlww (7) where, 1 , . . . , 1 , 2 1~ 1 0 1,2/,      nltxhw j jl l tljjtj (8) the tjw , ~ coefficients are associated with changes on a scale of length 12  jj and are obtained by sub sampling every 2jth of the tjw , ~ coefficients, which forms a portion of the maximal overlap discrete wavelet. however the orthonormal discrete wavelet transform (dwt), even if widely applied to time series analysis in many disciplines, has two main drawbacks: the dyadic length requirement (i.e. a sample size divisible by 2j ), and the fact that the wavelet and scaling coefficients are not shift invariant due to their sensitivity to circular shifts because of the decimation operation. an alternative to dwt is represented by a non-orthogonal variant of dwt: the maximal overlap dwt (modwt). 2.2. maximal overlap dwt (modwt) in contrast to the dwt, the modwt percival et al (2000) does not decimate the coefficients and therefore the number of scaling and wavelet coefficients at every level of the transform is the same as the number of sample observations. for this reason the modwt is also called non-decimated dwt. although it loses orthogonality and efficiency in computation, this transform does not have any restriction on the sample size and it is shift invariant. wavelet coefficients, i.e. tjw , ~ and scaling coefficients, i.e. tjv , ~ at levels j; j = 1, . . . , j, are obtained as follows:         1 0 mod ,1, 1 0 mod ,1, ~~~ and ~~~ l l nltjltj l l nltjltj vhvvgw (9) the relationship between interest rate, exchange rate and stock price: a wavelet analysis 223 the wavelet and scaling filters, lg ~ , lh ~ are rescaled as 2/2 ~ j j j g g  , 2/2 ~ j j j h h  . non-decimated wavelet coefficients represent differences between generalized averages of the data on a scale 12  jj (or level j). modwt provides the usual functions of the dwt, such as multiresolution decomposition analysis and cross-correlation analysis based on wavelet transform coefficients. but unlike the classical dwt, it can handle any sample size, it is translation invariant, as a shift in the signal does not change the pattern of wavelet transform coefficients; and provides increased resolution at coarser scales. in addition, modwt provides a larger sample size in the wavelet correlation analysis and produces a more asymptotically efficient wavelet covariance estimator than the dwt. 2.3. the wavelet variance, covariance, correlation and cross-correlation the basic idea of the wavelet variance is to substitute the notion of variability over certain scales for the global measure of variability estimated by sample variance. the wavelet variance of stochastic process x is estimated using the modwt coefficients for scale 12  jj through:     21 1 , 2 ˆ ˆ 1 ˆ     n jlk kj j jx w n  (10) where kjw ,ˆ is the modwt wavelet coefficient of variable x at scale j . 1ˆ  jj lnn is the number of coefficients unaffected by boundary, and 1)1)(12(  ll jj is the length of the scale j wavelet filter. although the wavelet covariance decompose the covariance between two stochastic processes on a scale-by-scale, in some situations it may be beneficial to normalize the wavelet covariance by the variability inherent in the observed wavelet coefficients. the wavelet covariance at scale j can be expressed as follows:         1 1 ,, ˆˆ ˆ 1 n jlk y kj x kj j jxyjxy ww n cov  (11) given that covariance does not take into account the variation of univariate time series, it is natural to introduce the concept of wavelet correlation. the wavelet correlation is simply made up of the wavelet covariance for {xt, yt} and wavelet variances for {xt} and {yt}. the modwt estimator of wavelet correlation can be expressed as follows:       jyjx jxy jxy cov    22 ˆˆ ˆ  (12) as with the usual correlation coefficient between two random variables,   1ˆ jxy  . the wavelet correlation is analogous to its fourier equivalent, the complex coherency (gençay et al (2002, p: 258)). the wavelet cross-correlation decomposes the cross-correlation between two time series on a scale-by-scale basis thereby making it possible to see how the association between two time series changes as a function of time horizon. genaçay et al (2002) define the wavelet cross-correlation as:       jj jkx jkx    21 , ,  (13) where  j 21 ,  j 22 are, respectively, the wavelet variances for x1,t and x2,t associated with scale j and  jkx  , the wavelet covariance between x1,t and x2, t – k associated with scale j . just as the usual cross-correlation is used to determine lead-lag relationships between two processes, the wavelet international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.220-228 224 cross-correlation should be able to provide a lead-lag relationship on a scale by scale basis (gençay et al (2002)). 3. data description and basic statistics the analysis was conducted using monthly data for the interest rate of american treasury securities at 3-month constant maturity provided by the federal reserve and the exchange rate between usd and euro. the closing s&p500 index is used as the indication of the stock price fluctuation. empirical analysis covers the period form january 1990 to december 2008 providing 228 observations in total. in this study, we investigate the returns series    1lnln  ttt ppr . initially table i shows some brief summary statistics for the returns series of interest rate, exchange rate and stock index respectively. from the table i, we make the following observations. (a) the mean of returns series is equal to zero for all series. (b) interest rate returns have higher standard deviation than exchange rate and stock index returns showing that the interest rate has higher volatility than the exchange rate and than the stock market. (c) monthly returns of interest rate tend to have high excess kurtosis. both series appear to have similar characteristics, in terms of mean and variation, but a more thorough description is available to use through a multi scale analysis. table 1. descriptive statistics for returns series min max mean std.dev skewness kurtosis interest rate -1.85 0.3 -0.02 0.17 -7.37 68 stock index -0.06 0.08 0 0.02 0.14 0.16 exchange rate -0.18 0.11 0 0.04 -0.88 2.04 4. multi scale analysis we apply the maximal overlap discrete wavelet transform to the monthly returns for the three series using the daubechies (d) wavelet filter of length l = 4, that is d(4), based on four non-zero coefficients daudechies (1992), with periodic boundary conditions. the application of the translation invariant wavelet transform with a number of scales j = 5 produces five vectors of wavelet filter coefficients, that is w5, w4, w3, w2, w1, and one vector of scaling coefficients, v5. since we use monthly data, the wavelet filter coefficients, w5,k, . . . , w1,k, represent progressively finer scale deviations from the smooth behavior, and correspond to 32 – 64, 16 – 32, 8 – 16, 4 – 8 and 2 – 4 months period, respectively. table 2. multi scale granger causality s5 d1 d2 d3 d4 d5 fx  ir 3.935* (0.001) 1.850* (0.038) 1.2413 (0.2489) 1.6985 (0.0833) 1.1638 (0.2918) 1.6188 (0.0565) sm  ir 2.910* (0.002) 1.405 (0.159) 1.2349 (0.2533) 1.6506 (0.0950) 1.9651* (0.0113) 2.8365* (0.0002) ir  fx 1.225 (0.276) 1.700 (0.063) 2.0217* (0.0183) 2.7712* (0.0032) 3.0075* (0.0001) 1.9646* (0.0126) sm  fx 2.087* (0.0271) 2.156* (0.013) 2.8408* (0.0007) 2.3289* (0.0130) 1.4176* (0.1202) 2.4540* (0.0012) ir  sm 2.1934* (0.019) 1.399 (0.162) 1.1638 (0.3065) 1.1361 (0.3371) 2.1623* (0.0044) 2.4685* (0.0011) fx  sm 1.653 (0.0934) 1.480 (0.127) 1.2736 (0.2273) 2.0022* (0.0349) 1.4643 (0.1003) 1.2351 (0.2348) note – s5 is the original data transformed by the wavelet filter d(4). the significances levels in parentheses. * significant at the 5% level. the main purposes of this paper are to examine the lead-lag relationship and cross-correlation between interest rate, stock market and exchange rate over the various time scales using wavelet analysis. to examine the lead-lag relationship in wavelet analysis, first is tested for granger causality up to level 5. the results of the granger causality tests are reported in table 2. as can be seen in table the relationship between interest rate, exchange rate and stock price: a wavelet analysis 225 2, the stock market and interest rate show a feedback relationship only at higher scales (d4 and d5). the results show also, the unidirectional causality from stock market to exchange market in various time scales and from interest rate to exchange market at scales d2, d3, d4 and d5. figure 1. wavelet cross-correlation between interest rate and exchange rate returns for the second purpose of our paper (cross-correlation in various time scale), we examine the cross-correlation between the stock market, interest rate and exchange rate in various time scale. in figures 1, 2 and 3 we report the estimated wavelet cross-correlations coefficients and the corresponding approximate confidence intervals against time leads and lags for all scales between the interest rate returns and exchange rate returns, interest rate returns and stock index returns and between exchange rate returns and stock index returns respectively. figure 1 shows that, for all scales, the relationship between interest rate and exchange rate in generally not significantly different from zero at all leads and lags (slightly significant at scale 3). this means that interest rate returns and exchange rate returns in this period were independent and historical information of interest rate was not significantly predictive for exchange rate. in figure 2, we report that at shortest scales, i.e. 1–3, the relationship between interest rate and stock index is not significantly different from zero. on the other hand, at the coarsest scales, i.e. 4–5, we report a significant positive relationship between the two series. also, at scale 5, we underline a positive leading relationship between interest rate and stock returns, and we note the asymmetry in the wavelet cross-correlation sequence. at the fifth scale (associated with associations of 32 to 64 months), the interest rate is positively correlated with the stock return at a lead 10 months but not at a lag of 10 months. this figure also shows that most of international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.220-228 226 significant coefficients have positive values. this indicates that the interest rate appreciation (depreciation) was associated with a fall (rise) in stock index. the wavelet cross-correlation provides that exchange rate returns and stock index returns are independent at short horizons (high frequencies). figure 2. wavelet cross-correlation between interest rate and stock index returns the figure 3 also shows a significant relationship between the two series only at coarsest scale. we note also that significant coefficients have positive values at leads and negative values at lags (scale 5). this means the existence for a bidirectional relationship between the two series at long horizons. 5. conclusion in this paper we apply a wavelet multi-scaling approach based on a maximum overlap discrete wavelet transform to investigate the relationship between interest rate, exchange rate and stock price over different time scale. through a scale by scale decomposition of the cross-correlation between two time series, we try to shed some light on the scaling properties for the relationship at different time horizons. the main results are summarized as follows:  the wavelet cross-correlation analysis shows that the relationship between interest rate and exchange rate is not significantly different from zero at all leads and lags and at all scales.  the relationship between interest rate and stock index is significantly different from zero only at the coarsest scales, i.e. 4–5, which correspond to longer horizons. the analysis provides evidence about the finding that interest rate returns are leading stock index returns. the relationship between interest rate, exchange rate and stock price: a wavelet analysis 227  only at low frequencies (longer horizons), we remark a significant relationship between exchange rate and stock index at this period. in general it seems that the interest rate and exchange rate series are generally quite independent at the period of studies and at all scales. there was, however a possible unidirectional causality running from interest rate to the stock price but not vice versa at highest scales. therefore, our results show that a possible bidirectional causality running between exchange rate and stock index only at longer horizons. figure 3. wavelet cross-correlation between exchange rate and stock index 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(2005), analysis of financial time series. second edition. wiley series in probability and statistics. international journal of economics and financial issues vol. 1, no. 2, 2011, pp.33-45 issn: 2146-4138 www.econjournals.com value relevance of accounting information in the united arab emirates jamal barzegari khanagha faculty of economics, management and accounting, yazd university, iran e-mail: barzegari@yazduni.ac.ir tel: +989131519858 abstarct: this paper examines the value relevance of accounting information in per and postperiods of international financial reporting standards implementation using the regression and portfolio approaches for sample of the uae companies. the results obtained from a combination of regression and portfolio approaches, show accounting information is value relevant in uae stock market. a comparison of the results for the periods before and after adoption, based on both regression and portfolio approaches, shows a decline in value relevance of accounting information after the reform in accounting standards. it could be interpreted to mean that following to ifrs in uae didn’t improve value relevancy of accounting information. however, results based on and portfolio approach shows that cash flows’ incremental information content increased for the post-ifrs period. keywords: value relevance, ifrs, accounting information, uae 1. introduction over the last three decades, the world economy and capital markets have become increasingly globalized and integrated. in this respect, the benefits of having one set of high-quality globally recognized financial reporting standards are significant. since convergence and harmonization of national generally accepted accounting principles with international financial reporting standards (ifrs) promises “transparent, comparable and consistent financial information” to guide investors in making “optimal investment decisions” (jacob & madu, 2004). the harmonization of accounting standards is also absolutely vital to building long-term global financial stability, creating truly international capital markets and providing full transparency for credit management(hansen, 2003). the united arab emirates (uae), currently launching itself onto the world financial stage with the setting up of a stock exchange and actively pursuing foreign direct investment (fdi) by embracing globalization, and adopting ifrs (irvine & lucas, 2006). wagdy (2001) asserts that investors’ need for reliable and relevant financial information has been the key factors of accounting reform in the middle east. these two factors protect domestic and foreign investors from any fraud or misleading financial data. value relevance approach measures both relevance and reliability because accounting information is reflected in the price (barth, beaver, & landsman, 2001). however, value relevance approach is an instrument to estimate quality of accounting information, which is a prime importance to the well-functioning of the economy (beuselinck, 2005). despite all efforts to develop in financial markets, accounting and economic growth, a crucial gap in the literature remains: to the best of our knowledge, there is no empirical research to identify the effect of accounting standards reforms on value relevance of accounting information in the uae. consequently, this study aims to investigate the value relevance of accounting information in uae. in particular, it measures whether the quality of accounting information has improved or whether it has not yet become relevant despite all efforts. the reminder of this paper is organized as follows. continuance of this section contains background and literature review and followed by a review accounting in uae. the second section related to methodology subjects and selecting data and sample. the third section discusses research findings. summary and discussions are presented in the final section. mailto:barzegari@yazduni.ac.ir international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.33-45 34 1.1. background and literature review a value relevance study is evaluation of the relationship between accounting information and capital market values (market values). beaver (2002) indicated that the theoretical groundwork of value relevance studies adopting a measurement approach is a combination of valuation theory plus contextual accounting and financial reporting arguments (accounting theory) that allows the researcher to predict how accounting variables and other information relating to market value will behave. holthausen and watts,(2001) suggest that value relevance studies use two different theories of accounting and standard setting to draw inferences: (i) “direct valuation” theory and (ii) “inputs-to equity-valuation” theory. direct valuation theory proposes a link between accounting earnings and stock market value. in direct valuation theory, accounting earnings is intended to either measure or be combined with the equity market value changes or levels. however, zaleha et al. (2008) point out that the conclusion usefulness paradigm proposes that accounting information is useful if utilized by users of financial statements for, or significantly associated with their decision making (riahi belkaoui, 2000) even though the information might not be stated at their best current value (scott, 2000). within this conception, the main users are those who make decisions having an impact on firms’ value, specifically decision-making by capital market participants (beaver, 2002; riahi belkaoui, 2000). in discussing the concept of relevance with regard to accounting information, riahi-belkaoui (2000) believes that accounting information is relevant if the information can influence decisions made by decision makers (i.e., its value relevance concept). studies seeking to demonstrate a link between accounting numbers and equity values were first published over 40 years ago. the first such article was by miller and modigliani (1966), which used data from the electricity industry to demonstrate that capitalized earnings on assets make the largest contribution to marketplace value. ball and brown (1968) and beaver ( 1968) are generally recognized as the fundamental studies on the information value of accounting numbers. ball and brown showed that the information content of the earnings figure is related to stock prices, and beaver observed both price and volume reactions to earnings reports. numerous value relevance studies have established, one stream of literature focuses on whether the value relevance of accounting information has declined/increased over time. prior research provides conflicting views. on the one hand, several prior literatures have found that the value relevance of accounting information has declined in recent years (core, guay, & van buskirk, 2003; ely & waymire, 1999; francis & schipper, 1999; graham & king, 2000; ho, c-s liu, & sohn., 2001; lev & zarowin, 1999; marquardt & wiedman., 2004; thinggaarda & damkierb, 2008). on the other hand, a number studies also have been carried out in recent years that showed value relevance of accounting information has increased. qystein and frode, (2007) evaluated the relevance of financial reporting over a relatively long period (over 40 years ). their research results showed that the valuerelevance of norwegian gaap was non-declining throughout 1965 to 2004. dung (2010) tested the value-relevance of financial statement information on the vietnamese stock market. the results showed that the value relevance of accounting was statistically meaningful, though somewhat weaker than in other developed and emerging markets. filip (2010) investigated the impact of the mandatory ifrs adoption on the value relevance of accounting in romania. findings suggest that the implementation of ifrs increased the value relevance of earnings. aljifri and khasharmeh (2006) investigated empirically the suitability of the international accounting standards (iass) to the united arab emirates (uae) environment. they used a variety of parametric and nonparametric approaches to examine the underlying factors that could affect the level of adoption of iass and to evaluate the suitability of such adoption to the uae environment (e.g. size of company, trading status, type of sector).the study found that there is a general consensus among the user groups (auditors, brokers, finance managers, and financial analysts) on the suitability of adoption of iass in the uae. in all of research studies that have been carried out there are no mention of the value relevance of accounting information in the uae. to the best of our knowledge, there is no empirical research also that uses regression-variations and the portfolio-returns approaches to test of value relevance in this country. therefore, an evaluation of the value relevance of accounting information, especially after changes in the economic and accounting environment in recent years is an important area to research. value relevance of accounting information in the united arab emirates 35 1.2 accounting in uae there are three main regulatory authorities in the uae corporate sector: the ministry of economy and planning, the central bank, and the emirates securities and authority of raw materials. in addition, the accountants and auditors association is the official body representing the accounting profession in the country. the compulsory disclosure requirements of state enterprises that each company must prepare financial statements, balance sheets, cash flow statements, statements of changes in capital, and the notes to the accounts. it should be noted that in the uae, companies preparing their annual reports within two to three months of the end of fiscal year (khaled aljifri & hussainey, 2007). according to central bank circular no 20/99, banks, financial institutions and investment companies in the uae are required to prepare their financial statements in accordance with the international accounting standards (iass) with effect from january 1, 1999. in 2004, the uae established the dubai international financial centre (difc), which is an onshore capital market designated as a financial free zone. in 2006, the difc legal framework requires banks and companies listed on the dubai international foreign affairs (difx) to implement international financial reporting standards (ifrs). all companies listed on market in abu dhabi (adsm) are required to publish ifrs financial statements since 2003 (khaled aljifri, 2008; deloitte, 2007). 2. methodology in this study, the regression-variations and the portfolio-returns approaches was used to investigate and to operationalize the value relevance of accounting information. it was because they provide different perspective on the issue of value relevance of accounting information. by using the regression-variations approach, we measured the value relevance as the percentage of variations in the returns or market value explained by the accounting figures. portfolio-returns approach shows a portion of total returns that could be earned from financial statement information which control for changes in the volatility of market returns over time. 2.1. regression-variations approach a regression-variations approach measures value relevance based on the explanatory power of accounting information as a measure of market value; the ability of earnings to explain annual marketadjusted returns (return model); and the ability of earnings and book values of equity to explain market values of equity (price model). 2.1.1 earning return model a large volume of literature has examined the usefulness of earnings information by employing a market return model (chen.c. j, chen. s, & su. x, 2001; harris, lang, & peter, 1994). in particular, the return model developed by easton and harris (1991) has been immensely popular amongst value-relevance researchers (ali & zarowin, 1992; amir, harris, & venuti, 1993; chan & seow, 1996; chen.c. j et al., 2001; m. s. harris & k. a. muller, 1999; harris et al., 1994; haw & qi, 1999), because it incorporates both earnings level and earnings changes as independent variables in explaining the dependent variable: annual market return on stock. the present study used easton and harris (1991) model with adjustments and suggested by biddle et al. (1995) and used in subsequent research(m. harris & k. muller, 1999; jun lin & chen, 2005; kothari, 2000). rjt = β0 + β1 epsjt / pjt-1 + β2 (epsjt – epsjt-1) / pjt-1 + ejt rjt: annual return (including cash dividends) of firm j shares for period t pjt-1: stock price at date of accounting announcement for firm j during period t epsjt: annual earnings per share for firm j during period t epsjt – epsjt-1: change annual earnings per share for firm j from period t-1 to t ejt: error term 2.1.2. price model following numerous prior value-relevance studies (amir et al., 1993; m. e. barth, 1994; burgstahler & dichev, 1997; filip & raffournier, 2010; m. s. harris & k. a. muller, 1999; landsman, 1986), a price model has also utilized in this study in addition to the return model. unlike the return model, the price model investigates the impact of accounting information on the market valuation of, rather than return on, equity stock; furthermore, a price model examines the impact of not international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.33-45 36 only earnings but also book value of equity on stock performance. traditionally, earnings and book values are considered to contribute to value relevance (burgstahler & dichev, 1997; ohlson, 1995). currently, however, the main financial statements include income statement, balance sheet and cash flow statement. thus the study used the model that shows all of the main financial statement as follows: pjt = β0 + β1 bvpsjt + β2 epsjt + β3 cfpsjt+ ejt pjt: the market price per share of firm j at time t bvpsjt: book value of firm j at time t epsjt: earnings of firm j for period ending at time t cfpsjt: cash flow of firm j for period ending at time t ejt : error term 2.2. portfolio-returns approach the portfolio-returns approach defines the value relevance of accounting measures as the proportion of information in security returns captured by the accounting measures (alford, jones, leftwich, & zmijewski., 1993; chang, 1998; francis & schipper, 1999; hung, 2001) . thinggaarda and damkierb (2008) further defined value relevance as the difference between the return on the long position and the return on the short position; that is, the market-adjusted return that can be earned on the long position and the market-adjusted return that can be lost on the short position. this approach measures value relevance as the total return that could be earned from a portfolio based on perfect foresight of earnings. value relevance is scaled by the total return earned on a portfolio based on advance knowledge of market prices. in this study, this approach attempts to calculate the proportions of all information in security returns that are captured by the earnings, roe and cash flows. this method aims to provide the evidence of value relevance of earnings, roe and cash flows by forming the hedge portfolio based on this information. this study used two portfolios a) a portfolio selection based on sign (sign-∆earn, sign-∆roe, sign-∆cf); and b) a portfolio selection based on sign and magnitude (∆earn, ∆roe and ∆cf). 2.2.1 portfolio selection based on sign (sign-∆earn) the portfolio-returns approach is based on alford et al. (1993), francis and schipper (1999), hellstrom (2006) and thinggaarda and damkierb (2008). as an example, following is the procedure for selecting a portfolio based on sign of changes in earn. first, an earnings-based hedge portfolio is created. the primary firm-specific return (pit-pit-1+d)/pit-1 is calculated for all firms over a 15 month period. the market-adjusted return on security j, r,t , is defined as the compound (with dividend) return minus the return on the value-weighted market portfolio for each year sample ( the study uses all share index return). all companies in the total sample are ranked according to the change in accounting earnings. the change in accounting earnings is calculated on a year basis. a hedge portfolio is formed by going long in shares with positive earning changes and short in shares with the negative earning changes. the market-adjusted return is later calculated for both the long position and short position as an average of returns for all companies included in the long short positions, respectively: where rj is a market-adjusted return for an individual company and nl and ns are the number of companies in the long position and in the short position, respectively. note that nl and ns are equal. the hedge portfolio return (value relevance) is defined as the difference between the return on the long position and the return on the short position: that is, the market-adjusted return that can be earned on the long position and the market-adjusted return that can be lost on the short position: second, for each accounting-based hedge portfolio and year, the market-adjusted returns on a portfolio formed on the basis of perfect foreknowledge of future stock returns are calculated. this portfolio takes long (short) positions in the stocks in each accounting-based hedge portfolio with positive (negative) 15-month market-adjusted returns. the market-adjusted return on this returnsvalue relevance of accounting information in the united arab emirates 37 based hedge portfolio in year t is denoted , where h is the type of accounting hedge portfolio. the accounting-based hedge portfolio returns are expressed as a percentage of . this controls for time-series differences in the variation in market-adjusted returns (francis & schipper (1999) , and the resulting ratio (denoted %mkt) describes the proportion of all information impounded in stock prices that is captured by accounting information in a given period (thinggaarda & damkierb, 2008). 2.2.2 portfolio selection based on sign and magnitude as mentioned above, portfolio selection based on sign and magnitude applies to ∆earn, ∆roe and ∆cf. following is a description for calculating the value relevance of earning with this method. the method for calculating other factors with the same roe and cash flow is similar. the primary calculations of market-adjusted returns are similar, based on the sign of accounting information. for example, for the ∆earnjt portfolio, we take long positions in the stocks with the highest 40% of ∆earnj,t and short positions in the stocks with the lowest 40% of ∆earnj,t, thereby disregarding the middle 20%. thus, both the sign and the strength of the change in earnings are extracted from the total available information in financial statements. the market-adjusted return is afterwards calculated for both the long position and short position as an average of returns for all companies included in the long short positions, respectively. the hedge portfolio return (value relevance) is defined as the difference between the return on the long position and the return on the short position: that is, the market-adjusted return that can be earned on the long position and the market-adjusted return that can be lost on the short position. 2.3. data and sample the data for this study were obtained from the gulfbase database, the stock exchange website of the abu dhabi stock market (adsm) and other database such as bloomberg and datastream. observations were compared across data sources for data accuracy. the study limit to this period and select abu dhabi securities markets since a) abu dhabi securities market (adsm) started operating in november 2000, b) adsm is larger than the dubai financial market (khedhiri & muhammad, 2008; moustafa, 2004), c) all companies listed on the abu dhabi securities markets (adsm) are required to publish ifrs financial statements since 2003 (aljifri, 2008; deloitte, 2007) and d) and because of availability of data. the uae sample is selected from the period 2001-2008 based on following criteria. the number of companies selected was based on several criteria. first, since this study investigates the effects of accounting reform on value relevance of accounting information. it was necessary to have companies in existence both before and after the reform in order to examine the effect of the reform on the value relevance of accounting information. therefore, companies that were listed just before or just after the reform were excluded. second, for most companies in uae the fiscal year ends of december. since it was necessary to have common period for the calculation of stock returns accumulation across all the sample companies, whose fiscal years ended at some time other than december were excluded from the sample. pursuant to the application of these selection criteria,, the final samples for uae consisted of 136 firm-year observations for price model(17 companies for 8 years) and 119 firm-year observations for return model and also portfolio approach (17 companies for 7 years). 3. research findings 3.1. descriptive statistics table 1 provides descriptive statistics for all the variables used in the regression analyses of uae data. the average per share market value of equity is 5.25ud for eight-year period with mean yearly standard deviation of 4.49ud. this show investor obtained an average annual 0.362 market return during this seven -year period with an annual mean standard deviation of 1.04. the sample shows the high standard deviation in the dataset, which confirms the variability of firm’s size and industry classification traded in the abu dhabi stock market. panel b and c show this situation was worse in the pre-reform period. comparing standard deviations eps, cfp and bvp show bvp has less standard deviation than the mean and others variables. it means better distribution than the other. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.33-45 38 table 1 descriptive statistics name of variables n mean std. dev. median panel a: full sample (2001,2-2008) p3 (market price per share of firm ) 136 5.25 4.49 3.945 eps (earning per share) 136 .39 .43 .26 bvp (book value of equity-per share) 136 2.73 2.46 1.98 cfp (cash flow per share) 136 .344 .93 .2 r (annual return ) 119 .362 1.04 .145 eps/p (earning per share / price) 119 .078 .057 .069 ∆eps(change annual earnings per share) 119 .016 .063 .0127 panel b: before reform p3 (market price per share of firm ) 34 2.26 1.42 2.08 eps (earning per share) 34 0.16 0.15 0.13 bvp (book value of equity-per share) 34 1.38 1.11 1.11 cfp (cash flow per share) 34 0.28 0.39 0.14 r (annual return ) 17 0.11 0.18 0.09 eps/p (earning per share / price) 17 0.06 0.03 0.07 ∆eps(change annual earnings per share) 17 0.00 0.04 0.00 panel c: after reform p3 (market price per share of firm ) 102 6.25 4.73 5.37 eps (earning per share) 102 0.47 0.47 0.31 bvp (book value of equity-per share) 102 3.19 2.62 2.41 cfp (cash flow per share) 102 0.36 1.05 0.24 r (annual return ) 102 0.34 0.81 0.21 eps/p (earning per share / price) 102 0.08 0.06 0.07 ∆eps(change annual earnings per share) 102 0.02 0.07 0.01 *all data are based on uae’s dirham (ud) 3.2. the inferential findings as mentioned earlier, the objectives of this study are to examine value relevance of accounting information, and to compare the value relevance between two regimes in two periods. to operationalize value relevance of accounting information, two empirical valuation approaches are employed: the regression-variations approach and the portfolio return approach. because these two approaches together provide different perspectives on the issue of value relevance of accounting information. 3.2.1 regression-variations approach result of coefficient test (redundant variables test and omitted variable test) for uae suggests price model with two variables (see below of table 2). redundant variables test suggests the dropping of cfp variable from model with three variables (.1671>.05). result of omitted variable test does not advise adding cfp variable to price model with two variable to increases the explanatory power of the model (.4245<.05). the first panel of table 2 shows that the r2 for the price model specification is 76.6% for the total sample and just coefficient of eps is statistically significant. comparison of coefficients indicates that eps of 4 has a higher explanatory power than any other variable. therefore, according to price model accounting information in the abu dhabi securities market (adsm) is value relevant. a comparison of the two results for before and after reform based on price model, demonstrates that the explanatory power (r2) for the period before reform is more than the period after reform. it means value relevance of accounting numbers decreased in the period after reform. consequently, the result indicates reform in accounting standards did not improve relevancy of accounting numbers in abu dhabi securities market. in panel b of table 2 provides the results of the return model. explanatory power (r2) for the return model specification is 30.3% for the total sample. therefore, according to these results it can be concluded that eps level and changes eps information in abu dhabi securities market are relevant for investors in their decision making. a comparison of explanatory power (r2) accounting numbers for the return model indicates decreasing of that in the period (2003-2008), after value relevance of accounting information in the united arab emirates 39 reform in accounting standards. so, the result of the return model also indicates reform in accounting standards did not improve relevancy of accounting numbers in abu dhabi securities market. table 2 result of regression-variations approach panel a: price model years pit=ß0+ß1bvpit+ß2epsit+eit pit=ß0+ß1bvpit+ß2epsit+ ß3cfpit+eit ß0 ß1 ß2 r 2 n ß0 ß1 ß2 ß3 r 2 200108 t-st. 2.97 .22 4 .766 136 2.8 .22 4.1 .41 .77 3.4*** .69 7.8*** 3.38*** .7 8.6*** 2.9*** 200102 t-st. .71 .19 7.7 .875 34 .68 .3 7.4 -.28 .90 6.7*** 2.2** 44*** 7*** 5.2*** 14*** -7*** 2003-08 t-st. 2.6 .06 5.6 .45 144 2.59 .02 5.4 .81 .51 5.5*** .49 15*** 6.2*** -.23 15*** 3.9*** panel b: return model years rit= ß0+ß1epsit/pit-1+ß2(epsitepsit-1)/pit-1 +eit ß0 ß1 ß2 r 2 n coefficient tests of cfp prob.f redundant variables .1671 omitted variables .4245 2001-08 t-st. .03 2.4 3.7 .303 119 .17 1.74** 2.11** 2002 t-st -.08 3.2 -.64 .302 17 -.9 2.34** -.63 2003-08 t-st .12 1.5 5.3 .282 102 .4 .66 1.73* notes: ***, **, * indicates significance at 0.01, 0.05 and 0.10 levels t-statistics based on white heteroscedasticity-consistent standard errors. *for full sample of return model is used gls with cross section weight * for full sample of both price model are used gls with fixed cross section and for sub-samples of price model are used gls with cross section weight. 3.2.2 portfolio-returns approach panel a (second column) of table 3 presents results for each year in the investigated period, the mean market-adjusted return on each accounting hedge portfolio (%). the value 19.4 in below ∆earn for year 2002 means person could earn 19.4 percent net market-adjusted (long position minus short position) in year 2002 if sign of earning changes was used to construct a portfolio. since this is more than zero it can be concluded that earning changes is relevant for investors to make wellinformed decisions. a comparison of these numbers, ∆earn (19.4%), ∆roe (15.1%) and ∆cfp (4.4%) for year 2002 shows that cash flow information isn’t relevant for investors in making investment decisions while earnings and roe information are relevant for investors. this also indicates present earning with (19.4%) is more relevant than the roe with (15.1%). the value 58.1 under ∆earn for year 2002 as % mkt ratio indicate that about 58.1% of the total perfect foresight returns are available to investors with advance knowledge of the sign of the earnings change. panel b of table 3 reveals mean market-adjusted returns on accounting hedge portfolio (%) and that a proportion of the total hedge portfolio market-adjusted returns can be earned by the perknowledge of the accounting information (%mkt) for the investigated period. the results in column of based on the sign; clearly demonstrate that foreknowledge of information in the financial statements would be highly relevant for investors. investment strategies based on a preview of the sign of the change in roe would earn an average market-adjusted return throughout the sample period of about 30.1%, compared with 17.4% for the ∆earn portfolio and 3.9% for the ∆cash portfolio. on the other word, all the accounting measures seem to be value-relevant to investors. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.33-45 40 the results in second and third line under sign and magnitude (panel b) indicate that accounting information are value-relevant in both period before (2002) and after reform (2003-2008) in abu dhabi securities market (adsm). in first period value relevance of sign_∆earn is more than the others while in second period sign_∆roe information is more relevant than others. a comparison of result of sign_∆earn shows that value relevance of accounting information has decreases in abu dhabi securities market stock exchange after accounting reform in this market. while the results based on sign-cash and sign_∆roe show increase in value relevance for the period after reform. panel a (first column) of table 3 shows, for each year in the investigated period, the mean market-adjusted return on each accounting hedge portfolio (%). the value 33.5 under ∆earn column for year 2002 means person could earn 33.5 percent net market-adjusted return (long position minus short position) based on sign and magnitude of earning changes. since this is more than zero we can conclude earning information is relevant for investors on the abu dhabi securities market (adsm) at year 2002. a comparison of numbers, ∆earn (33.5 %), ∆roe (21.8%) and ∆cfp (-2.2%) in first line of panel a of table 3 for year 2002 show that ∆earn (33.5%) are more relevant than any others variable for investors. they also show present earning and roe with 33.5% and 21.8% are more relevant than the cash flow with (-2.2%). the value 92.1 under ∆earn for year 2002 as %mkt ratio indicates that about 92.1 % of the total market adjusted returns are available to investors with advance knowledge of the sign and magnitude the earnings change. a comparison of the numbers in line for year 2002 demonstrate that earnings and roe changes are relevant while cash flow is not value relevance for investors in making decision. table 3 portfolio-returns approach panel a: mean market-adjusted returns on accounting hedge portfolio (%) and proportion of the total hedge portfolio market-adjusted returns can be earned by the per-knowledge of accounting information(%mkt)20022008. year based on sign & magnitude based on sing ∆earn ∆roe ∆cfp ∆earn ∆roe ∆cfp % %mkt % %mkt % %mkt % %mkt % %mkt % %mkt 2002 33.5 92.1 21.8 52.3 -2.2 -5.4 19.4 58.1 15.1 45.1 -4.4 -13.3 2003 10.9 27.7 24.7 62.9 -4.2 -10.7 21.5 64.1 21.5 64.1 -7.3 -21.7 2004 127.3 67.0 126.1 66.4 -18.4 -9.7 -34.8 -22.6 114. 74.0 -11.1 -7.2 2005 19.5 22.4 31.0 35.7 11.1 12.8 30.5 42.4 -10.7 -14.8 -3.2 -4.5 2006 2.3 5.8 -4.6 -11.4 5.4 13.3 0.8 2.4 12.6 37.9 2.2 6.7 2007 -16.8 -15.4 8.7 7.9 -53.9 -49.4 49.4 49.2 46.5 46.3 -45.9 -45.8 2008 -5.3 -12.6 14.4 34.0 25.6 60.7 -3.3 -9.5 1.2 3.5 25.0 72.2 panel b: mean market-adjusted returns on accounting hedge portfolio (%) and proportion of the total hedge portfolio market-adjusted returns can be earned by the per-knowledge of accounting information (average for full sample, before and after reform) year based on sign based on sing & magnitude ∆earn ∆roe ∆cfp ∆earn ∆roe ∆cfp % %mkt % %mkt % %mkt % %mkt % %mkt % %mkt 2002-08 27.6 30.7 31.9 35.9 3.9 11.4 17.4 30.9 30.1 38.7 3.9 11.3 2002 33.5 92.1 18.4 44.2 0.3 0.9 19.4 58.1 15.1 45.1 0.0 0.0 2003-08 26.7 20.5 34.1 34.5 4.5 13.2 17.0 26.4 32.6 37.6 4.5 13.2 panel b of table 3 shows mean market-adjusted returns on accounting hedge portfolio (%) and proportion of the total hedge portfolio market-adjusted returns can be earned by the perknowledge of accounting information (%mkt) for the investigated period. the results in column based on the sign and magnitude, clearly demonstrate that foreknowledge of information in the financial statements would be relevant for investors. investment strategies based on a preview of the sign and magnitude of the change in earnings (∆earn) would earn an average market-adjusted return value relevance of accounting information in the united arab emirates 41 throughout the sample period about 27.6%, compared with 31.9% for the ∆roe portfolio and 3.9% for the ∆cash portfolio. what is interesting in this comparing is that ∆roe portfolio has higher relevancy. so, the results show all of the accounting numbers are value relevance. investments based on accrual-based information are more profitable. the accrual-based information is more valuerelevance than cash based information. the results in second and third column reveal that accounting information are value-relevant in both periods before (2002) and after reform (2003-2008) in the abu dhabi securities market (adsm). in first period relevancy of ∆earn information is more than any others variable while in second period (after reform) relevancy of ∆roe information is more than others. a comparison of results of accounting numbers for two periods show value relevance of ∆earn and ∆roe decrease after reform. while the results based on ∆cash shows that value relevance of accounting information increases. 3.3 control variables (size and industry effects) first and second parts of the table 4 show the result of value relevance in small and large companies and results for finance and non finance companies. the explanatory power of model for small companies’ specification is 32% for the total sample and all coefficients are statistically significant. a comparison of coefficients indicates that the full model eps with 3.5 has a higher explanatory power than the other variables. further analysis reveals value relevance of accounting information in small companies (r2 = 32%) is less than the full sample (r2 = 76.6%). a comparison of the two results for before and after reform in small companies demonstrate explanatory power (r2) of accounting information decrease from 88% before reform to 39% after reform. it can be seen from table 4 that in the case of large companies, the value relevance of accounting information for these companies (r2 = 47%) is less than for small companies (r2 = 58%) and also less than that of the full sample (r2 = 766%). comparing the two results for before and after of reform, it can be seen that value relevance of accounting number decrease from 91% before reform to 37% after reform. consequently, the results indicated that there is a difference in value relevance of accounting information between large and small companies in abu dhabi securities market (adsm). the magnitude and frequency of the transitory elements of accounting information can, and are expected to, vary systematically across industries. therefore, value relevance of accounting information is different in various industries. for abu dhabi securities market sample finance companies are chosen because they are the majority in our sample and accounting regulations commonly is different in finance companies compare with other industries. table 4 result of regression approach based on firm size and industry pit=ß0+ß1bvpit+ß2epsit+eit pit=ß0+ß1bvpit+ß2epsit+eit pit=ß0+ß1bvpit+ß2epsit+eit years 20012008 2001-2002 2003-2008 ß0 ß1 ß2 ß0 ß1 ß2 ß0 ß1 ß2 small companies 1.9 .515 3.5 .11 1.7 -2 3.2 .29 2.95 t.st. 3*** 2.9*** 4.6*** 1.9 41*** -4.6*** 3.8*** 1.49 4.5*** r2 .58 .88 .39 n 4 32 4 8 4 24 large companies 5 -2.27 17.3 1.48 -1.7 17 7.6 -2.3 15.4 t.st. 2.5** -5.2*** .5 11*** -7*** 14*** 3*** -5.4*** 7.2*** r2 .47 .91 .37 n 4 32 4 8 4 24 finance companies 3.3 2.5 20 .65 .09 9.1 4.4 -2.7 20 t.st. 3.3*** -3.5*** 10*** 3.7*** .15 3.1*** 4*** -3.3*** 8*** r2 .62 .86 .61 n 6 48 6 12 6 36 non finance companies 2.7 .36 3.23 1.23 .16 5.69 3.2 .067 5.3 t.st. 3.4*** 1.45 6.4*** 3.6*** 1.38 4.4*** 4.9*** .414 6*** r2 .758 .53 .397 n 11 bb 11 22 11 66 notes: ***, **, * indicates significance at 0.01, 0.05 and 0.10 levels t-statistics based on white heteroscedasticity-consistent standard errors. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.33-45 42 the third section of table 4 shows that the result of r2 (62%) from the finance industry in abu dhabi securities market which is less than compare with full sample. a comparison of coefficients with full sample indicates eps with 20 has a higher explanatory power than the other variables as well and all coefficients are significant. as can be seen from the table, value relevance of the accounting number for finance industries in the period after reform (r2 = 61%) is less than the period before reform (r2 = 86%). it means reform in accounting standards did not improve relevancy of accounting numbers in finance companies. the fourth section of table 4 demonstrates that explanatory power (r2) of the model for non finance companies is 65.7% for the total sample and just coefficient of eps variable is not statistically significant. further analysis reveals value relevance of accounting information in non finance companies (r2 = 65.7%) is a little less than the full sample (r2 = 66.6%). a comparison of the two results for before and after reform in non finance companies demonstrate explanatory power (r2) of the accounting information decrease from r2 = 53% before reform to r2 = 39.7% after reform. accordingly, the result indicates first, value relevance of accounting numbers in finance industry and non finance companies is less than the full sample secondly, reform in accounting standards did not improve relevancy of accounting numbers in non finance and finance companies. thirdly, there is a difference in value relevance of accounting information between unlike industries in abu dhabi securities market (adsm). 4. summary and discussions this paper has examined the impact of regulatory reforms in uae on the value-relevance of accounting information. the value-relevance of accounting information is clearly supported by the current findings from the price model (with two independent variables) in the abu dhabi securities market (adsm). a comparison based on price model of periods before and after reform, showed that the explanatory power (r2) for the period before reform is higher than for the period after reform, which implies that the value-relevance of accounting numbers decreased in the period after reform. this finding may mean that reforms in accounting standards did not improve the relevance of accounting numbers in the abu dhabi securities market (adsm). to provide more convincing evidence of the value-relevance of accounting earnings, this study also used the returns model. the return model indicated that eps level and changes of eps information were value-relevant. results for the return model also documented a decline in the value-relevance of accounting earnings for the period after reform. findings of both methods based on the portfolio returns approach showed that selected accounting numbers are value relevant for abu dhabi securities market investors. a comparison of the results of the two methods periods before and after reform showed value relevancy of ∆earn and ∆roe decreased during the period after reform. the results also indicated that value relevancy of ∆cash increased in the period after reform based on both portfolio methods. a comparison of the results of ∆earn and ∆roe with ∆cash show that in the period before reform investors relied on ∆earn and ∆roe while in the period after reform they noticed ∆cash. however, the results showed that accounting reform had effect on value relevancy of accounting numbers although the effect for all selected numbers was not the same. therefore, findings of two approaches (regression and portfolio approach) supported claims that accounting information is value relevant in abu dhabi securities market. moreover, the findings also showed the following: 1) value relevance of accounting information is not the same between small and large companies. 2) value relevancy of accounting information in small companies is more than large companies in abu dhabi securities market. in abu dhabi securities market small companies are more likely to include start-up companies and investors may focus more on accounting numbers of these companies than large companies. as mentioned, value relevance of accounting information in uae decreased after reform in accounting standards. cho (2005)asserted the absolute magnitude of price change associated with accountings information was one main possible reasons for changes in the r2, in the case of uae, referencing to (barzegari, 2010) market index, price and return in abu dhabi securities market for years after reform was more than the absolute magnitude of accounting information. also, this may be due to the availability of only one year of data for return model and two years of data for price model in the period before reform. this is may be because of economic conditions in country and world crisis. value relevance of accounting information in the united arab emirates 43 findings from this study are relevant to standard setters and regulators for future directions in developing accounting standards. the results may be helpful to investors for understanding capital markets such as these countries, and may also provide insights for accounting standard setters and regulators. the result of the study revealed accrual based information were more value relevant than cash based information. and also the coefficient of eps was more than bvp. therefore, another avenue for future research is to explore the reasons for accrual based information' superiority over cash based information and earnings’ superiority over book value. investors tend to be more tolerant towards overvaluation when the economy and financial markets are doing well and less lenient during market bears and 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(2008). the value relevance of intangibles non-current assets in different economic conditions. international review of business research papers, 4 (2), 316-337. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(3), 917-925. international journal of economics and financial issues | vol 6 • issue 3 • 2016 917 mobile phone and child mortality: the case of developing countries azza mohamed hegazy* assistant professor, department of economics and foreign trade, faculty of commerce and business administration, helwan university, cairo, egypt. *email: azza_hegazy@yahoo.com abstract using the generalized method of moments methodology on a panel dataset of 43 developing countries covering the period 2000-2012, this study provides an econometric evidence that child mortality relates to mobile phone, health expenditure, gross domestic product per capita, female education, and sanitation. the results imply that mobile phone isn’t an important contributor in reducing child mortality. additionally, higher per capita income, total public expenditure, female education, and access to sanitation have a statistically significant favorable impact on child mortality. furthermore, public health expenditure almost has an insignificant impact. the results of this study benefit the policymakers in designing policies aiming to reduce child mortality in developing countries. keywords: mobile phone, child mortality, generalized method of moments model, developing countries jel classifications: i15, o15, o33 1. introduction health is one of the principal dimensions that represent the core of the millennium development goals (mdgs), as it is a pivotal role in reducing poverty, education, and gender equality (who, 2005. p. 7). moreover, the goal of good health and well-being is considered one of the sustainable development goals (sdgs) (icsu and issc, 2015). bloom et al. (2004) indicate that health capital has a positive impact on economic growth. the study concludes that increasing life expectancy by 1 year as a result of improving health conditions contributes to increasing economic growth by about 4% per annum. additionally, the study of aguayo-rico et al. (2005) attributes the difference in growth rates among countries to the difference in health level. as child’s health is considered one of the public health components, the fourth goal of the mdgs is represented in reducing under-five mortality by two-thirds over the period from 1990 to 2015. despite the progress in reducing the under-five mortality rate (ufmr), the rate announced in the millennium goals has not yet been achieved. globally, under-five mortality has dropped from 90 deaths per 1,000 live births in 1990 to 43 deaths per 1,000 live births in 2015, with an average decline of more than half. according to these rates, the goal of reducing ufmr by two-thirds will be achieved by the year 2025 (un, 2015a). the united nation launches the 2030 agenda including 17 sdgs and 169 targets that are built on the mdgs and complete what haven’t been achieved. one of the sdgs is to ensure healthy lives for achieving nine targets, one of these targets is to reduce newborn mortality to 12 deaths and under-five mortality to 25 deaths per 1000 live births by 2030 (un, 2015b). as the lack of knowledge, information and health services is considered one of the underlying causes of child mortality (under five and infant mortality) (unicef, 2009. p. 15), access to the mobile phone can play an essential role in reducing child mortality. mobile phone is characterized by being small in size, portable, relatively cheap, and easy to use. thus, there is broad agreement about the importance of mobile phone as an important factor in improving the usage and quality of health services provided to pregnant women and children (noordam et al., 2011. p. 623; modi, 2013. p. 1). hegazy: mobile phone and child mortality: the case of developing countries international journal of economics and financial issues | vol 6 • issue 3 • 2016918 the rapid expansion of mobile phone infrastructure, especially in developing countries, contributes to widening the coverage of most areas (mhealth alliance, 2012. p. 8). the additional coverage is reflected in the number of mobile subscribers that amount to about 5.5 billion in the developing countries out of 7 billion subscribers worldwide in 2014 (itu., 2015). therefore, there are increasing opportunities to access to maternal and child health information and services through the mobile phone. using and relying upon mobile phone in the health field is known as m-health (noordam et al., 2011. p. 622). accordingly, the main objective of this study is to answer two main questions: does the access to mobile phones has a statistically significant role in reducing child mortality in the developing countries? what are the other factors that possibly contribute to reducing child mortality in those countries? despite the general agreement about expected favorable impact of using the mobile phone on child mortality, the empirical evidence is still limit. most of the studies evaluate pilot projects that apply health programs through mobile phones in particular areas or on case study as the study of west (2015). according to our knowledge, the study of balcilar and kucuk (2014) is the only study that focuses on studying the impact of information and communication technology (ict) components and gender equality on child development using a cross-sectional data set of 136 developed and developing countries in 2006. based on the previous background and due to the lack of evidence of wide-scale impact, there is a necessity for an empirical study to test the impact of mobile phone on child mortality. therefore, the present study aims to estimate this impact in 43 developing countries over the period 2000 till 2012. the 43 developing countries was selected according to the availability of data out of 75 developing and less developed countries representing 98% of all maternal and child deaths at the global level, and of interest to “the commission on information and accountability for women’s and children’s health (coia).” the united nations founded coia in 2011 aiming to help these countries in fulfilling the fourth and fifth goals of the mdgs; reducing under-five mortality and maternal death. it proposes ten recommendations to strengthen ict role in these countries to achieve the mdgs (itu, 2013). this study includes five sections. the introduction represents the first section. the second section includes the existing literature. the third section contains the econometric model and data set. the fourth section deals with the estimation results of the study. finally, the fifth section presents the findings and provides policy recommendations. 2. literature review 2.1. mobile phone and child mortality since the year 2000, many development initiatives have been offered to overcome the information challenges facing developing countries and to close the technological, social, and economic gap. for instance in the year 2000, the g-8 provided the “digital opportunity task force” with the main objective was to provide the advice to governments and international organizations to close the digital gap (wb, 2003). also, a pair of important initiatives was taken by the international telecommunication union and united nations represented by the world summit on the information society in geneva (december 2003) and in tunisia (november, 2005) (itu & un, 2003). the primary aim of these two initiatives is to urge and spread the use of information and communication technology in developing countries seeking to close the digital gap between the developed and the developing countries and accordingly achieving the development goals included in the millennium declaration. furthermore, the un global strategy for maternal and child health stresses the importance of mobile phone and broadband internet access in health care services in improving women and children’s health (un, 2010. p. 10). mobile phone, like any ict device, allows the exchange and transfer of information worldwide without spatial or temporal barriers (shade et al., 2012. p. 157), with high efficiency and low costs (chen, 2004. p. 9). although it is common in recent years to have access to health information depending on computers especially after widening the internet infrastructure, relying on the mobile phone in the field of health care is now more important. mobile phone outperforms the computer and is favored by users because of the capability of using by all groups of society in all regions at any time (riley et al., 2011. p. 53), especially because smartphones allow the ability of connection to the internet. a survey conducted by ausaid & usaid (2012) on 2500 women in egypt, india, uganda, and papua new guinea found that 84% of these women desired to get better health care information, and 39% of them wished to have access to health information through their mobile phones. although many developing countries depend on local radio to provide some information concerning mothers and infants in local dialect or language, the radio can be replaced by the mobile phone. a project based on radio technology in delivering health care to pregnant women applied in tororo district of uganda in 1996 and resulted in reducing the rate of maternal mortality by nearly 50% by the year 1999 (musoke, 2001). lately, it was displaced by mobile phone as it is a cheaper and more applicable solution (noordam, et al., 2011. p. 2). however, this kind of projects can still be applied, and information can still be obtained from local radio through the mobile phone as the radio application is now available on mobile phone. as for the visual media through which some health information for pregnant women and infant are broadcasted and can change some views concerning the use of modern medical means (navaneetham and dharmalingam, 2002), it can be watched through smartphones. based on above, the importance of mobile phone is apparent as a tool for providing health services and information. the expected positive impacts of using mobile phone on child and maternal health flow through two channels: users and medical service providers in the health sector. in many developing countries, especially in africa, the majority of the population lives in rural areas that lack proper health care. this situation hegazy: mobile phone and child mortality: the case of developing countries international journal of economics and financial issues | vol 6 • issue 3 • 2016 919 leads many of them to go cities to receive health care, bearing high cost (mcnamara, 2007. p. 20). accordingly, the mobile phone is considered one of the important tools in this respect as it provides the possibility of receiving health information and facilitating the arrival of medical services that were not available, in addition to reducing medical care cost (itu, 2003. p. 84; hjelm, 2005. p. 60). doctors being geographically distant from patients is not an obstacle anymore to diagnose diseases and determine treatment in due time (west, 2015. p. 13). in bangladesh, mobile birth notification system “mobiles for health” was launched for the purpose of contacting health units to call for midwives in case working ladies need them. applying this system resulted in the fact that the number of births under the supervision of specialists reached about 89%. beforehand, about 90% of births used to take place outside hospitals (brownlee, 2012). there is no doubt that the increase in using smartphones and its applications will help in widening the scope of medical services either for users or service providers (riley et al., 2011. p. 54). smartphones that are linked to the internet allow for browsing medical reliable websites which help in obtaining medical information. users can search for a treatment and get all the health knowledge needed. moreover, doctors can search for medical information for the purpose of learning or conducting researches. for example, site as www. mamaye.org benefits shakeholders as it updates information on a daily basis which finally be reflected in a better child and maternal health (nyamawe and seif, 2014. p. 40). however, many people lack abilities and skills to search for the needed information by using the mobile phone on their own. thus, workers in the health sector can share medical information concerning the health of children and pregnant women using sending text messages to mobile phones (lund et al., 2014. p. 2), as maternal health is strongly linked to children’s health and their survival. relying on text messages returns to the ability to be sent easily, at a low cost for a high number of beneficiaries, within a short period, and is also suitable for all kinds of mobile phones (riley et al., 2011. p. 54). in zanzibar, the project “wired-mother” was adopted in 24 health units covering six districts to increase the percentage of mothers receiving medical care during pregnancy and after delivery. this project depended on text messages to spread medical information, and it provided the possibility of direct contact between mothers and health units through a system on the mobile phone (lund et al., 2014. p. 2). in rwanda, the rapid short message services (sms) application was applied in 2012 in four districts for the purpose of supporting and helping pregnant women and newborns. using this program helped workers in the health field to follow up pregnant women and urged them to obtain health care during pregnancy. it also helped them to improve communication in case of emergency (world vision international). in china, appointment attendance has been enhanced by 7% as a result of sending reminder text messages to women through mobile phones. as for malaysia, health care increased by 40% among mothers who received reminder messages (west, 2015. p. 5). furthermore, mobile phones allow the possibility of protecting mother and child from some diseases through sending text messages that announce launching of different vaccination campaigns, and clarify how to take precautionary measures to control or prevent the spread of a particular disease (wb, 2003. p. 22-23). phukan et al. (2009) prove that parents’ lack of information is one of the essential factors that lead to vaccination leak. on the other hand side, mobile phone contributes in gathering and providing workers in health care sector with information about patients. in rwanda “rapid sms application” that was applied to support pregnant women and infants helped in determining the causes of maternal and child death on the local basis (world vision international). moreover, mobile phone contributes in providing the opportunity of exchanging medical expertise and providing workers in remote regions with information and medical consultancy from their colleagues who have a greater opportunity to obtain information (mcnamara, 2007. p. 12). in ghana, nurse midwives depend on the mobile phone to discuss complicated cases with their colleagues and superiors (un, 2010. p. 10). in islands of gambia, workers in health sector send photos of patient’s symptoms to doctors in near cities to diagnose the disease without any transportation costs (wb, 2003. p. 23). based on the above, it is apparent that access to mobile phone technology can contribute to the effectiveness and efficiency of health services provided to mother and child which, naturally, will be reflected in child mortality reduction. west (2015) finds that the use of mobile phone has a favorable effect on a group of african countries under study, as the mobile phone technology provides the opportunity to improve doctors’ abilities and increase the quality of services rendered to critical cases for both mother and infant in due time. fedha (2014) concludes a positive relation between women who have mobile phones and the number of attending clinics during pregnancy period, as they were reminded of their appointments by the mobile phone. nyamawe and seif (2014. p. 41) return the reduction of maternal and child mortality in tanzania during the period from 1996 till 2010 to several projects that connected mothers to both health centers and midwives using text messages and mobile phone calls. the projects provided mothers with information related to their health condition in addition to some advises and warnings regarding critical cases. moreover, the project linked health units with hospitals that allowed workers in local units to obtain medical consultancies and recommends for critical cases. 2.2. other determinants of child mortality the gross domestic product (gdp) per capita, a proxy for standard of living, is considered one of the well-known determinants of child mortality. anyanwu and erhijakpor (2007. p. 16) emphasize that high per capita income leads to an increase in the demand for health care, assuming that it is a normal good. high income leads to the adoption of modern health technology that is reflected in the reduction of mortality rate (houweling et al., 2005. p. 1258). moreover, it allows the possibility of providing essential public infrastructures such as water, sanitation, nutrition, and better houses (cutler et al., 2006. p. 110). income has a tangible impact on health especially in low-income countries due to the prevalence of absolute deprivation that includes lack of food and clean water (anyanwu and erhijakpor, 2007. p. 16). o’hare et al. (2013. hegazy: mobile phone and child mortality: the case of developing countries international journal of economics and financial issues | vol 6 • issue 3 • 2016920 p. 413) show that the increase in average gdp per capita by 10% leads to a reduction in infant mortality rate by 10% in case of the prevailing infant mortality rate in the country is 50/1000 live births. the empirical study of fayissaa and gutema (2005. p. 126) on 31 sub-sahara african countries over the period from 1990 till 2000, finds that the increase in income per capita, food availability, urbanization, and the decrease in both illiteracy and carbon dioxide emission rate improve life expectancy at birth. additionally, hanmer et al. (2003) find that per capita income, health indicators, education and gender inequality are statistically significant determinants of infant and under-five mortality. it is also argued that health expenditure is an important determinant of under-five and infant mortality as it affects child health status. therefore, who (2007. p. 14) has designed a framework including six essential foundations for the sake of strengthening the health system. health expenditure is considered a proxy for the health system. bokhari et al. (2007. p. 257) conclude that public health expenditure has a significant impact on maternal and under-five mortality reduction. anyanwu and erhijakpor (2007. p. 28) find that public and total health expenditure have a remarkable effect on under-five and infant mortality in 47 african countries. gottret and schieber (2006. p. 4) conclude that public health expenditure in 81 medium and low-income countries has a greater impact on reducing maternal and under-five mortality than the impact of public investment in roads, education, and sanitation. houweling et al. (2005. p. 1261) conclude that public health expenditure has a significant effect on reducing child mortality rate among poor groups as compared to rich groups. issa and ouattara (2012. p. 28) find that public health expenditure is more efficient in lower development stages while private health expenditure is more efficient in reducing infant mortality in higher development stages. despite the importance of public sector in providing health services especially in developing countries and despite the fact that the existence of positive externalities or market failures justify the existence of public health sector, this does not mean that increasing public health expenditure guarantees achieving positive health outcomes (anyanwu and erhijakpor, 2007. p. 8). lewis (2006. p. 44) confirms the importance of having good governance to achieve efficient public health expenditure and increase health investment returns. kamiya (2010. p. 10) proves that public health expenditure will not pay off in the case of lack of complementary services such as pure water, sanitation, and communication infrastructure. in a panel study on 44 sub-saharan african countries during the years from 1995 till 2010, novignon et al. (2012. p. 6) conclude that total health expenditure leads to an improvement of life expectancy at birth and reduction of child mortality. the study, however, shows that the misallocation of resources and weak management in public health sector lead to an increase in child mortality in case of increasing public health expenditure. on the other hand, female’s education is considered one of the main determinants of under-five and infant survival and health. women are the first and principal sponsors for children so their education will be reflected in their behaviors concerning the best health-care for children (cutler et al., 2006. p. 110). educated women have greater ability to interact efficiently with health service providers, respond to treatment recommendations, most committed to childcare, and provide a clean living environment (smith and haddad, 1999. p. 16). the study of rowe et al. (2005) conducts a survey on a sample of ladies have children under 5 years in nepal in 2000. it concludes that educated women and dealing with media positively and strongly correlate with mother’s health information and behavior which reflect on her health as well as her children’s health. in a study conducted in 22 countries of latin america and the caribbean during the nineties, moore et al. (2003) conclude that the impact of female literacy and vaccination rates have a more significant impact on reducing under-five mortality as compared to the impact of the increase in gross national product per capita. despite the multiple benefits of educated women to their children, women’s education increases their chances for outdoor work and this will be at the expense of children’s care (smith and haddad, 1999. p. 16). nevertheless, it is expected that the advantages of female’s education on child mortality reduction exceed the negative impact of her going out to work. installing sanitation in houses is an another determinates of child mortality. the lack of sanitation in developing countries causes a recurrence of diarrheal disease, which is considered one of the leading causes of infant and under-five mortality (günther and fink, 2010. p. 2). 3. model specification and data 3.1. the model the arellano and bond (1991) estimation methodology is used to overcome the endogeneity problem that might arise from child mortality rate to one or more of the determinants and vice versa, as this problem leads to a possible correlation between the set of determinants and the error term of the model. the mentioned methodology is applied to test the impact of mobile cellular subscriptions and other important determinants of infant and under-five mortality, as presented in equation (1) as follows: , 0 1 , 1 2 , 3 , 4 , 5 , 6 , , ln exp = + + + + + + + i t i t i t i t i t i t i t i t mr b b mr b ph b gdppc b h b fedu b san u (1) where mri,t represents child mortality rate: under-five and infant mortality. mri,t−1 represents the lag of the child mortality rate. phi,t represents mobile cellular subscriptions or internet users. ln gdppci,t is a natural log of gdp per capita. hexpi,t refers to public or total health expenditure, fedui,t represents female education, sani,t denotes to sanitation facilities, and ui,t refers to the error term, with the subscript i for countries (i=1,….,n) and t for years (t=1,.., t). it is necessary to note that equation (1) is estimated twice; once by using the ufmr as a dependent variable in the model and the other by using the infant mortality rate as another dependent variable. also, to check the robustness of the model other explanatory variables were used. the indicator of internet users and total health expenditure replaced mobile cellular subscriptions and public health expenditure respectively. hegazy: mobile phone and child mortality: the case of developing countries international journal of economics and financial issues | vol 6 • issue 3 • 2016 921 to estimate the model using dynamic panel system generalized method of moments (gmm), the correct group of instruments must be valid, or in other words, it must be relevant and exogenous. first, to test for the relevance of the instruments, the f-statistic of the first stage regression of every endogenous variable on the group of instruments must exceed ten to ensure that the bias is smaller than the ordinary least squares estimation. secondly, to test for over identification the j-statistic test is used to test the hypothesis that the group of instruments are exogenous to the error term of the original model. if the null hypothesis is not rejected, then the group of instruments are exogenous. this method is characterized by its ability to tackle endogeneity problem that emerges from the omitted variables or measurement errors. the basic idea of gmm method is to put slope equation in the form of a dynamic panel data model previously referred to, then take the first differences of the equation variables, and use the lagged values for the levels of explanatory variables as instrumental variables (arellano and bond, 1991). based on the literature reviewed earlier, mobile cellular subscription is expected to have an adverse impact on child mortality rate. thus, an increase in mobile phone subscriptions implies a broader access to health care and services, which helps to decrease under-five and infant mortality rate. additionally, it is expected that gdp per capita, female’s education, and sanitation will have a favorable impact on child mortality rate. moreover, it is clear that the impact of public and total health expenditure on child mortality is somewhat ambiguous; consequently, the sign of the indicator can’t be predicted in advance. 3.2. descriptive data the present study use unbalanced panel data for 43 developing countries over the period 2000-2012 sourced from the world development indicators data set and listed in appendix a. table 1 gives the description of variables. table 2 represents descriptive summary statistics of the variables used in the empirical analyses. it shows that, on average, under-five mortality stands at 94.9 deaths per 1,000 live births while infant mortality stands at 62.2 deaths per 1.000 live births. mean mobile subscription is 29.9/100 while mean internet users stand at 6.1/100. 4. empirical results tables 3 and 4 present estimation results for ufmr and infant mortality rates (imr) respectively. the coefficients of the lagged under-five and infant mortality are positive and statistically significant, and they indicate that child mortality is persistent over time as the estimated values are close to one. the coefficients of mobile cellular subscriptions and internet users are unexpectedly statistically insignificant throughout the models. our results are in line with the study of balcilar and kucuk (2014) where they conclude that in the case of including control variables, the indicators of ict lost their significance impact on child development indicators including ufmr, and percentage of children under-five of low weight. although the pilot studies in the developing countries prove the significance of the mobile phone with respect to child mortality reduction, our insignificant results suggest that; first, our study is based on panel data, so any obstacle facing the mobile phone technology in the child health field is difficult to overcome rapidly and consequently translated in the insignificance of this variable. on the other side, the pilot studies are conducted on the micro level, as they examine pilot projects depending on the mobile phone in the child health field applied in a particular district or town. accordingly there exist a direct and immediate tackle of any problem facing the project, which is reflected in the significance of mobile phone. secondly, most of the developing countries’ population live in rural regions, and they suffer from a low standard of living. furthermore, most educated people in these countries are not familiar with the english language that is used to display most of the health information on the internet (omary et al., 2010. p. 44). while, the pilot projects that connect mothers with health units launch their application in the native language, and sometimes provide mobile phones at low prices or for free (lund et al., 2014. p. 2). moreover, the workers in any pilot project deal with mothers and help them to understand the programs so as to ensure the success of the pilot project and its significant impact of the mobile phone. finally, lack of electricity and the limited coverage of mobile networks in some regions are considered obstacles to the spread of this technology that limits the expected benefits of the mobile phone in developing countries (noordam et. al. 2011. p. 3). whereas, the pilot projects create appropriate circumstances that ensure the success before the implementation, for instance, the project utilizes electricity generators in the regions that suffer from lack of electricity. next, as the results of tables 3 and 4 show, the variable log gdp per capita has a favorable statistical significant impact on under-five and mortality rates. a result that is consistent with kamiya (2010); wang (2002); anand and barnighausen (2004); issa and ouattara (2012); and novignon et al. (2012). in contrast to anyanwu and erhijakpor (2007) that show weak effect, as table 1: variables description variable description under-five mortality rate (ufmr) probability of deaths per 1,000 live births aged 0-5 years infant mortality rate (imr) deaths per 1,000 live births aged 0-1 year gross domestic product (gdppc) gdp per capita in constant 2011 international dollars mobile cellular subscriptions (mobcs) mobile cellular subscriptions per 100 people internet users (netu) internet users per 100 people public health expenditure (hpub) percentage of public health expenditure of total health expenditure total health expenditure (hgdp) percentage of total health expenditure of gdp female education rate (fedu) primary completion rate for female (% of relevant age group) improved sanitation facilities (san) percentage of population using improved sanitation facilities hegazy: mobile phone and child mortality: the case of developing countries international journal of economics and financial issues | vol 6 • issue 3 • 2016922 they refer to the fact that the weak impact of per capita income on mortality rate is an indicator of little effect in poor countries compared to rich countries. as the results of tables 2 and 3 show, the estimated coefficients on public health expenditure is almost statistically insignificant while the estimated coefficient on total health expenditure is negatively significant. the significance of total health expenditure may return to the efficiency of the private health expenditure whereas the insignificance of public health expenditure outcome can be justified by the misallocation of resources and weak management that lead to the waste of the resources directed to public health expenditure. the results are consistent with kamiya’ result (2010) which clarifies that public health expenditure has no impact on child mortality. issa and ouattara (2012) conclude that the increase in total health expenditure has an insignificant impact on infant mortality reduction while public health expenditure has a significant one. on the other side, anyanwu and erhijakpor (2007) conclude that there is an inverse relationship between public health expenditure and child mortality rate. accordingly they highlight the importance of increasing public health expenditure in african countries for achieving the fourth goal of the mdgs. also, on a sample of 60 low-income countries, the study of wang (2002) reaches the same conclusion. finally, the study of berger and messer (2002) finds that increasing the share of government expenditure on health is positively correlated with mortality rate. regarding the variable of female education (fedu), the results of tables 3 and 4 show a statistically significant favorable impact on both under-five and infant mortality rates. these results highlight the importance of including the female education in any policy option concerning to child mortality. these results conform to the findings of anyanwu and erhijakpor (2007); anand and barnighausen (2004); and issa and ouattara (2012). on the other hand, wang (2002) finds a significant positive relation between female education (primary and secondary) and table 2: descriptive statistics variable mean maximum minimum sd ufmr 94.91109 226.9000 15.30000 46.21539 imr 62.15975 116.2000 13.10000 25.05832 gdppc 3622.618 16320.14 506.3607 3398.348 mobsc 29.89708 153.7856 0.000000 32.19621 netu 6.131681 55.41605 0.005902 9.229181 hpub 44.29253 79.22261 3.091015 14.25339 hgdp 5.440302 12.27262 1.446244 1.854190 fedu 65.53471 119.6577 12.47971 25.04949 san 40.01896 100.0000 6.600000 25.91217 source: authors’ estimations. sd: standard deviation, ufmr: under-five mortality rate, imr: infant mortality rate table 3: results of the gmm estimations dependent variable: ufmr variables model 1 model 2 model 3 model 4 constant 42.15908 (0.0106)** 28.40710 (0.0031)*** 50.06086 (0.0029)*** 28.96694 (0.0961)* ufmr−1 0.881548 (0.0000)*** 0.905793 (0.0000)*** 0.907104 (0.0000)*** 0.918609 (0.0000)*** ln(gdppc) −4.739706 (0.0140)** −3.157307 (0.0116)*** −5.806779 (0.0069)*** −5.935482 (0.0019)*** moscb −0.000695 (0.8958) −0.007370 (0.1321) netu −0.017672 (0.1603) −0.021099 (0.1635) hpub −0.025125 (0.3737) −0.047546 (0.0156)** hgdp −0.448782 (0.0016)*** −0.883789 (0.0001)*** fedu −0.119617 (0.0128)** −0.066190 (0.0029)*** −0.067318 (0.0145)** −0.042069 (0.0744)* san −0.252280 (0.0066)*** −0.191119 (0.0123)** −0.160681 (0.0559)* −0.050161 (0.5501) number of observations 203 281 250 280 j-statistic/p-value for j-statistic over identify test 9.401946 [0.152203] 7.336819 [0.196771] 9.852666 [0.275520] 8.692411 [0.275500] p-value are reported in parentheses, where *p<0.1, **p<0.05, ***p<0.01. values in square parentheses [.] are the arellano-bond autocorrelation test p values. gmm: generalized method of moments, ufmr: under-five mortality rate table 4: results of the gmm estimations dependent variable: imr variables model 1 model 2 model 3 model 4 constant 29.24067 (0.0497)** 16.43987 (0.0168)** 21.28598 (0.0600)** 21.18519 (0.0345)*** inf−1 0.891655 (0.0000)*** 0.900789 (0.0000)*** 0.906012 (0.0000)*** 0.901275 (0.0000)*** ln(gdppc) −3.398869 (0.0572)* −1.545429 (0.0416)** −2.374347 (0.0701)* −2.143294 (0.0784)* mobsc −0.001058 (0.8698) −0.003190 (0.2020) netu −0.000226 (0.9765) −0.001141 (0.8861) hpub −0.012447 (0.2442) −0.015509 (0.2247) hgdp −0.188312 (0.0721)* −0.270010 (0.0414)*** fedu −0.031913 (0.0731)* −0.037854 (0.0029)*** −0.027684 (0.0847)* −0.031100 (0.0548)** san −0.109516 (0.0666)* −0.075189 (0.0410)** −0.080862 (0.0307)*** −0.070996 (0.1172) number of observations 249 309 250 251 j-statistic/p-value for j-statistic over identify test 14.18894 [0.164547] 6.569335 [0.254689] 10.23965 [0.248607] 6.391605 [0.380781] p-value are reported in parentheses, where *p<0.1, **p<0.05; ***p<0.01. values in square parentheses [.] are the arellano-bond autocorrelation test p values. gmm: generalized method of moments, imr: infant mortality rate hegazy: mobile phone and child mortality: the case of developing countries international journal of economics and financial issues | vol 6 • issue 3 • 2016 923 mortality rate (infant and under-five mortality). also, using the share of female students in education, kamiya (2010) reaches the same conclusion. finally, as for the improved sanitation facilities, the results show a favorable impact on both infant and under-five mortality. these results consist with those of wang (2002); kamiya (2010); and anyanwu and erhijakpor (2007). they find that improved sanitation has a statistically significant effect on reducing child mortality. the study of günther and fink (2010) concludes that improving sanitation has a good impact on under-five health and confirms the importance of increasing governmental intervention in the field of improving sanitation. 5. conclusion and policy implication the present study uses gmm methodology on a panel data set of 43 developing countries (coia countries) over the period from 2000 till 2012 to estimate the impact of the mobile phone on child mortality. the estimation results show that mobile phone isn’t a significant factor in reducing child mortality. additionally, the results imply that gdp per capita, total health expenditure, female education, and access to sanitation have a statistically significant favorable impact on child mortality. furthermore, the results show that public health expenditure almost has an insignificant impact on child mortality rate, which possibly arises from misallocation of the resources in the public health system. nevertheless, to depend on a mobile phone, as one of the tools to reduce child mortality, policies and government interventions are needed to overcome obstacles in this respect. it is important to provide the infrastructure for mobile phone services network such that it covers the country as a whole including rural and remote regions that lack health care. as many countries depend on the private sector, which seeks profit, in providing mobile phone services, the government intervention is required to achieve the comprehensive coverage for mobile phone networks either by supporting, cooperating, or coordinating with private sector companies. the interest in infrastructure is not limited to mobile phone networks only, but it should include also providing the infrastructure needed for electricity and sanitation enhancement and widening. additionally, at the country level, it is necessary to launch health information system cares about child and mother health in the native language, and applicable on the mobile phone. moreover, policymakers should adopt policies that increase gdp per capita. it is also important to increase female education in countries under study. finally, allocating total and public health expenditure must be efficiently achieved to reach fruitful results regarding under-five and infant health. references aguayo-rico, a., guerra-turrubiates, i.a., montes, r. 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[last accessed january 2016]. african region: benin, botswana, burkina faso, burundi, cameroon, central african republic, chad, congo, congo, dem. rep., côte d’ivoire, gambia, ghana, guinea, lesotho, madagascar, malawi, mali, mauritania, mozambique, niger, nigeria, rwanda, sao tome and principe, swaziland, senegal, tanzania, togo, uganda, zambia; regions of the americas: mexico, peru, bolivia, guatemala; eastern mediterranean region: yemen, egypt, morocco; european region: azerbaijan, kyrgyzstan, uzbekistan; south-east asia region: pakistan, indonesia, nepal; western pacific region: philippines. . international journal of economics and financial issues | vol 6 • special issue (s7) • 201698 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s7) 98-102. special issue for "international soft science conference (issc 2016), 11-13 april 2016, universiti utara malaysia, malaysia” a conceptual framework for examining trust towards zakat institution mohamad zulkurnai ghazali1*, ram al jaffri saad2, muhammad syahir abdul wahab3 1tunku puteri intan shafinaz school of accountancy, college of business, universiti utara malaysia, 06010 uum sintok, kedah darul aman, malaysia, 2tunku puteri intan shafinaz school of accountancy, college of business, universiti utara malaysia, 06010 uum sintok, kedah darul aman, malaysia, 3tunku puteri intan shafinaz school of accountancy, college of business, universiti utara malaysia, 06010 uum sintok, kedah darul aman, malaysia. *email: zulghazali@uum.edu.my abstract this paper aims to propose a research conceptual framework for examining trust towards zakat institution amongst moslem business owners. an extensive literature review method was utilized to identify and analyze the relevant literatures in order to propose the framework. this paper identified four factors that influence the trust, namely, shared values, communication, non-opportunistic behaviour and perception on distribution. theoretical and practical implications of the paper as well as suggestions for future research were also discussed. keywords: zakat, trust, business, conceptual framework jel classification: l00 1. introduction zakat is one of the five main pillars of islam and it has been stated 30 times in the qur’an (al-qardawi, 2000). zakat literally means clean, pure, grow, multiply, and mercy (al-qardawi, 2000). it is also recognized as blessing, holy and fertile (syed et al., 2005). the main objectives of zakat are to physically help the underprivileged and to cleanse the soul of the tax payers. these are mentioned in surah at-taubah verse 103 (al-quran, 1994). at the early reign of caliph abu bakr al-siddiq, he had ordered the army to fight those moslems who refused to pay zakat, as it is a religious obligation, which was implemented during the life of prophet muhammad (peace be upon him) (ibrahim and musaini, 2010). zakat is important to achieve justice and socio-economic status amongst moslems (patmawati, 2008). in this sense, it would assist the poor and needy to obtain financial resources and improve their life (suprayitno et al., 2013). in malaysia, since the privatization of zakat institution, the overall zakat collection and distribution has improved tremendously (muhammad et al., 2015; wahid et al., 2005). the improvement is also contributed by introduction of various zakat payment channels such as online transfer, salary deduction and short messaging services. unfortunately, despite all the advances made, only a small percentage of moslem business owners paid their zakat to zakat institution or through formal channel. on average, the collection of the zakat amongst them in the country only covers 20% of overall potential zakat revenue (alias, 2013). in johor, only 4.5% or 3983 out of 87,617 moslem business owners paid zakat through the state’s zakat institution in 2012 (razaly et al., 2014). this problem is also observed in the federal territory since only 30% of them paid the zakat formally (bernama, 2013). despite such problem, there are still limited options available to address this issue (wahab and borhan, 2014). thus, this paper aims to propose a research conceptual framework for examining the trust towards zakat institution amongst moslem business owners in malaysia. this paper has the following structure: section 2 highlights the relevant literature review and hypotheses development. then, a discussion of the framework is illustrated. the paper ends with conclusion, implication and suggestion for further research. ghazali, et al.: a conceptual framework for examining trust towards zakat institution international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 99 2. literature review and hypotheses development 2.1. zakat practices and trust towards zakat institution zakat is consistent with the other four pillars of islam (shahadah, prayer, fasting and pilgrimage) since it contains element of the relationship with god (hablum minallah). it also requires interaction amongst moslems (singer, 2013). zakat is levied on money, investments (for income generation), animals, agriculture, trade and business. zakat on business income which is the focus of this paper is levied on the business net asset at the rate of 2.5% (jabatan zakat negeri kedah, 2015). proceeds from the collection of zakat is one of the methods in islam to confront and improve the welfare of the moslem community (johari et al., 2014). this practice is in line with malaysia’s government transformation plan to propel the nation towards a developed and high-income countries (pemandu, 2011). thus, zakat contribution does not merely fulfill the religious obligation but it also contributes to the overall prosperity of the country. although total collection of zakat has increased over the past decades, zakat payment through its institution amongst moslem business owners remains less encouraging. in 2012, zakat collected from the business segment amounted to rm470 million and it was the second largest contributor of the total zakat collection. but, this accounts merely 20% of its potential zakat revenue from this segment (alias, 2013). the remaining 80% of uncollected business zakat or about rm1.85 billion remains as a huge potential for the authorities to have their share. one of the possible causes for the low collection is due to some moslems businessmen who opt to pay directly to the recipients. as specified in the quran, surah attaubah verse 60 “zakat is for the poor and the needy and those who are employed to administer and collect it, and for those whose hearts are to be won over, and for the freeing of human beings from bondage, and for those who are overburdened with debts and for every struggle in god’s cause, and for the wayfarers: this is a duty ordained by god, and god is the all-knowing, the wise” (al-quran, 1994). according to the national council of fatwa, it is mandatory for moslems to pay their zakat to the institution while any direct distribution of zakat to the eligible recipients is permissible but considered as sinful, for disobeying the country’s islamic government decision. yet, this failed to curb the practice of direct distribution as zakat payers have been dissatisfied with the inefficiency of zakat distribution by the institutions (wahid et al., 2009). this has prompted some individuals to take action to pay their zakat directly to the recipients (wahid et al., 2009; wahid et al., 2010). if this trend continues, it will further jeopardize the institution’s reputation in carrying out their responsibilities. for example, leakages due to the direct distribution of tithe (zakat fitrah) in selangor within the past 16 years (1995-2011) has increased from rm1.8 to rm5.2 million which has spiraled to almost 300% (muhammad et al., 2015). thus, it can be implied that zakat payers have a lack of trust towards the institution especially in its capability to help the poor and destitute (sinar, 2014). from the sociological perspective, trust is defined as a dependency of a party towards the behaviour of the other party to perform a particular task (sztompka, 1999). this interpretation is also suitable to describe the roles and responsibilities of zakat institution in collecting and distributing zakat to the eligible recipients. when the trust became suspect, zakat payers will eventually choose to transfer their contribution to the indirect channel (muhammad et al., 2015; wahid and ahmad, 2014; ismail et al., 2011). for instance, the national audit department has reported a sum of rm13.85 million from a state’s zakat institution was used as a preliminary payment for the construction of an office building complex (jabatan audit negara malaysia, 2010). this has certainly caused a concern about the integrity of the institution in managing public’s fund. humans are rationale, observant and learned from past experience (bandura, 1986), and the outcome of their interaction enable them to pass judgement about the service provider’s trustworthiness. zakat institution must come up clean as a trust towards an institution greatly influences contributors’ confidence to continuously contribute and remain committed in supporting the entity (torres-moraga et al., 2010). 2.2. hypotheses development trust has received widespread attention in various disciplines such as business, social and economy. it is described as an element that functions like a lubricant in public relations and very instrumental in people’s everyday life (putnam, 2000). based on the review of relevant literature, this paper suggests four factors that can influence trust towards zakat institution. the following subsections discuss the influencing factors which are consistent with the commitment-trust theory (macmillan et al., 2005). 2.2.1. shared values shared values have been proposed as being a direct precursor to both trust and relationship commitment that are commonly accepted to both supplier and dealer in terms of behaviours, goals and policies (morgan and hunt, 1994). the values are influential in the development of trust and commitment on both parties. an identical result is also evidenced when existence of shared values drive funders to trust and place commitment towards their preferred non-profit organizations (macmillan et al., 2005). likewise, zakat institutions should stress on creating the common shared values with zakat payers towards developing trust and commitment. when zakat payers perceived that the institutions are doing well in helping the eligible recipients, it is more likely that the trust will be greater amongst them. thus, the following hypothesis is proposed: h1: shared values will have a positive influence on trust towards zakat institution amongst moslem business owners. 2.2.2. communication an effectiveness of a two-way communication has affected the level of trust amongst donors in the charity sector (torres-moraga et al., 2010). this can be even further strengthened when the ghazali, et al.: a conceptual framework for examining trust towards zakat institution international journal of economics and financial issues | vol 6 • special issue (s7) • 2016100 donors are informed how the funds raised would be used (kelly, 2012). a good communication flow would include the willingness of the charity to listen and seeking information about the funders needs through enthusiast frontline staff. a timely communication (moorman et al., 1992) will also help to minimize any dispute or misunderstanding. in addition, a stronger relationship with donors is attainable when they are well-informed by the charity on the work undertaken and still undergoing (bennett and barkensjo, 2005). at present, a lack of literature that explains communication between zakat institution and zakat payers warrants a further investigation whether a good communication between both parties is more likely to increase the trust or vice versa. thus, the following hypothesis is suggested: h2: communication between zakat institution and zakat payers will have a positive influence on trust towards zakat institutions amongst moslem business owners. 2.2.3. non-opportunistic behaviour this factor is based on the concept of opportunistic behavior reported in prior literature. it is also coined as “self-interest-seeking with guile” (morgan and hunt, 1994; williamson, 1993). in this study, this factor is constructed oppositely as non-opportunistic behavior to reflect the positive side of such behavior (macmillan et al., 2005). when a partner perceived to be engaging in a rightful (non-opportunistic) behaviour for a mutually beneficial long-term relationship, this will lead to a positive response by the other partner through higher level of trust in their dealings. ultimately, a trust in partner helps not only to reduce the risk of opportunistic behaviour (hödl and puck, 2014; madhok, 2006), but also reduces cost-relating factors in dealing with the likelihood of opportunism (dyer, 1997). in view of this, moslem businessmen expect that zakat institution to uphold high standards of ethical practice in managing zakat fund and less likely to act opportunistically. therefore, the suggested hypothesis is: h3: non-opportunistic behaviour will have a positive influence on trust towards zakat institution amongst moslem business owners. 2.2.4. perception on distribution the distribution of zakat fund to the eligible recipients differs from the practice of other charity or non-profit organization as the money collected must be distributed to eight different categories. each category will received one-eighth of the zakat fund including zakat institution as the amil (administrator/caretaker). however, when there are cases of prevalent destitute and poor being highlighted in the local media, contributors are beginning to feel suspicious on the usage of their money intended to help the needy ones. previous studies have indicated a problem of inefficiency in relation to the distribution of zakat recipients, giving rise to a negative perception of the zakat institution and vice versa (saad and abdullah, 2014). in relation to this, it was reported that about 57.1% of tax payers were not satisfied with zakat institution especially in the distribution of alms to the needy (ahmad and wahid, 2005; wahid and ahmad, 2014). in short, zakat payers’ perception on the distribution efficiency will determine the level of trust towards zakat institution. thus, the developed hypothesis is: h4: perception on distribution will have a positive influence on trust towards zakat institution amongst moslem business owners. 3. research conceptual framework the research conceptual framework is illustrated in figure 1. the framework postulates that shared values (h1), communication (h2), non-opportunistic behavior (h3) and perception on distribution (h4) are the influencing factor towards the trust. this is consistent with the commitment-trust theory (macmillan et al., 2005) and prior zakat literature (saad and abdullah, 2014; ahmad and wahid, 2005; wahid and ahmad, 2014). the framework also proposes a positive relationship between the independent and dependent variables. such relationship is also supported by other scholars (torres-moraga et al., 2010; macmillan et al., 2005; morgan and hunt, 1994). 4. conclusion, implication and future research this paper proposes a conceptual framework for examining trust towards zakat institution amongst moslem business owners. the commitment-trust theory is utilized as the underpinning theory. an extensive literature review found that shared values, communication, non-opportunistic behavior and perception on distribution are the potential factors that influence trust towards zakat institution. thus, there are included in the proposed conceptual framework. this paper has several implications in terms of theory and practice. theoretically, this paper integrates the commitmenttrust theory in the zakat context. most of prior zakat studies applied theory of planned behaviour to study issues regarding figure 1: research conceptual framework for examining trust towards zakat institution ghazali, et al.: a conceptual framework for examining trust towards zakat institution international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 101 zakat (ajzen, 1991). this paper also expands zakat literature since it suggests the influencing factors on the trust. these factors were consistently reported in other non-profit organizations and charity-giving related studies (sargeant and lee, 2004; sargeant and woodliffe, 2007; naskrent and siebelt, 2011). in terms of practical aspect, the information about the influencing factors can be used by zakat institution to take appropriate actions in improving the trust amongst the business owners. such trust is critical to encourage them to pay their zakat through the institution. this paper is conceptual in nature, therefore, no statistical analyses and empirical evidence are provided. further research could examine the extent to which the proposed factors influence the trust using mail survey approach. therefore, more conclusive empirical evidence would be provided. references ahmad, s., wahid, h. 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(1993), calculativeness, trust, and economic organization. journal of law and economics, 36(1, part. 2), 453-486. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(3), 1123-1131. international journal of economics and financial issues | vol 6 • issue 3 • 2016 1123 islamic finance: is it a time to be considered as an alternative during financial crisis times? a comparative study in gulf cooperation council badreldin f. salim1*, mohamed h. mahmoud2 1department of accounting and finance, dhofar university, salalah-sultanate, oman, 2department of banking and finance, sudan university of science and technology, khartoum, sudan, *email: badreldin@du.edu.om abstract this paper investigates the difficulties facing islamic finance performance during the financial crisis times and to what extent whether the time has now come to considered it as suitable alternative in such situations as there is general believe that it is the time now for islamic finance to be considered as a suitable alternative to the existing conventional system particularly during the crisis times. the study examined the financial performance of three islamic banks (ibs) in the middle east alongside with other three conventional ones operating in the same region. the study used the ratio analysis technique for evaluating sample banks performance during the crisis times. the study suggested that although ibs have shown some positive indicators, they were actually facing some difficulties which are seems to be relevant to integral parts of the system itself, and those drawbacks may need to be systematically handled before reaching any such conclusion. keywords: islamic finance, conventional banks, financial performance, challenges, financial crisis jel classifications: e44, g01 1. introduction islamic finance is related to offering financial services in accordance to islamic regulations. the main tool adopted by islamic financial intuitions (including banks) is to offer related services all over the world. the size and share of this type of finance has grown rapidly to shape significant share of international economy (imf, 2010). according to the world islamic banking competitiveness report published by ernst and young (2012), “islamic banking assets with commercial banks globally grew to $1.3 trillion in 2011, suggesting an average annual growth of 19% over past 4 years. the islamic banking growth story continues to be positive, growing 50% faster than the overall banking sector.” furthermore, according to the global islamic finance report (2012), “islamic finance is expected to account for 50% of all banking assets within next 10 years in islamic counties” (al-gazzar, 2014). islamic finance is believed to have a better performance compared with conventional one during the financial crisis time according to relevant literature (parshar and venkatesh, 2010). others have gone far and concluded that islamic finance is better than its counterparts conventional system particularly during the time the crisis, and that is because the former one has convenient regulatory frame work which is capital adequacy standard of the islamic financial service board (ifsb). even more scholars have suggested that global financial crisis can be tackled if conventional systems follow the islamic financial principles and guidance of shariah (kayed and hassan, 2011). shafique et al. (2012) suggested that no islamic banks (ibs) fail during the financial crisis and they were safe because their financing derived from deposits not by the borrowing. this was supported by ahmed (2010) who concluded that today’s world is facing excess leverage and speculative risks, and that islamic financial system is safe from all these threats. but it looks that islamic finance is facing many difficulties and challenges that need to be addressed probably before ascertaining that financial institutions could follow this type of finance especially during the time of financial crisis, since this type may has its own difficulties that linked with its special nature (khan and ahmed, 2001). this suggests that a close neutral salim and mahmoud: islamic finance: is it a time to be considered as an alternative during financial crisis times? a comparative study in gcc international journal of economics and financial issues | vol 6 • issue 3 • 20161124 evaluation may shed a light on the believe that although islamic finance institutions may appear to be capable of facing financial instability times compared with conventional one, islamic fiancé institutions have faced some litigation which may hurdle their performance especially in the long run (ausaf et al., 1998), (wilson, 2000), (al maraj, 2008) and (shamim, 2013). not only this but also conventional finance institutions may have shown better performance in some aspects compared to islamic one during the time of the crisis. having stressed that, this study is trying to identify the difficulties that may affect islamic financial institutions performance in order to initiate a scientific investigation of how to address these difficulties, in sake of seeing islamic finance with a strong relevant regulatory framework that offers a convenient solution not only during financial instability times but during all times as a reliable financial system worldwide. 2. literature review 2.1. islamic finance in gulf cooperation council (gcc) the gcc is at the heart of the islamic world, with the two holiest shrines under the guardianship of saudi arabia, a kingdom that prides itself on being governed under shariah law. it might therefore be expected that the gcc states would be at the centre of the rapidly expanding islamic finance industry, which encompasses retail and investment banking, insurance, fund management and the issuance and trading of shariahcompliant securities known as sukuk (wilson, 2009). the author also indicates that islamic financial institutions in the gcc are significant sources of capital and are contributing to the development of islamic finance worldwide, especially in asia. also, the study concluded that the preference for islamic banking in the gcc indicates that it is more of a bottom-up than a top-down movement. el-ghattis (2014) discussed the concern of the futures of islamic banking in the gcc. the futures triangle method is employed to provide insights into existing social dynamics affecting islamic banking. he indicates that the promotion of islamic banking required more economic growth and strong private sector. ifsb stability report (2015) reveals that the global islamic finance industry has been in an upward trajectory, evidenced by its assets’ double-digit compound annual growth rate of 17% between 2009 and 2013. the industry’s assets are estimated to be worth usd1.87 trillion as at 1h2014, having grown from usd1.79 trillion as at end-2013. the gcc region accounts for the largest proportion of islamic financial assets as the sector sets to gain mainstream relevance in most of its jurisdictions; the region represents 37.6% of the total global islamic financial assets. the middle east and north africa (mena) region (excluding gcc) ranks a close second, with a 34.4% share, buoyed by iran’s fully sharia-compliant banking sector. asia ranks third, representing a 22.4% share in the global total, largely spearheaded by the malaysian islamic finance marketplace. 2.2. challenges and difficulties affect ibs performance the discussion of islamic banking and finance has a long history in the world and gcc. the islamic finance and banking literature shows that many scholars have tackled the subject matter of the islamic finance challenges. and according to relevant literature these studies concentrate on some main challenges that thought to be having marked impact on hurdling islamic finance institutions, these challenges could be explained as following. 2.2.1. profitability although some studies state that there was no difference regarding profitability between islamic banking and conventional one before the occurrence of financial crisis. however, many studies indicate different conclusion later. bashir (2001) shed some light on the relationship between ibs characteristics and profitability measures which he founds respond positively to the increases in capital and loan ratios, in addition to short-term funding, non-interest earning assets, and overhead in promoting banks’ profits. 2 years later, the same author (bashir, 2003) confirmed in a cross-country analysis study that profitability indicators in ibs positively react to boost in loan ratios and capital. al-tamimi (2005) studied the determinants of uae commercial banks through a contrast between national and foreign banks, his study suggests that the bank portfolio combination and bank size were found to have highly significant relation with return on assets (roa) and return on equity (roe) for the national banks performance. hassan and bashir (2003) studied the effects of controlled and uncontrolled variables on ibs profitability during 1994-2001. they show that some economics variables such; capital, gross domestic product and conventional interest rates were positively related to profitability. haron (2004) investigates the determinants of profitability of ibs and he found strong linkage factors include liquidity, total expenditures, funds invested in islamic securities, and the percentage of the profitsharing ratio between the bank and the borrower of funds, also identified other less strong determinants such as funds deposited into current accounts, total capital and reserves, and money supply. alkassim (2005) assured that higher capital ratios support ibs profitability. however, while total loans support positively the two systems profitability, deposits affect positively only the profitability of conventional banks. the above literature addressed the factors that affect ibs profitability that in general affected by capital and bank size which may be week if compared with their counterparts’ conventional one. this initially means an advantage to conventional banks to make more profits than islamic one (kearney, 2012). moreover many studies during and after financial crisis suggest that ibs were not doing better regarding profitability compared with conventional banks. parshar and venkatesh (2010) used key performance ratios; argue that during the global crisis ibs in gcc region suffered in terms of capital ratio, leverage and return on average equity (roae). jaffar and manarvi (2011) used camel approach during 2005-2009, examined performance of 5 ibs against performance 5 conventional banks in pakistan. they conclude that ibs earned less on their assets, while conventional banks made more profit. akhtar et al. (2011) indicate that conventional banks were better than ibs in regards to profitability and risk management practices. kearney (2012) salim and mahmoud: islamic finance: is it a time to be considered as an alternative during financial crisis times? a comparative study in gcc international journal of economics and financial issues | vol 6 • issue 3 • 2016 1125 indicate that despite the fact that ibs are small size compared with conventional ones, and to make it even worse, conventional banks opened islamic windows to compete with them, and that despite the strong growth; most ibs have not been consistently profitable, particularly since the global financial crisis. moreover it was argued by čihák and hess (2008) that small size of ibs are more stable than small conventional bank while larger conventional banks are more stable than larger ibs. imtiaz (2012) using camel testing factors, analyze the performance of ibs and conventional banks in (gcc) during and after the crisis; he found that during the period of 2008-2011, ibs possessed adequate capital structure but have recorded lower roae and poor management efficiency. weak management performance itself was ascertained as factor which affects negatively ibs profitability when al-gazzar (2014) explained that in addition to capital adequacy and asset quality one of significant determinants of bank profitability is management. 2.2.2. efficiency although some studies such as al-gamal and inanoglu (2005) analyze and compare the efficiency of islamic and conventional banks and find no significant difference in some countries. again some studies such as shamsher et al. (2008) suggest that there is a substantial room for improvement in cost reduction and profit maximization in both banking systems. furthermore some other studies conclude different result such as iqbal (2007) who discusses the challenges facing the islamic financial services industry in addition to some difficulties he addressed about weak risk management and governance framework, disparity in theory and practice. mokhtar et al. (2008) while studying malaysia banks for the period 1997-2003 discovered that, even though the fully functional ibs were more efficient and well-organized in contrast to the islamic windows, still they were less efficient than the conventional banks. sungard (2008) provided a list of future challenges facing ibs. these challenges indicate performance inefficiency. ghayad (2008) shows that there were managerial variables that affect ibs performance. he believed that the members of sharia board may hurdle the performance of directors because they lack knowledge in other relevant fields. olson and zoubi (2008) studied and compared the islamic and conventional banks in the gcc. they found that profitability between islamic and conventional banks is not much different. however, ibs are found to be less efficient and are operating with higher risk. although some studies such as manzoor (2013) indicate that ibs were efficient during the crisis and may help to increase the efficiency of banking sector and economy as a whole economy in some areas, and even some studies conducted in gcc during the crisis such as ftiti et al. (2013) which targeted efficiency using the data envelopment approach. their study indicated that ib remains efficient during the crisis. other studies that discussed the same period such as hassan and dridi (2010) reached different conclusion while discussing the performance of ibs and conventional banks (cbs) during the global crisis. they realized that two system performance affected differently by the crisis, it was true that ibs approach limited the negative impact on profitability at the beginning of the crisis, but at a later stage the situation changed in favor of conventional banks as a result of weaknesses in risk management regarding ibs which may be an indication of inefficiency. 2.2.3. liquidity in the banking sector, the transformation of short-term liabilities to long-term assets on the balance sheet is one of the most crucial characteristics in banking that may lead to a liquidity risk for banks (berger and bouwman, 2009; diamond and dybvig, 1983 and bryant, 1980). the anxiety over liquidity risk is more severe with regard to ibs on account of the specific nature of islamic financial products and activities and also due to the restricted accessibility of shari’ah compatible money market instruments and “lenderof-last-resort” facilities (dusuki, 2007). accordingly, ibs may face a more critical and wider mismatch between its assets and liabilities. hence, it is a key challenge for ibs to ensure their ability to obtain adequate funds to offset such mismatch on their balance sheets. however, looking at the issue from another perspective, attaining or upholding a massive sum of liquid funds to evade liquidity risk, would positively increase the costs and negatively affect the effectiveness of the bank to enhance their profitability (dusuki, 2007). by considering such consequences, the principal challenges towards maintaining an equilibrium consists of key factors such as the safety and profitability of transactions, as well as the compliance with shari’ah concepts in banking operations. the latter represents the core concern of the liquidity risk management in islamic banking sector. many studies discuss the issue of liquidity before the crisis those either indicated that there are some differences regarding performance between ibs and conventional banks include liquidly such as samad and hassan (2000) or other studies such as (samad, 2004), which indicate that the only difference in favor of ibs is liquidity. after the financial crisis, some studies discussed this issue. turk and sarieddine (2007) concluded that although ibs are meeting their capital requirements, however, they have faced some other difficulties, liquidity is on the top of them. ismal (2008a) tackled shariah issues relevant to liquidity risk management; in this regard. he called for developing a practice based on modern banking standards considering the variety of methods and approaches offered by shariah in this regard. in practice, he called for organizational approach and islamic liquidity instruments and a regulatory framework to meet liquidity needs. ahmed (2010) indicted that one of the challenges that may face islamic banking industry in short-term is liquidity management. faizulayev (2011) tried to specify changes needed to be done in two systems regarding ibs the internal challenges need to be considered was lack of products for liquidity risk management. shafique et al. (2012) conclude that liquidity was one of the main factors that gave ibs performance advantage over traditional banks during the crisis. moreover shafique et al. (2012) argue that during the period of 2008-2010, although many banks bankrupted as a result of liquidity risk, ibs so far stayed safe and this was a result of their high liquidity. however opposite to this trend al-gazzar (2014) argue that although ibs outperformed conventional banks in some aspects during the salim and mahmoud: islamic finance: is it a time to be considered as an alternative during financial crisis times? a comparative study in gcc international journal of economics and financial issues | vol 6 • issue 3 • 20161126 crisis, however they had a weaker liquidity position in comparison to conventional banks. 3. research methodology 3.1. hypothesis h1: in the financial crisis times, the ibs’ earnings to assets are considered weak compared to conventional one. h2: ibs’ net profitability to shareholders is low than those of conventional one during financial crisis times. h3: during the crisis, the efficiency (cost to income) of conventional banks is stronger than those of islamic one. h4: in the financial crisis times, the ibs’ probability of default on debt contracts is higher than those of conventional one. h5: during the crisis times, the conventional banks’ ability of meeting recurring financial obligations and avoiding defaulting on financial obligations is lower than those of islamic one. 3.2. significance of the study financial institutions are very important for every economy because they are the most contributing factor to keep economies on the bath of economic growth and development. the purpose of this study is to investigate the difficulties facing islamic finance during the financial crisis times with regard to financial performance such as profitability, efficiency and liquidity and to what extent whether the time has now come to considered it as suitable alternative in such situations as there is a general believe that the time has now come for the islamic finance to be considered as a suitable alternative to the existing conventional system particularly during the crisis times. so, this paper is trying to contribute to the existing literature of islamic finance and enhancing the awareness of the position of it and filling the literature gap of considering the option that it is the time for islamic finance to be a suitable alternative or still there are more issues and challenges have to be addresses first before reaching any such conclusion. 3.3. data collection this paper has adopted multiple research techniques for data collection such as: comparative analysis technique and ratio analysis techniques, ratios reflect key areas of performance were used. they are reliable source in predicting potential bankruptcies to measure the profitability, efficiency, and liquidity of islamic and conventional banks, so the study compares the (roaa) ratio, (roae) ratio, (cost to income ratio [cti]) ratio gearing ratio; and (la/ta) ratio. 3.4. sample a sample of three ibs has been selected along side with an average of another three conventional banks operating in the same targeted area of gcc was used to represent the two financial systems. an average performance for conventional banks has been used instead of individual banks due to a sharp fluctuation in performance of the selected sample whereas this is not the case for ibs where the average performance was showing normal fluctuations in performance of selected ibs and as well as it is an objective of this study to clearly concentrate on the individual performance of each selected ibs against average performance of a conventional banks which helps to give more real results. relevant data obtained from both primary and secondary sources so as to attain objectives of the study. 3.5. data analysis the study used excel 2007 and spss for windows version 12. to process and analyze data. t-test, one way analysis of variance was used to test differences regarding performance of individual ibs and the average performance of conventional banks. a p < 0.05 was considered significant in all statistical tests. 3.6. findings in order to reach true and real conclusion on the ibs performance and the average conventional banks performance during the financial crisis time (2008-2009), the study examined the indicators of performance in each type separately. the study examined the individual performance of the three ibs against the average performance of individual conventional banks at time of the study. 3.7. the first hypothesis akhtar et al. (2011) argue that profitability is important to the shareholders of the banks on one side and on the other dish up as spine adjacent to unfavorable conditions which includes: losses on loans, or losses that originated due to unforeseen and sudden changes in economic conditions. roa and roe are the largely pertained ratios used to measure financial performance (berger, 1995; naceur and goaied, 2001; williams, 2003; kosmidou, 2008; siddiqui, 2008; sufian and habibullah, 2009). the first hypothesis has examined performance using return on average assets (roaa) ratio to compare performance of the two systems: roaa is the most important single ratio in comparing performance of banks. roaa shows the net earnings of the banks in relation to its total assets. roaa is a profitability ratio; a study of volatility of earning is helpful in evaluating performance. this is done through studying the mean and standard deviation of roaa. an ideal situation when a bank has a higher mean and a lower standard deviation of roaa. a higher standard deviation represents higher volatility and higher risk. therefore, the study examines the following hypotheses: h01: islamic roaa ≤ conventional roaa ha1: islamic roaa > conventional roaa. table 1 shows that the mean of roaa is declining for conventional banks and increasing for ibs. however, the conventional banks display a higher mean of roaa during the 2 years of study, the highest being 3.6% in 2008. on the other hand, the highest mean for ibs is 1.5% in 2009. salim and mahmoud: islamic finance: is it a time to be considered as an alternative during financial crisis times? a comparative study in gcc international journal of economics and financial issues | vol 6 • issue 3 • 2016 1127 the standard deviation of roaa for ibs increases from 0.8 in 2008 to 1.4 in 2009. the standard deviation for conventional banks is almost the same during the 2 years of the study. but generally the values of standard deviation for the two systems of banking are very similar. although ibs show lower ratios compared to the average of conventional banks. but these observed differences were not statistically significant as table 2 shows. when looking at the performance of the individual banks, table 3 gives clearer picture. it appear that roaa (average) ratio for individual conventional banks are slightly higher than for individual ibs, with no statistically significant differences found between the two systems of banks. also there were no statistical significant differences in roaa (average) ratios between individual conventional banks or between islamic individual banks. from the above analyses it could be concluded that, although there are differences in performance in favor of conventional banks in term of roaa ratios, however these differences were not significant. 3.8. the second hypothesis the second hypothesis used roae to compare performance of the two systems: roae indicates the profitability to shareholders of the firm after all expenses and taxes. it measures how much the firm is earning after tax for each dollar invested in the firm; a higher roae means better managerial performance. again an ideal situation when a bank has a higher mean and a lower standard deviation of roae. a higher standard deviation represents higher volatility and higher risk. the mean and standard deviation are calculated to explain both the return on investment and also the riskiness of these returns. therefore, the study examines the following hypotheses: h02: islamic roae ≤ conventional roae ha2: islamic roae > conventional roae. table 4 reveals that the mean of roae is declining for conventional banks and increasing for ibs. however, the conventional banks display a higher mean of roaa during the 2 years of study. the mean roae for conventional banks declined from 40.6% in 2008 to 20.5% in 2009. on the other hand, the mean roae for ibs increases from 7.4% in 2008 to about 10% in 2009. it was clear that, roae of ibs is lagging behind the conventional in the 2 years. in spite of that the standard deviation of roae for both systems of banks increases in 2009, the overall, ibs has less variability than conventional banks. table 5 reveals that, differences in roae ratios between ibs and conventional banks were statistically significant 3.9. the third hypothesis the third hypothesis used gearing ratio to compare performance of the two systems: this ratio measures the risk and solvency of the firm. this ratio determines the probability that the firm default on its debt contracts. higher levels of debt can lead to higher probability of bankruptcy and financial distress. if the amount of bank assets is greater than the amount of its all types of liabilities, the bank is considered to be solvent. gearing ratio was calculated as: gearing ratio= non-current liabilities/ (equity+non-current liabilities) h03: islamic gearing ratio ≤ conventional gearing ratio ha3: islamic gearing ratio > conventional gearing ratio. table 1: roaa bank system year mean±sd minimum maximum conventional banks 2008 3.59±1.36 2.4 5.07 2009 1.78±1.47 0.11 2.89 ibs 2008 0.96±0.8 0.25 1.83 2009 1.46±1.38 0.09 2.85 roaa: return on average asset ratio, sd: standard deviation, ibs: islamic banks table 2: differences in roaa ratios of the groups of banks during the whole period ratios mean±sd* (%) minimum maximum p value** conventional banks 2.69±1.6 0.11 5.07 0.09 ibs 1.21±1.04 0.09 2.85 *sd: standard deviation, **p-value from t-test, a p<0.05 is considered significant. ibs: islamic banks. roaa: return on average asset ratio table 3: differences in roaa ratios of the individual’s banks during the whole period bank system name of bank mean±sd p value p value*** conventional bank average 2.69±1.29 0.937* 0.669 ib d 1.64±0.28 0.559** e 0.45±0.5 f 1.54±1.84 *p value for conventional banks only, p value from the analysis of variance, **p value for ibs only, p value from the analysis of variance, ***p-value for all banks, p value from the analysis of variance. roaa: return on average asset ratio, ibs: islamic banks table 4: roe ratio bank system year mean±sd minimum maximum conventional banks 2008 40.61±14.89 27.23 56.65 2009 20.49±17.55 1.22 35.56 ibs 2008 7.45±7.85 1.35 16.31 2009 9.98±8.43 0.59 16.9 sd: standard deviation, ibs: islamic banks table 5: differences in roae ratios of the groups of banks during the whole period ratios mean±sd* (%) minimum maximum p value** conventional banks 30.55±18.26 1.22 56.65 0.02 ibs 8.72±7.42 0.59 16.9 *sd: standard deviation, **p value from t-test, a p<0.05 is considered significant, ibs: islamic banks, roae: return on average equity salim and mahmoud: islamic finance: is it a time to be considered as an alternative during financial crisis times? a comparative study in gcc international journal of economics and financial issues | vol 6 • issue 3 • 20161128 table 6 shows that regarding gearing ratio ibs were found to be far lagging behind conventional banks. the highest gearing ratio of 36.6% recorded by ibs was less than the lowest gearing ratio of 59.4% recorded by conventional banks. on the other hands, differences in gearing ratios of conventional banks compared to ibs were statistically significant as appear in table 7. the analysis of gearing ratio for individual ibs included in the study compared to the average of conventional banks as shown in table 8 explain that, ibs again show lower values of gearing ratio as compared to average of conventional banks. these differences in gearing ratios between islamic and conventional banks were found to be statistically significant (p = 0.001). 3.10. the fourth hypothesis the fourth hypothesis used cti ratio to compare performance of the two systems. this ratio measures efficiency of a bank since it compare cost to income, so using this ratio explain which extent ibs performance was efficient compared to conventional one. therefore, the study tests the following hypothesis regarding the cost to income ratio: h04: conventional cti ≤ islamic cti ha4: islamic cti > conventional cti. the minimum and maximum columns of table 9 favor the performance of conventional banks in comparison with the ibs, since conventional banks show decreasing cti ratio from 48.5 in 2008, to 44.15 in 2009, while ibs show increasing cti ratio from 38.4 in 2008 to 43.5 in 2009. also the lower ratios of ibs compared to conventional one show not statistically significant observed differences as shown in table 10. 3.11. the fifth hypothesis the fifth hypothesis has been examined using liquidity ratio to compare performance of the two systems. liquidity ratio indicates the ability of the bank to meet recurring financial obligations and avoid experiencing financial distress. this ratio indicates the amount of liquid assets a bank has to meet its liabilities. the higher liquidity ratio mean bank has larger margins of safety and ability to cover its short term obligations. the liquid ratio is calculated as liquid assets divided by total assets (la/ta). therefore, the study tests the following hypothesis regarding liquidity ratio: h05: conventional (la/ta) ≤ islamic (la/ta) ha5: islamic (la/ta) > conventional (la/ta). as shown in table 11, the liquidity ratio of ibs in general is higher than that of conventional one and was increasing from 74.5% in 2008 to 76.7% in 2009. regarding conventional banks they show a stable trend in liquidity ratio from 55.1 in 2008 to 55.6 in 2009. the increase in liquidity ratio for ibs has been accompanied by a decrease in the standard deviation from 30.6 in 2008 to 26.2 in 2009; which is a good sign, while the standard deviation regarding conventional banks remains the same during this period. table 12 shows that ibs’ liquidity ratio was higher at 75% compared to conventional banks’ liquidity ratio at 55%. but table 6: gearing ratio bank system year mean±sd minimum maximum conventional banks 2008 68.46±4.27 64.38 72.91 2009 64.13±6.69 59.43 71.79 ibs 2008 19.57±10.47 7.8 27.82 2009 25±11.3 14 36.57 sd: standard deviation, ibs: islamic banks table 8: differences in gearing ratios of the individual’s banks during the whole period bank system name of bank mean±sd p value p value*** conventional bank average 66.3±3.46 0.149* 0.001 ib d 20.91±9.77 0.496** e 29.84±9.52 f 16.13±11.79 *p value for conventional banks only, p value from the analysis of variance, **p value for ibs only, p value from the analysis of variance, ***p value for all banks, p value from the analysis of variance. sd: standard deviation, ibs: islamic banks table 9: cost to income ratio bank system year mean±sd minimum maximum conventional banks (average) 2008 48.5±44.2 11.86 97.65 2009 44.15±41.28 11.89 90.67 ibs 2008 38.41±0.75 37.88 39.26 2009 43.54±13.27 29.25 55.48 sd: standard deviation, ibs: islamic banks table 11: liquidity ratio bank system year mean±sd minimum maximum conventional banks 2008 55.13±30.6 23.3 84.4 2009 55.56±30.6 23.6 84.65 ibs 2008 74.48±30.61 39.32 95.2 2009 76.66±26.17 46.66 94.84 sd: standard deviation, ibs: islamic banks table 7: differences in gearing ratios of the groups of banks during the whole period conventional banks 66.3 5.55 59.43 72.91 0.0001 ibs 22.3 10.19 7.8 36.57 *sd: standard deviation. **p value from t-test, a p<0.05 is considered significant. ibs: islamic banks aq5 table 10: differences in (cti) ratios of the groups of banks during the whole period conventional banks 46.32 38.34 11,86 97.65 0.751 ibs 40.98 8.86 29.25 55.48 *sd: standard deviation, **p value from t-test, a p<0.05 is considered significant. ibs: islamic banks, cti: cost to income ratio aq5 salim and mahmoud: islamic finance: is it a time to be considered as an alternative during financial crisis times? a comparative study in gcc international journal of economics and financial issues | vol 6 • issue 3 • 2016 1129 the appeared difference in liquidity ratio was not statistically significant (p > 0.05). it was shown also from table 13 that differences in liquidity ratios are statistically significant between the average of conventional banks (p < 0.0001) and also between selected islamic indvidual banks (p = 0.001). comparisons of the trends in liquidity ratio are depicted in figure. to show a general picture of the performance of the two banking systems. from tables 1-13 it could be concluded that conventional banks in face of ibs show better profitability and more efficiency. ibs in face of conventional banks show a better liquidity and stronger solvency condition. 4. disscusion the first result (the conventional banks display a higher mean of roaa during the 2 years of study although the mean of roaa is declining for conventional banks and increasing for ibs and), goes in line with the conclusion of (abu loghod, 2010) and (ghafoor, 2009) and it is relatively similar to the conclusion of (hassan and dridi, 2010). however, it is different from the conclusion of (moin, 2008). this result also consistent with the conclusion of jaffar and manarvi (2011) who conclude that ibs earned less on their assets, while conventional banks made more profit. this result also supported the study of sadaqat et al. (2011) who indicate that conventional banks were better than ibs in regards to profitability and risk management practices. this result is consistent with kearney (2012) who indicate that despite the strong growth; most ibs have not been consistently profitable, particularly since the global financial crisis. the second result (the mean of roae is declining for conventional banks and increasing for ibs. however, the conventional banks display a higher mean of roaa during the 2 years of study). this result is consistent with the ansari and rehman (2011) who conclude that profitability measures of performance of roaa, roae and pem do not show (statistically) significant difference between the performances of islamic and conventional banks and reject the hypothesis that ibs are more profitable than conventional banks. the third result (the gearing ratio of conventional banks is higher than that of ibs. ibs were found to be far lagging behind conventional banks when gearing ratio is concerned), goes in line with (moin, 2008) who argue that ibs to be less profitable than its counterparts, their findings of profitability and risk and solvency perfectly fit in this risk-return profile and allow to conclude that conventional banks are more profitable, also more risky and less solvent than ibs. the fourth result (there is a slight difference in the mean cti ratio between the two systems of banking in 2008. but in 2009 the two systems of bank display similar cti ratios), goes in line with (ghafoor, 2009) and (kader and asarpota, 2007). however, it is different from the conclusion made by (moin, 2008). the fifth result (the liquidity ratio of ibs in general is higher than that of conventional ones), goes in line with (demirgüç et al. 2010), (abu loghod, 2010) and (čihák and hesse, 2008) and boumediene and caby, 2009) conclusion. however, this result differs from the results of (gamaginta and rokhim, 2011), and from the cross-country study of (čihák and hesse, 2008), which concludes that the level of stability among groups of banks has different tendency of comparison. 5. study limitation this study is limited firstly due to of small sample size, which contained only three ibs against an average of conventional banks in specific area which is gcc. another limitation is the length of the study which was 2 years. however, this is justified with nature of the study as the purpose was to examine the financial performance only during the financial crisis times. so, the study concentrated on the peak of the crisis which was the period of 2008-2009. a third limitation is that the researches were obliged according to high fluctuation to use average performance of conventional banks rather than sample of three individual conventional banks as the case of ibs, this limited the chances of comparing individual banks performance in the two systems. 6. conclusion from the above analysis it can be observed that liquidity ratios for ibs are higher compared to the conventional banks’. however, ibs pose the lowers ratios compared to conventional average regarding cti, roaa, roae, and gearing ratio. although some differences were not statistically significant as explained earlier (liquidity ratio, cti and roaa), we can conclude that although the results show that ibs appear to be better capitalized, more liquid, and at a stronger solvency condition compared to conventional banks. table 12: differences in (la/ta) ratios of the groups of banks during the whole period ratios mean±sd* (%) minimum maximum p value** conventional banks 55.34±27.39 23.3 84.65 0.21 ibs 75.57±25.5 39.32 95.22 *sd: standard deviation, la/ta: liquid assets divided by total assets. **p value from t-test, a p<0.05 is considered significant, ibs: islamic banks table 13: differences in (la/ta) ratios of the individual’s banks during the whole period bank system name of bank mean±sd p‑value p‑value*** conventional bank average 55.34±0.30 0.0001* 0.0001 islamic bank d 88.68±0.29 0.001** e 95.03±0.27 f 42.99±5.2 *p value for conventional banks only, p value from the analysis of variance, **p value for ibs only, p value from the analysis of variance, ***p value for all banks, p value from the analysis of variance. la/ta: liquid assets divided by total assets, sd: standard deviation, ibs: islamic banks salim and mahmoud: islamic finance: is it a time to be considered as an alternative during financial crisis times? a comparative study in gcc international journal of economics and financial issues | vol 6 • issue 3 • 20161130 however, this study suggests that ibs are not delivering better in profitability and are not more efficient than conventional banks during the crisis times offering important indicators of the type of challenges and difficulties that are faced by ibs that need to be addressed systematically before reaching any conclusion that it is an alternative to the existing financial system during the financial crisis times. references abu loghod, h.a. 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(2009), the development of islamic finance in the gulf cooperation council states. working paper, kuwait programme on development, governance and globalization in the gulf states, the centre for the study of global governance. author queries??? aq5: kindly cite significant value in the table part . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(3), 837-844. international journal of economics and financial issues | vol 6 • issue 3 • 2016 837 the effects of antidumping duties in a new open economy macroeconomics model chung-fu lai1*, xi-tsz lee2 1department of applied economics, fo guang university, yilan county, taiwan, 2department of applied economics, fo guang university, yilan county, taiwan. *email: cflai@gm.fgu.edu.tw abstract this paper presents new open economy macroeconomics as the analytical framework in attempt to integrate the characteristics of imperfect competition market and antidumping behavior into a two-country (home country and foreign country) model with micro-foundation. we analyze the long-term effect of implementing antidumping duty in home country on various microeconomic variables (i.e. consumption, output, price, exchange rate, and terms of trade [tot]) when foreign country engage in dumping behaviors toward the home country. theoretical inference and simulation analysis of this paper suggests a positive correlation between antidumping duty and domestic consumption, foreign consumption, world consumption, domestic price index, foreign price index, and exchange rate; whereas a negative correlation between antidumping duty and the domestic output, foreign output, and tot. moreover, the level of volatility in all macroeconomic variables rises when the ratio of export product price selling below its retail price in home country expands. keywords: antidumping duties, micro-foundation, new open economy macroeconomics jel classifications: f12, f13, f41 1. introduction economic liberalization and internationalization seem to have become the mainstream trends for international trade after the establishment of world trade organization (wto) in 1995. nonetheless after years of operation, developing and lesserdeveloped countries gradually realize that market opening does not bring relatively direct economic and trade benefits so they protest against market opening. on the other hand, developing countries and developed countries apply safeguarding policies for import to practice protectionism, such as antidumping policy. it is defined in article 6 of general agreement on tariffs and trade that dumping refers to the price of a product when sold in the importing country is less than the price of that product in the market of the exporting country. according to the “antidumping agreement” of wto, when dumping competing countries of trade becomes a fact and the said dumping behavior has caused material injury to the home-country industries, the countries suffering from dumping may impose specific antidumping duty on the dumping suppliers. for the last 30 years, antidumping policy comes one of the primary trade policy tools for many countries. in general, literature related to studies of the economic effect of antidumping policies can be summarized in three categories, as described below. the first category refers to the “empirical analysis on the effect of antidumping duty on upstream and downstream industries.” relevant research include the study conducted by webb (1992), he suggested that the imposition of antidumping duty will reduce the amount of import to the importing countries and increase output and profits. consequent, the domestic related upstream industries of importing countries will benefit from such policy, protecting the industries in home country but not necessarily in favor of the downstream industries and consumers’ benefits in the importing countries. kelly and morkre (1998) discovered the response of import quantity of foreign products in importing country is related to the elasticity of substitution between foreign and domestic goods. the second category refers to the “analysis of effect of antidumping duty on welfare.” relevant research includes the study conducted by prusa (1996), where he applied regression analysis and discovered that lower antidumping duty does not affect import after the imposition of antidumping duty while higher antidumping duty has significant and negative impact on import. another study conducted by prusa (1999) revealed substantial lai and lee: the effects of antidumping duties in a new open economy macroeconomics model international journal of economics and financial issues | vol 6 • issue 3 • 2016838 impact of antidumping duty on import, and showed the increase in antidumping duty will reduce import quantity and rising import price. the study of staiger and wolak (1994) revealed the impact of us antidumping duty on the amount of transactions, and found that the investigation effect, termination effect and cancellation effect of antidumping duty imposition will affect (or constrain) trade amount. anderson et al. (1995) discovered in their research that in the existence of actual trade barrier, antidumping policy will drive the social welfare of importing countries to rise on contrary. the last category refers to the “analysis of effect of antidumping on international trade.” relevant research includes the study conducted by feinberg and kaplan (1993), where they proposed forming industry protection through antidumping policy. the findings suggested that the compliant will have curbing effect on the import once filed, even if the outcome of antidumping investigation is overruled at the end. krupp and pollard (1996) explored into the case, where ruling outcome will have effect on the involving export and the import quantity of non-involving countries during the investigation period of all antidumping cases. in case the final verdict of antidumping case is affirmative at the time when the complaining country is conducting investigation on the dumping cases, the export quantity of the home country of involved supplier to the complaining country will face significant reduction during the investigation period and after the investigation. prusa (1999; 2001) analyzed the frequent use of antidumping system by industrial countries to protect their industries while developing countries also adopt the same pace actively. antidumping duty has tremendous impact on import and among the cases imposed with taxes, the export quantity were reduced by 70% while the import price rose by 30%. in terms of overruled antidumping cases, the manipulation of trade investigation alone can reduce the import quantity by 20%. durling and prusa (2006) discovered that antidumping duty will significantly reduce the export quantity of involving suppliers in the export to complaining country, namely antidumping will have significantly destructive effect on trade. in sum of the aforementioned, literature regarding the analysis of the effect of antidumping duty in general applies the effect of imposing antidumping duty on upstream and downstream industries, international trade effect, and welfare effect as the key analysis issues, with less discussion on the effect of involvement with open economy macroeconomic effects. for this reason, the paper intends to broaden the new open economy macroeconomics (hereinafter referred to noem) proposed by obstfeld and rogoff (1995) in attempt to discuss the effect of imposing antidumping duty on macroeconomic variables. the reason for noem related literature to quickly rise in the short run is primarily because the set of theoretical framework apply the structure of imperfect competition market as the analytical framework and features explicit micro-foundation. hence noem has drawn favor from many scholars who re-examine the various macroeconomic issues from the perspective of noem and the analysis of trade policy (i.e. tariff shock) effect is one of the issues discussed in noem. based on the noem model proposed by obstfeld and rogoff (1995), fender and yip (2000) analyzed the effect of tariff policy on the welfare and output, the findings showed that the increase of temporary tariff during the short term will lead to reduction in the domestic output with uncertain effect on foreign output. in the long run, the tariff policy will reach the same conclusion as that in the short run. for the effects of welfare, the increase in tariff will drive domestic welfare to rise but negative impact on foreign welfare. as a result, the rise in domestic import tariff will have the “beggar-thy-neighbor effect.” nonetheless the paper draws attention to antidumping policy turning into considerably important trade policy tools for countries worldwide. we find that there are currently no literature that explicitly explain the role played by antidumping duty in open economy and hence paper attempts to apply the noem proposed by obstfeld and rogoff (1995) as theoretical framework to analyze the long-term effect of implementing antidumping duty in home country on various microeconomic variables (i.e. consumption, output, price, exchange rate, and terms of trade [tot]) when foreign countries engage in dumping behaviors toward the home country. the paper is divided into four sections of discussion, with the exception of introduction, containing the following sections: section 2 comprises the building of theoretical model. section 3 covers the simulation analysis for analyzing the long-term effects of antidumping duty on macroeconomic variables. section 4 draws the conclusion and suggestion. 2. theoretical model 2.1. model setting this paper follows the noem proposed by obstfeld and rogoff (1995) as theoretical foundation with the primary assumptions as follows: 1. countries worldwide are classified as “home country” and “foreign country,” the following foreign economic variables are marked with “*” 2. the world population is distributed between intervals of [0,1], where home-country individuals are distributed between intervals of [0,n] and foreign individuals distributed between internals of [n,1] 3. all individuals are both consumers and producers, in addition to operating a company of monopolistic competition and using labor to produce 4. dumping behavior exists in the economic system, where export products of both countries are sold below the price of the products sold in domestic market, and both countries may impose specific antidumping duty against the dumping behaviors of the rival country. 2.1.1. household assume all individuals have the same preferences, utility (u) and consumption (c) and real money balance (m/p) forming the positive proportionality, but forming an inverse proportionality with output level (y). the lifetime utility function is configured below: 1 2log ( ) 1 2 s t s t s s ss t m u c y z p ε χ κ β ε −∞ − =     = + −  −    ∑ , ε > 0 (1) where, β is the discount factor (0 < β < 1), ε is the elasticity of marginal utility for real money balances, χ and κ represent the lai and lee: the effects of antidumping duties in a new open economy macroeconomics model international journal of economics and financial issues | vol 6 • issue 3 • 2016 839 significance degree of real money balances and output in utility function, and z refers to specific product. in equation (1), the consumption index is defined as the function of constant elasticity of substitution: c c z dz c z dzt h t n f t n = +           ∫ ∫ − − − , ,( ) ( ) 0 1 1 1 1δ δ δ δ δ δ , δ > 1 (2) where ch(z) is the consumption on the specific home-country product z by the home-country consumers, cf(z) is the consumption on the specific foreign product z by home-country consumers, and δ is the elasticity of substitution of products between two countries. it is induced from the definition of consumption function (equation 2) to yield the domestic price index (p) under expenditure minimization, as shown below: p p z dz p z dzt h t n f t n = + + −        ∫ ∫ − − − , ,( ) ( )( ) ( ) 0 1 1 1 1 1 1 1 δ δ δ τ λ , τ ≤ λ (3) likewise, foreign price index (p*) is yielded below: p p z dz p z dzt h t n f t n * * , * , * ( )( ) ( ) ( )= + − +        ∫ ∫ − − 1 1 0 1 1 1 1 1 τ λ δ δ −−δ , τ* ≤ λ (4) in the above two equations, ph(z) represents the price of homecountry product z denoted in home-country currency, pf(z) represents the price of foreign product z denoted in home-country currency, p zh * ( ) represents the price of home-country product z denoted in foreign currency, and p zf * ( ) represents the price of foreign product z denoted in foreign currency. additionally, because dumping behavior exists in the economic system, we assume the ratio of price for export products sold by both countries lower than the price of the product sold in domestic market is λ, both countries will impose antidumping tax against the dumping behavior of the other rival country. the rate of antidumping duty for home country and foreign country are τ and τ* respectively. the imposition of antidumping duty is important tools taken by government against the unfair trade behavior of selling below normal value in order to maintain fair trade and stabilize the domestic industry development. however, antidumping duty in general is assessed as equal to or less than the dumping margin, that is, τ ≤ λ. for any product, the law of one price is held below: p z e p zh t t h t, , * ( ) ( )= (5) p z e p zf t t f t, , * ( ) ( )= (6) where, e denotes the exchange rate. from equations (2) and (3), we can induce the consumption for specific home-country product and specific foreign products by representative home-country consumers as shown below: c z p z p ch t h t t , , ( ) ( ) =       −δ (7) c z p z p cf t f t t , , ( ) ( )( ) ( ) = + −      − 1 1τ λ δ (8) likewise, the consumption for specific home-country product and specific foreign products by representative foreign consumer is shown below: c z p z p ch t h t t , * * , * * * ( ) ( )( ) ( ) = + −        − 1 1τ λ δ (9) c z p z p cf t f t , * , * * * ( ) ( ) =         −δ (10) in the above two equations, c zh * ( ) denotes the consumption of specific home-country product z by foreign consumer and c zf * ( ) denotes the consumption of specific foreign product z by foreign consumer. 2.1.2. government to emphasize on the analysis of antidumping duty effect, assume the government does not have consumption expenditure, the government returns seigniorage revenue and antidumping duty revenue to the agents in a lump-sum fashion. hence the government budget constraint is shown below: m m p n p z p tt t t f t t t − + − =−1 1τ( ) ( ), (11) where the first item on the left of equation is the real seigniorage revenue, the second item on the left of equation is the real antidumping duty revenue, and the right side of equation is the real government transfer payments. 2.1.3. asset market assume the international capital market is integrated and each individual can buy and sell real bond (b) in the international capital market, where the relationship between the real interest rate (r) and the nominal interest rate (i) for bond at maturity is shown in the fisher equation below: 1 1 1+ = ++i p p rt t t t( ) (12) the bonds holding reflects the borrowing relation of residents between the two countries, which thereby meet nb n bt t+ − =( ) , * 1 0 or, b n n bt t * = − −1 (13) where, b refers to the bond quantity held by representative individual of the home country and b* refers to the bond quantity held by the representative individual of foreign country. lai and lee: the effects of antidumping duties in a new open economy macroeconomics model international journal of economics and financial issues | vol 6 • issue 3 • 2016840 2.1.4. budget constraint the budget constraint for representative individual is configured below: mt + ptct + ptbt = mt−1 + pt(1 + rt−1)bt−1 + ph,t (z)yh,t (z) + pttt (14) in the equation, the source of income for representative individual in period t, includes: money balances for period t−1 (mt−1), principal and interest of bond from period t−1 (pt(1 + rt−1)bt−1), output revenue (ph,t (z)yh,t (z)) and government transfer revenue (pttt). consumers can use such income during period t for money holding (mt), consumption (ptct) and bond purchases (ptbt). 2.1.5. aggregate demand from the consumption on specific home-country product by homecountry representative consumer (equation 7) and consumption on specific home-country products by foreign representative consumer (equation 9) yield to the product demand faced by home-country firm as below: y z nc z n c z n p z p c n h t h t h t h t , , , * , ( ) ( ) ( ) ( ) ( ) ( ) ( = + − =       + − + − 1 1 1 δ ττ λ δ * , * * * )( ) ( )1−        − p z p ch t t (15) likewise, from equations (8) and (10), we have: y z nc z n c z n p z pf t f t f t f t t , * , , * , ( ) ( ) ( ) ( ) ( )( ) ( ) = + − = + −     1 1 1τ λ −− − + −         δ δ c n p z p cf t t ( ) ( ), * * * 1 (16) 2.1.6. first order conditions the first order conditions of consumer for maximizing utility (equation 1) under budget restraints (equation 14) is: ct+1 = β(1 + rt)ct (17) m p i i ct t t t t= +      ( )1 1 χ ε (18) [ ( )] )y z k c ct t t w δ δ δδ δ + −= −      1 1 1 1 ( (19) where equation (17) is euler equation that depicts the intertemporal consumption behavior, equation (18) is the money demand equation that explains the substitution relation between real money demand and consumption, equation (19) is the labor supply equation that specifies the substitution relationship between labor supply and consumption. in the equation, cw denotes world consumption, and c nc n ct w t t≡ + − ∗ ( )1 . 2.2. derivation of steady-state we now discuss the effect of antidumping duty on the various macroeconomic variables. first, we assume the economic system in the absence of antidumping behavior and antidumping duty is given as initial state (namely 0 steady state) and as the basis of comparison, and then to derive the long-term steady state for the economic system. among the following symbols, the lower case “t” denotes the economic variables under long-term steady state and the lower case “0” denotes the economic variables under initial state. for example, ct and c0 each represents the consumption level under long-term steady state and initial state, respectively. steady state refers to the economic system is in the state of convergence after exogenous shock in the long run. under longterm steady state, all variables are constant, and bt = bt+1 = 0. therefore substitute the government budget constraint (equation 11) into the private budget constraint (equation 14) to yield: c p z y z n p z pt h t h t f t t = + −, , ,( ) ( ) ( ) ( )τ 1 (20) likewise, the equation for foreign country as below: c p z y z np z p t f t f t f t t * , * , * * , * * ( ) ( ) ( ) = +τ (21) 2.3. log-linearization the paper applies the practice proposed by uhlig (1995) in order to yield the closed-form solution. first, log-linearization is applied to the model before giving the parameters of the model for simulation analysis1. next, the variables undergo log-linearization near the initial state of each variable to yield the level of volatility of variables in the steady state. in the text, upper case “^” indicates the variables undergoing log-linearization. for example, if ˆ tx is the result of variable xt carrying out loglinearization near x0, then: 0 0 0 0 ˆ ln t t tt x x x dx x x x x − ≡ ≅ ≅ 2.3.1. log-linearized versions of price index substitute equations (5) and (6) to equations (3) and (4), and log-linearize the two equation yield: * , , ˆ ˆˆ ˆ ˆ( ) (1 )(1 )( ( ) )t h t t f tp np z n e p zλ τ= + − − + + (22) * * * , , ˆ ˆˆ ˆ ˆ(1 )( ( ) ) (1 ) ( )t h t t f tp n p z e n p zλ τ= − − + + − (23) subtract equation (23) from equation (22) to yield the difference of variation in the price index between two countries as: * * , , * ˆ ˆ ˆ ˆ( ) (1 ) (1 ) ˆ ˆ(1 )(1 ) (1 ) t t h t t f tp p n p z e n p n n λ λ λ λ τ λ τ − = + − − − + − − − − (24) 2.3.2. log-linearized versions of the law of one price apply log-linearization to equations (5) and (6) to yield: 1 due to the complexity in model configuration and to yield the closedform solution between exogenous variable and endogenous variables, the two methods more commonly used in literature are log-linearization and numerical simulations. the paper adopts log-linearization incorporated with numerical simulation analysis. lai and lee: the effects of antidumping duties in a new open economy macroeconomics model international journal of economics and financial issues | vol 6 • issue 3 • 2016 841 * , , ˆˆ ˆ( ) ( )h t t h tp z e p z= + (25) * , , ˆˆ ˆ( ) ( )f t t f tp z e p z= + (26) 2.3.3. log-linearized versions of world budget constraint use equations (20) and (21) to yield the budget constraint of the world: c nc n c n p z y z n p z p n p t w t t h t h t f t t f t = + − = + − + − ( ) ( ) ( ) ( ) ( ) ( ) * , , , , 1 1 1 τ ** , * * , * ( ) ( ) ( )z y z np z p f t f t t +τ (27) apply log-initialization to equation (27) and utilize equations (25) and (26) to yield: * * , , , * * * * , , , ˆ ˆ ˆˆ ˆ ˆ ˆ( ( ) ( ) (1 )( ( ) ) ) ˆ ˆˆ ˆ ˆ ˆ(1 )( ( ) ( ) ( ( ) ) ) w t h t h t t f t t f t f t t h t t c n p z y z p n p z p n p z y z p n p z p τ τ = + − + − − + + − + − + − + (28) 2.3.4. log-linearized versions of demand function apply log-linearization to equations (15) and (16) to yield: * , , , * * ˆˆ ˆ ˆ( ) ( ( ) (1 )(1 )( ( ) ˆˆ ˆ ) h t h t t h t w t t y z n p p n p z p c δ λ τ = − − + − − − + + (29) * , , * * , ˆˆ ˆ( ) ( (1 )( ( ) ) ˆˆˆ ˆ(1 )( ( ) )) f t f t t w f t t t y z n p z p n p z p c δ λ τ = − − − + − − + + (30) 2.3.5. log-linearized versions of labor supply function apply log-linearization to home-country labor supply function (equation 19) to yield: , ˆ ˆˆ(1 ) ( ) wh t t ty z c cδ δ+ = − + (31) likewise, for the foreign country, we have: * * , ˆ ˆˆ(1 ) ( ) wf t t ty z c cδ δ+ = − + (32) 2.3.6. log-linearized versions of money demand function apply log-linearization to the money demand function (equation 18) to yield: 1 ˆˆ ˆ t t tm p cε − = (33) likewise, for foreign country, we have: * * 1 ˆˆ ˆ t t tm p cε ∗− = (34) subtract equation (34) from equation (33), and use equation (24) to yield the following relation equation: * * * , , * 1 ˆ ˆˆ ˆ ˆ ˆ(1 ) ( ) ( ) (1 ) ˆ ˆ(1 )(1 ) (1 ) t t t t t h t f te m m c c n p z n p n n λ λ λ ε λ τ λ τ − = − − − − + − − − − + − (35) 2.3.7. log-linearized versions of tot define tot as the ratio between export product prices relative to import product prices, namely: tot p z e p z h t t f t = , , * ( ) ( ) (36) apply log-linearization to equation (36) to yield: * , , ˆ ˆˆ ˆ( ) ( )h t t f ttot p z e p z= − − (37) 2.4. steady-state solution apply log-linearization to equations (20) and (21) to yield: * * , , , ˆ ˆ ˆˆ ˆ ˆ ˆ( ) ( ) (1 )( ( ) )t h t h t t f t tc p z y z p n p z p τ= + − + − − + (38) * * * * * , , , ˆ ˆ ˆˆ ˆ ˆ ˆ( ) ( ) ( ( ) )t f t f t t h t tc p z y z p n p z p τ= + − + − + (39) we now can take thirteen equations with log-linearization, including price index (equations 22 and 23), law of one price (equations 25 and 26), world consumption equation (equation 28), demand function (equations 29 and 30), labor supply function (equations 31 and 32), home-country and foreign money demand function substations (equation 35, tot equation [equation 37]), and private budget constraint (equations 38 and 39) to solve sets of equations. the equations are solved to yield the relation equation for thirteen endogenous variables and exogenous variable, the thirteen endogenous variables including domestic consumption ( ˆtc ), foreign consumption ( ˆtc ∗ ), world consumption ( ˆ wtc ), domestic output ( ,ˆ ( )h ty z ), foreign output ( ,ˆ ( )f ty z ∗ ), price of specific home-country product in home country ( ,ˆ ( )h tp z ), price of specific home-country product in foreign country ( *,ˆ ( )h tp z ), price of specific foreign product in foreign country ( ,ˆ ( )f tp z ∗ ), price of specific foreign product in home country ( ,ˆ ( )f tp z ), exchange rate ( ˆte ), domestic price index ( t̂p ), foreign price index ( * t̂p ), and terms of trade ( ˆ ttot ). 3. the effects of antidumping duty on macroeconomic variables this section presents the outcome of simulation analysis to analyze the effect of antidumping duty on macroeconomic variables. 3.1. parameterization first, to simplify analysis in this paper, we set up two economic systems with equivalent scales as objects of analysis. hence the selection of parameters is possibly introduced with empirical data targeting at the united states and countries with similar scale (i.e., oecd countries and eu) to analyze the effect of antidumping duty between the united states and countries with similar scale. first we follow the configuration approach proposed by bergin et al. (2007) to set up the elasticity of substitution of products between countries (δ) as 5, and additionally applies the approach proposed by mankiw and summers (1986) and schmidt (2006) in relevant literature to set the elasticity of marginal utility for real money balances (ε) as 1. according to the outcome of antidumping case verdict for relevant solar energy products recently sold to china, as announced by united states department lai and lee: the effects of antidumping duties in a new open economy macroeconomics model international journal of economics and financial issues | vol 6 • issue 3 • 2016842 of commerce, and taking the antidumping duty case imposed with 26.33-58.87% of tax, the paper simulates the ratio of export products selling below the retail price in home country (λ) and the variation rate of home country antidumping duty (τ̂ ) as 25% and 60% respectively. as for the other policy variables, such as domestic money supply ( m̂ ), foreign money supply ( *m̂ ) and foreign antidumping duty ( *τ̂ ) are temporarily assumed with variable rate of 0 since they are not the key discussion of the paper. the configuration values of parameter (variable) are summarized in table 1. 3.2. simulation analysis this section applies the parameter (variable) values configured from previous section to conduct simulation analysis and analyze the effect of antidumping duty on exchange rate, price, consumption, output, and tot, the simulation outcome as shown in table 2. it is shown from table 2a-m that over the long run, an increase in antidumping duty will drive domestic consumption, foreign consumption, world consumption, domestic price index, foreign price index, price of domestic product selling in home country, price of domestic product selling in foreign country, price of foreign product selling in home country, price of foreign product selling in foreign country, and the exchange rate to go up. nonetheless, antidumping duty will cause the domestic output and foreign output to drop and tot to deteriorate. the degree of effect of antidumping duty on macroeconomic variables are determined the ratio of price of export product to the price of the product selling in home country. as the ratio of export product price selling below its retail price in home country rises, the effect resulted from antidumping duty on macroeconomic variables will become more intense. the economic intuition behind the aforementioned conclusion can be explained below. under an open economy system with imperfect competition, the government will transfer all revenue to the agent, hence the rise in antidumping duty represents more lump-sum transfer the household will receive, the consumption also increases accordingly. and, the increase in consumption will on one hand drive the price to go up while on the other hand improve demand for import, stimulating demand for foreign currency, exchange rate to rise, domestic currency to depreciate, and tot to deteriorate. moreover following the increase in dumping price differentiation, the rise in antidumping duty will have greater impact on the macroeconomic variables. table 1: parameters (variables) selected values symbol meaning value n country size 0.5 δ elasticity of substitution for cross-border products 5 ε elasticity of marginal utility for real money balances 1 λ ratio of export product price selling below its retail price 25%; 60% τ̂ rate of antidumping duty 25%; 60% table 2: long-term effect of domestic antidumping duty on macroeconomic variables a. long-term effect of domestic antidumping duty on domestic consumption ˆ tc τ̂ 0.25 0.6 λ 0.25 0.896 0.6 11.994 28.785 b. long-term effect of domestic antidumping duty on foreign consumption *ˆ tc τ̂ 0.25 0.6 λ 0.25 0.979 0.6 15.869 38.085 c. long-term effect of domestic antidumping duty on world consumption ˆw tc τ̂ 0.25 0.6 λ 0.25 0.938 0.6 13.931 33.435 d. long-term effect of domestic antidumping duty on domestic output yh, t (z) τ̂ 0.25 0.6 λ 0.25 −0.590 0.6 −7.673 −18.415 e. long-term effect of domestic antidumping duty on foreign output y zf t, * ( ) τ̂ 0.25 0.6 λ 0.25 −0.660 0.6 −10.902 −26.165 f. long-term effect of domestic antidumping duty on domestic price index t̂p (contd...) lai and lee: the effects of antidumping duties in a new open economy macroeconomics model international journal of economics and financial issues | vol 6 • issue 3 • 2016 843 table 2: continued * ,ˆ ( )f tp z τ̂ 0.25 0.6 λ 0.25 8.611 0.6 56.833 136.4 l. long-term effect of domestic antidumping duty on exchange rate ˆ te τ̂ 0.25 0.6 λ 0.25 0.065 0.6 17.5 42.0 m. long-term effect of domestic antidumping duty on tot ˆ ttot τ̂ 0.25 0.6 λ 0.25 −0.537 0.6 −28.083 −67.4 antidumping tax should not exceed the margin of dumping table 2: continued τ̂ 0.25 0.6 λ 0.25 7.417 0.6 38.042 91.3 g. long-term effect of domestic antidumping duty on foreign price index * t̂p τ̂ 0.25 0.6 λ 0.25 7.333 0.6 34.167 82.0 h. long-term effect of domestic antidumping duty on the price of domestic product z denoted in domestic currency ,ˆ ( )h tp z τ̂ 0.25 0.6 λ 0.25 8.139 0.6 46.25 111.0 i. long-term effect of domestic antidumping duty on the price of domestic product z denoted in foreign currency * ,ˆ ( )h tp z τ̂ 0.25 0.6 λ 0.25 8.074 0.6 28.75 69.0 j. long-term effect of domestic antidumping duty on the price of foreign product z denoted in domestic currency ,ˆ ( )f tp z τ̂ 0.25 0.6 λ 0.25 8.675 0.6 74.333 178.4 k. long-term effect of domestic antidumping duty on the price of foreign product z denoted in foreign currency (contd...) 4. conclusion and suggestions according to the definition in the “antidumping agreement” developed by the wto, the price of export product falling below the domestic sale price constitutes the suspicion of “dumping.” in case a specific product is suspected of dumping and causing the industries of importing countries to suffer damage while there is casualty between dumping and damage, the importing countries can apply for conducting antidumping investigation on the specific product of specific country. once verified by the investigation conducted by importing country with evidence showing the low price indeed damaging the industries of the importing country, “antidumping duty” will immediately be imposed to the importing products through low-price dumping. in consideration of antidumping policy becoming one of the considerably popular trade policy means in practice, this paper analyzes the effect of antidumping duty on macro economy in attempt to provide reference for relevant government sectors in the adoption of trade remedies. moreover, noem has been for more than 20 years today but is relatively deficient in terms of research related to trade policy effects (i.e. antidumping duty) compared with the prevalence of studies on the effects of monetary and fiscal policy. based on the above reason and under the theoretical framework of noem, this paper analyses the effect of antidumping duty on the macro economy. theoretical inference and simulation analysis of the lai and lee: the effects of antidumping duties in a new open economy macroeconomics model international journal of economics and financial issues | vol 6 • issue 3 • 2016844 paper shows the antidumping duty and domestic consumption, foreign consumption, world consumption, domestic price index, foreign price index, and exchange rate have a positive correlation, the antidumping duty and domestic output, foreign output, and tot present a negative correlation. moreover, the degree of volatility in all macroeconomic variables intensifies when the ratio of export product price selling below its retail price in home country expands. finally, it merits mentioning that although the theoretical framework of noem is brought into full play among many economic issues, it is usually established under many assumptions in reality to facilitate solution. the outcome yielded could somewhat vary if the attempt to relax one of the assumptions or configurations (i.e. the form of utility function,…,etc.) is made. the paper thus includes this shortcoming in the limitations while the study on the short-term effect of antidumping duty can be an issue for further expansion in the future. references anderson, s.p., schmitt, n., thisse, j.f. (1995), who benefits from antidumping legislation? journal of international economics, 38, 321-337. bergin, p., shin, h., tchakarov, i. (2007), does exchange rate variability matter for welfare? a quantitative investigation of stabilization policies. european economic review, 51, 1041-1058. durling, j.p., prusa, t.j. (2006), the trade effects associated with an antidumping epidemic: the hot-rolled steel market, 1996-2001. european journal of political economy, 22, 675-695. feinberg, r.m., kaplan, s. (1993), fishing downstream: the political economy of effective administered protection. canadian journal of economics, 26, 150-158. fender, j., yip, k.c. (2000), tariffs and exchange rate dynamics redux. journal of international money and finance, 19, 633-655. kelly, k.m., morkre, m.e. (1998), do unfairly traded imports injure domestic industries. review of international trade, 6, 321-332. krupp, c.m., pollard, p.s. (1996), market responses to antidumping laws: some evidence from us. chemical industry. canadian journal of economics, 29, 199-227. mankiw, n.g., summers, l.h. (1986), money demand and the effects of fiscal policies. journal of money, credit, and banking, 90, 1415-1433. obstfeld, m., rogoff, k. (1995), exchange rate dynamics redux. journal of political economy, 103, 624-660. prusa, t.j. (1996), the trade effects of us. antidumping actions. nber working paper, no. 5440. prusa, t.j. (1999), on the spread and impact of antidumping. nber working paper, no. 7404. prusa, t.j. (2001), on the spread and impact of anti-dumping. canadian journal of economics, 34, 591-611. schmidt, c. (2006), international transmission effects of monetary policy shocks: can asymmetric price setting explain the stylized facts? international journal of finance and economics, 11, 205-218. staiger, r.w., wolak, f. (1994), measuring industry specific protection: antidumping in the united states. nber working paper, no. w4696. uhlig, h. (1995), a toolkit for analyzing nonlinear dynamic stochastic models easily. center for economic research discussion paper, no. 97, tilburg university. webb, m. (1992), the ambiguous consequences of anti-dumping laws. economics inquiry, 30, 437-448. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(1), 279-287. international journal of economics and financial issues | vol 6 • issue 1 • 2016 279 effectiveness of foreign exchange market intervention in nigeria (1970-2013) siba dayyabu1*, ahmad azrin adnan2, zunaidah sulong3 1faculty of economics, accountancy and management sciences, universiti sultan zainal abidin, gong badak campus, 21300, kuala terengganu, terengganu, malaysia, 2research institute for islamic products and civilization, universiti sultan zainal abidin, gong badak campus, 21300, kuala terengganu, terengganu, malaysia, 3faculty of economics, accountancy and management sciences, universiti sultan zainal abidin, gong badak campus, 21300, kuala terengganu, terengganu, malaysia. *email: sibadayyabu@yahoo.com abstract the instability in the value of naira have made the central bank of nigeria (cbn) a regular actor in the foreign exchange market (fem) in its efforts to stabilize the value of naira and counter the disorderly behavior of the market. this paper examines the effectiveness of the cbn’s intervention operations in the fem using annual secondary time series data of four variables. the variables are the exchange rate, money supply, net foreign asset (a proxy for intervention variable), and lending rate ranging from 1970 to 2013. the result from the johansen juselius cointegration test shows that the naira exchange rate, intervention variable and monetary aggregates are cointegrated. the result from the error correction model also indicates that the naira exchange rate will adjust and re-establish itself at the speed of 12% annually. moreover, the result of the granger causality test the cbn intervention is non-sterilized. therefore, the cbn should provide an effective way through which its fem intervention could be efficient and sterilized so as to ensure stability in the exchange rate and the price level. keywords: foreign exchange market, nigeria, exchange rate jel classifications: e50, e52, e58, f31 1. introduction macroeconomic policies frequently have a significant impact on the overall economic performance of an economy. these policies are used to achieve several macroeconomic objectives such as sustainable economic growth, price and exchange rate stability, full employment level and a satisfactory balance of payments position (moreno, 2005). achieving these objectives is important for any reasonable economy to prosper, even though one objective may sometimes conflict with another. both monetary and exchange rates policies are used alongside with other macroeconomic policies, such as fiscal policy, to attain these ultimate macroeconomic objectives (mohamad, 2009). over two decades ago, the central bank of nigeria (cbn) have been intervening in the foreign exchange market (fem) to support and stabilize the value of the naira, although the supportive efforts remain temporarily and short-lived (sanusi, 2004; adebiyi, 2007). for instance, nigeria had been one of the most active countries in the fem between 1993 and 1995 (adebiyi, 2007; omojolaibi and gbadebo, 2014). in the month of december 2014 alone, the cbn spent about $2.3 billion to defend the naira from losing its value (nweze, 2015). also, in another effort to strengthen and stabilize the value of the naira, the cbn conducted another intervention operation in the first quarter of 2015. the process worth the cbn $4.7 billion (komolafe, 2015). basu and varoudakis (2013) argued that the main objectives of the central bank interventions in the fem, especially in countries with floating exchange rates are to: (i) prevent exchange rate misalignment; (ii) counter disorderly fem; (iii) manage foreign reserve; and (iv) “lean against the wind.” in most emerging market-oriented economies like nigeria, preserving a realistic value for the domestic currency is of paramount important considering the structure of the economy dayyabu, et al.: effectiveness of foreign exchange market intervention in nigeria (1970-2013) international journal of economics and financial issues | vol 6 • issue 1 • 2016280 and the desire to balance domestic production and consumption, create and improve the sources of foreign exchange earnings and attracts foreign capitals from multi-national corporations. it will also address the prolonged epidemics bedeviling nigerian economy among which include capital flights, massive importation of consumable commodities, brain drain and absence of linkages between production processes (sanusi, 2004). although many studies have been conducted on the effectiveness of central bank’s intervention operations, most of them focused on the developed economies in america, asia and europe. such studies are much scant in africa and nigeria in particular. for instance, in nigeria, only two studies (i.e., adebiyi, 2007; omojolaibi and gbadebo, 2014) are known to the authors. in line with this, the paper evaluates the efficacy of the fem interventions on the naira/us dollar exchange rate. the proceeded explanation in section one was the introduction. section two is the brief overview of the foreign exchange management in nigeria. in section three, theoretical and empirical evidences are presented and evaluated. in section four, method of data analysis is presented and evaluated. discussions follow in section five and in the concluding section (i.e. section six), the summary of the findings, and conclusion of the entire work are presented. also, recommendations follow based on the results findings. 2. brief overview of exchange rate management in nigeria nigeria had experienced a windfall in 1970s that was succeeded by years of budget deficit. this led to the emergence and implementation of structural adjustment programme (sap) in 1986 as recommended by the international monetary fund (imf) and world bank as a means of restoring and boosting the growth and development of a given economy (oyinbo and rekwot, 2014). among the conditions of sap was that naira must be devalued and allowed to float freely in the fem (deregulated); its value was to be determined by the market forces. since then, as opined by adebiyi (2007), cbn has been intervening in the foreign exchange purchases. although the value of the naira was relatively stable before 1986, the adoption of second-tier fem (sfem) in july, 1986 as one of the conditions of imf, naira has continued to depreciate: for instance, in 1985, naira was traded at ₦0.99=$1. but with the introduction of sfem in 1986, the merger of first and sfem in 1987, and the introduction of interbank rate in 1988 forced the value of the nigerian naira to depreciate to ₦1.75=$1.00, ₦4.54=$1.00, and ₦7.36=$1.00 respectively (cbn, 2014). in her efforts to stabilize the naira exchange rate, nigerian government came up with guided deregulation policy that pegged naira to us dollar at ₦21.886 in 1994. the re-introduction of the interbank autonomous fem in 1999 led naira to depreciate further to ₦86.46=$1.00. another policy, whole dutch auction system was introduced in 2006; consequently, naira depreciated further ₦117.97=$1.00 in december, 2007. concurrently, in 2008, there was financial crisis worldwide which is popularly known as “world economic meltdown.” the outcome revealed that naira value was depreciated further to ₦131.5=$1.00. by february 2009, naira/ dollar exchange rate stood at ₦142.00=$1.00 (aliyu, 2009). in another effort to ensure a stable value of the naira, policy makers in nigeria came up with retail dutch auction in 2013. unfortunately, the policy also forced naira to depreciate further to ₦157.31=$1.00 (cbn, 2014). the continuous depreciation in the value of naira/us dollar exchange rate is having strong correlation with the domestic price of goods and services. this relationship between the exchange rate depreciation and inflation has been discussed in detailed in the literature (laflechel, 1996; adebiyi, 2007; mohamad, 2009; aliyu et al., 2009). as such, any research that aims at stabilizing the domestic exchange rate in nigeria is of paramount important considering the effect of exchange rate on the domestic price of goods and services. from figure 1, it can be seen how the exchange rate, expressed in naira/us dollar keep rising (depreciation) constantly in a higher and persistent rate from 1986 when sap was introduced up till the time of this research. 3. literature review 3.1. conceptual and theoretical framework 3.1.1. the concept of exchange rate exchange rate is seen as the relative value of the domestic currency in terms of foreign exchange (mussa, 1984; ahmed, 2001). the exchange rate of a naira per us dollar is the amount of naira necessary required to obtain one unit of us dollar (jhingan, 2005; campbell, 2010; omojolaibi and gbadebi, 2014). the exchange rate is also defined as an asset price that value depends on the relative supply of and domestic and foreign financial assets and the domestic and foreign income (ardalan, 2004). 3.1.2. the concept of fem intervention fem interventions are also known as central bank interventions (dominguez, 1998) or official intervention (simwaka and mkandawire, 2006) or foreign exchange intervention as used by waheed (2010). official intervention refers to any official announcement, sales or purchases by a given governmental owned monetary authority that aimed at influencing the domestic currency (simatele, 2003). it has been apparently established that figure 1: naira exchange rate from 1986q1 to 2013q4 source: central bank of nigeria statistical bulletin (various years) dayyabu, et al.: effectiveness of foreign exchange market intervention in nigeria (1970-2013) international journal of economics and financial issues | vol 6 • issue 1 • 2016 281 higher valuation of currency affects the external competitiveness of domestically produced commodities (jhingan, 2005). this is because currencies with higher values tend to attract less foreign markets and vice versa. that is to say, countries with low-valued currency have higher external competitiveness advantages over their counterparts. as argued by sarno and taylor (2001) and simatele (2003), the issue whether fem interventions affect the value of a domestic currency or not is still a controversial issue in the field of financial economics. in addition, to understand the precise way through which central bank intervention influence the exchange rate one has to distinguish and clearly understand two types of fem interventions. these are the sterilized and non-sterilized fem interventions. 3.2. theories of fem interventions schmidt and wollmerschauser (2004) ascertained that the effectiveness of central bank intervention relies on the three fundamentals intervention channels as follows: 3.2.1. monetary approach to exchange rate determination it is the only channel of intervention influencing exchange rate under non-sterilized fem intervention. the transformation of macroeconomic perception which occur in the early 1970s due to the revolution from the monetarists and rational expectationists have led the “exchange rate” to be regarded as an asset price which value is determined by relative supply of and demand for domestic and foreign financial assets. foreign financial assets include monies, bonds and relative domestic and foreign income (ardalan, 2004). monetary approach to exchange rate determination seeks to highlight how the value of domestic currency is directly or indirectly affected due to the changes in the foreign and domestic supply of and demand for money. one important assumption of this approach is that, in the short run, prices are flexible (spolander, 1999). dominguez (1998) argued that monetary approach to exchange rate determination indicates a situation through which nonsterilized fem intervention affect the value of domestic currency exchange rate equal to the changes in the relative amount of supplies of domestic and foreign exchanges. 3.2.2. portfolio approach of exchange rate determination this is an exchange rate determination mechanism through which asset markets, rate of asset accumulation, current account balance and prices are working hand in hand with one another to affect the exchange rates. the essential feature of this approach is that investors are assumed to be rational and risk-averse (simatele, 2003). this compels them to balance their portfolios between domestic and foreign assets on the basis of their expected returns and risks associated with these returns (sarno and taylor, 2001). therefore, the major feature of this model is that investors strive to invest their portfolio either in the foreign or domestic assets considering the expected returns and relative riskiness of the both assets. after the central banks or monetary authorities have intervened in the fem, the amount of currency used during intervention operations is offset by domestic open market purchases. this is what is known as “sterilization.” this means that the intervention will have no or little effect on the quantity of money in circulation. what happened were just changes in the composition of portfolios from foreign to domestic assets, and vice-versa. as a result, market participants rebalance their portfolios through continues buying and selling of domestic and foreign assets. for instance, an increase in the supply of domestic currency (example, nigerian naira denominated assets) in the nigerian fem relative to the supply of foreign currency (example, us dollar denominated assets) will lead to the depreciation in the value of naira in the fem. this is how the portfolio balance model of exchange rate determination affects the value of the domestic currency. 3.2.3. signaling/expectations approach of exchange rate determination in both developed and emerging market economies fem, market participants are in close watch about the future actions of central banks and they consider these actions as the signals to future monetary policy. in most cases, press reports about the future action of central banks play an important role in changing the value of the domestic currency. it has been established in the literature that monetary authorities often sterilize the amount of currency used in the intervention operations through domestic open market purchases (kaminsky and lewis, 1996). on the other hand, central banks rarely provide information with regards to their intervention activities; even if they make the information available, they do so with a lag (adebiyi, 2007). the major aspect of this theory is that the central bank is the major actor and has superior information about the market than any other individual participant. as a result, other participants rely on press reports as a major source of information. in addition, even though central banks regularly sterilize their interventions, yet, it conveys significant information to the market participant with regard to the future monetary policy (akıncı et al., 2005b). signaling theory of exchange determination posits that central bank intervention operations signals changes in the future monetary policy and affects the behavior of other market participants (simatele, 2003). as argued by kaminsky and lewis (1996), if market participants expect future contractionary monetary policy, it leads to the appreciation in the value of domestic currency although no single transaction took place actually. this is the case even though the central banks offset the amount used in the intervention operations. the reverse is the case when the press reports claim that the intervention operations are going to be expansionary monetary policy (bonser-neal et al., 1998). 3.3. empirical evidences the practices, uses and effectiveness of official intervention in the fem as a policy toolkit for the attainment of price and exchange rate stability is a matter of controversial disputes (schmidt and wollmerschauser, 2004). this is due to the inconclusive findings from the previously conducted researches (edison, 1993; sarno and taylor, 2001; dominguez, 2003). dayyabu, et al.: effectiveness of foreign exchange market intervention in nigeria (1970-2013) international journal of economics and financial issues | vol 6 • issue 1 • 2016282 dominguez (1998) using garch (1, 1) model found that the secret foreign market intervention by the federal reserve of america increase the volatility of the us dollar while the broadcasted intervention lead to the uncertainty and disorder in the fem. this result did not corroborate with the study of bonserneal et al. (1998) although the later used different approach. meanwhile, bonser-neal et al. (1998) applied event-study model and found that federal reserve intervention operation in the fem is significant and effective in stabilizing the value of us dollar. in japan, kurihara (2011), reitz and taylor (2012), seerattan (2012) and hillebrand and schnabl (2008) argued that the foreign market intervention by the bank of japan is effective and significance in stabilizing the value of japanese yen. however, their finding did not corroborate with that of frenkel el al., (2005). in a another research carried out with the help of garch (1, 1), simwaka and mkwandawire (2006) found that official intervention in the fem by reserve bank of malawi (rbm) had an impact on kwacha, thou very negligible, but, still significant in reducing the undesired volatility of their currency. they concluded that net sales of dollars by rbm depreciated rather than appreciate the value of kwacha. in his effort to evaluate the intensity of foreign exchange intervention on monetary aggregates using autoregressive distributed lag (ardl) approach, adebiyi (2007) testified that there was no strong relationship between intervention variables and exchange rates. as a result, cbn’s intervention in the nigerian fem is sterilized. this is due to the inadequate funding of interventions due to lower reserve accumulation of the economy, the inconsistency of intervention policy with the macroeconomic policies as well as frequent interference of politicians in the process of policy implementation. looking at the works of dominguez (1998), hillebrand and schnabl (2008), guimaraes and karadacag (2005), domaç and mendoza (2004), simwaka and mkwandawire (2006), kurihara (2011) and reitz and taylor (2012) critically, they all use garch (1, 1) model in their researches, but, for the model to be statistically significant, it requires several years of daily data. but, due to the inadequate data of interventions in the countries understudies coupled with the absence of real intervention data in some countries, their findings from the garch (1, 1) model is less reliable. another weakness of garch (1, 1) is that it findings are based on the size of the movements between the variables under study not the direction of causality. lahura and marco (2013) investigated the relationship between undisclosed intra-daily data; inter-bank exchange rate and the amount of dollar purchased and sold using structural vector autoregressive (var) model. they found that foreign exchange intervention in peru was significant and effective in influencing exchange rate in the right direction, but sales interventions were found to be more effective than purchase interventions. omojolaibi and gbadebo (2014) investigate the effect of fem intervention on the stability of naira exchange rate. they applied ardl technique on four annual time series data ranging from 1970 to 2006. the data include the money supply, the cumulative net foreign asset, the cumulative foreign private inflow, the real gross domestic product and the structural break. the results have confirmed that there is longrun equilibrium relationship between the central bank intervention in the fem and the money supply variables. as a result, the cbn intervention operation is regarded as non-sterilized. despite the fact that this work is among the earliest empirical work in nigeria, (second to adebiyi, 2007), however, the researchers failed to include the exchange rate variable which is the main target of foreign exchange intervention. in addition, the method they applied (i.e., ardl) have been criticized for it have low degree of freedom when it comes to estimating an equation with the large number of regressors. this means that ardl cannot show more than one equilibrium relationship in a model (mehdi, 2011). base on the above empirical evidence, it shows that there is no conclusion regarding the effectiveness of foreign exchange interventions in the fem. however, previous studies argued that most frequent, predominant and concurrent interventions tend to be more effective than large one-off interventions seerattan (2012); sales intervention were found more effective that purchased interventions lahura and marco (2013); political interference and concurrence of policies tend to affect the effectiveness of interventions policies adebiyi, (2007); hillebrand and schnabl (2008) and most of the literatures which found the effectiveness foreign exchange interventions in reducing exchange rate volatility and disorderly market used structured var (svar) and var markov-switching models (seerattan, 2012). 4. methodology 4.1. data the research empirically investigates the effectiveness of fem interventions on exchange rate instability using nigerian naira/us dollar exchange rate. the study employed annual secondary times series data spanning from 1970 to 2013. the data were mainly sourced from the united nation statistical bulletin (2015) and cbn quarterly statistical bulletin (2012 and 2014). 4.2. method of data analysis for the purpose of this research, svar model base on the multivariate vector error correction model (vecm) is applied to examine the linear interdependence between the intervention variables, monetary aggregates and naira/us dollar variable to trace the effect of shocks emanating from the endogenous variable to other variables, and shade more light about the relative importance of each random foreign exchange policy in affecting the exchange rate in the model. 4.3. model specification the model used four variables that hypothesized exchange rate variable as the function of net foreign asset, money supply and interest rate respectively. + − + exrt = f (cnfat, m2t, lrt) (1) dayyabu, et al.: effectiveness of foreign exchange market intervention in nigeria (1970-2013) international journal of economics and financial issues | vol 6 • issue 1 • 2016 283 where exr represents the annual naira exchange rate per us dollar, cnfa stands for annual cumulative net foreign assets (the proxy of fem intervention variable), m2 represents the annual growth of money in nigerian economy (proxy as the money supply variable), and lr is the lending rate representing the interest rate variable. the t-sign denotes the time trend. the variables are converted into natural logarithms and composed in an econometric form in the equation (2) below. thus, the variables are separated from hetroskedasticity and their values can be presented as elasticity. lnexrt = α0+φ1lncnfat−1+φ2lnm2t−1+φ3lnlrt−1+µt (2) from the equation (2) above, α0 is the constant term, ø1, ø2 and ø3 are the slope coefficients and μt is the error term respectively. 4.4. unit root test the first stage in estimating the vecm begins by evaluating unit root tests. this is carried out to ensure the order of integration of the series and to avoid the incidence of spurious regression estimates. there are many ways of conducting unit root test, but this study uses the augmented dickey-fuller (adf) and phillips-perron unit root test of stationarity. these tests are performed by letting the exogenous variables be the regressors of the endogenous variables at level i (0) and at the first difference i (1). these involve the estimation of the equations (3) and (4) below: δyt=α0+βt+δyt−1+∑λtδyt−1+εt (3) yt=ϕ0+βyt−1+δt+ut (4) equation (3) above is the equation of adf unit root test of stationarity. from the equation, δ is the first difference lag operator, y is the variables under study, δyt = yt -yt-1 that are the first difference of yt. α0 is the constant, β is the coefficient on a trend series t, δ is the coefficient of yt−1, and, the null hypothesis h0: δ = 0 which means that yt has a unit root, against the alternative hypothesis h1 ≠ 0 indicating that there is the absence of unit root. εt is the white noise error term, mean zero sequence. on the other hand, equation (4) is the phillips-perron equation of unit root test. from the equation, yt represents the variables under study. ø0 is constant; β is the coefficient of trend seriesyt−1. the t-sign denotes the time trend. 4.5. cointegration test the next test that follows the unit root test is the co-integration test. the purpose of conducting cointegration analysis is to trace empirically the presence of long-run equilibrium relationships among the time series data in our model. in essence, the test is for the correlation between non-stationary time series variables. if two of the time series or more are themselves non-stationary, but a linear combination of them are stationary, then these time series are said to be co-integrated. a lot of economic series behaves that way and theory often predicted this. the statistical formulation of this example is what is called the co-integration model. there are many ways for testing cointegration. the most previously used cointegration test is the engel and granger (1987). this test involves the running of a static regression (after first conducting unit root test). unfortunately, engel and granger (1987) test of cointegration can only accommodate two variables. as a result, the most appropriate test for cointegration applied for this cointegration test is the multivariate johansen and juselius test of cointegration as discussed by johansen (1988; 1991), and johansen and juselius (1990). the main reason is because it permits the identification of multiple cointegration relationships. hendry and juselius (2001) argued that johansen method indicates two separate maximum eigenvalue tests (i.e. the trace statistics and the maximum eigenvalue statistics). both tests are used to examine the presence of cointegration relations the results from the two tests pave the way for applying the vecm. the trace statistics and maximum eigenvalue are represented in the equation below: ( ) 1 1 ˆtrace i j r t in ρ = + ∅ = − −∅∑ (5) ( )1ˆ 1max rtin +∅ = − −∅ (6) from the equations (5) and (6) above, r is the number of cointegration relations, ∅̂ is the eigenvalues, and t is the total number of observations respectively. the trace statistic tests the null hypothesis h0 that the number of divergent cointegrating equation is ≤ “r” against the alternative hypothesis h1 of n cointegrating vectors where n represents the number of variables within the model. on the other hand, the maximum eigenvalue tests the null hypothesis h0 of “r” the cointegrating vectors against the alternative hypothesis h1 of r+1 cointegrating vectors. 4.6. granger causality test specifically, granger causality test implies a correlation between the current value of one variable and the past values of other variables. it does not shows that changes in one variable cause changes in another variable. the use of the f-test to jointly test for the significance of the lags on the explanatory variables is the effective way to tests for “granger causality” between these variables. it is possible to have causality running from variable x to y, but not y to x; from y to x, but not x to y and from both y to x and x to y, although in this case interpretation of the relationship is difficult. the “granger causality” test can also be used as a test for whether a variable is exogenous i.e. if no variables in a model affect a particular variable. we test the absence of granger causality by estimating the following var model: y x yt i n t i n t t= ∅ + + + = − = −∑ ∑1 1 1 1 1 2 1 1 δ δ ε (7) x y xt i n t i n t t= ∅ + + + = − = −∑ ∑2 1 1 1 1 2 1 2 θ θ ε (8) from the equations (7) and (8) above, the parameters δ1, δ2 and θ1, θ2 and are the predicted coefficients lag of deterministic variables. from the equation (7), the hypothesis h0: δ1= δ2= δρ = 0 implies the rejection of the null hypothesis. it shows the existence dayyabu, et al.: effectiveness of foreign exchange market intervention in nigeria (1970-2013) international journal of economics and financial issues | vol 6 • issue 1 • 2016284 of granger causality between the deterministic variables under study (i.e., f-test x granger causes y). this is the same with the equation (8) above. the null hypothesis is rejected when the calculated f-statistics is greater than the critical value at the significant level. specifically, the causal relationship of the model can be expressed as the vecm equation that capture both the long-run causality (i.e., ect) and the short run ecm as in the equation below: ∆ ∆ ∆ lnexr ect lnexr lncnfa t t i n i t i n i t = ∅ + + + − = − = − ∑ ∑ 0 11 1 1 11 1 1 12 α β β 11 1 13 1 1 14 1 1 2+ + + = − = −∑ ∑ i n i t i n i t tlnm lnlrβ β ε∆ ∆ (9) from the equation (9) above, α11 is the coefficient of the error correction term, ectt−1, δ is the lag difference of the variables, ϕ0 is the constant term, β11i, β12i, β13i and β14i are the slopes of the coefficients, and ε1t is the stochastic error term respectively. 5. empirical results 5.1. descriptive statistics and correlation matrix most of the economic time series data are highly characterized as skewed (non-normal). the main reason is due to the presence of many outliers along the trend. from the table 1 below, jarque-bera test is applied to test the normality of the series. the study uses the mean based coefficients of skewness and kurtosis to check the normality of the variables within our model. skewness refers to the tilt in the distribution and should lie within the range of 0 and +3 for the series to be normally distributed. on the other hand, kurtosis refers to the peakedness of the distribution and is also expected to lie within the range of 0 and +3 for the series to be normally distributed. the null hypothesis used in the normality test assumes that the series are normally distributed against the alternative hypothesis of non-normality. if the probability value is below the jarque-bera normality test at 5% level of significance, then the series are not normally distributed. from the table 1 below, it is clearly seen that the series are far from been normal. the mean coefficients of jarque-bera show that the series are not normally distributed. on the other hand, the standard deviation of the frequency distributions insisted that the variables are far from being normal. the values of the standard deviation in the table 1 below show that net foreign asset (a proxy for intervention variable), money supply, exchange rates and imports are highly volatile compared to the interest rate. moreover, table 1 also portrays the results of pearson correlation matrix for the series. the coefficients from the correlation matrix show that there is evident of having higher multicollinearity problems. 5.2. lag selection criteria table 2 indicates the output of the lag selection criteria based on var framework. lag selection is selection is one of the important aspects in time series analysis. this research chooses akaike information criterion due to the nature of the small sample characterise by the research as recommended by liew (2004). 5.3. unit root test table 3 shows the adf and phillips-perron test of stationarity at levels (i.e., i (0). the data show mixed results and, as a result, it is non-stationary at levels i (0). table 3 below shows the existence of stationarity in the data at first difference i (1). this indicates that we have achieved the precondition for applying the structured var model since the variables are stationary at first difference i (1). 5.4. multivariate johansen and juselius cointegration test having confirmed that the variables are integrated at first difference, the next test that follows the unit root test is the co-integration test. the null hypothesis in the table 4 state that the variables are not cointegrated at 5% level of significance. in addition, while the trace statistics depicts the existence of cointegration equations, on the other hand, the maximum-eigen statistics indicates the table 2: lag selection criteria lag lr fpe aic sc hq 0 na 0.009 9.514 9.727 9.59 1 397.715 0.00e+00 −1.256 0.023* −0.797 2 47.715* 0.00e+00 −1.678 0.668 −0.836 3 37.108 1.19e-07* −2.009* 1.403 −0.785 *the lag order selected by each criteria. lr: sequential modified lr test statistic (each test at 5% level). fpe: final prediction error. aic: akaike information criterion. sc: schwarz information criterion. hq: hannan-quinn information criterion table 3: unit root test of stationarity variables adf phillips-perron order of integration at level at first difference at level at first difference i (d) lnexr −1.904 −3.646** −1.57 −3.651** i (1) lncnfa −1.655 −5.014* −0.636 −5.017* i (1) lnm2 −2.39 −3.982** −1.753 −4.040** i (1) lnlr −1.055 −4.801* −1.249 −6.275* i (1) *,**rejection of the null hypothesis at the 1% and 5% probability level respectively, adf: augmented dickey-fuller table 1: descriptive statistics lnexr lncnfa lnm2 lnlr 2.34 11.357 25.606 2.624 2.572 11.266 25.339 2.824 5.059 16.597 30.341 3.455 −0.604 5.981 20.764 1.792 2.35 3.315 2.848 0.481 −0.125 0.166 0.085 −0.377 1.251 1.718 1.849 1.742 5.461 3.069 2.37 3.765 0.065 0.216 0.306 0.152 98.275 476.992 1075.447 110.21 226.432 450.679 332.592 9.484 variables mean median maximum minimum sd skewness kurtosis jarque-bera probability sum sum sq. dev. correlation matrix lnexr 1 lncnfa 0.928 1 lnm2 0.941 0.934 1 lnlr 0.837 0.727 0.745 1 sd: standard deviation dayyabu, et al.: effectiveness of foreign exchange market intervention in nigeria (1970-2013) international journal of economics and financial issues | vol 6 • issue 1 • 2016 285 presence of 1 cointegration equations. thus, there is the existence of a long-run relationship between naira exchange rate, monetary aggregates and the cbn’s fem interventions. table 4 above shows the multivariate johansen cointegration test, the test is carried out based on the null hypothesis that the variables are not cointegrated. however, the study rejects the null hypothesis at 1% significant level. thus, both the trace and the maximum eigen statistics show that one cointegrating vector exists. as such, there is a long run relationship between the naira exchange rate, cbn’s foreign market intervention and the monetary aggregates. the cointegration equation is shown in the equation (10) below: cointegration equation: lnexrt=−39.88−0.70lncnfat−1+1.48lnm2t−1+1.37lnlrt−1 (10) from the equation (10) above, the long run coefficients of lnm2 and lnlr show positive value while that of lncnfa indicates the negative of their parameters. from the equation, only interest rate is not signed correctly. the negative relationship between the cbn’s foreign market operation and the naira exchange rate shows that 1% increase in the fund the cbn’s used to intervene in the fem will leads to 1.10% decrease (appreciation) in the value of naira-us dollar exchange rate. the relationship is also statistically significance at 5% significance level. the reason here is that the cbn’s fem intervention appreciates rather than depreciates the value of the naira-us dollar exchange rate. this clearly shows that cbn’s foreign market intervention is consistent with its objectives since the purpose is to save naira-us dollar exchange rate from continuous depreciations (komolafe, 2015; nweze, 2015). also, the positive long run relationship is found to exist between the volume of money supply (lnm2) and the naira-us dollar exchange rate and is statistically significant at 5%.the interpretation goes 1% increase in the volume of money supply (due to non-sterilization) will lead to increase (depreciation) in the value of naira-us dollar exchange rate by approximately 1.9%. increase in the volume of naira in circulation in the currency market, all things being equal, will lead to the depreciation in its value. looking it again from another angle, increase in the money in circulation increase the level of consumption. this will lead to “too much money chases too few goods” in the product market. the outcome is the general increase in the price of consumable goods and services. a country with domestic inflation tends to attracts fewer foreign markets. this affects the value of its domestic currency negatively. this shows that the cbn’s is nonsterilized. the finding is also consistence with findings of simatele (2003), simwaka and mkandawire (2006), adebiyi (2007) and omojolaibi and gbadebo, (2014). in addition, positive significant long run relationship is also found between the naira-us dollar exchange rate and the interest rate variable. the results show that 1% increase in the level of interest rate will lead to 1.65% increase (depreciation) in the value of naira-us dollar exchange rate. this is rather contrary to the theoretical underpinnings between the exchange rate and the interest rate. but, the justification in nigeria is that due to high rate of political instability coupled with the inadequate social amenities, increase in the level of interest rate will not attracts foreign investors. it will only increase the cost of production and discourage exportation. this eventually have negative effects on the naira-us dollar exchange rate. furthermore, the short run speed of adjustment based on the ecm is presented in the table 5. it is significant at 1% and it shows that naira exchange rate respond significantly to the cbn’s foreign market intervention to re-establish the equilibrium relationship at the speed of 12.6% annually. 5.5. diagnostic tests table 6 portrays the diagnostics statistics of the model. from the table, the adjusted r-square shows that 81 percent of the behavior of the naira/us dollar exchange rate is explained by the variables within the model. also, it is shown that the model is normally distributed, free from serial correlation and hetrokedasticity. for this reason, the model is efficient and suitable. 5.6. vecm pairwise granger causality even though the results from the cointegration test confirm the existence of the long-run causality between the exchange rate and interventions operations, it fails to show the direction of the causality. engle and granger, (1987) argued that the result of the co-integration tests above indicates that causality exists by definition in at least one direction. therefore, the next task is to show the direction of causality between the variables in the model. as a result, table 7 shows the existence and direction of the longtable 5: result of ecm variables coefficients standard error t-value p-value c 32.882 5.661 5.807 0.000* δlncnfa 0.046 0.182 0.235 0.400 δlnm2 0.076 0.024 3.071 0.002** δlnlr 0.013 0.029 0.478 0.314 ecm(−1) −0.126 0.029 −4.244 0.000* *,**indicate 1%, 5% significance level respectively, ecm: error correction model table 4: multivariate johansen and juselius cointegration test h0 eigen value trace statistics 5% critical value max-eigen statistics 5% critical value r=0 0.635 71.287 54.079* 40.337 28.588* r≤1 0.360 30.949 35.192 17.874 22.299 r≤2 0.204 13.074 20.261 9.150 15.892 r≤3 0.093 3.924 9.164 3.924 9.164 r indicates the number of cointegration vector. *rejection of the null hypothesis at the 1%, probability level respectively table 6: diagnostic tests tests statistics p-value r2 0.812 adjusted r2 0.669 jarque-bera 3.321 0.189 serial correlation 0.559 0.333 heteroskedasticity 0.103 0.163 dayyabu, et al.: effectiveness of foreign exchange market intervention in nigeria (1970-2013) international journal of economics and financial issues | vol 6 • issue 1 • 2016286 run and short-run causality amongst the variables in the model. from the table, there is, in the long-run unidirectional causality between money supply and naira usd exchange rate; money supply and fem interventions variable. likewise, unidirectional long-run causality is also found between interest rate and naira/ us dollar exchange rate. base on the pairwise granger causality, it reveals that there is, in the short-run, unidirectional causality running from the naira exchange rate to the money supply at 5% level of significance. also, interest rate was found to granger-cause naira exchange rate at one percent level of significance. surprisingly, no causality exists from exchange rate to fem interventions. this shows that the intervention operation by the cbn is “leaning against the wind”. furthermore, unidirectional causality exists from the interventions variable to exchange rate at five percent level of significance. this clearly shows that the fem intervention in nigeria is not sterilized both in the long-run and short-run respectively. for this reason, the high rate of the increase in the price of goods and services in nigeria is associated with the large amount of fund use in the foreign exchange intervention. this also corroborates with the findings of simatele (2003), adebiyi (2007), simwaka and mkandawire (2006), omojolaibi and gbadebo, (2014). 6. summary and conclusion the paper evaluates the efficacy of the fem interventions in the fem using nigeria as a case study. the paper further uses vecm to trace the relationship and nature of causality between the exchange rate and the intervention variables. the results show the presence of the long-run relationship between the intervention operation of cbn and naira exchange. moreover, the results from the famous pairwise granger causality test emphasize the presence of unidirectional causality running from intervention variables to the money supply. this has a severe effect on the price stability. as a result, the paper concluded that intervention operations in the fem embark upon by cbn is non-sterilized. the cbn have been active in the fem since 1986 (sanusi, 2004; adebiyi, 2007). but naira has also been losing its value in the fem woefully. that is to say, the cbn has little or no effect in stabilizing the value of naira. the main reason is the incapability of the cbn to sterilize the amount of money used during intervention operation. these have led to the persistent increase in the price of domestic goods and services. however, for intervention operation to be successful and effective, cbn must accumulate and maintain a reasonable amount of foreign reserve. foreign reserves are in most countries used to intervene in the fem. in addition, countries with high rate of foreign reserve tend to attract foreign investors than otherwise. the central bank management board, its policy formulation and implementations should be free from any political influences. that is to say, policy formulation in the central bank should be free for political interference. this will enable the management board to have professional personnel who will formulate and implement relevant policies that will restore and maintain a valuable and stable naira. cbn should make sure that all the amount of currency used during intervention operations are sterilized. it is well-known that nonsterilized interventions are associated with the increase in the volume of money in circulation. as a result, it leads to inflation, and it also affects the economic performance negatively. there must be a harmony between the monetary and fiscal and intervention policies. this will increase the effectiveness of all the policies because they are targeting and aiming at achieving the same goals. consequently, a stable and relatively valuable naira can be guaranteed. cbn should create exchange rate parity band beyond which naira will not be allowed to depreciate of appreciate as the case may be. bureau de change and parallel markets should be monitored and controlled properly. the main reason here is the wide gap between the naira official exchange rate and the naira exchange rate in the bureau de change and black marketers. the deregulation of the fem should be monitored extensively and with utmost care. this can be done by embarking on strategic interventions operations (for example, manage pegging) that will stabilize and restore the value of the naira. references adebiyi, m.a. (2007), an evaluation of foreign exchange intervention in nigeria (1986-2003). mpra paper (no. 3817), university library of munich, germany. ahmed, h. (2001), exchange rate stability: theory and policies from an islamic perspective. (no. 57), irti research paper. akıncı, ö., çulha, o.y., özlale, ü., şahinbeyoğlu, g. (2005b), the effectiveness of foreign exchange interventions for the turkish economy: a post-crisis period analysis. cbrt research department working paper, no. 05/06, february, 1-31. aliyu, s.u.r. (2009), impact of oil price shock and exchange rate volatility on economic growth in nigeria: an empirical investigation. (no. 16319). university library of munich, germany. aliyu, s.u.r., yakub, m.a.u., sanni, g.k., duke, o. (2009), exchange rate pass-through in nigeria: evidence from a vector error correction model. (no. 25023). university library of munich, germany. ardalan, k. 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(april 22, 2004). world bank policy research working paper, no. 3288. dominguez, k.m. (1998), central bank intervention and exchange rate volatility. journal of international money and finance, 17(1), 161-190. dominguez, k.m. (2003), the market microstructure of central bank intervention. journal of international economics, 59(1), 25-45. edison, j.h. (1993), the effectiveness of central bank intervention: a survey of literature after 1982. special papers in international economics, international finance section, department of economics princeton university, princeton, new jersey, usa. engle, r.f., granger, c.w. (1987), co-integration and error correction: representation, estimation, and testing. econometrica: journal of the econometric society, 55(2) 251-276. frenkel, m., pierdzioch, c., stadtmann, g. (2005), the effects of japanese foreign exchange market interventions on the yen/us dollar exchange rate volatility. international review of economics & finance, 14(1), 27-39. guimaraes, r., karacadag, c. (2005), the empirics of foreign exchange intervention in emerging market countries: the cases of mexico and turkey. in: money macro and finance (mmf) research group conference 2005, (no. 68). money macro and finance research group. hendry, d. f., juselius, k. (2001), explaining cointegration analysis: part ii. the energy journal, 22(1), 75-120. hillebrand, e., schnabl, g. (2008), a structural break in the effects of japanese foreign exchange intervention on yen/dollar exchange rate volatility. journal of international economic policy, 4(5), 389-401. jhingan, m.l. (2005), international economics. 5th ed. new delhi: vrinda publication (p) ltd. johansen, s. (1988), statistical analysis of co-integrating vectors. journal of economics dynamics and control, 12(2-3), 231-254. johansen, s. (1991), estimation and hypothesis testing of cointegrating vectors in gaussian vector autoregressive models. economertica, 59(6), 1551-1581. johansen, s., juselius, k. (1990), maximum likelihood estimation and inference on cointegration with applications to the demand for money. oxford bulletin of economics and statistics, 52(2), 169-210. kaminsky, g.l., lewis, k.k. (1996), does foreign exchange intervention signal future monetary policy? journal of monetary economics, 37(2), 285-312. komolafe, b. (2015), cbn spends $4.7bn to defend naira. vanguard. available from: http://www.vanguardngr.com/2015/04/cbn-spends4-7bn-to-defend-naira/. kurihara, y. (2011), intervention in the foreign exchange market and exchange rates in japan. 経営総合科学, 96(2011), 85-91. laflechel, t. (1996), the impact of exchange rate movements on consumer prices. bank of canada review. winter, 1996-1997, 21-32. mccarthy. lahura, e., vega, m. (2013), asymmetric effects of forex intervention using intraday data: evidence from per. (no. 430). bank for international settlements. liew, v.k.s. (2004), which lag length selection criteria should we employ? economics bulletin, 3(33), 1-9. mohamad, s. in: yussof, i. (ed). (2009), malaysia’s economy: past, present and future. 1st ed. kuala lumpur, malaysia: malaysian strategic research centre. moreno, r. (2005), motives for intervention. bis papers chapters, 24, 4-18. mussa, m.l. (1984), the theory of exchange rate determination. in: exchange rate theory and practice. chicago: university of chicago press. nweze, c. (2015), battle to save naira may be long, complex. the nation. available from: http://www.thenationonlineng.net/new/saving-thenaira-at-all-cost/. omojolaibi, j.a., gbadebo, a.d. (2014), foreign exchange intervention and monetary aggregates: nigerian evidence. international journal of economics, commerce and management united kingdom, 2(10), 1-21. oyinbo, o., rekwot, g.z. (2014), nexus of exchange rate deregulation and agricultural share of gross domestic product in nigeria. cbn journal of applied statistic, 5(2), 49-64. reitz, s., taylor, m.p. (2012), fx intervention in the yen-us dollar market: a coordination channel perspective. international economics and economic policy, 9(2), 111-128. sanusi, j.o. (2004), exchange rate mechanism: the current nigerian experience. paper delivered by the governor of the central bank of nigeria to the nigerian-british chamber of commerce on february 24, 2004, abuja, nigeria. sarno, l., taylor, m.p. (2001), official intervention in the foreign exchange market: is it effective and, if so, how does it work? journal of economic literature, 39(3), 839-868. schmidt, r., wollmershäuser, t. (2004), sterilized foreign exchange market interventions in a chartist-fundamentalist exchange rate model. würzburg economic papers (no. 50), university of wurzburg, institute for economic research. seerattan, d.a. (2012), the effectiveness of central bank interventions in the foreign exchange market. doctoral dissertation, school of social sciences theses, brunel university, brunel. simatele, m. (2003), financial sector reforms and monetary policy in zambia. ph. d thesis, university of coteborg, sweden. simwaka, k., mkandawire, l. (2006), the effectiveness of official intervention in foreign exchange market in malawi. mpra paper, (no. 1123), university library of munich, germany. spolander, m. (1999), measuring exchange market pressure and central bank intervention. working paper (no. e, 17), bank of finland studies working. taylor, m.p. (1995), the economics of exchange rates. journal of economic literature, 33(1), 13-47. united nation statistics division. (2015). available from: http://www. unstats.un.org/unsd/tradeserv/default.htm. waheed, m. (2010), foreign exchange intervention and sterilization: an investigation of state bank of pakistan’s reaction function. (no. 33161), university library of munich, germany. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 1001-1010. international journal of economics and financial issues | vol 5 • issue 4 • 2015 1001 migration remittances inflows and macroeconomic shocks: the case of egypt aliaa nabil khodeir department of economics, faculty of business administation, king saud university, saudi arabia, department of economics and foreign trade, faculty of commerce and business administration, helwan university, egypt. *email: aliaanabil2007@yahoo.com abstract this paper explores to what extent egyptian remittances inflows serve as a hedge against macroeconomic shocks. this is the first study applied on egypt focusing on both the determinants of remittances and their cyclical behavior at the same time. by estima ting a vector error correction (vec) model, it was found that remittances inflows were associated significantly with real per capita income, money supply and oil price, in both long and short run. this indicated that remittance flows to egypt were for investment and not for family support purposes. the analysis of impulse response functions confirmed that remittances inflows were procyclical with output shocks, reducing support for the ability of remittances as a hedge against macroeconomic shocks. this paper suggests that; policy makers should deal cautiously with the different aspects of remittances and its analysis could be applied to other small open economies. keywords: remittances, business cycle, macroeconomic shocks, egypt jel classifications: e32, f22, f24, o54 1. introduction in recent years external financial inflows disturbances represented one of the most important challenges faced by egyptian economy, being a developing country with low domestic savings. this became clear when capital inflows began to fall with the turmoil in the global financial markets. direct investment inflow (foreign direct investment [fdi]) decreased from 11578.1 million us$ in 2007 to 6385.6 million us$ in 2010 and in the same years, the official development assistance net (oda) decreased from 1136.35 million to 592.41million us$. with the onset of the egyptian revolution in 2011, foreign capital outflows increased, as a result of deterioration of the security situation and this disinvestment reached 482.7 million us$ (unctad statistics). on the other hand, by examining the structure of external financing, it has been observed that egypt had an access to large workers’ remittances. they increased from 7655.8 million us$ in 2007 to 12453.1 million us$ in 2010 and 14324.3 million us$ in 2011. in 2012, the level of remittances was equivalent to 8% of gross domestic product (gdp) and their contribution to the balance of payments exceeded that of tourism. according to the latest data available, they reached 17468.59 million us$ in 2013 after they were 19236.4 million in 2012 (unctad statistics). the fact that remittances inflows have surpassed both oda and fdi was confirmed for many of developing countries in recent world bank reports. the merit of remittances is that they are not so volatile and this makes economic policy makers more concerned about. the ups and downs of capital flows have severe effects on the economy. bayangos and jansen (2009) stated that remittance receipts in the philippines were less volatile than fdi, portfolio investments and external borrowings. in addition, unlike other capital flows, they were unrequited transfers that do not create obligations in the future (lueth and ruiz-arranz, 2007). nowadays, increasing attention by policymakers is devoted to labor mobility and their associated remittance flows in economic integration (barajas et al., 2012). accordingly, it is worth to make a search on the inward remittances being a crucial funding source to egypt. the purpose of this paper is to focus on both short and long run macroeconomic determinants of remittances. specifically, it is interested in the cyclical behavior khodeir: migration remittances inflows and macroeconomic shocks: the case of egypt international journal of economics and financial issues | vol 5 • issue 4 • 20151002 of egyptian workers’ remittances using remittances determinants as shocks to assess the expected response. the empirical studies on remittances determinants for egypt and their cyclical property are rare. el-sakka and mcnabb (1999) estimated two equations to discover the determining factors of both, remittances and imports financed by them during the period from 1967 to 1991. using annual data and ordinary least squares (ols), they found that exchange rate and interest rate differentials were important in attracting remittance flows through official channels. also, imports financed through remittance earnings had very high income elasticity which suggested that they were durable or luxury goods undertaken by higher income groups. bouhga-hagbe (2006) argued that altruism, as a motive to send money home, would contribute to the stability of these flows. he used cointegration techniques that relate workers’ remittances to agricultural gdp, which was used as an indicator of economic “hardship” in the home country. the estimation was made during the period 1975-2002 and based on (the logarithm of) original variables, and thus led directly estimating the long run relation among the variables. the empirical evidence suggested that in the long run, remittances were negatively correlated with agricultural gdp. this finding supported the view that altruism could have an important role in the flow of remittances to egypt, jordan, morocco, pakistan, and tunisia. in a recent study, sliman and tahar (2009) analyzed business cycle property of workers’ remittances during the period 19752006 in mediterranean countries (algeria, egypt, morocco, turkey and tunisia). using correlations of the cyclical components with the band pass filter, they concluded that remittances in algeria, egypt and morocco were countercyclical with respect to home gdp in contrast to tunisia and turkey remittances. by estimating a structural vector autoregressive (var) model containing host country’s gross national product, home country’s gdp, remittances, fdi and oda flows, they demonstrated that fluctuations in host gdp explained a large part of the forecast error variance in the cyclical components of remittances for tunisia, algeria, and morocco. in egypt, gdp explained a significant portion of the variance of remittances and workers remittances accounted about 43% of the variance of gdp. shocks of saudi arabia and egypt output had jointly positive and negative impacts. in conclusion, mediterranean countries presented some difference concerning cyclical properties of workers’ remittances. these previous studies had some limitations. the first study was concerned with limited factors which determine remittances using ols method that ignored the issues of endogeneity and stationarity. the other two studies analyzed the cyclical property of remittances by concentrating on output shock only. this study tried to overcome the limitations of previous studies. it estimated a vector error correction (vec) model and the impulse functions for egypt remittances receipts using annual data from 1980 to 2012. its main issue was to estimate the response of remittances to a number of macroeconomic variables, namely per capita growth domestic product (gdpp) as a representative of home business cycle, oil price as an indicator of host income, money supply as an indicator of financial development, exchange rate(er) as an indicator of domestic currency value, and lastly the total reserves as a reflection of economic-political stability in home country. the choice of reserves as a rough indicator of stability at home country was due to their high sensitivity to the instability recently witnessed in egypt revolution. it is worth mentioning that total reserves dropped to 15046.31 million and 11758.3 million us$ in 2011 and 2012 respectively after it had reached 33742.83 million us$ in 2010 (unctad statistics). also, egypt came in the front countries which had serious decline in reserves in 2011, followed by yemen and tunisia (arab labour organization, 2012). this study contributes to the current literature in several ways. first, this is the first study applied on egypt focusing on the determinants of remittances and considering their cyclical behavior analysis. second, it added the total reserves as a new rough indicator of stability at home country. third, the vec model of this study is distinguished of the econometric models of previous studies by its ability to reflect not only the long run but also the short run causality. fourth, it uses the generalized impulse response functions (girf) to avoid the problem of ordering the variables, in addition to the cholesky impulse response functions (cirf). fifth, it contains various forms of shocks represented by the shocks of oil, money supply, reserves, er and output shock. the paper proceeds as follows. section 2 presents a review of literature on remittances. section 3 addresses some facts on egyptian workers remittances. section 4 deals with data and non-stationarity. section 5 contains the empirical model. section 6 delivers the concluding remarks. 2. previous studies remittances determination had depended upon two kinds of motives of a worker’s decision to remit to home country; altruistic and investment motives. the first was related the extent of interest in migrant relative welfare and could be represented by micro or social determinants (for example: gender, age, marital status, skill levels, wage levels etc.). the second was related the extent of interest to invest and could be represented by macroeconomic determinants. remittances would be expected to be countercyclical if altruistic motives dominated the migrant’s decision, while procyclical if investment motives dominated. the cyclical property had a lot of implications on the remittances stabilizing role as a shockabsorber (sayan, 2006; bayangos and jansen, 2009; sliman and tahar, 2009; frankel, 2009). regarding remittances determinants at the level of a single state using time series data, different macroeconomic policy failures were tested in the study of el-sakka (2007) for jordan including er misalignment, interest rate differentials, inconsistent monetary policy, and inconsistent fiscal policy delegated by budget deficit. by applying the cointegration test, it was found that jordanian emigrants were sensitive to macroeconomic policy. for sri lanka, khodeir: migration remittances inflows and macroeconomic shocks: the case of egypt international journal of economics and financial issues | vol 5 • issue 4 • 2015 1003 lueth and ruiz-arranz (2007) estimated a vec model using quarterly data from 1996 till 2004 to determine the response of remittance receipts to macroeconomic shocks. the main focus was on the response of remittances to a number of macroeconomic variables, namely: real gdp, consumer price index (cpi), er, interest rate, and oil price. they found that remittances were positively correlated with oil price, but behaved procyclical, and declined when the sri lankan currency weakened. accordingly, sri lankan remittances seemed to be lower than the hedge against shocks than commonly believed. using a novel dataset of bilateral remittance flows, lueth and ruiz-arranz (2008) explored the determinants of workers remittances for some recipient and sending countries, during the period 1980-2004. by using pooled regression, it was found that some of the variables commonly used in gravity equations were very powerful in explaining remittance flows. also, the evidence on the motives to remit was mixed, but the altruism motive might be less than commonly believed. to encourage remittances and maximize their economic impact, policies should be directed at reducing transaction costs, promoting financial sector development, and improving the business climate. frankel (2009) study used the dataset of lueth and ruiz-arranz, and its econometric results confirmed the smoothing hypothesis, that remittances were countercyclical with respect to worker’s income in home country, while procyclical with respect to his income in host country. by focusing on bilateral data of the turkish and mexican economies, durdu and sayan (2008) used a dynamic stochastic general equilibrium model with sudden stops. the results indicated that remittances sent home by turkish workers abroad moved in the same direction as the business cycles in turkey, whereas remittance receipts of mexico were countercyclical. in a recent study, borja (2013) examined the properties and the cyclical nature of remittances in el salvador and dominican republic, two countries with large per capita remittance value. cirf were estimated by restricted and unrestricted var models to assess the effects that domestic gdp, us gdp and coffee prices had on remittances. the dataset used quarterly values and a countercyclical relationship between remittances and domestic output was found, supporting the altruistic motive to remit. at regional level, the paper of veeramoothoo et al. (2009) developed a stepwise regression model to explore how changes in macroeconomic factors affected the magnitude of workers’ remittances in latin american and caribbean countries. population, land area, and net migration were found to be significant at the 1% level of significance, while age dependency ratio, rate of unemployment and labor force were marginally significant at the 20% level. recently, yuni et al. (2013) carried out an investigation on the determinants of remittance across 21 african countries with a time frame from 1980 to 2011. the study used the generalized method of moments estimation in a dynamic panel and found that remittance receipt of the previous year, broad money growth, taxes, inflation, lending rate and age dependency ratio were significant determinants of remittances, while gdp per capita and real effective er were not. 3. remittances aspects in egypt egypt is considered one of the top emigrating countries; in 2005 it ranked 12th in the world in terms of number of emigrants. regarding the classification of migration into temporary and permanent, emigration flowed out of egypt has been classified as temporary, directed towards arab countries and especially gulf cooperation council (gcc) countries, and permanent directed towards european union and north american countries. flows of temporary migrants, more than 2 millions, to neighboring arab countries surpassed those of permanent ones. regarding the distribution of egyptian migrants by occupation and country, the gcc countries and libya attracted the highly skilled workers. economic factors were the main emigration causes, including issues of poverty attenuation, combating unemployment, enjoying higher returns for education, and achieving higher living standards (ghoneim, 2010). remittances reached 2.696 billion us$ in 1980, and increased to nearly 20 billion us$ in 2012. they increased at an average annual rate of 9.4% over the last 33 years. in the first half of 1980s (figure 1), remittances (r) had an upward trend until reached 20% of gdp with the gcc countries liberal policies towards migrants. in the second half of the 1980s, the egyptian remittances decreased to be around 10% of gdp, when the oil price dropped in 1986. the downward trend continued during 1990s as a result of the gcc countries policy of replacing the foreign labor with national labor forces, replacement of egyptian labor with asian labor in gcc countries, and the collapse of the east asian financial markets. remittances began to increase in 2000s with the boom of oil prices. regarding the world financial crisis, remittances did not face any decrease in 2008 but experienced a slight decrease in 2009 (glytsos, 2002; ghoneim, 2010; sliman and tahar, 2009). accordingly, the fluctuations of oil price and the substitution policies constitute the main factors of egyptian remittances trend. also, it is obvious that remittances exceed both fdi and oda inflows during the period under investigation except in 1990/1991 and 2006/2007. so, they constituted the largest source of external financing. figure 2 shows that the egyptian remittance receipts were less volatile than oda, fdi. the standard deviation of remittances figure 1: sources of foreign exchange inflows as a percent of gross domestic product during (1980-2012) source: author calculation depending on unctad statistics khodeir: migration remittances inflows and macroeconomic shocks: the case of egypt international journal of economics and financial issues | vol 5 • issue 4 • 20151004 amounts to 60% of the mean, compared with 64% for oda, and 142% of fdi. economic policy makers will be concerned about these fluctuations and have to understand the determinants of the inflows patterns. the demographic aspect of remittances also ensures the importance of oil price in remittances determination. according to the latest available bilateral data from the world bank in 2012, the saudi arabia ranked top among the countries from which egyptians send their remittances, as it contributed with 28% of egypt’s total remittances, followed by jordan with 19%, kuwait with 11%, libya with 10%, united of arab emirates with 5%, qatar with 3%, oman with 1% and bahrain with 1% (figure 3). so, remittances main bulk continued to come from oil exporter countries. regarding investigating the cyclical behavior of inward remittances, both of real remittances and gdpp (in us$ and deflated by us cpi have been de-trended by the hodrick prescott filter during the period 1980-2012. after the cyclical components have been estimated, correlation between the cyclical components of remittances and those of egypt real gdpp has been counted. the results showed a correlation of almost 20% in the investigated period; meaning that remittances to egypt seemed to be procyclical with its economic activity. 4. data and non-stationarity availability of data is a major problem for economic modeling in egypt. for this reason the current model was restricted to some variables for which homogeneous and long sufficient information has been found. the model focused on a number of main macroeconomic variables, often used in the literature as remittances determinants. the descriptive statistics of these variables were shown in table 1. the independent variables representing the home country included per capita income, total reserves, money supply and er. the independent variable representing the economic activity of many host countries was oil price. the study used annual data from 1980 to 2012 from unctad statistics and world bank development indicators. six variables were included: (1) r, the value of remittances inflows expressed as a ratio of the home country gdp (remittances are the sum of workers’ remittances, compensation of employees and migrants’ transfers); (2) gdpp, the per capita of the home country real gdp in us$, is calculated as the nominal value divided by cpi of united states (2000=100); (3) res, the home country real total reserves including gold in us$ at constant prices (2000); (4) ms, the value of broad money as a ratio of the home country gdp; (5) er, the nominal exchange rate of egyptian pound against us$; and (6) oil, the free market crude petroleum price index (2000=100). the model proposed to be used for egypt began by assuming that the decision to remit was a fairly complicated one. it depended not only on variables set related to both host and home countries but also on remittances purpose. the expected relationship between the variables and remittances inflows will be affected by purpose of transferring, whether for altruism or for investment. based on the previous studies (bouhga-hagbe, 2006; el-sakka, 2007; lueth and ruiz-arranz, 2007; mohaddes and raissi, 2011; abdih et al., 2012), the following relations can be described: the indicator of the level of income in home country (gdpp) was assumed to negatively affect remittances inflow, if remittances were mainly for family support. however, if remittances were for investment purposes, a positive relationship between income level and remittances inflows would be expected. similarly, the indicator of financial development level in home country (ms) could have either positive or negative impact on remittances inflows. this could also be applied when considering the impact of reserves (res) as an important indicator of economic-political stability. the level of the er matters because remitters take into account the value of the domestic currency when they remit. if goods in the home country become less expensive with the depreciation of the currency, one does not need to transfer as much money as before to buy a given amount of goods. on the other hand, a depreciation of home country’s currency can also make its migrants wealthier as it increases their purchasing power in their home country. therefore, this could give them incentives to transfer more money to buy more goods in home country. also, a depreciation of the domestic currency can increase the remittances ratio as it represents a reduction of the remittance cost. therefore, depending on how remittances were measured and migrants motivations, the effect of the er on remittances were unclear. the level of income in host countries represented by oil price (oil) is expected to have a positive impact on remittances flows, reflecting the fact that most overseas egyptian workers were figure 2: volatility of selected sources of foreign exchange inflows during (1980-2012) source: author’s calculation depending on unctad statistics figure 3: distribution of egyptian remittances by main source in 2012 source: author calculation depending on world bank khodeir: migration remittances inflows and macroeconomic shocks: the case of egypt international journal of economics and financial issues | vol 5 • issue 4 • 2015 1005 employed in arabian gulf states. however, it is important to take into consideration the role of competition circumstances and migrant incentives. taking into account the methodological approach followed in this paper, it was essential to start by testing the stationarity of variables. the study used the augmented dickey fuller test, one of the most common unit root tests. the null hypothesis tested is that the investigated variable had a unit root against the alternative that it did not have. at the level, statistical values of variables were less than their critical values. so, the null hypothesis of a unit root could not be rejected, while at the first differences, the statistical values became more than the critical values at the 5% significance. it meant that the alternative hypothesis could be accepted. the results were shown in table 2. the data series were found to be non-stationary in levels and stationary in the first differences. hence, all series were integrated of order one. the stationary time series of variables were shown in figure 4. 5. the empirical model the empirical framework is concerned with vec model and response functions for egypt remittance receipts. it aimed to investigate the macroeconomic determinants of remittances in short and long term and to analyze the cyclicity of remittances to the shocks in interested macroeconomic variables. this model implied three main steps: first, testing for the existence of a cointegration vector to recognize whether remittances were affected by interested variables in long run. second, estimating the vector of error correction to test whether remittances were affected by interested variables in short run. third, deriving the impulse response functions to determine the extent of remittances response to shocks in interested variables. the functional formula of the model can be summarized as follows: r= f (gdpp, res, ms, er, oil) the cointegration analysis had been conducted using the johansen approach (johansen and juselius, 1990). this test was suitable for the model as it included more than two variables. results of the johansen test for determining the number of cointegrating vectors were presented in table 3. the current work used one lag to preserve sufficient degrees of freedom. the probability values of both the trace test and maximum eigenvalue test referred to the existence of three cointegrating vectors at the 5% level. the results confirmed the existence of a stable, long run equilibrium relationship. in the long run, remittances moved with the other macroeconomic variables based on the following cointegrating relationship (standard error in parentheses): r = 0.042779 gdpp − 0.000117 res + 0.836782 ms – 0.122436 oil – 1.802356 er (0.00255) (0.00015) (0.08041) (0.00635) (0.50626) the equation indicated that in the long run, remittances associated with independent variables. the value of gdpp coefficient was positive and significant at the 5% level, meaning that remittances inflows increase by 0.04 as the per capita income increase by one. this indicated that the majority of remittances flows to egypt were for investment and not for family support purposes. income level rising in home country reflected increasing economic activity levels and hence, higher return rates on investments at home. also, remittances inflows were significantly correlated with the indicator of banking development. remittances inflows increased by 0.8 when money supply increased by one. table 1: descriptive statistics of the variables statistics r gdpp res ms oil er remit mean 8.494201 1191.678 11912.82 85.04389 129.4197 3.290816 5373.317 median 6.195043 1090.307 12838.58 85.61522 95.58333 3.388750 4574.882 maximum 19.53187 2350.237 26646.96 97.34642 372.1083 6.196242 15386.92 minimum 2.980656 551.7971 1358.662 62.82112 46.34167 0.700001 2769.655 sd 4.902797 473.9602 8491.763 8.212758 96.17615 2.044350 2622.998 observations 33 33 33 33 33 33 2.054084 source: author’s calculation, sd: standard deviation table 2: augmented dickey fuller test results level first differences intercept trend and intercept none intercept trend and intercept none r −1.39 (0) −1.46 (0) −1.09 (0) −5.53 (0) −5.65 (0) −5.53 (0) gdpp −0.26 (1) −3.76 (3) 2.23 (1) −4.60 (0) −4.35 (0) −3.69 (0) res −1.85 (1) −1.98 (1) −0.53 (0) −3.60 (5) −3.64 (5) −3.92 (0) ms −2.51 (2) −2.45 (2) −0.51 (1) −4.75 (0) −4.66 (0) −4.86 (0) oil 0.39 (0) −1.21 (0) 2.18 (2) −6.52 (0) −6.30 (1) −6.30 (0) er −0.90 (1) −3.36 (1) 0.66 (1) −3.51 (0) −3.45 (0) −3.16 (0) critical values critical values 1% −3.65 −4.27 −2.63 −3.66 −4.28 −2.64 5% −2.95 −3.55 −1.95 −2.96 −3.56 −1.95 10% −2.61 −3.21 −1.61 −2.61 −3.21 −1.61 source: author’s calculation. values in brackets refer to the lag periods selected by using schawarz’ criterion khodeir: migration remittances inflows and macroeconomic shocks: the case of egypt international journal of economics and financial issues | vol 5 • issue 4 • 20151006 concerning er, the results showed that there was a significant negative relationship between its level of and remittances inflow. this could be due to the existence of er pass-through phenomenon in egyptian economy (khodeir, 2012). the depreciation of home currency will lead to higher import costs, therefore, the domestic price level will increase. under these circumstances, migrants as investors will decrease their remittances to home country to avoid inflation. despite the significant influence of oil prices on remittances inflow, the coefficient sign was unexpected. this contradiction could be explained by the gap between the migrant income and the decision to remit. meaning that, oil price rise could lead to an increase in migrant income, but with time, the expected rise in production costs with its negative implications on the egyptian economy, being a country suffering from a lack of energy resources will reduce what is transferred from its migrants having investment motives. this is particularly important in egypt, since one of its future challenges is to satisfy the increasing domestic demand for oil while the production is falling. total oil consumption grew by an annual average of 3% over that past decade to 755,000 bbl/d in 2012. egypt’s oil consumption has surpassed production since 2010 (u.s. energy information administration, 2013). the percent of oil imports (both petroleum crude oils or bitumen and bituminous minerals) of total imports increased from 6 in 2009 to 14.3 in 2012 (unctad statistics). there was no significant relationship between remittances and reserves. this meant that egyptian migrants might not care about this variable for a long time. the effect of reserves seemed temporarily on the decision of migrants and this is what will be checked when conducting analysis in the short term. as the variables were cointegrated, the vec model could be developed. this model can check the existence of causality between variables. the estimated results for remittances as dependent variable were shown in table 4. the coefficient of error correction model was negative and significant. it represented the speed of adjustment for any disequilibrium towards long run figure 4: time series of variables in the first differences source: author calculation table 3: johansen cointegration test results hypothesized number of ce (s) eigenvalue trace statistic p max-eigen statistic p r=0 0.936798 188.1524 0.0000 85.60380 0.0000 r≤1 0.809668 102.5486 0.0000 51.42858 0.0002 r≤2 0.639543 51.12001 0.0239 31.63188 0.0142 r≤3 0.301419 19.48814 0.4583 11.11982 0.6354 r≤4 0.228377 8.368321 0.4269 8.037030 0.3750 r≤5 0.010630 0.331291 0.5649 0.331291 0.5649 source: author’s calculation. trend assumption: linear deterministic trend khodeir: migration remittances inflows and macroeconomic shocks: the case of egypt international journal of economics and financial issues | vol 5 • issue 4 • 2015 1007 equilibrium state. in the model, the speed of adjustment was about 88%, so it was relatively rapid. the model was significant at the 1% level according to the probability of f test. it had a high explanation power since the independent variables could explain about 83 % of remittances changes. there was neither serial correlation nor heteroskedasticity problem, regarding lm and breusch-pagan-godfrey tests respectively. the jarque-bera test did not reject the hypothesis of normality of residuals. table 4: vec estimates for remittances cointegrating equation cointegrating equation 1 cointegrating equation 2 cointegrating equation 3 r (−1) 1.000000 0.000000 0.000000 gdpp (−1) 0.000000 1.000000 0.000000 res (−1) 0.000000 0.000000 1.000000 ms (−1) 0.987238 −11.90736 −547.9627 (0.15115) (5.40425) (135.661) [6.53132] [−2.20333] [−4.03921] oil (−1) −0.205020 3.689640 171.2902 (0.02199) (0.78607) (19.7325) [−9.32493] [4.69376] [8.68061] er (−1) 3.250539 −113.2084 −4661.310 (0.56710) (20.2755) (508.969) [5.73188] [−5.58350] [−9.15834] c −79.35540 −221.9385 29513.92 error correction d (r) d (gdpp) d (res) d (ms) d (oil) d (er) cointegrating equation 1 −0.879632 16.02011 −375.6718 −0.885505 11.98230 −0.121033 (0.26655) (12.6971) (201.178) (0.79680) (8.09929) (0.08863) [−3.30011] [1.26171] [−1.86736] [−1.11132] [1.47943] [−1.36557] cointegrating equation 2 −0.000111 0.132378 −8.814448 −0.014824 0.595595 −0.002133 (0.00605) (0.28810) (4.56478) (0.01808) (0.18378) (0.00201) [−0.01831] [0.45948] [−1.93097] [−0.81993] [3.24089] [−1.06054] cointegrating equation 3 −0.000925 0.011659 −0.317030 −0.000296 −0.009602 −4.27e-05 (0.00022) (0.01030) (0.16326) (0.00065) (0.00657) (7.2e-05) [−4.27837] [1.13156] [−1.94192] [−0.45836] [−1.46087] [−0.59343] d (r[−1]) 0.196326 −3.816630 −26.84285 0.382089 1.990501 0.047324 (0.14634) (6.97087) (110.449) (0.43745) (4.44660) (0.04866) [ 1.34160] [−0.54751] [−0.24303] [0.87344] [0.44765] [0.97255] d (r[−2]) −0.168368 −8.682048 −39.83050 0.684519 −0.578813 −0.006072 (0.14238) (6.78243) (107.463) (0.42563) (4.32640) (0.04734) [−1.18252] [−1.28008] [−0.37064] [1.60825] [−0.13379] [−0.12826] d (gdpp[−1]) 0.024595 0.827276 17.71402 −0.039030 0.412195 −0.001577 (0.00745) (0.35500) (5.62468) (0.02228) (0.22645) (0.00248) [3.30030] [2.33038] [3.14934] [−1.75198] [1.82028] [−0.63651] d (gdpp[−2]) 0.001062 −0.416898 6.391483 0.015132 −0.374369 0.001147 (0.00683) (0.32542) (5.15611) (0.02042) (0.20758) (0.00227) [0.15544] [−1.28110] [1.23959] [0.74098] [−1.80348] [0.50495] d (res[−1]) 0.000497 −0.012603 0.079241 0.000669 0.008287 4.86e-05 (0.00018) (0.00842) (0.13338) (0.00053) (0.00537) (5.9e-05) [2.81272] [−1.49712] [0.59408] [1.26706] [1.54326] [0.82779] d (res[−2]) 0.000602 0.010753 0.200985 −0.000477 0.004497 8.20e-06 (0.00021) (0.01008) (0.15965) (0.00063) (0.00643) (7.0e-05) [2.84475] [1.06719] [1.25890] [−0.75513] [0.69962] [0.11657] d (ms[−1]) 0.260286 −3.499778 −87.11575 −0.129266 0.509462 0.028497 (0.10961) (5.22126) (82.7274) (0.32766) (3.33055) (0.03645) [2.37470] [−0.67029] [−1.05305] [−0.39452] [0.15297] [0.78187] d (ms[−2]) 0.251129 0.107761 153.1726 0.198137 2.561275 −0.034274 (0.09422) (4.48806) (71.1103) (0.28165) (2.86286) (0.03133) [2.66546] [0.02401] [2.15401] [0.70349] [0.89466] [−1.09403] d (oil[−1]) −0.037327 0.888276 6.768489 −0.053991 0.769003 −0.005508 (0.01584) (0.75466) (11.9571) (0.04736) (0.48139) (0.00527) [−2.35616] [1.17705] [0.56606] [−1.14005] [1.59748] [−1.04554] d (oil[−2]) −0.017013 1.410060 60.25865 −0.027941 0.622314 −0.006058 (0.01339) (0.63796) (10.1081) (0.04004) (0.40695) (0.00445) [−1.27037] [2.21025] [5.96141] [−0.69791] [1.52923] [−1.36033] d (er[−1]) 0.528554 116.0350 1545.150 −4.939402 21.82747 0.088358 (0.98162) (46.7604) (740.889) (2.93444) (29.8277) (0.32641) (cond...) khodeir: migration remittances inflows and macroeconomic shocks: the case of egypt international journal of economics and financial issues | vol 5 • issue 4 • 20151008 by using wald test to diagnosis the short run coefficients, it has been shown that each of the explaining variables, except er, had a significant influence on remittances in the short run at 5% level. also, the type of influence was compatible with that in the long run. this indicated, as mentioned earlier, that the majority of remittance flows to egypt were for investment and not for family support purposes. the insignificance of er reflected that its effect needs longer time to take place. the appearance of a positive significant impact of reserves on remittances insured that any changes in reserves in short run might lead to a temporary effect on remittances. this result is of great importance regarding egypt’s revolution shock and its implications. finally, after estimating the vec model, the study turned to apply two types of impulse response functions. the cirf, used by lueth and ruiz-arranz (2007) and the girf. in the current work cirf, the variables were ordered as listed in vec model. according to pesaran and shin (1997) and ben-kaabia et al. (2002) the girf was preferred that it did not require orthogonalization of shocks and is invariant to the ordering of the variables in the var. for kim (2012) it was extreme because it yielded a set of response functions that were based on extreme identifying assumptions that contradicted each other. the results for the two types of remittances impulse responses were presented in figure 5. in general, the shape and the size of the two impulse responses are quite different, except for the output shock. comparing between them illustrated substantial differences in the remittances response to the shocks of oil price, reserves, money supply, and er. this might lay doubts on what could be deduced. as the response of remittances to these kinds of shocks was ambiguous, it could be ignored. regarding the output shock, the response of remittances to a shock in home income was positive at each time responsive period. one standard deviation shock to gdpp each year led to a continuous increase in remittances during 10 years, ranged between 0.8% in the first year and 6% in the last year in girf or between 0.6% in the second year and 5.1% in the last year in cirf. the response of remittances to home income was positive according to the two types of irf, but faster in girf than in cirf. this kind of response reflects the importance of the investment motives. this procyclicity of remittances raises doubts of being a safeguard against output shocks in egypt. in other words, it implies that remittance flows may not be as important to smooth shocks in egypt as commonly believed. 6. concluding remarks this paper aimed to explore to what extent migrants remittances had supported egypt against economic shocks and whether likely to do so in the future. to achieve that, different macroeconomic variables were included. the variables were home income, oil price, money supply, reserves, and er. it used vec model and two types of impulse response functions to analyze short and long term implications. the results identified three cointegrating relations amongst the considered variables. in both the long and short run, remittances inflows were significantly associated with real per capita income, money supply, and oil price. reserves had a positive effect on remittances only in the short run, while er negatively affected remittances only in the long run. the study found that egyptian migrants were sensitive to macroeconomic variables of home and host countries. remittances inflows increased with the rise of home income levels, the increase of money supply as a reflection of financial development, the rise of reserves as an indicator of home stability, the decrease of oil price, [0.53845] [2.48148] [2.08554] [−1.68325] [0.73179] [0.27070] d (er[−2]) −1.812959 −37.23024 65.40063 2.055070 −73.44876 0.018908 (1.16767) (55.6230) (881.309) (3.49060) (35.4810) (0.38827) [−1.55263] [−0.66933] [0.07421] [0.58874] [−2.07009] [0.04870] c −1.824606 −7.579610 −1960.054 2.624672 −7.594720 0.292095 (0.56797) (27.0555) (428.677) (1.69786) (17.2583) (0.18886) [−3.21253] [−0.28015] [−4.57233] [1.54587] [−0.44006] [1.54662] r2 0.826964 0.833028 0.967554 0.614008 0.562367 0.518429 adjusted r2 0.641568 0.654129 0.932791 0.200446 0.093475 0.002459 sum square residual 21.48438 48751.77 12238802 191.9916 19836.85 2.375509 se equation 1.238789 59.01076 934.9867 3.703199 37.64197 0.411921 f-statistic 4.460534 4.656420 27.83274 1.484680 1.199354 1.004766 log likelihood −37.56009 −153.4676 −236.3520 −70.41197 −139.9796 −4.528370 akaike aic 3.570673 11.29784 16.82347 5.760798 10.39864 1.368558 schwarz sc 4.317978 12.04515 17.57077 6.508103 11.14595 2.115863 mean dependent −0.250520 58.58283 246.8540 −0.384517 8.696944 0.178535 sd dependent 2.069161 100.3400 3606.553 4.141456 39.53507 0.412429 determinant residual covariance (dof adjusted) 1.56e+11 determinant residual covariance 1.61e+09 log likelihood −573.3997 aic 45.82664 sc 51.15119 source: author’s calculation. standard errors in ( ), t-statistics in [ ], aic: akaike information criterion, sc: schwarz criterion, vec: vector error correction error correction d (r) d (gdpp) d (res) d (ms) d (oil) d (er) table 4: (continued) khodeir: migration remittances inflows and macroeconomic shocks: the case of egypt international journal of economics and financial issues | vol 5 • issue 4 • 2015 1009 and the appreciation of domestic currency. these results provided evidence showed more impact of investment over altruism motive of egyptian migrants to remit. regarding the econometric results, remittances inflows seemed to be procyclical in egypt, undermining their usefulness as shock absorber. this confirms that remittance flows to egypt were for investment and not for altruism purposes. the procyclicity of remittances raised doubts of being a safeguard against output shocks in egypt. the following policy recommendations are drawn from the results above: • decision makers should not depend on remittances as a direct policy to absorb the output shocks. • it is important to continue facilitating remittances inflows as an important external financial source, especially with the descriptive evidence about their advantage, that they are less volatile than fdi flows and oda, but without treating them as a substitute for structural reform policies, such as diversification of the export base. • there is a need to a specific institutional framework governing remittances to be directed to deal with the lack of encouraging investment policies that could attract the majority of remittances to small and medium-sized enterprises instead of unproductive investments in real estate. • the current work can be extended to investigate the effects of different regional and international shocks, as well as to be applied on the case of other labour exporting countries that receive large remittances inflows. acknowledgment this research project was supported by a grant from the research center for the humanities, deanship of scientific research, kind saud university. the author whould like to thank dr. azza hegazzy and dr. asmaa hussein for their language revision of the paper. references abdih, y., barajas, a., chami, r., ebeke, c. (2012), remittances channel and fiscal impact in the middle east, north africa, and central asia, imf working paper 12/104, international monetary fund. arab labour organization. (2012), employment and unemployment in arab countries, the 3rd report. barajas, a., chami, r., ebeke, c., tapsoba, s. (2012), workers’ remittances: an overlooked channel of international business cycle transmission? imf working paper 12/251, international monetary fund. bayangos, v., jansen, k. (2009), the macroeconomics of remittances in the philippines, institute of social studies, working paper, no. 470. ben-kaabia, m., gill, j.m., chebbi, h. (2002), the effect of long-run identification on impulse-response functions: an application to the relationship between macroeconomics and agriculture in tunisia, agricultural economics review, 3(2), 36-48. borja, k. 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(2009), macroeconomic determinants of worker remittances for latin american and caribean countries. journal of international business and economics, 9(4), 173-184. world bank. world development indicators. available from: http://www. datacatalog.worldbank.org/. yuni, d., omeje, a., asogwa, h. (2013), determinants of remittance: panel evidence from selected countries in africa. journal of economics and sustainable development, 4(20), 52-57. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(3), 995-1002. international journal of economics and financial issues | vol 6 • issue 3 • 2016 995 an innovative approach to the formation of a progressive taxation probabilistic model on personal incomes kalinina olga* peter the great saint-petersburg polytechnic university, 29 polytechnicheskaya street, st. petersburg 195251, russian federation, russian. *email: olgakalinina@bk.ru abstract this article suggests a mathematical justification of the possibility of transition to progressive taxation on personal incomes, allowing socially redistribute the tax burden between different groups without losing the total amount of tax yield to the state budget from personal income tax. the methods of the transition from a flat to a progressive tax scale of income taxation developed. a generalized mathematical model of transition to progressive taxation, which allows evaluating all possible options for the proposed reform of flat rate transformation, is suggested. an algorithm of modeling progressive income taxation is proposed, which takes into account the likelihood of tax evasion. in the following parts of the article a probabilistic model of progressive income taxation and a mechanism to optimize the level of tax rates is formed. a linear progressive tax scale with and without tax evasion are developed based on actual statistics. keywords: tax, innovation, probability, method, model jel classifications: c10, h24 1. introduction currently, issues related to the reform of income taxation, are of increasing importance, both in the russian federation as well as in various developed countries. income tax in russia is indeed one of the most important federal taxes and one of three tax along with value added tax and corporate profit tax, which provide the greatest revenues to the consolidated budget of the country. in 2001, the russian federation refused to introduction of progressive income tax and flat rate of 13% was forced. the main argument justifying the introduction of a flat tax rate, was the idea that the big revenues will be withdrawn from the shadow economy. currently, the most common form of realization of the socioorientated tax system in the world practice is the use of progressive taxation. it is explained by importance of social infrastructure branches development support which functioning is directed on improvement of conditions of formation and development of the human capital (zaborovskaya, 2014; 2015; rodionov et al., 2014; 2015; rodionov et al., 2014). this confirms validity of the mechanism of progressive taxation use. foreign experience of income taxation are investigated in the works by guner et al. (2014), kanbur and tuomala (2013), kovárnik and hamplová (2013), izotova (2011), lyashenko and muravꞌeva (2014), maslova and kazꞌmin (2013), ulezꞌko and orobinskaya (2013), tyutyuryukov (2013), and others. suggestions and recommendations for reform and improvement of the income tax system are contained in works by aliev et al. (2011), beskorovajnaja (2012), kashin (2012), korenꞌ (2014), kosov (2014), kushch and yanakov (2012), savina (2010), tarasova and goncharenko (2015), and others. issues, related to the transition to a progressive income taxation, are studied by scientists such as the akhmadeev and kosov (2015), bryzgalin (2009), gaponova and solovꞌeva (2014), grekov and senina (2015), panskov (2009), polievktova (2014), sheveleva and zheryakova (2015), ellaryan (2012), and others. olga: an innovative approach to the formation of a progressive taxation probabilistic model on personal incomes international journal of economics and financial issues | vol 6 • issue 3 • 2016996 2. problem formulation according to the aforesaid we propose two methods of linear and nonlinear transformation and a mathematical model of transition to a progressive income taxation based on them. the main provisions of the essence of these methods and models are as follows. linear transformation method allows transforming the original flat tax rate on the basis of progressive social significance single parameter the value of the income tax rates n1 for low-income groups. according to this method the value of the tax rates for different groups of the population ni are as follows: n n s n n i j s n n n i j i j j m j j = + −( ) −( ) −( ) = + −( ) −( ) −( ) = = ∑ 1 0 0 1 2 1 0 1 2 1 1 1 1 η mm ∑ (1) where s0 current tax base; n0 tax rate of flat tax rate, n0 = 13%; j index used to summarize the shares of ηj ratio; m the number of taxation groups; η j js s = 0 the distribution coefficients of monetary incomes of population groups as a proportion of total revenue s0. the idea of nonlinear transformation method is that it as well as the linear transformation method allows creating different tax rates for different groups, depending on their income. according to this method, special nonlinearity coefficient ki is added to the formula for calculating the tax rate ni, which allows to increase the tax rate not proportionally to all groups, but with greater restatement of the tax burden on the group with the highest incomes. the general formula for calculating tax rates by this method is the following: n n n n s k i i s j j k i j j m = + −( )⋅ + −( )  −( ) −( ) + −( )⋅  = ∑ 1 0 1 0 2 1 1 1 1 1 1 == + −( )⋅ + −( ) ⋅ −( ) −( ) + −( )⋅  = ∑ n n n k i i j j kj j m1 0 1 2 1 1 1 1 1 1η (2) it should be noted that such approaches to formation of functional economic dependences could be used not only in the solution of problems of the taxation, but also to determine various elements of prime cost of goods and services (nekrasova et al., 2015). on the basis of the two methods mathematical model of the transition to progressive income taxation can be generalized, adaptive to changing political, economic and social conditions at the same time allowing to calculate tax rates for different tax scales: n n n n k i i j j k i j j = + ⋅ −( )⋅ + −( ) ⋅ −( ) −( )⋅ + −( )⋅  = 1 0 1 2 1 1 1 1 1 1 τ η mm ∑ , (3) where τ = c c0 the ratio of the planned increase in tax yields; c0 the total yields from income tax at a flat rate; c total yields from personal income tax under the progressive scale. this model allows to evaluate different options for the proposed reform of transformation flat into progressive rate. there in before tax rates (equation 3) vary depending on the source of external conditions, as well as the goals and challenges faced by the public authorities, developing tax policy in the short and medium term. however, despite the various options for adjustment of tax coefficients (equation 3), the proposed model does not take into account the probability of non-payment of income tax by raising the tax rates transition from 13% of the linear rate to a higher rate of taxation for the affluent. in accordance with the above, the purpose of this study is to develop mathematical tools to build a probabilistic model of taxation, which more accurately reflects the process of taxation and addresses the problem of tax evasion. 3. problem solution 3.1. development of an algorithm for progressive model of income taxation constructing, taking into account the likelihood of tax evasion the problem of tax evasion is urgent and cause interest among scientists and economists. questions to avoid paying taxes are considered in works by feldstein (1999), mcguire et al. (2014), kubick et al. (2015), and others. the following problem is stated in the formation of a progressive income tax: to find such tax rates ni, that the amount of tax yields was the highest under the condition that the probability of actual payment of taxes depends on the level of tax rates. let us introduce the pi coefficient characterizing what part of the income tax will be paid by taxpayers in the real value of income falling within the ith interval, and therefore falls under the tax rate ni. these coefficients 0≤pi≤1 can be determined from statistical data on taxation, calculated by the federal state statistics service of the russian federation, the ministry of finance or the ministry for taxes and levies of the russian federation. further pi coefficients will be called income tax payment probabilities by taxpayers. let us assume that a taxpayer pays tax with probability pi, or doesn’t pay it at all. it is notable that the option of partial payment of the tax, i.e., display and payment only of a part of the income is not considered in this simple probabilistic model. olga: an innovative approach to the formation of a progressive taxation probabilistic model on personal incomes international journal of economics and financial issues | vol 6 • issue 3 • 2016 997 under this assumption, the formula calculating the total yield from income tax, taking into account the probability of paying it with the introduction of a progressive scale will be: c s n pi i i m i= ⋅ ⋅ = ∑ 1 (4) this formula allows to estimate the amount of tax yields, taking into account the probabilistic nature of the actual payment of the tax. it is important to note, that the higher is tax rate, the less likely the taxpayer will pay tax at such a high rate. suppose pi and ni are related by: pi=1−ni (5) for example, if the tax rate is not great, ni = 0.1, then the probability of paying it considering (5) would be big, pi = 0.9; if the rate ni = 0.6, then the probability is reduced to pi = 0.4. the presence of probability pi in the formula (4) prevents “voluntary” increase in tax rates ni, because this would immediately lead to lower tax probability pi. the presence of divergent trends in values ni and pi gives hope to the possibility of a correct formulation of solutions to optimize the tax scale parameters. formula (4) with (5) takes the form: c s n ni i i m i= ⋅ ⋅ −( ) = ∑ 1 1 (6) thus, the optimization problem comes down to picking ni tax rates so that to provide maximum values of tax yields сmax: c s n n n i i i m i i max max= ⋅ ⋅ −( ) = ∑ 1 1 (7) as a result, the problem reduces to finding the maximum of a function c with many variables ni. under the rules of search for several variables extremum function we have: ∂ ∂ = −( ) = ∂ ∂ = −( ) = c n s n c n s n 1 1 1 2 2 2 1 2 0 1 2 0 ................................ ∂ ∂ = −( ) =            c n s n m m m1 2 0 (8) therefore, optimal formulated values ni * , that provide maximum for the amount of tax levies сmax, will be: n n nm 1 2 0 5 * * * ... .= = = that is, the optimal tax scale in this simplest hypothetical case of a flat rate with the value ni=0.5; it gives more tax yield than any other scale. this finding explains the transition in 2001 to a flat tax rate, as the economy and the tax system at the time led to greater probabilities of tax evasion. let us consider refined, more realistic, probabilistic model of a progressive tax system. assume that pi and ni are connected by the relation: pi=1−bi. ni (9) where bi weights; b p ni i i = −1 can be determined on the basis of statistical data. examples of graphs of (9) for some values of bi are shown in figure 1. considering (9), the formula (4) takes shape: c s n bni i i m i i= ⋅ ⋅ −( ) = ∑ 1 1 (10) and the problem of optimization (10) reduces to finding the maximum of a function сmax with many variables ni. c s n bn n i i i m i i i max max= ⋅ ⋅ −( ) = ∑ 1 1 (11) under the rules of several variables extremum function search, we have: ∂ ∂ = −( ) = ∂ ∂ = −( ) = c n s bn c n s b n 1 1 1 1 2 2 2 2 1 2 0 1 2 0 ................................ ∂ ∂ = −( ) =            c n s b n m m m m1 2 0 (12) thus, optimal values for n i * rates will be: figure 1: functional connection pi=1−bi. ni olga: an innovative approach to the formation of a progressive taxation probabilistic model on personal incomes international journal of economics and financial issues | vol 6 • issue 3 • 2016998 n b1 1 1 2 * = ; n b2 2 1 2 * = ; n bm m * = 1 2 (13) the optimal solution provides a maximum tax levies and can serve as practical advice for choosing the parameters of the progressive tax scale. the accuracy of the constructed model will depend on the reliability of statistical data on taxation, i.e., knowledge of pi. the developed mathematical tools, including a probabilistic approach to the problem of registration of tax evasion, as well as the proposed adjustment mechanism of progressive scale obtained by linear (nonlinear) transformation, let us talk about the creation of a probabilistic model of incomes taxation of the population. the advantages of this model is that it allows to transform a progressive tax scale to clarified scale taking into account the additional possibilities of tax evasion associated with a change in tax rates as a result of progression in the income taxation. in accordance with the proposed model it is possible to find the optimal tax rates obtained on the basis of a probabilistic approach to the payment of taxes. the typical form of adjusted progressive scale shown in figure 2. the solid line shows the original scale 1, the dotted line adjusted scale 1* which results the optimization of tax rates ni according to formula (13). the above chart shows the mathematical recommendations to maximize tax levies, taking into account the probability of their payment pi: to slightly lower tax rates for groups with higher incomes and slightly increase to low-income groups. from the perspective of social orientation, this recommendation should not be done literally, i.e., for low-income groups unadjusted tax rate should be left. at the same time, for better personal income tax levies, the recommendations should be applied to groups with high incomes: it is advisable to adjust (decrease) the tax rate to compensate negative consequences of possible non-payment at higher rates. the amount of these adjustments is determined on the basis of solving optimization problems using formula (13). figure 2: the typical form of adjusted progressive scale it is worth noting, that the accuracy of adjusting the values of optimal tax rates depends on the reliability of statistical data for pi. the assessment of the shadow component calculations on the proposed probabilistic model shows that the adjustment of the scale leads to a nonlinearity coefficient k ≈ 0.05 and the adjustment coefficients tax on the value of ≈5-10% for the extreme groups. 3.2. formation of a probabilistic model for progressive income taxation and optimization of tax rates levels the following problem should be stated: it is needed to build a progressive scale of taxation that guarantees the same level of tax levies, as in the flat rate, but takes into account the probability of evasion of income tax. as in the previous section, a hypothesis is the rule that the higher the tax rate, the less the likelihood that the income tax will be paid, so the relationship (9). in accordance with the formula (4) the amount of tax levies in the probabilistic model is developed. c s n pi i i m i= ⋅ ⋅ = ∑ 1 (14) or considering (9): c s n bni i i m i i= ⋅ ⋅ −( ) = ∑ 1 1 (15) similarly to the proposed approach of building progressive tax scale, i.e., taking into account the condition of the linear increase in the tax rate: ni=n1+δ(i−1) δ=ni+1−ni=const (16) let us build a progressive scale with a linearly increasing tax rate. also demanding that progressive scale built so should provide the same amount of taxes collected, as flat. c n s n si i m 0 0 0 0 1 = = ⋅ = ∑ , (17) i.e., c=c0 (18) formulas (14), (16) and (17) give us: s n bn s n b n s n b n s nm m m m1 1 1 1 2 2 2 2 0 01 1 1 0−( )+ −( )+ + + −( )− =... ... (19) applying (15-18), we have: s n bn s n b n s n b n 1 1 1 1 2 1 2 1 3 1 3 1 1 1 2 1 2 −( )+ +( ) − +( )( ) + +( ) − +( )( )+ ∆ ∆ ∆ ∆ .... + + −( )( ) − + −( )( )( )− =s n m b n m s nm m1 1 0 01 1 1 0∆ ∆ (20) or olga: an innovative approach to the formation of a progressive taxation probabilistic model on personal incomes international journal of economics and financial issues | vol 6 • issue 3 • 2016 999 n s s s s n s s s m s n s b s b m m 1 1 2 3 0 0 2 3 1 2 1 1 2 2 1 + + + +( )− + + + + −( )( ) − + ... ...∆ 22 3 3 1 2 2 3 3 2 2 2 2 2 1 4 + + +( ) − + + + −( )( ) − + s b s b n s b s b m s b s b m m m m ... ...∆ ∆ ss b m s bm m3 3 2 1 0+ + −( )( ) =... (21) finally, this equation can be described as: αδ2+βδ+γ=0 (22) where, α β γ = −( ) = −( ) − −( ) = −( ) = == ∑ ∑∑ j s b j s n j s b n n j j j m j j j j m j m 1 1 2 1 2 1 1 11 1 0 ss n s bj j j m 0 1 2 1 −            = ∑ (23) from equation (21) we find the growth rate of the tax group δ: ∆ 12 2 4 2 , = − ± −β β αγ α (24) since δ purely positive value, the negative root in (23) should be dropped: ∆ = − + −β β αγ α 2 4 2 (25) substituting the values found in the δ (15), we obtain the final formula for finding ni: n n ii = + ⋅ −( )1 1∆ , i = 1, 2,…, m (26) thus, in the general case, we obtain (22), (24) and (25) to build a progressive tax scale, providing the same tax levies on personal income as the flat rate, provided based on the probability of nonpayment of tax, depending on the increase tax rates. hereafter it is more comfortable in the formula (22) to move to dimensionless quantities ηj: α η β η η = −( ) = −( ) − −( )      = == ∑ ∑∑ s j b s j n j b j j j m j j j j m j m 0 2 1 0 1 11 1 1 2 1    = − −                     = ∑γ ηs n n n bj j j m 0 1 0 1 2 1 , (27) where η j js s = 0 . considering the special case where in the formula (9) all bi = 1, i.e., pi=1−ni, formula (26) take the form: α η β η γ η = −( ) = −( ) −( ) = − − = = = ∑ ∑ s j s n j s n n n j j m j j m j j 0 2 1 0 1 1 0 1 0 1 2 1 1 1 2 1 mm ∑                     (28) 3.3. construction of the linear progressive tax scale for the proposed model to test the applicability of the proposed probabilistic model of a progressive income tax based on actual statistical data it is crucial to construct tax scale with and without evasion of income tax and comparable results. 3.3.1. construction of the linear progressive tax scales, excluding tax evasion on the basis of statistical data of the federal state statistics service of the russian federation for 2014 (to find the value of income distribution ηj) it is needed to build a progressive tax scale by the method of linear transformation. at the same time, considering the case in which the tax reform is not accompanied by an order to increase the total income tax, i.e., at equality of the tax base and the amount of total income tax before and after the introduction of a progressive tax scale: s s si i m = = = ∑ 1 0 andc n s ci i i m = ⋅ = = ∑ 0 1 (29) the results of calculation of tax rates by the formula (1) in the case of constant tax yield are presented in table 1 (section i). the range of low-income tax group n1 varies from 10% to 0%. notable, that many countries use full exemption from tax for lowincome groups, so the consideration of options n1=0 is important. the table 1 (section i) can be seen as a redistribution of the tax load on low-income groups to the wealthy. it is worth noting, that table 1: the results of calculations of progressive linear scale tax rates without probability of tax evasion, author’s calculations section no ηi ni (%) n1 (%) i=1 i=2 i=3 i=4 i=5 0.052 0.099 0.149 0.225 0.475 section i 13 13 13 13 13 13 10 10 11 12 13 14 5 5 7.7 10.4 13 15.8 0 0 4.4 8.7 13 17.5 section ii (τ=1.2) 13 13 13.9 14.7 15.6 16.5 10 10 11.9 13.8 15.7 17.5 5 5 8.6 12.1 15.7 19.3 0 0 5.2 10.5 15.7 21 olga: an innovative approach to the formation of a progressive taxation probabilistic model on personal incomes international journal of economics and financial issues | vol 6 • issue 3 • 20161000 when the load for the fourth group of taxpayers has not changed, for the fifth it increased by 35%. further we will consider the case where the transformation of a flat tax should be accompanied by an increase in the total income tax. for this we introduce the coefficient of the planned increase in tax yield due to the increase of the total income tax in τ times: c c= ⋅τ 0 . in the situation of flat rate taxation additional tax burden will fall on the entire population; in the progressive linear scale tax rates will be calculated for the tax base τ ⋅ s0 with the formula: n n n n i j i i j m= + ⋅ −( ) −( ) −( ) = ∑ 1 0 1 1 1 1 τ η (30) the results of calculation of tax rates by the formula (29) needed to increase tax yield by 20%, are shown in table 1 (section ii). gradations of tax rates n1 and the distribution of income of the population by groups ηi are similar to the data contained in table 1 and section i. the results, shown in table 1 (sections i and ii), let us visually compare the tax rates with an increase in tax yields of the total income tax by 20%. 3.3.2. construction of the linear progressive tax scales taking into account the tax evasion on the basis of the same statistical data of the federal state statistics service of the russian federation for 2014, according to the currently existing income distribution ηi, we construct a linear progressive tax scale, taking into account the possibility of tax evasion, while maintaining revenues in the case of switching to the progressive taxation. substituting these data into the formula (27), we obtain: α β γ = ⋅ = −( )⋅ = − −( ) s s n s n n n 0 0 1 0 1 0 1 2 10 34 1 2 2 976 . . . after setting these expressions in (24) we can obtain the desired value of δ for different values of n1. the results of these calculations for the three values of n1 = 0.1; n1 = 0.05 and n1 = 0 are summarized in table 2, section i (wherein n0 = 0.13). thus, in accordance with the method of linear transformation were formed and constructed linear progressive tax scales, considering the possibility of evasion of personal income tax, while maintaining budget revenues compared to the flat tax rate. now let us consider the case of evasion of income tax, with the possible increase in total budget revenues from paying it by introducing a progressive tax scale. if we want to collect tax yields in τ times greater than the flat rate tax, then: c n s n sj j j m j m = ⋅ = == ∑∑τ τ0 0 11 ( ) (31) based on the foregoing, the problem solution reduces to the previously considered, providing that in mathematical expressions and final formulas we replace n0 for n n0 0 ( )τ τ= ⋅ . the results of adjusted tax rates calculations, taking into account the probability of avoiding tax payment obtained by linear transformation, provided the planned increase in tax yields from personal income taxes are presented in table 2 (section ii). 4. conclusion based on the results shown in table 2, and comparing them with the results of the calculations presented in table 1, we can draw the following conclusions: • it is possible to build a progressive taxation scale, taking into account the probability of tax evasion, or ensuring equality of tax yield compared to a flat scale (table 2 and section i), or its increase in τ time (table 2 and section ii); • an increase in tax yields from personal income taxes as a result of the progressive tax scale, which takes into account the likelihood of tax evasion, is achieved due to some increase in tax rates: in particular, with n1 = 10% increase in tax rates for the second to fifth groups of the population amounted to 0.6-2.4%; when n1 = 5%, 0.1-0.4%; • the likelihood of non-payment of tax leads to a slight increase in tax rates, but tax levies are not reduced. these findings and the results obtained for the linear progressive scale. similarly, we can obtain the corresponding results for the non-linear taxation scale. table 2: the results of calculations of progressive linear scale adjusted tax rates, taking into account the probability of tax evasion, author’s calculations section no ηi ni (%) n1 (%) i=1 i=2 i=3 i=4 i=5 0.052 0.099 0.149 0.225 0.475 section i 13 13 13 13 13 13 10 10 11.6 13.2 14.8 16.4 5 5 7.8 10.6 13.4 16.2 13 13 13 13 13 13 section ii (τ=1.2) 10 10 12.5 15.0 17.5 20.0 5 5 8.5 12.0 15.5 19.0 0 0 4.5 9.0 13.5 18.0 olga: an innovative approach to the formation of a progressive taxation probabilistic model on personal incomes international journal of economics and financial issues | vol 6 • issue 3 • 2016 1001 references akhmadeev, r.g., kosov, m.e. 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(2014), assessment of conditions for formation and development of human capital in the regions of the russian federation. asian social science, 10(21), 267-274. . international journal of economics and financial issues | vol 5 • special issue • 2015116 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(special issue) 116-120. the spatial transformation of the urban environment in the conditions of post industrial development of society: dedicated to the 100th anniversary of jean gottmann, immanuel kant baltic federal university, 23-26 august 2015, russia. government regulation of advertising in the eurasian economic union: contradictions of public policy and advertising ethics il’ia a. bykov1*, tatiana a. cherkashchenko2, andrei y. dorskii3, elena a. kaverina4 1department of public relations in politics and public administration, saint petersburg state university, saint petersburg, russia, 2department of public relations in politics and public administration, saint petersburg state university, saint petersburg, russia, 3department of public relations in politics and public administration, saint petersburg state university, saint petersburg, russia, 4department of advertising, saint petersburg state university, saint petersburg, russia. *email: i.bykov@spbu.ru abstract the article deals with the problems of government regulation of advertising industry in the member states of the eurasian economic union (eaeu). the main purpose of the study includes evaluation of attitudes to the moral issues in advertising practice as well as government policy on the problem of unethical advertising. the study applies methodological framework of policy analysis toward the regulation of unethical advertising in the countries of the eaeu. the authors find out that there is no coherent public policy in this field in the eaeu. while russia attempts to apply international standards with self-regulation mechanisms in order to deal with unethical advertisements, the other member states prefer to use strict governmental control. in russia, there are two opposite tendencies: while mass media assign part of regulation to the government, the government does not want to adopt this role. the courts in russia prefer reactive regulation of advertising, usually trying to evade even obvious law cases. at the same time, facing no resistance from either governments or societies, some part of advertising industry tends to abuse ethic norms. the authors claim that this situation undermines the process of integration and differs significantly advertising industry in the countries of eaeu from advertising, for example, in the member states of the european union. keywords: eurasian economic union, advertising, government regulation, ethics, policy analysis jel classifications: m3, k2, f2, f6 1. introduction economic and political transformations in post-soviet states affect many aspects. advertising, being one of them, differs life in postsoviet society from soviet one significantly. advertising industry develops very rapidly in all post-soviet states. for example, in 1991 (the year of soviet union collapse) russian advertising market was about 3 million in us dollars, but today it is ranked among top-10 advertising markets in the world and goes around 10 billion in us dollars (communication market in russia, 2010). advertising industry in post-soviet countries runs under strong influence from international trends and professional standards, successfully copying all techniques and methods from western practices (deconinck and swinnen, 2012). however, contemporary advertising tents to be very sensitive for moral issues, applying for its theory and practice very normative terms like “corporate conscience” (bronstein, 2012), “self-regulation” (carusi and de grandis, 2012), “reputation” (ivancin, 2012), “moral responsibility” (lee and nguyen, 2013), “enhanced advertising ethics” (snyder, 2011), etc. thus, one should expect adoption of ethical standards of advertising in the post-soviet countries. however, advertising industry in the area has its unique trend in this aspect. it deals with unsettled standard for ethical advertisements. this issue corresponds strongly with well-known problems of business ethics in the post-soviet countries. for example, there is a great number of studies in the field of “corrupted” business practices in russia (galligan and kurkchiyan, 2012; ledeneva, 2006; shlapentokh, 2013). jaffe and bykov, et al.: government regulation of advertising in the eurasian economic union: contradictions of public policy and advertising ethics international journal of economics and financial issues | vol 5 • special issue • 2015 117 tsimerman (2005, p. 95) report “low levels of ethical standards among russian managers.” in russian language literature moral issues of advertising are regularly considered as a problem for economic and cultural development (akopyants, 2012; dorskii, 2008; fedotova, 2012; ivleva, 2010; stepchenko, 2012; sirotina, 2012; ulyanovsky, 2011). for example, akopyants (2012) points out the reasons for unethical advertising in the post-soviet countries. the first reason is economical: business tends to gain profit at the expense of social responsibility. the second reason deals with imperfections of government and public control. third reason reveals the ignorance of cultural differences. direct copying of advertisements sometimes causes cross-cultural breaches, which weakness public sense of moral values. this article focuses on the problems of governmental regulation, self-regulation and public control of advertising industry on the issues of ethics in the member states of the eurasian economic union (eaeu): the russian federation (russia), the republic of belarus (belarus), the republic of kazakhstan (kazakhstan), and the republic of armenia (armenia). the eaeu, being a descending organization for the commonwealth of independent states (cis), was established in 2010 and is considered to be a form of economic integration in the area of north eurasia with the aim on the boosting of economic growth and social development. one should expect close cooperation and significant unification in all aspects of economics in the eaeu. the study aims to explore politics of advertising regulation in the eaeu. obviously, advertising industries in the member states of the eaeu ought to have similar tendencies. taking into account the tendency of international standard’s localization, the authors propose a working hypothesis about existence self-regulation practice in advertising in the eaeu. self-regulation in advertising became an issue in 1952 (geller, 1952). though self-regulation has its weak sides (hastings et al., 2010), the contemporary best practices show advances of self-regulation upon governmental regulation (parsons and schumacher, 2012). sometimes a model of the great britain is believed to be a best way of self-regulation in advertising industry (muela-molina and perelló-oliver, 2014). 2. methodological approach the authors believe that the best methodological basis for this study is a policy analysis, which is described in details bardach, 2012; dunn, 2003; fischer et al., 2007; nagel, 1999; patton and sawicki, 1986, and many others. modern public policy studies usually apply advanced techniques like game theory or rational model (dye, 2007). in case of post-soviet studies, it is hardly to be “public” or “rational” versions of policy analysis because of “non-public” and “reactive” politics in the area. thus, researchers have to use classical process model to gain some understanding. the model describes a given policy by analyzing results of subsequent phases of policy process from problem identification, through examination of alternatives, political decision, and implementation to evaluation. in case of post-soviet studies sometimes, it is impossible to examine stages of policy process properly for unavailability of information. therefore, researchers have to reconstruct or deduct possible developments of policy. in this way, the most problematical phases in post-soviet policy are stages of problem identification, examination of alternatives, and political decision. this study bases on the open sources like research articles, mentioned in the introduction, advertising laws, and law enforcement practices in the countries of the eaeu. all investigated states have anti-monopoly regulation bodies with web sites to publish important information about law suites and jurisdictional precedents. very helpful for the study was the analysis of the information from web site of the federal anti-monopoly service of the russian federation (fas). also there is a web-site of the coordinating council on advertising at the interstate council for anti-monopoly policy, established by the member states of the cis (http://sovetreklama.org/). this coordinating council on advertising during its existence managed to provide 14 meetings and to publish electronic journal “the herald of coordinating council on advertising.” special mention should be made to the issued by the council in 2013 comparative study “review of the activities in the field of advertising in the member states of the cis” (review of the activities in the field of advertising in the member states of the cis, 2013). in order to evaluate public reaction on the problems of unethical advertising the study uses the help of the “medialogia” database, an automated real-time media monitoring and analysis system. the “medialogia” scans all russian national media and on-line sources along with other countries of the cis. the research with the “medialogia” shows popularity of the topic on “ethics” in public discourse. 3. ethical issues in advertising: the legislation of the eaeu in accordance with article 61 of the treaty on the eaeu “member states shall conduct coordinated policy in the field of consumer protection, aimed at creating equal conditions for nationals of member states to protect their interests from unfair business entities.” one element of this policy is the legislative regulation. all member states of the eaeu got advertising laws: the law of the republic of armenia “on advertising” (1996), the law of the republic of belarus “on advertising” (2007), the law of the republic of kazakhstan “on advertising” (2003), and the russian federal law “on advertising” (2006). these laws have certain similarity of approaches to advertising ethics, but we can observe some differences. for example, the laws of belarus and kazakhstan have the concept of “unethical advertising.” according to belorussian law unethical advertisement: • includes text, visual and (or) audio information that violates generally accepted norms of morality and ethics, including offensive words, comparisons and images with respect to race, nationality, appearance, age group, sex, language, profession, social category, religious, political, or other beliefs of citizens; • defames objects that are historical and cultural values; • denigrates state symbols (flag, emblem, anthem), official monetary unit of the republic of belarus or other states, international organizations, religious symbols; bykov, et al.: government regulation of advertising in the eurasian economic union: contradictions of public policy and advertising ethics international journal of economics and financial issues | vol 5 • special issue • 2015118 • defames any organization or citizen, any activity, profession, product; • discredits organization or citizen, do not use the advertised goods; • contains a negative assessment of the object of advertising; • contains a comparison of the advertised goods with the goods of another organization or another citizen, the advertised organization with another organization, the advertised results of intellectual activities with other results of intellectual activity advertised contests, lotteries, games, other playing, advertising, and other activities with other betting contests, lotteries, games, other playing, promotional and other events, bets; • introduces consumers misleading advertising, including through imitation (copying) of the total composition, text, images, music and (or) the sound effects used in the advertising of a publisher; • contains the words “gift,” “free,” “0 (zero) rubles,” or other words that give the impression of providing services (works), free of charge, if the provision of such services (such work) requires her to pay. the law of the republic of kazakhstan reads “unethical advertising” as material that: (1) contains textual, visual and audio information that violates generally accepted standards of humanity and morality through the use of insulting words, comparisons and images with respect to race, ethnicity, language, occupation, social status, age, gender, religious and political beliefs of individuals; (2) discredits objects of arts, culture, historical monuments, which are national or global heritage; (3) denigrates state symbols, the national currency of the republic of kazakhstan or a foreign currency, religious symbols. the law of the republic of armenia contains similar rules, prohibiting advertising which “violates decency of advertising,” namely: (a) discredits the conventional and national norms of morality; (b) contains insulting expressions, comparisons and images with respect to race, nationality, profession or social origin, age group or sex, language, religion or belief; (c) directly or indirectly discredits state symbols (flag, anthem, currency and so on), or expresses disrespectful attitude towards them; (d) discredits individuals and legal entities, as well as industrial, commercial or other activity, profession, and so on. it may be noted that art. 8 of the law of armenia, unlike the belarus and kazakh legislation does not protect the cultural heritage, and a ban on their defamation is not in the other articles of this law. the law of the russian federation has no concepts of “unethical” or “obscene” advertising. thus, ethics is interpreted differently within the eaeu. russia refuses to interfere in the sphere of ethics, which applies to the self-regulation of civil society. in belarus, on the contrary, the rules of ethics are established and supported by the state. in the laws of belarus, armenia and kazakhstan rules on self-regulatory organizations are missing. only russian law encourages the creation of self-regulatory organizations in the field of advertising. russian law contains a chapter 4, devoted to self-regulation in advertising. self-regulating organizations have the right to exercise control over professional activity of their members’ rules in the field of advertising, including the requirements of professional ethics. in russia, there are a bug number of non-governmental organizations to represent the advertising market. the largest of these is the association of communication agencies of russia (acar), which, in particular, is committed to developing, implementing voluntary ethical requirements for advertising and ensure control over their execution. despite the general tendency of the russian state to pass ethical regulation in the hands of civil society in the law “on advertising” of the russian federation includes provisions overlapping with the definitions of unethical advertising in belarus and kazakhstan: “in advertising it is not allowed to use expletives, indecent and offensive images, comparisons and statements, including with respect to gender, race, nationality, profession, social category, age, language of man and citizen, the official state symbols (flag, emblem, anthem), religious symbols, objects of cultural heritage (historical and cultural monuments) of the russian the federation, as well as cultural heritage sites included in the world heritage list” (on advertising, 2006, ch. 6, art. 5). thus, we can see the contradiction between the desire of the russian government to transfer control on advertising ethics to the hands of self-regulating non-governmental organization and the de facto control over unethical advertisements. 4. public engagement in regulation of advertising in the eaeu the possible explanation of this contradiction deals with the state of public consciousness in russia. to test this idea we can study mentions of ethics in the russian media with the help of the “medialogia.” this database can be easily searched by keywords. we run search request with keyword “ethics.” the search returns total 320431 mentions of ethics since december 31, 2003 till december 31, 2013. the results of a search query automatically ranked on popular topics. the most popular topic with ethic connection is “russian federation,” it has about 125000 mentions. the most important observation in our opinion is the fact that among the top newsmakers about moral issues almost there are no public figures and organizations. in the first hundred mentions of ethics there is only one religious organization: the russian orthodox church (14th place). the other non-governmental organizations are four political parties, represented in the state duma of the russian federation, the russian football union (24th place), and the union of journalists (94 place). among public figures, who do not occupy governmental positions, there are only two figures in the top-100: patriarch kirill (41th place) and opposition leader alexei navalny (58th place). thus, the ethical discourse in russia is completely usurped by the state and the organizations associated with the government is stable. if we take into consideration the organizations, which can control ethics of advertisements in russia, when we can observe bykov, et al.: government regulation of advertising in the eurasian economic union: contradictions of public policy and advertising ethics international journal of economics and financial issues | vol 5 • special issue • 2015 119 the same trend: the fas as a governmental branch takes on the 118th place, while self-regulatory organization acar is at 893rd place. based on this distribution, russian society does not expect from advertising to be a market with self-regulation: it binds all their hopes on the establishment of standards of ethics with the activities of the state. analyzing the russian self-regulating organizations in advertising, we find out that they are not willing to independently monitor compliance with ethics. thus, the acar has no special committee on ethics. the website of acar mentions “ethics” only eleven times with no real actions about unethical advertising (http://www.akarussia. ru). the authors of the study were really sunned that the acar has no task of responding to the consumers’ dissatisfaction by unethical advertisements. the consumers and citizens can complain about unethical advertising only to the government agency: the fas. in order to establish cooperation with industry professionals, the fas has created the expert council, which includes representatives of the acar as well. the board of the expert council meets twice a year on average by the initiative of the fas to consider the issues that the government has prepared. decisions of the council are consultative. similar councils have been established in some regions of russia in the regional offices of the fas. this practice can be considered as an element of co-regulation, but the problem of self-regulation does not address this practice. a rare example of self-regulating organization, which is ready to take responsibility for decisions in the field of unethical advertising, is the public advertising council of st. petersburg (http://spb.sovetreklama. org). thus, we see that the russian government seeks to transfer the responsibility for complying with the ethics of advertising self-regulatory organizations, but the professional community and the general public are not ready for that. in other countries of the eaec, as we already noted, there is no legally expressed will to encourage self-regulation and the selfregulating organizations do not even consider ethical standards as its mission. one can verify this statement by studying the sites of the leading self-regulating organizations in advertising in kazakhstan kazakhstan federation of marketing, advertising and pr (http://www.kfmr.kz) or belarus association of advertising organizations (http://aro.by). 5. conclusions in the beginning of the article, we stated that experience of the european union in the field could be very useful for the countries of the eaeu. the reason deals with the fact that the member states of the eu have chosen not to develop uniform legislation in the field of advertising, but to bring together the system of self-regulation. the current system of self-regulation of the eu arose in 2002, when the european advertising standards alliance (easa) became the single, authoritative voice of advertising selfregulation in europe. easa is active and transparent organization, which regularly publishes results of its work on-line (http://www. easa-alliance.org). according to easa1, there is only one cis 1 http://www.easa-alliance.org/about-easa/easa-members/noncountry in which the self-regulation in advertising is in progress: the russian federation. the others run without attempts to apply self-regulation in advertising. in russia, we find two opposite tendencies: while mass media, professional community of advertisers and society in general assign part of ethics regulation to the state, the state does not want to adopt this role. practice of fas councils, which is supposed to help with co-regulation, sometimes causes more problems than it resolves. in the eaeu, like most of the world, the word “ethics” is closely followed by the word “regulation” (carusi and de grandis, 2012). however, 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(2011), conceptual and technological bounds of advertising. saint petersburg: russian state pedagogical university. microsoft word 4 serbia[1].doc international journal of economics and financial issues vol. 1, no. 2, 2011, pp.54-73 issn: 2146-4138 www.econjournals.com application of method of financial risk in serbian companies survey sample company jelisavka bulatović college of textile design, technology and management, belgrade starine novaka 24, belgrade, serbia. tel: 00381/643502186 jelisavka.bulatovic@gmail.com abstract: the aim was to obtain information on the use of financial instruments hedging the serbian large and medium-sized enterprises, as well as to detect any differences between the characteristics of companies that use them or not used. survey researches based on telephone interviews with financial or accounting managers with a stratified random sample of 101 serbian companies and conducted in 2010. the contribution of this study comes from testing hypotheses about the relationships between the characteristics of serbian companies and the use of financial instruments hedging. finally, in the future, researchers should make use of this work and make a deeper study based on differentiation from serbian companies. in this way, it would be possible to include different sizes of companies (on the number of employees) to include different types of financial measures in relation to the size of the company, for example, the factor of annual revenues. key words: financial risk management instruments, survey research, χ2-test of independence, t-test differences of means 1. introduction volatility of market prices, especially commodity prices, interest rates, exchange rates and the risk of collection and the like, not only influence on the performance of enterprises and achieving maximum benefit for the owners, but to a large extent determine the survival of enterprises in the global environment. financial risks arising from financial transactions, and since all risks eventually have financial consequences, it considered that all risks are directly financially, according to peterlinin (2003). in practice, the role of financial professionals taking new dimensions, and chief financial officer (cfo-chief financial officer) in terms of business risk in the international scale and under global pressure all the more willing to share the burden of risk and modify the decision and management system (pickford, 2001, brealey , myers, 2003, christoffersen, 2003). jorion (2001) speaks of the years to share the financial industry from the prehistoric times of financial risks management and integrated risk management (integrated risk management or enterprise-wide risk management) which will include looks at the relationship of financial risk with some of its forms: market risk, liquidity risk, credit and operational risk. financial risk management practices by companies in the serbian economy imposed by the author as a topical and unexplored topic of research. special incentive for this research comes from a partpeterlin (2003, 2004a, 2004b), van horne (1992), vaughan, vaughan, (1998), pickford (2001), brealey, myers (2003), helle j. (2003), willimack, d.k. et al. (2002), pierson (2004). the study aims to examine the survey method: 1. does management in serbian business methods of protection against financial risks, 2. the degree to which individual risks affecting the operations of the company, 3. what kind of tools designed to apply, 4. to what extent the same time rely on the services of banks and other financial institutions, 5. which is the position of leadership in terms of quality of their services? at the same time, investigate the behavior of companies that measures used or not used. risk is the possibility of performing a situation, which may adversely affect the business, which can lead to disorder in achieving company goals. management is responsible and in charge of locating and identifying risks, determining its potential impact on business operations in the future and for effective application of method of financial risk in serbian companies survey sample company 55 governance. different forms of risks that the company faces in its business management can minimize, avoid, and switch to increase the security of your business, but also to accept higher risk and thus generate higher profits for their shareholders. in developed financial and business management, systems can use a set of different financial instruments that ware be implemented through various techniques and methods of risk management. on the concept of risk, especially on the financial risks and financial risks management wrote in his papers and books: leko, mates (1993), van horne (1992), orsag (1997, 2003), koch (1995), peterlin (2003, 2004a, 2004b), vaughan, vaughan, (1998), brealey and myers (2003), mcclave et al. (2005), ertugrul and hegde (2009), chemmanur et al. (2010), eugune et al., (2010), eisdorfer (2010) and others. types of risk that is exposed to a particular company depends on many factors such as type of work that the company does, how the activity, micro and macro environment and the like. an important factor from the point of responsibility for risks and opportunities to take risk management actions and company size where they are, in situations where companies are financially stable and more provides a broad range of possible courses of action. financial risks in the wider sense, refers to such risks drawing money from the company, the risk adverse among the company's financing, refinancing risk, price risk (market risk) and the like. while in the narrow sense means the liquidity risk, currency risk and interest rate risk. risk management is now a necessary part of business processes and is an integral part of the whole business. the process of risk management in the enterprise used to increase the company value. it consists of clearly defined steps, which, if applied in the proper order for enhanced decision support contributing to better understanding of the risks and their potential consequences. risk management deals with the identification of opportunities and possibilities of the company, avoiding the threats that come from around the company and that may adversely affect the financial position of the company. in accordance with changes in economy and finance have been developed and various forms of derivatives where the risks are transferred to the other side. it allows the investor vulnerable to the risk to minimize its exposure and transfer risk to another party that wants to take over and all the consequences that accompany such a decision. commercial derivative financial instruments are typical for developed financial systems such as the u.s., western europe and japan. today it is impossible to imagine a developed economy without securities, money, foreign exchange and even more important and significant financial derivatives. in this paper, it is a pioneering empirical research in the serbian chamber of practice, which will provide suggestions for future studies of similar content. quite apart from the methodological use value results, the author hopes will be achieved practical benefits of specific research findings and that they will promote the instruments of protection from financial risk in the most useful forms. the purpose of the conducted survey research is to capture the state, but also to find out the reasons for not using instruments of protection against financial risks and their lack of use by enterprises. all this would lead to the fact that i can give suggestions for any additional training of financial personnel, and general improvement of efficiency of activity, forms of innovation and modernization of their function and use. research hypotheses are as follows: i. it assumed that there is a correlation between risk management and financial management: the primary activities of the company, ownership, share of small shareholders in the ownership structure, tradition and reputation of the company. ii. hypotheses tested to determine whether there is a connection between the management of financial risks and the following variables: size and development of the total income of the company, the financial situation of the company, firm size, measured by the number of employees. iii. state of quality systems and risk management practices in serbian companies will research through testing whether the assumptions of dependency between the management of financial risks and the following features: the state of quality systems, development of financial controlling functions, the need for additional education on the protection of financial risk in the enterprise. iv. then, starting from the hypothesis that firms whose shares quoted on the stock exchange manage financial risks, the company’s protection from the risk of using the services of various banks and financial institutions are financially successful. financial risk management in the international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 56 enterprise linked to the attitude of enterprises by taking credit or placing their own surplus funds. v. orientation of enterprises into international markets and manages financial risks be examined using the following hypothesis: companies that focused on larger markets actively manage risk, companies that are oriented to international markets, and with greater geographic diversification, actively manage risks. in other words, companies oriented to export or import of a developed financial management. vi. the research function of the modern business managers in companies that manage financial risks will test the hypothesis that management of financial risks depend on: age, gender, education level financial managers. in particular the systematized financial risks which the (serbian) companies are exposed, methods of protection against these risks, and provides an overview summary of conclusions several recent surveys of similar content from the world. after describing the research, methodology follows the most exciting of the survey results and conclusions. the paper used methods of descriptive and inductive statistics. assessment conducted in a number of (post) strata, and the further analysis we used statistical tests, nonparametric and parametric: χ2-test of independence of two features, levine’s test of equality of variance and t-test differences of means of two populations. even when samples are large, statistical program, instead of z-tests conducted ttests. z-test assumes knowledge of key parameters, mean and standard deviation of the population. if that size not known, use the t-test, regardless of the size of the sample. t-test differences between the two populations arithmetic environment ware used when the levene f-test of differences of variances of two populations showed that there is no reason to reject the null hypothesis (where the population of interest investigations has as strong of variance). otherwise, use the welchov t-test differences of means of two populations. see example mcclave et al. (2005), tryfos (1996). the results were analyzed using the software packages spss (statistical package for the social sciences) and microsoft excel. 2. review of similar research in the world a search of secondary sources of information, literature and the internet, found the descriptions of similar studies and studies on the use of instruments of protection against financial risks carried out in other countries. in this chapter, we will give the results of functions and fourselected research. according to survey research conducted by pricewaterhousecoopers on the italian corporate treasuries, in cooperation with the italian association of corporate treasurers 2002nd on a sample of 56 medium and large companies, using a questionnaire with more than 100 questions, 32% surveyed companies exposed to interest rate risk hedging is not used, while 62% adopted only partial hedging. swap and collar interest rates are the most common forms of hedging instruments, i.e. 81% of them speak swaps, and 44% use collars. taking into account transactions with exchange rates, translational and economic exposures, the data indicate that 42% of italian treasury partially used for hedging such risks, while 40% do not use any hedging. measure the main argument of companies that do not use hedging in foreign exchange rates is the fact that such exposure cannot ware. as many as 87% of italian treasury does not accept any position in foreign currencies, regardless of the underlying exposure to exchange rate. futures contracts, options, spot contracts and financing are denominated in foreign currencies are the most used among all instruments for hedging against risks of exchange rate. pierson is for 2004 published a special report on the topic: managing financial risk: the chance and necessity. the survey conducted among 200 financial managers of leading dutch companies and they show that the idea of managing financial risks in the sample-included companies accepted only at the strategic level, it is still necessary to complete the transition to an operational level, with which so far behind in all areas. the survey found that a majority of 63% of the studied companies expected to solve the existing problems within the treasury of the introduction of appropriate modern technologies. improving the quality of information was the most important ranked in second place by nearly 90% of the company, a measurement of the treasury operations in the third place with 40% of the companies. the survey found that treasury management systems used in many cases have very little support back office. others are still administratively stronger, but have a weaker application of method of financial risk in serbian companies survey sample company 57 front office. the availability of information related to financial risk management is unsatisfactory, and the management function of financial risks ignored. in addition, a large canadian survey on a sample of the top 500 companies conducted by kpmg aimed to determine the profile of risk management. the risk have been identified as a potential threat to company goals, and 80% of respondents see the threat as an opportunity for profit. risk management function ware characterized as optimizing risk. most canadian financial manager believes that the role of the existing risk management to identify, manage, minimize and mitigate existing risks, not predict it. from this, it concludes that the existing risk management processes are passive and reactive, not proactive. market risk, strategic, economic and threatening risk clients are also important issues for canadian companies, while the political risk is the least important. similar to other studies presented here, less than half the respondents considered that the organizations in which employees have only a declarative formal risk management policy. frequency of reports on the risks varies from sector to sector. only 45% of executive directors receive reports on key indicators of risk at least once a month while other subjects receive quarterly data and less frequently. even 7% do not receive any information about risk, which considered unfavorable. according to research by george weiss center in 1998, among u.s. non-financial companies that use financial derivatives, 42% said they have increased their use, and 13% of them reporting that they have it out. the use of financial derivatives is much higher in large companies (83%) than small (12%), and is higher in enterprises of primary products (68%) and manufacturers (48%) than in the service industry (42%). there is also the conclusion that the intensity increase in the use of financial derivatives in the service companies increased much faster than in other companies. 3. survey research methodology 3.1. sampling strategy research on the use of instruments of protection against financial risks have been carried out in serbia in october and november 2010 design of the survey on a sample of 101 enterprises (statistical office of the republic of serbia). data collected by telephone interviews and respondents defined as financial managers or competent financial experts. structured questionnaire, in addition to 19 general, contained 10 specific questions with many choices, especially designed for this research. will briefly be described sampling strategy, i.e. methods of sample selection and methods of assessment parameters? the surveys on samples of companies (business surveys) see e.g. cox et al. (1995), as well as some applications in czaja r, blair, j. (1996), groves et al. (1988) and others. the importance of proper use of theory and test samples in practical research see fraser and simkins (2010), david l. olson, desheng dash wu (2008), millett (2004) and so on. to control the quality of data and indicators of statistical surveys, zhang et al., (2009) about established risk management in finance see tarantino and cernauskas (2011). the sampling methods see examples of cochran (1977), kish (1965), barnett (2002), levy and lemeshow (2003), and a survey of alreck and settle (1995), walton (1997) and others. as a framework for selecting, a random sample of companies served a list of fina from 2002. it considered that, although incomplete, list of used fina could serve as an acceptable framework for the selection of medium and large enterprises. the research has two active strata and for medium and large enterprises. for the selection of units within each stratum, we used the random number generator. model stratified sample of companies based on "number of employees" as the sole criterion of stratification, was used to (approximately) equal allocation of sample units to strata, and it ensured a controlled representation of two sizes of companies. thus, in this kind of research on a sample of n = 101 companies included n1 = 51 mid-sized companies (with 51-250 employees), the fraction of choices of f1 = 0.034, and n2 = 50 large companies (with more than 250 employees), the fraction of choices of f2 = 0.123. during the investigation it was found that companies that use hedging instruments only slightly more likely to belong to the group of large enterprises in terms of number of employees (56.1%) while among the companies that do not manage risk more medium-sized enterprises (55%) so to stratification criteria did not show relevant. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 58 χ2-test showed no statistically significant correlation between firm size (measured by number of employees) and the use of hedging instruments (χ2 = 1.200, p-value = 0.273), so that the analysis results shown here dropped by a special appreciation of the planned stratification. only after the completion of the research enterprise, classified by sector, type of ownership, region and other factors. within the (post) strata used is an impartial method of assessment ratios, and percentages, appropriate to a simple random sample. when estimating the proportion of the population of interval m p n  , where m is the number of units that have a particular characteristic and n is the number of units in the population, with a number of impartial appraisers ˆ m p n  , where m is the number of units in the sample that have a particular characteristic, n is the size of a random sample, the level of reliability (1 ) and the reliability coefficient of normal distribution / 2z , the following formula: / 2 / 2 ˆ ˆ ˆ ˆ(1 ) (1 ) ˆ ˆpr p p p p p z p p z n n              = (1 ) (1) standard error estimates of proportion, in the case of lack of proportion p of the population, given the following approximate formula: ˆ ˆ ˆ(1 ) 1p p p f n     (2) if the fraction of choices 0.05 n f n   factor correction for finite population 1 f ignored. for guidance on the precision of a large number of estimates (in the strata and post strata), with different sizes of samples, data is table a, which contains the maximum limits of error which, assuming a normal distribution approximation estimator p̂ , expected with a 95% reliability of parameter estimates for each sample size. table a. limits the maximum error / 2 ˆ ˆ( ( (1 ) / )z p p n  with (1 ) =0.95 sample size 0.5 ( 1.96 ) n  25 30 40 50 60 75 100  20.0%  17.9%  15.5%  14.2%  12.7%  11.5%  10.0% however, in the case of planned strata, estimates the proportion of population p data stratified sample calculated using the following formula: 1 ˆ h h st h h n p p n   , (3) while the corresponding variance estimates calculated using the following expression: 2 1 ˆ ˆ(1 ) var( ) (1 ) 1 h h h st h h h h p p p w f n      , (4) application of method of financial risk in serbian companies survey sample company 59 where ˆ hh h m p n  assessor proportion of strata h, hn the size of strata h, for h =1 ... h, h h n w n  h h h n f n  fraction of the elections and what is worth for any allocation for whatever number of strata, see kish (1965). fraction hf ignored when less than 0.05. 3.2. characteristics of companies in the sample most of the enterprises included in the sample are in belgrade (40.59%) from vojvodina (19.80%), šumadija and western serbia (11.88%), southern serbia (8.91%), eastern serbia (10, 89%) and partially central serbia (7.93%). in this survey are included medium and large serbian companies where the "number of employees" the primary factor for determining the size of the company. according to the classification of the european union, companies can been classified as large companies if they have more than 250 employees and the group of medium-sized if you have more than 50 to more than 250 employees so that the criterion used in the research. the average number of employees in surveyed companies in 2009 was 1027, with a rather large coefficient of variation of 254%. at least the company in the sample had only 51 employees and the largest 19,694 (economic chamber of the republic of serbia). companies classified into different activities according to the classification of economic activities based on the european classification of economic activities nace rev. 1, which is mandatory for all members of the european union. more than half of companies in the sample, 53.47% comes from manufacturing. companies from the construction sector are 14.85% of the sample, retail sale of 11.88%, and while companies from other activities: wholesale trade, hotels and restaurants, transport, storage and communication, real estate, renting and business activities involved in the sample with approximately 19.80% stake in the sample. given the sample size of 101 companies, nace classification is too detailed, and the company wills was be classified into two categories: 1. industrial companies, which include manufacturing, gas, electricity and water and construction; 2. commercial and service businesses, which include wholesale and retail trade, hotels and restaurants, transport, storage and communication, and real estate, renting and business activities. most of the enterprises belong to the group of industrial companies (over half), and a smaller number are trade and service companies (table 1). table 1. companies in the sample by group activities activities number of companies percentages industrial companies the trade and service companies 69 32 68,32 31,68 total 101 100 the study examined the age, or reputation of the company. the oldest old company is 172, and the youngest just 4 years. the average age of 39.14 years, the company is the coefficient of variation of 92%. approximately one half of the companies are under 25 years of age (50 companies 49, 5%), and it is a little over 75 years (the company with a long tradition and great reputation 14, i.e. 13.86%). companies ranging from 26 to 75 years are 37, i.e. 36.64% of the total number of surveyed companies. the number of firms in the sample who registered as joint stock companies is 50 (49.50%), while limited liability companies a little less, i.e. 40 (39.60%). further, the sample is 8.92% of companies that are public companies and 1.98% of companies that belong to the social. of the studied companies that registered as joint stock companies, shares of companies only in a minority of cases listed on the stock exchange (22.22%). for other companies the respondents answered that the shares not quoted on the stock exchange or "not know ", with a high probability that these companies are not even launched its shares on the market. the lowest total income researched the company for about 7 million dins (serbian), and the largest about 118 billion dins. the average international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 60 total income was 6.6 billion dins with a coefficient of variation 99.9%. distribution of companies according to total income, indicating that most companies in a range over 1 billion dins (46.54%). less than 50 million diners have nine companies i.e. 8.91% and between 50 million din to 1 billion, 45 companies, which amounts to 44.55% of the company. in the questionnaire, respondents asked about whether or not increasing the total revenue in their company over the previous year. in the majority of the studied companies (47.54%) total revenue growth, a smaller number of companies (19.65%) fall in total revenue over the previous year while 32.81% responded that the revenue is almost the same as last year. according to the respondents, as much as 80% of the company generally has a good financial situation of the company. in a small number of companies is a very bad financial situation (2%), mostly bad (10.9%) or very good (6.9%). in terms of generating sales, the majority of companies operate in most european markets (39.73%), and many of them operate on the serbian market (35.79%). only a small number of companies have a strong market position in the regional (14.21%) or international (10.27%) market. average share of exports in total revenue of the company is quite large and is as high as 54.95%, but should take into account that the answer to this question, only 64 companies, and that the standard deviation of 30.74% and the coefficient of variation of 56%. other companies that have not responded to this question, most likely have a small share of exports in total revenue, or even do not export, so the real average share of exports should be lower. according to the structure of funding is the largest average share of financing from own resources (79.87%), followed by the financing bank loans (29.96%). great is the average share of funding from other sources (57.67%), but this source of funding has led only six subjects. in assessing the representative ness of the average share of funding from its own funds and bank loans is necessary to take into account the large dispersion of the share of bank loans (the standard deviation of 25.9 and coefficient of variation of 86%), and shares of other sources (standard deviation and coefficient of 46.3 variation of 80%). a significant number of the studied companies use in their business systems for quality management according to iso (57.42%). total 15.90% of companies will soon receive iso certification and the management company has decided to 4% of the studied companies or is considering implementing the 2.88% of companies). almost 20 companies (19.80%) management does not consider the introduction of iso standards. financial controlling is carried out in most of the studied companies, including the nearly three-quarters (there is an organizational unit of 10.95%, controlling by another 41.63% units in the studied companies, controlling external consultant performs at 21.86% of companies in the sample). so, in a small number of companies there is an organizational unit for controlling, while in most of the controlling company by another unit (for example, accounting or finance) or an external consultant or auditor. it should be noted that a quarter of companies do not conduct financial controlling. 3.3. characteristics of respondents focused on collateral from financial risk, and therefore conducted an interview with a person who is best versed in the subject. respondent was in most cases the head of accounting or financial officer. the largest number of respondents was female (71.34%), and males only one-third. the youngest participant is 26 years old and the oldest 62nd the average age was 45.73 years, with a low standard deviation of only 8.24 years and the coefficient of variation of 18%. however, the distribution of respondents by age group shows a different picture, because even though 40.6% of respondents have more than 50 years, and the distribution of respondents by age right asymmetric. the largest number of respondents had completed university, academy or high school (68.4%). much fewer respondents completed high school (15.8%), and only a small number of respondents have a secondary school or high school. in addition, very few respondents have masters or doctoral degree. faculty of economics ware often referred to as an educational institution at which the participants gained a diploma (68.4%), followed by higher school of economics (15.5%). application of method of financial risk in serbian companies survey sample company 61 4. analysis of research results 4.1. impact of financial risk to the business enterprise for research purposes the financial risks classified into four groups: liquidity risk, currency risk, interest rate risk and price risk. respondents was asked to indicate the extent to which certain types of risks affect their business, where they were offered answered negatively affected, somewhat difficult, slightly difficult, and not at all difficult business. liquidity risk in most cases a negative effect on business, because of the liquidity crisis in which the serbian economy is in years. the largest number of companies believe that the currency risk of a negative effect on their business, possibly as a result of the fact that, because of the possibility of holding foreign currency deposits of enterprises, in recent years the rate of less predictable. most enterprises believe that interest rate slightly or somewhat more difficult business, and the same applies to price risk. table 2. structure of companies in the sample under the influence of certain types of risks to the business types of risk impact of risk liquidity risk currency risk interest rate risk price risk not at all difficult business (1) slightly more difficult business (2) somewhat difficult business (3) very negative impact (4) 8% 21% 34% 37% 11% 20% 32% 37% 13% 33% 35% 19% 9% 33% 35% 23% total 100% 100% 100% 100% 4.2. the use of hedging instruments of financial risks services of banks used in the third investigated serbian companies, followed by services of insurance companies, which use dozens of companies. it turned out that these subjects in more than half the cases are satisfied or very satisfied. a small number of respondents were dissatisfied or somewhat satisfied with the services of banks. very few companies use the services of investment funds, financial consultants or other organizations. few users of their services are generally satisfied or very satisfied. instruments protect against financial risks are used in two-fifths of companies (40.6%); much less the company has developed a clear policy of hedging. table 3. using instruments to protect against risk (n = 101) instrument knows use liquidity risk analysis of cash flow investing activities analysis of individual components of assets and liabilities by source of funds analysis of the creditworthiness 30% 28% 42% 27% 25% 23% currency risk forward foreign exchange contracts (currency futures) policy sales prices forward foreign exchange business (currency forward) harmonization of payment (leading and lagging) management of assets and liabilities natural insurance, i.e. linking payments (netting) currency exchange (currency swap) currency options 17% 16% 12% 11% 10% 9% 8% 8% 15% 14% 11% 10% 10% 5% 8% 7% interest rate risk harmonization of maturity and duration interest rate futures contract exchange rate (interest rate swap) interest rate risk management in the money market currency futures work (forward rate agreements) interest rate options the interest cap, collar or bottom 8% 7% 5% 4% 4% 3% 3% 8% 6% 4% 4% 3% 3% 2% international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 62 respondents asked to the selected method of protection against risks to state whether they know and/or used (not analyzed in this paper hedging of price risk). instrument of protection against liquidity risk about one-third of respondents know (30%) and cash flow analysis used investing activities (27%) and analysis of certain parts of assets and liabilities according to sources familiar with the funds 28% of respondents while 25% used. on the other hand, analysis of credit known by as many as 42% of respondents, but it uses only 23%. instrument of protection against currency risk is usually known (17%) and benefits (15%) currency futures contract, a similar situation with the policy of selling price. something less known (12%), benefits (11%) forward foreign exchange business, and the approximate percent of the measured alignment of payment and management of assets and liabilities. in less than 10% of the company are experts familiar with the linking of payments, currency substitution and currency options, and be used by companies of 5-8%. an instrument to protect against interest rate risk was very rarely use in serbian companies. he is best known and most used alignment maturity and duration, but only 8% of the investigated companies. interest rate futures contract known 7%, while it uses 6% of respondents, while other instruments known and used less than 5% of respondents. respondents asked to state the reasons for not using instruments of protection against financial risks and in most cases state that hedging instruments are not well known. very large number of respondents believes that the instruments are not efficient, and other reasons rarely mentioned. on the other hand, almost half of respondents did not want additional training on financial risk, which means that respondents do not use instruments because they poorly known, nor wish to be was trained on them. 4.3. correlation characteristics of the company and use the instruments of financial risk management the research results of methods of managing financial risks analyzed through the correlation of management of financial risks and the following company features: (1) general characteristics of enterprises, (2) the basic characteristics for the classification of companies, (3) monitoring trends in contemporary management, (4) using the services of financial institutions, (5) orientation of enterprises into the international market, (6) functions of financial manager. a company divided into two groups: companies that said to use the instruments of protection against financial risk (41 companies) and companies that said to not use (60 companies). these two groups would compare the company to test the association of selected characteristics of enterprises and the use of hedging instruments. the exception is the testing of hypotheses about the relationship of business enterprise and using the services of financial institutions, when the comparable features of companies that use the services of banks to protect against risk (29 companies) and who do not use bank services (72 companies). 4.3.1. general characteristics of serbian companies that manage financial risks general characteristics of enterprises for the purpose of this study defined as the primary activity of the company, ownership, the proportion of small shareholders in the ownership structure and reputation of the company. examine the hypotheses that examine the connection between the general features of serbian companies and the use of instruments of protection against financial risks, which listed in the introductory part of the paper. companies to a lesser extent, differ according to their activity and use of instruments to protect against financial risk. most companies that use the instruments of protection against financial risks come from the manufacturing industry, construction and retail trade. companies that do not manage financial risks also come up in manufacturing, construction and retail trade. however, this group has many companies from the tourism sector, and real estate, renting and business activities. application of method of financial risk in serbian companies survey sample company 63 table 4. the percentage of companies in the sample by use of instruments of protection against financial risk and by activities (nace classification) basic business enterprises used not used total manufacturing supply of gas, electricity and water construction retail wholesale hotels and restaurants transport, storage and communication real estate, renting and business activities 34,7% 3,9% 6,2% 2,4% 0,6% 5,4% 0,3% 18,8 % 0,9% 10,9% 4,8% 1,4% 2,1% 4,9% 2,7% 53,5% 0,9% 14,8% 11,0% 3,8% 2,7% 10,3% 3% total 53,5% 46,5 % 100% in certain categories of activities were less than 5 businesses, so it will be for the purpose of testing the statistical significance of companies (101 companies) grouped according to sectors in the industrial, commercial and service, as described in part, on the characteristics of companies in the cause. conducted a pearson chi-square test (χ2), which showed no statistically significant correlation between the activities of the company and managing financial risk (chi-square = 0.818, p-value = 0365). table 5. the number of firms in the sample by use of hedging instruments by group activities industries used not used total industrial companies 39 30 69 the trade and service companies 15 17 32 total 54 47 101 table 6. the number of firms in the sample by use of hedging instruments with regard to the form of property form property used not used total joint-stock company (a.d.) 27 23 50 limited liability company (d.o.o.) 16 24 40 public companies (j.p.) and social enterprises (d.p.) 6 5 11 total 49 52 101 companies that use hedging instruments often registered as joint stock companies from companies that do not manage financial risks. conducted a pearson chi-square test showed that there was no statistically significant correlation between the types of ownership of enterprises and financial risks management (chi-square = 1.923, p-value = 0.382). sample included respondents from companies that registered as joint stock companies asked to indicate the structure of ownership with respect to a portion of the state, small shareholders and large shareholders. average share of large shareholders in companies that registered as joint stock companies was 51.23% (25), an average annual share of state from 27.78% (14), and the lowest average share of small shareholders of 20.99% (11). it can be concluded that the largest share owned by a.d. type have large shareholders. table 7. the number of firms in the sample by using hedging instruments with respect to share ownership of small shareholders small shareholders used not used total small shareholders have an ownership stake 3 4 7 small shareholders have no ownership stake 2 2 4 total 5 6 11 the assumption of the study was that companies in the ownership structure of small shareholders are increasingly using methods of protection against the risk of companies that do not. hypothesis was rejected because it was conducted pearson's chi-square test showed that there was no statistically significant correlation between the management of financial risks and the share of small international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 64 shareholders in the ownership structure even at a high theoretical level of significance (chi-square = 0.052, p-value = 0.819). reputation of the company measured by its age since its establishment, which means that the tradition of the company's reputation measures. the average age of companies that use hedging instruments was 41.59 years and average age of companies that do not manage financial risks is 36.79 years. conducted a t-test differences mean age enterprises with regard to the use of hedging instruments and concluded that there was no statistically significant difference between the average age of companies that use hedging instruments and the average age of companies that do not use (t = 0.953, p-value = 0.341). table 8. reputation of the company (average age) of the company with respect to the use of hedging instruments using instruments the average age of companies standard deviation used 41,59 36,27 not used 36,79 35,27 4.3.2. correlation between categories of financial risk management with the basic features for classification of enterprises basic characteristics to classify companies as size and movement of total revenue, the financial situation of the firm and firm size expressed in number of employees. in this section, examine the hypothesis about the connection between categories of financial risk management with the basic features for classification of companies listed in the first part. companies that use-hedging instruments have a much higher average total income (9.671 million dins) from the companies that do not manage financial risks (3.131 million dins). he taken to t test the differences of average total income due to the use of hedging instruments. they conclude that there is a statistically significant difference between the average size of the total income of the company to use instruments of protection from financial risk and the average size of the total income of the company that does not use such instruments to the probability of error of 0.10 (t = 1.789, pvalue = 0.059 ). table 9. the average total income of companies in the sample with respect to the use of hedging instruments using instruments average total income standard deviation standard error mean used 9671152296 1549347902 154163970,3 not used 3131873277 1007845546 100283138,9 in companies that use the instruments of protection against financial risks total revenue in the current year growth of more frequent (34 companies) than is the case with companies who do not manage financial risks (14 companies). on the other hand, companies that do not use hedging instruments often stagnated by the size of total income (12 companies) than is the case with companies that actively manage financial risks (7 companies). pearson chi-square test showed a statistically significant correlation of movement of total revenue and managing financial risks with probability α = 0.01 (chi-square = 9.029, p-value = 0.001). table 10. the number of firms in the sample by use of hedging instruments with regard to the movement of total revenue in the current year compared to previous development of total revenues used not used total growth 34 14 48 remain at the same level of total income 7 12 19 fall 15 19 34 total 56 45 101 however, at first glance there is the big difference as far as the financial situation of enterprises and the use of instruments of protection against financial risk. the financial situation in enterprises that manage the risks in most cases is generally good (82.9%), but similar situations and application of method of financial risk in serbian companies survey sample company 65 with companies that do not use protective measures (78.3%). in other categories, there are also big differences. table 11. the number of firms in the sample by use of hedging instruments with regard to the financial situation of the company the financial situation used not used total very bad 1 1 2 mostly bad 5 6 11 mostly good 43 38 81 very good 3 4 7 total 52 49 101 for testing statistical significance, due to the small number of companies by groups connected to the category of very poor and mostly poor and mostly good categories and very good. conducted pearson's chi-square test showed that the sample did not provide enough arguments to reject the null hypothesis according to which there is no statistically significant correlation between assessed financial situation in the company and managing financial risk (chi-square = 0.17, p-value = 0.680 ). table 12. the number of firms in the sample by use of hedging instruments with regard to the financial situation of the company fewer categories the financial situation used not used total very or mostly bad 6 7 13 very or mostly good 46 42 88 total 52 49 101 the average number of employees is much higher in the studied companies that use hedging instruments (1,277 workers) in relation to companies that do not manage financial risks (945 employees). conducted a t-test differences of the average number of employees with respect to the use of hedging instruments, and it was concluded that there was no statistically significant difference between the average number of employees in firms that use hedging instruments and the average number of employees in companies who do not (t = 0.89, p-value = 0.187). table 13. the average number of employees in the sample with respect to the use of instruments of protection from financial risk using instruments the average number of employees standard deviation standard error mean used 1277 219,49 21,84 not used 945 261,33 26,00 companies that use hedging instruments often fall into the group of large enterprises in terms of number of employees (56.1%), while among the companies that do not manage risk more mediumsized enterprises (55%). according to pearson chi square test there was no statistically significant correlation between firm size (measured by number of employees) and the use of hedging instruments (chi-square = 0.8, p-value = 0.371). table 14. the number of firms in the sample by use of hedging instruments with regard to the size of the company company size used not used total medium enterprise (51-250 employees) 23 28 51 large enterprise (more 250 employees) 27 23 50 total 50 51 101 4.3.3. with contemporary management trends and management practices in serbian companies modern management trends specified for the purposes of this study as the use of quality systems, development of financial controlling and the need for additional training in the company. models of excellence (business excellence) rest on some of the quality system: iso standards, "six international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 66 sigma" approach, total quality management, or tqm, or the japanese system of business improvement methodology for "20 keys" or the like. the first part set out the hypotheses about the connection between modern management trends and risk management practices, which will now been tested. companies that use hedging instruments more frequently (63.3%) are certified by the iso norm (for any of the standards: iso 9001, iso 9002, iso 9003 or iso 14000 and it was in the company or at least in some parts of) compared to companies that do not manage financial risks (52.6%). companies that manage financial risks are also more active and positively oriented towards the quality system (whether the company is in the process of obtaining iso certification, or if the only decision taken management to be in to go, or at least thinking about the management quality system). conversely, companies that do not use hedging instruments also often do not even consider the introduction of iso standards. table 15. the number of firms in the sample by use of hedging instruments with respect to the state system of quality quality system used not used total the company has iso 32 26 58 the company is in the process of obtaining iso 10 6 16 management has just decided to introduce iso 1 3 4 management is considering introducing iso 1 2 3 management does not think about iso 8 12 20 total 52 49 101 for testing statistical significance, due to the small number of companies by groups, are connected to related categories of table 15, as shown in table 16 pearson's chi-square test showed that there was no statistically significant correlation between the state system of quality management and financial risk (chi-square = 1.376, p-value = 0.502). table 16. the number of firms in the sample by use of hedging instruments with respect to the state system of quality (combined categories) quality system used not used total the company has iso 32 26 58 the company is in the process of obtaining iso 12 11 23 management does not think about iso 8 12 20 total 52 49 101 companies that use hedging instruments often implemented financial controlling in any organizational form. for testing companies merged into two categories: companies that have the financial controlling and companies that do not. table 17. the number of firms in the sample by use of hedging instruments with regard to the development of the functions of financial controlling performance of financial controlling used not used total there is an organizational unit for controlling 6 5 11 controlling by another unit 24 18 42 external consultant / auditor 12 10 22 does not give effect to the financial controlling 8 18 26 total 50 51 101 table 18. the number of firms in the sample by use of hedging instruments with regard to controlling the function of financial development fewer categories performance of financial controlling used not used total implements the financial controlling 42 33 75 does not give effect to the financial controlling 8 18 26 total 50 51 101 application of method of financial risk in serbian companies survey sample company 67 conducted a pearson chi-square test showed a statistically significant correlation implementation of financial controlling and managing financial risks with probability of error of 0.05 (chi-square = 4.917, p-value = 0.026). interestingly, the studied companies that already use the instruments of protection against financial risks often express the need for additional training in this area. probably this is the case that the managers of these companies are aware of the dangers that their company has the financial risks, and measures of partial knowledge is not enough, and these are additionally want to learn. however, the difference between companies that use and that do not use hedging instruments is not great. pearson's chi-square test confirmed that there was no statistically significant correlation between the management of financial risks and the need for additional education about them (chi-square = 0.256, p-value = 0.612). table 19. the number of firms in the sample by using hedging instruments and the need for additional training on financial risk the need for education used not used total there is a need for additional education 25 22 47 there is no need for additional education 26 28 54 total 51 50 101 table 20. the number of firms in the sample by using hedging instruments is considering listing shares on the stock exchange listing of shares used not used total the shares are quoted on the stock exchange 12 10 22 shares are not quoted on the stock exchange 31 48 79 total 43 58 101 4.3.4. using the services of financial institutions by the entrepreneurs and the connection to the management of financial risks protection against financial risks is much more effective if they use the services of financial institutions. there are three hypotheses about the connection using the services of financial institutions by the entrepreneurs and management of financial risks, which will now, been tested. it assumed that the average total income of companies who use the services of financial institutions for protection from the risk of higher than companies that do not use such services. the research confirmed this hypothesis. he taken to t test the differences of average total income with respect to the use of services of financial institutions. it was concluded that there was no statistically significant difference between the average total income of the company who use the services of financial institutions and the average total income of the company that these services are not used with probability α = 0.05 (t = 1.26, pvalue = 0192). table 21. the average total income of companies in the sample with respect to the use of the services of different banks and financial institutions use of services mean standard deviation standard error mean do not use the services of financial institutions 15957074967 4902005589 487761750,2 use the services of financial institutions 7183924800 4947081524 492246917,8 companies that use the services of financial institutions to assess patients more likely to have revenue growth in the current year compared to last, less their incomes remain at the same level or fall, but it is the case with companies who do not use the services of financial institutions. pearson's chiinternational journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 68 square test showed a statistically significant correlation between growth in total income and using the services of financial institutions with probability α = 0.01 (chi-square = 11.304, p-value = 0.0035). table 22. the number of firms in the sample by using the services of financial institutions and assess the growth of total income (the previous 2008.) development of total revenues do not use services use services total growth 13 35 48 remain at the same level 20 13 33 fall 12 8 20 total 45 56 101 the financial situation of the researched companies that use the services of financial institutions is somewhat better than the situation of companies that do not use such services. conducted a pearson chi-square test showed that there is no statistical relationship between the financial situation of enterprises and management of financial risks (chi-square = 4.199, p-value = 0.240). table 23. the number of firms in the sample according to the financial situation of the company is considering using the services of financial institutions the financial situation do not use services use services total very bad 2 4 6 mostly bad 8 3 11 mostly good 32 43 75 very good 5 4 9 total 47 54 101 the average share of bank loans in the structure of financing of the company is somewhat higher in the studied companies that manage financial risks. he taken to t test the differences of average share of loans with respect to the use of instruments to protect against risks. it was concluded that there was no statistically significant difference between the average share of banks in the structure of financing companies that use hedging instruments and the average share of banks in the structure of financing companies who do not (t = 0.527, p-value = 0.600). table 24. the average share of bank loans in the structure of financing sources in the enterprise using instruments average share of loan standard deviation standard error mean used 32,16 23,53 4,71 not used 28,74 27,32 4,07 listing of shares on the stock market is more common in those companies in the sample that use hedging instruments. however, this difference is not great. conducted a pearson chi-square test showed that there was no statistically significant correlation between the types of ownership of enterprises and financial risks management (chi-square = 1.649, p-value = 0.199). 4.3.5. orientation of enterprises into the international market and financial risk management investigated companies operating in world markets more exposed to financial risks of companies that are strictly oriented to the domestic market. posted two hypotheses described in the introduction, which will now been tested. there is a big difference in the use of hedging instruments with respect to market size. however, companies that focused on regional, european and international market are more interested in the protection against financial risk. conducted a pearson chi-square test showed that there was no statistically significant correlation between market size and management of financial risks (chi-square = 7.704, p-value = 0.052). application of method of financial risk in serbian companies survey sample company 69 table 25. the number of firms in the sample by use of hedging instruments with regard to the size of the market market used not used total serbian 10 26 36 regional 9 5 14 european 21 19 40 internationally 6 5 11 total 46 55 101 average share of exports in total revenue was slightly higher in the studied companies that manage financial risks. he taken to t test the differences of average share of exports with respect to the use of instruments to protect against risks. they conclude that there is no statistically significant difference between the average share of exports in total revenue of companies that use hedging instruments and the average share of exports in total revenue of companies that do not use such instruments (t = 0.476, p-value = 0.636). table 26. average share of exports in total revenue due to the use of hedging instruments using instruments the average share of exports standard deviation standard error mean used 53,89 31,52 5,96 not used 50,04 32,58 5,43 4.4. correlation characteristics of managers and the use of instruments of protection against financial risks characteristics of managers could influence the use of hedging instruments. for example, one might assume that younger and more educated managers are more likely to use hedging instruments. hypotheses have been set in the introduction that will be test by comparing the characteristics of managers. equal the distribution of managers by gender and use of instruments of protection against financial risk. pearson's chi-square test confirmed that there was no statistically significant relationships between the gender managers and risk management (chi-square = 0.835, p-value = 0.361). the same is true of research results and for the age managers (chi-square = 0.367, p-value = 0.985). table 27. the percentage of companies in the sample by use of hedging instruments with regard to gender manager gender used not used total male 31,7% 26,7% 28% female 68,3% 73% 71,3% total 100% 100% 100% table 28. the percentage of companies in the sample by use of instruments of protection against risk with regard to the age managers age manager used not used total do 35 years 12,5% 13,3% 13,0% 35-40 years 17,5% 13,3% 15,0% 40-45 years 20,0% 20,0% 20,0% 45-50 years 10,0% 11,7% 11,0% more than 50 years 40,0% 41,7% 40,0% total 100% 100% 100% conclusion of the year confirmed by calculating the average ages of both groups were very similar. conducted a t-test differences in average age of managers with respect to the use of instruments to hedge and came to the conclusion that there was no statistically significant difference between the average age of managers who use hedging instruments and the average age of managers who do not use (t = 0.474, p-value = 0.637). international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 70 table 29. the average manager with respect to the use of hedging instruments using the instrument the average age of managers standard deviation standard error mean used 45,25 7,54 1,19 not used 46,05 8,72 1,13 education level managers could be crucial for the use of hedging instruments. it can be seen from table 30 that the managers who have completed college, academy or college, and managers with a master degree and doctorate significantly more likely to use hedging instruments. table 30. number of managers in the sample by use of hedging instruments with regard to their education education level used not used total middle school 243 598 841 gymnasium 420 378 798 high school 1287 1960 3247 faculty, academy 28763 14837 43600 m phil and phd 112 50 162 total 30825 17823 48648 for the purposes of testing this hypothesis, managers grouped in two sets with regard to education: (1) managers who have education below the college and (2) managers who have at least a university degree. pearson's chi-square test showed a statistically significant correlation with probability α = 0.05 between manager's education and the use of hedging instruments (chi-square = 5.09, p-value = 0.024). table 31. managers with regard to education and financial risk management education level used not used total high school or less education 6,33% 16,47% 10,04% faculty and higher education 93,67% 83,53% 89,96% total 100% 100% 100% 4.5. analysis of the impact of financial risk to the business enterprises of different characteristics analysis of the impact of different types of risks for companies by region, industry, company size and market determines which businesses are most and least vulnerable to liquidity risk, foreign exchange, interest rate and price risk. respondents asked to assess the extent to which individual risks affecting the operations of their companies. results were as follows: 1. liquidity risk are the most vulnerable companies in belgrade and vojvodina, mid-sized companies, companies from the manufacturing and construction industries and enterprises that operate in most european and international markets. 2. currency risk are the most vulnerable companies from vojvodina and part of central serbia, a medium-sized enterprises, enterprises in manufacturing and retail trade and hotels and restaurants and businesses that operate in the most international and regional markets. 3. interest rate risk are the most vulnerable companies from vojvodina and šumadija and western serbia, a medium-sized enterprises, enterprises in manufacturing and wholesale trade and most companies that operate internationally. 4. companies operating in southern and eastern serbia most exposed to price risk. these include companies in manufacturing and wholesale trade and most companies that operate in the domestic and international markets. medium and large companies alike are at risk from the impact of price risk. 5. prospects and recommendations the main result of this research is that serbian companies do not have a clear policy of active risk management. however, similar studies conducted worldwide have shown that the same is true for international companies, even those leading. according to the results here presented research, serbian companies recommended the following: application of method of financial risk in serbian companies survey sample company 71 1. within the company should conduct a thorough education of their financial staff that is not familiar with the issues of financial risk, or hedging instruments to been used. for efficient risk management are necessary and knowledge of the broader market situation, i.e. the interdependence of movement of market factors and elements of building the competitiveness of businesses and the impact of financial market institutions, as well as knowledge of specific hedging instruments. training should been conducted with care providers, i.e. banks, financial institutions and consultants, and with the help of experts, scientific and educational and scientific institutions. 2. it is useful to create a system of continuous management of their own situation and perspective of risk exposure as well as updates on market protection services, and all with the help of new technologies. such a system should inter alias contain reports on the effectiveness of action already taken to protect against some of its forms. 3. entry into the european union implies high european standards in one of the systems business excellence (e.g. according to iso). companies should introduce standards of transparency and oversight of management of financial risks of assisted new information technologies. such standards should been introduced as part of process control quality system (e.g., total quality management or tqm). institutions that offer services for protection against financial risks, including major banks, can accept the following warning conclusions of this study: 1. instruments of protection against financial risks using only 40% of the investigated companies, and the same proportion of companies want additional training on financial risks. only about 20% of companies have developed policies to offset the risk, and therefore need the help of appropriate hedging instruments manufacturers and financial consultants in introducing and developing the policy. 2. the main reason why companies do not use methods of risk protection is insufficient information on possibilities, i.e., methods, instruments, measures, mechanisms, and protection of existing services, and the perception of respondents that there are tools that offered under an effective and too expensive. 3. protection services of the financial risk should be transparent to clients and staff of banks and financial institutions should be accessible, where it is important to their education and kindness. therefore service providers, especially banks that serve the largest number of clients who are mostly satisfied, you should work on the system information and education, and practical use of such services. 4. research has shown that there is an association of use of such protection against financial risk and a number of characteristics of companies, national origin, width and other markets. it would be useful to banks and financial institutions and consultants to develop intensive care services, maybe even a particular set specific situations, and they offer a very "vulnerable" to corporate clients. 6. conclusion research objectives were to determine the extent to which serbian medium and large companies use hedging instruments of financial risk and whether there is a difference between the characteristics of companies that these instruments are used or not. the results of this study are not directly or fully comparable with the research, which several years ago on the topic of financial risk carried out in the world, due to differences in range, both in terms of the set of survey questions, as well as the size and structure of the sample companies. but this common and international studies that examined the financial managers are aware of risk in business, especially financial risk, that politics is seldom clearly defined and often only formally established and reactive and less proactive. certain functions and risk management are mostly centralized. it is not yet fully developed awareness of the real risk and its control, the most systematically developed and standardized features "financial risk managers" are absent, and the financial services sector is the only exception. according to the poll here shown, can been summarized that the instruments of protection against financial risks using two-fifths of the companies studied, and the same number of companies want additional training on this. only one in five companies included in the sample has developed a policy of hedging. companies often use the services of banks to protect international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.54-73 72 against financial risk; with those services in more than half, the cases are satisfied or very satisfied. managers studied most companies fear the risks of liquidity and currency risks, interest rate risk, while the least concerned. the paper examines in detail the companies that based on various characteristics (size, industry, region and market) most at risk of certain types of financial risk. respondents spontaneously mentioned that using these hedging instruments: promissory notes, bills of exchange, foreign exchange clauses, guarantees, and insurance quote. of instruments for the protection against liquidity risk, mostly used in cash flow analysis of investment activity and analyzes the individual components of assets and liabilities according to sources. of the instruments to protect against currency, risk mostly used currency forward contract (eng. currency futures), the policy of prices and foreign exchange futures transaction (eng. currency forward). of the instruments to protect against interest rate risk, the most used alignment maturity and duration, and interest rate futures contract (eng. interest rate futures). the reasons why companies do not use hedging instruments are insufficient knowledge about risk, and the perception of respondents that they are not sufficiently effective and too expensive. the contribution of this research is to examine the hypothesis that companies that use hedging instruments differ in their characteristics of companies that do not. we summarize only the main results of the research. it turned out that the studied companies that use hedging instruments often registered as joint stock companies, have much higher average income and income from these enterprises often increases over the previous year. companies with more people being employed more frequently used hedging instruments, the same goes for companies that apply controlling and quality systems in their operations. a special problem is the use of banking services to offset the risk. finally yet importantly, the managers of enterprises that use hedging instruments have a higher level of education. based on these results we can conclude that the use of instruments of protection against financial risks helps successful companies. the only systematic information continuously and proactively monitoring 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(15.11.2004) tarantino, a., cernauskas, d., 2011, essentials of risk management in finance (essentials series), john wiley&sons, inc., hoboken, new jersey. tryfos, p., 1996, sampling methods for applied research, wiley, new york. van horne, j. c., 1992, financial management and policy, mate, zagreb. vaughan, e., vaughan, t., 1998, risks and risk management, business advisor 11-12, zagreb. willimack, d.k., nichols, e., sudman, s., 2002, understanding unit and item no response in business surveys, survey no response, (groves, m., dillman, d.a., eltinge, j.l., little, r.j.a.), wiley, new york, pp. 213-228. zhang, f., tian, y., tony s. wirjanto, 2009, empirical tests of the float-adjusted return model, finance research letters, 6(4), 219-229. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(2), 562-572. international journal of economics and financial issues | vol 6 • issue 2 • 2016562 cash flow sensitivity of cash: a cross country analysis syed manzur quader1*, mohammed nayeem abdullah2 1independent business school, chittagong independent university, 16, jamal khan, chittagong, bangladesh, 2independent business school, chittagong independent university, 16, jamal khan, chittagong, bangladesh. *email: manzur@ciu.edu.bd abstract using a large panel of 5086 firms from 7 european countries, namely belgium, france, germany, italy, netherland, sweden and uk over the period of 1981 to 2010, we made attempt to see the effect of financial constraints on international corporate policies based on their liquidity demand. controlling for firm size, investment opportunities and alternative sources and competing uses of funds, a firm’s decision to change its cash holdings is found to be positively and significantly related with internal cash flows. our results further reveal that constrained firms like to save relatively more cash out of their cash inflows, whereas the unconstrained firms do not maintain any such significant cash hoarding behavior. the observed relationships prevail for the whole sample, within each countries and remain consistent across different estimation procedures and alternative financial constraint criteria. our results thus point to the fact that average firms in our sample face constrained access to external finance due to financially imperfect and incomplete markets. keywords: asymmetric information, financial constraints, cash hoarding jel classifications: c26, d92, g14, l21 1. introduction two significant areas of study in corporate finance are the effects of financial constraints, and the financial management process of firms. these two issues, although often studied separately, are fundamentally linked (almeida et al., 2004). the investment decision at the firm level is influenced by a mixture of internal and external factors stein (2003). firms whose investment is limited because of a lack of internal resources and a lack of access to external financing are referred to as financially constrained (fc) (cleary, 1999; kaplan and zingales, 2000). despite the link between financial constraints and corporate liquidity demand, the literature that examines the effects of financial constraints on firm behavior traditionally focuses on corporate investment demand (hubbard and palia, 1999). this approach focuses on comparing the empirical sensitivity of investment to cash flow across groups of firms sorted by various proxies of financial constraints, but has been criticized on a number of grounds by recent research (schiantarelli, 1996; hubbard, 1998; lensink et al., 2001; bond and van reenen, 2007; quader, 2013). the forcefulness of the suggestion proposed by fazzari et al., (1988) has been challenged on a hypothetical foundation by kaplan and zingales (1997), cleary et al. (2007), and almeida, campello, and weisbach (2002), while the robustness of cross-sectional outline presented in their empirical work has been questioned by (kaplan and zingales, 1997), cleary (1999) and erickson and whited (2000). the cross-sectional patterns reported by fazzari et al. (1988) can be consistent with a model with no financing frictions which casts doubt on the very meaning of the empirical cash flow sensitivities of investment reported in the literature. instead, the use of cash flow sensitivities of cash which is based on the premise that a firm’s propensity to save cash out of cash inflows should be related to the financial constraint it faces can avoid some of the problems associated with the investment-cash flow literature (almeida et al., 2004) and hence, is claimed to be a more powerful and convincing measure of the existence of financial constraints. since the onset of the financial and the sovereign debt crisis, investment in the euro area countries has been reduced and the crisis has not yet recovered (giavazzi and spaventa, 2010) and significant attention has been devoted to macroeconomic imbalances (gros, 2012). however, research on firms’ financing policy to manage internal and external capital has not received quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016 563 its deserved attention in the academic debates and in the policy management of the euro area. prior research involving this issue was largely focused on us corporations through the 1970s and 1980s, but started to appear on other countries by the early 1990s. audretsch and elston (2002) find higher cash flow investment sensitivity of liquidity constrained german firms during 1970-1986, while fohlin (1998) confirms such sensitivity for german firms during the 1903-1913 time period. in a comparative study between firms in belgium, france, germany and the uk, bond et al. (2003) present evidence that the investment of uk firms is comparatively more sensitive to cash flow fluctuations. on the other hand, aggarwal and zong (2006) show most firms in four largest industrialized countries, i.e., us, uk, japan and germany face constrained access to external finance due to financially imperfect and incomplete markets as a result of which investment levels are significantly positively influenced by the levels of internal cash flows. the strength of this relationship is also found to increase with the degree of financial constraints faced by these firms. while these studies show that fc firms have higher investmentcash flow sensitivities, our study attempts to detect financial constraints by comparing the cross-sectional variations in cash flow sensitivity of cash at the firm level which is novel. for this we use an unbalanced panel of 5086 firms from 7 european countries, namely belgium, france, germany, italy, netherland, sweden and uk over the period of 1981 to 2010. we believe that our study adds significant contribution to the contemporary literature by improving our understanding of international liquidity management; the interrelation between financial constraints and cash accumulation policies of non-us firms to be specific. our different model specifications strive to confront the challenges in examining the effects of capital market imperfections by considering the following: (i) whether firms show a positive tendency to save cash out of cash inflows; (ii) whether fc and unconstrained firms show different propensity to save cash (iii) whether there is any international differences between constrained and unconstrained firms in terms of their cash hoarding behavior. after controlling for firm size, investment opportunities and alternative sources and competing uses of funds, we find that a firm’s decision to change its cash holdings is positively and significantly related with internal cash flows. we further find that constrained firms like to save relatively more cash out of their cash inflows, whereas the unconstrained firms do not maintain any such significant cash hoarding behavior when we split our overall sample into fc and unconstrained categories using a financial constraint index from multiple discriminant analysis. we find such results prevail for the whole sample, within each country and consistent across different estimation procedures and alternative financial constraint criteria. the rest of the paper is structured into different sections as follows. section 2 is a brief literature survey, section 3 describes the empirical methodology, section 4 introduces the data, variable definitions and descriptive statistics, section 5 presents the empirical results along with robustness analysis and finally section 6 concludes the paper. 2. literature review carpenter and guariglia (2008) stated that the relationship between investment and cash flow has had a turbulent history. it was widely studied during the 1950s and the 1960s (hirshleifer, 1958; meyer and kuh, 1966; kuh, 1963). yet cash flow subsequently all but disappeared from the investment literature until its revival in the 1980s following the development of models of asymmetric information and an empirical breakthrough by fazzari et al. (1988). they estimated investment equations as a function of tobin’s q and cash flow using firm-level data. they found that cash flow tends to have a bigger effect on the investment of firms more likely to face financial constraints and interpreted this as evidence for the existence of information driven capital market imperfections. the free cash flow theory of jensen (1986) suggests that managers have an incentive to build up cash to increase the amount of assets under their control and to gain discretionary power over the investment decision of the firm. market-oriented financial systems where arm’s length lenders offer funds through commercial paper, corporate bond and equity markets, are more likely to show greater sensitivity to cash flow. relationship-oriented systems are likely to foster closer and more transparent arrangements that allow them to exercise greater scrutiny over borrowers, and as a result investors will be less sensitive to internal sources of funds. an excellent discussion of the principal differences between the two structures is given in rajan and zingales (2003). the evidence in allen and gale (2000) indicates that germany and the uk are good examples of the polar cases on the wide spectrum of financial systems in europe. in the uk, market capitalization as a percentage of gross domestic product (gdp) is some three times that of germany and corporate control is exercised by the financial markets rather than banks, in contrast to germany. nevertheless bond markets are much less well developed in germany and the uk versus the us. although firms in both countries rely heavily on internal funds, and the development of market finance has been significant in the period 1995-2004 even in germany (rajan and zingales, 2003), the impact of these systems could affect the sensitivity of investment to cash flow. analysis of these economies to internal funds at the margin is expected to show investment will be more sensitive to internal funds (cash flow) for countries where the financial system is relatively market-based, and vice versa, if the financial system is the driving force behind the importance of cash flow. current studies try to gain a better understanding by focusing on the causes of cash flow sensitivity (pawlina and renneboog, 2005; degryse and de jong, 2006). in particular, the asymmetric information problem of myers and majluf (1984) suggests that firms may suffer from under investment when the acquisition of external financing is costly. in that case, investment outlays will depend on the availability of internally generated resources, resulting in positive investment-cash flow sensitivity. not only extra equity may become excessively costly, but information asymmetry may also hamper firms in obtaining additional debt (stiglitz and weiss, 1981; greenwald et al., 1984). watson and wilson (2002) show that a financial pecking order among firms will be most apparent when information asymmetry between insiders quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016564 and outsiders is greater, leading to higher costs associated with external financing. as this problem increases with investment opportunities, it is typically argued that cash flow sensitivity should be higher for firms with high investment opportunities fazzari et al. (1988). next to asymmetric information, firms are also affected by the agency problem of free cash flow. at least in the case of listed firms, where management and ownership tends to be separated, over investment of free cash flow (jensen, 1986) can cause a positive relationship between cash flow and investment. this problem is likely worse for firms with little investment opportunities. almeida et al. (2004) empirically estimate the cash flow sensitivity of cash using a large sample of us manufacturing firms over the 1971-2000 period and find robust support for their theory. they hypothesize that constrained firms should have a positive cash flow sensitivity of cash, while unconstrained firms’ cash savings should not be systematically related to cash flows. lin (2007) examines the role of operating cash flow in firm cash policies using an unbalanced panel of 988 taiwanese firms. the main findings are as follows: (i) both fc and unconstrained firms display positive cash flow sensitivity of cash, (ii) the estimated cash flow sensitivity of cash for fc firms is significantly higher than that of fc firms in the usa, (iii) firms that have ever issued public debt save more cash out of their operating cash flow than firms that have never issued public debt, and (iv) omitting net debt and equity issuances from the cash regression produces downwardbiased cash-cash flow sensitivity estimates. marina and niehausb (2011) also find that fc firms increase their cash holdings as their cash flow increases, but unconstrained firms do not consistently show similar behavior. they also find that higher cash flows, on average, increase the likelihood of hedging for fc firms. d’espallier et al., (2008) evaluate two models commonly used for measuring financial constraints in their ability to discriminate between constrained and unconstrained firms. their findings suggest the superiority of the cash flow sensitivity of investment (cfsi) model over the communication for social change model for a sample of manufacturing smes in belgium. riddick and whited (2009) demonstrate that there is a negative relation between the cash flow fluctuation and the amount of the held cash. in other words, when a company’s cash flow is positive, cash holding variation is negative. on the other hand, if a company faces a negative cash flow, the variations in the retained cash will be positive. bao et al., (2012) also affirm the above conclusion. in addition, they contend that the cash flow sensitivity of cash is asymmetric to cash flow. all the results support their hypotheses that firms have different levels of responses to their cash holdings when facing positive and negative cash flows. akguc and choi (2013) highlight that public firms hold more cash than private firms in euro-zone countries than in non-euro countries, indicating greater precautionary demand for cash by public firms in euro countries. they also find that firms in countries with better shareholder protection hold less cash. this paper follows the approach of almeida et al. (2004), but uses a large panel of 5086 firms from 7 european countries, namely belgium, france, germany, italy, netherland, sweden and uk over the period of 1981-2010 and strives to find whether there is any significant inter and intra country difference in the cash hoarding behavior of the firms facing varying degree of financial constraints in our sample. 3. methodology due to the emerging criticism about the ability of the cfsi to capture financial constraints on both empirical and theoretical grounds, almeida et al., (2004) provided cash flow sensitivity of cash as an alternative measure to capture the same. this new measure predicts the change in cash and marketable securities out of the amount of cash flow generated by firms. according to their suggestions, there should be a strong positive relation between cash flow and changes in cash holdings for fc firms. as these firms cannot rely on external financing source, they prefer to hoard cash in order to avail positive investment opportunities. in contrast, unconstrained firms should not display any such relation. to test this argument using our cross country panel data, we will use the following model specification relating changes in cash holdings to cash flows, corporate investments, size and some additional explanatory variables such as working capital and short-term debt that control for competing uses of funds based upon the specification of almeida et al. (2004). δcash holdingsit = β0 + β1 cashflowit + β2 tobin’s qit + β3 sizeit + β4 expendituresit + β5 δnwcit + β6 δshort debtit + fi + τt + vit (1) here, the dependent variable is changes in the holdings of cash and marketable securities to total assets and our concern lies on its response to a shock to cash flows, captured by β1 in the above equation which is predicted to be higher for fc firms. we also control for size because of standard arguments of economies of scale in cash management. as the theory suggests that a constrained firm’s cash policy should be influenced by the attractiveness of future investment opportunities, we include tobin’s q as proxy for firms’ future growth opportunities. the expected sign of its coefficient is positive for constrained firms and unsigned for unconstrained firms. a firm’s decision to change its cash holdings may also depend on a number of sources and uses of funds, therefore, we include capital expenditures (expenditures), changes in non-cash net working capital (nwc), and changes in short-term debt (shortdebt). all of these three additional variables are scaled by assets. as firms can draw down on cash reserves in a given year in order to pay for investments, we expect β4 to be negative. we control for the change in nwc and changes in short term debt as these can be substitutes for or may compete for the available pool of resources (fazzari and petersen, 1993). as testing the implications of our model requires separating firms according to the extent of the financing frictions they face, we need to partition our sample using a plausible proxy for financial constraint status and estimate the above model separately on the sub-samples to distinguish the cash hoarding pattern of the fc and unconstrained firms. in this study, we employ multiple discriminant analysis to classify firms into groups according to a beginning-ofperiod financial constraint index zfc following aggarwal and zong quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016 565 (2006). they followed cleary(1999)’s approach of computing such index, but used a different set of variables in the discriminant function to overcome some limitations of cleary’s procedure. the computed financial constraint index is similar to altman’s z factor for predicting bankruptcy (altman, 1968; altman et al., 1977). the first step in discriminant analysis is to establish two or more mutually exclusive groups according to some explicit group classification and we use fixed charge coverage ratio (fccr) as the grouping criteria. ten percent of top and bottom companies are used in this paper to identify the extreme sets of companies with the highest and the lowest levels of financial constraints. coefficient values for each independent variable of the following equation are estimated so that the calculated zfc values best distinguish firms between the two groups. zfc = β1 cr + β2 cash holdings + β3 opm + β4 sales growth + β5 dr (2) where current asset is the current ratio (cr), cash holdings is cash and short term investment scaled by net fixed assets, operating profit margin (opm) is the net income margin, dr is debt ratio (long-term debt/total assets, sales growth is change in net sales in 2 consecutive years (net sales at time t-net sales at time t-1)/ net sales at time t-1). zfc value is calculated for each year for all firms to reflect that the variables used in the calculation are likely to be different in each period. firms are then sorted into fc (fc), partially fc (pfc), and non-fc (nfc) firms using the average z scores of firms for the 3-year period as financial constraint levels are likely to be consistent with the longer term policies of companies and tend not to change drastically in the short. the bottom 25% of the companies ranked by their average zfc values are categorized as fc, the middle 50% as pfc, and the top 25% as nfc. in all our estimations of equation 1, we need to account for firmfixed effects in order to control for possible simultaneity biases stemming from unobserved individual heterogeneity. besides, we must account for the endogeneity of financial and investment decisions. therefore, we prefer to use a fixed effect instrumental variables (feiv) approach. our set of instruments includes lags of the level of fixed capital (net plant, property, and investment to total assets), lagged nwc, and lagged short-term debt as well as fixed time effects following the rationale proposed by fazzari and petersen (1993) and almeida et al. (2004). 4. data we have collected data from the worldscope database currently owned by thomson reuters which describes the database as the financial industry’s premier resource of most comprehensive and accurate financial data on public companies resided outside of the united states of america1. we excluded all banks, life and non-life insurance, real estate, general financial, equity and non-equity investment instrument companies according to the 1 the data definitions and other information about the contents of the worldscope database are contained in http://extranet.datastream. com/data/worldscope/index.htm. ftse/dow jones industrial classification benchmark codes which are adopted by the database as its standard global classification tool codes as they follow different accounting practices. we also dropped all the observations with unexpected signs, like negative revenue, assets or investment and all the other observations with missing values for the required variables. then we deleted all the firms with <3 consecutive years of observations for any of the required variables. some firms operating for relatively longer period still have gaps in their panels, but have multiple three consecutive observations in them. finally, the dataset we use in our estimations is an unbalanced panel of 5086 firms from thirty five different sectors in seven european countries, namely united kingdom, germany, france, belgium, netherland, sweden and italy with a minimum of three to a maximum of 30 consecutive years of observations and a total of 53938 firm years. as we allow both entry and exit of firms over time, our estimations using this unbalanced panel data are expected to be free from any potential selection and survivor bias. all regression variables are winsored at the 1% and 99% level to omit extreme outliers. the latter rule is expected to eliminate observations reflecting very large mergers, extraordinary firm shocks, coding or severe measurement errors and is applied as a common procedure in the contemporary finance literature, e.g. hovakimian and titman (2006). table 1 reports means and distributional information for all the regression variables we use in this paper. table 1 gives mean and distributional information for all the regression variables for which data is collected from the worldscope global database for the 5086 european firms over the period 1981 to 2010. all financial variables are deflated with a gdp deflator and all regression variables are winsored at the 1% and 99% level to get rid of the extreme outliers. tobin’s q is calculated as the ratio of market value of assets to the book value of assets. market value is estimated as book value of total assets minus book value of equity plus market capitalization and book value of total asset is simply the value of total assets. the natural logarithm of total sales and the natural logarithm of the number of years a firm appears in the database are used as proxies for firm size and firm age respectively. financial slack (fslack) is calculated as ratio of cash and short term investment to total assets; cash flow as the ratio of funds from operation to total assets; fixed charge (fccr) as the ratio of interest expense on debt and other fixed charges to earnings before interest, taxes, fixed charges and depreciation and investment is calculated as the ratio of capital expenditure or additions to fixed assets to total tangible assets. nwc is non-cash nwc and stdebt is short term debt, both scaled by total assets. cr is current asset to current liability, opm, sgrth is calculated growth in total sales between 2 consecutive periods and zfc is the predicted financial constraint index from the discriminant analysis. mean and standard deviation of fccr is higher than all the other variables stated in the table 1. the fccr is especially helpful to see a company’s dependency on outside capital and it indicates whether a drop in profits may leave the company unable to pay its bills. the standard deviation of sgrth, opm and zfc are also quite high with mean of opm and zfc being negative. the mean of cash quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016566 flow is 0.06; however there are firm years with negative cash flows in our sample. table 2 reports summary statistics of the regression variables individually for three financial constraint categories and table 3 presents the same for 7 countries. unsurprisingly, the average nfc companies have healthier positions in terms of cash flow, fccr, opm and sgrth than their fc counterparts. average zfc for belgium, germany, sweden and uk are negative and so is their opm. not noticeable difference in terms of cash flow and size is seen amongst average firms in the seven countries. table 2 gives mean and distributional information for all the regression variables separately for the fc, pfc and nfc categories. all financial variables are deflated with a gdp deflator and all regression variables are insured at the 1% and 99% level to get rid of the extreme outliers. table 3 gives mean and distributional information for all the regression variables separately for the seven countries separately. all financial variables are deflated with a gdp deflator and all regression variables are insured at the 1% and 99% level to get rid of the extreme outliers. table 4 shows the correlations among the 10 variables and the zfc values. similar to cleary (1999)’s findings, we find evidence that net income margin has the highest correlation and current ratio and financial slack has negative correlation with zfc values. the strong positive correlations of cash flow and fccr with the zfc value are also in line with cleary’s findings. table 4 shows the correlations among our 10 variables of interest and the zfc values from the multiple discriminant analysis. 5. empirical results regression results for equation 1 are presented in table 5 where the explanatory variables are added sequentially in different models and model 6 is the full version of our chosen specification. all these models have been estimated using ols including a full set of sector and year dummies as regressors and clustering by company id has been used to get robust standard errors. model 7 is also estimated for the overall sample, but here cash flow variable has been interacted with different country dummy variables which allow the estimated cash flow coefficient to differ across observations in the different countries. the larger coefficients indicate greater influence of internal cash flows on cash hoarding behavior. as expected, the regression coefficients for cash flow are positive and significant not only for the overall samples in model 6, but also for each country in model 7. these results show that the firms’ cash saving policies are influenced positively and significantly by their cash generating capacity after controlling for firm size, investment opportunities and alternative sources and competing uses of funds. this clearly points to the fact that firms in our sample like to hoard cash out of their operating cash flows which indicates that most firms operate in imperfect and incomplete markets with limited and costly access to external finance. when comparing the regression coefficients for different countries, not much variation in the propensity to save cash out of internally generate cash flows are observed internationally. the estimated cash flow coefficient is found highest for sweden (0.197) and lowest for netherland (0.095) and those of other countries lie in between 0.11 and 0.15. the coefficient of capital expenditure has negative sign supporting the fact that a firm can use its cash reserves in a given year in order to pay for investments. the positive sign of tbnq indicates that an average firm cash policy is influenced by the attractive investment opportunities in future. table 1: summary statistics variable mean sd minimum q1 median q3 maximum n fslack 0.12 0.14 0 0.03 0.08 0.17 0.70 53938 cshflow 0.06 0.13 –0.61 0.04 0.08 0.12 0.32 53938 cr 1.72 1.29 0.27 1.05 1.39 1.93 8.81 53938 size 11.89 2.15 7.45 10.36 11.64 13.22 17.63 53938 dr 0.12 0.13 0 0.02 0.09 0.18 0.61 53938 fccr 16.05 109.78 –426.27 1.19 4.29 11.13 756.39 53938 exp 0.06 0.06 0 0.02 0.04 0.08 0.33 53938 tbnq 1.65 1.15 0.59 1.04 1.30 1.79 8.17 53938 opm –3.10 47.68 –372.22 0.32 4.84 9.90 37.06 53938 sgrth 14.08 41.33 –58.21 –2.95 6.62 19.23 266.05 48446 nwc 0.16 0.22 –0.50 0.02 0.15 0.30 0.74 53938 stdebt 0.09 0.1 0 0.02 0.06 0.13 0.50 53938 zfc –0.39 39.31 –340.71 1.03 5.46 10.46 51.77 48446 sd: standard deviation table 2: summary statistics by financial constraint categories variables fc pfc nfc mean sd mean sd mean sd fslack 0.141 0.168 0.102 0.105 0.142 0.15 cshflow –0.058 0.178 0.089 0.056 0.109 0.112 cr 1.797 1.641 1.59 0.940 1.856 1.414 size 11.129 2.067 12.207 2.068 11.973 2.207 dr 0.111 0.137 0.12 0.115 0.132 0.141 fccr –29.757 99.257 20.652 79.763 41.243 138.889 exp 0.052 0.062 0.058 0.05 0.072 0.069 tbnq 1.618 1.37 1.375 0.652 2.052 1.393 opm –33.894 77.709 4.929 2.941 7.023 44.234 sgrth 3.852 48.689 10.464 24.427 31.524 53.252 nwc 0.123 0.272 0.164 0.188 0.182 0.229 stdebt 0.118 0.13 0.09 0.09 0.069 0.082 z –29.943 69.758 5.548 2.568 17.271 6.727 fccr: fixed charge coverage ratio, opm: operating profit margin, cr: current ratio, dr: debt ratio, sd: standard deviation, nfc: non-financially constrained, pfc: partially financially constrained, fc: financially constrained quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016 567 dependent variable δcash holdings m1 m2 m3 m4 m5 m6 m7 cashflow 0.192*** 0.192*** 0.190*** 0.206*** 0.202*** 0.141*** (0.003) (0.003) (0.007) (0.007) (0.003) (0.003) tobinq 0.003*** 0.003*** 0.004*** 0.004*** 0.004*** 0.004*** (0.000) (0.001) (0.001) (0.000) (0.000) (0.000) size 0.001*** 0.000 0.000 0.001*** 0.001*** (0.000) (0.000) (0.000) (0.000) (0.000) expenditures –0.218*** –0.213*** –0.111*** –0.112*** (0.009) (0.007) (0.007) (0.007) δshortdebt –0.055*** 0.285*** 0.285*** (0.005) (0.006) (0.006) δnwc 0.366*** 0.366*** (0.003) (0.003) cashflowbel 0.132*** (0.016) cashflowfr 0.151*** (0.008) cashflowger 0.166*** (0.006) cashflowit 0.114*** (0.015) cashflowneth 0.095*** (0.014) cashflowsw 0.197*** (0.012) cashflowuk 0.130*** (0.004) constant –0.003 –0.007 –0.013 0.003 0.001 –0.014 –0.010 (1287.891) (1286.263) (291.780) (1274.041) (1148.533) (1147.815) table 5: estimation results contd... table 3: summary statistics by countries variables belgium france germany italy netherland sweden uk mean sd mean sd mean sd mean sd mean sd mean sd mean sd fslack 0.124 0.138 0.135 0.128 0.13 0.149 0.118 0.118 0.096 0.11 0.161 0.162 0.117 0.139 cshflow 0.063 0.13 0.067 0.098 0.061 0.128 0.063 0.079 0.094 0.088 0.046 0.153 0.059 0.148 cr 1.723 1.292 1.595 0.977 2.237 1.746 1.585 1.027 1.515 0.717 1.98 1.462 1.582 1.178 size 11.889 2.155 12.209 2.105 12.063 1.995 13.013 1.68 12.685 2.096 14.501 2.042 11.208 2.012 dr 0.122 0.129 0.132 0.121 0.112 0.127 0.133 0.12 0.137 0.121 0.132 0.137 0.116 0.133 fccr 16.053 109.783 18.255 93.42 12.232 101.269 16.598 89.987 17.96 75.733 10.319 138.596 16.923 121.423 exp 0.061 0.06 0.054 0.053 0.065 0.063 0.051 0.053 0.066 0.05 0.049 0.049 0.064 0.063 tbnq 1.65 1.154 1.491 0.942 1.564 1.014 1.347 0.713 1.575 1.06 1.961 1.42 1.774 1.29 opm –3.105 47.683 0.853 32.105 –5.637 39.527 –0.267 39.561 4.087 18.432 –12.834 71.439 –3.955 55.742 sgrth 14.076 41.335 10.415 31.163 9.44 36.256 10.262 32.341 10.797 31.738 16.773 45.625 18.037 47.52 nwc 0.161 0.224 0.167 0.208 0.224 0.24 0.147 0.207 0.153 0.178 0.205 0.214 0.132 0.225 stdebt 0.089 0.10 0.096 0.087 0.093 0.111 0.127 0.104 0.091 0.098 0.065 0.082 0.082 0.099 z –0.395 39.307 2.094 27.269 –3.423 34.647 1.105 33.901 5.058 14.618 –8.214 60.843 –0.247 44.849 fccr: fixed charge coverage ratio, opm: operating profit margin, cr: current ratio, dr: debt ratio, sd: standard deviation table 4: correlation variables cshflow cr dr fccr exp tbnq opm sgrth fslack size z cshflow 1.0000 cr –0.0555* 1.0000 dr –0.0214* –0.1801* 1.0000 fccr 0.3769* 0.0201* –0.1124* 1.0000 exp 0.1719* –0.1018* 0.0910* 0.0057 1.0000 tbnq –0.0707* 0.1142* –0.0666* 0.0759* 0.0718* 1.0000 opm 0.5989* –0.2501* 0.0637* 0.3208* 0.0356* –0.1837* 1.0000 sgrth 0.0378* 0.0067 0.0009 –0.0134* 0.0951* 0.1666* –0.0365* 1.0000 fslack –0.1361* 0.5405* –0.2121* 0.0522* –0.1050* 0.2899* –0.2912* 0.0518* 1.0000 size 0.2383* –0.1114* 0.2564* 0.0196* –0.0000 –0.1844* 0.2072* –0.0553* –0.1107* 1.0000 z 0.5973* –0.2127* 0.0560* 0.3074* 0.0516* –0.1549* 0.9981* 0.0237 –0.2615* 0.2020* 1.0000 fccr: fixed charge coverage ratio, opm: operating profit margin, cr: current ratio, dr: debt ratio, *indicates significance at 5% level quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016568 table 5 shows the estimated results using ols which includes a full set of sector and year dummies as regressors. our two model of interest as explained above are re estimated again using fixed effect and feiv technique to control for firm fixed effect and erogeneity of the regressors and results are reported in table 4 with robust standard errors. the fixed time specific effects are similarly controlled for by including year dummies as regressors. this do not make any qualitative change to our previous results and the cash hoarding behavior as explained above are found to prevail in our fixed effect and fixed effect 4 regression. however, the magnitudes of our coefficient of interest, fi1 decrease in all the cases except for sweden. other explanatory variables retain coefficients of similar magnitude, sign and significance almost. table 6 shows the estimated results of equation 1 using ols, fe and feiv. ols estimates include a full set of sector and year dummies as regressors, fe estimates include a full set of year dummies as regressors, feiv estimates include a full set of year dummies both as regressors and instruments. in addition to these, feiv includes lags of the level of fixed capital (net plant, property, and investment to total assets), lagged nwc, and lagged shortterm debt as instruments. table 6: estimated results of equation 1 using ols, fe and feiv dependent variable δcash holdings ols fe feiv ols fe feiv cashflow 0.141*** 0.130*** 0.121*** (0.003) (0.004) (0.005) tobinq 0.004*** 0.005*** 0.005*** 0.004*** 0.005*** 0.005*** (0.000) (0.001) (0.001) (0.000) (0.001) (0.001) size 0.001*** 0.013*** 0.013*** 0.001*** 0.013*** 0.013*** (0.000) (0.001) (0.001) (0.000) (0.001) (0.001) expenditures –0.111*** –0.130*** –0.114*** –0.112*** –0.130*** –0.113*** (0.007) (0.009) (0.010) (0.007) (0.009) (0.010) δnwc 0.366*** 0.364*** 0.404*** 0.366*** 0.364*** 0.406*** (0.003) (0.004) (0.008) (0.003) (0.004) (0.008) δshortdebt 0.285*** 0.278*** 0.314*** 0.285*** 0.277*** 0.315*** (0.006) (0.006) (0.009) (0.006) (0.006) (0.009) cashflowbel 0.132*** 0.069** 0.057* (0.016) (0.035) (0.035) cashflowfr 0.151*** 0.130*** 0.119*** (0.008) (0.013) (0.013) cashflowger 0.166*** 0.131*** 0.120*** (0.006) (0.009) (0.010) cashflowit 0.114*** 0.083*** 0.072** (0.015) (0.028) (0.028) cashflowneth 0.095*** 0.076*** 0.066*** (0.014) (0.025) (0.025) cashflowsw 0.197*** 0.267*** 0.260*** (0.012) (0.019) (0.020) cashflowuk 0.130*** 0.124*** 0.116*** (0.004) (0.006) (0.006) constant –0.014 –0.110** –0.112** –0.010 –0.107** –0.110** (1148.533) (0.046) (0.046) (1147.815) (0.046) (0.046) n 48446 48446 48446 48446 48446 48446 ng 5086 5086 5086 5086 r2o 0.212 0.217 0.213 0.218 r2b 0.290 0.293 0.289 0.292 r2w 0.250 0.248 0.251 0.249 sigmau 0.047 0.047 0.047 0.047 sigmae 0.077 0.077 0.077 0.077 rho 0.274 0.274 0.274 0.275 chi2p 0.000 0.000 ffp 0.000 0.000 ***, ** and * indicate significance at the 1%, 5% and 10%, level respectively and standard errors in parentheses, nwc: net working capital, feiv: fixed effect instrumental variables dependent variable δcash holdings m1 m2 m3 m4 m5 m6 m7 n 48446 48446 48446 48446 48446 48446 48446 r2a 0.080 0.081 0.081 0.097 0.099 0.268 0.269 standard errors are clustered at the firm level. ***, ** and * indicate significance at the 1%, 5% and 10%, level respectively and standard errors are in parentheses table 5: contd... quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016 569 table 7 presents the results obtained from the estimation of our baseline regression model after we classify our total sample into constrained and unconstrained categories using the predicted zfc index from the multiple discriminant analysis. total three estimated equations using feiv with robust standard errors for fc, pfc and nfc are reported and firms in all three categories display positive sensitivities of cash to cash flow. however, the sensitivities are found to decrease monotonically from constrained to unconstrained category and becomes statistically insignificant as well for the financially unconstrained firms. the sensitivity estimates is 0.129 for fc firms, 0.087 for partially constrained firms and 0.035 for nfc firms and all are statistically significant at better than the 5% level except for the unconstrained firms. these estimates suggest that for each dollar of additional cash flow, a table 8: robustness dependent variable independent variables δcash holdings cashflow tobinq size expenditures δnwc δshortdebt constant 1. size fc 0.135*** 0.008*** 0.035*** –0.180** 0.359*** 0.229*** –0.311*** (0.015) (0.002) (0.003) (0.025) (0.014) (0.021) (0.034) pfc 0.096*** 0.007*** 0.013*** –0.107*** 0.354*** 0.274*** –0.120*** (0.012) (0.001) (0.001) (0.015) (0.012) (0.014) (0.025) nfc 0.044** 0.005*** 0.010*** –0.068*** 0.441*** 0.421*** –0.138*** (0.020) (0.001) (0.002) (0.020) (0.020) (0.024) (0.023) 2. age fc 0.137*** 0.010*** 0.054*** –0.198** 0.388*** 0.284*** –0.621*** (0.021) (0.002) (0.005) (0.028) (0.014) (0.020) (0.062) pfc 0.099*** 0.004*** 0.018*** –0.124*** 0.339*** 0.258*** –0.198*** (0.013) (0.001) (0.002) (0.019) (0.012) (0.016) (0.019) nfc 0.039** 0.004*** 0.008*** –0.103*** 0.396*** 0.323*** –0.063** (0.016) (0.002) (0.001) (0.023) (0.020) (0.024) (0.025) 3. kz index fc 0.245*** 0.006*** 0.031*** –0.205** 0.410*** 0.319*** –0.213*** (0.026) (0.002) (0.003) (0.052) (0.016) (0.030) (0.47) pfc 0.097*** 0.003** 0.012*** –0.099*** 0.383*** 0.271*** –0.115*** (0.017) (0.001) (0.001) (0.015) (0.012) (0.014) (0.014) nfc 0.025* 0.003 0.010*** –0.061*** 0.283*** 0.217*** –0.128*** (0.014) (0.002) (0.002) (0.018) (0.016) (0.018) (0.023) ***, ** and * indicate significance at the 1%, 5% and 10%, level respectively and standard errors in parentheses, nfc: non-financially constrained, pfc: partially financially constrained, fc: financially constrained table 7: discriminant dependent variable δcash holdings all fc pfc nfc cashflow 0.121*** 0.129*** 0.087*** 0.035 (0.005) (0.015) (0.018) (0.028) tobinq 0.005*** 0.009*** 0.004** 0.003** (0.001) (0.002) (0.002) (0.001) size 0.013*** 0.032*** 0.008*** 0.011*** (0.001) (0.003) (0.001) (0.002) expenditures –0.114*** –0.179*** –0.091*** –0.096*** (0.010) (0.030) (0.016) (0.019) δnwc 0.404*** 0.370*** 0.347*** 0.430*** (0.008) (0.014) (0.013) (0.017) δshortdebt 0.314*** 0.256*** 0.268*** 0.363*** (0.009) (0.019) (0.015) (0.022) constant –0.112** –0.413*** –0.078*** –0.074** (0.046) (0.041) (0.013) (0.035) n 48446 12112 24223 12111 ng 5086 3150 3982 2722 r2o 0.217 0.194 0.142 0.165 r2b 0.293 0.165 0.145 0.107 r2w 0.248 0.289 0.181 0.281 sigmau 0.047 0.092 0.048 0.067 sigmae 0.077 0.109 0.058 0.065 rho 0.274 0.415 0.411 0.516 chi2p 0.000 0.000 0.000 0.000 ffp 0.000 0.000 0.000 0.000 ***, ** and * indicate significance at the 1%, 5% and 10%, level respectively and standard errors in parentheses quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016570 constrained firm will save around 13 cents, while unconstrained firms do nothing. the q-sensitivity of cash is always positive and significant, which shows that firms like to save cash to avail good investment opportunities in future. the coefficients for firm size, short term debt and nwc are positive, while those of the investment expenditures are negative. the coefficients of these regressors carry expected signs and are in line with previous studies. table 7 shows feiv results of equation 1 separately for the whole sample, fc, pfc and nfc groups separated using a predicted financial constraint index zfc from multiple discriminant analysis. the estimates include a full set of year dummies both as regressors and instruments and in addition, lags of the level of fixed capital (net plant, property, and investment to total assets), lagged nwc, and lagged short-term debt as instruments. besides the zfc, we also use three other financial constraint proxies to partition our sample. we construct an index of firm financial constraints based on results in kaplan and zingales (1997) (which we call the “kz index”) by applying the following linearization to the data and separate firms according to this measure. table 9: country specific dependent variable independent variables δcash holdings cashflow tobinq size expenditures δnwc δshortdebt constant 1. belgium fc 0.121*** 0.009*** 0.032*** –0.179** 0.370*** 0.256*** –0.413*** (0.015) (0.002) (0.003) (0.030) (0.014) (0.019) (0.041) nfc 0.035 0.003** 0.011*** –0.096*** 0.430*** 0.363*** –0.074** (0.028) (0.001) (0.002) (0.019) (0.017) (0.022) (0.035) 2. france fc 0.134*** 0.013** 0.022*** –0.223*** 0.293*** 0.251*** –0.359*** (0.033) (0.006) (0.008) (0.072) (0.032) (0.044) (0.091) nfc –0.047 0.006*** 0.022*** –0.139** 0.452*** 0.398*** –0.229** (0.064) (0.003) (0.007) (0.059) (0.044) (0.051) (0.086) 3. germany fc 0.121*** 0.014** 0.022*** –0.110** 0.264*** 0.205*** –0.282*** (0.027) (0.007) (0.007) (0.051) (0.025) (0.029) (0.076) nfc –0.008 0.008** 0.012 –0.015 0.333*** 0.236*** –0.158 (0.081) (0.004) (0.010) (0.074) (0.058) (0.090) (0.117) 4. italy fc 0.132* –0.033** 0.008 0.0305 0.311*** 0.241*** –0.110 (0.079) (0.002) (0.009) (0.110) (0.057) (0.058) (0.123) nfc 0.061 –0.003 0.038*** 0.010*** 0.487*** 0.515*** –0.451*** (0.107) (0.004) (0.012) (0.049) (0.057) (0.091) (0.154) 5. netherland fc 0.105* –0.017 0.027* –0.232 0.134** 0.139* –0.257 (0.057) (0.015) (0.015) (0.232) (0.066) (0.073) (0.164) nfc –0.081 0.014* 0.025** –0.180 0.432*** 0.196 –0.284** (0.231) (0.007) (0.011) (0.142) (0.069) (0.118) (0.140) 6. sweden fc 0.277*** 0.019* 0.081*** 0.115 0.620*** 0.500*** –1.054*** (0.079) (0.011) (0.019) (0.179) (0.090) (0.133) (0.245) nfc 0.126 0.012*** –0.002 –0.092 0.518*** 0.536*** 0.010 (0.123) (0.004) (0.005) (0.084) (0.104) (0.116) (0.077) 7. united kingdom fc 0.124*** 0.008*** 0.040*** –0.289*** 0.428*** 0.280*** –0.489*** (0.022) (0.003) (0.005) (0.048) (0.020) (0.032) (0.065) nfc 0.073*** –0.000 0.008*** –0.121*** 0.436*** 0.368*** –0.046 (0.034) (0.002) (0.003) (0.022) (0.021) (0.026) (0.038) ***, ** and * indicate significance at the 1%, 5% and 10%, level respectively and standard errors in parentheses, fc: financially constrained, nfc: non-financially constrained, nwc: net working capital kz index = –1.002 * cash flow + 0.283 * tobin’s q + 3.139 * leverage – 39.368 * dividends – 1.315 * cash holdings (3) the other two categories we use are size and age. our earlier results are found robust in all these three cases. the cash flow sensitivity of cash estimates reveal the same patterns reported in table 8. the sensitivity estimates are all positive and highly significant for constrained firms which make our earlier findings robust. coefficients for the other regressors attract the signs as previous ones. table 8 shows feiv results of equation 1 separately for the whole sample; fc, pfc and nfc groups separated using a size, age and kz index. the estimates include a full l set of year dummies both as regressors and instruments and in addition, lags of the level of fixed capital (net plant, property, and investment to total assets), lagged nwc, and lagged short-term debt as instruments. we also attempt to examine the cash flow coefficients for the fc versus the nfc groups in each country and the estimation result are presented in table 9. we omit the regression result for the pfc groups, but report the results for other two groups at quader and abdullah: cash flow sensitivity of cash: a cross country analysis international journal of economics and financial issues | vol 6 • issue 2 • 2016 571 the opposite ends. the divergence of cash saving behavior we found for the whole sample are also found in each countries on their own, i.e. significantly high cash flow sensitivity of cash for fcs and insignificant on the part of the nfcs. this finding is consistent with the view that irrespective of the countries, there are systematic differences between constrained and unconstrained firms in terms of the way they devise their cash hoarding policies. such differences manifest the presence of financial constraint due to capital market imperfection. table 9 shows feiv results of equation 1 for the fc and nfc groups separated using a predicted financial constraint index zfc from multiple discriminant analysis for each of the seven countries separately. the estimates include a full set of year dummies both as regressors and instruments and in addition, lags of the level of fixed capital (net plant, property, and investment to total assets), lagged nwc, and lagged short-term debt as instruments. 6. conclusion this paper makes an important contribution to the contemporary literature by examining the differential cash saving tendency for firms facing different financial constraint status to see the effect of capital market imperfection on international corporate policies. due to the prolonged debate started with fazzari et al. (1988) and kaplan and zingales (1997) on the ability of investment cash flow sensitivity to capture financial constraints, we have taken up the proposition of almeida et al. (2004) and rely on cash flow sensitivity of cash to capture the same but in a cross country setting for the first time. our estimated results from all our model specifications consistently indicate a substantially greater and significantly positive cash saving tendency out of internally generated cash flow for firm years belonging to the most fc categories which are most likely to face more severe asymmetric information related problems. however, the unconstrained firms do not follow any such systematic behavior. such relationship based on our whole sample remain evident for each of the seven countries as well when analyzed separately which conforms the fact that irrespective of the countries, there are systematic differences between constrained and unconstrained firms in terms of the way they devise their cash hoarding policies. the results suggest important policy implications for fc european firms which should be taken into consideration while managing their working capital and hoard a stock of internal funds to be used as a less costly alternative to external financing for availing profitable investment opportunities. this can potentially get them out of constraint financial status and allow them to enjoy the benefit of a potential positive income shock through their real activities. our results can guide future researchers to adopt similar investigations on the developing markets and may also influence the managerial decision regarding cash accumulation policy. references aggarwal, r., zong, s. 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(2002), small and medium size enterprise financing: a note on some of the empirical implications of a pecking order. journal of business finance and accounting, 29, 557-578 . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(5), 432-439. international journal of economics and financial issues | vol 7 • issue 5 • 2017432 islamic banks’ return on depositors and conventional banks’ deposit interest: is there causality? evidence of causality from bangladesh abdus samad1* , mohammad ashraful ferdous chowdhury2 1department of finance and economics, utah valley university, 800 west university pky, orem, ut 84097, usa, 2department of business administration, shahjalal university of science and technology, sylhet, bangladesh. *email: abdus.samad@uvu.edu abstract the critiques of the islamic bank allege that the depositors’ return and the return on loans of the islamic bank is nothing but the interest rate of the conventional banks and they simply follow the conventional banks interest rate. this paper empirically investigates the causal relation and the causal direction between the conventional banks’ interest rate and the islamic banks’ return applying vector error correction model. the results of the ver granger causality/block exogeneity wald tests show unidirectional causal relation and the direction of causality ran from the islamic banks’ rate of return to the conventional banks’ interest rates. keywords: conventional bank interest rate, islamic bank deposit and loan rate, granger causality, bangladesh jel classifications: g21, f31 1. introduction conventional banks and the islamic banks operate side by side but their modes of operation are different. interest is the life and blood of the conventional banks. the interest rate of the conventional bank is fixed whether they are paying interest to depositors or receiving interest from the borrowers. irrespective of the outcome of investment, the borrower of the venture investment has to pay the fixed interest. the mode of contract of the conventional bank is the avoidance of risk sharing in investment. similarly, the fixed interest payment to depositors irrespective of banks’ outcome of investment suggests the lack of risk sharing by the depositors. the profit and loss sharing (pls) is the most distinguishing feature of the islamic banks. unlike the conventional banks’ fixed interest income, the islamic banks’ return on financing is not fixed. islamic banks and the investors share the risk of investment. if there are profit from the investment, both bank and the investor distribute it based on prior agreement. if the investment incurs losses, both bank and the investors share the losses based on prior agreement. similarly, in mobilizing deposits, islamic banks offer financial incentives but the financial incentive of the islamic bank is not the fixed. the depositors of the islamic banks do not get fixed return for their deposits. it is the pre-agreed rate of returns, if there are profits generated through the investment of deposits. in islamic banks, current account deposits are based on two principles: al amanah and al wadiah. in amana deposits, interest-free deposits are held by the banks in trust (amanah). under amanah arrangement, the islamic bank treats the funds as a trust and cannot use these funds for its operations; it does not guarantee the refund of the deposit in case of any damage or loss to the amanah resulting from circumstances beyond its control. the wadiah deposits are the safe-keeping (wadiah) deposits. in wadiah, the bank is considered as a keeper and trustee of funds and has the depositors’ permission to use the funds for its operations in a shari´ah compliant manner. deposits under wadiah take the form of loans from depositors to islamic banks and the bank guarantees refund of the entire amount of the deposit. while these deposits can be withdrawn at any time, the depositors have no right to any return/profit on such deposits. however, depositors, at the bank’s discretion, may be rewarded with a profits. samad and chowdhury: islamic banks’ return on depositors and conventional banks’ deposit interest: is there causality? evidence of causality from bangladesh international journal of economics and financial issues | vol 7 • issue 5 • 2017 433 1.1. mudarabah saving deposit savings deposit accounts of the islamic banks operate in a different way. the depositors allow the banks to use their money invested in profitable business ventures which are legal and shari´ah compliant. generally, deposits in savings accounts are accepted by islamic banks on the basis of mudarabah where the depositor is rabb-ul-mal (investor) and the bank is the mudarib (fund manager). the profit will be shared as per a pre-determined ratio upon, while loss will be borne by the rabb-ul-mal. profit distribution amongst the depositors and the shareholders will be made according to the prearranged contract made at the beginning of each month to their investments. savings deposits are generally paced in a joint investment pool with other deposits mobilised by the islamic banks. 1.2. muderabah investment deposits deposits are accepted for a fixed period of time or term and are governed by the mudarabah contract with the bank. it is similar to fixed deposits of the conventional banks. when deposits are agreed for the fixed term no withdrawal is normally allowed until the end of the deposit term. however, some banks are allowing early withdrawals in an agreed notice period. term deposits are arrangement where depositors seek some return on their investments; they are taken on a mudarabah basis. these deposits are allocated to a number of investment pools and the islamic banks invest the pooled amount in shari´ah-compliant businesses. the profits from the assets are shared between the depositors and the bank according to a pre-determined ratio agreed upon at the beginning of contract. the profit sharing weightages are assigned based on the various tenures and the amount invested under the arrangement. and as required under mudarabah, depositors have to be informed in advance of the formula used for sharing the net earnings of the investment pool with the bank. in case of the unlikely event of loss, the depositors have to bear the loss on a pro-rata basis while bank goes un-rewarded for all its efforts. if a bank contributes its equity capital in a pool at the time of setting up an investment pool, the relationship will be a combination of musharakah and mudarabah, and the bank would be entitled to a proportionate profit on its own investment in relation to the total mudarabah investment pool. islamic banks can also open may announce murabaha and leasing funds in which the risk-averse investors may purchase units and be treated as rabbul-mal and get the quasi fixed-return from profits or rentals earned by the respective funds from the trading and leasing activities1. in summary, there is no fixed rate of return to any types of deposit accounts of the islamic banks. as the depositors undertake risk of their deposits under the muderabah saving deposits and the muderabah investment deposits, they earn money on their deposits as per prearranged contract. the key feature of this liability contract is that islamic banks neither guarantee the safety of depositors’ capital nor any fixed return on deposits. in this sense, islamic banks’, muderabah investment deposits are more risky than those of conventional banks’ fixed deposits and as such deserve more earnings. 1 www.financislam.com/depositw.html. the critiques of the islamic bank allege that the returns on the deposits and the loans of the islamic banks are simply the change of name. the name of interest is replaced by profit or rate of return. since there is no regulatory authority for controlling and supervising the rate of return of the islamic bank, the rate of return of the islamic banks simply follows the conventional banks market interest rates. the allegation is based on the lack of well-regulated functioning financial system determining interest rate which is found in the conventional system. although it is alleged that the islamic banks rates of return simply follow the conventional banks’ interest rate, there was no empirical evidence to substantiate the claim. the exploration and the direction of causality between the conventional banks’ deposit interest rate and the islamic banks’ rate of return to depositors is an important contribution of this paper in the banking literature. this paper is organized as: section ii describes the unique characteristics of islamic bank products. section iii provides the case for studying the bahrain’ banking section iv outlines a short survey of literature. section v provides the descriptions of data, methodology, and model. empirical results and conclusions were presented in section v. 2. islamic bank products and characteristics first, all activities including the banking business are guided by the divine book of islam, called the quran, and the shariah, the sunnah of prophet mohammad (sas). islam prohibits its followers to get involved in certain harmful activities such as the production and consumption of alcohol, gambling, prostitution, and pork. as these activities are prohibited in islam, islamic banks are not allowed to engage in financing these activities. islamic banks do not finance these activities. second, the most unique feature of islamic banking is the avoidance of riba (usury) in all financial transactions. the term “riba” is currently interpreted as interest rate. the quran, the divine book of islam, strongly prohibits riba. the quran says… “whereas allah permitted trading and forbidden riba” (quran: 2. p. 275). however, neither the quran nor the prophet of islamic did define what riba is2. the present scholars of shariah agreed that the predetermined fixed rate of return is not permitted in islamic banking business transactions. the prohibition of interest in banking business gives rise to the development of innovative mode of financial products by the islamic banks. the products, on the asset side of the balance sheet of the islamic bank, are: (i) musharakah (ii) muderabah (iii) murabahah (iv) bai baithaman ajil’ (v) bai al-salam (vi) ijarah (vii) istisna. 2 [umar b. al-khattab said, “there are three things: if god’s messenger had explained them clearly, it would have been dearer to me than the world and what it contains: (these are) kalalah, riba, and khilafah.” (sunan ibn majah, book of inheritance, vol. 4, #2727; samad and chowdhury: islamic banks’ return on depositors and conventional banks’ deposit interest: is there causality? evidence of causality from bangladesh international journal of economics and financial issues | vol 7 • issue 5 • 2017434 there are two types of the financing contracts. they are equity type and debt type contracts. musharakah’ (partnership) and ‘mudarabah’ (trust financing) are equity type contracts (hamwi and aylward (1999). musharakha: is a partnership and joint venture contract between the islamic bank and the investor where both parties provide capital and manage funds and projects. profits or losses accruing from the venture are distributed based on the proportion of capital and pre-determined agreement. the key features of this contract are: (i) pls. both parties share profits or loss. unlike conventional bank equity contracts where banks do not bear the risk of financing investments, islamic banks share the risk of investment. (ii) unlike conventional banks’ equity contracts where banks enjoy the fixed rate of return from investments, even when there are losses for the project, there is no predetermined rate of returns on investments for islamic banks. thus, pls, avoiding of fixed interest, is a key feature of islamic financing. justice requires that both share the risk of business. mudarabah: is a trust financing contract between islamic banks and investors where islamic banks provide all funds for a project and investors provide physical labor, intellectual, and management skills. profits from the projects are distributed based on a preagreed (ratio) arrangement. however, in cases of losses, banks, the provider of fund (called rab al maal), will bear the losses of fund and investor will bear the loss of his labor. the key feature of this contract is that there is no predetermined fixed rate of returns for bank; and both parties share the risk of investment. the key features of the musharakha and muderaba contract are: (i) pls. both parties share profits or losses. unlike conventional bank equity contracts where banks do not bear the risk of financing investments, islamic banks share the risk of investment. (ii) unlike conventional banks’ equity contracts where banks enjoy the fixed rate of return from investments, even when there are losses for the project, there is no predetermined rate of returns on investments for islamic banks. thus, pls, avoiding of fixed interest, is a key feature of islamic financing. justice requires that both share the risk of business. murabaha financing is a debt type contract. murabaha mode of financing is based on a ‘mark-up’ arrangement in which goods or assets are purchased by the bank on behalf of a client, and are sold to the client at a price equal to the cost of the item(s) plus a profit margin. under the murabaha financing contract, a client wishing to buy goods or assets approaches an islamic bank to buy them on their behalf. the islamic bank then buys the product at the current market price and adds a profit margin to it, and then re-sells the product to the client. the key feature is that there is no fixed interest involved, although the critiques of islamic banks do not admit it. they call it a “back door for interest-based financing” (chong and liu, 2009). bai baithaman ajil’ is a variant of the murabah (cost plus) financing contract. the difference is that the delivery of goods is immediate but the payment of goods is deferred. the payment may be made at installment. however, the price of the product is agreed to by both parties at the time of the sale but should not include charges for the deferred payment. bai al-salaam is a forward sale contract where an entrepreneur sells some specific goods to the islamic bank at a price agreed upon and paid at the time of contract but the delivery of goods is deferred for the future. al-ijera is a lease financing contract and is similar to a conventional bank lease contract. under this contract, the islamic bank purchases an asset for a customer and then leases it out to him for a fixed period at a fixed rental charge agreed upon at the time of purchase. a key difference with conventional bank leases is that the lessor i.e., islamic bank retains the risk of property ownership. note that shariah permits fixed rental charges for the use of asset/property services. istisna is a financing contract under which a manufacturer or a producer produces specific goods for future delivery at a predetermined price. the key feature of bai baithaman ajil’, bai al-salam, ijarah, and istisna3 is that financing is fully securitized and asset based. unlike conventional banks, islamic banks own the ownership of the goods until full payment is made. the products, on the liability side of the balance sheet of the islamic bank, are: (i) current account called al amana/wadiah deposits (ii) saving deposits alled mudarabah saving deposits (iii) muderabah investment deposits. 2.1. current account deposits it is similar to demand deposits of the conventional banks. in islamic banks, current account deposits are based on two principles: al amanah and al wadiah. in amana deposits, interest-free deposits are held by the banks in trust (amanah. under amanah arrangement, the islamic bank treats the funds as a trust and cannot use these funds for its operations; it does not guarantee the refund of the deposit in case of any damage or loss to the amanah resulting from circumstances beyond its control. the wadiah deposits are the safe-keeping (wadiah) deposits. in wadiah, the bank is considered as a keeper and trustee of funds and has the depositors’ permission to use the funds for its operations in a shari´ah compliant manner. deposits under wadiah take the form of loans from depositors to islamic banks and the bank guarantees refund of the entire amount of the deposit. while these deposits can be withdrawn at any time, the depositors have no right to any return/profit on such deposits. however, depositors, at the bank’s discretion, may be rewarded with a profits. 2.2. mudarabah saving deposit savings deposit accounts of the islamic banks operate in a different way. the depositors allow the banks to use their money invested in profitable business ventures which are legal and 3 see samad et al. (2005) and (chong and liu, 2009) for definition and features. samad and chowdhury: islamic banks’ return on depositors and conventional banks’ deposit interest: is there causality? evidence of causality from bangladesh international journal of economics and financial issues | vol 7 • issue 5 • 2017 435 shari'ah compliant. generally, deposits in savings accounts are accepted by islamic banks on the basis of mudarabah where the depositor is rabb-ul-mal (investor) and the bank is the mudarib (fund manager). the profit will be shared as per a pre-determined ratio upon, while loss will be borne by the rabb-ul-mal. profit distribution amongst the depositors and the shareholders will be made according to the prearranged contract made at the beginning of each month to their investments. savings deposits are generally paced in a joint investment pool with other deposits mobilised by the islamic banks. 2.3. muderabah investment deposits deposits are accepted for a fixed period of time or term and are governed by the mudarabah contract with the bank. it is similar to fixed deposits of the conventional banks. when deposits are agreed for the fixed term, withdrawal is normally not allowed until the end of the deposit term. however, some banks are allowing early withdrawals in an agreed notice period. term deposits are arrangement where depositors seek some return on their investments; they are taken on a mudarabah basis. these deposits are allocated to a number of investment pools and the islamic banks invest the pooled amount in shari´ah-compliant businesses. the profits from the assets are shared between the depositors and the bank according to a pre-determined ratio agreed upon at the beginning of contract. the profit sharing weightages are assigned based on the various tenures and the amount invested under the arrangement. and as required under mudarabah, depositors have to be informed in advance of the formula used for sharing the net earnings of the investment pool with the bank. in case of the unlikely event of loss, the depositors have to bear the loss on a pro-rata basis while bank goes un-rewarded for all its efforts. if a bank contributes its equity capital in a pool at the time of setting up an investment pool, the relationship will be a combination of musharakah and mudarabah, and the bank would be entitled to a proportionate profit on its own investment in relation to the total mudarabah investment pool. islamic banks can also open may announce murabaha and leasing funds in which the risk-averse investors may purchase units and be treated as rabbul-mal and get the quasi fixed-return from profits or rentals earned by the respective funds from the trading and leasing activities4. in summary, there is no fixed rate of return to any types of deposit accounts of the islamic banks. as the depositors undertake risk of their deposits under the muderabah saving deposits and the muderabah investment deposits, they earn money on their deposits as per prearranged contract. the key feature of this liability contract is that islamic banks neither guarantee the safety of depositors’ capital nor any fixed return on deposits. in this sense, islamic banks’, muderabah investment deposits are more risky than those of conventional banks’ fixed deposits and as such deserve more earnings. second, the profits and losses sharing under this contract (muderabah investment deposit) are not symmetric. under this contract, banks share profits but share no losses. depositors bear all losses (chong and liu, 2009). 4 www.financislam.com/depositw.html. 3. reasons for studying bangladesh bangladesh is one of largest muslim countries in the south east asia. its population, about 150 million, is mostly muslims. its large muslim population inspired the development of the islamic as early as 1983. bangladesh’s financial sector is consisting of a wide range of conventional and islamic financial institutions and markets. there are thirty eight domestic conventional banks, nine foreign banks, twenty nine financial institutions operating in bangladesh5. of the thirty eight domestic banks, seven banks are islamic banks. islami bank bangladesh ltd., is the third largest private bank in bangladesh. the financial sector is relatively large and provides a contribution to gdp. second, there is tremendous growth of banks and financial institutions in bangladesh. when bangladesh was born in 1971, there was no private bank. the five banks that bangladesh inherited from pakistan at the time of liberation were sonali bank, rupali bank, janata bank, agrani bank, and pubali bank. these banks were nationalized by the-then government of bangladesh and became the public sector banks. when the privatization policy was introduced in 1982, there was just one private domestic bank (pubali bank) in bangladesh. currently, there are forty-one private banks excluding four government owned banks. 4. survey of literature the extent of past scholarly research on islamic banking includes khan (1986), mannan (1968), iqbal and mirakhor (1999), and ahmad (1984). these authors discuss the theoretical development of institutional issues and concepts, including arabic concepts, and principles that are subject to interpretation. khan (1986) provided an important theoretical model of islamic banking and compared the model with conventional banking. he argued that islamic banks “treat deposits as shares and accordingly does not guarantee their nominal value” (p. 19). since profit and loss is equity, account depositors would be treated like shareholders of a bank and, therefore, “no official reserve requirement would be necessary for these investment deposits” (p. 20-21). chapra (1992) and siddiqi (1983) argued for islamic banking as the primary alternative of interest based conventional banking. they also argued that islamic banks were efficient to generate economic growth without getting involved interest. khan (1986) provided a good description of the development of islamic banks in egypt, kuwait, uae, and pakistan. kazarian (1993) compared two egyptian islamic banks with egypt conventional banks taking ratio of long term financing and found that the two islamic banks occupied a third position in egypt during 5 bank and financial institutions, ministry if finance, government of bangladesh 2010-2911. samad and chowdhury: islamic banks’ return on depositors and conventional banks’ deposit interest: is there causality? evidence of causality from bangladesh international journal of economics and financial issues | vol 7 • issue 5 • 2017436 1979-1990. aggarwal and yousef (2000) examined islamic banks mode of operations and found that the pls mode of islamic banks was minimum and the agency problem of islamic banks was more severe. samad et al. (2005) studied the bahrain and malaysia islamic banking finances and found that the muderabah and musharak, the distinct mode of islamic banks that distinguished islamic banks from the conventional banks are less than 4 percent of total financings. debt type financing such as murabah and ijarah appeared to be most popular and dominant of all other modes of financing. samad (1999 and 2004) compared the performance of islamic banks and conventional commercial banks of malaysia and bahrain with respect to (a) profitability (b) liquidity (c) capital management. eleven financial ratios were compared for the period 1991-2001 and found that there is no difference in profitability and liquidity performance between islamic a n d c o n v e n t i o n a l b a n k s . f a y e d ( 2 0 1 3 ) c o m p a r e d t h e profitability, liquidity, credit risk, and solvency performance of three egyptian islamic banks with six conventional banks during 2008-2010 and found superiority of conventional banks’ performance over islamic banks. chong and liu (2009) examined malaysian islamic banks and found that the pls mode of finance was minimum. the growth of islamic banking was largely driven by the islamic resurgence rather than by advantage of the pls mode of production. cevik and charap (2011) examine the empirical behavior of conventional bank deposit rates and the rate of return of islamic banks in malaysia and turkey and found that there was a long run co-integration between the series. samad (2013) investigated whether the global financial crisis (gfc) has had its impact on the efficiency of islamic banks estimated by using the time varying stochastic frontier function on the islamic banks of 16 countries. the efficiencies of islamic banks were estimated using cobb-douglas production function and found that the gfc had had no impact on banks’ efficiency. mean efficiencies between the pre gfc and the post global crisis were estimated 39 and 38% respectively and the difference was not statistically significant. the survey of literature shows no empirical study on the rate of return of the islamic banks’ deposits and the deposit interest rate of the conventional banks. 5. data and methodology 5.1. data annual data, 2005-2015, for the conventional banks’ interest rate on deposit and the islamic banks’ return to depositors were obtained from, the central bank of bangladesh. since the number of year is eleven and the data are annual, pooled data are used to increase the number of observations. the descriptive statistics of two variables, islamic banks’ rate of return to depositors (isbkdr), and the conventional banks’ deposit interest rates (conbkdi), are provided in table 1. 5.2. methodology 5.2.1. vector auto regressive model (var) when the distinction between endogenous and exogenous variables is not clear, var is an appropriate model (astrrious and stephen, 2007). since it was unknown whether, the islamic banks’ rates of return to depositors (isbkdr) or conventional banks’ deposit interest rates (conbkdi) was endogenous or exogenous, the paper applied the var model. in the var model, all variables are treated as endogenous. the best thing in the var is that the econometrician does not have to worry which variables are endogenous or exogenous. second, var is easy to estimate and the forecasts of var are in most cases far better than those obtained from the complex simultaneous model (mahmoud, 1984). vector error correction model (vecm) is applied to find the causality and the direction of the causality between them. in terms of two variables, isbkdr and conbkdi, vecm can be written and estimated from the model: ∆ ∆ ∆ isbkdr conbkdit i isbbkdrt i t t i n i n t = − + − + − + = = ∑ ∑ β α φϑ ε 1 1 1 1 1 (1) ∆ ∆ ∆ ψ conbkdi isbdr i conbkdit i t t i n i n t = − + − + − + = = ∑ ∑ β α ϑ ε 2 1 1 2 1 (2) where  t 1− = (isbkdrt-1 – αo−βconbkdit−1) is called the residual cointegration equation or error correction term (ect), εt is white noise error term. the sign of the ect, ϑt-1 for both equations, (1) and (2) is expected to be negative. 5.2.1.1. short run impact in (3), βi is the short run impact multiplier that measures the immediate impact of changes in conventional banks’ deposit interest, (conbkx-6) on the changes on islamic banks’ rate of return to depositors (isbky-6), it, thus, provides the short effect. table 1: descriptive statistics of conventional bank deposit interest (conbkx-6m) and islamic bank rate of return to depositors (isbky-6m) variable conbkdeposti isbkdeposir mean 8.283279 8.374750 median 7.655000 8.840000 maximum 395.0000 12.76000 minimum 0.070000 0.080000 standard deviation 20.24634 2.426699 skewness 18.80437 −1.710184 kurtosis 359.7346 7.172466 jarque-bera 1994447.0 101.8794 probability 0.000000 0.000000 sum 3081.380 703.4790 sum sq. dev. 152078.2 488.7759 observations 372 84 samad and chowdhury: islamic banks’ return on depositors and conventional banks’ deposit interest: is there causality? evidence of causality from bangladesh international journal of economics and financial issues | vol 7 • issue 5 • 2017 437 5.2.1.2. long term relation and granger causality test in the long run equilibrium, the ect is zero. if conbkdi and isbkdr deviate from the long run equilibrium, the ect will be nonzero and each variable adjusts to partially restore the equilibrium relation. the coefficient, φ, of the ect measures the speed of adjustment of the ith endogenous variable towards the equilibrium. since δyt in (3) does not, for sure, provide about long term relation/behavior, the incorporation of t-1, the ect resolves this problem and, thus, provides the existence of long term relation. the coefficient (φ) of the ect, ϑt−1 on the other hand, is the short term adjustment effect. it provides the speed/rate of adjustment when rates are out of equilibrium. the sign of φ is expected to be negative in the mean reverting case. based on henry (1995), the mean adjustment lag is calculate by the following equation: mal = (1−β)/φ (3) the equation (3) provides two sources of causation, first, δconbkx-6t and second, the cointegrating equation, ϑt−1. in the conventional granger causality test, null hypothesis: δconbkx-6t does not granger δisbkdrt−i is rejected if β≠0 (i.e., β is not significantly zero). with the incorporation of cointegrating eqauation, ϑt−1, additional source of causation is established. the null hypothesis: δconbkdrt−i does not granger δisbkdrt−i is rejected not only if β, the lagged values of y are not jointly significant i.e. β=0 but also if the coefficient of the ect, φ is significant, according to miller and russek (1990) and granger (1988). in other words, the ect opens up an additional channel for granger causality. the granger causality is established either through the significance of (i) φ, the ect by t-test; or (ii) joint test applied to the significance of the sum of lagged of each explanatory variables ∆ i n xt i =∑ 1 and α1 ∆ i n yt i =∑ −1 )�by a joint f or wald χ2 test. the causality in the long term exists only when φ, the coefficient of ect is statistically significant and different from zero (φ≠0). the application of the vec requires that the variables x and y must integrated of order i(1) i.e., x~(1) and y~(1). they are nonstationary at level but stationary at first difference. this requirements sets the stage for unit test and cointegration test. 5.2.2. unit root tests since the publication of nelson and plosser (1982), it is widely recognized that most time series macroeconomic variables contain unit root i.e., variable xt~i(1). so, this paper, first, examines the existence of unit root in y indices and x indices by using the augmented dickey-fuller (adf) and philip-paron tests (paron1989). in the following equation, the null hypothesis, α=0 is tested against the alternative hypothesis, α<0: δyt=α0+βt+γyt−1+ i k i∑ ∆ yt−1+εt (4) schwarz bayesian criterion will be used to determine the lag length or k. the results of adf and pp test are presented in table 2. the results of both adf and pp test demonstrated that both series are stationary at the level as well as at the first difference. 5.2.3. cointegration having established that the variables are non-stationary i.e. i(1), the presence of cointegration among these variables in level form is required for the model. consequently, the cointegration properties of the variables are examined. that is, it is necessary to determine whether there is at least one linear combination of these variables that is i(0). to investigate multivariate cointegration, this paper applies johansen (1991 and 1995) var based trace and maximum eigenvalue tests. johansen (1991 and 1995a) cointegration is a var test and written in general form as: ∆ ∆yt yt i yt i xt t i p = − + − + + = − ∑π τ β ε1 1 1 (5) where ∏ = − = ∑i i p 1 1 and τ β= − = + ∑ j j i p 1 based on granger’s theorem, if the coefficient matrix π has reduced rank r<k, then there exists k x r matrices α and β each rank r such that and is i(0). r is the number of cointegrating relations (the cointegrating rank) and each column of β is the cointegrating vector. the null hypothesis is that number of cointegration: h0: r=0 ha: r=1. the result of the johansen cointegration between the islamic banks’ rate of return to depositors (isbky-6m) and the conventional banks’ deposit interest rate (conbkx-6m) is presented in table 3. table 3 reports the result of the trace test and the max-eigen-value test. as the trace statistics and the max-eigen statistics are 14. 01 and 14.01 respectively and they are greater than their critical value 12.32 and 11.22 respectively, both tests reject the null hypothesis table 2: adf and phillips-parron unit root tests variables adf test (intercept) null hypothesis: variable has unit root lag length: (automatic-based on sic, maxlag=9 pp (phillips-parron) test null hypothesis: variable has a unit root level (t-statistics) 1st difference (t-statistics) level (t-statistics) 1st difference (t-statistics) conbkdi −19.37* −13.38* −19.35* 31.98* isbkdr −3.95* −6.97* −4.92* −17.21* *: significant at 1% level, **: significant at 5% level, ***: significant at 10% level. adf: augmented dickey-fuller samad and chowdhury: islamic banks’ return on depositors and conventional banks’ deposit interest: is there causality? evidence of causality from bangladesh international journal of economics and financial issues | vol 7 • issue 5 • 2017438 of no cointegration i.e., r = 0. the rejection of null hypothesis of no cointegration among the variables suggests the presence of one cointegrating equation. 6. empirical results 6.1. vec result the results of the vec model is presented in table 4. the result of the vec estimates, in table 4, demonstrates that the sign of the ect (ϑt−1) is negative and consistent as per the expectation of the error correction model. the coefficient of the ect (ϑt−1) is −0.58 and it indicates that the speed of adjustment was 58% if the conventional banks’ deposit interest rate was deviated from the long term equilibrium. third, the significance of the ect (ϑt−1) establishes long term granger causal relation between the two series. the var granger causality/block exogeneity wald test was performed in determining the causal direction. 6.2. var granger causality/block exogeneity wald tests result when the conventional banks’ deposit interest rate is a dependent variable, the χ2 test statistics is significant. the χ2 test statistics 3.89 and the low probability associated with the χ2 test statistics, in table 5, shows the islamic banks’ rate of return to depositors (isbkdr) had significant impact on the conventional banks’ deposit interest rate (conbkdi) and, thus, the direction of granger causality run from the islamic banks’ rate of return to depositors (isbkdr) to the conventional banks’ deposit interest rates. on the other hand, when the islamic banks’ rate of return to depositors is a dependent variable, the χ2 test statistics is insignificant. the high probability (0.16) of χ2 test statistics suggests that the conventional banks’ deposit interest rates had no impact on the rate of return to the depositors of islamic bank (isbkdr) and, thus, did not granger cause the islamic banks’ rate of return to depositors of bangladesh. the summery of the ver granger causality/block exogeneity wald test was that the was unidirectional granger causality running from the islamic banks’ rate of return to depositors to conventional banks’ deposit interest rate. the finding of this paper does not confirm the findings chong and liu’s (2009) in which they stated that the islamic banks’ rate of return simply follows the interest rate of the convention banks. 7. conclusions this paper examined the conventional banks’ annual deposit interest rate and the islamic banks’ rate of return to the depositors of bangladesh in determining whether there was a causal relation between them and the direction of causal relation during 20052015 with pooled data. the paper applied adf test and phillips-perron test for determining the stationarity of the series. the results of the test found that all series were stationary at both level and the first difference and thus reject the null hypothesis of non-stationarity. the paper tested whether the two series, the deposit interest rate of the conventional bank and the rate of return to the depositors of the islamic bank, were cointegrated by applying the johansen table 3: johansen cointegration tests result trend assumption: no deterministic trend series: conbkdeposti isbkdeposir lags interval (in first differences): 1-4 unrestricted cointegration rank test (trace) hypothesized no. of ce (s) eigenvalue trace statistic 0.05 critical value p** none* 0.176847 14.01653 12.32090 0.0258 at most 1 6.10e-05 0.004391 4.129906 0.9562 trace test indicates 1 cointegrating eqn(s) at the 0.05 level unrestricted cointegration rank test (maximum eigenvalue) hypothesized no. of ce (s) eigenvalue max-eigen statistic 0.05 critical value p** none* 0.176847 14.01214 11.22480 0.0158 at most 1 6.10e-05 0.004391 4.129906 0.9562 max-eigenvalue test indicates 1 cointegrating eqn(s) at the 0.05 level *denotes rejection of the hypothesis at the 0.05 level **mackinnon-haug-michelis (1999) p values table 4: *vec results error correction d (conbkdeposti) d (isbkdeposir) cointeq1 −0.581120 −0.084396 (0.14407) (0.11857) [−4.03368] [−0.71179] *1: standard errors in ( ) and t-statistics in [ ], *: significant at 1% level. vec: vector error correction table 5: result of ver granger causality/block exogeneity wald test dependent variable: d (conbkdeposti) excluded chi-square df p d (isbkdeposir) 3.889948 1 0.0486 all 3.889948 1 0.0486 dependent variable: d (isbkdeposir) excluded chi-square df p d (conbkdeposti) 1.886042 1 0.1696 all 1.886042 1 0.1696 samad and chowdhury: islamic banks’ return on depositors and conventional banks’ deposit interest: is there causality? evidence of causality from bangladesh international journal of economics and financial issues | vol 7 • issue 5 • 2017 439 cointegration test. the result of the johansen cointegration test established cointegration between the two series which established the stage for the vec. the result of the vec model found that the islamic banks’ rate of return to depositors (isbkdr) had significant impact on the conventional banks’ deposit interest rate. the significance of the ect (ϑt−1) establishes long term granger causal relation between the two series. the coefficient of the ect (ϑt−1) is −0.58 indicates that the speed of adjustment was 58% if the conventional banks’ deposit interest rate was deviated from the long term equilibrium. the var granger causality/block exogeniety wald test was performed in determining the causal direction. the probability of the of χ2 test statistics demonstrated unidirectional causality running from the islamic banks’ rate of return to depositors to the conventional banks’ deposit interest rate. the result of this paper does not confirmed the findings of chong and liu (2009) for malaysia. the absence of more data series prevented this paper to provide the robust conclusions. as paper relied on just one series i.e., annual rate, the result of the paper cannot considered robust. the incorporation and the examination of more data series such as the monthly deposit interest rate, quarterly deposit interest rate, and the half-yearly deposit interest rate of the conventional bank as well as the rate of return to the islamic banks’ depositors were essential for robust conclusions. however, the absence of such data set prevented this paper in providing such conclusions. references aggarwal, r., yousef, t. (2000), islamic banks and investment financing. journal of money, credit and banking, 32(1), 93-120. ahmad, z. (1984), concept and models of islamic banking: an assessment. islamabad: international institute of islamic economics. asterioius, d., stephen, h. (2007), applied econometrics. 2nd ed. basingstoke: palgrave macmillian. cevik, s., charap, j. (2011), the behavior of conventional and islamic bank deposit returns in malaysia and turkey, imf working paper no. 11/156. chapra, m.u. (1992), islam and economic challenge. leicester: islamic foundation. chong, b.s., liu, m.h. (2009), islamic banking: interest free or interest based? pacific-basin finance journal, 17, 125-144. fayed, m.e. (2013), comparative performance study of conventional and islamic banking in egypt. journal of applied banking and finance, 3(2), 1-14. granger, c.w.j. (1988), some recent development in a concept of causality. journal of econometrics, 39, 199-211. hamwi, b., aylward, a. 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(1990), co-integration and error correction models: the temporal causality between government taxes and spending. southern economic journal, 57, 221-229. mohmoud, e. (1984), accuracy in forecasting: a survey, journal of forecasting, 3, 139-159. nelson, c., plossar, c. (1982), trend and random walk in macroeconomics time-series: some evidence and implications. journal of monetary economics, 10, 139-162. parron, p. (1989), the great crash, the oil price shock, and the unit root hypothesis. econometrica, 57, 1631-1401. samad, a. (1999), relative performance of conventional banking visà-vis islamic bank in malaysia. iium journal of economics and management, 7(1), 1-25. samad, a. (2004), performance of interest-free islamic banks vis-à-vis interest based conventional banks of bahrain. iium journal of economics and management, 12(2), 115-129. samad, a. (2013), impact of global financial crisis: evidences from the cross-country islamic banks. british journal of economics, finance and management, 7(2), 4-63. samad, a., gardner, n., cook, b.j. (2005), islamic banking and finance in theory and practice: the malaysian and bahrain experience. american journal of islamic social sciences, 22(2), 71-86. samad, a., hassan, m., ghani, a. (2005), financial performance of commercial banks: a study of bahrain banking. middle east business and economic review, 17(1), 20-28. siddiqi, m.n. (1983), issues in islamic banking. leicester: islamic foundation. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(1), 80-86. international journal of economics and financial issues | vol 6 • issue 1 • 201680 conflict, defense spending and economic growth in the middle east: a panel data analysis serkan künü1, sertaç hopoğlu2*, gürkan bozma3 1department of economics, faculty of economics and administrative sciences, turkey, 2department of economics, faculty of economics and administrative sciences, iğdır university, turkey, 3department of economics, faculty of economics and administrative sciences, iğdır university, turkey. *email: sertac.hopoglu@igdir.edu.tr abstract the relationship between defense spending and economic growth is an active topic of debate for a long time. defense spending may have negative consequences on the growth performance of developing countries in such conflict-ridden areas as the middle east. this study is conducted to investigate the effects of defense spending on economic growth in a panel of twelve middle eastern countries over the period 1998-2012. the approach suggested by swamy and arora (1972) was employed for the empirical study. findings of the empirical study suggest that defense spending has a negative effect on economic growth, which aggravates during times of internal and external conflicts. keywords: defense spending, economic growth, conflict, middle east jel classifications: e60, f52, h56 1. introduction whether governments can achieve economic growth by means of increasing defense spending is an ongoing topic of discussion which has been busying the minds of economists for a long time. as to the keynesian view, defense spending has a positive impact on economic growth through a stimulation of aggregate demand, by triggering a rise in capital stock utilization, employment, profits and thereby creating an increase in investments. defense spending may have positive effects on growth, by creation of such hard infrastructure as roads, buildings, bridges, etc. and by development of technologies that can also be productively used in the private sector. in contrast, neoclassical view argues that defense spending negatively affects economic growth, by crowding-out private sector through channeling resources, which may otherwise be more productive in the private sector, to defense and related sectors. in case where national defense sector is not developed, national defense is highly dependent on imports of defense goods. this may also have negative growth consequences by increasing external debt and transferring valuable resources to abroad. empirical research on the defense spending-economic growth relationship has produced conflicting results so far, depending on the sample of country or groups of countries selected, the econometric model or approach or the data set used for the study. the literature on the subject is rich with studies on developing countries as well. with research on such developing areas like sub-saharan africa or south east asia, where conflicts are common, and on rival neighbors, such as greece and turkey or pakistan and india. however, there are several studies which focus on the middle east alone, a region which is ridden with serious conflicts and political tensions. the middle east is often included in panel studies containing many countries as “the middle east and north africa.” this study aims to investigate defense spending-economic growth relationship in the core of the middle east, where security is a constant concern. in this respect, a panel of twelve middle eastern countries including bahrain, egypt, iran, israel, jordan, lebanon, oman, turkey, kuwait, united arab emirates, yemen and saudi arabia1 were selected and panel data approach were 1 iraq, qatar and syria were excluded from the panel due to data issues. künü, et al.: conflict, defense spending and economic growth in the middle east: a panel data analysis international journal of economics and financial issues | vol 6 • issue 1 • 2016 81 applied to data over the period 19982012 to test the nature of defense-growth relationship. the effects of internal and external conflicts on defense spending and economic growth were also checked for in order to have a picture of the contribution of defense spending on national economies. as it was pointed out by dunne et al. (2004: 181), demand for higher defense spending may have serious macro consequences if increased military spending is financed by increasing money supply, borrowing from abroad or from within the country, or by depleting foreign exchange stocks. moreover, there may be indirect effects of defense spending on external indebtedness through purchase of expensive advanced technologies or intermediate goods required by the domestic defense industries from abroad (günlüksenesen, 2004: 147). the study is structured as follows: the second section of the study includes a literature survey on the defense spending-economic growth nexus. data and methodology are explained in the third section. empirical results are provided in the fourth section of the study. elaborations are made and some recommendations are given in the final and concluding section. 2. literature survey the nature of defense spending-economic growth relationship has been a hot topic for researchers. there are studies are conducted for individual countries which are known to have conflict or security issues. there is also a rich vein of literature focusing on panels of developing countries or countries situated in certain regions around the world. as for the former group, karagianni and pempetzoglu (2009) ran both linear and nonlinear granger causality tests to investigate defense-growth relationship for turkey over the period 1949-2004. linear granger causality test implied a unidirectional relationship from economic growth to defense spending. applying nonlinear baek and brock (1992) test modified by hiemstra and jones (1994), karagianni and pempetzoglu (2009) obtained a unidirectional causal relationship running from defense spending to economic growth. feridun et al. (2011) applied ardl approach of pesaran et al. (2001) and granger causality test to investigate the effects of military spending on economic growth of self-proclaimed turkish republic of northern cyprus over the period 1997-2007. they have found a unidirectional relationship running from defense expenditures to growth in north cyprus while kollias et al. (2004) found an instantaneous bidirectional relationship for south cyprus. wolde-rufael (2009) applied bounds test and granger causality test to data over the period 1970-2005 for ethiopia to obtain a positive unidirectional causality between defense spending and external debt and a negative relationship between growth and external debt. shahbaz and shabbir (2012) tested the defense-growth relationship for pakistan over the period 1971-2009 using ardl approach of pesaran et al. (2001), while also checking for the stability of the cointegration relationship using a rolling window approach. they have obtained a negative impact of defense spending on economic growth, with the direction of causality is from defense spending to economic growth. on the other hand, shahbaz et al. (2013) used pesaran et al. (2001) approach and vector error correction model for pakistan to conclude that there is a positive relationship running from defense spending to external debt and a negative unidirectional relationship from economic growth to debt over the period 1973-2009. there are also a number of single-country studies testing the defense-growth relationship for different countries in the middle east. using a nonlinear least squares approach on 1953-1992 data for israel, derouen (2000) concluded that non-defense government spending have a more sound positive effect on growth than the defense spending, particularly in the short-run. sezgin (2004) applied engle –granger causality test on data over the period 1979-2000 to test defense spending-external relationship in turkey. although the sign of the relationship is not clear in the long-run, sezgin (2004) found that defense spending is increasing turkish external debt in the short-run for the studied period. al-jarrah (2005) tested the relationship for saudi arabia for 1970-2003 period, first checking for the effect of defense spending on overall real gross domestic product (gdp), and then on non-oil real gdp in order to isolate the effects of oil revenues. using johansen (1988) cointegration test and granger causality tests, al-jarrah (2005) found a bidirectional causality between defense spending and economic growth and unidirectional causality running from non-oil economic growth to defense spending; with the effects of defense spending is negative and stronger in the short run. karagol (2006) studied the relationship between defense spending, external debt and economic growth in turkey. running johansen test, karagol (2006) estimated impulse-response functions and variance decompositions to find a positive relationship between defense spending and external debt. duella (2014) investigated the relationship for algeria using 1988-2010 data. applying johansen cointegration test, he concluded that there is a unidirectional causality running from military spending to economic growth, with the overall effect being negative in the long-run. abu al-foul (2014) employed toda and yamamoto (1995) approach to find out that there is a unidirectional relationship running from defense spending to economic growth in jordan over the 1988-2007 period. as an example of mixed results in the literature, using a data set for the 1992-2006 period and grouping countries as to their income levels and geographical regions, chang et al. (2011) applied the generalized method of moments (gmm) approach proposed by arellano and bond (1991) to a panel of 90 countries. chang et al. (2011) found that military spending negatively causes economic growth in the middle east-south asia and europe regions. using a two-step gmm approach, chen et al. (2014) found mixed results for different countries, grouped as to their income levels, economic bloc status (oecd, g7, asia and europe) and geographical locations. chen et al. (2014) concluded that there is short-run bidirectional causality between defense spending and economic growth in the middle east and north africa region. there is a rich literature focusing on groups of asian countries as well. hirnissa et al. (2009) investigated the relationship for asean-5 countries over the period 1965-2006 applying künü, et al.: conflict, defense spending and economic growth in the middle east: a panel data analysis international journal of economics and financial issues | vol 6 • issue 1 • 201682 pesaran et al. (2001) bounds test and stock and watson (1993) dynamic ordinary least squares (ols) approach. they have found a bidirectional relationship for singapore, a unidirectional relationship from defense spending to growth in indonesia and thailand and no relationship in malaysia and philippines. in another study on a panel of five other south asian countries for 1988-2007 period, pradhan (2010a) used johansen cointegration test and pedroni (2004) cointegration test, finding long-run unidirectional causality from economic growth to defense spending in indonesia, malaysia, singapore and thailand and a bidirectional causality in philippines. in addition to india and pakistan, wijeweera and webb (2011) tested the long-run relationship between military spending and economic growth for three more south asian countries of nepal, sri lanka and bangladesh using data from the 1988-2007 period. employing augmented dickey-fuller, kao residual cointegration and johansen-fisher panel cointegration tests and granger causality test in a fixed effect model, they have found that, although minimal, military spending has a positive effect in this group of countries; with a 1% increase in military spending causing a 0.04% increase in growth. in another study conducted by safdari et al. (2011), using pesaran et al. (2001) and toda and yamamoto (1995) approaches for a panel of south korea, malaysia, iran and saudi arabia over the period 1988-2006, no relationship was found for iran and saudi arabia, while a unidirectional relationship from growth to defense spending obtained in south korea and vice versa in malaysia. majority of the literature consists of studies conducted on groups of countries in which the middle east is usually included in general groups of developing countries or larger regions such as middle east and north africa. the relationship between defense spending and economic growth may also show differences according to the geographical location of countries as the state of spatial relations, especially those between neighbors, such as conflict or peace, may have an impact on military expenditure. in this respect, including the core of the middle east in enlarged regional contexts for research might not produce focused results, as regional proximity may induce increases in defense spending due to heightened regional risks or expectations of threat from nearby countries. highlighting this line of thinking, yildirim et al. (2011) used augmented feder – ram and solow defense – growth models in a data set of 133 countries for the 2000-2008 period. in both models, yildirim et al. (2011) obtained statistically significant effects of military spending on growth that are affected by spatial patterns. in the same fashion, pradhan (2010b) reached to the conclusion that geographical proximity of countries can affect each other’s defense spending. using johansen and pedroni approaches to test for the relationship between defense spending and economic growth in china, india, pakistan and nepal for the period 1988-2007, pradhan (2010b) found mixed results for the studied countries; while a unidirectional causality between defense spending and economic growth exists in china and nepal, the direction of the relationship is, however, is not clear for india and pakistan. there are also a limited number of studies focusing solely on the middle eastern countries. lebovic and ishaq (1987) used ols and two stage least squares methods on 1973-1982 data and reached out to the conclusion that defense spending is negatively effecting economic growth in the middle east. investigating the causal relationship between defense spending and growth in six gulf countries over the period 1975-1998, al-yousif (2002), using granger causality test within a multivariate error correction model framework has found mixed results for each of the studied countries. abu-bader and abu-qarn (2003) used multivariate johansen cointegration test and granger causality tests to check for causality between military spending and economic growth in egypt, israel and syria. they concluded that the military spending has a negative effect on growth in these countries in the longrun. yildirim et al. (2005) tested the relationship for turkey and middle east countries using fixed effects model and arellano and bond (1991) gmm technique over the period 1989-1999, finding a positive impact of defense spending on growth in the studied panel of countries. smyth and narayan (2009) used multiple cointegration tests for bahrain, iran, jordan, oman, syria, yemen over the period 1988-2002 to show that there is a positive relation between defense spending and external debt. using bootstrap panel causality test approach of kónya (2006), pan et al. (2014) studied the relationship between 10 middle eastern countries for the period 1988-2010. they found mixed results for different countries in the panel. abu-qarn (2010) studied the effects of defense spending on economic growth in israel and its arab rivals of egypt, syria and jordan for the 1960-2004 period using toda and yamamoto (1995) approach and generalized variance decomposition, finding weak causality from defense spending to economic growth or no causality. 3. methodology and data annual data from the sample period of 1998-2012 for twelve middle east countries; bahrain, egypt, iran, israel, jordan, lebanon, oman, turkey, kuwait, united arab emirates, yemen and saudi arabia were used in this study. a gdp-growth model including seven variables was established for the middle eastern countries mentioned above. following the literature, we obtained four models to measure the effects of defense spending on economic growth: model 1=gdpit=f(defit+popit+fdiit+corit) (1) model 2=gdpit=f(defit+popit+fdiit+corit+intit) (2) model 3=gdpit=f(defit+popit+fdiit+corit+extit) (3) model 4=gdpit=f(defit+popit+fdiit+corit+intit+extit) (4) i=1…….n t=1……….t, where gdpit is the rate of economic growth of country i at time t, measured as the gdp (at constant 2005 us dollars), defi represents the defense spending of country i (hence; defit/gdpit is rate of defense spending of country i to its gdp at a given time t), popit is population growth rate, fdiit represents the rate of foreign direct investment (fdi) to gdp, corit is country i’s corruption index value at time t, init and exit are country i’s internal conflict index künü, et al.: conflict, defense spending and economic growth in the middle east: a panel data analysis international journal of economics and financial issues | vol 6 • issue 1 • 2016 83 and external conflict index values at time t, respectively. table 1 shows a list of dependent and independent variables used in this study and their respective sources. gdp, fdi and population data are taken from the united nations conference on trade and development yearbook, 2014; defense spending is taken from stockholm international peace research institute yearbook, 2015 and external and internal conflict variables are taken from international country risk guide (icrg) yearbook, 2012. as explained by icrg (2012); internal conflict index value is an assessment of political violence in any country. the highest rating represents that there is no armed or civil opposition to the government while the lowest rating represents that there is an on-going civil war. on the other hand, external conflict index value is an assessment of the risk to the incumbent government from foreign action, including non-violent external pressure, withholding of aid, trade restrictions, territorial disputes, sanctions, etc. the analysis of panel data is the subject of one of the most active in econometric literature because of the fact that panel data provide such a rich environment for the development of estimation techniques and theoretical results (greene, 2012: 344). thus, we preferred to use a panel data approach to measure impacts of defense spending. fixed effects model and random (generalized least square) effects model are the most preferred analyses by researchers. the crucial appropriation between fixed and random effects is whether the unobserved individual effect embodies elements that are correlated with the repressors in the model; whether these effects are stochastic or not (greene, 2012: 347; baltagi, 2005: 19). in this study, we use a one-way random effect model in order to research impacts of defense spending on economic growth. therefore, we add the error terms to the models stated above and rewrite the equations as below: model 1=gdpit=ait+β1defit+β1popit+β2fdiit+β3corit+β4dummyit +uit+εit (5) m o d e l 2 = g d p i t= a i t+ β 1d e f i t+ β 2p o p i t+ β 3f d i i t+ β 4c o r i t+ β 4i n + β 5d u m m y i t+ u i t+ ε i t (6) m o d e l 3 = g d p i t= a i t+ β 1d e f i t+ β 2p o p i t+ β 3f d i i t+ β 4c o r i t+ β 5e x + β 5d u m m y i t+ u i t+ ε i t ( 7 ) model 4=gdpit=ait+β1defit+β2popit+β3fdiit+β4corit+β5in+β6ex+ β5dummyit+uit+εit (8) i=1…….n t=1……….t, where uit is the cross-section effect, εit represents error term and dummyit is dummy variable for global financial crisis of 2009. in this study, we use hausman (1978) test to select the most effective model. moreover, while estimating, we follow swamy and arora (1972), who suggest running two regressions to get estimates of the variance components from the corresponding mean square errors of these regressions. the first regression is “within regression” and the second regression is “between regression” (baltagi, 2005:16). 4. empirical results we apply hausman test to decide between fixed effects and random effects models. the value of hausman test is not significant, which means that random effects model is the best choice for analysis when compared to fixed effects model. therefore, only the results of random effects model are given in table 2. since random effects estimator is biased, robust standard errors must be generated. thus, the method developed by arellano (1987), froot (1989) and rogers (1993) was used for the robustness check of the study. as seen table 2, wald chi-square statistic which belongs to model 1 is 82.47 and significant, which means model 1 is fit. coefficients of defense spending, corruption and population growth variables are −0.149, 0.001 and −0.006, respectively, and z-values for these variables are -3.73, 0.29 and -0.15, respectively, meaning just defense spending is statically significant. these results suggest that corruption and population growth are not correlated with growth. on the other hand, fdi is highly positively correlated with economic growth; its coefficient is 0.22 and z-value is 6.07, which means that coefficient of fdi is statically significant at 1%. dummy variable for global crisis is also negatively correlated with economic growth and statically significant at 1%. in model 2, we add internal conflict as a control variable. diagnostic statistics of r2 and wald statistic for model 2 are 0.14, 191.55 respectively. after adding internal conflict, defense spending is negatively correlated with economic growth; its coefficient is −0.226 and z-value is −0.4.01, meaning that coefficient is statically significant at 1%. moreover, fdi and internal conflict are statically significant at 1% level. in model 3, we check for the effects of external conflict. coefficient of defense spending is negative and statically insignificant. fdi and external conflict are positively correlated and significant at 1% level. in our last model, we include external and internal conflict in model 1. here, defense spending is negatively correlated with economic growth and statically significant at 1% as in model 2. table 1: description of the variables variable description databank gdp real economic growth rate unctad fdi rate of real foreign direct investment (2005$)/ real gdp (2005$) unctad population population growth rate unctad defense spending rate of real defense spending (2005$)/ real gdp (2005$) sipri corruption corruption index icrg, 2012-table 3b dummy variable dummy variable for 2009 financial crisis internal conflict internal conflict index icrg, 2012-table 3b external conflict external conflict index icrg, 2012-table 3b gdp: gross domestic product, fdi: foreign direct investment, unctad: united nations conference on trade and development, sipri: stockholm international peace research institute, icrg: international country risk guide künü, et al.: conflict, defense spending and economic growth in the middle east: a panel data analysis international journal of economics and financial issues | vol 6 • issue 1 • 201684 its z-value is −3.98. moreover, fdi, internal conflict and dummy variable are statically significant at 1% 5%, and 10% level respectively. corruption is not statically significant in all models. in model 4, r2 is 0.15, wald statistic is 30.36 and significant at all levels. 5. discussion and conclusion the middle east has been a tumultuous geography throughout the history. struggle for utilization of rich underground resources, arab-israeli conflict and sectarian differences have been major sources of conflict in the middle east as well as the threat posed by terrorist groups of different orientations. this situation increased the relative necessity and importance of defense spending in the face of other public spending sub-categories such as education and health which may have more favorable effects on growth and development of the middle east countries. defense spending for protection against internal and external conflicts and for national interests has an influence on economic growth performances of countries. empirical studies on the literature have been generating conflicting results so far. the relationship between defense spending and economic growth was investigated for a panel of 12 middle eastern countries. panel data approach was employed to data for the 1998-2012 period. according to the results of the tests, economic growth in the studied panel of countries is negatively affected by defense spending. as expected, fdi has a positive effect on economic growth in these countries. expected results were also obtained when we control for the effects of global financial crisis of 2009; global economic crisis has a negative impact on the economic growth of studied middle eastern countries. checking for the effects of internal and external conflicts, our empirical findings point that negative effect of defense spending on economic growth aggravates during internal and external conflicts. 1% increase in defense spending in case of conflicts decreases the rate of growth by approximately 0.22%, with the effect on growth is a little bit lower during external conflicts than that of during internal conflicts. this may be resulting from the fact that most of the countries in our panel (except israel, and to some extent iran and turkey) are importers of defense goods. most of the countries in our sample have primitive or developing defense sectors. positive growth effects of investments to defense industry in developed countries generally occur through externalities in research and development, infrastructure and human capital. in the middle east, in general, increased demand for such goods during times of conflict consumes resources from other sub-categories of public spending, which are transferred to abroad to finance defense spending. according to the findings of the study, three separate policy recommendations can be made. first, public resources can be allocated to physical infrastructure in transportation, health, education, etc. and social areas such as arts and culture to decrease the possibility of internal conflicts. such investments in problematic regions may serve to curb conflicts. second, resources can be directed to measures for encouraging an export-oriented policy, improving bilateral trade ties with the rest of the world. increase of trade with neighbors would particularly decrease possibility of external conflicts. third, development of a domestic defense industry may be selected as a policy option and resources may be channeled to that direction, as done by iran, israel and turkey. the finding that the effect of fdi remains positive during conflicts, though, should be approached with caution. generally, investors refrain from making investments during crises due to uncertainty. geographical concentration of foreign investments in regions which are not affected by conflicts or deemed more secure by investors (such as the western part of turkey) may be a cause of this result. moreover, exclusion of lags from the study may prevent the observation of lagged negative effects of conflicts. in this respect, the nature of the relationship between fdi and economic growth under conflict conditions calls for further research with a more focused approach. references abu al-foul, b.m. 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(2011), military spending and economic growth in south asia: a panel data analysis. defence and peace economics, 22(5), 545-554. künü, et al.: conflict, defense spending and economic growth in the middle east: a panel data analysis international journal of economics and financial issues | vol 6 • issue 1 • 201686 wolde-rufael, y. (2009), the defence spending external debt nexus in ethiopia. defence and peace economics, 20(5), 423-436. yildirim, j., öcal, n., keskin, h. (2011), military expenditures, economic growth and spatial spillovers: a global perspective. international conference on applied economics-icoae, 2011. yildirim, j., sezgin, s., öcal, n. (2005), military expenditure and economic growth in middle eastern countries: a dynamic panel data analysis. defence and peace economics, 16(4), 283-295. . international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 245 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s8) 245-250. special issue for “fundamental and applied research in economics and management: new perspectives” agrarian policy of the region in terms of economic development innovation sergey m. reznichenko1, nadezhda k. vasilieva2, rustem a. shichiyakh3, yulia m. medvedeva4, yurii b. mindlin5* 1kuban state agrarian university, krasnodar, russian federation, 2kuban state agrarian university, krasnodar, russian federation, 3kuban state agrarian university, krasnodar, russian federation, 4national research nuclear university mephi (moscow engineering physics institute), moscow, russian federation, 5moscow state academy of veterinary medicine and biotechnology named after k.i. skrjabin, moscow, russian federation. *email: mindliny@mail.ru abstract one of actual problems of regional economies is the problem of the transition of inter-regional divergence and problematic regions to the model of “catching up” development, definition of the newest competitive domestic and world market, forms of development of the agrarian policy of the regional territories of the state. being a successful model of public-private partnerships and interaction between businesses, agro-industrial innovative education economic level represents the source of competitiveness of the region increases its level of importance and implementation of global processes in the agricultural sector. the cluster campaign of agrarian policy created on the account of affirmative synergy effects of regional agglomeration, network effects, diffusion of innovations, able to act as an accelerator of socio-economic education development stagnated production processes of problem regions, prevent deprivation in rural areas. plan for the development of agro-industrial economic cluster and the program of its implementation with the implementation of the comprehensive state support of innovative initiatives and education clustered development in regional areas. thus, the imperative of ensuring the unity of economic space establishes the need for modernization of program target management of socio-economic development of problem regions, in rural areas the formation of cluster strategies and network models of cooperation in agroindustrial complex. keywords: innovation, economy, region, competition, cluster, complex, state jel classifications: j43, o13, q13, q19 1. introduction the task of overcoming the recession in the region’s economy, at a time when the structure of its formation, all processes are moving into the recovery period, you must make a decision that contributed to the increasing importance of major economic processes in the region in an increasingly competitive world market, at different levels of the domestic market for basic manufactured products, and in various spheres of economic activities. in this context, the transition from the model of “catching up” to models of “advanced” development is possible only by increasing competitive capabilities: the cultivation of unique varieties of products, the introduction of the right policies for the livestock farming of the region and the overall agricultural potential of the region and state. in the conditions of globalization of world powers, increase of competitors market, developing new varieties of products, breeding of certain breeds increases the competitiveness of the national economy and agriculture. this policy enhance the region’s economy depends on the efficiency of competitive new forms of production organization and industrial clusters, which are understood concentrated on a certain territory a group of related companies; suppliers of equipment, components and specialized services; infrastructure; research institutes; universities and other educational organizations, mutually reinforcing each other and reznichenko, et al.: agrarian policy of the region in terms of economic development innovation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016246 strengthening competitive advantages of separate companies and organizations as well as the region’s economy as a whole. cluster approach the implementation of innovative approaches in the system of economic process in the management of agro-industrial development of the region is realized in the form of cluster policy efficiency of existing firms in the industry. in the world, on the territory of the main leading in this direction powers, we can distinguish two models in which cluster policy is carried out in the region’s economy-liberal (us, uk, australia, canada), in which a cluster is regarded as a market body, and the role of the federal government is removing barriers to its natural development, and dirigida (japan, korea, singapore, sweden, france, finland, slovenia), counting on the country’s active participation in the establishment and development of clusters. statistics held in russia cluster policy confirm the formation dirigistic model, which, in our opinion, the most effective in the modern russian conditions and aligned with the main legislative base of the state and basis of local government regions and localities. 2. materials and methods theoretical and methodological basis for the writing of this article was the classics, economic and management publications in the definition of the innovative cluster, the understanding of agrarian policy in the field of innovative reforms and ways of formation and change of public sector agriculture, development of agricultural sector of the regions and their assistance on the economic shell of the state and the world powers. special attention was devoted to the domestic and foreign scholars on the disclosure of major issues affecting the overall organizational formation of agricultural innovation clusters of enterprises and economic sectors, and economic processes of domestic and foreign policy activities of the innovation policy of the state and region. the research methodology is built on the dialectical method, systemic and strategic approaches to analyze objects. scientific provisions, conclusions and recommendations made in the article are based on the use of a range of methods of historical and logical analysis, comparison and synthesis, induction and deduction, economic-statistical method and expert evaluations. the information base of the research were the laws of the russian federation, the official publication of the state statistics, bodies of management of social-labor relations in the sphere of innovation development of the cluster policy, territorial sector, international labor organization, thematic collections and reference books, information published in scientific editions and periodicals, internet resources. the main sources of information for writing this article is based on publications and reports, contemporary scientific approaches to research of features of development of agriculture, the agricultural associations in the region and the economy of the russian federation, as well as the works of domestic authors on the organization and development of agro-industrial clusters and their role in the economic system of the russian federation. we used the methods of comparative analysis, groupings; a systematic approach based on the matching and comparison of theoretical and practical material and solve practical problems. 3. discussion implementation of the state agro-industrial cluster policy involves the development of strategies focused on the formation of clusters in the agricultural unions. economic development the basic processes of the domestic market of the agricultural sector, envisages by 2017, the increase in the gross domestic product, which would be impossible without the global system, the reform of key areas of economic and agricultural development. the policy of reforming the agricultural sector of the economy is a complex system of measures for efficient supply of the formation of agricultural industry and related sectors, which have a unique specificity in the stage of transition to an innovative way of formation, which is caused by the necessity of increasing the competitiveness of agricultural production and food supply security of the russian market and the integration of domestic production into the world economy (huhrin, 2012; silnov and tarakanov, 2015; ksenofontov et al., 2016). future the process of implementation of market policy reforms in agricultural policy of the economic sector of the country represents a complex of measures with separation of the main and priority directions for the supply of efficient formation of the agricultural sector. agricultural economics system of the russian federation is searching for a unique and perfect forms and methods of economic activity that will be most acceptable to the market structure of the country. modern approaches to innovative implementations in the agricultural policy of the regions and the country as a whole are based on upgrades and modifications for the development of the agricultural sector and require the development of new priorities for the establishment of an agricultural complex. a major role in the formation and embodiment in reality of the strategic course of innovative education of the agrarian sector of economy of the region belongs to the state management apparatus. the government should find a balance in cooperation with private business to abandon the practice of excessive interference in business as small scale and large businesses (il’yaschenko et al., 2015). priority strategic directions of the formation of agro-industrial enterprises should be tailored to regional characteristics, state policy, among which, first of all it is necessary to allocate a high proportion of the rural population and the level of rural unemployment (table 1). this allows you to define as priorities of reznichenko, et al.: agrarian policy of the region in terms of economic development innovation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 247 the cluster policy of the state support of development of regional agro-clusters. the development plan of the agricultural sector should also be based on spatial potential of development of the russian federation. the possibility of translating the strategy of development of agrarian society has targeted programs that represent a way of achieving assigned in the strategy goals. of course, innovative activity in each region should be supported and regulated by the state. this necessitates the creation of federal and regional bodies that will coordinate regulate and, if necessary, the unified management of innovative activity in various sectors of the economy, including the agricultural use of the experience of developed countries. the experience of state support of innovative activity in developed countries shows (silnov, 2015) that the government should formulate innovative policies that will ensure the competitiveness of the agricultural sector of the economy (moskalenko, 2015; kobersy et al., 2016). therefore, the strengthening of innovative activities should occupy the central place in realization of state policy in the agro-food sector of the russian federation. in this regard, in order to ensure innovative development of the regions and the country as a whole required the adoption of the federal law “on innovative activity.” it should be noted that most of the developed and implemented programs for the development of agriculture was front-covered the influence of socio-economic processes of large economic systems of a state or local-has been focused on improving the structure of cities, rural settlements or urban agglomerations. such programs are often done by way of budget co-financing of many disparate projects, but not as a means to supply progressive structural changes in the agricultural sector, the smoothing of social contradictions. effectively, in our opinion, is the program focal type, directed on formation of agrarian clusters on the basis of establishing a single orientation of agriculture, integrated development and use of territorial combinations of natural and economic resources, specialization and cooperation of production, territories and the competitive environment. research the state of the agrarian sector of the state, regions, settlements, market potential, competitive environment, allows us to identify the following potential agricultural clusters: a cluster for the production of meat and meat products, fruit cluster, the manufacturing cluster of wool products, the cluster of dairy products, etc. cluster structures occur in the institutional environment, characterized by certain qualitative properties that stimulate the clustering process. significant properties of institutions that contribute to the process of clusterization, is the significant level of competition, to encourage local entities to the integration interaction, and a high level of production concentration. the prevalence of households in agricultural production of the state is evidence of the predominance of natural and small-scale production and the almost complete absence of competition between producers as a key element of the cluster forms of business organization. and so low competition and concentration of production plunged to a lack of a critical mass of members of agrarian cluster. 4. results in this regard, important value is the development of small forms of managing in agrarian sector of the domestic economy. with this purpose, targeted programs are implemented, the states and regions, which determined the development of the peasant (farmer) farms to increase production and marketing of agricultural products through the supply conditions for the establishment, expansion and modernization of beginner farmers; organization of conditions for peasant (farmer) farms on the availability of financial resources; stimulation of transition of citizens, conducting a personal subsidiary economy, peasant (farmer’s) economy. in the course of formation and development of innovation activity of agrarian policy of the region and its impact on key economic processes must take into account the specificity of agriculture, its development trends and benchmarks (sen, 2016). the main production processes based on the use of land, plant and animal sector ensures the unity of technology and biological processes that determines the relationship between economy and ecology. based on these main components of the agricultural policy of the region innovation activity should be based and be aimed at the supply of effective and efficient growth of economic processes, rational use and consumption of intensive resourcesaving processes of agricultural production, bipolarization and ecologization of the production cycle, preservation of topsoil and other natural resources consumption. therefore, in the agricultural sector on a par with the already well-established areas of innovative economic activities, as well as with other types of innovation activity (organizational, social, industrial) is used selection genetic, reclamation-environmental and biotechnology-logical directions, which provide for the table 1: the proportion of urban and rural population and unemployment rate in 2016, % country the proportion of urban and rural population the unemployment rate urban rural urban rural russian federation 73.7 26.5 6.4 10.8 reznichenko, et al.: agrarian policy of the region in terms of economic development innovation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016248 formation and cultivation of new, not previously existing, highly productive and resistant to environmental influences of varieties and hybrids of plants and breeds of animals, the use and application of environmentally friendly and resource-saving technologies of processing of land and production of agricultural goods and the creation of biological resources to ensure conservation and protection of flora and fauna. specificity of the use of the most important definitions of the theoretical perception of the innovative capacity of the region to agricultural activities is also in the attraction of its main technological processes in the processes that occur in the environment-natural, in participating in the production process of organisms as well as other can be the object of innovative development of the agrarian policy and economic environment of the region. based on the established definition exists classification of innovative processes in agrarian sector of economy of region in clearly defined focus of operation, which relies on the account of specificity of both internal and external linkages agricultural industrial system and includes three groups of agro-industrial innovations (polunin, 2013; jose and padmanabhan, 2016): 1. innovations that are in their field use policies on the improvement of the production process; 2. innovations that improve the interaction of internal processes of agricultural industrial system; 3. innovations that improve the interaction of the external environment, the performance of agriculture. state policy in the framework of the long-term target program of agricultural sector of regions and their innovative formation assumes a secure document on “development of agriculture and regulation of markets of agricultural products, raw materials and food of the regions (2013-2020)” elaborated the sub-program “innovative development and information security.” the main objectives presented in this document for 2013-2020 are: • supply effective-productive activities of executive authorities of the regions in the field of agriculture development and economic potential, as well as control of the markets of agricultural products, raw materials and food; • provision of advisory services to agricultural producers; • sustainable development of agricultural production with increase in production and processing of agricultural products, improvement of its competitiveness through the introduction of scientific developments. • development and implementation of the policy of creation of cluster of enterprises with introduction of innovative technologies to improve the economic level of the regions. basic policy for the maintenance of economically stable functioning of the agricultural sector determines the development of conditions that will encourage the process of agrarian clusterization in the future will make of a particular region or particular area of application of this policy cluster enterprises are the most attractive. many of the world’s countries prefer to have as the main investor in the area of agrarian innovation and the economy of the region so-called venture capital funds (zakharov et al., 2016). the main activities of these firms maintain their small business is carried out by maintaining the policy risk of investing funds in innovation projects, not previously used in the production process in order ultimately to no small profit which can compensate for their previous and current failed investment (myrzaliev, 2014). for such functioning, not big on their activities and the sphere of dissemination of the firms flexibility and simplified system management apparatus, there is a wide scope of individual initiative actions that have the possibility of a flexible system of ntp, can be traced to the active involvement of its core business innovators and inventors with unique ideas to improve the processes that are acceptable in the field of agricultural policy. the policy provides a substantial performance of its core activities of venture capital firms. many of these firms, with the involved personnel with clearly defined and developed program implementation and development, bring not small contribution in economic development of the region, the main innovation of the agricultural sector, projects for the introduction and manufacture of completely new products, progressive technologies. therefore, this impact is currently funding venture capital firms actively takes its origins and development in many countries of the world, but also in the territory of our state, creating a large-scale joint ventures-cluster agricultural complex in the so-called special economic zones located in certain areas. improving the investment climate in the period of recovery growth primarily involves carrying out active innovative policy of the state contributing the greatest application of intellectual and scientific resources. effective mechanisms of innovation policy of development of agrarian fields in conditions of recovery growth are: 1. the establishment of the budget the minimum cost of financing of science and innovation and imparting to these articles a status protected; 2. the organization of innovation centers, such as innovative consulting center, center for agrarian reforms, center of scientific and technical information, and the coordinating council on innovation, carrying out analytical studies of innovative possibilities. one of the defining conditions for the establishment of agricultural cluster performs diversified structure of the economy. analysis of the structure of the manufacturing industries of the economy suggests that agricultural sector produces primarily products of low added value (goryushkina et al., 2016). while in the russian federation total per capita production of branches processing agricultural raw material exceeds the volume of per capita production of agricultural products, on average across reznichenko, et al.: agrarian policy of the region in terms of economic development innovation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 249 regions, the economic results of the industries of food and light industry per capita, taking into account included in the price the added value behind the economic results of agriculture. agro-industrial cluster policy should be based on supporting those industries and sectors of the economy, which are able to give a synergistic effect and give an impetus to the independent development of agricultural entrepreneurship. this effect, in particular, provides transportation infrastructure, which ensures the reliability of the relationships between entities, and consumer access to products. analyzing the agro-cluster as a form of institutionalizing of economic interests, should note their key role in the growth of the degree of employment the rural population. a necessary condition for the clusterization in the agro-industrial complex of the state, in our opinion, should be a restructuring of the system of trade and distribution of agricultural products and food. 5. conclusion the most important feature of the modern period of development of the agro-industrial complex is the need for maximum acceleration of scientific-technical progress as a process of gradual, technical, technological and socio-economic renewal and improvement of agricultural production to significantly enhance its effectiveness. scientific and technical progress, in turn, is a decisive factor of stability of development of agro-industrial complex solutions to complex socio-economic problems of the village. agriculture, as you know, is a fairly complex system consisting of different organizational and functional subsystems, and the production process consists of certain stages, and that determines a large diversity of factors of scientific and technological progress in the industry. here are the following groups of factors: biological, technical, technological, informational, organizational and legal. within these groups of factors determines the various directions, among which are at various stages of development of production of them are determined by the priority that is decisive for this period. a certain realization and implementation of the basic processes of the scientific-technical process is carried out through the realization of major innovative forms of economic development of the region, the providence of innovation course in the agricultural sector and the production, which allows in the future to achieve a positive effect. research conducted by many scientists give a reflection of what the conquest of innovation and their attainment in agricultural policy and its distribution contributes not only to maintaining a certain level of production, but also accelerates some of the processes of growing, processing crops that as a rule is accompanied by the acceleration of the final result-the profit of the manufacturer, thereby guaranteeing a stable financial position and economic stability of the region. a comprehensive analysis of the socio-economic trends, the implementation of innovative projects in the development of the region and its core activities of the agricultural sector, namely the development of an innovation cluster in the agricultural sector in conditions of recovery growth on the basis of the diagnostic indicators of its efficiency and effectiveness, as well as the spatial potential for the development of agriculture of the russian federation, it was evident that, despite the presence of a number of factors which have a deterrent effect on the functioning of the agrarian sector, low competitiveness, poor investment policy in the domestic agriculture formed the background of the transition to the cluster model of development, which in turn contributes to a more progressive stage of development of agriculture and the sphere of its influence. it is established that the formation of cluster-forming conditions will require active public policy, public impact aimed at increasing the level of competition and degree of concentration of production in the agricultural sector, improving the innovation component of the investment climate, diversifying the economic structure, promotion of industries and sectors of the regional economy, which are able to give a synergistic effect. for the formation of the resource base for support of investment projects it is necessary to make a state a grace exposure and funding, aimed at the formation and functioning of agro-industrial clusters of the agrarian sector means the basis of a single investment system, including institutions such as mutual fund agricultural consumer credit cooperatives, funds for mutual financial assistance, agricultural leasing funds, venture innovation fund and the institute of mortgage lending. only these projects are innovative updates of agrarian policy of the region, its economically stable activities will allow for effective performance of agro-industrial clusters and high-level qualitative indicators, derived products, which will enable the region and the country to reach the world level of market relations to improve and increase their competitiveness, striving to achieve the specified level in the leading countries. references goryushkina, n.y., shkurkin, d.v., petrenko, a.s., demin, s.y., yarovaya, n.s. (2016), marketing management in the sphere of hotel and tourist services. international review of management and marketing, 6(6), 207-213. huhrin, a. (2012), agro-industrial clusters: russian model. economics of agricultural and processing enterprises, 7, 30-34. il’yaschenko, d.p., chinakhov, d.a., danilov, v.i., schlyakhova, g.v., gotovschik, y.m. (2015), increasing strength and operational reliability of fixed joints of tubes by mma welding. paper presented at the iop conference series: materials science and engineering, 91(1), 12007-12010. jose, m., padmanabhan, m. (2016), dynamics of agricultural land use change in kerala: a policy and social-ecological perspective. international journal of agricultural sustainability, 14(3), 307-324. kobersy, i.s., khasiyeva, l.g., yakhina, v.d., ignatyeva, o.v., goloshchapova, l.v., shkurkin, d.v., sadykova, l.r. (2016), approaches to implementation of motivation as the complex conditions of increase of efficiency of social and labor relations: international experience. international review of management and marketing, 6(1), 208-217. reznichenko, et al.: agrarian policy of the region in terms of economic development innovation international journal of economics and financial issues | vol 6 • special issue (s8) • 2016250 ksenofontov, a.s., savon, i.v., serba, v.y., shkurkin, d.v. (2016), basics of modeling the probability of corporate borrowers’ default. international journal of economics and financial issues, 6(1s), 14-18. moskalenko, a. (2015), principles and problems of agricultural land rational use. economic annals-xxi, 5-6, 57-59. myrzaliev, b. (2014), state regulation of agricultural production. herald treasury. economic series, 2, 3-9. polunin, l. (2013), evaluation system study the competitiveness of enterprises in innovative regional policy. socio-economic processes and phenomena, 9, 7-12. sen, a. (2016), some reflections on agrarian prospects. economic and political weekly, 51(8), 12-15. silnov, d.s. (2015), security holes in manuscript management systems. arpn journal of engineering and applied sciences, 10(18), 7994-7996. silnov, d.s., tarakanov, o.v. (2015), assessing the stability of antivirus software and data protection means against erroneous outcomes. international journal of applied engineering research, 10(19), 40342-40349. zakharov, a.a., olennikov, e.a., payusova, t.i., silnov, d.s. (2016), cloud service for data analysis in medical information systems using artificial neural networks. international journal of applied engineering research, 11(4), 2917-2920. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 103-108. international journal of economics and financial issues | vol 7 • issue 2 • 2017 103 the role of tourism sector in economic growth: an empirical evidence from palestine mosab i. tabash* college of business administration, al ain university of science and technology, al ain, abu dhabi, united arab emirates. *email: mosab.tabash@aau.ac.ae abstract this study examines the long-term relationship between economic growth and international tourism receipts (itrs) in the state of palestine during the period 1995-2014. to achieve the purpose of the study, gross domestic product (gdp) is used as proxy for economic growth while itr is used as a proxy for tourism sector. the findings of the study showed that there is a unique long-term relationship between gdp and international tourism receipts. furthermore, granger causality test affirms a causal relationship from itr towards economic growth in the state of palestine. this paper uses an empirical evidence to show the role of tourism sector in economic performance of a country where its economy is highly dependable on foreign aids and donations. so, palestinian government should develop dynamic policies to promote tourism sector into the country. this in turn leads to generate employment opportunities, poverty alleviation and economic growth. keywords: tourism, palestine, economic growth, co-integration, causality jel classifications: c22, o11, l83 1. introduction the united nations world tourism organization defines tourism as: “social-economic aspects which allows the movement of people to countries or places outside their usual environment for personal, business and professional purposes. these people are called visitors and tourism has to do with their activities, some of which imply tourism expenditure” (paltrade report, 2013). with increasing globalization, tourism has become one of the largest and fastest growing sectors in the world. in 2011, the tourism industry generated an estimated 5% of global gross domestic product (gdp) and between 6% and 7% of the overall number of jobs globally. demand is expected to be high due to rising household incomes in emerging economies fuelling leisure activities and growing international trade. given its size, the sector is expected to have a considerable impact for economic growth, diversification, and structural transformation of economies (world tourism organization report, 2007). according to the world travel and tourism council (wttc), the tourism industry globally generated some us $ 2056 billon directly in 2012 and is expected to grow by an annual rate of 4.4% until 2023 (wttc report, 2012). the forecast growth of the tourism sector globally confirms the importance for the state of palestine of further developing and diversifying its tourism offer. tourism should keep growing worldwide by 3.8% per year on average between 2010 and 2020. for the middle east region, the direct contribution of tourism to regional gdp in 2012 was estimated at us $ 377.5 billion, or the equivalent of 4.5% of the region’s total gdp. in addition, it is estimated that tourism directly supported 7.9 million jobs at the regional level or the equivalent of 4.8% of total employment. it is forecast that tourism will directly contribute to 5.1% of total regional employment in 2013. tourism has recently come to the surface as the largest industry to impact the overall growth of the economy (lashkarizadeh, et al. 2012). tourism growth in any economy not only leads to economic development but also leads to advancements in other parts of the host country such as political, cultural and social environment. in many ways, international tourism receipts (itr) are considered to have impact on the long-term economic growth (brida, 2010). tabash: the role of tourism sector in economic growth: an empirical evidence from palestine international journal of economics and financial issues | vol 7 • issue 2 • 2017104 2. tourism sector in palestine tourism services are growing worldwide. tourism in the state of palestine refers to tourism in east jerusalem, the west bank and the gaza strip. in 2010, 4.6 million people visited the palestinian territories, compared to 2.6 million in 2009 (ma’an report, 2011). although it is difficult to describe the size of the palestinian tourism market accurately, estimates by the ministry of tourism and antiquities said that tourism revenues have steadily increased since 2005, with possibly a small decrease of between 1% and 2% in 2011 before growth returned back in 2012. out of the 3.5 million tours to palestinian tourist sites in 2012, a large percentage was made up of palestinians living in israel (35%), followed by the russian federation (12%), the united states of america (5%), italy (5%), poland (5%), germany (3%) and indonesia (3%). the state of palestine has many tourist assets to offer, including its climate and holy, cultural and natural sites. significantly, christian pilgrimage is the main tourism service in the state of palestine. the number of international tourist’s arrivals on west banks and gaza strip is growing up from <210,000 to more than 550,000 visitors with percentage of 61.8% as shown in figure 1. the tourism sector’s direct contribution to gdp is approximately 4% and 2% to total palestinian employment. there are significant challenges which have both slowed the development of tourism in palestine, and threaten to impede efforts for the sector to realize more of its potential. one of the biggest challenges is palestine’s image. palestine has suffered from the one-dimensional impressions given by some western media that palestine is a risky place to visit. the combination of a negative image, plus the physical barriers, closure of borders especially “tight closure of gaza strip” and restrictions on movements of people in west bank and east jerusalem are among many obstacles imposed by israeli government which in turn directly and indirectly impeding the palestinian tourism sector. tourism is an important sector for the palestinian economy, and it is possible to expand it further. it is very much clear that tourism is very impactful to palestinian economy in terms of generating employment opportunities and enhancing gdp. the relationship between tourism sector and economic growth is not empirically examined in palestine. so, this paper tries to test the relationship between the variables empirically and derive policies that can help policy makers of government of state of palestine to work on it. the main questions of this study: does tourism industry contribute to economic growth in palestine? and what is the nature of the relationship between tourism sector and economic growth in palestine? the paper is organized as follows: section one provides an introduction, section two covers the literature review, section three explains research methodology, section four shows the results and analysis of the study and conclusion is given in section 5. 3. literature review there are many studies documented the relationship between the impact of tourism sector on economic growth of any host country but there is a limited literature examining whether the impact is significant or not and who cause the other, like economic growth causes tourism sector or tourism sector causes economic growth, particularly in the context of the state of palestine. many research works suggest the view that tourism sector not only helps to create household income but also generating employment and foreign exchange respectively. therefore, (lee and kwon, 1995; lim, 1997) affirmed that the developed tourism sector in any country has been considered a positive contribution to economic growth. durbarry (2002) in his study, confirmed that the tourism sector leads economic growth in mauritius. he utilized co-integration and causality tests for the analysis. after that, eugenio and scarpa (2004) tested the kind of the relationship between economic growth and tourism for latin american countries from 1985 to 1998. his results showed that the tourism sector can foster economic growth for low and medium income countries but not for high income countries. kim et al. (2006) tested the relationship between tourism sector and economic growth for taiwan. he proved that there is a bidirectional causal relationship between tourism and economic figure 1: international tourism, number of arrivals source: world statistics data (2016) tabash: the role of tourısm sector in economıc growth: an empırıcal evıdence from palestıne international journal of economics and financial issues | vol 7 • issue 2 • 2017 105 growth in taiwan. after 1 year, khalil and kakar (2007) examined the shortand long-term causality between economic expansion and tourism receipts in pakistan. he concluded that there is a long-term association between the development of tourism sector and the economic growth of pakistan. at the same year, fayissa et al. (2007) investigated the relationship between tourism sector and economic growth using a panel data of forty two countries from africa. her results assured that tourism receipts had a significant impact on economic growth in sub-saharan african countries. followed by lee and chang (2008) study, he examined the direction of relationship between tourism sector and growth of the economy. the result affirmed a unidirectional relationship between tourism and growth for oecd countries. huang et al. (2008) investigated the relationship between tourism sector and economic growth. he used annual time series data covering the period 1995-2005 in 88 countries and used nonlinear model to determine the relationship between variables. his results concluded positive relationship between tourism receipts and growth of the economies for the countries under the study. after 1 year, fayissa et al. (2009) again examined the impact of tourism on economic development of seventeen latin american countries using panel data for 1995 to 2004. the results revealed that there is a positive relationship between the tourism receipts and gdp. ozturk and acaravci (2009) show that there is no unique long-term or equilibrium relationship between the real gdp and international tourism for turkey. in another study of asia, salleh et al. (2011) examined the relationship between tourism sector, trade and growth in asean countries. their results concluded a long-term correlation among foreign tourist arrival, economic growth and trade. in another study, orieqat and saymeh (2015) investigated the effects of growing tourism sector on the jordanian economy. they tested jordan tourism and its economic impact on economic growth. their results revealed that tourism has an important role in economic growth of jordanian economy. it is clear from the above mentioned literature that tourism sector contribute to economic growth particularly for developing countries. however, the direction of relationship between tourism receipts industry and economic growth is still unclear in case of state of palestine. there is no research work examined the relationship between the itr and economic growth has been taken place. this paper tries to investigate the relationship between economic tourism sector and economic growth in case of state of palestine. 4. research methodology 4.1. data and variables a time series data from 1995 to 2014 is used in this study. two variables gdp measured in u.s $ millions, represents the economic growth sector, and irt, represents the tourism sector, measured in u.s $ millions, are selected to achieve the purpose of the study. the data has been fetched from the world databank, world development indicators. all analysis is done using eviews. the flow chart for econometric analysis is shown in figure 2. 4.2. unit root test the first step of the study is to examine whether the time series are stationary or not. it is worthy to convert the data into stationary form since a non-stationary data may lead to misleading results containing problem of spurious regression with high r2 and t-statistics that appears to be significant, but the results do not have any economic meaning (enders and sandler, 2008). therefore, for accuracy of results and correct model evaluation, time series data should be separated from all effects, and the series should be stationary. thus, logarithms of time series were taken. augmented dickey–fuller (adf) and phillip-perron (pp) tests are used. the approach of adf test takes into account higher-order correlation by adding lagged difference terms of the dependent variable to the right-hand side of the regression. the adf test states series are whether stationary or not, can be defined as follows; t-1 k t t-1 t i i+ y +y = + t y + ∆ µ β ε∑ (1) ∆yt = yt −yt−1 where yt: dependent variable ∆yt: the first difference operator µ: constant term t: trend variable ϵt: stochastic disturbance term. there are hypothesis to test series: h0: φ = 0 (yt is non-stationary) h1: φ ≠ 0 (yt is stationary). if calculated t-value of variable is greater than adf critical t-value then h0 is rejected, thus the data is stationary (dickey and fuller, 1981). pp test is used to adjust with higher-order serial correlation in a given time series. phillips and perron (1988) adopted a non-parametric method. the test regression for the pp test is the autoregressive (1) process (philips, 1988). 4.3. johansen co-integration test johansen co-integration test determines whether the long-term relationship occurs between variables or not. after the variables became stationary at the difference, the second step is to test for co-integration using the johansen and juselius co-integration tests. johansen and juselius (1990) have developed two test statistics the trace test and the maximal eigenvalue test to determine the number of the co-integrating vectors. in the other words, if yt ~ i (1) and xt ~ i (1) then ϵt ~ i (0), so yt and xt are co-integrated. then the hypothesis will be as, h0: β = 0 (there is no co-integration between the series) h1: β ≠ 0 (there is co-integration between the series). if variables statistical value is greater than critical value, the null hypothesis should be rejected. this means there is a co-integration tabash: the role of tourism sector in economic growth: an empirical evidence from palestine international journal of economics and financial issues | vol 7 • issue 2 • 2017106 between series moving together in the long-term. to test it, maximum eigen and trace statistics are used. 4.4. granger causality test the spirit of granger (1987) found in the idea that if the two variables are co-integrated, then dynamic relationships is existing among them. granger causality test is used to determine the direction of causality. it has been developed to check whether or not the inclusions of past values of a variable x do or do not help in the prediction of the present values of variable y. the equations for granger causality test can be written as shown in equations 2 and 3. granger causality test, which depends on time series data, is made by the estimation of the equations as shown below with least squares method. xt = α + ∑βjxt-j+∑φiyt-i+ ut (2) yt = α + ∑βjyt-j+∑φjxt-j+ ut (3) where it is assumed that the disturbances u1t and u2t are uncorrelated. 5. results and discussion 5.1. descriptive statistics it is clear from table 1 that the maximum amount of gdp in palestine is reaching 12,716 u.s $ million and this is achieved in 2014. the same thing is applied to itr. it reaches u.s $615 millions in 2014 from 25 million in 1995 with growth rate equals to 95.93%. the median for the two variables is less than the mean which means that the data are positively skewed. 5.2. unit root test the results of unit root test are shown in table 2 and it is clear from the results that the null hypothesis of no unit roots for all figure 2: the flow chart of the econometric analysis table 1: summary statistics (u.s $ million) statistics gdp itr mean 6199.850 257.9500 median 4580.500 240.5000 maximum 12,716.00 615.0000 minimum 3283.000 25.00000 observations 20 20 tabash: the role of tourısm sector in economıc growth: an empırıcal evıdence from palestıne international journal of economics and financial issues | vol 7 • issue 2 • 2017 107 the time series are rejected at their second differences as the adf and pp tests statistic values are less than the critical values at 1%, 5% and 10% level of significance. the first row in table 2 for gdp shows that the p = 0.0007 is <α = 0.05 in adf test. similarly, for itr, the result from the second row shows that the p = 0. 0000 is <α = 0.05 in pp test. since, all the variables are stationary and integrated of same order, i.e., i (2). we can proceed for co-integration analysis. 5.3. johansen co-integration test tables 3 and 4 summarize the results of johansson test for the long relationship between itr and economic growth of palestine. both trace test and maximum eigen value confirmed that the variables are integrating at 1%, 5% and 10% level of significance. the first row of table 3 shows that the trace statistics (18.67446) exceeds the critical value of (15.41) at 95% confidence level for gdp and the trace statistics (17.98336) exceeds the critical value of (14.07) at 95% confidence level. it suggests that the null hypothesis of no co-integrating relationship is rejected. the results prove that there is a cointegrating relationship among the variables. further, the existence of cointegration leads to the existence of granger causality at least in one direction (granger, 1988). 5.4. granger causality test f statistics and probability values constructed under the null hypothesis of non-causality are reported in table 5. results reveal that there is a causal relationship between itr and gdp. furthermore, the results show there is a unidirectional causality between gdp and tourism receipts since it is significant at 5% level, as (0.01683) is <0.05. this leads us to affirm that itr granger causes the economic growth in the state of palestine and in a unidirectional way. 6. conclusion this study examined the relationship between tourism sector and economic growth of palestine. it revealed that there is a significant and long-term association between the tourism sector and growth of the palestinian economy. further, the results conclude that there is a unidirectional relationship between itr and the growth of the economy of palestine. these results are encouraging us to advice palestinian government to pay attention to the tourism sector as it is a vital for palestinian economy in variety of ways such as generating employments opportunities, household’s income and reducing the whole dependence on the international donations and gifts. based on the findings of this study, many policy implications can be adapted by palestinian government to foster the growth of the tourism sector. first, the palestinian government should work in enhancing the palestinian image as a destination of peace and love. secondly, the infrastructure sector should be developed particularly in building hotels and leisure places. thirdly, free movements and access to all places should be guaranteed to all tourists. this can be done by full coordination with israeli government as agreed on by oslo accord 1993. finally, coordination between public and private sectors is very important to train human capital and provide better services to all tourists such as offers, information, electronic communications and other support services. references brida, j. (2010), cruise tourism: economic, socio-cultural and environmental impacts. international journal of leisure and tourism table 3: johansen’s test (trace statistic) no. of cointegration equation(s) trace statistics critical values (%) 5 1 gdp null hypothesis h0: r=0 18.67446** 15.41 20.04 alternative hypothesis h1: r≥1 0.691102 3.76 6.65 **significant at 5% level. gdp: gross domestic product table 5: pair wise granger causality tests null hypothesis f statistics probability itr does not granger cause gdp 5.68535 0.01683** gdp does not granger cause itr 1.58398 0.24231 **significant at p value <0.05; ***significant at p value <0.1 (cumming, 2012). gdp: gross domestic product, itr: i̇nternational tourism receipts table 2: unit root test variable with intercept adf test phillip-person test level 1 first difference second difference level 1 first difference second difference t-statistic p value t-statistic p value t-statistic p value t-statistic p value t-statistic p value t-statistic p value gdp 1.072155 0.9955 −2.570371 0.1169 −5.206831** 0.0007 0.833407 0.9918 −2.570371 0.1169 −5.686277** 0.0003 itr −1.554464 0.4853 −4.221769** 0.0052 −4.541486** 0.0034 −1.527696 0.4984 −4.003905** 0.0047 −8.991037** 0.000000 *significant at p value <0.01; **significant at p value <0.05; ***significant at p value <0.1 (cumming, 2012). adf: augmented dickey–fuller, gdp: gross domestic product, itr: i̇nternational tourism receipts table 4: johansen’s test (max-eigenvalue statistic) no. of cointegration equation(s) max-eigenvalue critical values (%) 5 1 gdp null hypothesis ho: r=0 17.98336** 14.07 18.63 alternative hypothesis h1: r=1 0.691102 3.76 6.65 **significant at 5% level. gdp: gross domestic product tabash: the role of tourism sector in economic growth: an empirical evidence from palestine international journal of economics and financial issues | vol 7 • issue 2 • 2017108 marketing, 1(3), 205-226. cumming, geoff (2012), understanding the new statistics: effect sizes, confidence intervals, and meta-analysis, new york, usa: routledge. pp. 27-28. dickey, d., fuller, w. 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[last accessed on 2016 oct 15]. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1965-1972. international journal of economics and financial issues | vol 6 • issue 4 • 2016 1965 innovative approach to the development of the logistics system of supply of the arctic region space mikhail nikolayevich dudin1*, natalia pavlovna ivashchenko2, еvgenia еvgenevna frolova3, aslan huseynovich abashidze4, anait sergeevna smbatyan5 1russian presidential academy of national economy and public administration, 82, vernadsky prosp., moscow 119571, russian federation, 2lomonosov moscow state university, gsp-1, leninskie gory, moscow 119991, russian federation, 3pеоples friendship university of russia (rudn university), 6, miklouho-maclay street, moscow 117198, russian federation, 4pеоples friendship university of russia (rudn university), 6, miklouho-maclay street, moscow 117198, russian federation, 5ano “centre of expertise for the world trade organization,” 8/1, pokrovsky boulevard, moscow 109028, russian federation. *email: dudinmn@mail.ru abstract this article reviews the basic methodological approaches to the arrangement of the logistics supply of manufacturing, research or tourism facilities based in the arctic. the main purpose of this article was to optimize the processes of supply the arctic territories with the use of high-tech approach, which integrates the concept of “green” logistics technology (reverse logistics, in particular) and methods of economic and mathematical modeling for inventory management and planning the purchase of resources necessary to ensure the proper functioning of the arctic facilities. taking into account the fact that the arctic holds interests of many countries and corporations, as well as taking into account the fact that further development of the arctic must be environmentally responsible, the integration of traditional and new approaches to the arrangement of supply of the arctic facilities through the use of reverse logistic technologies of economic and mathematical modeling using the correlation-regression analysis were proposed. keywords: arctic, supply logistics, reverse logistics, correlation-regression analysis, ecosystem, environmental responsibility jel classifications: q57, q28 1. introduction development and exploration of the arctic region is currently unfolding very actively in both scientific and industrial production context. almost all countries that are part of the arctic council have their own strategies for development of the arctic, but only five countries (russia, the usa, canada, denmark and norway) have direct access to the coast of the arctic ocean. given that the territorial disputes between the five arctic states in many respects are still not completed, the competition for the most rapid, effective and large-scale development of the arctic is constantly increasing (lukin, 2010; smith, 2010; mazur, 2010). along with increased competition, there is also diversification of approaches to the exploitation of natural and resource potential (chater, 2012; cooke, 2011; unesco, 2009; hodgson, 2007). for example, the us abandoned the development of some deposits of hydrocarbon resources on their part of the shelf in 2015, but did not fold the scientific and research activities. russia, canada, norway and denmark are planning to develop the arctic tourism and create a new transport infrastructure (northern sea route, transnational northern transportation network with the arrangement of crosspolar flights). in the meantime, russia does abandon its deposits on the arctic shelf, large-scale in development and commercial operation, even despite the fact that many transnational mining corporations have left the arctic or folded (suspended) facilities for the exploration, development and production of hydrocarbon resources in this region. due to the fact that the arctic will not lose its commercial and scientific appeal in the long run, it can be assumed that the traffic flows in this region will show a constant increase in the near future. dudin, et al.: innovative approach to the development of the logistics system of supply of the arctic region space international journal of economics and financial issues | vol 6 • issue 4 • 20161966 this is primarily due to the fact that it is impossible to conduct commercial or research activities in the arctic without optimally organized logistics of supply. 2. methods we use an integrated knowledge-intensive approach to optimization of the arctic logistics in this article, using an environmentally-focused concept and methods of economic and mathematical modeling. the article suggests using correlationregression analysis for inventory management and procurement planning (orlova et al., 2015; box et al., 2015), which allows to define the conditional expectation of one dependent variable (y) as a function of a set of independent variables (xi) in terms of the nth number of observations taking into account the regression coefficients (βi) and the random component (ε): yi=β1+β2 x2+…+βk xki+εi,i=1,…,n (1) a special correlation coefficient (r) is calculated in order to identify or determine the relationship between the effective and factorial signs: r x-x y-y x-x y-y 2 2 = ( )( ) ( ) ( ) ∑ ∑ ∑ (2) it is recommended to use a standardized wilson formula or one of its modifications to calculate the optimal and economically feasible size of the order for the supply of certain resources (bowersox et al., 1991): q= 2cr h (3) where: q is the optimal size of the order for the supply of resource (resources); c is costs of order placement; r is the planned demand for resources (the required number of units); h is the costs associated with storing the unit of the reserves. we gave developed the following formulas to calculate the individual parameters of the economic and mathematical model proposed in the article and recommended for inventory management and planning of the resources procurement for the functioning of the arctic facilities: s=eb-ed+↓et (4) l t=1nl ∑ ∑ (5) i= sq w (6) where: s is environmental damage from supply to the arctic facilities and their storage of secondary resources to be exported to the mainland for disposal or recycling, corrected and assessed in terms of value; t is stability and reliability of resource supplies carried by the logistics aggregator to the arctic facilities; i is a coefficient of immobilization of resource reserves at the arctic facilities; eb, ed, ↓et are respectively the economic (cost) assessment of the benefit of functioning of the arctic facility, the environmental damage it causes, and the level of decline in environmental damage per unit of purchased resource or stored reserve; σl и σnl are the total amount of supplies of resources to the arctic facilities carried, respectively, in violation of the terms and conditions of the supply contracts and in compliance with the terms and conditions of the supply contracts; sq and w are a shaped reserve of resources that are stored at the arctic facility and the planned demand for resources (units of reserve and units of supply). 3. results the world ocean can be considered as a global transport system, which provides up to 80% of the total cargo turnover transported using the water transport. at the same time, the main burden of the cargo transportation in the share distribution falls on the atlantic ocean (figure 1). the arctic ocean provides only 5% of the world maritime cargo turnover. but at the same time, it is an important transport route for russia and european countries (norway, denmark, iceland). for example, the northern sea route provides russia with transportation of about 40 mln tons of various cargoes. at the same time, more than 70% is transportation of dry cargo, the rest is liquid cargo. there is a year-round navigation by the norwegian coast; the main cargo is fish, liquid and solid hydrocarbons, iron ore and timber. greenland and denmark regularly carry out transportation of various cargoes: greenland supplies fish and mining products, while denmark supplies food and consumer goods. coasting trade is very well developed in the coastal waters of iceland. the north-west passage (along the coast of north america through the canadian arctic archipelago) is less often used (tsetlin and krasnova, 2014, the arctic council, 2016). the arctic ocean is also used for the military and defensive purposes. during the second world war, the path of the arctic convoys went through the european part. currently, the royal danish navy and the royal norwegian navy have ships for work in light ice. the royal canadian navy (coast guard) includes 11 icebreakers. russia’s northern fleet, which is based on the coast of the barents and white seas, includes 40 icebreakers, and 5 of them are nuclear. the us pacific fleet is not equipped with nuclear icebreakers (it includes a total of 6 vessels equipped for work in heavy ice), but includes nuclear submarines, which carry dudin, et al.: innovative approach to the development of the logistics system of supply of the arctic region space international journal of economics and financial issues | vol 6 • issue 4 • 2016 1967 out both intelligence and research. russia is an undisputed leader among the arctic countries by the composition and quantity of the icebreaker fleet units (figure 2). one should not forget about the active research work in the arctic. for example, the international arctic science committee (iasc, 2016) was created in 1990, under which five working groups function on a regular basis (on atmospheric research, on marine research, on social and human development, on the ice cover research, as well as of the water area, the landscapes and biota). during the international polar year alone (2007-2008), about 286 different national research programs for the study of the biota and ecosystems of the arctic and polar territories were realized. of them, 85% of all completed projects (i.e. 243 projects) fell for the arctic countries (usa, canada, norway, finland, russia, sweden, denmark). the exception is iceland, which has not realized its own projects, but has participated in projects of the european countries (figure 3). as such, active research and socio-economic exchange between the arctic territories and the mainland requires new knowledgeintensive approaches to the construction of the functional logistics of supply, given that nearly all equipment, goods and household items, food, medicines and surgical dressing generally require the arrangement of special supply. in russia, northern territories, including the arctic, have been supplied and are still supplied with the required goods, household items and equipment primarily under the “northern delivery” program. in european countries, as well as in the countries of north america, polar and subpolar territories are supplied on a constant basis, but the most important and valuable goods are usually delivered in the spring-summer period, when navigation (air and sea) is not complicated by the harsh climate. in other words, russia uses target-oriented approach to supply the arctic territories, while the countries of north america and europe (european north) use a mixed approach (process of regular supply of arctic territories includes the programs of delivery of special goods during the spring-summer navigation) (dudin et al 2016; lukin 2010; smith 2010). at the same time, it should be taken into account that the environmental damage to the arctic ecosystem constantly increases, in part because goods imported into the arctic are not always fully utilized (which determines the appearance of the waste that is not disposed of in a natural way and is preserved in permafrost). besides, the arctic has already accumulated a sufficient amount of returnable packaging units, as well as disposable and reusable packaging that clutters and pollutes the natural space and water, poisons biota, etc. therefore, it is objectively obvious that there is a need to change the existing approaches and organization of supply to the construction of the relevant logistics processes. 4. discussion the logistics scientific paradigm has changed in recent decades. these changes primarily relate to the greening of building sociofigure 1: structure of the global marine cargo turnover, 2014-2015. (lappo and danilova, 2015; tarvainen et al., 2015) figure 2: number of icebreaking vessels in possession of the major arctic states, 2014-2015 (lappo and danilova, 2015; tarvainen et al., 2015; tsetlin and krasnova, 2014) figure 3: specific contribution of the arctic countries to the realization of research projects during the international polar year (2007-2008) (iasc, 2016; the arctic council, 2016) economic functional processes and other processes that directly relate to them. the environmental aspect of the global social and economic development was first raised in the 90s of the last century, which resulted in the concept of “sustainable development” that dominated for two decades. currently, the concept of “sustainable development” has evolved into the concept of “green economy,” which includes the aspect of social equality in addition to the environmental aspect. “green” or environmentally responsible logistics is a derivative functionality from the “green economy.” dudin, et al.: innovative approach to the development of the logistics system of supply of the arctic region space international journal of economics and financial issues | vol 6 • issue 4 • 20161968 increase in environmental responsibility in the transport and logistics field was called “green logistics” (chapple, 2008; mckinnon et al., 2015; ehrhart, 2012). “green” logistics (including in terms of the development of the transport and logistics potential of the arctic) is an arrangement of movement of cargoes and passengers and other transport and logistics services, the provision of which to the economic agents and agents of socio-residential sector is carried out with the use of environmentally friendly technologies that do not increase and at the same time reduce the level of anthropogenic and industrial impact on the global ecosystem. the key idea of the “green” logistics, which does not deny the traditional scientific postulates, is to “…deliver more using less…” (bowersox et al., 1991; coyle et al., 1992; apostol, 2012; mckinnon et al., 2015). in other words, green logistics includes two conceptual methodological provisions: • firstly, it requires a gradual and systematic abandonment of environmentally harmful and aggressive transport that uses gasoline and similar fuels with a high level of emission of carbon dioxide; • secondly, it requires intensification of the use of transport capacity, not only to reduce the pressure on the ecosystem, but also to reduce the burden on the transport and logistics infrastructure, the restoration of which is always characterized by high capacity of capital. for the arctic, with its unique and at the same time very fragile environment, the environmentally responsible logistics (including in the context of the supply of the arctic territories) is an urgent scientific and applied concept. in this context, the logistics solutions can have several basic options: a. long-term solutions focused on the complete modernization of transport used in the arctic (switching to environmentally friendly fuel, avoiding the use of machines non-resistant to the arctic climate). the solutions to improve transport and logistics infrastructure can also be implemented here (autonomous automated terminals for storing reserves, used cooperatively, etc.); b. medium-term solutions focused on reducing the industrial impact, including that associated with the supply of the arctic territories with essential goods (commodities, food, equipment, etc.). in this case, various forms of collective procurement can be used, as well as phasing out environmentally aggressive environmental aviation and navigation, transition to the fragmented delivery of small cargoes using environmentally friendly biopilot aircrafts; c. short-term solutions focused on the current ecological optimization of logistics procurement process through the construction of their most rational models and the use of reverse logistics technologies. the reverse logistics can be considered as a “green” logistics technology focused on the ensuring, through the collection (accumulation) of the obsolete, corrupted or damaged product, its packaging and transport packing, including for subsequent secondary or tertiary processing (recycling) or for the environmentally safe disposal that does not create an additional industrial or anthropogenic load on the environment (dyckhoff et al., 2013). in turn, modeling is based on the use of economic and mathematical methods and, in particular, correlationregression analysis. since we talked about the multiple regression equation in the method section, then, respectively, it is advisable in the first place to identify the main factors that will determine the optimal amounts of goods and supplies that are necessary to ensure the normal functioning of commercial firms, research expeditions, tourist groups or environmental volunteers. the second important aspect is that the process of supply should be described by a direct and return flow. hence, the process of supply of the arctic facilities with the necessary resources (commodities, raw materials, medicines and other goods) should be as follows (figure 4). in other words, each supply of the resources to the arctic facilities should be: • firstly, optimized and economically feasible taking into account the required reserve; • secondly, rationalized taking into account the reduction of the environmental, transaction and other costs; • thirdly, always be described by the presence of a reverse logistics flow (returnable packaging, flawed commodities, items that are out of operation). at the same time, management of the process of supply and formation of reserves should be described by simultaneous centralization (supply by a specialized logistics aggregator) and decentralization (requirements for the optimal and rational, economically sound volume of the order are set by each arctic facility independently). in addition, each arctic facility independently forms a return flow (secondary resources recycling and disposal). wilson formula and its modification for the calculation of the optimum size of the order are well known and presented in the method section of this article. therefore, we are not going to dwell on the methodological approaches to the calculation of the optimal and economically feasible size of the order; we will just take into account that the size of the order for the supply will depend on: 1. the current (formed) size (volume) of the reserve, frequency and certainty of supply; 2. the cost of the physical movement of the cargo in space; 3. the potential environmental damage associated with the delivery of the cargo, as well as the accumulated environmental damage (non-recycled packaging, packing, flawed goods); 4. the willingness of suppliers to use the returnable logistics flow to increase environmental supply and optimization of the logistics process. in view of the above, we can logically assume that the economic and mathematical model describing the state of reserves, as well as the logistics process of supply of the arctic facilities with necessary resources (commodities, raw materials, equipment, medicines, etc.), should include the following set of variables: 1. the planned demand for some type of resource for a certain time period (e.g., month, quarter, 6 months, etc.), i.e. the dudin, et al.: innovative approach to the development of the logistics system of supply of the arctic region space international journal of economics and financial issues | vol 6 • issue 4 • 2016 1969 number of stock units to be purchased (supplied) to meet the needs of functioning of the arctic facility. this, in accordance with wilson formula, also takes into account the resource consumption over a certain period, which is reflected in the calculation of the planned and economically feasible size of the order; 2. the estimated and corrected environmental damage in terms of value per unit of reserve/order. here the difference can be used between the economic evaluation of potential direct or indirect benefits from the operation of the arctic facility and the economic evaluation of environmental damage associated with the operation of the facility per unit of stock/order. in this case, the estimated environmental damage needs to be corrected (per unit of reserve/order), bearing in mind that the load on the ecosystem of the arctic will be reduced. this will be achieved through the return logistics flow (coordinated in time with direct logistics flow), during which secondary resources for recycling and/or disposal will be sent to the mainland; 3. the market price of the delivery and storage of the reserve unit, the price includes not only the actual value of the resource, but also the value of its physical movement in space from the supplier to the logistics aggregator and from the logistics aggregator to the arctic facility; 4. the stability and certainty of supply of resources by the logistics aggregator to the arctic facility. this indicator is figure 4: model of the process of supply of the arctic facilities with necessary resources dudin, et al.: innovative approach to the development of the logistics system of supply of the arctic region space international journal of economics and financial issues | vol 6 • issue 4 • 20161970 of economic and mathematical model of multiple regression. in particular, let’s assume that the nth arctic facility needs the ith resource, while the demand for this resource and the key variables of the model have been described by the following basic values over the past 27 months (table 1). at the same time, we should take into account that the reverse logistics flow for minimization of the environmental damage was used at the nth arctic facility from the 10th month, which reduced the level of environmental damage from the operation of this arctic facility, as well as reduced the cost of the delivery of the unit of the reserve of resource. but considering that arctic conditions cannot guarantee high stability and certainty of supply of resources from the mainland to the nth arctic facility, the current volume of reserves and the reserves immobilization coefficient also increases. the multiple regression model for this example will be described by the following values of the variables (table 2). best calculated as the ratio of the quantity of deliveries carried out in violation of the terms of contracts to the quantity of deliveries made on time and in compliance with the key terms of the contracts; 5. the current level of the reserves of resources (including safety stock in the case of a failure in supply) in terms of quantity, which is in storage at the arctic facility at a given time; 6. the coefficient of immobilization of reserves of resources, which are in storage at the arctic facility at a given time. this figure represents the ratio of the current amount of the reserve to the target demand for the resource. all the necessary formulas for the calculation of the indicators listed above can be found in the methodological section of this article, while we suggest to plan the demand for supply of resources and make decisions on the current reserves on the basis table 1: source data for inventory management and planning the procurement of the ith resource at the nth arctic facility period target demand for the resource (amount of purchases), units estimated and corrected environmental damage, $ per unit price of delivery per unit, $ stability/certainty of supply current volume of reserves, units coefficient of immobilization 1 1.019 16.2 305 0.9 31 0.03 2 1.031 16.4 330 0.9 31 0.03 3 1.076 16.5 330 0.9 32 0.03 4 1.124 17 330 0.9 34 0.03 5 1.144 17 331 0.9 34 0.03 6 1.163 18.5 331 0.75 35 0.03 7 1.004 18.6 331 0.7 70 0.07 8 1.017 19.2 331 0.75 71 0.07 9 1.025 19.4 331 0.6 72 0.07 10 1.063 19.5 331 0.75 117 0.11 11 1.187 19 298 0.8 131 0.11 12 1.209 18.3 293 0.8 133 0.11 13 1.215 17.4 290 0.8 134 0.11 14 1.296 16.4 287 0.9 143 0.11 15 1.333 15.3 280 0.9 147 0.11 16 1.387 14.7 276 0.75 153 0.11 17 1.400 14.4 273 0.7 196 0.14 18 1.515 14 273 0.75 212 0.14 19 1.599 13 273 0.6 224 0.14 20 1.602 12.7 273 0.75 224 0.14 21 1.659 12.7 273 0.8 232 0.14 22 1.721 12.5 273 0.55 275 0.16 23 1.800 12.6 273 0.55 288 0.16 24 2.066 12.5 273 0.9 331 0.16 25 2.231 12.1 273 0.9 424 0.19 26 2.503 12.1 273 0.8 476 0.19 27 2.765 12 273 0.7 525 0.19 table 2: coefficients of the multiple regression model for inventory management and planning of procurement of the ith resource at the nth arctic facility variable of the model coefficients y-crossing (target demand for the resource, i.e., target size of the order) 2150.624367 variable x1 estimated and corrected environmental damage per unit of the reserve of the resource −3.38558792 variable x2 price of delivery per unit of the reserve of the resource −1.60613002 variable x3 stability and certainty of supply of resources 35.65185294 variable x4 current (formed) volume of reserves of resources 4.577582564 variable x5 coefficient of immobilization of reserves of resources −5193.523483 multiple regression model view y ̂x=2150.62-3.39x1 − 1.61x2 + 35.66x3 + 4.58x4 − 5193.52x5 dudin, et al.: innovative approach to the development of the logistics system of supply of the arctic region space international journal of economics and financial issues | vol 6 • issue 4 • 2016 1971 the multiple regression model shows that variables x1, x2, x5 will adversely affect the target volume of the order and, respectively, reduce the demand of the nth arctic facility for the ith resource. in this case, the regression statistics shows that there is a very close connection between the effective and factorial signs in the economic and mathematical model (table 3). next, using the pair correlation, let’s construct paired linear regression equations for each factor, and then for an effective sign for the upcoming 10 periods (months). hence, the predictive model of inventory management and planning of procurement of the ith resource at the nth arctic facility will have the following form (table 4). t h u s , t h e o b t a i n e d d a t a a l l o w t o c o n c l u d e t h a t inventory management and planning of procurement of the ith resource at the nth arctic facility require to consider the following: • firstly, if the specifics of operation of the arctic facility does not change, then all other things being equal the demand for the ith resource will increase over the next 10 months by an average of 20-21%; • secondly, the corrected and estimated environmental damage will significantly reduce at least by 19% over the period under study, but the procurement costs will reduce by only 10%; • thirdly, the stability and certainty of supply of reserves of resources is likely to be insufficiently high, which in turn will cause an increase in the current level of reserves of resources and, accordingly, the level of immobilization of reserves at this arctic facility. 5. conclusions thus, summarizing this article, we consider it necessary to note that the transition to environmentally responsible logistics supply in the arctic is an objective necessity. in this case, the solutions on the greening of the logistics of supply of the arctic facilities (research, commercial or tourist) can be implemented in the short term through the use of reverse logistics technologies. the idea is to create a forward and reverse logistics flows, consistent in time, which will provide both the supply to the arctic facilities of necessary resources (commodities, equipment, medicines, foods, etc.) and the simultaneous transfer to the mainland of the accumulated volume of secondary resources (accumulated stocks of returnable packaging, packing, flawed goods, unused supplies and equipment), which can create a significant threat to the ecosystem of the arctic. in this case, the planning of the resource supply and inventory management should be implemented with the use of economic and mathematical modeling. this paper proposes a multiple regression model, which includes five most important variables that determine the sizes of the target procurements of resources based not only on the current formed volume of reserves and the level of immobilization of resources in reserves, but also on environmental damage. the suggested approach to the organization of supply, construction of logistics processes, as well as to the management of reserves at the arctic facilities (research, commercial or tourist) can be regarded as innovative and knowledgeintensive. this approach is based on the concept of “green” logistics (including the technology of reverse logistics) with the integration of economic and mathematical methods in inventory management and procurement planning, taking into account such an important parameter as the environmental damage from the supply of the arctic facilities with resources (research, commercial or tourist). the authors did not consider separate methodological issues on improving the institutional environment of the arctic logistics and harmonization of national and international organizational, economic and legal approaches to environmentally responsible development of arctic territories in this article. these and other aspects of sustainable and environmentally-focused development table 3: statistics of the multiple regression model for inventory management and planning of procurement of the ith resource at the nth arctic facility regression statistics multiple r 0.996849189 r2 0.993708306 normalized r2 0.992210284 standard error 41.84086047 observations 27 table 4: predictive model for inventory management and planning of procurement of the ith resource at the nth arctic facility period target demand for the resource (amount of purchases), units estimated and corrected environmental damage, $ per unit price of delivery per unit, $ stability/certainty of supply current volume of reserves, units coefficient of immobilization 28 2182.003 11.8 256.6 0.708 404.924 0.200 29 2234.278 11.5 253.8 0.703 421.220 0.206 30 2286.554 11.2 250.9 0.698 437.516 0.213 31 2338.829 10.9 248.0 0.693 453.812 0.219 32 2391.105 10.7 245.2 0.688 470.108 0.226 33 2443.380 10.4 242.3 0.683 486.404 0.232 34 2495.655 10.1 239.5 0.678 502.700 0.239 35 2547.931 9.9 236.6 0.673 518.996 0.245 36 2600.206 9.6 233.8 0.668 535.292 0.252 37 2652.481 9.3 230.9 0.663 551.588 0.259 dudin, et al.: innovative approach to the development of the logistics system of supply of the arctic region space international journal of economics and financial issues | vol 6 • issue 4 • 20161972 of the arctic as a world heritage will be discussed in more detail in other articles. references apostol, a.r. 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(2011), the promise and the problems of developing the arctic. in: the proceedings of the 20th world petroleum congress. p110-111. coyle, j.j., bardi, e.j., langley, c.j. (1992), the management of business logistics. st. paul, mn: west publishing co. p631. dudin, m.n., sekerin, v.d., gorohova, a.e., bank, s.v., danko, t.p. (2016), arctic zone: global strategic priorities for integrated development and infrastructure policy. man in india, 96(7), 2297-2313. dyckhoff, h., lackes, r., reese, j. (2013), supply chain management and reverse logistics. berlin-heidelberg: springer science & business media. p426. ehrhart, c.e. (2012), delivering tomorrow: towards sustainable logistics. (date views (01.10.2016). available from: http://www. delivering-tomorrow.com free. box, g.e.p., jenkins, g.m., reinsel, g.c., ljung, g.m. (2015), time series analysis: forecasting and control, 5th edition. new jersey: wiley. in-text citation should be (box, jenkins, reinsel, ljung, 2015). hodgson, g.m. (2007), evolutionary and institutional economics as the new mainstream? evolutionary and institutional economics review, 4(1), 7-25. international arctic science committee [electronic resource]. (n. d.), (date views 15.09.2016). available from: http://www.iasc.info/free. lappo, a., danilova, l. (2015), pilot projects on maritime spatial planning in the russian federation. bulletin of maritime institute, 30(1), 23-40. lukin, y.f. (2010), velikiy peredel arktiki [great redistribution of the arctic]. arkhangelsk: northern (arctic) federal university. p144. mazur, i.i. (2010), arktika-tochka bifurkatsii v razvitii globalnogo mira [the arctic as a bifurcation point in the development of global world]. age of globalization, 2(6), 93-104. mckinnon, a., browne, m., whiteing, a., piecyk, a. (2015), green logistics: improving the environmental sustainability of logistics. london: kogan page. p448. orlova, i.v., ugrozov, v.v., filonova, e.s. (2015), lineynaya algebra i analiticheskaya geometriya dlya ekonomistov [linear algebra and analytic geometry for economists]. moscow: publishing house uright. p372. smith, l.c. (2010/2012), the new north – the world in 2050. london: profile books. p322. tarvainen, h., tolvanen, h., repka, s. (2015), how can maritime spatial planning contribute to sustainable blue growth in the baltic sea? bulletin of maritime institute, 30(1), 86-95. tsetlin, a.s., krasnova, e.d. (2014), arktika: nauka v minus 40 [arctic: science at-40]. moscow: publishing house of the moscow university. p113. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(special issue) 397-405. 2nd afap international conference on entrepreneurship and business management (aicebm 2015), 10-11 january 2015, universiti teknologi malaysia, kuala lumpur, malaysia. international journal of economics and financial issues | vol 5 • special issue • 2015 397 role of psychological factors in individuals investment decisions hasrita lubis1, m. dileep kumar2, p. ikbar3, saqib muneer4* 1economic faculty (fakultas ekonomi), universitas islam sumatera utara, 20146, medan indonesia, 2university institute for international and european studies, university gorgasali, georgia, 3graduate school of business, universiti utara malaysia, malaysia, 4graduate school of business, universiti teknologi malaysia, malaysia. *email: saqibmuneer85@gmail.com abstract in this study, the authors intend to identify psychological factors which could influence the criteria for investment decision which are discussed with three dimensions (risk, repay and corporate data). with regard to this aim, the criteria for investment decision were examined through defense mechanisms, personality traits, emotional intelligence and financial literacy. defense mechanisms and certain personality traits have become prominent for risk criterion while defense mechanisms and financial literacyhave been important to repay criterion. lastly, for corporate data criterion, defense mechanisms, some personality traits and emotional intelligence have been found as important. within this scope, this study can be said to have carried out a preliminary research in its field in terms of explanatory variables. keywords: investment decision, defense mechanisms, personality traits, emotional i̇ntelligence, financial literacy jel classifications: e44, g23 1. introduction behavioral finance proposes that cognitive and affective bias which everyone could exhibit cause deviations from rational behavior. this argument has directed deep-rooted concepts in psychology to come into prominence and to be discussed in the financial context. besides, the submission that probabilities are not stochastic but subjective has enabled financial behavior to be better predicted by perceptions and attitudes. on the other hand, there is a heavy concentration on demographics and socio-economic factors in order to explain financial behavior in the extant literature. in this regard, the literature needs to investigate behavioral and attitudinal factors which would make a divergence between individuals. some researchers have stated that studies exerted little effort toward examining emotional and individual factors although the role of these factors on financial decision making has been manifested by some studies (sjöberg and engelberg, 2009). grable et al. (2008) mentioned that past research has not sufficiently focused on the manner how environmental or individual factors can influence both antecedents and consequences of financial behavior. moreover, they also asserted that little effort has been devoted to explaining the relationship between these factors and financial risk taking behaviors. from this point of view, the aim of this study is to establish variables influencing individuals’ investment decision criteria. within this framework, a survey based on voluntary participation has been conducted through a private bank customers. those participated in study were bank customers. that’s why they are familiar with the financial topics. also, relatively high educated and young people constituted sample profile and this is quite important to being acquainted with the concepts. the investment decision criteria as the dependent variable in this study has been discussed with three dimensions: risk, repay and corporate data. defense mechanisms, personality traits, emotional intelligence and financial literacy havebuilt up the independent variables. hence, this study can be said to be novel regarding explanatory variables. there are some studies correlating financial risk taking with personality traits. yet, to our knowledge, there exists no research including defense mechanisms into their financial framed models. however, in psychology, the relationship lubis, et al.: role of psychological factors in individuals investment decisions international journal of economics and financial issues | vol 5 • special issue • 2015398 between defense mechanisms and risk taking in general has been examined. in this respect, this is a preliminary study paying attention to defense mechanisms in financial risk taking setting. additionally, with the inclusion of emotional intelligence and financial literacy representing emotional abilities and financial knowledge respectively, we intend to deepeningthe comprehension of individual investment preferences. recent research has indicated that individuals do not rationally behave every time. thus, behavioral finance researchers have exerted great effort toward other components directing individuals to make finacial decisions. herein, this study contributes to the extant literature. this study revealed defense mechanisms as important factor on risk, repay and corporate data criteria for investment decision. besides, certain personality traits is shown to be significant for investment decision criteria. according to results, financial literacy had impact on repay criterion of investment decision while emotional intelligence was substantial factor in evaluating past performance of firms (i.e., corporate data criterion). all in all, this paper provides evidence of substantial components in making investment decisions by integrating financial literacy, emotional intelligence, personality and defense mechanisms into understanding this financial decision making process. this paper proceeds as follows: the first sectionboth communicates the prior research and also mentions about the independent variables which we would employ in explaining investment decision criteria of individuals. the second section includes research methodology and subsequently analyses to answer our research questions. in conclusion section, the results are discussed and future research suggestions are made. 2. literature review there are lots of studies concentrating on financial risk tolerance, risk taking and risk perceptions (e.g., wong and carducci, 1991; carducci and wong, 1998; grable, 2000). the research on the determinants of financial risk taking revealed that demographics, socio-economic, behavioral and personality factors have largely explainedthe variance in financial risk taking. further, some academicians have referred to neural basis of financial risk taking (kuhnen and knutson, 2005; kuhnen and chiao, 2009). as mentioned before, behavioral finance proposes that cognitive and affective bias which everyone could exhibit cause deviations from rational behavior. following this argument, researchershave started to examine deep-rooted concepts in psychology and to discuss them in the financial context. additionally, the assumption that probabilities are not stochastic but subjective has enabled financial behavior to be better predicted by perceptions and attitudes. on the otherhand, there is a heavy concentration on demographics and socio-economic factors in order to explain financial behavior in the extant literature. in this regard, the literature needs to investigate behavioral and attitudinal factors which would make a divergence between individuals. some researchers have stated that studies exerted little effort toward examining emotional and individual factors although the role of these factors has been manifested by some studies (sjöberg and engelberg, 2009). grable et al. (2008) mentioned that past research has not sufficiently focused on the manner of how environmental or individual factors can influence both antecedents and consequences offinancial behavior. moreover, they also asserted that little effort has been devoted to explaining the relationship between these factors and financial risk taking behaviors. weber et al. (2002) manifested that risk attitude or risk perception reduces the likelihood of risky behavior occurrence. namely, if individuals perceive the risk of any behavior as high they are less likely to exhibit that behavior. in another study, it was revealed that the related risk perceptions of those who prefer not to use online banking are higher than the people who use (demirdöğen et al., 2010). pasewark and riley (2010) suggested that investors take relevant corporate data, investment risk and repay capability into consideration while making investment decision. in this study, it is suggested that emotional intelligence, personality, defense mechanisms and financial literacy may influence the criteria for individuals’ investment decisions. this study employs the scale of investment decision criteria developed by the above-named authors. 2.1. emotional intelligence olson (2006) expressed that emotions which rational choice theory has ignored, however, could have an impact on financial behavior. emotions are thought as disordered interims of mental activities in western tradition (salovey and mayer, 1990). in this respect, individuals in rational choice process have to share their energy and time between solving their problem and hence making a decision and regulating their emotional activities. because, they ought todisplay an array of activities in order to understand, appraise and control their emotions respectively while trying solving a problem. therefore, individuals sometimes display irrational behaviors at the expense of experiencing psychological satisfaction or personal relief (gao and schmidt, 2005). on the other hand, it should be stated that decision making theory displays divergency regarding how emotion and rationale can exist together. indeed, some academicians assert that the removal of emotions from decision making process could drive individuals to make decision better while others proclaim that the capability of using emotions in the decision process represents a significant determinant of a good decision. especially, recent research articulates that emotional abilities and behaviors referring to emotional intelligence can enhance both the output and also the process in a decision making problem (hess and bacigalupo, 2011). emotions are seen as coordinated reactions, ensuing various psycological integral parts (i.e., cognitive, motivational, physiological, experiential systems) and these reactions are seen internally or externally while carrying positive or negative meanings (salovey and mayer, 1990). since both concepts are sometimes misused, it could be stated that mood is different from emotions in some aspects which it is free standing and not attributed to any object and lasting for some time period (olson, 2006). salovey and mayer (1990) defined this construct lubis, et al.: role of psychological factors in individuals investment decisions international journal of economics and financial issues | vol 5 • special issue • 2015 399 as “the ability to monitor one’s own and others’ feelings and emotions, to discriminate among them and to use this information to guide one’s thinking and actions.” they approached emotional intelligence as a subset of social intelligence and discussed it in three-dimensions: (1) appraisal and expression of emotion, (2) regulation of emotion, (3) utilization of emotion. schutte et al. (1998) fulfilled factor analysis on the 62-item construct of salovey and mayer (1990) and attained unidimensional 33-item measure which equally encompasses three dimensions of this conceptual model. they validated and proved it reliable and this study employs the above-mentioned scale. in the meanwhile, it should be noted that there are also some studies arguing the relationship between emotional intelligence and personality, cognitive or academic ability (rosete and ciarrochi, 2005; van der zee et al., 2002; lopes et al., 2003; vakola et al., 2004; van rooy and viswesvaran, 2004). 2.2. personality in explaining the differences between investor behaviors, lots of studies argued the role of personality on investing behavior. the logical connection between these two phenomena in this manner: personality influences risk perceptions or risk tolerance of investors and these risk reflections form the investor behavior (mayfield et al., 2008). it is said that personalityhas a relation to regret feeling regarding current investment as well as investment preferences (xiao et al., 2009). some research argued type a personality, myers-briggs personality type or sensation seeking on financial risk taking (carducci and wong, 1998; sjöberg and engelberg, 2009; filbeck et al., 2005) while other research employed big five personality traits in predicting financial behavior (xiao et al., 2009; mayfield et al., 2008; hunter and kemp, 2004). big five personality classification operationalizes personality traits and reduces it into five bilateral dimensions (i.e., extraversionness, agreeableness, conscientiousness, neuroticism, openness to experience). it is mentioned that big fiverelates to several personality scales (mccrae and john, 1992). this study utilized 44-item big five scale of benet-martinez and john (1998). 2.3. defense mechanisms defense mechanisms are defined asuseful but unconcious responses keeping ego from to be dissociated. defense mechanisms of ego, one of major contributions in psychoanalysis, are known to be “relevant to drives, affects, development, personality, adaptation, and psychotherapy” (plutchik, 1995). anxiety, whether the cause is real or not, is recognized as the most unappealing feeling for individuals. moreover, it can be experienced both internally and also externally. individuals experience internally caused anxiety under a conflict between their conscious and subconscious (bovey and hede, 2001). bond (1995) gives that definition of defense mechanisms: “patterns of feelings, thoughts or behaviors that are relatively involuntary and arise in response to perceptions of psychic danger. they are designed to hide or to alleviate the conflicts or stressors that give rise to anxiety.” according to psychoanalysts, everybody displays these mechanisms to some extent. but this does not imply that they are all favorable. as a matter of fact, classic psychoanalysts recognize defense mechanisms of ego as undesirable form of mental functioning and state that these mechanisms should be given up after they have realized the function of protectingimmature ego (plutchik, 1995, p.17). recent research has attempted to extend this classical view and asserted that certain defense mechanisms are useful and adaptive. there exist adaptations in every one’s life whichhelp individuals developing their ego. by means of these adaptations, individuals abandon particularly primitive defense mechanisms (white, 1963; as cited in plutchik, 1995, p.18). defense mechanisms are sometimes mistaken with coping styles. this discrimination may work best: although defense mechanisms are immature and unconscious processes of mental development, coping styles are deemed as mature and conscious problem solving methods (plutchik, 1995). in order to operationalize these mechanisms, this study employs defense style questionnaire 40 by andrews et al. (1993). this 40-item scale encompasses 20 defense styles with two items each. also, authors discuss defense mechanisms with three dimensions: immature, neurotic and mature defense mechanisms. in this study, only neurotic and mature defense mechanisms were utilized since it is assumed that bank customers as adults would not display immature or primitive defense mechanisms. namely, there are 15-item in defense mechanism scale in our study. self-assessment of unconscious defense styles comes under criticism in some manner. one of them is whether individuals could self-assess their unconscious defense styles. motivation, self-awareness and openness level of individuals constitute these limitations (bond, 1995; davidson and macgregor, 1998). it is unlikely for an individual to form a habitual activity by appealing to the certain defense mechanisms more (andrews et al., 1993). then, defense mechanisms such as personality could help in explaining individual behavior. in this regard, defense mechanisms are expected to influence investment decisions via risk taking. many investment decisions are made under uncertainty and uncertainty makes people experience anxiety. this may be a logical connection between defense mechanisms and investment decision. 2.4. financial literacy as a financial capability indicator, financial literacy has been focus of interest for both scholars and also policy makers. now, individuals are more responsible and active for their individual retirement plans. why is it so difficult to allocate individuals’ excess funds through possible investment instruments any longer? this hardness might be arisen since they are confused with these complex and multiplexed products (or services). this seems more valid especially for the inexperienced or the unsophisticated (van rooij et al., 2011). it is reported that a vast quantity of households have not been acquainted with most primary economical notions and making plausible investment decision suffers from this serious illiteracy (lusardi and mitchell, 2007a; 2007b). financial literacy lubis, et al.: role of psychological factors in individuals investment decisions international journal of economics and financial issues | vol 5 • special issue • 2015400 is suggested to be relevant to risk perceptions and investment decisions. it is proposed in a study (lachance and tang, 2012) that trust promotes the intentness of taking risk while investing and it is enhanced by some financial literacy. a study of chen and volpe (1998) provided evidence that highly financially illiterate participants had an inclination to make implausible decisions in terms of managing their personal finance. the body of literature on the determinants of financial literacy is abounding. it is generally accepted that demographics relate to how much individuals financially know about. more specifically, chen and volpe (1998) have showed that low level of financial literacy has been more seen amongst women, those with little work experience, those under age 30. lusardi et al. (2010) provided evidence that women are less financially literate than men and also that cognitive ability and education could improve the literacy level. additionally, men, those who work in banking and finance sector and those having both high income and educational level are more literate (al-tamimi and bin kalli, 2009). in contrast to these findings above, ludlum et al. (2012) stated that financial literacy has not varied according to gender while maritual status has made a difference. are the individuals’ investment choices affected by the level of financial literacy? or, those who prefer particular products or services may vary according to their financially knowledge level. prior studies gave some evidence for these foremost questions. more specifically, financial literacy level made influence on wealth accumulation (lusardi and mitchell, 2007a), saving and investment decision (bayer et al., 1996; hilgert et al., 2003; lusardi and mitchell, 2007b), stock (van rooij et al., 2011) or mutual fund participation (müller and weber, 2010) debt (lusardi and tufano, 2009), adjustable rate mortgage ownership (smith et al., 2011) and personal budget management (sharahbani, 2012), credit management (hilgert et al., 2003) and credit card usage (ludlum et al., 2012). within this framework, it is expected in this study that financial literacy would make a divergence between individuals’ investment decision criteria. in measuring financial literacy level of individuals, the scale by van rooij et al. (2011) was employed. this scale divides financial literacy into two components: basic and advanced financial literacy and consists of 16 questions having one true answer. a financial literacy index is calculated from the true anwers of participants. 3. methodology 3.1. sample study sample comprised of 320 participants throughwhich one-toone survey on voluntary basis has been conducted. who participitated in the study are private and public bank customers. in datacollection process, branch manager of related bank has asked customers visiting the branch to participate in the survey. in this manner, the random sampling method giving equally chance to every one has been used. it can be accepted that participants are familiar with the fundamental financial concepts since they are bank customers. when demographics examined, it is seen that approximately 75% of them comprised of graduates or higher study at least. hence, they are considered to have reading comprehension to answer questions. 50% of the participants were male. the people aged between 20 and 40 accounted for nearly 77% of the sample. most of participants (55%) consisted of married individuals. briefly, it can be said that study sample comprised of relatively high educated and young individuals and dispersed equally in terms of gender and marital status. 3.2. variables this study includes five fundamental variables; defense mechanisms, emotional intelligence, personality and basic financial literacy as independent variables and criteria for investment decision as dependent variable. for defense mechanisms scale, it was employed by andrews et al. (1993). defense mechanisms can be divided into three dimensions-mature, neurotic and immature mechanisms. yet, this study utilized only mature and neurotic ones on the basis of primitive and inadaptive nature of immature defense mechanisms. unidimensional emotional intelligence scale of schutte et al. (1998) was used in this study. personality can be examined in five dimensions; extraversion, agreeableness, conscientiousness, neuroticism, openness to experience. personality traits have been operationalized by the scale of benetmartinez and john (1998). for basic financial literacy measure, we employed van rooij et al. (2011). through the true answers participants gave, a financial literacy index has been calculated. pasewark and riley (2010) have determined the criteria for investment decisions of individuals. this study employed only three criteria (i.e., risk, repay and corporate data criteria). 3.3. analyses to test research hypotheses, firstly factor analysis and subsequently reliability analysis have been fulfilled (table 1). barlett sphericity test value was calculated as 2.980,204 at 0.000 significance level. thus, it can be said that there is no relationship between variables and the observations are convenient for factor analysis. by calculating kmo value, it was examined whether sample size is enough or not. kmo test value with 0.821 was calculated above acceptable level (good). table 1 shows eigenvalue, percentage of explained variance, reliability results and item numbers of each factor. factors between f1 and f11 was called in the following way: f1: defense mechanisms (mature), f2: defense mechanisms (neurotic), f3: emotional intelligence, f4: personality (extraversion), f5: personality (agreeableness), f6: personality (conscientiousness), f7: personality (neuroticism), f8: personality (openness), f9: investment decision criterion (risk), f10: investment decision criterion (repay), f11: investment decision criterion (corporate data). as in the study of van rooij et al. (2011), basic financial literacy level is calculated through the true answers of questions and this measurement is no subject to factor analysis. following validity and reliability analysis, correlation analysis to examine possible relationships between variables was performed lubis, et al.: role of psychological factors in individuals investment decisions international journal of economics and financial issues | vol 5 • special issue • 2015 401 (table 2). in this study, since the dependent variable has three dimension, it was measured in three forms: f9: investment decision (risk), f10: investment decision (repay), f11: investment decision (corporate data). thus, there is a relationship between neurotic defense mechanisms, extraversion, agreeableness, openness and risk criterion of investment decision. and, there is an association between all independent variables-excluding mature defense mechanisms and emotional intelligence and repay criterion of investment decision. lastly, all variables except conscientiousness and basic financal literacy correlate with the corporate data criterion of investment decision. additionally, risk, repay and corporate data criteria of investment decision have a positive association between each other with the value above 0.50 and at 0.000 significance level. following correlation analysis, to identify the determinants of each investment decision criterion, stepwise regression analysis was individually fulfilled. therefore, every dependent variable was regressed on variables by starting from including the one with the highest correlation coefficient into the model. 3.4. risk criterion first of all, to determine the motives for individuals focusing on risk criterion of investment decision, stepwise regression analysis was performed (table 3). correlation analysis indicated that there were four variables related to risk criterion: f2: defense mechanisms-neurotic (0.453**), f4: personality (extraversion) (0.374**), f8: personality (openness) (0.337**), f5: personality (agreeableness) (0.294**) (table 2). all models were at significant at 0.000 level. the last model in which all variables were included has greatest explaining power in the models. yet, openness became insignificant in this model. other variables were significant at 0.005 level (table 3). table 3: stepwise regression results for risk criterion model variables statistics coefficient β significant adjusted r2 significant 1 neurotic (f2) 0.453 0.000 0.198 0.000 2 neurotic (f2) 0.501 0.000 0.205 0.000 extraversion (f4) 0.166 3 neurotic (f2) 0.489 0.000 0.202 0.000 extraversion (f4) −0.146 0.121 openness (f8) 0.071 0.433 4 neurotic (f2) 0.390 0.000 0.242 0.000 extraversion (f4) −0.229 0.019 openness (f8) 0.007 0.941 agreeableness (f5) 0.283 0.009 table 1: validity and reliability analysis validity and reliability defense mechanisms emotional intelligence personality investment decision criteria f1 f2 f3 f4 f5 f6 f7 f8 f9 f10 f11 s4 s11 e3 k1 k11 k18 k27 k36 i1 i2 i7 s8 s14 e4 k3 k12 k19 k28 k37 i5 i3 i8 s15 e5 k4 k13 k20 k29 k38 i6 i9 e6 k6 k30 k39 i10 e17 k7 i11 k8 i12 eigenvalues 2.868 3.043 3.233 3.658 3.060 3.428 3.700 3.168 2.922 3.093 3.606 % of variance 2.063 2.189 2.326 2.631 2.202 2.466 2.662 2.279 2.102 2.225 2.594 reliability 0.496 0.624 0.834 0.850 0.772 0.845 0.903 0.855 0.786 0.610 0.889 table 2: correlation analysis f f9 f10 f11 f1 f2 f3 f4 f5 f6 f7 f8 f12 f9 1 0.526** 0.549** 0.094 0.453** 0.071 0.374** 0.294** −0.109 0.160 0.337** 0.032 f10 1 0.503** 0.153 0.411** 0.151 0.329** 0.208* −0.201* 0.223* 0.289** 0.292** f11 1 0.183* 0.408** 0.246** 0.347** 0.360** −0.128 0.365** 0.403** 0.158 f1 1 0.261** 0.234* 0.343** 0.121 0.117 0.392** 0.321** −0.064 f2 1 0.388** 0.531** 0.212* 0.077 0.297** 0.399** −0.091 f3 1 0.517** 0.316** 0.143 0.380** 0.202* −0.132 f4 1 0.426** −0.007 0.442** 0.433** −0.021 f5 1 −0.282** 0.515** 0.580** 0.278** f6 1 −0.158 −0.213* −0.494** f7 1 0.487** 0.037 f8 1 0.145 f12 1 *,**p<0.05 lubis, et al.: role of psychological factors in individuals investment decisions international journal of economics and financial issues | vol 5 • special issue • 2015402 the findings that there is significant relationship between risk criterion and personality and defense mechanisms can be deemed as notably important. to date, although the existence of studies indicating the relation of financial risk taking and personality, there exist no studies estimating financial risk taking with defense mechanisms. this study contributes to the exant literature with the finding that both personality and also defense mechanisms could explain financial risk taking. 3.5. repay criterion to identify the determinants of repay criterion of investment decision, stepwise regression analysis was performed (table 4). correlation analysis showed that there are seven variables in relation to repay ceriterion: f2: defense mechanisms-neurotic (0.411**), f4: personality (extraversion) (0.329**), f12: financial literacy (0.292**), f8: personality (openness) (0.289**), f7: personality (neuroticism) (0.223*), f5: personality (agreeableness) (0.208*), f6: personality (conscientiousness) (−0.201*) (table 4). all models were significant at 0.000 level. yet, all variables except neurotic defense mechanisms and financial literacy were not able to be significant even at 0.10 level (table 4). hereupon, stepwise regression analysis including only significant variables (i.e., neurotic defense mechanism and financial literacy) was again performed (table 5). as seen, both two models were significant at 0.000 level and the explaining power of the model (adjusted r2) was increased. and both variables were also significant at 0.000 level. in addition to significant defense mechanism, financial literacy coefficient also became significant in estimating repay criterion of investment decision. this is notably important finding since financial literacy is, in deed, required in order to compute repay expectation of any investment alternative. 3.6. corporate data criterion to establish motives for individuals concentrating on corporate data criterion while making investment decision, regression analysis were performed (table 2). correlation analysis revealed that there are seven variables in relation to corporate data criterion: f2: defense mechanisms (neurotic) (0.4081**), f8: personality (openness) (0.403**), f7: personality (neuroticism) (0.365**), f5: personality (agreeableness) (0.360**), f4: personality (extraversion) (0.347**), f3: emotional intelligence (0.246**), f1: defense mechanisms (mature) (0.183*) (table 2). all models were significant at 0.000 level. yet, explaining power (adjusted r2) showed variability between models and certain variables were found insignificant even at 0.10 level (table 6). then, these results necessiated the analysis to be repeated. thus, a new regression analysis including only significant variables such as neurotic defense mechanisms, emotional intelligence and openness was again fulfilled (table 7). explaining power of models has been progressively increased and all variables in all models were significant at 0.05 level. the important findings in this analysis are that (1) defense mechanisms remained significant estimator of corporate data criterion, (2) openness became important for corporate data criterion, (3) particularly emotional intelligence having no impact on other decision criteria became significant for corporate data criterion. table 4: stepwise regression results for repay criterion model variables statistics coefficients β significant adjusted r2 significant 1 neurotic (f2) 0.41 0.00 0.162 0.00 2 neurotic (f2) 0.42 0.00 0.155 0.00 extraversion (f4) −0.01 0.91 3 neurotic (f2) 0.43 0.00 0.260 0.00 extraversion (f4) 0.03 0.75 financial literacy (f12) 0.34 0.00 4 neurotic (f2) 0.42 0.00 0.261 0.00 extraversion (f4) −0.00 0.99 financial literacy (f12) 0.33 0.00 openness (f8) 0.09 0.31 5 neurotic (f2) 0.42 0.00 0.259 0.00 extraversion (f4) 0.01 0.90 financial literacy (f12) 0.29 0.00 openness (f8) 0.07 0.42 neuroticism (f7) −0.08 0.39 6 neurotic (f2) 0.37 0.00 0.262 0.00 extraversion (f4) −0.03 0.76 financial literacy (f12) 0.29 0.00 openness (f8) 0.04 0.64 neuroticism (f7) −0.08 0.42 agreeableness (f5) 0.13 0.21 7 neurotic (f2) 0.37 0.00 0.259 0.00 extraversion (f4) −0.02 0.83 financial literacy (f12) 0.30 0.00 openness (f8) 0.07 0.50 neuroticism (f7) −0.09 0.37 agreeableness (f5) 0.15 0.17 conscientiousness (f6) −0.07 0.51 lubis, et al.: role of psychological factors in individuals investment decisions international journal of economics and financial issues | vol 5 • special issue • 2015 403 4. conclusion in this study, individuals’ considerations of investment decision criteria have been argued from the behavioral finance perspective. within this framework, risk, repay and corporate data criterion of investment decisions have been tried to be explained with personality, defense mechanisms, emotional intelligence and financial literacy level. in this regard, this can be deemed as one of the preliminary studies. there are some studies examining the relationship between personality, financial literacy and financial risk taking. however, there were no studies aiming to explain financial behavior with emotional intelligence and defense mechanisms. accordingly, this study can be said to be novel and contributory to the literature in this manner. this study has argued three components influencing individuals’ investment decision and all analyses have been individually performed for these three components. academicians in finance and particularly behavioral finance domain have exerted more effort to financial risk taking. this study revealed that other behavioral and psychological factors such as defense mechanisms and personality have impact on financial risk taking behavior. similarly, repay expectations have importance on investment decision. according to this study results, repay criterion of individuals are influenced by their defense mechanisms and financial literacy levels. last but not least, in evaluating past performance of any investment alternatives, personality, defense mechanisms and emotional intelligence of individuals had a place in making investment decision. the findingwhich can be interpreted in that past behavior may have table 6: stepwise regression results for corporate datacriterion model variables statistics coefficient β significant adjusted r2 significant 1 neurotic (f2) 0.408 0.00 0.160 0.00 2 neurotic (f2) 0.329 0.00 0.219 0.00 openness (f8) 0.267 0.00 3 neurotic (f2) 0.345 0.00 0.225 0.00 openness (f8) 0.244 0.00 neuroticism (f7) −0.116 0.16 4 neurotic (f2) 0.307 0.00 0.223 0.00 openness (f8) 0.217 0.02 neuroticism (f7) −0.116 0.16 agreeableness (f5) 0.087 0.40 5 neurotic (f2) 0.304 0.00 0.217 0.00 openness f8) 0.211 0.03 neuroticism (f7) −0.121 0.16 agreeableness (f5) 0.078 0.48 extraversion (f4) 0.025 0.80 6 neurotic (f2) 0.261 0.01 0.232 0.00 openness (f8) 0.151 0.13 neuroticism (f7) −0.092 0.28 agreeableness (f5) 0.040 0.72 extraversion (f4) 0.044 0.66 emotional intelligence (f3) 0.179 0.07 7 neurotic (f2) 0.261 0.01 0.225 0.00 openness (f8) 0.157 0.13 neuroticism (f7) −0.088 0.32 agreeableness (f5) 0.043 0.70 extraversion (f4) 0.044 0.66 emotional intelligence (f3) 0.183 0.08 mature (f1) −0.021 0.82 table 7: stepwise regression results for corporate data criterion (only significant variables ıncluded) model variables statistics coefficient β significant adjusted r2 significant 1 neurotic (f2) 0.408 0.000 0.160 0.000 2 neurotic (f2) 0.295 0.001 0.222 0.000 emotional intelligence (f3) 0.285 0.002 3 neurotic (f2) 0.272 0.002 0.242 0.000 emotional intelligence (f3) 0.204 0.035 openness (f8) 0.184 0.048 table 5: stepwise regression results for repay criterion for neurotic defense mechanism and fi nancial literacy model variables statistics coefficients β signficant adjusted r2 significant 1 neurotic (f2) 0.41 0.00 0.162 0.00 2 neurotic (f2) 0.44 0.00 0.266 0.00 financial literacy (f12) 0.33 0.00 lubis, et al.: role of psychological factors in individuals investment decisions international journal of economics and financial issues | vol 5 • special issue • 2015404 influence the actual behavior through attitudes corresponds with social behavior theory. to conclude, trying to understand financial decisions by paying attention to these kind of psychological factors may contribute to behavioral finance literature. any investment decision represents a financial behavior and the subjects of these behaviors are individuals. accordingly, this consideration requires these kind of behavioral and attitudinal components to be included into research models. and this preliminary study can be said to justify this requirement. as in any study, there are some limitations in this study. with a larger sample, it is obvious to attain more generalizable results. we suggest researchers design their studies by 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(2009), economic environment and personality: how do they ınfluence ınvestment decisions and regret? social behavior and personality, 37(10), 1297-1304. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 102-111. international journal of economics and financial issues | vol 13 • issue 1 • 2023102 historic spatial inequality and poverty along racial lines in south africa faraaz shahaboonin, oladipo olalekan david, abigail van wyk* school of economic sciences, north-west university. south africa. *email: abigail.stiglingh@nwu.ac.za received: 10 october 2022 accepted: 03 january 2022 doi: https://doi.org/10.32479/ijefi.13803 abstract south africa faces many socio-economic challenges, which include sluggish economic growth, increasing unemployment rates, increasing inequality, and high poverty levels., this paper focused on examining how spatial inequality cause these socio-economic issues. the main thrust of the paper is to briefly investigate two major aspects, firstly the root cause of spatial inequality in south africa, and secondly the impact that spatial inequality has on socio-economic indicators such as economic inequality, poverty, and employment levels. this research used a mixed methodology approach. empirical research findings proved that apartheid policies contributed to high levels of poverty and inequality in south africa. as the empirical results show, the existing inequalities in south africa are predominantly based on a racial sub-group basis, which confirms the causal relationship with historic apartheid spatial policies enforced on a racial basis. primary research findings depicted that the post-apartheid era is characterised by high poverty levels and huge inequality with bulk of blacks exposed to diverse macro-economic challenges. policy recommendation wise, it was suggested that the government should continue to redress the systems of apartheid and use policies that help to eradicate poverty. keywords: economic growth, poverty, spatial inequality, unemployment, gini co-efficient jel classifications: d63, j1, q01, r1 1. introduction 1.1. background and context south africa is recognised as one of the most unequal countries in the world (bhorat et al., 2015). this inequality is illustrated by the current income/expenditure gini co-efficient which is 0.65 (world bank, 2021). this indicates a high level of inequality according to the income measure with the top 10% of earners taking home 65% of total income, while the rest of the population at 90% earn just 35% of total income (webster, 2019). while the level of income inequality is one of the highest in the world it is not the only form of inequality south africa is battling with. another more deeply rooted inequality is that of spatial inequality. spatial inequality can be defined as the inequality of wellbeing across different regions within a country, measured by both social and economic indicators (kanbur and venables, 2005); (kidokoro et al., 2022). spatial inequality has previously been analysed in the form of spatial opportunity structure, which focuses on the effect geographic location has on the gains from individual attributes, and the individual attributes that are acquired by individuals in different geographic locations (kadi et al., 2022). the spatial opportunity structure focuses on socio-economic, geographical, political, and institutional elements to underpin its theories (galster and sharkey, 2017). according to hartzenberg (2005) the spatial inequality present in south africa can be traced back to apartheid policies which enforced spatial divisions based on race. the mass displacement of certain races as well as restrictions on movement based on race, has prevented equal access to economic opportunities that lie within the major economic hubs and city centres (turok, 2018). one of the policies that created this spatial division was the bantu homelands act which displaced millions of south africans, this journal is licensed under a creative commons attribution 4.0 international license shahaboonin, et al.: historic spatial inequality and poverty along racial lines in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 103 confining them to rural underdeveloped areas under the guise of newly created states (klein, 1987). these states were purposefully located great distances from urban hubs and city centres. in addition to this, residential segregation policies led to the creation of race specific townships, which included large scale housing projects located on the outskirts of major cities, serving as a form of dormitory for the work force (todes and turok, 2017). these oppressive policies have long lasting effects which can still be seen today, with around 43% of black south africans still residing in the former homelands, even after the end of the apartheid era. this is a major contributor to the current poverty levels afflicting south africa, with more than 75% of rural households being dependant on state social grants in order to fulfil basic needs (todes and turok, 2017). a major issue with spatial inequality in south africa is the mismatch between the areas where the workforce resides and the areas that they work in. this is highlighted by turok and borelsaladin (2013) by mentioning that approximately 52% of jobs were created in urban areas which only housed 34% of the population, emphasising the lasting disparities in economic opportunities. this research aimed at investigating the effect of this spatial inequality on economic growth and poverty within south africa. 1.2. problem statement the current issue of spatial inequality in south africa is a result of the apartheid policies which enforced spatial divisions within south africa. these divisions were specifically designed to suppress citizens according to their race, excluding them from economic participation at higher levels (hartzenberg, 2005). these apartheid policies deprived south africans of colour the opportunity to gain wealth and resources, which ultimately resulted in the high levels of poverty and spatial inequality we are faced with in south africa. this issue is exacerbated by the fact that south africans of colour make up over 90% of the total population in sa (statistics south africa, 2002). the research be aimed at investigating the relationship between spatial inequality and the levels of poverty, according to race within south africa. the study will attempt to gain an understanding on why spatial inequality is still prevalent in south africa almost three decades later after independence. the effects of spatial inequality on poverty will also be investigated. these are important aspects which need to be understood for south africa to experience inclusive growth and development, in contrast to the increasing inequality that has plagued the nation since colonial times (international monetary fund, 2020). 1.3. research objectives the primary objective of this research is to investigate the relationship between the historic spatial inequality, and poverty along racial lines in south africa. to facilitate the achievement of the primary objective, the following theoretical objectives are examined in the study: • to determine the origin and existing causes of spatial inequality in south africa • to determine the effects of spatial inequality on poverty, specifically between races and regions. to facilitate the achievement of the primary objective, the analytical and empirical portion of the study consists of the following objectives: • to analyse the trends of inequalities such as, income inequality, employment inequality, and location inequalities (urban/rural). this will be accomplished by firstly conducting a qualitative analysis and thereafter presenting correlation data on real current values for the selected proxy indicators. 1.4. overview the research begins with the first section which is the literature review in which four sub-topics will be discussed and these are the origins of spatial inequality in south africa; measuring inequality; inequality based on ethnic sub-group; and spatial inequality in south africa. thereafter, the theoretical framework will outline the research design and context; the methodology; and the data and sources used. the results and analysis follow in the form of a qualitative analysis on inequality elements, followed by a short empirical correlation analysis. lastly the recommendations and conclusion wrap up this research study. 2. literature review this section seeks to present the theoretical literature review of this study. 2.1. the origins of spatial inequality in south africa in a debate regarding the truth and reconciliation committee held in parliament in 1998 former president thabo mbeki described south africa as a country divided by material conditions, into two nations, one black and the other white, with the latter having easy access to a developed economic, physical, educational, and other infrastructure. the large part of south africa is black and poor, and lives under the conditions of a grossly under-developed infrastructure (mbeki, 1998). the statement by the then deputy president mbeki highlights the dichotomous nature of the socioeconomic situation that is still present in south africa today. the inequality in south africa that is persistent today has originated over a century ago, when the british colonial states of the cape, natal, and boer republics of orange free state, and transvaal were granted their independence in 1910 (leacock, 1910). the ensuing peace settlement between the british empire and their former colony states allowed for racial discrimination to take hold at the very foundations of the new south african state. the colonisation and resultant creation of an apartheid state is the root cause of the racial exclusion which has led to unequal access to resources and economic opportunities between white and “nonwhite” citizens (gelb, 2003). under the apartheid state new laws were implemented which systematically oppressed the “non-white” citizens specifically targeting black citizens. one of the key focuses of the apartheid shahaboonin, et al.: historic spatial inequality and poverty along racial lines in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023104 policies were spatial targeting, an example of a spatially oriented apartheid policy is the natives land act of 1913, which displaced millions of south africans, confining them to rural underdeveloped areas and prevented the black ownership of land outside of designated zones (klein, 1987). these areas being typically rural and under-developed had a severe lack of supporting infrastructure critical to socio-economic development which prevented the socio-economic development of “black reserves” while preventing black south africans from accessing the economic opportunities that were present in the major cities and the rest of the country, as well (adetoro et al., 2022). this has resulted in a form of inequality which is based on geographical location known as spatial inequality which can be defined as the inequality of wellbeing across different regions within a country, measured by both social and economic indicators (kanbur and venables, 2005). 2.2. measuring inequality in south africa south africa faces one of the highest levels of inequality in the world by many measures (bhorat et al., 2015). inequality can be described as the differences in status, rights, opportunities, or endowments that are present between individuals or population groups (koh, 2020). to measure the level of inequality in south africa the gini coefficient would be used as a measure. the gini coefficient measures income inequality within a country by comparing the wealth distribution among the population (aburto et al., 2022). the resultant level of inequality is represented by a value between zero and one, zero being complete equality and one being complete inequality (canton, 2021). it is the most commonly used inequality measure due to its efficiency and simplistic scale of measurement which allows for an easy comparison of inequality between countries (boyce, 2021). the gini co-efficient would be used in this analysis due to its simplicity, efficiency. however, the gini measure does have its limitations. one of the foremost limitations is its focus on income. the problem lies within multiple differing income measures which would affect the resulting gini coefficient depending on which measure is used (chitiga et al., 2014). while this may be the foremost limitation globally, in the south african context there are two weightier shortfalls of the gini coefficient, which are: its inability to recognise broader socio-economic inequalities; and the exclusion of the informal sector in its measurement. the impact of this limitation would be greater in nations that have a very large informal sector, and battle widespread socio-economic issues, such as south africa. in these cases, it would be advisable to consult additional indicators of equality and or poverty such as the human development index or the multidimensional poverty index. however, for the purpose of a domestic comparison between sub-groups the gini coefficient would suffice as a measure of comparison. the broad gini coefficient of the entire country is of limited relevance when analysing spatial inequality and poverty trends within the country. this is especially true in the south african case since south africa faces many types of internal socio-economic inequalities (deghaye and mckenzie, 2012). to address this issue and allow the gini coefficient to measure the extent of spatial inequality in south africa the gini coefficient would be applied to specific sub-categories within the south african population such as gini by race and gini by settlement type. 2.3. inequality based on ethnic sub-group the reason spatial inequality in south africa will be analysed along the criteria of ethnic sub-groups is due to historic apartheid policies being enforced by the above criteria, which is seen as the root cause of inequalities in south africa. to grasp the level and intensity of inequality in south africa a better understanding of the composition of the population is needed. table 1 shows demographic data for 1991 and 2001. from the data it is apparent that majority of the population is made up of africans and this is over 80%, it is also evident that the african demographic group was the only group which has experienced an increase in percentage share of total population, indicating that africans contributed to a vast majority of the population growth that south africa has experienced. the above statistics imply that if inequality and poverty in south africaaffect the nation at large, it would affect the african race at a greater rate, due to their larger representation within the population of the country. this means that out of every 100 people affected by inequality or poverty, 81 people would be black and just over seven people would be white, based solely on the ethnic composition of the population. white people form 16.5%, coloured 10.5%, indian 3% of the total population as of 1991. in 2019, there were changes and africans formed 81.2%, whites 7.6%, coloureds, 8.7% and indians 2.5% of the total population. it is important to note this going forward, so that the statistics are not misinterpreted, since a skewed distribution by ethnicity is expected to bend towards the black african sub-group. now that the ethnic composition of the population is known, as well as how it is expected to affect the inequality results, the first proxy indicator of inequality can be analysed, which is real annual mean expenditure by ethnic group. expenditure is used as a proxy for inequality since it synthesises living standards as well as the distribution of income and wealth. the results obtained from the living conditions survey and the income expenditure survey are presented in table 2 below. the data below shows that for the period 2006 up to 2011 all ethnic sub-groups experience an increase in expenditure, with a slight decrease in 2015. this indicates that the economy grew in the period 2006–2011, however the question at hand is how the benefits from this growth was table 1: population composition of south africa year ethnic sub-group percentage of population 1991 african 70 white 16.5 coloured 10.5 indian 3 2019 african 81.2 white 7.6 coloured 8.7 indian 2.5 source: statista (2019) shahaboonin, et al.: historic spatial inequality and poverty along racial lines in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 105 distributed and it should be noted that increase in expenditure does not always leads to economic growth. it is noted that the nine-year average of annual mean expenditure for black africans is 15,459, while for whites it is 107,676. this result is contrary to what is expected based on the population composition. black africans which are the largest ethnic group of the population spend the least, while white south africans, forming under 10% of the population, spend the most on average. the results therefore indicate severe income and expenditure inequality between different ethnic subgroups in south africa. now that it is clear that income inequality exists between the different ethnic sub-groups in south africa, the inequality within each ethnic sub-group will be analysed by referring to the gini coefficient of each sub-group independently. this is done to gain an understanding on whether the level of inequality is the same within each sub-group as it is between each sub-group. a large difference in inequality levels of between and within ethnic subgroups would suggest that the inequality is based on ethnicity. the 2015 overall national gini coefficient of 0.65 (statistics south africa, 2019) would be used as a baseline to compare the 2015 gini coefficient of each ethnic sub-group. the data in table 3 shows that the black african subgroup has the highest level of within sub-group inequality with a gini coefficient of 0.57, followed by the coloured sub-group with a gini coefficient of 0.56. the indian and white sub-groups show lower levels of within sub-group inequality, with gini coefficients of 0.45 and 0.41 respectively. the results obtained indicate that the level of within sub-group inequality is lower than the national level of inequality. this affirms that inequality in south africa is skewed with a racial bias. furthermore, the black african sub-group was the only ethnic sub-group which has become more unequal between 2006 and 2015 with the gini coefficient increasing from 0.54 to 0.57 in this period, despite an increase in annual average expenditure within the sub-group for the same period. this indicates that the increase in expenditure was captured by a small portion within the subgroup, which further exacerbates the issue of inequality. this result affirms the notion that the underlying cause of this inequality is the lasting effects of previously enforced apartheid policies, which were specifically harsh on the black african sub-group. another indicator of inequality among the different ethnic subgroups which relates to spatial inequality is the percentage of land ownership in urban areas that each ethnic subgroup holds in comparison to the sub-group’s percentage of total urban population. the data in figure 1 suggest that there is a very large disparity between the percentage of land owned by ethnic subgroups in urban areas and the population of the sub-group in urban areas. the greatest disparities occur in the white and black subgroups, with whites owning just under 50% of urban land while constituting <10% of the urban population. on the contrary, blacks own 30% of urban land while they make up over 80% of the urban population. the coloured and indian sub-groups both constitute <10% of the urban population with similar land ownership. these large disparities in urban land ownership can be traced back to apartheid spatial policies such as the bantu homeland citizenship act of 1970, which prevented black south africans from owning land outside of their designated homelands (sa history online, 2014). the income inequality and urban/rural land ownerships statistics are confirmed by the data in table 4 which show that the levels of inequality in urban areas are significantly higher than that of the rural areas. the decrease in inequality over the nine-year period is relatively small and is not in line with achieving the goals of section 25 of the south african constitution, which aims to allow south african citizens equitable access to land on a racial and gender basis (land audit report, 2017). table 2: distribution of real annual mean expenditure by ethnic group ethnic sub-group mean 2006 2009 2011 2015 av black african 11,005 14,145 18,396 18,291 15,459 coloured 19,405 25,207 31,850 31,951 27,103 indian/asian 39,840 51,744 67,386 58,249 54,305 white 103,012 107,774 142,613 77,308 107,676 source: (statistics south africa: report 03/10/2019, 2019) table 3: gini co‑efficient by ethnic group (2006‑2015) ethnic group year gini co‑efficient black african 2006 0.54 2009 0.57 2011 0.55 2015 0.57 coloured 2006 0.56 2009 0.53 2011 0.53 2015 0.56 indian/asian 2006 0.52 2009 0.50 2011 0.45 2015 0.45 white 2006 0.43 2009 0.39 2011 0.41 2015 0.41 source: (ies 2005/06, lcs 2008/09, ies 2010/11, and lcs 2014/15; own calculations) source: (department of rural development and land reform, 2017) figure 1: urban land ownership and urban population by ethnic sub-group shahaboonin, et al.: historic spatial inequality and poverty along racial lines in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023106 2.4. spatial inequality in south africa while the data above focuses on inequality between and within ethnic sub-groups, another important variant of inequality affecting south africa is spatial inequality. to measure the levels of spatial inequality in south africa the proxy indicator of annual mean and median expenditure would be used once again, however it would be analysed at a provincial level. the use of the annual mean expenditure at a provincial level would allow for the comparison between the income of the provinces which housed former bantustans or ‘homelands’ and the provinces in which major economic hubs were situated. a large difference in expenditure between these provinces would confirm that the former spatial apartheid policies such natives land act of 1913 have had a lasting effect on the progress and development of certain provinces, while allowing other provinces to agglomerate wealth at an unnatural rate (department of trade and industry, 2018). before the expenditure at a provincial level is analysed, it is important to identify the provinces which housed the former homelands. as figure 2 illustrates, the former homelands were concentrated in the provinces of limpopo, eastern cape, northwest, and kwazulu natal. table 4 which depicts the real annual mean expenditure of each province shows that in 2015, gauteng and the western cape were the two provinces with the highest expenditure by a considerable margin, with expenditures of 48,219 and 47,592 respectively. the northern cape, free state, and mpumalanga follow with expenditures between 23,300 and 28,500. the eastern cape, north-west, kwazulu-natal, and limpopo have the lowest expenditures ranging from 16,300 at the lowest to 20,900 at the highest. the data collected shows that the provinces with the lowest expenditures are all provinces in which there was a high concentration of homelands during apartheid. this confirms that spatial inequalities created by apartheid spatial policies such as the natives land act of 1913 and the bantu homeland citizenship act of 1970 has lasting repercussions that are still present today. the provinces in which these homelands were concentrated experience spatial inequalities as recent as 2015, resulting from the hindered socio-economic and infrastructural development that those areas were subjected to for decades under apartheid law. according to table 5 it is clear that the spatial inequality present in south africa today is largely based on the effects of concentration of wealth within certain provinces which form the economic hubs in the country, with a strong racial bias towards the ownership of this lucrative land. these differences in agglomeration between the provinces were borne out of deliberate spatial targeting under the apartheid regime. this ultimately hindered the socio-economic and infrastructural development of the provinces, which housed the bantustan homelands, which were designated for black ownership. this has also resulted in an unequal distribution of land between the different ethnic sub-groups in south africa (klein, 1987). the bantu homelands act of 1970 which lead to unequal distribution of land as well as policies such as the pass laws act of 1952, prevented the equal access to economic opportunities, which ultimately resulted in the severe income/expenditure and spatial inequalities we face in south africa today. table 4: mean expenditure and gini coefficient by settlement type settlement type year mean gini co‑efficient urban 2006 29,870 0.65 2009 34,836 0.62 2011 43,394 0.62 2015 40,290 0.61 rural 2006 8,058 0.53 2009 8,981 0.51 2011 13,190 0.55 2015 11,658 0.55 source: (ies 2005/06, lcs 2008/09, ies 2010/11, and lcs 2014/15; own calculations) source: todes and turok, 2018 figure 2: a map of the former homelands shahaboonin, et al.: historic spatial inequality and poverty along racial lines in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 107 3. theoretical framework and method 3.1. research design and context to facilitate the achievement of the primary objective, the analytical/empirical portion of the study consists of the following objective: • to analyse the trends in poverty, income, and employment, as well as the distribution of asset ownership, according to the sub-groups of race. the research builds on the spatial opportunity structure which is recognised as the foundational determinant of inequality (galster, 2012). spatial opportunity structure deals with the effect that geographic location has on the gains from individual attributes, and the individual attributes that are acquired by individuals in different geographic locations which entails many social, economic, and political elements (galster, 2012). many academics prefer to employ a qualitative analysis when conducting research based on the spatial opportunity structure, due to the unquantifiable nature of the many elements being considered. therefore, before the data is analysed empirically, a qualitative analysis will be done to fully grasp the multidimensional nature of spatial inequality in south africa. in order to conduct the qualitative analysis, spatial inequality would be dissected into three categories of inequality being: economic and wealth inequality, labour and employment inequality, and social inequality. the adaptation of the theory of spatial opportunity structure to fit the south african context should rely on elements which reflect the south african socio-economic situation. as such, the following defining indicators have been selected as elements which contribute to spatial inequality in south africa: poverty, race, income, employment, and land ownership. since these elements are quantifiable either directly, or through the use of a binary variable, it is possible in this case to use quantitative measures to provide empirical evidence supporting the theory of spatial opportunity structures in south africa. 3.2. methodology this research is a mixed methodology approach, due to the unquantifiable properties of spatial inequality. it is deductive in nature and will consist of the qualitative analysis of three main types of inequality that contribute to spatial inequality and a quantitative analysis of cross-sectional data, with the aim of verifying the relationship and correlation between the variables selected to represent spatial inequality. the indicators used to represent these variables are as follows. spatial inequality will be represented by a proxy indicator which is ownership of land. the proxy indicator for spatial inequality will take the form of a dummy variable for land ownership. poverty will be measured by comparing incomes with the lower bound poverty line, to determine poverty status, and then would take the form of a dummy variable for poverty. employment and race will also take the form of dummy variables. due to the broad multidimensional nature of the question at hand the quantitative method will only be used to conduct a correlation analysis in an attempt to provide supporting data to the findings in qualitative analysis. formulating an empirical regression that is capable of comprehensively measuring the relationship between the variables that are recognised as determinants of inequality, is beyond the scope of this study. the indicators used within the empirical portion of this research are a cross-sectional data source, which provide synthesised numerical values, that allow for them to be used in conducting a correlation analysis, with the results allowing for a descriptive interpretation. the aim of conducting a correlation analysis is to determine the magnitude of the influence of the variables upon each other. 3.3. data, sources, and limitations data regarding spatial inequality, land ownership, race, employment, income, poverty, will be retrieved from stats sa. the data provided by statistics south africa, 2019 is sourced from the general household survey of 2017, which is also administered and monitored by stats sa, and as such is considered a reliable source of cross-sectional data. the relevant data will then be selected, formatted, and compiled using microsoft excel, before being exported to software’s such as eviews and spss for analysis. a sample of 9999 responses have been collated for analysis. a limitation of using cross sectional data is that it captures the characteristics of variables for one specific point in time only. this means that the study cannot analyse the effects that poverty and economic growth have on spatial inequality over a period of time, but rather at a specific point in time only. due to this limitation, the origin of spatial inequality in south africa is discussed in the literature review, to highlight historical influences of spatial inequality. while the current level and trends of spatial inequality is examined below through the qualitative and quantitative lens. 4. results and analysis measuring inequalities in relation to spatial inequality cannot properly be done through the lens of gini coefficient values only. in order to truly understand the level of inequality, a multidimensional way is going to be used in the analysis. therefore, the qualitative analysis will further explore two dimensions of inequality, being economic inequality and labour inequality. table 5: distribution of real annual mean expenditure by province province year mean real exp gini western cape 2015 47,592 0.62 eastern cape 2015 18,262 0.65 northern cape 2015 23,343 0.60 free state 2015 28,421 0.60 kwazulu natal 2015 18,436 0.61 north-west 2015 20,809 0.61 gauteng 2015 48,219 0.61 mpumalanga 2015 23,932 0.62 limpopo 2015 16,338 0.61 source: (ies 2005/06, lcs 2008/09, ies 2010/11, and lcs 2014/15; own calculations) shahaboonin, et al.: historic spatial inequality and poverty along racial lines in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023108 4.1. economic inequality the literature review has already covered certain aspects on economic inequality relating to expenditures analysed according to the sub-groups of race, settlement type, and province. this was done to analyse economic inequality in relation to spatial inequality along racial lines. however, to grasp the overarching levels of economic inequality its qualitative analysis will analyse the expenditure distribution by each decile, this will provide a general overview of the trends in income inequality levels, conceptually akin to the gini coefficient and palma ratio. to examine the nature of income/expenditure inequality, the data is graphically presented according to deciles. this allows for the visualisation of the different levels that income is captured, by ten equally sized deciles. figure 3 clearly shows that the trend in expenditure is severely skewed to the right, being captured by the richest 10% in the country. the nine-year period saw this trend furthers skewing to the right, peaking in the nineth decile, indicating that expenditure inequality is increasing in south africa. the fact that there is a decrease in expenditure by the 10th decile might seem as if inequality is decreasing, however the decile saw only a 4.6% decrease in expenditure, which isn’t remotely significant compared to the expenditure in 2015 of 52.6%. an increase in expenditure share over the 9 years takes place between sixth and the ninth deciles, this indicates that the uppermiddle to the lower-top earners have captured a greater share of income. based on the fact that the only other expenditure growth takes place in the fourth and fifth deciles, which are relatively insignificant capturing a combined 0.3% increase, we conclude that the remaining 4.3% of expenditure is captured by the sixth to nineth deciles, as confirmed by their respective expenditure growth. it is evident that expenditure inequality trends in south africa are a cause for concern. over the 9-year period the bottom 40% of earners saw no growth at all, while the top decile only decreased its share of expenditure by 4.6%. unfortunately, the top decile still spends more than the entire nine decile below it. unless radical interventions are put in place rapidly, the inequality trends will continue to worsen. 4.2. labour inequality labour market inequality can be seen as a direct influence on economic inequality, evidence of this lies in the measures of these inequalities, where the incomes that are earned through labour are reflected by the income expenditure measure (hjorthen et al., 2022). it is also a key attribute of spatial inequality; therefore, it is important to analyse the levels of inequality of labour along the lines of spatial inequality. this involves the analysis of labour trends in relation to race and settlement type. firstly, the labour market trends will be analysed at the national level, as this gives an overarching view of the state of the national employment levels. over a 7-year period between 2011 and 2017, the unemployment rate has steadily increased to 27.5% from 24.8% (statistics south africa, 2019). this 2.7% increase is reflected by the total number of unemployed, which also increased at a similar rate of 2.6% (statistics south africa, 2019). the non-economically active group has decreased by 4.1%, however this does not match the very low increase in employment of just 1.5%. this implies that the increase in unemployment rate is due to the combination of previously employed people becoming unemployed as well as noneconomically active youth not being able to find a job once they have reached the age of economic participation. now that the overall labour trends have been analysed, the labour trends according to race can be put into perspective. table 6 above shows that between 2011 and 2017, all ethnic sub-groups have seen an increase in unemployment rate, this trend is in line with the overall national trends discussed above. however, the black african sub-group saw a larger increase in total unemployment, increasing by 2.9%, while all other ethnic groups saw minimal total increases below 1%, with indians being the second highest increase at 0.9%, while the white and coloured sub-groups saw an increase of only 0.5%. aside from the labour trend over the 7 years, the total unemployment statistics can showcase the inequality in the labour market, according to race. when the total values of unemployment are analysed, we see the true level of inequality in the labour market. the highest unemployment rate across all ethnic subgroups belong to the black african sub-group at 31%. the second highest unemployment rate belongs to the coloured sub-group at 23.5%, while the indian and white sub-groups have relatively low unemployment rates, at 11.6% and 6.7%, respectively. this data showcases the historic inequalities enforced within the labour market based on race, as discussed in the literature review. unfortunately, the current trend in the labour market is only further exacerbating this issue. the labour market trends between urban and rural settlement types follow the same patterns as the national labour market trends and trends within racial sub-groups. the urban employment rates have increased by 3.1%, slightly more than the national trend of 2.7%, while the rural unemployment rate is directly in line with the national trend showing an increase of 2.7%. the difference between the rural and urban unemployment rate isn’t very large at just 4%, with the trend over seven years slowly closing that gap as the urban unemployment rate accelerates at a faster pace. source: ies2005/06 and lcs 2014/15 figure 3: distribution of expenditure shares by decile shahaboonin, et al.: historic spatial inequality and poverty along racial lines in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023 109 4.3. descriptive statistics the indicators used to represent the selected variables are as follows. spatial inequality will be represented by a proxy indicator which is ownership of land. the proxy indicator for spatial inequality will take the form of a dummy variable for land ownership. poverty will be measured by comparing incomes with the lower bound poverty line, to determine poverty status, and then would take the form of a dummy variable for poverty. employment and race will also take the form of dummy variables. due to the cross-sectional nature of the data used in this study, most of the data gathered has been converted to a binary definition. it is therefore expected that the descriptive statistics for the binary variables would be in decimal form, ranging from 0 to 1. table 7 shows that the average income for the representative population sample is just r 1166.25, which is relatively low and below the upper bound poverty line. this reflects the income levels in south africa (van der berg and louw, 2004). the mean of the dummy variable for poverty reflects the low-income rates, as the resulting 0.82 is very close to 1, indicating that most of the population lives in poverty (aliber, 2003). high poverty rates and low average incomes are often accompanied by high unemployment rates (aliber, 2003), the data confirms this since the mean for the employment dummy variable is just 0.32, which indicates that only 32% of the population in the data set is employed. the mean for the land ownership dummy variable is also low at just 0.30, which indicates a high concentration of land ownership. the mean of the binary variable for race is 0.11, this is very close to 0 indicating that a majority of the sample group are classified as non-white. table 8 correlation results show that income and race have a weak positive correlation of 0.005. according to the race binary variable the positive correlation indicates that income will be greater for whites. this result may seem weak, however considering the demographics of south africa, whites represent <10% of the population, thus the result is expected to be skewed and bear a low positive correlation as opposed to a strong positive. the result therefore supports the theory that there is a presence of income inequality in south africa, along racial lines (moyo, 2014). income and land also have a positive relationship of 0.063, which is generally expected since an increased income would increase the purchasing power of an individual, allowing them to purchase land. alternatively, the land or residential property may be the source of income itself. the reason that the correlation value is weak could be the fact that, historically in south africa, the ownership of land is highly concentrated (moyo, 2014). this is reflected by race and land ownership, which have a stronger positive correlation of 0.133, indicating that the concentration of land ownership in south africa is based more on race than income levels. this result supports the theory that land ownership is concentrated along racial lines in south africa (moyo, 2014). land ownership and employment also have a positive correlation of 0.172, this implies that most landowners are employed. income and poverty have a strong negative relationship of −0.220, this is expected since the upper-bound poverty line is set at r1330 (woolard and leibbrandt, 1999), therefore any person with an income greater than r1330 would not be considered poor. income also has a positive correlation of 0.131 with employment, this is expected since those who are employed earn an income. the reason that this correlation is not stronger is due to large amounts of social grants being received by unemployed people in south africa (satumba et al., 2017), and as a result they earn an income through social grants despite being unemployed. poverty and race have a positive correlation of 0.100, which indicates that race does have an influence on poverty status to a certain degree, this is supported by the fact that majority of the table 6: employment by ethnic sub-group year black african coloured nea employed unemployed unemployment rate nea employed unemployed unempl. rate 2011 46.8 38.0 15.2 28.6 37.0 48.6 14.4 22.9 2012 46.2 38.6 15.3 28.3 36.3 48.3 15.4 24.1 2013 45.5 39.3 15.2 27.9 36.1 48.5 15.4 24.1 2014 45.1 39.5 15.5 28.1 35.0 49.4 15.6 24.0 2015 43.2 40.6 16.2 28.5 35.9 49.3 14.8 23.0 2016 42.8 40.0 17.3 30.2 36.6 48.9 14.5 22.9 2017 41.6 40.3 18.1 31.0 36.6 48.5 14.9 23.5 year indian/asian white nea employed unemployed unempl. rate nea employed unemployed unempl. rate 2011 40.7 53.1 6.2 10.5 31.6 64.4 4.0 5.8 2012 41.1 52.7 6.3 10.6 32.3 63.8 3.9 8.5 2013 39.2 53.4 7.5 12.3 31.8 63.6 4.6 6.8 2014 41.3 51.7 7.0 12.0 32.4 62.6 5.0 7.4 2015 40.5 51.7 7.8 13.1 31.7 63.7 4.6 6.8 2016 40.6 52.2 7.2 12.0 32.3 63.0 4.7 6.9 2017 38.8 54.1 7.1 11.6 31.7 63.7 4.5 6.7 source: qlfs 2011-2017 table 7: descriptive statistics mean sd income 1166.25 11286.85 race 0.11 0.317 land 0.30 0.457 poverty 0.82 0.384 employment 0.32 0.465 source: compiled by the authors (2022) shahaboonin, et al.: historic spatial inequality and poverty along racial lines in south africa international journal of economics and financial issues | vol 13 • issue 1 • 2023110 table 8: correlation results and analysis income race land poverty employment income 1.000 race 0.005 1.000 land 0.063** 0.133** 1.000 poverty −0.220** 0.100** −0.139** 1.000 employment 0.131** 0.070** 0.172** −0.604** 1.000 “**” indicates significance at the 0.001 interval source: compiled by the authors (2022) table 9: significance income race land poverty employment income race 0.635 land 0.000 0.000 poverty 0.000 0.000 0.000 employment 0.000 0.000 0.000 0.000 source: compiled by the authors (2022) people living in poverty in south africa are people of colour (meth and dias, 2004). race and employment also have a weak positive correlation of 0.070, which indicates that race also has an influence on employment albeit low. poverty and land have a negative correlation of −0.139, which implies that the poor don’t own land. this might seem like an obvious result however the magnitude of concentration of land ownership in south africa can only be put into perspective once we acknowledge that the mean value for the poverty indicator is 0.82, which is a vast majority of the population living in poverty. poverty and employment also have a strong negative correlation of −0.604. this implies that a vast majority of the poor are unemployed. table 9 significance levels indicates that there’s a positive relationship of .635 between income and race and all other variables indicates an interval level of 0.000. 5. conclusion and recommendations as discussed in the literature review and further analysed both qualitatively and quantitatively, spatial inequality present in south africa can be traced back to apartheid policies which enforced spatial divisions based on 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(2021), south africa overview. united states: world bank. 18 march 2021. available from: https://www.worldbank.org/en/ country/southafrica/overview [last accessed on 2021 apr 02]. . international journal of economics and financial issues | vol 5 • special issue • 2015 173 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(special issue) 173-182. economics and society in the era of technological changes and globalization higher education institutions grading: administrative and support personnel andrey vladimirovich kirillov1*, mikhail vasilevich vinichenko2, alexander vasilevich melnichuk3, yulyia alexandrovna melnichuk4, yulyia lakina5 1russian state social university, 129226, moscow, russia, 2russian state social university, 129226, moscow, russia, 3russian state social university, 129226, moscow, russia, 4russian state social university, 129226, moscow, russia, 5russian state social university, 129226, moscow, russia. *email: mav68@rambler.ru abstract this article describes main grading principles applied in russia as well as internationally. the grading system is based on those used by hay group and watson wyatt. we evaluated existing grading examples for administrative and support personnel, methodology, effectiveness and how it affects performance results in higher education institutions. based on this, we set goals, principles and established regulatory basis for implementing grading in the university. in addition to this, we studied all possible ways to create effective working group to carry out this task and, its activities and performance in proceeding with administrative and support personnel optimization and organizational reform at large aiming to create a sustainable effective structure in the university. the effectiveness key performance indicators, their use as well as the positions’ scale, compensation packages and re-designed remuneration system were introduced. nevertheless, during this process we identified a number of problems that university leadership faced while implementing reform. these problems occurred largely due to personnel non-readiness for cordial changes, lengthy decision making and complex management system (at the level of the ministry of higher education and other related regulatory bodies) that constantly changes during reform system and counter reforms danger. we would like to point out that grading was carried out by university personnel without third party involvement that lead to effective management team formation. keywords: grading, hay group and watson wyatt technology, effectiveness indicators, optimization, positions importance, positions assessment, ranking factors, compensation system, remuneration structure, organizational and staff structure jel classifications: i21, i28 1. introduction it is well known from russia’s history how difficult it was to implement peter’s the great “table of ranks” that determined the ranks ratio by seniority and ranks consistency. the only service regulating factor was personal merits and seniority. the past approach determining the status by kind of nobility or “breed,” “paternal honor” ceased to exist and that aroused indignation among russian elite that reached the top and reaped their fruits of many years of struggle for a place under the sun. peter’s “table of ranks” conceptually changed the public servant value, all the subjects of the fatherland and the emperor and made them to perform duties more efficiently in serving russia. at the same time new opportunities were opened for creative and talented people of all classes, including the lower ones, the number of which was enormous. the soviet union leadership also sought to create a motivation and stimulation system where remuneration directly depended on professionalism and education level. since 1968, single wage rating guide had been adopted in all economy sectors leading to creating a russian federation unified system of classification and information coding, which was harmoniously merged with national classificatory of workers occupations, employees positions and job wage categories. these categories and personnel qualification ranking system, in a certain sense, can serve as grading prototype (kibanov et al., 2014). kirillov, et al.: higher education institutions grading: administrative and support personnel international journal of economics and financial issues | vol 5 • special issue • 2015174 market relations and labor market formation in russia led to the need to revise administrative-command system accustomed view on wages, as a part of national income given by the state to meet personal workers and employees needs that is distributed among them in accordance with their work quantity and quality (bogatyreva, 2014). indeed, the changed production conditions, markets development for goods, services and labor forced employers to seek more flexible, transparent and “agile” system to form organizational and personnel structure inseparably linked to the personnel evaluation, motivation and development system (chulanova, 2015). when employment relationship between an organization and employees starts, it is extremely important not only to identify desired employees’ behavior but also provide rewards and punishments mechanisms that are able to enforce working discipline for all parties involved into the business processes without any exception (melnichuk, 2012). at the same time, there is a need in clear understanding by both management and staff, their position’s role, place and value in product creation process whether producing good and/or providing services. this tool in conjunction with the talent management system enables an organization to attract and retain qualified personnel (dolgorukova, 2014). the competitive advantage concept at the account of human capital is mostly relevant to education and scientific fields. russian universities are not alien in their desire to reach international standards in providing educational services (kozhaev and tyrina, 2012). today, it is extremely important to understand that grading increasingly acquires the character of social institution, which has a regulating effect on any social system, thereby providing its regulatory standards and actions stability (kirillov, 2013). such type of stability connects all management system units. as a result, the society at large have a common understanding of regulations, standards of conduct leading to management system regulatory basis creation. foreign scientists and experts also sought to create an optimal system for stimulating personnel and organizational development that increases their market value in the labor market. as a result, grading was developed (grading a classification, order, sorting). from the grading definitions it seems possible to extract the following: “grading is positions grouping on certain grounds (the definition of “weight,” classification, etc.) aiming to standardize remuneration in an organization”(chemekov, 2007). looking at the grading definition, we can see similarities with the russian positions wage categories, but on the other hand, there are differences. grade, when translated into russian, means rank, class, level. grade specifies positions significance range within certain limits. the position itself has a specific role in the organization, as well as upper and lower limits of pay but in grading, employee on a position of a lower level may receive compensation higher than his/her colleague of higher rank. the main condition is to perform those tasks that increase the organization’s profit at large (tanatova, 2009). grading technology originated in the us in the early 60-ies of the xix century. edward n. hay was one of this technology pioneers. he developed a comprehensive personnel assessment technology based on a number of predetermined indicators and criteria. it has its own methodology, though not quite simple but, in general, correct and valid and has proved itself to be effective. the main thing that makes hay grading attractive is its transparency, fairness and reliability in a certain sense. these grading technology qualities attract the attention of many companies management and allow them to manage personnel more effectively as well as to carry out organizational planning and reduce hidden costs in business processes. the grading technology importance and effect was recognized by our university (tanatova, 2009). 2. methodology 2.1. grading method fundamentals russian state social university (rssu) new management team had a goal to increase the university effectiveness and began their work from developing new strategy and proceeded with optimizing administrative and support personnel that have direct impact on the entire university effective performance. the grading aims to assess all positions and management levels based on their final results impact independently either this is a company or higher education institution. basically, we needed to develop indicators that will link a position’s level value to system/company/university effectiveness that may include but not limited to: • responsibility level • professional competences • management level • decision making • financial results • personal leadership skills, etc. these all form the system of interconnected levels and functions that transforms into management hierarchy and based on the positions’ impact on the organization effectiveness and productivity. we also have to bear in mind that every organization is complex structure and there are many factors that have an impact on its activities and financial results. thus, while introducing grading, we had to create the conditions for personnel development, motivation and involvement into business processes such as: variable remuneration levels based on professional skills assessment and personal achievements, social guarantees and other benefits. what important is to link positions’ value within the organization (internal) to their market value (external), which creates additional complications as sometimes the market has unclear requirements for one or the other position. the other problem is internal positions assessment and personnel evaluation. communication and negotiation skills come handy in such situation. at the end, we have a level system for each personnel group with their own compensations levels, benefits, etc. that is built on kirillov, et al.: higher education institutions grading: administrative and support personnel international journal of economics and financial issues | vol 5 • special issue • 2015 175 professional skills, personal competences and impact on the overall organizational results. 2.2. hay group and watson wyatt methods the most known grading methods are hay group and watson wyatt. we will briefly look into each of them to justify the method’s choice for developing rssu grading system. edward hay’s method is based on the wildcard tables where positions’ effectiveness measuring in organization is based on interconnected effectiveness indicators merged into three factors: know-how, problem solving and accountability. the assessment tables are developed for each factor. watson wyatt method is based on slightly different approach. it divides all positions into categories, then assesses them and distributes among available grades in “grade map.” the company has one hierarchy for any organization’s activity. the system has 25 levels and each position is assessed based on 7 indicators that reflect the main functions for each position at any company: • functional knowledge • business expertise • leadership • problem solving • nature of impact • area of impact • interpersonal skills. the grading consists of three stages. the first stage is to identify the company’s grade. the second is to identify the category (band) into which the position fits the best and the third is to assign grade to the position in its category. the third stage is the most important one where the position’s significance is identified through grade assignment. hay group method is universal and is not linked to any particular industry or economic field but the complexity lays in its algorithm and assessment tables’ structure. watson wyatt method is oriented on management grading for management and specialist level. as rssu goal was to grade management personnel thus we took watson wyatt principles as the basis while designing our own grading system. nevertheless, we also took into account hay group recommendations in proceeding with profiles’ check for each position (profile is converted to “percentage” where the total sum or all indicators should be 100% and then compared to the one in assessment table). in general, all grading methodologies aim to solve management problems in organizations that want to increase their effectiveness. the main goal in it is to use the working power productively (chulanova, 2014). in spite of difference, grade is common across organizations and lays in the base of any compensation package, basic salary verification for each personnel category and is linked to its market value. this system is regularly evaluated to identify setbacks and to improve it further. 2.3. position significance identification methods position significance identification within the organization is the most important element in grading process. different methods apply to reach the grading goals, for instance, analytical and nonanalytical methods are widely used. analytical methods are: • comparative analysis positions assessment based on simple point scoring. the result is position’s weight in the organization. • expert evaluation. • non-analytical methods are (maloletko et al., 2015): • pared comparison • direct ranking • classification. both methods are useful but have positive and negative aspects of its use. non-analytical method results are difficult to transform into concrete numbers but we can see positions order. analytical method is more complex but gives us the clear picture of how positions are placed within a grade as well as general “grade map.” analytical method is more expensive and requires highly qualified professionals involvement into the design and implementation. different computer systems/programs are used to manage competencies development applied to selected jobs as well as their evaluation (finogeev and fionova, 2015). western countries prefer more simple assessment method – special questionnaires, which are processed using special programs. the result is positions description, its value, effectiveness and qualification indicators that are compared to requirements for candidates (paq, fja, cmq, jei, mosaic, ijas, oai, codap, wps, pmpq, o*net, executive checklist) (chemekov, 2007). these methods are universal and could apply for any position. some organizations design their own assessment and grading systems using external and internal capacities. for example, university of pennsylvania (usa) developed the following questionnaire: “please, list 10 main tasks for this position starting from the most important one. include the time used to perform each of them in way that no more than 25% of time is allocated for 1 task. please, identify the importance of each task for this position on a scale from 1 to 5, where 1 less important and 5 most important” (chemekov, 2007). 2.4. rssu grading: identifying methodology each organization that decides to grade its personnel should create its own table of ranks. while working on such system, it is very important to use all existing examples, learn from their lessons and results but what we should not do is to simply take it and apply in our own organization. the organizations internal conditions, its culture and traditions should be taking into account during this process. in addition to this, we also advise to consider the certain disciplines specific features, such as music, painting, acting and others, which have their own special evaluation criteria (shcherbakova, 2014). rssu management considered grading as one of main instruments during optimization aiming to create understandable and kirillov, et al.: higher education institutions grading: administrative and support personnel international journal of economics and financial issues | vol 5 • special issue • 2015176 transparent system that show each staff member role and position as well as suitable compensation and benefits. first of all, this was relevant for those who make profit for the university or more simple “earns money.” thus principles for forming the real and fair positions ranking were developed. hay group methodology was adapted to russian environment having in mind that we started grading the state higher education institution. in developed technique we also considered systems and individuals information security. we believe that payroll system transparency should not affect single individual interests. this project aspect is based on matyash c.a. (head of the department, rssu) works, which are dedicated to creating personal data coding system for guarantee its security (matyash, 2009). this is a necessity to be taken into account, as today we have an issue with protecting personal data in modern organizations. primarily, this is because such information can be used by hackers to obtain various financial benefits using other people information, for instance, loans, account access, etc. as well as blackmailing for affecting subject of their attention (melnichuk, 2014). during design and research stages, the attention was paid to the following factors: • combination of administrative duties and teaching and support ones • positions market value, existing level of compensation in state and private sectors for similar positions, work force availability with required professional and personal skills, replacement options • suitable grading methods identification. upon completing extensive research of existing grading systems and their application, we identified main grading system development stages at rssu (faculty members grading was performed separately): • working group formation • concept development • indicators identification and ranking for positions assessment • development of scale for assessing the position indicators • basic positions selection for the 1st stage of assessment • grade identification for basic positions • grade table development for all management and administrative personnel at rssu • compensation system development for each grade. in spite of the clear goals and outcomes, the biggest challenge at the planning stage was university’s personnel reaction on changes. the vast majority of people are wary of change, especially when they do not understand processes and activities. chulanova (2014) rightly notes “the main problem in introducing grading is the resistance to innovations if any changes occur even positive one. this happens because it is psychologically difficult for staff to adjust to new systems and standards. as a consequence, the grading impact may not be seen or even damage the present situation, if we do not take additional measures to alert employees about the upcoming changes and transition to the new pay system. employees must be notified 2 months before the new system comes in force. during the project preparation and implementation all employees should be regularly updated on the developments and upcoming changes.” the backbone in successful implementation lays in transparent and clear communication to all parties involved on what the benefits of a new system are, what a new organizational culture is, what values and mission are as well as how university’s performance and effectiveness would improve. 3. results 3.1. working group and grading concept the grading system can be developed by the external consulting companies as well as by internal organizational resources (chulanova, 2010). we decided to follow the second pass because the university has comprehensive and extensive experience in such matters. the working group was nominated and consisted of university top-management, authors of this article, who have experience in implementing grading in different companies (some, in particular, o. bakhtina, was involved in establishing grading system in other companies holding top-management positions; others developed fundamentals and provided consulting services in this field). the concept development process was in close cooperation between group’s members, university management and deans in particular. in addition, everyone understood that innovations always increase their developers’ and implementators cost on the labor market (vinichenko, 2010). working group main principles while developing the grading concept were: • to assess the position and not the person • to apply it to real time situation and projecting to the future • to use the actual functions assign to one or the other position without taking into account temporarily duties and responsibilities. the grading concept was approved by academic council following by rector’s order “on position grading at rssu.” this regulatory document was based on russia legal acts, rssu statute, collective agreement, internal rssu labor and academic regulations, rssu corporate codes, rector’s orders and instructions, rssu development strategy until 2020 and other russian state social university local acts. 3.2. assessment indicators: selections and ranking we consider that employees’ financial remuneration should be based on their personal contribution in achieving organization’s strategic goals. thus, we chose key performance indicators (kpi) as main assessment indicators for top management and senior management at the university. rssu management’s kpi are based on the ministry of education (moe) effectiveness indicators but we decided to make it more detailed to be able to scale them down to other staff members. what we add to existing list is (figure 1): • qs indicators • brand recognition • satisfaction indication • processes quality • market share (in providing educational services) • financial means availability kirillov, et al.: higher education institutions grading: administrative and support personnel international journal of economics and financial issues | vol 5 • special issue • 2015 177 the next step was to distribute the mentioned above performance indicators in percentage (figure 2) among vice rectors. this allowed us to create the somewhat “responsibility” system for meeting kpi and rssu effectiveness at the end. such system will enable us to manage moe monitoring results and adjust rssu performance and development accordingly without any additional workload (reporting especially) for every department and staff member involved. we also paid attention to all management duties and responsibilities including their personal responsibilities for fulfilling main and additional effectiveness indicators, which ideally, should reach 100% fulfillment (figure 3). when setting main duties and responsibilities for rssu topmanagement the main goals for increasing rssu effectiveness were taking into account. this required very clear kpi for key management positions that would enable us to use balanced score card in staff evaluation and in setting compensation packages. 3.3. scale system development, basic positions selections and grades identification when developing scale system for positions assessment, we identified five levels in rssu hierarchy (table 1) such as: • executive • top-management • middle management • first-line management • specialists (non-management staff). all levels were divided in 27 grades. 27th grade was assigned to university’s rector. each hierarchy level has 5 grades. nonmanagement level has 7. each hierarchy level includes a number of basic positions as shown in table 2: executive rector and vice rectors, topmanagement dean, head of the department (direct supervision by the rector), middle-management head of the department, director of the center, director of the institute, first-line figure 1: russian state social university effectiveness indicators figure 2: “responsibility” system for key performance indicators fulfillment table 1: rssu management levels level grade management level and position 1 27 executive rector 26 vice rectors 25 24 23 2 22 top-management deans, directorate directors 21 20 19 18 3 17 mid-level head of the departments 16 15 14 13 4 12 first-line managers head of the divisions 11 10 9 8 5 7 non-managerial specialist 6 5 4 3 2 1 kirillov, et al.: higher education institutions grading: administrative and support personnel international journal of economics and financial issues | vol 5 • special issue • 2015178 managers head of the sector, head of the group, head of the division. duties and responsibilities were identified based on positions’ hierarchy. this is how we see this: executive responsible for units key indicators; top-management responsible for some elements of the units key indicators; middle-management manages tasks assigned and responsible for some groups of indicators; first-line manager manages tasks assigned and responsible for indicators related to assigned tasks; specialist implements tasks assigned. 3.4. grades scale for all administrative and support personnel at rssu while developing grades scale, we thought that uniform name should be given to all university’s departments: old and new ones. we came to the following uniform structure and names: • department should include minimum of 2 divisions • division should consist of minimum of 5 people • sector should consist of minimum of 3 people. as we already mentioned above, the first stage was to grade central management and faculty (deans only) that are under rector’s direct submission as shown on table 3. further down we identified priorities for key structures (red line) while the other support functions came third (blue line). centers and institutions equated to business units that generate additional income for the university (doesn’t include educational services to students). we also left a window to introduce new positions’ name but they have to equal to standards positions within the grade and to be approved by the rector and rectorate. during the discussions within the working group and in consultations with other management team members, we proposed to allow deputy positions only for two levels executive (if needed) and top-management. this allowed us to keep the personnel number low and optimized workload and financial resources more effectively. as an example, figure 4 shows the structure and grades assigned under the vice rector for strategic development and informatization (makushkin and smirnov, 2015). as the result, the university organizational structure became lighter: 7 directorates were optimized and transformed into departments, 50 duplicated functions were centralized. 3.5. compensation system by grades grades system became a basis to introduce transparent compensation structure at the university. when developing remuneration structure and compensation system, we kept in mind that rssu is a state university and basic salary is calculated in accordance with russian regulations setting professional and qualification groups and professional and qualification levels thus rssu grading system is the basis for calculating stimulating part of employees compensation package (figure 5). we adopted the postulate that all organizational and staff structures changes will be performed within existing payroll fund for each functional blocks. at same time, the optimization and double functions centralizations allowed us to increase real employee’s total income (figure 6). employees financial insensitive and stimulation was directly linked to their effectiveness. stimulating remuneration part per grade (so-called “surcharge”) was calculates as the average level of the corresponding additional payments of all positions on a given grade. the other important issues to tackle was to eliminate discrepancies in employees income on the same grade to acceptable level (figure 7). we agreed that new rssu employees’ performance assessment should become a key element in setting the total remuneration and in particular, additional payment (bakhtina et al., 2015). the employee’s performance assessment system is based on the following principles and rules: figure 3: personal responsibility shares for rssu rector primary and secondary performance indicators table 2: basic positions’ grades level grade title representative duties and responsibilities 1 27-23 executive rector, vice rector, financial director responsible for units key indicators 2 22-18 top-management deans and head of the departments (direct supervision) responsible for some elements of the units key indicators 3 17-13 middle management head of the department director of the center director of the institute manages tasks assigned and responsible for some groups of indicators 4 12-8 first-line managers head of the division head of the sector head of the group manages tasks assigned and responsible for indicators related to assigned tasks 5 7-1 specialists (non-managerial level) leading specialist specialist expert implements tasks assigned as a part of general function kirillov, et al.: higher education institutions grading: administrative and support personnel international journal of economics and financial issues | vol 5 • special issue • 2015 179 • all rssu employees must be assessed • assessment is conducted by direct supervisor and based on: • self-assessment • objective information on personal employees effectiveness • constant activities monitoring • each staff member must know: • performance assessment principles • evaluation scale description • main requirements for efficiency level • current tasks table 3: grades for direct submission structures level grade level and position 1 27 executive rector 26 1st vice rector 25 vice rectors: es and tm, sciences and research, strategy, administration 24 vice rectors: international relations, education 23 financial director, hr director 2 22 top management deans: social work, management in social field, social assurance 21 deans: humanities and social, it, legal 20 deans: phycology, occupational safety legal department head security department head 19 deans: social medicine, arts 18 head of internal audit department 3 17 middle management 16 15 14 head of department to ensure the activities of collegial bodies 13 4 12 first-line mangers 11 mobilization department head 10 9 8 figure 4: structure and grades assigned under the vice rector for strategic development and informatization kirillov, et al.: higher education institutions grading: administrative and support personnel international journal of economics and financial issues | vol 5 • special issue • 2015180 • indicators and assessment criteria, which are key in the current evaluation period. every supervisor must give feedback to employees: to deliver the assessment results, give recommendations how to increase efficiency and effectiveness. the assessment results can be appealed: • at superiors • at ascending management hierarchy until the vice-rector in charge • in the commission on labor disputes (can be accessed at any stage of the appeal) • the assessment results are used: • when determining the amount of additional payments and bonuses • when determining the necessity for further professional education • when determining the further career development. the transfer to new grading system within the university implies that the fund allocated for employees’ compensation will be optimized and certain financial means may become available to fund other important activities at rssu. the decision was made to allocate this “freed” financial fund to stimulate publication and research activities as well as to stimulate meeting other university’s effectiveness criteria in accordance with the moe regulations. 4. discussion when we started implementing grading system at rssu, we faced a number of problems or better to say, we identified a number of problems at the university that might become obstacles to successful grading implementation. first problem was that large number of midand top-managers were not ready for changes neither morally nor informationally. using observation and survey method, we discovered that 23% of those participating in grading understood clearly the grading goals and principles. even without showing counter reaction, they were not always on time and accurately executing given tasks on developing recommendations on existing structures optimization, placing them in new organizational structure, determining managers and other staff grades. only 12% of employees involved into the grading implementation submitted all requested information on time and successfully executed given tasks. second problem followed from the first, when the main workload on implementing and carrying out grading became working group responsibility. this lead to making arbitrary decisions on assigning grades and establishing new organizational forms, determining their place and role in rssu. then, new organizational chart and figure 5: russian state social university employee compensation package: grades system place figure 6: employees’ total income: before and after grading figure 7: establishing transparent compensation system (example: head of the division) kirillov, et al.: higher education institutions grading: administrative and support personnel international journal of economics and financial issues | vol 5 • special issue • 2015 181 subsequent grades were presented to the academic council where the actual discussion started. such approach, where comments and recommendation are given not through the process but at the decision making stage, hampered the final decision making, timing and implementation itself. this also generated ‘post-discussion’ effect, which meant that top-management tried to push useful, in their view, but narrow decisions related to fragmentary issues behind the scenes. our experience shows that 78% of participants behave and perform this way. third problem is complexity of managing staff effectively under uncertainly. “shaking up” the old system and creating a new one on its basis has been carried out in “stir” and unstable environment. the university leadership had to support the old system in working shape and, at the same time, had to create a new effective management system including ranking, motivation and stimulation systems leaning on the same people. this affected large number of university staff in terms of workload that especially instigated fear among them for their own place and position at the university. during social opinion poll, we found that 76% of employees didn’t understand clearly what has been happening, while 88% were afraid that their position would deteriorate. furthermore, with time passing by, the atmosphere was slowly heating up and resistance growing even among those employees and midto top managers who didn’t seem to oppose reforms process prior. forth problem was time. everyone felt that they were running behind and real workload and tasks to be tackled were much higher than initially envisaged. one of the ways to solve it was to extend working time for working group to 12-14 h continuously with partial involvement of executives and grading specialists from rssu human resources, records management and archival department. the team motivation was simple to create new effective system that will affect all sides of university life and increase its effectiveness and productivity. financial motivation wasn’t in place. as the result, we formed effective, minded and creative team that got involved into all reorganizational and development processes independently from the field. in general, grading system allowed to develop positions structure in accordance with specialization field and place them in order and at specific level using qualification requirements, work duration at rssu and in general, responsibility level (managerial and financial), decision making complexity and difficulty as basic factors or position effectiveness indicators. at the same time, as we experienced, grading is complex and versatile, very time-consuming and sometimes tedious job, which involves a large number of staff, different level managers and experts. during the struggle for a place in grade “under the sun,” some midand up managers sought to use all correct and incorrect methods and principles to reach higher grade for themselves at the first place clearly understanding that this will allow them to raise grades for their personnel, departments and structures ranking. along with this, we saw the problem zone to stop complex university grading completely as it stretched in time extensively. the hidden and explicit opposition gradually started having an impact on staff and faculty mood. thus, we believe that it is necessary to conduct reforms by means of grading as more quickly as possible relying on a core team of associates covering all activities fields in organization. 5. conclusion summarizing all stated above, we conclude that designed grading system for administrative and support staff became an important element in forming highly qualified, professional team at rssu that shares and supports university values and corporate culture. grading is an instrument for building transparent, manageable and fare remuneration and career development systems for rssu personnel. having clear grades system, we were able to avoid doubled and “orphan” functions, different remuneration levels for performing similar tasks as well as were able to develop career passes for each staff member. changes in rssu organizational and personnel structures aimed to optimize number of administrative and support staff. grading allowed us to: • approve principles in forming remuneration fund for departments • create transparent and fare compensation system • form understandable and clear career development passes • allow each supervisor to decide on his/her subordinates compensation level within the allocated for this fund. thus, each position in the grading system has found its place in the “table of ranks” and received a proper assessment in salary differentiation providing employees with not only management skills, but also professional career development. note that implementation of effective system for employees motivation is one of the most important tasks at the current stage of russian higher education development. therefore, we are confident that the practical application of the developed technique should provide a significant increase of higher education efficiency. references bakhtina, o., kirillov, a., matyash, s., urzha, o. 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(2010), problematic issues of labour resources development in russian: problems of today. social policy and sociology, 1(5), 25-34. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(1), 575-582. international journal of economics and financial issues | vol 7 • issue 1 • 2017 575 the driving forces of economic growth before and after the 2008 global financial crisis phan the cong1*, hoang khac lich2 1faculty of economics and law, university of thuongmai, vietnam, 2faculty of development economics, university of economics and business, vietnam national university, hanoi, vietnam. *email: congpt@tmu.edu.vn abstract this paper investigates the determinants of economic growth in two different periods, 2002-2008 and 2008-2013. as national output can be determined by the functions of production and consumption, the explanatory variables consist of growth rates of investment, labor, household consumption, government spending and exports. analyzing the data of 129 countries, this paper has four main findings: (i) investment and exports have positive impacts on economic growth; (ii) labor has significant positive impact if we investigate the period from 2002 to 2013 as a whole. the effect is only positive in the first period with low statistically significance while remains unclear in the second period; (iii) household consumption has ambiguous impact on economic growth. there exists some evidences (with 90% confidence level) that household consumption might produce a minor adverse effect on economic growth; (iv) the relationship between economic growth and government spending is positive in the first period and negative in the second. keywords: determinants of economic growth, global financial crisis, public expenditure jel classifications: a12, g01, f43, a12 1. introduction economic growth is a topic attracting much of attention from both policy makers and macroeconomists. some economic theories explain why economic growth rates are different across countries. for example, classical macroeconomic theory argues that the long-run output is determined by capital, labor and technology, expressed by a production function. meanwhile, keynes believes that short-run output is influenced by aggregate demand including household consumption, investment, public expenditure and net exports. this means that the determinants of economic growth in the short-run are different from that in the long-run. there is a vast body of literature investigating the impact of these factors on economic growth. for example, solow (1957) and mofrad (2012) study the important role of capital in production. pye (2012), schultz (1961), grossman (1972), and devol and bedroussian (2007) focus on labor, including both quantity and quality. pakko (2002), among others, examines the contribution of total factor productivity (tfp). duesenberry and income (1949), veblen (2007) and karim et al. (2010) evaluate the impact of household consumption. khan and reinhart (1990) and poirson (1998) investigate the contribution of private investment to national output, while barro (1990) and devarajan et al. (1996) focus on public expenditure. in addition, there are many articles discussing the important role of exports. however, all of the literature mentioned above do not discuss the determinants of economic growth in the period of global financial crisis, particularly the periods before and after year 2008 (as we will see below, this task is the first contribution of this paper). besides, this paper also focuses on the relationship between public expenditure and economic growth. many economists are interested in the direction of this relationship, positive or negative, while the others consider the causal relationship between these variables. the story of “chicken and egg,” whether public expenditure impact on economic growth, or conversely, economic growth drives public expenditure, are sometime raised. however, the findings from the existing literature are inconsistent and controversial. there are some articles attempt to figure out and to explain the consistency and the differences of the previous findings by cong and lich: the driving forces of economic growth before and after the 2008 global financial crisis international journal of economics and financial issues | vol 7 • issue 1 • 2017576 making a literature survey. nijkamp and poot (2004), for example, synthesize 93 articles discussing the impact of fiscal policies (including public expenditure, tax rate, education spending, defense and infrastructure expenditure) on economic growth. in which, 41 articles provide empirical findings on the impact of total public expenditure: 29% of the total agree that expanding government expenditure slows down economic growth, 17% believe the opposite direction, and more than half of the literature cannot conclude the relationship between these variables. this controversial could be caused by the difference in the research scopes. some researches focus on the high income countries while the rest do not do so. the findings of the studies focusing on a specific group of countries seem to be consistent. this is because of the similarity of the countries, such as development level, political issues, institution, and geography. while the impact of public expenditure on economic growth is controversial, the impacts of the other factors (tax rate, education spending, defense and infrastructure expenditure) are quite consistent. although the study of nijkamp and poot (2004) is meticulous, it is still criticized about the non-random sampling which might leads to bias results. similarly, bergh and henrekson (2011) also review many articles examining the negative relationship between public expenditure and economic growth in the high income countries. the authors study public expenditure as a whole rather than some specific ones. the notable point in this study is the explanation of the causal relationship between public expenditure and economic growth. more specifically, tax and fees are important funds for public expenditure however they are also the burdens for economic agents. therefore, some researches find the positive impact of public expenditure, while the others find the negative. there is also an opposite relationship that economic growth drives public expenditure. for example, an increasing unemployment in the recession periods leads to a high fraction of government budget spending for social issues. as there are many controversial explanations for the causal relationship, rarely researchers come up with a unique conclusion. recently, churchill et al. (2015) review 87 empirical studies on the impact of public expenditure on economic growth. using hierarchical meta-regression analysis, the authors show that the results found in previous studies depend on explanatory variables, analysis methods, and country development levels. specifically, the negative effects are often found in the studies focusing on high income countries, using a proportion of gross domestic product (gdp) as public expenditure, and gdp per capita as a dependent variable. meanwhile, the estimation results are not statistically significant for developing countries. when all countries are pooled, the correlation is insignificant in the case of total government expenditures but negative and significant in the case of government consumption. here, the authors argue that government consumption cannot improve productivity. it can be said that the last three studies mentioned above provide a comprehensive description of the relationship between public expenditure and economic growth. the existing articles differ in term of country sampling, time of data, variables, and methodologies. similarly, this paper attempts to study the relationship between public expenditure and economic growth in two sub-periods by using panel data analysis method. with the data of 129 countries during 2002-2013, this paper analyzes a fixed effect model in which investment, labor, household consumption, public expenditure and exports are explanatory variables. it shows that the sign of the relationship between public expenditure and economic growth changes over two periods (the explanation can be found in bergh and henrekson, 2011), while the other correlations are quite consistent. particularly, an increase in public expenditure speeds up economic growth during 2002-2008, but slows down economic growth during 2008-2013. investment, labor and exports have positive impact on economic growth while household consumption shows a doubt of its positive effects. in period 2002-2008, higher consumption leads to a lower economic growth (this result is significant at a level of confident 90%). the limitation of this paper is that some factors shown in ram (1986) are omitted in the regression model, such as government size measured by a ratio of public expenditure to gdp, and thus it does not investigate the optimal level of public expenditure. this is because the variables selected in this paper are based on production and consumption function. the remaining of this paper is structured as the following. section 2 presents literature review on determinants of economic growth. section 3 describes methodology and data. section 4 discusses results and section 5 concludes. 2. literature review on determinants of economic growth a common challenge in empirical studies is the selection of appropriate variables. this is a very laborious work and effort, and sometime it cannot give us desired results. the difficulties seem to be double as the dependent variable is economic growth, because it is resulted by too many variables. sala-i-martin et al. (2004) use a special method, called bayesian averaging of classical estimates (bace), to find out the most appropriate variables explaining economic growth. there are 18 variables are selected from 67 variables, for example, primary enrollment ratio, the ratio of investment to gdp, life expectancy. notably, the public expenditure is also among 18 variables. similarly, bergh and karlsson (2010) use bace method to show that the rate of savings, annual inflation, fertility, labor force, and exports are the most important factors. hence, depending on variable selections, the findings might differ across papers. in this paper, the variables are selected from two basic economic functions, production and consumption. the production function shows that output is determined by capital, labor and technology. the consumption function shows that output is determined by aggregate demand consisting of household consumption, investment, public expenditure and net exports. there are various studies discussing the impact of these variables on economic growth. 2.1. production function approach 2.1.1. capital solow (1957) is one of the most influential researches on the role of capital in economic growth. using time series data of the cong and lich: the driving forces of economic growth before and after the 2008 global financial crisis international journal of economics and financial issues | vol 7 • issue 1 • 2017 577 united states, the author showed that from 1909 to 1949, output per worker has doubled and 87.2% of that achievement came from changing technology and the rest from increasing capital. however, solow also suggested that in the long run, it would be inefficient to depend solely on capital to stimulate growth. specifically, since growth will reach the steady state in the long run, increasing capital is only capable of being the driving force in the short run. mofrad (2012) used iran’s data in the period 1991-2008 to illustrate solow’s idea. the two main conclusions are: (i) capital can contribute to the short-term increase in gdp; however (ii) in the long run, the effect might possibly change to negative. 2.1.2. labor labor contributes to economic growth in terms of both the scale and quality. while the scale of labor can be observed easily, the quality of labor has to be assessed through many different criteria such as training level (literacy rate, high school graduation rate, trained worker rate, tertiary education rate), health (weight, height, life expectancy, diseases rate) and attitude (disciplined, diligence, creativity...). among them, the first two criteria have been investigated and analyzed regularly by economic researchers. first of all, regarding the size of labor force, pye (2012) suggested that large population might contribute to growth through large market size as well as abundant input for production. using australian data from 1980 to 2011, the author successfully identified a positive relationship between labor size and gdp growth. however, he also gave a warning signal on some unexpected negative consequences of labor-dependent growth. specifically, if labor productivity remains unchanged, relying too heavily on labor force expansion to replace capital might cause wage costs to increase. regarding the quality of labor, schultz (1961) argued that education is not only the output but also the input of the growth process. to illustrate the idea, he has investigated the data and found that investing in human capital development would bring significant benefits to the society. recently, kiani and jumani (2010) also studied the effect of education on economic growth in pakistan and showed that real gdp would increase by 2.67% and 2.8% for every 1% increase in the primary and secondary school enrolment rate, respectively. these results have provided clear evidences of the sensitivity to change of economic growth due to potential change in education indexes. besides education, the effect of labor force’s overall health condition on economic growth has also attracted the attention of many researchers. grossman (1972) considered health not only as a significant factor towards personal welfare but also as an input for production. moreover, employee’s health condition might have an indirect impact on the productivity of family members besides its direct impact on the productivity of the patient (devol and bedroussian, 2007). 2.1.3. tfp due to rising competitiveness and resources scarcity, improving productivity has proved to be one of the most prioritized issues for many sectors, regions and nations. the history of world’s economic development has witnessed continuous improvement in labor productivity over time while consistently considered it to be a good representative for general productivity. however, a skillful and healthy worker without the support of machinery and capital might still has lower productivity than the inferior ones with full support of necessary technology and sufficient capital. therefore, labor productivity might not be comprehensive and suitable in explaining economic growth and thus the concept of tfp is formed. in general, tfp measures the relationship between output and aggregate inputs (including qualitative factors such as technology, management capabilities, business environment...). over time, more and more countries have chosen tfp to represent productivity. it can be said that discussing the role of tfp in economic growth is equivalent to discussing the change in technology and efficient use of resources. pakko (2002) analyzed the us data from 1954 to 2000 to conclude that technology is an important driving force which accounts for approximately 60% of the us economic growth. based on these findings, the author suggested that investing on research and development for new technology is extremely crucial in improving productivity. 2.2. the consumption function approach when calculate gdp using the consumption approach, we often refer to the expenditures of the economic agents including household consumption, firm investment, government spending, and net exports. theoretically, increasing these expenditures has some massive impacts on aggregate demand as well as economic growth. 2.2.1. household consumption many studies have demonstrated that the role of consumption in economic growth is relatively clear. for example, duesenberry and income (1949) and veblen (2007) suggested that rising consumption reduces savings and possibly increases output. in contrast, harbaugh (1996) did not consider consumption to be beneficial for economic growth because it might lead to increased savings. it seems a bit confusing but he explained that along with rising income, demand for individual savings also rise, possibly to take into account the future consumption (e.g. retirement). this might lead to higher savings and lower social investment than before, thereby contracting growth. the debate on this topic did not stop there. research by karim et al. (2010) on the relationship between consumption and economic growth in malaysia showed that increased consumption stimulates production and increases output through changing the aggregate demand. however it is only the case in the short run. in the long run, economic growth also affects individuals considerably thus consumption stimulation policies which only change individual consumers are not capable of promoting long-term growth. 2.2.2. private investment in order to investigate the impact of private investment on economic growth, khan and reinhart (1990) has extended the solow (1957)’s theoretical framework on the determinants of economic growth. using data from 24 developing countries, they found that investment of the private sector has a positive and direct impact on economic growth. particularly, it is significantly stronger cong and lich: the driving forces of economic growth before and after the 2008 global financial crisis international journal of economics and financial issues | vol 7 • issue 1 • 2017578 than the effect of the public sector’s investment. similarly, poirson (1998) analyzed data from 53 developing countries in 1980 and recognized the importance of private investment in contributing to the development of these countries. in other words, the role of private investment is undoubtedly crucial, and even more crucial than the public investment. therefore, recognizing and ensuring a comfortable investment environment for the development of private sector should be considered as an important goal for many countries, especially the developing ones. 2.2.3. net exports according to the international trade theory, it would be much more beneficial for a country to specialize in production and exchange with other countries than to try to produce all kinds of goods. in many empirical studies on the role of trade in economic growth, the values and weights of exports or trade in gdp are commonly used. many authors suggested that these indexes might be used to measure the openness of an economy. however, it should be useful to note that regressing total economy’s output on trade only implies correlation but not causation because the set of independent variables suffers from significant multicollinearity. in general, the effect of trade on economic growth still remains controversial. 2.2.4. public expenditure the view of academic scholars around the world on the relationship between public expenditure and economic growth has been constantly changing over time. first of all, many authors, such as barro (1990), confirmed the existence of a positive relationship. however, barro also considered public spending as a major cause of market distortions. therefore, it should not be a permanent stimulation of economic growth. the relationship between public spending and economic growth is non-linear and possibly u-shaped. accordingly, in the early stages of development, public expenditure increases with total output due to the fact that the improvement of marginal productivity of capital outperforms the negative impact of tax burden. however, to a certain extent, the effect might reverse and public spending could hamper economic growth. indeed, devarajan et al (1996), using data from 43 developing countries over a 20 year-period (1970-1990), also suggested similar result. in general, the impact of total public expenditure on economic growth is still a debate. there are three main findings: (1) public expenditure speeds up economic growth, (2) public expenditure slows down economic growth; and (3) there exists an optimal level of public expenditure. • does public expenditure speed up economic growth? barro (1991) studies the data of many countries in the period 1960-1985 to examine the relationship between total public expenditure and real gdp. he finds a positive and significant impact of public expenditure. however, barro also believes that public expenditure can become a major cause of market distortions. therefore, it is not a permanent solution for growing an economy. after barro (1991), many researchers also show the positive impact of public spending one economic growth: for example, alexiou (2007) studies the data of greek; alexiou (2009) studies 7 countries in south east europe during 1995-2005. most of them argue that public expenditure increases aggregate demand, thus fosters economic growth. • does public expenditure slow down economic growth? the negative impact may be due to the institutions weakness leading to inefficient expenditure. this explanation seems to be appropriate for low development countries where corruption is a serious problem. besides, the negative effect can be caused by spending for social issues rather than economic growth. some examples can be listed as the following: saunders (1985) analyzes the data of oecd countries; devarajan et al. (1996) use the data from 43 developing countries over a period of 20-year (1970-1990), most authors agree that inefficiencies in monitoring mechanisms of public expenditure lead to lower growth rates. • does the optimal level of public expenditure exist? barro (1990) suggests that the relationship between public expenditure and economic growth is non-linear, expressed by the inverted u-shaped. accordingly, public expenditure increases with output in the early stages of development. the reason is that the increase in government expenditure increases the marginal productivity of capital that dominates the negative impact of the tax burden. however, over a certain level of public expenditure, called the optimal level of public expenditure, the effect occurs in the opposite direction, i.e., public expenditure reduces economic growth. there are many macroeconomists aiming to find the optimal public expenditure. peden (1991), for example, analyses the data of us from 1889 to 1986 and shows that maximum output can be achieved at 20% of gross national product (gnp) as government expenditure. this means that, 35% of gnp as us government expenditure in 1986 is over the threshold. for the case of iran, abounoori and nademi (2010) suggest that the optimum level is 34.7% of gdp. of which 23.6% of gdp should be spent for consumption, the remaining is for investment. thereby, the authors recommend that the iran government expenditure is exceeded optimal level in the period 1969-2006. pevcin (1996) uses panel data to analyze the case of european developing countries in the period 1950-1996. he finds a positive relationship between public expenditure and economic growth. however, he also believes that these countries are in the early stages of “inverted u curve”, and the optimal level of public expenditure is from 36% to 42% of gdp. 3. methodology and data 3.1. methodology the main method of this research is regression analysis with panel data from 129 countries in three different periods (1) from 2002 to 2013, (2) from 2002 to 2008, and (3) from 2008 to 2013. since each country has its unique, time-invariant characteristics, both fixed effects model (fem) and random effects model are adopted. however, fem might be more appropriate because its capability of solving the endogeneity problem, which is relatively common in macroeconomic research due to the fact there are many factors affecting a single macroeconomics variable. indeed, the results of a hausman test on the suitability of two models also confirm the superiority of fem. cong and lich: the driving forces of economic growth before and after the 2008 global financial crisis international journal of economics and financial issues | vol 7 • issue 1 • 2017 579 several diagnostics test with the fem are conducted in order to guarantee the reliability of results. firstly, adjusted-wald test (green, 2000) rejected the null hypothesis of no heteroscedasticity problem in regression models for each period. as a result, robust standard errors would be used in order to overcome the problem. secondly, pevcin (2004) test showed that the cross-correlations between standard errors in the initial model are relatively significant. the problem should be fixed by using the driscoll and kraay (1998)’s method. finally, using wald test, it would be sensible to conclude that auto-correlation is not a problem in all three models. final estimated results with suitable correction are presented below for analyzing and concluding. the regression model can be expressed as below:        it 0 1 it 2 it 3 it 4 it 5 it gdpp = + invest + labor + consum + govexp + export b b b b b b where the variables are described in table 1. 3.2. data our dataset, which is extracted from the world development indicators database, consists of 129 countries from 2002 to 2013. observations are divided into two sub-periods: from 2002 to 2008 and from 2008 to 2013. by doing so, we would be able to investigate the potential changes in the contributions of all factors to economic growth due to the 2008 global financial crisis. the set of variables, includes the growth rate of gdp per capita, investment, labor, household consumption, government expenditure and exports, comes from the theory of production function and consumption function. descriptive statistics (mean, variance, min and max) are presented in the appendices. in general, average gdp growth rate for all countries is approximately 5.1%, and 2.9% for the whole period, before 2008 and after 2008, respectively. this is quite a clear indication of the 2008 global financial crisis. moreover, the growth rates of investment and government spending also decelerated after the crisis. in contrast, household consumption did increase form 0.07% to 3.05%. however, it might only be the consequence of rising overall inflation post-crisis. 4. results initial estimated results (without tests and corrections) for all three periods are recorded in table 2. three models have some significant properties in common. first of all, investment and exports have positive impacts on economic growth. in particular, the impact of exports is much more significant in post-crisis period than before while the impact of investment is relatively similar before and after the crisis. secondly, there impact of labor force, household consumption and government expenditure on economic growth are inconsistent among three models. in the next part, after correcting some potential problems in the regression models, these initial results are investigated and discussed more carefully. estimated results after overcoming potential problems in the initial regression model are presented in table 3 in columns fem4, fem6 and fem8 for heteroscedasticity and columns fem5, fem7 and fem9 for the standard errors’ problem. in fact, our first initial observation still holds for the corrected result. specifically, the growth rates of investment and exports do have positive impacts on economic growth. however, the impacts are stronger in the latter period. notably, these differences are significant only for exports but not for investment. on average, 10% increase in exports led to 1% and 1.4% increase in gdp in the first and second sub-period, respectively. in other words, this result means that investment and exports play a crucial role in fostering economic growth in the short-run, especially in the post-crisis period. besides, table 2 also proposes some different and interesting conclusions regarding the impacts of labor force size, household consumption and government spending on economic growth. specifically, labor force did have significant positive impact if we investigate the period from 2002 to 2013 as a whole. in fact, the effect is only positive in the first sub-period with low statistically significance while remains unclear in the second sub-period. this result might be caused by the variable itself, i.e., growth rate of labor force generally has positive impact on output, but it is not a key factor to overcome the difficulty of global financial crisis. table 1: variables list variables description gdpp growth rate of gdp per capita (annual % growth) invest growth rate of gross capital formation (annual % growth) labor growth rate of total labor force (annual % growth) consum growth rate household consumption (annual % growth) govexp growth rate of total government expenditure (annual % growth) export growth rate of exports (annual % growth) gdp: gross domestic product table 2: initial estimated empirical results variables 2002-2013 2002-2008 2008-2013 (fem1) (fem2) (fem3) invest 0.0543*** 0.0664*** 0.0799*** (11.02) (8.93) (12.88) labor 27.60*** 19.25+ −6.049 (3.33) (1.8) (−0.55) consum −0.00169* −0.000693 0.234*** (−1.96) (−0.84) (14.07) govexp −0.00803** 0.0639*** −0.0357*** (−2.61) (11.93) (−9.41) export 0.149*** 0.0961*** 0.143*** (17.38) (7.77) (16.43) _cons 2.335*** 3.005*** 1.613*** (14.22) (12.16) (8.46) n 1548 774 774 r2 0.29 0.295 0.6 t-statistics in parentheses. +p<0.10, *p<0.05, **p<0.01, ***p<0.001 cong and lich: the driving forces of economic growth before and after the 2008 global financial crisis international journal of economics and financial issues | vol 7 • issue 1 • 2017580 regarding the household consumption, its impact on economic growth in the whole period 2002-2013 or in the first sub-period is still ambiguous. however, there exist some evidences (with 90% confidence level) that household consumption might produce a minor adverse effect on economic growth. contrastingly, household consumption and growth has a positive and statistically significant relationship if only the sub-period 2008-2013 is considered. in fact, 10% increase in household consumption might contribute to approximately 2.34% in gdp. this result supports the conclusion of harbaugh (1996) and karim et al. (2010) that household consumption may not be an important factor for longrun growth, as it may reduce investment. anyhow, it is the most important factor in the post-crisis period. regarding the government expenditure, its impact on economic growth is found to be ambiguous using data for the whole period. however, considering two sub-periods separately produces a significant difference. specifically, the correlation between economic growth and government spending is positive in the first and negative in the second sub-period. there are many factors leading to this difference but the world’s overall economic condition might be one of the most influential. before 2008, governments around the world had the opportunities to invest in production infrastructure thanks to relatively high growth rates. on the other hand, the 2008 world financial crisis has forced governments to spend larger fraction of budget on social purposes, hence causing the negative correlation between government expenditure and economic growth. in fact, if we investigate the case more thoroughly, other factors such as the expenditure composition or efficiency might also possibly explain our finding. however, due to the limited scope of this study, we will leave them for potential future research. 5. conclusion to investigate the main determinants of economic growth before and after global financial crisis, this paper analyzes the data of 129 countries with fixed effect models. the results show that investment and exports has a positive relationship with economic growth. specifically, the impact of exports on growth rate in period 2008-2013 is stronger than that in the previous period. besides, the impact of household consumption is ambiguous, positive in the latter period, and negative in the previous one. economic growth increases along with public expenditure during 2002-2008, but it decreases later on. labor has a positive contribution to economic growth rate during the first period, but it has an ambiguous impact during the second one. although showing some significant results, this paper still has some limitations. firstly, it omitted some variables showing in ram (1986), the seminal article on the topic of public expenditure, such as government size measured by a ratio of public expenditure to gdp. thus, this paper does not study the optimal level of public expenditure. secondly, this paper uses fem to overcome the endogenous problem statistically, i.e.,0 to deal with the problem of omitted variable, and not for other reasons of endogeneity such as (1) mutual relations between the independent and dependent variables, (2) the uncertainty in measurement, and (3) the impact of lagged dependent variable. for the future research, the government size would be taken into account and the method of two stages least square (2sls) or generalized moment method could be applied. references abounoori, e., nademi, y. 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(2010), government size and growth: accounting table 3: corrected results variables 2002-2013 2002-2008 2008-2013 (fem4) (fem5) (fem6) (fem7) (fem8) (fem9) invest 0.0543* 0.0543* 0.0664** 0.0664*** 0.0799*** 0.0799*** (2.34) (2.39) (3.24) (3.89) (7.19) (19.17) labor 27.60* 27.60*** 19.25+ 19.25* −6.049 −6.049 (2.08) (4) (1.92) (2.48) (−0.34) (−0.57) consum −0.00169+ −0.00169 −0.000693+ −0.000693 0.234*** 0.234*** (−1.68) (−1.64) (−1.93) (−0.70) (3.9) (7.93) govexp −0.00803 −0.00803 0.0639*** 0.0639*** −0.0357*** −0.0357*** (−0.42) (−0.36) (5.66) (11.61) (−5.78) (−9.40) export 0.149*** 0.149*** 0.0961** 0.0961*** 0.143*** 0.143*** (6.45) (8.86) (2.92) (13.05) (8.4) (17.55) _cons 2.335*** 2.335*** 3.005*** 3.005*** 1.613*** 1.613*** (10.46) (7.09) (6.84) (6.15) (5.77) (13.25) n 1548 1548 774 774 774 774 r2 0.29 0.295 0.6 t-statistics in parentheses. +p<0.10, *p<0.05, **p<0.01, ***p<0.001 cong and lich: the driving forces of economic growth before and after the 2008 global financial crisis international journal of economics and financial issues | vol 7 • issue 1 • 2017 581 for economic freedom and globalization. public choice, 142, 195213. churchill, a.s., yew, s.l., ugur, m. 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(2004), determinants of long-term growth: a bayesian averaging of classical estimates (bace). american economic review, 94(4), 813-835. saunders, p. (1985), public expenditure and economic performance in oecd countries. journal of public policy, 5(01), 1-21. schultz, t.w. (1961), investment in human capital. the american economic review, 51(1), 1-17. solow, r.m. (1957), technical change and the aggregate production function. the review of economics and statistics, 39(3), 312-320. veblen, t. (2007), the theory of the leisure class. new york, ny: oxford university press. appendices appendix tables appendix 1: statistical analysis, period 2002-2013 variable mean standard deviation min max observations gdpp overall 4.006901 4.432958 −36.0471 37.99873 n=1548 between 2.384997 −0.91103 13.28314 n=129 within 3.742105 −37.0003 33.44343 t= 12 invest overall 6.383493 24.92102 −64.7204 755.7443 n=1548 between 8.212742 −4.67227 82.99075 n=129 within 23.53906 −131.699 679.137 t=12 labor overall 0.016135 0.015913 −0.10195 0.077116 n=1548 between 0.012296 −0.02504 0.041663 n=129 within 0.010155 −0.06078 0.072648 t=12 consum overall 1.487246 101.9879 −3984.21 290.1639 n=1548 between 28.42795 −317.749 13.66301 n=129 within 97.97519 −3664.97 609.4002 t=12 govexp overall 5.468361 38.80492 −77.1812 1378.306 n=1548 between 10.83729 −0.65067 107.7289 n=129 within 37.27211 −179.442 1276.045 t=12 export overall 6.236479 10.75969 −45.8938 85.61331 n=1548 between 4.050276 −3.46404 18.13166 n=129 within 9.974114 −49.9521 76.29341 t=12 cong and lich: the driving forces of economic growth before and after the 2008 global financial crisis international journal of economics and financial issues | vol 7 • issue 1 • 2017582 appendix 2: statistical analysis, period 2002-2008 variable mean standard deviation min max observations gdpp overall 5.117758 4.198526 −32.8321 37.99873 n=774 between 2.658228 0.180071 16.07932 n=129 within 3.256862 −32.5309 32.19377 t=6 invest overall 8.758925 16.20125 −55.3892 152.5739 n=774 between 6.543385 −2.449 37.51054 n=129 within 14.83043 −72.3237 142.9096 t=6 labor overall 0.017615 0.016506 −0.10195 0.077116 n=774 between 0.013054 −0.03657 0.052233 n=129 within 0.010156 −0.04777 0.074699 t=6 consum overall −0.07159 144.1354 −3984.21 290.1639 n=774 between 57.17988 −643.73 16.5787 n=129 within 132.3882 −3340.55 933.8219 t=6 govexp overall 5.49864 22.97041 −77.1812 565.5389 n=774 between 10.74062 −13.4173 108.402 n=129 within 20.32301 −126.83 462.6355 t=6 export overall 8.744887 10.18627 −45.8938 85.61331 n=774 between 5.216119 −1.24297 27.53433 n=129 within 8.759459 −46.3185 69.70284 t=6 appendix 3: statistical analysis, period 2008-2013 variable mean standard deviation min max observations gdpp overall 2.896043 4.385068 −36.0471 27.49896 n=774 between 2.849411 −4.93643 12.28615 n=129 within 3.340988 −29.5138 18.38134 t=6 invest overall 4.008061 31.13096 −64.7204 755.7443 n=774 between 13.5349 −16.5752 139.9901 n=129 within 28.05581 −154.015 619.7622 t=6 labor overall 0.014656 0.015164 −0.06223 0.061334 n=774 between 0.013135 −0.02284 0.037823 n=129 within 0.00765 −0.02474 0.044685 t=6 consum overall 3.046079 6.053899 −33.5382 56.00542 n=774 between 3.042387 −4.14974 10.74733 n=129 within 5.239604 −30.7187 48.30418 t=6 govexp overall 5.438082 49.8593 −29.9801 1378.306 n=774 between 20.15099 −5.46763 228.8752 n=29 within 45.63457 −251.409 1154.869 t=6 export overall 3.728071 10.73924 −45.7725 84.44024 n=774 between 4.084541 −5.81099 25.55829 n=129 within 9.937592 −46.7142 72.46267 t=6 tx_1~at/tx_2~at international journal of economics and financial issues | vol 6 • special issue (s7) • 2016304 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s7) 304-312. special issue for "international soft science conference (issc 2016), 11-13 april 2016, universiti utara malaysia, malaysia” exploring the concept of debt from the perspective of the objectives of the shariah zairani zainol1*, aini nur hajjar khairol nizam2, rosemaliza ab rashid3 1islamic business school, college of business, universiti utara malaysia, sintok 06010, kedah, malaysia, 2islamic business school, college of business, universiti utara malaysia, sintok 06010, kedah, malaysia, 3islamic business school, college of business, universiti utara malaysia, sintok 06010, kedah, malaysia. *email: zairani@uum.edu.my abstract debt is now considered a norm in everyone’s life. in malaysia, the robust expansion of loans to the household sector has led to rising household debts. the objective of this paper is to explore the concept of debt in islam from the perspective of the objectives of the shariah (maqasid shariah). this study employs the qualitative methodology utilizing an in-depth interview with selected informants representing experts in the shariah. the findings indicate that from the goals and objectives of the shariah point of view, the rules for incurring debt differ according to specific circumstances. debt should only be incurred for the purpose of necessity (daruriyyat) where the absence of debt might bring harm to the person in need. in general, acquiring debt for the purpose of complementary benefits (hajiyyat) and embellishment (tahsiniyyat) are still allowed but is not encouraged1. keywords: debt, islam, the objectives of the shariah jel classification: h63 1 this research was funded by ministry of higher education under fundamental research grant scheme. 1. introduction incurrence of debt has become a norm in our daily life. every household would inevitably be involved in some form of debt depending on the needs of the individual. in malaysia, the continuous increase in household debt over the years is no longer limited to meeting the basic needs of life (abidin et al., 2013). the availability of various types of debt financing in the market enable households to acquire basic necessities such as house and vehicle as well as fulfill the education requirements (sabri, 2014). it should be noted that islam does not prohibit debt which has become a necessity, especially in a consumerist society in these modern times (buang, 2009). however, according to othman and sipon (2014), islam highly discourages heavy use of debt. it is considered to have a serious and direct effect on a muslim’s belief or conviction for it could lead to harmful consequences. it is found that people with higher religious social norms are likely to have lower financial debt (sipon et al., 2014). moraru (2012) also observed that religious young people, that is, those who consider themselves as religious, pray regularly and regard religion as important part of their daily life are more debt averse compared to non-religious young people. this might be due to the fact that religious people who live in accordance to their religious beliefs feel uncomfortable if they are not able to repay their debts. therefore, they would rather avoid incurring debts knowing that they might face difficulties in repaying them. nevertheless, debt which is incurred in accordance with the shariah is permissible and justified (bakri, 2011). hence, people who are in need are allowed and encouraged to take loans without guilt. in fact, it is the responsibility of the lenders to extend loans to assist those in need. islam permits its believers to cater for all levels of benefits and interests for the betterment of life. however, islam has imposed certain limitations and constraints concerning the use of debts for acquisition of luxury goods and maximization zainol, et al.: exploring the concept of debt from the perspective of the objectives of the shariah international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 305 of satisfaction. in reality, however, a disturbing trend in malaysia today is the increasingly high percentage of financing for luxury spending (hatta and dien, 2014). sulaiman (2009) observes that some people are generally forced into debt or taking loans to enjoy a more comfortable standard of living by having basic needs such as vehicles, appliances, furniture and other complementary items. likewise, others acquire debt for the purpose of doing business or expanding their business empire. under these circumstances, acquiring debt is not forbidden (sulaiman, 2009). nevertheless, the amount of debt acquired must be proportional to the quantum of income earned from which the individual has to repay the debt and have sufficient balance to maintain a reasonable lifestyle. however, sulaiman (2009) further asserted that debt should not become a habit and must be avoided due to the adverse effects on one’s life such as hardships, anxieties and stress which eventually could disrupt the family institution as well as weaken the ties of brotherhood and friendship. mokhtar and ismail (2013) claimed that islamic banks and financiers play an important role in making available funds without riba to the muslims. however, they argued that the debt provided by islamic financial institutions was not solely driven by necessity and complementary benefits needs. there are also individuals who incur debt for the purpose of embellishment while others use debt as a means to accumulate wealth (mokhtar and ismail, 2013). therefore, it is crucial to understand how the use of debt could be applied in achieving the goals and objectives of the shariah. hence, the objective of this paper is to explore the concept of debt from the perspective of the objectives of the shariah. accordingly, this paper is divided into five parts. the first part is the introduction to the paper, followed by an explanation on the review of literature and research methodology in the second and third parts, respectively. the fourth part of this paper discusses the results of the study, while the final part is the conclusion. 2. literature review 2.1. definitions and basic concept of debt in islam the definition of debt according to islam could be viewed from several aspects. according to imam shafie, debt is the transfer of the use of a property by the owner to another person (zuhaily, 2002). the borrower must return the property in the same condition as before or replace it with goods of equal value to the borrowed property. malikis scholars defined debt as a valuable property provided by the creditor to the borrower, solely for the benefits that arise from the property (zuhaily, 2002). creditors obtain periodically parts of the property that are repaid by the borrower according to the amount of liabilities. hanafis scholars also has a similar view, that is, debt is a special contract where a product is given for the use of the borrower by the creditor and it has to be repaid in the equivalent value (zuhaily, 2002). imam hanbali also explained that debt could be recognized as a contract made by the creditors, which involves an agreement to transfer the property to the borrower with the borrower’s promise to return it (zuhaily, 2002). generally, the main feature of the practice of borrowing in islam is based on the concept of ta’awun (mutual cooperation), which is mutual help to assist a person in need (sulaiman, 2009). in other words, loans serve to strengthen the relationship between the borrower and lender. zuhaily (2002) defined loan literally as cutting-off a portion, which means that the person who is extending the loan gives a part of his property to the borrower. apart from that, a loan is also known as salaf which means an advance that refers to the amount of the loan extended to the borrower with an expectation of repayment in the future (zuhaily, 2002). haqqi (2009) mentioned that in the contract of loan or qard, the borrower acquires an absolute right of property on the things lent and comes under an engagement to return an equal quantity of things of the same kind. 2.2. history of debt according to bakri (2011), debt is justified and is in accordance with islamic law. people who are in need are allowed to incur debt (bakri, 2011). the history of debt in islam is mentioned in the quran in surah al-baqarah verse 245: who is there among you who will lend to allah a good loan that he may return it after multiplying it manifold? allah alone can decrease and increase (wealth) and to him you shall all return. (surah al-baqarah 1:245) maududi (1972) stated that “good loan” in this verse refers to the loan which is lent without any personal gain or interest but is given with the sole intention to please allah. thus, islam encourages muslims to give debt to those who are in need. this good deed will be duly rewarded by allah. the history of debt during the times of the prophet pbuh is evident in the various hadith related to debt. the prophet pbuh was also unable to fulfill his needs during his days which required him to borrow from others (mushlih and shawi, 2008). mushlih and shawi (2008) stated that this is clear from the hadith narrated by abu hurairah r.a. in sahih al-bukhari; 2390, book 43, hadith 6: a man demanded his debts from allah’s messenger (pbuh) in such a rude manner that the companions of the prophet intended to harm him, but the prophet (pbuh) said, “leave him, no doubt, for he (the creditor) has the right to demand it (harshly). buy a camel and give it to him.” they said, “the camel that is available is older than the camel he demands.” the prophet (pbuh) said, “buy it and give it to him, for the best among you are those who repay their debts handsomely.” the history of debt in islam is also narrated in another hadith by jabir bin abdullah in sahih al-bukhari 2394, book 43, hadith 10 (mushlih and shawi, 2008). the hadith stated that: “i went to the prophet (pbuh) while he was in the mosque. after the prophet (pbuh) told me to pray two rakaat, he repaid me the debt he owed me and gave me an extra amount.” based on this hadith, it shows that the prophet pbuh himself also acquired debt to meet his needs. he even stated that the best among people is the one who repays his debt more than the principal amount borrowed. zuhaily (2002) pointed out that in the hadith zainol, et al.: exploring the concept of debt from the perspective of the objectives of the shariah international journal of economics and financial issues | vol 6 • special issue (s7) • 2016306 narrated by ibnu mas’ud it was mentioned that the prophet (pbuh) said: “every two loans extended by a muslim to another count as one charitable payment.” this hadith has also been narrated by ibn majah and ibn hibban in his sahih, as well as al-bayhaqi in al-shawkani (vol. 5. p. 229) (zuhaily, 2002). according to zuhaily (2002), there is also another hadith recited by ibn majah and al-bayhaqi on the authority of anas ibn malik, and by al-tabarani and al-bayhaqi in similar wordings on the authority of umamah (r.a); al-haythami (vol. 4. p. 126). it is narrated on the authority of anas that the messenger of allah (pbuh) said: “on the day i ascended to heaven, i saw writing on the door of paradise that read: “every charity is rewarded 10-fold, and every loan is rewarded 18-times.” i said: “o jibril, why is a loan rewarded more than charity?” he said: “because a person may ask for charity when he does not need it, but the borrower only borrows in cases of dire need.” these two hadiths show that islam encourages muslims to give out loans. bakri (2011) explained that allah swt regards the act of giving out loans as charity. this is because people usually incur debt due to desperate needs. thus, muslims are encouraged to give loans in order to ease the borrowers’ hardships. however, islam also seriously cautions against the harmful consequences of debt. this is evident in another hadith explained by hajar and al-asqalani (1997, as cited in hatta and dien, 2014) which is narrated by jabir who said: “a man died and we washed him, enshrouded him, and embalmed him. the prophet (peace be upon him) came to us to perform janazah prayer. we asked him: are you going to perform janazah prayer? he then took small step and asked: is with him a debt? we answered: two dinar, then he turned away. abu qatadah was then willing to bear the debt. and the prophet immediately performed the janazah prayer. then 1 day the prophet asked abu qatadah concerning the two dinar and he responded that the debt had been paid. the prophet then said: now his skin is relieved.” narrated by ahmad bin muhammad bin hanbal bin hilal al-shaybani, musnad ahmad (beirut: muassasa al-risala, 1420h, vol. 30. p. 58). hajar and al-asqalani (1997) provides a clarification of the hadith by stating that this hadith reveals the difficulty arising from the use of debt, and thus cautions from being in debt unless absolutely necessary. therefore, debt should be taken only if necessary and the debtor must strive hard to repay it. the culture of being in debt is strictly forbidden in islam since it only could be incurred for meeting a particular purpose (sobian and rahman, 2010). 2.3. debt from the perspective of the goals and objectives of the shariah the objectives of the shariah essentially reflect the broad and comprehensive understanding of the objectives of the ruling of shariah revealed for the benefit of mankind (auda, 2007). the ruling is revealed from allah swt. the maqasid shariah, an arabic term, is a combination of two words, that is, maqasid or goals and objectives and shariah. maqasid could be defined as the objective, aim or intention while shariah is the law of islam. thus, the objectives of the shariah is the objective of the implementation of hukm or command (naim, 2003). the maqasid shariah is translated as the objectives of shariah (laldin and furqani, 2013). it is considered by laldin and furqani (2013) as the broad framework governing the financial sphere that provides guidelines and directions to ensure the realization of maslahah or benefit and the prevention of mafsadah or harm in all financial transactions. laldin and furqani (2013) further clarify that the objectives of shariah remain theoretical until they are applied and brought into the realm of reality. the objectives of the shariah is classified into two main categories, namely the general or maqasid al-amm, the specific or maqasid al-khassah. ashur (2013) defined the general objective as the deeper meaning and inner aspects of wisdom by the lawgiver in all or most of the areas and circumstances of legislation. it is mainly concerned with the public affairs of muslims and lays out specific rules and laws to regulate civil and social dealings. it also refers to the attainment of what is good and beneficial, which is maslahah (benefit/interest) and prevention of the evil and harmful that is mafsadah (ashur, 2013). on the other hand, specific maqasid or maqasid al-khassah is an objective of the shariah which governs a few groups of certain laws such as family laws. some examples are the prohibition of causing harm or danger to women, preventive element in punishment and abolishing scam in wealth management (azhari and chik, 2011). naim (2003) stated that the implementation of an action in a way that is contrary to islamic law with the excuse of meeting the objective of shariah is rejected. it should be highlighted that the ultimate goal is to perform these actions in a manner guided by islamic law. therefore, it is important to achieve the objectives of shariah in a manner that is in accordance with the islamic law. according to dusuki and bouheraoua (2011), islamic scholars such as al-shatibi divided the general objectives of shariah into three sub categories, which are the daruriyyat or basic needs (necessity), the hajiyyat or comforts (complementary benefits) and the embellishments or tahsiniyyat (luxuries). dusuki and bouheraoua (2011) further defined necessity as the elements in life that individuals are dependent upon. human life would be incomplete if these aspects are not fulfilled. it comprises the fundamental aspects outlined in the objectives of shariah, which are protection of religion, life, intellect, lineage (honor) and property. the welfare of the individuals and the society at large is established through the preservation of these elements. necessity has become a key requirement for human life in this world and the hereafter. complementary benefits refer to those things that are required by humans to provide comfort and harmony in life as well as to avoid hardships that result in trouble and short life span (dusuki and bouheraoua, 2011). the absence of this would not disrupt an individual’s life if the aspect of necessity has been fulfilled. complementary benefits, in other words, focuses on the desire to restore and improve human life. it also zainol, et al.: exploring the concept of debt from the perspective of the objectives of the shariah international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 307 reflects the objective of removing hardships and enhancing an individual’s life. as for embellishment, it is a situation that leads towards betterment in life (kamali, 2002). it denotes the interests, the realization of which results in improvement and attainment of that which is desirable. thus, embellishment includes customs and good manners, keeping clear of filth and bad attitudes as well as performing the recommended practices of worship (kamali, 2002). however, individuals should not focus only on embellishment as it would lead to undesirable problems in life caused by the neglect of things that are necessity. nevertheless, it is encouraged to adhere to complementary benefits and embellishment for the proper maintenance of necessity (dusuki and bouheraoua, 2011). razali and zakaria (2015) asserted that the need to incur debt to fulfill the basic needs of life is one way of achieving the objectives of the shariah as it aims to maintain public interest. individuals should refer to the level of needs stated in the objectives of shariah namely, necessity, complementary benefits and embellishment when making decisions to incur debt (razali and zakaria, 2015). imam al-ghazali divided and ranked the order of needs as necessities, complementary benefits and embellishment as one of the dimensions under the objectives of the shariah framework (auda, 2007). based on the current scenario, among the main objectives of most consumers in incurring debt are for acquiring luxuries and satisfaction of wants (hatta and dien, 2014). khan (1995) as cited in hatta and dien (2014) further highlighted the unanimous view among the classical and contemporary scholars that excessive use of debts, credits and loans is deemed as not fulfilling the purpose and principles of shariah. similarly, zuhaily (1991) as cited in hatta and dien (2014) also asserted that debts or loans are only permissible for those who are in real need. 3. research methodology this study employed a qualitative approach to achieve its objective. in-depth interviews were conducted with four informants who were selected based on their expertise and educational background. two informants were from the kedah islamic religious affair department, one from the shariah court, kedah while the fourth one is a shariah expert who is also an academician. the informants for this study were chosen based on their expertise in the area of the research study. they were selected on the basis of their knowledge and understanding of the subject matter being examined. according to creswell and clark (2004), a phenomenological study involves a long interview with up to 10 people. in contrast, mason (2012) argued that having a smaller number of interviews that are creatively and interpretively analyzed is acceptable. similarly, patton and cochran (2002) pointed out that the sample size for qualitative research is typically small. the interviews were conducted with four informants as the point of saturation has been achieved. this is in line with patton and cochran (2002) who stated that one-way of identifying the number of informants needed is to continue interviewing until nothing new is derived from the data analyzed. purposive sampling techniques are also referred to as nonprobability sampling or purposeful sampling (teddlie and yu, 2007). the type of purposive sampling used in this research is snowball sampling. the sample constituted cases of interest from sampling people who know people that generally have similar characteristics who, in turn know people, also with similar characteristics (palinkas et al., 2013). according to creswell (2007), various forms of interview designs could be developed utilizing a qualitative investigational perspective to obtain dense, rich data. in particular, turner (2010) asserted that developing an interview protocol is one of the most crucial components of the interview design. this study used a standardized open-ended interview. accordingly, the terms of the wording of the interview protocol were structured based on the research questions and the research objectives. informants were asked identical questions which were deliberately worded so that responses are open-ended (gall et al., 2003). this open-endedness allows the participants to provide as much detailed information as they desire and it also allows the researcher to ask probing questions as a means of follow-up. the interview protocol developed was further reviewed by academic experts to ensure that the guideline questions used in the interview are able to address the research questions. more importantly, reviewing the guideline questions ensures the clarity and continuous flow in the structure and framework of the questions. according to miles et al. (2014), the instrument’s validity and reliability in qualitative research depend largely on the skills of the researcher. creswell and miller (2000) suggested that validity is affected by the researcher’s perception of validity in the study and the choice of paradigm assumption. on the other hand, patton (1997) stated that the validity lies in the extent to which an instrument looks as if it measures what it is intended to measure. therefore, a pilot study was conducted to enable the researcher to validate the interview questions. this is done through a few review and discussion sessions with selected academicians to verify the extent to which the interview questions are able to provide appropriate answers to achieve the objectives of the research. data collection was done through face-to-face interviews with the informants. the informants were chosen based on their expertise in the area of the research study. knowledge and understanding of the subject matter, that is, shariah, particularly the objectives of the shariah, formed the basis of selection of the informants. 4. results and discussion 4.1. definitions and basic concept of debt in islam based on the primary data collected, the following are the definitions and basic concepts of debt in islam. the informants are respectively coded as i1, i2, i3 and i4 to facilitate understanding. various definitions of debt have been proposed by islamic scholars. most of the informants concurred that the definition of debt as put forth by the classical islamic scholars is still applicable in zainol, et al.: exploring the concept of debt from the perspective of the objectives of the shariah international journal of economics and financial issues | vol 6 • special issue (s7) • 2016308 this modern times. according to informant i1, loans should be extended without any commercial value attached: debt in islam means that we take a loan from someone or we lend money to someone without reward or no commercial value…the debtor cannot ask for profit from people but the reward is from allah. looking from another perspective, i1 proposed a definition of debt as the burden that the debtors need to bear as they have to repay the full amount of the debt. this could be inferred from his statement below: the one who borrows the property bears the burden of the debt incurred. if he cannot repay until the time of his death, his soul will be suspended between the earth and the sky. it means that his soul will be in suspension until his relatives help in resolving his debt, then the soul rises to the sky. islam tells us to refrain from debts if possible and the prophet also taught us to seek solace in prayers “allahumma inni a’uzubika minal hammi wal hazan, wal ‘ajzi wal kasal, wal jubni wal bukhl, wa a’uzbika min ghalabatid-dayni wa qahri-rijal.” ghalabatid-dayni means the unpaid debts and we should ask allah for protection. thus, in islam debt is something that should be avoided if possible, but giving loans and credit is encouraged. the contemporary islamic scholar zuhaily (2002) defined debt literally in the arabic term, which is al-qard. informant i2 relates the definition of debt with the common circumstances where the lender usually extends the loan only to people that he knows. he stated that: debt which is known by the term al-qard means cutting off the property and handing over to the debtor because it is a piece of property of the person who gave it…debt in islam is given in the form of love to those who will use it and will return it at a time that has been agreed upon. this means those who borrow from people are in need of it. if he does not need it and is not desperate, he will not borrow. so, people lend out of compassion. that is why if someone is going to lend us, it will be for the people they know only. and if we were to borrow from the bank, we need to fill in many forms. this loan is for the purpose of love but will be reinstated, which means it will be repaid. on the other hand, informant i3 defined debt as a liability to the borrower as the borrower has to pay back the property or the amount borrowed to the lender in the future. i3 further stated that the property involved in the debt has to have value. if the property does not have any value, then it cannot be considered as a loan to the borrower. this could be inferred from his statement below: debt is the liability of a person when he is given something valuable from others in the hope that it will be given back. the purpose of the loan is more towards helping people thus there is no fixed period for the repayment. it is an act by the lender of the valuable property. in terms of definition, mal or property is of two kinds, that is, mal mutaqawwam and mal ghairu mutaqawwam which means the valuable and valueless property. in the case of loans, for it to be valid or not depends on the value of the debt. so, if we give an object that has no value as a loan, for example, we give an excrement or just a stick of wood that does not have value to the debtor, it is not counted as a debt. debt is a thing of value given to someone and hopefully that debt or the item will be returned or repaid. similarly, informant i4 defines debt in relation to the value of the property being loaned to the borrower. specifically, the value of the property depends on the needs of the borrower and not the lender. he said: debt in a simple word is a person that gives something which is valuable to those who ask and those who asked for it must repay. this is in contrast to charity where we give these properties to people who do not even ask for it. and when i said to give something of value, it means it is of worth to the person whose is requesting for it. it means that is what he needs and only he knows whether something is valuable or not for him. islam encourages us to always help each other in righteousness. this is based on verse 2 of surah al-maidah in holy quran, which states: o ye who believe! violate not the sanctity of the symbols of allah, nor of the sacred month, nor of the animals brought for sacrifice, nor the garlands that mark out such animals, nor the people resorting to the sacred house, seeking of the bounty and good pleasure of their lord. but when ye are clear of the sacred precincts and of pilgrim garb, ye may hunt and let not the hatred of some people in (once) shutting you out of the sacred mosque lead you to transgression (and hostility on your part). help ye one another in righteousness and piety, but help ye not one another in sin and rancour: fear allah for allah is strict in punishment. (surah al-maidah: 2, translated by ali, n.d.) this means that muslims should help each other when in need. all four informants agreed that the basic concept of debt in islam falls under the concept of mutual cooperation (ta’awun) which means helping each other. i1 stated that the needs of everyone differ from one another and we cannot have everything in life. he believes that debt, which is allowed in islam, is a blessing from allah as he said: “debt is used to help fellow muslims or fellow human beings to fulfill their wishes. this is based on the concept of helping or mutual cooperation.” i2 also emphasized that the basic concept of debt is to help one another. he said: “debt is allowed in islam. this is because there is a connection of debt with a verse in the qur’an that mentioned the word mutual cooperation, which means mutual help.” accordingly, i3 gives an example that shows how debt is considered as a mutual cooperation. he stated: “in my opinion, the basic concept of debt is more to mutual cooperation…we can see it for example, qard hasan as one form of debt that is based on good faith.” i4 also believes that providing loans is one of the ways to help those in need as he said: zainol, et al.: exploring the concept of debt from the perspective of the objectives of the shariah international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 309 it is basically through providing loans that we can help the person in need and if we are able to do so, we have fulfilled what allah suggested, that is helping our neighbour. but it does not mean the person incurring the debt is in disgrace as the person is in trouble. if we can, we must help people in trouble. therefore, it could be concluded that extending a loan is an action of giving something of value to someone who is in need. it is based on the concept of mutual cooperation, that is, helping each other, particularly those in need. 4.2. history of debt debt has been in existence since the beginning of mankind. it has been the nature of humans to continuously seek support from others due to their inability to undertake things on their own. all the informants stated that debt has been a norm since the beginning of human history. they also mentioned that incurring debt has been in practice during the times of the prophet muhammad pbuh. this is evident from the various hadiths that dealt with debt. i1 gave an example when he said: the prophet also incurred debt. when the prophet died, he owed a sack of grain to a jew. he had pledged his armor as collateral. this meant that if he could not pay back then the jew will keep his armor. this indicates that the debt will be settled. however, saidina ali went to repay the debt and take back the armor. it shows that if the prophet also could not avoid debt, let alone us as a normal human being. however, the level of debt has to be controlled and there must be discipline in debt culture. according to i2: during the time of the prophet there were people who also acquired debt. this can be seen through the hadith of the prophet. there are many hadiths relating to this, for example the hadith narrated by muslim, al hakim and ahmad, a martyr will be forgiven for all his sins except his debt. basically, a martyr will go to heaven but if he has not paid his debt, unfortunately he is prevented from going to heaven. from this hadith it could be seen that debt was prevalent during the time of the prophet. although i3 referred to a different hadith, it still has the same statement regarding the history of debt. he said: if we look at the hadith of the prophet we can see that prophet muhammad said that: “i saw on the night journey a door to paradise on which the following was written: charity is repaid tenfold, and a loan 18-fold. i said: o jibril, how can a loan be more meritorious than charity? he replied: because one asking for charity may still have some resources left, while the borrower does not borrow unless his basic needs are not fulfilled.” this was narrated by ibn maajah. so those who owe are more desperate to get these loans compared to people who ask for alms. perhaps, people who ask for alms, we do not know whether they were really desperate for the money given. but for the one who is requesting for loan, he is in a desperate situation. nevertheless, i4 argued that as debt is related to the relationship between humans, it falls under muamalat or man-to-man relations. he stated that although debt was prevalent from the beginning of mankind, with the advent of islam, debt became more organized to ensure justice for all human beings. he said: we must understand that debt falls under the muamalat which covers the relationship between man and man. so, in terms of this, the history of debt is long and we cannot determine when it began. this is because it already was customary for man to borrow. however, with the advent of islam, the existence of debt was recognized and the islamic law outlined the ways of incurring debt so that injustice does not occur. further, the longest verse in surah al-baqarah is related to debt. this means in islam all things are governed by the islamic muamalat or man-to-man relations. prophet also incurred debt and repaid it more than the amount due. so this shows that, debt has existed since the time of the prophet and islam laid out the concept of debt in an organized manner. to sum up, the history of debt could be traced to the beginning of human history. debt has been used in muamalat or man-to-man relations to facilitate human dealings. the advent of islam has brought a more organized concept of debt to ensure justice for all parties involved in the transaction. 4.3. debt from the perspective of the objectives of the shariah according to the literature, the objectives of the shariah is broadly classified into general and specific objectives. with regards to debt, all informants agreed that debt could be incurred to achieve the objective of shariah, that is, to utilize it for the benefit of mankind. however, the general objective of the shariah, which is to decide on the permissibility of debt, it depends on the purpose of incurring the debt and is categorized as necessity, complementary benefits or embellishment. i1 stated that even though debt is allowed in islam, we are not encouraged to take it excessively as debt is only to be incurred to fulfill basic needs or necessity. he said: in terms of requirements, debt is not necessarily to be used in necessity but also in situations such as complementary benefits and embellishment. as an example, if a person or children and wife would have starved as they do not have any food to eat the debt will be deemed as necessity. complementary benefits are debt taken for the purpose of buying a car or other things. as for embellishment, it is when we borrow money to buy accessories such as a second home or another car. in all the three categories, debt is allowed. but, in terms of the debt position, there are debts that are encouraged and discouraged. asking for loans is allowed but it is not encouraged. islam does not punish, but guides and educates the society as to the types of debt that could be incurred. borrowing for the purpose of embellishment is allowed but it is not recommended and should be controlled. further, i2 was of the view that there is a need to ensure that debt is acquired based on its priority. he also concurred that the rules of debt might change according to the situation of the individuals. he said: zainol, et al.: exploring the concept of debt from the perspective of the objectives of the shariah international journal of economics and financial issues | vol 6 • special issue (s7) • 2016310 in islam, we must give priority to the basic needs first, food, shelter and clothing. all this is to help us in worship. when these basic necessities have been fulfilled, then we go for comfort. same goes for debt. it should be incurred in the order of priority. although it is allowed in islam, one is not encouraged to have excessive debts. the ability to repay also should be taken into consideration. however, in some cases, the rules of debt changes according to the situation. if someone is really in difficulty and in need of the money to support his family, it becomes compulsory for him to take loans. i3 explained how debt is compulsory in each aspect of the goals and objectives of the shariah that falls under the necessity category. he further stressed on the importance of knowing the priorities when incurring the debt: in relation to debt, it does not just focus on hifzu mal or preservation of wealth. its scope is wider. for example, in situations of necessity when we are desperate, such as having sick children, there is high cost of treatment or we are very hungry and there is no other source of income, we have to obtain loans. at that time, we want to preserve the lives or hifzu nafs. in certain circumstances, we might incur debt for the purpose of protecting the religion or hifzu din. an example is when we wish to protect the faith of a person, such as court case on child custody. to protect the faith of the child from the non-muslims, we are forced into debt because we have no money to pay the legal costs. the scope of the goals and objectives of the shariah with regard to debt is wide and not just confined to the protection of property. under necessity, debt is allowed. if we look at debt for the purpose of complementary benefits, it emphasizes more on the fact that if we do not comply then it would lead to trouble. however, it does not affect our lives directly. therefore, we need to understand from the point of aulawiyyat or our priorities. we must understand the position of our priorities, be it from the necessity, complementary benefits or embellishment aspects. if we do not understand, then we would be highly in debt. nevertheless, i4 stated that individuals have different needs and the priority lies with the individual himself. however, he also stressed the need for the individual to look at his ability to repay the debt. he said: in whatever allah’s commands, it must be aimed at protection of the five aspects, whether to protect all or any of them. as an example in the case of debt, the debtor is forced to endure the things he cannot afford. if there is no channel for debt, a desperate person will do anything. he will steal and it will threaten the property. he will also be able to kill, and this will be life-threatening. he can also drink alcohol to forget the problem and this will disturb the mind. and this will lead to more adverse effects, such as social problems and threaten the off-springs. thus, debt is important in the context of the goals and objectives of the shariah as it is a necessity. as for need, it is subjective depending on the individual. the individual’s needs vary therefore the debt incurred is also for different purposes and necessities. one important thing to look at is the ability to repay the debt. therefore, it is up to the individual to determine whether it is appropriate to incur debt based on his own circumstances in light of the goals and objectives of the shariah. an equally important consideration is the ability to repay the debt. 4.4. important guidelines in islam regarding debt based on the primary data collected, informants have outlined a few important guidelines that need to be taken into consideration regarding debt. most of the informants stressed on the need to adhere to the guidelines when dealing with debt transactions as outlined in verse 282 of surah al-baqarah: o ye who believe! when ye deal with each other in transactions involving future obligations in a fixed period of time reduce them to writing. let a scribe write down faithfully as between the parties: let not the scribe refuse to write as allah has taught him so let him write. let him who incurs the liability dictate but let him fear his lord allah and not diminish aught of what he owes. if the party liable is mentally deficient or weak or unable himself to dictate let his guardian dictate faithfully. and get two witnesses out of your own men and if there are not two men then a man and two women such as ye choose for witnesses so that if one of them errs the other can remind her. the witnesses should not refuse when they are called on (for evidence). disdain not to reduce to writing (your contract) for a future period whether it be small or big: it is just in the sight of allah more suitable as evidence and more convenient to prevent doubts among yourselves; but if it be a transaction which ye carry out on the spot among yourselves there is no blame on you if ye reduce it not to writing. but take witnesses whenever ye make a commercial contract and let neither scribe nor witness suffer harm. if ye do (such harm) it would be wickedness in you. so fear allah; for it is allah that teaches you. and allah is well acquainted with all things. (surah al-baqarah: 282; translated by ali, n.d.) according to this verse, there are a few requirements to be fulfilled when dealing with debt transactions. it includes written documentation and also the presence of a witness during the transaction. i1 added that there is also a need for the individual to control his desire. this is because as humans, it is common to have desires for many things. however, this desire should be controlled by adhering to what has been recommended in islam: first is to educate the heart. the prophet said the original cause of a matter is heart. if the heart desires a lot of things than it will cause a lot of debt. so, the key is to become zuhud and restrain oneself…look at our ability and act in moderation. for example, with a salary of rm1,000 a month, a small car is adequate. if we have more income, it does not matter if we want to use luxury cars. we must act according to our own ability. apart from that, i1 also stressed on the need to have good financial planning in managing debt. he said: we must have good financial management. debt should not be taken for the purpose of having big feast, or to own a big car. if possible the debt must be based on the priorities, is controlled and centered on the debtor’s ability to pay. this is called a balanced debt. zainol, et al.: exploring the concept of debt from the perspective of the objectives of the shariah international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 311 meanwhile, i2 emphasized that every debt must be repaid. he also stated that an individual should know how to identify his needs and know the priorities. he said: the debt must be repaid. if not, the deeds done will not be accepted. third, there is a different need for each individual. therefore, the individual must know how to prioritize. i3 indicated that the individual should be aware of his own capability to ensure that the debt taken is not excessive as it could eventually lead to over-indebtedness. he also mentioned that the debtor should have a strong determination to repay the debt under any circumstance: we have to look back on our own ability to pay. this is because the debt must be repaid no matter what. hence, when we feel that it is outside our ability to repay this will bring harm to ourselves. we must have a strong determination to repay the debt even if we cannot afford to pay it back today. in many circumstances, the debtor indeed intended from the beginning to not repay the debt. i4 pointed out that if the debtor has a strong determination to pay but still could not pay the debt, he could ask for a better way to settle the debt from the lender. this could be either through extending the repayment period, reducing the amount of debt or by writing off the debt. he said: debtors in islam should have an earnest determination to pay off debts or have a strong intention to do so. this is important because if the debtor has a strong intention to pay the debt and suddenly he dies, allah will help him…he also must try his best to repay the debt and is encouraged to give more than the amount due. if he cannot, he can ask for an extension of time, seek reduction in the amount of debt or request to write off the debt if he is unable to repay. however, this is subject to the consent of the lender. in conclusion, debt contracts should be dealt with in accordance with the guidelines given in the al-quran. however, the individual also must have the initiative to avoid incurring excessive debts that could cause harm in the future. he should assess his own purpose in incurring the debt and also his ability to make repayments. 5. conclusion islam permits debt as it brings benefits to individuals as well as facilitates the fulfillment of their needs. debt should be incurred based on the needs of the individual and not for the sake of gaining luxuries without taking into consideration the potential adverse effects. it should be highlighted that the basic concept of allowing debt to be incurred in islam is to help each other as stipulated in the mutual cooperation. however, islam forbids the taking of usury where the lender is taking advantage of the desperate situation of the debtor. debt should be limited for the purpose of fulfilling the individual’s needs and not for the sake of wealth accumulation. since debt activity falls under muamalat or man-to-man relations which governs the social interactions among humans, its history could be traced to even before the advent of islam. with the onset of islam, debt has become more organized. moreover, islam also has brought justice to both the lender and debtor by outlining the guidelines for conducting debt transactions. from the objectives of the shariah point of view, the rule of taking debt might change according to the situation. in some cases, debt is not encouraged even though it is allowed. apart from that, the debtors also should only incur debt for the purpose of necessity 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(2002), financial transactions in islamic jurisprudence. vol. 1. damascus: darul al-fikr. . international journal of economics and financial issues | vol 6 • special issue (s7) • 2016333 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s7) 333-336. special issue for "international soft science conference (issc 2016), 11-13 april 2016, universiti utara malaysia, malaysia” an investigation of situational inhibitors to informal learning amongst accountants muhammad syahir abdul wahab1*, ram al-jaffri saad2, mohammed amir mat samsudin3 1school of accountancy, colleague of business, universiti utara malaysia, 06010 uum sintok, kedah darul aman, malaysia, 2school of accountancy, colleague of business, universiti utara malaysia, 06010 uum sintok, kedah darul aman, malaysia, 3school of accountancy, colleague of business, universiti utara malaysia, 06010 uum sintok, kedah darul aman, malaysia. *email: syahir@uum.edu.my abstract a case study was conducted to investigate situational inhibitors to informal learning activities amongst accountants in a public firm in malaysia. four situational inhibitors emerged from the data analysis. the accountants reported that lack of time, lack of proximity to colleagues’ working areas, lack of support from others and structural inhibitor as the inhibitors to the learning. the paper proceeds to outline the theoretical and practical implications as well as suggestions for future research. keywords: accountant, informal learning, situational inhibitors jel classification: d9 1. introduction the emergence of informal workplace learning in the late 1980s is due to limitation of formal workplace learning to deliver its expected benefits (clifford and thorpe, 2007). for instance, rothwell (2003) found that not more than 30% of what workers learn in formal learning activities can be transferred to job and then improve work performance. this phenomenon shows that formal workplace learning is no longer sufficient to support continuous learning at the workplace (billett and choy, 2013; kim and mclean, 2014; marsick, 2009). therefore, the focus of professional development has shifted from formal to informal learning activities in recent years (billett and choy, 2013; clifford and thorpe, 2007; marsick, 2009). over the last decade, informal learning has received widespread attention amongst professionals such as nurses (bjørk et al., 2013), human resource management practitioners (crouse et al., 2011), teachers (lohman, 2009), managers (ashton, 2004; billett, 2003) and accountants (abdul et al., 2012; hicks et al., 2007). this paper focuses on accountants in public accounting firm since the learning is important to keep abreast with the changes in current and future work environment (hicks et al., 2007; malaysian institute of accountants (mia), 2011; 2014). however, recent evidence indicates that their informal learning is less encouraging. this problem is associated with situational inhibitors (audit oversight board malaysia (aob), 2010; 2011; 2013). despite such problem, a research that further explains this issue is still limited. therefore, the purpose of this paper is to investigate situational inhibitors to informal learning activities amongst them. this paper is structured as follows; section 2 provides a brief review of relevant literature. following this, the research method is outlined which then leads to discussion of research findings. finally, the conclusions, implications and suggestions for further research are provided in section 5. 2. literature review workplace learning refers to continuing professional education in the accounting profession (mia, 2011; 2014). the learning is important for accountants to develop and maintain knowledge and skills within their professional environments (international wahab, et al.: an investigation of situational inhibitors to informal learning amongst accountants international journal of economics and financial issues | vol 6 • special issue (s7) • 2016 334 federation of accountants [ifac], 2008; mia, 2011; 2014). it can be categorized into formal and informal. formal learning refers to education that is systematic, structured and formal in nature (ifac, 2008). attendance to courses, conferences and seminars, post-graduate studies and diploma courses are the recognized formal learning activities (mia, 2011; 2014). informal learning, which is the focus of this paper, is termed as unstructured learning in the accounting profession (ifac, 2008; mia, 2011). it takes place as part of accountants’ work and related to accounting and auditing matters (ifac, 2008; mia, 2011). informal learning activities of them include reading, using audio/video and distance learning (mia, 2011). meeting, briefing and discussion are also their informal learning activities (ifac, 2008; mia, 2011). situational inhibitor is situational factor within one’s working environment that can reduce his/her ability to gain access to, and pursue informal learning opportunities (cross, 1981; lohman, 2000). therefore, in this research situational inhibitors refer to situational factors within a public accounting firm environment that can inhibit accountants from informal learning activities. 3. research method 3.1. selecting the case study an in-depth case study was undertaken at one of the public accounting firms located in alor setar, kedah, malaysia. this firm was selected since it committed to the research project; that is, full access and participation was offered to the researchers by the firm’s partners. in-depth case is adopted because the influence of situational inhibitors to informal learning is a complex phenomenon and subjective in nature (ellinger and cseh, 2007; marsick, 2009); hence, an in-depth case is considered as the suitable approach to capture the complexity and subjectivity. the case study also enables the researchers to obtain a detailed explanation of the topic studied from the research participants (yin, 2003). therefore, an effective result can be delivered and it is more likely to be useable by those in the observed situations. 3.2. selecting the research participants within the case study five chartered accountants in the public accounting firm who are holding the current membership in the mia participated in this research. they were selected as informal learning is compulsory for professional development (mia, 2011). more female than male (female = 60%, male = 40%) accountants participated in the research. of five participants, majority (60%) of them were under 35 years old. the participants were one branch head/deputy president, two senior auditors, one audit associate and one tax associate. in addition, four (80%) participants are involved in audit work and only one (20%) in taxation. 3.3. data collection and analysis procedures this research utilized open-ended interview method (gubrium and holstein, 2002). such interview is appropriate since the researchers wanted to minimize the variation in the questions that are posed to the research participants. the interview was also useful because it was desirable when obtaining the same information from each interviewee at several points in time or when there were time constraints for data collection and analysis (gubrium and holstein, 2002). the interview also allowed the researchers to collect detailed data systematically and facilitate comparability amongst all the research participants (gubrium and holstein, 2002). the interview sessions had taken about two months to complete. the interviews were undertaken on the agreed day and time. each interview normally took around two hours. however, there were instances when the researchers needed to visit the research site again. this was to meet the participants who could not be interviewed during the first visit due to job commitment. the researcher transcribed each audio-recorded conversation and transformed them into a text. the data were analyzed using a manual analysis procedure due to small number of participants. the researcher then read carefully for several times the participants’ transcribed texts to gain a sense of each participant’s story and to identify the significant statements that could be detected in them. in addition, respondent validation was also utilized to reduce personal bias. 4. research findings to investigate the situational inhibitors to the learning, the following questions were posed to the research participants during the interview sessions: “what are the situational inhibitors to informal learning activities” and “how the inhibitors influence your informal learning activities? four situational inhibitors reported by the accountants. the following sub-sections describe the findings. 4.1. lack of time the first situational inhibitor is lack of time. the research participants indicated that this situation constraints informal learning activities. for examples: “aaaaa., i think one of the big problems for audit firm is high workload, everything has to follow dateline, time is so limited for reading and discussion, oh my god, i don’t think we have to learn during weekend, it is time for family, right” mr. a. “ok, sometimes there are new changes in financial reporting standards, i want to develop my knowledge and skills on the standards through reading, meeting or discussion, but time is so limited for the activities, emm…, workload is so high, especially during peak time, this problem always happens to audit firm and we cannot avoid it” mrs. c. mr. a and mrs. c reported that lack of time due to heavy workload especially during audit peak period reduced reading, discussion and meeting opportunities. thus, it can be learnt that the accountants’ informal learning activities are less likely to take place because of this inhibitor. 4.2. lack of proximity to colleagues’ working areas the second situational inhibitor is lack of proximity to colleagues’ working areas. the research participants indicated that this situation limits informal learning opportunities. for instances: “there is something i eager to tell you, staffs in audit department are always outstation, they go to clients’ offices for audit purposes, this situation causes problem to me if i want to organize face to wahab, et al.: an investigation of situational inhibitors to informal learning amongst accountants international journal of economics and financial issues | vol 6 • special issue (s7) • 2016335 face meeting and discussion with them, i also have difficulty to get detailed explanation about something that i don’t know, aaaa…. could you imagine how difficult my situation, i don’t know how to solve this problem” mrs. d. “being away from each other especially in the same department is a problem to me, if i want to make discussion. or eemmmm… to organize meeting and briefing i think, so many disruptions not only to my learning but to my work, this problem of course is a big deal to me, my works still need to be accomplished as planned, how i’m going to do that…hahahaha” mr. b. mrs. d and mr. b reported that the physical distance between each other in the same technical area disrupted their ability to conduct meeting, group discussion and meeting. thus, it can be said that the accountants’ informal learning activities are less likely to occur if this inhibitor exists in their working environment. 4.3. lack of support from others the third situational inhibitor is lack of support from others. the research participants indicated that this scenario restricted informal learning activities. for examples: “emm, aaa, this is one of the main reasons, you know they did not allow me to use the computer, only they can use it, this problem occurred since we have to share the computer, problem you know if i want to search out learning materials in the internet or conduct on-line discussion. emm. haha…, maybe they don’t want me to move forward or they are too busy, or they think that i have to learn something through self-learning, self-reading for instance, hahaha., they believe that i have to take my own initiative, this usually happened when i was junior”mr. b “aaaa…, lack of support from each other is one the factors that can reduce our motivation to engage in the learning activities, for instances, emmmm…reading, discussion and knowledge sharing, we have to find other alternatives to solve the encountered problems, this situation really bothers me. this reluctance is due to negative attitude, they are busy and don’t care about us, no wonder they don’t want to help my learning” mrs. e mrs. b and mrs. e reported that reluctant of others to support them restricted access to learning materials, discussion, reading and knowledge sharing. thus, it can be learnt that this situational factor can inhibit the accountants’ informal learning activities. 4.4. structural inhibitor the fourth situational inhibitor is structural inhibitor. the research participants indicated that this problem inhibits informal learning activities. for examples: “haha…emm., you know there is another factor that can influence my work, i have to handle everything here, i am responsible to know everything, i think other staff members are experiencing this problem too, some only involved in auditing and some only involved in taxation, there are administrative staffs who don’t know about audit fee, she didn’t ask or discuss with others about it, what a problem”mrs. d. “emm…, i think i know what the other departments are doing here, this is because our office is small, two storeys only, but i don’t know what staff members in other branches are doing, we rarely conduct meeting or discussion together, no platform to carry out such learning activities, ohhhh….as a result, i have little knowledge about what they are doing, i have a lack of knowledge about their work” mr. a. mrs. d and mr. a reported that physical separation between departments and branches reduced their opportunities to ask question, discuss and meeting for knowledge sharing. thus, it can be learnt that the accountants’ informal learning activities are limited because of the situation. 5. conclusions, implications and future research this study investigated situational inhibitors to informal learning activities amongst accountants. a qualitative case study that involved a public accounting firm in malaysia was employed. from the undertaken research, it was found that lack of time, lack of proximity to colleagues’ working areas, lack of support from others and structural inhibitor constrained their informal learning activities. other scholars also reported that lack of time (crouse et al., 2011; lohman, 2006; 2009), lack of proximity to colleagues’ working areas (abdul et al., 2012, lohman and woolf, 2001), lack of support from others (ellstrom et al., 2008; jurasaite-harbison, 2009) and structural inhibitor (ellinger and cseh, 2007; jurasaiteharbison, 2009) were the inhibiting factors to informal learning amongst professionals. the research findings are also consistent with behaviorism orientation of adult learning theory. the orientation postulates that situations within one’s immediate working environment are more likely to influence informal learning activities (pavlov, 1927; skinner, 1938; watson, 1930). in short, the research findings supported the prior literature. this research has several implications to theory and practice. theoretically, this research develops a greater understanding of the situational inhibitors from the perspective of accountants. practically, the research findings are important for public accounting firms and accounting profession to create a more conducive work environment for the learning. such environment can support their continuous professional development in order to uphold public interest, trust and integrity. this research employed a qualitative case study and involved a small number of participants. thus, the findings are descriptive in nature and less generalization. further research could test the significant level of the inhibitors on the learning using statistical analyses and considering a wider sample frame. references abdul, w.m.s., selamat, m.h., saad, r.a. 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(2003), what ceos expect from corporate training: building workplace learning and performance initiatives that advance. new york: amacom. skinner, b.f. (1938), the behaviour of organisms: an experimental analysis. new york: appleton-century-crofts. watson, j.b. (1930), behaviourism. chicago: university of chicago press. yin, r.k. (2003), case study research: design and methods. 3rd ed. thousand oaks, ca: sage publications. . international journal of economics and financial issues | vol 6 • special issue (s8) • 2016240 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s8) 240-244. special issue for “fundamental and applied research in economics and management: new perspectives” psychological aspects of management and economics of higher education maria p. glyzina1, andrey d. telesh2*, safura s. muradova3, anatoly i. chernykh4, vitaly m. smolentsev5, elvira v. koroleva6 1don state technical university, rostov-on-don, russian federation, 2polytechnic institute (branch) of the don state technical university, taganrog, russian federation, 3southern university (institute of management, business and law), rostov-on-don, russian federation, 4kuban state technological university, krasnodar, russian federation, 5kuban state agrarian university, russian federation, 6vladivostok state university of economics and service, vladivostok, russian federation. *email: tagpolitech@gmail.com abstract this paper considers the idea that the creative productivity of and psychological basis for achieving high results is expressed in general abilities, creativity, optimism, belief in success and motivation in all social spheres. management education is crucial for the formation of future professionals in all areas of public life. the article contains analysis of development of new progressive models of management education which should combine the basic types of controls: administrative (command) and motivational management, project management and process management. to control dynamics, which was considered more “progressive,” there are two problems. the first is the problem of the relation of design (innovation) and process (recurring) activities, the other activities of education authorities, particularly at the municipal level, a significant proportion of time and energy which is the current routine functions the payment of salaries to employees of educational institutions, etc. in the modernization models of management education need to move from the traditional use of two control mechanisms planning (many “activities”), and pervasive control for the full set (cycle) mechanisms, such as: analysis of current state controlled educational system, the forecast of development of the education system, goal setting, scheduling development tasks, providing resources, monitoring the development of the educational system, which is the essence of operational management. keywords: higher education, psychology, management of education, modernization of education, economic education jel classifications: a20, a29, i21, i29 1. introduction what helps and what hinders a person to achieve success; can you talk about the psychological key to the success of the psychological barriers to success? the answers to these questions require a survey of those personal qualities that demonstrate people who achieve success. a number of works suggests that the creative productivity of and psychological basis for achieving high results is expressed in general abilities, creativity, optimism, belief in success and motivation. it is a high achievement motivation, will to succeed will determine the actual results of the activities successful people. the need for modern organizations to respond flexibly to the demands of the competitive environment, the transition to the knowledge economy, increased competition for the speed of business processes, development of online communities has led to the fact that the management in organizations was based on the team approach, i.e. to use as the basic unit of control is not a major labor groups or individual employees and management and project teams. at the same time the management has been understood primarily as a change management, and the main efforts of the heads moved from vertical to horizontal relationships. today the interest of psychologists actively manifested in relation to problems of organization, team interaction, improving the performance of teams, optimizing their development, technology team building, developing a new model of leadership based on the principle of command and not individual leadership. currently glyzina, et al.: psychological aspects of management and economics of higher education international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 241 one of the dominant models of professional activity of senior and middle rank is the joint management activities (jma) involving several senior management functions related to the regulation of intergroup interaction led by their structural units and/or organizational subsystems. for each head part in cooperation with other managers work as a very broad and diverse “functional load” expressed a special role position manager “partner for jma” (bondarevskaya, 2004). building an effective system of socially-psychological training of managers as subjects jma is impossible without an adequate understanding of how this aspect of managerial activities is reflected in the professional consciousness of managers, what place it occupies in the structure of their “basic ideas.” in the development of new progressive models of education management must find the optimal combination of types of controls: • administrative (command) and motivational management (control, motivating participants in the educational process to perform the required action, for example, through forms of material and moral incentives); • project management (management in dynamics managing change in the system of innovative activity, etc.) and process management (management of the operation “static” a regular, repetitive activity under constant external conditions). to control dynamics, which was considered more “progressive,” there are two problems. the first is the problem of the relation of design (innovation) and process (recurring) activities. this problem is very simple. if, say, the entire education system (municipal, regional, etc.) is entirely immersed in an innovative mode, then it will obviously complete chaos. and, in particular, for the 200 years of activity of the ministry of education (education) in russia in the education system was held on 26 reforms?! too often (barsukova, 2010). on the other hand, in the activities of education authorities, particularly at the municipal level, a significant proportion of time and energy is the current routine functions the payment of salaries to employees of educational institutions, etc. 2. literature review the analysis of literary sources showed that in recent years a number of studies in the field of economic education and management education in the following areas: • create models of the organization of the process of economic education in higher secondary schools (andreev, 2005); • orientation of youth in the economic professions; • training of future specialists of economic profile in the system of higher and secondary education; • personal development specialist in the sphere of economy. based on the analysis of literature sources and work experience in the field of management education, we can conclude that it is based on the idea of having to design such pedagogical conditions of learning in which the content of the educational process would be focused on the development of professionally significant qualities of the personality of the future specialist: competence, responsibility, mobility, flexibility, adaptability, competitiveness. 3. materials and methods in the modernization models of management education need to move from the traditional use of two control mechanisms planning (many “activities”), and pervasive control for the full set (cycle) mechanisms (novikov et al., 2016), such as: analysis of current state controlled educational system needed to produce the “reference point” against which will be measured the development of the system subject to control actions or otherwise. a comparison of the current system state with the views that reflect her “perfect condition” allows a first approximation to assess the current effectiveness of its functioning. the forecast for the development of educational system, conducted without regard to the possible control actions, allows you to judge what will be the dynamics of the educational system and how it will be disposed of or to approach the “ideal state,” if not to take further action (andropova, 2004). goal setting implies the formulation of common goals of development, as well as performance criteria that reflect compliance with present and/or future state of the educational system the goals of its development. in the planning phase is the definition of a set of development goals actions, events, etc. that will allow you to reach or get as close as possible to the goals in the existing or forecast conditions. the defined planning set of actions requires appropriate resourcing, including motivational, financial, personnel, information and other resources (see transfer of resource provision above), which is one of providing control functions in development of the educational system. control over the development of the educational system is the constant monitoring for changes to the system caused by control actions taken in accordance with the plan, and to identify deviations from the plan. since the development of the educational system is continuous (in time) process, as new information becomes available (resulting from the implementation of control functions) on the challenges of development may need further corrective action, which is the essence of operational management. as you complete each of the planned stages of development of the educational system for the successful implementation of the next steps necessary to analyze the changes, summarizing the experience of development, which should be used when developing strategy and tactics for the future management of the educational system. the analysis of the sources generally showed the necessity of transferring the entire system of education management on a modern footing. 4. results and discussion for the management of modern education on macro and micro level is extremely important is to master the skills students absorb knowledge and process information with the new information and computer technologies. the results of the experiment showed glyzina, et al.: psychological aspects of management and economics of higher education international journal of economics and financial issues | vol 6 • special issue (s8) • 2016242 that the level of formation of key components of the information technology competence of students managers is still at a high enough level. such as information technology training of students negatively affects the quality as general professional and special training, is not conducive to successful mastering of disciplines of economic cycle. therefore, it is necessary to create in the educational process of the system of conditions for the formation of key information technology competencies, which we presented in didactic, organizational, pedagogical and psycho-pedagogical. the results of the formative experiment the following was done: 1. established methods for the determination of levels of formation of key information technology competence of students-managers; 2. revealed the original quality level of formation of key information technology competencies; 3. identified educational goals stages of learning; 4. established the structure of the subject content of professional courses in economics. methods of diagnostics of educational process based on data about structure of core competencies: substantive-evaluative, motivational and strong-willed, socio-cultural and professionalpersonal components. to methods for “measuring” the study of the signs we carried the following (azarova, 2004; 2009; novikov et al., 2015): individual and collective interviews; observation of work of students in lectures and practical classes; surveys; review and analysis of case studies; observation of activities of students in creating non-standard situations; for student work in the team; computer testing of students and the analysis of its results. methods of diagnosis of process of formation of key information technology competencies at three stages of development are shown in tables 1-3. qualittive characteristics of the stages of development of key competences of future managers in conjunction with selected signs, these components allowed us to obtain more reliable information about the actual state of the process of formation of key information technology competencies. methods of diagnosis we need the measurement tool by which you can objectively assess the dynamics of the learning process. the evaluation activities of the students expressed the qualitative characteristics. one of them is “education,” reflecting the student’s ability to operate with knowledge and skills to solve theoretical and practical professional tasks. data on students achieving a certain level of formation of key competences provide a meaningful choice of further ways of learning, differentiation and individualization of the learning process. the process of formation of key information technology competencies was to compare the levels of proficiency of individual students and in fixing the achieving (or not achieving) each student a certain level of formation of a component of key information technology competencies. the main purpose of the formation of key information technology competencies of students at the first stage was the assimilation of basic knowledge and skills required to adapt to the learning environment (belousova, 2010; rylov et al., 2016). meaningful evaluation component of professional economic competence at the first stage was characterized by the mastery of the skills students absorb knowledge and process information with the new information and computer technologies (shkurkin et al., 2016). the conscious motivation for learning helped students to develop independence in finding the right knowledge, formed the skills to use information systems computer technology. the formation of the socio-cultural component contributed to intellectual development, interdisciplinary synthesis of the subjectively new knowledge on the basis of economic and information technology knowledge. developed the need for continuous updating of knowledge, accumulated experience of getting new interdisciplinary knowledge formed the communication skills of the students. the use of an educational-methodical complex at this stage (lecture notes, the content of laboratory and practical trainings, methodological guidelines) contributed to the systematization of economic knowledge, formation of understanding of economic laws and economic transformation processes taking place in our country. studied theoretical material was reinforced when the practical and laboratory tasks developed by teachers taking into account the principle of independence and individualization of learning. the tasks were designed to test not only formal knowledge but also skills and skills of the students. analyzing the data obtained, the students were able to design their own actions that contributed to the development of thinking skills, memory, logical thinking, develop practical skills and demonstrate independence (belousova, 2010; kobersy et al., 2016). practical tasks allow you to see the relationship between the studied items and the ability to apply the acquired knowledge in professional economic activity. the use of computer laboratory and practical base allowed the students table 1: methods of diagnosis of process of formation of key information technology competencies at the first stage personality manifestation methods of diagnosis mastering the skills to update knowledge. the perception of information and assimilation of knowledge using information technology know how to organize knowledge, solve problems with a computer computer testing, interviews, surveys; monitoring the activity of students in the discussion of the basic professional concepts the conscious urge to assimilate knowledge able to find necessary knowledge individual interviews, written and oral surveys, questionnaires awareness of the project and educational activities as a means of intellectual development synthesize knowledge, create models and explore them observation, interviews, computer testing the need for continuous updating of knowledge, development of communicative acquire new knowledge practical assignments, observation of the conduct of the search activity of the student glyzina, et al.: psychological aspects of management and economics of higher education international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 243 to form the necessary professional skills as a condition for the successful formation of key information technology competencies. at the end of the first stage of training was defined the level of formation of personal qualities of students required for professional competence development, the results are presented in table 2. these data were compared with the results obtained at the beginning of training. it can be stated that the level of forded key information technology competencies at the first stage in the group increased. the results of this study it can be concluded that most students had strong interest in obtaining modern professional economic knowledge. the manifestation of cognitive abilities of students at this stage of the research was expressed in the motivation to acquire new knowledge, increased interest in the study of economic and information technology disciplines. observing students in different learning environments has shown that learning occurs in learners according to their individual characteristics and interests. the formation of a meaningful evaluation component of the information-technological competence promotes the development of students such qualities as independence, persistence, responsibility, activity. reaching the first level of forded key information technology competencies, students recognize the connection of the study material with practical activities, the role of computer technology in the search for new knowledge, which is a means of selfrealization and self-affirmation. the analysis allowed to identify that the formation of key information technology competencies in the process of educational activities in the first stage, their level of education increased. it encourages trainees to improve their knowledge and needs in the development of new. in the learning process we developed a system of tests of achievements, allowing to control the quality of information technology training of students-managers. 5. conclusion project training activities contributed to the assimilation of new professional knowledge, the mastery of rational methods of work, development of skills in the use of information technology. in the process of learning the students acquired practical skills, learned to use computer technology and programs to acquire new knowledge. the students developed the desire to defend their point of view, there is a responsibility for the results of their work. especially it was necessary to stimulate in the students the desire to seek unconventional approaches to the solution of professional economic and managerial tasks, mastery of the techniques of modeling and solution of applied problems. it took to form the belief that “obtaining” new knowledge is one of the important functions of intellectual activity, to guide them in the practical table 2: methods of diagnosis of process of formation of key information technology competencies at the second stage personality manifestation methods of diagnosis the ability to use acquired knowledge in practice, improve the perception and updating of knowledge, development of cognitive abilities independently find the necessary knowledge and research tasks using a computer practical tasks, observation of work of students the ability to focus on the tasks at hand, the solution in their practice analyze the knowledge and apply them in practice computer testing, individual interviews a manifestation determination, responsibility, practicality understand the role of knowledge for development of creative thinking interviews, analysis of listeners’ questions, observation of collective work of students adaptability, competitiveness, self-improvement in applying knowledge in professional activities techniques of computer collecting and storing information independently and find the optimal solution to the task observation of the conduct of search activities when making decisions on practical tasks on the basis of independently obtained information table 3: methods of diagnosis of process of formation of key information technology competencies in the third stage personality manifestation methods of diagnosis mastering skills of creative application of knowledge, the active reproduction of knowledge and skills in practice synthesize and analyze new knowledge, possess the methods of independent work practical exercises, observation of collective work of students, creating situations that require teamwork the development of motives for non-standard creative approach in the application of knowledge understand the role of knowledge in the development of creative thinking. can use the knowledge to find creative solution of professional problems individual interviews, express interviews, practical tasks mastering skills of creative application of knowledge using computer technologies, identity know how to use information and computer technology in the search for new knowledge, to independently find solutions to different production situations monitoring the search activity of students, the preparation of messages using the information received via the network creative approach in their professional activities, competence own creative methods of independent work, possess a predictive design method, know how to analyze situations and find optimal solutions to professional problems observation, interviews, questionnaires glyzina, et al.: psychological aspects of management and economics of higher education international journal of economics and financial issues | vol 6 • special issue (s8) • 2016244 application of information technology. the implementation of the objectives of the second phase is reflected in the change in the content of didactic complex as a primary means of organization of educational process of the polytechnic college. didactic support included in addition to lectures, a set of practical tasks with increasing levels of complexity, the system of independent works, use of media, allowing implementing the principle of independence and individualization of learning. a set of case studies allowed to solve tasks of varying difficulty based on individual mastery of the material. controls included control tasks, allowing estimating the degree of assimilation of the studied material, computer-based tests on the research issues, as well as controlling practical tasks. didactic potential of such learning tasks allows you to organize creative activities. at the beginning of the second stage and after it was determined the level of achievement of students. transition from one level to another was accompanied by changes in cognitive abilities of students, memory, developed creative thinking, communication skills, adaptability, and competitiveness. this indicated the approach to the goal the formation of key information technology competencies in the process of educational activity. reaching the first level of forded key information technology competencies, students recognize the connection of the study material with practical activities, the role of computer technology in the search for new knowledge, which is a means of selfrealization and self-affirmation. references andreev, a. 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(2016), re-engineering as the process of business adaptations. international journal of economics and financial issues, 6(1s), 126-132. rylov, d.v., shkurkin, d.v., borisova, a.a. (2016), estimation of the probability of default of corporate borrowers. international journal of economics and financial issues, 6(1s), 63-67. shkurkin, d.v., ryazantsev, s.v., gusakov, n.p., andronova, i.v., bolgova, v.v. (2016), the republic of kazakhstan in the system of international regional integration associations. international review of management and marketing, 6(6), 174-179. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 243-248. international journal of economics and financial issues | vol 7 • issue 2 • 2017 243 research gap of entrepreneurship, innovation, economic development, business incubators studies in indonesia lina gozali1*, maslin masrom2, habibah norehan haron3, teuku yuri m zagloel4 1department of industrial engineering, faculty of engineering, universitas tarumanagara, jl. s parman no 1, jakarta, 11440, indonesia, 2razak school of engineering and advanced technology, universiti teknologi malaysia, jalan sultanyahya petra, 54100, kuala lumpur, malaysia, 3razak school of engineering and advanced technology, universiti teknologi malaysia, jalan sultanyahya petra, 54100, kuala lumpur, malaysia, 4department of industrial engineering, faculty of engineering, university of indonesia, kampus ui, depok, 16424, west java, indonesia. *email: ligoz@ymail.com abstract in many developed countries, many business incubators (bi) take part to help starts-up company to develop their own business; especially the baby born business cannot compete with the giant industries that have been the old business player. universities play an important role in motivating young graduates to become technology entrepreneur. unemployment in indonesia is still the main issue for the government program to increase welfare in the future. in year 2014 the data from statistic center of indonesia state that indonesia has 4% unemployment from indonesia’ work generation. in indonesia, incubators has been developed since 1992 initiated by the government, cooperative department and also universities. the aim of this paper will determined the gap among some research and studies about entrepreneurship, innovation, economic development and bi in indonesia. for the methodology of this paper will be described by comparison literature study, so in the future research could give contribution to blank area of study. keywords: innovation and creative, economic development, framework, business incubator, indonesia jel classifications: economic development, innovation, technological change, and growth 1. introduction in many developed countries, many business incubators (bi) take part to help starts-up to develop their own business, especially the baby born business cannot compete with the giant industries that have been the old business player. it is widely accepted that the first incubator was created by joseph mancuso in batavia, new york, in 1957 on a former massey-ferguson facility (leblebici and shah, 2004). such as in 1959, united states government wanted to develop small and medium enterprises (smes), create new jobs, pull economy out of depression by subsidizing academics and individuals to integrate existing resources to supply what smes needed at the beginning (wen et al., 2012). from the 1970s onward, bi have spread out all over the world (albert and gaynor, 2001). estimates indicate that today their number worldwide rises to 3000: one-third is located in north america; 30% in western europe and the rest is dispersed over the far east (20%), south america (7%), eastern europe (5%) and africa, the middle east and other regions (5%) (european commission, 2002). the first chinese incubator was started in 1987 in wuhan, hubei province by minister of science and technology (yan, 2003). as china embarked on the gradualist path to a market economy, bi became a key tool in chinese government’s economic development strategy in the mid and late 1990s. at that time, a primary strategy of the chinese government for fostering the sustainable high growth of its economy was to promote a range of high-tech industries (xu, 2001). in january of 1995, taiwan’s small and medium enterprise agency (smea) of ministry of economic affairs was assigned to launch sme incubation policy as one of the moves under the macro policy of “asia pacific operation center.” half a year later, smea assigned institute of management of technology of national chiao tung university to complete the “planning report for sme incubator center.” gozali, et al.: research gap of entrepreneurship, innovation, economic development, business incubators studies in indonesia international journal of economics and financial issues | vol 7 • issue 2 • 2017244 in german, boom of technology and incubator centers that started in the 1980s and the spread to austria (todtling and todtling-schonhofer, 1990; stenberg et al., 1996, galley, 1997) and united kingdom monck et al. in 1988; massey et al. 1992; westhead and storey, 1994. and in swiss, there was only a discussion about the necessity of an explicit technology policy in the beginning of the 1990s, but with almost no results (thierstein and wilhelm, 2001). the aim of this paper will determined the gap among some research and studies about entrepreneurship, innovation, economic development and bi in indonesia. 2. literature study a bi is an organization that provides physical space and support programs for entrepreneurs or early stage start ups to deal with difficulties in the initial stage (mian, 1996; smilor, 1987; smilor and gill; 1986). advantages of business incubation in general instead of starting from scratch, smes and start-ups benefit from the bi’s knowledge and networking that help young companies to succeed more quickly. in summary the bi client can expect faster sales, smarter growth, fewer mistakes, less costs, and overcome market failures. young business face specific risks; they lack information and business skills despite good business ideas, market orientation, marketing skills, and knowledge on accounting and book keeping. the incubator approach wants to help the entrepreneur to overcome these risks and to support the realization of promising business ideas through specific services. a bi is as we defined earlier setup “to reduce the chances of failure in early stage companies and result in the financial viability and growth of firms that it supports.” therefore incubators in india are setup to create sustainable and strong entrepreneur support infrastructure to enable young technology inventors and entrepreneurs to find the necessary support and access to resources to build successful start-ups. the heart of an incubator therefore, is the start-up. the success of bi and technology parks in university settings is often determined by how well technology is transferred from the labs to their startup firms. university technology transfer offices (uttos) function as “technology intermediaries” in fulfilling this role. yet, entrepreneurship theory and research on the role of the utto in business incubation and new venture formation is sparse. to move the research along, we use grounded theory to build a framework to address two questions: (a) which uttos’ structures and licensing strategies are most conducive to new venture formation; and (b) how are the various uttos’ structures and licensing strategies correlated with each other. our findings reveal a complex set of relationships between utto structure and strategies, new venture formation, and business incubation (markman et al., 2005). universities play an important role in motivating young graduates to become technology entrepreneur (te). the increasing number of graduate entrepreneurs will reduce the unemployment rate and even will increase the number of field work. many developing countries have experimented with a variety of programs and schemes supporting smes, often with assistance from multilateral and bilateral organizations. business incubation programs or initiatives have arisen especially over the last decade, with varying degrees of success (manan and yunos, 2001). bi is an organization that systemize the process of creating successful new enterprise by providing them with a comprehensive and integrated range of services. both in developed and developing countries, governments have been playing a key role in defining policies, programs and instruments which support the development of micro, smes. the need to build a public university bi is the startup companies cannot compete or survive with the giant industries. the second reason is many of them failed and cannot built their company sustainability. 2.1. bi in indonesia indonesian government put high attention in developing te among young graduates from all universities in indonesia. therefore every university in indonesia was encouraged to have their own bi that could provide entrepreneurial activities and to facilitate the development of invention and innovation among potential student to become real te. in indonesia, the change can be seen from two contradictive sides, as an opportunity and as a threat. looking at the ability indonesia possesses, one possible positive change can be seen in middle sized and small industries. in indonesia, incubators has been developed since 1992 initiated by the government, cooperative department and also universities. this effort continued in 1997 when there was a program called the development of entrepreneurship culture in universities and of its activity was new entrepreneur incubator. up till now in year 2012 there are 23 incubators which still in operation. most of bi in indonesia was established by universities (72%), which the rest was established by private sector (21%) and government institution (7%) (bank indonesia, 2006). unemployment in indonesia is still the main issue for the government program to increase welfare in the future. in year 2014 statistic center of indonesia states that “indonesia has 4% unemployment from indonesia” work generation, and indonesia still has 11.5% people in poverty of economic condition. in supporting government program to reduce the number of poor people, entrepreneurship project in many universities hope can be one of the solutions to reduce poverty. according to bank indonesia, factors that make the development of incubators in indonesia decreased among others are: • limitation of operational facilities that causes the low rate of in wall tenants absorption ability. • the lack of seed capital support that makes incubator not professionally handled and there are significant numbers of in wall tenants that cannot obtain seed capital even though their business is feasible. • commitment and government support is relatively lacking and inconsistent in developing incubators. gozali, et al.: research gap of entrepreneurship, innovation, economic development, business incubators studies in indonesia international journal of economics and financial issues | vol 7 • issue 2 • 2017 245 in indonesia, cooperative department and small enterprises (1998/1999) and the ministry of cooperative and smes of indonesia (menteri negara koperasi dan usaha kecil dan menengah republik indonesia, 2002) stated that the basic concept of incubator is an institution that provides 7’s: • space • shared office facilities • service which is a management counseling: marketing, finance, production, technology and others • support in terms of business research and development as well as access of technology usage • skill development which is training, business plan formulation, management training and others • seed capital and the effort to gain capital access to financial institution • synergy which is creating an adequate business network, local and international. nowadays, indonesian government put high attention in developing te among young graduates from all universities in indonesia. 23 incubator (2012) which still in operation. most of bi in indonesia was established by universities (72%), which the rest was established by private sector (21%) and government institution (7%), (bank indonesia, 2006). 3. comparison study and research gap 3.1. research of entrepreneurial university, role, partnership and mapping in indonesia meliala (2004) research title is bi as an important element in establishing the entrepreneurial university (case study): the bi center bandung, institute of technology. research purpose to explore current practices of entrepreneurial university in bandung institute of technology (itb) indonesia. the result of this literature study research that itb bi will support the entrepreneurial university by: facilitating the implementation of technology, building innovative and ethnical enterprises, improving expertise and facilities utilization. moeliodihardjo et al. (2012) research title is university, industry, and government partnership: its present and future challenges in indonesia. the purpose of this literature study and research to presents the current situation of the university–industry– government partnership in indonesia, in the context of university readiness to contribute to the government strategy as outlined in the mp3ei (master plan for acceleration and expansion of indonesia economic development) 2011-2025. and the result obtained that government, universities, and industries are still in their respective institutional spheres in indonesia, and a strong commitment, indications that the overall level of commitment to r&d may be low. mirzanti et al. (2015) research title is mapping on entrepreneurship policy in indonesia. to define the mapping of entrepreneurship policy in indonesia. the current research addresses research questions, namely the objectives of entrepreneurship policy; categories of entrepreneurship policy in different units of analysis; and entrepreneurship policy programs. an exploratory qualitative descriptive research design is used in this study. the analysis is conducted within the principles of categorization of entrepreneurship policy content. as shown in table 1, the study uses documentation reading technique, which identifies and categorizes policies related to entrepreneurship in the order. the categorization is based on keywords from entrepreneurship research framework which differentiate the unit of analysis (macro and micro level) and policy stage as well (agenda setting, formulation, and implementation stage). an exploratory qualitative descriptive research design is used in this study. the analysis is conducted within the principles of categorization of entrepreneurship policy content. as shown in table 1, the study uses documentation reading technique, which identifies and categorizes policies related to entrepreneurship in the order. the categorization is based on keywords from entrepreneurship research framework which differentiate the unit of analysis (macro and micro level) and policy stage as well (agenda setting, formulation, and implementation stage). until the final research, the government programs that have been identified and associated with entrepreneurship, there were 12 bi, soft loan (kur), etc. 3.2. research about success factor of bi in indonesia studies hutabarat and dina (2012) research title is success factor for bi in creating successful startup firms. the purpose of research is developing a new process model for new bi in indonesia. this research underlying attributes of successful new venture development in an incubator environment, the bi should focus on the process of incubation rather than on the incubator facility and its design. the methodology are as below: (1) investigating the incubation process in indonesia by conducting qualitative research. (2) benchmarking the incubation process in indonesia with hacket and dilts incubation process model. (3) finding the best practice in indonesia by conducting qualitative research. (4) developing a new appropriate business incubation process model for indonesian bi. the research are still in progress and has no conclusion yet. gozali et al. (2015) research title is critical success factor of successful e-bi framework in indonesia public universities. objectives of this research are: (1) determine the critical success factors in creating the successful e-business incubation for indonesian public universities, (2) investigate the incubation process in indonesia, (3) propose and develop a new appropriate e-business incubation process framework for public universities in indonesia. research methodology framework for some public universities in indonesia. the research methodology finding the best framework for e-bi in indonesia public universities. and for this paper has not given the final conclusion yet. 3.3. research about bi framework and model in indonesia studies dhewanto et al. (2012) research title is moderating effect of cluster on firm’s innovation capability and business performance: a conceptual framework. this paper tries to conceive a conceptual framework for analyzing cluster effect on firm’s innovation capability and firm’s business performance. the gozali, et al.: research gap of entrepreneurship, innovation, economic development, business incubators studies in indonesia international journal of economics and financial issues | vol 7 • issue 2 • 2017246 methodology of this research are using analytical hierarchical process they construct the index as a proxy to of internal innovation capability of firms. every factor is considered as first layer factors and each has its own sub-factors. technological factor consists of (a) ratio of r&d expenditure to sales; (b) possession of intellectual property rights; and (c) technical and management system. managerial organizations consists of three sub-factors: (d) practicing qc circle; (e) cross-functional team; and (f) sharing information. whereas human resources consists of (g) degrees of top management; (h) attitudes toward communication of top management; and (i) degree of employees. therefore we would like to make hypotheses as follows: h1: technological factors have positive effect on firm’s innovation capability. h2: managerial organization has positive effect on firm’s innovation capability. h3: human resources have positive effect on firm’s innovation capability. the result of this research, the conceptual framework in this paper needs “no “empirical research to test the hypotheses. from our perspective, this paper is a preliminary work before the survey to the information communication technology (ict) companies within the ict clusters in west java province, indonesia. payumo et al. (2014), research title is an entrepreneurial, research-based university model focused on intellectual property management for economic development in emerging economies: the case of bogor agricultural university, indonesia. the purpose of this research to provide strategic model to maximize university research outputs, knowledge transfer and innovation to empower regional communities, and promote strategic and transformational partnerships, private sector engagement and economic growth opportunities for both the institution and the region. the result of literature study research obtain strategies and lessons learned from ipb in its goal of becoming an entrepreneurial, research-based university – an emerging model for higher-education institutions in emerging economies to better interface core missions in education and research with societal benefits. coyanda (2013) the research title is the framework for te development through incubation process in universities in indonesia. the objective of this research to propose the framework for te development through incubation process in universities in indonesia. for this research, the study employed qualitative methods research design. the sample was chosen based judgment sampling technique. qualitative data were obtained through face to face in depth interviews with the key information from selected universities in indonesia and malaysia, industries and indonesian government. on top of that, the authors were also employed document review to strengthen and support the research finding. the result of this studies that the proposed main factor consist of four key main factors such as: student, internal environment and external environment, the policy maker and university. 3.4. research of bi for creative and innovative economic development in indonesia supriyadi (2012) research title is local economic development (led) and triple helix: lesson learned from role of universities in higher education town of jatinangor, west java, indonesia. the purpose to describe the terms of role universities play in led program, forms and mechanisms of interaction the triple helix in program of led, as well as the positive impact the university’s role in led that can support regional development planning that is sensitive and responsive to the needs of local communities. this study used a qualitative approach to seeking the truth through discovery of the essence of something, to put a human as research instrument that is responsive and adaptive. conducted participant observation approach, the researcher is directly involved as active agents and sources of information, participate actively participating in learning process directly, or table 1: research gap of business incubator studies in indonesia description authors janita zoel dina dhewanto moelio dihardjo supriyadi john rudito payumo hutabarat isti herliana mary-unani lina business incubator x x x x x entrepreneurial ent univ bi innovation part-nership eco dev ict eco dev research based capacity mapping innovation creative bi success factor of bi x x framework x x x x indonesian society x x x x x x x x literature study x x x x higher education x x x public university x (itb) x x x (ipb) x quantitative/ qualitative analysis quali ahp quali quali quali quali quan quali quali quan quali quan ent univ: entrepreneur university, eco dev: economic development, ict: information communication technology, ahp: analytical hierarchy process, quali: qualitative method, quan: quantitative method, itb: institute technology of bandung, ipb: agricultural institute of bogor, bi: business incubator gozali, et al.: research gap of entrepreneurship, innovation, economic development, business incubators studies in indonesia international journal of economics and financial issues | vol 7 • issue 2 • 2017 247 be passive recipients of information, as well as melting together researchers in the research process as an insider and outsider simultaneously. case study approach is expected to unveil and explore the phenomenon and context that includes a focus on the role of universities in led. the result of this research that success of local initiatives be determined by joint efforts of the community, government, business, and academia in developing innovative solutions to address local socio-economic problems. rudito (2014), research title is the improvement of community economy as impact of corporate social responsibility program: a case study in pengalengan, bandung, west java, indonesia. the purpose of adescribed a successful and innovative collaboration between private sector and community through a corporate social responsibility (csr) program that integrated local culture and ideas in the implementation. this study is an ethnography study. it maps the social condition in the community studied to gain the proper perspective how the people behave and proposed a model of csr program for a company (start energy) addressed to local community in which operate. generally, this model approach in three ways. first, social mapping through interview and participative observation was conducted around a month. the number of respondents of this study was more than 25 people included local authorities, local informal leaders and local people. second, social networking analysis through observation and interview was conducted around four to 6 months. this approach is to understand the model of connectivity and relationship among members in the community. third, focus group discussion approach is to confirm the social mapping finding and was conducted twice involving 12 participants. the result of this study has proved, using cultural approach as main method to propose a suitable csr program through community development and indicating a positive change in the targeted community both intern of economic and also value orientation that bring the community to sustainability growth. hutabarat and pandin (2014), research titile absorptive capacity of business incubator for sme’s rural community located in indonesia’s village. to propose is bi that already successful work in develop country. therefore this study combines quantitative and qualitative approaches (gilbert, 1992), which involves a complex research design, usually with stages of research that may iterate (danemark et al., 2002), such as this research. by combining the methods, the study experts to reach a more comprehensive, nuanced understanding of the implementation of absorptive capacity in village based bi, the experience and the ways the organization adopt and use and manage innovation to meet their strategic need. through a combination of methods, this research is in a position to elucidate these processes as this approach prevent it from missing complementary picture provided by either method. the result the model through a combination of methods, this research is in a position to elucidate these processes as this approach prevent it from missing complementary picture provided by either method. herliana (2015) research title is regional innovation cluster for sme: a triple helix concept. the objective of the paper to know: (1) factors that contribute to the growth of sme cluster. (2) how regional innovation clusters to promote growth of smes. (3) how role of abg to enhancing business growth of smes. the research method is the case study method with the unit of analysis is the industrial cluster of food in west java. industrial clusters foods represent clusters formed due to historical factors. research technique used is a combination of qualitative and quantitative data required the qualitative and quantitative data in the form of primary data and secondary data. the primary data is searchable by a variety of ways: in-depth interviews (in depth interviews), observation, secondary data was obtained by collecting documents and literature. the analysis technique used is descriptive analysis of qualitative/narrative. result of this research prove the role of the academic, business and government are: (1) improved business insight. (2) facilitate the provision of raw materials. (3) increase knowledge of technology. (4) technology of production. (5) information technology. (6) facilitate marketing of products. maryunani and mirzanti (2015) research title is the development of entrepreneurship in creative industries with reference to bandung as a creative city. this paper on two general questions, namely on how to develop entrepreneurship in the creative industries in bandung and how local characters (e.g. quality of life and the education system) of bandung will impact the development? this literature study result that bandung as a city in indonesia can be considered as a creative city. from education institution’s perspective, bandung is known as an education city, there are a lot of school or education institutions here in bandung with various subjects from technology, information, science, and management. some of those are also offer entrepreneurship course. the description of all research gap from all of this study can be found in table 1. the main group of research gap division consist of bi, entrepreneurship, success factor of bi, framework, indonesian society, literature study, higher education, public university, qualitative and quantitative analysis. 4. research and discussion after studying all the related papers the picture of research gap is available in table 1. from the main group of bi only five papers done this research on, from the group of entrepreneurship all of the research mention about entrepreneurship, from the group of bi just 2 papers mention about the bi, 4 papers study to create framework, 8 papers study area in indonesia society, 4 papers study in literature study method, 4 papers in higher education 5 papers study about entrepreneurship in public university. mostly all of the papers’s methodology in qualitative analysis and just 3 papers in mix model analysis. for the future research the study will concentrate in successful factor of bi framework in public university in indonesia. references albert, p., gaynor, l. 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(1996), the university business incubator: a strategy for developing new research/technology-based firms. the journal of high technology management research, 7(2), 191-208. mirzanti, i.r., simatupang, t.m., larso, d. (2015), mapping on entrepreneurship policy in indonesia. procedia-social and behavioral sciences, 169, 346-353. moeliodihardjo, b.y., soemardi, b.w., brodjonegoro, s.s., hatakenaka, s. (2012), university, industry, and government partnership: its present and future challenges in indonesia. procedia-social and behavioural sciences, 52, 307-316. monck, c.s.p., porter, r.b., quintas, p., storey, d.j., wynarczyk, p. (1988), science park and the growth of high technology firms (london: croom helm). payumo, j.g., arasu, p., fauzi, a.m., siregar, i.z., noviana, d. 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(2001), preface. in: zhang, j., editor. chinese science and technology incubators: case study and development strategies. beijing, china: scientific and technical documents publishing house. p1-3. yan, z. (2003), the development history of science and technology incubators in china. in: zhao, y. editors. a report on the development of science and technology incubators in china. xiamen, china: xiamen university press. p3-9. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2023, 13(1), 89-101. international journal of economics and financial issues | vol 13 • issue 1 • 2023 89 real exchange rate of moroccan currency: appreciated or depreciated? mohammed amine lezar* senior expert, arab planning institute, p.o. box 5834 safat 13059, state of kuwait. *email: mlezar@api.org.kw received: 27 september 2022 accepted: 18 december 2022 doi: https://doi.org/10.32479/ijefi.13747 abstract in this paper, we measure and evaluate the real parity of the moroccan dirham during the period 1980-2020. the objective is to highlight the evolution of the real exchange rate of the dirham, and in particular to show if whether it has been overvalued against currencies of the main trading partners and competitors of morocco. contrary to many studies which used a simple method to calculate the real parity which consisted of assigning each country of the main trading partners a relative weight equivalent to its share in morocco’s external trade, we calculate the weights by combining both bilateral import weights and a double weighting for export to reflect both importance of each country in morocco’s import and export as well as the degree of competition of exporters in usual third markets. calculation of real parity of the dirham reveals three main periods: a strong depreciation during 1980-1990; an appreciation during the period 1991-2000; and a resumption of a weaker depreciation for the last period 2001-2020. these trends are related to both changes in nominal effective exchange rate and in relative prices. results obtained in the present paper are generally close to those calculated by the international monetary fund for morocco and are strongly correlated with them and the trends in both remain the same. keywords: real exchange rate, appreciation, moroccan dirham jel classifications: f31, f33 1. introduction generally defined as the value of one currency in terms of another, the exchange rate has always been the subject of debate among many economic experts, academics and monetary policymakers. interest in this topic was at the center of abundant literature that tried to explain the determination of the exchange rate as well as its influence on the whole economy, particularly the foreign trade competitiveness. one of the primary reasons for the significance of the exchange rate is its importance as a macroeconomic policy variable. exchange rate management, as an economic policy tool, aims to boost a country’s competitiveness and economic development (karakostas, 2021). a currency’s exchange rate, expressed in nominal terms, does not reflect the level of its purchasing power, and much less the degree of competitiveness of an economy. rather, the real level of the exchange rate is the relevant one. this is because it accounts for evolution in nominal parity, variations in prices and production costs in one country compared to those of the trading partners or competitors. it shows how changes in country’s exchange rates and prices influence its competitive position internationally. an appreciation of the real exchange rate is associated with a loss of competitiveness. in morocco, the appropriate level of the dirham’s exchange rate and its real parity have always been at the center of economic debate. certain economic actors find that the exchange rate policy adopted by the country is penalizing exporters. some economists believe that significant appreciation in the real exchange rate occurred at the end of the 1990 s what involved a weakening of competitiveness of the exposed sectors (bouoiyour and marimoutou, 2005). this journal is licensed under a creative commons attribution 4.0 international license lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 202390 precisely, the general confederation of moroccan enterprises (cgem)1 considers that the real exchange rate of the dirham has appreciated over the years, which has led to a loss of market share at the international level. the clothing industry association (amith) considers that morocco’s real exchange rate appreciated considerably against some asian competitors in morocco’s clothing sector2 such as vietnam, cambodia, bangladesh and middle eastern countries, such as egypt, that sell their products in the same markets as morocco. this real appreciation resulted after real devaluations adopted by these countries (agenor and el aynaoui, 2015). according to the amith “the return to the normal level of the dirham’s exchange rates would imply a devaluation of 11-12%”. in the same way, the standard chartered bank in london found that a 10% devaluation would allow morocco to recover lost competitiveness which started in 1997 (gulf news, 2001). on his side, many international monetary fund mission reports under article iv revealed an overvaluation of the dirham. for example, in 2013, the real appreciation varied from 1.3% to 11.3%. on their side, the monetary policymakers perceived the exchange rate policy as successful in accommodating shocks without much risk on economic competitiveness. other researchers found also that the real effective exchange rate was appreciated in certain periods. for example, ezzahid and maouhoub (2020) show that from 2000q1 to 2019q4 the real effective exchange rate has a downward tendency. this means real appreciations of moroccan dirham. others found that the rer in morocco exhibited mixed patters–appreciation in the 1990 s followed by depreciation during 2000 s due to lower inflation than in trading partners. over the longer term, morocco has experienced real exchange rate (zuzana et al., 2013). these debates and discrepancies on the real value of the dirham raise many questions: has the dirham been overvalued against the currencies of morocco’s main competitors and trading partners? if so, is it due to an unfavorable inflation differential in morocco compared to these countries, or to a nominal appreciation of the dirham, or to both at the same time? the present paper attempts to answer these questions by calculating and evaluating the real parity of the moroccan dirham. the simplest method, used often by many studies, to calculate this parity consists of assigning each country of the main trading partners a relative weight equivalent to its share in morocco’s external trade. however, this method does not take into consideration the competitiveness of exporters on third markets, in particular those with which morocco has weak bilateral trade. to overcome this constraint, this paper will assess and calculate the weights by combining both bilateral import weights and double export weights. indeed, weightings assigned to these countries must reflect both importance of each country in morocco’s import 1 created in 1947, the cgem is the representative of the private sector to public and institutional authorities. it speaks on behalf of its 90,000 direct and affiliated members and ensures a favorable economic environment for business development. https://www.cgem.ma 2 sector contributing to one-third of moroccan exports in 1990s-2000s. and export as well as its degree of competition in usual third markets. the importance of imports from each country represents its share of moroccan imports. we will use a double weighting for export to consider each country’s share of moroccan exports and competition experienced by moroccan exporters in usual foreign markets from local producers and exporters from third countries. the paper is structured as follows: the first part presents different concepts of real exchange rates as well as their theoretical bases. the second part explains the methodology for computation of real exchange rate of a currency, in particular optimal choice of the sample of main trading partners and competitors as well as the relative weighting coefficients. the third part attempts to compute changes in real rate of the dirham, to analyze its evolution during the period 1980-2020, and to compare it with that established by the international monetary fund for morocco. the last part concludes the paper. 2. the real parity of a currency: review of litrature the real exchange rate of a currency is generally defined as: • the nominal exchange rate adjusted by the differential in price levels between countries. in other terms, it is the nominal exchange rate deflated by the level of foreign prices, or costs, relative to the level of domestic prices, or costs, measured in common currency • the relative price of tradable goods compared to non-tradable goods. the relative price synthesizes the set of incentives that orient the allocation of resources in a country between the two sectors of tradable goods and non-tradable goods and reflects consumer preferences between the two types of goods. considered as the most common definition, the first concept is related to purchasing power parity theory (chinn, 2006). it compares the relative value of currencies by measuring the relative prices of baskets of domestic and foreign consumption or production. this concept of real parity is known as the “external real exchange rate” because it compares the relative prices of baskets of goods produced or consumed in different countries. the second concept, or the “internal real exchange rate” compares, for an economy, the internal relative prices of the production or consumption of tradable goods relative to non-tradable goods. the real exchange rate is in this case a domestic resources allocation indicator. in fact, the concept of a real exchange rate derives from the purchasing power parity theory. it was also at the center of reflection of several theories emanating from different analytical approaches, in particular the approach relating to: (i) the “mundellfleming one composite good model,” which focuses on the competitiveness of the whole goods, and (ii) the “trade-goods real exchange rate” approach based on the competitiveness of exchangeable goods (hinkle and nsengiyumva, 1999). relative labor costs, expressed in foreign currency, for all tradable and non-tradable goods, is another concept of the real exchange rate, although its use is uncommon compared to the two other lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 2023 91 concepts. this section will thus present and analyze the different theoretical concepts relating to real exchange rates and examine the methodological foundations specific to each concept. 2.1. real exchange rate and purchasing power parity purchasing power parity (ppp) is the oldest theory of the exchange rate3 and has occupied a central place in the analysis of the classical economists such as david ricardo. it defines the ppp of one currency against another as the exchange rate that equates the unit value of each of these two currencies. the value of a currency is determined in this case by the amount of goods and services it allows to acquire, i.e. by its internal purchasing power which changes in inverse proportion to the general domestic price level (drunat et al., 1994). the theory of ppp is based on the law of one price which considers that a good should have the same price in all countries when expressed in a common currency (rogoff, 1996). there are two versions of the ppp theory: absolute ppp: this version considers that the purchasing power of a national currency is identical on the domestic market and abroad. the nominal exchange rate between two currencies (edc) is thus equal to the ratio of domestic (pad) and foreign current prices (paf) of a standard basket of goods, as shown by the following equation: edc pad paf = (1) absolute ppp states that the rer between two currencies should equal 1, so when prices are converted to a common price, it should be possible to buy a similar basket of goods in two different countries with the same amount of currency (cuestas et al., 2022). in practical terms, absolute ppp has been lightly used given insufficient data on the costs of the same baskets of goods in different countries. moreover, even assuming that there is a perfectly identical methodology in all countries, which is not usually the case for establishing price levels, absolute ppp is not usually exactly verified. indeed, the arbitration of economic agents does not take place when the price differences between countries are too small to compensate for the additional cost linked to transport costs, taxes and duties, etc. relative purchasing power parity: it considers that the nominal exchange rate is proportional to the ratio of domestic and foreign price levels. changes in exchange rates compensate for inflation differentials between countries (benassy, 1993). therefore, the real exchange rate is constant, but not necessarily equal to unity, as is the case with absolute ppp. rerdc k edcpgf pgd edc pgd pgf = = = . ( ).constant (2) rerdc: real exchange rate in national currency. edc: nominal exchange rate, defined as the number of units of national currency per unit of foreign currency. pgf, pgd: respectively the foreign and domestic price indices. k: constant 3 it was developed by the swedish economist cassel in 1916. unlike the version of absolute ppp, which takes into consideration standard baskets, relative ppp is interested with representative baskets. on the other hand, the latter relates exchange rate fluctuations to inflation rates while the absolute version attributes them to the general price level (clark et al., 1994). many authors point out that when the ppp condition holds, it only holds in the long run. relative ppp has been widely used by most countries due to the availability, monthly, of consumer price indices, especially in most developing countries. these indexes, which often represent the prices of both tradable and non-tradable goods, are most used to calculate the real exchange rate based on ppp. real exchange rates based on consumer prices, however, raise two important issues. first, these prices can be influenced by price controls, subsidies, and indirect taxes; hence the need, in interpreting real exchange rates based on consumer price indexes, to distinguish between the effects of changes in indirect taxes, subsidies and price controls and those arising from price changes4. second, countries’ consumer price indexes are determined based on different baskets of goods which weights often reflect consumers behaviors that may differ from country to country. this limits the usefulness of the real exchange rate based on the consumer price index for comparing living standards. despite its simplicity, the ppp theory has several limitations. first, it assumes verified the law of one price. also, there are significant fluctuations in real parities. in this regard, lindert, krugman, obstfeld and others have made it a theory valid only over a long period for example, according to p. lindert.” the ppp has better explanatory power over long periods, especially those which do not end in brutal shocks, than for movements from one month to another or from one year to the next” (lindert, 1989). short-term exchange rate variations are, in fact, essentially determined by fluctuations in interest rates and financial factors, in connection with the masses of capital circulating between financial centers in search of better remuneration. 2.2. mundell-fleming approach or real exchange rate approach based on the overall production costs the second main concept of the real exchange rate is based on the mundell-fleming open economy macroeconomic model used for industrialized countries. in this model, the price index in the definition of the real exchange rate corresponds to a production cost index, which reflects the costs of products intended for both local and foreign market (exports), unlike the consumer price index in ppp theory which reflects the prices of goods produced and sold locally as those imported. the real mundell-fleming exchange rate can be expressed, in terms of foreign currencies, as follows: mfrerfc efcgdpdd gdpidf � � �. (3) 4 consumer price indices are subject to seasonal variations which, although not a problem for the analysis of annual data, may cause seasonal fluctuations in real exchange rates calculated based on quarterly or annual data. lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 202392 mfrerfc: mundell-fleming real exchange rate, in foreign currency. efc: nominal exchange rate index, defined as the number of units of foreign currency per unit of national currency. gdpdd, gdpdf: domestic and foreign gdp deflators, respectively. the mundell-fleming model considers domestic gdp and exports as a single composite good whose prices evolve in the same way. likewise, the foreign currency prices of imports are assumed to evolve in a comparable manner to the foreign gdp deflator. thus, the prices in foreign currency of exports and imports are determined as follows: efcgdpidd efcpxdc pxfcdpibf pmfc. .= = = (4) pxdc, pxfc: domestic export price deflator in local and foreign currency, respectively. pmfc: domestic import price deflator (in foreign currency). tt: terms of trade. from the two previous equations we get: mfrerfc pxfc pmfc = = tt (5) thus, the mundell-fleming formulation does not distinguish between the terms of trade and the real exchange rate. since export prices are assumed to be equal to the local gdp deflator and import prices equivalent to the foreign countries’ gdp deflator, the real exchange rate and the terms of trade are the same. this model is generally appropriate for industrialized countries, particularly because of the large share of manufactured products in their foreign trade and the low variation in the terms of trade. it is less, however, so for many developing countries whose exports are dominated by primary products and whose terms of trade are determined exogenously. in these countries, export prices often fluctuate much more than the gdp deflator and it is often better to distinguish between the terms of trade and the real exchange rate. production cost indices (such as the gdp deflator) include export prices but exclude import prices of finished goods, while price indices, like consumer prices, include import prices of finished goods and set aside export prices. on another side, the non-availability of the gdp deflator on an no annual basis is another limitation on the use of the real mundell-fleming exchange rate for these countries (edwards, 1989a). 2.3. real exchange rate based on tradable goods the “trade-good real exchange rate” is defined as the relative cost of producing tradable goods, measured in a common currency, in the home country and in foreign countries. this version of the real exchange rate uses indexes of prices or production costs relative to tradable goods, rather than the indexes of prices or costs corresponding to all goods as is the case with the ppp theory or the mundell-fleming model. there are two kinds of internationally tradable goods: homogeneous standard and more diversified products, often manufactured. the law of the single price, which is logically more applied only to tradable goods, is more appropriate in the case of homogeneous goods and could lead to a price equalization after considering the costs of transport, tariffs, and other costs of transactions. indeed, if the transaction costs are negligible (gold for example), the real exchange rate of tradable goods should be equal to 1 (absolute ppp). if transaction costs are negligeable, but constant, the real exchange rate for homogeneous goods should tend to be constant (relative ppp)5. diversified manufactured products, on the other hand, are often imperfect substitutes. however, international markets are quite important for tradable goods with abundant supply potential and very strong competition. hence, even if manufactured products are not perfectly substitutable, their elasticities are significant and their prices and production costs more competitive. the usefulness of the real exchange rate for tradable goods in the case of developing countries depends on the structure of production of these goods whether they are homogeneous or diversified. countries producing only homogeneous goods are “price takers” and face perfectly elastic foreign demand. in this case, foreign demand, rather than domestic demand, will determine prices and hence be at the origin of domestic and foreign price standardization. however, some developing countries produce homogeneous and differentiated goods while their real exchange rates for tradable goods may vary depending on their competitiveness. 2.4. exchange rate theories and choice of price or cost indices to establish the real exchange rate the choice of price or cost indices to establish the real exchange rate of a currency is quite important and it is crucial in computing real exchange rates, making it necessary to determine which of them is more appropriate for different policy objectives (edwards, 1989b). for ppp theory and the mundell-fleming model, the choice of price indices is relatively straightforward. for the theory of the real exchange rate based on tradable goods, this choice is however quite problematic given the lack of data necessary to determine the real parity for most developing countries. several price indices were then proposed to determine the real exchange rate based on tradable goods: wholesale prices, value added deflators for manufactured goods, unit export values and unit labor cost of work. 2.4.1. wholesale prices wholesale price indices are heavily weighted for tradable goods and are therefore generally more representative of these goods than other indices of tradable goods and non-tradable goods. the real exchange rates for these goods calculated on the basis of these prices are thus often used in the import and export equations for the case of industrialized countries. since wholesale prices are not 5 the assumption that the relative cost of the basket of tradable goods should be stable implies the following remarks: (i) the composition of tradable goods may change over time; (ii) if the weightings of the categories of goods are different in several countries, a change in the relative prices of certain tradable goods may cause a change in the relative prices of different baskets; and (iii) variations in trade policy or transaction costs can lead to price differences between countries. lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 2023 93 appropriate or available for many developing countries, a country’s overall production cost is sometimes measured by other variables, such as the consumer price index or the gdp deflator. 2.4.2. the value-added deflators of manufacturing products they are often used to estimate real exchange rates and assess the competitiveness of tradable goods. for its part, the international monetary fund (imf) establishes in its “international financial statistics” database, real exchange rates based on various indices including the deflators of value added in the manufacturing sector. this indicator, however, is not appropriate for computation of real exchange rates for most developing countries because, in general, the manufacturing sector remains weak and characterized by low production of tradable goods. 2.4.3. unit export values the real exchange rate calculated based on these unit export values in the manufacturing sector is another indicator used to assess the competitiveness of tradable goods in the most industrialized countries. the imf uses this indicator for more than 20 countries. this concept of real exchange rate is however useful for countries exporting diversified manufacturing products and less so for countries exporting homogeneous primary products (coffee, cotton, etc.). one of the main limitations of this index is that it can also be subject to sampling bias. it does not include all goods that can be exported; it only covers tradable goods that are priced low enough at the observed exchange rate to be exported. furthermore, if the goods traded are close substitutes, the real export-based exchange rate is unlikely to change much (clark et al., 1994). the real exchange rate can also be biased if the unit value of a developing country’s exports increases, over time, following structural increases in value added in the export sector for example, through the diversification of high added value products. 2.4.4. labor costs in the tradable goods sector some economists, such as marsh and tobarick, highlight three advantages of unit labor costs to assess the competitiveness of industrialized economies: the data relating to these costs on a comparable basis; they constitute an important component of the overall cost of production; in the end, labor costs often constitute a component implemented to ensure macroeconomic stability and competitiveness in industrialized countries. given these advantages, the imf calculates real exchange rates for 21 industrialized countries based on unit labor costs in the manufacturing sector. the main drawback of these costs, however, is that they consider a single factor of production “labor.” in addition, they measure the relative profitability of producing tradable goods only under certain conditions such as, for example, the need for all countries to have the same technology. in conclusion, the ppp theory, the mundell-fleming model, and the tradable goods approach have placed particular importance on the concept of the real exchange rate. the price indexes used to calculate rer are generally determined by theoretical considerations and data availability. if the goal is to capture international price competitiveness on the demand side, the producer price index (ppi) and wholesale price index (wpi) frequently capture tradable goods prices the best. unit labor costs in the tradable sector, on the other hand, provide an informative assurance. the ratio of tradable-nontradable good prices is frequently proxied in a dependent economy framework by the ratio of ppi (or wpi) to cpi. however, empirical work for ppi/wpi and unit labor cost series is frequently constrained by more limited data availability. as a result, aggregate-level studies typically calculate the rer series using cpi (demir and razmi, 2020). the availability of the consumer price index for most countries makes it easy to measure the real exchange rate based on ppp. this is a measure that is internationally comparable. while for the mundell-fleming model, establishing the real exchange rate based on gdp deflators is suitable for developed countries whose external trade is dominated by manufactured products and remains less appropriate for developing countries whose exports are generally dominated by commodities and for which the terms of trade fluctuate considerably. likewise, the lack of, or insufficient, wholesale price data makes it difficult to calculate the real exchange rate based on tradable goods for a significant number of developing countries. in addition, the usefulness of export unit values and wholesale price indices in these countries are limited by the importance of standard materials in their exports, for which they are “price takers.” 3. concepts and methodology for computation of the effective exchange rate the calculation of the real exchange rate requires consideration of three fundamental elements: the identification of nominal and real exchange rates as well as the appropriate measures of these indices; the assignment of the appropriate weighting per country and finally the choice of the appropriate price or cost indices. if the operational formulas to establish nominal exchange rates and the methodologies for determining country weights do not contain discrepancies among the different versions of the real exchange rate based on ppp, the mundell-fleming model and the competitiveness of goods tradable, the conception of appropriate indices of prices or costs to calculate the real parity of a currency differs, however, from one theory to another. in addition, it is often difficult to have adequate price or cost indices in the case of developing countries. for most of these countries, the consumer price index and the gdp deflator, disseminated on a monthly basis for the former and annually in general for the latter, are the only suitable indices. chinn (2006) has indicated that unit labor costs are not always available on a timely or consistent basis, hence, in general trade weighted indices are usually constructed using either consumer price index (cpi) or producer price index (ppi). this section will present, first, the various concepts and usual calculation methods relating to the nominal and real exchange rates, the way of determining the weights attributed to each country forming part of the sample taken into consideration to determine the real parity, and finally the choice of appropriate price or cost indices. lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 202394 3.1. real parity of a currency: concepts and calculation methodology 3.1.1. nominal and real effective exchange rate the variation in the exchange rate of a currency against a single foreign currency remains of limited meaning and scope since the variation against other currencies could take place in an opposite sense, hence the need to follow the evolution of the exchange rate not only with respect to a single currency but with respect to several currencies through the nominal effective exchange rate. defined as the weighted average of the bilateral exchange rates of a currency vis-à-vis those of the main trading partners and competitors, the nominal effective exchange rate thus makes it possible to indicate to what extent the nominal value of this currency evolves vis-a-vis to those of these countries. it can be expressed as follows: neer e i n it weighti� � � �100 1 ( ) (6) neer: nominal effective exchange rate. n: number of countries; ∏: geometric mean. eit = eit/ei0: the index of the exchange rate at period t relative to the exchange rate at base period t = 0; eit: the currency value of the ith partner country compared to the dirham at time t; weight i: the weighting coefficient relating to the ith country, such that weighti i n � �� 11 ; however, changes in the nominal effective exchange rate alone do not reflect the level of a currency’s purchasing power or the magnitude of changes in a country’s competitiveness. changes in domestic prices relative to its trading partners or competitors have the same effects as a change in the nominal exchange rate. thus, for example, if prices increase faster in a country compared to abroad, the competitiveness of its exports is weakened if this increase is not compensated by a depreciation of the same magnitude of its nominal exchange rate. hence the need to establish the real effective exchange rate which is defined as the nominal effective exchange rate adjusted for the evolution of relative prices, or costs, of the main partner and competitor countries. it thus allows us to establish to what extent the real purchasing power of a currency changes over a given period. reer e p i n it it weighti� � � �100 1 ( ) (7) reer: real effective exchange rate; pit = pit/p i0: the price index relating to period t compared to the price index relating to the base period; pit: the price index of the i th country compared to the price index of morocco (relative price index). 3.1.2. weighting system for the calculation of the nominal or real effective exchange rate of the currency of a country, it is necessary to consider a sample of representative countries with which it maintains significant trade relations or whose presence in usual third markets would compete with its exports. a weighting coefficient is then granted to each country and which essentially depends on the objective sought. the most common means of calculating an effective real exchange rate is to weight the currencies by trade weights (chinn, 2006). the simplest method is to give each country a relative weight equal to its share in the trade of the country in question. however, when trade flows differ significantly between countries for imports and exports, it is preferable to calculate separate effective exchange rates for imports and exports, which would allow the impact of exchange rate movements to be assessed on these imports and exports. in addition, if a country has significant competitors in third markets with which it has low trade, determining the appropriate weights is more complicated. on the other hand, if a country’s trade transactions are denominated in international currencies rather than in the currencies of trading partners (many products are settled in dollars), the weights need to be adjusted to reflect the currency composition of foreign trade rather its geographical origin and destination. in general, four methods are commonly used to calculate the weights used to establish effective exchange rates: model-based weighting, double-weighting system, weighting in function bilateral trade and weighting linked to world trade. i. model-based weighting under a model-based weighting system, each currency is assigned a coefficient based on the comparative impact (elasticity) of exchange rate fluctuations on the trade balance of the country concerned. for example, the imf uses a “multilateral exchange rate model” to calculate the effect of exchange rate fluctuations on the trade balance of a given country and, therefore, to determine the weights. allocated to bilateral rates included in the effective exchange rate index. this model-based weighting system remains, however, quite complex given the difficulty of estimating the elasticity of prices and foreign trade flows, which limits its use. ii. double weighting system in the domestic market, local producers of import substitution goods compete with foreign exporters. the relative importance of each of these exporters can be considered as equal to the market share it has in the domestic market, that is, its share in the total imports of the host country. in addition to external trade, the weighting system must consider the competitive relationships between exporters in third markets. indeed, it is possible that two countries experience strong competition in third markets while their bilateral trade is weak. in this case, a change in the exchange rate in one of the two countries will affect assuredly the competitive position of the other. for example, although morocco has low trade with tunisia, the two countries export similar products to the european union, the two countries’ main trading partner. therefore, a variation in the real bilateral exchange rate between the tunisian dinar and the euro has, other things being equal, an impact on moroccan exports to the european union. at the level of each third market, the exporters of the country in question face competition from local producers and competition from exporters from other countries lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 2023 95 in these markets. the weights derived from these two factors are referred to as the “double export weights.” thus, bilateral exchange rates between a country’s currency and that of its competitors are weighted according to “the contribution of each of the competing countries to the overall supply of competitive goods, including the supply of goods from national producers, in each market and according to the comparative advantage in each market of national exports.” the calculation of the overall trade weights assumes a combination of the bilateral import weights and the double export weights. this method is similar to that used by the imf to calculate real exchange rate indices for a large number of countries. iii. weightings based on bilateral and global trade the other two weighting systems, based on bilateral and aggregate trade, are in fact particular applications of the double weighting method. a. weightings according to bilateral trade under the bilateral weighting mechanism, a weighting proportional to the share of a country’s exports and imports is assigned to each of its trading partners. thus, in export markets, competition from third countries is not considered and the domestic producer is considered to be the only competitor in terms of exports. for imports, competition between foreign suppliers is considered and a weighting coefficient is assigned to each according to the proportion of all imports that can be attributed to it. the bilateral import weights are calculated in the same way as the import weights, i.e. in the same way for the calculation of the overall trade weights. b. weightings based on global trade as part of the mechanism for calculating the overall weighting coefficients, the currency of each partner country is assigned a weighting coefficient proportional to the share of total exports of all the partner countries of that country. this global weighting mechanism therefore takes competition between producers in third markets to an extreme, but completely ignores the importance of a particular market for a given country. 3.1.3. choice of price or cost indices for the calculation of real exchange rates, it is important to use similar price or cost indices for all the countries concerned. as pointed out before, the essential difference between the three versions for the calculation of the real exchange rate is in the use of different domestic and foreign price or cost indexes. thus, the ppp theory considers the consumer price index to estimate the real exchange rate of a currency; mundell-fleming theory prefers the gdp deflator and, finally, tradable goods theory uses price or cost indices for tradable goods. what are therefore the main advantages and limitations of each of these indices? consumer price indices, often representing the prices of both tradable and non-tradable goods, are the most common price measure used to calculate the real exchange rate of a currency. they have the advantage of being available and published periodically (monthly) by most countries, including developing ones. however, they have several drawbacks: they include the prices of products and services that are not traded internationally. they are influenced by indirect taxes, subsidies and sometimes, control measures. they are determined in different countries based on baskets made up of different goods, and different weightings, generally reflecting dissimilar consumer behavior between countries. they may experience seasonal variations which may cause fluctuations in real exchange rate indices calculated based on quarterly or annual data. regarding the gdp deflator, it has often been considered that it can be a good index for computation of the real exchange rate (mundell-fleming). its main merit is that it is a representative index of aggregate prices of production. one of the main limitations, however, is the non-availability for many developing countries of statistics on the gdp deflator on a non-annual basis. in addition, it is often not appropriate for international comparisons between developing countries due to the non-standard calculation methods used by some of these countries. as for wholesale prices and producer prices, they have the advantage of reflecting the evolution of prices especially in the industrial sector, hence a possibly more precise approximation of the price of merchandises making up international trade. however, they are the subject of several criticisms. they often depend on the price of imported goods which does not reflect the cost situation in the domestic market. the real exchange rate calculated using these two measures varies very little since these indices are often dependent on commodity prices especially in developing countries. despite their limitations, a significant number of economists have proposed that an adequate approximation of the relative prices of tradable and non-tradable goods can be done respectively through the foreign wholesale price index and the domestic consumer price index. however, two drawbacks characterize this proposal: the selection of the components to be included in each index and the weighting to be assigned to each component. among the costs used to calculate real exchange rates, unit labor costs, normalized unit labor costs and various measures of value added. unit labor costs relating to the manufacturing sector are considered as the most important in assessing the competitiveness of an economy for several reasons. they are a true indicator of the relative profitability of tradable goods. they are very convenient from a statistical point of view since comparable data for the manufacturing sector exist for several countries. they are considered as more stable than the prices of relative goods and, therefore, contribute to a better measure of the economic competitiveness of countries. several remarks are in order, however. the gains in labor productivity achieved by replacing this labor with capital goods are counterbalanced by the increase in capital costs, which means that the reliance on unit labor costs labor can lead to an overvaluation of productivity gains. unit labor costs also include a cyclical element in that the productivity of labor varies according to economic cycles (periods of drought, war,). however, it is possible to eliminate the effect of these cyclical factors using different statistical techniques. lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 202396 moreover, like the other price indexes, there are several analytical problems relating to the use of this index for the measurement of the real exchange rate: an indicator based on the evolution of wage rates is strongly sensitive to variations in cyclical productivity. for this reason, many economists develop “normalized” unit labor cost indices that correct for changes in wage rates and, therefore, for competitiveness due to these changes in productivity. these indices are calculated, however, only for a limited number of industrialized countries. other limitations: the wage rate considers only one factor of production, namely labor. also, the capital/labor ratio may vary between countries, which risks introducing a bias to the index. finally, the low quality and the limited availability of data on wage rates for developing countries constitute another limitation of this indicator (table 1 presenting some characteristics of certain price-cost indices). 4. calculation of the real exchange rate of dirham and analysis of its evolution during the period 1980-2020 in the light of the previous discussion related to the methodology of calculating the real effective exchange rate development, this section proposes to calculate that of the dirham during the period 1980-2020, to analyze its evolution and to compare the results obtained with those of the imf. 4.1. methodology for computation of the real effective exchange rate of the dirham computation of the development of the real parity of the dirham is carried out in four stages as follows: designation of the countries to be used for the establishment of the index; determination of the weighting system and the weights assigned to each country; choice of the appropriate price index or costs; and calculation of the nominal and real effective exchange rate of the dirham. choice of countries initially focused on several partner countries and competitors of morocco representing different regions of the world (europe, america, africa, asia). the number of countries has been reduced to 23 for many reasons including: low representation of certain countries as trade partners (e.g., norway, denmark, etc.), competition in third markets (hungary, czech republic, mexico, chile, thailand, egypt.), too low inflation levels (argentina, brazil) or too high (turkey) during certain periods, which is likely to bias the calculation of the real effective exchange rate of the dirham. the selected countries represent nearly 80% of morocco’s international trade. these are mostly composed of countries in the euro area; certain main industrialized countries (united states, united kingdom, japan); as well as emerging countries competing with south-east asia (india, indonesia, south korea, china, etc.), and africa (tunisia). weightings allocated to these countries reflect both importance of each country in morocco’s import and export volumes as well as its degree of competition in third markets (table 2). indeed, the importance of imports from each country represents its share of moroccan imports. we use a double weighting for export to consider each country’s share of moroccan exports and competition experienced by moroccan exporters in usual foreign markets from local producers and exporters from third countries6. for instance, although spain is the largest trading partner for morocco, its competitive intensity in third markets is only 4.7%. the biggest competitors are germany (19.2%) china (10.4%) respectively. however, the exchange rate of the dirham continues to rely heavily on: the euro and the us dollar levels recorded on international currency markets; with any appreciation (depreciation) of the euro against the us dollar, the dirham reacts in the same way against the us currency, that is to say an appreciation or depreciation vis-à-vis the euro. 4.2. methodology for computation of the weighting coefficients weight allocated to a country j in the basket, is established on the basis of its importance in morocco’s imports and exports, as well as its degree of competition vis-à-vis her exports in third markets. weightj = α (part_impj i) + ½ β ( part_expj i + dconcj) (8) or: i: morocco α: the share of imports in total trade, i.e. 56%; β: the share of exports in total trade, i.e. 44%; 6 for more information about double weighting, see: zanello and desruelle (1997), a primer of on the imf’s information notice system. imf working paper. wp/97/71. may. 14-18. table 1: characteristics of certain price indices-costs price index-costs used periodicity data availability in developing countries observations consumer price index (cpi) monthly most countries widely used in developing countries gdp deflator annually most countries gdp deflators can be strongly influenced by volatile commodity prices unit cost in manufacturing industry annually some countries indicator suitable for the industrial sector. manufacturing industry deflators annually certain countries wholesale price index (wpi) monthly few countries not suitable for most developing countries because of the predominance of primary materials. export unit value index annually certain countries average wage rate annually certain countries useful when available but may be biased by variations in productivity. unit labor cost annually very few countries useful when available source: maciejewski (1983), real effective exchange indices: a re-examination of the major conceptual and methodological issues. staff papers, vol. 30. no 3. imf, september. 491-541 lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 2023 97 part_impj i: the share of country j in morocco’s imports from the sample countries part_expj i: share of country j in morocco's exports to the sample countries. ( _ exp )( _ ) ( _ e üüü üüü ≠ ≠ − = ∑ ∑ morocco k k jk ij morocco k k moroccok i part part market part part market dconcj represents the competitive intensity at the level of exports between morocco and country j on third markets. part-marketj k: market share of country j in market k. example: calculation of the weight of spain in the basket • spain's share in moroccan imports from the sample is 19.4%. • spain's share in moroccan exports to the sample is 23.1%. • degree of competition between exporters from morocco and spain, on third-party markets, is 2.4%. spain weight = 0.64* 19.4% + ½* (0.36* (23.1% + 4.7%)) = 17.4% several price indices have been used for calculating the real exchange rate of the dirham such as: wholesale price, consumer price, gdp deflator, unit labor cost, etc. the use of these indices has been restricted by several limitations (mentioned previously), only the consumer price index, published by the imf (imf database, international financial statistics, consumer price index), is retained due to its availability on a monthly basis for all the countries in the sample. the imf also uses the latter index to establish the real effective exchange rates of the currencies of most of its member countries7. 4.3. analysis of evolution of real effective exchange rate of the dirham during the period 1980-2020 calculation of real parity of the dirham during the period 1980-2020 reveals three main phases: a strong depreciation between 1980 and 1990; an appreciation during the period 1991-2000; and a resumption of a weaker depreciation than that of the first phase, for the last period (2001-2020) (figure 1). these trends are related to both changes in nominal effective exchange rate and in relative prices. results obtained in the present paper are generally close to those calculated by the imf for morocco and are strongly correlated and 7 the limits are mainly due either to a lack of data, (unit labor cost, etc.), or to a periodicity established on a basis other than monthly (gdp deflator, or the use of different baskets or weightings to establish a price index (wholesale price index, consumer price index, etc.). table 2: weight attributed to each country in the sample (in %) country weight country weight country weight france 21.7 united kingdom 4.0 tunisia 0.9 spain 17.4 india 2.5 austria 0.7 germany 9.3 portugal 1.7 greece 0.6 china 9.0 switzerland 1.6 irlande 0.6 italy 7.7 japan 1.5 indonesia 0.5 united states 7.5 sweden 1.5 finland 0.4 netherlands 4.4 south korea 1.3 malaysia 0.4 belgium 4.3 canada 0.9 source: author’s calculations source: author’s calculations figure 1: evolution of the real effective exchange rate of the dirham (1980-2020) lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 202398 the trends remain the same (figure 2). the differences between the two studies sometimes observed are generally due to difference in both composition of the samples of countries used to calculate the real parity of the dirham and in weightings assigned to each country8. it should be noted in this regard that the imf establishes real effective exchange rate indices for more than 180 countries that it publishes on a monthly, quarterly, and annual basis in imf database: international financial statistics, real effective exchange rate. 8 the sample of countries used by the imf to calculate the real exchange rate of the currencies of the various member countries, including the dirham, and the related weights are not published by this institution. 4.3.1. strong real depreciation of the dirham during the period 1980-1989 the real parity of the dirham depreciated by 3.5% on an annual average compared to the sample of the selected countries during this period. this result is mainly linked to a depreciation of the nominal effective exchange rate of 4.1% on annual average which was however attenuated by an unfavorable inflationary differential for morocco of 0.6%. the analysis of the real depreciation of the dirham against the main international currencies shows that it depreciated against the euro by (3.8%)9, the dollar by (5.2%) and the japanese yen by (7.3%) (figure 3). this development is due to inflationary differentials in morocco compared to its main trading partners and above all a strong nominal depreciation of the dirham against other currencies, in particular following the successive devaluations of the dirham between 1980-1982, and 1983-1985, which marked a new phase of exchange rate policy in morocco to cope with an overvaluation that arose after the adoption of regime of the dirham’s quotation basket in 1973 (hamdouch, 1988)10 (figure 4). in fact, the moroccan political exchange rate entered a new cycle characterized by a shift in the value of the dirham, the adjustments have occurred mainly to offset the inflation differential between morocco and key partners and correct the overvaluation in real terms dirham recorded in the late 70 s (bouzahzah and bachar, 2013). most of the nominal depreciation of the dirham took place during the period 19801985. morocco has made a series of corrections to its exchange rate values as part of the effective application of the structural adjustment programs. a devaluation of 10% for the dirham was 9 it is a fictitious euro established by the european central bank. 10 between september 1980 and march 1986, the dirham depreciated 143% against the us dollar, 86% / german mark and 40% / french franc. source: author’s calculations and imf database: international financial statistics. real effective exchange rate. https://data.imf.org. (*) data relating to the real exchange rate of the dirham calculated by the imf are available only from 1988. figure 2: calculation results of evolution of real effective exchange rate of the dirham compared to that calculated by the imf (1980-2020) (*) source: author’s calculations figure 3: evolution of the real exchange rate of the dirham against the currencies of sample countries (1980-2020) lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 2023 99 undertaken in august 1983 followed by another one in 1984 by 7% between february and april in that year. further, in 1985, a devaluation of 13% was applied between march and july. taking into account two earlier devaluations in 1980 by 15%, depreciation between mid-september 1980 and end of march 1982, the dirham has lost 53% of its value in 1985 (belghazi, 1991). the devaluations adopted by morocco is in fact part of a global approach aimed at reducing short-term imbalances and restructuring the moroccan economy as a whole in the medium and long terms (el bouhadi et al., 2008). in all, after an overvaluation between 1970 and 1980, the dirham recorded a continuous undervaluation during the decade 1980-9011. the remarkable reversal of the real effective exchange rate trends is due to a change both in the nature of the currencies making up the basket and in their quotation rate, resulting in an implicit shift in the dirham (bouoiyour et al., 2002). the various devaluations of the dirham which have taken place as part of the structural adjustment programs to promote export performance and reduce import surge have also contributed decisively to this undervaluation (sagou and mourji, 1988). 4.3.2. assessment of real parity during the period (1990-2000) this period was first marked by a change both in the combination of currencies making up bank al-maghrib’s basket and in the quotation rates, resulting in a devaluation of the dirham of 9.25% in may 1990. this measure has allowed following the slowdown in economic growth and the current account deficit linked to a deterioration in terms of trade (achy and milgram, 2003). in other terms, due to the deterioration of terms of trade during the period 1987-1989 that caused a worsening of the trade deficit, the 11 “during the 1980s, following the structural adjustment program of 1983, the exchange rate policy had the effect of generating a slow movement of real depreciation. moroccan authorities decided this devaluation to further support the competitiveness of the export sector and improve the profile of the balance of payments (bouzahzah and bachar, 2013). however, despite this action, the real effective exchange rate index showed an average annual appreciation of 1.7%. this development is due both to a nominal average annual appreciation of the dirham by 1.2% and to price differentials of 0.5%. morocco recorded an average nominal annual appreciation of the dirham of 1.1% in the first real appreciation period (1990-1995) and an unfavorable inflationary gap of 1.3% compared with the main trading partners. however, morocco managed to control its inflation rate during the second half of the decade (1996-2000), which made it possible to attenuate the level of appreciation of the real parity of the dirham at the end of this period. the real exchange rate of the dirham appreciated annually by an average rate of by 2.3% against the euro during the period 19902000, given the effect of a nominal appreciation of 1% and an unfavorable inflationary differential of 1.3% (figure 3). however, it depreciated against the dollar by 1.4%, mainly due to a nominal depreciation of 2.5%. the dirham has also appreciated in real terms against certain emerging countries’ currencies, mainly due to the sharp depreciation in exchange rates experienced by some countries during this period. this is particularly the case with asian countries that devalued their currencies following the asian financial crisis of 1997-1998. 4.3.3. resumption of real depreciation of the dirham during the period (2001-2020) on april 25th, 2001, morocco reorganized the basket of currency quotation of the dirham, which led to a nominal depreciation of source: author’s calculations figure 4: evolution of neer, reer and relative price indices (1980-2020) neer: nominal effective exchange rate reer: real effective exchange rate lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 2023100 5% ((bouoiyour et al., 2002)12. this measure, which the authorities achieved by increasing the weight of the euro in the basket, aimed at boosting export earnings, tourism revenues, transfers of moroccans living abroad, and foreign direct investments. it aimed also to avoid any loss of competitiveness-price and offset the inflation differential between morocco and its partners (bouzahzah and bachar, 2013). on april 15th, 2015, the weightings of the currencies making up the dirham’s quotation basket were modified (raised from 20% to 40% for the us dollar and decreased from 80% to 60% for the euro) to better reflect the changes in structure of foreign trade (ait ali, 2018). morocco launched on january 15th, 2018, a new exchange rate regime. this regime represents voluntary and gradual transition from a fixed exchange rate regime to a more flexible one (bank al-maghrib, 2022a). it will, according to the ministry of economy and finance, “determine the parity of the dirham within a fluctuation band of ±2.5%, against ±0.3%, compared to a central rate set by the bank al-maghrib based on a basket of currencies made up of the euro and the dollar at 60% and 40% ratios respectively. the objective of this flexibility in the exchange rate regime is to strengthen the resilience of the national economy to exogenous shocks, to support its competitiveness and to improve its level of growth” (moroccan ministry of the economy and finance, 2018). on march 9, 2020, the monetary authorities decided to continue the exchange regime reform process by proceeding with a second widening of the dirham’s fluctuation band from ±2.5% to ±5% either side (bank al-maghrib, 2022b). regarding the evolution of the real parity of the dirham for the period (2001-2020), we observe an average annual depreciation, mostly between 2001 and 2012, of about 0.4% under the effect of a nominal depreciation (0.1%) and a deflationary gap in favor of morocco of (0.3%) due to lower inflation rate than the competitors and the trading partners (zuzana et al., 2013). the appreciation of the dirham in real effective terms has been reversed since 2001. the 5% nominal devaluation of the dirham in april 2001 partly reversed the real appreciation experienced between 1990 and 2000. since the devaluation, the dirham continued to depreciate in real effective terms reflecting partly the low inflation in morocco relative to its trading partners and partly the appreciation of the euro with respect to the dollar (imf, 2005). more specifically, the real effective exchange rate of the dirham experienced the following changes: • a depreciation of 0.6% against the euro mainly due to a nominal depreciation resulting, on the one hand, from the appreciation of the euro and, on the other hand, from the strengthening of the weight of the single currency in the dirham quotation basket following the reorganization of the currency basket. • an appreciation against the dollar and the japanese yen of 1.1% and 1.2% respectively due to an overvaluation in nominal terms of the dirham in connection with the depreciation the 12 the monetary authorities have in fact changed the weighting of the various currencies of the basket by allocating greater importance to the euro to the detriment of the dollar to better reflect morocco’s anchoring in the eurozone. greenback and the japanese currency, despite an inflationary gap in favor of morocco. 5. conclusion the analysis of the evolution of the real parity of the dirham revealed different trends during the period 1980-2020. first a strong depreciation during the decade 1980-1989, linked mainly to the various sliding and devaluation operations carried out during the first 5-year term. subsequently, the dirham appreciated particularly during the first half of the 1990 s, due to higher inflation compared to its trading partners, particularly in the eurozone, and a nominal appreciation of the dirham which is explained, on the one hand, by the weakness of european currencies vis-à-vis the dollar which led, through the mechanism of quotation of the dirham, an appreciation of the local currency against the euro and, on the other hand, by devaluations made by certain emerging countries, especially in asia, during the financial crises of the 1990 s. from 2001, the real exchange rate depreciated in line with the control of the inflation rate and the nominal depreciation of the dirham vis-à-vis various currencies of trading partners and competing countries, particularly following the various readjustments of the dirham quotation basket. the calculation of the real effective exchange rate of the dirham was based on a sample of countries that have significant trade relations with morocco or which would compete with its exports in usual third markets. the weights for each country of the sample were established by combining both bilateral import weights and double export weights. however, it should be noted that these weighting deserves to be nuanced. indeed, it considers the overall imports and exports of each country, which makes it likely that a country could be considered as a competitor in third markets when in fact the structure of its exports to these third markets differs from that of morocco. despite this limitation, this method is widely used since it is difficult to have homogeneous products comparable from one country to another. analyzing the evolution of the real parity of morocco, the paper has certainly observed the depreciation of the dirham during in certain periods and the appreciation during others. the question that then arises is whether such an appreciation is a negative sign that has penalized the competitiveness of the moroccan economy, as the cgem and amith claims, or it is only a logical consequence following changes in the fundamentals of the economy? establishing the real exchange rate is, evidently, necessary but remains insufficient to determine whether the value of a currency is appropriate or not and therefore whether it affects, positively or negatively, the competitiveness and economic growth of a country. indeed, knowing that movements in the real effective exchange rate only give an indication of the evolution of price competitiveness, an appreciation in real terms of a currency is often interpreted as a loss of economic competitiveness, attributed to the nominal anchor of the exchange rate (the misalignment approach) (femise, 2000). on the contrary, the fundamentals approach does not consider appreciation synonymous to a loss of competitiveness if the movement of the real exchange rate is due to structural and fundamental changes in the lezar: real exchange rate of moroccan currency: appreciated or depreciated? international journal of economics and financial issues | vol 13 • issue 1 • 2023 101 economy. competitiveness can only be affected if the observed real exchange rate deviates significantly from the equilibrium one, i.e., the exchange rate which corresponds to the economic fundamentals. based on these considerations, it is important to determine the real equilibrium exchange rate of the dirham and to compare it with that observed to be able to judge whether the appreciation of the currency reflects the evolution of economic fundamentals and, therefore, does not negatively affect the country’s external competitiveness. references achy, l., milgram, j. (2003), does a free trade area favor an optimum currency area? the case of morocco and the european union. in: management du taux de change au maroc. morocco: national institute of statistics and applied economics (insea). p.77. agenor, p.r., el aynaoui, k. (2015), growth strategy for 2025 in evolving international environment. morocco: office chérifien des phosphates (ocp group) policy center. p.55. ait ali, a. (2018), the role of a flexible foreign exchange system in macroeconomic adjustment: the case of morocco. policy brief. december. pb-18/40. available from: https://www. policycenter.ma/ sites/default/files/pcns-pb18-40-en.pdf bank al-maghrib. (2022a), implementation of the reform of the exchange rate regime: available from: https://www.bkam.ma/ en/find-information-about/reform-of-the-exchange-rate-regime/ presentation [last accessed on 2022 sep 10]. bank al-maghrib. (2022b), foreign exchange regime. available from: https://www.bkam.ma/en/monetary-policy/strategic-framework/ presentation [last accessed on 2022 aug 22]. belghazi, s. (1991), accumulation et ajustement au maroc. (accumulation and adjustment in morocco). economic and socialism review, 9, 30-32. benassy, a. (1993), comment se fixent les taux de change? (how are exchange rates set?). problèmes economiques, 38, 2342. bouoiyour, j., marimoutou, r.s. (2005), exchange rate regime, real exchange rate, trade flows and foreign direct investments: the case of morocco. catt. france: university of pau. p.7. bouoiyour, j., marimoutou, v., reya, s. (2002), taux de change réel d’équilibre et politique de change au maroc: une approche non paramétrique. (real equilibrium exchange rate and exchange rate policy in morocco: a non-parametric approach’’). france: university of pau and the pays de l’adour. center for prospective studies and international information. p.97. 1st quarter. bouzahzah, m., bachar, r. (2013), exchange rate policy in morocco and persistence of real exchange rate misalignments. international journal of economics and financial issues, 4, 122-134. chinn, m.d. (2006), a primer on real effective exchange rates: determinants, overvaluation, trade flows and competitive devaluation. working paper 11521. national bureau of economic research (nber). p.8-12. clark, p., bartolini, l., bauoumi, t., symanski, s. (1994), taux de change et données fondamentales de l’économie: un cadre d’analyse. (exchange rates and economic fundamentals: a framework for analysis). washington, d.c: imf. p.9-15. cuestas, j.c., monfort, m., shimbov, b. (2022), has the relationship between the real exchange rate and its fundamentals changed over time? baltic journal of economics, 22(2), 68-89. demir, f., razmi, a. (2020), the real exchange rate and development. theory, evidence, issues, and challenges. vol. 289. massachusetts: university of massachusetts amherst economics. working papers. p.11-12. drunat, j., dufrenot, g., mathieu, l. (1994), les théories explicatives du taux de change: de cassel au début des années 80. (explanatory theories of the exchange rate: from cassel to the early 1980s). french economic review, 1994, 57-63. edwards, s. (1989a), real exchange rates in developing countries: concepts and measurements. vol. 2950. cambridge: nber. working paper. p.25. edwards, s. (1989b), real exchange rates, devaluation, and adjustment’. cambridge, mass: mit press. el bouhadi, a., elkhider, a., kchirid, m., el abbassi, i. (2008), les déterminants du taux de change au maroc: une étude empirique entre 1975: i and 2006: iii. (the determinants of the exchange rate in morocco: an empirical study between 1975: i and 2006: iii). faculty of law of marrakech. morocco: cadi ayyad university. p.4. ezzahid, e., maouhoub, b. (2020), real effective exchange rate dynamics in morocco: exploring balassa-samuelson effect under capital account liberalization. journal of international studies, 13(1), 375. femise. (2000), le rôle des marchés monétaire et financier dans le cadre de la zone euro: analyse comparative du maroc, de la tunisie, de la turquie et d’israël. (the role of monetary and financial markets in the framework of the eurozone: comparative analysis of morocco, tunisia, turkey and israel). euro-mediterranean forum of institutes of economic sciences. cemafi. france: university of nice sophia-antipolis. p.17-20. general confederation of moroccan enterprises. available from: https:// www.cgem.ma [last accessed on 2022 jun 17]. gulf news. (2001), morocco not to devalue dirham again. available from: https://www.gulfnews.com/uae/morocco-not-to-devaluedirham-again-1.424008 hamdouch, b. (1988), fonds monétaire international et politique de change: le cas du maroc. international monetary fund and exchange rate policy: the case of morocco. in: colloquium (la crise et l’endettement du tiers monde. (the crisis and the indebtedness of the third world). organized by the association of moroccan economists. edition maghrébines. international monetary fund. p.339-358. hinkle, e.l., nsengiyumva, f. (1999), external real exchange rates: purchasing power parity, the mundell-flemeing model, and competitiveness in traded goods. united kingdom: world bank, oxford university press. p.99. imf. (2005), morocco-selected issues. country report no. 05/419. washington, dc: imf. p.43. available from: https://www.imf.org/ external/pubs/ft/scr/2005/cr05419.pdf karakostas, e. (2021), the significance of the exchange rates: a survey of literature. modern economy, 12, 1628-1647. lindert, p.h. (1989), economie internationale (international economy). economica, ). 8th ed. paris. france, 464. maciejewski, e.b. (1983), real effective exchange indices: a reexamination of the major conceptual and methodological issues. vol. 30. united states: imf staff papers. p.491-541. moroccan ministry of the economy and finance. (2018), passage vers un régime de change plus flexible. (transition to a more flexible exchange rate regime). available from: https://www.finances.gov. ma/fr/pages/detail-actualite.aspx?fiche=2464 rogoff, k. (1996), the purchasing power parity puzzle. journal of economic literature. 34, 648. sagou, mourji. (1980), l’expérience du maroc en matière d’ajustement pour la croissance. (morocco experience of adjustment for growth). in: colloquium: les politiques pour la croissance dans les pays en développement. (policies for growth in developing countries). mohammedia: p.101-134. zanello, a., desruelle, d. (1997), a primer of on the imf’s information notice system. imf working paper. wp/97/71. p.14-18. zuzana, b., balazs, é., thouraya, h. (2013), the real exchange rate and external competitiveness in egypt, morocco and tunisia. african. development bank. working paper series no 187. p 4-8. ijefi subroto okey.indd international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 860-867. international journal of economics and financial issues | vol 5 • issue 4 • 2015860 revitalization of pancasila economic system in the globalization era waspodo tjipto subroto* department of economics, faculty of economics, state university of surabaya, indonesia. *email: waspodotjipto@yahoo.co.id abstract implementation of the policy will effect the economic system of economic growth and prosperity of a nation. follow the globalization of economic liberalization is detrimental to most of the people of indonesia for the door wide open to free competition so it is very unfortunate that the developed countries are relatively better equipped to compete because it is supported by fi nancial capital and modern technology. for socializing pancasila economic system (pes), there needs revitalization movement pes in a more systematic and planned so that the system is able to host in his own country. revitalization of pes needs to be pursued constantly and sustained through the implementation of economic policies in favor of the people and to anticipate the growing infl uence of economic globalization and spread to various world. revitalization is expected to bring the indonesian people toward the common good in adapting to the era of globalization. keywords: pancasila, economic system, globalization jel classifi cations: f6, p 1. introduction within the democratization of the globalization phenomenon affects the life of mankind on this earth. the passing of an era of globalization which is supported by the rapid development of information technology and communications, adding to the faster development of the following socio-economic impacts that go with it. shixiong (2012) says even with the spirit of globalization democratization wide open competition in a variety of human activities in the world. competition between nations that seems clear is competition for the pursuit of prosperity and well-being that are often ignored the norms and ethics in business or economic activity. freedom is likely to raise competition in the era of globalization impact ample opportunity for investors to take part to play dominance in economic activity. this condition is often known as a form of neo-liberalism which gives wide opportunities to compete in the business world. even allegations that globalization is a condition created by the capitalists in order to freely colonize other nations in other forms, namely the competitiveness they have to play a role and hegemony in economic activity. globalization deliberately created by the capitalists to dominate the competition in economic activities, because they feel ready to enter the arena of free competition in all aspects of life. globalization is a wide open competition, thus giving fresh air for the capitalists who have high competitiveness to win the competition, often blamed as a form of neo-liberalism to a nation that its competitiveness is low. the capitalists are the average of these rich countries, especially the sponsors of globalization because they are ready to compete. in the spirit of globalization which brings freedom, to position of capitalists to play a role in the world economic arena. with their high competitiveness that will control the world’s political and even economic activity, so that competition practices is to understanding of neoliberalism. the capitalists in the guise of globalization hide the neoliberal economic plan that aims to achieve maximum profi ts in a way that seems democratic, mutual cooperation and open. globalization is a systematic process to overhaul the economic structure of poor countries, mainly in the form of stunting increased role of the state and the role of the market, thus facilitating the economic integration of poor countries into the hands of the capitalists from rich countries. of common sense can be seen subroto: revitalization of pancasila economic system in the globalization era international journal of economics and financial issues | vol 5 • issue 4 • 2015 861 that the dangers of globalization for poor countries basically lies in the weakness of governments in poor countries to protect the interests of the country and its people, and the increasing economic dependence of poor countries to meet the interests of investors from rich countries. with the increasing economic dependence of poor countries to meet the interests of investors rich countries, the functions of government in the economy of poor countries tend to change, that of serving and protecting the interests of the people to serve and protect the interests of investors rich countries. at a more extreme, globalization led to the widening social and economic inequalities, and the increasing dominance of the capitalist rich countries of the ownership of factors of production in every poor country. thus, when the international globalization causes an increasing dependence of poor countries, domestically he became a trigger helter contained the foundation of social integration in society. with such danger, it is easy to understand when calvanagh and mander (2008) prefers to call globalization as imperialism. as they point out, behind the dissemination of globalization actually resides on a particular class interests, the new international capitalist class who are trying to widen their influence and economic domination throughout the world. era of globalization regrowth merchantilist the views of the 17th century and the 18th, so it makes economic globalization as an attempt to obtain a trade surplus in order to strengthen the country. alexander hamilton, merchantilist fi gures from the united states in 1791 relating to the protection of usa policy in the industry write that: not only prosperity, but the dependence of poor countries to manufacture industrial goods and technologies need to be maintained (gilpin, 2009). colonial era of globalization efforts are directed to meet the needs of countries that had already been developed by exploiting the country or region that is still underdeveloped. economic globalization that has been rooted for centuries has continued to evolve. commitment that led to the globalization of world trade that was driven by the united states was the fi rst time only by 23 countries. the evolution of economic globalization is now growing very rapidly since the late 1980s. this condition is contrary to pancasila economic system (pes), which guarantees economic democracy without glorifying the broadest possible competition, as developed by the understanding neoliberlisme. democracy is more concerned with economic cooperation rather than competition and social fraternity. pancasila economy (hamid, 2006) expect, (a) the economy is driven by the stimulation of economic, social and moral, (b) there will of society to achieve socio-economic equality, (c) nationalism always economic policy, and (d) cooperative is a based of the economy national, and (e) there is a balance between centralism and desentralisme in economic policy. pes is not liberal-capitalistic, but not the economic system etatistic. yet the market remains coloring system economic life. this is as set forth by the explanation of article 33 uud 1945, as follows: in section 33 set forth the basis of economic democracy, the production is done by all, for all, under the direction or the inspection, members of the community. prosperity of society that comes fi rst, not the prosperity of the individual. for this reason the economy is structured as a joint effort based on the principle of kinship. wake up in accordance with the company that is cooperative. pes is very diffi cult to be developed in the era of globalization that emphasizes free competition. this challenge becomes even more severe, because there is a growing spirit of individualism as a result of the outbreak of the infl uence of capitalist ideology-liberalism (or neoliberalism). with the emergence of business groups national embracing ideology of global capitalism, apparently emerging spirit of ‘greed’ new economic interests against the interests of the people (mubyarto, 2005). to control this condition, pes should be based on a policy of reconstruction and economic system in favor of the people. the economy is driven by the stimulation of economic, social, moral and civilized. indonesia needs to foster the spirit of the nation to realize social and economic equality. sense of nationalism has always animated the economic policy makers in order to grow the economy. economy needs to grow back to the teachings of the cooperative who are based of the national economy. in economic development, there should be a balance between centralism and desentralisme in economic policy so that more priority to equitable distribution of wealth and prosperity for the whole of indonesia. 2. economic development of the era of globalization economic globalization that has lasted many centuries ago, based on the interests of countries that have developed economies to seek riches for the prosperity of his country, regardless of the partner country or colony. for developed countries it is important is the accumulation of wealth, or gold, and their welfare. economic globalization during the last fi ve centuries of european colonialism aimed at getting of wealth in the world that were previously unreachable. cristobal colon, which become known as christopher columbus, with fi nancial support from the king and queen of spain sailed across the sea to get to that reported by the asia abundant with natural resources and gold. the search for new territory to acquire wealth for the relatively rich countries of this kind continues. in historical records related to other globalization, it can be argued that the efforts made famous spokesman for the united kingdom in the 1890s, cecil rhodes, who expressed the need for countries to get new land, because land (colonies) which could benefi t the new country (wayne, 2007). so the colonial era of globalization efforts are directed to meet the needs of countries that had already been developed by exploiting the country or region that is still underdeveloped. economic globalization (gianfranco and kerstin, 2011) has been rooted for centuries has continued to evolve. signifi cant point occurred in 1947 coming into force and the institutionalization of the general agreement on tariffs and trade or gatt. commitment that led to the globalization of world trade that was driven by the united states was the fi rst time only by 23 countries. the evolution of economic globalization is now growing very rapidly since the late 1980s. through long negotiations conducted during the 8 years of gatt, known as the uruguay round in 1995 subroto: revitalization of pancasila economic system in the globalization era international journal of economics and financial issues | vol 5 • issue 4 • 2015862 had decided to form the world trade organization (wto). wto membership continued to growth reaching 148 countries by 2005, with a wider coverage area, which is related to the liberalization of the traffi c of goods and services. the continued development of theories related to economic integration, trade liberalization became the spearhead of economic globalization. development of world trade is growing rapidly since the gatt. much more rapid economic growth in the range of the last two decades. implementation of the decisions of the uruguay round of world trade is accelerating. globalization, which in international trade to trade liberalization, has eliminated signifi cant trade barriers, both tangible barriers of prices and nonprices barriers such as import bans, quotas, import licenses, and so forth. the inclusion of liberalization of services sector in the world economy, as the implementation of general agreement on trade and services, the corner position of many developing countries, including indonesia, which is generally very weak in the service sector. at the macro-global free trade is the increase refl ects an increase in welfare of the people of the world. however, this conclusion is questionable when viewed whom or which countries whose economies are experiencing a rapid increase. trade expansion, especially in developed countries to make developing countries more and more behind. concentration of world trade is still centered in the northern countries such as north america and western europe, while the country is concentrated in asia only japan and china. globalization of trade for developing countries has also been degrading to the exchange rate of exports to imports of manufactured goods it needs. in fact, the decline rate is likely to get worse and cause the transfer of real resources caused by the loss of potential revenue on exports as a result of deterioration of the exchange rate. based on this fact, stiglitz (2008) says for the implementation of globalization, including the various agreements on trade review and radically reconsidered. in a theoretical perspective, the benefi ts of economic globalization is very importance to promise that the growing prosperity of the world community. with the removal of barriers in international economic relations will encourage increased efficiency and production of goods and services. economic specialization occurs. increased trade and investment, developing the production technology, all of which lead to an increase in world output, which means the world welfare is also increasing, therefore, trade barriers, either in the form of high cost and non-cost should be minimized, even eliminated. through the wto and other international institutions it is always a duty to perform. economic freedom of the world regarded as the best solution to improve the output of the world theory. in economic terms, the economic freedom of the will to realize the called pareto optimality. the concept of the theory is incentive launched in the late 1980’s and early 1990’s. therefore, not surprising at that time thinking about the current economic globalization coloring almost the whole world (nederveen, 2007). terminology associated with globalization, as countries without border, economic liberalization, free trade, or global economic integration into a kind of feeling which is believed to be carrying the world on economic progress, eliminating poverty and reducing disparities between countries. efforts toward globalization was strongly supported economic superpowers, who are already familiar with the pattern of trade liberalization. dolores (2012) clearly as globalization of the economy on a limited scale (or so-called economic regionalization) is often regarded as a success story is the economic integration of western european countries are now members of the european union. therefore, many countries that “practice” to prepare for the globalization of the economy through regional economic integration. in the asia pacifi c region in the form of asia pacifi c economic cooperation (apec), which led countries such as australia, america, and canada. in a smaller scale also formed north american free trade area (nafta), asean free trade asrea (afta), and so on. variety of organization of the world economy is expected to help accelerate the realization of globalization for raising prosperity of the world. prospective of economic globalization are very confi dent that the promises of globalization and the increased prosperity of the world of international cooperation. therefore they are not allowed to declare the existence of barriers that can impede the movement of goods and services and capital (gilpin, 2009). in fact, the idea is to liberalize world trade has a precondition that the actors who will integrate its economy must have a balanced force. this is the prerequisite conditions are not the economic power between nations is still very limited, so the practice of economic globalization cannot be done. if want this done is limited to countries that are relatively balanced, which is usually limited to certain areas, that the concept of regional economic theory is called integration. union activities such as the formation of regional economic to the region’s economy initiated prior to entering of era global economic liberalization. 3. capitalism in an era of economic globalization globalization is essentially a new liberal ideology that drives the free market mechanism. globalization opens up the transparency of trade that ignores the efforts embodiment of justice, equality and welfare mondial. swasono (2007) view that the empirical and theoretical, economic globalization and free trade that occurs at this time has been systematically planned by the rich countries with global capitalism, which uses its own power or through-economic institutions in the global fi nancial under its infl uence. even mubyarto (2005) more sharply said that economic globalization is greed, imperialism, and very determine to the economy of developing countries. to integrate the global economy, through the institutions of economic-financial world, was made uniform rules, norms standards, the standard economic law, and a variety of general provisions relating to international economic relations. various provisions that are generally adopted from what was already in force and become a habit in industrialized countries are based on subroto: revitalization of pancasila economic system in the globalization era international journal of economics and financial issues | vol 5 • issue 4 • 2015 863 the ideology of liberal-capitalist economy. through economic institutions and international fi nancial, prepared a variety of global agreements that are not always suitable and advantageous developing countries like indonesia. sivakumar and krishnaswami (2012) says, this then gave birth to the suspicion of the existence of particular interest and the imposition of the will to realize the economic globalization. direction of economic globalization was not changed much since fi ve of the last century until now, namely the interests of the economic superpowers to gain economic benefi ts from the merging of the world economy. policies are applied in developed countries are often in confl ict with the principle of the development of globalization. united states and some western european countries are very sturdy to protect the farmers and zoo with a very large subsidy policy aims to unlittle role of government in the economy. increased government expenditure to gdp in industrialized countries can be interpreted as a systematic process to overhaul the economic structure of poor countries, in the form of litleled role of the state and increasing the role of the market so as to facilitate the integration and control of the economy of poor countries is under the control of the state capitalist rich countries (baswir, 2008). globalization forum international, has compiled some of the urgent plan for the internationalization of the activities carried out in order, among other things: first, the establishment of new international institutions to: (1) prevent the transmission of disease, confl ict, and international environmental destruction, and (2) establish international norms regarding the rights and standards which will mostly be applied at the national level. second, the re-arrangement (reform) the international fi nancial system. third, institutional re-arrangement procedures of world bank and regional banks like the asian development bank (adb), which has a similar function. and fourth, the re-arrangement of the wto. economic globalization that has lasted many centuries ago, based on the interests of countries that have developed economies to seek riches for the prosperity of his country, without much care for the partner country or colony. for developed countries it is important is the accumulation of wealth, or gold, and their welfare. economic globalization during the last fi ve centuries of european colonialism aimed at getting of wealth in the world that were previously unreachable. cristobal colon, which became known as christopher columbus, with fi nancial support from the king and queen of spain sailed across the sea to get to that reported by the asia abundant with natural resources and gold. the search for new territory to acquire wealth for the relatively rich countries of this kind continues. so the colonial era of globalization efforts are directed to meet the needs of countries that had already been developed by exploiting the country or region that is still underdeveloped. globalization of trade for developing countries has also been degrading to the exchange rate of exports to imports of manufactured goods it needs. in fact, the decline rate is likely to get worse and cause the transfer of real resources caused by the loss of potential revenue on exports as a result of deterioration of the exchange rate. based on this fact stiglitz (2008) called for the implementation of globalization, including the various agreements on trade review and radically reconsidered. economic globalization in theory could increase the intensity and activity of world economic activity. increased activity of economic activity will bring benefi ts to improving the welfare of the people of the world. with the removal of barriers in international economic relations will encourage increased effi ciency and production of goods and services. sajid and rice (2009) says, economic globalization will increase the fl ow of trade and investment between countries, developing production technology leads to an increase in world output, which in general will improve the welfare of mankind in the world. therefore, ghosh (2008) says trade barriers, either in the form of high cost and non-cost should be minimized, even eliminated if necessary. policies need to be implemented to minimize barriers by various international economic institutions. freedom of the world economy is considered as an effective effort to improve the output of the world, which led to the welfare of the world. the economic freedom will bring optimization products. the spirit of the optimization and distribution of products being developed in the late 1980’s and early 1990’s. the concept of thinking about economic globalization continues to growth almost all over the world. impact of economic liberalization conditions as if the country without borders clear physical, sweeping free trade to the various commodity sectors. global economic integration is believed to be carrying the world on economic progress, eliminating poverty and reducing disparities between countries rich and poor. policy toward globalization was strongly supported economic superpowers, who are already familiar with the pattern of trade liberalization. economic globalization in the regional (economic regionalization) is often regarded as a success story is the economic integration of western european countries are now members of the european union (wayne, 2007). the success story has become a reference for other regional countries, so many countries in the region “training” to prepare for the globalization of the economy through regional economic integration. in the asia pacifi c region in the form of apec which led countries such as australia, america, and canada. in a smaller scale also formed nafta, afta, and so on. in a next step, the various devices of the world economic organization formed with the hope will help accelerate the realization of economic globalization for raising prosperity of the world. prospective of economic globalization are very confi dent that the promises of globalization and the increased prosperity of the world of international cooperation. obstacles that may be the movement of goods, services, and capital needs to be eliminated (gilpin, 2009). in fact, the idea to liberalize world trade is not easy to implement, especially for countries that are not yet ready to compete or have low competitiveness. liberalization, says of ernesto and winden (2010) is essentially free competition would require a balanced quality of the participants of the competition. if quality and capital strength are not balanced, we can be sure the competition will be won by the strong competitiveness. in fact the conditions of economic power between nations is still ago, so if going to compete would be out of balance. liberalization in the economic globalization will only lead to developed countries to subroto: revitalization of pancasila economic system in the globalization era international journal of economics and financial issues | vol 5 • issue 4 • 2015864 victory in the competition. even if economic integration need to be implemented, should be limited to certain areas of strength are relatively balanced. the theory of regional economic integration, should take priority over development through regional cooperation (david, 2008). in the empirical perspective, economic globalization has become a tool for developed countries to exploit and benefi t economically from these countries is growing. in fact, from a theoretical perspective of economic globalization is not really applicable, because it is still not same of economic forces in the countries of this world. therefore, it should be free competition in the economic globalization cannot be done throughly, but should gradually start from a specifi c region corresponding to the capabilities and readiness of each country (rodrik, 2008). this condition should be an important record for developing countries to anticipate shortages and competing for their readiness in the face of economic globalization. 4. pes the basic principle in pes, its application is based on the philosophy of pancasila and the uud 1945. values and norms embodied in the ideology of pancasila and uud 1945 as the based for the development of the economic system, which is essentially to bring about social justice for all indonesian people. these objectives can be achieved if economic policy in favor of the people at large, meaning that the people’s economy needs to be stepped up as the based for economic growth in indonesia. economic activities should be carried out based on the principles of pancasila democracy. similarly, the principles of economic democracy that has been constitutionally stipulated in the uud 1945, namely: a. article 23: confi rms that the rights of parliament, among others: • accept/reject the draft budget with the act • establish a tax law • defi ne the range and value of currency by the act • checking the state of fi nancial responsibility by the act. b. article 27: affi rming that every citizen has the right to decent work and livelihoods c. article 33: among other claims, that the economy is structured as a joint effort based on the principle of family d. article 34: the number of factors are poor and neglected children maintained by state even in detail in chapter 33 uud 1945 asserted that: (1) the economy is structured as a joint effort basic family, (2) the branches of production are important and dominate the life of many state-run, (3) earth and water as well as wealth controlled by the state is in it, and used as much as possible for the welfare of the whole people of indonesia, (4) national private sector development to support national economic growth. populist economic activity driven by the stimulation of economic, social and moral nation, so there is the will of the people to achieve social and economic equality. nationalism, says oludele et al. (2012) has always animates the policies and the implementation of the economic system. characterized by the cooperative principle of the family is the cornerstone of the national economy. there is a balance between centralism and desentralisme in economic policy. pes so that non-liberal-capitalistic, not is the economic system of the etatistik. never the less the market mechanism remains coloring system economic life (mubyarto, 2005). indonesia’s economy is a typical system should keep in mind the points listed in the pancasila. the precepts of pancasila, social justice for all people of indonesia are the most relevant precepts to develop the economic system. precepts of social justice for all people of indonesia contains two meanings: 1. the principle of fair distribution of income, which is based on a free fi ght liberalism 2. principles of economic democracy, namely the uud 1945 provided for in articles 23, 27, 33, and 34. under the state constitution, the pes more pro-people economic policies that many countries have towards the realization of social justice by applying the basic family’s economy. pes more priority to the welfare of the entire nation of indonesia, but it guarantees economic democracy and protect the economic rights or property of someone. although the interests of the joint, but the economic rights of individual citizens of indonesia remain secured and protected so as to make economic activities more conducive to improving the business activities to achieve common prosperity. 5. pes in the era globalization economic globalization towards the direction of economic liberalization that is loaded with free competition in various sectors of production of goods and services. in this free competition of global capitalism into the direction of the commander and controller of the world economy. the capitalist, says olivia et al. (2011) is relatively advanced technology and monetary support and competitive spirit that is more competitive, so that their position as the global economic control. practices of economic globalization that gave birth to the hegemony of developed countries to developing countries is very detrimental to the country that are less prepared to competition (martin, 2008). these conditions also create a hegemony of big business against small business, because large employers are relatively better equipped to compete in a liberalized global economy. disclosure of the capitalists who built the spirit of economic liberalization, it would be very detrimental to the economic actors who are less able to competition and open up wide opportunities for large employers to small master. these conditions need to intervene system of economic policy in favor of the weak to protect the hegemony of big business, so that the interaction of economic openness to ensure an equitable and not detrimental to one party. in the face of economic liberalization, have to be realistic that it is impossible unstoppable globalization or avoid it. globalization on various aspects of life will continue to run without any power that can stop it. to adapt to the globalization of the economy we need to improve the capability and competitiveness of the economy is continuously synergize the potentials of local and national level to competition in the global arena. another effort is to forge subroto: revitalization of pancasila economic system in the globalization era international journal of economics and financial issues | vol 5 • issue 4 • 2015 865 partnerships and to invite other countries to act together to resist the principle of economic cooperation which is unfair and detrimental to one party, which made economic institutions and global fi nance. the struggle to create a fair statement of cooperation and not harm the national interest, should always be sought in anticipation of global economic cooperation. the trend of economic globalization is happening today should be observed and economic cooperation is necessary to arrange mutually benefi cial and respectful of each other. era of economic globalization which impose liberalization, should be categorized as a form of neo-liberalism. moreover, the economic power into a tool of coercion powerful state against another state in its political ideology. similarly, in the process of globalization, powerful states often use economic institutions worldwide to support its policies, the impact on profi ts continue to fl ow to developed countries. although the spirit of mutual cooperation, the more benefi t there is often still on the parties to the advanced industrial countries that are already familiar with the practices of free competition in the economy, as the derivation of the ideology and the liberal philosophy of life. economic globalization is full of liberal-capitalist ideological charge, with a face that resembles the derivation of this ideology. globalization is bringing liberalistic ideology is clearly incompatible with the ideology of pancasila, so we need to be careful in react. similarly, in addressing the practices of economic globalization, need to be reviewed from the view of pancasila ideology which is essentially public interest. keynes in 1936 alone to make a revolution by demonstrating that economic science is learned and developed over 150 years since 1776 is a false science that should be abandoned if the capitalist system to survive (mubyarto, 2005). the basic point is most obvious mistake is the belief is always the balance (equilibrium) between the supply and demand as understood as natural law. economics in indonesia, as in many other developing countries, is also not relevant to public welfare or for the greatest welfare of the people. thought economics in indonesia since the mid-fi fties is the science which teaches the individual greed of natural objects, which teaches the properties of self-interest in every person and than the principle of the spirit of togetherness and family. the concept of pancasila economy contrary to the orthodox neoclassical economics is now taught in colleges and high schools, which assumes households or communities as more consumers who only act as a collection of “compulsive shoppers” and on the other hand the producer business world is very noble work of producing goods and services to the public interest. prosperity and welfare of the people/society is always considered a business mission. then the investor is always considered a “savior gods” whose job “prosperous society” or to create new jobs for workers who need them. indonesia’s economic experts tasked with undertaking the suffering of the people must stand in the front row overhauled neoclassical economics courses that have been accepted as orthodox religious teachings. whereas orthodox neoclassical fl ow is extremely harmful to society because it teaches a lot of greed on the nature of individual objects. economics is the science of economics pancasila, moral values and the correspondence moralities indonesia. pancasila ideology agreed as a way of life so that everyday behavior, including the practices of economic activity is based on the norms contained in the nation’s outlook on life. practices need to refl ect the norms of economic activities are contained in the precepts of pancasila. the practice of economic activity necessary application divine values, humane, nationalistic, and populist, and social justice. empirical fact, many economic activities in the era of globalization is that deviate from the norms of the ideology of the indonesian nation. economic globalization is often run over a lot of public interest, especially the neglected role of groups and interests, such as farmers, laborers and lower-class workers whose interests are often sacrifi ced. the act of the capitalists who rely on capital intensive and technology often result in workers losing their jobs, their own set of strategic commodities prices, so that the nation’s economic sovereignty in the hands of other countries or international institutions. scenario of global economy mechanism and controlled by international economic institutions which of course brings the mission interests of developed countries in a spirit of global corporations. how naive, in a country like indonesia is still developing the competitiveness is still low and poverty is still relatively high, and support practices of global economic activities which contribute to the inequalities and injustices of the world economy. these conditions should be anticipated in order not to increase the width of the gap between the developed countries to developing countries. system of economic policy should be based on the ideology of pancasila, the values and norms that growth in the people of indonesia. policy of the economic system known as pes that favored the implementation practices to the people or democracy based economy, with policies that seek to tackle poverty, reduce inequality and for the welfare of the people based on the ethics of pancasila (mubyarto, 2005). efforts to realize the economic system of pancasila, of course not easy, because dealing with a group of investors with a relatively more modern technology. moreover, the spread of individualistic attitudes and ideology of liberalism or capitalism-often known as neoliberalism on the national business community, so there is the nature of greed to profi t as much as possible in the business and economic activities. development of an individualistic nature of the fl ow carried by currents of globalization on indonesia society is connoted as a modern lifestyle, is a daunting challenge to realize the economy is based on pancasila democracy. 6. revitalization of pes in the era globalization indonesia needs to address the nation carefully to the phenomenon of globalization that tends to harm the national economy. due to economic globalization tends to benefi t the industrialists who have capital and a handful of large national employers who benefi t from the mechanism of free competition. globalization has been driven by the capital from industrialized countries and in cooperation with the main agent in developing countries in an subroto: revitalization of pancasila economic system in the globalization era international journal of economics and financial issues | vol 5 • issue 4 • 2015866 effort to capital accumulation. in fact, according baswir (2008) in the state recurring attitudes that oppose the practice of economic liberalization, especially of the lower classes that are sure to feel the impact. many non-governmental organizations are joining the world community of the world social forum, indicating their resistance to the global economic policies that are controlled by fi nancial sector development of global economic institutions, namely: the wto, international monetary fund and world bank. third of global economic institutions continue to seek to control the world economy, with policies based on the spirit of free competition that tends to favor the capitalists who have relatively high competitiveness, both capital and technology. the phenomenon of economic activities in indonesia, in response to the conventional economic system that relies on market mechanisms to support free competition, have raised the discourse of pes. in fact, since 1980 has promoted the concept of economic started pancasila. socialization of the concept of pancasila economy is still not as expected. implementation of a democratic economy based on pancasila values and norms are still many obstacles, especially by the economic elite and modern lifestyle trends that tend to be individualistic as brought by globalization. implementation of pes in an effort to alleviate poverty and reduce inequality of wealth for the welfare of the social justice needs to be revitalized role that the indonesian national development goals can be realized. a variety of barriers, obstacles and challenges facing the implementation of pes must be addressed immediately. it is appropriate pes could be hosted in their own country. then the various government economic policy should be implemented in an effort to revitalize the economic system of pancasila. revitalization of pes needs to be pursued in a sustainable manner consistent with the policy. internal policies in the country, the government of indonesia to implement various policies of the national economy is based on economic democracy with the principle of pancasila democracy. this is to anticipate the impact of the passing of an increasingly global economy spread to various parts of the world, including indonesia. economical national policy should always be based on norms and values of pancasila as the nation’s life and philosophy as the basic for the organization of the state. economic activities that are labor intensive and basic family, should take precedence. in the exit policy, the government of indonesia that with all powerness and infl uence, need to forge partnerships with countries to strengthen the unity of common fate in tackling inequality between developed and developing countries is widening. this effort is aligned with the international forum of globalization, which some urge to do the reform planning in the context of internationalization, namely: first, the establishment of new international institutions to: (1) prevent the transmission of disease, confl ict, and international environmental destruction, and (2) establish international norms regarding the rights and standards that most would be applied on a national level. second, the rearrangement (reform) the international fi nancial system. third, institutional re-arrangement procedures of world bank and regional banks like the adb, which has a similar function. and fourth, the re-arrangement of the wto. to implement these planed, the leaders of developing countries would need to equip themselves with a strong political will. simultaneously, they are also required to continue to join forces and strengthen the relationship between the members of the developing world se. bargaining position of developing countries should be increased to deal with the oligarchy developed countries. this effort is expected to prevent the leaders of developed countries to keep going with the neoliberal economic planed they are. the pace of economic globalization is essentially an imperialist neo-liberal practices of the developed countries must be stopped immediately. pancasila economy needs to be revitalized to support the national development of indonesia. the concept of pancasila economy needs to be socialized to be more popular in the community an ongoing basic among economic actors and the entire nation of indonesia. pancasila economy concept should be endeavored to host their own country. this policy needs the political will that the government understood the concept of pancasila economic society in general. for most experts economic trapped by the “mistaken belief” that economics is value free and global (universal). economics of constitution is not believed to be infl uenced by the time when and place where he was born. as a result, the concept of pancasila economy unacceptable by indonesia’s own economists, because the concept of a special kind of economic science economic pancasila is considered absurd. however, this view needs to be minimized so that the application of the concept of pancasila economy could be the basic for the economic system in indonesia. 7. conclusion of exposure in front of a few conclusions can be stated as follows: 1. globalization and economic liberalization is deterimental to most of the people of indonesia for the door wide open to free competition so it is very unfortunate that relatively developed countries are ready to compete because it is supported by fi nancial capital and modern technology 2. pes is an economic policy in accordance with the condition of indonesia, because it would be effective in reducing unemployment, poverty and wealth inequality. but pes is still not popular in the community and be accepted by most of indonesian society, because of ignorance of economic systems. in additional many economists argue that the pes does not have a strong theoretical basic so impressed and not making it up are universal 3. there needs revitalization movement pes in a more systematic and planned so that the system is able to host in his own country. revitalization can be implemented through various government polities that favor economic system to the people by not reducing economic democracy 4. revitalization of pes needs to be pursued constantly and sustained through the implementation of economic policies in favor of the people and to anticipate the growing infl uence of economic globalization and spread to various world. subroto: revitalization of 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5.0 and later.) >> /namespace [ (adobe) (common) (1.0) ] /othernamespaces [ << /asreaderspreads false /cropimagestoframes true /errorcontrol /warnandcontinue /flattenerignorespreadoverrides false /includeguidesgrids false /includenonprinting false /includeslug false /namespace [ (adobe) (indesign) (4.0) ] /omitplacedbitmaps false /omitplacedeps false /omitplacedpdf false /simulateoverprint /legacy >> << /addbleedmarks false /addcolorbars false /addcropmarks false /addpageinfo false /addregmarks false /convertcolors /noconversion /destinationprofilename () /destinationprofileselector /na /downsample16bitimages true /flattenerpreset << /presetselector /mediumresolution >> /formelements false /generatestructure true /includebookmarks false /includehyperlinks false /includeinteractive false /includelayers false /includeprofiles true /multimediahandling /useobjectsettings /namespace [ (adobe) (creativesuite) (2.0) ] /pdfxoutputintentprofileselector /na /preserveediting true /untaggedcmykhandling /leaveuntagged /untaggedrgbhandling /leaveuntagged /usedocumentbleed false >> ] >> setdistillerparams << /hwresolution [2400 2400] /pagesize [612.000 792.000] >> setpagedevice . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 551-555. international journal of economics and financial issues | vol 7 • issue 2 • 2017 551 corporate regulation of unethical practices: assessment of nigeria’s commercial banking industry olabode a. oyewunmi1*, olamide olusanmi2, olusola j. olujobi3, folashade adegboye4 1college of business and social sciences, covenant university, ogun state, nigeria, 2college of business and social sciences, covenant university, ogun state, nigeria, 3college of business and social sciences, covenant university, ogun state, nigeria, 4college of business and social sciences, covenant university, ogun state, nigeria. *email: olabode.oyewunmi@covenantuniversity.edu.ng abstract evidently, a culture of due compliance has been eroded on multiple levels within nigeria’s commercial banking industry. hence, corporate values and professional ethics are being sacrificed on the grounds of; being competitive, returning impressive profit margins and increasing market share. historical antecedents and emerging trends indicate the long term adverse effects of corporate malpractices, especially when left unmitigated by affected stakeholders. the appreciable decline in global oil prices has reenergized corporate regulatory oversight in nigeria. the aim in this regard and as widely publicized; is to sanitize the wider business environment and importantly renew the public trust, domestically and internationally. apparent trends of insider dealing practices subsist in nigeria’s banking industry, even though very limited conclusive cases are available for exhaustive analysis. this fact is further validated by the various interventions of the requisite regulatory agencies, coupled with the local and international commentaries in this regards. instructively, deployment of statutory-oversight by the requisite agencies has prevented a systemic collapse of banking industry. the paper also succinctly explored the essence of the stakeholder theory, as a basis to validate the necessity of corporate regulatory intervention. relevant evidences, specific statutes and others verifiable sources utilized to expound on the theme of the paper. it is opined that there must be active collaborations between corporate stakeholders and the regulatory structures, particularly against the backdrop of nigeria’s unfolding socio-economic peculiarities. keywords: regulation, banking, compliance, unethical, insider dealing and stakeholder jel classifications: e52, e58 1. introduction the significance of the relationship between corporate regulation and unethical practices, notably insider dealings, cannot be relegated, especially when considered in the context of a transitional banking industry. such an assessment becomes more meaningful when construed in the light of some happenings associated with nigeria’s commercial banking industry. moreover, the adoption of various technological platforms, coupled with increased access and market penetration further affirms the need for elevating the monitoring of banking transactions. such an approach will contribute in measurable respects to promoting the corporate values, professional ethics as well as the overall sanctity of the industry. trends of insider dealings related to the nigerian banking industry system have historical antecedents dating back over three decades. the central bank of nigeria (cbn) examiners identified that a wide range of corporate abuses and unethical practices were significantly impairing corporate performance in the commercial banking industry. instructively, the principal factor underlying bank failure in as regards 1980s and 1990s has been attributed to board and management related practices consequently, in the early to the mid-2000s, there was a recapitalization policy drive, which manifested in several public shares offers as well as mergers and acquisitions. it is also instructive to note the changes in the top hierarchy of the apex bank and its related policy shifts and adjustments. it is very evident that poor corporate governance practices have manifested in deficiencies relative to; banks earning assets especially loans, maintenance of the statutory obligor limit and advances connected with insider abuse. such can also be attributed oyewunmi et al.: corporate regulation of unethical practices: assessment of nigeria’s commercial banking industry international journal of economics and financial issues | vol 7 • issue 2 • 2017552 to management inefficiencies and as well as the escalation of insider transactions. a more robust implementation in 2015 of treasury single account has further brought to the light the scope of unhealthy practices amongst several commercial banks. it particularly highlighted unethical practice of holding multiple accounts by individuals and corporate bodies which facilitated round tripping of funds amongst other illegal purposes and ends that are contrary to public policy. also noteworthy is the era when specific banks deployed as “market makers” in view of the negative down trend in the stock and derivatives market. the timely intervention of regulatory authorities mitigated the impact of heavy liquidity out-flows experienced by some banks, and thus negatively affecting their day to day operations. thus, it came to the light that with the aid of insider information, some banks were able to avoid harsh regulatory sanctions. the elastic effects of the corporate rearrangements exercise came to the light primarily because of sitting government’s resolve to adopt the liquidation option rather than bailing out the banks. unchecked practices of insider dealings usually undermined established policies resulting in corporate failures in diverse respects coupled with the attendant negative macro-economic effects. hence, the role of corporate regulation via applicable laws and policies cannot be relegated in order to manage the diverse incidences of insider dealings (abubakar, 2013). it is not practical to deal exhaustively with every instance of unethical business (insider dealings) and the dynamics of the corporate banking regulations. hence, the approach adopted in this paper is to purposively construe existing evidences as a basis to expound on fundamental issues relative to non-compliance and part-compliance with applicable laws, codes, regulations and established industry practices. 2. regulation of commercial banks the dilemma bedeviling nigeria’s banking industry is best exemplified by the failed bank and financial malpractices in banks (recovery of debt) act, 2004. the crisis majorly centered on non-fulfillment of credit and loan obligations by identifiable insider actors. hence, the commercial banking space was evidently eroded by this inappropriate trends, coupled with other species of corporate abuse and unethical practices. the failed banks act was indeed timely and restored some sanctity to the commercial banking environment. it is noteworthy there were other laws in this respect, but due enforcement was relatively lacking to achieve the desired outcomes. nigeria’s banking industry is regulated in specific respects by notable enabling laws. the applicable laws include the companies and allied matters act (cama) of 2004, cbn act, 2007, the banks and other financial institutions act, 2004 and to some extent the nigeria deposit insurance cooperation act, 2006 no. 22 of 1988. the laws in various regards deal with issues like; disclosure of interest by insiders, and the system of cbn off-site surveillance and the on-site audits of banks. a notable feature of the industry is low ethical standard and transparency. these are manifesting in the rising cases of unwholesome practices being recorded. the focus of the regulators typically lies in reducing sharp and unorthodox practices, promoting filing of accurate financial reports and timely reporting of unethical practices; strengthening internal governance structures, sanctioning managerial incompetence. in effect, such an outlook will contribute in measurable respects to lowering corporate losses, reduce bank frauds and further highlight the importance of maintaining functional internal control systems. 3. banking ethics: conceptual and practical overview generally, a professional banker stands in a position of trust in relation to the public. it is fiduciary in nature and as such is accountable to specific interests or groups. a banker can also be appropriately regarded as a custodian of individual, group, corporate and national wealth. typically, bankers are involved with managing the finances of; individuals and corporate entities. the essence of professionalism in banking lies in the ability and competence to give the customer basis for complete trust as well as faultless service. sustainable banking activities thrive on maintaining public confidence and trust. the bank that lacks such essentials will progressively lose its competitive element or dynamic. professionalism requires optimal adherence to the highest standards of ethics and due compliance as required by the prevailing law. it is the fundamental platform for ensuring a robust, effective and sustainable banking system. it thus suffices to say that inspite of the evident regulatory gaps attributable to the commercial banking sub-sector; the actors are still subject to the well-established concept of the ethical compliance. this connotes in certain respects that stakeholders have an apparent right to expect a business to be conducted ethically, and a view to the contrary will harm the corporate entities long-term interests and good will (duska, 2007). interestingly, the prevalence of unethical practices in the banking industry, particularly in the mode of insider dealings, further exemplifies corrupt tendencies attributable to the broader political and socio-economic national context. in the circumstances, regulatory have had to adopt various measures to secure depositors and shareholders funds. the ill-preparedness and negligence of the regulator contributed to the level of distress in industry over time, and this has manifested in low productivity across other sectors which rely on the financial support of the banks in growing their businesses. it is instructive to note that such an outcome negates customary function of governmental regulatory agencies, duly empowered regulate the activities of commercial banks. this can be effectively carried out; in as much as such does not amount to the control and undue interference with the legal business activities of the corporate entities (akinbola et al., 2013; nwano, 2013). the frenzy associated with the policy driven recapitalization activities of commercial banks (2003-2007), evidently stretched the limit of ethical compliance. this conclusion can be drawn as background incidents unfolded as regards the questionable means oyewunmi et al.: corporate regulation of unethical practices: assessment of nigeria’s commercial banking industry international journal of economics and financial issues | vol 7 • issue 2 • 2017 553 used to secure bank deposits, fraudulent share subscriptions coupled with other unethical practices geared towards securing undue advantage. the constant pressure and influence to maintain a competitive advantage has undeniably tainted the fundamental of the commercial banking environment, thus further impairing the transparency and business confidence index attributable to nigeria’s business environment. this trend of distress assumed a different dimension in the early 2000s. a wave of public share offers and series of mergers and acquisitions was experienced in the commercial banking industry. it was primarily geared at regaining public trust and to achieve some degree of stability in the banking system. a reasonable number of the corporate arrangements did not stand the test of time as was typified by corporate maneuverings on multiple levels with diverse consequences for individual and corporate interests. the intervention of the asset management company of nigeria (amcon) as a ‘bridge bank’ and in taking buying over bad debts of distressed banks has further highlighted the instability within the corporate structure of certain banks. this is evident as amcon exercises its wide regulatory powers to restore some degree of sanctity to the affected banks. 3.1. insider dealings: regulatory overview in the legal parlance, who is an insider? an insider by section 315 of the investment and securities act (isa) and rule 110(3) of the securities and exchange commission rules and regulations 2013 is a person in possession of price sensitive information and deals on the securities of such company. the cama 2004 laws of the federation of nigeria, section 111(1) of the isa 2007 (isa) prohibits any person who is an insider of a company from purchasing, selling or otherwise trading in the securities of such company which are offered to the public either for sale or by subscription if he or she has information which he or she knows is unpublished and price sensitive information in respect of those securities. rule 17 of the code of corporate governance for public companies in nigeria disallows the directors of public companies, their immediate families, their wives, sons, daughters, mothers or fathers and other relatives from trading in the securities of that company. according to the provision of section 116 (1) isa, the securities and exchange commission’s investments and securities tribunal may order any person who is culpable of insider dealing to pay compensation to any aggrieved person for the purchase or sale of such securities. section 115 of the isa also makes provisions for criminal sanction against any person who engages in insider dealing to be liable on conviction in the case of an individual to a fine of not <5000 naira or any amount equivalent to the double of the amount of profit he got or losses he averted by the use of the information or to an imprisonment for a term not exceeding 7 years and in the case of a body corporate fine of not <1 million naira or amount twice the amount of profit got or loss it averted by the use of such information. the deterrence effect of the stipulated fines is however debatable. the concept of ethics converges in certain respects with the widelydebated issue of morals or morality. the former can be broadly depicted as conforming to stipulated codes and practices within a given context. in effect, the term can be regarded as the foundation of personal, corporate and national success. in the more exclusive and corporate sense, ethics encapsulates the minimum benchmarks by which of measuring the competence of individuals involved in the practice of a given profession or calling. the profession of banking is indeed one that is integral to overall national economic development, and as such one which demands maintenance of high and consistent ethical standards. it is in adopting such a high-level trust posture, lies foundation of securing the enduring confidence of the diverse stakeholder base. thus, it rests on the stakeholders to ensure that the ethical compliance remains an integral part of their business processes. moreover, regulation has its limits, as even with the considerable level of regulation and scrutiny, avoidance and non-compliance is still very evident. insider dealings covers a range of issues such as; non-disclosure of the interest conflicting interest relative the principal actors in a transaction; diversion of assets for personal use and abuse of position abuse to facilitate transactions to the detriment of the corporate interest. other dimensions entail exploiting weak corporate governance structure for personal gains as well specific forms of managerial abuse. hence, these dimensions of insider dealings contribute to impairing public confidence, especially in a context where illegitimate use of sensitive market and financial information is left unregulated and is allowed to thrive to the detriment of other stakeholders (davies, 1997). there are incidences of unwholesome practices being recorded for banks, several banks engage in some sharp and unorthodox practices to achieve compliance with some regulatory requirements. certain conducts are classified unprofessional/unethical some are; conflicts of interests, engaging in extraneous activities which interfere with or constrain a bank’s primary responsibility, colluding with third parties to inflate contracts. these includes amongst others; analysis of the volume of deposits and evasion of insurance premium, mandatory cash reserve requirements, imposition of previously undisclosed charges on customer’s accounts; failure to submit report on dismissed/terminated staff to cbn and allowing proven fraudulent staff to resign, failure to submit report on eligible credit to cbn for necessary audit and monitoring. it also includes; misuse of information, manipulation or nondisclosure of material information to derive some benefit or avoid liability, running down competitors through deliberate misinformation. misuse of various financial derivatives, deliberate rendition of inaccurate returns the regulatory authorities with intent to mislead, misuse of confidential information gained through banking operations. these amongst others, are forms of unethical practices which escalate the risks attributable to the banking system. 4. insider dealings: stakeholders perspective the full effects of insider dealings in nigeria’s commercial banking industry came to the fore in 2009 as the apex bank rescued oyewunmi et al.: corporate regulation of unethical practices: assessment of nigeria’s commercial banking industry international journal of economics and financial issues | vol 7 • issue 2 • 2017554 eight banks, associated with non-performing loans estimated at n3 trillion. the cbn at the time had injected over n620 billion in the banks, dissolving the management board and appointing a new team to manage the affairs of the affected banks. according to the regulator, the non-performing loans due largely to exposure to capital market trading and the oil and gas sector had negatively impacted on the shareholders’ funds. the sharp and consistent decline in global oil prices (2015-2016), coupled with the negative impact on the value of the local currency and changes in governmental policy will further test the sanctity and veracity of processes in the existing commercial banks. this outlook is instructive in view nigeria’s overreliance on oil revenues and its associated risks and collateral damage, especially in periods of lower earnings from crude-oil sales. moreover, such negative or unfavorable indicators are to further test the credibility of the institutions operating in the financial sector of the economy. notably, the new managements set up to run the affairs of the rescued banks were then mandated to seek core investors that would bring in new expertise and capital to strengthen the banks. however, shareholders of some of the banks went to court challenging the legality of the cbn’s action. the cbn has been relatively successful in facilitating the establishment and functioning of the amcon. specifically, it has provided an appropriate option to handle the issue bad debts in a fiscally responsible and sustainable manner. it is also noteworthy, that the asset management and recovery centric institution, has taken up over n1.7 trillion of non-performing loans in the books of the banks, replacing it with tradable bonds. multiple and various forms of corporate arrangements and re-arrangements have occurred since the advent of amcon as the banks seek to retain their relevance in commercial banking environment. for organized labor, liquidating virile ‘rescued’ banks were rather hasty and could hurt the economy deeply. in fact, for them it is tantamount to carrying out anti-national policies over which they requested presidential intervention. the workers under the aegis of association of senior staff of banks, insurance and financial institutions (assibifi), nigeria labor congress affiliate, urged the supervising ministry and the presidency to critically look at all the current issues in the banking industry patriotically rather than leaving them in the hands of uninformed and biased regulators (the nigerian voice, 2011). the national president of the union at the time lamented that the policies being pursued by the cbn presently would rather create more chaos for the nigerian economy. moreover, such a posture by the cbn had the potential of escalating public distrust in the stability and viability of the banking industry, and thereby constraining financial standing of the affected banks (the nigerian voice, 2011). the assibifi president said that the utterances of the leadership of the cbn on the state of these banks were questionable as it could be considered that there was a preconceived intention to liquidate the banks irrespective of their financial health. it was also noted by the leader of the workers’ union that, one of the banks was declared illiquid for financing government-guaranteed projects. the disclosure issue is a recurring issue that continues to put the commercial banking system in bad light. this is evident on the part regulators and operators as both seek to promote their own interests to the detriment of the largely undiscerning public. it is important for all stakeholders to synergize in this respect, coupled with the much needed political will to ensure policy consistency and implementation (the nigerian voice, 2011). 5. a brief judicial viewpoint on insider dealings in the case of securities and exchange commission v. texas gulf sulphur company (1966); it was decided that any person in possession of inside information should either disclose the information or abstain from trading on such information. also, instructive in this regards; is the case of united states v. carpenter (1986); where the court upheld the conviction of the defendants who received confidential information from a journalist rather than from the company contrary to the mail and wire fraud statutes. similarly, in the decided case of united states v. o’hagan (1997) where o’hagan utilized inside information to buy call options on pillsbury stock and made profits of over $4 million. the court rejected o’hagan claim that he owed no fiduciary duty to pillsbury and that he did not commit any fraud and the court upheld his conviction. in nigeria, on january 6, 2014, the securities and exchange commission’s administrative committee overturned the registration of sterling registrar limited, a division of sterling bank plc for unauthorized apportionment of shares of japaul oil and maritime services plc. it also barred kalstead farms investment limited and five other persons, with the staff of sterling registrar from involving in capital market activities for a given period. the requisite fines levied and the additional charges were imposed, considering each day of the unauthorized allotment (abugu, 2015). 6. conclusion and recommendations the trend of insider dealings in nigeria’s commercial banks is quite evident. it has also evolved in certain respects as the processes and practices become more integrated and complex. recognition of the negative implications of insider dealings for the banking sub-sector and the wider economy has reinforced the essence of due regulation. however, in order achieve optimal returns, it is important for all the stakeholders to engage more effectively to promote the goals that are productive and sustainable in the long-term. it is instructive to consider the peculiarities of nigeria’s banking industry. specifically, the banks are gradually integrating into the global financial markets and are thus more prone to a wider spectrum of risks which they are sometimes ill equipped to effectively address. hence, the need for an approach that is; proactive, interventionist and protects the overall sanctity of the industry. the lessons from other mature climes must also be adapted with circumspect bearing in mind variances in the operating environment. the cbn must lead the course to protect shareholders’ interests who are the primary victims of the negative effects on insider oyewunmi et al.: corporate regulation of unethical practices: assessment of nigeria’s commercial banking industry international journal of economics and financial issues | vol 7 • issue 2 • 2017 555 dealings. as the apex bank, it should be duly involved in the process, but ensuring fair treatment of all the banking operators. as a regulator, it is expected to design realistic benchmarks, coupled with ensuring effective monitoring and due compliance with established guidelines. a practical whistle blowing framework must be established to facilitate exposure and mitigate the trend of insider dealings. such a measure would contribute in the detection and prosecution of person involved in insider dealing, especially as regulators are not aware of the commission of the crime which occurs internally within the corporate context. the regulatory interventions by the cbn are consistent with the essence of the well-established management theoretical foundation, that is, the stakeholder theory. specifically, mitigation of insider dealings by way of corporate regulation reinforces the standpoint that; the corporate body was created to serve multiple interests and stakeholders who have a legitimate stake in the organization’s performance or output (mercer, 1999). the scope of stakeholders can in effect be enlarged to capture any person or collective of persons that is directly affected or may be potentially affected by the achievement of the organization’s objective (freeman, 1984) hence, a deviation from appropriate pathways to achieve the corporate goals necessitates some form of intervention to protect the matrix of interests associated with the corporate entity. essentially, the goal is to ensure an effective balancing on the rights and obligations attributable to persons or groups expressly or implicitly affected by the performance of the organization (sayre-mccord, 2000). in more practical terms, stakeholder rights are centered on the progressive negotiations, contextual compromises, agreements as well as compliance on multiple levels amongst the requisite parties. thus, where corporate trends, practices or outcomes cannot be captured within recognized, appropriate and measurable parameters, such can be duly considered as being for the benefit or gain of identifiable stakeholder. this is instructive, as there are indeed legitimate options and processes for deriving and sustaining value, wealth and rewards for the multiple interests connected with corporate entity. the focal point should thus be to advance and entrench the acceptable and legitimate avenues for creating corporate wealth as a veritable means to diminish the incidences of insider dealings amongst other unethical corporate practices. there is need for application severe penalties for the offence considering the consequences and prevalence. the training and equipping of the law enforcement agencies and statutory regulatory authorities is also necessary for insider dealings detection, investigation and prosecution. severe criminal sanction may fail to serve as deterrence, if the suspected insiders are not arrested for prosecution and punishment. in effect, a contrary posture will only escalate the fears of the shareholders and further dampen public trust in the commercial banking system. nigeria, can ill afford to project a culture of condoning unethical practices, as the banks are fundamental to the recovery of the socio-economic indicators, currently (2017) experiencing a notable decline. instructively, the issues captured above further highlight the scope of the corporate governance dilemma bedeviling nigeria’s commercial banking industry. references abubakar, g. 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(1997), 521 u.s. 642. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 875-883. international journal of economics and financial issues | vol 5 • issue 4 • 2015 875 rethinking of coase theorem: externalities and uncertainty evgeny a. kuzmin1*, sergei m. semyonovykh2 1chair “corporate economics,” ural state university of economics, ekaterinburg, russian federation, 2chair “theory of state and law,” ural state university of economics, ekaterinburg, russian federation. *email: kuzminea@gmail.com abstract a behavior of economic agents in many respects depends on taking into account those conditions that have appeared around them. traditionally, to such conditions, researchers have referred the uncertainty and factors of the institutional control, often projected on a value of the transaction costs. studies in stimulants for any form of the agents’ behavior lead us to an analysis of the coase theorem, which is expected to explain a number of similar regularities. however, ambiguous approaches to the theorem interpretation generate conflicts in a perception and identification of externalities. it is a solution to this challenge, which is a focus of this research. in a critical review of works by coase and his followers, the theorem statement has been made clearer; we have also put forward a hypothesis on an origin of the externalities and introduced additional criteria to identify them. the paper has given a scientific rationale for an author’s assumption that the utility of impure goods depends on the vector of the externalities, which ultimately determines the stratification in a field of the externalities (positive or negative). keywords: externalities, coase theorem, uncertainty jel classifications: а11, b40, b25 1. introduction the coase theorem in any of its interpretations has been for a long time a subject of critical evaluations, numerous objections and even negations. among researchers involved in a verification of its provisions, there were grebennikov and rivera (2007), shapiro (1974), allen (1998), zerbe (1980), etc. it seems that the whole barrage of criticism and debates has as its basis that numerous wordings for the theorem were incorrect and even inconsistent with coase’s ideas. in some cases, judgmental conclusions of the resource allocation effectiveness, that make, according to widespread beliefs, its “smooth” statement, do not have sufficient arguments. this is also fair for its “severe” form, when we are also talking about the zero transaction costs. this combines two paradoxical terms in quite a non-obvious conclusion. it is this cornerstone, which makes a situation when the theorem has become a kind of a long-held conventional assumption. further insistence on such a dogmatic paradigm within the institutional economics would be a mistake. available theoretical contradictions are mainly embodied in a challenge of the perception and the correct identification of the externalities. their appearance in the economics, one-way or another, is associated with the transaction costs and the uncertainty. at the same time, the strict implementation of the theorem’s original hypotheses as such allows us to say of a lack of criteria using, which we consider the externalities positive or negative. only after a verification of these parameters, one may thoroughly discuss ways and opportunities to internalize the externalities, surely, if necessary. that is why a focus of this research is mainly on a detailed analysis of coase’s provisions, as well as those of his followers. it would not be an exaggeration to say that a falsification of the controversial content of the theorem puts a fatal barrier for a development of theoretical ideas in the today’s institutionalism. in this context, clarifications for the coase theorem and criterial conditions of the externalities identification may solve a number of academic challenges regarding research in behavior of economic agents in terms of changing environment parameters. so, we pay the primary attention here to the uncertainty of various types, which in a sequential cycle implement an opportunity to make changes to the externalities. the author’s approach assumes hypothesizing and a thorough argumentation for a number of hypotheses, which are presented in detail below. kuzmin and semyonovykh: rethinking of coase theorem: externalities and uncertainty international journal of economics and financial issues | vol 5 • issue 4 • 2015876 2. literature review 2.1. the theorem interpretation it is commonly believed that the coase theorem was stated on the basis of coase’s ideas by eminent researcher stigler, who was the person giving them a much more distinctive and concise form, “the theorem … says that in terms of the perfect competition, the individual and public (social) costs will be zero” (stigler, 1966. p. 113). nevertheless, it has turned to be just one among its numerous interpretations. in fact, contrary to the widespread position, the provisions of the theorem had been presented to the academic community something earlier by coase (coase, 1959. p. 27) himself. however, it is the wording by stigler that has become the most well-known and cited in academic papers. at the same time, so far, there have been in use various versions for the theorem proposed by other researchers. for example, among those, who put forward their own interpretation with an eye on the coase’s research, we may refer to calabresi (1968), regan (1972), polinsky (1974) and allen (1999). another group of researchers is much more conservative in their views on the externalities. in their papers, one may find quite a similar description for the theorem preventing us from saying of any differences in approaches. into this group we may include papers by galperin et al. (1999), grebennikov and rivera (2007), tarushkin (2004), kapelyushnikov (2006), etc. the disunity between interpretations of the theorem is primarily explained with the fact that it has embodied a number of fundamental provisions sounded by coase, which can be hardly combined in the synectic way in a single axiomatic statement. in addition, it is not a surprise that wordings of the theorem are essentially different, without losing an important epistemological sense. anyway, they all describe regularities in representation of the externalities in a form of identities of the institutional mechanism to control relations. the main parameters for this mechanism have still included the costs (the resources) and the effects (outcomes) that determine the utility from making an economic action. calabresi (1968. p. 68) believes that the coase theorem is inextricably connected to the transaction costs and the environment condition. therefore, he assumes that in an absence of the transaction costs for a transaction and legal obstacles to bargaining, the inefficient usage of resources might be neutralized with the market itself. a similar interpretation makes it possible to confirm a conclusion of the relative mutual reporting between the transaction costs and the uncertainty (at least in terms of some types of the uncertainty). calabresi indirectly points out to an importance of the constitutive condition, under which the self-organization appears in a form of “the represented rationality in the resource use,” namely, to the properties of predictability and structured nature of the environment. legal barriers in this regard are a prototype of imperfect institutional standards, regulations and bureaucratic processes to make a transaction. the transaction costs in the same way describe the environment, market, but in a sense that they are intended to overcome the asymmetry of the information between contractors and consolidate the transaction conditions. thus, the rationality in economic processes occurs with sustainability maintenance, when other alternatives are a priori disadvantageous for all the stakeholders, or unknown. in other words, such the rationality or optimality remains conventional until the time when new alternatives are known. the strictly unilateral statement for the theorem by calabresi in terms of the rational use of resources does not explain all the heuristic potential, intended by coase. it is clear that the theorem potential is essentially higher than one could imagine. regan (1972. p. 427) puts forward the wording close in its meaning. in contrast to the previous definition, the theorem is complemented with limitations in its applicability. among other things, it specifies conditions, under which causal relationships will be relevant, “in the world of the perfect competition, the comprehensive information and the zero transaction costs, when legal standards related to an initial impact of the expenditures, associated with external factors, are not influenced, the distribution of resources in the economics will be efficient.” we believe that this interpretation of the coase theorem is exactly the most accurate. it seems to be productive to apply it in an analysis with a number of limitations and observations. several aspects simultaneously contribute into it. on the one hand, the theorem includes an important point of the perfect competition; on the other hand, it speaks of the distribution efficiency instead the rational use of resources. the last point needs further explanations. it is assumed that under the perfect competition and the zero transaction costs, any activity should be a priori efficient. here the everyday uncertainty is eliminated with the availability of the information. the resource allocation exactly becomes possible owing to following the comprehensive information about a mark in the absence of the negative externalities. the only subjective element in this design is the available rationality in decisionmaking. a change to the environmental conditions due to the permanent apperception of ongoing actions makes changes to the perception of the efficiency. it is clear that in this regard the simple transactions (as opposed to the complicated ones) have been only released from the momental uncertainty. at the same time, complex transactions keep staying influenced by forces to achieve an ambiguous outcome; therefore, it is impossible to say of any efficient resource allocation for them. other interpretations of the theorem are fully difficult to be included in a circle of credible wordings. so, polinsky refers to a shortened version of the theorem, assuming the following statement, “if the transaction costs are zero, and a structure of legal standards is insignificant, the efficiency will be anyway achieved” (polinsky, 1974. p. 1665). we should mention that the cumulative transaction costs, in our view, even under conditions of the perfect competition, are unable to be zero. according to the theorem in its truly correct interpretation, the external transaction costs are only not available. the costs of an internal nature remain positive, as economic agents have been still in need to coordinate their activities with that adjustment or adaptation to the conditions of the perfect competition. unambiguous conclusions by some researchers saying the contrary are incorrect. a good example is allen, who makes a categorical generalization, “with the absent transaction costs, the resource allocation does not depend on the kuzmin and semyonovykh: rethinking of coase theorem: externalities and uncertainty international journal of economics and financial issues | vol 5 • issue 4 • 2015 877 distribution of property rights” (allen, 1999. p. 897). however, this interpretation of the theorem does not contain terms of its applicability. a remark that with the zero transaction costs the resources are invariable in respect to the property rights faces a number of inconsistencies. firstly, as we have mentioned earlier, the zero transaction costs may only appear in the “robinson crusoe economy,” and even in terms of the perfect competition, economic agents bear their internal transaction costs. thus, the overall transaction costs are positive and not zero. at the same time, a review of other types of markets with such a statement for the theorem, including the perfectly competitive market, becomes possible when we only say of external transaction costs instead of all kinds of transaction costs. secondly, under real economic conditions, an interrelation between the allocation of resources and the distribution of the property rights is in place. an economic agent, acting according to the principle of economic rationality, maximizes its own utility, which, on the one hand, is described with an increase in a return on the resources available, and, on the other hand, an increase in resources as such, while the property rights play here a crucial role. the completed review of papers and their critical analysis has given us an opportunity to identify a group of researchers, who are inclined to adhere to the long-held interpretation for the coase theorem. in the most papers, it is stated as follows: if the property rights are well defined and the transaction costs are zero, then the resource placement (allocation) (production profile) will remain unchanged and efficient, regardless of changes to the distribution of the property rights (kapelyushnikov, 2006; arkhipov and bolyshakov, 2009; tarushkin, 2004). in the discussion regarding the zero transaction costs, we have already made the appropriate remark. therefore, we will proceed with another interpretation for the theorem. among papers in this regard, we may refer specifically to galperin et al. (1999. p. 473), who say that the externalities may be converted into the internalities by securing the property rights. hence, the coase theorem in their version takes a completely different form, “the externalities may be internalized by securing the property rights for objects that generate them and by sharing these rights if it does not require the high transaction costs. if these rights are well outlined and may be traded on a market, the market mechanism may bring parties to an efficient agreement.” to this, we should add that the issue of the externalities lies in the inefficient allocation and use of resources and products in the economics due to differences between the individual and public costs or the individual and public utilities (sidorovich, 2001. p. 216). obviously, a solution to this issue cannot avoid specifying a value of the costs. our ideas in this regard will be presented below. to summarize the above mentioned, we may conclude that the reviewed interpretations demand their essential refinement. their use in a learning process may lead to a number of paradoxes, which would be mostly contrary to the economic logic. the disunity and ambiguity of interpretations for the theorem assume direct or indirect vulgarization of coase’s ideas. at the same time, in view of all possible statements, we do not think reasonable to make our own contribution into the theoremizating to present the own view of the theorem. the best option to neutralize disagreements is elaboration of fundamental provisions stated earlier by coase himself. they are they that help to make a holistic view of the issue. 2.2. coase view of the transaction costs and the externalities 2.2.1. original wording for the theorem when reviewing the theorem, it is impossible to ignore its primary source, i.e., the paper by coase entitled “the problem of social cost.” it has produced many interpretations, sometimes not only different between each other, but also from ideas and author’s conclusions mentioned in the paper. there are no doubts that a search for a starting point in a research is an important point to rethink the theorem compared to known wordings. as a confirmation for this statement, it is amazing that coase does not use a concept of the transaction costs as such, although the most of publications mentioned in the review of literature include them. actually, they stand for expenditures in time of making a deal, which “notwithstanding the pricing system, assume smooth functioning (i.e., without the costs)” (coase, 1960. p. 6). at the same time, an absence of the transaction costs for a deal aimed at its making does not mean that the transaction costs must be zero for the theorem hypothesis to be true. it is important to remember that the costs to make a deal are in a sense a part of the transaction costs. considering coase’s view of painless deals at the market (ibidem, p. 10), we can reasonably conclude that the costs that an economic agent may have at all stages of deal-making (before making the deal, in time of the deal and when the deal has already been made), are nothing else but the external transaction costs. another aspect of the non-compliance is a dispositive statement (according to some theorems) that concerns issues of resource allocation, specifically a nature of the allocation. we share the coase’s view and have reasonably proved a role of the allocation optimality, mentioned above. regarding the optimality, coase says, “if we want to achieve the best allocation of resources, it is desirable for the both parties to consider and undertake harmful effects from (troubles) decision-making in their activities” (ibidem, p. 13). this quite an important update let us saying of the inaccuracy in many statements of the theorem. looking through the mentioned coase’s paper, we also face a number of considerations of the efficiency, but only in a sense that the initial delineation of legal rights influences the performance of the economic system (ibidem, p. 16) rather than the performance in the resource allocation or usage. as a result, the original version of the coase theorem, published in his work, sounds that “if market operations were free of charge, all the questions (issues of mutual equitableness) would assume that rights of different parties should be clearly defined with easily forecasted results from legal actions” (ibidem, p. 19). this statement is very far from the conclusions, included into the theorem by other researchers. nevertheless, in such a form, the kuzmin and semyonovykh: rethinking of coase theorem: externalities and uncertainty international journal of economics and financial issues | vol 5 • issue 4 • 2015878 theorem reveals a clear correlation between the uncertainty and the transaction costs. 2.2.2. provisions of coase’s theory based on the original wording for the coase theorem, one may make a number of important theoretical conclusions (tarushkin, 2004. p. 29) that embodies the fundamental provisions. firstly, the theorem establishes a connection between the environmental uncertainty and the enforcement of the property rights. as a result, an influence of the externalities on a behavior of economic agents not involved in making a deal, becomes clearer and only takes an effect when the property rights have not been defined or enforced. it is worth mentioning that the positive and negative externalities manifest themselves not depending on an extent, to which the property rights have been secured. external effects are an unavoidable consequence from the available open business system. their manifestation can be only neutralized up to an acceptable level, as the market is “constantly in a state of the uncertainty and movement” (slater, 1996. p. 50). a market balance is not constant, and at any given moment, it faces changes. an ability of the externalities to be internalized with the applied theory of pigou (“of differential taxes or subsidies” (pigou, 1920. p. 193) is a responding measure to an increase in differences between individual interests and the interests of the market and the society (ibidem, p. 189-190). here we follow the opinion that a transformation of the externalities into the internalities with an artificial control by the government or with a natural control by other institutions of self-organization only causes a temporary, and quite a short-term internalization. the market movement, one-way or another, will give an impulse causing the situation, when measures previously taken are not enough or redundant with respect to the given case. the perfect world of economic agents, ceteris paribus, may partially correspond to the logic, “when the property rights have been clearly defined, then all the externalities are internalized” (tarushkin, 2004. p. 29). however, it is seemingly not enough for all the externalities to become internal. secondly, the coase theorem gives grounds to say that the transaction costs (at least, external) are an indicator to measure the environmental uncertainty. for other types of the uncertainty, we may put a hypothesize that the internal transaction costs are generated by the uncertainty of the second and third types (namely, the uncertainty of decision making and consequences from these decisions, respectively). as we have said before, the zero transaction costs only appear in the economics of one subject – the robinson crusoe economy. each entity will have the internal costs to coordinate and maintain “the economic system on the go.” this reasonably suggests that when the external transaction costs are positive, and the property rights have not been defined or properly executed, there is the uncertainty in the economic system and it causes the constant and continuous allocation of resources between the economic agents. third, going away from the transaction costs, the coase theorem outlines a way for a possible solution to the externalities. institutional horizontal expanding in a form of making basic and derivative imperative standards (including the property rights), structures the economic cooperation. external consequences for other agents with growing scales of the institutional expansion are much more considered in transformational functions presented in its errors. the top-down expansion of the institutional system is necessary in this context, “for a case” when the manifestation of self-organization had been innated at a level of genetics. in those special moments, when the self-organization is limited or faces controversy institutional standards, the top-down expansion occurs by itself, as a response to a collision of rules and mechanisms that prevent the self-organization. fourthly, referring to the self-organization issue, it is worth paying attention to one of the consequences from the coase theorem concerning the government intervention in the economics. a confrontation of pigou and coase’ ideas may be solved with quite a simple modification of those differential taxes and subsidies, which limit a rational choice of counterparties. as a result, resources are not withdrawn from the economics; instead, they are only redistributed through a kind of contract between parties, producing a new value of the rational behavior. thus, the government intervention question is reduced to an extent, to which the economics (or a group of agents) is capable to the selforganizing and a value of the cost of the rational behavior for all stakeholders. as a result, with the perfect balance of powers, the horizontal institutional expanding lets us limit the intervention in the economics. a confirmation for this thesis can be found in coase’s paper, he suggests that the government intervention is only specifying the property rights, i.e., making an exclusivity regime, otherwise, “if we try to imagine a system of the property rights, which would be required, and deals, to be made... then... paying a compensation for a damage, to which (the actions have led – author’s remark) to obtain the cost of a good, (will evidence – author’s remark) probably numerous ‘market failures.’ such situations usually lead... to the comprehensive government intervention” (coase, 1995. p. 73). in this regard, calabressi and melamed present their amazing views. they expand the typology of rights, introducing the property rights, the law of responsibility and the inalienable rights. however, the most important finding of the researchers is that “the specification of the property rights is not enough to ensure the best for social results” (calabressi and melamed, 1972). this conclusion is largely contrary to the ideas of coase as the “rights of responsibility are associated with the higher degree of the government intervention than with the property rights and the inalienable rights because the government should determine at the beginning the significance of (a value of) the right” (conybeare, 1980. p. 313). fifth, in view of some researches, the coase theorem defines a role and significance of the private property. as the property rights arise because of actions that generate rights, the recognition of these rights makes a foundation for the future exchanges and appearance of new actions that redistribute rights. as a result, the foundation appears, without which the economic exchange would not be possible. development of the private property, rather expanding the rights for it, in the sense that not all the property rights have kuzmin and semyonovykh: rethinking of coase theorem: externalities and uncertainty international journal of economics and financial issues | vol 5 • issue 4 • 2015 879 been fully defined and implemented, will reduce the uncertainty of the environment and make it more predictable. having examined the coase theorem, made a number of its provisions clearer and systematized conclusions, we should refer to theoretical and methodological computations for the ratio of individual and social costs, which determine an appearance of the positive and negative externalities. 3. methods 3.1. the basic criteria to classify the externalities taking as true a hypothesis that interests of each party (economic agents) may be measured with a ratio of common and social effects, it makes sense to identify cost elements taken to their calculation. to do this, we should refer to categories of the costs and the value to be discussed below. it is important to clarify here that individual and social effects are calculated with a difference between the unearned incremented value of the received goods from the positive externalities and the costs, which have made possible such an increment. given that a calculation of the unearned incremental cost of the goods utility also goes in pair with the utility category, for which a quantitative measure in any plausible form is not available, we propose to use for this an indicator of the opportunity cost for those conventional goods that are a consequence of the positive externalities; and the index of the opportunity damage for the negative externalities. considering the parameter of the unearned incremental cost, we need to make a number of assumptions. first, the economic agent rationally acts with its usual maximization of the return; and, secondly, in estimates of the received goods the agent is limited by the market in a sense that all the resources are acquired on it and at a market price. referring to an indicator for the alternative damage, we should make clearer how to measure the social and individual costs. it is accepted that the social costs include the individual costs and the external costs (mankiw, 2011. p. 198; lipsey and harbury, 1992. p. 87; taylor and weerapana, 2009. p. 431; just et al., 2004. p. 529; mceachern, 2008. p. 373). a comparison between the individual and the social costs is a basis for a definition of the positive and negative externalities. the most researchers think that “the negative externalities (external effects) arise in such a case, when the individual costs are lower than the social ones, in case of the positive externalities on the contrary, when the social costs are lower than the individual” (nigmatullina, 2011. p. 37). using this inequality between the costs, the criterion condition to classify the externalities seems to be quite reasonable. however, considering all the circumstances to assess the individual costs, one should pay attention to the content of the social costs. the well-known thesis that the social costs include, among other things, the individual costs needs clarifications and can be disproved. it seems that a concept of the social costs can be applied both narrowly and in its broad interpretation. the narrow wording for the social costs comes from the fact that the social (public) costs are nothing else but the costs incurred by other subjects in relation to the particular economic agent. this interpretation is to the most part subjective. it assumes that the initiating economic agent is excluded from a total circle of subjects, whose costs are taken into account and accepted to find the total costs. the broad wording is based on the return statement saying that the initiating economic agent is equally considered regarding the other subjects and its costs should be included as a part of a base to count the social (public) costs. it seems that the logic to calculate the social costs was build on the wide wording that has become a true dogma within the institutional theory. we believe that such logic causes a problem of double counting. as a result, the in equation is reduced to a value of the external costs. a record for the in equation becomes in this case as follows: posextern indc socc indc forc indc forc : , , . > > + >     0 (1) where, posextern – positive external effects (externalities); indc – individual costs; socc – social (public) costs; forc – external costs. negextern indc socc indc forc indc forc : , , . < < + <     0 (2) with, forc ≥ 0 and negextern: forc∈c where, negextern – negative external effects (externalities). it is clear from the systems of in equations that a size of the individual costs does not influence the typing of the externalities. this actually confirms our idea (regarding the social costs) that to find an operator for the externalities, we need to go from their narrow instead of the broad understanding. then the in equation will be valid. 3.2. contradictions in methodology and hypothesis logical comparisons and research let us believe that conclusions from the first and second in equations (1 and 2 respectively) have no economic sense. coming from the broad understanding of the social costs, under conditions where the externalities are over zero, the positive externalities appear. the situation is different when the conditions change – finding solutions becomes simply impossible. the matter is that as the costs cannot be negative, then under conditions, when the identification of the negative externalities is in progress, the externalities become a complex value. as a result, there is no real solution to the in equation (2). the only option possible to eliminate contradictions is that with the negative externalities the in equation is unstrict (as assumed). then, applying the assumption, a criterion for externality typing may be described as follows: with the external costs equal or less than zero, the negative externalities occur and it is wrong. kuzmin and semyonovykh: rethinking of coase theorem: externalities and uncertainty international journal of economics and financial issues | vol 5 • issue 4 • 2015880 the correct assumption would be a reverse one, i.e., with that the external costs over zero the negative externalities arise, while when they are zero – the positive ones. to say this, one may go from the broad understanding of the social costs and include the new criterion into the system of conditions. as an additional criterion, we propose using the utility criterion. surely, it is sometimes impossible to identify a quantitative value for the utility of a good or a set of goods1, but other is possible – to find a field of the utility. thus, in relation to the externalities, we may hypothesize that the positive externalities will be available in presence of the public utility; while the negative – under a condition, when the utility is missing, or rather, when any losses (damages) appear. hence, the externalities from activities by the initiating economic agent occur if and only if the external costs in relation to a resulting effect (good) are not available, but at the same time, there is some utility from this good. in the similar way, we can also describe conditions for the negative externalities, when the external costs in relation to the resulting effect (good) are over zero, and their impact causes a damage. despite all the grounds for such judgments, we are not inclined to absolutize the mentioned criteria to classify the externalities. as the externalities in their nature and content are indispensable, then any action of an initiating economic agent may be either positive or negative, or neutral. criteria are much legitimate with other things being equal, when the economic behavior of the initiating agent is discrete. but there is an option when the economic agent brings its position to the conditional optimum and is adjusting and fitting to changing environmental conditions, this means that it will prefer a solution that only partially meets the original (e.g., having implemented an institutional opportunity to get a compensation for the negative externalities). the mentioned indispensability of the externalities in this regard is not opposed to an option of their neutralization as viewed by coase. his solution to the issue of the externalities is in line with the rational of the economic behavior when building-up the property rights and available institutions to monitor their exercising, in the natural and quite logical way, cause that the agent takes into account a cumulative side effect for all the third parties, whose property rights are associated with results of operations. on the contrary, such a conclusion says that the externalities can be internalized if and only if the vartational uncertainty manifests itself2. making new ownership rights is nothing else but the artificial making the new “rules of the game.” the externalities can certainly be internalized by institutional expansion as a result of the manifested 1 “… it is impossible to express the utility … in absolute units, because there is objectively no ‘unit of the welfare’” (valtuh, 1965. p. 175). 2 the vartational uncertainty is a powerful, but not the only catalyst for the institutional expanding. an additional incentive for new institutions to be deployed, new standards, regulations and mechanisms to be established is the general uncertainty of the environment. it is worth here paying attention to a nature of the institutional expanding, which can manifest itself both proactively and in a forced manner. to our mind, the vartational uncertainty says of the forced nature of a transformation of the institutional order, while the uncertainty of the environment says of its proactiveness, which demonstrates an ability to self-organization and adjustment. the vartational uncertainty term was introduced into scientific circulation by the author of this paper (kuzmin, 2012). vartational uncertainty and the environmental uncertainty, while one should pay attention to the mentioned additions with regard to the externalities identifying as a criterion. from here there is the second hypothesis saying that the externalities are a result of the available environmental uncertainty, which to some extent is solved with the institutional expansion. the statics of the conventional examples given by coase imposes a number of restrictions on the applicability of the uncertainty analysis to develop a behavior pattern. to maintain the integrity of theoretical points, we see efficient to keep the vartational uncertainty within the pattern, but with the zero value. in other words, the given uncertainty in coase’s static examples has not enough time to appear, as the cycle of a successive change to the uncertainties is interrupted before its end. in the real economics, the cycle will end closed and the vartational uncertainty will manifest itself. the manifestation of the vartational uncertainty plays a key role for a transformation of environment’s conditions and the uncertainty associated with it. as far as the environment faces changes due to an appearance of new institutional sectors, the vartational uncertainty grows and bring the business system to another development cycle. it seems that it is in the new development cycle, when other types of the uncertainty will not have so high values as they did in previous one. this observation may seem paradoxical and controversial in many aspects, but an essence and a nature of the vartational uncertainty are actually to have an impact upon the entire system. the authors’ reasoning to support their point is based on a number of logical assumptions. first, the vartational uncertainty within a business system does not present itself on a continuous basis. at the beginning of the cycle implementation, the vartational uncertainty either is absent, or takes values close to zero. later, when a chain of consequences from implemented managerial decisions starts influencing the environment in such a way that the existing rules, standards and mechanisms face a number of insoluble contradictions, the vartational uncertainty will raise. at the same time, a change to the institutional order as a response to the vartational uncertainty is not a substitute for the environment's uncertainty, which is manifested in activities made by other economic agents. secondly, having reached a certain critical value, the vartational uncertainty acts as a trigger for an adjustment mechanism, when new “rules of the game” appear or when those existing go through changes. only when the vartational uncertainty exceeds a certain boarder level, the new institutional sectors appear, the horizontal or vertical institutional expansion become obvious. thirdly, an influence of the vartational uncertainty (up to the critical value) is not sufficient to have an essential impact on other types of the uncertainty. dynamics of the vartational uncertainty mainly depends on consequences of the made managerial decisions at the very moment when the rationality, the efficiency and the optimality of these solutions have been in question and when there is quite a natural need in making new rules and standards. thus, based on the narrow understanding of the social costs, we can include among them the costs that depend on the direct and indirect damage of all stakeholders (the third parties) with the exception of the costs occurred by the initiating economic agent. at the same time, there is a distinct disadvantage in the narrow kuzmin and semyonovykh: rethinking of coase theorem: externalities and uncertainty international journal of economics and financial issues | vol 5 • issue 4 • 2015 881 understanding of the social costs. as an appearance and an impact of the negative externalities do not only influence other subjects, but also the initiating economic agents, it is necessary to enter into the books those costs that are caused by them due to the available feedback. by the classification, such costs are not included in any of the known groups. i think that it would be reasonable to consider such costs as the extra expenditures. some value of these costs may be absorbed in the costs of “an error” regarding the transformational or transactional function. however, a clarification of similar phenomena goes beyond the scope of this research. 4. discussion taking the externalities that appear in the economics as a kind of conventional goods, we may reveal distinct parallels between the utility theory and the theory of externalities. to do this, we refer to the action of analogies when the externalities are understood as a commodity, while an impact of the externalities as a result of the acceptance-free deal (by analogy with the offer)3. in this case, the public offer is a result of the social contract, where a ban for actions is expressed with laws and regulations, assuming the commensurate responsibility. hence, when there are no such standards, any subject feels free to make both positive and negative externalities. it is necessary to explain that in case of the positive externalities, there is no fee to get goods; otherwise, with such a fee in place, a status of the externalities would be lost. with regard to the negative externalities, the similar conclusion would be fair, although, here in the presence of the damage, the utility for the third parties does not appear. it is lost in the profit of the initiating economic agent. costs incurred by the third parties with the negative externalities, may be in part correlated with the opportunity cost, which “the consumer” has paid for a good or a service without the measured utility of the good for the himself/herself. as a result, the incurred costs are not covered with the expected value (utility), while, on the contrary, they cause them damage, reducing their own value (capitalization). to sum up the abovementioned regarding the positive and negative externalities, as well as individual and social costs, it makes sense to introduce a refined understanding of criterial conditions, under which the externalities appear, which is presented as follows: posextern indc socc indc forc u forc vc : , ; ; lim ( ) . > > > →  c adverse 0 0       (3) 3 for this case, there is a very important remark that a transaction is acceptance-free. in other words, under ideal conditions of the comprehensive certainty, the third parties would only have a focus on the positive externalities, while the negative externalities would be suppressed. however, the real conditions do not let us achieve the sufficient certainty for, firstly, economic agents to have an opportunity to respond to any actions by other stakeholders; secondly, to have the comprehensive and accurate information on consequences from these actions before their implementation. where, uc – external (social/public) benefit; vcadverse – direct or indirect external loss from an influence of the externalities. negextern indc socc indc forc u forc vc c : , ; lim ; ( ) . < < → ≥  0 0 adverse       (4) the positive and negative externalities from formulae (3) and (4) are differentiated in their simultaneous meeting two criteria. however, from here we may conclude that there are options, when one of the criteria the utility may take other values than those specified in assumptions. therefore, the question of typing for the externalities, when the assumption by the costs is met, while by the utility is not met, has remained polemical. in this regard, it is necessary to pay attention to approaches that present the relationship between the utility category and such measures, as the cost and the price. into the circle of researchers, who laid the fundamentals in this field, we may include marshall (1890), orzhentsky (1895), ovsiyenko (1983), raleygh (1888), etc. one of the first publications, which establishes a clear relationship between the price and the utility, is locke’s paper. he assumes that a natural value of any thing is in its ability to meet needs, “and the more they contribute into our well-being, the more their price is” (locke, 1691. p. 66). this statement was later used by smith (1812. p. 1, 64) to support and develop his own ideas. in works by other researchers engaged in this field of interests, the utility was seen through a prism of market pricing. rykachev makes a fair remark, saying, “the cost’ and ‘the utility’... are found in a struggle of the supply and the demand” (rykachev, 1903. p. 84). thus, the somewhat different view appears validated by marx (1949. p. 660) in an availability of the consumer and exchange value, based on the “natural utility.” before there had been permanently appeared ideas that the very utility makes a basis to make an exchange. in this manner, raleygh (1888. p. 75), in assessments of the demand, referred to the utility associating it with a product or a good, for which it is possible to determine a fee for consumption. marshall had a similar view saying, “the expediency or the utility of a thing... is usually measured with a value of the money that the person (the consumer – author’s remark) is willing to pay for it” (marshall, 1890. p. 151). thus, the functioning of any economic agent is primarily focused on making the utility and enhancing it in a tangible or intangible form. producing “the thing” without the utility will cause the case when its value is missing, even taking into account spent resources to get it. in other words, “the utility serves as the main function and the target function of the immediate social specific labour” (nauchitel’ and smirnov, 1979. p. 92). this thesis is confirmed in other papers. having compared several goods, engels quite reasonably concluded, “if production costs for the two things are the same, then the benefit will be a decisive factor to determine their external value” (engels, 1955. p. 553). this conclusion is difficult to be overestimated, in fact, it gives an answer to the question of the mutually subordinated utility and the costs. kuzmin and semyonovykh: rethinking of coase theorem: externalities and uncertainty international journal of economics and financial issues | vol 5 • issue 4 • 2015882 a number of characteristics of the utility is specifically seen in a case of the negative externalities. if for the positive externalities any utility is not paid and no any significant external costs appear to consume it and further use, then for the negative externalities the situation is contrary. it is with the negative externalities when there are changes to consumer properties of assets. given that an impact of the effect is expressed in both the direct and indirect damage, we may reasonably assume that the consumer properties of available resources will be partially or completely changed. we think that the consumer properties as a term in this manner takes a slightly different meaning than in its traditional understanding. on the one hand, an activity of the economic agent is described with the productive efficiency of the transformation function. it is known that this process includes at least three larger units, i.e. an entrance, a direct conversion, and an exit. the impact of the negative externalities is possible at all stages of a transformation, therefore both raw materials, semi-finished products and finished products will be subject to changes. on the other hand, the economic agent may operate without active transactions and function in a passive mode, such as, e.g., giving its property for rent. in this case, the negative externalities may also affect a status of these assets and decrease their consumption (custom) properties. based on the specifics, with which the consumer properties appear, we may say that in the context of the theory of the externalities, the external costs will depend on characteristics of the utility. this conclusion needs some author’s remarks. firstly, as we have already mentioned, the costs appear in response to a change to the constant position of the optimality. they are also described with the fact that the benefit is maximized at a required level. secondly, an impact of the externalities may only be identified after changes to the consumer properties that either lead to an appearance of the costs, or do not. then a role of the utility as a basic criterion to include the externalities into the positive or negative ones does not require more evidence and seems to be quite scientifically reasonable. thus, based on these conclusions from the synectic review of the mechanism to make the externalities, we conclude that the utility theory only identifies the vector of the externalities and the stratification of the field of externalities (positive or negative) and ultimately depends on whether there is the utility (or the maleficence) in place for a subject. 5. conclusion a summary of the findings let us confidently say of available significant contradictions in the coase’s theory. as we have already seen, the theorem is quite different from the perfect description of economic regularities. securing or expanding the property rights is not yet a condition, under which the transaction costs are zero, as viz. it becomes clear that this is not sufficient. at the same time, other statements for the theorem presented by researchers, to the most extent distort the original promise inherent to coase’s ideas. our considerations are partly a solution to the gathered disagreements introducing additional criterial conditions to identify externalities. they, first of all, include the utility, which gives to estimations a weighted character and eliminates cases, where the positive externalities (in theory) manifest themselves with the “negative benefit.” besides, we have made an important refinement for the approach to an assessment of the social costs. their narrow interpretation is with reason opposed to the broad definition, where the costs of an initiating agent regarding the externalities are included in the total bulk of the costs incurred by all subjects within the economic systems. in this regard, a question of internalization for the externalities is no less than relevant. our understanding of this process derives from an assumption that the externalities are a result of the available uncertainty of the environment, which to some extent is neutralized with horizontal or vertical institutional extending. from here, we conclude that the externalities may only be converted into the internalities in terms of the vartational uncertainty, owing to which new “rules of the game” are made. however, the statics of coase’s conventional examples imposes a number of restrictions on the applicability of the uncertainty analysis to develop the behavior model. as potential for further research in this field, we consider a search for a point of optimality with a ratio of positive and negative cumulative effects to be presented with further papers. references allen, d.w. 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(1980), the problem of social cost in retrospect. research in law and economics, 2, 83-102. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 262-269. international journal of economics and financial issues | vol 7 • issue 4 • 2017262 the relationship between elastic money growth and prices in countries with the largest money stock: an econometric review farah durani* faculty of finance, university of business and technology, jeddah, saudi arabia. *email: f.durani@ubt.edu.sa abstract the main objective of this paper is to examine the relationship between money expansion and inflation rates and asset price fluctuations across countries charged with highest money creation. the u.s.a, india, china and japan reported with highest money stock in the world are studied for about 55 years. this research considers the monthly data of m2, the consumer price index, stock index values and real estate values in the stated countries. johansen’s cointegration test indicates that a long term equilibrium relationship is seen between money supply and inflation rates and money supply and asset prices in all the four countries except india where money supply is not significantly cointegrated with the asset prices. granger causality test results offer no definite inference, in china and japan causality is mostly not established between the variables, however in the u.s.a and india significant causal relationship is seen. keywords: causality, co-integration, money supply, inflation, asset prices, stock indices, real estate indices jel classifications: c3, e300 1. introduction this paper is an attempt to validate quantitatively the theory of instability of elastic money. a stance that elastic nature of fiat money is mainly responsible for inflation and asset price fluctuations is maintained and tested via granger causality tests and johansen’s co-integration tests. four countries namely japan, the u.s.a, india and china, due to their leading money supply figures, have been selected to carry out this analysis. the study period is almost 55 years for all the countries except china, for which the data could not be found beyond 16 years. this research is not attempting to prove or disprove the keynesian or monetarist assertions towards the phenomenon of inflation. our stance is to validate the fact that inflation which is said to eat up the value of fiat money, is only and only caused by the increased supply of it. secondly, the monetary impulses in the form of loose money supply put pressure on asset prices like stock and real estate prices which do not reflect the investor preferences but the easy money that has found its way into such markets. therefore, this research would test the causality and co-integration between money supply growth and inflation and asset prices. the empirical analysis of the relationship between money supply and prices, and money supply and asset prices has received much attention in the past few decades. most of the studies conducted, attempt to validate or refute the quantity theory of money. as price stability has remained one of the overriding objectives of the monetary policy, many scholars have attempted to approach the money price relationship to ascertain whether the objective is achieved or not. this empirical study will embrace the approach of validating the ill effects of fiat money systems in terms of deterioration of people’s purchasing power and the creation of asset price bubbles. 2. literature review not many studies are conducted to investigate the causality between money supply and prices for a sample of countries that have higher money growth, however many researches have been conducted to study the individual countries for the same. durani: the relationship between elastic money growth and prices in countries with the largest money stock: an econometric review international journal of economics and financial issues | vol 7 • issue 4 • 2017 263 the single country analyses of similar studies have yielded the mixed results. for example, dave and rami (2008) studied the causality between money supply and price level in india for the time period 1953-2005 using monthly data. the results show that the money is endogenous and it is partially determined by the price level. similarly the results also show that the monetary policy in india with respect to the money supply only have limited impact on the inflation, and main reason behind the increase in the rate of inflation in india is due to increase in the money supply. ma and sun (2004) investigated the relationship between the money and price relationship in china. by using the granger causality test, the authors tried to examine two aspects of the price level, namely the inflation and deflation. the empirical study suggested that the money in china was endogenous during the period of inflation. emerson (2006) examined the validity of the quantity theory of money in case of the united states from 1959 to 2004. the main aim of this study was to find out the relationship between prices, money, interest and output in the long run. the long term relationship among the variables was studied via co-integration analysis using the johansen test and the augmented dickey fuller (adf) unit root test was employed to test for the stationarity. the results showed that price levels in the united states are affected by the money supply; however no long term association between money and prices is seen. katrin et al. (2008), studied prices and inflation in japan in various time horizons and determined that the causality runs from money to the prices. sharma et al. (2008) in their study in india examined the causality between prices, output and money in india. using the bivariate methodology to test the granger causality between prices level, money supply and output (using frequency domain), the authors concluded that the there is money-output trade-off in the short run however in the long run money supply have impact on the price level but not on the output. diaz and kirkby (2013) examined the quantity theory of money in case of united states for the period 1960-2009. the results show that the quantity theory of money holds in the long run during the 1960-2009 which means that the money supply in united states has long run impact on the price level. however in the short run the relationship does not hold during the study period. gerlach (1995) tried to test the quantity theory of money using the long run averaged data across various countries. this paper was aimed at finding the relationship between the long run average inflation, real income growth and the money growth. the study concluded that the findings of a one to one relationship of inflation and money growth is sensitive with respect to the inclusion of the data from some countries which have very high rate of inflation. studies related to the relationship between increase in the money supply and asset prices, show mixed results. arif et al. (2012)’s study aimed to test the linkage between money supply, liquidity, share price and interest rate on quarterly data from 1968 to 2011. the results show that the changes in the money supply have positive effect on the liquidity and this result is in line with the existing theory. the authors also extend the liquidity equation to the price of the assets where the results show that the changes in the liquidity also have positive effect on the prices of the shares controlling for the earning effect. yao et al. (2011)’s study was based on china between june 2005 and september 2010 and the authors examined the effect of the monetary policy on the asset prices using the monthly data. using the johansen co-integration method based on granger causality and the vectors autoregressive (var), the results showed that monetary policies in china have little impact on the asset prices in the short run. other studies of this nature have been carried out in countries like malaysia, pakistan, nigeria and australia, showing either the causality or long-term equilibrium relationship between money supply growth and asset prices. 3. data and methodology this study examines the causality and long-term relationship in terms of cointegration between money supply and general prices, money supply and asset prices. the countries selected to test this causality are the united states of america, japan, china and india. the reason this research has selected the u.s.a, china and japan is that these stand as world’s largest economies and their central banks are charged with chasing high money supply growth. as reported by the financial times (2015), china’s broad money supply within 2007-2013 has outgrown the rest of the world. johnson (2015) in financial times as indicated in the figure 1, listed countries in accordance to their broad money creation, china, united states and japan topped the list. these countries even contribute in major proportions to the world broad money stock, johnson (2015 ft). india, though not as advanced in money creation as other three, still tops the list of emerging economies with very high money growth. it is thought to be intriguing to explore the causal relation between money supply and prices in these countries where money supply has been continuously on the rise. additionally like the united states and japan, china’s surge in money supply is seen to fuel bubbles in its real estate and stock markets. with this pre-consideration, the research aims at uncovering rather validating the ill effects of increased fiat money figure 1: world broad money statistics durani: the relationship between elastic money growth and prices in countries with the largest money stock: an econometric review international journal of economics and financial issues | vol 7 • issue 4 • 2017264 supply on prices in general (the purchasing power of the common man) and on asset prices in the u.s.a, japan, china and india. the monthly data of broad money indicator m2 is collected for the united states of america, japan, china and india. the price is taken as monthly consumer price index (cpi) data for these countries. the stock indices and real estate indices are taken as proxies for stock prices and property prices respectively. monthly average values of dow jones industrial index, nikkei 225, shanghai stock exchange composite index and sensex have been acquired for the u.s.a, japan, china and india respectively. monthly averages of s and p home price index are taken as proxy for property values in the u.s.a. for japan, india and china, property total return indices have been taken as proxies for property prices. 4. model building adf test: causality tests of granger assume that the time series involved in the analysis are stationary. therefore, tests of stationarity should precede tests of causality (gujarati, 2004. p. 794) to rule out any possibility of spurious, or nonsense regression, which is likely to distort the meaningfulness of the results obtained. in order to test for the stationarity, each time series acquired will go through adf test. as in all we have 4 time series for each country i.e., monthly money supply, cpi, stock index values and property index values. all the 16 time series collected should pass through the adf test to test for the unit root. yt is a random walk (with no constant and linear trend): ∆ ∆yt yt uti yt i i n = − + +−∑δ α1 (1) yt is a random walk with drift (with constant): ∆ ∆yt yt uti yt i i n = + − + +−∑β δ α1 1 (2) yt is a random walk with drift around a stochastic trend (with constant and linear trend): ∆ ∆yt t yt uti yt i i n = + + − + +−∑β β δ α1 2 1 (3) where t is the time or trend variable and ut is a pure white noise error term and where ∆yt−1 = (yt−1-yt−2), ∆yt−2 = (yt−2-yt−3), etc. the number of lagged difference terms to include is often determined empirically. in adf we test whether δ = 0. in each case, the null hypothesis is that δ = 0; that is, there is a unit root-the time series is nonstationary. the alternative hypothesis is that δ < 0; that is, the time series is stationary. the unit root test is conducted for all the four time series (money supply, cpi, stock index values and property index values) in each country under consideration. the lag length is taken in accordance to the schwarz information criterion given automatically in the e-views unit root test. 4.1. granger causality test correlation may not always refer to causation in any meaningful sense of that word. granger (1969) approached the problem of whether x causes y by seeing how much of y is explainable by the past values of y and if adding lagged values of x improved the explanation then x is said to help in predicting the values of y, hence x is said to granger cause y. this is ascertained by the statistically significant value of the co-efficient of lagged x. the method of granger causality measures the precedence and information content but may not validate causality in a sense the word is commonly used. is it y that “causes” the x (y→x) or is it the x that causes y (x→y), where the arrow points to the direction of causality. the granger causality test assumes that the information relevant to the prediction of the respective variables, y and x is contained solely in the time series data on these variables. the granger causality models are typically put in terms of bivariate regressions of the form, yt iyt i ixt t i n i n = + − + +∑ ∑α α β ε0 (4) xt ixt i iyt i ut i n i n = + − + − +∑ ∑α α β0 (5) this research conducts the granger causality test between the first differenced forms of “money supply and cpi,” “money supply and stock index values” and “money supply and property index values” in all the four countries i.e., china, india, japan and the u.s. this test will reveal whether it is the money supply that causes the changes in general prices and asset prices or vice-versa. ln ln lnmst i mst i i cpit i t i n i n = + − + − +∑ ∑α α β ε0 (6) ln ln lnmst i mst i i spt i t i n i n = + − + − +∑ ∑α α β ε0 (7) ln ln lnmst i mst i i rept i t i n i n = + − + − +∑ ∑α α β ε0 (8) where ln ms stands for natural logarithmic values of money supply, ln cpi for natural logarithmic values of cpi, ln sp for natural logarithmic values of stock prices and ln rep for natural logarithmic values of real estate prices. akaike information criterion is used for the optimal lag length selection. 4.2. johanssen’s cointegration test the johansen test is precisely a multivariate generalization of the augmented dickey-fuller test. the generalization calls for examination of linear combinations of variables for unit roots. the johansen test and estimation strategy (maximum likelihood) makes it possible to estimate all cointegrating vectors when there are more than two variables. if there are three variables each with unit roots, there are at most two cointegrating vectors. more generally, if there are n variables which all have unit roots, there are at most n−1 cointegrating vectors. the johansen test provides estimates of all cointegrating vectors. though johannsen test is used widely for multivariate cointegration testing, the author has used it to test the cointegration of only two variables. the cointegration method characterizes the existence of a long-run relationship. according to johansen (1988), a p-dimensional var of order k (var [k]) can be specified as follows: zt = d+p1zt−1+…. pkzt−k+ωt(t = 1….t) (9) durani: the relationship between elastic money growth and prices in countries with the largest money stock: an econometric review international journal of economics and financial issues | vol 7 • issue 4 • 2017 265 ∆ π ∆zt d kzt k zt i t i k = + − + − +∑ ( )θ ω 1 1 (10) here ∆ is the first difference operator, π and θ are p-by-p matrices of unknown parameters and ω t is a gaussian error term. the impact matrix π could contain the long-run information about the relationship between money supply and cpi or money supply and stock index values or money supply and property index returns. a full column rank of the matrix π implies that all variables in the zt are stationary. when the matrix has zero column rank, the expression is a first differenced var involving no long-run elements. if, however, the rank of π is intermediate meaning that 0 < rank (π) = r < p, there will be r cointegrating vectors that make the linear combinations of zt become stationary or integrated. this study performs two johanssen cointegration tests. first, the maximum likelihood estimation procedure that provides a likelihood ratio test, called a trace test, which evaluates the null hypothesis of, at most, r cointegrating vectors versus the general null of p cointegrating vectors. a second, likelihood ratio test is the maximum eigenvalue test, which evaluates the null hypothesis of r cointegrating vectors against the alternative of (r + 1) cointegrating vectors (johansen 1991). 5. estimation results the results of adf test show the order of integration. the following table gives the summarized results of adf for all the time series in the select four countries (tables 1-4). the adf results for all four countries in summary show that the data mostly becomes stationary after first differencing. therefore, in order to conduct the granger causality test the first differenced time-series for all variables has been generated. 5.1. granger causality results pair-wise granger causality test requires an optimal lag length to establish the causality between the variables. the results obtained are very much sensitive to the lag length criterion used. we have used var lag order selection criteria (var) to arrive at the optimal lag length. in order to determine the significant lag values, var uses five different criteria viz. 1. lr: sequential modified lr test statistic (each test at 5% level) 2. fpe: final prediction error 3. aic: akaike information criterion 4. sc: schwarz information criterion 5. hq: hannan-quinn information criterion. this test depends democratically on final prediction error, akaike information criterion and schwarz information criterion for the lag length selection. the all countries summary of bivariate granger causality test provided in table 5 gives an overall picture of causality between various variables in all the four countries. in japan we see that money supply does not granger cause cpi and property returns index. however significant causality can be seen running from money supply to nikkei 225 and reverse from nikkei 225 to the money supply. in the u.s.a a bivariate causality is seen running between money supply and cpi and money supply and dow jones industrial index. we do not see money supply in the u.s.a granger causing s and p home price index, however interestingly reverse causation is significantly established. in india the results are little different, a bivariate granger causality running between money supply and cpi is seen, with no significant causality between money supply and sensex stock index. money supply in india however is granger causing property total returns with no feedback present. the granger causality test results for china show that money supply does not granger cause cpi, stock index returns or property returns. the reverse causality is also not present. china is the only country where no short term bivariate causality could be established between money supply and cpi, stock index and property index (table 6). evident from the results given above, the long term cointegration between money supply and cpi is established by both trace test and max-eigen test in all the four countries. for japan we can see that the null hypothesis is rejected in case of cointegration between money supply and cpi and money supply and property returns, however we do not have enough evidence to reject the null hypothesis of no cointegrating vector in case of money supply and nikkei 225. therefore significant long term association can be inferred between money supply and cpi, money supply and property index in japan. in case of the united states of america the null hypothesis of “no cointegrating vector” and of “at most one cointegrating vector” are rejected, indicating the presence of 2 cointegrating equations at 5% significance level. therefore we can infer that there is a strong long-term relationship between money supply and cpi, money supply and djia and money supply and s and p home price index in the u.s.a. rejection of the null hypothesis means that there is significant long-term association between the variables. for india, we can conclude that there are two cointegrating equations at 5% level signifying a strong long-term relationship between money supply and cpi in india. but we are not able to reject the null hypotheses for the cointegration between “money supply and sensex” and “money supply and property returns,” therefore we conclude that there is no long-term association between the same. in case of china, there are two cointegrating equations with respect to “money supply and cpi” and “money supply and shanghai composite stock index,” which indicates that these variables show strong long-term association. the cointegration between money supply and property returns show that there is one cointegrating equation at 5% level of significance. money supply in china is cointegrated with cpi, stock index and property index returns. 6. conclusion this study has investigated empirically how the elastic nature of fiat money is mainly responsible for inflation and asset price fluctuations. granger causality tests and johansen’s cointegration tests were used on four countries namely, japan, the u.s.a, india and china, due to durani: the relationship between elastic money growth and prices in countries with the largest money stock: an econometric review international journal of economics and financial issues | vol 7 • issue 4 • 2017266 table 1: adf test results japan exogenous level first difference intercept intercept and trend none intercept intercept and trend none money supply t-statistics 1.936141 −2.32588 2.975386 −3.6244* −4.3813* −1.8237 critical values at 5% −2.86533 −3.41606 −1.94126 −2.86533 −3.41606 −1.9412 p 0.9999 0.4188 0.9994 0.0055 0.0025 0.0650 cpi t-statistics −1.5861 −0.8143 1.0426 −3.2612* −3.5350* −2.2210* critical values at 5% −2.8654 −3.4161 −1.9412 −2.8654 −3.4161 −1.9412 p 0.4892 0.9627 0.9225 0.0171 0.0365 0.0255 nikkei (si) t-statistics −1.55683 −1.84416 −0.44178 −20.299* −20.287* −20.295* critical values at 5% −2.8652 −3.4159 −1.9412 −2.8652 −3.4159 −1.9412 p 0.5042 0.6822 0.5232 0.0000 0.0000 0.0000 property index tot t-statistics −1.83155 −2.10421 0.002385 −17.274* −17.252* −17.2583* critical values at 5% −2.8687 −3.4214 −1.9416 −2.8687 −3.4214 −1.9416 p 0.3649 0.5413 0.6828 0.0000 0.0000 0.0000 the significance level is outrightly mentioned at 5% and the p values are given for both augmented dickey fuller test and granger causality. for johhansen's cointegration the significance value cant be gotten from eviews, however the test statistics are easily indicated to be significant at 5% level table 2: adf test results usa exogenous level first difference intercept intercept and trend none intercept intercept and trend none money supply t-statistics 8.937182 5.213527 10.04840 −1.4613 −7.9331* −0.4191 critical values at 5% −2.86558 −3.41644 −1.94129 −2.86568 −3.41645 −1.9413 p 1.0000 1.0000 1.0000 0.5528 0.0000 0.5321 cpi t-statistics 2.61980 −4.07949 8.912788 −14.662* −15.098* −2.1097* critical values at 5% −2.86556 −3.41643 −1.94128 −2.8655 −3.4164 −1.9412 p 1.0000 0.0070 1.0000 0.0000 0.0000 0.0336 djii (si) t-statistics 1.27601 −1.203953 2.562123 −26.093* −26.235* −25.9006* critical values at 5% −2.86555 −3.416410 −1.94128 −2.86556 −3.41642 −1.941288 p 0.9986 0.9082 0.9977 0.0000 0.0000 0.0000 s and p home price index t-statistics −1.44195 −2.962981 0.207156 −3.0197* −3.0271 −2.8866* critical values at 5% −2.86970 −3.422903 −1.94174 −2.8697 −3.4229 1.941745 p 0.5619 0.1443 0.7459 0.0341 0.1263 0.0039 the significance level is outrightly mentioned at 5% and the p values are given for both augmented dickey fuller test and granger causality. for johhansen's cointegration the significance value cant be gotten from eviews, however the test statistics are easily indicated to be significant at 5% level table 3: adf test results india exogenous level first difference intercept intercept and trend none intercept intercept and trend none money supply t-statistics 1.755837 −3.83931 4.266890 −3.3472* −4.3996* −0.6153* critical values at 5% −2.86566 −3.41659 −1.94130 −2.865643 −3.416590 −1.941298 p 0.9997 0.0151 1.0000 0.0133 0.0023 0.4507 cpi t-statistics −0.065465 −3.967964 2.854666 −4.5585* −4.5495* −2.5196* critical values at 5% −2.865536 −3.416382 −1.941285 −2.865536 −3.416382 −1.941285 p 0.9510 0.0101 0.9991 0.0002 0.0013 0.0115 sensex (si) t-statistics −1.358891 −2.015876 2.833932 −19.2668* −19.2817* −18.8896* critical values at 5% −2.867859 −3.420022 −1.941542 −2.867874 −3.420045 −1.941543 p 0.6030 0.5906 0.9990 0.0000 0.0000 0.0000 property index tot t-statistics −1.787658 −2.275410 0.748856 −9.3823* −9.3227* −9.3544* critical values at 5% −2.897223 −3.465548 −1.944811 −2.8976 −3.4662 −1.9448 p 0.3841 0.4421 0.8741 0.0000 0.0000 0.0000 the significance level is outrightly mentioned at 5% and the p values are given for both augmented dickey fuller test and granger causality. for johhansen's cointegration the significance value cant be gotten from eviews, however the test statistics are easily indicated to be significant at 5% level durani: the relationship between elastic money growth and prices in countries with the largest money stock: an econometric review international journal of economics and financial issues | vol 7 • issue 4 • 2017 267 their leading money supply figures. this multi-country analysis of the influence of elastic money supply on cpi and asset price yields varied yet interesting results. the johansen’s cointegration test results in japan show that there is significant long-term relationship between money supply cpi and money supply property returns. index, however no granger causality is seen running between these variables. interestingly money supply and nikkei stock index are not cointegrated significantly, yet show significant bivariate granger causality. in the u.s.a money supply is strongly cointegrated with cpi, stock index and property index values, showing a strong long term association between these variables. money supply in the u.s.a seems to be influencing heavily the inflation rates and asset prices. the granger causality results also validate a causality running from money supply to cpi and to dow jones industrial index with the feedback. money supply in the u.s.a is not granger causing the s and p home price index returns; however the reverse causality is significantly established. the empirical analysis in case of india shows strong cointegration between money supply and cpi, but does not validate the same between money supply and sensex and money supply and property table 4: adf test results china exogenous level first difference intercept intercept and trend none intercept intercept and trend none money supply t-statistics 2.376635 −0.073039 2.281838 −0.92193 −3.739973 0.504057 critical values at 5% −2.876595 −3.433651 −1.94250 −2.87659 −3.433651 −1.94250 p 1.0000 0.9950 0.9948 0.7796 0.0220 0.8235 cpi t-statistics −2.649670 −2.848468 −1.330267 −5.830830 −5.860826 −5.837643 critical values at 5% −2.877186 −3.434569 −1.942574 −2.877186 −3.434569 −1.942574 p 0.0850 0.1821 0.1694 0.0000 0.0000 0.0000 s seci (si) t-statistics −2.71044 −2.985782 −0.305484 −7.70088 −7.68563 −7.71232 critical values at 5% −2.87560 −3.432115 −1.942383 −2.87560 −3.43211 −1.94239 p 0.0740 0.1388 0.5747 0.0000 0.0000 0.0000 property index tot t-statistics −2.51264 −2.279695 −1.55852 −12.1551 −12.1983 −12.1197 critical values at 5% −2.88505 −3.446765 −1.94344 −2.88524 −3.44707 −1.94347 p 0.1149 0.4414 0.1116 0.0000 0.0000 0.0000 h0: the variable has a unit root. *denotes the rejection of the unit root null hypothesis for the 5% significance. the choice of optimum lag for the adf test was decided on the basis of minimizing the schwarz information criterion table 5: all countries summary of granger causality tests null hypothesis observe f-statistics p reject/do not reject japan money supply does not granger cause cpi 712 0.46905 0.8956 do not reject cpi does not granger cause money supply 712 1.01924 0.4227 do not reject money supply does not granger cause nikkei 225 717 3.09132 0.0007 reject nikkei 225 does not granger cause money supply 717 3.65836 9.e-05 reject money supply does not granger cause property index 231 0.53324 0.5874 do not reject property index does not granger cause money supply 231 0.54084 0.5830 do not reject the u.s.a money supply does not granger cause cpi 673 2.06533 0.0252 reject cpi does not granger cause money supply 673 7.14182 1.e-10 reject money supply does not granger cause djii 673 4.22307 1.e-05 reject djii does not granger cause money supply 673 5.31898 1.e-07 reject money supply does not granger cause s and p home 336 1.42191 0.1692 do not reject s and p home does not granger cause money supply 336 2.10498 0.0238 reject india money supply does not granger cause cpi 672 6.75567 5.e-10 reject cpi does not granger cause money supply 672 6.32566 3.e-09 reject money supply does not granger cause sensex 410 1.01739 0.4069 do not reject sensex does not granger cause money supply 410 0.85368 0.5124 do not reject money supply does not granger cause property values 49 3.94843 0.0265 reject property values does not granger cause money supply 49 1.15322 0.3250 do not reject china money supply does not granger cause cpi 185 0.21831 0.9943 do not reject cpi does not granger cause money supply 185 0.85732 0.5745 do not reject money supply does not granger cause shanghai comp 192 0.85383 0.5777 do not reject shanghai comp does not granger cause money supply 192 1.82105 0.0602 do not reject money supply does not granger cause property returns index 106 1.07676 0.3881 do not reject property returns index does not granger cause money supply 106 0.37080 0.9461 do not reject durani: the relationship between elastic money growth and prices in countries with the largest money stock: an econometric review international journal of economics and financial issues | vol 7 • issue 4 • 2017268 returns. the money supply in india is granger causing the cpi with the feedback. no causality is seen between money supply and sensex; however significant causality is inferred from money supply to property returns without the feedback. money supply in india seems to be significantly causing the inflation rates and property returns, but not the stock index returns. for china cointegration tests show that money supply is strongly cointegrated with all the three variables. therefore long term strong relationship can be assumed between money supply and cpi and money supply and asset prices in china. the granger causality results in china show no causality what so ever running from money supply to cpi and asset prices. over all, in all the four countries money supply seems to have significant long term influence on price levels and asset prices. references ariff, m., chung, t., shamsher, m. 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(2011), on china’s monetary policy and assets price. nottingham, uk: the university of nottingham. international journal of economics and financial issues vol. 1, no. 2, 2011, pp.46-53 issn: 2146-4138 www.econjournals.com can e-payment systems revolutionize finance of the less developed countries? the case of mobile payment technology helmi hamdi1 central bank of bahrain-financial stability directorate & cergam-cae, université paul cézanne aix-marseille iii. p.o box 27, manama, kingdom of bahrain e-mail: helmi.hamdi@cbb.gov.bh abstract: technological progress in mobile industry makes mobile phones the most adopted technology of the last decade by the rich as well as poor. mobile phones were at first intended for voice communication; nowadays they are used for sending and receiving information providing many advanced services to their users. recent generation of mobile phones allows consumers to carry out transactions in the real and the virtual world by the use of mobile devices through mobile networks. it is done by using mobile device such as mobile phone or pda which is connected to payment access using mobile operator network. the aim of this paper is to analyze the technological evolution of mobile phones and to identify the macroeconomic consequences of their introduction into the financial sector. key words: e-payment system, mobile payments, financial exclusion, economic growth jel code: g21, o30, r11 1. introduction since a few years, new forms of electronic payments have emerged. their aim is to enhance and improve the efficiency of traditional payment systems notably cash and checks. these new devices have information stored in a microprocessor or on a computer database which allow dataincluding account balances, personal information, pin codes, the history of the shopping information and loyalty rewardsto be stored on the card. among these new innovations, two monetary forms have quickly received considerable attention around the world. the first one is the electronic money card (also known as electronic cash, e-purse, e-currency, digital currency, digital money, scrip or digital cash) and the second one is the mobile payment via a personal mobile telephone (m-payment). the e-money card is a new means of payment which makes it possible to transfer value from card to terminal or card to electronic wallet, both in the real world and via networks. this monetary innovation is seen as a fundamental achievement; it carries a preloaded monetary value and can be used as a means of payment for multiple small value purchases (van hove, 2006; hamdi, 2007). the purse contains a microprocessor in which information and monetary value are stored. it represents a technological advance on cards with magnetic stripes, and also includes a higher level of security that can dramatically reduce fraud because chip cards are much more difficult to counterfeit than magnetic stripe cards (chaum, 1997). mobile payment is a new channel used to conduct financial or commercial transaction between buyers and sellers by the means of mobile devices through mobile network. it is done by using mobile 1 the opinions expressed in this article are those of the author and they do not necessarily represent the official position of the central bank of bahrain. can e-payment systems revolutionize finance of the less developed countries? the case of mobile payment technology 47 devices (cell phone, pda etc) that are connected to payment access using mobile service provider network. a service provider server is connected to the bank server using merchant which performs authentication and authorization function, and subsequently presented with a confirmation of the completed transaction2. this payment technology eliminates the need to visit the bank’s branch. consumers can easily manage all their financial needs with a lower transaction costs. in this paper; we will focus only on mobile payments technology for three reasons: first, because despite the strong interest worldwide in e-money, the technology is still at an early stage of development and many experiences were failing3 (hamdi 2007, 2009). second, because innovations in mobile phones have quickly evolved in the recent years and the mobile phone becomes the smart phone offering a wide range of services for its users. finally, because the world adoption of mobile phones has exploded in the last few years (by the rich and the poor) making this technology the best device facilitating the financial inclusion for the poor. the aim of this paper is to analyze the possible economic consequences of the introduction of mobile money into the financial and commercial sector. this article is divided into two parts: first, we analyze the evolution of mobile phones’ technology over the time and we present the different new services that are offered to their holders. second, we study the challenge of mobile money as a new payment device facilitating the financial inclusion of unbanked households notably from the poor countries. 2. evolution of the mobile phone technology the technology of the mobile phones has grown over time moving from the first generation in the 1970s to the fourth generation. today’s mobile phone is not only a simple device of voice communication, but also a smart telephone with many applications similar to a laptop. the aim of this section is to analyze the evolution of mobile phones’ technology over time and to present the different new services that are offered to their holders. 2.1. mobile phone as a communication device mobile phones were born in the united states in the early forties. they were a heavy device with restricted services; they were costly and constrained by imperfect mobility (vesa, 2005). since then, engineers and developers were working to improve the performance of the technology and to enhance its use. as a result the first generation (1stg) of mobile phones was born in 1970 and they were initially installed in vehicles; they were called “car phone service”. the 1stg of mobile phones has started to be in widespread use in the eighties with the introduction of cell phones that were based on cellular networks. in the nineties the second generation (2ndg) of mobile phones using the global system for mobile communication (gsm) technology was introduced. the new device was less large and more manipulative than the 1stg. it has allowed users to benefit from many new services such as the global positioning service (gps), short messaging service (sms), voice messaging, fax and other services. consequently, mobile phones became popular and the number of subscribers rose drastically. in 2002, a third generation of mobile phones was appeared. the 3rdg was considered as a revolution in the telecommunication sector because it offers a wide range of advanced services for users such as broadband internet, bluetooth, wi-fi and the high-tech video call. nowadays the demand for mobile phones continues to increase at a phenomenal rate of growth and prices continue to decline. table 1. worldwide evolution of mobile cellular subscriber (1997-2008) 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 mobile cellular subscribers (millions) 215 318 490 738 961 1’157 1’147 1’763 2’219 2’757 3’305 4’100 source: itu world telecommunication/ict indicators database 2009. 2 tata consultancy services (2008)” alternative payment systems, chapter-17 in payment card”. certificate program in payment cards competency v1.3tcs ftc (a domain competency centre) 3 major e-money experiences are still in their primary stage and they have not been in widespread use so far either in the european union or in other industrial countries. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.46-53 48 the figure 1 illustrates the worldwide evolution of the mobile purchased in 2009 and table 1 shows the worldwide evolution of the cellular subscribers since 1997. mobile phones seem to be the most successful technology and the most adopted; becoming an integral part of the 21st century landscape. figure 1. the worldwide evolution of the purchasing of mobile phones (million) 0 50 100 150 200 250 300 350 smartphones mobiles 2nd half of 2008 2nd half of 2009 source: gartner 2009 innovation in mobile phones has always been evolving over the time and the technology has been improved. currently, many sophisticated services are added to the 3rdg mobile phones including financial services. nowadays the mobile phone is in a widespread adoption and this technology is not used only as a mean of communication but also as a new payment solution. today’s mobile phones (called 4thg) can store money (as information) in the sim card or in an internal or external memory card and can be used as a device to transfer monetary value from person to person in the real and the virtual world. mobiles phone are becoming a means of payment and a channel to conduct financial services. this system was born in the recent years and it has received a large acceptability from emerging countries which are excluded from the financial services. in france, the experience of mpayment was first experienced on 20th of may 2010 at nice; consumers seem to be charmed and 500 merchants are already interested about the adoption of this new payment technology. 2.2. mobile phone as a new payment device mobile money is a new payment technology used to facilitate financial or commercial transactions (called m-commerce) between buyers and sellers by the use of a mobile phone as an alternative for credit and debit cards, cash, or other means of payments. monetary value is stored as credit information and can be transmitted through a secure applet. mobile money can be used in the traditional market for both micro and retail transactions. payment with mobile phones in the traditional market is based on contactless technology called near field communication (nfc) with a compatible payment terminal. similar to the stored-value card, an nfc is a new short-range device equipped with a chip that stores the users account information, while merchants require special point of sale readers (pos). the chip is either separated from the sim card of the mobile network operator or embedded in it. customers can pay both by swiping the phone across a special reader or by composing a personal identifying code (pin) into the phone to authorize payments via a short message service (sms). mobile money can also be used in the virtual market via the wireless application protocol (wap) service for the two kinds of transactions and without using a credit card or bank account. generally, m-money aims to replace cash for small transactions and eliminate its drawbacks4. m-money was also created to reduce transaction costs of traditional means of payments and to provide a new way of storing and transporting purchasing power temporally. this technology would facilitate 4 the costs of cash holding are high and disadvantages of cash are numerous – including retail transaction accounting, theft, loss of cash, safekeeping and security, deposit costs, as well as costs related to cash management services provided by financial institutions. for more details see hamdi h (2007) can e-payment systems revolutionize finance of the less developed countries? the case of mobile payment technology 49 a variety of low value retail transactions and would consequently be a substitute for real cash. mpayment has also a great advantage compared to other pos cards: while debit or credit cards are not efficient for micro-payment because the transaction related-cost is high for both the consumer and the merchant, m-payment can be used at a low cost. as a modern and rapid payment means, it will certainly be of great convenience for its users. m-money provides numerous benefits to consumers, merchants, banks and mobile operators. benefits to consumers include convenience, speed and possible rewards, such as discounts on future purchases, obviation of the need to have the correct change for a transaction or to handle a lot of small coins. the incidence of error in calculating change from transactions would also be reduced. benefits to merchants include receiving cash in advance of the delivery of goods and services, increased loyalty, potentially faster payment processing at the point of sale, and potentially lower payment processing costs. benefits to banks consist of gain of time related to cash and checks management. this means that they are better supervised by bankers than other traditional tools of payment (hamdi 2007). m-money may also benefit to banks by reducing costs; enhancing customer service and improving the banking competitive advantage. for mobile operators, m-payments provide new opportunities to drive additional revenue via mobile shopping and payment traffic. operators can enhance their services portfolio, encourage their brands and create strategic marketing differentiation attracting new consumers. 3. the relationship between mobile payment systems and the access to finance near than hundred years ago, an austrian economist schumpeter argued that banks play a major role in economic development due to their ability to managing risk, creating wealth and allocating capital into wealth-creating projects5. banks have economies of scale in providing information; lowering transaction costs; mobilizing savings for investment and improving the liquidity of assets available to saver. financial intermediaries may help promote resource allocation and accelerate growth by increasing savings and improving borrowing options and the reallocation of capital. for schumpeter, financial intermediaries are at the core of financial development and financial development is the hub of economic growth. in developed economies, banking sector is dynamic and the financial sector is highly developed. however, in poor countries, the financial sector is archaic and people face a financial exclusion. financial exclusion is the phenomenon by which a certain segment of the population is deprived of the access to indispensable financial services; i.e. banking account. financial exclusion can be a serious barrier hindering the economic development and an impediment to growth. in this section we firstly illustrate the relationship between finance and growth; secondly, we identify the macroeconomic consequences of the introduction of mobile payment into the financial sector. 3.1. finance and growth: lessons from the theory finance is at the hub of economic development and financial services sector becoming one of the most significant sectors in modern societies. affordable and appropriate finance enables business to work efficiently. the financial sector mobilizes saving and allocates credit across space and time; it provides funds for businesses to innovate, generate new technologies and new more productive ways of operating. based on empirical demonstrations; scholars6 suggest that efficient financial systems are crucial in channeling funds to the most productive uses and in allocating risks to those who can best bear them, thus boosting economic prosperity, improving opportunities and income distribution, and reducing poverty (world bank, 2008). in more advanced service economies, the financial sector employs more than the manufacturing of apparel, automobiles, computer, pharmaceuticals, and steel combined (harker and zenios 2000). as the table 2 shows; thefinancial sector is even more significant for economic development in both modern and emerging economies. 5 schumpeter, j a. 1912. “the theory of economic development”. cambridge, ma: harvard university press, 1934. 6 king and levine (1993, 2003), levine and zervos (1998), rajan and zingles (1998). international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.46-53 50 table 2. importance of the financial sector in selected countries (2009) countries number of people employed in the financial sector % of active population % of financial sector to gdp france 430 000 2.5% ≈ 4 % usa 2 500 000 7.5% 5.% germany 712 000 7% 5.5% italy 337 000 3.2% 3.5% switzerland 330 000 7% 9% cyprus 53.000 10% 18% israël 89 000 10% 18% singapore 65 000 8% 8% hong-kong 87 000 8.2% 9% source: us bureau of labor statistics (2009), cpss (2010) and countries’ central banks (2010) in the modern financial service economies such as in the us, france, germany and switzerland, a large part of households are banked. more that 80 percent of customers have a banking account. the high financial inclusion allows households of developed countries to get better information about the financial environment; it increases the consumers empowerments and offers them a wide range of financial services such as new means of payments (stored-value-card, debit/credit card) and new delivery channel of making transactions (e-banking, atm). financial development may allocate wealth in the economy to their most productive uses and creates an environment favorable for the entry of new firms, innovation, and growth. as king and levine indicate (1993) “higher levels of financial development are significantly and robustly correlated with faster current and future rates of economic growth, physical capital accumulation and economic efficiency improvements… finance does not only follow growth: finance seems importantly to lead to economic growth.” 3.2. the macroeconomic consequences of mobile payment in the poor countries access to finance is narrow; people face a financial exclusion7. in some countries such as india or sub-saharan africa, almost 70 percent of population lives in rural areas where access to banking services is very limited8. according to a recent study of the world bank (2008) more than 75 percent of people from developing countries are unbanked. households save their money in their houses (pockets and cash boxes or under mattresses) because on the one hand, the density of the branch’s physical footprint is not sufficient and on the other hand the banking services fees are unaffordable. people do not have bank accounts or payment cards and banks are only accessible to privileged elite (high income earners) 9. in many developing countries, savers are required to deposit more than their annual per capita income in order to open a deposit account with a bank. for example, to open a checking account in cameroon, a person needs more than $700, an amount higher than the per capita gdp of the country. in other regions, the account maintenance is exorbitant and sometimes costs 50 percent of per capita gdp (30% in uganda). the world bank study (2008) shows that on average an amount equal to at least 50 percent of per capita gdp is necessary to open a checking account in some poor countries. the figure 2 illustrates the proportion of households with an account in a financial institution in many regions of the world. it shows that less than 20 percent of sub-saharan african households have a banking account. this situation inhibits the economic development, increases poverty and social inequality. 7 financial exclusion refers to a process whereby people encounter difficulties accessing and/or using financial services and products in the mainstream market that are appropriate to their needs and enable them to lead a normal social life in the society in which they belong (european commission 2008, p 9). 8 ifad (2001) “the challenge of ending rural poverty », rural poverty report 2001. oxford university press. 9 the ethnical race, income, education, sex are other reasons for being unbanked. in this paper we consider that for poor economies, the major reason is the expensive cost of financial service. for more detail, see fdic( 2009). can e-payment systems revolutionize finance of the less developed countries? the case of mobile payment technology 51 figure 2. proportion of households with an account in a financial institution 0 10 20 30 40 50 60 70 80 subsaharan africa east-asia europe and central asia latin america and caribbean middle east and north africa south asia note: figure shows the highest and lowest national percentages for the countries in each region. arrows reflect the median for each region. source: honohan (2006). nowadays, mobile payment seems to be the best tool able to create a new financial architecture and capable to reduce the financial fracture between the rich and the poor (hamdi 2010). in africa, more than 50 percent of population has a mobile phone and less that 20 percent of them have an account in a financial institution. around the world, 1 billion of poor people are unbanked but do have mobile phones10. the cgap study (2009), expects that by 2012 the number of mobile subscriber will attain 1.7 billion, making mobile phones a direct conduit to nearly half of the world’s unbanked people. the move toward an m-payment system may provide a fabulous opportunity to realize greater financial inclusion. barriers to the use of financial services may disappear progressively and financial services will be accessible to all at an affordable price. with mobile phones, customers do not have to walk miles to find a banking branch; they are instead carrying the banking branch in their pockets (bueno, 2008). thus, access to financial services will increase when the use of mobile for commerce rise. this situation may encourage households to have a banking account and to enjoy the benefits of financial services. the use of mobile phones technology for everyday commercial transactions could make economic activities flourish, enabling the entrance of new firms and encouraging people to consume11. money under mattress could move into the financial institutions and it could be better managed in favor of economic activities such as credit allocations and investment. banking activities will become dynamic, access to loans will be easier and economic activities will prosper. in this sense, mobile phones have the potential to bridge the digital divide and allow organizations and individuals to reach out to one another more easily than ever before12. in this paper we suppose that m-payment could facilitate the financial development (inclusion) and that the financial development could contribute to increase incomes of the poorer (through interest earned) and enhance their ability to undertake profitable investments and other activities. as a result, m-payment could enhance gdp of poor economies. many developing countries such as philippine, kenya and brazil have tested the m-payments experience in their economies. consequently, their mobile operators, financial institutions, consumers, merchants and the economy on a whole, have 10 national consumer law center (2009), “cell phone e-wallets for the unbanked and immigrant”. nclc report. june 2009, boston. 11 according to global insight research, growth in electronic payments in the u.s, has added an additional us$6.5 trillion to real consumer spending (adjusted for inflation) over the last two decades. the cumulative gain was almost us$10 trillion, a growth increase of 0.5 percentage points per year, or the equivalent of 1.3 million new jobs. 12 gs1 group (2008), “mobile commerce: opportunities and challenges mobile commerce overview: why mobile is changing the way business happens. gs1 mobile com white paper february 2008 edition international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.46-53 52 started to benefit from the financial and the technological innovations. the cgap study (2009) shows that m-payments activities have generated in 2009 us$7.8 billion in new revenues for the mobile money industry coming from transaction fees, improved loyalty, and more cost efficient airtime distribution13. in the near future m-payment could incontestably revolutionize economies and finance of the third world. 4. conclusion since the last decade, the mobile phone industry has gradually added many services to be accessible through the use of mobile phone. as a result, the demand for mobile phone has increased considerably making them highest demanding telecommunications technologies of the last few years by rich and poor households. currently, mobile networks cover more than 80% of the world’s population and nearly 3 billion people are estimated to have a mobile phone (itu 2009). the most recent generation of mobile phone (4thg) offers financial services to their users. mobile phones are becoming payment devices able to transfer monetary value from person-to-person in the real and the virtual world. today one can pay with mobile money without revealing the personal mobile phone number and authorize all the mobile phone payments with a mouse click. the aim of the present contribution is twofold: first it presents the evolution of the technology in mobile phones industry since the seventies and second it analyzes the economic consequences of the high penetration of the technology for the less developed countries. we demonstrate that the performance of mobile phones and the new services that they offer (financial services) make this technology the best tool facilitating access to basic financial services for the poor. mobile phones are the only available technology that can change economies of the developing countries. the move toward an m-payment system creates an unprecedented opportunity to extend the benefits of financial services to the third world. references bueno, m. (2008), “an overview of the mobile phone banking industry”, working paper ie business school. madrid. cgap, (2009), “window on the unbanked: mobile money in the philippines. available at http://www.cgap.org/p/site/c/pubs/. chaum, d. (1997), "how much do you trust big brother?," ieee internet computing, 1(6), 8-16, nov. 1997, doi:10.1109/mic.1997.10044. cpss, (2009), “statistics on payment and settlement systems in selected countries -cpss publications no 88 december 2009. european commission, (2008), “financial services provision and prevention of financial exclusion”. bruxelles. fdic, (2009), national survey of unbanked and under banked households, fdic 2009 gs1 group, (2008), “mobile commerce: opportunities and challenges mobile commerce overview: why mobile is changing the way business happens. gs1 mobile com white paper february 2008. guillaumont s j., kpodar, k. (2008),“financial development and poverty reduction: can there be a benefit without a cost? imf wp/08/62. washington. hamdi, h. (2007), “some ambiguities concerning the development of electronic money” financial theory and practice. 31(3), 293-307. hamdi, h. (2009), ‘the problem of the diffusion of innovations: the case of moneo in france”. public and private services in the global economy, reser book 2009. hamdi, h. (2010), is there a relationship between e-payment system and economic growth? global business and economic anthology. 2, 113-122. harker p t., zenios, s.a. (2000), “what drives the performance of financial innovations? performance of financial institutions:efficiency, innovation, regulation” combridge university press. 13 cgap study (2009), “window on the unbanked: mobile money in the philippines. available at http://www.cgap.org/p/site/c/pubs/. can e-payment systems revolutionize finance of the less developed countries? the case of mobile payment technology 53 honohan, p, (2006), “household financial assets in the process of development.” policy research working paper 3965, world bank, washington dc. ifad, (2001), “the challenge of ending rural poverty”, rural poverty report 2001. oxford university press. itu, (2009), “world telecommunication/ict indicators” database 2009. king r g., levine, r. (1993), finance and growth: schumpeter might be right, quarterly journal of economics. 108(3), 717-37. levine r., zervos s, (1998), “stock markets, banks, and economic growth," american economic review, 88(3), 537-58. national consumer law center, (2009), “cell phone e-wallets for the unbanked and immigrant”. nclc report. june 2009.boston. rajan r g. and zingales, l. (1998), "financial dependence and growth," american economic review, 88(3), 559-86. rajan r g. and zingales l, (2003), “the great reversals: the politics of financial development in the 20th century,” journal of financial economics, 69, 5–50. schumpeter, j.a. (1912), “the theory of economic development”. cambridge, ma: harvard university press, 1934. us bureau of labor statistics, (2010), “occupation employment and wage, occupation employment statistics”. washington 2010. van hove, l. (2006), "what future for electronic purses?", lammer th. (ed.), handbuch e-money, e-payment & m-payment, springer verlag, pp. 379-405. vesa a,. j. (2005), “mobile services in the networked economy”. irm press. world bank, (2008), “access to finance and development, in finance for all: policies and pitfalls in expanding access”. a world bank policy research report. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(2), 40-46. international journal of economics and financial issues | vol 8 • issue 2 • 201840 a gravity approach to determinants of export in a small open economy: evidence from jordan metri f. mdanat1*, taleb a. warrad2, loay m. salhieh3, talah s. arabiyat4 1department of management sciences, german jordanian university, jordan university, jordan, 2department of business economics, jordan, 3department of logistic sciences, german jordanian university, jordan, 4department of management sciences, german jordanian university, jordan. *email: metri.mdanat@gju.edu.jo abstract this study seeks to identify the main factors affecting exports in small open economies. it uses panel data from 2001 to 2014 and a gravity model to identify these factors in one such economy. our results are relevant for policymakers in small economies which engage in free trade agreements (fta) and trade liberalization to pursue economic development via trade openness and investment. we found mixed results as to the direction of the relationship between fta and exports, a positive contribution of relative income in boosting exports and negative distortionary effects of distance and costs on exports. these findings suggest that there are differential impacts of trade liberalization over time on the export performance of small open economies. hence, policies aiming to maximize the benefits of trade agreements and reduce costs may be helpful in promoting exports. keywords: gravity model, export determinants, economic growth jel classifications: f1, f13, f43 1. introduction the engagement of small open economies in trade goes back more than 100 years. to boost economic growth, most small economies have made free trade agreements (ftas) and followed a path of trade openness. according to jansen (2004), small economies characterized as open to trade because they have to rely on imports and exports tend to be highly concentrated in a few sectors, making them highly vulnerable to the deleterious effects of globalization. historically, these countries have suffered from trade deficits which dampened their economic development and they continue to do so (zahonogo, 2017). there has been an ongoing debate and conflicting views regarding the relationship between trade openness and economic growth in small open economies. the results of empirical research have provided no definitive answer. many studies have found that the impact of trade openness on growth depends on the country’s level of development, economic structure and reform policies (chang et al., 2009). some researchers (kipkoech, 1990; edwards, 1998; mccombie and thirlwall, 1999; yanikkaya, 2003) have found that trade openness has had an adverse impact on growth in small open economies. others have argued that trade liberalization and reform have increased inequality (unctad, 1997; faux and mishel, 2000; naschold, 2002). we have identified several studies supporting the view that trade openness and reforms affect growth positively and can reduce poverty (aksoy and beghin, 2005; hansen and rand, 2006; blalock and gertler, 2008; maertens et al., 2011). factors determining trade between countries in general and exports in particular, such as relative income, the engagement of the country in free trade and distance, have received little attention in empirical research. only a few empirical studies (arora and vamvakidis, 2004; kowalski et al., 2015) have investigated factors determining exports. a country’s comparative advantage and natural resource endowment are important determinants of its export performance (kowalski, 2010) and its ability to diversify exports, as well as to penetrate new markets (jansen, 2004). in addition, the main determinants of export performance, such as trade policy, exchange rate regime and labor skills, enhance the ability of the country to increase its exports (penkova-pearson, 2011). other determinants are political and economic stability and the extent of capital investment in the country (edwards and alves, 2005). thus, the need to diagnose export performance is mdanat, et al.: a gravity approach to determinants of export in a small open economy: evidence from jordan international journal of economics and financial issues | vol 8 • issue 2 • 2018 41 vital for small economies and understanding export determinants is a crucial step toward improving policy action to promote exports growth and alleviate trade deficits. using panel data covering the period 2001–2014, this study investigates the main determinants of export performance and proposes a gravity model to account for their effects. the general objective of the study is to identify the determinants of jordan’s exports. specifically, the study seeks answers to the following questions: 1. what is the relative importance of the income factor for export performance? 2. what is the relative importance of the distance and/or adjacency factor for export performance? 3. how have the various trade agreements affected the development of jordan’s exports? this paper is organized in the following manner. section ii reviews the literature on the relationship between trade and economic growth using a standard gravity model. section iii provides an overview of export performance in jordan. section iv presents the theoretical model. section v discusses the estimation results and section vi concludes the study. 2. literature review some small open economies that have tried to stimulate and enhance export performance to contribute to their future economic growth have achieved the goal of strong export growth, while others have not and are still far from improving export performance. furthermore, even when these countries have achieved high export growth, the impact on the economy has been weak (abdmoulah and laabas, 2010). a report by dfid (2015) found that some countries benefited more than others from trade liberalization and reforms. in many small countries, exports are considered an engine of economic growth (unctad, 2003). however, empirical studies of the relationships among trade, exports and economic growth have had mixed results. some have found a unidirectional effect of growth on exports (soufan, 2014), while others have found that it is exports which affect growth (dumitriu et al., 2010; agrawal, 2014). overall, research into export determinants in small economies remains limited, with confusing results and inadequate statistical methodologies. it is apparent that only a few empirical studies (arora and vamvakidis, 2004; kowalski et al., 2015) have investigated the factors determining exports. research related to export determinants shows that distance is no longer a barrier to trade (alawin, 2009) and that the higher the weight and shorter the distance between the countries, the stronger the trade flows between them (smarzynska, 2001). using a gravity model, found that accession to the world trade organization (wto) had a positive effect on jordan’s foreign trade performance. karam and zaki (2012) also employed a gravity model to investigate the impact of wto commitments on trade in services in 21 countries, and found that being a wto member boosted trade in services. lawless (2009) employed a gravity model for ireland and found that distance had strong negative effects on exports, while common languages and infrastructure development had positive effects on trade between countries. on the other hand, found that factors such as culture and geography strongly affect a country’s total trade. empirical results of research by sandberg et al. (2006) show that history and regionalism have had strong and significant effects on the trade of caribbean community member countries. additionally, income per capita and population have significant and positive effects on trade, while the distance between trading partners exerts the expected negative effect (brodzicki and uminski, 2013). oh and sardar (2013) employed a gravity model and found that bangladesh’s exports were heavily dependent on the us market. other studies that have applied a gravity model across regions and industries show significant disparities among states and industries (funk et al., 2006). nevertheless, gravity models have been used in explaining trade performance between countries and within the same region. a study by chi and kilduff (2010) found that greater geographic distance between trading partners and the usa significantly impeded their exports to the usa, while each country’s infrastructure development, literacy rate and language commonality with the usa were pivotal factors in determining its competitiveness. artal-tur et al. (2014) studied the cases of france and egypt to provide evidence of how proximity enhances trade. they found that additional trade effects are found in countries sharing closer ties and that migrants appear to help firms to deal with fixed trade costs, influencing the trade-migration linkage and resulting in specific trade effects. in general, the above studies that have been conducted using a gravity model are limited in their scope and findings. in addition, the periods covered by their analyses have been found to be inconsistent, so that these studies have failed to explain the presence of a persistent trade deficit during the last few decades in jordan. 3. trade developments, export direction and diversification the development of the jordanian trade balance shows that domestic exports recorded strong growth during the period 2001– 2014, with an average annual growth rate of 12%. this remarkable growth was due to the role of the private sector in boosting exports by penetrating new markets, as well as the export growth strategy which was adopted in the late 1980s. additional factors were the exchange rate regime which was first adopted in the mid-1990s, the free market policy, the liberalization of the economy and the ftas that jordan signed with other countries and blocks. the government can be considered to have used such agreements as a tool to generate export-led growth. implementation of its growth strategy has ensured that export performance continues to drive the economy forward. despite all these developments, however, the intended economic benefits have not yet materialized, as jordan still has a large trade deficit and high rates of unemployment and poverty. graph 1 shows that exports via fta to the various blocks increased in value from jd 1352.4 million in 2001 to jd 5164 million in 2014. this amount represents around 75% of domestic exports. nevertheless, busse and gröning (2008) found that the various ftas and wto accession had had no statistically significant impact on jordan’s trade flows. the exception was the agreement with the usa, which was found to have led to a steep increase in jordan’s exports to the united states and a rise in imports from other nafta member countries. mdanat, et al.: a gravity approach to determinants of export in a small open economy: evidence from jordan international journal of economics and financial issues | vol 8 • issue 2 • 201842 among the main determinants of jordan’s export performance are the nature and structure of exports, as well as the types of goods exported. during the last 14 years, jordan has witnessed little change in its export structure. the country relies strongly on the export of a few classes of primary goods, while imports, which constitute around 70% of jordan’s foreign trade, consist of a variety of products. exported goods mainly comprise clothes, manufactured plastics, machinery and transportation equipment, raw materials and petroleum products. in 2014, clothing and machinery accounted respectively for 17.6% and 5% of exports, while the relative importance of raw materials and petroleum products decreased to 20% in the same period. thus, this type of export structure can be seen as mainly responsible for the weak performance of exports in the economy and the inflexibility of the economic structure. in addition, exports will become more vulnerable in the international markets. based on the un’s standard international trade classification (sitc), commodities are usually categorized as primary goods and manufactured goods. graph 2 shows that according to this classification, an average of around 59% of jordan’s exports in 2001 were primary goods, while 41% were manufactured goods. the share of primary goods in exports had increased slightly to 62.1% by 2014. changing the composition of exports toward manufacturing industries is vital if jordan is to achieve rapid and sustainable economic growth. graph 3 shows that during the first 14 years of this century, exports were driven by chemicals, animal food and manufactured goods. there was little change in this pattern from 2000 to 2009, then in the following 5 years, exports of animal and vegetable oils and fats increased strongly, but otherwise the same structure and composition of goods continued to dominate. jordan’s export performance cannot therefore be characterized as impressive. this structure of products exported reflects jordan’s limited competitiveness and its weakness in diversifying exports and in penetrating new markets. in short, from 2010 to 2014, the only notable change in the structure of exports was an increase in the share of primary products, as can be seen in graph 3. as for the geographical structure of destination markets and the distribution of exports, data for the period 2001–2014 show that export diversification and the penetration of new markets were below expectation, contributing to weak export performance overall. according to the national export strategy 2014–2019 (nes), around 41% of jordanian exports target old and traditional markets, while 61% target new markets, but less than 1% of new exports actually penetrate new markets.1 however, the increase in production assists in increasing exports, as do trade agreements with other countries. given the strong competition from other countries that jordan’s exports face, exports of new products and the penetration of new markets are still weak; therefore, products need to be further diversified in order for jordan’s exports to compete in international markets. graph 4, charting the distribution of exports from 2000 to 2014, shows that they were mainly concentrated in the middle east region. around 50% of jordanian exports go to arab countries. the country that receives the second largest proportion of jordanian exports is the usa, 1 ministry of industry, trade, and supply, 2014, “national export strategy 2014–2019.” source: central bank of jordan, monthly and annual data graph 1: jordan’s exports through free trade agreements, 2001–2014 source: central bank of jordan, monthly and annual data graph 2: export structure according to standard international trade classification, 2001 mdanat, et al.: a gravity approach to determinants of export in a small open economy: evidence from jordan international journal of economics and financial issues | vol 8 • issue 2 • 2018 43 at 16.6%, followed by india (10.7%), the eu (4.1%) and china (2.3%), while around 29% go to the rest of the world. additional indicators of jordan’s export performance for the years 2001–2014, listed in table 1, are the number of products, their concentration and diversification, based on the three-digit sitc product classification. according to the methods approved by the united nations conference on trade and development (unctad), the number of products is relevant because the more types of products that are exported, the greater the diversity of exports. the second measure is the concentration index, which reflects the degree to which a country’s exports are concentrated on a small number of products or a small number of trading partners. the third measure is the diversification index, which ranges between zero and unity, with higher values indicating a more concentrated trade structure and weaker diversification. the data in table 1 suggest that jordan is catching up with other countries concerning the number of products exported, as there was a small increase from 210 in 2001 to 218 in 2014. as for the concentration index, the fact that this increased by 23% from 0.13 in 2001 to 0.16 in 2014 (compared to 0.06 in more advanced economies) means that jordan’s exports are increasingly more concentrated in a narrow range of products. however, these values represent the lowest degree of concentration in developing countries. with regard to export diversification, countries that have lower concentration rates have more diversified exports. a country with an index closer to zero has great export diversification. in jordan, the high value of the diversification index, which stood at 0.65 in 2014, indicates that jordan’s exports are highly dependent on primary goods, which in return leads to unstable prices and trade shocks. graph 5 shows jordan’s export diversification and intensification during the last years. according to the nes, around 41% of jordan’s exports are of old and traditional commodities to old markets, while 61% of exports are old products to new markets. only 2% are of new commodities to new markets and 7% are new commodities going to old markets. 4. theoretical background to examine export fluctuations and performance in small open economies, we employed a gravity model, which has become an essential tool for analyzing trade performance. over the years since table 1: export concentration and diversification, jordan, 2001–2014 year number of products concentration index diversification index 2001 210 0.13 0.54 2002 213 0.15 0.62 2003 216 0.13 0.60 2004 213 0.14 0.59 2005 221 0.14 0.60 2006 222 0.14 0.65 2007 218 0.15 0.58 2008 220 0.19 0.61 2009 217 0.16 0.60 2010 222 0.17 0.64 2011 222 0.18 0.65 2012 222 0.16 0.65 2013 219 0.15 0.67 2014 218 0.16 0.65 source: unctad, 2016 source: central bank of jordan, monthly and annual data graph 3: evolution of jordan’s exports by commodities, 2000–2014 graph 4: export direction 2000–2014 source: central bank of jordan, monthly and annual data mdanat, et al.: a gravity approach to determinants of export in a small open economy: evidence from jordan international journal of economics and financial issues | vol 8 • issue 2 • 201844 the pioneering work of tinbergen (1962) and anderson (1979), this model has witnessed many developments, shortening the gap between theory and empirical work. the application of the current model is not restricted, as in previous versions, and new factors can be added and tested easily. a review of empirical gravity models indicates that a majority of them take account of distance, income, population, transportation costs, labor costs and tariffs. some researchers have focused on the effects of amending them by adding other factors (anderson and marcouiller, 2002; buch et al., 2003; kristjan, 2013). the significance of the gravity model itself and its direct influence on trade direction and relationships in the context of small economies have been addressed within narrow limits. the use of gravity models, as explained earlier, is found to be inconsistent for jordan; they suffer from weaknesses and spurious regression. generally, according to the gravity approach, total bilateral trade between any two countries is positively related to their size and negatively related to the trade cost between them. the basic gravity model specification, similar to newton’s law, takes the following form: x ky y tij i j ij= α β θ / (1) xij = exports from country i to country j; or total trade (i.e. xij +xji) y = economic size, usually measured by gross domestic product (gdp) or population size. t = trade costs. standard proxies used for trade costs in gravity equations include distance, adjacency, common language, colonial links, common currency, island, landlocked, institutions, infrastructure and migration flows. hence, a basic econometric gravity model for exports flows can be written in log form as: ln(xij) = b0+b1ln(yi/yj)+b2ln(distij)+uij (2) where all variables are as defined before and uij is the random error term. according to this approach to trade, the expected sign is positive for the relative income variable and negative for the cost/distance variable. in this study, the focus is on exports instead of total trade, due to the importance of export performance for growth and poverty reduction. annual panel data were used in the estimation, covering the period 2001–2014. 4.1. empirical analysis all estimations are based on data concerning jordan’s exports to its main trading partners. according to the basic gravity model, the main determinants of jordan’s exports are relative gdp, an indicator of geographical distance (between capitals), and a set of dummy variables representing various bilateral trade agreements signed by jordan after the year 2000. equation 3 represents the gravity model of jordan’s exports: lexpoijt = α0+α1lgdpijijt+α2lremijt+α3d1+α4d2+α5d3+uijt (3) where lexpoijt is the natural logarithm of bilateral jordanian exports; lgdpijijt is the natural logarithm of relative bilateral income measured by real gdp for corresponding pairs of countries; lremijt is the distance indicator calculated as log (distance between capitals/(gdpi/gdpj)); and d1, d2 and d3 are dummy variables representing jordan’s bilateral trade agreements with canada, turkey and the usa respectively. one of the most serious problems in using a gravity model to capture the determinants of exports in small open economies is that there are many factors correlated with the model variables such as political, cultural, demographic and economic variables (zarzoso and lehmann, 2003). if we ignore these variables, biased estimates will affect the results (gómez and milgram, 2010). therefore, several studies have used panel data to capture the time effect and cross-country effects to control for unobserved heterogeneity (glick and rose, 2002). in this study, we used panel egls in order to correct for cross-sectional variance, heterogeneity and autocorrelation. the sample used in estimation covers 14 years and 28 cross-sections producing a sample size of 392 observations. table 2 presents the estimated results obtained from the model using panel egls. the results of the estimation of the gravity model for bilateral jordanian exports is satisfactory, as evident from the high value graph 5: export diversification and intensification index source: national export strategy 2014–2019 mdanat, et al.: a gravity approach to determinants of export in a small open economy: evidence from jordan international journal of economics and financial issues | vol 8 • issue 2 • 2018 45 of the coefficient of multiple determination (adjusted r2 = 81%) and significant value of the fisher test (f-statistic = 328). the results show that variations in independent variables explain around 81% of the variation in the dependent variable. in addition, all estimated coefficients carry the correct expected sign and are statistically significant at better than 1%. the estimated elasticity of the relative income variable is below one (inelastic at 48%), meaning that a 1% increase in the relative income of trading partners will increase exports by about 0.48%, keeping other things constant. this indicates that the trade of small open economies with higher income countries is more likely to enhance export performance. the estimated elasticity with respect to the cost (distance variable) is about −0.25% (inelastic), meaning that a 1% decrease in trade cost (relatively closer trading partners) will expand jordanian exports by about 0.25%, other things kept constant. turning to the effects of the fta between jordan and the united states, which came into force in december 2001, the estimated coefficient of the dummy variable is 0.75, statistically significant at better than 1%. the implication of this result is that this fta makes a strong and positive contribution to boosting jordanian exports. the estimated coefficient with respect to the fta with turkey, which came into force more recently, in march 2011, is −1.73, but with weak statistical significance at only about 7%. the estimated coefficient for the fta with canada, which came into force only in october 2012, is −0.68, statistically significant at better than 1%. the gravity model results support the proposition that the existence of long-term trading relationships between jordan and other countries are most favorable for improving trade in this small open economy. the results of the estimation may also indicate that ftas have a negative impact on exports in the short run (as in the cases of jordan’s agreements with canada and with turkey), which tend to become positive over the longer term (as in the case of the usa-jordan fta). our results on the impact of ftas on jordanian exports are consistent with the results of busse and gröning (2008). 5. conclusions and policy implications this study has uses a gravity model of small open economy exports to investigate the factors determining exports to trading partners. there are several interesting findings for small open economies: first, jordan’s exports are still concentrated in primary goods and driven by chemicals, food and animals, and manufactured goods. this lack of diversification may result in more vulnerability in the international markets. second, the adoption of an aggressive trade liberalization strategy has exposed domestic producers and exporters to strong competition, which has made it difficult to export new products and to penetrate new markets. third, the response of jordanian exports is found to be inelastic with respect to both income and cost shocks. this result is consistent with the results on lack of export diversification in terms of both composition and direction. finally, policymakers should consider taking several steps to enhance jordan’s export performance, the major policy implication being that greater product diversification will be required in order for jordan’s exports to compete in international markets and expand in response to ftas. finally, the mixed results on the direction of the impact of existing ftas on jordanian exports indicate the importance for policymakers, when undertaking new trade agreements, of taking into account the differential impact of trade liberalization on exports over time. references abdmoulah, w., laabas, b. 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(2001), does relative location matter for bilateral trade flows? an extension of the gravity model. journal of economic integration, 16, 3. soufan, t. (2014), factors that affect jordan’s exports during the period (2003-2012). international journal of business and social science, 5, 6. tinbergen, j. (1962), shaping the world economy: suggestions for an international economic policy. new york: the twentieth century fund. united nations conference on trade and development (unctad). (1964). united nations conference on trade and development (unctad). trade and development report. geneva: unctad; 1997. yanikkaya, h. (2003), trade openness and economic growth: a crosscountry empirical investigation. journal of development economics, 72(1), 57-89. zahonogo, p. (2017), trade and economic growth in developing countries: evidence from sub-saharan africa. journal of african trade, 10(3), 41-56. zarzoso, i., lehmann, f. (2003), augmented gravity model: an empirical application to mercosur-european union trade flows. journal of applied economics, 6(2), 291-316. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 706-713. international journal of economics and financial issues | vol 7 • issue 4 • 2017706 assessing the effectiveness of the monetary policy instrument during the inflation targeting period in south africa lumengo bonga-bonga* department of economics and econometrics, university of johannesburg, south africa. *email: lbonga@uj.ac.za abstract since the adoption of inflation rate targeting policy, there has been a great concern on the effectiveness of the monetary policy instrument to curb inflation in south africa. the effectiveness of monetary policy instruments to control the level of inflation has been widely criticised not only in the south african context but also internationally. this paper assesses how inflation react to monetary policy shocks in south africa during the inflation targeting period by making use of the structural vector error correction model (svecm). the results of the impulse response function obtained from the svecm show that, on average, contractionary monetary policy that intends to curb inflationary pressure has been impotent in south africa. however, the contractionary monetary policy shocks managed to reduce output. the paper suggests that it is time a dual target, inflation and output, be considered in south africa to avoid the harm caused on output growth from monetary policy actions related to the constraint of inflation targeting. keywords: inflation targeting policy, structural vector error correction model, south africa jel classifications: c50, e52, e58 1. introduction inflation targeting has become a monetary policy of choice in several countries since the 1990s. the policy was pioneered in new zealand in 1990. as for emerging markets, chile was the first country to adopt inflation targeting in 1991 (mishkin, 2000). with regards to the operations of inflation targeting policy, monetary authority sets an explicit target for inflation rate and communicates the target to the public. moreover, the monetary authority makes use of the main policy instrument, the interest rate, to control the level of inflation. the conventional practice for the control of inflation is that the central bank, the monetary authority, raises the interest rate to cool down the economy to subdue inflationary pressure. thus, inflation targeting central banks rely on interest rate, especially contractionary monetary policy, to compel inflation to remain within the target. however, stiglitz (2008) noted that this practice is always not successful, especially in emerging and developing economies, as these economies often miss the target due to circumstances beyond the control of their central banks. consequently, for stiglitz, inflation targeting policy has failed in emerging markets and developing economies. a number of authors attribute the failure of monetary policy instruments to contain inflationary pressure in emerging and developing economies to their vulnerability to global shocks (mishkin and schmidt-hebbel, 2007; blanchard and gali, 2007). commodities and trade shocks have been found to be larger and more persistent and have contributed to the macroeconomic volatility in emerging and developing countries (mendoza, 1995). among other things, the effectiveness of a monetary policy is assessed by its ability to control inflation, albeit in the presence of external shocks (clarida et al., 1999; rasche and williams, 2005). it is then important to evaluate how monetary policy instruments has fared in affecting inflation in emerging markets in general and in south africa during the inflation targeting period. with a potent monetary policy instrument, it is expected that contractionary monetary policy shocks should be able to reduce inflationary pressure. south africa adopted inflation targeting as the anchor of monetary policy in february 2000. the initial target, decided by the minister of finance in collaboration with the south african reserve bank (sarb), was to achieve an average inflation rate bonga-bonga: assessing the effectiveness of the monetary policy instrument during the inflation targeting period in south africa international journal of economics and financial issues | vol 7 • issue 4 • 2017 707 of between 6% and 3% interval in 2002. the sarb has used the repo rate as the policy instrument to control the level of inflation and contain it within the chosen interval. the effectiveness of the policy instrument to control the level of inflation has been widely criticised not only in the south african context but also internationally. with the critics pointing out from a substantial lag for monetary policy changes to affect inflation to the inability of the policy instrument to effectively affect inflation level (bernanke and woodford, 1997; mishkin, 2002). since early 2007 the annual inflation rate in south africa has evolved outside the interval of 3-6%. the continual increase in the repo rate to curtail the inflation rate has accelerated its trend rather than subduing it. the aim of this study is therefore to assess the extent to which the monetary policy instrument, the repo rate, has managed on average to influence inflation rate and economic activities in south africa. this paper uses the structural vector error correction model (svecm) to characterise the dynamics of inflation to monetary policy instrument shocks. furthermore, this study also assesses the responses of the credit extended to the private sector and the real domestic product (gross domestic product [gdp]) to monetary policy instrument shocks. the remaining of the paper is structured as follows: section 2 the theories and literature review on inflation targeting policy. section 3 discusses the trend of inflation and the monetary policy instrument in south africa. section 4 discusses the data and methodology of the svec model. section 5 focuses on empirical results and discussion on the findings of the paper. section 6 concludes the paper. 2. literature review inflation rate targeting (it) was first adopted as monetary policy by the reserve bank of new zealand in 1990, followed by the bank of canada in 1991, and the bank of england in 1992. it has gained popularity in both industrial countries and emerging economies. to date the number of countries following this monetary policy is more than 20. svensson (2007) argues that a successful it policy is characterized by, (1) an announcement of the numerical inflation target, (2) an implementation of monetary policy that gives a major role to an inflation forecast, (3) an adoption of short-term interest rates as the only monetary policy instrument, and (4) a high degree of transparency and accountability. proponents of inflation targeting policy (bernanke et al., 1999; de simone, 2001; corbo et al., 2002; neumann and von hagen, 2002; hyvonen, 2004; imf, 2005; vega and winkerlied, 2005; mishkin and schmidt-hebbel, 2007) demonstrate empirically that inflation targeting is associated with an improvement in overall economic performance. according to these authors the rationale behind this success is that by targeting directly price, inflation target plays a role of explicit and a strong nominal anchor. the application of the it policy necessitates that the monetary authority announces the numerical target (point or interval). the central bank should also set out the period within which inflation will reach the target level. whenever the inflation is outside the target, the central bank uses the short-term interest rates to bring it back within the target range. such an explicit mandate requires independence of monetary authority, which in turn is accountable for missing the objective. the issue of accountability leads to improved communication or transparency with the public through the published inflation reports, minutes of monetary policy committee meetings and inflation forecasts of central bank econometric models. without accountability and transparency, it is difficult to establish credibility, and hence anchor inflation expectation. the results of different studies suggest that inflation levels, persistence, and volatility are lower in inflation-targeting countries than in “nontargeters.” furthermore, output volatility has improved during the post-targeting period. finally, exchange rate pass-through effects have been reduced after the adoption of it. besides the improvement of economic performance, johnson (2002; 2003) provides strong evidence of an immediate fall in inflation expectations after the adoption of it. likewise, gürkaynak et al. (2007), levin et al. (2004), castelnuovo et al. (2003) argue eloquently that inflation expectations are more anchored for targeters than nontargeters, particularly at longer horizons. consequently, supporters of this view claim strongly that monetary policy has become more efficient under inflation-targeting. on the other hand, ball and sheridan (2005), roger and stone (2005), epstein and yeldan (2007) state that the earlier victory proclaimed by the proponents of it is still to be tested. their analysis shows that industrialized “nontargeters,” like targeters, have experienced low inflation and high output growth during the same period. similarly, for the same period their volatility of inflation and output growth declined. hence, one cannot attribute a recent disinflation and increase in output growth solely to the success of the it policy. as ball and sheridan (2005) clearly put it, the economic environment has been fairy tranquil during the inflation-targeting era, and central banks have not been tested severely. likewise, rogoff (2006) assigns these benefits to the forces of globalization. to support the effectiveness and success of it, it should be tested during the hostile periods of high inflation, such as the current rise in global food and oil prices. 3. inflation targeting in south africa like many emerging market economies, in the aftermath of the asian crisis, the sarb adopted inflation rate targeting as its monetary policy in early 2000. inflation becomes the primary and sole mandate of sarb, with a freely floating exchange rate. similar to many targeters, the adherence to this new monetary policy framework reinforced the sarb independence. sarb ascribes to 3-6% target range to be achieved within the 2 years after its adoption. the subsequent characteristics of it, as explained above, became reality in the south african context. to achieve its credibility the sarb should bring inflation rate within the target range by increasing or decreasing its monetary instrument, the repo rate. the repo rate, which represents the cost of holding money, is the rate that the sarb charges commercial banks. by using the repo rates the sarb controls directly liquidity in the market. for example, if bonga-bonga: assessing the effectiveness of the monetary policy instrument during the inflation targeting period in south africa international journal of economics and financial issues | vol 7 • issue 4 • 2017708 the central bank feels that there is excess liquidity in the market, it increases the repo rate to create shortage. the commercial banks will react to this contractionary monetary policy by increasing their lending rates. this will result in the decrease in the money demand and consequently the total demand. as the total demand decreases, the price level will tend to fall. figure 1 shows that inflation rate first reached the target band in august 2001. however, this success was short lived, in that the terrorist attack in the us on september 11, combined with massive depreciation of south african rand put high pressure on inflation rate reaching a pick of 10.5% in october 2002. the sarb reacted by increasing the repo rate (figure 2) from december 2001 to september 2002 where the repo rate increased from 9.5% to 13.5%, respectively. the central bank action combined with the investigation committee, initiated by the government to investigate possibility of speculative attacks against the rand, helped reduced inflation. inflation was reduced gradually to below 6% in june 2003. the decline in inflation was followed by monetary easing up to 8% in december 2003. as depicted in figure 1, inflation was back in up trend in march 2005 crossing the 6% limit in june 2007. from june 2006, onward the sarb has followed a contractionary policy increasing the repo rate from 7% to 11% in december 2007; that is, an increase of 4%. in the same time inflation, has increased from 3.9% to 8.6% for the same period. during the period 20072009, inflation has increased, reaching the 12% level in 2008. this shows the influence of the global financial crisis or external shocks on the south african inflation rate. figure 2 overlays the headline inflation rate and the repo rate, the sarb’s policy rate. the aim is to see whether the increase in the policy rate was successful in decreasing the inflation rate. it is difficult to tell from to conclude from the graphical representation on the comovement of the two variables as they seem to depict pro-cyclicality in a number of periods. also, it is difficult to detect clearly any lag effect, which is necessary in the reaction between the two variables. thus, this can only be a matter of empirical analysis. 4. methodology of the svec model in assessing how monetary policy instrument affects inflation in south africa this paper uses the svec model to characterize the dynamics of inflation rate to monetary policy instrument shocks. the modeling of dynamic behaviour of economic variables, through the impulse response function (irf) analysis, is extensively used in a vector autoregressive (var) framework. nonetheless the var model is “a-theoretic” and therefore there is little economic content in the results provided from the irf analysis. like structural var (svar) models, the svec models provide a framework where the results that are obtained from the irf have an economic meaning. contrary to svar models, svec models are suitable for identifying economic shocks when cointegration relationship exists between variables in the model. svec analysis starts from a reduced form standard vec model. ∆ γ ∆ γ ∆y y y yt t t p t p t= + + + +− − − − +αβ µ ' ...1 1 1 1 1 (1) where, yt is a k × 1 vector of time series, г1… гp−1 are k × k coefficient matrices. the reduced form disturbance µt is a k × 1 unobservable zero mean white noise process with covariance matrix ʃµ. from johansen’s (1995) version of the granger’s representation theorem it follows that the vec model has the following moving average representation: y l yt i t i t = + + = ∑ξ ξµ µ* *( ) 0 1 (2) where, ξ γ= −⊥ ⊥ ⊥ − ⊥ = − ∑β α β α( ( ) )' 'ik i i p 1 1 1 and represents the l o n g r u n e ff e c t s o f f o r e c a s t e r r o r i m p u l s e r e s p o n s e . ξ ξ* *( )l lj j j= = ∞ ∑ 0 is an infinite-order polynomial in the lag operator with coefficient matrices ξ j * that tend to zero as j→∞. it contains transitory effects. the term y0 * contains all initial values of the vector time series (). the forecast error impulse responses based on ξ and the ξ(l) are without economic meaning as they are obtained from the reduced form disturbance (equation 2). structural shocks need to be identified for a meaningful impulse response analysis. the relationship between the reduced-form disturbances and the underlying structural shocks is written as follows: µt = aεt (3) where, k × 1 vector εt contains the unobservable structural shocks, and has a covariance of ʃε. substituting equation (3) in equation (2) yield a structural irf given by ξa. the long-run effects of εt shocks will therefore be given by ξa. this matrix has a rank k−r, where r is the cointegrating rank of the system. in particular, if the system has r cointegrating relations, k = (k−r) shocks have permanent effects, while at most r shocks have transitory effects. to exactly identify permanent shocks k(k−1)/2 additional restrictions (elements of the matrix ξa set to zero) are needed. similarly, r(r−1)/2 additional contemporaneous restrictions are needed to identify the transitory shocks. together, figure 1: inflation (cpix) figure 2: inflation and repo rates bonga-bonga: assessing the effectiveness of the monetary policy instrument during the inflation targeting period in south africa international journal of economics and financial issues | vol 7 • issue 4 • 2017 709 these are a total of k(k−1)/2 restrictions necessary to just identify matrix a. 5. data and empirical analysis this study employs seasonally adjusted monthly data for south africa for the period from february 2000 to august 2016. february 2000 corresponds with the official starting of inflation targeting policy. in the benchmark specification, the svec model includes the following variables: • the natural logarithm of credit extension (credit) • the natural logarithm of manufacturing production used as a proxy for real gdp (manu). appendix figure 1 shows that the two series present a common trend and may be used of a proxy of each other • the prime rate as a proxy for repo rate (interest). appendix figure 1 shows that the trend of the prime rate corresponds to the repo rate • the headline inflation rate1 (infla) • the international commodity price (com) as an exogenous variable in the svec model to control for price puzzle. the series are sourced from the sarb database. appendix table 1 presents the unit root test of all the endogenous variables. all the endogenous variables are integrated of order one, i(1). this was tested with the augmented dickey–fuller test whereby a trend was included in the test for the series credit and manu and only constant was included for interest and infla. as the svecm analysis necessitates that variables be cointegrated and that the number of cointegrating relationship be known for the identification of shocks, appendix table 2 presents the trace test statistics. for the testing procedure, the johansen trace test was used. the number of autoregressive lags in the system chosen according to the akaike information criteria is two. appendix table 2 indicates that there is existence of two cointegrating relationships in the system. the vector of structural shocks in this study is given as ε ε ε ε εt manu credit interst t t infla t t=( ), , , ' . as in section 4, for a 4-variable vec we need k(k−1)/2 = 6 linearly independent restrictions to exactly identify the structural shocks. since we have two cointegrating relations (r = 2), the number of shocks with permanent effects are k = k−r = 2. a total of 2 shocks will have permanent effects, whereas r = 2 shocks have transitory effects. in our 4-variable vec model we assume that only shocks in credit will not have permanent effects. to identify the three permanent shocks, k(k−1)/2 = 1 additional restriction is imposed in the long-run impact matrix ξa. so we will assume in addition that productivity is only driven by technology shocks, εmanu. the identification of the long run matrix ξa in the 4-variable system is as follows: 1 it is important to note that the south african reserve bank (sarb) was targeting cpix-inflation from 2000 to 2008 instead of the headline cpi. in 2008 the sarb reverted back to targeting headline cpi inflation. ξa =             * * * * * * * 0 0 0 0 0 0 0 0 0 (4) unrestricted elements are indicated by asterisk. referring to the vector of structural shock above, the interpretation of the above matrix is that shocks to price have no long run effects on manu, credit or interest. also, shocks to interest have no long-run effects on manu, credit and infla. the rationale behind the interpretations is that nominal variables such as price and interest should not influence economic activity in the long term. another interpretation from this matrix, as discussed above, is that productivity is only driven by technology shocks, εmanu, and not any other shock. as said earlier we need 6 linearly independent restrictions to exactly identify the structural shocks. but as it stands now the two zero columns represent kr = 4 linearly independent restrictions and the zeros in (4) represent only five linearly independent restrictions. we then need in addition r(r−1)2 = 1 contemporaneous restriction to unravel the effects of the two transitory shocks. the one additional restriction is therefore reported in the contemporaneous or short term matrix a. the choice made is that shocks to infla do not contemporaneously affect interest. there should be a lag effect, especially in the case of south africa. the short run matrix is therefore represented as: a=             * * * * * * * * * * * * * * *0 it is important to note that the vecm from which our svec model is derived is estimated with four endogenous variables ordered as manu, infla, credit and interest and com as the exogenous variable. following the steps explained above for the svec estimation, we obtain the results of the irfs reported in figures 3-5. 6. discussion of the results figures 3-5 provide the responses of infla, manu and credit to monetary policy shocks, respectively. confidence intervals for the impulse responses are bootstrapped by procedure described in breitung et al. (2004). bootstrap from percentile method proposed by hall (1992) is used to construct the 95% confidence interval. figure 3 shows that a positive monetary policy shocks, monetary policy contraction, reduces slightly inflation but the effect is not statistically different to zero at 95% confidence level2. this outcome points to the possibility that either positive monetary shocks are 2 although there seems to be a statistically negative effect from periods 9 to 12, we cannot discard that the upper bound of the confidence interval is not different to zero. this was confirmed with the 95% efron percentile confidence interval. bonga-bonga: assessing the effectiveness of the monetary policy instrument during the inflation targeting period in south africa international journal of economics and financial issues | vol 7 • issue 4 • 2017710 unable to cause a decrease in inflation or that there is substantial lag in the effect of monetary policy on inflation rate. whichever the case may be, this indicates the ineffectiveness of monetary policy instrument in affecting inflation in south africa. this finding is supported by a number of studies (bonga-bonga and kabundi, 2013; gupta and komen, 2008). the inability of the monetary policy shocks to influence the level of inflation raises a concern on the success of inflation targeting monetary policy stance. this apprehension is echoed by jean-claude trichet, the former president of the european central bank, remarking that central banks do their best work when their threats to raise interest rate deter inflation actions3. figure 4 displays the reaction of the manufacturing production, proxy for gdp, to monetary policy shocks. 3 from the article titled “ecb likely to hold rates steady and enjoy the gap” published in the sunday time newspaper of 9 march 2008. there is a clear negative effects of positive monetary policy shocks on manufacturing production in south africa, before the effect dies out after 10 months. while monetary policy shocks are not able to reverse an increasing trend in inflation, as seen in figure 3, however, these shocks happen to depress economic growth. this outcome provides enough reason to question the effectiveness of inflation targeting in south africa. it is important to note that a number of studies attribute the failure of the monetary policy tool to contain inflationary pressure in emerging and developing economies to the growing influence of external shocks (roger, 2010). it is in that context that inflation targeting policy in general evokes an escape clause to justify a temporary inability of the monetary authority to contain inflation within the target due to external shocks. however, south africa being an open economy, there is a possibility that there will always be external shocks hitting the economy; this in fact will result in the escape clause becoming an “escape goat” to justify the failure of the monetary policy tool to control inflation. a change of monetary policy stance from a simple inflation targeting to a dual target of inflation and employment (output growth), as applied in the usa, may be an option for bolstering monetary policy in south africa. why should the sarb continuously increase interest rate that has a neutral effect on inflation but compromises the growth path of the country as reported in figure 4? another important question is to assess the extent to which contractionary monetary policy has succeeded to curb credit demand in south africa. we ought to believe that the successful operation of the credit channel could contribute the effectiveness of the contractionary monetary policy to control inflation in south africa. given that a contractionary monetary policy is assumed to increase debt service costs and impairs assets and collateral of households and firms, contractionary monetary policy shocks are expected to decrease the aggregate price level (inflation) through the decrease in aggregate demand. figure 5 displays the responses of the total credit extension from positive monetary policy shocks. the effects of monetary policy shocks on credits extension are neutral. this outcome confirms the findings of a number of studies that credit extension is insensitive to high interest rate in south africa. for example, bonga-bonga (2008) alluded to the poor savings, especially household savings in south africa, which lead to high demand for credit. the high dependence on debt by household has rendered credit extension insensitive to contractionary monetary policy. it is evident from appendix figure 1 that credit growth has been in an uptrend despite a continuous increase in interest rates. this outcome may suggest that, among other things, the inability of the monetary policy tool to control inflation in south africa may be due to the insensitivity of the credit demand to contractionary monetary policy shocks. the outcome of this paper that positive monetary policy shock failed to curb credit extension should imply that the 2005 national credit act, as an additional measure to regulate the credit market figure 3: responses of inflation (infla) to monetary policy shocks figure 4: responses of manufacturing production to monetary policy shocks figure 5: responses of credit extension to positive monetary policy shocks bonga-bonga: assessing the effectiveness of the monetary policy instrument during the inflation targeting period in south africa international journal of economics and financial issues | vol 7 • issue 4 • 2017 711 in south africa, does not prove to be an enabler to curb credit extension in south africa. this is confirmed in appendix figure 1 showing the upward trend of credit extension, even in the periods post 2005. 6.1. robustness test to test the robustness of our results, we apply different identifications, especially the zero restrictions in the short run matrix. we apply a zero-contemporaneous restriction for shocks to inflation on manufacturing production. we can observe that the results reported in figure 6, showing the responses of monetary policy shocks to manufacturing production, are similar to those reported in figure 4, although in figure 6 the effects die out after 8 months rather than 10 months as in figure 4. 7. conclusion there is an increasing debate amongst academic, policymakers, and the public as to whether inflation rate targeting is an effective monetary policy. in south africa, the central bank has embarked in monetary tightening for more than a year, but it has been unable to bring inflation back to the target band. this study endeavoured to assess the effectiveness of monetary policy instrument, the repo rate, in influencing inflation rate in south africa since the adoption of inflation rate targeting. the framework used is the svecm that facilitates the analysis of the dynamics of inflation to monetary policy instrument shocks. this study found that positive monetary policy shocks are unable to negatively affect inflation after a period of more than 20 months. this pointed to the ineffectiveness monetary policy in affecting inflation in south africa. similarly, monetary policy in south africa seems less potent in curbing demand for money, though this should be an important channel through which monetary policy should affect inflation. these facts prove that economic agents in south africa are insensitive to short-term interest rates. credit demand by the private sector remains immune to central bank policy. however, this study shows that monetary policy does affect the real output in south africa. a positive monetary policy shock decreases manufacturing production after 6-7 months. the study concludes that inflation rate targeting as applied in south africa does not help to curb inflation and credit demand by the private sector remains immune to central bank policy. the study then suggests that like in the usa, a dual inflation and employment (real output) target may be an option to consider for monetary policy in a developing country such as south africa. references ball, l., sheridan, n. (2005), does inflation targeting matter. in: bernanke, b.s., woodford, m., editors. the inflation targeting debate. chicago: nber, university of chicago. bernanke, b.s., laubach, t., mishkin, f.s., posen, a.s. (1999), inflation targeting: lessons from the international experience. princeton: princeton university press. bernanke, b.s., woodford, m. (1997), inflation forecasting and monetary policy. journal of money, credit and banking, 29, 653-684. blanchard, o., galí, j. (2007), real wage rigidities and the new keynesian model. journal of money, credit and banking, 39(s1), 35-65. available from: http://www.ideas.repec.org/a/mcb/jmoncb/ v39y2007is1p35-65.html. bonga-bonga, l. (2008), national savings and fiscal policy in south africa. an empirical analysis. ersa working paper no. 84. bonga-bonga, l., kabundi, a. (2013), monetary policy action and inflation in south africa: an empirical analysis. the african finance journal, 13, 25-37. breitung, j., brugemann, r., lutkepohl, h. (2004), structural vector autoregressive modelling and impulse response function in applied time series econometrics. in: lütkepohl, h., kräzig, m., editors. applied time series econometrics. cambridge: cambridge university press. castelnuovo, e., nicoletti-altimari, s., rodríguez palenzuela, d. (2003), definition of price stability, range, and point targets: the anchoring of long-term inflation expectations. in: issing, o., editor. background studies for the ecb’s evaluation of its monetary policy strategy. frankfurt: european central bank. clarida, r., gali, j., gertler, m. (1999), the science of monetary policy: a new keynesian perspective. journal of economic literature, 37(4), 1661-1707. corbo, v., landerretche, o., schmidt-hebbel, k. (2002), does inflation targeting make a difference? in: loayza, n., soto, r., editors. inflation targeting: design, performance, challenges. santiago: central bank of chile. neumann, m.j.m., von hagon, j. (2002), does inflation targeting matter? federal reserve bank of st louis review, 84(1), 127-148. de simone, f.n. (2001), inflation targeters in practice: a lucky lot? contemporary economic policy, 19, 239-253. epstein, g., yeldan, e. (2007), developing policy alternatives to inflation targeting: the new façade of neoliberal conditionality. new delhi: political economy research institute, mimeo. gupta, r., komen, k. (2008), time aggregation and the contradictions with causal relationships: can economic theory come to the rescue? university of pretoria working paper 2008-02. gürkaynak, r., levin, a., marder, a., swanson, e. (2007), inflation targeting and the anchoring of inflation expectations in the western hemisphere. in: mishkin, f., schmidt-hebbel, k., editors. monetary policy under 28 inflation targeting. santiago: central bank of chile. hall, p. (1992), the bootstrap and edgeworth expansion. new york: springer-verlag. hyvonen, m. (2004), inflation convergence across countries, discussion paper 2004-04. sydney: reserve bank of australia. imf. (2005), world economic outlook. washington, dc: international monetary fund. johansen, s. (1995), likelihood-based inference in cointegrated vector autoregressive models. oxford: oxford university press. johnson, d.r. (2002), the effect of inflation targeting on the behavior of expected inflation: evidence from an eleven-country panel. journal of monetary economics, 49(8), 1493-1519. johnson, d.r. (2003), the effect of inflation targets on the level of expected inflation in five countries. review of economics and figure 6: responses of manufacturing production to positive monetary policy shocks with different identification bonga-bonga: assessing the effectiveness of the monetary policy instrument during the inflation targeting period in south africa international journal of economics and financial issues | vol 7 • issue 4 • 2017712 statistics, 55(4), 1076-1081. levin, a., natalucci, f.m., piger, j.m. (2004),the macroeconomic effects of inflation targeting. federal reserve bank of st. louis review, 86(4), 51-80. mendoza, e. (1995), the terms of trade, the real exchange rate, and economic áuctuations. international economic review, 36(1), 101-137. mishkin, f.s. (2000), inflation targeting in emerging-market countries. american economic review, 90(2), 105-109. mishkin, f.s. (2002), from monetary targeting to inflation targeting: lessons from industrialised countries. in: banco de mexico, stabilization and monetary policy: the international experience. mexico: bank of mexico; 2002. p. 99-139. mishkin, f.s., schmidt-hebbel, k. (2007), does inflation targeting make a difference? nber working papers no. 12876. rasche, r.h., williams, m.m. (2005), the effectiveness of monetary policy. federal reserve bank of st. louis working paper no. 2005-048b. roger, s., stone, m. (2005), on target? the international experience with achieving inflation targets. imf working paper 05/163. rogoff, k. (2006), implication of globalization monetary policy. in: the new economic geography: effects and policy implications, papers and proceeding of 2006 jackson hole symposium. kansas: federal reserve bank. roger, s. (2010), inflation targeting turns 20. finance and development, 47(1), 46-49. stiglitz, j.e. (2008), the failure of inflation targeting. project syndicate. available from: http://www.project-syndicate.org/commentary/ stiglitz99. [last accessed on 2017 feb]. swensson, l.e.o. (2007), inflation targeting, ceps working paper no. 144, princeton university. vega, m., winkelried, d. (2005), inflation targeting and inflation behavior: a successful story? international journal of central banking, 1(3), 153-175. bonga-bonga: assessing the effectiveness of the monetary policy instrument during the inflation targeting period in south africa international journal of economics and financial issues | vol 7 • issue 4 • 2017 713 appendix table 1: unit root test at the level series adjusted t-statistics infla −0.642 credit 7.273 interest −2.059 manu −0.458 adf is augmented dickey-fuller test where the null hypothesis is of a unit root in the series. the estimated regressions include a constant and a trend. appendix figure 1: variables appendix appendix table 2: johansen cointegration test null hypothesis number of ce eigenvalue trace statistics 5% critical value p none* 0.310 79.692 63.876 0.001 at most 1* 0.288 46.721 42.915 0.020 at most 2 0.121 16.523 25.872 0.451 at most 3 0.055 5.045 12.518 0.590 trace test indicates 2 cointegrating eqn(s) at the 5% level. *denotes rejection of the hypothesis at the 5% level . international journal of economics and financial issues | vol 5 • special issue • 2015 165 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(special issue) 165-172. economics and society in the era of technological changes and globalization assessment of level of risk in decision-making in terms of career exploitation aleksandr sergeevich semenov1*, vladimir sergeevich kuznetcov2 1national mineral resources university “university of mines,” russian federation, 199106, saint-petersburg, vasilievsky ostrov, 21 line, 2, russian, 2national mineral resources university “university of mines,” russian federation, 199106, saint-petersburg, vasilievsky ostrov, 21 line, 2, russian. *email: loader3@yandex.ru abstract when designing career plots the raw data are stochastic in nature. from the results of the determination of these initial data depends not only the final result of the design or evaluation, but also the feasibility of the development of the field. while there are significant errors associated with the probabilistic nature of the source data and measurement errors and errors of calculations. risk assessment is an integral part of project documentation. the project decision-making occurs under conditions of uncertainty and risk. to minimize uncertainty, it is first necessary to identify the area of potential risk, to determine the probability of its occurrence and the potential consequences. if adverse effects cannot be excluded, a more complete understanding of the problem and contributes more mindful response to the potential risk. analysis of the traditional approaches to designing open pits in the face of uncertainty of input data, revealed that used design methods do not account for the risk that entails the adoption and implementation of inefficient design solutions. risk assessment is made in the design process and includes qualitative and quantitative analysis. if the evaluation of the project will be adopted for implementation, the mining companies are already faced with some problems of risk management. according to the results of the project accumulates statistics, which allows you to more accurately identify risks and work with them. when the uncertainty of the project is too high, then it can be sent back for revision, then again, there must be a risk assessment. keywords: open-pit mine, a working platform, risk, design, reliability, probability, source data jel classifications: j54, m14 1. introduction uncertainty information leads to uncertainty in the choice of design solution, while uncertainty determines the approach to the problem. uncertainty can be caused by the absence or lack of information. this situation is typical for operations in which the role of uncontrollable factors plays a geological conditions. in other cases, there is uncertainty in the result organized resistance (burenina, 2009; geoff, 2000; tufano, 1996). management of project risk systematic processes associated with identification, risk analysis and decisions that mitigate the negative consequences of inaccurate initial geological and feasibility data, maximizing the probability of achieving the optimal parameters and indicators of the project (burenina the problem of the accuracy and reliability of design solutions a characteristic feature of the present stage of development of the mining industry. in the area of improving the reliability of the design, there is a wide range of quarries outstanding issues. category accuracy stands as one of the objective criteria for the results of design and evaluation. burenina (2009), geoff (2000), roland (2000), a guide to the project management body of knowledge (2010), tufano (1996), topka (2003), u. s. bureau of mines (1993). risk analysis using the method of monte carlo simulation is quite a complicated procedure, with only a computer implementation. the result of this analysis is the probability distribution of possible semenov and kuznetcov: assessment of level of risk in decision-making in terms of career exploitation international journal of economics and financial issues | vol 5 • special issue • 2015166 outcomes of the project (for example, the probability of npv<0 and the expectation of the amount of damage). you must separate the concepts of risk and uncertainty in the mind of their non-identity. in conditions of uncertainty it is possible to start implementing the project, to postpone action, either to abandon its implementation. unlike uncertainty, risk arises when the decision to implement the project, i.e., the risk accepted. decisions, and accordingly, the implementation of certain actions entail and taking appropriate risks. therefore, the completeness and the quality of their evaluation depends on the result: minimize losses to the successful implementation of the project as a whole (meredith and mantel 2012, vellani, 2007; grey, 1999). qualitative and structural changes in the economic model of our country, the requirements of the market of mineral resources, investment especially open mining, caused the complication of the requirements for the design decisions, the need for rational and optimal decisions, reducing the risk of design; raised the question of the reorganization of the design process, extensive development of feasibility studies and the improvement of design methods opencast, assessing and managing project risk. when designing quarries the raw data are stochastic. from the results of the determination of these initial data depends not only the final result of the design or evaluation, but also the feasibility of developing the deposit. while there may be significant errors associated with both the probabilistic nature of the source data and measurement errors and errors of calculations. risk assessment is an integral part of project documentation (arsentie, 2002). the project decision-making occurs under conditions of uncertainty and risk. to minimize the uncertainty in the first place it was necessary to identify the area of potential risk, determine the probability of its occurrence and the potential consequences. if the negative effects cannot be excluded, a more complete understanding of problems and promotes a more deliberate response to potential risk (arsentie, 2002). the analysis of traditional approaches to the design of carrier-ditch, in the conditions of uncertainty of the initial data, it was found that prima-employed design methods fail to account for the risk that entails the adoption and implementation of inefficient design decisions (arsentie, 2002). for reliability improvement project decision making must take into account the probabilistic nature of the source data. consider the width of working platforms, namely dynamic design system parameters with the stochastic nature of. probabilistic in nature due to the irregularity of conduct blasting in the quarry, aparallactus in the direction of movement of excavators in the conduct of mining operations, the organization works in career and other reasons of technological nature. a large number of factors affecting the value of the width of the work sites, are not reliable. width of work sites that depend on many random variables is itself a random value. according to the theory of probability random variable is such that experience, it can take a certain value, and do not know in advance what (mustafa and al-bahar, 1991). the study of the laws of distribution of the width of the work sites in open pit mines-analogues allows you to set quantitative indicators, edit them, and to ask when designing and planning of mining operations defined their values. the distribution law of a random variable called value, establishes a connection between the possible values of the random variable and their corresponding probabilities (semenov, 2014; qi, 2013; zhang, 2010). 2. methodology the laws and parameters of the distribution width of the working platforms can be installed in statistical processing of data obtained at existing quarries-analogues, implementing steeply dipping ore deposits. the statistical processing of the material is carried out by determining the characteristics of a random variable is the empirical average of the expectation, the central moments of the distribution of normalized indices of asymmetry and kurtosis (arsentiev, 2002; burenina, 2009; semenov, 2014; camus, 2002). empirical average width of the working platforms b n bi i n = = ∑1 1 ,m (1) вi the value of the random variable work sites (i = 1, 2, 3…n). the central moment of the distribution of the random variable k-th order µκ = − = ∑1 n ( )b bi k i n 1 (2) the second central moment is called the variance characterizes the dispersion of the random variable and is the average of the square of its deviation from the mean b µ σ2 2 2 1 = = − = ∑1 n ( )b bi i n (3) the third central moment characterizing skewness of a distribution µ3 3 1 = − = ∑1 n ( )b bi i n (4) the fourth central moment called kurtosis, characterizing peakedness distribution µ4 4 1 = − = ∑1 n ( )b bi i n (5) the expectation of the random variable semenov and kuznetcov: assessment of level of risk in decision-making in terms of career exploitation international journal of economics and financial issues | vol 5 • special issue • 2015 167 e b b p p i i i n i i n ( ) = ⋅ = = ∑ ∑ 1 1 (6) рi the probability of a random variable b, (i = 1, 2, 3.n) the values ∑2, µ3, µ4 allow us to determine the normalized asymmetry index β µ µ 1 3 2 3 2 = / (7) and the normalized measure of kurtosis β µ µ 2 4 2 2 = (8) the values of these characteristics are determined by the parameters of all the major distributions. to establish the law, which can be approximated distribution functions, you should use the schedule pearson (roland, 2000), where the applied field in the plane ([beta]1, [beta]2) for different distributions normal, beta distribution, gamma distribution and log-normal. mathematical processing of empirical data conducted by ore quarries-analogues, has allowed to obtain the distribution of the width of the working platforms for these quarries. for solving the problem were treated with the provisions of the mining pits-analogues. width measurement sites were conducted on the entire working area of the quarry on the horizons of the testing. when measuring the width of the work sites received 844 values of ore and 1025 breed. the results of measurements of the width of the work sites by ore quarries-counterparts, implementing steeply dipping deposits, are presented in table 1. according to the results of the measurements used to construct the histogram of the width of the work sites (figure 1). characteristics of the random variable defined by the formulas (1-5): ore  p m= 28 5, b m= 31 µ3 736381= µ4 12646493= the breed 2 m=16 0, b m= 29 µ3 3669= µ4 264200= figure 1 sharply asymmetric distribution of the width of the work sites. variation series with this distribution is log-normal (lognormal) distribution, where the normal distribution are subject to the values of the logarithm of the random variable. when using the logarithmically normal law are natural or decimal logarithms for all values of the random variable. cumulative distribution function of the width of the working platforms f b b e db b bb ( ) ln ( ln ) ln ln ln= ⋅ ⋅ − − ∫ 1 2 1 1 2 0 2 σ π σ (9) (sigma)ln 2 the variance of the logarithm of the width of the working platforms; (sigma)ln the standard deviation (standard) empirical number; bln the empirical average of the logarithms of the width of the work sites. a lognormal distribution is characterized by the probability density, which in this case has the form f b b e b b ( ) ln (ln )ln ln= ⋅ ⋅ ⋅ − − 1 2 2 2 2 σ π σ (10) the variance of the logarithm of the width of the working platforms σln (ln ln ) 2 2 1 1 = − = ∑n b b mi med ii n (11) n the number of measurements equal to the sum of the frequencies of the empirical distribution; bmed the median value of the width of the work sites, m; mi frequency i-th measurement interval. the mathematical expectation of the width of the working platforms e b e b ( ) ln ln = + σ 2 2 (12) figure 2 shows the curves of chastoty width working platforms ore quarries-analogues. figure 1: histograms of the distribution of the width of the working platforms ore career, earning their steeply dipping deposit semenov and kuznetcov: assessment of level of risk in decision-making in terms of career exploitation international journal of economics and financial issues | vol 5 • special issue • 2015168 normal dispersion may be determined according to the formula (49) σ σ σ2 2 2 2 2 = ⋅ −e e eb ( )ln ln (13) in the case when the values of the dispersions and small curves density distribution of the normal and lognormal close to each other and in the limit, when seeking the variance to zero, they are the same. integrals and probability density function of the lognormal law not table round, so the theoretical probability density built directly by the formula (10). the values of the logarithms of the width of the working platforms for career, earning their polymetallic deposit, are presented in table 2. the data presented in table 2 reflect the histogram of the logarithms of the width of the work sites (figure 3) and the table 1: the results of measurements of the width of the working platforms ore pit the measurement intervals of the width of the working sites frequency, mi cumulative frequency, м chastoty, m’ % accumulated chastoty ore the breed ore the breed ore the breed ore the breed 0-10 81 72 81 72 9.1 7.0 9.1 7.0 11-20 272 291 353 363 30.8 28.4 39.9 35.4 21-30 261 276 614 639 29.5 26.9 69.4 62.3 31-40 98 173 712 812 11.0 16.8 80.4 79.1 41-50 64 108 776 920 7.2 10.6 87.6 89.7 51-60 48 63 824 983 5.4 6.1 93.0 95.8 61-70 9 21 833 1004 1.0 2.1 94.0 97.9 71-80 8 13 841 1017 0.9 1.3 94.9 99.2 81-90 4 5 845 1022 0.5 0.5 95.4 99.7 91-100 4 3 849 1025 0.5 0.3 95.9 100 101-110 3 852 0.4 96.3 111-120 8 860 0.9 97.2 121-130 3 863 0.4 97.6 131-140 3 866 0.4 98.0 141-150 4 870 0.5 98.5 151-160 5 875 0.5 99.0 161-170 171-180 2 877 0.2 99.2 181-190 191-200 7 884 0.8 100 amount 884 1025 100 100 table 2: the values of the logarithms of the width of the work sites career earning polymetallic deposit intervals of measurement the logarithm of the width of the working platforms frequency, mi cumulative frequency, m chastoty, m’ % accumulated chastoty ore the breed ore the breed ore the breed ore the breed 1.61-1.9 31 29 31 29 3.6 2.8 3.6 2.8 1.91-2.2 44 36 75 65 4.9 3.5 8.5 6.3 2.21-2.5 76 81 151 146 8.6 7.9 17.1 14.2 2.51-2.8 96 98 247 244 10.9 9.6 28.0 23.8 2.81-3.1 125 139 372 383 14.1 13.6 42.1 37.4 3.11-3.4 241 256 613 639 27.2 25.0 69.3 62.4 3.41-3.7 98 173 711 812 11.2 16.9 80.5 79.3 3.71-4.0 78 124 789 936 8.8 12.1 89.3 91.4 4.01-4.3 46 72 835 1008 5.2 7.0 94.5 98.4 4.31-4.6 14 17 849 1025 1.6 1.6 96.1 100 4.61-4.9 16 865 1.8 97.9 4.91-5.2 12 877 1.3 99.2 5.21-5.5 7 884 0.8 100 sum 884 1025 figure 2: the integral curves of chastoty width career working platforms semenov and kuznetcov: assessment of level of risk in decision-making in terms of career exploitation international journal of economics and financial issues | vol 5 • special issue • 2015 169 integral curves of the particulars of the logarithms of the width of the work sites (figure 4). using expressions (11-13), we determine the values of σln 2 , σln , e b( ) , bln : ore ln ,p 2 0 49= ln ,p = 0 7 e b p( ) ,= 30 6 b pln ,= 317 the breed ln ,b 2 0 36= ln ,b = 0 6 e b b( ) ,= 29 4 b bln ,= 3 20 thus, the probability density function of the lognormal distribution width of the working platforms ore quarries counterparts, according to the expression (10), f bp bp e bp ( ) , (ln , ) ,= ⋅ ⋅ − − ⋅1 0 7 2 317 20 49 π ore (14) f b b ep b bp ( ) , (ln , ) ,= ⋅ ⋅ − − ⋅1 0 6 2 3 2 2 0 36 π the breed (15) at a known density function probability distribution may determine the probability that a continuous random variable width sites, will take the value corresponding to the specified interval (b1, b2). this probability is defined as the definite integral of the differential of the function taken within b1 to b2. p b b b f b dbi b b ( ) ( )1 2 1 2 < < = ∫ (16) graphically the probability of a magnitude bi the plot (b1, b2) is expressed by the area under the curve of probability density distribution, that is, with this plot. for this polymetallic career hit probability of the width of the working sites in the interval (b1 = 25 m b2 = 35 m). p b( ) .25 35 0 21< < = 3. result when designing quarries as the risk measure is taken the difference between the unit and the probability of occurrence of this event (arsentiev, 2002; meredith and mantel 2012, “the owner’s role in project risk management,” 2005, unks and thor, 2008; mustafa and al-bahar, 1991). r p= −1 ( )ε (17) possible accounting of both economic and psychological consequences of risk (camus, 2002; kerzner, 2009). in the justification of risk should be taken into account subjective factors, as defined objective situation may present varying degrees of risk from the point of view of a specialist in different conditions. in this case, the risk is understood as the probability of economic losses associated with not acknowledge the calculated values of the width of the work sites. the probability distribution of a random variable is approximated by a lognormal law. degree of risk r(b) can be expressed through the probability of hitting the actual values bi on a given area, limited left value bmin, and to the right value bi, at which the total development costs (∑c) matches ∑c by bmin r p b f b bi= − = − − 1 1( ) ( ln ln ) min lnσ (18) p(b) the likelihood that the actual width of the work sites for a specified period of; (sigma)ln the standard deviation of the empirical range of the logarithm of the random variable; f(b) lognormal distribution function. in studies (arsentiev, 2002; roland, 2000; hill, 1993; semenov 2014). the determination of the risk level of the normal distribution law. at a certain density distribution of the width of the working figure 3: histograms of the distribution of the logarithms of the width of the working sites polymetallic career figure 4: the integral curves of chastoty logarithms width job career sites semenov and kuznetcov: assessment of level of risk in decision-making in terms of career exploitation international journal of economics and financial issues | vol 5 • special issue • 2015170 career sites, you can determine the level of risk of failure to achieve the set width of working platforms r b b e db i b b b b ii ( ) ln ( ln ln ) ln ln ln= − − − ∫1 1 2 1 1 2 0 2 0 σ π σ (19) ln b0 the value of the logarithm of the width of the work sites, the corresponding ( )ln lnb −3σ . the risk value for normal distribution of the logarithm of the width of the work sites are presented in table 3. a graph of the level of risk of failure to achieve the set width of the working career sites are presented in figure 5. analysis of the graph shows that for the conditions of ore pit in the period of development, economic risk would be 54% and 33%, respectively, when the width of the working platforms 24 m and 33.6 m 4. discussion in paper (hill, 1993) is considered as a variant of the deposit development assessment based on regression analysis, which involves the use of the method of least squares on the basis of: the formulation of the model view, based on the relevant theory figure 5: a graph of the level of risk of failure to achieve the prescribed the width of the working platforms ore pit of relationships between variables; оf all the factors influencing the productivity of a sign, it is necessary to identify the most significant influencing factors; steam regression sufficient if there is a dominant factor, which is used as an explanatory variable. it is therefore necessary to know which other factors are assumed to be unchanged as in the further analysis they have to take account of the simple model and to move multiple regression; examine how a change in one trait variation changes the other. but this method has the following disadvantages: purposeful rejection of other factors; the impossibility of identifying. measuring certain variables (psychological factors); lack of professionalism researchers simulated; aggregation of variables (as a result of aggregation of the information is lost); incorrect determination of the structure of the model; the use of temporal information (change the time period, you can get different results regression); specification errors: wrong choice of a mathematical function; undercount in the regression equation of a significant factor, the use of paired regression, instead of multiple); sampling error, as the researcher often has to do with sample data when establishing regular connection between the features. sampling errors arise due to heterogeneity in the initial statistical population that is in the study of economic processes; measurement errors are the most dangerous. if the error specification can be reduced by changing the shape of the model (a kind of mathematical formulas), and sampling error increasing the amount of raw data, the measurement error nullify all efforts to quantify the relationship between attributes. it is of interest to identify the psychological consequences of risk. when designing quarries better to deal with reverse function fears of the consequences of increased risk (zhang, 2010). discusses four risk attitude: • bold attitude ∏c (ẟ) = a(1–e –ẟ); (20) • equality attitude ∏p (ẟ) = aẟ; (21) • cautious attitude ∏0 (ẟ) = a(e ẟ–1); (22) • no risk ẟ = 0 ∏hp (ẟ) = 0; (23) а: the ratio of proportionality, it is recommended to take а = 2.37; d: the relative increase compared to its minimum value (when ẟ = 0). the relative increment of the logarithm of the width of the working platforms (compared to ln ln lnb b0 3= − σ ) δ = −ln ln ln b b b i 0 0 (24) values with different levels of risk are shown in table 4. figure 6 shows the function of the fears of the consequences of the relative increase of the logarithm of the width of the working platforms with different attitudes to risk. table 3: the degree of risk associated with different values of the logarithms of the width of the working sites the logarithm of the width of the working sites ln bi level of risk r(b), % ln ln lnb b0 3= −  1.25 100 ln ln lnb b1 2= −  1.9 97.7 ln ln lnb b2 = − 2.55 84.1 ln ln *b b e3 = − 2.76 75 ln lnb b4 = 3.2 50 ln ln lnb b5 2= +  3.64 25 ln ln lnb b6 3= +  3.98 0 semenov and kuznetcov: assessment of level of risk in decision-making in terms of career exploitation international journal of economics and financial issues | vol 5 • special issue • 2015 171 figure 6: function concerns the consequences of the relative increase the logarithm of the width of the working platforms with a bold attitude taken ẟc = 1.56 (point 1. figure 6). when the level of risk 50%. in this case the function level concerns will be ∏h = 1.87. when even the attitude to risk ẟp = 0.88 (point 2. figure 6). while cautious attitude ẟo = 0.59 (point 3. figure 6). obtained values of the logarithms of the width of the working area at ∏h = 1.87 are given in table 5. determining the level of risk (table 6) is possible using dependencies ∆ = −31( ) δ δ i c (25) and table 6 for the normal distribution law. thus, when existing in this career, the lognormal distribution width of work sites, the optimum width of the work sites will be 24-33.6 m risk design will be 54-33%. consideration of the psychological aspects of the decision shows that in this case, even the orientation of the cost of the minimum width of the work sites at a rate of 24 meters increases the risk, but to work with high-risk economically feasible. to reduce the level of risk should seek to increase the value of the expectation width worksites career, reduce the probability of occurrence of widths worksites less regulatory minimum. 5. conclusion width career working platforms should be considered as a random variable, subject to certain laws of distribution. to evaluate the probabilistic nature of the width worksites quarries developing steeply dipping ore deposits, it is advisable to use the lognormal distribution. knowledge of the form of the distribution width career working platforms allows us to estimate the level of risk of failure in the draft adopted by the width of the work sites associated with the probabilistic nature of the source data. table 4: the width of the work sites at different level of risk exponent values with different levels of risk, % 0 20.3 15.9 25 50 75 the relative increase in, ẟi 0 0.52 10.04 10.21 10.56 10.912 the logarithm of the width of the working platforms, lnb 10.25 10.9 20.55 20.76 30.2 30.64 eẟ 1 1.68 2.83 3.35 4.76 6.76 width of work sites, b, m 3.5 6.7 12.7 20.1 24.2 38.2 references a guide to the project management body of knowledge, (2010), in: project risk management. vol. 11. pennsylvania, usa: project management institute. arsentiev, a.i. (2002), performance quarries. saint-petersburg: state mining institute, technical university. p85. burenina, g. (2009), strategic analysis of the risks of industrial enterprise. saint-petersburg spbguef. camus, j. (2002), management of mineral resources. mining engineering (sme), 25, 17-25. geoff, k. (2000), risk management systems. risk professional, 2(1), 19-31. grey, s. (1999), practical risk assessment for project management. technometrics, 41(4), 380-381. hill, j.h. (1993), geological and economical estimate of mining projects. london. kerzner, h. (2009), project management a systems approach to planning, scheduling, and controlling. 10th ed. new york: john wiley. p1122. meredith, j., mantel, s. (2012), project management a managerial approach. 8th ed. hoboken, n.j.: wiley. p589. mustafa, m., al-bahar, j. (1991), project risk assessment using the analytic hierarchy process. ieee transactions on engineering management, 38, 46-52. qi, e. (2013), proceedings of 20th international conference on industrial engineering and engineering management theory and apply of industrial engineering. heidelberg: springer. roland, k. (2000), towards a grand unified theory of risk. operational risk. london: infroma business publishing. p61-69. semenov, a. (2014), assessment of project risk in the hierarchical table 5: the logarithm of the width of the work sites under different attitude to risk attitude to risk lnb в, m ẟi level of risk r(b), % bold 3.2 24.2 1.56 50 smooth 2.35 10.5 0.88 9.53 careful 1.98 7.3 0.53 3.12 no risk 1.25 3.5 0 0 table 6: the dependence of the level of risk r(b) ratio of ∆ for a normal distribution ∆ r(b), % ∆ r(b), % ∆ r(b), % 0.1 46.02 1.1 13.57 2.1 1.786 0.2 42.07 1.2 11.51 2.2 1.391 0.3 38.21 1.3 9.68 2.3 1.072 0.4 34.46 1.4 8.08 2.4 0.82 0.5 30.85 1.5 6.68 2.5 0.621 0.6 27.43 1.6 5.48 2.6 0.446 0.7 24.2 1.7 4.46 2.7 0.347 0.8 21.19 1.8 3.59 2.8 0.255 0.9 18.41 1.9 2.87 2.9 0.187 1.0 15.87 2.0 2.28 3.0 0.135 semenov and kuznetcov: assessment of level of risk in decision-making in terms of career exploitation international journal of economics and financial issues | vol 5 • special issue • 2015172 organization of the process of design of complex technical systems. world applied sciences journal, 30(8), 1080-1082. the owner’s role in project risk management, (2005). washington. dc: national academies press. topka, v. (2003), new critical path method – linear relations. proceedings of 17th world congress on project management. tufano, p. (1996), who manages risk? the journal of finance, 51(4), 1097-1137. u. s. bureau of mines (1993), surface and underground mining. in: bureau of mines cost estimating system handbook. p631. unks, r., thor, l. (2008), the maricopa integrated risk assessment project: a new way of looking at risk. community college journal of research and practice, 32(11), 904-906. vellani, k. (2007), strategic security management a risk assessment guide for decision makers. amsterdam butterworth-heinemann. zhang, j. (2010), iclem 2010 logistics for sustained economic development: infrastructure. information integration: proceedings of the 2010 international conference of logistics engineering and management. october 8-10; 2010, chengdu, china, reston, va.: american society of civil engineers. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 682-691. international journal of economics and financial issues | vol 7 • issue 2 • 2017682 effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach arintoko1*, insukindro2 1department of economics and development study, universitas jenderal soedirman, purwokerto, indonesia, 2depatrment of economics, universitas gadjah mada, yogyakarta and bank indonesia institute, jakarta, indonesia. *email: arintokoz@yahoo.co.id abstract this study develops macroeconomic models that involves the output gap, the level of prices, interest rates, exchange rates, current account, foreign direct investment and portfolio investment. the modeling adapts to the characteristics of the data, the perspective of a new macroeconomic theories that are relevant to the conditions in indonesia, and the appropriate methodology used structural cointegrating vector autoregression. the test results indicate the presence of four significant cointegrations and affect change in macroeconomic variables that are endogenous. the four cointegrations are output gap, price, interest rates and exchange rates cointegration. the long-term relationships indicate that exchange rates cointegrated against the output gap, price, interest rate on the one hand and cointegrated by the interest rate, current account and foreign direct investment on the other. the exchange rate has a relationship with key macroeconomic variables in indonesia. taking into account the increasing globalization of economic and financial, policy of inflation targeting in indonesia should be consistent in giving more attention to exchange rates and financial markets. keywords: long-term relationships, structural cointegrating vector autoregression, inflation targeting jel classifications: c51, e10, e58, e66 1. introduction in globalization, the issue of the exchange rate becomes the attention of researchers and policy makers. interconnection via the exchange rate channel is becoming more important in addition to the current account channel in an open economy. openness of economy is marked by increasing dynamic mobility of foreign capital will further increase the interconnection between the exchange rate and foreign investment with macroeconomic variables such as the level of the output, interest rates, inflation, and current account. in the context of inflation targeting policy, the role of the exchange rate is the key in the design of monetary policy to the open economy. recently, exchange rate is still being debated in the monetary policy, for example, in taylor (2001). studies through the development of macroeconomic models in the context of an open economy based on the new macroeconomic perspective become an alternative to the researchers debates. macroeconomic models are more likely describe the interconnections and interdependencies between variables as the impact of risk and uncertainty of globalization. consequently economic policy, especially monetary policy will emphasize forward looking and looking important role in macro-economic shock. in studies using time series, there are still a lot of researches in indonesia that do not investigate the cointegration based on economic theory in the model, except models with the approach of error correction model (ecm) and vector ecm (vecm). theoretical approach used mostly pays less attention to microeconomic aspects. cointegration needs to be investigated when most of the macroeconomic variables have a stochastic trend in time series analysis. cointegration becomes an important trait in contemporary time series analysis. cointegration approach is also associated with the need to analyze the short-term and long-term impact to the economy. short-term economic fluctuations deeply considering the role of shock and its association with long-term relationships of macroeconomic variables, associated with this study need to be carried out. in the context of an open economy, arintoko and insukindro: effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach international journal of economics and financial issues | vol 7 • issue 2 • 2017 683 the role of shock is more important along with the increasing relations between macroeconomic variables. the relationships between macroeconomic variables in the economy increasingly becomes a concern, especially in connection with monetary policy focused on inflation targeting as the perspective of a new consensus macroeconomics (ncm). in the context of the current economic and financial globalization, it requires empirical study basing on the principles of the new neoclassical synthesis (nns) and ncm in the development of macroeconomics models in indonesia. it requires the adjustment of existing predecessor studies based on the same scope of topic or study, in terms of the theoretical approach, the methodology and the selection and measurement of variables. this is carried out and adjusted to focus the necessary research. the study with the model describing multi long-term relationship based on the theory needs to involve it in the effect on endogenous variables individually. the model is a model that describes the interdependence and interconnection of macroeconomic variables in indonesia in the economic and financial globalization as a consequence of the current open economy. the key variables in this problem is the exchange rate, foreign direct investment and portfolio investment because all three have a significant relationship with the main variables of macroeconomic; they are output gap, prices and interest rates, as well as the crucial variable of the current account. the use of time series model is not appropriate before testing the cointegration. if the data have a stochastic trend, it will have implications for the inaccurate estimated short-term change. therefore, the test on the effect of short-term change of predetermined variables, in this case is lag variables (as in the estimation of time series models, such as vector autoregression [var] and vecm), to the changes in variables concerned is invalid and insignificant economically without linking to the long-term relationship. estimated time series models carried out without taking into account long-term relationship provide insignificant result of shock impact analysis economically. it requires model approach that establishes a restriction based on the theory to determine the longterm relationship as anchor. in understanding the interdependence between macroeconomic variables, the shocks of macroeconomic variables need to be identified by the structural cointegrating var (scvar) model to study the effect of a shock on changes in the macroeconomic variables. 2. methodology 2.1. data the data required in accordance with the kinds of variables studied are secondary data, obtained from data published by bank indonesia, the central bureau of statistics, international monetary fund, the oecd, the central bank of indonesia’s trading partners and other credible sources both in publications as well as through on-line website. in accordance with the problems and objectives, the time period of data used starts from 2001q1 to 2013q4. description of the variables are presented in table 1. 2.2. model engle and granger (1987), johansen (1991) and phillips (1991) suggest that cointegration is a possible way to solve the problem of spurious regression with the existence of unit root variables. engle and granger (1987) state that the existence of cointegration between integrated variables (nonstationary) is prevalent to be investigated prior to parameter estimation or hypothesis testing. long-term relationship that does not contain unit root, i(0), indicates that the basic theory supports it as suggested in garratt et al. (2003). the presence of cointegration or long-term relationship based on a theory will make analysis of short-term fluctuations and the shock impact to be more significant. this is because changes of short-term behavior can be compared with equilibrium (the longterm) as anchor. however, cointegration between variables is a very special phenomenon. garratt et al. (2003) suggests that the intertemporal optimization problem faced by households and firms (as in real business cycle or rbc models) allows a steady-state or long term relationship. intertemporal optimization is an element in the nns elements according to goodfriend and king (1997), in addition to rational expectation, imperfect competition, and expensive price adjustment. in the principles of the new synthesis as the reference table 1: variables in the model name of variable notation variable measurement output gap between domestic and world relative price of domestic and world relative interest rate of domestic and world real effective exchange rate current account foreign direct investment portfolio investment y−yw p−pw r−rw reer ca fdi pi gap between real output of indonesia and rest of the world gap between price index of indonesia and the world, proxied by consumer price index with base year 2002 (0.25 ln (1+r/100) for sbi/bi rate and 0.25ln (1+rw/100) for 3-month libor) real index measured by weighted basket of currencies of the indonesia partner countries percentage of gdp of indonesia percentage of gdp of indonesia percentage of gdp of indonesia gdp: gross domestic product arintoko and insukindro: effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach international journal of economics and financial issues | vol 7 • issue 2 • 2017684 of nns and ncm, woodford (2009) suggests the importance of using observed data, model establishment emphasizes on a model established on a theory rather than based solely on more general relationships. woodford also emphasizes the unity between the inseparable micro and macro-economic aspects as a basis for testing the short-term and long-term effect by the change in the economy. the idea of arestis (2009) and angeriz and arestis (2007) representing ncm, develops macro-economic models for open economy. the relationship of variables in the model allows the relationship of output, price, interest rate, exchange rate, and current account cointegration. however, because cointegration is a very special symptom, all cointegrations assumed in arestis’s model do not necessarily occur. the debate on the empirical result of the curve j effect (cheewooi and tze-haw, 2008; insukindro and rahutami, 2007; aziz, 2008; ahmad and yang, 2004; baek et al., 2006; ardalani and bahmani-oskooee, 2007 and halicioglu, 2007) encourage the assumption that current account cointegration does not occur (not supported by theory). economic theory in the model is the basis of long-term relationship or cointegration. basic micro theories allow the long-term relationship. theory or basic micro about the consumption of time series selection and intratemporal between domestic goods and imported goods in gali and monachelli (2005) and beidas-strom and poghosyan (2011) is the basis of long-term relationship in the output cointegration to the interest rate and exchange rate, as well as foreign direct investment (moosa, 2002), through the transfer of technology to support production activities. in arestis et al. (2010), the maximization problem faced by suppliers who have the opportunity to change the price will generate the relationship between inflation with the output gap and inflation expectation. this relationship can be associated with long-term relationship between prices and the output gap. meanwhile, household consumption on goods composite in which there are imported goods allows the exchange rate pass-through into domestic prices. this transmission underlies long-term relationship between the output gap and the exchange rate. the rules of monetary policy modeling the nominal interest rate determined by inflation, output gap and real exchange rate (taylor, 2001) on the study evaluation of ball (1999), svensson (2000) and taylor (1999) and discussed by obstfeld and rogoff (1995). these are as the basis of the nominal interest rate cointegration to the output gap, inflation and exchange rates. taylor’s rule model of monetary policy is also followed by gali and monacelli (2005), lubik and schorfheide (2007), arestis (2009a), and beidas-storm and poghosyan (2011). cointegration of exchange rate based on the model of arestis (2007) and angeriz and arestis (2007) as well as the mechanism of foreign exchange market in response to demand for foreign exchange is not only at the time of the entry of foreign direct investment, but also at the time of the reversal of risk to the stability of the exchange rate (agarwal, 1997). the significance of cointegrations is negative with error correction coefficient between −1 and 0, indicating a correction toward equilibrium (long-term) by endogenous variables when there is exogenous shock effect each time period. the research model is designed for the indonesian economy characterized by a small open economy with free floating exchange rate and adopting inflation targeting, as well as emerging markets countries with dynamic economic growth and high investment. the model representing the characteristics consists of four main equations representing the four blocks, namely, (1) the equation output (representing is curve), (2) the price equation (representing phillips curve, (3) the policy interest rate equation (representing the rule of monetary policy), and (4) the exchange rate equation. the four models are treated as cointegration equation in the structural model. in the short term, the model expansion is designed as a forward looking model. a forward looking model is a display of the new keynesian framework and in the perspective of ncm based on dynamic optimization model with nominal rigidity and imperfect competition as central elements in the new synthesis of conveyed by goodfriend and king (1997). as in ncm model in the version of arestis (2007; 2009) models, in a long-term relationship, money is not included in the model and the money is neutral in the long term. in the short-term dynamics, money is treated as a residual in the model and does not have feedback in affecting other variables. in the macroeconomic literature, the is curve describing the relationship between the interest rate and output is required to understand how monetary policy and financial market affect the output. the changes in interest rate (r) affect the three components of aggregate expenditure; they are consumption (c), investment (i), and net exports (nx) (hubbard et al., 2012. p. 309). in the development, the output does not only have the relationship with the interest rate (r) as in the is curve, but other variable, namely the exchange rate (e) also affects net exports (nx). output in the long term is a reflection of the strength of aggregate demand and supply. the changing technology is the decisive factor in the long-term output growth through the increase in productivity as in the neoclassical growth theory. neoclassical model argues that economic development requires high capital investment. longterm growth can only be achieved through the development of technology, capital accumulation and population growth. foreign direct investment can encourage economic growth when the technology development has a consistent and permanent positive effect. according to neoclassical theory, foreign investment is like domestic investment, it will increase domestic production through the development of technology and the spillover effect as well as capital accumulation. investment factor supply and the development of technology will increase the potential output that determines the output gap occurred. as in garratt et al. (1998), that technological development in a small open economy is determined by the level of world technological development. in relation to the interest of the central bank in conducting monetary policy, the concept of output gap is more important than the output level because the output gap reflects economic fluctuation more arintoko and insukindro: effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach international journal of economics and financial issues | vol 7 • issue 2 • 2017 685 which becomes the focus of the central bank (hubbard et al., 2012). the concept of output gap used in this model refers to garratt et al. (1998) that is the output gap between domestic and world. the natural rate of output depends on the productivity and world output as in the model of gali and monacelli (2005). the output gap between domestic and world in this case is determined by the flow of foreign direct investment that has an impact on technology spillover and knowledge on domestic. the effect of foreign direct investment to output growth is widely studied, for example in the study of borensztein et al. (1995; 1998), balasubramanyam et al. (1996), alfaro et al. (2003) and ray (2012). the key relationship between inflation and monetary policy models is represented by the inflation equation (wickens, 2008). according to keynesian model, inflation is determined from the phillips curve. at first, phillips curve expresses the relationship between inflation and unemployment. phillips curve evolves to become the new keynesian phillips curve (nkpc) where inflation is not dependent on unemployment. the modification of nkpc appeared is called as hybrid nkpc. the equation system in the model built consists of the following equations: y y r r reer fdi r r y y p t t w t t w t t t t w t t w t − = + − + + − = + − +     0 1 2 3 0 1 2 ( ) ( ) ( −− + +p reer pit w t t) 3 4 α1 > 0; α2 > 0; α3 > 0 (1) p p y y reert t w t t w t− = + − +  0 1 2( ) β1 > 0; β2 > 0 (2) r r y y p p reer pit t w t t w t t w t t− = + − + − + +0 1 2 3 4( ) ( ) γ1 < 0; γ2 < 0; γ3 < 0; γ4 < 0 (3) reer r r ca fdit t t w t t= + − + +0 1 2 3( ) y y p p r r reer ca fdi pi w t w t w t t t t t −( ) −( ) −( )                         λ1 > 0; λ2 > 0; λ3 > 0 (4) ca y y reer fdit t t w t t= + − + +0 1 2 3( ) χ1 > 0; χ2 > 0; χ3 > 0 (5) fdi y y p p r r reert t t w t t w t t w t= + − + − + − +0 1 2 3 4( ) ( ) ( ) δ1 < 0; δ2 < 0; δ3 < 0; δ4 < 0 (6) pi y y p p r r reert t t w t t w t t w t= + − + − + − +0 1 2 3 4( ) ( ) ( ) φ1 < 0; φ2 < 0; φ3 < 0; φ4 < 0 (7) y yt t w− is the output gap between domestic and world, r rt t w− is the relative interest rate of domestic and world, reert is real effective exchange rate, fdit is foreign direct investment, pt pt w is relative price of domestic and world, cat is the current account, and pit is portfolio investment. in addition to the four main equations in a model system, there are three other endogenous variables; they are the current account, foreign direct investment and portfolio investment. the three variables represent a long term relationship of external variables reflecting domestic and global economic linkages. garratt et al. (2003) suggests the need for an econometric approach in analyzing the macroeconomic model in which the variables are interacting each other with a variety of possibilities through the possible logic theory. scvar model is able to explain the short term dynamics as in the var, in addition to the establishment of long term relationship based on economic theory. the relationship between variables is possible in the short-term as in the relationship between variables in the long term according to the theory. logic theory explaining the relationship between long term variables based on micro model and macroeconomic theories as in theory or literature can be used to describe the relationship between variables in the short term. analysis of the short-term dynamic response to the economic shock can be carried out when there is a relationship between variables in the long-term based on the theory through the restriction imposed (garratt et al., 2003). the importance of shock as discussed in bernanke et al. (1997) is for a better understanding of the role of the us monetary policy after the post-war business cycles. the understanding of the role of monetary policy leads to an understanding of the implications of monetary policy on the economy stabilization effect in the short term. in the perspective of macroeconomic nns and ncm based on the new synthesis, it states that a shock can affect demand and supply, as well as the importance of the role of monetary policy on the short term economic stabilization. garratt et al. (2003) also suggests that the strength of intertemporal optimization approach lies in the identification of macroeconomic disruption as a shock in the process of emergence of tastes and technology. rbc theory states real shock as the measurement of most fluctuations in the business cycle. rbc theory sees fluctuations in the business cycle as an efficient response to exogenous changes in the situation of the real economy. 3. results and discussion 3.1. unit root and cointegration test unit root test indicates that all variables have the same degree of integration on i (1). the test is carried out by augmented dickeyfuller statistical test following garratt et al. (2003) and jacobs et al. (2003). the unit root test results are presented in table 2. arintoko and insukindro: effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach international journal of economics and financial issues | vol 7 • issue 2 • 2017686 from the cointegration test using the result of trace statistic test1 in table 3, it can be concluded that there are four cointegrations. there are four cointegrations representing the output equation, the price equation, the interest rate equation and the exchange rate equation.  = − − − 1 0 14 889 0 145 0 0 094 0 0 0194 1 0 1 805 0 0 0 0 029 0 043 1 0 014 0 . . . . . . . . 00 0 009 0 0 11 794 1 0 029 0 111 0 . . . .− −             y y p p r r reer ca fdi pi w t w t w t t t t t −( ) −( ) −( )                         the four cointegrations do not contain unit root, i(0), indicating that the basic theory supports it as suggested in garratt et al. (2003). the presence of cointegration or long-term relationship based on a theory will make the analysis of short-term fluctuations and the impact of a shock to be more significant. this is because changes of short-term behavior can be compared with equilibrium (the long-term) as anchor. the four cointegrations that do not contain unit root is the precondition of the implementation of the model containing cointegration in scvar model. cointegration of output gap indicates the presence of a long-term relationship between the output gap and the interest rate, exchange rate, and foreign direct investment. cointegration of price indicates the presence of a long-term relationship between price and the output gap and the exchange rate. among the variables developed in phillips curve for the open economy allow the occurrence of cointegration in this research. cointegration of interest rate indicates the presence of a long-term relationship between the interest rate and the output gap, the price level, exchange rate and portfolio investment. according to taylor rules, the variables in the development of monetary policy rules, except for portfolio investment, are cointegrated or establish a long-term relationship. meanwhile, the cointegration of portfolio investment in this research indicates the relationship between the financial market and domestic and world relative interest rate. cointegration of exchange rate indicates the presence of a longterm relationship between the real effective exchange rate and interest rate, the current account and foreign direct investment. the long-term relationships indicate that the exchange rate is connected to the output gap, the price, the interest rate on the one hand and cointegrated with the interest rate, the current account and foreign direct investment on the other. the exchange rate has a key relationship with macroeconomic variables in indonesia. cointegrations of output, price, interest rate and exchange rate are significant in the model with a coefficient between −1 and 0 in each 1 using johansencointegration test equation. cointegration of output has significant effect on the output gap equation with a coefficient of −0.676. cointegration of price has a significant effect on the output gap with a coefficient of −0.813. cointegration of interest rate has a significant effect on the output gap with a coefficient of −0.995. cointegration of exchange rate has a significant effect on the output gap and the exchange rate with a coefficient of −0.306 and −0.596, respectively. the output gap adjusts back to its equilibrium, or the equilibrium of interest rate and the equilibrium of exchange rate. exchange rate variable adjusts back to the equilibrium of price and its equilibrium. meanwhile, behavioral variables, such as the current account, foreign direct investment and portfolio investment will likely not reach the equilibrium and the implications will be difficult to predict when there is an external shock compared to the relatively manageable variables that are the level of output, price, interest rate and exchange rate. 3.2. result of scvar model estimation the result indicates that the macroeconomic variables individually can be affected by the equilibrium (long-term) of the other variables in addition to the variable itself. the results of scvar model estimation are presented in table 4. this result differs from rahutami (2007), sugeng (2012) and suhartoko (2013) who found the effect of equilibrium (long term) on the variables themselves. in the short-term, inflation (relative to the domestic and world) and the current account changes have significant effect on the growth of table 2: unit root test variable adf test with intercept with intercept and trend t-statistics p t-statistics p y−yw −0.603 0.861 −1.613 0.773 ∆(y−yw) −2.907 0.052 p−pw −2.049 0.266 −1.736 0.721 ∆(p−pw) −7.005 0.000 r−rw −2.558 0.109 −2.625 0.271 ∆(r−rw) −4.254 0.002 reer −2.578 0.104 −2.264 0.445 ∆reer −7.637 0.000 ca −2.231 0.198 −2.611 0.278 ∆ca −9.547 0.000 fdi −2.096 0.247 −2.546 0.306 ∆fdi −9.892 0.000 pi −2.600 0.101 −2.682 0.248 ∆pi −8.415 0.000 testing with maximum 10 lags. probability based on one-tail p value of mackinnon (1996), all variables are stationary at first differences, i(1) with α=5% except ∆(y−yw) with α=10%. adf: augmented dickey-fuller table 3: the result of cointegration test h0 h1 trace statistic critical value 0.05 p r=0 r=1 182.326* 125.615 0.000 r<1 r=2 128.866* 95.754 0.000 r<2 r=3 84.968* 69.819 0.002 r<3 r=4 54.438* 47.856 0.011 r<4 r=5 29.537 29.797 0.054 r<5 r=6 13.178 15.495 0.108 r<6 r=7 0.901 3.841 0.343 *significant at the critical value of 0.05, indicating 4 cointegration equations, source: bank indonesia, central statistic agency, international monetary fund, and bank for international settlements, processed arintoko and insukindro: effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach international journal of economics and financial issues | vol 7 • issue 2 • 2017 687 the domestic and world output gap. inflation has a positive effect, while the current account has a negative effect on the growth of the output gap. if domestic inflation is higher than the world inflation, it will increase the output gap, while the improvement of current account will reduce the output gap. relatively high inflation will reduce the growth of domestic output due to weak demand caused by high inflation. the characteristics of economic growth in indonesia indicate that demand factor plays a major role in the short-term output fluctuations. the magnitude and trend of the current account deficit in indonesia also contributes significantly to slow down the growth of output. this means that the current account contributes significantly to the growth of the domestic economy. openness and globalization will provide unfavorable effect for indonesia when there is an imbalance in the current account. in the short term, the exchange rate, current account and foreign direct investment have significant and positive on the relative inflation. the exchange rate has a positive effect, while the current account and foreign direct investment have negative effect on inflation. the increase in the real exchange rate means that the price of domestic goods and services are relatively expensive against the price of foreign goods and services. if the exchange rate increases, this condition is associated with the high domestic prices in the short term. this condition causes the current account to go down or increasing the deficit. at the level of equilibrium of real exchange rate, the occurred current account deficit is associated with the entry of net capital. such a situation is consistent with the economic theory of open economy and the fact occurred in indonesia. there is no other variable, except the interest rate which affects positively the relative domestic and world interest rate changes in the short term. in the short term, the changes in interest rate and foreign direct investment have negative effect on the exchange rate changes. the effect of endogenous variables in the short term takes place with a lag of one period. lag variables have an effect in the possible model due to psychological, technological, and institutional factors as suggested in gujarati and porter (2009). given that the macroeconomic model is based on the microeconomic aspects, then these factors possibly affect on the behavior of individual agents as a representation of economic behavior. the involvement of the lag time is also in accordance with the inflation targeting framework in indonesia which is looking forward in accordance with the policy impact on inflation that requires time lag. 3.3. impact of shocks the impact of the shock to the output gap is the rising prices (inflation), rising interest rate, but provides a positive impact on the current account. the positive impact on the current account is derived from the increasing demand on domestic by world as a representation of the relative improvement in the world economy toward domestic. the positive impact of the exchange rate may occur along with a positive impact on the current account. in contrast, the output gap shock has a negative and steady impact on foreign direct investment and portfolio investment. the output gap shock will reduce foreign direct investment and portfolio investment. price shock has a positive and steady impact on the output gap, price itself, interest rate, exchange rate and the current account balance, while it has a negative and steady impact on foreign direct investment and portfolio investment. interest rate shock has a negative and steady impact on the output gap. interest rate shock has a negative impact on foreign direct investment and portfolio investment. exchange rate shock has an impact on the increase of output gap as shown in figure 1. when there is an impact, then the increase in the domestic currency causes a decline in exports so that domestic output is down and the output gap increases. the exchange rate shock has a negative impact (decrease) from the beginning and steady on the price and interest rate. the increase in unexpected exchange rate encourages the price level and the interest rate falls. the exchange rate shock increases the value of the exchange rate itself. the increase in unexpected exchange rate encourages the rise in the further exchange rate. current account shock has an impact to an increase of the output gap and interest rate steadily. the current account shock has an impact to increase the price, but it is not steady. the exchange rate responds positively on the current account shock. meanwhile, foreign direct investment responds negatively on the current account shock steadily. table 4: summary of result of scvar model variable sign of the significant estimated parameters of endogenous variables in the model ε^1 1t− δ(y−y w) (−) ε^2 1t− δreer (−) ε^3 1t− δ(y−y w) (−) ε^4 1t− δ(y−y w) (−) δreer (−) δ(y−yw)t−1 δ(y−y w) (−) δca (−) δpi (+) δ(p−pw)t−1 δ(y−y w) (+) δfdi (+) δ(r−rw)t−1 δ(r−r w) (+) δreer (−) δfdi (−) δreert−1 δ(p−p w) (+) δfdi (+) δcat−1 δ(y−y w) (−) δ(p−pw) (−) δfdit−1 δ(p−p w) (−) δreer (−) δpi (−) δpit−1 δfdi (−) average r2 0.546 average 2r 0.394 scvar: structural cointegrating vector autoregression arintoko and insukindro: effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach international journal of economics and financial issues | vol 7 • issue 2 • 2017688 foreign direct investment shock has an impact on an increase in the output gap steadily as shown in figure 2. foreign direct investment shock will lead to the transfer and abundance of technology from developed countries to developing countries to be disrupted so that it will reduce domestic output steadily and the output gap increases. portfolio investment shock has an impact to the decrease in the output gap, prices, interest rates, and the current account as shown in figure 3. conversely, portfolio investment shock has an impact to the increase in the exchange rate and foreign direct investment steadily. in general, the contribution of shock itself on endogenous variable variation individually is the greatest. the dominance of the interest rate shock occurs in affecting the interest rate variation in a time horizon of 30 quarters. meanwhile, the variations of foreign direct investment and portfolio investment variable are not overly dominated by the shock itself. the average interest rate shock dominates the effect on changes in foreign direct investment and portfolio investment. the steady final impact as in table 5 is the permanent or constant impact on individual variables. the majority of macroeconomic variables shocks have a negative impact on individual variables. the output gap has a negative impact (rise) by its own shock, price shock, exchange rate shock, current account shock, foreign direct investment shock, if there is unanticipated increase of the shock variables. exchange rate variable has a positive response to all the unanticipated increase in the variables, except the interest rate shock. foreign direct investment rises to respond on the unanticipated decline in the output gap, the price, and the interest rate. conversely, foreign direct investment rises by responding to unanticipated rise in the exchange rate, current account, foreign direct investment and portfolio investment. foreign direct investment negatively responds to the unanticipated rise in the output gap, the price and the interest rate. portfolio investment negatively responds to the unanticipated rise in the output gap, the price, the interest rate and the current account. the results of the shock impact indicate that the variables of exchange rate, foreign direct investment and portfolio investment are responsive to the unanticipated changes. this means that these three variables are relatively unstable when there is an unexpected change. conversely, the shock of these three variables will decrease the interest rate. the price gap and price expectation variable in the model have an effect on the magnitude and pattern of response without changing the direction of the response from positive to negative or vice versa. the study of aizenman et al. (2008) indicates that the central banks in 16 inflation emerging targeting countries do not follow the pure inflation targeting strategy, but respond systematically to the real exchange rate shock. the degree of dependence on export goods will reinforce this finding. in accordance with the study result of aizenman et al., the study confirms that the exchange rate shock is the key in affecting the domestic economy. exchange rate shock can cause high effect on domestic inflation in the case of depreciation, the problem on the export competitiveness in the case of appreciation, and the trade flow in the case of excessive exchange rate volatility (jefferis, 2012). 4. conclusion and implications in the economic and financial globalization, the exchange rate plays a key role in indonesia which embraces open economy. multi long-term relationship through the exchange rate is proven in indonesia’s macroeconomic model. the more dynamic mobility of foreign capital proves the significance of foreign direct investment and portfolio investment in the long-term relationship on other main macroeconomic variables, such as output level, interest figure 1: response of the variables in the model to exchange rate shocks arintoko and insukindro: effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach international journal of economics and financial issues | vol 7 • issue 2 • 2017 689 rate, inflation and the current account. in the context of inflation targeting policy, the role of the exchange rate is the key in the design of monetary policy for an open economy, such as indonesia that is more appropriate to apply the rules of the policy rather than by discretion. the shocks of exchange rate, foreign direct investment and portfolio investment play a major role in affecting the interest rate changes. unanticipated rises in the exchange rate, foreign direct investment and portfolio investment are responded by the decline in domestic and foreign relative interest rates. because there is the linkage implication between financial market and domestic and world relative interest rate, then the policy of interest rate determination needs to be directed not only on price stability, but also on the stability of financial market by taking into account the global financial conditions. monetary policy in the determination of the interest rate is not only based on macroeconomic factors, such as inflation, exchange rate and economic growth, but also takes into consideration to the condition of the financial market as part of the macroprudential policy. shortterm capital inflows need to be part considered in performing the policy of interest rate determination. the response of interest rate policy will be different between when high capital inflows and low capital inflows or even negative. the consistency of attention to the stabilization of the exchange rate will support the efforts to stabilize the financial systems, including financial market, in addition to supporting the price stabilization. figure 2: response of the variables in the model to foreign direct investment shocks table 5: summary of analysis of shock impact through impulse response function shock final impact as the steady impact output gap price interest rate exchange rate current account foreign direct investment portfolio investment output gap + + + + + – – price + + + + + – – interest rate – + + – + – – exchange rate + – – + – + + current account + – + + + + – foreign direct investment + + – + + + + portfolio investment – – – + – + + arintoko and insukindro: effect of exchange rate, foreign direct investment and portfolio investment on the indonesian economy: a structural cointegrating vector autoregression approach international journal of economics and financial issues | vol 7 • issue 2 • 2017690 references agarwal, r.n. 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(2009), convergence in macroeconomics: elements of the new synthesis. american economic journal: macroeconomics, 1(1), 26-279. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s3) 76-82. special issue for “asia international conference (aic 205), 5-6 december 2015, universiti teknologi malaysia, kuala lumpur, malaysia” international journal of economics and financial issues | vol 6 • special issue (s3) • 201676 the mediating influence of team alignment on the relationship between plant turnaround maintenance planning and plant turnaround maintenance performance jalal ud din akbar1*, zulkipli b. ghazali2 1department of management and humanities, universiti teknologi petronas, bandar seri iskandar, 31750 tronoh, perak, malaysia, 2department of management and humanities, universiti teknologi petronas, bandar seri iskandar, 31750 tronoh, perak, malaysia. *email: jalaluddin77@gmail.com abstract in the plant turnaround, the operating assets and machinery of the organization shut down for overhauling and some capital work. this activity is very expensive and the time allocated is very low. therefore, a good management system is required for planning all the activities of the plant turnaround maintenance. as the number of people involved in the maintenance, process is high, so teamwork is required to carry the work of plant turnaround maintenance. the alignment of team with the goals and objectives of plant turnaround maintenance has been one of the concerns for the academics and researchers. in spite of the positive impact of the team alignment on the performance of the company, only some of the organizations consider themselves having high performance due to team alignment. the previous research finding suggests that the best turnaround methodology and tools do not guarantee turnaround success as due to many reasons. so therefore, the current study attempts to use mediating approach of alignment in plant turnaround maintenance. the survey questionnaires distributed among the technological advance and capital-intensive organizations in malaysia covering oil and gas, petrochemical plants, cement plants, palm oils and power plants with a 31 companies yielding a 31% response rate. the study found that there is a positive influence for team alignment mediating the relationship between plant turnaround maintenance planning and performance. keywords: plant turnaround maintenance, team alignment, management, planning, performance, mediation jel classifications: j52, l25 1. introduction the large process industries, which include refineries, power plants, cement plant, petrochemical plants and palm oil plants, convert a large amount of raw materials to other products by chemical, physical and mechanical process. the process-based industries use a batch process to produce the products in batches and continuous process to convert raw material in a continuous process (ghazali, 2010). the economical and safe availability of the plant is made sure through the reliability of the process plants which is maintained through plant turnaround maintenance having merits of low risk of unscheduled or catastrophic failures (ghazali, 2010; mclay and ltd, 2003; obiajunwa, 2007). in the processing industry, turnaround maintenance is important to avoid unscheduled breakdowns of the equipment affecting the revenue of the company (pokharel and jiao, 2008). the plant is revitalized, improve, modified and maintained through the turnaround (ghazali, 2010). the turnaround maintenance is needed to be carried out after a few years in the refineries and other petrochemical companies as they run continuously (hameed and khan, 2014; lawrence, 2012). in the case of the oil and gas industry, the turnaround event is very critical as there is no productivity at all and the revenue is lost to the cost of the event (hameed and khan, 2014). the previous research shows that despite the fact that the organizations have best turnaround methodologies and tools, yet 1 out of 4 of all turnarounds completely failed and 80% of all turnaround do not achieve the planned goals resulting in poor performance. to many reasons, one of the reason is the team akbar and ghazali: the mediating influence of team alignment on the relationship between plant turnaround maintenance planning and plant turnaround maintenance performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 77 functional deficiency and misalignment with plant turnaround goals (shirley, 2012). 1.1. objectives the current study will focus on plant turnaround effectiveness with following objectives: • to identify the relationship between plant turnaround planning and performance in plant turnaround maintenance. • to identify the effect of mediation of team alignment on the relationship between plant turnaround planning and performance. 1.2. conceptual framework the following are the conceptual frameworks for the current study (figure 1). 2. literature review the technical uncertainties in plant turnaround contain risks to the plant reliability and security, and may result in cost overruns and schedule slippages. the valuable resources and reserves of the organization used in the expensive work of the plant turnaround maintenance so the events of the plant turnaround maintenance are completed within the allocated time limits to avoid time and cost overrun. so it is compulsory to align the turnaround and business objectives of the organization (halib et al., 2010). the organization must have some sort of mechanism for efficient and effective planning of turnaround to achieve the performance of the event within time and allocated budget by keeping the cost at lowest possible level and defined work process in terms of quality at highest possible level (tu et al., 2001; pokharel and jiao, 2008; raoufi and fayek, 2014). the major contributor of the cost overruns and schedule slippages are delays, additional work and emergent work, therefore best planning practices have to be adopted to overcome these issues and to improve and increase the turnaround organizational performance (raoufi and fayek, 2014). in general, the ordinary organizations act as a dynamic systems and the high performance is achieved when all of its components work together competently (kheirandish, 2014). 2.1. performance generally, in the organizations, the business, and the technology contribution towards the objectives measured by performance. the performance between organization technology utilization and competitive edge is related to the effectiveness of the alignment (croteau et al., 2001). in the plant turnaround maintenance, the performance indicators of health, safety, environment, cost, quality, and time are check with the objectives and goals set in the preparation and planning phase. the information is collected for the cost duration, manhours, quality and efficiency of the work and measure against the objectives of the turnaround. as there are a lot of events involved so there may be chances that one or many of the performance indicators might be compromised (lenahan, 1999). therefore, the organization has to measure the performance and examine the developments. a balanced criteria for measuring the performance has to be used to guard against misleading factors (ben-daya et al., 2009). the firm performance can essentially be enhanced by alignment, with numerous factors of resources, technology, size and environment (dickson et al., 2006). the plant turnarounds consist of four basic phases, namely initiation, planning, execution and termination (debakey et al., 2007; gandolfo and vichich, 2007). the management function of planning, organizing, leading and control (campling et al., 2008) are utilized all throughout turnaround maintenance at different degrees. for example, the planning and organizing are more required in planning phase than in initiating phase though leading and control are more needed in execution stage than other phases. these four phases are also followed in malaysian process based industries for plant turnaround maintenance (ghazali, 2010). as there are four functions of management, however, the current study will only focus on the management function of planning. 2.2. planning in plant turnaround projects for the schedule turnaround maintenance of the organizational facilities, most of the companies have a proper set of the planning process for handling the turnaround maintenance and capital work (voogd, 2014) because the planning process is the important forecast of the successful turnaround maintenance. the organizations use best practices of planning and execution for the turnaround to be successful. the successful turnaround does not only depends on the best planning practices and procedures used, but the integration of the turnaround teams in the whole process of maintenance (vichich, 2006). the turnaround maintenance is an asset management, which always portrayed by controllable and some uncontrollable elements that may influence its results. the controllable part dealt wisely by the turnaround team, which predicts the consistency of the turnaround maintenance. the controllable factors contribute to the consistency and high performance of the turnaround maintenance. these factors include the alignment of team and time schedule, control, the level of preparations and ability to carry out the work. the uncontrolled circumstances include work scope change, unforeseen risks, conflicts, misalignments etc., which may cause hindrance in achieving the performance of the turnaround maintenance. however, the risks of the unsuccessful ending of the c ba c' planning performance alignment performanceplanning figure 1: the conceptual framework of planning with performance using alignment as mediator akbar and ghazali: the mediating influence of team alignment on the relationship between plant turnaround maintenance planning and plant turnaround maintenance performance international journal of economics and financial issues | vol 6 • special issue (s3) • 201678 turnaround maintenance into a disastrous situation be minimized if not eradicated by using best planning procedures for time schedule, early identifications and predictions of risks, scope definition and strong team alignment. among the many factors, team alignment has much more influence on the turnaround maintenance than the other factors usually in complex turnarounds. the turnaround team follows the best plans to follow and execute the turnaround maintenance, which implies that all the plans for the execution of the turnaround are integrated and strategic decisions made for carrying out the process. the success and competitive edge for the turnaround maintenance is achieved through early planning, identifying and mitigating the risks at early stages, managing the work scope and alignment of the teams (vichich, 2006). the literature shows that the planning is the most important element for controlling the plant turnaround maintenance resulting in high performance so the following hypothesis formulated. h1: planning positively related to performance. 2.3. alignment in the academic dictionary, alignment is characterized as the state of being in acceptable conformity and modification or having the parts in genuine relative position (griffith and gibson jr, 2001; morris, 1982). the alignment refers to a common understanding of the course of action of an organization and the procedures and techniques anticipated to achieve results (chonko and weeks, 2008; connors and smith, 1999). the course of action of alignment relies on the possibility that there are some system and procedure of the business segments and components (chonko and weeks, 2008). in the alignment, the specialist or professional working in different business units works together for collaboration, cooperation and value creation (chonko and weeks, 2008; hansotia, 2004). the alignment is the process of bringing altogether the individuals with different priorities to a common objective which has direct links with the business needs and success (griffith and gibson jr, 2001). the alignment characterized as a state in which employees in an organization have identical practices and attitudes towards teamwork and individual efforts to accomplish the basic targets and the general objectives of the organization that centered or revolved around the business accomplishments and achievements. the organization is concentrating more on expanding utilization of teamwork, collaboration, and teams (chonko and weeks, 2008). the team is the collections of people working as a single social unit in a given environment (business or organization) with common responsibility. the meaning of the teamwork is different across the various cultures (nyberg et al., 2009). it shows the roles and responsibilities of a group of people (gibson and zellmerbruhn, 2001; nyberg et al., 2009). the team members rely upon one another and on one another’s skills. the team achievement depends on the member’s capacity to communicate and their level of obligation to the work outlines and the attainment of the objectives (nyberg et al., 2009). the teams is having experts with differing capacities who must integrate and coordinate with the clients and develop associations with others in the organization to make progress (chonko and weeks, 2008; ingram et al., 2005). the successful organizations utilizes business deals that fit out and have cooperative teamwork through linkages among them (chonko and weeks, 2008; collins and porras, 1994). the former studies indicate that the relationship are deteriorated and breakdown due to conflict, strife, disregard and negative perceptions, distinct objectives, different thinking methods and techniques, physical segregation, the differences among business units, cultural and social contrast, and absence of alignment (chonko and weeks, 2008; guenzi and troilo, 2006; homburg and jensen, 2007; homburg et al., 2008; kotler et al, 2006; lorge, 1999; mattyssens et al., 2006; strahle et al., 1996). the main constraints for the implementation of the plans of an organization come from the employees of the organization. the creation of an inter-departmental team in the organization is very difficult due to differences in incentive plans, their inspiration, priorities and their communication styles. the capital projects mostly faces the problem of misalignment. as the members of the different functional groups are different in their priorities, so it is very important to align the priorities of these different functional groups with good and competent team leadership to keep the team intact. the internal and external environment of an organization helps in the determination of alignment in an organization (chonko and weeks, 2008). in the case of plant turnaround maintenance, regardless of the best practices and procedures of planning, 80% of turnaround do not meet its goals and objectives. moreover, in these circumstances the organizations lose their ability for development, improvement as the business is unable to set clear goals and reasonable control for the turnaround and revisit the set targets, and goals time again all through the planning process. the teams cannot achieve alignment without the strong establishment of the scope and its certain accuracy (voogd, 2014). so the success is achieved through best plans and its alignment with organization goals and objectives as well as with the project development process (vichich, 2006). the research shows that the alignment in groups and teams result in positive attitudes (adkins et al., 1996; lynn, 2007; nyberg et al., 2009). the teams is very important for attaining opportunities for the business and the alignment plays an important role in availing these opportunities (chonko and weeks, 2008). the integration results in satisfactory work processes which includes informal discussions about the problems and issues arises, ease in communications, dealing with the difficulties of work, high task achievement, easy decision making, work scope certainty, simple ways of communication and development of the friendly environment and reducing conflicts among team members (nyberg et al., 2009). from the literature, it is evident that for the most part, the alignment plays an important role in the success of any business and organization and especially in plant turnaround maintenance. 2.4. the mediating role of team alignment there has been much discussion on the perfect way to measure the alignment, and mostly in literature, the focus is on the fit or alignment of business strategy with the it. the study conducted by venkatraman (1989) has much focus on the best-suited approach used to measure the alignment. however, bergeron et al. (2001) akbar and ghazali: the mediating influence of team alignment on the relationship between plant turnaround maintenance planning and plant turnaround maintenance performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 79 emphasized that it is that specific situation which decides the best method to measure the alignment (ismail and king, 2014). the work of drazin and van de ven (1985) and venkatraman 1989 mostly focused on the concept of fit and alignment and its implication on the performance of the organization on operational and theoretical level. venkatraman (1989) follows six different viewpoints for defining the alignment i.e. mediation, moderation matching, gestalt, profile deviation and covariation. in mediation, the alignment considers the intervention between the predictor variable and dependent variable. the empirical testing of the mediation perspective was carried out by bergeron and raymond in 1995 and teo and king in 1996 and both studies found the positive relationship between the predictor and dependent variables (kefi and kalika, 2005). in another study, it found that the relationship between rational behavior and performance positively mediated by goal alignment. which means that the high performance of relational behavior between the parties was achieved through the goal alignment (stephen and coote, 2007). the mediating effect of alignment is also present between flexibility and performance in erp projects in which alignment was an essential requirement and has strategic importance and priority among the management. the researchers and scholars are now giving priority to alignment for value adding to the businesses and high performance (chan and reich, 2007). some of the researchers like chan, 1992, 1997; sabherwan and chan, 2001; and cragg et al., 2002 considers the mediation of alignment and fit more superior to the matching approach in terms of explaining the results and conclusions (taskin and verville, 2010). from the literature, it shows that the mediation approach for measuring the alignment yields positive results. so the following hypothesis formulated. h2: the team alignment mediate the relationship between planning and performance. 3. research methodology survey research is the suitable mode of collecting primary data which illustrate measure or analyze individual and societal wisdom, opinions, qualities, choices and attitudes (fink, 2003; 2008). the surveys help the researchers in knowing the rate or percentage of the characteristics and opinion of a population (salant et al., 1994). the most suitable methodology focused around the research questions, goals, and expected the investigation, is the quantitative data examination in which data collected through questionnaire survey studies. by measuring the alignment, the researcher has to focus on the employee or subordinate attitudes, beliefs and the abilities to understand these issues (reich and benbasat, 1996). in this study, the questionnaires distributed mainly to oil and gas companies, petrochemical plants, cement plants, palm oils and power plants. the reason for choosing these companies is that these companies have a large number of physical assets and facilities. in addition, for maintaining these physical assets these companies carries out plant turnaround maintenance on a regular basis according to their plans and schedule. 3.1. sampling design a. target population: ta managers, ta engineers, ta supervisors and ta technical staff. b. sample size: the data is collected from different sectors related to oil and gas, palm oils, petrochemical plants, cement plants and power plants. the respondents are people working on plant turnaround maintenance and are randomly selected from the company. the data is collected from 31 malaysian companies from the above listed sectors. c. the sampling design: simple random sampling (probability sampling). in the statistics, the simple random sample is the probability sampling technique in which each and every member of the population has a known and equivalent possibility of being chosen as a subject (sekaran, 2009). this sampling technique has the slightest possibility of biases in the information and the conclusion made out of the testing is more generalizable. 3.2. sources of measuring instruments in this study, interval scale is used and utilizes five point likertscale stating from strongly disagree to strongly agree. the instruments for measuring the variables drawn from different articles and sources. the planning measured through 17 items, alignment through 28 items and performance through seven (7) items. 3.3. data analysis techniques in this research, the spss 22 used for data analysis. 4. results and discussions 4.1. descriptive statistics and correlations the descriptive statistics and correlation shown in the table 1. there is a significant correlation of planning with performance (r = 0.770) and alignment (r = 0.788). the mean values and standard deviation also given in the table 1 for planning, alignment and performance respectively. 4.2. regression analyses the effect of the hypotheses checked through linear regression. in mediation for the predictor, mediator, and the dependent variable, there are four types of relationship checking. the detail given below: 1. the relationship of planning with performance 2. the relationship of planning with alignment 3. the relationship of alignment on performance table 1: descriptive statistics and correlation construct mean sd planning alignment performance planning 4.44 0.29 1.00 alignment 4.29 0.26 0.788** 1.00 performance 4.15 0.26 0.770** 0.777** 1.00 **significant at 95% confidence level. sd: standard deviation akbar and ghazali: the mediating influence of team alignment on the relationship between plant turnaround maintenance planning and plant turnaround maintenance performance international journal of economics and financial issues | vol 6 • special issue (s3) • 201680 4. the relationship of planning with performance using alignment as mediator. the hypothesis are developed for the 1st and 4th relationships based on literature and which are the objective of this study. 4.2.1. the relationship of planning with performance the regression results of the planning with performance reported in table 2. as shown, the β value of the relationship of planning with performance is β = 0.705, t value = 6.506 and p < 0.01 which is significant at 0.01 confidence interval. this proved hypothesis h1 which is “planning is positively related to performance.” the r2 = 0.593 shows the level of closeness of planning and performance or simply the level of explanation of the performance by planning. the model for the above table 2 given below in figure 2. 4.2.2. the relationship of planning with alignment the regression results of the planning with alignment reported in table 3. as shown, the β value of the influence of planning on alignment is 0.725, the t value = 6.506 and p < 0.01 which is significant at 0.01 confidence interval. the r2 = 0.621 shows the level of closeness of planning and alignment or simply the level of explanation of the alignment by planning. the model for the above table 3 given below in figure 3. 4.2.3. the relationship of alignment on performance the regression results of the alignment with planning reported in table 4. as shown, the β value of the influence of alignment on performance is 0.773, the t value = 6.651 and p < 0.01 which is significant at 0.01 confidence interval. the r2 = 0.604 shows the level of closeness of alignment and performance or simply the level of explanation of the performance by alignment. the model for the above table 4 given below in figure 4. in the next stage, we run the mediation analysis using alignment as mediating variable to check the impact of planning on performance. 4.2.4. the relationship of planning with performance using alignment as mediator the mediated regression analysis used to test hypothesis h2. the regression results for the planning on performance reported in table 5. as shown, the β value planning is β = 0.381, t = 2.361 and p < 0.025 which is significant at 0.05 confidence interval. the β value for alignment is β = 0.446, t = 2.545 and p < 0.017. this shows that alignment has significant and positive impact on performance, which confirms the mediation of alignment. the mediation, in this case, called partial mediation. it also means that with the introduction of the alignment as a mediator the hypothesis h2 is supported which states that “the team alignment mediate the relationship between planning and performance.” the value of r2 = 0.67 significantly improved after the alignment mediating the relationship of planning with performance. the model for the above table 5 given below in figure 5. 5. conclusion this paper sheds light on the importance of the planning on the success of the plant turnaround maintenance in the presence of the alignment. it provides a clear understanding of the importance of alignment of the teams and groups working in plant turnaround maintenance by analyzing the mediating impact of team alignment on the relationship between planning and performance in the plant turnaround maintenance. the mediating approach of team performanceplanning β=0.705, sig=.000 figure 2: the relationship of planning with performance alignmentplanning β=0.725, sig=.000 figure 3: the relationship of planning with alignment performancealignment β=0.773, sig=.000 figure 4: the relationship of alignment on performance performanceplanning alignment 025β=0.725, sig=.000 β=0.446, sig=.017β= 017β=0.381, sig=.025 figure 5: the relationship of planning with performance using alignment as mediator table 5: results of mediation regression analysis construct performance β value r2 t value significance value planning 0.381 0.67 2.361 0.025 alignment 0.446 2.545 0.017 table 2: regression analysis: planning versus performance construct performance β value r2 t value significant values planning 0.705 0.593 6.506 0.000 table 3: regression analysis: planning versus alignment construct alignment β value r2 t value significant values planning 0.725 0.621 6.894 0.000 table 4: regression analysis: alignment versus performance construct performance β value r2 t value significant values alignment 0.773 0.604 6.651 0.000 akbar and ghazali: the mediating influence of team alignment on the relationship between plant turnaround maintenance planning and plant turnaround maintenance performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 81 alignment will specifically support the effectiveness of the plant turnaround maintenance by achieving objectives and goals within the time schedule and allocated budget. it will help in understanding the behavior and attitude of the teams in the plant turnaround maintenance and its environment. the team leaders will use 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(2014), organizational effectiveness of turnarounds and team staffing. available from: http://www.ipaglobal.com/organizationaleffectiveness-of-turnarounds-and-team-staffing. . international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 251 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s8) 251-256. special issue for “fundamental and applied research in economics and management: new perspectives” innovative territorial clusters yurii b. mindlin1, sergey v. novikov2, sergey v. kireev3, alexsandr a. adamenko4, oksana v. belitskaya5* 1moscow state academy of veterinary medicine and biotechnology named after k.i. skrjabin, moscow, russian federation, 2moscow aviation institute (national research university), moscow, russian federation, 3national research nuclear university mephi (moscow engineering physics institute), moscow, russian federation, 4kuban state agrarian university, krasnodar, russian federation, 5kuban social and economic institute, krasnodar, russian federation. *email: ya-ksei@yandex.ru abstract the emergence of new centers of economic growth, which will unite scientific, educational and industrial potentials, and would also enhance the competitiveness of enterprises and the region organizations as research and education in the future will have a multiplier effect on the shaping of economic processes, which helps to attract investment. this trend of building new centers, implementing efficient activities will affect the transition of russian economy to innovative type of development. the relevance of the implementation of innovative type of economy development on the basis of innovative territorial clusters is dictated by the need to ensure balanced and sustainable development of national economic systems through the unwinding of selected innovative areas of the state. such territories are actively formed at the present time can become innovative territorial clusters. these formations of the modern world, they had a different policy and the implementation of its activities, to present the latest shapes and signs of competitiveness are a kind of “springboard” in the economy of the future. the competitiveness of the economy of the region, the state, the region now depends not only on technical achievements, inventions, but also on organizational changes that contribute to their business results and marketing innovation in the field of promotion and implementation of regional clusters. keywords: cluster, innovation, region, competitiveness, cluster policy, efficiency jel classifications: f63, o10, o22, o29, l59 1. introduction formed spatial state economic space has led to significant differentiation of subjects of the state on the level and nature of socio-economic development. progressive experience of civilized territories shows that their competitiveness at the state level is largely based on consolidated on the basis of the business entities. in this regard, education is latest paradigm of innovation economy are closely interrelated with the formation of zonal and polar forms of organization “critical mass” of activity of subjects of the state. based on this modernisation vectors of different variants of the meso policy should include the formation of cluster forms, as polar foci of economic growth, expansionary-penetrating capacity which is able to affect the adjacent territory, “involving” them in the zones of business activity and escalation. in a market economy the territory of the insufficiently used potential of joint capabilities to solve problems of life support from the standpoint of formation of mechanisms of state interaction and actualization of the concepts of leveling, pole and harmonized development based on the clusterterritorial approach, which allows to harmonize and coordinate the interaction between territorial and industrial entities, infrastructure and social services. objectives of cluster and regional policy in the context of the economic system are the development of the sector of small and medium enterprises around big companies with domestic and foreign capital, the creation of new jobs and, ultimately, improving the innovative capacity and competitiveness of the state, as well as the distribution of growth points in the territory to ensure the uniformity and balance of spatial development. mindlin, et al.: innovative territorial clusters international journal of economics and financial issues | vol 6 • special issue (s8) • 2016252 however, the russian economic science is not yet unified approach to the definition of territorial clusters (zakharov et al., 2016), insufficient methodological support of the diagnostic potential of clusterization of choosing the optimal model of cluster innovation policy, taking into account the specifics of development of economic system, estimation of efficiency of innovative cluster development in a particular area. in addition, the cluster organization of the territory of the domestic economy, its individual sectors investigated so far fragmentarily, in fact, partly due to the complexity of both object and subject. the relevance of this writing is due to the need for implementation at the state level, new models of the consolidation of the business units joint ventures, commercial activities, contributing to the multiplier effect in the creation of gross regional product, implementation of innovative component of economic policy and the basis of devices of control and management of innovative territorial development of the cluster. 2. materials and methods theoretical and methodological basis for the writing of this article was the classics, economic and management publications in the definition of the innovative cluster, understanding of the innovation cluster as factor of increase of competitiveness of the region and the state as a whole, the development of the cluster policy of the state and the world powers, domestic and foreign scholars, human resource management, potential, common organizational formation of innovation clusters of enterprises and economic sectors, economic processes of domestic and foreign policy activities of regional clusters. the research methodology is built on the dialectical method, systemic and strategic approaches to analyze objects (lorenzini, 2014). scientific provisions, conclusions and recommendations made in the article are based on the use of a range of methods of historical and logical analysis, comparison and synthesis, induction and deduction, economic-statistical method and expert evaluations. the information base of the research were the laws of the russian federation, the official publication of the state statistics, bodies of management of social-labor relations in the sphere of innovation development of the cluster policy, territorial sector, international labour organization, thematic collections and reference books, information published in scientific editions and periodicals, internet resources. when writing work has taken into account the data characterizing trends in the development of institutional and socio-labor relations in the system of innovative economy, marketing research both external and internal market regional clusters. 3. discussion theory of development and formation of innovative clusters and their policy implementation in the social and economic sphere of activity attracted the attention of scientists and trainees in a very recent time (shkurkin et al., 2016). but, despite not really longterm data and trends in the russian scientific community, this theme becomes relevant and often discussed. in 2012 the government approved and submitted a list of innovative clusters, as well as introduced a program to support cluster initiatives and initiatives. a document establishing the basic framework for the development of innovative cluster policy in russia is the concept of long-term socio-economic development of the russian federation for the period until 2020. this document contains the basic conditions of modernization of the economic sphere and realization of competitive advantages of regions allocated to the creation of a system of territorial clusters. on the development of regional clusters, their relevance and strengthen the growth of the economic system is not drawn little attention in legislative documents, resolutions and decrees of the ministry of economic development of the russian federation. pursuant to the instructions of the president of the russian federation ministry of economic development announced among the economically employed population, the competition for the selection and inclusion of innovation clusters. after completing the procedure of selection of candidates was formed a list of 25 programs of formation and support the effective implementation of innovative territorial clusters. for the formation of these systems you must have basic selection criteria: world level of competitiveness of enterprises (ryumkin, 2009; ksenofontov et al., 2016), dynamics of continuous growth of production volume, significant ntp as a research and educational organizations. not a small range of models of development of innovative territorial clusters determines the feasibility of tacking a tool of state support, taking into account the major distinctive criteria and characteristics of the areas where the formed cluster. however, this instrument of state support can influence not only to innovation policy, cluster development and also address other areas: housing construction, development of transport and energy, engineering and other infrastructure development areas (zhang et al., 2016). on the basis of the list of selected innovative clusters and their development programs, taking into account their innovative and productive potential, the extent of the examination of the submitted applications were determined 2 groups. the first group includes 14 clusters, programs of their development and main activities project activities will be supported by grants from the federal budget of the russian federation on the territory of their location and implementation of activities. mindlin, et al.: innovative territorial clusters international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 253 subsidizing these innovative clusters produced over 5 years from 2013 to 2018, the total amount of cash receipts will amount to 5 billion rubles annually. the second group includes 11 regional clusters; programs of their development require some modifications and upgrades. for a more precise definition and characteristics of all existing regional clusters and their innovation policy development conduct analysis of territorial and branch structure of the domestic clusters. in accordance with the specific economic sector of the state, the geographical feature of these clusters was formed in 6 industry areas: 1. nuclear and radiation technologies; 2. manufacture of aircraft and spacecraft; 3. pharmaceuticals; 4. new materials; 5. chemicals and petrochemicals; 6. it and electronics. in order for these areas to develop effectively, had the highest world levels of competitiveness in relation to world markets need rational distribution of these areas within a favorable site for the implementation of their activities? analysis of their location within the boundaries of the state suggests that the country’s leadership pays special attention to the leading regions (federal districts), which provide the primary production potential, favorable social and development infrastructure. a major percentage of innovative territorial clusters in the european part of the state, since this area has the greatest population density and the leading economic activity. the asian part of russia includes in its potential, only 7 of the 25 innovation clusters. the main part of the cluster is based in the rapidly developing regions with high level of innovation activities: privolzhskiy (9 clusters), central (6 moscow, moscow oblast), siberian (5 clusters). innovation clusters volga region constitute more than a third of the clusters, but their scale is not so great (barycheva et al., 2014; silnov and tarakanov, 2015). the total number of such innovative entities in the form of territorial clusters is almost on the same level with the central federal district, which reflects approximately equal to the production capacity of the clusters. one cluster has the ural and far eastern federal district. policy of innovative development cluster is reflected in the activities of the titan cluster, cluster aircraft and shipbuilding khabarovsk territory. their location and area of operation due to the fact that the basic materials, production resources and raw materials located within walking distance, but, despite this, there are also its negative side is the low equipment of transport infrastructure the degree of development and distance from potential consumers of products. the newly formed clusters, which were included in the list of innovative, have features and characteristics of different models of territorial organization of productive activities in the sphere of economic activity (ryumkin, 2012). so from the point of view of the territorial arrangement we can distinguish the following clusters: • in a clearly designated and provided with the boundaries of functioning (but “sarov innovation cluster,” zheleznogorsk); • associations of enterprises, scientific and educational organizations in the framework of the network of large-scale agglomerations; • the clusters, dispersed throughout the territory. innovative territorial clusters are distributed mainly in areas with a high level of concentration of ntp and production capacity. these territories are characterized by the location of special economic zones, closed administrative-territorial entities: sarov, moscow, troitsk, perm, khabarovsk, etc. many of the resulting innovation clusters have formed their work on already existing specialization of industrial enterprises; these include innovative territorial clusters located in the republic of tatarstan, the arkhangelsk oblast, and khabarovsk krai. their future operation originates in the dense transition results in ntp activities already engaged in the production of industrial companies. the main attraction is the creation of new small or medium-sized clusters, which will reflect the main economic activity of the enterprise and the region as a whole. the development of productive capacities and attracting investment partners of the innovation cluster is a key development programme and the achievement of goals of the cluster. after all, for the implementations of the planned achievements are not always enough of those budget subsidies, then it is necessary to conduct the proper preparation of the image of investmentattractive enterprises (oleinikova et al., 2016). in general, when the characteristics of the innovation project each cluster have its own potential growth, unusual functioning and existing on-site locations manufacturers. in order to analyze the functioning of the russian clusters is necessary to assess its most important indicator-the total economic potential. the indicator of economic potential includes the following characteristics: industrial, investment and scientific and technical progress. production capacity is the main factor that determines the potential and existing territorial competitiveness of the cluster. one of the indicators which allow evaluating the production potential of the cluster is the volume of total revenues from sales of noncommodity products. so in 2012, the total volume of this index was 1.9 trillion rubles, and in 2016, 3.8 trillion rubles, the rate of increase was 105%. mindlin, et al.: innovative territorial clusters international journal of economics and financial issues | vol 6 • special issue (s8) • 2016254 the leading place in terms of total revenue took a territorial cluster on the branch line “chemicals and petrochemicals.” revenue this innovative project for the year amounted to 1.1 trillion rubles, but the child clusters of this industry has also not remained aloof and has an aggregate amount of not less 274.4 billion rubles in average per cluster industry trends. such positive dynamics of development of innovative clusters is not left without attention of the ministry of energy of the russian federation approved the plan of development and functioning of innovative territorial cluster of industry for the period until 2030, which contains the investment projects of russian companies. this policy involves the creation and development of 6 petrochemical clusters: west siberian, volga, caspian, northwestern, east siberian and far eastern. the average indicators of development of innovative clusters and their total revenue refer to the information technology and electronics 174.4 billion rubles and the smallest rate are in the innovation clusters of the industry “nuclear and radiation technologies 73.6 billion rubles, and “pharmaceuticals” 45.5 billion rubles.” in order for policy innovation territorial cluster expected results, necessary in the daily activities of enterprises to make adjustments in the production of goods, provision of services, development of raw material and much more. all these measures and actions are interrelated with the implementation of the main organizationaleconomic activities. 4. results currently, the russian economy has received even a small, but significant practical and theoretical experience in the creation of innovation clusters. it is therefore important to generalize the experience of their development, and also try to assess the impact of clusters on innovation activity of russian regions. treatment of innovative types of clusters is different. on the one hand, there is a statement that they are characterized by the presence of the only research centers, technology parks, business incubators and other research institutions. on the other hand, deserves attention and a broader understanding of their content as the traditional types of clusters: innovation can be industrial clusters, but they must have the specialization in knowledgeintensive industries. this implies that innovation cluster is required, in addition to industrial enterprises and financial institutions, centers of learning and innovation, allowing using the benefits of market mechanism. as a result, the cluster faster and more efficiently “transmitted” the new knowledge, scientific discoveries, and inventions. the difference of the innovative cluster is that the cluster companies are not going to complete the merge, and create an interface that allows them to maintain the status of a legal entity and cooperate with other enterprises, forming the cluster and beyond (mikhaylov, 2015). they formed a complex combination of competition and cooperation, especially in innovation processes. in addition, regional clusters act as an important instrument of modern innovation policy of the regions of the state. they are promoted as the role of the so-called tools “assembly” and structural renovation of many areas of economic activities which constitute the individual elements of innovation systems in the region (science, business, educational activities and more). but the main goal of innovative clusters in the process of formation of their joint projects is unchanged and unwavering, is the growth of the major signs of the competitiveness of all participants and active members of the cluster. there are examples where enterprises of such industries as metallurgy, petrochemicals, actively export their products, providing intensive interregional integration, raw material independence (hjalager, 2010), was able to reduce production costs, and received substantial financial and organizational sources of investment and innovation. savings, additional revenue through the introduction of deeper processing of raw materials allows such companies to produce the innovation processes of the reconstruction, modernization and technological re-equipment. domestic and foreign experience allows asserting that there is a strong impact of cluster integration on investment and innovative activity of the enterprises of a petrochemical complex. integration in the petrochemical industry aimed at reducing the “double overhead,” respectively, the increase in profits of all the subjects as a source of financing of innovations allows to consolidate and refresh formed the technological chain, to eliminate complexity independent of the output of domestic enterprises on the external market. socio-economic upbringing of the regions, developing on their territory of an economic system involve the consideration of the interests and sustainable conditions for the functioning of industrial companies, forming potential of the region and largely determine social and political stability. in this regard, regional policy and strategy development of regions should be based on a comprehensive analysis of the functioning of the regional companies and the consistency of regional and sectorial objectives (manova et al., 2015). this applies to budget-regional companies forming the economic profile of territorial-industry complex of the region. the priority of development of such structures embodied in the concept of long-term socioeconomic development of the russian federation until 2020. in this policy document as one of transition to innovative model of development of the country named the creation of a network of regional production structures, realizing the competitive potential of the territories. clusters have a high capacity for innovation, because the cluster members are able to respond quickly to the needs of customers, they have access to new technologies. also inside the cluster possible cooperation in the implementation of scientific research and competitive pressures encourage businesses to innovate. important is the fact that the feature clusters are closely linked with characteristics of the institutional environment and infrastructure of the region where clusters form. the direction of the relationship is determined bilaterally. the development of clusters is affected by the mindlin, et al.: innovative territorial clusters international journal of economics and financial issues | vol 6 • special issue (s8) • 2016 255 development of supporting infrastructure in the region. effective clusters help to develop the region’s economy by structuring of the regional business space. the influence of clusters on the socio-economic development of the region in the form of feedback can be seen in the resulting innovation activity of enterprises in the region. clusters contribute to positive externalities associated with the presence in the same area of companies whose activity is aimed at creating a single product or service. these externalities are manifested in the increase of innovative activity at the concentration of human capital. the result of the interrelation of the level of clustering of the regions and the share of innovative products in the region. 5. conclusion in domestic science has developed conceptual approaches to methods of assessment of the impact of clusters on innovative activity of regions that allow demonstrating a strong correlation between indicators of cauterization and innovative activity in the region. there are practical examples of such integration implemented in the created special economic zones, techno parks, businessincubators, etc., in our opinion, it is necessary to lend a helping hand research in this field. evaluation of the efficiency classes of the cluster expects to take into account such indicators as the number of innovative start-ups took investments for their development. they can be brought into the funding strategy of the clusters located in the region. the practical effectiveness of the cluster policy in the russian economy is connected not only with modernization of production and infrastructure, but with their support from the state. the role of the human resources (sergeevich and vladimirovich, 2015), research and innovation centers to improve innovative activity in the region-based cluster is a priority and strategic. the contours of the emerging program of support to clusters in general correspond to the best foreign experience. however, it is impossible to completely discount risks of its surface sources, without substantial changes to the format and improving the efficiency of interaction between organizations in clusters. the improvement of cluster policy is an implementation of a set of measures in the following key areas: institutional mechanisms and a culture of coordination between the different actors in the clusters, with an emphasis on new approaches, an effective mix of economic activities of companies; the absolute priority should be the principle of achieving consensus solutions to common problems of competitiveness; the development of control systems in the cluster based on feedback between the participants (in the future, the transition to certification of quality management cluster program the european cluster excellence initiative); organization of training for cluster managers; active involvement of private companies, especially small and medium-sized, statesupported projects of the cluster; the implementation of joint projects of cluster members in the field of research, development and innovation; special attention should be given to business cooperation with scientific and educational organizations; the involvement of clusters in the process of formation of strategy of development of region; formation of associations (networks) clusters; internationalization activities of clusters (search for investors, suppliers, markets; inclusion in the international network of practitioners and experts; formation of clusters and brand building communications in the context of globalization). clusters represent a developing system. successful today due to various reasons (including the external-progress of science and technology, changes in world market conditions, etc.), tomorrow they may lose the dynamism and prospects. rapidly growing clusters often face a variety of barriers and restrictions due to which implementation of joint projects can take years, and the maturity to take decades. the difference in the dynamics and effectiveness of cluster development provokes new risks for policy: the latter can lose its effectiveness if the original selection of objects to support later will be suboptimal (or even incorrect). in this regard, of particular importance is the monitoring and evaluation of performance of clusters, which is designed to lay the information basis for subsequent adjustments of the list of participants supported by the state, and the extent and directions of such support. the present report is the first step towards establishing a system of information and analytical support of the cluster policy in russia. references barycheva, a.v., erlygina, e.g., shtebner, s.v. (2014), the cluster approach in the transition to innovative type of economic development. izvestiya vysshikh uchebnykh zavedenii, seriya teknologiya tekstil’noi promyshlennosti, 2014(4), 149-152. hjalager, a. (2010), a review of innovation research in tourism. tourism management, 31(1), 1-12. ksenofontov, a.s., savon, i.v., serba, v.y., shkurkin, d.v. (2016), basics of modeling the probability of corporate borrowers’ default. international journal of economics and financial issues, 6(1s), 14-18. lorenzini, e. (2014), innovation and e-commerce in clusters of small firms: the case of a regional e-marketplace. local economy, 29(8), 771-794. manova, k., wei, s., zhang, z. (2015), firm exports and multinational activity under credit constraints. review of economics and statistics, 97(3), 574-588. mikhaylov, a.s. (2015), conceptualizing international cluster. mediterranean journal of social sciences, 6(3), 11-18. oleinikova, s.a., kravets, o.y., zolotukhina, e.b., shkurkin, d.v., kobersy, i.s., shadrina, v.v. (2016), mathematical and software of the distributed computing system work planning on the multiagent approach basis. international journal of applied engineering research, 11(4), 2872-2878. ryumkin, a.i. (2009), development of innovative clusters based on business-government partnership using the example of tomsk. studies on russian economic development, 20(4), 400-409. ryumkin, a.i. (2012), formation of an innovative cluster of subsoil usage. studies on russian economic development, 23(1), 57-65. sergeevich, s.d., vladimirovich, t.o. (2015), virus detection backdoor in microsoft security essentials. information (japan), 18(6), 2513-2520. mindlin, et al.: innovative territorial clusters international journal of economics and financial issues | vol 6 • special issue (s8) • 2016256 shkurkin, d.v., shestopal, s.s., gurieva, l.k., blaginin, v.a., gurianov, p.a. (2016), basic characteristics of an intensive type of the reproduction process in the regional economy. international review of management and marketing, 6(1), 95-100. silnov, d.s., tarakanov, o.v. (2015), analysis of modern attacks on antiviruses. journal of theoretical and applied information technology, 76(1), 59-63. zakharov, a.a., olennikov, e.a., payusova, t.i., silnov, d.s. (2016), cloud service for data analysis in medical information systems using artificial neural networks. international journal of applied engineering research, 11(4), 2917-2920. zhang, d., cai, j., liu, j., kutan, a.m. (2016), real estate investments and financial stability: evidence from regional commercial banks in china. european journal of finance, 7, 1-25. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 1029-1037. international journal of economics and financial issues | vol 5 • issue 4 • 2015 1029 a comprehensive definition of the concept of innovation in russian and international science viktoriya valeryevna manuylenko1,2*, andrey aleksandrovich mishchenko2, olga borisovna bigday3, yekaterina leonidovna putrenok4, anna valeryevna savtsova5 1department of banking and finance, the institute of management and economics, north-caucasus federal university, stavropol, russia, 2department of economics and finance, the institute of management and economics, stavropol university, russia, 3department of management, the institute of management and economics, stavropol university, russia, 4department of economics and finance, stavropol university, russia, the institute of management and economics, 5department of banking and finance, the institute of management and economics, north-caucasus federal university, stavropol, russia. *email: vika-mv@mail.ru abstract theoretical and methodological studies of innovation content and essence show that methodological assessment approaches fail to represent an explicit conceptual and categorical framework for the category under consideration, which carries ambiguous connotations both in russian and foreign theory of innovation. this paper explores the essential theoretical conceptual properties of innovation, which is considered a system enabling to argue that a system-wide definition of the innovation concept is the most preferable in terms of comprehensiveness. from a theoretical perspective, we have provided insight into the innovative process by stages within the innovation system, and presented a set of innovation functions, including intensive development and reputation functions; we have traced the logical interrelation between such concepts as “idea,” “novelty,” “invention,” “innovation,” “innovative product,” “innovative service,” “innovative product line.” it is assumed that a methodological innovation assessment should be based on a comprehensive synergy-oriented approach. the methodological principles for the innovation system construction have been formed. keywords: innovations, innovative process, innovation functions jel classifications: b4, d2, l1 1. introduction although the problems of innovations as a source of competitive business advantages in a changeable environment need a long time to emerge, there is no consistent definition of innovation both in russian and foreign theory and practice. innovation is defined as a change (valenta, 1985; voldachekand vodachkova, 1989), a process in different modifications (gvishiani, 1986; 2007; twiss, 1998; myers and marquis, 1969; santo, 1990; 2004; bezdudnyi et al., 1998; gokhberg, 2011; ilyenkova, 2007; yagudin et al., 2009); a result souder et al. (1990), vertakova and simonenko, (2008), an innovative product (kotler, 2008; utkin et al., 1996); an innovative service (pinningo; valdaytsev), and others. most academic economists equate such concepts as “novelty,” “invention,” “innovative product,” “innovative service,” “invention,” “discovery,” etc. thus, currently, innovation is a complicated phenomenon, having a versatile essence, which should be examined from a system perspective. a theoretical uncertainty of innovation essence ultimately impairs its objective assessment, as it is commonly believed that the respective methodological measurement methods should reflect the conceptual framework. therefore, the definition of economic content of innovations is an essential element of methodological basis for their assessment. in this respect, it is appropriate to construct the innovation concept in the modern development context that proves the relevance of research. the purpose of research is to justify the key trends in the formation of modern methodological tools for innovation assessment based on the respective innovation conceptual framework. research objectives include analyzing the economic concept content of innovations, their functions, and expressing the author’s opinion on this issue; proving the necessity for a comprehensive innovation manuylenko, et al.: a comprehensive definition of the concept of innovation in russian and international science international journal of economics and financial issues | vol 5 • issue 4 • 20151030 assessment from a standpoint of formation and development of the innovation assessment methodology. the theoretical and methodological framework of research is the works of domestic and foreign academic economists, the oslo manual on the essence and content of innovations and similar concepts (innovative process, innovative product, innovative service, etc.). the methodological framework of research consists of logical, scientific approaches to study the innovation concept essence and content. using such methods as analysis, synthesis, detailed elaboration, generalization, clustering, formalization, abstractlogical method, the innovation concept essence was identified in theoretical and methodological terms. a working hypothesis of research relies on a conceptual thesis that the modern innovation assessment methodology shall be based on an appropriate conceptual framework, consistent with business development conditions. it suggests the following: clarifying the innovation essence and content definition; predetermining the development of innovation assessment methods. the theoretical relevance of research is in the logical interrelation between such concepts as “idea,” “novelty,” “invention,” “innovation,” “innovative product line” revealed by the authors; in the presented set of functions of innovation, including the intensive development and reputation functions; in the updated and presented innovation properties, such as novelty, innovativeness, industrial applicability, marketing, economic and/or other effects; in the introduced comprehensive definition of innovation, covering all aspects of innovative process, where an idea is turned into reality, which constantly interacts with the internal and external business environment, the specifics of innovative process itself, favoring the successful service or product launch on the market; in the presented stage wise innovative process content; and in the justified comprehensive innovation assessment approach from the methodological perspectives. 2. literature review 2.1. the historical aspect of the innovation concept origination and establishment peter ferdinand drucker, american economist, argued that the introduction of innovations is a science subject to development (drucker, 2012). making a retrospective journey into the history, it should be noted that, according to kondratyev, innovations are one of the important reasons of the large cycles of market conditions (large cycles, “long waves”) and their duration, and exploring the dynamics of inventions in the context of large cycle phases, he distinguished them from inventions and discoveries (kondratyev, 2002). as a result, it became necessary to study innovations in the dynamic (static) aspects (the ultimate result of research and production cycle). joseph alois sсhumpeter, austrian economist, the pioneer of innovations and kondratyev’s successor, regards the renewal of innovation capital in kondratyev’s wave theory as an opportunity to overcome crisis and decline in industrial production. study of the key tenets of the innovative process theory, presentation of a invention as a change in technology and management, new combinations of resource use are reflected in “the economic cycles” (1939). in this regard, an entrepreneur, a businessman is considered a significant link between the invention and innovation in the innovative process (kondratyev, 2002; shumpeter, 2007). as a result of the investigations carried by kondratyev and schumpeter, the cyclic regularities of technological progress were revealed; the idea of interaction between technological and institutional changes was justified. in a market economy, the concept of innovation has an independent nature, but it is also used to characterize similar terms, such as “innovative process,” “innovative activities,” etc. a significant contribution to the innovation theory is the development of technological wave concepts by domestic economists. 2.2. interrelation of innovation to similar concepts (idea, novelty, invention, innovative product, innovative service, innovative product line) innovation is an act of introducing something new, a new idea, more effective device or process (lat. update, improvement, eng. – (synonym) invention). it turns out that the terms “innovation” and “invention” are equated, being defined as a developing complex process of innovation creation, distribution, use, focused on efficiency growth and development of innovative activities. the innovation and invention are also equated by the following academic economists: anshin (2005), beshelev and gurvich (1990), lapin (2008), medynskiy (2008), mensch (1979); novelty and invention balabanov (2001); innovation and novelty by gvishiani (2007), karpenko (2013), mukhamedyarov (2010), ogoleva (2004), sokolov (1997), rumyantseva (2007), believes that innovation is a novelty that has gained a new quality since acceptance for the distribution. there is also a fundamentally opposite opinion, according to which the invention is a progressive novelty, used in dynamics and being new for the organizational system, which accepts and applies it. as a rule, novelties create the novelty market, and innovations create the competitive innovation market, and the investments create the capital market, forming together the field of innovative activities. according to korobeynikov et al. (2000) and trifilova (2005) a novelty is a new idea, realized in the process of developing a new product, method, new technology, etc.; innovation is a new (retrofittable, upgradable) product or technology, created using novelty and being marketable, or introduced into production, management and other activities (korobeynikov et al., 2000). in other words, the technological novelty is a source of technological innovation that gains such a quality since the initiation of distribution as a new product. tsvetkov (2011) also distinguishes the economic categories of “novelty” and “invention” and defines the innovation through a process based on the practical implementation of novelty, resulting in the meaningful basis of invention as a process. innovation is an object, introduced into production upon the completed scientific research or discovery made, differing from the previous analogue by qualitative parameters. certain academic economists add that innovation is a specifically material object that is successfully introduced into production and brings profit. manuylenko, et al.: a comprehensive definition of the concept of innovation in russian and international science international journal of economics and financial issues | vol 5 • issue 4 • 2015 1031 the center for economic and social studies of the republic of tatarstan defines the novelty as a new phenomenon, discovery, idea, method, etc. designed as a result of research, developments or experimental works on the efficiency improvement in specific areas, and the innovation as the implementation of novelty, including a complex process of creation, distribution and use of novelty as a new practical tool to meet the human needs that change with the development of social and cultural systems and subjects. thus, this is the result of investing in new equipment, technology, management system, labor organization and others. anshin states that novelty is a potential innovation, a new solution prior to its commercialization, i.e., practical use of novelty, accompanied by its market penetration. vertakova and simonenko (2008) suggest that innovations are based on novelties, inventions, i.e., novations. the practical application of invention and discovery in any field of human activity leads to creation of a new product (technology) and eventually it determines the transformation of idea, underlying the invention, to the innovation, which in its turn stimulates the emergence of new ideas. consequently, there arises an innovation spiral, presented as “scientific and technological progress idea invention technological progress idea invention” (vertakova and simonenko, 2008). bezdudnyi et al. (1998) determine the semantic differences between the concepts of novelty, invention, and innovation (lapin, 2008). fatkhutdinov believes that novelty is a completed result of applied and fundamental studies, developments and experimental works in a certain area to improve its effectiveness: discoveries, inventions, patents, trademarks, innovation proposals, know-how, scientific principles and others. the invention is a novelty that is used since its market launch, gaining a new quality, and eventually turning into innovation (fatkhudinov, 2011). thus, the innovation is a broader concept than the invention. novikov holds a similar position that novelty and novation are the actually completed result of research, developments and experimental works to improve the effectiveness in a certain area (discoveries, inventions, patents, know-how, documents for a new (retrofittable, upgradable) product, technology (production process) and other recommendations, methods, instructions, standards, results of market research, innovative proposals). the novelty in the form of new knowledge, approaches, methods gains a new quality, turning into innovation (invention) since the period of its introduction and initiation of distribution, and the innovation is a final result of novelty implementation to achieve the economic, social, environmental, scientific and technical or other effect, accepted by the society. however, such representations of innovation implementation, in our opinion, are incomplete, as the interrelation chain lacks such concepts as “idea,” “innovative service,” “innovative product,” “innovative product line.” at the same time, certain academic economists equate the terms “invention” and “discovery.” kantorovich assumes that innovations are scientific discoveries (inventions) with the practical use that correspond to the social, economic, political demands and bring results in certain activities (kantarovich, 1986); the potential risk related to innovation implementation is not considered in the definition. santo and twiss use the term “invention” to characterize innovations (santo, 2004; twiss, 1998). at the same time, we should bear in mind that the concepts of “invention” and “discovery” are closely related to the innovation concept, but differ from it: • the discovery is made by a lone inventor, and the innovation is produced by groups and takes the shape of an innovation project; • the discovery occurs by chance, and the innovation is a result of scientific inquiry; • the target of innovation, as opposed to the discovery, is the tangible benefit. the authoring team under the direction of ilyenkova believes that research and technology developments, inventions are the subtotal of research and production cycle, taking into account the practical application and turning into scientific and technical innovations, i.e., the final cycle result as a special commodity that is a scientific and technical product. scientific and technological developments and inventions, i.e., application of new knowledge for their practical use, research and technical innovations are the materialization of new ideas, knowledge, discoveries, inventions and technological developments in production for their commercial sales to meet the individual customer needs (ilyenkova, 2007). in anshin’s opinion, the invention is a new technical solution that develops into the innovation only after its commercialization. vertakova and simonenko claim that the invention is the highest level of innovation (vertakova and simonenko, 2008), distinguishing the following key features of innovations: relevance and rationality of changes in the previous state, specified by a person; acquiring practical application of change used in the given area for the first time; products, technologies, social, economic, environmental and management processes as the subject of changes; means of objective achievement and company development, enhancing its performance growth. drucker distinguishes the following sources of innovative ideas: (1) an unexpected event (unexpected success, failure, an external event); (2) incongruence (a discrepancy between the reality and its perception), (3) the inventions for the process needs (imperfection and failures to be eliminated); (4) instant changes in the composition of economic activity type or market; (5) demographic changes; (6) changes in understanding, location and important adjustments; (7) new knowledge (scientific, unscientific) (drucker, 2012). so, the distinguishing features of innovations are novelty, innovativeness, industrial applicability, marketing, obtaining economic and/or other effects. in the context of market economy, the methodology for describing innovations is based on the international standards (the frascati manual that does not consider innovations in the field of organization and management since 1963, and the oslo manual since 1992). manuylenko, et al.: a comprehensive definition of the concept of innovation in russian and international science international journal of economics and financial issues | vol 5 • issue 4 • 20151032 the oslo manual notes that innovation interpretation is complicated by the fact that a substantial part of products and processes forming them are complex systems. a minimal sign of innovation is novelty or significant improvement of a product, process, marketing or organization method in the practice of business entity that suggests rating to innovative products, processes and methods, created by organizations for the first time and/or products, processes and methods, taken from other organizations, and the common feature is their introduction. a new (retrofittable, upgradable) product is introduced in use after its market launch, and new production processes, marketing or organizational methods are introduced after their real application in the organization’s activity. national lawmakers distinguish two types of innovative goods, works and services from the perspective of novelty, these are: newly implemented ones, including the substantially new ones or significantly modified ones, and those subjected to improvement. comparison of national and international legislation shows that the current russian laws bring the definition of innovation into proximity with the international standards, considering it as a result of activities, a process of change, product, service, commodity, and new method. 2.2.1. functions of innovations the essence of innovation as an economic category consists in its functions, showing its purpose within the state economy system and business activities (table 1), although some academic economists denote them without specific identification. notably, in 1911 schumpeter defined five common changes, predetermining innovations, such as: application of a new technique, new process procedures or new market collateral for production (purchase − sale); launching products with new properties; using new raw materials; changes in production organization and its material and technical support; creation of new sales markets. a considerable shortcoming of schumpeter’s definition is that innovation is limited to only one economic activity, excluding the possibility to introduce new sorts of raw materials, to change the qualitative and quantitative staff composition, and the necessity to achieve the efficiency is omitted. the definitions (given in the national and international laws, by buymov and vaisman (2010); vinokurov (2005); ovodenko (2003); utkin et al., (1996); gokhberg, (2011); souder, et al., (1990); note that innovation is implemented as a new service, product, and, therefore, the concepts of “innovative service” and “product” are equated (twiss, 1989; utkin et al., 1996; souder et al., 1990). along with this, the oslo manual suggests an expression “product innovations in service sector,” which covers the essential improvements of service rendering means (by effectiveness, quickness), supplement of the available services with new functions or properties, or introduction of brand-new services. in addition, the concept of “innovative product” contains changes in design and packaging used to increase the product appeal or present it on a new market or market segment (oslo manual, 2010). in compliance with the current russian laws, the innovative goods, works and services are collectively referred to as the new ones or those subjected to various process modifications during the last 3 years, which is incorrect, in our opinion. borlakova (2014) believes that competitive advantages of an innovative product at the innovation stage are conditioned by its temporary novelty and unique nature. kleinknecht and coombs make a clear distinction between process innovations and product innovations, distinguishing: unambiguous product innovations for ultimate consumption; new investment goods – production of consumer goods and services; new technological devices and new technological materials – production of investment and consumer goods; scientific instruments for laboratory tests and use for laboratory purposes; and unambiguous process innovations of production facilitation (coombs and kleinknecht, 1983). in our opinion, it is required to differentiate clearly the concepts of “innovative service” and “innovative product.” an innovative product is a result of innovative activities carried out by the companies, expressed either in a tangible, informational form, or as work performed and services rendered, and intended to meet the consumer needs. its basic distinguishing features include a physical form of the fundamentally new (improved) finished product, integrity, marketability, product conformity to the key development priorities of the country, region. an innovative service is a type of innovative activities, which does not result in a new tangible innovative product, but changes the quality of the existing product to satisfy the specific consumer needs for the purpose of its sale. therefore, a service, being intangible, may often act as an elementary constituent of some innovative product, further turning into a product. the reasonable product “saturation” with related services facilitates the commercialization of respective innovations as far as a product does not need any additional efforts, but works with a click of a button or a single turn of key. it is important to bear in mind that creation of new products requires substantial investments due to research and development (r and d), and introduction of process innovations. the effective commercialization due to the larger innovation potential and stable market position in a certain professional sphere (available client base) allows developing and introducing the related products in line with the new market expectations, opportunities, potential (including a virtual component, i.e., services as well). developing the related innovative products in the subsequent innovation cycles, i.e., brand-new products as they are associated with a virtual (service) base, represented by independently developing services with regard to a growing number of developed products, we may see the cyclic innovation reproducibility. so, initially and subsequently created and developed innovative products represent an innovative product line, reflecting the development level, consistency and stability of the company’s innovative activities. the innovative product line shows its creditworthiness as with its expansion it may consider the market expectations, thus affecting them. it is fair to note that manuylenko, et al.: a comprehensive definition of the concept of innovation in russian and international science international journal of economics and financial issues | vol 5 • issue 4 • 2015 1033 an innovative (potential) by-product is defined as an increased innovation potential, which raises the possibility to generate new ideas, methods of their transformation into novelties, inventions and advanced innovations up to a totally new level. 3. results 3.1. we have established the logic interrelation of the concepts we have established the logic interrelation of the concepts of “idea,” “novelty,” “invention,” “innovation,” “innovative product,” “innovative service” and “innovative service line” (figure 1). summarizing the above, we should distinguish the following theoretical approaches to innovation definition depending on the research object and subject (figure 2). 3.2. we have formed a comprehensive definition of innovation concept we have formed a comprehensive definition of innovation concept, describing it as a system, which includes all aspects of innovative process, where an idea is first turned into reality, constantly interacting with an internal or external environment of the business entity, the specifics of the innovative process itself, thus contributing to successful product/service launch. its main purpose is to ensure the effectiveness (economic, scientific and technical, industrial, social, environmental or other beneficial effect). thus, we acknowledge that innovation evolves in time with an explicit staging. therefore, innovation is an integral, complex, contradictory and dynamic system, being ultimate practical resultoriented, where a certain effect is achieved through interaction of its elements and complex processes. in the context of theoretical construction of the innovation definition, the interpretation above lays a methodological basis for creation of innovation assessment system for each stage of implementation; it ensures the appropriate concept flexibility and scientific rigor, relying on the multi-purpose nature description. 3.3. we have revealed the content of innovative process as a complex process we have revealed the content of innovative process as a complex process, which forms and implements a new quality table 1: functions of innovation as an economic category name of academic economist functions description most domestic and international academic economists, the authoring team under the direction of ilyenkova (2007) and twiss (1998) changes changes are the specific innovation content shumpeter (2007) an obvious factor of changes in products, processes, marketing and organization innovation is a fundamental change of creation, consisting in a new combination of production means production studying the innovative business essence, innovation describes a quantitative product changes, taking into account all variations in affecting factors. if we change the function form for a combination of factors, we will obtain an innovation, characterized by a new scientific and organizational combination of operating factors, motivated by entrepreneurial spirit; or a new moment of economy dynamization lapin (2008) cultural development human life and activities as a whole; in a wider philosophical context vertakova and simonenko (2008) reproductive an important source of finance for extended reproduction investment investing the profit from innovations stimulating stimulating the business activity by innovation profit zasimenko (2007) economic involvement in the commercial (non-commercial) exchange with research and technology achievements, fostering the distribution of industrial experience at the national (international) level krasnikova and evgrafova (2011), novikov (2010) attraction of new production forces, fostering better performance and production efficiency, different cost reduction the rise in living standards of each person and society in general due to the variety and quality of produced products, services, satisfaction of human needs bringing the production structure in line with the structure of the changed needs, promoting maintenance of the demand-supply and production-consumption balance the application of creative abilities and knowledge of a certain person, human intellect, boosting further creative activity growth authors’ opinion intensive development its implementation suggests the better competitiveness of the product and entire business entity in future; in this case the innovations are regarded as a development source, provided that they are intensively and effectively used, and under favorable conditions for their initiation reputational it determines the image of the company, which uses innovations manuylenko, et al.: a comprehensive definition of the concept of innovation in russian and international science international journal of economics and financial issues | vol 5 • issue 4 • 20151034 of innovation system, represented as the subsequent stages of innovation development and introduction, interrelation between the components thereof, aimed at enhancing its efficiency. figure 3 shows the pattern of innovative process as a transformation of idea, which is relevant (according to the marketing study) and feasible (according to the innovation potential assessment), into an innovative service or product, admitted to the market (commercialization and diffusion), underlying further innovations (innovative product line). for innovative process staging, having a cyclic nature, but forming an integral, complex entity – (figure 4). therefore, the results are as follows: we have developed and extended the theoretical interpretations of economic essence of innovations, assuming the following: (1) presentation of a set of innovation functions, including intensive development and reputation functions; (2) establishment of a logical interrelation between the concepts of “idea,” “novelty,” “invention,” “innovative product,” “innovative service,” and “innovative product line;” (3) introduction of a comprehensive definition of innovations; (4) insight into the stagewise innovative process within the innovation system. ultimately, the innovation essence is specifically expressed in a system, hence, for the purpose of innovation assessment, it is necessary to proceed from the following fundamental provision: innovation is a system, constantly interacting with the internal and external environment (manuylenko, 2012), which is created by the subjects of innovative activities. to ensure the assessment efficiency, the innovation assessment methodology (scoring system) requires specifying the principles, i.e., initial rules to build the assessment process correctly, in our opinion (table 2). 4. conclusion this research may be further developed to form the methodological innovation assessment tools, which should be based on the comprehensive approach. the innovation assessment system should be built though a sequence of interrelated elements, where each element with a certain purpose is a link in chain of other elements. building up the assessment system begins with the goal setting, and is followed by identification of the indicators which will ensure its achievement. the ultimate goal of the innovation assessment system is to raise the economic business effectiveness. the objectives of innovation assessment should be represented as the indicators being the reference points for innovation assessment and innovative process optimization. the primary goal may be divided into subgoals, attributable to certain assessment elements, or products, markets, performance, quality or opportunities for study and modification to create and introduce new products, process, methods of product promotion and launch and/or changes in organizational practice or structure. the data on goals may be a source of secondary information on the properties of different innovations. so the key innovation assessment criteria within the innovation assessment system are the innovative activities: innovation culture, business, potential, environment, product, project, risks, etc. figure 1: the logical interrelation pattern for the concepts of “idea,” “novelty,” “invention,” “innovation,” “innovative product,” “innovative service” and “innovative product line” figure 2: theoretical approaches to the definition of innovation manuylenko, et al.: a comprehensive definition of the concept of innovation in russian and international science international journal of economics and financial issues | vol 5 • issue 4 • 2015 1035 figure 3: summarized pattern of innovative process figure 4: innovation process stages manuylenko, et al.: a comprehensive definition of the concept of innovation in russian and international science international journal of economics and financial issues | vol 5 • issue 4 • 20151036 table 2: methodological principles of innovation assessment (author’s opinion) first group: general principles ‑ to define the nature of innovation assessment system second group: special principles to ensure better innovation assessment system functioning comprehensiveness is manifested in the aspect of systematization law: implementation within the system of approaches, methods, means, techniques, tools, procedures, technologies, which comprehensively characterize the state of innovations; ensuring the plenitude of indicator system being formed, considering the key information sources; building up a complete assessment system regulation the development of the internal system of rules, procedures, which regulate the assessment process decomposition the innovation assessment system breakdown into subsystems of different levels (innovative activities of the country, region, innovation company, innovative activities of the company, innovation project, etc.) regularity a regular assessment to detect the existing negative trends in innovative activities; it is necessary to specify an optimal assessment interval (regularity) goal orientation assessment orientation towards the achievement of the goal and objective set for this purpose materiality structuring the system indicators in line with the most relevant innovation parameters; excluding redundant indicators within the system; creation of time series for the system being formed, suitable for the shortand long-term forecasting methods used agility considering the time factor in relation to the state of the assessed object and subject, and to the assessment process itself objectivity an innovation assessment extension with the methods, other than non-formalized (logical) methods adaptability self-orientation to the personal safety, a drive for balance condition; it reflects the changes in internal and external environment, having negative impact on innovations, and providing for development adjustment, adoption of managerial decisions within the framework of the approved innovation policy validity presentation of a real state of affairs in the assessment process with the further use; provision of full and accurate information on the company’s innovation infrastructure adequacy key principles of the innovation assessment system are based on a deep comprehension of economic law mechanisms in the innovation sphere, the experience, accumulated by the innovation science in the course of theoretical and practical studies of the innovation assessment issues accuracy the creation of a high-quality database under conditions of uncertainty, taking into account the growing data volume; the federal statistical data narrow down the assessment potential multiple assessment approaches are considered in the context of the law of requisite variety, providing for the use of maximum possible number of methodologies, methods, means, techniques, tools for innovation assessment equilibrium a complete consistency, comparability, interdependence of all the components of the innovation assessment system a logic nature and reasonability of the applicable assessment approaches, methodologies, methods, means, techniques, and tools transparency the open innovation model implementation, complete and timely provision of information about the applicable approaches, methodologies, methods, means, techniques, tools, procedures, technologies within the innovation assessment system effectiveness an ultimate result, manifested in the aspect of the law of economic expediency flexibility a rapid consideration of the current economic development conditions continuity of external and corporate innovation assessment, the unity of synthesis and analysis alternativeness the use of new alternative approaches, methodologies, methods, means, techniques, tools within the innovation assessment system that is critical under uncertainty conditions the conformity of assessment approaches to the international standards means the adoption of the best foreign assessment practices using the advanced information technologies based on application of up-to-date mathematic model methods, and dedicated software priority and severalty of innovative activities means distinguishing the specific assessment indicators of innovation, being a part of basic economic activity the professional competence of evaluation authorities prevents errors innovation safety is the conformity of the assessment process to the internal and external regulatory base; exclusion of error and abuse risk; availability of the information security system to conclude, the introduction of a comprehensive description of the innovation concept contributes to the development of methodological tools, based on a comprehensive innovation assessment approach, thus having a positive effect on the ultimate result of innovative activities. the practical implications of the research are the development of innovation assessment system, providing improvement of the assessment objectivity and effectiveness. manuylenko, et al.: a comprehensive definition of the concept of innovation in russian and international science international journal of economics and financial issues | vol 5 • issue 4 • 2015 1037 references anshin, v.m. 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(2007), determination of the enterprise innovation potential. predprinimatelstvo, 7, 74-76. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(1), 6-13. international journal of economics and financial issues | vol 7 • issue 1 • 20176 effects of corporate governance structures on enterprise risk management practices in malaysia zuraidah mohd-sanusi1*, shayan motjaba-nia2, nurul a. roosle3, ria n. sari4, agus harjitok5 1accounting research institute, universiti teknologi mara, malaysia, 2accounting research institute, universiti teknologi mara, malaysia, 3department of accounting, kolej matrikulasi melaka, malaysia, 4department of accounting, faculty of economics, universitas riau, indonesia, 5department of management, faculty of economics, universitas islam indonesia, indonesia. *email: zuraidahms@salam.uitm.edu.my abstract the risk management requirement, as part of best corporate governance practices has become compulsory for the public listed companies (plcs) in malaysia. this study examines on the existing governance structures including establishment of risk management committee (rmc), board independence, auditor quality and institutional ownerships would influence the extent of enterprise risk management (erm) practices. the study derived the aggregate erm scores in measuring the relevant control and risk management practices of plcs. for the purpose of the study, governance structure is proxied by rmc, board independence, auditor quality and institutional ownerships. using a sample of large companies, data were regressed using regression analysis, based on three regression models. the study found that the establishment of rmc provided greater awareness of erm within particular organization. however, the other governance variables have made less contribution to the risk management awareness and practices within a particular organization. keywords: enterprise risk management, corporate governance, bursa listing requirement, monitoring mechanism, risk management committee jel classifications: g3, g31 1. introduction the companies’ failures together with others high profile corporate scandals have led to an issue concerning the efficiency and role of corporate governance nowadays. firms that face financial difficulties were normally involved in many fundamental mistakes. as pointed out by stulz (2009), these fundamental mistakes involved relying on past data, focusing on narrow measures of risk, overlooking knowable risks, overlooking concealed risks, failing to communicate risk and managing risks in real time. the lessons learnt from the crisis should lead to more involvement by companies in enterprise risk management (erm). companies that move beyond traditional risk management to implement a more comprehensive approach to their control environment will be better placed to prevent, minimize, or recover from losses in shareholder value (deloitte, 2013). risk management has attracted an increasing interest among corporations, practitioners, regulators and academicians, more commonly, term as erm (desender, 2009; lam, 2001; liebenberg and hoyt, 2003; manab et al., 2007; miccolis and shah, 2000). many executives strongly believe that erm is of primary importance to business enterprise. the challenge is how to ensure risk management is applied effectively. many acknowledged there is a wide spectrum of erm practices out there even in developed countries. in malaysia, the implementation is at low level in particular among public listed firms. as discussed by ping and muthuveloo (2015), the extent of risk management practices are far beyond satisfaction through the disclosure of risk policies and management as per committee for sponsoring organizations (coso)-erm guidelines. they argued that companies need to disclose more information pertaining to risks as this would help investors in better decision making relating to achievement of firms objectives. malaysian firms would benefit from coso-erm framework in evaluating their risk weaknesses. the effectiveness of erm program requires a lot of resources which ultimately need for the board’s approval. the role of board of directors could be considered as crucial factor that influences the mohd-sanusi, et al.: effects of corporate governance structures on enterprise risk management practices in malaysia international journal of economics and financial issues | vol 7 • issue 1 • 2017 7 extent of erm (kleffner et al., 2003). in the context of malaysian setting, risk management has been cited as a key responsibility of the board of directors. the risk management requirement, as part of best corporate governance practices has become compulsory for the public listed companies (plcs) which is part of the malaysian code on corporate governance (mccg) (“the code”) and bursa malaysia listing requirements (securities commission, 2012). the increasing roles of the board are the basis element that drives the other seven components in coso-erm (2004) framework which requires discipline and structure. while directors’ role significantly and increasingly affected by “the code” an issue that constitutes the effectiveness of board of directors has become increasingly important nowadays. as role of the board in influencing erm is heightened, it is argued that the effectiveness of board’s monitoring role is through its independence, given the mixed empirical findings on board independence (dionne and triki, 2004). the objective of the study is to examine the influence of corporate governance mechanisms that are establishment of a risk management committee (rmc), board independence, institutional ownership and auditor quality on the extent of firms’ erm practices. this study contributes to the empirical evidence of risk management, commonly known as erm and corporate governance literature. the study not only explores the factors associated with the extent of firms’ erm practices but also provides insight into erm practices adopted by malaysian listed firms. a continuous effort to improve corporate governance through risk management initiatives is needed to create more awareness, interest and focus among public listed firms (plcs) to adopt and implemented erm. such understanding would provide usefulness to the regulators, standard setters, investors, and professional bodies in particular and stakeholder in general. 2. literature review 2.1. malaysian corporate governance environment the bursa malaysia listing requirement formerly known as the klse listing requirements revamped in 2001 mandated all listed firms to disclose their compliance with the mccg in the annual report. in other words, public listed firms have to state their corporate governance compliance or non-compliance in their annual reports in accordance with the recommendations set out in the mccg. the implication of these is greater obligations for public listed firms in enhancing corporate governance regime. the mccg also recommends appointment of remuneration and nomination committees by the board of directors apart from the mandated audit committee since 1993. the code also recommended establishment of a rmc and corporate governance committee but less frequently set up by plcs. risk elements can be identified in the corporate governance definition. the mccg also states as principle that the board of directors should maintain a sound system of internal control. this led to the issuance by the exchange of ‘‘a guidance on statement of internal control’’ in may 2000. this guideline explains the key areas that directors must pay attention to before they make a statement of internal control in their companies’ annual reports. the guideline emphasizes the need for proper risk management which is a critical element of a sound system of internal control. in making the internal control statement, a listed firm is required to address issues related to internal controls as recommended by the principle and best practices in the mccg. this includes that the board of directors should (a) maintain a sound system of internal control to safeguard shareholders’ investment and the firm’s assets, (b) identify principal risks and ensure the implementation of appropriate system to manage risk, and (c) review adequacy and the integrity of the firm’s internal control systems. 2.2. background of erm “the decline of many asian corporations could be directly tied to a failure in corporate governance with respect to risk management and control” (harvey and roper, 1999). for example, during malaysian economic crisis in 1997/1998 tenaga nasional berhad and malaysia airline system suffered huge foreign exchange losses due to failure in managing risk. erm is a more advanced and sophisticated approach to risk management emerged in the 1990s (simkins and ramirez, 2008). the framework incorporates and extends the broadly established “internal control – integrated framework” of 1992 with the target to satisfy both, the need for internal control and the implementation of a risk management process. the erm framework has been released in september 2004 and defines a new standard for a comprehensive risk management. a common risk framework for its widely known definition by most corporations is the one proposed by the coso of the treadway commission through its 2004 erm – integrated framework which defined as: “a process, affected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.” this framework is set up with established key concepts, principles and techniques intended for corporations to better control their activities in moving toward achievement of their established objectives (committee of the sponsoring organizations of the treadway commission, 2004). in its new, integrated erm framework, coso envisions erm as a continuous process that is overseen by senior executives and boards, and as the responsibility of everyone in the organization. committee of the sponsoring organizations of the treadway commission (2004), identifies components of erm and makes a direct relationship between these and organizational objectives, including strategy, operations, reporting, and compliance. additionally, the new integrated coso framework 2013 is a very broad one that includes both strategic risk management and corporate governance. the coso board believes internal control is an integral part of erm but that erm is broader in scope (mcnally, 2013). the role of risk management has been changed dramatically in corporations, previously often denoted with the corporate insurance mohd-sanusi, et al.: effects of corporate governance structures on enterprise risk management practices in malaysia international journal of economics and financial issues | vol 7 • issue 1 • 20178 demand and hedging. more and more are started to pay much attention to additional types of risk such as operational, reputation and strategic risks. traditional risk management was rather seen more into financial discipline. the erm functions are directed by a senior executive commonly known as chief risk officer (cro) and the role of the board in monitoring risk measures and setting limits for these measures has increased at many corporations (beasley et al., 2005; kleffner et al., 2003; liebenberg and hoyt, 2003). the top level management is responsible for putting in place a well-defined risk governance framework and formulating the appropriate risk strategies. at the operational level, the roles of the business units are to ensure that key risks are appropriately identified, assessed and mitigated. kleffner et al. (2003) cited that erm requires an enterprise-wide top down approach of managing risk holistically across the enterprise. there are different guidelines for erm frameworks in existence, each of them describe how a firm should practically approach risks within the internal and external environment faced by the organization. the coso “erm – integrated framework” (2004) however, is by far the most widely accepted and used framework as the standard for complying with regulated and legislated internal control, risk management and reporting requirements. these are derived from the way management runs the enterprise and are integrated with management process. erm consists of eight interrelated components with much influence of the firms’ specific characteristics i.e., size, industry, maturity, management style, etc. the process is not strictly a serial one, but multidirectional and an ongoing process (committee of the sponsoring organizations of the treadway commission, 2004; 2013). these factors reflect the role of corporate governance in erm which is desired by external and internal constituencies. furthermore, most of the literature on erm has focused solely on developed countries. evidence shows that the erm concept is still not widely practiced in malaysia despite having received much attention over the past years (wan daud and yazid, 2009). it is important to note that the development and application of erm, as a new concept of managing risks holistically, is rather limited in practice. this study will examine the impact of corporate governance factors on erm practices. it is asserted that characteristics of corporate governance encourage firms to increase its erm practice, which is beneficial to shareholders. 2.3. hypotheses development it is expected that the disclosure of control and risk management practices, which is still voluntary, indicates that the firm is very sensitive to the need to identify and manage those risks (desender, 2009). this is further supported by ponnu (2008) whom found improvement in disclosure of risk management and internal control among malaysia listed companies in providing empirical evidence on the extent of corporate governance practices and firm performance. liebenberg and hoyt (2003) cited that the trend towards the adoption of erm programs is usually attributed to a combination of internal and external factors. the author cited that overall the major external factors that have driven firms to approach risk management in a more holistic manner are a broader scope of risks arising from factors such as globalization, industry consolidation, and deregulation; increased regulatory attention to corporate governance; and technological progress that enables better risk quantification and analysis (liebenberg and hoyt, 2003). this is in line with malaysia government initiatives of openness and transparency for the better of public investments. 2.3.1. rmc and erm past literatures have recognized the extent of erm implementation through the existence of cro or rmc (hoyt et al., 2006; liebenberg et al., 2003). some study even recommended on establishment of separate risk management function drawn from a variety of disciplines rather than a combined with audit committee for risk management effectiveness (fraser and henry, 2007). in malaysia, the board of banking institutions is required to establish a rmc as stipulated in appendix 2 of bnm guidelines gp 1: guidelines on directorship in the banking institutions (bnm). indeed larger listed companies also have generally established a rmc headed by the ceo or senior management member. it is expected the role of board to oversee the establishment and implementation of risk management system can be delegated through the rmc. while firms are mandated to set up an audit committee, no similar requirements are imposed concerning the establishment of other board committees such as rmc (subramaniam et al., 2009; yatim, 2010). a board committee is an efficient mechanism for focusing the company on appropriate risk oversight, risk management and internal control and that an appropriate board committee may be the rmc or other relevant committee, although ultimate responsibility for risk management would still rest with the full board (asx, 2007, p.33 as cited in subramaniam et al., 2009). establishment of sub-board committees such as a rmc is recognized as one of an erm governance structures (deloitte, 2013; standard and poor, 2005). a firm that establishes ones demonstrates a greater awareness of the importance of risk management and control (coso, 2004). the aicpa-cima research series by beasley et al. (2010) reported movement of firms to strengthen enterprise risk oversight through separate risk committee. a conceptual study by cernaukas et al. (2009) cited that such creation would be able to reduce the future risk management failure coincides with current global financial crisis. such establishment should enhance the activities of risk management within particular organization. the above arguments suggest the following hypothesis in an alternative form: h1: the extent of firms’ risk management practices is positively related to establishment of a rmc. 2.3.2. board independence and erm prior studies generally posit that board independence from management provides the most effective monitoring and control of firms’ activities (fama and jensen, 1983). many scholars and corporate governance codes stress the important role of board of directors. the board of directors is usually considered as one of the most important mechanisms used under agency theory. the principal role of a board of directors is to represent the interests of the firm’s shareholders. agency literature suggests that board independence provides the most effective monitoring and controlling of firm activities in reducing opportunistic managerial mohd-sanusi, et al.: effects of corporate governance structures on enterprise risk management practices in malaysia international journal of economics and financial issues | vol 7 • issue 1 • 2017 9 behaviors and expropriation of firm resources (yatim, 2010). in the malaysian context, the klse listing requirements amendments released january 2001 require at least one third of the board to comprise of independent directors (bursa malaysia, 2001). thus it is expected that the board of directors with higher proportion of outside directors is more likely to provide oversight of a firm’s risk management activities. in this sense, borokhovich et al. (2004) reports a positive relation between the number of outside directors on the board and the quantity of interest rate hedging held by the firm. it is concluded that unrelated directors play an active role in the decision making of risk management policy. companies with greater non-executives representation are expected to favor more extensive risk management and (internal or external) auditing in order to complement their own monitoring responsibilities. the following hypothesis is proposed in the alternative form: h2: the extent of firms’ risk management practices is positively related to board independence. 2.3.3. institutional ownership and erm inclusion of institutional investors regards as importance to corporate governance in acting of monitoring control such as board independence. institutional investors who have greater ability to influence firm risk management policy are more likely to be responsible for this external pressure to install control associated with erm (liebenberg and hoyt, 2003). it is regarded as a monitoring agent (abdul-wahab et al., 2008). fama and jensen (1983) argued that outside directors have strong reputational incentives to effectively monitor ceos and management. shleifer and vishny (1997) argue that large “outside” ownership can help reduce agency conflicts because they have the power and incentive to prevent expropriation by insiders. in this regard, large outside ownership plays a monitoring role and can be expected to put more pressure on management to disclose additional information. likewise hoyt et al. (2006) find erm usage to be positively related to institutional ownership. these support the contention that pressure from institutional investors is an important determinant of erm adoption. it is measured as the percentage of the firm’s stock held by institutional ownership above five percent outstanding shares. the implication that should be highlighted is that corporate governance plays an important role in assessing risk management’s value through quality governance in terms of strong internal and external corporate governance. h3: the extent of firms’ risk management practices is positively related to institutional ownership. 3. methodology 3.1. data collection the population comprises of the bursa malaysia plcs which annual reports are available as at december 31, 2013. the period chosen for the study is to reflect the revision of mccg (the code) in 2012. this study excludes from the sample those firms related to the financial industries such as banks and insurance companies due to different compliance and regulatory environment, and therefore need to be studied independently (yatim, 2010; linsley and shrives, 2006). one firm is eliminated from the sample in absence of the accounting data. a sample of 87 companies was chosen randomly to eliminate bias in the selection process. the sample comprising a wide cross-section of industries such as industrial products, consumer products, technology, construction, trade and services, properties, plantations, and infrastructure companies. 3.2. model of study the study test the extent of the firms’ erm practices against risk management committee (rmc), board independence (bod-ind), institutional ownership (inst_own), auditor quality (big 4), firm size (ln_ta), leverage (lev) and profitability (eps). the model is based on desender (2009), beasley et al. (2005) and beasley et al. (2008). the following regression equation is estimated in the study: erm = α + β1rmc + β2bod_ind + β3inst_own + β4big4 + β5ln_size + β6lev + β7profit + ε 3.3. development of erm score the aggregate erm scoring sheet to measure the relevant control and risk management practices based on prior work developed by desender (2009) derived from the coso-erm framework. the list is composed of 87 items, scoring 1 or 0. an assessment of the state of internal control is checked upon the internal control guidelines (icgs) issued by the institute of internal auditors malaysia (iiam) (institute of internal auditors malaysia, 2000) while measurement of risk management effort upon the coso-erm 2004 framework (committee of the sponsoring organizations of the treadway commission, 2004). table 1 shows the definition and measurement of the variables in the study. thus information about firms’ specific types of control and risk and related erm practices are evaluated through their publicly available annual report. by making reference to the work of desender (2009) it is expected that the disclosure of control and risk management practices indicates table 1: definition and measurement of variables variables (acronym) measurement predicted significance dependent variable erm aggregate scores of erm item practices disclosed based on desender (2009) independent variable rmc rmc established and disclosed in annual report + bod_ind independence non-executive directors + auditor quality big 4=1; non-big 4=0 + inst_own the percentage of the firm’s stock held by institutional ownership above five percent outstanding shares. + control variable size log of total asset (ln_ size) + leverage lev=totaldebt/totasset + profitability eps + eps: earnings per share, erm: enterprise risk management, rmc: risk management committee mohd-sanusi, et al.: effects of corporate governance structures on enterprise risk management practices in malaysia international journal of economics and financial issues | vol 7 • issue 1 • 201710 that the firm is very sensitive to the need of identifying and managing those risks. the items of dependent variables are numerically scored on a dichotomous basis (haniffa and cooke, 2002). disclosure index were employed in this study when a partial form of content analysis where the studied items are specified ex ante (beattie et al., 2004). when no significance is given to any specific user groups, the usage of unweighted index is considered the most appropriate (cooke, 1989). according to the unweighted disclosure index, a firm is scored “1” if the information related to an item disclosed in the specific sections of the narratives of annual report and “0” if it is undisclosed. the total score is then computed as the aggregate scores of erm item practices disclosed by each sample firm. 3.4. measurement of variables the measurement of erm is based on the aggregate scores of erm item practices disclosed by each firm adapted from desender (2009). in addition to the four explanatory variables, this study also includes three firm-specific characteristics identified in prior research as determinants of erm practices. these variables consist of size, leverage and profitability. the inclusion of profitability variable is based on its most common financial proxy to control the level of risk within an organization (table 1). 4. analysis of results 4.1. descriptive analysis table 2 report descriptive statistics for sample firms. it highlights all the variables used in the test of association between independent variables and the extent of firms’ erm practices. the main objective of describing all the variables is to identify the distribution of the data. 4.2. correlation analysis table 3 shows the correlation between all independent variables and dependent variables. the establishment of a rmc, auditor quality and institutional ownership are strongly correlated with erm practices at significant level of 0.01 and 0.10 respectively. it failed to find any significant correlation of other corporate governance mechanism that is board independence with erm. in terms of control variables, size and also profit are strongly correlated with erm at significant level of 0.01. these findings support the empirical evidence in previous literature on the importance of firm-characteristics in determining the level of erm (beasley et al., 2005; desender, 2009; liebenberg and hoyt, 2003; beasley et al., 2008). since agency costs are expected to be higher in larger organizations, it is contended that large firm need greater monitoring and thus the need for comprehensive risk management. 4.3. results of regression analysis this study performed all variables using an ordinary least square analysis, the results of which are presented in table 4. the regression is an extension of the correlation analysis done as above. model 1 is based on the full regression model that was developed in the methodology section. in model 2 and 3, separate analyses are done on the effect of independent variables after controlling for the rmc sample and non rmc sample. as shown in the table 4, model 1 has better r2 among all the models. the fits of the full model (i.e., model 1) in explaining erm practices with r2 of 0.34, is statistically significant since the significance = 0.011 (p < 0.01). these suggest that a significant percentage of variation in erm practices can be explained by 34% of the variance in the four independent variables, after controlling the control variables. the strongest unique contribution of corporate governance mechanism on erm practices is an establishment of a rmc. the largest beta value is 0.24, evidence through a significant value of 0.017. this suggests that firms with an establishment of a rmc will provide greater awareness in risk management and control, and enhance risk management practices within particular organization. the next strongest governance table 2: descriptive statistics (n = 87) variable minimum maximum mean ± sd skewness kurtosis erm 25.0 62.0 37.4138 ± 6.24 1.026 2.116 inst_own 0.00 29.53 6.3433 ± 7.93 1.250 0.821 bod_ind 0.200 0.833 0.4381 ± 0.12 0.979 0.858 rmc 0.00 1.00 0.5287 ± 0.50 −0.117 −2.084 big 4 0.00 1.00 0.66 ± 0.48 −0.664 −1.596 ln_size 10.76 17.38 13.4169 ± 1.37 0.857 0.405 lev 0.000 0.747 0.2435 ± 0.18 0.633 −0.011 profit 0.00 1.50 1.4943 ± 0.28 0.023 −2.047 erm: enterprise risk management, rmc: risk management committee table 3: summary of the correlation results erm rmc bod_ind inst_own big4 ln_size lev eps erm rmc 0.352*** bod_ind −0.070 0.128 inst_own 0.166* 0.046 −0.081 big4 0.266*** 0.187** 0.069 −0.017 ln_size 0.482*** 0.260*** −0.091 0.352*** 0.319*** lev 0.020 −0.122 0.042 0.110 0.023 0.270*** eps 0.382*** 0.121 −0.026 0.235** 0.020 0.432*** −0.115 ***correlation is significant at the 0.01 level, **correlation is significant at the 0.05 level, *correlation is significant at the 0.10 level. erm: enterprise risk management, rmc: risk management committee, eps: earnings per share mohd-sanusi, et al.: effects of corporate governance structures on enterprise risk management practices in malaysia international journal of economics and financial issues | vol 7 • issue 1 • 2017 11 variables that contribute to erm is auditor quality measured by big four audit firm, with coefficient of 0.137 but statistically insignificant with significance = 0.107; slightly far from the conventional level (p < 0.10). the other governance variables have lower beta values indicating those variables are made less contributions. it is interesting to note that for control variables, size and profitability (both at p < 0.05) are significantly associated with erm. for leverage, the study failed to find any association between leverage and erm practices. 4.4. sensitivity analysis two sensitivity tests are performed to provide confidence in the robustness of results. first, as part of the sensitivity analysis, the results are repeated using 65 items. the list of erm scoring sheet originally composed of 87 items which include mandatory and non-applicable items to malaysian listed firms. all items were initially checked against the mandatory requirements in malaysia in order to arrive at the checklist with items relevant to the malaysian environment. these items were compared with the listing requirements for bursa malaysia, the internal control guidance issued by the iiam and the mccg (“the code”). some items were excluded in this process. for example, information on board responsibility; audit committee responsibility; training, coaching and educational programs and compliance with recommendations of corporate governance were treated as mandatory information as per listing requirements for bursa malaysia and hence, excluded. the final checklist excluded another twelve items from the original list such as information on data management, computer systems, privacy information held on customers and software security, all of which sub-headed under technology risk for event identification, risk assessment and risk response components, due to the non-applicability of the items to all firms (more than 95% are not disclosing such items). the study finds this does not change the conclusion found in table 4. the results presented in table 5 indicate that the governance variable, that is an establishment of a rmc, is still positive and significant using 65 items. the study concluded that the direction of association between rmc towards the extent of firm’s erm practices is significant and positive although slightly weaker than the original full sample. however for other governance variables that are board independence, institutional ownership and audit quality, the results do not affect firms’ erm practices. for control variables, the effect remains the same. for a second part of the sensitivity test, the results are tested using the weighted erm following desender (2009). this study finds a slightly improve model compared to full sample as in table 4. the result presented in table 6 for the association between rmc and firms’ erm are fully in line with the result in table 4. indeed the significant and positive association is much higher than the previous model (p < 0.01). nonetheless, for the presence of big four audit firm the study find positive and significant association with the extent of erm practices which support the findings found by desender (2009) and beasley et al. (2005). concerning the control variables only size is significant while profit variable is statistically insignificant towards firms’ erm practices. 5. conclusions the study derived the aggregate erm scores using prior work by desender (2009) and the coso-erm eight components framework, in measuring the relevant control and risk management practices of plcs. an assessment of control is based upon the table 4: summary of the regression analysis results variables model 1 model 2 rmc=0 model 3 rmc=1 intercept 19.041** 24.629*** 15.489 rmc 0.240** board independence −0.080 −0.014 −0.127 institutional ownership 0.002 0.008 −0.038 big four 0.137 0.184 0.149 control independent variables size 0.266** 0.250 0.335* leverage 0.005 −0.248 0.129 eps 0.233** 0.317* 0.283 r2 0.344 0.269 0.316 adjusted r2 0.286 0.141 0.211 f value 5.921*** 2.090* 3.006** ***significant at the 0.01 level, **significant at the 0.05 level, *significant at the 0.1 level. rmc: risk management committee, eps: earnings per share table 5: summary of sensitivity analysis (1) result variables standardized coefficient t significant (α) intercept 13.009* 1.904 0.061 rmc 0.231** 2.329 0.022 board independence −0.077 −0.814 0.418 institutional ownership 0.000 −0.004 0.997 big four 0.108 1.078 0.284 control independent variables size 0.284** 2.236 0.028 leverage 0.050 0.488 0.627 eps 0.222* 2.065 0.042 r 0.579 r2 0.335 f 5.696*** ***significant at the 0.01 level, **significant at the 0.05 level, *significant at the 0.10 level. rmc: risk management committee, eps: earnings per share table 6: summary of sensitivity analysis (2) result variables standardized coefficient t significant (α) intercept 2.625*** 3.941 0.000 rmc 0.297*** 3.021 0.003 board independence −0.071 −0.760 0.449 institutional ownership 0.038 0.381 0.704 big four 0.198** 1.998 0.049 control independent variables size 0.212** 1.684 0.096 leverage −0.001 −0.015 0.988 eps 0.177 1.657 0.101 r 0.587 r2 0.345 f 5.944*** ***significant at the 0.01 level, **significant at the 0.05 level, *significant at the 0.10 level. rmc: risk management committee, eps: earnings per share mohd-sanusi, et al.: effects of corporate governance structures on enterprise risk management practices in malaysia international journal of economics and financial issues | vol 7 • issue 1 • 201712 icgs issued by bursa malaysia (2001) while measurement of risk management effort upon coso-erm framework. information about firms’ specific types of control and risk and related erm practices is evaluated through their publicly available annual report and the company website. the study explores the extent of firms’ erm practices derived from the eight components of cosoerm framework (committee of the sponsoring organizations of the treadway commission, 2004; 2013). furthermore, the study examines how the existing governance structures including establishment of rmc influence the extent of erm practices. consistent with past studies, erm program increases with an establishment of rmc (yatim, 2010), board independence (desender, 2009), institutional ownership (liebenberg and hoyt, 2003), and auditor type (beasley et al., 2005). firms that established a rmc, who acts like a representative on the board of directors, will provide better oversight on erm. firms with higher quality of board, measured through board independence are more likely to provide top support and encouragement to erm effectiveness. while institutional investors have greater ability to influence firm risk management policy, audit quality measured through auditor type (i.e. big four audit firm) are well versed with its knowledge spill over in assisting firms on erm. as such this study will examines whether these corporate governance will influence erm practices of public listed firms in malaysia. an examination of corporate governance mechanisms namely the board independence, institutional ownership, and audit quality including erm governance structures that is rmc in emerging market such as malaysia provides useful information to our regulators in enhancing and promoting more transparency and openness through corporate risk management practices. for firms, such findings should urge them to take an integrated approach to erm which promulgates as the best practice by industry organizations. it is interesting to note that the mccg added a new function of internal audit role on risk management which requires the internal auditors to assume primary responsibility for monitoring enterprise risk exposures. as highlighted by manab et al. (2007) risk management should not be led by the internal audit division as this would contradicts their independent roles. in view of this, thus it is suggested that government should enhance risk management initiatives by making compulsory requirement of establishing a rmc on public listed firms in malaysia. while this study provides some insights into firms’ erm practices in malaysia, it is subjected to a number of limitations. first, the study use publicly available data to proxy the extent of firms’ erm practices. to the extent that annual report does not reflect the true state of control and risk management practices, the results are limited. second, there may be other organizational governance characteristics of erm deployments that were not reflected in this study. for example, board compositions such as board size, chairman-ceo separation, board expertise, and ownership concentration are some variables not included in this study. recent corporate governance scandals have significantly increased expectations about the roles of corporate governance participants including regulators and local and international investors. some of these expectations relate to calls for expanded risk management activities. research methods such as interviews and surveys may be complementary to the archival data method in order to provide more meaningful insights to findings of the study. there is a need for future research on the role of holistic risk management as it is relatively an unexplored field. future empirical research should spawn on the issue of erm effectiveness particularly on specific way that erm enhances shareholder value. this may include ways to measure risks that is non-quantifiable in nature. 6. acknowledgments we would like to thank the accounting research institute and the research management institute, universiti teknologi mara, in collaboration with the ministry of education of malaysia, for providing support to this project. we are grateful for the grant, without which we would not be able to conduct this study. references abdul-wahab, e.a., how, j., verhoeven, p. 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(2010), board structures and the establishment of a risk management committee by malaysian listed firms. journal of managerial governance, 14, 17-36. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(5), 259-265. international journal of economics and financial issues | vol 7 • issue 5 • 2017 259 china’s economy and the global financial crisis sima siami-namini* department of agricultural and applied economics, texas tech university, usa. *email: sima.siami-namini@ttu.edu abstract the aim of this article is to provide a brief overview of the increasing importance of china’s economy around the world economy, and to discuss the impacts of the global financial crisis on china’s economy. while china’s economic growth remained well above international averages, its drop was of the same order of magnitude as for the us. the question is that how china responds to the global financial crisis. using two individual vector autoregression (var) models, i analyze the relationship between china’s output and two foreign outputs including us and germany over the period of 1979-2013. the results of var granger-casualty show that china’s output and us output does affect each other. also, china’s output affect germany output, but not vice versa. besides that, china’s output illustrates variance decomposition (vdc) of us output with 3.21%, and us output explains vdc of china’s output with 0.14%. china’s output illustrates vdc of germany output with 7.84%, and germany output explains vdc of china’s output with 1.36%. therefore, the impact of us output shock on china is greater than germany output shock. keywords: global financial crisis, china’s economy, vector auto-regression model jel classifications: g01, e37, c32, f43 1. introduction china’s economy has emerged as a major economic power in the new global economy during the last two decades. much of china’s high economic growth attribute to large-scale capital investment and rapid productivity growth. from 1978 to 2010, the share of china’s gross domestic product (gdp) based on purchasing power parity (ppp) exchange rates1 increased from 1.7% to 9.5% in the world economy. the rising share of china in the world economy has had contribution to global growth. in 2013, the share of china’s gdp in the world economy equaled 6.1%. chinese trade volume has doubled once every 4 years since the 1980’s, and gaining speed after the economic reforms launched in 1992. with this rapid growth, china’s share of world exports had risen to 12% in 2013, and then china has become the world’s leading exporter. china’s exports have reduced the consumer price indices around the world, but at the same time, this competition has generated dislocations for many producers in other countries. 1 a ppp exchange rate is the number of units of a country’s currency required to buy the same amounts of goods and services in the domestic market as u.s. dollar would buy in the united states (who, 2015). on the other hand, china’s imports ranked second in the world at about 1.95 trillion us dollars in 2013. during the global financial crisis and aftermath, china’s stimulus package has been a major prop for global commodities prices. in china, the rising inflation has led to a monetary tightening which in turn had a major effect on global commodity prices. therefore, the main question of this article is to know what major sources explain china’s vigorous economic growth and how china responds to the global financial crisis. empirical studies such as hu and khan (1997) identified three major sources including the accumulation of capital (perkins, 1988; 1989; chow, 1993), productivity and global integration to explain the vigorous economic growth of china. other studies stressed the importance of foreign direct investment (fdi) as a key factor in determining potential growth in china (berthelemy and demurger, 2000). in the same way, china’s production processes showed high strengths in terms of innovation, not only on the level of production but also by incorporating the administration and planning processes acquired due to the innovation, which was brought in through fdi (buckley et al., 2007). willett et al. (2011) investigated economic growth in the united states and siami-namini: china’s economy and the global financial crisis international journal of economics and financial issues | vol 7 • issue 5 • 2017260 other countries during the global financial crisis through 2009 and found that, while countries like china and india had been able to maintain high growth rates, their shortfalls of economic growth below past trends have not been that much different than for the united states itself. some related studies have also investigated the relationship between macroeconomic variables of china with other countries. for instance, using cointegrated and autoregressive vectors, de la cruz gallegos (2012) showed that chinese economy has a positive causal relationship on united states, canada, european union and japan on selected economics variables including employment, economic growth and productivity. but, in the mexican case the relationship is negative, which is consistent with other studies and show the existence of competition between countries. accordingly, gosse and guillaumin (2013) implemented structural vector auto-regression (var) model with exogenous influences from the world economy represented by us financial data, but no output effect. the international monetary fund (imf) (2014) found that during the global financial crisis, china’s expansion provided a buffer for emerging market growth, whilst china’s recent slowdown has reduced growth in these economies. some studies have investigated the relationship between china’s foreign trade and economic growth. for instance, ho et al. (2015) used quarterly data from 2005 to 2013, and found evidence of unidirectional causality between gdp and export in china. jiang et al. (2017) investigated the impact of recent financial crisis on six major stock markets including united states, britain, germany, hong kong, japan, and china during pre-crisis period, crisis period and post-crisis period. using a var model and conducted granger causality tests, they found that financial crisis has reinforced the interdependence relationship of global stock markets, and general co-movements of global stock markets persist after the crisis and remained stronger in some economies. for germany, japan and hong kong, the impact of the global financial crisis was stronger because they are highly open economies. but in the china case, as the degree of openness is relatively low and the chinese stock market was supervised by the government to a certain extent, therefore, the crisis has not much affected the economy as compared with other countries. following the literature review, this research article provides a brief history of china’s economic growth, and discusses somehow about the impacts of the global financial crisis on china’s economy. while china’s high growth rate during the crisis was the envy of most other countries, its growth was lowered by the global financial crisis, offering that the decoupling of china’s growth from the advanced countries may not be as great (li et al., 2012). correspondingly, i use the impulse responses of a var model to compare the effect of foreign output shocks originating from the us and germany on the chinese economy (as two top trading partners with china). from 1979 to 2013, the impact of a us output shock on china is greater than germany output shock. exposure to china has grown more rapidly than exposure to the us, reflecting the rapid growth in cross-strait trade intensity between china and us in the last decade. also, europe economies that have booming trade with china are likely to exhibit similar results, questioning the common practice of using germany as a proxy for foreign output effects in the region. then, i provide two examples motivating the need to include both us and germany output effects in modeling of china’s economy. this analysis is divided into the following subheadings: section 2 analyze china’s economy during the global financial crisis and aftermath. section 3 presents the theoretical framework. section 4 presents data and methods. section 5 provides empirical results and final section presents the key points emerging from the investigation. 2. china during the global financial crisis and aftermath the global financial crisis of 2007-2008 and aftermath, threatened the total collapse of large financial institutions, which was prevented by the bailout of banks by national governments, but stock markets dropped worldwide and pushed the us and global economies into the recession (fredrick and addison, 2015). the crisis spread from real estate to other sectors of economy and across the globe leads to the global financial crisis. although china could maintain relatively high economic growth, the negative effects from the global financial crisis on china were considerably stronger than is often realized. this misconception arose largely because china continued to have one of the highest rates of economic growth across the globe, recording 9.6% in 2008 and 9.2% in 2009. what is typically missed is that, while most countries would be delighted to have such growth, these rates reflected a substantial drop from the 14.2% growth in 2007 (li et al., 2012). in terms of the falls in growth rate during the crisis period and aftermath, china was hit hard as many of the advanced economies. the economist intelligence unit (eiu) projects that china’s real gdp growth will slow considerably in the years ahead, averaging 6.3% from 2014 to 2020, and 4.1% from 2021 to 2030 (morrison, 2015). the global financial crisis spread through several channels, but financial channels were the most important in the early stages. financial institutions from several countries, especially in europe, had invested heavily in securities linked to the us real estate market. these investors suffered huge losses, and generated a general flight to safety which led to large capital outflows from emerging market economies that had few direct linkages with the us real estate market (li et al., 2012). china proved to be largely immune to these wealth and capital flow effects. fdi in china decreased during the beginning of financial crisis and rebounded to almost the pre-crisis level later. in 2007, china’s net fdi equaled $139.1 and decreased to $114.79 billion and $87.17 billion in 2008 and 2009, dropping 17.4% and 24.06% year on year, respectively, increased to $185.75 billion in 2010, and $170.45 billion in 2011. the crisis affected the economic outlook and risk attitudes across the globe and china’s stock market was no exception. starting in october 2007, the stock market in china crashed, wiping out more than two-thirds of its market value, and a same story happens to the real estate market, since most of the people believe that investing siami-namini: china’s economy and the global financial crisis international journal of economics and financial issues | vol 7 • issue 5 • 2017 261 in property is safer than putting money in the banks. nevertheless, the impact was less than the trade channel. consequently, the falling demand in advanced economies had a huge impact on their demand from china. china’s exports fell about 17% in 2009, before recovering to growth in 2010, as the advanced countries began to grow again. the rebounds of economic growth in advanced countries have been modest, which in turn limited the size of the rebound in china’s exports. china maintains a sustainable economic growth over the long-term because of development of the domestic market. in china, the impact on economic growth was roughly the same as in the country of origin clearly shows that not only china have a major impact on the world economy but also the world economy can have a major impact on it. this should not be surprising since china’s exports make up roughly 41% of its gdp after 2010 and china depends heavily on western demand for its goods. the high level of export dependence implies that china is strongly coupled rather than decoupled with the global economies, while on the financial side its restrictions have kept the strength of its coupling substantially weaker, although well above zero (li et al., 2012). it is important to know; how did china maintain a high growth rate during the crisis? in 2008, china adopted a combination of an active fiscal policy and a loose monetary policy by introducing a $586 billion stimulus package for 2009 and 2010, which in turn prompted a surge in bank lending. substantial funds from bank lending was funneled into the stock and property markets rather than real economic activities, which contributed to the partial recovery of china’s stock markets from the lows reached in early 2009. after adopting the expansionary fiscal policy, china’s debtto-gdp ratio was still lower than 20% at the end of 2009. in 2010, the chinese central government budget deficit remained only 1.7% of gdp, as compared with 8.9% in the united states. in 2011, china held foreign exchange reserves of about $3 trillion, the highest level in the world. therefore, china could take advantage of its strong reserve position to adopt a large stimulates package without having to worry about high borrowing costs to fund its government spending, or generating a balance of payment crisis. while china has been loosening its control on international financial flows since wto entry in 2001, they have enough effectiveness to limit international financial flows. most financing for development in china continues to be from domestic sources. foreign-funded banks remain too small to play an influential role in the financial system. in addition, china has only slowly pursued liberalization of its domestic financial sector. between 2007 and 2009, the total losses in china’s financial system were limited to just over 2% of china’s pre-crisis gdp (li et al., 2012). china’s economy still faces some major challenges including low domestic consumption levels, high dependence on exports, and serious questions about the efficiency of the extremely high levels of investment. then, a substantial rebalancing of the economy is needed to provide a more sustainable domestic growth strategy, and reduce the treat that importing countries will take protectionist measures against china’s exports. a stimulus plan to inject $586 billion into china’s economy was quite successful in reducing the size of the slowdown in economic growth, but it carried adverse side effects in terms of increasing inflation and contributing to what many see as a real estate bubble, therefore showing signs of a short-run philips curve where rapid expansions of aggregate demand tend to increase both economic growth and inflation. these inflationary concerns in turn stimulated the most recent tightening of monetary policy. on the other hand, nonperforming bank loans have been a problem for some time, and the rapid expansion of credit during the stimulus program has brought this problem to the fore again. as most of the chinese banks remain dominated by the government, banks will not refuse to offer new loans if the authorities demand that they do so, even as old loans sour. new lending by banks was equivalent to 31% and 21% of gdp in 2009 and 2010, respectively, and 39% and 34% of gdp if off-balance-sheet lending is factored in. by march 2011, china’s credit-to-gdp ratio had already risen to 166% as compared to 120% at the end of 2008, and it has risen to alarming levels in the past 2 years due to massive off-balance-sheet financing, and raised a red flag for future asset quality problems in banks. 3. data and methods in this research article, the relationship between china’s output and foreign outputs (here, us and germany) have been examined, separately. the quarterly data for all variables are retrieved from gvar toolbox 2.0, covering the sample period from 1979:01 to 2013:01. table 1 shows the data description. the variables include domestic output (here y for china’s output), foreign outputs (deuy for germany output, and usy for us output), inflation (cpi), interest rate (ir), real exchange rate (ex), and crude oil spot price (oil). exogenous oil price inflation is added to the phillips curve to solve any potential price puzzle (kim and roubini, 2000). to identify the relationship between variables, suppose that the economy is described by the following var (p): yt = a1 yt−1+…+apyt−p+ut (1) where yt is a (n×1) vector of all endogenous variables, ai is a (n×n) matrix of parameters for i = 1,2,…,p and ut is a (n×1) vector of residuals with ut~n(0,∑u) i proceed to test the existence of co-integrating relations among the domestic and foreign outputs using the johansen co-integration test and var granger causality, respectively. likewise, variance decompositions (vdc) serve as tools for evaluating the dynamics interactions and strength of causal relations between variables in the system. the zero restrictions are tested by computing the modified wald test statistic. this method is applicable whether the var’s stationary, integrated of an arbitrary order, or co-integrated of an arbitrary order. 4. empirical results before conducting any econometric analysis, the time series properties of the data must be analyzed. this section first conducts augmented dickey-fuller (adf) and philip-perron (pp) tests to siami-namini: china’s economy and the global financial crisis international journal of economics and financial issues | vol 7 • issue 5 • 2017262 establish the order of integration for all variables. table 2 presents the results of the tests for presence of a unit root in the levels and in the first differences for all variables. the results clearly do not provide evidence against the unit roots in the levels. meanwhile, the test for a unit root in the first difference series indicated strong rejection of the null hypothesis in all series. therefore, all data series are integrated of order one. so, the first difference of the data series of the variables is stationary. a trade interpretation of business cycles confirms cointegration between domestic output, foreign outputs and the other variables (mills and pentecost, 2003). the johannsen test confirms the existence of the long-run relationship between variables based on maximal eigenvalue and trace statistic of the stochastic matrix. table 3 shows the results from the cointegration tests. both tests reject the null of zero cointegrating vectors. the hypothesis that there is at least one cointegrating vector cannot be rejected on the other hand; that is, based on the cointegration test, there is no support for both variables in the system being stationary. based solely on the evidence in table 3, i conclude that there exists a cointegrating relationship between variables. consequently, the long-run relationship is estimated with the engle-granger two step procedure using us and germany outputs for foreign output in two following models: y1,t = −209.46+3.67 usy-8.99 fx+1.54 oil+ey1,t (2) y2,t = −421.94+6.39 deuy-15.83 fx+1.42 oil+ey2,t (3) i used us output in model i (equation 2) and germany output in model ii (equation 3) as foreign output, separately. i considered oil price and foreign outputs as exogenous variables, and the real exchange rate least exogenous. furthermore, domestic output (here china’s output) is followed by domestic inflation and the monetary reaction function. the adf statistics for tests of non-stationary on the residuals, ey1,t and ey2,t, showed that they are stationary with an associated mackinnon (1996) around 5% critical value of −3.44, then confirming co-integration in both models. both models confirm that foreign output has positive effect on china’s output, exchange rate has negative effect on china’s output, and oil price has positive effect on china’s output. the existence of a long-run relationship between data series means that these variables are causally related at least one direction. is change in us output or germany output causing a change in china’s output? to answer this question, i implemented the granger non-causality based on var model as residuals in both equation 2 and 3 are stationary. i first determine the optimal order of the var model using schwarz information criterion and hannan-quinn point toward two lags. then, i constructed two var models in their levels with a total of two lags. table 4 presents the chi-square statistic and probability values constructed under the null hypothesis of non-causality. it can be observed that china’s output and us output does affect each other very much. the results show that china’s output affect germany output, but germany output does not affect china’s output. in both models, ir, inflation and oil price does affect china’s output. also, in both models, oil price does affect us output and germany output. in both models, inflation does affect by china’s output, exchange rate and oil price. in addition, ir does affect by inflation in models i and ii. in both models, exchange rate does affect by foreign output and ir. vdc is useful in quantifying causal linkage between variables. the results show the extent to which a variable is exogenous explains most of its shock can be found; it then does not allow variances of other variables to contribute to it being explained. obviously, in term of the own shock being explained, china’s output itself and secondly table 1: data d escription data description y china output deuy germany output usy us output cpi consumer price index ir interest rate ex real exchange rate oil crude oil spot price table 2: unit root tests variables deuy usy y cpi fx ir oil adf levels −2.53 −2.69x 1.39 −2.68 −0.11 −2.09 −0.89x first differences −9.43 −9.43 −2.65 −2.87 −11.00 −8.95 −8.95 pp levels −2.27 −2.43 3.84 −1.87 −0.16 −1.96 −1.04 first differences −9.61 −7.63 −9.26 −3.98 −10.99 −9.11 −13.03 adf: augmented dickey fuller, pp: phillips-perron table 3: johansen cointegration test hypothesized number of ce (s) based on maximal eigenvalue of the stochastic matrix based on trace statistic of the stochastic matrix eigenvalue 5% critical value p-value trace statistic 5% critical value p-value us germany us germany us germany us germany us germany us germany none 94.76 123.03 69.82 69.82 0.0002 0.0000 43.00 68.68 33.88 33.88 0.0031 0.0000 at most 1 51.76 54.36 47.86 47.86 0.0205 0.0108 23.40 24.00 27.58 27.58 0.1572 0.1344 at most 2 28.36 30.35 29.80 29.80 0.0725 0.0432 15.95 15.96 21.13 21.13 0.2280 0.2270 at most 3 12.42 14.39 15.49 15.49 0.1380 0.0730 10.0 14.22 14.26 14.26 0.2119 0.0508 at most 4 2.42 0.16 3.84 3.84 0.1200 0.6861 2.42 0.16 3.84 3.84 0.1200 06861 siami-namini: china’s economy and the global financial crisis international journal of economics and financial issues | vol 7 • issue 5 • 2017 263 us output to lesser degree illustrates its relative erogeneity with over 90.47% and 55.91% of own variances being explained by their own innovations in panel a and b of model i, respectively. besides that, i found that china’s output illustrates vdc of us output 3.21% in panel b of model i, and us output explains vdc of china’s output with 0.14% in panel a of model i. also, in term of the own shock being explained in model 2, china’s output itself and secondly germany output to lesser degree illustrates its relative erogeneity with over 87.19% and 67.26% of own variances being explained by their own innovations in panel a and b of model ii. furthermore, i found that china’s output illustrates vdc of germany output 7.84% in panel b of model ii, and germany output explains vdc of china’s output with 1.36% in panel a of model ii (table 5). figure 1 shows china’s output response to the us and germany shocks in two var models, separately. each part on the left side and on the right side of figure 1 represents the response in china’s output to the same sized output shock originating from the us and germany, respectively. the five parts on each panel represent the impulses resulting from estimates over different sample periods, starting from 1979 when cross-strait links were initiated and then sequentially omitting the earliest 5 years from subsequent samples. this figure also illustrates the speed at which china’s exposure to both economies has risen over time. omitting the years 1979 to 1984 more than doubles the output rise caused by a positive foreign output shock; the earliest 5 years have almost non-existent cross-strait trade. after 1984, the trade growth has consistently increased with the lifting of cross-strait trade restrictions, as seen in figure 1; the gap at each 5-year interval grows consistently larger through time. the largest increase in the gap occurs when omitting the years 1994 to 1999, representing the particularly intensive trade that has taken place since 1999. this increased exposure to foreign outputs shocks seems to fit quite closely with the nature and intensity of china’s economic linkages with the us and germany. as economic linkages deepen table 4: test for granger-causality model i: us output as foreign output dependent variable y usy fx ir cpi oil y 6.26 (0.0438) 0.89 (0.6418) 5.37 (0.0681) 7.40 (0.0247) 17.61 (0.0001) usy 9.63 (0.0081) 0.56 (0.7550) 3.95 (0.1387) 0.42 (0.8108) 14.65 (0.0007) fx 1.64 (0.4398) 6.65 (0.0359) 9.77 (0.0076) 1.51 (0.4711) 4.24 (0.1195) ir 2.01 (0.3664) 1.53 (0.4650) 2.81 (0.2453) 28.99 (0.0000) 7.43 (0.0243) cpi 25.84 (0.0000) 1.96 (0.3744) 9.47 (0.0088) 1.75 (0.4160) 9.22 (0.0100) oil 3.86 (0.1454) 1.32 (0.5181) 6.60 (0.0369) 6.22 (0.0447) 9.98 (0.0068) model ii: germany output as foreign output dependent variable y deuy fx ir cpi oil y 1.29 (0.5251) 0.21 (0.8990) 14.18 (0.0008) 5.78 (0.0557) 13.56 (0.0011) deuy 10.51 (0.0052) 1.31 (0.5188) 1.60 (0.4487) 1.42 (0.4907) 31.06 (0.0000) fx 1.25 (0.5362) 6.43 (0.0401) 5.67 (0.0594) 1.33 (0.5149) 5.43 (0.0663) ir 3.07 (0.2156) 4.92 (0.0853) 3.57 (0.1680) 31.01 (0.0000) 8.13 (0.0171) cpi 24.43 (0.0000) 1.16 (0.5594) 5.57 (0.0616) 3.35 (0.1868) 8.78 (0.0124) oil 5.39 (0.0674) 0.61 (0.7386) 5.93 (0.516) 7.55 (0.0228) 9.44 (0.0089) table 5: variance decomposition panel a of model i. variance decomposition of y panel a of model ii. variance decomposition of y period y usy cpi fx ir oil y deuy cpi fx ir oil 1 100.0000 0.000000 0.000000 0.000000 0.000000 0.000000 100.0000 0.000000 0.000000 0.000000 0.000000 0.000000 2 93.65697 0.030988 2.034139 0.694501 0.001545 3.581859 94.51870 0.685875 1.438067 0.452731 0.021234 2.883388 3 91.10971 0.025384 3.973799 1.502816 0.350858 3.037428 92.57630 0.924465 2.943308 0.701485 0.273581 2.580856 4 90.77223 0.065775 4.647333 1.658775 0.645106 2.210785 92.45718 0.993244 3.439073 0.566106 0.696497 1.847903 5 90.99028 0.109962 4.426344 1.400263 0.895232 2.177917 92.39993 0.981064 3.160873 0.482447 1.162763 1.812922 6 91.20059 0.122305 3.826944 1.133914 1.166570 2.549674 91.84029 0.967081 2.610545 0.759308 1.654030 2.168747 7 91.26238 0.108285 3.207095 1.021777 1.494559 2.905901 90.86148 0.989941 2.135341 1.359242 2.179961 2.474039 8 91.15101 0.093042 2.743264 1.029952 1.884232 3.098497 89.67068 1.065352 1.872941 2.076131 2.745045 2.569849 9 90.87963 0.098884 2.488231 1.072294 2.323108 3.137852 88.41950 1.193008 1.826466 2.726900 3.343547 2.490579 10 90.47364 0.137508 2.428833 1.089573 2.794414 3.076030 87.19336 1.361603 1.943954 3.219891 3.963113 2.318080 panel b of model i. variance decomposition of usy panel b of model ii. variance decomposition of deuy 1 0.676810 99.32319 0.000000 0.000000 0.000000 0.000000 3.433753 96.56625 0.000000 0.000000 0.000000 0.000000 2 2.119923 96.84269 0.002645 0.195669 0.410923 0.428152 5.834720 90.12021 0.022273 0.330969 0.021155 3.670672 3 2.943694 92.96040 0.009644 0.754780 0.506082 2.825398 7.025699 89.57160 0.024057 0.275650 0.021317 3.081676 4 3.386634 86.19671 0.107248 1.969873 0.515321 7.824212 7.893530 88.92985 0.161771 0.285057 0.016512 2.713278 5 3.536229 78.12216 0.398936 3.903858 0.511302 13.52751 8.296369 85.69655 0.644370 0.852232 0.041919 4.468558 6 3.525293 70.79777 0.843618 6.250847 0.499404 18.08307 8.339828 80.85706 1.457803 2.043497 0.137807 7.164003 7 3.452721 65.09209 1.317180 8.609365 0.482252 21.04639 8.218757 76.08340 2.404831 3.516453 0.290652 9.485910 8 3.366802 60.95552 1.716890 10.70817 0.465924 22.78669 8.065842 72.20922 3.297777 4.910546 0.474550 11.04206 9 3.285399 58.02238 1.992980 12.44460 0.456069 23.79857 7.934996 69.33502 4.035954 6.039559 0.674669 11.97980 10 3.213281 55.91379 2.138833 13.83251 0.456464 24.44512 7.837185 67.25910 4.593061 6.872059 0.886641 12.55195 siami-namini: china’s economy and the global financial crisis international journal of economics and financial issues | vol 7 • issue 5 • 2017264 between the economies, the estimated impact of a shock increases. moreover, since the economic influence of us on china has been increasing much faster than the germany influence, historical samples will tend to overstate the influence of the us relative to germany. for instance, the 1979-2013 sample indicates a us shock will have a greater effect than one from germany. given cross-strait integration has been almost exclusively through trade, the results provide strong evidence of the importance of the trade channel to china. as a result, existing statements concerning the predominance of us shocks in other east asia countries such as china are likely to be overstated using this framework. this dynamic approach does allow broad statements to be made about the current impact of a germany output shock. transmission of germany shocks to china is exclusively through trade, and figure 1 shows that the magnitude of these shocks reflects the nature of cross-strait trade. 5. conclusions in this research article, i presented a brief history of the impact of global financial crisis on the china’s economy. for analyzing the impact of foreign output on the china’s output, i provided two individual var models and considered two major trading partner with china including us and germany as a sample of figure 1: china’s output responses to us and germany output shocks siami-namini: china’s economy and the global financial crisis international journal of economics and financial issues | vol 7 • issue 5 • 2017 265 european countries for the period between 1979 and 2013. the results of var granger causality showed that china’s output and us output does affect each other very much. also, china’s output affect germany output, but not vice versa. the findings showed that china’s output illustrates vdc of us output with 3.21%, and us output explains vdc of china’s output with 0.14%. also, china’s output illustrates vdc of germany output 7.84%, and germany output explains vdc of china’s output with 1.36%. the results of irf in both var models, showed that although a full set of impulses were produced, i considered only the foreign output sourced shocks here. my analysis concentrates on foreign output shocks emanating from germany and the us. finally, i considered two applications around the chinese economy to demonstrate the importance of accounting for china in the modeling of foreign output effects. it was found that using the us or germany as foreign output failed to show the full extent of china’s reliance on external markets, or its export-led growth recovery after the global financial crisis. references berthelemy, j.c., demurger, s. (2000), foreign direct investment and economic growth: theory and application to china. review of development economics, 4(2), 140-155. buckley, pj.., clegg, l.j., cross, a.r., liu, x., voss, h., zheng, p. (2007), the determinants of chinese outward foreign direct investment. journal of international business studies, 38(4), 499-518. chow, g.c. (1993), capital formation and economic growth in china. quarterly journal of economics, 108, 809-842. de la cruz gallegos, j.l. (2012), the effects of china performance on world economic growth, an empirical approach. international journal of business, humanities and technology, 2(2), 199-211. fredrick, k., addison, h. (2015), boom and bust: a look at economic bubbles. us: hershel, williams. gosse, j.b., guillaumin, c. (2013), can external shocks explain the asian side of global imbalances? lessons from a structural var with block exogeneity. review of international economics, 21(1), 85-102. ho, k.y., wang, k., wang, w. (2015), foreign trade and economic growth in recent china: a granger causality analysis. a new paradigm for international business, chapter 2, 91-96. hu, z.f., khan, m.s. (1997), why is china growing so fast? international monetary fund staff paper, 44(1), 116. international monetary fund (imf). (2014), world economic outlook: on the receiving end? ch. 4. external conditions and emerging market growth before, during, and after the global financial crisis. jiang, y., yu, m., hashmi, s.m. (2017), the financial crisis and comovement of global stock markets-a case of six major economies. sustainability, 9, 260. kim, s., roubini, n. (2000), exchange rate anomalies in the industrial countries: a solution with a structural var approach. journal of monetary economics, 43(3), 561-586. li, l., willett, t.d., zhang, n. (2012), the effects of the global financial crisis on china’s financial market and macro-economy. research international, 2012, 961694. mackinnon, j.g. (1996), numerical distribution functions for unit root and co-integration tests. journal of applied econometrics, 11(6), 601-618. mills, t., pentecost, e. (2003), is there a relationship between real exchange rate movements and the output cycle? economic modeling, 20(3), 593-603. morrison, w.m. (2015), china’s economic rise: history, trends, challenges, and implications for the united states. congressional research service crs report for congress 7-7500. washington, dc: crs. pagan, a., pesaran, m. (2008), econometric analysis of structural systems with permanent and transitory shocks. journal of economic dynamics and control, 32(10), 3376-3395. perkins, d. (1988), reformisng china’s economic system. journal of economic literature, 26, 601-645. perkins, d. (1989), china: asia’s next economic giant? seattle. washington, dc: university of washington press. willett, t.d., priscilla, l., nan, z. (2011), global contagion and the decoupling debate. in: yin-wong, c., vikas, k., guonan, m., editors. the evolving role of asia in global finance (frontiers of economics and globalization). vol. 9. bingley: emerald group publishing. p215-234. world bank. (2014), world development indicator. washington, dc: world bank. world health organization. (2015), purchasing power parity 2005. geneva: who. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 515-525. international journal of economics and financial issues | vol 7 • issue 4 • 2017 515 determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) rami obeid1*, mohammad adeinat2 1department of business economics, the university of jordan, amman, jordan, 2department of business economics, the university of jordan, amman, jordan. *email: rami.obeid3@gmail.com abstract this study aimed at measuring the factors that affect the net interest margin (nim) in the commercial banks operating in jordan using the data on annual frequency for 19 commercial banks covering the study period (2005-2015) (panel data). econometric models were built and analyzed using testing both fixed effects model and random effects model. the hausman test was used to get the optimal model. the results revealed that external factors had bigger effect on the nim than the internal factors. keywords: net interest margin, commercial banks, monetary policy instruments, panel data jel classification: g21 1. introduction the nim1 is one of the most important factors that measure the efficiency of banks as intermediaries that manage savings and provide loans. according to several studies, the high nim is a barrier for investment and would most likely affect economic growth diversely, especially in the developing economies.2 this vital impact of nim on the macroeconomy made several countries explore the structure and components of nim and their effect on the banking sector. literature included varied opinions on the optimal nim. however, some studies indicated that the high nim resulting from low interest on deposits and high interests on loans discourages savings and increases the cost of borrowing for potential borrowers and, hence, leads to a decrease in investment.3 as the same time, however, the notably low nim cannot be considered a positive indicator sometimes, especially, when the systems are free and insufficient supervision systems as the mechanisms that regulate the intervention of the central bank in any bank that suffers from financial problems will be most likely 1 nim is measured as the interest received on credit facilities (loans) minus the interest paid on deposits. 2 financial stability report. 2014. central bank of jordan. 3 brock, p.l., suarez, l.r. (2000), understanding the behavior of bank spreads in latin america. journal of development economics, 63, 113-135. absent. in other words, if a weak bank is allowed to continue its business and operations, it might adopt strategies that are based on offering low interest rates on loans to get bigger market share. on the other hand, there are some studies that linked the high nim to the decline in the efficiency of the banking system. however, this situation might help enhance the soundness of the banking system through utilizing the gains from the high nim margins in sustaining the capital bases of banks.4 regarding the components of the nim and its determining factors, the literature indicated that there are several determinants that vary by country. for example, some studies stated that the determinants are bank-specific factors while other studies pointed that the industry-specific factors, especially monetary policy instruments, are more important. nevertheless, some other studies inserted that the macroeconomic variables are of the most important determinants of the nim, especially in the developing countries.5 4 saunders, a., schumacher, l. (2000), the determinants of bank interest margins: an international study. journal of international money and finance, 19(6), 813-832. 5 hamadi, h., awdeh, a. (2012), the determinants of bank net interest margin: evidence from the lebanese banking sector. journal of money, investment and banking, 23(3), 86-98. obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017516 this paper tries to determine the factors that affect the nim in the sample of the commercial banks in jordan. 2. study importance and objectives the jordanian banking system is relatively high relative to the size of the jordanian economy compared to the countries of the region. the assets of licensed banks reached jd 45.2 billion at the end of 2015 with the credit facilities portfolio comprising the bulk of banks’ assets. the share reached 46.8% of banks’ assets at the end of 2015 compared to 43.2% at the end of 2014. the high percentage of banks’ interest revenues (credit interest debit interest) to their total revenues is a good indicator since it implies the increasing reliance of banks on their core business represented by extending credit facilities that helped sustain the profits of banks and, hence, the financial stability in jordan. therefore, it is important to determine the factors that control nim in the commercial banks in jordan. the nim is an indicator of operational efficiency in banks that is considered an important and a vital instrument for evaluating managerial effectiveness and efficiency in utilizing their resources and controlling their expenses. the interest of the supervisory authorities and bankers in the operational efficiency of banks is attributed to several reasons of which the most important is that efficiency measures signal the success or the failure of banks, and capacity of banks in continuing their core role in the national economy of providing liquidity and financing needs to finance various economic activities that in turn enhance economic growth in jordan.6 this paper aims at investigating the effect of the macroeconomic variables on nim in the commercial banks operating in jordan, besides analyzing the factors that affect their nim to present suitable recommendations that help the commercial banks operating in jordan in improving their operating efficiency and enhancing their profits that then reflects positively on the national economy and helps achieve the desired economic development as the study provide an opportunity for the banks to address the issues that might lead to increase in the losses or decrease in profits to consider when designing their policies and strategies. 3. study problem this study investigates the determinants of nim of the commercial banks operating in jordan through studying and analyzing the effect of internal and external factors on the nim. the internal factors refer to bank-specific factors, whereas external factors are represented by industry-specific and macroeconomic variables. the study problem can be formulated by the following questions: • what are the determinants of nim in the commercial banks operating in jordan? • are economic variables an important determinant of nim in the commercial banks operating in jordan? • how effective are the monetary policy instruments in affecting nim? 6 financial stability report. 2014. central bank of jordan. 4. study hypotheses the study examines the following hypotheses: 1. there is no effect of banks’ assets on nim in the commercial banks operating in jordan. 2. there is no effect of clients’ deposits on nim in the commercial banks operating in jordan. 3. there is no effect of leverage ratio on nim in the commercial banks operating in jordan. 4. there is no effect of operating expense ratio (cost-income ratio) on nim in the commercial banks operating in jordan. 5. there is no effect of loans to assets ratio on nim in the commercial banks operating in jordan. 6. there is no effect of provisions to loans on nim in the commercial banks operating in jordan. 7. there is no effect of the share of assets of the largest five banks in total assets on nim in the commercial banks operating in jordan. 8. there is no effect of the share of foreign currency loans in total loans on nim in the commercial banks operating in jordan. 9. there is no effect of the share of foreign currency deposits in total deposits on nim in the commercial banks operating in jordan. 10. there is no effect of macroeconomic variables (growth rate of gross domestic products and inflation) on nim in the commercial banks operating in jordan. 11. there is no effect of monetary policy instruments on nim in the commercial banks operating in jordan. 5. interest rate concept the classical economists looked at interest rate as an incentive for individuals and institutions to save. in other words, it encourages deferring consumption. the classical theory of interest rate is known as the saving and investment theory and time preference theory. one of the most prominent proponents of this theory from the economists of this school is ricardo. this theory was revised by other economists like wallace and peugeot. the classical theory inserted that interest rate is a premium that must be paid to individuals to motive them to postpone consumption in the present time. at the same time, the interest rate is a price that must be paid for using money as a capital. this theory assumes that individual by nature prefers current consumption to future consumption but could be persuaded to save in return for monetary premium on saving (interest rate). nevertheless, interest rate is one of the elements of the cost of investment. interest rate is determined by the intersection of saving and investment curves, i.e., it sets the equilibrium between the supply of money and the demand for money (capital). in other words, the equilibrium interest rate is determined by the intersection of the saving supply curve and investment demand curve, the point at which the quantity supplied of savings equals the quantity demanded of investments. after the classical school, the swedish economist knut wicksell developed the loanable funds theory, which is looked at as an extension or an improvement of the classical theory in interest rate. it is therefore called the neoclassical theory of interest rate. obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017 517 the theory was also developed by several swedish economists like bertil, lindahl and hansen. this theory is distinguished for its focus on the vital economic role of money. it takes into consideration monetary and non-monetary factors when determining the interest rate. it also takes into consideration the banking credit as a part of the quantity supplied of money and its impact on interest rate. the theory also discussed the money hoarding and claimed that it is an effective element and a part of the demand for loanable funds. after the loanable funds theory, the keynesian school developed a theory called liquidity preference theory. keynes was one of its pioneers. keynes considered interest rate as a pure monetary phenomena and not a real phenomenon as was considered by the classical school. interest rate is determined by the interaction of monetary factors, meaning the demand and supply of money. according to keynes, there is no return from money hoarding. on the contrary, giving up money (liquidity) is the source of return. money is scarce, and since it is demanded by households and investors, a price must be paid to the holders of money to give them an incentive to give up money and buy less liquid but more risk assets. therefore, interest rate is defined according to keynes as the price paid for using the liquid money. liquidity preference theory is an integral part of his theory of effective aggregate demand. it explains the relationship among the demand for liquid assets, interest rates, illiquid asset prices, and profit rates expectations, investment and employment. in other words, both uncertainty and expectations play a prominent role in determining interest rates and thus affecting income levels and other economic variables. keynes means by liquidity preference the incentives for individuals to accumulate wealth in the form of liquid assets (cash) instead of illiquid assets (like bonds). according to keynes, there three motives that affect the demand for money. they are transaction motive, precautionary motive and speculative motive. after keynes, baumol claimed that the demand for liquid assets for transaction and precautionary motives is positively related with interest rates. in other words, speculation is not the only motive that depends on interest rate. transaction and precautionary motives do as well harris (1981). in light of the above, it can be concluded that classical theory, the theory of loanable funds, the liquidity preference theory of interest rate, are not theories of interest rate determination. classical theory highlighted the real factors represented by savings and investment as determinants of interest rates. the theory of loanable funds combined monetary and real factors to illustrate how the interest rate was determined. whereas the liquidity preference theory focused on the monetary factors represented by the money supply and the demand for money in determining the interest rate. the new theory of interest addressed the critiques of these schools. the most known economist who developed this theory are hicks and hansen. they combined both the loanable funds theory and keynesian liquidity preference theory to build a complete and a comprehensive theory of interest rate determination. this theory was built by combining four factors: savings, investment, liquidity preference, and quantity of money. in other words, the theory combined real and monetary factors to determine interest rates. hansen used these factors as determinants of interest rates. the development of interest rate theories continued with fridman who developed the monetary theory to determine interest rates. he distinguished between equilibrium and disequilibrium interest rates. he stated that the relationship between capital and interest rate in the demand equation is negative, while in the money supply equation is positive. the intersection of demand and supply outputs the equilibrium interest rate and capital. this is the situation when the equilibrium prevails. in case of disequilibrium, friedman distinguished between the presence and absence of production motive. in there is a motive for increasing output the investors will not be motivated to raise capital at any rate of interest. consequently, the market equilibrium interest rate will be low. therefore, investors will be motivated to borrow for the future while savers will not be willing to lend money. in there was a motive for increasing production and the use of technology by investors, the demand for capital increases, and consequently interest rates will increase.7therefore savers will be willing to lend capital. at the same time, investors will refrain from raising the amount of capital in the light of their fears that this will raise interest rate. 6. the developments of nim in the commercial banks in jordan during the period (2005-2015) the nim in the commercial banks in jordan witnessed varied trends during the period (2005-2015). it increased from about 5.78% at the end of 2005 to 6.10% at the end of 2015, or an increase by 32 percentage points. as figure 1 shows, the nim fluctuated upward and downward during the period (2005-2015). however, witnessed a declining during the period (2010-2014) before moving upward in 2015. regarding the average interest rate on deposits, it realized an upward trend during the period (2005-2008) increasing from 2.23% at the end of 2005-4.02% at the end of 2008, with the latter being the maximum rate during the period. however, it witnessed a fluctuating trend during the period (2008-2015). it followed a downward trend during the periods (2008-2010) and (2013-2015) and an upward trend during the period (2010-2013). the interest rate on deposits reached 2.11% at the end of 2015, which is the lowest rate during the period (2005-2015). regarding the average interest rate on credit facilities, it followed an upward trend during the periods (2005-2008) and (2011-2013) and a downward trend during the periods (2008-2011) and (20132015). the average interest rate on credit facilities increased from 8.01% at the end of 2005-8.21% at the end of 2015. the average interest rates on deposits and credit facilities recorded their highest values in the wake of global financial 7 fridman, m. (1983), prix et theorie economique. paris: economica. obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017518 crisis at the end of 2008 when they reached 4.02% and 9.45% respectively as the banks tried to attract liquidity and savings by offering high interest rates on deposits. at the same time, the banks raised the interest rates on credit facilities to protect against the possible risks in that time. the nim recorded its highest value at the end of 2010 because of the relatively high value of the average interest rates on credit facilities at the end of 2010 and the relatively low average interest rate on deposits. the lowest average interest rates on deposits were at the end of the study period (the end of 2015) when it reached 2.11%. oppositely, the lowest average interest rates on facilities were at the beginning of the study period (the end of 2005) when it reached 8.01%. regarding the nim, it achieved its minimum at the end of 2007 when it reached 5.41%. by comparing nim in the commercial banks in jordan with some selected 12 countries, it is noted that ranks fifth among these countries ranked in descending order.8 since the nim in jordan is still high relative to a number of selected countries, the cbj asked the banks in several occasions to adopt more flexible policy and response to its measures represented by the cutting of the interest rates on its monetary policy instruments several times and reflect these on lowering the interest rates, especially on credit facilities. the cbj also restricted the ability of banks in raising interest rates on credit facilities by releasing treating clients with transparency and fairness instructions no. 56/2012 dated 31-10-2012 that mandated the banks to link the variable interest rates on the loans to individuals with one of the monetary policy instruments, jodibor9 or treasury bills rates. in light of this analysis, it is noted that the nim remains is still high in the banking sector and reflects some kind of exaggeration in achieving the greatest possible profit by passing some costs and expenses through this margin despite the above-mentioned measures of the cbj. as stated previously, the nim measures the efficiency and effectiveness of banks in utilizing their sources of funds and playing a key role in financial intermediation between savers and borrowers. however, if the high margin is accompanied by low interest rates on deposits and high interest rates on facilities, savings will be discouraged and the cost of borrowing for investors will increase. consequently, investment declines and the economic growth contracts.10 this entails on the cbj to adopt further measures that help reduce the nim and to use the monetary policy tools more deliberately in a way to that reduces the nim or curbs its increases and exploring the ways to achieve this, in addition to the cbj could use moral suasion to convince banks to reduce the margin (figure 2). 8 financial stability report. 2015. central bank of jordan. 9 jodibor is a domestic reference indicator of interbank lending rates in jordanian dinar. the association of banks in jordan selected 10 banks that were asked to price overnight interbank lending rates. the jodibor is then calculated by averaging eight out of ten of these rates after excluding the highest and lowest values. 10 brock, p.l., suarez, l.r. (2000), understanding the behavior of bank spreads in latin america. journal of development economics, 63, 113-135. 7. literature review there are several studies that researched the determination of the factors that affect the nim. a study by husni and al-abadi (2008) analyzed the factors that affect the interest margin in banks operating in jordan for the period (1992-2005). the study concluded that achieving higher interest margin is constrained by the bank’s ability to maintain low leverage and grant loans. the study also found a statistically significant correlation (association) between the size of bank and interest margin. in addition, the study revealed that the banks that have large market shares are not capable of determining the prices. moreover, there were no statistically significant effect of macroeconomic variables on interest margin. another study by shami et al. (2015) aimed at investigating the impact of the marketing policies of the banks operating in jordan on the performance of the banking sector through measuring the effect of several variables on the return on assets and nim. the study used the data for 13 commercial banks covering the period (2002-2012). regarding the effect on nim, the analysis results showed that the value of rewards that banks give to their clients are passed through to the interest margin. the effect was positive and statistically significant for the variables of rewards, bank figure 1: evolution of interest rate margin and interest rate on deposits and credit facilities (2005-2015) (%) figure 2: net interest margin for jordan and selected countries (2015) (%) obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017 519 size, expenses, loans and inflation. whereas it was negative and statistically significant for the variables of economic growth and capital. hishem et al (2008) analyzed the factors that affect the profitability of commercial banks in tunisia for the period (1996-2003). the study concluded that there exists a direct relation between both operational expenses and size and nim. it also found an inverse relation between equity and nim. moreover, there were no statistically significant effect of macroeconomic variables on nim. fungacova and poghosyan (2008) aimed at analyzing the determinants of nim in the banks operating in russia focusing on the banks’ ownership structure using data covering the period (1999-2007). they found evidences indicating that the bank ownership structure is an important determinant of nim. for example, the impact of risk aversion, credit risk and the size of operations varies by the type of bank owners (public sector, domestic private sector or foreign private sector). the study also found that the effect on nim of operational expenses is positive and statistically significant and of liquidity is negative and statistically significant for the three bank ownership categories. however, there was no effect of market share on nim. the study of hamadi and awdeh (2012) included an analysis of the determinants of nim in the banks operating in lebanon using bank-specific variables, industry-specific variables, variables measuring monetary policy and macroeconomic variables for the period (1996-2009). the paper built seven models for both domestic and foreign banks separately. the study found that the nim of domestic banks was different from foreign banks. the study found that the size of the bank, liquidity, efficiency, capital (leverage), credit risk, concentration, dollarization and economic growth all have negative impact on the nim. whereas deposit growth rate, lending, inflation, rediscount rate, national savings, investment, interbank lending rates all had a positive impact on nim. regarding the foreign banks, the variables of size, liquidity, capital and credit risk had no statistically significant effect on nim. the other variables as well had no statistically significant effect on nim, except for the cost to income ratio that had a negative and statistically significance effect on nim and national savings that had a positive and a statistically significant effect on nim. dumicic and ridzak (2012) analyzed the determinants of nim in the banks in the mena region for the period (1999-2010). the study concluded there was a decline in the nim in the period that preceded the year 2008 because of the high capital inflows and the sustainable economic environment. however, during the global financial crisis, with the rise in public debt accompanied by the surge in economic risks and slowdown of capital inflows, the nim increased. whereas other variables. raharjo et al. (2014) analyzed the determinants of nim in the commercial banks in indonesia by studying internal factors (bank-specific factors) and external factors. regarding the internal factors, it included the following variables: bank assets, profitability, efficiency, capital adequacy, liquidity and risk. the external factors included market power, inflation and interest rate. the used the fixed effects regression models over panel data for the indonesian commercial banks covering the period (2008-2012). the study concluded that nim in the indonesian banks is affected by the internal factors of varying levels of statistical significance. for the external factors, inflation was the only variable that affected nim at 5.0% level of significance. 8. research methodology and the econometric model in general, and according to the studies surveyed previously in this paper about the factors that might affect the nim, the factors that might affect nim are internal and external factors. the internal factors include variables that are bank-specific, whereas the external factors include industry-specific factors ad macroeconomic variables.11 it can be noticed in the studies surveyed previously that there are several determinants of nim that vary across countries. for example, some studies pointed to the bank-specific factors as the most important determinants of nim, while some other inserted that the banking industry-specific factors, especially monetary policy tools, are more important. whereas some other studies considered the macroeconomic factors as of the most important factors that explain nim, particularly in the developing countries.12 it can be noticed from many of the studies published in this context that the studies that researched the factors that affect the nim applied to the commercial banks operating in jordan are limited, especially after the developments that took place in 2012, when the cbj set the monetary policy operational framework through the corridor system. the system aims at directing the short-term interbank interest rates towards its targeted level. and hence affect the market interest rates. the deposit window represents the lower limit for the corridor system. the upper limit is the overnight repurchase agreement. the cbj strengthened the role of monetary policy in affecting the interest rates in the market b releasing the treating clients with transparency and fairness instructions no. 56/2012 dated 31-10-2012 that mandated the banks to link the interest rates on the loans to retail clients with one of the monetary policy instruments, jodibor or treasury bills rates. this shows the vital role of monetary policy in affecting the nim. therefore, this study is distinguished from the previous work by including the overnight deposit window rate as the most important tool that affect the interest rates on the retail loans directly or indirectly. if the banks link the deposit window rate with their variable interest rates, then the impact will be direct on the interest rate on loans at these banks. however, if the link was with jodibor, then, according to corridor system explained above, the impact will be indirect through the effect of deposit window rate on interest rates on interbank loans, and hence affecting the reference rate (jodibor) and the interest rate in the market. however, unlike 11 raharjo, p.g., hakim, d.b., manurung, a.h., maulana, t.n.a. (2014), the determinants of bank’s interest margin in indonesia: an analysis of fixed effect panel regression. international journal of economics and financial issues, 4(2), 295-308. 12 hamadi, h., awdeh, a. (2012), the determinants of bank net interest margin: evidence from the lebanese banking sector. journal of money, investment and banking, 23(3), 86-98. obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017520 previous studies, this study did not use interbank loans rate as an independent variable. the reason behind this idea is the existence of high (strong) correlation between deposit window rate and interbank loan rate; the correlation coefficient between these two variables was 0.91. regarding the other monetary policy tools, the required reserve ratio was not included in the study as one of the variables due to its high constancy since rarely changed this ratio over the study period. regarding the overnight repurchase agreements interest rate (the upper limit of the corridor), its effect on nim was not included in this study. the trace of the interbank loans rate according to the corridor system during the period (20052015) shows that they move with the overnight deposit window with values close to these of the deposit window rate (figure 3). whereas the interest rates on the overnight repurchase agreements are not close to the interest rates on interbank loans. this might be attributed to the high interest rates on the overnight repurchase agreements, which shows the existence of a strong impact from the overnight deposit window rates on the interbank loans interest rates, and consequently on the interest rates on the loans to the clients of banks, not to mention the other effect of the interest rate of the deposit window on the interest rates of the deposits of banks clients, which means that there is a clear and a predictable effect of interest rates on the nim. in order to determine the factors that might affect nim in the commercial banks in jordan, the impact on the nim will be measured by proposing a multiple regression model that takes into consideration the internal factors as well as the external factors, including the macroeconomic factors that might affect the nim in the commercial banks in jordan. the panel data will be used as a sample of the study that includes 19 commercial banks and covering the period (2005-2015). using the fixed-effects model and random effects model. the panel data estimation outputs more precise results as it takes into consideration the data that are time variant in the time series and the cross-sectional dimension for variance units (banks). the cross-sectional time series estimation helps contain the severity of multicollinearity that takes place in the time series. it also controls the heteroscedasticity problem when using the cross-sectional data.13 latter in this study, hausman test will be used to determine the best tool to examine this model, meaning fixed-effects model versus random effects model. this study uses the following model: nimit = β0+β1sizit+β2depit+β3eqtit+β4cirit+β5loanit+β6llp it+β7diwt+β8conct+β9loandolt+β10depdolt+β11gdprt+ β12inft+ϵt where: β’s: model parameters. i: bank. t: time series in years. ϵt: random error. 13 green ,w. 2003, econometric analysis, 5th ed. new jersey, upper saddle river: prentice hall. p 272. 8.1. the dependent variable net interest margin (nim). it equals the difference between credit interest rates (on loans) and debit interest rates (on deposits) divided by total assets. this method of measurement was adopted frequently in the relevant literature (shami et al., 2015; raharjo et al., 2014; hamadi, and awdeh, 2012). 1. the variables that measure the internal factors (bank-specific factors). these include: a. siz: natural logarithm of assets. several studies showed that the relationship of this variable with nim is direct, the bank takes advantage of its size by reducing expenses (cutting the interest rates on deposits) and, hence, the nim increases. b. dep: the rate of change in the clients’ deposits. the relationship of this variable with nim might be direct or inverse. the decline in clients’ deposits might lead to a decline in bank’s liquidity that then leads to an increase in interest rates on deposits to attract new clients and/or an increase in interest rates on loans because of the decline in bank’s liquidity. the net impact on nim depends on which of these two effects dominate the other. c. eqt: equity to assets ratio (leverage ratio). this ratio enhances the bank’s ability to withstand risks. hamadi, and awdeh (2012) found that there is an inverse relationship between this variable and nim. when the bank retains a high portion of equity might lead the bank to increase interest rates on deposits to attract new clients to enhance its liquidity, hence, the nim goes down especially if accompanied with cutting the interest rates on credit facilities. nevertheless, koehn and samtomero (1980) found that the relationship between this variable and nim is positive. d. cir: cost (expenses) to income ratio, despite the fact that the high cir might lead the bank to include it in the nim and hence increasing the margin, some studies like hamadi, and awdeh (2012), found that there is a positive relationship between this variable and the nim. the study attributed this positive relationship to the fact that the figure 3: interbank overnight lending rate, overnight deposit window rate and overnight repurchase agreements (corridor system) (2005-2015) (%) source: database of the central bank of jordan obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017 521 banks that have higher operational efficiency relatively will be able to cut interest rates on loans and/or increase interest rates on deposits since such types of banks that have a high operational efficiency targets to enhance its competitiveness in the market. e. loan: loan to asset ratio. the 2014 financial stability report issued by the central of jordan indicated that the expansion of lending lead to increase in nim. several studies showed that the relationship between this ratio and nim is positive. f. llp: provisions to loans ratio. this ratio measures credit risk. the high llp ratio increases the nim because bank often pass the costs of provision to nim (poghosyan, 2012). therefore, the relationship between this ratio and nim is expected to be positive (ben naser et al., 2014). 2. variables related to monetary policy: a. diw: overnight deposit window rate in jd. this tool reflects the attractiveness of the jordanian dinar. the increase in the rate of this monetary policy tool leads to increases in the interest rate on deposits and on loans in jordanian dinar. the net impact on nim depends on the magnitude of the increase in interest rates on loans and on deposits. raising the overnight deposit window rate will make the banks deposit their excess liquidity in the central bank. these banks will also increase the interest rates on deposits to attract more savings. on another strand, as previously mentioned, the impact of this monetary policy tool on the interest rates on loans will be evident especially after the release of the instructions of treating customers with fairness and transparency besides the design of the monetary policy operational framework and the corridor system. according to the “treating clients with transparency and fairness instructions,” if banks linked the overnight deposit window rate with the variable interest rates, there would have been a direct effect on the interest rates on loans at these banks. however, if the link was to jodibor, according the previously mentioned corridor system, there will an indirect effect through the impact of deposit window rate on the interest rates on interbank loans, and consequently affecting the reference rate (jodibor) and, hence, the interest rates in the market. 3. industry-specific variables a. conc: the share of assets of the largest five banks in total assets. this variable measures the competitiveness and concentration in the banking sector. the higher the concentration in the banking sector, the higher the nim because this will help banks that have high excess liquiditythat usually do not need to pay high interest rates on deposits stronger power in determining nim (financial stability report, 2014. central bank of jordan). b. loandol: the ratio of loans in foreign currency to total loans. this direction of the relationship of this ratio to nim depends on the outcome of two effects: the decline in the interest rates on deposits in jordanian dinar and the decline in the interest rates on loans in jordanian dinar. the final impact depends on the magnitude of decline in the two interest rates. c. depdol: the ratio of deposits in foreign currency to total deposits. as with the previous variable, this direction of the relationship of this ratio to nim depends on the outcome of two effects: the share of foreign currency deposits relative to the domestic currency deposits (dollarization) and liquidity. the higher the share, the higher the rates the banks offer to deposits to attract more clients. the decline in liquidity might force the banks to increase interest rates on the loans in jordanian dinar. the final impact depends on which of these two forces dominates the other. 4. economic variables a. gdpr: the growth rate of real gdp as a very common reflection of the economic conditions. the higher the growth rate in real gdp, the higher the nim since the improvement in economic conditions is usually connected with the increase in the demand for loans. therefore, banks may not cut interest rates on credit facilities at the same rate of reduction on deposits as a response to the central bank’s interest rate cuts (the central bank of jordan’s financial stability report, 2014). b. inf: inflation rate (consumer’s price index). it measures the general price level. regarding its effect on nim, it depends on whether inflation is expected or not expected. if the inflation is expected, then the relationship is positive. however, if inflation is not expected, the relationship will be negative (perry, 1992). there are other studies that indicated that the high inflation rates leads to uncertainty in the economy, and, hence, might lead to an increase in nim (poghosyan, 2012). regarding the correlation matrix that includes the correlation coefficients among all the variables in the study, it is shown in table 1. the strength of the relationship among study independent variables is used to examine the presence of the problem of multicollinearity. this problem is considered severe in case the correlation coefficient between two explanatory variables exceeded 0.80. as shown in table 1, most of the variables are weakly correlated except for the correlation between the growth rate of real gdp and the ratio of deposits in foreign currency to total deposits whose coefficient approximated 0.81. since the correlation coefficient between these two variables exceeded 0.8 slightly, another test was conducted to check the presence of multicollinearity problem between these two variables, which is variance inflation factors test (vif). in this test, the explanatory variable is used as a dependent variable and then regressed o all the other explanatory variables. the coefficient of determination (r2) is used to calculate the vif as follows: 2 1 vif 1 r = − if vif <5, then this indicates the presence of severe multicollinearity (o`breien, 2007). therefore, one of the variables must be eliminated from the estimated model. the test is shown in table 2. as appears in the table, the vif values for depdol and rgdp obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017522 were 3.33 and 4.17 respectively. therefore, based on the previous benchmark, the multicollinearity problem is not present among the study variables. regarding the descriptive analysis of the study variables, they are shown in table 3. there are important implications that can be concluded from the table. for example, credit facilities ratio for the commercial banks operating in jordan for the period (2005-2015) averaged 45.0% (i.e., the formed 45.0% of total assets). moreover, the ratio of deposits in foreign currency to total deposits was 26.0% on average during the study period. the share of foreign currency credit facilities from total credit facilities averaged 12.0% during the study period. it is also noticed that the share of the assets of the largest five banks in total assets ranged from 54.0% and 66.0% during the study period. finally, the growth rate of real gdp and inflation during the study period approximated 5.0% and 4.0% respectively. 9. analysis of econometric model results 9.1. stationarity of the panel data before analyzing the results of the econometric model, the stationarity of panel data series must be tested to examine the presence unit root problem in any of the model variables using im, pesaran and shin w-stat and pp fisher chi-square tests. as shown in table 4, all variable were stationary when testing the level of the variables, except for the share of assets of the largest five banks in total assets, the ratio of loans in foreign currency to total loans the growth rate of real gdp that became stationary on the first difference. this leads us to another test, which is kao residual cointegration to test the presence of cointegration of the variables that were not level stationary. this testing tool tests the presence of unit root for the estimated residuals. the test results are shown in table 5. as appears in the table, there exists a cointegration among the non-stationary variables, there the null hypothesis of the absence of cointegration is rejected. 9.2. estimating the model the determinants of nim in the commercial banks in jordan table 6 shows the statistical results of the two models of the fixed and random effects. as realized, the explanatory power of the two statistical models is different. the coefficient of determination (r2) was 55.0% for the fixed effects model and 35.0% for the random effects model. whereas the value of adjusted r2 was 47.4% for the fixed effects model and 31.0% for the random effects model. f statistic was statistically significant for both models. the value durbin watson statistic was 1.78 and 1.67 for the fixed effects and the random effects model respectively, which adds to the strength the models of this study. regarding the variables used in the models, the analysis results were as follows: 1. bank-specific variables: the statistical results showed that there is a negative and statistically significant effect of the clients’ deposits (liquidity) on the nim. this shows that the banks raise the interest rates on deposits in case these declined. consequently, the nim declines. to compensate for the increase in the interest rate on deposits, the banks raise the interest rates on loans. this raising of the interest rates increases the nim more the higher loans to deposits ratio (the increase in the interest rates on loans may exceed the increase in the interest rates on paid on deposits, therefore the nim may increase). regarding the cost (expenses) to income (cir) ratio, the results showed that there exists a statistically significant negative relationship between this ratio and nim. the higher the cir ratio, the lower the nim. this relationship could be positive, this will be the case if banks pass the additional cost or expenses to their clients either by raising the interest rates on loans or by cutting the interest rates on deposits or both. regarding equity to assets ratio, the results showed that there exists a statistically significant positive relationship between this ratio and nim. the higher this ratio, the more liquidity allocated to strengthen the capital base in the bank to withstand risks. this in turn reduces the bank’s liquidity. consequently, banks increase the interest table 1: correlation matrix variable nim siz dep eqt cir loan llp diw conc loandol depdol gdpr inf nim 1 0.07 −0.11 0.08 −0.24 0.14 0.05 0.14 0.18 −0.06 0.22 0.17 0.05 siz 0.07 1 −0.12 −0.04 −0.20 0.08 0.06 −0.21 −0.22 0.21 −0.25 −0.24 −0.06 dep −0.11 −0.12 1 0.05 0.00 −0.10 −0.11 0.09 0.12 −0.07 0.14 0.12 −0.01 eqt 0.08 −0.04 0.05 1 −0.14 −0.12 −0.03 −0.07 −0.08 0.07 −0.10 −0.09 0.01 cir −0.24 −0.20 0.00 −0.14 1 0.20 0.37 0.20 −0.06 0.09 −0.23 −0.23 −0.01 loan 0.14 0.08 −0.10 −0.12 0.20 1 −0.04 0.07 0.11 −0.08 0.04 0.09 0.13 llp 0.05 0.06 −0.11 −0.03 0.36 −0.04 1 −0.17 −0.19 0.18 −0.15 −0.29 −0.14 diw 0.14 −0.21 0.09 −0.07 0.20 0.07 −0.17 1 0.62 −0.47 0.75 0.67 0.50 conc 0.18 −0.22 0.12 −0.08 −0.06 0.11 −0.19 0.62 1 −0.69 0.63 0.71 0.50 loandol −0.06 0.21 −0.07 0.07 0.09 −0.08 0.18 −0.47 −0.69 1 −0.64 −0.68 −0.03 depdol 0.22 −0.25 0.14 −0.10 −0.23 0.04 −0.15 0.75 0.63 −0.64 1 0.81 0.31 gdpr 0.17 −0.24 0.12 −0.09 −0.23 0.09 −0.29 0.67 0.71 −0.68 0.81 1 0.38 inf 0.05 −0.06 −0.01 0.01 −0.01 0.13 −0.14 0.50 0.49 −0.03 0.31 0.38 1 nim: net interest margin table 2: vif for depdol and rgdp dependent variable independent variables r2 vif depdol all the other explanatory variables in the model 0.70 3.33 rgdp all the other explanatory variables in the model 0.76 4.17 obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017 523 rates on loans. this might also be accompanied by paying higher rates on deposits (the increase in the interest rates on deposits may be lower than the increase in the interest rates on loans) to attract more clients, especially due to the high equity to assets ratio. the results showed that there is a positive but not statistically significant relationship between assets and the nim. it is known that large banks have a competitive advantage and are able to determine the prices in the market. as for the provisions to loans ratio, the results showed that this ratio is positively related to nin but not statistically significant. if the relationship was statistically significant we would have reached to a conclusion that the banks raise the nim to cover the costs of provisions. finally, with regard to the loans to assets ratio, its relationship with the nim was positive but not statistically significant. 2. variables related to monetary policy tools: the statistical results clearly showed that that the biggest effect on the nim is the interest rate on the overnight deposit window. the statistical models showed that there is an inverse relation between the deposit window interest rate and the nim. the coefficients of the deposit window interest rate in both the fixed effect and the random models was −0.94 and −0.92 respectively. this indicates the strength of the relationship between the deposit window interest rate and the nim. it also reveals the effectiveness of monetary policy in affecting table 3: descriptive statistics of the explanatory variables variable observations mean median standard deviation minimum maximum skewness siz 209 8.89 8.91 0.76 2.33 9.94 −5.82 dep 209 0.27 0.09 1.77 −0.4 25.53 13.93 eqt 209 0.14 0.14 0.04 0.07 0.33 1.13 cir 209 0.57 0.53 0.2 0.18 1.74 1.91 loan 209 0.45 0.46 0.12 0.05 0.72 −0.83 llp 209 0.05 0.04 0.04 0 0.24 1.81 diw 209 0.03 0.04 0.01 0.02 0.05 0.01 conc 209 0.62 0.63 0.03 0.54 0.66 −1.14 loandol 209 0.12 0.12 0.01 0.1 0.14 −0.19 depdol 209 0.26 0.24 0.06 0.2 0.36 0.59 gdpr 209 0.05 0.03 0.02 0.02 0.08 0.35 inf 209 0.04 0.05 0.04 −0.01 0.14 1.05 table 4. stationarity testing using im, pesaran and shin w-stat and pp fisher chi-square tests variable type of test value on level without trend (i (0)) value on first difference without trend (i (1)) nim ips 7.47494 (0.0000)*** pp 163.157 (0.0000)*** siz ips 12.0367 (0.0000)*** pp 92.2445 (0.0000)*** dep ips 5.33704 (0.0000)*** pp 200.604 (0.0000)*** eqt ips 0.50692 (0.6939) 8.70911 (0.0000)*** pp 56.3321 (0.0280)** cir ips 4.03289 (0.0000)*** pp 61.6602 (0.0089)*** loan ips 0.98106 (0.1633) 5.76331 (0.0000)*** pp 60.2619 (0.0122)** llp ips 1.80986 (0.0352)** pp 84.7630 (0.0000)*** diw ips 2.23029 (0.0129)** pp 12.9026 (1.0000) 51.7435 (0.0677)* conc ips 10.0214 (1.0000) 3.47506 (0.0003)*** pp 0.00079 (1.0000) 50.1589 (0.0896)* loandol ips 1.08707 (0.8615) 7.38492 (0.0000)*** pp 18.0815 (0.9975) 349.993 (0.0000)*** depdol ips 1.50030 (0.0668)* pp 34.1464 (0.6483) 79.8564 (0.0001)*** gdpr ips 0.54491 (0.7071) 3.24184 (0.0006)*** pp 13.1595 (0.9999) 51.3631 (0.0725)* inf ips 0.20378 (0.4193) 3.89506 (0.0000)*** pp 134.744 (0.0000)*** *values in parenthesis represent probability. *significant at 10.0% level of significance, **significant at 5.0% level of significance, ***significant at 1.0% level of significance table 5: kao residual cointegration testing among non-stationary variables adf t-statistic p adf −7.563741 0.0000 residual variance 0.000314 hac variance 0.000369 obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017524 the nim either directly or indirectly as previously stated. the low interest rate of the overnight deposit window will result in a decrease in the interest rate on the deposits of banks’ clients, which will consequently increase the nim. moreover, according to the corridor system, the decrease in the interest rate of overnight deposit window will lead to a decrease the lower limit of the corridor system, and may result in a lower interbank lending rate and then the reference price (jodibor), which may lead to a reduction in the interest rate on customer loans. since the relationship between the deposit window interest rate and the nim was negative, the decrease in interest rate may be greater on the customer deposits than on customer loans and thus will lead to an increase in nim. 3. industry-specific variables: the statistical models showed that the share of assets of the largest five banks of total assets with nim is positive and statistically significant. this indicates that large banks have monopolistic power in setting market prices (interest rates). regarding the share of foreign currency deposits in total deposits, its relationship with nim was positive and statistically significant. this means that the higher share of foreign currency deposits at the expense of their counterpart in jordanian dinar (dollarization) will force the banks to raise the interest rates on deposits in the domestic currency to attract more jd deposits. moreover, in light of the decline of banks liquidity in jordanian dinar, the banks might as well raise the interest rates on jd loans to compensate for the decline in liquidity. however, the increase in interest rate may be less on the customer deposits than on customer loans and thus will lead to an increase in nim. regarding the ratio of loans in foreign currency to total loans, its relationship with nim was positive and statistically significant, will implies that the demand for loans in jordanian dinar might lead to a decline in interest rates on deposits in the jordanian dinar and/or a decline in interest rates on loans in the jordanian dinar. however, the decline in interest rate may be greater on the deposits than on loans. therefore, the nim increases. 4. variables related to the macroeconomy: regarding the macroeconomic variables, the results showed that there exists a positive and a statistically significant relation between the growth rate of real gdp and the nim. the improvement in the economic conditions leads to improvements in the banking business in general. consequently, the confidence of investors in establishing projects and/or expanding their established projects. therefore, the demand for loans increase, and, hence, the interest rates on loans increase and so the nim as a result. regarding inflation, the model showed that there exists a negative and statistically significant relationship between inflation and nim. this is attributed to the reason that the price decline decreases the need of individuals to their savings in banks and their need to borrow. therefore, the increased savings at banks make them cut interest rates on deposits. moreover, the decline in the need of individuals for borrowing make the banks cut interest rates on loans. consequently, the nim increases. nevertheless, the price increase force individuals to withdraw part of their savings to meet their consumption needs. their need for borrowing increases also. these forces make the banks raise interest rates on deposits and loans. the magnitude of increase may be bigger on loans than on deposits. consequently, the nim increases. to determine which of the two models and fixed effects and random effects is more appropriate in explaining the nim variations, hausman test was used. in this test, the more precise model is determined and selected. in case of accepting the null hypothesis, the random-effects models is selected. i case the null hypothesis was rejected, the fixed-effects models is selected: h0: the random-effects model is preferred to the fixed-effects model. therefore, the generalized least squares (gls) method is used. h1: the fixed-effects model is preferred to the random-effects model. therefore, the ordinary least squares method is used. in other words, if the calculated value of χ2 is statistically significant at 5.0% level of significance, then the null hypothesis is rejected and the fixed effects model is selected. as appears from table 6, the values of χ2 statistics is approximately 27.5 and is statistically significant. the tabulated χ2 at 11 degrees of freedom (the number of explanatory variables) is 19.68. therefore, the calculated value of χ2 statistic is greater than the value χ2 from the relevant table. consequently, the null hypothesis is rejected and the fixed-effects model is preferred to the random-effects model. 10. conclusions and recommendations the study investigated the factors affecting the nim in the commercial banks operating in jordan during the period (20052015) using the fixed-effect panel least squares and the randomtable 6: statistical results of the estimated econometric model to measure the determinants of nim variables coefficients fixed effects coefficients random effects siz 0.001658 (0.1112) 0.001484 (0.1298) dep −0.001396*** (0.0001) −0.001257*** (0.0002) eqt 0.081290*** (0.0002) 0.062109*** (0.0009) cir −0.007453** (0.0467) −0.008169** (0.0250) loa 0.004437 (0.6450) 0.011703 (0.1194) llp 0.006382 (0.7492) 0.016695 (0.3670) diw −0.942639*** (0.0000) −0.925264*** (0.0000) conc 0.155271*** (0.0000) 0.150691*** (0.0000) loandol 0.501602*** (0.0000) 0.494889*** (0.0000) depdol 0.220918*** (0.0000) 0.215535*** (0.0000) rgdp 0.077564* (0.0922) 0.077953* (0.0877) inf −0.023902 (0.2710) −0.023780 (0.2715) constant −0.179000*** (0.0000) −0.173656*** (0.0000) r2 0.550047 0.350041 adjusted r2 0.474213 0.310248 number of observations 209 209 f-statistic 7.253238 8.796464 p (f-statistic) 0.0000 0.0000 durbin-watson 1.780744 1.668757 hausman test χ2 statistics 27.465486 p (χ2) 0.0001 values in parenthesis are probabilities. *significant at 10.0% level of significance, **significant at 5.0% level of significance, ***significant at 1.0% level of significance obeid and adeinat: determinants of net interest margin: an analytical study on the commercial banks operating in jordan (2005-2015) international journal of economics and financial issues | vol 7 • issue 4 • 2017 525 effect estimated gls. the study showed that the nim is affected by several internal and external factors. accordingly, this study came out with the following recommendations: 1. it is important to that the concentration in the banking sector be reduced due to its unfavorable effect of raising the nim. one path for this is licensing new banks in a deliberate manner. banks with excess liquidity that usually do not need to pay high interest rates on deposits have higher market power in determining the interest rate margin in jordan. 2. it is important that the central bank of jordan stress on banks to keep improving their operational efficiency and enhance their contribution to financing various economic activities at a reasonable cost. it is also important request banks not to raise their profit margins overstatedly, especially when both operating expenses and provisions for non-performing loans are relatively low. 3. it is important that the banks allocate their profits to their capital bases in a deliberate manner due to their effect on rising the nim. 4. the central bank of jordan should use its monetary policy instruments in a prudent manner and take into consideration its direct and indirect effects on nim through the effect of these instruments on economic variables that in turn affect the nim. 5. the central bank of jordan should use its monetary policy instrument of moral suasion to convince banks to reduce their nim. in turn, the commercial banks should also fulfill their moral responsibility to reduce the interest rate margin by not pricing their products in an exaggerated manner, and a way that commensurate with their real costs and expenses. references ben naceur, s., goaied, m. (2005), the determinants of the commercial bank interest margin and profitability: evidence from tunisia. journal of frontiers in economics and finance, 5(1), 106-130. ben naser, k., martinez, e., pineda, a. (2014), determinants of banks net interest margins in honduras wp163. imf working paper. brock, p.l., suarez, l.r. (2000), understanding the behavior of bank spreads in latin america. journal of development economics, 63, 113-135. dumicic, m., ridzak, t. (2012), determinants of bank’s net interest margins in central and eastern europe, croatian national bank. financial stability reports, different years, the central bank of jordan; 2014. fridman, m. (1983), prix et theorie economique. paris: economica. fungacova, z., poghosyan, t. (2011), determinants of bank interest margin in russia: does bank ownership matter? economic systems, 35(4), 481-495. hair, j., anderson, r., tatham, r., black, w. 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(2015), banks offer lottery prizes: what are the implications. journal of management, marketing and logistics, 2(3), 215-221. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(4), 104-112. international journal of economics and financial issues | vol 7 • issue 4 • 2017104 human capital investment and economic growth in saudi arabia: error correction model abla a. h. bokhari* department of economics, faculty of economics and administration, king abdulaziz university, jeddah, saudi arabia. *email: abokhari@kau.edu.sa abstract to examine the relationship between investment in human capital and economic growth in the kingdom of saudi arabia for the period 1970-2014. quantitative research design has been implemented. granger causality approach has been employed, followed by error correction model. the data stationarity and integration order have been tested, using the augmented dickey-fuller. any long-run or short-run causality was not observed between expenditure on education and economic growth (per capita gross domestic product). 73.6% variation has been indicated by fixed capital formation of gross national product, which is considered as an effective aspect. the results indicated that results are statistically significant with p value (0.000) at 5% level of significance. investment in human capital, with the right policy assessments and rehabilitation, can be translated into an essential element of growth in the saudi economy. keywords: economic growth, human capital, error correction model jel classifications: g0, g10, g38 1. introduction human capital alludes mainly to heath, education on-job training. according to imran et al. (2012) “the aggregation of the innate abilities and the knowledge and skills that individuals acquire and develop throughout their lifetime.” according to ocel report, human capital can be termed as “the knowledge, skills, competencies and attributes embodied in individuals that facilitate the creation of personal, social and economic well-being” (oced, 2001. p. 18). the human capital and economic growth relationship lingered as an important subject matter in the literature of economic theory. it is copiously used in both historical literature and economic research. nowadays, there is expanding evidence on the significance of human capital investment in sustaining economic growth. in saudi arabia, a considerable emphasis on human research was placed due to its essential role in accomplishing the objectives of socio-economic development and growth. allocations assigned for human resources development, witnessed a remarkable continuous increase during the country’s developing process, and its nine (5-year) plans (1970-2015). expenditure on human resource development accounted for sr7 billion during the first program (1970-1975)1, while investment in social and health amounted to sr3.5 billion. maintaining to give priorities for human resources, the country allocated sr731.5 billion (50.6% of total government expenditure on development) for human resources during the ninth plan, and sr273.9 billion (18.96) for social and health (ministry of economics and planning, 2014). coping with rapid worldwide economic and technological changes, saudi arabia focuses on putting more efforts and programs for the sake of developing its human resources’ capacities. despite this, several challenges need further efforts targeting the development of human resources. in addition to the heavy reliance on oil, saudi arabia is facing several economic challenges in term of its human resources. the primary intention of the study was to find the impact of saudi arabian investments on human resources and economic growth. expenditure on health and education was used as proxies for human capital investments. the fixed capital formation was the proxy for physical capital, and economic growth was explained by per capita gross domestic product (gdp). 1 this amount was mainly allocated for education. bokhari: human capital investment and economic growth in saudi arabia: error correction model international journal of economics and financial issues | vol 7 • issue 4 • 2017 105 the error correlation model has been applied to examine the human capital investment and economic growth in saudi arabia. the strong connection between the error correction and cointegration models stems from the granger theorem of representation. this theorem states that two or more integrated time series, which are cointegrated have a representation of error correction. precisely, these concepts are isomorphic as each idea implies of others. it is important that the statistically model integrated data must make reference to the many econometric error correction models (ecms) (grant and lebo, 2016). the causal relationship is carried out for the period 1971-2014, following granger causality and ecm approaches. the study has been divided into three sections. the theoretical framework regarding the association between human capital and economic growth is represented in the first section. also, a brief of previous empirical studies has been reviewed. the second section concerns with the empirical model of investigating the relationship between investment in human capital and economic growth. estimates are carried out through e-views statistical package. johansen (1991) co-integration approach has been performed, followed by ecm and granger causality test. in the third section, finally, the empirical results discussion, and present some concluding remarks have been summarized. 2. theoretical framework economists have long recognized human resource as an essential element of nations’ wealth. the idea that investment in human resources results in increased economic growth, date back to the time of smith (1776), or even earlier2. in this book “wealth of nations,” smith introduced human being as a part of the nations’ wealth, by which he developed the basic concepts of growth theory. subsequently, many other scholars involved importance to the idea of human capital as an investment that generates a return. however, these contributions had not been firmly developed into theoretical formation till the second half of the twentieth century. in pursuit of the upsurge of growth theory in the 1950s and 1960s, the relationship between human capital and economic growth gained increasing visibility and had been extensively discussed in the economic literature. a growing attention was given to the quality of labor, especially the level of education and training. based on solow’s (1956), the contribution and the analysis of growth accounting turn out to be increasingly prevalent. following by chicago school studies (schultz, 1961; becker, 2009), the obvious entrant was human capital. earlier, economists limited their views of human capital to the importance of acquired skills through education from which better opportunities and salary differentiation can be accrued. in its place, chicago school theories measured the impact of human capital on economic growth at the macro level. 2 the concept of co-integration has been introduced by granger (1983) followed by engle and granger (1988), then tested with the var approach by johansen (1988). johansen method allows for more than one cointegrating regression, unlike the engle–granger approach. theodore schultz (1961)3 played a crucial role in emerging the awareness for the importance of human capital investment. it has mainly recognized the human capital as one of the important factors that determine economic growth. this theory concentrated on the investment in human capital that yields a return over an extended period. six major categories have been discussed: healthcare services and facilities; on-job training; formal education, elementary, secondary and higher levels; study programs for adults; and migration for the sake of job opportunities. becker (2009) developed the main idea of what is termed as “the economic approach of human behavior,” presenting education as an instrument to obtain qualified and better-paid job opportunity. investment logic was patiently embraced when speaking about education and training, using the impact of differences in abilities and differences in opportunities. later, becker the work of 1962, defined human capital theory in terms of the individuals’ investment in education up to the point, where their return from extra income will be equal to the cost of education4. subsequently, the endogenous theories of growth focus on the significance of human capital on economic growth and emerging a notable pioneering study in this field (romer, 1986; barro, 1991). similar to physical capital, lucas (1988) clarified human capital as a factor of production in theory. it has been claimed that the accumulation of human capital is accountable for a sustained economic growth. barro (1991) declared that educational situation of a country is considered as a motor generating tool for economic growth. thus, based on this theory, human capital impact on economies appear mainly through capital accumulation, which is generated through education and health. when the society education and the population health (human capital) increase, the productivity increases, and correspondingly, welfare and economic growth increase. over the last four decades, a large body of literature on economic growth has been produced exploring the association between human capital investment and economic growth directly. a large number of growth regressions including human capital variables have been presented. in this study, barro (1991) applied data for 98 countries for the period 1960-1985, where the school enrollment rates of 1960 were used as a proxy for human capital as related to the real growth rate per capita gdp. the results showed that 1% percentage increase in the enrollment of primary school and secondary school caused 2.5% and 3% increase in gdp growth respectively. it has been concluded that there is a significant difference between the gdp growth and education. akpolat (2014) studied the long-run impact of both human and physical capitals on economic growth, using the panel data set of thirteen developed and eleven developing countries. the results suggested that the effect of physical capital and education expenditures on economic growth during 1970-2010 in the developed countries was higher than effects in the developing countries. inversely, the influence of life expectancy at birth on economic growth is higher in the developing countries. 3 schultz is a nobel prize-winning economist who was credited for embedding the concept “human capital,” and he was the first to relate productivity and education. 4 in his nobel lecture “the economic way of looking at life,” published by journal of political economy. bokhari: human capital investment and economic growth in saudi arabia: error correction model international journal of economics and financial issues | vol 7 • issue 4 • 2017106 various theoretical literatures assessed the importance of human capital as an element of the economic growth; empirical studies revealed conflicted results and human capital has been depicted as a driver of economic growth for developing countries as well (hanushek, 2013; whalley and zhao, 2013; murphy and topel, 2016). human capital provides with the skills and knowledge that is brought by an individual to an organization (hanushek, 2013). some of them state that human capital positively affects the economic growth, while some deny the existence of any relation between economic growth and human capital components. their mixed and ambiguous results may be due to several reasons, which includes the adopted methodology and estimating approach, spurious regressions, data quality and the selected variables as proxies for human capital. 3. empirical studies human capital is introduced differently in empirical studies depending on the theory, and often been measured concerning explicit knowledge and cognitive skills. hence, education and training are considered as key contributors to knowledge and expertise development and used to influence the human capital impact in the production and growth process (wilson and briscoe, 2004). while, barro (1991) measured school enrollment rates for the purpose of examining the association between economic growth and human capital. some other economists estimated the stock of human capital employing different educational factors such as education expenditure (akpolat, 2014), tertiary education (chudárková and verner, 2012), quality of schooling (hanushek and kimko, 2000)5, skilled-adults (romer, 1986) or research and development (r and d) (khan et al., 2015). factors such as high-level qualification; the level of graduation output; the number of hours per week spent on self-study; rates of return to education; matching of education to occupation; and many others are mentioned by oced (2001)6. mostly, standard health indicators used in literature included the public spending on healthcare expenditure (elmi and sadeghi, 2012); per capita health expenditures (hassan and kalim, 2012); numbers of beds in medical institutions (taban, 2006); life expectancy at birth (akpolat, 2004; taban, 2006). regarding the society, health level is an essential element that contributes to human capital; taban (2006) examined the causal relationship between health and economic growth in turkey. several health indicators have been used in the matter of its relation to economic growth. the number of beds in medical institutions, the number of persons per health care providers, and life expectancy at birth were utilized as proxies for human capital. all previous indicators have found a causal relation with gdp, except the number of medical institutions. rivera and currais (2003) investigated the effect of health investment on productivity in organization for economic 5 however, hanushek and kimko (2000) does not attempt to use alternative formulations of modeling application, but rather they concentrate on constructing new measures of labor-force quality and student cognitive performance. these two factors were found to be necessary for growth. 6 a total of 24 factors are introduced to measure human capital by the oecd in 2001 on “the well-being of nations: the role of human and social capital.” co-operation and development (oecd) countries employing log-linear equation based on the augmented solow model. the results have shown the positive impact in the health sector of the economy (helliwell et al., 2014). with the higher rates of human capital and physical accumulation, long-term sustainable economic growth is established. it relies on the capability of economy to assemble financial resources and to ensure the admittance by people to the productive assets, which must be invested more effectively. this process may review the role that financial institutions have played in growth and financial intermediation, explicitly to assemble the savings and allocate them to most growth-promoting and productive activities. the main dispute is that greater financial intermediation, provides rise to the higher productivity; and thus, obtaining higher national income/per capita (mahran, 2012). a study by mahran (2012) examined the empirical association between financial intermediation and economic growth for saudi arabia during the last decades. the autoregressive distributed lag technique has been adopted to co-integrate the related ecm. the results indicated that financial intermediation has influenced negatively on long-run real gdp despite the minimal limitations imposed on the working of domestic financial system. samargandi et al. (2014) investigated the influence of the financial development on economic growth concerning the oil-rich economy of saudi arabia. by doing so, a difference has been established between the influences of financial development on the non-oil or oil sectors of the economy. the results have evaluated that the financial development has a positive effect on growth of the associated non-oil sectors. in comparison, its effect on the total gdp growth and oil-sector growth is either insignificant or negative. it has been recommended that the association between the growth and financial development might be essentially diverse in resource dominated economies. other studies confirmed the positive bidirectional causality between human capital and economic growth in the short-run or the long-run terms, the role of physical and human formation has also been studied (tang, 2011; aka and dumont, 2008; bilgili and ozturk, 2015). following the emc methodology, rahman (2011) found bidirectional causality between education expenditure and gdp in bangladesh for the period 1990-2009. elmi and sadeghi (2012) revealed that there is a unidirectional short-run causality from gdp to health care spending in developing countries during the period 1990-2009. hussin et al. (2012) found that economic growth has a bidirectional longrun with education and labor while, in the short-run granger causality indicated a significant coefficient of education. whereas, insignificant coefficient of labor as related to gdp growth in malaysian economy was also indicated during the period 1970-2010. hassan and kalim (2012) found long-run triangular bidirectional causality between education, health and gdp in pakistan during 1960-2012. rehman et al. (2014) suggested bidirectional causality in long-run and short-run causality between enrollment in both primary and high schools and economic growth. however, a significant impact appears bokhari: human capital investment and economic growth in saudi arabia: error correction model international journal of economics and financial issues | vol 7 • issue 4 • 2017 107 for primary school compared to high school enrollment on the economic growth in pakistan. 4. methodology the impact of human capital investment on the economic growth in saudi arabia during 1971-2014 has been evaluated by utilizing qualitative and quantitative method. augmented dickey-fuller (adf) unit root tests was applied to test the data properties and their stationarity. the existence of log-run relationship between the series of variable was evaluated. vector ecm (vecm) was established to identify short-run relationship and error correction term (ect). granger causality was applied to examine the evidence of a bidirectional causal relationship between investment on health and economic growth. figure 1 has elaborated the procedure graphically below. furthermore, the study has evaluated the impact of human capital investment on the economic growth by applying regression analysis using spss version 20 and eviews. 4.1. empirical model in this section, ecm is applied to examine the causal relationship between investment in human capital and economic growth. income (gdp) per capita has been used7 to measure the economic growth. for human capital investment, two proxies have been used, which includes education as measured by government expenditure on education (formal and literacy) and health as measured by government spending on health. as both human and physical capitals directly affect the productive capacity of the economy, gross fixed capital formation is induced in the model, as a proxy for physical capital. the time series data for all variables during the period 1971-2014 was attained from official national statistics, published by the saudi arabian monetary agency. adopting error correction mechanism in examining the relationship between investment in human capital and gdp growth involves three main steps. first, determining the integration order by using adf unit root test, second, running co-integration test, third and last, investigating the long-run and short-run causality relationship. 4.1.1. model specification the model equations’ variables were converted to the logarithmic form, as followed: lgt = α1 + β1let + δ1lht + γ1lft + εt1 (1) let = α2 + ϕ2lgt + δ2lht + γ1lft + εt2 (2) lht = α3 + ϕ3lgt + β3let + γ3lft + εt3 (3) lft = α3 + ϕ4lgt + β1let + δ4lht + εt4 (4) where, t lg = per capita gross domestic product, 7 as; it enables to expand the country’s output at a faster rate than its population growth rate. le = expenditures on education, lh = expenditures on health, lf = gross fixed capital formation, α, β, δ, γ, ϕ = variables parameters, ε = random disturbance term. 4.1.2. unit root test to examine the above-mentioned relationship, the first and most important phase to run a non-spurious regression, detecting the non-stationary variables has been carried out8. data series was examined for the existence of possible unit roots to detect the integration order of the model variables. adf, initially formulated by dickey and fuller (1979; 1981), unit root test was obtained to check data stationarity9. since the absolute value of adf statistic at level is lower than the critical value; the four variables have a unit root (not stationary). but they became stationary after the first difference (with intercept, with intercept and trend, and without both), at 1% level of significance, as shown in figure 1. when the first difference was taken, the unit root was eliminated, as shown in table 1. thus, the first difference series, can be directly used for the time series econometric modeling (co-integration regression). 4.1.3. co-integration using the methodology developed in johansen (1991) enables to run the vector auto-regression (var) model based on co-integration test. 8 generally, non-stationary of explanatory variables due to the presence of unit roots lead to spurious regression and misleading results. in spurious regression, a high value of r and a lower value of durbin–watson statistics are likely to be found. 9 a series is thought to be stationary when the mean and autocovariance of the considered series do not depend on time. if time series are not stationary (non-stationary), the assumptions for the asymptotic analysis of engle/ granger causality test will not be useable. figure 1: procedure to evaluate the impact of human capital investment on the economic growth in saudi arabia bokhari: human capital investment and economic growth in saudi arabia: error correction model international journal of economics and financial issues | vol 7 • issue 4 • 2017108 1 1 1 1 1 1 1 1 1 1 1 1 0 1 1 1 0 0 t t t t p p t t i t i i i p p t i t i i lg lg le lh lf lg le lh lf u α ϕ β δ γ ω φ θ ψ − − − − − − = = − = = ∆ = + + + + + ∆ + ∆ + ∆ + ∆ + ∑ ∑ ∑ ∑ (5) 2 2 1 2 1 2 1 2 1 2 2 0 1 2 2 1 0 0 t t t t p p t t i t i i i p p t i t i i le lg le lh lf lg le lh lf u α ϕ β δ γ ω φ θ ψ − − − − − − = = − = = ∆ = + + + + + ∆ + ∆ + ∆ + ∆ + ∑ ∑ ∑ ∑ (6) 3 3 1 3 1 3 1 3 1 3 3 0 0 3 3 1 1 0 t t t t p p t t i t i i i p p t i t i t lh lg le lh lf lg le lh lf u α ϕ β δ γ ω φ θ ψ − − − − − − = = − = = ∆ = + + + + + ∆ + ∆ + ∆ + ∆ + ∑ ∑ ∑ ∑ (7) 4 4 1 41 1 4 1 4 1 4 4 0 0 4 4 1 0 1 t t t t p p t t i t i i i p p t i t i i lf lg le lh lf lg le lh lf u α ϕ β δ γ ω φ θ ψ − − − − − − = = − = = ∆ = + + + + + ∆ + ∆ + ∆ + ∆ + ∑ ∑ ∑ ∑ (8) as johansen (1991) approach is quite sensitive to the lag length, the suitable number of lag should be determined in a systematic manner. to do that, several selection information criteria can be used10. in this study, akaike information criterion (aic) has been selected. the criterion specified optimal lag length at p = 2 (2nd order) of the var model subjected to co-integration restrictions. the two suggested tests find out the number of co-integration vectors the included the trace and maximal eigen value statistics applied. according to the results in table 2, both trace test and max-eigen value test yield two co integrating equations at the 0.05 level. 4.1.4. ecm and causality test as series are known to be co-integrated confirming two co-integration vectors, hence a long-run equilibrium relationship existed between investment on education, health, fixed capital formation and per capita gdp. granger causality test and the vecm can be carried out at this stage. ect is demonstrated as shown in the following equations: 11 11 11 1 0 11 11 1 1 1 0 0 p p t t i t i i i p p t i t t i i lg lg le lh lf ect α ω φ θ ψ η µ − − = = − − = = ∆ = + ∆ + ∆ + ∆ + ∆ + + ∑ ∑ ∑ ∑ (9) 22 22 22 0 1 22 22 2 1 2 0 0 p p t t i t i i i p p t i t t i i le lg le lh lf ect α ω φ θ ψ η µ − − = = − − = = ∆ = + ∆ + ∆ + ∆ + ∆ + + ∑ ∑ ∑ ∑ (10) 10 such as, aic; hannan-quinn criterion; schwartcz information criterion; mean absolute error; and final prediction error criterion. table 1: results of adf unit root variables at level first difference intercept/no trend intercept/trend no intercept/no trend intercept/no trend intercept/trend no intercept/no trend lg −3.041565 (0.0391) −3.229640 (0.0926) 1.260463 (0.9448) −4.916098 (0.0002) −4.977586 (0.0012) −4.653409 (0.0000) le −4.999500 (0.0002) −6.286305 (0.0000) 3.412827 (0.9997) −8.328533 (0.0000) −9.444136 (0.0000) −6.068577 (0.0000) lh −0.269377 (0.9198) −3.324266 (0.0789) 2.834116 (0.9984) −3.883322 (0.0049) −5.703891 (0.0002) −2.953072 (0.0042) lf −2.027583 (0.2744) −2.484096 (0.3340) 2.174728 (0.9919) −8.588125 (0.0000) −8.590756 (0.0000) −7.821291 (0.0000) results of johansen co-integration test hypothesized number of ce (s) trace statistic 0.05 critical value max-eigen statistic 0.05 critical value none 182.5321 47.85613 139.9088 27.58434 at most 1 42.62323 29.79707 34.71728 21.13162 at most 2 7.905945 15.49471 7.014212 14.26460 at most 3 0.891734 3.841466 0.891734 3.841466 adf: augmented dickey-fuller bokhari: human capital investment and economic growth in saudi arabia: error correction model international journal of economics and financial issues | vol 7 • issue 4 • 2017 109 33 33 33 0 1 33 33 3 1 3 0 0 p p t t i t i i i p p t i t t i i lh lg le lh lf ect α ω φ θ ψ η µ − − = = − − = = ∆ = + ∆ + ∆ + ∆ + ∆ + + ∑ ∑ ∑ ∑ (11) 44 44 44 0 0 44 44 4 1 4 0 1 p p t t i t i i i p p t i t t i i lf lg le lh lf ect α ω φ θ ψ η µ − − = = − − = = ∆ = + ∆ + ∆ + ∆ + ∆ + + ∑ ∑ ∑ ∑ (12) the vecm estimated results based on the baseline co-integrated model indicated that ect found to be significant, insuring the existence of a long-run equilibrium between variables. the speed of adjustment toward long-run equilibrium is about 0.36, meaning that 36% of the preceding period’s disequilibrium, which was corrected by the system in the current period. in the same way, 36% of the previous year’s gdp disequilibrium in the long-run will be eliminated each year. the ect is insignificant neither the education nor in fixed capital formation equations. in the health equation, the coefficient on the ect (−1) is 0.019, indicating that 1.9% of adjustment is needed in the long-run (table 3). when long-run co-integration between variables is confirmed, engle and granger (1987) suggested that the existed causal association must be either in one direction (unidirectional causality) or both directions (bidirectional causality). at this point, causality test can be employed, noting that the standard causality test is more suitable for the stationary series11. alternatively, granger causality/block exogeneity wald test has been employed based on vecm to determine the causality directions. table 4 displayed chi-squared statistics for the joint significance of the model explanatory variables. as shown, there is no causality association between expenditure on education and gdp growth, but between education expenditure and health. unidirectional causality has been found from fixed capital formation and gdp, and from health expenditure to capital formation. the relationship between health expenditure and gdp seems to be the only bidirectional causality in the model. the short-run causal relationships are conducted using the wald test, from which the results suggested that lh and lf are the granger causality of the lg in the short-run. this stated that in the short-run per capita gdp will be affected by health expenditure and fixed capital formation. while, insignificant coefficient of education expenditure (le) indicated that investment on education does not influence economic growth in the short-run. additionally, lg and le are the granger causality for health expenditure (lh), which is, in turn, granger causality for capital formation (lf) in the short-run. in comparison with physical capital (fixed capital formation), investment in human capital (expenditure on education and expenditure on health) jointly have a higher significant impact on economic growth (per capita gdp). the results in table 5 have shown the pearson correlation between gross national product (gnp) and expenditure on education. the relationship between gnp and expenditure on education is highly and positive correlated. the results also predicted that this relationship is statistically significant at 5% level of significance (0.000 < 0.05, n = 44). the results have shown correlation between gnp and expenditure on health. the relationship between gnp and expenditure on health illustrated to be highly and positive correlated. with the p = 0.000, the results predicted to be statistically significant at 5% level of significance. pearson correlation test has also been applied among gnp and fixed capital formation. the pearson correlation coefficient has determined that the relationship between gnp and fixed capital 11 test the degree of causality among two variables, determining whether the endogenous variable can be treated as an exogenous variable or not. meanwhile, the block exogeneity causality in vecm eliminates the influence of all other endogenous variables other than the lag of the considered dependent variable. table 2: vecm variable coefficient se t-statistics ect (−1) 0.357814 0.28237 1.26717 d(lg (−1)) 0.347045 0.23294 1.48985 d(lg (−2)) −0.0.82946 0.26186 −0.31676 d(le (−1)) 0.058258 0.14532 0.40089 d(le (−2)) −0.076091 0.13811 −0.55095 d(lh (−1)) −0.006703 1.56358 −0.00429 d(lh (−2)) 1.138702 1.09112 1.04361 d(lf (−1)) −0.310955 0.14190 −2.19142 d(lf (−2)) −0.032024 0.12562 −0.25493 c 0.006245 0.03879 0.16099 r2 0.694832 f-statistic 6.830653 adjusted r2 0.593109 p (f-statistic) 0.000019 se of regression 0.130960 mean dependent variable 0.058040 sum squared residual 0.514519 sd dependent variable 0.205306 log likelihood 31.57447 durbin–watson statistics 1.692399 se: standard error, sd: standard deviation, vecm: vector error correction models, ect: error correction term figure 2: variables conversion to stationary source: e-views results. bokhari: human capital investment and economic growth in saudi arabia: error correction model international journal of economics and financial issues | vol 7 • issue 4 • 2017110 formation, which was positively correlated. the results have also stated that this relationship is statistically significant with the p value (0.000) at 5% level of significance. the results for regression analysis have shown the dependency of education expenditure on gnp. the coefficient of determination (r2) has determined the total variation by the education expenditure in the gnp. a total of 80.5% variation is indicated by the expenditure on education in the total variation of gnp, which is assumed to be large. the results also indicated that results are statistically significant with p value (0.000) at 5% level of significance. it means that gnp of saudi arabia can be increased with an increase in expenditure on education. the regression analysis between gnp and health expenditure has also been evaluated. the results have indicated that these two variables are statistically significant with p value (0.000) at 5% level of significance. however, the total variation in the gnp has been explained by the health expenditure. the coefficient of determination has indicated that 83.4% variation is explained by health expenditure on gnp. it can be determined that, with the increase in health expenditure gnp also increases. the results for regression analysis have shown the dependency of fixed capital formation on gnp. the coefficient of determination (r2) has determined the total variation by the fixed capital formation in the gnp. a total of 73.6% variation is indicated by the fixed capital formation in the total variation of gnp, which is assumed to be large. the results were statistically significant with p value (0.000) at 5% level of significance. it means that gnp of saudi arabia can be increased with an increase in fixed capital formation. the results have also shown the results obtained by applying the regression analysis through eviews, taking dependent variable “gnp”, and independent variables expenditure on education, expenditure on health and fixed capital income formation respectively. the results of all three variables are same as the regression applied on spss. the results for all three independent variable taking “gnp” as dependent variable are found to be statistically significant. 5. discussion in the present study, expenditure on health and education has been considered as the core proxy for investment in human capital. physical capital has been employed in empirical studies with a comparison of human capital and associated impact on the economic growth12. even though the impact of human capital on economic growth is the targeted subject; whereas, physical capital, and economic growth relationship are also noteworthy. the causal relationship between human capital and gdp in bangladesh for the period 1990-2009 has been studied by rahman (2011), which included the real gross fixed capital formation in the proposed empirical model. a significant stable long-run relationship existed between all variables according to the results. it has been mentioned that including human capital investment in the growth model of bangladesh improved the significance of physical capital coefficients. imran et al. (2012) reported that physical capital did not contribute to economic growth in pakistan because the human capital was not supported as required. total productivity relies on the effective interaction of human and physical capitals. hussin et al. (2012) revealed that fixed capital formation (physical capital) has a positive relationship with gdp. examining a panel set of data for the period 1970-2010 of 13 developed and 11 developing countries, akpolat (2014) realized that investment in physical capital and education are more efficient to increase 12 rahman (2011), imran et al. (2012), hussin et al.(2012), akpolat (2014), khan et al. (2015) and many others. table 4: regression analysis variables coefficient se t-statistic p gnp and expenditure on education 314998.3 38136.95 8.259661 0.0000 gnp and expenditure on health 365518.6 32633.37 11.20076 0.0000 gnp and fixed capital formation 329389.4 44438.93 7.412181 0.0000 gnp: gross national product, se: standard error table 3: vec granger causality/block exogeneity wald tests dependent variable∆lg dependent variable∆le dependent variable∆lh dependent variable∆lf variables chi-square variables chi-square variables chi-square variables chi-square ∆le 1.008329 (0.6040) ∆lg 3.039807 (0.1287) ∆lg 7.503035 (0.0235) ∆lg 1.281570 (0.5269) ∆lh 7.189892 (0.0275) ∆lh 1.878448 (0.3909) ∆le 9.355696 (0.0093) ∆le 0.497867 (0.7796) ∆lf 6.236271 (0.0442) ∆lf 0.693535 (0.7070) ∆lf 2.247113 (0.3251) ∆lh 41.95792 (0.0000) all 49.70004 (0.0000) all 17.45153 (0.0078) all 21.23711 (0.0017) all 104.7129 (0.0000) pearson correlation tests correlation between gdp and expenditure on education 0.897 correlation between gdp and expenditure on health 0.913 correlation between gdp and fixed capital formation 0.858 gdp: gross domestic product, vec: vector error correction bokhari: human capital investment and economic growth in saudi arabia: error correction model international journal of economics and financial issues | vol 7 • issue 4 • 2017 111 gdp in the developed countries as compared to the developing countries. the direction of causal relationship between physical capital and economic growth has been embraced in the causality analysis implemented by khan et al. (2015). while investigating human capital and economic growth nexus, the result indicated the importance of physical capital as a factor of production in the economic growth of pakistan. concerning the granger causality relationship, empirical studies fall short of providing the consensus results. several studies could not confirm the influence of human capital on economic growth. amassoma and nwosa (2011) found no causality between human capital development and economic growth in nigeria. khan et al. (2015) stated that there were no long-run or short-run causal relation between health and economic growth in pakistan during the period 1971-2012. hassan and kalim (2012) suggested that no causality found between per capita health expenditure and capita gdp in the short-run, but it exists on the long-run. jihène (2013) found no significant relationship between human capital and economic growth in morocco and tunisia, while a significant relation existed in case of japan and korea. unlike previous studies, a unidirectional causal relationship has been identified in several studies, either from human capital to growth or from growth to human capital. mehrara and musai (2011) indicated a unidirectional causal impact from gdp to health expenditure while they have no supported evidence that health expenditure can promote long-run economic growth in iran. in a later study, mehrara and musai (2013) found a strong causality from economic growth to education. education does not have any significant impact on economic growth in shortor long-run. in greece, solaki (2013) suggested a positive relationship between education and economic growth in the period 1961-2006. the results mentioned a unidirectional causality running from tertiary education and public expenditure on education to real per capita gdp. secondary education seems to be oppositely directed referring to the influence from real per capita gdp to secondary education. however, elmi and sadeghi (2012) confirmed a unidirectional short-run causality from gdp to health care spending; however, in the long-run, bidirectional relationship has been found between health care spending and economic growth. briefly, according to the previous empirical studies’ reviewed in the present study showed that the impact of investment in human capital on economic growth is still arguable. while some might have declared that it has the significant effect, others fail to prove this. the casual direction of the relationship between factors included as human capital and economic growth have also been observed arguable. consequently, the present study has evaluated the long-run and short-run causal relationships between investment in human capital (namely education and health) and saudi arabian economic growth have been attempted. 6. conclusion in the attempt to investigate the impact of human capital investment on economic growth in saudi arabia during 1971-2014, the ecm approach has been employed. data properties were examined to verify their stationarity using adf unit root tests, which indicated that variables tested stationary at first order. johansen (1991) co-integration was confirmed, which clarified the existence of the long-run relationship between the four variables’ series. afterword, vecm was established to identify short-run relationship and ect. expenditure on education and fixed capital formation have found to be with non-significant impact on gdp. however, expenditure on health was observed strongly correlated with per capita gdp in the long-run and short-run. granger causality found evidence of a bidirectional causal relationship between investment on health and economic growth. it has shown a unidirectional causality from investment in health to investment in education and from physical capital to economic growth. however, it is pertinent to pinpoint that investment in human capital (expenditure on education and expenditure on health) jointly have a higher significant impact on economic growth (per capita gdp) than investment in physical capital (fixed capital formation). these results proved that the massive investments in education fail to generate productivity and growth in saudi arabia, but investment in health and physical capital significantly contribute to economic growth. 7. recommendations the desirable policy which government needs to estimate, can be through reforming its educational system to become more market oriented. increasing the quality and quantity of skills, innovations, r and d and entrepreneurship are needed to shift human capital towards the required participation in the real labor market, leading to higher and sustainable economic growth. references aka, b.f., dumont, j.c. 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(2004), the impact of human capital on economic growth: a review. impact of education and training, third report on vocational training research in europe: background report. luxembourg: office for official publications of the european communities, cedefop reference series, no. 54. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(special issue) 406-411. 2nd afap international conference on entrepreneurship and business management (aicebm 2015), 10-11 january 2015, universiti teknologi malaysia, kuala lumpur, malaysia. international journal of economics and financial issues | vol 5 • special issue • 2015406 relationship of transformational leadership, organizational learning and organizational performance amena y. mutahar1*, amran md rasli2, basheer m. al-ghazali3 1faculty of management, universiti teknologi malaysia, johor, malaysia, 2faculty of management, universiti teknologi malaysia, johor, malaysia, 3faculty of management, universiti teknologi malaysia, johor, malaysia. abstract purpose of this study is to analyze the influence of transformational leadership on organizational performance through the dynamic capabilities of organizational learning in telecom sector of kingdom of saudi arabia (ksa). structural equation modeling was used to test the research hypotheses. the data was collected through survey questionnaires which were distributed to the employees of telecom sector of ksa. a random sample of 70 employees was used to collect the data. the response rate was 80%. the results reveal that transformational leadership positively influences the organizational performance and learning. the study also confirms existence of positive association between organizational learning and performance. the study is useful for the managers in telecom sector to understand the impact of transformation leaders to enhance learning capabilities of the employees which ultimately increases the performance of the employees in telecom sector. keywords: transformational leadership, organizational learning, organizational performance jel classifications: d8; l25 1. introduction transformational leadership style boosts up consciousness of collective interest among the organization’s members and helps them to achieve their mutual goals. theories of transformational leadership emphasize emotions, values and the importance of leadership focused on encouraging creativity and new ideas in employees (garcía-morales et al., 2012). leadership plays a crucial role in firms’ innovation, because leaders can introduce novel ideas into an organization, establish specific goals, and encourage innovation initiatives from subordinates (noruzy et al., 2013). individual, group and organizational outcome have been associated with leadership styles, and transformational leadership is believed to achieve outstanding levels of outcome from their followers (khan et al., 2014). leadership leads to procedural changes which organizations are facing in the dynamic competitive environment and no doubt transformational leadership plays a crucial role in an organizational success. a number of studies have analyzed the impact of transformational leadership on the performance of organization via intermediate constructs such as entrepreneurship (garcía-morales et al., 2006), culture (ogbonna and harris, 2000), climate (yasir et al., 2013) similarity in top management teams (colbert et al., 2008), flexibility (rodriguez ponce, 2007), knowledge management (gowen et al., 2009), enhancing human resource management (zhu et al., 2005), and absorptive capacity (garcía-morales et al., 2008) and competitive strategies (menguc et al., 2007). nevertheless, having a complete understanding of all the processes through which leaders exert this influence is still quite limited and mostly speculative (bass, 1999). this research is to analyze empirically the influence of transformational leadership on the performance of the organization through organizational learning. 2. organizational learning organizational learning is the competency “within an organization to maintain or improve performance based on experience. this mutahar, et al.: relationship of transformational leadership, organizational learning and organizational performance international journal of economics and financial issues | vol 5 • special issue • 2015 407 activity involves knowledge acquisition (the development or creation of skills, insights, and relationships), knowledge sharing (the dissemination to others of what has been acquired by some), and knowledge utilization (integration of learning so that it is assimilated and broadly available and can be generalized to new situations)” (dibella et al., 1996). organizational learning is a continuous process through which an organization increases and enhances the knowledge generated by individuals in a systematic way through cognitive and behavioral change improvement and ultimately transforms this knowledge as a part of the overall organization’s knowledge system (senge, 1990). organizational learning comprises positive connotations, the reason being that this form of learning is associated with performance improvements (senge, 1990). previous research studies assert relationship between leadership and organizational learning (mcgill et al., 1992). transformation leadership establishes teams and provides them with the required direction, required energy and required support to execute the processes of change and organizational learning (bass, 1999). the basic purpose of organizational learning is to improve the quality and quantity of performance, allowing the firm to increase and improve sales, to achieve more support and to create, maintain and enlarge its customer base. further, organizations that learn and learn quickly increase strategic capability, enabling them to sustain a position of competitive advantage and improve their results. these attitudes, behaviors, and strategies of organizational learning guide organizations to superior long-term performance (bass, 1999; garcía-morales et al., 2012; noruzy et al., 2013). 2.1. transformational leadership and organizational performance the style of leadership has been emphasized as one of the most important individual influences on firms’ innovation, the reason being that leaders can directly decide to introduce new ideas into an organization, set specific goals, and encourage innovation initiatives from subordinates (noruzy et al., 2013). transformational leadership is a contemporary, hands-on approach that helps one leads people and brings change in organizations (bhat et al., 2013; qureshi et al., 2014; qureshi et al., 2015). bass (1999) defined transformational leadership as the style of leadership that leads to increased consciousness of shared interest among the members of the organization and it also helps them in achieving their collective goals. various theories of transformational leadership put emphasis on values, emotions and the importance of leadership in order to encourage creativity in employees. many research studies have concluded that transformational leadership has a positive influence on the performance of the followers and organizational outcomes. a number of comparative studies carried out by researchers have also testified that transformational leadership behaviors have a positive relation with subordinate effectiveness in multiple organizational settings (bass, 1999). transformational leadership usually carries an effect on performance which is over and above the effect exerted by transactional leadership (bass, 1999). transformational leaders possess charisma, deliver inspiration and also promote intellectual stimulation (bass, 1999). charisma is responsible for generating the pride, respect and faith that leaders work to inspire their employees to inculcate in them, their leaders, and the organizations for which they are working. the term organizational performance refers to capability of a firm to materialize such objectives as high profit, good financial results, large market share, quality product, and survival at pre-determined time utilizing relevant strategy for action (koontz and donnell, 1993). previous researchers found that there is direct influence of transformational leadership on organizational performance (bass, 1999; garcía-morales et al., 2008; garcía-morales et al., 2012; menguc et al., 2007). h1: a positive association exists between transformational leadership and organizational performance. 2.2. transformational leadership and organizational learning previous studies established the link between leadership and organizational learning (senge, 1990; senge et al., 1994; tushman and nadler, 1986). as transformational leadership develops teams and offers them with the required direction, required energy, and required support so that the processes of change and organizational learning can be induced (bass, 1999). the aforesaid style of leadership allows organizations enjoy learning through experimentation, exploration, and communication (menguc et al., 2007; senge et al., 1994; tushman and nadler, 1986). transformational leader will be a catalytic agent, an advisor, an organizer and a trainer in organizational learning. such a leadership style also lets the leader to compel him to learning, to become its main motivating force, and to offer whatsoever is required to overcome inner suspicion and outer problems and hurdles to institute learning within the organization (senge et al., 1994). the impact of transformational leadership on organizational communication and the effect of communication on organizational learning result in an indirect effect of transformational style of leadership on the organizational learning through communication in the organization (senge et al., 1994; argyris and schön, 1996). therefore, on the basis of the above opinions, the capacity for transformational leadership is considered to be one of the most important factors of developing organizational learning in firms (garcía-morales et al., 2012). h2: a positive association exists between transformational leadership and organizational learning. 2.3. organizational learning and organizational performance the extensive literature stresses the importance of organizational learning for the survival of organizations and its effective performance (argyris and schön, 1996; inkpen and crossan, 1995; senge, 1990). nevertheless, empirical research to analyze this relationship is limited, for the reason that various hurdles, such as vagueness or the time delay between the two (today’s learning will affect tomorrow’s performance) and the likelihood that external mutahar, et al.: relationship of transformational leadership, organizational learning and organizational performance international journal of economics and financial issues | vol 5 • special issue • 2015408 factors camouflage the results of learning. research must analyze empirically the impact of organizational learning on performance in technological firms. however, limited knowledge is available related to the mechanisms that transmute organizational learning into performance (inkpen and crossan, 1995). organizational learning is found to have a positive impact on performance improvements. this positive impact normally happens in both technological companies and manufacturing organizations (argyris and schön, 1996; senge, 1990). organizations that show an increased breadth, depth, and greater speed of organizational learning usually have greater performance degrees (garcía-morales et al., 2012; bass, 1999). those organizations which encourage the learning spirit sacrifice immediate performance in order to gain future performance, because immediate performance is due to the organizational learning drawn from yesterday, while future performance will be an outcome of today’s learning process (senge, 1990). h3: a positive association exists between organizational learning and organizational performance. figure 1 shows the research framework of the study. 3. methodology this section describes the methodology, including sample size of the research, sources used to get the data and statistical tools used for the analysis. 3.1. data collection and analysis a cross sectional survey method is used for the present study and the questionnaire used draws on the previous researchers (garcía-morales et al., 2012) and is adapted through appropriate modification to align with the kingdome of saudi arabia (ksa) context which helps establish the ecological validity and reliability of the instrument. the questionnaire is made up of two parts namely; part i) personal information of the respondents and background section with 7 items; part ii) transformation leadership, organizational learning, and organizational performance as perceived by the area, regional and branch managers and contains 3, 4, and 10 items respectively. total 70 survey questionnaires were distributed using snowballing technique to the area, regional and branch managers in telecom sector of ksa. a response rate of 80% was noticed in the study. structural educational modeling (sem) technique comprises of two parts that are done separately. the first part is measurement model stage that is performed to specify how the latent independent variables are measured with respect to observed dependent variables. the second part is structural model stage; this stage specifies the interrelationship of latent variables between constructs (hair et al., 1995). this analysis of the two separate models is tremendously important (hair et al., 1995). they are presented as a path diagram because of the complex nature of the models that highlights the relationship between both the measured variables and constructs (hair et al., 1995). the structural model was analyzed by using amos 18. 4. data analysis and results in the present study 12% of the respondents were <30 years of age, 30% between 31 and 35 years. 28% between 35 and 40 years while respondents who are among the age of 49 years and above is 30%. the maximum numbers of respondents were in the age group of 31-35 years and 49 years and above. 19% of the respondents were having higher education, 25% were having maximum education while 56% were having postgraduate qualification. data shows that 68% of the respondents were having the experience of <5 years in the current position, 23% were having the experience of 5-10 years in the current position, 7% of the respondents were having the experience of 15-20 years in the existing position while 2% were in the current position for 20 years to above. 4.1. reliability of constructs table 1 shows confirmatory factor analysis (cfa) results which were performed to determine the factor loadings for each item, along with its reliability scales (i.e. cronbach’s alpha and co-efficient rho). factor loading above than 0.50 indicated fitness of the item to latent constructs (hair et al., 1995). further the construct have reliability indicators above than 0.70 and are considerably internally consistent (hair et al., 1995). constructs having average variation extraction above 0.50 are producing considerable variation (hair et al., 1995). the questionnaire consists of four constructs including one exogenous and endogenous variable. transformational leadership construct is measured by three items and has the reliability of 0.722 and factor loading range of 0.60-0.79. organizational learning construct is measured by 04 items and has the reliability of 0.676, and factor loading range 0.55-0.66. organizational performance has six items with factor loading range 0.64-0.80, cronbach’s alpha at 0.84. this indicates figure 1: research framework table 1: factor loading and reliability analysis latent constructs items alpha value factor loading range transformational leadership 03 0.722 0.60-0.79 organizational learning 04 0.676 0.55-0.66 organizational performance 06 0.874 0.64-0.80 mutahar, et al.: relationship of transformational leadership, organizational learning and organizational performance international journal of economics and financial issues | vol 5 • special issue • 2015 409 that the questionnaire has the sufficient internal consistency, factor loadings and composite reliability. 4.2. cfa results cfa is a statistical technique used to verify the factor structure of a set of observed variables. cfa allows the researcher to test the hypothesis that a relationship between observed variables and their underlying latent constructs exists. the researcher uses knowledge of the theory, empirical research, or both, postulates the relationship pattern and then tests the hypothesis statistically. the study employed cfa on four latent constructs with transformational leadership having 3 items, organizational learning having 4 items, and organizational performance having 10 items. as the constructs are already determined, that is why cfa was used (figure 2). each item loading should be >0.5 in order to be considered. tables 2-4 shows the item loading of all items of our latent constructs: since the factor loading of last 4 items of last construct is <0.5, therefore they were excluded in subsequent phase and the new model is developed. 4.3. model fit summary (structural analysis) the model provides an acceptable fit to the data, i.e. the values of normed fit index (nfi), comparative fit index (cfi), root mean square error of approximation (rmsea), goodness of fit index (gfi) and adjusted goodness-of-fit index (agfi) were found according to the cut points in both the measurement models. model fit is achieved by testing the modification indices. gfi, rmsea and chi-square statistic are the indices that are usually used for measures that are called absolute fit measures. these measures find the degree to which the overall model predicts the observed covariance or correlation matrix. nfi, cfi and agfi figure 2: confirmatory factor analysis results figure 3: structural equation modeling result table 2: transformational leadership item statement factor loading tl1 my leader transmits the organization’s mission, reason for being and purpose to all employees 0.70 tl2 he/she increases employees level of enthusiasm 0.60 tl3 he/she emphasizes the use of employees intelligence 0.77 table 3: organizational learning item statement factor loading ol1 under his/her leadership, the organization has acquired and shared much new and relevant knowledge that has provided competitive advantage to the organization 0.60 ol2 the organization’s staff has acquired some critical capacities and skills that are providing competitive advantage 0.55 ol3 organization’s improvement have been influenced fundamentally by new knowledge entering the organization (knowledge used) 0.58 ol4 the firm is a learning organization 0.66 table 4: organizational performance item statement factor loading prf1 economic profitability or roa has increased during the last 3 years 0.75 prf2 financial profitability or roe has considerably increased during the last 3 years 0.80 prf3 return on sales (percentage of profits over billing volume) has increased during the last 3 years 0.70 prf4 during the last 3 years, market share of the organization is in its main products has increased 0.76 prf5 organization’s market share is in its main services in the market 0.64 prf6 during the last 3 years, there has been a tremendous growth in sales of organization’s main products 0.72 prf7 i intend to switch to the organization offering higher salary 0.4 prf8 the physical working conditions are very comfortable to work in 0.11 prf9 spirit of cooperation and teamwork exists in the organization 0.38 prf10 my organization assists me to gain more working experience in the job that i am doing 0.23 roa: return on assets, roe: return on equity, prf: ??? mutahar, et al.: relationship of transformational leadership, organizational learning and organizational performance international journal of economics and financial issues | vol 5 • special issue • 2015410 are the indices of measures that are known as incremental fit measures. these measures compare the proposed model to some baseline model, most often referred to as the null model. the null model should be some realistic model that all other models should be expected to exceed. byrne (2001) proposed a gfi model as measured by the gfi, claiming that gfi index must exceed 0.80. in addition, it is a basic criterion that both indices of nfi and ifi exceed 0.90 for acceptable model fitness, while the recommended fit values for cfi should be more than 0.90 and agfi more than 0.80. in general, if the value of χ2/df is smaller than 5, it is considered to be a good fit. conversely, a rmsea of <0.08 suggests a good fit. table 5 indicates the values of fit indices are above or equal to the standards. this shows that the model exhibits complete fitness of its variables. 4.4. analysis of model the final result of sem for this study is presented in the figure 3. according to figure 3, the standard coefficient of transformational leadership and organizational performance is 0.55 with a p < 0.05 which provides enough evidence to reject null and accept h1 which claims the positive relationship between transformational leadership and organizational performance. coefficient of relationship between transformational leadership and organizational learning is 0.52 and p = 0.01 indicates the positive and significant relationship between transformational leadership and organizational learning which accept the h2. path coefficient increased organizational learning will positively affect the organizational performance. h3 is stated as organizational learning positively relates with organizational performance. path coefficient between organizational learning and organizational performance is 0.37 and p = 0.03 depicts the acceptance of the hypothesis h3. table 6 provides the summary of the results. 5. discussion and conclusion the results show that there exists a strong relationship between transformational leadership and organizational performance. telecom industry needs transformational leadership to improve their organizational performance and the effect is further enhanced with the combined effect with organizational learning. the results also show that there exists a positive relationship between transformational leadership and organizational learning which is confirmed by other studies (garcía-morales et al., 2012; noruzy et al., 2013). the more the leader exerts influence as transformational leader, the more is the organizational learning. this study established relationship of the transformational leadership and organizational learning, so organizations which are striving for improving learning should focus on transformational leadership in the organization in order to improve organizational learning. 5.1. limitations and future research directions transformational leadership as an area of academic research is relatively at early stage in ksa. the result of this study can be used as a benchmark for other developing countries. this would hopefully add significant contribution to the conceptual and empirical research in this evolving area. the qualitative techniques can also be employed to further explore the nature and variables in this study. future researches may include the telecom organizations of other regions and/or corporate sectors. references argyris, c., schön, d.a. (1996), organizational learning it: theory. method and practice. reading, ma: addison-wesley. bass, b.m. (1999), two decades of research and development in transformational leadership. european journal of work and organizational psychology, 8(1), 9-32. bhat, a.b., rangnekar, s., barua, m. (2013), impact of transformational leadership style on organizational learning. elite research journal of education and review, 1(4), 24-31. byrne, b. (2001), structural equation modelling with amos. new jersey: lawrence erlbaum associate. colbert, a.e., kristof-broiatn, a.l., bradley, b.h., barrick, m.r. (2008), ceo transformational leadership: the role of goal importance congruence in top management teams. academy of management journal, 51(1), 81-96. dibella, a., nevis, e., gould, j. (1996), understanding organizational learning capability. journal of management studies, 33, 361-379. garcia-morales, v., llorens-montes, f., verdu-jover, a. (2006), antecedents and consequences of organizational innovation and organizational learning in entrepreneurship. industrial management & data systems, 106(1), 21-42. garcía-morales, v.j., jimenez-barrionuevo, m.m., gutierrezgutierrez, l. (2012), transformational leadership influence on organizational performance through organizational learning and innovation. journal of business research, 65, 1040-1050. garcía-morales, v.j., matías reche, f., hurtado torres, n. (2008), influence of transformational leadership on organizational innovation and performance depending on the level of organizational learning in the pharmaceutical sector. journal of organizational change management, 21(2), 188-212. gowen, c.r., henagan, s.c., mcfadden, k.l. (2009), knowledge table 5: model fit summary fitness indices standard values achieved values gfi ≥0.90 0.910 nfi ≥0.90 0.861 rmsea p<0.08 0.081 cfi ≥0.90 0.0.90 agfi ≥0.80 0.82 chi-square (χ2/df) <3 2.97 gfi: goodness of fit index, nfi: normed fit index, rmsea: root mean square error of approximation, cfi: comparative fit index, agfi: adjusted goodness-of-fit index table 6: summary of hypotheses hypotheses statement result h1 a positive association exists between transformational leadership and organizational performance accepted h2 a positive association exists between transformational leadership and organizational learning accepted h3 a positive association exists between organizational learning and organizational performance accepted mutahar, et al.: relationship of transformational leadership, organizational learning and organizational performance international journal of economics and financial issues | vol 5 • special issue • 2015 411 management as a mediator for the efficacy of transformational leadership and quality management initiatives in us health care. health care management review, 34(2), 129-140. hair, j., anderson, r.e., tatham, r.l., black, w.c. 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(2013), relations between transfromational leadership. organizational learning, knowledge management, organizational innovation, and organizational performance: an empirical investigation of manufacturing firms. international journal of advanced manufacturing technology, 64, 1073-1085. ogbonna, e., harris, l.c. (2000), leadership style, organizational culture and performance: empirical evidence from uk companies. international journal of human resource management, 11(4), 766-768. qureshi, m.i., khan, n.u., rasli, a.m., zaman, k. (2015), the battle of health with environmental evils of asian countries: promises to keep. environmental science and pollution research, 22(15), 1-8. qureshi, m.i., rasli, a.m., awan, u., ma, j., ali, g., alam, a., zaman, k. (2014), environment and air pollution: health services bequeath to grotesque menace. environmental science and pollution research, 22(5), 3467-3476. rodriguez ponce, e. (2007), leadership styles, strategic decision making and performance: an empirical study in small and medium-size firms. interciencia, 32(8), 522-528. senge, p., roberts, c., ross, r.b., smith, b.j., kleiner, a. (1994), the fifth discipline field book. new york: doubleday publ. senge, p.m. (1990), the fifth discipline: five practices of the learning organization. new york: doubleday. tushman, m.l., nadler, d.a. (1986), organizing for innovation. california management review, 28(3), 74-92. yasir, m., imran, r., irshad, m.k. (2013), mediating role of organizational climate in the relationship between transformational leadership, its facets and organizational performance. actual problems of economics/aktual’ni problemi ekonomìki, 145(7), 559. zhu, w.c., chew, i.k.h., spangler, w.d. (2005), ceo transformational leadership and organizational outcomes: the mediating role of human-capital-enhancing human resource management. leadership quarterly, 16(1), 39-52. . international journal of economics and financial issues | vol 6 • special issue (s3) • 2016144 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s2) 144-152. special issue for “asia international conference (aic 2015), 5-6 december 2015, universiti teknologi malaysia, kuala lumpur, malaysia” what does matter? liquidity or profitability: a case of sugar industry in pakistan muhammad zulqarnain safdar1*, muhammad zahid awan2, zeeshan ahmed3, muhammad imran qureshi4, tafakhar hasnain5 1department of management sciences, abbottabad university of science & technology, abbottabad, kpk, pakistan, 2department of business administration, gomal university, dera ismail khan, kpk, pakistan, 3department of business administration, gomal university, dera ismail khan, kpk, pakistan, 4department of commerce, gomal university, dera ismail khan, kpk, pakistan, 5department of business administration, gomal university, dera ismail khan, kpk, pakistan. *email: zulqarnain.safdar@gmail.com abstract keeping in mind the keynes of the pakistan’s sugar industry in its overall economic well-being, the current work objects to examine the liquidityprofitability trade off in sugar industry of pakistan. secondary data of the non-financial companies which are listed on kse is used for sugar industry over the last 5 years. present study used different analytical tools like reliability analysis, descriptive statistics, multiple regression analysis, correlation and tests of significance to test the causal linkage in liquidity and profitability. results of regression analysis showed that, hypothesis one is rejected because liquidity generates positive impact on return on assets (roa) and found significant at 1% level. hypothesis two of the current study is rejected because liquidity causes positive impact on return on equity (roe) and found significant at 1% level. according to regression analysis, hypothesis three is also rejected because liquidity influences return on capital employed (roce) positively and found significant at 1% level. results of correlation analysis discovered that liquidity of sugar mills is positively and significantly correlated with all measures of profitability, i.e., roa, roe and roce. findings of current research suggest managers to come out of the dilemma with respect to liquidity and profitability tradeoff. it is further concluded that managers can increase the firm’s profitability and shareholder’s value if they invest effectively and efficiently in liquid assets. finally this study’s results make it important for the reason that it is one of the fewer researches going in contrast to the existing knowledge base. keywords: liquidity, profitability, trade-off, sugar industry of pakistan jel classification: g33 1. introduction one of the basic concerns of managers and different business owners around the globe is to formulate a strategy so that they can manage their company’s routine operations to meet the obligations they are subject to, for enhancing shareholder’s wealth and profitability (eljelly, 2004). liquidity tends to play an imperative role in the smooth running of any business organization (bhunia, 2010). one of the key issues in liquidity management is the attainment of preferred liquidity-profitability trade off (raheman et al., 2009). nwaezeaku (2006) conceptualize liquidity as the feasibility by which assets can be converted in to cash form (when selling is made at market price) or the extent to which an asset is convertible to cash. bodie and merton (2000) are of the opinion that relative ease, cost and speed with which an asset can be converted into cash is called liquidity. owolabi et al., (2011) argued that liquidity of various companies is a necessity to make sure that they are capable to meet their obligations in short-term period of time. inadequate liquidity potentially forced the firm to liquidate their assets and result in poor credit standing (zainudin, 2006). liquidity-profitability trade off is an important aspect regarding working capital management. the organization’s working capital is in low amount; it increases profit but reduces liquidity (dash and ravipati, 2009). the components of working capital are connected to a firm’s liquidity feature (enyi, 2006). when the revenues a company surpass its expenses then this safdar, et al.: what does matter? liquidity or profitability: a case of sugar industry in pakistan international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 145 called profitability (ajanthan, 2013). the increase in profits at the expense of liquidity is a threat for the organization that brings hurdles for company. for that reason, there should be maintained a liquidity-profitability trade off, ultimately two main aims of an organization (raheman and nasr, 2007). profitability serves as a tool that measures a company’s economic achievement in relation to its capital invested (pimentel et al., 2010). a company with heavy investment in short-term assets results in reduction of this rate of return (vishnani and shah, 2007). aburime (2008) has been reported to calculate profit by subtracting opportunity cost of factor of production (of the output) from revenue generated from sale (of that output). there is little risk and low level of profitability if the firms have greater amount of liquidity. this is the reason that in routine course of business firms needs to maintain balance in liquidity and profitability (niresh, 2012). trade off in liquidity and profitability attracts key conscience in the manufacturing industry (aminu, 2012). financial manager’s responsibility is to retain a balance between risk and profitability (ben-caleb et al., 2013). for maintaining working capital of an organization at optimum level, the managers first evaluate the risk and return trade-off (sharma, 2001). sugar industry, due to nature of its operations, faces many challenges. the volatility in interest rates, foreign exchange fluctuations, unstable commodity (fuel) prices have led to unpredictability of profits and cash flows in these firms. firm with greater amount of liquidity might be having little risk and at that time low profitability. on the contrary, organizations with low liquidity level might be on the verge of higher risk levels that ultimately confirms higher returns. liquidity and profitability grabs key attention for their connection with the company’s survival, growth and sustainability. these two extremes become sources of different opinions amongst researchers, experts, financial analysts and managements of profit-oriented companies. when making a decision about liquidity or profitability, the authorities of an organization are caught into a dilemma regarding management of company’s financials. the problem addressed here stipulates the identification of liquidity profitability trade off in sugar industry. 2. literature review gallagher and andrew (2000) argued that to make payments of current liabilities, management of liquidity is very significant for every business organization. firm’s liquidity and profitability are considered an important concepts regarding management of the working capital (lamberg and valming, 2009). for any company cash and marketable securities position indicates the liquidity (brigham and houston, 2011). the real world is no ideal and some of these limitations incur cost that could have been avoided if the firms were to hold liquid reserves (deloof, 2001). effective management of liquidity enables firm to absorb high profit which in turn increase the wealth of stockholders (ben-caleb, 2009). it is necessary for a firm that continues to exist must remain liquid in order to stay safe (bhavet, 2011). the theme behind the liquidity concept is not too straight; it refers to the current/short-term assets and liabilities management (prasana, 2000). tsomocos (2003) argued that as per survival growth perspective, organizations ought to think of their survival prior profit generation. earlier researches spotted the inter relation in working capital management and its constituents, and organizational profitability (awad and jayyar, 2013). narware (2004) stated that size of company’s working capital declines with respect to its sales, if a company wishes to face the higher risk for earning maximum profits. profitability is affected when the firm takes the decisions regarding management of working capital (raheman and nasr, 2007). numerous previous studies had supported the theory regarding trade off in liquidity and profitability. earlier researches comprised of garcía-teruel and martínez-solano (2007), bhunia and brahma (2011), falope and ajlore (2009), samiloglu and demirgunes (2008), mathuva (2009), dash and hanuman (2008), uyar (2009), raheman and nasr (2007), akella (2006), nobane and alhajar (2005), alamer et al., (2015), lazaridis and tryfondis (2006), eljelly (2004), deloof (2003) and shin and soenen (1998). in above studies, they all showed an indirect association among profitability and liquidity. chakraborty (2008) analyzed that it is not working capital that has any effect on the improvement of the profitability, rather they are negatively associated. nobanee and alhajjar (2005) revealed that decrease in the period of average collection, cycle of cash conversion, period of inventory conversion and lengthening period of deferred payable cause firm’s profitability to increase. samiloglu and demirgunes (2008) argued that liquidity and profitability are positively associated with each other for the reason that the growth in firm’s sales cause liquidity to increase. don (2009) explored that liquidity is more important because the survival of the company is directly linked with liquidity. bardia (2004) argued that liquidity and profitability are directly associated with one another and their argument is in line with the study proposed by narware (2004). filbeck and krueger (2005) found that firms must reduce their financing costs, and tie fund in current assets. lee and kang (2008) investigated the concept that more risk means more profit. takon and ogakwu (2013) examined the impact of liquidity on return on assets (roa). they stated that liquidity and its management become concerned for company’s managers. the study concluded that a firm can enhance its profitability by setting a first-class petite cycle of cash conversion, credit policy and efficiency in the cash flow management procedures. bolek (2013) examined the liquidity-profitability relationship and risk in promising companies. the results of the study proved that each profitability ratio is influenced by different factors relating to liquidity and risk but the associations are similar and can expect the growth of profitability when free cash flow is increasing and the cycle of cash conversion is in declining pattern. assets’ structure ratio, in each model, was considerable signifying that the higher this ratio is (the current assets grow) the higher the profitability signifying the conservative approach to working capital. uremadu et al., (2012) found that profitability measure roa is indirectly affected by liquidity measures, i.e., creditor’s payment period, cash conversion period. bolek and wiliński (2012) concluded that the development of financial liquidity measured in terms of quick ratio (qr) receivable conversion period/average collection period (acp) negatively influence roa. ben-caleb et al., (2013) studied that a negative association exists between period of cash conversion and firm’s capital employed’ return (roce). safdar, et al.: what does matter? liquidity or profitability: a case of sugar industry in pakistan international journal of economics and financial issues | vol 6 • special issue (s3) • 2016146 based on the above discussion, following model is proposed for the current study (figure 1). 3. the research hypotheses 3.1. hypothesis 1 h1: liquidity negatively affects roa. 3.2. hypothesis 2 h1: there exists a perception of negative relationship in liquidity and return on equity (roe). 3.3. hypothesis 3 h1: a negative relationship is perceived to be existed in liquidity and return on capital employed (roce). 4. research methodology sugar sector of pakistan is selected for current research. according to pakistan sugar mills association (psma) there are 83 sugar mills in pakistan; 45 in punjab, 08 in khyber pakhtunkhwa and 30 in sindh. in present study, a sample of 36 sugar mills was selected which is 43% of total population. the selection of sample is based on the availability of data and listed in karachi stock exchange. secondary data is used for sugar industry over the last 5 years, starting from 2007 and ending on 2011. data for current research is extracted from the sampled sugar mill’s annual reports, accessible from state bank’s publication. apart from these sources, relevant data relating to sugar mills is collected from annual reports of psma. the collected data of current work is analyzed through statistical package like spss, software version 22.0. present study used different analytical tools like reliability analysis, descriptive statistics, multiple regression analysis, correlation and tests of significance to test the causal linkage in liquidity and profitability of pakistan’s sugar industry. 4.1. specification of variables in this study liquidity and profitability are two basic indicators used to estimate the relationship and taken as independent and dependent variable respectively. the liquidity position of selected sugar mills is measured by means of liquidity ratios; current ratio (cr), qr/acid-test, sor/absolute liquid ratio, current assets turnover ratio (catr), inventory turnover ratio (itr) and acp whereas profitability is measured by means of profitability ratios; roa, roe and roce. the current study is carried out to test the causal linkage in liquidity and profitability of pakistan’s sugar industry. for this purpose following econometric models more technically called linear regression models are specified to test the hypothesis for empirical investigation and analysis: model 1: roant=βo+β1crnt+β2qrnt+β3sqrnt+β4catrnt+β5i trnt+β6acpnt+u model 2: roent=βo+β1crnt+β2qrnt+β3sqrnt+β4catrnt+β5it rnt+β6acpnt+u model 3: rocent=βo+β1crnt+β2qrnt+β3sqrnt+β4catrnt+β5 itrnt+β6acpnt+u where, roant: return on assets of sugar companies n (n = 1, 2, 3,…, 36 companies) at time t (t = 1, 2,…, 5 years) roent: return on equity of sugar companies n (n = 1, 2, 3,…, 36 companies) at time t (t = 1, 2,…, 5 years) rocent: return on capital employed of sugar companies n (n = 1, 2, 3,…, 36 companies) at time t (t = 1, 2,…, 5 years) βo = the intercept of equation, β1, β2, β3, β4, β5, β6 = slope coefficient or regression coefficient, u = unexplained variable or error term, cr: current ratio, qr: quick ratio, sqr: super quick ratio, catr: current assets turnover ratio, itr: inventory turnover ratio, acp: average collection period. 5. data analysis 5.1. reliability analysis theoretically, reliability is “the degree to which measures are free from error and therefore yield consistent results” (peter, 1979). cronbach’s alpha is a model of internal consistency, based on the average inter-item correlation. according to nunnally (1978) and churchill (1979), it is compulsory for data to be reliable, to have in cronbach’s alpha α > 0.7. from the table 1, it is concluded that all the variables related to liquidity and profitability used in this study are reliable because the cronbach’s alpha α for all the variables listed in the table 1 exceed 0.7, which are according to the nunnally’s reliability recommendations. 5.2. descriptive statistics in present study, the basic features of a data are portrayed through the utilization of descriptive statistics. the descriptive statistic regarding liquidity indicators showed in table 2 indicates that the mean value of cr is 2.83 with minimum 2.10 and maximum 3.90 and standard deviation of 42.7%. in case of qr, standard deviation is 20.9% with mean value of 1.77, minimum of 1.14 figure 1: research framework (researcher constructed) safdar, et al.: what does matter? liquidity or profitability: a case of sugar industry in pakistan international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 147 and maximum of 2.10. the average or mean value of company’s sqr is 1.51 with lowest of 0.96 and highest of 1.72 and standard deviation of 18%. the above mean values of current, qr and sqr are according to the standard rules. this indicates that on average, sugar mills are quite able to meet their short-term or current liabilities as they are matured. the mean values of catr and itr are 9.32, 20.47 times with standard deviations of 1.85, 3.46 respectively. the standard deviation for acp is about 5 days with an average of 29-30 days. minimum time to receive cash payments from customers is 22 days whereas it takes maximum 35-36 days to collect cash. the descriptive statistic regarding profitability indicators showed in table 2 indicates that the mean or average value of roa is 52.4% with minimum 39.0% and maximum 75.0% with 10.3% of standard deviation. it signifies that the company’s profitability can deviate from mean or average to each side by 10.3%. the mean or average values of roe and roce are 53.6%, 54.6% with standard deviations of 10%, 9.2% respectively. 5.3. correlation analysis table 3 represents the correlation analysis of all the variables investigated in present work. a positive and significant relationship is observed in liquidity indicators; cr (r = 0.489, p < 0.01), qr (r = 0.661, p < 0.01), sqr (r = 0.560, p < 0.01), catr (r = 0.475, p < 0.01), itr (r = 0.604, p < 0.01), acp (r = 0.689, p < 0.01) and profitability measure roa. the correlation coefficient r values for all the predictor variables cr, qr, sqr, catr, itr, and acp are 0.810, 0.833, 0.852, 0.817, 0.729, and 0.630 respectively. these values indicate positively correlation with profitability measure, roe and found statistically significant at 1% level. the relationship between qr, sqr and roce is positive but statistically insignificant as observed from their p values. only the cr is positively correlated with roce as evidence from correlation coefficient value r = 0.541 and found significant at 1% level. others variables; catr, itr and acp are also positively correlated with roce but significant at 5% level. overall correlation analysis illustrates that all the liquidity indicators are positively and significantly correlated with profitability. table 3 exhibits that liquidity indicators showed positive and significant relationship with profitability. 5.4. regression analysis regression analysis is used to find out the strength of the association or relationship between several independent variables and dependent variable. model 1: roant=βo+β1crnt+β2qrnt+β3sqrnt+β4catrnt+β5i trnt+β6acpnt+u table 4 shows the multiple regression results for model 1. to assess the overall significance of the model, analysis of variance table 1: reliability analysis serial number name of variables cronbach’s alpha 1 current ratio 0.726 2 quick ratio 0.874 3 super-quick ratio 0.763 4 current assets turnover ratio 0.806 5 inventory turnover ratio 0.817 6 average collection period 0.717 7 return on assets 0.792 8 return on equity 0.709 9 return on capital employed 0.770 source: author’s computations (spss, 21.0 version) table 2: descriptive statistics (n=36) serial number variables minimum maximum mean±standard deviation 1 current ratio 2.10 3.90 2.8375±0.42684 2 quick ratio 1.14 2.10 1.7667±0.20905 3 super-quick ratio 0.96 1.72 1.5089±0.17993 4 current assets turnover ratio 5.50 11.55 9.3194±1.85908 5 inventory turnover ratio 14.30 7.50 20.4722±3.46135 6 average collection period 22.10 35.70 29.6556±4.93451 7 return on assets 39.00 75.00 52.4167±10.30499 8 return on equity 34.10 68.20 53.6472±10.02320 9 return on capital employed 29.70 75.90 54.6333±9.16077 source: author’s computations (spss, 21.0 version) table 3: correlation analysis cr qr sqr catr itr acp roa roe roce cr 1 qr 0.746** 1 sqr 0.779** 0.947** 1 catr 0.875** 0.913** 0.950** 1 itr 0.641** 0.640** 0.655** 0.592** 1 acp 0.600** 0.792** 0.738** 0.716** 0.620** 1 roa 0.489** 0.661** 0.560** 0.475** 0.604** 0.689** 1 roe 0.810** 0.833** 0.852** 0.817** 0.729** 0.630** 0.613** 1 roce 0.541** 0.318 0.250 0.387* 0.382* 0.376* 0.193 0.388* 1 **p<0.01, *p<0.05. cr: current ratio, qr: quick ratio, sqr: super quick ratio, catr: current assets turnover ratio, itr: inventory turnover ratio, acp: average collection period, roa: return on assets, roe: return on equity, roce: return on capital employed safdar, et al.: what does matter? liquidity or profitability: a case of sugar industry in pakistan international journal of economics and financial issues | vol 6 • special issue (s3) • 2016148 also called (anova) test is applied. the value of f-statistic is 11.38 with p < 0.001 indicating that current model is statistically significant at 1%. it is observed that tolerance (tol) values of all the predictor variables are not equivalent to zero or close to zero so these variable are not related to each other. consequently, all the predictor variables used in present research contribute more information to regression model. also variance inflation factor (vif) values of all variables are <4, so there is no multicollinearity among independent variables, and these independent variables are independent. the coefficient of multiple correlations “r” among the dependent variable, roa and the independent variables, cr, qr, sqr, catr, itr and acp is 0.838, which shows that profitability is exceedingly responded by the indicators of liquidity. it is revealed that value of r2 is 0.702, shows that 70.2% of variation in roa was accounted by the mutual variation in cr, qr, sqr, catr, itr and acp. furthermore, the value of adjusted r2 is 0.64; indicates that about 64.0% of the variation in roa is elucidated by the predictor variables, cr, qr, sqr, catr, itr and acp. it is observed that, cr, qr, sqr and itr makes the utmost contribution to the prophecy of the roa with a beta coefficient of (β = 1.681, p < 0.01), (β = 1.057, p < 0.01) (β = 0.394, p < 0.05) and (β = 0.649, p < 0.01) respectively. this means that 1 standard deviation change in cr, qr, sqr and itr brings about 1.681, 1.057, 0.394, and 0.649 standard deviation change in roa respectively. as beta coefficients of these variables are positive, so the relationship of these independent variables is positive with criterion variable. whereas beta coefficients for acp is (β = 0.330, p < 0.05), showing that this variable makes the least positive contribution to the prophecy of the roa. similarly the variable catr makes the least and negative contribution to the prophecy of the roa with beta’s coefficient (β = −0.046, p < 0.05). to check the autocorrelation between the independent variables, a famous statistical test “durbin watson” introduced by statisticians durbin and watson is applied in this analysis. the durbin watson statistic verify the serial correlation of residuals (i.e., error terms) in several types of regression models. from the table 4, the value of durbin watson d-statistic for model 1 is 1.929 that is near to 2.0. thus there is no serial correlation or autocorrelation amongst variables. model 2: roent =βo+β1crnt+β2qrnt+β3sqrnt+β4catrnt+β5i trnt+β6acpnt+u table 5 shows the multiple regression results for model 2. the value of f-statistic is 24.97 with p < 0.001 indicating that current model is statistically significant at 1%. it is observed that tol values of all the predictor variables are not equivalent to zero or close to zero so these variable are not related to each other. the vif values of all variables are <4, so there is no multicollinearity among independent variables. the coefficient of multiple correlation “r” among the dependent variable, roe and the independent variables, cr, qr, sqr, catr, itr, and acp is 0.915, that shows that profitability, is exceedingly responded by the indicators of liquidity. it is revealed that value of r2 is 0.838, shows that 83.8 % of variation in roe is accounted by the mutual variation in cr, qr, sqr, catr, itr, and acp. furthermore, the value of adjusted r2 is 0.804; indicates that about 80.4 % of the variation in roe is elucidated by the independent variables, cr, qr, sqr, catr, itr, and acp. it is observed that cr, qr, catr and itr make the utmost contribution to the prophecy of the roe with a beta coefficient of table 4: regression analysis model 1 b se β t p< tol vif (constant) 6.269 8.294 2.305 0.024 current ratio 23.575 9.604 1.681 3.322 0.002 0.883 1.132 quick ratio 46.223 15.404 1.057 3.001 0.005 0.741 1.350 super-quick ratio 18.193 26.232 0.394 2.455 0.020 0.738 1.355 current assets turnover ratio −9.318 2.899 −0.046 −2.137 0.043 0.445 2.247 inventory turnover ratio 0.138 0.495 0.649 2.850 0.007 0.647 1.545 average collection period 0.823 0.363 0.330 2.269 0.031 0.472 2.119 r=0.838, r2=0.702, df1=6, r2 change=0.702 f-statistics=11.385, durbin watson=1.929, df2=29, adjusted r2=0.640 dependent variable: return on assets tol: tolerance, vif: variance inflation factor, se: standard error table 5: regression analysis model 2 b se β t p< tol vif (constant) 3.269 5.852 2.531 0.018 current ratio 17.762 6.298 0.550 2.820 0.009 0.834 1.199 quick ratio 14.818 10.102 0.699 3.215 0.001 0.940 1.064 super-quick ratio 34.307 17.202 0.155 2.103 0.040 0.625 1.600 current assets turnover ratio 3.327 1.901 0.381 2.295 0.023 0.735 1.361 inventory turnover ratio 0.410 0.324 0.675 3.172 0.002 0.861 1.161 average collection period −0.243 0.238 −0.131 −1.023 0.315 0.341 2.933 r=0.915, r2=0.838, df1=6, r2 change=0.838 f-statistics=24.969, durbin watson=1.901, df2=29, adjusted r2=0.804 dependent variable: return on equity tol: tolerance, vif: variance inflation factor, se: standard error safdar, et al.: what does matter? liquidity or profitability: a case of sugar industry in pakistan international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 149 (β = 0.550, p < 0.01), (β = 0.699, p < 0.01), (β = 0.381, p < 0.05) and (β = 0.675, p < 0.01) respectively. as beta coefficients of these variables are positive, so the relationship of these independent variables is positive with criterion variable. whereas beta coefficients for sqr is (β = 0.155, p < 0.05), showing that this variable makes the least positive contribution to the prediction of the roe. similarly the variable acp makes the least and negative contribution to the prophecy of the roe with a beta coefficient of β = −0.131 that is not statistically significant at 1% and 5% level. t-statistic and the significant values in the table 5 indicate that the variables, cr, qr and itr cause significant impact on roe at 1% levels. while the impact of sqr and catr on roe is significant at 5% levels. in case of acp has insignificant impact on roe. the value of durbin watson d-statistic for model 2 is 1.901 that is near to 2.0. thus there is no serial correlation or autocorrelation amongst variables. model 3: rocent =βo+β1crnt+β2qrnt+β3sqrnt+β4catrnt+β5 itrnt+β6acpnt+u table 6 shows the multiple regression results for model 3. the value of f-statistic is 4.635 with p < 0.01 indicating that current model is statistically significant at 1%. the tol values of all the predictor variables are not equivalent to zero or close to zero so these variable are not related to each other. vif values of all variables are <4, so there is no multicollinearity among independent variables. the coefficient of multiple correlation “r” among the dependent variable, roce and the independent variables, cr, qr, sqr, catr, itr and acp is 0.70, that shows that profitability, is exceedingly responded by the indicators of liquidity but low as compared with model 1 and model 2. it is also observed that value of r2 is 0.49, shows that 49 % of variation in roce is accounted by the mutual variation in independent variables, which show that variation is weak as compared with model 1 and model 2. furthermore, the value of adjusted r2 is 0.384; indicates that about 38.4% of the variation in roce is elucidated by the independent variables, which is low as compared with previous model. it is observed that, cr, qr and acp make the utmost contribution to the prediction of the roce with a beta coefficient of (β = 0.914, p < 0.05) and (β = 1.690, p < 0.01) and (β = 0.408, p < 0.05) respectively. as beta coefficients of these variables are positive, so the relationship of these independent variables is positive with criterion variable. whereas beta coefficient for catr and itr are (β = 0.265, p < 0.05), (β = 0.206, p > 0.05) respectively, showing that this variable makes the least positive contribution to the prediction of the roce. similarly the variable sqr makes the negative contribution to the prediction of the roce with a beta coefficient of β = −0.460 that is statistically significant at 5% level. t-statistic and the significant values in the table 4 indicate that the variables, cr, qr and itr cause significant impact on roce at 1% levels. while the impact of sqr and catr on roe is significant at 5% levels. in case of acp has insignificant impact on roce. the value of durbin watson d-statistic for model 3 is 1.890 that is near to 2.0. thus there is no serial correlation or autocorrelation amongst variables. 5.5. uni-dimensional analysis in this analysis all the predictor variables, i.e. cr, qr, sqr, catr, itr, and acp are taken together as “liquidity” to measure the liquidity position of all sugar mills, while the profitability measures, i.e., roa, return on roe and roce remained the same. 5.6. uni-dimensional correlation analysis uni-dimensional correlation analysis is used to measure the strength or degree of linear association between independent variable, liquidity and dependent variables, roa, roe and roce. in table 7, the correlation coefficient r values indicate the positive and significant relationship between liquidity and profitability measures, roa, roe, roce and fount statistically significant at 1% level of significance. overall correlation analysis shows that liquidity is positively and significantly correlated with profitability. 5.7. uni-dimensional regression analysis the uni-dimensional regression analysis is used to determine the strength of the relationship between independent or predictor variables, liquidity and a dependent or criterion variables, roa, roe and roce. model 1: roant =βo+βliquiditynt+u from the table 8 the value of f-statistic is 33.41 with p < 0.01 indicating that current model is statistically significant at 1%. the multiple correlation coefficients “r” between the dependent variable, roa and the independent variable, liquidity is 0.754 that shows that profitability is highly responded by the liquidity. the value of r2 0.569 shows that 56.9% of variation in roa was accounted by liquidity. the value of adjusted r2 is 0.554; table 6: regression analysis model 3 b se β t p< tol vif (constant) 27.661 11.360 2.199 0.032 current ratio 16.243 12.225 0.914 2.514 0.015 0.829 1.206 quick ratio 17.345 19.609 1.690 2.732 0.007 0.917 1.091 super-quick ratio −90.723 33.392 −0.460 −2.471 0.019 0.798 1.253 current assets turnover ratio 4.928 3.690 0.265 2.293 0.030 0.395 2.532 inventory turnover ratio 0.768 0.630 0.206 1.220 0.232 0.372 2.687 average collection period 0.419 0.462 0.408 2.435 0.021 0.677 1.477 r=0.700, r2=0.490, df1=6, r2 change=0.490 f-statistics=4.635, durbin watson=1.890, df2=29, adjusted r2=0.384 dependent variable: return on capital employed tol: tolerance, vif: variance inflation factor, se: standard error safdar, et al.: what does matter? liquidity or profitability: a case of sugar industry in pakistan international journal of economics and financial issues | vol 6 • special issue (s3) • 2016150 indicates that about 55.4% of the variation in roa is explained by the independent variable, liquidity. it is observed that, liquidity makes the high contribution to the prediction of the roa, with a beta coefficient of 0.754. t-statistic and the significant values indicate that the variables, liquidity generate significant impact on roa at 1% level as obvious from p value. as observed the value of durbin watson d-statistic for model 1 is 1.951 that is near to 2.0. thus there is no serial or correlation autocorrelation amongst variables. model 2: roent=βo+βliquiditynt+u table 9 shows uni-dimensional regression results for model 2. the value of f-statistic is 62.17 indicating that current model is statistically significant at 1%. the coefficient of multiple correlations “r” among the dependent variable, roe and the independent variable, liquidity is 0.804, which shows that profitability, is highly responded by the liquidity. the value of r2 0.646 shows that 64.6% of variation in roe is accounted by liquidity. the value of adjusted r2 is 0.636; indicates that about 63.6% of the variation in roe is explained by the independent variable, liquidity. it is observed that, liquidity makes the high contribution to the prediction of the roe, with a beta coefficient of 0.804. t-statistic and the significant values in the table 9 indicate that the variables, liquidity generate significant impact roe at 1% level as obvious from p value. the value of durbin watson d-statistic for model 2 is 1.890 that is near to 2.0. therefore, there is no serial correlation or autocorrelation amongst variables. model 3: rocent=βo+βliquiditynt+u table 10 depicts uni-dimensional regression results for model 3. the value of f-statistic is 7.88 indicating that current model is statistically significant at 1%. the coefficient of multiple correlations “r” among the dependent variable, roce and the independent variable, liquidity is 0.704 that shows that profitability is highly responded by the liquidity. the value of r2 0.496 shows that 49.6 % of the variation in roce is accounted by liquidity. the value of adjusted r2 is 0.481; indicates that about 48.1% of the variation in roce is explained by the independent variable, liquidity. this model overall shows moderate or low variation in dependent variable as compared with model 1 and model 2. it is observed that, liquidity makes the high contribution to the prediction of the roce, with a beta coefficient of 0.704. t-statistic and the significant values in the table 10 indicate that the variables, liquidity generate significant impact on roce at 1% level as obvious from p-value. as seen from the table 10, the value of durbin watson d-statistic for model 3 is 1.873 that is near to 2.0. thus there is no serial correlation or autocorrelation amongst variables. key findings of the current study are found by testing the different hypothesis of the study. findings of the study negated the proposition as liquidity positively affects the roa, roe and roce. t-statistic and the significant values in the multiple and uni-dimensional regression analysis indicate that liquidity has direct influence on profitability, i.e. roa, roe and roce which is significant at 1% level. first hypothesis of the study was liquidity negatively affects roa. the hypothesis is rejected as liquidity positively affects the roa. the value of f-statistic is 33.41 with p < 0.01 indicating that model 1 is statistically significant at 1%. t-statistic and the significant values in the table 8 indicate that liquidity has direct influence on roa and significant at 1% level. second hypothesis of the study was that there exists a perception of negative relationship in liquidity and roe. the hypothesis is rejected as liquidity positively affects the roe. the value of f-statistic is 62.17 with p<0.01 indicating that model 2 is statistically significant at 1%. t-statistic and the significant values in the table 9 indicate that liquidity generate positive impact on roe and significant at 1% level. third hypothesis of the study was that a negative relationship is perceived to be existed in liquidity and roce. the hypothesis is rejected as liquidity positively affects the roce. the value of f-statistic is 7.88 with p < 0.01 indicating that model 3 is statistically significant at 1%. t-statistic and the significant values in the table 10 indicate that liquidity has positive influence on roce and significant at 1% level. table 7: correlations analysis return on assets return on equity return on capital employed liquidity return on assets 1 return on equity 0.613** 1 return on capital employed 0.193 0.388* 1 liquidity 0.704** 0.804** 0.434** 1 **p<0.01, *p<0.05 table 8: uni-dimensional regression anaysis model 1 b se β t p< tol vif (constant) 4.775 8.335 0.573 0.570 liquidity 0.712 0.130 0.754 5.780 0.000 1.000 1.000 r=0.754, r2=0.569, df1=1, r2 change=0.569 f-statistics=33.408, durbin watson=1.951, df2=34, adjusted r2=0.554 dependent variable: return on assets tol: tolerance, vif: variance inflation factor, se: standard error table 9: uni-dimensional regression anaysis model 2 b se β t p< tol vif (constant) 5.278 6.208 0.851 0.401 liquidity 0.766 0.097 0.804 7.885 0.000 1.000 1.000 r=0.804, r2=0.646, df1=1, r2 change=0.646 f-statistics=62.170, durbin watson=1.890, df2=34, adjusted r2=0.636 dependent variable: return on equity tol: tolerance, vif: variance inflation factor, se: standard error table 10: uni-dimensional regression anaysis model 3 b se β t p< tol vif (constant) 26.080 10.285 2.536 0.016 liquidity 0.452 0.161 0.704 2.807 0.000 1.000 1.000 r=0.704, r2=0.496, df1=1, r2 change=0.496 f-statistics=7.881, durbin watson=1.873, df2=34, adjusted r2=0.481 dependent variable: return on capital employed tol: tolerance, vif: variance inflation factor, se: standard error safdar, et al.: what does matter? liquidity or profitability: a case of sugar industry in pakistan international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 151 6. policy implications current research plays an aide in the existing knowledge base of liquidity profitability trade off particularly in sugar industries. it provides an evidence of the fact that negates negative relationship between the two variables. findings of the present research make it important for the reason that it is one of the fewer researches going in contrast to the existing knowledge base. findings of current research will help managers to come out of the dilemma with respect to liquidity and profitability tradeoff. the research suggests that managers need not worry about distinguishing investments into liquid or non-liquid assets, as it suggests investments in more liquid assets do not reduce the profitability of the firm. 7. conclusion current study was aimed at investigating the liquidity-profitability trade off in sugar industry of pakistan. on this rationale, a sample of 36 sugar mills was selected which is 43% of total population. secondary data of the non-financial companies which are listed on kse is used for sugar industry over the last 5 years, starting from 2007 and ending on 2011. results of this study articulated that liquidity of sampled sugar mills is positively linked to their profitability. results of regression and correlation of current study discovered that liquidity is positively and significantly related with the profitability of sampled sugar mills. findings of current research suggest managers to come out of the dilemma with respect to liquidity and profitability tradeoff. it is further concluded that 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(2006), liquidity-profitability trade-off: is it evident among malaysian smes?. international journal of management studies, 13(2), 107-118. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(1), 234-240. international journal of economics and financial issues | vol 7 • issue 1 • 2017234 determinants of external debt: a panel data analysis for oil and gas exporting and importing countries abdul waheed* department of economics and finance, college of business administration, university of bahrain, bahrain. *email: awaheed@uob.edu.bh abstract this study investigates the macroeconomic determinants of external debt in oil and gas exporting and importing countries. the study uses panel data of 12 oil and gas exporting and 12 oil and gas importing countries covering the period 2004-2013. the study identifies eight macroeconomic factors that significantly affect the external debt of oil and gas exporting and importing countries. the major lesson learnt from this study is the importance of avoiding particular generalization for external debt accumulation factors for oil and gas exporting and importing countries. furthermore, the effect of different macroeconomic factors can be different in these two groups of countries. keywords: external debt, panel data, oil and gas, exports and imports jel classifications: c13, c33, q41, f14 1. introduction the recent decades witnessed a significant increase in external debt of many developing countries due to persistent current account and fis al imbalances. this rising burden of external debt and high debt service payments is becoming a constant source of concern for these economies. the determinants of external debt in developing countries have generated a lot of interest among scholars and policy makers in recent years. most of the previous studies are either time series or cross sections and there are few studies that used panel data. this study uses panel data analysis for two reasons. first given the rapid changes in global macroeconomic environment in the past years, the application of panel data approach seems to be highly preferred, as it allows to control time-specific events that are linked to overseas borrowing. second most of the previous studies used aggregate set of data. since it is believed that determinants of external debt could be different in various economies, this study tries to explore the determinants of external debt in the sample of oil and gas exporting and importing countries. the study focuses on oil and gas exporting and importing countries for various reasons. first, the oil and gas exporting countries are mostly high income and oil and gas importing are mostly low income indebted countries. second, the oil and gas exporting countries have surplus in their current account while oil and gas importing countries are facing a deficit in their current account. third, both classifications of countries are badly suffering from high external debt, and many of them are classified as highly indebted poor countries (hipc) by the world bank. the findings from this study will be a great help for designing their external debt reduction strategy. after introduction section, the rest of the paper is organized as follows. section-2 discusses the review of literature. section-3 presents the modeling framework and the econometric models for both oil and gas exporting and importing countries. section-4 first performs the preliminary data analysis and then discusses the panel data models’ estimation results. section-5 concludes the study, discusses the policy implications and set directions for further research. 2. review of literature there are several studies that investigated determinants of external debt using time series, cross section or panel data. since the current waheed: determinants of external debt: a panel data analysis for oil and gas exporting and importing countries international journal of economics and financial issues | vol 7 • issue 1 • 2017 235 study uses panel data, therefore, this review of literature mainly focuses on the findings of panel studies barro (1979) argued, theoretically and empirically, that temporary increase in income plays a counter cyclical role on debt in the us, and also that there is an expected positive effect of infl tion on debt. eichengreen and portes (1986) using the data for 16-23 countries for the period 1930-1938 performed both cross-section and panel data analysis. the studied indicated that there is insignificant effect of export instability and degree of openness on external debt. only the log of gross domestic product (gdp) per capita was found to have significant effect on external debt. on panel data regression, all variables except export variability turned out to be statistically significant. in their study, they identified the problem of potential simultaneity, which requires the attention of the future studies. hajivassiliou (1987), used the data for 79 developing countries for the period 1970-1982 to estimate the determinants of demand for and supply of loans. the author addressed the problem of heterogeneity by introducing an error-components structure in the model. the effect of total debt service to export ratio, import to gdp ratio, interest and principal to export ratio was positive on demand for borrowing, while the effect of real gdp per capita was negative. the study identify that the existing foreign exchange reserves can serve as an alternative to external debt. it is also pointed out by the study that high debt obligations are accompanied by high demand for new funds. tiruneh (2004) conducted a panel data study for sixty heavily indebted poor countries and non-heavily indebted less-developed countries to explore the demand for external borrowing in the 1980s and 1990s. the estimation results of random and fixe effects model for pooled data of 1982-1998 showed that capital flight, debt service payments, the imports to gdp ratio, income per capita, and the growth rate of gdp are the key determinants of the demand for external borrowing. the cross-section pooled time-series analysis for heavily indebted poor countries indicated that sluggish economic growth, high past debt service payments, income instability and demand for foreign exchange to finance their import bills, are the main reasons for external borrowing. the author suggested for debt relief for poor nations and sound debt management strategy to avoid debt crisis. colombo and longoni (2009) analyzed the determinants of long term external debt for a large sample of developing countries. the study included 61 developing countries, some of them were hipc, and covered the period 1970-2000. in addition to the standard economic variables, the study also included the sociopolitical factors in the model to explain the level of external debt of the developing countries. the study found that external debt is positively correlated to the level of economic development, the degree of openness and the level of education. the external debt is also found higher in those countries that have more flexible exchange rate system. the financial depth and inflation have positive effect on external debt. it is also found that a higher degree of institutional quality allows developing countries to take on more external debt. the open and competitive electoral system has the positive effect on external debt. this shows that higher transparency of the electoral system and higher political stability are rewarded by international financial markets forslund et al. (2011) identified the determinants of public debt in a large sample of developing and emerging market-countries. the data set consists of an unbalanced panel of 1558 observations covering 104 countries for the 1990-2007 period. the study found that financial deepening and gdp have significant positive effect on public debt, while past debt and real exchange rate depreciation have significant negative effect on public debt. the study did not find any signifi ant effect of infl tion, current account, bank crisis, default, openness, debt contraction, and debt explosion on public debt in the full sample. however, there was a change in the results for the presence of capital controls. in a recent study bittencourt (2013) investigated the determinants of external debt in south america, covering the period 1970-2007. the estimation results of principal component and dynamic panel data analysis confirmed that economic growth has the ability to significantly reduce the debt in the region. the other important determinants as suggested by the literature, such as infl tion, inequality or executive (better checks and balances) did not present the expected nor clear-cut estimates on external debt. however, the authors come up with the conclusion that these results cannot be generalized. 3. the modeling framework for a sustainable solution to the debt problem, it is important to focus upon the elements in the economy that generate the need to borrow. there are several frameworks in which the debt can be analyzed; however, the econometric models of this study are based on the emerging literature on the two gap model (chenery and strout, 1966) and the three gap model (bacha, 1990)1. these gap models identified three possible sources for accumulation of debt, which includes the saving-investment gap, foreign exchange gap and fiscal-constraint gap. the fiscal constraint gap is particularly important to this study keeping in view the samples of oil and gas exporting and importing countries. for oil and gas exporting countries, the foreign-exchange gap is less important but for oil and gas importing countries, this is very important in addition to the saving-investment gap. there are at least four ways to finance a deficit in budget. printing money, running down resources, domestic borrowing and/or external borrowing. the budget constraint can be represented as: tt+(dt-dt−1) = gt+r dt−1 (1) where tt is the government revenue, dt and dt−1 is the current and past debt respectively, gt is government expenditure, and r is the interest on accumulated debt. thus, from the fiscal side debt accumulation, after simplification can be represented as dt=gt-tt+(1+r) dt−1 (2) 1 for a critical review of the gap models and other theoretical frameworks waheed (2007). waheed: determinants of external debt: a panel data analysis for oil and gas exporting and importing countries international journal of economics and financial issues | vol 7 • issue 1 • 2017236 where gt-tt is the primary budget deficit. an increase in government expenditure or interest on debt will increase current debt, while government revenue reduces the need for borrowing and ultimately the debt. from the balance of payment perspective, debt can be accumulated as follows: cab=xt-mt-r dt−1 (3) kab=(dt-dt−1)+(rt-rt−1) (4) where current account balance (cab) is the cab and kab is the capital account balance. xt is exports of goods and services, and mt is the imports of goods and services. r is the international reserve. since the cab+kab = 0, thus debt accumulation from balance of payment side can be represented as: dt=mt-xt+(1+r) dt−1-∆r (5) the debt accumulation from saving-investment gap can be represented as: st+(dt-dt−1) = it+r dt−1 (6) where st is the saving and it is the investment. the re-arrangement of (6) will result following debt identity: dt=it-st+(1+r) dt−1 (7) thus, the main factors that affect the debt of a nation from (2), (5) and (7) can be listed as government expenditure, government revenue, interest on debt, export of goods and services, imports of goods and service, international reserve, investment and savings. these are the factors that are identified by the economic theory. in empirical analyses some additional variables are also identified as potential determinants of external debt. inflation is an important variable that affect external debt and extensively used in empirical studies (barro, 1979; forslund et al., 2011; bittencourt, 2013). several empirical studies found that economic growth measured by gdp or gdp per capita is also an important variable that significantly affect external debt (hajivassiliou, 1987; selami, 2004; tiruneh, 2004). instead of using imports and exports separately, the empirical studies used cab (forslund et al., 2011) or trade balance (colombo and longoni, 2009; selami, 2004). in the same way instead of using government expenditure and government revenue separately the budget deficit variable is used in empirical studies as potential determinants of external debt (bader and magableh, 2009; awan et al., 2011). benedict et al. (2014) identified foreign direct investment (fdi) as significan determinant of external debt. sachs and berg (1998) believed that in many countries the main reason for accumulation of external debt is the more reliance on external borrowing rather than raising the taxes. keeping in view the economic theory and findings of the previous empirical studies, and region specific conditions, two different econometric models are used for oil and gas exporting and importing countries. following model is used to explore the determinants of external debt in oil and gas exporting countries. edit=∝0+∝1gdpit+∝2cabit+∝3ggrit+∝4ggeit+∝5infit+∝6poi lit+∝7resit+∝8invit+μit (8) the description of all above variables is available in appendix table 1. the parameters ∝2, ∝4, ∝5 are expected to be positive while ∝1, ∝3, ∝6, ∝7 are expected to be negative. the sign of ∝8 is an empirical issue. the μit is the error term. the determinants of external debt of oil and gas importing countries is estimated using following model. edit=β0+β1gdpit+β2tbit+β3ggrit+β4poilit+β5redit+β6fdiit+β7 gdsit+β8invit+ωit (9) the description of all above variables is available in appendix table 1. the parameters β2, β4, and β5 are expected to be positive. the parameters β1, β3 and β7 are expected to be negative. the sign of the parameters β6 and β8 is an empirical issue. the ωit is the error term. 4. estimation results 4.1. data and preliminary analysis the data set covers the period 2004-2013. the sample consists of 12 oil and gas exporting countries and 12 oil and gas importing countries. the list of countries included within the study is given in appendix table 2. the variables used to measure external debt is the gross external debt to gdp ratio, which is obtained from regional economic outlook of international monetary fund (imf). the other macroeconomic data are collected from the world development indicators of the world bank and the international financial statistics of imf. table 1 in the appendix provides the description of each variable used in the model and the sources of data. table 1 indicates that the oil and gas importers are lagging behind the oil and gas exporters in economic growth, cab, government expenditure and revenue, and foreign exchange reserve. the external debt accumulation is high in oil and gas importing countries, while the average rate of investment and inflation are almost same in both groups of countries during 2004-2013. the table 1: selected economic indicators (average 2004-2013) economic indicator oil and gas exporters oil and gas importers real gdp growth (%) 6.37 4.97 current account balance (% of gdp) 22.65 -2.03 external debt (% of gdp) 47.41 61.64 general government expenditure (% of gdp) 35.37 29.05 general government revenue (% of gdp) 42.05 23.34 foreign exchange rescue (billion us$) 64.06 8.33 gross fixed capital formatio (% of gdp) 26.96 26.19 inflation rat (%) 7.50 7.33 source: author’s estimation, gdp: gross domestic product waheed: determinants of external debt: a panel data analysis for oil and gas exporting and importing countries international journal of economics and financial issues | vol 7 • issue 1 • 2017 237 current decline in international oil prices may reverse the trend as the oil and gas exporters are experiencing a sharp decline in their revenue. this may results in a slowdown in economic growth, increase in external debt and inflation rate figure 1 shows the trend of external debt to gdp ratio of oil and gas exporting countries. the ratio has been very high as 60% in 2004, and then it decreases to 40% in 2006. after that it had a fluctuating trend between 30% and 50%, and finally it was at the level of little above then 30% in 2013. for oil and gas importing countries, figure 2 shows that the external debt to gdp ratio was as high as 80% in 2004, but it had a declining trend after that, and it reached to the level of 50% in 2008. after that, the external debt to gdp ratio has a rising trend and in 2013, it was more than 60%. it seems that the external debt problem is more serious in oil and gas importing countries than the oil and gas exporting countries. however, the current decline in international oil prices may reverse the trend as oil and gas export is a major source of foreign exchange earnings for oil and gas exporting countries. on the other hand, the decline in international oil prices may benefit oil and gas importing countries, as it is the major component in their import bill. tables 2 and 3 provide the cross correlation of different variables for oil and gas exporting and importing countries. it is clear from table 4 that gdp, cab, price of oil and foreign exchange reserves are negatively correlated with external debt in oil and gas exporting countries, while government expenditure, revenue, inflation and investment are positively correlated with external debt. for oil and gas importing countries, table 2 shows that gdp, trade balance, and domestic savings are negatively correlated with external debt, while government revenue, price of oil, interest on debt, fdi and investment are positively correlated with external debt. basically, these preliminary correlations suggest that the relationship between macroeconomic variables and external debt is weak in most of the cases. however, there is a negative relationship between external debt and economic growth in both regions, which is in accordance with economic theory. furthermore, the external debt is positively correlated with price of oil in oil and table 2: cross correlation matrix for oil and gas exporting countries, (2004-2013) ed gdp cab ggr gge inf poil res inv ed 1 gdp −0.155 1 cab −0.183 0.750 1 ggr 0.187 0.078 0.330 1 gge 0.556 −0.016 −0.052 0.667 1 inf 0.191 0.029 −0.136 −0.035 0.114 1 poil −0.124 0.301 0.246 0.032 0.003 0.055 1 res −0.162 0.756 0.717 0.194 0.115 −0.073 0.215 1 inv 0.011 −0.100 −0.037 −0.201 −0.267 −0.194 −0.163 0.056 1 source: author’s estimation, gdp: gross domestic product, cab: current account balance, gge: general government expenditure, fdi: foreign direct investment table 3: cross correlation matrix for oil and gas importing countries, (2004-2013) ed gdp tb ggr poil red fdi gds inv ed 1 gdp −0.362 1 tb −0.181 0.501 1 ggr 0.131 −0.320 −0.237 1 poil 0.079 0.208 −0.172 0.096 1 red 0.685 −0.294 −0.202 0.215 −0.116 1 fdi 0.435 −0.396 −0.423 0.311 −0.153 0.328 1 gds −0.126 0.271 0.837 −0.002 −0.118 −0.231 −0.112 1 inv 0.196 −0.402 −0.257 0.437 0.065 −0.012 0.573 0.290 1 source: author’s estimation, gdp: gross domestic product, cab: current account balance, gge: general government expenditure, fdi: foreign direct investment figure 1: trends in external debt of oil and gas exporting countries source: author’s estimation figure 2: trends in external debt of oil and gas importing countries source: author’s estimation waheed: determinants of external debt: a panel data analysis for oil and gas exporting and importing countries international journal of economics and financial issues | vol 7 • issue 1 • 2017238 gas importing sample, while it is negatively correlated with oil and gas exporting sample of countries. this is another important find ng, which will be further analyzed in the econometric models, that takes care of causation. 4.2. model estimation results the models for both oil and gas exporters and importers are estimated employing the panel least square method. there are several advantages of panel data analysis over the cross-section and time-series data analysis. according to baltagi (2005), in panel data analysis, there is a possibility of less co-linearity among variable and more degrees of freedom. the panel data analysis can better detect and measure effects, which simply cannot be observed in cross-section or time-series data analysis. the parameter heterogeneity is a typical short coming of regression analysis based upon a sample of the large set of countries. to control this full sample is divided into oil and gas exporting countries and oil and gas importing countries that takes care of the level of development. the estimation results for both groups of countries are given in table 4. theoretically, if a country has more income, it may not require external funding and reduce the chances of borrowing. on the other hand, a higher income is an indicator of credit worthiness and may get more loan, resulting higher borrowing and debt. essentially in both models the coefficients of gdp variable are negative and highly significant, which highlight the effectiveness of economic growth in reducing external debt in the region. the coefficients of variable cab and tb represent the predicted positive sign and these are statistically significant. this suggests that increase in current account or trade deficit will stimulate external debt in the region. there is an important role of general government revenue (ggr) and expenditure in external debt. increase in government expenditure has a positive effect on external debt if local markets are shallow. on the other hand, an increase in government revenue, reduces the need for further borrowing. bader and magableh (2009) confirmed the significant positive effect of the budget defici on external debt. awan et al. (2015) also found that fiscal deficit is a significant determinant of external debt. the coefficient of general government expenditure (gge) is statistically significant and positive in the sample of oil and gas exporting countries, while it was insignificant in oil and gas importing countries (that’s why not included into the model). this indicates that reduction in gge can decrease external debt of these countries. the coefficient of ggr is negative and highly significant in both models, but its magnitude is higher in oil and gas exporting countries compared to oil and gas importing countries. the international price of oil is also playing an important role in external debt of oil and gas exporting and importing countries. as expected the coefficient of poil is negative for oil-gas exporting countries but positive for oil-gas importing countries. this shows that an increase in international price of oil is expected to reduce the external debt of oil and gas exporting countries but worsen the debt burden in oil and gas importing countries. the inflation is also contributing to external debt in the region, particularly in oil and gas exporting countries. because most of these countries are following fixed exchange rate system, an increase in the inflation rate put the pressure on exchange rate and to maintain the fixed rate, these countries need foreign exchange, which can be met through foreign borrowing that may result in accumulation of external debt. the effect of investment on external debt is very high in the region. this effect is more in oil and gas importing countries compare to oil and gas exporting countries. the investment is affecting external debt positively in oil and gas importing countries, and negatively in oil and gas exporting countries. the domestic saving has expected negative effect on external debt of oil and gas importing countries. since oil and gas importing countries have very low saving rate, this force them to borrow abroad extensively. the increase in domestic saving will decrease their external debt by a large amount. foreign exchange reserves are another source of external finance just like external debt. high foreign exchange reserve may result in reduced willingness to borrow. on the other hand, an increase in reserve, may indicate an enhanced ability to manage the debt, which may result increase borrowing to build up reserves. the coefficient of res is negative and highly significant in oil and gas exporting countries. the foreign exchange reserves of most of the table 4: model estimation results oil and gas exporting countries oil and gas importing countries variable coefficient t-statistic p variable coefficient t-statistic p constant 50.434 1.427 0.156 constant 47.422 2.713 0.008 gdp −0.131 −3.742 0.000 gdp −0.159 −2.726 0.007 cab 0.933 3.111 0.002 tb 5.607 4.490 0.000 ggr −2.758 −3.198 0.002 ggr −1.538 −2.383 0.019 gge 4.041 5.183 0.000 poil 0.240 1.878 0.063 inf 1.344 2.825 0.006 red 19.083 8.523 0.000 poil −0.179 −1.993 0.049 fdi 1.750 2.622 0.010 res −0.113 −3.388 0.001 gds −5.157 −4.204 0.000 inv −0.682 −1.702 0.092 inv 5.352 4.320 0.000 adjusted-r² 0.52 f-statistic 16.90 adjusted-r² 0.60 f-statistic 22.92 dw statistic 0.45 p (fstatistic) 0.00 dw statistic 0.58 p (fstatistic) 0.00 source: author’s estimation, gdp: gross domestic product, cab: current account balance, gge: general government expenditure, fdi: foreign direct investment waheed: determinants of external debt: a panel data analysis for oil and gas exporting and importing countries international journal of economics and financial issues | vol 7 • issue 1 • 2017 239 countries in this region are very low. an effort to increase foreign exchange reserve will lower the external debt burden. the results presented in table 4 have been subjected to several robustness checks. the validity of these results are confirme by comparing them with the results obtained in the previous studies, using different estimation methods and different sample sizes. the two models results are good based on the adjusted-r2 and f-statistic. the explanatory power of all models is between 50% and 60%, and these models are overall highly statistically significant. the bias proportion and variance proportions were also reasonable in both models, showing their good forecast ability. 5. conclusion and policy implications in this study, the determinants of external debt are explored in oil and gas exporting and importing countries. the results from the study confirmed that the determinants of external debt, and their effects are different in oil and gas exporting and importing countries. the panel data estimation results for oil and gas exporting countries show that increased economic growth, foreign exchange reserves, ggr, price of oil, and domestic investment are the important factors in reducing external debt. the current account deficit, gge and inflation are accumulating external debt of these countries. the policy makers in these countries should focus on particularly current account defi it and infl tion for reduction of external debt. moreover, these countries need to increase the ggr and cut expenditures as this has the strong effect in reducing external debt. the estimation results of oil and gas importing countries are slightly different than the oil and gas exporting countries. the increase in economic growth, ggr, and gross domestic savings (gds) are important factors in reducing external debt in oil and gas importing countries. the increase in trade defi it, international price of oil, interest payment on external debt, fdi and domestic investment are resulting in higher external debt in oil and gas importing countries. the policy makers in these countries are needed to pay special attention in reducing trade deficit and findin the new sources of government revenue and providing incentive to domestic savers to boost the domestic saving. the future research can be extended in many directions. first the sample can be extend to include other oil and gas exporting and importing countries in the rest of the asia or even the rest of the world. second, the study focused only economic factors, which can be further extended to include administrative and uncertainty related factors. finally, the external debt variable can be disaggregated to short-term and long term and into different currency compositions. the core lesson learnt from this study is the importance of avoiding particular generalization for external debt accumulation. it is necessary for the policy makers to know the importance and effect of each factor that are responsible for external debt accumulation. this will help policy makers to handle the issue properly and to avoid any possible crisis. 6. acknowledgment this paper is the outcome of the research project entitled. “sustainability and determinants of external debt: empirical analysis for bahrain” funded by the deanship of scientifi research, university of bahrain, kingdom of bahrain. references awan, a., asghar, n., rehman, h. (2011), the impact of exchange rate, fiscal deficit and terms of trade on external debt of pakistan: a cointegration and causality analysis. australian journal of business and management research, 1(3), 10-24. awan, r., anjum, a., rahim, s. (2015), an econometric analysis of determinants of external debt in pakistan. british journal of economics, management and trade, 5(4), 382-391. bacha, e.l. (1990), a three gap model of foreign transfers and the gdp growth rate in developing countries. journal of development economics, 32(3), 279-296. bader, m., magableh, i.k. (2009), an enquiry into the main determinants of public debt in jordan: an econometric study. dirasat administrative science, 36(1), 181-190. baltagi, b.h. (2005), econometric analysis of panel data. new york: john wiley and sons ltd. barro, r. (1979), on the determination of public debt. journal of political economy, 87, 240-270. benedict, i., ehikioya, i.l., asin, o.m. (2014), determinants and sustainability of external debt in a deregulated economy: a cointegration analysis from nigeria (1986-2010). american international journal of contemporary research, 4(6), 201-214. bittencourt, m. (2013), determinants of government and external d e b t : e v i d e n c e f r o m t h e yo u n g d e m o c r a c i e s o f s o u t h america. ersa working paper no. 341, economic research southern africa. chenery, h., strout, a.m. (1966), foreign assistance and economic development. american economic review, 56(4), 679-733. colombo, e., longoni, e. (2009), the politics of external debt in developing countries. department of economics, university of milan working paper series no. 176. p1-22. eichengreen, b.j., portes, r. (1986), debt and default in the 1930s: causes and consequences. european economic review, 30(3), 599-640. forslund, k., lima, l., panizza, u. (2011), the determinants of the composition of public debt in developing and emerging market countries. review of development finance, 1, 207-222. hajivassiliou, v.a. (1987), the external debt repayments problems of ldc’s: an econometric model based on panel data. journal of econometrics, 36(1-2), 205-230. imf. (2015-2006), regional economic outlook: middle east and central asia. washington, dc: international monetary fund. sachs, j., berg, a. (1988), the debt crisis. structural explanations of country performance nber working series no. 2607. cambridge, ma: national bureau of economic research. selami, s. (2004), an empirical note on external debt and defence expenditures in turkey. defence and peace economics, 15(2), 199-203. waheed: determinants of external debt: a panel data analysis for oil and gas exporting and importing countries international journal of economics and financial issues | vol 7 • issue 1 • 2017240 tiruneh, m.w. (2004), an empirical investigation into the determinants of external indebtedness. prague economic papers, 3, 261-277. waheed, a. (2007), foreign public capital and economic growth of developing countries: a selected survey. in: siddiqui, a., editor. india and south asia: economic development in the age of globalization. usa: m.e. sharpe. world bank. (2015), world development indicators. washington, dc: the world bank. appendix table 1: definition of variables and sources of data variable definition data source ed gross external debt regional economic outlook-imf gdp gross domestic product world development indicators-wb cab current account balance regional economic outlook-imf ggr general government revenue regional economic outlook-imf gge general government expenditure regional economic outlook-imf inf inflation rat regional economic outlook-imf poil price of oil organization of petroleum exporting countries res foreign exchange reserve regional economic outlook-imf inv gross capital formation world development indicators-wb tb trade balance world development indicators-wb red interest on external debt world development indicators-wb fdi foreign direct investment world development indicators-wb gds gross domestic savings world development indicators-wb gdp: gross domestic product, cab: current account balance, gge: general government expenditure, fdi: foreign direct investment, data sources: imf(2015-2006) and world bank (2015). table 2: list of countries oil exporters oil importers algeria egypt bahrain jordan iran lebanon iraq mauritania kuwait morocco oman pakistan qatar sudan saudi arabia tunisia united arab emirates oil and gas importers oil and gas exporters armenia azerbaijan georgia kazakhstan kyrgyz republic uzbekistan tajikistan appendix tables . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2015, 5(4), 995-1000. international journal of economics and financial issues | vol 5 • issue 4 • 2015 995 mediating effects of cash management in relationship between capital structure and liquidity in small and medium enterprises ibrahim danjuma*, mohammed sangiru umar, dahiru dauda hammawa department of management technology, modibbo adama university of technology, yola adamawa state, nigeria. *email: ibro.danjuma@gmail.com abstract this study attempts to establish the relationship that exists between capital structure, cash management and liquidity in some selected small and medium enterprises in jimeta, adamawa state, nigeria. it also investigates the mediating effect of cash management in the association of capital structure and liquidity. a total of 365 copies of questionnaire were administered to 366 small and medium scale enterprise but a total 310 copies of questionnaire were returned fully and appropriately filled. the study made use of but primary and secondary method in collecting data. a cluster sampling method was used in this study and purposive sampling was also used to choose units of analysis in all clusters. descriptive and inferential statistic such as frequencies mean, and standard deviation including pearson’s correlation coefficient, multiple regression and sobel test were employed to obtain results. the results indicate that there is a positive significant relationship between capital structure and cash management, capital structure and liquidity, liquidity and cash management at a correlation of 0.657, 0.657 and 0.640 respectively, significant at 0.01 level (2-tailed) and df = 309. to support the correlation analysis, the regression analysis was also used to see the variability in the relationship and it indicates that 43.1% and 43% of the variability in both cash management and liquidity can be explained by the capital structure of the firm and also 41% of the variability in liquidity can be explained by cash management. the sobel test and the kenny and baron approach were used to test the mediating effect of cash management in the relationship between capital structure and liquidity and it indicate a partial mediation between the variables. a single research methodology approach was used and the findings from this research are cross sectional, future research through other methods could be undertaken to triangulate and also should be taken across time. the study recommends that chief financial officers exercise caution while choosing the amount of debt to use in their capital structure since a positive relationship exist between capital structure, liquidity and cash management. keywords: cash management, capital structure, liquidity, mediation jel classifications: g3, j52 1. introduction liquidity has major impact in capital structure decision making when financial institutions want to provide finance in a particular business, they need to analyses the liquidity of that business in which they are investing or given out loans. cash management is also an important aspect that needs to be considered by all small and medium scale enterprises. there is extra money to earn by managing the liquidity of the company in the right way. most of the companies do not have any employee that is managing the liquidity of the companies (babi, 2012). with cash management, companies will get rid of unnecessary restricted capital and by being efficient a great deal of money will be earn and invested them properly. there is a big opportunity to see if the company’s liquidity will be more efficiently managed through cash management thinking. moreover, most of the studies in these aspects are either on capital structure and liquidity (sibilkov, 2007; ofumbia and uchenna, 2012), capital structure and cash management (grinblatt and titman 2004) or liquidity and cash management (collins and jarvis, 2000; gitau, 2012). against the aforementioned background, this study was aimed at empirically testing the relationship between cash management and capital structure; capital structure and liquidity and between danjuma, et al.: mediating effects of cash management in relationship between capital structure and liquidity in small and medium enterprises international journal of economics and financial issues | vol 5 • issue 4 • 2015996 cash management and liquidity, albeit within the context of small and medium enterprises in nigeria. in addition, the study was also aimed at investigating whether capital structure has significant influence in relationship between cash management and liquidity. these are hypothesized in figure 1. 2. literature review and hypothesis development 2.1. cash management and capital structure motazed (2012) indicated that there is a significant relationship between capital structure and cash management and also revealed an inverse relationship between the size of debt and managed cash flow. he further revealed a direct relationship between increase capital due to equity with managed cash flows by using a regression analysis. hurdon (2001) found that, since cash management involve proper management of cash flows, proper cash amount are kept for transactional motive. the firm buys factors of production on cheaper prices when opportunity comes. he therefore established a positive relationship between management of cash and a method of business finances. he used a multiple regression model. the findings is inconsistent with the result of hwee (2012) which revealed a negative relationship between capital structure and cash management but consistent with the findings of motazed (2012) which indicated a positive relationship between the capital structure and cash management. p1: there is significant relationship between cash management and capital structure in small and medium enterprises 2.2. capital structure and liquidity sibilkov (2009) examined the relationship between asset liquidity and capital formation. he concluded in his research with the help of multiple regression model that liquidity of assets has been positive relation with leverage. the study indicated that lower assets liquidity reduces the cost of debt and for that reason companies use more debt. he also concluded that his research showed some relations about secured and unsecured debt. he gave details that the relation between secured debt and asset liquidity is safe and positive while the unsecured debt is negatively correlated with firm’s liquidity. sarlija and harc (2012) conducted a research on whether capital accumulation has been affected by liquidity. he argued in some countries, the liquid firms financed by their own capital rather than outsiders and they were less leveraged. he demonstrated that increasing the level of inventory leads to an increase in debt of the company and increasing level of cash in current assets leads to decrease in debt long term as well as short term. he examined in his research with the help of pearson correlation coefficient that there is negative relationship between liquidity and capital structure. he also concluded that the share of retained earning s as well as equity to capital is not correlated with equity. these result is inconsistent with other empirical studies such as sibilkov (2009) and hadlock and james (2002), which revealed a positive relationship between liquidity and capital structure. other studies revealed a negative relationship such as berger and bonaccorsi di patte (2006) and simerly and li (2000) respectively. p2: there is significant relationship capital structure and liquidity in small and medium enterprises 2.3. cash management and liquidity mathuva (2009) studied the impact of cash management and its implication on liquidity and took almost 30 listed firms as a sample and all these companies were listed in nairobi stock exchange and the data was taken from 1993 to 2008. there were certain findings of his research by analyzing the fixed effects regression models. firstly, there is a negative relationship between the time when the cash is collected from the customers and the firm’s productivity. this depicts, firms that are more profitable enjoys less time period for the collection of cash from the customers as compare to ones which are less profitable. secondly, there is a positive relationship between the inventories when they were brought in and the period to which they are sold and the firm’s profitability. the interpretation comes out as that the firms or the organizations which take more time to keep the inventories it reduces the costs of the disruption in the process of production and usually the business losses as there is the insufficiency in the goods. this situation decreases the operating cost of the firm. the third assumption of the research was the association between the average payment period and profitability and found out to be positive. the more the time taken to disburse to the creditors, the profitability will increase. most empirical studies a from non-financial firms (shin and soenen, 1998, wang, 2002; deloof, 2003) corroborate that of mathuva (2009) and sharma and kumar (2011) who argue in favor of a negative relationship between cash management, liquidity and firm profitability. p1: there is significant relationship between cash management and liquidity in small and medium enterprises 3. methodology a sample of 365 from the registered small and medium enterprises within jimeta was drawn at random. the sampling frame for this study is determine from the population of registered small and medium scale enterprises in jimeta metropolis. a total of 310 questionnaires were returned fully and appropriately filled. these represent a response rate of 86.1%. the sample is deduced from the four industries consisting of genetic industry, service industry, trading industry and manufacturing industry with jimeta figure 1: proposed conceptual framework for the study as hypothesized by the authors danjuma, et al.: mediating effects of cash management in relationship between capital structure and liquidity in small and medium enterprises international journal of economics and financial issues | vol 5 • issue 4 • 2015 997 metropolis. a cluster sampling method was used in this study. in accordance with this sampling technique, the small and medium business was divided into industries which include genetic industry, services industry, manufacturing industry and trading industry. maville and goddard (1996) define cluster sampling as “a sampling that subdivides the population in to subgroup called clusters.” purposive sampling was used to choose unit of analysis in all clusters. a units were used in the administration of questionnaire from all the number of small and medium business in all the clusters. the study concentrated on issues related to capital structure, cash management and liquidity which can only be answered by chief financial officer (cfo’s) of the selected small and medium enterprises. the study made use of questionnaire as the research instrument. the majority of questions used were adapted from a study on capital structure and liquidity by lee (1987), with modifications to suit the research context. the research instrument was validated using expert opinion validity. this entails seeking the opinion of expert on finance and entrepreneurship. the test-retest method was used to check the reliability of the scale in this study. 4. results specifically, pearson’s correlation and regression analysis are used to determine causal relationship and the variability of the variables. and rq4: hierarchical multiple regression sobel test analysis was used to determine the type of mediation that is whether it is full or partial mediation. 4.1. relationship between capital structure and cash management the correlation co-efficient measured the degree to which two things vary together (adeniji, 2011). this hypothesis correlated two variables: capital structure and cash management. the findings on table 1 shows a significant positive relationship between capital structure and cash management and the pearson correlation using 2-tailed at r = 0.657, 0.01 significant level and 309 degree of freedom. therefore, we reject the null hypothesis which states that there is no significant relationship between capital structure and management and accept the alternate hypothesis which states that there is a significant relationship between capital structure and cash management. 4.2. relationship between capital structure and liquidity table 1 further correlate the relationship between capital structure and liquidity and the findings indicate a significant positive relationship between the variable that is capital structure and liquidity. the pearson correlation using 2-tailed at r = 0.656, 0.01 significant level at 309 degree of freedom. therefore, we accept the alternate hypothesis which states that there is a significant relationship between capital structure and liquidity and reject the null hypothesis which states that there is no significant relationship between capital structure and liquidity. 4.3. relationship between cash management and liquidity the results for the relationship between cash management and liquidity as shown also in table 1 provide evidence that a positive relationship exist between the two variables, therefore we accept the alternate hypothesis which state that there is a significant relationship between cash management and liquidity and reject the null hypothesis which state that there is no significant relation between cash management and liquidity based on the pearson correlation using 2-tailed indicates that r = 0.640 at 0.01 significant level of 309 degree of freedom. 4.4. relationship between capital structure and cash management however, after using correlation to create causal relationships between the variables, thus the study regressed the influenced of cash management on capital structure for effect size. the f statistics which states the overall significant of the model has the value of 233.339 with (309) degrees of freedom. the significant of f is 0.000 and as such the null hypothesis can be rejected at 1% level. that is cash management is influenced by capital structure. the corresponding t statistics for capital structure is 15.275 which have a significant level of. 000. thus, the finding supported the fact that capital structure contribute to effective cash management. the r2 for the regression is 0.431 and the r2 adjusted is 0.429. the standard error of the estimate is 0.56433. in this study, 43.1% of the variability in cash management can be explained by capital structure while the remaining 56.9% is due to other unexplained factors. thus we reject the null hypothesis and accept the alternate hypothesis. 4.5. relationship between capital structure and liquidity the study revealed that f-statistics which states the overall significant of the model has the value of 232.440 and degrees of freedom stood at 309. and the significant of f is 0.000 an as such the alternate hypothesis is accepted at 1% significant level. that is liquidity can be influence by the capital structure of a firm. the corresponding t statistics for capital structure is 15.246 and has a significant level of 0.000. thus the finding supported the fact that a capital structure of the firm influences the liquidity of that firm. the r2 for the regression is 0.430 and the r2 adjusted is 0.423. the standard error of the estimate is 0.61381. by this 43.00% of the table 1: correlations between capital structure, cash management and liquidity capital structure cash management liquidity capital structure pearson correlations significant (two-tailed) n 1 310 0.657** 0.000 310 0.656** 0.000 310 cash management pearson correlations significant (two-tailed) n 0.657** 0.000 310 1 310 0.640** 0.000 310 liquidity pearson correlations significant (two-tailed) n 0.656** 0.000 310 0.640** 0.000 310 1 310 correlations are significant at: **p<0.001, *p<0.05 level (two-tailed) danjuma, et al.: mediating effects of cash management in relationship between capital structure and liquidity in small and medium enterprises international journal of economics and financial issues | vol 5 • issue 4 • 2015998 variability in liquidity can be explaining by capital structure. the remaining 57.0% is due to other unexplained variables. thus, we accept the alternate hypothesis and reject the null hypothesis. implying that the respondents agreed that liquidity is influenced by capital structure. 4.6. relationship between cash management and liquidity the regression of the influence of liquidity on cash management showed that, f-statistics has 214.112 value with (309) degree of freedom. the significant of f is 0.000 and as such the alternate hypothesis is accepted at 1% level. that is liquidity is influence by cash management. the corresponding f-statistics for liquidity is 14.633 with a significant level 0.000 thus the finding supported the fact that cash management influenced the level of liquidity in a given enterprises. the r2 for the regression is 0.410 and the r2 adjusted is 0.408 with 0.57462 standard error of the estimate. therefore the study indicates that 41% of the variability in liquidity can be explained by cash management while the remaining 51% is due to other unexplained variables thus we reject the null hypotheses and accept the alternate hypothesis as demonstrated in table 2. similarly, mediation test were carried out to establish whether the conditions proposed by baron and kenny (1986) are met. a modified version of sobel test used to calculate the sobel z-value and the significant of the mediation effect of cash management in the relationship between capital structure and liquidity. table 3 indicates that the four conditions for mediation according to baron and kenny (1986) are met. first there is an effect to be mediated (b = 0). second, there is a significant relationship between capital structure and mediator (b = 0.664, p < 0.01) and third the coefficient of the mediator (cash management) is significant in regression three (b = 0.721, p < 0.01) with both capital structure and cash management as predictors. finally, the absolute effect of capital structure on liquidity is less in regression (standardize beta = 0.640) than in regression two (standardized beta = 0.657). 5. discussion 5.1. relationship between capital structure and cash management the first objective of this research work is to determine the effects of capital structure on cash management in the selected sme’s. the relationships among variable can be described in terms of whether they change together or separately. if the change in one variable will be in concomitance with the change in another, that change refers to as positive correlation but when they move in opposite direction the change is negative. therefore, the first hypothesis correlated capital structure and cash management and found a significant positive relationship between these two variables. in the same vein regression analysis was also carried out to determine the extent to which capital structure influences cash management. the study showed that about 43.1% of the variability in cash management can be explained by capital structure. these supported the results from other studies. motazed (2012) studies the relationship between capital structure and cash management using a regression analysis. he found a significant positive relationship by the two variables. hurdon (2001) found that, since cash management involve proper management of cash. he established a positive relationship between management of cash and a method of finances using a multiple regression model. on the other hand, manesh wt al. (2013) examine the relationship between structure of financial resource and management of cash flow from the tehram stock exchange using a regression analyses found a positive significant relationship between management of cash flow and structure of financial resource. nevertheless, shen (2012) examines the role of financial flexibility in capital structure decisions. financial flexibility is measured internally as cash and debt capacity. he supported the notion that financial flexibility is the most important consideration in financing decision debt capacity and external equity flexibility are shown to be the most important determinants of leverage. 5.2. relationship between capital structure and liquidity the second hypothesis correlated two variables: capital structure and liquidity. the findings of the correlations indicated a positive significant relationship between capital structure and liquidity. the pearson correlation stood at 0.656. to further support the findings regression analysis was also conducted to determine the extent of variability of the relationship between capital structure and liquidity. the study showed that about 43% of the variability in liquidity can be explained by capital structure. these support the result from other studies. sibilkov (2009) examine the relationship between asset liquidity and capital formation, using multiple regressions found that liquidity of asset has a positive relation with leverage and that lower asset liquidity reduces the cost of debt and form the reason companies used more debt. similar studies conducted a research to determine whether capital formation has been affected by liquidity (sarlija and harc, 2012). they argued that liquid firms financed by their own capital rather than outsiders and they were less leveraged. this result is also consistent with other empirical studies of hadluck and james (2002), which revealed a positive relationship between capital structure and liquidity. yaser (2012) examine the impact of liquidity on capital structure of textile sector of pakistan. the result of this studies demonstrated that liquidity has least impact of capital structure. also found out that liquidity must be taken into account when the companies want to get the additional capital table 2: regression summary of capital structure, cash management and liquidity path standardized estimate t-value significant capital structure→cash management (r 0.431) 0.664 15.275 0.000 cash management→liquidity (r 0.410) 0.589 14.633 0.000 capital structure→liquidity (r 1.044) 0.721 15.246 0.000 danjuma, et al.: mediating effects of cash management in relationship between capital structure and liquidity in small and medium enterprises international journal of economics and financial issues | vol 5 • issue 4 • 2015 999 from outsiders. moreover, he was on the view that the easiest way to increase the capital is to issue the long term bond with interest. shivdasani and stefanscu (2010) analyze the implication of capital structure on defined benefit corporate pension plan. using a regression modal, he found that organization settle their leverage ratio to judge the firm pension asset. he also found that discouraging pension policies in capital structure test have the risk and it is most important and it is related to business failure. lipson and mortal (2012) examined the relationship between capital structure and liquidity of a sample of idea “n” firms. contrary to the existing literature, he found no empirical evidence between firm liquidity and capital structure and this is due to the fact that distinction features of emerging markets, namely less sophisticated capital markets, higher information asymmetry concentrated ownership and constrained access to debt. fayez (2012) examine the relationship between stock liquidity and capital structure, using a sample of 38 industrial companies listed on amman stock exchange (ase) over a period of 20002009. the univariate and panel regression analysis was used. the result show insignificant relationship between the three measure of liquidity and book leverage and market leverage. these results are inconsistence with lipson and mortal (2012) and frider and mortall (2006) using u.s firms. 5.3. relationship between cash management and liquidity pearson’s b-variant correlation coefficient and regression analysis was used to test the relationship between cash management and liquidity and also the variability of the relationship. the findings indicated a positive and significant relationship between the two variables (r = 0.640, p < 0.01) supporting hypothesis 3. the study showed that about 41% of the variability of liquidity can be explained by cash management. these supported the findings of other studies as that of mathuva (2009) who studied the impact of cash management and its implication on liquidity and took 30 listed firms as a sample. these companies were listed in nairobi stock exchange and the data was taken from 1993 to 2008. he found a positive relationship between cash management of the firm and its liquidity. also studies by shin and soenen (1998), wang (2002) and deloof (2003) both corroborated these study’s findings. 5.4. mediating effect of cash management in the relationship between capital structure and liquidity the study investigated and tested the mediating effect of cash management in the relationship between capital structure and liquidity. the findings indicate that mediating effect of cash management on association between capital structure and liquidity satisfied the conditions of mediation as pointed out by barron and kenny (1986). this is true because proper cash management keeps the company liquid and also with cash management companies will get rid of unnecessary restricted capital (babi 2012). this finding supported the studies conducted by motazed (2012) which postulated that the presence of proper cash management will determine the method of business finances and the findings of mathuva (2009) who studied the impact of cash management and liquidity and found a significant positive relationship between the variable. furthermore, mediating effects of cash management in the relationship between capital structure and liquidity is further confirmed by significant sobel z value of 6.3101 (p < 0.05). 6. conclusion and policy implications the aim of this research was to establish whether or not a relationship exists between capital structure and cash management, capital structure and liquidity and cash management and liquidity. and to see whether there is mediating effect of cash management in the relationship between capital structure and liquidity. the evidence from this study showed that there is a significant positive relationship between capital structure and cash management, capital structure and liquidity, cash management and liquidity. finally, the researcher confirmed the mediating effect of cash management between capital structure and liquidity using sobel test. the study recommends that managers’ should be careful while using the method of finance since a positive and significant relationship exist between capital structure and liquidity since financial institutions use firm liquidity position to determine whether or not to issue out loan to a particular business. since according to the results of investigation it was specified that there is positive significant relationship between capital structure and cash management, it is concluded that the types of capital structure is effective on cash management policies in order to have a better image of current and future cash amounts. therefore, it is recommended that cfo’s should manage to in rest with more knowledge and clear information about financial situation of companies and they should also obtained result as a basic in identifying the investment portfolio or supplying any credit. the management of sme’s should maintain its current asset for meeting its short term obligation. they should increase their liquidity by shortening debtor’s collection period for a better liquidity position since there is positive relationship between cash management and firm liquidity. the result comes out with a series of issues that need to be addressed by both management and researcher. in order to have a meaningful interpretation of the results between the relationships of the study variables, it is always important to determine the role of the third variable in the relationship. rosenberg (1968) argues that variable ends up with facts but incomplete understanding. a study that does not consider the possibility of a mediator effect in the data may miss more explanation for an outcome (nixon, 2015). table 3: summary results of multiple regressions of hierarchical steps step model b r r2 r1 2 p value 1 m_caps tom_cmgt 0.664 0.657 0.431 0.000 2 m_cgmt tom_lqt 0.589 0.640 0.410 0.000 3 m_caps tom_lqt 0.721 0.656 0.430 0.000 4 block 1 0.455 0.640 0.410 0.408 0.000 block 2 0.401 0.712 0.507 0.504 <0.05 source: field survey, 2015. note: block 1=regression coefficients of mv and dv. block 2=regression coefficients of iv, mv predicting dv danjuma, et al.: mediating effects of cash management in relationship between capital structure and liquidity in small and medium enterprises international journal of economics and financial issues | vol 5 • issue 4 • 20151000 a research that address mediation effects will thus offer a more accurate estimation of the relationship between the variables studied in this regard the impact of cash management in the relationship between capital structure and liquidity should always be addressed by researcher if good decisions and conclusions are to be made. thus, the study provides valuable compact of ideas, facts, and figures that can be used by academics, management practitioners and consultant in understanding the mediating effect of cash management in the relationship between capital structure and liquidity. references adeniji, a. a. 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(2013). impact of liquidity on capital structure of textile sector of pakistan, journal of economics and finance, 1(6), 223-233. microsoft word erdinc et al.doc international journal of economics and financial issues vol. 1, no. 1, 2011, pp. 1-11 www.econjournals.com firm size and capital structure decisions: evidence from turkish lodging companies erdinc karadeniz mersin university, school of tourism & hotel management 33343 ciftlikkoy campus, mersin/turkey e-mail: ekaradeniz@mersin.edu.tr serkan yilmaz kandır cukurova university, faculty of economics and administrative sciences 01330 balcali campus, adana/turkey, e-mail: skandir@cu.edu.tr ömer iskenderoğlu niğde university, faculty of economics and administrative sciences niğde/turkey, e-mail: oiskenderoglu@nigde.edu.tr yıldırım beyazit onal cukurova university, faculty of economics and administrative sciences adana/turkey, e-mail: ybeyazit@cu.edu.tr abstract: aim of this study is to investigate the role of firm size on capital structure decisions of turkish lodging companies. in this context, a survey questionnaire is developed and sent to unquoted turkish lodging companies. 163 lodging companies answered the survey and they are classified according to their sizes. empirical findings reveal that firm size is a significant factor for capital structure decisions of turkish lodging companies. firm size seems to affect lodging companies in using incentives, issuing common stock, using personal debt and determining target debt ratio. most of the empirical findings seem to support pecking order theory. keywords: firm size, capital structure, pecking order theory, trade-off theory; lodging companies. jel classifications: g32, m20 1. introduction the relationship between capital structure decisions and firm value has been extensively investigated in the past few decades. modigliani and miller (1958), modigliani and miller (1963) are generally perceived as milestones among capital structure studies. they construct the role of taxes, market value of firm and cost of capital in capital structure decisions. likewise, jensen and meckling (1976) and myers (1977) introduce bankruptcy and financial distress costs and agency costs, respectively. these concepts are considered as the basics of trade-off theory. according to this theory, any increase in debt level causes an increase in bankruptcy, financial distress and agency costs, and hence decreases firm value. thus, an optimal capital structure may be acquired by establishing equilibrium between tax advantages and financial distress and bankruptcy costs of debt. in order to establish this equilibrium firms should seek debt levels at which the costs of possible financial distress offset the tax advantages of additional debt (karadeniz et al., 2009). pecking order theory may be thought as an alternative to the trade-off theory. myers and majluf (1984) assume that there is an information asymmetry among investors. since investors generally have less information than insiders do, common stocks would be undervalued by the market. moreover, firms do not have target capital structures. the pecking order theory maintains that firms prefer internal to external financing sources. they use external financing only when internal funds are not sufficient. international journal of economics and financial issues, vol. 1, no. 1, 2011, pp.1-11 2 lodging companies are capital intensive, as they require huge capital at both investment and operating phases. since assets of lodging companies mostly consist of fixed assets, share of long-term debt and owners’ equity naturally increase. furthermore, because of the structure of the industry, lodging companies are highly sensitive to systematic risks. therefore, lodging companies face high levels of operating and financial risks (andrew and schmidgall, 1993). all these characteristics make it important to determine the composition of capital structure and the factors affecting leverage decisions. aim of this study is to investigate the role of firm size on capital structure decisions of unquoted turkish lodging companies. moreover, the roles of trade-off and pecking order theories in explaining the capital structures of the lodging companies are scrutinized. a survey is constructed according to the objectives of the study and sent to 619 lodging companies. 163 of the 619 lodging companies returned. first, the data is examined generally and frequency distributions are interpreted. second, lodging companies are classified according to their sizes and it is examined whether there are differences in responds of the firms with diverse sizes. finally, chi-square and anova tests are employed to measure whether there are differences among the financing decisions of different size groups. the rest of the paper is organized as follows: section 2 reviews the literature. section 3 explains data, methodology and research questions, respectively. section 4 reports the empirical results. section 5 presents the conclusions. section 6 and section 7 summarizes limitations and implications. 2. literature review there is growing body of literature focusing on capital structures and the factors affecting the capital structures of the companies. employing various econometric methods, several studies investigate capital structures of companies. in addition to econometric techniques, some other empirical studies employ survey methods. the studies that employ econometric methods report a positive relationship between firm size and leverage and they conclude that trade-off theory is valid (chen and hammes, 1997; wiwattanakantang 1999; colombo, 2001; fama and french, 2002; fattough et al., 2003; deesomsak et al., 2004; voulgaris et al., 2004; gaud et al., 2005; hol and wijst, 2006; huang and song, 2006; sayılgan et al., 2006; zou and xiao, 2006; feidakis and rovolis, 2007; qian et al., 2007; tortop, 2007; daskalakis and psillaki, 2008; heyman et al., 2008). however, since survey is constructed and used in this study, our focus will be on the studies that employ surveys. ang et al. (1997) determine bank credits, retained earnings and trade credits as the main sources of financing for publicly traded indonesian firms. graham and harvey (2001) find that financial managers take into account flexibility and credit ratings when they issue bonds. on the other hand, dilution effect and recent price increases are taken into consideration during common stock issues. as a result, both pecking order and trade-off theories seem valid for us firms. bancel and mitto (2004) determine financial flexibility, credit rating and tax advantage of debt as the major variables that affect debt policy of companies in 16 european countries. brounen et al. (2005) find that financial managers in netherlands, uk, france and germany establish a target debt ratio. in this context, they assert that tradeoff theory is valid for these countries. frielinghaus et al. (2005) maintain that south african companies prefer more debt in early stages, while they opt for internal sources as the life stages advance. they conclude that this finding favors pecking order theory. beattie et al. (2006) find that most of the publicly traded small and medium sized uk firms do not determine a target leverage ratio. on the other hand, the number of big sized firms that specify a target leverage ratio seems to be larger. grundströmer and gustafsson (2007) report financial flexibility, long-term capacity and credit rating as the most important factors that affect capital structure decisions of publicly traded swedish companies. although the determinants of capital structure are well documented, there is little work on the capital structure of firms in the tourism industry. kwansa and cho (1995) investigate the impact of the trade-off between financial distress costs and tax earnings in the us restaurant industry. they report a significant bankruptcy cost effect on capital structure and firm value. upneja and dalbor (1999) detect a positive relationship between before and after tax rates of us restaurant companies and their leasing activities. özer and yamak (2000) examine financial sources used by lodging companies with less than 100 rooms located in istanbul. they find that lodging companies appear to use internal funds and firm size and capital structure decisions: evidence from turkish lodging companies 3 debt, respectively, in their investment stage. retained earnings appear to be the major source of funds in the operating stage. upneja and dalbor (2001) indicate that debt ratio is positively related to growth opportunities, firm quality, and share of fixed assets for publicly traded us lodging companies. on the contrary, non-debt expenses and debt ratio seem to be negatively related. moreover, firm size and debt ratio do not seem to share a significant relationship. nuri and archer (2001) report higher debt ratios for uk lodging industry than the debt ratios for uk retail industry. they point out that the trade-off theory rather than the pecking order theory is more consistent with the lodging and retail industries in the uk. dalbor and upneja (2002) suggest that long-term debt usage shares a positive relationship with risk and firm size in publicly traded us restaurant firms. furthermore, firm quality and growth opportunities, are found to be related negatively with long-term debt usage. elgonemy (2002) reports advantages and disadvantages of debt financing and debt alternatives in the lodging companies. phillips and sipahioğlu (2004) present evidence on the independence of financial performance and capital structure for publicly traded uk lodging companies. moreover, lodging companies seem to prefer external sources, since capital return is at a low level. tang and jang (2007) find that long-term debt level is positively related to fixed-assets level and growth opportunities for the us lodging companies. however, they cannot find evidence of relationship among, leverage ratio, volatility of earnings, firm size, profitability, and free cash flow. karadeniz et al. (2009), report a negative linkage among debt ratio and effective tax rates, tangibility of assets, return on assets of publicly traded turkish lodging companies, whereas free cash flow, non-debt tax shields, growth opportunities, net commercial credit position, and firm size do not appear to be related with the debt ratio. they conclude that these findings support neither pecking order theory nor the trade-off theory exactly. 3. data and methodology the survey, which had been constructed according to the objectives of the study, was sent by e-mail and mail. the survey had been constructed and pre-tests had been performed in the period between february 2007 and april 2007. by may 2007, surveys were sent to the lodging companies and 163 of them responded by september 2007. research population consists of turkish lodging companies that have tourism operation license. according to the republic of turkey ministry of culture and tourism data for the year 2006, 2475 lodging companies have tourism operation license. the size of the sample should be at least 25% of the population in order for sample to proxy the population (churchill, 1991). at 95% confidence level and aiming for 25% of the population, sample size was calculated as 619 lodging companies according to absolute precision criterion. out of the 619 lodging companies, 163 lodging companies agreed to participate the survey, resulting in 26,3% response rate. in the literature, response rates vary between 1,7% and 86,3% (ang et al., 1997; özer and yamak, 2000; graham and harvey, 2001; brounen et al., 2005; frielinghaus et al., 2005; beattie et al., 2006; grundströmer and gustafsson, 2007). the survey package included a questionnaire for the financial or accounting managers of unquoted lodging companies. the questionnaire in the survey package is constructed in light of graham and harvey (2001), özer and yamak (2000). there are totally 18 questions in the survey. the first 5 questions in the survey are designed to identify the lodging company. other questions are related with financial sources used to finance setup investments ongoing operations and future investments. moreover, some questions are related with basic financial problems of the lodging companies and the factors that affect the maturity and amount of financial sources. nevertheless, in order to be compatible with the objectives of the study, we analyze the questions related with identifying the company and the linkage between firm size and choice of financial sources. we obtain data from 163 lodging companies. first, the data is examined generally and frequency distributions are interpreted. second, lodging companies are classified according to their sizes and it is examined whether there are differences in responses of firms with diverse sizes. the size groups are constructed according to the number of personnel. finally, chi-square and anova analyses are employed to measure whether there are differences among the financing decisions of different size groups. the criteria used for classifying lodging companies come from the small and medium size enterprises definition of european union commission. according to this definition, the companies that employ 0-49 personnel are classified as small sized companies. the companies that employ international journal of economics and financial issues, vol. 1, no. 1, 2011, pp.1-11 4 between 50 and 249 personnel are defined as middle-sized companies. the companies that employ more than 250 personnel are referred to as big companies (yılmaz, 2003). research questions: toward the objectives of the study, several research questions are constructed. these research questions are presented below. 1) do the financial source preferences of turkish lodging companies for financing initial investments differ according to the firm size? according to trade-off theory, as big companies better diversify risk and have lower level of default risk, they tend to use debt in financing setup investments (rajan and zigales, 1995; jaggi and gül, 1999). on the other hand, according to pecking order theory, as companies become bigger, they provide more information and face less asymmetric information problem. thus, cost of equity of big companies is less than that of smaller companies. as a result, pecking order theory suggests that as companies get bigger they tend to depend on equity rather than debt (frank and goyal, 2003). 2) do the financial source preferences of turkish lodging companies for financing ongoing operations differ according to the firm size? trade-off theory conjectures that as big companies are credible in money markets and they have lower levels of agency cost, they depend on debt in financing their ongoing operations (jaggi and gül, 1999; bhaduri, 2002). however, pecking order theory asserts that since big companies have sufficient levels of internal sources, they tend to use internal sources at the first place. debt takes the second place and issuing common stock is the last resort (petersen and rajan, 1994; akhtar and oliver, 2005). 3) do the financial source preferences of turkish lodging companies for financing future investments differ according to the firm size? according to trade-off theory, as default risk of big companies is smaller, big companies tend to use debt in financing their future investments (jaggi and gül, 1999; bhaduri, 2002). however, pecking order theory assigns internal sources a priority in financing future investment opportunities (myers and majluf, 1984). 4) do the ranking of financial source preferences of turkish lodging companies differ according to the firm size? trade-off theory maintains a positive relationship between firm size and leverage. big companies are credible in money markets and their agency cost of debt is at a lower level. thus, big companies are expected to intensively use debt (rajan and zigales, 1995; jaggi and gül, 1999; bhaduri, 2002; brierly and bunn, 2005). on the other hand, pecking order theory suggests that big companies have sufficient levels of internal sources and lower cost of equity. as results, they incline to use retained earnings as the primary financing source. any excess financial needs are met by debt and they issue common stocks at the last step (frank and goyal, 2003; mira and gracia, 2003; daskalakis and psillaki, 2008). 5) do turkish lodging companies’ composition of debt differ according to the firm size? either trade-off or pecking order theory suggests a pervasive impact of firm size on composition of debt. 6) do turkish lodging companies’ target debt-to-asset ratio for the following three years differ according to the firm size? trade-off theory asserts the existence of a target debt ratio. accordingly, companies should determine an optimal target capital structure in order to balance benefits and costs of using extra debt. moreover, big companies are assumed to determine target debt ratio more often than small companies do. in this sense, graham and harvey (2001) find that big companies have more rigid target debt ratios than small and medium sized companies. however, pecking order theory conjectures that shifts in the debt levels of companies are independent of predetermined capital structures. in other words, companies do not have target leverage and realized leverage ratios are determined by the difference between investments and retained earnings (myers and majluf, 1984; rajan and zingales, 1995). firm size and capital structure decisions: evidence from turkish lodging companies 5 4. empirical results among the 163 respondents of the survey, 140 are hotel, 1 is motel, 8 are boutique hotel, 8 are holiday village and 1 is pension. 5 respondents do not specify the kind of the lodging company. the majority of the respondents are hotel companies with an 88,6%. the number of the other type of lodging companies is rather small. according to the geographic region, 31 lodging companies operate in the mediterranean region, whereas 49 lodging companies operate in each of the aegean and marmara regions. there are 34 lodging companies in central anatolia region. 160 of the lodging companies submit their human resources information. among those companies, 45 of them are classified as small sized, while there are 85 medium sized and 30 big sized lodging companies, respectively. the financing preferences of lodging companies during the initial stage according to their sizes. among the 160 lodging companies that submit their personnel information, 45 are small-sized, 85 are medium-sized and 30 are big-sized companies. we test the relationship between size of the companies and financing preferences during the initial stage. thus, we expect to learn whether financing preferences during initial stage shows variability due to firm size. independent of the size of the company, equity is the major source of funds during initial stage. bank credit and incentive takes the second and third places, respectively. this finding suggests that financing source preferences of lodging companies during the initial stage is not affected by the size of the lodging company. since investments are primarily financed by internal sources and secondary by external sources, financing initial stage seem to obey pecking order theory. table 1 summarizes the chi-square test that is designed to examine the relationship between firm size and the financing preferences during the initial stage. the large p values in table 1 reveal that we cannot observe statistically significant linkages between firm size and financing initial investments by bank credit, equity, trade credit, industrial development bank loan and common stock issue. on the contrary, there is a statistically significant relationship between firm size and using incentives in financing initial investments. we conclude that big-sized lodging companies use incentives more than small-sized lodging companies. table 1. analyzing the relationship between firm size and financing preferences for initial investments by chi squared test financing preferences x2 value d.f. p value bank credit 1,148 2 0,563 incentive 9,314 2 0,009* equity 0,857 2 0,651 trade credit 1,811 2 0,404 industrial development bank loan 1,747 2 0,417 common stock issue 2,511 2 0,285 *significant at 0,01 level. d.f., degrees of freedom. the financing preferences of lodging companies for their ongoing operations according to their sizes. retained earnings are the primary financing source for ongoing operations. bank credit and trade credit come in the second and third places, respectively. financing options for ongoing operations show similarity between big and small sized lodging companies. however, bank credit is the most important financing source for medium-sized lodging companies. retained earnings are the secondary sources, whereas trade credits take the third place. since internal sources are opted for external sources, big and small sized lodging companies seem to obey pecking order theory in financing their ongoing operations. table 2 indicates that there is not any statistically significant relationship among firm size and financing ongoing operations by retained earnings, bank credit, factoring, incentives and trade credit. nevertheless, we detect a statistically significant relationship between firm size and common stock issue. likewise, we observe a significant linkage between firm size and personal debt. in this manner, as companies become bigger, they tend to use financial sources obtained by issuing common stock and from personal debt in financing ongoing operations. international journal of economics and financial issues, vol. 1, no. 1, 2011, pp.1-11 6 table 2. analyzing the relationship between firm size and financing preferences for ongoing operations by chi squared test %2 value d.f. p value retained earnings 0,468 2 0,792 common stock issue 26,494 2 0,000* bank credit 3,701 2 0,157 leasing 3,245 2 0,197 factoring 1,274 2 0,529 personal debt 5,103 2 0,078** incentive 3,421 2 0,181 trade credit 1,044 2 0,593 *0,01 significance level. *0,01 significance level. d.f., degrees of freedom. the financing preferences of lodging companies for future investments according to size. table 3 demonstrates that independent of firm size, majority of lodging companies tend to finance future investments by internal sources. debt takes the second place. this finding seems to support pecking order theory. table 3. distribution of financing preferences of lodging companies for their future investments according to size internal sources debt common stock issue lodging companies nonuser user nonuser user nonuser user small 3 20 19 4 23 0 medium 5 47 30 22 51 1 big 5 17 10 12 22 0 total 13 84 59 38 96 1 the p values in table 4 reveal that there is no relationship between firm size and using internal sources or issuing common stock in financing future investments. nevertheless, we detect a statistically significant relationship between firm size and using debt in financing future investments. table 4. analyzing the relationship between firm size and financing preferences for future investments by chi squared test x2 value d.f. p value internal sources 2,293 2 0,318 debt 6,976 2 0,031* common stock issue 0,874 2 0,646 *0,05 significance level. d.f., degrees of freedom. ranking financial sources used for meeting fund requirements due to sizes of lodging companies. the relationship between firm size and ranking of financial sources is analyzed by anovas test. table 5 depicts that lodging companies prefer internal sources as the primary financing source. debt and issuing common stock are the following financing alternatives. this finding is robust among different firm sizes and consistent with pecking order theory. table 6 summarizes the anova test results which is performed to test whether the ranking of financing preferences change due to firm size. large p values indicate that financing preferences are not impacted by firm size. the distribution of debt maturity preferences of lodging companies due to firm size table 7 examines the preferences for composition of debt according to the firm sizes. findings reveal that lodging companies with different sizes have similar preferences toward not using debt. moreover, medium-sized lodging companies tend to use long-term debt. on the contrary, big-sized lodging companies seem to prefer short-term debt. firm size and capital structure decisions: evidence from turkish lodging companies 7 table 5. ranking financial sources used for meeting fund requirements due to sizes of lodging companies internal source debt common stock issue small mean 1,13 1,89 2,94 observation s 45 36 35 std. dev. 0,344 0,465 0,236 medium mean 1,09 2,01 2,85 observation s 80 70 65 std. dev. 0,284 0,525 0,364 big mean 1,17 1,82 2,77 observation s 24 28 22 std. dev. 0,381 0,723 0,429 table 6. analyzing the impact of firm size on rank of financial source preference by anova test financial source sum of squares d.f. mean of squares f stat. p value internal source 0,140 2 0,070 0,683 0,507 debt 0,874 2 0,437 1,408 0,248 common stock issue 0,420 2 0,210 1,760 0,177 table 7. the distribution of debt maturity preferences of lodging companies due to firm size lodging companies long-term and shortterm debt are used equally debt is not used short-term debt is preferred long-term debt is preferred small 4 24 8 4 medium 11 31 13 23 big 0 11 11 7 total 15 66 32 34 table 8 summarizes the results of chi square test that analyzes the relationship between firm size and the preference for the composition of debt. low p value specifies no relationship between firm size and composition of debt. thus, we observe the existence of a statistically significant relationship between firm size and composition of debt. table 8. analyzing the relationship between firm size and composition of debt x 2 value d.f. p value composition of debt 15,757 6 0,015* *0,05 significance level, d.f., degrees of freedom. distribution of attitudes toward target ratio according to sizes of lodging companies when we examine the attitudes of lodging companies toward target debt ratio, 10 big sized and 13 medium-sized lodging companies seem to have a target debt ratio. the number of small-sized lodging companies, which accept to have a target debt ratio, is only three. table 9 presents the distribution of lodging companies’ attitudes toward target debt ratio. findings indicate that majority of the lodging companies do not determine a target debt ratio. we observe a similarity between these findings and pecking order theory. table 9. distribution of attitudes toward target debt ratio according to firm size lodging companies determining target debt ratio not determining target debt ratio small 3 40 medium 13 68 big 10 20 total 26 128 international journal of economics and financial issues, vol. 1, no. 1, 2011, pp.1-11 8 for the 26 lodging companies that have target debt ratios, the target debt ratio is determined as 43, 08%. among the 23 lodging companies that specify their target debt ratios, 10 of them are classified as big-sized and 13 of them are classified as medium and small sized company. the average target debt ratio of big-sized lodging companies is computed as 31%, whereas the same ratio is 52, 38% for medium and small sized lodging companies. these figures show that big-sized lodging companies have lower target debt ratios than medium and small sized lodging companies. this finding supports trade-off theory and it is compatible with graham and harvey (2001). table 10. analyzing the relationship between firm size and target debt ratio by chi square test a chi square test is employed to analyze the relationship between firm size and target debt ratio and findings are summarized in table 10. we can conclude that there is a statistically significant relationship between firm size and target debt ratio. 5. conclusions aim of this study is to investigate the role of firm size on capital structure decisions of unquoted turkish lodging companies. furthermore, validity of trade-off and pecking order theories in explaining the capital structures of the lodging companies are examined. a survey is constructed in the light of the recent literature and sent to 619 lodging companies. 163 of the 619 lodging companies returned at september 2007. the survey results suggest that there is a statistically significant relationship between firm size and using incentives in financing setup investments. furthermore, we detect a statistically significant relationship between firm size and common stock issues. likewise, we observe a significant linkage between firm size and personal debt. however, financing preferences for setup investments, ongoing operations and future investments seem to be independent from firm size. moreover, there is a hierarchical preference for internal sources, debt and common stock issues. this sequential order of financing sources is compatible with pecking order theory. other findings are also related with the validity of pecking order theory in explaining the capital structures of turkish lodging companies. three points call for pecking order theory. first, lodging companies prefer internal sources in financing their investments. second, we cannot observe a pervasive target debt ratio among lodging companies. third, among the minority that have target debt ratios, big sized lodging companies determine lower target debt ratios. moreover, big lodging companies appear to depend on short-term debt. the reason is that short-term debt does not require collateral and contract. this finding is in line with pecking order theory. on the other hand, we observe a statistically significant relationship between firm size and determining a target debt ratio. this finding supports trade-off theory. since big companies could reach money markets more easily, tendency of determining target debt ratios is stronger for bigger companies. finally, big lodging companies appear to use incentives more heavily than small companies do. this finding necessitates a thoroughly review of incentive policy for tourism industry. the characteristics of lodging companies require a high level of fixed asset investments. thus, we expect equity and long-term debt intensive capital structures for lodging companies. the responds we receive by the survey are in line with this expectation. turkish lodging companies seem to prefer equity and long-term debt in a sequence. this sequential order may be the result of lodging companies’ financing habits of not using capital markets. first, lodging companies are not inclined to issue common stock. equity is generally obtained by retaining income. besides, the priority of retained earnings may arise from the difficulties in obtaining long-term debt. the reason lying behind this difficulty would be related with the unique feature of turkish capital market. corporate bond is not a popular debt instrument in turkish capital market. however, there is a dynamic treasury bill and government bond markets. the latter debt instruments may be crowding out corporate bonds and limit financing x 2 value d.f. p value target debt ratio 8,833 2 0,012* *0,05 significance level d.f., degrees of freedom. firm size and capital structure decisions: evidence from turkish lodging companies 9 opportunities for companies. the only available long-term debt instrument for turkish lodging companies is the bank credits. there may be some arrangements and incentives in the capital markets for facilitating lodging companies’ issuing long-term securities. this would relieve the problem of depending highly on retained earnings and bank credits. 6. limitations we confront some constraints during the survey sending and collecting period. first, accounting registers do not seem to be smooth due to concerns related with tax issues. moreover, many lodging companies do not have finance departments. in these companies, accounting departments try to handle responsibilities of finance department. natural result of this malfunction is that accounting managers lack critical financial information of the lodging company. another problem arises from the content of the survey questions. some of the questions cannot be comprehended by the respondents. in addition, some numeric questions are not replied due to privacy concerns. source of the last limitation is the high level of employee turnover in lodging companies. since accounting and financial managers of lodging companies frequently alter their employers, they may not know the previous practices of the lodging company. 7. implications for future studies although determinants of capital structure have been studied intensively for manufacturing or financial companies, there is limited number of studies for the tourism industry. moreover, considerable portion of these studies employ econometric methods and test validity of several capital structure theories. naturally, these studies depend on the availability of the data. data requirements enforce focusing on publicly traded tourism companies. new survey-based studies would enlarge the scope by covering unquoted tourism companies. future studies may also compare capital structure of unquoted tourism companies in various countries. references akhtar, s., oliver, b. 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(2006), the financing behaviour of listed chinese firms. the british accounting review, 38(3), 239-258. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1956-1964. international journal of economics and financial issues | vol 6 • issue 4 • 20161956 management of the formation of rating preferences of economic entities upon collective choice yury d. motorygin1*, vladimir s. artamonov2, alexander v. maximov3, elena n. trofimets4, valeriy y. trofimets5 1saint petersburg university of state fire service of emercom of russia, 149, moskovsky avenue, saint petersburg, 196105, russia, 2russian ministry for civil defense, emergencies and elimination of consequences of natural disasters, teatralny prospect, 3., moscow, 109012, russia, 3saint petersburg university of state fire service of emercom of russia, 149, moskovsky avenue, saint petersburg, 196105, russia, 4saint petersburg university of state fire service of emercom of russia, 149, moskovsky avenue, saint petersburg, 196105, russia, 5saint petersburg university of state fire service of emercom of russia, 149, moskovsky avenue, saint petersburg, 196105, russia. *email: malygin_com@mail.ru abstract the applicability of a set of methods in the case of obtaining mixed results of the final ranking of economic entities in the process of their rating assessment has been substantiated. a new method of the formation of rating preferences upon collective choice has been proposed. the methodology is based on the following: an information base in the form of a summary table of ratings of compared entities; a procedure for the formation of rating preferences based on a rank-sum (or arithmetic means of ranks); a procedure for the formation of rating preferences with the joint application of rating arithmetic means and position indicators; a procedure for the formation of rating preferences using the kemeny median. the proposals for the calculation of weighting factors of the voting procedures and modification of the procedure for profiling the preferences using the kemeny median have been made. an algorithm for the use of the proposed method has been developed. methodology testing has been conducted upon the rating assessment of the financial and economic condition of industrial enterprises. keywords: system analysis, management of economic systems, economic-mathematical modeling, rating assessment, financial and economic condition jel classifications: p40, p49 1. introduction the lack of information on business entities that complicates the process of taking managerial decisions by the business management regarding the selection of partners in the course of their activities is one of the urgent problems of the modern economy. the lack of information makes analysts look for new ways of getting the information on specific business entities. the formation of ratings, which is a comparison of economic entities by a range of qualitative and quantitative characteristics and their ranking in order to identify the best and worst ones, is one of the ways to disseminate information on economic entities available to all interested users. thus, currently much attention is paid to the calculation of various ratings of different economic entities, starting with the countries and ending with individual enterprises. a number of major specialized rating agencies operate in the world economy. they provide sufficiently high quality services for the calculation of ratings. the services of these agencies are very popular because of high utility of the information provided. the features of the national economy often complicate the calculation of ratings with the use of foreign methods. this resulted in the emergence of a large number of original methods, the authors of which tried to take into account the peculiarities of the activities of various economic entities. nevertheless, the problem of constructing adequate methods for their ranking is still relevant, including in terms of methodology: data bases of methods, weight coefficients of local criteria, methods of obtaining the integrated motorygin, et al.: management of the formation of rating preferences of economic entities upon collective choice international journal of economics and financial issues | vol 6 • issue 4 • 2016 1957 rating score and a number of other elements differ. therefore, the use of different methods often leads to controversial conclusions about the final ranking of economic entities. the aggregation of results obtained under different procedures is one of the approaches to improve the adequacy of the final ranking. certainly, this approach leads to a significant increase in calculation costs, but, taking into account the modern development of computer technology, this aspect is of secondary importance for the problem under review. 2. literature review the problem of the formation of ratings of economic entities has different aspects-practical, methodical, financial and economic, mathematical aspects-which was reflected in numerous publications on this theme. an overview of approaches to the formation of rating systems by russian and western agencies can be found in the works (karminskiy et al., 2005; karminskiy and polozov, 2016). the banking sphere was an initial direction of ratings. a review of approaches to the construction of bank rating models, including as a basis for the systems of early warning of defaults is presented in the works (altman and saunders, 1998; amato and furfine, 2004; trueck and rachev, 2008; yuksel, 2010; rognoni, 2011; karminskiy, 2015). the article (altman and rijken, 2004) is one of the fundamental works in the sphere of rating models, which examines an issue of the stability of such models. currently, corporate ratings are gaining a growing importance. with regard to industrial enterprises, they play an important role in the organization of syndicated lending and public tenders and serve as a basis for the formation of corporate bond ratings (carling et al., 2007). a large number of works are devoted to the issues of the rating assessment of the financial status of enterprises (kotlyar, 1999; schiborsch, 2000; postyushkov, 2001; kovalev and volkova, 2002; ginzburg, 2004, etc.). the mathematical aspects of rating procedures are reflected in the numerous works on econometrics, mathematical statistics, quantitative methods of financial analysis, expert evaluations (podinovskiy, 2007; goryunov, 2012; saaty and vargas, 2013; eiselt and sandblom, 2013; doumpos and zopounidis, 2014; batkovskiy, 2015, etc.). the mathematical aspects of the rating procedures are reflected in numerous works on econometrics, mathematical statistics, quantitative financial analysis methods, expert evaluations (podinovskiy, 2007; goryunov, 2012; saaty and vargas, 2013; eiselt and sandblom, 2013; doumpos and zopounidis, 2014; batkovskiy, 2015, etc.). the integral use of economic-mathematical methods and models is one of the principles of their application in the solution of complex management problems. for this purpose, two directions the parallel use of methods (simultaneous use of different methods at the same stage of the problem solution) and sequential use of methods (the use of different methods at different stages of the problem solution) can be distinguished. the need for the parallel use of different methods (models) is due to the need to improve (enhance) the solution, which is obtained by applying a single method (model). a set of models jointly used to solve the same problem, is called an ensemble (committee) of models. in the last decade, ensembles of models have become an area of active research in data mining (nisbet et al., 2009; perner, 2010, alvo and yu, 2014; larose and larose, 2015, etc.). 3. methodology 3.1. methodology information base a concept of a rank of an entity underlies the proposed methodology of forming the rating preferences of economic entities under collective choice. a rank (r) of an entity shall mean a serial number of the entity in the list of analyzed entities after their ordering upon descending ranking values. in this case, the rule of rank assignment to the entities shall be as follows: 1. if in a set of rating values all numbers are different, each entity is given a unique rank ri; 2. if in a set of rating values there is a group of k equal ranking values xi = xi+1 = xi+2 =… = xi+k, then the rank of the respective entities will be the same and equal to the arithmetic means of their serial numbers. the entity following this group gets a rank equal to ri + k; 3. the entity with the maximum rating value shall have a rank equal to 1; 4. the entity with the minimum rating value has the highest rank value equal to n kmin + 1, where n is a number of entities in the list, kmin means a number of repeating minimum rating values in the list of entities. using the introduced concept of a rank of an entity, a profile of entities preferences (entities ranking) is developed for each of the aggregated methods of the rating assessment. preference profiles are grouped in a summary table of entities ranks (table 1), which is an information base for the methodology of the formation of rating preferences under collective choice. 3.2. formation of the rating preferences based upon the rank sum or ranking arithmetic means final ranking of entities can be constructed based on the data of table 1 by calculating the sum of ranks for each of the entities analyzed ( m j ij i=1 r = r ,j=1...n∑ ) and their subsequent ordering in ascending order rj. this method is called a rank sum method. it is obvious that ranking will be similar if we divide each of the table 1: a summary table of entities ranks methods compared entities entity 1 entity 2 …… entity j …… entity n method 1 r11 r12 …… r1j …… r1n method 2 r21 r22 …… r2j …… r2n …… …… …… …… …… …… …… method i ri1 ri2 …… rij …… rin …… …… …… …… …… …… …… method m rm1 rm2 …… rmj …… rmn motorygin, et al.: management of the formation of rating preferences of economic entities upon collective choice international journal of economics and financial issues | vol 6 • issue 4 • 20161958 values rj by the number of the methods used m. this method is called a method of ranking arithmetic means. the main advantage of the rank sum method and the method of ranking arithmetic means is in their simplicity. however, it should be noted that they have a significant disadvantage. this disadvantage is caused by the fact that the ranks are measured on an ordinal scale. the works (schrader, 1971; kemeny and snell, 1972; orlov, 1996) show that only members of the variation series, in particular the median, can be reasonably used as an arithmetic mean of all the mean values in an ordinal scale. however, in practice, it is impractical to completely ignore the arithmetic mean value, due to the familiarity, clarity and, as a consequence, its high prevalence. however, when using the arithmetic mean there occur well-known situations known as “the average temperature in the hospital” or “the central part of the donut.” such contradiction can be resolved if we take into account the fact that the arithmetic mean is a sufficiently stable score at a small scatter of data being processed, otherwise its use is a purely formal procedure. thus, it can be concluded that the final ranking upon the rank sum method or the method of ranking arithmetic means should be carried out only with adequate consistency of preference profiles obtained by different methods. a concordance coefficient can be used to assess the degree of consistency of preference profiles. this coefficient is defined by the follwoing formula: m 2 2 i i=1 12s w= m n(n -1)-m t∑ (1) where s the sum of squares of the differences between the sum of ranks and their average value; m the number of the methods used; n the number of the entities analyzed; ti an indicator of linked ranks in ith preference profile. if a summary table of entities is used as the information base, a value s can be determined by the following formula: 2n m ij j=1 i=1 1 s= r m(n+1) 2       ∑ ∑ (2) where rij a rank assigned to the j th entity upon the ith method. an indicator of linked ranks ti is calculated by the formula: ip 3 i ki ki k=1 t = (h -h )∑ , i = 1…m (3) where pi the number of groups of equal ranks in the i th preference profile; hki the a number of equal ranks in the kth group of linked ranks of the ith preference profile. if there are no matching ranks in the preference profile, then hki = 0 and pi = 0, consequently ti = 0. the analysis of the national and foreign literature allows to set the limit value for the concordance coefficient w = 0.5 (schrader, 1971; kemeny and snell, 1972). when w < 0.5 preference profiles are not consistent, when 0.5 ≤ w <0.7 not sufficiently consistent, when 0.7 ≤ w < 0.9 consistent, when w ≥ 0.9 extremely consistent. when w ≥ 0.7 preference profiles are considered consistent and in order to develop the final ranking of enterprises we can use the rank sum method or the method of ranking arithmetic means. when w < 0.7 preferences profiles are not sufficiently consistent and to develop the final ranking the use of the mentioned methods is not entirely correct, which is particularly manifested when w < 0.5. therefore, there is a need to develop other approaches and methods that make it possible to overcome the disadvantages of the rank sum method or the method of ranking arithmetic means. 3.3. formation of rating preferences upon the joint application of the method of ranking arithmetic means and the method of ranking position indicators the proposed approach is designed to compensate in some way for the shortcomings of the rank sum method and the method of ranking arithmetic means and provides more correct development of the final ranking of the entities at a value of concordance coefficient w < 0.7. the approach implies the joint application of the method of ranking arithmetic means and the method of ranking position indicators. this approach is consistent with the concept of sustainability, considering the use of a variety of methods for processing the same data in order to form conclusions, obtained simultaneously in all methods used. to adjust the rankings obtained by the method of ranking arithmetic means, it is proposed to use the ranking position indicators. this approach is due to the fact that when measured on an ordinal scale (the rank scale is their representative) it is correct to use the members of the variation series (in particular, a median should be used as a mid-scale, which can be mathematically proved). quartiles, deciles, percentiles, etc. can be the members of the variation series, describing the position of the data. it is proposed to use three position indicators: a median, a lower quartile and an upper quartile. a preference profile median shall mean the importance of the rank located in the middle of the profile. for a profile with an odd number of ranks, a rank located in the center of the profile will be a median. for a profile with an even number of ranks, an arithmetic mean of two central ranks will be a median. preference profile quartiles shall mean the significance of the ranks, dividing the preference profile into four equal parts. the lower quartile separates the one-fourth of the profile with the lowest values of ranks, while the upper quartile separates the one-fourth of the profile with the highest values of ranks. respectively, a median is a medium quartile. motorygin, et al.: management of the formation of rating preferences of economic entities upon collective choice international journal of economics and financial issues | vol 6 • issue 4 • 2016 1959 the approach implies the element-wise summation of the final ranks obtained by the method of arithmetic means and the method of ranking position indicators: r =r +rj ap j a j p (4) where rj a a final rank of the jth entity obtained by the method of ranking arithmetic means; rj p a final rank of the jth entity obtained by the method of ranking position indicators; rj ap a final rank of the jth entity obtained upon the joint application of the method of arithmetic means and the method of ranking position indicators. the final ranking is the result of the ordering of final ranks rj ap in ascending order. 3.4. formation of rating preferences based on the kemeny median with the formation of rating preferences, the natural presumption is that the final ranking should be as close as possible to the preference profiles (rankings) based on different methods. such ranking will correspond to the kemeny median: n a b j=1p p*= d(p ,p )argmin∑ (5) where d(pa,pb) the distance between rankings constructed by using the methods a and b. the construction of the final ranking with the use of the kemeny median requires the introduction of the distance between any two rankings pa and pb. in the basic procedure for finding the kemeny median, such distance is introduced on the basis of the matrix of relations and the matrix of losses, the construction and processing of which require a sufficiently large number of additional processing operations. the specifics of the problem considered allows to avoid the construction of these matrices, since the ranks of entities derived from the calculated rating scores by the methods described above, not the expert opinions located in the space of non-numeric objects, serve as the processed data. taking into account the specifics of the problem, a concept of distance between the rankings should be introduced. definition: the distance between the rankings pa and pb, described by the vectors rj a and rj b respectively, is a value d(pa,pb) equal to the sum of modules of differences of the elements located on the same places in their respective vectors, i.e., the distance between the rankings pa and pb and is calculated as follows: n a b a b j j j=1 d(p ,p )= r -r∑ (6) based on the introduced concept of distance between the rankings, the problem of finding the final ranking can be expressed in the following optimization formula: m i i=1 d(p ,p*) min∑ (7) where p* the final ranking. the final ranking p* can be considered as a set element (pi). in this case, the solution of the optimization problem will be reduced to one of the rankings that are based on the above methods. in our opinion, it is more reasonable to find a new ranking pm+1 = p*, the sum of distances from which to all other rankings is minimal. at the same time, a danger of a situation of “getting into the centre of the donut” is smoothed over by the non-euclidean nature of the introduced metrics and optimization nature of the task. consequently, the final ranking p* obtained based on the modified kemeny median is more objective in comparison with the ranking obtained based on the rank sum method. 3.5. the algorithm of the formation of rating preferences upon collective choice having considered the specific issues associated with the development of the method of the formation of rating preferences of economic entities upon collective choice, we propose an algorithm for the use of the developed method as a summary logical conclusion (figure 1). 4. results 4.1. a brief description of the task of the rating assessment of the financial status of enterprises testing of the proposed methodology has been carried out on the task of the rating assessment of the financial status of industrial enterprises. the financial status of an enterprise is a complex characteristic of its position, which is determined by a system of indicators reflecting the availability, distribution and use of financial resources of an enterprise. the rating assessment of the financial status is a tool for comparing the indicators of financial and economic activities of competing companies. as a rule, it is conducted in the interests of external users: investors, shareholders, creditors, customers, tax authorities, auditors, etc. the rating assessment is based on the official financial statements containing the limited information on the activities of the enterprise. it does not imply an in-depth study of various aspects of financial-economic activities of the enterprise and its main purpose is to get an integrated rating numeric score for the subsequent ranking of compared enterprises. today in russia, there are different methods of the rating assessment of the financial status of enterprises. the conducted analysis of the subject area and literary sources of educational, scientific and applied nature has allowed to identify a number of methods, which are, in our opinion, the most widely used. such methods are as follows: a method of bakanov and sheremet (bakanov and sheremet, 2001) a method of ginzburg (ginzburg, 2004), a method of grafova (grafova, 2003), a method of the motorygin, et al.: management of the formation of rating preferences of economic entities upon collective choice international journal of economics and financial issues | vol 6 • issue 4 • 20161960 company inek (kotlyar, 1999), a method of kovalev (kovalev and volkova, 2002), a method of postyushkov (postyushkov, 2001), a method of savitskaya (savitskaya, 2000), a method of selezneva and ionova (selezneva and ionova, 2006), a method of shadrina (shadrina, 2008), a method of schiborsch (schiborsch, 2000). however, it should be noted that in a number of methods there is a clearly defined system of indicators, based on which the rating score is calculated. there are only general guidelines for its construction. this circumstance does not allow for the correct comparative analysis of these methods. therefore, for further consideration we have selected methods, the authors of which, in addition to the method of the rating score calculation, provide a system of indicators, which is an information base for the rating calculation. these methods include the methods of kovalev, the company inec, schiborsch, ginzburg, postyushkov. to test the developed method, six industrial companies were selected (with the code names “quantum,” “prometheus,” “emerald,” “pulsar,” “alpha” and “spectrum”), which provided the necessary reports for the calculation of indicators of their financial status. figure 1: the algorithm of the formation of rating preferences upon collective choice motorygin, et al.: management of the formation of rating preferences of economic entities upon collective choice international journal of economics and financial issues | vol 6 • issue 4 • 2016 1961 4.2. rating assessment of the financial status of enterprises in accordance with the algorithm of the application of the developed method, the rating assessment of enterprises by using the methods developed by kovalev, inek company, schiborsch, ginzburg and postyushkov has been conducted at the first stage. the calculated final rating values are given in table 2. a summary table of ranks of enterprises is formed on the basis of table 2 and the rules of rank assignment (table 3). at the next stage, the assessment of the degree of consistency of preference profiles is conducted. for this purpose the concordance coefficient is calculated by the formula (1): 5 2 2 2 2 i i=1 12s 12×256.5 w= = =0.593 5 ×6×(6 -1)-5×12 m n(n -1)-m t∑ since 0.5 ≤ w < 0.7, the preference profiles are deemed not sufficiently consistent. thus, to construct the final ranking it makes most sense to use either a method of the collective rating formation based on the joint use of arithmetic means and ranking position indicators, or a method of the collective rating formation based on the modified kemeny median. let us conduct the rating assessment of the selected enterprises, using the above methods. using the first method, we calculate the final ranks of the enterprises by using arithmetic means of ranks, based on ranking position indicators and on their joint application (table 4). the final ranking is the result of the final rank ordering rj ap in ascending order (table 5). the second method that has been proposed for the formation of rating preferences is based on the application of the kemeny median. the first phase of this method involves the construction of the matrix of distances between the rankings obtained by using methods of kovalev, inec company, schiborsch, ginzburg and postyushkov upon the formula (6) (table 6). after the construction of the matrix of distances between the final rankings, we obtain the final ranking p* based on the solution of the optimization task (7). the task (7) has a significant computational complexity, so for its solution it is advisable to use the appropriate software. the excel add-in “search for solution” is recommended as such software. the kemeny median found is given in table 7. the final ranking of enterprises p* is shown in table 8. 5. discussion analyzing the results obtained (tables 5 and 8), it is easy to note that the final rankings obtained on the basis of the two proposed methods are slightly different from one another. this applies to table 2: a summary table of rating scores of enterprises method enterprises quantum prometheus emerald pulsar alpha spectrum kovalev’s 15.0 49.5 42.6 68.0 23.3 94.4 inek 22.0 22.0 27.0 8.0 14.0 26.0 schiborsch’s −0.5 7.6 10.9 11.6 −3.3 12.8 ginsburg’s 288.0 192.0 167.0 167.0 266.0 152.0 postushkov’s 1.456 1.219 1.046 −0.285 −0.788 2.649 table 3: a summary table of ranks of enterprises method enterprises quantum prometheus emerald pulsar alpha spectrum kovalev’s 6.0 3.0 4.0 2.0 5.0 1.0 inek 3.5 3.5 1.0 6.0 5.0 2.0 schiborsch’s 5.0 4.0 3.0 2.0 6.0 1.0 ginsburg’s 6.0 4.0 2.5 2.5 5.0 1.0 postushkov’s 2.0 3.0 4.0 5.0 6.0 1.0 table 4: the rating assessment of enterprises on the basis of joint application of arithmetic means and ranking position indicators calculated values enterprises quantum prometheus emerald pulsar alpha spectrum final ranking upon arithmetic means 5.0 3.5 2.0 3.5 6.0 1.0 final ranking upon position indicators 5.0 4.0 2.5 2.5 6.0 1.0 summary ranking upon arithmetic means and position indicators 10.0 7.5 4.5 6.0 12.0 2.0 final ranking upon arithmetic means and position indicators 5.0 4.0 2.0 3.0 6.0 1.0 motorygin, et al.: management of the formation of rating preferences of economic entities upon collective choice international journal of economics and financial issues | vol 6 • issue 4 • 20161962 the enterprises “emerald” and “pulsar,” as well as enterprises “quantum” and “alpha,” which had the same position in the second ranking. if we take into account the results of the two final rankings, it can be assumed that the financial-economic condition of the enterprise “emerald” slightly exceeds the financial-economic status of the enterprise “pulsar,” while the financial-economic condition of the enterprise “quantum” significantly exceeds the financial-economic condition of the enterprise “alpha.” despite some differences in the final rankings, their concordance coefficient w = 0.985, indicating a high degree of consistency of the estimates, so the resulting ranking can be constructed by using the rank sum method (table 9). the obtained resulting ranking confirmed our assumptions about certain superiority of the enterprise “emerald” to the enterprise “pulsar,” and the enterprise “quantum” to the enterprise “alpha.” with the accumulation of statistical information on the rating assessment of enterprises, weight coefficients for each of the discussed methods can be introduced into the proposed procedure for finding the kemeny median, which allows to increase even more the objectivity of the resulting rating score. obviously, if the ranking pa is closer to the final ranking p* than the ranking pb, the weight of the method a must be higher than the weight of the method b, and vice versa. since the best ranking corresponds to a smaller distance, the weight coefficients can be found by the following formula: i i m i=1 i 1 d(p ,p*) v = 1 d(p ,p*)∑ (8) where vi a weight coefficient of the i th method. thus, for the above example the calculated weights of methods are shown in table 10. it should be noted that the weight coefficients calculated upon the results of the current procedure may be used in the subsequent procedures. it is obvious that if the other enterprises are involved in the rating assessment, then the weights calculated by the formula (8) will differ from the weights calculated last time. in order to stabilize the weights, the current and previously calculated weights are averaged, thus a new weight takes account of the value of “old” weights. this procedure is recurrent in nature and corresponds to the procedure for exponential smoothing of weights with a coefficient equal to a = 0.5. thus, with regard to the weights of methods, the formula of finding the final ranking can be written as follows: m ® i i i=1 (v ×d(p ,p*)) min∑ (9) note that, despite its advantages, the method of the formation of collective preferences based on the modified kemeny median has one significant drawback it is much more complicated in terms of the applied calculation procedures. in particular, in order to find the final ranking p* the algorithms based on the method of branches and borders or gradient search methods should be used, so the practical application of the method is associated with its implementation at the software level. in the absence of specific software the task (9) can be efficiently solved by using the excel add-in “search for solution,” in which a method of generalized gradient and the evolutionary method are implemented to solve nonlinear tasks. 6. conclusion currently, there are various methods of the formation of ratings of economic entities. each of the methods is usually a set of table 5: the final ranking of enterprises based on the joint application of arithmetic means and ranking position indicators rank place enterprise 1 1st spectrum 2 2nd emerald 3 3rd pulsar 4 4th prometheus 5 5th quantum 6 6th alpha table 6: matrix of distances between the rankings method method sum of distances kovalev’s inek schiborsch’s ginsburg’s postushkov’s kovalev’s 0.0 11.0 4.0 3.0 8.0 26.0 inek 11.0 0.0 10.0 9.0 8.0 38.0 schiborsch’s 4.0 10.0 0.0 3.0 8.0 25.0 ginsburg’s 3.0 9.0 3.0 0.0 10.0 25.0 postushkov’s 8.0 8.0 8.0 10.0 0.0 34.0 table 7: the kemeny median of rankings of the enterprises calculated values enterprises kovalev’s inek schiborsch’s ginsburg’s postushkov’s kovalev’s kemeny median 5.0 4.0 3.0 3.0 5.0 1.0 final ranking upon the kemeny median 5.5 4.0 2.5 2.5 5.5 1.0 motorygin, et al.: management of the formation of rating preferences of economic entities upon collective choice international journal of economics and financial issues | vol 6 • issue 4 • 2016 1963 indicators of the financial-economic condition of a business entity, the distribution of weight coefficients on the local criteria and the procedure for their integration into the integral rating indicator. therefore, there is a problem of choosing any one method and conducting on its basis the rating assessment of economic entities or the simultaneous use of several proven methods. in our opinion, the latter approach is more reliable, but in this case there is a need to form the collective rating by combining some rankings obtained with the use of each of the methods. this integration leads to a significant increase in calculation costs. thus, the practical application of the proposed approach implies the development of the automation system of the formation of collective rating preferences. references altman, e., rijken, h. 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(2000), sravnitelnyy analiz konkurentosposobnosti i finansovogo sostoyaniya predpriyatiy otrasli i/ili regiona [comparative analysis of competitiveness and financial condition of the enterprises of the industry and/or a region]. marketing in russia and abroad, 5, 92-111. schrader, y.a. (1971), ravenstvo, skhodstvo, poryadok [equality, similarity, order]. moscow: science. table 8: the final ranking of enterprises upon the kemeny median rank place enterprises 1 1st spectrum 2.5 2nd-3rd emerald, pulsar 4 4th prometheus 5.5 5th-6th quantum, alpha table 9: resulting ranking of enterprises rank place enterprises 1 1st spectrum 2 2nd emerald 3 3rd pulsar 4 4th prometheus 5 5th quantum 6 6th alpha table 10: weight coefficients of methods calculated upon the data of the working example methods distance to the kemeny median weight coefficients of methods kovalev’s 4 0.17 inek 8 0.08 schiborsch’s 2 0.33 ginsburg’s 2 0.33 postushkov’s 8 0.08 motorygin, et al.: management of the formation of rating preferences of economic entities upon collective choice international journal of economics and financial issues | vol 6 • issue 4 • 20161964 selezneva, n.n., ionova, a.f. (2006), finansovyy analiz. upravlenie finansami: uchebnik [financial analysis. financial management: textbook]. moscow: unity-dana. shadrina, g.v. (2008), kompleksnyy ekonomicheskiy analiz khozyaistvennoy deyatel’nosti [comprehensive economic analysis of economic activity]. moscow: its eaoi. trueck, s., rachev, s.t. (2008), rating based modeling of credit risk: theory and application of migration matrices. new york: academic press. yuksel, a. (2010), credit risk modeling: with stochastic volatility, jumps and stochastic interest rates. saarbrücken: lap lambert academic publishing. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(3), 20-30. international journal of economics and financial issues | vol 7 • issue 3 • 201720 evidence on the extent of cosmetic earnings and revenues management by jordanian companies ahmad ahed bader1*, mousa mohammad abdullah saleh2 1department of financial and administrative sciences, al-balqa’ applied university, aqaba branch, jordan, 2department of financial and administrative sciences, al-balqa’ applied university, jordan. *email: aaab@bau.edu.jo abstract this study investigates anomaly and rounds up or down in financial accounting numbers (sales, net income, and comprehensive net income) by applying benford’s law to first and second digit numbers of 164 jordanian firms, for period from (2000 to 2014). furthermore, jordanian firms classified into two groups (positive and negative net income), the first digit testing shows jordanian companies to have inaccurate financial accounting numbers for sales accounts, regardless of their profit or loss results, and companies with positive net income have low evidence for manipulating net income, but firms with negative net incomes don’t manipulate it, and negative net income firms have evidence to manipulate comprehensive net income where positive net income firms don’t do such manipulation, for testing second digit there are no significant evidences for rounds up or down sales, net income, and comprehensive net income accounts, so effective acts to reducing cosmetic earning management are needed. keywords: benford’s law, cosmetic earning management, cosmetic revenues managements jel classifications: l66, m41 1. introduction many companies are manipulating revenues and profits for many reasons, for instance they makes income smooth by viewing the earning in stable manner to stakeholders (jordan et al., 2008). this manipulations by managers produces fake financial statements to their users, hence the creditors, investors, or anyone have interests in these statements will be making wrong decisions according to the manipulations of financial statements. actively, juggler’s managers contravenes the fundamental quality of accounting numbers which are faithful representation that emphasize on competency, neutrally, and accurately of accounting numbers according to the international accounting standards number 1 (ias1). actually, the patterns of rounds up earnings done by firms managers calls cosmetic earning management (jordan et al., 2014), so it will be useful to detects if there are such patterns to fix the errors that done by them on the financial statements by authorities or investors. this paper investigates the possible manipulation by jordanian firms to their financial statements for the three accounts: revenues, net income, and comprehensive net income. many papers investigate the rounds up or down in incomes such as, (nigrini, 2005; al-darayseh and jahmani, 1999; al-darayseh et al., 2000; kinnunen and koskela, 2003; jordan et al., 2008; yang and wang, 2008; darayseh et al., 2010; jordan and clark, 2011). also some researchers examine manipulation on sales revenue (jordan et al., 2009). this paper will adds to the work of authors by investigating manipulation phenomenon in comprehensive net income reported in financial statements of jordanian firms, such as investigating if there are any manipulation in comprehensive net income, which is important because some of the account includes in it, like fair value adjustments comes from revaluation that made by managers and some subjectivity are subject to it (siam and abdullatif, 2011), so it will be useful to see if there are anomalies within this account. benford’s law applied in many areas, and also this law used in accounting and auditing to detect frauds, benford’s law says the frequencies of first numbers like one, two, etc., occurs more than last numbers like 7, 8th, and 9 for the first digit in any numbers and we have positive skewness (lin and wu, 2015). for example, in number 29587, the first number 2 called first digit, number 9 is second digit, number 5 third digit, number 8 fourth digit, and so on. some companies’ rounds up the second digit to increase the first digit by one, so if the second digit rounded up by adding bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 2017 21 one to it, will be more attractive to stakeholder. representing the previous number as 30,000 will be more attractive than 29,000, and doing such rounding will lead to differences in actual frequencies more than the expected frequencies based on benford’s law. this research will show if there are any anomalies in second digit for sales, net income, and comprehensive net income compared to expected frequencies presented in benfords table for the second digit. this paper will extend work of (al-darayseh and jahmani, 1999) were the authors examine the frequencies of first and second digit of income reported in annual report of the jordanian listed companies, and numbers of companies tested were 74 for the period from january 1990 until december 1994. the authors also excluded the negative income from the sample, so the differences between this research and (al-darayseh and jahmani) research were in the size of the sample of this survey which examine 164 companies from different sectors (financial, services, and industrial), so all of the sectors are covered, and the time for sales and net income from (2000 to 2014), and for comprehensive income from (2009 to 2014). the reason behind starting from 2009, that most companies started reporting comprehensive income in 2009, and so there are no data available before 2009 for comprehensive income, and the last difference where this paper examine also the negative numbers of net income (kinnunen and koskela, 2003), and lastly testing anomalies in comprehensive net income. so this paper benefits literature by examine the anomalies of comprehensive income in developing countries like jordan, and also provide stakeholders with information about rounds up or down in jordanian companies listed in amman stock exchange. if there are no rounds of financial numbers, this will be a good point for jordanian companies and that gives evidence of low risk for financial manipulation and enhances the sound of faithful representation that mentioned in ias1. the results reveals that jordanian firms have inaccurate accounting numbers especially in sales accounts, and for net income the manipulation is only for firms that reported positive net income. furthermore, the surprising issue has to do with firms reporting loss in their income manipulating comprehensive net income but was not in companies with profitable results. lastly, there is no significant evidence of rounds up or down on sales, net income, and comprehensive net income accounts except for net income accounts within negative net income firms is partly significant. the results of this research may be important to investors, creditors, lenders, and stakeholders. it is also important for jordanian authorities to produce acts that reduce anomalies in financial accounting numbers for jordanian firms listed in amman stock exchange. 2. importance of research there are one research studied the anomalies of income first and second digit (al-darayseh and jahmani, 1999), and their results for the first digit where there are no deviations based on benford’s law, but for second digit there is small deviation. the authors concludes there are accurate financial numbers presented in the annual report of jordanian firms, and so it is useful to assert on the accuracy of financial numbers within companies listed in amman stock exchange for the period from (2000 to 2014). this paper extended the work done by (al-darayseh and jahmani, 1999), which was conduct for the period from (1990 until 1994) to see if there are any changes on this phenomenon today, and also this research covers companies from different sectors such as industrial, services, and financials. assessing all sectors are important to stakeholders, especially for investors because they have different preference in their investments and also some of investors make diversifications, so covering all sectors are important to them in adding to their knowledge about anomalies in financial accounting numbers produced by jordanian firms listed in amman stock exchange. the third aspect which distinguishes this research from other researches where in studying comprehensive net income, so based on researches published in this field, this paper covers this account. the reason behind examining this account is the nature of items included in it like fair value items, so the fair values in some cases are subject to fraud (siam and abdullatif, 2011). this paper will benefits the authorities by adding to their knowledge about the existence of fraud within jordanian companies, and how to take some actions to enhance the accuracy of accounting numbers that produced by firms, and investigating manipulations are also important to creditors or lenders because some of creditors or lenders analyze financial statements of borrowers or business customers before taking the decision of lending them. the results of this paper may have some effects on such judgments by knowing that jordanian firms are manipulating their accounting numbers or not. at present time, and to the best of researcher knowledge, no previous studies examine comprehensive net income accounts to see if there any manipulation by jordanian firms or not based on their results (loss or profit) and to see if there are differences between them. 3. literature review benford’s law in 1938, investigate occurrence of numbers for first digit from 1 to 9. he uses logarithm to calculate the frequencies of different set of numbers such as book pages, reverse lengths, people street addresses, and population numbers in the u.s states (hassan, 2003; nigrini, 2005), and also to second digit, third digit, and fourth digit. benford’s law concludes that the occurrence of first numbers, for instance zero and 1 more likely to occurs than last numbers such as 9. in table 1 (nigrini, 2005) presents the frequencies for numbers based on benford’s law. table 1 presents the frequencies of numbers in each position, many of researchers uses benford’s law to detect fraud, manipulation, and rounding of accounting numbers, so this law applies for different accounts in different countries, whether are developed or not. in jordan (al-darayseh and jahmani, 1999) tested if the occurrences of numbers appears in first and second digit for income account confirms the expected random distribution presented by benford’s law too. the authors covers the period from (1990 until 1994) for 74 jordanian companies. the authors also excludes firms bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 201722 that reported loss in income, and uses as well, z-score and chi-square to test the conformity with expected frequencies. accordingly, the results for first digit not widely deviated from expected distribution, for second digit there are small deviations, but in general, income numbers are accurate. in 2000, al-darayseh conducted research with other authors, (al-darayseh et al., 2000), for turkish firms listed in istanbul stock market with same methodology used by al-darayseh and jahmani in 1999, and they test the same account income for the period (1991-1995), and arrived to the result that the first and second digit don’t deviated widely from benford’s law. some researchers like (kinnunen and koskela, 2003) investigates cosmetic earning management across 18 countries (australia, belgium, canada, denmark, finland, france, germany, hong kong, italy, japan, singapore, spain, sweden, switzerland, the netherlands, norway, united kingdom, and the united states of america), they examine net income for profit or loss and net sales too, and they gathers data for the 5 years from (1995 to 1999), and their findings shows 50% of the countries observed significant manipulations for tested accounts. actually, the highest manipulations were in spain, hong kong, and singapore, and the lowest were in finland, denmark, sweden, and norway, but united kingdom manipulation was small and not significant. kinnunen and koskela proves that anomalies phenomenon varies between countries so some countries have high cosmetic earning management while others have low, and some other countries don’t have. some researchers conduct research on u.s firms like (jordan et al., 2008), they select 1002 publicly trading companies in u.s for financial statement data in 2006, and they also took income accounts to investigate if managers manage earnings to reach cognitive reference points in both cases (profit and loss). in addition, authors excluded firms that reported extraordinary and discontinued items from sample to keep income account free of stir, and they also investigate if companies characteristic (firm size, debt leverage, and operating performance) relates to phenomenon of reacting cognitive reference points, but in this issue which the authors excluded firms that reported loss, the results shows firms with profit manipulating second digit to reach cognitive reference point and the opposite for companies that reported loss. for firm size, they present small firms that tends to manipulate income more than large firms, lowleverage firms rounds the second earnings digit over a wider range than the high-leverage firms, and lastly the authors took returns on assets as proxy for operating performance variable and they found high roa firms have limited rounding compared to low roa firms which seems more aggressive in manipulations. some researchers, like (yang, and wang, 2008) argues that the rounding of earning numbers is not the subject of first and second digit only but also the subject of third, fourth and fifth digit, and so they test this proposition. they investigate ownership structure factors, examine the phenomenon on taiwan companies for period from (2002 to 2006), and uses pre-tax income account. they found positive pre-tax earnings if number nine in second or third or fourth digit it rounded by added one to it, for negative pre-tax income there are low 0 and high 9 occurrences in second digit, but for third, fourth and fifth there were no deviation from the expected, which means that the rounding in negative income is lower than positive income. lastly, they found the firms with low degree of insider ownership are more likely to manipulate earnings numbers than firms that have high degree of insider ownership. in 2009 jordan point out that the importance of sale revenues to investors is assessing firm quality by measuring growth percentage in sales (jordan et al., 2009). hence any manipulation in sales will result in net income, and their sample consist of 1002 companies listed in u.s for year 2006, and the result shows u.s firms manipulating sales account so numbers zero have high frequencies and number 7 have low frequencies based on benford’s law. in 2010 darayseh conduct a research with others on companies working at gulf cooperation council (uae, qatar, oman, saudi arabia, kuwait, and bahrain) (darayseh et al., 2010), they tested the second digit frequencies for 310 firms for the period (20022006), and the results shows income numbers are not accurate. some researchers study the differences before and after sarbanesoxley act (sox) of 2002 like (jordan and clark, 2011) in income numbers for second digit. the period before sox was from (1997 to 2000) and for period after it was from (2003 to 2006), and the result shows rounding for zero and nine with statically significance, but for the period after sox it show rounding but not statically significant, which means that some legislations like sox have effects in reducing manipulations that made by firms. (wilson, 2012) assert on the finding of jordan and clark in 2011, and they gathered the results for 2009 for net sales and net incomes, and their result shows that sox act plays a good rule in reducing manipulation by u.s firms. some researchers like (geyer, 2012) extended the job of others to investigate if sales accounts are rounded by u.s firms for 2008, and the author didn’t stop there, but he extend his investigation by testing if the type of industries sectors have more manipulation than others, and his finding shows the companies to manipulate their sales, and the industries which have this phenomenon was industrial, health care, and financial sectors. the authors also show the larger firms to manipulate sales more than smaller one. some researchers like (cox et al., 2012), tries to investigate inappropriate rounding in earning but they didn’t take the hole u.s firms as the previous researchers, they investigate the phenomenon for each companies and collected data from (1955 to 2010) for each companies, and they conduct test for 6593 firms individually and found 13 companies of them manipulating their earning accounts. it’s useful to see if the rounding in revenue and earning differs from the companies that have loss or profit, so (he et al., 2013), conducts research that investigate this phenomenon for the period of (1950-2010) for 193788 revenue observations, 153994 positive earnings and 39794 negative earnings observation. the results of their research that table 1: benford’s law: expected digital frequencies digit position in number first digit second digit third digit fourth digit 0 0.11968 0.10178 0.10018 1 0.30103 0.11389 0.10138 0.10014 2 0.17609 0.10882 0.10097 0.10010 3 0.12494 0.10433 0.10057 0.10006 4 0.09691 0.10031 0.10018 0.10002 5 0.07918 0.09668 0.09979 0.09998 6 0.06695 0.09337 0.09940 0.09994 7 0.05799 0.09035 0.09902 0.09990 8 0.05115 0.08757 0.09864 0.09986 9 0.04576 0.08500 0.09827 0.09982 source: (nigrini, 2005), based on nigrini 1996 this is the original source insert it bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 2017 23 the companies are rounding both accounts of revenues and earnings, so rounding earnings is significantly greater than revenues for profitable companies, and the opposite for companies which have loss. some researchers like (johnson and wigginman, 2013), uses benford’s law on the following three account: total general revenues of the primary government, total fund balance of the general fund, and total fund balance of the governmental funds for the 50 state in u.s for the period of 3 years. they also used mean absolute deviation model (mad) which was developed by them, and (mad) is better for the small sample set, and found the following results: for the total fund balance of the governmental funds account there is nonconformity for using benford’s law, but for total general revenues of the primary government and total fund balance of the general fund both of them have acceptable conformity. in 2013, two researchers (kang and jin, 2013), made a research close to the job done by jordan with other researchers in 2008, they examine if korean firms has rounded the second digit and also they investigate the relationship between firm characteristics and rounding phenomenon. this phenomenon pointed for high levered firm than low one, and if the levered firms have loss they don’t involve in such phenomenon. for companies having positive earning, it seems that smaller companies involve in rounding numbers more than larger companies, and the opposite when firms have negative earning the larger firms are more manipulating than smaller one. the effect of loss leads firms that audited from big-4 audit firms to manipulate more than firms audited by non big-4 audit institutions. other researchers like (özarı and ocak, 2013) tested not only sales and revenues but also other accounts such as cost of goods sold (cogs) and operating expenses for first digit until fourth digit. the sample is for turkish companies for the period form (2005 to 2010) for five industries that consist of 181 companies, and their results are: for first digit of both companies that reports profit or loss, there are no significant difference from benford’s distribution to sales, income, (cogs), and operating expenses, the result also for the second, third, and fourth digit same as the first digit, and there is no evidence on manipulation. some researchers like (geyer and drechsler, 2014) investigate if long term debt accounts are manipulated by u.s firms and results shows there are aberration for observed account compared to benford’s law. yet, another research conducted for the first time at japanese companies by (he and guan, 2014), they aims to investigate benford’s law for revenues and earning accounts, and their results shows that japanese managers are tampering with their revenues and earning accounts and this tampering differs from industry to another, and also the managers are manipulating their earnings more than revenues. in 2014, he and tian conducted research to see if research and development expenses (r and d) account obeys benford’s law or not by u.s firms for the period (1950-2012), (he and tian, 2014), and they divided the period to two parts first one from (1950 to 1974) and the second one from (1975 to 2012) before and after statement of financial accounting standards no. 2, which was forcible after 1974. their results were that u.s firms are rounding r and d account for both periods, and they says that companies conceive r and d as investment account so if it larger that’s mean a good signal for investors and also to reduces their profit. jordan again with other researchers (jordan et al., 2014) investigates the effect of corporate governance legislation like sox, but in this research they test if cosmetic earning management decreased after ontario bill (198) and also the other corporate governance legislations in 2002. for the period before that legislation from (1990 to 1999), manipulations happened by canadian firms, and for the period after legislation from (2003 to 2012) there was no sign of rounding financial numbers. in indian country (shette and kuntluru, 2014) conducted paper to see if indian firms are rounding up profits after taxes and earnings per shares (eps) for 1707 listed indian firms for the period (1991-2012) they found firms to round up there reported income, they found high deviations of numbers occurrences in companies with high income, and also after fraud investigation in croatian firms by (slijepčević and blašković, 2014) they found some signs of fraud, like the one in the correlation between reports and their net income losses. some researchers like (garza-gomez et al., 2015) investigate if segment earnings reports are rounded up to reach cognitive reference points for public u.s firms and they found the managers of segments to round up their earnings. the authors collected data from (1998 to 2011) using benford’s law so their research added to literature knowledge, and also the segment reports manipulated, so the auditor should take in their consideration the risks of auditing such accounts. in 2015 jordan with other researchers (jordan et al., 2015) conducted research to see if eps rounding phenomenon changed after sox. they found companies rounding the eps before sox but after sox there is no sign of it, so their research assure on the effectiveness of sox in reducing firms earning management. benford’s law also used to detect fraud in covered bonds (kienle, 2015) by using that law to detect if assets covered by bond manipulated or not and his result shows the numbers in assets covered by bond following benford’s law. therefore, benford’s law is an effective tool to detect rounding phenomenon not only for earnings accounts, but also for all accounts. some researchers like (lin and wu, 2015) investigate if corporate governance legislations has reduce rounding up phenomenon by taiwan firms but the results shows that taiwan’s companies are rounding earnings account despite of corporate governance legislations. many studies conducted recognize benford’s law to be a useful tool in detecting fraud or earning management and they used it for different financial accounting numbers. their results presents rounding phenomenon to be widespread in different regions whether in developed or undeveloped countries. lastly, literature shows some of legislations like sox to have good results in reducing earning management. 4. research hypotheses this paper will examine the anomalies in first digit and in rounding up or down in second digit for three accounts which are sales, net income, and comprehensive net income that reported by jordanian firms in their annual reports. this research tests the following hypotheses: hypothesis 1: the frequency of first digits for sales, net income and comprehensive net income accounts within jordanians companies reported positive net income following benford’s law digit frequencies. bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 201724 hypothesis 2: the frequency of first digits for sales, net income and comprehensive net income accounts within jordanians companies reported negative net income following benford’s law digit frequencies. by testing both of the first and the second hypothesis we will obtain evidence if jordanian firms manipulating first digit for the three accounts: sales, net income, and comprehensive net income. actually, some researchers shows a relation between earnings and share price, where the positive earnings have higher relation than the negative earnings with share price, which means that the mangers of profitable firms have more incentives to manipulate earning numbers than firms that reported loss (yang, and wang, 2008), so it’s useful to compare between firms with positive income and the ones with negative net income that tested in first and second hypothesis. the phenomenon of rounding up negative earnings numbers is less significant than firms with positive earnings. hypothesis 3: the frequency of 0 as the second digits of sales, net income and comprehensive net income accounts within jordanians companies reported positive net income higher than expected, and the frequency of 9 is lower than expected. hypothesis 4: the frequency of 0 as the second digits of sales, net income and comprehensive net income accounts within jordanians companies reported negative net income is lower than expected and the frequency of 9 are higher than expected. by testing both of the third and fourth hypotheses we will show if jordanian firms are rounding up their financial numbers for companies having positive net income, and also to see if firms with negative net income are rounding down the three accounts chosen in this study. 5. methodology and data analysis 5.1. methodology data are collected from annual reports of jordanian firms listed in amman stock exchange, for sales and net income accounts data collected from (2000 to 2014) annually, and for comprehensive net account data collected from (2009 to 2014) because most of companies start publishing their comprehensive net income in 2009. companies with zero sales excluded from sample, so the number of observation of firms which have positive net income to sales and net income accounts comes to 1395 observations for both, and for firms that reported negative net income 542 observations for both accounts, and number of observations for comprehensive net income account which also classified as positive net income and negative net income were 602 and 371 observations respectively. at the beginning, collected datasets tested whether benford’s law can be applied on them or not, so if mean of observed digits larger than the median, and the skewness value is positive, (özarı and ocak, 2013), then benford’s law can applied. secondly, chi-squared test used to know if observed frequencies for first and second digit to all numbers of 1, 2,……9 confirms frequencies on benford’s law, so if calculated chi-squared is larger than tabulated chi-squared, this mean there are anomalies, and therefore, chi-squared calculated based on the following equations, (lin and wu, 2015): 1. first chi-squared equation used for first digit to all of accounts for numbers from (1 to 9): χ2 0 e 0i=1 np np np = − ∑ [ ] 9 2. second chi-squared equation used for second digit to all accounts for numbers from (0 to 9): χ2 0 e 2 0i=1 np np np = −∑[ ] 9 where: p0 is expected proportions; pe is observed proportions; and n is number of observations. 3. thirdly mad used to test first digit for all accounts based on (nigrini, 2011) to overcome the problems arise from small dataset “conclusion of nonconformity when the data are not biased, and therefore in conformity,” (johnson and wigginman, 2013), so it is useful to use (mad) test to give more evidence on conformity and to overcomes the problems presented previously, so (mad) calculated in the following equation, (johnson and wigginman, 2013): mad= 1 n f |x x|i i n −∑ 1 where n is the sample size; xi is the sample value; x – is expected value, f is the frequency. and therefore, the results of calculated (mad) interpreted based on nigrini. there are four types of result: (close conformity, acceptable conformity, marginally acceptable conformity, and nonconformity), presented in (table 2) as the following table 2. 4. lastly, z-statistic test used to shed more lights on the number like 0, 1, 2 … 9 in first and second digit if it confirms expected frequencies based on benford’s law, so this test go more deeper than chi-squared and (mad) tests, so z-value calculated on the following equation, (he and guan, 2014): z= p p 1/2n p 1 p /n 0 0 0 | | ( ) ( ) − − − where: p is observed proportions; p0 is expected proportions, and sample size is represented by n. and (1/2n) applied only when it smaller than absolute value of p-p0. table 2: nigrini (2011) mean absolute deviation model for 1st digit location rate of mad first digits close conformity 0.000-0.006 acceptable conformity 0.006-0.012 marginally acceptable conformity 0.012-0.015 nonconformity >0.015 source: http://www.nigrini.com/forensicanalytics.htm, mad: mean absolute deviation bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 2017 25 and z-value tested at 95% confidence level, so if value of significance <5% for z-value that’s mean the deviation between observed and expected frequency is significant, and the digit observed is deviated from benford’s law. 5.2. data analysis 5.2.1. descriptive statistic in table 3 the results of descriptive measure are presented for all accounts as follow table 3. based on the results presented benford’s law can applied to dataset for all accounts, where mean is larger than median to all accounts, and for negative numbers it calculated after taking the absolute numbers to remove the effect of negative sign (özarı and ocak, 2013). 5.2.2. results of chi-square, (mad), and z-statistic tests in table 4 the results show (chi-square test) for companies which have positive net income don’t confirms benford’s law distribution where is chi-square calculated 25.333 larger than chi-square tabulated 15.507, and (mad) results show the distribution of first digit as marginally accepted. this means sales accounts not accurate, and some companies are rounding some digits. to shed more lights, for numbers which don’t obey expected distribution z-value for number 2 is low occurrence than expected and number 6 has higher occurrence than expected and both of them are significantly differs at 5% where is there significance 0.0012 and 0.0072 respectively, so the final result shows companies with positive net income don’t have accurate sales numbers. as with firms that have negative results, table 5 shows (chi-square test) don’t confirms benford’s frequency when the calculated chi-square is larger than tabulated, also (mad) test confirms the finding of chi-square with results of nonconformity. for negative net income results companies don’t confirms its expected frequency by comparing it with sales accounts for companies that have positive net income nonconformity is lower than unprofitable firms, also z-value for numbers 2 is rounded down and it differs significantly. this result is same for profitable and unprofitable firms, and for digit number 4 companies reported loss rounding it down also at significant level, and lastly firms with loss have also inaccurate numbers more than firms with profit based on (mad) test. for second digit of firms that have profit the results for chi-square test presented in (table 6), and shows companies following benford’s law where the calculated chi-square of 8.407 is less than it tabulated 16.919. form the table the frequency of 0 numbers is higher than the expected and number 9 is lower than expected, so this sign that firms rounding up sales account but z-vale test are not significant at 5%, which means companies don’t rounding up its sales accounts. in table 7 the results of calculated chi-square is 10.164, which it is smaller than tabulated 16.919, and this result means companies following expected frequencies based on benford’s law, rounding numbers down. for companies reported loss where portions of number 0 should be smaller than expected and for numbers 9 should be higher than expected because in previous study companies tend to round down their revenues and net income accounts. in table 7 the frequencies of number 0 is larger than expected, and also number 9 has higher frequencies than expected, so number zero restrict the role of rounding down and also the frequencies is not significant, therefore firms which reported loss don’t round down their sales numbers. table 3: descriptive statistic for sales, net income, and comprehensive net income companies group statistic sales net income comprehensive net income companies reported positive net income mean 67,494,349 9,842,260 12,221,962 median 9,775,076 1,234,959 1,378,726 skewness 10.72341 6.7283 11.44306 minimum 2,665 249 1,721 maximum 4,624,127,707 360,174,000 886,627,681 number of observation 1395 1395 602 companies reported negative net income (absolute) mean 17,530,117 2,183,864 1,900,297 median 3,272,997 520,183 595,819 skewness 8.77709 6.72514 7.27742 minimum 3,255 1,695 2,664 maximum 769,257,468 68,855,313 58,113,000 number of observation 542 542 371 table 4: distribution of first digit for sales at companies which have positive net income number 1 2 3 4 5 6 7 8 9 observed proportion (%) 28.674 14.265 11.541 10.824 8.387 8.530 7.025 5.735 5.018 expected proportion (%) 30.103 17.609 12.494 9.691 7.918 6.695 5.799 5.115 4.576 deviation rate (%) −1.429 −3.344 −0.953 1.133 0.469 1.835 1.226 0.620 0.442 z statistics 1.135 3.244 1.036 1.386 0.6 2.689 1.902 0.99 0.726 p value 0.257 0.001* 0.3 0.166 0.55 0.007* 0.057 0.322 0.468 number of observation (n)=1395, chi-square calculated to all of digit 25.333, where chi-square tabulated 15.507 at 8 degree of freedom mad is 0.012724 (marginally acceptable conformity). *significance at 5% two-tailed test, mad: mean absolute deviation bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 201726 table 8 present the results for first digit with companies having profit, firstly chi-square tests show that numbers don’t confirms benford’s law when calculated chi-square 18.486 higher than tabulated at 15.507, and the next test conducted is (mad) and the result is 0.0106. when the result of (mad) between 0.006 and 0.012 that means digit frequencies is acceptable conformity, hence number 5 has frequency more than expected with p-value (1.71%), and number 6 has less occurrence than expected with p = 3.3%, so both numbers differs significantly, which mean profitable jordanian firms have anomalies in their net income accounts for first digit. table 9 shows chi-square tests is confirms benford’s law when calculated chi-square less than tabulated one, (mad) test also shows frequencies of digit as acceptable conformity, and z-value tests also has no significant difference between observed and expected, therefore companies reporting loss don’t have anomalies compared with firms reporting profit that have anomalies in first digit numbers. in table 10 chi-square reveals there are confirmation to benford’s law when calculated is 13.911 and when tabulated 16.919, and frequencies of observed 0 is higher than expected and also number 9 occurs less than expected. such phenomenon may indicate firms which are rounding up their net income as having no significant differences. the numbers 7 has negative deviation −1.723% with p = 2.793%, this may indicate anomalies, but in general companies don’t make rounding phenomenon. table 5: distribution of first digit for sales for companies which have negative net income number 1 2 3 4 5 6 7 8 9 observed proportion (%) 33.579 14.022 13.469 6.089 6.089 8.487 7.380 5.351 5.535 expected proportion (%) 30.103 17.609 12.494 9.691 7.918 6.695 5.799 5.115 4.576 deviation rate (%) 3.476 −3.587 0.975 −3.602 −1.829 1.792 1.581 0.236 0.959 z statistics 1.718 2.136 0.621 2.762 1.498 1.583 1.483 0.151 0.965 p value 0.086 0.032* 0.535 0.005* 0.134 0.113 0.138 0.880 0.334 number of observation (n)=541 chi-square calculated to all of digit 22.18162259, where chi-square tabulated 15.507 at 8 degree of freedom mad is 0.02004164 (nonconformity). *significance at 5% two-tailed test, mad: mean absolute deviation table 8: distribution of first digit for companies which have positive net income number 1 2 3 4 5 6 7 8 9 observed proportion (%) 28.387 18.710 12.832 10.538 9.677 5.233 5.161 4.158 5.305 expected proportion (%) 30.103 17.609 12.494 9.691 7.918 6.695 5.799 5.115 4.576 deviation rate (%) −1.716 1.101 0.338 0.847 1.759 −1.462 −0.638 −0.957 0.729 z statistics 1.368 1.044 0.341 1.024 2.384 2.131 0.962 1.562 1.238 p value 0.171 0.296 0.733 0.306 0.017* 0.033* 0.336 0.118 0.216 number of observation (n)=1395 chi-square calculated to all of digit 18.48698512, where chi-square tabulated 15.507 at 8 degree of freedom mad is 0.010606515 (acceptable conformity). *significance at 5% two-tailed test, mad: mean absolute deviation table 6: distribution of second digit for sales for companies that have positive net income number 0 1 2 3 4 5 6 7 8 9 observed proportion (%) 13.405 11.111 9.749 9.892 9.892 9.821 8.530 9.319 10.036 8.244 expected proportion (%) 11.968 11.389 10.882 10.433 10.031 9.668 9.337 9.035 8.757 8.500 deviation rate (%) 1.437 −0.278 −1.133 −0.541 −0.139 0.153 −0.807 0.284 1.279 −0.256 z statistics 1.612 0.284 1.316 0.617 0.128 0.148 0.989 0.323 1.642 0.295 p value 0.107 0.776 0.188 0.537 0.898 0.883 0.323 0.746 0.329 0.762 number of observation (n)=1395 chi-square calculated to all of digit 8.40738928, where chi-square tabulated 16.919 at 9 degree of freedom. table 7: distribution of second digit for sales account for companies which have negative net income number 0 1 2 3 4 5 6 7 8 9 observed proportion (%) 14.945 10.148 12.177 10.517 9.779 9.225 6.827 9.225 7.934 9.225 expected proportion (%) 11.968 11.389 10.882 10.433 10.031 9.668 9.337 9.035 8.757 8.500 deviation rate (%) 2.977 −1.241 1.295 0.084 −0.252 −0.443 −2.510 0.190 −0.823 0.725 z statistics 2.069 0.842 0.899 0.064 0.124 0.276 1.935 0.079 0.602 0.528 p value 0.038* 0.399 0.368 0.949 0.901 0.782 0.053 0.936 0.547 0.597 number of observation (n)=542 chi-square calculated to all of digit 10.16447476, where chi-square tabulated 16.919 at 9 degree of freedom. *significance at 5% two-tailed test table 9: distribution of first digit for companies which have negative net income number 1 2 3 4 5 6 7 8 9 observed proportion (%) 30.074 16.605 14.945 8.303 8.672 7.011 5.166 3.690 5.535 expected proportion (%) 30.103 17.609 12.494 9.691 7.918 6.695 5.799 5.115 4.576 deviation rate (%) −0.029 −1.004 2.451 −1.388 0.754 0.316 −0.633 −1.425 0.959 z statistics 0.015 0.557 1.660 1.020 0.570 0.208 0.539 1.408 0.966 p value 0.988 0.5779 0.096 0.307 0.568 0.834 0.590 0.159 0.334 number of observation (n)=542 chi-square calculated to all of digit 8.078836013, where chi-square tabulated 15.507 at 8 degree of freedom mad is 0.009954137 (acceptable conformity). mad: mean absolute deviation bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 2017 27 in table 11 the result of testing second digit for companies which reported loss, the chi-square tests reveals companies obey benford’s law when calculated chi-square is 11.933 which is less than tabulated one 16.919 at 9 degree of freedom. as mentioned earlier companies with loss has more 9 and less 0 occurrence, the result shows less zero numbers than expected but not significant and more of number nine but here the difference is significant, so companies somewhat rounding dawn their net loss. this means jordanian firms tend partially to round down their net income if reporting net loss should decrees their bad results. for example, showing loss in 1.9 million is better than 2 million to their investor because the nature of human looks at the first numbers in general. this phenomenon is confirmed by many researchers (kinnunen and koskela, 2003). tables 12-15 present the results of testing first and second digit for comprehensive net income for both firms result (profit or loss). table 12 shows calculated chi-square at 11.633 and its less than the tabulated which is 15.507, and that means jordanian firms following benford’s law frequencies to all digits from 1 to 9, and also the same confirmation is asserted by (mad) test where it was 0.009 and fill within an acceptable conformity. z-statistic reveals that number 9 occurs more than expected with p-value at 1.9%, which means that first digit, to some extent is not accurate for firms with profit in their comprehensive net income. in table 13 the test of conformity based on chi-square confirm the following for one digit at benford’s law where calculated chisquare is lower than tabulated one, but (mad) test shows there is nonconformity to benford’s law, so in this test there is difference between profitable and unprofitable one. firms reporting loss tend to manipulate comprehensive net income unlike profitable one, and companies that have low occurrences in number one, their deviation are −5.305% and their z-value are significant. for second digit test, companies which have positive comprehensive net income, chi-square test present companies that confirms benford’s law to have the calculated at 8.706 and it is smaller than the tabulated of 16.919. number 0 has high occurrences than expected but its value not significant, and number 9 has positive difference 0.47% and also not significant. this means profitable companies don’t have rounds up phenomenon to their comprehensive net income account. in table 15 the result of chi-square reveals nonconformity to benford’s law where its calculated value at 29.60 and its larger table 10: distribution of second digit for companies which have positive net income number 0 1 2 3 4 5 6 7 8 9 observed proportion (%) 12.688 12.688 10.896 10.394 8.961 10.538 10.609 7.312 8.244 7.670 expected proportion (%) 11.968 11.389 10.882 10.433 10.031 9.668 9.337 9.035 8.757 8.500 deviation rate (%) 0.720 1.299 0.014 −0.039 −1.070 0.870 1.272 −1.723 −0.513 −0.830 z statistics 0.787 1.485 0.017 0.047 1.286 1.054 1.587 2.198 0.630 1.063 p value 0.431 0.137 0.986 0.962 0.198 0.292 0.112 0.027* 0.528 0.287 number of observation (n)=1395 chi-square calculated to all of digit 13.911664, where chi-square tabulated 16.919 at 9 degree of freedom. *significance at 5% two-tailed test table 11: second digit distribution for companies which has negative net income number 0 1 2 3 4 5 6 7 8 9 observed proportion (%) 11.439 9.041 9.041 9.779 10.701 8.672 10.517 10.517 9.225 11.070 expected proportion (%) 11.968 11.389 10.882 10.433 10.031 9.668 9.337 9.035 8.757 8.500 deviation rate (%) −0.529 −2.348 −1.841 −0.654 0.670 −0.996 1.180 1.482 0.468 2.570 z statistics 0.313 1.653 1.377 0.498 0.448 0.712 0.870 1.128 0.309 2.068 p value 0.754 0.098 0.168 0.618 0.654 0.476 0.384 0.259 0.756 0.038* number of observation (n)=542 chi-square calculated to all of digit 11.93397039, where chi-square tabulated 16.919 at 9 degree of freedom. *significance at 5% two-tailed test table 12: first digit distribution for companies which has positive comprehensive net income number 1 2 3 4 5 6 7 8 9 observed proportion (%) 28.571 18.106 12.625 9.635 9.635 5.648 5.316 3.821 6.645 expected proportion (%) 30.103 17.609 12.494 9.691 7.918 6.695 5.799 5.115 4.576 deviation rate (%) −1.532 0.497 0.131 −0.056 1.717 −1.047 −0.483 −1.294 2.069 z statistics 0.775 0.267 0.035 0.047 1.484 0.946 0.420 1.349 2.331 p value 0.438 0.789 0.971 0.962 0.137 0.343 0.674 0.177 0.019* number of observation (n)=602 chi-square calculated to all of digit 11.63353023, where chi-square tabulated 15.507 at 8 degree of freedom mad is 0.009806593 (acceptable conformity). *significance at 5% two-tailed test, mad: mean absolute deviation table 13: first digit distribution for companies which have negative comprehensive net income number 1 2 3 4 5 6 7 8 9 observed proportion (%) 24.798 18.329 15.903 9.704 9.973 7.547 5.391 4.582 3.774 expected proportion (%) 30.103 17.609 12.494 9.691 7.918 6.695 5.799 5.115 4.576 deviation rate (%) −5.305 0.720 3.409 0.013 2.055 0.852 −0.408 −0.533 −0.802 z statistics 2.171 0.295 1.907 0.008 1.369 0.552 0.225 0.347 0.615 p value 0.029* 0.767 0.056 0.993 0.170 0.580 0.821 0.727 0.538 number of observation (n)=371 chi-square calculated to all of digit 10.24437, where chi-square tabulated 15.507 at 8 degree of freedom mad is 0.01566339 (nonconformity). *significance at 5% two-tailed test, mad: mean absolute deviation bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 201728 than the tabulated one of 16.919 for negative comprehensive net income, and by testing the rounding down phenomenon, number 0 has a high occurrence which restrict rounding down phenomenon, number 9 has higher occurrence with positive deviation of 0.66% and both numbers are insignificant, and number 7 has low occurrence as expected and this difference is significantly. this means inaccurate reported financial number s, but no sign of rounding down phenomenon. 6. discussion and conclusion many researchers are using benford’s law to detect if companies have manipulated their financial numbers. this paper was conducted to see if companies have inaccurate financial numbers, to see if there are rounding up phenomenon in profitable firms, and also to see if there are rounding down phenomenon in losing firms. this investigation was conducted about the following three accounts: sales, net income, and comprehensive net income. the result of testing first hypothesis, which investigate the first group that reported positive net income, to see if the first digit is following benford’s law or not. for sales account the result shows companies which don’t follow benford’s law, the numbers 2 and 6 have higher occurrences than expected, so this results asserted by (jordan et al., 2009) where they conclude that u.s firms are manipulating sales account, which is opposite to (özarı and ocak, 2013) conducted in turkish firms which are following benford’s law. firms with net income accounts also don’t follow benford’s law with number 5 have higher occurrences than expected and number 6 have lower occurrences than expected. this result is in contrary to (al-darayseh and jahmani, 1999; özarı and ocak, 2013) where they conclude net income account is confirms benford’s law. lastly, comprehensive net income companies confirms with benford’s law, which means sales and net income accounts inaccurate based on benford’s law, in contrast to comprehensive net income. for hypothesis number two which investigate the second group, the companies that have negative net income to see if first digit are following benford’s law or not, for sales account the results show jordanian companies don’t follow benford’s law, number 2 and 4 have low occurrences significantly, and this result is in contrary to (özarı and ocak, 2013) and the same with (he et al., 2013) which his results reveals this account manipulated. the result for net income account shows conformity to benford’s law and this results not confirms either by (he et al., 2013) or by (özarı and ocak, 2013), and for comprehensive net income based on (mad) tests is nonconformity. so far, sales account for both groups (profitable and unprofitable) have manipulated first digit. based on (mad) test profitable companies are less significant to manipulate and this finding same as (he et al., 2013; he and guan, 2014) where profitable firms have less incentives to manipulate their revenues. for net income, profitable firms have nonconformity but losing firms confirm benford’s law. this means profitable companies have more incentives to cosmetic their incomes and that results confirms by (he et al., 2013; he and guan, 2014) which showed profitable firms having incentives to manipulate their earnings more than losing firms. lastly, for comprehensive net income comparison based on (mad) tests where chi-square is same for both of them, so profitable companies have acceptable conformity where losing firms have nonconformity. this means losing firms have more incentives to manipulate their accounts than profitable one, therefore this account shows that it’s more important to unprofitable firms than profitable one in decreasing their bad results. the result for testing third hypothesis: if profitable firms has more zero and few nine occurrence of numbers, for sales account there are more zero and few nines but this phenomenon is not significant. secondly, for net income there are more zeros and few nines occurrence but also this difference is not significant and this result agrees with the results of (al-darayseh and jahmani, 1999; özarı and ocak, 2013). lastly, for comprehensive net income there are more zero numbers and more nines also, this account restrict rounding up phenomenon and also it’s not significant. lastly for hypothesis number four, which supposed that losing firms has rounded down their loss with few zeros and more nines occurrence than expected by benford’s law. for sales account, there are more zeros and more nine so this account doesn’t round table 15: second digit distribution for companies which have negative comprehensive net income number 0 1 2 3 4 5 6 7 8 9 observed proportion (%) 15.094 10.782 7.817 8.086 10.512 6.739 8.625 12.129 11.051 9.164 expected proportion (%) 11.968 11.389 10.882 10.433 10.031 9.668 9.337 9.035 8.757 8.500 deviation rate (%) 3.126 −0.607 −3.065 −2.347 0.481 −2.929 −0.712 3.094 2.294 0.664 z statistics 1.775 0.286 1.895 1.478 0.222 1.821 0.381 1.988 1.471 0.365 p value 0.075 0.774 0.057 0.139 0.824 0.068 0.702 0.046* 0.141 0.714 number of observation (n)=371 chi-square calculated to all of digit 29.60702073, where chi-square tabulated 16.919 at 9 degree of freedom. *significance at 5% two-tailed test table 14: distribution of second digit for companies which have positive comprehensive net income number 0 1 2 3 4 5 6 7 8 9 observed proportion (%) 13.123 13.289 8.970 9.635 9.801 9.468 7.641 8.804 10.299 8.970 expected proportion (%) 11.968 11.389 10.882 10.433 10.031 9.668 9.337 9.035 8.757 8.500 deviation rate (%) 1.155 1.900 −1.912 −0.798 −0.230 −0.200 −1.696 −0.231 1.542 0.470 z statistics 0.810 1.403 1.506 0.640 0.120 0.096 1.360 0.126 1.266 0.340 p value 0.417 0.160 0.131 0.521 0.904 0.922 0.173 0.899 0.205 0.733 number of observation (n)=602 chi-square calculated to all of digit 8.706659945, where chi-square tabulated 16.919 at 9 degree of freedom. bader and saleh: evidence on the extent of cosmetic earnings and revenues management by jordanian companies international journal of economics and financial issues | vol 7 • issue 3 • 2017 29 down, for net income, number zero has low frequency and high occurrence for number nine and this phenomenon is partially significant from the nine’s side and results asserted by (özarı and ocak, 2013), and for the last account net comprehensive income, for number zero and nines they have more frequencies than expected which mean this account doesn’t have rounding down phenomenon. the result for testing third and fourth hypothesis which related to second digit, presents sales account for profitable companies has rounding up phenomenon, but it’s not significant, and for unprofitable firms rounding down phenomenon is not present. this means chance of rounding is more for profitable companies. for both net income accounts (profitable and unprofitable), firms results have showed rounding up and down respectively, but for firms which have profit this phenomenon is not significant in contrast to firms that have losses with rounding down phenomenon to be partly significant. lastly, for comprehensive net income there is no sign of rounding up or down for both groups (companies having profit results, and firms having loss results), and in general the results is same with (özarı and ocak, 2013). the main findings show jordanian companies to have inaccurate financial numbers, companies with positive net income to have less incentives to manipulating sales account compared to unprofitable firms, profitable firms have manipulating net income where firms with negative net income don’t manipulate their net income, and in contrast negative net income firms care about manipulating comprehensive net income, where positive net income companies don’t care about manipulating this account. there is also no significant evidence of rounding up or down sales, net income, and comprehensive net income accounts except net income accounts within negative net income firms group is partly significant. 7. recommendations and suggestions for future researches it’s useful to use benford’s law by jordanian authorities to detect if the financial numbers produced by companies are manipulated or not, to ensure the accuracy of annual report at jordanian firms. such action will give stakeholders some confidants of jordanian firms. the result shows some financial accounts to be not accurate, and so jordanian authorities and their corporate governances should play more effective roles to ensure more accuracy of financial accounting numbers produced by jordanian listed firms. for example, sox plays important rule to reduce manipulating financial numbers (jordan and clark, 2011; wilson, 2012), and accordingly, jordanian authorities should develop a corporate governance act like sox and ontario bill 198 (jordan et al., 2014). also it’s useful to investigate in future research the reasons behind jordanians companies that reporting loss in their bottom line of net income to manipulating their first digit of comprehensive net income where that phenomenon in firms reported positive net income is not happened, in other words what are the catalysts or incentives to do such manipulating by unprofitable firms where manipulating is not a concern of profitable firms for comprehensive net income, and also to 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(2008), anomalies in earnings numbers and insider ownership: evidence from taiwan. asia pacific management review, 13(4), 667-681. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(1), 87-95. international journal of economics and financial issues | vol 6 • issue 1 • 2016 87 profitability of directional change based trading strategies: the case of saudi stock market monira essa aloud* department of management information systems, college of business administration, king saud university, saudi arabia. *email: mealoud@ksu.edu.sa abstract an event-based framework of directional changes (dc) and overshoots maps financial market (fm) price time series into the so-called intrinsic time where events are the time scale of the price time series. this allows for multi-scale analysis of financial data. in the light of this, this paper formulates dc event approach into three automated trading strategies for investments in the fms: zi-directional change trading (dct0), dct1, and dct2. the main idea is to use intrinsic time scale based on dc events to learn the size and the direction of periodic patterns from the asset price historical dataset. using simulation models of saudi stock market, we evaluate the returns of the automated dc trading strategies. the analysis revealed interesting results and evidence that the proposed strategies can indeed generate effective trading for investors with a high rate of returns. the results of this study can be used further to develop decision support systems and autonomous trading agent strategies for the fm. keywords: directional changes, financial forecasting, automated trading, financial markets, simulation jel classifications: g11, g14, g17 1. introduction financial markets (fms) are institutions where the exchange of assets takes place meant for investment functions. fms facilities trading in financial securities, commodities and other exchangeable assets depend on the type of the market. therefore, fms knowing into different groups, with regarding the kind of traded asset. some examples of fms are commodity markets, stock markets, and foreign exchange (fx) markets. for a good introductory reference to fms, we refer the interested reader to sharpe et al. (1995). one of the important research activities associated with fms is to design investment trading strategies. in this paper, we propose investment automated trading strategies based on the directional change (dc) event approach glattfelder et al. (2011); aloud et al. (2011); tsang (2010). rationality is one of the major assumptions behind many economic theories regarding fms tsang and martinez-jaramillo (2004). in the past, most of the economics analysis of fms depends on efficient market hypothesis (emh). the emh states that fms are assumed to be “informationally efficient” if the current market price fully reflects all the available information fama (1965). the weak form of emh is associated with the concept of random walk hypothesis cootner (1964) where asset returns are serially independent. that means price time series in fms do not follow any trend or pattern. therefore, historical price data cannot be used to predict the future changes of the asset price for investors’ opportunities. the fm literature has featured an extended debate on the effectiveness of technical analysis on analyzing price time series grossman and stiglitz (1980); tirole (1982); lo (1988); tsang and martinezjaramillo (2004); cont (2001). some argue that prices cannot be predictable from studying and analyzing price and market historical data. numerous empirical studies have been conducted to examine emh by defining the statistical properties of assets’ prices leroy (1973); lucas (1978) which evidently uncovered empirical evidence of various price anomalies, and therefore have confirmed positive observed evidence on the effectiveness of technical analysis for analyzing financial price time series. as a result, price time series in fms can by studied, analyzed and hence can be predictable. computing has revolutionized the way business is done and the domain of finance in particular. financial transactions data are now recorded at increasing levels of detail due to advances in computer aloud: profitability of directional change based trading strategies: the case of saudi stock market international journal of economics and financial issues | vol 6 • issue 1 • 201688 technology and data storage dacorogna et al. (2001). studying the fms using a massive number of data, referred to as high-frequency data (hfd), without doubt considerably enhance the understanding of fms behavior. the availability of large amounts of data per day has opened new opportunities for analyzing empirical data, searching for periodic patterns and hence investment opportunities by means of building automated trading systems. the analysis of hfd is nontrivial given that quoted prices/transactions are irregularly spaced in time in complicated sequence dacorogna et al. (2001). advances in computing and algorithms enable us to analyze data efficiently, and processing power allow for the simulation of fm behavior as result open new area for studying fms and designing automated investment trading strategies, which is the subject of this paper. automated trading strategies have become a hot topic in the field of fms, and various strategies have been designed and developed aiming to maximize investors’ potential profits. it is as well-known as algorithmic trading kim (2007). in fms, automated trading is a general name means employing techniques to trade in assets, such as stocks, and currencies, automatically by computers which in turn involves the determination of a set of rules for order’s timing, price, type {buy, sell} and quantity to invest kim (2007); booth et al. (2014). automated trading strategies combine diverse trading rules of technical indicators and fundamental parameters. therefore, use artificial intelligent techniques, machine learning and data mining among others to find optimal parameters to generate those trading rules automatically from studying historical market data. automated trading strategy is increasingly becoming the decisionmaking tool of preference for traders to accomplish investments efficiency. many attempts have been made to design and develop automated investment trading strategy for the fms kim (2007); booth et al. (2014). the motivation for such automated trading strategy comes from a variety of fields, ranging from financial behavior and econometric analysis to evolutionary computation, data mining, and machine learning booth et al. (2014); nuij et al. (2013). in the literature, the design of the automated trading strategy ranges from simple budget constrained zerointelligence (zi) strategy as in duffy and unver (2006); gode and sunder (1993), to intelligent strategy, such as in cliff and bruten (1997); kampouridis and tsang (2010); tsang et al. (2002). different automated trading strategies presume different means of identifying arbitrage opportunities in the fms. in aloud et al. (2012), we have constructed an automated trading strategy called zi-dct0 based on combining: (i) the dc event approach aloud et al. (2011) and (ii) trend following (tf) and contrary trading (ct) investment strategies for fms. trading in the fms is highly active at some time periods, but calm down at other time periods which make the flow of price changes based on physical time discontinuous. therefore, using fixed time scales for studying the price changes in the fm runs the risk of missing arbitrage opportunities glattfelder et al. (2011). the dc event approach captures key periodic price activities in the time series based on the trader’s profit expectations. given a fixed threshold size of magnitude λ, the dc approach defines alternating dcs as a price move of magnitude λ in the price time series from the last price extreme. therefore, zi-dct0 trader commits himself to a fixed threshold size and type of trading {tf, ct} for identifying arbitrage opportunities in the price time series. in aloud (2015), we have derived an automated trading strategy from zi-dct0 called directional change trading (dct1), where zi-dct0 has been improved by the integration of an intelligence learning model fed by historical price dataset of eur/usd currency pair from oanda fx market maker. the central idea behind dct1 is to learn from historical price dataset to determine the size and direction of periodic patterns in the price time series. thus, the dct1 is able to recognize the size and the direction of periodic patterns in a price time series such as dc and overshoot (os) events from historical price dataset. this may possibly be the means of providing successful decision support systems for traders in the fms. dct1 employees, a mere learning mechanism from historical price dataset which avoids the complexity of intelligent artificial strategies and also the vagueness of zi and buy-and-hold trading strategies where a trader place orders randomly, subject to budget constraints. the results analysis revealed interesting profit outcomes and consequently evidence that dct1 can indeed generate a high rate of profits for investors in the fx market. in light of this, the contributions of this paper in two folds: first, to examine the profitability and efficiency of the automated dc trading strategies – zi-dct0 and dct1 in the saudi stock market (ssm) (www.tadawul.com.sa). there are a number of reasons why ssm is used in this analysis. analysis and explanations that automated trading strategies are profitability and efficiency in ssm have received very limited attention. to the best of our knowledge, this is the first study to examine the impact of automated trading strategies in ssm. the second contribution, to improve dct1 trading rules by means of self-awareness of the trading performance during the market run, we call this new form dct2. this paper takes a financial computational point of view for designing and developing automated investment trading strategies in the fms. from a financial computational point of view, investment decision procedures are able to be encoded in algorithms and systems. we argue that, the effective investment decisions of a trade are determined by the trader’s computational power, in another word, we refer to this as the computational intelligence determines effective investment decisions. the rest of the paper is organized as follows. section 2 provides a definition of the dc event approach. the zi-dct0 trading strategy is described in section 3. dct1 is depicted in section 4 while a description of dct2 is provided in section 5. the experimental design, agent-based simulation, and empirical results are presented in section 6. a summary and conclusions are provided in section 7. 2. dc event approach hfd are irregularly spaced in time in a complicated sequence which makes the flow of physical time discontinuous. serving the literature, we found three methods to handle this issue dacorogna et al. (2001); engle and russell (2006). the first method employs aggregating price information by inserting prices between fixed aloud: profitability of directional change based trading strategies: the case of saudi stock market international journal of economics and financial issues | vol 6 • issue 1 • 2016 89 and determined times which results in a loss of price details during active periods. the second method considers a price time series of price ticks and times between the price occurrence which referred to as point process (bauwens and hautsch, 2009). the advantage of such method is the incorporation of duration which permits analytical results to be determined. in contrast, the drawback of the point processes is that time is measured in terms of physical time units. the third methods proposed analyze price time series by dc event approach which is based on intrinsic time rather than physical time guillaume et al. (1997); glattfelder et al. (2011); aloud et al. (2011); tsang (2010). this method is used for a discontinuous time series: on the announcement of political or economic news, there tends to be a sharp rise in market trading activity in response to the news (figure 1). intrinsic time is described based on price events where the direction of the price trend changes from upward to downward or vice versa aloud et al. (2011). time flows unevenly: any occurrence of a dc event represents a new intrinsic time, independent of the notion of physical time changes. physical time adopts a point-based system while intrinsic time adopts the event-based system. physical time is homogenous in which time scales equally spaced based on the chosen time unit (e.g., minutes) while intrinsic time is irregularly spaced in time since time triggers at alternating events of price dcs of size λ. the basic unit of intrinsic time is an event where event is the total price change of size λ from the last price extreme, a high or low when a downward or upward dc is to be detected, respectively aloud et al. (2011). the time in dc event approach is a dynamic object which adapts to market activity. a dc event can take one of the two forms a downturn event or an upturn event tsang (2010). a downward run is a time period between a downturn dc event and the next upturn dc event, whereas an upward run is a time period between an upturn dc event and the next downturn dc event. a downturn dc event dismisses an upward run and starts a downward run, whereas an upturn event terminates a downward run and starts an upward run. a dc event is usually followed by a price os event rather than a reverse dc event direction glattfelder et al. (2011); tsang (2010); aloud et al. (2011). the os event represents the price move beyond the dc event. an os event can take one of two forms: a downturn os event or an upturn os event. figure 1 illustrates how the price curve is composed of dc and os events. let us define λ as the price threshold at which the price time series is mapped. using a price threshold of size λ, we map the price time series into a sequence of price dcs and os. the initial condition of the sequence is as follow: the initial price p0 and last price extreme p ext is assign as initial value the asset’s price at the start of the price time series sequence p0 at time t0; the initial physical time is t0; the initial price trend mode which alterations between upward and downward run indicating the expected mode of the dc event. algorithm 1 illustrates how to define dc and os events during a time period t. a given price threshold of size λ discretizes the price time series into a sequence of → down turn dc event → down turn os event → up turn dc event → up turn os event → down turn dc event → algorithm 1: dissect the price time series from time t0 and measure dc and os with a λ price threshold. require: initialize variables (mode is upturn event, price threshold λ (fixed) ≥ 0, pext= p(t) at time t0) update latest ti with t if mode is upturn event then if p(t)t ≤ pext × (1 − λ) then dc event ← downturn event pext ← p(t) else pext ← max (pext, p(t)) endif else//mode is downturn event if p(t) ≥ pext × (1 + λ) then dc event ← upturn event pext ← p(t) else pext ← min (pext, p(t)) endif endif 3. zi-dct0 zi-dct0 aloud et al. (2012) is a trading strategy derived from the dc event approach where a zi-dct0 trader commits himself to a fixed threshold and a trading method for studying the price times series. the trading method can be one of two forms: ct or tf trading. despite the effectiveness of tf and ct investment methods, comparatively few works have explored figure 1: price movements within 24 h are shaped by directional changes (dc) points (diamond) with a threshold λ = 0.4%. a total price movement between two local values (minimum and maximum price) is decomposed into dc (solid lines) and an overshoot (dashed lines) events aloud: profitability of directional change based trading strategies: the case of saudi stock market international journal of economics and financial issues | vol 6 • issue 1 • 201690 the application of learning and patterns detections to improve tf and cf investment methods. zi-dct0 has been designed based on incorporating tf and ct investment methods addicted to the dc event approach in which dc event approach serves as a learning model for detecting periodic patterns in the price time series. tf trading method is an extensively adopted investment method in fms owing to the simplicity of the principle on which tf is based and its effectiveness covel (2004); fong et al. (2011); szakmarya et al. (2010); fong et al. (2012). tf takes a rule-based approach established on the directions of price trends, where a trader takes advantages of the price trend on the assumption that the present price trend will carry on in the same pattern. the principal of tf is that a trader will track the price trend with the hypothesis that some traders have market information prior to the general public which is reflected in the price trend covel (2004). a tf trader places a sell order when the price is falling while a buy order is placed when the price is rising. a number of effective tf investments have been applied and examined in stock markets fong et al. (2011), currency markets james (2003) and commodity futures’ markets szakmarya et al. (2010). comparable to the tf investment method is the ct method with respect to the direction of the price trend. a ct trading rule places a buy order in the expectation that the price will change in the reverse trend direction. for instance, a ct trading rule may possibly point out a buy order opportunity when the price falls by 0.03% and after that places a sell order if the price rises by 0.06%. algorithm 2: the core trading mechanism for the zi-dct0. require: initialize variables (mode is upturn event, price threshold λ (fixed) ≥ 0, pext= p(t) at time t0) update latest ti with t if mode is upturn event then if p(t) ≤ pext × (1 − λ) then mode ← downturn event pext ← p(t) sell→zi-dct0 ct, buy→zi-dct0 tf else pext ← max (pext, p(t)) endif else//mode is downturn event if p(t) ≥ pext × (1 + λ) then mode ← upturn event pext ← p(t) buy→zi-dct0 ct, sell→zi-dct0 tf else pext ← min (pext, p(t)) endif endif algorithm 2 demonstrates the core trading mechanism for zi-dct0. prior to trading in the market, a zi-dct0 will commit himself to a fixed price threshold and type of trading {tf, ct}. on every occasion of an upturn dc event (according to the used threshold), a zi-dct0 will determine that the price trend is on an upward run. this could mean an opportunity to buy for ct and to sell for tf. correspondingly, a downturn dc event indicates an opportunity to sell for ct and to buy for tf. incorporating the dc event approach as a learning model for the tf and ct investment methods will reduce the complexity of analyzing and studying the price time series. hence, traders can capture the short-term dynamics involved in a price time series based on the trader’s expectations of the market towards an understandable depiction of the price dynamic. therefore, zi-dct0 will permit the detection of fewer major periodic stable patterns in a price time series. cautiousness in choosing an appropriate threshold is important to reflect the real price dynamic, known that, when using either a large or a small threshold, zi-dct0 possibly will fail to spot numerous significant patterns on the time series of prices. the results reported in aloud et al. (2012); aloud (2015), provide evidence of the efficiency and effective of zi-dct0 in studying the fm price time series and therefore generating satisfactory returns of investments in the fx market. the limitations of zi-dct0 is the randomness and consistent in selecting the threshold’s magnitude and the type of trading. a similar trading strategy to the zi-dct0 is presented by alfi et al. (2009a, c, b) wherein a trader places an order if the price fluctuations exceed a defined threshold specified by the trader. the threshold remains constant during the trading period in the market. the core difference between zi-dct0 and the one introduced in alfi et al. (2009a, c, b), is that zi-dct0 considers the price trend direction and the price os. 4. dct1 dct1 is an intelligence investment trading strategy driven from the zi-dct0 where a trader commits himself to a fixed threshold and a trading method for studying the price time series using dc event approach, which is based on intrinsic time aloud (2015). the dct1 is capable to recognize periodic patterns in a price time series such as dc and os events. this may possibly be the key to providing effective investment decision support for traders in the fms. dct1 employs a simple learning mechanism which avoids the complexity of artificial intelligent investment strategies and also the vagueness of zi and buy-and-hold strategies wherein traders place orders randomly, subject to budget constraints. prior to trading in the market, the dct1 trading strategy involves learning from historical price dataset to identify the estimated magnitude and direction of diverse periodic patterns. therefore, dct1 aims to overcome two main limitations of the zi-dct0 which are the randomness in choosing a threshold and a trading method (ct or tf) by learning from the historical asset price dataset prior to the process of choosing a threshold and a trading method with regard to the achieved profitability. algorithm 3 demonstrates the core trading mechanism for a dct1 trader. a dct1 trader will examine the achieved profitability of the asset in term of its historical price dataset by iterating through a defined number of diverse thresholds which are generated randomly within a defined range. for each threshold of magnitude λ, a dct1 trader will examine the historical price dataset using the dc event approach in two folds: firstly as a ct and secondly as a tf trade (as described in section 3). consequent to the aloud: profitability of directional change based trading strategies: the case of saudi stock market international journal of economics and financial issues | vol 6 • issue 1 • 2016 91 dct1 trader placing an order, the rate of investment (roi) as a performance indicator will be computed. roi is a performance measure defined as the total investment returns over a defined period of time, divided by the cost of the investments. the roi is expressed as a percentage and is either positive or negative, which means that correspondingly, the dct1 trader achieves either a profit or makes a loss. at the end of the examination process, the threshold and the trading method that results in the most profitable return with reference to the roi will be chosen for the dct1 trader’s decision with regard to placing an order. in our previous work aloud (2015), we evaluate the efficiency of dct1 in terms of roi through diverse experiments using the bid and ask prices for eur/usd currency pairs from the oanda trading platform over the year 2008. we compared the resulting roi from zi-dct0 and dct1. the analysis of the results revealed motivating results and evidence that the dct1 be able to produce an effective automated trading strategy for investors with a satisfactory rate of return. this study has confirmed the feasibility and effectiveness of employing learning as part of an automated trading strategy in that dct1 are designed to adapt to price trend directions and hence deduce periodic patterns of a different magnitude. one of the main advantages of the dct1 design is the combination of classical tf and ct investment rules and a learning model from historical price dataset, which could significantly improve computational effectiveness and the predictability of price trend directions, and uncover the magnitude of periodic patterns. tf and ct strategies have been extensively adopted by investors in the fms. to the best of our knowledge, no related work in the literature has investigated tf and cf investment strategies within a learning model based on the detection of periodic dc events. 5. dct2 dct2 is intelligence automated trading strategy driven from dct1. a dct1 trader chooses a threshold of fixed magnitude and type of trading based on the learning process of historical price data. during the market run, the chosen threshold and type of trading remain constant. in fms, the dynamic of asset’s price time series is not constant and depends on market information. for illustration, on the announcement of political or economic news, there tend to be sharp changes in prices in response to the news, even during calm time periods. dct2 aims to overcome the limitation of the consistency of using the same threshold magnitude and type of trading for dct1 for the duration of the trader’s trading in the market. algorithm 3: the core trading mechanism for the dct1. require: initialize variables (mode = upturn event, pext = p(t) at time t0, highest roi = 0) input (pn, λmin, λmax)//pn training price dataset is used to train trader to find the best investment threshold and type of trading; n length of training dataset; λminis the minimum threshold; and λmax is the maximum threshold. for (i = 0; i < 50; i + +) do//examining 50 randomly generated thresholds begin λ = generate random threshold [λmin, λmax] for (y = 0; y < 2; y + +) do//examining two trading types where y = 0 is ct and y = 1 is tf begin for (t = 0; t < n; t + +) do//loop training price dataset begin if (mode = upturn event) then if p(t) ≤ pext × (1 − λ) then mode ← downturn event pext ← p(t) ct→buy, tf→sell else pext ← max (pext, p(t)) end if upturn event price examination else//mode = downturn event if pt ≥ p ext × (1 + λ) then mode ← upturn event pext ← p(t) ct→sell, tf→buy else pext ← min (pext, p(t)) end if downturn event price examination endif event examination roi = evaluate()//roi (rate of investment) is the result of evaluating the trader profit/loss for the given values of λ and y. end for end loop training price dataset if (roi highest roi)then 4xdc = λ//best threshold 4xdc ω = y//best type of trading ω highest roi = roi endif end for end loop trading type end for end loop random threshold the dct2 learning process considers the adaptation to the new market conditions throughout the trading period in the market. the adoption process of dct2 is modeled explicitly in an endogenous way and periodically with a defined fixed periodicity. in the literature, the automated traders’ adoption process to the new condition of the market is modeled periodically with a defined fixed periodicity lebaron (2001); markose et al. (2003); martinez-jaramillo and tsang (2009) or with a periodicity that is generated by a behavioral constraint markose et al. (2003); martinez-jaramillo and tsang (2009); winker and gilli (2001). we set the adaptation of the dct2 with fixed periodicity in which dct2 will be able to retrain every week time period of the simulation. this is because we wanted to give the dct2 the opportunity to advance during that period and possibly perform better than the retrained dct2 based on the status of the price time series dynamic. in an endogenous adoption way, dct2 will take a decision to change its used threshold and method of trading based on its performance on the market in terms of wealth. more specifically, dct2 will be modeled through a behavioral constraint which will force a dct2 to search for new threshold and method of trading whenever his wealth falls below a threshold, which is equal to half of its initial wealth in the market. therefore, a dct2 trader will launch a dc event mechanism considering the aloud: profitability of directional change based trading strategies: the case of saudi stock market international journal of economics and financial issues | vol 6 • issue 1 • 201692 most recent market and historical price information to decide on suitable threshold and method of trading. following on, the threshold for the retraining condition is reset to half of the dct2 trader’s current wealth. we considered that both learning and adaptation processes should be key features in designing automated trading strategies. the implementation of behavioral constraint in automated trading strategies is a critical design component given the necessity for strategy adaptation to the new conditions of the market environment as seen in lebaron (2001); markose et al. (2003); martinez-jaramillo and tsang (2009). 6. experiment in this section, we report on the experiments undertaken in the agent-based stock market (absm) that we developed. our aim is to examine the profitability of the automated dc trading strategies in term of the agents’ rois which can consequently inform the design of trading strategies and decision support systems for the trading in the fms. 6.1. dataset in this study, we used an hfd of stock indices historical prices provided from the ssm. hfd in finance refers to a vast number of data transactions records and their associated characteristics at frequencies higher than on a daily basis dacorogna et al. (2001). according to dacarogna et al. “the number of observations in one single day of a liquid market is equivalent to the number of daily data within 30 years” (dacorogna et al., 2001, p. 6). two groups of stock indices from the ssm were chosen to evaluate the three automated dc trading strategies. these two groups are the banks and financial services indices and telecommunication and information technology indices, all of which cover the period from december 1, 2014, to may 25, 2015. figure 2 shows the time evolution of the five stock indices over the whole test period. for each share, we use bloomberg datastream to obtain hfd information. the raw trading information was tick data, including bid and ask price and each record is time stamped. each price index dataset is fed into the absm via the market-maker. the time-span of the price dataset is critical in the study, given that different amounts of data examination possibly will provide ratios of precision interesting to study. 6.2. absm in our absm, there is a market for one trading asset and populated with n trading agents who participate in the market by means of buying and selling stock assets. for analytical simplicity, there is one trading asset available for trading in the simulation. we focus our attention on the profitability and efficiency of the agents’ trading strategies (and consequently behavior) and for this purpose we use a dataset of high-frequency historical prices for ssm assets and feed these prices into the simulation. the prices are fed over a defined 6 months period, and hence the agents react to such information. the historical price data acts as a constant so that multiple simulation runs can be performed in which aspects of the dc automated trading strategies can be modified and systematically studied. this enables us to study and analyze the ensuing trading behavior and data generated with regard to the agent portfolio from the simulation. each trading agent can hold at time t during the simulation run, two different types of asset: a risk-free asset (cash), and a risky asset (stock asset). before the simulation launch, each trading agents endowed with 10,000 amounts of cash and without any assets. a trading agent invests 100% of its cash when buying, and 100% of it shares when selling. every trading agent j has a portfolio which records the results of the agent’s transactions for the period of the simulation run. the net asset value (nav) at time t denoted by navj,t signifies the current cash value of an agent j’s account. in particular, the navj,t is the amount of cash in the agent j’s account plus all unrealized profits and minus all unrealized losses associated with all the account’s open positions. the clearance mechanism of the market simulation is simple where every market order at time t will be totally executed while limit orders will be executed when their constraints are satisfied. a market order is an order for immediate execution in the market at the current price of the asset. in contrast, a limit order is an order in which an agent j specifies the price at which it is willing to buy or sell a number of assets. an update will take place for each agent’s portfolio that has an executable order at time t. afterward, the simulation’s time turns from t to t+1. therefore, the asset’s price is adjusted to the prices at time t+1 using the historical prices dataset. hence based on the recent price of the asset, the portfolio will be updated for each agent holds an open order at time t+1. 6.3. assumption we formulate the following six assumptions in modeling the agents’ trading mechanism in the absm: figure 2: time evolution of (left axis) five stock indices closing prices and (the right axis) the corresponding closing prices over the period from december 1, 2014, to may 25, 2015 the banks and financial services indices are: the saudi american bank, the saudi british bank, al rajhi bank. the telecommunication and information technology indices are: saudi telecom company and zain mobile telecommunications company aloud: profitability of directional change based trading strategies: the case of saudi stock market international journal of economics and financial issues | vol 6 • issue 1 • 2016 93 • assumption 1: we assume that the trading agents endowed with 10,000 amounts of cash and without any shares. • assumption 2: we assume that an open order cannot be adjusted by increasing or decreasing the order size. • assumption 3: there are two types of orders: a market order and a limit order. • assumption 4: we restrict the quantity of open orders held by an agent j at time t to be one opened order. • assumption 5: the market does not imply fees for the transactions. • assumption 6: a trading agent invests 100% of its cash when buying and 100% of it shares when selling. in essence, the main reasons for these simplification assumptions is that by making these six assumptions the complexity of the automated trading strategy is reduced to a level that can be studied and analyzed within the scope of this work. simplicity and unification the initial variable of the agents’ characteristics is a fundamental block to plainly compare the efficiency of the automated trading strategies. hence, allocating variable quantities results in a substantial complication of the comparison analysis. the relaxation of these six assumptions does not affect the generality of the simulation results shown in our paper. nevertheless, we are aware of the importance of the role of quantity and diversity as a choice variable. 7. results and discussion in this section, we perform simulation experiments on the three automated dc trading strategies by fed the simulation with historical price data, and hence the agents’ trading strategies respond to such information. the simulation is fed with different stock index price data over the diverse time horizon to avoid the possibility of overlearning from past data. the learning process for the dct1 and dct2 traders is over a 2 months period. the results generated from the simulation run are averaged over 10 independent simulation runs, each run adopting different initial seeds provided by random number generators, and different ranges of threshold values. we performed each independent simulation run with the same parameter configuration values, but with different seeds and ranges of threshold values, to ensure that the results of the simulation are consistent; this allows us to establish the robustness and accuracy of the simulation results. one way to evaluate the performance of the automated dc trading strategies is to examine the generated trading returns. thus, we used the roi as a performance indicator (described in section 4). table 1 summarizes the performance induced by the three automated dc trading strategies over the test period from december 1, 2014, to may 25, 2015. it is very obvious from table x that earning high roi is highly dependent on detecting the magnitude and most importantly the direction of periodic dc and os price events in the price time series. for illustration, the adopted trading type for zi-dct0, which achieved higher returns on investments than the other trading type was used by both dct1 and dct2 for all of the five stock indices. for the sample test period, the average roi (4%) for the zi-dct0 (tf) is the lowest amongst the other strategies, while just for sabb stock index it achieved the highest roi (16.9%). therefore, the magnitude of the used threshold (λ) plays a vital role in detecting arbitrage opportunities and hence its impact on roi. in general, for the majority of roi, the trading agents made more profits than losses based on the different used thresholds. this indicates that the returns are significant but also reminds us of the importance of learning for fitting an appropriate threshold magnitude and trading type based on the asset price time series. by way of illustration, with a threshold of 5% and tf trading type, a zi-dct0 agent would make a loss of 6.1% on the zain index, whereas with the same threshold and trading type the zi-dct0 agent would make a profit on the other four stock indices. this is because the price fluctuations of zain index frequently change slightly on both trend directions. this illustrates the fact that the zi-dct0 contrarian trader made a profit of 6.61% with a threshold of 5% as it takes advantage of the slight price trend movements. it is difficult from the experiments results to identify the most suitable threshold magnitude and type of trading for the zi-dct0 trader and we cannot say with any certainty that a certain threshold is a perfect match for a stock index. instead, a threshold magnitude and type of trading must be chosen for each stock index based on many criteria, amongst which is the status of the price evolution. learning from historical price data should be mandatory because it enables the individual to improve his wealth in relation to the price evolution. we consider learning to be of central importance in designing an automated trading strategy because in real life the dynamic changes in the fms certainly have an influence on the evolution of the price time series and hence in the traders’ table 1: detailed roi (as a percentage) performance comparison on ssm indices over the test period from december 1, 2014, to may 25, 2015 stock index zi-dct0 (ct) (%) zi-dct0 (tf) (%) dct1 (%) dct2 (%) λ roi λ roi λ tt roi λ tt roi sabb 5 7.88 5 16.9 5.9 tf 13.6 5.9 tf 13.6 rajhi 4 30 4 12.2 10 ct 21.3 4.2 ct 55.1 samba 7 74.11 4 8.60 7.1 ct 74.11 5.9 ct 84.9 stc 7 12.7 7 2.21 4 ct 14.11 4.70 ct 79.96 zain 5 6.61 6 −6.1 9 ct 10.2 8 ct 11.51 average 6 31 5 4 8 ct 30 6 ct 58 the banks and financial services indices are: samba, sabb, rajhi. the telecommunication and information technology indices are: stc and zain mobile telecommunications company (zain). the average reported results are: the used threshold (λ), roi, and the selected type of trading method (tt). samba: the saudi american bank, sabb: the saudi british bank, rajhi: al rajhi bank, stc: saudi telecom company, roi: rate of investments, tf: trend following, ct: contrary trading aloud: profitability of directional change based trading strategies: the case of saudi stock market international journal of economics and financial issues | vol 6 • issue 1 • 201694 trading strategies. additionally, it is common for traders to adjust their trading strategy if they are not performing well with regard to their investment returns. therefore from table 1, we find that dct2 achieves the best trading performance with regard to the roi. this is a significant result as it implies that the efficiency of learning in achieving high investment returns. an important observation to highlight is that the detected dct1 and dct2 thresholds magnitude and type of trading for the different five stock indices are roughly similar. thus, this confirms that financial price time series exhibits periodic patterns. this is a good starting result regarding automats’ trading strategies; though a full study through comparison with different trading strategies over different time periods and using different assets price time series will be more comprehensive, as this will show the whole picture and effectiveness of the adopted trading strategy. to summarize, the results indicate that prices in fms exhibit “os” and accordingly a dc trade simply makes a profit when there are price os. the results in table 1 draw attention to the importance of considering events in studying the price time series in fms, rather than physical time changes owing to the long coastline of price changes based on intrinsic time. intrinsic time enables the analyst to capture the short-term price dynamics, based on the analyst’s expectations of the market. in addition, intrinsic time reduces the complexity of real-world price time series given the small number of price points for evaluation. the computational costs (which include the cost of evaluating the price data) should not be disregarded. therefore, it must be considered when it comes to deciding on an approach for studying the price time series in fms. 8. conclusion asset trading in the fms is an important decision-making problem which involves both selections of trend movement magnitude and direction. despite the fact that many promising works have been reported for predicting prices, detecting periodic patterns, and managing trading using computational techniques, considering all of them is challenging as of their complexity. in this paper, we pioneer in formulating dc event approach into automated trading strategies and evaluate their profitability performance in the ssm. three automated dc trading strategies are presented: zi-dct0, dct1, and dct2, which designed as a decision making support system tool for financial investors. this paper offers a plain demonstration of the definition of the dc event approach, in combination with the motivation behind introducing this approach as an automated trading strategy, its advantages and significance, and the working mechanisms. the dc event approach has the potential to become a robust foundation tool for automated investment trading in the fms. our study implies that being able to recognize dc and os events in the price time series may be the key to providing effective decision support in the fms. the simple learning mechanism employed by the automated dc trading strategies is effective for detecting arbitrage opportunities. although, we cannot draw more generic conclusions regarding the use of other automated intelligence learning trading strategies in the fms, our results provide evidence that a complex automated learning trading strategy may not be necessary. one of the significant features of the automated dc trading strategies is the combination of classical tf and ct investment rules with a learning model from asset’s historical prices, which can extensively advance computational effectiveness and the predictability of price trend magnitudes and directions, as well as uncover periodic patterns in the price time series. tf and ct strategies have been widely adopted by investors in fms. to the best of our knowledge, no related work in the literature has explored tf and cf investment strategies within a learning model based on the detection of periodic dc patterns. this study has demonstrated the feasibility of employing learning from historical data as part of a trading strategy in that both dct1 and dct2 are designed to adapt to market price trend directions and hence deduce periodic patterns. we believe that modeling of learning in automated trading strategies in important. in dct2, learning is triggered in two different ways: endogenously and with fixed periodicity. future work will consider the combination of evolutionary learning techniques with a dc event approach for developing automated trading strategies for investment in the fms. 9. acknowledgments we would like to thank the deanship of scientific research and humanities research center in king saud university for their support. we would like to thank the capital market authority in saudi arabia for providing the ssm datasets. we are very grateful to prof. m. fasli, prof. e. tsang, prof. r. olsen and dr. a. dupuis for their insightful suggestions and advice during the course of this study. we would also like to thank the anonymous reviewers for their useful comments and suggestions. references alfi, v., cristelli, m., pietronero, l., zaccaria, a. 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(2001), indirect estimation of the parameters of agent based models of financial markets. geneva: technical report, fame research paper, university of geneva. international journal of economics and financial issues vol. 3, no. 4, 2013, pp.885-900 issn: 2146-4138 www.econjournals.com 885 board of directors independence and firm value: empirical evidence based on the bucharest stock exchange listed companies georgeta vintilă the bucharest university of economic studies, department of finance 6, romana square, 1st district, postal code: 010374, postal office: 22, romania. e-mail: vintilageorgeta@yahoo.fr ştefan cristian gherghina the bucharest university of economic studies, department of finance 6, romana square, 1st district, postal code: 010374, postal office: 22, romania. e-mail: stefan.gherghina@fin.ase.ro abstract: this paper examines the influence and causal relationship between board of directors independence, ceo duality, and firm value. by estimating multivariate regression models for panel data, unbalanced, for a sample of companies listed on the bucharest stock exchange, there resulted a positive influence of the percentage of independent directors on firm value, but down to a threshold of their representation of 47.23 percent, whereupon their influence becomes negative. when we employed fixed-effects models, the relationship previously mentioned was not statistically validated. however, the results provide support for a lack of statistically significant relationship between the percentage of non-executive directors and firm value. besides, by estimating fixed-effects models we found a positive influence of ceo duality on industry-adjusted tobin’s q ratio, but not statistically significant when estimating models without cross-sectional effects. the causal relationships between board independence and firm value identified based on granger causality are not robust. keywords: independent directors; non-executive directors; firm value; panel data regression models; granger causality; vector autoregression jel classifications: g32; g34 1. introduction corporate governance covers all the procedures which ensure the fact that management operates in order to satisfy shareholders’ interests (kanagaretnam et al., 2007). thereby, based on its importance within modern corporations, board of directors as internal mechanism of corporate governance was slightly disputed (iwasaki, 2008; jensen, 1993), but widely researched and criticized within the pale of specific literature (adams et al., 2010; ezzamel, 2005). agency theory reflects the prevailing approach as regards the investigation towards the relationship between board independence and firm value. this prevalent theory suggests that information asymmetry, as well different aims between principals (shareholders) and agents (management) impose costs on principals when an agent holding discretionary authority pursues his objectives rather than shareholders’ interests. bebchuk and fried (2003) noticed that there are not a priori reasons in order to assume the fact that managers’ aim is shareholders’ wealth maximization. according to byrd and hickman (1992) and fama and jensen (1983), the companies are mitigating their agency costs through implementing an appropriate monitoring system such as efficient oversight of managers by board members. furthermore, fama and jensen (1983) underlined the efficiency towards managers’ monitoring when corporate boards are dominated by outside independent members. besides, hossain et al. (2000) mentioned that the value of outside members among boards is determined through their ability against the assessment of corporate performance, whereas insiders cannot often own this virtue. as much, we ascertain a narrowed efficiency of insiders as corporate monitors. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.885-900 886 the aim of this research consists in the empirical investigation of the influence and causal relationship between board of directors independence assessed through the percentage of independent directors, as well the percentage of non-executive directors and firm value. moreover, we will investigate the impact and causal relationship between ceo duality and industry-adjusted tobin’s q ratio employed as proxy for firm value. this study is important since it provides the first empirical results for a sample of companies listed on the bucharest stock exchange (bse) over 2007-2011. the novelty of this study is depicted by the examination of board independence based on a sample of companies listed on the romanian stock exchange. notwithstanding, romania is acknowledged as post-communist country from eastern europe, nevertheless scanty regulated concering corporate governance. with respect to the privatisation process, boycko et al. (1996) advocated the postive effects of this course, respectively the decline of agency problems and the growth of efficiency by way of improvement the monitoring systems. thus there are provided the required incentives to the agents in order to act properly. besides, the privatisation process of romanian companies owned by the state during the communist regime, initiated after 1990, was not entirely accomplished. likewise, the act of privatisation is endless litigated and bounded to corruption. according to stulz (2006), when state behaves improper the individuals who control the state actuate in own interests rather than enforcing property rights and facilitating contracting among private parties. the remainder of this paper is organized as follows. section two presents the regulations towards board independence within the companies listed on the bucharest stock exchange. section three reviews the literature on the relationship between board independence and firm value and shows the research hypotheses. the research sample alongside all the employed variables and empirical methods are described in section four, whilst section five provides the empirical results. last section concludes the paper. 2. board independence regulations within the bucharest stock exchange listed companies we emphasize the prevalence of unitary boards within the companies listed on the bse. besides, law 31/1990 on trading companies points out that corporate boards of directors shall have the following main competencies that may not be delegated to directors: to establish the main directions of activity and development of the company; to establish the accounting and financial control system and to approve the financial planning; to nominate and dismiss directors and to establish their remuneration; to supervise directors’ activity; to prepare the annual report, to organise the general meeting of shareholders and to implement its decisions; to introduce the request for opening the insolvency proceedings of the company according to the law on insolvency proceedings. however, directors shall be nominated by the ordinary general meeting of shareholders, except for the first directors which are appointed through the constitutive act. the nominees for the positions of directors shall be appointed by the current members of the board or by the shareholders. moreover, for the duration of the term of office, directors may not conclude an employment contract with the company. if directors were nominated among the employees of the company therefore the individual employment contract shall be suspended over the term of office. in romania, corporate governance principles and recommendations are expressed within the bucharest stock exchange corporate governance code (2008). thus, the companies admitted to trading on the regulated market of the bse shall adopt and comply with the provisions out of the romanian corporate governance code, but on a voluntary basis. it is mentioned that the board structure of the companies should ensure a balance of executive and non-executive directors or independent directors in a flawless framework, insofar that no individual or small group of individuals can dominate the board’s decision making process. consequently, an adequate number of nonexecutive directors shall be independent by considering the fact that they do not maintain, nor have recently maintained, directly or indirectly, any business relationships with the issuer or persons linked to the issuer, of such significance as to influence their autonomous judgment. the independence of non-executive directors shall be evaluated based on the following criteria: a non-executive director is not an executive director of the company or of an entity controlled by it and has not been in such a position for the previous five years; he is not an employee of the company or of an entity controlled by it and has not been in such a position for the previous five years; he does not receive and has not received significant additional remuneration from the company or of an entity controlled by it, apart from a fee received as non-executive director; he is not and does not board of directors independence and firm value: empirical evidence based on the bucharest stock exchange listed companies 887 represent in any way a significant shareholder of the company; he does not have and has not had within the last financial year a significant business relationship with the company or of an entity controlled by it, either directly or as a partner, shareholder, director, or employee of a body having such a relationship; he is not and has not been within the last three years a partner or an employee of the present or former external auditor of the company or of an entity controlled by it; is not an executive director in another company in which an executive director of the company is a nonexecutive director; he has not served on the board as a non-executive director for more than three terms; he is not a close family member of an executive director or of persons in the situations above mentioned. the guide for implementing corporate governance code (2010) notice the fact that at least half of the total number of directors should be non-executive and at least a quarter of them shall be independent. usually, the chairman of the board is independent. 3. literature review and hypotheses development although the relationship between the monitoring function related to corporate boards of directors and firm value has been extensively researched (berle and means, 1932; jensen and meckling, 1976; fama and jensen, 1985), there are not congruent points of view towards the sense of relation between the monitoring role exerted by outside directors and its effect on firm value (hermalin and weisbach, 2003; denis and mcconnell, 2003). thereby, morck et al. (1988), hermalin and weisbach (1991), mehran (1995), and klein (1998) reported a lack of a statistically significant relationship between board independence and firm performance, whereas agrawal and knoeber (1996) and bhagat and black (2001) concluded a negative relationship. contrariwise, rosenstein and wyatt (1990) noticed positive share-price reactions at director appointments on board. however, whilst insiders are an important source of company-specific information for boards, we distinguish different aims against shareholders’ wealth maximization due to the private benefits and lack of independence towards ceo (raheja, 2005). as opposed raheja (2005), outside directors confer an independent monitoring, but they own reduced information as regards the constraints and opportunities of the companies. therefore, as benefits (costs) of monitoring rise, the boards will perform a better (lower) monitoring through the rise (reduction) of outside members. hermalin and weisbach (1988) suggested that outside directors are potential sources of counselling, thus being able to enhance the proficiency and expertise of boards. likewise, mariolis (1975), koenig et al. (1979), and mace (1986) mentioned that outside directors can serve as source of prestige by offering new business contacts. we notice two competing theories regarding board characteristics emphasized by boone et al. (2007). the inefficient board hypothesis highlights the inefficient organization of boards unless regulations force them to a more efficient size and composition. in fact, boards may be structured either haphazardly or perversely. unfortunately, if boards are perversely inefficient, its structure will not increase firm value, but will facilitate the extraction of private benefits by managers at shareholders’ expenses. the economic hypothesis or the efficient board hypothesis emphasizes that board structure is endogenous driven by unique specific characteristics to every company and the tradeoff between costs and benefits. besides, boone et al. (2007) notice that board structure is endogenous, being required its adjustment according to the characteristics of the environment where the company operates. by investigating the forces that drive board size and composition, boone et al. (2007) established three non-mutually exclusive testable hypotheses. thus, the views of fama and jensen (1983), coles et al. (2008a), and lehn et al. (2009) are reflected through the scope of operations hypothesis which involves that board structure is driven by the scope and complexity of the firm’s operations. the measures of firm scope and complexity including firm size, age, and number of business segments are positively related to board size and the proportion of independent outside directors. as the companies are growing, its boards of directors are extending due to the net benefits of monitoring and specialization by board members. the monitoring hypothesis defined out of research employed by demsetz and lehn (1985), raheja (2005), gillan et al. (2011), and harris and raviv (2008) emphasizes that board size and composition are positively related to private benefits of managers and negatively related to the cost of monitoring. thereby, board size implies a tradeoff between the benefits and costs of monitoring. from the studies of hermalin and weisbach (1998) and baker and gompers (2003) was developed the negotiation hypothesis according to which board international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.885-900 888 composition emerges from a negotiation between the ceo of the company and its outside board members. according to duchin et al. (2010), we highlight three broad views concerning the way how boards operate. thereby, window-dressing view supported by romano (2005), also called co-option (coles et al., 2008b), shows the establishment of numerical targets as regards independent directors through the medium of regulations. however, this circumstance will not improve corporate governance since managers can select directors that meet the criteria of independence according to regulatory definitions, but are still excessively congenial to management. bhagat and black (2001) reported that low-profitability companies decide to increase the independence of boards, but there is no evidence that this strategy works. entrenchment view advocates that managers dislike independent boards and look for their dismissal from oversight. optimization view shows that managers trade off the strengths and weaknesses of inside and outside directors towards counselling and monitoring in order to maximize shareholders’ wealth. based on these considerations, we draw the first and the second hypotheses which will be tested within current study: h1: the percentage of independent directors has a positive influence on the value of listed companies on the bucharest stock exchange. h2: the percentage of non-executive directors has a positive influence on the value of listed companies on the bucharest stock exchange. ceo duality occurs when the same person holds the functions of ceo and chairman of the board of directors (rechner and dalton, 1991). therefore, the cadbury report (1992), titled financial aspects of corporate governance emphasized the concentration of power when the roles of ceo and chairman are combined in one person. anyway, the cadbury report (1992) recommended a division of responsabilities at the head of the company in order to ensure a balance of power and authority, such that no one individual has sovereign powers of decision. agency theory supports the negative effect of ceo duality due to the limitations of ceos’ towards the settlement of decisions in shareholders’ interests (jensen and meckling, 1976; fama and jensen, 1983), whereas stewardship theory maintains the positive effect related to ceo duality and argues the improvement of organizational efficiency thereupon shareholders’ wealth (miller and friesen, 1977; stoeberl and sherony, 1985; anderson and anthony, 1986; donaldson and davis, 1991; finkelstein and d’aveni, 1994; dahya et al., 1996; brickley et al., 1997; bhagat and black, 2001). according to berg and smith (1978), the ceos which hold the position of chairman of the board can select board members among the individuals with a similar attitude. thus, jensen (1993) argued that ceo duality provides an excessive power to the ceo as against decision taking process, as well the possibility to accomplish their own aims. iyengar and zampelli (2009) mentioned that ceo can lower the monitoring power related to the board, following the fulfillment of his objectives without taking in account the costs bore by shareholders. on the contrary, miller and friesen (1977) stressed the ability of the companies towards the quick act at outside events, respectively the efficiency of decision taking system if both functions are held by a single person. likewise, finkelstein and d’aveni (1994) promoted the unification of ceo and chairman roles in order to avoid confusions or ambiguities related to multiple authorities. on the basis of these considerations we state the third hypothesis which will be tested within current study: h3: the separation of roles related to the ceo and chairman of the board has a positive influence on the value of listed companies on the bucharest stock exchange. 4. data and research methodology 4.1 sample selection and variables description our initial sample comprised all the companies listed on the bucharest stock exchange on all three tiers between 2007-2011. subsequently, we removed from our sample the companies from financial intermediation sector (eleven companies) including credit institutions (three banks), financial investment companies (five sifs), and financial investment services companies (three ssifs), since these companies are regulated by specific rules. likewise, we dropped from the initial sample the companies out of ‘unlisted’ tier (twenty five companies) and the companies out of ‘international’ tier (two companies). therefore, our final sample shows the following distribution: 63 companies in 2007, board of directors independence and firm value: empirical evidence based on the bucharest stock exchange listed companies 889 67 companies in 2008, and 68 companies between 2009-2011, counting 334 statistical observations. the industry membership of selected sample is sundry as following: wholesale/retail, construction, pharmaceuticals, manufacturing, plastics, machinery and equipment, metalurgy, food, chemicals, basic resources, transportation and storage, tourism, and utilities. table 1 describes all the variables employed in the empirical research. table 1. description of variables variable definition variable regarding firm value qadj industry-adjusted tobin’s q ratio. tobin’s q ratio was computed as the market value of assets divided by the book value of assets, where the market value of assets equals the book value of assets plus the market value of common equity less the sum of the book value of common equity. variables regarding corporate board of directors independence ind the ratio between the number of independent directors on corporate board of directors and the total number of directors on board (%). ind2 the percentage of independent directors on corporate board of directors squared (%). ned the ratio between the number of non-executive directors on corporate board of directors and the total number of directors on board (%). ned2 the percentage of non-executive directors on corporate board of directors squared (%). variable regarding ceo duality ceodual dummy variable if the ceo holds simultaneously the positions of ceo and chairman = 1; if the ceo does not hold simultaneously the position of ceo and chairman = 0. control variables fs firm size, as the annual total assets (logarithmic values). lev leverage, computed as debt/book value of assets. sgrowth sales growth, as the relative increase of sales from the previous year (%). listing the number of years since listing on the bse (logarithmic values). source: author’s processing. all data was hand collected, besides the source of it being represented by the annual reports disclosed by the companies. the value of selected companies will be measured through tobin’s q ratio, but industry-adjusted, similar eisenberg et al. (1998), in order to account for the varied industry membership. thereby, we employed the method described by kaplan and zingales (1997), gompers et al. (2003), and bebchuk et al. (2009). nevertheless, we have not considered the market value of debt at the numerator, respectively the replacement cost of assets at denominator. further, after we have computed tobin’s q ratio for each company, we have adjusted it according to industry membership. thus, the difference between tobin’s q ratio of a certain company and industry’ median tobin’s q ratio is ∆q, while industry-adjusted measure of tobin’s q ratio (qadj) is defined as follows: qadj = sign(∆q)*sqrt(|∆q|), where sign(∆q) is the sign of difference between tobin’s q ratio of a certain company and industry’ median corresponding to tobin’s q ratio, whereas sqrt(|∆q|) is the square root of absolute value of ∆q. we decided to use median instead of mean because our data did not follow a normal distribution. the annual total assets (logarithmic values) will be employed as proxy for firm size. in fact, large companies require an additional managerial effort and a multifarious expertise, thus registering a higher size and independence related to corporate board of directors. therewith, large companies benefit of more outside contractual relationships (booth and deli, 1996) than small companies, being emphasized a higher degree of transparency within these types of organizations (lang and lundholm, 1993; king et al., 1992). according to coles et al. (2008a), guest (2008), and linck et al. (2008), board size and independence are positively related to several firm characteristics as indebtedness level, the age of the company, and industrial diversification. there is showed that highly leveraged companies with a long history and significant diversification are more complex and request superior experience and skills (fama and jensen, 1983; guest, 2008). we will employ debt/book value of assets in order to control for the indebtedness level, considering the use of debt in order to restrict managerial discretion by reducing the size of cash-flow. the growth opportunities are proxied by the relative increase of sales from the previous year. the cost related to managers’ monitoring increases international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.885-900 890 with growth opportunities (smith and watts, 1992; gaver and gaver, 1993), being argued the fact that faster-growing companies will record a reduced size of boards and a higher percentage of insiders due to higher monitoring costs (lehn et al., 2005). this circumstance is confirmed by linck et al. (2008), who identifed that faster-growing companies registered a reduced size of board, as well a lower board independence. moreover, we will use the logarithmic values as regards the number of years since listing on the bse. black et al. (2006) and balasubramanian et al. (2010) mentioned that younger firms are likely to be faster-growing and perhaps more intangible asset intensive which can lead to higher tobin’s q ratio. 4.2 empirical framework the hypotheses stated within section three will be empirically tested by estimating multivariate regression models for panel data, unbalanced, both without cross-sectional effects and fixed-effects models. besides, in order to detect potential nonlinear relationships we will estimate several polynomial regression models. similar baltagi (2005), we consider the following general form of panel data regression model without cross-sectional effects: y = α + x β+ u i = 1, ..., n, t =1, ..., t (1) where y is the dependent variable (industry-adjusted tobin’s q ratio), x is the vector of explanatory variables (variables regarding board of directors independence and ceo duality, as well control variables), the i subscript denotes the cross-section dimension, respectively the companies listed on the bse, whereas t subscript denotes time, respectively the period 2007-2011. according to baltagi (2005), most of the panel data applications employ a one-way error component model for the disturbances as following: u = μ + υ , where μ shows the unobservable individual-specific effect, whilst υ shows the remainder disturbance. as well, we will consider the following general form of the fixed-effects model, where μ are assumed to be fixed parameters to be estimated, whereas the remainder disturbances stochastic υ independent and identically distributed iid(0, σ ): y = (α + μ ) + x β + υ i = 1, ..., n, t =1, ..., t (2) the causal relationship between board independence and firm value, employing additionally ceo duality, will be investigated by the instrumentality of granger (1969) approach. thus, by considering two time series x and y, it is said that x granger-cause y if a prediction of y based on a set of information which comprises the history of x is better than a prediction which disregards the history of x. there will be estimated the following regression equations: y = α + α y + … + α y + β x + … + β x + ε (3) x = α + α x + … + α x + β y + … + β y + u (4) the null hypothesis stipulates that h0: β = β = ... = β = 0, respectively x does not grangercause y in the first equation, whereas y does not grager-cause x in the second equation. in order to test for stationarity related to selected time series we will employ the test of dickey-fuller (1979) by estimating the following regression model: ∆y = α + γy + ∑ β ∆y + ε (5) as well, we will perform the test of phillips-perron (1988) by estimating the following regression model: ∆y = γy + u , because it corrects for serial correlations and heteroskedasticity in the errors. the null hypothesis considers that time series are non-stationary h0: γ = 0, while the alternative hypothesis states that time series are stationary h1: γ < 0. subsequently, we will employ the vector autoregressive technique (var). therefore, by considering y the vector of studied variables and ε the vector of innovations, we will estimate a var(p) model as following: y = a y + … + a y + bx + ε . moreover, the model var(p) can be represented as following: ∆y = ∏y + ∑ γ∆y + bx + ε , by considering that ∏ = ∑ a − i, whereas γ = ∑ a . the potential long-term connections will be empirically tested by employing johansen (1991) cointegration test. this procedure consists in estimating the matrix π out of an unrestricted var model, respectively testing if the restrictions required by the reduction of the matrix π rank can be rejected. board of directors independence and firm value: empirical evidence based on the bucharest stock exchange listed companies 891 5. empirical results 5.1 descriptive statistics table 2 shows descriptive statistics regarding all the variables employed within empirical research. the mean percentage of independent directors is only 13.77 percent. in fact, we notice that the recommendation out of the guide for implementing corporate governance code (2010) which states that at least a quarter of the total number of directors shall be independent is not followed. moreover, the mean percentage of non-executive directors (54.43 percent) highlights that the balance between executive and non-executive members recommended by the bucharest stock exchange corporate governance code (2008) is accomplished. table 2. summary statistics variable n mean median min max std. dev. qadj 334 0.08928 0.00000 -0.81178 1.87060 0.570688 ind 334 0.137700 0.000000 0.000000 0.800000 0.174208 ned 334 0.544390 0.600000 0.200000 0.888890 0.176366 ceodual 334 0.389221 0.000000 0.000000 1.000000 0.488305 fs 334 8.241298 8.193217 6.977173 10.52934 0.610849 lev 334 0.387540 0.353737 0.006916 1.940834 0.285651 sgrowth 334 0.070588 0.045353 -0.913607 2.503076 0.356558 listing 334 0.968339 1.041393 0.000000 1.204120 0.253036 source: author’s calculations. description of the variables is provided in table 1 table 3 exhibits the frequency table of the percentage of independent directors and nonexecutive directors, while table 4 shows the frequency table of ceo duality for the companies listed on the bse.for independent directors we remark that the threshold of 50 percent is almost not exceeded, whereas the percentage of non-executive directors registers the highest frequency between 30 percent and 40 percent. likewise, in average, within 60.95 percent out of the selected companies, the roles of ceo and chairman of the board are performed by different persons. by comparison, de andres et al. (2005) reported the following average values as regards the percentage of outside directors on corporate boards of directors: uk (48 percent), usa (79 percent), canada (74 percent), belgium (76 percent), spain (75 percent), france (81 percent), italy (74 percent), switzerland (90 percent). table 3. frequency table as regards the percentage of independent directors and non-executive directors for the companies listed on the bucharest stock exchange variable 2007 2008 2009 2010 2011 n % n % n % n % n % 0%<=ind<=10% 33 52.3809 34 50.7462 36 52.94118 36 52.9411 36 52.9411 10%<ind<=20% 16 25.3968 17 25.3731 17 25.00000 17 25.0000 16 23.5294 20%<ind<=30% 3 4.76190 3 4.47761 2 2.94118 2 2.94118 2 2.94118 30%<ind<=40% 6 9.52381 7 10.4477 7 10.29412 7 10.2941 8 11.7647 40%<ind<=50% 4 6.34921 4 5.97015 4 5.88235 4 5.88235 4 5.88235 50%<ind<=60% 1 1.58730 1 1.49254 1 1.47059 1 1.47059 1 1.47059 60%<ind<=70% 0 0.00000 0 0.00000 0 0.00000 0 0.00000 0 0.00000 70%<ind<=80% 0 0.00000 1 1.49254 1 1.47059 1 1.47059 1 1.47059 80%<ind<=90% 0 0.00000 0 0.00000 0 0.00000 0 0.00000 0 0.00000 90%<ind<=100% 0 0.00000 0 0.00000 0 0.00000 0 0.00000 0 0.00000 0%<=ned<=10% 0 0.00000 0 0.00000 0 0.00000 0 0.00000 0 0.00000 10%<ned<=20% 1 1.58730 1 1.49254 1 1.47059 0 0.00000 1 1.47059 20%<ned<=30% 3 4.76190 3 4.47761 2 2.94118 2 2.94118 2 2.94118 30%<ned<=40% 20 31.7460 21 31.3432 22 32.35294 23 33.8235 22 32.3529 40%<ned<=50% 1 1.58730 1 1.49254 1 1.47059 1 1.47059 3 4.41176 50%<ned<=60% 17 26.9841 22 32.8358 20 29.41176 20 29.4117 19 27.9411 60%<ned<=70% 7 11.1111 6 8.95522 6 8.82353 6 8.82353 7 10.2941 70%<ned<=80% 12 19.0476 11 16.4179 14 20.58824 15 22.0588 13 19.1176 80%<ned<=90% 2 3.17460 2 2.98507 2 2.94118 1 1.47059 1 1.47059 90%<ned<=100 0 0.00000 0 0.00000 0 0.00000 0 0.00000 0 0.00000 source: author’s calculations. description of the variables is provided in table 1. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.885-900 892 table 4 shows the frequency table of ceo duality for the companies listed on the bse.for independent directors we remark that the threshold of 50 percent is almost not exceeded, whereas the percentage of non-executive directors registers the highest frequency between 30 percent and 40 percent. likewise, in average, within 60.95 percent out of the selected companies, the roles of ceo and chairman of the board are performed by different persons. by comparison, de andres et al. (2005) reported the following average values as regards the percentage of outside directors on corporate boards of directors: uk (48 percent), usa (79 percent), canada (74 percent), belgium (76 percent), spain (75 percent), france (81 percent), italy (74 percent), switzerland (90 percent). table 4. frequency table of ceo duality within the companies listed on the bucharest stock exchange ceodual 2007 2008 2009 2010 2011 n % n % n % n % n % no 33 52.38095 40 59.70149 43 63.2352 44 64.70588 44 64.7058 yes 30 47.61905 27 40.29851 25 36.7647 24 35.29412 24 35.2941 source: author’s calculations. description of the variables is provided in table 1. table 5 provides the pearson correlation coefficient matrix. thereby, the values related to the correlation coefficients does not show strong correlations between the independent variables used in the empirical investigation. table 5. pearson correlation coefficient matrix variable qadj ind ned ceodual fs lev sgrowth listing qadj 1 .129 * -.018 .019 .054 .321** .072 -.021 (.018) (.737) (.725) (.326) (.000) (.187) (.701) ind .129 * 1 .202** -.086 .479** -.070 .004 -.150** (.018) (.000) (.115) (.000) (.199) (.942) (.006) ned -.018 .202 ** 1 -.222** .255** -.142** .060 -.028 (.737) (.000) (.000) (.000) (.009) (.276) (.616) ceodual .019 -.086 -.222 ** 1 -.050 .010 -.011 .013 (.725) (.115) (.000) (.360) (.855) (.845) (.814) fs .054 .479 ** .255** -.050 1 .076 .055 -.110* (.326) (.000) (.000) (.360) (.167) (.320) (.045) lev .321 ** -.070 -.142** .010 .076 1 .082 .047 (.000) (.199) (.009) (.855) (.167) (.134) (.387) sgrowth .072 .004 .060 -.011 .055 .082 1 .009 (.187) (.942) (.276) (.845) (.320) (.134) (.865) listing -.021 -.150 ** -.028 .013 -.110* .047 .009 1 (.701) (.006) (.616) (.814) (.045) (.387) (.865) source: author’s calculations. description of the variables is provided in table 1. notes: **significant at 1% level; *significant at 5% level. also, the results of empirical study are not affected by the multicollinearity phenomenon which involve higher variances and covariances of the regression coefficients’ estimators, higher confidence intervals of the estimators due to higher standard deviations, the distortion of results related to student’s t-test due to higher standard deviations, a higher coefficient of determination, the instability of estimators and its standard deviations at small changes of data. 5.2 empirical evidence towards board independence influence on firm value table 6 shows the coefficients of the multivariate regression models without cross-sectional effects. therefore, the results of the first econometric model provide support for a positive influence related to the percentage of independent directors out of the boards of the companies listed on the bse on firm value. notwithstanding, by estimating a polynomial regression model (model 2), there resulted a nonlinear relationship between the percentage of independent directors and firm value. however, even if the percentage of independent directors within the companies listed on the bse is lower, we notice a negative influence related to the percentage of independent directors on industry-adjusted board of directors independence and firm value: empirical evidence based on the bucharest stock exchange listed companies 893 tobin’s q ratio beyond the threshold of 47.23 percent1. furthermore, by considering the percentage of non-executive directors (models 3 and 4) and ceo duality (models 1-6), there resulted the lack of a statistically significant relationship related to firm value. thus, by estimating several multivariate regression models without cross-sectional effects, the first hypothesis h1 is partly statistically validated, whereas the second and the third hypotheses, h2 and h3, are rejected. likewise, the influence of control variables on firm value was acknowledged only for the debt/book value of assets which positively influences industry-adjusted tobin’s q ratio in all the estimated models. table 6. regressions’ results of board independence and ceo duality on firm value (models without cross-sectional effects) variable 1 2 3 4 intercept 0.242085 (0.522456) 0.474713 (0.989534) -0.284445 (-0.652395) -0.455872 (-0.834738) ind 0.596345 ** (3.053351) 1.307014** (2.956517) ind2 -1.383417 † (-1.790468) ned 0.077472 (0.425673) 0.674659 (0.582686) ned2 -0.553895 (-0.522283) ceodual 0.034274 (0.567098) 0.023953 (0.395862) 0.027191 (0.434171) 0.027622 (0.440526) fs -0.057699 (-1.041336) -0.083975 (-1.469639) 0.017280 (0.337702) 0.020600 (0.399092) lev 0.669913 *** (6.417735) 0.689100*** (6.588911) 0.641299*** (6.007786) 0.644406*** (6.020855) sgrowth 0.076714 (0.925994) 0.073595 (0.891144) 0.070623 (0.839339) 0.068950 (0.817949) listing -0.039011 (-0.331343) -0.089668 (-0.742875) -0.077403 (-0.652012) -0.078404 (-0.659619) f-statistic 8.308296*** 7.627402*** 6.601074*** 5.684449*** r-sq 0.132280 0.140730 0.108035 0.108781 adj r-sq 0.116359 0.122279 0.091669 0.089644 observations 334 334 334 334 source: author’s calculations. description of the variables is provided in table 1. notes: †p < .10; *p < .05; **p < .01; ***p < .001. the t-statistic for each coefficient is reported in parentheses. table 7 reports the results of multivariate fixed-effects regression models. although the coefficients of model 2 confirm the nonlinear relationship between the percentage of independent directors and firm value validated in the second model out of table 6 the relationship was not statistically validated based on the significance level associated to student’s t test. by considering the percentage of non-executive directors (models 3 and 4), the lack of impact on firm value was recognized. unlike the results out of table 6, we notice a positive influence of ceo duality on industry-adjusted tobin’s q ratio (models 1-6). thus, by estimating several multivariate fixed-effects regression models, the first and the second hypotheses, h1 and h2, are rejected, whilst the third hypothesis h3 is accepted. in addition, we confirm the positive influence related to the indebtedness level on firm value, as well the negative impact of the number of years since listing on the bse (logarithmic values) on firm value, in all the estimated models. 1 we consider the following notations: y = firm value, x = the total number of independent directors on corporate board, x2 is the total number of independent directors on corporate board, but squared. by considering the coefficients associated to x and x2, then: y = 1.307014*x + (-1.383417)*x 2 dy/dx = 1.307014+ 2*(-1.383417)*x = 1.3070142.766834*x 1.3070142.766834*x = 0 → 2.766834*x = 1.307014 → x = 47.23% international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.885-900 894 table 7. regressions’ results of board independence and ceo duality on firm value (fixed-effects models) variable 1 2 3 4 intercept 0.658033 (0.361315) 0.600001 (0.329279) 0.626741 (0.342389) 0.591805 (0.307597) ind 0.665710 (0.610848) 3.866536 (1.140401) ind2 -8.633518 (-0.996962) ned 0.262287 (0.419396) 0.437010 (0.146918) ned2 -0.171400 (-0.060089) ceodual 0.190465 † (1.760239) 0.181374† (1.670287) 0.193264† (1.755121) 0.192100† (1.714937) fs -0.012710 (-0.056215) -0.006975 (-0.030839) -0.015154 (-0.066816) -0.015462 (-0.068025) lev 1.066094 *** (5.974708) 1.060821*** (5.942475) 1.063455*** (5.955224) 1.061446*** (5.831675) sgrowth 0.079992 (1.030637) 0.079987 (1.030567) 0.078572 (1.011081) 0.078739 (1.010643) listing -1.082889 *** (-4.139537) -1.082347*** (-4.137407) -1.082531*** (-4.136008) -1.082855*** (-4.128440) f-statistic 3.900389*** 3.861023*** 3.894736*** 3.827429*** r-sq 0.522698 0.524523 0.522336 0.522343 adj r-sq 0.388686 0.388672 0.388223 0.385869 observations 334 334 334 334 source: author’s calculations. description of the variables is provided in table 1. notes: †p < .10; *p < .05; **p < .01; ***p < .001. the t-statistic for each coefficient is reported in parentheses. 5.3 empirical evidence towards the causal relationship between board independence and firm value table 8 shows the results of granger causality test. we distinguish the fact that industryadjusted tobin’s q ratio does not granger cause the percentage of independent directors, as well the percentage of independent directors does not granger cause firm value. besides, the industry-adjusted tobin’s q ratio granger causes the percentage of non-executive directors by considering the third lag, although the inverse causal relationship was not confirmed. likewise, ceo duality granger cause industry-adjusted tobin’s q ratio by considering the second lag, but the inverse causal relationship was not evidenced. table 8. granger causality test null hypothesis lag 1 lag 2 lag 3 n f-statistic prob n f-statistic prob n f-statistic prob qadj does not granger cause ind ind does not granger cause qadj 266 0.05351 1.08423 0.8172 0.2987 198 0.76220 0.79687 0.4680 0.4522 130 0.14995 0.99243 0.9295 0.3988 qadj does not granger cause ned ned does not granger cause qadj 266 0.64241 1.58032 0.4236 0.2098 198 0.19147 0.45800 0.8259 0.6332 130 2.67096 0.55417 0.0505 0.6463 qadj does not granger cause ceodual ceodual does not granger cause qadj 266 0.01408 0.49681 0.9056 0.4815 198 0.34282 2.56980 0.7102 0.0792 130 0.00983 0.79265 0.9987 0.5002 source: author’s calculations. description of the variables is provided in table 1. table 9 reports the results of the tests for time series stationarity, respectively augmented dickey-fuller (adf) and phillips-perron (pp). therefore, by analysing the results of the employed tests we notice that industry-adjusted tobin’s q ratio is stationary, both for level data and for the first difference data. on the contrary, the percentage of independent directors, as well the percentage of non-executive directors are first-difference stationary. however, the methodology of vector autoregressive model suggests the fact that all the employed variables shall be stationary. nevertheless, we will follow harvey (1990) according to which the traditional approach of var enthusiasts is to work on level, even if some of the series are non-stationary. board of directors independence and firm value: empirical evidence based on the bucharest stock exchange listed companies 895 table 9. investigating the stationarity of time series method qadj ind ned i(0) i(0) i(0) statistic prob.** statistic prob.** statistic prob.** adf fisher chi-square 406.323 0.0000 51.1905 0.9101 100.331 0.9905 pp fisher chi-square 402.288 0.0000 15.1393 0.3687 29.4827 0.2896 method i(1) i(1) i(1) statistic prob.** statistic prob.** statistic prob.** adf fisher chi-square 654.235 0.0000 19.6560 0.1414 43.8674 0.0079 pp fisher chi-square 667.814 0.0000 16.8834 0.0770 41.0948 0.0036 source: author’s calculations. description of the variables is provided in table 1. notes: ** probabilities for fisher tests are computed using an asymptotic chi-square distribution. table 10 reports the selection criteria as regards the var lag order. thus, based on the five selection criteria (lr, fpe, aic, sc and hq), for three theoretical lags is recommended only one lag for the var model ‘qadj-ind-ned’. table 10. var lag order selection criteria lag logl lr fpe aic sc hq 0 1.066049 na 0.000207 0.029753 0.095927 0.056642 1 606.0168 1172.674 2.16e -9.138720* -8.874024* -9.031165* 2 607.4290 2.672415 2.42e-08 -9.021985 -8.558768 -8.833764 3 620.5957 24.30771* 2.27e-08 -9.086088 -8.424349 -8.817201 source: author’s calculations. description of the variables is provided in table 1 notes: * indicates lag order selected by the criterion; lr: sequential modified lr test statistic (each test at 5% level); fpe: final prediction error; aic: akaike information criterion; sc: schwarz information criterion; hq: hannan-quinn information criterion. table 11 provides the estimation for the var model ‘qadj-ind-ned’, as well the roots of characteristic polynomial based on which we will verify the stability condition of the estimated model. we notice that the var model ‘qadj-ind-ned’ is stable since all roots are subunitary. as much, the estimated var model could be employed in order to describe the autoregressive relationships between board of directors independence and firm value. table 11. the estimation of var model ‘qadj-ind-ned’ and roots of characteristic polynomial variable qadj ind ned roots modulus qadj(-1) 0.321172 (0.04854) [ 6.61656] 0.000783 (0.00253) [ 0.30991] -0.004382 (0.00451) [-0.97156] 0.997491 0.958454 0.319238 0.997491 0.958454 0.319238 ind (-1) 0.218961 (0.16648) [ 1.31520] 0.988958 (0.00867) [ 114.061] 0.016650 (0.01547) [ 1.07622] ned(-1) -0.240345 (0.16112) [-1.49170] 0.017064 (0.00839) [ 2.03353] 0.965054 (0.01497) [ 64.4550] intercept 0.042985 (0.09084) [ 0.47319] -0.008202 (0.00473) [-1.73375] 0.017741 (0.00844) [ 2.10158] source: author’s calculations. description of the variables is provided in table 1. notes: standard errors in ( ) & t-statistics in [ ]. table 12 reports the results of unrestricted cointegration rank tests (trace and maximum eigenvalue). the procedure of cointegration developed by johansen (1991) shows the lack of a longterm relationship between board independence and firm value. both trace test and max-eigenvalue test indicates no cointegration at the 0.05 level. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.885-900 896 table 12. johansen cointegration test hypothesized no. of ce(s) eigenvalue trace statistic 0.05 critical value prob.** none 0.091099 26.91704 29.79707 0.1037 at most 1 0.039000 8.004320 15.49471 0.4650 at most 2 0.000644 0.127647 3.841466 0.7209 hypothesized no. of ce(s) eigenvalue max-eigen statistic 0.05 critical value prob.** none 0.091099 18.91272 21.13162 0.0994 at most 1 0.039000 7.876673 14.26460 0.3913 at most 2 0.000644 0.127647 3.841466 0.7209 source: author’s calculations. description of the variables is provided in table 1. notes: * denotes rejection of the hypothesis at the 0.05 level; ** mackinnon-haug-michelis (1999) p-values. figure 1 provides a graphical representation of impulse response functions related to the var model ‘qadj-ind-ned’. figure 1. impulse response functions related to var model ‘qadj-ind-ned’ source: author’s calculations. description of the variables is provided in table 1. thereby, a shock of one percent in the percentage of independent directors (the middle graph out of the first row) involves an increase of industry-adjusted tobin’s q ratio, whereas a shock of one percent in the percentage of non-executive directors (the third graph from the right side out of the first row) implies a decline of firm value. besides, a shock of one percent in firm value causes an increase of the percentage of independent directors (the first graph from the left side out of the second row) and a reduction of the percentage of non-executive directors (the first graph from the left side out of the third row). 6. discussion and conclusions current research provides the first empirical results for a sample of companies listed on the bucharest stock exchange as regards the influence and causal relationship between board of directors independence proxied by the percentage of independent directors, as well the percentage of nonexecutive directors and firm value measured out through industry-adjusted tobin’s q ratio. withal, we investigated the impact and causal relationship between ceo duality and firm value. therefore, the employed descriptive research acknowledged the accomplishment of the balance between executive and non-executive directors. however, the balance was not fulfilled between executive and independent directors. after we estimated multivariate regression models for panel data, unbalanced, there resulted the fact that beyond the threshold of 47.23 percent, the influence of independent directors on firm value is negative, though this relationship was not statistically validated when we estimated fixed-effects models. thereby, we emphasize the truthfulness of several doubts which stress the fact that not all independent directors are efficient towards monitoring management. besides, with -0.25 0.00 0.25 0.50 0.75 1.00 1 2 3 4 5 6 7 8 9 10 accu mu lated r espo n se o f qad j to qad j -0.25 0.00 0.25 0.50 0.75 1.00 1 2 3 4 5 6 7 8 9 10 accumu lated r esp o n se of qad j to ind -0.25 0.00 0.25 0.50 0.75 1.00 1 2 3 4 5 6 7 8 9 10 accu mu lated r esp o n se o f qad j to ned .0 .1 .2 .3 1 2 3 4 5 6 7 8 9 10 accumu lated r esp o nse o f ind to qad j .0 .1 .2 .3 1 2 3 4 5 6 7 8 9 10 accu mu lated r espo n se o f ind to ind .0 .1 .2 .3 1 2 3 4 5 6 7 8 9 10 accu mulated r esp on se o f ind to ned -.1 .0 .1 .2 .3 .4 .5 1 2 3 4 5 6 7 8 9 10 accu mu lated r esp on se of ned to qad j -.1 .0 .1 .2 .3 .4 .5 1 2 3 4 5 6 7 8 9 10 accumu lated r espo n se o f ned to ind -.1 .0 .1 .2 .3 .4 .5 1 2 3 4 5 6 7 8 9 10 accu mu lated r esp o nse o f ned to ned ac c um ula te d re sponse to chole sky one s.d. innova tions ± 2 s.e. board of directors independence and firm value: empirical evidence based on the bucharest stock exchange listed companies 897 respect to the selected sample there could be detected several cases within ceo was involved in nominating independent directors (shivdasani and yermack, 1999). thus, we highlight the lack of directors’ independence and management entrenchment, opposed to shareholders’ expectations. subsequently, our results provide support for a lack of statistical significance regarding the relationship between the percentage of non-executive directors and firm value, as much being confirmed previous studies (morck et al., 1988; hermalin and weisbach, 1991; mehran, 1995; klein, 1998). furthermore, the estimated fixed-effects models shows a positive influence of ceo duality on industry-adjusted tobin’s q ratio, being supported stewardship theory and confirmed the arguments of its upholders (miller and friesen, 1977; stoeberl and sherony, 1985; anderson and anthony, 1986; donaldson and davis, 1991; finkelstein and d’aveni, 1994; dahya et al., 1996; brickley et al., 1997; bhagat and black, 2001). likewise, the relationship between ceo duality and firm value was not statistically validated after we employed econometric models without cross-sectional effects. not least, the causality research concludes the fact that the identified causal relationships are not robust. the first limits of current research emerge from the reduced number of statistical observations. in fact, we are aware that this research was employed on a country characterized through a less developed capital market and implicitly reduced number of listed companies. afterwards, we distinguish several inconveniences as regards the demarcation between independent directors and nonexecutive directors due to the fact that selected companies does not report a transparent board structure within the annual reports. as future research we consider the study of the influence exerted by female non-executive directors on firm value. on this line we underline the proposal for a directive of the european parliament and of the council on improving the gender balance among non-executive directors of companies listed on stock exchanges and related measures (2012). the motivation towards our future research come out from the fact that the proposed directive sets a minimum objective of 40 percent by 2020 for members of the under-represented sex for non-executive members of the boards of publicly listed companies in europe or 2018 for listed public undertakings, with the exception of small and medium enterprises. by taking into consideration the reduced number of independent directors on boards within the companies listed on the bse, we recommend an increase of their representation, as well an improvement of transparency towards nominating the members out of management structures. references adams, r.b., hermalin, b.e., weisbach, m.s. 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(2006). financial globalization, corporate governance, and eastern europe. nber working paper no. 11912. *** law 31/1990 on trading companies, re-published, updated 2013, title iii, chapter iv, section iii, sub-section i unitary system (art. 137 art. 1521). international journal of economics and financial issues vol. 3, no. 4, 2013, pp.932-937 issn: 2146-4138 www.econjournals.com 932 the calculation of structural budget balance: case of morocco abdelmonaim tlidi department of economics, university of mohammed v-souissi, rabat, morocco. email: mtlidi2010@gmail.com abstract: in this paper, we present the concept of the structural budget balance and its empirical application on the moroccan data. for this, we choose the two-step method. in the first step, we estimate the potential production according to hodrick-prescott's method, obtaining the output gap value. this allows us to identify the business cycles of the moroccan economy during the period 19802011. in the second step, we evaluate the sensitivity of the fiscal revenue and the public expenditure to economic activity. the obtained results show that the sensitivity of the fiscal revenue and the public expenditure are very low. we deduce that the budget balance in moroccan economy is mainly structural and less sensitive to the business cycle. keywords: budget balance; structural budget balance; hodrick-prescott method; potential production jel classifications: e62; h62 1. introduction the budget balance is defined as the difference between total government revenue and its expenditures. it could be a surplus, balance or deficit. it is considered as the main indicator to appreciate the stance of the fiscal policy. it is analyzed as the sign of the presence or absence of an expansionary fiscal policy. indeed, an important deficit means that the government pursues a keynesian economic policy based on the expenditure, while a moderate or nil deficits indicates the use of a budget austerity, supported by the advocate of a modest state (monnier and tinel, 2006). indeed, the change in a budget balance can be due not only to the government actions but also to the fluctuations in an economic activity. thus, in a recession phase, the household incomes and the companies profits decrease, the taxes revenue turndown and hence the budget deficit becomes very wide. in the converse, for an expansion phase, the tax revenues related to value added tax (vat), the income tax (ir) and corporate tax (is) increase, which provide a positive budget balance. hence, we distingue two notions of fiscal balance: the structural budget balance and the cyclical budget balance. the first results from the deliberate actions of the public authorities while the second is due to the fluctuations of the economic activity. this article aims to estimate the structural budget balance in moroccan economy. for this, we use an approach known in the literature as two-step method, which is used by the international organizations (eu, imf, and oecd)(1). its calculation allows us to estimate the impact of fiscal policy on the macroeconomic variables such as global domestic production (gdp) and household consumption. thus, in the second section, we present our methodology for calculating the structural budget balance and in the third section, we give our application. forth section concludes. 2. methodology of calculating the structural budget balance to calculate the structural budget balance, we use the two-step method, proceeding in two steps. the first step evaluates the potential production while the second step aims to estimate the budgetary elasticities of revenue and expenditure regarding to the economic activity changes. 2.1. evaluation of the potential production the potential production is defined as the maximum level of production in a long term under low unemployment level and without inflationary pressures (okun, 1962, cadoret et al., 2004). its fluctuation is called output gap, which is equal to the relative difference between actual gdp and (1) european union (eu), international monetary fund (imf) and organization for economic cooperation and development (oecd). the calculation of structural budget balance: case of morocco 933 potential gdp. generally, the output gap is used in an environmental scan; it allows identifying the different cycles of economic growth. therefore, if an effective production is greater than a potential production (output gap positive), then there is a pressure on the capacity of production factors and hence an excess demand, which generate inflationary pressures. in the other hand, if an effective production is smaller than a potential production (output gap negative), then this implies that there is a partial use of the production factors and hence an excess offer, which generate disinflationary pressures. however, the potential production is an unobservable variable; hence it requires for its calculation many statistical and theoretical assumptions. to evaluate it, there are in the literature two methods: the first method extracts the trend of gdp by using a purely statistical approach, it is called univariate method. it uses the smoothing technique of moving averages that needs only the gdp series information. this means that the effective gdp gravites around to the potential gdp in a long period (clerc, 2002). note that this method contains several techniques like those of hodrick and prescott (1980), beveridge and nelson (1981), harvey (1989) and baxter and king (1995). nevertheless, these techniques have two major inconvenient (2). the first inconvenient appears in the case of a sudden rupture of the trend when a chosen technique will smooth the potential production on several years without taking into account the trend break. the second inconvenient occurs in the extreme points where the trend value cannot be calculated by the moving average technique. one of the ways to resolve the extreme point’s problem is to prolong artificially the time series by using some forecast methods. the second method formalizes the production function, it is known as structural method. it often identifies the production's factors like the labor and capital factors, and specifies the production functions like the cobb-douglass or leontief functions and estimates their parameters by using some statistical inference's methods. this method also appears to be theoretically more robust than the nonstructural methods, because, it incorporates the behavior of agents and the constraints of the production factors. nevertheless, it is more complex than the univariate method because the empirical implementation of such production function requires a considerable effort (chagny and döpke, 2001). among the methods cited above, we have opted for the hodrick-prescott technique (hodrick, 1997). our motivation for this technique is justified by its simple way to be implemented compared to other methods, which require more information and assumptions relating to the economic interrelationships. moreover, the hodrick-prescott technique is largely used by the international institution like the eu and the imf (hedwig and werner, 1997; tanimoune et al., 2008). 2.2 evaluation of budgetary elasticities 2.2.1. evaluation of fiscal elasticity the second step for our methodology is to evaluate the fiscal and expenditure elasticities to economic activity. for this, we use the ordinary least squares (ols) method which involves the government revenue relative to the gdp (in logarithms): where r represents the public revenue and y denotes the effective production which is measured by the gdp. in the following, we give the fiscal elasticity that is equal to the ols estimator: 2.2.2. elasticity of public expenditure regarding to the public expenditure, we can pointed out that their main components (3) are naturally invariant in relation to economic activity fluctuations. this is mainly due to the incompressibility of the public expenditure and to the lack of the unemployment benefits system in morocco. (2) the advantages and disadvantages of these methods, which carry a comparative analysis, are detailed in (chagny and döpke, 2001; ladiray et al., 2003). (3) the main components of public expenditure is staff costs, public debt service, compensation fund expenditures which is currently subsidizing the price of the essential consumer goods (sugar, wheat, petroleum products, butane gas) and investment expenditure. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.932-937, vol. 3, no. 4, 2013, pp. 934 thus, we consider a priori a little sensitivity of the public expenditure to the economic activity ≈ 0. el ansary (2009) confirms this requirement and illustrates that the public expenditure has a structural nature, and hence their variation is independent to the economic environment. in some developed countries that introduced an unemployment compensation system, the elasticity of public expenditure is often negative. this is because when an economic activity decrease, the unemployment increases and hence its expenditure becomes more important. conversely, when an economic activity is in the expansion phase, the unemployment rate falls and hence its expenditure decreases. once the budget elasticities and the potential production are calculated, we deduce the structural budget balance according the two step approach as follows: where:  r and d are, respectively, the fiscal revenue and the public expenditure;  and are, respectively, elasticities of the fiscal revenue and expenditure to the economic activity ;  denotes the output gap ;  sb is the global budget balance. 3. application of the method in two steps for the case of morocco 3.1. estimation of potential production in morocco to estimate the potential production in morocco, we use the hodrick-prescott technique. as mentioned above, this method produces a bad result in the extreme points of the series. to close this gap, we extend artificially the gdp series beyond 2011 using the prognostics of the commissariat for planning of morocco (4) for 2012 and 2013. we model the gdp as an arima (p, d, q)(5) of order p, d and q, which are estimated by the box and jenkins methodology(6). we find that log (gdp)~arima (0,1,1). based on this model, we forecast the gdp series from 2014 to 2020. this allows us to restore the gdp series from 1970 to 2020. the application of the hodrick-prescott technique for λ=100(7) value we permit to calculate potential production where its evolution is shown in figure 1(a). the analysis of business cycle helps to identify the expansion and slowdowns phases in the moroccan economy. these phases are detected from the sign of the difference between gdp and its potential level (8). according to figure 1(b), we can deduce that they are four cycles (9) for the moroccan economy from 1980 to 2011: the two low cycles are (1980-1987) and (2000-2007) and the two high cycles are (1988-1999) and (2008-2011) (10). 3.2. evaluation of the fiscal elasticity to estimate the fiscal elasticity, we have largely followed the methodology of bouthevillain and garcia (2000). thus, we have distinguished four categories of taxes: the household income tax (it), the corporate tax (ct), the value added tax (vat), and the tax on consumption (tc). these tax (4) exploratory economic budget for 2012 (commissariat for planning, 2012). (5) autoregressive integrated moving average. (6) for more detail for this method, see box et al. (1994). (7) the choice is often related to the periodicity of the series in question: λ =100k2 where k is the number of period in the year. thus, λ =100 for annual data (k=1), λ =1600 for quarterly data (k=4), λ =14400 for monthly data (k=12), λ=270400 for weekly data (k=52). (8) this difference is obtained by using the formula: = ( ∗) ∗ where y is the effective production and y* is potential production. a positive output gap is a sign of tension on the production system, while a negative output gap reflects an under-utilization of the factor productivity. (9) a cycle is a period between two successive troughs. (10) the low cycle is a period for which the gdp is below than its potential level while the high cycle is a period for which the gdp is above its potential level. the calculation of structural budget balance: case of morocco 935 revenues are related to economic activity fluctuations. other types of fiscal revenue like the customs duty, the registration fees and of stamp and the non-fiscal revenue are neglected; because their variations are not directly affected by the economic environment. figure 1. evolution of the potential production in morocco we note that the moroccan agriculture is exempted from the taxes; hence the fiscal elasticity should be calculated on the non-agricultural gdp. in the following, we provide the regression model for the different types of taxes: where ri: the various categories of taxes, gdpna : the non-agricultural gdp, αi : a constant terme and νi : the residue. and : is the fiscal elasticity for each tax category relative to the nonagricultural gdp. the results of the estimated parameters for the equation (4) are given in table 1. table 1. regression results of different types of taxes on gdp (in logarithms) in the following, we deduce the estimation of the fiscal elasticity: where rrf is the total tax revenue. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.932-937, vol. 3, no. 4, 2013, pp. 936 from this estimation, we conclude that an increase of 1% of the non-agricultural gdp produces an increase of 1.33% of the fiscal revenue. this result illustrates clearly that the moroccan fiscal system is weakly sensitive to the economic activity. 3.3. evaluation the structural budget balance after estimating the fiscal elasticity and the potential production, we shall determinate the structural budget balance. for this, we refer to equation (3) and give the following calculation of sbs: as shown in figure (2) below, the structural budget balance appears to be closest to the global budget balance. the high level of the structural balance is due to the incompressible nature of the public expenditures, which is mainly constituted by the staff expenditure, the public debt service and the compensation fund expenditures. also, the highness of the structural balance level is due to the lower elasticity of the fiscal revenue in relation to the economic activities. thus, the evaluation of cyclical component of the budget balance is very small (11). indeed, during the low cycles i.e., (1980-1987) and (2000-2007), the cyclical budget balance is respectively equal (in average) to 0.28% and 0.65% of gdp. similarly, during the high cycles (1988-1999) and (2008-2011), the cyclical component is respectively equal (in average) to 0.66% and 0.71% of gdp. figure 2. evolution of the sbb, the sb and the sbc in morocco 4. conclusion in this study, we have calculated the structural budget balance via the two-step method. firstly, we have estimated the potential production using the hodrick-prescott technique. secondly, we have evaluated the first element (fiscal elasticity) of the budgetary elasticities by the ols method while the second element (expenditure elasticity) is considered a priori near to zero. we have found that the budget balance in morocco is highly structural and is not influenced by the economic environment. references bouthevillain, c., garcia, s. (2000). limites des méthodes d’évaluation et pertinence du concept de déficit public structurel. revue française d’economie, 15(1), 106–107. box, g.e.p., jenkins, g.m., reinsel, g.c. (1994). time series analysis, forecasting and control. prentice hall, englewood clifs, 3rd edition. bruno, c. (1999). les déficits publics en europe: suggestions pour un nouvel indicateur de l’orientation de la politique budgétaire. ofce, 1999-05. (11) cyclical component of the budget balance results from the difference between the global budget balance and the structural budget balance. the calculation of structural budget balance: case of morocco 937 cadoret, i., benjamin, c., martin, f., herrard, n., tanguy, s. (2004). econométrie appliquée : méthodes, applications, corrigés. de boeck, bruxelles, belgique. changny, o., döpke, j. (2001). measures of the output gap in the euro-zone: an empirical assessment of selected methods. working paper 1053, kiel institute for the world economy. clerc, l. (2002). pib potentiel, écart de production et politique monétaire. bulletin de la banque de france, no: 103, 93-103. el ansary, a. (2009). evaluation de la soutenabilté de la politique budgétaire au maroc. thesis for access to chief engineer, ministry of the economy and finances, morocco. hedwig, o., werner, r. (1997). les estimations de l’écart de production de la commission européenne. economie internationale, 69, 77–95. hodrick, r.e.p. (1997). post-war u.s. business cycles: an empirical investigation. journal of money, credit and banking, 29, 1–16. ladiray, d., mazzi, g.l., sartori, f. (2003). statistical methods for potential output estimation and cycle extraction. working papers and studies, european commission.association (1962). monnier, j.m., tinel, b. (2006). endettement public et redistribution en france. cahiers de la maison des sciences économiques, 6006. okun, a. (1962). potential gnp: its measurement and significance. american statistical association. tanimoune, n.a., combes, j.l., plane, p. (2008). la politique budgétaire et ses effets de seuil sur l’activité en union economique et monétaire ouest africaine (uemoa). economie & prévision, 5(186), 145–162. . international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 31 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s2) 31-36. special issue for “state and municipal regulation, investment, commerce: national and international aspects of the business” analysis of researching dynamics and structure of consumer expenditure of the russian population raisa ilyinichna buneeva1, maria vitalyevna buneeva2, valery valeryevich toropov3, elena alekxeevna khryuchkina4* 1lipetsk institute of cooperation (branch) belgorod university of cooperation, economics and law, 25a, zegel st., lipetsk, 398002, russia, 2lipetsk institute of cooperation (branch) belgorod university of cooperation, economics and law, 25a, zegel st., lipetsk, 398002, russia, 3lipetsk institute of cooperation (branch) belgorod university of cooperation, economics and law, 25a, zegel st., lipetsk, 398002, russia, 4lipetsk institute of cooperation (branch) belgorod university of cooperation, economics and law, 25a, zegel st., lipetsk, 398002, russia. *email: aleks777.71@mail.ru abstract the model of consumption, consumer behavior (character of consumption), volume and structure of consumption are determined by the person’s style and lifestyle. in their turn, style and lifestyle are formed on the basis of the consumer’s level of life, i.e. the level of prosperity and benefits consumption defined by the needs, ways and forms to satisfy them based on the real consumer demand. the article shows the results of the analysis related to the researches that prove the influence of the consumer factor on the level of people’s lives by dynamics and structure of consumer expenditures. key words: level of people’s life, consumer factor, resources’ provision of consumption, households, economic entities, consumption factor jel classifications: d01, d14, i31, j31 1. introduction due to the evolution of the labor economy, a complex of categories was formed in its categorical apparatus. these categories are basic for cognizing social and economic relations, terms and conditions, and factors of their formation and development. the category “level of people’s life” holds a special place among these categories. no scientific research devoted to the problems of developing economy and social area, including those of forming the population profits and consumption of benefits produced by the society, is made without this category (klimenko et al., 2005). studying the essence of the category “level of people’s life” interpreted by thesaurus and encyclopedic sources in economy as well as by the researchers working at these problems showed practically complete coincidence of the interpretations. in every definition of the level of people’s life it is directly related to the measure or level of satisfying needs in spite of slight differences in defining their composition, terms and conditions of forming the level of life and basis for its comparison (klimenko and oberemko, 2013). in our research the subject is determined as a process of forming the level of people’s life under the influence of the consumption factor. based on the subject of the research, we adhere to the identity of understanding the level of people’s life and prosperity, consumption of benefits created by the society in economy (as material products) and social area (as non-material benefits, i.e., services). 2. methodology due to the diversity of factors related to the consumption formation and following the requirement related to the specifics of the subject and object to be researched, the basics of the methodology must be made by those factors that form general terms and conditions of benefits consumption and affect their quantitative and qualitative buneeva, et al.: analysis of researching dynamics and structure of consumer expenditure of the russian population international journal of economics and financial issues | vol 6 • special issue (s2) • 201632 changes. leading factors of the consumption formation must be singled out on the basis of such research method that allows taking into account the system interrelations of factors, and analyzing their impact on the consumption with the aid of qualitative indicators by using veracious statistical data reflected by the system of federal statistical surveillance. the system of indicators that enter calculation procedures of the methodology should not be “congested” qualitatively. in the contrary case the methodology will cause difficulties when used in the analytical practice. the area of using the methodology must be reflected by its title that will allow analysts to minimize temporary expenditures for searching for the methodological tool to solve the set research task (klimenko and sonnikov, 2012). taking into account the set provisions, the method of parameterization was selected as a basic method for the development of the methodology to analyze factors of the consumption formation. its implementation means distinguishing parameters that reflect the essential characteristics of the system or process under research. in the offered methodology the object of the research includes the consumption as a system economic phenomenon. its subject is a process to form consumption that takes place under the influence of interrelated factors. taking it into account, in the methodology group parameters of analyzing factors are determined in compliance with the determining factors of the consumption formation: macroeconomic – the state of economy and dynamics of its development, infrastructural – the population provision with crediting and state of indebtedness under credits, and structural – structure of consuming goods and services, inclination of the population to savings. the methodology was tested as a whole in russian households in 2013-2014. it showed that the state of the economy is characterized by the growth of macroeconomic parameters of consumption. it is stipulated by two basic reasons caused by negative consequences from complicating international economic relations, slowing down the tempo of economic growth due to the sanction policy of the eu countries and the usa, and a growth of the expenditures for final consumption due to the development of inflation processes. our conclusions became the results of generalizing works of the researchers: hill et al., 2010; engel et al., 2001; erhard, 2001; johansson, 2001; klimenko and klimenko, 2015 p. 251-259). 3. result 3.1. researching dynamics and structure of consumer expenditures we define the revealing of problems peculiar of the life level to be the subproblem of analytical researches related to the influence of consumption on the level of people’s life. we are based on the hypothesis about the pre-determination of the state and dynamics of consumption by the conditions formed in the economic system. its element is a sector of households (population) as a special category of economic entities. as it was specified when setting the research task, researching of the resources’ provision of consumption and dynamics of the economic state of households that reflects the profit component is determined as the first area of researching the influence of the consumer factor on the level of people’s life. we determine the next direction of analytical researches of the consumer factor in the system of factors that form the level of people’s life, as it was specified above, as the research of the expenditure component of consumption expressed by the indicators of the size and composition of consumer expenditures of households and their structural allocation for various social and economic categories. 3.2. dynamics of expenditures for final consu mption made by russian households depending on the place of residence the research showed that for 2009-2013 the expenditures of the russian households increased by more than 150%, the most noticeably by 160.33% as compared to 2009 in households that live in the rural area (profits, expenses and households consumption, 2010-2014; russian statistical annual, 2010-2014). in terms of expenditures classified by the federal statistical survey, the maximum tempo of growth characterizes the expenditures for transportation – 207.73% as compared to 2009 as a whole for all households, including 204.42% for urban and 221.36% for rural households. in our opinion, this circumstance is explained not so much by the growth of the transportation services used by the population but by the growth of the transportation tariffs. the minimum tempo of growth for the researched period was formed for the expenditures for education – 100.53% as compared to 2009 as a whole for all households. it was stipulated by the growth of expenditures for these purposes carried out by the households living in the urban area (104.10%), while in rural households the expenditures for education for the research period decreased by 20.27% and made up only 79.73% as compared to 2009. in our opinion, this fact requires a special research of the reasons that stipulated the decrease in the population’s expenditures for education that cannot be explained by the deficiency of financial resources spent for final consumption, especially taking into account high tempos of the realized irrational demand for alcohol and tobacco: 171.28% as compared to 2009 as a whole for all households, including 168.83% for urban and 179.33% for rural ones. in absolute terms the top-ranking area of expenditures included expenditures for food. they accordingly made up rub 4,216.8 on average per one member of the household, including rub 4,325.7 per one member of the urban household, and rub 3,905.0 per one member of the rural household. in 2013 the minimum amount of expenditures accrued on average to one member of the household was spent for education, accordingly rub 133.7 per month for all households, rub buneeva, et al.: analysis of researching dynamics and structure of consumer expenditure of the russian population international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 33 157.3 for urban and rub 66.1 for rural ones (profits, expenses and households consumption in, 2010-2014; russian statistical annual, 2010-2014). value changes of expenditures of households for final consumption were accompanied by adequate changes of their structure. the maximum percentage in the total amount of expenditures during the whole period of the researches steadily includes expenditures for table food, with its share as a whole in households varying within 30.0%, 29.0% in urban ones, and 42.0% in rural households. by the end of the research period the percentage of the expenditures for education in all categories of households has not made even 1%. according to the dynamics of structural indicators of households’ expenditures for final consumption, there is a tendency of the decrease in the percentage of expenditures for table food (as a whole per 3.3% points for all households), clothes and footwear (0.7% point), and education (0.6% point). it coincides both in urban and rural households. at the same time if in urban households the percentage of expenditures for housing and utilities services and fuel materials, signal communication decreased (by 0.3% and 0.4% points, respectively), by 2013 in rural households the share of these types of expenditures in total expenses for final consumption remained stable. concurrently with this, in the researched period there was a tendency of rather considerable growth of the percentage of expenditures for transportation – by 4.3% points for all households, including 4.3% points for households from the urban area, and 4.1% points for households from the rural area. 3.3. dynamics of expenditures for final consumption made by russian households depending on the number of children in households in the demographic layer according to the criteria related to the presence of children aged under 16 in households, the dynamics of expenditures for final consumption accrued to one member of the household had an incremental nature. however, in this case it is impossible to distinguish a definite area of expenditures that dominates according to tempos of their growth simultaneously in all categories of households with a different number of under-age children. so, for the research period expenditures for transportation grew most quickly in families with one or three children. they have made up 249.42% and 366.43%, respectively, as compared to 2009. in families with two children expenditures for hotels, cafes and restaurants grew. they have made up to 244.95% as compared to 2009. expenditures for the health care grew in families with four and more children. they have made up 312.11% as compared to 2009 (profits, expenses and households consumption in, 2010-2014; russian statistical annual, 2010-2014). the positions of outsiders according to tempos of the growth of expenditures in households with under-aged children were accordingly taken by expenditures for education (in families with one child or two children 110.14% and 152.44% as compared to 2009), hotels, cafes, and restaurants (in families with three, four and more children 106.85% and 117.88%, respectively, as compared to 2009). it is necessary to especially emphasize that for the research period only in one category of households with under-aged children – families with three children – expenditures for the organization of rest and cultural events, education decreased. in 2013 the expenditures for these purposes made up 94.64% and 92.83%, respectively, as compared to 2009. in absolute terms of expenditures of families with children regardless of their number, expenditures for table food are at the top. for example, in 2013 in families with one under-aged child they made up rub 3,324.8 per month per one member of the household, rub 3,275.4 in families with two children; rub 3,100.5 in families with three children; rub 2,109.2 per month in families with four and more children (profits, expenses and households consumption in, 2010-2014; russian statistical annual, 2010-2014). similarly to the current tendencies for households as a whole revealed by us before, expenditures for education hold outsiders positions. herewith, the more children in families, the more considerable these expenditures decrease from rub 167.3 per month per one family member in households with one child to rub 34.1 per month per one family member in families with four and more children. in households with children as well as in a whole for all population the percentage of expenditures for education is at the bottom in total expenditures for final consumption: 1.3% in families with one child with the decrease by 0.5% point as compared to 2009, 1.1% in families with two children with the decrease by 0.1% point, 0.6% in families with three children with the decrease by 0.4% point, and 0.7% in families with four and more children with the increase by 0.2% point as compared to 2009. from the point of view of tendencies related to the decrease in share of separate areas of expenditures for the final consumption, only the decrease in expenditures for table food is peculiar of all households regardless of the number of children. for the research period this decrease made up from 3.8% points in families with one child to 8.7% points in families with four and more children. herewith, in the total amount of expenditures for the final consumption, the percentage of expenditures for table food grows in direct ratio to the increase in the number of children in households, and according to the data of 2013, it holds 28.0%, 29.3%, 32.3% and 42.9%, respectively, in the categories of households under consideration (with one, two, three four and more children). buneeva, et al.: analysis of researching dynamics and structure of consumer expenditure of the russian population international journal of economics and financial issues | vol 6 • special issue (s2) • 201634 we think this fact is natural and corresponds to the current realties in final consumption that is peculiar of households with children. however, it is impossible to make a similar conclusion in relation to the appeared growth of irrational consumer demand for alcohol and tobacco. the growth of the percentage of this area of expenditures for final consumption shows it. so, in families with one child the growth of the indicator for 2009-2013 was 0.2% point, it was 0.3% point that is up to 2.4% in families with two children, 0.6% point up to 2.3% in families with three children, and 0.1% point up to 2.1% in families with four and more children. as it goes from this appendix, during the research period the share of expenditures for transportation grew as quickly as possible in families with one, two and three children. it was by 6.4%, 4.7%, and 9.6% points, respectively. as for families with four and more children, the share of expenditures for household goods, household appliances and homecare had grown by 3.0% points by the beginning of the research period. 3.4. dynamics of expenditures for final consumption made by russian households depending on social status, education, and age of the household head it is determined that from the point of view of maximally high dynamics expenditures for final consumption, as compared to 2009, according to the basic tempo of growth the leading positions in the growth of expenditures are held by the households, where their heads perform economic activity in the form of hotel or restaurant business (219.62% as compared to 2009), they are employees involved in accounting and servicing (175.78%); they have post-graduate professional education (220.23%) and are aged from 20 to 25 (187.95%). in households where heads are not involved in the formal sector of economy, i.e., are not involved in any kind of business, the maximum tempo of growth of expenditures for final consumption is peculiar of households whose heads are unemployed – 191.91% as compared to 2009. in their turn outsiders according to the minimum tempos of the growth of expenditures for final consumption during the research period include the households whose heads were involved in areas related to real estate operations, leasing and services providing (115.42% as compared to 2009); they were managers of government authorities of all levels (124.17%); they had higher professional or incomplete higher professional education (150.85%); they were aged under 20 (89.63%). the latter characteristic related to the differentiation of households heads (age) is correlated to the minimum tempo of the growth of expenditures for final consumption that is peculiar of households heads that are not involved in economy in the “students” category that has made up 90.45% as compared to 2009. in absolute terms of expenditures for final consumption in 2013, the positions of leaders and outsiders in the considered criteria related to distinguishing households are allotted as follows: • according to the criterion related to the involvement in types of economic activity, households whose heads are involved in financial activity are at the top (rub 24,439.7 per one member of the household per month), while outsiders include households heads involved in agriculture, hunting and forestry (rub 9,240.5 per month per one family member), • according to the criterion related to the type of professional work – accordingly heads that are specialists of the highest qualification level (rub 18,968.6 per month per one member of the household), and households heads that are skilled agricultural and forestry employees (rub 8,344.3 per month per one family member), • according to the criterion related to non-employment in the formal sector of economy – household heads that are students (rub 13,666.0 per month per one household member) and unemployed heads of households (rub 7,300.3 per month per one household member), • according to the criterion related to the educational level – households heads with post-graduate professional education (rub 35,967.2 per month per one household member) and households heads that have primary or no elementary education (rub 9,067.7 per month per one household member), • according to the age criterion – heads of households in the age group from 21 to 25 (rub 15,644.4 per month per one household member) and heads of households in the age group up to 20 (rub 7,648.7) (profits, expenses and households consumption in, 2010-2014; russian statistical annual, 2010-2014). 3.5. dynamics of consumer expenditures of the russian population depending on the place of residence one more area of our research included analysis of the dynamics and structure of specifically consumer expenditures of the population. it was revealed that in the territorial layer according to the place of households residence the quickest tempos characterize the growth of consumer expenditures of rural households – 165.78% as compared to 2009 against 155.57% in urban households under the average value of 157.78% for all households. in the macro-structure of areas of consumer expenditures of households expenditures for non-grocery goods hold the leading positions in both categories of households, rural and urban. the tempo of their growth was accordingly 167.41% and 181.89%. for households as a whole as well as households living in the urban area consumer expenditures for non-grocery goods are maximum according to the size calculated on the basis of one member of the household per month. for example, in 2013 they made up rub 5,600.3 as a whole for households, and rub 6,250.9 for urban households (profits, expenses and households consumption in, 2010-2014; russian statistical annual, 2010-2014). in 2013 in rural households consumer expenditures for food topped and achieved rub 4,073.8 per month per one household member. in its turn, the minimum size of consumer expenditures was formed for such area as alcohol: as a whole for households such buneeva, et al.: analysis of researching dynamics and structure of consumer expenditure of the russian population international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 35 expenditures made up rub 233.2 per month per one family member including rub 259.7 in urban households and rub 157.5 in rural households (profits, expenses and households consumption in, 2010-2013). however, in our opinion, the growth of consumer expenditures for alcohol, 159.40%, 159.72% and 155.79%, respectively, cannot be acknowledged as positive because of irrational character of this type of consumer expenditures. value changes of consumer expenditures of households naturally came with changes in their structure. in particular, in spite of the domination of expenditures for food in rural households mentioned above, their percentage in the total amount of consumer expenditures for 2009-2013 decreased by 5.8% points down to 41.8% with the relevant growth of profits for non-grocery goods by 4.6% points. for the research period in urban households the decrease in the percentage of expenditures for food was 2.4% points, down to 31.3%, and the growth of the percentage of expenditures for nongrocery goods was 3.0% points, up to 39.8%. it stands out the multidirectionality of the dynamics of the percentage of expenditures for paying for services: in urban households the decrease by 0.5% point down to 27.15% by the end of the research period; in rural households the growth by 1.1% point up to 18.1%. 3.6. dynamics of consumer expenditures of the russian population depending on the number of children in households the dynamics of consumer expenditures in the demographic layer of households differentiation, i.e., depending on the number of children also had a positive directionality towards the growth. it varies from 160.36% as compared to 2009 in families with four and more children, to 166.12% in families with three children according to the total amount of consumer expenditures. the decrease in the full size of consumer expenditures accrued to one family member per month related to the increase in the number of children is a natural tendency for households. for example, in 2013 in households with one child rub 12,831.8 were accrued on average to one family member per month, rub 10,710.1 in families with two children, rub 9,149.2 in families with three children, and rub 4,422.7 in families with four and more children (profits, expenses and households consumption in 2010-2014; russian statistical annual 2010-2014). it is obvious that the largest families with four and more children suffer specific problems with the consumption of non-grocery goods. it is possible to judge about this by the fact that in 2013 according to the full size expenditures for non-grocery goods topped in households with the smallest number of children (rub 5,437.1, 4,605.4 and 3,984.3 per month per family member), and expenditures for food in households with four and more children (rub 2,152.7 per month per one family member). according to the tempo indicators of the dynamics of consumer expenditures of households with children, it is impossible to make a firm conclusion about the character of their changes. so, according to the growth tempo expenditures for non-grocery goods top in families with one child (177.28% as compared to 2009); expenses for alcohol (accordingly 180.68% and 227.76%) in families with two and three children; and expenditures for paying for services (203.94% as compared to 2009) in families with four and more children. the dynamics of structural indicators of consumer expenditures of households with families according to the directionality coincides with similar changes peculiar of households differentiated according to the place of residence. besides, there is also a decrease in the percentage of expenditures for food from 3.4% points (31.5% in the total amount of consumer expenditures of families with one child) down to 8.8% points (43.9% in the total amount of consumer expenditures of families with four and more children) with the adequate growth of the percentage of expenditures for non-grocery goods: by 4.0, 3.1, 7.8 and 4.3% points in four categories of households with different number of children. 4. discussion in the economic aspect the relation of needs and the level of life means the contradiction between something the person needs (it complies with the person’s idea about the desired level of life) and something he/she really has according to the achieved level of life. based on this, it is possible to make a conclusion that the process of consumption has a dual nature. it is possible to distinguish objective and subjective components in it. the objective component shows the character and level of implementing the person’s life suggestions, i.e. the satisfaction from the achieved level of life. the subjective component characterizes personalized estimation of the needs satisfaction level. in other words, the objective component of consumption forms ideas of the person about the desired level of his life, i.e. it determines future needs, and the subjective component defines the real level of life that depends on the current level of consumption. hence, the level of life appears as a consequence of three conditions arising from the process of benefits consumption: to what extent the person’s needs are met; how much he/she is satisfied with it; and how the results of this implementation are correlated to social standards and resources of the company that are reflected by the consumption norms. generalizing the above, we will note that according to our idea of the mechanism of consumption influence on the level of people’s life, the relation between the phenomena pieces of mechanism has a cyclic and insular nature. it is stipulated by the impossibility to entirely satisfy the person’s needs due to the effect of the economic law of needs rising. the occurrence of new, higher level needs is a natural consequence of an increase in the life level. in its turn, it causes new motifs of buneeva, et al.: analysis of researching dynamics and structure of consumer expenditure of the russian population international journal of economics and financial issues | vol 6 • special issue (s2) • 201636 the consumption behavior and as a new level of consuming benefits that are adequate to the occurrence of new needs. 5. conclusion the results of researching the dynamics and structure of consumer expenditures of the population showed that: • expenditures for final consumption grow quicker in the households from non-urban areas. the maximum tempo of the growth characterizes expenditures for transportation, while the minimum one characterizes expenses for education with a considerable decrease in expenditures for these purposes in households. expenditures for table food top according to the absolute value and percentage in the total sum of expenditures for final consumption in all categories of households according to the place of residence. • analogous tendencies in forming expenditures for final consumption and their structural dynamics characterize the households differentiated according to the demographic criteria, i.e. according to the number of children. the difference includes only the value of the percent of expenditures according to their dominating type – expenditures for table food – is considerably lower than that in households as a whole, • according to the dynamics, tempos expenditures for final consumption of the households where heads perform economic activity in the form of hotel or restaurant business, are employees involved in accounting and servicing; have post-graduate professional education and are aged from 20 to 25 grow as quickly as possible, • outsiders according to the dynamics tempos of the growth of expenditures for final consumption include the households whose heads are involved in areas related to real estate operations, leasing and services providing; are managers of government authorities of all levels; have higher professional or incomplete higher professional education; are aged under 20, • in the territorial layer according to the households’ residence, consumer expenditures of rural households grow as quickly as possible, and in the macro-structure of consumer expenditures both categories of households, rural and urban, are characterized by a higher growth of expenditures for non-grocery goods. according to the full size, expenditures for non-grocery goods top in urban households, while expenditures for food top in rural ones. the percentage of expenditures for paying for services in urban and rural households is changed diversely: towards the growth for the urban households, and towards the decrease for rural ones, • in the demographic layer according to the number of children in households, consumer expenditures are also characterized by a stable growth that is maximum in families with three children. the natural tendency for households with children includes a decrease in the full size of consumer expenditures accrued to one member of the family per month with an increase in the number of children. the most multi-child families with four and more children suffer specific problems related to consuming non-grocery goods. it is proved by the domination of expenditures for food, • according to tempo indicators of the dynamics of consumer expenditures of households with children in families where there is one child, expenditures for non-grocery goods top, expenditures for alcohol top in families with two and three children, and expenditures for paying for services top in families with four and more children, • the dynamics of structural indicators of consumer expenditures of households with children according to the directionality coincides with similar changes peculiar of the households differentiated according to the place of residence. in particular, there is a tendency of a decrease in the percentage of expenditures for food with an adequate growth of expenditures for non-grocery goods. references engel, d.f., blackwell, r.d., miniard, p.w. (2001), consumer behavior. saint-petersburg: peter. erhard, l. (2001), prosperity for all. moscow: delo. hill, n., brierley, j., macdougall, r. (2010), measuring customer satisfaction (translated from english). moscow: infra-m. johansson, s. (2001), conceptualizing and measuring quality of life for national policy. fief working paper series, 171, 1-16. klimenko, o.i., dmitrieva, v.y., igolkina, t.n. (2005), economic basics of social work. belgorod: cooperative education. klimenko, o.i., klimenko, a.a. (2015), role, functions and types of a brand as individualization means of products and organizations mediterranean. journal of social sciences, 6(2), 251-259. klimenko, o.i., oberemko, v.v. (2013), criteria and methods of comprehensive estimation of competitiveness of organizations and their improvement. bulletin of the belgorod university of cooperation, economic and law, 4(48), 188-193. klimenko, o.i., sonnikov, a.v. (2012), family economics: peculiarities of forming and perspectives of development: monograph. belgorod: publishing house of the belgorod university of cooperation, economic and law. profits, expenses and households consumption in 2009, (according to sampling households budgets). (2010), statistical bulletin. moscow: rostat. profits, expenses and households consumption in 2010, (according to sampling households budgets). (2011), statistical bulletin. moscow: rostat. profits, expenses and households consumption in 2011, (according to sampling households budgets). (2012), statistical bulletin. mocsow: rostat. profits, expenses and households consumption in 2012, (according to sampling households budgets). (2013), statistical bulletin. mocsow: rostat. profits, expenses and households consumption in 2013, (according to sampling households budgets). (2014), statistical bulletin. mocsow: rostat. russian statistical annals. 2009: statistical collection. (2010), moscow: rosstat. russian statistical annals. 2010: statistical collection. (2011), moscow: rosstat. russian statistical annals. 2011: statistical collection. (2012), moscow: rosstat. russian statistical annals. 2012: statistical collection. (2013), moscow: rosstat. russian statistical annals. 2013: statistical collection. (2014), moscow: rosstat. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1338-1343. international journal of economics and financial issues | vol 6 • issue 4 • 20161338 changes in the unconditional variance and autoregressive conditional heteroscedasticity amado peiró* universitat de valència, valencia, spain. *email: amado.peiro@uv.es abstract this paper argues that a simple white noise process with one jump in its unconditional variance may give rise to the presence of autoregressive conditional heteroscedasticity (arch) effects, and, surprisingly, this may occur in determinate circumstances even when the jump is very brief. though arch effects are not denied, this evidence, together with some empirical results obtained from standard & poor’s 500 returns, allows one to question whether they are a general and regular property of so many economic and financial series. keywords: autoregressive conditional heteroscedasticity, stock returns, unconditional variance jel classification: g12 1. introduction more than three decades ago engle (1982) introduced a new class of stochastic processes called autoregressive conditional heteroscedasticity (arch) models and used them to estimate the variance of uk inflation. this seminal contribution generated huge interest and very soon different types of arch models were proposed: garch, integrated garch (igarch), exponential garch or arch-m, to name just a few from the many models which constitute, in engle’s (2002) own words, a continually amazing soup of volatility models. one of the main reasons that underlie this huge interest in arch models is the profusion of economic series that seem to present arch effects. this is especially true with regard to financial series; returns from different assets and from different markets seem to exhibit arch effects almost universally. given this profusion and the fact that volatility is a key variable in many financial models, the analysis of arch has received great attention from many researchers. among these many researchers, very few have studied the consequences of outliers or breaks in volatility in arch models and the potential spurious or misleading conclusions that may follow. already diebold (1986) pointed out that integrated variance models could correspond to “stationary garch movements within regimes, with an unconditional “jump” occurring between regimes.” when analyzing the us long-run interest rate, franses (1995) showed that a one-time variance change spuriously suggested that this variable could be described with an igarch process, and, moreover, the sub-periods did not show characteristics of arch. franses et al. (2004) show that patches of additive outliers can have substantial effects on tests for arch. more recently, hillebrand (2005), rapach and strauss (2008), xu and phillips (2008) or gregory and reeves (2010) have drawn the attention to the fact that outliers, structural breaks or simple changes in the unconditional variance may lead to parameter bias or severe model misspecifications. more specifically, they argue that neglecting or ignoring these features yield severe upward biases in the estimation of the persistence of garch models. though most research on this topic highlights its effect on persistence, the impact of breaks or jumps could be much more important. not only the persistence, but even the mere existence of arch or its magnitude could be due to these changes, even when they are limited to very few variables in the process. this paper aims to explore the possibility that the magnitude of arch effects or the plain existence of arch, according to usual tests, in so many financial and economic series may originate from the presence of short breaks in the unconditional variance of the variables. in order to achieve this objective, section 2 presents peiró: changes in the unconditional variance and arch international journal of economics and financial issues | vol 6 • issue 4 • 2016 1339 a white noise process with one jump in its conditional variance and studies, via monte carlo simulations, the existence of arch effects in these processes. in section 3, arch is tested in standard & poor’s (sp) 500 returns with different samples and with different return frequencies, and the robustness and sensitivity of the arch effects is casually examined. finally, section 4 summarizes the main results and conclusions. 2. some simulations let us consider the following process: ( ) ( ) ( )1 1 1 , 1, 2, , , 1, 2, , 2 2 2     − + + = = … + + …t t t t t y t t ( ) ( ) ( )1 1 1 , 1, 2, , 2 2 2     − − + = = + + …t t t t t y t (1) where, εt is i.i.d. n(0,1), 0 < λ < 1, and γ > 1. for notational convenience, and without loss of generality, let us also suppose that λt is even (odd) if t is even (odd). this process is composed by t variables which follow a standard normal distribution with the exception of the λt central variables which follow a normal distribution with expectation 0 and variance γ2. thus, for example, if t = 100, λ = 0.04 and γ = 2, the following process is obtained: yt = εt, t = 1, 2,…,48, 53, 54,…,100 yt = 2εt, t = 49, 50, 51, 52 with εt i.i.d. n(0,1). that is, the process is formed by 100 variables, all of which are n(0,1) excepting the 4 central variables which are n(0,22). obviously, the process {yt} is not i.i.d. it is stationary in the mean, but non-stationary in the variance. however, the process formed exclusively by the first (or by the last) (1−λ)t/2 variables is a simple i.i.d. n(0,1) process, and the process formed by the λt central variables is a simple i.i.d. n(0,γ2) process. this process can be regarded as a white noise n(0,1) process with an episode of higher variability at the middle. by construction this process presents arch. however, for low values of λ, the arch is due to the existence of a few consecutive variables with a higher variance surrounded by variables with a lower variance. it is not a general property of the whole process. neither the process formed only by the first (1−λ)t/2 variables, nor the process formed only by the last (1−λ)t/2 variables, nor the process formed exclusively by the λt central variables presents arch. but the whole process does present arch because it has been built in such a way that the variables with different variances are grouped apart. this process is similar to a discrete mixture of (two) normal distributions. these models were proposed by christie (1983) or kon (1984) to analyse the unconditional distribution of stock returns. however, there is a fundamental difference. while in, for example, kon (1984) the returns are drawn randomly from either of the two normal distributions, in (1) the variables drawn from the two distributions are grouped in a deterministic way. the variables with a higher variance are consecutive in the middle of the process, and not scattered randomly. on the other hand, it is evident that this process fulfills the famous observation made by mandelbrot (1963) and frequently invoked in arch literature: “large changes tend to be followed by large changes–of either sign–and small changes tend to be followed by small changes.” it would be interesting to test for arch in process (1). the existence of arch effects in a series is usually tested by using the lagrange multiplier (lm) test of engle (1982). consequently, to test for arch, the following regressions will be carried out: y y ut i p i t i t 2 1 2= + + = −∑α β where, α, β1, β2,…,βp are parameters, and ut is the error term. the statistics tr2, where t is the sample size and r2 is the coefficient of determination, will be computed for p = 1, 5 and 10. these statistics will be denoted by lm(1), lm(5) and lm(10), respectively. under the null hypothesis of absence of arch effects, β1 = β2 = ..... = βp = 0, these statistics follow asymptotically a χ2 distribution with p degrees of freedom. in order to analyze the possible presence and intensity of arch effects in these processes, 10,000 realizations were simulated for different sets of values of t (50, 250, 500, 1,250 and 2500), λ (4%, 8% and 12%), and with γ equal to 2. lm tests were run for these simulated processes. table 1 presents the relative frequency of rejections of the null of absence of arch at the 5% significance level. several conclusions arise from table 1. firstly, for each value of t, the probability of concluding the existence of arch increases with the proportion λ. secondly, for each value of λ, the empirical probabilities of rejection increase clearly with the sample size. for t = 50 and λ = 0.04 these probabilities are rather low, but they increase monotonically with the sample size. the same occurs for λ = 0.08 or for λ = 0.12. as a consequence of this increase, they approach to unity for large sample sizes. in fact, they are virtually equal to unity in many cases for t = 1250 or t = 2500. this implies that with at least 4% of central variables whose standard deviation table 1: rejections in lm tests with simulated processes t λ λt γ lm (1) lm (5) lm (10) 50 0.04 2 2 5.3 2.4 0.9 250 0.04 10 2 25.7 38.9 35.4 500 0.04 20 2 41.2 65.0 70.1 1250 0.04 50 2 71.0 94.4 97.3 2500 0.04 100 2 91.3 99.8 99.9 50 0.08 4 2 9.6 5.3 1.1 250 0.08 20 2 40.0 64.0 67.2 500 0.08 40 2 61.6 89.3 93.3 1250 0.08 100 2 90.3 99.8 100.0 2500 0.08 200 2 99.4 100.0 100.0 50 0.12 6 2 13.9 8.4 1.4 250 0.12 30 2 48.2 76.6 81.3 500 0.12 60 2 71.2 95.6 97.9 1250 0.12 150 2 96.4 100.0 100.0 2500 0.12 300 2 99.9 100.0 100.0 percentages of rejections at the 5% significance level in lm tests for arch in 10,000 simulations of processes (1) for different values of t and λ. lm: lagrange multiplier, arch: autoregressive conditional heteroscedasticity peiró: changes in the unconditional variance and arch international journal of economics and financial issues | vol 6 • issue 4 • 20161340 is the double of that of the other variables, one may expect to find arch with a very high probability for these sample sizes. in terms of financial returns, this would mean that in 5 years of daily returns (t = 1250, approximately) with two central months whose daily returns (λt = 50, approximately) had a standard deviation that was the double of that of the others, arch would follow in 94.4% of cases, according to the lm(5) test. the previous proportions of central variables with a higher variability (4%, 8% or 12%) are arbitrary. they have been chosen so that λt is equal to, at least, a few variables with higher standard deviation. it would be interesting to study the effects of lower proportions. therefore, proportions as low as 4‰, 8‰, or 2% will be considered, but the sample sizes must now be high enough so that λt must yield at least a few central variables with a higher standard deviation. table 2 presents the results obtained with these new values for t and λ. once again, the rates of rejections increase when λ increases, but, for these large sample sizes, they all are well above the significance level of 5%, even for a proportion as low as λ = 0.004. thus, for example, for t = 5000 and λ = 0.004, the probability of finding arch is 43.7% with the lm(10) test. in other words, this means a probability of 43.7% of finding arch with 20 years of daily returns (t = 5000, approximately) with a given variability, with the exception of those in the central month (λt = 20, approximately) whose variability is twice of the others. finally, it is also interesting to analyze the effects of γ on the rates of rejection. γ = 2 is probably a moderate ratio between the standard deviation of central variables and the standard deviation of the non-central variables. higher values such as γ = 3 or γ = 4 suppose a higher ratio which could be more plausible to give account of different episodes of higher variability in many processes, and in particular in many financial markets. table 3 shows the results of lm tests for these values. the empirical rejection rates increase strongly when γ increases. for t = 2500 and λ = 0.004, the probabilities of finding arch with the lm(5) test, for example, go from 24.0% for γ = 2, to 76.7% for γ = 3, and to 95.3% for γ = 4. from the perspective of financial markets, this last value would imply that the probability of concluding arch with 10 years of daily returns that include only 2 weeks of “abnormal” daily returns is 95.3%. taking into account the values of the preceding simulations, the conclusions are clear and sharp. they show that: (i) evidence of arch is not found or is hardly found for determinate combinations of t, λ, γ; (ii) the probability of finding arch increases monotonically with t, λ, γ; (iii) processes with high values for t and/or γ present arch effects with a very high probability, even for very low values of λ. by construction, process (1) presents arch; therefore, it should not be surprising rejections of the null of no arch. what is very surprising is the high proportion of rejections with so few variables with a higher variance. only a few variables drive the results obtained with very large samples. though arch does exist in all these cases, it is not a general or regular property of the process. rather, arch is due to the existence of two different regimes involved in process (1) which are reflected in each of the two equations that compose this process. instead of thinking this process as a regular process with systematic arch all over time, it would be wiser to consider this process as formed by two different regimes. each of them does not present arch, but the co-existence of both regimes does imply the manifestation of arch effects1. one could question if these results are due to the fact that the group of variables with higher variance is located exactly in the middle of the series. simulations (not shown but available upon request) with this group of variables located in different intervals of the sample showed very similar results. analogously, one could question if the results are due to the fact that the variables with higher variance are consecutive in one single group. once again, new simulations showed that similar results would also apply (with the appropriate modifications) to other hypothetical processes where the variables with higher variability were scattered in a few groups. for example, the results for t = 5000 and λ = 0.004 are very similar when arranging the λt variables with higher variance in one single group of 20 variables, than when arranging them in two separate groups of 10 variables each, or when they are arranged in four separate groups of 5 variables each. of course, in the limit, when these variables are scattered randomly, arch evidence disappears. therefore, the preceding simulations show that a long series with a short episode of higher variability will present arch effects with a high probability. evidently, these results do not imply that 1 in addition, it is interesting to note that these simulated series systematically present excess kurtosis or high autocorrelations of absolute values, among other stylized facts of asset returns (see, for example, cont, 2001). table 2: rejections in lm tests with simulated processes t λ λt γ lm (1) lm (5) lm (10) 1000 0.004 4 2 10.5 10.5 9.4 2500 0.004 10 2 16.5 24.0 22.9 5000 0.004 20 2 24.0 39.8 43.7 10,000 0.004 40 2 35.8 62.1 70.2 1000 0.008 8 2 18.1 25.6 22.8 2500 0.008 20 2 31.1 50.6 54.8 5000 0.008 40 2 47.6 75.4 81.7 10,000 0.008 80 2 70.2 94.7 97.3 1000 0.02 20 2 38.8 61.8 66.7 2500 0.02 50 2 65.9 91.4 98.2 5000 0.02 100 2 88.3 99.5 99.9 10,000 0.02 200 2 98.8 100.0 100.0 percentages of rejections at the 5% significance level in lm tests for arch in 10,000 simulations of processes (1) for different values of t and λ. lm: lagrange multiplier, arch: autoregressive conditional heteroscedasticity table 3: rejections in lm tests with simulated processes t λ λt γ lm (1) lm (5) lm (10) 1000 0.004 4 3 30.7 35.9 31.8 2500 0.004 10 3 58.0 76.7 77.6 5000 0.004 20 3 81.9 96.0 96.9 10,000 0.004 40 3 96.7 99.9 100.0 1000 0.004 4 4 49.5 58.3 54.3 2500 0.004 10 4 82.0 95.3 95.8 5000 0.004 20 4 99.9 100.0 100.0 10,000 0.004 40 4 99.9 100.0 100.0 percentages of rejections at the 5% significance level in lm tests for arch in 10,000 simulations of processes (1) for different values of t and γ. lm: lagrange multiplier, arch: autoregressive conditional heteroscedasticity peiró: changes in the unconditional variance and arch international journal of economics and financial issues | vol 6 • issue 4 • 2016 1341 this is the only fact that explains the existence of arch effects in so many series or that it is the main factor; it could be just a contributing factor of limited importance or a determining factor only in some cases. the relevant question, therefore, is whether these limited episodes of higher variability play an important role in the arch evidence reported in so many actual economic or financial series. a clear-cut answer to this question is difficult, but two pieces of evidence suggest that very frequently the answer may be affirmative. first, if it is the case, longer series will present arch evidence much more often than shorter ones, as episodes of higher variability are much more probable in long series than in short series. second, if it is the case, arch detection relies on a few observations and small changes in these observations would significantly alter the results in arch tests. in the next section some evidence on these two points will be reported. 3. evidence on sp’s 500 returns arch evidence has been reported in many different series. in what follows the sp’s 500 composite index will be considered from 1950 to 2009. though this is the only series studied in this article, it is a financial series of the maximum importance with a large coverage of us equities and a rather long time span. besides, this series has very often been used in arch modeling. daily closing values were available from january 3, 1950 to december 31, 2009. after excluding those days when stock markets were closed, daily returns were obtained by logarithmic differences; that is by rt = log(it/it−1), where rt is the return for day t, it is the daily index for the same day and it−1 is the daily index for the preceding day. thus, the series of daily returns is composed by 15,096 observations. weekly returns have been computed by subtracting to the logarithm of the value of the index in the last trading day (usually friday) of a certain week the logarithm of the value of the index in the last trading day (usually friday) of the preceding week. in this way, a series of 3130 weekly returns has been obtained. monthly returns have been obtained by subtracting to the logarithm of the value of the index in the last trading day of the month the logarithm of the value of the index in the last trading day of the preceding month. the series of monthly returns is composed by 720 observations. as in the preceding section, the existence of arch effects in a series will be tested by using the statistics lm(1), lm(5) and lm(10). with these statistics and with daily returns arch is tested in the 240 different quarters comprised between the first quarter of 1950 and the fourth quarter of 2009. a typical quarter includes between 61 and 63 daily returns. table 4 shows the proportion of rejections at the 5% significance level. in 23 out of the 240 quarters the null of no arch was rejected at the 5% level when using the statistic lm(1), in 21 with lm(5), and in 14 with lm(10). it is surprising that, though arch is considered to be very usual among financial series, only a few quarters (<10%) present evidence of these effects. moreover, as the probability of a type i error is 5%, the rejections do not exceed by a large amount what is to be expected in absence of arch effects. the proportion of rejections increases significantly when the same tests are applied with daily returns to each of the 60 years comprised between 1950 and 2009. a typical year includes between 251 and 252 daily returns. now, in the 60 years, the null hypothesis of absence of arch is rejected in 21 of them with the lm(1) statistic, in 29 with the lm(5) statistic and in 26 with the lm(10) statistic; that is, the rates of rejections are comprised between one third and one half, which mean that arch effects are frequent though not pervasive. with longer sample periods, such as periods of 5 years or decades, the evidence in favor of arch in daily returns becomes overwhelming. a period of 5 years includes about 1260 daily returns, and a decade about 2520 daily returns. in all but one 5-year period the null hypothesis of nonexistence of arch is rejected with the different lm statistics, and in all decades this hypothesis is always rejected. let us now consider weekly returns instead of daily returns. as the number of weeks comprised in a quarter is relatively low (about 13), it does not seem reasonable to analyze the existence of arch effects in a quarter by using weekly returns. instead, the shortest time span will now be a year, which typically comprises between 51 and 52 weekly returns. with the same lm tests, table 4 shows the proportion of rejections with weekly returns at the 5% significance level in the 60 years comprised between 1950 and 2009. these proportions are very low again. indeed, when the lm(10) statistic is used, the proportion of rejections is exactly equal to the size of the test (5%). with 5-year periods or decades the results are rather different; between 67% and 83% of the 5-year periods and almost all decades present evidence of arch with the different lm tests. finally, let us consider monthly returns. analogously to the limitation exposed above, it does not seem reasonable to conduct arch tests in a given year with only 12 observations. accordingly, table 4 only shows the results for 5-year periods and decades. arch is found in between one sixth and one fourth of the 12 5-year periods, and in one third of the six decades. all this evidence suggests that arch may not be a ubiquitous feature of stock index returns when considering moderate sample sizes such as quarters or years of daily returns, years of weekly returns, or 5-year periods or decades of monthly returns. on the contrary, with larger sample sizes the detection of arch effects is an almost universal rule. these facts reflect that arch detection occurs much more frequently with longer series, where episodes table 4: rejections in lm tests with sp returns period t lm (1) (%) lm (5) (%) lm (10) (%) daily returns quarters 61-63 23/240 (9.6) 21/240 (8.8) 14/240 (5.8) years 251-252 21/60 (35) 29/60 (48) 26/60 (43) 5-year periods 1256-1265 11/12 (92) 12/12 (100) 12/12 (100) decades 2510-2529 6/6 (100) 6/6 (100) 6/6 (100) weekly returns years 51-52 7/60 (12) 4/60 (6.7) 3/60 (5.0) 5-year periods 260-261 8/12 (67) 10/12 (83) 9/12 (75) decades 520-522 5/6 (83) 6/6 (100) 6/6 (100) monthly returns 5-year periods 60 2/12 (17) 3/12 (25) 2/12 (17) decades 120 2/6 (33) 2/6 (33) 2/6 (33) proportions of rejections in lm tests for arch in sp daily, weekly and monthly returns at the 5% significance level. the samples are: 240 quarters (1950q1, 1950q2,…, 2009q4), 60 years (1950, 1951,…, 2009), 12 5-year periods (1950-1954, 1955-1959, …, 2005-2009) and 6 decades (1950-1959, 1960-1969,…, 2000-2009). t denotes the typical sample size. lm: lagrange multiplier, sp: standard & poor peiró: changes in the unconditional variance and arch international journal of economics and financial issues | vol 6 • issue 4 • 20161342 of higher variability are much more probable. for example, in process (1), if t = 1000 and λ = 0.02, the probability that a sample of size n will contain all the observations coming from the variables with higher variance will be 4.4% for n = 60, 30.8% for n = 250, and 96.0% for n = 500 in temporal terms, this means that in 4 years of daily returns (t ≈ 1000) with the daily returns in the central month (λt ≈ 20) having a higher variability, the probability that a quarter (n ≈ 60) will contain this central month is about 4.4%, for 1 year (n ≈ 250) the probability is 30.8%, and for 2 years (n ≈ 500) it is 96.0%. nevertheless, these longer series that cover a large span of time include more returns of the same frequency than shorter series, and the power of the lm tests will increase with the sample size. therefore these two factors are inextricably linked; longer series will contain more observations (and, consequently, statistical tests will be more powerful) and will have a higher probability of changes in variability (and, according to the simulations of the preceding section, arch will follow). to disentangle both elements would require a specific study, but, in any case, the preceding evidence shows that short or moderate samples with reasonable sizes, such as those formed by one quarter or by 1 year of daily returns, do not present arch evidence systematically, while longer samples do. if arch in a process is due to a few variables with higher variability, small changes in these variables would alter significantly the results of arch tests. on the contrary, if arch is a general property of the process, not due to a few variables, small changes in these variables would not have an important effect on arch results. to cast some light on this point, arch tests were repeated in those samples which present arch evidence, according to the results shown in table 4, but replacing the most extreme squared return by the mean in the sample. thus, for example, in those quarters with arch evidence for daily returns, the most extreme squared return was replaced by the mean of the squared returns in the same quarter, and the lm tests were run again. table 5 shows that arch effects were found in only 5 out of the 23 quarters with previous evidence of arch, in 2 of the 21 quarters and in 2 of the 14 quarters, according to the different lm statistics. that is, arch evidence disappeared in 18 out of the 23 quarters whose lm(1) statistics were significant. it also disappeared in almost all (19) quarters whose lm(5) statistics were significant, and in 12 out of the 14 quarters with a significant lm(10) statistic. though these extreme returns are probably among the most influential in each quarter, it is surprising to see how heavily the autocorrelation structure of squared returns depends on one single value in a sample typically formed by 60-65 observations. analogously, when taking into account years of daily returns, the most extreme squared return in each year with arch effects has been replaced by the mean of the squared returns in the same year. the number of rejections also decreases strongly, but not as drastically as with quarterly samples. arch evidence disappears in 10 out of the 21 years that presented previous evidence according to the lm(1) statistic, in 9 out of the 29 years with the lm(5) tests, and in 8 out of the 26 years with the lm(10) statistic. these results indicate the sensitivity of these tests, as they are affected by only one observation (maybe the most influential) out of some 250 observations in each year. however, the same casual study of robustness with longer periods of daily returns show that, in all the 5-year periods and decades with arch evidence, the results did not change when replacing the most extreme squared return by the mean squared return, but this is hardly surprising as only one out of about 1250 or 2500 observations had been changed. the same informal tests of robustness with years of weekly returns suggest that arch is not a robust feature as the evidence disappeared in more than half of the years (4 out of 7 and 3 out of 4, according to the lm(1), lm(5) statistics, respectively) and in all the years (3 out of 3), according to the lm(10) statistic. nevertheless, it must be admitted that, in spite of these drastic changes in years of weekly returns, the arch evidence disappears much less with longer periods of weekly returns such as 5-year periods or decades. finally, the arch evidence with monthly returns seems to be also very sensitive, as it disappears in more than the half of the 5-year periods, and in half of the decades. when the results in tables 4 and 5 are taken together, one comes to the conclusion that arch is a common phenomenon of long periods with large samples, such as 5-year periods or decades of daily or weekly returns. with shorter periods or with smaller samples, arch is not a prevalent and robust feature. it is neither prevalent nor robust with quarters or years of daily or weekly returns, or with 5-year periods or decades of monthly returns. in fact, robust arch evidence is almost absent in quarters of daily returns, in years of weekly returns and in 5-year periods of monthly returns. all these results point to the possibility that short episodes of higher variance could be behind many series that present arch evidence. finally, it is important to stress that process (1) does not pretend to be a “model” for any economic or financial series. it simply intends to illustrate the effects of a break in the unconditional variance of a very simple process on the existence of arch effects. it is table 5: rejections in lm tests with sp returns in periods with previous arch evidence after replacing the most extreme return period t lm (1) (%) lm (5) (%) lm (10) (%) daily returns quarters 61-63 5/23 (23) 2/21 (9.5) 2/14 (14) years 251-252 11/21 (52) 20/29 (69) 18/26 (69) 5-year periods 1256-1265 11/11 (100) 12/12 (100) 12/12 (100) decades (6) 2510-2529 6/6 (100) 6/6 (100) 6/6 (100) weekly returns years 51-52 3/7 (43) 1/4 (25) 0/3 (0) 5-year periods 260-261 8/8 (100) 8/10 (80) 8/9 (89) decades 520-522 5/5 (100) 5/6 (83) 6/6 (100) monthly returns 5-year periods 60 1/2 (50) 1/3 (33) 1/2 (50) decades 120 1/2 (50) 1/2 (50) 1/2 (50) proportions of rejections in lm tests for arch in sp daily, weekly and monthly returns at the 5% significance level after replacing the most extreme squared return by the mean in the same period. the samples are those quarters, years, 5-year periods and decades which presented arch effects according to the results in table 4. t denotes the typical sample size. arch: autoregressive conditional heteroscedasticity, lm: lagrange multiplier, sp: standard & poor peiró: changes in the unconditional variance and arch international journal of economics and financial issues | vol 6 • issue 4 • 2016 1343 also important to stress that only one financial series has been examined. much more work is needed and further research should consider different types of jumps in different processes as well as examine other series in the light of the evidence reported here. 4. conclusions the study of the effects of jumps or breaks in unconditional volatility on arch models has usually been limited to the effects on persistence of garch models, however, the literature is very sparse or non-existent on a much more important topic such as their effects on the effective existence of arch in time series as an overall, regular and systematic property of these series. in order to cast some light on this point, two arguments are presented in this paper. first, a simple white noise with a jump in its unconditional variance is taken into account and different simulations with this process show that arch follows very frequently in conventional tests even with short episodes of higher variance. second, sp’s 500 returns for different sample periods and different frequencies are examined. the results obtained show that arch is not a usual feature of short or moderate periods or samples and, moreover, arch evidence does not seem to be very robust in many cases. all these arguments allow one to question whether arch effects are a general property of economic and financial series and, conversely, to wonder whether short jumps in the unconditional variability may play an important role in these effects. of course, this does not question the effective existence of arch as a regular feature of many economic and financial series, but it draws attention to the fact that in some cases the results obtained may be contaminated by brief unconditional variance jumps. references christie, a. (1983), on information arrival and hypothesis testing in event studies. working paper, university of rochester. cont, r. (2001), empirical properties of asset returns: stylized facts and statistical issues. quantitative finance, 1, 223-236. diebold, f.x. (1986), modeling the persistence of conditional variances: a comment. econometric reviews, 5, 51-56. engle, r. (1982), autoregressive conditional heteroscedasticity with estimates of the variance of united kingdom inflation. econometrica, 50, 987-1007. engle, r. (2002), new frontiers for arch models. journal of applied econometrics, 17, 425-446. franses, p.h., van dijk, d., lucas, a. (2004), short patches of outliers, arch and volatility modelling. applied financial economics, 14, 221-231. franses, p.h. (1995), igarch and variance change in the us long-run interest rate. applied economics letters, 2, 113-114. gregory, a.w., reeves, j.j. (2010), estimation and inference in arch models in the presence of outliers. journal of financial econometrics, 8, 547-569. hillebrand, e. (2005), neglecting parameter changes in garch models. journal of econometrics, 129, 121-138. kon, s.j. (1984), models of stock returns – a comparison. journal of finance, 39, 147-165. mandelbrot, b. (1963), the variation of certain speculative prices. journal `of business, 36, 394-419. rapach, d.e., strauss, j.k. (2008), structural breaks and garch models of exchange rate volatitlity. journal of applied econometrics, 23, 65-90. xu, k.l., phillips, p.c.b. (2008), adaptive estimation of autoregressive models with time-varying variances. journal of econometrics, 142, 265-280. . international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 103 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s2) 103-109. special issue for “state and municipal regulation, investment, commerce: national and international aspects of the business” the formation of the operating interaction mechanism of the public and corporate finances in the sphere of social service of the population: methodology, theory and practice konstantin aleksandrovich karsakovich* russian state social university, wilhelm pieck street, 4, build 1, moscow 129226, russian federation. *email: karsakovich_kos@mail.ru abstract in this article the existing mechanism of cooperation between state and corporate finance in the field of social services are analyzed. the methodology of the formation of this mechanism, the legal aspects and the project approach are included. the factors that hinder the development of this mechanism are detected. they are: shortcoming of existing federal legislation; low wages and high load per social worker; outdated material and technical base of social service institutions; undeveloped market of social services. also, the scheme to attract private investment in social services is formed based on public-private partnership: concession agreement; long-term lease; personnel outsourcing or out staffing. keywords: corporate and public finance, the mechanism of cooperation of finance, social services for the population jel classifications: h44, h42, m54 1. introduction in modern conditions, the development of the sphere of social service of the population in russia is defined by the access of separate categories of citizens to receiving the corresponding services for activity maintenance and it is generally defined by availability of the state financial funds. the system of social service provides the facilities to the country population within the constitutional guarantees, as a rule, free of charge, except private establishments. and, of course, the state, according to the constitution of the russian federation, is obliged to assume burden of creation of the absent institutions for the concrete period in case of need and to be constantly engaged in maintenance and development of the available economy potential of social welfare by the process of emergence of new needs for a certain type of public services. that is why effective operation of the interaction mechanism of the public and corporate finances in the sphere of social service of the population allows to liquidate various gaps in financial security of appropriate programs, to increase service quality on the mutually advantageous basis. as a result, the aim of the article is to carry out the analysis of the operating interaction mechanism of the public and corporate finances in the sphere of social service of the russian federation population, including methodology of its construction and to reveal shortcomings of its functioning on practical examples. 2. methods the complex of the general scientific principles, approaches and methods is applied for realization of the aim and research task. the main cognitive methods were: empirical methods of literature study; desk researches; an abstract and logical method (by theoretical generalizations and development of conclusions); a method of induction and deduction (by determining essence, the content and a role of social service of the population in development of the social sphere); economical statistical methods (by research of indicators of the sphere of social service development); grouping (by the determining and comparison of the problems revealed in the sphere of social service of the population). karsakovich: the formation of the operating interaction mechanism of the public and corporate finances in the sphere of social service of the population: methodology, theory and practice international journal of economics and financial issues | vol 6 • special issue (s2) • 2016104 the problems of interaction of corporate and public finances were considered by the majority of native authors, such as v. varnavsky, l. yefimova, d. zaytsev, a. boyko, v. vorotin, n. grinchuk and other works that were considered earlier by the author in the article defined the public-private partnership (ppp) as one of the effective instruments of interaction of the public and corporate finances. however, in general, the mechanism of interaction of the public and corporate finances wasn’t considered by authors and the question concerning embedding of such tool as ppp in this mechanism isn’t considered (karsakovich, 2015). the most powerful source of a covering of social orientation expenses are budget funds. the state stimulates, localizes or limits these or those social programs by establishing forms and methods of planning and use of state and local budgets. social expenses are included into structure of both the state and local budgets, but their types, total amount and specific weight as a part of the relevant budget considerably differ. functioning specific and a special role of local budgets are reflected in composition and structure of their expenses as despite the differentiation of social expenses in different levels budgets, the majority of the funds, which are aimed at groups of people or the specific person, are directed to local budgets channels (kovalev, 2010). so, federal budget execution for expenses on social service by the ministry of labour and social protection of the russian federation in dynamics of 2012-2014 are presented in figure 1 (execution of the federal budget expenditure by the ministry of labor and social protection of russian federation for the years 2012-2014). these expenses were aimed at providing of the work of all establishments of social service system. the funds that are received from providing chargeable social services including partial payment become the second important financing source. the third aspect, which is also considered in financing social service organizations, is charitable contributions and donations. 3. results considering the above-mentioned financing sources the author’s idea of the operating mechanism of financial security of social service system in the russian federation is represented in the scheme on the figure 2. further, we will consider each element of this mechanism closer and we will distinguish shortcomings in its work. as it can be seen from the offered scheme, the act of the russian federation no. 442-fl “about the bases of social service of citizens in the russian federation” (federal law from december 28, 2013 no. 442-fl “about the bases of social services for citizens in the russian federation”) became a basis of such mechanism. it is also important to consider legal aspects of operation of such mechanism. so, on the basis of the budgetary legislation of the russian federation (budget code of russian federation from july 31, 1998 no. 145-fl) and an order of purchase execution of social services for providing the state and municipal orders in the social service sphere the financing of social services which are realized by socially oriented non-profit organizations (npos), by non-state institutions, by individual entrepreneurs is carried out by granting of subsidies from the relevant budget. the citizen has the right to address to another supplier of social services who isn’t included in the individual program, but is in the register of suppliers in the subject of the russian federation, for example, on the basis of the ministry of social protection of the population data only in the moscow region in such register by the beginning of 2015 were included 204 suppliers of the social services which are under authority of the territorial subject of the russian federation (the register of social service providers of moscow region). at that, it should be noted that expenses on providing social services according to the cost of the individual program, which is calculated according to per capita standards of social service financing, are compensated to the supplier. methodical instructions by calculation of per capita standards of financing of social services are approved by the government of the russian federation (government resolution of the russian federation from december 1st, 2014 no. 1285 “about the calculation of capitation financing of social services” the guarantee system). the order of cost calculation of granting types of social services and forms of social service is carried out on the basis of the per capita standard of financing of social service, which is approved by authorized body (government) of the subject of the russian federation. as a result, author singles out following points as the main indicators for an assessment of efficiency of financial security social service system of the population at the state and municipal levels: 1. percent of citizens satisfaction with rendering of social services by social service institutions, from total number of the citizens who addressed for receiving the corresponding social services 2. level of an average salary of social workers in establishments of social service in comparison with an average salary of the region 3. a part of the rendered social services for aged citizens and disabled people by non-state establishments of social service, in the total number of the same category of the citizens who figure 1: the expenses of the federal budget on social service in dynamics of 2012-2014 karsakovich: the formation of the operating interaction mechanism of the public and corporate finances in the sphere of social service of the population: methodology, theory and practice international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 105 received services which are realized by establishments of social services of all ownership forms 4. the part of buildings and constructions (fixed assets) which demand reconstruction or are at a breaking point, shabby buildings in a total amount of buildings and constructions of establishments of social service for citizens of advanced age, disabled people, persons without definite place of adobe and occupations 5. a part of the non-state organizations, individual entrepreneurs who render social services, in total quantity of establishments of all ownership forms of social service. by every index the dynamics of their execution according to the ministry of labor and social protection is presented and the plan for 2015 is created in percentage. therefore, in figure 3 positive dynamics and rather high rates of relatively stable increase of the figure 2: the operating mechanism of financial security social service system of the population of the russian federation karsakovich: the formation of the operating interaction mechanism of the public and corporate finances in the sphere of social service of the population: methodology, theory and practice international journal of economics and financial issues | vol 6 • special issue (s2) • 2016106 percent of citizens satisfaction with rendering social services by social service institutions are kept (growth within of 0, 2-0, 8% annually). in addition, the level of an average salary of social workers grows significantly in establishments of social service in comparison with an average salary of regions of the russian federation, there is annual growth by 10% in comparison with previous years (the ministry of labor and social protection of the russian federation). in figure 4 falling of an indicator of existence of the buildings and constructions which demand repair for stationary establishments of social service by 0.5% annually, is obviously traced. on the other hand, the number of the non-state organizations rendering social services increases and respectively there is a proportional growth of number of the rendered services to aged citizens and disabled people. as a result, for improvement of quality of satisfaction of needs of elderly citizens and disabled people in social services by social service institutions, on the basis of the analysis of dynamics of financial security assessment indicators of this sphere an important aspect is adaptation of social service system of the population to the changing legal social and economic conditions, including the organization of effective interaction of the public and corporate finances. ensuring of this process requires carrying out arrangements for updating and harmonious development of legislative base at the federal and regional levels. in addition, we will note that in the law (federal law from december 28, 2013 no. 442-fl “on the basis of social services for citizens in russian federation”) implementation of interdepartmental interaction by providing social services on the basis of the regulations approved by public authorities of subjects of the russian federation is supposed. on the basis of article 7 of the act (federal law from december 28, 2013 no. 442-fl “on the basis of social services for citizens in russian federation”) ministry of labor of russia approves recommendations on realization of interdepartmental interaction of public authorities of the territorial subject of the russian federation concerning the providing social services. in turn, the territorial subject of the russian federation approves the corresponding regulations of interdepartmental interaction of public authorities of this territorial subject of the russian federation in connection with realization of powers of the subject of the russian federation in the social service field. the act (federal law from december 28, 2013 no. 442-fl “on the basis of social services for citizens in russian federation”) contains the norms providing control (supervision) in the sphere of social service, including public control. however, this mechanism doesn’t work effectively in connection with the revealed factors: 1. the existing federal law no. 442-fz (federal law from december 28, 2013 no. 442-fl “on the basis of social services for citizens in russian federation”) doesn’t allow to satisfy fully needs of the population in social service with high quality. at the beginning of 2013 only 17.5 thousand people were in waiting list for receiving services in stationary establishments of social service. almost the same number of 17.9 thousand people were standing in a queue for receiving social services at home that has made in the first case 6.5% and 0.12% in the second case from all number of the registered for receiving social services. this situation exists because in the existing acts (federal law from december 28, 2013 no. 442-fl “on the basis of social services for citizens in russian federation”; budget code of russian federation from july 31, 1998 no. 145-fl; the register of social service providers of moscow region; government resolution of the russian federation from december 1st, 2014 no. 1285 “about the calculation of capitation financing of social services” the guarantee system) there is no list of the corresponding bases for a specification of those citizens who need social service. as a result, the right of citizens for social service is determined with the help of the approved types of social service, and the content of these social services isn’t concretized. thus, there is an inequality of the citizens’ rights for obtaining the corresponding quality of social services in region as in different territorial subjects of the russian federation social service is realized on the basis of various internal acts. figure 3: indicators of an assessment of financial security of social service system of the population at the state and municipal levels figure 4: indicators of an assessment of financial security of social service system of the population at the state and municipal levels karsakovich: the formation of the operating interaction mechanism of the public and corporate finances in the sphere of social service of the population: methodology, theory and practice international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 107 2. low salary level and high commitments on one social worker in social service system forms deficiency of qualified personnel. so, by the end of 2014 the size of an average monthly salary of the social worker made 58% of the level of an average monthly salary in the russian federation. but, the loading on one social worker in the context of all regions doesn’t decreasing what indicators testify: 10.1 in tula region, 10.6 in the leningrad region, 11.1 in kaliningrad areas at 6.9 in the russian federation in general. 3. availability of the operating establishments of social service with out of date material base. in the end of 2014 8% from total number of social service establishments need reconstruction, these are more than 200 buildings, more than 120 buildings and constructions are in critical and shabby condition. 4. the market of social services doesn’t develop fully. the low share of the operating non-state enterprises (socially oriented npos, individual entrepreneurs, philanthropists and volunteers) testifies it. and it is only 2, 6% or more than 80 establishments of social service in non-state property. almost in all regions the number of the citizens receiving social services free of charge increased. but, only in 15 subjects of the russian federation additional categories of free services recipients are defined legislatively. active work on modernization of social service has begun in absolute majority of territorial subjects of the russian federation. it was shown in implementation of the new projects, ideas and initiatives directed at positive changes, at improvement of society life – both for certain people and for the whole state. so, due to desk research results it is revealed that at the heart of methodology of creation of interaction mechanism of the public and corporate finances in the sphere of social service of the population design approach works effectively. so, only in 42 territorial subjects of the russian federation by 2015 the state and municipal private partnership is successfully developed for introduction of innovative social practices in regions. as a result of introduction and distribution of social projects 10 thousands of the social sphere employees are involved and representatives of non-state sector are joining more actively. the analysis of the projects presented at a forum of social innovations in the region (forum of social innovations for regions) confirms that in 99% of projects financing from budgets of various levels was used. but only 1% was attracted by other sources of financing (charitable contributions, direct investments). we will consider these projects closer. 4. discussion the construction project of an annex (further the center) to the building of state budgetary institution so “samara regional gerontological center” became a practical example of interaction of corporate and public finances. in addition, the room of an annex is transferred to the investor for free use, which is 100% of rooms to a payback period of investment expenses by providing social services for 60 beds according to the contract for social stationary service (it allows to receive 75% of labor part of pension). after achievement of the period of payback such tool as the concessional agreement which allows 50% of rooms turns on and it is transferred to the date of profit reception after the termination of a payback period, thus 50% of rooms are transferred to state budgetary institution (the remained 50% of rooms are transferred to state budgetary institution after period of validity of the concession agreement). the similar project is developed in moscow for konkovo boarding house in which veterans of war and disabled people undergo rehabilitation. besides, this boarding house will have considerable economy of money due to involvement of experts out of the number of staff on terms of outstaffing. thus, in similar projects interaction of the public and corporate finances is carried out within the following scheme represented in figure 5. as a result, by means of design approach it is possible to build the effective mechanism of interaction of the public and corporate finances in the sphere of social service of the population, which will allow to solve the following problem directions from a position of the government: 1. construction of new places for removing a problem of the growing waiting list; 2. replacement of the existing shabby/emergency fund; 3. a solution of the problem of budgetary funds deficiency due to involvement of private investors’ financial resources; 4. transfer to business the maintenance burden of socially significant objects. thus, despite the lack of system legal regulation, the increasing development is gained by ppp in social service. ppp as practice shows, leads to optimization of costs maintenance of a system of social service state organizations, increase in volumes and improving in the conditions of the market competition the quality of the social services provided to the population. application of tax privileges, which at the federal level are absent due to the lack of the corresponding legislative norm, becomes the main stimulating mechanism of corporate finance involvement to the sphere of social services. however, in the concept of development of charity and volunteering in the russian federation (order of the government of russian federation from july 30, 2009 no. 1054-r “about the concept of promoting of volunteering charity work in russian federation”) approved by the order of the government of the russian federation in 2009 a point on introduction of tax privileges on charitable donations of legal entities is designated. there is such point in the existing concept of long-term development of the russian federation figure 5: scheme of involvement of private investments into the sphere of social service karsakovich: the formation of the operating interaction mechanism of the public and corporate finances in the sphere of social service of the population: methodology, theory and practice international journal of economics and financial issues | vol 6 • special issue (s2) • 2016108 till 2020 (order of the government of russian federation from november 17, 2008 no. 1662-r “about the concept of long-term socio-economic development of russian federation for the period till 2020”). the relevant bill is necessary for realization of tax privileges at the federal level. however, there are appropriate authorities of territorial subjects of the russian federation for the introduction of the effective tax privileges and they are defined within the tax code of the russian federation (tax code). but, except tax privileges there are other ways of their development in practice of the interaction organization of the public and corporate finances. so, public recognition becomes essential incentive for involving of corporate finance to the sphere of social service. studying the international experience of conducting corporate business in regions, the solution of social problems is set up by all means. in this case, it is possible to apply various organizational decisions within corporation. so, for example, within one company the special division of social problems is created. besides, the legislation of the russian federation allows to create corporate charity foundation as, for example honor and dynasty charity foundations (charitable foundation “honor”; charitable foundation “dynasty”) which will be able to realize more large-scale social projects. in some cases, the corporate sector can direct the target financial resources within realization of the principles of corporate social responsibility through funds of local community (partnership of community foundations) and achieve goals in the sphere of social services. the ministry of economic development of the russian federation in 2014 created the concept of development of the corporate social reporting, within its realization it is offered to stimulate joint-stock companies which has a share state ownership, to the publicity concerning realizing social programs to involve to cooperation all potential stakeholders (interested parties). in this cases, information resources and media support play huge role. so, within work of the russian union of industrialists and entrepreneurs more than 100 organizations place such reports in public (russian union of industrialists and entrepreneurs). the general contribution to charity from corporate charity foundations in the countries with the most developed traditions in this sphere according to the international organization sesr (committee of support of corporate philanthropy [sesriem]) makes to 1-2% of gross domestic product of the european country (germany, switzerland) these are about 2 billion dollars a year that is comparable to all expenditure of the budget of the russian federation on social service of citizens in the amount of 10,229 billion rubles. dynamics in this sphere in the russian federation remains positive, according to the ministry of economic development npo grew during the 2-year period from 2012 to 2014 by 16.5%, the average number of volunteers for 36%, there are more than 113 thousand socially oriented non-profit organizations in total in the country (ministry of economic development of russian federation). however recognition of such organizations or publicizing of activity of charity foundations remains at a low level. from a position of government bodies there is no information campaign for advancing of charity supporting, volunteering, activity of socially oriented non-profit organizations and charity foundations questions in society, work with them has to become the popular, standard and prestigious direction. and only after gradual promoting of this direction, it is possible to speak about efficiency of interaction of the public and corporate finances in the sphere of social services. 5. conclusion the analysis of the existing mechanism of financial provision of social services to the population russian federation suggests that a separate mechanism of interaction of state and corporate finance in this area is at the formation stage and it is presented by the author as a sequence of actions, functions of specific members and building the relationships between the state authorities and business: 1. the situation analysis in the sphere of social services is carried out by the ministry of labor and social protection of russian federation and executive authorities of russian federation. including the measures that are continuously carried out to ensure savings of financial resources, the formation of reserves funds for example for unforeseen expenses, that are made to eliminate emergencies and to restore the lost property by direct interaction with the russian ministry of emergency situations. 2. the provision of improving the legal framework in the field of social services by the ministry of labor and social protection of the russian federation, including the proposals in order to change the law in particular, that one that provides the gradual introduction into a system of social services of such instrument as ppp. in their turn, the public authorities of russian federation must build mechanisms of cooperation with non-governmental organizations, including socially oriented non-profit, philanthropists and volunteers for mutually solving problematic issues in the field of social services. 3. improving the organization and management of statistics of basic indicators that in complex characterize the system of social services. organized by the ministry of labor and social protection of the russian federation in appliance with the federal state statistics service and the executive bodies of the russian federation in the sphere of control of financial flows in the form of charitable help from the corporate sector into social services. 4. reduction of the waiting list for social services can be achieved by updating the material and technical base of the social services system. this area is built on the basis of co-financing from the budgets of various levels and attracting the corporate finance in the form of charity. 5. involvement of the corporate finance increases the responsibility of the ministry of labor and social protection of russian federation concerning the improvement of quality in the field of social services. this direction is realized by means of the organization of monitoring and evaluation of the quality of the providers of social services by specially created commissions, which include control and monitoring public authorities, involvement of experts in health, education and other non-profit organizations. also, the executive authorities of the russian federation may establish boards of trustees of institutions of social services, and may karsakovich: the formation of the operating interaction mechanism of the public and corporate finances in the sphere of social service of the population: methodology, theory and practice international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 109 develop methodological recommendations for determining the key performance indicators of social service providers and employees of social services, including their leaders. the financial reward of these employees also depends on the implementation of social services achieved from the key performance indicators (qualitative and quantitative). for its turn, it is recommended that the ministry of labour and social protection of russian federation must adopt a common system of performance indicators of social service providers. evidently from the above interrelationships the main advantages of financing the sphere of social services based on attracting the corporate finance are to reduce the waiting list for social services and improving their quality. this trend is confirmed by the results of the ministry of economic development of russian federation, which are also aimed at improving the availability and quality of social services by increasing the flexibility of their financing. that is the concept of the work of the ministry that determines that not only government agencies can get government funding for the provision of social services, but also ngos, which have proved their effectiveness and stability, as well as business organizations. the selection is made on a competitive basis or through the mechanism of targeted consumer subsidies vouchers (interview with the director of the department of innovative development of the ministry of economic development of russian federation artem shadrin “results of activity of ngos is significant not only in the social plan, but also in terms of budgetary efficiency”). in this case, the person receives the right to choose the organization, public or private. an example of such a voucher in medicine can be called a birth certificate in the framework of the national project “health” (national project “health”). to the ministry of labour and social policy, this will be an important instrument for the usage of such a mechanism in the provision of social services in the system of social services. according to the results of this study, in spite of all positive changes that are taking place in the social sphere, they are not systematic. social services and, moreover, the system of social services does not fully meet the modern requirements. still relevant is the problem of the availability and quality of social services. less than 2% of all social services share the services provided by ngos. incentives and mechanisms for involving into the social sphere by the private investor are not fully used. there are no clear mechanisms for the transfer of state property into temporary private ownership, also the performance standards for social services by private organizations are not defined, the risk of financial loss by the contract parties is still can be found. there is no federal legislation on the basis of ppps, municipal-private partnership in the social sphere. so there are the new goals and objectives for the author of the article that must be resolved in further investigations. references budget code of russian federation from july 31, 1998 no. 145-fl (edition from 07.13.2015). available from: http://www.consultant. ru/popular/budget/. charitable foundation “dynasty.” available from: http://www. dynastyfdn.com/. charitable foundation “honor.” available from: http://www.pochet.ru/ about.html. committee of support of corporate philanthropy (sesriem). available from: http://www.cecp.co/. execution of the federal budget expenditure by the ministry of labor and social protection of russian federation for the years 2012 -2014. available from: http://www.rosmintrud.ru/ministry/budget/1. federal law from december 28, 2013 no. 442-fl “on the basis of social services for citizens in russian federation.” available from: http:// www.consultant.ru/document/cons_doc_law_156558/. forum of social innovations for regions. available from: http://www. socio-forum.ru/2015/prezentacii-luchshih-socialnyh-proektov. interview with the director of the department of innovative development of the ministry of economic development of russian federation artem shadrin “results of activity of ngos is significant not only in the social plan, but also in terms of budgetary efficiency.” available from: http://www.ivsezaodnogo.rbc.ru/navigator/articles/54. karsakovich, k.a. (2015), public-private partnership as a tool for the implementation of programs of social service of the population in modern conditions of the russian economy. microeconomics, 3, 58-62. kovalev, v.v. (2010), corporate finance and accounting: concepts, algorithms, and performance. moscow: prospekt. ministry of economic development of russian federation. available from: http://www.economy.gov.ru/minec. national project “health.” available from: http://www.ria.ru/ society/20090512/170852739.html. order of the government of russian federation from november 17, 2008 no. 1662-r (edition from 08.08.2009) about the concept of long-term socio-economic development of russian federation for the period till 2020. available from: http://www.consultant.ru/ document/cons_doc_law_82134/. order of the government of russian federation from july 30, 2009 no. 1054-r “about the concept of promoting of volunteering charity work in russian federation.” available from: http://www.consultant. ru/document/cons_doc_law_90313/. partnership of community foundations. available from: http://www.pcf.org/. russian federation government resolution from december 1st, 2014 no. 1285 about the calculation of capitation financing of social services. the system guarantee. available from: http://www.base. garant.ru/70813480/#ixzz3ge0akl8g. russian union of industrialists and entrepreneurs. available from: http:// www.rspp.ru/simplepage/472. tax code (edition from 06.08.2015). available from: http://www. consultant.ru/popular/nalog1/. the ministry of labor and social protection of russian federation. (n.d.), official information resource. available from: http://www. rosmintrud.ru/. the register of social service providers of moscow region. available from: http://www.ouszn.umi.ru/allnews/reestr_postavwikov_social_ nyh_uslug_moskovskoj_oblasti/. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 32-39. international journal of economics and financial issues | vol 7 • issue 2 • 201732 housing loans: what about personality traits? elisa gambetti1*, fiorella giusberti2 1department of psychology, university of bologna, bologna, italy, 2department of psychology, university of bologna, bologna, italy. *email: e.gambetti@unibo.it abstract to investigate the role of personality traits (16pf model) on psychological attitudes about mortgage behaviour, 263 participants were asked their preferences and perceptions about housing loans. results showed that: extraversion positively predicted the preference for housing loans with adjustable rates, but also the tendency to change this preference; anxiety negatively predicted the preference for having housing loans, preferring fixed-rate mortgages, and the perception of high risks and low levels of predictability; tough-mindedness was positively associated with a preference for fixedrate mortgage (maintaining this preference over time), and with the perception over adjustable-rate mortgages of low risks and low predictability; independence negatively predicted the preference for adjustable-rate mortgages. these findings fit with a growing body of evidence suggesting that individual differences influence perceptions and preferences about mortgages. keywords: personality, mortgage, risk perception, preferences jel classifications: e44, g23 1. introduction the influence of individual differences on decision-making has been highlighted for many topics in psychological literature, such as gain and losses contexts, risk-taking and risk preferences, and evaluation of probabilities (butler and mathews, 1987; lauriola et al., 2014). however, in the behavioral finance literature, a few studies have modeled the mortgage market behaviors based upon dispositional factors which would make a divergence between individuals (wang et al., 2008; gambetti and giusberti, 2014). this research fills a void in the literature evaluating the impact of personality traits on consumer behaviour, with a special focus on housing loan preferences and risk and predictability perceptions. 1.1. mortgage loans mortgages are loans that are specifically tied to real estate property, that is owned by the borrower in exchange for money that is paid in instalments over time. mortgage loans typically are long-term contracts that require periodic payments in order to cover interest and capital sum. the complexity of mortgage products increased in the last 20 years helping the consumption and investment needs of borrowers. recent studies showed that many consumers often make choices which they regret after the decision and/or take on debt that they have little or no capacity to repay (essene and apgar, 2007). the financial marketplace offers many types of mortgage loans, which are differentiated by two principal factors: the amount of principal and interest payments over the life of the mortgage, and the duration of the mortgage loan. the combination of these characteristics allows a large variety of distinct mortgage products. actually the fixed-rate mortgage loan (i.e., the amount of interest and principal payments and the duration of the contract are constant over the term of the mortgage) is the dominant contract in the united states, and the popularity of the adjustable rate mortgage (i.e., the amount or the duration of the mortgage are periodically reset) is substantially smaller (u.s. census bureau, 2011). in contrast, in the united kingdom and europe, the adjustable rate mortgage loan is the dominant contract (chambers et al., 2009). 1.2. personality and borrowing behaviour decisions about mortgages underlie various individual variables: previous studies showed that age (until 65 years old), income, and consumption of housing services are positively associated with the amount of the housing loans (chambers et al., 2009). gambetti and giusberti: housing loans: what about personality traits? international journal of economics and financial issues | vol 7 • issue 2 • 2017 33 moreover, the decision makers’ preferences about risk-taking could also influence the decision to take out a mortgage and/or the choice of the specific kind of mortgage loan because of the several risks associated, such as the interest rate volatility, the risk of needing the invested funds for another purpose during the course of a long-term loan, and the uncertainty about the cash flows to the lender due to the prepayment option granted to the homeowner. the literature distinguished between stimulating risk taking, connected with more experiential and action-oriented personality features such as sensation-seeking and impulsivity (eysenck and eysenck 1978; wong and carducci, 1991), need for arousal (figner et al., 2009), low self-control trait (freeman and muraven, 2010), and trait anger (gambetti and giusberti, 2009), and instrumental risk taking, associated with more rational and goal oriented personality characteristics, such as need for cognition (zaleskiewicz, 2001), internal locus of control (wang et al., 2008) and perfectionism (brand and altstötter-gleich, 2008). in contrast, risk aversion is associated with negative attitudes and narrow attention that cause overestimation of risks and may lead to the loss of profitable financial opportunities (lo et al., 2005). it is the case of trait anxiety, worry, and social anxiety that predict risk-avoidance in behavioral risk-taking tasks (maner et al., 2007). in general, personality influences risk taking or risk aversion through risk perceptions or risk tolerance of people and these risk reflections form the financial behavior (mayfield et al., 2008; lubis et al., 2015). specifically, introversion, independence and emotional stability were found robust predictors of saving and borrowing behaviour. specifically, introverted people are more inclined to save, avoiding loans, than extraverted, because they are prone to spend short time with other people, incurring in less extra expenditures (nyhus and webley, 2001). moreover, they are pessimistic about life and events and they are prone to be guided by rationality and principles, and, consequently they take less financial risks than extraverts (sadi et al., 2011). autonomous people are usually sceptical and curious, they consider more information and make more calculative decisions than highly accommodating individuals (chitra and sreedevi, 2011) and, ultimately, they are prone to favour saving and to avoid debt in order to maintain their independence (nyhus and webley, 2001). finally, emotionally stable people are more able to save money and to avoid asking for loans than the emotionally unstable who are prone to give in to short term desires engaging in impulsive and excessive buying (hoch and loewenstein, 1991). recent studies showed that these financial behaviours rise because emotionally stable individuals feel anxious and scared of failure when making financial risky decisions and, for this reason, they are prone to avoid risky choices (young et al., 2012). these data seem opposing with previous research showing a positive relationship between trait anxiety and risk avoidance (maner et al., 2007). these contrasting data can be explained with the different models considered for measuring personality traits. in particular, neuroticism (versus emotive stability) in the big five model is a higher-order personality trait that refers to a broad overall of different traits, such as anxiety, fear, moodiness, worry, envy, frustration, jealousy, and loneliness (costa and mccrae, 1992). individuals who score high on neuroticism are likely to experience different kind of negative feelings as anxiety, anger, guilt and depressive mood. these dispositional emotions can have different effects on decision-making: for example, in financial domain, anxiety is positively related with risk-avoidance, whereas anger negatively (gambetti and giusberti, 2014). for this reason the big five model may not be the most useful for model to assess whether and how specific personality traits influence financial decisions. in conclusion, there has been low attention paid to the role that personality factors may play in preferences and perceptions about a specific kind of loan, that is housing loan. this is somewhat surprising because, for example, some personality characteristics, such as emotional stability and self-control (versus impulsivity and anxiety) were found to be very important to make informed choices in order to shop for mortgage (hurd and swallen, 1997). 1.3. the present study the current study explores the relationship between personality and home mortgage perceptions and preferences. personality was evaluated by the 16pf factor model (cattell et al., 1993), that is a well-validated and useful taxonomy (hofer and eber, 2002) and it incorporates five personality traits: extraversion, anxiety, tough-mindedness, independence and self-control. indeed, these personality traits might have some influence on the preference to buy housing loans: extraversion for spending attitudes, low anxiety for high level of self-confidence in their ability for financial control in uncertain future, tough-mindedness for ability to making decisions in objective and practical manner, independence and selfcontrol for capability to plan their life controlling their impulses. moreover, personality of home buyers may also be important to predict the preference for a particular type of loan. specifically, anxious individuals and people with high tough-mindedness could prefer a fixed-rate mortgage loan, because the former do not tolerate uncertainty (ellsworth et al., 2003) and the latter are resistant to change (cattell et al., 1993). moreover, people with high scores on self-control also might prefer fixed-rate hosing loan because they are concerned about following accepted rules, evince self-discipline and, consequently, prefer practical and safe choices (cattell and schuerger, 2003). on the other hand, extraverted and independent individuals, who are prone to take risks (sadi et al., 2001) and to make favourable and convenient choices (chitra and sreedevi, 2011) respectively, might prefer adjustable-rate mortgages that represent the more advantageous but also the more risky kind of housing loans. the personality traits may also affect the tendency to change (or not) preference for a specific kind of housing loan (fixed or adjustable rate mortgage). this is an important aspect to consider because it provides information on the stability (or not) of the mortgage preference. previous studies showed that extraverted (extraversion) and open to change people (with low tough-mindedness and high independence traits) are prone to changing preference in different fields (nicholson et al., 2005). moreover, people with higher scores on neuroticism (anxiety) and conscientiousness (self-control) were consistent in safe decisions in financial domain (soane and chmiel, 2005). thus, we hypothesized that extraversion and independence predict changing preference about housing mortgages, whereas anxiety, tough-mindedness and self-control predict a stability in mortgage preferences. gambetti and giusberti: housing loans: what about personality traits? international journal of economics and financial issues | vol 7 • issue 2 • 201734 in addition, we sought to evaluate the individual perceptions about housing loans such as risk perception and predictability. the first refers to the likelihood of risk paying high interests. the second factor measures the sense of control regarding the possibility to forecast the variation in time of the total cost. previous studies already showed that trait anxiety was associated with high perception of risks about mortgages and low perception of housing loan predictability (gambetti and giusberti, 2014). however others personality traits, such as extraversion, tough-mindedness, independence and self-control, have not been associated with these specific housing loan perceptions in previous investigations, but it is possible that there is an association given that. extraversion and low self-control predicted low weight attribution to possible negative consequences and low risk perception in different fields (mayfield et al., 2008; jia et al., 2015). moreover, openness to experience (low tough-mindedness and high independence) positively correlated with high levels of risk acceptance in the financial field (fenton-o’creevy et al., 2004). on the basis of this body of research, we expected that extraversion and independence would activate low risk perception and high predictability of housing loans, whereas anxiety, toughmindedness and self-control would activate a perception of high risks and low predictability of housing loans. 2. method 2.1. sample 463 individuals (47.4% men) were recruited for the study at work (i.e., offices, shops, stores, university and banks). the average age of the sample was 48.3 years (standard deviation = 8.5), ranging from 29 to 65 years. all participants provided informed consent prior to the study and their participation was voluntary. demographic variables concerned education (10.6% primary school, 49% secondary/high school, 40.4% bachelor ’s or graduate degree), and household income (18.3% <10,000 euros, 30.8% 10,000-20,000 euros, 38.4% 20,000-40,000 euros, 12.5% >40,000 euros). participants were also asked to provide information about their experience in economics: 44.9% of the sample was inexperienced, 55.1% studied financial topics or worked in the field of economics. 2.2. personality traits personality traits were measured using the 16pf-5 (cattell et al., 1993), that is a self-report questionnaire in which the sixteen primary traits converged to make up the five bipolar global factors. specifically, extraversion (versus introversion) represents tendencies for moving toward social interaction: a consistently high pattern indicates a person who is warm (a), animated (f), boldly outgoing (h), self-disclosing (n) and group oriented (q2). high levels of anxiety (versus low anxiety) were typical of people who are often reactive (c), suspicious of others (l), worried (o), and tense (q4). tough-mindedness (versus receptivity) describes different aspects of reserve: high pattern typifies a person who is somewhat disinterested in people (a), has a factual and unsentimental approach of life (i), is practical and concrete in focus (m) and is set in his/her ways (q1). independence (versus accommodation) refers to assertiveness and ability to influence others (e), determination (h), open to change (q1) and suspicious (l). finally, the selfcontrol (versus lack of restraint) is defined by self-discipline and inhibition of impulses and desires (q3), rigidity of thought (g), practicality (m) and lack of spontaneity (f). cronbach’s alpha coefficients were 0.86 for extraversion, 0.79 for anxiety, 0.81 for tough-mindedness, 0.83 for independence and 0.80 for self-control in the present sample. 2.3. housing loan questionnaire the questionnaire was adapted by gambetti and giusberti (2014) and investigated the participants’ housing loan preferences and perceptions. it is composed by 5 questions: 2 questions (a and b) concerned housing loan preferences, 1 question is about changing of preferences (c) and other 2 questions (d and e) concerned the risk perception and the participants’ predictability toward housing loans respectively. specifically, question a “have you ever raised a housing loan for buying an home?” had a dichotomous answer (0 = no, 1 = yes), and question b “what kind of housing loan did you chose?” or if participants never have a mortgage “what kind of mortgage do you prefer?” targeted two kinds of housing loan: fixed-rate mortgage and adjustable-rate mortgage. these two kind of housing loans were also presented for question c (only for participants which have or had a mortgage) “if you have to decide now, what kind of mortgage do you chose?.” participants were asked, for each kind of housing loan, to rate again on 10-point scales their risk perception and their belief about predictability even if they had never taken a housing loan (question d “how much do you perceive the housing loan to be risky?;” question e “how much do you believe the total cost of the housing loan to be predictable?).” 2.4. procedure participants completed the 16pf-5 questionnaire in a counterbalanced manner, that is, either before or after completing the housing loan questionnaire. they were encouraged to answer as honestly as possible, told that there were no right or wrong answers, and assured that their answers would remain confidential. 3. results 3.1. data analysis and descriptives in order to measure the changing of preferences about mortgages, we compared the responses on question c of the housing loan questionnaire with the responses on question b, attributing the score 0 if participants did not change response and the score 1 if they did. a hierarchical multiple linear regression analysis was performed on each score of the housing loan questionnaire, considering as independent variables in step one, demographic variables (i.e., age, gender, education, and household income) and experience in economics, and in step two personality traits (i.e., extraversion, anxiety, tough-mindedness, independence and self-control). multicollinearity diagnostics suggested adequate independence of all predictors (all tolerance levels <0.80; tabachnick and gambetti and giusberti: housing loans: what about personality traits? international journal of economics and financial issues | vol 7 • issue 2 • 2017 35 fidell, 2007). moreover, on questions a and b of the housing loan questionnaire, five different regression analyses were performed considering as independent variables the primary scales of each 16pf-5 global factor and controlling for demographics. descriptives and inter-correlations are reported in table 1. 3.2. housing loan preferences 45% of the sample had a housing loan, 55% had never take out a housing loan. the results of the regression analysis showed that the preference for housing loans was predicted by age in step one, and both extraversion (positively) and anxiety (negatively) in step two. table 2 summarizes the regression coefficients from this analysis. the five regression analyses of the primary scales of each global factors on question a scores, controlling for demographics, showed that social boldness (a primary factor of extraversion and independence) positively predicted preference for mortgage, whereas vigilance (a primary factor of anxiety) negatively predicted this preference. moreover, the regression analyses also showed that warm, practical (primary factors of toughmindedness), spontaneous and expedient (primary factors of self-control) people preferred to buy mortgages. a preference for a fixed-rate mortgage was expressed by 48.9% of the sample; the adjustable-rate mortgage was chosen by 46.6%; 4.6% did not answer question b. the results of the regression analyses are shown in table 2 for the 16pf global factors and in table 3 for the primary factors and reveal that fixed-rate mortgage was positively associated with gender (1 = m, 2 = f), experience, anxiety (apprehension) and tough-mindedness (reserved, practical and traditional people) whereas negatively with extraversion (liveliness). adjustable-rate mortgage was negatively associated with gender, anxiety (self-assured people), tough-mindedness (warm, unsentimental, practical and open to change people) and independence (shy and vigilant people) and positively with income and extraversion (warmth). moreover, the regression analyses of primary factors also showed that rule-consciousness (primary factor of self-control) negatively predicted the preference for adjustable-rate mortgage. 3.3. changing of preferences 22.9% of the sample changed preferences about mortgage, and 22.9% maintained the same choice; 54.2% did not answer question c. the results of the regression analysis showed that changing choice about housing loan was predicted by gender in step one, and by both extraversion (positively) and tough-mindedness (negatively) table 2: logistic regressions of a and b questions on 16pf-5 global factors for each global factor predictor variables question a (housing loan) question b (fixed‑rate) question b (adjustable-rate) b (s.e.) wald r2 b (s.e.) wald r2 b (s.e.) wald r2 step 1 0.05; 2 5 =12.42* 0.08; 2 5 = 9.72* 0.10; 2 5 =12.38* age 0.03 (.01) 8.29** 0.25 (0.03) 0.67 −0.04 (0.03) 2.27 gender 0.24 (0.16) 2.16 0.97 (0.32) 9.08** −1.13 (0.32) 12.32** education −0.17 (0.24) 0.05 0.34 (0.43) 0.65 −0.39 (0.39) 1.00 income 0.03 (0.11) 0.06 −0.37 (0.22) 2.84 0.59 (0.22) 6.97** experience −0.02 (0.10) 0.04 0.39 (0.19) 4.13* −0.23 (0.18) 1.67 step 2 0.11; 2 5 =17.94** 0.32; 2 5 =36.48** 0.26; 2 5 =22.54** extraversion 0.19 (0.07) 6.61** −0.37 (0.14) 6.56** 0.40 (0.13) 8.43** anxiety −0.14 (0.07) 3.48* 0.31 (0.12) 3.79* −0.31 (0.11) 3.94* tough-mindedness −0.11 (0.08) 1.86 0.88 (0.19) 20.58** −0.60 (0.16) 13.18** independence 0.13 (0.08) 2.40 0.11 (0.17) 0.39 −0.38 (0.18) 4.56* self-control 0.04 (0.08) 0.30 −0.21 (0.17) 1.45 −0.10 (0.15) 0.47 *p<0.05, **p<0.01. se: standard error table 1: means, standard deviations and inter-correlations of the principal measures principal measures means (sd) inter-correlations 1 2 3 4 5 6 7 8 9 10 1. housing loan decision 0.43 (0.49) 1 2. fixed-rate mortgage 0.43 (0.49) 0.02 1 3. adjustable-rate mortgage 0.48 (0.50) 0.01 −0.84** 1 4. changing preference 0.50 (0.50) −0.11 −0.13 0.10 1 5. predictability 5.62 (2.02) 0.04 −0.13 0.06 −0.11 1 6. risks 4.61 (1.70) 0.18** −0.02 0.02 0.08 0.14 1 7. extraversion 4.15 (2.03) 0.18** −0.16* 0.16* 0.30** 0.16 0.16* 1 8. anxiety 5.46 (1.98) −0.16* 0.33** −0.25** 0.19* −0.16* 0.16* −0.04 1 9. tough-mindedness 6.19 (1.94) −0.16* 0.39** −0.24** −0.22** −0.15* −0.09 −0.26** −0.06 1 10. independence 4.97 (1.80) 0.11 −0.11 −0.15 0.26** 0.17* 0.04 0.20** 0.13 −0.45** 1 11. self-control 6.33 (1.80) −0.06 −0.03 −0.05 −0.16* 0.07 0.03 −0.19* −0.04 0.40** −0.25** risks and predictability variables were the mean scores of the two kind of interest rate mortgages. *p<0.05, **p<0.01. sd: standard deviation gambetti and giusberti: housing loans: what about personality traits? international journal of economics and financial issues | vol 7 • issue 2 • 201736 in step two. table 4 summarizes the regression coefficients from this analysis. 3.4. risk perception the results of the regressions of question d scores are shown in table 5 and reveal that the risk perception (for fixed-rate and adjustable-rate mortgages) was positively associated with anxiety, and negatively with tough-mindedness (only for adjustable-rate mortgage). 3.5. housing loan predictability the results of the regressions of question e scores are shown in table 6 and reveal that the perception of predictability was negatively associated with anxiety (for the two kind of mortgages) and tough-mindedness (for adjustable-rate mortgage). table 3: regressions of a, b and c questions on 16pf-5 primary scales for each global factor (controlling for demographics) predictor variables question a (housing loan) question b (fixed‑rate) question b (adjustable-rate) b (s.e.) wald r2 b (s.e.) wald r2 b (s.e.) wald r2 introversion/extraversion 0.11; 25 =23.95** 0.06; 25 =9.54* 0.04; 2 5 =7.29 reserved/warm (a) 0.03 (0.09) 0.11 −0.15 (0.09) 3.08 0.21 (0.11) 3.84* serious/lively (f) 0.05 (0.07) 0.39 −0.14 (0.07) 3.39* 0.01 (0.09) 0.01 shy/bold (h) 0.18 (0.08) 5.13* −0.03 (0.08) 0.17 −0.03 (0.10) 0.10 private/forthright (n) 0.19 (0.07) 1.79 0.08 (0.07) 1.07 −0.05 (0.09) 0.28 self-reliant/ group-oriented (q2) 0.07 (0.08) 0.70 0.07 (0.08) 0.92 0.12 (0.09) 1.64 low/high anxiety 0.07; 24 =13.35* 0.17; 2 4 =22.67** 0.17; 24 =21.93** emotionally-stable/ reactive (c) −0.07 (0.08) 0.87 0.13 (0.16) 0.70 −0.23 (0.15) 2.24 trusting/vigilant (l) −0.18 (0.06) 5.02* 0.01 (0.06) 0.04 0.10 (0.08) 1.66 self-assured/ apprensive (o) 0.04 (0.07) 0.36 0.25 (0.11) 4.54** −0.35 (0.12) 9.01** relaxed/tense (q4) 0.04 (0.07) 0.36 0.02 (0.07) 0.07 0.09 (0.09) 0.90 receptivity/ tough-mindedness 0.08; 24 =16.92* 0.17; 2 4 =34.92** 0.24; 24 =27.65** warm/reserved (a) −0.16 (0.07) 5.30* 0.25 (0.07) 10.99** −0.29 (0.11) 9.26** sensitive/ unsentimental (i) −0.07 (0.07) 0.97 −0.06 (0.07) 0.70 0.46 (0.11) 17.55** abstracted/practical (m) 0.18 (0.08) 4.75* 0.45 (0.09) 22.11** 0.53 (0.13) 17.43** open-to-change/ traditional (q1) −0.10 (0.07) 2.41 0.25 (0.07) 10.56** −0.21 (0.09) 5.05* accomodation/independence 0.09; 2 4 =20.04** 0.05; 24 =9.13* 0.19; 2 4 =18.53** deferential/dominant (e) −0.07 (0.07) 1.19 0.09 (0.07) 2.06 −0.02 (0.10) 0.02 shy/bold (h) 0.29 (0.07) 14.86** 0.07 (0.07) 1.09 −0.41 (0.11) 12.78** trusting/vigilant (l) −0.03 (0.06) 0.26 −0.07 (0.06) 1.32 −0.17 (0.08) 4.68* traditional/ open-to-change (q1) 0.05 (0.06) 0.68 −0.17 (0.07) 6.12* 0.12 (0.11) 1.28 lack of restraint/self-control 0.08; 24 =16.94** 0.11; 24 =20.98** 0.12; 24 =20.31** lively/serious (f) −0.15 (0.07) 5.17* 0.14 (0.07) 4.19* −0.06 (0.08) 0.48 expedient/ rule-conscious (g) −0.17 (0.08) 4.37* 0.14 (0.09) 2.69 −0.27 (0.11) 6.78** abstracted/ practical (m) 0.28 (0.09) 9.25** 0.22 (0.09) 5.21* 0.55 (0.13) 16.94** tolerates disorder/ perfectionistic (q3) −0.02 (0.06) 0.07 0.09 (0.07) 1.99 0.01 (0.08) 0.03 *p<0.05, **p<0.01. se: standard error table 4: logistic regression of changing preferences predictor variables b (s.e.) wald χ2 r2 step 1 16.86* 0.13 age −0.05 (0.03) 2.88 gender −0.47 (0.26) 3.15* education −0.24 (0.38) 0.42 income −0.04 (0.18) 0.04 experience −0.16 (0.17) 0.89 step 2 14.70* 0.23 extraversion 0.30 (0.12) 6.28* anxiety 0.06 (0.11) 0.26 tough-mindedness −0.20 (0.14) 3.00* independence 0.10 (0.15) 0.44 self-control −0.10 (0.15) 0.51 *p<0.05. se: standard error gambetti and giusberti: housing loans: what about personality traits? international journal of economics and financial issues | vol 7 • issue 2 • 2017 37 table 6: hierarchical multiple linear regressions of predictability about different kinds of housing loan predictor variables β t f adjusted r2 a. dependent variable: fixed-rate mortgage step 1 2.55* 0.05 age −0.09 −1.31 gender 0.03 0.38 education 0.11 1.56 income 0.02 0.21 experience −0.12 1.77 step 2 1.85* 0.08 extraversion −0.04 −0.52 anxiety −0.19 −2.31* tough-mindedness 0.01 0.09 independence 0.14 1.80 self-control 0.08 1.17 b. dependent variable: adjustable-rate mortgage step 1 3.23** 0.05 age 0.04 0.51 gender −0.09 −1.21 education 0.19 2.55* income 0.07 0.88 experience 0.06 0.88 step 2 2.45** 0.10 extraversion −0.09 −1.35 anxiety −0.16 −2.62* tough-mindedness −0.15 −1.89* independence −0.01 −0.01 self-control 0.11 1.64 *p<0.05, **p<0.001 table 5: hierarchical multiple linear regressions of risk perception about different kinds of housing loan predictor variables β t f adjusted r2 a. dependent variable: fixed-rate mortgage step 1 2.50* 0.05 age −0.01 −0.15 gender −0.20 −2.61* education −0.02 −0.03 income 0.09 1.19 experience 0.15 2.27* step 2 2.05* 0.09 extraversion 0.11 1.53 anxiety 0.15 1.73* tough-mindedness 0.07 0.84 independence −0.10 −1.35 self-control 0.03 0.44 b. dependent variable: adjustable-rate mortgage step 1 3.55** 0.07 age 0.03 0.41 gender −0.15 −1.97* education 0.05 0.65 income −0.03 −0.34 experience −0.17 −2.68** step 2 2.64** 0.11 extraversion 0.04 0.63 anxiety 0.15 1.95* tough-mindedness −0.16 −2.12* independence 0.01 0.08 self-control 0.07 1.01 *p<0.05, **p<0.001 4. discussion the current study investigated the influence of personality traits in mortgage preferences and perceptions, contributing to the literature on psychological differences underlying taking out home mortgage loans, and extending the understanding of the role of individual characteristics in financial behaviour both theoretically and practically. the present study showed that personality predicts the preference for specific type of mortgages. the marketplace offers numerous varieties within fixed-rate mortgages and adjustable-rate mortgages, but these two loan types represent the first important step when shopping for a mortgage. the present data showed that extraversion is positively associated with the choice to access a housing loan, preferring adjustable-rate mortgages. this finding could be explained by the tendency of extraverted people to be daring and uninhibited, venturing forth in a fearless manner (high social boldness) and to give more importance to current rather than future gains, even if they can take more risks in the future (depue and collins, 1999). indeed the preference for an adjustable-rate mortgage may be currently (after the economic crisis of 2008 in europe) an excellent choice for low payments in the near term. moreover, extraverts are motivated to move toward others for emotional closeness, attachment and connection (high warmth), spending a lot of time in social activities and travels (nettle, 2005). in this sense, adjustable interest rates could be the best decision for this kind of people who could not plan to live in the property for which mortgage were bought long enough for the rates to rise. this study also showed that extraversion predicted changing preference about the kind of housing loan, probably choosing the most advantageous mortgage at that time. as for anxiety, the present results showed that it predicts the preference for to not have housing loan and, in case they are forced to do, to prefer fixed-rate mortgage. the main advantage of this kind of loan is that it is easy to understand and vary little from lender to lender. moreover the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise. people with high anxiety are proneness to avoid risk-taking, giving a selective attentional bias towards threatening stimuli and a low sense of personal control over situations (butler and mathews, 1987; maner et al., 2007). for this reason vigilant and apprehensive individuals could prefer this kind of housing loan even if, when interest rates are high, qualifying for a loan could be more difficult because the payments may be less affordable. the present results about housing loan risk and predictability perception are in accordance with such interpretation: trait anxiety is positively associated with risk perception about the two types of mortgages, whereas the opposite happens for housing loan predictability. this is in line with previous studies showing that anxiety is related to the perception of high risks and low predictability across different kind of financial products and situations (lowenstein and lerner 2003; gambetti and giusberti, 2014). moreover, our results showed that individuals with high toughmindedness, who are reserved, practical and traditional, prefer fixed-rate mortgages rather than adjustable-rate ones. this gambetti and giusberti: housing loans: what about personality traits? international journal of economics and financial issues | vol 7 • issue 2 • 201738 preference could be due to their inclination for predictable and familiar solutions and their caution about new ideas (cattell et al., 1993). indeed the fixed-rate mortgage guarantees the same payment and the same interest rate over time and, for this reason, is considered a traditional and safe financial solution, suitable for all those who want to buy or to renovate a house without surprises related to interest rate fluctuations. the present data also showed that people with high tough-mindedness perceive low risk but also a low level of predictability about adjustable-rate mortgages. in contrast to anxious people who are generally prone to overestimate risks, individuals who score high on tough-mindedness could be inclined to objectively assess the risks probably because of their tendency to approach problems in a logical, objective and practical manner, scarcely influenced by emotions (cattell and schuerger, 2003) but, on the other hand, they prefer to buy the more predictable housing loans as anxious ones. indeed, this personality trait could drive them to give more weight than others to the fact that adjustable-rate mortgages are unpredictable, if interest rates are climbing or a steady, whereas fixed-rate mortgages allow to have a precise schedule of economic releases because nothing will change the rate. these specific characteristics of the two loan types probably lead high tough-mindedness people to prefer fixed-rate mortgages, without changing preference over time. as for independence, the present study showed that, contrary to the hypotheses, this personality trait negatively predicted the preference for adjustable-rate mortgage. in the 16pf model, independence trait indicates a person who is assertive and dominant, adventurous and fearless in approaching new people and situations and open to change, whereas low scores, those at the accommodating end of the scale, tend to be cooperative, deferential and trusting (cattell and schuerger, 2003). our results showed that accommodating people, who are shy and trusting, prefer adjustedrate mortgage perceiving predictable (although in reality it is not so), probably because they are prone to accept the motives of financial consultants following their advices. indeed, since 2008 in europe the adjusted-rate mortgage is more advantageous than the fixed-rate one, and for this reason is the type of mortgage most recommended by financial institutions. finally, self-control global factor failed to make a statistically significant unique contribution, over the other 16pf global personality factors, in explaining the variance in preferences and perceptions about mortgage. it is possible that low self-control trait influences only stimulating risk-taking (freeman and muraven, 2010), that is the willingness to take risks in adrenaline situations, and not instrumental risk-taking as could be choosing an adjustablerate mortgage. however, the regression model of the four primary factors, that define self-control, on mortgage preferences showed that, consistently with our hypotheses, serious and practical individuals (high self-control) prefer a fixed rate mortgage, while expedient and abstracted ones (low self-control) an adjustable-rate mortgage. this finding is in line with research showed that who are low on openness to experience and high on conscientiousness tend to take low risks in financial field (mayfield et al., 2008). in conclusion, the evidence presented in this study allows some preliminary generalizations about how personality might influence preferences and perceptions in financial field, defining specific personality profiles related to the preference for certain financial choices. the present findings have important theoretical and practical implications. at theoretical level, they may help to better understand how the dispositional emotions affect choices and decision-making in the economic field, emphasizing the utility of cognitive models of emotion on decision making (lowenstein and lerner, 2003; peters et al., 2006). moreover, this study highlights the utility of the 16pf5 in financial research for several reasons: the presence of validity scales through which it is possible to identify individuals who responded in unusual or compliant manner, the presence of sixteen primary traits that are 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(2001), beyond risk seeking and risk aversion: personality and the dual nature of economic risk taking. european journal of personality, 15, 105-122. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s3) 12-21. special issue for “asia international conference (aic 2015), 5-6 december 2015, universiti teknologi malaysia, kuala lumpur, malaysia” international journal of economics and financial issues | vol 6 • special issue (s3) • 201612 lock-up expiry and trading volume behaviour of malaysian initial public offering’s abdolhossein zameni1*, othman yong2 1henley business school, university of reading malaysia, malaysia, 2graduate school of business, universiti kebangsaan malaysia, malaysia. *email: a.zameni@henley.edu.my abstract the study aims to investigate the lock-up provisions of initial public offering’s (ipos) and its effects on trading volume changes around the lock-up expiry date of malaysian ipos by using both the event study methodology and the comparison period returns approach (cpra). unlike the us and the uk, malaysia’s lock-up length is fixed and the number of shares that should be under the lock-up is pre-determined by the security commission. the sample comprises 379 malaysian ipos, issued from january 2001 to december 2011. the results of the event study methodology and cpra shows a positive abnormal trading volume at lock-up expiry date for ipo market, except for the ace market, construction and technology sectors, which is negative and is not consistent with our hypothesis and there is no evidence in previous literatures regarding the significant negative trading volume before and after the lock-up. high trading volume at and around the lock-up expiration is compatible with shareholders’ selling due to diversification reasons and wealth recognition and which is also an indication of insider’s lack of confidence about a company’s future prospect. significant negative trading volume can be interpreted in a way that insiders of those related boards and sectors do not sell their shares significantly but would rather watch what would happen to the market and are optimistic about market’s future. furthermore, when we do not adjust the trading volume for the market, the cpra methodology does not show abnormal trading volume between event window and non-event windows. keywords: lock-up provision and malaysiain initial public offering market, trading volume behaviour, trading board jel classifications: g02, g10, g14, g18, g38 1. introduction how the initial public offering’s (ipo) firm can decrease investors’ uncertainty? the study of williamson (1996) mentioned lock-up as a bonding mechanism is a proper tool for reducing the uncertainty around any non-spot transaction. lock-up, or better known as share moratorium in malaysia, and lock-in in the uk, means controlling shareholders of ipo firms to bind themselves not to sell portions of their shareholdings during a lock-up period immediately after the ipo. the exact lock-up expiry date and the portion that can be sold each time are mentioned in the prospectus of every ipo firm. in some countries, the length of lock-up is flexible, while in others, is fixed by the related authorities. in malaysia the lock-up period is determined by security commission (sc) and is fixed. generally, lock-up contracts exist to reduce the information asymmetries between shareholders and managers, following the ipo (brau et al., 2004). lock-up is attractive to investors due to accessibility to significant information related to uncertainty of the ipos within the duration of share lock-up, and the fact that lock-up duration signals the issuer’s uncertainties. the concept of uncertainty proposes that investors will diverge in their expectations because uncertainty produces disagreement and as believed by many scholars, investors’ disagreement leads to high trading volume. karpoff’s (1986) model contends that trading volume is a good proxy divergence for opinion among investors and therefore, rises in trading volume means investors either have divergent understanding on information or have similar understanding which were divergent before expectations. in addition, other studies such as harris and raviv (1993), scheinkman and xiong (2002), and hong and stein (2003), show that divergent opinions motivate trading activity. trade activities zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 13 happen shortly following the lock-up expiry date and show the market’s attitude to the company’s actual value. in most cases, lock-up expiry can critically hit the stock market as by the time the lock-up expires, company insiders come into the market and the amount of public float stocks rise greatly. many scholars have reported a substantial price decline and a persistent rise in trading volume around lock-up expiry (ofek and richardson, 2000; bradley, et al., 2001; field and hanka, 2001). the outcomes reveal that the market explains heavy trading as bad and thin trading as good news (mohan and chen, 2002). as such in malaysia lockup length is fixed and pre-determined, significant trading volume will show uncertainty of investors and insiders about company’s future prospect. therefore, investigating the movement of trading volume around the lock-up expiry will be a useful indication for investors, which show the insiders opinion about the company. the study of espenlaub et al. (2001) indicates that us lock-up durations is almost standardized at 180 days while the uk shows greater difference. in the malaysian market, several required lock-up periods are imposed and are compulsory, whereas the us and uk markets are free of these compulsory rules. in the case of malaysian ipos, lock-up provision for each board and some sectors are different which creates a unique opportunity to examine the trading volume around the lock-up expiration dates. in asian capital markets, ipo plays an important role in assigning new capital. the importance of the screening practice by malaysian regulators to identify the performance of the ipo and equity market is inline with malaysia’s aspiration to become the world’s hub for islamic capital market and a developed country in the year 2020. given the importance of such behavioural implications, this paper seeks to examine one of the main events of each ipo firm that could potentially explain insiders’ heterogeneous beliefs in a sample of 379 ipos in malaysia. this study is expected to be a main contribution to the literature on trading behaviour of insiders after the lock-up expiry date of malaysian ipos. in this paper, two different event study methodology and hypothesise are used. the results indicate that the abnormal volume around the unlock day is significantly positive for the ipo market, some sectors and trading board. beside this increase, there is a significant decrease in trading volume for the ace market, construction and technology sectors, which is not consistent with our hypothesis and there is no evidence in previous literatures regarding the significant negative trading volume before and after the lock-up. the remainder of this paper is organized as follows. following the introduction section, section 2 discusses the related literature and section 3 describes the data and methodology. section 4 presents the results, whilst section 5 concludes the paper. 2. literature review brav and gompers (2003) propose that insiders can signal quality of the company using three tools: under-pricing, the portion of stocks locked-up, and the duration of lock-up. after the expiration date, only the percentage of outstanding shares held by insiders can be sold. this percentage of sold shares can raise the public float and enlarge information asymmetry among insiders and buyers. mohan and chen (2002) assert that a lower trading volume after an expiration of lock-up is good news, but large trading volume is bad news. unlike the us and uk, malaysian lock-up length is fixed and the amount of shares which should be under the lock-up is pre-determined by sc thus, lock-up length does not carry any information about insider’s behaviour. but, the trading volume around unlock day is a good proxy for insider’s perception of the company. a model by leland and pyle (1997) declares that the portion of shares kept by insiders at the ipo time can be accepted as a signal of quality. hence, insiders of high quality companies like to keep most of their shares after the ipos, and consequently remain more undiversified. ofek and richardson (2000) mention that we can expect certain features after the lock-up expiration. particularly, we can expect rise in trading volume because of change in supply of shares and the reason behind this rise is amount of liquidity trading (noninformation based). secondly, rise in trading volume shows an asset price risk diversification of insiders. field and hanka (2001), alamer (2015a; 2015b), bradley et al. (2001) and ofek and richardson (2000) express that lock-up expiration causes a persistent 40% rise in trading volume. field and hanka (2001) interpret that an insider trading activity sends noticeable signals for the investors, as the lack of confidence of insiders about the futures’ prospects, motivates sales of stocks after the expiration. consequently, sales by insiders at and around the expiration day may generate negative signals (brau et al., 2004). cao et al. (2004) assert that at and around lock-up expirations, significant diversification selling happens and cause a growth in market liquidity. the reason behind it is that primary owners and early investors generally have a big portion of their personal wealth involved in the company. moreover, cao et al. (2004) mention that most of the sales seem to be information selling because the lock-up expiry is the initial opportunity for insiders to offer their stocks without early declaration and, therefore, there is an initial chance to perform on their personal intuitions about the companies’ actual value without suffering from all the expenses of any price decreases by revealing their trades. bajo (2010) argues that abnormal trading volume is inline with fama’s et al., hypothesis (1969), if it is simultaneous with announcing of new information. it is not common or normal that stock exchange commissions use trading volume as a means of control and find probable misuses (bajo, 2010). bajo (2010) mentions that abnormal trading volume is created by informed traders hence, this extra trading activity may cause future share’s excess performance. bajo (2010) cites abnormal trading by itself does not show a plausible sign for the future returns; consequently, by reviewing the trading volumes, it is not possible to distinguish between bad and good effective events. bajo (2010) argues that abnormal trading is a positive signal on average. zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 201614 by delving into the malaysian literature in the ipos field, the results show more research on the performance of an ipo itself while there is a gap in studies on the effect of expiration of lock-up contracts on the trading volume (appendix). however, lock-up provision is compulsory for new issuance companies in malaysia, but there is a slight difference in length of lock-up provision in each board. we can compare the results, and see in which board and sector(s) the fluctuation of trading volume is higher. this outcome shows in which sector(s) the financial efficiency is more than others. 3. methodology and data 3.1. sample and procedures the sample employed in this study comprises all ipos listed on the main board, second board, mesdaq, main and ace market after the lock-up expiration from january 2001 to december 2011. the final sample of 379 includes all offer for sale ipos listed on bursa malaysia that are affected by lock-up agreements is used. january 2001 is selected as the beginning date since the after-effects of the 1997 financial crisis had been negated by that time. this study defines the event horizon as the (−20, +20) days’ time period surrounding the lock-up expiry. the variable that is used in this study is trading volume. besides the main methodology of the study, the masulis (1980) comparison period returns approach (cpra) methodology is also used as a robustness test. in addition, for the cpra methodology, the event horizon is (−30, +30) days’ time period surrounding the lock-up expiry. the data employed in this research were collected from the bursa malaysia website (http://www.bursamalaysia. com), the sc (www.sc.com.my), the star online website (http:// biz.thestar.com.my/marketwatch/ipo), the http://www.klse.info website and datastream. 3.2. proposed hypotheses mostly, ipos may show abnormal trading activities after the lockup expiration as an index of insider confidence. hence, the heavy sale of insiders instantly after the lock-up expiry is understood as a clue of low insider confidence. this is explained to be a bad signal related to the companies’ prospects. on the other hand, if there are no abnormal changes in insider trading volume subsequent to the lock-up expiry, it is seen by the investors as a signal of high insider confidence, and thus, a pleasant index of future company value. ofek and richardson (2000) and field and hanka (2001) and brau et al. (2004) prove the results of other scholars, on positive abnormal volume surrounding the unlock day. h1: the abnormal volume around the unlock day is significantly positive for the ipo market. this hypothesis is divided into two parts: in malaysia, firms are listed on trading boards of the bursa malaysia and are classified into different sectors which show their main businesses. here, we can breakdown the sample by industrial sectors and board of listing. by breaking down the sample in this way, the source of variation in the trading volume of lock-up expiration due to a company’s specific characteristics and broad economic characteristics may be traced (page and reyneke 1997). h1.1: the abnormal volume around the unlock day for each board is significantly positive. h1.2: the abnormal volume around the unlock day for each sector is significantly positive. 3.3. methods this section explains two methodologies used to calculate and test the effects of volume around lock-up expiries. 3.3.1. analysing abnormal volume binder (1998) argues the event study methodology is the standard method to test the effect of some event on company shareholders’ fortunes. goergen et al. (2010), in their paper on the hong kong ipo market, applied the following equations for measuring abnormal daily trading volume around the unlock day: vrit v v v vt it mt it mt = =− − ∑1 52 100 49 [ ( )] this equation is used to calculate the market adjusted volume ratio (mavr), vrit of firm i on day t. in this formula, vit is the trading volume of firm i and vmt is the market index on day t. the vmt can be downloaded from datastream database. avrt is a daily average abnormal volume across n companies: avr n vrt it i n = = ∑1 1 and, mavrs is average abnormal volume for n companies in the event window (t1, t2), where s is: s=t2−t1 mavr s avrs t t t t = = ∑1 1 2 respectively. for testing the avrt and mavrs, the standard t-test is applied. if the avrt and mavrs are bigger than one, the trading volume on day t over the event window is abnormal. 3.3.2. cpra along with the mentioned methodology for capturing the abnormal trading volume around the lock-up expiration, the cpra by masulis (1980) is also conducted. cpra methodology is used for confirming the results of the previous method. according to brown and warner (1980) study, the cpra is as powerful as the market adjusted approaches. in this methodology, mean daily trading volume (mdtv) for comparison period (non-event period) and also observation period (event period) is calculated. actually, the event is the lock-up expiration day. we define an event period (event window) as (−2, +2) days prior and following the event day for capturing the effects of lock-up expiration and the comparison period as (−30, +30) days before and after an event period (masulis, 1980). all the hypotheses are the same as the ones in the previous method, but we test mdtv instead of avs. the related null hypotheses are as follow: zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 15 h0: the mdtv is zero for ipo market, all trading boards and all sectors. a null hypothesis for comparison period is as below: h0: the mdtv of the event period equals the mdtv of the nonevent period for ipo market, all trading boards and all sectors. 4. findings 4.1. profiles of the ipos sample table 1 shows number of companies in each board between january 2001 and december 2011. total number of active companies for main, second, mesdaq boards and main and ace markets is 379 between the years of 2001 and 2011. 4.2. sectors table 2 shows the number of companies with a complete set of trading volume, in each sector from january 2001 until december 2011. the mining sector is excluded from analysis because of less number of companies. 4.3. descriptive statistics of main variables (trading volume) during the event window from 2001 to 2011 table 3 shows two event windows the first event window’s duration is (−20, +20) and the second event window’s (cpra) duration is (−30, +30) days before and after the expiration day. the lowest mean trading volume belongs to the main board, which is 266,000 shares and the highest mean trading volume belongs to the main market, which is 1,235,000 shares. the lowest trading volume range is 541,581,000 shares, which belongs to the main board and the highest trading volume range is 44,488,000 shares which belong to the main market. 4.4. abnormal volume surrounding the lock-up expiration day for each board and ipo market the market-adjusted abnormal volume ratio (avr) is not significantly bigger than one on the first day of the main board’s lock-up expiration, revealing that there is no abnormal trading volume. the average mavr over the (−20, +20), (−2, +2) and (−7, +7) windows around the first lock-up expiry is significantly bigger than one with values of 1.681, 1.747 and 2.319, respectively. the avr is not significantly bigger than one on the first expiry day and other days except day three after the lock-up expiry of the second board, indicating that there is no abnormal trading volume. the mavr over the (−20, +20), (−2, +2) and (−7, +7) windows around the first lock-up expiry is significantly bigger than one with values of 3.781, 4.290 and 3.584, respectively. the avr is not significantly bigger than one on the first expiry day of the first and second mesdaq lock-up expiration; this shows that there is no abnormal trading volume. the mavr over the (−20, +20), (−2, +2) and (−7, +7) windows around the first lock-up table 1: number of companies in each board panel a main board second board mesdaq total 2001 6 14 20 2002 19 16 8 43 2003 17 18 14 49 2004 14 23 26 63 2005 10 16 41 67 2006 3 7 22 32 2007 10 8 2 20 2008 7 8 8 23 total 86 110 121 317 panel b main market ace market 2009 11 2 13 2010 21 6 27 2011 12 10 22 total 44 18 379 after 3rd august 2009, the structure of bursa malaysia changed from three boards to the main and ace markets, respectively. the number of companies before 3rd august 2009 for main and second boards is 10 and 1, respectively table 2: numbers of companies with a complete set of close price each sector construction 10 consumer products 65 finance 5 industrial products 109 mining 1 plantation 5 property 16 technology 83 trading/services 85 total 379 table 3: descriptive statistics of trading volume during the event window from 2001 to 2011 model n mean median sd range volume, main board, first method 3526 270.90 78.7 553.60 5415.80 volume, main board, cpra 5246 266.54 80.6 559.38 6020.80 volume, second board, first method 4510 542.38 76.0 1498.70 21662.70 volume, second board, cpra 6710 513.33 66.0 1470.79 21662.70 volume, mesdaq first expiry, first method 4961 993.93 140.2 2067.79 13900.30 volume, mesdaq first expiry, cpra 2684 867.98 130.0 1797.23 13900.30 volume second expiry, first method 4961 278.86 100.0 507.95 4670.70 volume, mesdaq second expiry, cpra 7381 296.02 114.6 527.24 4670.70 volume, main market, first method 1804 1235.32 232.6 2964.45 44488.10 volume, main market, cpra 2684 1247.63 227.9 3164.66 44488.10 volume, ace first method 738 364.93 80.4 1099.96 14394.50 volume, ace, cpra 1098 368.13 91.6 969.78 14394.50 volume, ipo market, first method 15539 649.35 108.3 1894.11 44488.10 volume, ipo market, first method 15539 649.35 108.3 1894.11 44488.10 sd: standard deviation, cpra: comparison period returns approach, ipo: initial public offering’s zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 201616 expiry is significantly bigger than one with values of 1.968, 2.869 and 2.271, respectively. the avr and the mavr are not significantly bigger than one on the first expiry day of the main market expiration, which denotes that there is no abnormal trading volume. the avr is significantly less than one on the first expiry day of the first ace lock-up expiration, meaning that there is no abnormal trading volume as what we want. trading volume does not rise significantly one day after the expiry of the first lock-up period. the mavr over the (−20, +20) and (−2, +2) windows around the first unlock day is significantly lesser than one with values of 0.794 and 0.534. field and hanka (2001) also report that volume for vc backed companies reduces after expiration and goes to its highest point on day +1. the avr is significantly different from one on the first expiry day for the ipo market, showing that there is abnormal trading volume. in addition, seven days before expiry and seven days after expiry show an abnormal trading volume. on the expiry day, trading volume increases by 161%. trading volume rises significantly by 118% one day after lock-up expiration. the mavr over the (−20, +20), (−2, +2) and (−7, +7) windows around the first lock-up expiry is significantly bigger than one with values of 2.275, 2.725 and 2.424, respectively (table 4). 4.5. abnormal volume surrounding the lock-up expiry for each sector (trading volume effect) the avr is significantly lesser than one on the first expiry day of the construction sector. this result denotes that there is no abnormal trading volume as what we are looking for (table 5). the avr is significantly bigger than one on the first expiry day of the consumer products sector, demonstrating that there is abnormal trading volume. nevertheless, trading volume rises significantly by 269% one day after the expiry of the first lock-up period. the mavr over the (−20, +20), (−2, +2) and (−7, +7) windows around the first lock-up expiration is significantly bigger than one with values of 2.961, 4.876 and 3.73, respectively. the avr is not significantly bigger than one on the first expiry day for the industrial products sector, meaning that there is no abnormal trading volume. the mavr over the (−20, +20), (−2, +2) and (−7, +7) windows around the first unlock day is significantly bigger than one with values of 2.857, 2.352 and 1.962, respectively. the avr is not significantly bigger than one on the first expiry day of the properties sector, denoting that there is no abnormal trading volume. the mavr over the (−2, +2) and (−7, +7) windows around the first unlock day is significantly bigger than one with values of 1.581 and 1.280, respectively. the avr is not significantly bigger than one on the first expiry day of the plantation and finance sectors, outlining that there is no abnormal trading volume. the avr is significantly lesser than one on the first expiry day of the technology sector, asserting that there is abnormal trading volume at 10% significance level but not as we expect. the t ab le 4 : v ol um e re ac ti on s of a ll tr ad in g bo ar ds a nd i p o m ar ke t o f m al ay si a’ s st oc k m ar ke t a ft er lo ck -u p ex pi ra ti on d ay s n a bn or m al v ol um e −7 −6 −5 −4 −3 −2 −1 0 1 2 3 4 5 6 7 (− 7, +7 ) (− 2, +2 ) (− 20 ,+ 20 ) m ai n bo ar d 86 1. 7 5. 7 2. 5 1. 9 1. 5 2. 8 1. 4 1. 9 1. 1 1. 6 1. 7 1. 5 1. 1 6. 8 1. 7 1. 7 1. 7 2. 3 te st v al ue =1 0. 4 0. 3 0. 1 0. 2 0. 3 0. 1 0. 5 0. 2 0. 7 0. 3 0. 3 0. 2 0. 6 0. 3 0. 4 0. 00 1* ** 0. 06 7* * 0. 00 8* ** se co nd b oa rd 11 0 3. 4 4. 4 2. 5 1. 9 2. 2 3. 7 4. 5 4. 0 3. 8 5. 4 4. 1 2. 6 3. 2 4. 9 3. 1 3. 8 4. 3 3. 6 te st v al ue =1 0. 2 0. 07 3* * 0. 3 0. 6 0. 3 0. 2 0. 2 0. 1 0. 1 0. 2 0. 04 ** 0. 2 0. 4 0. 2 0. 5 0. 00 0* ** 0. 00 0* ** 0. 00 0* ** fi rs t m e sd a q ex pi ry 12 1 1. 2 2. 9 1. 1 0. 8 2. 9 2. 5 1. 7 2. 0 3. 8 4. 3 2. 2 3. 0 2. 6 1. 8 1. 1 2. 0 2. 9 2. 3 te st v al ue =1 0. 7 0. 5 0. 8 0. 7 0. 5 0. 5 0. 6 0. 5 0. 4 0. 3 0. 4 0. 4 0. 4 0. 4 0. 7 0. 00 0* ** 0. 02 2* * 0. 00 0* ** se co nd m e sd a q ex pi ry 12 1 0. 7 0. 1 1. 2 0. 7 1. 4 1. 3 5. 2 5. 1 0. 9 0. 7 0. 8 0. 4 0. 4 0. 4 0. 4 1. 2 2. 6 1. 3 te st v al ue =1 0. 4 0. 01 1* * 0. 9 0. 6 0. 7 0. 8 0. 2 0. 2 0. 9 0. 6 0. 4 0. 1 0. 00 8* ** 0. 02 5* * 0. 01 4* * 0. 4 0. 2 0. 5 m ai n m ar ke t 44 0. 8 0. 7 0. 8 0. 8 0. 9 1. 4 1. 1 1. 2 0. 9 1. 0 0. 9 0. 9 0. 7 0. 8 1. 9 1. 0 1. 1 1. 0 te st v al ue =1 0. 4 0. 05 6* 0. 3 0. 4 0. 6 0. 3 0. 8 0. 5 0. 7 1. 0 0. 8 0. 5 0. 2 0. 3 0. 5 0. 8 0. 3 0. 9 a c e m ar ke t 18 0. 3 0. 3 0. 4 0. 4 1. 6 0. 4 0. 4 0. 5 0. 5 0. 9 0. 3 0. 7 1. 8 1. 1 1. 9 0. 8 0. 5 0. 8 te st v al ue =1 0. 00 0* ** 0. 00 0* ** 0. 00 ** * 0. 00 2* ** 0. 67 0. 01 0* * 0. 00 1* ** 0. 00 3* ** 0. 16 0. 79 0. 00 2* ** 0. 5 0. 44 0. 84 0. 60 0. 05 8* * 0. 00 6* ** 0. 12 ip o m ar ke t 37 9 2. 1 3. 7 2. 0 1. 5 1. 7 2. 7 2. 5 2. 6 2. 2 2. 9 2. 4 1. 8 1. 9 4. 3 2. 3 2. 3 2. 7 2. 4 te st v al ue =1 0. 01 3* * 0. 07 5* 0. 01 ** 0. 06 1* 0. 01 4* * 0. 00 7* ** 0. 01 2* * 0. 00 6* ** 0. 00 6* ** 0. 01 5* * 0. 00 4* ** 0. 00 3* ** 0. 01 4* * 0. 09 8* 0. 02 7* * 0. 00 0* ** 0. 02 5* * 0. 00 0* ** ** *, ** , * in di ca te s ig ni fic an ce a t t he 1 % , 5 % a nd 1 0% le ve ls (t w ota ile d te st ), re sp ec tiv el y. ip o : i ni tia l p ub lic o ff er in g’ s zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 17 mavr over the (−2, +2) window around the first unlock day is significantly lesser than one with value of 0.677. the avr is not significantly bigger than one on the first expiry day of the trading/services sector, highlighting that there is no abnormal trading volume. the mavr over the (−20, +20), (−2, +2) and (−7, +7) windows around the first lock-up expiry is significantly bigger than one with values of 1.768, 1.511 and 1.551. 4.6. results of comparison period return approach a table 6 follows which compares the mdtv (for trading volume) of portfolio’s lock-up expiry period (event period) with the mean mdtv of pre and post lock-up expiry which is called comparison period. they report significant mdtv for all trading boards, sectors and ipo market. 4.6.1. abnormal trading volume for all trading boards and ipo market table 6 shows a mdtv of all trading boards, ipo market and sectors of malaysia’s stock market during lock-up expiration. in addition, table 6 shows significant difference between mean mdtv of event period and non-event period. there is no significant mdtv for the unlock day of the main board, second board, first mesdaq expiration and main market, but for days surrounding it, there is abnormal daily trading volume. there is a significant mdtv for the unlock day for the second mesdaq expiration and ace market. the mean of mdtv of the event period equals the mean mdtv of non-event period for all sectors. there is a significant mdtv for the lock-up expiry, and the week before and after ipo market. the mdtv of the event period equals the mdtv of non-event period for ipo market. espenlaub et al. (2001) mention that higher volume at and around the lockup expiration is compatible with shareholders’ selling due to the diversification reasons. 4.6.2. abnormal trading volume around the lock-up expiry for each sector there is no significant mdtv for the lock-up expiry of the construction, consumer products, industrial products, properties, technology and trading/services sectors (table 6). there is a significant mdtv for the lock-up expiry of the finance and plantation sectors. the mean mdtv of the event period equals the mean mdtv of non-event period for all sectors. day after lock-up expiration shows a significant increase in mdtv for the second board, consumer products, industrial products and trading/service sectors. day after lock-up expiration shows a significant decrease in mdtv for the main board and main market and also for the properties sector. 7. conclusion and future research the study aims to investigate the ipo lock-up provision and its effects on trading volume changes around the lock-up expiry date of malaysian ipos by using both the event study methodology and the cpra as proposed by masulis (1980). unlike the us and t ab le 5 : v ol um e re ac ti on s of s ec to rs o f m al ay si a’ s st oc k m ar ke t a ft er lo ck -u p ex pi ra ti on se ct or s c on st ru ct io n 10 1. 1 1. 0 0. 6 0. 8 0. 9 1. 4 1. 0 0. 5 0. 5 1. 3 1. 2 1. 0 2. 6 1. 1 1. 6 1. 1 1. 0 1. 1 te st v al ue =1 0. 8 1. 0 0. 1 0. 5 0. 7 0. 5 1. 0 0. 06 * 0. 07 3* 0. 7 0. 7 0. 9 0. 5 0. 9 0. 6 0. 1 0. 9 0. 5 c on su m er p ro du ct 65 2. 4 4. 8 2. 1 1. 8 2. 1 3. 8 5. 7 4. 7 3. 7 6. 6 3. 6 2. 3 3. 0 5. 6 4. 1 3. 0 4. 9 3. 7 te st v al ue =1 0. 2 0. 08 1* 0. 1 0. 2 0. 2 0. 08 2* 0. 06 * 0. 06 * 0. 04 4* * 0. 09 2* 0. 09 * 0. 1 0. 2 0. 2 0. 2 0. 00 0* ** 0. 00 2* ** 0. 00 0* ** fi na nc e 5 0. 2 0. 4 0. 3 0. 9 1. 3 0. 5 1. 0 1. 6 0. 6 1. 0 0. 2 1. 5 1. 2 0. 9 0. 4 1. 5 0. 3 0. 9 te st v al ue =1 0. 01 1* * 0. 87 5 0. 2 0. 87 6 0. 12 4 0. 00 6* ** 0. 9 0. 7 0. 97 0. 92 0. 06 * 0. 7 0. 72 6 0. 03 3* 0. 00 3* ** 0. 64 6 0. 34 5 0. 86 3 in du st ri al p ro du ct s 10 9 2. 7 3. 2 5. 6 2. 6 1. 7 1. 7 3. 3 2. 1 2. 6 2. 4 2. 7 2. 4 2. 0 2. 1 6. 8 2. 9 2. 4 2. 0 te st v al ue =1 0. 09 5* 0. 07 0* 0. 2 0. 15 3 0. 31 7 0. 30 2 0. 1 0. 3 0. 22 0. 15 0. 2 0. 09 * 0. 09 3* 0. 05 3* 0. 30 5 0. 00 0* ** 0. 00 1* ** 0. 00 0* ** pl an ta tio n 5 0. 3 0. 7 0. 7 0. 9 3. 2 0. 4 1. 0 1. 2 0. 7 1. 1 0. 5 1. 6 1. 5 0. 5 0. 2 1. 3 0. 9 1. 0 te st v al ue =1 0. 01 2* * 0. 45 3 0. 3 0. 75 8 0. 32 7 0. 00 8* ** 0. 9 0. 8 0. 49 0. 92 0. 08 * 0. 4 0. 69 3 0. 05 5* 0. 00 4* ** 0. 23 6 0. 39 5 0. 82 5 pr op er tie s 16 1. 4 1. 2 1. 0 2. 4 1. 4 2. 3 1. 2 1. 8 1. 1 1. 5 0. 7 0. 7 0. 9 0. 9 0. 6 1. 1 1. 6 1. 3 te st v al ue =1 0. 5 0. 8 1. 0 0. 3 0. 6 0. 3 0. 8 0. 5 0. 8 0. 7 0. 5 0. 5 0. 9 0. 9 0. 4 0. 4 0. 05 9* 0. 06 5* te ch no lo gy 83 0. 5 1. 1 0. 5 0. 4 0. 5 0. 4 0. 5 0. 6 0. 8 1. 1 1. 0 1. 7 0. 8 1. 0 5. 8 1. 1 0. 7 1. 1 te st v al ue =1 0. 01 5* * 0. 94 5 0. 07 * 0. 00 4* ** 0. 00 9* ** 0. 00 1* ** 0. 08 * 0. 09 * 0. 41 0. 87 0. 9 0. 3 0. 40 7 0. 91 5 0. 38 2 0. 58 0. 05 2* 0. 75 6 tr ad in g/ se rv ic es 85 1. 3 2. 2 1. 7 1. 1 1. 4 2. 2 1. 4 1. 5 1. 5 1. 0 2. 6 1. 3 0. 9 2. 4 0. 9 1. 8 1. 5 1. 6 te st v al ue =1 0. 5 0. 2 0. 08 * 0. 9 0. 3 0. 09 7* 0. 5 0. 2 0. 3 1. 0 0. 2 0. 5 0. 8 0. 3 0. 8 0. 00 0* ** 0. 05 9* 0. 00 2* ** ** *, ** , * in di ca te s ig ni fic an ce a t t he 1 % , 5 % a nd 1 0% le ve ls (t w ota ile d te st ), re sp ec tiv el y zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 201618 d ay s n m d t v (% ) si gn ifi ca nt d if fe re nc e be tw ee n m ea n m d t v o f e ve nt p er io d an d no nev en t p er io d −7 −6 −5 −4 −3 −2 −1 0 1 2 3 4 5 6 7 m ea n m d t v o f e ve nt p er io d m ea n m d t v of n on -e ve nt pe ri od be fo re th e an no un ce m en t m ea n m d t v of n on -e ve nt pe ri od af te r th e an no un ce m en t m ai n bo ar d 86 0. 93 2. 98 3. 08 1. 39 4 2. 54 6 0. 48 1. 72 3. 78 7 1. 46 8 0. 8 4. 66 7 0. 93 3 0. 95 9 0. 6 1. 9 1. 65 1 2. 09 3. 09 pva lu e 0. 00 2* ** 0. 11 0. 25 0. 00 8* ** 0. 02 3* * 0. 03 1* * 0. 03 2* * 0. 26 3 0. 03 6* * 0. 05 8* 0. 01 3* * 0. 24 3 0. 02 8* * 0. 05 * 0. 00 9* ** 0. 70 8 0. 63 4 se co nd b oa rd 11 0 3. 2 1. 8 0. 4 0. 8 0. 5 0. 7 2. 7 0. 3 0. 9 1. 0 0. 4 1. 4 0. 9 0. 6 0. 5 1. 12 0 4. 47 1. 17 pva lu e 0. 16 0. 16 0. 17 0. 05 2* 0. 02 5* * 0. 06 1* 0. 05 8* 0. 21 0. 04 4* * 0. 06 9* 0. 28 0. 11 0. 01 9* * 0. 2 0. 09 * 0. 46 9 0. 91 8 fi rs t m e sd a q e xp ir y 12 1 1. 32 0. 13 0. 22 1. 81 −0 .1 4 −0 .2 6 1. 39 0. 81 0. 88 0. 03 0. 48 −0 .3 6 0. 37 −0 .3 −0 .0 4 0. 57 0 0. 75 5 .9 76 pva lu e 0. 54 0. 89 0. 79 0. 43 0. 37 .0 71 * 0. 43 0. 34 0. 52 0. 97 0. 43 .0 80 * 0. 48 0. 1 0. 9 0. 83 6 .8 47 se co nd m e sd a q e xp ir y 12 1 −0 .7 6 3. 15 −0 .3 8 1. 61 1. 84 6. 88 1. 90 −0 .7 3 −0 .0 3 0. 43 −0 .3 8 −0 .2 6 −0 .0 9 −0 .2 −0 .0 1. 69 0 1. 12 2. 49 pva lu e 0. 02 5* * 0. 26 0. 18 0. 46 8 0. 39 4 0. 44 6 0. 45 0. 03 9* * 0. 48 3 0. 64 7 0. 48 1 0. 26 1 0. 05 5* 0. 08 * 0. 9 0. 64 3 .8 38 m ai n m ar ke t 44 0. 39 0. 35 0. 46 1. 12 1. 11 0. 77 1. 19 1. 41 0. 64 0. 60 0. 46 0. 19 0. 65 3. 9 0. 5 .9 21 1. 34 6 1. 45 1 pva lu e 0. 19 0. 09 8* 0. 07 3* 0. 04 2* * 0. 04 8* * 0. 25 0. 01 8* * 0. 23 0. 04 3* * 0. 02 4* * 0. 16 0. 32 0. 01 9* * 0. 2 0. 1 .6 47 .5 45 a c e m ar ke t 18 −0 .2 08 23 .9 −0 .1 3 0. 80 9 1. 88 7 2. 21 9 −0 .0 4 −0 .2 38 0. 80 7 −0 .4 16 5. 79 2 −0 .0 62 0. 98 0. 6 1. 2 .4 66 1. 83 1. 03 2 pva lu e 0. 49 0. 35 0. 50 0. 31 .0 97 * 0. 39 0. 90 .0 82 * 0. 27 0. 11 0. 34 0. 85 0. 16 0. 2 0. 3 .4 56 .5 29 ip o m ar ke t 37 9 0. 74 0 1. 52 2. 64 1. 16 2 1. 14 5 1. 32 0 0. 77 1. 85 0 1. 00 7 0. 72 3 1. 91 0 0. 82 2 0. 80 8 1. 3 0. 9 1. 18 2. 68 1. 81 pva lu e 0. 00 0* ** 0. 06 2* 0. 02 8* * 0. 16 2 0. 00 0* ** 0. 00 0* ** 0. 00 3* ** 0. 00 1* ** 0. 00 0* ** 0. 00 3* ** 0. 00 3* ** 0. 04 1* * 0. 00 0* ** 0. 09 * 0. 00 ** * 0. 38 7 0. 54 4 se ct or s c on st ru ct io n 10 0. 01 5 0. 13 1. 92 0. 50 2 0. 33 1 0. 19 6 0. 00 8 0. 97 6 0. 22 5 1. 13 5 0. 99 8 0. 99 3 0. 21 7 1. 5 0. 0 0. 50 8 0. 82 7 .6 90 pva lu e 0. 96 0. 65 0. 28 0. 27 0. 54 0. 56 0. 98 0. 38 0. 69 0. 28 0. 30 0. 26 0. 68 0. 1 0. 9 0. 61 3 .6 80 c on su m er p ro du ct 65 0. 79 0. 40 0. 35 1. 05 2. 07 1. 36 1. 73 0. 36 1. 18 0. 56 1. 07 0. 59 0. 78 1. 1 0. 7 1. 03 9 4. 59 2 1. 31 1 pva lu e 0. 05 4* 0. 18 0. 15 0. 04 0* * 0. 14 0. 04 8* * 0. 12 0. 19 1 0. 04 3* * 0. 24 1 0. 12 0. 09 5* 0. 02 7* * 0. 2 0. 1 0. 62 2 .7 39 fi na nc e 5 1. 01 0. 23 1. 23 1. 21 1. 23 2. 23 2. 03 −0 .2 3 0. 23 0. 68 1. 35 −0 .0 6 0. 24 0. 2 3. 5 1. 99 6 1. 52 8 4. 33 0 pva lu e 0. 23 1 0. 23 0. 34 0. 12 3 0. 56 3 0. 75 3 0. 33 3 .0 53 * 0. 23 4 0. 74 2 0. 34 5 0. 89 5 0. 65 3 0. 2 0. 4 0. 65 4 0. 72 6 in du st ri al p ro du ct s 10 9 3. 58 0. 67 0. 06 0. 70 0. 49 0. 41 2. 56 0. 27 0. 43 1. 24 0. 27 1. 26 0. 86 0. 0 0. 8 −0 .9 79 1. 96 2 1. 17 0 pva lu e 0. 19 0. 06 9* 0. 71 0. 13 0. 04 0* * 0. 37 0. 11 0. 30 0. 05 4* .0 69 * 0. 20 0. 22 0. 06 6* 0. 8 0. 02 ** 0. 46 7 0. 75 0 pl an ta tio n 5 2. 05 0. 54 4. 29 4. 21 1. 73 3. 89 5. 08 −0 .5 3 0. 82 0. 73 12 .7 5 −0 .0 6 0. 33 0. 4 3. 7 1. 99 6 1. 52 8 4. 33 0 pva lu e 0. 34 0. 47 0. 37 0. 30 0. 30 0. 37 0. 41 0. 05 3* 0. 35 0. 54 0. 36 0. 88 0. 72 0. 5 0. 3 .6 54 0. 72 6 pr op er tie s 16 −0 .3 2 14 .7 19 .9 −0 .1 9 1. 72 0. 56 1. 92 0. 20 −0 .4 3 0. 54 1. 99 0. 13 1. 19 1. 5 3. 1 0. 55 8 3. 41 6 2. 80 3 pva lu e 0. 09 4* 0. 32 0. 35 0. 58 9 0. 33 6 0. 27 3 0. 27 4 0. 77 5 0. 03 8* * 0. 50 3 0. 20 6 0. 71 4 0. 2 0. 3 0. 2 0. 62 4 0. 63 3 ta bl e 6: m d t v o f a ll tr ad in g bo ar ds , i p o m ar ke t a nd s ec to rs o f m al ay si a’ s st oc k m ar ke t d ur in g lo ck -u p ex pi ra ti on (c on td ).. . zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 19 the uk, malaysia’s lock-up length is fixed and number of shares should be under the lock-up is pre-determined by sc. the sample comprises of 379 malaysian ipos, issued from january 2001 to december 2011. as we expected, there is a significant increase in most boards, sectors and ipo market. a volume rise after the lock-up expiration is also cited by field and hanka (2001), bradley et al. (2001) and ofek and richardson (2000). field and hanka (2001) interpret that an insider trading activity sends noticeable signals to the investors as the lack of confidence of insiders about the company’s future prospects, which motivates sales of stocks after the expiration. on the other hand, if there are no abnormal changes in insider trading volume subsequent to the lock-up expiry, it should be seen by the investors as a signal of high insider confidence and thus, a pleasant index of future company value. beside this increase, there is a significant decrease in trading volume for the ace market, construction and technology sectors, which is not consistent with our hypothesis and there is no evidence in previous literatures regarding the significant negative trading volume before and after the lock-up. these results can be interpreted in a way that insiders of those related boards and sectors do not sell their shares significantly and watch what will happen to the market in future and are optimistic about future. furthermore, when we do not adjust the trading volume for the market, the cpra methodology does not show abnormal trading volume between event window and non-event windows. there is a rise in the ipo market but there is a significant negative mean daily trading for the second mesdaq expiration, ace market, finance and plantation sectors, which is close to the result of the first methodology. as conclusion, for the expiry day, the first and second methodologies show almost the same result, but in the wider window, there is a difference between these two methodologies due to market adjustment. references alamer, a.r.a., salamon, h.b., qureshi, m.i., rasli, a.m. (2015a), csr’s measuring corporate social responsibility practice in islamic banking: a review. international journal of economics and financial issues, 5(1s), 198-206. alamer, a.r.a., salamon, h.b., qureshi, m.i., rasli, a.m. (2015b), how do we measure corporate social responsibility of islamic banks through their business processes and oriented outcomes? international journal of economics and financial issues, 5(1s), 190-197. bajo, e. (2010), the information content of abnormal trading volume. journal of business finance and accounting, 37(7-8), 950-978. binder, j. (1998), the event study methodology since 1969. review of quantitative finance and accounting, 11(2), 111-137. bradley, d.j., jordan, b.d., yi, h.c., roten, i.c. (2001), venture capital and ipo lockup expiration: an empirical analysis. journal of financial research, 24(4), 465-493. brau, j.c., carter, d.a., christophe, s.e., key, k.g. (2004), market reaction to the expiration of ipo lockup provisions. managerial finance, 30(1), 75-91. brav, a., gompers, p.a. (2003), the role of lockups in initial public offerings. review of financial studies, 16(1), 1-29. brown, s.j., warner, j.b. (1980), measuring security price performance. journal of financial economics, 8(3), 205-258.d ay s n m d t v (% ) si gn ifi ca nt d if fe re nc e be tw ee n m ea n m d t v o f e ve nt p er io d an d no nev en t p er io d −7 −6 −5 −4 −3 −2 −1 0 1 2 3 4 5 6 7 m ea n m d t v o f e ve nt p er io d m ea n m d t v of n on -e ve nt pe ri od be fo re th e an no un ce m en t m ea n m d t v of n on -e ve nt pe ri od af te r th e an no un ce m en t te ch no lo gy 83 1. 03 −0 .0 1 0. 81 0. 34 0. 93 0. 35 1. 43 0. 26 0. 68 0. 45 5. 95 −0 .5 9 1. 51 1. 0 −0 .1 0. 63 4 0. 94 6 1. 39 6 pva lu e 0. 24 0. 99 0. 38 0. 31 0. 41 0. 68 0. 07 2* 0. 17 0. 27 0. 49 0. 29 0. 00 2* ** 0. 19 0. 4 0. 6 0. 55 1 0. 48 1 tr ad in g/ se rv ic es 85 0. 84 8. 05 0. 20 1. 98 1. 81 0. 36 1. 90 −0 .0 9 2. 40 0. 37 1. 33 0. 51 1. 02 4. 3 0. 9 0. 98 6 1. 66 0 1. 57 1 pva lu e 0. 04 1* * 0. 13 0. 43 0. 01 1* * 0. 06 1* 0. 23 9 0. 06 6* 0. 48 5 0. 03 9* * 0. 13 0. 26 7 0. 20 3 0. 06 3* 0. 2 0. 1 0. 45 9 0. 44 1 ** *, ** , * in di ca te s ig ni fic an ce a t t he 1 % , 5 % a nd 1 0% le ve ls (t w ota ile d te st ), re sp ec tiv el y. m d t v : m ea n da ily tr ad in g vo lu m e ta bl e 6: (c on tin ue d) zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 201620 cao, c., field, l., hanka, g. (2004), does insider trading impair market liquidity? evidence from ipo lockup expirations. journal of financial and quantitative analysis, 39(01), 25-46. espenlaub, s., goergen, m., khurshed, a. (2001), ipo lock-in agreements in the uk. journal of business finance and accounting, 28(9-10), 1235-1278. fama, e., fisher, l., jensen, m., roll, r. (1969), the adjustment of stock prices to new information. international economic review, 10, 1-21. field, l.c., hanka, g. (2001), the expiration of ipo share lockups. journal of finance, 56(2), 471-500. goergen, m., mazouz, k., yin, s. (2010), price, volume and spread effects associated with the expiry of lock-in agreements. pacific-basin finance journal, 18(5), 442-459. harris, m., raviv, a. (1993), differences of opinion make a horse race. review of financial studies, 6(3), 473-506. hong, h., stein, j. (2003), differences of opinion, short-sale constraints, and market crashes. review of financial studies, 16(2), 487-525. karpoff, j.m. (1986), a theory of trading volume. journal of finance, 41(5), 1069-1087. leland, h.e., pyle, d.h. (1997), informational asymmetries, financial structure, and financial intermediation. journal of finance, 32(2), 371-387. masulis, r.w. (1980), the effects of capital structure change on security prices. journal of finacial economics, 8, 139-178. mohan, n.j., chen, c.r. (2002), information content of lock-up provisions in initial public offerings. international review of economics and finance, 10(1), 41-59. ofek, e., richardson, m. (2000), the ipo lock-up period: implications for market efficiency and downward sloping demand curves. unpublished working paper. stern school of business, nyu. page, r., michael, j. (1997), the timing and subsequent performance of initial public offerings (ipos) on the johannesburg stock exchange. journal of business finance and accounting, 24(9-10), 1401-1420. scheinkman, j., xiong, w. (2002), overconfidence and speculative bubbles. journal of political economy, 111(6), 1183-1219. williamson, o.e. (1996), the mechanisms of governance. oxford: oxford university press. zameni and yong: lock-up expiry and trading volume behaviour of malaysian ipo’s international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 21 appendix lock-up contracts and insider trading in malaysia (extracted from bursa malaysia and sc). this part explains the rules and regulations and also insider trading on the main and second boards, mesdaq, main market and ace market of bursa malaysia. actually, most of this part talks about the listing requirements that have been taken from the bursa malaysia and security commission websites. before 3 august 2009, the types of companies that could be listed on the main board, second board and mesdaq were different from main market and ace market. the main and second board’s moratorium based on bursa malaysia’s listing requirement is as below: i. main and second board: yes. ii. mesdaq board: yes, moratorium is applied for all listings. the following explains the rules and regulations based on listing requirement from the main market and ace market (after 3 august 2009). i. lock-up period of main market: “promoters” entire shareholdings for 6 months from the date of admission. 2ace market: promoters’ entire shareholdings for six (6) months from the date of admission, subsequent selling down with conditions. i. the moratorium assigns to the entire shareholdings of the promoters of an applicant for a period of 6-month from the date of admission to the exchange. ii. upon the expiry of the 6-month period stated above, the listed corporation must ensure that the promoters’ aggregate shareholdings amounting to at least 45% of the nominal issued and paid-up ordinary share capital of the listed corporation remain under moratorium, for another period of 6-month. iii. thereafter, subject to sub-rule (d) below, the promoters may sell, transfer or assign up to a maximum of 1/3rd per annum (on a straight-line basis) of the shares held under moratorium. international journal of economics and financial issues vol. 3, no. 4, 2013, pp.973-976 issn: 2146-4138 www.econjournals.com 973 purchasing power parity in the case of romania: evidence from structural breaks oguz ocal nevsehir university, avanos vocational school, nevsehir, turkey. email: oguzocal@nevsehir.edu.tr abstract: purchasing power parity has most likely been one of the most investigated issues of the last decades within economic literature. the results from such studies are not consistent and not only important for policy makers and economists but also extremely important for policy implications in international finance. purchasing power parity states the exchange rate between two countries should reflect the relative purchasing power of these two countries. this study tests the validity of the purchasing power parity hypothesis in romania with employing zivot–andrews unit root test by taking structural break into account. we use annual data from 1991 to 2012 and the results show that purchasing power parity does not hold in romania. keywords: purchasing power parity; real exchange rates; structural breaks jel classifications: f30; f31 1. introduction purchasing power parity (ppp here after) is a vital structure block of numerous macroeconomic models so that the ppp hypothesis is important for policy implications to decisionor policy makers of central banks, multinational firms and exchange rate market participants. also ppp has been viewed as an equilibrium condition, as an exchange rate determination theory and as a basis for international comparison of income (sideris, 2006). ppp theory is an important issue for exchange rate determination in international economics literature. theory of ppp is suggests that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries (taylor, 2009). this means that between two currencies exchange rate should be equal to the ratio of the two countries price level of a fixed basket of goods and services. the basis for ppp is the “law of one price”. early literature on the validity of ppp is voluminous but there is no agreement on the validity of the ppp yet. for developed countries, it has been extensively tested, but it is abundant in developing countries (taylor 1988, 2003, 2009, taylor and taylor 2004). the other view of these empirical findings, researchers believe that in short run the validity of ppp has uncertainty but they may be more willing to believe ppp’s validity in the long run, since the price differentials between two countries is unsustainable in the long-run. also the ppp hypothesis existing empirical literature results inconsistencies can be explained with that past studies indirectly accept that exchange rate behaviour is naturally linear. generally most of these studies suggest that the ppp holds in the long-run but the empirical validity of ppp in transition economies remains an unsolved issue (acaravcı and ozturk, 2010). the different types of empirical studies on ppp can be categorised in firstly correlation studies, secondly unit root tests studies and thirdly cointegration studies (acaravci and acaravci, 2007). mainly study of the empirical literature which tests the ppp hypothesis for romania presented at table 1. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.973-976 974 table 1. literature review for ppp in romania author(s) method conclusion choudhry (1999) fractional and harris-lnder cointegration tests no evidence christev and noorbakhsh (2000) stock-watson dynamic ols johansen cointegration weak evidence barrow and radulescu (2002) cointegration analysis no evidence barlow (2003) co-integration analysis weak evidence sideris (2006) johansen cointegration larsson panel cointegration strong evidence solakoglu (2006) panel approach strong evidence beirne (2007) johansen co-integration larsson panel co-integration weak evidence cuestas (2009) ng and perron unit root tests kss nonlinear unit root tests strong evidence koukouritakis (2009) johansen cointegration test weak evidence kasman et al. (2010) lm unit root tests strong evidence acaravcı and ozturk (2010) adf unit root tests kpss unit root tests weak evidence chang et al. (2011) nonlinear panel unit root test strong evidence aslan and kula (2011) univariate and panel lm unit root tests strong evidence although the most tested theories in the international economics literature, the empirical findings for the ppp hypothesis are mixed (taylor 1988, 2003, 2009). this article aims to investigates the validity of ppp in romania for the period 1991-2012 this long period will differ this study from previous literature that most of the empirical studies determined that the ppp holds in the long-run. the following section of the study provides the analytical framework. section 2 shows the sources of the data, methodology and empirical results and in sections 4 provides conclusions. 2. analytical framework for the strong form of ppp, the nominal exchange rate is proportional to the relative price so that the real exchange rate remains constant overtime. p p neer rr *  (1) in equation (1); rer is the real exchange rate, rne is the nominal exchange rate, p* is the foreign prices and p is the domestic prices. the real exchange rate can be shown in logarithmic form by equation (2), )log()log()log()log( * ppneer rr  (2) equation (3) represents the model of mean reverting real exchange rate: ttrtr neer   1)log()log( (3) in equation (3);  is the constant term,  is the error term. real exchange rate series should be stationary for the ppp hypothesis. real exchange rate series stationary means that if there is a change in the price level between two countries, it will be offset by an equal depreciation/appreciation on the nominal exchange rate. if there is a unit-root in the real exchange rate, we can say that the real exchange rate shocks are permanent and there is no ppp between two countries. purchasing power parity in the case of romania; evidence from structural breaks 975 3. data, methodology and empirical results previous literature of ppp stand on the linear unit root tests, but recent studies account for nonlinearities and/or structural breaks in real exchange rates. also the discussion on the validity of ppp empirical results has no agreement yet. this study will extend the ppp literature by using annual data that covers the period from 1991 to 2012 and take the us dollar as reference currency to construct the real exchange rates for romania. the price series are based on the consumer price index and the nominal exchange rates are the end period spot rates relative to the us dollar (domestic price of the us dollar). all data are taken from the international monetary fund’s international financial statistics database. za tests models are stated as the following forms: )6()()(: )5()(: )4()(: 1 1 12211 1 1 1211 1 1 1211 tjt k j jt c t c t ccc t tjt k j jt b t abb t tjt k j jt a t aaa t yydtdutycmodel yydttybmodel yydutyamodel                        in the level of the series model a allows for a change, in the slope of trend of a series model b allows for a change while model c combines both changes in the level and the slope of trend. table 2. zivot-andrews test results model type t stat model a -3,726 2005 (-4,80) model b -3,553 2000 (-4,42) model c -3,967 2009 (-5,08) note: critical values at 5% are presented in parenthesis. zivot–andrews test is used to examine whether ppp holds in romania for a long time by taking structural break into account. zivot–andrews test results are presented in table 2 and test results suggests that ppp doesn’t hold for romania. 4. conclusion the purpose of this research is to investigate the ppp in romania because the results of the previous empirical studies inconsistent. also ppp has been a great important factor that to understand the behaviour of exchange rates for policy makers. in this study, we apply the zivot-andrews unit root test to re-examines the validity of ppp for romania. in romania, the early literature on the validity of ppp has mostly motivated on the use of unit root tests which disregard structural break. this study is different from the previous literature by using zivot–andrews test with applying exchange rates in romania for the period of 1991-2012. our results show that ppp doesn’t hold in romania at least for the period of 1991-2012. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.973-976 976 references acaravci, s.k., acaravci, a. (2007), nonstationarity and the level shift for turkish real exchange rates. empirical economics letters, 6, 517-523. acaravcı, a., ozturk, i. (2010), testing purchasing power parity in transition countries: evidence from structural breaks. amfiteatru economic, 12(27), 290-298. aslan, a. and kula, f. (2011), purchasing power parity in eastern european countries: further evidence from black market exchange rates. amfiteatru economic, 13(29), 287-294. barlow, d. (2003), purchasing power parity in three transition economies. economics of planning, 36(3), 201-222. barlow, d., radulescu, r. (2002), purchasing power parity in the transition: the case of the romanian leu against dollar. post-communist economies, 14(1), 123-135. beirne, j. (2007), purchasing power parity in the european union: a cointegrated approach and transition economies. in: european economics and finance society, 6th annual meeting of the eefs international conference, sofia, bulgaria. christev, a., noorbakshsh, a. (2000), long-run purchasing power parity, price and exchange rate in transition: the case of six central and east european countries. global finance journal, 11, 87-108. chang, h-l. su, c-w., zhu, m-n., liu, p. (2011), re-examining long-run purchasing power parity for central and eastern european countries: nonlinear panel unit root tests. applied economics letters, 18(5), 411-415. choudhry, t. (1999). purchasing power parity in high-inflation eastern european countries: evidence from fractional and harris-lnder cointegration tests. journal of macroeconomics, 21(2), 293-308. cuestas, j.c. (2009), purchasing power parity in central and eastern european countries: an analysis of unit root and nonlinearities. applied economics letters, 16(1), 87-94. kasman,s., kasman, a., ayhan, d. (2010), testing the purchasing power parity hypothesis for the new member and candidate countries of the european union: evidence from lagrange multiplier unit root tests with structural breaks, emerging markets finance & trade / 46(2), 53–65. koukouritakis, m. (2009), testing the purchasing power parity: evidence from the new eu countries. applied economics letters, 16(1), 39–44. sideris, d. (2006), purchasing power parity in economies in transition: evidence from central and east european countries. applied financial economics, 16(1-2), 135-143. solakoglu, e.g. (2006), testing purchasing power parity hypothesis for transition economies. applied financial economics, 16, 561–568. taylor, m.p. (1988), an empirical examination of long-run purchasing power parity using cointegration techniques. applied economics, 20, 1369–1381. taylor, m.p. (2003), purchasing power parity. review of international economics, 11(3), 436-452. taylor a.m., taylor m.p. (2004), the purchasing power parity debate. journal of economic perspectives, 18(4), 135–158. taylor, m.p. (2009), long-run purchasing power parity and real exchange rates: introduction and overview. applied economics letters, 16, 1–4. zivot, e., andrews, d. (1992), further evidence on the great crash, the oil price shock, and the unit root hypothesis. journal of business and economic statistics, 10(3), 251270. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 377-383. international journal of economics and financial issues | vol 7 • issue 2 • 2017 377 analyzing the effects of fiscal policy on income distribution: a comparison between developed and developing countries hale balseven1*, can tansel tugcu2 1akdeniz university, turkey, 2akdeniz university, turkey. *email: halebalseven@akdeniz.edu.tr abstract the study examines the effect of fiscal policy on income distribution in developed and developing countries. the study analyzes the explanatory power of tax and transfers on income inequality in 17 developing and 30 developed countries in between 1990 and 2014 by using linear panel data estimation techniques. according to the findings, tax revenues decrease income inequalities in developing countries while social benefits decrease income inequality in developed countries. also, the economic growth has negative impact on income distribution in developing countries whereas the economic growth and inflation have positive impact on income distribution in developed countries. keywords: fiscal policy, income distribution, tax and expenditure policy jel classifications: d63, d31, h20 1. introduction nowadays equalities in income distribution have become an important research topic of modern macroeconomics. even in countries taking place within the group of developed ones where welfare state applications are common, some deterioration has been experienced in distribution indicators. studies analyzing oecd countries determine that while the gini coefficient was 0.29 in the mid-1980’s, it has increased to 0.32 in 2011/12 (oecd, 2012). apart from a few exceptions in developing countries, income distribution inequalities– which are already higher than developed countriescontinue to increase. the deterioration in income distribution might arise from the distribution of income in factor markets and/or from the redistribution of income with the fiscal policy. especially the fact that states have lost their elasticity in using the fiscal policy during the globalization process is argued to decrease the redistribution power of the state as an actor which decreases the income inequalities of the market. the deterioration effect of other factors on income distribution such as growth, inflation and unemployment, has become an important discussion topic especially following the global recession. on the other hand, the reasons exclusive to developing countries in terms of the inequalities in income distribution shall also not be disregarded. the main characteristics differentiating developing countries from developed ones with regards to inequalities in income distribution are the narrow tax base of these countries, the low level of unregistered employment as well as the low level of social transfer. in this study, the effects of fiscal policy on income distribution are explained through a comparison made between developed and developing country groups. it is seen that studies conducted in this subject focus mostly on developed countries. the fact that a limited number of studies have been conducted in developing countries unlike the group of developed countries might be explained with the lack of data. the purpose of this study is to determine similar factors explaining income inequality in both country groups and to distinguish the different ones according to their significance level. in this framework, the study has contributed to the studies as comparing the distributional effects of taxes and expenditures in developed and developing countries. the current study differs from the previous studies in terms of revised data set and the analysis of multiple variables. in this study, the direct effects of taxes and expenditures on income distribution have been discussed while the indirect effects of balseven and tugcu: analyzing the effects of fiscal policy on income distribution: a comparison between developed and developing countries international journal of economics and financial issues | vol 7 • issue 2 • 2017378 government policies through changes made in relative prices and in household behaviors have been disregarded. the second and third section of the study reveal the theoretical and empirical literature. in the fourth section, the model and data have been analyzed. in the last section, the evaluation and conclusions of the study take place. 2. the theoretical literature according to kuznets (1955), the two important factors affecting the gross income distribution are savings and economic growth. as to him, while income inequalities increase during the first phases of economic growth, income distribution tends to get even fairer as economic growth continues and the country gets further developed. the increase of the gini coefficient in developing countries is explained in this context. in addition to a wide literature concerning the validity of the relationality named inverted-u, counter studies also exist. bourguignon and morrison (1990) point out that the importance of income factors decrease when variables such as the education level are incorporated. more important are the increases in the inequality levels of many developed countries such as the usa and england, experienced in the recent period. nowadays, the role of regional economic developmentbased on trade, technological change and interregional wage differentials-on income distribution inequalities is being analyzed. especially in developed countries, the role of wage differentials in explaining income distribution inequality is appreciated to be important. atkinson (1997) points out that in england, there are clear findings on the differences related to the distribution of wages. while real earnings increased by 11% in the lowest income bracket between the years 1979-1995 in england, they increased by 50% in the highest income bracket. in addition to the increased differential experienced between the earnings of the employed population in this country, the increasing importance of self-employment as well as the increasing number of households having no employment income take place among factors affecting the deterioration in income distribution. with regards to those who are not employed, social security is the main source of income. at this stage, the distributional effect of the state comes into play, expressed as the difference between the market income and the income after taxes and transfers. until the first half of the 1980s, the gini coefficient of the market income increased sharply while coefficients of incomes obtained after taxes and transfers had a milder increase. after 1984, an exact opposite situation has been experienced. according to atkinson (1997), the striking decrease occurring in the re-distribution effect of transfers and direct taxes after this date, is the result of political changes that have contributed to income inequality. indeed, the role played by the state in re-distributing the income and contributing to development during the 1950s and 1960s has undergone a radical change starting from the 1970s. theories defining the redistributive interventions of the state as an inefficiency area have a significant impact lying at the bottom of this change. during this period, theories of laffer and laviatan suggesting that high tax rates dissuade economic activities have especially gained wide currency. with musgrave (1959), the economic interventions of the state, which were valid until the 1970s, had become a part of the theory under the famous stabilization, allocation and distribution branches of government. here, allocation efficiency and distributive justice are defined as the conflicting areas between the purposes of the state. during the last years, it has been suggested that redistribution and efficiency might not always be conflicting, that in other words, there might not be a trade-off between them. boadway and keen (2000) explain situations where redistribution might in fact be efficiency-enhancing in the economic process. especially, those are aid programs devoted to poor people and pareto improvements creating efficiency gains in social security. recently, tax and expenditure programs that might enhance the related efficiency and their regional and territorial differences are being modeled. when we consider this situation together with the approach arguing that the redistributive effects of taxes and transfers depend on their magnitude, composition and the progressive nature of each component; the necessity of analysis based on multi-factors becomes evident. 3. the empirical literature the magnitude of the redistributive interventions of the state and the mechanisms used in this respect are the areas where empirical studies concentrate. in oecd countries, it has been calculated that the inequality after taxes and transfers was 25% lower than the inequality before taxes and transfers at the end of the 2000s for the oecd average (oecd, 2012). 3/4 of the decrease in the inequality is explained by transfers while the rest is explained by direct taxes towards households (joumard and pisu, 2012; oecd, 2012). especially cash transfers constitute the most important item leading to a decrease in the inequality (about 19%) measured as the decrease in the market income concentration before and after transfers. payments made to pensioners have the highest share in cash transfers. during the studies, the reasons explaining the limited redistributive effect of taxes have been mentioned as the use of consumption taxes and social security payments instead of progressive income tax, the limited progressivity of the tax tariff and the fact that tax expenditures provide advantage over high income families. similarly, bastagli et al. (2008) put forth that the redistributive effect of the fiscal policy was getting realized in terms of the expenditures and transfers of the budget. according to prasad (2008), a strong and negative relation exists between social transfer expenditures and inequality in developed countries. more than half of the redistributive effects of social transfers (80% in switzerland and 70% in germany) derive from pension benefits. niehues (2010) analyzed the social expenditure categories that are effective in decreasing income inequality for the eu countries. according to this study, social benefits are not an effective category of social expenditures for decreasing income inequality while payments related to social security, such as unemployment and pension payments seem to be more efficient. on the other hand, it has been determined that mean-tested benefits have an increasing balseven and tugcu: analyzing the effects of fiscal policy on income distribution: a comparison between developed and developing countries international journal of economics and financial issues | vol 7 • issue 2 • 2017 379 effect on income inequality emerging after tax and expenditures and not a decreasing effect. fuest et al. (2010) analyzed the effects of the tax and benefit system on income distribution in the eu countries based on the sequential accounting approach and the factor source decomposition approach. according to the first approach, social benefits are the most important factor on inequality. as to the second approach, social benefits are negligible and sometimes they have a slightly positive effect on inequality. here taxes and social contributions are the most important factors contributing to the decrease of inequality. authors explain this opposite result with the different normative focus points of these two approaches and especially argue that social benefits have objectives different than redistribution. gregorio (2002) examined the effect of education and social expenditures on income distribution between 1960 and 1990 in african, asian, latin american and oecd countries. the findings of the study reveal that education and social expenditures have an improving effect on income distribution. nevertheless, in addition to these items, income factors also play a moderate role in explaining the differences among countries and these variables cannot explain the major part of the inequality among countries. on the other hand, prasad (2008) made a comparison between six latin american countries and the oecd countries with regards to the effect of taxes and expenditures on income inequality. according to this study, income inequality only decreased by 1.4 points through taxes and expenditures in latin american countries while it decreased by 16 points in oecd countries. the contribution of direct taxes to inequality has only been a decrease of 0.6% in the gini coefficient. indirect taxes such as the value added tax, customs duties and import tariffs have increased income inequality by 0.5 points. in another study (mahler and mckeever, 2009) a comparison has been conducted between market income inequality and disposable income inequality in more than 100 developed and less-developed countries for a period of 25 years. according to this study, the gini coefficient of the market income increased by 68 gini points since 1980 while it increased 38 points after the state intervention. these results reveal that the redistribution policies of the state do not progress at the same level with the market income increase. furthermore, while the market income increases by 64 point in developed countries and by 70 points in developing countries, the ratios are respectively 26 and 44 following the state intervention. this situation shows that in comparison to developed countries, the state is more efficient in redistribution in developing countries. in a study conducted over 150 developed and developing countries between the years 1970 and 2009, martinez-vazquez et al. (2012) examined the tendency of the tax and expenditure policy in changing the inequality trends. authors presented findings on the redistributive effects of especially health, education, housing and social security expenditures. taxes have a very low redistributive effect, especially in developing countries. finally, as mentioned earlier, the study points out that financial instruments based on expenditures are more efficient in decreasing income inequality, compared to the financial instruments taking place at the income side of the budget. cevik and correa-caro (2015) analyzed the effects of the fiscal policy on income distribution in china, bric countries together with 30 developing countries. in contradiction to other studies, in this analyze it has been determined that while public expenditures had an aggravating effect on income distribution in those countries, taxation had an improving effect. while the redistribution effect of the fiscal policy was stronger in china in comparison to bric and other developing countries, this effect had not been found strong enough so as to compensate the income distribution aggravating effect of other influential factors. to conclude, the limited number of comparative analyses made between countries on the income inequality decreasing effects of fiscal policy has reached different results. for instance when oecd countries are compare with latin american countries, it is observed that this effect is rather low in latin american countries. as this comparison is made between with less-developed countries, the effect seems to be low in developed countries. compared to taxes, transfers seem to be a more effective tool of the fiscal policy in decreasing income distribution inequalities. in developed countries, more than half of the redistribution effect of social transfers takes its source from pension benefits. in developing countries, social transfer mechanisms redistributing income in a systematic manner are more limited. 4. the data and model the multivariate framework includes gini_market and gini_net coefficients, nominal gdp growth rate, annual inflation rate, total unemployment rate, central government tax revenue in current us dollars, central government social contributions in current us dollars, central government interest expense in current us dollars, central government subsidies in current us dollars and central government social benefits in current us dollars of 17 developing and 30 developed countries1. the data for gini coefficients were attained from the standardized world income inequality database (swiid version 5.1) of solt. gdp growth, inflation and unemployment data were obtained from the world bank-world development indicators database. the data for all fiscal/financial variables were gathered from the imf-government finance statistics database. the data set covers the period 1990-2014 and variables excluding gini_market, gini_net, gdp growth, inflation and unemployment are in natural logarithms. all the fiscal/financial variables include social security funds. 1 the notations “developing and developed” exactly reflect the imf’s classification. the developing countries are belarus, bolivia, brazil, bulgaria, costa rica, croatia, egypt, georgia, india, indonesia, iran, moldova, peru, romania, south africa, thailand and uruguay. the developed countries are australia, austria, belgium, canada, cyprus, czech republic, denmark, estonia, finland, france, germany, greece, iceland, ireland, israel, italy, south korea, latvia, lithuania, luxemburg, netherlands, norway, portugal, slovakia, slovenia, spain, sweden, switzerland, england and the usa. balseven and tugcu: analyzing the effects of fiscal policy on income distribution: a comparison between developed and developing countries international journal of economics and financial issues | vol 7 • issue 2 • 2017380 the effects of government intervention on income inequality in selected country groups were investigated by using a linear panel data model that can be formulated in the following manner: yi,t= ci,t+αgrowthi,t+βinfi,t+δunempi,t+σtaxi,t+ϕconti,t+θinti,t +ψsubi,t+ηbenefi,t+εi,t where y is the vector of dependent variables (i.e. gini_net and the difference between gini_net and gini_market (hereafter, gini_diff)), growth is the rate of nominal gdp growth, inf is annual inflation rate, unemp is total unemployment rate, tax is central government tax revenue, cont is central government social contributions, int is central government interest expense, sub is central government subsidies, benef is central government social benefits, c is constant and ε is serially uncorrelated error term. 5. the methodology in this study, estimation of the constructed model was done by using linear panel data estimation techniques. the ordinary least squares (ols), the fixed-effects model (fem) and the randomeffects model (rem) can be followed for the estimation of linear panel equations. since the ols ignores the unobservable effects which are one of the most important components of panel data analysis, fem or rem is generally utilized for the estimation. however, the existence of cross-sectional dependence (cd) and unit root in data should be checked before the estimation. the cd is an important problem for the panel data econometrics. high degrees of globalization or cross-unit relations may give rise to the existence of this problem. in case of panel data which is cd, the estimation results generally become inconsistent and upward-biased (bai and kao, 2006). so, it is important to test the existence of cd before the analysis. this study utilizes the cd test which was developed by pesaran (2004) for investigating the existence of cd. under the null hypothesis of no cd, this statistic is asymptotically distributed as standard normal and efficient for the case of large n and small t. the cd test statistic proposed by pesaran (2004) is as follows: 1 1 1 2 ˆ ( 1) n n ij i j i t cd p n n − = = +   =    −   ∑ ∑ where t is time interval, n is the number of cross-sections, and ˆijp is pair-wise correlation between cross-sections. in addition to cross-sectional dependency, it is necessary to ensure that the variables under consideration are stationary. in this context, the panel unit root test developed by by im et al. (2003) (hereafter, ips) was executed to the data. the ips test assumes that the persistence parameters of the autoregressive process vary freely across cross-sections. if the purpose of the panel analysis is to obtain a general result by using the data of randomly selected units from the whole sample, the rem is an appropriate choice. however, if the aim is to reach a general result by employing the data of a fixed group, the suitable model is fem (baltagi, 2005). in this study, since the considered sample is randomly selected, the rem theoretically seems to be the proper choice. the usage of rem requires no correlation between unobservable effects and explanatory variables. hausman (1978) and hausman-taylor (1981) developed a test statistic (i.e. hausman test) which shows the estimator of rem (feasible generalized least squares) is unbiased and consistent under the null of no correlation between unobservable effects and explanatory variables. if the null hypothesis is rejected, then the estimator of fem (within estimator) should be used. in this study, hausman test statistic was used for the determination of the correlation between unobservable effects and explanatory variables. panel data analysis accommodates two unobservable effects which should be investigated before the estimation. these are group and time effects. breusch and pagan (1980) developed lm statistics in order to test the existence of group and time effects in rem (green, 2003). lm1 statistic tests the significance of group effects under the null of no group effects and lm2 statistic tests the significance of time effects under the null of no time effects. if one of the null of lm1 or lm2 is rejected, the model is one-way rem; on the other hand, if both the nulls of lm1 and lm2 are rejected then the model takes the form of two-way rem. considered test statistics are formulated as follows (baltagi, 2005): lm nt t u i j u uu n t 1 2 2 2 1 1= − − ⊗       ( ) ( ) ~ ' '  lm nt n u j i u uu n t 2 2 2 2 1 1= − − ⊗       ( ) ( ) ~ ' '  the existence of group and time effects in fem is evaluated by an anova-f statistic which was developed by moulton and randolph (1989). this f-statistic tests the significance of group and time effects under the nulls of no group and no time effects. the formulation of considered f-statistic is as follows (baltagi, 2005): f md dmd dm p r gy nt k p r = − − − + −          ' ' ' ' ~ ( ) / ( ) / ( ) one of the most important diagnostics in econometric studies is to determine whether there exists serial correlation in the data. wooldridge (2002) proposed an ar(1) serial correlation test under the null hypothesis of no serial correlation. the test is applied by regressing the residuals from the ols estimation of first-differenced variables on the lagged residuals. if the residuals from this estimation have an autocorrelation coefficient of −0.5, then the null hypothesis cannot be rejected. the study employed a wald test (far(1)) developed by drukker (2003) for this matter. another important diagnostic which should be taken into account in panel data studies is to check the existence of multicollinearity. for this purpose, variance inflation factor (vif) was utilized. if the estimated vif is smaller than 10, multicollinearity is not balseven and tugcu: analyzing the effects of fiscal policy on income distribution: a comparison between developed and developing countries international journal of economics and financial issues | vol 7 • issue 2 • 2017 381 an important problem; if it exceeds 10, then it could be serious problem. in case the value which is over 10, probability of vif that is measured as (1/vif) should be evaluated. if the probability is smaller than 0.01, there is no multicollinearity among explanatory variables, otherwise there exists (gujarati, 2004). the last diagnostic that was considered in the study is about the existence of heteroscedasticity. standard error component of the established model assumes that the regression disturbances are homoscedastic with the same variance across time and groups. when heteroscedasticity is present, homoscedastic disturbances will result in consistent but inefficient coefficients and biased standard errors (baltagi, 2005). the heteroscedastic models assume that the variances of the error terms change between cross-sectional units and this difference is not accounted for by variables. breusch and pagan (1979) proposed a test statistic (bph) under the null of homoscedasticity for testing the existence of heteroscedasticity in error terms. this test statistic uses the residuals from the ols estimation. if we expect heteroscedasticity to exist in error terms in the rem or fem cases, then the statistic based on the ols estimation may also be used in the both models. once the heteroscedasticity is detected, one possible way to correct heteroscedastic bias in the variance-covariance matrix is to use the white’s estimator (erdem and tugcu, 2011). 6. findings the existence of cd was checked and results were reported in table 1. accordingly, either for developed or for developing countries, there is no statistically significant cd problem at 1% level of significance. as mentioned, the ips test was utilized for investigating the existence of unit root in data. results reported in table 2 indicated that most of the variables are level-stationary. besides, all variables are first-difference stationary. after completing the cd and unit root analyses, the constructed model was estimated by using appropriate estimation techniques and results were presented in table 3. first of all, at 1% level of significance, the hausman test statistics showed that models except the one with the dependent variable gini_diff for developing country group should be estimated by using the random effect model. and, it is proved by the statistics that the models except the one with the dependent variable gini_diff for developed country group contain both statistically significant group and time effects. the existence of heteroscedasticity in the model with the dependent variable gini_net for developing group was corrected by utilizing the cross section covariance method of white, and the existence of serial correlation in all models was corrected by incorporating the ar(1) process to the estimations. finally, the vif statistics indicated that multicollinearity is not a problem for any of the estimations. according to the estimated coefficients for developed country group, when the dependent variable is gini_diff; inflation and interest expense were found as the statistically significant factors that decrease the gini coefficient, whereas economic growth, unemployment, tax revenue and social benefits increase it. among the variables with positive coefficient, social benefit has the largest magnitude. other coefficients were not found to be statistically significant. when the dependent variable is gini_net; inflation, interest expense and subsidies were found as the statistically significant variables that decrease the gini coefficient. all other variables have statistically insignificant coefficients. table 1: cross-sectional dependence test results dependent variables cd test for developed group cd test for developing group gini_diff 1.766 (0.07) 2.090 (0.03) gini_net −0.093 (0.92) 1.046 (0.29) numbers in parentheses are p values table 2: unit root test results variables developed group developing group constant constant+trend constant constant+trend gini_diff −2.879 (0.00) −3.200 (0.00) 0.064 (0.52) −3.180 (0.00) gini_net −2.207 (0.01) −1.877 (0.03) −0.780 (0.21) −0.783 (0.21) growth −9.944 (0.00) −8.035 (0.00) −8.260 (0.00) −4.988 (0.00) inf −26.655 (0.00) −20.007 (0.00) −174.278 (0.00) −157.151 (0.00) unemp −4.259 (0.00) −1.878 (0.03) −3.850 (0.00) −2.749 (0.00) tax −5.884 (0.00) −3.104 (0.00) −1.247 (0.10) −2.878 (0.00) cont −11.566 (0.00) −9.004 (0.00) −3.793 (0.00) −5.713 (0.00) int 1.134 (0.87) −2.939 (0.02) −0.291 (0.38) −7.130 (0.00) sub −1.178 (0.11) −3.167 (0.00) −11.191 (0.00) −10.915 (0.00) benef −1.963 (0.02) −3.518 (0.00) −3.686 (0.00) −1.608 (0.05) δgini_diff −12.051 (0.00) −9.846 (0.00) −5.164 (0.00) −5.287 (0.00) δgini_net −9.875 (0.00) −7.413 (0.00) −8.214 (0.00) −5.562 (0.00) δgrowth −18.200 (0.00) −13.619 (0.00) −17.209 (0.00) −14.411 (0.00) δinf −32.269 (0.00) −28.269 (0.00) −297.014 (0.00) −336.667 (0.00) δunemp −13.149 (0.00) −10.422 (0.00) −16.803 (0.00) −13.693 (0.00) δtax −16.356 (0.00) −14.482 (0.00) −10.794 (0.00) −9.346 (0.00) δcont −23.185 (0.00) −17.987 (0.00) −19.465 (0.00) −19.317 (0.00) δint −12.365 (0.00) −9.714 (0.00) −19.158 (0.00) −15.989 (0.00) δsub −16.565 (0.00) −14.205 (0.00) −9.204 (0.00) −6.225 (0.00) δbenef −14.125 (0.00) −10.379 (0.00) −11.285 (0.00) −10.634 (0.00) δ is first-difference operator. numbers in parentheses are p values balseven and tugcu: analyzing the effects of fiscal policy on income distribution: a comparison between developed and developing countries international journal of economics and financial issues | vol 7 • issue 2 • 2017382 estimates for developing country group indicated that, when the dependent variable is gini_diff; only tax revenue was found as a statistically significant factor that increases the gini coefficient. all other variables have statistically insignificant coefficients. when the dependent variable is gini_net; economic growth was seen as the single statistically significant factor that increases the gini coefficient, whereas tax revenue and social contributions decrease it. among the variables with negative coefficient, tax revenue has the largest magnitude. all other variables have statistically insignificant coefficients. 7. discussion and conclusion in this study, the factors that are supposed to be effective on income distribution have been analyzed by treating on a comparative basis of the developed and the developing countries. as distinct from the other studies, the current study makes a research on factors that are effective in diminishing inequalities by the state by establishing an analysis on the gini-net coefficient as well as on the difference between the market gini coefficient and the gini coefficient obtained after state intervention. furthermore, in addition to indicators related to taxes and expenditures, the study also takes into consideration macroeconomic factors that are important for developing countries such as growth, inflation and unemployment. the study reaches a common conclusion with the studies mentioned before in that social benefits are the most important item that increases inequality differences in pro and post government intervention in developed countries. similarly, as indicated in other studies, the study evidences that tax revenues have a positive impact on income distribution, although not as much as social benefits. as a conclusion expected in this country group, interest expenditure is a variable effecting positively of the gini-net. in this study, it has been found that subsidies have an decreasing effect in income inequality, which had not been analyzed in the previous studies. the study is in parallel with the study of cevik and correa-caro (2015) in that tax revenues have an improving impact on income distribution in developing countries with regards to both gini-diff and gini-net. furthermore, social security payments also create a diminishing impact on inequalities. it has been noted that transfers, interest expenditures and subsidies, which fall into the expenditure side of the finance policy in developing countries, do not have a significant explanatory power. this conclusion is consistent with the literature arguing that the re-distributional effect of social transfers is limited in developing countries (joumard and pisu, 2012; oecd, 2012; martinez-vazquez et al., 2012). on the other hand, this aspect suggests that other factors are effective in explaining income distribution inequality in the related country group, the progressive tax rates coming in the first place. these factors could not be analyzed in the study, due to restricted data. further studies that take into consideration other data resources as well as different estimation techniques possibly extend the scope and results of current study. besides, the results indicate that the redistributive impact of the state is more effective in developed countries compared to developing countries in terms of growth, social benefits and interest expense. with regards to macroeconomic factors, inflation is an effective factor in both kinds of gini coefficients in developed countries. similarly, economic growth and unemployment have a positive effect on income distribution in this country group. on the other hand, as to developing countries, economic growth is an important factor increasing inequalities, which points out that there is necessity to design a policy that considers income distribution in developing countries. the results of the study suggest that the quantity and quality of the social benefits, such as the implementation of benefits that target low income groups, is one of the most effective ways of reducing inequality in developing countries. references atkinson, a.b. (1997), bringing income distribution in from the cold. the economic journal, 107, 297-321. table 3: results of the estimation variables coefficients and test statistics developed group developing group gini_diff gini_net gini_diff gini_net independent variables growth 0.028 (0.03) −0.001 (0.93) 0.007 (0.41) 0.030 (0.07) inf −0.043 (0.04) −0.026 (0.05) −0.001 (0.50) 0.001 (0.44) unemp 0.089 (0.00) 0.031 (0.12) 0.036 (0.18) −0.029 (0.55) tax 0.373 (0.08) −0.136 (0.32) 0.360 (0.05) −0.962 (0.09) cont −0.018 (0.81) −0.036 (0.44) −0.029 (0.23) −0.115 (0.01) int −0.405 (0.07) −0.256 (0.07) −0.010 (0.86) 0.006 (0.95) sub −0.217 (0.14) −0.306 (0.00) 0.011 (0.46) −0.037 (0.20) benef 2.435 (0.00) −0.195 (0.60) −0.244 (0.17) 0.131 (0.59) diagnostics hausman 18.746 (0.02) 12.939 (0.11) 26.891 (0.00) 14.292 (0.07) lm1/fgroup 2267.327 (0.00) 3965.898 (0.00) 58.122 (0.00) 1927.332 (0.00) lm2/ftime 1.480 (0.22) 6.613 (0.00) 2.826 (0.00) 4.813 (0.02) bph 28.49 (0.00) 9.46 (0.00) 44.15 (0.00) 0.17 (0.67) far 77.262 (0.00) 301.376 (0.00) 19.078 (0.00) 196.645 (0.00) vif 1.26 1.26 1.16 1.16 numbers in parentheses are p values. vif: variance inflation factor balseven and tugcu: analyzing the effects of fiscal policy on income distribution: a comparison between developed and developing countries international journal of economics and financial issues | vol 7 • issue 2 • 2017 383 bai, j., kao, c. 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[last accessed on 2017 feb 29]. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1299-1303. international journal of economics and financial issues | vol 6 • issue 4 • 2016 1299 the role of domestic private investment in promoting per capita income convergence amongst association of southeast asian nations-5 economies sallahuddin hassan1*, musa murtala2 1school of economics, finance and banking, universiti utara malaysia, malaysia, 2department of economics, usmanu danfodiyo university, sokoto, nigeria. *email: din636@uum.edu.my abstract using data spanning 1980-2014, this study investigates the phenomena of per capita income convergence across a panel of association of southeast asian nations-5 (asean-5) economies. the study also delves on the role of domestic private investment in facilitating per capita income convergence amongst the economies. employing seemingly unrelated regression augmented dickey-fuller test to investigate per capita income convergence of the countries to the group average, it was observed that, as opposed to malaysia and singapore, economies of indonesia, philippines and thailand tend convergence to the group average. on the impact of gross domestic investment (gdi) on per capita income convergence, results from system generalized method of moments indicate that gross domestic product gap ratio between a pair of economies tend to diminish with a reduction in the gdi gap ratio between the economies. keywords: convergence, domestic capital formation, seemingly unrelated regression augmented dickey-fuller, generalized method of moments, asean-5 jel classifications: e31, e52, e58 1. introduction one of the major implications of neoclassical growth theory is that relatively poor economies, with low initial per capita, tend to grow faster than relatively richer ones to a point where convergence in per capita income across world economies would be achieved. on the whole, the economic convergence proposition rests upon two assumptions: diminishing marginal return on physical capital and technological gap (khan and kumar, 1993). one of the assumptions of neoclassical growth model of solow (1956) is that relatively poor economies have low capital to labour ratios compared to the richer ones. as a result, capital investment in such economies with low capital-labour ratios is expected generate higher returns on capital than in the relatively richer economies. furthermore, in search for higher returns on investments, international capital flows from economies with relative capital abundance to economies where relative capital scarcity exists. consequently, poor economies would grow faster than the richer ones. investment is very central the idea convergence. this is the case because the rate of return on investment is an important determinant of catch-up among economies. therefore, the high the volume of investment in a low-performing economy, the higher the chances that the economy would do better in terms of catch-up. the second basis for income convergence has to do with technology transmission. richer economies have high stock of technology relative to the poor ones and as a result technology is transferred from richer economies to the poor ones. however, the rate of technology absorption of a country is a positive function of technology gap between the economy and world technology stock. hence, relatively poor economies would growth faster than the richer ones. recent decades have witnessed proliferation of studies aimed at testing the validity of convergence hypothesis as well as exploring on various determinants of convergence. islam (2003) provides a comprehensive survey of convergence literature. by and large, hassan and murtala: the role of domestic private investment in promoting per capita income convergence amongst association of southeast asian nations-5 economies international journal of economics and financial issues | vol 6 • issue 4 • 20161300 it can be said that results emanating from cross-section and panel data studies are supportive of the convergence hypothesis. prominent among cross-section based studies include: kormendi and meguire (1985), baumol (1986), grier and tullock (1989), barro and sala-i-martin (1992) and rodríguez-pose et al. (2012). on the other hand, knight et al. (1993), islam (1995), mccoskey (2002), weeks and yao (2003) and lei and tam (2010) are among the famous studies that used panel data. in contrast to cross-section and panel data related studies, time-series based studies, such as carlino and mills (1993), aubyn (1999), cellini and scorcu (2000) and habibullah et al. (2012), reported more conflicting findings. however, despite such efforts, there appears to be an apparent neglect on investigating the role domestic investment in determining per capita income convergence in general and particularly association of southeast asian nations-5 (asean-5) economies. therefore, this study seeks to examine the role of domestic investment in achieving per capita income convergence amongst the asean-5 countries. the paper further delves on the performance of individual economies in terms of achieving convergence the group average. in addition to conventional unit root testing procedures, the paper utilized an alternative approach based on seemingly unrelated regression augmented dickey-fuller (suradf). asean-5 comprises of: indonesia, malaysia, philippines, singapore and thailand. the economies are pioneer member of asean. present membership composition of the association is made up of 10 economies, the additional ones being brunei, cambodia, lao dpr, myanmar and vietnam. asean-5 economies are considered suitable sample for the fact that the economies for a couple of reasons. the countries are the pioneer members of the association, and as a result forming a better sample to explore the extent to which the association achieve its first objective of accelerating “the economic growth, social progress and cultural development in the region through joint endeavours ….” given the fact that one of the cardinal objectives of establishing the group has to with achieving economic growth, and by extension economic convergence, investment is required. to provide some insight on economic performance amongst asean-5 countries, the rankings of 10 year average per capita gross domestic product (gdp) of the countries over the period 1960-2014 are presented in table 1. for the entire period under review, singapore maintained the lead in terms of average annual per capita gdp. the economy has not been overtaken throughout the period. as for the malaysian economy, it was also observed that the economy maintained consistent performance, ranking second for the whole sample period. philippines on the other hand ranked third, next to malaysia, for the decades 1960-1969 and 1970-1979 before being overtaken to rank forth for the subsequent decade – 1980-1989 – by the thailand economy. prior to overtaking philippines in 1980-1989 to rank third for the rest of period under review, the thailand economy ranked forth for the decades 1960-1969 and 1970-1979. finally, for the first three decades reviewed (1960-1969, 1970-1979 and 1980-1989) indonesia ranked fifth and forth for the last three decades. the ranking provided above may not be unrelated to the capital stock available in each economy and rate of return on investment. furthermore, figure 1 shows plots for the standard deviation, as a measure of convergence, for both per capita income and gross domestic fixed capital formation over the period under review for the asean-5. as can be observed, both measures depicts similar pattern, except for the period 1998-2002, when the convergence in gross domestic capital formation increased as shown by fall in the standard deviation. the rest of the paper is structured into three sections. section two hosts methodology. section three contains empirical results. finally, section four provides policy implications and conclusion. 2. methodology 2.1. data data covering the period 1980-2014 on the variables of interest were obtained from the world bank. our choice of timeframe for the study was mainly influenced by data availability. in order to remove the inherent cyclical effect present in most macroeconomic time series data, we follow the common practice of averaging data points over 5 year non-overlapping periods. thus, arriving at seven observations per variable for each panel member. 2.2. empirical model in the standard literature of economic convergence, gdp deviations are calculated using three alternatives: deviation of individual economies from their group average; difference between the gdp of a particular country and that of a chosen reference economy; and pair-wise output differences of all possible pairs for a given sample of economies. figure 1: convergence in per capita gross domestic product and gross fixed capital formation, 1980-2014 table 1: real gdp per capita ranking asean-5 economies country 1960-69 1970-79 1980-89 1990-99 2000-09 2010-14 indonesia 5 5 5 4 4 4 malaysia 2 2 2 2 2 2 philippines 3 3 4 5 5 5 singapore 1 1 1 1 1 1 thailand 4 4 3 3 3 3 gdp: gross domestic product, asean-5: association of southeast asian nations-5 hassan and murtala: the role of domestic private investment in promoting per capita income convergence amongst association of southeast asian nations-5 economies international journal of economics and financial issues | vol 6 • issue 4 • 2016 1301 following ben-david (1993) and ben-david and bohara (1997), for a sample of n economies with annual per capita gdp given by yit and its average as y̅t, convergence or divergence of incomes can be described by an estimation of equation 1. yi,t−y̅t=φ(yi,t-1−y̅t-1)+ϵi,t, (1) if φ<1, it shows evidence of per capita income convergence. letting zit=yit−y̅it and zi,t−1=yi,t-1−y̅t-1, equation 1 can be written as: zit=φzi,t−1 (2) furthermore, equation 2, according to nelson and plosser (1982), can be presented in an adf framework as: z z z eit i i t j p i j i t j i t= + ∑ ∆ +− = −φ δ, , , ,1 1 (3) therefore, testing the hypothesis that φ<1 narrows down to a unit root test using adf approach. in this study, suradf procedure is employed to test the convergence hypothesis using equation 3. suradf was proposed in breuer et al. (2001; 2002). the approach entails performing adf unit root test within the framework of sur. the method offers a number of advantages over single equation adf and other traditional panel data unit root testing procedure. the main disadvantage associated with suradf method is the lack of standard distribution. simulations using the underlying dataset have to be carried out in the course of using the method. critical values for the suradf test were generated by simulation using 10,000 replications using the underlying dataset. two alternatives are commonly employed in testing the hypothesis that φ<1 in economic convergence literature: one, employing the traditional time-series based single equation adf test. two, pooling data to perform a panel data based unit root test, as ones due to levin et al. (2002) and im et al. (2003). however, both single equation adf test and traditional panel data unit root testing procedures suffer some drawbacks. at least within the context of testing the convergence hypothesis across a sample of economies located within a given region, conclusions based single equation adf may be erroneous. this is the case because such economies, as the case of asean-5, are very much unlikely to be independent. as noted in ben-david and bohara (1997), in such instances, the error covariance structure of ϵit is not a diagonal one. this by implication implies that shocks transmit across sampled countries and thus results based on single equation adf test can be inaccurate. as for the traditional panel data based unit root test procedures, rejecting the null hypothesis that a given series does not contain a unit root does not mean that the series are independently stationary for each of the panel members. in other words, traditional panel unit root testing methods cannot be used to detect the mix of i(0) and i(1) in a panel setting (breuer et al., 2001). taking into account these issues, we resort to suradf method to test the convergence hypothesis for the asean-5 economies. given the assumption that marginal return on investment, and by extension economic growth, is a negative function of capital-labour ratio in a given economy, it is logical to believe that as the capitallabour ratio of two economies converge; the growth rate gap between the economies diminishes. it is against this background that this study hypothesised that for any pair of countries, gdp gap ratio is a positive function of domestic capital formation gap ratio as depicted by equation 4. pgdprijt=pgdirijt+gfcerijt+topnrijt+ϵijt (4) where, pgdpijt=|pgdpit−pgdpjt|/(pgdpit+pgdpjt), gdirijt=|pgdiit−pgdijt|/(pgdiit+pgdijt), gfceijt=gfceit+gfcejt/2, topnijt=topnit+topnjt/2, εit is the error term and subscripts i, j and t account for data points for countries i and j in year t. the variables used in this study to estimate equation 4 are gdp per capita (pgdp), gross domestic investment (gdi), government final gross consumption expenditure (gfce) and trade openness (topn). with the exception of topn, which is measured as a total trade share of gdp, all other variables are measured in constant usd. following choi (2004; 2009), this study pooled series gap pairs for 10 possible pairs of countries in estimating the hypothesized relationship.1 equation 4 was estimated using model 1, model 2 and model 3. model 1 estimates the relationship between pgdpr and gfcf alone. model 2 estimates the relationship between the variables of interest, controlling for topn. finally, in model 3 we control for both gfce and topn. generalized method of moments (gmm) proposed in blundell and bond (1998) was used in estimating the relationship. parameter estimates using system-gmm are more consistent when handling data with shorter time span. 3. empirical results 3.1. unit root test table 2 shows suradf test results. the test was performed on the deviation series (yit−y̅t) for each economy. for comparison purposes, we perform both adf and suradf tests on the series. as the table shows, the economies of indonesia, philippines and thailand show evidence of convergence to the group average over the period 1960-2014. however in malaysia and singapore 1 the pairs are: indonesia-malaysia, indonesia-philippines, indonesiasingapore, indonesia-thailand, malaysia-philippines, malaysia-singapore, malaysia-thailand, philippines-singapore, philippines-thailand and singapore-thailand. hassan and murtala: the role of domestic private investment in promoting per capita income convergence amongst association of southeast asian nations-5 economies international journal of economics and financial issues | vol 6 • issue 4 • 20161302 the null hypothesis of no convergence cannot be rejected over the sample period. 3.2. system gmm estimation table 3 contains estimation results of model 1, model 2 and model 3. results for model 1 show a positive relationship between the gap ratios of real pgdp and that of real gdi per capita. the relationship is statistically significant at 10% level of significance. according to the results, on the average, 1% increases in the level of real gdi gap ratio between two economies leads to a 0.17% increases in the gdp gap ratio amongst the asean-5 economies. by controlling for topn in model 2, the estimated parameter for gdi increases to 0.34. this suggests that the convergence is stronger after controlling for the average topn for each pair of economies. the relationship is also statistically significant at 5% level of significance. model 3 that controls for the government final consumption expenditure and topn also indicate that lower gdp gap ratios are associated with low gdp gap ratio amongst the asean-5 countries. on the average, a 1% decreases in the gdi gap ratio tends to lower real gdp ratio by 0.36%. the relationship is also statistically significant at 5%. 4. conclusion and policy implications findings from the study show a positive link between gdi gap ratio and real gdp gap ratio (convergence). this implies that gdi plays a significant role in facilitating per capita income convergence across asean-5. in other words, as two economies become similar in terms of gdi, the gdp gap ratio between them shrinks. in line with this finding, it is recommended that governments in asean-5 should strengthen the existing investment promotion policies and create new incentives (both tax and non-tax) policies capable of enhancing domestic private investment in order to facilitate convergence across the economies. references aubyn, m.s. (1999), convergence across industrialised countries (1890–1989): new results using time series methods. empirical economics, 24(1), 23-44. barro, r.j., sala-i-martin, x.x. (1992), convergence. journal of political economy, 100(2), 223-251. baumol, w.j. (1986), productivity growth, convergence, and welfare: what the long-run data show. the american economic review, 76(5), 1072-1085. ben-david, d. (1993), equalizing exchange: trade liberalization and income convergence. the quarterly journal of economics, 108(3), 653-679. ben-david, d., bohara, a.k. (1997), evidence on the contribution of trade reform towards international income equalization. review of international economics, 5(2), 246-255. blundell, r., bond, s. (1998), initial conditions and moment restrictions in dynamic panel data models. journal of econometrics, 87(1), 115-143. breuer, j.b., mcnown, r., wallace, m. (2002), series-specific unit root tests with panel data. oxford bulletin of economics and statistics, 64(5), 527-546. breuer, j.b., mcnown, r., wallace, m.s. (2001), misleading inferences from panel unit-root tests with an illustration from purchasing power parity. review of international economics, 9(3), 482-493. carlino, g.a., mills, l.o. (1993), are us regional incomes converging? a time series analysis. journal of monetary economics, 32(2), 335-346. cellini, r., scorcu, a.e. (2000), segmented stochastic convergence across the g-7 countries. empirical economics, 25(3), 463-474. choi, c. (2004), foreign direct investment and income convergence. applied economics, 36(10), 1045-1049. choi, c. (2009), does bilateral trade lead to income convergence? panel evidence. journal of economic development, 34(1), 71-79. grier, k.b., tullock, g. (1989), an empirical analysis of cross-national economic growth, 1951–1980. journal of monetary economics, 24(2), 259-276. habibullah, m.s., dayang-affizzah, a.m., puah, c.h. (2012), regional income disparities in malaysia: a stochastic convergence analysis. malaysian journal of society and space, 8(5), 100-111. im, k.s., pesaran, m.h., shin, y. (2003), testing for unit roots in heterogeneous panels. journal of econometrics, 115(1), 53-74. islam, n. (1995), growth empirics: a panel data approach. the quarterly journal of economics, 110(4), 1127-1170. islam, n. (2003), what have we learnt from the convergence debate? journal of economic surveys, 17(3), 309-362. khan, m.s., kumar, m.s. (1993), public and private investment and the convergence of per capita incomes in developing countries, imf working paper no, 93/51. knight, m., loayza, n., villanueva, d. (1993), testing the neoclassical theory of economic growth: a panel data approach. staff papersinternational monetary fund, 40(3), 512-541. kormendi, r.c., meguire, p.g. (1985), macroeconomic determinants of growth: cross-country evidence. journal of monetary economics, 16(2), 141-163. lei, c.k., tam, p.s. (2010), a panel data approach to the income convergence among mainland china, hong kong and macao. table 2: unite root test results country t-statistic suradf critical values adf suradf 0.01 0.05 0.10 indonesia −4.356 [1]* −3.391[1]* −2.706 −1.932 −1.498 malaysia −2.232 [1] −1.075[1] −2.935 −2.154 −1.724 philippines −0.358 [1] −3.477[1]* −2.796 −2.027 −1.605 singapore −0.890 [1] −1.560[1] −2.903 −2.118 −1.691 thailand −2.316 [1] −1.831[1]** −2.912 −2.197 −1.786 * and ** indicate rejection of the null hypothesis that real per capita gdp of a particular economy is not converging to the group average at 5% and 10% levels of significance, respectively. numbers in brackets represent the lags included to ensure that serial correlation is removed. the critical values for adf test statistic are: −4.143, for 1% level of significance; −3.497, for 5% level of significance; and−3.178, for 10% level of significance. adf test was carried out including both intercept and trend. critical values for suradf are generated by monte carlo simulation using 10,000 replications based on the underlying dataset. gdp: gross domestic product, adf: augmented dickey-fuller, suradf: seemingly unrelated regression augmented dickey-fuller table 3: system gmm estimates on the relationship between per capita income convergence and gross domestic investment regressors model 1 model 2 model 3 lgdirijt 0.174 [0.090]** 0.341 [0.099]* 0.360 [0.103]* lopnijt 0.031 [0.005]* 0.033 [0.010]* lgfceijt 0.685 [0.420] constant −10.792 [2.240]* −16.2397 [4.452]* −28.606 [8.636]* * and ** indicates that a parameter estimate is statically significant at 5% and 10% levels of significance, respectively. numbers in brackets are standard errors. gmm: generalized method of moments hassan and murtala: the role of domestic private investment in promoting per capita income convergence amongst association of southeast asian nations-5 economies international journal of economics and financial issues | vol 6 • issue 4 • 2016 1303 journal of the asia pacific economy, 15(4), 420-435. levin, a., lin, c.f., chu, c.s.j. (2002), unit root tests in panel data: asymptotic and finite-sample properties. journal of econometrics, 108(1), 1-24. mccoskey, s.k. (2002), convergence in sub-saharan africa: a nonstationary panel data approach. applied economics, 34(7), 819-829. nelson, c.r., plosser, c.r. (1982), trends and random walks in macroeconomic time series: some evidence and implications. journal of monetary economics, 10(2), 139-162. rodríguez-pose, a., psycharis, y., tselios, v. (2012), public investment and regional growth and convergence: evidence from greece. papers in regional science, 91(3), 543-568. solow, r.m. (1956), a contribution to the theory of economic growth. the quarterly journal of economics, 70(1), 65-94. weeks, m., yao, j.y. (2003), provincial conditional income convergence in china, 1953–1997: a panel data approach. econometric reviews, 22(1), 59-77. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(4), 172-176. international journal of economics and financial issues | vol 8 • issue 4 • 2018172 influence of audit quality, pattern of loans concentration and company size to banking loans (agency problem of creditor – debtor at manufacture company in indonesia) ria1*, muhammad nuryatno2 1,2doctoral program of economy – trisakti university, indonesia, 1lecturer of universitas nasional, indonesia. *email: riasakti321@gmail.com abstract this study aims to analyze the influence of audit quality, loan concentration pattern, and company size to large of loans. this research uses quantitative method with regression analysis model by stratified random sampling based on subsector strata in manufacturing company that go public in indonesia stock exchange. this study shows that there is a positive and significant correlation between audit qualities to the loans, there is a negative and significant correlation between loan concentration patterns to the loans, there is a positive and significant correlation between company sizes on the loans and roa, current ratio and age of the company can be a control variable to the loans keywords: audit quality, loan concentration pattern, company size, loans jel classifications: m4, m41, m42 1. introduction along with the era of globalization where is increasingly tight economic competition, most companies require external funding in addition to the main internal funding. if the company depends only on limited internal funding it will be difficult for the company to face the existing competition (expanding, funding research and development, etc.). the tight competition and operational activities that must be financed compel the company to use external funding. debt is mostly chosen by most companies as an external source of funding, because the debt is not permanent and the cost is relatively cheaper when compared to the cost of issuing new shares that require the cost of share capital. meanwhile, according to roberts and sufi (2009), on the one hand, funding affects real economic activity due to the limitation of creditors on corporate investment that aims to suppress managerial behavior that will affect the quality of a company’s financial statements. while it is known to maintain the quality of financial statements of a company, high quality audit of course is needed. according to armstrong et al. (2010), before providing loans for capital, lenders typically require companies to provide audited financial statements, to assess the company’s ability to pay its debts. it is conceivable that the company’s accounting statements present improper asset values, unclear performance measures, or hard-to-use performance measures to forecast future cash flows or risks, lenders will find it difficult to assess the quality of corporate credit, have difficulty in accessing debt markets with cost effective. the statement is in line with the results of research conducted by beatty et al. (2009) which states that firms with low quality financial statements are more likely to rent than get financing from debt. high quality audit proved to improve the quality of financial statements (christiani and nugrahanti, 2014; subagyo and olivia, 2012; linata and sugiarto, 2012). from a series of studies, reflected that the quality of a company’s financial statements is strongly influenced by the quality of audits conducted by external auditors. in addition to being an important stakeholder, lenders can use highquality external audits to reduce credit risk. if credit risk can be minimized with high audit quality, then the use of collateral that also serves to reduce risk is likely to be reduced. the statement is also supported by research conducted by yang (2014) which ria and nuryatno: influence of audit quality, pattern of loans concentration and company size to banking loans (agency problem of creditor – debtor at at manufacture company in indonesia) international journal of economics and financial issues | vol 8 • issue 4 • 2018 173 shows that there is a negative relationship between audit quality and the use of the guarantee, this means that the higher the quality of audits carried out then the use of guarantees applied to the company will be reduced and vice versa. in this study other than audit quality, the researcher also tried to use variable of loan concentration pattern, and company size in bank loan decision based on the obligation of go public company to regularly convey audited financial information to the public, including banking party. the bank relies on the reporting and auditing system to provide information on the use of the credit it provides to the accepting company. it also adds control variables to complement the causal relationship between variables and thus the empirical model of the research becomes more complete and better (hartono, 2010). the results of the analysis will also be better able to explain the phenomenon optimally and have higher statistical strength (murniati et al., 2013). return on assets (roa) is useful to measure the profitability of the company for the use of its assets. while the current ratio (ratio) functioned to measure the ability of the company to pay off the short-term debt by using current assets owned. in addition, also added control variables in the form of company’s age to reflect the duration of relationship between banks and companies that play a role in solving the problem of information asymmetry and reduce the use of collateral. this study re-examined the effect of variables that have been described previously by using the context of companies listed on the bei. based on the background that has been put forward, the authors are interested to examine the “influence of audit quality, loan concentration pattern, and company size on loans”. based on the background research, then the formulation of the problem in this study are as follow: 1. does the audit quality positively affect the loans? 2. does the loan concentration pattern positively affect the loans? 3. does the size of the company have a positively effect on the loans? 4. what is roa, current ratio and company’s age can be a control variable in the relationship of quality audit role roles, loan concentration patterns, and company size to the loans? 2. literature reviews and hypothesis grand theory in this research is “agency theory” where creditors act as principal, while the lending company as agent. the agency relationship between the bank and the recipient company can lead to a condition of information imbalance (asymmetric information) because the receiving company has more information about the utilization of the loan than the lending bank. jensen and meckling (1976) explain that the use of debt through a loan will divert some agency costs from the agency’s (agency cost of equity) to the creditor (agency cost of debt). the researcher’s consideration of the possible role of audit quality, loan concentration pattern, and company size in bank lending decisions is based on the obligation of a public company to regularly deliver audited financial information to the public, including banks. the bank relies on the reporting and auditing system to provide information on the use of the credit it provides to the accepting company. the principal and agent relationship between the bank and the company that receives the loan is the relationship between the commercial lender that provides the loan capital and the borrower obtains the investment return from the loaned capital (jensen and meckling, 1976). increased information about the borrower will lower the risk for the lender and assist the lender in pricing the loan (sengupta, 1998). this study considers the inclusion of the relevant control variables involved in this study: roa as the roa for the firm. current ratio is measured by the ratio of current assets to current liabilities and years since the company established by the natural logarithm of the company’s age. based on literature review, the hypothesis that can be proposed in this study are as follows: 1. quality audits in a company are positively associated with large bank loans. 2. pattern concentration loans in a company are positively associated with large bank loans. 3. the size of a company is positively related to the size of the banking loan. 4. roa, current ratio and age of the company can be a control variable in the relationship of the role of audit quality, loan concentration pattern, and the size of the company to the loan 3. research methods this research was conducted on companies listed on the indonesian stock exchange (bei) by using quantitative data and secondary data sources, such as the financial statements of companies listed on the stock exchange in 2010-2014 accessed through www.idx. co.id and data in the indonesian capital market directory (icmd). based on conceptual framework, structural model formulation which is analyzed to test hypothesis in this research is as follows loans = b0 + b1 aud_qual + b2 cbp + b3 size + b4 age + b5 current + b6 roa + e1 loansit = the amount of loan for firm i in year t, measured by the natural logarithm of the amount of debt of the company bank. auditit = audit quality for company i in year t, using dummy variable: given number 1 if kap is included into kap big four or its affiliates and number 0 for kap not included in kap big four or its affiliates. cbpit = the concentrated borrowing patterns for firm i in year t, measured negatively by the number of banks that are the provider of corporate credit. sizet = company size for firm i in year t, measured by natural logarithm of total company asset. ria and nuryatno: influence of audit quality, pattern of loans concentration and company size to banking loans (agency problem of creditor – debtor at at manufacture company in indonesia) international journal of economics and financial issues | vol 8 • issue 4 • 2018174 roait = roa for firm i in year t, measured by comparison of net income to average total assets. currentit = current ratio for firm i in year t, measured by the ratio of current assets to current liabilities. ageit = long years since company was established for company i in year t, measured by natural logarithm of company age. e = error. the populations of this research are listed in indonesia stock exchange in 2010-2014. companies with incomplete data, such as the unavailability of adequate data in the financial statements relating to the proxy used and the financial statements presented in units of the us dollar ($) are not included in the sample. in addition, firms with no financial statements available and those whose book periods differed were not included in the sample.the samples are companies manufacturing sector in the indonesia stock exchange. data collection methods used in this study was the observation of data obtained through the collection of data by observing, recording and studying the descriptions descriptions of books books, scientific papers in the form of journals, theses and documents documents contained in the icmd. data analysis techniques used to solve problems in this research using regression analysis. this analysis is used to find and get a picture of the effect of audit quality, loan concentration pattern, and company size on loans in the manufacturing sector companies in the indonesian stock exchange with spss (statistical product and service solutions). 4. results and discussion 4.1 results regression analysis used in this study is multiple linear regressions analysis. regression analysis results can be seen in the following table 1: 4.1.1. testing of fit model fit model testing is done by looking at the significance value f in the following table 1: in the table 1, it is known that the fit model test results with sig value. 0.031 <0.05 which means that independent variables are can be used to predict the dependent variable. 4.1.2. determination coefficient test testing the coefficient of determination is done by looking at the value of adjusted r square in the following table 2: according to the table 2, it can be seen that the test results adjusted r2 is 0.209, meaning independent variables affect the dependent variable of 20.9% while the rest of 79.1% influenced by other variables. 4.1.3. hypothesis testing after all assumptions are met, then the next is to test the hypothesis to determine the effect of independent variables to the dependent variable by using the t test with the following results: from table 3, it is known that t significance value for audit quality variable is 0.006 <0.05 so that mean first hypothesis in this research accepted. this means that audit quality has a significant effect on the loan. from table 3, it is known that the significance value t for the loan concentration pattern variable is 0.019 <0.05 so that the second hypothesis in this research is accepted. so there is a negative and significant influence between the patterns of loan concentration to the loan. this means that the lower the concentration pattern of the loan will increase the loan, and vice versa from table 3, it is known that t significance value for firm size variable is 0,016 <0.05 so that mean fourth hypothesis in this research accepted. this means that the size of the company affect the loan. table 1: results of fit model test model sum of squares df mean square f sig. 1 regression 72.205 6 12.034 2.020 0.031a residual 1674.019 281 5.957 total 1746.224 287 table 2: result of determination coefficient test model r r2 adjusted r2 1 0.203a 0.413 0.209 table 3: result of t‑test model unstandardized coefficients standardized coefficients t sig. b std. error beta 1 (constant) 7.093 3.075 2.307 0.022 audit 0.569 0.301 0.112 1.891 0.006 cbp −0.095 0.051 −0.111 −1.874 0.019 size 0.141 0.100 0.083 1.410 0.016 roa 1.007 1.431 0.042 0.704 0.048 current −0.041 0.133 −0.018 −0.310 0.036 lnage 0.214 0.290 0.043 0.739 0.019 ria and nuryatno: influence of audit quality, pattern of loans concentration and company size to banking loans (agency problem of creditor – debtor at at manufacture company in indonesia) international journal of economics and financial issues | vol 8 • issue 4 • 2018 175 based on the test results, note that the significance value of t for the roa variable is 0.048 <0.05 so that means roa effect on the loan. for current ratio variable is equal to 0.036 <0.05 so that mean current ratio influence to loan. so also variable age of company is equal to 0.019 <0.05 so that mean age of company influence to loan. 4.2 discussion 4.2.1. quality audit to loans based on the first hypothesis testing, it can be seen that the significance value t for the audit quality variable is below 0.05 so it means the first hypothesis in this study is accepted. thus, audit quality has a positive relationship with the loan. audit quality is a major contributor to financial stability and serves to rebuild market confidence and confidence. eskandari et al. (2014) in eskandari et al. (2014) stated that the auditor is legally entrusted to perform the audit under applicable rules and performs an important role in providing an opinion on whether a financial report is presented correctly and reasonably. the quality of the audit is related to the opinion received by the company from its auditor. audit opinion is given to the auditor by not considering the company’s financial condition, whether it is in profit or loss condition. in other words, the company’s financial circumstances do not affect the opinions given by the auditor. although the auditor provides unqualified opinion, the company may be in a state of losing money. this means that unqualified opinion can guarantee the ability of the company to repay its loan in relation to the loans imposed on the company. this shows that audit quality has an effect on loan. so even if big companies can provide large loans, it can guarantee that they will be able to repay the loan properly in the future. therefore, lenders pay attention to the quality of the audit in providing loans and the proportion of collateral. 4.2.2. loan concentration patterns to loans based on the results of the second hypothesis testing, it is known that there is a negative and significant relationship between the pattern of loan concentration to the loan. the result can be seen from the significance value t for the loan concentration pattern variable under 0.05 with the negative beta value, so that means the second hypothesis in this study is accepted. a company loan can be concentrated on one lender with the intent to reduce overall oversight costs, increase control of the lender, and strengthen the relationship between the lender and the company as the recipient of the loan. thus, concentrated loans can be attributed to lower credit costs. this indicates that the increase in loans is influenced by the pattern of lower loan concentration. in other words, the less (the more concentrated) the number of lenders of a company the less the proportion of collateral is given. decisions on the use of guarantees are influenced by moral hazard and adverse selection issues. while moral hazard and adverse selection issues can be reduced by the nature of the relationship between the lender and the borrower. 4.2.3. company size to loans based on the test results, it is known that the significance value t for the firm size variable is below 0.05 so that means the third hypothesis in this study is accepted. then the sizes of the company affect the loans. the reason for the acceptance of this hypothesis is that both large and small companies ensure that large firm sizes have large debts and small firms are weighed down by a small proportion of loans, which may be otherwise, depending on the performance of each company. this makes the size of the company affect the loan. company size is basically the grouping of companies into several groups, including large companies, medium and small. company scale is a measure used to reflect the size of the company based on the total assets of the company. so companies with small and large scale companies guarantee that the insurer will charge higher and lower loans, although there are other factors that affect it such as the quality of the audit or the proportion to the other party. for the control variables are roa, current ratio and company’s age, also affect the loans. thus it can be said that the roa, the current ratio and the age of the company can be a control variable to the loans. to target the company’s performance, operational and solvency risks, the added roa and current ratio as control variables. in addition, years from the time the company was established (natural logarithms of company age) were also included in control variables to control relationships between banks and firms, as the results of previous studies indicate that the relationship between banks and firms can solve the problem of information asymmetry and reduce the use of collateral. likewise the results of this study stated that roa, current ratio and age of the company as a control variable affect the loan because in providing guarantee, the lender pay attention to the ratio of profitability, liquidity ratio and age of the company, but also they pay attention to the pattern of loans concentration. 5. conclusion based on the principal problems and research results can be formulated the following conclusions: 1. there is a positive and significant correlation between audit qualities to the loans. 2. there is a negative and significant correlation between loan concentration patterns to the loans. 3. there is a positive and significant correlation between company sizes on the loans. 4. roa, current ratio and age of the company can be a control variable to the loans. referring to the research results and conclusions, here are some suggestions. 1. in research with similar topics in the future there can be added other variables related to the loan such as ownership structure or gcg, and add period of observation period. 2. for further research may use different proxies for firm size in addition to total assets, such as sales of the company. ria and nuryatno: influence of audit quality, pattern of loans concentration and company size to banking loans (agency problem of creditor – debtor at at manufacture company in indonesia) international journal of economics and financial issues | vol 8 • issue 4 • 2018176 references armstrong, c.s., wayne, r.g., weber, j.p. 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(2014), does high-quality auditing decrease the use of collateral? analysis from the perspective of lenders’ self-protection. china journal of accounting research, 7(3), 203-221. international journal of economics and financial issues vol. 1, no. 4, 2011, pp.145-152 issn: 2146-4138 www.econjournals.com inflation and financial sector correlation: the case of bangladesh abu n. m. wahid department of economics, tennessee state university, usa email: jda@tnstate.edu muhammad shahbaz comsats institute of information technology, lahore campus, lahore, pakistan email: shahbazmohd@live.com pervaz azim government college university faisalabad, pakistan email: dr_azim@hotmail.com abstract: this paper examines the impact of inflation on financial development in case of bangladesh for the period of 1985-2005. in doing so, ardl bounds testing approach and error correction method (ecm) have been employed. empirical findings reveal that high trends of inflation impede the performance of financial markets. gdp per capita promotes development of financial sector through its causal channels. keywords: financial sector, inflation, bangladesh, ardl approach jel classifications: d14, e31 1. introduction this paper deals with the correlation between inflation and financial development in case of bangladesh for the period of 1985-2005 in long run as well as in short run. economic theory reveals that developed financial sector mobilizes savings efficiently and reallocates the resources to productive projects and hence stimulates economic activities in the country. however, high rate of inflation worsens the efficiency of financial sector through financial market frictions and slows down the economic performance. inflation tends to induce volatility in equity returns as well as lowers the real return on savings. in inflationary periods, governments are inclined to impose additional tax burden on the financial sector to reduce their budget deficits (bencivenga and smith, 1993). it is observed that inflation impedes the performance of financial markets by reducing the level of investment in the economy. the link between inflation and financial development has not been studied for bangladesh. the main objective of present study is to investigate the association between inflation and financial development by employing autoregressive distributive lag model (ardl) framework utilizing time series annual data. 2. review of literature it is quite well-established that inflation impedes long run economic growth and distorts macroeconomic stability. de gregorio (1993), fischer (1993), barro (1998), bullard and keating (1995), clark (1997), bruno and easterly (1998), and fischer (2005) affirm that moderate levels of inflation offset the mundell-tobin effect, consequently having detrimental impact on economic growth. similarly, cooley and hansen (1989) and de gregorio (1993) conclude that high levels of inflation reduce the labor supply and hence economic growth. international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.145-152 146 inflation also adversely affects capital accumulation and investment and deteriorates income distribution (shahbaz et al. 2010). following goldsmith (1969), mckinnon (1973), king and levine (1993), levine and zervos (1998), beck et al. (2000), and beck and levine (2004), seem to suggest that financial development has a positive impact on long run economic growth. while bonfiglioli (2006), bittencourt (2007) and shahbaz and farid (2011) conclude that financial development seems to reduce either income inequality or poverty through physical capital formation and economic growth. boyd and champ (2003) find that inflation hurts economic growth through declining financial development, especially by damaging the operation of financial markets. demirguc and maksimovic (1998) report positive relationship between inflation and financial crisis empirically due to frictions in financial markets. according to mundell (1963) and tobin (1965), portfolio allocations are influenced by inflation due to low returns on capital, leading to improvements in investment activities. this situation spurs growth process in the economy. in the same way, english (1999) argues that higher rates of inflation compel the individuals to surrogate purchased transactions services for money balances that not only augment the supply of financial services and stimulate financial development as well. on the empirical surface, english (1999) provides empirical evidence and concludes that inflation has positive effect on financial development. in contrast, haslag and koo (1999), and boyd et al. (2001) conclude that high rates of inflation adversely affect financial development as predicted theoretically. a recent case study of brazil by bittencourt (2007, 2011) using time series and panel data concludes that high inflation has positive impact on financial development due to poor macroeconomic performance. in the case of zimbabwe, murombedzi (2008) reports that increased inflation damage the development of financial institutions through troubling channels. correlation in such case is found to be weak. the studies also find non-linear relationship between both variables and suggest a particular threshold i.e. 15 percent per year. conversely, khan et al. (2006) differ with previous threshold level by suggesting a new threshold point with the argument that the threshold level of inflation is about 3-6 percent and beyond this point, inflation has a strong adverse impact on the development of financial sector. whereas, boyd et al. (2001) consider that inflation has negative but minimal impact on financial development. naceur and ghazouani (2007) using gmm approach report that inflation deteriorates financial development and financial development increases as inflation exceeds threshold point. kim et al. (2010) investigate long-and-short runs effect of inflation on financial development using pooled mean group estimator developed by pesaran et al. (1999) for 87 countries over the period of 1965-2005. their results indicate that inflation has inverse impact on financial development in long run while positive effect in short span of time. 3. model and data due to its well-established advantage, [bowers and pierce (1975) and ehrlich], we specify a log-linear model for our problem as follows: ttttttt trssgdpinffdfd    lnlnlnlnln 6543121 (1) where tfd is financial development proxied by credit to private sector as share of gdp, tinf is for inflation, gdp per capita is indicated by tgdp , tss denotes social spending as share of gdp (education, health, and infrastructure expenditures), ttr trade as share of gdp (exports as share of gdp + imports as share of gdp) and t is residual term. the data on all the relevant variables have been collected from the world development indicators (wdi-2007, cd-rom). table-1 predicts that inflation is inversely but weakly linked with the development of financial sector, social spending, gdp per capita, and trade openness. financial development is associated positively and strongly with social spending, gdp per capita and trade openness. social spending is correlated negatively with inflation but positively with gdp per capita and openness of trade, and trade openness and gdp per capita are correlated positively. inflation and financial sector correlation: the case of bangladesh 147 table 1. descriptive statistics and correlation matrix variables tfdln tinf ttrln tssln tgdpln observations 21 21 21 21 21 mean 2.83041 1.6816 3.2628 1.0995 5.7769 median 2.8033 1.7917 3.3446 1.2089 5.7485 maximum 3.4679 2.3978 3.6109 1.4279 6.0698 minimum 2.0794 0.6931 2.8909 0.7608 5.5774 skewness 0.4111 0.5478 0.2357 0.2248 0.1556 kurtosis 0.0007 -0.6204 -0.1843 -0.0878 0.4058 jarque-bera 1.2716 1.7966 1.8922 1.7376 1.6644 probability 0.5295 0.4072 0.3882 0.4194 0.4350 tfdln 1.0000 tinf -0.3358 1.0000 ttrln 0.9307 -0.4880 1.0000 tssln 0.7786 -0.4505 0.8823 1.0000 tgdpln 0.9797 -0.2979 0.9104 0.7159 1.0000 4. methodological framework to analyse long run relationship between inflation and financial development, we did not focus on traditional cointegration approaches such as engle-granger (1987), johansen (1992) and johansen-juselius (1990) cointegration approaches. we used advanced approach to test whether long run relationship between the variables exists or not by applying autoregressive distributive lag model (ardl) bounds testing approach developed by pesaran et al. (2001)]. ardl bounds testing approach has numerous advantages. for instance, this approach can be applicable if running variables have ambiguous order of integration i.e. purely i(0), purely i(1) or i(0) / i(1) which is not acceptable in traditional approaches1. the ardl bounds testing approach is more suitable and provides better results for small sample size (haug, 2002). the short and long-run parameters are estimated simultaneously. the unrestricted error correction model is used for equation-1 as following: t t i t s i t r i t q i t p i ttttttt trssgdpinf fdtrssgdpinffdfd                 0 1 0 1 0 1 0 1 0 1654321 lnlnln lnlnlnlnlnln (2) where, difference is shown by  , s indicate long run coefficients and short run coefficients are represented by  ,,, and  . the hypothesis of no cointegration deals with 0: 65432  nh and 0: 65432  ah is an alternative hypothesis of cointegration. next step is to compare the calculated f-statistic with critical bounds generated by pesaran et al. (2001). there is no cointegration if calculated f-statistic is less than lower critical bound (lcb). if calculated f-statistic is more than upper critical bound (ucb) then hypothesis of cointegration is accepted. the decision about cointegration is inconclusive if value of f-statistic is between lower and upper critical bounds. the selected ardl model is used to estimate long run relationship between the variables. for short run behaviour of the variables, we use error correction version of ardl model as following: 1 the engle-granger (1987), johansen (1992) and johansen-juselius (1990) cointegration approaches require that variables should be integrated at unique level of integration. international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.145-152 148 tt n s st m r rt q k kt p j tt ecmltsslgdpinffd             1 0 5 0 4 0 3 0 121 lnln (3) the significance of an error correction term i.e. 1tecm shows deviations in regressed variable. these deviations are a function of both the levels of disequilibrium in the cointegration relationship as well as the deviations in the other regressors. the stability tests such as cumulative sum of recursive residuals (cusum) and cumulative sum of squares of recursive residuals (cusumsq) are also applied to test the goodness of fit for ardl model. 5. empirical results primarily adf unit root test is applied to test the order of integration of the variables and results are reported in table-2. the unit root analysis shows that the variables do not seem to be stationary at their level form. at 1st difference, all the variables are found to integrated at i(1). this implies that variables have same level of stationarity and we should apply ardl bounds testing approach to cointegration to test long run relationship between the variables. table 2. unit-root analysis adf at level adf at 1st difference variables intercept and trend prob values intercept and trend prob – values tfdln -3.0405 0.1476 -4.3839 0.0133 tinf -3.1687 0.1199 -4.8237 0.0063 ttrln -1.6065 0.7515 -3.4508 0.0778 tssln -2.6716 0.2575 -4.5713 0.0100 tgdpln -3.0492 0.1456 -3.9980 0.0288 the appropriate lag order of variables should be fixed before proceeding to the ardl bounds testing approach to cointegration (pesaran et al. 2001). the results reported in table-3 imply that lag order is 1 based on the minimum value of sbc. in such small sample data set, we cannot take lag more than 1. the appropriateness of lag order avoids the spuriousness of ardl bounds testing approach to cointegration results. the results of the ardl bounds testing approach are also shown in table-3 indicating that our estimated f-statistic is 25.265 exceeds upper critical bound (ucb) i.e. 11.65 at 1 percent level of significance. this implies that the hypothesis of cointegration may be accepted and confirm long run relationship between the variables. next step is to examine the marginal impacts of inflation, social spending, economic growth and trade openness on financial development. table 3. lag length selection order of lags lr pfe sbc f-test statistics 0 na 1.19e-09 -6.112267 nil 1 132.2365* 7.06e-13* -12.41004* 25.265* sensitivity analysis serial correlation lm, f = 0.4858 (0.6322) arch test = 1.7594 (0.2081) normality j-b value = 0.6572 (0.7199) heteroscedasticity test, f = 4.1972 (0.2092) ramsey reset test, f = 3.0480 (0.1233) note: * shows significant at 1% level of significance. inflation and financial sector correlation: the case of bangladesh 149 the ols regression results are reported in table-4. the lag of dependent variables is also included in model to test the impact of previous financial sector's policies on financial development. our empirical evidence reveals that lagged coefficient of financial development shows positive effect on financial development in current period at 1 percent significance level. this implies that improved financial sector policies in previous period will develop financial sector in current period in bangladesh. the relationship between inflation and financial development is negative and statistically significant. this confirms that inflation has deleterious effect on financial development and it is statistically significant at 5 percent level of significance but that is found to be minimal i.e. a 0.0264 percent financial development is eaten up by 1 percent increase in inflation. this shows that inflationary environment deteriorates financial development by lowering money supply and restricting financial resources for investment projects. furthermore, high inflation is linked with high opportunity cost of holding money that declines the efficiency of financial institutions and hence development of financial sector. table 4. long-run analysis dependent variable = tfdln variable coefficient t-statistic prob-values constant -6.1861 -6.3626 0.0000 1ln tfd 0.3360 3.7253 0.0023 tinf -0.0264 -2.1710 0.0476 tgdpln 1.4020 6.7822 0.0000 tssln 0.2541 4.9487 0.0002 ttrln -0.0713 -0.9254 0.3704 r-squared = 0.9966 adjusted r-squared = 0.9954 akaike info criterion = -4.223 schwarz criterion = -3.925 log likelihood = 48.238 f-statistic = 827.22 prob(f-statistic) = 0.00 durbin-watson stat = 2.240 the positive and statically significant relationship is found between economic growth and financial development at 1 percent level of significance. this implies that a rise in income per capita increases financial development i.e. there is 1.4 percent increase in financial development due to 1 percent increase in gdp per capita. the impact of social spending on financial development is positive and statistically significant at 1 percent level of significance. a 1 percent increase in social spending improves the development of financial sector by 0.2541 percent. finally and surprisingly, coefficient of trade pushes down the performance of financial intermediaries insignificantly. the short run results are shown in table-5 and we used error correction method to obtain short run behaviour of independent variables on development variable. the estimate of lagged ecm term identifies the speed of adjustment from short run towards long run equilibrium path. it is pointed out by bannerjee and newman (1998) that error correction term with negative sign and statistically significant at high level of significance further corroborates established long run relationship between the variables. our empirical exercise considers that the estimated value of coefficient of 1tecm is equalant to -0.9359 and it is statically significant at 5 percent significance level. this shows that any changes in short run towards long run is corrected by 93.59 percent per year in development of financial sector. international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.145-152 150 table 5. short run analysis dependent variable = tfdln variable coefficient t-statistic prob. value constant -0.0078 -0.4282 0.6776 1ln  tfd 0.4379 3.9943 0.0025 tgdpln 1.0802 1.8030 0.1015 1ln  tgdp 0.3971 0.6210 0.5485 tinf -0.0366 -3.6148 0.0047 tssln 0.0350 0.5373 0.6028 1ln  tss 0.1660 3.7759 0.0036 ttrln -0.0900 -0.7632 0.4630 1tecm -0.9359 -2.7574 0.0202 r-squared = 0.8441 adj-r-squared = 0.7194 akaike info criterion = -4.403 f-statistic = 6.771 prob(f-statistic) = 0.003 durbin-watson = 2.065 in this section, empirical results also provide evidence for short run, current value of financial development is also improved by its previous policies at 1 percent level of significance. income per capita spurs the financial development at 10 percent level of significance. inflation decreases the efficiency of financial sector over a short span of time. improved social spending increases the development of financial sector with lag impact. the effect of trade openness on financial development is genitive but statistically insignificant. the stability of ardl model is investigated by applying the cumulative sum (cusum) and cumulative sum of squares (cusumsq) test on the recursive residuals (see figure 1 and 2). figure 1. plot of cumulative sum of recursive residuals -10 -5 0 5 10 96 97 98 99 00 01 02 03 04 05 cusum 5% significance the straight lines represent critical bounds at 5% significance level. inflation and financial sector correlation: the case of bangladesh 151 figure 2. plot of cumulative sum of squares of recursive residuals -0.4 0.0 0.4 0.8 1.2 1.6 96 97 98 99 00 01 02 03 04 05 cusum of squares 5% significance the straight lines represent critical bounds at 5% significance level. 6. conclusions and policy implications the present study also confirms that inverse correlation between inflation and financial development exists in case of bangladesh. from the ardl bounds testing approach to cointegration, we report that inflation reduces the efficiency of financial intermediaries in the long-and-short runs. financial sector improves its performance through its previous policies and 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(1965), money and economic growth, econometrica, 33, 671-684. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(3), 1081-1091. international journal of economics and financial issues | vol 6 • issue 3 • 2016 1081 macroeconomic factors and the indian stock market: exploring long and short run relationships kiran kumar kotha1*, bhawna sahu2 1indian institute of management indore, india, 2indian institute of management indore, india. *email: kirankumar@iimidr.ac.in abstract the rapid growth of indian economy during the last two decades raises empirical questions regarding the fundamental connection between stock price and key macroeconomic indicators. this paper aims to examine long and short run relations between selected macroeconomic indicators and stock market returns with reference to india. this study employs monthly data from july 2001 to july 2015 since major stock market reforms viz., ban of badla system, introduction of rolling settlement and introduction of stock derivatives, were all implemented in july 2001. with the help of cointegration and error correction model (ecm), the study reveals the presence of long run relation between the bse sensex and select macroeconomic indicators viz., exchange rate, wholesale price index, t-bill rates and m3. keywords: macroeconomic indicators, stock returns, co-integration jel classification: g15 1. introduction there may be a strong intuitive appeal attached to the belief that relationships exist between macroeconomic fundamentals and equity returns, but we lack correspondingly strong empirical support that goes with it. macroeconomic variables can be understood as: variables reflecting general economic conditions, variables related to interest rate and monetary policy, variables concerning price level and variables involving international activities. general economic conditions include variables like industrial production index or unemployment rate. the variables concerning interest rate and monetary policy include interest rate, term spread, default spread, money supply, etc., variables focussing on price level may be general price level index or inflation rate. variables involving international activities are exchange rate or foreign direct investments (fdi), etc., studies have used different macroeconomic variables to examine which factors have the most critical impact upon stock returns. one of the notable multi factor models, as proposed by chen et al., (1986) used empirical evidence to extend other risk factors besides the notion of equity market risk premium as propagated by capital asset pricing model (capm). they used various macroeconomic shocks including, industrial production index, inflation, risk premium, default spread and term structure, as additional factors in the market model. there exists a huge volume of literature on how stock returns get influenced. much of the investigation between stock returns and economic forces is based on the presumption that macroeconomic indicators are highly influential in predicting stock returns and asset prices. one popular area of financial research is studies on the factors that affect stock returns. as per the basic standard stock valuation model, determinants of stock price are “expected cash flows” from the stock and “required rate of return” as per the riskiness of the stock. macroeconomic indicators affect a firm’s cash flows and also influences risk-adjusted discount rate. the required rate of return comprises of risk free rate along with the measure of asset’s risk. this nominal risk free rate depends upon real interest rate as well as expected inflation. risk free rate has an inverse relationship with stock prices. similar is the case with inflation. inflation depresses stock market (detina, 1991). relationship of equity returns with money supply might be an empirical question. we know money supply is positively related with inflation rate, hence it might adversely affect stock returns. money supply may also lead to increasing cash flows by building economic stimulus leading to increasing stock prices. kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 20161082 expectations also play a very important role in determining stock returns and these expectations, whether adaptive or rational, get influenced by economic fundamentals. changes in macroeconomic conditions affect current and future investment decisions i.e., an inflation shock may result in a change in the expected return of an asset. most popular models to determine stock returns in finance textbooks are capm and arbitrage pricing theory (apt). capm is derived from markowitz’s concept of diversification and it was further developed by sharpe (1964), lintner (1965), mossin (1966). capm is generally considered a single factor model because it states that only market factor is to be considered for determining stock returns. investors need to be compensated in two ways, time value of money and risk. time value of money is represented by risk free rate that compensates for placing money in any investment over a period of time. investors, after diversifying their portfolios, are concerned only with systematic risk or market risk (beta) which is inherent to the market. sources of systematic risk could be interest rate changes, inflation or even recession as they affect the entire market. apt (ross, 1976; roll and ross, 1980) is a form of multi-factor model which claims that shocks or surprises of possible multiple factors can be used to explain stock returns. an asset’s return can be predicted using the relationship between the asset and many common risk factors. apt predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macroeconomic variables. a multi factor model can also be thought of as the one in which macroeconomic variables are used to explain stock returns. since information technology (it) revolution, information or news is readily accessible. access to information is easy and universal. this changing dynamics of the environment has indeed made financial markets more efficient. stock markets react promptly to any news, good or bad, whether political tensions, war situations, regulatory changes in business environment or movements in global markets. efficient market hypothesis (emh) is an idea partly developed in the 1960s by eugene fama. it states that it is impossible to beat the market because prices already incorporate and reflect all relevant information. one cannot outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments. stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. asset prices fully reflect all available information. there are three variants of the hypothesis: “weak,” “semi-strong,” and “strong” forms. the weak form of the emh claims that prices on traded assets (e.g., stocks, bonds or property) already reflect all past publicly available information. the semi-strong form of the emh claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. the strong form of the emh additionally claims that prices instantly reflect even hidden “insider” information. emh states that if the market is efficient then we cannot forecast stock returns leaving no arbitrage opportunities to make profit. if the market is efficient, it means that all the relevant information is captured and is getting reflected in the prices. we can say that if these macroeconomic variables are insignificant in explaining stock returns and stock returns are also insignificant in explaining macroeconomic variables, then the market is efficient. interpretation of co-integration with respect to market efficiency depends upon how efficiency is defined mukherjee and naka (1995). if we see market efficiency as lack of arbitrage opportunities, then the presence of co-integration (long run equilibrium relationships) among variables is a sign of market inefficiency. prominent macroeconomic variables generally considered are: inflation rate, exchange rate, money supply, level of economic activity and interest rates. there cannot be a finite list. other macroeconomic variables can be unemployment rate, savings, exports, fdi, fiscal policy (budget deficits), oil prices, and gold prices. even the spread between short and long interest rates, expected and unexpected inflation, high and low grade bonds (chen et al., 1986) can be analysed while observing stock returns. relationship between stock returns and macroeconomic variables can be viewed in two ways. one view is to see the stock market as the leading indicator of economic activity the macroeconomic variables based on the findings that stock market rationally signals changes in real activity. another view is that macroeconomic variables influence and predict stock returns. we find that current economic activities can explain stock market returns since the stock market reflects macroeconomic variables on stock price indices. knowledge of sensitivity of stock markets to key macroeconomic variables and vice versa is important in areas of investment, finance and business environment. the present study improves the earlier studies in the indian context and offers a value addition to the existing literature. this paper is organised as follows: section 2 reviews previous literature followed by section 3 giving data related issues. section 4 details the methodology employed and section 5 presents the results. 2. literature review there exists vast literature on the association between macroeconomic variables and stock returns. although results are mixed, most studies have shown evidence that there are significant relationships between macroeconomic variables and stock returns. an early paper that opened up avenues for research in this regard was by chen et al. (1986). ‘simple and intuitive financial theory’, as they put it, is a well-known phrase in literature. economic news can be measured as innovations in variables. they tried to explore the set of economic variables that systematically influence stock returns and also asset pricing. these variables were, priori, sources of systematic risk. economic variables which were significant in explaining stock returns were industrial production, changes in risk kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 2016 1083 premium, twists in yield curve and also measures of unanticipated inflation and changes in expected inflation during periods of high volatility. real per capita consumption and index of oil price get insignificant. starting with the developed countries, morelli (2002) has taken monthly uk data from january 1967 to december 1995 and tried to analyse “conditional stock market volatility” and “conditional macroeconomic volatility.” to estimate conditional volatility garch, arch models are used. macroeconomic variables incorporated in the study are industrial production, real retail sales, money supply, inflation and exchange rate (german deutsche mark/pound). a vector autoregressive (var) model of order 12 is constructed which indicates that only exchange rate (dm/pound) can explain some significance in predicting stock market volatility while no significance was observed in terms of ability of stock market’s volatility to predict macroeconomic volatility. results of regression analysis done on conditional stock market volatility estimated from arch model on all macroeconomic volatilities reveals that none of the macroeconomic volatilities can explain stock market volatility. in fact, only 4.4% of variation in stock market volatility is explained by macroeconomic volatility. they estimated a best-fit model for conditional stock market volatility where measures of conditional volatility of macroeconomic variables are included as weighted variables. based on a significant change in log-likelihood value, best model is one in which “conditional volatility of inflation” is included. overall they have concluded that volatility in macroeconomic variables selected in the study do not explain volatility in the stock market. flannery and protopapadakis (2002) have estimated a garch model of daily equity returns in which realized returns and their conditional volatility depend upon 17 macro series announcements over the period 1980-1996. out of these, three nominal factors, consumer price index (cpi), ppi and a monetary aggregate, are taken; three real factors, balance of trade, employment report and housing starts, are also considered. popular overall measures of economic activity like industrial production or gnp are not taken into consideration as real gnp was not significantly affecting conditional return volatility nor was it affecting the trade volume. as per the results, out of the 17 macro indicators, six are strong risk factor variables. two inflation measures, cpi and ppi, affect only level of market returns. real variables like, balance of trade, employment/unemployment and housing, affect only conditional volatility of returns. norway is a small open economy with not so mature financial markets. gjerde and saettem (1999) have done a study on norway using multivariate var framework. apart from stock returns, they have taken macroeconomic variables like, interest rate, inflation, industrial production, consumption variable, oil prices, exchange rate (nok/usd) and oecd industrial production index, taking monthly observations from 1974 to 1994. consumption variable checks whether assets will be priced as per their co-variances with aggregate consumption (consumption based asset pricing model). innovation accounting results reveal that domestic industrial production explains about 8% of variance in real stock returns whereas innovations in real stock returns account for only 1% of variance in industrial production. stock returns show a delayed but positive response towards industrial production. stock return’s response is immediate and negative to changes in interest rate. real interest rate changes affect both stock returns and inflation. stock returns explain little variation in inflation. norway is an oil-dependent country and hence stock returns respond actively to oil prices. both oil prices and real activity affects stock returns here unlike the european markets. mukherjee and naka (1995) have taken six macroeconomic variables, exchange rate, inflation, money-supply, real economic activity, long term government bond rate and call money rate in japan. monthly data was taken from january 1971 to december 1990. vector error correction mechanism (vecm) is applied for analysis; they also apply likelihood ratio to check if linear trend exists. results of trace test and λmax test indicate that there is more than one co-integrating relation. they have based their analysis on the co-integrating vector that is represented by the largest eigen-value. they found that a co-integrating relation exists and stock prices contribute to this. results indicate that the relation between tokyo stock exchange (tse) and exchange rate is positive since tse increases as yen depreciates against us dollar. relation between tse and inflation is negative. relationships between tse and money-supply, and tse and industrial production are positive. in japan, money-supply’s positive effect on stock prices through augmented corporate earnings overpowers the negative effect because of inflation. there is a negative relation between tse and long term government bond rates but a positive relation between tse and call money rates. they argue that in japan it is possible that the nominal risk free component of discount rate in valuation model is better served by long term government bond rate rather than short term rate. they believe that vecm consistently outperforms var; with vecm one can avoid the potential misspecification bias inherent in var. according to them var is incapable of exploring long term as well as short term relations in the presence of co-integration. with the help of root mean square test and theil’s inequality coefficient they show that forecasting errors are less with vecm as compared to var. considering korea, a well cited paper is by kwon and shin (1999) who use co-integration test and granger causality test from a vector ecm (vecm) to check whether stock price indices are co-integrated with a set of macroeconomic variables namely, production index, exchange rate, trade balance and money supply. for stock returns they have taken value-weighted korea composite stock price index and small-size stock price index. monthly data is studied from january 1980 to december 1992. results indicate that there is no co-integrating relation between stock price indices and any single macro variable. in fact, stock indices are co-integrated with a combination of four macroeconomic variables. they claim that macroeconomic variables are significant in predicting changes in stock prices. pierdzioch et al. (2008) have opted for a recursive modelling approach to forecast stock market volatility in real time. they have used monthly real time macroeconomic variables for germany from 1994 to 2005. to evaluate accuracy of these forecasts, they have used three different criteria statistical criteria, utilitykotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 20161084 based criterion and an options-based criterion. results prove that the forecasts of stock market volatility based on real time macroeconomic data can be compared with the forecasts based on revised macroeconomic data. another important paper is by darrat (1990) who used multivariate granger causality to check if economic variables (including base money and fiscal deficit) affect stock returns in canada. monthly data is taken from january 1972 to february 1987. darrat focussed on the role of fiscal policy (budget deficit) in determining stock prices. toronto stock exchange 300 index is taken as a proxy for stock returns. multivariate granger causality test along with akaike’s final prediction error (fpe) and specific gravity criterion are applied. percentage change in monetary base (average for the month) is taken as a proxy for monetary policy. change in cyclically-adjusted (structural) budget deficit is taken as a proxy for fiscal policy. monthly data on cyclically adjusted deficits are unavailable in canada. series is obtained by residuals from regressing actual total budget deficits on current and lagged values of industrial production index since monthly real gnp data is also not available. other variables included in the study are: industrial production index, long term interest rates, short term interest rates, exchange rate movements, inflation rate and volatility of interest rates. common lag length for all variables may give biased results. hence, with akaike’s fpe criterion, appropriate lag length for each explanatory variable is determined. lag that minimizes autoregressive fpe is selected. bivariate regression is estimated in which stock prices are regressed against own lagged values and on lagged values of other variables, taken one at a time. specific gravity criterion is used to estimate trivariate regressions. finally likelihood test is performed. their results imply that in canada budget deficits exert a significant lagged impact upon stock prices even when other variables are excluded. monetary policy has insignificant lagged relationship with stock prices. in canada stock prices fully reflect all available information on monetary policy, as revealed by the study. for singapore, mookerjee and yu (1997) have tested for degree of informational efficiency in stock market with respect to a subset of macroeconomic variables. sample period spans from october 1984 to april 1993. four macroeconomic variables are used: two measures of money supply (narrow and broad), nominal exchange rate and aggregate foreign currency reserves. the all share price index was chosen to trace the stock market in singapore. engle and granger co-integration test gives the result that stock prices are co-integrated with both money supply measures and aggregate foreign exchange measures, but not with exchange rate. they have made conclusions on efficiency by linking co-integration to market efficiency. finding of cointegration is interpreted as potential market inefficiency. three of the four macro indicators are co-integrated with stock prices, suggesting potential inefficiencies in long run. for short run, we get conflicting evidence on informational efficiency of the equity market in singapore. maysami et al. (2004) have examined the co-integration between macroeconomic variables and sector indices, mainly finance index, property index and hotel index. monthly data is obtained from january 1989 to december 2001. their findings include significant positive relationship between inflation and singapore stock returns. short term interest rates showed positive relationship with singapore’s equity market whereas long term interest rate showed negative relationship. positive correlation is observed between money supply changes and stock returns. similarly positive relationship is observed between exchange rate and singapore stock market. as per the finance index, finance sector is significantly affected by changes in inflation rate, exchange rate, and both short term and long term interest rates. short and long term interest rates, and money supply do not have significant effect on singapore hotel index but significant negative relation is observed between the hotel sector and exchange rates. it is interesting to see how developing markets respond to the economic fundamentals as compared to well developed and more organized markets. talking about emerging economies, a study on thailand by tangjitprom (2011) uses four macroeconomic variables namely, unemployment rate, interest rate, inflation and exchange rate. lead-lag relationship is analysed through var model and granger causality test. variance decomposition is used to examine sensitivity of stock returns to each macroeconomic factor. sectorial analysis is done using sectorial indices as each industry is sensitive to macroeconomic indicators differently. monthly data spans from january 2001 to december 2010. due to unavailability of monthly gross domestic product (gdp) data unemployment rate, that represents general business condition and business cycle factor, is taken. to trace stock market movement set50 index, mai index and average stock return of top ten securities are taken. regression analysis with macroeconomic variables as explanatory variables and stock returns as dependent variables shows that interest rate and exchange rate are significantly negative. both inflation and unemployment rate get insignificant in explaining stock market performance. using short term interest rate instead of long term, or using real variables instead of nominal does not alter the result. variance decomposition reveals that interest rate is the most important economic variable in explaining stock returns. few lagged macroeconomic variables can explain stock returns, whereas lagged stock returns can significantly explain most of the macroeconomic variables except unemployment rate. hence stock market performance is a good indicator of the future macroeconomic scenario. a well cited paper on india is that of ahmed (2008). analysis has been done taking quarterly data spanning from march 1995 to march 2007, using variables like, index of industrial production (iip), money supply, interest rate, exchange rate, fdi inflows, and export earnings. for analysing stock returns, bse sensex and nse nifty have been taken. toda and yamamoto granger causality test and johansen’s co-integration test were applied to check for long run direction of causality. short run causal links were explored using variance decomposition and impulse response functions. sims’s var is applied. co-integration regressions indicates the presence of long run relationship between stock prices-fdi, stock prices-money supply, stock prices-iip. movement in bse sensex influences exchange rate and iip, but nse nifty does not influence them. results reveal that nse nifty influences exchange rate, exports, iip and money supply, while interest rate and fdi are causing kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 2016 1085 nse nifty returns. broadly, same is observed for bse sensex. results reveal that stock price movement is causing movement in iip, implying stock prices lead real economic activity. fdi causes movement in stock prices but stock price movement does not affect fdi. stock price movement affects export flows through its effect on exchange rate. in short run, sensex and nifty influence exchange rate. on the other side, exchange rate does not affect bse sensex and nse nifty. study reveals that money supply does not affect stock returns but interest rate does. the paper also concludes that even monetary policy measures that affect interest rates are influential in determining stock returns. pal and mittal (2011) observed indian capital markets and macroeconomic variables like, inflation rate, interest rate, exchange rate and gross domestic savings (gds). quarterly data has been taken from the first quarter of 1995 to the last quarter of 2008. co-integration test is applied to check for long run relationship and ecm is applied to check for short run patterns. they started with the null hypothesis that macroeconomic variables do not have any significant impact upon stock prices. s&p cnx nifty and bse sensex serving as a proxy for stock returns have been taken as dependent variables. partial elasticity analysis is done on logarithms of models. ecm shows that inflation rate affects both bse sensex and s and p cnx nifty significantly. interest rate impacts movements in s and p cnx nifty. exchange rate significantly affects bse sensex. gds shows no association with bse sensex and s&p cnx nifty. they conclude that macroeconomic variables do have a significant impact upon stock returns in the indian context. bse sensex and nse nifty show high correlation with each other because of similar composition. results which indicate that these indices are reacting differently in the context of the same macroeconomic variable are questionable. naik and puja (2012) investigated indian equity market through bse sensex and macroeconomic variables like, iip, wholesale price index (wpi) as a measure of inflation, money supply, t-bill rates as a measure of interest rates and exchange rate. monthly data is studied from april 1994 to june 2011. to check for long run equilibrium relationship, johansen’s co-integration and vecm are applied. stock prices are positively related to money supply and iip, and negatively related to inflation. exchange rate and short term interest rate are found to be insignificant in explaining stock returns. granger causality suggests that macro variables may be causing stock prices in long run but not in short run. bidirectional causality exists between iip and stock prices. unidirectional causality is observed from money supply to stock prices, stock return to inflation and interest rate to stock indices. naka et al. (1998) tried to see the impact of economic reforms of 1991 on indian capital markets. for equity market bse data is taken. vecm is employed to check for co-integration (long run equilibrium relationship) among the factors. through impulse response and variance decomposition they have demonstrated effects of macroeconomic factors on indian stock markets. macroeconomic variables considered in the study are: industrial production index (proxy for output), cpi (proxy for inflation), m1 (narrow money; proxy for money supply) and money market rate in bombay interbank rate (proxy for interest rate) and period of study ranges from the first quarter of 1960 to the fourth quarter of 1995. their investigation implies that inflation and output growth are the main determinants of bse and performance of bse has improved as compared to pre-1991 period. another study on india by singh (2010) attempted to explore causal relations between stock market and macroeconomic variables by applying granger causality test. monthly data from april 1995 to march 2009 has been used. macro indicators like wpi, iip and exchange rate are observed. bse sensex is taken as a proxy for indian equity market. strong correlation is observed between bse sensex-iip and bse sensex-wpi, but not for exchange rate-bse sensex. granger causality test indicated that iip is the only variable having bilateral causal relationship with bse sensex. considering the lower middle income countries, gunasekarage et al. (2004) have done a study on sri lanka, examining macroeconomic influence on stock market. they have used colombo all share price index to represent the stock market. macroeconomic variables like, money supply, t-bill (measure of interest rate), cpi (proxy for inflation rate) and exchange rate, are taken. monthly data is analysed from january 1985 to december 2001. vecm, impulse response function and variance decomposition are employed to check for long run and short run relationships. results from vecm suggest that lagged values of macroeconomic variables like, cpi, money supply and interest rate, significantly influence the stock market. interest rate serves as the strongest determinant compared to other variables in the study. it influences stock returns and also gets influenced by stock returns. except for interest rates (t-bill rates) stock indices are unable to explain any movement in other macroeconomic indicators. both variance decomposition and impulse response function suggest that economic indicators can explain only a small margin of error variance of equity returns. sohail and hussain (2009) have examined short run and long run relationships between macro indicators and stock returns in pakistan. macroeconomic variable like, cpi as a measure of inflation, iip, real effective exchange rate, money supply and 3 month treasury bill rate, are observed. for tracing lahore stock exchange lse25 index is taken. monthly data spanning from december 2002 to june 2008 is taken. co-integration test was applied to check for long run relationship. ecm checks for short run dynamics. variance decomposition gives further evidence of interactions among variables. in long run, inflation is negatively impacting stock prices while iip, real effective exchange rate and money supply are having a positive effect on stock returns. 3 month t-bill rate is insignificant in explaining stock returns in long run. among macro indicators taken in the study inflation explained maximum variance. after a thorough review of literature, we found that the following variables are extensively used in literature viz., money supply, interest rate, inflation rate and exchange rate, as macroeconomic indicators. based on the underlying economic theory and literature, we frame the following hypotheses. kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 20161086 when we talk of inflation as per the money demand theory, economic activity is negatively related to inflation, therefore stock returns are also negatively influenced by inflation fama (1981). an increase in inflation may also lead to an increase in nominal risk free rate, and also the discount rate, leading to declining stock prices as stock prices are the discounted value of expected cash flows. thereby inflation and stock returns must show negative relation with each other. geske and roll (1983), mukherjee and naka (1995), naka et al (1998), sohail and hussain (2009), pal and mittal (2011) show significant negative relation between inflation and equity returns. relationship between money supply and stock prices lies in ambiguity. if increase in money supply leads to economic stimulus resulting in corporate earnings, it will increase stock prices. however when increase in money supply leads to increase in inflation, it would raise discount rate, reducing stock prices. hence relation between money supply and stock returns is still an empirical question. mukherjee and naka (1995) sohail and hussain (2009) show that money supply and stock prices positively relate to each other. interest rate is another fundamental macroeconomic variable having significant impact upon stock returns. reduction in interest rate reduces the cost of borrowing, serving as an incentive for firms and increasing their stock prices. hence, interest rates and stock returns must show negative relation with each other. gjerde and saettem (1999) also show interest rate to be negatively related to stock prices. impact of exchange rate on an economy depends upon its level of international trade and also trade balance. depreciation of currency leads to an increase in demand for exports, thereby increasing cash flows in the country under the assumption that demand for exports is elastic. in such a case, the impact of exchange rate depends upon whether the firm is an exporting firm or import dominant. depreciation of domestic currency induces investors to shift funds from domestic assets to foreign currency assets, depressing stock prices. hence we hypothesize a positive relation between exchange rate and equity market. mukherjee and naka (1995) conclude that exchange rate is positively related with stock returns whereas pal and mittal (2011) show significant negative relation between exchange rate and stock market returns. 3. data in this paper, we investigate the case for india using monthly frequency of data and taking macro-economic variables namely, inflation rate, interest rate, money supply and exchange rate. we have taken wpi as a proxy for inflation. for interest rates, we use 365 days government of india t-bill rates. for money supply, we have taken broad money (m3). exchange rate is obtained through us dollar/indian rupee fx spot rate. for tracking stock returns in india, we have taken s and p bse sensex, the benchmark stock index for the indian equity market. level of economic activity is one of the crucial determinants of stock returns. gdp is the most comprehensive measure of real economic activity in an economy. in india, gdp data is available only on a quarterly basis. to avoid potential degrees of freedom problem in var model because of lack of observation points, we employ monthly data. iip shows the amount of industrial production or level of manufacturing in an economy and is available at a monthly frequency, but over the years contribution of iip is declining since the major contribution in gdp comes from the service sector and not from the manufacturing sector. as per planning commission report, in 2014 contribution from industry is around 24.2% whereas service sector contributes as much as 57.9%. hence, we have excluded iip from the study. data for exchange rate (us dollar/indian rupee), s and p bse sensex and s and p bse 500 is collected from thomson reuters. for interest rates, 365 days government of india t-bill rate that is implicit yield at cut-off price (in per cent) and m3 (broad money supply) is taken from epwrf time series data base. the study covers the period from july 2001 to july 2015. the reason we have taken 2001 as the starting year is because indian stock markets are at a nascent level and are more prone to manipulation coupled with physical exchange of shares and incomplete markets, with no efficient hedging instruments for investors and the presence of fixed period of settlement system. indian financial markets have gone through several reforms during this period. derivative instruments (index and stock) were introduced in india during 2000 and 2001. ipo relaxation for information technology, media and telecommunication companies, i.e., permission to issue a minimum of 10% shares, came into existence on 15th october 1999. venture capital guidelines came into existence on september 15, 2000. collective investment scheme regulations came into existence on july 15, 1999. flexible face value concept came into existence on october 11, 1999. negotiated deals were not permitted from september 14, 1999. internet trading was permitted by sebi board on january 25, 2000. corporate governance came into existence on january 1, 2000, to be adhered by all a group s&p cnx nifty index companies by march 31, 2001. all deferral products namely, albm/bless/mcfs/cns, ceased to be available for all scrips from july 2, 2001.with these infrastructure and regulatory improvements, indian stock markets are in a far better position to absorb and react at a much faster pace to any information arrival. most of the existing studies focussed a period of infancy level in indian stock market and hence reported a bi-directional causality between most macro-economic variables and the stock market. 4. empirical methodology in line with the literature, we examine long run relationships among macro variables and stock index returns by employing co-integration analysis. a brief methodology on multivariate co-integration is presented below. co-integration analysis is designed to find linear combination of variables that also removes unit root. for example, if yt and xt are both i(1), then there may be a unique value of β for which yt βxt is i(0), that is no unit root in the relation linking xt and yt. co-integration is a testable restriction on a dynamic model. co-integration vectors, if exist, determine i(0) relations that hold between variables which are individually non-stationary. such relations are often referred to as “long run equilibrium” relationships since they prove as attractors towards which kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 2016 1087 convergence occurs. conclusion on co-integration cannot be made by a mere visual inspection of graphical plotting of variables that might look or do not look cointegrated. the only way to find is through a careful statistical analysis. co-integration analysis is inherently multivariate, it considers a set of integrated variables as a single time series that cannot be cointegrated. johansen (1991) test is a preferable multivariate co-integration test that accounts for more than one cointegrating relation unlike engle granger test. the test for co-integration between the xs is calculated by looking at the rank of the matrix π. rank of a matrix is equal to the number of its characteristic roots (eigenvalues) that are different from zero. xt = atxt-1 + εt (1) δxt = atxt-1 – xt-1 + εt = (at-1) xt-1 + εt = п xt-1 + εt where xt denotes a vector of n variables; xt and εt are n × 1 vectors and at is an n × n matrix of parameters. if rank of п is 0, each element of п equals 0. then δxt = εt. thus the first difference of each xt is i(0) since all the {xi,t} sequences are unit root processes and there is no linear combination of the variable that is stationary. at the other extreme, suppose п is of full rank, then long run solution is given by n independent equations. each of these n equations is an independent restriction on the long run solution of the variables. the n variables in the system face n long run constraints, each of the n variables contained in vector xt must be stationary with long run values. in general, if the rank of п is r, then there are “r” co-integrating vectors. number of distinct cointegrating vectors can be found by characteristic roots of п. rank of a matrix is equal to the number of characteristic roots that differ from zero. we can obtain estimates of п and also the characteristic roots. we need to test for number of characteristic roots that are insignificantly different from 0. johansen test comprises of trace test and max-eigen test. λi denotes estimated values of characteristic roots obtained from estimated п. trace statistic tests whether number of distinct cointegrating vectors is less than or equal to r. the farther the estimated characteristic roots are from 0, the greater is λ trace. max-eigen statistic tests whether number of co-integrating vectors is r, against the alternative of r+1. meanwhile, co-integration as such does not speak anything about the direction of causality. hence, estimation of ecm is important. the concept of error correction basically refers to the adjustment process between short-run disequilibrium and a desired long run position. as per engle and granger, if two variables are cointegrated, then there exists an error correction data generating mechanism, and vice versa. two variables that are cointegrated would not drift apart over time; this concept provides insight into the long-run relationship between the two variables and testing for the co-integration between two variables. 1 ˆ( ) (1 ) p trace j j r r t inλ λ = + = − −∑ max 1ˆ( , 1) (1 )rr r t inλ λ ++ = − − (2) where λj are the estimated values of characteristic roots (eigenvalues) obtained from π` matrix. t = number of observations, r = number of co-integrating vectors. the trace test statistics test the null hypothesis that the number of distinct cointegrating vectors is less than or equal to r against the alternative hypothesis of more than r co-integrating relationships. it is clear that λtrace = 0 when λj = 0. the farther the estimated characteristic roots are from zero, the more negative is ln (1-λj) and larger would be the λtrace. the maximum eigenvalue statistics test the null hypothesis that the number of co-integrating vectors is less than or equal to r against the alternative of r + 1 co-integrating vectors. again, if the estimated value of the characteristic root is close to zero, λmax will be small. to examine the short run causality, granger causality test is employed. since the future cannot predict the past, if variable x granger causes variable y, then changes in x should precede changes in y. therefore, a regression of granger’s concept of causality states that any time series xt granger-causes another time series yt, if series yt can be predicted with better accuracy by using past values of xt rather than by not doing so, keeping other information identical, obtained by excluding all information on xt from yt. toda and yamamoto (1995), propose an applicable methodology independent of the integration or co-integration properties of the model. in this method a modified wald test is used to contrast the parameters of the var. an extended var model is used, whose order is determined by the number of optimal lag lengths in the system (k) and the maximum number of times one must differentiate the variables (dmax). when a var max (k+dmax) is predicted (where max d is the maximum order of integration to occur in the system), this test displays asymptotic chi-square distribution, it is also shown that if variables are integrated of order d, the usual selection procedure is valid whenever k ≥ d. toda and yamamoto test has been used to capture long-run causality pattern. in the granger test we deal with bilateral causality but many times we come across multivariable causality which can be resolved through vector auto regression. models (vars) were popularised by sims (1980) as a natural generalisation of univariate autoregressive models. according to sims, if there is true simultaneity among a set of variables, they should all be treated on an equal footing. there should not be any priori distinction between endogenous and exogenous variables. in var framework each of the current values depends on different combinations of the previous k values of both variables and error terms where k refers to the lag term. y1t = β10 + β11 y1t−1 + β1k y1t−k+α11 y2t−1 + α1k y2t−k + u1t (3) y2t = β20 + β21 y2t−1 + β2k y2t−k + α21 y1t−1 + α2k y1t−k + u2t where uit is a white noise disturbance term with e(uit)=0, (i = 1, 2), e(u1t, u2t)=0. the most fundamental advantage with var is that there is no need for the researcher to specify which variables are endogenous or exogenous all are endogenous. impulse responses trace out the responsiveness of the dependent variables in the var to shocks to each of the variables. so, for each kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 20161088 variable from each equation separately, a unit shock is applied to the error, and the effects upon the var system over time are noted. thus, if there are g variables in a system, a total of (g*g) impulse responses could be generated. variance decompositions offer a slightly different method for examining var system dynamics. they give the proportion of the movements in the dependent variables that are due to their ‘own’ shocks versus shocks to the other variables. a shock to the ith variable will, of course, directly affect that variable, but it will also be transmitted to all of the other variables in the system through the dynamic structure of the var. variance decompositions determine how much of the s-stepahead forecast error variance of a given variable is explained by innovations to each explanatory variable for s = 1,2. 5. empirical results the descriptive statistics for all five variables is shown in table 1. these variables are bse sensex, m3 (broad money supply), wpi, and exchange rate and t-bill rates. for a standard normal distribution, skewness should be zero and kurtosis should be at three. it can be observed that frequency distribution of the above mentioned variables are not normal. the jarquebera statistics also confirm the same. as is obvious, standard deviation indicates that stock returns are more volatile as compared to macroeconomic indicators. since the time series analysis can only be done with a stationary data series so as to avoid spurious results, augmented dickey fuller (adf) test is employed to check for stationarity. as shown in table 1, all the series are found to be at non-stationary at levels. however, after first differencing, we get stationary series for all the variables even at 1% level. thus all the variables are integrated of the order i(1). this table reports descriptive statistics of the variables used in the study for the period july 2001 to july 2015. log (m3) stands for natural logarithm of month end broad money supply. log (wpi) stands for natural logarithm of monthly average wpi. log (exchange rate) stands for natural logarithm of monthly average of usd/inr. t-bill rate stands for monthly average of 365 days government of india treasury bills. last column reports daily percentage change in sensex values. adf test is employed to check the presence of unit root in the series at the levels and first differences. table 2 represents unrestricted co-integration rank test. johansen’s multivariate co-integration test is employed to check for number of co-integrating relationships among the underlying variables. we observe trace statistic and max-eigen statistic to identify the number of co-integrating vectors. results indicate presence of one long run relationship between macro indicators and stock market returns. this table reports test statistics of trace and λmax are based without a linear trend (µ = 0). the critical values at 5% level are obtained from osterwald-lenum (1992). the null hypothesis implies at most r cointegrating vectors, where r is the order of co-integration. normalized co-integrating coefficients are displayed as follows:xt = (sensext, tbillt, wpit, xratet, m3t) bt = (1.00, 5.1464, −1.5666, −4.1392, −0.4907) the co-integrating relationship can be expressed as sensext = 1.5666wpit+4.1392xratet+0.4907m3t–5.1464tbillt (1.06) (1.64) (3.14) (-5.14) the t-statistics are reported in parentheses. the coefficients for wpi and money supply are positive and statistically significant. interest rate shows negative and statistically significant relation with stock returns. exchange rate shows positive but insignificant relation with stock returns. for money supply, the positive relation indicates that an increase in money supply leads to economic stimulus resulting in corporate earnings, hence leading to an increase in stock prices. mukherjee and naka (1995), sohail and hussain (2009) show that money supply and stock prices positively relate to each other. as proposed, interest rate shows negative relationship with stock returns. reduction in interest rate reduces the cost of borrowing, serving as an incentive for firms and increasing their stock prices. gjerde and saettem (1999) also show interest rate to be negatively related to stock prices. exchange rate and stock returns show positive relation with each other. depreciation of currency leads to an increase in demand for exports, thereby increasing cash flows in the country under the assumption that demand for exports is elastic. in such a case, impact of exchange rate depends upon whether the firm is an exporting firm or import dominant. depreciation of domestic currency induces investors to shift funds from domestic assets to table 1: descriptive statistics statistic log (m3) log (wpi) log (exchange rate) t-bill rate change in sensex % mean 12.99 4.95 3.88 6.77 1.49 median 14.09 5.02 3.85 7.04 1.27 maximum 15.21 5.23 4.19 9.92 28.26 minimum 10.61 4.58 3.67 3.59 −23.89 standard deviation 1.75 0.20 0.13 1.51 6.92 skewness −0.17 −0.37 0.79 −0.24 −0.18 kurtosis 1.15 1.65 2.76 1.93 4.66 jarque-bera 24.86 16.52 17.79 9.67 20.40 probability 0.00 0.00 0.00 0.01 0.00 adf test-levels adf test-first differences −2.24 −13.22 −1.83 −12.72 −1.34 −4.86 −2.79 −15.48 −2.42 −11.77 adf test table values at 1%, 5% and 10% level are 4.01, 3.43 and 3.14 respectively kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 2016 1089 foreign currency assets depressing stock prices. mukherjee and naka (1995) also conclude that exchange rate is positively related with stock returns. a contrasting result is obtained for inflation as it is showing a positive relation with stock returns. maysami et al. (2004) and ratanapakorn and sharma (2007) show positive relation between inflation and stock returns. indian economy as well as indian capital markets are evolving at a rapid growth pace and hence equities are serving as a hedge against inflation. results of the vecm are presented in table 3. as can be seen from the reported adjusted r2, 11% of the variation in bse sensex is explained by the macroeconomic variables viz., interest rate (t-bill rates), money supply (m3), inflation (wpi) and exchange rate (usd/inr). similarly, for interest rates, it is 6%, for money supply it stands at 6% and for exchange rate and inflation it is 4% and 4% respectively. it clearly suggests that only 11% of movements in stock returns are getting influenced by these macroeconomic variables at monthly frequency. panel a of this table reports long run relation (normalized cointegrating relation) coefficients between logged values of sensex and logged values of macroeconomic indicators. panel b reports the coefficients of vecm. the numbers in parentheses estimated coefficients are standard errors and the numbers in square brackets are t-statistics. co-integration results are reported in table 3 which suggests that there exists long run relationships among variables, but says nothing about the direction of causality. engle and granger suggest that, if variables are co-integrated in long run then there must exist unidirectional or bidirectional relationship between variables. to shed more light into the findings of vecm model, the results of variance decomposition analysis are reported in table 4. the reported figures indicate the percentage of movement in each variable that can be attributed to its own shock and the shocks to the other variables in the system. these are provided for five difference lagged time horizons: 1 month, 5 months, 10 months (short run), 15 months and 20 months (long run). the results support the argument that the movements in the sensex can be explained by some of the macroeconomic indicators analysed. in the 1st month, 100% of the variability in the sensex is explained by its own shocks while after 10 months, 84.73% of variability is explained by its own innovations; 7.37% by the shocks from t-bills; 6.27% by the shocks of wpi. similarly, sensex accounts for the variation after 10 months in exchange rate by 18.74% and about 8.74% variation in t-bills. this further supports the earlier result that the direction of causality runs from sensex to exchange rate. table 2: multivariate co-integration tests using johansen’s method null: number of cointegrated vectors trace statistic critical value at 5% level max-eigen statistic critical value at 5% level r=0 80.04 77.74 43.64 36.41 r≤1 36.39 54.64 20.39 30.33 r≤2 16 34.55 10.86 23.78 r≤3 5.13 18.17 3.12 16.87 r≤4 2.01 3.74 2.01 3.74 table 3: vector error correction estimates panel a: normalized cointegrating coefficients variable ln_sensex(−1) ln_t‑bill(−1) ln_wpi(−1) ln_xrate(−1) ln_m3(-1) constant coefficient 1.0000 −5.1464 1.5666 4.1392 0.4907 −29.8206 standard error (−1.0004) (−1.4765) (−2.5270) (−0.1562) t-statistic [−5.14439]*** [1.06102] [1.63795] [3.14129]*** panel b: error correction coefficients error correction d (ln_sensex) d (ln_t-bill) d (ln_wpi) d (ln_xrate) d (ln_m3) cointeq1 0.0116 0.0050 −0.0081 −0.0030 −0.0922 (−0.0050) (−0.0072) (−0.0036) (−0.0017) (−0.0266) [2.3112]** [0.6903] [−2.2425]** [−1.7336]* [−3.4691]*** d (ln_sensex[−1]) −0.0181 0.2498 0.1291 0.0262 −0.4596 (−0.0893) (−0.1278) (−0.0644) (−0.0304) (−0.4730) [−0.2025] [1.9544]* [2.0053]** [0.8636] [−0.9717] d (ln_t-bill[−1]) 0.0553 −0.2435 −0.0288 −0.0133 0.0683 (−0.0567) (−0.0812) (−0.0409) (−0.0193) (−0.3005) [0.9747] [−2.9988]*** [−0.7041] [−0.6881] [0.2273] d (ln_wpi[-1]) 0.2976 0.0191 0.0084 −0.0259 −0.2733 (−0.1069) (−0.1530) (−0.0771) (−0.0363) (−0.5662) [2.7829]*** [0.1250] [0.1087] [−0.7117] [−0.4827] d (ln_xrate[−1]) −0.2327 0.0807 0.5177 0.1415 −0.4980 (−0.2681) (−0.3836) (−0.1932) (−0.0911) (−1.4196) [−0.8682] [0.2103] [2.6792]*** [1.5528] [−0.3508] d (ln_m3[−1]) −0.0455 0.0177 −0.0020 0.0111 −0.0499 (−0.0146) (−0.0209) (−0.0105) (−0.0050) (−0.0772) [−3.1179]*** [0.8466] [−0.1924] [2.2442]** [−0.6461] c 0.0127 −0.0029 −0.0020 0.0014 −0.0088 (−0.0053) (−0.0076) (−0.0038) (−0.0018) (−0.0279) [2.4083]** [−0.3850] [−0.5365] [0.8011] [−0.3135] adjusted r2 0.11 0.06 0.04 0.04 0.06 f-statistic 4.42 2.72 2.11 2.04 2.63 *,**,***denote statistical significance at the 10%, 5% and 1% levels respectively kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 20161090 this table reports the results of variance decomposition analysis over five different lagged time horizons. panel a reports the percentage movement in sensex that can be attributed to itself and other variables. panel b reports the percentage of movement in macroeconomic indicators that is attributed to sensex. 6. conclusion this paper explored the nexus between indian stock market and selected macro-economic indicators by performing necessary analysis that addresses long run and short run relations. specifically, the study employs monthly data from july 2001 to july 2015 along with johansen’s co-integration analysis and granger causality tests are performed. the results are interesting and useful in understanding the dynamic relations between stock returns and macro-economic factors. the study finds support for the presence of one cointegrating vector between sensex and macro-economic indicators viz., exchange rate, money supply, wpi and treasury bill rate. further, the study observes that three out of four factors (viz., wpi, money supply and t-bill) are relatively more significant in a long run relation. turning to short run relations, the study reports bi-directional causality between sensex and exchange rate. inflation and money supply show positive and significant relation with stock returns. interest rate shows negative and insignificant relation with stock market returns. we can say that indian capital markets are showing signs of market inefficiency because of co-integration between stock returns and macroeconomic indicators. references ahmed, s. 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(1992), a note with quantiles of the asymptotic distribution of the maximum likelihood co-integration rank test statistic. oxford bulletin of economics and statistics, 54, 461-472. table 4: variance decomposition results panel a: percentage of the movement in the sensext explained by shocks lags (n) ln_sensext-n ln_t-billt-n ln_wpit-n ln_xratet-n ln_m3t-n 1 100.00 0.00 0.00 0.00 0.00 5 91.38 1.61 4.93 0.11 1.96 10 84.73 7.37 6.27 0.42 1.20 15 77.50 14.04 6.88 0.78 0.80 20 71.07 19.99 7.19 1.11 0.64 panel b: percentage of a shock to sensext-n explaining movements in ln_sensext ln_t-billt ln_wpit ln_xratet ln_m3t 1 100.00 2.49 0.12 25.23 2.05 5 91.38 8.02 1.41 21.59 2.30 10 84.73 8.74 2.71 18.74 1.22 15 77.50 8.93 3.76 16.28 0.86 20 71.07 8.99 4.54 14.34 0.84 kotha and sahu: macroeconomic factors and the indian stock market: exploring long and short run relationships international journal of economics and financial issues | vol 6 • issue 3 • 2016 1091 pal, k., mittal, r. 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(2010), causal relationship between macro economic variables and stock market: a case study for india. pakistan journal of social sciences, 30(2), 263-274. sohail, n., hussain, z. (2009), long-run and short-run relationship between macroeconomic variables and stock prices in pakistan: the case of lahore stock exchange. pakistan economic and social review, 47(2), 183-198. tangjitprom, n. (2011), macroeconomic factors of emerging stock market: the evidence from thailand. international journal of financial research, 3(2), 105-114. toda, h.y., yamamoto, t. (1995), statistical inference in vector autoregressions with possibly integrated processes. journal of econometrics, 66, 225-250. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(1), 153-160. international journal of economics and financial issues | vol 8 • issue 1 • 2018 153 the effects of international trade openness on government revenue: empirical evidence from middle east and north african region countries rawan f. shubati1*, taleb awad warrad2 1department of business economics, university of jordan, amman, jordan, 2dean of faculty of business, middle east university, amman, jordan. *email: rawan.shubita@gmail.com abstract this study investigates the impact of international trade openness on government revenue in middle east and north african (mena) countries for the period of 2000-2015. more specifically, this study examines the relationship between government revenue and international trade openness, real gross domestic product (gdp) per capita, corruption level measure, and population. the study utilized panel data, covering the period of 2000-2015, for nine selected mena countries. the results of the study, using the panel fully modified least squares, highlights the negative impact of international trade openness on government revenue. moreover, the results indicate that countries with a higher real gdp per capita and lower corruption level have more government revenue while the total population plays a negative role in government revenues. keywords: trade liberalization, government revenue, gross domestic product jel classifications: e01, f1, h5 1. introduction the role of trade openness as a proxy indicator of trade liberalization is one of the vital issues that have been investigated widely in the economic literature. several studies argued that trade openness as an “engine of growth” can play a significant role in improving economic growth and the level of development. especially in the long run, due to the ability of international trade in increasing productivity and encouraging greater efficiency, it has been revealed that internationally active countries tend to be more productive (kim et al., 2013; shahbaz, 2012; dong, 2014). in general, developing countries suffer from a large deficit in both public budget and current account balance. in addition to insufficient domestic financial resources as a main source of fund. however, the different types of financial inflows play an important role in case of developing countries to finance government expenditure and achieve long-run developmental strategies (todaro and smith, 2009). hence, the importance of this study comes from identifying the potential benefit of international trade openness in driving government revenue flows. recent studies attempt to identify the potential factors that can be related to promoting domestic financial flows. trade liberalization is considered by many studies as one of the major determinants of financial flows, especially government revenue. 2. background several studies explored the potential linkage between international trade openness and public government revenue as an example of domestic financial flows. direct and indirect tax types are considered as one of the major domestic financial resources that can be used to finance government expenditure. the relationship between international trade openness and government revenue has been widely investigated. according to previous literature, there are two different arguments about the impact of trade openness (free trade) on government revenue: the positive effect argument and the negative effect argument. the positive effect argument: previous studies attempted to examine the main determinants of government revenue in shubati and warrad: the effects of international trade openness on government revenue: empirical evidence from middle east and north african region countries international journal of economics and financial issues | vol 8 • issue 1 • 2018154 general and tax revenue. specifically, several studies (stotsky and woldemariam, 1997; bornhorst et al., 2009; drummond et al., 2012) aimed to identify the potential factors that can be related to better the tax revenue inflows. the empirical evidence of these studies show that the degree of international trade openness plays a positive role in enhancing the tax revenue by increasing the productivity of output and promoting economic growth and hence, generating more government revenue. the outcomes of recent studies support the positive effect argument of international trade openness on government revenue in general, and tax revenue in particluar. mushtaq et al., (2012) analyzed the determinants of tax revenue in pakistan over a period of 1975-2010. this study used the following explanatory variables: exchange rate, population, gross domestic product (gdp), and trade openness. the study’s results highlighted that international trade openness is one of the most important determinants of tax revenue in pakistan. in addition, jaffri et al.s. (2015) study investigated the potential linkage between trade liberalization and tax revenue in pakistan during the period of 1982-2013 by using the autoregressive distributed lag model. the empirical study evidence showed a positive impact of trade liberalization on tax revenue over the study period. the results indicate that in the longrun, a 1% increase in international trade openness leads to 0.35% increase in tax revenue. based on this, the study recommends the policymakers to reduce the restrictions on international trade and take advantage of the positive role of international trade openness in enhancing the total tax revenue by reducing tax evasions and tax exemptions in pakistan. gnangnon (2017) indicated that trade openness has a positive impact on tax revenue, based on the panel data for 169 countries among which 37 where least developed countries during the period of 1995-2013. the study showed that the positive role of trade liberalization depends on the level of development of the country and the level of its domestic trade liberalization policy. the general argument indicates that restriction in the trade policy weakens the positive impact of trade openness on government revenue and hence, the tax revenue. in addition, a higher level of development measured by the real gdp increases the positive impact of trade openness on tax revenue, especially in the long-run. lutfunnahar (2007) explored the main determinants of tax revenue performance in bangladesh by using tax revenue as a percentage of the gdp as a dependent variable. he argued that bangladesh has a low tax ratio and the study results suggested that increasing the trade openness will lead to better tax revenue performance. the study results highlighted that international trade related positively to tax revenue and is considered to be one of the main variables that determine the tax effort. chaudhry and munir (2010) used the same explanatory variables as lutfunnahar’s (2007) study to investigate the determinants of tax revenue in pakistan from 1973 to 2009. the empirical evidence showed that international trade openness, and international financial flows (external debt, foreign aid), and political stability are the major determinants of tax efforts in pakistan. the study also showed that foreign trade played a key role in enhancing the tax revenue as a percentage of the gdp ratio, since pakistan increased the degree of trade liberalization over the study period and which contributed positively to the tax revenue performance. they argue that pakistan suffered from a high budget deficit with low tax ratio (tax revenue/gdp), but after boosting the trade openness the tax ratio increased. in general, the empirical evidence for most of the studies that analyzed the main determinants of tax revenue support the positive impact of trade openness on the performance of tax revenue. however, this positive effect of trade openness on government revenue depends on several factors, such as the structure of trade liberalization and the impact of the existing free trade structure on each component of government revenue, in addition to the import and export price elasticity (frankel, 1999). in addition, findings from several studies on international trade openness and non-tax resource revenue showed that free trade positively affects the domestic non-tax revenue resources as a percentage of the gdp by, enhancing the mobilization of these types of domestic revenue (crivelli and gupta, 2014; brun et al., 2015; thomas and trevifo, 2013). 2.1. negative effect argument on the other hand, several studies argued that trade liberalization can lead to a reduction in government revenue; the rationale behind this negative argument is based on the fact that developing countries rely heavily on indirect tax revenue sources, such as import tariffs. so, when countries increase their degree of openness to international trade, it induces a reduction of the restrictions on imports tariff tax and hence, it decreases the tax revenue. the general negative argument of trade liberalization on tax revenue, based on recent studies, argues that there is a potential loss in government revenue as result of decreasing the tax on international trade to facilitate free trade (khattry and rao, 2002). the empirical evidence from recent studies (such as khattry and rao, 2002) showed that increasing the degree of international trade openness contributes negatively to the total tax revenue in low-middle income countries. the study shows that the structural characteristics of low-middle income countries, such as the size of population, the degree of urbanization, and the age dependency ratio and others explain the negative effect of international trade openness on government revenue. cagé and gadenne’s (2014) study indicated that international trade openness induces extra financial costs related to international trade tax cuts in developing countries. however, in developed countries, increasing the degree of trade openness does not have a negative effect on government revenue. this is because the high-income developed countries have efficient tax management systems which can compensate any decline in the tax burden in foreign trade by imposing tax on domestic transactions. the main conclusion of this study is that international trade openness leads to a reduction in the total tax revenue, especially in the long-run. 3. data, methodology and econometric model 3.1. the econometric model models based on economic theory and previous empirical studies, such as brun and gnangnon, (2017), will be estimated in order to shubati and warrad: the effects of international trade openness on government revenue: empirical evidence from middle east and north african region countries international journal of economics and financial issues | vol 8 • issue 1 • 2018 155 achieve the study objective and test the main study hypotheses. to analyze the impact of international trade openness on government public revenue, a log linear form, such as the following, is used: logy1it = α0+α1logx1it+α2logx2it+α3logx3it+α4logx4it+ԑit where: • logy1it: denotes government public revenue, excluding grants, as a percentage of the gdp. • logx1it: the logarithm of international trade openness of a country, measured by the sum of exports and imports for goods and services in terms of dollars, as a percentage of the gdp measured in terms of dollars. • logx2it: the logarithm of the real gdp per capita, measured in terms of dollars. • logx3it: the logarithm of the total population. • logx4it: the logarithm of the corruption level. • α0: the intercept. • α1,….,α4: the estimated parameters for the independent variables. • ԑit: the error term. 3.2. study sample the study used the annual database, covering the period of 20002015, for selected countries from the middle east and north african (mena) regions. the selected countries are: algeria, bahrain, egypt, iraq, jordan, kuwait, lebanon, morocco, oman, qatar, saudi arabia, and tunisia. the country selection was based mainly on the data availability. 3.3. study hypotheses the following null hypotheses were formulated: h0: there is no significant relationship between international trade openness and government revenue. h01: there is no significant relationship between government revenue and the real gdp per capita. h02: there is no significant relationship between government revenue and corruption level. h03: there is no significant relationship between government revenue and total population. 3.4. study variables measurement in order to test the study’s hypotheses, the model variables need to be defined and measured. as for the study dependent variable, there are two main types of financial flow: the first one is the domestic financial flow, while the other one is the international financial flow. according to shukla and glenday (2001), domestic financial flows are when government public revenue is considered as one of the main tools for fiscal policy, and government revenue is defined as the domestic financial inflow that the government received from different sources as follows: 1. taxable sources (direct tax): taxes imposed on different sources of income and wealth and paid by mainly by the public (individuals and corporations), indirect tax: sales tax (tax on goods and services). 2. non-taxable sources: income from government-owned corporations, capital inflows in the form of external loans and debts from international financial institutions, and foreign aid from other counties. the general argument on trade openness, as one of the study’s independent variables, is based on the previous literature (akubu et al., 2015; hysa et al., 2014; kose et al., 2009) which denotes that trade openness, as a proxy for trade liberalization, has a positive role in promoting and enhancing economic growth and trade openness, and thus, is considered as one of the main determinants of economic growth and is considered as an engine of growth. there are different measures for international trade openness, the most popular one being the sum of total exports and imports as a percentage of the gdp. based on several researches (brun and gnangnon, 2017; masood et al., 2016; pattayat, 2016; chaudhry and munir, 2010), the following control variables are expected to be included: real gdp per capita, total population, corruption index. real gdp per capita: according to the world bank, the real gdp per capita can be used as a proxy indicator for social welfare and used as a benchmark to compare the standard of living between the countries. real gdp per capita is calculated as the total economic output of a country divided by its total population, adjusted for inflation. c o r r u p t i o n l e v e l i n d e x : a c c o r d i n g t o t h e wo r l d w i d e governance indicators, a corrupt practice is the offering, giving, receiving or soliciting, directly or indirectly, of anything valuable to influence the actions of another party improperly. 4. empirical analysis this section presents the empirical portion of the study. the analysis of the results will be conducted according to the following three steps: 1. examine the stationarity of each variable using panel unit root tests. 2. examine the long run-relationship between the study variables. 3. depending on 1 and 2, a proper method of estimation will be chosen. 4.1. panel unit root tests before testing the existence of a cointegration relationship between the study variables, the stationarity of the variables are tested by applying the different types of panel stationarity tests at both the levels differently. the results with constant, constant and trend are presented in tables 1-4, respectively. it is important to detect whether the study variables have unit root. there are various methods that can be used to test the stationarity of variables. summary is considered as a formal test method that includes the major types of panel unit root test. the general hypotheses for a panel unit root test are as follow: shubati and warrad: the effects of international trade openness on government revenue: empirical evidence from middle east and north african region countries international journal of economics and financial issues | vol 8 • issue 1 • 2018156 • null hypothesis: panel data has a unit root (non-stationary). • alternative hypothesis: panel data does not have a unit root (stationary). tables 1 and 2 present the testing of the null hypothesis of the unit root of the study variables by applying a summary test type at level with the individual effects and individual linear trends, respectively. based on the probability value, we can take the decision regarding the stationarity of the study variables. if the probability value is <5%, we reject the null hypothesis and accept the alternative hypothesis. this means that the study variables at level do not have a unit root. on the other hand, if the probability value is more than 5%, we fail to reject the null hypothesis and reject the alternative hypothesis, meaning that the study variables have a unit root. if the results are mixed, we take the decision based on the majority of test method results. hence, if most of the methods show that the study variable has a unit root, the decision will be that the study variable is non-stationarity. on the other hand, if most of the methods show that the study variable does not have a unit root, the decision will be that the study variable is stationarity. according to table 1, government public revenue (tgr) and the international trade openness of a country (top) has a unit root table 1: panel unit root test: level variables exogenous variables methods statistic value p value decision tgr individual effects levin, lin and chu −1.4291 0.0765 non-stationary im, pesaran and shin w-stat −0.57878 0.2814 non-stationary adf-fisher chi-square 19.9816 0.3339 non-stationary pp-fisher chi-square 22.6035 0.2063 non-stationary top individual effects levin, lin and chu −1.59068 0.0558 non-stationary im, pesaran and shin w-stat 0.27319 0.6076 non-stationary adf-fisher chi-square 11.8965 0.8525 non-stationary pp-fisher chi-square 11.1831 0.8864 non-stationary cor individual effects levin, lin and chu −2.30818 0.0105 stationary im, pesaran and shin w-stat −1.46503 0.0715 non-stationary adf-fisher chi-square 25.9767 0.1003 non-stationary pp-fisher chi-square 25.2025 0.1194 non-stationary pop individual effects levin, lin and chu −1.70468 0.0441 stationary im, pesaran and shin w-stat 0.63738 0.7381 non-stationary adf-fisher chi-square 32.4612 0.0194 stationary pp-fisher chi-square 2.69370 1.0000 non-stationary gpc individual effects levin, lin and chu −3.885 0.0001 stationary im, pesaran and shin w-stat −1.09644 0.1364 non-stationary adf-fisher chi-square 21.5038 0.2548 non-stationary pp-fisher chi-square 12.9913 0.7921 non-stationary table 2: panel unit root test: level variables exogenous variables methods statistic value p value decision tgr individual effects levin, lin and chu −1.1058 0.1344 non-stationary individual linear trends breitung t-stat 0.32464 0.6273 non-stationary im, pesaran and shin w-stat 0.89496 0.8146 non-stationary adf-fisher chi-square 12.1809 0.8378 non-stationary pp-fisher chi-square 15.4666 0.6297 non-stationary top individual effects levin, lin and chu −1.32458 0.0927 non-stationary individual linear trends breitung t-stat 0.42042 0.6629 non-stationary im, pesaran and shin w-stat 0.27277 0.6075 non-stationary adf-fisher chi-square 16.2454 0.5754 non-stationary pp-fisher chi-square 13.9501 0.7323 non-stationary cor individual effects levin, lin and chu −0.65163 0.2573 non-stationary individual linear trends breitung t-stat −0.46709 0.3202 non-stationary im, pesaran and shin w-stat −0.80078 0.2116 non-stationary adf-fisher chi-square 22.6818 0.2031 non-stationary pp-fisher chi-square 18.5060 0.4228 non-stationary pop individual effects levin, lin and chu −20.3304 0.0000 stationary individual linear trends breitung t-stat 2.32242 0.9899 non-stationary im, pesaran and shin w-stat −26.2292 0.0000 stationary adf-fisher chi-square 159.097 0.0000 stationary pp-fisher chi-square 6.55016 0.9934 non-stationary gpc individual effects levin, lin and chu 0.71640 0.7631 non-stationary individual linear trends breitung t-stat 2.33490 0.9902 non-stationary im, pesaran and shin w-stat 3.20938 0.9993 non-stationary adf-fisher chi-square 10.1648 0.9264 non-stationary pp-fisher chi-square 3.15998 1.0000 non-stationary shubati and warrad: the effects of international trade openness on government revenue: empirical evidence from middle east and north african region countries international journal of economics and financial issues | vol 8 • issue 1 • 2018 157 which is at level with the individual effects. with regard to levin, lin and chu tested that the corruption level (cor), real gdp per capita (gpc) are stationary at level but the majority results for other test types show that cor, gpc have a unit root. with regard to adf fisher chi-square and levin, lin and chu tested that the total population (pop) is stationary, but the majority results for other test types show that pop has a unit root. according to table 2, government public revenue (tgr), international trade openness of a country (top), the corruption level (cor), gdp per capita (gpc) have a unit root at level with the individual effects and individual linear trends. with regard to levin, lin and chu, im, pesaran and shin w-stat and adf fisher chi-square tests, the total population (pop) is stationary but the majority results for other test types show that pop has a unit root. tables 3 and 4 present the testing of the null hypothesis of the unit root of the study variables by applying the summary test type at 1st difference with the individual effects and individual linear trends, respectively. according to table 3, government public revenue (tgr), international trade openness of a country (top), the corruption level (cor), real gdp per capita (gpc), total population (pop) are stationary at first difference with the individual effects. according to table 4, the government public revenue (tgr), international trade openness of a country (top), the corruption level (cor) is stationary at first difference with the individual effects and individual linear trends. with regard to breitung t-stat, the total population (pop) and real gdp per capita (gpc) have a unit root but the majority results for other test types show that the pop and gpc are stationary. the main conclusion is that the study data are stationary after taking the first difference into consideration. 4.2. panel cointegration test it is critical to examine the existence of a cointegration relationship between the study variables in order to check whether these variables have a long-run stable relationship. developing a panel cointegration model is the main target of this study. to achieve this target, there is a precondition for running the panel cointegration model, in other words (cointegration regression), and that the study variables must be non-stationary at level. however, when the variables are converted into first difference, it will become stationary. the general hypotheses for panel unit root test are as follow: • null hypothesis: there is no cointegration in the model. • alternative hypothesis: there is a cointegration in the model. according to the kao panel cointegration test (engle granger based), there is one deterministic trend specification which is the individual intercept. table 5 presents the outcome of this test for the study model. if the probability value is <5%, we can reject the null hypothesis and accept the alternative one, meaning that the study variables are cointegrated. on the other hand, if the probability value is more than 5%, we will fail to reject the null hypothesis and reject the alternative one, meaning that the study variables are not cointegrated. with regard to the kao test outcomes in table 5, the probability value is <5%, meaning that the study variables for each model have a long-run, stable relationship. 4.3. model estimation in light of the results of the panel stationarity and cointegration tests, the model cannot be estimated directly with the panel ordinary least squares (ols). to avoid the problem of spurious regression, a panel fully modified ols (fmols) was used to estimate the model’s long-run parameters. the results of applying panel fully modified least squares are shown in table 6 below: according to the previous studies, there are different types of factors that have a potential impact on the government revenue. these factors include both the supply side and demand side factors (brun and gnangnon, 2017). this study analyzed the potential role of some of these factors, such as: 4.3.1. international trade openness the study used international trade openness as a traditional measure for trade liberalization by considering the summation table 3: panel unit root test: 1st difference variables exogenous variable methods statistic value p value decision d (tgr) individual effects levin, lin and chu −2.69274 0.0035 stationary im, pesaran and shin w-stat −2.85569 0.0021 stationary adf-fisher chi-square 39.5585 0.0024 stationary pp-fisher chi-square 95.7312 0.0000 stationary d (top) individual effects levin, lin and chu −5.13671 0.0000 stationary im, pesaran and shin w-stat −3.68057 0.0001 stationary adf-fisher chi-square 45.4309 0.0004 stationary pp-fisher chi-square 85.7624 0.0000 stationary d (cor) individual effects levin, lin and chu −6.82269 0.0000 stationary im, pesaran and shin w-stat −5.55652 0.0000 stationary adf fisher chi-square 65.3645 0.0000 stationary pp-fisher chi-square 96.7489 0.0000 stationary d (pop) individual effects levin, lin and chu −15.9662 0.0000 stationary im, pesaran and shin w-stat −15.5127 0.0000 stationary adf-fisher chi-square 158.534 0.0000 stationary pp-fisher chi-square 7.12886 0.9890 stationary d (gpc) individual effects levin, lin and chu −2.54573 0.0055 stationary im, pesaran and shin w-stat −2.15906 0.0154 stationary adf-fisher chi-square 30.8497 0.03 stationary pp-fisher chi-square 34.444 0.0111 stationary shubati and warrad: the effects of international trade openness on government revenue: empirical evidence from middle east and north african region countries international journal of economics and financial issues | vol 8 • issue 1 • 2018158 of the total export and import as a percentage of the gdp. the results of the model are reported in table 6. the results show that the international trade openness (top) coefficient is associated negatively with the government revenue (tgr) as a dependent variable; meaning that a 1% increase in international trade openness leads to 0.228% decline in the government revenue. this relationship has a significance level of 1%, wherein the results are consistent with the outcomes of khattry and rao’s (2002) study. this result supports the negative perspective of the relationship between international trade openness and government revenue. the rationale behind this negative argument is based on the fact that international liberalization induced a reduction in the taxes imposed on international trade transactions and hence, reduced the government revenue. previous studies (agbeyegbe et al., 2006) have argued that this negative impact can be offset only if the countries are able to recover these losses in the foreign trade tax from other resources, such as domestic tax sources, imposed on domestic transactions. table 4: panel unit root test: 1st difference variables: exogenous variables methods statistic value p value decision d (oda) individual effects levin, lin and chu −2.22671 0.0130 stationary individual linear trends breitung t-stat −2.25999 0.0119 stationary im, pesaran and shin w-stat −1.9271 0.0270 stationary adf-fisher chi-square 27.0990 0.0404 stationary pp-fisher chi-square 98.4920 0.0000 stationary d (fdi) individual effects levin, lin and chu −8.43573 0.0000 stationary individual linear trends breitung t-stat −5.56191 0.0000 stationary im, pesaran and shin w-stat −7.58889 0.0000 stationary adf-fisher chi-square 77.0248 0.0000 stationary pp-fisher chi-square 91.2491 0.0000 stationary d (tgr) individual effects levin, lin and chu −8.24354 0.0000 stationary individual linear trends breitung t-stat −5.36828 0.0000 stationary im, pesaran and shin w-stat −5.50619 0.0000 stationary adf-fisher chi-square 58.514 0.0000 stationary pp-fisher chi-square 77.7774 0.0000 stationary d (top) individual effects levin, lin and chu −5.86559 0.0000 stationary individual linear trends breitung t-stat −3.28127 0.0005 stationary im, pesaran and shin w-stat −2.58814 0.0048 stationary adf-fisher chi-square 34.8833 0.0098 stationary pp-fisher chi-square 91.3201 0.0000 stationary d (cor) individual effects levin, lin and chu −6.78376 0.0000 stationary individual linear trends breitung t-stat −5.8113 0.0000 stationary im, pesaran and shin w-stat −6.01492 0.0000 stationary adf-fisher chi-square 65.051 0.0000 stationary pp-fisher chi-square 91.8147 0.0000 stationary d (pos) individual effects levin, lin and chu −2.48914 0.0064 stationary individual linear trends breitung t-stat −2.441 0.0073 stationary im, pesaran and shin w-stat −2.39683 0.0083 stationary adf-fisher chi-square 33.9099 0.0129 stationary pp-fisher chi-square 70.9330 0.0000 stationary d (pop) individual effects levin, lin and chu −21.2729 0.0000 stationary individual linear trends breitung t-stat 2.88624 0.9981 non-stationary im, pesaran and shin w-stat −17.1031 0.0000 stationary adf-fisher chi-square 89.9424 0.0000 stationary pp-fisher chi-square 6.34448 0.9946 non-stationary d (doc) individual effects levin, lin and chu −2.97528 0.0015 stationary individual linear trends breitung t-stat 1.17272 0.8795 non-stationary im, pesaran and shin w-stat −1.28149 0.1 non-stationary adf-fisher chi-square 28.5417 0.0453 stationary pp-fisher chi-square 35.7808 0.0075 stationary d (gpc) individual effects levin, lin and chu −3.85369 0.0001 stationary individual linear trends breitung t-stat 0.08055 0.5321 non-stationary im, pesaran and shin w-stat −2.03294 0.0210 stationary adf-fisher chi-square 34.0085 0.0126 stationary pp-fisher chi-square 48.4338 0.0001 stationary table 5: kao residual cointegration test cointegration test statistic value p value adf −4.16252 0.0000 table 6: estimation result for the model using fmols variable coefficient standard error t-statistic p value top −0.227934 0.014005 −16.27549 0.0000 gpc 0.054014 0.001778 30.3778 0.0000 pop −0.002044 0.000634 −3.224717 0.0016 cor −0.047592 0.010698 −4.448652 0.0000 source: authors calculation using eviews. fmols: fully modified ordinary least squares shubati and warrad: the effects of international trade openness on government revenue: empirical evidence from middle east and north african region countries international journal of economics and financial issues | vol 8 • issue 1 • 2018 159 4.3.2. the real gdp per capita the real gdp per capita considers a proxy measure for the level of development. real gdp per capita (gpc) has a positive and significant impact on the government revenue at 1% significant level, meaning that a 1% increase in the real gdp per capita leads to a 0.054% increase in the government revenue. these results are consistent with the outcomes of (agbeyegbe et al., 2006) other studies which argued that a high real gdp per capita reflects a higher capacity for paying taxes and hence, this leads to more tax revenue collection. 4.3.3. total population the relationship between the total population (pop) and government revenue (tgr) is negative and significant at 1%, meaning that a 1% increase in the total population results in 0.002% decline in the government revenue. therefore, we conclude that the total population has a weak negative effect on the government revenue. these results are consistent with the outcomes of (khattry and rao, 2002; bahl, 2003) other studies, which argued that in case of the faster growth in population, it is difficult for the government to capture the new taxpayers, especially in the short-run. based on this, we can conclude that a higher size in the total population leads to lower tax revenue. 4.3.4. the level of corruption the impact of the corruption level (cor) on government revenue is negative and significant at 1%, meaning that a 1% increase in the corruption level leads to 0.048% decline in the government revenue. this result is consistent with the outcomes of bird et al. (2008). the study argued that a lower corruption level contributes positively in the mobilization of the government revenue and hence, enhances the performance of tax collection. with regard to this, a lower corruption level leads to more government revenue. 5. conclusion the main goal of this study is to empirically test whether the existence of international trade openness as a proxy measure for trade liberalization is associated with providing more domestic financial flows measured by government public revenue in mena countries, during the period of 2000-20015. consequently, the study looks deeply into more related elements by exploring the main factors that determine domestic financial flows. the study used international trade openness as a traditional measure of trade liberalization by taking the summation of the total export and import as a percentage of the gdp. the empirical results indicated that the existence of international trade openness induced a reduction in the government public revenue. these results are consistent with the outcomes of khattry and rao’s research (2002). based on the above discussion, we conclude that the empirical results of the study support the negative perspective of the relationship between international trade openness and government revenue. the rationale behind this negative argument, based on the fact that developing countries rely heavily on indirect tax revenue sources such as import tariffs. therefore, when countries increase the degree of openness to international trade, it induces a reduction in the restrictions on import tariff tax and hence, it decreases the tax revenue. hence, the main conclusion of this study is that there is a potential loss in government revenue as result of decreasing the tax on international trade for facilitating free trade in developing countries. references agbeyegbe, t.d., stotsky, j., woldemariam, a. 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(2009), economic development. 10th ed. essex, uk: pearson education. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.1-7 issn: 2146-4138 www.econjournals.com 1 testing nonlinear inflation convergence for the central african economic and monetary community emmanuel anoruo coppin state university, baltimore, maryland, usa. email: eanoruo@coppin.edu vasudeva n.r. murthy creighton university, omaha, nebraska, usa. email: vmurthy@creighton.edu abstract: this paper uses nonlinear unit root testing procedures to examine the issue of inflation convergence for the central african economic and monetary community (cemac) member states including cameron, central african republic, chad, equatorial guinea, gabon and the republic of congo. the results from nonlinear star unit root tests suggest that inflation differentials for the sample countries are nonlinear and mean reverting processes. these results provide evidence of inflation convergence among countries within cemac. the finding of inflation convergence indicates the feasibility of a common monetary policy and/or inflation targeting regime within cemac. keywords: inflation convergence; star; nonlinear unit root tests; inflation differential; cemac jel classifications: c22; e31; f15; f36 1. introduction the issue of inflation convergence has become an important topic in both domestic and international macroeconomics. inflation convergence in a group of similar countries indicates the integration of goods markets. in integrated markets, inflation rates generally exhibit convergence in the long run. inflation convergence also has many policy implications for the effectiveness of the countries’ central banks’ monetary policies. furthermore, for reliable econometric modeling for both structural analysis and forecasting, the order of the time series needs to be tested. while there is a plethora of econometric studies investing the convergence of inflation rates for many advanced countries and organization of economic co-operation and development (oecd) countries exists, hardly there are any serious econometric attempts to test this phenomenon for african countries. the need for investigating the inflation convergence in african countries is imminent as many of these countries are implementing economic liberalization policies, experiencing globalization, getting integrated, and becoming a part of the recent technological revolution in communications. furthermore, often, some of these countries aspire for the formation of common currency and monetary areas. even for the advanced and oecd countries, most of the existing studies employ the widely used dickey-fuller (df) and the augmented dickey-fuller (adf) type linear unit root tests. recently, it has been empirically demonstrated that the statistical power of the linear unit root type tests are very low if the true data generating process (dgp) is indeed nonlinear in nature. when we study inflation in a particular economy or convergence of inflation phenomenon across countries, it is quite apparent that inflation rates may exhibit nonlinearities in the presence of transaction costs, arbitrage and especially, inflation targeting monetary policies. under inflation targeting, the dgp becomes a nonlinear process because the responsiveness of the central bank may change depending on whether the prevailing inflation rate is above or below a well-defined target, thus creating a “band of inaction” (see, kapetanios et al. 2003: christopoulos and leon-ledesma, 2007). in the literature, recently there have been some empirical attempts to employ nonlinear unit root tests, especially in the case of developed countries. for instance, gregoriou and kontonikas (2006) using nonlinear unit root testing procedure examined the time series properties of inflation in seven countries (i.e. australia, canada, chile, israel, new zealand, sweden and uk) that have adopted inflation targeting. they found that inflation deviations from the target for the seven sample countries are characterized by a nonlinear mean-reverting process. based on this finding, international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.1-7 2 they concluded that the implementation of inflation targeting strategy by these countries has been a success. koćenda and papell (1997) examined the issue of inflation convergence for the european union using a panel data approach. they find evidence of inflation convergence within the european union. holmes (2002) using panel data unit root and cointegration procedures investigated the extent of long run inflation convergence among the european union countries. he finds evidence in support of inflation convergence for the sample countries during the time period 1983 through 1990. gregoriou and kontonikas (2009) model the behavior of inflations from the target for a sample of five oecd countries including australia, canada, new zealand, sweden and the united kingdom. these five countries adopted inflation targeting regimes over the 1990s. they find that inflation deviations from the target are nonlinear. they therefore concluded that inflation differentials should be modeled as nonlinear processes. spiru (2008) using time series and panel unit root testing procedures, examined the issue of nonlinear inflation convergence for central and east european (cee) economies. spiru finds that inflation rates for the sample countries are nonlinear and have converged. spiru, further points out that participation in the exchange rate mechanism (erm) tends to favor inflation convergence. however, the introduction of a single currency and a common monetary policy account for a certain degree of divergence within the cee. weber and beck (2005) investigate both the extent and dynamics of inflation differentials in major emu countries; preand postthe introduction of the euro. they find evidence that inflation differentials for the sample countries are mean reverting indicating the existence of β-convergence. busetti, et al. (2006) examined the convergence properties of inflation differentials for countries of the european monetary union (emu) for the time period running from 1980 through 2004. they divided the sample period into two; 1980 – 1997 and 1998 – 2004. they find evidence supportive of inflation differentials for the period 1980 through 1997 but not for the second period running from 1998 to 2004. lane (2006) examined the time series properties of inflation differentials for emu member countries. lane found that inflation differentials among emu member states are persistent. kisswani and nusair (2011) using the standard augmented dickey-fuller (adf) unit root test examined the time series properties of inflation differentials for indonesia, malaysia, the philippines, singapore and thailand relative to the u.s. and japan. they found that the inflation differential series are stationary, indicating the existence of inflation convergence among the sample countries. the preceding studies focused attention on the issue of inflation convergence in the context of emu. thus, it is evident that little or no attention has been devoted on this issue relative to monetary unions in africa, including cemac. the success of the emu cannot be generalized to africa. kimenyi and kuhlmann (2012) point out that the regional integrations in africa face a number of challenges such as political instability, social and cultural barriers, weak infrastructure and multiple memberships in regional organizations. in addition, most of the earlier studies used linear unit root tests, which have been shown in the literature to have low statistical power in the presence of nonlinearity. this paper makes two contributions to the literature. first, the study extends the discussion on inflation convergence to the central african economic and monetary community (cemac) countries. second, the study applies the kapetanios, shin and snell (hereafter kss) and kruse (2011) procedures that take into account the ability to account for both possible nonlinear trends and asymmetric adjustment in the mean reversion process. the remainder of the paper is organized as follows. section 2 discusses the econometric techniques of the study. section 3 presents the data and the descriptive statistics. section 4 furnishes the empirical results. section 5 offers the summary and policy implications of the study. 2. econometric techniques the empirical analysis of the study begins with the application of the linear unit root procedures advanced by ng and perron (2001). the ng and perron (2001) unit root procedures combine the modified information criterion and the generalised least squares methods to attain better power and size. in particular, they proposed the following unit root procedures; the mzαgls, mztgls, msbgls and the mptgls. the mzαgls and mztgls are the modified versions of the phillips’ (1987) conventional unit root tests. the msbgls refers to the modified version of bhargava’s (1986) standard r1 test while the mptgls is the modified version of the point optimal procedure proposed by elliot et al. (1996). testing nonlinear inflation convergence for the central african economic and monetary community 3 to ascertain whether the inflation differentials exhibit nonlinear behavior, this paper also implements the bds test proposed by brock et al. (1987, 1996). the study provides a brief description of the bds procedure as this test has become standard and has been extensively used in the extant literature. the bds test is applied to the residuals of the series of interest (in our case, inflation differentials). the test statistic is assumed to be asymptotically standard normally distributed with zero mean and a unit variance [i.e. n(0,1)]. under the bds test, the null hypothesis is that the variable of interest is independently and identically distributed. the rejection of the null hypothesis indicates the presence of nonlinearity in the data generating process. the complete underpinnings of the bds test can be found in brock et al. (1987, 1996). 2.1 kss (2003) unit root test kapetanios, shin and snell (2003) (hereafter kss) have shown that a dgp’s nonlinear unit root behavior can be captured through a model that allows the autoregressive parameter to vary smoothly in a two regime model for which the change in regime is smooth rather than abrupt. moreover, in such a model, the nonlinear behavior of the data generating process shows symmetric adjustments for deviations above and below the equilibrium level. they call their model, the exponential star model [estar]. in this paper, we follow their suggestion in the literature to test the mean reversion property of the inflation differential series for cemac countries. a brief introduction of kss is in order. for a detailed mathematical discussion of the model, see kapetanios et al., 2003]. kapetanios et al. (2003) specify the following estar model for the dgp, xt:   tdtttt xxxx    ]exp(1[ 211 (1) where, θ is a parameter that determines the degree of mean reversion. the stochastic term t is assumed to be normally distributed, with a zero mean and a constant variance. in model (1), the maintained hypotheses are that h0: unit root (θ=0) and that ha : nonlinear, but globally stationary (θ > 0). as testing (1) is not mathematically feasible given that λ is not identified under the null hypothesis, kss suggest that we use a first-order taylor approximation to estimate the estar model (1) under the null by re-estimating the following regression model controlling for serial correlation by adding the lagged terms:     j i tititt errorxxx 1 3 1  (2) in model (2), the null hypothesis is that δ =0 and the alternate hypothesis is that δ <0. in order to estimate the kss nonlinear model (2), it is suggested that we employ the technique of the ordinary least squares (ols). for conducting the unit root test, the test statistic t nl, is obtained by dividing the estimated δ in the model (2) by its standard error and reported as   ˆ../ˆt nl es . kss provide the critical values at the 1%,5% and 10% significance to be used in conducting the test. 2.2 kruse (2011) nonlinear unit root test kapetanios et al. (2003) assume that in the original specified model along the lines of (1), the location parameter, c, to be zero. but, recently, kruse (2011) has shown that in real world examples, the possibility of non-zero location parameter is imminent. therefore, he extends the kapetanios et al. (2003) unit root test to allow for a nonzero location parameter. this test is called, in the time-series econometrics literature, the kruse tau test. [see, for a detailed mathematical discussions and statistical derivations, kruse (2011)]. furthermore, kruse (2011) provides the critical values for conducting this test, besides statistically demonstrating the superiority of the test. he shows that the kruse tau test performs extremely well in terms of statistical power and size properties. 3. data and descriptive statistics the data consist of quarterly observations on consumer price index (cpi) for cameron, central african republic, chad, equatorial guinea, gabon and the republic of congo. the data were retrieved from the international financial statistics (cd october 2012) published by the international monetary fund (imf). inflation rates for the sample countries were calculated using the following expression: international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.1-7 4 100* 1      p p t t t (3) where πt is the rate of inflation and p is the consumer price index. the study period runs from the second quarter of 1990 through the first quarter of 2012. table 1 furnishes the descriptive statistics for the inflation rate series. the mean values for inflation rates ranged from a high of 1.66 percent for chad to a low of 0.58 percent for gabon. the minimum and maximum statistics reveal inflation rates fluctuated within the study period. for example, the inflation rate for cameron varied from a minimum of -3.25 percent to a maximum of 18.66 percent. the statistics presented in table 1 reveal that chad (5.32 percent) posted the highest standard deviation while cameron (2.57 percent) recorded the least. the results show that inflation rates for the sample countries are positively skewed with the exception of equatorial guinea. the jarque-bera and kurtosis statistics indicate that inflation rates are statistically significant. these statistics suggest that inflation rates for the sample countries are characterized by much higher distributions than the normal distribution. table 1. summary statistics of inflation rates cameron car chad eq. guinea gabon rep. of congo mean 0.95 0.92 1.02 1.66 0.58 1.28 maximum 18.66 15.35 24.58 13.34 18.87 25.56 minimum -3.25 -3.46 -10.52 -10.74 -10.21 -7.53 std. dev. 2.57 2.77 5.32 3.58 3.20 3.93 skewness 4.39 2.20 1.09 -0.21 2.36 3.14 kurtosis 28.92 11.15 6.86 7.74 17.84 19.31 jarque-bera 2747.39*** 314.28*** 72.00*** 83.16*** 889.32*** 1119.95*** probability 0.00 0.00 0.00 0.00 0.00 0.00 *** indicates rejection of the normality assumption at the 1% level of significance in order to test inflation convergence, we define inflation differential as:  xtitty  (4) in equation (4),  it is the observed rate of inflation in the i th country during a given period and  xt is the average rate of inflation for cemac during the same time period. the order of integration of the variable yt is used to determine the presence or lack of convergence of inflation differentials. if the observed yt variable for a given country is found to have one order of integration [i. e. i ~ (0)], then the variable or the series is stationary and hence, there is inflation rate convergence. 4. empirical results the empirical results of the study are discussed in this section. table 2 displays the results from the linear ng and perrion (2001) unit root tests including the mzagls, mztgls, msbgls and mptgls. these tests produced mixed results. for example, in the case of cameron, the results from the mzagls (-25.44) and mztgls (-3.56) tests suggest that the null hypothesis that the inflation differential series are unit root processes should be rejected at the 1 percent level of significance. however, the test results from the msbgls (0.14) and mptgls (0.97) are all less than the critical values at the conventional levels indicating that the null hypothesis that the inflation differentials are unit root processes should not be rejected. similar results are indicated for the other sample counties. the results from the mzagls , mztgls, msbgls, and mptgls linear unit root procedures are inconsistent. as it has been noted in the literature, linear unit root tests tend to suffer from low power in the presence of nonlinearity in the data generating process. given the inconsistent results provided by the linear unit root testing procedures, the study next applies a battery of nonlinear unit root tests. in particular, the study implements the kss nonlinear unit root tests. prior to implementing the nonlinear star unit root tests, the study utilized the bds procedure to test the null hypothesis of linearity against the alternative of a nonlinear model. the results from the bds tests are presented in table 3. based on the results from the bds procedure, the null hypothesis of linearity is rejected in favor of the alternative of nonlinearity in all of the cases. for example, in the case of cameroon, the test statistic is 3.904 with a p-value of 0.000, indicating that the null hypothesis should be rejected at the 1 percent level of significance. similar results are testing nonlinear inflation convergence for the central african economic and monetary community 5 indicated for the other sample countries with the exception of the republic of the congo, where the null hypothesis is rejected at the 5 percent level of significance. table 2. ng and perron (2001) unit root test results series lag(s) mza gls mztgls msbgls mptgls cameroon 1 -25.44*** -3.56*** 0.14 0.97 central african republic 0 -42.30*** -4.52*** 0.11 0.79 chad 1 -108.16*** -7.35*** 0.07 0.23 equatorial guinea 8 0.17 0.27 1.61*** 139.33*** gabon 0 -42.97*** -4.63*** 0.11 0.57 republic of the congo 3 -4.28 -1.45 0.34*** 5.74*** critical values 1% -13.80 -2.58 0.17 1.78 5% -8.10 -1.98 0.23 3.17 10% -5.70 -1.62 0.28 4.45 *** and *** indicate rejection of nonlinearity hypothesis at the 1%, and 10% levels, respectively. the optimal lags were determined by the modified akaike information criterion. table 3. bds linearity test results series stat m p-value decision cameroon 3.904*** 5 0.000 reject h0 central african republic 2.625*** 5 0.009 reject h0 chad -5.555*** 9 0.000 reject h0 equatorial guinea 8.307*** 5 0.000 reject h0 gabon 3.046*** 5 0.002 reject h0 republic of the congo 1.948** 5 0.050 reject h0 *** and *** indicate rejection of linearity hypothesis at the 1%, and 10% levels, respectively. having established that the inflation differentials for cemac member countries are nonlinear, the study next applies the kss nonlinear unit root tests. the nonlinear kss unit root tests were conducted using the raw, demeaned and detrended inflation differential data for cemac member states. table 4 presents the results from the nonlinear kss unit root test results. the results suggest that the null hypothesis of nonlinear unit root in the inflation differentials for the sample countries should be rejected. in each case, the test statistic is greater than the critical value at least at the 5 percent level of significance. for instance, in the case of cameron, the test statistics -3.66, 3.78, and -3.75, respectively for raw, demeaned and detrended inflation differential data are statistically significant at the 1 percent significance level. the results from the kss procedure indicate that the null hypothesis of nonlinear unit root should be rejected for the inflation differentials for the sample cemac member states. table 4. kss nonlinear unit root test results series raw demeaned detrended cameroon -3.66*** -3.78*** -3.75*** central african republic -4.14*** -4.20*** -4.33*** chad -4.99*** -4.99*** -5.15*** equatorial guinea -6.28*** -5.82*** -5.83*** gabon -2.66** -2.99** -3.40** republic of the congo -7.13*** -7.11*** -7.11*** critical values 1% -2.82 -3.48 -3.93 5% -2.22 -2.93 -3.40 10% -1.92.85 -2.66 -3.13 *** and ** indicate rejection of the null hypothesis at the 1%, and 5% levels, respectively international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.1-7 6 to check the robustness of the results obtained from the kss nonlinear unit root tests, the study applies the kruse (2011) nonlinear unit root testing procedure. again, the kruse (2011) nonlinear unit root tests are conducted using the raw, demeaned and detrended inflation differential data for cemac member states. table 5 displays the nonlinear unit test results from the kruse (2011) procedure. the results indicate that the null hypothesis of nonlinear unit root in the inflation differentials for the sample countries should be rejected at least at the 5 percent level in all of the cases. table 5. kruse nonlinear unit root test results series raw demeaned detrended cameroon 14.78*** 15.43*** 15.41*** central african republic 18.95*** 19.54*** 20.50*** chad 24.59*** 24.60*** 26.18*** equatorial guinea 44.31*** 40.34*** 40.41*** gabon 7.86* 10.73** 13.20** republic of the congo 50.19*** 50.04*** 50.07*** critical values 1% 13.15 13.75 17.10 5% 9.53 10.17 12.82 10% 7.85 8.60 11.10 ***, ** and * indicate rejection of the null hypothesis at the 1%, and 10% levels, respectively taken together, the results from the various nonlinear unit root tests reveal that inflation differentials for cemac member states are nonlinear stationary processes. these results provide evidence in support of inflation convergence among cemac members. this finding is consistent with holmes (2002) and kocenda and papell (1997) who found evidence supportive of inflation convergence within the european union. 5. summary and policy implications this paper has examined the existence of inflation convergence among cemac member countries ― namely, the central african economic and monetary community (cemac) member states including cameron, central african republic, chad, equatorial guinea, gabon and the republic of congo. in particular, the study applied a number the kss and kruse (2011) nonlinear unit root tests. the results from these unit root testing procedures indicate that the inflation differentials are nonlinear and stationary processes. the policy implications of the findings of convergences are twofold. first, the finding of convergence implies that shocks to inflation differentials are not persistent indicating that the goods markets for the cemac member states are integrated. second, the existence of inflation convergence among cemac member states weakens the effectiveness of their domestic monetary policy tools. for further research, it would be informative to extend the discussion on inflation convergence to other regional integrations in africa using nonlinear unit root procedures such as those applied by the present study. it would also be interesting to trace the source of nonlinearity in the inflation differential series for cemac member states. references bernard, a.b., durlauf, s.n. (1995), convergence in international output. journal of applied econometrics, 10, 97-108. bernard, a.b. and durlauf, s.n. (1996), interpreting tests of the convergence hypotheses. journal of econometrics, 71, 161-173. bhargava, a (1986), on the theory of testing for unit roots in observed time series. review of economic studies, 53, 369–384. busetti, f., forni, l. harvey, a., venditti, f. (2007), inflation convergence and divergence within the european monetary union. international journal of central banking, 3(2), 95-121. christopoulos, d. k., leãn-ledesma, m. a. (2007), a long-run non-linear approach to the fisher effect, journal of money, credit and banking, 39(2-3), 543-559. testing nonlinear inflation convergence for the central african economic and monetary community 7 cuestas, j.c., garratt, d. (2011), is real gdp per capita a stationary process? smooth transition, nonlinear trends and unit root testing. empirical economics, 41, 555-563. elliot, g, rothenberg, t.j, stock, j.h. (1996), efficient tests for an autoregressive unit root. econometrica, 64, 813–836. gregoriou, a., kontonikas, a. (2006), inflation targeting and the stationarity of inflation: new results from an estar unit root test. bulletin of economic research, 58(4), 309-322. gregoriou, a., kontonikas, a. (2009), modeling the behavior of inflation deviations from the target. economic modeling, 26, 90-95. holmes, m. (2002), panel data evidence on inflation convergence in the european union. applied economics letters, 9, 155-158. kapetanios, g., shin, y., snell, a. (2003), testing for a unit root in the nonlinear star framework. journal of econometrics, 112, 359–379. kimenyi, m., kuhlmann, k. (2012), african union: challenges and prospects for regional integration in africa. the whitehead journal of diplomacy and international relations, 13(2), 7-27. kisswani, k.m., nusair, s.a. (2011), non-linear convergence in asian interest rates and inflation rates. mpra paper 34179. koćenda, e., papell, d. (1997), inflation convergence within the european union: a panel data analysis. international journal of finance and economics, 2, 189-198. kruse, r. (2011), a new unit root test against estar based on a class of modified statistics. stat papers, 52, 71–85. lane, p.r. (2006), the real effects of emu. centre for economic policy research working paper 5536. ng, s., perron, p. (2001), lag length selection and the construction of unit root tests with good size and power. econometrica, 69(6), 1519-1554. phillips, p.c.b. (1987), time series regression with a unit root. econometrica, 55, 311–340. phillips, p.c.b., perron, p. (1988), testing for a unit root in time series regression. biometrica, 75, 35–346. spiru, a. (2008), inflation convergence in central and eastern european economies. romanian economic and business review, 3(4), 14-34. weber, a.a., beck, g.w (2005), price stability, inflation convergence and diversity in emu: does one size fit all? cfs working paper no. 30, center for financial studies, frankfurt. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.16-26 issn: 2146-4138 www.econjournals.com 16 long memory analysis: an empirical investigation rafik nazarian islamic azad university central tehran branch, iran. email: raf.nazariyan@iauctb.ac.ir esmaeil naderi ma student in economics, faculty of economic, university of tehran, iran. email: naderi.ec@ut.ac.ir nadiya g. alikhani ma in economics, department of economics science and research branch, islamic azad university, khouzestan-iran. email: n.alikhani@khouzestan.srbiau.ac.ir ashkan amiri ma student in economics, islamic azad university central tehran branch, iran. email: ashkan_amiri2001@yahoo.com abstract: this study is an attempt to review the theory and applications of autoregressive fractionally integrated moving average (arfima) and fractionally integrated generalized autoregressive conditional heteroskedasticity (figarch) models, mainly for the purpose of the description of the observed persistence in the mean and volatility of a time series. the long memory feature in figarch models makes them a better candidate than other conditional heteroskedasticity models for modeling volatility in financial series. arfima model also has a considerable capacity for modeling the return behavior of these time series. the daily data related to tehran stock exchange (tse) index was used for the purpose of this study. considering the fact that the existence of conditional heteroskedasticity effects were confirmed in the stock return series, robust regression technique was used for estimation of different arfima models. furthermore, different garch-type models were also compared. the results of arfima model are indicative of the absence of long memory in return series of the tse index and the results from figarch model show evidence of long memory in conditional variance of this series. keywords: stock market; long memory; arfima; figarch. jel classification: c13; c59; g10; g17 1. introduction today, with the increasing growth in financial markets, the changes in these markets have had great influences on the countries’ economy (chuang et al., 2012). accordingly, achieving a sustainable economic growth requires equipment and optimal allocation of resources at the national level and the realization of this may not be possible without the help of financial markets because any recession or booms in the larger markets can impress not only the national economies but also the world economy (eizaguirre et al., 2009). on the other hand, there is an interaction between economic growth and the markets development (bumann et al., 2013). basically, due to the clarity of information, fluidity and also the existence of speculators and investors with different decisions, there have been complicated behaviors and many volatilities; this situation makes managing and controlling them even more difficult. one of the reasons is that the price of a property is dependent on its risk or conditional variance (conrad et al., 2011). so, by modeling price volatilities of a property such as the shares, firstly, brokers can determine the appropriate wage rates, secondly the assets managements in the firms can also prevent the losses and damages caused by long memory analysis: an empirical investigation 17 the high volatility in assets return and thirdly it makes it possible for the investors to avoid probable losses in the future by investigating how the current volatilities impact upon the future volatilities (mun and brook, 2012). on the other hand, emh built based on random walk models has been one of the basic challenges facing financial analysts since according to this hypothesis, the complex behavior of the financial markets cannot be modeled and predicted. by finding the roots of this issue, it can be found that the basic assumptions of the emh cannot take into account all the elements involved in the financial markets. the most important assumption is that markets do not have memory in the sense that yesterday’s happenings will not influence today’s events and that investors are risk averse and always carefully consider all the information in the market (burton, 1987). however, the results of many applied studies are indicative of the fact that majority of the investors are under the influence of the happenings in the market and form their expectations of the future stock prices in keeping with their experiences. this fact points to the conclusion that markets have memory (granger and joyeux, 1980). in addition, one cannot make a confident assertion that all the investors in the financial markets behave logically but that they may do trading and favor risking without paying attention to the market information because always some investors may make a profit and some may sustain losses. therefore, although based on the assumptions of emh, financial markets are apparently unpredictable, the fact is that this is not the case (sowell, 1992). thus, the assumptions of the emh were faced with such criticisms and "fractal market hypothesis" (fmh) was proposed which was able to provide a more comprehensive analysis of the markets. this hypothesis, in fact, implied the existence of a market composed of numerous investors pursuing their goals with different investment horizons. the types of information important to each one of these investors is different. on this basis, as long as the market sustains its fractal structure, it will stay stable without considering time scale of the investment horizons. on the other hand, when all the investors in the market have the same time horizon, the stability of the market will be undermined because people will do trading drawing on similar market information (baillie, 1996). although rejecting the emh implies non-randomness and, as a consequence, predictability of different series, this result is achieved because emh has been formed based on the random walk model and consequently the existence of a linear structure in the behavior of the market (brock et al., 1992). on the other hand, with regard to the financial markets which mainly have a complex and chaotic structure, fmh analyzes and assesses the issue of predictability from the perspective of nonlinear models (vacha and vosvrda, 2005). although accepting the dependence of the behavior of a financial market on the fmh is a confirmation of the use of different non-linear models in consonance with the feature of long memory (e.g., auto regressive fractionally integrated moving average or arfima model) and also different types of neural network models (e.g., nonlinear neural network auto regressive or nnar model as a dynamic model), it should also be noted that the fact that the inherent features of the mentioned markets (e.g., long memory) can improve the results of modeling should not be overlooked. in this way, with the development of financial markets, an increase in the number of investors in these markets, and existence of a close relationship between these markets and macroeconomic variables during the last two decades, prediction of the financial assets prices behavior in the dynamic field of economy and capital markets has promoted into one of the most important issues in financial sciences so that, this issue guides the policy-makers, planners, researchers, and investors in exact and efficient assessment of assets pricing, optimal allocation of financial resources and performance evaluation of risk management. in line with this, many of the studies during the recent years have been focused on this issue which helps improve traditional linear and nonlinear models in forecasting and making more accurate predictions. traditionally, auto regressive conditional heteroskedasticity models were used for modeling return volatilities because these models have theoretical, financial and economical foundations. at the same time, these models have not yielded favorable results in forecasting financial markets because they do not take into consideration the long memory feature which is one of the most important features in modeling and forecasting of the financial markets. therefore, during the recent years, auto regressive fractional integrated conditional heteroskedasticity models which are based on long memory have been an appropriate response to eliminate the mentioned limitations and for this reason they are frequently used, see e.g. kasman et al. (2009), conrad et al. (2011), aye et al. (2012) and tan et al. (2012). international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.16-26 18 hence, the present study attempts not only to use the different models based on long memory (arfima) but also model tehran stock exchange price index volatility by using the conditional heteroskedasticity models especially figarch in forecasting the dependent variable. for these purposes, we will utilize the data related to daily time series from 25/3/2009 to 22/10/2011 (616 observations) out of which 555 observations (about 90% of the observations) were used for modeling and 60 observations for out-of-sample forecasting. 2. methodology after many important studies were conducted on the existence of unite root and cointegration in time series starting in 1980, econometrics experts examined other types and subtypes of non-stationary and approximate persistence which explain the processes existing in many of the financial and economic time series. today, different studies have been and are being conducted on these processes including "fractional brownian motion" and "fractional integrated process" and the "processes with long memory" (lento, 2009). hurst (1951) for the first time found out about the existence of processes with long memory in the field of hydrology. after that, in early 1980s econometricians such as granger and joyex (1980) and hosking (1981) developed econometric models with long memory and specified the statistical properties of these models. during the last three decades, numerous theoretical and empirical studies have been done in this area. for example, (mandelbrot, 1999; lee et al. 2006; onali and goddard 2009)’s studies can be mentioned as among the most influential in this regard. the concept of long memory includes a strong dependency between outlier observations in time series which, in fact, means that if a shock hits the market, the effect of this shock remains in the memory of the market and influences market activists’ decisions; however, its effect will disappear after several periods of time (in the long term). thus, considering the nature and the structure of financial markets such as the stock market, which are easily and quickly influenced by different shocks (economic, financial and political), it is possible to analyze the effects of these shocks and in a way determine the time of their disappearance by observing the behavior of these markets (los and yalamova, 2004). meanwhile, the long memory will be used as a means of showing the memory of the market. by examining the long memory, the ground will also be prepared for improvement of financial data modeling. 2.1. arfima model one of the most popular and most flexible models with the long memory is the arfima model in which fractional cointegration degree (d) is representative of the long memory parameter because it is indicative of the features of the long memory in the time series of the related variable. after making sure about the existence of this feature in a time series using acf1 tests, classic r/s2 analysis and also semi-parametric methods such as gph3, mrs4, etc. (xiu and jin, 2007), the most important stage in the process of estimation of these models is the "fractional differencing" stage; economists, however, used first-time differencing in their empirical analyses due to its ease of use (in order to avoid the problems of spurious regression in non-stationary data and the difficulty of fractional differencing). undoubtedly, this replacement (of first-time differencing with fractional differencing) leads to overor under-differencing and consequently loss of some of the information in the time series (huang, 2010). on the other hand, considering the fact that majority of the financial and economic time series are non-stationary and of the differencing stationary process (dsp5) kind, in order to eliminate the problems related to over differencing and to obtain stationary data and get rid of the problems related to spurious regression, we can use fractional integration. another interesting point is that fractional integration can assume different values, but a specific value for this parameter (d) is indicative the long memory feature. two conditions need to be met for assuming these values. firstly, if -0.5 d 0.5, a series exhibits a stationary and invertible arma process with geometrically bounded autocorrelations. in other words, when 5.00  d , the autocorrelation function decreases 1 auto correlation function 2 rescaled range analysis 3 geweke and porter-hudak 4 modified rescaled range 5 and some are also trend stationary processes long memory analysis: an empirical investigation 19 hyperbolically and the related process is a stationary long memory process meaning that the autocorrelations decay to zero and will not be summable. when 05.0  d , the long memory process will be invoked. the medium-term memory shows that the related variable has been overdifferenced and under such conditions, the reverse autocorrelation function decreases hyperbolically. the second condition is that a non-stationary is exhibited by the series if 0.5d1 (hosking, 1981). finally, it is worth mentioning that spurious long memory should not be overlooked; in fact, spurious long memory happens as the result of structural breaks and inattention to nonlinear transformations (kuswanto and sibbertsen, 2008). therefore, based on the concepts introduced, we can correctly model the behavior of a variable using this model. the general form of the model arfima(p,d,q) is as follows: (1) ttlyll ttt d ,...,3,2,1)()()1)((   in which )(l is polynomial autocorrelation, )(l represents moving average polynomial, l is lag operator, t is the mean of ty . besides, in this equation, ttt yz  and is cointegrated with rank d. features of z are dependent on the d value. if 5.0d , covariance of the model will be fixed and if 0d , it will have long memory feature (hosking, 1981). p and q are integers and d is a long memory parameter. dl)1(  represents a fractional differencing operator which is calculated using the following formula: (2) j jjj j d l j d ll )()1( 00              in the above equation, it has been hypothesized that ),0(~ 2 t nt  and also arma section of the model are reversible (aye et al., 2012). 2.2. tests used for identifying the long memory features the most important step in estimating a model with long memory feature is examination of the existence of this feature in the return and volatility of the mentioned series. identifying the existence of long memory feature via techniques such as acf test, gph test, etc. is possible; in the following section. 2.2.1. acf test this method is one of the most popular tests identifying the long memory feature first introduced by ding and granger (1996). in this test, autocorrelation graph decreases from a certain value very slowly or hyperbolically (not exponentially). therefore, such time series have long memory feature. it means that these processes cannot be produced by determined and specific ar and ma lags because in these series, ar and ma have infinite order (xio and jin, 2007). 2.2.2. the gph test (spectral density method) this method is based on frequency domain analysis. in the framework of spectral and frequency domain analysis, the observed time series is weighted summation of the underlying time series which have different periodical patterns. periodogram technique is used for differentiating between short and long memories. this technique was proposed by gewek and porter-hudak (1983) and is often known as the gph estimator. overall, gph statistics estimates the long memory parameter (d) which is based on the following periodogram regression: (3)   jjj ewwi  )2/sin(4ln)](ln[ 10  in which tjwj /2 , nj ,...,2,1 and je represent residuals of the model and jw refers to fourier frequency transformation ( tn  ). finally, )( jwi is a simple periodogram which is defined as follows: (4)    t t tw tj je t wi 12 1 )(   thus, the gph statistic equals 1̂ . international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.16-26 20 2.3. different types of arch models auto regressive conditional heteroskedasticity (arch) models first proposed by engel (1982) later on expanded by borlerslev (1986) include the kind of models that are used for explaining the volatilities of a time series. following that different types of arch models were introduced. they are divided into two groups: linear (igarch and garch) and nonlinear models (egarch, tgarch, pgarch, figarch, etc.). 2.3.1. linear garch models borlerslev (1986) started introducing the generalized model of arch, i.e., garch model based on engel’s arch model. the distinguishing factor between these two models is the existence of variance lags in the conditional variance equation. in fact, garch model has a similar structure to arma. stipulated forms of this model include: (5) )1,0(~, nzhz m tttt ttt     (6) 2 1 2 1 tt ttt h hh      equation (5) above is a mean equation which includes two sections; one of them is t , which should be an appropriate structure for explaining mean equation, and the other is t , which is indicative of residuals in the model above which has heteroskedasticity variance and is consisted of two normal elements ( tz and conditional standard deviation ( th )). as a matter of fact, ht is a conditional variance equation that is estimated along with the mean equation to eliminate the problems related to the heteroskedasticity variance t . in the equation (6),  is the average of 2 t , the 2 1t coefficient indicates the effects of arch and 1th coefficient represents the effects of garch (chang et al., 2009). one of the most important features of this model is the existence of temporary shocks imposed on the time series under investigation (kittiakarasakun and tse, 2011). furthermore, the results of engel and borlerslev’s (1986) studies show that in some of the cases the garch equation mentioned above has a unit root. it means that, for example, in garch(1,1), the 11   value is very close to one. in this case, the garch model is cointegrated and is called igarch. in these models, if there is a shock to the time series under investigation, it will have lasting effects and become noticeable in the long term (poon and granger, 2003). 2.3.2. nonlinear garch models or the figarch model figarch model was first proposed by baillie (1996). in this model, a variable has been defined as fraction differencing, which ranges from zero and one. a general form of the figarch(p,d,q) is as follows: (7) tt d lbll  )()()1( 2  in equation (7), )(l is the function of appropriate lag (q), )(lb is the function of appropriate lag (p), l is the lag operator, and d represents fraction differencing parameter. if d=0, the figarch model will turn into garch, and if d=1, it will turn into igarch. it should be noted that in these models, the effects of the shocks are neither lasting as in igarch models nor temporary as in garch models; the effects are between these two extremes meaning that the effects of the shocks will decrease at a hyperbolic rate. 2.4. criteria for comparing forecasting performance on the whole, mse and rmse criteria are among the most frequently used criteria for comparing forecasting accuracy of the models among other criteria for fitting the accuracy of prediction. in this study, we used the mse criterion for comparing forecasting accuracy of the models because this criterion has important features among which is taking account of the outlying data in comparing forecasting accuracy of the models. besides, this criterion has a higher accuracy as against rmse which shows the error differences as lower (swanson et al., 2011). long memory analysis: an empirical investigation 21 (8) n ssr n yy mse tt     2)ˆ( 3. results analysis for the purpose of this study, we used daily data of the tehran stock exchange (tse) index from 2009/25/03 to 2011/22/10. it should also be mentioned that the acronyms of the variables used in this study include: tedpix (tehran exchange dividend price index) and dlted, showing the difference of the logarithm (return) of the dividend price index. 3.1. descriptive analysis of the data considering the importance of the utilized data in this study, before modeling the mentioned index, a descriptive statistics related to the data will be analyzed first (see table 1 for details): table 1. descriptive statistics accounting value criterions accounting value criterions 9953.99 (0.000) jarquebra 616 observations 108.81 (0.000) boxljung q(10) 0.00193 mean 241.25(0.000) mcleod-li q2(10) 0.00797 s.d 8.9832 (0.000) arch (10) 2.2684 skewness 22.1799 kurtosis with a brief look at the above table, it can be found that the mean of time series return in tehran exchange return in the period under investigation is 0.00193 and its standard deviation is 0.00797. by comparing these two, it can be realized that this time series has experience a high level of volatility during this period. the jarque-bera test indicates non-normal distribution of this time series. besides, the kurtosis statistics also indicate that the distribution of the mentioned time series is fat tail. observing the liang-box statistics (with ten lags), can find, the null hypothesis about the lack of a serial correlation between the terms of the time series be rejected. the mcleod-lee statistics also reject the null hypothesis about the lack of serial correlation between square of the time series return) which is, in fact, expressive of the existence of nonlinear effects in this time series. it should be mentioned that the results of engel’s test were consistent with mcleod-lee’s test and confirmed the hypothesis about conditional variance of the time series return. 3.2. stationary test as the next step, stationary of the dlted series (done to prevent creation of a spurious regression) will be assessed using different tests (see table 2 for the results). table 2. the results related to stationary of the stock return series test critical stat. accounting value result adf6 -1.9413 -16.586 stationary ers7 3.2600 0.9403 non-stationary pp8 -1.9413 -17.543 stationary kpss9 0.4630 0.590 non-stationary if the long memory feature does not exist, it is expected that the series becomes stationary by first differencing, but the results of first differencing show that stock return series is stationary in adf and pp tests while in the kpss and also ers test the results are indicative of non-stationary of the series (see table 2 for the results). such conditions might have been caused by the long memory feature in this series. for this reason, the long memory feature in the stock return series (by fractional differencing series) was further analyzed by the researchers. besides, interpreting the autocorrelation plot can also help to find if there is long memory in the stock return series; as shown in fig. 1 below, 6 augmented dickey–fuller 7 elliott, rothenberg and stock 8 philips-prone 9 kwiatkowski–phillips–schmidt–shin international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.16-26 22 the autocorrelation between different lags in the time series has not disappeared even after about 30 periods and, in fact, these autocorrelations in the series are decreasing at a very slow rate. this is anomalous to the behavior of autocorrelation of the stationary series in which the autocorrelations between different lags in the series decrease exponentially. figure 1. acf graph for stock return series 3.3. examining the fractal market hypothesis generally, dependence of the behavior of a market on the efficient market hypothesis depends on the significance of long memory parameter in its time series. in general, models that are based on long memory are highly dependent on the value of long memory parameter and also attenuation of the autocorrelation functions. on this basis, in the following subsections, the values of long memory parameter are estimated using the gph. on the whole, this test is conforms to the frequency domain analysis and uses the log-period gram technique; this technique is a means for differentiating short and the long memory processes. it should also mentioned that slope of the regression line resulting from applying the log-period gram technique gives us the long memory parameter and if significant, the significance of the related feature in the stock return series can be inferred and the fractal market hypothesis is confirmed. the results of this test have been provided in table 3 below. table 3. estimation of d parameter using gph test based on the nls method series d-parameter t-stat. prob. stock series 0.14088 3.13 0.002 stock return series 1.04695 12.3 0.000 as shown in table 3 above, the value for long memory parameter is non-zero (and also lower than 0.5) which is a confirmation of the existence of long memory in the stock return series. therefore, two conclusions can be drawn from the above test: first, the fractal market hypothesis is supported. the second conclusion is that this series should be fraction differenced once again so that modeling can be done in conformity with it. therefore, although the existence of the long memory feature was confirmed in the return index, in the following sections, we will also focus on the existence of this feature in the stock volatility series. on this basis, in the following sections, stock return series models will be focused on using the models that are based upon long memory. 3.4. estimation of the arfima model there are different methods for estimation of the arfima model and d parameter including approximate maximum likelihood (aml), exact maximum likelihood (eml), modified profile likelihood (mpl), and non linear least square (nls) (ooms and doornik, 1998). in the present study, eml, mpl, nls methods have been selected for estimating these types of models using oxmetrics software. furthermore, based on the akaike information criterion, a comparison was made between different models of arfima and the model that is found to have the lowest score of the information criterion, will be the best model for explaining mean equation of the stock return series. long memory analysis: an empirical investigation 23 table 4. the results of estimation of different models of arfima models akaike information criterion arch test ml nls eml arfima(1,0.14,1) -7.2126 -7.3241 -7.3235 4.8(0.02) arfima(1,0.14,2) -7.2153 -7.3289 -7.3242 3.9(0.04) arfima(2,0.14,1) -7.2124 -7.3234 -7.3226 4.4(0.03) arfima(2,0.14,2) -7.2125 -7.3250 -7.3237 5.7(0.01) according to table 4, it can be concluded that arfima(1,0.14,2) has the lowest akaike information criteria score and has the best performance (see table 5 for specifications). table 5. the results of estimation for arfima(1,0.14,2) variables coefficient t-stat. prob. constant 0.0316 2.21 0.002 d-arfima 0.1408 3. 13 0.000 ar(1) 0.8541 31.41 0.000 ma(1) 0.6163 18.67 0.000 ma(2) 0.2358 3.53 0.004 dummy(1) 0.079 7.28 0.000 dummy(2) 0.0519 8.73 0.000 it is worth mentioning that, the dummy variables introduced in the above equation can be defined as the following: dummy(1) are related to the financial crisis in 2007-2008 and dummy(2) is related to transferring the shares of telecommunication company of iran in the stock in line with the implementation of article 44. additionally, considering the fact that diagnostic tests conducted on residuals of the related model are indicative of the existence of conditional variance heteroskedasticity effects (in table 5), robust regression was used for estimating this model. 3.5. estimating the different types of garch models according to the results provided in table 4, the arfima (1,0.14,2) model, based on the akaike statistics, has the best performance and based on the arch test, the effects of the arch (conditional heteroskedasticity variance) are confirmed to exist in residuals of these models and consequently, in order to eliminate the problems associated with heteroskedasticity variance, models of the arch family can be used. therefore, in the next part, not only the long memory feature will be tested in the stock volatility index, there will also be a focus on modeling variance equation of the series using garch models including those with long memory (fractal) and the non-fractal ones. the results related to different forms have been presented in table 6. table 6. different types of garch models models arfima(1,1) arfima(1,2) arfima(2,1) arfima(2,2) aic sbc aic sbc aic sbc aic sbc garch -7.3182 -7.2523 -7.3243 -7.2501 -7.3172 -7.2430 -7.3133 -7.2309 egarch -6.9688 -6.8864 -6.9667 -6.8761 -6.9651 -6.8744 -6.9618 -6.8629 gjr-garch -7.3221 -7.2478 -7.3349 -7.2525 -7.3244 -7.2420 -7.3209 -7.2302 apgarch -7.3341 -7.2518 -7.3308 -7.2402 -7.3333 -7.2426 -7.3271 -7.2281 igarch -7.3125 -7.2548 -73122 -7.2463 -7.3114 -7.2455 -7.3075 -7.2333 figarch(bbm) -7.3126 -7.2384 -7.3343 -7.2588 -7.3088 -7.2264 -7.3073 -7.2166 figarch(chang) -7.2991 -7.2250 -7.2981 -7.2155 -7.2976 -7.2151 -7.2937 -7.2031 all the proposed models shown in table 6 have been based on different mean equations with long memory and as shown in this table, different combinations include three general parts: the first part of that (at the top of the table) includes different non-fractal models of conditional heteroskedasticity variance, the second part includes the combination of a conditional heteroskedasticity variance with unit root model (igarch), and finally, the third part (down the table) includes the different types of fractal conditional heteroskedasticity variance models (figarch). international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.16-26 24 by comparing information criteria related to different types of garch models, it can be easily found that the arfima (1,2)-figarch(bbm) model has the lowest akaike and schwarz information criteria, so, it is the best model for explaining the behavioral pattern of volatility in the stock series (see table 7 for the coefficients for variables of this model and the statistics related to significance of these coefficients). another conclusion to be drawn from the results shown in the table is the existence of the long memory feature in the stock volatility series. furthermore, statistics related to examining the existence of heteroskedasticity variance in residuals of this model (statistics related to liang-box, mcleod-lee and arch) have also been presented the table 7 with the estimation of this model. table 7. estimating arfima-figarch model results mean equation variables coefficient standard error t-statistic probability c 0.002 0.0008 2.56 0.010 d-arfima 0.18 0.014 12.85 0.000 ar(1) 0.28 0.073 3.93 0.000 ma(1) -0.09 0.008 -12.09 0.000 ma(2) -0.11 0.016 -6.47 0.000 dummy(1) 0.06 0.009 6.16 0.000 dummy(2) 0.04 0.005 7.84 0.000 variance equation variables coefficient standard error t-statistic probability c 1.94 0.776 2.51 0.006 d-figarch 0.31 0.031 10.06 0.000 arch 0.56 0.259 2.19 0.028 garch 0.75 0.154 4.85 0.000 log likelihood 1891.932 boxljung q(10) 12.06 (0.098) akaike -7.334374 mcleod-li q2(10) 4.87 (0.771) schwarz -7.258863 arch(10) 0.0031 (0.955) source: the findings of the study according to the table 7, there are some points worth mentioning. first of all, the dummy variables introduced in the mean equation of the above model indicate the existence of unusual shocks to the time series under investigation. furthermore, in the model under investigation all the coefficients (except the constant) are significant at .95 level of confidence. the results of liang-box test show no sign of serial correlation in the residuals of this model. the existence of heteroskedasticity variables in the residuals was also negated based on the results from mcleod-lee and arch test. 4. conclusions and implications the present study evaluated different models (both fractal and non-fractal) for modeling volatilities of the tse index. accordingly, first of all the existence of long memory feature in this series was considered and on this basis, the existence of the long memory feature was confirmed in the return and volatility of the stock, and, consequently, arfima(1,0.14,2) model was selected as the best explainer of the behavior of mean equation. then the conditional heteroskedasticity was tested and modeled (and confirmed) in different mean equations with long memory. the results of this study confirmed the existence of the long memory feature in the in the mean and variance equation of the mentioned series and finally arfima(1,2)-figarch(bbm) model was selected as the best. based on the findings, the behavior of the stock index has modeling capability and, accordingly, the efficient market hypothesis about it will be rejected. on the other hand, due to the existence of long memory property in both return and volatility indices, fractal market hypothesis is confirmed about it and it can be concluded that nonlinear models and those dealing with long memory have higher level of forecasting accuracy in comparison with their counterparts. some suggestions can also be made based on the results. one is that as regards the existence of long memory feature in tehran stock exchange price index return, paying attention to this fact can help improve the results of modeling and consequently economic predictions because this feature suggests that although the current shocks will have their effects at that very time or at the most with a long memory analysis: an empirical investigation 25 small delay, a remarkable part of these shocks can influence the behavior of the time series with such feature in the future; therefore, as it was confirmed in this study and in many other studies, taking this feature into account will lead to improved performance in the models; investors and 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kirikkale university, department of economics, yahsihan / kirikkale, turkey. phone: +90 318-3574252 e-mail: taylan.dogan@gmail.com abstract: this study investigates the response of unemployment to selective macroeconomics shocks for the period of 2000:q1-2010:q1. it finds that positive shocks to growth, growth in export and inflation reduce unemployment. on the other hand, shocks to exchange rate, interbank interest rate and money supply increase unemployment. the results are consistent with phillips curve and okun’s law suggestion. namely, negative relationship between output and unemployment and positive relationship between unemployment and inflation are found. also, this study finds consistent results with earlier literature. keywords: macroeconomic variables; vector autoregressive model; impulse-response function jel classification: e24; c22 1. introduction the shocks to output extract influence on unemployment through the relationship between output and unemployment implied by okun’s law. this relationship might be changed in terms of magnitude, but it implies as positive shocks to output reduce unemployment. economy’s output and unemployment are related through, as mentioned, okun’s law but the recent study of daly and hobijn (2010) show that this relationship between output and unemployment is not the one predicted by okun’s law for the united states: decline in output created by recent crisis is found to be two times more unemployment than the one that okun’s law suggests to be. in the literature, there are various factors that have effect on unemployment. cascio (2001) investigates monetary policy and unemployment relationship for 11 oecd countries over 1979:q11998:q4 by using vector autoregressive (var) model. according to cascio (2001), monetary shocks influence unemployment but they differ from country to country. namely, local factor(s) is/are important how a labor market is influenced. karanasou and sala (2010) investigate driving forces behind unemployment for australia over time and find that reasons behind unemployment differ according to period investigated. for example, 1970’s driving force behind unemployment is oil shock while in 1990s and 2000s; interest rate is important driving force. yet, currently, the most influential factor is the tight foreign demand due to global crisis. further, another recent study on unemployment by valletta and kuang (2010) shows that the recent increase in unemployment is conjectural rather than structural for the united states. in general, conjectural fluctuations, like fluctuation in exchange rate, international interest rate, and decline in foreign demand are the shocks that extract influence on unemployment. ravn and simonelli (2007) find that monetary policy shocks extracted influence on unemployment for the united states over 1953:q3-2003:q1. djivre and ribon (2003) study monetary policy influence on unemployment, inflation and exchange over 1990-1999 for israel and they found that tight monetary policy shocks increase unemployment. there is no many macro empirical studies on unemployment in turkey. further, in studies regarding turkey’s unemployment, structural breaks have not been considered so as they have not been introduced in var specification. this study considers possible structural breaks in the series in order to assess dynamic relationships around impulse-response functions. for turkey, berument et al. (2006, 2009) and berument (2008) investigates macroeconomic policy shocks on unemployment by using var models. the general conclusion derived from those studies is that positive income shocks reduce unemployment. aktar and ozturk (2009) study interaction among macroeconomic variables for turkey and find that positive income shocks create international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.71-78 72 statistically significant negative effect on unemployment. they, also, find that export is not statistically significant influence on unemployment. dogrul and soytas (2010) investigate relationships among unemployment, oil price and interest rate and find that interest rate shocks left long-term impact on unemployment even though initial impact on unemployment is negative and insignificant. in short, the macroeconomic policy variables thought to extract influences on unemployment are economic growth, interbank interest rate, inflation rate, growth in export, exchange rate and growth in money supply and the period of study is determined by availability of the data set, which there is not quarterly data available before 2000. the study uses quarterly data that consist of the period between 2000:q1 and 2010:q1 in order to explore macroeconomic shocks effects on unemployment. the results indicate that positive shocks to growth, growth in export and inflation reduce unemployment. on the other hand, positive shocks to exchange rate, interbank interest rate and money supply increase unemployment. the findings are consistent with phillips curve and okun’s law suggestion. namely, negative relationship between output and unemployment and positive relationship between unemployment and inflation are found. the rest of this paper consists of three sections. next section introduces the methodology used in this paper. the second is that data used in the study are briefly discussed and empirical analysis follows this brief discussion. the last one provides the concluding remarks. 2. econometric methodology to investigate the effects of macroeconomic variables, this study considers the vector autoregressive (var) model, 1 , 1, , p t i t i t ti y y d t t       (1) where yt=(y1t, y2t,…,ymt)′ is an m×1 vector of jointly determined dependent variables, dt is an q×1 vector of deterministic and/or exogenous variables, and {φi, i=1, 2,…,p} and ψ are m×m and m×q coefficient matrices. in this model e(t)=0, e(tt′)=∑ for all t, where ∑={σij, i, j=1, 2,…,m} is an m×m positive definite matrix, e(tt′)=0 for all t=t′ and e(t|wt)=0. under the assumption of all the roots of 1 | | 0 p i m ji i z     fall outside the unit circle, yt would be covariance-stationary and equation (1) can be rewritten as the infinite moving average representation as seen in equation (2). 0 0 , 1, ,t i t i i t ii iy b z d i t           (2) in which the m×m coefficient matrices bi can be obtained using the following recursive relations 1 1 2 2i i i p i pb b b b         for 1, 2, ,i   with b0=im and bi=0 for i<0, and zi=biψ. the generalized impulse response function is given by equation (3). 1/ 2( ) , 0,1, 2, ,gj jj n jn a e n     (3) equation (3) measures the effect of one standard error shock to the jth equation at time t on expected values of x at time t+n (pesaran and shin, 1998). 3. data and empirical analysis this paper uses quarterly data that consist of the period over 2000:q1 to 2010:q1 in order to investigate the effects of macroeconomic shocks on unemployment. initial investigation by taking quarterly average indicates that all variables contain seasonality, so that all series are deseasonalized by using troma/seats method in order to conduct further study on data. later, graphics of all variables are investigated and by doing so, the behaviours of the series over time are explored and whether there is any structural break in series is observed. because in the case of structural break(s), the techniques based on unit root tests are not healthy for further investigation, this issue is further discussed after unit roots in series are checked. macroeconomic variables and unemployment: the case of turkey 73 the list variables used in this study after seasonal adjustment are unemployment rate, real gross domestic product (gdp) growth (real gdp is seasonally adjusted real gdp divided by seasonally adjusted gdp deflator so that real gdp growth is ln (real gdpt/real gdpt-1) *100, where t=1,2,...,t), export growth (ln (exportt/ exportt-1)*100, where t=1,2,...,t), exchange rate (amount of dollar is bought by one turkish lira), interbank interest rate, inflation (ln (cpit / cpit-1)*100, where t=1,2,...,t and cpi stands for consumer price index) and the last variables is the growth in money supply (growth in m1 is ln (m1t / m1t-1)*100, where t=1,2,...,t). figure 1. seasonally adjusted time series plots 6 8 10 12 14 16 00 01 02 03 04 05 06 07 08 09 unem ployment -3 -2 -1 0 1 2 3 00 01 02 03 04 05 06 07 08 09 growth -8 -6 -4 -2 0 2 4 00 01 02 03 04 05 06 07 08 09 export 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 00 01 02 03 04 05 06 07 08 09 exchange rate 0 2 4 6 8 10 00 01 02 03 04 05 06 07 08 09 interbank interest rate 0 40 80 120 160 200 00 01 02 03 04 05 06 07 08 09 inflation -5 0 5 10 15 20 25 00 01 02 03 04 05 06 07 08 09 m oney supply figure 1 shows the seasonally adjusted series used in this study and all variables are collected from database of the central bank of turkey. on the left-hand side of the top row of figure 1, the unemployment rate series is shown. unemployment from 2000 to the beginning of 2002 looks like an upward trend and, after that, it fluctuates between 10% and 11% until 2008. unemployment after 2008 starts increasing dramatically as it happens before 2002. in the second quarter of 2009, it settles down between 13-14 %. unemployment variable indicates behaviour in that there are structural breaks. unemployment rate between 2002 and 2008 differs from earlier and later periods. hence, for two periods, it can be seen from analysis of the graph of that unemployment series have structural breaks. from the graph given in the middle of the top row of figure 1, the behaviour of economic growth can be seen over time. in this period, there have been two economic crises that turkish economy has faced with. those were 2001 and 2008 economic crisis. in the periods other than crisis, international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.71-78 74 growth rate fluctuates between 0% and 2%. in contrast, the growth rates in crisis periods drop to, as much as, -2.5 percent. the graph given on the right hand-side of the top row of figure 1 is growth in export that has faster growth rate and an upward trend between 2000 and mid-2001. on the other hand, export growth after mid-2001 has downward trend. the fast export growth initially might be related to devaluation undertaken in that period. the serious drop observed in 2008 is very much related to decline in international demand. after 2008, the export returns close to its before-crisis level. if the crisis is not taken into consideration, deseasonalized export growth after 2001 slows down according to figure 1. on the left-hand side of the middle row of the figure 1, the graph of exchange rate can be seen and when it is investigated, a policy change can be clearly observed to happen in 2001. in this year, turkish lira became free-floating currency. at the middle of the figure1, the graph of interbank interest rate shows fast increase in interest rate due to liquidity shock in the spring of 2000. due to rapid flow of capital out, the devaluation became inescapable result in that period (butkiewicz and ozdogan, 2009). this is the first thing that gets our attention. second, this fast increase is followed by a fast decline after the beginning of 2001. lastly, the fast drop trend slows down at the end of 2001. inflation rate, on the left hand-side of the middle row of figure 1, declines from 5% to 3% due to policy implemented throughout 2000s (see, butkiewicz and ozdogan, 2009; and yeldan, 2002 for the policies followed). the influence of the 2001 crisis strikingly is shown in data, inflation picks up and becomes 8.5%. further, in the same year, as its increase, very fast decline in inflation rate is observed. in 2002, inflation goes down even more and get lower than the 2001 crisis level, less than %2. inflation rate in 2003 looks better than earlier year and it goes down below 1% and up until 2009, it stays below 1%. due to economic downturn in 2008, inflation even goes to 0.2%. in 2009, it starts to increase again and it comes close to 2% in the beginning of 2010. when the graph of deseasonalized growth in money supply (m1) in the bottom row of the figure 1 is investigated, a big jump in 2005 is a striking situation: money supply jumps about 23%. in other times, growth in money supply fluctuates between 1% and 7%. after deseasonalization of series, augmented dickey-fuller (adf) unit root tests suggested by said and dickey (1984) are applied to all variables. adf tests results are seen in table 1 below. adf tests are implemented in both level and first-difference. according to adf unit root tests, growth, export growth, exchange rate and money supply growth are all i(1) series. on the other hand, as mentioned above, unemployment, interest rate and inflation rate have all structural breaks in visual inspection. here, somebody should note that unemployment rate and inflation rate, unlike the other variables, are not stationary at level, but stationary at first difference. further, interest rate is not stationary at both levels and first difference. as explained above, there are two structural breaks in unemployment data and one in both interest rate and inflation data. perron (1989) indicates that 1929 great depression and 1973 oil supply shock extracts permanent effects on economy and creates structural change. perron (1989) develops a unit root test that takes those structural changes into consideration. according to perron’s method, structural changes in economy are exogenous and known in advance. on the other hand, zivot and andrews (1992) (hereafter za) take perron’s test statistics differently and they questions whether structural break is determined exogenously or endogenously. za investigate endogenous structural break and, in their case, the time of structural break is not known exactly. in addition, lumsdaine and papell (1997) develop a unit root test that allows two structural breaks in a series. in lumsdaine and papell (1997) test, za test is extended to allow two structural breaks. in parallel to lumsdaine and papell (1997) test, lee and strazicich (2003) (hereafter ls) develops a test based on lagrange multiplier and it allows two endogenous structural breaks. in graph 1, all of the seasonally adjusted series are seen to have structural breaks. when the graphs of the series are examined in detail, except for economic growth and unemployment, they can clearly state that export growth, exchange rate, interbank interest rate, inflation and money supply variables have a single structural break in both constant term and trend term. as explained above, the unemployment series has two structural breaks while the economic growth series has a single break at constant term. in the second and third columns of table 1, adf test results are seen and those test results are not valid in the case of structural break(s). therefore, to unemployment rate, export growth, exchange rate, interbank interest rate, inflation and money supply, the unit root test developed by za, macroeconomic variables and unemployment: the case of turkey 75 which allows a single break at both constant and trend, is applied. the test is also applied to the economic growth with allowing a break for the constant term. the test results are seen in the fourth and fifth columns of table 1. the fourth column of table 1 provides structural time determined by za test endogenously. with the exception of unemployment series, the evidence from za tests rejects the null hypothesis that series is nonstationarity at 5 percent significant level. table 1. unit root tests adf testa zivot-andrews mint-statisticsb lee-strazicich tstatisticsc variables level first difference tb1 mintstatistics tb1 tb2 t-statistics unemployment rate -1.944 -4.220* 2004:q2 -3.583 2002:q4 2008:q2 -6.612 * growth rate -4.388* -8.813* 2008:q2 -6.677* export growth -5.110* -3.874* 2008:q4 -6.549* exchange rate -3.790* -3.440* 2001:q3 -6.549* interest rate -1.691 -1.819 2003:q3 -5.457* inflation rate -1.064 -5.501* 2004:q3 -15.772* growth in money supply -5.168 * -10.320* 2006:q3 -6.274* notes: *shows that it is statistically significant at 5% level. a test contains constant term; testing hypothesis has variable unit root and one-sided test; the critical values for 1%, 5% and 10% significant level are -3.605, -2.936, and -2.606 respectively. b testing hypothesis has variable stable/no unit root and it is one-sided test; the critical value for %5 significant level is -4.42 for only allowing for break in intercept and -5.08 for allowing for break in both intercept and trend. c test contains both constant and trend terms; testing hypothesis has variable unit root and one-sided test; the critical value for %5 significant level is -5.28. when the dynamics of turkish economy after 2000 are taken into consideration, each structural break characterizes each breaking period well. as discussed above, existence of two structural breaks for two different periods is emphasized in unemployment series. due to this reason, the result of za test for unemployment series is consistent with the dynamics of the series. as the dynamics of the unemployment series are accounted into consideration, the ls test, which allows two structural breaks at a constant term, is applied. namely, the ls test allows level shifts for two different periods and it is applied to unemployment series. ls unit root test results are shown in the sixth and seventh columns of table 1. the sixth column of table 1 provides break points and the seventh column of table 1 gives ls t-test statistics. the break dates seen in the sixth column of table 1, 2002: and 2008:2, are quite consistent with dynamics of turkish economy after 2000. the results in table 1 reject the null hypothesis of nonstationarity for unemployment at 5 percent significant level. once the dynamics of turkish economy are taken into consideration, the za and ls tests, which are consistent with those dynamics and their results accounting for structural break/breaks for each series are thought, each series used in the study is stationary at level. this result indicates that there is no stochastic trend in unemployment, economic growth, export growth, exchange rate, interest rate, inflation and money supply growth series. var processes can be well used for application for small and moderate samples in describing data generation process. in general variables are handled endogenously in those models and they allow capturing rich dynamics within data. further, statistical techniques are used to put restrictions rather than using theoretical considerations and/or assumptions. if time series have stochastic trend, stochastic trend should be taken in consideration when investigating the dynamic interactions among the series. if there is common stochastic trend in data generation process of set of variables, they are international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.71-78 76 cointegrated variables according to granger (1981) and engle and granger (1987). if it is so, var model is not good to handle the series. it is better to use vector error correction models (vecm) that capture cointegration structure within such set of series (johansen, 1991). as mentioned above, the time series used in this study are found as stationary processes with structural breaks. therefore, we use var model in order to investigate the dynamic linkages among the series considered. before examining the dynamic effects of the economic growth, export growth, exchange rate, interest rate, inflation and growth in money supply on unemployment series, the study considers the endogenously founded two structural breaks by ls test for unemployment series. for them, it uses dummy variables to control the structural breaks for the unemployment series in the var model. in allowing for two breaks in the intercept, the dummy variable are defined as following: a period, at which the change in the parameters of the trend function occurs, will be referred to as the time of break, or tbi for i = 1, 2. dut(tb1) and dut(tb2) that are the break dummy variables for the mean shift occurring at times tb1=2002:q4 and tb2=2008:q2, respectively. the break dummy variables have the following values: for i = 1 and 2, dut(tbi) = 1 and dt t(tbi) = 0 if t > tb1; 0 otherwise. to examine the effects of the economic growth, export growth, exchange rate, interest rate, inflation and growth in money supply series on unemployment series when one standard deviation shock is given to these series in the var model, first, the optimal lag length of var model is determined. for determining the length of lag in the var model, this study uses the akaike information criteria (aic), schwarz information criteria (sic) and likelihood ratio (lr). starting with p=1 in an ascending order, the uncorrelatedness of residuals until the residuals become uncorrelated by using these information criteria are checked out. if the lr for the var model proves to be uncorrelated for a given p, it is the one chosen as p for the model. as suggested by lr, the longest lag order of the identified var model is 2 for 8 specifications, while aic and sic indicating the longest lag order of the identified var model is 5. moreover, due to sample size, the study also uses 2 for the longest lag order of the identified var model. figure 2 reports the generalized impulse response functions by pesaran and shin (1998) for the unemployment when one generalized standard deviation shock is given to the economic growth, export growth, exchange rate, interbank interest rate, inflation and growth in money supply series. here, effects of a unit standard deviation shock are examined for sixteen periods or four years. response of unemployment to the shocks to the economic growth, seen on the left-hand side the first row in figure 2, has significant influence for the first four periods. the influence of growth rate innovation on unemployment for the first four periods is negative. the innovation reaches its maximum impact at the fourth quarter. the result on the right-hand side of the first row given in figure 2 indicates that the response of unemployment is reported when one generalized standard deviation shock is given to the growth in export. innovation in the export extracts positive and statistically significant influence on unemployment for the first two periods. the graph given on the left hand-side of the second row in the figure 2 shows that in the case of exchange rate shocks, unemployment response is positive and statistically significant for the first five periods and it loses its influence later on. the following variable in figure 2, which is given on the right-hand side of the second row, is interbank interest rate. the unemployment response to interbank interest rate is always positive. it follows different behaviour than the other variables. it has significant influence for the first four periods and it reaches its maximum effect on the fourth quarter. on the other hand, the first two quarters have positive and significant impact and it hits its minimum impact at the third quarter, but it attains its maximum impact by jumping from its deep. after that, it loses its influence on unemployment. inflation influence on unemployment can be seen on the left-hand side of the last row of the figure 2. here, the results on response of unemployment to inflation confirm phillips curve implication. namely, there is inflation-unemployment trade-off. here, the response of unemployment to inflation is negative and significant for the first four quarters. its influence increases over time. that is, it reaches its maximum at the fourth quarter. the last variable studied is growth in money supply, given on the right-hand side of bottom row in figure 2. the response of unemployment to innovation in money supply growth is statistically significant for the first four periods and its influence on unemployment is negative. it has similar movement like interbank interest rate, the response of money supply goes down a deep at third quarter and from this deep it jumps to its maximum at fourth quarter. macroeconomic variables and unemployment: the case of turkey 77 figure 2. the effect of the economic growth, export, exchange rate, interest rate, inflation and money supply series on the unemployment series -.8 -.4 .0 .4 .8 2 4 6 8 10 12 14 16 response of unemployment to gdp growth -.8 -.4 .0 .4 .8 2 4 6 8 10 12 14 16 response of unemployment to growth in export -.8 -.4 .0 .4 .8 2 4 6 8 10 12 14 16 response of unemployment to exchange rate -.8 -.4 .0 .4 .8 2 4 6 8 10 12 14 16 response of unemployment to interbank interest rate -.8 -.4 .0 .4 .8 2 4 6 8 10 12 14 16 response of unemployment to inflation -.8 -.4 .0 .4 .8 2 4 6 8 10 12 14 16 response of unemployment to growth in money supply response to generalized one s.d. innovations ± 2 s.e. 4. conclusion in this study, macroeconomic variables influence on unemployment by including structural breaks which the literature previously has not taken in consideration when unemployment was studied in turkey. as well as there have not been much macro empirical studies that worked this issue for turkey. all the variables used in this study have statistically significant influence on unemployment international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.71-78 78 and they do not extract statistically significant impact more than five periods. gdp growth, export growth and inflation create negative impacts on unemployment but exchange rate, interbank interest rate and money growth extracts negative influences on unemployment. further, the findings are consistent with previous literature. lastly, the findings are also consistent with phillips curve relationship that foresees negative relationship between unemployment and inflation and okun’s law relationship that expresses a negative relationship between output and unemployment. references aktar, i., ozturk, l. 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(2002), behind the 2000/2001 turkish crisis: stability, credibility, and governance, for whom? ideas conference on international money and developing countries: theoretical and policy issue in the current context, 16-19 december, chennai, india zivot, e., andrews, d.w.k. (1992), further evidence on the great crash, oil-price shock and the unit-root hypothesis. journal of business and economic statistics, 10(3), 251-270. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(4), 256-264. international journal of economics and financial issues | vol 8 • issue 4 • 2018256 investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization sabastine mushori1*, delson chikobvu2 1central university of technology, p.o. box 1881, welkom, 9460, south africa, 2university of the free state, p.o. box 339, bloemfontein, 9300, south africa. *email: smushori@gmail.com abstract a dynamic stochastic methodology in optimal portfolio selection that maximizes investment opportunities and minimizes maximum downside risk while taking into account implicit transaction costs incurred in initial trading and in subsequent rebalancing of the portfolio is proposed. the famous mean-variance (mv) model (markowitz, 1952) and the mean absolute deviation (mad) model (konno and yamazaki, 1991) both penalize gains (upside deviations) and losses (downside deviations) in the same way. however, investors are concerned about downside deviations and are happy of upside deviations. hence the proposed model penalizes only downside deviations and, instead, maximizes upside deviations. the methodology maintains transaction cost at the investor’s prescribed level. dynamic stochastic programming is employed with stochastic data given in the form of a scenario tree. consideration a set of discrete scenarios of asset returns and implicit transaction costs is given, taking deviation around each return scenario. model validation is done by comparing its performance with those of the mv, mad and minimax models. the results show that the proposed model generates optimal portfolios with least risk, highest portfolio wealth and minimum implicit transaction costs. keywords: investment opportunities, downside risk, uncertain implicit transaction costs jel classifications: c01, c58, d81, g11 1. introduction individual investors, investment managers and fund managers are all concerned with achieving optimal portfolios of a set of investment assets. models for portfolio selection have evolved over the years starting with markowitz’s (1952) mv formulation to more recent stochastic optimization forms (hiller and eckstein, 1993; vladimirou and zenios, 1997). regardless of whether portfolios are selected for a bank’s derivative mix, an investor’s equity holdings or a firm’s asset and liability management, the common objective in all models is the minimization of some measure of risk while maximizing some reward measure. the mv model has enjoyed popularity over the years despite its criticisms. the mv portfolio analysis has the following simplifying assumptions: i. the assets’ returns are multivariate normally distributed, ii. the investor’s utility function is quadratic, and iii. there are no transaction costs. none of these is exactly true in actual markets. many studies show that returns from hedge funds are not normally distributed (brooks and kat, 2002). pratt (1964) concludes that a quadratic utility function is very unlikely because it implies increasing absolute risk aversion. volatility treats risks and opportunities equally yet investors are concerned about downside deviations (losses) and are happy of upside deviations (gains). hakansson (1971) explains that in the absence of transaction costs, myopic policies are sufficient to achieve optimality. the incorporation of transaction costs in any model provides essential “friction” which without it the optimization has complete freedom to reallocate the portfolio every time-period, which (if implemented) can result in significantly poorer realized performance than forecast, due to excessive transaction costs (hakansson, 1971). these costs can turn highquality investments into moderately profitable investments or low-quality investments into unprofitable investments (d’ hondt and giraud, 2008). in this study, a stochastic multi-stage upsidedownside deviation (smudtc) model is proposed that takes into mushori and chikobvu: investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization international journal of economics and financial issues | vol 8 • issue 4 • 2018 257 account a risk-averse investor’s view of minimizing maximum downside risk while maximizing upside deviations (gains) in an uncertain environment. the model captures uncertainty in both portfolio risk and gain by way of scenarios, which is a representative and comprehensive set of possible realizations of the future. this is achieved by taking deviations around each return scenario. the smudtc model also takes into account uncertainty of implicit trading costs incurred by the investor during initial trading and in subsequent rebalancing of the portfolio. 2. literature review as a way of overcoming the limitations of the mv model, alternative risk measures were developed. konno and yamazaki (1991) propose the mad model in order to overcome the problem of computational difficulty inherent in the mv model. the mad model does not require calculation of the variance-covariance matrix of asset returns and results in optimal portfolios with fewer assets (simaan, 1997). similar to the mv formulation, the mad model penalizes both upside deviations and downside deviations. however, upside deviations are desirable to any investor while downside deviations are not. thus the proposed model maximizes upside deviations and minimizes downside deviations in the presence of implicit transaction costs. the models, mv and mad, are both deterministic. a number of researchers in the literature have studied optimal portfolio selection in the presence of transaction costs. gulpinar et al. (2004), incorporate proportional transaction costs in a multi-period mv formulation. glen (2011) considers a mv portfolio rebalancing strategy with transaction costs comprising fixed charges and variable costs that include market impact. the variable transaction costs are assumed to be non-linear functions of the traded value. however, implicit transaction costs follow a random-walk process and hence, the use of a non-linear function to approximate such costs seems inappropriate. xia and tian (2012) estimate implicit transaction costs in shenzhen a-stock market using the daily closing prices, and examine the variation of the cost of shenzhen a-stock market from 1992 to 2010. the bayesian gibbs sampling method proposed by hasbrouck (2009) is used to analyze implicit costs in the bull and bear markets. kozmik (2012) discusses asset allocation with transaction costs formulated as multi-stage stochastic programming model. transaction costs are regarded as proportional to the value of assets bought or sold, but no implicit trading costs are considered in the model. conditional value-at-risk is employed as a risk measure. brown and smith (2011) study the problem of dynamic portfolio optimization in discrete-time finite-horizon setting and also consider proportional transaction costs. lynch and tan (2010) study portfolio selection problem with multiple risky assets. analytic frameworks are developed for the case with many assets taking into account proportional transaction costs. while the study of optimal asset allocation has received fair consideration in the literature, it is important such studies to have accounted for implicit transaction costs for they are invisible and dependent on the chosen strategy. these costs are difficult to measure and can turn high-quality investments into moderately profitable investments or low-quality investments into unprofitable investments (d’hondt and giraud, 2008). the model being proposed addresses the impact of implicit transaction costs by employing dynamic stochastic programming which takes into account scenarios and stages. uncertainty of asset returns, implicit trading costs and risk is accounted for by using a set of scenarios. the model employs stochastic programming with recourse by rebalancing portfolio compositions at discrete timeintervals as new information on asset returns become available. this study’s contributions include: a. the development of a multi-stage stochastic model that maximizes portfolio gains and minimizes maximum downside risk in the presence of uncertain implicit transaction costs incurred during initial trading and in subsequent rebalancing of portfolios, b. the development of a strategy that captures uncertainty of stock prices and corresponding implicit trading costs by way of scenarios in uncertain environments. 3. problem statement a multi-period discrete-time optimal portfolio strategy is determined over an investment horizon [0,t]. the planning phase [0.t] where t<t, consists of non-overlapping time-intervals indexed by t = 1,2,…,τ, and (τ,t] is the period to maturity of the investment. initial investment takes place at t = 0, and during the period (0,τ], the investor makes adjustments to his portfolio at each of the τ periods as new information on assets’ returns become available. this adjustment of the portfolio results in the investor incurring some transaction costs as he buys and sells shares of some securities. these transaction costs tend to erode the benefits of investment, hence the need to minimize them. thus, the study considers an investor who is interested in maximizing portfolio gains (upside deviations) while keeping portfolio losses (downside deviations) to the minimum and implicit transaction costs at some prescribed level. this is achieved by employing dynamic stochastic programming in which uncertainty about future events is described by a discrete probability distribution of random parameters carried by a finite number of scenarios with prescribed probabilities. it is assumed that this discrete probability distribution is a reliable substitute of the true underlying probability distribution. each complete realization of all uncertain parameters is a scenario along the multi-period horizon. 3.1. scenario generation let i={i:i=1,2,…,n} be a set of risky assets for an investment. the information available about the single uncertain parameter, the risky active yield, is a set of scenarios rist, where s∈ω={s: s=1,2,…,s} is a finite set of discrete scenarios. each scenario has an associated probability ps such that 1 1 s ss p = =∑ . scenarios are arranged in the form of a tree spanning along the succession periods and being of length equal to the planning horizon τ. each path represents a scenario, s, and each node of the tree represents a time when a decision is made and implemented. the decision process is non-anticipative, that is, a decision at a particular stage does not depend on the future realization of the random events. the recourse decision at period t is dependent on the outcome of period t−1. given the event history up to time t, rt,the uncertainty in period t + 1 is characterised by finitely many possible outcomes for the observations rt+1. below is an example of a scenario tree with a three-three branching structure in a 2-time period (figure 1). mushori and chikobvu: investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization international journal of economics and financial issues | vol 8 • issue 4 • 2018258 3.2. model constraints an investor who has capital w0 to spend in his initial portfolio is considered. this capital is distributed among the n-securities of the initial portfolio. let xt = [x1,1,t,x1,2,t...,x2,1,t, x2,2,t...,xi,s,t] t, i = 1,…,n;s = 1,…,s;t = 1,…,τ, be the investor’s optimal strategy to be achieved at the end of the planning horizon. it is noted that xist is the proportion of wealth, wt, of period t allocated to buy shares of asset i of scenario s in period t. observe that 1 1 1, 1, 2, , . n s it isti s x x t τ = = = = = …∑ ∑ if aist and vist are the proportions of wealth, wt, used to buy and sell, respectively, shares of security i of scenario s of period t, then xist = xi,s,t−1+aist-vist,i = 1,2,…,n;s = 1,2,…,s;t = 1...,τ. it is assumed that the investor cannot buy and sell the same asset at each time when portfolio rebalancing takes place. that is, aist∙vist = 0. the expected return of asset i of period t i s g i v e n b y , 1, , ; 1, , ,it s ist ists qr p r x i n t τ∈= ⋅ ⋅ = … = …∑ where q⊂ω is a set of scenarios of asset i of period t. thus, the gross expected portfolio return of period is given by 1 , 1, 2, , ; 1, 2, , . s pt s ist ists r p r x i n t τ = = ⋅ ⋅ = … = …∑ suppose that the portfolio is self-financing, this results in the constraint. 0≤vit≤xit, (1) w h e r e it ist ss qv v p∈= ⋅∑ a n d .it ist ss qx x p∈= ⋅∑ t h e constraint ensures that the volume of asset i of period t sold for portfolio rebalancing must not exceed the volume of the asset in the portfolio. in a self-financing portfolio being rebalanced, the amount of money got from selling asset i of period t should be at most the amount of money used to buy asset j (i≠j) of the same period. hence the following results: 1, 0 , 1, , , 1, , , n ist jsti a j j i a v s s t τ ∈ = ≠ ≤ ≤ = … = …∑ ∑ (2) where set a contains all assets for which volumes have been bought. the investor ensures that no short-selling takes place by having the constraint 0≤xist≤uist, i=1,…, n;s=1,…, s; t=1,…,τ, (3) where uist is the maximum proportion allowed for each asset i of scenario s in period t. let the transaction cost rates for buying and selling shares of asset i in scenario s of period t during portfolio rebalancing be kist and list respectively. thus either kist∙aist = 0 or list∙vist = 0 or both are zero. this results in the transaction cost for buying or selling shares of asset i of scenario s of period t being kist∙aist+list∙vist. the expected transaction cost of the portfolio of period becomes. { } 1 , 1, , ; 1, , . s s ist ist ist ist ists p k a l v r i n t τ = ⋅ ⋅ + ⋅ ⋅ = … = …∑ thus getting the net expected portfolio return, npt, of period t as { } 1 , 1, , ; 1, , , s pt pt s ist ist ist ist ists n r p k a l v r i n t τ = = − ⋅ ⋅ + ⋅ ⋅ = … = …∑ with the net portfolio wealth of period t given by wt = (1+npt)∙wt−1,t=1,…,τ (3) 3.3. portfolio risk the study assumes that the investor intends to choose a portfolio with minimum of the maximum downside deviations of asset returns relative to expected portfolio return. let the downside risk of asset i of scenario s in period t be defined by mist = |min [0,rist-rpt]|. this gives the expected portfolio risk in period t as 1 . s s ist ists p m x =∑ the expected portfolio risk for the period [0,τ] becomes 1 1 1 s s ist istt s p m x τ τ = =∑ ∑ letting 1 s t s ist ists z p m x = = ∑ results in the expected portfolio risk for the entire planning phase as 1 1 p tt h z τ τ = = ∑ 3.4. portfolio gain portfolio gain is defined as an upside deviation of an asset return from expected portfolio return at any period t. the study assumes that the investor wants to maximize upside deviations of asset returns resulting in better investment opportunities. let the upside deviation of asset i of scenario s of period t be defined by nist = max [0,rist-rpt] this gives the expected upside deviation of the portfolio of period t as 1 s s ist ists p n x =∑ . hence the expected upside deviation of the portfolio for all time-periods becomes 1 1 1 s s ist istt s p n x τ τ = =∑ ∑ figure 1: a scenario tree mushori and chikobvu: investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization international journal of economics and financial issues | vol 8 • issue 4 • 2018 259 if 1 , s t s ist ists y p n x = = ∑ then the expected portfolio gain for the whole rebalancing period is given by 1 1 p tt y τ ϕ τ = = ∑ 3.5. the multi-stage stochastic optimization (smudtc) model there is a bi-criteria objective to be satisfied in the study by maximizing portfolio gain while minimizing maximum downside risk. since the intention of the investor is to minimize portfolio risk, it is achieved by maximizing the negative of the downside risk, that is, maximizing 1 1 .p tth z τ τ = − = − ∑ this results in a single objective where the investor maximizes the sum of the negative loss and gain of the portfolio of any period t. thus, the objective function becomes ( ) 1 1 1 ( ).p p t tt tmaximize h y z τ τ ϕ τ = = − = −∑ ∑ letting λ to be the minimum acceptable transaction cost and θ to be the minimum portfolio expected return, the following multistage stochastic model with uncertain implicit transaction costs is obtained: maximize 1 1 1 t tt t y z τ τ τ = =  − ∑ ∑ subject to wt = (1+npt) wt-1, t=1,…,τ, θ≤npt, t=1,…,τ 1 0 , 1, , ; 1, , , s t s ist ists z p m x i n t τ = = − = … = …∑ 1 0 , 1, , ; 1, , , s t s ist ists y p n x i n t τ = = − − = … = …∑ { } 1 , 1, , ; 1, , , s s ist ist ist ist ists p k a l v r i n tλ τ = ≥ + = … = …∑ 1, 0 , 1, , ; 1, , , n ist istj j i i a a v s s t τ = ≠ ∈ ≤ ≤ = … = …∑∑ 1 1 , 1, , ; 1, , s ists x i n t τ = = = … = …∑ 0≤vit≤xit, i=1,…, n; t=1,…,τ, 0≤xist≤uist, i=1,…, n; s=1,…, s; t=1,…,τ 0≤aist, i=1,…, n; s=1,…, s; t=1,…,τ the model (4) has a non-linear objective function, and the third and fourth constraints are also non-linear. in order to transform the model into a stochastic linear programming model, the following changes are made. for each scenario s, let kist≥mist = |min[0,rist-rpt]|, s=1,2,…, s. this gives the expected portfolio risk of period t as 1 , s s ist ists p k x =∑ with the expected portfolio risk for the period [0,τ] becoming 1 1 1 . s s ist istt s p k x τ τ = =∑ ∑ t h e n l e t t i n g 1 s t s ist ists j p k x = = ∑ gives the expected portfolio risk for the entire planning phase as 1 1 tte j τ τ = = ∑ similarly, for each scenario s, let dist≥nist=max[0,rist-rpt], s=1,2,…, s. this results in 1 s s ist ists p d x =∑ as the expected upside deviation of the portfolio of period t. therefore, the expected upside deviation (gain) of the portfolio for the period [0,τ] becomes 1 1 1 . s s ist istt s p d x τ τ = =∑ ∑ . by letting 1 , s t s ist ists q p d x = = ∑ the expected portfolio gain for the entire planning phase becomes 1 1 tt f q τ τ = = ∑ the model (4) becomes equivalent to the following stochastic linear programming model maximize 1 1 1 [ ]t tt tq j τ τ τ = = −∑ ∑ (5) subject to wt = (1+npt) wt-1, t=1,…,τ, θ≤npt, t=1,…,τ 1 0 , 1, , ; 1, , , s t s ist ists j p k x i n t τ = = − = … = …∑ 1 0 , 1, , ; 1, , , s t s ist ists q p k x i n t τ = = − = … = …∑ 1 0 , 1, , ; 1, , , s t s ist ists j p k x i n t τ = = − = … = …∑ 1 0 , 1, , ; 1, , , s t s ist ists q p d x i n t τ = = − − = … = …∑ { } 1 , 1, , ; 1, , , s s ist ist ist ist ists p k a l v r i n tλ τ = ≥ + = … = …∑ 1, 0 , 1, , ; 1, , , n ist isti a j j i a v s s t τ ∈ = ≠ ≤ ≤ = … = …∑ ∑ 1 1 , 1, , ; 1, , , s ists x i n t τ = = = … = …∑ 0≤vit≤xit, i=1,…, n; t=1,…,τ, 0≤xist≤uist, i=1,…, n; s=1,…, s; t=1,…,τ 0≤aist, i=1,…, n; s=1,…, s; t=1,…,τ the following theorem shows that models (4) and (5) are equivalent and yield the same optimal values. 3.6. theorem 1 if x* is an optimal solution to (4), then (x*, e*, f*) is an optimal solution to (5). conversely, if (x*, e*, f*) is an optimal solution to (5), then x* is an optimal solution to (4). proof without loss of generality, let * *istx x= . if x* is an optimal solution to (4), then (x*, e*, f*) is a feasible solution to (5), where mushori and chikobvu: investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization international journal of economics and financial issues | vol 8 • issue 4 • 2018260 and 1 1 tt e j τ τ = = ∑ 1 1 1 . s s ist istt s p k x τ τ = = = ∑ ∑ 1 1 1 s s ist istt s p m x τ τ = = ≥ ∑ ∑ 1 1 1 min 0, s s ist ist ptt s p x r r τ τ = =  = ⋅ ⋅ − ∑ ∑ 1 1 tt f q τ τ = = ∑ 1 1 1 s s ist istt s p d x τ τ = = = ∑ ∑ 1 1 1 s s ist istt s p n x τ τ = = ≥ ∑ ∑ 1 1 1 (max 0, ) s s ist ist ptt s p x r r τ τ = =  = ⋅ ⋅ − ∑ ∑ if (x*, e*, f*) is not an optimal solution to (4), then there exists a feasible solution (x, e, f) such that e*<e and f*<f, where e 1 1 1 s s ist istt s p k x τ τ = = = ∑ ∑ 1 1 1 | min[0, ] | s s ist ist ptt s p x r r τ τ = = = ⋅ ⋅ −∑ ∑ and f 1 1 1 s s ist istt s p d x τ τ = = = ∑ ∑ 1 1 1 | mix[0, ] | s s ist ist ptt s p x r r τ τ = = = ⋅ ⋅ −∑ ∑ it is observed that * * 1 1 1 | min[0, ] | s s ist ist ptt s p x r r e e τ τ = = ⋅ ⋅ − = <∑ ∑ . and that * 1 1 1 | min[0, ] | s s ist ist ptt s e e p x r r τ τ = = < = ⋅ ⋅ −∑ ∑ . also * * 1 1 1 max 0, s s ist ist ptt s p x r r f f τ τ = =  ⋅ ⋅ − = < ∑ ∑ and that * 1 1 1 max 0, s s ist ist ptt s f f p x r r τ τ = =  < = ⋅ ⋅ − ∑ ∑ . this is a contradiction since x* is an optimal solution of (4). conversely, if (x*,e*,f*) is an optimal solution of (5), then x* is an optimal solution of (4). otherwise, there exists a feasible solution x to (4) such that e* * 1 1 1 | min[0, ] | s s ist ist ptt s p x r r τ τ = = = ⋅ ⋅ −∑ ∑ 1 1 1 | min[0, ] | s s ist ist ptt s p x r r τ τ = = < ⋅ ⋅ −∑ ∑ and f* * 1 1 1 (max 0, ) s s ist ist ptt s p x r r τ τ = =  = ⋅ ⋅ − ∑ ∑ 1 1 1 (max 0, ) s s ist ist ptt s p x r r τ τ = =  < ⋅ ⋅ − ∑ ∑ =f which contradicts that (x*, e*, f*) is an optimal solution to (5). this completes the proof. 3.7. transaction cost measurement transaction cost analysis has become increasingly important in helping firms and individual investors measure how effectively both perceived and actual orders are executed. transaction costs are either implicit or explicit. market fees, clearing and settlement costs, brokerage commissions, and taxes and stamp duties are all explicit costs. implicit costs are invisible and are strongly related to the trading strategy. they can broadly be put into three categories which are market impact, opportunity costs and spread. when an investment is immediately executed without delay, implicit costs are largely a result of market impact or liquidity restrictions only. in such a case, market impact is defined as the deviation of the transaction price from the `unperturbed’ price that would have prevailed if the trade had not occurred. in the proposed model, immediate trade execution is assumed and market impact is taken to account for the total implicit transaction costs. the study applies the approach by hau (2006) and considers the transaction price to be the asset’s last price of the month. the spread mid-point benchmark is used and the effective spread is evaluated as twice the distance from the mid-price measured in basis points. taking pm as the mid-point of the bid-ask spread and pt as the transaction price, the effective spread (implicit transaction cost) is calculated as 200 | | t m trade m p p spread p × − = 4. data, model application and results the study uses historical monthly data of securities traded on the johannesburg stock market from january 2008 to september 2012. the following criteria are used to select securities available for portfolio selection: a. stocks with negative mean returns for the entire period of study are excluded from the sample, b. companies which were not on the list by january 2008 and only entered the johannesburg stock exchange (jse) afterwards are excluded, and c. assets having the highest positive mean returns calculated for the entire period are taken to become our initial portfolio. mushori and chikobvu: investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization international journal of economics and financial issues | vol 8 • issue 4 • 2018 261 the study uses historical simulation and takes empirical distributions computed from monthly returns as equi-probable scenarios. taking pi,t to be a monthly price of asset i considered in period t, a return scenario, rist, for the asset i of period t is calculated as , , 1 , 1 i t i t ist i t p p r p − − − = . five scenarios for each asset in each period t are considered, giving a total of 5n scenarios in each period where n is the number of assets for selection. a scenario consists of an asset return and the corresponding implicit transaction cost. it is assumed that both asset return and the corresponding implicit cost are random since it is in the buying or selling of securities, whose prices are random, that implicit transaction costs are incurred by an investor. implicit costs are calculated from the effective bidask spread corresponding to each selected asset return. the initial portfolio is selected from 13 securities and empirical distributions of these 13 securities are considered. each security has 54 historical monthly returns and random numbers are used to select an asset return and associated implicit transaction cost corresponding to a scenario of a security. this is done by numbering the months 1–54. the transaction cost is given as a rate and each scenario is considered as equally likely to occur, giving a probability of 1 5n for each scenario. it should be noted that scenarios are only considered for the proposed smudtc model and other models use mean returns, mean implicit transaction costs and risks calculated for the entire period in the study. the period under study is divided into two, giving in-sample and out-of-sample data. the in-sample period starts from january 2008 and ends march 2012. the second period starts from april 2010 to september 2012. in each period, the performance of each model is analysed. first-stage optimal portfolios generated by the smudtc model are compared with optimal portfolios from the mad, mv and minimax models (appendix). in a real-life environment, comparison of models is usually done by means of ex-post analysis. it is also noted that portfolio performances are usually affected by market trend, hence the need to subject the proposed smudtc model to these two periods and evaluate its performance. an investor who has r10,000 to spend on his initial portfolio is considered in the study. 4.1. in-sample analysis a gams software is used to solve the four models. in analysing the performance of each model, the gross portfolio mean return, portfolio risk, total implicit transaction costs incurred and the gross and net portfolio wealth are evaluated. neither portfolio mean return nor portfolio risk is constrained, and diversification limits from 0.1 to 0.4 are used. the optimal portfolios generated by the four models are shown in table 1. the phrase `div. lim’ stands for diversification limit. it is observed that, for each given diversification limit, the smudtc optimal portfolios have the least gross mean portfolio return and the investor incurs the least implicit transaction costs. the mm optimal portfolios have the highest gross expected portfolio returns followed by the mv-generated optimal portfolios. however, the mm-investor incurs the greatest implicit trading cost followed by the mv-investor. it is clearly evident, that despite having the least expected portfolio returns, smudtc optimal portfolios have the greatest portfolio wealth for every diversification limit considered. the mad-generated optimal portfolios have greater wealth than those of mv and mm optimal portfolios. the trend remains the same as portfolios become less diversified. 4.2. out-of-sample analysis in a real-life environment, validation of models is usually done by ex-post analysis. this is achieved by making a comparative evaluation of model performance on in-sample and out-of-sample data sets. the period from april 2010 to september 2012 provides the out-of-sample data set for the smudtc model. table 2 shows the performance of the smudtc model together with mv, mad and minimax models (appendix). the information in table 3 shows that mm optimal portfolios have the highest gross expected portfolio returns followed by mv and mad optimal portfolios respectively. the information in the table shows that mm optimal portfolios have the highest gross expected portfolio returns followed by table 1: summary statistics of in-sample optimal portfolios div. lim mad mv mm smudtc 0.10 mean return 0.027 0.030 0.034 0.003 risk 0.024 0.001 0.034 0.001 gross wealth 10265.76 10303.55 10339.30 10066.72 implicit cost 710.10 835.42 901.70 40.22 net wealth 9555.66 9468.12 9437.60 10026.50 0.15 mean return 0.024 0.032 0.038 0.004 risk 0.027 0.001 0.038 0.001 gross wealth 10236.14 10316.92 10380.50 10065.00 implicit cost 855.25 929.73 721.45 29.33 net wealth 9380.89 9387.18 9659.05 10035.67 0.20 mean return 0.023 0.033 0.041 0.003 risk 0.028 0.001 0.041 0.001 gross wealth 10225.12 10330.33 10409.00 10056.44 implicit cost 1092.00 818.23 746.40 25.36 net wealth 9133.12 9512.10 9662.60 10031.08 0.25 mean return 0.022 0.033 0.043 0.003 risk 0.029 0.001 0.043 0.001 gross wealth 10216.15 10330.92 10428.00 10050.86 implicit cost 396.25 760.18 883.25 23.20 net wealth 9819.90 9570.74 9544.75 10027.66 0.30 mean return 0.021 0.033 0.044 0.003 risk 0.029 0.001 0.044 0.001 gross wealth 10211.78 10331.02 10443.60 10045.83 implicit cost 445.30 757.81 1023.30 53.84 net wealth 9766.48 9573.21 9420.30 10028.63 0.35 mean return 0.021 0.033 0.046 0.003 risk 0.029 0.001 0.046 0.001 gross wealth 10207.83 10331.02 10457.80 10051.63 implicit cost 444.45 757.80 1083.60 18.79 net wealth 9763.38 9573.22 9374.20 10032.84 0.40 mean return 0.020 0.033 0.047 0.004 risk 0.030 0.001 0.047 0.001 gross wealth 10204.72 10331.02 10469.20 10047.63 implicit cost 343.80 757.79 984.40 5.52 net wealth 9860.92 9573.23 9484.80 10042.11 mushori and chikobvu: investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization international journal of economics and financial issues | vol 8 • issue 4 • 2018262 mv and mad optimal portfolios respectively. it is also evident that the mm optimal portfolios have the highest portfolio risk with the smudtc optimal portfolios’ risks being the least for all diversification levels considered in the study. the smudtc optimal portfolios bear the least implicit transaction costs with the mm optimal portfolios having the highest transaction costs. it is also clear that the smudtc optimal portfolio has the greatest wealth for every diversification limit considered. all these features are evident in the in-sample analysis above. thus, the smudtc investor has advantages of having high net expected portfolio returns and incurring the least implicit transaction costs during trading over his mm-, mvand madcounterparts. 4.3. sensitivity analysis model sensitivity analysis is carried out using both in-sample and out-of-sample data. this is done by finding the sensitivity index (si) for each parameter where the output percentage difference is calculated by varying one input parameter from its minimum value (zero in this case) to its maximum value (hoffman and gardner [1983]; bauer and hamby [1991]). the si is calculated using the formula max min max d d sensitivity index d − = , where dmin and dmax are the minimum and maximum output values respectively resulting from varying the input parameter over its entire range. zero is taken to be the minimum input value for each parameter with the maximum value constrained by the diversification limit considered and is given as the best weight of the chosen asset in the optimal portfolio. diversification limits of 0.1, 0.2 and 0.3 are considered. the smudtc model is stochastic and works by replacing one parameter (of the optimal portfolio) by a `less’ profitable one when the weight of the chosen asset is zero. the condition that the total weight of assets in the optimal portfolio must be unity provides for the inclusion of a less profitable asset in the ̀ new’ optimal portfolio. this results in a relative sensitivity value. hence, the dmin value of model output is a relative value. therefore, by applying the method above we are finding relative sensitivity analysis of the model parameters. table 2 shows in-sample model sensitivity analysis where there are very small variations in portfolio wealth resulting from each asset being removed from the optimal portfolio. the proxy optimal portfolio has wealth increase of at most 0.05% and decrease of at most 0.049%. this shows that the smudtc model is not significantly influenced by individual parameter choices. the risk si varies from 0 to 0.2, with zero being the modal si. this again may imply that model output values are not strongly dependent on certain individual parameters. the cost si range from −78.4% to 32.6%. these large values (numerically) are a result of very small implicit transaction costs incurred which have been used in the calculation. table 1 shows the implicit transaction costs associated with smudtc optimal portfolios. 5. conclusion portfolio selection that incorporates transaction costs in the literature is mostly devoted to proportional transaction costs. there is extensive use of the mv and mad models in financial optimization yet both models penalise upside deviations (gains) table 2: in-sample smudtc model sensitivity analysis div. lim parameter max. value cost si risk si wealth si 0.1 x1 0.1 0.0000 0.2297 −0.00045 x2 0.1 0.1000 0.1228 −0.00024 x4 0.1 0.0000 0.0397 0.00002 x5 0.1 0.0000 0.1228 −0.00024 x6 0.1 0.0000 0.1561 −0.00017 x7 0.1 0.1000 0.1367 −0.00034 x8 0.1 0.0000 0.3262 −0.00033 x9 0.1 0.0000 0.0552 −0.00012 x10 0.1 0.0000 0.0776 −0.00032 x11 0.1 0.0000 0.0756 −0.00014 0.2 x1 0.2 0.0000 0.1356 −0.000073 x2 0.2 0.1000 −0.0410 −0.000047 x4 0.2 0.0000 −0.1798 0.000495 x6 0.2 0.0000 0.1893 0.00012 x9 0.2 0.0000 −01309 0.00022 0.3 x1 0.3 0.1000 −0.7836 −0.000509 x2 0.3 0.2000 −0.5172 −0.000867 x3 0.3 0.0000 0.0164 −0.000662 x4 0.3 0.0000 -0.4888 −0.000078 table 3: summary statistics of out-of-sample optimal portfolios div. lim mad mv mm smudtc 0.10 mean return 0.027 0.029 0.031 0.005 risk 0.002 0.002 0.1 0.0009 gross wealth 10269.80 10289.02 10314.80 10064.57 cost 432.00 426.34 502.10 15.36 net wealth 9837.80 9862.68 9812.70 10049.21 0.15 mean return 0.025 0.028 0.033 0.006 risk 0.022 0.002 0.143 0.0009 gross wealth 10251.75 10277.97 10332.30 10070.17 cost 479.10 397.32 411.15 17.27 net wealth 9772.65 9880.65 9921.15 10052.90 0.20 mean return 0.024 0.027 0.035 0.007 risk 0.023 0.002 0.2 0.0007 gross wealth 10240.20 10268.25 10346.80 10073.55 cost 223.20 378.64 503.60 8.00 net wealth 10017.00 9889.61 9843.20 10065.55 0.25 mean return 0.023 0.026 0.036 0.007 risk 0.025 0.002 0.25 0.0006 gross wealth 10229.25 10259.68 10356.25 10080.73 cost 248.50 356.71 591.00 7.40 net wealth 9980.75 9902.97 9765.25 10073.33 0.30 mean return 0.023 0.026 0.036 0.008 risk 0.025 0.002 0.25 0.0006 gross wealth 10221.70 10255.02 10362.50 10081.56 cost 272.80 340.06 550.00 6.64 net wealth 9948.90 9914.96 9812.50 10074.92 0.35 mean return 0.021 0.025 0.037 0.008 risk 0.026 0.002 0.333 0.0006 gross wealth 10214.90 10250.44 10368.30 10082.44 cost 270.55 318.87 502.10 6.36 net wealth 9944.35 9931.57 9866.20 10076.08 0.40 mean return 0.021 0.025 0.037 0.007 risk 0.027 0.002 0.333 0.0007 gross wealth 10209.60 10247.81 10373.20 10075.40 cost 215.20 306.70 440.40 6.80 net wealth 9994.40 9941.12 9932.80 10068.60 mushori and chikobvu: investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization international journal of economics and financial issues | vol 8 • issue 4 • 2018 263 and downside deviations (losses) in the same way. it is important to differentiate upside deviations from downside deviations since positive deviation is desirable to any investor while negative deviation is undesirable. hence this paper proposes a new model that accounts for better investment opportunities (upside deviations), risk (downside deviations) and implicit transaction costs in a dynamic uncertain environment. the study considers uncertainty in asset returns, portfolio risk and implicit trading costs incurred during initial trading and in subsequent rebalancing of the portfolio. the proposed model is tested using real data from an emerging market and its performance is compared with those of mv, mad and minimax models. the results show that the proposed model generates optimal portfolios with least risk, highest portfolio wealth and minimum implicit transaction costs. the model is suitable for a risk-averse and conservative investor. references bauer, l.r., hamby, d.m. (1991), relative sensitivities of existing and novel model parameters in atmospheric tritium dose estimates. radiation protection dosimetry, 37(4), 253-260. brooks, c., kat, h. (2002), the statistical properties of hedge fund index’ returns and their implications for investors. journal of alternative investments, 5, 26-44. brown, d.b., smith, j.e. (2011), dynamic portfolio optimization with transaction costs: heuristics and dual bounds. management science, 57(10), 1752-1770. d’hondt, c., giraud, j.r. (2008), transaction cost analysis a-z, a step towards best execution in the post-mifid landscape’. glen, j.j. (2011), mean-variance portfolio rebalancing with transaction costs and funding changes. the journal of operational research society, 62(4), 667-676. gulpinar, n., rustem, b., settergren, r. (2004), multistage stochastic mean-variance portfolio analysis with transaction costs. innovations in financial and economic networks, 3, 46-63. hakansson, n.h. (1971), multi-period mean-variance analysis: toward a general theory of portfolio choice. journal of finance, 26(4), 857-884. hasbrouck, j. (2009), trading costs and returns for u.s. equities: estimating effective costs from daily data. the journal of finance, 64(3), 1445-1477. hau, h. (2006), the role of transaction costs for financial volatility: evidence from the paris bourse. journal of the european economic association, 4(4), 862-890. hiller, r.s., eckstein, j. (1993), stochastic dedication: designing fixed income portfolios using massively parallel benders decomposition. management science, 39, 1422-1438. hoffman, f.o., gardner, r.h. (1983), evaluation of uncertainties in environmental radiological assessment models. report number nureg/cr-3332. konno, h., yamazaki, h. (1991), mean absolute deviation portfolio optimization model and its applications to tokyo stock market. management science, 37, 512-529. kozmik, c. (2012), multistage risk-averse asset allocation with transaction costs. proceedings of the 30th international conference mathematical methods in economics. lynch, a.w., tan, s. (2010), multiple risky assets, transaction costs and return predictability: allocation rules and implications for u.s. investors. journal of financial quantitative analysis, 45(4), 1015-1053. markowitz, h.m. (1952), portfolio selection. journal of finance, 7(1), 77-91. pratt, j. (1964), risk aversion in the small and in the large. econometrica, 32, 122-136. simaan, y. (1997), estimation of risk in portfolio selection: the mean-variance model versus the mean absolute deviation model. management science, 43(10), 1437-1446. xia, r., tian, c. (2012), an analysis of the implicit transaction cost of shenzhen a-stock market using bayesian gibbs sampling. advances in intelligent systems and computing, 136, 413-420. vladimirou, h., zenios, s.a. (1997), stochastic linear programs with restricted recourse. european journal of operational research, 101, 177-192. young, m. (1998), a minimax portfolio selection rule with linear programming solution. management science, 44(5), 673-683. mushori and chikobvu: investment opportunities, uncertain implicit transaction costs and maximum downside risk in dynamic stochastic financial optimization international journal of economics and financial issues | vol 8 • issue 4 • 2018264 appendix 6. a review of some validation models t h e r e a r e a n u m b e r o f m o d e l s o n p o r t f o l i o s e l e c t i o n presented in the literature to date. however, comparison in this study is restricted to the widely used mean-variance, mad and minimax models. the following is a review of these models. 6.1. mv model the mv model is proposed by markowitz (1952). this model minimizes portfolio variance (risk) subject to expected portfolio return achieving a prescribed level. the mathematical formulation of the model is as follows: maximize 1 1 n n ij i ji j x xϕ σ = = = ∑ ∑ subject to 1 , n i ii r xρ = ≤ ∑ 1 1 , n ii x = = ∑ 0≤xi≤ui, i = 1,…,n where σij is the covariance between assets i and j, xi is the proportion of wealth invested in asset i, ri is the expected return of asset i in each period, ρ is the minimum rate of return desired by an investor, and ui is the maximum proportion of wealth which can be invested in asset i. 6.2. minimax model the minimax model is proposed by young (1998) in which minimum return is used as a measure of risk. it is a linear programming model which is formulated as follows: maximize mp subject to 1 0 , 1, , , n i it pi w y m t t = ≤ − = …∑ 1 , n i ii g w y = ≤ ∑ 1 , n ii w w = ≥ ∑ 0≤wi, i=1,…,n. where yit is the return of one dollar invested in security i in period t, iy is the mean return of security i, wi is the portfolio allocation to security i, mp is the minimum return on the portfolio, g is the minimum level of return, and w is the total allocation. 6.3. mad konno and yamazaki (1991) propose the mad model and show that it behaves in the same manner as the mv model when the assets’ returns are multi-variate normally distributed. the mad model is formulated as given below: maximize 1 1 t tt y t β = = ∑ subject to 1 0 , 1, , , n t it ii y a x t t = ≤ + = …∑ 1 0 , 1, , , n t it ii y a x t t = ≤ − = …∑ 1 , n i ii r xρ = ≤ ∑ 1 1 , n ii x = = ∑ 0≤xi≤ui, i = 1,…,n, where ait = rit-ri, 1 | |, n t it ii y a x = = ∑ ri is the expected portfolio return in period t, rit is the return of security i of period t, ρ is the minimum rate of return desired by the investor, and ui is the maximum proportion of wealth that can be invested in asset i. . international journal of economics and financial issues | vol 6 • special issue (s5) • 2016 53 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s5) 53-64. assessment of human capital in the agricultural enterprises of the republic of kazakhstan zhanna serikovna bulkhairova1, karlygash toleubaevna alenova2*, anar zhaskaratovna nukesheva3, aliya sabirzhanovna ismailova4 1s. seifullin kazakh agro technical university, 62 prospect pobedy, astana, republic of kazakhstan, 2s. seifullin kazakh agro technical university, 62 prospect pobedy, astana, republic of kazakhstan, 3s. seifullin kazakh agro technical university, 62 prospect pobedy, astana, republic of kazakhstan, 4s. seifullin kazakh agro technical university, 62 prospect pobedy, astana, republic of kazakhstan. *email: honeyzhu@mail.ru abstract nowadays for kazakhstani agricultural enterprises that work in the present conditions the most important is the formation of new and more effective control systems, where the main thing is the correct assessment and subsequent management of human capital. the author assesses the human capital in agriculture in the republic of kazakhstan. to assess the level of development of human capital in agriculture, two interconnected blocks of indicators: indicators of conditions of the human capital and indicators of its operation results have been selected. the authors performed quantitative transfer of characteristic values into their qualitative analogues, did the ranking of areas based on entropy and analyzed by the method of factor analysis the dynamics of human capital development in agriculture. keywords: human capital, human capital assessment, production indicators, financial indicators, social indicators, innovation, entrepreneurship indicators jel classifications: j24, j43, j50, q12, o15 1. introduction 1.1. introduction of the problem in the transition to the innovative development special importance is given to the management of human capital, especially in the agrarian sector. the effective use of human capital is one of the main driving forces of modern agrarian reform and the objective factor of sustainable development of agricultural production, along with the development of social and labor sphere of agriculture, formation and development of working potential. it must be emphasized that, despite the positive developments in the labor force in agriculture some problems have not fully been solved. with the resumption of economic growth in agriculture many agricultural organizations are particularly experiencing labor deficiency. the problem is amplified by demographic decline, irrational employment of the rural population in the agricultural sector, low wages in agriculture, poor working conditions and living standards in rural areas, manual work in the agricultural sector (akimbekova, 2010; koncevaya et al., 2013). one of the main factors of efficiency of functioning and sustainable development of agriculture is the human potential. it consists of qualified professionals workers with higher and specialized secondary education. and at this time the aiming of the agricultural sector of the economy for sustainable growth leads to the relevance of the human capital management (aubakirov and maidirova, 2002; klinova and sidorova, 2012). at the present stage of social-economic transformation in the agricultural sector it is of urgency to assess the current human capital, because it is labor force which is the fixed capital of the enterprise. human capital evaluation question was focused on in a sufficiently large number of works, both domestic and foreign. their analysis shows that there are different approaches to the evaluation of human capital, but there is no complete method, including in connection with the evaluation of human capital in bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 201654 agriculture. assessment of human capital in the agricultural sector at all levels should be carried out in dynamics, and it is necessary to identify the factors that have a significant impact on its change, so there is the need to develop methods of factor analysis of human capital dynamics (loseva, 2010; epishkin, 2013; russiyan, 2014). 1.2. literature review the concept “human capital” appeared in the scientific vocabulary in the mid-1960s. usually, human capital means the calculated resource that is aimed at supporting the functioning of the established economic structures. this understanding of human capital is compared with the marxist notion of man as a determining productive force of the society. also this concept includes productive effect of investment in human capital, which leads to the development of the individual as an economic factor (shingarov, 2012). the oxford dictionary of business provides the following definition of human capital, ‘the ability and skills, general or specific, acquired by a person in the course of training and work experience’ (business: the oxford dictionary, 1995). in kazakhstan scientific space the human capital theory began to emerge in the writings of scholars at the beginning of xxi century. this is due to the adoption of long-term strategies for the country’s development. thus, dzhumambaev considered problems of management of the human factor and its role in ensuring the effectiveness of the organization. particular attention is paid to the problems of human capital by mukhamedzhanova who proves the importance and priority of human capital for economic development of kazakhstan (aubakirov and maidirova, 2002; dzhumabaev, 2002). onyusheva, in turn, believes that knowledge, but not capital and not the means of production have become a major economic resource, determining, ultimately, the competitiveness of the national economy of kazakhstan (onyusheva, 2012). in table 1 the author collected the basic definitions of human capital, which were given by a variety of domestic and foreign authors. 2. methods to characterize the level of development of human capital in agriculture a system of two interconnected blocks of indicators indicators of conditions of the human capital and indicators of the results of its operation is required. the following considerations are taken into account to select of indicators: • the number of indicators should not be too large not to impede the interpretation and not to increase the complexity of collecting primary information; • indicator values should be directly according to statistics agency of kazakhstan or obtained by calculation from the known statistical indicators; • indicators that have the greatest informative value and significance for the formation and development of human capital in terms of its impact on economic growth should be selected; • it is necessary to use only the relative indicators, as the absolute value may be directly dependent on the region and distort the real assessment; • indicators should be interchangeable, i.e., duplicate the semantic content, or should be complementary. relevant indicators are shown in table 2 (loseva, 2010). we will consider the ranking algorithm for regions in terms of development of human capital in agriculture. 2.1. stage i: transfer of the quantitative characteristic values into their quality analogues let’s compile tables 3 and 4, where the columns are numerical values of the above two units interconnected by regions of kazakhstan indicators where k is a predetermined number of quality levels, which we will set to 10. table 1: the results of the study of human capital structure theories theory author the essence of the author’s approach to human capital theory shultz (1968) human capital is valuable qualities acquired by a person which can be amplified by respective commitments becker (2003) human capital is generated by investment in a human, among which are education, training in the workplace, expenditure on health, migration and the search for information on prices and incomes tnurow (1970) the human capital of people is their ability to produce goods and services sagadiyev (2013) human capital is not a virtual concept, not a metaphor, but rather a strict scientific term, which entered the arsenal of modern economic theory, implying “a set of knowledge, skills, abilities and skills embodied in people and enabling them to create personal, social and public welfare” mukhamedzhanova (2001) human capital: • self-expansion of human capabilities, allowing creating value than was originally input in a person • category of social reproduction, having cyclic form • objective economic relations occupying a central place in the system of economic relations of society, influencing the pace and direction of technological progress, the efficiency of the production and reproduction process, being a leading factor in economic growth meldahanova (2010), kolpakova 2010) human capital is a set of accumulated knowledge, education and human resources, professionalism that will improve the productivity in terms of industrial and innovative development of the country and the impact of costs and investments in people, to ensure the competitiveness and sustainability of the national economy to achieve a high quality of life dobrynin and dyatlov (loseva, 2011; parhomchuk, 2010) the form of human manifestation of productive forces in a market economy, included in the socially oriented market economy as the leading creative factor of social reproduction source: made by the author bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 2016 55 table 2: indicators of the level of human capital development in the regions modalities for the functioning of human capital the results of the application of human capital 1. labor market indicators and labor resources • the level of employment in agriculture, thousand people • the number of employees in agriculture, people • the number of self-employed in agriculture, people • the immigration rate (in rural areas) the immigration rate of the population is the difference between the number of arrivals to the country of citizens and the number of departures, divided by the total population 1. productive indicators • gross labor productivity (the ratio of the volume of agricultural production to total employment) mil/pers. • the total turnover of the implementation cost of livestock crop production in agricultural formations per capita, thousand tenge/pers. • the index of physical volume of gross production (services) of agriculture, % to the previous year 2. investments in human capital • the share of expenditure on science and research and development in the gross output of goods (services) in agriculture, % 2. financial indicators • the level of profitability (loss) of agricultural production in the agricultural enterprises (percentage) • ratio of average nominal wage and expenditures for living • the amount of budget expenditures per employee in agriculture, mil/thousand people 3. indicators of social sphere • proportion of population with income used for consumption below the subsistence level in rural areas (%) • the depth of poverty in rural areas (%) • the combined share of the coverage of education of the population living in rural areas, aged 6-24 years (%) • the volume of rendered health services and social services in rural areas (thousand tenge) 3. indicators of innovation, entrepreneurship • internal costs on r&d in agriculture, thousand tenge source: was done by the authors based on the source (loseva, 2011). r&d: research and development table 3: qualitative analogues of the quantitative modalities of indicator values of human capital in agriculture of kazakhstan regions the labor market and labor resources investments in human capital social sphere 1 2 3 4 5 6 7 8 9 the labor market and labor resources the number of employees in agriculture the number of self-employed in agriculture the immigration rate the share of expenditure on science and research and development in the gross output of goods (services) in agriculture proportion of population with income used for consumption below the subsistence level in the rural area the depth of poverty in rural areas the combined share of the coverage of education of the population living in rural areas, aged 6-24 years the volume of rendered health services and social services in rural areas akmolinsk 4 6 5 6 5 7 7 7 6 aktubinsk 6 5 6 6 5 6 6 7 4 almaty region 5 4 6 6 6 7 8 6 5 atyrau 7 6 6 6 5 8 7 4 5 western kazakhstan 6 4 6 6 5 6 7 7 6 zhambyl 5 4 5 6 7 6 6 5 5 karaganda 6 6 6 6 6 5 7 5 7 kostanai 7 5 6 6 6 5 5 7 7 kyzylorda 4 5 5 6 4 7 6 6 6 mangystau 5 5 5 6 3 7 7 5 4 south kazakhstan 6 5 7 6 6 5 6 6 6 pavlodar 6 5 5 6 4 5 5 8 5 north kazakhstan 6 5 6 6 7 6 7 7 5 east kazakhstan 7 6 7 6 6 5 6 7 6 source: calculated and compiled by the authors bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 201656 1. we find xmax and xmin initially we define the quantified homogeneity (volatility) values of each feature on the coefficient of variation across the regions: *10 % 0  =v x (1) where the numerator is standard deviation, and the denominator is arithmetic average found by the formulas:  = − =∑ ∑( ) ;x x n x x n 2 (2) if v > 33%, then a set is quantitatively heterogeneous and as xmax and xmin we take accordingly the highest and lowest values of a quantitative trait. if v≤33%, then in this case, variability is slight, for these characteristics we input maximum and minimum boundary ourselves, based on the semantic content of the parameter. 2. we find the length of the quality interval: h x x k max min= − −1 (3) 3. we transfer each quantitative value of the characteristic into its qualitative analog by the formulas: if “the more, the better” is matching, then, k x x hi i min= − +1 (4) if “the less the better” is matching, then, k x x hi max i= − +1 (5) meantime, the quality values can be expressed as an integer and fractional numbers. but we will take integer values to be definite. thus, by the characteristic which values were little varying initially, the areas obtain similar qualitative value (for example, in terms of economic activity). if the characteristic’s values differ considerably, then the areas finally are in the qualitative range from 1 to 10 (e.g., internal research costs on research and development [r&d] in agriculture) (loseva, 2011). 2.2. stage ii: the ranking of areas based on entropy we’ll make rankings of areas separately for each block of indicators: the operation conditions and the results of functioning of human capital. this requires determining the integral quality of each area by all indicators included in a particular block. the basis of the proposed method of ranking is the statement that the successful operation of the system (areas) is largely determined by its stability. therefore, based on this goal, as a result of the control process facilities system must obtain some balance and stability by all characteristics. a measure of this stability is the entropy of the system, which in its turn depends on the entropy of characteristics that describe the system’s objects. meantime, the integral quality of areas (for all n-indicators of human capital) is not an arithmetic sum of the qualities of its characteristics, but the integral sum in the form: s i h x i i mj jj n ( ) ; ,= = =∑ 1 1 (6) table 4: qualitative analogues of quantitative modalities of indicator values of human capital in agriculture of kazakhstan regions productive financial innovation and entrepreneurial activity 1а 2а 3а 4а 5а 6а 7а gross labor productivity the total turnover of the implementation cost of livestock crop production in agricultural formations in per capita indexes of physical volume of gross production (services), in agriculture the level of profitability (loss) of agricultural production in the agricultural enterprises ratio of average nominal wage and living expendiure the amount of budget expenditures per worker in agriculture internal costs on r&d in agriculture akmolinsk 6 5 5 5 4 5 5 aktubinsk 5 6 4 5 5 4 5 almaty region 5 5 4 6 5 7 4 atyrau 5 4 4 5 6 5 4 western kazakhstan 5 6 4 6 5 5 5 zhambyl 4 6 5 4 5 5 7 karaganda 5 5 6 6 4 4 5 kostanai 4 4 6 4 5 5 5 kyzylorda 6 5 5 5 5 5 4 mangystau 4 5 4 4 5 3 south kazakhstan 5 6 5 6 5 4 5 pavlodar 5 5 6 7 6 5 6 north kazakhstan 6 6 5 6 5 5 7 east kazakhstan 5 6 4 5 5 4 6 source: calculated and compiled by the authors. r&d: research and development bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 2016 57 where hj is entropy of j characteristic; xji is qualitative value of j characteristic for i of the same area. the entropy of a characteristic is defined by shannon’s formula: h p ln pj ii m i = =∑ 1 1 ( ) (7) where pi is the probability of i characteristic value, and the sum of the probabilities of all values in each characteristic is equal to 1. the more entropy has a characteristic, the more orderless it is, the more attention must be paid to it by the governing body and the higher its importance at this stage of system’s operation. over the time, the quality values of a characteristic can change therefore, the entropy will change, and the importance of the characteristic as well. irregularity of quality assessments by some characteristic is a signal to the management action. small entropy of a characteristic tells about its stability for all objects. if the qualitative assessment on the basis of stability is high, then the management action is not required, just control is enough. if a stable characteristic takes lower values, in this case as well as for an unstable characteristic, appropriate action is required. on the other hand, it is necessary to monitor entropy of characteristics in time. in some cases, consistently high values of a characteristic may indicate stagnation, and an incentive is required for further development. so, first we determine the probability of each value of the indicator for each area. the greater the integral quality of an object, the greater its rating. in the same way the ranking is done on the second block of indicators the results of the operation and in general two blocks of indicators. based on the identification of areas rated separately for each block one can identify the link between the operation conditions (factor characteristic) and the results of functioning of human capital (productive characteristic) (loseva, 2011). 2.3. method of factor analysis in agriculture, the dynamics of human capital development for effective management of human capital in the field of agriculture management it is important not just to evaluate its condition, but also to analyze the dynamics of development, and to identify factors that have the most significant impact. with this aim it is proposed to use the index method. according to the methodology, the change in the level of human capital in agriculture of an area depends on the change of the conditions and the results of its functioning, interconnected with each other, i.e.,, i i ihc func res= * (8) in its turn, changes in the conditions and the results of functioning of human capital are determined by the change of factors, characterized by the numerical value of pi. let’s denote the base value of the factor p0, and the current p1. thus, the change of factor is expressed: i p pi = 1 0 (9) which is said to be an individual indicator. individual indicators are combined into a group, describing some single characteristic of human capital such as demographics. thus, the group indicator is a character index: i n s p pk k = + −∑1 1 11 0 ( ) (10) where sk = 1, for direct dependence of change of individual and group indices; sk = −1 for inverse dependence. group indicators should only be positive, i.e., connection of their changes with the change in the complex index is direct. the complex index of human capital in agriculture is determined by the following formula: i i i ifunc lm ihc ss= + + (11) i i i ires p f iiea= + + (12) where ilm is group indicator of the labor market and human resources, iihc is group indicator of investment in human capital, iss is group indicator of the social sphere, ip is production group indicator, if is financial group indicator, iiiea is group indicator of innovation, entrepreneurial activity (loseva, 2011). 3. results 3.1. transfer of quantitative characteristic values into their quality analogues let’s set up the tables 3 and 4, where in columns the numerical values of the above two blocks of related indicators (tables 3 and 4) for 14 regions and the republic of kazakhstan are given. 3.2. calculate entropy of block indicators “modalities for the functioning of human capital” we’ll make rankings of areas separately for each block of indicators: modalities for the functioning of human capital and the results of the application of human capital. to do this, we must determine the integral quality of each area in all indicators falling within a particular block. let’s take the first indicator “level of employment in agriculture” and determine the probability of emergence of each of its values for the republic of kazakhstan and for the 14 areas (table 5). we calculate the entropy of the level of employment by formula 7: ( ) 10 10 101 0.8 * 0.3* 0.3* 0.900898524 8 3 3 h ln ln ln= + + = similarly, we define the entropy of other indicators included in the first and second blocks. the results are listed in tables 6 and 7, accordingly. bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 201658 we calculate the entropy of the number of employees in agriculture by formula 7: 10 10 10 (2) 0.7* 0.4* 0.3* 0.977380595 7 4 3 h ln ln ln= + + = we calculate the entropy of the number of self-employed in agriculture by formula 7: 10 10 10 (3) 0.7 * 0.4 * 0.2 * 0.938076336 7 4 2 = + + =h ln ln ln we calculate the entropy of the immigration rate by formula 7: 10 (4) 0.14 * 0.047106113 14 = = −h ln we calculate the entropy of the share of expenditures on science and research and development in the gross output of goods (services), in agriculture by formula 7: h ln ln ln ln ln ( ) . * . * . * . * . * ( ) . 5 0 5 10 5 0 4 10 4 0 2 10 2 0 2 10 2 0 1 10 1 = + + + + = 5587123557 we calculate the entropy of the proportion of people whose income table 5: the probabilities of emergence of each value of the indicator “level of employment in agriculture” regions quantitative values-“the level of employment in agriculture” how often this value is found in 14 regions (b) probability of emergence of this value p=b/k, k=10 akmolinsk 4 3 0.3 aktubinsk 6 8 0.8 almaty region 5 atyrau 7 western kazakhstan 6 zhambyl 5 3 0.3 karaganda 6 kostanai 7 kyzylorda 4 mangystau 5 south kazakhstan 6 pavlodar 6 north kazakhstan 6 east kazakhstan 7 source: calculated and compiled by the authors table 6: entropy of block of indicators “modalities for the functioning of the human capital in agriculture” (the first block) regions the labor market and labor resources investments in human capital social sphere 1 2 3 4 5 6 7 8 9 the labor market and labor resources the number of employees in agriculture the number of self-employed in agriculture the immigration rate the share of expenditure on science and research and development in the gross output of goods (services) in agriculture proportion of population with income used for consumption below the subsistence level the rural area the depth of poverty in rural areas the combined share of the coverage of education of the population living in rural areas, aged 6-24 years the volume of rendered health services and social services in rural areas akmolinsk 4 6 5 6 5 7 7 7 6 aktubinsk 6 5 6 6 5 6 6 7 4 almaty region 5 4 6 6 6 7 8 6 5 atyrau 7 6 6 6 5 8 7 4 5 western kazakhstan 6 4 6 6 5 6 7 7 6 zhambyl 5 4 5 6 7 6 6 5 5 karaganda 6 6 6 6 6 5 7 5 7 kostanai 7 5 6 6 6 5 5 7 7 kyzylorda 4 5 5 6 4 7 6 6 6 mangystau 5 5 5 6 3 7 7 5 4 south kazakhstan 6 5 7 6 6 5 6 6 6 pavlodar 6 5 5 6 4 5 5 8 5 north kazakhstan 6 5 6 6 7 6 7 7 5 east kazakhstan 7 6 7 6 6 5 6 7 6 entropy 0.9008 0.9773 0.93807 −0.0471 1.5871 1.3098 1.2452 1.4893 1.3369 source: calculated and compiled by the authors bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 2016 59 is used for consumption below the cost of living in the rural area by formula 7: 10 10 10 (6) 0.5 * 0.4 * 0.4 * 5 4 4 0.1* (10) 1.309864685 = + + + = h ln ln ln ln we calculate the entropy of the depth of poverty by formula 7 in the rural area: 3.3. calculate entropy of block indicators “the results of the application of human capital” we calculate the entropy of the gross labor productivity by formula 7: h l ln ln(1 ) = 0.8*a n 10 8 0 3 10 3 0 3 10 3 0 900898524+ + =. * . * . we calculate the entropy of the total turnover of the implementation cost of livestock crop production in agricultural formations in per capita by formula 7: h ln ln ln ln ( ) . * . * . * . * . 2 0 6 10 6 0 6 10 6 0 2 10 2 0 2 10 2 1 256765913 a = + + + = let’s calculate the entropy index of physical volume of gross production (services) of agriculture by formula 7: h(3 ) = 0.6* 10 6 +0.5* 10 5 +0.3* 10 3 =1.014260806a ln ln ln we calculate the entropy level of profitability (loss) of agricultural production in the agricultural enterprises by formula 7: h ln ln ln ln ( ) . * . * . * . * ( ) . 4 0 5 10 5 0 5 10 5 0 3 10 3 0 1 10 1 284597531 a = + + + = we calculate the entropy ratio of average nominal wage and the subsistence level by formula 7: 10 10 10 (5 ) 0.10 * 0.2 * 0.2 * 0.643775165 10 2 2 h a ln ln ln= + + = we calculate the amount of entropy budget expenditures per employee in agriculture according to formula 7: h ln ln ln ln ( ) . * . * . * ( ) . * ( ) . 6 0 8 10 8 0 4 10 4 0 1 10 0 1 10 1 00554815 a = + + + = 22 we calculate the entropy of internal costs on r&d in agriculture by formula 7: 10 10 10 (7 ) 0.6 * 0.3* 0.2 * 6 3 2 10 0.2 * 1 .311462381 2 h a ln ln ln ln = + + + = 3.4. rank regions based on entropy thus, the greatest entropy is possessed by “the index of physical volume of gross agricultural production (services),” and the least by “the proportion of people whose income is used for consumption below the subsistence level in rural areas.” in general, visually uneven distribution of qualitative values for all indicators is observed. table 7: entropy block of indicators “the results of the application of human capital” (the second block) regions productive financial innovation and entrepreneurial activity 1а 2а 3а 4а 5а 6а 7а gross labor productivity the total turnover of the implementation cost of livestock crop production in agricultural formations in per capita indexes of physical volume of gross production (services), in agriculture the level of profitability (loss) of agricultural production in the agricultural enterprises ratio of average nominal wage and living expendiure the amount of budget expenditures per worker in agriculture internal costs on r&d in agriculture akmolinsk 6 5 5 5 4 5 5 aktubinsk 5 6 4 5 5 4 5 almaty 5 5 4 6 5 7 4 atyrau 5 4 4 5 6 5 4 western kazakhstan 5 6 4 6 5 5 5 zhambyl 4 6 5 4 5 5 7 karaganda 5 5 6 6 4 4 5 kostanai region 4 4 6 4 5 5 5 kyzylorda region 6 5 5 5 5 5 4 mangystau 4 5 4 4 5 3 south kazakhstan 5 6 5 6 5 4 5 pavlodar region 5 5 6 7 6 5 6 north kazakhstan 6 6 5 6 5 5 7 east kazakhstan 5 6 4 5 5 4 6 entropy 0.9008 1.2567 1.0142 1.2845 0.6437 1.0055 1.3114 source: calculated and compiled by the authors. r&d: research and development bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 201660 we define integral quality of each area accounting for the entropy of values of all indicators of the first and second blocks by the formula 6 (s(1) akmolinsk region): ( ) ( ) 1 1 4 * 0.9008 6 * 0.9773 5 * 0.93807 6 * 0.0471 5 *1.5871 7 * *1.3098 7 *1.2452 7 *1.4893 6 *1.3369 58.142 n j ji j s h x = = = + + + − + + + ++ + = ∑ similarly, we define the integral quality of each area accounting for the entropy of values of the first block of indicators by formula 6. the results are summarized in table 8, accordingly. similarly, we define the integral quality of each area accounting for the entropy of values of the second block of indicators by the formula 6. the results are summarized in table 9, accordingly. s a h x j n j ji1 6 0 9008 5 1 2567 5 1 0142 5 1 2845 4 0 6 1 ( ) = = + + + + = ∑ * . * . * . * . * . 4437 5 1 0055 5 1 3114 37 3411 + + = * . * . . the greater the integral quality of an object, the greater must be its rating. therefore final ranking of the areas takes the form as in table 10. sakmolinsk=s(1)+s(1a)=58.142+37.3411=95.948285 from table 10 it is clear that the north-kazakhstan area under the terms of the functioning of human capital in agriculture has the highest rating since the integral quality of the object is the largest among the other objects (103.5804). the lowest rating is in mangystau region, the integrated quality of which is 74.55515. 3.5. the factor analysis methodology on the basis of the ranking of the regions separately for each block it can be detected that there is a connection between operation conditions (factor characteristic) and the results of the functioning of human capital in agriculture (productive characteristic). according to the method of factor analysis in agriculture, the dynamics of human capital development, changes in the conditions of functioning of human capital (factor characteristic) and the results of functioning of human capital of the republic of kazakhstan (productive characteristic) are determined by the change of 11 factors/indicators selected in the table 11, characterized by the numerical value of pi. let’s denote the value of the indicator p0 for 2009 and pi for 2013. thus, the changes of the individual indicator are determined by formula 9. the employment level in agriculture 148.9 0.97066493 153.4 i = = ii−1=0.97066493−1=−0.02933507 similarly, we define the change factor ii, ii−1, each indicator field of the first and second blocks by formula 6. table 8: integral quality of each area based on the entropy of the first block of indicators “modalities for the functioning of the human capital in agriculture” s(1) 58.142 s(2) 54.675 s(3) 58.032 s(4) 57.287 s(5) 50.910 s(6) 53.392 s(7) 58.207 s(8) 58.619 s(9) 52.843 s(10) 49.239 s(11) 57.075 s(12) 52.421 s(13) 60.432 s(14) 60.443 source: calculated and compiled by the authors table 9: integral quality of each area based on the entropy of the second block of indicators “the results of the application of human capital” s(1а) 37.3411 s(2а) 36.321 s(3а) 38.0539 s(4а) 34.1454 s(5а) 38.611 s(6а) 38.7782 s(7а) 37.7335 s(8а) 34.6562 s(9а) 36.6734 s(10а) 25.3165 s(11а) 38.6197 s(12а) 42.6223 s(13а) 43.1488 s(14а) 37.6324 source: calculated and compiled by the authors table 10: ranging of the areas on agricultural conditions of functioning of the human capital akmolinsk 95.48285 aktubinsk 90.99632 almaty region 96.08602 atyrau region 91.43262 west kazakhstan 89.52114304 zhambyl region 92.16985 karaganda region 95.94072 kostanai region 93.27512 kyzylorda region 89.51625 mangystau region 74.55515 south kazakhstan region 95.69489 pavlodar region 95.04365 north kazakhstan region 103.5804 east kazakhstan region 98.07499 source: calculated and compiled by the authors 3.6. calculate group indicators and complex human capital index in agriculture now we calculate the group of indicators ilm, iihc, iss, ip, if, iiiea; complex index of conditions for the functioning of human capital (ifunc) and the complex index of the results of functioning of human capital (ires); index of functioning of human capital bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 2016 61 in agriculture i in all indicators of the first and second block of akmolinsk region are shown in the formulas 11, 12 and 10, accordingly. the results are summarized in table 12. 1 1 *1* 0.735535636 1 .183883909 4lm i = + = 1 *1* 0.637034653 1.637034653ihc = + = 1 1 *1* 0.371532293 1.092883073 4ss i = + = 1 1 *1* 0.694272369 1 .231424123 3p i = + = 1 1 *1*1 .622842657 1.540947552 3f i = + = table 12: the calculation of group indices of human capital changes in agriculture in the republic of kazakhstan regions ilm iihc iss ip if iiiea ifunc ires ihc akmolinsk 1.18 1.63 1.09 1.23 1.5 1.87 1.28 1.52 1.40 aktubinsk 1.51 1.06 1.19 1.55 1.20 1.33 1.24 1.35 1.30 almaty region 1.29 1.35 1.19 1.32 1.74 1.04 1.28 1.34 1.31 atyrau 1.10 1.45 1.17 1.88 2.74 1.18 1.23 1.82 1.50 west kazakhstan 1.24 4.24 1.29 1.87 1.47 6.49 1.89 2.61 2.22 zhambyl 1.25 1.45 1.18 1.60 1.65 1.00 1.29 1.39 1.34 karaganda 1.17 1.06 1.05 1.92 1.42 1.47 1.59 1.09 1.32 kostanai 1.07 2.12 1.33 1.21 1.16 1.96 1.40 1.45 1.42 kyzylorda 1.36 1.30 1.18 1.49 2.47 1.66 1.28 1.83 1.53 mangystau 1.53 2 1.62 2.25 1.98 2 1.70 2.07 1.88 south kazakhstan 1.03 1.14 6.37 1.82 1.89 1.84 1.96 1.85 1.90 pavlodar 1.00 1.55 1.19 1.50 1.83 2.37 1.23 1.87 1.51 north kazakhstan 1.05 1.19 1.02 1.48 1.57 1.00 1.08 1.32 1.20 east kazakhstan 1.05 1.47 1.32 1.67 1.63 2.56 1.27 1.91 1.56 source: calculated and compiled by the authors table 11: calculation of individual indicators of changes in human capital in agriculture of akmolinsk region indicator р0 рi i p pi == 1 0 ii-1 modalities for the functioning of the human capital the indicators of the labor market and human resources the level of employment in agriculture, th. pers. 153.4 148.9 0.97066493 −0.02933507 the number of employees in agriculture; pers. 644 481 694 413 1.07747629 0.077476295 the number of self-employed in agriculture, people 110 116 104925 0.9528588 −0.0471412 the immigration rate (in rural areas) 0.01374 0.00362 0.26346434 −0.73653566 investments in human capital the share of expenditure on science and research and development in the gross output of goods (services), agriculture, % 0.133583 0.218680 1.63703465 0.637034653 indicators of social sphere proportion of population with income used for consumption below the subsistence level in the rural areas (%) 6.1 4.3 0.70491803 −0.29508197 the depth of poverty in rural areas (in %) 0.9 0.8 0.88888889 −0.11111111 the combined share of the coverage of education of the population living in rural areas, aged 6-24 years (in %) 49.8 54.8 1.10040161 0.100401606 the volume of rendered health services and social services in rural areas (thousand tenge) 5581835.3 936254.5 1.67732376 0.677323765 the results of the application of human capital productive indicators gross labor productivity (the ratio of the volume of agricultural production to total employment), mil./pers. 1316.05 1555.34 1.1818244 0.181824399 the total turnover of the implementation cost of livestock crop production in agricultural formations per capita, thousand tenge/pers. 152.28 245.69 1.61340951 0.613409509 the index of physical volume of gross production (services) of agriculture, in% to the previous year 145.6 130.9 0.89903846 −0.10096154 financial indicators the level of profitability (loss) of agricultural production in the agricultural enterprises (percentage) 14.8 25.0 1.68918919 0.689189189 ratio of average nominal wage and a living standard 2.85 3.27 1.14736842 0.147368421 the amount of budget expenditures per employee in agriculture, mil/thousand 52165.98 93183.31 1.78628505 0.786285046 indicators of innovation, entrepreneurial activity internal costs on r&d in agriculture, thousand tenge 269 680 506441.4 1.877934589 0.877934589 source: calculated and compiled by the authors. r&d: research and development bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 201662 1 1 *1* 0.877934589 1.877934589 1iiea i = + = 3 1.183883909 *1.637034653*1.092883073 1.284242082 funci = = ires = = 1 231424123 1 540947552 1 877934589 1 527420653 3 . * . * . . 3 1.284242082 *1.527420653 1.400563415hci = = tables 11 and 12 show that in the akmolinsk region index of the change of human capital in agriculture is 1.4, i.e., ihc growth makes up 40%, where the special role is played by the index of results of functioning of human capital in agriculture, especially the index of innovation, entrepreneurial activity. that is ii-1 on internal costs on r&d in agriculture made up 0.877934589. the growth of this indicator in akmolinsk region in 2013 compared to 2009 amounted to 236,761.40 tenge, which is approximately 1.877 times higher and which ultimately has a positive effect on the development of akmolinsk region as a whole. since the main purpose of the entrepreneurial activity is profit, then achievement of that in practice is possible by ensuring economic stability in a market environment characterized by financial stability, competitiveness of products and technology, production and sales efficiency due to the innovative activity of the entrepreneurs. innovations serve as a specific tool that is business incentive mechanism, but not innovations as such, but directed organized search for novelties, the constant focus business entities to achieve market competition. thus, the current economic situation calls for new solutions to use and activate the resource potential at all management levels. it is necessary to pay attention to the indicators of social sphere (1.092883073), where there is a downward trend, and compared with other indicators they are the lowest. it had a negative trend indicator the combined share of education of the population living in rural areas, aged 6-24 years, which was 0.100401606 (table 11). this indicator in 2013 compared to 2009 increased by only 5%, or 1.1 times that in our opinion is a very slight increase. that is, the administration of akmolinsk region should pay special attention to the education of the population aged 6-24 years, living in rural areas and to take measures that will lead to an increase in this indicator. if possible, more funds should be allocated for education, greater advertising opportunities related to education for young people, etc., which should ultimately lead to an increase in access to education and youth interest in this matter. 3.7. group indicators and complex human capital index in agriculture similarly, we define the group of indicators ilm, iihc, iss, ip, if, iiiea; complex index of conditions for the functioning of human capital (ifunc) and the complex index of the results of functioning of human capital (ires); index of functioning of human capital in agriculture ihc all indicators of the first and second blocks of each region are given in the formulas 11, 12 and 10 accordingly. the results are summarized in table 12. 4. discussion 4.1. discussion group indicators and complex human capital index in agriculture so, according to the table 12, the highest index of the change of human capital in agriculture in the republic of kazakhstan for 2009-2013 (table 12) is in west kazakhstan region being 2.22 and the lowest index of the change in human capital is in the northkazakhstan region being 1.20. this suggests that the maximum increase in the index changes of human capital in agriculture taken place in the west kazakhstan region amounted to about 127%, while the index significantly influenced the results of functioning of human capital in agriculture, especially in the field of innovation and entrepreneurial activity. that is, it is necessary to pay attention to the index internal costs on r&d in agriculture, which in 2013 compared to 2009 increased by 6.4 times or by 234,010 thousand tenge. we can say that there is the growth of funding r&d, the idea is that it should lead to the development of new crops, products, etc., causing agriculture to develop, which can lead to the growth of interest on the part of human capital and the possible influx of labor in this sector of the economy. regarding the indicator the labor market and labor force, there is a downward trend and this indicator is 1.24. particular attention the administration of the west kazakhstan region should pay to the indicator the number of employees in agriculture, which in 2013 compared to 2009 decreased by 4,332 people (0.73 times). that is, we see a clear trend of human capital outflow from agriculture. this evolution was mainly due to the fact that today, fewer people want to work in agriculture because of poor working conditions, low wages when compared with other industries, poor infrastructure, often seasonal work, etc. 4.2. discussion group indicators and complex human capital index in agriculture of north kazakhstan and akmolinsk regions in the northern kazakhstan region the index of change of human capital in agriculture, which has had a significant impact to the index of the results of functioning of human capital in agriculture, especially in the financial sector grew by 20.3%. financial indicator mainly increased due to the index the volume of budget expenditure per person employed in agriculture, i.e., in 2013, compared with 2009 it increased by 50,134 million tenge/ thousand people (almost 2 times). leaders of the region should also pay attention to the internal costs on r&d in agriculture, as there is no reduction or trend growth. gross internal costs on r&d in agriculture accounted for the decrease in 2013 compared to 2009 by 311 thousand tenge. in akmolinsk region (table 12), the following thing is shown: the index change of human capital in agriculture for 2009-2013 was 1.18, i.e., an increase over a given period of time only by 18%. on the growth of the index in the change of human capital in agriculture of akmolinsk region generally, a significant impact had indicator of innovation, entrepreneurial activity 1.87, which includes internal costs on r&d in agriculture, and investment in human capital 1.63 (share of costs on science, research and bulkhairova, et al.: assessment of human capital in the agricultural enterprises of the republic of kazakhstan international journal of economics and financial issues | vol 6 • special issue (s5) • 2016 63 development in the gross output of goods (services) in agriculture). gross internal costs on r&d in agriculture from 2009 to 2013 increased from 269,680 to 506,441.4 thousand tenge, or 1.87 times, it can be said that the rise in this indicator is almost double. the share of expenditure on science and research and development in the gross output production (services) of agriculture from 2009 to 2013 increased by 0.85097%. the smallest increase is observed in the indicators of social sphere 1.09, which includes the following indicators: the proportion of people whose income is used for consumption below the subsistence level in rural areas; the depth of poverty in rural areas; combined share of education of the population living in rural areas, aged 6-24 years; volume of services in the field of health services and social services in rural areas (thousand tenge). at the same time the local authorities need to pay special attention to the following indicators: the proportion of people whose income is used for consumption below the subsistence level in rural areas, and the depth of poverty in rural areas. since on other indicators there is a small increase though, on those indicators there is no growth. thus, on the basis of table 12 the administration of kazakhstan should pay attention to the indicator of the labor market and human resources, which in most cases is relatively low. this indicator includes the following indicators: the level of employment in agriculture, the number of employees in agriculture, the number of self-employed in agriculture, immigration rate (in rural areas), that is, to improve these indicators in the infrastructure it is necessary to fund more rural areas, raise wages in agriculture, to create privileges and bonuses for young professionals who want to work in agriculture, etc. 5. conclusions based on personal observations of the author’s it is necessary to improve the quality of the following indicators: • the portion of people whose income is used for consumption below the subsistence level in rural areas. the portion of population with income used for consumption below the subsistence level in rural areas is higher than in the city. on poverty reduction increased income compared to the cost of living, reducing unemployment and the provision of adequate social assistance influences. constant monitoring the causes of poverty and the assessment of the impact of certain factors on its reduction will make the process manageable and provide itemized achieving the goals of poverty reduction in rural areas. • the portion of the population’s education coverage living in the rural areas, at the age of 6-24 years old. dynamic development and improvement of economic relations creates problems for kazakhstan education system to improve the quality of general education and vocational training of students and, in particular, the maintenance and development of a network of rural educational institutions. by the growth of this indicator the following factors may be caused: electronic networking of schools and the education of new computer technologies; increase the diversity of types and kinds of schools; the introduction of new forms of organization of the educational process characterized by multifunctionality and integrative educational function. • the volume of services rendered in the field of health and social services in rural areas. in modern society, the main priority is health because it determines the state of the economic and social status of the country, its role and place in the global community. however, there is a difference in health care organizations in the rural areas and cities, namely a special way of life of villagers, the settlement system, low (compared with the city), population density, poor quality, and sometimes the lack of roads, the specific agricultural labor leave their imprint on the organization system of medical care to villagers. development of the primary units of rural health care should be supported by the following main priority actions in the organization and provision of primary health care to the rural population: comprehensive study of the state of the rural population health by organizing and holding mass medical examination of the villagers in different regions of kazakhstan to determine the true incidence; the introduction of rural health care via rural family doctor institution must be accompanied by serious preparation for therapy and related disciplines, etc. the growth of these indicators leads to public interest, and gradually the growth of human capital in agriculture will take place. thus, the proposed algorithm in this publication makes it possible to estimate the generalized rating of each region of kazakhstan in terms of development of human capital in agriculture, as well as the rating of individual components: the block “modalities for the functioning of the human capital” on employment, social and investment; for the block “results of the use of human capital” in manufacturing, financial, innovation and entrepreneurial activity. this analysis will help identify the strengths and 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(1970), investment in human capital. belmont, ca: wadsworth publishing company. p15. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2017, 7(2), 437-447. international journal of economics and financial issues | vol 7 • issue 2 • 2017 437 exchange rate movements, stock prices and volatility in the caribbean and latin america andre yone haughton1, emma m. iglesias2*†1 1department of economics, university of the west indies mona, kingston 7, jamaica, 2department of applied economics, ii. facultad de economía y empresa, university of a coruña, campus de elviña, a coruña, 15071, spain. *email: emma.iglesias@udc.es abstract we analyze the interrelationship between stock prices and exchange rates in the only two caribbean countries with stock market and floating exchange rates: jamaica and trinidad and tobago. we also study the same four latin american countries as in diamandis and drakos (2011). using their model, our results show a very mild relationship between both variables in jamaica, trinidad and tobago, argentina and brazil, but we cannot find any relationship in the other countries as in diamandis and drakos (2011). however, when we extend their model including a generalized autocorrelation conditional heteroskedasticity (component to examine the impact of volatility, our results changed drastically: stock prices significantly impacted the exchange rate in the tranquil sub-period and the full period for jamaica, over all three periods for trinidad and tobago and in the tranquil period for argentina, mexico and chile. this shows the importance of incorporating volatility explicitly in the model. our results have the policy implications that governments in the previous countries should try to prevent a currency crisis by stimulating economic growth and the expansion of the stock market to attract capital inflow as in lin (2012). keywords: exchange rates, stock prices, volatility jel classifications: f31, g01 † authors are very grateful for the useful comments received at the world finance conference in 2016. the second author is very grateful for the financial support from the spanish ministry of science and innovation, project eco2015-63845-p and from xunta de galicia, project ed431c2016/007. 1. introduction research on the interaction between exchange rate and stock prices has received more attention since the recent global financial crisis. researchers in the unites states and asia mainly, have been trying to estimate the direction of causality between both variables. according to lin (2012), there are two main theories surrounding their interaction: (1) the one proposed by dornbusch and fisher (1980) with the “flow oriented” models of exchange rates, which looks specifically at the balance of trade between countries. theoretically, exchange rate fluctuations influence the output and hence competiveness of firms. if firms are more competitive this has a direct positive effect on its stock prices, since stock prices represent future cash flow streaming for a company. (2) the second approach, the “stock oriented” model of exchange rate proposed by frankel (1983) and branson (1993), states that advances in the stock market affect exchange rate through the liquidity and the wealth effects. a decrease in stock prices reduces the wealth of local investors, which lowers their demand for money. then banks react by lowering interest rates which dampens capital inflows, reducing the demand for local currency and therefore depreciates the local currency. since domestic and foreign assets are not perfect substitutes in the portfolio balancing effect, as investors adjust their portfolio ratio of domestic to foreign assets in response to changes in economic conditions, the exchange rate responds accordingly. evidence of either theory is not uniform across countries as various studies employing a range of different techniques revealed varying results. most of these studies have been focused on north america, europe, asia, and latin america to a lesser extent but none have investigated this issue in the caribbean, from the best of our knowledge. recently, hassanain (2017) has analyzed the case of the gulf cooperation council. our objective is to analyze the interrelationship between the stock market and the exchange rates in the two caribbean countries that haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017438 have floating exchange rates and stock markets: jamaica and trinidad and tobago. we also study the same four latin american countries as in diamandis and drakos (2011): argentina, brazil, chile and mexico. we follow lin (2012) by analyzing the relationships between the exchange rate market and the equity market during the tranquil (2002-2008) and during crisis (2008-2012) periods and we also use the autoregressive distributed lag (ardl) model bounds test approach proposed by pesaran et al. (2001). diamandis and drakos (2011) claim that the type of exchange rate regime being operated in the particular country will influence the long run relationship between both variables. all the countries in this study operate a float or managed float exchange rate regime. the relationship between exchange rate and stock prices have a tendency to be greater during crisis periods as returns in asset markets are lower and volatility are higher (lin, 2012; guo et al., 2011). therefore, we extend diamandis and drakos (2011) and lin (2012) studies to incorporate a generalized autocorrelation conditional heteroskedasticity (garch)(1,1) component as in bollerslev (1986) in the ardl framework to take account of the impact of risk in the model. note that the importance of volatility is made clear in many contexts nowadays also in the caribbean countries (see for example mapp and wiston (2015) who analyze the impact of the informal economy on the volatility in the caribbean countries). our objective in this paper is to show that volatility must be modeled explicitly also when analyzing the relationship between stock prices and exchange rates. gordon and pettiford (2016) have also demonstrated how accounting for arch effects can be a crucial factor to establish relationships among macroeconomic variables. like in asia, north america and europe, the global financial crisis in 2008 resulted in an immediate decline in the stock prices (sp in figure 1) in the caribbean and latin american countries (figure 1). notice the behavior is similar for the countries in each group, and also stock prices in latin america tend to be higher (corresponding to larger economies) than the caribbean. exchange rates in our caribbean and latin america countries depreciated as a result of the financial crisis (figure 2). the shift figure 1: stock prices in jamaica, trinidad and tobago, argentina, brazil, chile and mexico for jamaica in particular is more obvious given that exchange rates are higher and appear to be less stable than the other countries (figure 3). we therefore expect a stronger relationship between the exchange rate market and the stock market in jamaica. even though caribbean and latin american countries have floating exchange rates, their central banks can intervene the market to curtail rapid depreciations. in the event of a sudden decline in the value of the domestic currency, the central bank might increase interest rates to attract foreign investors thereby increasing the supply of foreign currency or sell reserves to maintain currency stability. if interest rates are already high (such is the case in jamaica), further increases will reduce economic activity thereby reducing productivity of firms and therefore the value of their stock. jamaica level of reserves has not been enough to keep the currency stable. to account for this in our analysis, we follow lin (2012) by including net international reserves (nir) and interest rate variables in our model. this will improve our results and correct for omitted variable biases. the following section provides a brief overview of the current literature. 2. literature review research on the interrelationship between exchange rates and stock prices has been carried out for a variety of countries using various techniques which have produced varying results. in latin america, diamandis and drakos (2011) analyze the long run relationship and short run dynamics between exchange rates and stock prices as well as the impact of exogenous shocks on four countries: argentina, brazil, chile, and mexico using cointegration techniques and granger causality tests. they found no significant long run relationship between stock prices and exchange rates for each country. however, after incorporating the us stock market, their results show that stock prices and exchange rates are positively related, with the us stock market facilitating the transmission between the two in these countries. the interaction is independent of the sample choice but hansen and johansen (1993) instability tests show that some of their cointegrating coefficients are stable overtime. empirically, the research is largely concentrated on more developed countries. early research by neih and lee (2001) examine the dynamic relationship between stock prices and exchange rates for the g7 countries using basic cointegration tests and vector error correction models (vecm) from 1993 to 1996. this research did not account for dual causality between the variables and their findings suggest that there is no long run relationship between stock prices and exchange rate in the g7 counties. muller and verschoor (2006) examine how multinational firms in the us are affected by exchange rate fluctuations. they believe that currency movements are a major source of macroeconomic instability which affects a firm’s value; a situation they refer to as exchange rate exposure. theoretically, they outline several reasons why the exchange rate/stock price interaction might be asymmetric. these include the asymmetric impact of hedging on cash flow, firms pricing to market strategies, asymmetry due to hysteric behavior, investors over reaction and mispricing errors and nonlinear currency risk exposure.1 1 for more in-depth analysis see muller and verschool (2006). haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017 439 also on the us, vygodina (2006) uses a granger causality test to investigate the relationship between stock prices and exchange rates controlling for the size of the firm from 1987 to 2005. the results found causality from large stock prices to us exchange rate but no causality from small stock prices. the results from the subsamples show that there might be evidence to support the claim that causality between the two variables is changing overtime. some have also explored the issue in asia. pan et al (2007) used granger causality tests and vector autoregressions to examine the dynamic linkages between exchange rate and stock prices in seven asian countries: hong kong, japan, korea, malaysia, singapore, taiwan and thailand from 1988 to 1998. their results showed significant causal relationships for hong kong, japan, malaysia and thailand before the financial crisis. they also found evidence of causal relationships between the equity market to the foreign exchange market for hong, korea and singapore. they also found causality from exchange rate to the stock market for all countries except malaysia, while there is no causality from stock prices to exchange rates. they claim their results are robust to a variety a testing procedures including causality tests and variance decomposition. yau and nieh (2006) empirically investigate the new taiwan dollar exchange rate against the japanese yen on stock prices in japan from 1991 to 2005. granger causality test showed that no short run causal relationships existed between the variables for both countries. also, the findings suggest there is no relationship between the exchange rate and the respective stock prices in the long run. yau and neih (2009) also examined the relationship between japanese exchange rate and taiwan stock market using a threshold error correction model proposed by enders and siklos (2001). their findings suggest that there is a long run equilibrium relationship between the taiwan dollar, the japanese yen and the stock prices of japan and taiwan, but asymmetry only exist for taiwan as the effects of the japanese exchange rate is symmetric. zhao (2010) used monthly data from 1991 to 2009 to examine the dynamic effects between exchange rate and stock prices in china by employing a vector autoregressive approach (var) and a multivariate garch. their results show that there is no definite long run relationship between the chinese renminbi real effective exchange rate and stock prices in china. they also found no spill over effects between the two variables. the paper goes a step further to examine the cross volatility effects between stock market and the exchange rate using likelihood ratio tests. the results show that there is volatility spill over effects from stock prices to exchange rate and from the exchange rate to stock prices. more recently, tsai (2012) uses quantile regression to investigate the relationship between stock price index and exchange rate in six asian countries: singapore thailand, malaysia, philippines, south korea and taiwan. the results supported a priori information that the two variables are negatively related. more specifically, the negative relationship observed is more pronounced when exchange rates are extremely low or extremely high. this result is supported by the portfolio balancing effect in these two markets which outlines that an increase (decrease) in the returns on stock price index will result in an appreciation (depreciation) of the domestic currency via a decrease (increase) in the exchange rate. tsai (2012) findings also suggest that the relationship is not homogeneous across countries and across market situations and the coefficients may vary since the portfolio balancing effect is not present all the time in every market. they explain that a significant impact of stock prices on exchange rates exist in time where large sums of capital enter or exit the market. our research in this paper follows the method of lin (2012) who examines the relationship between the exchange rate and stock prices in asia’s emerging markets from 1986 to 2010. using monthly data, the ardl model proposed by pesaran et al. (2001) was employed. this method is designed to account for structural breaks and data that are integrated of different orders. the results from the cointegration tests as well as the short run causality tests indicate that the co-movement between exchange rate and stock prices increases during times of economic crisis and it reduces when the economies are stable. these results correspond with the general literature on exchange rate spill over effects on the stock market. the results also show that most spill overs are in the channel from stock price shocks figure 3: exchange rates and stock prices in jamaica figure 2: exchange rates trinidad and tobago, argentina, brazil and mexico haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017440 to exchange rates. in theory, economic slowdown reduces the value of companies stocks causing investors to withdraw their capital which reduces the demand for the domestic currency and out downward pressure on the exchange rate. apart from the findings for aggregated data, lin (2012) also examined the issue using industry level data, and the results indicated that the co movement is weak for export oriented industries such as it for example. all in all, the findings suggest that the interrelationship between exchange rate and stock market is driven by changes in the capital account rather than changes to trade balance in these asian countries. our research estimates the interrelationship between stock prices and exchange rates using the same approach as in diamandis and drakos (2011) and lin (2012) by employing the bounds cointegration tests in the ardl model, since it provides meaningful long run results even if all the variables are not integrated of the same order. during crisis period, market returns are lower and volatility is higher as the correlation between assets prices tends to be greater see (see e.g., climent and meneu (2003) and guo et al., 2011). this justifies our extension incorporating a garch(1,1) component in our ardl framework as volatility (risk) is also a determining factor in the relationship between prices and exchange rates. the remainder of the paper is organized as follows: section 3 outlines the data, data sources, the methodology employed and the results. section 4 concludes. appendix a contains some of the tables a1-a6 and figures a1 and a2. 3. data and methodology 3.1. data we examine the interrelationship between the stock index and the exchange rate in the caribbean and latin america using monthly data from 2002 to 2012. data on the share price index (sp), the exchange rate relative to the us dollar (fx), the money market rate (mm) and foreign reserves minus gold (r) are collected from the international monetary fund (imf) international financial statistics. all data are transformed into logarithms. the data begins in january 2002 which is approximately the same time the asset bubble began to develop in the international asset markets. in this way we also minimize any effects of the jamaican and the mexican financial crisis of the 90’s. on the other hand, the reason to finish our sample size in 2012 is in order to remove the economic effects of the big increase in debt of the economy in jamaica that happened in that year. in early 2010, the jamaican government asked the jamaica debt exchange to retire high-priced domestic bonds and reduce annual debt servicing. however, debt continued to be a serious concern, forcing the government to negotiate and sign a new imf agreement in may 2013 to gain access to approximately $1 billion additional funds. as a precursor, the government instigated a second national debt exchange in 2012. first we analyze the data across the full time period and later we split the data into two parts: (1) the first sub-sample from 2002:01 to 2008:08 (the so called tranquil period) where the asset bubble was developing. (2) the second sub-sample is taken from 2008:09 to 2012:02 (the crisis period). this will provide useful comparisons of the interrelationship between the variables before and after the announcement of the recent global financial crisis. the summary statistics are provided in table 1 for the full sample 2002:01-2012:02, as well as each sub-sample periods. figures a1 and a2 in appendix a show the evolution of exchange rates in latin america and the caribbean. 3.2. methodology and results 3.2.1. unit root tests to test for a long run relationship between the stock prices and exchange, the order of integration of each variable must first be examined. through careful examination of the movements of the data for the countries of the caribbean and latin america overtime, it is visible that structural breaks may exists at different points in time (figures 1-3 in section 1). if such structural breaks table 1: summary statistics variables mean±sd tranquil period (2002/01 to 2008/08) crisis period (2008/09 to 2012:02) full period (2002/01 to 2012/02) stock prices jamaica 0.151±0.048 −0.004±0.049 0.008±0.049 trinidad and tobago 0.012±0.031 −00.1±0.031 0.007±0.032 argentina 0.019±0.071 0.013±0.093 0.016±0.079 brazil 0.019±0.072 0.007±0.074 0.136±0.073 chile −0.126±0.171 −0.134±0.123 −0.134±0.123 mexico 0.017±0.049 0.010±0.063 0.014±0.054 exchange rate jamaica 0.005±0.009 0.004±0.015 0.005±0.012 trinidad and tobago −0.000±0.003 0.000±0.003 0.000±0.003 argentina 0.009±0.066 0.008±0.014 0.009±0.054 brazil −0.005±0.055 −0.003±0.047 −0.002±0.542 chile −0.063±0.081 −0.069±0.185 −0.069±0.185 mexico 0.001±0.020 0.004±0.042 0.003±0.030 interest rate jamaica −0.007±0.242 −0.056±2.370 −0.007±0.222 trinidad and tobago 0.012±0.171 −0.169±0.409 −0.049±0.287 argentina −0.384±8.614 0.006±0.921 −0.244±6.928 brazil −0.078±0.678 −0.073±0.375 −0.071±0.590 chile −0.989±0.489 −2.590±0.579 −2.590±0.680 mexico 0.007±0.549 −0.094±0.234 −0.026±0.465 foreign reserves jamaica 0.003±0.059 −0.003±0.075 0.000±0.064 trinidad and tobago 0.019±0.047 0.004±0.025 0.014±0.041 argentina 0.015±0.062 0.001±0.019 0.009±0.054 brazil 0.022±0.059 0.013±0.019 0.189±0.049 chile −0.166±0.131 −0.069±0.101 −0.165±0.131 mexico 0.009±0.022 0.010±0.037 0.009±0.027 all data is analyzed in logarithms. sd: standard deviation haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017 441 are not accounted for, it increases the likelihood of failing to reject the null of a unit root (e.g., lin, 2012). therefore, unit root tests are sensitive to the alternative to a trend break hypothesis. consequently, along with the usual augmented dickey fuller (1979) (adf) unit root test, we also employ the zivot and andrews (1992) and the clemente et al. (1998) unit root tests which both account for the presence of structural breaks in the data. the zivot and andrews (1992) allows for a structural break in the data set which may occur in the intercept or trend or both. the break is determined endogenously as the test supports various criteria for detection. the zivot and andrews (1992) can be specified in one of three general forms: model a accounts for break in intercept only; model b accounts for break in trend only and model c accounts for break in both intercept and trend. consider the following: suppose the structural shift occurs at a period 1<tb<t in the data set, and given the following ar(1) process; yt=φ+yt−1+εt (1) then the models are outlined as follows: model a ( ) k 1 i 1t t t t t i t y t du y c y − −== + + + + +∑ϕ β τ λ α ∆ ε (2) model b ( ) k 1 i 1t t t t t i t y t dt y c y  − −== + + + + +∑ϕ β λ α ε∆ (3) model c ( ) ( ) k 1 i=1t t t t i t i t y t du dt y c y  − −= + + + + + +∑ϕ β τ λ λ α ∆ ε (4) where; φ and t represent the deterministic intercept and trend respectively, dut(λ)=1 if t>t(λ) and 0 otherwise; allows for break in intercept and, dtt=t−tλ if t>tλ, and 0 otherwise; allows for break in trend. ∆ is the difference operator and the error term εt~iid(0,σ 2) is assumed to be identically and independently distributed with mean zero and constant variance. the null hypothesis of the zivot and andrews (1992) test is that yt has unit root i(1) with no exogenous structural break against the alternative that series is a stationary i(0) with structural break at some unknown point in time. the minimum t-value for the zivot and andrews test is selected for the endogenously determined break point 1<tb<t. here the test statistics are larger than that of the adf since it allows for endogenous break points. the lag length is selected using the schwarz bayesian criterion. to increase robustness of our results, we also employ the clemente et al. (1998) test which extends zivot and andrews (1992) test to include two structural breaks, allowing for double changes in the mean, modeling both additive outliers (ao) schemes and innovative outliers (io) schemes. the ao scheme is derived from the following: 1 1 2 2t t ty d du d du y= + + + ϕ (5) where, k k 1 1 2 2 1j 0 i 0 k i t b t i t b t i t t i t=1 y dt dt y y − − −= = − = + + + + ∑ ∑ ∑    ∆ τ τ α θ ε (6) the test procedure searches for the minimum t-statistics where α = 1, in equation (6) above. if the breaks are as a result of the io case then the model is estimated as equation (7) below: 1 1 2 2 1 1 2 2 1 t t t b t b t k t t i ti y d du d du dt dt c y −= = + + + + + +∑ ϕ δ δ ∆ ε (7) where du1t and du2t are defined as above, and dtbi; (i =1, 2), are impulse variables equal to 1 if t=tbi+1 and 0 otherwisetbi represents the time of the shifts in the data. once more, the error term εt~iid(0,σ 2) is assumed to be independent and identically distributed with mean zero and constant variance. the results are provided in table 2. the results from the unit root tests with and without structural break(s) confirm that our variables of interest, mm, sp, fx and r are integrated of different orders over time and across countries. table 2 shows the results of the three unit root tests employed in the analysis; the augmented dickey fuller (1979) tests with no structural break(s), the zivot and andrew test (1992) with 1 structural break and the clemente et al. (1998), with two structural breaks. the results of the augmented dickey fuller (1979) tests show that all variables for all six countries are integrated i(1) series except brazil’s exchange rate and interest rates and mexico’s exchange rate. the zivot and andrews (1992) tests shows that most variables from all countries have at least 1 significant structural break in the data. the structural break for stock prices for jamaica and trinidad and tobago occurs late 2003, while the structural break for the latin american countries occurred mid 2007 or 2008, approximately the time when the asset bubble started peaking. the structural break in the exchange rate for jamaica, argentina, brazil, chile and mexico occurs at late 2008; while for trinidad and tobago it occurred late 2009. the structural break for interest rate data is a little less aligned: for jamaica and brazil is at early 2010; for trinidad and tobago it is early 2009; for mexico early 2004; argentina 2005 and chile 2009. the international foreign reserves variables shows the largest disparity, since the structural breaks for all countries are occurring at different years: jamaica 2004, trinidad and tobago 2005, brazil 2007, argentina 2009, chile 2009 and mexico 2010. overall, by taking account of one structural break in the data, the results show that all variables are integrated i(1) series except interest rates for trinidad and tobago, chile, argentina and exchange rates for chile and brazil. to extend the analysis and increase robustness of the results, we further employ the clemente et al. (1998) unit root test, with two structural breaks. the results show that all variables except interest rates for trinidad and tobago, mexico and argentina haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017442 foreign reserves are integrated i(1) with a possible structural break in the trend, intercept or both. the structural breaks for stock prices for jamaica, trinidad and tobago are in 2003 and 2008; argentina 2008 and 2009 and chile 2003 2009, while the structural break for brazil occurred in 2003 and 2005. clearly, it appears that the first structural break for stock prices in 5 of the 6 countries occurred with the beginning of the asset bubble in 2003, while the second structural break for all countries except brazil occurred either in 2008 or 2009, approximately the time when the asset bubble peaked. the results for exchange rates using the test with two structural breaks are different across all countries: for jamaica the break occurs in 2005 and 2008; trinidad and tobago 2009 and 2010; both breaks for brazil occurred in 2004, mexico 2008 and 2009, argentina 2002 and 2008 and chile 2003 and 2008. the structural breaks for interest rate data using this test shows for jamaica the breaks occurred in 2004 and 2011; for trinidad and tobago the breaks occurred 2006 and 2008; brazil 2003 and 2006; mexico 2003 and 2009; argentina 2002 and 2005 while chile 2003 and 2006. the international foreign reserves variable also show disparity across countries. using this test the structural breaks are registered in different years: jamaica 2003 and 2009; trinidad and tobago 2004 and 2005; brazil 2002 and 2006, mexico 2005 and 2009; argentina 2002 2005 and chile 2008 and 2011. overall, the first structural break in this second test occurs at a similar point in time to the structural break in the zivot and andrew (1992) test in most instances. overall all three tests indicate that unit roots are present in some of the variables. there was no variable where all three tests results agree on no unit root; and therefore there is no clear evidence that any of variables are i(0). 3.2.2. bounds tests for cointegration the results from the unit root tests with and without structural break(s) confirm that our variables of interest, mm, sp, fx and r are integrated of different orders over time and across countries. therefore, the regular engle and granger (1987) and var based tests of johansen (1992) and johansen and juselius (1998) are mis-specified given these conditions. to correct this, we follow lin (2012) by employing the ardl bounds test approach proposed by pesaran et al. (2001). this approach solves the problem, as it provides valid test results even if the variables are integrated of different orders. using this bounds test procedure the order of integration of the variables does not have to be the same; i.e., it accounts for the inclusion of both i(0) and i(1) in the same equation. here similar to lin (2002) we employ the bounds test corresponding to case v, from pesaran et al. (2001) which accounts for an unrestricted intercept and an unrestricted trend in the model. the model is specified in var terms as follows: p i 1 , 1, 2 .,t i t i tz t z t t−== + + + = …∑α ω γ ε (8) where α represents a (k + 1) vector of intercepts/drifts and ω is a vector of (k + 1) trend coefficients. given this, pesaran et al. t ab le 2 : u ni t r oo t t es ts : a d f, z iv ot a nd a nd re w s (1 99 2) a nd c le m en te e t a l. (1 99 8) te st s v ar ia bl es ja m ai ca tr in id ad a nd t ob ag o a rg en ti na b ra zi l c hi le m ex ic o u ni t r oo t t es t w ith n o st ru ct ur al br ea ks st oc k pr ic es −3 .2 82 −2 .4 47 −2 .6 02 −2 .1 67 −2 .6 34 −1 .6 34 e xc ha ng e ra te s −2 .6 40 −3 .7 81 −5 .1 10 * −4 .4 52 * −2 .6 86 −3 .6 37 * in te re st ra te s −3 .0 76 −0 .9 94 −4 .3 86 * −4 .4 84 * −3 .3 15 −2 .7 76 fo re ig n re se rv es −2 .8 13 −0 .6 06 −1 .0 92 −1 .8 19 −− 0. 89 9 −2 .3 57 u ni t r oo t t es t w ith o ne s tr uc tu ra l br ea k st oc k pr ic es −3 .8 00 [0 3/ 11 ] −3 .3 69 [0 3/ 09 ] −4 .0 43 [0 8/ 06 ] −3 .5 86 [0 8/ 06 ] −4 .2 17 [0 7/ 11 ] −4 .4 31 [0 8/ 06 ] e xc ha ng e ra te s −3 .4 87 [0 8/ 09 ] −4 .7 11 [0 9/ 07 ] −6 .9 94 [0 8/ 09 ] −7 .3 39 * [0 8/ 09 ] −5 .3 30 * [0 8/ 08 ] −6 .0 25 [0 8/ 09 ] in te re st ra te s −4 .7 92 [1 0/ 03 ] −7 .7 07 * [0 9/ 01 ] −1 1. 76 6* [0 5/ 11 ] −5 .4 91 [1 0/ 01 ] −5 .8 45 * [0 9/ 01 ] −4 .0 03 [0 4/ 08 ] fo re ig n re se rv es −3 .8 20 [0 4/ 02 ] −2 .9 19 [0 5/ 07 ] −2 .6 71 [0 9/ 12 ] −4 .6 80 [0 7/ 02 ] −2 .5 54 [0 9/ 06 ] −3 .0 77 [1 0/ 07 ] u ni t r oo t t es t w ith tw o st ru ct ur al br ea ks st oc k pr ic es −2 .4 56 [0 3/ 10 , 0 8/ 11 ] −4 .3 73 [0 3/ 08 ,0 8/ 06 ] −4 .0 35 [0 8/ 09 , 0 9/ 02 ] −3 .6 16 [0 3/ 01 ,0 5/ 06 ] −3 .8 94 [0 3/ 02 ,0 9/ 02 ] −3 .7 19 [0 3/ 02 , 0 9/ 01 ] e xc ha ng e ra te s −4 .4 45 [0 5/ 08 , 0 8/ 08 ] −4 .4 45 [0 9/ 05 ,1 0/ 09 ] −3 .8 86 [0 2/ 10 , 0 8/ 07 ] −2 .9 05 [0 4/ 06 ,0 4/ 01 ] −3 .8 95 [0 3/ 07 ,0 8/ 09 ] −6 .7 56 [0 8/ 07 ,0 9/ 11 ] in te re st ra te s −4 .6 49 [0 4/ 01 , 1 1/ 01 ] −1 1. 77 8* [0 6/ 01 , 0 8/ 12 ] −4 .9 91 [0 2/ 05 , 0 5/ 09 ] −4 .3 37 [0 3/ 05 , 0 6/ 07 ] −5 .3 19 [0 5/ 06 ,0 9/ 11 ] −6 .6 13 * [0 3/ 08 ,0 9/ 02 ] fo re ig n re se rv es −3 .7 70 [0 3/ 12 , 0 9/ 06 ] −3 .6 91 [0 4/ 04 , 0 5/ 05 ] −5 .6 70 * [0 2/ 12 , 0 5/ 12 ] −4 .0 43 [0 2/ 10 ,0 6/ 03 ] −4 .4 56 [0 8/ 03 ,1 1/ 1] −2 .7 99 [0 5/ 04 ,0 9/ 10 ] c ri tic al v al ue s fo r 5 % s ig ni fic an ce le ve l f or u ni t r oo t t es ts w ith o ne a nd tw o st ru ct ur al b re ak s ar e (− 4. 80 0) a nd (− 5. 49 0) re sp ec tiv el y. t he ti m e of th e st ru ct ur al b re ak is g iv en in p ar en th es is [] fo llo w in g th e or de r [ ye ar /m on th ]. *i nd ic at es si gn ifi ca nc e at th e 5% le ve l, re je ct in g th e nu ll of a u ni t r oo t. a d f: a ug m en te d d ic ke y fu lle r haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017 443 (2001) derived the following vecm corresponding to equation (8) above, with being the difference operator: p 1 i 1 , 1, 2 .,t t i t i tz t z z t t− −== + + + + = …∑α ω ∏ θ ∆ ε∆ (9) here the (k+1)×(k+1) matrices p 1 i 1k j i + == +∑π µ and p i 1 1, 2 ., 1i j i p== − = … −∑θ µ , as outlined by lin (2012), contain the long run multipliers and the short run dynamic coefficients of the vecm and zt is the vector of dependent variables yt and regressors xt. after regressing the ardl model, the bounds test procedure requires conducting an f-test on the joint significance of lagged levels of the variables in the model. the null hypothesis is that the lagged levels of the variables are insignificant i.e., π = 0 against the alternative that they are jointly significant i.e., π = 0. under the ardl model, the f-statistic can no longer be compared to the critical values of the f-tables. instead, the bounds test provides two asymptotic critical values for which to compare the calculated f-statistic. it provides a lower bound critical value assuming the variables are i(0) and an upper bound critical value assuming the variables are i(1). if the f-statistic is greater than the critical value for the upper bound, the null of no cointegrating relationship can be rejected. if the f-statistic falls between the upper and lower bound then the test is inconclusive and if the f-statistic is lower than the critical value for the lower bound then the null of no cointegrating cannot be rejected. the results for any long run relationship between the variables using the bounds test for cointegration are provided in table 3. here the null hypothesis is the no-long run level relationship. in what follows we restrict our analysis to the conclusive cases. the results of the bounds test show that stock prices movements significantly impact exchange rate movements in the tranquil period as well as over the entire period of the sample for argentina and brazil. stock prices also significantly affect the exchange rate during the crisis period in jamaica. these results are evidence of the stock oriented model (frankel, 1983; branson, 1993), where a decrease in stock prices reduces the wealth of local investors, which lowers their demand for money; banks react by lowering interest rates which dampens capital inflows, reducing the demand for local currency and therefore depreciates the local currency. according to lin (2012), this suggests that governments should try to prevent a currency crisis by stimulating economic growth and the expansion of the stock market to attract capital inflow. on the flip side, exchange rate movements significantly impact stock price movements in jamaica in the non crisis period and in trinidad and tobago in the full sample, evidence of the “flow oriented” models of exchange rates. a fall in the exchange rate increases the cost of production to firms and therefore their output and competiveness. if firms are less competitive this has a negative effect on its stock prices. this appears to be the case in jamaica, as sharp exchange rate depreciations are relayed to stock prices in crisis period. there is no evidence to suggest any significant impact of exchange rate on stock prices for jamaica over full sample. the results from the bounds test found no evidence to suggest that either exchange rate movements affect stock price movements or vice versa in trinidad and tobago, chile and mexico. this coincides with the general literature which states there is no long run relationship between the two (zhao, 2010; neih and lee, 2001; diamandis and drakos, 2011). 3.2.3. ardl garch(1,1) we go one step further to include a garch(1,1) component in the ardl framework to incorporate the impact of volatility in the model, similar to chen et al. (2013), in modeling the effect of oil prices on global fertilizer prices. we specifically examine the impact of stock price shocks on exchange rates since this is the more prevalent channel in our analysis thus far. the new specification of the model is the same as the one given in (9), but when writing the conditional error correction model where the dependent variable is the first difference of the exchange rates, the disturbance is specified to follow a garch(1,1) model. the results are provided in tables a1-a6 in appendix a. by including this volatility factor, the results change drastically and now we find strong relationships: for jamaica there is evidence of the stock oriented model in the crisis period and over the full period of study. the arch effects are statistically significant across all three periods, showing the presence of a significant volatility. trinidad and tobago also shows evidence of the stock oriented model in all three samples: the tranquil period, the crisis period and the full period in the study. once more arch effects are statistically significant across all three samples and the garch effect is present for the full period only showing that there is a less persistent volatility across all three samples and a more persistent volatility across the full period only. the money market rate is significant in the crisis period and the reserves are only statistically significant over the full period of study. table 3: bounds test for cointegration analysis bounds test jamaica trinidad and tobago argentina brazil chile mexico full sample from 2002m1 to 2012m06 f[fx|sp, mm, r] 4.160 4.160 9.20* 6.410* 3.350 0.610 f[sp|fx, mm, r] 5.440 7.510* 2.920 4.600 2.650 3.190 tranquil period 2002m1 to 2008m08 f[fx|sp, mm, r] 2.300 3.900 35.06* 6.620* 4.450 4.020 f[sp|fx, mm, r] 6.300* 2.370 2.17 4.700 1.870 2.130 crisis period 2008m09 to 2012m05 f [fx|sp, mm, r] 19.005* 2.690 2.65 3.630 5.06 2.340 f [sp|fx, mm, r] 4.406 5.310 4.23 3.240 2.08 3.230 critical values are from pesaran et al. (2001), table ci (v), case (v), unrestricted intercept and unrestricted trend, lower bound i (0)=4.87 and upper bound i (1)=5.85 at the 5% level of significance. *indicates that cointegration exists at the 5% level of significance. the results for table 3 were done for different lag structures, and the results were robust to that haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017444 in argentina, changes in stock prices have a significant effect in all periods; showing evidence of the stock oriented model, similar to the results from diamandis and drakos (2011), who found the same relationship using the us stock market as a transmission variable. the arch volatility component is also statistically significant in all three periods, showing evidence of a significant less persistent volatility. the money market rate and the reserves are statistically significant in the sub-samples but not over the full period of study. it may be explained by the existence of an unaccounted structural break that may have disrupted the results in the full sample. in brazil, changes in stock prices are significant. here as well, arch effects are present in the tranquil period as well as the full period. the money market rate and the reserves are statistically significant in the full period of study. for mexico, there is evidence of the stock oriented model in the tranquil period; and the stock index is statistically significant. the money market rate is statistically significant in the full period of study. the reserves are statistically significant in the tranquil and full period, but insignificant during crisis period, and the arch element is statistically significant only in the crisis period. there is evidence of the stock oriented model in chile in the tranquil period as well as in the full period but not in the period of crisis. the arch effect is present over the full period while the garch effect is present in the tranquil period only. interest rates are statistically significant in in the tranquil period as well as the full period. 4. conclusions we also study the same four latin american countries as in diamandis and drakos (2011): argentina, brazil, chile and mexico. following lin (2012), who examined the same issue in six asian emerging markets and also employed the ardl model bounds test approach proposed by pesaran et al. (2001), we also include interest rates and nir variables in our analysis to avoid any omitted variable bias. we extend diamandis and drakos (2011) and lin (2012) by expanding the ardl model including a garch component to examine the impact of volatility. first, we use the structural break unit root tests of zivot and andrews (1992) and clemente et al. (1998) to show a significant structural break in the exchange rate, stock prices and our other control variables around the time of the 2008 crisis in all analysed countries, leading us to check our results in three periods: the full sample and in two subsamples before and after 2008. our results from the bounds test showed a very mild relationship between both variables in jamaica, trinidad and tobago, argentina and brazil, but we cannot find any relationship in the other countries as in diamandis and drakos (2011). however, when we include the garch component in the ardl framework our results changed drastically: stock prices significantly impacted the exchange rate in the tranquil sub-period and the full period for jamaica, over all three periods for trinidad and tobago and in the tranquil period for argentina, mexico and chile. this shows the importance of incorporating volatility explicitly in the model. our results have the policy implications that governments in the previous countries should try to prevent a currency crisis by stimulating economic growth and the expansion of the stock market to attract capital inflow as in lin (2012). references branson, w.h. 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(1992), further evidence of the great crash, the oil-price shock and the unit-root hypothesis. journal of business and economic statistics, 10, 251-270. appendix a table a1: results from the ardl-garch for jamaica jamaica tranquil period (2002/01 to 2008/08) crisis period (2008/09 to 2012:02) full period (2002/01 to 2012/02) coefficient p value coefficient p value coefficient p value ∆spt−1 −0.028 (0.012) 0.018* 0.000 (0.001) 0.715 −0.028 (0.005) 0.000* ∆mmt−1 −0.003 (0.002) 0.113 −0.000 (0.000) 0.929 −0.005 (0.001) 0.002* ∆rt−1 0.016 (0.007) 0.016* −0.001 (0.001) 0.001* 0.002 (0.005) 0.664 spt−1 0.003 0.002 0.135 0.076 (0.007) 0.000* −0.004 (0.002) 0.000* mmt−1 0.001 (0.002) 0.484 0.014 (0.002) 0.000* 0.001 (0.001) 0.342 rt−1 0.001 (0.001) 0.305 0.001 (0.002) 0.657 0.002 (0.000) 0.001* fxt−1 −0.002 (0.007) 0.781 −0.084 (0.011) 0.000* −0.005 (0.002) 0.038* arch 1.538 (0.427) 0.000* 2.247 (0.897) 0.012* 2.696 (0.320) 0.000* garch 0.108 (0.063) 0.088 0.012 (0.051) 0.829 0.016 (0.019) 0.393 *indicates significance at the 5% level. adrl: autoregressive distributed lag, garch: generalized autocorrelation conditional heteroskedasticity table a2: results from the ardl-garch for trinidad and tobago. trinidad and tobago tranquil period (2002/01 to 2008/08) crisis period (2008/09 to 2012:02) full period (2002/01 to 2012/02) coefficient p value coefficient p value coefficient p value ∆spt−1 0.000 (0.001) 0.715 −0.016 (0.012) 0.178 −0.005 (0.001) 0.000* ∆mmt−1 0.000 (0.000) 0.929 0.000 (0.000) 0.548 0.000 (0.000) 0.666 ∆rt−1 −0.002 (0.001) 0.001 0.000 (0.004) 0.869 0.000 (0.002) 0.793 spt−1 −0.003 (0.000) 0.000* 0.076 (0.007) 0.000* −0.001 (0.000) 0.034* mmt−1 −0.006 (0.001) 0.000* 0.014 (0.002) 0.000* 0.000 (0.000) 0.596 rt−1 0.004 (0.000) 0.000* 0.001 (0.002) 0.657 0.001 (0.000) 0.027* fxt−1 −0.033 (0.003) 0.000* −0.084 (0.114) 0.000* −0.006 (0.003) 0.056 arch 4.147 (0.963) 0.000* 2.247 (0.897) 0.012* 1.325 (0.329) 0.000* garch 0.012 (0.021) 0.560 0.010 (0.050) 0.829 0.314 (0.048) 0.000* *indicates significance at the 5% level. adrl: autoregressive distributed lag, garch: generalized autocorrelation conditional heteroskedasticity haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017446 table a3: results from the ardl-garch for argentina. argentina tranquil period (2002/01 to 2008/08) crisis period (2008/09 to 2012:02) full period (2002/01 to 2012/02) coefficient p value coefficient p value coefficient p value ∆spt−1 0.025 (0.020) 0.220 0.001 (0.010) 0.865 0.012 (0.007) 0.104 ∆mmt−1 −0.001 (0.000) 0.000* 0.000 (0.001) 0.725 −0.000 (0.001) 0.808 ∆rt−1 0.000 (0.017) 0.998 −0.003 0.048) 0.995 −0.046 (0.021) 0.030* spt−1 −0.025 (0.004) 0.000* 0.001 (0.005) 0.851 0.003 (0.254) 0.229 mmt−1 0.019 (0.002) 0.000* 0.035 (0.008) 0.000* −0.001 (0.001) 0.543 rt−1 0.029 (0.002) 0.000* 0.003 (0.001) 0.007* −0.000 (0.000) 0.445 fxt−1 −0.547 (0.060) 0.000* 0.005 (0.025) 0.839 −0.002 (0.006) 0.714 arch 1.954 (0.541) 0.000* 1.424 (0.529) 0.007 2.709 (0.292) 0.000* garch −0.014 (0.035) 0.692 0.085 (0.048) 0.077 *indicates significance at the 5% level. adrl: autoregressive distributed lag, garch: generalized autocorrelation conditional heteroskedasticity table a4: results from the ardl-garch for brazil brazil tranquil period (2002/01 to 2008/08) crisis period (2008/09 to 2012:02) full period (2002/01 to 2012/02) coefficient p value coefficient p value coefficient p value ∆spt−1 −0.131 (0.049) 0.007* −0.053 (0.146) 0.715 −0.029 (0.051) 0.558 ∆mmt−1 −0.007 (0.004) 0.084 0.011 (0.034) 0.740 −0.004 (0.005) 0.381 ∆rt−1 −0.102 (0.052) 0.049* −0.891 (0.483) 0.065 −0.081 (0.064) 0.198 spt−1 −0.005 (0.018) 0.755 0.172 (0.108) 0.114 0.008 (0.020) 0.067 mmt−1 0.012 (0.017) 0.497 0.078 (0.088) 0.375 0.029 (0.015) 0.047* rt−1 0.001 (0.005) 0.912 0.049 (0.030) 0.099 0.005 (0.005) 0.038* fxt−1 −0.026 (0.034) 0.437 0.313 (0.085) 0.000* −0.015 (0.034) 0.668 arch 1.392 (0.488) 0.004* 0.302 (0.315) 0.314 1.345 (0.375) 0.000* garch −0.0968 (0.074) 0.193 0.536 (0.581) 0.356 *indicates significance at the 5% level. adrl: autoregressive distributed lag, garch: generalized autocorrelation conditional heteroskedasticity table a5: results from the ardl-garch for mexico mexico tranquil period (2002/01 to 2008/08) crisis period (2008/09 to 2012:02) full period (2002/01 to 2012/02) coefficient p value coefficient p value coefficient p value ∆spt−1 0.011 (0.051) 0.822 0.005 (0.131) 0.967 0.016 (0.054) 0.774 ∆mmt−1 −0.001 (0.004) 0.730 0.034 (0.052) 0.511 −0.002 (0.005) 0.782 ∆rt−1 −0.073 (0.089) 0.413 0.133 (0.255) 0.602 −0.018 (0.099) 0.857 spt−1 −0.010 (0.004) 0.020* −0.223 (0.164) 0.175 −0.008 (0.005) 0.117 mmt−1 −0.025 (0.015) 0.093 −0.069 (0.094) 0.467 −0.029 (0.012) 0.013* rt−1 0.017 0.005 0.002* 0.084 0.055 0.125 0.015 (0.004) 0.002* fxt−1 −0.139 (0.055) 0.011* −0.330 (0.163) 0.043* −0.117 (0.039 0.003* arch −0.089 (0.142) 0.531 0.440 (0.372) 0.236 0.560 (0.117) 0.000* garch 0.241 (1.675) 0.886 0.329 (0.365) 0.367 0.316 (0.182) 0.083 *indicates significance at the 5% level. adrl: autoregressive distributed lag, garch: generalized autocorrelation conditional heteroskedasticity table a6: results from the ardl-garch for chile. chile tranquil period (2002/01 to 2008/08) crisis period (2008/09 to 2012:02) full period (2002/01 to 2012/02) coefficient p value coefficient p value coefficient p value ∆spt−1 0.096 (0.079) 0.226 −0.269 (0.158) 0.088 −0.017 (0.007) 0.826 ∆mmt−1 −0.026 (0.124) 0.037 −0.007 (0.287) 0.795 −0.002 (0.101) 0.860 ∆rt−1 −0.057 (0.074) 0.445 −0.224 (0.164) 0.172 −0.007 (0.101) 0.948 spt−1 −0.062 (0.023) 0.007* −0.037 (0.069) 0.590 −0.071 (0.254) 0.005* mmt−1 0.001 (0.010) 0.080 −0.007 (0.008) 0.375 −0.003 (0.005) 0.532 rt−1 0.062 (0.020) 0.002* 0.056 (0.391) 0.151 0.062 (0.021) 0.003* fxt−1 −0.187 (0.060) 0.002* −0.184 (0.117) 0.116 −0.178 (0.061) 0.003* arch 0.201 (0.196) 0.304 0.250 (0.398) 0.630 0.371 (0.116) 0.001* garch 0.722 (0.314) 0.020 0.614 (0.639) 0.336 *indicates significance at the 5% level. adrl: autoregressive distributed lag, garch: generalized autocorrelation conditional heteroskedasticity haughton and iglesias: exchange rate movements, stock prices and volatility in the caribbean and latin america international journal of economics and financial issues | vol 7 • issue 2 • 2017 447 figure a1: exchange rate in the caribbean and latin america figure a2: (a and b) exchange rate in jamaica and chile ba . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(5), 184-189. international journal of economics and financial issues | vol 8 • issue 5 • 2018184 inequality of interregional development in riau indonesia; panel data regression approach muhammad hidayat1*, ranti darwin2, m. fikry hadi3 department of economics, faculty economic and business, universitas muhammadiyah riau, indonesia, 2department of economics, faculty economic and business, universitas muhammadiyah riau, indonesia, 3department of economics, faculty economic and business, universitas muhammadiyah riau, indonesia. *email: m.hidayat@umri.ac.id abstract this study aims to analyze the trends and factors of inequality of inter-regional development in riau province period 2011–2016. analyzer used in the form of index theil, bonet index, and regression of panel data with fix effect model. the analysis result with theil and bonet index shows the decreasing trend of interregional development inequality, and the source of inequality comes from within the development area (within) with the percentage of 58–68%. the result of fixed effect model regression states that the variable of fiscal decentralization, government expenditure, human development index, and economic growth have negative and significant relation to inequality. while the variables of natural resource differences have a positive and statistically insignificant relationship. keywords: inequality development, data panel regression, riau jel classifications: d63, o53, r58 1. introduction the agenda 2030 for sustainable development goals or sdgs is a new development agreement that encourages shifting changes toward sustainable development based on human rights and equality to promote social, economic and environmental development. sdgs are enforced with universal, integration and inclusive principles to ensure that no one will be missed or “no-one left behind.” sdgs consist of 17 goals and 169 targets in order to continue the efforts and achievement of the millennium development goals that ended late in 2015 ago. one of the global goals compiled in the 2030 sustainable development agenda is to reduce inequality within and among countries (sdgs bappenas, 2017). riau province is one of the areas that serve as the center of trade of western indonesia and the region which is included in the main corridor of the master plan for the acceleration of economic development of indonesia (mp3ei) sumatra region. in the process of regional development needs to be identified about the potentials and problems of the region. according to that then at least the existing problems can be anticipated and utilize its potential optimally. the economy of riau province over the last 5 years with the use of gdp data including oil and gas, since 2011 has been growing positively with a fluctuating rate, with the growth rate in 2011 at 5.57% and in 2015 by 0.22% and the average growth of 2, 95%. furthermore, with the use of data without oil and gas riau economic growth rate in 2011 amounted to 7.76% and continued to fluctuate until 2015 to 2.01% with an average growth of 4.90%. meanwhile, the distribution of riau province’s revenue, based on gini index data for 2011–2015 shows that in general in riau province there is a fluctuating change from 0.360 in 2011 to 0.400 in 2012, in 2013–2014 decreased by a value of 0.37 and 0.35, then in 2015 again increased from the previous year to 0.36. changes from year to year still show the happening inequality between individuals because the index is still above 0.300 (>0.300). economic development is related to economic growth and is accompanied by changes in the distribution of output and economic structure (nafziger, 2012). ideally, economic development will hidayat, et al.: inequality of interregional development in riau indonesia; panel data regression approach international journal of economics and financial issues | vol 8 • issue 5 • 2018 185 result in high economic growth while increasing prosperity and reducing the level of development inequality. this is in contrast to the general condition occurring in riau province where the growth of relatively high economic growth is accompanied by an increase in income inequality. based on this, it needs an indicator of development performance that has function and can be used to analyze the development in a region. inequality also often occurs significantly between districts/cities within the province itself. it is further said that interregional inequality occurs as a consequence of concentrated development. by identifying the factors that cause inequality in development, it is expected to anticipate the inequality in order to synchronize the development of the region can be immediately created. theoretically, the relationship of economic growth with inequality is known as the kuznets hypothesis and the neo-classical hypothesis which states that at the beginning of development will be accompanied by an increase in income/development inequality. the research on this topic has grown constantly. overseas research conducted by barro (2000); frank (2009); halter et al. (2014); benjamin et al. (2017) and domestic research by sari and pujiyono (2013); dewi and ida (2014); bakri et al. (2016); hidayat and rahayu (2018) the findings indicate that the long-term relationship between inequality and growth is naturally positive in the hypothesis of kuznet and driven primarily by concentrations at each income level. maslikhina (2016) states that the occurrence of interregional inequality in russia during the period 1994–2014 using theil index. spatial inequality level, tendencies and structural features in russia as a whole and in several russian macro-regions (federal districts) were identified. the link between interregional inequality in russia and economic growth was identified. research conducted by bonet (2006) states that the effect of fiscal decentralization on development inequality. the similar findings also found in research by apriesa and miyasto (2013) which states that the effect of fiscal decentralization on income inequality has a positive and insignificant relationship. the research results in bakri et al., (2016) declare that fiscal decentralization represented by balancing funds affects development inequality significantly and negatively. based on the research by hidayat (2014); mopangga (2014) stated that the influence of government expenditure and human development index (hdi) on inequality, based on the first result states that government expenditure and hdi is a source of inequality, while the second result states that government expenditure of inequality and hdi can reduce inequality. according to sjafrizal (2012) there are several key factors that caused the inequality of development between regions: (1) the difference in the content of natural resources, (2) differences in demographic conditions, (3) lack of mobility goods and services, (4) concentration of economic region activities, (5) development funds allocation among regions. 2. methodology the research used is descriptive quantitative research. the study was conducted in riau province. the regions that are the unit of analysis are 12 regions in riau province consisting of 2 cities, pekanbaru and dumai and 10 districts of kuantan singingi, indragiri hulu, indragiri hilir, pelalawan, siak, kampar, rokan hulu, rokan hilir, bengkalis and meranti islands. the execution time of the research is conducted for 1 (1) year. the type of data used in this study is secondary data which means that publication data of central bureau of statistics in the form of time series data fiscal decentralization, government expenditure, hdi, natural resources, economic growth and inequality from 2011 to 2016. 2.1. measurement of regional inequality development 2.1.1. bonet index this index is a measurement made by bonet (2006) to measure inequality among regions in colombia. bonet index in the province for period t (ibi,t) , , , 1 = −i ti t prov t pdrb pc ib pdrb pc (1) according to kuncoro (2013), the formula states that a perfect equality occurs when the per capita gdp per capita region is equal to the province per capita grdp. bonet index value approaching 0 (zero) can mean that the per capita gdp disparity is lower. if the value is higher, it can be interpreted that the per capita gdp per capita among high-rise regions or regional economic growth happens unevenly. ibi,t = inequality of the district/city; pdrb pci,t = grdp per capita district/city; pdrb pcriau,t = grdp per capita province. 2.1.2. theil index theil index is useful for decomposing total disparities into inequality between regions and within regions. the calculation of this index has the utility of analyzing geographic concentration trends over a given period and can examine a more detailed picture of spatial inequality. the theil index equation is written as follows (fujita and hu, 2001; hidayat, 2014; maslikhina, 2016): 1 =   =     ∑ n i i ii y i y log x (2) i = inequality (theil index); yi = grdp district/city i/grdp province; xi adalah population district/city i/population province,       i i i y y log x = partial inequality. the first theil index values are non-negative; a theil index of 0 indicates perfect equality. decomposability of overall inequality into inequality between regions development and inequality within regions development allows us to research spatial structure of interregional inequality (equations 3 and 4). hidayat, et al.: inequality of interregional development in riau indonesia; panel data regression approach international journal of economics and financial issues | vol 8 • issue 5 • 2018186 4 0 1 = = +∑ g g g i i y i log ∈     =        ∑ i gi g igi sg g y yy i xy x .............(3) 4 0 1 log =   =       ∑ gg gg y i y x ∈ ∈ = =∑ ∑g i g i i sg i sg y y x x . .........(4) i0 = inequality between regions development (between) 4 1= ∑y ig g g = inequality within regions development (within) yi = gdp district i / gdp province xi = population district i/population province 2.2. the definition of operational variables formulation of model analysis of the factors that influence inequality of development between regions in riau province used several variables that can be defined as follows: (1) inequality of development, calculated using theil index and bonet index. the theil index is used to identify inequality between regions and the bonet index is used in the equations of panel data regression model; (2) fiscal decentralization with the measurement of the degree of fiscal decentralization which is the amount of the original regional revenue section of all total local revenue received. the unit of the fiscal decentralization variable is percent; (3) government expenditure by measuring the ratio of government expenditure to grdp; (4) hdi used in the publication of the central bureau of statistics; (5) natural resource difference (sda) is calculated based on gdp share of mining sector by district/city; (6) economic growth, this variable uses gdp data with constant 2010 prices during the period 2011–2016, the value of units used in the form of percentages. 2.3. the determinants of development inequality analyzing the factors that influence the inequality between in riau province used regression of panel data. the function formed resembles the regression equation used by cahyono et al. (2017); hidayat (2014); mopangga (2014) with inter-regional inequality (ineq) is allegedly influenced by the variables of fiscal decentralization (df), government expenditure (pp), hdi (ipm), natural resource (sda) and economic growth (lpe). the variables that have the greatest regression coefficient value, are considered to have an important role in influencing the fluctuation of inequality in riau province. the general form of an equation: ineq = {df, pp, ipm, sda, lpe} (5) linear equations of panel data regression model: ineqit = αit+β1 dfit+β2 ppit+β3 ipmit+β4 sdait+β5 lpmit εit (6) 2.4. regression panel data pooled data panel is a combination of cross section and series data. in other words panel data is the data from some of the same individuals observed in a certain period of time. if we have t time periods (t = 1,2., t) and n the number of individuals (i = 1,2., n), then with panel data will have total observation units as much as nt. if the number of time units is the same for each individual, then the data is called a balanced panel. if otherwise, the number of time units is different for each individual, then it is called the unbalanced panel (baltagi, 2008). in this research, the data used is a balanced panel. because the data obtained from 12 districts/cities observed in the period of 6 years so obtained 72 observations. in general, by using panel data, it will generate different intercepts and slope coefficients on each company and time period. therefore, in estimating equation (6) it will be highly dependent on the assumptions we make about intercepts, slope coefficients, and disturbance variables. in panel data model analysis there are three approaches: pooled least square (pls), fixed effect model (fem), and random effect model (rem). in this study, the model used only the fem. 2.5. fem problems arising from the use of pls method is the assumption that intercepts and coefficients of each variable are the same in each inter-area observed. to take into account, the individuality of each cross-section unit can be done by making a different intercept in each region. in the fixed effects method, dummy variables are added to change the intercept, but other coefficients remain the same for each observed region. based on the assumption of the structure of the residual variancecovariance matrix, in the fixed effects model, there are 3 estimation methods that can be used: (1) ordinary least square (ols/lsdv), if the residual variance-covariance matrix structure is assumed to be homoskedastic and no cross-sectional correlation; (2) weighted least square, if the structure of the residual variance-covariance matrix is assumed to be heteroskedastic and there is no crosssectional correlation; (3) seemingly uncorrelated regression, if the structure of the residual variance-covariance matrix is assumed to be heteroskedastic and there is a cross-sectional correlation (widarjono, 2013). 2.6. hypothesis testing before testing hypothesis (f-test, t-test, and r2), then first the model is tested to fulfill best linear unbiased estimator requirement that is tested with classical assumption test, that is autocorrelation test, multicollinearity test and heteroskedasticity test (widarjono, 2013). 3. result and discussion 3.1. trends inequality of development theil index calculation results in figure 1 show that there is inequality in the development of riau province, during the 2011–2016 which continues to fluctuate. from 2012 until 2016 there was a decrease (convergence) from 0.183 to 0.134, this indicates the occurrence of equitable regional development. furthermore, the decline was due to the economic improvements hidayat, et al.: inequality of interregional development in riau indonesia; panel data regression approach international journal of economics and financial issues | vol 8 • issue 5 • 2018 187 occurring in each region and the period of transition of emerging that has been running for more than 10 years. this phenomenon is in line with the neo-classical hypothesis which at the beginning of development will be followed by inequality and if economic conditions have stabilized, then inequality will decrease. the result of theil index decomposition will give an overview of the main source of inequality. based on figure 2 in the period 2011–2016, the largest source of inequality in riau province comes from within regions development with the fluctuation trend in the year 2011 amounted to 58.46% and in 2016 to 68.62%. whereas inequality that comes from between regions development only accounted for about 30–40%. the used of the bonet index provides an overview of inequality occurring in each region, the smallest or near-zero values indicating low inequality and a value close to one is indicating very high inequality. the calculation results are presented in table 1. based on the table, each region experiences fluctuations. the regions that have the greatest value of siak regency, pelalawan, rokan hulu, kampar, dumai city, and indragiri hilir. conversely, the area that has the smallest value is pekanbaru city. moreover, the region where experiencing an increasing trend every year is kuantan singingi regency, bengkalis. aside from those two areas, the inequality is experiencing a downward trend. the integration of both indexes concludes that the inequalities in riau province has experienced a downward trend starting from 2012 to 2016. 3.2. econometric results panel data regression to identify the factors influencing inequality of inter-regional development in riau province, it used regression data panel with fem approach. summary of results regression fem presented in table 2. based on the research results obtained by the regression equation as follows: ineqit = 1.378–0.0013 df-0.0055 pp-0.0161 ipm+0.0009 sda0.0039 lpe+εit the result of regression fem for the value of r2 is 0.9841, it shows that 98.41% consisting of fiscal decentralization, government expenditure, hdi, natural resource difference, and economic growth influence the inequality of inter-regional development in riau province. meanwhile, the value of adjusted r2 is 0.9795, which is used to compare the model when there are additional variables and the use of other models. an f-statistic p = 0.0000 gives the meaning that simultaneously significant variables to the inequality of development that occurred. based on table 2, it gives information about inequality value of each region assuming another variable is considered zero (caterisparibus). the result of regression indicates that siak, pelalawan, rokan hulu, kampar, dumai, and pekanbaru city have positive values with the meaning that this region has a share as the cause of inequality to other regions. based on the value of coefficient and probability t, fiscal decentralization has a negative and significant relation to development inequality. this suggests that the fiscal decentralization that has occurred may reduce the level of inequality that occurred in riau province. this situation is because the original revenue of each region has a total area of about 3–9% for the district and 10-40% for the city area. thus, each region will be able to independently improve the economy. the results of this study are in line with research by bakri et al. (2016) which states that fiscal decentralization has a negative and significant relationship to development inequality. this research is also in agreement with the theory issued by sjafrizal (2012), stating that fiscal balancing or decentralization funds are one of the factors to reduce the level of development inequality. government spending has a negative and significant relationship to development inequality, this is based on a negative coefficient figure 1: trend theil index inequality in riau province, 2011–2016 figure 2: percentage source of inequality in riau province, 2011–2016 table 1: trend bonet index value in riau province, 2011–2016 kabupaten/kota 2011 2012 2013 2014 2015 2016 kuantan singingi 0.070 0.132 0.146 0.153 0.120 0.136 indragiri hulu 0.058 0.124 0.138 0.140 0.088 0.093 indragiri hilir 0.180 0.104 0.078 0.058 0.047 0.026 pelalawan 0.478 0.399 0.364 0.333 0.304 0.262 siak 0.607 0.598 0.583 0.554 0.557 0.526 kampar 0.218 0.187 0.176 0.185 0.189 0.190 rokan hulu 0.371 0.370 0.375 0.383 0.392 0.394 bengkalis 0.080 0.152 0.163 0.179 0.206 0.213 rokan hilir 0.152 0.121 0.123 0.123 0.121 0.125 meranti 0.269 0.179 0.142 0.114 0.076 0.051 pekanbaru 0.098 0.057 0.057 0.050 0.018 0.002 dumai 0.205 0.192 0.197 0.220 0.205 0.177 hidayat, et al.: inequality of interregional development in riau indonesia; panel data regression approach international journal of economics and financial issues | vol 8 • issue 5 • 2018188 value and a small probability of t of 0.05. this result states that government spending is able to reduce the inequality of interregional development that occurred in riau province. this is because the ratio of government expenditure to gdp generated has a small value which means that ongoing government expenditure can increase the output of production value or gdp of each region, in other words, there is efficiency in government expenditure. in line with this, each region in order to be able to maintain the value of the existing ratio. however, the results of research are not in line with mopangga research (2014) and hidayat (2014) states that government expenditure is a source of inequality. based on the value of coefficient and t probability, the hdi has a negative and significant relationship to development inequality. the situation is caused by the hdi value of each region has no significant difference. this fact can not be separated from the performance of each region that prioritizes human development both in terms of planning and implementation at the stage of development. this result is in line with research by hidayat (2014) which resulted that the hdi has a negative effect on development inequality that occurred in riau province. increasing the education of certain levels will improve the quality of human resources that will impact on the use of physical capital to be more efficient and labor will become more productive. thus, the productivity of both physical capital and labor will increase, and will eventually increase economic growth and development gaps may decrease. the different natural resources that exist in each region is one of the factors that can increase the inequality of development in riau province. this is based on the value of the coefficient is marked positive. this result is in accordance with the theory proposed by sjafrizal (2012), that one of the factors affecting development inequality is the difference in the content of natural resources. furthermore, on the basis of the probability that t yields are insignificant, this suggests that the differences in natural resources have not had a great effect in the short term on increasing inequality in development. additionally, to anticipate long-term events, local governments have a duty to continue to optimize the potential of the economy, so it is not entirely dependent on the results of mining both oil and gas and minerals. according to table 2, economic growth has a negative and significant relationship to development inequality. this state shows the convergent position of inequality. this phenomenon when synchronized with a neo-classical hypothesis or reversed u-curve, the current position is in the process of decreasing inequality or convergence conditions. this result is in line with research by barro (2008); halter et al. (2014), that economic growth is negatively related to development inequality. meanwhile, these results are not in line with research by bakri et al. (2016); dewi and ida (2014); frank (2009); sari and pujiyono (2013) that economic growth is positively related to development inequality, in other words, economic growth that occurs can increase the inequality of development. 4. conclusion the calculation results with theil index during 2012–2016 began to decrease (convergence), and the source of inequality comes from within the development area (within) with the percentage of 58– 68% of total inequality. the bonet index also shows a downward trend (convergence). inequality during the same period, and based on this index the region has the greatest value of siak, pelalawan, rokan hulu, kampar, dumai, and indragiri hilir. the result of fem regression indicates that the variable of fiscal decentralization (df), government expenditure (pp), hdi (ipm), and economic growth (lpe) have a negative and significant correlation. meanwhile, the variable of natural resource difference (sda) has a positive and statistically insignificant relationship. table 2: summary of regression results fem method: pooled egls (cross-section weights) variable coefficient standard error t-statistic p c 1.378860 0.135060 10.20927 0.0000 df? −0.001373 0.000336 −4.083323 0.0001 pp? −0.005564 0.002148 −2.590325 0.0123 ipm? −0.016189 0.001725 −9.386082 0.0000 sda? 0.000991 0.000863 1.147854 0.2560 lpe? −0.003993 0.000997 −4.006084 0.0002 fixed effects (cross) _bengkalis--c −0.031062 _meranti--c −0.125537 _dumai--c 0.071854 _pelalawan--c 0.146533 _inhil--c −0.200736 _pku--c 0.025818 _inhu--c −0.134965 _rohil--c −0.151723 _kampar--c −0.011359 _rohul--c 0.138546 _kuansing--c −0.111790 _siak--c 0.384421 r-squared 0.984135 mean dependent var 0.296847 adjusted r-squared 0.979520 s.d. dependent variable 0.282819 s.e. of regression 0.036486 sum squared residual 0.073217 f-statistic 213.2405 durbin-watson statistic 1.077911 prob (f-statistic) 0.000000 significant level 0.05, fem: fixed effect model hidayat, et al.: inequality of interregional development in riau indonesia; panel data regression approach international journal of economics and financial issues | vol 8 • issue 5 • 2018 189 5. acknowledgment this research can be done with the encouragement and assistance from various parties. we are from the research team, thanking the ministry of research, technology and higher education for funding this research and providing useful feedback in conducting this research. we would also like to thank the universitas muhammadiyah riau, the central bureau of statistics (bps) and the regional development planning agency (bappeda) as well as various parties who helped provide support to the research team in preparing this research. references apriesa, l.f., miyasto, m. 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(2013), ekonometrika pengantar dan aplikasinya. yogyakarta: upp stim ykpn. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(2), 287-297. international journal of economics and financial issues | vol 8 • issue 2 • 2018 287 impact of credit risk management on the performance of selected nigerian banks e. chuke nwude1*, chinedu okeke2 1department of banking and finance, faculty of business administration, university of nigeria nsukka, enugu campus, nigeria. 2zenith bank, central business district, abuja, nigeria. *email: chuke.nwude@unn.edu.ng abstract this study investigated the impact of credit risk management on the performance of deposit money banks in nigeria using five banks that had highest asset base. ex-post facto research design was adopted using dataset for the period 2000–2014 collated from the annual reports and financial statement of the selected deposit money banks. three hypotheses were proposed and tested using ordinary least square regression model. the findings reveal that credit risk management had a positive and significant impact on total loans and advances, the return on asset and return on equity of the deposit money banks. the study recommended that bank managers need to put more efforts to control the non-performing loan by critically evaluating borrowers’ ability to pay back. the regulator should strengthen its monitoring capacity in this regard. keywords: credit risk, bank performance, risk management, return on equity, return on asset, non-performing loans jel classifications: g21, g32 1. introduction for every endeavor that involves the mortal being there is risk. financial institutions are piloted by human beings and therefore incur challenges for a multitude of reasons, some of the major causes of such problems continues to be directly related to lax credit standards for borrowers and counter parties, poor portfolio risk management, lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank’s counter parties. banks use customers deposit to generate credit for their borrowers, which in fact is a revenue generating activity for banks. this credit creation process exposes the banks to high default risk which might lead to financial distress including bankruptcy. banking industry is no doubt the most regulated sector in any economy because of the riskiness of its operation. as a result risk management in banks is a discipline every participants and players in the industry need to align with. this is why the subject of risk occupies a central position in the business decisions of bank management. investors and the general public to a large extent approach banks for loans and advances in large volumes which constitute riskassets of banks and necessitate the need for provisioning against them. as long as there is risk there is need for risk management. risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor and control the probability and impact of unfortunate events. deposit money banks assume various kinds of risks in the process of providing financial services as lending is the core business activity of banks. the loan portfolio is typically the largest asset and the predominant source of revenue to banks and also one of the greatest sources of risk to a bank’s safety and soundness. at the core of credit extension in the banking industry risk management is seen as the process of identifying risks, assessing their implications, deciding on a course of action, and evaluating the results. effective risk management seeks to maximize the benefits of a risky situation while minimizing the negative effect of the risk. adequate management of credit risk in financial institutions is critical for their survival and growth. to accomplish this, the bank management must have a thorough knowledge of each portfolio composition or mix, industry and geographic concentrations of credits, average risk ratings, and other aggregate characteristics. they must be sure that the policies, processes, and practices implemented to control the risks of individual loans and portfolio segments are sound and that lending nwude and okeke: impact of credit risk management on the performance of selected nigerian banks international journal of economics and financial issues | vol 8 • issue 2 • 2018288 personnel adhere to them. many nigerian banks had failed in the past due to inadequate management of their risk exposure. the problem has continued to affect the industry with serious adverse consequences as banks are generally subject to wide array of risks in their business operations. against this background, the need to empirically examine the impact of credit risk management on the performance of selected deposit money banks in nigeria becomes necessary. in this regard the main objective of this study is to critically evaluate the effect of credit risk management on the performance of selected nigerian commercial banks. in line with this, the specific objectives of the study are to ascertain the impact of credit risk management on (i) total loans and advances (ii) return on assets (roas) (iii) return on equity (roe) of the selected deposit money banks in nigeria. in line with the specific objectives the study will seek to provide solutions to the research questions such as, to what extent has credit risk management affected (i) total loans and advances (ii) roas (iii) roe of the selected deposit money banks in nigeria? as a follow-up to the research questions raised above, the following hypotheses were tested. h1: credit risk management has no positive and significant impact on (i) total loans and advances (ii) roas (iii) roe of the selected deposit money banks in nigeria. the study focused on the impact of credit risk management on some of the profitability indices of selected deposit money banks in nigeria. the study period covered is 2000–2014. the five banks with highest asset base were selected which are first bank of nigeria plc, united bank for africa (uba), diamond bank plc, zenith bank plc and guaranty trust bank (gtbank) plc. the base year 2000 was chosen because the transition to democratic civilian government came into being on may 29, 1999 with full year effect from 2000. the year 2000 started a new environment for banking practice in nigeria. this study will be of immense benefit to both the selected banks and other banks’ management in observing the weight credit risk management exerts on the selected performance indices of banks. this is likely to spur them to critical review of their credit risk management styles. the findings will enable investors and general banking public to place judgment on the bank management in terms of leadership capacity having observed the level of nonperforming loans (npls) in the banks, total asset value, roas, and roe. essentially, the results of the study can provide an input reference document for further researches in evaluation of risk management. it also provides policy makers more insight into risk management and guide them in policy making, implementation monitoring. 2. literature review 2.1. conceptual review the perspectives of risk differ and risk definition depends on and affected by the risk observer. hillson (2002) states that the way risk is perceived influences the manner in which it is handled. to kannan and thangavel (2008), risk implies exposure to uncertainty or threat. risk sometimes entails some economic benefits as firms may derive considerable gains by taking risk. kaye and lowe (2010) are of the view that risk is integral to opportunities and threats which may adversely affect an action or expected outcome. drucker (1977) submits that business grows through greater risk taking. hillson and murray-webster (2011) see risk as ‘uncertainty that matter’ in business enterprise. in support of drucker (1977) and hillson and murray-webster (2011), olajide (2013) explains that recent economic volatility gives risk management a new focus and eminence. they are of the opinion that getting rid of risk can undermine the source of value creation which truncates potential opportunities. bakpo and kabari (2009) stressed that one of the most important decision problems that require serious attention is granting of loans by a financial institution. according to idowu and awoyemi (2012), liquidity risk, market risk, foreign exchange risk and solvency risk are the most applicable risk to the banks. in accordance with basel ii accord, credit risk, market risk, and operational risk are types of risks usually found in the banking organization. (a) credit risks also known as default risk, is one of the oldest. it is the most vital forms of risk faced by banks as financial intermediaries (broll et al., 2002). it is the potential loss arising from the failure of a borrower to meet its obligations in accordance with agreed terms. (b) market risks is risk in volatility in the market that affects the bank’s return. it is the risk of loss from adverse movement in financial market rates (interest and exchange rate, bond, equity or commodity prices). a bank’s market risk exposure is determined by both the volatility of underlying risk factors and the sensitivity of the bank’s portfolio to movements in those risk factors (zahangir and masukujj, 2011). (c) operational risk is the potential financial loss as a result of breakdown in day to day operational processes. it can arise from failure to comply with policies, laws and regulations, from fraud or forgery. these include direct and indirect laws resulting from inadequate or frail internal processes, people and systems or from external event. moreover, nigerian deposit insurance corporation (2009) stressed that insider abuse is perhaps the most significant factor that led to bank failure. many owners and directors abused or misused their privileged positions or breached their fiduciary duties by engaging in self-serving activities. the abuses included granting of unsecured credit facilities to owners, directors and related companies which in some cases were in excess of their banks statutory lending limits in violation of the provisions of the banks and other financial institutions act (bofia) of 1991 as amended; granting of interest waivers on non-performing insider-credits without obtaining cbn prior approval as required by bofia; diversion or conversion of banks resources to service their other business interests such as allocation of foreign exchange without naira cover to insiders which later crystallized as hard-core debts; compelling their banks to directly finance trading activities either through the banks or other proxy companies, the benefits of which did not accrue to the banks. where losses were incurred, they were passed to the banks. credit risk management provides a clear and structured approach to identifying, measuring and prioritizing risks in order to take nwude and okeke: impact of credit risk management on the performance of selected nigerian banks international journal of economics and financial issues | vol 8 • issue 2 • 2018 289 appropriate actions to minimize losses. an effective credit risk management (ecrm) practice does not eliminate risks, but minimize risks. the implementation and maintenance of ecrm warrants firm commitment to improve the efficiency of business processes. the efficiency can attracts some benefits like (i) saving resources: time, assets, income, property and personnel; (ii) protection of an organization reputation and public image; (iii) prevention or reduction of legal liabilities; (iv) increasing the stability of operations and promoting continuous improvement; (v) protecting people and environment from harm; (vi) avoiding fines for corporate non-compliance with regulations and legislation; (vii) enhancing the ability to prepare for unforeseen and unexpected circumstances; (viii) enhancing competitive advantage through improved decision support and market intelligence based on more accurate risk-adjusted management information; (ix) improved shareholder value and confidence, which is especially valuable in times of crisis when shareholder trust is stressed to its maximum limits; and (x) assisting in clearly defining suitable risk management techniques, including insurance needs (meulbroek, 2002; hillson, 2006; protiviti inc., 2006). in the case of banks, according to abdullahi (2013), the issue of credit risk is even of greater concern because of the higher level of perceived risks resulting from some of the characteristics of clients and business conditions that they find themselves in, which needs thorough empirical examinations. sequel to this, olalekan and adeyinka (2013) pointed out that while banks are expected to absorb the losses from the normal earnings, there may be some unanticipated losses which cannot be absorbed by normal earnings. credit risk management is critical to every business and especially to banks whose stock is cash. the main profitable activity of the bank is lending money and the underlying principle of lending is risk mitigation, which goes with determining a borrower’s ability and propensity to repay the loaned amount. credit risk management starts with assessing the likelihood of credit risk; determining this risk involves reviewing the borrower’s past credit history and earned income. someone with a good credit rating poses less of a risk than someone with a poor credit history. it is therefore, inevitably not possible to separate banking with credit risk management; which has to be a continuous process and implemented wherever banking business exist. effective credit-risk management requires financial managers or risk manager to have in depth understanding of the corporate financial risks and how they interrelate with credit risk. this demands analysis of the business environment in which the bank operate and the assessment of the credit risk in terms of likelihood and impact on the entity`s loan portfolio and profitability. the assessment avails important information to banks necessary to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred. 2.2. theoretical review profitability is one of the ultimate goals of banks and so all strategies and activities are designed to realize this grand objective. as banks increases and maximizes its profits, it must either increases risk or lower its operating cost. banks make money from a series of activities of borrowing and deposits but the occurrence of npls and advances is considered as losses to the bank. higher npl means higher losses, which adversely influence the banks available capital for further borrowing and hence the efficiency of banks investment is affected, further influencing the profitability. npls can be attributed to both macroeconomic conditions and banks specific factors. excessive risk taking valued by loans-to assets ratio and growth rate of banks loans can as well lead to high npls. profitability will generally vary directly with riskiness of bank’s portfolio and operations. as a result in order to increase the return, banks need to know which risk factors have greater impact on profitability which eventually leads to bank financial performance. saunders and cornett (2005) stated that the pervasive incidence of non-performing loan is one of the prime causes of failure in the banking system. the very nature of the banking business is so sensitive because more than 85% of their liability is deposits from depositors. while banks engage in lending as main source of income, they are at the same time exposed to various risks which if not properly analyzed and managed could threaten its continued existence. even though the survival of any bank depends largely on its effective risk management strategies, some bank executives do neglect this aspect of bank job purely for selfish motives. soyemi et al. (2014) emphasized that excessive and poorly managed risk can no doubt lead to losses and thus endanger the safety of a bank’s depositors. once risks have been identified, they should be measured in order to determine their impact on the banking institution’s profitability and capital. this can be done using various techniques ranging from simple to sophisticated models. accurate and timely measurement of risk is essential to effective risk management systems. studies on the influence credit risk management practices on financial performance have been largely conceptual drawing on the theoretical frameworks provided by institutional regulators. tandelilin et al. (2007), rivard and thomas (1997), li (2007) and kim and santomero (1998) opine that a major objective of bank management is to increase shareholders’ return as an index of bank performance. they maintain that this objective often comes at the cost of increasing risk. they detailed bank risks to include interest risk, market risk, credit risk, off-balance risk, technology and operational risk, foreign exchange risk, country risk, liquidity risk, and insolvency risk. the bank’s motivation for risk management comes from those risks which can lead to bank underperformance. schroeck (2002), nocco and stulz (2006) in ariffin and kassim (2009) stress the importance of good risks management practices to maximize firms’ value. while the former proposes that ensuring best practices by instituting effective and prudent risk management practices: increase earnings, the latter specifically posits that effective enterprise risk management have a long-run competitive advantage to the firm (or banks) compared to those that manage and monitor risks individually. in the light of this and as a follow-up, a holistic approach is suggested in managing risk. according to bikker (1999) and kosmidou (2008) concept of bank performance can be expressed in multidimensional ways which nwude and okeke: impact of credit risk management on the performance of selected nigerian banks international journal of economics and financial issues | vol 8 • issue 2 • 2018290 include competition, concentration, efficiency, productivity and profitability. these are the multidimensional nature of the concept of bank performance which calls for wide range of its measures. however the most frequently used measure of banking profitability are roa, roe ratio and net interest margin (nim). despite the fact that roe is still the primary performance measure for the most investors and analyst, sometimes roas provides a better understanding of a company performance as pointed out by hagel et al. (2010). besides some experts consider that a single ratio cannot be a good proxy for bank performance due to the complex operational environment of banks (yang, 2012). 2.3. empirical review credit risk is a serious threat to the performance of banks and as a result various researchers have examined the impact of credit risk on banks in varying dimensions. hakim and neamie (2001) as documented in ariffin and kassim (2009) examine credit risk and bank’s performance in egypt and lebanon banks in the 1990s by using data for banks from the two countries over the period 1993–1999, the study estimates an ordinary least squares regression (ols) model of bank return with varying intercepts and coefficients. the findings show that credit variable is positively related to profitability, while liquidity variable is insignificant across all banks and have no impact on profitability. the study also finds a strong link between capital adequacy and commercial bank return, with high capitalization being the hindrance to return. the study concludes that the capital is a sunk cost with large banks realizing high profits in absolute but not in percentage terms. burner (2010) observed that a reduction in real risk-free rates of interest to historically low levels led to credit expansion in a ferocious search for yield among investors. major financial crisis around the world can be attributed to inordinate ambition to return excellent return to their owners by decision makers and the board thereby taking excess risk to boost stock prices. adeusi et al. (2013) focused on the association of credit risk management practices and bank financial performance in nigeria. using a secondary data for 10 banks and for four years reported an inverse relationship between financial performance of banks and doubtful loans, capital asset ratio was found to be positive and significant. similarly it suggests that the higher the managed funds by banks, the higher the performance. the study concludes a significant relationship between banks performance and risk management. hence, the need for banks to practice prudent risks management in order to protect the interests of investors. kargi (2011) evaluated the impact of credit risk on the profitability of nigerian banks. financial ratios as measures of bank performance and credit risk were collected from the annual reports and accounts of sampled banks from 2004 to 2008 and analyzed using descriptive, correlation and regression techniques. the findings revealed that credit risk management has a significant impact on the profitability of nigerian banks. it concluded that banks’ profitability is inversely influenced by the levels of loans and advances, npls and deposits thereby exposing them to great risk of illiquidity and distress. epure and lafuente (2012) examined bank performance in the presence of risk for costa-rican banking industry during 1998–2007. the results showed that performance improvements follow regulatory changes and that risk explains differences in banks and npls negatively affect efficiency and roas while the capital adequacy ratio has a positive impact on the nim. kithinji (2010) assessed the effect of credit risk management on the profitability of commercial banks in kenya. data on the amount of credit, level of npls and profits were collected for the period 2004–2008. the findings revealed that the bulk of the profits of commercial banks are not influenced by the amount of credit and npls, therefore suggesting that other variables other than credit and npls impact on profits. kolapo et al. (2012) investigated the relationship between bank performance and credit risk management using panel data regression for the period 2000–2010. it could be inferred from their findings that roe and roas both measuring profitability were inversely related to the ratio of non-performing loan to total loan of financial institutions thereby leading to a decline in profitability. ahmad and ariff (2007) examined the key determinants of credit risk of commercial banks on emerging economy banking systems compared with the developed economies. the study found that regulation is important for banking systems that offer multi-products and services; management quality is critical in the cases of loandominant banks in emerging economies. an increase in loan loss provision is also considered to be a significant determinant of potential credit risk. the study further highlighted that credit risk in emerging economy banks is higher than that in developed economies. ben-naceur and omran (2008) in attempt to examine the influence of bank regulations, concentration, financial and institutional development on commercial banks’ margin and profitability in middle east and north africa (mena) countries from 1989 to 2005 found that bank capitalization and credit risk have positive and significant impact on banks’ nim, cost efficiency and profitability. al-khouri (2011) assessed the impact of bank’s specific risk characteristics, and the overall banking environment on the performance of 43 commercial banks operating in 6 of the gulf cooperation council countries over the period 1998–2008. using ols regression analysis, results showed that credit risk, liquidity risk and capital risk are the major factors that affect bank performance when profitability is measured by roas while the only risk that affects profitability when measured by roe is liquidity risk. ahmed et al. (1998) in their study found that loan loss provision has a significant positive influence on npls. therefore, an increase in loan loss provision indicates an increase in credit risk and deterioration in the quality of loans consequently affecting bank performance adversely. furthermore, hakim and neamie (2001) also as documented in ariffin and kassim (2009) examine credit risk and bank’s performance in egypt and lebanon banks in the 1990s by using data for banks from the two countries over the period 1993–1999, the study estimates a fixed effects model of bank return with varying intercepts and coefficients. the findings show that credit variable is positively related to profitability, while liquidity variable is insignificant across all banks and have no impact on profitability. the study also finds a strong link between capital adequacy and commercial bank return, with high capitalization being the hindrance to return. the study concludes that the capital is a sunk cost with large banks realizing high profits in absolute but not in percentage terms. nwude and okeke: impact of credit risk management on the performance of selected nigerian banks international journal of economics and financial issues | vol 8 • issue 2 • 2018 291 another dimension is offered by bruner (2010) on taking excessive risk to boost performance. burner (2010) observed that a reduction in real risk-free rates of interest to historically low levels led to credit expansion in a ferocious search for yield among investors. he attributes major financial crisis around the world to inordinate ambition by decision makers and the board of directors to return excellent return to their owners which push them to taking excess risk to achieve this objective. hosna et al. (2009) reemphasized the effect of credit risk management on profitability level of banks. they concluded that higher capital requirement contributes positively to bank’s profitability. muhammed et al. (2012) used descriptive, correlation and regression techniques to study whether credit risk affect banks performance in nigeria from 2004 to 2008. they also found that credit risk management has a significant impact on profitability of nigerian banks. boahene et al. (2012) used regression analysis to determine whether there is a significant relationship between credit risk and profitability of ghanaian banks. they followed the line of hosna et al. (2009) by using roe as a measure of bank’s performance and a ratio of npls to total asset as proxy for credit risk management. they found empirically that there is an effect of credit risk management on profitability level of ghanaian banks. the study also suggests that higher capital requirement contributes positively to bank’s profitability. liyuqi (2007) examined the determinants of bank’s profitability and its implications on risk management practices in the united kingdom. the study employed regression analysis on a time series data between 1999 and 2006. six measures of determinants of bank’s profitability were employed. he proxied internal determinants of bank’s performance as liquidity, credit and capital. gdp growth rate, interest rate and inflation rate were used as external determinants of banks profitability. the six variables were combined into one overall composite index of bank’s profitability. roa was used as an indicator of bank’s performance. it was found that liquidity and credit risk have negative impact on bank’s profitability. poudel (2012) appraised the impact of the credit risk management in bank’s financial performance in nepal using time series data from 2001 to 2011. the result of the study indicates that credit risk management is an important predictor of bank’s financial performance. fredrick (2010) also demonstrated that credit risk management has a strong impact on bank’s financial performance in kenya. meanwhile, jackson (2011) towed the line of fredrick (2010) by using camel indicators as independent variables and roe as a proxy for banks performance. his findings were also in line with that of fredrick who also concluded that camel model can be used as proxy for credit risk management. musyoki and kadubo (2011) also found that credit risk management is an important predictor of bank’s financial performance. they concluded that banks success depends on credit risk management. while analyzing the credit risk management efficiency in nigerian commercial banking sector from 2004 through 2009, onaolapo (2012) provides some further insight into credit risk management as profit enhancing mechanism. they used regression analysis and found rather an interesting result that there is a minimal causation between deposit exposure and bank’s performance. muhammed et al. (2012) used descriptive, correlation and regression techniques to study whether credit risk affect banks performance in nigeria from 2004 to 2008. they also found that credit risk management has a significant impact on profitability of nigerian banks. 2.4. review summary several works motivated this research though as highlighted in the empirical review. among such works are adeusi et al. (2013), boahene et al. (2012), epure and lafuente (2012), kolapo et al. (2012), muhammed et al. (2012), onaolapo (2012), poudel (2012), al-khouri (2011), jackson (2011), kargi (2011), musyoki and kadubo (2011), fredrick (2010), hosna et al. (2009), ariffin and kassim (2009), liyuqi (2007) and hakim and neamie (2001) who with regression analysis found significant relationship between credit risk management and profitability of banks. they mainly employed roe and roa as measures of bank performance and a ratio of npls to total asset as proxy for credit risk management. even though the survival of many banks depends on its effective risk management strategies, only few studies have actually investigated concepts of risk management in deposit money banks with the aim of statistically determining their impact on bank performance in nigeria. more so, the relationships that exist between risk management and bank performance have not received the desired attention in finance literatures. the need to fill the aforementioned knowledge gaps justifies the relevance of this study. against this background, the need to carry out this research becomes necessary in order to objectively and empirically examine the impact of risk management and the performance of nigerian deposit money banks. 3. methodology the research design adopted in this study is the ex post facto and analytical design. the data set is secondary data obtained from the central bank of nigeria statistical bulletins and annual reports of the five selected banks (diamond, first, gtb, uba and zenith). the study borrowed its analytical model from the work of kaaya and pastory (2013) which examined credit risk and commercial banks performance in tanzania. the linear regression employed by the authors is of the form: y=α+β1x+µ (1) where y=roa (as measure of bank profitability), x=impaired loans, β=coefficient of the independent variable, µ=error term. models for this study will be patterned after the above model but with introduction of a control variable, natural logarithm of total asset. the functional relationships for hypotheses one, two and three are therefore specified as follows: hypothesis one: tlar=α+β1nplr+β2nlta+µ (2) hypothesis two: roa=α+β1nplr+β2nlta+µ (3) hypothesis three: roe=α+β1nplr+β2nlta+µ (4) in writing the model equation, the following symbols were used to denote our respective variables. return on asset=roa, return on nwude and okeke: impact of credit risk management on the performance of selected nigerian banks international journal of economics and financial issues | vol 8 • issue 2 • 2018292 equity=roe, npla/total loans=nplr, total loans and advances/ total asset=tlar, natural log of total asset=nlta. 3.1. dependent variables roe and roas are two measures for deposit money banks’ profitability. the data used to calculate these two ratios are retrieved from the annual reports and financial statements of the selected commercial banks between the periods 2000 and 2014. roa=earnings before interest and tax/total asset while roe=earnings after interest and tax/shareholders’ funds. total loans and advances ratio (tlar) is one of our independent variables and is calculated as the ratio of total loans and advances to total assets. it is an indicator of how loans and advances are covered by the total assets. 3.2. independent variable npls ratio (nplr) is an indicator that measures credit risk management. npls can be defined as a sum of borrowed money upon which the debtor has not made his or her scheduled payments for at least 90 days. a nonperforming loan is either in default or close to being in default. nplr=total npls and advances/total loans and advances. 3.3. control variables natural logarithm of total asset is usually used as proxy for bank size. since every other variable in our model equations are in ratios, we find it necessary to logarithmize the absolute value of the total assets to bring all the variables to equal base. we transformed to natural log simply because our best results during the preliminary tests are based on that transformation after several trials. 3.4. techniques of analysis the objective of this study is to examine the impact of credit risk management on selected deposit money banks in nigeria for the period 2000–2014. to achieve this objective the ols regression was used in analysis. the use of linear regression helps to determine the effect of the independent variable(s) on the dependent variable and to what degree. in other words, it determines both direction and magnitude of the relationships. data collected were presented with the aid of tables. diagnostic tests such as for normality and unit root were carried out. 4. data presentation and analysis 4.1. data presentation table 1 presents the data from annual reports and statement of accounts of selected deposit money banks namely diamond, first bank, gtbank, uba and zenith bank while table 2 contains the descriptive statistics of the variables. 4.2. preliminary tests 4.2.1. test for normality to confirm if the data set assume a pattern of standard normal distribution we utilized the jarque-bera (jb) statistic. table 2 showed that all the variables are normally distributed as the p-values are greater than the critical value of 0.05 and all rightbank year roa roe nplr tlar ta (n’million) diamond 2000 0.0092 0.7484 0.0133 0.0199 110,994,950 2001 0.0260 1.2162 0.1664 0.2003 115,047,860 2002 0.0261 1.0854 0.2331 0.1046 118,249,720 2003 0.0269 0.9340 0.0811 0.2133 120,326,540 2004 0.2630 0.9365 0.0633 0.1266 122,004,950 2005 0.0281 0.8482 0.273 0.3173 124,994,957 2006 0.2370 1.0125 0.0659 0.2702 223,047,862 2007 0.0281 1.4746 0.0722 0.382 312,249,721 2008 0.2490 1.7967 0.0132 0.2761 603,326,540 2009 −0.0149 −0.6747 0.0087 0.3074 604,000,914 2010 0.0172 0.9011 0.0751 0.4833 548,402,560 2011 −0.0380 −3.1596 0.0185 0.5005 714,063,959 2012 0.0267 3.1879 0.0166 0.1275 1,059,173,257 2013 0.0245 4.1110 0.021 0.1208 1,354,930,871 2014 0.0139 1.9047 0.0324 0.1332 1,750,270,423 first 2000 0.0293 6.3612 0.02601 0.1427 256,500,000 2001 0.0330 7.9285 0.182 0.2457 275,450,000 2002 0.0387 6.0319 0.0635 0.312 284,650,000 2003 0.0395 6.4648 0.2241 0.255 302,456,000 2004 0.0451 6.3369 0.205 0.0514 312,490,000 2005 0.0401 6.1659 0.3024 0.3038 377,496,000 2006 0.0367 5.3718 0.0718 0.3252 540,129,000 2007 0.0289 3.1254 0.0791 0.2873 762,881,000 2008 0.0326 3.0641 0.0112 0.321 1,165,461,000, 2009 0.0276 2.8212 0.0091 0.3451 1,667,422,000 2010 0.0170 1.9688 0.0882 0.5184 1,962,444,000 2011 0.0213 2.9089 0.0249 0.4582 2,463,543,000 2012 0.0300 4.3603 0.0142 0.1188 2,770,675,000 2013 0.0236 3.6384 0.0231 0.1132 3,246,577,000 2014 0.0197 0.3483 0.1579 0.144 3,586,433,000 gtb 2000 0.0195 0.9364 0.1032 0.2001 102,500,080 2001 0.0264 1.2756 0.2203 0.2309 110,865,000 2002 0.0251 1.5756 0.0913 0.1331 125,400,000 2003 0.0324 1.5416 0.0833 0.2441 132,500,000 2004 0.0394 2.2888 0.1332 0.1503 154,800,000 2005 0.0417 1.7769 0.2909 0.2874 167,897,704 2006 0.0328 2.8925 0.0631 0.306 305,080,565 2007 0.0320 3.2532 0.0802 0.2643 478,369,179 2008 0.0390 0.2364 0.024 0.2896 963,118,828 2009 0.0324 0.2227 0.0122 0.3645 1,078,177,585 2010 0.0407 3.3726 0.0911 0.4963 1,168,052,897 2011 0.0402 3.5101 0.0262 0.5001 1,608,652,646 2012 0.0618 5.7941 0.0295 0.1254 1,620,317,223 2013 0.0527 5.8132 0.0199 0.1097 1,904,365,795 2014 0.0518 6.3491 0.0432 0.217 2,126,608,312 uba 2000 0.0053 0.9242 0.0344 0.2561 178,500,000 2001 0.0074 1.3352 0.0165 0.2433 195,580,000 2002 0.0092 1.4594 0.0233 0.1772 201,305,000 2003 0.0115 2.0053 0.0732 0.1009 201,150,000 2004 0.0142 2.7202 0.1332 0.2441 225,000,000 2005 0.0253 3.0411 0.2702 0.3306 248,928,000 2006 0.0147 3.2458 0.0511 0.2642 851,241,000 2007 0.0259 3.4500 0.0663 0.2497 1,102,348,000 2008 0.0359 4.6395 0.0202 0.2861 1,520,093,000 2009 0.0113 1.1958 0.0044 0.3222 1,400,879000 2010 0.0060 0.1675 0.0669 0.4638 1,432,632000 2011 −0.0002 −1.013 0.0301 0.3895 1,655,465,000 2012 0.0238 2.8727 0.0115 0.1773 1,933,065,000 2013 0.0233 2.8186 0.0256 0.1241 2,217,714,000 2014 0.0181 2.4305 0.0344 0.1339 2,338,858,000 zenith 2000 0.0100 0.7871 0.0322 0.1335 186,500,000 2001 0.0122 1.1513 0.1662 0.2633 205,896,000 2002 0.0170 1.1860 0.0144 0.2447 225,980,000 2003 0.0211 1.9880 0.0413 0.3115 265,800,000 table 1: computed data of selected deposit money banks (contd...) nwude and okeke: impact of credit risk management on the performance of selected nigerian banks international journal of economics and financial issues | vol 8 • issue 2 • 2018 293 tailed with skewness that ranged between 1.54 and −0.45 and peakedness of between 4.06 and 1.64. 4.2.2. test for stationarity to ensure that the parameters estimated are stationary (stable over time) we utilized the augmented dickey-fuller (adf). at lag of one table 3 indicates that for all our variables, the probability values for our five standard criteria (levin, lin and chu in pesaran and shin w-stat, adf fisher chi-square and pp fisher chisquare) are all <5% critical value. therefore, we reject the null hypotheses that our variables have unit root (are not stationary), and accept the alternate hypotheses that our variables have no unit root (are stationary). 4.3. test of hypothesis test of hypothesis one (h1) which states that credit risk management has no positive and significant impact on total loans and advances of the selected deposit money banks in nigeria. from the table 4, our explanatory variable, nplr, has positive and non-significant impact on total loans and advances of selected nigerian deposit money banks. this was explained by the positive coefficient value of our explanatory variable and the corresponding probability value of the t-statistic 0.0658, which is >5% critical value. the r2 is the summary measure that tells us how well the sample regression line fits the data. from the model above, r2 of 0.52 means that 52% variation in tlar was explained by a change in npls, and the remaining 48% was explained by variables not included in the model. the overall regression is confirmed to be significant as indicated by the p-value of the f-statistics. durbinwatson (dw) statistic approximate value of 2.39 shows there is a trace of negative serial autocorrelation. the null hypothesis is rejected while the alternate hypothesis accepted. this implies that credit risk management has a positive but non-significant impact on total loans and advances of deposit money banks in nigeria. test of hypothesis (h2) two which states that credit risk management has no positive and significant impact on roa of the selected deposit money banks in nigeria. from the table 5, our independent variable, nplr has positive and non-significant impact on the roas of the selected deposit money banks. this was explained by the positive coefficient value of our independent variable and the corresponding probability value of the t-statistic 0.3601, which is greater than critical value of 0.05. the r2 is the summary measure that tells us how well the sample regression line fits the data. from the model above, r2 of 0.60 means that 60% variation in roas was explained by a change in npls, and the remaining 40% was explained by variables not included in the model. the overall regression is confirmed to be significant as indicated by the p-value of the f-statistics (p = 0.0117). durbin watson statistics (dw) approximate value of 2.33 shows that there is a trace of negative serial autocorrelation. the null hypothesis is not accepted while the alternate hypothesis is not rejected. this implies that credit risk management has a positive and nonsignificant impact on the roa of deposit money banks in nigeria. test of hypothesis three (h2) which states that credit risk management has no positive and significant impact on roe of the selected deposit money banks in nigeria. from the table 5, our independent variable, nplr, has positive and non-significant impact on the profitability of nigerian deposit money banks. this was explained by the positive coefficient value of our independent variable and the corresponding probability value of the t-statistic 0.61, which is >0.05 critical value. the r2 is the summary measure that tells us how well the sample regression line fits the data. from the model above, r2 of 0.58 means that 58% variation in roe was explained by a change in npls, and the remaining 42% was explained by variables not included in the model. the overall regression is confirmed to be significant as indicated by the p-value of the f-statistics. durbinwatson statistics (dw) approximate value of 2.21 shows that there is a trace of negative serial autocorrelation. the null hypothesis is rejected while the alternate hypothesis is accepted. this implies that credit risk management has a positive and non-significant impact on the roe of deposit money banks in nigeria. 4.4. implications of results this study examined the impact of credit risk management on the performance of nigeria banks from 2000 to 2014. bank year roa roe nplr tlar ta (n’million) 2004 0.0255 2.2712 0.2113 0.1993 296,500,000 2005 0.0277 2.3853 0.2774 0.2909 329,716,511 2006 0.0249 2.5047 0.0691 0.2541 608,505,175 2007 0.0263 3.7794 0.0555 0.3136 883,940,926 2008 0.0291 5.5569 0.0214 0.288 1,680,302,005 2009 0.0177 1.4622 0.0143 0.3325 1,789,458,000 2010 0.0273 2.1235 0.0754 0.4407 1,573,196,000 2011 0.0263 2.6309 0.0218 0.3891 2,169,073,000 2012 0.0385 6.1028 0.0119 0.1452 2,436,886,000 2013 0.0326 5.3136 0.0185 0.1067 2,878,693,000 2014 0.0355 6.3402 0.02771 0.2331 2,987,600,000 source: computations from annual reports and statement of accounts of selected deposit money banks, roa: return on asset, roe: return on equity, nplr: non-performing loan ratio, tlar: total loans and advances ratio table 1: (continued) table 2: descriptive statistics of computed data of selected deposit money banks indices roa roe tlar nplr ln (ta) mean 0.02652 0.263080 0.19560 0.070561 14.28920 median 0.02110 0.263300 0.024600 0.032200 14.68214 maximum 0.031000 0.440700 0.480000 0.277400 15.72666 minimum 0.012500 0.106700 0.072500 0.011900 10.88358 standard deviation 0.007375 0.092222 0.124430 0.081687 1.985723 skewness 0.536578 0.027120 0.348003 1.548395 −0.451650 kurtosis 1.644040 2.512120 3.166743 4.062090 1.988132 jarque-bera 1.551247 0.150606 0.747614 6.698839 1.781938 probability 0.354441 0.927463 0.516688 0.035105 0.482345 sum 0.263000 3.946200 3.501100 1.058410 199.8880 sum square deviation 0.000874 0.119067 0.120716 0.093418 31.90323 observations 15 15 15 15 15 source : researchers computation, roa: return on asset, roe: return on equity, nplr: non-performing loan ratio, tlar: total loans and advances ratio nwude and okeke: impact of credit risk management on the performance of selected nigerian banks international journal of economics and financial issues | vol 8 • issue 2 • 2018294 following a detailed cross sectional data analysis, the findings revealed plausible results on the economic growth parameter. the implications of these findings are discussed in line with the objectives of this study. as revealed from the finding of this study, credit risk management has a positive and significant impact on total loans and advances of the selected deposit money banks in nigeria. also a cursory examination revealed that the rate of table 3: pool unit root test pool unit root test: summary series: roa, tlar, nplr, log (ta), roe sample: 2005 2014 exogenous variables: individual effects automatic selection of maximum lags automatic lag length selection based on sic: 0–1 newey–west automatic bandwidth selection and bartlett kernel method obs cross sections t-stat prob** null: unit root (assumes common unit root process) levin, lin and chu t* 20 3 −6.01165 0.0000 null: unit root (assumes individual unit root process) im, pesaran and shin w-stat 20 3 −2.47422 0.0076 adf fisher chi-square 20 3 18.4432 0.0051 pp fisher chi-square 20 3 28.3339 0.0001 source: researcher’s eviews results, roa: return on asset, roe: return on equity, nplr: non-performing loan ratio, tlar: total loans and advances ratio table 4: regression result of hypothesis one dependent variable: tlar method: least squares date: 08/9/16 time: 14:52 sample: 2000 2014 included observations: 15 variable coefficient standard error t-statistic prob. c 0.074144 0.263357 0.281534 0.7831 nplr 0.062433 0.344571 0.471408 0.0658 nlta 0.013345 0.018945 0.704397 0.4946 r-squared 0.523424 mean dependent var 0.263080 adjusted r-squared 0.466005 s.d. dependent var 0.092222 s.e. of regression 0.097424 akaike info criterion −1.642634 sum squared resid 0.113897 schwarz criterion −1.501024 log likelihood 15.31976 hannan-quinn criter. −1.644143 f-statistic 0.272371 durbin-watson stat 2.390369 prob (f-statistic) 0.026155 source: researcher’s eviews results, roa: return on asset, roe: return on equity, nplr: non-performing loan ratio, tlar: total loans and advances ratio, nlta: natural log of total asset table 5: regression result of hypothesis two dependent variable: roa method: least squares date: 08/9/16 time: 14:52 sample: 2000 2014 included observations: 15 variable coefficient standard error t-statistic prob. c 0.0574127 0.017132 3.031492 0.0025 nplr 0.019988 0.023425 0.761743 0.3601 nlta −0.003484 0.001132 −2.816775 0.0143 r-squared 0.6020197 mean dependent var 0.024267 adjusted r-squared 0.432179 s.d. dependent var 0.008385 s.e. of regression 0.005318 akaike info criterion −7.107776 sum squared resid 0.000348 schwarz criterion −6.966166 log likelihood 41.30032 hannan-quinn criter. −7.109285 f-statistic 5.202117 durbin-watson stat 2.331326 prob (f-statistic) 0.011721 source: researcher’s eviews results, nplr: non-performing loan ratio, nlta: natural log of total asset nwude and okeke: impact of credit risk management on the performance of selected nigerian banks international journal of economics and financial issues | vol 8 • issue 2 • 2018 295 penetration of credit management by financial institutions as selected within the region contributes to 6% of npls. this implies that on the average about 6% of the total loans and advances constituted irrecoverable loans which is bad and considered as losses. several reasons may have been behind the dismal performance. top among these reasons is high incidence of business failures. bobakovia (2003) asserts that the profitability of a bank depends on its ability to foresee, avoid and monitor risks, possible to cover losses brought about by risk when arisen. this has the net effect of increasing the ratio of substandard credits in the bank’s credit portfolio and decreasing the bank’s profitability (mamman and oluyemi, 1994). the bank supervisors are well aware of this problem, it is however very difficult to persuade bank managers to follow more prudent credit policies during an economic upturn, especially in a highly competitive environment. they claim that even conservative managers might find market pressure for higher profits very difficult to overcome. as revealed from the tables 5 and 6, credit risk management has a positive and significant impact on profitability of the selected deposit money banks in nigeria. also a cursory examination revealed that the rate of penetration of credit risk management by the selected financial institutions within the region contributes to 2% of returns generated from the assets of these banks within the period (2000–2014). this implies that on the average about 2% of the total returns on investment was generated through the assets. although, the result from the hypothesis tested indicates that credit risk management had positive and significant impact on profitability, compared to other regions several reasons may have been behind the dismal returns on assets. top among these reasons is high incidence of npls. however, according to imf (2013), the banking sector time series (including that for the npls) have recent and fundamental structural breaks due to the major consolidation since 2005–06, and the significant changes in the structures of the banks’ balance sheets following their surrender of bad assets. as shown on table 2, the mean of roe from 2000 to 2014 period of our study is 26% which is relatively fair as yearly returns to owners’ capital. the consolidation challenges and global economic meltdown were part of factors which contributed to low returns on equity. the result of our hypothesis indicated that credit risk had a positive and non-significant impact on roe. loans should be made available only to borrowers who are likely to be able to repay and who are unlikely to become insolvent. credit analysis of potential customers is carried out in order to judge the credit risk with the borrower and to reach lending decisions. loan payments are monitored and action taken when a customer defaults. ahmed et al. (1998) in their study found that loan loss provision has a significant positive influence on npls. therefore, an increase in loan loss provision indicates an increase in credit risk and deterioration in the quality of loans consequently affecting bank performance adversely. 5. conclusion the findings from the specific objectives of this study are that credit risk management had a positive and non-significant impact on total loans and advances, the roa, roe of the selected deposit money banks in nigeria. in line with the findings of this study, we recommend bank managers need to put more efforts to the credit risk management by critically evaluating borrowers’ ability to pay back. there is need to strengthened bank lending policy through effective and efficient regulatory supervision and monitoring when facility is given out especially during utilization of the facility by the borrower. banks should try as much as possible to strike a balance in their loan pricing decisions. this will help them to be able to cover cost associated with lending and at the same time, maintain good banking relationship with their borrowers. references abdullahi, s.r. 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(2011), risk management practices: a critical diagnosis of some selected commercial banks in bangladesh. journal of business and technology, 4(1), 13-35. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(5), 294-299. international journal of economics and financial issues | vol 8 • issue 5 • 2018294 probability selection of dormitory house for students yunisvita yunisvita1, imelda imelda2*, fachrizal bachri3, nazeli adnan4, saadah yuliana5 1department of development economic, sriwijaya university, indonesia, 2department of development economic, sriwijaya university, indonesia, 3department of development economic, sriwijaya university, indonesia, 4department of development economic, sriwijaya university, indonesia, 5department of development economic, sriwijaya university, indonesia. *email: imeldazainal@unsri.ac.id abstract this research aims to analyze the factors that determine the student probability to choose their residence between private boarding houses and unsri dormitories. using the binomial logistic regression models of the 275 samples of student respondents of unsri in indralaya campus, the probabilities to choose where to live in private boarding houses is significantly affected by the rental price, but the changes of the rental rates do not alter in the student probability to live in private boarding houses. the most decisive variable is the perception of the location such as the distance to the campus location, public facilities, entertainment, dining, efficiency motive and transportation costs. the negative sign of the value of perception of the location means that the better the perception of respondents about the location of residence will increase the possibility of choosing to stay at private the boarding house. similarly, the increase in income will increase the likelihood of respondents to choose boarding house, while on the contrary when it comes to the the number of facilities. keywords: logistic binomial, boarding/dormitories house, rent price, income, location jel classifications: d31, r3 1. introduction the number of unsri students has increased every year which comes from the city of palembang or from districts/cities in south sumatra and other regions of south sumatra. for students coming from outside the region, the choice to continue their studies at sriwijaya university due to several reasons, partly because of faculties/departments is desirable and in accordance with the interests and talents are not in the area of origin, or because they received scholarships that require to continue his studies in unsri. as a result, demand for a place to stay for prospective students who become temporary shelters for the undergoing study increases. the large number of students who come to the city brings a result the demanding needs of temporary residence (dormitory) is still required for their studies. boarding house is not just a place to rest, but also a place to learn, discuss, create, work assignments and other necessities. students who have family or relatives can stay there, although now it is rarely done. for students there are few options besides staying in the family, among others, is a contract house, boarding school students, guard mosques, boarding and lodging house. contracts house is rented house, the form of the house were rented out to the community, especially for students who settle near the campus, during a period in accordance with the lease agreement and the agreed price. around unsri campus there are also many houses that are rented, the tenant is usually the immigrant students who will live together with a group of friends to be more thrifty. campus unsri like several other campuses also provide the building as a dormitory building to be occupied by students. definition hostel in kbbi are residential buildings that are homogenous (similar). student dormitory at the university of sriwijaya called the rusunawa and there is also apartment unsri. there are several factors that influence the decision of students to choose his residence. students also put out the costs for daily needs are numerous, so that the students should be able to anticipate the expenditure to be able to reduce the cost of his life. for economic yunisvita , et al:. probability selection of dormitory house for students international journal of economics and financial issues | vol 8 • issue 5 • 2018 295 reasons, some students prefer to rent a modest boarding house rooms that are cheaper when compared to boarding houses especially with the luxurious apartment or house. apart from the the great need of life that affect student’s decision in choosing a place to stay there are also other factors, for example, choosing a place to stay in a strategic location as close to the campus, where to eat, cafe, photocopy, shopping centers, or places of entertainment, according to soemantri various reasons that lead students chose to stay or spend the night at a location nearby the campus is able to save on transportation costs, provided various facilities required for students, and the ease of obtaining information because it is close to a fellow student. some choose a place to stay because of supportive environment and conducive to learning or some are more like the crowds. moreover, rental prices and facilities is also a consideration students in choosing a place to stay. therefore, this research wants to analyze the factors that influence the decision of students in choosing a place to stay. it also will compare prices between rental apartment unsri apartment or boarding house around unsri indralaya campus. 2. literature review eckert (in karsidi, 2002) indicate the factors which are very important and affect the demand for the housing market, which is: • economic factors, changes in economic factors that affect housing demand is income, interest rate, lending policies, the level of rents and house prices. • the social factor is population density, family size, education, crime rate and age distribution. • factors including zoning administration, government services and tax levels of society. • environmental factors, changes in the environmental factors that affect the demand for housing is topography, landform, soil conditions and services such as parking facilities, shopping centers, schools, places of worship, transportation. the main determinant of the demand for housing is demographics, but other factors such as income, housing prices, the cost and availability of loans, consumer preferences, the preferences of investors, the price substitution and price all play a complementary role. the core of demographic variables include the size of the population, and population growth, more and more people in the economy, the greater the demand for housing. consumer behavior towards a particular item can be analyzed through the theoretical value (utility theory), which discusses the pleasure obtained satisfaction or a person from consuming goods (sukirno, 2003). there are basically two approaches used to explain consumer behavior, which is marginal utility approach and indifference approach. marginal utility approach starts on the supposition that means that every consumer satisfaction can be measured by money or other units. with the theory of this approach consumers always try to achieve the maximum total satisfaction. while this indifference approach, the approach that requires the belief that customer satisfaction can be measured by making a choice. choice theory (theory of choice) in economics begins by describing preference (choice) of a person. choice theory is the interrelationships between preference (choice) and a variety of obstacles that cause a person to determine his choices. preferences include options from the simple to the complex, to show how anyone can feel or enjoy everything done. but everyone is not free to do anything you want and they are constrained by time, income and many other factors in determining his choice. the model used by economists should also describe how the obstacles can determine how individuals make choices based on their preferences. there are two requirements of consumers achieve a balance of consumers (consumer equilibrium), which is: (1) can be purchased with the resources they have (revenue), and (2) satisfaction reached as high as possible (figure 1). rachmawati (2013) states that the students allowance and significant negative effect, rental rates and facilities offered boarding positive and significant effect, on students preferences in choosing a boarding house in the village or village tawanggede sumbersari. kos is an elastic goods, which is kos requested is strongly influenced by the large-small price. if based on the income elasticity of demand, it is stated that the boarding is a necessity goods (primary) students. if based on the cross elasticity, stated that the relationship between kos kos upper middle and lower middle is the substitution (replacement). using multiple dimensions of factors, including factors references, reputation, safety, price, environmental, service, amenities and location, hajar et al. (2012), concluded that the most dominant factor affecting student’s decision in choosing a boarding an environmental factor boarding with eigenvalues which is 4.119 and diversity of variants of 19.613%. rated loading greatest factor in this factor is owned by boarding a clean environment variable that is equal to 0.797. research by muliana and kustiwan (2011) concluded that the distribution pattern of location of residence students who live away from the family is concentrated closer to the campus area. this is because the main priority in the choice of location of residence by students who live away from the family is a short distance from the campus. location of residence is a factor that affects the characteristics of student travel. weighting method with known that the place of residence is determined by many factors, including the location, facilities, contracts and pricing. the results showed that the location criteria is factors that are most appropriate to determine boarding places (supriana, 2012). cahyani and diah (2012) investigated consumer preference apartment in bandung using quantitative descriptive method. the results of this study is that there are five (5) factors in considering the purchase of an apartment which is the proximity to the workplace, completeness apartment facilities, ease of access to the toll, the price and the location in the city center. for the convenience students have higher expectations on shelter than their parents and are willing to pay the extra fee. this led the university plans to build houses in addition to existing dorms so yunisvita , et al:. probability selection of dormitory house for students international journal of economics and financial issues | vol 8 • issue 5 • 2018296 that it becomes an important option for students. although security and cost is an important consideration, but it turns out there is a very important facility for the students which is the bedrooms, parking, bed, laundry, internet access, fitness center, showers, cable tv and dinner (la roche et al, 2010). the choice of staying on campus for students is also associated with factors such as the characteristics of the campus, the composition and activities of students, campus security, the cost of living outside the campus, and the crime rate. ong et al. (2013) found that there is a positive and significant relationship between the percentage of students who live on campus to campus activities, the size of the campus, campus security and rental rates small apartment off campus. it was also found negative and significant relationship between the percentage of students who live on campus with students acceptance rate, the number of enrolled students, the existence of distance learning programs, population, crime rates and rental rates in the large apartment outside campus. the study of student satisfaction choose where to live in trondheim, norway examined through a quantitative survey which covers five aspects: (1) type of the owner, (2) the impact of demographic variables, (3) location of residence, (4) different characteristics of residence, and (5) individual facilities (eg kitchen/bathroom). the results showed that the most important variable for student satisfaction on a place to stay, the first is the type of owner. second, the quality characteristics of the dwelling and the third, is the location (thomsen and eikemo, 2010). according to muslim et al. (2012), conceptually there are some views to measure student satisfaction of the residence is the condition of student life, community, facilities and services, social activities students, cost of living and students preferences. all views are very informative for all stakeholders in the university provide a conducive environment for students to improve a better life. 3. research methods this study discusses the factors that influence the selection and the price difference lease student residence sriwijaya university campus indralaya dependent variable is the election decision dwelling, while the independent variable is the price of the rent, household income, facilities, and location. this type of research is hypothesis testing with the unit of analysis is students who choose to stay in apartment/rusunawa unsri and students living in boarding houses around unsri campus indralaya. the number of samples to be taken to follow the provisions of gay and diehl (sanusi, 2014). therefore this study correlational nature of the sample of college students either choose a place to stay at apartment unsri and boarding around the campus indralaya as many as 275 people. the sampling technique is done by using the technique of accidental, which is a technique to determine the respondents by anyone who is deemed suitable as a source of data will be given a questionnaire. a statistical technique used is the binomial logistic regression method. the model used is the cumulative density function or a function is asymptotically (between 0 and 1) in the objective function, in this case is a logit model with the following equation: pr (y = 1 | x) = ln [p/(1-p)] = b0 + b1x1 + b2x2 + b3x3 + b4x4 + e where: y = response selecting dwelling (a value of 1 if the respondent choose boarding houses and 0 if not); b0 = constant; b1., b4 = regression coefficients of the variables x1., x4; x1 = rental price; x2 = income families; x3 = facilities; x4 = location. tests of significance on the parameters is done by looking p value compared with α (level of significance) used in two tail null hypothesis. as for the overall significance statistics using the likelihood ratio (lr statistics). lr statistic follows the χ2 distribution (chi-square) with df equal to the number of independent variables (gujarati, 2013). 3.1. goodness of fit test to assess the goodness of fit of the mode, two criteria are used, namely (sujarweni, 2014): 1. hosmer and lemeshow’s goodness of fit test, i.e., if the probability value is >5%, it means the binomial logistic regression model was unfit for further analysis. 2. assess the fit model, namely the reduction in the value -2log likelihood -2log likelihood initial value in the next step will mean hypothesized model fit to the data. 3.2. operational definition of variables and indicators variable dimension indicator scale y=selection decisions shelter selection decisions shelter selection dwelling 1=select lodging house 0=select apartment/ rusunawa nominal x1=rental price housing rental prices that must be paid by the consumer the amount of student expenditure on shelter in rupiah (idr) interval x2=family income total family income of students total revenue in rupiah interval x3=facility shelter facilities offered dwelling number of facilities provided by the owner of the dwelling such as a wardrobe, a bed, a desk, wifi, living room, kitchen and bathroom interval x4=location the location of dwelling refers to the economic factors of existence shelter considered student perceptions about the existence shelter to the location of the campus, public facilities, places of entertainment, dining, efficiency motif and transportation costs ordinal yunisvita , et al:. probability selection of dormitory house for students international journal of economics and financial issues | vol 8 • issue 5 • 2018 297 4. results and discussion 4.1. distribution of respondents by economic variables characteristics of respondents by economic variables are categorized based on the price of rent, income parents and an extra amount of rent. respondents who paid the rent of idr 3,900,001 idr 6,500,000 is the biggest part of all respondents surveyed, the proportion was 50%. table 1 also shows that the lease on the top two intervals have a distribution of respondents do not differ much, respectively 19.27% and 21.45%, or a total of about 40%, while 10% of the respondents to pay the rent more than idr 6,500,000. on average their rent paid respondent is idr 4,505,273, means that there are 43.27% of the respondents to pay the rent above that average. the next economic variables are parents income respondents. in table 2, there are two intervals of the income distribution have <10% are on <idr 1 million and between> idr 2,000,000 to idr 2,500,000. most distributions are parents income respondents interval of rp 1,000,000 idr 1,500,000 ie, a quarter of all respondents surveyed. in proportion differed very well there (the proportion of about 25%) in the highest income interval or> idr 3,000,000. overall table 2 shows that the income of the parents respondents varied greatly. 4.2. distribution of respondents by the social demographic variables socio-demographic variables were observed from respondents include age, gender, national origin and the number of facilities provided by the owner of the dwelling. based on the respondent’s age interval is 16–21 years. respondents who are 19 years old is the biggest part in the study, which covers two-fifths of all respondents. followed by respondents aged 20 years who is a third of the respondents and the other part is a quarter of respondents aged 16–18 years. if the gender aspect of concern, then the ratio of the number of respondents male and female is 2: 3, or 45% of respondents are male and 55% female. for students who choose to stay in boarding houses or apartments/ rusunawa indralaya, then it assumes that the respondents were at least not from indralaya. based on the category of the origin of south sumatra, respondents still dominated by students from all districts/cities in the province of south sumatra, while respondents from outside of south sumatra in sumatra island including the north sumatra, lampung, bengkulu, aceh, jambi, west sumatra and riau. it is quite encouraging that 1 out of 4 students from other provinces in sumatra. in terms of competition among universities in sumatra, sriwijaya university seems quite competitive. issues that should be pursued further was able to compete in indonesia, as it seems from all respondents surveyed, <10% of it comes from outside sumatra, some of them in west java, jakarta, banten, central java, makassar and bangka belitung. especially when considering the university’s vision srwijaya who wants to become a world class research university, optimism should continue to be built in order to interested students from abroad. one factor that can not be overlooked is the preferred place to stay, both on campus and around campus indralaya, along with the facilities available. here are the facilities provided by the owner or manager of a place to stay either in boarding houses and apartment/rusunawa. in this research facility that serves both may include a bed, a dresser, a desk, wifi, kitchen and bathroom, as shown in figure 2. number of facilities provided by either the owner or manager of a place to stay fully as 6 kinds as mentioned earlier is the biggest distribution is 24%. followed by 5 kinds of facilities are available as much as 20.7% with four main facilities ie bed, desk, kitchen and bathroom while the latest types vary between cabinets and living room. respondents who declared three kinds of facilities available numbers were almost as much as stating provided 5 kinds of facilities, where two major facilities are bathroom and kitchen, while the third facility varies between the bed or the living room. 4.3. binomial logistic regression estimation results in the model of respondents preferences in choosing a place to stay dependent variable is a dummy, the probability of staying in boarding houses = 1 and rusunawa = 0. the result indicates the value of chi-square was significant with 95% confidence level as shown in table 3. table 3 indicated that the feasibility of regression models assessed using arithmetic significance value that is equal to 0.174 >0.05. this means that the binomial logistic regression models unfit for further analysis, because there is no real difference between the predicted classification by classification were observed. to assess the model fit is with a reduction in the value of −2 log likelihood beginning with a value of −2 log likelihood in the next table 1: frequency distribution of respondents by rental housing rent interval (idr) respondent total (%) 1.300.000–2.600.000 53 (19.27) 2.600.001–3.900.000 59 (21.45) 3.900.001–6.500.000 137 (49.82) 6.500.001–9.100.000 19 (6.90) >9.100.000 7 (2.55) total 275 (100.00) source: field survey, 2016 table 2: frequency distribution of respondents by income parents income interval (idr) respondent total (%) <1.000.000 17 (6.2) 1.000.000–1.500.000 67 (24.4) >1.500.000–2.000.000 54 (19.6) >2.000.000–2.500.000 24 (8.7) >2.500.000–3.000.000 49 (17.8) >3.000.000 64 (23.3) total 275 (100.00) source: field survey, 2016 yunisvita , et al:. probability selection of dormitory house for students international journal of economics and financial issues | vol 8 • issue 5 • 2018298 step. demonstrated that the results of this study are impairment −2 log likelihood early (in block 0) is equal to 324.217 with −2 log likelihood in the next step (block 1) that is equal to 130.765. thus, the hypothesized model fits the data. based on the results of the regression, all independent variables significantly. value b variable rental rates and income is 0,000; and 0,452; means that every one-unit increase in rental rates, for example, from idr. 1,300,000 to idr 2,600,000 makes odds choose where to live in the boarding house does not change with exp (0.000) = 1.000. different with the income variable in which the sign of the coefficient is positive then the income of parents of respondents causes a direct effect. the estimation results show any accretion income of parents of respondents would make the odds possibility to live in boarding houses be increased by exp (0.452) = 1.572, an increase of 57.2%. different from the income of parents who bring a positive influence, the number of facilities led to a negative influence. the estimation results show each additional type of facilities will make the odd possibility to live in boarding houses to be reduced by 65%. it turns out that the facility did not make a lot more respondents would prefer to stay in the boarding house. these results are consistent with the findings of la roche, et.al, (2010), that student live on campus (dormitory) due to the availability of facilities. conceptually the existing facilities can indeed be a measure of the level of student satisfaction in choosing a place to stay (muslim et al., 2012). while the negative correlation of respondents’ perception about the location means that the odds of the possibility of choosing a place to stay in boarding houses will be reduced by 79.7% if the perception assessment score increased by one unit. the smaller score indicates higher the value perception of respondents. in other words, if the respondents rate the better location (value score of close to 1), the possibility to live in boarding houses increased. the real effect of variable this location is an important determinant of student satisfaction and the election of residence (thomsen and eikemo, 2010; supriana, 2012) 5. conclusion from the results of descriptive analysis, binomial logistic regression models and test the average difference, it can be concluded the following matters: 1. parents income of respondents and the number of facilities available at the residence to variations with an average of idr 3.77 million per month and 4 types of facilities combined beds, cabinets, desks, wifi, kitchen, and bathroom. 2. almost half of the respondents pay their rent between idr 3,900,000 to idr 6,500,000, with an average rental price idr 4.51 million per year. there are differences in the average rental price between boarding houses and subsidized apartments with a difference of idr 507,030.4. 3. opportunity of choosing a place to stay in boarding houses significantly influenced by the price of the rent, the income of the parents, the number of existing facilities and the perception of location of residence. the variables most decisive table 3: results estimation of rental price, parent’s income, total facility and location perception according to respondent against housing options variable b s.e wald sig exp (b) 95% ci for exp (b) lower upper rent price 0.000 0.000 24.354 0.000 1.000 1.000 1.000 income 0.452 0.158 8.171 0.004 1.572 1.153 2.143 facilities −1.049 0.234 20.002 0.000 0.350 0.221 0.555 location −1.594 0.600 7.055 0.008 0.203 0.063 0.659 constants 3.865 2.119 3.327 0.068 47.722 initial – 2 log likelihood: 324,217; −2 log likelihood: 130,765 model chi square: 11,517 (df=8; sig=0,174) figure 2: distribution of respondents by number of facilities available for both source: field survey, 2016 figure 1: indifference curve source: nicholson, 2002: 77. 1 i1 shows yet optimal customer satisfaction. 2 i2 shows the consumer reaches the point of maximum. 3 i3 showed consumer budgets are not enough to meet the needs of goods x and y. yunisvita , et al:. probability selection of dormitory house for students international journal of economics and financial issues | vol 8 • issue 5 • 2018 299 opportunity to live in boarding houses is the perception of the location such as the distance to the campus location, public facilities, places of entertainment, dining, motif efficiency and transportation costs. the negative sign means that the value perception of the location, the better the perception of respondents about the location of residence will increase the possibility of choosing to stay at the boarding house. similarly, the increase in income will increase the likelihood of respondents chose boarding houses, whereas the opposite with the number of facilities. references cahyani, p, diah, d. (2012), preferensi konsumen apartemen di kota bandung. temu: ilmiah iplbi. gujarati, d.n. (2013), dasar-dasar ekonometrika. edisi 5. jakarta: salemba empat. hajar, s., susilawati, m., nilakusmawati, d.p.e. (2012), faktor-faktor yang memengaruhi keputusan mahasiswa dalam memilih rumah kost. e-jurnal matematika, 1(1), 25-31. karsidi, a. (2002), analisis faktor-faktor yang berpengaruh terhadap permintaan dan penawaran rumah sederhana di kota semarang. tesis. program pasca sarjana universitas diponegoro. la roche, c.r., flanigan, m.a., copeland, p.k. (2010), student housing: trends, preferences and needs. contemporary issues in education research, 3(10), 45-50. muliana r. and kustiwan i. 2014 perilaku pemilihan lokasi tempat tinggal dan karakteristik perjalanan mahasiswa di kota bandung jurnal perencanaan wilayah dan kota b 1 37-43. muslim, m.h., hafazah, a.k., ishak, c.a. (2012), satisfaction of students’ living environment between on-campus and off-campus settings: a conceptual overview. procedia-social and behavioral sciences, 68, 601-614. nicholson, w. (2002), microeconomic theory basic, principles and extensions. new york: the dryden press. ong, s.e., milena, p., andrew, s. (2013), demand for university student housing. journal of housing research, 22(2), 141-164. rachmawati, s. (2013), analisis preferensi mahasiswa dalam pemilihan tempat kos (studi: kawasan kos di kelurahan ketawanggede dan kelurahan sumbersari, kota malang). jurnal ilmiah feb, 2(1), 1-15. sanusi, a. (2014), metodologi penelitian bisnis. : salemba empat. sujarweni, v.w. (2014), spss untuk penelitian. : pustaka baru press. supriana, i.w. (2012), sistem pendukung keputusan dalam pemilihan tempat kost dengan metode pembobotan (studi kasus: sleman yogyakarta). jurnal ilmu komputer, 5(2), 11-16. sukirno, s. (2013), mikroekonomi. edisi ketiga. : rajawali pers. thomsen, j., terje, a.e. (2010), aspect of student housing satisfaction: a quantitative study. journal of housing and the built environment, 25(3), 273-295. . international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 99 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s3) 99-108. special issue for “asia international conference (aic 205), 5-6 december 2015, universiti teknologi malaysia, kuala lumpur, malaysia” ownership structure, corporate governance and firm performance pang elvin1*, nik intan norhan bt abdul hamid2 1faculty of management, universiti teknologi malaysia, malaysia, 2faculty of management, universiti teknologi malaysia, malaysia. *email: epang2@live.utm.my abstract based on previous studies, ownership structure is not standardized across different country and economic sectors. in other words, each country or economic sector might have different types of sustainable ownership structure that contribute to the competitive and healthiness of a firm. failure to establish a sustainable ownership structure may produce a result that is contradicted from what is expected by the shareholders. this situation frames a picture that ownership structure is a vital determinant in enhancing firm performance. by highlighting the corporate governance components that normally used in the academic research, this study tends to identify the important components that applied in the reforms of the malaysian corporate governance. this study is needed as a tool to proof whether the ownership structures and corporate governance practices are truly influenced firm performance. the purpose of the study is to investigate the relationship between firms’ ownership structures, corporate governance practices and firm performance. specifically, this study narrows the ownership structures categories into; institutional, government, family, foreign, managerial and concentrated. besides, this study focuses on ten corporate governance components which include board structure, ceo duality, board size, independent board of directors, directors’ professionalism/qualification, board meeting, board committee, directors’ remuneration, transparency and disclose, merger and acquisition. firm performance will be measured in the aspect of accounting profitability-return on asset and return on equity; and market performance tobin-q, price to earnings and price to book value. the participating firms of this study are non-financial public firms that are actively listed in the main market of bursa malaysia during the 5-year period (2010-2014). the sample will be tested and analyzed by using empirical quantitative method, linear regression, multiple regression and panel data regression analysis. keywords: ownership structure, corporate governance, bursa malaysia jel classifications: h5, h7, p4 1. introduction the financial performance of a firm can be analyzed in terms of profitability, dividend growth, sales turnover, asset base, capital employed among others (almajali et al., 2012). however, there is still debate among several disciplines regarding how the performance of firms should be measured and the factors that affect financial performance of companies (liargovas and skandalis, 2008). a single factor cannot reflect every aspect of a company performance and therefore the use of several factors allows a better evaluation of the financial profile of firms. numerous of strategic management and finance literatures (jensen and meckling, 1976; bolton and scharfstein, 1990; proffitt, 2000; cuevas-rodríguez et al., 2012) showed that agency theory plays as an important link between the ownership structure and firm performance. according to shleifer and vishny (1986), agency cost is one of the critical factors that affects a firm’s financial and nonfinancial performance. berger and patti (2000) stated the ownership structure of a firm should be considered when examining empirically financing issues. this is because differences in ownership structures impact on efficiency of aligning the objectives of insiders (manager) with those of providers of finance (shareholders). firm performance is very essential to a firm’s ownership structure and corporate governance practice as it is an outcome which has been achieved by an individual or a group of individuals in an organization related to its authority and responsibility in achieving the goal elvin and hamid: ownership structure, corporate governance and firm performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016100 legally, not against the law, and conforming to the morale and ethic (maury, 2006). pedersen and thomsen (2000) stated that different countries posit different controlling identities such as government and cooperatives which need to be addressed separately due to their different objectives in firms. claessens et al. (1999) stated that the ownership structure in east asian corporations grouped into four different categories which includes; families, the state, widely held financial institutions such as banks and insurance companies, and widely held corporations. consequently, each firm in different ownership structure applied their own operation arrangement and strategies to run their operation and thus affect firm performance in different way. according to claessens et al. (2002), unlike other listed companies in economically advanced countries where ownership is diversified owing to numerous shareholders, most east asian companies are owned and controlled by family groups. in other words, the majority of family firms have relatively concentrated equity ownership in malaysia. claessens et al. (2002) and samad (2004) indicated that many listed firms in malaysia are owned or controlled by family members and that these companies appear to be inherited by their own descendants. there are two theoretical viewpoints on the role of family ownership (anderson and reeb, 2003; lee, 2006; jiraporn and dadalt, 2007; pindado and requejo, 2014). first, founding families firms will limit managers’ ability to manage earnings and second, there is a likelihood that the controlling families engage in expropriation of minority shareholders’ interest that would result in lower performance. for example, members of the controlling family usually hold top management positions and can exercise control over the board which in turn may provide them with opportunities to expropriate minority shareholders. according to ball et al., (2003), malaysia is identified as a country with high political connection and high concentrated shareholding that may reduce the level of financial reporting quality. prior literatures on corporate disclosure orientation in government owned companies suggest that agency conflicts in these companies are relatively higher than private owned companies (eng and mak, 2003; luo et al., 2006). prior studies found that the extent of government intervention on firm’s performance is mixed due to two different perspectives. some firms with government intervention performed better as they are under the “watchful eyes of the public” and thus more concerned to maximize the shareholders’ value (ang and ding, 2006; lau and tong, 2008; najid and rahman, 2011) while other firms with high government ownership are restricted on their innovation and more focus on public service which resulted in poor performance (ball et al., 2003; wei and varela, 2003). according to najid and rahman (2011), government-linked companies (glcs) have been criticized for being too risk-averse and lacking sufficient entrepreneurial drive and also been charges that certain glcs’ investments have been politically rather than commercially motivated. the primary objectives of enhancing the national welfare and other non-profit considerations may not be consistent with value maximization objective of other private commercial enterprises, thus contributing to the high agency costs. indeed, the relationship between ownership structure and firm performance has been an issue of interest among academics, investors and policy makers because it is also a key issue in understanding the effectiveness of alternative governance system. implementing a good corporate governance practice could ensure the flow of firm operation and the return on investment of owner and investors. denoted from agency theory, corporate governance problem arises with self-interest behavior (shleifer and vishny, 1986). the agency problem in this context refers to the investors concerns on their funds are not expropriated or wasted on unattractive projects. in order to minimize firm agency costs, a good corporate governance system should provide some kind of legal protection for the rights of both large and small investors (loh and zin, 2007). the existing corporate governance literatures has largely dealt with an analysis of institutional arrangements in american, british, australian, german and japanese firms, with much less attention paid to firms from emerging markets (elston and goldberg, 2003, galbreath and galvin, 2008; switzera and tang, 2009). according to sulong and nor (2008), the corporate governance environment in east asian is much more different in develop markets such as united states and united kingdom. as a result, the study of relationship between corporate governance and firm’s performance does not reach a consensus among researchers. nevertheless, the variance in results may be related to the firm’s sector and time framework in which the studies were conducted. sun et al. (2010) pointed out that corporate governance research in asia has not received attention from western researchers and publications, making asia a fertile ground for future research in corporate governance mechanisms. further, due to structural differences in the national political economies, corporate governance practices needs to be understood in the context of specific legal, political, and regulatory systems. against this backdrop, it is far less known about the corporate governance mechanisms in emerging markets such as malaysia. as being mentioned, each type of ownership structures influences the firm performance in a different way. the ownership structure plays an important role in determines a firm ultimate success. nevertheless, the same issue goes to firms’ corporate governance practice. derived from previous studies, ownership structure and corporate governance practice are not standardizing across different economic situation as there are differences in areas such as corporate law and investor protection (ugurlu, 2000; shakir, 2008). in other words, the effects of ownership structures and corporate governance may be mediated by country-specific factors, such as national culture, business practices, national tax incentives, and differences in national legal structures. in sum, each economic sector might have different types of sustainable ownership structure and corporate governance practice that contribute to the competitive and healthiness of the firm. failure to establish a sustainable ownership structure and corporate governance may produce result that is contradicted from what is expected by the shareholders. this situation frames a picture that ownership structure and corporate governance are vital determinants in enhancing firm performance. elvin and hamid: ownership structure, corporate governance and firm performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 101 2. literature review 2.1. agency theory according to jensen and meckling (1976), agency relationship has arisen when; an agent (manager) acts as a decision maker in the firm on behalf for the principal (owner or shareholders). the manager of the firm is essentially an agent of the shareholders. in other words, a firm’s shareholders considered to be the principal and manager to be the agent. the principal-agent model enriches a chain of command. for example, a principal, a supervisor, and an agent or one principal and many agents, or other steps towards a full-fledged an organization tree. generally, the principal and the agent have agreed upon a fee schedule to be paid to the agent for his or her services toward the firm (jensen, 1993). to be more precise about principal-agent model, the agent’s contribution is to expand shareholders’ wealth through the growth of the firm’s profitability and market stock price (shleifer and vishy, 1986). basically, the agent receives payment from the principal at the same time he or she has to take a costly action (supply effort) to produce any output (jensen and meckling, 1976). however, it is difficult to measure the effort and contribution of an agent. especially for multiple-agent firm, it is sometimes difficult to define and measure their contribution to firm value (jensen, 1993). in addition, the nature of strategic interaction among principals and agents becomes an important facet of the problem. as a result, principal is hard to predict the long-run consequences of an agent’s actions based on the observation of short-run contribution. bolton and scharfstein (1990) stated the central idea behind the principal-agent model is the principal might too busy with works and so hires an agent to conduct a firm’s operation. consequently, being too busy also means the principal cannot monitor the agent perfectly. the difficulty arises in monitoring the act that the agent chooses (decision-making). according to proffitt (2000), chain of command (ownership structures) may affects agency costs and thereby influences firm performance. a principal-agent problem arises in many spheres of economic activity (jensen and meckling, 1976; shleifer and vishy, 1986). commonly, the agent performs the expected tasks in a way contrary to the principal’s best interests. however, there could also be disagreements on the allocation of fund between principal and agent in some cases. the problem here is that the principal cannot verify that the agent has behaved appropriately. jensen and meckling (1976) explored the ownership structure of firms, involving how equity ownership by managers aligns managers’ interests with those of owners. as a result, jensen and meckling (1976) found that if the contract between the principal and agent is outcome based; the agent is more likely to behave in the interests of the principal. the theory of agency is one part of a broad research program in evaluating firm performance. although the agency framework is quite broad, however, it provides the applications and fertile ground for further work. the basic issue is whether principal and agent relationship can persist with generating efficient outcomes in the firm. this study focuses on isolating the extent of the principal-agent problem. the oriented towards enrichment of the theory may improve modeling methods and therefore clarification of existing theoretical work. to address this problem, this study includes ownership structure and corporate governance variables in explaining firm performance. consequently, be expected that study of the agency relationship will aid the understanding on ownership structures and therefore to identify the most efficient way to govern a firm. 2.2. past studies on the relationship between ownership structure and corporate governance and the hypotheses development mak and li (2001) examined the relationship between corporate ownership and board structure in singapore, by using a sample of 147 firms listed on stock exchange of singapore in year 1995, the result shown that managerial ownership, government ownership and board size are negatively related to the proportion of outside directors whereas block holder ownership is positively related to dual leadership structure (ceo duality). booth et al. (2002) examined whether internal monitoring mechanisms control for agency conflicts in a firm. by using 100 largest non-financial firms on fortune’s custom ranking in year 1999, booth et al. (2002) found that the percentage of outside directors is negatively related to managerial ownership and ceo duality less likely when managerial ownership increased. based on the study conducted by bekiris (2013) that using an extensive sample of greek listed firms, the results of the study show ceo is also the chairman of the board tends to have fewer outside directors and lower block holder ownership. the paper also provides evidence that independent boards are more likely to be employed by firms with higher external block holder shareholdings and whose board size is negatively correlated with managerial ownership and board independence. these results demonstrate that ownership structure has significant effects on the composition of corporate boards. the incentive conflict arising from the separation of the management and ownership of corporate resources has been extensively researched. based on the study conducted by claessens et al. (1999) which examined 2,980 publicly-traded firms in east asian, the result of the study shows that the separation of ownership and control is most pronounced among family-controlled firms and among small firms. large family-controlled firms in korea, singapore, and taiwan display a significant wedge between ownership and control. in addition, the study also found older firms are more likely family controlled and more than two-thirds of listed firms are controlled by a single shareholder. claessens et al. (1999) claimed that a dominant and large shareholder with ceo duality is increases managerial opportunism and expropriation of minority shareholders in family firms. by using a sample of 128 publicly-listed firms in hong kong in year 2003, lam and lee (2008) argued neither agency theory nor stewardship theory can effectively explain the duality-performance relationship. they found ceo duality is good for non-family firms, while non-duality is good for family-controlled firms. in brief, the composition of boards of directors is related to the effectiveness of an organization. however, with the mixed results, there is no clear understanding on board structure, ceo duality and independence board of directors measures with ownership elvin and hamid: ownership structure, corporate governance and firm performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016102 structures (shareholding statistic). furthermore, there are not much empirical evidences who clarify this relationship in malaysian context. accordingly, based on the discussion in the literatures, to answer the research questions and to respond to this conflict the following hypotheses are developed: h1: ownership structure has a positive significant influence on board structure. h2: ownership structure has a positive significant influence on ceo duality. h3: ownership structure has a positive significant influence on board size. h4: ownership structure has a positive significant influence on independence board of directors. it is essential to refer to studies that have attempted to identify a relationship between demographic characteristics of board of directors and organizational performance. juravich (2012) found that average educational level of directors is positively associated with the level of innovation. nevertheless, the same authors found no association between innovation and heterogeneity of educational specialities/educational background variety. horvath and spirollari (2012) suggested that a lower age favors risks propensity in strategic decision-making and firms with younger mangers will experience greater growth and variability in profitability from industry averages than will firms with older mangers. on the other hand, koufopoulos et al. (2008) used a sample of 27 chairman of greek corporations listed in the athens stock exchange, the authors, found a positive relationship between age and competitive positioning which indicates that, the older the chairperson, the better the competitive positioning. whereas, the relationship between age and overall firm performance was found to be negative, indicating that even if the chairperson is older and more experienced the possibly efficient performance of the firm does not depend on that. based on this extensive review, it seems that the results of earlier studies on the relationship between a director’s characteristics and firm performance are not very conclusive. it seems that although previous studies have adopted mostly accounting-based measures of performance, they have shown contradictory findings that imply that they have not been successful in finding a clear link. additionally whilst the role of the chief executive continues to receive great scrutiny there is limited research on the role of the board of directors (koufopoulos et al., 2008). previous studies contribute to the corporate governance literature by identifying a specific set of demographic and directors’ characteristics and testing how those are linked with organizational performance. in short, this study aims to employ a methodology to shed new light onto the professionalism/qualification of board directors nexus across a variety of ownership structure. this study aims to advance the corporate governance research agenda by investigating the link between the ownership structure and professionalism/qualification of board directors. the research also indicates that understanding the variables that influence top management team enhances value creation to investors and shareholders. accordingly, the related hypothesis is as follow: h5: ownership structure has a positive significant influence on director’s professionalism and qualification. based on the foregoing, an understanding of the frequency of board meetings and its determinants should presumably shed light on the effectiveness with which the board carries out its oversight functions. from the face of it, the number of meetings held by the board could be evidence of how effective the board has been in monitoring management. according to vafeas (1999), hahn and lasfer (2007), for a board to be effective it need not necessarily meet frequently. board effectiveness could be a function of number of other factors (i.e., existence of standing committees of the board, independence of directors, director ownership, presence of block holders and the financial position and performance of the company). how these factors influence the frequency of board meetings is not at all clear. determining the direction of the relationship between the factors and meeting frequency is thus a question that requires empirical testing. this study aims to identify how ownership structure influences board activity as measured by board meeting frequency. hence, the following hypothesis is presented: h6: ownership structure has a positive significant influence on board meeting. the relationship between the various characteristics of ownership structure and corporate governance is an open empirical question. corporate boards perform important decision control tasks, such as determining executive compensation, reviewing the financial statements and nominating new executives and directors (hayes et al., 2004). these functions are thought to be suited best for non-executive directors, since they require board members to act as monitors over management. conversely, corporate boards also perform tasks of decision management, such as setting long-term strategy and making suitable investing and financing decisions. klein (1998) provides an interesting insight into this issue by observing that executive directors should be most useful serving in standing board committees focusing on decision management tasks (investment and finance committees), and non-executive directors in committees focusing on decision control tasks (the remuneration, nomination, and audit committees). this discussion therefore suggests that the standing board committees is what is important, and not the composition of the board as a whole. interestingly, most empirical research studying the relationship between ownership structure and corporate structure uses data in developed countries such as united states and provides mixed results (klein, 1998; hermalin and weisbach, 2003; brick and chidambaran, 2010). importantly, the generalizability of these results regarding the corporate governance practices may not extend across national boundaries. while the assumption of a utility maximizing agent is universal, each country’s regulatory and economic environment, the strength of capital markets, and current governance practices are different. as a result, the importance and value of various governance structures should be separately examined in each country. this paper focuses on corporate governance in the malaysia and the results presented here are of potential interest to regulators, managers, shareholder activists, elvin and hamid: ownership structure, corporate governance and firm performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 103 and investors in the malaysia, as well as to academic researchers. in particular, put in the backdrop of the recommendations of the malaysia code on corporate governance (2012), these results are enlightening as to the role of government in corporate governance. more broadly, this study points to the empirical examination of corporate governance in malaysia contexts as a fruitful task in understanding alternative governance structures. accordingly, the related hypothesis is as follow: h7: ownership structure has a positive significant influence on board committee. past studies have shown mixed results regarding the relationship between ownership and directors’ remuneration. for example, wahab and rahman (2009) examined 434 firms listed on bursa malaysia from year 1999 to 2003, they found a negative relationship between institutional ownership and director remuneration and suggesting the result is by reason of the effectiveness of institutional monitoring. similarly, by using a sample of 546 firms publicly traded in uk over the period of year 2000-2004, dong and ozkan (2007) stated that institutions are more involved in corporate governance and serve a better monitoring and disciplining. jaafar et al. (2012) stated that ownership concentration bring impacts on directors’ remuneration in certain firms. for instance, a familyowned firm can manipulate remuneration through combine power and control to mitigate effectiveness monitoring by remuneration committee, which provided an opportunity for them to expropriate private benefit. this actions might results in losses for minority shareholders due to fewer dividends available for pay out. from an investor’s point of view, directors’ remuneration is one of the measures of a company performance. the directors’ remuneration is calculated at a given amount, but, in order to assess performance over time, the difference or change in directors’ remuneration from one date to another can be determined to see whether shareholder value has been created or destroy. regarding the important of directors’ remuneration as proxy of created shareholder value; this study emphasized the dimension of created shareholder value process and its relationship with company performance criteria. therefore, the following hypothesis is presented: h8: ownership structure has a positive significant influence on directors’ remuneration. derived from a study of voluntary disclosure by hong kong and singapore firms, chau and gray (2002) report a positive relationship between outside ownership and disclosure. xiao and yuan (2007) using an ordinary least-squares-regression model to test the relationship among ownership structure, board composition and the level of voluntary disclosure. their results show higher blockholder ownership and foreign shares ownership is associated with increased disclosure. however, managerial ownership, state ownership, and legal-person ownership are not related to disclosure. an increase in independent directors increases corporate disclosure while ceo duality is associated with lower disclosure. their paper also found that larger firms had greater disclosure. conversely, the results goes different in the study conducted by eng and mak (2003), the results shown that lower managerial ownership and significant government ownership are associated with increased disclosure and the blockholder ownership is not related to disclosure. the results also reveal that an increase in outside directors reduces corporate disclosure while larger firms had greater disclosure. bekiris (2013) examined 41 listed firms on bahraini stock exchange in year 2010, the analysis of the study shows that there is a significant negative association between block holder ownership and voluntary disclosures. however, managerial ownership and governmental ownership are not associated with voluntary disclosures. based on these conflicting results, it is not clear whether the ownership structure are able to affect company disclose and transparency. furthermore, it is not clear which measures has highest relative content with firms’ transparency and disclose. accordingly, the related hypothesis is as follow: h9: ownership structure has a positive significant influence on transparency and disclose. ownership has a role in the probability of a firm engaged in merger or acquisition. caprio et al. (2011) analyze how the ownership stake of the largest shareholder and family control affect mergers and acquisitions decisions. by using 777 continental european firms in the period of year 1998-2008 as the sample of study, caprio et al. (2011) found that increase in the size of the largest shareholder’s voting rights lowers the probability of an acquisition, and family control further decreases it. the result also reveal that family firms are less likely to make acquisitions than non-family firms. the same results goes to the study conducted by shim and okamuro (2011). they analyze the differences in merger decisions and the consequences between family and non-family by using a unique japanese dataset from a period of high economic growth (1955-1973), the results suggest that family firms are less likely to merge than non-family firms are and non-family firms benefit more from mergers than family firms do. based on this extensive review, it seems that the ownership structure is one of the important determinants in forming mergers and acquisitions. hence, the following hypothesis is presented: h10: ownership structure has a positive significant influence on merger and acquisition. according to one definition, corporate governance is the system by which business corporations are directed and controlled (oecd, 2004). corporate governance delimits the distribution of rights and duties amongst the different participants in the firm, and sets rules and procedures for making decisions. corporate governance also provides structures through which aims and objectives are set, and through which monitoring is carried out (mckinsey and company, 2000). bebchuk et al. (2008) and khatab et al. (2011) stated that corporate governance decreases shareholder risk through the legal protection of shareholder rights and creating mechanisms of company management that allow shareholders to be assured that the management uses the investment efficiently. in other words, corporate governance is generally considered be important in contributing to owners’ rights and benefits and through strategic policies enhancing performance and creating wealth. a firm elvin and hamid: ownership structure, corporate governance and firm performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016104 corporate governance practices affect its overall operation and performance. comprehensive cross-industry comparisons of corporate performance are extremely difficult to carry out and to interpret. in order to extend the literatures, this study tends to examine the association between ownership structures and a comprehensive set of corporate governance variables. 2.3. past studies on the relationship between ownership structure, corporate governance and firm performance and the hypotheses development amran and ahmad (2009) used 896 firms that were listed on bursa malaysia from year 2000 to 2003 as the sample of their study, the findings reveal that not all elements of governance mechanisms are significant and the effects differ between family-businesses and non-family businesses. the results indicate that board size and leadership structure affect the firm value for all sample. businesses do practice separate leadership structure outperform than duality leadership. further analysis shows that smaller board size contributes positively towards better performance in nonfamily firms. tham and romuald (2012) examined relationship between corporate governance mechanisms and firm performance by using panel data of 20 public listed firms in bursa malaysia from the period of year 2006 to 2010, consistent with the study conducted by amran and ahmad (2009), they found smaller board size leads to better firms’ performance. the study also suggested that higher proportion of managerial ownership (directors who are also owner) tend to benefit firm performance. conversely, based on the study conducted fauzi and locke (2012) examined 79 firms that listed in new zealand stock exchange, the result reveals that board size, board committees, and managerial ownership have a significant impact on firm performance. fauzi and locke (2012) claimed that large boards improve firms’ performance as it can provide greater monitoring. meanwhile, non-executive directors, female directors on the board and concentrated ownership lower the firm performance. sulong and nor (2008) examined the relationships between dividends, types of ownership structure and board governance variables on firm performance among malaysian listed companies. by using 406 firms non-financial listed in bursa malaysia for the period of year 2002-2005 as the sample of their study, the result shows that dividend has a positive significant effect on firm performance. the finding suggests that dividends can play its important monitoring role in reducing agency costs among malaysian listed firms. whereas ownership concentration, managerial ownership and on board governance variables (board size, independent board of directors and ceo duality) provided insignificant effect to firm performance in their study. krivogorsky (2006) examined 81 firms from nine european countries, the results indicate a strong positive relation between the level institutional ownership, portion of independent directors on the board and profitability ratios. however, there is no strong relation between the portion of inside directors or level of managerial ownership and profitability in these 81 european firms. dehaene et al. (2011) whose analyzed a sample of 122 belgian firms and verified whether the board composition has an impact on the firm performance, as measured by return on equity and assets. their study found that firms with duality leadership shows higher return on asset (roa) compared to firms with separate leadership. the study also reveal a significant positive relationship between the number of external directors and roe, this means that the more external directors, the better the performance. gupta et al. (2006) used a sample of 178 firms in s&p/tsx index (year 2002-2004) and correlating the composite corporate governance scores (board composition; board and ceo compensation; shareholder rights; and board governance disclosure) with various financial and market measures (tobin’s q, price to book value [ptbv] and roa). overall, the study did not find any association between the composite corporate governance scores and various measures of firm performance. the same results goes to study conducted by ghazali (2010) whose tested 87 non-financial firms that listed on bursa malaysia in year 2001, the results showed that board size and independence were not statistically significant in explaining corporate performance. however, the study found that government as a substantial shareholder and foreign ownership were statistically significantly associated with tobin’s q. while many previous studies have examined the direct effect of ownership structure, corporate governance and firm performance, there is a need of comprehension on how the different types of ownership structures and corporate governance practices impact on the firm performance. hence, this study intends to investigate the joint effects of corporate governance mechanisms on the relationship between types of ownership structure and firm performance. in addition, this study tends to identify which type of ownership structure and corporate governance practice are more feasible, practical and profitable in each type of economic sector in malaysia since most researches concentrating on ownership structure, corporate governance and firm performance were conducted overseas with little research actually taking place in malaysia. in order to achieve these objectives, the hypotheses developed in this study are as below: h11: ownership structure has a positive significant influence on firm accounting profitability. h12: ownership structure has a positive significant influence on firm market performance. h13: corporate governance has a positive significant influence on firm accounting profitability. h14: corporate governance has a positive significant influence on firm market performance. h15: ownership structure and corporate governance have a positive significant influence on firm accounting profitability. h16: ownership structure and corporate governance have a positive significant influence on firm market performance. 3. research methodology in competitive business environment, the ownership structure and corporate governance have played and will continue to play a strong role in facilitating business growth by putting in place procedures and regulations that will support a business-friendly environment. this study aims to achieve few results, firstly, elvin and hamid: ownership structure, corporate governance and firm performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 105 to identify the relationship between ownership structures and corporate governance (hypotheses 1-10), secondly, to examine the effects of ownership structure on firm performance (hypotheses 11 and 12), thirdly, to examine the effects of corporate governance on firm performance (hypotheses 13 and 14), and lastly, to identify the relationship between ownership structure, corporate governance and firm performance associate with control variables (cvs) (hypotheses 15 and 16). in sum, the relations between these variables in this study is summarized in the research conceptual framework (figure 1). this study aims to investigate the relationship between firms’ ownership structures, corporate governance and firm performance. specifically, this study narrow the ownership structures categories into; institutional-owned, government-owned, family-owned, foreign-owned, managerial-owned and concentrated-owned. this study focuses on ten corporate governance components which include board structure, ceo duality, board size, independent board of directors, directors’ professionalism/qualification, board meeting, board committee, directors’ remuneration, transparency and disclose, mergers and acquisitions. firm performance will be measured in the aspect of accounting profitabilityroa and return on equity (roe); and market performancetobin-q, price to earnings (pe) and ptbv. this study conduct long-term post-performance evaluation which covering 5 years financial data period starting from year 2010 to the end of year 2014. specifically, the study will be carried out by empirical analysis which is based on the available firms’ data provided by bursa malaysia. according to glasow (2005), 5 years post-performance evaluation provide more current information about areas that have changing population and/or characteristics because they are based on the data from the previous year and data that are less than 5-year-old. moreover, long-term postperformance evaluation is based on larger sample sizes and will therefore be more reliable (hooy and tee, 2009; liu, 2011). the 5 years post-performance evaluation is based on five times as many sample cases than the short term evaluation (1-3 years). for some characteristics this increased sample is needed for the evaluation to be reliable enough for use in certain applications. the population of the study is the firms that publicly listed in the main market of bursa malaysia from the year 2010 to 2014. however, all finance-related firms, banks, insurance, unit trusts and utilities companies were excluded from the sample due to their difference in the regulatory requirements, financial reporting standards and compliance (claessens et al. 2002; sulong and nor, 2008). firms that are classified as pn4 companies and industries with less than eight firms were also excluded from the sample (davidson et al., 2005; hashim and devi, 2008). finally, this study was left with the sample of 696 firms covering the sectors of construction, consumer products, industrial products, plantation, properties, technology, trading and services. the larger numbers of firms sample were expected to make the study more transparent and representative of firms in malaysia. in the case of 5 years financial data analysis, the period is 5 calendar years (cover from 1st january 2010 to 31st december 2014). this study collects firms’ information continuously and then aggregates the results over a specific time period (5-year). the information and financial data of firms are collected through the audited company annual report. data related to ownership structure (e.g., shareholding statistic) and corporate governance (e.g., board composition, board size and leadership structure) will manually collected from firms’ annual reports, whilst accounting performance measures were retrieved from the datastream provided by universiti teknologi malaysia. after collecting data, the data will be entered to the software (statistical package for the social sciences and eview) for processing and developing information patterns related to the context of testing research hypotheses. a 95% confidence level is the conventionally accepted level for most business researches, most commonly expressed by denoting the significant level as p ≤ 0.05 (hamid, 2010; nakhaei, 2014). the analyzing of data involves three parts: (i) descriptive statistics, (ii) linear and multiple regression (iii) panel data regression analysis. the variables of the study are categorized into three types: the independent variables (ivs), dependent variable (dvs) and cvs. for the purpose of achieving the research objective and hypotheses, the dvs for this study is firm performance. the firm performance is proxy by the accounting profitability and market based performance while the ivs are types of ownership structures and corporate governance components. table 1 shows all the variables that will employ in the study including the measurement for each of them. 4. conclusion the subject of financial performance has received significant attention from scholars in the various areas of business and strategic management. it has also been the primary concern of business practitioners in all types of organizations since financial performance has implications to organization’s health and ultimately its survival. high performance reflects management effectiveness and efficiency in making use of company’s resources and this in turn contributes to the country’s economy at large. the importance of the study emerges from the fact that ownership figure 1: research conceptual framework elvin and hamid: ownership structure, corporate governance and firm performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016106 structures and corporate governance plays a significant role in enhancing firm performance, and providing critical information to researchers, shareholders, manager and investors. with the mixed result from previous research papers, the study of the ownership structures and corporate governances are great important to explore as they brings impact on firm performance. different types of ownership structures and corporate governances mechanisms that applied in each firms resulted in diverse firm’s performance. from a risk tolerance perspective, it is important to consider the identity and position of each entity in the ownership structure and how it may be exposed to firm performance or other risks through their involvement in the board. it is questionable that shareholders are most certainly focuses on the financial beneficial while some managers are looking for intense managerial authority rather than pursuing firm goal. besides provides a significant proof, a study that focus on each economic sector in bursa malaysia is needed as an added literature which is currently lack of compared to develop market studies. on the surface, every economic sector is different. to understand sector competitiveness and profitability, one must look beyond their differences and view industries at a deeper level. an analysis of firms in a specific sector reveals the roots of the sector’s profitability at any point in time while providing a framework for anticipating and influencing changes in sector competitiveness and profitability over time. with the objective of identification on which type of ownership structure and corporate governance component has the most impact on firm performance, the result of this study is relevant in the evaluation of possibility for existing firms to reform their ownership structures and corporate governance practices in order to achieve superior performance. in other words, this research aims to explore the benefit of generates new models for more effective deliberation and exceptional ownership structure and corporate governance practice. besides, the result of the study would enhances the understanding of the role of ownership structures and corporate governance components in each economic sector which is an issue that is surprisingly neglected in the literatures. there is a need of comprehension on the different types of ownership structures and corporate governance practice that suitable to each economic sector. this study will empirically implement a comprehensive analytical framework of firm performance in the case of listed firms on bursa malaysia. this study meant to answer the question of which type of ownership structure and corporate governance practice have the greatest impact on the firm performance in the aspect of accounting profitability and market performance in each sector. in other words, this study tends to identify which type of ownership structure and corporate governance practice are more feasible, practical and profitable in each type of economic sector in malaysia. the information of the study can be used as a guideline for firms in considering which types of ownership structures and table 1: summarization of variables and the measurements variables measurements ivs ownership structures government ownership percentage of ordinary shares held by government ownership in firm institutional ownership percentage of ordinary shares held by institutional ownership in firm family ownership percentage of ordinary shares held by family members ownership in firm foreign ownership percentage of ordinary shares held by foreign company ownership in firm managerial ownership percentage of ordinary shares held by director/executive ownership in firm concentrated ownership percentage of ordinary shares held by top ten shareholders ownership in firm corporate governance board structure composition of board ceo duality a ceo that also serves as a chairman board size the number of directors independent board of directors proportion of non-executives independent directors professionalism/qualification directors attended the mandatory accreditation program board meeting the number of board meeting per annum board committee the number of board committee remuneration total cash amount of directors’ remuneration transparency and disclose transparency and disclosure scorecard mergers and acquisitions mergers or acquisitions activities occurred dvs accounting profitability roa net income/total assets roe net income/total equity market performance tobin’s q market capitalization+total debt/total asset pes current market price/earning per share ptbv current market price/book value per share cvs firm size the natural log of total assets firm age continuous variable which begins from the firm’s date of corporation leverage the ratio of total debt to total assets roa: return on assets, roe: return on equity, cvs: control variables, pes: price to earnings, ptbv: price to book value, dv: dependent variables, iv: independent variables elvin and hamid: ownership structure, corporate governance and firm performance international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 107 corporate governance practice will benefit most to the firm and drive the firm into competitive edge. two features of this study deserve emphasis. first, a change in ownership is inevitably tied to a change in sample data; the model has the feature that a redistribution of shareholdings has no perfect substitute. the analysis will proved that an integrated firm and a non-integrated firm have access to identical performance measures. second, this study examines the importance of alternative corporate governance components in malaysia public listed firm. unlike the earlier literatures on the corporate governance effects of firm performance, this model has the feature of identify the influences of various corporate governance components. the objective is to provide some systematic evidence on the extent to which different governance forces discipline performing managers. references almajali, a.y., alamro, s.a., al-soub, y.z. 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(2007), ownership structure, board composition and corporate voluntary disclosure: evidence from listed companies in china. managerial auditing journal, 22(6), 604-619. international journal of economics and financial issues vol. 1, no. 4, 2011, pp.172-179 issn: 2146-4138 www.econjournals.com estimating pakistan’s time varying non-accelerating inflation rate of unemployment: an unobserved component approach farzana shaheen school of social sciences federal urdu university of arts, sciences and technology islamabad, pakistan. email: fshaheen80@hotmail.com azad haider, corresponding author school of economics, quaid-e-azam university, islamabad, pakistan. email: azadhaider@gmail.com sajid amin javed school of economics, international islamic university, islamabad, pakistan. email: sajidamin78@gmail.com abstract: this paper envisages estimating the time-varying non-accelerating inflation rate of unemployment (tv-nairu) as an unobserved stochastic variable for pakistan over the time period 1973-74 to 2007-08 using kalman filter. results of the study are evident that tv-nairu increased from 5.3 percent (1990-91) to 8.12 percent (2004-05) and falls to 6.17 percent again in 2007-08 which is above the actual unemployment rate. the results also indicate that the nairu is a relevant concept and the unemployment gap should be one of the factors considered when assessing inflationary pressure in pakistan. key words: pakistan, unemployment, inflation, nairu, phillips curve jel classification: e0, e23, e31 1. introduction the idea of a “natural” rate of unemployment was first proposed by friedman in 1968 wherein it is roughly equivalent to the amount of frictional and structural unemployment persisting even when the labor market is in equilibrium.1 the term nairu was first coined by modigliani and papademos in 1975. according to friedman (1968) and phelps (1968) "there is not a long-term trade-off between inflation and unemployment: in the long run, unemployment depends on structural variables, whereas inflation is a monetary phenomenon". a trade-off exists between unemployment and inflation in the short-run indicating that if unemployment falls below the nairu, inflation will rise until unemployment rate returns to the nairu. the existence of a nairu, therefore, has immediate implications for the conduct of economic analysis and policies. the issue has been extensively analyzed both at the regional as well as country level but remains unexplored in case of pakistan. available studies estimate constant nairu.2 this study tries to fill the void and estimates the tv-nairu for pakistan over the time period 1973-74 to 2007-08 using annual data to guide its anti-inflation and anti-unemployment policies. "the time-varying nairu (tv-nairu) approach attempts to provide an indication of the path the nairu has taken over a particular period by including variables which capture the impact of significant supply side shocks, over the period in question, and which could be expected to influence the nairu" [mcmorrow and roeger (2000) p.4]. the accurate measurement of the tv-nairu is very difficult due to uncertainty, which flows from the fact that it is an unobservable variable and has 1 mcmorrow and roeger (2000) 2 iqbal (1995) estimates constant nairu for pakistan over the period 1978-1993 estimating pakistan’s time varying non-accelerating inflation rate of unemployment: an unobserved component approach 173 to be estimated using different specifications and different modeling approaches. the problem is that all these approaches give different results. the uncertainty also comes from point estimates of nairu. the rest of this paper is organized as follows. section 2 highlights shortly the development of unemployment rates in pakistan. some empirical literature review is briefly discussed in section 3 and the model is specified in section 4. estimation results of time-varying nairu are presented in section 5 and finally section 6 concludes the study. 2. the behavior of unemployment in pakistan the unemployment rate, an important macroeconomic indicator, is the unemployed population expressed as a percentage of the currently active population.3 in all five year plans of pakistan policies to reduce unemployment were proposed however most of them proved ineffective. figure 1 depicts the unemployment rate for pakistan exhibiting an increasing trend over the period 1973-74 to 1980-81 while a decline is registered in 1981-82 and then it started increasing again. it decreased again from 1983-84 to 1986-87; but remained constant during 1987-88 to 1988-89. the unemployment rate in 1990-91 jumped to 6.28 from the previous year’s 3.1 per cent.4 the figure also shows that the overall unemployment rate is on a decline from 2005-06. a plausible explanation can be a steeper decline in unemployment in the rural regions. further, this decline can safely be attributed to numerous reasons, a flourishing economy being one of them. this declining trend in unemployment rate continued in 2006-07 and 2007-08. figure 1. unemployment rate source: various issues of pakistan labor force survey and economic survey of pakistan from1973 to 2008. 3. empirical literature: a brief description the expectations-augmented phillips curve is the simplest theoretical framework that incorporates the nairu concept in a transparent way, which gordon (1997) has summarized in the form of the so-called “triangle model”. in this model, inflation is determined by three factors: inertia, the demand shock as proxied by unemployment gap and supply shocks. below review of some of the empirical studies on nairu is briefly discussed. gordon (1997) estimates time-varying nairu using different inflation indices for u.s economy. the results show that the sum of coefficients on the inflation inertia variable are close to unity and the coefficient on the unemployment gap are always highly significant and of the correct sign. richardson, et al. (2000) used the kalman filter and hodrick prescott multivariate (hpmv) approaches to estimate the tv-nairu for 21 oecd countries using data from 1962 to 1999. the results of the study illustrate that the phillips curve explains the inflationary development for past 3 economic surveys of pakistan (various issues) 4 the jump might be attributed to conceptual dimensions of unemployment as labor force survey (lfs) 1990-91 adopted the new definition of unemployment (majid,2000). international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.172-179 174 three to four decades in all countries and unemployment gap is significant in explaining the inflation. the results of kalman filter and hpmv filter are highly correlated with each other and also these unemployment gaps consistent with the earlier studies on oecd countries in (2000). hirose and kamada (2002) estimates time-varying nairu and potential growth using kalman filter from 1983:q2 to 2002:q2 for japan. the tv-nairu was about –4 percent in the 1980s and there has been a downward trend between 1992 and 2002. the parameters of the phillips curve are unstable since 2000. the study suggests that there should be considerable caution to use nairu estimates as a guide for macroeconomic policy. in another study, greenslade, et al. (2003) estimates tv-nairu for the uk over 1973 to 2000 by applying the kalman filter. the results from different models show that nairu reached a peak in the mid-1980s and thereafter tend to fall and that actual unemployment was below the nairu in the second half of the 1990s.5 in the period of economic expansion unemployment falls below the nairu and this negative unemployment gap puts upward pressure on inflation. stephanides (2006) estimated the constant and time varying nairu in three countries; usa, japan and european union using maximum likelihood, kalman filter and the non-linear least squares. the main findings of the study suggest that the nairu estimates are measured with large uncertainty and have extensive variability across the countries and specifications. furthermore, mehihovs and zasova (2009) estimate nairu and non accelerating inflation rate of capacity utilization (naircu) for latvia using kalman filter in both structural and the reduced-form. the authors report that tvnairu for latvia decreased from 14.3 percent at the beginning of 1997 to 7.4 percent at the end of 2008. the estimate for the time-varying nairu from the end-2005 to mid2008 was above the actual unemployment rate, suggesting that latvia's tense labor market situation most likely fuelled a rise in the inflation rate. we conclude this section by providing findings of epstein and macchiarelli (2010). the authors estimate nairu for polish economy using kalman filter over the period 1995-2008. the results are evident that estimated unemployment gap follows the post-reform business cycle in poland. the literature on estimating a tv–nairu usually uses state space models or kalman filter [kalman (1960), kalman and bucky (1961)] to capture the dynamics of the nairu over time.6 the overall of different studies suggests that there should be considerable caution to use nairu estimates as a guide for macroeconomic policy. 4. model specification this section outlines the data and model specification to be used to estimate tv-nairu for pakistan. annual data for the variables is drawn from labour force survey and economic survey of pakistan for the period 1973/74-2007/08. we employ a general-to-specific approach (omitting insignificant variables) for estimation. two lagged terms for price inflation (capturing inertia), unemployment gap (the demand shock), oil prices (supply shock) and a dummy variable that shows change in inflation along with constant term are included in phillips curve equation. 7 we use oil prices as proxy for supply-side shock in phillips curve equation. we follow denis et al. (2002) and epstein and macchiarelli (2010) for analysis and estimations. there are two steps used to estimate nairu. in the first step, the unemployment is decomposed using kalman filter. the second step identifies cyclical component according to phillips curve relationship. 4.1. first step in first step unemployment rate is decomposed into a stochastic trend and cyclical component as: ** )( tttt uuuu  (1) where trend component follows local linear trend model as given below: 5 the results about nairu series are influenced by a signal-to-noise ratio which is assumed to be 0.16 6 see gordon (1997, 1998) and staiger et al. (1997a,b) for the seminal contributions, gerlach and smets (1999), apel and jansson (1999), among many others laubach (2001), fabiani and mestre (2000and 2001), logeay and tober (2006), and fitzenberger et al ( 2007) and denis et al ( 2002,2006). 7 greenslade et al. (2003) estimating pakistan’s time varying non-accelerating inflation rate of unemployment: an unobserved component approach 175 tttt uu    * 1 * (2) while the trend component is assumed to follow random walk with drift as follows ttt   1 (3) the drift term, assumed to be stochastic, allows following random walk. both error terms (ηt) and (ωt) are independent and identically distribution (iid) normal with zero mean and constant variance and are mutually uncorrelated. according to danis et al (2002) "the rationale for choosing such specification is the observed non-stationarity of the unemployment rate. while using kalman filter the standard deviation innovation can be estimated, but there exists the problem often encountered in the literature that estimated trends are too smooth or too noisy". this problem can be overcome by fixing variance of estimated unemployment trend as suggested by gordon, 1997 and oecd, 2000. gordon (1997) suggests "smoothness prior", which means that you need to fix the variance of trend innovation. according to him when standard deviation of ηt=0, then this denotes time invariant or constant nairu; otherwise nairu varies by an amount ηt in each period. in this context we assume "smoothness prior" and fix the variance of trend innovation at lower bound of 0.1 consistent with gordon (1997).   ttttttttt uuuuuu    2*21*1* )( (4) the unemployment gap is modeled as an ar(2) process and is assumed to be stationary and requires θ1+θ 2 < 1.8 kalman filter is employed to estimate these components using equations (2) and (4). the results of the first step are reported in table 1 set out in the next section. 4.2. second step in the second step, we identify cyclical component using phillips curve as in eq (5) below.   t oil t oil ttttttt dppuuc    121 * 231211 (5) where δ is the first order of difference of variable while 1t is the inflation in time period t+1. c denotes constant term and t , 1t and 2t is inflation in time period t, t-1 and t-2 respectively. further *tt uu  stands for unemployment gap while oil tp and oil tp 1 denote oil prices in time period t and t-1 respectively. dummy variable for inflation9 and error term are denoted by d and t . the results against eq (5) are furnished in table 2 while figure 2 depicts the estimated tvnairu for pakistan. for estimation of equation (5) we require a non-linear estimation. for increased precision, the estimation is initialized with an ols regression where the unemployment gap is first approximated by the cyclical component obtained in the first step. the cyclical component ( *tt uu  ) is consequently treated as unobserved and hence re-estimated within equation (5) under the specification in equation (4). the results are shown in next section. 5. estimation results and discussion the estimation results of first step of kalman decomposition are presented below in table 1 while table 2 presents results of kalman filter estimation of tv-nairu for pakistan. 8 denis et al. (2002) 9 the shift dummy variable is included in order to account for changes in inflation. in particular, by imposing a change in the mean value for inflation, i.e. d=0 when inflation was mostly trending lower or equal to its mean value and d=1 for otherwise; i.e. when inflation trended higher its mean value. international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.172-179 176 table 1. first step results: kalman decomposition variables coefficient s.e z-statistic (u-u*) t-1 0.490442* 0.025031 19.59324 (u-u*) t-2 -0.23396* 0.023083 -10.1355 log likelihood -240.113 note: * mean significant at 1 percent level of significance. as is evident from table 1, θ1 and θ 2 are 0.49 and -0.23 respectively and statistically significant at 1 percent level of significance. sum of both θ1+ θ 2 is less than one indicating the stationary process which shows that unemployment gap in pakistan follow an ar (2) process. next we turn to second step results. table 2. second step (kalman filter estimate) results for nairu of pakistan cyclical component and phillips curve estimates maximum likelihood and statistics estimation periods:1974-2007 (35 variables coefficients s.e z-statistics constant 1.826964* 0.288453 6.333668 δπt -0.32334* 0.04603 -7.02468 δπt-1 0.102784* 0.027172 3.782738 δπt-2 0.103761* 0.020676 5.01846 (u-u*) -0.59348* 0.14702 -4.03675 ptoil 0.038374* 0.004255 9.018277 ptoil (-1) -0.05171* 0.005164 -10.0133 d -2.23152* 0.173204 -12.8838 unemployment cycle ar(2) terms (u-u*)t-1 0.742401* 0.075767 9.798468 (u-u*)t-2 -0.27438* 0.067754 -4.04966 log likelihood -236.401 note: * mean significant at 1 percent level of significance. following general to specific approach, only significant variables and lag lengths are included and reported in this study leaving us with two lags of inflation that are significant. oil prices turned out to be significant only with one lag. the estimated coefficient on unemployment gap is -0.59 exhibiting that an increase in unemployment gap by 1 percent causes inflation to decrease by 0.59 percent. the relationship between the unemployment gaps and past changes in inflation is statistically significant. oil prices shock contributes to inflation positively and n increase in oil prices by 1 percent causes inflation to increase by 0.03 percent. the tv-nairu for pakistan registers mixed trend evident from figure 2 wherein actual unemployment rate together with the estimated tv-nairu is reported. tv-nairu increased during 1975-76 to 1979-80 except 1978-79 while a declining trend is documented for 1980s. again, in 199091, it increased from 3.21 percent to 5.37 percent. actual unemployment rate registered an increase from 3.13 percent to 6.28 percent for the same time period. in 1991-92 and 1992-93 actual unemployment rate decreased to 5.85 and 4.73 percent respectively followed by similar trends for tvnairu. the decrease in unemployment rate can be attributed to the general expansion of the economy and in particular the specific employment generation schemes such as national selfemployment scheme and youth investment promotion society (yips). notably tv-nairu increased from 5.3 percent in 1990-91 to 8.12 percent in 2003-04. the unemployment rate increased to 8.3 percent in 2001-02 while it declined from 8.3 percent in 2001-02 to 7.7 percent in 2003-04, due to, mainly, to steeper decline in women’s unemployment. in recent years there has been a downward trend in the tv-nairu from 8.12 percent in the 2004-05 to current estimates of 6.17 percent. the overall unemployment rate is also on the decline from 2005-06 majorly due to a visible decline in unemployment in the rural regions. this decline can also safely be attributed to numerous reasons, a flourishing economy being one of them. the estimate for the tv-nairu from the time period 2003estimating pakistan’s time varying non-accelerating inflation rate of unemployment: an unobserved component approach 177 04 to 2007-08 was above the actual unemployment rate, suggesting that pakistan's labor market situation most likely fuelled a rise in the inflation rate. figure 2. actual unemployment rate and nairu using kalman filter 1/ trend* is a first step kalman decomposition results. figure 3 (below) shows that the unemployment gap estimates obtained in the second step was positive between 1975-76 and 1977-78, in 1981-82 and 1983-84, in 1985-86 respectively. it is also positive between 1984-85 and 1988-89, 1990-91 and 1991-92, 1996-97 and 2002-03. the negative unemployment gap is documented for 1978-79, 1980-81, and 1984-85. similar results are found for recent times as is evident from estimates between 2003-04 and 2007-08. time periods 1990-91, 199900, 2006-07 and 2007-08 put evidence for the wider unemployment gaps of 0.9, 0.77, -1.1 and -0.97 percent respectively. in 1990-91, the labor force survey revised definition of unemployment as mentioned earlier. partly because of this and also due to global recession, the unemployment gap increased in 2000-01. the gap appears to have hit a bottom during current downturn driven by global financial crises. figure 3. unemployment gap using kalman filter international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.172-179 178 6. concluding remarks the study estimates pakistan's time varying nairu for period ranging from 1973-74 to 200708. by any measure the nairu is very hard to determine because it is an unobservable variable. we provide estimates of a time–varying nairu based on the kalman filter. the application of the kalman filter for the assumption of a time-varying nairu the unemployment rate is first assumed to be described by the sum of a trend and a cyclical component [denis et al. (2002), horn et al. (2007), epstein and macchiarelli (2010)]. the trend component is regarded as a benchmark for the equilibrium unemployment rate, while the cyclical component as a reference for the unemployment gap. in the second step, a standard philips curve relationship is applied to help model the cyclical component. the estimates presented in this study suggest that the tv-nairu in pakistan is currently around 6.7 percent. according to these estimates, it reached to a peak in 2004-05 gaining a value as high as 8.12 percent and tends to decline through the 2007-08. the estimate for the tv-nairu from the time period 2004-05 to 2007-08 is above the actual unemployment rate, suggesting that pakistan's labor market situation most likely fuelled a rise in the inflation rate and the findings are in concurrence with mehihovs and zasova (2009). the results of this study indicate that the tv-nairu is a relevant concept and the unemployment gap should be one of the factors considered when assessing inflationary pressure [szeto and guy (2004)]. one would further need to look tv-nairu for other price indices and the economic determinants of the nairu. references apel m. and p. jansson (1999), "a theory-consistent system approach for estimating potential output and the nairu ", economics letters, 64, 271-275. denis, c., k. mc morrow and w. röger (2002), "production function approach to calculating potential growth and output gaps – estimates for the eu member states and the us", ecfin economic paper, no, 176. denis, c., k. mc morrow and w. röger (2006), "calculating potential growth rates and output gaps a revised production function approach ", european commission. economic papers no 247 epstein, n. and c. macchiarelli (2010), "estimating poland’s potential output: a production function approach" imf working paper, wp/10/15 fabiani, s., and r. mestre (2000), "alternative measures of the nairu in the euro area: estimates and assessment", european central bank working paper no.17. fabiani, s., and r. mestre (2001), "a system approach for measuring the euro area nairu", ecb working paper 65. fitzenberger, b., w. franz and o. bode (2007), "the phillips curve and nairu revisited: new estimates for germany" kiel working paper no. 1344 friedman, m. (1968), "the role of monetary policy", american economic review papers and proceedings, 58(1), 1-17. gerlach, s. and f. smets (1999), "output gaps and monetary policy in the emu area.", european economic review, 43(4-6), 801–812. gordon, r j (1997), "the time-varying nairu and its implications for economic policy" the journal of economic perspectives, 11(1), 11-32 gordon, r j (1998), "foundations of the goldilocks economy: supply shocks and the time-varying nairu”, brookings papers on economic activity, 2, 297 346. greenslade, j. v., r. g. pierse and j. saleheen (2003), "a kalman filter approach to estimating the uk nairu" bank of england working paper no. 179 hirose, y. and k. kamada (2002) "time-varying nairu and potential growth in japan" bank of japan working paper 02-08 horn, g., c. logeay, s. tober (2007). "estimating germany’s potential output" paper presented at the workshop "potential output and economic policy in europe" organized by the german federal ministry of economics and technology in brussels on 21 september 2006. iqbal, z. (1995), "constraints to the economic growth of pakistan: a three-gap approach" the pakistan development review 34: 4 part iii (winter 1995) pp.1119-1133 kalman, r. e. (1960), "a new approach to linear filtering and prediction problems", journal of basic engineering, transactions of the asme –82, 35-45. estimating pakistan’s time varying non-accelerating inflation rate of unemployment: an unobserved component approach 179 kalman, r. e. and r.s. bucy (1961), "new results in linear filtering and prediction theory", journal of basic engineering, transactions of the asme –83, 95-107. laubach, t. (2001), "measuring the nairu: evidence from seven economies" the review of economics and statistics, 83(2), 218-231 logeay, c. and s. tober (2006), "hysteresis and the nairu in the euro area", scottish journal of political economy, 53(4), 409–429. majid, n. (2000). "pakistan: employment, output and productivity" issues in development, discussion paper 33, international labour office (ilo) geneva mcmorrow, k. and w. roeger (2000), "time – varying nairu/nawru estimates for the eu’s member states", directorate-general for economic and financial affairs (ecfin) of the european commission economic papers no. 145. mehihovs, a. and a. zasova (2009),"the assessment of natural rate of unemployment and capacity utilization in latvia" working paper latvijas banka isbn 9984-676-43-9 modigliani, f and l. papademos (1975) “targets for monetary policy in the coming year, brooking papers on economic activity 1, 141-163 oecd (2000), "the concept, policy use and measurement of structural unemployment", annex 2. estimating time varying nairu across 21 oecd countries. pakistan, government of (various issues) “labour force survey” islamabad: federal bureau of statistics. pakistan, government of (various issues) “pakistan economic survey” islamabad: finance division. phelps, e. s. (1968), "money, wage dynamics and labour market equilibrium", journal of political economy, 76(4) (part 2), 678-711. richardson, p., l. boone, c. giorno, m. meacci, d. rae, and d. turner (2000), "the concept, policy use and measurement of structural unemployment: estimating a time varying nairu across 21 oecd countries", oecd economics department working papers, no. 250, oecd publishing. szeto, k. l. and m. guy (2004), "estimating a new zealand nairu", new zealand treasury working paper 04/10 staiger, d., j.h. stock and m. watson (1997), “the nairu, unemployment and monetary policy”, journal of economic perspectives (winter). staiger, d., j.h. stock and m. watson (1997a), "how precise are estimates of the natural rate of unemployment? in reducing inflatio", motivation and strategy, c.d. romer and d.h. romer, eds., chicago: university of chicago press. stephanides, g. (2006), "measuring the nairu: evidence from the european union, usa and japan" international research journal of finance and economics issn 1450-2887 issue 3. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.27-34 issn: 2146-4138 www.econjournals.com 27 pre-consolidation and post-consolidation of nigerian banking sector: a dynamic comparison anthonia t. odeleye department of economics, caleb university, imota, lagos state, nigeria. tel.:+2348033618174; email: antileye@yahoo.com abstract: the central bank of nigeria’s (cbn) recent reform to consolidate the banking sector through drastic increase to #25billion as minimum capital base of any bank led to a remarkable reduction in the number of banks from 89 to 24 in 2005; changed their mode of operations and their contributions to the nation’s economic development. drawing on original research on consolidation of banking sector, this study examined the impact of consolidation on performance of nigerian banks for the period 1999 to 2011. it employed chow test; a parameter stability test which showed that there was parameter instability after the consolidation. system gmm (generalized methods of moments) estimation was further used to ascertain the directional and magnitudinal (size) impact of consolidation on the banks’ efficiency. with emphasis on earnings per share as a proxy for consolidation, it is inferred that nigerian banking consolidation exercise did impact their efficiency positively. keywords: consolidation; reform; chow test; dynamic panel; endogeneity; efficiency jel classifications: g21; g28; g29 1. introduction the primary objective of nigerian banks’ consolidation reform was to guarantee an efficient and a sound financial system. the reform was designed to enable the banking sector develop the required capacity to support the economic development of the nation by efficiently performing its functions as the head of financial intermediation (lemo, 2005). thus, it was to ensure the safety of depositors’ money, position banks to play active developmental roles in the nigerian economy; become major players in the sub-regional, regional and global financial markets and compete favourably with international banks. the central bank of nigeria’s (cbn) recent reform to consolidate the banking sector through drastic increase to #25billion as minimum capital base of any bank led to a remarkable reduction in the number of banks from 89 to 24 in 2005; changed their mode of operations and their contributions to the nation’s economic development. nigeria had the second largest financial sector in africa in terms of bank assets, market capitalisation, and a number of listed companies in the stock market, after south africa. also, banking subsector was the main source of corporate financing in the nigerian financial sector (zhao and murinde, 2009), the nigerian banking sector had undergone a number of major changes over the last two decades caused by restructuring and liberalisation of the financial sector as well as technological progress. before 1987, the nigerian monetary authorities restricted entry, controlled branch expansion and set both deposit and lending rates. this institutional framework led to a situation of virtually little or no competition in the sector, with the concentration of activities in the four largest banks. in 1990s, a lot of structural reforms were observed in the sector. there was a significant closure of banks, takeover of management and control by the central bank of nigeria (cbn) and the nigerian deposit insurance corporation (ndic). the mandatory capital level was increased to #500,000.00, while the statutory minimum risk-weighted capital ratio remained at 8% on average, the number of banks in nigeria shrank by approximately 22% between 1997 and 1999 (asogwa, 2004). the adoption of universal banking in nigeria necessitated the cbn to strengthen the regulatory and supervisory framework. the requirement of capital base was again increased to #2 billion in 2002 while the risk-weighted capital ratio was raised to10%. in 2004, the cbn announced a new 13 point reform agenda which was intended to promote soundness, stability and efficiency of the nigerian banking sector and to enhance its competitiveness in the african regional and global international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.27-34 28 financial system. one of the 13 point agenda was to raise the minimum capital base to #25 billion approximately 18 months (december, 2005) after the announcement with the statutory minimum riskweighted capital ratio maintaining at 10%. when the new reform was announced, out of the 89 banks operating in the banking sector, about 5-10 banks’ capital base was already #25billion; 11-30 banks’ capital base was within #10 to #20 billion; the remaining 50-60 banks were quite below #10 billion (zhao and murinde, 2009). the attempt to meet the minimum capital base triggered the merger and acquisition in the industry. further, banks raised capital from local as well as foreign direct investment. this led to the increase in the industry’s capitalisation as a percentage of stock market capitalisation and market’s liquidity during its 2005-2006 financial year. at the end of the18 months given by the cbn, only 25 out of 89 banks were standing with 21 private publicly quoted banks, 4 foreign banks but no government-owned bank. the reform brought about changes in size, structure and operational characteristics of the nigerian banking system (ibid). eventually, 24 larger and better-capitalised banks are currently in operations in nigeria. it is argued that consolidation could increase banks’ propensity towards risk taking through increases in leverage and off-balance sheet operations (somoye, 2008). furlong (1994) stated that an early view of consolidation in banking was that it made banking sector more cost efficient because larger banks could eliminate excess capacity in areas like data processing, marketing or overlapping branch networks. table 1 depicts trend of minimum paid-up capital of commercial and merchant banks in nigeria between 1952 and 2010. it had been an upward movement since independence till date. the paper investigated the impact of consolidation on performance of banks in nigeria. the main contributions of the paper are in two fold. first, it fills gaps in the literature with particular reference to nigeria’s banking reform exercises. second, it employs dynamic panel as a methodological innovation to investigate the performance differential between pre-consolidation and post-consolidation periods. the remainder of the paper is as follows: section 2 reviews past studies while methodology and data are described in section 3. main results and discussion (with robust tests) are presented in section 4 and section 5 concludes the paper. table 1. overview of minimum paid-up capital of banks in nigeria (1952 2010) year type of bank minimum capital requirement (mkr) 1952 commercial banks £12,500.00 1969 commercial banks £300,000.00 1979 commercial banks merchant banks #600,000.00 #2,000,000.00 1988 (feburary) commercial banks merchant banks #5,000,000.00 #3,000,000.00 1988 (october) commercial banks merchant banks #10,000,000.00 #6,000,000.00 1989 commercial banks merchant banks #20,000,000.00 #12,000,000.00 1991 commercial banks merchant banks #50,000,000.00 #40,000,000.00 1997 commercial banks merchant banks #500,000,000.00 #500,000,000.00 2000 commercial banks merchant banks #1,000,000,000.00 #1,000,000,000.00 2001 commercial banks merchant banks #2,000,000,000.00 #2,000,000,000.00 2005-date commercial banks #25,000,000,000.00 source: author’s computation, 2013. pre-consolidation and post-consolidation of nigerian banking sector: a dynamic comparison 29 2. review of relevant literature strand of financial literature has examined the effects of financial reforms on banks’ performance measured by either efficiency or productivity without comparing their business cycles (pre and post-consolidation). this study fills the gap. berger and allen (1998) examined mergers which occurred in the 1980s that involved banking organizations with at least $1 billion in assets and got to a conclusion as a result of the data aggregated to the holding company level, using frontier methodology and the relative industry rankings of banks participating in mergers. frontier methodology involves econometrically estimating an efficient cost frontier for a cross-section of banks. for a given institution, the deviation between its actual costs and the minimum cost point on the frontier corresponding to an institution similar to the bank in question measures x-efficiency. they found out that, on average, mergers led to no significant gains in x-efficiency. molyneux, altunbas and gardener (1997) underscored the importance of efficiency in banking and pointed out that higher efficiency could be expected to ‘lead to improve financial products and services, a higher volume of funds intermediated, greater and more appropriate innovations, a generally more responsive financial system, and improved risk-taking capabilities if efficiency profit gains were channeled into improved capital adequacy positions. they opined that bank efficiency was of critical importance to the evaluation of bank’s performance. onaolapo (2008) employed camel rating system to examine the effectiveness of recapitalization. he found that recapitalization had improved the financial health of banks. this finding was collaborated by sani (2004). using a regression model, sani discovered a positive and significant relationship between recapitalization policy and economic growth in nigeria. to the contrary, adegbaju (2008) examined the effectiveness of recapitalization on the performances of 20 nigerian banks. he discovered that while few banks recorded appreciable improvements in their performances, majority of the banks remained the same or even worse off. okafor (2009) research on consolidation exercise in nigeria employed capital adequacy asset quality liquidity and management. 2004 -2005 was regarded as the pre consolidation period while 2006-2009 was regarded as the post consolidation period, she concluded that consolidation improved the overall performance of banks in terms of assets size, deposit base, capital base and capital adequacy , however it did not contribute to the profit efficiency of those commercial banks. using the dynamic panel gmm method on a cross sectional data from 2000 -2010, barnos and caporale (2008) came to a conclusion that consolidation specifically reduced foreign ownership of commercial banks and also through merger and acquisition banks were more cost efficient. the investigation carried out by elumilade (2010) on the effects of mergers and acquisitions on the efficiency of financial intermediation in the nigerian banking industry had evidence that the consolidation programme induced mergers and acquisitions in the banking industry and improved competitiveness and efficiency of the borrowing and lending operations of the nigerian banking industry. olaosebikan (2009) investigated the efficiency of the nigerian banking system between 1999 and 2005. bank efficiency was evaluated using data envelopment analysis (dea). the results indicated that efficiency fluctuated during the first part of the period and improved during the recent years, a period associated with the increase in minimum capital requirement, differences in banks’ efficiency was explained by problematic loans and their size. donwa and odia (2011) investigated the impact of the consolidation on banking industry in the nigerian capital market between 2004 and 2008 using primary (questionnaires) and secondary data from the nigerian stock exchange. when the data was analyzed with the chi-square test and anova, it was found that bank consolidation affected the industry significantly as most of the banks had to go to the capital market to raise the required amount by issuing securities. they submitted that banks’ consolidation had increased public awareness and operations of the nigerian capital market just as the capital market had continued to be an easy and cheap source of funds for banks in the post consolidation era. based on their findings, it was recommended that the banks and capital market regulatory authorities should continue to monitor and institute reforms program that would better reposition the banking industry as a major player in the nigerian capital market and the economy. adegboyega (2012) evaluated the impact of mergers and acquisitions on performance of banks in nigeria. pre-merger and post merger financial statements of two consolidated banks were international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.27-34 30 obtained, adjusted, carefully analyzed and compared. the result revealed that all the two groups produced in addition to operational and relational synergy, financial gains far more than the 2+2=5 synergistic effects. ratio technique and inferential statistical tools were used to highlight synergistic effects on the merging banks. berger and udell (1995) used 1980-1988 as its study scope and the thick frontier approach (tfa) method. the study found out that deregulation of deposit rates caused an increase in average cost in us banks especially the smaller ones, hence it led to reduced efficiency while during postderegulation periods, and their average coast fell owing to the structural change. sobodu and akiode (1995) employed data envelopment analysis (dea) to study the efficiencies of banking institutions in nigeria under the privatisation policy, the study showed that the efficiency of the nigerian banking system declined significantly during period of financial deregulation compared to its levels before consolidation, they also discovered that privately owned banks operated more efficiently than government owned banks. favero and papi (1995) used a sample consisting of 174 italian banks, which represented 80 percent of total deposits, cross-sectional data from 1991 to 1995 and used the data envelopment analysis (dea) as its methodology. the major findings showed that efficiency of banks was mainly determined by productivity and specialisation by bank size and lesser by their locations. erel (2006) studied the effect of bank mergers on loans price. he found out that on average mergers reduced loan spreads, and that the results were stronger for acquirers with large declines in operating cost post merger. according to him, merger and acquisitions did not decrease the spread of the loans, because, by the time one or more banks were merged together at least they would be stronger more than before and that would allow them to spread credits to borrowers more than before. lamberte and manlagnit (2004) examined the recent consolidation trends among depository institutions (commercial banks and thrifts) in philippine for the period between 1989 and 1994. the study found out that market concentration increased significantly, midsize commercial banks were gaining market share at the expense of large banks in most markets. in addition, roger and ferguson (2009) studied the financial consolidation. their study concluded with an extensive evaluation of the potential effects of financial consolidation on the efficiency of financial institutions, competition among such firms, and credit flows to households and small businesses according to willson, wilson and goddard (2008) consolidation in the us had empirical evidence that there was often little improvement in efficiency or performance of merged entity. the study also suggested that the hubris and agency motives for merger may be relevant, or that synergy derived more from enhanced market power than from cost savings de young (1993) studied 348 merged banks, of which 43 percent were intercompany ones. the study estimated preand post-merger cost efficiency by applying a thick frontier approach. prior to merger, the acquiring banks were more cost efficient than the target; however, in the three years period after the merger, cost efficiency improved in about 64 percent of the cases. 3. methodology and data the theory of efficiency was the theoretical foundation of the study. this study employed generalized methods of moments (gmm) a more captivating method, which combined both time series and cross sectional data; it is highly useful because of the dynamic nature of the variables used. it made use of secondary data of 20 out of the 24 consolidated banks currently operating in nigeria between 1999 and 2011; sourced from nigerian stock exchange’ fact book (various issues). variables such as dividend per share (dps), earnings per share (eps), deposit, profit after tax (pat) and loans and advances (l&a) were proxied for consolidation (explanatory) and total assets for efficiency (dependent). the scope was divided into two: six years for pre-consolidation (1999-2004) and six years for post-consolidation (2006-2011). in exploring the impact of the consolidation exercise on banks’ efficiency in nigeria, the research employed chow test; parameter stability test to ascertain if truly there was a structural break in banks’ efficiency after the consolidation exercise. since the chow test gave a fore knowledge as to the presence or absence of structural break, system gmm (generalized methods of moments) estimation was further used to ascertain the directional and magnitudinal (size) impact of consolidation on banks’ efficiency. pre-consolidation and post-consolidation of nigerian banking sector: a dynamic comparison 31 3.1 model specification the chow test formula is specified as: f(k,n2+n2-2k)=(ssep-(sse1+sse2));k, (sse1+sse2); (n1+n22k) (1) where: ssep= sum of squared error term for pooled model sse1=sum of squared error term for group 1 sse2=sum of squared error term for group 2 k= no of estimated parameter (including constant) n2= no of banks in pre consolidation period n2=no of banks in post consolidation period a dynamic panel is the estimation technique this research employed, it is a model in which the current value of the dependent variable (y) is a function of the current value of independent variable and a lagged value of y, a typical dynamic is given as: effit=β1effit-1 +β2(dpsit) +β3(epsit) +β4(depositit)+ β5(patit) + β6(l&ait) + τt+ψi + εit (2) where; effit is the proxied for total assets of bank i at time t effit-1 is the lagged value of total assets of bank i at time t (dpsit) is the dividend per share of firm i at time t (epsit) is the earnings per share of firm i at time t (depositit) is the total deposit of firm i at time t (patit) is the profit after tax of firm i at time t (l&ait) is the total loans and advances of firm i at time t τt represents time effects ψi represents the firm specific fixed effects εit represents the stochastic term. β1…β6 are the coefficients of the parameters. 4. results and discussion 4.1 chow test the chow test shows that there is parameter instability in the bank consolidation. the following facts emerged: f-statistics (5, 219) = 3.22 p – value = 0.008 the piece of fact extracted from the result showed an f-statistics value that was significant at 5% level of significance, thus giving adequate information to reject the null hypothesis which asserted that there was no parameter instability in the model tested, implying that indeed the consolidation exercise impacted banks’ efficiency in nigeria. 4.2 dynamic panel data estimation owing to the technical deficiency of the ordinary least square and generalized least square estimation techniques, (both of which provide the econometric framework for the pooled regression, fixed effect method and random effect method of estimating panel models), the system gmm technique is employed as it helped contain the auto-correlation tendencies in the dynamic panel model. the difference gmm estimator (a close alternative) does not include level equations in its estimation. the system gmm estimator however includes both level and difference equations, generates more efficient instruments for estimation and also useful in correcting the endogeneity bias, which is peculiar to dynamic panel models. in this wise, the result of the system gmm is presented in table 2 for both pre-consolidation and post-consolidation periods. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.27-34 32 table 2. pre and post-consolidation’s results dependent variable: total asset variables pre-consolidation % post-consolidation % asset-1 0.00378852 0.003 0.46896078* 0.47 pat 0.30632521* 0.31 0.1050969 0.11 deposit 0.4701028* 0.47 0.33065887 0.33 eps 0.14763619 0.15 0.08230442** 0.82 dps -0.03691459 0.37 0.02566863 0.26 l&a 0.30243556* 0.30 0.11103173 0.11 note: * p<0.05; ** p<0.01; independent variables: (pat, deposit, dps, eps, l&a) diagnostics results: pre-consolidation: arellano-bond test for ar (1) in first differences: z = -1.66 pr > z = 0.096 arellano-bond test for ar (2) in first differences: z = -1.44 pr > z = 0.151 hansen test of overid. restrictions: chi2 (5) = 0.00 prob > chi2 = 1.000 post-consolidation: arellano-bond test for ar (1) in first differences: z = -1.42 pr > z = 0.156 arellano-bond test for ar (2) in first differences: z = -0.05 pr > z = 0.958 hansen test of overid. restrictions: chi2 (5) = 3.36 prob > chi2 = 0.499 the diagnostic tests indicate that the instruments used to check the endogeneity problems are valid and strictly orthogonal with the regression disturbance term. in addition, the autocorrelation test shows that there is no second order serial correlation problem and therefore the lags of the dependent variable and other variables used as instruments are strictly exogenous, thus good instruments (blundell et al., 2000; bond, hoeffler and temple, 2001 and hoeffler, 2002). quantitatively, as revealed in table 2 (the percentage column) consolidation, though positively impacted banks efficiency but had minimal impact. evident from the table 2 shows that a one percent increase in profit after tax and deposit brings about 0.10% and 0.33% increase respectively in total asset (proxy for banks’ efficiency). further, banks’ efficiency proxied by total assets improves by 0.82% and 0.11% via the consolidation exercise resulting from a one percent increase in earnings per share (eps) and loans & advances respectively. table 2 reveals that consolidation actually had a declining impact on majority of the adopted proxies for banks’ efficiency. the results show that profit after tax (pat), dividend per share (dps), loans and advances (l&a), bank deposit (deposit) all have a reducing effect on total assets, which is the adopted index for banks’ efficiency. however, earnings per share (eps) reveal that consolidation does impact banks’ efficiency. the results further indicate that it is 99% statistically significant in determining efficiency of nigerian banks. with emphasis on earnings per share as a proxy for consolidation, it is inferred that bank consolidation does impact banks’ efficiency positively. 5. conclusion banking consolidation is a matter of concern to cbn, as it may have adverse consequences on the systematic stability of the industry. the magnitude of consolidation effect depends on specific circumstances of each economy, such as regulatory framework, supervision practices, international financial integration, and financial market sophistication. however, since consolidation is likely to continue in the financial markets, further policy measures may be necessary in order to maintain a competitive environment and strengthen market efficiency and profitability. to achieve the intended purpose, these policies have to work with the incentive structure of market forces, including technological progress and international financial integration. further, to ensure the optimum success of the consolidation programme, in particular the post consolidation integration issues, there is the need for the cbn to sponsor training programmers’ on post-consolidation integration and corporate culture conflict management. this would assist to mitigate conflicts associated with consolidation, thereby facilitating the sustainability of the mega banks. pre-consolidation and post-consolidation of nigerian banking sector: a dynamic comparison 33 the study covered only 20 out of the current 24 mega banks operating in the country due to non-availability of relevant data. it is therefore, suggested that further research in this area of study be conducted on a ten year basis for rigorous comparison. references adegbaju, a.a., olokoyo f.o. 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(2009), banks’ competition, risk taking and productive efficiency: evidence from nigeria’s banking reform experiments, stirling economics discussion paper, pp. 2009-2023, university of stirling. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(5), 130-139. international journal of economics and financial issues | vol 10 • issue 5 • 2020130 accruals in the prediction of forthcoming cash flows in the companies listed at pakistan stock exchange rai imtiaz hussain1,2*, noor saadah zainal abidin1, faridah ibrahim1, jaspal singh joginder3 1department of business and accounting, infrastructure university kuala lumpur, malaysia, 2department of management sciences, university of okara, pakistan, 3department of accounting, sunway university business school, sunway university, malaysia. *email: rai.hussain@uo.edu.pk received: 20 june 2020 accepted: 27 august 2020 doi: https://doi.org/10.32479/ijefi.10313 abstract this research founds the relative predictabilities of accruals and further disaggregated accruals–trading accruals, non-trading accruals, and financial accruals in the estimation of future cash flows. the research also examines the effect of the global financial crisis on this association between accruals and future cash flow prediction. the research uses annual data from the period of 1999 to 2018 from 453 firms, which includes 9060 observations. the whole sample period covers data from 1999 to 2018, during the financial crisis period from 2008 to 2009 and pre financial crisis period from 1999 to 2007 and post global financial crisis period 2010 to 2018. to examine the relationship between accruals, disaggregated accruals, and estimation of future cash flows, hypotheses were developed and seasoned through ols. the outcomes confirm that financial accruals, non-trading accruals, and total aggregated accruals were significant, but trading accruals was not a significant contributor to the estimation of future cash flows. moreover, there was no significant effect of the global financial crisis on the relationship among disaggregated accruals and forecast of imminent cash flows during pre and post and during the global financial crisis period. keywords: accruals, trading accruals, financial accruals, non-trading accruals, global financial crisis jel classifications: go1, g30 1. introduction this article explores the reliability of accruals in the estimation of forthcoming cash flows. cash flow prediction is always remained the prime task before making investment decisions. stakeholders like investors want to know the future cash flows to make comparison with the worth of investment because the current market value of expected cash inflows is an investment (al-attar and maali, 2017; efayena, 2015; farshadfar and monem, 2019; khansalar and namazi, 2017; lewellen and resutek, 2016; richardson et al., 2005). if the current worth of forthcoming cash flows is higher than the primary investment, it is favorable and if the current worth of coming cash flows is less than the basic investment, it is unfavorable. the cash flows generated by the companies help the share price to rise (richardson et al., 2005; barth et al., 2001) and motivate potential investors to invest in those companies who have higher share prices in the stock exchange. financial statements provide evidence to assist creditors and investors to foresee future cash flows (khan and mayes, 2009; irwin, 2015; flynn et al., 2016). however, if the forecasted future cash flows deviate from actual, it would be crucial for amendments in financial statements (zayed and liu, 2014). the data presented in financial statements is recorded on accruals-based accounting, as young (1994) mentioned that earnings calculated based on accruals were a more powerful predictor than cash-based accounting. all the future cash flow prediction depends on the financial data provided in the financial statements of the firms. therefore, financial statements should represent the true and fair value of financial assets and resources and managers have exerted such this journal is licensed under a creative commons attribution 4.0 international license hussain, et al.: accruals in the prediction of forthcoming cash flows in the companies listed at pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 131 responsibilities and powers to perform these duties through agency theory (namazi and rezaei, 2016; young, 1994; morris, 1987). hence, managers are responsible for providing accurate and fair financial statements as investors usually use that information to make an investment decision. generally, financial statements manipulated through earnings management; therefore, reliability and relevance challenged often. farshadfar and monem (2019) worked on the relevance of accruals in financial statements that ignored in prior literature (fuad et al., 2019; lai et al., 2013). the reliability of financial reporting is essential in the estimation of forthcoming cash flows as the investor’s belief in the financial statement. owners also assess the managers’ performance through relevance and reliability of items reported in financial statements published, and that later used for investment (efayena, 2015; irwin, 2015; blessing, 2016; frank, 2018; fuad, juliarto and harto, 2019). financial information reported in financial statements sends signals to investors to interpret signals and make economic decisions (morris, 1987), hence, the investor’s belief that data postulated in financial statements is the significant information to invest in the company. the well-designed model of (dechow et al., 1998; barth et al., 2001) is widely used to investigate the association among earnings, accruals and cash flows. most of the prior researchers (dechow et al., 1998; barth et al., 2001; richardson et al., 2005; arthur et al., 2010; barth et al., 2015; darjezi, 2016; lewellen and resutek, 2016; khansalar and namazi, 2017; farshadfar and monem, 2019) used accruals (accounts receivable, accounts payable, inventory) and found accrual-based accounting improved forecaster in the forecasting of future cash flows than cash base accounting (bushman et al., 2016). most of the researchers worked on trading accruals only whereas (khansalar, 2012; khansalar and namazi, 2017) decomposed accruals into working accruals (already used in prior studies of dechow, 1994; dechow et al., 1998; barth et al., 2001; richardson et al., 2005; khansalar, 2012; bloomfield et al., 2014; hui et al., 2016; al-attar and maali, 2017; frank, 2018; farshadfar and monem, 2019), non-trading accruals (termed as non-current operating assets in the studies of (dechow et al., 2014; irwin, 2015; farshadfar and monem, 2019) and financial accruals (termed as financial assets in prior studies of (dechow et al., 2014) and (khansalar, 2012; khansalar and namazi, 2017), initially, used in the researches(richardson et al., 2005; dechow et al., 2014; dechow, 1994; dechow et al., 1998) and later used in the studies of (farshadfar and monem, 2019; hussain et al., 2020). the scope of reliability of accruals is examined from balance sheet items and based on estimates and subsequently, tested association among accruals and future cash flows. the future cash flow estimation is a complicated concept that is still under discussion (isab, 2010). accrual based accounting is considered a better predictor of future cash flows than cash based accounting (dechow et al., 1998). therefore, the financial statements should prepare on accruals-based accounting principles (young, 1994; hertzberg et al., 2010; bloomfield et al., 2014; ciconte et al., 2014; dechow et al., 2014; barth et al., 2015; casey et al., 2017; leal et al., 2017; fuad et al., 2019). accruals narrated in financial statements by various accountants are inconsistent and customarily recorded on the concept of earnings management. therefore, it generates the problem of accruals’ reliability. the lack of accruals’ reliability adversely affects future earnings persistence and vice versa (khansalar and namazi, 2017; farshadfar and monem, 2019; dechow et al., 1998; dechow et al., 2014; dechow et al., 2019; richardson et al., 2005). the persistence in earnings explains the degree of current earnings’ ability to sustain to subsequent periods. earnings persistence is lower if it is recognized based on the accrual than if it is recognized based on the cash component of earnings (hirshleifer et al., 2009; chen and li, 2013; dechow et al., 2014; hui et al., 2016). the future cash flow predicted based on such accruals that were recorded in financial statements using creative accounting techniques, the accuracy of such predicted future cash flows become a question mark. the managers are making financial decisions using such predicted future cash flows facing the problem of financial distress (dechow et al., 2014). on the other hand, investors who are making investment decisions in stocks using such predicted future cash flows could not see actual stock price as it deviates from its fundamental values (dechow et al., 2019; lewellen and resutek, 2016). as the accruals represented in financial statements manipulated through earnings management (mulenga and bhatia, 2017), this study shows how disaggregated accruals like trading accruals, non-trading accruals and financial accruals with their relevant component – assets and liability affect the forecast of forthcoming cash flows in companies listed at pakistan stock exchange. the estimation of forthcoming cash flows remained under investigation in various developed countries but the still underresearched topic in developing countries like pakistan where investors had to rely only on the stock price in capital markets like pakistan stock exchange (psx). the current research is built on the enhancement of the study of khansalar (2012) to extend the scope of accruals into aggregated accruals (total of all three accruals), disaggregated accruals (trading accruals, non-trading accruals, and financial accruals) with their relevant assets and liabilities component and see the reliability of accruals-based on the low, medium and high level of reliability. information provided in financial statements are used for investment decision making and to understand equity market and it is the prime duty of secp to regulate companies listed in pakistan. most investors are making investments in the manufacturing sector and need to be researched to secure their investment and give them the knowledge to see their future value of the investment. however, few studies are conducted in asia to see the forecasted cash flow based on accruals and phenomenon is less explained even though having vital role in organizational performance, but none of the studies is directly conducted in manufacturing sector considering accruals especially working accruals, non-current accruals, and financial accruals and their relevant assets and liabilities (nallareddy et al., 2020). furthermore, it is difficult to predict which one is a comparative improved accrual of upcoming cash flows. the study is vital for investors and stock market players because they can become aware of the role of accruals hussain, et al.: accruals in the prediction of forthcoming cash flows in the companies listed at pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020132 in the estimation of forthcoming cash flows. furthermore, the regulators can watch about the proper recording of accruals in the financial statements. 2. literature review 2.1. future cash flows prediction cash flow prediction plays a vital role in the investment decision. the purpose is to see the future cash inflows and outflows in advance to make a better decision for both investment and optimum use of funds (nallareddy et al., 2020). on the other side, it also minimizes the cost of capital borrowings (ciconte et al., 2014; bushman et al., 2016; al-attar and maali, 2017) as the business knows the future inflows. previously financial statements such as income statement or earnings were determined sole indicators, but now cash flows are deemed essential for decision making as earnings were easily manipulated through creative accounting theory (kim and kross, 2005; hong et al., 2017; shah et al., 2009) whereas, (fuad et al., 2019) cited earnings as superior to predict future cash flows than current operating cash flows. while in economic analysis or decision making, a fiscal prediction is the primary objective of the economist. prior studies (hertzberg et al., 2010; agana et al., 2015; namazi and rezaei, 2016) called the capacity and capability of cash generation as the primary measure for decision making and investors always looked-for firms with free flow cash flows. lenders and creditors also held specific objectives in looking at the cash flows of the company. one of the main objectives of cash flows is deemed to allow stakeholders about future value, estimated return period and ambiguity of future cash flows (fasb, 1978). the numerous prior researchers worked on the forecast of future cash flows, and a significant part of this work done in developed economies. the results of all prior researchers were different and contradictory. earnings were considered more potent in the estimation of forthcoming cash flows (kim and kross, 2005; dechow et al., 1998; badertscher et al., 2012; barth et al., 2015; sinnewe et al., 2017) and different from those who were on the other side, were rated past cash flows better predictor for future cash flows (nallareddy et al., 2020). 2.1.1. future cash flows prediction in developed countries earning is superior forecaster than past cash flows from operations in the estimation of forthcoming cash flows and also increases the accuracy of future cash flow forecasting (hribar and yehuda, 2015; kim and kross, 2005; hirshleifer et al., 2009; hong et al., 2017; finger, 1994; murdoch and krause, 1989). dechow et al. (1998) and khansalar (2012) researched the association of earnings, accruals and cash flows and found results consistent with finger (1994). the primary debate of past earnings better predictor than past cash flows for the estimation of forthcoming cash flows rejected in the study of (barth et al., 2001). the results were different due to the impact of accruals. the theory on the prediction of cash flows further enhanced in the studies of (farshadfar et al., 2010; farshadfar and monem, 2019). the researchers used earnings plus depreciation and amortization and working capital from operations in the estimation of forthcoming cash flows for australian companies. the inclusion of firm size as an intervening variable made studies more exciting and compelling. nallareddy et al. (2018) investigated the relative ability of earnings and cash flows in the estimation of forthcoming cash flows due to mixed evidence in past literature. the findings of the research were that cash flows had better predictive abilities over earnings in the estimation of future cash flows in us companies. khansalar (2012) and khansalar and namazi (2017) had researched the reliability of accruals and the prediction of cash flows. three categories of accruals were introduced in the study to confirm which one is a better predictor of future cash flows. financial accruals were found with higher reliability and found with higher predictabilities for future cash flows, and non-trading accruals were on the other extreme side. farshadfar and monem (2019) investigated the predictive abilities of accruals – working, non-current operating accruals and financial accruals and future operating cash flows using australian firms. the findings of the study contradicted with many prior studies (such as khansalar, 2012; khansalar and namazi, 2017) as working capital and noncurrent operating accruals found better predictor than financial accruals in uk. on the other hand, there are few demerits of future cash flow prediction. first, cash flows forecasting based on limited information. accountants frequently gather known information and use this information to predict future cash flows. this information is often wrongly estimated; therefore, it predicts inaccurate future cash flows (farshadfar and monem, 2019). secondly, cash flow prediction is often affected by unforeseen factors that quickly change the estimated values. thirdly, the business environment is dynamic and volatile; therefore, cash flow prediction is affected. so, cash flow estimation often adjusted in an extended period. still, future cash flow prediction is necessary for the stakeholders in investment decision making and future expansion plans. it also helps the management to avoid financial distress. this research measures the impact of trading accruals, non-trading accruals and financial accruals on the estimation of forthcoming cash flows. 2.1.2. future cash flows prediction in developing and emerging economies al-attar and maali (2017) worked on the earnings quality and estimation of forthcoming cash flows from the information narrated in balance sheet. the data took from the 50 companies listed in the tehran stock exchange from 2009 to 2013. the findings of the study exhibited that increase in quality of earnings; the accuracy of prediction of cash flows from the operation would increase. further, it is reliable for the estimation of future operating cash flows. aghaei and amir (2010) and namazi and rezaei (2016) also studies the manufacturing companies listed at tehran stock exchange. the findings were consistent with the prior studies conducted in iran. the benefits of future cash flow prediction involve discounted cash flows of estimating the future cash flows at present in malaysian companies. if the present value is more significant than investment, the investor makes an investment decision (wan hussain, et al.: accruals in the prediction of forthcoming cash flows in the companies listed at pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 133 ismail et al., 2012). secondly, companies benefit from operating leverage. thirdly, free cash flows provide the cash which left on hand after paying the expenses. it is also essential to reinvest free cash flows. jemaa et al. (2014) worked on prediction of future cash flows in tunisian context and preferred operating cash flows over earnings. whereas, disaggregated accruals were found with better predictabilities in the studies of (mulenga and bhatia, 2017) and similar findings generated in the context of saudi arabia (senan, 2019). hussain et al. (2020) studied the further disaggregated accruals in pakistan stock exchange and identified that financial accruals had more predictabilities than other disaggregated accruals in manufacturing companies. prediction of future cash flows also remained under discussion in nigeria in prior studies (efayena, 2015; blessing, 2016; frank, 2018; umoren and umoffong, 2018). past earnings were found better predictor than cash flows in the findings of umoren and umoffong (2018), and (frank, 2018). both past earnings and past cash flows had predicted abilities for imminent upcoming cash flows (efayena, 2015; blessing, 2016). 2.2. independent variables 2.2.1. trading accruals trading accruals are often known as working capital accruals (badertscher et al., 2012; dechow et al., 2014; holten and bøllingtoft, 2015; hribar et al., 2018; fuad et al., 2019; dechow, 1994; dechow et al., 1998; khansalar, 2012; khansalar and namazi, 2017). trading accruals decomposed into receivables, inventories, payables, depreciation, amortization, and others (khansalar, 2012; dechow, 1994; dechow et al., 1998; barth et al., 2001; barth et al., 2012; barth et al., 2016; farshadfar et al., 2010; farshadfar and monem, 2019; badertscher et al., 2012) and found with the ability to increase predictive ability about future cash flows. farshadfar and monem (2019) and (khansalar, 2012) calculated these accruals as the difference between trading assets and trading liabilities whereas richardson et al. (2005) and hribar and yehuda (2015), hui et al. (2016) termed it as a change in operating assets and change in operating liabilities. a limited review regarding how trading accruals influence the estimation of forthcoming cash flows cited hereafter. 2.2.1.1. trading accrual as predictor of future cash flows trading accruals are considered a mostly better predictor of future cash flows. trading accruals based on working capital accruals and mostly represents a change in accounts receivable, change in accounts payable, change in inventory, plus depreciation, amortization and other accruals (barth et al., 2001; richardson et al., 2005; khansalar, 2012; khansalar and namazi, 2017) and recorded as change in current operating assets and change in current operating liabilities (richardson et al., 2005; khansalar, 2012). trading accruals were found better predictors in prior literature (such as richardson et al., 2005; khansalar, 2012; khansalar and namazi, 2017). the hypothesis is generated as under: h1: trading accruals as a component of disaggregated accruals have the better predictabilities to forecast future operating cash flows in manufacturing firms listed at pakistan stock exchange (psx). 2.2.2. non-trading accruals these accruals are associated with non-current assets of the firm that are not frequently bought and sold, for example, property, plant, and equipment, intangibles, and investments (dechow et al., 2014; khansalar and namazi, 2017; farshadfar and monem, 2019). these accruals are aligned with non-trading assets (called non-current operating assets) and non-trading liabilities (also called non-current operating liabilities) and found from the difference of non-trading assets (∆nta) and non-trading liabilities (∆ntl). richardson et al. (2005) and farshadfar and monem (2019) called these accruals as non-current operating accruals (∆nco). these accruals measured from the change in non-current assets, net of long-term investment and advances, less change in non-current liabilities, net of long-term debt. these accruals based on management’s subjectivity and discretion; therefore, non-trading accruals are assigned with a low level of reliability (dechow et al., 1998; dechow et al., 2011; khansalar, 2012). a limited review regarding how non-trading accruals influence the estimation of forthcoming cash flows cited hereafter. 2.2.2.1. non-trading accruals as predictor of future cash flows non-trading accruals not often used in the estimation of forthcoming cash flow in prior studies. richardson et al. (2005) worked on non-current operating accruals in his studies and found significant in the estimation of forthcoming cash flows. khansalar (2012) used non-trading accruals in the estimation of forthcoming cash flows and also assigned non-trading liabilities with high reliability than non-trading assets. on the other side, non-current operating accruals were not found reliable for the estimation of forthcoming cash flows in the studies of farshadfar and monem (2019). h2: non-trading accruals as a component of disaggregated accruals have better predictabilities in the prediction of future operating cash flows in manufacturing companies listed at psx pakistan. 2.2.2.2. financial accruals farshadfar and monem (2019) represented financial accruals in terms of financial activities such as dividends, allotment of bonds and shares and debt service. dechow et al. (2014) and khansalar (2012) referred to financial accruals as a change in financial activities (∆fin). financial accruals include the difference between long term investment, short term investment and long-term debt and short-term debt and stock (both ordinary and preferred) (dechow et al., 2008). prior studies did not include financial accruals (dechow et al., 1998; barth et al., 2001; richardson et al., 2005) but well-addressed in studies of khansalar (2012), khansalar and namazi (2017), dechow et al. (2014); barth et al. (2016). financial accruals were allotted high reliability (dechow et al., 2008; khansalar, 2012) as these accruals fluctuate with fair market value; even sometimes considered as cash equivalents (dechow et al., 2008). the company’s shares are traded in the stock exchange, which represents the current market value of the company (dechow et al., 2008). long term debt and short-term debt show the current cost of estimated cash flows, and that paid after a specific time with interest (khansalar, 2012). therefore, financial accruals are assigned with high reliability in the present study also. a limited review regarding how financial accruals influences the estimation of forthcoming cash flows cited hereafter. hussain, et al.: accruals in the prediction of forthcoming cash flows in the companies listed at pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020134 2.2.2.3. financial accruals as predictor of future cash flows financial accruals were found more predictable in future cash flows generation (khansalar, 2012). khansalar (2012) used regression models to compare predictabilities of trading accruals, non-trading, and financial accruals and found the financial accruals more predictable than trading and non-trading accruals. financial accruals were found more persistent in the estimation of forthcoming cash flows in the findings of richardson et al. (2005). on the other hand, some researchers concluded that financial accruals were not found significant in the estimation of forthcoming cash flows in the studies of farshadfar et al. (2017) and oei et al. (2008). based on the empirical literature following relationship is expected. h3: financial accruals as a component of disaggregated accruals have better predictabilities in the prediction of future operating cash flows in manufacturing companies listed at psx pakistan. 2.2.3. total accruals total accruals defined as the difference between assets and liabilities excluding cash as because in cash-based accounting, only cash and capital is mentioned in the balance sheet (richardson et al., 2005). earnings composed of accruals and operating cash flows (dechow, 1994; dechow and dichev, 2002; sloan et al., 2004; chotkunakitti, 2005; dechow et al., 2008). accruals accounting is a system of accounting in which revenues and expenses are recognized and reported in financial statements when they have occurred and not when they are received or paid (iasb, 2010; richardson et al., 2001; bazley et al., 2004; elliott and elliott, 2018). under south this system of accounting, assets and liabilities generated from the transaction and most of the researcher declared accrual accounting superior to cash accounting for decision making (fasb, 1978; iasb, 2010; elliott and elliott, 2018) but accrual-based earnings were deemed less persistent than cash-based earnings, and this is primarily due to subjectivity of accruals (sloan, 1996). the term of the subjectivity of sloan (1996) used like accounting term reliability. reliability could be used interchangeably with the notion of sloan (1996) as subjectivity. two qualities are associated with financial information to make it more reliable and useful, i.e. reliability and relevance (fasb, 2002; dechow et al., 2008). lev and sougiannis (1996) and later sloan et al. (2004) confirmed that less regular accruals found less predictable for future earnings whereas less verifiable accounting estimates compromise the value of accounting numbers (watts, 2003). accruals represent the difference between accruals earnings and cash earnings (healy, 1985). some of the prior studies documented that historical operating cash flows combined with aggregated accruals components are superior to earnings and historical operating cash flows in the estimation of forthcoming cash flows (barth et al., 2001; al-attar and hussain, 2004; ebaid, 2011; al-attar and mali, 2018). disaggregating earnings into aggregated accruals and operating cash flows were conducted in prior studies to enhance the predictabilities of the earnings in future cash flows and further disaggregating accruals into its components strengthen predictabilities of earnings (barth et al., 2001; al-attar and hussain, 2004; ebaid, 2011). furthermore, the reliability and relevance of aggregated accruals also affect the persistence of earnings in the estimation of forthcoming cash flows (al-attar et al., 2008). on the other hand, prior studies found that operating cash flows only as a better predictor than operating cash flows with aggregated/disaggregated accruals in the estimation of forthcoming cash flows (chotkunakitti, 2005). moreover, few studies found no apparent difference between accruals combining operating cash flows and operating cash flows only in the estimation of forthcoming cash flows. 2.2.3.1. total accruals as predictor of future cash flows accruals used as a predictor of future operating cash flows create noisy measurement farshadfar and monem (2019) but is used in many prior studies (such as dechow et al., 1998; barth et al., 2001; richardson et al., 2005; dechow et al., 2008; barth et al., 2016) worked on the disaggregation of accruals into major six components and found more predictive power of total accruals in predicting future cash flows. arthur et al. (2010) and lai et al. (2013) investigated disaggregated accruals, and future cash flowed prediction in the us and found that the predictive abilities of disaggregated accruals improved in the estimation of future cash flows. farshadfar and monem (2019) also studied on accruals components in australia and reported that it had enhanced forecasting of future cash flows. farshadfar and monem (2019) disaggregated accruals and found their components had better predictive abilities than accruals. based on the empirical literature following relationship is expected. h4: aggregated accruals deemed better predictor than disaggregated accruals components (trading, non-trading, and financial accruals) in the prediction of future operating cash flows in manufacturing companies listed at psx pakistan. 2.3. global financial crisis global financial crisis had expected to have an impact on the association of accruals and prediction of future cash. therefore, following hypothesis is developed: h5: global financial crisis had significant impact on the relationship of accurals and prediction of future cash flows in manufacturing companies listed at psx pakistan. 3. research methodology 3.1. sampling and data collection the study used the cash flow prediction models already developed by barth et al. (2001) and later used by khansalar (2012) and khansalar and namazi (2017) to find out predictabilities of various disaggregated accruals. the model used an ordinary least square model to compare the predictive abilities of cash flows for a 1-year-ahead. the secondary data was used from the year 1999 to 2018 for 20 years. all manufacturing listed firms at psx selected as samples for this research. the total sample of this research was 485 manufacturing firms listed at psx (psx, 2018). non-financial firms were not included as those did not have trading accruals. the manufacturing sector was selected as a sample because it was the most significant contributor to the gdp of pakistan, i.e. 20.91%. the data for 453 firms was available for research due to the mergers of firms, delisted firms. therefore, 9,060 observations were used to generate the findings of the study. the data was gathered directly from the financial statements of these firms as no database was available in the country. hussain, et al.: accruals in the prediction of forthcoming cash flows in the companies listed at pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 135 the firms selected in the sample have homogeneity as these are registered at psx and follow the same ifrs and ias. pakistan did not have its own ifrs but follow the same gaap developed by iasb and fasb. 3.2. measurement of variables 3.2.1. independent variables the author used trading accruals, non-trading accruals, financial accruals, and total accruals as independent variables and reported in table 1. the measurement of variables is also shown in table 1. all the variables were deflated by total accruals like in prior studies (khansalar, 2012). 3.2.2. dependent variable future cash flows are measured in terms of operating cash flows generated in business and shown in table 1. the operating cash flows are used as a dummy for the calculation of future cash flows (barth et al., 2001; richardson et al., 2005; khansalar, 2012; farshadfar and monem, 2017). 3.2.3. global financial crisis the manufacturing firms listed in the pakistan stock exchange have to face the global financial crisis in 2008-2009. the author used the global financial crisis as a dummy variable to see its impact on the predictors on the estimation of forthcoming cash flows. 3.3. model specification the study included time horizon, therefore, balanced panel data was employed as consist with prior studies of (farshadfar et al., 2010; khansalar, 2012; khansalar and namazi, 2017; farshadfar and monem, 2019). the regression equation is narrated below: fcf,t+1 = α+β1∆trading accruals i,t+β2∆non-trading accruals i,t+β3∆financial accruals i,t+β4∆total accruals i,t+εi,t here; fcf = future cash flows prediction β1= represents change in trading accruals β2= represent change in nontrading accruals, β3= represent change in financial accruals β4= represent change in total accruals εi,t= error term 4. empirical findings 4.1. descriptive statistics table 2 reported the descriptive statistics of the study. it showed that the maximum operating cash flow was 176.15, whereas trading accruals (ta) was 19.66. furthermore, total accruals (tacc) was 79.42, and non-trading accruals (nta) was 77.92, and financial accruals (fa) were 21.95. meanwhile, minimum operating cash flows were −64.96, and ta was −2145.94 and tacc was −13.38. moreover, nta was −8.30 and fa was −49.00. table 2 also depicted the values of mean, median, standard deviation and observations of the data. the mean of operating cash flows was 0.14, and the ta was −4.91, whereas tacc was 0.39, and nta was 0.76. the value of mean for fa was −0.34. the median of operating cash flows was 0.012, and ta was 0.00 and tacc was 0.28. whereas nta was 0.55 and fa was −0.24. the standard deviation value of operating cash flows was 4.99, whereas ta was 93.01. the value for tacc was 2.94 and nta was 3.17 and fa was 1.43. the total number of observations of operating cash flows, ta, tacc, nta, and fa was 9060 for each. 4.2. stationarity test table 3 showed the stationarity test of all variables of the study. the outcome showed that all variables of interest were found stationary at 1st difference which meant series combined at order one, and the series was i (1). these results suggested that all variables were stationary and could use for penal data analysis. table 1: measurement of variables variable description source prediction of forthcoming cash flows future cash flows mean cash flows generated through operating activities of the business barth et al. (2001); richardson et al. (2005); khansalar (2012); farshadfar and monem (2017) trading accruals trading accruals is calculated as the difference between trading assets and trading liabilities barth et al. (2001); richardson et al. (2005); khansalar (2012); farshadfar and monem (2017) non-trading accruals non-trading accruals is calculated as the difference between non-trading assets and non-trading liabilities dechow et al. (2008) and khansalar (2012) and farshadfar and monem (2017) financial accruals financial accruals is calculated as the difference between financial assets and financial liabilities khansalar (2012); farshadfar and monem (2017); hussain et al. (2020) total accruals total accruals are the sum of all three accruals or aggregated accruals dechow (1998); barth et al. (2001); khansalar (2012); farshadfar and monem (2017) dummy variable pre and post and during the global financial crisis is measured through a dummy variable farshadfar and monem (2017) table 2: descriptive statistics variables mean median maximum minimum sd skewness kurtosis trading accruals (ta) −4.911784 0.000000 19.66800 −2145.949 93.01395 −20.06249 417.3861 non-trading accruals (nta) 0.760162 0.555500 77.92200 −8.308000 3.171695 19.16766 411.5834 financial accruals (fa) −0.343631 −0.241000 21.95000 −49.00900 1.439286 −15.47122 575.2919 total accruals (tacc) 0.395878 0.281500 79.42200 −13.38300 2.944505 19.71556 481.5420 net operating cash flows 0.140486 0.012000 176.1540 −64.96600 4.991435 29.64640 1069.313 hussain, et al.: accruals in the prediction of forthcoming cash flows in the companies listed at pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020136 table 3: adf unit root test results variables i (0) (means at level) prob.** trading accrual −4.7732 0.0000 non-trading accrual −10.5735 0.0000 financial accruals −7.39895 0.0000 total accruals −6.05895 0.0000 net operating cash flows −29.1279 0.0000 table 4: results of correlation variables 1 2 3 4 5 net operating cash flows 1 trading accrual 0.021568 1 total accruals 0.050801 0.010977 1 non-trading accrual 0.026996 0.059242 0.904101 1 financial accruals 0.006048 −0.015636 −0.203827 −0.549239 1 table 5: redundant fixed effects tests effects test statistic d.f. prob. cross-section f 1.383057 (452,7697) 0.0000 cross-section chi-square 636.737573 452 0.0000 table 6: correlated random effects hausman test test summary chi-sq. statistic chi-sq. d.f. prob. cross-section random 37.293510 4 0.0000 4.3. correlation analysis the correlation coefficient is presented in table 4. the results showed that operating cash flows have a significant positive correlation with trading accruals, non-trading accruals, total accruals, and financial accruals. the results revealed that the value of the correlation coefficient was not exceeding the benchmark of 0.9 suggested by hair et al. (2019) and field (2017) for multicollinearity. therefore, it was evident that the problem of multicollinearity did not exist in this model. 4.4. decision of fixed effect method versus common constant method redundant fixed effects tests were run to decide about the standard constant method or fixed effects method of the panel regression model. the results showed chi-square is significant as p < 0.000, which suggested that the fixed effect model is appropriate (table 5). 4.5. decision of random effect method versus fixed effect method hausman test was used to decide whether to go with a random effect method or fixed effects method of a panel regression model. table 6 suggested that the fixed effect model is appropriate. 4.6. panel regression analysis table 7 shows the results of regression analysis. the hypotheses predict that accruals as a component of disaggregated accruals have table 7: panel regression model variables net operating cash flows coefficient se prob. constant 0.170182 0.059226 0.0041 trading accrual 0.001420 0.000781 0.0692 non-trading accrual −0.347880 0.100610 0.0005 financial accruals −0.203196 0.090729 0.0251 total accruals 0.434218 0.089148 0.0000 r-squared 0.0823 adjusted r-squared 0.0279 f-statistic 1.5138 prob (f-statistic) 0.0000 table 8: effect of accruals on fcf during global financial crisis variables net operating cash flows coefficient se prob. constant 0.1858 0.0643 0.0039 trading accrual 0.0014 0.0007 0.0703 non-trading accrual −0.3504 0.1007 0.0005 financial accruals −0.2044 0.0907 0.0243 total accruals 0.4367 0.0892 0.0000 dummy variable (d1) −0.0907 0.1465 0.5357 r-squared 0.0823 adjusted r-squared 0.0278 f-statistic 1.5112 prob (f-statistic) 0.0000 *d1=financial crisis period dummy better predictabilities in the prediction of forthcoming cash flows in companies listed at psx pakistan. to test these predictions, we regressed operating cash flows on trading, non-trading, financial and total accruals. table 7 showed that trading accrual (β = 0.01, p = 0.07) was an insignificant predictor of future operating cash flows, so, h1was rejected. non-trading accrual (β = −0.35, p = 0.00) was a significant predictor of future operating cash flows, providing support for h2. similarly, a significant negative relationship with operating cash flows found for the financial accruals (β = −0.20, p =0.03), which supports h3. a significant positive association was found between the total accruals (β = 0.43, p = 0.00) and operating cash flows, supporting h4. table 7 showed 2.7% of the explanatory power of the model that was represented by the adjusted r-square. it means that the independent variables in this model were explaining 2.7% change in the dependent variable. the value of f-statistic was found significant that identify that model as best fits the population from which the data sample. in this equation, only one variable was insignificant and did not explain the dependent variable. all other variables were significantly different from zero and had predictabilities to explain the dependent variable. table 8 showed the effect of independent variables on future cash flows prediction during global financial crisis. the during global financial crisis was represented as dummy variable (d1). the coefficient of d1 was −0.0907 and p = 0.5357 which is >0.05, therefore, we reject the effect of global financial crisis. table 9 showed the effect of independent variables on future cash flows pre and post global financial crisis. the pre and post hussain, et al.: accruals in the prediction of forthcoming cash flows in the companies listed at pakistan stock exchange international journal of economics and financial issues | vol 10 • issue 5 • 2020 137 global financial crisis was represented as dummy variable (d2). the coefficient of d2 was −0.2753 and p = 0.0372 that is <0.05, therefore, we reject the effect of pre and post global financial crisis. 5. discussion and implications the study was conducted to see the impact of disaggregated accruals on the estimation of forthcoming cash flows. accruals were disaggregated into trading accruals; non-trading accruals and financial accruals. trading accruals were found statistically insignificant in the forecasting of future cash flows in companies listed at pakistan stock exchange. this finding is consistent with the research of richardson et al. (2005), dechow et al. (2008) and frankel and sun (2018) who have found that trading accruals were an insignificant predictor of future operating cash flows but contradict to the studies of farshadfar and monem (2019). non-trading accruals were found significant in the estimation of forthcoming cash flows in companies listed at pakistan stock exchange. this finding is matching with the finding by lewellen and resutek (2016) and farshadfar and monem (2019), who argued that nontrading accruals as a component of disaggregated accruals have better predictive abilities in the prediction of future operating cash flows. the results interpret that financial accruals have a significant negative relationship with an estimation of forthcoming cash flows, which is consistent with the study by khansalar (2012) who found that financial accruals are more significant, in the estimation of forthcoming cash flows, than other components of accruals like trading accruals and non-trading accruals but inconsistent with the studies of farshadfar and monem (2019). total accruals have a significant positive relationship with the estimation of forthcoming cash flows that are in line with the research conducted by farshadfar and monem (2019). the past earnings disaggregated into accruals have better predictability than past cash. the findings were consistent with prior studies conducted in emerging markets (efayena, 2015; blessing, 2016; frank, 2018; umoren and umoffong, 2018). the results were also found consistent with developed economies where financial accruals and trading accruals were significant in prediction of upcoming cash flows (farshadfar et al., 2010; khansalar, 2012; khansalar and namazi, 2017; farshadfar and monem, 2019). the effect of global financial crisis during the crisis and pre and post global financial crisis on the relationship of accruals and future cash flows prediction was not found that means there was no effect of global financial crisis on the association of variables in companies listed at psx. the empirical results are again contradictory and need to be conducted including other financial companies like insurance, banks etc. furthermore, more variables such as length of operating cash cycle, management role, earnings and earnings before interest and tax. income statement and balance sheet are used to prepare a statement of cash flows on accruals based accounting. prospect investors can see the reliability of accruals and estimation of forthcoming cash flows in pakistani stock exchange. therefore, financial statements should be prepared for reliable and relevant information. the study provides guidelines to users of the financial statement such as financial analysis, creditors and prospect investors to see which part of cash flows activity is important for the estimation of forthcoming cash flows. 6. conclusion in this study, the author finds out the disaggregation of accruals into trading, non-trading and financing accruals and their predictabilities of future cash flow in the pakistani context. the main question was to see whether it improved the predictive power of these disaggregated accruals over total accruals to explain future cash flows. the study analyzed a sample of 9060 observations related to 453 manufacturing firms over the 1999 to 2018 period. the results of the study suggested that financial and non-trading accruals were relevant in forecasting future cash flows, but trading accruals could not be found significant in the approximation of forthcoming cash flows. whereas, the fourth variable, i.e. total accruals, were also established substantial effect on prediction of imminent cash flows. furthermore, the predictabilities of total accruals found more than the disaggregated accruals components. the study was carried out in emerging markets of pakistan on the prediction of future cash flows. further study needs to be conducted for comparison between developed and developing countries. moreover, moderating variable should be included to enhance the body of knowledge in this field of research. references agana, j.a., mirkeku, k., appiah, k.o. 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(2014), engineering, construction and architectural management article information. engineering construction and architectural management, 21(2), 170-189. international journal of economics and financial issues vol. 3, no. 4, 2013, pp.874-884 issn: 2146-4138 www.econjournals.com 874 the interest rate channel in turkey: an investigation with kalman filter approach taha bahadır sarac department of economics, faculty of economics and administrative sciences, nigde university, turkey. email: tbsarac@nigde.edu.tr okyay ucan department of economics, faculty of economics and administrative sciences, nigde university, turkey. email: okyayu@hotmail.com abstract: the monetary authority affects the aggregate demand and investment expenditure via controlling short run interest rates. it is important to satisfy the price stability together with working interest rate channel. this study aims to investigate the validity of interest rate channel in turkey since the inflation targeting period starting with the year 2002. the sample period covers quarterly data from 1990:1 to 2011:3. it is stated that after the 2002 efficiency of interest rate channel increases. keywords: kalman filter; markov switching; monetary policy; turkey jel classifications: c32; c34; e52 1. introduction the economy policies generally are divided into monetary policy and fiscal policy. while fiscal policy uses the government expenditures and taxes as the instruments, monetary policy uses money supply, short term interest rate, discount rate and etc. however, there are differences of opinion among the economists, i.e,which one is more effective on the economic activity level. classical economics that is the dominant economic thought up to the great depression emhasizes that there is no need any government intervention and economies are in balance. moreover, any disequilibrium is equalized by the wages and flexible prices. following by the classical economic thought, the dominant one is the keynesian thought in which economies with underemployment are in equilibrium. keynesian thought stresses that fiscal policy is more effective than monetary policy due to the liquidity trap and zero sensitivity of investment to the interest rates. in the beginning of 1960’s monetary thought come on the scene and express that money supply has a fundamental role on determining the economic performance. if we look over the turkish economy, up to the 2000 it is seen that monetary pociy is restricted over against expansionary fiscal policy. however folowing by the economic crisis in the 2001, as part of the inflation targeting significant progress toward increasing the independence of executing the monetary policy of central bank has made. in this context, inhibiting the treasury from borrowing short term funds from central bank may be thought as an important development. it indicates that the macroeconomic stability is satisfied both by performing the structural reform and insisting on fiscal discipline together with increasing the applicability of inflation targeting regime. as a result of this macroeconomic stability, it emphasizes that efficiency of central bank gradually increases. so, contrary to the 1990’s central bank is more effective for achieving the price stability by using monetary transmission mechanism during this inflation targeting period. monetary transmission mechanisms that covers the effect of monetary policy to the real macroeconomic variables, such as aggregate supply, unemployment and inflation have been examined through interest rate channel, exchange rate channel, bank credit channel and equity price channel. beside this, it may be examined the interest rate channel in turkey: an investigation with kalman filter approach 875 by dividing into two channels so called interest rate and bank credit channels. following by an expansionary monetary policy, interest rate falls and this causes a rise in investment and gdp at the interest rate channel. at the bank credit side, an expansionary monetary policy increases the the bank reserves and bank deposits together with a rise in quantity of bank loans available. therefore, this increase will cause investment spending to rise, leading an increase in gdp. in this study we aim to test the validty of interest rate channel for turkish economy. although there are huge number of study dealing with this, most of them use causality tests to validate the monetary transmission mechanisms. however, causality test does not allow to observe the trend of monetary transmission mechanism along the whole time period. at the interest rate channel known as traditional keynesian monetary transmission mechanism, effects of interest rate to the the economy are founded on the money market views of keynes. keynesian model emphasizes that equilibrium interest rate is determined by money demand and money supply. that is why, interest rate level can be adjusted by monetary policy leading to an increase in investment. however, at the interest rate channel it is stated that a fall in the interest rate causes a rise not only in investment but also in consumption expenditure. the sticky price assumption looms large in this channel. as to this, following by a fall in the short run nominal interest rates, lower interest rates then lead to decrease in short run real interest rates. according to the rational expectation theory, it is agreed that long term real interest rates will be the average of the expected short term interest rates. therefore, as seen in figure 1, this fall in long term real interest rates affect the firms’s investment and consumption expenditure (mishkin, 1995; kutter and mosser; 2002). figure 1. interest rate channel the purpose of this paper is to contribute to the existing literature by analysing the monetary transmission mechanism by using markov-switching method and kalman filter that allows to observe the effect of inflation targeting regime on interest rate channel in the given period. the paper is organized as follows. section 1 discusses the theory. section 2 summarizes the literature. the econometric methods and analysis are presented in section 3. the overall conclusions are in the final section. 2. literature review following by friedman and schwartz (1963) who denote money supply affecting the real economy, most of the economist agree that monetary policies affect the real economy at least in the short run. however there is no consensus how monetary policy affect the real economy. thus, there are lots of study resulting several conclusions about monetary transmission mechanisms so called “black box” (bernanke ve gertler, 1995, 1). table 1 presents the summary of this literature review about interest rate channel. money supply rise a fall in short term real interest rates a fall in long term real interest rates increase in investment expenditure aggregate demand rise increase in consumption expenditure international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.874-884 876 table 1. literature review of related works author(s) countries and period method results taylor (1995) selected oecd countries (1970-1995) var analysis interest rate elasticity of investment decreases and interest rate eleasticity of consumption decreases especially in usa. butzen et al. (2001) belgium (1985-1998) panel data analysis the contractionary monetary policy causes a fall in firm profit. peersman and smets (2001) selected european countries (1980-1998) var analysis a temporary rise in nominal and real short run interest rate, cause a temporary fall in output level. angeloni et al. (2002) selected european countries (1971-2000) var analysis an unexpected short run interest rate causes a fall in output level after a year. sellon (2002) usa (1972-2000) graphical analysis the changes in financial system cause a rise in efficiency of monetary policy. çiçek (2005) turkey (1995:1-2003:2) var analysis after a contractionary monetary policy, real production decreases and this will be through in two quarter terms. zhang and sun (2006) china general equilibrium analysis the efficiency of interest rates on consumption is limited without credit sector. therefore, credit sector develops the efficiency of interest rate channel will rise. iwata and wu (2006) japan non-linear structural var analysis when nominal interest rate is zero level, monetary policy shock affects the real economy. yue and zhou (2007) china (1996:012005:08) granger causality test there is no causality neither between investment expenditure and the market interest rate nor between household consumption and the market interest rate. erdem et al. (2007) turkey (1989:1-2005:2) kalman filter approach a rise in interest rates cause a fall in output deficit. papadamou and oikonomou (2007) selected european countries (1996:042004:04) var analysis the interest rates are efficient on industrial production index and interest rate channel works. aktaş et al. (2008) turkey (2001:072008:08) regression analysis the interest rate channel is efficient via market interest rates. büyükakın et al. (2009) turkey (1990:012007:09) causality tests a change in interest rates attracts investment, price level and output. demary (2010) 10 oecd countries (1970:1-2005:4) var analysis a rise in interest rates cause a fall in output level. marius and angela (2010) romania (2000-2009) graphical analysis after the 2000, efficiency of interest rate channel has risen via structural reforms in the economy especially banking sector. sun et al. (2010) china (1996:1-2008:1) var analysis gdp has decreased over against a unit shock of repo rate. erdoğan and yıldırım (2010) turkey (1995:012008:09) var analysis interest rate channel did not work before the 2002, however it has worked after the 2002. the interest rate channel in turkey: an investigation with kalman filter approach 877 abdel-baki (2010) egypt (1991-2009) structural var analysis following by the reform of banking sector, efficiency of the interest rate channel rises. in addition to this, exchange rate is an another important variable at this point. claus (2011) new zelland (only one quarter data is used) general equilibrium analysis the effects of shocks will be higher without using interest rate channel. mukherjee and bhattacharya (2011) selected mena countries (1990-2009) panel data analysis the consumption and investment expenditure are sensitive to interest rates. 3. econometric analysis this part is divided into two sections. first one is econometric method and second one is econometric analysis. 3.1 method 3.1.1 markov switching model markov switching models were introduced in econometrics by goldfeld and quant (1973). regime switching models are regarded as a promising way to capture nonlinearities in time series. that is mostly true for markov switching model in which the probabilities of switching from one regime to another are assumed to be constant in the next period (maddala& kim, 1998, 455). expansion and recession periods are estimated as to state variable, ts , that is defined directly and randomly. in regime switching models, ts is assumed to take integer values, i.e. 1, 2,....ts n  . as to n state markov chain, current regime ts depends only the 1ts  . this implication is given by equation (1).   1 2 1/ , ,.... /t t t t t ijp s j s i s k p s j s i p         (1) where   , 1,2,...ij i j n p  gives the state transition probability. thus, ijp shows the probability of state i following by state j and total probabilities are equal to 1 as seen in equation (2). 1 2 .... 1pi pi pin    (2) the representation of all probabilities in n n matrix is given in equation (3). 11 21 1 12 22 2 1 2 ... ... ... .... n n n n nn p p p p p p p p p p                , 1 1, 1, 2,..., , 0 1 n ij ij j p i n p      (3) for the two state case, we have:     1 1 1 1ˆ 2 t t t t t t p s p s               (4) where  1,t t ty   .if 11ˆ  tt is known the regime for t may be estimated by the given information at 1t  . as to equation (4) probabilities of yt conditional on st and 1t  as a collection in a (2x1) vector are given in equation (5).              ),2( ),1( 1 1 ttt ttt t syf syf    (5) the joint probability of yt and st is given by the equation (6).      1 1 1, ,t t t t t t t tf y s j f y s j p s j        , j = 1,2 (6) international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.874-884 878 for the two state case, equation (6) leads to equation (7). the output t̂ t is calculated by manipulating 11 ˆ  tt (hamilton, 1994).       1 2 2 1 1 1 / 1 1 1 ˆ, t t t t t t t t t t t s s f y f y s p s               (7) 3.1.2 kalman filter method kalman filter method based on the estimation of statespace models is defined with the following equations in which ty is dependent variable and tx is the explanatory variable. 1, 2,....,t t t t ty x t n      (8) 1t t tn    (9) 1t t tv    (10) where t is constant, t is the coefficient of explanatory variable and ,t tn and tv are the error terms. equation (8) represents the observation (or measurement) equation, equation (9) and (10) represent the state (or transition) equation. this system of equations are given in vector form with equation (11) and equation (12) as observation and state equations respectively. the transition equation describes the dynamics of the coefficient tz , which is assumed to follow a random walk process. t t ty z   (11) 1t t tz az w  (12) where tz is the time varying parameters imply  ,t t  ,  implies constant term vector and a implies identity matrix, t and tw are independent error terms. they are assumed to be independent white noise processes. here, coefficients can change over time and this model allows parameter estimates to respond differently under alternative policy regimes. the model takes into account for the lucas (1976), engle and watson (1987) and hatemi-j (2002) critiques. as to lucas (1976), in the policy regimes macroeconomic parameter estimates are not invariant to changes and thus such estimates may be useless for forecasting the impact of the policy changes. in addition changes in the unobservable components of economic variables such as expectations will cause structural change in the data generating process and model misspecification is another justification for using time-varying coefficient (tvc) models. the nonwhiteness of the estimated error terms from the misspecified model can be explained by the changing coefficient values in the tvc model (hatemi-j and irandoust, 2008, 620-621). 3.2 econometric analysis 3.2.1 data the sample period covers quarterly data from 1990:1 to 2011:3. the raw data has been collected from central bank of republic of turkey (cbrt) and international financial statistics (ifs) data bases. 3.2.2 model following by mukherjee ve bhattacharya (2010), we agree to use the following models:        0 1 2 3 4 1model 1: / ( ) / /pc y r g y y c y            (13)        0 6 7 8 9 2model 2: / ( ) / /p pi y r g y y c y            (14) where 0 and 0 are the constants, all 1 2, ,.... q   regression coefficients and 1 , 2 are the error terms. in addition table 2 presents the definition of variables. the interest rate channel in turkey: an investigation with kalman filter approach 879 table 2. variables and definitions variables definitions  /c y : the ratio of private consumption expenditures over gdp  /g y : the ratio of government consumption expenditures over gdp  /pc y : the ratio of aggregate private sector credits over gdp  /pi y : the ratio of private investment expenditure over gdp  y : percentage change of the real gdp  inf : percentage change of consumer price index  r : interbank interest rate 1) inflation is only used in markov switching method. 2) the variables except interest rate are seasonally adjusted by tramo-seats method. 3) inflation rate data covers from 1988:1 to 2011:4. 3.2.3 results 3.2.3.1 unit root test lee and strazicich (2003) unit root test results are presented in table 3. according to the unit root test results, we have found that  /c y ,  /pc y ,  /pi y and  y series are stationary in first differences and other series are stationary in levels. table 3. lee-strazicich unit root test results series t-stats break points first break points second break points  /c y -5.50 (3) -11.89 (0)* 1994:2 2007:2 2005:3* 2006:4*  /g y -6.64 (0) 1994:3 2000:1  /pc y -5.51 (7) -9.59 (0)* 2000:1 2005:4 2001:1* 2007:1*  /pi y -4.84 (7) -6.76 (3)* 2000:3 2005:4 1997:4* 2007:3*  y -4.32 (8) -9.49 (3)* 2003:1 2007:4 1993:3* 1999:2*  inf -8.78 (0) 1993:2 2002:1  r -8.92 (1) 1994:3 2001:2 1) the values within parentheses represent optimal lag lengths for autocorrelation. 2) critical values at .05 significance level for lee&strazicich test are taken from lee and strazicich (2003, 1084) for model c and they are -5.59, -5.74, -5.67,-5.71,-5,65,-5,73 respectively. 3) (*) indicates the t-stats and break points in first diffrences. 3.2.3.2 markov regime switching method markov regime switching method is used to investigate the efficiency of monetary policy interest rate channel in the different inflation periods. graph 1 presents the estimation results of two regime so called contraction and expansion periods. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.874-884 880 graph 1. markov regime switching method results 1990 1995 2000 2005 2010 0.25 0.50 0.75 1.00 probablities of contraction rejime (filtered) 1990 1995 2000 2005 2010 0.25 0.50 0.75 1.00 probabities of expansion regime (filtered) 1990 1995 2000 2005 2010 0.25 0.50 0.75 1.00 probablities of contraction rejime (smoothed) 1990 1995 2000 2005 2010 0.25 0.50 0.75 1.00 probabilities of expansion regime (smoothed) according to the results in graph 1, probabilities, number of observations corresponding to the related periods are presented in table 4. table 4. regime properties and transition matrix transition matrix regime contraction expansion contraction 0.50125 0.12820 expansion 0.49875 0.87180 regime properties regime number of observations periods average probabilities average durations contraction 13 1988:1 1991:1 0.813 9.40 quarter 2 1992:2 – 1992:3 0.630 2 2002:2 – 2002:3 0.590 26 2003:3 – 2009:4 0.894 4 2010:2 – 2011:1 0.795 expansion 4 1991:2 – 1992:1 0.917 9.80 quarter 38 1992:4 – 2002:1 0.965 3 2002:4 – 2003:2 0.613 1 2010:1 – 2010:1 0.745 3 2011:2 – 2011:4 0.864 linearity lr-test chi^2(4) = 43.518 (0.0000)* approximate upperbound: (0.0000)* note: the likelihood ratio (lr) test implementing the upper bound of davies (1987) also suggests that all models reject the null of linearity at the .01, .05 and .10 significance levels and certify the use of regimeswitching models. probabilities of contraction regime (smoothed) probabilities of expansion regime (smoothed) probabilities of contraction regime (filtered) probabilities of expansion regime (filtered) the interest rate channel in turkey: an investigation with kalman filter approach 881 table 4 shows that after the inflation targeting regime probabilities of contraction increase also during (2003:3-2009:4) period. this result also indicates that monetary policy is efficient to control high inflation most of inflation targeting period which starts at january 2002. 3.2.3.2 kalman filter method kalman filter method needs stationary variables so variables used in the analysis are all stationary. here crisis dummies are d1, d2 and d3 are for the years 1994, 2001 and 2008 respectively. kalman filter method is used to determine the paramaters which are chanching over the time. and we also expect that interest channel is more efficient during the inflation targeting regime. in other words, the values of the 1 and 6 is becoming high after the inflation targeting regime is adopted by the central bank of turkey. so we have performed the kalman filter method, and showed the results in graph 2 and 3. graph 2. kalman filter method results (model 1) -.15 -.10 -.05 .00 .05 .10 .15 92 94 96 98 00 02 04 06 08 10 interest rate parameter ± 2 rm se -4 -2 0 2 4 6 92 94 96 98 00 02 04 06 08 10 (g/y) parameter ± 2 rm se -.3 -.2 -.1 .0 .1 .2 92 94 96 98 00 02 04 06 08 10 economic growth parameter ± 2 rm se -150 -100 -50 0 50 100 92 94 96 98 00 02 04 06 08 10 (cp /y) parameter ± 2 rm se when we analyze kalman filter method results, we have seen that interest rate effects consumption and investment expenditures negatively. especially, as can be seen in graph 3, the effect of interest rate on consumption expenditures undergone a sharp change during inflation targeting period. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.874-884 882 graph. 3 kalman filter method results (model 2) -.12 -.08 -.04 .00 .04 .08 92 94 96 98 00 02 04 06 08 10 interest rate parameter ± 2 rm se -4 -3 -2 -1 0 1 2 92 94 96 98 00 02 04 06 08 10 (g/y) parameter ± 2 rm se -.20 -.15 -.10 -.05 .00 .05 .10 92 94 96 98 00 02 04 06 08 10 economic growth parameter ± 2 rm se -80 -40 0 40 80 92 94 96 98 00 02 04 06 08 10 (cp/y) paramet er ± 2 rm se 4. conclusions while the central bank of republic of turkey implements implicit inflation targeting from 2002 to 2006, from 2006 to present explicit inflation targeting has been implemented. following by the inflation targeting regime practice, it is observed that a noticeably decrease in the inflation level occurs. it is approximately 70.01 % and 11.6 % in the 1983-2001 and 2002-2011 periods respectively . this case indicates that inflation targeting regime is an effective monetary policy instrument. the efficient monetary policy means monetary transmission mechanism works well. this study aims to investigate the economic influences of the inflation targeting regime on the interest rate channel. results show that inflation targeting regime is effective not only on decreasing the inflation rates but also on increasing the performance of interest rate channel. in other words, central bank is effective on both consumption and investment expenditure in the inflation targeting regime period. especially, it is stated that its ability on controlling the consumption expenditure increases. the interest rate channel in turkey: an investigation with kalman filter approach 883 references monal, a.b. 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(2006) china’s consumer credit sector expansion and monetary transmission mechanism: what should china’s central bank do? journal of chinese political science, 11(1), 79-93. international journal of economics and financial issues vol. 1, no. 4, 2011, pp.211-219 issn: 2146-4138 www.econjournals.com investigating seasonal patterns in developing countries: the case of fyrom stock market1 andreas georgantopoulos department of public administration, panteion university of political and social sciences, greece. email: ageorgantos@yahoo.com anastasios tsamis department of public administration, panteion university of political and social sciences, greece. email: atsamis@panteion.gr abstract: this paper uses a data set from fyrom stock exchange to investigate the presence of calendar effects in this recently organised equity market during the period 2002–2008. five well known calendar effects are examined by both mean (ols) and variance (garch) regressions; the day of the week effect, the january effect, the half month effect, the turn of the month effect and the time of the month effect. results indicate that two of the tested calendar effects are present in the mse (day of the week and january effects) and conclusions using linear and various garch methodologies, always converged to the same results. this survey’s evidence are in line with the majority of similar research which report that calendar effects are still present especially in developing equity markets. however, considering the low level of liquidity and maturity of this market, we would expect more effects to appear significant. keywords: calendar anomalies, mean stock returns, volatility, fyrom jel classifications: c32, g10. 1. introduction since the seminal work of fama (1965), a vast number of studies have been developed regarding security price anomalies. some of them are broadly known as calendar effects. the most important calendar effects studied are the day of the week effect (significantly different returns on some day of the week; usually higher friday returns and lower monday returns), the monthly (or january) effect (relatively higher january returns), the half month effect (returns are statistically higher over the first half of the month), the turn of the month (statistically higher returns on turn of the month days than other trading days) and the time of the month effect (returns are higher on the first third of the month). thaler (1987a, 1987b) provides an early and partial survey, while mills and coutts (1995) and coutts et al. (2000) provide selective and more recent international references. other studies have examined the time series stock price behaviour in terms of volatility by using generalised autoregressive conditional heteroskedasticity (garch) models (french et al., 1987; hamao et al., 1990; nelson, 1991; campbell and hentschel, 1992; and glosten et al., 1993). for example, french et al. (1987) support that unexpected stock market returns are negatively correlated to the unexpected changes in volatility, while campbell and hentschel (1992) found that an increase in volatility raises the required rate of return on common shares and hence lowers stock prices. generally, all those studies report that returns in stock markets are time varying and conditionally heteroskedastic. 1 the early edition of this paper was presented at the "7th annual conference of the hellenic finance and accounting association", 12-13 december, 2008, crete, greece. international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.211-219 212 this study investigates the existence in fyrom stock exchange (mse) of five well known calendar effects (day of the week effect, january effect, half month effect, turn of the month effect and time of the month effect, as defined above) in mean stock returns and their variances. the survey is motivated by a number of factors: (i) investigating five calendar anomalies by applying both mean and variance specifications for an emerging balkan stock market where to the best of our knowledge previous literature findings do not exist; (ii) covering a period which includes some of the most important macroeconomic, political and stock market reformations that took place in the tested country; (iii) avoiding data mining phenomenon by using data sets that are not repeatedly used in similar studies and are different from those studies in which the calendar effects originally discovered and (iv) enriching the existing calendar effects literature by presenting results from a developing country located in the balkan peninsula. the paper is organised as follows: section 2 describes the data set. section 3 describes the methodology employed in the study. section 4 presents the empirical findings, while a summary of results and concluding remarks are presented in section 5. 2. data analysis our data set consists of daily closing values (in logs) for the mbi – 10 index, which is the basic index used in the mse. the mbi – 10 index is a price index weighted with the market capitalization. it is consisted of 10 listed ordinary shares, chosen by the stock exchange index commission. the commission performs regular (twice a year) and extraordinary (if extraordinary circumstances occur) revisions to the index. regarding the most important dates in the short history of the fyrom as an independent country, it is worth noting that the former yugoslav republic of macedonia was created in 1991 due to the break-up of yugoslavia. an absence of infrastructure, united nations sanctions on its largest market federal republic of yugoslavia, and a greek economic embargo hindered economic growth until 1996. worker remittances and foreign aid have softened the volatility of the subsequent recovery period. gdp has increased each year except 2001, rising by 5% in 2000. however, growth in 1999 was held down by the severe regional economic dislocations caused by the kosovo war. the privatisation program of 2000 was proved to be successful boosting the country's reserves to over $700 million. also, the leadership demonstrated a continuing commitment to economic reform, free trade and regional integration. the economy can meet its basic food needs but depends on outside sources for all of its oil and gas and most of its modern machinery and parts. inflation jumped to 11% in 2000, largely due to higher oil prices. since 2002, the fyrom shows some important signs of growth. due to the relevant stability in the balkan region, investments in the region have increased in the period 2002 – 2006 by more than 50% (with greece being by far the primary investor), inflation shows a downward trend while gdp increased by approximately 3% during this period. regarding the fyrom stock exchange (mse), it is worth mentioning that its story began in 1995. on 13 september 1995 the inaugural meeting of the mse took place. this is the official date of the establishment of the first organised securities exchange in the history of the country considering that fyrom had never before a stock exchange. the exchange was established as a joint stock company operating on a non-profit basis, with a founding capital of one million deutschmarks. the total number of the initial founders of the fyrom stock exchange was 19 (13 banks, three insurance companies and three saving houses). these founders simultaneously became first exchange members with right to trade in securities. the exchange's first transaction day is connected with the date of 28 march 1996. in the beginning the exchange was open for trading twice a week, on tuesdays and thursdays. in 2002, ‘the takeover law’, the missing link in the chain of securities legislation in the fyrom was adopted. the number of trading days was increased to four days of the week, monday to thursday. in 2003 the mse signed memorandums of understanding with the stock exchanges in belgrade, zagreb and sofia. in 2004, a third issue of denationalisation bonds of the fyrom was listed. the new listing rules entered into effect. in 2005, the fyrom stock exchange was accepted as a corresponding member of the federation of european stock exchanges (fese). the main characteristic of the year 2006 was the entrance of capital inflow from regional investors (mainly greece) into fyrom capital market. finally, the year 2007 was the most successful since the investigating seasonal patterns in developing countries: the case of fyrom stock market 213 foundation of mse back in 1996. the mse realised record turnover of 41.7 billion euros and mbi 10 index achieved its biggest value breaking the barrier of 10,000 index points. the data set covers a period from january 2002 until july 2008 (excluding holidays). this period covers a long stock market cycle characterised as a bull market for the region, excluding the stock market crash period started on september 2008 due to the global financial crisis. the ‘close to close’ data does not contain information about the payment of dividends on stocks. although, there exist some evidence that the payment pattern of dividends may be a reason for seasonality in nondividend adjusted returns (phillips-patrick and schneeweis, 1988), most of the studies on calendar effects use non-dividend adjusted returns allowing for direct comparisons to the previously published results. furthermore, the vast majority of previous studies which use non-dividend adjusted data report that systematic dividend payment patterns do not significantly change their results (e.g., fishe et al., 1993; french, 1980; lakonishok and smidt, 1988). 3. methodology the calendar effects in mean stock returns are studied by the ols regression of the complete return series on appropriately defined dummy variables2. on the other hand we allow variances of errors to be time dependent to include a conditional heteroskedasticity that captures time variation of volatility in stock returns applying the garch (p,q) model proposed initially by engle (1982) and further developed by bollerslev (1986)3. therefore, garch [1,1] models, including appropriately defined dummies, are used for testing the calendar effects in conditional variance of stock index returns. the parameters are estimated following the quasi-maximum likelihood (qml) estimation introduced by bollerslev and wooldridge (1992)4. estimation of calendar effects: the day of the week effect is studied, using a model, originally proposed by french (1980). in this framework, the trading time hypothesis is evaluated, according to which returns are created only on the working days of the week. this hypothesis is tested, using the following regression with dummy variables (e.g., french, 1980; rogalski, 1984; jaffe and westerfield, 1989; agrawal and tandon, 1994; mills and coutts, 1995):    5 2 1 i titit dr  (1) where tr is the daily logarithmic return on a selected index, itd = 1 for day i and 0 for all other days (i = 2,…,5 corresponds to tuesday through to friday), 1 indicates the mean daily return for monday, while 2 to 5 represent the difference between the mean daily return for monday and the mean daily return for each of the other days of the week and t is an error term assumed to be identically and independently distributed (iid). if there are no differences among index returns across days of the week, the parameters of 2 to 5 are zero. therefore, the null hypothesis of the relevant wald test is the following: 0:0 ih  for i = 2,…,5. if the null hypothesis is rejected, then stock returns should exhibit some form of the day of the week seasonality. the day of the week effect in variance is studied by estimating the following conditional volatility function: 1 to address the drawback of the ols that error terms may not be white noise due to autocorrelation and heteroskedasticity problems resulting to misleading inferences, the significance of the regression estimates (tstatistics) is observed using the newey -west heteroskedasticity and autocorrelation – adjusted standard errors (newey and west, 1987). 3 one disadvantage of using the garch [1,1] with the relevant dummies for each anomaly is the possibility of being too restrictive. in order to assess the conditional variance better, we include additional terms in the conditional variance equation. specifically we include (a) additional lag values for the arch term [garch (1,2)] and (b) additional lag values for the garch coefficient [garch (2,1)]. the results for all indices are robust with our previous findings and these findings are not tabulated and reported. 4 the ljung-box q and arch-lm tests for various lags are also employed in the investigation of each calendar anomaly in variance for all markets. the results, not presented here, confirm that the standardized residuals terms have constant variances and do not exhibit autocorrelation. international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.211-219 214     5 2 2 1 2 1 2 i itittt dhah  (2) 2 th is the conditional variance of t in the equation (2). here, we take into account the possibility that the lagged values of the squared residuals and the conditional variances might be too restrictive. if there is no day of the week effect in variance, the parameters 2 to 5 are zero, so the relevant null is 0:0 ih  for i = 2,…,5. for the monthly or january effect, the model used is described by the following equation (e.g., gultekin and gultekin, 1983; jaffe and westerfield, 1989; raj and thurston, 1994):    12 2 1 i tititr  (3) where, it = 1 if the return at time t belongs to month i and 0 if the it belongs to any other month (i = 2,…,12 corresponds to february through december). the intercept 1 measures the mean return for january, while the coefficients 2 to 12 represent the average differences in return between january and each individual month. the null hypothesis tested in this equation is 0:0 ih  for i = 2,…,12. as before, days before stock market vacations are excluded from the analysis. as in the case of the day of the week effect, the monthly effect in variance is studied by estimating the following equation:     12 2 2 1 2 1 2 i itittt hah  (4) for the half month effect we follow lakonishok and smidt’s (1988), defining as h1t = 1 if day t is from the first to the fifteenth calendar day of the month if it is a trading day, and if it is not, to the next trading day, and h1t = 0 otherwise. the mean and variance models for the half month effect are the following: tttr   110 (5) tttt hhah 1 2 1 2 1 2    (6) lakonishok and smidt (1988) find that the mean returns on days around the turn of the month are significantly higher than the mean returns on the rest of the month days. moreover they observe that the returns are higher especially during a four day period starting from the last trading day of the old month until the first three business days of the new month. to test for the existence of turn of the month effect in mean return in the data set the following model is used: ttttttttr   )3()2()1()1()2()3( 6543210 (7) where m(-3)t to m(+3)t are turn of the month dummy variables. the turn of the month effect in variance is tested by using the following model: ttttttttt hah )3()2()1()1(()2()3( 654321 2 1 2 1 2    (8) the last anomaly to be investigated is the time of the month effect. this monthly anomaly was first identified by kohers and patel (1999). they split a calendar month into three segments. the first segment extends from the 28th day of a previous month to the 7th day of the month, the second segment extends from 8th day to the 17th day of the month and the last segment consists of the other days, that is, the 18th day to the 27th day of the month. using the standard & poor’s index (s&p) during the period january 1960 – june 1995 and the nasdaq index during the period january 1972 – june 1995, they investigating seasonal patterns in developing countries: the case of fyrom stock market 215 reported that the returns are highest during the ‘first third’, experience a drop during the ‘second third’ and are lowest, and in most cases negative, during the ‘last third’ of a month. further they indicate that this pattern remained remarkably consistent for the two indices examined. it also held up well over the business cycles and many different sub periods tested. following kohers and patel (1999) the below regression is estimated: tttt ddr   32210 (9) where rt is the mean return of the stock index on day t and the dummy variable dit indicates the day on which the return is observed (d2t = first third month days and d3t = second third month days). d2t attains a value of 1 if the return is observed on the first third of the month days, 0 otherwise. similarly, d3t attains a value of 1 if the return is observed on the second third of the month days, 0 otherwise. on the other hand, in order to test the time of the month effect in variance, we used the following equation: ttttt ddhah 3221 2 1 2 1 2    (10) 4. empirical results table 1 reports on descriptive statistics for the mbi – 10 index regarding the tested period. the highest average daily (15.1231) appeared in 2 july 2002, while the minimum price (-11.6751) appeared in 29 november 2002. overall, descriptive statistics indicate that returns are not normally distributed and are characterised as leptokurtic and skewed. table 1. summary statistics index mean minimum maximum std. dev. skewness kurtosis mbi – 10 index 0.122934 11.6751 15.1231 1.6894428 0.730598 16.81697 table 2 displays the estimation results of equation (1). from this table, it is clear that the day of the week effect exists (weakly though) in the fyrom stock exchange. monday appears to have the highest and statistically significant returns while friday appears to have the lowest and negative returns (reverse monday effect). table 2. the day of the week effect in mean index 1 2 3 4 5 wald mbi – 10 index 0.1602 * (0.1199) 0.0938 (0.1684) 0.0111 (0.1681) 0.1102 (0.1672) -0.2182* (0.1671) 2.1311* [0.0861] notes: *, **, *** denote significance at 10%, 5% and 1% respectively. standard errors are reported in parentheses and p values in brackets. this note also applies to the subsequent tables. table 3 presents the results of estimating the variance model (equation 2), where it can be seen that the day of the week effect strongly exists in the mse. monday presents high and statistically significant variance while friday appears to have lower (but strongly significant) variance than monday’s. table 3. the day of the week effect in volatility index  β γ 2 3 4 5 wald mbi – 10 index 2.0177*** (0.2321) 0.1161*** (0.0008) 0.7587*** (0.0123) -1.0839 (0.4184) 2.1974 (0.2852) -2.6879 (0.2572) -2.5378*** (0.2441) 2.2696** [0.0472] the results for the mean model (equation 3) are presented in table 4, where it was found that the monthly effect strongly exists in the fyrom stock exchange. february has positive and statistically significant returns, while april and may show significantly lower (and negative) returns than february. furthermore, testing the monthly effect in variance (equation 4), it appears that the international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.211-219 216 monthly effect exists, since the variances of february, april and may are negative and statistically significant. moreover, january shows the highest positive and significant variance while december has the lowest, so according to the garch [1,1] methodology, january effect exists in fyrom stock market. table 4. the january effect in mean table 5. the january effect in volatility table 6 shows that there is no evidence proving the existence of the half month effect in mean for the mbi – 10 index (equation 5), since mbi – 10 index does not present statistically different results for the first half of the month days. table 6. the half month effect in mean same results are reported measuring the above effect in variance (equation 6), as tabulated in table 7. therefore, the half month effect is absent from the mse as both results from both models imply. table 7. the half month effect in variance index     mbi – 10 index 0.2721*** (0.0957) 0.1474*** (0.0428) 0.7843*** (0.0511) -0.1379 (0.1136) index mbi – 10 index α 2.2448*** (0.7025) β 0.1409 *** (0.0264) γ 0.5405 *** (0.0101) δ2 -1.4514** (0.7247) δ3 -0.8621 (0.6888) δ4 -0.7671*** (0.6818) δ5 -1.7561** (0.6877) δ6 -1.9688 (0.6941) δ7 0.1811 (0.7342) δ8 -1.762 (0.6928) δ9 -1.2667 (0.6905) δ10 -1.6811 (0.6857) δ11 -1.2565 (0.6859) δ12 0.0051 (0.2628) wald 2.2005 ** [0.0174] index mbi – 10 index β1 0.2468 (0.2041) β2 0.3682** (0.2983) β3 0.2974 (0.2849) β4 -0.5521*** (0.2728) β5 -0.4279** (0.2714) β6 -0.4169 (0.2740) β7 0.0879 (0.2715) β8 -0.0471 (0.2706) β9 -0.0701 (0.2708) β10 -0.2975 (0.2714) β11 0.2251 (0.2744) β12 0.0051 (0.2628) wald 2.2539 ** [0.0103] index 0 1 mbi – 10 index 0.1669 (0.0727) 0.0855 (0.1049) investigating seasonal patterns in developing countries: the case of fyrom stock market 217 table 8 presents the results of testing the turn of the month effect in mean (equation 7). the turn of the month effect appears to be absent from the fyrom stock exchange regardless the fact that coefficient (λ5) is statistically significant at a 95% level of confidence. table 8. the tom effect in mean index 0 1 2 3 4 5 6 wald mbi – 10 index 0.0761 (0.2574) 0.1521 (0.2561) 0.1626 (0.2568) -0.2084 (0.2559) 0.2461 (0.2563) 0.5621** (0.2562) 0.0824 (0.2561) 1.1521 [0.3299] results of the turn of the month effect in variance (equation 8), presented at table 9, are in line with those of the mean model, since the wald test results cannot reject the null hypothesis of equal variances (although, coefficient δ5 appears to be ‘weakly’ significant). table 9. the tom effect in volatility index  β γ 1 2 3 4 5 6 wald mbi – 10 index 0.2587** (0.1071) 0.1534*** (0.0464) 0.7519*** (0.0577) -0.5445 (0.3526) -0.2389 (0.3579) 0.4828 (0.4824) -0.8131 (0.3639) 2.0348 (3.9219) -2.7158 (3.0141) 1.0822 [0.3801] table 10 presents the calculations from testing the time of the month effect in the mse, where it was found that this effect is not present using the mean equation (equation 9), since none of the tested variables present significance. table 10. the time of the month effect in mean index 0 1 2 wald mbi – 10 index 0.1849 ** (0.0941) -0.0171 (0.0008) -0.1701 (0.1325) 1.0237 [0.3598] finally, table 11 shows the estimation results for the variance model (equation 10). these findings appear to be in line with the mean model estimates; the only difference is that coefficient (δ2) shows a very weak sign of significance at only 10 percent level. however, overall significance as measured by the wald test implies no rejection of the null hypothesis. table 11. the time of the month effect in volatility index    1 2 wald mbi – 10 index 0.4038** (0.1464) 0.1501*** (0.0394) 0.7671*** (0.0619) -0.1911 (0.1624) -0.2984* (0.1608) 1.7642 [0.1729] 5. summary and concluding remarks this study has provided an exhaustive empirical analysis for five calendar effects in mean stock returns and their variances in order to test the existence / non – existence of these market anomalies in the fyrom stock exchange (mse) by using daily closing values of the mbi – 10 index, for the period 2002 2008. we documented the existence / non-existence of the january (monthly) effect, the monday (day) of the week effect, the half month effect, the turn of the month effect and the time of the month effect in mean stock returns (ols) and their variances (garch 1,1). the empirical analysis is summarized and tabulated in table 12 for the mean and the variance models. it clearly emerges from the table that the day of the week effect and the monthly effect are present in the mse using both mean (ols) and variance (garch) equations. these findings suggest that calendar effects are real and exist in the stock markets around the world especially in the newly formed and emerging financial markets. the case of the former yugoslav republic of macedonia is evidence pointing in this direction. however, we would expect a larger number of calendar effects to be significant, since the other three tested anomalies (i.e. half month effect, turn of the month effect and time of the month effect) have been found absent from the mse. so, it would be interesting to international journal of economics and financial issues, vol. 1, no. 4, 2011, pp.211-219 218 investigate whether these three absent calendar anomalies were present the years before the period covered from this survey (i.e. 1996 – 2002). table 12. summary of calendar effects mbi – 10 index in mean in variance day of the week effect weak strong monthly effect strong strong half month effect none none turn of the month effect none none time of the month effect none none in a decision-making process, a rational financial decision maker must take into account not only returns but also the variance (i.e. risk) or volatility of returns. the calendar effect patterns in return and volatility might encourage investors to take advantage of some regular market shifts by designing and implementing trading strategies, which account for such predictable patterns. uncovering certain volatility patterns in returns might also benefit investors in valuation, portfolio optimisation, and risk management. however, obtaining profits from calendar anomalies is a risky business, especially in balkan stock markets (e.g. fyrom stock exchange), which display high volatility and sudden movements that cannot be followed reactively. future research may examine the calendar anomalies on emerging markets such as mse by covering a switch from a strong bull to a severe bear 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(2003), ‘anomalies and market efficiency’, in handbooks of the economics of finance (eds) konstantinides g., harris m. and stulz r., north – holland, amsterdam, 937–972. steeley, j.m. (2001), ‘a note on information seasonality and the disappearance of the weekend effect in the uk stock market’. journal of banking and finance, 25, 1941 – 1956. thaler, r.h. (1987a), ‘anomalies: the january effect’. journal of economic perspectives, 1, 197-201. thaler, r.h. (1987b), ‘anomalies: seasonal movements in security prices ii: weekend, holiday, turn of the month and intra-day effects’. journal of economic perspectives, 1, 167-177. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(4), 61-67. international journal of economics and financial issues | vol 8 • issue 4 • 2018 61 the relationship between exchange rate volatility and foreign direct investment in turkey: toda and yamamoto causality analysis zerrin kiliçarslan* erciyes university, kayseri vocational school, turkey. *email: zkaan@erciyes.edu.tr abstract many countries have embraced the floating exchange rate system with the collapse of the bretton woods system. as a result of the transition to the floating exchange rate system, the volatilities in exchange rates have become a major problem for countries. the volatility in exchange rates affects the expected benefits of foreign direct investments (fdi) as it increases uncertainty for investors. therefore, fdi has become one of the important factors affecting the flow of investment. in this study, the relationship between exchange rate volatility and fdi in turkey for the period 2005q4-2018q1 was analyzed using toda-yamamoto causality test. real effective exchange rate volatility is estimated using the generalized autoregressive conditional heteroscedasticity model. as a result, a one-way causality relationship from fdi to exchange rate volatility has been found. keywords: foreign direct investment, exchange rate volatility, toda and yamamoto causality jel classifications: f21, f31, c22 1. introduction many countries have adopted the floating exchange rate system by abandoning the fixed exchange rate system with the collapse of the bretton woods system. with the adoption of the floating exchange rate system, the volatilities in exchange rates have become a major problem for countries. exchange rate volatility refers to all movements and changes that are effective for the depreciation/valuation of a currency (martins, 2015. p. 14). exchange rate volatility is an important factor that investors take into account when making investment decisions abroad. exchange rate volatility affects the prices and quantities of the inputs and outputs of the mncs and leads to competitiveness in the global market (kumarasamy, 2010. p. 1). exchange rate volatility affects the expected returns of foreign direct investments (fdi), which are considered as capital transfers. for this reason, both the level of exchange rate and the level of volatility may have an effect on the investment level (chowdhury and wheeler, 2008. p. 2; asmah and andoh, 2013. p. 2). exchange rate volatility can encourage or deterrent direct foreign investments. the withdrawal of fdi, which has a positive influence on economic growth, has become an important policy target for many countries. fdi has many positive externalities such as providing foreign currency inflows, increasing capital accumulation, creating employment, providing technology and skill transfer, and increasing productivity. according to husek and pankova (2008), the depreciation of the currency of the host country will attract fdi inflows for two reasons. first, the depreciation of the currency reduces the production costs (labor and other productive inputs) in the home country, thus makes the home country attractive for fdi seeking production efficiency. second, the depreciation of the currency of the host country lowers the value of assets in the host country in other currencies, including the currency of the home country. according to this, the cost of fdi in foreign currency is decreasing and the host country is becoming attractive for fdi (asmah and andoh, 2013. p. 1-3). fdi can also affect exchange rate volatility. fdi can increase productivity in the traded good sector and thus reduce real exchange rate volatility by balancing the relative prices of nontraded goods. fdi inflows lead to appreciation of the real exchange rate by increasing the capital stock in the host country. fdi kiliçarslan: the relationship between exchange rate volatility and foreign direct investment in turkey: toda and yamamoto causality analysis international journal of economics and financial issues | vol 8 • issue 4 • 201862 increases existing capital stock and causes technology to spread. technology spillovers lead to increased production and lower prices of non-tradable goods. thus, fdi leads to depreciation of real exchange rate. however, the increase in the production of non-traded goods increases the disposable income and thus the exchange rate appreciates (biswas and dasgupta 2012. p. 335). the purpose of this study, the relationship between fdi and foreign exchange rate volatility by toda and yamamoto causality test to analyze for example 2005q4-2018q1 period in turkey. the rest of the paper is organized as follows. the next section provides the theoric framework on the relationship between fdi and exchange rate volatility. in section 3 provides an overview of the applied literature on the relationship between fdi and exchange rate volatility. in section 4, data and econometric methodology adopted to estimate the causality relationships among the selected variables are presented. the results from toda yamamoto causality analysis are summarized in section 5, while the final section 6 provides brief conclusions. 2. the impact of exchange rate volatility on foreign direct investment foreign investors are directing their investments to other countries in order to reduce their production costs and to benefit from cheap raw materials and labor in the host country. fdi depends on factors such as economic and political structure, investment incentives, trade policies (tax exemption or reduction) in the country to be invested. besides these, real exchange rate volatility also affects direct foreign investment decisions. real exchange rate volatility creates an ambiguous environment for investment decisions. such an environment causes either “redistribution of resources between sectors and countries” (production flexibility) or “investors delay investment decisions” (postpone, delay hysteresis) (azid and kousar, 2005. p. 749-750). 2.1. production flexibility approach and export substitution according to aizenman (1992), foreign direct investment is motivated by the initiative of the manufacturer to increase production flexibility. this flexibility offers the manufacturer the option of adjusting the international production model, at the cost of extra production capacity transportation cost (aizenman, 1992. p. 2). the production flexibility approach suggests that exchange rate volatility leads to redistribution of resources between sectors and countries. the basic assumption of this approach is that producers must have the flexibility to adjust variable factors (i.e., capital costs, labor costs, etc.) following price variability as a consequence of foreign exchange movements, and thus tend to invest more. when exchange rate volatility increases in the host country, firms place greater emphasis on manufacturing flexibility advantage against the uncertainty risk. in countries experiencing uncertainty about the exchange rate, fdi may be higher because this uncertainty is an obstacle to trade. multinational companies shift the production of their exported products to foreign markets through direct capital investments. multinational companies shift the production of their exported products to foreign markets through direct capital investments. this reduces costs and creates a new market for the product. therefore, to avoid the uncertainty affecting the price of the goods they trade, multinational companies are increasing their fdi to replace the decline in trading volumes at the higher volatility markets (goldberg and kolstad, 1995, khraiche and gaudette, 2013. p. 3144, kumarasamy, 2010. p. 11). the level of exchange rate affects the fdi in many directions depending on the target of the goods produced. if the investor wants to produce for the host country’s market, fdi and trade can be considered as substitutes. in this case, the appreciation of the home country currency increases the purchasing power of local consumers, thereby increasing fdi inflows. on the other hand, a depreciation of the real exchange rate of the recipient country increases the fdi by reducing the cost of capital (chowdhury and wheeler, 2008. p. 2). as a result, according to this approach, exchange rate volatility of host country is increasing fdi. this effect occurs in the long term. 2.2. hysteresis (postpone or delay) theory firms tend to postpone or delay their investments (e.g.. in the acquisition process) when faced with high exchange rate volatility. in the face of uncertainty, firms often prefer not to wait instead of sticking to a certain production capacity. waiting is a suitable alternate for investing or not investing (brzozowski, 2003. p. 8). since fdi usually involves sunk costs in foreign countries, the best response of multinational companies may be to wait for a more favorable exchange rate before investing abroad. therefore, the irrevocability of investment expenditures and the expectation of new information leads to investment decisions being sensitive to the real exchange rate uncertainty (jeanneret, 2007. p. 2). according to goldberg (2009), the logic underlying the approach to avoidance of risk is that investors want to compensate for the risks that the uncertainty of the exchange rate leads to in the investment returns. when exchange rates are highly variable, the expected values of investment projects are reduced and thus fdi is reduced (asmah and andoh, 2013. p. 2). this effect is considered more effective than the production flexibility approach in explaining the shortterm effects of exchange rate volatility (nyarko et al., 2011. p. 279). as a result, according to this approach fdi decreases as volatility increases in exchange rate. 3. literature review numerous empirical studies have been conducted to analyze the effect of exchange rate volatility on fdi. some studies have shown that exchange rate volatility has a positive effect on fdi and some have a negative effect. in table 1, some of the studies examining the effect of exchange rate volatility on fdi are given. 4. data and econometric methodology 4.1. data in this study, fdi (us dollars) and exchange rate volatility variable will be used for the 2005q4-2018q1 period in turkey. because kiliçarslan: the relationship between exchange rate volatility and foreign direct investment in turkey: toda and yamamoto causality analysis international journal of economics and financial issues | vol 8 • issue 4 • 2018 63 author period/country method conclusion dal bianco and to loan (2017) 1990-2012 10 selected latin america and the caribbean region panel data analysis a statistically significant negative effect of exchange rate volatility on fdi is found kenneth et al. (2017) 1980-2014 kenya error correction model, multiple regression exchange rate volatility coefficient is negative martins (2015) 1976-2013 brazil ardl approach reer volatility has a statistically significant negative impact on brazilian fdi inflows in both short and long-terms polat and payaslıoğlu (2015) 2004–2014 turkey markov switching model there was no evidence supporting the effect of rer level or volatility on monthly fdi inflows azhar et al.(2015) 1981-2013 saarc countries gmm the result shows that there is a negative relationship between exchange rate volatility and fdi abri and baghestani (2015) 1980-2011 eight emerging asian countries time-series and panel data analysis results indicate that greater foreign investment in the form of fdi was more effective in reducing real exchange rate volatility for china, india, malaysia, singapore, and south korea. in contrast, greater fdi increased real exchange rate volatility for indonesia, the philippines, and thailand wang (2013) 1994-2012 bric countries ardl approach, cointegration, error correction model the results indicate a negative long-run relationship between exchange rate volatility and fdi for india and russia. the existence of a short-run association was found in china, india, and russia. however, for brazil no connection between the two variables was observed asmah and andoh (2013) 1975-2011 27 subsaharan african countries gmm the exchange rate volatility has a strong negative influence on fdi chaudhary et al. (2012) 1980-2010 asian economies ardl approach there is positive and significant effect of volatility exchange rate on fdi in long run and short run ullah et al. (2012) 1980-2010 pakistan cointegration technique exchange rate volatility negatively relates with the fdi renani and miraftah (2012) 1980q2-2006q3 iran johansen and juselius’s cointegration system approach the findings of this study reveal that volatility of exchange rate have negative relationship with fdi ellahi (2011) 1980-2010 pakistan ardl approach the result shows that exchange rate volatility has negative impact on fdi inflow in short run and has positive impact in long run osinubi and amaghionyeodiwe (2009) 1970-2004 nigeria error correction model exchange rate volatility has positive and significant impact on fdi udomkerdmongkol et al. (2009) 1990-2002 16 emerging countries from latin america, asia and africa panel data analysis the results show that exchange rate volatility has a negative effect of on fdi del bo (2009) 1982 and 2005 53 developed and developing countries panel data analysis the results show that exchange rate volatility has a damping effect on fdi flows. schmidt and broll (2009) 1984–2004 outward fdi flows from the us to six selected partner countries. panel data analysis the empirical analysis shows that exchange rate volatility has a statistically significant negative effect on us outward fdi flows for the majority of industries. udoh and egwaikhide (2008) 1970-2005 nigeria regression analysis the results concluded that inflation uncertainty and exchange rate volatility negatively and significantly affected the fdi in nigeria table 1: relationship between fdi and exchange rate volatility survey (contd...) kiliçarslan: the relationship between exchange rate volatility and foreign direct investment in turkey: toda and yamamoto causality analysis international journal of economics and financial issues | vol 8 • issue 4 • 201864 it is an unobservable variable, the real exchange rate volatility series will be measured by the conditional variance values to be obtained from the generalized autoregressive conditional heteroscedasticity (garch) model (bollerslev, 1986). the real effective exchange rate and fdi data are taken from bruegel and ifs, respectively. the variables were seasoned and their logarithms were taken. in this study, exchange rate volatility and to analyze the relationship between direct foreign investment for turkey, toda and yamamoto (1995) causality test will be used. before doing toda and yamamoto (1995) causality analysis, the augmented dickey-fuller and phillips-perron (p-p) unit root tests will be used to determine the stationarity of the series. the toda-yamamoto (1995) test can be used to estimate the var model in which the level values are included, even if the variables are not stationary. therefore, information losses can be prevented. for the todayamamoto method, the maximum integration level (dmax) of the variables and the lag length (k) should be determined using the var model. the maximum integration degree (dmax) of the variables must be smaller than the lag length (k). then, the lag length (k) is added to the highest degree of integration (dmax). the var model for lag [k+(dmax)] is estimated. mwald hypothesis test is applied. it is determined whether there are causalities by investigating whether the coefficients of k lags in the system var (k + dmax) are equal to zero as a group with mwald test. more specifically, causality relation is determined if the h0 hypothesis that the coefficients are equal to zero as a group and the result of the mwald test is rejected. it is assumed that the error terms are subject to a zero mean, a constant variance, and a white noise process in which autocorrelation does not exist. in this case, the var model for exchange rate volatility (vol) and fdi can be written as: lfdi lfdi lfdi lvol t i i k t i j t j j k k d i t i = + + + = − − = + + − ∑ ∑α α α δ 0 1 1 2 1 1 max ii k j t j j k k d tlvol = − = + + ∑ ∑+ + 1 2 1 1 δ λ max (1) lvol lvol lvol lfdi t i i k t i j t j j k k d i t i = + + + = − − = + + − ∑ ∑β β β ϕ 0 1 1 2 1 1 max ii k j t j j k k d tlfdi = − = + + ∑ ∑+ + 1 2 1 2 ϕ λ max (2) according to equation 1, the h0 hypothesis implies that the exchange rate volatility is not a granger cause of fdi. that is, if δ1i≠0ɐi, it will be one-way causality relation from foreign exchange rate volatility to fdi. in equation 2, the h0 hypothesis is that fdi is not the granger cause of the exchange rate volatility. similarly, if ϕ1i≠0ɐi, fdi is expressed as granger’s cause of exchange rate volatility. 4.2. econometric results 4.2.1. real effective exchange rate volatility modeling in this study, the garch model is used in the real effective exchange rate volatility modeling (bollerslev, 1986). in the garch (p, q) process, the lagged values of the conditional author period/country method conclusion coleman and tettey (2008) 1970-2002 ghana cointegration and ecm the study showed that the volatility of the real exchange rate has a negative influence on fdi inflow furceri and borelli (2008) 1995-2004 35 emu neighbourhood countries panel data analysis the results show that while there is not a linear relation between exchange rate volatility and fdi, the effect of exchange rate volatility crucially depends on the level of openness chowdhury and wheeler (2008) 192-2005 canada, japan, the united kingdom, and the united states var model the results show that shocks to exchange rate fluctuations have a positive effect on fdi and that this effect is realized with a lag goldberg and kolstad (1995) 1978 and 1991 canada, japan and uk adf unit root test and regression analysis exchange rate uncertainty increases fdi by foreign firms barrell et al. (2003) 1982-1998 europe and uk gmm they found strong negative relation between us fdi and exchange rate volatility in europe and uk brzozowski (2003) 1990 19 emerging market and 13 transition countries fixed effects ols and gmm arellano-bond models exchange rate uncertainty and volatility may negatively influence the decision to locate investment in transition and accession countries. nominal exchange rate uncertainty seems to particularly hamper fdi inflows in accession countries benassy-quere et al (2001) 1984-1996 42 developing countries panel data analysis they found a negative impact of exchange rate volatility on flows of fdi. cushman (1988) 1963-1986 the united states from the united kingdom, france, germany, canada and japan seemingly unrelated regressions approach the results show that there is a significant positive correlation between exchange rate volatility and fdi flows fdi: foreign direct investments, ardl: auto regressive distributed lag table 1: (continued) kiliçarslan: the relationship between exchange rate volatility and foreign direct investment in turkey: toda and yamamoto causality analysis international journal of economics and financial issues | vol 8 • issue 4 • 2018 65 variance are also included in the model. the garch (p, q) model is defined as follows: σ ω α ε β σt i t j t j i q i p 2 1 2 2 11 = + +− − −= ∑∑ (3) in equation 2, σ2 denotes the conditional variance of the error term. the first term (ω) represents the average, the second term is the arch term, and the third term is the garch term. in this study, the ma (1) model is constructed for the real effective exchange rate and it is tested whether the real effective exchange rate variable has the autoregressive conditionally varying variance (arch). the lagrange multiplier (lm) test developed by engle (1982) is used when testing whether a variable contains arch effects in the literature. the hypothesis set in equation 2 is tested. h0 = α1=α2= =αp=0 h0 ≠ α1≠α2≠ ≠αp≠0 (4) in the case of lm>  p 2 (p degrees of freedom) table, the null hypothesis can be rejected and the existence of arch effect and model specification can be decided. after accepting the arch effect, the most commonly used garch (1,1) model for volatility estimation was developed. as shown in table 2, according to the arch lm test for determining volatility in real effective exchange rate, the probability value of χ2 was found to be significant at 5% level. this result indicates that the null hypothesis, which means equal variance, will be rejected, that is, the arch effect exists. so it has serial volatility. thus, the garch variance series obtained from the garch (1,1) effect in the real exchange rate shows that it can be used as a measure of the real exchange rate volatility. in table 3, the estimated coefficients of exchange rate volatility for turkey is presented. 4.2.2. unit root test results before beginning the analysis of toda and yamamoto (1995) causality, adf (augmented dickey fuller, 1981) and pp (phillips and perron, 1988) unit root tests were used to determine the maximum degree of integration of the variables in the model. the unit root test results of the variables in the study are presented in table 4. according to the adf test and the phillips-perron test, the level of the foreign variable was not stationary. however, the first difference was found to be stable at the direct investment level of 5% significance. the volatility variable was found to be stationary at the level value. in this case, the maximum degree of integration of the variables is (dmax = 1). 4.2.3. determination of lag length to be able to perform the toda-yamamoto test, the number of lag length to be used in the var model needs to be determined. the lag length, which makes the critical values such as lr, final prediction error (fpe), akaike (aic) and hannan quinn (hq) smallest, is determined as 2 (table 5). according to the results, the appropriate number of lag for the toda-yamamoto causality test was determined by adding the maximum degree of integration of the variables (dmax = 1) to the optimal number of delays for the var model (k = 2). var model was estimated at 3rd grade [(k + dmax) = 2+1=3] and mwald hypothesis test was performed. in the toda-yamamoto causality table 2: lm test results heteroskedasticity test: arch f-statistic 36.30182 prob. f (1,47) 0.0000 obs*r2 21.35355 prob. chi-square (1) 0.0000 ardl: auto regressive distributed lag, lm: lagrange multiplier table 3: estimated coefficients of exchange rate volatility for turkey test coefficient standard error z-value p-value garch (1,1) −0.120391 0.045275 −2.659089 0.0078 table 4: adf and phillips-perron unit root test results variable adf (%5) phillips-perron (%5) level (intercept) 1st different (intercept) level (intercept) 1st different (intercept) order of integration lfdi −2.543538 (−2.922449) −6.744010 (−2.923780) −2.675275 (−2.922449) −6.767569 (−2.923780) i (1) lvol −5.981510 (−2.922449) −7.648950 (−2.925169) −5.981510 (−2.922449) −19.90862 (−2.923780) i (0) table 5: determination of lag length lag logl lr fpe aic sc hq 0 −114.0441 na 0.860855 5.525907 5.608654 5.556237 1 −30.11232 155.8732 0.019147 1.719634 1.967873* 1.810623 2 −24.22901 10.36584* 0.017535* 1.629953* 2.043684 1.781601* 3 −22.93090 2.163519 0.020023 1.758614 2.337837 1.970922 4 −19.31384 5.683948 0.020539 1.776849 2.521565 2.049817 5 −15.07451 6.258061 0.020541 1.765453 2.675661 2.099080 6 −14.59153 0.666961 0.024703 1.932930 3.008630 2.327217 7 −11.77039 3.627180 0.026760 1.989066 3.230259 2.444013 8 −10.95790 0.967250 0.032173 2.140853 3.547537 2.656458 *indicates lag order selected by the criterion. lr: sequential modified lr test statistic (each test at 5% level). fpe: final prediction error. aic: akaike information criterion. sc: schwarz information criterion. hq: hannan-quinn information criterion kiliçarslan: the relationship between exchange rate volatility and foreign direct investment in turkey: toda and yamamoto causality analysis international journal of economics and financial issues | vol 8 • issue 4 • 201866 test, there is no need for preliminary tests used to determine unit root and cointegration properties. as can be seen from table 6, according to the results of the modifiye wald (mwald) statistic, there is a one-way causality relation from fdi to vol and h0 is rejected. nevertheless, there was no causality relation from vol to fdi. the h0 hypothesis has been rejected. in this case, the period of analysis for turkey, oneway causal relationship between fdi and exchange rate volatility has been found. the direction of causality is from fdi to vol. 5. conclusion foreign investors are investing in countries other than the home country, such as reducing costs, making use of cheap raw materials and labor from the host country. fdi depends on various factors (economic and political structure, investment incentives, trade policies) in the host country. in addition, the real exchange rate volatility, which causes uncertainty for investment decisions, also affects fdi decisions. on the one hand, uncertainty arising from exchange rate volatility in the host country leads to an increase in fdi, which leads to redistribution of resources. on the other hand, it causes investors to postpone investment decisions and thus reduce fdi. in this study, the relationship between exchange rate volatility of fdi in turkey, were analyzed using toda-yamamoto causality test. one-way causality relation has been found from fdi towards exchange rate volatility. this result shows that exchange rate volatility is influenced by fdi inflows, which is a major source of capital financing. in the literature examining real exchange rate volatility and fdi relationship, most of the studies analyzed the effect of exchange rate volatility on fdi . few studies have examined the effect of fdi on exchange rate volatility (abri and baghestani, 2015). this study differs from 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(2007), foreign direct investment and exchange rate volatility: a non-linear story. national centre of competence in research financial valuation and risk management working table 6: toda-yamamoto causality test results null hypothesis chi-square (χ2) probability decision lvol is not the cause of lfdi 2.309271 0.5107 h0is accepted lfdi is not the cause of lvol 8.917796 0.0304 h0 is rejected kiliçarslan: the relationship between exchange rate volatility and foreign direct investment in turkey: toda and yamamoto causality analysis international journal of economics and financial issues | vol 8 • issue 4 • 2018 67 paper no. 399. kenneth, m.k., muniu, j., kosgei, m. (2017), short and long run effects of exchange rate volatility on foreign direct ınvestment in kenya. international journal of economics, commerce and management, 5(11), 386-389. khraiche, m., gaudette, j. 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(1988), testing for a unit root in time series regression. biometrika, 75(2), 335-346. polat, b., payaslıoğlu, c. (2015), exchange rate uncertainty and fdi inflows: the case of turkey. asia-pacific journal of accounting and economics, 23(1), 112-129. renani, h.s., maryam, m. (2012), the ımpact of exchange rate volatility on foreign direct ınvestment in iran. procedia economics and finance, 1, 365-373. schmidt, c.w., broll, u. (2009), real exchange rate uncertainty and us foreign direct ınvestment: and empirical analysis. review of world economics, 145(3), 513-530. toda, h.y., yamamoto, t. (1995). statistical ınference in vector autoregressions with possibly ıntegrated processes. journal of econometrics, 66(1-2), 225-250. udoh, e., egwaikhide, f.o. (2008), exchange rate volatility, ınflation uncertainty and foreign direct ınvestment in nigeria. botswana journal of economics, 5(7), 14-31. udomkerdmongkol, m., morrissey, o., gorg, o. (2009), exchange rates and outward foreign direct ınvestment: us fdi in emerging economies. review of development economics, 13(4), 754-764. ullah, s., haider, s.z., azim, p. (2012), impact of exchange rate volatility on foreign direct ınvestment a case study of pakistan. pakistan economic and social review, 50(2), 121-138. wang, d. (2013), the impact of exchange rate volatility on foreign direct investment (fdi) in bric countries research project submited in partial fulfillment of the requirements for the degree of master of finance, saint mary’s university . international journal of economics and financial issues | vol 6 • special issue (s4) • 2016 111 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s4) 111-117. special issue for "international conference of accounting studies (icas 2015), 17-20 august 2015, institute for strategic and sustainable accounting development (issad), tunku puteri intan safinaz school of accountancy, college of business, universiti utara malaysia, malaysia" the nexus between rates of return on deposits of islamic banks and interest rates on deposits of conventional banks in a dual banking system: a cross country study abdurraheem abdulazeez adewuyi1*, asmadi mohamed naim2 1islamic business school, college of business, universiti utara malaysia, malaysia, 2associate professor of islamic finance, islamic business school, college of business, university utara malaysia. *email: aabdulaziz70@yahoo.co.uk abstract the paper investigates the existence of a long-run relationship between conventional interest rates (ir) and rates of return on deposit of islamic banks in the contemporary dual banking systems on a cross-country basis. the study employs autoregressive distributed lag (ardl) modeling approach to cointegration analysis. the study finds the existence of the long run relationship between rates of return on deposits of islamic banks and ir on deposits of conventional banks during the period 2007-2015. the study also finds a bidirectional causal relationship running between rates of return on deposits of islamic banks and conventional ir. the study statistically provides empirical insight into the relationship between the rate of return on deposits of islamic banks and the conventional ir on a cross-country basis using an ardl model. keywords: dual banking, co-integration, autoregressive distributed lag, malaysia, indonesia, bahrain jel classification: g2 1. introduction islamic financial system, given its ethical value propositions, is considered a more equitable alternative to the conventional financial system. it proposes risk and reward sharing system among the stakeholders as against risk-transfer system of the conventional financial system. this proposition is aptly captured in the axiom al ghunm bil ghurm (i.e., one is entitled to gain only if he assumes responsibility for risk) and also al-kharaj bil dhaman (i.e., the gain must accompany liability for loss) (isra, 2013). this fundamental concept of islamic finance underlines the principles of justice, fairness, and equity between surplus units and deficit units of financial markets. these principles explain the prohibition of interest as a “price” in economic and financial transactions under sharia. however, there have been concerns towards the practice of islamic financial institutions (ifis) benchmarking many of their financial services on the conventional interest rates (ir). this is considered as being paradoxical to a genuine spirit of the prohibition of ir under sharia. el-gamal (2003) observes that the bulk of islamic financial services are benchmarked on ir such as london inter-bank offer rate. this becomes an issue of great concern as most muslim deposit customers of islamic banks keep their monies with islamic banks to screen their wealth from the effects of ir. the concern is further reinforced by the saying of the prophet (may peace be upon him) as reported by abu sa'id al-khudri who reported allah's messenger (pbuh) as saying: “you would tread the same path as was trodden by those before you inch by inch and step by step so much so that if they had entered into the hole of the lizard, you would follow them in this also” sahih muslim: book 34, (6448). chong and liu (2009) in their study on the rate of return (ror) risk of islamic financing in malaysia concluded that islamic banking system in malaysia is not very different from the conventional banking system. this has been raising questions on the inherent capability of islamic financial system as being a better alternative to the conventional financial system. adewuyi and naim: the nexus between rates of return on deposits of islamic banks and interest rates on deposits of conventional banks in a dual banking system: a cross country study international journal of economics and financial issues | vol 6 • special issue (s4) • 2016112 ifis in dual banking systems such as in malaysia, indonesia, and bahrain operate within the same economic and financial environments as their conventional counterparts. these operating environments are usually not structured by islamic economic and financial norms and values. the ifis therefore, have to compete not only among themselves but also with other conventional financial institutions. given the reality of their operating environments and exigency of overriding business interest, ifis undertake some financial services with reward systems akin to conventional services such as taking a deposit from customers and reward them in like manner as deposit customers in conventional banking system. even though ifsa 2013 (islamic financial services act, 2013) in malaysia has introduced some fundamental changes in the treatment of customers’ investment deposit accounts in islamic banks’ balance sheet, it is imperative to investigate the relationship between the conventional ir and ror on deposit of islamic banks. asmadi and zairani (2015. p. 25) espousing the position of sharia on the issue of ir in islamic financial transactions state that “an important feature of ifis is that in line with the prohibition of payment and receipt of a fixed or pre-determined rate of interest, the ror is not known and is not fixed. the ror can be determined only ex-post or by the actual profit accrued from real sector activities.” this presupposes that ror on islamic bank deposit which could only be determined ex-post should not have a relationship with the conventional ir which is usually predetermined. the prohibition of payment and receipt of the ir as captured above is anchored on the warning from allah; see (qur’an 2: 278-279). however, a number of studies have shown that countries like malaysia and turkey where both conventional and islamic banking systems coexist, ir, albeit indirectly, influences the behavior of ifis (haron and ahmad, 2000; obiyathulla, 2004, 2008; kaleem and md isa, 2008; zainol and kassim, 2012; anuar et al., 2014; ergec and kaytanci, 2014). the objective of the paper is to investigate the existence of a long run associations between conventional banks’ deposit ir and rates of return on deposit of islamic banks in the contemporary dual banking systems as is the case in malaysia, indonesia, and bahrain. the study employs autoregressive distributed lag (ardl) model to investigate the existence or otherwise of long run association between conventional ir and ror on deposit of islamic banks. the paper is divided into five sections. section one gives a brief introduction and followed by a review of the existing literature. the third section discusses the methodology while the fourth section shows the data analysis. the final section summarizes the main findings and concludes the paper. 2. literature review haron and ahmad (2000) in their study of the effects of conventional ir and rate of profit on funds deposited with islamic banking system in malaysia find a negative relationship between the ir of conventional banks and the interest-free deposits in islamic banks in malaysia. this means that when conventional ir rises, deposit size of islamic banks tends to fall. the study adopted the adaptive expectation model to measure the effects of rate of profit declared by islamic banks on deposits placed by their customers. obiyathulla (2004) concludes that though, islamic banks operate on interest-free principles, the economic environment in a dual banking system inevitably exposes them to the problems of ir risk the way it affects the conventional banks. it was found that despite the fact that islamic banks and conventional banks operate under different laws in malaysia, there appears to be the interaction of forces between the two systems (obiyathulla, 2008; zainol and kassim, 2012). obiyathulla (2004) finds that a dual banking system such as in malaysia provides an avenue for linkage and arbitrage between the two banking systems which are usually exploited particularly by non muslim customers who operate without hindrance in the two segments of the nation’s financial market. similarly, cevik and charap (2011) investigated the behavior of conventional and islamic bank deposit returns in malaysia and turkey and found that between january 1997 and august 2010, the correlation between conventional bank deposit rates and islamic banks’ deposit rates of return were as high as 91% for malaysia and 92% for turkey. the study provides evidence that changes in islamic banks’ deposit rates of return are caused by changes in conventional bank deposit rates. kaleem and md isa (2008) in their study of the impact of fluctuation of the conventional ir on islamic term deposit ror confirm the relationship between conventional ir and ror paid by islamic banks on their deposit accounts. the study uses the interest offered by commercial banks, finance companies, and merchant banks. the study concludes that conventional deposit ir granger causes deposit profit rate of islamic banks. the study was however limited to malaysian banking operating environment. kasri and kassim (2009) also investigated determinants of savings in the islamic banks in indonesia and found an inverse relationship between conventional ir and deposits of islamic banks. this means that when ir rises the deposit of islamic banks falls. this suggests that investment deposit account holders in islamic banks are also utility maximizers and, therefore, can be influenced by changes in conventional ir in their investment decisions just like conventional banks’ depositors. zainol and kassim (2012) also find that islamic banks are sensitive to changes in the conventional ir because many islamic banks’ products are benchmarked against the conventional ir. they further assert that volatility of the conventional ir affects islamic banks’ incomes as well as the value of the banks’ assets and liabilities. the study concludes that ir movements could lead to depositors switching their accounts in banks. sanwari and zakaria (2013) in their study of the sensitivity of islamic banks to macroeconomic conditions conclude that islamic banks are sensitive to movements in ir. the study affirms that islamic banks, to retain their customers often, face displaced commercial risk. in this case, they have no alternative than to increase the profit payable on deposits of investment account holders when the market ir goes up. adewuyi and naim: the nexus between rates of return on deposits of islamic banks and interest rates on deposits of conventional banks in a dual banking system: a cross country study international journal of economics and financial issues | vol 6 • special issue (s4) • 2016 113 the findings of anuar et al. (2014) corroborate the results of many of the previous studies that profit rates of islamic banks are significantly influenced by the ir of the conventional banks both in the short and long run. the study determines the existence or otherwise of association between profit rates of islamic banks and ir of conventional banks in malaysia. the study employs var order selection procedure and johansen cointegration test to determine the existence of a long-run relationship between islamic profit rates and conventional bank ir in malaysia. it also uses granger-causality test to determine the direction of causality between the variables. their findings suggest that the actual practice of islamic banks in the area of profit rate determination is at divergence with the principle of islamic finance which is to a large extent by profit-loss sharing principle. similarly, ergec and kaytanci (2014) found causality running from conventional deposit ir to the ror on deposit of turkish islamic banks. however, contrary to the studies asserting the influence of conventional ir on islamic ror, a study on indonesia by affandi and tamanni (2010) finds that islamic banking deposits are not sensitive to the ir as an instrument of monetary policy changes in indonesia. also in this line of the argument, ariffin and tafri (2014) provide evidence that ir has no influence on the operations and particularly the quality of the assets of the ifis. from the literature, it is observed that most studies are mostly focused on malaysia, turkey, and indonesia. this study, therefore, aims at further expanding and enriching the literature on the association between conventional ir and ror on deposit of islamic banks by extending the investigation to cross country dual banking operating environments. this allows for a broader view of the effect of conventional ir on the ror of islamic bank deposits. this study also employs a sophisticated econometric technique, ardl approach to cointegration introduced by pesaran and shin (1999) and pesaran et al. (2001). ardl approach to cointegration is considered to have a greater advantage over the other approaches to cointegration because it is applicable even if the variables are integrated of different orders and allows assignment of the various optimum lags to variables in determining cointegration (raji et al., 2014). cointegration exists only when there is truly a relationship linking two variables becomes overriding requirement for any economic model using non-stationary time series data (asteriou and hall, 2007). 3. methodology 3.1. data collection and analysis the data for the study are made of ir on deposit of conventional banks, the ror on deposit of islamic banks, money supply, and inflation. the ror on deposit of islamic banks is the dependent variable; ir is the key explanatory variable while real money supply and inflation serve as control variables. the study uses ror on 3-month tenor deposits of islamic banks and the ir on 3-month tenor term deposits of conventional banks for malaysia, indonesia, and bahrain. it employs quarterly data from 2007 to 2015. the data are obtained from the monthly statistical bulletins and other reports of the central banks of each of these countries. 3.2. model the study employs ardl approach to cointegration otherwise called bound test to determine the long run association between ror on deposits of islamic banks and rate of interest of conventional banks. ardl was introduced by pesara and shin (1999) and pesaran et al. (2001). the study also employs granger-causality test to determine the direction of the causal effect of the variables. the following general equation is presented: 1 0   − − = = = + + +∑ ∑ n m t i t i i t i t i i y y x u (1) the ardl involves two stages. the first stage is to investigate the existence of long-run relationship between the variables by computing the f-statistics. f-statistics test the joint significance of the parameters. the computed value of f-statistics is compared with the two bounds i(0) and i(1) critical values. the existence of cointegration is established if the computed f-statistics is greater than the upper bound critical value. on the other hand, if the value of f-statistics is lower than the lower bound critical value, nonexistence of cointegration is therefore established. however, if the value of f-statistics falls between the two bound critical values, the result is inconclusive. we move to the second stage to estimate both long run information and how much of the adjustment to the long equilibrium takes place in each period. at this juncture the coefficients of the long term relations are estimated and error correction model associated with the long-run estimates obtained. the rule is that ecm must have a significant probability value with a negative coefficient. 1 1 1 1 0     − − − − − = = ∆ = + ∆ + ∆ − +∑ ∑ n m t i t i t i t t i i y y x e (2) the model specification is given as follows: 0 1 2 3 1 0 0 4 1 1 2 1 0 3 1 4 1          − − − = = = − − − = − − ∆ = + ∆ + ∆ + ∆ + ∆ + + + + + ∑ ∑ ∑ ∑ n n n t t i t i t i i i i n t i t t i t t t ror ror ir lrm inf ror ir lrm inf u (3) ror is the ror on 3-month deposit of islamic banks while ir is the ir on 3-month term deposit of conventional banks. liquidity risk management (lrm) is a natural logarithmic form of the real money supply. the money supply used in this study is m2. inf represents inflation rate and β0, β1, β2, β3, β4, β5 and α1 α2 α3; α4 are parameters. ∆ stands for the first difference operator while ut is the error term 3.3. granger causality test once the existence of long run association (cointegration) has been established among the variables, we then investigated causality between them. adewuyi and naim: the nexus between rates of return on deposits of islamic banks and interest rates on deposits of conventional banks in a dual banking system: a cross country study international journal of economics and financial issues | vol 6 • special issue (s4) • 2016114 0 1 2 3 1 0 0 4 1 0 t 1 u       − + − − − = = = − = ∆ = + ∆ + ∆ + ∆ + ∆ + ∑ ∑ ∑ ∑ n n n t t i t i t i i i i t n t i i ror ror ir lrm inf ect (4) 4. empirical findings augmented dicky fuller (adf) test was applied to test for unit root in each of the variables. table 1 shows the result of unit root test for ror, ir lrm and inf in malaysia, indonesia and bahrain. for malaysia, the result indicates that ror, ir, and lrm are not stationary at level. the adf statistics for each of the variables are lower than the critical values at 5% significance level. therefore, the null hypothesis that the variables have unit root at level cannot be rejected. however, they became stationary at the first difference i(1) while inf became stationary at level. in the case of indonesia, ror, ir lrm, and inf all became stationary only at first difference. as for bahrain, ir and lrm were found to be stationary at the level, i(0) while ror and inf became stationary at first difference, i(1). the fact that the variables are integrated of different orders suggests ardl as the appropriate approach to cointegration in this study. 4.1.existence of long run relationship between ror and ir using ardl bound test results of bound test showing the long run relationship (co-integration) between the variables in the models for malaysia, indonesia and bahrain are presented in table 2. the rule is that existence of cointegration is established if the computed f-statistics is greater than the upper bound critical value. on the other hand, if the f-statistics is lower than the lower bound critical value, non-the existence of cointegration is therefore established. however, if f-statistics falls between the two bound critical values, the result is inconclusive. in malaysia, the result shows a high level of cointegration among ror on deposits of islamic banks, ir on deposits of conventional banks, real money supply (lrm) and inflation (inf). for example, when ror is used as the dependent variable with ir, lrm and inf as explanatory variables, the f-statistics value is 20.3830 which is higher than the upper bound critical value 4.049 at 5%. this means that ir, lms, and inf have an adamant long run relationship with ror. each of the explanatory variables is made to take a turn as the dependent variable to determine the level of cointegration. by considering ir as the dependent variable, the result also shows a long run relationship between ir and ror with f-statistics value of 5.1446. also, cointegration is observed when inflation takes turn as the dependent variable with an f-statistics value of 9.8333. however, for lrm, the f-statistics value of 3.7216 falls between lower and upper bound critical values at 95%. this suggests the existence of cointegration but not conclusive at this stage. the long run relationship between ror and ir in indonesia is similar to the situation reported above for malaysia. the bound test result reported for ror with f-statistics value of 8.5065 is greater than the upper bound critical value 4.049 at 5%. the f-statistics for ir when it takes a turn as dependent variable gives a value of 6.8772 which is also greater than the upper bound critical value at 5% significance level. this shows the strong long run relationship between ror and ir in indonesia as well. the long run relationship between lrm as the dependent variable with ror, ir, and inf as explanatory variables exhibit the same characteristics of no conclusive cointegration as was observed in malaysia. the f-statistics is 3.6566 and falls between lower and upper bound critical values at 95%. by considering inf as the dependent variable, it gives a high level of cointegration with ror, ir and lrm with an f-statistics value of 17.0740 greater than the bound critical value of 4.049 at 95%. similarly, the result of the bound test for bahrain also shows a significant relationship between ror and ir. the values of f-statistics 4.4550 for ror and 22.0840 for ir respectively present a long-run relationship between the variables. in contrast to the non-existence of cointegration among the variables in malaysia and indonesia when lrm took a turn as the dependent variable, there is evidence of the existence of cointegration among the variables in bahrain when lrm takes a turn as the dependent variable. table 1: unit root test country variable model type level first difference adf critical value adf critical value malaysia ror c −2.013008 −2.951125 −7.948531 −3.639407*** ir c −1.225073 −2.981038 −5.732306 −3.711457*** lrm c −0.134921 −2.948404 −4.416923 −3.639407*** inf c −3.569899 −2.951125** indonesia ror c −2.118298 −2.948404 −5.356607 −3.639407*** ir c −2.123151 −2.951125 −4.507241 −3.639407*** lrm c −1.461570 −2.967767 −3.326400 −2.967767** inf c −0.210758 −2.948404 −4.794961 −3.639407*** bahrain ror c −2.37992 −2.97185 −7.05815 −3.689194*** ir c −6.00621 −3.670170*** lrm c −4.960197 −3.661661*** inf c −0.373713 −2.960411 −3.68626 −3.670170*** ** and *** represent the critical value at 5% and 1% level of significance respectively. adewuyi and naim: the nexus between rates of return on deposits of islamic banks and interest rates on deposits of conventional banks in a dual banking system: a cross country study international journal of economics and financial issues | vol 6 • special issue (s4) • 2016 115 4.2. granger causality the results of granger causality tests between the variables for malaysia, indonesia, and bahrain, are shown in table 3. a significance level of the chi-square value obtained from the wald test on the lagged explanatory variables determines the existence of short-run causality running from one variable to the other. the t-statistics associated with the lagged ect on the other hand determines the significance of the causal impacts in the long run. for malaysia, the result shows both short and long run bidirectional causality running between ir and ror. over the short term, causality runs between the two variables. the chi-square obtained from wald test performed on ir when ror is the dependent variable is 5.9496 and significant at 5%. the chi-square value for ror when ir is the dependent variable is 26.3851 which is significant at 1%. this means that there is short run bidirectional causality running between ror and ir. there is also long-run causality running between ror and ir as the coefficient of ect (−1) for ror model is −0.87313 and that of ir model is −0.48814 which are significant at 5% and 1% respectively. ect (−1) indicates the speed at which residuals adjust to the long run equilibrium. this therefore, means that in addition to the existence of a long-run relationship between ror and ir, as confirmed by bound test, ror and ir could granger-cause each other in malaysian banking sector. this suggests that the players in both the islamic and conventional segments of the malaysian banking sector do respond to changes in ir and rates of return on the deposit accounts of the customers of each other. this means that deposit customers of banks in islamic banking sector react to and are influenced by ir movements in the conventional segment of the banking sector. similarly, deposit customers of banks in the conventional segment also respond to and are also influenced by the circulation of the ror in the islamic banking segment. similarly, the result of the short run and long run causality tests to determine the pairwise causal relationship between ror, ir lrm and inf in indonesia, as presented in table 3 shows the same trend as in malaysia. the short and long run causal relationship tests between ror and ir in particular also show a bidirectional relationship running from ror to ir as well as from ror to ir. likewise malaysia and indonesia, the short and long run causal relationship between ror and ir in bahrain is also bidirectional. this is because, the chi-square obtained from the wald tests table 2: result of bound test f-statistics bound critical values @ 90% @ 95% @ 99% (0) i (1) i (0) i (1) i (0) i (1) 2.425 3.574 2.850 4.049 3.817 5.122 malaysia fror [ror|ir, lrm, inf] = 20.3830*** fir [ir|ror, lrm, inf] = 5.1446** flrm [lrm|ror, ir, inf] = 3.7216* finf [inf|ror, ir, lrm] = 9.8333*** indonesia fror [ror|ir, lrm, inf] = 8.5065** fir [ir|ror, lrm, inf] = 6.8772*** flrm [lrm|ror, ir, inf] = 3.6566** finf [inf|ror, ir, lrm] =17.0740*** bahrain fror [ror|ir, lrm, inf] = 4.4550** fir [ir|ror, lrm, inf] = 22.0840*** flrm [lrm|ror, ir, inf] = 4.2741** finf [inf|ror, ir, lrm] = 2.7194* ***, ** and * represent 99%, 95% and 90% level of significance respectively table 3: result of granger causality between pair of variables dependent variable ∆ror ∆ir ∆lrm ∆inf ect(-1) malaysia ∆ror -5.9496** [0.015] 1.2249 [0.268] 555.4174*** [0.000] −0.87313** [−2.4001] ∆ir 26.3851*** [0.000] -4.4897** [0.034] 292.60351*** [0.000] −0.48814*** [−3.2831] ∆lrm 2048.0*** [0.000] 3661.9*** [0.000] -4446.0*** [0.000] −010752** [−2.5235] ∆inf 23.2947*** [0.000] 5.8201** [0.016] 0.15947 [0.690] -−0.70963*** [−6.6637] indonesia ∆ror -4.5203** [0.033] 0.020128 [0.887] 6.8210*** [0.009] −0.49704*** [−3.4965] ∆ir 45.65061*** [0.000] -1.52731 [0.217] 33.3096*** [0.000] −0.17907*** [−3.2877] ∆lrm 59.4115*** [0.000] 40.9071*** [0.000] -171.6460*** [0.000] -∆inf 2.0734 [0.150] 6.2286** [0.013] 4.9738** [0.026] -−0.68603** [−2.6340] bahrain ∆ror -15.8128*** [0.000] 5.1246** [0.024] 5.7668** [0.016] −0.76840*** [−3.9624] ∆ir 229.5835*** [0.000] -0.017875 [0.894] 1.2523 [0.263] −0.93089*** [−7.0692] ∆lrm 10544.2*** [0.000] 1632.3*** [0.000] -8.6640*** [0.003] −0.34009** [−2.4717] ∆inf 49700.8*** [0.000] 5261.0*** [0.000] 77.3394*** [0.000] --chi-square in [ ] and t-statistics in ( ) are reported for variables and ect (-1) respectively. ** and *** represent 5% and 1% significance levels respectively. adewuyi and naim: the nexus between rates of return on deposits of islamic banks and interest rates on deposits of conventional banks in a dual banking system: a cross country study international journal of economics and financial issues | vol 6 • special issue (s4) • 2016116 performed on the two variables are significant even, at 1% significance level. the result, therefore, establishes a solid causal relationship between ror and ir in malaysia, indonesia and bahrain both in the short and long run. 4.3. diagnostic tests the study applies some diagnostic tests to ensure the models’ fitness and stability. the diagnostic tests reported are in respect of the models in which ror serve as the dependent variable for each of the countries as reported in table 4. the results show that the models are free from serial correlation and heteroscedasticity. the models are also found to be fit and stable. 4.4. model stability test cumulative sum of recursive residuals and the aggregate sum of the square of recursive residuals present how steady and fit models are. cumulative sum of recursive residuals was proposed by galpin and hawkins (1984) to check the assumption of normality and other aspects of model misfits. a model is considered fit and stable if the graph is in between the two straight lines representing upper and lower bounds at the 5% significance level. the result of the cumulative sum of recursive residuals and the aggregate sum of the square of recursive residuals for the models for ror-ir relationship in which ror stands as the dependent variable are presented in figure 1a and b for malaysia, figure 2a and b for indonesia and figure 3a and b for bahrain. figures 1a and b confirm the fitness and stability of the model in which ror is used as a dependent variable for malaysia. this is borne out by having the graphs in between the two straight lines. we also observe the stability of a similar model for indonesia. this is presented in figure 2a and b. the stability and fitness of the ror model for bahrain are also considered fit and stable as shown in figure 3a and b. 5. conclusion and recommendations in this study, we investigate the existence of long run relationship (cointegration) between the ror on deposits of islamic banks and ir on term deposits of conventional banks in malaysia, indonesia and bahrain using ardl approach to cointegration. we find the existence of both short and long run relationships between rates of return on deposit of islamic banks and ir on deposits of conventional banks during the period 2007-2015. we also find that causality runs between ir on deposits of conventional banks and ror on deposits of islamic banks in malaysia, indonesia, and bahrain. this finding is in agreement with those reported table 4: diagnostic tests country test statistics lm tests malaysia serial correlation chsq (1) 1.7339 [0.188] heteroscedasticity chsq (1) 1.9019 [0.168] indonesia serial correlation chsq (1) 2.6002 [0.107] heteroscedasticity chsq (1) 0.21760 [0.641] bahrain serial correlation chsq (1) 0.059500 [0.807] heteroscedasticity chsq (1) 1.4766 [0.224] the probability values are reported in the parenthesis [ ] figure 1: malaysia. (a) plot of cumulative sum of recursive residuals. (b) plot of cumulative sum of squares of recursive residuals a b figure 2: indonesia. (a) plot of cumulative sum of recursive residuals. (b) plot of cumulative sum of squares of recursive residuals a b figure 3: bahrain. (a) plot of cumulative sum of recursive residuals. (b) plot of cumulative sum of squares of recursive residuals a b adewuyi and naim: the nexus between rates of return on deposits of islamic banks and interest rates on deposits of conventional banks in a dual banking system: a cross country study international journal of economics and financial issues | vol 6 • special issue (s4) • 2016 117 by (obiyathulla, 2004, 2008; haron and azmi, 2008; kasri and kassim, 2009). after more than three decades of impressive growth and development of islamic financial system, there is a need for a paradigm shift from operational pragmatism to a truly islamic finance by the true spirit of ir prohibition by allah. there is, therefore, an urgent need to embark on intensive research on how to make profit and loss sharing (pls) model of islamic finance attractive in such a way that risks associated with information asymmetry could be minimized, and investors would find it profitable. once the problems related to pls are minimized, both ifis and depositors would be certain of truly islamic returns on their investments. rates of return on deposits of islamic banks would find their real levels which would in no doubt be at variance with the conventional ir at all times. the results of this study are expected to contribute towards better understanding of the implications of continuing benchmarking islamic banking services on conventional ir. this understanding is expected to stimulate increased efforts towards the search for alternative financial services that will not comply with sharia requirements only in form but also in substance. the study has also further enriched the literature on the relationship between the ror on deposits of islamic banks and conventional ir in dual banking environments using a robust econometric technique. references affandi, a., tamanni, l. (2010), monetary policy shocks and islamic bank deposits in indonesia dual banking system after the financial crisis. (icbe), 1, jfekon. anuar, k., mohamad, s., shah, m.e. (2014), are deposits and investment accounts in islamic banks in malaysia interest-free? jkau islamic econ, 27(2), 27-55. ariffin, a.f., tafri, f.h. (2014), international conference on business sociology and applied sciences, kuala lumpur. asmadi, m.n., zairani, z. (2015), islamic banking operations: products and services. sintok: uum press. asteriou, d., hall, s.g. (2007), applied econometrics. 2nd ed. basingstoke: palgrave macmillan. cevik, s., charap, j. (2011), the behavior of conventional and islamic bank deposit returns in malaysia and turkey. imf working paper wp/11/156. international monetary fund. chong, b.s., liu, m.h. (2009), islamic banking: interest-free or interest based? pacific-basin finance journal, 17(1), 125-144. el gamal, m. (2003), “interest” and the paradox of contemporary islamic law and finance. fordham international law journal, 27(1), 108-149. ergec, e.h., kaytanci, b.g. (2014), the causality between returns of interest-based banks and islamic banks: the case of turkey. international journal of islamic and middle eastern finance and management, 7(4), 443-456. galpin, j.s., hawkins, d.m. (1984), the use of recursive residuals in checking model fit in linear regression. the american statistician, 38(2), 94-105. haron, s., azmi, w.n.w. (2008), determinants of islamic and conventional deposits in the malaysian banking system. managerial finance. 34 (9), 618-643. haron, s., ahmad, n. (2000), the effects of conventional interest rates and rate of profit on funds deposited with islamic banking in malaysia. international journal of islamic financial services, 1(4), 1-7. isra. (2013), islamic financial system: principles & operations. 2nd ed. kuala lumpur: international shari’ah research academy for islamic finance. kaleem, a., md isa, m. (2003), causal relationship between islamic and conventional banking instruments in malaysia. international journal of islamic financial services, 4(4), 2-4. kasri, r., kassim, s.h. (2009), empirical determinants of savings in the islamic banking: evidence from indonesia. jkau islamic econ, 22(2), 3-23. obiyathulla, i.b. (2004), dual banking systems and interest rate risk for islamic banks. the journal of accounting, commerce, and finance islamic perspective, 8(182), 1-42. obiyathulla, i.b. (2008), the islamic interbank money market and dual banking system: the malaysian experience. international journal of islamic and middle eastern finance and management, 1(3), 210-226. pesaran, m.h., shin, y. (1999), an autoregressive distributed lag modeling approach to cointegration analysis. in: strom, s., editor. paper presented at econometrics and theory in the 20th century: the ragnar frisch centennial symposium. ch. 11. cambridge: cambridge university press. pesaran, m.h., shin, y., smith, r. (2001), bound testing approach to the analysis of level relationships. journal of applied econometrics, 16, 289-326. raji, j.o., juzoh, j., jatan, m. (2014), real money supply, price and fiscal deficit in nigeria: evidence from multivariate granger-causality tests. journal of economic cooperation development, 35(4), 85-112. hadith of the prophet. following the footsteps of the jews. sahih muslim book 34 (6448). available from: www.islamweb.net. sanwari, s.r., zakaria, r.h. (2013), the performance of islamic banks and macroeconomic conditions. isra international journal of islamic finance, 5(2), 83-98. zainol, z., kassim, s. (2012), a critical review of the literature on the rate of return risk in islamic banks. journal of islamic accounting and business research, 3(2), 121-137. . international journal of economics and financial issues | vol 6 • special issue (s3) • 201644 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s3) 44-49. special issue for “asia international conference (aic 2015), 5-6 december 2015, universiti teknologi malaysia, kuala lumpur, malaysia” improving shareholder value through corporate governance mechanism in malaysian listed companies mohammed yussoff ibrahim1, ayoib che ahmad2, muhammad anees khan3* 1department of management & humanities, universiti teknologi petronas, bandar seri iskandar, malaysia, 2uum college of business, universiti utara malaysia, kedah, malaysia, 3department of management & humanities, universiti teknologi petronas, bandar seri iskandar, malaysia. *email: lookanees123@gmail.com abstract this paper proposes to investigate the postulations of renowned agency theory and shareholder value (shv) in relation to corporate governance (cg) attributes. shv is of a great concern to the shareholders of firms. shv have been investigated by numerous studies of cg but with inconsistent empirical evidence. this study will focus on investigating the impact of cg attributes on shv measured by tobin’s q or return on both equity and assets. the paper conceptualized four attributes (separate leadership, proportion of independent director, independent chairman, independence of nomination committee) from cg mechanism in relation to shv in companies listed on bursa malaysia. this is a conceptual paper which proposes to investigate the relationship between shv and separate leadership, shv and proportion of independent director, shv and independent chairman, shv and independence of nomination committee in the context of malaysia. the proposed study has value for malaysian government, policy makers, corporate boards, stock exchange and shareholders by highlighting the distinct impact on shv and its relation with separate leadership, proportion of independent director, independent chairman, and independence of nomination committee. keywords: shareholder value, corporate governance mechanism, bursa malaysia jel classification: g34 1. introduction after the collapse of enron (2001), worldcom (2002) and recent financial and economic crises respectively, investors, stakeholders and shareholder lost their confidence which increased the issue of shareholder value (shv). this issues of shv, increasing rapidly during the last two decades throughout the world and especially in developed countries like uk, us and australia, etc. with the opening up of free trade concept and liberalization, the concern for shv also spread to the developing and emerging countries like malaysia. a lot of focus has been given from time to time to control the massive governance problems and to come out with good corporate governance (cg) solutions for increasing the shv. good cg is a setup which, enhance equity, transparency and, firm overall performance to the stakeholders. cg leads to maximize the value of the shareholders legally, ethically and on a sustainable basis (murthy, 2006). it is argued that cg most important functions is to ensure the quality of overall firm financial performance and thus maximizing the shv. as cg environment varies from country to country and from firm to firm (farber, 2005). that is why most of the countries, including malaysia have laid down their own malaysian codes cg (mccg) (2000; 2007; 2012) cg mechanism to look for suitable opportunities in order to maximize their shv. the main objective of this study is to investigate whether internal cg mechanisms such as separate leadership, proportion of independent director, independent chairman, and independence of nomination committee affect shv or not. the underpinning theory for governance studies is agency theory because it can be used and applied in the area of value maximization and cg (maseda et al., 2012). therefore, in this proposed study, the monitoring role of separate leadership, proportion of independent director, independent chairman and, independence of nomination committee are argued to increase the firm financial performance and thus shv. ibrahim, et al.: improving shareholder value through corporate governance mechanism in malaysian listed companies international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 45 2. literature review 2.1. cg mechanism cg broadly refers to the mechanisms, processes and relations by which corporations are controlled and directed. according to james wolfensohn, president of the world bank: “the governance of companies is more important for world economic growth than the government of countries.” cg mechanism is an effective monitoring devices for constraining illegal activities and improving shareholder wealth (hashim and devi, 2007). the linkages between shv and cg attributes is important because investors and creditors may wish to invest in firms with good governance to reduce their costs of capital and increase the firm value (ali shah et al., 2009). thus, cg mechanism is like a monitoring system (gul et al., 2003), which helps in improving the overall performance of the firm (watts and zimmerman, 1986), and is linked with firm overall financial performance and shv (gul et al., 2003). cg continues to be an area of importance while shv still appears to be a problematic issue. it is suggested that for gaining higher financial performance and shv, the importance of cg cannot be ignored. studies in developed countries investigated the impact of cg mechanisms on shv and firm financial performance and found a very effective role of cg mechanism on shv (hillman and keim, 2001). it is important to note that effective cg system is necessary to restore investor’s confidence (shen and chih, 2007), because it maximize the shv (ali shah et al., 2009). hence, a common belief is that effective cg mechanism may assist in maximizing the shv. therefore, cg mechanism is frequently seen as a major device to minimize the wrong decision and maximize the shareholder wealth. 2.2. shv shv is the value delivered to shareholders due to successful business operation and management’s ability to grow earnings, dividends and share price (stout, 2013). shareholder primacy theory state that corporations were owned by their shareholders; that directors and executives should do what the company’s owners/shareholders wanted them to do; and that what shareholders generally wanted managers to do was to maximize “shv,” measured by share price (hillman and keim, 2001). increasing the shv is of prime importance for the management of a company. the management must have the interests of shareholders in mind while making decisions. the higher the shv, the better it is for the company and management. for this to happen, cg mechanism is considered the most important devices for monitoring the firm financial performance and increasing the shv (shen and chih, 2007). therefore, this study have focused on the impact of cg mechanism (separate leadership, proportion of independent director, independent chairman, independence of nomination committee), as part of cg mechanism, and relate them to corporate performance and shv. study conducted on the relationship of cg mechanism yield mixed result for instance, empirical results indicate that separate leadership is positively related to the shv but this finding is incongruent with most empirical studies in developing economies (pfeffer, 1973). similarly, proportion of independent directors is also positively related to shv which support the finding and arguments of saleh et al. (2005), that large proportion of independent directors have a positive relationship with firm performance while opposing the finding of benkel et al. (2006). empirical results shows that independent chairman plays a very positive role in shv maximization and firm financial performance. alternatively, outside directors is negatively related to the firm performance. finally, many studies suggest that nomination committee can affect the shv negatively (lang and stulz, 1993). hence shv seen as a major concern by the investor, shareholders and stakeholder. 3. research objectives • to analyze the association between separate leadership and shv • to analyze the association between proportion of independent directorship and shv • to analyze the association between independent chairmanship and shv • to analyze the association between independence of nomination committee and shv. 4. research question this main question of this study is to examine that “what is impact of internal cg mechanism (separate leadership, proportion of independent directorship, independent chairmanship, and independence of nomination committee) on shv?” the following conceptual framework is developed based on the above discussion to examine the relationship between cg mechanism (separate leadership, proportion of independent director, independent chairman, and independence of nomination committee) and shv. the links between cg mechanism and firm financial performance are illustrated in figure 1. in the above conceptual framework, shv is a dependent variable, while cg mechanism (separate leadership, proportion of independent director, independent chairman, and independence of nomination committee) are independent variables respectively. the proposed study concentrate to fill the gap by providing the basic concepts, relation, and impact of cg mechanism (separate leadership, proportion of independent director, independent chairman, and independence of nomination committee) on firm financial performance. 5. hypothesis of the proposed study 5.1. separate leadership and shv agency theory postulates that separation of decision and control functions of the board is an effective monitoring device of managers for better performance of firms (fama and jensen, 1983). ibrahim, et al.: improving shareholder value through corporate governance mechanism in malaysian listed companies international journal of economics and financial issues | vol 6 • special issue (s3) • 201646 hence, agency theory is applicable to board leadership structure in relation to shv (daily and dalton, 1997). by separation of leadership we mean, that chairman cannot perform dual role as a chairman as well as a chief executive officer (shakir, 2009). based on mccg (mccg, 2012), recommendation “the positions of chairman and ceo should be held by different individuals and the chairman must be a non-executive member of the board.” empirical findings showed mixed and inconclusive relationship between leadership structure and shv (dulewicz and herbert, 2004; weir and laing, 2000; weir et al., 2002). for instance, rechner and dalton (1991) found that firms with the separate board leadership structure increase value and performance. similarly in line with previous, separate leadership has a positive and significant relationship with shv (marn and romuald, 2012; bhagat and bolton, 2008). but on the other hand, firms with separate leadership yield lower shv (dey et al., 2011), and thus there is negative relationship between separate leadership and firm performance (ponnu, 2008). furthermore, dual role of chairman has a negative impact on maximizing shv and overall firm performance (jackling and johl, 2009; yusoff and alhaji, 2012). whilst, in contrast to previous lines duality has no negative impact on shv (shukeri et al., 2012). hence, upon reviewing the literature, it can be concluded that there is inconclusive, mix, and unclear empirical findings regarding the relationship between separate leadership and shv which necessitate its further investigation. therefore, based on agency theory, the author proposes and support further empirical investigation of the relationship between separate leadership and shv through following hypotheses: h1: separate leadership has positive association with shv. 5.2. proportion of independent director and shv agency theory advocate that, an independent board of director is more likely to be vigilant for agency problems and is dedicated to monitor management performance and behavior for maximizing the shv (fama and jensen, 1983). similarly, the mccg (mccg, 2000; 2007; 2012) recommends “ensuring the value and effectiveness of independent director on the board of the company.” research conducted on the relationship between proportion of independent director and shv yield mixed and inconclusive results. for example, panasian (2003), stated that if proportion of independent director on board increased then it will be more beneficial for firm agent principal problem and shv. thus, independent director is positively correlated with shv of the firm (rosenstein and wyatt, 1990). similarly, studies conducted in us, australia, europe and pakistan also suggested the same positive correlation between independent director on the board and shv (ritchie, 2007). furthermore, other empirical studies also support that for increasing overall firm value the director independence is utmost important and cannot be ignored (peasnell et al., 2005; agrawal and knoeber, 1996; baysinger and butler, 1985). therefore, recent research shows a positive relation between independent director on the board and shv (coombes and wong, 2004; gonzález and garcía-meca, 2014). but on the other hand, klein (2002) and garcía lara, osma et al. (2007) supported that independent director on the board have a negative impact on shareholder wealth. it is also argued that in many cases independent director on the board tend to be related to fraud which in turn reduce the shv (beasley, 1996). similarly, another study also found a negative relation between board independence and shareholder’s wealth (bhagat and black, 2000; linck et al., 2008). while postma (2001), found no relation in between independent director on the board and shv. at the end it can be argued that studies concerning the effect of independent directors on shareholders’ value come to no end. hence based on agency theory and above inconclusive literature the author support and develop the following hypothesis; h2: independent director has a positive impact on shv. 5.3. independent chairman of the board and shv the standard principal-agent model suppose that chairman independence is important for minimizing the agency problem which effect the overall performance and shv of the firm (fama, 1980). similarly, based on the recommendation of mccg (mccg, 2012), “the positions of chairman and ceo should be held by different individuals and the chairman must be a non-executive member of the board.” there is always a positive response from stakeholders if a firm announce independent chairman of the boards (balsam et al., 2011b; coles and hesterly, 2000), because firms can be effectively monitor through an independent chairman of the board (alkdai and hanefah, 2012). upon reviewing the literature some evidence support the hypothesis that independent chairman on board is improving shv; some got the result that an independent board had a reversely impact on management performance and shv, other evidence suggest there is no significant relation. figure 1: corporate governance internal mechanisms and shareholder value conceptual framework separate leadership proportion of independent director independent chairman independence of nomination committee shareholder value h1 h2 h3 h4 ibrahim, et al.: improving shareholder value through corporate governance mechanism in malaysian listed companies international journal of economics and financial issues | vol 6 • special issue (s3) • 2016 47 thus, previous empirical finding about the relationship of independent chairman and shv provide inconclusive and mixed result. for example, according to coles and hesterly, (2000), agency problem will be a big issue in the absence of independent chairman of the board (balsam et al., 2011b). while, on the other hand, separate chairman of the board has less value in firm financial performance and shv (jackling and johl, 2009). further added that outside independent chairman of the board is costly than that of its value creation (balsam et al., 2011a). therefore, based on agency theory and inconclusive mix result we shall further try to explore the relation between independent chairman and shv to see if our conclusion is consistent with any of the above results. thus, based on the above discussion the author develop and support the following hypothesis; h3: independent chairman has a positive impact on shv. 5.4. independence of nomination committee and shv agency theory suggests that the major function of a board is to monitor firm management. nomination committees can play a vital role in enhancing board members independence and reducing the influence of management (westphal and zajac, 1995; cotter and silvester, 2003). thus, nomination committee independence is more likely to be watchful for agent and principal conflict which in turn will increase the overall firm value. the mccg (mccg, 2000; 2007; 2012) also highlight the importance, value and effectiveness of the nomination committee independence. research conducted on the relation between nomination committee independence and shv provided mixed and inconclusive results. for example, there is a positive relationship in between independence of nomination committee and shv (golden and zajac, 2001; shivdasani and yermack, 1999). similarly, independence of nomination committee will improve firm financial performance and shv (cotter and silvester, 2003; chhaochharia and grinstein, 2009). but on the other hand there is a negative effect of nominating committee independence on shv (vafeas, 1999). furthermore, beasley (1996), also find the same negative correlation in between independence of nomination committee and shv. hence upon reviewing the literature, we found different result some evidence support that nomination committee have an positive impact on shv; some study postulating that independence of nomination committee have no significant impact on shv while other got the result that an independent nomination committee on board had a reversely impact on the overall performance of the firm. thus, the relation between nomination committee independence and shv has been examined in numerous studies but provide a mixed result. accordingly, in keeping with our prior literature, we expect that if an independent director is a member of the nomination committee, this will have a positive impact on the shv. therefore, based on agency theory and previous mix empirical findings discussed above the author develop and support the following null hypothesis; h4: independence of nomination committee has a positive impact on shv. 6. scope and methodology of the study the proposed study uses sample size comprises of 320 firms listed on malaysia stock market, during the period 2010-2013. the study selects these firms for their relevance in malaysian economy. financial institutions and insurance firms are excluded, as is common in this type of studies because of their particular accounting practices (gonzález and garcía-meca, 2014). the accounting data on financial statements is secondary in nature and will be obtained from datastream database, while data on cg mechanism (separate leadership, proportion of independent director, independent chairman, independence of nomination committee) come directly from company’s annual reports, which are available on the companies websites or through bursa malaysia website. the data will be analyzed through multiple regression, correlation and descriptive analysis for relationship and results interpretation. 7. measurement of variables following table1 shows the measurement of dependent and independent variable of the study with their respective references, i.e. dependent variable (shareholders value will be measure through tobin’s q while separate leadership and independent chairman will be measured by a dummy variable (1 and 0). similarly, proportion of independent director will be measure by percentage of independent director to total director. moreover, nominating committee independence will be measured by the proportion of independent non-executive director in nomination committee to total committee members. 7. conclusion and significance the proposed study will empirically examine how cg mechanism (separate leadership, proportion of independent director, independent chairman, and independence of nomination table 1: measurement of variables variables measurement with reference (s) dependent variable: shv will be obtained using tobin’s q model. i.e., total market value of firm divided by total assets value (davies et al., 2005) separate leadership dummy: if separate leadership than 1 otherwise 0 ((alzoubi and selamat, 2012)) proportion of independent director percentage of independent directors out of total board of directors (luan and tang, 2007) independent chairman dummy: if independent chair than 1 otherwise 0 (aggarwal et al., 2010) nomination committee independence independent non-executive director in nomination committee/total committee members (habbash, 2013) shv: shareholder value ibrahim, et al.: improving shareholder value through corporate governance mechanism in malaysian listed companies international journal of economics and financial issues | vol 6 • special issue (s3) • 201648 committee) will impact shv and help in maximizing the overall financial performance and shv in malaysian listed firms. secondly this proposed study will contribute the latest literature to shv and cg. thirdly the proposed study will give a clue on how much mccg (mccg, 2012) has impacted the cg standards in maximizing the shv and firm performance because mccg (2012) is introduced during this era. hence this paper proposes to examine the impact of separate leadership, proportion of independent director, independent chairman, and independence of nomination committee on shv in malaysian listed firms for 20102013. moreover the results of this proposed study will help board of directors, policy makers, government, security commission of malaysia and bursa malaysia for further improvements of the relevant policies and regulations in future. 8. acknowledgment this research project has been funded wholly by university research internal fund of the universiti teknologi petronas malaysia. references aggarwal, r., erel, i., stulz, r., williamson, r. 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(2012), corporate governance and firm performance of listed companies in malaysia. trends and development in management studies, 1, 43-65. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(4), 1328-1337. international journal of economics and financial issues | vol 6 • issue 4 • 20161328 individual choice of a pension fund in russia: are the investment results of the fund important? karen a. tumanyants1*, eugenia v. gulyaeva2 1volgograd state university, volgograd, russia, 2russian presidential academy of national economy and public administration, volgograd, russia. *email: tka210@gmail.com abstract the paper presents the econometric assessment of the influence on the market positions of the fund of nominal yield volume and the sharpe ratio formed in the pension savings investment by non-state pension funds in the russian federation. using pair and multiple regression models and also a fixed effects model, the authors did not find any statistically important correlation between the investment results and insured persons’ choice of a pension fund. the results of the study point to weak stimuli for the participants of the pension sphere to improve the investment process quality and deformation of competition in the pension services market. keywords: yield, sharpe ratio, competition jel classifications: g23, d40, d12 1. introduction the state funding of pension obligations through placing of pension contributions in the financial market requires solving a classical problem of the relationship between the agent and the principal. the problems occurred due to the necessity to use services provided by financial institutions (agents) to invest pension savings of the future pensioners (principals) (philippon, 2012). the long-term period between the time when a person pays pension contributions and the time when a person receives a pension even deepens the problem. the reduction of a risk of the agent’s opportunist behaviour requires forming efficient stimuli to keep the beneficiary’s interests (financial services authority, 2012). potentially, a conflict of interest between the savers and financial institutions during the investment of pension savings can arise because of the amount of yield and a risk during pension assets placing and also the value of expenses payable for the agent’s services (pitt-watson et al., 2014). a classical recipe of fair management of the relationship between the agent and the principal is to create a competitive environment. it is believed that if the principal can choose among several agents to conclude a contract with and has the right to change the agent then sufficient motivation for the agent’s fair behaviour is provided automatically (philippon, 2012). with more suppliers of financial services in the market, the competition among them becomes more intense which makes the consumer win more. from this point of view it is quite logical that most countries, while creating a cumulative model of the pension system, took into consideration functioning of several independent financial intermediaries: pension funds, pension accounts management companies (mcs), banks, insurances companies and even the enterprises of the real economy providing various pension plans (tapia and yermo, 2007). it was expected that due to their work a competitive pension market would be formed where home economics would get an access to services which are optimal with cost and quality consideration. as the result of the pension reform in the russian federation, since 2003, the citizens have started to form obligatory pension savings. the legislation gave a citizen the right to choose an organisation which could invest pension savings in financial assets. in different times, their number was changing but on average there were almost 100 of non-governmental pension funds and about 50 mcs, including a governmental one. the tumanyants and gulyaeva: individual choice of a pension fund in russia: are the investment results of the fund important? international journal of economics and financial issues | vol 6 • issue 4 • 2016 1329 article is to find out whether russians considered the results of an institution’s previous investments when choosing a financial institution. the answer to this question will let find out how competition stimulates the participants of the russian market to raise the efficiency of pension savings management. will negative effects for the consumer occur as a result of assets concentration in the pension industry, dominance of a number of organisations in the pension market or even full monopolization of the process of placing pension contribution into the financial instruments? is it efficient to appeal, in the competition for a client in russia, to rational motives for yield maximization, risk minimization and expanses of investment or use mainly “non-price” methods of marketing: an image of an organization, its size, brand awareness etc.? section 1 of the paper presents a brief literary review on the issue studied; section 2 provides mathematical models on the basis of the russian empirical data. section 3 presents the results of the study. 2. a literature review the studies of the peculiar features of the competitive environment in the pension system are carried out in four major conceptual directions. in the first one (“quazi-market”), the specific character of the pension insurance market is explained by the fact that it is not a full-working market in its traditional meaning. the second direction evaluates the scale effect, its influence on the expenses and cost of services in the system. the third direction considers the anomalies of the pension industry through the prism of various aspects of behavioral economics. the fourth direction connects the phenomena occurring in the pension market with information problems (“information asymmetry”). every approach makes attempts to evaluate the deformation of the market using quantitative methods. the scientific research in the abovementioned approaches is not carried out in isolation; most of the works have a closely-related character. a. pension system as a “quazi-market”: scholars such as impavido et al. (2009) and valdés-prieto (2007) describe the pension industry using the term “quazimarket” paying particular attention on the peculiarities of supply and demand. among the participants of the branch are not only commercial firms but also non-commercial organizations and also governmental companies. the motivation of the last two groups of economic entities is, as a rule, different from the market one (tumanyants, 2014; bateman and thorp, 2007). the demand for the financial services in the pension system with obligatory savings has a specific character because the consumer often does not pay in “ready cash” and only redistribute a part of the target budget savings formed by taxes for labour and/or state allocations. in case, the participation in the funding part of the pension system is voluntary, the companies providing the pension insurance services have to compete with other financial institutions for the savings of home economics (claessens, 2009). that provides the necessary motivation level to reduce expenses in the pension industry even if there is no perfect competition (benediktsson et al., 2001). in professional pension plans the competition level is traditionally lower because of the significant and often dominant influence of the employers on the choice of a pension plan and its terms, which mainly has a negative impact on the transparency and risk level (clark and bennett, 2001; van der merwe, 2004). a funding pension system, while joining social and political risks with financial ones, takes a special place different from the market of any other product or service in any national economics. severinson and stewart (2012) argue in favor of the presence of several companies in the pension services market with the intention to minimize the influence of operations with pension savings on the situation of the fund market and diversify management risks, and also to preserve pension institutions’ independence from political influence. their research especially underlines that the government’ strengthening of the restrictions on investment activity leads to its unification and decrease the profit from competition. kominek (2012) comes to the same conclusion based on the analysis of the work of polish pension funds. competitive relations promotion is encouraged by the decrease of administrative barriers to enter the branch, first of all, license requirements (van der merwe, 2004). b. scale effect in pension industry: a separate research direction is connected with the assessment of the effect of economy on the scale and influence of the pension market structure on the amount of expenses and prices in the field. for example agostini et al. (2014) analyzed the quarterly data about the work of the funds in chili for 8 years and found a positive effect of the scale in the pension industry in this country. funds merger in this country (their number decreased from 21 in 1994 to 6 in 2012) let the funds reduce operating expenses but led to a small growth in prices for their services for the consumers. consolidation of small and medium danish pension funds also led to the growth in expenses efficiency (bikker, 2013). in the study by acemoglu et al. (2008) it is shown theoretically and empirically that the competition does not always lead to the expenses optimization. the authors illustrated that result of the study also on the basis of the pension services market. using a regression analysis of almost 5000 surveys of pension funds with defined benefits of different countries during the period from 1990 to 2008, dyck and pomorski (2011) found a higher efficiency of large-scale pension plans in comparison with small ones. the result was achieved due to both lower expenses and higher yield. bauer et al. (2010) studied 463 american pension funds with defined benefits during the period from 1990 to 2006 and 248 american funds with defined contributions from 1997 to 2006, and on the contrary, recognized small pension funds to be more competitive. they lose to large-scale funds in unit costs but get higher yield due to investments into american companies of small capitalization. in view of tight liquidity of the assets tumanyants and gulyaeva: individual choice of a pension fund in russia: are the investment results of the fund important? international journal of economics and financial issues | vol 6 • issue 4 • 20161330 of these emitters, large-scale funds cannot use high expansion rates of this sector of the american economy. c. pension market from the view of behavioral economics: barr and diamond (2010) explain the pension market long-run declination from the optimal position by the imperfection of decision-making process by home economics. the excessive volume of diverse information about financial products provokes rather passive behaviour of the consumers, than their wish to puzzle out in the firm’s offers. for example in sweden there are about 700 existing pension funds. the abundance of offers leads to the fact that most swedes do not make their individual choice, relying on the options provided automatically. loewenstein and ubel (2008) underlined the impetuosity in decision-making process by home economics, their dependence from certain circumstances in which the decision is made and even the way to present the source information. thaler and sunstein (2008) call the idea of homo economicus a fiction, and prove that people just are not used to behave in a rational way but they make mistakes systematically. that is why people should not be given the right of choice. the choice must be made by an expert for them. the researchers called their approach “libertarian paternalism.” tapia and yermo (2007), based on a large number of empirical studies, also doubt that most of the individuals can make right decisions from a strategic view. in the same paper the authors determined negative dependence between a number of alternatives of home economics and a number of the participants of pension programmes who make their individual choice. in latin american and central and eastern european countries, where the investment menu offers quite a limited choice of variants (from 2 to 5), the total of those who had made an individual choice is at least 85%. whereas, in sweden and australia, it does not reach even 10%. the consumer who had once made a choice, in the future changes the counteragent voluntary very really as it takes some efforts, if not material than at least time ones. as a result, the demand for financial products in pension provision sphere is characterized by high inertness that prevents competitive relationship to develop. pitt-watson et al. (2014) studied 23 researches and paid attention to the fourfold difference in the expenses volume between pension funds close to each other in characteristics, and that, in their opinion, proves the absence of competition in the sphere. they explain it by the following reasons: • full costs of the services proved by financial institutions are not declared to the customers; • the customers often rely on the employer’s choice of a pension plan; • the customers do not pay much attention to the expenses. the last point is proved by the authors by the fact that the annual cost of expenses is perceived as a small value. however, taking into consideration a long-term character of pension savings, annual costs influence the final result dramatically. for example an annual charge of 1.5 with the existing level of yield would result in a 37% “tax” for 6 years. barr and diamond (2010) estimate 1% of the annual assets cost paid by a client to be 19.6% loss of the total volume of savings for 40 years. at the same time the results of the study by palme et al. (2007) are not so much simple. the authors found the evidence which proves the pension programmes participants’ rational behavior and contradicts it at the same time. in particular, the population’s lack of foresight to their pension savings can be a result of not the problems to get and analyze information or decision-making process but the result of waiting for the state support of their financial status in their old age. caliendo and gahramanov (2013) show in their paper that level of income of those families which do not make savings does not differ dramatically during the whole life from those who make pension savings regularly. d. information asymmetry in pension system: the precondition for the individual rational behavior is made extremely rarely in the sphere of pension accounts management. one of the reasons is that the customers do not have an access to all necessary information which can be the result of the following factors (barr and diamond, 2010; bogle, 2014; world bank and international monetary fund, 2005): • information is not free of charge; even if there is a necessity to buy it, it takes time to search information and study it; • low information transparency of pension institutions; • a high level of information uncertainty about the future status of financial markets and the results of pension saving investing; • physical limitations, because all information necessary for the analysis consists of a huge amount of data. however, even it is, for instance, not difficult to get the information, problems rise while right processing and interpretation by the individuals. the problem of a low level of the financial awareness by the most part of the population is still actual for all countries in the world. for example, as the inquiries of the americans show, more than half of them do not see any difference between shares and obligations (orszag and stiglitz, 2001). as a rule, the right choice in the pension insurance sphere requires to compare various kinds of information that may turn to be not an easy task (bogle, 2014; loewenstein and ubel, 2008). when the criteria to choose a counteragent in the pension market are earning yield and risk, a widespread mistake of a consumer becomes orientation to more actual measures of these indexes for the last period (world bank and international monetary fund, 2005; thaler and sunstein, 2008). in view of high volatility, short-term indicators are less representative in comparison with the data for a long time period. for 9 years, the mean place of russian mc which got the best yield from pension savings for that period is just 18.5; only three, including the leader, from 54 investment portfolios have a mean place in yield <20 (tumanyants and utuchenkova, 2014). as a result, the information asymmetry effect rises inevitably in the markets with financial mediators (sy, 2009; pitt-watson et al., 2014). information problems, and also the peculiarities described tumanyants and gulyaeva: individual choice of a pension fund in russia: are the investment results of the fund important? international journal of economics and financial issues | vol 6 • issue 4 • 2016 1331 in section 1.3 of this paper, stipulate the price insensitivity of the volume of demand for the services provided by financial institutions in the sphere of pension provision. to sum up, even if there are some independent suppliers of services in the pension sphere it does not mean that the market will function as a full one. the analysis of the main conceptions let to suppose that the activity of some independent investment institutions in the modern pension market in russia do not lead to the improvement of the “contract” conditions for future pensioners when talking about yield, risk and investment expenses. the existing character of relationship “agentprincipal” in the russian pension industry, despite their formally competitive character, does not have stimulus for financial agent to improve the mentioned parameters of their services for the clients. the sense of the hypothesis tested is in the fact that the share of the investment institution in the pension market in russia does not depend from the level of its activity in investing pension funds. the hypotheses is supported by the proof of irrational behaviour of the russian home economics and limitation of positive impact on the customers from some suppliers of financial services in the sphere of pension provision, supplementing foreign studies on this problem. as far as the authors know, this is the first study of the problem based on the empirical data in russia. 3. econometric analysis of competition in the modern pension market in russia the existing model of pension system in russia includes unfunded and funded components. the employer’s contribution for the financing of pension savings since 2002 are accumulated on the individual account of the person insured in the pension fund of the russian federation (pfr). since 2005 the employee could resend his/her pension savings for investment in the financial market, into one of the mcs or in one of the non-state pension funds (npf). if the employee did not express his/her will the savings were automatically sent over to the state corporation bank for development and foreign economic affairs (vnesheconombank). once a year, the employee could change the organization investing his/her pension savings. table 1 shows that during that time, with stagnating number of clients of state and private mcs, the number of clients increased sharply. an active flow of clients resulted in the fact that the share of npf increased from 1.1 to 28.2% for 9 years. the impulse for this study is the aspiration to understand whether over 20 millions of russians took into consideration the previous results of its work in the financial market, when making a decision to conclude a contract with a certain npf? a. methods and logics of the study: despite several dozens of service suppliers existing in the russian pension market, there is a need to define to what extent the competition among them for a client motivates financial institutions to prove their work. among the potentially possible factors influencing the choice of npf, we can name the level of yield and risk of pension investments, cost of services and quality of clients care and service. in contrast with an absolute majority of the countries, the russian npf do not have premium from the assets volume. according to the russian law, the amount of services provided by npf is limited within 15% from the annual yield. the volume of return and yield, published by npf, includes the compensation of all expenses and reflects a net financial result from pension savings investments allocated on the client’s account. therewith, the expenses of financial institutions are not an independent tool of competition in russia. that is why we refused from the approach used in the mutual research by the world bank and international monetary fund (2005), where the relationship between yield and cost of services provided by hungarian pension funds was considered. the absence of a direct sustainable correlation has shown that the clients of the funds were ready to suffer higher expenses without compensation if they got additional benefits. an obvious contradiction to the principals of rational behavior let come to the conclusion about the absence of competition in the pension market in hungary. until quite recently, pension payment in the frames of obligatory pension insurance was not provided. the participants of this pension programme are the citizens born in 1967 and later. before, during 3 years the contributions to the cumulative part of a pension were paid to men and women born in 1953 and 1957 and later. however, the first payments to those age groups were made only since 2012 and due to a small volume of savings; the majority of pensioners got the payments in a lump sum. thus, the difference in service in pension payment could not influence the choice of a pension fund by a potential client. therefore, it is logical to suppose that yield and risk of investment activity of npf becomes the main criterion to choose an npf in russia. table 1: choice of the participants of pension savings programme, million people (percentage) organization 2005 2006 2007 2008 2009 2010 2011 2012 2013 non-state pension funds 0.60 (1.1) 0.90 (1.5) 1.88 (3.0) 3.62 (5.3) 5.68 (8.2) 8.72 (12.5) 11.88 (16.1) 16.57 (21.8) 22.19 (28.2) mcs 0.69 (1.2) 0.79 (1.3) 0.86 (1.4) 0.92 (1.4) 0.86 (1.3) 0.68 (0.9) 0.63 (0.9) 0.59 (0.8) 0.53 (0.7) vnesheconom bank 54.52 (97.7) 57.63 (97.2) 59.96 (95.6) 63.16 (93.3) 62.54 (90.5) 60.63 (86.6) 61.33 (82.9) 58.94 (77.4) 56.08 (71.1) total 55.81 59.32 62.70 67.70 69.08 70.03 73.96 76.10 78.80 source: review of pension saving investments in 2013//the ministry of finance of the russian federation, mc: management company tumanyants and gulyaeva: individual choice of a pension fund in russia: are the investment results of the fund important? international journal of economics and financial issues | vol 6 • issue 4 • 20161332 a traditional index uniting these two aspects of the operations in financial market is the sharpe ratio. nevertheless, most population evaluates the competitiveness of financial institutions by nominal yield from the savings contributed. that is why, as well as in the research by the imf (2007); we used both indexes in the regression studied. an important positive correlation between nominal yield and/or the sharpe ratio in pension savings investment into npf, on the one side, and the share of a certain npf in the pension savings investment market will give the evidence that the efficiency of investment is a valid tool of competition for clients capture. in this case competitive relationship becomes a stimulus for financial institutions to provide high yield, including per unit of a risk (koulis and botsaris, 2009). this means that the depositor gain from the work of several independent companies in the pension sphere. to increase the results validity, besides a model of linear regression, a doubly logarithmic model was made (barros et al., 2008; glans, 2008) and a logarithmiclinear model (pitselisa et al., 2015). in the conditions of high passivity of home economics’ behaviour the market shares of financial institutions can change very weakly, but clients’ reaction on the results of their investment activity, initially, can come out in the dynamics of the percentage of npf in the market, which let evaluate the logarithm of the market share. the logarithm of the regressors in the doubly logarithmic model gives a possibility to test a guess of the clients’ increased sensitivity not to yield volume the sharpe ratio, but to their changes. in other words, the clients can become more sensitive to the tendencies of investment results to change, rather than to the results. besides, logarithm indexes let reduce the risk of heterosсedasticity of the data (bikker et al., 2012). following tuladhar (2009), we used in modeling not only a least-square method but also a model of fixed effects. according to the order existing in russia, the change of an organization which invests the pension savings of an insured person can be made next year after an application is submitted to the pfr. thereafter, we think that the information about the yield and the sharpe ratio for t-year become available for clients in t + 1 year, in the same year a client, if finding out a more optimal variant for him/herself, submit an application to the pfr, and in the t + 2 year his/her pension account is transferred to a new npf. we made two groups of a model: in the first one the dependent variable is presented by the market share (share, in share) of clients of i-npf in the total number of clients of all the npf in t + 2 year; in the second one – a number of clients of i-npf (client, in number of persons) in t + 2 year. the yield indexes were used as regressors (yield, in percentage per year) and the sharpe ratio (coeff_sharp, percentage point per unit of standard declination) for t-year. b. information base of the study: in contrast with the study carried out by the imf (2007), we included in the regressors not only the annual yield but also the cumulative yield from 2005 to t-year (yield_cum, in percentage for the period). kominek (2012) proved in the study the use of the cumulative yield of pension funds by the fact that clients can quite logically prefer to estimate the investment results of npf for a more long-run time period. as npf started to work with pension savings in different years and some of npf stopped that work in the period analyzed, then a set of organizations investing pension savings used to change all the time. that is why the empirical basis of the study is presented by the data on npf which provided that service during the whole period analyzed. the clients of 39 npf, included in the selection, make from 60% to 80% of clients of all npf, which let characterizing the selection as e representative one. the npf, included in the selection, took part in 18 mergers with other funds during the period studied. aimed at using in the calculations the correct values we deducted from the index of share and client npf per year when the merger of another fund took place, the value of the fund joined. thereafter the data values were not corrected because we considered that those clients who turned to be in npf not by their own choice but as a result of the merger, in future had a chance to evaluate the results of the new fund’s investment and change that fund for another one if they wanted. the control variables in the regressions were presented by the data on the number of clients of npf (client_base, number of persons), size of assets of npf (asset, million rubles) in t-year and also the life of npf in the market (experience, number of years) by t + 1 year. with other equal conditions the control variables must have a positive influence of the market share of npf. in log-log models the experience variable was not used because its value in all npf rises up to the same level. the information source is the annual data of the federal service for financial markets of the russian federation and the central bank of the russian federation for the period from 2005 to 2013. the characteristics of the values are listed in table 2. starting since 2014, the state has imposed a moratorium on the change of npf till the end of the procedure of npf selection into the guaranteed pension savings system being created. in this connection, there is no sense to use the data after 2013. c. the results of modeling: the heterosсedasticity-adjusted results of assessment of coefficients of pair and multiple regressions (tables 3-8) table 2: descriptive statistics in npf variable mean value mid-point standard deviation minimal value peak value client 215545 40421 413768 118 2492093 share 0.017 0.003 0.031 0.00001 0.163 yield_cum 48.495 45.4369 24.719 11.5982 130.808 yield 9.574 9.0 8.949 0.000 62.37 coeff_sharp 6.167 5.685 3.023 2.312 21.808 asset 21554.8 1868.38 77051.4 120.571 773474 client_base 236711 68287 424769 5068 2519687 experience 12.769 13.000 2.803 4.000 18.000 npf: non-state pension fund tumanyants and gulyaeva: individual choice of a pension fund in russia: are the investment results of the fund important? international journal of economics and financial issues | vol 6 • issue 4 • 2016 1333 show the absence of statistically important correlation between the results of investment activity of and npf and its status in the market. the coefficients with yield_cum and yield variables in the multiple regression model (5) table 3 are statistically significant at 95% confidence level for the share of clients of i-npf (table 3), however, the values of these coefficients are very small and they have even a negative value for a cumulative yield which is contrary to the common sense. the same situation is found in the doubly logarithmic model (table 4). the change of the annual yield of i-npf by 1% with a probability of 90% leads to its market share change only by 0.08%. models 1-4 show the importance of the coefficients with regressors for the equation estimating their influence on the number of clients of npf (table 6) and also the rate of changes of clients of npf (tables 7 and 8). but a low coefficient of the r2 determination indicates a bad quality of the models. besides, a negative volume of the coefficient with the yield variable (tables 6 and 7) and its logarithm (table 8) is contrary to the common sense. the frames of the fixed effects model revealed a positive and statistically important influence of the change of the cumulative yield of i-npf on the rates of changes of the number of its clients (table 7), however, the singularity of this variant and not a high coefficient of the r2 model do not give enough evidence to disprove the hypotheses suggested. table 3: the results of assessment of correlation between the market share of npf and the results of investment activity of npf over the period of 2005-2013 (a linear regression model) dependant variable: market share of npf (share, share from the total number of citizens insured in npf) method/model least-squares fixed effects regressor (1) (2) (3) (4) (5) (6) yield_cum 4.92×10−5 (8.05×10−5) −9.32×10−5 (8.16×10−5) −0.0003** (0.0001) −4.41×10−5 (6.96×10−5) yield 0.0002 (0.0002) 0.0001 (0.0001) 0.0003** (0.0001) 6.826×10−5 (5.631×10−5) coeff_sharp −0.0017 (0.001) 0.002 (0.001) 0.0004 (0.0006) 0.0011* (0.0006) asset −8.78×10−8 (1.34×10−8) −9.425×10−9 (1.325×10−8) client_base 6.018×10−8*** (7.268×10−9) −9.646×10−9 (1.12×10−8) experience 0.0008 (0.0006) −0.301 (0.208) constant 0.015*** (1.732) 0.016*** (0.004) 0.007 (0.005) 0.008 (0.006) 0.0015 (0.005) 0.031*** (0.0096) standard error of regression 0.031 0.033 0.031 0.031 0.0178 0.0079 r2 0.002 0.002 0.027 0.032 0.677 0.164 number of cases 195 234 195 195 195 195 *p<0.1; **p<0.05; ***p<0.01. npf: non-state pension fund table 4: the results of assessment of correlation between the market share of npf and the results of investment activity of npf over the period of 2005-2013 (a doubly logarithmic model) dependant variable: variation of the market share of npf in the total number of persons insured in all npf (l_share, in percentage to the previous year) method/model least-squares fixed effects regressor (1) (2) (3) (4) (5) (6) l_yield_cum 0.174 (0.273) 0.116 (0.375) −0.669** (0.289) −0.1699 (0.291) l_yield −0.003 (0.088) −0.063 (0.105) 0.0769* (0.0438) 0.0685 (0.049) l_coeff_sharp 0.145 (0.322) 0.156 (0.553) −0.0409 (0.231) −0.1077 (0.204) l_asset −0.0208 (0.1306) 0.0273 (0.272) l_client_base 1.236*** (0.209) −0.0229 (0.339) constant −6.308*** (0.999) −5.538*** (0.284) −5.905*** (0.545) −6.194*** (1.198) −17.00*** (1.567) −4.823** (2.213) standard error of regression 2.096 2.041 2.097 2.072 1.194 0.619 r2 0.002 0.000 0.001 0.004 0.674 0.053 number of cases 195 191 195 152 152 152 *p<0.1; **p<0.05; ***p<0.01. npf: non-state pension fund tumanyants and gulyaeva: individual choice of a pension fund in russia: are the investment results of the fund important? international journal of economics and financial issues | vol 6 • issue 4 • 20161334 4. conclusion the modeling results show the absence of a significant correlation between the efficiency of investment activity of a financial institution and its status in the pension service market which proves the hypothesis developed. when choosing npf the russians follow the factors which are not connected with the quality of pension saving management among which there can be an image of npf, marketing policy efficiency, scale and qualification of the agent network, relationship of npf with big employers, etc. the study results indicate weak motivation for efficient placing of pension savings into npf in russia. that means that getting the highest yield (an optimal balance of yield and risk) is not an instrument for competition in the pension market in russia and the depositors do not win from a possibility to choose an organization managing their pension savings. the same results were found in a study of the pension markets in poland and hungary (imf, 2007; world bank and imf, 2005) and also in the latin american seven countries (tuladhar, 2009). the importance and a universal character of the problem of a table 6: the results of assessment of correlation between the number of clients of npf and the results of investment activity of npf over the period of 2005-2013 (a linear regression model) dependant variable: number of clients of npf (client, number of people) method/model least-squares fixed effects regressor (1) (2) (3) (4) (5) (6) yield_cum 3459.2** (1715.2) 1983.78 (1622.73) −513.37 (909.6) 759.92 (768.6) yield −2170.71* (1122.74) −2916.97*** (1057.30) −105.68 (778.14) −20.767 (489.018) coeff_sharp 35896.4** (16437.5) 28515.7* (16892.7) 5024.9 (7683.24) 4130.47 (4160.49) asset 0.07 (0.163) 0.1212 (0.116) client_base 0.81*** (0.169) 1.043*** (0.0699) experience 15056.6* (8797.95) −5823.65 (8971.44) constant 47,792.2 (57,071.1) 212,854*** (58,815) −5820.04 (71,682) −32,551.7 (69,520.0) −175,140* (97,791.7) −21,851.0 (93,705.8) standard error of regression 405,884.2 386,446.6 400,320.8 400,084.0 203,969.6 99,359.85 r2 0.043 0.003 0.069 0.0795 0.765 0.75 number of cases 195 234 195 195 195 195 *p<0.1; **p<0.05; ***p<0.01. npf: non-state pension fund table 5: the results of assessment of correlation between the market share of npf and the results of investment activity of npf over the period of 2005-2013 (a logarithmic-linear model) dependant variable: variation of the market share of npf in the total number of persons insured in all npf (l_share, in percentage to the previous year) method/model least-squares fixed effects regressor (1) (2) (3) (4) (5) (6) yield_cum 0.0009 (0.0059) −0.0021 (0.0072) −0.01 (0.00768) 0.0044 (0.0069) yield −0.007 (0.0079) −0.0009 (0.00787) 0.0085 (0.00675) −0.002 (0.0044) coeff_sharp 0.0407 (0.0519) 0.0499 (0.0622) −0.031 (0.052) 0.016 (0.019) asset 8.6×10−7 (2.26×10−6) 3.038×10−7** (1.33×10−7) client_base 2.94×10−6*** (7.07×10−7) 1.938×10−7 (3.27×10−7) experience 0.034 (0.096) −0.173** (0.087) constant −5.701*** (0.413) −5.679*** (0.329) −5.907*** (0.398) −5.854*** (0.431) −6.183*** (0.904) −3.794*** (0.915) standard error of regression 2.098 2.075 2.095 2.105 1.702 0.571 r2 0.0001 0.001 0.004 0.004 0.359 0.07 number of cases 195 234 195 195 195 195 **p<0.05; ***p<0.01. npf: non-state pension fund tumanyants and gulyaeva: individual choice of a pension fund in russia: are the investment results of the fund important? international journal of economics and financial issues | vol 6 • issue 4 • 2016 1335 table 7: the results of assessment of correlation between the number of clients of npf and the results of investment activity of npf over the period of 2005-2013 (a doubly logarithmic model) dependant variable: variation of number of persons insured in npf (l_client, in percentage to the previous year) method/model least-squares fixed effects regressor (1) (2) (3) (4) (5) (6) l_yield_cum 0.905*** (0.277) 0.858** (0.376) 0.0822 (0.298) 0.766** (0.2936) l_yield −0.299*** (0.0866) −0.198* (0.106) −0.059 (0.045) −0.024 (0.0479) l_coeff_sharp 0.776** (0.311) 0.362 (0.543) 0.166 (0.235) −0.003 (0.179) l_asset 0.0001 (0.1306) 0.1304 (0.275) l_client_base 1.194*** (0.216) −0.013 (0.334) constant 7.228*** (0.990) 11.149*** (0.297) 9.291*** (0.532) 7.137*** (1.194) −3.385** (1.6099) 6.926*** (1.903) standard error of regression 2.071 2.092 2.092 2.041 1.18 0.606 r2 0.0497 0.019 0.0299 0.073 0.694 0.344 number of cases 195 191 195 152 152 152 *p<0.1; **p<0.05; ***p<0.01. npf: non-state pension fund weak reaction of the consumers of pension products to their quality are proved by the attempts of a number of countries to find the ways to solve it. in poland, the state used a lottery to divide the clients who did not make their own choice among small pension funds which had shown good investment results. in macedonia such citizens are divided by the government between two existing pension funds using a special technique comparing the yield of competitors for the previous period. in armenia the citizens, who cannot make a choice by themselves, are divided between two existing funds in proportion to citizens who had made their choice. as competition in the pension market does not perform a function to regulate a conflict of interest in “principal-agent” relationship then some countries have chosen a way of centralization of management of pension savings in hands the state institutions. sovereign investment pension funds exist in 23 countries. a small number of npf which worked with pension savings during the whole period analysed and a moratorium on pension savings imposed by the government since 2014 determined quite a small number of cases, which limits the quality of the statistic analyses carried out in the paper. nevertheless, the hypotheses proposed in the future can be tested in the total choice of npf and mcs, and also using in the models additional control variables, for example a form of ownership – npf/mc; their affiliation to a large financial industrial group, network size and the expenses for advertisement of npf. the study carried out provides the basis for investigation of a complex table 8: the results of assessment of correlation between the number of clients of npf and the results of investment activity of npf over the period of 2005-2013 (a logarithmic-linear model) dependant variable: variation of number of persons insured in npf (l_client, in percentage to the previous year) method/model least-squares fixed effects regressor (1) (2) (3) (4) (5) (6) yield_cum 0.015** (0.0066) 0.012 (0.00791) 0.003 (0.0076) 0.0038 (0.0069) yield −0.011 (0.007) −0.01496* (0.00788) −0.0038 (0.0067) −0.001 (0.0044) coeff_sharp 0.1221** (0.519) 0.075 (0.0649) −0.009 (0.051) 0.008 (0.019) asset 1.22×10−6 (2.31×10−6) 3.538×10−7*** (1.33×10−7) client_base 2.82×10−6*** (7.32×10−7) 1.818×10−7 (3.28×10−7) experience 0.069 (0.097) 0.181** (0.088) constant 9.867*** (0.4189) 10.569*** (0.335) 9.8635*** (0.3997) 9.677*** (0.4304) 8.986*** (0.932) 8.021*** (0.92) standard error of regression 2.0896 2.12 2.09197 2.087 1.69 0.572 r2 0.033 0.002 0.0303 0.045 0.383 0.337 number of cases 195 234 195 195 195 195 *p<0.1; **p<0.05; ***p<0.01. npf: non-state pension fund tumanyants and gulyaeva: individual choice of a pension fund in russia: are the investment results of the fund important? international journal of economics and financial issues | vol 6 • issue 4 • 20161336 of determinants of a consumer’s choice in the russian pension market. the necessity to increase the efficiency of savings placement in funding of pension obligations in russia requires making a reform in the national model of pension system taking into consideration the results of the study carried out and international experience. it seems appropriate to turn to a centralized order of pension savings investment in the frames of the unified nationwide fund. that will allow decreasing administrative and regulative expenses of functioning of a cumulative component of the pension system in comparison with the centralized model existing in russia (agostini et al., 2014). however, the efficiency of the centralized model is determined by the level of the governmental accountability to the society, transparency and formalization of the savings investment procedures, political elite’s readiness to follow the population’s long-term interests. in russia, the fulfillment of these circumstances is not guaranteed. partly, this gap can be filled with the state recognition of a passive investment strategy for such a unified fund (sy, 2009), and its portfolio structure is determined normatively by stock index (benchmark). the experience of the latin american countries shows that the reduction of risks in index investment can be also promoted by the differentiation of the investment portfolio structure for different age groups of the population. nevertheless, the problem of the preference of centralized investment of obligatory pension savings in comparison with a decentralized, “competitive” one requires to be studied separately. 5. acknowledgments the paper is made in the frames of scientific project no.14-02-00112 supported by the russian foundation for the humanities. references acemoglu, d., kremer, m., mian, a. 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(2004), the occupational pillar of the south african pension system. development southern africa, 21(2), 303-327. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.93-106 issn: 2146-4138 www.econjournals.com 93 state dependence in unemployment nisar ahmad1 department of border region studies, university of southern denmark, sønderborg, alsion 2, 6400, denmark. phone: office +45 6550 1773, fax +45 6550 1779. email: nisar@sam.sdu.dk abstract: this study examines the extent state dependence among unemployed immigrants in a dynamic discrete choice framework. three alternative methodologies are employed to control for the problem of the initial condition. the empirical findings show that there is a considerable correlation between the unobserved individual heterogeneity and the initial condition and that the degree of state dependence is overstated if we do not address this problem. the results show that an individual who was unemployed at period “t-1” has 6.5 percentage points higher probability of being unemployed again at period t compared to an individual who was employed at period “t-1”. keywords: immigrants; unemployment; state dependence; unobserved heterogeneity; dynamic random effects models. jel classifications: c23; c25; j22 1. introduction high unemployment among immigrants has increasingly become a focus for policymakers in many countries. the effectiveness of public policy directed towards the unemployment problem might depend on the extent of state dependence in unemployment. for example, consider a policy change which has the effect of temporally moving unemployed workers into employment. if there is a positive true state dependence in employment, the policy intervention will cause a persistent increase in employment. consequently, the intervention is likely to reduce the number of individuals who are dependent on benefits or live on a low income (prowse, 2005). in this case, changes in benefit rules are also more likely to meet their objectives (jörgen hansen, lofstrom, & zhang, 2006). on the other hand, if the observed serial persistence in unemployment is due to the permanent unobserved heterogeneity, then the policy stated above is less likely to have an effect. but it is important to know whether the state dependence is driving employment prospects (known as true state dependence), or conversely, whether unobserved heterogeneity plays that role (known as spurious state dependence). put differently, is the mere experience of being unemployed a relative disadvantage to a person, or can it be attributed to unobserved individual heterogeneity (knights, harris, & loundes, 2002)? kari (2003) has described various reasons for true state dependence. for example, firms try to figure out the quality of workers from their labour market history (katz & gibbons, 1991). similarly, firms can rank job applications based on the duration of unemployment of the job seekers (blanchard & diamond, 1994). therefore, a firm might find it optimal to use different employment criteria for different groups of job seekers (sattinger, 1998). in addition, eriksson (2002) argues that discrimination based on employment status is an equilibrium hiring strategy. even firms are allowed to set wages according to the workers’ expected productivity. as a result, an unemployed person may be permanently affected when applying for vacancies. (heckman & borjas, 1980) describe how experience of unemployment may change the behaviour of the unemployed person by changing his preferences and constraints. other reasons for true state dependence are reduced productivity due to deteriorating existing human capital and the prevention of the accumulation of human capital (mincer 1 i gratefully acknowledge the comments i received from michael svarer. i would like to thank michael rosholm for helping me to get access to the data from the danish institute of local government (akf). international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.93-106 94 & polachek, 1974). as explained in (kari, 2003), the above discussion implies a causal relationship of previous unemployment with future unemployment. some persons may be observed continuously unemployed since their probabilities of getting a job are limited due to unobserved characteristics (e.g. lack of punctuality). if the unobserved characteristics among individuals remain uncontrolled and if they are correlated over time, previous unemployment may appear to determine further unemployment solely because it acts as a substitute for temporally persistent factors. this results in overestimation in the magnitude of state dependence and, accordingly, in false policy recommendations (kari, 2003). several studies have investigated the issue of state dependence and unobserved heterogeneity in unemployment. most recently, stewart (2006) has examined the extent of the state dependence in unemployment for the uk, and the role played in this by low-wage employment. the study shows that an individual unemployed at t-1 is more than twice as likely to be unemployed again at t as someone who was employed at t-1, but otherwise has the same observed and unobserved characteristics. however, corcoran and hill (1985) find that past unemployment does not increase the current unemployment probability for prime age men, once unobserved heterogeneity and data collection procedures are controlled for. but most of the studies show the existence of strong state dependence in unemployment, see for example, narendranathan and elias (1993) for britain, hyslop (1999) for the us, frijters, lindeboom, and van den berg (2009) for holland, haan (2006) for germany, islam (2006) for sweden, among other studies. jorgen hansen and lofstrom (2009) have shown that immigrants have a greater degree of state dependence in welfare participation than native. they have also argued that the state dependence among the swedes appears to be due to the unobserved heterogeneity, possibly welfare preferences, to a greater extent than it is among the immigrants from refugee countries. le maire and scheuer (2006) have found evidence of a positive and significant state dependence for selected groups with weak labour market participation in the danish labour market. in this study, special attention is paid to control the unobserved heterogeneity and initial condition problem. these issues are addressed by using alternative estimators, i.e. the wooldridge estimator and the heckman estimator, and the results are compared to assess their robustness. the empirical findings reveal a significant state dependence in unemployment. the estimates also show considerable correlation between the unobserved individual heterogeneity and the initial condition, which implies that the degree of state dependence is overstated if we do not control for it. the results show that an individual who was unemployed at period t-1 has 6.5 percentage points higher probability of becoming unemployed again at period t compared to an individual who was employed at period t-1. this average partial effect is the same for western compared to non-western immigrants and women compared to men. the rest of this study is organized as follows: descriptions of the behavioral model and econometric specification are presented in section 2 along with explanations of the alternative estimators used in this study. section 3 gives a data description and some descriptive analysis. empirical results are discussed in section 4. section 5 concludes the study. 2. behavioural model and econometric specification discrete choice models of labour supply are based on the concept of random utility (train, 2009). the theory of decision making is very simple. the aim of the decision maker n (individual) is to maximize his life time utility  u by optimally choosing from a finite number of alternatives  j of leisure and income at a specific time  t . njtu is the utility that the decision maker n gets from the alternative j at time t. he will choose alternative i if and only if tijuu njtnit  , . the researcher does not observe the actual utility obtained by the decision maker, but he observes some characteristics  nts of the decision maker and some characteristics of the alternatives  njtx that may lead to the decisions made by the decision maker. for the researcher, this utility can be decomposed into two very general parts, i.e., representative utility  njtv and the unobserved part of utility  njt , i.e., njtnjtnjt vu  . here njtv is a function which relates the observed factors to the decision state dependence in unemployment 95 maker's utility, for example, in case of a linear representative utility ntnjtnjt sxv   . the inclusion of the lagged values of the choice variable makes this decision process dynamic. due to the unobserved factors, the researcher cannot predict the actual decisions, but he can make some probabilistic statements about the choices of the decision maker. these choice probabilities depend upon the characteristics of the decision maker, the attributes of alternatives and the assumptions about the unobserved part njt . the choice probability for the alternative i can be written as follows:  tijvvp njtnjtnitnitnit  and prob  (1) by using an indicator function and the distribution of unobserved components, the choice probability can be written as follows:     and nnnjtnitnitnjtnit dftijvvip   (2) here i(.) equals 1 if the statement in the brackets is true. otherwise it is 0. the assumptions about n will lead to various econometric specifications of the discrete choice models. 2.1 modelling state dependence and unobserved heterogeneity (true or spurious state dependence) state dependence is a behaviour in which an individual’s preference in a particular state at time t will increase the probability of being in the same state at period at period t+1, conditional on the observable characteristics. in the context of the labour market, the working behaviour of the last period affects the current labour supply decision. heckman and willis (1977) have discussed two possible types of state dependence. first, true state dependence will be observed if an individual's presence in a state at time t changes prices, preferences or constraints which are relevant for their future behaviour. for example, this could take the form of a past unemployment experience decreasing the individual's stock of human capital, which in turn decreases his future wage (mincer & polachek, 1974). alternatively, fixed costs related to job search can make unemployment more attractive if the individual is already unemployed instead of employed (heckman & borjas, 1980). secondly, spurious state dependence will be observed if there is inter-temporally correlated unobserved individual specific heterogeneity. this heterogeneity can be time varying or time invariant, or a combination of both. for policy makers it is important to know whether the state dependence drives the unemployment prospects or, conversely, if it is heterogeneity. state dependence can be modelled by introducing a lagged unemployment state indicator 1nty into the representative utility. if the representative utility is linear in the observed factors, then the utility function will take the following form: njtntntnjtnjt ysxu   1 . there will be a positive true state dependence if 0 , with the assumption that the unobserved components njt are independently distributed over n, j and t. in the above specification it is also assumed that only the previous year’s employment status matters to the current behaviour. hence, true state dependence is markovian. this specification is based on the presence of search and transition costs (see, for example, hyslop (1999)). heckman and borjas (1980) have also discussed several other representations of the true state dependence. any dynamics related to observed factors can be handled by using a conditional discrete choice specification, which consistently estimates the model. if the unobserved components njt are not independently distributed due to the possible existence of unobserved heterogeneity, then these can be decomposed into two parts, i.e., *nts  and njt , where * nts represents the unobserved individual specific attributes. now the utility function will take the form: njtntntntnjtnjt sysxu   * 1  . (3) many studies have used this equation to analyse state dependence in unemployment, using a dynamic random effects probit model, for example stewart (2007). 2.2 econometric specification this paper uses several dynamic estimators to model the probability of unemployment. these estimators include a lag dependent variable to allow for state dependence. special attention is given to international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.93-106 96 the treatment of unobserved heterogeneity and initial conditions, since ignoring these can produce overstatement of the true state dependence in unemployment. 2.2.1 standard random effects probit model the dynamic empirical model of unemployment probability involves consistent estimation of the following reduced form equations of the behavioural process described in equation (3):       ,...,2;,...,1 0,,|1pr 11 ttniuxyixyy itiititiititit    (4) where ity is an indicator function for unemployment, itx is a vector of explanatory variables (includes personal and other characteristics).  and  are the unknown parameters to be estimated. i is an individual specific component which captures the time invariant unobserved human capital and taste, and itu is a possibly serially correlated error term that can vary over i and t 2. asymptotics of the model depend on n, whereas t is small and taken as fixed. depending on the assumptions made about unobserved heterogeneity and explanatory variables, different estimators are used in order to consistently estimate the model. the unemployment probability is modeled using a dynamic random effects probit model given in the following equation: 1 * itiititit uxyy    (5)    0,,|1pr *1   itiititit yixyy    ,0~ 2uit nu  where *ity is a latent variable and we observe 1ity if 0 * ity . the standard probit model assumes that i is uncorrelated with the explanatory variables itx . for identification purposes, normalization is required since y is a binary variable. a convenient one is to assume 12 u . the composite error term  itiit uv   will be correlated over time due to individual specific time invariant i terms, even if itu is assumed to be iid. in this case, the correlation of the composite error term  itiit uv   over time is given as follows:   1 ,, 2 2      stvvcorr isit (6) the estimated parameters of the standard random effects probit model are biased if unobserved variables are correlated with observed variables. mundlak (1978) and chamberlain (1982) provide another estimator that allows correlation either between i and the time means of the explanatory variables or the combination of their lags and leads. in other words, the estimator assumes that the relationship between itx and i is completely captured by including the means of time varying explanatory variables or combinations of their lags and leads. the relationship can be written as follows:  2 1 ,0~ e wheror  iidnaxax ii t t itiiii    (7) substituting this expression with the first expression in equation (5), we get the following extended specifications of the standard random effects models, known as correlated random effects model.   0,n~ where 2u1*  ititiiititit uuaxxyy   (8) or   0,n~ where 2u 0 1 *  ititi t t titititit uuaxxyy     (9) 2 to make these standard models comparable with heckman estimator we estimated all models from t =2,…t. state dependence in unemployment 97 in this study the specification in equation (8) is used for estimating random effects models. again, normalization is necessary and it is assumed that 12 u . the correlation between the composite error term itiit uv   for the different periods can be written as follows:   1 ,, 2 2       stvvcorr isit (10) an advantage of this specification is that one can perform a standard wald type test to verify the correlation between itx and i . 2.2.2 heckman’s estimator3 the inclusion of the lag dependent variables creates the problem of initial condition, which implicitly assumes that the initial observations are independent of the unobserved variables (as assumed in section 2.2.1 and 2.2.2). in simple terms, this assumption means that the start of the behavioral process coincides with the start of the observation period for each individual. this assumption is too strong for this study, since this study uses data from 1994 to 2003, and clearly 1994 is not the start of the behavioral process for some individuals. therefore, estimation requires some assumptions about the initial observation 1iy and the unobserved heterogeneity i . heckman (1981) has specified the following reduced form equation for the initial observation. 1 * 1 ii zy i   (11) where 1iz includes 1ix or other exogenous variables and i is allowed to be correlated with i , but uncorrelated with itu for 2t . it can be written as: 0;1   iii u using orthogonal projection, with i and 1iu independent of one another. it is also assumed that 1iu satisfies the same distributional assumptions as itu for 2t . the linearized reduced form for the initial period can therefore be written as follows: 11 * 1 iii uzy i   (12) the outcome probability and the joint likelihood function of  iti yy ,...1 for an individual i given i can be written as follows:                                  n i t t iititii t t iiiititiii dfyaxyxyzl yaxyxyz 1 * 2 1 * 11 * 1 2 1111 * 12.12 12.12     (13) this expression is maximized for a random sample of individuals.  is a standard normal cumulative distribution function. f is the distribution function of   * and  .1   stewart (2006) has provided a new stata command, “-redprob-” for estimating heckman’s estimator. in this procedure, the integral over * is evaluated using the gaussian-hermite quadrature, (stewart, 2006). 2.2.3 wooldridge’s conditional maximum likelihood estimator4 the heckman estimator approximates the joint distribution of all the outcomes of the endogenous variables. however, it is very rarely used since standard software does not include estimation routines to estimate the heckman estimator. alternatively, wooldridge (2005) has provided a simple solution to approximate the initial condition problem by specifying the distribution of the unobserved individual heterogeneity, conditional on the initial condition. the main advantage as claimed by wooldridge is that it can be implemented using standard econometrics software. in wooldridge estimators the distribution of the unobserved effect can be specified as follows: 3 this discussion is derived from stewart (2007), the detailed discussion about this estimator can be found in heckman (1981b) 4 this discussion is based (chrysanthou, 2008) international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.93-106 98     ,..., ;,~,/ 121111 itiiiitiiii xxxyaxyxnxy    (14) the explanatory variables for all periods under consideration are included in a row vector ix . generally, if the above density is allowed to depend on all elements of ix then the way in which any time-constant exogenous variables can appear in the structural density is restricted. to increase the explanatory power, we can include time-constant explanatory variables, but we will not be able to identify separately the partial effect of the time constant variables from its partial correlation with i (wooldridge, (2005): p.44). the density of the observed decision  iti yy ,...1 , conditional on   iii xxyy and ,,11 , can be written as follows:                              t t iitt y iitt ty t axyyxaxyyx 1 111111 1 1.  (15) in order to find the joint distribution, we need to integrate out i against the normal  2,0  . this will give the likelihood function as follows:       daxyyxaxyyxr t t y iitt y iitt t t 11. 1 1 111111                              this expression of the likelihood function is identical to the structure of the standard random effects probit model; the only difference is that the explanatory variables at time t now also include the initial value of the dependent variables i.e., 1iy . it is assumed that the data are observed for each cross-sectional unit in all time periods. although, given a specific sample selection, mechanisms can be employed for the subset of the observations forming a balanced panel. the estimation can be carried out by adding 1iy and ix as the additional explanatory variables n at each time period and using a computationally easy standard random affects probit software (e.g. -xtprobitin stata). in this study we have estimated both heckman and its approximation by the wooldridge estimator to see the robustness of our results. stewart (2007) has analyzed alternative estimators, including heckman and wooldridge type estimators, for dynamic discrete choice models. their paper gives an examination of the relative merits of the heckman, orme and wooldridge estimators. it also analyzes the differences between the three estimators. in the context of an empirical illustration, it uses a model of unemployment probability, after which, it presents a monte carlo experiment for finite sample performance. 3. data and descriptive analysis the data used in this study is drawn from danish administrative registers supplied by statistics denmark to the danish institute of local government studies (akf)5. it is yearly panel data which includes the full population of immigrants in denmark, aged 15 and above6. it covers approximately 20% of the immigrant population in the period from 1994 to 2003. the sample contains information on a very large number of labour market and demographic characteristics of the individuals and their families. in order to avoid selection problems due to education and retirement, the sample is restricted to individuals between age 25 and 59 (both included). the analysis is also restricted to married or cohabiting individuals because explanatory variables include spouse information. self-employed and wage earners have different behaviour regarding labour supply, hence the former are excluded from the sample. in order to avoid biasness due to frequent entry and exit of immigrants, we restricted the analysis on a balance panel. the final sample consists of 6767 individuals. the disposable income of the spouse is used to capture the effect of the exogenous income on the unemployment. it is approximated by using the following expression: 5 i would like to thanks akf for providing the data. 6 the data is recorded every year in the third week of november. state dependence in unemployment 99 disposable income7 = personal income + capital income + family benefits + housing benefits + flow value of property – total taxes personal income is the actual taxable income of a person during the calendar year. it does not include pension or labour market contributions, tax free loans, housing transfers, child benefits, other tax free income, etc. family benefits mainly include child benefits or other family transfers from the government. to correct the homeowners' disposable income, so that it is comparable to that of those renting their home, the flow value of property is calculated by multiplying the value of property with the interest rate8. permanent and transitory definitions of the spouse’s disposable income are used as explanatory variables to illustrate the effect of the exogenous changes in income (similar to hyslop (1999) and croda and kyriazidou (2005)). the permanent income is just the average income of the individual over the years, whereas the transitory income is the annual deviation from this average. immigrants are sub-divided into two main categories, namely western and non-western immigrants. statistics denmark classifies the following as western countries: 27 eu-countries, iceland, norway, andorra, liechtenstein, monaco, san marino, switzerland, the state of vatican city, canada, usa, australia and new zealand. all other countries are classified as non-western countries. approximately 52% of the immigrants in the sample are from non-western countries. the dependent variable used in this study is the status of unemployment. a person is considered unemployed if he or she does not have a job, but has searched for it, and is available for work. the unemployment status and other explanatory variables are recorded in the 3rd week of november every year. the data does not include information about the duration of unemployment, so we cannot distinguish between longer and shorter unemployment spells. the lists of the explanatory variables along with the summary statistics are reported in table 1. the table shows that 9.2% of all immigrants 7 disposable income is adjusted for inflation using consumer price index with 1994 as base period. 8 annual bond yields (all central-government bonds and mortgage-credit bonds) are used as interest rate (it really does not matter which interest rate we use). it is taken from the website of denmark’s national bank. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.93-106 100 in the sample (1994-2004) are unemployed. non-western immigrants have much higher unemployment (14.2%) compared to western immigrants (4.2%). moreover, the comparison of individual characteristics shows that non-western immigrants are relatively young, have a high proportion of young children, a low proportion of post-secondary education, a low proportion of employed spouse and they are considerably less experienced compared to western immigrants. for example, the average age, proportion of young children, years of experience, and proportion of postsecondary education for non-western immigrants are 40.81, 0.19, 9.29, and 0.20 respectively. whereas the equivalent figures for non-western immigrants are 44.48, 0.12, 11.79, and 0.406, respectively. the probabilities of unemployment, conditional and unconditional on the previous unemployment status at (t-1) for various groups, are reported in table 2 for the sample period 19942003. the raw unconditional probability of being unemployed for all immigrants is 9.23% in the sample. the probability of being unemployed conditional on being employed in the previous period is 4.40%, while the conditional on being unemployed in the previous period is 46.9%. in simple words, about 46.9% of the individuals who were unemployed at period t-1 are still unemployed at period t. thus, the probability of being unemployed at period t is much higher for those who were also unemployed at t-1. hence there is a strong evidence of state dependence in unemployment. table 2. conditional and unconditional probabilities of unemployment unconditional probabilities (1) conditional probabilities partial effect (4) = (3) (2) probability ratio (5) = (3) / (2) employed at t-1 (2) unemployed at t-1 (3) all immigrants 0.092 0.044 0.469 0.425 10.66 western ( 42.8% ) 0.042 0.024 0.382 0.358 15.92 non-western ( 57.2% ) 0.147 0.068 0.495 0.427 7.28 male 0.088 0.042 0.449 0.407 10.69 female 0..097 0.045 0.489 0.444 10.87 columns 4 and 5 in table 2 formalise state dependence by presenting two descriptive measures. column 4 shows the partial effect of previous year unemployment status on the probability of unemployment in the current period. raw data shows that an individual who was unemployed at period t-1 has about 42.5 percentage points higher probability of being unemployed again at period t compared to an individual who was employed at period t-1. column 5 shows how many times more likely it is for those who stay unemployed in comparison to those who move into unemployment in the next period. someone unemployed at t -1 is more than 10 times as likely to be unemployed at t as someone employed at t -1. these partial effects and probability ratios are higher for western compared to non-western immigrants and women compared to men. these figures clearly show strong evidence of state dependence in the raw probabilities, but the question is how much of this observed state dependence is due to observed and unobserved characteristics and how much stems from true state dependence. 4. results the results of different models, described in the previous section, are reported and discussed in this section. first, the results for all immigrants are analysed. second, the issue of state dependence is analysed across gender and country of origin. the estimation results of random effects probit models for the probability of being unemployed, using different estimators are reported in table 3. a lag dependent variable is included in all models to allow for state dependence. yearly dummies are included to control for the time effect. pooled probit estimates are shown in column 2 for the comparison. this model assumes the whole panel as a large cross section; therefore, it does not allow any correlation across different periods. this restrictive pooled probit model provides inefficient parameter estimates, but it is an initial consistent estimate of the parameters (maddala, 1987). state dependence in unemployment 101 table 3. estimation results for unemployment probabilities of all immigrant pooled probit random effects probit wooldridge estimator heckman’s estimator variable coefficient (s.e) coefficient (s.e) coefficient (s.e) coefficient (s.e) lag unemployment 1.004** (0.036) 0.785** (0.041) 0.750** (0.041) 0.722** (0.041) unemployment status (period 1) 0.216** (0.037) (lag unemployment ) (western) 0.243** (0.053) 0.177** (0.058) 0.172** (0.059) 0.148** (0.059) (lag enemployment ) (female) 0.053 (0.046) 0.068 (0.051) 0.044 (0.051) 0.048 (0.051) employment status of spouse -0.139** (0.025) -0.151** (0.029) -0.152** (0.030) -0.151** (0.030) age -0.086** (0.014) -0.093** (0.017) -0.123** (0.017) -0.124** (0.017) age squared 0.001** (0.000) 0.001** (0.000) 0.002** (0.000) 0.002** (0.000) children (0-2) 0.106** (0.026) 0.136** (0.029) 0.213** (0.035) 0.215** (0.036) children (3-6) 0.041** (0.020) 0.062** (0.023) 0.098** (0.026) 0.097** (0.026) children (7-9) 0.012 (0.021) 0.022 (0.024) 0.026 (0.025) 0.023 (0.025) contry of origin (western) -0.207** (0.029) -0.227** (0.036) -0.177** (0.037) -0.223** (0.038) country of origin spouse (western) 0.046 (0.044) 0.050 (0.057) 0.026 (0.059) 0.017 (0.060) experience -0.147** (0.011) -0.198** (0.014) -0.131** (0.015) -0.133** (0.015) experience squared 0.003** (0.001) 0.005** (0.001) 0.005** (0.001) 0.005** (0.001) insured 0.668** (0.053) 0.779** (0.065) 0.643** (0.093) 0.654** (0.093) descendant -0.126* (0.074) -0.150* (0.091) -0.152* (0.093) -0.138 (0.094) homeownership -0.190** (0.024) -0.206** (0.030) -0.204** (0.031) -0.195** (0.031) high school -0.065* (0.040) -0.075 (0.053) -0.042 (0.055) -0.057* (0.056) post secondary education -0.052** (0.026) -0.069** (0.034) -0.042 (0.035) -0.060* (0.036) vocational traning -0.253** (0.030) -0.314** (0.039) -0.274** (0.040) -0.311** (0.041) female 0.005 (0.026) 0.016 (0.032) -0.023 (0.034) -0.013 (0.034) permanent spouse’s income /10000 -0.004** (0.002) -0.006** (0.003) -0.005 (0.003) -0.004 (0.003) temporary spouse’s income 0.004 (0.003) 0.005 (0.003) 0.004 (0.003) 0.005 (0.003) constant 0.800** (0.290) 1.058** (0.351) 1.875** (0.378) 1.988** (0.380) u 0.456** (0.023) 0.480** (0.023)  0.172** (0.014) 0.187** (0.015) 0.204** (0.015)  0.913** (0.111) note: estimation results include year dummies and arrival cohorts in all specifications. ** parameter estimate is significant at 5% level of significance. s.e (standard error) * parameter estimate is significant at 10 % level of significance. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.93-106 102 the estimated degree of state dependence will be overestimated in the model, since serial dependence over time in unobserved factors is estimated as state dependence. the likelihood ratio test can be applied in random effects specification to test zero correlation over time, i.e., 0 . the test was rejected, i.e., 0 , implying that reported pooled probit estimates are rejected in favour of the random effects probit estimates. in random-effects models the likelihood (for an independent unit i) is expressed as an integral, which is computed using the gauss-hermite quadrature. after fitting the model, the quadrature checks are undertaken, and the results show that the parameter estimates were nearly invariant to the quadrature point variation. hence, the estimated results can be explained confidently. all models, except pooled probit models, are estimated with the assumption that the explanatory variables could be correlated with the unobserved heterogeneity (correlated random effects). this correlation is allowed by augmenting the standard random effects model with means of explanatory variables. the argument that correlation between the initial condition and the unobserved heterogeneity results in an over-estimation of the extent of state dependence in employment is confirmed by wooldridge’s and heckman’s estimators. one of the major advantages of wooldridge’s estimator is its computational simplicity, which reduces the estimation process quite a lot, as compared to heckman’s estimator, developed by stewart (2006)9. the proportion of the total error variation attributed to unobserved individual heterogeneity, ρ, was significantly higher in this estimator. tests of the exogeneity of the initial conditions can be performed in both wooldridge’s and heckman’s estimators. in wooldridge estimator, the coefficient on the initial value of unemployment status is statistically significant. with regard to the heckman estimator, the exogeneity of the initial condition requires that 0 , which is also strongly rejected. this indicates considerable correlation between the initial condition and unobserved heterogeneity, and thus must be taken into account. the coefficient of the lagged unemployment status is highly significant in all the estimated models. this indicates a positive state dependence in unemployment after controlling for the unobserved effects. random effects probit and pooled probit estimates use different normalizations for identification; hence for comparison these estimates should be adjusted. random effects use 12 u , and therefore the reported parameter estimates are the ratio of the true parameters with the u , whereas, the reported estimated parameters of the pooled probit model are the ratio of the v , as it uses the normalization 12 v . hence, the random effects parameter estimates have to be multiplied by the factor vu   ˆ1 for the comparison (see arulampalam (1999) for details). the rescaled lagged unemployment coefficients in the random effects models are reduced to 0.714, 0.676 and 0.644 for the random effects, the woodridge and heckman estimators respectively. these results confirm that the correlation between the initial condition and the unobserved individual heterogeneity provides inconsistent pooled probit estimates and overstates the extent of the state dependence. the magnitude of parameters in non-linear models is difficult to interpret directly; instead it can be used to calculate partial effects with respect to an explanatory variable. in discrete choice models, such as random effects probit models, these effects depend on all other parameters and levels of the explanatory variables. the inclusion of lagged dependent variable in our formulation allows us to find transition probabilities in the estimated model, i.e. we can find the probability of unemployment conditional on the unemployment status in the previous period. table 4 shows such conditional probabilities. for comparison, column one reports the raw conditional probabilities from the observed data (already reported in table 2). the table shows that about 46.9% of the unemployed individuals at period t-1 are still unemployed at period t. this observed state dependence in unemployment is reduced by more than half in the pooled probit model where we have controlled for observed explanatory variables, but still no serial correlation in the unobserved part is allowed. state dependence further reduces to 9.7% in the random effects probit model which confirms that there is 9 in this study, the heckman estimator took approximately 9 days to achieve convergence with our sample data, whereas, the wooldridge estimator converged in 2 hours. state dependence in unemployment 103 serial persistence in unemployment due to unobserved heterogeneity. finally, state dependence reduces to 8.8% and 7.7% in the wooldridge and heckman estimators, which solves the initial condition problem. similarly, the observed transitional probability (4.4%), i.e. the probability of unemployment in the current period conditional on being employed in the previous period, reduces to 1.2% after controlling for unobserved heterogeneity and initial condition. the average partial effect (ape)10 with respect to the unemployment status of the previous period is the change in the predicted probability of unemployment when lagged unemployment status changes from 0 to 1. the estimated average partial effects at average values of explanatory variables for different groups are reported in table 5. the pooled probit model gives an average partial effect of 17.9%, less than half of the observed effect. the wooldridge and heckman estimators reduce the observed ape by about one-sixth, i.e. 6.9% and 6.5% respectively. an individual with a given set of observed and unobserved characteristics has about 6.5% percentage points higher probability of being unemployed again if he was unemployed at period t-1 compared to an individual who was employed at period t-1. stewart (2007) found ape of 15 percentage points for low wage employment in uk. similarly, kari (2003) found an analogous effect to be 9-25% for finland. the magnitude of predicted probability ratio (pr) shows that an individual with a given set of observed and unobserved characteristics has about 6 times higher probability of being unemployed again if he was unemployed at period t-1 compared to an individual who was employed at period t-1. in denmark, the unemployment rate is much higher for non-western immigrants as compared to western immigrants. there are various reasons for this which can be seen in the observed characteristics of the two groups. for example immigrants of non-western countries are less educated, have less labor market experience and have less vocational training than western immigrants. they are also different in unobserved personal characteristics, for example, religion and attitude towards work. so, the first hypothesis is to test the difference in the magnitude of state dependence for western and non-western immigrants with the assumption that both of these groups have the same observed and unobserved characteristics. this test is carried out by including an interaction term11 of lagunemployment status with western immigrants in the model and statistically testing the difference between average partial effects for western and non-western immigrants12. the standard errors are calculated using the delta method. the results show that there is no statistical difference in the ape of the previous year’s unemployment status for western and non-western immigrants. 10     ittitt xyxyape   ,0,1 11 11 following ai and norton (2003), the correct partial effect of an interaction term is obtained involving two dummy variables. 12     ittitt xwesternyxwesternywesternape   ,1,0(,1,1()( 11 international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.93-106 104 women’s choice of labor supply is specifically influenced by various factors such as children and gender specific role in marriage. sociological theories suggest that attitudes toward gender roles and the appropriate allocation of time between labour and non-labour market differ across religious groups, (maneschiöld & haraldsson, 2007). so, it would be interesting to test the difference in the magnitude of state dependence across gender. theoretically, there is no prior expectation about this comparison; hence this is purely an empirical question. again, the hypothesis of no difference in the partial effect of state dependence across gender is carried out under the assumption that both male and female have the same observed and unobserved characteristics. again the results show that there is no statistically significant difference in the ape for men and women. it is assumed that the income of the person is exogenous to the labour supply of his or her partner. in other words an individual observes his partners income before taking his participation decision. in the literature on the topic, this is not an unlikely assumption (see for example, hyslop (1999) and croda and kyriazidou (2005)). the partner’s income is divided into a permanent and a transitory component. the theoretical expectations about the effects of these components of income on the participation decision are explained in hyslop (1999). he argues that transitory non-labour income has a direct effect on the labour supply (since the individual expects to have permanent income in all future periods, which is already taken into account in the first period). hence, according to hyslop, changes in temporary income are important determinants of the participation decision. alternatively, in the classical labour supply model, people optimize their labour supply subject to budget constraint. therefore, labour supply is directly affected by changes in the permanent income, whereas, changes in temporary income are only important if there are credit constraints. in the empirical literature, the evidence of the effect of the permanent income of the spouse on labour force participation is mixed. hyslop (1999) has found a negative effect of permanent income on the employment participation of married women in the us. using similar methodology, croda and kyriazidou (2005) also found a negative effect of permanent spouse income on the participation probability of married women in germany. interestingly, using the same methodology, (islam (2006)) found a statistically positive and significant effect of the permanent spouse income for married women in sweden. the study argues that this finding may also reflect the predominant dual-income familystructure in sweden, while hyslop’s (1999) findings reflect the u.s. single-income family-structure. all the above-mentioned studies, however, report a negative effect of temporary spouse income. in this study i found a negative effect of the permanent and a positive effect of the temporary income on the unemployment probability, but these effects are statistically insignificant. regarding other determinants of unemployment, a significantly negative effect is found for the linear term of age. however, on the other hand, the quadratic term of age is statistically positive. the combined effect of the linear and quadratic term of age suggests that relatively young people have a lower probability of unemployment than old people. the estimated parameters of the different levels of education show that post-secondary education and vocational training have negative effects on the unemployment probability. the results show that children of different age groups increase the probability of unemployment. especially, pre-school age children were found to have a much stronger effect on the unemployment probability than relatively older kids. this is in accordance with the fact that young children decrease the preference for work, especially for women. the parameter estimates state dependence in unemployment 105 for the descendent, homeownership, experience, and the employment of spouse show a negative and statistically significant effect on the unemployment probability. 5. conclusion the labour market behaviour of immigrants is examined in a dynamic discrete choice framework. the random effects probit specification is used for the estimation. particular attention is paid to control for the unobserved heterogeneity and the initial condition. the specific objective is to analyze the issue of state dependence and the unobserved heterogeneity in unemployment. the empirical findings show a considerable correlation between the unobserved heterogeneity and the initial condition. ignoring it could result in an overstatement of the extent of the state dependence. the results show an evidence of state dependence in the unemployment behaviour of immigrants. the extent of state dependence is reduced by almost one-sixth of the observed persistence after observed and unobserved factors are controlled for. the results show that an individual (with the same observed and unobserved characteristics) who was unemployed at period t-1 has 6.5 percentage points higher probability of being unemployed again at period t compared to an individual who was employed at period t-1. this average partial effect is the same for western compared to non-western immigrants and women compared to men. references arulampalam, w. (1999). practitioners' corner a note on estimated coefficients in random effects probit models. oxford bulletin of economics and statistics, 61(4), 597-602. blanchard, o.j., diamond, p. (1994). ranking, unemployment duration, and wages. review of economic studies, 61(3), 417-434. chamberlain, g. (1982). panel data: national bureau of economic research cambridge, mass., usa. chrysanthou, g.m. (2008). determinants of trade union membership in great britain during 19912003. corcoran, m., hill, m.s. (1985). reoccurrence of unemployment among adult men. journal of human resources, 20(2), 165-183. croda, e., kyriazidou, e. (2005). intertemporal labor force participation of married women in germany: a panel data analysis. paper presented at the eea-esem 2004 conference. eriksson, s. (2002). imperfect information, wage formation, and the employability of the unemployed: institute for labour market policy evaluation (ifau). frijters, p., lindeboom, m., van den berg, g.j. (2009). persistencies in the labour market: iza discussion papers. haan, p. (2006). slowly, but changing: how does genuine state dependence affect female labor supply on the extensive and intensive margin? jeps working papers(06-002). hansen, j., lofstrom, m. (2009). the dynamics of immigrant welfare and labor market behavior. journal of population economics, 22(4), 941-970. hansen, j., lofstrom, m., zhang, x. (2006). state dependence in canadian welfare participation: iza discussion papers. heckman, j.j. (1981). heterogeneity and state dependence studies in labor markets (pp. 91-140): university of chicago press. heckman, j.j., borjas, g.j. (1980). does unemployment cause future unemployment? definitions, questions and answers from a continuous time model of heterogeneity and state dependence. economica, 47(187), 247-283. heckman, j.j., willis, r.j. (1977). a beta-logistic model for the analysis of sequential labor force participation by married women. the journal of political economy, 85(1), 27-58. hyslop, d.r. (1999). state dependence, serial correlation and heterogeneity in intertemporal labor force participation of married women. econometrica, 67(6), 1255-1294. islam, n. (2006). dynamic labour force participation of married women in sweden. rapport nr.: working papers in economics(184). kari, h. (2003). education and unemployment: state dependence in unemployment among young people in the 1990s’: helsinki. katz, l., gibbons, r. (1991). layoffs and lemons. journal of labour economics, 9, 351-380. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.93-106 106 knights, s., harris, m.n., loundes, j. (2002). dynamic relationships in the australian labour market: heterogeneity and state dependence. economic record, 78(242), 284-298. le maire, d., scheuer, c. (2006). determinants of labour force participation for selected groups with weak labour market attachment: a panel data analysis for denmark: velfærdskommisionen. maddala, g.s. (1987). limited dependent variable models using panel data. journal of human resources, 22(3), 307-338. maneschiöld, p.-o., haraldsson, b. (2007). religious norms and labour supply of married women in sweden. finnish economic papers, 20(1), 41-56. mincer, j., polachek, s. (1974). family investments in human capital: earnings of women marriage, family, human capital, and fertility (pp. 76-110): nber. mundlak, y. (1978). on the pooling of time series and cross section data. econometrica: journal of the econometric society, 46, 69-85. narendranathan, w., elias, p. (1993). influences of past history on the incidence of youth unemployment: empirical findings for the uk. oxford bulletin of economics and statistics, 55(2), 161-185. prowse, v. (2005). state dependence in a multi-state model of employment dynamics: iza discussion papers. sattinger, m. (1998). statistical discrimination with employment criteria. international economic review, 205-237. stewart, m.b. (2006). maximum simulated likelihood estimation of random-effects dynamic probit models with autocorrelated errors. stata journal, 6(2), 256. stewart, m.b. (2007). the interrelated dynamics of unemployment and low‐wage employment. journal of applied econometrics, 22(3), 511-531. train, k. (2009). discrete choice methods with simulation: cambridge university press. wooldridge, j.m. (2005). simple solutions to the initial conditions problem in dynamic, nonlinear panel data models with unobserved heterogeneity. journal of applied econometrics, 20(1), 39-54. . international journal of economics and financial issues | vol 6 • special issue (s2) • 201650 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s2) 50-57. special issue for “state and municipal regulation, investment, commerce: national and international aspects of the business” gold and its determining role in modernization and technological processes related to changing geo-economic structure of the world mihail nikolaevich dudin1*, vladimir dmitriyevich sekerin2, anna evgenevna gorohova3, vladimir ivanovich gayduk4, tamara petrovna danko5 1russian academy of entrepreneurship, 14 radio street, moscow 105005, russian federation, 2moscow state university of mechanical engineering, 38 bolsheaya semenovskaya street, moscow 107023, russian federation, 3moscow state university of mechanical engineering, 38 bolshaya semenovskaya street, moscow 107023, russian federation, 4kuban state agrarian university, 13 kalinina street, krasnodar 350044, russian federation, 5plekhanov russian university of economics, 36 stremyanny per., moscow, 117997, russian federation. *email: dudinmn@mail.ru abstract this article considers the role of gold in the world economy and its place in contemporary structures of gold-value reserves of the leading countries of the world. it also takes into account the historical experience of using gold in various periods (epochs). the theme of the article is rather urgent at the moment of transformation and occurrence of a new transitional stage in the world economy, because traditionally at any transitional period the investment activity was focused on the least risky investments. investments in precious metals are thought to be such investments. they do not lose their value and price during the long period of time. the following essential conclusions were received within this article: (1) gold is the most demanded precious metal in terms of decreasing risks of accumulation and investments. the main part of the gold obtained industrially is presented by centralized reserves (standard ingots of chemically pure gold), (2) gold mining is limited in the world because natural reserves of this metal are irretrievable; at the same time modern physical and chemical technologies allow to artificially grow crystals of gold; however, such technologies are characterized by high cost and low level of returns from their use, (3) gold as a resource will continue playing a psychologically stabilizing role; herewith, the information resource (business information) required for ensuring the world stable social and economic development will get basic value. keywords: gold, gold and foreign currency reserves, economic crisis, factorial analysis, cluster analysis jel classifications: q32, q34, h54, p45 1. introduction at all times of the active economic history of the humankind the notions of wealth and people’s perception of gold as a monetary metal were universalized. as a consequence, its place in the economic activity of the contemporary society was steadfastly stipulated. since the chronicle appearance, gold has played an important role in the system of currencies and credit relations. however, its meaning was not always univalent (calvet et al., 2009; hansen, 2014). when the leader was changed in the world economic system, the monetary unit of the financial and currency center lost its “attractiveness,” and at this stage gold became the most demanded tool for international financial operations. numerous factors affected and still go on affecting such state of things. it is necessary to particularly mention geo-economic “behavior” of the leading countries of the world system among them (bernheim and rangel, 2009; daheim and uerz, 2008). at the contemporary historical stage we observe the change of the pax americana (the epoch of america) to the pax sinica (the epoch of china). due to this, in the immediate future the us dollar will obviously lose its status of the principle international payment unit more and more. nevertheless, we will note a number of factors due to which the us dollar became the principle world currency (kolganova, 2013; dudin et al., 2013; krainer, 2014): dudin, et al.: gold and its determining role in modernization and technological processes related to changing geo-economic structure of the world international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 51 • certainty as for debentures of the us government that are nominated in the national currency, and theoretically the usa can pay off their external debts through a simple increase in the monetary emission. • “special” relations of the us government with middle east monarchies; consequently, the middle east oil is sold exclusively for the us dollars. • us circumspect policy on attracting “intellect” from abroad; as a result, at the present time the usa remains the most developed country in the area of development projects. • battle-worthy army equipped with modern weapons and nato bases located around the world. referring to the history of the world economy development, it is necessary to note that during the period of financial instability, the role of gold in international currency and credit relations more often and especially intensively became the object of closer attention on the part of many researchers (klimov, 2007; fedorova and lanets, 2013). the evidence of it is a rather long list of scientific references presented at the end of the article. it considers concepts of the role of gold in macro economy. based on the above, according to the authors, the research of the role of gold in contemporary international currency and credit relations is a rather urgent theme. 2. methodology works of national and foreign researchers devoted to various aspects of the theory of the world economy, market of gold and banking were the theoretical basis of this article. the following methods were applied as the methodological basis: analysis, synthesis, analogy, comparison, induction and deduction, mathematical and statistical (cluster, factor and method of statistical surface). while writing this article, the authors took into account and used the results and conclusions from numerous works of the leading russian and foreign specialists in the area of gold value relations as well as materials of online resources. on the basis of the existing works, the authors’ concept in relation to the view of perspectives of the development of the world currency and gold value relations was stated. 3. results currency relations are the aggregate of monetary relations that define payment and settlement operations between national economies. currency aspects of countries of the world are in direct relationship to the state of international economic relations between basic centers of economic growth (the north america, europe and asia-pacific region). the integration of russia in the global geo-economic environment is rather complicated and manifold task. its successful implementation requires circumspect, scientifically developed strategy and accurate and pragmatic management on the part of the state. now the world geo-economic space is presented by the arena of actions related to interests of geo-economically powerful regional unions. russia heads one of them. this is the eurasian economic union. these entire coalitions act according to the regulations of the world trade organization, the international monetary fund and the world bank that are the implementation of the geo-economic structure of the world. at the moment the geo-economic structure of the world is in the state of transformation. the starting point of the current period of the transformation of the world geo-economic structure is the mortgage crisis of the usa that with time turned into the 2008 economic crisis, debt crisis of the european union that started in 2010, and economic crisis in russia (2014-2015). in a greater or lesser degree the latter is related to the economic crisis in the world. as a consequence, the architecture of the world geoeconomy undergoes considerable structural changes. above all, it is expressed in gradual changing of traditional leaders of the world economy. in recent time china has been asserting itself rather strongly. however, this state still refrains from a real challenge for the role of the only leader of one of the economic centers of the world. so, the change of positions in the rating of leading economies is an example of it. up to 2011 the economy of japan was considered to be the second economy after the usa. however, starting from 2011, the economy of china has been considered to be the second economy of the world (gold survey, 2012). in addition, we can also observe the accumulation of considerable financial resources for non-traditional geo-economic players of the world china, brazil, india, and russia. however, the lack of gold and foreign currency reserves is observed in the traditional “triad” of the geo-economic structure of the world europe, the north america, and the asia-pacific region. consequently, in certain cases considerable indicators of the external debt can several times surpass specific value of the gross domestic product calculated according to the purchasing power balance. at the same time the situation related to gold and foreign currency reserves and economy functioning in debt on the edge of default in europe and asia-pacific region provokes a discussion, because there is transformation of the geo-economic leader: the prc replaces japan. at the same time asia-pacific region is expended. that’s why in the geo-economic aspect these tendencies can be regarded as differently directed. as a result, the top-ranked rich and stable countries have to call on “new” geo-economic centers with the request to deposit gold and foreign currency reserves for maintaining geo-economic stability of the first ones and preventing them from geo-economic catastrophe of the global scale. the international role of gold and foreign currency reserves of any country of the world depends on the economic power of this country and its place in the world economy. today in case of the shift of the geo-economic center of the world economy to the east and parallel process related to the increase in the importance of the developed markets (above all, it is related to china and india), there is a situation when the government of the usa finds it more and more difficult to maintain the role of the us dollar as the principle means of exchange and transactions in the world trading and on the international markets of capital. in their published works some researchers and scientists state that countries whose currencies are the reserve currencies must have a deficit of accounting current operations in order to ensure international liquidity (svetlova, 2012; gennaioli et al., 2014; gossé and plihon, 2014). however, when the amount dudin, et al.: gold and its determining role in modernization and technological processes related to changing geo-economic structure of the world international journal of economics and financial issues | vol 6 • special issue (s2) • 201652 of the negative trading balance becomes too high, the country accumulates unstable external debt due to the burden related to serving this debt. thus, the dollar liquidity required for financing the world trade and capital movement will increase in the near future, and decrease the impact of the us economy. that’s why in the multipolar world where the size of economies of china and the european zone is on the same level as the us economy, the international role of us dollar will decrease in favor of the increasing role of the currency of the new-old geo-economic centers of the world. besides, other countries such as japan, brazil, countries of the persian gulf, the republic of korea, republic of south africa and the european economic union play important roles. everything taking place on the world arena will lead to the greater centralized network of financial centers, and as a result, the us dollar will lose the role of the principle world currency, and the role of gold will traditionally increase for the transitional period. the gold and foreign currency reserves of one state can be located on the territory of another state according to relevant international agreements. in the interwar period there was an event that is now known as “moscow gold” (corrected oro de moscou) or “gold of the republic” (corrected oro de la republica). these names define the action related to the transfer of 510 tons of gold that is approximately equal to 73% of the total volume of the gold and foreign currency reserves in the bank of spain from their initial location in madrid to the soviet union in several months after the beginning of the spanish civil war. this transfer took place according to the order of the government of the second spanish republic headed by francisco largo caballero on the initiative of its minister of finances juan negrin. the term also covers the further issues related to selling the gold in the ussr and using the received funds. the remaining quarter of the gold and foreign currency reserves of the bank including 193 tons was exchanged to the currency in france. this was an operation also known as “gold of paris” according to the analogy of the above term. during the second world war shortly before the occupation of the nazi germany the government of belgium evacuated the gold and foreign currency reserves of the country to dakar (africa) 221 tons. however, the french state (vichy france) contributed to delivering this gold to the bank of the third reich. it is interesting that at the present moment the federal republic of germany (frg) gold is stored not only on the territory of frg but also in the usa, great britain, and france. and this is the first time after the second world war when a special commission of the bundestag intends to check the storage of the german gold abroad. this is the german gold that has a lot of contradictory factors in the history. some researchers think that exactly before the capitulation of the third reich the german gold was transferred to swiss banks, and due to it the “german” economic wonder took place. due to this, the role of gold as never before deserves a detailed research in the structure of the international gold and currency system. that’s why it will be logical to define what development stages the gold exchange systems have undergone for the whole period since the moment of forming the most stable world economic relations of the state level (approximately the 17th19th centuries) to our time. every stage is characterized by basic principles of the system functioning, but it also has definite succession in relation to the previous one. table 1 graphically shows basic stages of forming the world gold exchange system. for the first time the principles of the paris currency system came into operation in britain (1867). its characteristic feature was free movement of gold in the system of international and currency relations. banks of the states that participated in the conditions of the paris currency system freely exchanged banknotes to gold. at the beginning of the 20th century the growing power of germany, france and the usa undercut the position of great britain in the international currency system. after the beginning of the first world war the gold standard collapsed. the movement of gold in the international payment turnover was banned. it was replaced by banknotes that could not be exchanged to gold. in the usa this situation turned into the great depression (1932-1933). in april 1935 the president of the usa roosevelt issued an edict about actual confiscation of gold that was stored in ingots and coins from the population and organizations (kolganova, 2013). the gold confiscated from citizens of the usa was sent to the fort knox national depository (kentucky) of the federal reserve system that is still operating. thus, to a large extent the trust in the us dollar is based not only on the possibilities of the american economy, ideal reputation of the debtor, but also on the gold stored in the fort knox. that’s why it is not occasional that at the present time at the beginning of the downfall of the usa power, they quite often publish information that a number of highly developed countries sent an audit to check their gold and foreign currency reserves in the usa. less developed countries simply take their gold from the depositories on the territory of the usa. for example, venezuela did it. after the end of the first world war there was a necessity to organize a new world currency system. its principles and fundamentals were realized in the genoese currency system at the international conference on economic and financial issues in genoa (italy) in 1922. except gold and pound, it was also recommended to use us dollar. both currencies were meant to perform the role of the international payment means that received the name of a gold standard. it resulted in the change of the new world economic and trading leader. the usa succeeded britain. the basic principles of the gold standard were analogous to the table 1: basic stages of forming the world gold exchange system stage period of activity paris currency system 1816-1914 first transitional currency financial period 1914-1927 genoese currency period 1922-1933 second transitional currency financial period 1933-1944 bretton woods currency system 1944-1976 third transitional currency financial period 1976-1978 jamaican currency system 1978-2008 fourth transitional currency financial period 2008-present time dudin, et al.: gold and its determining role in modernization and technological processes related to changing geo-economic structure of the world international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 53 principles of the preceding paris system. however, certain changes were made. the gold exchange standard was a form of the gold standard when separate national banknotes were exchanged not to gold but to currency of other countries. the middle and the end of the 30s of the 20th century were unstable for the international currency system. the depression of 1929-1933 vividly showed that the world economy was to be reformed. 1944 was the next stage of the evolution of the international currency system of the world economy. at the bretton woods conference the gold standard was adopted. it was based on the gold and two gold exchange currencies the us dollar and british pound. later it became clear that the british pound could not maintain the exchange to gold under equal conditions with the us dollar. on february 4, 1965 charles de gaulle gives an order to cancel the use of us dollar in france as the only payment world unit and states about the transfer of the country to the gold exchange standard. in spring of the same year usd 750 million were delivered from france to the usa. it was the first tranche from the target usd 1.5 billion that was to be exchanged to gold. later on the reality showed that it was quite difficult for the usa to adhere to the practice related to exchanging us dollar to gold. in 1972 the international committee on reforming the international currency system was formed. it dealt with the development and agreement of new principles of its functioning. in 1976 at the conference in jamaica representatives of 20 countries came to an agreement about reforming the world currency system. later in 1978 the jamaica agreements were ratified by the majority of countries that were members of the international monetary fund. in accordance with the jamaica system, the gold exchange relations are based on specific principles. the basic ones include official cancellation of the gold standard; special drawing rights standard is introduced; freely convertible currency of the most developed capitalistic countries of the world (us dollar, frg mark, british pound, french franc, swiss franc, japanese yen, later euro, etc.) are acknowledged as reserve currencies; the mode of freely floating currency rates is established. economic importance of gold is in its use as money goods together with other noble metals during a considerable historical period, and in its monopole use in the international currency and financial relations since the end of the 19th century (naim, 2009). however, with time as a result of official demonetization of gold, it got out of free monetary and currency circulating and started being used as reserves. operations related to this noble metal take place on specific markets. in the world there are special trading gold centers where it is regularly sold and bought. this metal is supplied to markets in the form of standard ingots: • ingots of international standard in 400 troy ounces with the assay not lower that 995. • large ingots with assays from 900 to 916.6 and weight of above 100 troy ounces. • small ingots several tens of troy ounces. golden coins of both old coinage and modern anniversary and souvenir coins act as objects of operations on the markets related to gold. today there are more than 50 markets of gold. the highest number of markets of gold is in asia (about 19 objects). in america it is possible to count 14 markets of gold. in the western europe there are about 11 such markets, and in africa there are about 8 markets. the leading place belongs to the markets of gold in london and zurich. depending on the regime provided by the state, markets of gold are classified into the following: • the ones of the world importance (london, zurich, new york, honk kong, dubai, etc.). • markets of gold that are less important than the world ones, however they are internal and free (paris, istanbul, milan, rio de janeiro). • local controlled markets (shanghai, athens). • black markets (lagos, etc.). the contemporary world market of gold was formed in 19611968. it was officially documented and acknowledged as gold pool. it includes the following countries of the capitalistic world the usa and countries of the western europe. the aim of creating this market was to maintain prices for gold on the free market on the official level. in the 70s of the 20th century gold auctions selling gold from public auctions were organized. such auctions were held from time to time by the international monetary fund, governments of the usa, india, portugal, etc. in the period from 1976 to 1980 the international monetary fund conducted 45 auctions and sold 777.6 tons of gold. in 1978-1979 during 19 monthly auctions the usa sold 491 tons of gold for the amount of usd 4.1 billion. at the end of the 20th century central banks became the main players on the world market of gold. only in 1997 they sold 825 tons of gold. thus, the netherlands, belgium, austria, canada, australia partially sold their gold and foreign currency reserves (from1/3 to 2/3), and argentina sold its whole gold and foreign currency reserves including 125 tons of gold (egorova et al., 2015). major owners of gold are central banks of such countries as belgium, italy, the netherlands, the usa, france, frg, and switzerland. about 80% of the world centralized reserves of gold fall at industrially developed countries. 110 thousand tons of the mined gold were accounted from 1493 to 1993 (500 years), and for the whole history of gold mining (about 6 thousand years) more than 125 thousand tons. the republic of south africa is the largest gold miner in the world. every year this country mines above 22% of the world volume of gold mining. in due time, the soviet union was rather serious gold miner. in some years gold mining in the ussr suppressed 130 tons per year. to compare, in 1914 the russian empire mined 59.2 tons of gold, and about 1,600 tons were stored in depositories of the state bank. the first official data about currency reserves of the ussr was published in 1935. at that time they were 2,050 tons. the currency reserves included 2.5 thousand tons of gold extracted from subsoil of the ussr. 4-5 thousand tons were requisitioned from the russian orthodox church (it was used mainly for industrialization in the ussr). undefined amount of gold was taken from the defeated nazi germany and its allies after the second world war. the minimum amount of the gold reserve in the ussr was fixed at dudin, et al.: gold and its determining role in modernization and technological processes related to changing geo-economic structure of the world international journal of economics and financial issues | vol 6 • special issue (s2) • 201654 the end of the 90s of the 20th century. its reason was unsuccessful attempt of the ussr management to reform the socialistic system and the considerable decrease in prices for oil on the world markets (egorova et al., 2015). annual extraction of gold in separate countries is as follows (kolganova, 2013): • up to 50 tons (brazil, ghana, canada, peru, chile) • from 50 to 100 tons (indonesia, uzbekistan) • 250 tons (australia) • above 300 tons (the usa) • above 450 tons (the republic of south africa). today gold remains rather reliable highly liquid reserve assets of central banks of the leading countries of the world. concurrently the scales of private hoarding (gold accumulation by individual persons) do not decrease. at the present time central banks and international organizations (such as the international monetary fund) form under one fifth of the global reserve of gold as reserve assets (110 central banks and international organizations possess 29,000 tons). in average, gold makes up 15% from the official gold and foreign currency reserves of the country. however, the share differs from country to country. countries with the developed economy in the western europe and the north america usually have above 40% of their total external reserves in gold, basically as inheritance from the gold standard. on the contrary, developing countries do not have such historical heritage, and, consequently, they have smaller gold and foreign currency reserves. as a rule, this is about 5% or less of the total volume of their external reserves in gold. in their turn, as a rule, central banks of the developing countries were net sellers. however, since 1989 we have been able to observe changes in attitudes of these central banks to gold. during two decades gold has been goods that was purchased and sold worldwide mainly by individual persons. this period finished in 2009, and 2010 was the first year when the turnovers of gold in the official sector surpassed turnovers in the private one. a number of reasons contributed to it. the most important one includes the fact that the economy of a number of developing countries grew very quickly. at the present time these countries are more and more often defined as buyers of a considerable volume of gold for their reserves. its basic reason was the wish to move in the direction of restoring the balance between foreign currencies and gold. western central banks have more than a 10 years history in relation to so called “golden agreements” with one another and private sector. the central bank gold agreement-3 that has been in force until recently legally covers selling gold from central banks of the european zone, sweden, and switzerland. like previous two agreements, central bank gold agreements-3 is meant for 5 years. in this case, from september 27, 2009 (as soon as the term of the second agreement expired) to september 26, 2014. in 2014 the european central bank and 20 central banks of europe more declared about signing the central bank gold agreements-4 (cbga, 2015). the agreement was signed by the central bank of the european union, and central banks of such european states as belgium, frg, estonia, ireland, greece, spain, france, italy, cyprus, latvia, luxemburg, malta, the netherlands, austria, portugal, slovenia, slovakia, finland, sweden, and switzerland. the central bank gold agreements-4 (cbga, 2015) have the following features: • gold remains an important element of global currency reserves • members of the agreement will coordinate their transactions with gold in order to avoid market shocks • members of the agreement will not sell considerable volumes of gold • this agreement will be reconsidered in 5 years. it is necessary to note that the development of new technologies and changes of traditional financial instruments in the people’s perception considerably affected the world market of gold and bore such a new phenomenon as digital gold currency. this is one of the forms of digital money on the basis of the gold ounces. the us securities in the form of a golden certificate can be considered as the prototype of such gold currency. from 1873 to 1933 this golden certificate could be exchanged to gold at the first request. digital golden currency is also supported by gold. gramm of gold or troy ounce is a typical payment unit of this currency. however, they also use other payment units such as the golden dinar. performing their activity on various financial markets, a number of companies created terms and conditions for the circulation of the digital gold currency. every such company created a system that allows users to make settlements with one another in units that maintain the same value as golden ingots. these companies provide the world financial and currency system with a new type of independent currency. thus, at the present time it is possible to conclude that gold plays an important role in functioning of the world gold exchange and financial and credit system. it is obvious that gold is a universal precious metal that can be used for regulating various financial standards. 4. discussion international gold and foreign currency reserves are highly liquid assets in external structures. such assets are most often represented by gold or foreign currencies. they are inspected by governmental credit and monetary regulation authorities. it means that they can be used in case of deficit of the payment balance and the national currency. the greatest part of the world market makes payments in us dollars. it means that almost all principle banks store large international reserves in us dollars. figure 1 shows data about 20 countries with the largest gold and foreign currency reserves. taiwan and siangan (known as honk kong) are included in the countries from figure 1. both territories enter prc. however, de facto taiwan is an independent economic player of the global scale. its economy influence in the world and gold and foreign currency reserves are comparable to gold and foreign currency reserves of russia at the moment of comparison. as for siangan, according to the british-chinese agreement (dated 1997), it has an opportunity to conduct its own policy, including in the area of international trading during 50 years. about 50% of all international gold and foreign currency reserves are formed in these countries. it is necessary to note that rather often they establish dependence of the size of gold and foreign currency reserves on any resource dudin, et al.: gold and its determining role in modernization and technological processes related to changing geo-economic structure of the world international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 55 of surpluses. for example, in the russian federation the size of gold and foreign currency reserves is related to the price for the urals oil. figure 2 graphically analyzes researches of the statistical surface of the interrelation between the price for urals oil and gold and foreign currency reserves of the russian federation for the period of 2008-2014. it is possible to proportionally mark integral connection of these two indicators. in addition, we can also observe direct proportional dependence (the growth of the price for urals oil from usd 39 to usd 109 in the period from 2008 to 2012 and the increase in the gold and foreign currency reserves of the russian federation from usd 438 billion to usd 537 billion). this component is proportional to the integral for the researched period and lies in the decline of the regulated size of the gold and foreign currency reserves. it allows to take into account unsystematic factors (sanctions of the west against russia and as a result the use of the gold and foreign currency reserves for maintaining the economy of the country in 2013-2015). except the russian federation, the largest holders of gold and foreign currency reserves in the world include the usa, prc, japan, india, brazil, saudi arabia, mexico, poland, malaysia, thailand, indonesia, turkey, great britain, the south korea, taiwan, siangan, switzerland, and singapore. using the cluster analysis, we selected 20 countries with the largest gold and foreign currency reserves. figure 3 graphically shows this aggregate made up by the authors. in accordance with the above segmentation, the first cluster the usa (1) can be characterized as the only currently super-state. especially, it refers to economic indicators (gross domestic product [gdp] volume, gdp per head). it is also necessary to take into account that us dollars are used in the majority of trades worldwide. as for gold, it has already lost its former attractiveness for the usa because to some extent dollar managed to replace gold in the currency financial system of the world. the second cluster cpr (2), japan (4) is characterized by a high level of competitive positions and considerable interests of local investors in gold. the third cluster india (3), russia (5), brazil (6), and saudi arabia (12) is characterized by high potential opportunities for quick growth of competitiveness that are based either on surplus from selling mineral resources or competitive advantages from local cheap work force. central banks of these countries display considerable interest in gold. taking into account the characteristics of main factors of its economic positions in the world economy, the fourth cluster mexico (8), poland (14), malaysia (16), thailand (15), indonesia (10) and turkey (11) can be characterized as the one with the growing competitiveness. however, it is not sufficient for participating in the world markets of gold. the fifth cluster includes great britain (7), the republic of korea (9), taiwan (13), siangan (17), switzerland (18), and singapore (19). this cluster is characterized by non-proportionality to the actual sizes of the state (area, population) and its influence in the world economy, including that on the market of gold. so, the main market of gold and the world gold council are located in london. in order to reveal basic factors of the gold impact in the world economic system, the factor analysis was applied. figure 4 shows the graphic representation of this aggregate. 14 statistical indicators for 19 countries with the most considerable gold and foreign currency reserves were selected for the analysis. 2013 was selected for the analysis because the statistical indicators for this period were the most complete. the main principles of their selection included accessibility, veracity and compliance with the criteria of the research. these principles were founded in the first part of the 20th century within creating mathematical basis of the contemporary economic science. in accordance with the “enrockment” criteria of cattell (coudert and raymond, 2010; coudert et al., 2015), on the basis of the received results, from the selected indicators we defined 5 groups of factors affecting the role of gold in the world economic system. we define the first group of factors as economic and trading because it was formed mainly by such indicators as gdp, volume of export and import, volume of direct foreign investments, etc. all its indicators are positive except the accounting of current operations. it can be caused by the fact that it is negative in a great number of highly developed countries (the usa, britain, figure 1: countries with the largest gold and foreign currency reserves as on 2014 (the world factbook, 2015) figure 2: statistical dependence of interrelation of the “urals” oil price and gold and foreign currencies reserves of the russian federation for the period of 2008-2014 (the world factbook 2015; central bank of russia, 2015) dudin, et al.: gold and its determining role in modernization and technological processes related to changing geo-economic structure of the world international journal of economics and financial issues | vol 6 • special issue (s2) • 201656 and japan) and capitalistic states (poland, turkey, and mexico) (mwase and yang, 2012). the second group of factors can be interpreted as demographic because it is based on the indicators related to the size of population, and gdp per head. this factor is “contradictory” according to its impact because gdp per head has a negative impact, while the size of population has a positive one. the third group of factors directly consists of the indicators related to the dynamics and volume of gold and foreign currency reserves. in this case this factor is a key one. the fourth group of factors includes indicators of the “potential internal credit” category. it is natural that it has a negative impact on the role of gold in the world economy, because having considerable indicators the internal credit forms a sort of psychological certainty in stability and does not make the government of central bank actively acquire gold on the global markets. the fifth group of factors (other factors) has low indicators on the edge of minimum error and virtually does not affect the role of gold in the world economy. it is necessary to note that only the first four factors considerably influence the state and dynamics of gold exchange operations in countries with the largest gold and foreign currency reserves. especially, it is related to the first group of factors that includes the greatest number of indicators (factors 1-6 on figure 4). accordingly, this group has the greatest impact on the state and dynamics of the gold value processes. negative pressure of indicators means that there is specific misbalance of the world market of gold (fedorova and afanasiev, 2013; dudin et al., 2015). above all, it is explained by possible historical overestimation of the role of gold in the world economy (ivaniuk et al., 2014). thus, at this stage it is possible to resume that on the one hand the role and importance of gold in the world currency, financial and credit system is rather significant, because gold is virtually the only standard of measuring national reserves for all countries. on the other hand, there is no doubt that gold and foreign currency reserves must be formed adequately to economic and social development of the country. under the conditions when the leitmotif of the economic development includes cognitive resources, the importance of material resources considerable decreases. that’s why while remaining the most convenient means of forming reserves, accumulation, and the most optimal object of investing, gold does not hold that generally valid unique importance that characterized it earlier. 5. conclusions in the period of the contemporary unstable financial and economic satiation in the world, it is rather difficult to speak about potential efficiency and profitability of investing private, corporate or state savings. it is possible to single out the following basic advantages of investing in gold: • investing monetary funds and generally financial resources in gold is an efficient and operant method of protection from inflation. • possibility to earn profit in case of the price growth on the world market. • banking metals have the highest standard; herewith, unlike jewelries, their buy-back is carried under the same conditions as purchase (jewelries are bought-back as salvage). • ingots of gold, coins are convenient for storing and practically do not change under the impact of external factors; consequently, they do not require special terms and conditions of storage. the contemporary situation on the market of gold can be characterized as a rising trend with strong movements because the prices for this banking metal grow exponentially. it is stipulated by several factors. the basic factor of the gold price growth is purposeful weakening of the us dollar. if the us dollar weakens, consequently, the gold is fixed in the rising trend almost simultaneously. moreover, it becomes more available for customers from the non-dollar zone. figure 3: hierarchical clustering of countries with the largest gold and foreign currencies reserves due to the role of gold in their economy (the world factbook, 2015) figure 4: graph of dispersions for defining number of factors that affect the role of gold in the world economic system (the world factbook, 2015) dudin, et al.: gold and its determining role in modernization and technological processes related to changing geo-economic structure of the world international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 57 however, herewith, it is necessary to note that in addition to the advantages of investing in gold, there is a problem related to selling the metals that have been acquired, because in countries with the transitive economy (particularly, in russia, india, brazil, and china) the consumer market of banking metals and precious stones including gold is not well-developed. consequently, the basic turnover touches on the jewelries market. herewith, jewelries do not fulfill functions of accumulation and saving. for national economies the formation of gold and foreign currency reserves is an objective necessity because gold and foreign currency reserves ensure the support of economic and social stability during crisis periods. however, experts agree more and more that the role of gold in the world economy can be considerably overestimated. on the background of global economic tendencies and constant loss of the role of the world leader by the usa, it is the most probable that the formation of a new international financial and credit and reserve system based on the reasonable diversification will be required. references bernheim, b.d., rangel, a. 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[last accessed on 2015 nov 05]. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(6), 84-89. international journal of economics and financial issues | vol 8 • issue 6 • 201884 wage-profit rate schedules in case of saudi arabia abdullah algarini* college of economics and administrative sciences, al imam mohammad ibn saud islamic university, riyadh 7527, saudi arabia. *email: a_baros@hotmail.com received: 08 august 2018 accepted: 16 october 2018 doi: https://doi.org/10.32479/ijefi.7250 abstract this paper uses the real wage-profit rate schedule to examine the direction of technical change in saudi economy during 1990–2016. we find that technical change is hicks-neutral (i.e., increasing both labor and capital productivity) between 1990 and 2004; and marx-biased (i.e., increasing labor productivity with declining capital productivity) over the period 2005–2014. the most noteworthy aspect of the saudi economy pattern of technical change is that it has started to enter a phase of steady decrease in the profit rate and increase in the real wage, as seems to be the historical experience of many developed countries. the growth of real wage continues to grow by increasing 9.6%, 19.5%, and by 130%, while the profit rate grows by 11.8%, 5.7%, and −20.5% in the first three periods, respectively. keywords: productivity of labor and capital, saudi arabia, capital-labor ratio, wage-profit rate jel classifications: e24, j3 1. introduction in saudi arabia, the unexpected revenues from oil booms in the midand late 1970s increased the expenditure on infrastructural programs which included the rehabilitation and construction of school buildings, and improvements in communication networks, transportation, and health centers, therefore creating substantial demand for construction labor. due to revenues from oil, industrialization has been growing fast in saudi; the oil sector grew 78% in 2011 (ministry of planning and economics, 2012)1. although economic growth reached 11% in 2011, unemployment is still a problem in saudi arabia. in 2011, the unemployment rate was about 12 percent with almost 28 million in the labor force2. however, saudi arabia is like many developing countries that are experiencing rapid technological change in the last three decades. this technological change may alter the sharing of output between workers and capitalists. 1 ministry of commerce and investment on https://mci.gov.sa/en/pages/ default.aspx. 2 ministry of labor and social development: https://mlsd.gov.sa/en/. since 1980s, saudi arabia has shifted from export to crude oil to oil industry and then to the petrochemical industry by utilizing new technologies3. this change may lead to an increase in wage sharing or the economy becoming more capital intensive, producing the same effects, but on a much larger scale. this paper attempts to test the shape and the shift of wage and profit rate relation in saudi economy by using input-output analysis. the input-output data used in this study is based on the saudi economy during the period 1990–2016 in six phases. some researchers have used this approach to examine the existence of switchingpoints and to show the existence of reswitching and capital deepening, a common puzzle in capital theory (soklis, 2011; da silva, 1987). furthermore, the advantage of the input-output method is that we can find the real wage share and the profit margin for a specific year and observe the behavior (and relationship) of the inputs. as stated in the theory, we will attempt to observe whether the empirical data supports the theory that predicts that wage-profit rate relations are downward sloping. it is also interesting to investigate what has 3 http://www.mci.gov.sa/en/pages/default.aspx. this journal is licensed under a creative commons attribution 4.0 international license algarini: wage-profit rate schedules in case of saudi arabia international journal of economics and financial issues | vol 8 • issue 6 • 2018 85 happened to the productivity of labor, the productivity of capital, and the capital-labor ratio. the shift of the real wage share and profit rate will answer this question. the rest of the paper is structured as follows. section 2 reviews the empirical literature, section 3 derives the method of calculating real wage-profit rate schedule and discusses the different types of technical change, section 4 defines the data and the resources, and section 5 and 6 review the results and offer some conclusions. 2. review of literature marquetti (2003) analyzes whether technical change follows the capital-using, labor-saving pattern. he finds that most of the world economy follows the marx-biased technical change pattern over the period 1964–1990. he shows that labor productivity increases, while capital productivity falls in that period. however, he finds that in some countries in the 1980s the non-marx-biased pattern happens. felipe et al. (2008) examine the total economy for india and china during the period 1980–2003. they show that both capital and labor productivity increase, but not in the same proportion. the change is close to the technical change of the hicks-neutral pattern. felipe and kumar (2010) use the real wage-profit rate schedule to study the direction of change in the economy of india over 1980–2007. they find that in most periods labor productivity increases, while capital productivity falls (marx-biased technical change). however, post 2000, they find that both capital and labor productivity increase (hicks-neutral pattern). this study favors the technical change of capital in india’s organized manufacturing sector over all this period. ferretti (2008) uses classical theory of income distribution to examine the facts of economic growth. he makes use of a wageprofit frontier in order to explore the patterns of technical change in 18 industrialized economies during the period 1961–2005. this study reveals that even though there is an unequal development of technical change in those countries, there is a significant prevalence of labor-saving and capital-using changes (marx-biased technical change). 3. theoretical framework of the wage-profit rate schedule it is not surprising that the social consumption-growth rate schedule is exactly the same as the wage-profit rate schedule. the social consumption-growth rate represents the distribution of output between gross investment in future output and consumption while the real wage-profit rate schedule represents the distribution of the value of output between wages and profit, including depreciation (foley and michl, 1999)4. 4 this paper replicates the procedure in foley and michl (1999) to obtain the real wage-profit rate schedules for the case of saudi economy. since the growth-distribution schedule describes both the distribution of output between consumption-investment (c-i) and wage-profit (w-π), it shows the aggregate national income and production accounts as following: x ≡ c+i = c+(gk+δ)k (1) by dividing on labor force l, we find: x ≡ c+i = c+(gk+δ)k (2) in general, net output is: y ≡ x-d = c+(i-d) = c+gk k, where d is the depreciation 5. (3) the cash flow is: x = w+z, where w all wages go to workers, z is gross profit, π is net profit, d is depreciation, and z = π+d. therefore, we know that gross output can be written as follows: x = w+z = w+π+d = w+π, where π = rk, r is the net profit rate, and d = δk, δ is the depreciation rate. this equation implies: x = w+rk+δk (4) x = wl+rk+δk, where w, is the total wages for all labors l (5) in other words, the wage-profit rate schedules, in terms of productivity of labor and capital, can be derived from equation 5 as: x/l = wl/l+rk/l+δk/l, this equation implies to: x w r k l k l = + + δ , where profit rate, v = r+δ (6) we can write k l x l x k x = = / / φ where φ = x k is the capital productivity, and we can then plug it in equation 6 to get: φ   = +     x x w v this equation implies: 1 v w x    = −   (7) equation (7) is known as the real wage-profit rate schedule that shows the tradeoff between wages and profit, given the value of net output, labor and capital productivity (katsinos and mariolis, 2012). the procedure illustrates the relationship between real wages and the profit rate in a capitalist economy. this equation will construct curves that will enable us to observe changes in the shapes of the curves and the existence of a switching point between two technologies, as well as the possibility of re-switching6. 5 all variable dividing on the price in 1990 purchasing power parity, except labor, so we talk about the real wage and profit rate. 6 the possibility of re-switching may be clear since this study takes into consideration the average for each five years between every two points of the time series during the period from 1990 to 2016 of this analysis. algarini: wage-profit rate schedules in case of saudi arabia international journal of economics and financial issues | vol 8 • issue 6 • 201886 the relationship between the real wage w and the profit rate v is presented by differentiating equation (7) with respect to v: w x x k xv k  ∂ = − = − = − ∂ (8) a given methodology that comes from productivity inputs, equation 8 represents a straight line with slope equal to –k, the capital-labor ratio. when real wages are equal to the net product, y, the profit rate, v = 0. when the real wage is zero, the net profit rate is equal to ϕ. in this paper, we study the technical change between labor productivity and capital productivity in the case of the industrial sector in saudi arabia. a change in the slope of real wage-profit rate schedule or a shift in the schedule is an indicator of the direction of technical change7. we use this approach to analyze the technical change as following: • if labor productivity x > 0, then the productivity of labor has increased and technical change is labor-saving pattern. • if the capital productivity ϕ > 0, then the productivity of capital has increased and technical change is capital-saving pattern. knowing this, we can classify the industry into one of following: • if x >0 and ϕ = 0, then labor-saving technologies are used, i.e., the slope of wage-profit rate (k) is steeper. the vertical intercept shifts upwards while the horizontal intercept remains constant. this case is the harrod-neutral technical change. • if the technical change of labor and capital are equal (labor and capital-saving), this implies that slope of the wage-profit rate schedule remains unchanged, and both vertical and horizontal intercept move outwards. this case is called the hicks-neutral technical change. • if x = 0 and ϕ > 0, then capital-saving technologies are used and the slope of the wage profit rate schedule is flatter, i.e., the vertical intercept remains unchanged while the horizontal intercept moves outwards. this case is called the solowneutral technical change. • if x > 0 and ϕ < 0, then labor-saving technologies are used. the slope is steeper where the vertical intercept moves upwards and the horizontal intercept moves inwards. this is called the marx-biased technical change. • the change in capital productivity between an original year and the next year can be calculated by gk = + −   1 1 , and the change in labor productivity between an original year and the next year by g x xl = + − 1 1 . 4. data the real wage-profit rate schedule of saudi’s organized industrialization sector for the average years 1990–1994, 1995– 1999, 2000–2004, 2005–2009, 2010–2014, and 2015–2016 are published from the ministry of commerce and industry and the 7 i follow the notation in felipe and kumar (2010) that is a different notation from the notation in foley and michl (1999). ministry of labor and social development8. this paper uses the variables as follows: • x: real gross domestic production in year 1990 purchasingpower-parity terms. • k: estimated net fixed standardized capital stock in purchasing power parity. • l: total number of employees. table 1 shows labor productivity, x=x/l, capital-labor ratio, k=k/l and capital productivity, ϕ = x/k. all data is accounted as a ratio so it does not depend on the measuring units. 5. results of wage – profit technical change we will show the tradeoff between wages and profit at a certain level of production. this study depends on two curves that will enable us to understand the shapes and the switching point between two technologies, productivity of labor and capital, during the period from 1990 to 2016 in six phases by taking the average of those years. equation 7shows a positive solution for the maximum and minimum value of profit margin and wage, where w x v = −( )1  using this formula, table 2 shows us the maximum and minimum value of profit margin and real wage in average years from 1990 to 2016. the changes in the productivity of labor and capital can be described in terms of shifts of the wage-profit schedule in table 2. this table illustrates the relationship between profit (v) and wage (w) in different periods. this relationship is a straight line defined by two points (v, w). (0, x) corresponds to the minimum rate of profit and the maximum level of the real wage, and the point (ϕ, 0) corresponds to the minimum of the real wage and the maximum rate of profit. in the original period, the maximum real wage and profit are $15,272 and 451%, respectively. in the second period, the maximum real wage and profit are $16733.57 and 504%, respectively. this value increased until they reach $20,001 and 533% for the wage rate and profit rate, respectively, in the third period. in period 5, the real wage reaches $46,111, while the profit rate decreases to 424%. the growth of real wage continues to grow by 9.6%, 19.5%, and by 130%, while the profit rate grows by 11.8%, 5.7%, and −20.5% in the first three periods, respectively, however, during 2015 and 2016, both real wage and profit rate decrease to $38,553 and 356%, respectively. we know from the law of demand when price decreases, the quantity demanded of the good increases. but this does not happen in the case of re-switching. the decrease of the rate of interest does not lead to more capitalintensity for a certain technique. this analysis explains the situation when the relationship between the value of the capital-labor ratio and the rate of profit is increasing. this reverse capital intensity also implies that the demand curve for capital is not always downward sloping. 8 annual survey of industries, ministry of commerce and industry and ministry of labor and social development from different years. algarini: wage-profit rate schedules in case of saudi arabia international journal of economics and financial issues | vol 8 • issue 6 • 2018 87 figure 1 shows us the real wage-profit rate schedules for the period from 1990 to 2016. it illustrates the tradeoff between real wage and profit rates. between 1990 and 2004, the vertical and horizontal intercepts of the real wage-profit rate schedule shifts outwards, i.e., both labor and capital productivity increase slowly, though they do not increase by the same proportion. the technical change in this period is called hicks-neutral. however, between 2005 and 2014, the vertical of intercept of the real wage-profit rate schedule shifts outwards, i.e., labor productivity increases. at the same, the horizontal intercept shifts inwards, i.e. capital productivity decreases. in other words, the technical change is the labor-saving and capital-using pattern that is called marx-biased. between 2015 and 2016, both the vertical and horizontal intercepts of wage-profit schedule shift inwards, i.e. productivity of labor and capital fall, and this result may reflect the recent deterioration of oil prices. as shown in figure 1, the slope of the real wage-profit rate schedule derived via the plot of wage versus profit rate is equal to –k. this value gives the direction of technical change. it indicates that the direction of technical change is the result of both changes in labor productivity and capital productivity (x and ϕ) and illustrates the labor-capital ratio (k). as stated in the theory, this result shows that the empirical data supports the theory that predicts that the wage-profit rate relations are downward sloping. table 1: productivity of labor and capital and capital-labor ratio for saudi arabia years labor (l) labor productivity (x) capital – labor ratio (k) capital productivity (ϕ) average of labor productivity (x)* average of capital productivity (ϕ)** 1990 8019241.82 14668.50 2772.07 5.29 1991 8349912.53 14087.61 3213.26 4.38 1992 8641624.44 13612.06 3212.17 4.24 1993 8855042.88 13283.99 3281.57 4.05 1994 9024620.68 13034.37 2751.77 4.74 13737.30 4.54 1995 9067023.08 12973.42 3042.64 4.26 1996 9141642.10 12867.52 3004.14 4.28 1997 9252274.55 12713.66 3152.72 4.03 1998 9271389.09 12687.45 3248.96 3.91 1999 9663993.09 12172.02 3261.48 3.73 12682.81 4.04 2000 9800755.42 12002.16 3355.50 3.58 2001 9973490.03 11794.29 3371.47 3.50 2002 10288735.47 11432.92 3319.25 3.44 2003 10642121.38 11053.27 3710.99 2.98 2004 11010029.01 10683.92 4501.88 2.37 11393.31 3.17 2005 11312873.09 10397.91 5607.18 1.85 2006 11687965.47 10064.22 6595.17 1.53 2007 12053051.07 9759.38 8162.40 1.20 2008 12302928.50 9561.16 9634.54 0.99 2009 12860170.83 9146.87 8594.02 1.06 9785.91 1.33 2010 13485479.54 8722.74 9569.23 0.91 2011 14264717.86 8246.24 10633.10 0.78 2012 14927699.73 7880.00 10984.61 0.72 2013 15477700.67 7599.98 11413.50 0.67 2014 16164549.73 7277.05 11783.04 0.62 7945.20 0.74 2015 16602213.65 7085.22 11747.06 0.60 2016 17079002.65 6887.42 10007.51 0.69 6986.32 0.65 *x is calculated as average annual rate of labor productivity, **ϕ is calculated as average annual rate of capital productivity. source: author’s calculations from 1990 to 2016 table 2: real wage-profit rate schedule for saudi arabia profit (ν) wage w 1990–1994 w 1995–1999 w 2000–2004 w 2005–2009 w 2010–2014 w 2015–2016 0 15272.40 16733.57 20001.43 34281.68 46111.59 38553.57 0.5 13755.91 15164.78 18181.50 30483.29 40675.07 33141.80 1 12239.43 13595.98 16361.57 26684.91 35238.55 27730.04 1.5 10722.95 12027.18 14541.64 22886.52 29802.03 22318.28 2 9206.47 10458.39 12721.70 19088.14 24365.51 16906.51 2.5 7689.99 8889.59 10901.77 15289.75 18928.98 11494.75 3 6173.51 7320.79 9081.83 11491.36 13492.46 6082.98 3.5 4657.02 5751.99 7261.91 7692.98 8055.94 671.21 3.56 4468.94 5557.42 7036.18 7221.87 7381.66 0 4.24 2409.87 3427.32 4565.10 2064.46 0 4.51 1585.62 2574.67 3575.94 0 5.04 0 934.32 1673.00 5.33 0 589.12 5.50 0 source: author’s calculations from 1990 to 2016. *average annual rate of wage that we calculated it by using average of labor productivity (x), average of capital productivity (ϕ) in table 1, and profit rate (ν) in this table algarini: wage-profit rate schedules in case of saudi arabia international journal of economics and financial issues | vol 8 • issue 6 • 201888 figure 2 shows the three variables ϕ, x, and k. in the periods from 1990 to 2002, both capital and labor productivity increase. this is reflected in figure 1 by a near-parallel inwards shift in the real wage-profit schedule (hicks-neutral technical change). however, in the period from 2004 to 2012, labor productivity increases, while capital productivity declines (marx-biased technical change). this is the result of the increase of labor productivity because of an increasing capital-labor ratio (k/l = x/ϕ). post 2014, both labor and capital productivity decrease and the capital to labor ratio are constant. this gives our picture in figure 1 a near-parallel inwards shift in the real wage-profit schedule (hicks-neutral technical change). it is important to compare the kind of technical change of the saudi economy with other countries. foley and michl (1999) suggest a relationship between capital productivity and labor productivity across developed countries. they find that labor productivity increases and capital productivity decreases. also, they find multiple switch-points between the two techniques. they state that entrepreneurs choose the capital technique when the slope of wage-profit rate is flatter and choose labor technique when the slope of real wage-profit rate is steeper. in the case of saudi arabia, in the beginning of the period, both labor and capital productivity increase, and entrepreneurs selected labor and capital-saving techniques (hicks-neutral technical change). the switch-point between labor and capital starts in the period from 2004 to 2012. the vertical intercept of the real wage-profit rate shifts outwards and the horizontal intercept shits inwards. in this case, labor productivity increases and capital productivity falls (x > 0, ϕ < 0). it shows that technical change is labor-saving and capital-using (marx-biased). 6. conclusion utilizing the real wage-profit rate schedule, we examine the direction of technical change in the case of the saudi economy during the period from 1990 to 2016. we find that the productivity of labor and capital increases, and the technical change of labor and capital is almost equal (hicks-neutral technical change) through the period from 1990 to 2004. however, hicks-neutral may be only a passing phase before we see a return to the long-term trends of marx-biased technical change. in the period from 2005 to 2014, labor productivity increases while capital productivity decreases (marx-biased technical change). there is switchingpoint illustrated in this result since the vertical intercept moves outward and the horizontal intercept moves inward. during 2015 and 2016, both labor and capital productivity decrease. the decline may be caused by the increase in relative prices of other inputs such as raw materials that generate inefficiency (michl, 1988). this assumption is reasonable since saudi arabia is experiencing relatively high inflation, around 4.5% in average, and high prices of oil that are still influential in the economy of saudi arabia during that period9. the most noteworthy aspect of the saudi economy pattern of technical change is that it has started to enter a phase of steady decrease in the profit rate and increase in the real wage as seems to be the historical experience of developed countries. the growth of real wage continues to grow by 9.6%, 19.5%, and by 130%, while the profit rate grows by 11.8%, 5.7%, and −20.5%, in the first three periods, respectively. 7. acknowledgment i greatly appreciate the financial support provided by the sheikh mohammad al-fouzan macroeconomic forecasting chair for saudi arabia economy (smf chair) at al imam mohammad ibn saud islamic university (imsiu), riyadh, saudi arabia. references da silva, e.a. (1987), wage-profit trade-offs in brazil: an input/output analysis, 1970-1975. science and society, 50, 347-354. felipe, j., kumar, u. (2010), technical change in india’s organized manufacturing sector. levy economics institute of bard college working paper no. 626. felipe, j., laviña, e., fan, e.x. (2008), the diverging patterns of profitability, investment and growth of china and india during 19802003. world development, 36(5), 741-774. ferretti, f. (2008), patterns of technical change: a geometrical analysis using the wage-profit rate schedule. international review of applied 9 the highest year-to-year inflation rate was in 2008 that reached 11.10% during that period. figure 1: real wage–profit rate schedule for saudi figure 2: labor productivity, capital productivity, and capitallabor ratio algarini: wage-profit rate schedules in case of saudi arabia international journal of economics and financial issues | vol 8 • issue 6 • 2018 89 economics, 22(5), 565-583. foley, d.k., michl, t.r. (1999), growth and distribution. cambridge, ma: harvard university press. katsinos, a., mariolis, t. (2012), switch to devalued drachma and costpush inflation: a simple input-output approach to the greek case. modern economy, 3, 164. marquetti, a.a. (2003), analyzing historical and regional patterns of technical change from a classical-marxian perspective. journal of economic behavior and organization, 52(2), 191-200. michl, t.r. (1988), why is the rate of profit still falling? summer research workshop. the jerome levy economics insititute, working paper no.7. saudi arabian ministry of commerce and investment. (2018), annual report in different years. available from: https://www.mci.gov.sa/ en/pages/default.aspx. saudi arabian ministry of planning and economics. (2018), annual report in different years. available from: https://www.mep.gov. sa/en. saudi arabian ministry of labor and social development. (2018), annual report in different years. available from: https://www.mlsd.gov. sa/en/node. soklis, g. (2011), shape of wage–profit curves in joint production systems: evidence from the supply and use tables of the finnish economy. metroeconomica, 62(4), 548-560. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.83-92 issn: 2146-4138 www.econjournals.com 83 the contagion effects of sovereign downgrades: evidence from the european financial crisis shaen corbet department of economics, finance and accounting, national university of ireland, maynooth, ireland. tel: +353 87 067 1690. email: shaencorbet@gmail.com abstract: this research examines the effects of sovereign downgrades on european financial markets between 2005 and 2012. vector autoregression (var) techniques are used to investigate the presence of contagion effects after a sovereign downgrade across equity indices, five year credit default swaps (cds) and ten year government bonds of the investigated european states. sovereign downgrades are found to be associated with an increase in equity returns, and cause significant increases in the cost of insuring debt through cds and the yield of government debt. the greek and irish downgrades are to found to have significant reverberations throughout european financial markets. german cds spreads are found to increase when a european state is downgraded, signalling their use by investors as a barometer of european-wide defaults. though credit rating agencies clearly missed the european sovereign crisis prior to 2007, their rating downgrades are still found to cause significant effects within european financial markets. keywords: sovereign ratings; var; contagion; financial crisis; stock markets. jel classifications: g01; g15 1. introduction since 2010, international credit rating agencies have downgraded numerous european states, with the outlook for all being placed firmly under the microscope. this has raised many doubts about the credibility of credit rating agencies as to why they have implemented these downgrades in the midst of crisis, rather than during its evolution. the downgrades implemented were centralised on the main problematic states of greece, ireland, spain, italy and portugal. but other states, perceived to be more economically stable such as france, belgium and austria have also been subjected to similar fates. this research specifically investigates the contagion effects of these individual downgrades across european financial markets, through the main financial inter-linkages provided by equity markets, five year credit default swaps (cds) and ten year government debt. the credit rating agencies under investigation are moody’s, fitch and standard and poors. vector autoregression (var) techniques are used to test for the presence of contagion through the implementation of dummy variables denoting the announcement of a sovereign downgrade. the channels in which contagion may spread have increased in europe since the establishment of the euro currency in 1999. fratzscher (2002) found that the aggregation of numerous states into this currency union has increased the correlation of equity returns across europe. sy (2009) found that credit rating agency announcements could cause contagion effects in europe as a result of rating-based triggers such as banking regulation changes, ecb collateral rules, cds contracts and other investment mandates. areski et al. (2011) found that the holdings of foreign debt by domestic banks and european-wide debt within european banks could enhance contagion effects. the authors focused on the effects of ratings announcements for european countries between 2007 and 2010 to find significant spillover effects. ehrmann et al. (2010) uncovered evidence of substantial international spillover effects across numerous international asset classes during the recent crisis, while kiff et al. (2012) found evidence supporting rating agency failure during the european crisis and conclude that ratings should incorporate obligor’s resilience to stress scenarios in their methodology. bissoondoyal-bheenick (2012) argued that there are more significant spillover effects after a rating change when links in financial markets are analysed in comparison to similar trade links, and international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.83-92 84 that there appears to be a contamination effect in terms of contagion present for both upgrades and downgrades. alsakka and ap gwilym (2012) investigated pre and post-crisis rating agency decisions for countries in europe and central asia to find strong spillover effects through currency markets, with the magnitude of these spillover effects more pronounced in crisis periods rather than periods of relative financial calm. de santis (2012) investigated the influence of rating agencies in spreading crisis to europe from greece, ireland and portugal. this research finds that three factors can explain the recorded developments in sovereign spreads: an aggregate regional risk factor, the country-specific credit risk and the spillover effect from greece. gande and parsley (2005) found that a country’s rating downgrade has a significant negative effect on the sovereign bond spreads of other countries. li et al. (2008) investigated contagion effects from rating announcements in asia from 19902003 to find that the contagion effect caused a rating announcement in one country to affect stock market returns in other crisis-influenced countries. alternatively, el-shagi (2010) could not find evidence supporting the same hypothesis, finding that the accusations against credit rating agencies were unconvincing given that most downgrades of sovereign debt occurred towards the end of a crisis. afonso et al. (2011) investigated financial market inter-linkages in the time period before and after a ratings announcement. the authors find significant responses of government bond yield spreads to changes in rating notations and outlook, with announcements not anticipated at the one to two month horizon but there is bi-directional causality between ratings and spreads within two weeks after the announcement. the spillover effects are also found to run from lower ranked countries to those with a higher ranking and there are persistent effects present for recently downgraded countries. to effectively model the european crisis and the effects of rating agencies’ announcements, event studies were found to be inappropriate in capturing the spillover effects between markets. thus in light of the models used by arezki et al. (2011) inspired by the previous work of favero and giavazzi (2002), a var (vector autoregression) framework is found to be most appropriate, with dummy variables implemented to capture the effect of sovereign rating news on the included equity, five year cds (credit default swap) and ten year sovereign bond markets. this enables the capture of the dynamics spillover effects of rating agency announcements on these specific financial markets by controlling for the lagged effects of fluctuations in these asset classes. the remainder of the paper is organised as follows. section 2 discusses the credit rating agencies reaction to the sovereign debt crisis. section 3 introduces the data, methodology and structure of the models. section 4 summarises the results of the research and section 5 concludes. 2. the reaction of credit rating agencies to the european financial crisis credit rating announcements are based on rating changes (upgrades or downgrades), revisions of previous outlooks and reviews for future ratings changes. these differing types of rating changes can occur simultaneously, even differing between the three companies investigated. there has been a large increase in the number of european downgrades since 2007. there has also been a significant increase in the number of ‘negative outlook’ changes which indicates potential downgrades within the next two years, and an increase in the number of ‘negative watch’ announcements which indicates an impending downgrade within ninety days. 2.1. types of credit rating announcements there were ninety rating announcements between the period january 2005 and january 2012 for the main european sovereign states investigated in this research. the main downgrades and negative outlook changes are included in table 1. table 2 summarises the announcements based on the issuing credit agency. it shows that of the ninety announcements, there were thirty-five downgrades, thirty-three outlook revisions and seventeen combined announcements, with five countries being placed on review for downgrade in the next ninety days. standard and poor is the most frequent announcer (thirty-six) and most frequent down-grader (fifteen). there was only one upgrade (belgium in may 2006) for the countries investigated in the sample. since then, up to january 2012, only two other european countries investigated in this research received a positive announcement from the three rating agencies. table 2 also presents the announcements based on the outlook portrayed (either positive or negative), of which there are only three positive announcements in total between 2005 and 2012. the contagion effects of sovereign downgrades: evidence from the european financial crisis table 1. rating agency actions for investigated european countries january 2005 to january 2012 number country agency date change action grade 1 belgium fitch 02/05/2006 upgrade and stable outlook aa+ 2 italy fitch 25/05/2006 negative watch aa 3 italy fitch 19/10/2006 downgrade and stable outlook aa 4 italy s&p 19/10/2006 downgrade a+ 5 greece s&p 14/01/2009 downgrade a 6 ireland fitch 06/03/2009 negative watch aaa 7 ireland s&p 30/03/2009 downgrade aa+ 8 ireland fitch 08/04/2009 downgrade and negative outlook aa+ 9 ireland s&p 08/06/2009 downgrade aa 10 ireland moody’s 19/07/2009 downgrade aa2 11 greece fitch 22/10/2009 downgrade and negative outlook a 12 ireland fitch 04/11/2009 downgrade aa 13 greece fitch 08/12/2009 downgrade and negative outlook bbb+ 14 greece s&p 16/12/2009 downgrade bbb+ 15 greece moody’s 22/12/2009 downgrade a2 16 greece fitch 09/04/2010 downgrade and negative outlook bbb 17 greece moody’s 22/04/2010 downgrade a3 18 greece s&p 27/04/2010 downgrade bb+ 19 spain s&p 28/04/2010 downgrade aa 20 spain fitch 28/05/2010 downgrade and stable outlook aa+ 21 greece moody’s 14/06/2010 downgrade ba1 22 ireland s&p 24/08/2010 downgrade aa 23 spain moody’s 30/09/2010 downgrade aa1 24 ireland fitch 06/10/2010 downgrade and negative outlook a+ 25 ireland s&p 23/11/2010 downgrade a 26 ireland fitch 09/12/2010 downgrade and stable outlook bbb+ 27 ireland moody’s 17/12/2010 downgrade baa1 28 greece fitch 21/12/2010 negative watch bbb 29 greece fitch 14/01/2011 downgrade and negative outlook bb+ 30 ireland s&p 02/02/2011 downgrade a 31 greece moody’s 07/03/2011 downgrade b1 32 spain moody’s 10/03/2011 downgrade aa2 33 greece s&p 29/03/2011 downgrade bb 34 ireland s&p 01/04/2011 downgrade bbb+ 35 ireland moody’s 15/04/2011 downgrade baa3 36 greece s&p 09/05/2011 downgrade b 37 greece fitch 20/05/2011 downgrade and negative outlook b+ 38 belgium fitch 23/05/2011 negative watch aa+ 39 greece moody’s 01/06/2011 downgrade caa1 40 greece s&p 13/06/2011 downgrade ccc 41 ireland moody’s 12/07/2011 downgrade ba1 42 greece fitch 13/07/2011 downgrade ccc 43 greece moody’s 25/07/2011 downgrade ca 44 greece s&p 27/07/2011 downgrade cc 45 italy s&p 19/09/2011 downgrade a 46 italy moody’s 04/10/2011 downgrade a2 47 italy, spain fitch 07/10/2011 downgrade a+ 48 spain s&p 13/10/2011 downgrade aa 49 spain moody’s 18/10/2011 downgrade a1 50 belgium s&p 26/11/2011 downgrade and negative outlook aa 51 austria, france, germany, spain, ireland, italy, s&p 05/12/2011 negative watch 52 austria fitch 16/12/2011 downgrade aa+ 53 belgium moody’s 16/12/2011 downgrade aa3 54 ireland, italy, fitch 16/12/2011 negative watch international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.83-92 86 spain 55 austria, france, spain s&p 13/01/2012 downgrade aa+, aa, a 56 belgium, italy, spain fitch 27/01/2012 downgrade aa. aa-, a 57 italy s&p 31/01/2012 downgrade bbb+ note: the above table represents the main credit announcements in terms of downgrades from january 2005 to january 2012 for the rating agencies s&p, fitch and moody’s. table 2. segregated rating agency actions for investigated european countries january 2005 to january 2012 fitch moody’s s&p total rating changes upgrades 1 0 0 1 downgrades 7 13 15 35 outlook revision positive 1 0 0 1 negative 10 9 12 31 maintained 0 0 1 1 combined announcements outlook revisions with an upgrade 1 0 0 1 outlook revisions with an downgrade 11 2 3 16 country under immediate review 0 0 5 5 totals 31 24 36 91 note: the above table represents the total number of rating agency announcements segregated by rating announcement type and the rating agency making the announcement. 2.2. sequencing of the european credit rating announcements the rating agencies presented in tables 1 and 2 were concentrated from january 2005 until january 2012. table 1 shows that prior to january 2009, there were only four major announcements for european countries. this is clear evidence that the three rating agencies investigated in this research did not anticipate the economic problems in europe. figure 1 echoes this sentiment, presenting the monthly number of sovereign upgrades and downgrades compared to the median eba banks (european banking authority) five year probability of default. the european sovereign crisis stemmed from an international banking crisis, but the lag between the implementation of negative announcements and downgrades from the three rating agencies and the peak of the european banking crisis is indisputable. credit rating announcements are not only concentrated over time, but are also concentrated geographically. table 3 describes the geographical division of rating announcements from january 2005 until january 2012 for the european countries investigated. greece, ireland, spain, italy and portugal account for over 83% of total rating agency actions. greece has the highest number of downgrades, while germany, the netherlands and the united kingdom had no downgrades during the investigated period, but were all placed under review as the crisis escalated. the contagion effects of sovereign downgrades: evidence from the european financial crisis figure 1. number of rating announcements and the median eba banks five year probability of default note: figure 1 shows the downgrade of sovereign states and the peak of the european banking crisis (q3 2008) as measured by the median eu banks probability of defaults as measured through kamakura. table 3. geographical segregation of rating agency actions from january 2005 to january 2012 country rating change outlook change combined under review totals austria 2 1 0 0 3 belgium 2 1 2 0 5 france 1 1 0 1 3 germany 0 1 0 1 2 greece 9 5 14 0 28 ireland 7 4 9 0 20 italy 5 4 3 1 13 netherlands 0 0 0 1 1 spain 8 5 1 0 14 united kingdom 0 0 0 1 1 totals 34 22 29 5 90 note: the above table represents the style and geographical segregation of the rating announcements in the investigated period. 3. data, methodology and structure of the models the var model comprises of three equations each representing a facet of a given financial market, namely the main equity market index, the sovereign cds spread and the ten year government bond yield. data for the ten largest european countries are used (austria, belgium, france, germany, greece, ireland, italy, netherlands, spain and the united kingdom). the data spans from january 2005 until january 2012, representing 1,879 observations. to obtain robust estimators to possible remaining heteroskedasticity and autocorrelation in the residuals, a white correction is performed on the standard deviation of the estimated coefficient. a sequence of impulse dummy variables , are used to indicate the release date or a particular announcement. var techniques are used to measure the return impact , of these ratings announcements on market i at time t. formally, the relationship with the market return and the rating announcement news of a series of l rating announcements where j=1,……, l is expressed as: = + ∑ + (1) where is i.i.d and represents the white noise residual. if the coefficient associated with is significant, it indicates that the ratings announcement d leads to abnormal returns for the market i at time t. this specification relies on two assumptions. the first is that market i is assumed to be efficient as the return does not depend on past variables. second, the specification above relies on the assumption that financial markets are not interrelated. thus the model in this paper is of the form: international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.83-92 88 = ( ) + (2) where is a n-dimension vector of asset prices that are taken in logarithms on market i, ( ) is a nxn lag polynomial with = , are reduced-form disturbances with zero means and constant covariance matrix with variances given by e[ ]= and e[ , ]=0 for i not equal to j. as the model is specified in levels, the impulse dummies are deemed to be inappropriate. to be consistent with the specification in difference as in the equations above, we use step dummies that are represented as , where = ∑ . hence the specification of the estimation becomes: = ( ) + ∑ + (3) where is a matrix of nxk lag polynomial, with k representing the number of credit rating announcements included in the estimation model. using such a specification will allow us to obtain unbiased estimates of the effect of the rating announcements on the markets prices of the investigated indices to extract the effects of the announcements , from that of the natural structural linkages that exist between markets ( ). the effects of a change in outlook or indeed the impact of multiple announcements are also included in the model. in the case of the effects of a rating announcement on a particular sovereign jurisdiction, the specification is now expressed as: = ( ) + + + + (4) in equation (4), dg represents downgrades, oc is the coefficient on the dummy variable for rating agency outlook changes and ma is based on multiple announcements. further the specification for an investigation based on the source of the rating agency announcement is expressed as: = ( ) + + & + + (5) the results of this var model generate estimates of the effects on each market investigated based on the source of the announcement. this offers evidence as to whether one rating agency was viewed by the market to be more or less influential than its counterparties. the next model investigates whether there is a difference in the impact on the investigated markets based on the initial sovereign rating present at the time of the announcement. in theory, the downgrade of a high investment grade product by one grade may have a large impact, or indeed the downgrading of a sovereign state to default status. the rating announcements are then segregated into high and low investment grade and then high and low junk grade based on the individual rating agencies grading mandates. the var models are then run to analyse any specific differences and are expressed as: = ( ) + . + . + + + (6) the final var specification is based on the impact of a specific sovereign downgrade on the individual major european financial markets investigated. in this case, the specification changes to include the seven separate step dummies representing the european jurisdictions that have been subjected to downgrades and the var model investigates the effects on equity, cds and sovereign bond markets separately. the models are expressed as: = ( ) + + + + + + + + + (7) 4. results in a preliminary analysis, the augmented dickey fuller test confirms that each series contains a stochastic trend. similarly, johansen’s cointegration testing leads to the acceptance of the presence of at least one cointegration relationship within the equations. it is therefore important to separate the direct impact of the rating news from the diffusion process that exists between the investigated financial markets. the results of the hausman test lead us to rejects the equality of the coefficients associated with the dummy variable at a minimum of the 5 per cent level. this suggests that there is heterogeneity of coefficients associated with the different dummy variables across the investigated countries. this highlights the transmission heterogeneity of rating news across european countries, preventing the use of panel data techniques, thus the analysis is completed on a country by country level. to test for interdependence between markets, the model is first estimated without considering any exogenous variables. the results are reported in table 4. each equation includes a lagged exogenous variable and the estimated coefficient is statistically significant and not different from one. the contagion effects of sovereign downgrades: evidence from the european financial crisis this result adds further confirmation to the findings of the unit root in the cointegration tests. the investigation highlights the existence of a transmission mechanism between the investigated markets and countries. not taking such interdependence into account would not allow for discrimination between the impacts of rating news and the natural diffusion process that already exists in the investigated markets due to structural relationships. table 4. interdependence between the markets under investigation austria belgium france germany greece ireland italy nether. spain uk variable 1: equities equities 1.062*** 1.025*** 0.951*** 1.002*** 1.022*** 1.032*** 0.977*** 0.974*** 0.984*** 0.964*** cds -0.012** 0.001 -0.004 -0.003 -0.02*** 0.001 -0.017** -0.001 -0.02*** -0.007 bonds 0.091*** 0.009 0.047 -0.007 0.033 0.015 -0.023 0.041 0.018 -0.002 variable 2: cds equities -0.742 -0.71*** -0.68*** -0.397** -0.49*** -0.299 -0.28*** -0.692 -0.45*** -0.111 cds 0.862 0.791*** 0.686*** 0.753*** 0.771*** 0.748*** 0.909*** 0.818*** 0.834*** 0.882*** bonds -0.053 0.214* -0.173 -0.073 0.303*** 0.561 0.348*** -0.019 0.014 -0.136* variable 3: bonds equities -0.121 -0.12*** -0.09*** -0.012 -0.09*** -0.07*** -0.07*** -0.07*** -0.018 0.001 cds -0.011 0.006 -0.001 -0.002 0.015** 0.001 -0.002 0.000 0.027*** -0.012 bonds 1.161 1.203*** 1.096*** 1.151*** 1.093*** 1.194*** 1.128*** 1.149*** 1.013*** 1.035*** notes: robust standard errors are in parentheses, where ***p<0.01, **p<0.05 and *p<0.10. table 5. impact of downgrades and downgrade by agency on the sovereign state investigated austria belgium france germany greece ireland italy nether. spain uk variable 1: impact of a downgrade equities 0.0012 0.0011 0.0013 0.0029* 0.0004 0.0023 0.0035* 0.0015 0.0013 0.0016 cds 0.0071 0.0078 0.0059 0.0096 0.0030 0.0067 0.0073 0.0084 0.0063 0.0020 bonds 0.0018 0.0017 0.0023 0.0029* 0.0055** 0.0038*** 0.0014 0.0004 0.0013 0.0021 variable 2: impact of a fitch downgrade equities -0.0049 -0.0021 -0.002 -0.0003 0.0023 -0.0096 -0.0014 -0.0015 -0.0022 -0.0013 cds 0.0096 0.0075 0.0069 0.0141 0.0024 0.0023 0.0135 0.0071 0.0082 0.0053 bonds 0.0022 0.0067*** 0.0033 0.0004 0.0026 0.0028 0.0073*** 0.0002 0.0003 -0.0019 variable 3: impact of a s&p downgrade equities 0.0046* 0.0042* 0.0039 0.0056** 0.0027 0.0054* 0.0061** 0.0041 0.0031 0.0036 cds 0.0131 0.0114 0.0044 0.0109 0.0039 0.0069 0.0102 0.0138 0.0099 0.0047 bonds 0.0016 -0.0017 0.0012 0.0037 0.0083** 0.0037 -0.0004 0.0000 0.0029 0.0037 variable 4: impact of a moody’s downgrade equities 0.0037 0.0005 0.0009 0.0029 -0.0075* 0.0227 0.0064* 0.0010 0.0034 0.0026 cds -0.0085 0.0018 0.0089 0.0019 0.0041 0.2037 -0.0075 0.0101 -0.0033 -0.0089 bonds 0.0016 0.0006 0.0027 0.0051 0.0074 0.0063* -0.0044 0.0010 0.0003 0.0049 notes: robust standard errors are in parentheses, where ***p<0.01, **p<0.05 and *p<0.10. table 6. impact of negative reviews and multiple announcements on the sovereign state investigated austria belgium france germany greece ireland italy nether. spain uk variable 1: impact of a negative review equities -0.001 -0.0017 -0.0019 -0.0027 -0.001 -0.0019 -0.0029 -0.0007 -0.0012 -0.0007 cds 0.0019 0.0058 0.0032 0.0049 -0.012 0.0069 0.0043 0.0084 0.0016 0.0038 bonds 0.0021 0.0006 0.0033** 0.0000 -0.001 0.0000 -0.0005 0.0006 -0.0007 -0.004* variable 2: impact a multiple rating agency announcement equities 0.0014 0.0001 0.0001 0.0014 0.0009 0.0011 0.0008 0.0007 -0.0000 0.0014 cds 0.0076 0.0118 0.0059 0.0106 0.0033 0.1597 0.0089 0.0133 0.0073 0.0035 bonds 0.0013 0.0006 0.0021 0.0033* 0.0034 0.0037 0.0009 0.0011 0.0013 0.0023 notes: robust standard errors are in parentheses, where ***p<0.01, **p<0.05 and *p<0.10. 4.1. the effects of rating agency decisions on european financial markets the models are segregated to investigate the direct impact of a downgrade on the selected european financial markets. table 5 displays the var results based on an included dummy variable signalling a downgrade and indeed, the rating agency that made the downgrade. table 6 displays the var results by country when a negative outlook or negative review was issued. these results are also adopted to include simultaneous announcements, thus include downgrades with attached negative international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.83-92 90 outlooks and reviews (which signal consideration for further downgrades in the short to medium term). investigating the impact of sovereign downgrades and the origin rating agency offers some interesting results. first, there are uniform reactions to a downgrade, through increases in equity market returns and the yield demanded by investors for sovereign debt. german cfd spreads also showed significant reactions, indicating that insurers required a higher premium for risk. this may be explained through the german position as a central strength of the eurozone; therefore, the german cds would have been viewed as an alternative measure of perceived european-wide risk. fitch and standard and poors appear to have the largest impacts across the european nations investigated. there was a large reaction of irish equity, cds and bond markets to moody’s downgrades. negative reviews are associated with decreased returns across all equity markets, with the deepest falls in germany, portugal, italy, ireland and spain. greece consistently possessed the highest risk of default in terms of five year cds and ten year government bond yields, but actually showed alleviation in pressure based on these cds and bond yields at the time of a downgrade. when multiple announcements were made simultaneously, there was a sharp increase in cds spreads, indicative of increased perceptions of risk and default throughout the financial community. table 7. impact of downgrade based on whether investment or junk grade sovereign status austria belgium france germany greece ireland italy nether. spain uk variable 1: impact of high investment grade downgrade equities 0.0023 0.0029* 0.0029 0.0033 0.0039 0.0034 0.0048** 0.0029 0.0031 0.0025 cds -0.0049 -0.0021 -0.0009 0.0031 -0.0029 -0.0001 -0.0015 -0.003 -0.0082 -0.0012 bonds 0.0041** 0.0018 0.0047*** 0.0049** 0.0003 0.0031* -0.0019 0.0027 -0.0002 0.0036* variable 2: impact of low investment grade downgrade equities 0.0005 0.0001 0.0004 0.0041 -0.0029 0.0034 0.0022 0.0013 -0.0004 0.0018 cds 0.0142 0.0205 0.0125 0.0158 0.0069 0.0154 0.0171* 0.0289 0.0228* 0.0073 bonds 0.0012 0.0038 0.0027 -0.0006 0.0047 0.0036 0.0056** -0.002 -0.0006 0.0014 variable 3: impact of high junk grade downgrade equities -0.0035 -0.0029 -0.0021 0.0001 -0.0085 -0.0039 -0.0025 -0.002 -0.0039 -0.0016 cds 0.0081 0.0085 0.0100 0.0194 0.0018 0.0293 0.0143 0.0253 0.0081 0.0025 bonds 0.0009 0.0014 0.0001 0.0026 0.0219*** 0.0131*** -0.0007 0.0008 0.0072 -0.0009 variable 4: impact of low junk grade downgrade equities -0.0023 -0.0028 -0.0052 -0.0031 -0.0069 -0.0045 0.0006 -0.004 0.0007 -0.0025 cds -0.0101 -0.0029 0.0063 0.0035 0.0033 -0.0051 -0.0094 0.0024 -0.0034 -0.0041 bonds -0.0018 0.0013 -0.0021 -0.0022 0.0034 -0.1093* 0.0024 -0.000 0.0037 0.0019 notes: robust standard errors are in parentheses, where ***p<0.01, **p<0.05 and *p<0.10. high investment grade is denoted as aaa to a+ for fitch and s&p, and aaa to a1 for moody’s. low investment grade is denoted at a to bbbfor fitch and s&p and a2 to baa3 for moody’s. high junk grade is ranked as bb+ to b for fitch and s&p and ba1 to b2 for moody’s and finally low junk grade is ranked as bto sd/default for fitch and s&p and b3 to d for moody’s. 4.2. the impact of downgrades based on rating agency grading between 2005 and 2012, greece was the only european country identified by rating agencies to be in a state of default. table 7 shows the var results based in the spillover effects within the european markets at the time of a downgrade segregated by their investment status. variables 3 and 4 in table 7 are based solely on the greek downgrade. seven states in total were downgraded. for high investment grade ratings, equity market returns increased initially after a downgrade, but sovereign debt markets showed substantial stress. this may be caused by the shock of an investment grade asset being identified as being in trouble. when a state has fallen to junk status, the effects of a downgrade are amplified, as seen in the dramatic widening of cds spreads. this effect was evident during the downgrades of portugal, spain, greece, ireland and italy. once a state was downgraded to junk status, the scenario was accompanied by a fall in european equity markets. the piigs showed tremendous pressures in cds and bond markets as the possibility of a european default was deemed increasingly credible. contagion effects are also significant throughout european markets. germany shows increasing stress levels through increasing 10 year bund yields and 5 year senior cds spreads, providing evidence that the german markets were indeed being used by investors as a barometer of european-wide financial health. this is particularly interesting as german markets were not downgraded throughout the period investigated. this investigation clearly shows that the effects of contagion within the eurozone had been effectively the contagion effects of sovereign downgrades: evidence from the european financial crisis priced in by investors, who were planning for what would happen after a default rather than the primary question of who was going to default. table 8. impact of country-specific downgrade on sovereign financial market austria belgium france germany greece ireland italy nether. spain uk variable 1: austrian downgrade equities 0.0002 0.0036 0.0012 0.0043 0.0010 0.0027 0.0051 0.0076 -0.0038 0.0062 cds 0.0153 -0.0033 0.0289 0.0125 -0.0405 0.0143 0.0226 0.0043 0.0002 -0.0087 bonds -0.0044 -0.0088 -0.0050 0.0028 -0.0097 0.0025 0.0059 -0.017* -0.0044 0.0064 variable 2: belgian downgrade equities -0.0096 -0.0027 -0.0049 -0.0037 -0.0023 -0.0009 -0.0043 -0.0025 -0.0039 -0.0041 cds 0.0042 -0.0047 0.0012 0.0149 0.0273 0.0028 0.0116 0.0056 0.0008 0.0067 bonds 0.0011 0.0006 0.0011 -0.0069 -0.0024 -0.0034 0.0073 -0.0032 -0.0133 -0.0123* variable 3: french downgrade equities 0.0002 -0.0037 0.0079 0.0125 0.0088 0.0023 0.0141 0.0099 -0.0011 0.0034 cds -0.0099 0.0246 0.0056 0.0073 -0.0089 0.0163 0.0315 0.0421 0.0069 -0.0053 bonds -0.0045 0.0033 -0.0074 0.0002 0.0157 -0.0011 -0.0037 -0.025* 0.0194 -0.0005 variable 4: greek downgrade equities -0.0029 0.0073* -0.0033 -0.0019 -0.0043 -0.0023 -0.0019 -0.0028 -0.0024 -0.0019 cds 0.0094 0.0246 0.0067 0.0018 0.0112 0.0190 0.0066 0.0307 0.0012* 0.0012 bonds 0.0009 0.0033 0.0063 0.0011 0.0085* 0.0038 0.0033 0.0027 0.0039 0.0025 variable 5: italian downgrade equities 0.0060 0.0073* 0.0092 0.0138*** 0.0034 0.0064 0.0125** 0.0077* 0.0086* 0.0079* cds -0.0082 -0.0046 -0.0035 0.0200 -0.0019 -0.1207 0.0042 -0.0188 -0.0037 -0.0063 bonds 0.0035 0.0048 0.0063 0.0111** 0.0106* -0.0013 0.0027 0.0054 -0.0072 0.0126*** variable 6: spanish downgrade equities -0.0023 0.0026 0.0023 0.0045 0.0118* 0.0052 0.0092* 0.0044 0.0015 0.0038 cds -0.0186 0.0019 0.0036 -0.0069 -0.0233 -0.0113 -0.0033 0.0005 -0.0098 -0.0045 bonds 0.0071* -0.0014 0.0105** 0.0141*** -0.0079 0.0049 0.0007 0.0044 -0.0001 0.0062 variable 7: irish downgrade equities 0.0066* 0.0028 0.0032 0.0059* -0.0049 0.0071* 0.0064* 0.0029 0.0041 0.0037 cds 0.0075 0.0002 0.0114 0.0062 -0.0007 0.0331 0.0126 0.0239 0.0066 0.0084 bonds 0.0010 0.0025 0.0003 0.0010 0.0035 0.0124*** 0.0019 -0.0012 0.0055 -0.0001 notes: robust standard errors are in parentheses, where ***p<0.01, **p<0.05 and *p<0.10. 4.3. contagion effect on european financial markets due to a sovereign downgrade the contagion effects of downgrades are shown in table 8. the size-adjusted inter-country connections, which are found to be in the worst economic health, should theoretically cause the largest reactions. the austrian and belgian downgrades were associated with simultaneous large increases in other states’ cds spreads offering evidence of spill-over effects. but most interestingly the austrian and french downgrades appear to relieve pressure from the greek situation, perhaps as investor’s reevaluated the potential recapitalisation and quantitative easing actions of the ecb and indeed the imposed restrictions of the imf, given the clear evidence of contagion being already present. greek cds spreads also show pressure reduction when their struggling counterparts italy, spain and ireland were downgraded. this may be evidence of the shifting focus of international financial markets as different states were placed under the spotlight. at the time of these rating decisions, the sheer turmoil and panic across states was so immense that nobody could be certain of whom was next to be in focus. the interactions between the struggling states are clearly obvious, with a downgrade of one being priced by the market as a faltering of the eurozone as a whole. also of note are the german cds and bond reactions to the italian and spanish downgrades. there is a sharp widening of cds spreads and increase in the european benchmark german bundrates, signifying the stresses present as larger-nations became victim to the negative sentiment offered by the rating agencies. 5. conclusions this paper investigates the contagion effects of sovereign rating agency announcements across the main european financial markets using daily data on the investigated countries’ domestic equity indices, five year senior credit default swaps (cds) and ten year sovereign government-issued bonds during the period 2005-2012. it finds that downgrades were associated with an increase in equity international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.83-92 92 returns with a simultaneous increase in the yields demanded for sovereign debt. german cds spreads show a large increase, indicative of their use as a european-wide barometer of default based on the widespread potential for contagion effects to escalate and spread given the market expectations throughout of a default of a european state. in terms of the individual rating agencies, both fitch and s&p were associated with the largest impacts on financial markets. negative reviews were also found to have a negative impact on the investigated markets, with the outlook of this announcement indicating a downgrade in the next ninety days. simultaneous announcements are found to have a much more pronounced negative effect, dampening investor aspirations as the announcements are associated with a downgrade of a european state with an outlook of further downgrades on the horizon. there is also a correlation between the starting point of the credit rating of a country being downgraded and the depth of the spillover effects found using the var methodology, again with the focus of negative investors shifting to germany as the centre-piece european state. the growth of the european union has enabled this phenomenon, as investors now clearly see the contagion trail between all the interconnected european states and germany as the largest sovereign state in the conglomerate. overall, credit rating agencies are found to have a significant influence in terms of initiating contagion effects on the european financial markets examined in this paper. the methodology and modelling of the sovereign states they monitor must be called into question, as if they see fit to downgrade european nations emphatically since 2010, why is it that they did not do so in the escalation of the crisis. the rating agencies must now learn from their mistakes, primarily to regain credibility with the financial community, but also given the important role through the significant effects that they have been found to possess on financial markets. references alfonso, a., furceri, d., gomes. p. (2012) sovereign credit ratings and financial market linkages: application to european data, journal of international money and finance, 31(3), 606-638. alsakka, r., ap gwilym, o. (2013) rating agencies’ signals during the european sovereign debt crisis: market impact and spillovers, journal of economic behaviour & organization, 85, 144-162. arezki, r., candelon, b., sy, a.m.r. (2011) sovereign rating news and financial markets spillovers: evidence from the european debt crisis, ifm working paper, 11/68. bissoondoyal-bheenick, e. (2012) do sovereign rating changes trigger spillover effects? research in international business and finance, 26(1), 76-96. de santis, r.a. (2012) the euro area sovereign debt crisis: safe haven, credit rating agencies and the spread of fever from greece, ireland and portugal, european central bank working paper 1419. ehrmann, m., fratzscher, m., rigobon, r. (2011) stocks, bonds, money markets and exchange rates: measuring international financial transmission, journal of applied economics, 26(6), 948-974. el shagi, m. (2010) the role of credit rating agencies in financial crises: event studies from the asian flu, cambridge journal of economics, 34(4), 671-685. favero, c.a., giavazzi, f. (2002) is the international propagation of financial shocks non linear? evidence from the erm, journal of international economics, 57(1), 231-246. fratzscher, m. (2002) financial market integration in europe: on the effects of emu on stock markets, international journal of finance and economics, 7(3), 165-193. gande, a., parsley, d.c. (2005) news spillovers in the foreign debt markets, journal of financial economics, 75(3), 691-734. kiff, j., nowak, s.b., schumacher, l.b. (2012) are the rating agencies powerful? an investigation into the impact and accuracy of sovereign ratings, imf working paper, 12/23. li, h., jeon, b.n., cho, s-y., chiang, t.c. (2008) the impact of sovereign rating changes and financial contagion on stock market returns: evidence from five asian countries, global finance journal, 19(1), 45-55. sy, a.m.r. (2009) the systemic regulation of credit agencies and rated markets, world economics, 10(4), 69-108. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(6), 104-109. international journal of economics and financial issues | vol 8 • issue 6 • 2018104 does the management information system causes competitive advantage for banks working in jordan? eman ahmad al hanini1*, samerra’a z. al oqaily2 1department of accounting, faculty of business, balqa applied university, al salt, jordan, 2balqa applied university balqa electronic academy, salt, jordan. *email: eman.hanini@bau.edu.jo received: 16 august 2018 accepted: 18 october 2018 doi: https://doi.org/10.32479/ijefi.7135 abstract the current study aimed at identifying the role of management information system (mis) in achieving competitive advantage for banks operating in jordan. the study examined the dimensions of the following competitive advantage: cost, quality, presentation, flexibility and creativity. in order to achieve the objectives of the study, a questionnaire was distributed to the sample of 78 respondents from randomly commercial and islamic chosen banks in jordan. the data were analyzed through the use of the statistical analysis program spss. the study found that there is a statistically significant relationship between the mis and the achievement of a competitive advantage in banks operating in jordan. the study recommended that banks should offer training courses for employees to raise their awareness of the importance of mis and their role and contribution to the excellence of the banks. the researchers also pointed out to the need of increasing bank’s financial allocations to purchase machines and software that are seen to develop the business of banking. keywords: management information systems, competitive advantage, quality jel classifications: d83, g411, m41 1. introduction management information system (mis) is a computerized administrative and financial information database, which is designed to produce organized reports about operations for each level of management in the company easily and quickly. the main purpose of mis is to provide the bank’s management with information related to overall performance and assist in the decision-making process. this is due to the fact that the banking sector is one of the most vital and productive sectors of the services provided and the major role that it plays in the national economy. based on this, general information technology and mis in particular have a strong impact on competitive advantage, both in terms of cost, which means managing operations at low prices compared to competitors or differentiation in quality, which means performing operations correctly to provide products that fit the needs of customers. hence, this study is intended to identify the role of mis in achieving a competitive advantage for banks operating in jordan. 1.1. the significance of the study the significance of the study stems from the fact that it links two important topics: mis and competitive advantage in such an important economic sector like banks. while the competition among banks is at its peak, mis has become an important resource for banks to track their competitors, fulfill their clients’ desires and cope with rapid changes taking place in the outside environment. 1.2. problem of the study the main problem of the study is to answer the question: “is there a role for mis in achieving competitive advantage in banks this journal is licensed under a creative commons attribution 4.0 international license al hanini and al oqaily: does the management information system causes competitive advantage for banks working in jordan? international journal of economics and financial issues | vol 8 • issue 6 • 2018 105 operating in jordan?” this question is to be answered through the study of the dimensions of the competitive advantage of (cost, quality, presentation, flexibility, creativity). 1.3. hypotheses of the study the study hypotheses are based on the following main null hypothesis: “there is no statistically significant relation between administrative information systems and the achievement of competitive advantage in banks operating in jordan” the five sub-hypotheses are as follows: hypothesis 1: there is no statistically significant relation between the mis and the reduction of the cost of services provided by banks operating in jordan. hypothesis 2: there is no statistically significant relation between mis and improving the quality of services provided by banks operating in jordan. hypothesis 3: there is no statistically significant relation between mis and improving the presentation of services provided by banks operating in jordan. hypothesis 4: there is no statistical relation between the mis and the flexibility of the system of services provided by banks operating in jordan. hypothesis 5: there is no statistically significant relation between mis and improving creativity in banks operating in jordan. 1.4. the study model 2. theoretical framework and literature review 2.1. mis mis is considered as one of the computerized information system application that provides information to management on a regular basis in the form of printed or presented reports or in the form of responses that appear on the computer screen, which contributes to decision making. it is a means of achieving mutual communication through providing fast, accurate and low-cost communication between the levels and functions of banks to facilitate the flow of information within the banks themselves and with their external environment (taha, 2000). these systems are based on development, improvement and decision-making because of their viability with the organization, and their uncomplicated and inexpensive maintenance. they are flexible and capable of changing the organization. moreover, they are able to store and process an enormous amount of information with a small storage space in the fastest and most accurate manner (salem, 1985). the mis components are inputs, processes and outputs (idrees, 2007). mis support the organization’s ability to build a strategic database that contains many information on the operations and activities of the organization, customers, suppliers, competitors and the surrounding environment that assist the organization in strategic planning and strategic initiatives (abdelqader, 2010). 2.2. competitive advantage in banks competitive advantage is the companies’ ability to provide a product with characteristics of differentiation, lower costs, and creativity. this feature is able to attract more purchase requirements for products and the create alliances and partnerships with international industrial companies, which positively reflects on consumer confidence and product quality. it, likewise, improves the level of national income (al talbany, 2012). the competitive advantage of the bank lies in the discovery of new and more effective methods other than those used by other competing banks. it is also known as the skill, technology or supplier that enables the bank to provide better values and benefits compared to the competitors. it also emphasizes its excellence and difference to customers (mohammad, 2017). 2.3. the role of mis in achieving competitive advantage in banks mis helps banks in: (mohammad, 2017) and (hawary and winton, 2004) 1. improving the productive efficiency of the bank through the following dimensions: • cost: this means that the department of operations reduces the cost of providing services compared to competitors, until it reaches a premium. • after quality: refers to the performance of services properly, to suit the needs of customers. • flexibility: it means responding quickly to changes that may be needed in the design of products or services to fit the needs of customers, or change the ways of service performance, or change the performance time. • delivery: design and delivery of new services to customers in the shortest time, i.e., speed of delivery, and speed of development. 2. contributing to the achievement of creativity in: where the information management systems contribute to the development of new services, and the development of methods and methods of efficient design and delivery of services, and extends to after-sales services. 2.4. literature review mohammad’s (2017) study entitled “the characteristics of mis and their impact on achieving sustainable competitive advantage: from the point of view of workers in the banking sector in the state of khartoum sudan” aimed at identifying the effect of the characteristics of administrative information in achieving sustainable competitive advantage from the point of view of workers in the banking sector in khartoum state. the study found that there is a relationship between the characteristics of administrative information systems in achieving the competitive advantage of sustainable banks. the study found that there is a strong and positive relationship between the characteristics of a mis and competitive advantage in the banking sector in the state of khartoum, and that the presence of scientific qualification helps al hanini and al oqaily: does the management information system causes competitive advantage for banks working in jordan? international journal of economics and financial issues | vol 8 • issue 6 • 2018106 to enhance this competitive advantage. the study recommended that attention should be paid to administrative information systems in all banking departments and to intensifying training courses for bank employees. mobaydeen’s study (2015) “strategic information systems and their impact on achieving competitive advantage in jordanian potassium companies” the study aimed at measuring the impact of strategic information systems in achieving the competitive advantage of potash companies in jordan. the study found that the application of strategic information systems contributes in the achievement of competitive advantage at the latest (low cost, differentiation, alliances). the study concluded that in order to develop the company’s profiles, it is necessary to rely on market research and identify the need of customers and work to establish organizational culture within the company based on employment strategies information systems. the study recommended that attention should be given to building strategic information resources, focusing on their inputs and increasing the efficiency of coordination between the operational operations of the subsidiary companies of the factory. abu kareem (2013) studied the relationship between mis in improving administrative performance in non-governmental organizations in gaza strip. the study found that computers, followed by users, and software, are the most important and influential resources to improve the performance of administrative information systems, and the least influential are specialists, technicians and databases. the study concluded that improving the performance of administrative information systems is related to improving the administrative performance according to the variable years of service and scientific qualification. the study recommended that the development of the performance in companies and non-governmental organizations in gaza strip depends heavily on the existence of an information technology department and the appointment of specialists. abu baker (2013)’s study entitled “the role of strategic information systems in supporting and achieving the competitive advantage of egyptian insurance companies.” the study aimed at evaluating the effectiveness of the information systems used in the insurance sector and presenting the problems faced by these companies and determining the role that strategic information systems play in achieving competitive advantage. the study found that in order to achieve competitive advantage, it is necessary to invest the strategic information learned from the strategic information systems for the development of services and the quality of strategic decision-making. the study concluded that the process of data processing, data storage and strategies is characterized by their high capabilities in strategic information systems, which is reflected positively in decision-making and achieve competitive advantage. the study recommended that these companies raise their capabilities and provide the capital needed to invest in information technology. a study of (shaheen, 2011) entitled “factors affecting the efficiency and effectiveness of computerized accounting information systems in commercial banks in palestine” analyzed factors and effects that determine the level of efficiency and effectiveness of accounting information systems and their impact on palestinian commercial banks. the study found that the legal factors and professional controls, social and economic culture are the most important factors affecting effectiveness and efficiency. the study concluded that these factors vary depending on the level of interest and support received from the banking department. the study recommended that the technical factors have a significant impact on accounting systems and that more efforts must be made in order to develop them. al yassiry and nawras, (2007) investigated the role played by the strategic information systems in measuring the impact of strategic information systems on the outstanding performance of the iraqi private banking sector. the study found that banks are aware of the importance of strategic information systems and their keenness to develop their performance to achieve a competitive advantage provides them with a sustainable competitive path through the provision of effective strategic systems. the study recommended that banks should recognize outstanding performance to ensure that competitive opportunities for sustainable development are promoted. a study of abdelqader, (2010) entitled “the role of strategic information systems in enhancing competitive advantage: the case of algerian institutions.” the study aimed at linking the role of information systems with the competitive advantage in the algerian administrative environment. it also linked the role these systems play as a strategic tool to achieve this advantage. the study found a positive correlation between statistical requirements of information systems and the competitive advantage of algerian industrial establishments. the study recommended the need for algerian industrial institutions to increase their capabilities by adopting a kind of partnership in them, such as mergers or strategic alliances to provide the necessary capital to invest in information technology, support research and development functions and the need to deal with information as a major and important resource for the company. we note that previous studies have been applied to banks operating in other countries such as the study of (mohammad, 2017) which has been applied in sudan and study of (hawary and winton, 2004) in algeria, but this study has been applied in jordan. 3. methodology 3.1. data collection sources there were two types of sources of data collection. the primary sources constitute the questionnaire that was used to collect data about views of the study sample. the questionnaire was designed according to the likert scale from 1 to 5. the secondary sources of data are books, periodicals and websites related to the topic of the study. 3.2. population and sample of the study the population of the study consists of all banks operating in jordan, local and foreign; commercial and islamic. the central bank of jordan website has shown that the number of banks involved in the study reached the number of 25 including one al hanini and al oqaily: does the management information system causes competitive advantage for banks working in jordan? international journal of economics and financial issues | vol 8 • issue 6 • 2018 107 commercial bank and four islamic banks (central bank, 2018). the sample of the study included a random sample of 78 respondents from the employees of these banks at different administrative levels. ninety questionnaires were distributed among which 78 were analyzed. the following table 1 describes the sample of the study. 3.3. statistical analysis the following statistical methods were used in data analysis and hypothesis testing: 1. reliability test (α) reliability analysis: the alpha-cronbach test was used to measure the internal stability of the resolution paragraphs and the internal consistency between respondents’ responses where the coefficient of stability (α) 85.2% which is excellent compared to the acceptable rate of 60%. 2. the normal distribution test (kolmogrov-smirnov): after conducting the necessary statistical analysis, the data were distributed naturally. the mean z for all hypotheses was greater than the significance level of 5% as shown in the table 2. 3. testing the strength of the model: the strength test of the model is used to ensure that there is no overlap between the hypotheses, where the correlation matrix is extracted between these hypotheses (correlation matrix). the inflation factor (vif) variance inflationary factor is calculated and amounted to 2.514. this means that there is no overlap between the hypotheses of the study and vif is calculated as follows: 2 1 1 vif 2.514 1 0.776)1 r −(− = = = r is the highest link strength within the correlation matrix. 4. test hypotheses: the hypotheses of the study were tested using the following statistical tests: • one sample t-test at a significant level (significance) of 5%, according to the rule of decision which provides acceptance of the hypothesis if the calculated t is less than the value of the table, and reject it if it is larger. • descriptive analysis which includes the frequencies, the mean and the standard deviation to accept or reject the statements of hypothesis. the researchers found out the following: 3.4. the main hypothesis there is no statistically significant relationship between mis and achieving competitive advantage in banks operating in jordan. table 3 shows the results of the statistical analysis. since the calculated t is greater than the t tabular, this means rejecting the null hypothesis and accepting the alternative hypothesis, that is, there is a statistically significant relationship between mis and the achievement of competitive advantage in banks operating in jordan. 3.5. the first hypothesis there is no statistically significant relationship between the mis and the reduction of the cost of services provided by banks operating in jordan. the following table 4 shows the results of the statistical analysis. since the calculated t is greater than the t tabular, this means rejecting the null hypothesis and accepting the alternative hypothesis. the following table 5 shows the arithmetic mean and standard deviation of each hypothesis: 3.6. the second hypothesis there is no statistically significant relationship between mis and improving the quality of services provided by banks operating in jordan. the results of the analysis are presented in table 6. since the calculated t is greater than the t tabular, this means rejecting the null hypothesis and accepting the alternative hypothesis. the following table 7 shows the arithmetic mean and the standard deviation of each hypothesis. 3.7. the third hypothesis there is no statistically significant relationship between mis and improving the provision of services provided by banks operating in jordan. the following table 8 shows the results of the analysis of this hypothesis. table 1: study sample description description commercial islamic total count (%) count (%) count (%) age 24–35 years 24 (47.1) 9 (33.3) 33 (42.3) 33–44 years 18 (35.3) 18 (66.7) 36 (46.2) 45 and over 9 (17.6) 0 (0.0) 9 (11.5) qualifications diploma 0 (.0) 1 (3.7) 1 (1.3) ba 31 (60.8) 21 (77.8) 52 (66.7) m.a. 15 (29.4) 5 (18.5) 20 (25.6) ph.d. 5 (9.8) 0 (0.0) 5 (6.4) experience <4 years 18 (35.3) 6 (22.2) 24 (30.8) from 4 years to 7 years 9 (17.6) 12 (44.4) 21 (26.9) from 8 to 14 years 18 (35.3) 9 (33.3) 27 (34.6) 15 years and over 6 (11.8) 0 (.0) 6 (7.7) position deputy or assistant general manager 1 (2.0) 4 (14.8) 5 (6.4) department director 11 (21.6) 3 (11.1) 14 (17.9) branch manager 17 (33.3) 6 (22.2) 23 (29.5) employee 22 (43.1) 14 (51.9) 36 (46.2) total 51 (100.0) 27 (100.0) 78 (100.0) table 2: one-sample kolmogorov-smirnov test hypothesis h1 h2 h3 h4 h5 h kolmogorov-smirnov z 1.794 2.397 2.790 1.946 2.141 2.470 table 3: results of main hypothesis testing calculated t t table sig t result mean±sd 13.635 1.986 0.000 rejected 4.088±0.705 table 4: results of first hypothesis testing calculated t t table sig t result mean±sd 10.150 1.986 0.000 rejected 4.064±0.926 al hanini and al oqaily: does the management information system causes competitive advantage for banks working in jordan? international journal of economics and financial issues | vol 8 • issue 6 • 2018108 since the calculated t is greater than the t tabular, this means that the null hypothesis and accepting the alternative hypothesis. the following table 9 shows the arithmetic mean and the standard deviation of each hypothesis. 3.8. the fourth hypothesis there is no statistical relationship between the administrative information systems and the flexibility of the system of services provided by banks operating in jordan. the following table 10 shows the results of the analysis of this hypothesis. since the calculated t is greater than the t tabular, this means rejecting the null hypothesis and accepting the alternative hypothesis. the following table 11 shows the arithmetic mean and the standard deviation of each hypothesis. 3.9. the fifth hypothesis there is no statistically significant relationship between mis and improving creativity in banks operating in jordan. the following table 12 shows the results of the analysis of this hypothesis. since the calculated t is greater than the t tabular, this means rejecting the null hypothesis and accepting the alternative hypothesis. the following table 13 shows the arithmetic mean and the standard deviation of each hypothesis. 4. results and recommendation 4.1. results after conducting the spss statistical analysis, the researcher came to find the following: 1. there is a statistically significant relationship between the mis and the reduction of the services costs provided by banks operating in jordan. offering banking services to customers with the lowest costs makes the bank stand out of the crowd among other competing banks. 2. there is a significant statistical relationship between the mis and improve the quality of services provided in banks operating in jordan. this means that the administrative information systems in the bank facilitate the use of various methods to improve the quality of services provided and the use of multiple methods of quality control which helps the bank to achieve competitive advantage. 3. there is a statistically significant relationship between mis and the improvement of the services provision by banks operating in jordan because mis enables the bank to offer its clients services in the appropriate time and the fastest way possible. 4. there is a significant statistical relationship between the mis and the flexibility of the system of services provided by banks operating in jordan. mis help banks to change the methods of performance of services as required by customers and the rapid response of the bank to changes in the development of products or services offers a competitive advantage. table 5: first hypothesis paragraphs no. statement mean±sd 1. the bank is keen to exploit the resources available to it in the best possible way which helps achieving a competitive advantage among its competitors. 4.13±1.011 2. the bank’s provision of its services to its customers by incurring a lower cost than that of the competing banks brings the bank a competitive advantage. 4.04±0.973 3. the bank’s provision of its services to its customers in return for charging them a lower cost than the competing banks brings the bank a competitive edge. 4.03±0.911 the role of mis in achieving competitive advantage for banks operating in jordan through the cost dimension. 4.064±0.926 table 6: the results of the second hypothesis testing calculated t t table sig t result mean±sd 11.256 1.986 0.000 rejected 3.996±0.781 table 7: second hypothesis paragraphs no. statement mean±sd 1. the bank uses a variety of methods to improve the quality of the services provided which helps achieving a competitive advantage for the bank. 4.08±0.879 2. the bank’s use of multiple methods of quality control at the bank is a competitive advantage. 4.01±0.860 3. the bank seeks to use iso standards in quality control to achieve competitive advantage 3.90±0.877 the role of mis in achieving competitive advantage for banks operating in jordan through quality dimension. 3.996±0.781 table 8: the results of the third hypothesis testing calculated t t table sig t result mean±sd 12.939 1.986 0.000 rejected 4.209±0.825 table 9: third hypothesis paragraphs no. statement mean±sd 1. the bank’s commitment to time of service delivery provides the bank with a competitive advantage. 4.55±0.878 2. the speed with which the bank develops the services required by the customer gives it a competitive advantage. 4.05±0.966 3. the ability of the bank to deliver its services faster than its competitors is a competitive advantage. 4.03±0.868 the role of mis in achieving competitive advantage for banks operating in jordan through post-submission. 4.209±0.825 table 10: the results of the fourth hypothesis testing calculated t t table sig t result mean±sd 12.470 1.986 0.000 rejected 4.068±0.757 al hanini and al oqaily: does the management information system causes competitive advantage for banks working in jordan? international journal of economics and financial issues | vol 8 • issue 6 • 2018 109 5. there is a statistically significant relationship between mis and improvement of creativity in banks operating in jordan. mis prepare the bank to use highly efficient methods in the design of products and services. likewise, the bank’s following up customers’ feedback and suggestions with regard to the products and design it provides grants a competitive advantage. 4.2. recommendations 1. banks management should offer its staff courses related to administrative information systems and raise the employees’ awareness of the importance of these systems at work in order to achieve the competitive advantage of the bank. 2. further research should be conducted to investigate the role of the use of administrative information systems and their impact in achieving competitive advantage in sectors other than banks such as hospitals, universities and others. 3. banks should consider administrative information systems as one of the major and primary of its resources and their employees should be aware of the importance of information technologies leading to the success and excellence of banks. 4. banks should raise financial allocations for investing in information technology, research and development, design of operations, products and services, and adequate financial allocations for the purchase of modern equipment and software for the bank’s business running. references abdelqader, s. (2010), the role of strategic information systems in enhancing competitive advantage: the case of algerian institutions, phd thesis, university of algiers, algeria. abu baker, e. (2013), the role of strategic information systems in supporting and achieving the competitive advantage of egyptian insurance companies. paper presented to the 11th annual scientific conference, business intelligence and knowledge economy, al-zaytoonah university. jordan: faculty of economics and business, amman, jordan. abu kareem, a. (2013), the relationship of management information systems in improving administrative performance: a study of non-governmental organizations in gaza strip (unpublished master thesis), islamic university, gaza. al talbany, n., al-agha, m., marwan, s. (2012), strategic planning and its relationship to competitive advantage: a study on pharmaceutical distribution companies in gaza governorate. alazhar university, gaza. palestine, 14(2), 22-34. al yasiri, a., nawras, m. (2007), strategic information systems and their role in achieving distinguished performance an empirical study on a sample of iraqi private banks. journal of administration and economics, 12(3), 32-45. central bank of jordan. (2018), banking sector directory. available from: http://www.cbj.gov.jo/pages/viewpage.aspx?pageid=141. hawary, m., winton, y. (2004), the impact of management information system in achieving competitive advantage in industrial companies: evidence from algeria. rist, 14(2), 26-69. idrees, t. (2007), administrative information systems in contemporary organizations. university administration. 1st ed. egypt: alexandria. mobaydeen, h. (2015), strategic information systems and their impact on achieving competitive advantage in potash company in jordan. jordanian journal of business administration, 11(2), 481-508. mohammad, s. (2017), characteristics of administrative systems and their impact on achieving sustainable competitive advantage. journal of economic sciences, 18(1), 1-17. salem, s. (1985), information and computer system: principles of systems analysis and design, implementation of systems and performance measurement. kuwait: dhait assalasil for printing and publishing. shaheen, a. (2011), factors affecting the efficiency and effectiveness of computerized accounting information systems in commercial banks in palestine. palestine: unpublished master thesis, islamic university of gaza, gaza. taha, t. (2000), banking managment: banking information systems. egypt: alexandria. table 11: fourth hypothesis paragraphs no. paragraph mean±sd 1. the bank’s change of service performance methods as required by customers grants it a competitive advantage. 4.17±0.763 2. the bank’s rapid response to changes in the development of the products or services offered by the bank grants it a competitive advantage 4.12±0.837 3. the bank’s change in the time of performance of the service at the will of its customers brings the bank a competitive edge. 3.92±0.894 the role of mis in achieving competitive advantage for banks operating in jordan through flexibility. 4.068±0.757 table 12: the results of the fourth hypothesis testing calculated t t table sig t result mean±sd 12.528 1.986 0.000 rejected 4.103±0.777 table 13: fifth hypothesis paragraphs no. paragraph mean±sd 1. the bank’s use of highly efficient methods of product and service design is a competitive advantage for the bank. 4.23±0.867 2. the bank’s use of new and innovative ways of delivering services to its customers is a competitive advantage for the bank. 4.04±0.874 3. the bank’s following up with customers after obtaining products or services and seeking their feedback and suggestions helps to achieve a competitive advantage for the bank. 4.04±0.844 the role of mis in achieving a competitive advantage for banks operating in jordan through creativity dimension. 4.103±0.777 508 resource limit is reached resource limit is reached the website is temporarily unable to service your request as it exceeded resource limit. please try again later. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(4), 250-255. international journal of economics and financial issues | vol 8 • issue 4 • 2018250 product design mall of islamic microfinance institutions supporting economic empowerment islamic boarding school indonesia (case study islamic boarding school abdussalam) anas alhifni1*, nurul huda2, muslich anshori3, biyati ahwarumi4 1airlangga university, lecturer of islamic economics faculty djuanda university, and currently completing ph.d islamic economics airlangga university, indonesia, 2senior lecturer of faculty of economics, yarsi university, indonesia, 3faculty of economic and busines, airlangga university, indonesia, 4postgraduate airlangga universiuty and lecturer institutions of boarding school sunan drajat, indonesia. *email: anas.alhifni@unida.ac.id abstract islamic boarding school in indonesia currently has many economic sectors including islamic microfinance services such as baitul mal wat tamwil (bmt) one of islamic boarding school abdussalam. the purpose of this study is to find out how the design of mall products that can be applied by islamic microfinance institutions to support economic empowerment islamic boarding school. research method in this research use qualitative approach with descriptive technique. data collection techniques use observation, interview and focus group discussion to determine the right product design and in accordance with the condition of sharia micro finance institution in islamic boarding school. the results of this study indicate that the product design that can be developed by bmt barokah abdussalam is the design of cash waqf mall products with two approach models and zakah infaq sadaqa mall product with two approach models, and from both models can be applied if bmt can optimize the source of social funds so that it can distribute the fund is one of them through the development of product design proposed in this research. the results of this study can be applied by other islamic boarding school who have sharia micro finance institutions and has the same criteria with islamic boarding school abdussalam. keywords: product design, islamic microfinance, empowerment islamic boarding school jel classification: i125, g23, do2 1. introduction sharia microfinance institutions in indonesia are growing very rapidly, there are some problems faced by islamic microfinance institutions such as lack of qualified human resources and operational support facilities so that services to the public are not yet optimal, lack of human resources due to the low knowledge of the management of the institution, and the weakness of the institution’s human resources in the field of product innovation (sudarsono, 2003; hamdan, 2012; kholis, 2012; salem, 2013). the institute is not only in the wider community but also in islamic boarding school, one of them is in islamic boarding school abdussalam, islamic boarding school has several sectors such as agriculture, plantation, animal husbandry, trade and financial services, baitul mal wat tamwil (bmt) barokah abdussalam, some of the problems faced by islamic boarding school such as the lack of capital for the development of all sectors, so that the existence of islamic microfinance institutions can be utilized properly, but it is difficult to materialize because the existing financial products are very limited and is still a product that is individual and not can be directly utilized by each sector. based on the above background, the research question in this research is how the proposed mall product design can be applied by islamic microfinance institution in islamic boarding school abdussalam and can support economic development in islamic boarding school. 2. literature review islamic boarding school has a special characteristic that is different from the others, islamic boarding school has a central alhifni, et al.: product design mall of islamic microfinance institutions supporting economic empowerment islamic boarding school indonesia (case study islamic boarding school abdussalam) international journal of economics and financial issues | vol 8 • issue 4 • 2018 251 figure that is highly respected and obeyed the kiyai, the existence of chaplain can give a big influence to students and the community, especially in understanding the science and entrepreneurship of soul entrepreneurship, it becomes an asset especially in the development of islamic boarding school which has a very large population of student (hakim, 2003; fauzan, 2006). islamic boarding school also has formal and informal education institutions, a large number of student can influence the increasing demand for goods and services, especially in meeting the needs of student both for learning and daily consumption (fauzan, 2006; adikrishna, 2011; tan, 2014; thahir, 2014). islamic boarding school abdussalam has the first two main sectors of the economic sector (trade, farming, plantation, agriculture and services), both education formal sectors, from both sectors the economic sector is a sector that has economic potential which is very large if it can be managed properly. the sharia micro finance institution in indonesia is a financial institution consisting of sharia financing savings and loan cooperatives (kspps), sharia financial services cooperatives (kjks), and bmt, all of these institutions are selfproductive enterprises and investments to improve the quality of economic activity, or may be referred to as institutions providing storage, financing, and payment services for services transactions aimed at middle and lower income groups and small entrepreneurs on the basis of helping and managing based on sharia principles salidin, 2000) in this research is sharia micro finance institution in the form of bmt. the main concept of bmt is to conduct coaching and financing in accordance with the principles of sharia in all economic activities, especially in supporting the economic activities of middle and lower society (sudarsono, 2003; romdoni, 2008). the characteristics of lkms according to salidin (2000. p. 71) are as follows: 1. business-oriented, seeking joint profit, increasing the most economic utilization for members and their environment. 2. not a social institution, but can be utilized to streamline the use of zakah, infaq, sedaqa (zis), and waqf. 3. growing from the bottom based on the participation of the surrounding community. 4. owned jointly and controlled by a small community of the bmt environment itself, and not the property of a particular person. 5. prioritize savings rather than borrowing. to optimize the function of bmt as a sharia microfinance institution needs to continue to develop its products so as to provide greater financial access to the middle and lower society. according to kotler (2000. p. 382) there are several stages in product development: 1. appearance of ideas the search for ideas can be obtained through research, consumer observation, managerial thinking and so on. 2. screening ideas the resulting ideas are then filtered and discuss their weaknesses and strengths. 3. development and presentation of concepts the ideas that have been filtered are then presented in clear and systematic concepts to make it easier to understand. 4. development of marketing strategy the existing product in the form of a concept must then be made a marketing strategy of the product and determine the market segmentation of the product. 5. business analysis after the company has developed a business strategy, management can evaluate the achievements of the strategy that has been made before. 6. product development the next stage is product development on r & d or product in physical form (if the product is in physical form). 7. testing the market this stage when the product is given the brand, packaging and program on consumer responses 8. stages of commercialization stages of launch, at this stage the company is obliged to determine when, who and how the product is marketed. 3. research methods this research uses the qualitative approach, with descriptive analysis technique to describe mall product design that can be applied, as for data collection technique using interview, focus group discussion and nonparticipant observation. focus group discussion technique is used to determine the conformity of product design with the condition of islamic boarding school abdussalam so that the proposal of each product can be applied directly by bmt barokah abdussalam to support economic empowerment in islamic boarding school. 4. research results product development is always done by the company to the existence of the company (kotler, 2000. p. 374), one of the goals in product development is to meet the needs of consumers who are not satisfied, and provide wider access (buchori, 2001. p. 101). as explained by kotler (2000. p. 382) there are eight stages in product design, but in this study, the product design developed focuses on the third stage of idea generation, idea filtering, development and presentation of the concept of each proposed product to be able to implement in bmt barokah abdussalam. the results of the fgd have been conducted by researchers with the chairman of bmt (marsud, m.pdi), manager (ghazali, s.pdi) supervisor (anis hifni, m.pdi, kh hafiluddin muhammad yusuf), islamic boarding school abdussalam (utsman hasan), syafi’i and selamet widodo), islamic economists (t. rifqy thantawi, m.si, sofian muhlisin, llm, rully trihantana, s.si., m.si), a supervisor from the cooperative office kab. kubu raya (syahid, mm), and it ussi experts (alif sukanah, se) and researchers. the results of the fgd resulted in several proposals of product design that could be applied by bmt barokah abdussalam in supporting the economic empowerment of islamic boarding school abdussalam after going through several stages as above: idea generation, idea filtering, development and presentation of the concept of each proposed product. alhifni, et al.: product design mall of islamic microfinance institutions supporting economic empowerment islamic boarding school indonesia (case study islamic boarding school abdussalam) international journal of economics and financial issues | vol 8 • issue 4 • 2018252 in general, mall products are products that have a social purpose because the funds come from social funds such as zis and wakaf, there are several product designs that can be designed by bmt to optimize social funds fund, especially in empowering islamic boarding school, will clearly be discussed as follows: 1. mal products using waqf cash waqf is the restraining of treasures that can be utilized (zuhaili, 1989), waqf is also an instrument that can be utilized by islamic boarding school in increasing the empowerment of islamic boarding school and the surrounding community, the role of waqf as education development has been developed since umayyah dynasty although not yet tangible places of special education such as islamic boarding school (alhifni, 2017). things to consider in waqf is the values maqashid shari’ah, waqf must give a real impact, especially in the fulfillment of three needs namely dharuriyat, hajjiyat and tahsiniyat. currently under development is cash waqf and productive waqf used as an empowerment instrument as implemented in islamic boarding school darut tauhid (alhifni, 2017) the existence of waqf as an empowerment instrument can be utilized optimally, empowerment can be explained as a process to powerless or the process of empowerment (power/ability) to the helpless party (sulistyani, 2004. p. 25). empowerment process, student have the power to act effectively to change life and environment for the better (alhifni, 2017). muhammad (1997) explains that his law allowed, by making the dinar as a venture capital and then the profits distributed to mauquf ‘alaih. the opinion of some scholars of the syafi’i school of thought also allows the money waqf (kasdi, 2016). in the development of cash waqf has been developed in indonesia one of them in financial institutions and educational institutions because it is very easy to be accessed by the community. haura et al. (2015) indonesia has a huge potential of cash waqf and can be managed by bmt. the management of waqf money in bmt involves 3 parties namely the ministry of cooperatives and smes, indonesian wakaf board (bwi) and bmt, in this case who act as nazir is bmt. regulation of the minister of religious affairs no.4 of 2009 on the administration of wakaf money registration, in it mentioned the existence of sharia financial institutions receiving moneywomen (lks-pwu). so that rules can be justified if bmt manages money waqf (ascarya, 2015; fanani, 2011). ascarya (2015) proposed a model that integrates between waqf and sharia microfinance institutions. mannan in haura et al. (2015) initiated the money waqf by establishing social investment bank limited in bangladesh which is packaged in cash waqf certificate instrument mechanism. this model is considered very appropriate to realize social welfare and help stimulate economic growth at the bottom of the community. products empowerment using cash waqf is a product that can be developed by bmt as well as can perform bmt function as a baitul mal institution that can act as a nazir waqf. clearly, the flow of its application can be explained in the following explanation: a. implementation of cash waqf in bmt barokah abdussalam bmt barokah abdussalam enrolls to bwi as nazir manager of money waqf, to grow the interest of bmt members to the waqf, need to be made some strategies.firstly socialization about cash waqf to all members of bmt (community), both specify the amount of cash waqf that can be used as a program to optimize the collection of cash waqf, the third provide ease of payment such as ball picking system, payment can be done in formal education, can be done cutting the savings with a light nominal, so that all stakeholders feel given the ease in distributing property in the form of wakaf property, the fourth selection of assets to diversion money wakaf must be really productive such as agricultural land, plantation, animal husbandry, educational facilities, trade and others, so there is a special attraction for wakif to channel funds. the funds collected from cash waqf are channeled to productive sectors such as agriculture, plantation, livestock, and trade, on the supervision of bmt as a nazir, so that bmt can ensure that waqf asset runs productively. b. benefit of cash waqf for bmt and islamic boarding school abdussalam 1. benefits for bmt barokah abdussalam 2. getting a chance as a nazir of a waqf 3. getting a source of capital more easily and efficiently 4. bmt can manage the funds for the purchase of productive assets that can be utilized bmt and islamic boarding school 5. increasing the role of bmt as an ummah empowerment institution (especially islamic boarding school abdussalam) c. benefit for islamic boarding school abdussalam 1. the problem of limited facilities and infrastructure can be overcome. 2. the problem of limited capital for economic sector development of islamic boarding school can be overcome. 3. islamic boarding school get assistance in the form of productive assets that can be managed properly, the form of assets can be in the form of agricultural assets, plantation, animal husbandry, trade and educational facilities. 4. providing opportunities for student community to play a larger role so as to increase the independence of islamic boarding school and the community. 5. increasing public trust in islamic boarding school d. cash waqf scheme as an economic empowerment instrument islamic boarding school through bmt 4.1. model i cash waqf next is the second model, the second model difference with the first model, the second model is more flexible and easier to apply and more profitable, especially in maintaining the sustainability of bmt and all economic sectors in islamic boarding school abdussalam. the model is as shown in figure 1. 4.2. model ii cash waqf [figure 2] both models can be applied if they meet the following conditions: 1. the cash waqf funds have been collected, this is very important because the model will not work if the waqf funds are not collected, so it is necessary to make an efficient and easy-to-use fund-raising strategy as described earlier. 2. supported by competent human resources both bmt human resources and human resources sector. for the readiness of this human resources, bmt can cooperate with universities alhifni, et al.: product design mall of islamic microfinance institutions supporting economic empowerment islamic boarding school indonesia (case study islamic boarding school abdussalam) international journal of economics and financial issues | vol 8 • issue 4 • 2018 253 especially in providing knowledge training on the management of waqf funds and waqf assets, so that the human resources can manage it well and can be justified. 3. bmt must be able to determine the assets that can truly be productive and ensure the sustainability of these assets well. one of the requirements for the management of waqf is the waqf property should not be reduced and traded, so that needed human resources that can analyze well in determining the productive waqf assets. 4. using a good and transparent administrative system, the use of modern administration is needed to safeguard the nazir and maintain the wakif trust in bmt as a nazir, bmt also needs to make periodic reports not only submitted to indonesian waqf board and department of cooperatives but also delivered on wakif. 5. managed with the principle of helping and prioritizing the interests of the ummah above personal interests. 2. mal products using zis figure 1: model 1: cash waqf as an instrument of economic empowerment products synergize islamic boarding school through baitul mal wat tamwil (bmt). (a) bmt get permission from bwi and dinas koperasi as a nazir waqf money, (b) wakif pays waqf funds on bmt, (c) nazir (bmt) channeled the waqf funds to productive assets (estate and agricultural land), (d) the result of utilization of productive waqf property is channeled as a form of business capital in the sector (livestock and trade), (e) the results of capital utilization managed by the livestock and trade sectors are then paid on the bmt as a nazir, (f) nazir (bmt) distributes waqf funds along with the results of the utilization of such funds on formal productive education assets and non-formal education facilities islamic boarding school, (g) the result of utilizing waqf asset is stored in bmt as a waqf nazir to be used as the next productive waqf development, (h)bmt reports the management of cash waqf that has been administered to indonesian waqf board and department of cooperatives source: research data is processed figure 2: model ii: cash waqf as an instrument of economic empowerment products synergize islamic boarding school through baitul mal wat tamwil (bmt). (a) bmt get permission from bwi and dinas koperasi as a nazir waqf money, (b) wakif pays waqf funds on bmt, (c) znazir (bmt) issued the waqf funds on productive assets (estate and agricultural land, (d) the results of utilization of productive waqf property stored in bmt, (e) bmt provides business capital in the form of musyaraka contracts on livestock and trade, (f) livestock and trade sectors pay borrowed funds from bmt along with revenue sharing from the fund manager, (g) nazir (bmt) issued other waqf funds along with the results of the utilization of such funds on the productive assets of formal education facilities and education nonformal, (h) the result of utilization of waqf asset is stored in bmt as a waqf nazir to be used as waqf development, (j) bmt reports the management of cash waqf that has been managed to indonesian waqf board and department of cooperatives source: research data is processed alhifni, et al.: product design mall of islamic microfinance institutions supporting economic empowerment islamic boarding school indonesia (case study islamic boarding school abdussalam) international journal of economics and financial issues | vol 8 • issue 4 • 2018254 zakah means sacred, blessed, grown, and praiseworthy (zuhaili, 1989. p. 498) zakah is the act of transferring wealth from muzakki to the mustahiq group, so zakah is closely related to economic empowerment because it is also a transfer of economic resources (rifqi, 2006. p. 2). zakah is one of the empowerment instruments applied by rasulullah saw as head of state, in its current development, acting as amil zakah not only government, even many financial institutions like bmt, the educational institution like islamic boarding school acting as laz (amil zakah institution) one of them bmt barokah abdussalam. the existence of bmt barokah abdussalam as a sharia microfinance institution that manages zis funds must be able to channel the funds on target and according to its allocation so as to give better impact especially in supporting the empowerment in islamic boarding school abdussalam. a. implementation of zis in bmt barokah abdussalam bmt barokah abdussalam has received permission from the office of cooperative district. kubu raya in 2014 as an islamic microfinance institution that can manage zis fund, interview result and observation of researcher indicate that until now there is no member, outside party or institution that channel zis fund through bmt barokah abdussalam, so there is no fundraising from fund the zis. there are several strategies that can be implemented by bmt barokah abdussalam to give interest to members, institutions, companies to channel their zakat funds through bmt, first to cooperate with islamic boarding school to publish an appeal of students, teachers, alumni, guardian of all economic sectors to distribute zis funds through the bmt, both cooperate with members who have ushaa or business to distribute zis funds through bmt, the third appealed to all members of the bmt to channel zis funds through bmt, the four in cooperation with companies and educational institutions, the fifth doing promotion through the media on line. the distribution can be distributed in several forms such as scholarships for student, assistance for members who are included in the eight categories of ashnaf, the use of infaq and shadaqah funds as a subsidy of financing margins on the economic sector of islamic boarding school abdussalam, the development of formal and informal education facilities and infrastructure, and so on adjusted to the conditions of bmt and islamic boarding school during the distribution of zakah funds are still in the criteria of eight ashnaf. b. the benefits of zis for bmt and islamic boarding school abdussalam 1. benefits for bmt barokah abdussalam a. getting a chance as an ‘amil b. obtain sources of capital funds that can be used as a supporter of economic empowerment of the ummah c. increasing the role of bmt as an ummah empowerment institution (especially islamic boarding school abdussalam) 2. benefit for islamic boarding school abdussalam a. the problem of limited facilities and infrastructure can be overcome. b. the problem of limited capital for economic sector development of islamic boarding school can be overcome. c. islamic boarding school get assistance in the form of productive assets that can be managed properly, the form of assets can be in the form of agricultural assets, plantation, animal husbandry, trade and educational facilities. d. providing opportunities for santri community to play a larger role so as to increase the independence of islamic boarding school and the community. e. increasing public trust in islamic boarding school and bmt barokah abdussalam. 3. zis scheme as an economic empowerment instrument islamic boarding school through bmt. the first model focuses on empowerment using zakat funds, while the second empowerment focuses empowerment using infaq and shadaqah funds, clearly, both models can be explained in the following figure. 4.3. model i zis the second model focuses more on empowerment using infaq and shadaqah funds, ii to facilitate the allocation of funds, because the funds can be allocated in accordance with the desired bmt. the model is as shown figure 3. 4.4. model ii zis [figure 4] both models can be applied if they meet the following conditions: 1. zis funds have been collected, this is very important because the model will not work if the zis funds are not collected, so it is necessary to make an efficient and easy zis fund collection strategy as described earlier. 2. supported by competent human resources both bmt human resources and islamic boarding school. for the readiness of this human resources, bmt can cooperate with universities especially in providing knowledge training about zis fund governance, so that the human resources can manage it properly and can be justified. figure 3: model i: empowerment using zakah fund. (a) muzakki paid zakah on baitul mal wat tamwil (bmt) barokah abdussalam, (b) bmt barokah abdussalam distributes zakah funds in the form of consumptive such as scholarship, teacher salary and social assistance for members who fall into the category of eight ashnaf, (c) bmt barokah abdussalam distributes zakah funds in a productive form such as giving member business capital, and student business capital so that the fund can be productive, (d) to ensure the funds can be channeled properly and can be productive, bmt barokah abdussalam needs to do coaching regularly, (d) bmt barokah abdussalam reported the management of zakah funds at the cooperative office of kubu raya regency periodically source: research data is processed alhifni, et al.: product design mall of islamic microfinance institutions supporting economic empowerment islamic boarding school indonesia (case study islamic boarding school abdussalam) international journal of economics and financial issues | vol 8 • issue 4 • 2018 255 3. the bmt should be able to determine that those receiving zakah funds are properly included in the eight ashnaf as the main condition in the disbursement of zakat funds. 4. using a good and transparent administrative system, the use of modern administration is needed to maintain muzakki’s trust and maintain muzakki’s trust in bmt as’ amil. bmts also need to make periodic reports not only submitted to the cooperative service but also delivered to muzakki. 5. managed with the principle of helping and prioritizing the interests of the ummah above personal interests. 5. conclusion as the result of the research shows that product design that can be developed by bmt barokah abdussalam is the design of cash waqf mall product with two model approach and prod zis mall with two approach model, and from both models can be applied if bmt can optimize the source of social fund so it can distribute the fund is one of them through the development of product design proposed in this research. references adikrishna, n.g. (2011), the common room design of islamic boarding school: a preliminary research in yogyakarta islamic boarding school. international journal of engineering and technology, 11(4), 127. alhifni, a. (2017), waqf an instrument of community empowement in islamic boarding school daarut tauhiid in indonesia. journal of islamic economics, banking and finance. 13(2), 76-82. ascarya, s.r. (2015), paper presented at inaugural annual symposium on islamic finance 2015 islamic finance: a catalyst for shared prosperity, istanbul, turkey. p8-9. buchori, n.s. (2012), koperasi syariah teori dan praktek. banten: pustaka aufa media. fanani, m. (2011), pengelolaan wakaf tunai. jurnal walisongo, 19(1), 179-196. fauzan, a. (2006), islamic boarding school dan pemberdayaan ekonomi. jurnal ibda, l(4), 5, 7, 8. hakim, l. (2003), pola pembelajaran di pesantren. jakarta: ditjen kelembagaan agama islam kementrian agama. hamdan, h.o.p. (2012), is microfinance program in malaysia really effective in helping the poor? journal world review of business research, 2(1), 78-83. haura, a., lukman, m.b., hendri, t. (2015), analisis pengelolaan wakaf uang pada koperasi jasa keuangan syariah (pendekatan analytical network process). jurnal muzara’ah, 3(2), 89-105. kasdi, a. (2016), pemberdayaan wakaf produktif untuk pengembangan pendidikan. jurnal edukasi penelitian pendidikan islam, 11(1), 159-163. kholis, n. (2012), the contribution of islamic microfinance institution in increasing social welfare in indonesia a case study of bmt’s role at pakem market micro traders yogyakarta. yogyakarta: head of islamic economic departement, faculty of islamic studies, islamic university of indonesia. kotler, p. (2000), manajemen pemasaran. jakarta: pt. prenhallindo. muhammad, a.b. (1997), risalah fi jawazi waqf al-nuqud. beirut: dar ibn hazm. rifqi, m. (2006), akuntansi lembaga keuangan publik islam, modul mata kuliah. yogyakarta: fiai uii. p2. romdoni, a. (2008), lembaga keuangan syariah. jakarta: zikrul hakim. salem, a. (2013), islamic vs convensional microfinance institutions: performance analysis in mena countries. international journal of business and social research, 3(5), 223-230. salidin, d. (2000), konsep dasar ekonomi dan lembaga keuangan islam. bandung: linda karya. sudarsono, h. (2003), bank dan lembaga keuangan syariah, deskrips idan ilustrasi. yogyakarta: ekonisia, fakultas ekonomi universitas islam indonesia. sulistyani, a.t. (2004), kemitraan dan model-model pemberdayaan. yogyakarta: graha ilmu. tan, c. (2014), educative tradition and islamic schools in indonesia. journal of arabic and islamic studies, 14, 48-50. thahir, m. (2014), the role and function of islamic boarding an indonesian context. tawarikh: international journal for historical studies, 5(2), 198-210. zuhaili, w. (1989), al-fiqh al-islam wa adillatuhu, cet. 3, beirut: daral-fikr. figure 4: model ii: empowerment using zakah fund. (a) muzakki paid infaq and shadaqah on baitul mal wat tamwil (bmt) barokah abdussalam, (b) bmt barokah abdussalam distributes infaq and shadaqah funds in consumptive forms such as scholarships, teacher salaries, and assistance to loyal members, (c) bmt barokah abdussalam distributes infaq and shadaqah funds in the form of productive capital such as providing business capital for members and students, in some financing schemes, namely trading scheme (subsidized margin), cooperation scheme (subsidized basic financing), rent lease scheme (subsidized rent) development of learning facilities and infrastructure and economic sector equipment as well as infrastructure sector development, (d) to ensure the funds can be channeled properly and can be productive, bmt barokah abdussalam needs to do coaching regularly, (e) bmt barokah abdussalam reported the management of zakah funds at the office of cooperatives kab. kubu raya regularly source: research data is processed . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(3), 1200-1208. international journal of economics and financial issues | vol 6 • issue 3 • 20161200 stock market development and economic growth: evidences from asia-4 countries muhammad azam1*, muhammad haseeb2, aznita binti samsi3, jimoh olajide raji4 1school of economics, finance and banking, college of business, universiti utara malaysia, kedah, malaysia, 2school of economics, finance and banking, college of business, universiti utara malaysia, kedah, malaysia, 3school of economics, finance and banking, college of business, universiti utara malaysia, kedah, malaysia, 4school of economics, finance and banking, college of business, universiti utara malaysia, kedah, malaysia. *email: drazam75@yahoo.com abstract the main purpose of this study is to examine the role of stock markets in economic growth for four asian countries namely bangladesh, india, china and singapore. annual time series cross country data over the period 1991 to 2012 and autoregressive distributed lag bound testing approaches an analytical technique are used. our results suggest that there is long-term cointegration among economic growth, foreign direct investment (fdi), stock market development and inflation. the long-term elasticity estimates of the stock market development in all countries show expected sign but statistically significant only in china and singapore. incoming fdi is found to have positive relation to economic growth in all countries except india and statistically insignificant for all countries except china. in the short-run, stock market also has positive relation to economic growth in all countries but significant only in india and china. the impact of fdi on growth is significant and positive only for singapore. the results indicate that the inflation variable is statistically significant in bangladesh and singapore. the empirical findings of the study reveal that stock market development and fdi inflows play vital roles in the process of economic growth and development in these selected countries. keywords: economic growth, stock market, autoregressive distributed lag model, asia-4 countries jel classifications: c22, o16, o40, o53 1. introduction the prominence of stable financial market has been emphasized for the growth of a nation because a well-established stock market is generally believed to be an indicator of complete macroeconomic performance of a country. the proponents of stock market believe that it plays a pivotal role in the development of commerce and industry and as a result, it affects the economy of a country. generally, the theoretical discussions concentrate on the growing intermediation part and functions of the stock market in encouraging liquidity, mobilizing and assembling savings, engendering information for prospective investments and capital allocation. it is assumed that the existence of active and stable stock market can stimulate the rate of economic growth. bagehot (1873) reveals that finance plays a crucial role in economic growth. in a study, schumpeter (1911) focuses on the prominence of banking system in economic growth. the studies of goldsmith (1969), mckinnon (1973) and shaw (1973) suggest that financial system performs a key role in economic growth. according to levine (1997. p. 691), “to organize the vast literature on finance and economic activity, i break this primary function into five basic functions. specifically, financial systems: facilitate the trading, hedging, diversifying, and pooling of risk, allocate resources, monitor managers and exert corporate control, mobilize savings, and facilitate the exchange of goods and services.” in a study, caporale et al. (2004) argue that a well-built stock market helps the investors to circumvent risk when capitalizing in encouraging projects. in addition, active stock markets perform a decisive role in assigning investment to the corporate sector. this will definitely have a factual influence on the entire economy. also, finance is as a result not only pro-growth, but also pro-poor. thus, the decision makers should consider the significance of financial sector development and formulate constructive policy (beck et al., 2000; 2008). a well-functioning stock market contributes to total productivity, and developed financial markets are considered to azam, et al.: stock market development and economic growth: evidences from asia-4 countries international journal of economics and financial issues | vol 6 • issue 3 • 2016 1201 be important component of long-run economic growth (levine et al., 2000; husain, 2006; yartey, 2008; ozturk, 2008; acaravci et al., 2009; barna and mura, 2010; cooray, 2010; shin, 2013). it is therefore expected that every stable stock market will expedite the convenience of long-term capital for cost-effective activities of production which is required for the process of economic growth and development. as it’s believed, a suitable and smooth functioning stock market signifies a substantial condition for financial sector evolution. this is also considered a pre-requisite to the sustainable economic growth and development that makes the national economy to enhance more foreign investors. for example, bencivenga and smith (1991) note that by decreasing uncertainty, the upsurge in liquidity may condense saving rates enough to invite a destructive impact on economic growth. in a study, mayer (1988) expounds his views on this issue, noting that equity issuance is a quite negligible cause of corporate finance. in a similar study, stiglitz (1994) asserts that stock market liquidity will not boost incentives for consuming resources to obtain information. however, stiglitz claims that satisfactorily functioning stock market will expose information rapidly through price changes and efficient public exposure will decrease incentives to information acquirement. while, lucas (1988) considers finance to be an “overstressed” factor of economic growth robinson (1952) affirms that economic growth is not caused by finance. similarly, sarkar (2007) has shown that there is no relationship between stock market and economic growth. the study of ergungor (2008) suggests that financial system’s structure is unrelated to economic growth. the study finds that there is a non-linear (contingent) linkage between economic growth and financial structure. the effect of the stock market on economic growth is so far a debatable issue as many prior studies have explained stock market from different perspectives. according to levine (1996. p. 7) do stock markets affect overall economic development? some analysts have viewed stock markets in developing countries as ‘casinos’ that have little positive impact on economic growth.” in a study, husain (2006) points out that japan has the most advanced stock market followed by east asia such as china, korea, malaysia, thailand, singapore, hong kong, philippines and indonesia. according to ghosh and revilla (2007), asia’s stock markets have been key source of funding for the region, though, their full capacity has not yet been exploited effectively. the study of lipinsky and ong (2014) notes the significance of the asian stock market, suggesting that the role played by the stock market in corporate financing in asia is undeniably estimable. the character of asia’s stock markets as a vital driver of economic growth in the region is yet to be duly appreciated. an important feature of the asia’s stock markets is that it has become relatively more cohesive with the international financial system. it has been observed that foreign investments have risen in many of the region’s stock markets since the asian financial crisis. this is the case in some of the bigger markets, recommencing their enlargement following the severe cutback during the global financial crisis. in asia’s stock markets, the number of foreign listings has tripled during the past 10 years, although still small (2% of the total) if compared to 10% each in the usa and europe, middle-east and africa. whereas, nearly 20,000 companies are listed in asia’s stock markets, just under the rest of the world collective the numbers of listed companies are over 10,000 in the usa and a total of 13,300 in europe, middle-east and africa in 2012. this study strives to examine the relationship between the stock market development and economic growth in selected countries from asia namely bangladesh, india, china and singapore (hereafter bics). these countries are, respectively, low income, lower middle income, upper middle income, and high income countries based on the world bank classification. for empirical analysis, time series cross country data over the period 1991 to 2012 are used. the study investigates whether stock markets play paramount role in promoting economic growth of bics. further, to evaluate whether stock market cause economic growth, or economic growth cause stock market development. a novel striking feature of this study is that, it is distinguished from the other studies in term of time period, set of variables, set of countries and empirical methodology. the outcomes are expected to serve as guide to decision makers in formulating policy that may promote the stock market development to enhance higher level of economic growth. apparently, empirical studies on stock market development and economic growth in bics countries generally appear to be rare. therefore, this study will contribute and enrich the literature in this area of study. the remainder of the study is designed as follows: section 2 reviews empirical studies on the relationship between stock market development and economic growth. section 3 deals with the data and empirical methodology. section 4 interprets the empirical findings. finally, section 5 presents the conclusion of the study. 2. literature review the available literature reveals that several prior studies have examined the connection between stock market development and economic growth, yet, they have not reached conclusion as their results remain contradictory. while some have found a positive relationship between these variables, others have reported negative or mixed results. for example, atje and jovanovic (1993) employ a data set for 39 countries and finds statistically significant positive relationship between stock markets and economic growth for the period 1980-1988. the study of thornton (1995) uses data from 22 asian, latin american and caribbean developing economies and observes that in many cases, financial deepening does not make much difference to economic growth. also, for eight countries, no lead-lag link was identified and for other six countries, economic growth led to financial deepening. the study adds that though, the financial deepening does not make a difference, it is more expected to stimulate economic growth than to impede it. in a study for greece during 1986-1999, hondroyiannis et al. (2005) find a bi-directional relationship between economic growth and capital market development. nieuwerburgh et al. (2006) find a long-term relationship between financial market and economic development in belgium during 1873-1935, and suggests that stock markets development causes economic growth in the country. in the case of sub-saharan africa, enisan and olufisayo (2009) observe that the stock market development and economic growth has a significant positive long-run relationship during the period 1980-2004. for azam, et al.: stock market development and economic growth: evidences from asia-4 countries international journal of economics and financial issues | vol 6 • issue 3 • 20161202 egypt and south africa, the stock market is co-integrated with economic growth and the granger causality test indicates that stock market granger causes economic growth. other results of granger causality tests suggest a bidirectional link between stock market and economic growth for cote d’ivoire, kenya, morocco and zimbabwe. however, in the case of nigeria, weak evidence is observed for the relationship between these variables. the study of boubakari and jin (2010) obtains different results on the relationship between stock market and economic growth for five euronext countries namely belgium, france, portugal, netherlands and united kingdom during 1995:q1 to 2008:q4. the study reports a positive relationship between the stock market and economic growth for some countries where the stock market is liquid and extremely active. conversely, the causality linkage is rejected for those countries where the stock market is small and less liquid. for the study of 42 emerging markets during 1995-2006, masoud and hardaker (2012) find that the stock market development has a significant positive impact on economic growth. miguel et al. (2013) report bidirectional causality between the stock market and economic growth in portugal for the period 1993-2011 but find no flow of causality from bank financing to economic growth. in the work of azam (2013), financial deepening is found to have a statistical positive relationship to economic growth for azerbaijan during 19952011, while no evidence is found in the case of kazakhstan. in the case of the former communist countries of central and eastern europe and the commonwealth of independent states, cojocaru et al. (2014) indicate that credit to the private sector used for financial development has a positive impact on economic growth during 1990-2008. balago (2014) finds that financial sector development variables including banking sector credits, total market capitalization and foreign direct investment (fdi) have positive impact on economic growth in nigeria during 1990-2009. in another study, nguyen and pham (2014) find causality between stock market development and economic growth in canada but it is not the case in australia during 1981:q3 to 2012:q3. in the case of canada, the findings suggest that stock market development and economic growth have long-run linkage and that the stock market development does help boost the future economic growth. some prior studies have empirically estimated the financial development and economic growth relationship in the context of asian countries. for example, a study by ahmed and ansari (1998) examine financial sector development and economic growth relationship for south asian-3 countries namely india, pakistan, and sri lanka for the period 1973-1991. empirical findings from causality analysis suggest that financial sector development causes economic growth in the granger sense for these countries. luintel and khan (1999) use annual data ranging from a minimum of 36 to a maximum of 41 years for 10 countries namely costa rica, colombia, greece, india, korea, malaysia, philippines, sri lanka, south africa, and thailand. the results reveal bidirectional causality between financial development and economic growth in all 10 countries. another study by caporale et al. (2004) examined the connection between financial development and growth for some selected countries namely argentina, chile, greece, korea, malaysia, philippines and portugal during the period 1977:1-1998:4. the findings reveal a connection between the variables only for 5 out of 7 countries. for 3 south asian countries namely bangladesh, india, and pakistan, the study of wadud (2005) finds that there is causality running from financial development to economic growth over the period 1976-2002. over the period 1980-2004, tang et al. (2007) examine the relationship between stock markets and economic growth in asian-12 countries. their findings indicate a long-run linkage between stock markets and economic growth only in four out of twelve countries namely china, philippines, singapore and taiwan. results of granger causality tests reveal that there is bidirectional causality relationship between stock markets and economic growth only in the case of china, hong kong, indonesia, malaysia and thailand. however, in the case of japan and korea, a unidirectional causal effect runs from the stock markets to economic growth in the short-run. for india and singapore, causality runs from economic growth to stock markets in the short-run, but in the case of sri lanka, no causality is found among the variables. mun et al. (2008) also finds that stock market development granger causes economic growth without a feedback for malaysia during the period 1977-2006. azam et al. (2014) finds that fdi, infrastructure, saving, energy consumption and income are the important determinants of romanian’s stock market during 1990-2013. azam and ibrahim (2014) observe that fdi inflow has a positive impact on the stock market of malaysia during 1988-2012. on the other hand, numerous erstwhile studies have found insignificant or weak negative relationship between the stock market development and economic growth. for example, in a study, harris (1997) re-examines the correlation between stock markets and economic growth on the data earlier used by atje and jovanovic (1993), but finds no proof that the level of stock market determines the growth per capita output. the results of ram (1999) reveal that there is insignificant or weak negative relationship between financial development and real gross domestic product (gdp) per capita growth rate for 95 countries. the study highlights that, contrary to the conclusions reached in many prior studies, the empirical result found does not favor the view that financial development encourages economic growth. the empirical findings of arestis et al. (2001) during the period 1968-1998 indicate that both stock markets and banks appear to play a key role in promoting economic growth in france, germany and japan. however, in the case of united kingdom and united states, the relationship between financial development and economic growth is found to be statistically weak. empirical results of dawson (2003) reveal that financial development has an insignificant impact on economic growth for 13 central and east european countries (ceecs) over the period 1994-1999. the study further maintains that economic growth in ceecs is not inhibited by underdeveloped financial sector. in a similar study, the findings of azarmi et al. (2005) do not favor the hypothesis that the stock market development is related to the economic growth in india during the period 1981-2001. in particular, the study finds an inverse relationship between stock market development and economic growth for the postazam, et al.: stock market development and economic growth: evidences from asia-4 countries international journal of economics and financial issues | vol 6 • issue 3 • 2016 1203 liberalization period. naceur and ghazouani (2007) indicate that the relationship between stock market development and growth is insignificant for 11 mena countries for the period 1979-2003. in addition, it is found that the connection between bank development and economic growth is negative after controlling for the stock market development in these selected countries. findings by demetriades and hussein (1996) reveal little evidence to show that financial sector is prominent to stimulate economic development for 16 countries1,2. in their study, haque and hossain (2011) find that dynamic model used in the study is not meaningful to detect the stock market relationship to per capita growth rate in the saarc region during 1980-2008. the study suggests that stock market and liquidity do not have any important effects on the real economic growth in the saarc countries. another study by wang and ajit (2013) shows that there is opposite relationship between the stock market and economic growth in china during the period 1996-2011. the results of owusu and odhiambo (2015) also suggest that in the long-run, stock market developments and capital account liberalization policies have no encouraging impact on economic growth in ghana. similar results obtained for ghana by owusu and odhiambo (2014) also indicate that the stock market developments and capital account liberalization policies have no positive impact on economic growth in the long-run. the general observation from the review of previous studies is that the connection between stock market development and economic growth is either positive or negative and in some cases, no relationship at all. the variation in results may be due to peculiarity of the country under study or the nature of data. in view of the contradictory or inconclusive results reported by the prior studies where some have found positive, negative or even mixed results, the present study hypothesizes as follows: h0: there is robust linkage between the stock market and growth on bics. ha: there is no robust linkage between the stock market and growth on bics. 3. data and methodology 3.1. data sources and variables the study employs annual time series data for four asia countries namely bangladesh, india, china and singapore. the data cover the period 1991 to 2012. the variables used are gdp per capita 1 costa rica, el salvador, greece, guatemala, honduras, india, korea, mauritius, pakistan, portugal, south africa, spain, sri lanka, thailand, turkey and venezuela. 2 wang and ajit (2013) have also shown that the study wan (2002) failed to find any visible relationship between capital market development and growth in china. (current us$), stock market capitalization of listed companies (percent of gdp) is the share price times the number of shares outstanding, inflation is the annual growth rate of the gdp implicit deflator, and fdi net inflows (current us$). the data for all variables are obtained from the world bank database (2014). the annual cross section descriptive statistics of all the variables included in this study are reported in table 1. 3.2. model specification in order to verify the linkage among economic growth, stock market development, inflation rate and incoming fdi variables, the following model is proposed to be used. yt = α0 + α1smct + α2inft + α3fdit + εt (1) where, y represents the gdp per capita, smc stands for market capitalization, inf denotes inflation, fdi stands for foreign direct investment, and εt is the error term. theoretically, study expects the regression coefficient α1 to be positive implying that stock market development contributes to economic growth. inflation as a macroeconomic variable has been included in the model since high inflation is believed to indicate macroeconomic instability of a country. consequently, inflation negatively affects economic growth and thus, the sign of coefficient α2 is expected to be negative. fdi contributes to the economy in several ways such as increased competition due to access to bigger markets with variety of products, creating job opportunities and increasing government revenue, etc. therefore, it is expected that the sign of the coefficient α3 is positive. 3.3. unit root test generally, most macroeconomic variables are non-stationary and therefore, the study start by ascertaining the presence of unit root in all series in spite of the fact that autoregressive distributed lag (ardl) approach can be applied irrespective of the order of integration (i(0) or i(1)) of the series. there are many tests for unit root to confirm the stationarity of variables as described in literature. these tests include phillips and perron (pp) by phillips and perron (1988), augmented dickey and fuller (adf) test by dickey and fuller (1979), df-generalized least squares unit root test proposed by elliott et al. (1992), kpss test presented by kwiatkowski et al. (1992), ng-perron unit root test by ng and perron (2001) and zivot and andrew unit root test proposed by zivot and andrews (2002). this study uses dickey and fuller (1979) and phillips and perron (1988) unit root tests because they ensure robustness ofthe results. the estimation of pp statistics employs bartlett kernel with newey-west bandwidth. specifically, pp test corrects for higher order autocorrelation and the likely problem of heteroscedasticity in the series (kouakou, 2011) while table 1: descriptive statistics countries mean±sd y smc inf fdi bangladesh 438.11±164.97 6.53±5.70 6.14±2.53 0.465±0.492 china 2069.04±1964.93 43.01±40.70 4.64±6.24 110.38±108.02 india 730.97±431.17 50.21±31.14 7.97±3.31 12.48±13.93 singapore 30421.84±12280.63 161.41±50.93 1.98±1.73 225.77±19.461 fdi: foreign direct investment, sd: standard deviation azam, et al.: stock market development and economic growth: evidences from asia-4 countries international journal of economics and financial issues | vol 6 • issue 3 • 20161204 adf requires that the error term is devoid of autocorrelation and is homogeneous (owoye and onafowora, 2007). the lags used for the estimations under the two methods are automatically selected. 3.4. tests for cointegration to examine the long-run relationship among the variables, most relevant methods of cointegration require that the order of integration of each variable be tested. there are many univariate co-integration approaches such as ardl or bound test, fully modify ordinary least squares developed by phillips and hansen (1990) and the engle and granger (1987). this study utilizes ardl approach. the ardl bound testing approach to cointegration was introduced by pesaran et al. (2001). generally, ardl is a frequently used technique because of its various advantages over other techniques. the main advantage of the ardl model is that it can be employed whether series are stationary at level i(0) or at first difference i(1). in addition, another merit of this model is that both short-run and long-run estimates can be made simultaneously. pesaran et al. (2001) provided two sets of critical values for a given level of significance. these are lower bound value and upper bound value. the former case assumes that all the series are stationary at level i(0) and the latter assumes that all the series are stationary at first difference i(1). the sample used in this study consists of 23 observations and uses the critical values provided by narayan (2005), narayan and boulton (2004). the models to be estimated for the ardl bound testing for cointegration are specified in equations (2-5). 0 1 1 2 1 3 1 4 1 5 1 6 1 0 7 8 0 0 t t t t t i t i t i t i p p i t i i t i t i i y y smc inf fdi y smc inf fdi ρ ρ α α α α α α α α α ε − − − − − − = = − − = = ∆ = + + + + + ∆ + ∆ + ∆ + ∆ + ∑ ∑ ∑ ∑ (2) ∆ ∆ smc smc y inf fdi smc t t t t t i i t = + + + + + − − − − = −∑ β β β β β β ρ 0 1 1 2 1 3 1 4 1 5 1 1 ++ + + + = − − − == ∑ ∑∑β β β ε ρ 6 1 7 8 11 i i t i i t i i t i t i p i p y inf fdi∆ ∆ ∆ (3) ∆ ∆ inf ind y smc fdi inf t t t t t i i t = + + + + + − − − − = −∑ δ δ δ δ δ δ ρ 0 1 1 2 1 3 1 4 1 5 1 1 ++ + + + = − − − == ∑ ∑∑ δ δ δ ε ρ 6 1 7 8 11 i i t i i t i i t i t i p i p y smc fdi ∆ ∆ ∆ (4) ∆ ∆ fdi fdi y smc inf fdi t t t t t i i t = + + + + + − − − − = −∑ λ λ λ λ λ λ ρ 0 1 1 2 1 3 1 4 1 5 1 1 ++ + + + = − − − == ∑ ∑∑ λ λ λ ε ρ 6 1 7 8 11 i i t i i t i i t i t i p i p y smc inf ∆ ∆ ∆ (5) where, α0, β0, δ0, λ0 are drift components, εt represent white noise error term, δ stands for first difference and rest of the variables are as defined earlier. the objective of this test is to confirm whether the coefficients of the level series of equations (2-5) are jointly significantly different from zero against the corresponding alternative hypothesis. 4. empirical results 4.1. unit root test results the results of the unit root tests are reported in table 2. the results show that some variables (inflation of bangladesh, inflation of india, inflation and stock market of singapore) are stationary at level, i(0). the remaining variables that are non-stationary at level became stationary at first difference. the results reveal that the variables are of different order of integration, i(0) and i(1). thus, the application of ardl model is appropriate in testing the cointegration among the variables. 4.2. ardl cointegration test results the results of bound f-test are reported in table 3. this study uses the critical tabulated values presented by narayan (2005) as reported in table 4. if the calculated f-statistics is greater than the upper bound value, the h0 of no cointegration is rejected. on the other hand, if the f-statistics falls below the lower bound values, then, h0 of no cointegration cannot be rejected. finally, if the computed f-statistic falls between upper bound and lower bound values, the results are inconclusive. the results reported in table 3 shows that, for bangladesh, the null hypothesis of no cointegration is rejected at 1% significant level when each of y and inf is considered as dependent variable. similarly, with each of smc and fdi as dependent variable, for bangladesh, the null hypothesis of no long-run relationship among the variables is also rejected at 5% level table 2: unit test results country variable level series first difference adf test statistics pp test statistics adf test statistics pp test statistics bangladesh y 4.701 4.701 −5.539*** −6.461*** smc −1.160 −0.981 −4.563*** −6.681*** inf −3.340** −3.312** −6.510*** −12.174*** fdi 0.575 2.124 −4.627*** −4.774*** india y 1.036 1.040 −3.431** −3.386** smc −2.409 −2.409 −6.952*** −8.308*** inf −2.733* −2.686* −6.058*** −6.366*** fdi −0.957 −0.873 −5.264*** −5.260*** china y 0.338 7.280 −7.330*** 8.353*** smc −2.389 −2.310 −4.344*** −7.189*** inf −1.719 −1.719 −3.241** −3.142** fdi 3.466 3.100 0.057 −4.572*** singapore y 0.734 0.639 −3.271*** −3.234** smc −3.488** −3.479** −5.690*** −7.040*** inf −3.310** −3.304** −6.243*** −9.159*** fdi 1.665 −0.123 −5.843*** −7.486*** the optimal lag length is selected automatically based on the aic in adf approach. in the pp test technique, the optimal lag is selected based on newey west (using a bartlett kernel). ***,** and * denote statistical significance at 1%, 5% and 10% level respectively. adf: augmented dickey and fuller, fdi: foreign direct investment, pp: phillips and perron, aic: akaike information criterion azam, et al.: stock market development and economic growth: evidences from asia-4 countries international journal of economics and financial issues | vol 6 • issue 3 • 2016 1205 of significance. in the case of india, the null hypothesis of no cointegration cannot be accepted as the f-statistics for each of y, smc, and fdi as dependent variable is greater than the upper critical bound value at 10%, 1%, and 1% level of significance respectively. for singapore, inf and fdi are co-integrated with other explanatory variables when each is used as dependent variable. finally, for china only fdi as dependent variable has a long-run relationship to other variables in an equation. overall, the bound results suggest the existence of long-run relationships among the variables (y, smc, inf, and fdi). therefore, we proceed to estimate the long-term and short-term regression coefficients. 4.3. long-run relationship the long-run estimates of y with respect to smc, inf and fdi are reported in table 5. results show that smc in bangladesh, india, china and singapore has expected sign but only statistically significant at 5% level in china and singapore. however, inf shows unexpected sign in all but statistically significant only in singapore. finally, fdi has the expected sign for all countries except in the case of india and statistically insignificant in bangladesh and india, significant in china and singapore. 4.4. short-run relationship results given in table 6 indicate that smc has expected sign in all countries but statistically significant at 1% and 5% level only in india and china respectively. this implies that a 1% increase in smc contributes 2.193% in india and 0.244% in china. in addition, inflation shows unexpected sign in all countries except in india but statistical significant only in bangladesh and singapore. the inflation variable is statistically insignificant in india and china but statistically significant in bangladesh and singapore at 10% and 1% level respectively. in summary, there is evidence of both long-term and short-term relationship between economic growth, stock market development, inflation and fdi in case of bangladesh, india, china and singapore. we further perform diagnostic tests and the results are presented in table 7. the results show that there is no evidence of serial correlation, the functional form and the normality are okay, and the models do not suffer from heteroscedasticity problem. hence, models passed all the diagnostic tests. over all, these results are in line with the findings of relevant studies including tang et al. (2007), caporale et al. (2004), mun et al. (2008) and azam and ahemd (2015). 5. concluding remarks this examined the vital role of stock markets in economic growth in the context of asia-4 countries over the period ranging from 1991 to 2012. we employed the ardl bound testing approach table 3: bounds cointegration test–an ardl approach equations based on variables computed f-statistics decision f(yban/smcbaninfbanfdiban) 5.263*** cointegration f(smcban/ybaninfbanfdiban) 5.207** cointegration f(infban/ybansmcbanfdiban) 5.940*** cointegration f(fdiban/smcbaninfbanyban) 4.084** cointegration f(yind/smcindinfindfdiind) 3.680* cointegration f(smcind/yindinfindfdiind) 6.686*** cointegration f(infind/yindsmcindfdiind) 3.073 no cointegration f(fdiind/smcindinfindyind) 9.285*** cointegration f(ychi/smcchiinfchifdichi) 125.69*** cointegration f(smcchi/ychiinfchifdichi) 1.620 no cointegration f(infchi/ychismcchifdichi) 0.792 no cointegration f(fdichi/smcchiinfchiychi) 20.907*** cointegration f(ysin/smcsininfsinfdisin) 1.425 no cointegration f(smcsin/ysininfsinfdisin) 2.963 no cointegration f(infsin/ysinsmcsinfdisin) 5.225** cointegration f(fdisin/smcsininfsinysin) 4.981** cointegration the test equations include only constant term. the lag selection based on sbc and manual selection. ***,** and * denote statistical significance at 1%, 5% and 10% significance level respectively. ban, ind, chi and sin are country codes for bangladesh, india, china and singapore respectively, fdi: foreign direct investment, ardl: autoregressive distributed lag table 4: tabulated critical bound value 1% significance 5% significance 10% significance lower bound upper bound lower bound upper bound lower bound upper bound 3.657 5.256 2.734 3.920 2.366 3.353 the critical bound values are reported from narayan (2005) case iii page no. 1988 table 5: long-term estimates for economic growth (y) country variables coefficient standard error bangladesh smc 209.62 2267.121 inf 343.90 3952.201 fdi 1.829 18.222 india smc 48.74 83.011 inf 34.83 119.670 fdi −0.0084 0.066 china smc 9.381** 4.042 inf 8.468 12.746 fdi 0.028** 0.003 singapore smc 39.105** 37.051 inf 3166.312*** 1092.534 fdi 0.658*** 0.107 *** and ** denote statistical significant at 1% and 5% level respectively, fdi: foreign direct investment table 6: short-term estimates for economic growth (y) countries variables coefficients standard error bangladesh smc 1.927 1.407 inf 3.162* 1.783 fdi 0.0168 0.025 india smc 2.193*** 0.595 inf −0.023 5.873 fdi −0.002 0.004 china smc 0.244** 0.349 inf 1.517 2.033 fdi 0.003*** 0.493 singapore smc 10.992 8.875 inf 268.702*** 3.312 fdi 0.185*** 0.041 *** and ** denote statistical significant at 1% and 5% level respectively azam, et al.: stock market development and economic growth: evidences from asia-4 countries international journal of economics and financial issues | vol 6 • issue 3 • 20161206 as analytical technique. the empirical results imply that there is long-term cointegration among the macroeconomic variables used such as economic growth, fdi, stock market development and inflation. whereas, the long-term estimated coefficients of stock market development for all countries show expected signs, they are only statistically significant at 5% level for china and singapore. the fdi inflows validate positive impact on economic growth for all countries except in the case of india, and statistically insignificant for all except in the case of china. the short-term analysis of stock market demonstrates positive impact on economic growth in all countries but only significant at 1% level in india and china. the impact of fdi inflow on economic growth is significant and positive at 5% level only for singapore. however, the inflation variable is statistically significant in bangladesh and singapore at 10% and 1% level respectively. the empirical findings of the study reveal that stock market development plays a significant role in the process of economic growth and development in these selected countries. our results further suggest that along with the stock market development, one cannot ignore the importance of fdi inflows to economic growth. the encouragement of stock market and incoming fdi certainly contribute to the enhancement of economic growth and development. the findings of the study have some valuable policy implications. the policy makers need to formulate effective and prudent policy in order to expand stock market and encourage foreign investment. given these sound policies, the outcome will further improve the macroeconomic performance of these economies. references acaravci, s., ozturk, i., acaravci, a. 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(2002), further evidence on the great crash, the oil-price shock, and the unit-root hypothesis. journal of business and economic statistics, 20(1), 25-44. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.152-169 issn: 2146-4138 www.econjournals.com 152 smes record keeping in ghana: has vat made it better? philip kofi adom department of economics, university of ghana, ghana. tel: +233246763661. email: adomonline@yahoo.co.uk kwaku amakye department of banking and finance, university of professional studies, accra, ghana. email: amakye2002@yahoo.com edinam doh business school, university of ghana, city campus, ghana. email: edilas14@yahoo.com regina anku business school, university of ghana, city campus, ghana. email: reginaanko@yahoo.com abstract: with the introduction of the vat flat rate scheme, which brings on-board traders on whom the vat record-keeping requirements would or might prove burdensome, concerns arise on the potential impact of the ‘vat record keeping requirement’ on sme’s record keeping. the focus of this study was to investigate the effect of the record-based controls of vat on firms’ record keeping skills and accounting system based on a sample of 250 sme’s selected from five key trading centres in the accra metropolis. the result showed that completion of the vat monthly return form imposes more cost on traders than the vat invoice book. firms who receive education from vat officials are found to be 0.102 more likely to complete the vat monthly return form than firms who do not receive education from vat officials. also, firms who receive education from vat officials are 0.849 times as likely as those firms who had not received education from vat officials to complete the vat invoice book by self. generally the result showed that the ‘record-based controls of vat’ has significantly improved sme’s record keeping skills and accounting system albeit it is found to be stringent relative to other record keeping types kept by sme’s. keywords: record-based control of vat; smes; ghana; survey research design jel classifications: h00; h2; h25; h32 1. introduction small and medium enterprises constitute about 90 percent of all registered companies in ghana (venture capital trust fund, 2007). they are believed to contribute about 70 percent of ghana’s gross domestic product (abor and quartey, 2010). sme’s contribute significantly to the growth of the economy by serving as primary sources of employment, main sources of continued job creation, tax revenue, the foundation for sustained growth of large corporations, basis of national competitiveness and sources of innovation and entrepreneurship. however, it has been difficult to tax these types of businesses because some do avoid registration through rhythmic movements; do not keep records; do not file returns; plead ignorance, and have low turnover and revenue potential. the tax authorities have, over time, adopted methods to tax sme’s in ghana. in 1998, the vat system was re-introduced in ghana after a failed attempt – due to widespread public opposition – in 1995. to make way for easy collection of vat in the informal retail distributing trade sector, the flat rate vat scheme was enacted by an act of parliament in 2007, act 734, in an amendment to the value added tax act, 1998, act 546. the flat rate vat scheme is a simplified tax collection system which is to ensure that retailers of goods charge a vat/national health insurance levy of three smes record keeping in ghana: has vat made it better? 153 percent. under the new arrangement, “a taxable person who is a retailer of goods shall account for the value added tax payable under this section at a flat rate of 3% calculated on the value of the taxable supply” – value added tax (amendment) act, 2007. vat is a consumption tax which is based on a system of self-assessment under which registered traders make their own declaration of tax liability at the end of the tax period of one month defined under the vat act 1998, (act 546). under the vat law, every person liable to tax under the act is required to keep a record of all supplies made or received and vat paid or charged in each tax period. this implies that the vat law imposes some sort of record-keeping requirements on registered traders. this raises concerns as most of these smes in ghana are unstructured business units operating in the informal sector with little aptitude for record-keeping. the severity of the problem became more complex with the introduction of the flat rate scheme which brings onboard traders on whom the vat record-keeping requirements would or might prove more complicated and burdensome. the main purpose of this study is to determine the impact that the vat record keeping requirement has had on small and medium enterprises’ record keeping skills and accounting system. specifically the study seeks to find out if the vat record keeping requirements are too stringent; whether vat record keeping requirement has improved smes record keeping skills or not, and whether the impact of vat on firms’ record keeping skills and system differ with firm size, education, kind of business and the frequency of visits by vat officials. primarily the paper used the accra business community as the case study. firms from five main business centres in the accra metropolis were sampled. these markets are makola market, okaishie market, agbobloshie market, abosakai market, and kantamanto market. these markets were chosen due to their high business concentration and heterogeneity in business. various aspects of smes and vat have been extensively investigated in the literature (see: storey, 1994; weston and capeland, 1998; michaelas et al, 1999; lopez and aybar, 2000; kayanula and quartey, 2000; fisher and reuber, 2000; abor and biekpe, 2006; abor and quartey, 2010; gockel and akoena, 2002; go et al, 2005; lephoto, 2007; carare and danninga, 2008). however, no effort has been made to explore the potential impact of vat record keeping requirement on smes record keeping skills and system in the literature. the focus of this current study is to fill this gap that exists in the literature. specifically the study seeks to test the following hypotheses: 1. vat record controls are too stringent 2. there is no significant relationship between the frequency of visits by vat officials, the filling of the vat invoice book, the filling of the vat monthly return form, firms’ record keeping skills, firms’ accounting keeping system, and the extra cost imposed by vat record based controls 3. firms with an encounter with vat officials are more likely to complete the vat record books. the rest of the article is organised as follows: section ii reviews literature; section iii describes the method of the study; section iv discusses results, and section v concludes and makes policy recommendations. 2. literature review definition of smes the issue of what constitute smes has been extensively investigated in the literature. basically, the classification of firms has been based on the following criteria; capital assets, skill labour, turnover level, firm size, legal status, and method of production (see bolton committee, 1971; storey, 1994; weston and copeland, 1998; jordan et al., 1998; michaelas et al., 1999; lopez and aybar, 2000). the general conclusion emanating from these classifications suggests that there is no ‘one-fit-all’ definition for smes. in ghana, various classifications on what constitute smes have been provided. a cursory glance at them all indicates that the most frequently used criterion for classification has been the employment size (kayanula and quartey, 2000). the ghana statistical service for example classifies firms with less than 10 employees as small-scale enterprise and firms with more than 10 employees as medium and large-sized enterprises. osei et al. (1993) classified smes into three categories; micro, very small, and small. using a cut-off point of 30 employees, the authors indicated that micro enterprises are firms that employ less than 6 workers; exceedingly small firms are those that employ between 6 and 9 workers, and small firms are those that employ between 10 and 29 workers. in a more international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.152-169 154 recent survey by the regional project on enterprise development, ghana manufacturing, micro enterprise employs less than 5 workers; small enterprise employs between 5 and 29 workers; medium enterprise employs between 30 and 99 workers, and large enterprise employs 100 and above (see teal, 2002). the national board for small scale industries (nbssi), however, base their classification on employment size and value of fixed asset. based on these criteria, small enterprise are firms having not more than 9 workers and plant and machinery value of not more than 10 million ghana cedis. using the same criteria, however, the ghana enterprise development commission (gedc) used an above 10 million ghana cedis value of plant and machinery. causes of smes failure despite the scores of benefits provided by smes, its development has been impeded by several factors both financial and non-financial. largely, however, financial reasons have frequently been cited in the literature as the most prevalent factor that impedes smes start-ups and progress. as a result of the perceived high risk connected to smes, financial institutions both formal and informal feel reluctant to extend credit to such business entity for risk of default. cook and nixson (2000) indicated that the development of smes is always constrained by the limited availability of financial resources, to meet their operational and investment needs. other studies such as levy (1993) and parker et al. (1995) have shown that access to credit is a serious challenge to smes development. however, other authors have argued that the failure of smes is more of non-financial reasons than financial reasons. for instance, green et al. (2002) indicated that identifying a product and a market, acquiring necessary property rights or licenses, and keeping proper records are more fundamental to running an sme than finance. tushabonwe-kazoobu (2006) examined the causes of small business failure in the towns of bushanyi and mbara in uganda using a total of 133 businesses. he categorised the factors into internal factors and external factors. out of the total 133 businesses sampled, 33% of them cited poor record keeping as an internal impediment to business growth. also, out of the total 133 businesses surveyed, 53% of them cited taxation (vat) as the major constraint to business growth. also, other non-financial reasons such as weak institutional capacity, lack of managerial skills and training, existence of laws, regulations and rules that hinder the development of smes, and lack of access to appropriate technology have been identified to disrupt smes start-ups and development (see: sowa et al., 1992; aryeetey et al. 1994; parker et al. 1995; kayanula and quartey, 2000; gockel and akoena, 2002). value-added tax in ghana one of the utmost significant events of the 1990 tax reform was the advent of vat to replace the then sales tax. this move by the government was deemed necessary since the then sales tax had a narrow tax bracket and problems of tax administration inefficiencies, reduced compliance and international competitiveness (i.e. less competitive export sector). it was envisaged that the recordbased control of vat with verifiable audit trail would improve efficiency of domestic indirect tax collection, promote export development strategy by charging zero rate for exports and also provide tax refunds for the inputs embodied in export production, promote economic growth through enhanced tax base, and promote a self-assessment culture. vat was first introduced in 1995 but withdrawn due to public outcry. the main reasons cited for the initial rejection included: high rate (17%), low threshold (annual turnover of 25 million cedi), public information, campaigning and taxpayer education was too poor. after three years of reconsideration, vat was successfully reintroduced in 1998 under vat act 546. this time the added value of all goods (except agriculture and basic goods) and services were taxed with a rate of 10% and a threshold of 200 million cedi annual turnover (suppliers of goods). in 2000, a major review of the vat system was completed, which resulted in a tax rise to 12.5% and a broadening of the tax base by lowering the threshold for suppliers of goods to an annual turnover of 100 million cedi. the extra 2.5% increase was to be used, by getfund, to support educational development in the country. in 2004, there was another revision of the vat rate from 12.5% to 15% with the extra 2.5% to be allocated to the national health insurance trust fund to facilitate and improve access to health in the country. to make way for easy collection of vat in the informal retail distributing trade sector, the flat rate vat scheme was enacted by an act of parliament in 2007, act 734, in an amendment to the value added tax act, 1998, act 546. the flat rate vat scheme is a simplified tax collection system, smes record keeping in ghana: has vat made it better? 155 which is to ensure that retailers of goods charge a vat/national health insurance levy of three percent. under the new arrangement, “a taxable person who is a retailer of goods shall account for the value added tax payable under this section at a flat rate of 3% calculated on the value of the taxable supply” – value added tax (amendment) act, 2007. cited as an advantage of its introduction the record-based controls of vat with verifiable audit trail has been envisaged to improve the efficiency of domestic indirect tax collection and record keeping of businesses. however, there seems to be no paper that explicitly investigates the impact of the record-based controls of vat on sme’s record keeping system. nonetheless, there exist empirical works that evaluate the superiority of vat over other forms of tax, and the impact of vat on consumers. in terms of generating higher revenues, there have been works that have established the superiority of vat in this light. tait (1988) confirms that, in almost all developing countries where vat has been introduced, its contribution to tax revenue has been increasing. the author concludes that the superiority of vat over other forms of indirect taxes stems from its revenue buoyancy, neutrality in both domestic and international trade and the difficulty for evasion. gillis (1990) also concludes that the earned reputation of vat as a “money making machine” stems from the record of vat in generating large amounts of revenue quickly in a comparatively painless manner. in south africa, go et al (2005) concluded that vat is the most effective instrument for generating revenue. the superiority of vat over other forms of indirect tax has been argued along the lines of promoting international competitiveness. krugman and feldstein (1989) conclude that, vat is not a protectionist measure; indeed, the allegedly pro-competitive device of export rebates is essential if the vat is not to act as an export tax, which in turn is actually a protectionist measure that would reduce both imports and exports. the authors added that vat would most assuredly fall heavily on traded rather than non-traded goods, which would constitute a bias against both exports and imports. however, cnossen (1991) indicates that by applying a zero rate to export (and allowing reclaim of tax paid on exports) and by taxing imports equally with domestic products, tax neutrality in international trade is ensured. also because vat is a consumption tax, researchers and other stakeholders have been worried about the potential additional burden on consumers due to its potential inflationary effects. thus, consumers are likely to experience an increase in the price of consumable goods and services as a result of vat. in assessing the potential inflationary impact of vat, there have been some empirical findings in the literature. in a survey of oecd countries carried out by lephoto (2007); the author concluded that vat had little or no effect on prices. in germany, carare and danninga (2008) found that increases in core inflation following the 2007 vat hike was smaller than expected, leading to speculation about delayed inflationary effect. burges and stern (1993) affirm that, within domestic indirect taxation, a movement to a system like vat is justified by the reasons that it is non-cascading and does not interfere with the production efficiency. 3. data and methodology the main population for this study is small and medium enterprises in the accra business community that have registered for vat and collecting vat. specifically the study focused on five main market centres in the accra community. these include makola market, okaishie market, abosakai market, agbobloshie market and kantamanto market. these markets were chosen for three main reasons; their high business concentration nature, heterogeneity in markets concentration and to get a fair representation of the situation. the makola market is situated at the centre of accra on the kojo thompson road. this market largely deals in cooking utensils, foodstuffs both perishable and non-perishable, canned foods, animal products, and traditional clothes and jewellery. these products are either sold in small wooden shops, on tables or concrete made shops. in terms of gender composition, the makola market is a female dominated market. the okaishie market centre, which is close to the makola market on the kwame nkrumah avenue, largely deals in provisions, cosmetics, hardware, original-made clothes, shoes and sandals operating in small and large concrete made shops with some selling in open spaces. kantamanto market is another major market centre close to the okaishie market where market participants primarily deals in second-hand imported clothes, sandals, hardwares, shoes, slippers operating in concrete made shops and some sold in open spaces. the agbobloshie market which is near the timber market on the fadama road also deals largely in international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.152-169 156 foodstuffs ranging from animal to non-animal products. mostly, market women sit and sell in open spaces and small wooden structures (kiosk). lastly the abosakai market, which is close to the agbobloshie market, deals primarily in imported second-hand spare parts of automobiles. market participants are mostly males who operate in concrete made shops. a total of 50 small and medium enterprises registered and collecting vat were selected from each market. thus, a total of two hundred and fifty (250) smes were selected for the survey. the convenience sampling technique was chosen ahead of the probability sampling technique in this study. this is because the convenience sampling affords flexibility and data collection luxury contrary to the probability sampling techniques, which requires more formal access to lists of valuations. for example, in this study, the use of the probability sampling technique would require that, in each market, we get formal lists of all sme’s registered with vat and collecting vat. this will be a hilarious exercise which will require lots of time and cost. thus, although the convenience sampling technique has been criticised as causing under-representation or over-representation of some groups within a sample, the ease with which it affords the researcher in getting access to useful information, which might not be possible under the probability sampling techniques case is the main justification for its use in this study. the study employed self-administered questionnaires to collect data. the questions were homogeneous on all issues across all individual sample units. specifically the questionnaire was divided into five different sub-headings namely; business characteristics, sme’s record keeping prior and post vat, and perception of sme’s on the impact of vat on sme’s record keeping. in the first section business units were required to provide responses on ownership, years of operation, educational level, nature of business and employment size. the second and third sections of the questionnaires sought to draw responses from respondents on the impact of vat on their record keeping skills. the last section sought to seek opinions from respondents on the impact of vat on sme’s record keeping system and skills. 4. empirical results and discussion in this section, a detailed analysis of the major findings of the article is provided. specifically the section is sub-divided into the following subsection. characteristics of smes, sme’s record keeping status prior to vat, sme’s record keeping during vat, the average additional cost burden imposed by vat record keeping requirement, and impact of vat record keeping requirement on sme’s record keeping skills 4.1 characteristics of sme’s in all, a total of 222 out of the 250 registered vat traders completed the self-administered questionnaires. 50 out of the 222, representing 22.5 percent, are into the sale of provisions while 46, representing 20.7 percent, are into the sale of automobile parts. the remaining 50.5 percent of the sample are into the sale of general goods, building and construction materials, secondhand clothing, jewelry, and cosmetics. the level of education for these firms is low. 85.1 percent of the sample has education attainment up to senior secondary school level while the remaining 14.9 percent of the sample have education above senior secondary school level. the cross tabulation of business and education level reveals that the highest attainable level of education is senior secondary school. this suggests that there is no significant difference in educational attainments among traders surveyed. the level of employment size is also low. 95.1 percent of the sample representing 212 has a labour force size of less than 5 employees with the remaining 4.9 percent of the sample employing larger than 5. these details are well spelt out in tables 1 and 2. smes record keeping in ghana: has vat made it better? 157 table 1. cross tab of nature of business and educational level level of education total basic middle/jss secondary polytechnic university other nature of business general goods 0 7 28 6 3 0 44 building and construction 0 2 5 1 3 0 11 secondhand clothes 3 12 17 3 0 1 36 provisions 0 12 24 9 5 0 50 cosmetics 1 6 15 5 0 0 27 automobiles 0 12 32 1 1 0 46 other 0 1 4 1 1 1 8 total 4 52 125 26 13 2 222 table 2. cross tab of nature of business and firm size number of workers total < 5 >5 but <10 >10 but < 20 >20 nature of business general goods 40 4 0 0 44 building and construction 9 1 0 1 11 secondhand clothes 35 1 0 0 36 provisions 48 1 1 0 50 cosmetics 26 0 0 1 27 automobiles 46 0 0 0 46 other 8 0 0 0 8 total 212 7 1 2 222 4.2 background check on sme’s record keeping pattern prior to registering for vat in this survey, the authors sought from traders the status and nature of records kept prior to joining vat. the rationale was to provide a background on sme’s record keeping profiles and habits. the survey revealed that 83.8 per cent representing 186 of the sample kept record with 81.7 percent of this, representing 152, keeping the record by self. in terms of the relative ease, 147 firms, representing 96.7 per cent, recorded their books with relative ease while the remaining 3.3 per cent did it with some level of difficulty. the survey also revealed that the main books of account kept included sales book, cash book, and stock book, which are simple to keep and trader friendly. for those who sought assistance in keeping records consisted of 18.3 percent representing 34 firms. out of the 34, 32 of them representing 94.1 per cent sought the services of employees while the remaining 5.9 per cent sought help from relatives. the average cost for seeking extra services from employees was high for 57.6 per cent, moderate for 33.3 per cent, and exceptionally high for 6.1 per cent of the sample that sought assistance from employees. using cross tabulation, the authors investigated whether the average additional cost imposed by keeping records differed across business units. the result showed homogeneous cost across business units (i.e. high average cost) except for those into the sale of provisions that experienced a moderate cost (see table 3). international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.152-169 158 table 3. nature of business and average cost incurred in keeping records what was the average cost incurred total very high high moderate no cost nature of business general goods 0 7 0 1 8 building and construction 1 3 0 0 4 secondhand clothes 0 4 0 0 4 provisions 0 1 8 0 9 cosmetics 1 1 1 0 3 automobiles 0 3 1 0 4 other 0 0 1 0 1 total 2 19 11 1 33 next the authors tested to see if this difference in cost observed is real or due to chance variation. the chi-square test indicates that the differences are real and not due to chance variation (see table 4). this we explain as been due to differences in the degree of skill required but has nothing to do with the differences in the education levels. lastly the survey revealed that 16.2 percent representing 36 did not keep record specifically for reasons such as low level of education, lack of accounting skills, and lack of knowledge on the need to keep records. table 4. chi-square tests value df asymp. sig. (2-sided) pearson chi-square 33.007a 18 .017 likelihood ratio 35.458 18 .008 linear-by-linear association .620 1 .431 n of valid cases 33 a. 27 cells (96.4%) have expected count less than 5. the minimum expected count is .03. generally, it is evident from the above analysis that, although, the level of education of firms interviewed is low, the books of accounts kept prior to joining vat posed relatively high cost to few firms. this goes to explain that records kept prior to joining vat was less stringent for firms. 4.3 sme’s record keeping post vat registration next the authors examined how the introduction of vat has changed the status, nature, and cost of keeping a record for sme’s. as a result of migrating onto vat the scope of records kept by businesses changed by the inclusion of the vat invoice book and the monthly vat returns form. firms continued to keep other book of accounts for reasons of determining profit, tax declaration, future references, and reconciliation of accounts. regarding the completion of the vat invoice book, 85.1 per cent representing 189 firms self-complete the invoice book with 96.3 percent of them doing it with relative ease and 3.7 per cent doing it with some difficulty. only 14.9 per cent of the sample, representing 33 firms, is unable to complete the vat invoice book by self. this implies that the vat invoice book poses “threat of extra cost of keeping record” to few firms. this presupposes that the record keeping requirement of the vat invoice book does not differ significantly from the other books of account kept by firms prior to joining vat. however, with regard to the completion of the monthly return form, only 17.6 per cent of the sample is able to complete it by self with the remaining 82.4 per cent of the sample unable to complete it by self. this means that, as a result of migrating onto vat, more firms are exposed to the risk of incurring extra cost burden in keeping their accounts. in all, a total of 39 firms are able to complete both the vat invoice book and monthly return by self while a total of 150 firms out of the 183 firms that are unable to complete the monthly returns by self, complete the vat invoice book by self. 33 firms, however, are unable to complete both the vat invoice book and returns form by self. controlling for firms who have had an encounter with vat officials, 37 firms who have had an encounter with vat officials are able to complete both the invoice book and the returns form while smes record keeping in ghana: has vat made it better? 159 147 firms are able to complete the invoice book by self but not the monthly returns form. only two firms that have not had an encounter with vat officials are able to complete both vat record accounts by self. thus, many of the traders who received education from vat officials were able to complete the invoice book by self but not the monthly return form. this gives a clear picture that education of traders by vat officials has been biased towards the completion of the vat invoice book (see table 5). table 5. contact with vat officials and filing of vat returns do you receive education from vat officials do you fill the vat returns yourself total yes no yes do you fill the vat invoice yourself yes 37 149 186 no 0 33 33 total 37 182 219 no do you fill the vat invoice yourself yes 2 1 3 total 2 1 3 4.3.1 frequency of visit by vat officials and the keeping of vat records by traders next the authors test to see if a relationship exist between the frequency of vat education by vat officials and the completion of the vat record books by self. using measures of association the authors investigated the relationship between frequency of vat education and the completion of the vat record books by self. the result as shown in tables 6a and 6b indicates the rejection of the null hypothesis that there is no significant relationship between the frequency of vat education received and the completion of vat returns. thus, there exists a significant positive relationship between the frequency of vat education received from officials and the completion of vat returns even though the strength of this relationship is weak. thus, the more firms receive education from vat officials the more they are, in a better position, to complete the vat returns form by self thereby avoiding extra cost imposed by vat record keeping. however, as shown in tables 7a and 7b, the authors did not find a significant relationship between the completion of the vat invoice book by self and the frequency of vat education received. as indicated earlier, the vat invoice book is similar in many forms to other record keeping books kept by firms and thus, requires less assistant to complete it for a greater proportion of the traders. interestingly, however, education of traders on record keeping by vat officials has instead been more centered on the completion of the vat invoice book than the monthly return form. table 6a. directional measures of frequency of vat education and filling of vat monthly returns value asymp. std. errora approx. tb approx. sig. ordinal by ordinal somers' d symmetric .181 .067 2.555 .011 how often dependent .264 .098 2.555 .011 do you fill the vat returns yourself dependent .137 .052 2.555 .011 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.152-169 160 table 6b. symmetric measures value asymp. std. errora approx. tb approx. sig. ordinal by ordinal kendall's tau-b .190 .071 2.555 .011 kendall's tau-c .148 .058 2.555 .011 gamma .424 .150 2.555 .011 n of valid cases 219 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. table 7a. directional measures of frequency of vat education and filling of vat invoice book value asymp. std. errora approx. tb approx. sig. ordinal by ordinal somers' d symmetric .022 .063 .348 .728 how often dependent .034 .098 .348 .728 do you fill the vat invoice yourself dependent .016 .047 .348 .728 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. table 7b. symmetric measures of frequency of vat education and filling of vat invoice book value asymp. std. error approx. tb approx. sig. ordinal by ordinal kendall's tau-b .024 .068 .348 .728 kendall's tau-c 0.18 .050 .348 .728 gamma .060 .172 .348 .728 n of valid cases 219 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. 4.3.2 the relative risk of keeping vat records using the cross tabulation, the authors estimate the relative risk of the event that a firm who have received education from vat officials is more likely to complete the vat record books by self. the relative risk of completing the vat record books is the ratio of the probability that a trader, who has had education from traders, will complete the vat records books by self to the probability that a trader, who has not had education from traders, will complete the vat record books by self. the result of the risk estimate as shown in table 8 indicates that firms who receive education from vat officials are 0.253 times as likely to complete the vat monthly return form by self as firms who do not receive education from vat officials. alternatively, firms who receive education from vat officials are 2.493 times as likely as firms who do not receive education from vat officials not to complete the monthly return form by self. using the odds ratio, firms who receive education from vat officials are 0.102 more likely to complete the vat monthly return form than firms who do not receive education from vat officials. also, as shown in table 9, firms who receive education from vat officials are 0.849 times as likely to complete the vat invoice book by self as firms who do not receive education from vat officials. smes record keeping in ghana: has vat made it better? 161 table 8. risk estimate for completing vat monthly returns value 95% confidence interval lower upper odds ratio for do you receive education from vat officials (yes / no) .102 .009 1.150 for cohort do you fill the vat returns yourself = yes .253 .108 .594 for cohort do you fill the vat returns yourself = no 2.493 .503 12.366 n of valid cases 222 table 9. risk estimate for completing vat invoice book do you fill the vat invoice yourself total yes no do you receive education from vat officials yes count 186 33 219 % within do you receive education from vat officials 84.9 (%) ?15.1% 100.0 (%) no count 3 0 3 % within do you receive education from vat officials 100.0 % .0 (%) 100.0 (%) total count 189 33 222 % within do you receive education from vat officials 85.1 (%) 14.9 (%) 100.0 (%) risk estimate value 95% confidence interval lower upper for cohort do you fill the vat invoice yourself = yes .849 .803 .898 n of valid cases 222 this confirms the fact that the vat record keeping (monthly returns form) requirements is too stringent relative to other record keeping books by firms. this conclusion is confirmed by firms’ responses to the question; is the vat record keeping requirement too stringent relative to other record keeping requirements? out of the total 222 registered traders surveyed, 74.3 per cent indicated that the vat record keeping requirement is too stringent relative to other record keeping while 25.7 indicates that it is not too stringent. mainly they provide the reasons as: complex calculation, demands a lot of information, and is time consuming. the low level of education of firms as indicated earlier is the thrust of this conclusion. 4.4 average extra cost imposed by keeping vat records as discussed above, few firms are able to complete the monthly returns form by self. as a result, many of them sought assistance of some form. in this section, the authors consider the additional cost burden that this situation poses to traders. the survey showed that, a total 172 firms, representing 94.5 per cent, sought the services of employees while the remaining 5.5 per cent were assisted by family members. this implies that completion of the vat monthly return form exposes more traders to the risk of incurring extra cost. using cross tabulation the authors investigated whether the mode of assistance sought is homogeneous across business units. as shown in table 10, there is no significant difference in the mode of alternative assistance sought. in other words, the alternative means of completing the vat returns form is homogeneous across firms. this is confirmed by the chi-square test. as shown in table 11, the asymptotic significance values for all the summary statistics are statistically not different from zero which implies that the alternative means of filling vat international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.152-169 162 monthly return forms is homogeneous. this presupposes that all firms captured in this survey have the equal likelihood of been exposed to the risk of incurring extra cost in keeping vat monthly return form. table 10. nature of business and type of assistance sought if no via what means do you fill the monthly return form total employee relative nature of business general goods 38 2 40 building and construction 5 0 5 secondhand clothes 25 3 28 provisions 38 2 40 cosmetics 24 0 24 automobiles 36 3 39 other 7 0 7 total 173 10 183 table 11. chi-square test value df asymp. sig. (2sided) pearson chi-square 3.905a 6 .690 likelihood ratio 5.485 6 .483 linear-by-linear association .025 1 .874 n of valid cases 182 a. 8 cells (57.1%) have expected count less than 5. the minimum expected count is .27. out of the total firms that sought assistance in completing the vat return form, 173 of them incurred extra cost in keeping vat accounts while the remaining did not. the cost is moderate for 140 firms and high for the remaining 33 firms. those who did not incur extra cost were those who sought assistance mostly from friends and relatives. further the authors investigated whether the average cost imposed by vat record accounts differs across business type. the result as shown in table 11 indicates that the average cost imposed by vat monthly return form is moderate for many of the firms but high for only a few. using the cross tabulation alone it is impossible to tell whether these differences are real or due to chance. using the chi-square test the authors investigated this. as shown in table 12, the asymptotic significance values for the pearson chi-square and likelihood ratio test are both significant at the 5% level. this implies that the differences in cost incurred in keeping vat monthly return forms across firms are real and not due to chance variation. table 12. nature of business and cost imposed by filing monthly returns what is the average cost incurred total high moderate nature of business general goods 8 30 38 building and construction 1 4 5 secondhand clothes 2 25 27 provisions 5 32 37 cosmetics 11 13 24 automobiles 4 32 36 smes record keeping in ghana: has vat made it better? 163 other 2 4 6 total 33 140 173 chi-square tests value df asymp. sig. (2-sided) pearson chi-square 16.623a 6 .011 likelihood ratio 15.068 6 .020 linear-by-linear association .176 1 .675 n of valid cases 173 a. 5 cells (35.7%) have expected count less than 5. the minimum expected count is .95. also, the authors test whether the extra cost imposed by keeping vat records differs with the level of firms’ education, frequency of vat education received, and the size of the firm. these details are shown in tables 13-15. table 13. chi-square tests of firms’ education level and average cost imposed by vat returns value df asymp. sig. (2-sided) pearson chi-square 5.151a 5 .398 likelihood ratio 4.234 5 .516 linear-by-linear association .041 1 .839 n of valid cases 173 a. 6 cells (50.0%) have expected count less than 5. the minimum expected count is .19. table 14. chi-square test of size of the firm and average cost imposed by filing of vat returns value df asymp. sig. (2-sided) pearson chi-square 1.720a 2 .423 likelihood ratio 3.032 2 .220 linear-by-linear association 1.306 1 .253 n of valid cases 173 a. 4 cells (66.7%) have expected count less than 5. the minimum expected count is .19. table 15. chi-square test of vat education and average cost imposed by vat returns value df asymp. sig. (2-sided) pearson chi-square 15.880a 4 .003 likelihood ratio 14.412 4 .006 linear-by-linear association 3.624 1 .057 n of valid cases 172 a. 4 cells (40.0%) have expected count less than 5. the minimum expected count is .58. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.152-169 164 as shown in table 13, the asymptotic significance value for all summary statistics are statistically not different from zero which implies that extra cost imposed by vat returns does not differ with the level of education. also, table 14 indicates that the cost imposed by keeping vat returns does not differ significantly with the size of a firm. lastly table 15, however, shows that the cost of keeping vat records by traders differs significantly with the frequency of vat education received by traders from vat officials. while the chi-square is useful for determining whether there is a relationship, it does not disclose the strength of this relationship. using directional measures, the authors further investigated the strength of association or relationship that exist between the cost of keeping vat returns and the frequency of the vat record keeping education by officials. as shown in tables 16-17, the approximate significance values are statistically different from zero. thus, there exists a significant relationship between the cost imposed by keeping vat returns and the frequency of the vat record keeping education. the value of each measure is more than 0.15 which signifies a stronger relationship between the frequency of vat education and the extra cost imposed by keeping vat returns. table 16. directional measures of cost of keeping vat returns and frequency of vat education value asymp. std. errora approx. tb approx. sig. ordinal by ordinal somers' d symmetric .177 .071 2.394 .017 how often dependent .230 .092 2.394 .017 what is the average cost incurred dependent .144 .059 2.394 .017 a. not assuming the null hypothesis. b.using the asymptotic standard error assuming the null hypothesis. table 17. symmetric measures of cost of keeping vat returns and frequency of vat education value asymp. std. errora approx. tb approx. sig. ordinal by ordinal kendall's tau-b .182 .073 2.394 .017 kendall's tau-c .143 .060 2.394 .017 gamma .442 .173 2.394 .017 n of valid cases 172 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. the difficulty in completing the monthly return form causes delays in monthly return payments, which sometimes based on the severity of the problem, causes the vat office to attain a success rate less than the target. in order to recoup these delayed payments, the office of vat incurs extra cost. 4.5 impact of record-based controls of vat on traders’ record keeping skills and system in this section, the authors examine the effect of vat record keeping requirement on firms’ record keeping skills and accounting system. out of the total 222 firms surveyed, 219 of them had an encounter with vat officials. out of this, 174 of them had experienced improvement in their record keeping skills and accounting system; 29 of them had not experienced any improvement in both their record keeping skills and record keeping system; 14 of them had experienced improvement in their record keeping system but not skills, and only 2 of them had experienced some improvements in their record keeping skills but not system. in sum, a total of 188 firms indicated improvement in their record keeping system while 31 indicated that vat record keeping requirement has not improved their record keeping system. similarly, a total of 176 firms indicated improved record keeping skills while 43 of them concluded that vat record keeping requirement has not improved their record keeping skills. judging by the law smes record keeping in ghana: has vat made it better? 165 of large numbers, it can be concluded that the record keeping requirements of vat has improved firms’ record keeping skills and accounting system. firms were further asked to indicate the extent to which the vat record keeping requirement has improved their record keeping skills and accounting system. in all, a total of 36.9 per cent and 37.4 per cent of the sample indicate that the vat record keeping requirement has had a high effect on their record keeping skills and accounting system, respectively. also, 38.3 per cent and 42.8 of the sample indicated that the vat record keeping requirement has had a modest impact on their record keeping skills and accounting system, respectively. the impact of vat record keeping requirement on firms’ record keeping skills and accounting system is, however, small for 17.1 per cent and 14.4 per cent of the sample, respectively and nil for 7.7 and 5.4 per cent of the sample, respectively. from the above analysis, the authors further tested to find out if the impact of vat record keeping requirement on firms’ record keeping skills and accounting system differs across firms. as shown in tables 18-19, the impact on firms’ record keeping skills and accounting system is high for firms into the sale of general goods, building and construction materials and secondhand clothes but moderate for firms into the sale of provisions, cosmetics, automobiles, jewelry, etc. using the chisquare test the authors further tested to find out if the differences observed are due to chance variation or real. result of the chi-square tests shows that the observed differences are real but not due to chance. in other words, there exists a significant difference in the impact that vat record keeping requirement has on firms’ record keeping skills and accounting system across business units. table 18. nature of business and impact of vat on firms record keeping skills impact of vat on record keeping skills total high moderate low no impact nature of business general goods 29 7 8 0 44 building and construction 7 0 4 0 11 secondhand clothes 27 4 5 0 36 provisions 7 25 4 14 50 cosmetics 7 19 0 1 27 automobiles 4 26 16 0 46 other 1 4 1 2 8 total 82 85 38 17 222 chi-square tests value df asymp. sig. (2-sided) pearson chi-square 1.351e2a 18 .000 likelihood ratio 144.300 18 .000 linear-by-linear association 22.609 1 .000 n of valid cases 222 table 19. nature of business and the impact of vat on firms’ record keeping system impacted of vat on firms’ record keeping system total high moderate low no impact nature of business general goods 29 8 7 0 44 building and construction 7 0 4 0 11 secondhand clothes 29 5 2 0 36 provisions 8 30 2 10 50 cosmetics 6 20 0 1 27 automobiles 3 26 17 0 46 international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.152-169 166 other 1 6 0 1 8 total 83 95 32 12 222 chi-square tests value df asymp. sig. (2-sided) pearson chi-square 1.407e2a 18 .000 likelihood ratio 149.781 18 .000 linear-by-linear association 26.727 1 .000 n of valid cases 222 a. 14 cells (50.0%) have expected count less than 5. the minimum expected count is .43. also, the authors tested to find out if there is a relationship between the frequency of visits by vat officials and the impact that the record-based control of vat has on firms’ record keeping skills and accounting system. evidence as shown in tables 20-21 indicates that there exist a significant relationship between the frequency of vat education received, and the impact that such education has on firms’ record keeping skills at the 5% significance level. this relationship is stronger as the values of the various measures exceed 0.15. table 20. directional measures of frequency of vat education and the impact on firms record keeping skills value asymp. std. errora approx. tb approx. sig. ordinal by ordinal somers' d symmetric .180 .076 2.301 .021 has this education improved your record keeping skills dependent .143 .061 2.301 .021 how often dependent .244 .103 2.301 .021 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. similarly, there is evidence in support of a significant relationship between frequency of education received and the impact that such education has on firms’ record keeping system (see tables 22 to 23). the relationship as described by the kendall’s tau-b and kendall’s tau-c is weak but strong per the value given by the gamma statistic. seen as a check and balance tool, the vat record books ensures sanity in record keeping, minimizes error and speeds up the process of record keeping. table 21. symmetric measures of frequency of vat education and the impact on firms record keeping skills value asymp. std. errora approx. tb approx. sig. ordinal by ordinal kendall's tau-b .187 .079 2.301 .021 kendall's tau-c .154 .067 2.301 .021 gamma .361 .147 2.301 .021 n of valid cases 219 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. smes record keeping in ghana: has vat made it better? 167 table 22. directional measures frequency of vat education and the impact on firms record keeping system value asymp. std. errora approx. tb approx. sig. ordinal by ordinal somers' d symmetric .135 .069 1.905 .057 has this education improved your record keeping system dependent .098 .051 1.905 .057 how often dependent .218 .110 1.905 .057 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. table 23. symmetric measures frequency of vat education and the impact on firms record keeping system value asymp. std. errora approx. tb approx. sig. ordinal by ordinal kendall's tau-b .146 .074 1.905 .057 kendall's tau-c .106 .056 1.905 .057 gamma .344 .166 1.905 .057 n of valid cases 219 a. not assuming the null hypothesis. b. using the asymptotic standard error assuming the null hypothesis. 5. conclusion and policy recommendations the primarily objective of this paper was to determine the effect that the record-based controls of vat has on smes record keeping skills and accounting system. keeping of vat records is found to expose more traders to risk of incurring extra cost. this cost is found to differ significantly with the type of business and frequency of vat education, but does not differ significantly with the level of education of traders and size of firm. specifically completing the monthly return form exposes more traders to the risk of incurring additional cost than the filling of the vat invoice book. firms, who receive education from vat officials, are found to be 0.102 more likely to complete the vat monthly return form than firms who do not receive education from vat officials. also, the authors found that firms who receive education from vat officials are 0.849 times as likely as those firms who had not received education from vat officials to complete the vat invoice book by self. the study also found a significant relationship between the frequency of vat education and the filling of the vat returns form. however, the authors did not find a significant relationship between the frequency of vat education and the filling of the vat invoice book by self. generally, there is evidence in support of the fact that the vat record keeping requirement has significantly improved firms’ record keeping skills and accounting system even though it is found to be stringent relative to other record keeping requirements kept by firms. the ancient cry of low tax revenues in the economy is a reflection of both tax noncompliance and inefficiencies within the tax system. difficulty in completing monthly returns have either increased cost in businesses or caused delays in monthly payments often time. also, the low coverage of vat makes the current vat registered traders less competitive as their unregistered competitors continue to attract buyers to their end due to price advantage. all these impose an enormous cost on the economy since there is twin revenue slack in tax incomes. education of traders on the completion of the monthly return form by vat officials should be intensified. the lag in education experienced is the thrust for the high cost imposed by vat on traders. the vat office should consider renewing their efforts on educating traders on the need to keep business records and how to keep them. frequent visits by vat officials and regular organised seminars and workshops by stakeholders on the need to and how to keep records will prove international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.152-169 168 tremendously valuable. the vat office should beef up their current coverage to ensure equity in the system. this will require that more new personnel be enrolled onboard. as currently done in the agricultural and educational sectors, the government can make it a national policy where a significant number of national service personnel are recruited every year in all districts to assist in achieving 100 per cent coverage. references abor, j., biekpe, n. 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(2006), causes of business failure in uganda: a case study from bushenyi and mbarara towns. african quarterly 8(4), available at http://www.africa.ufl.edu/asq/v8/v8i4a3.htm weston, j.f., copeland, t.e. (1998), managerial finance, cbs college publishing, new york. international journal of economics and financial issues vol. 2, no. 3, 2012, pp.357-372 issn: 2146-4138 www.econjournals.com bank savings and bank credits in nigeria: determinants and impact on economic growth orji anthony department of economics, university of nigeria, nsukka, nigeria. tel: +234 8038559299. email: tonyorjiuss@yahoo.com abstract: this study investigated the determinants of bank savings in nigeria as well as examined the impact of bank savings and bank credits on nigeria’s economic growth from 19702006. we adopted two impact models; distributed lag-error correction model (dl-ecm) and distributed model. the empirical results showed a positive influence of values of gdp per capita (pcy), financial deepening (fsd), interest rate spread (irs) and negative influence of real interest rate (rir) and inflation rate (infr) on the size of private domestic savings. also a positive relationship exists between the lagged values of total private savings, private sector credit, public sector credit, interest rate spread, exchange rates and economic growth. we therefore recommend, among others, that government’s effort should be geared towards improving per capita income by reducing the unemployment rate in the country in a bid to accelerate growth through enhanced savings. keywords: bank; saving; credit; financial sector; economic growth jel classifications: e51; g21; g24; o16; o4 1. introduction recent macroeconomic developments in nigeria’s financial sector reveal a strong desire by the monetary authorities to reposition nigeria’s financial system to meet the trend of globalization. however, banks’ participation in the financial sector of developing nations like nigeria raises many questions which remain unanswered. key among them is the issue of how effective they have been in mobilizing private domestic savings and in channeling the savings to enhance growth through the distribution of credits. as capital formation is an important factor in economic growth, countries that are able to accumulate high level of capital tend to achieve faster rates of economic growth and development. the effects of investment on economic growth are three-fold. firstly, demand for investment goods forms part of aggregate demand in the economy. thus a rise in investment demand will, to the extent that the demand is not satisfied by imports, stimulate production of investment goods which in turn leads to high economic growth and development. secondly, capital formation improves the productive capacity of the economy. thirdly, investment in new plant and machinery raises productivity growth by introducing new technology and innovation which would also lead to faster economic growth. to finance investment required for economic growth, the economy needs to generate sufficient savings or borrow from abroad. however, borrowing from abroad may not only have adverse effects on the balance of payment as these loans will have to be serviced in the future but it also carries a foreign exchange risk. therefore, domestic savings are necessary for economic growth because they provide the domestic resource needed to fund the investment effort of a country. banks are statutorily vested with the primary responsibility of financial intermediation in order to make funds available to all economic agents. the intermediation process involves moving funds from surplus economic units of the economy to deficit economic units (uremadu, 2002; nnanna et al., 2004). financial intermediation is an important activity in the economy because it allows funds to be channeled from people who might otherwise not put to productive use to people who will. in this way financial intermediation helps to promote a more efficient and dynamic economy. according to gershenknon (1962), banks more effectively finance industrial expansion than any other form of international journal of economics and financial issues, vol. 2, no.3, 2012, pp.357-372 358 financing in developing economies. in nigeria, banks are the largest financial intermediaries in the economy. financial intermediaries help to bridge the gap between borrowers and lenders by creating a market with two types of securities, one for the lender and the other for the borrower (vane and thompson, 1982). however, the extent to which this could be done depends on the level of development of the financial sector as well as the savings habit of the populace. the availability of investible funds is therefore regarded as a necessary starting point for all investment in the economy which will eventually translate to economic growth and development (uremadu, 2006). conceptually, savings represent that part of income not spent on current consumption. when applied to capital investment, savings increase output (olusoji, 2003). institutions in the financial sector like deposit money banks (dmbs) or commercial banks mobilize savings deposits on which they pay certain interest. to effectively mobilize savings in an economy the deposit rate must be relatively high and inflation rate stabilized to ensure a high positive real interest rate, which motivates investors to save from their disposable income. the recent consolidation initiative which has reduced the number of banks from eighty-nine (89) to twenty-four (24) is a step towards this market-based direction. it aims at reducing the cost of capital by allowing domestic economic units to achieve efficient portfolio diversification in order to increase the liquidity of investments; and opening the financial industry to foreign investors. ultimately, the reform initiative is meant to produce a sound and healthy financial services sector, which is crucial if the country must avail itself of the windows of opportunity opened up by globalization, to develop the economy and further the country’s industrialization. access to financial services is important for growth and poverty reduction. access to credit that enables an individual to accumulate funds in a secure place over time can strengthen productive assets by enabling investment in microenterprises, in new tools, equipment or fertilizers, or in education or health, all of which can play an important role in improving their productivity and income. however, in many developing countries like nigeria, commercial bank lending or access to formal financial services for the poor majority of the population remains very limited. credit is the main channel through which savings are transformed into investments. however, not all savings are used to finance investment despite high demand for credit because the credit market in nigeria is rationed (soludo, 1987; azege, 2007). indeed, the lack of credit has been cited by firm managers in africa as their most important constraint (bigstein and soderbom, 2005). lack of funds has made it difficult for firms to invest in modern machines, information technology and human resources development which are critical in reducing production costs, raising productivity and improving competitiveness. low investments have been traced largely to banks unwillingness to make credits available to manufacturers, owing partly to the mis-match between the short-term nature of banks’ funds and the medium to long term nature of funds needed by industries. in addition, banks perceive manufacturing as a high risk venture in the nigerian environment, hence they prefer to lend to low-risk ventures, such as commerce, in which the returns are also very high. even when credit is available, high lending rate ,which was over thirty percent (30%) at a time, made it unattractive; more so when returns on investments in the sub –sector have been below ten percent (10%) on the average (nwasilike, 2006). in fact, some “watchers” of developments in the industry have accused banks of enjoying abnormal profits by charging high rates on credits whilst paying considerably lower rates on deposits. bankers on their own part have argued that the perceived high spread is necessitated by the high costs of running banking business arising from regulating costs as well as those induced by the environment where they operate such as costs of power and infrastructural decays, etc (afolabi et al., 2003). following the liberalization of the financial sector in 1986, interest rate became market determined and soon soared above repression regime values. despite high inflation rates, real interest rate as at 2000 was over 15% (cbn, 2007). the high spread of lending and deposit rates has also constituted a serious disincentive to effective financial intermediation in nigeria. the performance of saving mobilization in nigeria has not been encouraging. instead of increasing to match the development challenges, there is a clear indication of saving decline in nigeria, inspite of various policy measures. these measures include rural banking program, establishment and expansion of people’s bank of nigeria, primary mortgage institutions, insurance companies and the social insurance trust fund which was reconstituted from the national provident fund. in fact, the national bank savings and bank credits in nigeria: determinants and impact on economic growth 359 bureau of statistics (nbs) estimated nigeria’s gross national saving in 1993 to be n63.4 billion rising from n59 billion in 1991, and declined again to n59 billion in 1996. to curb this decline, the operational environment for banks was further liberalized with the introduction of universal banking in 2001, while the supervisory framework of the financial system was enhanced with the establishment of a new department in the central bank to supervise other institutions. according to nnanna (2002), by the end of 2001 the financial sector in nigeria consisted of 90 deposit money banks, 747 community banks, 6 development finance institutions, 1 stock exchange, 1 commodity exchange, 5 discount houses, 74 primary mortgage institutions, 98 finance companies, 118 insurance companies and 80 bureau de change. however, only 10 banks control about 53% of the total deposits, 46.5% of the total credits, and 50.8% of the total assets in the industry. in 2002 the monetary policy implementation committee were faced with some challenges, as the problem of excess liquidity persisted, and the demand perceive in the foreign exchange intensified. this could be attributed to the monetary control frame work, which relied heavily on credit ceilings and selective credit control which increasingly failed to achieve the set monetary targets as their implementation became less effective with time. however, following needs (2004), the desired private credit sector for investment purposes has to be of medium and long-term nature, with low interest rates, ideally single digit. incidentally, the total asset base of the entire nigerian banking industry is estimated at a mere us $24 billion, while the deposit base is a paltry us $15 billion. the quantum of government domestic debt by way of treasury bills and bonds alone (about 73%) relative to domestic deposits constitutes major impediment to private sector investment financing (cbn, 2007). meanwhile the financial strength of other financial service providers in the system is equally small as shown below:  capital market: 265 listed stock, and market capitalization of us $17 billion as at june 2004.  insurance: total assets of us $ 7 billion and gross premium of n37 billion.  primary mortgage institutions: total asset base (us $500m), and capital of us $20 million in 2003.  development finance institution: permanent capital of us $48 million. this huge gap between financing needs and the available financing capacity represents major constraints to growth opportunities in business financing, and accords with one of needs (2004) strategy of stimulating real sector financing by mobilizing cheap long term saving. table 1. the ratio of loans to small scale enterprises (sses) to commercial banks total credit year comm.bank loans to sse (=n=’m) comm. bank total cedit (=n=’m) comm. banks loans to sse as per. (%) of total credit 1999 46,824.0 353,081.1 13.3 2000 44,542.3 508,302.2 8.7 2001 52,428.4 796,164.8 6.6 2002 82,368.4 954,628.8 8.6 2003 90,176.5 1,210,033.1 7.5 2004 54,981.22 1,519,242.7 3.6 2005 50,672.6 1,899,346.4 2.7 2006 25,713.7 2,524,297.9 1.0 source: cbn (2007). it is evident from the table 1 above that commercial bank lending in nigeria remains very unstable and this has made its contribution to the development of small scale business enterprises very insignificant. it is worthy to note that according to cbn (2007), the commercial banks loans to small scale enterprises as percentage (%) of total credit declined from 48.8% in 1992 to 32.2%, 22.2%, 22.9%, 25.0%, 17.0%, and 15.5% in 1993,1994,1995,1996, 1997 and 1998, respectively. from the table above we can also see a consistent decline from 13.3% in 1999 to 1.0 2006. this could be partially attributed to the abolition of mandatory banks’ credit allocation of 20 % of its total credit to small scale enterprises wholly owned by nigerians which took effect from october 1, 1996. international journal of economics and financial issues, vol. 2, no.3, 2012, pp.357-372 360 despite the fact that nigeria has implemented some economic policies that are based on financial liberalization as elucidated in the structural adjustment programme (sap) and other banking reforms, the issue of the persistent low level of economic development in nigeria still remains a matter of great concern. it has been argued that this is the outcome of capital shortage (yohannes, 1994). to this end, it becomes imperative to carry out an empirical investigation on the performance of the banking sector as a financial intermediary. the research questions arising from the above issues and the objectives we seek to pursue are therefore as follows: (a) what are the determinants of bank savings in nigeria? (b) what is the impact of bank savings and bank credits on nigeria’s economic growth? 2. literature review 2.1. theoretical literature the classical economists did the first theoretical explanation of the determinants of savings and its importance. smith (1776) recognized the importance of savings when he observed that, “capital is increased by parsimony and diminished by prodigality and misconduct”. prior to 1936, the classical economists propounded their theory on the savings and asserted that a negative relationship existed between savings and interest rate. keynes (1936) defined savings as the excess of income over expenditure on consumption. this means that saving is that part of disposable income of the period which has not passed into consumption (umoh, 2003; uremadu, 2006). given that income is equal to the value of current output; and that current investment (ie gross capital formation) is equal to the value of that part of current output which is not consumed, savings is equal to the excess of income over consumption. hence, the equality of savings and investment necessarily follow thus: income = value of output = consumption + investment………..….. (1) savings = incomeconsumption…………………………………….(2) from (1) savings = investment…………………………………..…………… (3) keynes maintains that on the aggregate, the excess of income over consumption (otherwise called savings) cannot differ from addition to capital equipment (i.e. gross fixed capital formation or gross domestic investment). savings is therefore a mere residual, and the decision to consume and the decision to invest between them determine the volume of national income accumulated in a period. in the keynesian view therefore, rising income would result in higher savings rates. as a matter of fact, savings is regarded as being complementary to the consumption function. in its simplest form, the savings function is derived from the linear consumption function when the autonomous consumption expenditure is separated off (umoh, 2003). anyanwu and oaikhenan (1995) classified the determinants of savings into objective and subjective factors respectively. the objective factors are the quantifiable and verifiable determinants of savings. these include; the level of income, the rate of interest, inflation rate, expectation about inflation rate, and saving facilities. on the other hand, the subjective determinants of savings are the non-quantifiable and non – traceable factors that influence savings behaviours and which are largely psychological in nature. these include; the instinct for precaution, the desire for bequest, habits and cultural factors. 2.2. empirical literature on bank savings, bank credits and economic growth domestic savings mobilization by commercial banks and credit allocation functions stem from their role as the financial intermediaries in the domestic economy. the link between domestic savings, commercial bank credits and economic growth is not a new discovery. its debate has a long pedigree and is marked with conflicting conclusions. the difference in conclusion is due not only to differences in theoretical perspectives, but also to the way in which the link between them is taken into account by researchers. the financial sector limits, prices, pools and trades all the risks involved in a transaction and provide incentives for savers to invest by matching potential earnings with those risks. empirical research has shown that financial depth is generally associated with an increase in gdp (levine, 2005).in contrast, distorted financial markets with high macro – economic instability, direct government involvement and weak regulation can have extremely adverse effects on economic bank savings and bank credits in nigeria: determinants and impact on economic growth 361 growth. as a result the focus of many recent works on the financial sector has been on deepening and broadening financial markets in developing countries and on improving financial sector regulation, supervision, and governance. the increasing participation of commercial banks has been one of the most striking structural changes experienced by banking systems in developing countries over the past decade. in nigeria, the number of banks stands at 24 due to the recent bank consolidation exercise. common argument against bank credits is that banks might tend to “cherry pick” the most profitable customers, reducing financing to some sectors, increasing the risk exposure of micro – finance banks, and these affect the overall distribution of credit. in particular, the main area of concern is the availability of credit to private investors and small businesses. in many developing countries, small businesses account for a very significant share of total value added and generate a large traction of the total jobs in the economy. banks are perceived as having a comparative advantage over other institutions in small business lending. this role is likely to be more important in less developed countries that are generally more heavily dependent on bank financing. in argentina, for example, 79 percent of small industrial firms have bank debt (llorens et al, 1999). moreover, small businesses tend to have exclusive dealings with a single bank with which they have a strong relationship. given the paucity of information about small businesses, these relationships enable banks to generate information on the risk characteristics of individual investors or small firms. therefore access to credit by private investors and small businesses would be reduced if banks were to neglect small business and/or drive domestic micro – finance banks from the market, destroying the information generated through bank – borrower relationships. for example, greenwoood and jovanovic (1990) show that domestic savings and bank credits provides a vehicle for diversifying and sharing risks, inducing capital allocation shift towards risky but “high expected return” projects. this shift then spurs productivity improvement and economic growth. diamond (1983) argues that household facing liquidity risks prefer liquid but low – yield projects to liquid but high – yield one, while banks pooling liquidity risks, would like to invest a generous portion of their finds into liquid but more profitable projects. bencivenga and smith (1998) argue that financial intermediaries, by eliminating liquidity risks, channel house holds’ financial savings into illiquid but high – return projects and avoid the premature liquidation of profitable investments, which favours efficient use of capital and promotes economic growth. tsuru (2000) argues that financial intermediation could affect the savings rate, and then capital formation and growth, through its impact on four different factors; (i) idiosyncratic risks; (ii) rate – of – return risks; (iii) interest rates and (iv) liquidity constraints. a number of recent studies, however, have shown that commercial banks seem to improve banking system efficiency and thereby contribute to overall banking stability in developing countries (levine and loayza (1999), barajas, et al. (2000), classens, et al. (2000); clarke et al, (2000), and dages et al. (2000). on the other hand, the effect of bank credits in developing countries especially in nigeria remains largely unexplored. there is however very little literature that deals directly with the implications of bank credit to investors and small businesses in developing countries. argentina is among the few countries for which we found such studies. bleger and rozenwurcel (2000) indicate that bank participation in argentina is associated with a reduction of bank credits to small businesses from around 20 to 16 percent of total lending between 1996 and 1998. in contrast, escude, et al (2001) found that despite their lower tendency to lend to small businesses, banks have increased both their propensity and their market share of lending to the sector between 1998 and 2000. finally, using a rich data set on argentinean business debtors in december 1998, berger et al., (2000) found that large banks and foreign-owned banks are less inclined to extend credit to smaller firms, which are likely to be informationally opaque. given the paucity of research on the impact of private domestic savings and bank credits on economic growth in nigeria, and owing to the importance of this issue from a policy standpoint, further empirical investigation is clearly warranted. international journal of economics and financial issues, vol. 2, no.3, 2012, pp.357-372 362 3. methodology this section deals with model specifications, data definitions, data transformations, estimation procedures, evaluation techniques, and sources of data. given the nature of the objectives of this study, the ardl-ecm models will be adopted. to achieve the first objective, we have adopted and modified the model specifications of uremadu (2007) to come up with our model of bank savings in nigeria. here, using the ordinary lest square (ols) technique, per capita income (pcy) and other variables are regressed on the total private domestic savings / gdp at current market price ratio. to achieve the second objective, we shall adopt a second model specification. here, we are interested in studying the impact of private domestic savings and bank credits on nigeria’s economic growth. thus, we shall modify and extend the model specifications of azege (2007). using the ols techniques, total private savings, private sector bank credits, and other variables are regressed on gdp. 3.1 specification of models 3.1.1 model i the total private domestic savings / gdp ratio equation to be estimated is specified as follows: tpsy = f (pcy, rir, fsd, irs, infr) … (1) where: tpsy = total private domestic savings / gdp ratio at current market prices. the ratio will help us ascertain the size of these savings. pcy = gdp per capita at current naira income of the people. increase in per capita income of the people will impact positively on their savings ability (uremadu, 2006). rir = real interest rate. this is defined as the nominal interest rate from savings deposits minus annual inflation rate. it impacts positively on total savings. fsd = financial deepening. its proxy is captured by broad money (m2) as ratio to gdp. financial deepening enhances increase in volume of all monies in circulation in the economy. efficient financial intermediation will increase financial deepening. effective financial deepening (which is also a proxy for financial sector development) will have a salutary effect on the economy as well as a positive effect on savings mobilization. irs = interest rate spread. this is defined as interest rate differential between maximum lending rate and savings deposits rate. it has a negative impact on savings. interest rate determination is a critical factor in the loanable funds market given its role in the mobilization and allocation of financial resources or credit in an economy. infr = inflation rate. it impacts negatively on domestic savings mobilization. it should be well noted that inflationary expectations play an important role in the supply of and demand for loanable funds. to make equation (1) amenable for empirical verification, we transform it into an econometric equation; tpsy = 0+1pcy + 2rir+3fsd+4irs+5infr+ (2) where: i = parameters to be estimated. = error term assuming that the variables in equation (2) are not well behaved, we rewrite it as: ∆tpsyt=0+1(∆pcyt-i) +2(∆rirt-i) +3(∆fsdt-i) +4(∆irst-i) +5(∆infrt-i) +t (3) where: ∆ difference operator i parameter to be estimated t-i= unknown lags to be estimated  error term equation (3) captures our objective. it assumes that all the variables are well behaved, otherwise equation (3) translates to: ∆kotpsyto1(∆k1pcyt-i) 2(∆k2rirt-i) 3(∆k3fsdt-i) 4(∆k4irst-i) 5(∆k5infrt-i)t (4) where: k = order of differencing. bank savings and bank credits in nigeria: determinants and impact on economic growth 363 equation (4) assumes that: k0≠ k1, k 2, k3, k4, k5. else if ko is equal to any of k1, k2…k5, then we shall investigate the presence of a co-integration amongst the variables. if the residuals are stationary and a long in relationship is established, then the parameters will thus be suitably estimated by introducing an error correction mechanism as developed by engle and granger (1987). this will enable us separate the long run relationship of tpsy from its explanatory variables. note that if there is evidence of co-integration, then equation (4) converges to the error correction model (ecm) as shown below: ∆kotpsyto1(∆k1pcyt-i) 2(∆k2rirt-i) 3(∆k3fsdt-i) 4(∆k4irst-i) 5(∆k5infrt-i)6(ecmt-i)+t (5) where: 6=the speed of adjustment parameter ecmt-i=the residual or error correction mechanism of the previous year. however, to ensure the parsimonious nature of the model, equation (5) translates to an auto regressive distributed lag (ardl) model as shown below. ∆kotpsyt oi (∆kotpsyt-i) i   n i 1 ∆kizt-q6(ecmt-i)  (6) i=1 where, zt – q = vector of macroeconomic controls that includes all other explanatory variables in the model. ardl [1, 3] will be used to avoid unnecessary loss of degrees of freedom. also model simulation will be carried out to avoid specification error and to ensure the marginalization of the entire irrelevant variables in the ardl model. but if our auto-regressive variable (∆ko tpsyt-i) becomes marginalized in the process of simulation, then equation (6) translates to only distributed lag (dl) model as stated below: ∆kotfst oi   n i 1 ∆kizt-q6(ecmt-i) t (7) i =1 however, if the co-integration test fails to sail through, we will no longer estimate equation 6 and 7 but rather equation 4. but based on the afore-mentioned theoretical postulates we shall use the ardl approach to co-integration (ardl ecm) developed by pesaran, et al (2001) as used in sarka (2007). 3.1.2 model 2 model 2 shall be used to capture the second objective. thus, we specify the model as: gdp = f (tps, prcy, pucy, irs, exr) (8) where gdp = gross domestic product (proxy for economic growth in nigeria) at current market prices. tps = total private savings (made up of savings, time and demand deposits in the commercial banks as a proxy) prcy = the ratio of commercial banks’ private sector credits to gdp. (measures the degree of bank loan financing to the private sector in the economy). pucy=the ratio of commercial banks’ public sector credits to gdp irs = interest rate spread (measures the difference between maximum lending rate and deposit rate). proxy for incidence of investment. excr= exchange rate to make equation (8) fit for computation, we present it as; gdp = βo +β 1tps + β2 prcy + β3 pucy + β4 irs + β5exr +t (9) to enable us measure the rate of growth of gdp, equation 9 transforms to a semi – log (log lin) model. (see gujarati, 2007:182). this will also ensure numerical accuracy. equation (9) transforms into a semi log model as follows. in gdpt = β0 +β1tpst + β2 prcyt + β3pucyt + β4irst + β5exrt + t… (10) equation (10) is the general model specification for objective (2). this model assumes that all the variables are well behaved. that is each of the variables is stationary at order zero. otherwise, equation (10) translates to: international journal of economics and financial issues, vol. 2, no.3, 2012, pp.357-372 364 ∆foln gdptβoβ1 (∆f1tpst-i) β2(∆f2prcyt-i) β3(∆f3 pucyt-i) β4(∆f4irst-i) β5(∆f5 exrt-1)t (11) where: ∆= difference operator t = time equation (11) assumes that: f0  f1, f2, f3, f4, f5 else, if f0 is equal to any of f1, f2, f3, f4, f5 then a test for co – integration will be carried out between the endogenous variable and that explanatory variable (s). if the unit root test shows evidence of co – integration, we introduce an error correction mechanism. the equation (11) translates to an error correction model (ecm) as shown below: ∆foln gdptβoβ1 (∆f1tpst-i) β2(∆f2prcyt-i) β3(∆f3 pucyt-i) β4(∆f4irst-i) β5(∆f5 exrt-i) β 6(ecm)t-i+t (12) where: β6 = speed of adjustment ecmt-1 = error correction mechanism of the previous year. in order to ensure that our model is kept as simple as possible (i.e. parsimonious), equation (12) is transformed into an auto-regressive distributed lag (ardl) model as stated below: ∆foln gdpt = βo+i (∆fo lngdpt-i) βi   n i 1 ∆fizt-jb6(ecmt-i) t (13) i=1 where zt-j = vector of all other explanatory variables as contained in equation (10) apart from ecm. ardl (1, 3) shall be used to avoid unnecessary loss of degree of freedom. also to avoid specification error in our ardl model, a simulation process shall be applied. however, caution will be taken as not to totally marginalize the core variables of the research. note that if in the cause of model simulation, our auto regressive variable (∆fo lngdpt-i) becomes marginalized; then equation (11) translates to only distributed lag (dl) model as shown below: ∆fo in gdpt = β0 + βi n (∆fizt-j ) β6(ecmt-i) t (14) i=1 however, if the test of co integration fails to sail through, we will no longer estimate equation 13 and 14, rather equation (11). 3.2. justification of the models the two models for this study were carefully chosen to capture all the objectives of the study. the major characteristics of an econometric analysis are incorporated in the model specifications in a systematic manner. this study employed an autoregressive distributed lag to co-integration approach (ardl – ecm), which is a highly statistical technique/approach to determining the co-integration relation in time series data samples for validity (ghatak and siddiki, 2001). 3.3. estimation procedure the time series properties of the data will be examined using the ordinary least square (ols) technique .the choice of ols is due to its popularity in estimating time series econometric models. the parameters estimates of ols regressions normally have the best linear unbiased estimator (blue) property. the estimation commences with a unit root test to confirm the stationarity states of the variables that entered the model. in order to test for stationarity of the data used in this study, the augmented – dickey fuller (adf) test will be used. the first step is to test for stationarity at level, without constant and trend. if the variables are non – stationary, then the next step is to difference and test for the stationarity of differenced variables. if the variables become stationary after first difference then it is concluded that the variables are integrated of order one i.e. i (1). after that, cointegrating regression will be obtained from the normalized coefficients of the model generated from co integrating vector. should co-integration exist, the error correction model (ecm) will be estimated by applying the ecm version of ardl where the speed of adjustment to bank savings and bank credits in nigeria: determinants and impact on economic growth 365 equilibrium will be determined. in all, the diagnostic tests of the stochastic properties of the models will be carried out. 3.4. the unit root test to test for the stationarity of the data, we employ the augmented dickey fuller (adf) univariate unit root test. (dickey – fuller, 1981) equation (15) expresses the model for the adf test when only a constant is included. ∆savt = β1+β2savt-1+  m i 1 ώi∆savt-1+εt (15) where  savt is the differenced savings variable. β1 is the intercept parameter, β2 is the mean reversion parameter, ώi is the coefficient of the lagged domestic savings variable, m denotes the number of lags needed for bank credits, and εt is the white noise error term at time t. the null hypothesis therefore, if that nigeria’s domestic savings has a unit root, lag selection (value of m) will be determined by the akaike information criteria. 3.5. data sources the data for the study was obtained from the central bank of nigeria (cbn) statistical bulletin (various issues) and national bureau of statistics (nbs). all data series are annual and span the period 1970 2006. 4. empirical results 4.1 stationary test on tpsy d = first difference operator dd = second difference operator l = logging critical values; 5% = -.952, 1% = -2.639 ***1%, **5%, *10% table 2. unit root tests variable t-adf δ lag t-lag t-prob drir -5.6724** 15.636 1 1.9519 0.0603 ddrir -7.4509** 20.033 1 2.8067 0.0087 dltpsy -8292** 0.32807 1 1.3073 0.2010 ddltpsy -7.3402** 0.35675 1 2.7874 0.0091 dlpcy -3.7525** 0.054848 1 -0.23894 0.8128 ddlpcy -11.142** 0.048428 1 5.1521 0.0000 dlirs -6.2512** 0.54202 1 1.4109 0.1685 ddlirs -10.769** 0.63562 1 4.4978 0.0001 dlinfr -6.0853** 0.74255 1 2.3573 0.0251 ddlinfr -7.8207** 0.96446 1 3.1199 0.0040 dlfsd -3.9515** 0.18138 1 -0.17292 0.8639 ddlfsd -6.9727** 0.20902 1 2.0845 0.0457 the result from the table 2 above shows that there exists unit root problem in levels. hence, variables were differenced to achieve stationarity. also, we conducted a residual test. the result of the residual test of the long run relationship among the cointegrated variables is shown in table 3 below: table 3. residual test variable t-adf ∑ lag t-lag t-prob residual -3.0739** 0.036747 1 3.1320 0.0037 nb: ** indicates significant at 5% level, *indicates not significant at 5% level. the result above shows that the variables are not stationary at order zero and as such unit root is present in the model. the residual test of table 3 confirms the tie between saving and all the explanatory variables at 5% level of significance. this means that these variables are cointegrated. furthermore, long run relationship is a necessary and sufficient condition for running an error international journal of economics and financial issues, vol. 2, no.3, 2012, pp.357-372 366 correction model to check the adjustment to equilibrium following the generation of error correction mechanism from the residual test. ecmt-1 is the speed of adjustment to equilibrium in the model. the empirical result in table 4 shows that all our explanatory variables were statistically significant as shown by the t-value statistics. the coefficient of determination – r2 shows that explanatory variables explained approximately 98% of the variation in saving size. nevertheless, the impact of each variable is discussed in turn below; table 4. modeling tpsy by ols variable coefficient standard error t-value t-prob part r2 pcy 0.00019 0.00007 2.714 0.0068 0.2267 rir-1 -0.004754 0.000786 -6.051 0.0000 0.5580 fsd-1 0.30375 0.042015 7.230 0.0000 0.6431 irs-1 0.0014114 0.0004802 2.939 0.0864 0.2295 infr-1 -0.004837 0.000692 -6.994 0.0000 0.6278 ecm-1 -0.13018 0.10826 -1.202 0.2389 0.0475 r2= 0.98 dw=2.39 (1) per capita income (pcy) the result shows that per capita income has a statistically significant positive relationship with the size of saving. therefore, a unit increase in per capita income at present will lead to 0.00002 units increase in the total private domestic saving in the nigerian economy. this shows that as per capita income increases total private domestic saving increases though at a very low rate. the significance of this gdp per capita (pcy) is proper and good for the economy because growth in gdp per capita income will engender high savings and investment which will further lead to more growth in capital formation and reinvestment. however, the low level of the positive relationship between pcy and tpsy suggests that majority of the populace on the average, are low income earners. it then implies that an increase in people’s disposable income would lead to an increase in their propensity to save. the keynesian absolute income hypothesis is found to hold for saving behaviour in nigeria. the coefficient of per capita income is positive and statistically significant. thus the nigerian experience provides support for the argument that, for countries in the initial stages of development, the level of income is an important determinant of the capacity to save. in this respect, our results are consistent with the cross-country results of hussein and thirlwall (1999), loayza et al., (2000) and the results for india of athukorala and sen (2004). this implies that the high unemployment rate which results in low disposable income is a strong impediment in raising the saving rate in nigeria. further more, some empirical evidence show that the level of real per capita income has a positive impact on saving rates and that this is usually greater in low-income countries as against richer ones. loayza et al (2000) found that in developing countries, a doubling of income per capita is estimated to raise long-run private saving by 10 percentage points of disposable income. a direct implication is that development-enhancing policies are an effective means of rising private saving. pasinetti (1962) have argued that income inequality is an important determinant of saving. their models focus on functional distribution of income, that is, the type of distribution where income is the sole criteria. schmidt-hebbel and serven (2000) posit that the links between income inequality and saving cause income concentration to have a positive effect on household saving, but a negative effect on corporate and public saving. thus, they result in an ambiguous effect on aggregate saving. (2) real interest rate (rir) the result shows that real interest rate in nigeria has a statistically significant negative relationship with savings in the long run .this result does not conform to a priori expectation because theoretically, interest rate is expected to be positively related to savings. however, the result shows that a unit increase in one period lag value of real interest rate will lead to 0.005 unit decrease in total private domestic saving in the nigerian economy. this reverse sign expectation of real interest rate (rir) could be due to the following reasons: (i) it is high nominal interests that do indeed influence savers in nigeria rather than the real rate. this is in agreement with uchendu (1993)’s finding “that nominal savings interest rate is the main determinant of financial savings in nigeria”. however, real rate is still bank savings and bank credits in nigeria: determinants and impact on economic growth 367 significant in impacting on savings mobilization in nigeria. reduction in inflation rate and proper sensitisation of savers on the vital role real interest rate play on savings mobilization may make investors give due attention to real rates while trying to save or invest in deposit accounts. (ii) the rudimentary level of development of the nigerian financial sector in mobilizing savings through interest rate influence. some authors, including mckinnon (1973), shaw (1973), and athukorala and sen (2004) have argued that the relationship between real interest rate and saving is positive for a developing economy. they hinge their argument on the fact that the financial markets of these countries are not well developed. in an environment where self-financing and bank loans make up the bulk of investment funds, accumulation of financial saving is determined more by the desire to invest than the desire to live on interest income. as a result, the greater part of household saving will be in the form of cash and nearmoney assets. thus, the substitution effect will usually be much greater than the income effect of an interest rate change. our result is consistent with those of loayza et al., (2000). (3) financial deepening (fsd) the above results show that financial deepening which represents the level of financial sector development has a positive significant relationship with total private domestic saving. this result conforms with the early theoretical postulation that increased financial deepening leads to greater private domestic saving. as the result reflects, a 1% increase in one period lag of financial deepening, in the long run, will lead to 30% increase in the size of total private domestic saving in the nigerian economy. this shows that higher degree of financial sector development in nigeria will positively affect the size of saving in the economy. this can be enhanced by financial liberalization which consists of elimination of credit ceilings, interest rate liberalization, easing of entry for foreign financial institutions, enhanced prudential guidelines and supervision, and the development of capital markets. loayza and shankar (2000) find that financial development has led the private sector to increase the durable goods component of their assets. the effect of financial development on saving rates can be separated into a direct short-run impact, which is usually negative, and an indirect longrun impact, which is generally positive (loayza et al, 2000). however, whether increased financial development itself significantly increases overall propensity to save depends on the extent of substitution between financial saving and other items in the household’s asset portfolio. consequently, the expected signs of this relationship in the private saving function are ambiguous (athukorala and sen, 2004). (4) interest rate spread (irs) the above regression result shows that interest rate spread (irs) has a positive significant relationship with the size of domestic savings. that is to say, the higher the interest rate spread, the higher the saving, hence, the greater the level of private domestic savings in nigeria. as the result reflects, a 1% increase in one period lag of irs will result to a 0.1% increase in the size of private domestic saving in the long run. this result does not conform to a priori expectation but it is consistent with the finding of uremadu (2007). he suggests that the positive relationship of spread (irs) with savings could be due to the fact that people consider some other reasons for financial savings other than the spread and /or yield. (5) inflation rate (infr) the result above shows that inflation rate has a significant negative relationship with the size of domestic savings in the long run. this implies that persistent inflation has an adverse effect on private domestic saving in the long run. this conforms with theoretical postulations because during inflation period, savings have lesser value than the amount deposited, hence people are discouraged from saving. as the result reveals, a 1% increase in the one period lag of inflation rate will lead to 0.5 % decrease in the size of private domestic saving. since, domestic inflation rate (infr) is negatively significant in impacting on volume of savings mobilized in nigeria, there is need to reduce its bad effect via minimizing all inflationary pressures on the economy. its rise also affects negatively on both the real interest rate and spread, twin factors that policy makers have to always keep on guard while formulating policies to accumulate adequate savings for investment. the impact of inflation on saving in the life-cycle model is through its role in determining the real interest rate. this is based on the assumption of the absence of real balance effect of inflation and the non-existence of money illusion in people’s saving behaviour. athukorala and sen (2004) affirm that inflation may not always be neutral international journal of economics and financial issues, vol. 2, no.3, 2012, pp.357-372 368 because in the first place, the inflation rate is more difficult to predict in the long run than in the short run. besides, inflation brings about uncertainty in future income streams, thus resulting in higher savings on precautionary grounds. lastly, they posit that inflation could influence saving through its impact on real wealth. skinner (1988) and zeldes (1989) observe that an increase in uncertainty should raise saving since risk-averse consumers set resources aside as a precaution against possible adverse changes in income. carroll (1991) shows that uncertainty helps to explain why consumption is highly correlated with income in the case of young consumers who expect their incomes to increase in the future but do not know by how much. uncertainty also explains why the older population saves a positive amount as they face a lot of uncertainty regarding the length of their life and health costs. carroll and samwick (1995a) obtained results which suggest that precautionary saving may account for a large chunk of household wealth. loayza et al., (2000) find a positive and significant relationship between inflation and private saving rate. (6) error correction mechanism (ecm) the result shows that 13% of the error in the model can be corrected by the error correction mechanism of the immediate past (ecm_1). this means that the model returns to equilibrium by 13%.this may be due to some structural rigidity that affects savings in the economy, as well as other economic and political factors that inhibit the speed of adjustment between the short run and long run in our domestic economy. 4.2. modeling gdp by ols 4.2.1 stationary test on gdp d = first difference operator dd = second difference operator l = logging critical value; 5% = -1.952, 1% =-2.639 ***1%, **5%, *10% table 5. stationarity test variable t-adf δ lag t-lag t-prob dlgdp -2.5092* 0.32838 1 -1.4319 0.1625 ddlgdp -6.9666** 0.33415 1 2.24882 0.0321 dltps -1.5006 0.13577 1 -0.76821 0.4484 ddltps -6.6445** 0.12965 1 2.3177 0.0275 dlprcy -2.9157** 0.35815 1 -1.2664 0.2151 ddlprcy -11.170** 0.29484 1 5.1781 0.0000 dlpucy -3.0410** 0.19415 1 -2.7959 0.0089 ddlpucy -5.9384** 0.21874 1 0.95704 0.3459 dlirs -6.2733** 0.54066 1 1.4293 0.1632 ddlirs -10.781** 0.63465 1 4.5093 0.0001 dlexr -2.7350** 0.34051 1 -0.80567 0.4268 ddexr -6.4919** 0.359 1 1.8835 0.0694 the result from the table above shows that there is no suspicion of the presence of unit root at 5% level of significance. table 6. modeling gdp by ols variable coefficient standard error t-value t-prob part r2 constant 4.6753 0.83761 5.582 0.0000 0.5179 ltps_1 0.37482 0.44253 0.847 0.4039 0.0241 lprcy 0.73124 0.15297 4.780 0.0000 0.4407 lpucy-1 0.20251 0.089402 2.265 0.0311 0.1503 lirs-1 0.24757 0.10996 2.251 0.0321 0.1487 lexr-1 0.27853 0.095128 2.928 0.0066 0.2282 r2= 0.99 dw= 1.85 nb: ** indicates significant at 5% level, * indicates not significant at 5% level. bank savings and bank credits in nigeria: determinants and impact on economic growth 369 the above result shows that out of five explanatory variables four of them were statistically significant while total private saving (tps) was not statistically significant. the coefficient of determination r2 shows that explanatory variable explained approximately 99% of the variation in gross domestic product which is the proxy for economic growth. nevertheless, the impact of each variable is discussed in turn below: (1) total private saving (tps) the regression result shows that total private saving is positively related to economic growth proxied by the gross domestic product. as the result reflects, at one period lag, the elasticity of total private saving to gdp is 0.37. in other words, a 1% increase in tps leads to 37% increase in gdp in the long run. this implies that increased saving will enhance the growth of the nigerian economy. this conforms to a priori expectation since increased domestic savings will lead to greater availability of investment fund which will lead to greater capital formation, increased productivity, and higher growth of the economy. however, this result is not statistically significant which could be as a result of the low savings culture of the nigerian populace. (2) bank credits to private sector (prcy) as the result reflects, prcy has a statistically significant positive relationship with economic growth. this implies that as bank loans to the private sector increase, we expect that a rational consumer will put that into good use, and as such boost the economic growth of the country. this conforms to a priori expectation since increase in bank credits to the private sector will enhance private sector transactions level and investments within the economy and subsequently accelerate the growth of the economy. however ,the result shows that the elasticity of bank loans to private sector is 0.73.this means that the degree to which economic growth increase as a result of a 1% increase in prcy is 73%.this result further reinforces the significance of private sector development in contributing to economic growth of the nation. the greater the level of funding and support given to private sector by banks, the higher its contribution to the acceleration of economic growth. this is consistent with the finding of azege (2007) and orji (2009). (3) bank credits to public sector (pucy) the result shows that pucy has a statistically significant positive relationship with economic growth proxied by gdp. this reveals that economic growth is significantly enhanced by increase in government expenditure funded by borrowing from the banks. this government funding by borrowing is done through the bond market. hence, this result conforms to a priori expectation since increase in government expenditure will increase output and boost economic growth. however, as the result reflects, the elasticity of pucy to gdp is 0.2 at one period lag. this implies that the degree of responsiveness of economic growth to a 1% increase in bank loans to the public sector is 20%.since government or public sector has a direct influence on the economy, one cannot underestimate the impact of government expenditure on projects funded by private banks on the economy. (4) interest rate spread (irs) our regression result reflects that interest rate spread (irs) has a statistically significant positive relationship with economic growth. the result shows that at one period lag, the elasticity of economic growth to irs in the long run is 0.25.this implies that the degree of responsiveness of economic growth to a 1% increase in irs is 25% in the nigerian economy. since economic growth hinges on the availability and accessibility of loans at the right prices, investment spending and capital formation would be encouraged so long as the projected net returns on investment yields a profitable income (uremadu, 2007). (5) exchange rate (exr) we can deduce from our regression result that exchange rate has a statistically positive relationship with economic growth (proxied by gdp). this does not conform with the theoretical postulation that as the exchange rate appreciates against the domestic currency, net exports fall and gdp, which is the proxy for growth, decreases as well. but for the nigerian economy, as reflected in the result, elasticity of gdp to exr at one period lag is 0.3.this implies that the degree or responsiveness of economic growth to a 1% increase in exchange rate is 30% in the long run. however, this result reveals that as exchange rate continues to increase in favour of the nigerian economy, in the long run it will lead to increase in economic growth. international journal of economics and financial issues, vol. 2, no.3, 2012, pp.357-372 370 5. conclusion and recommendations this study has investigated the determinants of bank savings and the impact of bank credit on economic growth in nigeria. following the behavioral pattern of the variables of this study we adopted two impact models, error correction distributed lag model and distributed lag model. the result of the error correction distributed lag model shows that all the explanatory variables were statistically significant. also, the coefficient of determination (r2) was found high which showed that the explanatory variables were able to account for the total variation of the dependent variable – size of saving. the value of durbin-watson statistic (dw) shows that there was no presence of autocorrelation; hence, the model produced a parsimonious result. the empirical result of the distributed lag model shows that out of five explanatory variables, only four of them were statistically significant. such variables include logged bank loans to private sector ,logged bank loans to public sector at lag one, logged interest rate spread at lag one, and logged exchange rate at lag one. also the coefficient of determination (r2) is found to be a high which indicates that the explanatory variables were able to account for the total variations of the dependent variable –gross domestic product. the value of durbin-watson statistics (dw) shows that there was no presence of auto correlation; the model produced a parsimonious result. some major recommendations for policy can be drawn from the analysis above. these include; 1. the focus of development policy in nigeria should be to increase the productive base of the economy in order to reduce unemployment and improve the per capita income of the people. for this to be achieved, a diversification of our resource base is indispensable. the policy thrust should include a return to agriculture, the adoption and implementation of a comprehensive energy policy, with stable electricity as critical factor, the establishment of a viable iron and steel, industry, the promotion of small and medium scale enterprises and a serious effort at improving information technology. increase in per capita income and reduction in unemployment will lead to greater services which will consequently drive growth through investment and capital formation. 2. government should gear its efforts towards reducing domestic inflation in order to arrest its negative impact on both real interest rates and spread. the recent move by the central bank of nigeria to adopt inflation targeting is a step towards the right direction if the necessary macro economic environment is put in place for its implementation. 3. there is need for government to pursue financial sector development because from our analysis we discovered that financial deepening will encourage increase in the size of saving. when the size of saving is increased, enough bank loans will be available for both the private and public sector which will enhance economic growth. to this end therefore, there is need to develop our financial intermediaries towards greater effectiveness and efficiency. a sound financial system instills confidence among savers such that resources are effectively mobilized to increase productivity in the economy. 4. there should be determined effort by the monetary authorities to bridge the widening gap existing between lending rate and savings rate, so that the people will be fully motivated to save in a bid to generate needed loanable funds for investment in nigeria. 5. in line with one of needs financial sector strategies, exchange rate in nigeria should be stabilized within favourable boundaries and made more competitive to enhance nigeria’s export promotion targets thereby discouraging unwholesome importation of ostentatious goods which reduces people disposable income and savings ability. 6. the structure of credit allocation by the commercial banks should be made to favour the private sector more than the public sector since the impact of credit on economic growth is more from the private sector than the public sector. references afolabi, j.a., ogunleye, r.w., bwala, s.m. 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(1994), “macroeconomic policy and stock market efficiency in nigeria: a case study” in: achi, a., wangwe s., and drasek, a.g (eds.). economic policy experience in africa: what have we learned? nairobi: aerc. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(4), 140-146. international journal of economics and financial issues | vol 8 • issue 4 • 2018140 the economic effects of the tax reform: dynamic input-output model approach cheng-yih hong1*, chen-jung hsu2, jian-fa li3 1faculty of finance, chaoyang university of technology, taiwan, 2department of business administration, chaoyang university of technology, taiwan, 3faculty of finance, chaoyang university of technology, taiwan. *email: hcyih@cyut.edu.tw abstract the financial crisis in 2008 severely damaged taiwan’s economy, increased unemployment, and reduced the national income level, which has remained low ever since. these consequences have affected funding for various pension systems, particularly national pensions, and thus are of great concern to the government. the national pension act stipulated a 1% business tax increase to fund the national pension system. hence, this study investigates the impact the act on economic growth and offers feasible suggestions for reform based on empirical evidence. dynamic input-output models are designed to analyze the various positive and negative impacts on the economy. empirical evidences suggests that although raising business tax by 1% yields certain negative outcomes, proper use of transfer expenditure with financial flexibility yields more positive outcomes, manifested in the growth of nt$ 8.622 billion, 2.2 billion, and 2.256 billion in induced production, gross added value, and earned income, respectively, as well as the employment increase of 3232 new workers. finally, through the tax revenue model, transfer expenditure is estimated to yield an additional nt$ 5.4711 billion from business tax, personal income tax, and corporate income tax as a “fiscal dividend.” keywords: tax reform, dynamic input-output model, business tax, economic effects jel classifications: c67, d57, e62, h20 1. introduction the financial crisis in 2008 not only severely damaged the world’s economy but also greatly increased countries’ debts and decreased their fiscal spaces, thereby causing difficulty implementing national insurance in most countries. once a country falls into financial difficulty, the promotion and maintenance of national insurance becomes extremely challenging. one such example is the current situation in taiwan, which is further compounded by the combination of an aging society and low birth rate, both of which exacerbate uncertainty over the funding of the national pension system. modern governments should not overlook the close interrelationships between a country’s tax structure, economic growth, and national pension system. the tax structure and economic growth influence one another, and these two factors combined determine whether the national pension system is tenable. numerous countries are currently facing the same problems as taiwan, namely issues relating to the soundness of the national pension system’s financial structure, an aging society and low birth rate, imbalance in state revenue and expenditure, and social problems due to globalization, all of which intensify the difficulties of maintaining a national pension system. according to article 47 of taiwan’s national pension act, “ the funding for the subsidized premium and related expenses which should be assumed by the central competent authority according to the act will be in the following orders. (1) surplus from public welfare lottery for the national pension payment; and (2) increase the levying rate for business tax by 1%.” the levying rate for business tax refers to taxation to maintain financial soundness in the national pension system, a goal that other countries have attempted to achieve through tax reform. one notable example is japan, which relies on increased consumption tax to support its social security system, including basic pensions. however, previous studies have indicated that raising business tax affects not only a country’s economic growth and financial structure and causes price fluctuations but also its human capital and population growth. hong, et al.: the economic effects of the tax reform: dynamic input-output model approach international journal of economics and financial issues | vol 8 • issue 4 • 2018 141 in summary, national pensions are part of a country’s social security system, which affects quality of life among the populace. therefore, developed countries all view national pensions as a symbol of national progress. the taiwanese government is currently considering the feasibility of implementing a tax reform to maintain its national pension system, and thus must increase the levying rate for business tax to ensure financial soundness. although this could reduce economic activity in society, the additional revenue from business tax could help mitigate the monetary burden of the national pension system, improve social welfare, and increase tax revenue. therefore, the present study investigates two aspects of increasing the levying rate for business tax by 1%. the first is the impact of such an increase on the economy. the second is the economic spillover of weakening the fiscal crowding out effect. moreover, time must be considered. raising business tax could cause commodity prices to rise (corporate goods price index and consumer price index) and consumer demand to drop, thereby negatively affecting the economy and increasing the unemployment rate. however, raising business tax by 1% to fund the national pension system could increase fiscal spaces for the government and increase the budget available for social security, thereby improving the economy and increasing the employment rate and tax revenue. to investigate negative economic impact, the present study must establish an industrial relations price spillover model, economic spillover model, and employment model. to investigate positive economic spillover, a tax revenue model and employment model are required. all of these models are based on the dynamic industrial relations equilibrium model with adjustments corresponding to their purposes. 2. literature review in 2014, japan announced a social insurance and tax reform to raise consumption tax to 8%. the additional revenue would be used to provide half of the national treasury’s share of the funding for national pensions. the reform was designed as a measure to ensure stable funding for national pensions and japan has plans to further raise consumption tax to 10% in the future to further strengthen the financial structure of the social insurance system. governments often rely on tax reform to replenish fiscal revenue or adjust the tax structure to stimulate economic growth. hence, financial policies are frequently used as solutions to postwar economic and social problems (judd, 1987; chamley, 1986; koester and kormendi, 1989; barro, 1990; turnovsky, 1990; rebelo, 1991; jones and manuelli, 1992; stokey and rebelo, 1995; razin and yuen, 1996; uhlig and yanagawa, 1996; kim, 1998; canton, 2001; yakita, 2003; hek, 2006). recently, some countries have implemented tax reforms to stabilize social insurance funding and maintain the social security system. economic growth, tax reform, and social security must all be considered for a country’s future development. previous studies have provided extremely variable information regarding the precise nature of the interrelationships between these three factors, indicating that differences related to time, location, and the environment can result in different conclusions (marsden, 1983; skinner, 1987; koester and kormendi, 1989; martin and fardmanesh, 1990; wang and yip, 1992; mendoza et al., 1997; kneller et al., 1999; myles, 2000; angelopoulos et al., 2007; keen et al., 2011). keen et al. (2011) concluded that raising consumption tax affects a country’s level of economic activity in the short term; however, this view is not shared in all countries. therefore, the present study constructs a literature review on the economic impact of tax reform and changes in the tax structure on economic development to further understand the issues surrounding national pensions. tax revenue is a problem closely related to considerable economic growth. this is particularly noticeable among the members of the organisation for economic co-operation and development (oecd), which commonly adopt tax reform as a major solution to tax revenue, although the results vary from country to country (kneller et al., 1999; gesko, 2013; klitgaard and christian, 2014). kneller et al. (1999) suggest that distortionary taxation decreases economic growth, whereas nondistortionary taxation does not. angelopoulos et al. (2007) indicate that different tax rates cause varying degrees of impact on economic growth; raising earned income tax reduces economic growth, whereas raising capital gains tax and corporate income tax achieves the opposite chiefly because the government uses tax revenue for productive investment, thereby stimulating economic growth. mendoza et al. (1997) analyze consumption tax, capital gains tax, and earned income tax and found that although different tax rates lead to varying degrees of impact on economic growth, the impact of each type of tax was negligible and nonsignificant. in addition to studies on developing countries, marsden (1983) compares countries with both high and low income and found that in such countries, the average tax rate invariably exerts a negative effect on economic growth. skinner (1987) indicates that gross tax revenue is negatively correlated with economic growth. martin and fardmanesh (1990) investigate tax burden to analyze economic growth and found the two to be negatively correlated. koester and kormendi (1989) argue that the average tax rate has a nonsignificant influence on economic growth, a finding corroborated by wang and yip (1992). branson and lovell (2001) maintain that the tax burden to be negatively correlated with economic growth. harberger (1964) asserts that changing the tax rate influences only investment behaviors and not economic growth and that tax policies exert little impact on long-term economic growth. engen and skinner (1996) assert that although lowering tax rates stimulates economic growth, raising them does not necessarily negatively affect economic growth. milesi and roubini (1998) contend that consumption tax and capital gains tax hinder longterm economic growth. some studies have explored the economic impact of altering the rates of different tax types. yamarik (2000) indicates that direct taxes are detrimental to economic growth, whereas indirect taxes have only a nonsignificant effect on economic growth. kocherlakota and yi (1996) conclude that neither highest tier personal income tax rates nor the effective rate of protection hong, et al.: the economic effects of the tax reform: dynamic input-output model approach international journal of economics and financial issues | vol 8 • issue 4 • 2018142 significantly contribute to economic growth in the united states. lee and gordon (2005) identify that corporate income tax has a significant negative impact on economic growth. kocherlakota and yi (1997) analyze economic growth from the perspective of the tax burden and tax structure and propose adjusting the tax structure to lower the ratio of direct taxes to indirect taxes, supplemented with comprehensive support measures to stimulate economic growth. charlet and owens (2010) propose a flat tax rate for value-added tax, as well as the use of revenue from broad-based value-added tax for transfer payments. by contrast, mirrlees et al. (2010) argue that multiple tax rates are more appropriate for value-added tax than other forms of tax. arnold (2008) reviews data of 21 oecd members after the 1973 oil crisis and indicates that under the premise of fixed tax revenue, when the portion of corporate income tax is levied by consumption tax and property tax, the resultant tax structure stimulates economic growth. auerbach and kotlikoff (1987) conduct a structural analysis on dynamic fiscal policies and identify that consumption tax is advantageous for economic growth because it encourages saving and enables greater capital formation than does income tax. brander and dowrick (1994) recognize the close association between economic prosperity and demographic transition, asserting that each country enjoys the “demographic dividends” that promote a positive increase in gross domestic product (gdp) per capita. bloom et al. (2001; 2003) suggest that as much as one third of economic growth can be attributed to such demographic dividends, an assertion observed in east asia (brander and dowrick, 1994; bloom et al., 2001; bloom et al., 2003; kelley and schmidt, 2005; bloom et al., 2010). demographic transition changes the tax structure, thereby strengthening factors of uncertainty in the maintenance of the national pension system. because of aging societies and low birth rates, many countries have reached turning points in economic development. park and shin (2011) suggest that specific countries have gradually transformed from demographic dividends to a demographic burden. furthermore, tax reform affects not only economic systems but also commodity processes; the influence of business taxes on prices is notable in this regard. such influence is a focal point of tax reform, as asserted in previous studies (creedy, 1999; tait, 1991; murrell and yu, 2000; karadag and westaway, 2000; alm and melnik, 2005; sparks et al., 2004; shanmugam and sthanumoorthy, 2004). these studies have investigated the influence of tax reform on a country’s economy from various angles, focusing on developed countries. in addition, most of these studies have relied on conventional quantitative economic models for empirical evidence. because taiwan is in the process of becoming a developed country, its economic development is facing industrial transformation. hence, an investigation into its tax system or national pension system requires an analysis of its industrial structure. although a number of domestic studies on these topics have used industrial relations, they have either confined themselves to using conventional and unsophisticated models or have oversimplified the models used to analyze economic impact. such empirical analyses are prone to underor overestimation. moreover, static industrial relations models tend to overlook timerelated changes, which is another factor that can widen the gap between inferred results and reality. therefore, to investigate the economic impact of raising business tax by 1%, the present study relies on dynamic industrial relations models for more credible analysis of tax reforms and the national pension system. 3. empirical model 3.1. measurement of the economic spillover effects following miyazawa (2002) and hong et al. (2017b), the dynamic industry-related model could be constructed as follows: x t k d i i m a i m f e d+( ) = + − ) − +− −1 1 1( )] [( ) ] i is the identity matrix; k is investment coefficient matrixes, d=i−a−c, where consumption (c) and investment (k), a is the input coefficient matrix (n×n). tese i m f total economic spillover effects d direct spil � = −( )δ 1 llover effects d first indirect spillover ef i m f � �� �� + −( ) γ* δ 1 ffects d second indirect spillover effect i m f � ��� ��� + −( ) γ* δ 2 ss � ��� ��� (1) m̄ represents the diagonal matrix of import coefficient (n×n); is the amount of the domestic final demand for industry i; γ* 1 = k d+i i i m)a − −( ) ( ) − −1 3.2. measurement of the gross induced added value tv w i m f total gross induced added value j g d direct gross ind � = −( )δ 1 uuced added value j g d first indirect gros w i m f � ��� ��� + −( ) γ* δ 1 ss induced added value j g d second indirec w i m f � ���� ���� + −( )γ*[ ]δ 2 tt gross induced added value � ���� ���� (2) wj g is the rate of gross induced added, and vj g is the gross added value in the industry j. w w w w w v x j n. g g g n g j g j g j =    = =1 2 1 2 , , , , 3.3. measurement of the induced income of employment te = w i-m f total induced income of employment j l 1 d direct income � ( )δ oof employment j l * 1 d first indirect induce + w i-m f � ��� ��� γ δ( )  dd income of employment j l * 2 d second indire + w [ i-m f ] � ���� ���� γ δ( ) cct induced income of employment � ���� ���� (3) hong, et al.: the economic effects of the tax reform: dynamic input-output model approach international journal of economics and financial issues | vol 8 • issue 4 • 2018 143 wljis the rate of induced income of employment. 3.4. measurement of the persons employed δ δ γl i m fi d= −( ) + − +{ }1 1 2* ( )( ) *i m f f hd d iδ δ (4) hi is the employment coefficient matrix. 3.5. measurement of the tax revenue 3.5.1. measurement of the business tax trbusinesstax * j g w t= −( ) + − +         i m f i m f f d d d δ δ δ 1 1 2 γ ( ) ( ) * * bb e (5) tb e is the indirect effective tax rate. 3.5.2. measurement of the personal income tax following the effective tax rate (jnto, 2010), the tax revenue model could be constructed as follows: trpersonalincome tax = −( ) + − +         i m f i m f f d d d δ δ δ 1 1 2 γ* ( ) ( ) ** *w tj g p e (6) tb e is the effective tax rate of personal income. 3.5.3. measurement of the corporate income tax trcorporateincometax = −( ) + − +         i m f i m f f d d d δ δ δ 1 1 2 γ*( ) ( )  * *w tj g c e (7) tc e is the effective tax rate of the corporate income. 4. empirical results this study conducts an empirical analysis on the positive and negative impacts of tax reform on a country’s economy. the results are as follows: 4.1. scale of economic impact the scale of the economic impact of raising business tax by 1% refers to the degree of impact on production, gross added value, and earned income. 4.1.1. estimated economic impact the mean price elasticity of industry demand is −0.05694 (hong et al., 2017a) and the increase of business tax by 1% yields a consumption loss of approximately nt$ 602.072 billion. the present study uses this as the basis for estimating the increased tax rate’s impact on the economy. table 1 shows the individual impacts of the direct effect, first spillover, and second spillover in the form of induced production, gross induced added value, induced earned income, and total unemployment. the direct impact is approximately nt$ 361.27 billion and the first and second indirect spillovers are approximately nt$ 255 billion and 131.17 billion, respectively. combined, these amount to approximately nt$ 747.42 billion worth of economic impact in the form of induced production. such a loss in induced production further causes corporations’ direct gross induced added value (approximately nt$ 65.84 billion) and indirect spillover (approximately nt$ 124.89 billion) to decrease by approximately nt$ 190.73billion. in addition, induced earned income was reduced by approximately nt$ 195.61 billion, which causes 28,024 people to lose their jobs and 15,099 to directly become jobless. 4.1.2. positive economic spillover effect the empirical analysis in the previous section verifies that although raising business tax can have a negative economic impact, it can also enhance flexibility in financial expenditure. shifting the lightened financial burden of transfer expenditure to social security stimulates the economy and increases employment, thereby creating a positive economic spillover effect. the economic spillover that lightens the government’s financial burden and allows for transfer expenditure amounts to approximately nt$ 833.64 billion, which enables 31,256 people to become employed. the gross induced added value and induced earned income increase by approximately nt$ 212.73 billion and 218.17billion, respectively, thereby effectively enhancing corporate business performance and labor income. a comparison table 1: economic impact spillover stage economic effect-induced gross added value-induced induced income of employment unemployed direct impact 361.27 65.84 125.58 15,099 first impact spillover 255.00 79.56 41.96 6,283 second impact spillover 131.17 45.33 28.06 6,641 total impact 747.42 190.73 195.61 28,024 unit: nt$ billion, people table 2: positive economic spillover effect spillover stage economic effect-induced gross added value-induced induced income of employment employment creation direct spillover effects 402.94 73.43 140.07 16,841 first indirect spillover 284.41 88.74 46.80 7,008 second indirect spillover 146.30 50.56 31.30 7,407 total spillover effects 833.64 212.73 218.17 31,256 unit: nt$ billion, people hong, et al.: the economic effects of the tax reform: dynamic input-output model approach international journal of economics and financial issues | vol 8 • issue 4 • 2018144 between tables 1 and 2 suggests that the positive effect is greater than the negative effect; induced production, gross induced added value, and induced earned income increase by approximately nt$ 86.22 billion, 22 billion, and 22.56 billion, respectively. in addition, 3232 people become employed. these figures imply that a government raising business tax to properly solve the problem of national pensions can yield more positive economic outcomes despite some negative effects. the positive economic effects appear to be wide-reaching and potent. in addition to induced production, they enable the creation of a corporate operating profit margin, increase labor income, and alleviate the unemployment problem, which has recently become more severe in taiwan. because taiwan is undergoing industrial transformation, how positively these effects influence different industries determines the level of future success. 4.2. economic spillover effects on tax revenue the empirical results in table 2 provide sufficient evidence of the transfer effects of using business tax revenue in fiscal policies. the spillover of these effects induces increased production, corporate gross added value, and earned income, all of which generate more tax revenue from business activities, personal income, and corporate profit. the present study investigates business tax, personal income tax, and corporate income tax. the results are listed in table 3. of the aforementioned three types of tax, personal income tax has the greatest source of revenue, contributing 71.64% of the total tax revenue of approximately nt$ 54.7 billion. by contrast, corporate income tax and business tax contribute 16.00% and 12.37%, respectively. regarding the spillover effect on tax revenue, the direct effect accounts for approximately nt$ 26.4 billion, whereas the two spillovers combined account for approximately nt$ 28.3 billion. 5. concluding remarks 5.1. conclusion the success of tax reform must be examined from positive and negative perspectives. therefore, this study uses a dynamic industrial relations model as the basis for an economic spillover model, gross added value model, earned income model, and tax revenue spillover model to examine various topics. this study draws the following conclusions: the models suggest that a government can increase its financial flexibility and maintain the required level social security expenditure, thereby negating the aforementioned economic impact and inducing additional production, gross added value, and earned income of nt$ 8.622 billion, 2.2 billion, and 2.256 billion, respectively, in addition to the employment increase of 3232 new workers. therefore, although raising business tax to support national pensions yields negative outcomes, it yields more positive effects with implementation based on appropriate planning. a government’s financial flexibility can further raise tax revenue. according to the estimation results, the increased revenue from business tax, personal income tax, and corporate income tax amounts to approximately nt$ 54.7 billion, which although not necessarily a large sum, faced with a growing fiscal deficit can be considered a fiscal dividend due to a properly executed tax reform. 5.2. suggestions after numerous stages of economic development and industrial transformation, particularly the substantial overseas investment and offshoring of major industries in the 1990s, the investment level and industrial hollow-out in taiwan have degenerated to the point that there is neither sufficient investment, be it foreign or domestic, to drive economic growth, nor a strong enough research and development capacity to enhance the industrial structure. consequently, taiwan’s economy has been weak for over a decade and the lack of momentum has gradually deprived the government of the tax revenue and financial flexibility required to maintain a balance between economic growth and the industrial structure. the financial crisis in 2008 severely damaged the world’s economy and delivered a heavy blow to taiwan by pushing it into a long-term recession and indirectly exposing serious shortfalls in the funding of labor pensions, the national pension system, and military, civil servant, and teacher annuities. this piqued concerns regarding the future and encouraged heated debates on the reform of various pension systems. economic theories tend to attach great importance to the tradeoff relationship, with particular emphasis on how to trade off efficiently. in the present study, the trade-off was to raise business tax by 1% to maintain the national pension system. however, this reform being implemented without supplementary measures inevitably cause a considerable economic impact that can hinder economic growth and raise the unemployment rate. therefore, whether this reform is an effective trade-off is questionable. according to the empirical analysis in this study, if tax reform is implemented to prevent a halt to the national pension system but is done so without appropriate supplementary measures, the economic impact alone will cause a loss of 0.1546% of the real gdp (nt$ 747.42 billion divided by nt$ 48,351.99 billion) in 2016 and a 0.2386% increase in unemployment. by contrast, proper supplementary measures implemented with financial flexibility could induce a gain of 0.1724% of the real gdp (nt$ 833.64 billion divided by nt$ 48,351.99 billion) and a 0.2661% decrease in unemployment. therefore, the difference between table 3: economic spillover effects on tax revenue spillover stage direct effects first indirect spillover second indirect spillover total effects business tax 3.270 2.308 1.187 6.766 personal income tax 18.944 13.371 6.878 39.193 corporate income tax 4.230 2.986 1.536 8.752 total tax revenue 26.444 18.665 9.601 54.711 unit: nt$ billion hong, et al.: the economic effects of the tax reform: dynamic input-output model approach international journal of economics and financial issues | vol 8 • issue 4 • 2018 145 the two approaches determines the impact on the economy and outcome of the practice. economic development is closely related to the economic system. in particular, the social security system not only governs the health and quality of life of the populace but also represents advancement for a civilized country. however, the implementation and maintenance of a national pension system require stable funding and cannot depend on the country’s fiscal budget in the long term. this is particularly true in times of economic instability because a country would be hard pressed to support its national pension system on a limited budget. this study verifies that raising business tax yields positive and negative outcomes and recommends relaxing financial policies for sufficient financial flexibility. therefore, the taiwanese government is advised to stimulate the economy through financial expenditure (transfer expenditure in this study’s analysis) to not only overcome the impact 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(2000), can tax policy help explain state-level macroeconomic growth? economics letters, 68(2), 211-215. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(3), 105-111. international journal of economics and financial issues | vol 8 • issue 3 • 2018 105 the acceptance of islamic banking products in libya: a theory of planned behavior approach walid ali albashir1, yuserrie zainuddin2, shrikant krupasindhu panigrahi3* 1faculty of industrial management, university malaysia pahang, gambang, kuantan, malaysia, 2faculty of industrial management, university malaysia pahang, gambang, kuantan, malaysia, 3faculty of industrial management, university malaysia pahang, gambang, kuantan, malaysia.*email: pshrikant@ump.edu.my abstract the purpose of this paper is to identify key factors affecting acceptance level of islamic banking customers in libya. despite of growth of islamic banking all over the world, it is still underdeveloped financial sector in libya. libyan customers are unaware of islamic banking and are unable to make decision on the acceptance of islamic banking. we suggest a modified theory of planned behaviour model including perceived risk as an important ingredient to customer decision making process. the model is tested against a sample of 293 banking customers using self-administered survey questionnaire. the quantitative results revealed that subjective norm and perceived behavioural control are more significant to increase intention to use islamic banking. customer attitude and perceived risk was found to have no significant influence on intention to accept islamic banking at 0.05 level. this research suggests that islamic banks need to develop effective marketing strategy emphasizing on sharia instrument like islamic assurance and beliefs along with perceived risk to satisfy the value of potential customers. as an implication, focusing on risk management while providing quality information to the customers towards islamic banking products will lead to increase customer’s intention. keywords: islamic banking, theory of planned behavior, behavioral intention, perceived risk, customer involvement jel classifications: c3, g41, o33 1. introduction islamic banking is growing rapidly all over the globe. as reported by (linda, 2014), for years islamic banks have been growing at a double digit pace at an average rate of 17% per year, two to three times faster than the conventional banks. however, in an interview to reuters by libyan governor saddek omar elkaber attending the opening of the arab economic forum 2013 mentioned that the growth of islamic banking has not encouraged and have been dominated by the undeveloped financial sector in libya (laessing, 2013). standardization is the biggest problem in the islamic banking industry to interpret of what is and what not islamic banking is. the various interpretations may confuse customers and may affect their selection of the islamic banking services. the common problems that customers feel uncomforted with are a lack of transparency in products and services (panigrahi et al., 2018). such issues lead to a decrease in intention to go for islamic banking products. over recent decades the islamic banking industry has emerged as one of the fastest growing industries and has spread to all corners of the globe, receiving wide acceptance from muslims and nonmuslims (iqbal and molyneux, 2016). islamic banking is now a well-known term and has emerged as one of the most important industries worldwide. islamic banking is known for its interest free concept and operates in many countries including bahrain, pakistan, jordan, iran, sudan, united kingdom, singapore and malaysia. islamic banking and finance has undergone rapid transformation and growth from an industry striving to satisfy the muslim community needs, to a multibillion dollar industry upholding islamic principles. this study employs ijzen’s theory of planned behavior (tpb) to investigate the level of islamic banking usage amongst customers in libya. the study on islamic banking will shed some light on the intention of the libyan banking customers. the study is unique because there have been lack of studies focusing on adoption albashir, et al.: the acceptance of islamic banking products in libya: a theory of planned behavior approach international journal of economics and financial issues | vol 8 • issue 3 • 2018106 of islamic banking in libya. libyan have already implemented the islamic banking system as an alternative to the conventional system, but still the adoption of the islamic products are not widely accepted by the customers. this may be due to lack of information availability, lack of perception on quality of the islamic products, low innovation of islamic banking compared to convention banking system. furthermore, it is very crucial for the customers to patronize islamic banking system (dusuki and abdullah, 2007). perception of libyan customers towards islamic banking products (ahmad and ahmad, 2004) and key factors influencing such perception is the main theme of this study. 2. theoretical reviews as technical barriers disappear, a pivotal factor in harnessing this expanding power becomes the ability to create applications that people are willing to use. therefore, practitioners and researchers require a better understanding of why people resist using information technologies in order to devise practical methods for evaluating technologies, predicting how users will respond to them, and improving user acceptance by altering the nature of technologies and the processes by which they are implemented. the tpb was first proposed by ajzen (1991) from the background of social psychology. in psychology, the tpb is a theory about the link between beliefs and behavior (ajzen, 1991). according to tpb there are three main constructs that identifies intention to use the technology. these are attitude, subjective norm (sn), and perceived behavioral control. this study included perceived risk as an additional component in tpb to propose a modified tpb model that can improve the acceptance level of the customers. this study is concerned to explain customer’s intention to use islamic banking products. however, in this area and concept of behavioral intention prior studies have deliberately focused in developed countries (chibelushi and costello, 2009; dwivedi et al., 2009; karakaya and shea, 2008; mohamad and ismail, 2009) as well as in developing countries (duncombe, 2011; olatokun and kebonye, 2010; sin et al., 2009; sutanonpaiboon and pearson, 2006) have concluded that the chapter on adoption is old whereas; others have urged for the new dimensions of understanding islamic banking adoption and usage issues by customers. 3. review of literature while numerous studies have been undertaken to examine issues in the wider context of islamic banking system, comprehensive and continuous research in the area of marketing particularly, consumer adoption of islamic banking services in the specific context of libya has been rather limited. it is crucial to gain a thorough understanding of the differentiated needs and preferences of customers between these two regions, so that appropriate marketing strategies can be formulated to capture the market, instead of having a uniform marketing strategy for all the segments across (lim et al., 2006; zeithaml, 2000). a detailed theoretical map has been developed using a quantitative paradigm. we suggest a model with the factors like customer attitude, sn, perceived behavioral control, perceived risk, customer involvement and perceived usefulness affecting intention of customers accepting islamic banking. 3.1. customer attitude (ca) customer attitude is defined as an individual’s attitude towards an object need not be related to any single behavior performed with respect to the object (cushman and mcphee, 2013). an individual’s attitude towards an object influence the overall pattern of response to the object. in order to understand the reason for islamic banking adoption it is important to understand individual’s behavioral attitude that influence their purchase intention (george, 2004). some studies have focused on customer’s attitude towards ict adoption jun and jaafar (2011) who found that online security, privacy protection, and after sale service are believed to be complicate for online purchase and could directly influence customer’s attitude. furthermore, thaw et al. (2012) investigated on consumer’s perspective towards islamic banking adoption and concluded that secured online transaction privacy of personal data and trustworthiness of islamic banking are crucial elements that affects individual’s attitude. the attitude towards the behaviour is determined by the sum of accessible behavioural beliefs, which refers to the subjective probability that the behaviour will achieve expected outcomes positively or negatively. 3.2. subjective norms (sn) sn is defined as a person’s “perception that most people who are important to him/her think he/she should or should not perform the behavior in question” (ajzen and fishbein, 1980). attitude toward behavior is a function of the product of one’s salient beliefs that performing the behavior will lead to certain outcomes, and an evaluation of the outcomes, i.e., rating of the desirability of the outcome. sn is the second main determinant of tpb that is assumed to be a part of belief that specific individuals approves of disapproves the performing of behavior (ajzen, 2005). individuals who believe that they are motivated to comply with others to perform their behavior are actually surrounded with social pressure and the individuals who are motivated to comply and disapprove by avoiding performing the behavior will have sn. on the other ground, two empirical works have examined the acceptability of bank clients on the musharakah mutanaqisah home financing namely (fauziah et al., 2008). moreover, studying sn, and its effects on the consumer’s intention towards the actual behavioural (e.g., (ajzen and fishbein, 2004; al-maghrabi and dennis, 2012; sadeghi and farokhian, 2011). these studies however have examined different research objective. thus it can be said that sn is expressed symbolically that is the combination of normative beliefs and motivation. items to measure this construct are adapted from (yap et al., 2012). 3.3. perceived behavioral control (pbc) pbc is defined as “an individual’s perception of how easy or difficult it would be carry out a behaviour. pbc denotes a subjective degree of control over the performance of a behaviour for the given outcome.” pbc is included as an exogenous variable that has both a direct effect on actual behavior and an indirect albashir, et al.: the acceptance of islamic banking products in libya: a theory of planned behavior approach international journal of economics and financial issues | vol 8 • issue 3 • 2018 107 effect on actual behavior through intentions. the indirect effect is based on the assumption that pbc has motivational implications for behavioral intentions. when people believe that they have little control over performing the behavior because of a lack of requisite resources and opportunities, then their intentions to perform the behavior may be low even if they have favorable attitudes and/or sn concerning performance of the behavior. in the literature of social psychology, pbc has been debated topic on the nature and role of pbc by clarifying the role of tpb and describing its underlying dimensions. control beliefs and perceived power control play an important role for the acceptance of islamic banking. ajzen (2002) proposes tpb with the same tra tools but with perceived behavioral control (pbc) as an additional instrument that captures volitional factors for predicting human behavior (ajzen, 1991; conner and armitage, 1998). meanwhile, yu (2012) uses knowledge as a moderator of the relationship between attitudes, sn and perceived behavioral control on intention to buy. 3.4. perceived risk (pr) the special characteristics of financial services and the higher levels of perceived risk that confront consumers to influence and support consumers’ online banking services adoption decision (aldás-manzano et al., 2009). although studies showed perceived risk as an important factor that influences online banking adoption (gerrard and cunningham, 2003; hewer and howcroft, 1999), only limited work has been carried out to identify risk dimensions in this context (littler and melanthiou, 2006). moreover, it is also crucial for managers to understand the barriers to islamic banking adoption in order to assign resources effectively to obtain competitive advantages and increase efficiency in the banking system. for a client to claim a benefit in the form of return as propagates by the islamic principle, he should equally assume some risk (ghayad, 2008; kamarulzaman and madun, 2013). perceived risk therefore plays an important role in trade and investment decision of islamic banking consumers. researches in different contexts reveals the effect of perceived risk on the consumer decision (gerrard and cunningham, 2003). unlike in conventional banking where the depositors assume less risk due to the prior knowledge of the return, islamic banking depositor faces a relatively high risk as the amount to be earned is not known rather depends on the outcome of the business (amin et al., 2011) noted that in conventional system the capital of the financial institution is at risk before that of the depositors. but in islamic financial institutions the reverse seems to be the case. this, according to thambiah et al. (2013) affects the level of confidences of the users of islamic banking products and services. the aforementioned review of literature provides basis of developing research framework of the current study and its hypothesis. tpb model is adopted as an underpinning foundation to investigate the relationship between the variables in the study. customer attitude, sn perceived behavioral control and perceived risks are hypothesized to have positive influence on customer involvement, perceived usefulness and behavioral intention to use islamic banking products. the research framework is provided in figure 1. 4. methodology quantitative method using positivist paradigm was adopted in the study. the targeted population were the existing islamic banking customers in libya. they were targeted because they possess knowledge and experience and ability to make decision on islamic banking products and shariah complaints. to ensure the respondents sampled matched the purpose of the study, nonprobability purposive sampling technique was used to ensure the collected data were from valid sources. the purpose of the survey instrument used in this study was to investigate the extent to which the tpb factors improve customer involvement and their intention to accept islamic banking system in libya. regression analysis and confirmatory factor analysis were utilized to test the hypotheses postulated in the study. purposive sampling technique was used to select the sample and in order to achieve positive response rate, 500 questionnaires were distributed to the selected customers that reach out to the islamic banking counter in the libyan banks. out of the 500 distributed, the researcher was able to collect 305 questionnaires during the period of four months with an equivalent percentage of 61%. furthermore, 12 questionnaires out of 305 were removed due to unanswered response or biased responses. thus with an effective sample of 293 and the overall response rate of 58.6%, the data for the hypotheses testing and data analysis were made accessible. response rate is provided in table 1. the rate of response depends on the geographical areas of the country. in order to increase the response rate the rule of thumb provided by zikmund and babin (2006), the questionnaire should not exceed six pages and if the missing data is more than 10%, then such responses cannot be used for the analysis anymore figure 1: research framework table 1: response rate for the survey survey responses number of questionnaire percentage total questionnaire distributed 500 100 completed questionnaire received 305 61 unusable questionnaire 12 <20 unanswered items usable questionnaire 293 58.6 albashir, et al.: the acceptance of islamic banking products in libya: a theory of planned behavior approach international journal of economics and financial issues | vol 8 • issue 3 • 2018108 (cavana et al., 2001; hair et al., 2013a). the response rate in this research is considered as appropriate as it comes under the range of 21–50% response rate provided by (carle et al., 2009; randall ad gibson, 1990). in line with the other studies in the arabic countries (moideenkutty et al., 2011) performed research based in oman with the response rate of 49.5%, (agnaia, 1996) with an response rate of 27% in the case of libyan companies, (yildiz and gomes, 2011) with the response rate of 47% in the case of libyan companies. thus based on the previous study’s response rate in the developing arab countries, the response rate of 66.2% is acceptable. in total, 2.4% of the respondents failed to participate in the study due to incomplete questionnaire. these were valid as the percentage was too low and as the interpretation and discussions of the results were not affected. 5. results quality of the data collected through survey questionnaire was performed to make sure the data can be analyzed. according to sekaran (2006) the survey responses collected must be at least 75% in order to fulfill the purpose and objective of the study. furthermore, zikmund et al. (2012) mentioned that it is crucial to check the data quality via omissions, legality and consistency. information collected through survey may lack with uniformity as an example, the survey responses for the specific questions may not be ticked at proper place or few questions may be remained unanswered. thus editing of such data makes them relevant and appropriate without any errors. due to closed ended questions used for this study, the coding and editing was not a big issue as the responses were in numerical form. once the editing and coding of the data is performed, data screening process was performed to identify the missing data and ensure that the data entered is without any outliers and the data are normally distributed. according to plonsky (2015) data screening is performed to analyze whether the assumptions for advanced statistical process have been met by the study. however, martin and bridgmon (2012) mentioned that data screening process is crucial before going for the data analysis and hypothetical testing. 5.1. demographic background of the respondents a sample of customers having islamic banking account in libya were asked to complete a 43 items survey consisting of five point likert scale index including demographic questions and descriptive question on their views towards acceptance of islamic banking. full result of the demographic profile of the respondents are provided in table 2. out of 293 respondents, 250 were male and 43 were female. the age of the respondents stated that majority of the customers were of 51 and above. the demographic information on income showed that the normal range of salary for the customers were between 3001 and 5000 lyd. from the qualification of the respondents, it was found that majority of them (100 respondents) were having master degree followed with 73 respondents having a doctorate degree. from the qualification level of the respondents, it is confirmed that they had sound knowledge to give their view on the questions asked. knowledge of the respondents is also important to decrease the response bias (hair et al., 2006; kline, 2011). regarding the occupation, it was found that 136 customers are self-employed whereas 83 were students and 62 were employed. regarding the descriptive question, it was found that all the respondents were having islamic banking account. but, it was surprise to know that majority of the customers were unaware on islamic banking products. 5.2. reliability and validity table 3 show that the composite reliability for all the constructs meeting the benchmark of 0.70 (hair et al., 2013a; nunnally, 1978). according to grandzol and gershon (1997) reliability table 2: demographic information of the respondents demographic profile frequency (%) gender male 250 (85.3) female 43 (14.7) age (years) 20–30 32 (10.9) 31–40 40 (13.7) 41–50 72 (24.6) 51 and above 149 (50.9) income below 1000 lyd 1 (0.3) 1001–2000 lyd 32 (10.9) 2001–3000 lyd 80 (27.3) 3001–5000 lyd 123 (42.0) above 5000 lyd 57 (19.5) education intermediate 24 (8.2) bachelor 56 (19.1) masters 100 (34.1) doctorate 73 (24.9) others 40 (13.7) occupation housewife 12 (4.1) employed 62 (21.2) self employed 136 (46.4) student 83 (28.3) having islamic account yes 293 (100) no 0 (0) aware of islamic products yes 119 (40.61) no 28 (9.55) not sure 146 (29.2) is islamic banking better than conventional? yes 189 (64.5) no 34 (11.6) not sure 70 (23.9) table 3: reliability and validity test variables cr cronbach’s alpha ave perceived risk 0.838 0.809 0.565 perceived behavioral control 0.888 0.819 0.615 sn 0.888 0.839 0.666 customer attitude 0.890 0.854 0.671 customer involvement 0.843 0.827 0.571 perceived usefulness 0.874 0.870 0.582 behavioral intention 0.982 0.866 0.723 ave: average variance extracted; ave>0.5 is acceptable; cr>0.7 is acceptable. sn: subjective norm, cr: composite reliability albashir, et al.: the acceptance of islamic banking products in libya: a theory of planned behavior approach international journal of economics and financial issues | vol 8 • issue 3 • 2018 109 is the set of latent construct indicators that are consistent with their measurements. reliability represents the degree at which two or more indicators share in their measurement of constructs. reliability represents the degree at which two or more indicators share in their measurement of constructs. according to cronbach (1951), cronbach alpha is used because it did not require multiple administrations of the survey instruments. using confirmatory factor analysis, construct reliability and average variance extracted (ave) are calculated based on formulas by fornell and larcker (1981) to further confirm on the reliability of the constructs. composite reliability was used as an indicator to determine the reliability of the measurement scale of the constructs. in the measurement model, it was noticed that the ave for all the variables were above the required level of 0.50. thus it is confirmed that the criteria of ave was satisfied. the result on ave also provided an additional support for convergent validity. it was also possible to provide the discriminant validity between the factors due to positive definite issue of the matrix. 5.3. regression analysis in the structural model, direct influence of customer attitude, perceived behavioral control, sn, perceived risk, customer involvement and perceived usefulness on intention to use islamic banking were examined. structural equation modeling (sem) was used to confirm the hypothesized model in the form of structural model. according to (byrne, 2013; panigrahi et al., 2018), “sem is particularly valuable in data analysis where the patterns of interrelationships among the constructs are specified according to a prior established theory. the final re-specified model presented in figure 2 succeeded in configuring the important factors in the current research. after removing the non-significant items from perceived risk and perceived behavioral control, an examination of the goodnessof-fit indices showed that the model fitted the data effectively (χ2 = 647.103, df = 543, p = 0.000). the cfi = 0.977, tli = 0.975, rmsea = 0.026 and χ2/df = 1.192. based on an examination of goodness-of-fit indices including the normed chi-square value, final model appears to have a better fit compared to previous models. table 4 shows the standardized regression weights of the final re-specified model. in this model no path was found to be nonsignificant indicating that the model is acceptable. furthermore, table 4: standardized weight for final re‑specified model regression paths estimate cr p perceived_usefulness←perceived risk 0.593 6.661 *** customer_involvemnt←customer_attitude 0.074 1.158 0.247 customer_involvemnt←pb control 0.284 4.384 *** customer_involvemnt←subjective_norms 0.293 3.909 *** customer_involvemnt←perceived_usefulness 0.328 6.164 *** intention←customer_involvemnt 0.485 5.373 *** intention←perceived_usefulness 0.377 5.833 *** intention←customer_attitude −0.073 −1.21 0.226 intention←pb control 0.132 1.942 0.042 intention←subjective_norms 0.186 2.531 0.011 intention←perceived_risk −0.068 −0.923 0.356 the goodness fit indices was also in the range of the absolute fit threshold value provided by (hair et al., 2013b). pr3 was having factor loading of 0.288 and pbc4 was having 0.335 of factor loading which was < 0.5. thus these two items were removed from the final re-specified model. from the square multiple correlation result, it is noted that the model fit criteria are solved and there is a positive influence of perceived behavioral control (β = 0.284, p = 0.001) and sn (β = 0.293, p = 0.001) on customer involvement. furthermore, it was also found that perceived behavioral control (β = 0.132, p = 0.042) and sn (β = 0.186, p = 0.011) was also having significant influence on behavioral intention to accept islamic banking. with the significant standardized regression weights of all the constructs and items, the overall square multiple correlation was found to be 0.68 (68%) which is considered as very strong and significant finding of the study. finally, from the results of the re-specified model shown in figure.2, it can be seen that the cfi (0.9) (acceptable fit criteria) and rmsea < 0.08 is fit (hooper et al., 2008). this shows that the measurement model has a good fit with the data (anderson and fornell, 1994). thus overall the model is fit. figure 2: final re-specified model albashir, et al.: the acceptance of islamic banking products in libya: a theory of planned behavior approach international journal of economics and financial issues | vol 8 • issue 3 • 2018110 5.4. managerial implications the major implications of the current research for practice are discussed in emphasizing the importance of perceived risk in using islamic banking and presenting a tpb framework that is effective in developing the intention to purchase to enhance purchase intention of customers. with respect to the perceived risk dimension, this research provides valuable insights for the islamic banks by identifying the significant impact of perceived risk provided to the customers through islamic banking to buy their products. even for the islamic banking products providing a good risk management perspective plays a crucial role in customer’s positive attitude and intention to use islamic banking. the finding of the research suggests that creating a positive intention by focusing on risk management when providing quality information to the customers towards islamic banking products may be considerations for the banks to increase customer’s intention. 6. conclusions in the current study, the ability of the tpb in predicting intentions was investigated and the results at best were moderate to strong due to the inclusion of sharia instruments with islamic banking products. while all the hypotheses for the research are supported including the contribution of including perceived risk as an additional factor of the tpb, the result of the research are important regardless of consistent findings in statistical significance. from the square multiple correlation result obtained in figure 2 it can be concluded that the effect of perceived behavioral control towards intention was 13.2% followed by influence of perceived behavioral control on customer involvement by 28.4%. thus from the four attributes of tpb, perceived behavioral control and sn are very important for the increase customer involvement and intention. as a result, this research suggests that islamic banks develop effective marketing strategy emphasizing on sharia instrument like islamic assurance and beliefs along with perceived risk to satisfy the value of potential customers. future studies should consider the impact of various external variables like demographic factors, security, organisational factors like management support, customer value and many others in the islamic banking context. references 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(2012), business research methods. boston: cengage learning. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(1), 8-16. international journal of economics and financial issues | vol 9 • issue 1 • 20198 can corporate responsibility improve business financial performance? a research insight alphonse kumaza1*, yuanqiong he2 1huazhong university of science and technology, school of management, 1037 luo yu road, hongshan district, wuhan city, hubei province, people’s republic of china,2huazhong university of science and technology, school of management, 1037 luo yu road, hongshan district, wuhan city, hubei province, people’s republic of china. *email: getalphonse@gmail.com received: 23 october 2018 accepted: 24 december 2018 doi: https://doi.org/10.32479/ijefi.7286 abstract social responsibility engagement and business financial performance have received countless authorial observations. while many support the assertion that social responsibility imposes financial strains on the enterprise’s incomes, little proof exists to support the claim social responsibility engagement benefits the business. thus, the study’s scrutiny of the proposition has produced an ample and concrete argument for the postulation, having recognised volatility and contentiousness of the corporate/responsibility dichotomy. focused interviews generate data for analysis through an spss regression technique for findings. the result indicates statistically significant the numerical tests and coefficients, which attest to corporate responsibility (cr) profiting businesses and, therefore, a strong proof that cr prospers enterprises operations. these social values (including social licence, legitimacy and good corporate public standing) when quantified, represent profits for the business. the evidence, therefore, provides a platform for local authorities and corporations’ dialogue on the social change agenda for social justice. the research establishes that quantification, in monetary value terms, of nonfinancial social indicators proves cr flourishes business activities. thus, this measurement lack, for social licence, legitimacy and company’s good image, which constitute colossal corporate profits, and little scholarly work through this approach that social responsibility promotes business financial prosperity, is a significant departure from the traditional, general and unspecific treatment of societal non-financial assets. this is an unexplored, novel and pristine area and deserves a future academic examination. keywords: corporate responsibility, social licence, legitimacy, business financial performance, ghana jel classifications: l25, m14, o16 1. introduction corporate responsibility (cr) or corporate citizenship is a contested construct, and a terrain, which attracts huge authorial attention, delving into such areas as business appropriate roles and place in society and the resulting ramifications for business financial performance. the “old school” view that an enterprise has no business in social agenda except makes profits for its stockholders (friedman, 1970) perhaps invokes the passion for the ensued age-long debates among scholars. interestingly, there seem to be no endpoints insight and the bourgeoning and fast mutating character of cr continues to be disputed. the lack of monetary values measurement of host communities’ non-financial assets for corporations, namely social licence, legitimacy and company’s good image, which constitute colossal corporate profits, and little scholarly work through this technique for the proposition social responsibility promotes or favours business financial performance, is the gap in this field. in earnest, business active participation in social discourse is gathering momentum and the government’s public domain opening for private sector involvement signifies the commencement of an enhanced dialogue for social justice. however, the change waves sweeping across corporate social responsibilities’ (csr) this journal is licensed under a creative commons attribution 4.0 international license kumaza and he: can corporate responsibility improve business financial performance? a research insight international journal of economics and financial issues | vol 9 • issue 1 • 2019 9 management seems to be oblivious to a great number of companies which are unheedful to the social discourse agenda, betting the scrutiny of whether corporate responsibilities are achievable at great cost to business, or promote and improve business financial performance. of course, shell refusal for oil spillage accountability in niger delta contrary to its 2012 sustainability report and monsanto genetically modified seeds provision to farmers in contravention of its 2011 csr/sustainability report sharply contrast with aaron feuerstein’s donation at functions and paying the workers’ salaries for months when he rebuilds the fire-razed factory (byrnes et al., 1998), while kellogg company’s provision of technical assistance and direct services to african-american men and boys through the community pride food stores offering services and reviving richmond city and virginia, and runs top-notch free transports for customers and discounts for communal work participants. again, the norwegian-based norsk hydro assumption of responsibility, for the well-being of many towns by boosting the local economies via jobs, schools, and housing for the people (may et al., 2007), is an epic gesture and highly laudable. the foregoing represents the cr interesting and nebulous terrain, which is constantly managed by corporations for selfish profits interests, while others generously pursue good social objectives. this sharp blatant dichotomy observable in unheedful and heedful enterprises makes the corporate responsibilities agenda an inexplicable sphere, leading to abuses by the majority of transnational conglomerates with increasing business externalities and/or the compounding complications of markets inadequate measurements of corporate operating environments’ pollution. this difficulty has led to cr description as an oxymoron because social initiatives have been carelessly managed in stakeholder communities (devinney, 2009). the assertion, no studies ever proved that business financial performance improves just by engaging in corporate citizenship (vilanova et al., 2009) can be misconstrued that social accountability endeavours are without business benefits. however, enterprise requirement of the ‘social licence’ as legitimacy and acceptance indicator, which when quantified in monetary terms, represents huge income source to business, is empirically proven (interview with david johnson, stakeholder relations, west africa, gfgl, on 26th august 2016). it is believed that quantification in financial value terms, social licence, legitimacy, and acceptance can produce an imaginable financial windfall for businesses. the proposition that legitimacy and social good image of a business, when translated into financial terms, could represent a substantial monetary value for corporate entities dismisses the claim that cr reduces corporate profits and other financial assets. the paper believes the recent private sector’s enhanced activities in the previously excluded public domain is an indication of business readiness and willingness to dialogue with public authority for the social change agenda. thus, from a public perspective, cr is gradually becoming a framework to ensure public interests, restructure procedures by which enterprises demonstrate good citizenship vis-à-vis commitments to stakeholder constituencies. in view of the foregoing, the following queries such as ‘are the goals of social responsibilities of business being achieved?’ and ‘has corporate engagement in stakeholder community development initiatives improved business financial performance and/or outlook?’ deserve scrutiny. meanwhile, the overarching aim is to explain that corporate responsibility in the business governance agenda signifies a substantial capital for the enterprise and, therefore, validates a postulation which includes robust reputational and financial gains (lee et al., 2013). specifically, an argument is advanced to support the assertion corporate objectives and social responsibilities are in a constant flux yet benefit business and host communities, and that compliance with social commitments improves business monetary values and profits. in a nutshell, corporate citizenship is loosely deployed to include those initiatives that are undertaken by business in host communities to improve lives and build sustainable corporate operating environments and reduce enterprise externalities as a way of addressing the complex complications of markets inadequate measurements of business environmental pollution, while corporate governance denotes business general administration via the corporations control systems for achieving organisational objectives. 2. exploration and review of the literature 2.1. institutional theory from institutional theory perspectives, corporate citizenship is considered a governance system, which acknowledges stakeholder constituencies and their vast interests. in this context, carroll (1999) references cr as obligatory tasks through legal compliance or societal expectation, yet some scholarly articles highlight its benevolence character. vogel (2006) describes those strategies of organisations which seek a conducive working atmosphere for workers, advance the concerns of communities and that which benefits business as constituting social responsibility. this view agrees with the agency theory and likens the explanation of business characteristics in management research (garriga and melé, 2004) to disincentivise business ethics (fourcade and khurana, 2013). unfortunately, charity and/or benevolent character of cr even receives scholarly praiseworthy in prominent policy papers of leading business groups (kinderman, 2012) including some public policy institutions as the employment green paper (2001) defining the construct as an enterprise voluntary commitment that seeks stakeholder needs. nonetheless, the theory seeks to place social responsibility clearly within a broader field of state-influenced regulation, which reduces a business-centered approach; a mechanism considered, however, as inconclusive (orlitzky and swanson, 2008). the theory also frowns on the notion that corporations embrace social responsibilities to increase financial performance and concludes such a reasoning or logic lacks grounds because it makes blurred the construct understanding and undermines enterprises motivation kumaza and he: can corporate responsibility improve business financial performance? a research insight international journal of economics and financial issues | vol 9 • issue 1 • 201910 for engaging in social responsibilities. corporate responsibility is, therefore, considered as an activity which should be upheld to demystify the long-standing construct perception as business benevolence, making social undertakings and initiatives mythical for some unheedful corporations. furthermore, great differences exist globally among regions and countries in construct understanding and, being mostly global north countries’ concept before spreading wild to global south economies, it de-emphasises parochial business value and profit maximisation proposition. to employ efficiency and profit maximisation logic in explaining corporate entities engaging in interventions in host communities does not carry weight because evidence suggests that most japanese and european enterprises do not embrace the concept, yet they are successful and break-even in the marketplace (matten and moon, 2008). however, most enterprises rather become apprehensive of social accountabilities (banerjee, 2000) and encourage observable irresponsibility in corporate operations, where unfair environmental practices (jermier et al., 2006) reduce the emphasis on policy-backed responsibilities (crouch, 2004). this development demonstrates that enterprises represent an entity important than just self-centred and parochially profit-driven and rent-seeking agents in society, and therefore, entails that though complying with social responsibilities promotes business financial performance, using this rationality as the foundation for understanding the construct is flawed. the theory also views corporate bodies as a political creation with initial “limited liability” to operate and pursue stakeholder goals and values but gradually expand beyond limits (roy, 1999), making corporate authority an issue of employment, consumption, environmental quality, and social equality (parkinson, 2003). thus, corporate entities are seen penetrating cultures, prompting understandings and practices surrounding such enterprises as the mcdonalds, the starbucks’ (ritzer and jurgenson, 2010), and the disney’s in the sphere of consumption (bryman, 1999) and the immediate gender consideration (orenstein, 2011). more so, the theory considers corporate enterprises as having linked political power via informal rules to establish legitimacy (north, 1990), while situating social responsibility in business management firmly to reinforce its importance to corporations. this, therefore, confirms that csr is a reality and constitutes a business key component with enormous gains for wealth creation, growth, and development. meanwhile, the so-called dimension of capitalism and multi-stakeholder involvement are coordination issues, exhibiting themselves in different economic systems and markets of western and european countries, while the institutional distinction is linked to different engagements (rupp et al., 2006). it is, however, surprising to note that organisational theorists since the 1960s theorise cr and other environmental considerations on corporations or organisations but not the business’ on the environments. the time is, therefore, now for organisational theorists to integrate such efforts and energies in unearthing how business organisations are also altering the natural environment while creating their own environments and other sectors which receives little attention from corporate entities. some authors indicated that research in managing the global operations of trans-national conglomerates has been adaptive (westney and zaheer, 2001; geppert et al., 2006). thus, an interdisciplinary theory that explains business vis-à-vis society should be developed through institutional theory for better understanding. the institutional theory, however, attempts to clarify this phenomenon from a two-pronged approach, namely, institutional dynamics and institutional diversity. indeed, particular behaviours can be institutionalised and any deviation(s) attracts sanctions (streeck and thelen, 2005), implying a reference to formal institutions. this explains the general view of regulative and normative institutions, cognitive dimensions, and clarifies different ways of institutional identity and dissimilar scopes (scott, 1995). moreover, the foundations explain the reasons underlying institutions as consequences of history and rules (thelen, 1999). therefore, to simply fathom a particular institution just by considering its present economic purpose is inconclusive. thus, institutions take their roots from history because, mostly, they are products of conflicts, controversies, and compromises. indeed, institutions once established exhibit own characteristics and often sediment power relationships by defining rights and responsibilities, and invariably influence social actors for durability (jackson and apostolakou, 2010). additionally, understanding business accountability as an enterprise charity serves to subordinate it to stockholders and explains the institutional dimension and practices as observed in some developed countries. in international management, responsibility and other governance practices are fused and, therefore, generated debates among scholars on different layers of the construct that are observed in countries. in this regard, corporate management practices are limited and confined to other economies. a study suggests, in general terms, that csr and institutionalised social cohesion cannot be used for each other (jackson and apostolakou, 2010). nonetheless, a counter-critique of this view may be valid and thus, somehow posits, among others, that institutions can empower stakeholders to put corporate establishments under tremendous pressures to adopt and execute social programmes as the basis for the legitimacy of corporate activities (aguilera et al., 2007; campbell, 2007). for instance, an empowered labour union may use its entrenched power to pressurise enterprises to better and improve standards throughout the organisation and approve initiatives of general acceptability. measurement indicators are biased toward explicit csr and this bias is reflected in corporate disclosures (vitols and kluge, 2011), while implicit csr indicators can be blurred and interpreted as such. consequently, as social indicators reflect outcomes in an insufficient and uncomparable manner, to explain whether the classification provides equivalent results and also agree with favourable consequences is difficult. the above-mentioned institutional environments scrutinise how national institutions are linked with capitalism-influenced csr, while noting, for instance, that the construct is us’ invention (kang and moon, 2011). kumaza and he: can corporate responsibility improve business financial performance? a research insight international journal of economics and financial issues | vol 9 • issue 1 • 2019 11 through complementarity rules, the explanation is made of how institutions impact csr on similarity logic of contrast. this theoretical perspective goes to generalise shareholder-influenced csr (kinderman, 2012; brammer et al., 2012). arguments for relative cases of controlled market economies and stakeholder-driven governance practised in germany and france as compared to south korean stateled market economies support different csr governance systems. it is further observed that other characteristics also engender social development while considering an implicit form of csr as an instrument of solidarity to influence the construct, after all, which interrelation indicates a shift in governance institutions (suggestive of countries moving toward shareholder-oriented governance) and makes enterprises adopt the anglo-american csr type. for instance, germany adopts the explicit and business-driven csr, which is a more mandatory approach to social standards and leads to heated discussions with unions (brammer et al., 2012). the spread of an anglo-american construct among diverse societies is an indication of institutional innovation which forever will mutate to produce its kinds. this thinking, in part, supports the position that managers embrace csr based on institutional contexts (witt and redding, 2011). the analysis for five countries confirm dissimilar csr agenda and proposes other concept variants. in fact, the significant varieties that exist show stakeholder-oriented and production-oriented types practised in many countries. this distinction, therefore, demonstrates csr diversity and indicates different stakeholders and countries, where employees’ role in organisations in japan considered important is contrasted with less important employees’ duties in state/society csr as practised in south korea. furthermore, two innovations in csr are introduced, which include static and welfare systems (koos, 2012). thus, the institutional influence is realised at a multi-layer level and permits harmony among institutions, including shaping the cr agenda, suggesting patterns of private enterprises’ public engagement, and treating differences in practices (koos, 2012). 2.2. cr construct cr is an evolving concept and poses universal definitional headaches. many definitions have arisen yet carroll’s (1979) is widely used and referenced in many publications on csr discourse. the landmark book, “social responsibilities for businessman” arguably begins the modern literature on csr (bowen, 1953), indicating that no businesswoman existed or acknowledged in formal writings. bowen believes that corporate objectives pursuance necessarily affects people’s lives, society, and communities, and as such a business must plan for those needs, values, and aspirations. this early definition undoubtedly provides a pathway for contemporary definitions and makes bowen famous in establishing corporate power and responsibility harmony. this view that the enterprise spans a breadth of markets, conducts research, develops the test, and manufactures eclectic products and services, and its presence, growth fluctuations, and practices affects many people and communities supports the claim that business must embrace csr with a view to compensating the external stakeholder constituencies. rahman (2011) observes that cr decisions transcend primary economic or technical goals while recognising the construct’s fluidity and proposes handling it in a managerial context. it is claimed that the responsibility agenda predicate on longterm commercial benefits for the firm (p. 70) and contribute to establishing corporate governance and/or management and accountability nexus. heald (1970) argues that cr must be demonstrated in real policy frameworks. by this, a reference is made to community-oriented programmes and business executives who are predominantly preoccupied with corporate philanthropy and community relations. johnson (1971), however, defines a socially responsible enterprise as those that declare huge profits and satisfy employees and other stakeholder’s needs and stresses that business social obligation is the pursuance of socio-economic goals through elaborate practices approved and implemented by the business. moreover, the committee for economic development (ced) opines that business establishment is granted by public authority and its purpose is social values and needs protection. ced further indicates that the social agreement is undergoing a crucial transformation and enterprises are expected to take charge of social responsibilities and to serve wide-ranging human values. in its roles, business should contribute substantially to improve social living standards and satisfy public expectations. further, csr is considered as a business desire to act in an ethical manner and contributes its quota to society, improves living standards of workforce and families, and ensures sustainable communities. similarly, australian parliamentary joint committee on corporations examines csr from the following standpoints; (a) considering and managing companies’ social and environmental impacts; (b) pursuing and creating opportunities and (c) “enlightened self-interest” approach to normalising stakeholder interests in corporate governance. to delineate the corporate citizenship boundaries, carroll (1991) establishes a four-pronged csr principle, which includes economic, legal, ethical and philanthropic obligations. the economic responsibilities relate to a business productive capacity for goods and services, creating job opportunities and ensuring optimal wages. to achieve these value creation objectives, other resources, including technology are deployed. as the beneficiary of production proceeds, a business must fulfill its tax obligations for developing the infrastructure of the incorporated country. therefore, business economic responsibility is about delivering products and be profitable. indeed, seven economic activities are delineated, which include, satisfying customers with real value commodities; earning profits for investors; creating new wealth; promoting social values (as their wages rise) through new jobs; defeating envy, treat people equitably and improving lives; promoting innovation; and avoiding exploitation of the majority poor and underprivileged (novak, 1996). it is necessary that business laws are passed to regulate corporate behaviour since corporations are perceived to act unlawfully hence, the basis for legal responsibility. however, kumaza and he: can corporate responsibility improve business financial performance? a research insight international journal of economics and financial issues | vol 9 • issue 1 • 201912 laws have limited scope and cover only what is known and about to happen, since human actions determine the present circumstance of the law, and by mere provision of a legal minimum for business conduct (which are reactive, instructing direction to do things) is inadequate. again, ethical responsibilities are moral rights of people which are exercised (smith and quelch, 1993) and include social norms, institutions, and decisions, either expected (positive) or prohibited (negative) in society, although not written laws (carroll and shabana, 2010). these injunctions, therefore, constitute business ethical obligations in stakeholder communities. nowadays, society disregards productivity as moral justification for business wealth generation, but non-economic effects on society, which includes employee and customer welfare system, stakeholders and business operating environments. discretionary obligations are voluntary services that compensate the people and societies because corporations operate in communities and their activities impact social values. businesses are considered good citizens not by economic performance but social contributions that lift the poor from poverty and squalor. the contract of engagement is changing…and business must serve wide-ranging social needs (chewning et al., 1990). that corporate decision-making negatively affects communities and lives supports an implied corporate/social contract a position strongly conceived by theorists, which spells out business social expectations and specific business decision-makers’ responsibilities (beuachamp and bowie, 1983) because it has links with people’s welfare and better living standards. it further posits that social progress should weigh equal in balance with enterprise’s economic progress, and as a social institution, corporations must join hands and build structures amongst which are the family, the educational system to improve living conditions (chewning et al., 1990). the modern corporate world is characterised by professional managers whose decisions impact communities (miller, 1993) while exploiting societal resources to enrich corporate industrial objectives. a growing consensus, therefore, suggests that business must assist in solving corporate externalities since enterprise taxes alone are insufficient (jamal and bowie, 1995) to ameliorate appalling environmental pollution. indeed, business possesses massive economic resources including know-how and financial power (lippke, 1996) to develop host communities if so wishes. 3. method this projects the scientific assumptions and strategies in the paper, situating the study among the existing research traditions. specifically, focused interviews technique relevant for field data gathering is executed and a questionnaire designed, which is personally served to research audience. the study deploys a regression method of data analysis. the research data is obtained from the online information systems of global reach as the foundation for primary information gathering and without which the empirical data collation is difficult. the investigation conducted interviews for thirty representatives of three mining trans-national conglomerates selected. the population from which individual management is selected represents the enterprises. these individuals include david johnson, stakeholder relations, west africa and his two deputies responsible for corporate affairs plus other departmental heads (goldfields ghana); the corporate affairs head including other senior management manning security, environment and human resource (asanko gold ghana); and the president and his vice plus other departmental heads managing environment, human resource and security portfolios (golden star resources). however, the investigation goes an extra mile to gather individual data, from the community opinion leaders, representatives of community-based environmental institutions, plus nongovernmental actors in mining exploration and development, aimed at authenticating and cross-referencing the company data obtained. the focused/semi-structured interview technique is deployed to gather field data because it enables thorough scrutiny of information and also encourages the investigation to interview details and processes. the on-site interviews also make the investigation to scrutinise the objects under study for an in-depth understanding. meanwhile, an enterprise data is obtained from 30 management staff representing the mining multi-national enterprises. information on the impacts of mining is vigorously elicited, pursued and recorded. this information aims to discover enterprises’ management understanding for ramifications of their prospecting activities and the safeguards and/or strategies adopted to curb these challenges. information on community-support and future considerations are also pursued. the investigation used prepared questions which were subsequently altered for dynamism and nature of responses by the respondents. to validate and cross-examine the business data, the investigation interviewed fifty key participants. though the individual information is merely aimed at cross-referencing the corporate data, it also legitimises data collation process and empowers the investigation to identify misleading responses for reconciliation. this method of data gathering gives freedom to the investigation to decide the manner and sequence of questions in the interviews process, and the decisions to explore reasons and motive aimed at confining issues the respondents are familiar with. in general, therefore, this method is deployed in proposition design to constitute unstructured interviews. indeed, this method benefits the investigation by allowing a complete data gathering with much precision for questionnaire design, leading to increased credibility for findings. again, the personal involvement and/or contact with the respondents increases response rates and, more so, allows the investigation to have more order and flow of questions. it also helps the investigation to introduce necessary modifications in the scheduled interviews based on initial results, which is not possible kumaza and he: can corporate responsibility improve business financial performance? a research insight international journal of economics and financial issues | vol 9 • issue 1 • 2019 13 in the case of only a survey study without early interviews. further, the interviews method offers the investigation expansive data discovery which is perhaps difficult using only a questionnaire or participant observation (blaxter, hughes, and tight, 2006). it also allows the research to generate real-life and authenticated data that stand the taste of time. besides, this method in objectives setting is important (hamel et al., 1993; yin, 1994) underscoring its use in this research. this technique deployment in data gathering has some few shortcomings. these are biases resulting from fatigue in dealing with large participants and the investigation becoming very much involved with the interviewees. data generated from qualitative interviews is huge and overwhelmingly voluminous (neuman and robson, 2007), and an hour interview may produce gigantic data which can take several pages and many hours or days to transcribe (dörnyei, 2007). challenges of potential bias in generating information via interviews exist, yet it is used for small-scale researches. the study employs the regression technique because it derives predictors and unknown variables for the predictions. the deployment of this procedure, as an spss statistical package, stems from its measure for cause and effect within and among variables. meanwhile, as a statistical prediction tool, predicting variables, given the other when those variables are interrelated, it shows a mathematical average measurement of variables’ relationships and as such includes a measure deployed in an unknown variable prediction. it estimates dependent variables from independent ones and also shows the error involved in estimations. more so, it helps in identifying the correlation, and an actual relationship enables the value estimation for which it is valid. the variables’ relationships are the same until the calculations are made. while the dependent variable assumes any value taken at random, independent ones are fixed. in a regression calculation, one dependent measure is selected but many autonomous variables are considered. research indicates that a regression analysis only gives confidence levels to the investigation that the predictions are okay except proving the claim. 4. empirical results 4.1. quality criteria for measures the demographic variables indicate participants’ stratification (as male and female) and their agreement percentages with specific questions. male constitutes 42.5% (n = 17) and female 57.5% (n = 23) of the whole population (40). participants’ age groups include 41–50 (n = 37, 92.5%) and 51–60 (n = 3, 7.5%), while 72.5% (n = 29) and 27.5% (n = 11) are married and unmarried respectively. 45.0% (n = 18) obtain bachelor degree, 42.5% (n = 17) acquire master degree, and 12.5% (n = 5) have postgraduate degree. the respondents’ professional positions are branch manager (45.5%, n = 18) and president, corporate affairs (55.0%, n = 22). they work from between 1-10 and 11-20 years, representing 55.0% (n = 22) and 45.0% (n = 18) respectively. mining services participants represent 17.5% (n = 7) and 82.5% (n = 33) is mining multi-national enterprises (table 1). the r column variable, where r = 0.793a, demonstrates strong variables relationships between predictors and the outcome. similarly, the r2 (0.629) determines the variance outcome and statistical significance. it, therefore, indicates the model predictor can predict the outcomes (table 2). the overall standard error coefficient (0.30060) shows insignificant value, meaning that the variables are within preferred regression limits. the variance analysis, also called anova table, describes the variability (inconsistency) among measures (table 3). the source column includes regression, residual and total, where the corresponding values (22.088 and 13.012) denote response variance variability. thus, the anova determines the model variables predictive capability. the p < 0.001 indicates statistical significance and, therefore, makes the model a suitable predictor of the event, where f (3, 36) = 20.371, p < 0.001. 5. discussion the study’s objective is to provide evidence favouring the proposition cr promotes business financial prosperity. in specific terms, it is to argue that corporate objectives are achieved when business attends to social needs while validating the claim quantification of societal non-financial assets, including social licence and legitimacy improves corporate monetary value and performance. the subsequent discussion is to advance these objectives through the statistical findings. table 4 includes p-values of each term, statistical tests, and coefficients. statistically significant p-values suggest that a predictor shows prominence and needs to be reported on since predictors’ variables affect response variables. therefore, the coefficients (0.582, −0.741 and −0.659) specify statistical significance (0.001 × 3), meaning the constructs are monotonically table 1: descriptive analysis of demographic variables characteristics sub level frequency (%) gender male 17 (42.5) female 23 (57.5) age 41–50 37 (92.5) 51–60 3 (7.5) marital status married 29 (72.5) single 11 (27.5) education university 18 (45.0) graduate school 17 (42.5) post graduate school 5 (12.5) position branch manager 18 (45.0) president corporate affairs 22 (55.0) period of work 1-10 22 (55.0) 11-20 18 (45.0) business id mining 33 (82.5) mining services 7 (17.5) table 2: model summary model r r2 adjusted r2 standard error of the estimate 1 0.793a 0.629 0.598 0.60120 apredictors: (constant), board diversity ensures effective cg for csr, decoupling csr from corporate affairs attracts and improves corporate attention, cg equals accountability to stakeholders kumaza and he: can corporate responsibility improve business financial performance? a research insight international journal of economics and financial issues | vol 9 • issue 1 • 201914 related. more so, the t-values (4.299, −3.455, and −3.368), show the little variability of model variables, suggesting the constructs share associations. further, the error coefficients (0.135, 0.215 and 0.196), which are an average distant line, display insignificant measures, indicating the measures are closely related. more importantly, the constant’s value (4.859) implies that the model takes a mathematical value of 4.859, giving the independent predators. therefore, a unit change of the constant (4.859) results in this measure (0.582) of change in ‘cg equals accountability to stakeholders’. further, one unit change of the model’s constant (4.859) changes the measures (−0.741 and −0.659) and confirms ‘decoupling csr from corporate affairs attracts and improves corporate attention’ and ‘board diversity ensures effective cg for csr’ validity respectively. the foregoing results vehemently support the claim that corporate responsibilities and business objectives, though in constant flux, are intertwined and incentivise common goals. this argument that corporate responsibilities seek to promote and improve business financial performance and prosperity through social legitimacy and consumer confidence is validated. the proposition that corporate responsibilities encourage an enhanced business value creation and prosperity cannot, however, be under-estimated. this is because the monetary value quantification for a social licence, legitimacy, and upright corporate image represents a gargantuan income stream for the business, and thus undertaking commitment initiatives in stakeholder communities for livelihoods improvement is necessary and as a compensation. therefore, the assertion that social responsibility reduces business financial performance and prosperity (vilanova et al., 2009) is outdated and obsolete, which represents a myopic and unenlightened view of business activities valuation calculus. the realisation, by some few trans-national conglomerates that embracing social responsibilities is business prosperity, enables them to execute stakeholder community development programmes to improve relations rather than animosity, which corroborates barnett’s (2007) assertion that increased profits and rent-seeking do not serve the business interest, since increased financial performance might be perceived as less social good, resulting in rising profits to favour investors and upper management, and may incentivise cynicism and violence from local populations. the paper’s findings are critically important to policy-makers and local authority because the compounding complications of markets inadequate measurements of business externalities are unresolved and, quantifying, in monetary terms, business non-financials would help resolve the perennial challenge of corporate production cost externalisation, including pollution of business operating environments, since it is known corporations also get monetary benefits from the stakeholder communities and not only the former being charitable and/or benevolent to the latter. the paper could not agree more with the proposition that csrs incentivise business profits, value creation, and improved financial performance, making corporate citizenship an attractive arena for business grasp with sincerity. 6. conclusion the bourgeoning and fast mutating character of cr place business directly in public domain and it is required to actively participate in social change dialogue with the local authority to shape ways through which corporations can contribute meaningfully to their operating environments improvement. providing basic amenities, welfare packages and/or other development initiatives in host communities is welcomed wholeheartedly by some heedful and notable enterprises. for instance, the norwegian-based norsk hydro assumption of responsibility for the well-being of many towns by boosting livelihoods via jobs, schools, and housing for the people (may et al., 2007) and kellogg company’s provision of technical assistance and direct services to african-american men and boys through the community pride food stores offering services and reviving richmond city and virginia, and runs topnotch free transports for customers without cars, and discounts for communal work participants are encouraging. table 3: anovaa model sum of squares df mean square f sig. 1 regression 22.088 3 7.363 20.371 0.000b residual 13.012 36 0.361 total 35.100 39 adependent variable: csr and business are related and complementary. bpredictors: (constant), board diversity ensures effective cg for csr, decoupling csr from corporate affairs attracts and improves corporate attention, cg equals accountability to stakeholders table 4: regression coefficientsa coefficientsa model unstandardized coefficients standardized coefficients t sig. b standard error beta 1 constant 4.859 1.156 4.202 0.000 cg equals accountability to stakeholders 0.582 0.135 0.497 4.299 0.000 decoupling csr from corporate affairs attracts and improves corporate attention −0.741 0.215 −0.394 −3.455 0.001 board diversity ensures effective cg for csr −0.659 0.196 −0.348 −3.368 0.002 adependent variable: csr and business are related and complementary. bpredictors: (constant), cg equals accountability to stakeholders, decoupling csr from corporate affairs attracts and improves corporate attention, board diversity ensures effective cg for csr kumaza and he: can corporate responsibility improve business financial performance? a research insight international journal of economics and financial issues | vol 9 • issue 1 • 2019 15 by the statistical results, the paper finds that business engagement in social undertakings correlates with financial benefits which include corporate societal approval, legitimacy, consumer confidence, and good social standing. the measurement of these values gives an unimaginable windfall to corporations, which unfortunately is not realised because of methodological and quantification challenges. it is, therefore, hoped that business in conjunction with local authorities and the stakeholder constituencies engage in ways to formalise appropriate measurement criteria for social non-financial values. indeed, as business utilises local resources for profits, its participation in building economically viable stakeholder communities (crane, 2008) is highly expected. employing stakeholder governance model, an enterprise prospers and becomes more successful by maintaining a continuous development-linked association with its host-constituent communities (barnett and salomon, 2012). the foregoing instances validate the finding, social responsibility thrives business financial prosperity. that devoting part of business proceeds for community improvement efforts improves business financial performance is not an understatement, and cannot, however, be over-emphasised. thus, the quantification, in monetary values, of the corporation’s non-financial benefits namely social licence, legitimacy and company’s good image constitute colossal corporate profits. in this view, corporate accountability has become a pre-condition for business success, which invariably heightens stockholders’ importance (epstein et al., 2015). it is, therefore, misleading to consider corporate responsibilities burdensome for business financial resources (friedman, 1970), and the apparent evidence lack to support the position cr improves companies’ financial performance (vilanova et al., 2009) implies that enterprises do not benefit from embracing social responsibilities. meanwhile, a body of studies reveals that cr and business financial performance share harmony and, therefore, makes the business beneficiary of stakeholder initiatives implementation (walsh et al., 2003; orlitzky et al., 2003). the statistical result that “csr and business are related and complementary” suggest a strong authentication for the proposition corporate responsibilities help not only stakeholder communities via development programmes but also business through the grant of a social licence, legitimacy, and good corporate public standing. all this, when quantified, represents profits for the business. the finding’s practical implication agrees with tschopp and nastanski’s (2014) perception of little measurement information availability and indicators’ non-financial, while standards absence prevalence (tschopp and nastanski, 2014) has made it difficult for quantification of business benefits from the stakeholder communities. the novel expose of an empirical foundation for the proposition that social licence, legitimacy and good public enterprise outlook obtainable from cr are major incomes sources for companies makes this new field a future academic research point and to establish a proper understanding of how valuable these social non-quantified parameters are for the business. 7. acknowledgment my gratitude goes to david johnson, stakeholder relations and his two deputies responsible for corporate affairs (goldfields ghana); adelaide boye (mrs.), corporate administration manager, african mining services, accra office; corporate affairs of asanko gold ghana; and the president, and his vice, of golden star resources ghana for interviews and survey data gathering. i am also indebted to my beautiful daughter, caitlyn edudzi mic-kumaza, for being an inspiration on this long and difficult journey. i recall times that my leaving ghana back for school (in china) makes you cry. to all whose names did not appear, i say a big thank you. to god be the glory. references aguilera, r.v., rupp, d.e., williams, c.a., ganapathi, j. 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(1994), applied social research methods. in: case study research: design and methods. vol. 5. beverly hills, ca: sage publications. international journal of economics and financial issues vol. 3, no. 4, 2013, pp.910-922 issn: 2146-4138 www.econjournals.com 910 an assessment on the relationship between informal economy and educational level in turkey mehmet ela department of public finance, faculty of economics and administrative sciences, osmaniye korkut ata university, osmaniye, turkey. email: mehmetela@osmaniye.edu.tr abstract: the informal economy is an obscure concept but it contains several economic transactions. it is a very difficult task to measure its size and dimensions, however economists have developed reliable methods to predict the size and impact of informal economy in a given country or economic region. studies in turkey and abroad indicate that informal economy in this country is considerably large and sprawling. existence of informal economy is a significant problem in any country since it negatively affects the national economic system. so far, policies deployed to deal with the negative outcomes of informal economy in turkey mainly focused on tax policies and wages. on the other hand, increased educational attainment and provision of contemporary educational programs should be considered as better means to reduce the size and negative impact of informal economy. however, before using education to solve problems related to informal economy, the educational system needs to be restructured along with other restructuring efforts in economy, politics and legal systems. increased educational attainment should also contribute to resolution of such social problems as economic growth and unfair income distribution in the country. keywords: informal economy; education; informal employment jel classifications: e24; e26; h52 1. introduction the informal economy covers a wide range of activities and it is called different names. it is hard to measure the informal economy. in turkey, however, it is well known that the ınformal economy is very high. in terms of its reasons, it is classified four groups as economic, financial, political and administrative, moral and psychological. reasons of informal economy and their effects vary from country to country. for turkey, magnitude of reasons varies too. it is claimed negative and positive opinions about its effects. but its negative effects are more and more plausible. education can be proposed as the factor that finishes the reasons of ınformal economy. in turkey, the basic educational indicators, especially in the last period exhibit a positive image. i̇ncreasing in ınvestments in education, literacy rate, teacher and graduated rates and quality in education can be seen in turkey. this situation is promising for turkey which has young population; because education has both personal and social benefits. in terms of benefits, education reduces inequality in income distribution, fertility and crime rates and unemployment; meanwhile it provides economic growth. benefits of education are in association with the many reasons of informal economy. on the other hand, employment in informal economy and number of active people in underground economy reduces with the increase in education level. aim of this study is to see how increased educational attainment and quality could solve the informal economy problem is explained with consideration given to country specific conditions.  this study is a part of master thesis titled “the relationship of the informal economy and education level in turkey”. the author acknowledges the valuable comments received from his supervisor dr. hasim akca. an assessment on the relationship between informal economy and educational level in turkey 911 2. definition of the informal economy the identification of the informal economy is difficult due to the fact that the scope of informal is very extensive and multi-dimensional. in other words, it is difficult to make a general definition included all the informal economy activities. in addition, the scope and structure of the informal economy differentiate according to perception of researchers and different economic systems (yilmaz, 2004:16). according to the issue emphasized, it is used different names to identify the informal economy (us, 2006:97). so, we can’t say there is a general and exhaustive definition (isik and acar, 2003:118-119). there are a lot of definitions in literature but the most commonly used definition of informal economy is “all currently unregistered economic activities, which contributed to the officially calculated gross national product” (hassan, 2011:4). according to another definition, “those economic activities and the income derived from them that circumvent or otherwise avoid government regulation, taxation or observation” (schneider, 2008, p.90). when ınformal economy is defined the following definitions are typically used (minfin):  “fiscal definition: it confines the informal sector to activities which contravene tax regulations and fail to be reported by financial authorities. examples of such activities are the hiding of sales by a company from the fiscal authorities, the false bookkeeping or the scale of undervalued real estate.  market definition: it focuses on the difference between payable and non-payable services. from this perspective, the informal sector covers unregistered activities and undeclared labor but against additional payment. such activities are considered to be parallel to declared labor but outside its cope.  legal definition: it encompasses all activities conducted in contravention of the law. its scope covers the trade in stolen vehicles and goods, drug trafficking, corruption practices and money laundering.  statistical definition: it discerns those activities which should be reported in official statistics but they are not. the portion of the economy on which statistical data is completely lacking is viewed as hidden and it is not subject of statistical studies. its scope includes the economy which is characterized by unwillingness to be put under observation, as well as that part of the formal economy which cannot be studies due to the lack of relevant data”. 3. reasons of informal economy due to the fact that every country has typical economic and social structure, reasons of informal economy have different impacts on economy in different countries. in developed countries, reasons of informal economy depend on factors as tax structure and labor market regulations but in underdeveloped countries in addition to these factors, demographic ones as population growth and urbanization affect ınformal economy. in turkey, in terms of its reasons, it is classified four groups as economic, financial, political, administrative and social. economic reasons that lead to ınformal economy are specific to turkey. since 1970, there is high inflationary trend in turkey and so it increases informal economy (dpt, 2001a:4). because of high inflation, producer and consumer’s fictive profit is taxed and therefore they choose activities in informal economy (rakici, 2011:355). on the other hand, employment is very large in agricultural and service sector and these sectors are very complex to be controlled (isik and acar, 2003:120). and people lose their jobs because of economic crisis choose ınformal sector to earn income (sarili, 2002:42; rakici, 2011:.355). in turkey there are a great number of small scale enterprises and these don’t have proper recording and documenting (rakici, 20011:355). and so controlling them by inspectors is very hard, so they are convenient for ınformal economic activities (dpt, 2001a:3). in developing countries generating employment is very slowly and seeking job is expensive, thus in these countries unqualified and undereducated labor force works in ınformal sector and earn less (cetintas and vergil, 2003:18; akturk, 2005a:298-299; aydemir, 1995: 57). unemployment is another factor which causes informal economy in turkey (ozlale, 2008:6). due to technology and population growth, people migrate from rural areas to urban areas and they can’t get a job because of skill inconsistencies. inequality of income distribution causes ınformal economy too. in countries where income distribution is unequal and income is insufficient, the size of informal economy increases enormously (ay, 2006:61). as a result of unequal income distribution, people have little income international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.910-922 912 choose informal sector with the intention to earn much (dpt, 2001a:3). besides, fast population growth and urbanization makes unskilled people choose informal sector (dpt, 2001a:3; us, 2006:98). lastly, globalization changes competition environment in turkey and firms employ cheap labor in ınformal economy (tandircioglu, 2002:5; isik and acar, 2003:120). financial reasons that lead to ınformal economy in turkey arises from high tax and social security burden. due to a lot of people work in informal economy, tax base remain limited and people work in formal economy pays too much tax (acar and turkis, 2001:180; cetintas, 2003:8). in turkey tax equity isn’t constituted properly and there is a big proportion of tax revenue composes of indirect taxes revenue (sugozu, 2010:166; ozlale, 2008:6). as a consequence of that people try to evade tax and don’t believe the tax equity. many tax exemptions make tax payers hide their incomes and not to go over the limits of the exemptions because of that informal economy raises (sarili, 2002:40). on the other hand, tax and social security amnesty granted frequently raise amnesty expectation and reduce tax compliance (savasan, 2006:42; karakoc, 2004:99). tax auditing is not effective and sufficient due to the fact that tax auditing entities have authority chaos. therefore, efficiency of the tax auditing and penalties reduces in turkey. taxpayers can’t understand and follow the tax low due to complex tax legislation and frequent tax law amendment. so, financial reasons are effective in increasing the informal economy. political and administrative reasons are among main problems raise the informal economy (dpt, 2001a:6). in turkey, malpractice and excessive red tape makes the informal economy attractive (cetintas, 2003:10; toptas, 1998:75-76; guloglu et al., 2003: 85). in turkey, a firm spends twenty percent of its time to carry out the processes which the state wants (cetintas, 2003:10). firms which wanted to avoid from excessive red tapes choose ınformal economy to work. precarious decisions of political parties about tax make taxpayers choose the informal economy in order to protect their benefits (kildis, 2000:198; sugozu, 2010: 191). social reasons of the in the informal economy show that moral fiber and tax perception doesn’t decrease the informal economy (ulgen and ozturk, 2007:13; toptas, 1998:50). on the other hand, in turkey, there is no concordance about taxes between state and taxpayers (aydemir, 1995:47) and taxpayers think that government expenditures aren’t efficient (gib, 2009:30). these reasons we mentioned reduce tax compliance and increase the informal economy. 4. literature review informal economy analyzed by a lot of researchers and tried to find a solution. but solutions are frequently about taxes or economic conditions. surely, informal economy is relevant with these factors. but to date educational solution has been ignored mostly or mentioned shortly. but in turkey some literature shows that educational level reduces the size of informal economy. some studies examine informal employment as a part of ınformal economy for turkey and other countries. akturk (2005a:298-299) emphasizes that in developing countries, mostly undereducated labor work in unskilled jobs due to the fact that there is not sufficient potentiality of creating employment. on the other hand he show that as educational level decreases in rural area among women, size of informal economy raises approximately ninety percent and in urban area the educated people don’t choose the informal sector in turkey. similarly, sisman (1999:78-79) emphasizes that in developing countries undereducated and unskilled people are obliged to work in ınformal sector. sarili (2002:40-48) remarks that unskilled labors are expensive for employers and therefore the size of informal economy is high in turkey. yuzbasioglu (2010:44), remarks that there is a cause-effect relationship between education and enformal employment and show that as educational level raises ınformal employment decreases. this finding is confirmed by guloglu et al. (2003:55). mckeever (1998:1209) came to the conclusion in his study which he conducted in south africa, that especially people who are not white, women and people who have low educational level were employed more frequently in informal economy. in other studies which were done in south africa, while nattrass (1987) deduced that 88% of those who were employed informally were women and that they were unqualified and were working in jobs which required no qualifications, beavon and rogerson (1986) came to the conclusion in their studies that tha majority who were employed informally were less educated (mckeever, 1998:1219). an assessment on the relationship between informal economy and educational level in turkey 913 some studies emphasize the demographic and social factors affect informal sectors and education. akturk (2005b:291) remarks that there is not sufficient employment in turkey and especially in urban areas. but immigrants who are undereducated are going on migrating from rural to urban areas and they choose ınformal sector necessarily. similarly us (2006:98) shows that the social and demographic structure of turkey raise the ınformal employment. on the other hand ulgen and ozturk (2007:18) remarks that educational policy is not sufficient and reformer, therefore education can’t effective in addressing the needs of labor market. toptas (1998:82) and yurdakul (2008:220) suggest that education which provides skill and practice will get the informal employment under control. other studies examined illegal economy and showed that education is not effective in decreasing the illegal sector activities precisely in turkey (see ozsoylu, 1999). guloglu et al. (2008:31) remarks that children who work in informal sector don’t have education and therefore they can work in illegal sector more easily. about tax moral saracoglu (2008:19), remarks that tax compliance can increase or decrease as educational level increase. celikkaya and gurbuz (2008:31) examined tax compliance in eskişehir and found that with increment of educational level, increment of favorableness about tax amnesty and its effect on informal economy is seen. 5. education and informal economy informal economy is in relation with many factors. these factors which it is in relation with can be seen clearly in the reasons of informal economy. the factors which are in question can be listed as economic, social, ethical and political. besides being affected by these factors, informal economy also affects certain factors. moreover, informal economy can feed upon itself (aydemir, 1995: 59) one of the factors which are mentioned is education. the level of education affects informal economy either directly or indirectly. for direct impact, together with the increment of the level of education, an employment in informal economy and a decrement in the number of people who operate in the underground economy through perpetration is seen, as for indirect impact, it is probable to mention about the effects of unemployment, distribution of income, tax incomes, tax ethics, the factors of population increment which are all the reasons of informal economy. since, together with education, the distribution of income recovers, in regard to the economic growth tax incomes and the tax compliance increases, the increment of population in relation to fertility decreases and unemployment decreases together with the level of education. but, in defiance of the international literature, the effect of education on unemployment isn’t quite powerful in turkey as well. hence, education affects informal economy through informal employment and underground economy. the relationship between the level of education and informal economy is dual. while, the decrement of informal economy as the level of education rises and the decrement of the activities of underground economy through the decrement of crime rates can enable the dimension of informal economy to decrease, the existence of informal economy can cause the level of education to decrease especially because of children abandoning their education and doing informal activities. hence, while education can decrease informal economy, the existence of informal economy can cause the level of education to decrease depending on the number of children which take place in informal economy. because, child labor force is used densely (ekin, 1995: 83). in informal education where children are employed, no occupation is given place. furthermore, it is easy to push children, who haven’t received enough education, to crimes (guloglu et al., 2003: 60-73). hence, the existence of informal economy affects the factor of education through decreasing the level of education on one hand, and on the other, it gets affected by education which is preferred less by educated people. education is a key factor in decreasing the dimension of informal economy when the indirect and direct relation between education and informal economy is taken into consideration. informal economy can be taken under control through educating the labor force enabling it to become more professionalized and hence through decreasing the unqualified labor force (yurdakul, 2008: 220). 5.1. education and informal employment there isn’t a definite cause-effect relationship between the level of education and informal employment. informal employment is seen more frequently in places where the level of education is low (yuzbasioglu, 2010: 44). the fall of education and the level of quality is one of the important reasons for informal employment (guloglu et al., 2003: 55). besides lack of education, the fact that people have deficiency in the subject of consciousness of social security is an important factor in international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.910-922 914 informal working (yereli and karadeniz, 2004:113). hence, the possibility of finding a place for themselves in the recorded sector for the region whose education level is low decreases. the unqualified workforce who couldn’t find enough work possibilities in the recorded sector searches an employment possibility in the unrecorded sector and for this reason unrecorded economy generally consists of unqualified people. being unconscious about social security, the low level of education prevents unqualified people to become selective. on the other hand, because of the taxes and social security premiums, unqualified workforce is a high cost value for the employer and this is another factor for why informal employment rises (sarili, 2002:40). according to the tax auditing staff, the personnel being mentioned which doesn’t have enough education and professional consciousness reasons the informal employment in our country to grow vastly (guloglu et al., 2003:86). the relationship between educational level and informal employment gets affected from the development level of countries and hence from such factors as the use of technology, socio-economic structure etc. in developing countries, where creating new employment facilities is limited, causes workforce which generally consists of low educational level and which isn’t employed in formal sectors, to be employed in informal sectors where certain jobs are done such as working in noninstitutionalized houses, creating custom manufacturing, hawking, bagel selling, water selling all of which are easy to enter and exit from the market, which don’t need any professionalism or education and don’t need an extensive amount of stock (akturk, 2005a:298-299). on the other hand, in regard to the fast changing conditions of the developing countries, the social politics not being noticed much or the problems which are faced with the financing of these politics structure the problem. as a result, in order for the people who have no qualifications to meet their needs in developing countries, their only choice is the working possibilities in informal economic facilities (sisman, 1999:78-79). technological development necessitates the change of the production structure and the need for new characteristics in workforce. the fast changing technology, information economy, globalization and the increasing international rivalry increased the need for qualified workforce (basesgioglu, 2007:6). especially in the industry sector, because of the technological development instead of the production based on labor, productions based on machines are used. this condition caused the unqualified workforce to become unemployed. hence, the workforce who became unemployed tended to move towards informal activities because of sustentation doubts (sarili, 2002:42). the situation of education not being able to give answers to new needs is especially a crucial problem for turkey. the deficiencies in our countries education politics is a big concern to the employment market. the relativist lowness of the educational level, made it harder for the working population to answer the fast changing needs of the economy. hence, the reason for which human sources don’t meet the needs for specifications of the contemporary economy became one of the major factors which nurtured informality (ulgen and ozturk, 2007:18). a country’s socio-economy and demographic structure can also indicate the greatness of the relationship between education and informal economy. it is seen that it is the informal economy actions which come into being in the consequence of employment not being able to meet the vastly increasing population and as a result of the fast immigration development from village to town and unplanned urbanization (us, 2006:98). the situation in turkey can be briefly mentioned like this as well. since the first years of it republic, turkey owns a speed of approximately 2,5% of population increment. the fast increment of the population and the immigration from village to towns which has been increasing since the 1950’s has created a labor market whose characteristics are some of the factors which cause the development of informal economy. even though employment opportunities are not facilitated for the present unemployed in towns, a vast amount of unqualified workforce which pile up in towns together with population increment and immigration created the result for the labor owners to work with less payment and without owning social security (akturk, 2005b:291; guloglu et al., 2003:67). as a result, together with our country’s socio-economic and demographic structure, the level of education is another factor which also fosters informal economy. as it can be seen from table 1, out of the total education levels, as the education levels come closer to higher education levels, informal working decreases. the highest number in informal working belongs to males who are elementary school graduates with a percentage of 50%. the least belongs to the higher education graduate males with a percentage of 2%. both with male and female, the highest number of informal working both with males and females are primary school graduates. an assessment on the relationship between informal economy and educational level in turkey 915 again, both with male and female the lowest number of informal working are associate, bachelors, master’s degree and doctorate degree graduates. in informal employees, those who are illiterate or are literate but don’t have a diploma have a smaller number of informal employee rates excluding associates, bachelors, master’s degree and doctorate degree graduates. formal employee rate increases together with the education level. in formal employees, are associate, bachelors, master’s degree and doctorate degree women graduates are the group with the largest rate which are 44%. the education groups with the smallest rate of formal employee number are those who are illiterate or literate but don’t have a diploma. table 1. the educational status of formal-informal employees (2006) % status of education formal employees informal employees male female male female those who are illiterate or is literate but doesn’t have a diploma 0,01 0,01 0,10 0,18 primary school graduates 0,32 0,14 0,50 0,45 elementary school, middle school or an equivalent graduate 0,15 0,08 0,22 0,16 high school and equivalent graduate 0,31 0,31 0,16 0,17 associate, bachelors, master’s degree or doctorate degree graduates 0,21 0,44 0,02 0,04 total 100 100 100 100 source: san (2009:456) during the years between 2002 and 2006, in informal employees, together with the increment of the level of education informal employment decreases. between the years of 2002-2006 informality among those who are illiterate is more than 91%. with middle school graduates the informal employment rate is 29%. while the informal employment rate is 25% with associate graduates, among university graduates this rate falls to 8% (yuzbasioglu, 2010:44). when the data and table 1 is taken into consideration, it can be seen that educational level is a valve which prevents informal employment. hence, the increment in education level brings together a decrement in informality. this situation can be evaluated as a positive condition. because, in a period which schooling and higher education graduates are in an increment, knowing the fact that the increment in the level of education decreases informal employment strengthens the view of educational investment and the quality increment in education will decrease the informal employment in the future. in other words, an education which is to be given in order to increase workforce professionalism can enable informal economy to be under control through decreasing unqualified workforce (toptas, 1998:82; yurdakul, 2008:220). furthermore, since small and medium sized managements in turkey have a high rate in the total number of employment, precautions towards the professionalism of those who work in these managements can be taken in order to keep them under records (sarili 2002:48). as a result, together with the informing and awareness raising campaign named ‘humlan’ which is used in sweden to decrease informal employment, the aim of the project is decreasing unemployment through increasing education and employment (tisk, 2003:30). similarly, through increasing vocational education and employment, decreasing informal economy in our country can be provided. 5.2. education and underground economy informal economy is composed of two types of activities as criminal and non-criminal activities. criminal activities are mentioned with names as underground economy, black economy, underground economy, twilight economy, moon light economy (bagirzade, 2012: 199-206). including criminal activities crime economy, which we call, underground economy, consists of market channel and supply and demand but also, producing and/or marketing secretly the goods which is forbidden or taken into controlled to be produced or marketing because of health, security, morality etc. issues. according to another approach, underground economy activities are all illegal but profitable activities which fulfill the blanks in the government administration operated via organized crime syndicate (ozsoylu, 1999:1). international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.910-922 916 not having an occupation as a result of being uneducated, people are driven to gain unjustified benefit by illegal activities (altug, 1999:197). uneducated people can also commit illegal activities, can occupy underground economy. on the other hand, being employed illegally, children’s chances of being educated are taken from their hands. it becomes fairly easy for those children to be pushed to crime (guloglu et al., 2003:60). the factor that is to be emphasized in turkey is that as a society, we don’t have enough education level and our education system cannot deter from committing a crime. in such an atmosphere, necessary constraints to prevent underground activities are disappeared (ozsoylu, 1999:34). 5.3. reasons of informal economy and relation with education reasons of informal economy can be classified as economic, financial, social, moral and bureaucratic. among these mentioned reasons, especially economic reasons are essential for our country. because economic factors become prominent in our country in which there are a structural transformation and immigration from agricultural sector to industry and service sector with the development in technology. on the other side, economic factors are supported by social and demographic factors. as a matter of fact, in our country in which population growth rate and urbanization are high, the informal employment level is also high. education is closely related with these mentioned economic, social and demographic factors. related factors with educations are tax income and ethics, economic growth, unemployment, population growth and income distribution. while increases in these mentioned factors increase informal economic extent, education act as a deterrent for these factors not to increase informal economy. 5.3.1. relation of informal economy, economic growth and education informal economy has a bulk of negative impact. one of them is that informal economy’s shifting the sources to less productive fields. it is not expected from informal economy to be high productive because they are happening in small and/ or medium sized enterprise with low ration of owner’s equity (yilmaz, 2006:167). hence, sources that shifted to informal economy are used in unproductive fields and in this situation country development is delayed. accordingly, actors in informal economy cannot convert their income into physical and financial investments (ay, 2006:64). moreover, existence of informal economy hinders the positive results that expected from competitive regulations (aslanoglu and yildiz, 2007:133). it is only possible for a country to reach high standards of living and provide productivity growth with catching sustainable and permanent growth trend. thus, permanent development in a country will have a reducing effect on informal economy. indeed, informal economy in developed countries is less than developing countries. due to the growing rates cannot raise necessity welfare and productivity in turkey, it cannot create a reducing impact on informal economy (yurdakul, 2008:219). most important effect of education is on growth and development. one way of education impact on economy is via increasing labor productivity. education enhances labor productivity indeed and provides essential externality for sustainable growth (ozyakisir, 2011:56). on the other hand, education by providing technological growth increases productivity so economic growth as well. besides, countries with high level education can internalize new technology quicker (keskin, 2011:140). by this side, education enable technological advance (yumusak, 2008:17). education can also increase the growth with enhancing resources used in economy. thus, there is mutual relationship between education and growth. while growing economies find opportunities to convey more resources to education, on the other hand, increasing education expenses contribute economic growth to the extent of improving manpower (altundemir, 2008:52). nevertheless, an important point is that, development can derive from canalizing resources gained from growth to education. otherwise, there cannot be mentioned a relationship between education and economic development. 5.3.2. relation of informal economy, income distribution and education being one of the main reasons for informal economy, distortion of income distribution both increase the informal economy and existence of informal economy distorts income distribution (rakici, 2011:357) relation of income distribution with informal economy occurs when groups, getting low portion from income, make supply for informal employment to rise their income (dpt, 2001b:3). as well as causing small kids to work unrecorded, distortion of income distribution also an assessment on the relationship between informal economy and educational level in turkey 917 extends marginal sector, so in this sector, too, procedures are taken unrecorded causing increase in tax evasion (vdd, 2007:62-63). on the other hand, existence of informal economy spoils the income distribution. being unable to continue its maintenance even in the absence of informal economy, market economy while market economy couldn't provide fair income distribution even in the absence of gray market, in the existence of gray economy the result of the factors which have the same quality and quantity and entering the production period ends with the different incomes from each other creates a condition opposition for those who functions in gray economy (yilmaz, 2006:167-168). existence of informal economy hinders to accumulation of funds in social security system. in condition of not having enough funds in social security system, social transfers cannot be taken place to low-income groups which are to be arranged by the government and because of this life conditions of low-incomes become harder, inequality in income distribution effects social justice negatively (ulgen and ozturk, 2007:5). informal employment is mostly a social problem. uninsured employments are generally unqualified individuals, member of low-income group. uninsured employments cannot get enough family health services, and they cannot get enough income to maintain minimum necessity of human life during old age. in a nutshell, working without insurance cause permanent inequality (savasan, 2011:36-37). education affects income distribution implicitly because of relations with factors like growth and population, and it affects directly economic structure by increasing income level (akca and ela, 2012:247). direct impact is mostly related with individual income. because of being among the determiner of individuals income and being close relationship between education and productivity growth, which reflects on fees, working class who getting higher education is also expected to get higher income on condition that there is no decline in productivity (turkmen, 2002:50). according to table 2, there can be seen that generally formal employees gain more fees on average than informal employees. both among formal and informal employees, males earn more than females. even though price gap is high with formal employees in sectorial context, this gap is low with informal ones. thus, among informal employees males get maximum 467,34 and minimum 389,99 while females get maximum 330, 12 and minimum 321,79. among formal employees, gap rises up to 300 turkish liras (tl). it is seen evidently here that informal economy decomposes the income distribution. whereas formal employees earn more, informal ones get less and income distribution is corrupted against informal employees. table 2. average wage of formalinformal employees (2006) sectors formal employees informal employees male female male female manufacturing industry 661,72 544,62 443,98 321,79 wholesaling, retail trade, restaurants and hotels 633,24 543,94 389,99 327,29 financial board, insurance, occupation of immovable property, assistant service 800,72 811,17 467,34 330,12 social services, social and individual services 944,56 915,62 402,26 324,9 source: san (2009:458) viewing the income distribution from aspect of education, on table 19, it is seen that income is rising with the level of education. annual average gross earning gap between primary and lower education level and college and higher education level is 15.000 tl in total. thus, education is one of the important factors to arrange income distribution. that is because educational equalization must be paid attention, educational investments must be increased and not ignoring the quality while doing this. the impact of education on income growth is about tax revenue from one aspect. educated classes rise up tax revenue to the extent that they can employ and decrease taxation pressure causing informal economy. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.910-922 918 5.3.3. relation of informal economy, population growth and education the rapid population growth in turkey is a phenomenon that affects all the institutions and development. the population growth affects every reform movement and development attempt negatively. rapid population growth blocks the people to get a more share of the increase in welfare and the rapid process of economic change. it makes the development attempts harder and there becomes a growing need to housing, health, education and infrastructure (guloglu et al., 2003:61). population growth makes us to increase the sources for investment and decrease the capacity of informal economy to get the income for those sources. the relationship between the population growth and the informal economy is mostly unemployment. as long as enough employment cannot be performed for the increasing labor depending on population growth, the size of the informal economy will increase. in this respect, the rapid population growth in turkey and the properties of labor market formed by the migration from towns to cities since 1950 are the efficient factors for the expanding of informal economy (dpt, 2001a:3). education decreases population growth by decreasing fertility. this situation is the same in turkey. we can see that with the increase of education level fertility increases. according to the studies done in turkey, it can be seen that there is a negative relationship between the education level of woman and fertility (akca and ela, 2012:233). in this way, education not only causes the increase of productivity and human capital by increasing the individuals’ properties but also forms an opportunity to bring up more qualified and educated people by decreasing the population growth. because, for the decreasing population the investment amount will decrease and increasing education will increase the informal employment and guilt economy. 5.3.4. relation of informal economy, unemployment and education unemployment is an important factor in the formation of informal economy especially in the developing economies (onder, 2001-2002:244). in developing countries, in formal sectors it is restricted to form new employment opportunities and it costs much for the process of investigation of work in formal economy (cetintas and vergil, 2003:18) and these cause employment in informal sector that requires lower education level and less capital such as contract manufacturing, itinerant trade, hawking, selling water (dereli, 2007:70; akturk, 2005a:298-299). economic crises mostly affect less unqualified workers and small businesses. the first losers of their jobs in crises are in this group. fort this reason crisis causes both the finding out job in informal sector for workers and directing of small businesses to informality (savasan, 2011:14). technological developments and the change in the structure of employment labor market affect the unemployment and informal economy. movement from agricultural sectors to industrial services, productivity increase and crises decrease employment and this causes the unemployment of unqualified migrated people and direction to informal employment. especially in industrial sectors, owing to the technological developments labor dependent production replaced by machine dependent production. this situation causes the unemployment for the unqualified labor force. and this labor force moves to informal activities because of livelihood concerns (sarili, 2002:42). supporting of informal economy of the labor market can be increased by education (toptas, 1998:82). the increase of labor force and expertise with the increase of education is an important factor for the increasing of informal economy. but the education policy in our country does not suit the necessary properties for labor force. in our country, education is disconnected to work-life and there are two important reasons for this. the first one is that the population is not directed for the labor force demands and millions of people are educated in the fields which are not needed. the second one is that the education cannot meet the needs of work-life in content (dpt, 2001b:37-39). because the human sources do not have the properties that a contemporary economy needs, this becomes one of the important factors that increase informality (ulgen and ozturk, 2007:18). 5.3.5. relation of informal economy, tax and education one of the important factors of informal economy is to decrease the tax income that is the main investment resource of countries. tax and informality is a process that feed and strengthens each other. the informality of some economical activities causes the less payment or not payment of taxes and as a result tax income of countries decreases (gib, 2009:33). tax pushes the system to informality and with the expansion of informal parts taxes become heavier (bilen, 2007:137). an assessment on the relationship between informal economy and educational level in turkey 919 especially in developing countries, great sources needed for education must be obtained by countries (arabaci, 2011:102). the reason for this is that education is individual, social and economic (ozbaran, 2004:129). education both increases human capital and economic growth and growing economies supply more resources for education (altundemir, 2008:52; ozyakisir, 2011:55). in this respect, the increase in education level increases the sources by forcing growing and increases informal employment and this increases the income of countries. and this will be an opportunity to decrease the tax load and to spread the tax to the base. the change in education level affects the viewpoint to tax and arrangements related to tax. the increase of tax compliance with the growth in education level is an opportunity for the decrease of informal economy. some studies done in some cities in turkey support this view (see celikkaya and gurbuz, 2008; coban and sezgin, 2004). education level is important for the acceptance of taxes for taxpayers more easily and the occurring of tax applications. with the right and good quality education the viewpoint of taxpayers can be affected positively for taxes (cicek et al., 2008:35). the positive attitude to taxes is an opportunity to correct the taxes of informal economy. only educated tax payers can use the way of tax evasion by understanding the tax laws better. torgler (2003) stated that educated tax payers will be slow for the conformity of taxes because the educated people can understand the tax evasion opportunities better and they will be aware of how the countries will use the taxes. richardson (2006) stated that higher general education will cause lower tax evasion (saracoglu, 2008:19). therefore, increase in education level cause both tax evasion by understanding the tax rules better and tax compliance by getting more conscious about taxes. in the studies done in our country, yeniceri (2004:922) in his study for i̇stanbul found that higher level educated people can use the advantages of tax opportunities more because of their high knowledge about taxes. according to the study, the thought that the country cannot use the taxes better spreads out with the growth ıf education level. similarly, in the study done by celikkaya and gurbuz (2008:52) in eskişehir, the growth in education level increases the question of where the countries spend the taxes. in a study done by saracoglu (2008:31) in turkey, in all levels of education it is stated that spending of taxes is not affective. with the increase of education level of tax payers their viewpoint to tax regulations and taxes can change. in their studies, celikkaya and gurbuz stated that with the increase of education level tax amnesty can be used as an instrument for recording the informal economy. in their studies, coban and sezgin (2004:791) stated that by decreasing the tax rates informal economy will decrease and tax income will increase. because the informal economy consists of great scope, its relation with education can be seen in different areas. it is remarkable for turkey that the people operate in informal employment and underground economy is mostly uneducated. with the increase of schooling and the literacy rates, the decrease of population growth and the employment increase, some expectations about the decrease of informal economy in turkey will strengthen. 6. results and recommendations the size of informal economy in turkey is extremely big and shows structural property. uneducated people working at agricultural sectors immigrate to cities by the effects of technology and population growth and they cannot find any jobs related to their education level. to live their life, they move to informal employment or underground economy. increasing of education level and the quality is an important factor for the decreasing of informal economy that causes a lot of problems in economy. high educated people prefer formal employment and get higher income and get rid of underground economy. besides, the increase in education level minimizes the negative effects that cause the growth of informal economy. education increases the tax income and the factors of economic growth, decreases unemployment and population growth and organizes income spread and tax ethics. the increase of education level in turkey is a key element for the decrease of informal economy. international journal of economics and financial issues, vol. 3, no. 4, 2013, pp.910-922 920 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(2010) kayıt dışı ekonomi ve i̇stihdam üzerindeki etkileri. ankara: türkiye kamusen yayınları, no.32. . international journal of economics and financial issues | vol 6 • special issue (s2) • 201614 international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2016, 6(s2) 14-23. special issue for “state and municipal regulation, investment, commerce: national and international aspects of the business” topical issues of the theory and practice of import substitution in the russian federation victor yakovlevich belobragin1*, petr iosifovich burak2, tatiana ivanovna zvorykina3, victor grigorievich rostanets4, shamil magomedovich magomedov5 1all-russian scientific and research institute for certification, 3, electrichesky lane, moscow, 123557, russia, 2institute of regional economic research, 29/16, sivtsev vrazhek lane, moscow, 119002, russia, 3institute of regional economic research, 29/16, sivtsev vrazhek lane, moscow, 119002, russia, 4institute of regional economic research, 29/16, sivtsev vrazhek lane, moscow, 119002, russia, 5institute of regional economic research, 29/16, sivtsev vrazhek lane, moscow, 119002, russia. *email: sss2800@mail.ru abstract the article analyzes the status and prospects of development of the activities of governing bodies and industries in the russian federation in the field of import substitution. it is shown that after the crisis of 1998, the first significant measures to reduce the volume of imports by development of domestic production were taken in russia. then, the process of import substitution slowed. this problem greatly exacerbated due to the introduction of economic sanctions by the west and by the russian counter-measures to restrict imports, mainly food. in this connection, dependence of a number of important sectors of the economy on imports and the lack of measures taken at all levels of management of the economy to improve the efficiency of import substitution are shown. one reason for this situation is weak development of scientific and methodological foundations of this economic phenomenon. the elements of the theory of import substitution and practical recommendations on the use of program-target method for planning work on import substitution through the development and implementation of targeted programs at the federal, regional and enterprise levels were proposed. keywords: import substitution, import replacement, competitiveness, quality, targeted programs jel classifications: l10, l16, f51, b41, d24 1. introduction the term “import substitution” is one of the leaders in the number of mentions on the internet: search on “import substitution” in yandex generates 2 million results. this is understandable, because the problem of import substitution is discussed intensively at different venues and from different points of view. in his annual address to the federal assembly, russian president putin noted a reasonable import substitution – this is our long-term priority, regardless of external circumstances (putin, 2014). the scientific, technical and economic literature discusses the issues of import substitution in relation to specific sectors, less often – to the regions. the issues of how to avoid distortions and realize the potential of import substitution in russia were addressed in the discussions at the moscow economic forum in 2014 and 2015. the authors of this article also contributed to the discussion of this issue (antonova and belobragin, 2015; belobragin and zvorykina, 2015). however, many methodological issues in the debate remained unclear: how to ensure the comprehensiveness of the decisions taken by the federal authorities, regions, business communities; where, at what time and what cost the plans of import substitution will be implemented; there is no established terminology in this area of activity. in other words, a theory of import substitution in the framework of the science of strategic management is required. belobragin, et al.: topical issues of the theory and practice of import substitution in the russian federation international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 15 some important issues of the theory and practice of import substitution, its impact on competitiveness and sustainable development of enterprises, industries, regions and the country as a whole will be considered from a systemic position by the authors in this article. 2. methodology 2.1. historical background and elements of the theory of import substitution import substitution as a phenomenon first emerged after the second world war, when the colonial system collapsed and new states of the former colonies and dominions gained relative economic independence. the problems of replacing imported goods supplied by the metropolises for economic and employment recovery emerged. in subsequent years, import substitution was carried out by latin america and by developed countries as a non-market way to improve the competitiveness of products through providing various preferences to business from the state. (kadochnikov, 2005). this practice was carried out in a number of industries in the ussr. in post-soviet russia, the first visible steps on import substitution were made after the devaluation of the ruble in 1998, when the volume of imports to russia declined significantly, which was the most important factor in economic growth, especially in manufacturing, in 1999-2000. for example, with the participation of the russian meat union, back in 2002, protective measures against imports of finished meat products were developed simultaneously with the introduction of a package of measures to improve product quality. today, foreign sausage and ham are rare on supermarket displays. russian meat processing plants produce even sausages that are complex in the production, such as brunswick. the share of the remaining imports in this group of products does not exceed 5% (petrov 2015a; petrov, 2015b). at the beginning of the 2000s, russian steel plants did not produce large-diameter pipes for the laying of main oil and gas pipelines, and transneft, gazprom and other companies purchased them abroad. as part of the program of import substitution, the united metallurgical company in collaboration with a group of peer companies has mastered modern integrated production of this type of pipes by 2008. as a result, today the share of domestic pipes used by gazprom in the construction of gas transportation routes is up to 95%. then the process of import substitution slowed. at the same time, the practice of import substitution before the last crisis in 2014 has identified a number of significant gaps in some industries. in the automotive industry, the share of imports dropped from 59% in 2009 to 25.4% in 2013 thanks to foreign firms setting up manufacturing facilities in russia. however, this is mostly a “screwdriver” production. the legislative requirement to increase the share of purchase of auto components of the russian manufacturers has not been established. as a result, the share of the car components of domestic manufacturers is < 10% (brooks, 2013). the so-called localization primarily involves the production of simple car elements (for example, the frame for “volvo” truck assembled at the plant in kaluga, in the moscow region, is made of swedish steel using the foreign equipment and “volvo” technology). the russian authorities did not demand technology transfer from foreign investors to russian companies (naude et al., 2013; sonway and barber, 2000). the problem of import substitution exacerbated due to economic or political upheavals, such as the economic crisis of 2008-2009, a significant depreciation of the ruble in late 2013 and in 2014, and the introduction of strict sanctions against the russian economy in relation to the events in ukraine. the situation in 2014 activated the process of import substitution in russia, including at the level of state policy. 2.2 methodical approach to import substitution in a variety of industries let’s consider the state of import dependence in a number of sectors of the economy that can hardly be called something other than critical. almost 18% of the gdp of the country is directly linked to imports (tsvetkov, 2010). the policy of the 90s of the last century has almost led to the elimination of the entire industry sectors – production of the electronic component base; production in the light industry was largely reduced, which is particularly alarming; machine-tool industry collapsed – 99% of machines for mechanical engineering are imported from abroad. shopping malls, warehouses of goods, service stations for foreign cars are now located on the grounds of the famous moscow machine-tool plants named after ordzhonikidze, “red proletarian,” grinders, leningrad plant named after sverdlov. krasnodar and ivanovo machine-tool plants can barely survive. an important area of it is 90% dependent on imports: 94% of software and 99% of computers. in instrument making industry, the import of medical and industrial automation devices is 80-90%. one reason for this situation is the lack of the modern component base. the share of imported components in engineering depending on the machine type ranges from 25% to 100%, the data on car components is listed above. the share of imports in the pharmaceutical and medical technology segment is 80%, and for some products it reaches 100%. the services are the result of direct interaction between the consumer and the performer and the result of the independent activity of the performer to meet the needs of customers (gost iso 9000-2011), their provision is interconnected not only with production, but also with the process of interaction. provision belobragin, et al.: topical issues of the theory and practice of import substitution in the russian federation international journal of economics and financial issues | vol 6 • special issue (s2) • 201616 of services involves the use of technical equipment, chemicals, measurement means and methods, innovative technologies, etc. research conducted at the institute of regional economic studies has shown that up to 80% of foreign drugs, materials and equipment is used in the provision of some services, such as beauty services (hairdressing, spa services), cleaning services, dry-cleaning and laundry services. it is advisable to take advantage of this opportunity and suggest a strategy of independent development of services based on the application of innovative technologies for import substitution in order to achieve a leading position in the provision of services. a problem of import substitution in the shipbuilding industry is very acute. the participation of russian producers in the supply of equipment for the construction of ships is excluded already at the stage of preparation of the technical documentation. rural producers are almost 100% dependent on imports of corn seeds and breeding livestock. we will especially consider the status of the import substitution of food, the import share of which reaches 39% (petrov, 2015; tsvetkov, 2010). the dependence of the domestic processing industry and trade on supplies from abroad is particularly evident in view of the fact that the government of the russian federation responded to western sanctions on august 7, 2014 and limited the export to russia of a number of products, introduced a complete ban on imports of beef, pork, poultry, and partially finished meat products, fish, cheese, milk, fruits and vegetables from australia, canada, the eu, the us and norway for 1 year (fedolyak, 2014). total annual import of the restricted production was at the time estimated at $9.1 bln. analysis of the food sector of the russian economy has shown that in an average year, our country imports food products for $50 bln, of which $37 bln falls on imports from non-cis countries. the expenses of $11 bln are understandable. but how can we explain the import of fish and fish products worth $2.5 bln, import of 750 thousand tons of potatoes and up to 15% of the total sales of onions and carrots? before turning to the analysis and generalization of measures on import substitution, it is necessary to state the position of the authors on some of the elements of the theory of import substitution on the assumption that such area of economic activity as import substitution cannot develop without scientific and methodical bases. on the one hand, the theory contributes to the production of new knowledge, on the other hand, it is enriched by the sum of the knowledge gained from experiments and practical experience. the starting position is that import is one of the parties to the international division of labor. it is impossible to produce a whole range of products – for example, engineering products – in one country or grow tropical products grown in the north. ricardo’s classical theory of comparative advantage is also valid (ricardo, 1955). therefore, the extent of the need for import and import sufficiency should be assessed in every sector and region (semenov, 2012). import of the unique equipment and new technologies should be preserved while keeping adapting to the conditions of the western embargo. the recommendations of the soviet economists from 1989 on the import policy are interesting: target for the austerity, prudent use of monetary funds, refusal to purchase products that are not necessary (brief dictionary of economics, 1984). 3. results of research 3.1. ensuring comprehensiveness in addressing the problems of import substitution we will illustrate this thesis with an example of mastering the production of the machine capable to displace foreign manufacturers of similar equipment from the market. high precision machining requires that the most important components and details of the future competitive machine – for example, bearings – also have a higher precision class. many related problems have to be solved simultaneously: where to find engineers who can design it; particularly hard special steels that are indispensable in the production of key components of highprecision machines; high quality and perfect electronics; high quality masters able to work on such equipment. accurate classification of the forms of import substitution. according to the authors, two types of import substitution should be considered: the organization of the own production and the replacement of one importing country with another. 3.2. import substitution by organizing the own production there are three areas: • import substitution of relatively simple products, which requires development of new technologies and modern production taking into account the cost-effective use of resources. this can be implemented within a year; • import substitution and organization of mass (serial) production of complex products that require modernization of production, development of critical technologies, organization of mass training. it will take 2-3 years; • import substitution of complex products, the production of which requires research, long design and development cycle, and construction of new production facilities while significantly reducing resource intensity. it will take at least 3-5 years. to implement these three areas, the measures of the federal and regional level on import substitution should be developed, and, of course, additional funding is required. according to glazyev, average production for import substitution worth 1 mln rubles will require no <500 thousand. rubles in investment. 3.3. import substitution by replacing one importing country with another we propose to introduce a new term and call this approach “import replacement.” it should be considered in two ways: • enforced, when importing country for any reason can belobragin, et al.: topical issues of the theory and practice of import substitution in the russian federation international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 17 no longer supply the products (in the final result, import replacement is transformed into import substitution); • for commercial reasons. in the case of import replacement, it is important to conduct an audit of the fund of standards and adopt measures to tighten the conformity assessment procedures (certification, testing and monitoring). 3.4. import substitution in the service sector in the area of activity close to the authors, the services sector, given the urgency and scale of the operations for the implementation of import substitution and normative legal acts entered into force, it is necessary to conduct research to identify the primary and the mediumand long-term challenges for ranking the problems faced by the industry of consumer services. for instance, all supplies should be started to produce a lot earlier than the equipment used. the entire range of materials used, equipment, etc. should be worked through. the study will have the following tasks: • research of the services market of russia and its interaction with other foreign countries; • analysis of domestic production and identical products of the foreign counterparts; • research of professional and higher education institutions for the presence of professionals who can work in this field and the development of professional standards for these specialties. after solving this problem, the industry will be independent of foreign countries and russia will have its own developed industrial base and new jobs. thus, complex research will form the strategy of import substitution in one of the most socially important sectors of the economy – the services sector. 3.5. current and future issues of import substitution when solving the current and future issues of import substitution, two factors should be taken into account: • import substitution as a non-market mechanism objectively affects the decrease of competitiveness: • import substitution policy promotes economic growth in the short term, in the best case – in the medium term. long-term strategy (taking into account import substitution policy) should be built on the basis of improving the competitiveness at all economic levels – federal, regional, enterprises (organizations). the authors propose to formulate strategic goals for sustainable development of import substitution by using the ideas proposed by the professors of the french business school insead kim and mauborgne and described in the paper “blue ocean strategy.” this book was the result of a study of more than thirty sectors in the last 100 years. by analyzing the data obtained, the authors found a certain sequence of strategic thinking that preceded the creation of a new market or industry. they called it a blue ocean strategy. kim and mauborgne include all industries that currently do not exist in the blue ocean; they call them an unknown market space, free from competition. in blue oceans, according to the scientists, the demand is created rather than is the subject of a fierce struggle. there is ample opportunity for the company to develop, increase profits and rapidly grow (kim and mauborgne, 2008). the logic of the blue ocean strategy differs from traditional strategies that focus their attention on the struggle in the existing market space, which the authors called a scarlet ocean. the researchers say that the scarlet oceans represent all the industries of today – a known market space. the boundaries of the sector are clearly defined and are not contested, and the rules of competition are absolutely clear. under these rules, companies are trying to outdo each other to get the right to meet as much of the existing demand as possible. with the increased competition in this market, the growth and profit prospects for the company are becoming increasingly questionable. new items are transformed into mass consumer goods, and the growing competition, as kim and mauborgne say, colors the waters of this business ocean into blood red (kim and mauborgne, 2008). the main differences of the strategies identified by kim and mauborgne are presented in the table 1. kim and mauborgne believe that in the long term, the blue oceans will become the main source of economic growth, and the potential of the majority of the segments of the scarlet oceans will be gradually reduced. this will be possible thanks to the fact that technological advances provide only an increase in productivity of the industry, allowing providers to create a wide range of goods and services. import substitution is an important lever for the economy, designed to solve a number of acute and urgent issues of the country’s exit from the crisis. however, at the same time, it is necessary to solve a strategic task – move from import substitution to the exportoriented economy, i.e., focused on the “blue ocean strategy,” gradually displacing the “scarlet ocean” of import substitution. 4. discussion 4.1. strategic measures to focus the systemic work on import substitution the participants of the process of import substitution, primarily investors, need basic and unambiguous prospects for this activity table 1: the scarlet ocean strategy against the blue ocean strategy scarlet ocean strategy blue ocean strategy struggle in the existing market space creating a free competitive market space victory over competitors ability to be not afraid of competition exploiting existing demand creation and mastery of new demand value/costs compromise destruction of the value/costs compromise construction of the entire system of the company activity based on the strategic choices focused either on differentiation or low costs construction of the entire system of the company activity in accordance with the objective of simultaneously achieving differentiation and cost reduction belobragin, et al.: topical issues of the theory and practice of import substitution in the russian federation international journal of economics and financial issues | vol 6 • special issue (s2) • 201618 and stable conditions and rules of the game (peregorodieva, 2012). “even our retaliatory sanctions” are not new stable conditions for decades, but only temporary restrictions for… 1 year (boldyrev, 2014; burko, 2013). in such circumstances, investment becomes very risky. therefore, the main incentive for small and medium businesses, in particular for the farmer, is to ensure sales. 4.2. setting priorities setting priorities with limited resources is special in times of economic crisis. “due to the modernization of industry, construction of new enterprises, localization of competitive production in russia, we will be able … to significantly reduce the import of many items, give our market back to domestic producers,” – said putin. “this includes the production of software, electronic equipment, power equipment, textile industry and, of course, the food market. i consider it necessary in the short term to analyze the possibilities of competitive import substitution in the industry and agriculture ….” analysis of the initiatives of the federal and regional governments, unions, associations and other organizations conducted by the authors showed that the timing of a number of programs, plans and projects is greatly underestimated, and at first can be defined as “an arrogant faith in success.” there are statements by the persons responsible for this area of activity that in case of nondelivery for the embargo of products for civilian objects, they can be mastered by our industry in a period of 6 months to 2 years. let’s consider a hypothetical real term of mastering the propulsive system as part of a vehicle: • development of technical specifications and the project – 6 months; • design – 3 years; • bringing to the design parameters – at least a year; • preparation for production, including personnel, even it is carried out in parallel with the design – 1 year. as a result, the cycle is not < 5 years. for simple products for machine building, the timing in the official’s statement is real. creation of fixed assets for the modern high-tech, knowledgeintensive industries should be started from scratch. there is no hope for import substitution in agricultural production in the short term. import substitution in the meat food sector will require up to 7 years, with greater efforts in the area of beef cattle, associated with a long investment cycle and livestock farms payback. import substitution with domestic fruit will require a long time as well – 8-10 years for apples. at the same time, import substitution for the “borscht set” – potatoes, cabbage, carrots, beets and onions – is possible in the short term (belobragin and zvorykina, 2015). 4.3. investments the costs of implementation of the import substitution program are not entirely clear yet. there are different opinions. economic development minister of the russian federation ulyukayev offers to use state funds that some believe are absolutely inviolable. chubais believes that it is relatively painless to increase the public debt. president of the association “rosagromash” babkin believes that “you need to change lending policy under which loans cost 25-25%, reducing them to 3%. reduce taxes. expand the tax maneuver in the opposite direction – the resources in the domestic market should be cheaper. organize a system of support for noncommodity exports” (babkin, 2014). the industry development fund established in accordance with the federal law “on industrial policy of the russian federation” may become an important source of lending to enterprises in import substitution. the fund provides for the use of the mechanism of recurrent financing at reduced rates for investment projects of the medium-sized businesses. the russian ministry of industry has already worked out the fund operation scheme and has planned about 19 bln. rubles in the budget of 2014-2017 for its funding. 4.4. state support for import substitution according to the government of the russian federation, government costs on import substitution through to 2020 will amount to 1.265 trillion rubles (about 23 billion euros). the ministry of industry and trade has approved more than 2 thousand projects designed to reduce russia’s dependence on imports in various sectors. in support of these projects, a powerful mechanism for standardization will be used. rosstandart adopted a standardization sheet for 2015-2017 in the field of import substitution. it includes the development of specific national standards for industries that will receive state support in the work on import substitution. the sheet is based on a direct order from the ministries, especially the ministry of industry and trade of russia. 500 standards will be developed in the first stage of 2015-2017, which will close the need for regulations on the program of the ministry of industry and trade of russia. emphasis will be placed on the machines and oil and gas equipment. they will allow companies to establish commercial production of goods, where the dependence on imports proved critical. 400 documents are based equally on the international and european standards; they include some american astm standards for test methods. the remaining standards are the original design. there are cases when the company urgently needs legal and technical documentation to launch the production of important products for the country. in this case, it can work with translated documents. then, requirements that are more stringent than international will be introduced in the standards. in practice, it is a “pulled” belobragin, et al.: topical issues of the theory and practice of import substitution in the russian federation international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 19 standardization, as was done with the classes of motor fuel – from euro-2 to euro-5 (antonova and belobragin, 2015). brand new rules were introduced in the federal law “on standardization in the russian federation,” which allows the russian ministry of industry and other ministries conducting the work on import substitution to refer to the existing standards. it was enforced on july 1, 2015. this will set out the text of the standard that will simplify the process of its development, coordination and assessment in the legal act (antonova and belobragin, 2015). 4.5. real situation in import substitution and ways to improve efficiency in this area unfortunately, the authors have no access to summarized material on the country, so we use information on individual sectors and industries. it was noted above that the russian ministry of industry has developed a detailed plan of import substitution in the industry. the ministry of agriculture of russia and individual corporations and associations have similar plans. taking into account previous work, we can say that the fundamental issues of import substitution were addressed in the field of military shipbuilding on missile carriers “borei-a” and multi-purpose nuclear submarines “yasen-m” with the use of exclusively russian technology. the practice of public procurement of imported products is implemented only when there are no domestic counterparts. in 2015, “gazprom neftekhim salavat” is going to finish the construction of the complex for the production of acrylic acid and acrylates – a basis for the production of many hygiene products; so far, almost the entire required volume of these products is purchased abroad. after entering the full production capacity at the plant “tobolsk-propylene,” which belongs to the group of companies “titan,” russia will turn from an importer into an exporter of this product. for example, the association “soyuzmoloko” developed the program of development of the industry for the coming years after the imposition of sanctions. dairy industry expects to receive 60 bln rubles of additional budget funding in 2015-2020. during this period, it is expected to completely eliminate dependence on imports, which currently stands at 40%. state aid, according to industry executives, should be provided not only in “monetary terms:” even in the case of the lifting of sanctions, the government should protect dairy producers from large-scale imports, for example, by tightening phytosanitary requirements, more stringent quality control of imports. let’s consider the regional problem on the example of the republic of tatarstan. the ministry of industry and trade of the republic believes that the potential for import substitution in the country is $4 bln in machinery and $540 mln in chemistry and petrochemistry products. the ministry’s website has a list of petrochemical products, the production of which should be developed in the republic of tatarstan. it is also advisable to pay attention to the development of instrument engineering in the republic. for example, kazan medical instruments plant could increase output by three times as part of the import substitution program. but it needs to build the sterilization center on the territory of the plant. today, the company needs state support, preferential loans and building permits. according to the ministry of construction, architecture and housing of the republic of tatarstan, the republic imports cement, ceramic tiles, clinker bricks and plate glass in full, and soft roofing waterproofing materials, dry building mixes, plasterboard, sanitary ware, linoleum, wallpaper in large volumes. however, the capacities of the republican enterprises for these types of goods are not fully loaded. for example, plants of dry mixes in almetyevsk and kazan could fully supply all the businesses and contracting works in the republic. however, the promoted brands are purchased today. as for agriculture, according to the relevant ministry, tatarstan is able to provide itself with food in full. for example, in 2013 it produced 318 thousand tons of meat, while consumption was slightly < 300 thousand tons. the republic needs to increase the production of meat products and sausages, the quality of which would satisfy the consumer, and to resolve the issue with the placement of domestic products in retail chains. according to the minister of agriculture of the republic, the balance of import and export of agricultural products in 2013 amounted to +24 bln rubles. surplus of milk, meat, potatoes and sugar, according to the minister, is the potential for access to foreign markets. the bottleneck in the agriculture of the republic is the fruit and berry area. ministry has just started to develop the program “gardens of tatarstan” and create clusters in berry area. so far, tatarstan annually imports fruit and vegetable production for 1.2 bln rubles. the possibility of a balanced policy of import substitution, which takes into account the effects in the short and long term and consistent with the basic strategic priorities of the republic of tatarstan, was discussed in september 2014 in moscow as part of the strategic session “import substitution in the republic of tatarstan: diagnosis, programs, implementation mechanisms.” the outcome of the session was the following conclusions: • the main problem of import substitution is the inability of the state to create the conditions for a stable internal demand for substitutable products; • the most promising model of development of high-tech small and medium enterprises in the framework of the policy of import substitution is corporate venturing; • priority areas of import substitution are the development in food production to ensure food security in the region and the export-oriented industrial production; • financial resources allocated to regional science should be concentrated in the areas that will ensure the implementation of priority development projects; belobragin, et al.: topical issues of the theory and practice of import substitution in the russian federation international journal of economics and financial issues | vol 6 • special issue (s2) • 201620 • it is necessary to conduct a comprehensive analysis of the list of imported goods in comparison with similar products produced in the republic of tatarstan, and to assess the potential of import substitution for each significant position; • it is desirable to establish a single information system in order to ensure the management of the implementation of the industrial policy of the republic of tatarstan; • it is necessary to analyze the global commodity markets in terms of outstanding needs (with significant prospective capacity), which can help determine products that are in priority for the industry development (antonova and belobragin, 2015). 4.6. problems arising in the course of the practical implementation of import substitution one of the most acute problems that have emerged in the process of import substitution is the failure of the state to create the conditions for a stable internal demand for substitutable products in the economic crisis. the lack of the required number of workers and professionals. they are required in all stages of the process of import substitution. the demographic situation is that there is a rapid decrease in the number of the younger generation, i.e., people entering the labor market, the reduction in staff qualification. can the highest quality from design to product be ensured at such qualifications? there is an acute shortage of engineers and technologists in the industry. many experts moved abroad, university graduates who studied at the institution with bologna system come to production poorly prepared, with a low level of knowledge. 4 years are not enough to prepare a good engineer. the enterprises don’t need bachelors with a poor level of knowledge. unemployment shows a positive trend and is about 3%. hrs of companies have extremely narrow range of highly skilled workers in these conditions. ensuring the competitiveness of the export-oriented products requires a high level of scientific and technological developments. however, the industry science is almost completely destroyed, and the recovery of the scientific school will require 15-20 years. high wear of production capacity, which is 60-70%, requires investments, including in the development of the machine-tool industry. statistics show that over the past 15 years, the share of corporate profits in gdp has declined in russia; as a result, they have less funds to invest. in terms of financial stagnation in the economy, reducing gdp growth to near zero, the state support for modernization is limited. another source – loans, with a high interest, as much as 20% – is limited for most companies. imitation of import substitution. there is a tendency of increase in the volume of production of the overseas developments assembled from imported components (efanova, 2015). industrial assembly is the most primitive form of import substitution, which does not allow to create a domestic technological base, while the intellectual rent remains abroad, and russian enterprises have to deal with lowskill work on assembly of machines from ready components and assemblies (nikolaev, 2014). it is necessary to develop domestic technological base through the transfer of technology as a whole, purchase of licenses and renewal of the best technical solutions, based on its scientific and technical potential. even at the level of programs and plans for import substitution, the export-oriented projects are rare. a very acute problem is the quality of import-substituting products. we will illustrate this problem with the import substitution and import replacement of food. let’s consider this issue in more detail. following the results of audits of public organizations, such as rosсontrol, a significant portion of import-substituting products is not tested for quality and safety. the list includes cottage cheese, sour cream, sausages, salted salmon, red caviar, bottled water, chicken fillet. new producers and products that are designed to replace imports do not meet the regulatory requirements for quality and safety (www.kachestvo.ru). the quality of our usual products began to fall sharply just after the ban on imports. the market was flooded with new manufacturers and products that were designed to replace imports by quantity, but according to research, not by quality. input control exercised by retailers does not cope with the increased number of new products, and the phenomenon of state control has almost lost its meaning in recent years, under the action of the federal law no. 293. according to the chairman of the consumer rights protection society m. anshakov, it is a paradoxical situation – manufacturers can produce sausages without meat and call them meat products without any liability. volume of the forged food products on the st. petersburg market after the embargo has increased by 10%. situation in the meat and dairy industries is especially tense. “the most expensive ingredient in meat products is beef. analyzing ten kinds of dumplings where it was stated on the package, we found that only three samples really contained beef. the others used cheaper raw materials – chicken, sometimes pork. it wasn’t like that a year ago”, – says the chairman of the st. petersburg consumer organization “public control” vsevolod vishnevetskiy. the manufacturers change the ingredients in dairy products just as willingly. the undisputed leader in forging is butter. following the results of the inspection, 15 of the 30 samples proved to be counterfeit. the content of milk fat in some was no more than 5% (russian newspaper 2015, april 7). during the rating assessment of the quality of bread in krasnoyarsk, the experts rejected 40% of the samples: some of them had the potato disease or mold colonization. especially worrisome situation is with the quality of products that were import substitution of the eu countries and the united states for goods produced in asia and china. according to a. popova from the federal service on customers’ rights protection and human well-being surveillance, the volume of imported meat, dairy products, fish, vegetables and confectionery rejected during inspection by sanitary doctors belobragin, et al.: topical issues of the theory and practice of import substitution in the russian federation international journal of economics and financial issues | vol 6 • special issue (s2) • 2016 21 increased significantly compared with the year before last. by the way, if you consider each product separately, the most complaints are about confectionery products (the percentage of rejections has grown 24-fold, fruits and berries – 12-fold, dairy products – 4-fold, fish – 1.5 times). what are the main directions of improving the quality and safety of food? we noted the need for stricter requirements when assessing compliance on the part of state bodies and public organizations above (petrov, 2015a). the same measures should be carried out by the trade links as well. it is important to clearly comply with the requirements of technical regulations of the customs union (tr cu). 11 tr cu in the area of food safety are currently approved and entered into force, including “on food safety” (tr cu -021/2011), “food products in part of marking” (tr cu -022/2011), “on the safety of meat and meat products” (tr cu -034/2013), “on the safety of milk and dairy products” (tr cu -033/2013). the information and comments on the introduction of technical regulations are placed in the monthly editions of the magazine “standards and quality” under the heading “technical regulation in the customs union.” the compliance with the requirements of technical regulations on a voluntary basis is provided by the interstate and national standards, lists of which are approved for each technical regulations, as well as lists of standards on the rules and methods of researches (tests) and measurements, including on the rules of sampling necessary for the application and enforcement of the requirements of the tr. thus, tr and standards on products and test methods form a tandem that ensures the safety of agricultural products, their trade advantages and competitiveness. for example, a list of standards for “milk” tr contains more than 100 documents on standardization, for the “meat” tr – 270 standards, including 138 on production and 152 on the test methods. as of january 1, 2015, the fund of national and interstate standards in the field of agro-industrial complex is about 3,900 documents, of which 44% set quality requirements, 48% set requirements to the test methods of production, 3% set requirements to baby foods. renewability of the standards in the field of agro-industrial complex in recent years has averaged 180 standards per year, while 361 standards were approved in 2013 and more than 300 standards were approved in 2014, of which about 280 were interstate standards adopted by the interstate council. the standards are developed at the modern scientific and technical level, ensure the unity of methods to control the quality and safety of agricultural products, contribute to the reduction of technical barriers to trade between the cis countries and form a common approach to consumer and environmental protection. food safety system ensures the safety requirements at all levels of the food chain, is based on the iso standards of 22000 series, including haccp requirements, prerequisite and traceability programs. the main standard from this series iso 22000:2005 is widely used around the world. as of the end of december 2013, 26,847 certificates were issued in 142 countries. china is in the first place with 9,406 certificates, russia occupies a modest place with 279 certificates. the haccp system elements are included in the tr cu “on food safety,” article 10 part 3, and provide control in all stages of food production where a dangerous situation may emerge. 5. conclusion the above analysis of the quality of products shows that the import substitution of the food group was implemented defectively, without the participation of requirements of the consumer market. however, the quality factor is important from the point of access of domestic products to foreign markets. foreign researchers noted that the qualitative characteristics define competitiveness by 60-70% (versan, 2014a). its other components are also important – price, ease of maintenance, cost of consumption, but in terms of import substitution in connection with the sanctions, they are secondary in relation to quality. with regard to agricultural products, it is necessary to ensure the supply of the quality products throughout the supply chain to the consumer – from field to counter. this is possible with the development of program management principles, as mentioned by putin in his message to the federal assembly (putin, 2014). in order to successfully meet the challenges of import substitution and export growth, it is advisable to use three types of programs: federal, regional and enterprise programs. federal programs are financed from the federal budget, regional programs are financed from local budgets, enterprise programs are financed from the funds allocated to them as the participants of the program, as well as from their own funds. at the federal level, a list of products should be drawn up, for which improving the competitiveness is a priority for import substitution. state support for the development and implementation of targeted programs for these types of products should be carried out by targeted incentives not only for the enterprise producing finished products, but, if necessary, to other participants in the program, and provide the control of the targeted use of provided funds. as part of the program, measures to encourage import substitution and export growth in relation to the above targets should be proposed, including the reduction of loan rates and tariffs for energy resources and services of natural monopolies, tax incentives, support for achieving the objectives through the measures of technical regulation and standardization, simplification of administrative procedures, etc. belobragin, et al.: topical issues of the theory and practice of import substitution in the russian federation international journal of economics and financial issues | vol 6 • special issue (s2) • 201622 methodical, information and consultation assistance in the organization of this work, employees education and training, making best practices available to businesses, etc. should be provided. it is required to ensure an adequate public significance of the problem of import substitution and state supervision over the quality of products. at the regional level, it is advisable to develop the domestic programs on import substitution of products for a significant increase in gross regional product and solution of social problems. at this, regional capabilities to support operations should be used, including use of the opportunities of the region to assist businesses in dealing with personnel issues, implementation of infrastructure measures, organizational and methodological assistance in improving the quality, exchange of best practices, regional benefits in rent, advertising, and the conditions for fair competition. enterprise targeted programs should have clear tasks to ensure the required level of product quality, increase in productivity, standardization, resource provision, as well as creation of effective quality management system at enterprises, organization of partnerships with suppliers on the basis of mutual interest, cooperation with all interested parties (state, regional and local authorities, ngos, investors, etc.). the scientific developments of the scientific research institute of certification can be used to develop programs of all levels (versan, 2014b), as it made recommendations for regions on the organization of development (with the support of regional administrations) of product programs to improve the quality of competitive products at the enterprise. one of the authors of the article took part in the creation of these documents. 1. import is one of the parties to the international division of labor. it is impossible to produce a whole range of products – for example, engineering products – in one country or grow tropical products grown in the north. but the policy of the 1990s has almost led to the elimination of the entire industry sectors. the problem of import substitution worried the economists and industrialists in the past, but the response of the government of the russian federation to western sanctions that have restricted exports to russia of a number of goods, mainly food, has exacerbated this problem (buchwald et al., 1994). 2. work on import substitution of products is very important for modern russia. the issues of import substitution must be tackled in a systematic way. 3. it is necessary to study and solve a number of theoretical problems, clarify the objective function of import substitution, determine the conditions of the transition from import substitution to export-oriented economy. 4. import substitution is extremely expensive, own funds of the enterprise are not enough, a strong government support and a solid injection of funds are required. 5. the task of import substitution is, without exaggeration, the task of creating an entirely new industry, able to solve much more complex technical problems at a completely new organizational and qualitative level. 6. without resolution of quality problems in the broadest sense of the word – quality of the products, high-quality training of specialists and officials, business focused on quality, quality of program management, – we cannot solve the problem of increasing our competitiveness and import substitution, this should be an essential component of our economic and social development strategy at the present stage. 7. the mechanism of implementation of the 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(2014b), problems of growth of the real economy. management by objectives. economics and management: problems and solution, 2, 11-18. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(3), 193-199. international journal of economics and financial issues | vol 9 • issue 3 • 2019 193 the role of financial inclusion and competitive advantage: evidence from iraqi islamic banks hayder m. kareem al-duhaidahawi1,2*, jing zhang1, mustafa s. abdulreza3, sinan abdullah harjan1*, sayyed sadaqat hussain shah1 1school of management, huazhong university of sciences and technology, wuhan, china, 2banking and financial sciences, imam al-kadhum college, baghdad, iraq, 3al-furat al-awsat technical university/technical institute of al musaib, iraq. *email: sinan_harjan@hust.edu.cn received: 08 march 2019 accepted: 04 may 2019 doi: https://doi.org/10.32479/ijefi.8080 abstract the purpose of this study is to investigate whether the financial inclusion play a significant role in in achieving the competitive advantage (ca) in iraqi banks particularly, islamic banks. the target sample of this study is composed of customers using the technological instrument to access the services as achieving the financial inclusion. using a simple random sampling method to select the target sample of the study and designing a questionnaire for this purpose, (250) questionnaires were distributed and (20) were ignored, as they did not meet the respondents’ answers. thus, the questionnaires analyzed were (230) questionnaires. deceptive and regression analysis as statistical analysis are appropriate to the purposes of this study were carried out. the main results of this study were the significant effect of financial comprehensiveness on achieving the ca of institutions regarding customers. this study recommended that banking managerial staff has to focus on providing banking services using technological instrument because they constitute financial inclusion and thus achieving the ca of banks, as well as certain programs are needed in the banks to raise the technological awareness of current and prospective customers. keywords: financial inclusion, competitive advantage, islamic banks jel classifications: g29, l19, e59 1. introduction financial inclusion includes all those economic agents who have an access to formal financial services and are using these services effectively every day. to be able to access a transaction account is the first step to comprehend financial services more broadly because such an account enables people to save money, deposit payments and receive them. transactional calculation could be a beginning and will lead to other financial services, due to which guaranteeing the people’s worldwide-access to account is the main attention of the world bank group’s financial inclusion initiative by 2020. it has become a significant public policy based on priority to follow the current worldwide financial crisis. for example, as the result of the financial crisis, the leaders of g20 organization, recognized the jointly strengthening policy purposes of financial inclusion (ahamed and mallick, 2019). currently, financial inclusion is the center of attention of all the stake holders i.e. experts in the field of research, finance and industry. past studies conducted on this issue concluded that financial inclusion is closely in relation with economic growth, which stirred researchers’ interest. in this study the concept of financial inclusion deals with financial services like deposits, insurance etc., their accessibility and personnel who are in the industry. in other words, a tremendous inclusion of financial services to the society signifies that the this journal is licensed under a creative commons attribution 4.0 international license al-duhaidahawi et al.: the role of financial inclusion and competitive advantage: evidence from iraqi islamic bank international journal of economics and financial issues | vol 9 • issue 3 • 2019194 conditions which allows participants to use formal financial systems to benefit themselves and ensure the stability of their capital amount (kim et al., 2018). since late 1990s, this term “financial inclusion” has been focused stimulatingly covering both the aspect of policy-making issue of those who are excluded persons and researches conducted on those who are the financial exclusion of socially excluded individuals have occurred (leyshon and thrift, 1993, 1994,1995); (collard, 2007) 2. literature review previous literature based on research studies offers detailed conclusions and suggestions on the optimistic role of financial inclusion in indorsing comfort of households and economic development while trivial consideration has been paid to examine whether such a progress goal has consequences on soundness of banks: among reasons, one the significant is to why banking sector ‘shy away’ or reluctant to spread financial facilities to underprivileged sections of the society. in current era of sophisticated technological development, institutions deal in finance are progressively penetrating novel chances and delivers and looking at the profits of micro-finance operational approach. by misusing larger scale, talent and technological capacity (peachy and roe, 2006; demirgüc-kunt et al., 2008; (beck and demirgüç-kunt, 2011), banks are expected to offer financial amenities to a greater client base positively at an abridged cost, whereas supporting reduce the risk by taking more non-wholesale funding as confidence on larger part of non-deposit funding paid to the current shortage of asset banking in the us (e.g.; poghosyan and cihak, 2011). conducting a research on a big sample of banks data numbered 2600 covering 86 countries since 2004-2012, the study focused on the significance of different dimensions of financial sectors and its impacts on the stability of banking sector as an important regulatory issues at micro finance level and conclude that financial inclusion and stability of banking sectors are complementary. sarma and pais (2011) study human development index with the index of financial inclusion finding the existence of correlation between both. particularly, the study propose that the factors related to socio-economic and infrastructure like income, inequality, literacy, physical infrastructure and urbanization for information play a significant role in financial inclusion. this study focuses to discover the association between financial inclusion and economic growth of countries that are part of oic organization which holds financial exclusion level higher as compared to other countries. it is anticipated that the researcher would be able to explore a close relationship between financial inclusion and economic growth, that’s growth flow is considerably high due to islamic financial system. the data collection source was world bank’s global foundation for democracy and development (gfdd), and world development indicator, and the financial access survey of imf (fas). the oic contains of 57 countries, gfdd like fas do not comprise palestine and data concerning somalia are missing from inclusion. thus, 55 oic countries include, three countries from east asia and pacific, eight countries from europe and central asia, two countries from latin america and caribbean, 18 countries from middle east and north africa, four from south asia, and 20 countries from sub-saharan africa, somalia is not included. table 1 shows the lists of these countries. the sample of covering period is from 1990 to 2013 because of the consideration that there is considerable missing data. in the study of kim et al. (2018) financial inclusion has proven to be a vital policy priority as a result of the prevailing global financial crisis. we have less knowledge of the fact that how it affects financial services. putting into practice a worldwide sample totaling 2635 banks in different 86 countries from 2004 to 2012, we conclude that higher level of financial inclusion results in better stability of banks. this positive relationship is mainly noticeable to banks having higher deposit funding share and lower marginal costs of providing banking services; and even those which function in countries with sturdier institutional excellence. the outcomes are vigorous to instrumental variables analysis, monitoring for bank secure effects and substitute measures of financial inclusion. results of the study shows that ensuring inclusive financial system is crucial for both development goal and policy that is prioritized by banks which is good for banks stability (ahamed and mallick 2019). literature demonstrates that there is a distance between financial institutions and customers which weakens the effectiveness of financial services through intensification of asymmetric information problem (degryse and ongena 2005). the aim of this study is to explore the factors which are aiding financial inclusion throughout emerging economies. the authors examine the ecosystems using fsqca of forty three countries worldwide, aims to launch the configurations of ecosystem mechanisms which empower financial inclusion and what lead to financial exclusion. results indicate three outlines of factors influencing financial inclusion like high socio-demographic and political factors in the absence of economic development; high social, technological and economic factors in the nonappearance of political development; and political and economic factors in the absenteeism of social and technological development. there are two combinations of factors that influence financial exclusion, are the nonappearance of social and economic factors in the occurrence of political and technological development; to sum up, and the configuration with absent socio-demographic, technological and political factors of development. the results attained hold policy implications for countries looking for developing financial inclusion, demarcating the most significant ranges of the ecosystem to indorse and support. kabakova and plaksenkov (2018) study on financial inclusion are composed of numerous types. one among them includes over-all studies of fi as a current economical phenomenon among different countries with different political and economic background. whereas early research papers only deliberated the definition of fi and its nature (dev, 2019). as a key enabler for development, financial inclusion is resolutely positioned on the agenda of most governments as a crucial policy priority. by means of macro data, the collection discloses the variety in the efforts towards attaining financial inclusion and dire need of a broadminded approach in financial inclusion. far from this, the round table delivers regional viewpoints addressing policies and financial inclusion practices in india, south africa, and australia. ©2015 production and hosting by elsevier ltd on behalf of indian institute of management bangalore. (arun and kamath, 2015) al-duhaidahawi et al.: the role of financial inclusion and competitive advantage: evidence from iraqi islamic bank international journal of economics and financial issues | vol 9 • issue 3 • 2019 195 revolutionizing local environmental regulation can substitute the creation of new eco-industries. a competitive advantage (ca) cab be benefitted by these eco-industries in the international market. this article studies empirical evidence of the impact of domestic renewable energy policies on the export effectiveness of renewable energy goods (wind and solar pv). by using gravity model of international trade with a balanced dataset of 49 (for wind) and 40 (for pv) countries covering the period 1995-2013. the severity of renewable energy policies can be provided by connected dimensions. econometric model displays evidence of ca positively correlated with domestic renewable energy policies, continued in the wind industry but brief in the solar pv industry. we propose that the reason for the dynamic difference lies in the underlying technologies involved in the two industries (kuik et al., 2018). the main purpose of this paper is to inspect the effect of enterprise risk management (erm) on ca implying the moderating role of information technology (it) scopes including it strategy and its structure. survey questionnaires numbered 84 were obtained administering self-constructed iranian financial institutions. partial least squares structural equation modeling approach was used for data analysis and hypotheses testing. the results presented that erm related positively with the ca of the firms. the results also presented that it strategy and structure had a direct effect on the ca as a well as moderating effect on erm-ca relationship. this study covers past erm studies by considering iran as developing country which was abandoned among past empirical studies. it also covers past erm works by empirically assessing erm, it, ca and relationships among them. this paper delivers visions into the value of application of erm in organizations which may promote ca. additionally, this study offers implication in terms of manager’s planning and decision making to consider it as one of the critical success factors of erm practices (saeidi et al., 2019). 2.1. financial inclusion financial inclusion provides individuals and companies access to useful and affordable financial products and services that meet their needs i.e. transactions, payments, savings, credit and insurance and are provided in a sophisticated way. financial inclusion, defined as the use of formal financial services, crucially determines economic development. individuals who are not financially excluded are able to invest in education and promote businesses (fungáčová and weill, 2015) financial inclusion has numerous assistances for poor families. it delivers low-income individuals with the possibility to save which nurtures steadiness in personal finance, and a high level of use of bank deposits that backs to securing a more steady deposit base for banks during distressed times (ozili, 2018). in order to deepen the concept of financial inclusion, the board of governors of the central banks and monetary institutions on 27/4 of each year devoted a day to financial coverage to encourage banks and non-banking financial institutions to develop their services and provide more appropriate banking and financial products to improve the incomes of the major arab communities. statistics from international financial organizations show that nearly 69% of the adult population, or 3.8 billion, has bank accounts in different countries. in iraq, the central bank of iraq, within the strategy for the years 2016-2020, many directions including the development and expansion of the proportion of financial coverage so that the dealers are defined of financial banks and work significantly to raise the proportion of financial coverage of 11%, a very small proportion reached by countries the world is developing, and this low ratio is due to three reasons: 1. the low percentage of banking density for many years now to reach about one bank branch for a cluster of (35,500) people in 2016, after it was in 2003 about one bank for every (75,000) people because of the failure of banking mechanisms and techniques used and the lack of banking plans to expand the expansion the network of banking branches and the spread of their services in the largest area within the geographical area of iraq, noting that the global standard of one bank branch to serve every ten thousand people and shown below in table 1. 2. the high rate of unemployment due to the lack of adequate employment opportunities for young men and women who are able to work after 2003 because of the destruction of many factories, farms and public and private companies, where the average unemployment to about 19% of the total population, especially its important role as being able to develop the national economy. table 1: geographical spread of atm machines years number of adults 1000 an individual number of atm number of payment points the ratio 2011 19929 467 50000 2.3 2012 20569 467 50000 2.2 2013 21227 647 30000 3.1 2014 21926 337 30000 1.5 2015 22082 580 30000 2.6 2016 22654 660 30000 2.9 source: central bank of iraq table 2: poverty and the rate of unemployment year poverty ratio (%) poverty gap unemployment rate total number of bank branches 2014 30 6.6% 12.7 1047 2015 31 854 2016 866 2017 25 859 2018 22.5 19 source: central bank of iraq al-duhaidahawi et al.: the role of financial inclusion and competitive advantage: evidence from iraqi islamic bank international journal of economics and financial issues | vol 9 • issue 3 • 2019196 3. the rise of poverty indicators according to statistical indicators issued by the central bureau of statistics and the ministry of labor and social affairs as mentioned in table 2 issued by the department of statistics and research. 2.2. ca competition is the essence of the success or failure of enterprises; it also regulates the precision of enterprises’ activities and their contribution to the performance of enterprises such as creativity, cultural interconnection or proper implementation of performance. therefore, enterprises are looking for competitive strategies by researching and investigating competitive sites that are attractive to them in the field of work that the establishments are concerned with. all with a view to achieving a profitable position and achieving sustainability in the services or goods of enterprises in the face of competitive market forces (porter, 1998). thus, in the current times that undergo change, enterprises are branded by a highly competitive working environment. it makes them concentrate to allot time, energy and financial resources to measure performance aiming to attain strategic goals. perhaps some of the enterprises that have neglected and ignored planning and strategic objectives have were adversely affected and made their access to a ca harder than other facilities. it is therefore important for enterprises to distinguish themselves from their competitors by achieving a sustainable ca through efficiency operational and strategic planning (niven, 2006). (gomes and mario, 2015) described that one of the most important questions was discussed. its argument in strategic management is how an enterprise can accomplish ca. as we see ca is seen as the main source for achieving a distinct performance of enterprises which represents the end of strategic management. 2.3. evolution of ca to learn about the stages of evolution of ca, it must be back in time to 1985 when michael introduced porter michle porter in his paper, published in the journal of harvard business school, was then an early who presented an integrated framework on the ca, stressing the importance and the need to use the ca, especially in industrial establishments as the most important tool and the most influential in the performance of enterprises. porter, 1998 has shown ca as the mechanism through which enterprises can convert strategies to practice in order to maximize the value provided by enterprises and may take many steps from them lower prices without competitors’ prices with similar profit or provide unique benefits for goods or services at price that surpasses its competitors or other practices. we therefore note that ca is growing substantially beyond the value that enterprises are able to provide to customers, which increases the cost of providing this value-product or service. value has been defined as the reason customers want to pay for it. this value can be achieved through two things as mentioned: providing goods or services for a price less than the price of competitors or offering unique and unique benefits at a higher price than competitors. these are called both types of ca: cost leadership and excellence respectively. the ca has attracted interest from both enterprises and researchers alike (gomes and mario, 2015) several developments have taken place in the concept of ca and mechanisms “resource-based view” as an alternative to the strategy. porter justified their vision by saying that the biggest differences in profitability were not among the facilities in but they were in facilities in the same field; therefore, they suggested that the reason was not to the organizational factors in the industry these factors are not responsible for achieving profitability of enterprises, however the hidden factors that affect profitability lie in what is within the established resource and assets it enables competition not only that, in the current economy we note that intangible assets have become the cause president of the ca. similarly, as a normal result of the resource-based vision, a new vision has been employed, knowledge-based view, “focusing on knowledge as the most important strategic resource owned by enterprises and contribute to ca.” in addition to the previously mentioned visions of ca, (poth, 2014) other theories of ca include market-based view and market-based theory explains the role of directing industrial factors and the external market as the most important determinants of the performance of enterprises, so we note that these the theory focuses on the environment of installations and external factors that significantly affect their performance. therefore, this vision depends primarily on the porter model of the five market forces: current competitors, newcomers, customers, suppliers, and alternatives. (wang, 2014) “capacity-based theory,” “capability-based view.” which claims that art is the source of ca, as resources are the source of these capabilities? include these capabilities: the ability to learn and create new knowledge, and the ability to perform frequently for associated tasks. by providing services or goods. in the same context, the relational view was presented focus on network processes and routine routines as a significant unit of analysis to reach full comprehension and realization of ca. thus, this theory argued the resource-based theory, citing that source ca extends beyond the boundaries of the enterprise and includes four aspects: the assets of specific relationships, knowledge exchange processes, complementary resources and effective governance. many researchers have stressed the importance of the enterprises have made a great effort to build up their network of relations and commercial interactions between the enterprises, in relation to these flow of resources and information or related to institutional, political, economic, legal, social, technological, regional, etc., (wang, 2014) 2.4. ca concept many researchers and academics have identified ca with definitions that differ in subtlety the study was therefore interested in searching for the most famous definitions in order to expand its contents and a comprehensive definition that makes it easier for the reader to understand what is meant by ca (porter, 1998), where ca was defined as the result of an enterprise’s ability to perform a group of the activities necessary to efficiently obtain the cost is lower than the competitors and shape the activities. in a unique way to enable them to gain value in their customers. while (epetimehin, 2011) in his research paper defined ca as a capacity the institution that functions in one or several manners that competitors cannot perform and meet; in marketing strategy, apply a strategy and context that does not dilute competition. while male, (poth, 2014) defined ca as a concept that is usually cast-off to al-duhaidahawi et al.: the role of financial inclusion and competitive advantage: evidence from iraqi islamic bank international journal of economics and financial issues | vol 9 • issue 3 • 2019 197 describe comparative performance for competitors in a particular market environment; it is said that that entity has a ca if it has the capacity to create more economic value than its competitors in the same market. therefore, enterprises have two options to achieve the two ca are: first: achieve ca through excellence in a site within the labor market through providing superior customer service or achieving lower cost; and second, achieving ca through excellence in efficiency through excellence in skills and resources. therefore, the ability of enterprises to achieve ca is through the ability to identify and understand the competitive forces in the market and how they change over time are associated with the same time efficiency to transfer and manage resources necessary for timely and appropriate competitive feedback. 3. methodology 3.1. method – (quantitative) quantitative methods highlight objective measurements and the statistical, mathematical, or numerical analysis of data collected through questionnaires and surveys, or by manipulating pre-existing statistical data using computational techniques. quantitative research focuses on gathering numerical data and generalizing it across groups of people or to explain a particular phenomenon” (babbie, 2010); (anon, 2017); (muijs, 2004). 3.2. study population and sampling the sample will be in iraqi banks consumers. 3.3. data collection the questionnaire will be collected by means of questionnaire for the sample banks where at least 250 questionnaires will be distributed to the sample customers. 3.4. data analysis the data are analyzed by the statistical package for social sciences (amos) and (spss). 3.5. research instrument-(questionnaire) the questionnaire was designed according to the five-item likert paragraphs containing (strongly agree-5agree 4neutral-3disagree-2strongly disagree-1-). 3.6. research model figure 1 illustrates the association between our study’s variables including the independent, moderate and dependent variables. 4. results and discussion 4.1. descriptive statistics table 3 presents the four axes of the research. the first axis refers to access to banking services. paragraphs (1) and (6) have the highest mean (4.5) with a standard deviation (0.8). this gives us a clear view that iraqi islamic banks the research sample is able to deliver its banking services to the most geographical point possible through the branches of banking and points of sale spread and thus reach the various social groups and this is clear through the consensus of the sample members and the ability of iraqi islamic banks to provide a variety of banking services supports the idea of inclusion of money. as for the second axis, which refers to the use of banking services by various social groups, paragraph (10) obtained the highest mean of 4.6 and a standard deviation (0.6). this indicates that there are different categories of customers of these banks benefiting from various services the most important banking accounts that enable customers to exploit their savings in different banking fields as well as the possibility of settling their daily payments through electronic payment cards. as for the third axis, which refers to the quality of banking services provided as paragraph (14) on top of the middle of the calculation of (4.4) and a standard deviation (0.6), which indicates to us that islamic banks in iraq provide banking services characterized by high quality and this is clear through which is confirmed by the responses of the sample members of the study, and therefore, the provision of banking services with high interest creates a state of competition between these banks to provide banking services with the best quality. figure 1: research model source: designed by authors table 3: descriptive statistics no variables mean±s.d 1 access of financial services 4.5±0.8 2 4.1±1 3 4.1±0.9 4 4.4±0.8 5 4.4±0.8 6 4.5±0.8 7 useage of financial services 4.2±0.7 8 3.9±0.9 9 4.3±0.8 10 4.6±0.6 11 4±0.7 12 4.1±0.8 13 quality of financial services 4.2±0.8 14 4.4±0.6 15 4.1±0.7 16 4±0.8 17 4.2±0.7 18 3.8±0.8 19 competitive advantage 3.9±0.8 20 3.8±0.8 21 4±0.8 22 4±0.8 23 3.9±0.9 24 3.8±0.9 al-duhaidahawi et al.: the role of financial inclusion and competitive advantage: evidence from iraqi islamic bank international journal of economics and financial issues | vol 9 • issue 3 • 2019198 as for the fourth axis, this refers to the ca, paragraphs (21) and (22) have reached the highest mean of (4) with a standard deviation (0.8). this gives us a clear perception that the iraqi islamic banks can obtain a ca through applying the idea of financial inclusion as it enables it to provide high quality banking services and this enables it to achieve market share and therefore compete with other commercial banks to provide the best banking services, and it is clear that all paragraphs of the questionnaire has achieved a middle of the upper than the default medium of (3), indicating that financial inclusion can be done islamic banks iraqi sample to achieve a ca compared to other banks. 4.2. regression analysis 1. the first hypothesis: there is no significant statistical relationship between the provision of banking services and the achievement of ca. the results of table 4 show the association between the first independent variable of banking services and the dependent variable of ca. the study used a significant level (0.05). based on the results obtained according to the linear regression model, the association coefficient (0.977) and the coefficient of selection (0.954) providing the banking services by the islamic banks the sample of the research can achieve a ca for these banks and since the association coefficient is positive, it can be concluded that the relationship is statistically significant because the value of p is less than the moral level (0.05) calculated was greater than a (1.671), which confirms that there is an impact of the provision of banking services in achieving ca and thus accept the hypothesis of nothingness. 2. the second hypothesis: there is no statistically significant relationship between the use of banking services and the achievement of ca. in table 5, the results show the correlation between the first independent variable using the banking services and the dependent variable of ca. the study used a significant level (0.05). based on the results obtained according to the linear regression model, the correlation coefficient (0.986) and the coefficient of selection (0.972) the use of banking services by the customers of islamic banks the sample of the research can achieve a ca for these banks since the coefficient of correlation positively can be concluded that the relationship is significant statistical significance that the value of (p) is less than the moral level (0.05), in addition to the value of was calculated (1.671), which confirms that there is an impact on the use of banking services in achieving ca and thus accept the hypothesis of nothingness. 3. the third hypothesis: there is no significant statistical relationship between the quality of banking services and the achievement of ca. the results of table 6 show the correlation between the first independent variable of banking quality and the dependent variable of ca. the study used a significant level (0.05). based on the results obtained according to the linear regression model, the correlation coefficient (0.966) and the limiting factor (0.933) the quality of the banking services provided by the islamic banks. the sample of the research can achieve a ca for these banks. since the coefficient of correlation is positive it can be concluded that the relationship is statistically significant because the value of p is less than the moral level (0.05) calculated was the largest of the tabular value of $ (1.671), which confirms that there is the impact of the quality of banking services in achieving ca and thus accept the null hypothesis. 5. conclusion based on the role of financial coverage, we have a clear vision that the iraqi islamic banks sample research able to deliver banking services to the most possible geographical point through the branches of banking and points of sale scattered and thus access to various social groups and this is clear through the consensus of the sample on that, the introduction of high-end banking services creates a competitive situation among these banks to provide the best quality banking services. in addition, this gives us a clear perception that the islamic banks of iraq sample research can achieve a ca through the application of the idea of financial inclusion because it could provide high quality banking services and this enables them to achieve market share and thus compete with other commercial banks to provide the best banking services, clearly, that all sections of the questionnaire have achieved a mean of higher than the default ratio of (3), indicating that the financial inclusion iraqi islamic banks sample research can achieve a ca compared to other banks. for the future research, this study recommended that banking managerial staff has to focus on providing banking services using technological instrument because they constitute financial inclusion and thus achieving the ca of banks, as well as certain programs are needed in the banks to raise the technological awareness of current and prospective customers. 6. acknowledgment this research is sponsored by the national natural science foundation of china under grant no. 71672068. table 4: association between banking service delivery and competitive advantage variable r r2 β t sig. competitive advantage 0.977 0.954 0.977 31.67 0.000 source: others depend on spss table 5: association between the use of banking service and competitive advantage variable r r2 β t sig. competitive advantage 0.986 0.972 0.986 41.09 0 source: others depend on spss table 6: association between quality of banking service and competitive advantage variable r r2 β t sig. competitive advantage 0.966 0.933 0.977 32.07 0 source: others depend on spss al-duhaidahawi et al.: the role of financial inclusion and competitive advantage: evidence from iraqi islamic bank international journal of economics and financial issues | vol 9 • issue 3 • 2019 199 references ahamed, m.m., mallick, s.k. 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(2014), theories for competitive advantage. in: hasan, h., editors. being practical with theory: a window into business research. wollongong, australia, pp. 33-43. theori. available from: http://www.eurekaconnection.files.wordpress.com/2014/02/ p-33-43-theories-of-competitive-advantage-theori-ebook_ finaljan2014-v3.pdf. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(4), 16-26. international journal of economics and financial issues | vol 8 • issue 4 • 201816 interface of insurance and economic growth: nigerian experience adedokun lateef adetunji1, e. chuke nwude2*, sergius n. udeh3 1department of banking and finance, college of business and management studies, kaduna polytechnic, kaduna, nigeria, 2department of banking and finance, faculty of business administration, university of nigeria, enugu campus, enugu state, nigeria, 3department of accountancy and finance, godfrey okoye university, enugu, enugu state, nigeria. *email: chuke.nwude@unn.edu.ng abstract the study aims to confirm the existence of positive and significant relationship between insurance penetration/activity and economic growth in nigeria. applying ordinary least square model on nigerian time series data for the period 1996–2015 reveals that insurance industry makes positive and significant contribution on nigeria’s economic growth. based on the findings, it is recommended that government should implement economic policies capable of stimulating insurance industry activity such as the enforcement of the statutory insurances; insurance industry stake-holders should improve the insurance image laundry and market awareness activity by promoting systematic educational campaign in the media and among the general public. keywords: insurance, economic growth, nigeria, insurance premium, insurance investment, emerging economy jel classifications: c32, e31, e37, f31, o52 1. introduction as we rightly know, insurance is a scheme used to mitigate the effects of misfortune through provision of financial compensation from the pool of accumulated contributions or premium by all persons participating in the scheme. in developed economies, insurance does contributes a lot to the well-being of the citizenry and the economy at large. here in nigeria, an emerging economy in africa, there is crisis of confidence towards the industry. nigerians developed strong apathy towards insurance and this made the industry a pariah industry in nigeria. the distrust was deeply bred so much that the performance of insurance stocks on the nigerian stock exchange (nse) has been negatively affected. many of the stocks could not go beyond the minimum price per share of 50 kobo in the market and very few investors do trade on them. this scenario has refused to change with time. as a result it is generally believed that insurance inclusion is very low in nigeria. due to the negative attitude of people toward insurance, the ability of the nigeria insurance industry to contribute significantly to the economic growth of the country has been in doubt. many observers attribute claims fraud syndrome, religious antagonism and unfavourable macroeconomic environment as some of the major problems undermining insurance in nigeria. careful study on the nigeria’s insurance industry reveals that it has been confronted with problems of products selling rather than marketing, limited underwriting capacity, expertise, weak research capacity, institutional framework, lack of proper infrastructure, denial of genuine claims, lopsided office distribution, lack of proper education and awareness creation, fraudulent behaviour of insurance intermediaries, fraudulent claims syndrome, unfavourable macro-economic environment, religious antagonism, lack of reliable ict, limited retention capacity among others which are likely to prevent insurance in nigeria from meeting the expectation of the insuring public and consequently may not be contributing significantly to the nigeria’s economic growth. in view of the aforementioned challenges facing the nigeria’s insurance industry, the question on the lips of many observers has been, “does insurance developments make a positive and significant contribution to economic growth in this country nigeria? intuitively a diligent answer should be that’ insurance development does not have a positive and significant effect on economic growth in nigeria but this remains a hypothesis. adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 2018 17 on account of the aforementioned challenges confronting nigeria’s insurance industry which include products selling rather than marketing, limited underwriting capacity, expertise and skill, weak research capacity and institutional framework, lack of proper infrastructure, denial of genuine claims, lopsided office distribution, lack of proper education and awareness creation, fraudulent behaviour of insurance intermediaries, fraudulent claims syndrome, unfavourable macro-economic environment, religious antagonism, lack of reliable ict, limited retention capacity among others, can insurance development in nigeria still impact positively and significantly on the nigerian economic growth? even with the perceived insignificant contribution of insurance to nigeria’s economic growth, it still remains unclear the extent of the impact of insurance on nigeria’s economic growth since many researchers’ attention and research efforts were focused on insurance-growth nexus of the g-7 nations, oecd countries and other developed economies of the world rather than nigeria. given the dearth of empirical studies along this line this study seeks to determine whether there is existence of positive and significant relationship between insurance development and economic growth in nigeria. the study covers the 55 insurance companies duly registered pursuant to the insurance act 2003 and operating in nigeria. the period covered by the study is 1996–2015. the choice of the period is justified by the facts that the base year, 1996 was the year that immediately precedes year 1997 that witnessed the promulgation of two land mark insurance decrees which are the national insurance commission decree no 1 and the insurance decree no 2 thereby creating an unprecedented framework for hitherto better reform and regulation of insurance business in nigeria. secondly, there is relative availability and regularity of data within the period. the relevant data for the study beyond the end of year 2013 was not readily available for observation as year 2015 was currently running as at the time of data collection for this work. consecutive 20-year period data can be sufficient for validity of statistical analyses and findings. the study employs ordinary least square and pairwise granger-causality test on nigerian time series data for the period 1996–2015. on the significance of this work, the study will provide input materials for further research. the insurers and reinsurers will be exposed to the direction and magnitude of their activity towards economic growth. the insurance regulators and policy makers will observe the level of contribution of insurance to economic growth which would enhance the quality of their policy making, oversight function and regulation of the industry for better performance to meet global challenges and better contribution to economic growth. due to non availability and irregularity of data prior to 1996, the study is only able to use 20 years annual time series data (out of which 2014–2015 data are projected) for the estimates, which may have some slight statistical implications on the estimate results of the study. the rest of this paper is divided into four sections. section 2 discusses the review of related literature while section 3 states the methodology; section 4 presents the data and its analysis. section 5 concludes the paper. 2. review of related literature 2.1. conceptual review the concept of insurance in its modern form was introduced into nigeria by the european trading companies mostly british in the closing years of 19th century. these companies started affecting their insurance with established insurers in the london insurance market. as time went on, some british insurers appointed nigerian agents to represent their interest in the country. these agents later transformed into full branch offices of their parent companies in britain. the first company to establish a full branch office in nigeria was the royal exchange assurance company in 1921, which was later followed by other british insurers and indigenous nigerian insurers and reinsurers such as national insurance corporation of nigeria established in 1969 and the nigeria reinsurance corporation established in 1977 operating in nigeria till today. between 1958 when the first indigenous insurance company the african insurance company limited was established up to 2005, there were a total of 104 insurance companies and 4 reinsurance companies in nigeria (badejo, 1998; osunkunle, 2002 adedokun, 2013). ever since the emergence of indigenous insurance companies in nigeria, there have been allegations of risks of potential abuse, low awareness, poor market penetration, low operating capital as well as low capacity for retention and acceptance of foreign risks. all these and more led to massive regulation of the insurance sector. the first major step at regulating the activities of insurance business in nigeria was the report of obande commission of 1961 which resulted in the establishment of department of insurance in the ministry of trade and which was later transferred to the ministry of finance. the report also led to the enactment of insurance companies act of 1961 which came into effect on may 4, 1967. the office of the registrar of insurance was created by the provisions of the act to supervise insurance practice. other provisions of the act included minimum capital requirement and other conditions for registration, monitoring and control of insurance operations generally. this was followed by a series of legislation which sought to further the course of insurance regulation in the country. the next major attempt at regulating insurance in the country was the promulgation of the nigerian insurance decree, 1976. the insurance act 2003 section 86 provides that naicom shall be responsible for the administration and enforcement of the act setting the criteria and standards for registration, policy provision, rates, expenses, limitations, valuation of assets and liabilities, investment of funds, the qualification of sales representatives et cetera. recapitalization section 9(4) of insurance act 2003 provides for recapitalization for the various categories of insurance which include life, general, composite and reinsurance. in 2003, capital base requirements were as follows: life insurance was n150 m, general insurance was n200 m, composite insurance was n350 m and reinsurance was n350 m respectively. in 2005/2006 after recapitalization exercise, capital base was raised as follows: life insurance n2billion, non-life insurance n3billion and reinsurance n10billion. the recapitalization was done through the use of merger and acquisition which resulted to the reduction adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 201818 of insurance companies from 104 to 49 and from 4 reinsurance companies to 2 (fatula, 2007). during the last decades, there has been faster growth in insurance market activity in both developing and transition economies given the process of financial libration and financial integration (brainard, 2008 in philip, 2011), which raises questions about its impact on economic growth. philip (2011) citing favara (2003) and levin (2004) observes that research efforts so far have not examined the impacts of other financial markets or instruments on economic growth in similar depth. compared to the vast literature focusing on bank, stock and bond markets and their respective environment, the insurance sector has hardly been investigated in its role regarding the economic growth. as noted by oke (2012) and shittu (2012) insurance companies affect economic growth by providing protection for the insured through the channels of marginal productivity of capital, technological innovation and savings rate. through this process, insurance industry contributes to the growth of nigerian economy and in view of the gap in the literature we intend to embark on the assessment of contribution of insurance industry to nigeria’s economic growth. appah (2010), dwivedi (2002), appah and ateboh-briggs (2013) accept economic growth as a sustained increase in per capita national output or net national product over a long period of time. appah and ateboh-briggs (2013) stated that the economic growth that is, the rate of increase in total output must be greater than the rate of population growth. to measure economic growth, economists generally examine the rate of change in real gross domestic product (gdp) from 1 year to the next. in the view of central bank of nigeria (2008) gdp is the money value of goods and services produced in an economy during a period of time irrespective of the nationality of the people who produced the goods and services. it is usually calculated without making any allowance for capital consumption (or deductions for depreciation). furthermore, gdp based on expenditure is the total final expenditure at purchases’ prices (including the f.o.b. value of exports of goods and services) less the f.o.b. value of imports of goods and services. in short, gdp is the total volume of production that has taken place in the economy irrespective of the nationality of the people who produced the goods and services. it is the total production that has taken place in nigeria by nigerians themselves and foreigners living in nigeria (buhari, 1993). some of the main determinants of economic growth as identified by riley (2015), which apply for both developing and developed countries although with the relative weighting attaching to each depending on the individual circumstances facing each country or region include: (1) growth in physical capital stock leading to a rise in capital per employee (capital deepening); (2) growth in the size of the active labour force available for production; (3) growth in the quality of labour (human capital); (4) technological progress and innovation driving productivity improvements i.e., higher gdp per hour worked; (5) institutions including maintaining the rule of law, stable democracy, and macroeconomic stability; (6) rising demand for goods and services – either led by domestic demand or from external trade. basically, economic growth is driven by rising aggregate demand (ad) and growing long-run aggregate supply (lras). increases in lras bring about a rise in productive potential. higher levels of ad for goods and services provide the impetus for this productive potential to be used. in the short term, economic growth is caused by an increase in ad. if there is spare capacity in the economy then an increase in ad will cause a higher level of real gdp. from the above submissions, economic growth is a long-term expansion of the productive potential of the economy. it can be measured as an increase in real gdp, national output and national income. the real gdp is the market value of all goods and services produced in a nation during a specific time period. real gdp measures a society’s wealth by indicating how fast profits may grow and the expected return on capital. it is labelled “real” because each year’s data is adjusted to account for changes in year-to-year prices. the real gdp is a comprehensive way to gauge the health and well-being of an economy. gdp according to the cbn’s conceptual operational definition is the total monetary value of goods and services over a period of time usually a year. general insurance premium (gip) is the price paid for various general insurance policy purchased. life insurance premium (lip) represents the price paid for various life assurance products. total insurance investment (tii) is conceptualized as economic activities embarked upon by insurance carriers to increase, improve and maintain the productive quality of the stock of the capital injected into the economy. tii as captured in naicom reports are government securities; stocks and bonds; real estate and mortgage; policy and other loans; cash at hand and deposits; and bills of exchange. number of insurance companies (nic) represents registered and operating in nigeria under the insurance laws. gross fixed capital formation (gfcf) is a component of expenditure approach to calculating gdp which refers to the net increase in physical assets (that is, investment less disposals) within the measurement period. it does not account for depreciation of fixed capital and also does not include land purchases (financial items). fire insurance claim (fic) is the total claim paid to policy-holders for losses under fire insurance policies. auto-insurance claim (aic) connotes the total claim paid to policy-holders for losses under motor insurance policies. employers liability insurance claim (elic) means the total claim paid to employees for injury, death or losses suffered by them in the course of their duty under employers’ liability insurance policies. marine insurance claim (mic) is conceptualized as claim paid to policy-holders for losses under marine polices. inflation (inf) connotes the percentage rate of increase in price level over time. 2.2. theoretical review it is generally believed that insurance inclusion is very low in nigeria due to the negative attitude of people towards insurance (obasi, 2010 cited in elendu, 2013). the ability of the insurance industry to contribute significantly to the gdp has been hampered by the challenges facing the industry in its discharge of duties that contribute to the economic growth. insurance marketing in nigeria is in a critical state. osoka (1992) highlights the prevalence of confusion among insurance marketers between selling and marketing. according to him, while selling is concerned with creating demand for the products that have already been decided, marketing is directed towards identifying the needs and wants of customer and planning to satisfy those needs. limited expertise and skill is another challenge militating against the development of nigerian insurance market. adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 2018 19 nduna (2013) points out that african insurance industry has not developed sufficient research and development capacity and has traditionally relied on the expertise from the advanced economies with the result that the industry is always lagging behind in terms of product innovation. he further asserts that lack of proper infrastructure, such as good road network and telecommunication often militates against effective operation of insurance companies. moreover, weak institutional framework and other factors such as denied or delayed indemnification of risk victims with genuine insurance claims, lopsided distribution of insurance offices, lack of awareness, lack of proper education and fraudulent behavior of those selling insurance among others, were also identified as causal reasons for low insurance penetration in nigeria (akpan, 2005; ibok, 2006). because of the confidence crisis of the industry, obasi (2010) observes that nigerians developed strong apathy for insurance which made the industry a pariah industry which has refused to change with time as policy documents still carry clauses that breed distrust with customers. researchers have also proven that other major problems undermining insurance in nigeria include claims fraud syndrome, religious antagonism, and unfavourable macroeconomic environment. adedokun (2014) citing onaolapo (2000), points out that claims and fraud management in the developed markets has a dimension different from nigeria since the main area of strength that has given the developed markets like the united kingdom and america a hedge over emerging markets like nigeria is the extent of use of information technology to manage data exchange. the problems militating against the achievement of claims management objectives in nigeria are enormous. some of them are moral hazards or dishonesty of some clients and intermediaries; premium undercutting at the instance of brokers; lack of database facilities to support claims management efforts as obtains in developed markets; unethical practices by market operators/intermediaries and non-remittance of insurance premia (onaolapo, 2000; irukwu, 2009; vikash, 2012; and isimoya, 2014). gill et al. (1994) describe insurance fraud as knowingly making a fake claim, exaggerating a claim or adding extra items to the claim or being in any way dishonest with the intention of gaining more than legitimate entitlement. to bates and atkins (2007), insurance fraud involves a mild inflation of the amount of a property lost or damaged through organised criminal activity to obtain large sum of money. yusuf (2006) posits that religion historically has provided a strong source of cultural opposition to life insurance as many religious people believe that a reliance on life insurance results from distrust of god’s protecting care. until the 19th century, european nations condemned and banned life insurance on religious basis (yusuf et al., 2009). some scholars are of the opinion that religious antagonism to life insurance still remains in the northern part of nigeria and some islamic countries (yusuf, 2006; elendu, 2013). 2.3. empirical review existence of relationship and causality between insurance development and economic growth has been much hypothesized over the years. there are three schools of thought in the literature concerning the nature of relationship between insurance and economic growth. the first school of thought postulates that insurance leads to economic growth while the second school of thought holds that economic growth leads to the development of the insurance sector (patrick, 1966). the third school of thought, according to haiss and sumegi (2008), suggests bidirectional relationship between insurance development and economic performance. akinlo (2013) posits that the available empirical evidence on the insurance-growth relationship has produced mixed results. some studies such as webb et al. (2002), boon (2005) and arena (2008) found a unidirectional causality running from insurance development to economic growth while ching et al. (2010) reported the reverse. while the findings of the study by kugler and ofoghi (2005) support bidirectional relationship between insurance and economic growth, others provided evidence of neutrality of insurance and economic growth. according to blum et al. (2002), the link between insurance and the real sector can be classified in terms of causality with respect to five hypotheses: (1) no causal relation (2) demand-following, that is, economic growth leads to a rise in demand for insurance (3) supply leading, that is, growth in insurance smoothes shortterm economic volatility and thus induces economic growth in the long run, plus growth in investment by insurance companies induces economic growth (4) negative causal link from insurance to growth, e.g., growing insurance causes more careless behavior (moral hazard) resulting in a less efficient and more volatile economy (5) interdependence or bidirectional causal relationship. the summary of some empirical studies on insurance development and economic growth is shown in table 1. from the foregoing empirical findings related to the contributions of insurance industry to economic growth the results up to date are mixed, it can be inferred that there is a strong concern for insurance development visa-vis economic growth in the literature. as far as nigeria’s economy is concerned, insurance-growth nexus status has not been clearly and empirically determined. our study hereby assesses the contribution of insurance industry to nigeria’s economic growth. 3. methodology 3.1. research design annual time series secondary data formed the data set for the study. sources of data include central bank of nigeria’s 2013 statistical bulletin, nigerian insurance statistics and directory for 2011, the national bureau of statistics and the world bank national accounts and oecd national accounts file available at: www.indexmundi.com/facts/nigeria/gfcf. the area of this study is the nigerian insurance industry (market) which comprises the registered and operating insurance companies, reinsurance companies, brokers, agents and consultants. the population of the study consists of the 55 insurance carriers including the 2 existing reinsurers in the industry (leadway assurance, 2013). the study adopts quota sampling design which is a form of non-probability sampling method where representatives of different characteristics existing in the population are captured in the sample. hence, the research sampled 49 insurance companies consisting of all the 24 insurance companies listed in the nse, the 2 currently existing reinsurance operators (1 quoted and 1 unquoted) and 23 insurance companies which are not listed in the nse but have consistently adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 201820 author(s) sample methodology main results outreville (1990) cross-sectional data from 55 developing countries ols on pooled time series and cross-sectional data relationship between property-liability premia is positive brown and kim (1993) 1980–1987 cross-sectional data for 45 countries ols on cross-sectional data social backing influences insurance demand beenstock et al. (1998) 1970-1981 cross-sectional data covering 12 countries pooled time series and cross-sectional analyses premiums are correlated to interest rate and gnp zhuo (1998) cross-regional data on china for the period 1986-1995 cross-regional and time series analyses there is a significant correlation between insurance consumption and gdp per capital browne et al. (2000) 1986–1993 cross-sectional data on oecd countries pooled cross-sectional panel data model income and legal system are positively correlated to insurance consumption while loss probability and wealth are negatively correlated with insurance consumption ward and zubruegg (2000) 9 oecd countries annual data for 1961–1996 co-integration analysis and causality tests insurance industry granger-causes economic development in some countries while reverse is the case in other countries beck and webb (2002) 14 european cross-country data for 1998-2010 cross-country analysis evidences of negative coefficient for countries with islamic origin and positive correlation between institutional development and insurance demand are found webb et al. (2002) 55 countries including 17 eu countries data for 1980-1996 ols on panel and cross country analysis financial intermediation is significant and a combination of insurance and banking has the strongest impact on growth kugler and ofoghi (2005) time series data from uk from 1966 to 2003 for long-term insurance, and from the period 1971 to 2003 for general insurance johansen’s cointegration test relationship between development in insurance market size and economic growth for all components of insurance market is found and causality in short run exists from life, life and pecuniary loss insurance to economic growth arena (2006) cross-country panel data for the period 1976 to 2004 from 56 (both developed and developeing) countries gmm for dynamic models of panel data a positive and significant effect of total, life and non-life insurance market activity haiss and sumegi (2008) cross-country panel data from 1992 to 2005 from 29 european countries ols on cross country panel data a positive impact of life insurance on gdp growth in 15 eu countries. for the nmss from cee, they found a short-run impact for non-life insurance consumption krishna (2008) time series data on indian economy ols on time series data the contribution of the insurance sector to economic development is positive and exhibits a long-run equilibrium relationship marijuana et al. (2009) cross-country data from 10 transition european union member countries in the period from 1992 to 2007 ordinary least square on cross-country data iinsurance sector positively and significantly affects economic growth vladimir and dragan (2010) panel data from ex-yugoslavia region for the period 2004–2008 country-specific fixed effects models insurers provide positive effect on economic growth both as providers of insurance risk management and indemnification and as institutional investors odhiambo (2011) time series data on south africa for the period of 1960 to 2006 trivariate-causality model and ecm the hypothesis of finance-led growth do not hold in south africa that is, finance has nothing to do with the growth of south african economy table 1: summary of selected empirical studies on insurance development and economic growth (contd...) adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 2018 21 author(s) sample methodology main results mojekwu et al. (2011) time-series data on nigerian economy within the period of 1981–2008 dynamic factor model economic growth is positively correlated with insurance which implies that if insurance contribution increases, economic growth will also increase philip (2011) time series data on nigerian economy over the period of 1970–2008 johansen cointegration and vector ecm the hallmark finding on insurance sector did not reveal any positive and significant effect on economic growth in nigeria within the period of study oke (2012) time series data on nigeria from the period of 1985 to 2009 fixed effect model and co-integration analysis insurance sector growth and development positively and significantly affects economic growth. the result of the granger causality test indicates that the extent of influence the insurance sector growth had on economic growth was limited and not direct because of some cultural, attitudinal traits and values in the economy shittu (2012) time series data on nigeria for the period of 1970–2010 cointegration test and ecm the financial intermediaries have significant impact on the growth of nigerian economy. lezaazi and tamunonimim (2012) time series data on nigeria from 1980 to 2011 ols, johansen co-integration, granger causality, impulse response, and variance decomposition procedures on annual rate of change in nigeria claims payment on accident, fire, motor vehicle and employers’ liability insurance policies affect growth in gfcf in the short run. existence of unidirectional causality flow from gfcf to claims paid on fire and marine policies was also found by the study hou et al. (2012) panel data over 1980-2009 for twelve euro countries ols on cross country data evidence supporting that life insurance and banking activities are important predictor of economic development in euro zone was found chen et al. (2012) cross country panel data on a maximum of 60 countries over 1976–2005 two-step system gmm approach positive impact of the development of the life insurance market on economic growth was confirmed and also that the insurance-growth nexus varies across countries with different conditions was revealed. ozuomba (2013) annual time series data on nigeria for the period 1998–2007 cointegration and ecm there is significant relationship between insurance premium and economic growth in nigeria richard and victor (2013) johansen co-integration test and ecm insurance premium capital has significantly impacted on economic growth in nigeria; the level of tii has significantly effected on economic growth in nigeria; and there is a causal relationship between insurance sector development and economic growth in nigeria yinusa and akinlo (2013) time series data on nigeria over the period 1986–2010 ecm cointegration exists between insurance development and economic growth in nigeria lee et al. (2013) cross country data for 41 countries within three levels of income over the period of 1979–2007 surafd test, panel cointegration test and panel granger causality test there was a concrete evidence favouring the hypothesis of long run equilibrium relationship between real gdp and real lip after allowing for heterogeneous country effect akinlo and apanisile (2014) cross-country data on sub-saharan africa over the period 1986-2011 pooled ols, fixed effect model and gmm panel model insurance has positive and significant impact on economic growth in sub-saharan africa table 1: (continued) (contd...) adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 201822 operated in the market for at least ten years. the relevant annual data were collected on gdps, components of premium income from general insurance (non-life) and life assurance, tii, and number of existing insurance companies in nigeria for the model. standard tests which include stationarity and normality tests and descriptive statistical analyses were carried out to ascertain the characteristics of variables in the estimation models. others include tests for skewness, mean, median, kurtosis, jack-bera and augmented dickey–fuller tests. regression analyses were also carried out to determine the relationship between the endogenous and exogenous variables of the estimation models. test of significance of the overall regression (f-test) and direction and degree of relationship (t-test) and the coefficient of determination (r2-test) were carried out. the study constructs two primary disaggregated models one for insurance premium, nic and tii-gdp. the model is patterned after the standard multivariate regression analysis as well as granger causality technique, within the context of solo swan economic growth model. the patterns are in line with the works of monogbe (2015) and lezaazi and tamunonimim (2012) but modified to suit our own purpose and produce a more reliable result. the  monogbe (2015) and tamunonimim (2012) models are respectively stated as: gdp=bo+b1tcp+b2tip+b3tin+b4tir+ut. where: tcp = total claim payment; tip = total insurance premium; tin = total insurance investment; tir = total insurance returns. the study applies time series regression analysis using e-view 7.2 version and employed the impact model to estimate the relative effects of the correlates. the analytical framework of this study consists of five basic steps carried out on the models specified. they include: unit root test, descriptive statistical analysis, correlation matrix, and ordinary least square regression method and granger causality test. 3.2. standard tests stationarity, normality tests and descriptive statistical analyses were carried out to ascertain the characteristics of variables in the estimation models. the tests include tests for skewness, mean, median, kurtosis, jack-bera and augmented dickey–fuller tests. 3.3. regression analysis regression analyses are also carried out to determine the relationship between the endogenous and exogenous variables of the estimation models. the research carried out the tests of significance of the overall regression (f-test) and direction and degree of relationship (t-test) and also the coefficient of determination (r2-test). pair-wise granger-causality tests shall be carried out to determine the direction of causality between the dependent and independent variables of the estimation models. 3.4. models specification and definition of the variables given our theoretical and empirical review, and in line with solow swan economic growth model rooted in cobb-douglas modified production function, we construct and specify insurance penetration and economic growth models thus: gdp=f (gip, lip, tii, nic) (1) where, gdp = gross domestic product, gip = general insurance premium, lip = life insurance premium, tii = total insurance investment, nic = number of insurance companies. expressing equation (1) in econometric model we have: gdp=β0+β1gipjt+β2lipjt+β3tiijt+β4nicjt+ut (2) differencing, we have: author(s) sample methodology main results cristea et al. (2014) annual time series data on romania over the period 1997 – 2012 testing a set of correlations there was an evidence in support of an important correlation with direct influence between the variables pradhan et al (2016) using panel data for the association of south east asian nations (asean) regional forum (arf) countries for the period of 1988-2012. multivariate framework which includes panel cointegration and panel granger-causality tests. all the variables were found to be cointegrated and it was revealed that a network of causal connections including short-run bidirectional causality between insurance market penetration and economic growth existed. muye and hassan (2016) panel data model for a set of 22 countries over a period of 2004–2012 difference gmm estimation technique the study revealed a strong evidence of positive and significant effect from the islamic insurance activities on economic growth liu et al. (2016) cross-country panel data on g-7 countries bootstrap granger-causality test, johansen cointegration test and gmm system estimator the study revealed the existence of long-run relations between the series and the results of the bootstrap granger-causality test showed that the short-run causal relationships are country-specific source: constructed by the authors, lip: life insurance premium, cee: central and eastern europe, nms: new eu member state, ecm: error correction model, gmm: generalised method of moment, suradf: seemingly unrelated regressions augmented dickey fuller, tii: total insurance investment table 1: (continued) adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 2018 23 model for h01 ∆gdpjt=β0+β1∆gipjt+β2∆lipjt+β3∆tiijt+β4∆nicjt+ut (3) ∆gdpjt=β0+β1∆lipjt+ut (4) ∆gdpjt=β0+β1∆tiijt+ut (5) ∆ gdpjt=β0+β1∆nicjt+ut (6) βo = intercept, β1-β4 = parameters of the estimate, j (= 1,2,3.....n) represents each company in the sample, t (= 1,2,3......t) denotes the time period for each company, ut = error term. a priori expectations are β1, β2, β3, β4 >0. 4. empirical results and findings 4.1. descriptive statistics and normality test table 2 shows that all the series display a high level of consistency as their mean and median values are perpetually within the minimum and maximum values of these series. moreover, the relatively low standard deviation for most of the series indicates that deviations of actual data from their mean are very small. furthermore, it can be seen from the table that two variables namely gdp and lip are leptokurtic (peaked) relative to the normal as the kurtosis of each exceeds three. this is characteristic of financial data as posited by brooks (2010). however, the remaining three are platykurtic as their kurtoses are below three. finally, all series are normally distributed as their jarque bera-associated p-values exceed 0.05. in order to examine the possible degree of association among the variables, we obtain the correlation matrix of the dependent and independent variables. table 3 reports the sample correlation matrix of the variables employed in the study. the correlation table 3 gives a preliminary idea of direction of relationship between the selected variables. in general, the results in table 33 below show that in terms of magnitude, the correlation coefficient is generally high; while two variables have negative correlation others are positive. 4.2. test for linearity the results in table 3 show that two variables, lip and tii are positively correlated with gdp with coefficients of 0.469 and 0.123 respectively. these suggest that increase in each of these series will lead to corresponding increase in economic growth. moreover, lip-gip, tii-gip and tii-lip are positively correlated as shown on the table 4 meaning that increase in any of the correlates in each case increases the other. however, nic is negatively correlated with all other variables as shown in the table 4, which signifies that increase in the nic leads to decrease in all other variables. 4.3. test for stationarity to ensure that the relationship estimated by the regression between the variables is not a spurious one, the series data employed need to be stationary as believed by koutsoyannis (1977). table 4 shows the results of adf unit root test carried out on the series. all variables are found to be stationary at first difference as test statistics are higher than critical value at 5% critical level. these results make them to be free for use in our statistical analyses. to ensure that the relationship estimated by the regression between the variables is not a spurious one, the series data employed need to be stationary as believed by koutsoyannis (1977). table 4 shows the results of adf unit root test carried out on the series. all variables are found to be stationary at first difference as test statistics are higher than critical value at 5% critical level. these results make them to be free for use in our statistical analyses. 4.4. test of hypothesis ∆gdpjt=β0+β1∆gipjt+β2∆lipjt+β3∆tiijt+β4∆nicjt+ut table 5 presents regression results for the contribution to gdp discussed in methodology part, where gdp is the dependent variable. table 5 shows that gip affects gdp negatively. gip coefficient is −8.06 which means that one unit increase in gip decreases gdp by 8.06 units. the statistical significance of gip on gdp is 0.0216 which is <0.05. this means that gip predicts effect on gdp with 97.84% probability. lip affects gdp positively with lip coefficient of 2.28 which means that one unit increase in lip increases gdp by 2.28 units. the statistical significance of lip on gdp is 0.0010 which is <0.05. it means that lip predicts effect on gdp with 99.9% probability. nic coefficient is −726190.7 meaning that 1 unit increase in the nic decreases gdp by 726190.7 units. the statistical significance of nic on gdp is 0.0000 which is far <0.05. it means that nic predicts effect on gdp with 100% probability. tii coefficient is 3.87 suggesting that one unit increase in tii increases gdp by 3.87 units. the statistical significance of tii on gdp is table 2: basic descriptive statistics statistics dgdp dgip dlip dnic dtii mean 25351884 0.003434 0.000403 82.31579 0.006599 median 18564590 0.003429 2.39e-07 55.00000 0.005046 maximum 80222530 0.005694 0.001555 117.0000 0.013571 minimum 3989450. 0.001750 4.84e-08 55.00000 0.002955 standard deviation 23960485 0.001101 0.000554 29.89807 0.003892 skewness 1.185554 0.681053 1.020480 0.164705 0.943999 kurtosis 3.072647 2.745321 2.689214 1.094527 2.231391 jarque-bera 4.455046 1.520155 3.374169 2.960308 3.289609 probability 0.107795 0.467630 0.185058 0.227603 0.193050 sum 4.82e+08 0.065250 0.007652 1564.000 0.125376 sum sq. dev. 1.03e+16 2.18e-05 5.53e-06 16090.11 0.000273 observations 19 19 19 19 19 source: authors’ computed using e-view 7.2 adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 201824 0.0050 which is <0.05. it implies that tii predicts effect on gdp with 99.5% probability. thus, the result of the analysis states that nic and gip have negative and significant effects on gdp while tii and lip have positive and significant effects on gdp. furthermore, the table presents the figures for the whole equation. r2 represents the prediction level of variance in gdp by gip, lip, nic and tii which is 0.92. this implies that 92% of gdp can be predicted from the independent variables. adjusted r2 (89.7%) avoids the overestimation effect of adding more independent variables to the model. therefore, adjusted r2 is differing by 2.3% (92–89.7%). according to the table of f-distribution, critical value of f-distribution at 5% significance level is 3.32. in table 5, the value of f-statistic is 40.3 which exceeds the critical value of f (3.32). therefore, the regression as a whole is significant, meaning that the regression variables (gip, lip, nic and tii) reliably predicts gdp. moreover, the p-value (significance) is 0.000000 which also indicates that gdp is predicted with 100% probability by the independent variables. therefore, the f-value associated p-value proves that there is significant relationship between the gdp and the regressor variables within the nigerian insurance industry. summarily, the result of our regression analysis shows that insurance premium, nic and insurance investments effect on gdp in the nigeria’s economy. given the fact that the coefficients of lip and tii are positively signed and the p-values of their t-statistic (0.0010 and 0.0050) which are proxies for insurance penetration and activity respectively are less than the 0.05 level of significance, we reject the null hypothesis and accept the alternative hypothesis. insurance industry makes positive and significant contribution on nigeria’s economic growth based on the fact that the coefficients of lip and tii are positively signed and the p-values of their t-statistic (0.0010 and 0.0050) which are proxies for insurance industry development are less than the 0.05 level of significance, we reject the null hypothesis. 5. conclusion and recommendations the goal of this study is to provide a systematic assessment of contribution of insurance industry to nigeria’s economic growth. the study delved into the theory of insurance and its table 3: correlation matrix variables dgdp dgip dlip dnic dtii dgdp 1.000000 −0.264877 0.469484 −0.719095 0.123282 dgip −0.264877 1.000000 0.586399 −0.310710 0.773240 dlip 0.469484 0.586399 1.000000 −0.700678 0.758114 dnic −0.719095 −0.310710 −0.700678 1.000000 −0.703530 dtii 0.123282 0.773240 0.758114 −0.703530 1.000000 source: authors’ computation using e-view 7.2 table 4: summary of the adf unit root tests variable adf statics 5% critical value order of integration p-value remarks gdp −3.998133 −3.052196 i (1) 0.0080 stationary at 1st diff. gip −4.730683 −3.098896 i (1) 0.0028 stationary at 1st diff. lip −4.878149 −3.052169 i (1) 0.0014 stationary at 1st diff. nic −4.306614 −3.098896 i (1) 0.0058 stationary at 1st diff. tii −4.306614 −3.098896 i (1) 0.0058 stationary at 1st diff. source: authors’ computation using e-view 7.2 (an extract) table 5: regression results for the test of hypothesis one/model one dependent variable: dgdp method: least squares sample (adjusted): 1996–2014 included observations: 19 after adjustments variable coefficient se t-statistic prob. c 1.29e+08 10902738 11.84256 0.0000 dgip −8.06e+09 3.12e+09 −2.585147 0.0216 dlip 2.28e+10 5.53e+09 4.130191 0.0010 dnic −726190.7 109850.0 −6.610751 0.0000 dtii 3.87e+09 1.16e+09 3.328692 0.0050 r-squared 0.920095 mean dependent var 25351884 adjusted r-squared 0.897264 s.d. dependent var 23960485 se of regression 7679908. akaike info criterion 34.76705 sum squared resid 8.26e+14 schwarz criterion 35.01558 log likelihood -325.2870 hannan-quinn criter. 34.80911 f-statistic 40.30177 durbin-watson stat 1.843461 prob (f-statistic) 0.000000 source: authors’ computation using e-view 7.2. se: standard error adetunji, et al.: interface of insurance and economic growth: nigerian experience international journal of economics and financial issues | vol 8 • issue 4 • 2018 25 contribution to economic growth as a risk transfer mechanism, indemnification provider and institutional investor in the capital market which is quite consistent with the works in the most recent literatures on insurance-economic growth nexus such as in hais and sumegu; webb et al., kugler and ofoghi, vladimir and dragan. we formulated growth model patterned along the solow swan economic growth model that originated from cobb-douglas modified production function for our statistical estimations. the findings revealed that insurance penetration and activity have contributed positively and significantly to nigeria’s economy with the implication that increase in insurance penetration and activity will provoke an increase in nigerian economic growth. however, negative and significant impact of gip and nic which may be due to the country specific factors, are inconsistent with some previous studies and contrary to a-priori expectation. based on the findings of this study we recommend that government should formulate and implement economic policies capable of stimulating insurance industry activity such as the enforcement of the statutory insurances. the insurance supervisory agency, the national insurance commission (naicom), should endeavour to further reduce the number of underwriting firms in nigeria to the figure with which the existing insurance business opportunity can cope with a view to paving way for emergence of mega insurance companies and minimizing the preponderance of unethical practice in all its ramifications in the nigerian insurance industry. this can be 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(1998), insurance sector development and economic growth: an empirical analysis from china portfolio management. china: university of manheimer. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(2), 70-78. international journal of economics and financial issues | vol 8 • issue 2 • 201870 privatization effect on shareholder value in the jordanian state owned enterprises riyad neman darwazeh1*, mohammad dabaghia2 1business faculty, al-ahliyya amman university, jordan, 2business faculty, al-ahliyya amman university, jordan. *email: riyaddarwazeh@yahoo.com abstract privatization is the act of reducing the role of government or increasing the role of the private institutions of society in satisfying people’s needs; it means relying more on the private sector and less on government. the jordanian government adopted a privatisation program in 1996 to enhance the efficiency and productivity of government owned companies. the principal objective of this study is to examine the effects of the privatisation program on enhancing the performance of state-owned enterprises in jordan. data from 23 companies covering the period from 1996 to 2013 have been used to test the research hypotheses. the data was then analysed using dependent samples t-tests and multiple regression analysis. the results analysis shows that the privatisation program had a significant positive relationship with shareholder value in the jordanian state owned enterprises. keywords: privatization, state owned enterprises, shareholder value jel classifications: l32, l33 1. introduction over the past decades and due to the global competition and changes in the global market during the 1980s, the market shifted to internationalization (maditionst et al., 2009; tortella and brusco, 2003). governments switch to privatization programs to increase performance efficiency and improve the economic situation (megginson, 2016; rahbar et al., 2012). privatization from the government’s viewpoint enhances public companies’ performance, and solves the social, economic and political issues resulted from the governmental poor role in managing and monitoring the state-owned enterprises (clarke et al., 2005; shirley and walsh, 2000). governments believe that the private sector is outperforming the public sector due to the nature of the activities, procedures, optimal uses of resources and the clear goals (seppälä et al., 2001). it is becoming quite hard to find a country that has not adopted a privatization program or at least included it in their policy agenda (kikeri and nellis, 2004). rahbar et al. (2012) defined privatization as a government attempting to allocate some or all of its state owned enterprises by transferring the ownership to the private sector. mansfield and pollins (2009) defined privatization as a transfer of the control and/or ownership of business and industry from the public realm to the private sector. in 1961 the german government sold the majority of volkswagen stocks by issuing public shares which known later as the first privatization transaction (kouser et al., 2012). the program was founded for the first time in the united kingdom under the thatcher government in 1980. the british government felt disappointed with the soes’ weak indicator related to companies performance, and shifted to the privatisation program (megginson, 2016; carter, 2013; kouser et al., 2012; boutchkova and megginson, 2000; souza and megginson, 1999; burton, 1987). after the adoption from the united kingdom, many countries have followed and adopted privatization programs like denmark, chile, malaysia and singapore. these countries have believed in the program’s ability in enhancing governmental companies’ performance (kouser et al., 2012). after 1987, the program spread very fast worldwide, especially in brazil, south america, mexico, africa, bangladesh, and south asia by issuing public shares or selling to another company (kikeri and nellis, 2004). privatization darwazeh and dabaghia: privatization effect on shareholder value in the jordanian state owned enterprises international journal of economics and financial issues | vol 8 • issue 2 • 2018 71 as a global phenomenon has captured the scholars’ attention to study the potential effects of the program. the vast spread of privatization program worldwide had encouraged many countries to change their governmental companies’ ownership (boubakri et al., 2013; ramadan, 2011; de groote et al., 2005; pompo and ramirez, 2003; sun and tong, 2002). waterhouse (1989) documented that there are some common reasons encouraging governments to implement privatization as follow: • raise the revenue for the state • promote increased efficiency • reduce government interference in the economy • promote wider share ownership • provide the opportunity to introduce competition • expose soes to market discipline governments believe that the private sector outperforms and more efficient than the public sector in terms of business results (carter, 2013; boubakri et al., 2013; kouser et al., 2012). the political interference in business leads to a distortion of business objectives, and increased restrictions faced by managers. in addition, the weak monitoring of government companies decreases the motivation among workers (marcelin and mathur, 2015; nabin et al., 2014; delfgaauw and dur, 2010; francois, 2000; shleifer and vishny, 1994; vickers and yarrow, 1989). this requires restructuring the state-owned enterprises to reduce government interference in the economy. the global trend in privatization for the period 1991-2016 can clearly be seen in the following table. table 1 shows the worldwide revenues from privatization us$ billions. francois (2000); laffort and tirole (1993) studies the privatization effect on changing the company’s performance from the agency theory perspective, and assured that changing the incentives for managers by implementing a privatization program could lead to reducing the agency conflicts and improve companies’ performance. incentives have to be offered in order to motivate agents adjusting their aims to be in line with shareholders’ interests instead of acting merely out of self-interest (macías, 2002). a free market economic system was adopted in jordan, this gives the private sector the main role in economic activity in order to reach an equitable distribution of gains, and achieve economic and social development (gowland and aiken, 2003). however, numerous factors led to the development and expansion of the public sector role in economic activity over the years, especially during the seventies and eighties, which led to reducing the contribution of the private sector in this activity (executive privatization commission, 2014). based on epc (2014) first factor is meeting the growing need for infrastructure development, and it should be noted in this regard that the expanding role of the public sector has been concentrated mainly in infrastructure projects such as telecommunication, education, health, energy, transportation, water, and social welfare. second factor is addressing the economic and social crises synchronizing with private sector reluctance to invest in projects that require large capital, and the availability of financing to government representatives in foreign aid and loans has played a major role. to meet these challenges, jordan has taken upon itself to implement national programs of economic reform aimed to restore fiscal and monetary stability, and to create a structural correction to provide a suitable environment for the resumption of acceptable and sustainable growth. the indicators show that there were tangible successes on some levels regarding cash stability and build an appropriate level of reserves. thus, there is a need for more effort and more trends towards privatization to continue with the same stream of success (al-rabadi, 2003; ammari, 2002). an effective and efficient private sector plays an important role in stimulating the economic development of country (ramadan, 2011; kouser et al., 2012; makokha, 2013). scholars have suggested that the development of financial sector provides a reliable prediction about the economic development of the country in the foreseeable future (megginson, 2016; boubakri et al., 2013). that is why the global phenomenon “privatization” has experienced tremendous growth over the last few decades around the world (rahbar et al., 2012). scholars have done a masterful job of articulating privatization program effect on companies’ performance, but no final and clear conclusion can be drawn (rahbar et al., 2012; amess and robert, 2007). many studies have highlighted the effect of privatization on enhancing the governmental companies’ performance in the developed countries, while developing countries require more studies (megginson, 2016; avsar et al., 2009). since the early 1980s many developing countries had implemented privatization program following a lead from the developed countries, thus, the ownership of a vast number of state owned enterprises had been transferred to the private sector (carter, 2013; rahbar et al., 2012; kouser, 2012). despite the tremendous efforts in assessing the effect of privatization on companies’ performance but no final and clear conclusion can be drawn, as well, research on the success/failure of this change of ownership has generated some interesting debate on the actual effects of the privatisation program (carter, 2013; boubakri et al., 2013; avsar et al., 2009). table 1: worldwide revenues from privatization 1991-2016 year amount us billions year amount us billions 1991 48 2004 98 (↑) 1992 32 (↓) 2005 140 (↑) 1993 60 (↑) 2006 120 (↓) 1994 80 (↑) 2007 140 (↑) 1995 85 (↑) 2008 115 (↓) 1996 100 (↑) 2009 270 (↑) 1997 160 (↑) 2010 215 (↓) 1998 140 (↓) 2011 90 (↓) 1999 140 (no change) 2012 185 (↑) 2000 182 (↑) 2013 200 (↑) 2001 45 (↓) 2014 215 (↑) 2002 75 (↑) 2015 325 (↑) 2003 49 (↓) 2016* 270 (↓) *: until october 2016. source: megginson (2016) darwazeh and dabaghia: privatization effect on shareholder value in the jordanian state owned enterprises international journal of economics and financial issues | vol 8 • issue 2 • 201872 previous studies argued that performance under private ownership is superior, as well these studies supported the positive impact of privatization (amess and roberts, 2007; brown et al., 2006; okten and arin, 2006). other researchers stated that public ownership should not be considered a barrier preventing companies from being more efficient in the market (saygili and taymaz, 2001; wang, 2005). scholars study the impact of privatization on enhancing the state owned enterprises’ performance and recorded a positive impact on profitability, efficiency, productivity, as well a decreasing in the companies’ debt but few number of studies addressed the effect on the shareholder value (megginson, 2016; alaei and anderson, 2014; boubakri et al., 2013; carter, 2013; mohammad, 2012; ramadan, 2011; shukla, 2009). similarly, nazir and afza (2009) pointed out the privatization ability in enhancing the governmental companies’ performance. despite the long history of privatization, most of the studies were conducted in developed countries, while few studies have been conducted in developing countries including jordan (ramadan, 2011; gowland and aiken, 2003). the shortage of studies that examine the effect of privatization on state owned enterprises’ performance in jordan provides a wide unexplored area to understand the changing in performance due to the changing in ownership. within this gap in the literature, and to bring this plan to actualization, it is a crucial agenda for the researchers to check the effect of privatization on state owned enterprises’ performance in jordan. the central bank of jordan have announced in 2015 that the gdp growth in jordan was 2.4%, which reflects an unexpected deceleration in the first quarter of the year due to the low percentage from the public sector participation, while real gdp growth is forecasted at 3% in 2016, reflecting additional investment projects in the medium term. the above statistics clearly reveals the unsatisfactory results of companies under the government’s authority with a limited appearance of the private sector. from the above discussion it is clear that privatization affects the companies’ performance and literature review reveals the same. in the above discussion, we have seen that many countries have adopted privatization program in order to improve the state owned companies’ performance in international level. this study examines privatization’s ability in improving performance indicators in the jordanian companies in terms of increasing shareholder value. the specific objective of this research is to check whether privatization affect shareholder value measured by economic value added (eva) and shareholder value added (sva) in the governmental jordanian companies. if so, to find out the relationship between privatization and shareholder value, the researcher set the following hypotheses. h1: there is a positive relationship between privatization and eva in the governmental jordanian companies. h2: there is a positive relationship between privatization and sva in the governmental jordanian companies. 2. literature review agency theory is dealing with managing the relationships between principal-agent (eisenhardt, 1989; jensen and meckling, 1976). based on agency theory, a government in privatisation is the principal, and the agents are the privatised enterprises. the government is representing public interests with the goal of fostering economy, maximising social welfare, and maintaining a high level of employment. the existence of agency relationship creates agency problems due to the different objectives between the shareholders and the management (krause and bruton, 2014; westphal and zajac, 2013; wiseman et al., 2012). privatized organizations are focusing on maximizing their profit and shareholder wealth (wiseman et al., 2012). the conflicting and competing goals, as well different risk preferences between government and privatized firms increased principal-agent problems (saltaji, 2013; fong and tosi, 2007; gomez‐mejia and wiseman 2007; bonazzi and islam, 2007). eisenhardt (1989) argued that the principle of agency theory assumes that in both private and public companies, the managers work hard to maximise the profits. over the past two decades, the political theory of shareholder value has become entrenched as a precept of corporate governance among companies located in the united states and britain (lazonick and o’sullivan, 2000). creating and measuring shareholder’s value has becoming an important issue for discussion around the world, because it gives a clear image and perception about the company’s performance (chari, 2009; shukla, 2009). marshall (1975) mentioned that companies create value when the return exceeds the price of capital. chari (2009) defined shareholder value creation as any return which exceeding the cost of capital. shareholder value is created when profitability exceeds investor expectations as measured by the cost of capital (shukla, 2009). black and wright (2001) defined shareholder value as the difference between the corporate value and the debt. dalborg (1999) assured that value is created when the amount return to the shareholder in the form of dividend and capital appreciation exceeds the risk-adjusted rate of return required in the stock market. stancic et al. (2012), burksaitiene (2015) and copeland et al. (2000) stated that companies should be aware how to allocate their resources effectively, and managers must focus on building shareholder value as a part of their responsibility by actively engaging in the procedure of identifying good investment opportunities. kapoor (2006) defined shareholder value as any potential growth in share price or earning, due to management performance, and its capability to maximize free cash flow with the passage of time. stancic et al. (2012) stated that if the return on invested capital exceeds the weighted average cost of capital (wacc), then the value is created. darwazeh and dabaghia: privatization effect on shareholder value in the jordanian state owned enterprises international journal of economics and financial issues | vol 8 • issue 2 • 2018 73 mauboussin (2011) argued that there was a big misunderstanding according to the shareholder value definition, because the majority believe that shareholder value is created when the short-term for the share price is maximised. it is also and in the early stage to build value for a company, then the share price will follow and reflect this enhancement, so the main goal here is building value. financial managers should care about shareholder value because if shareholders feel unsatisfied, they can simply change their investment or at least change the management (brealey and myers, 2000). indeed, shareholder value is a standard to evaluate the companies’ performance (koslowski, 2000). copeland et al. (2000) pointed out that the most important idea from measuring the shareholder value is to help the managers to make value created decisions, and orient all employees towards value creation. the investors in the stock market al.ays seek to gain high returns on their investment (hasani, 2012). scott (1998) added that shareholder value is another term for the total value of equity of a firm or its market capitalization. many shareholders believe in the “bird in the hand” theory, so, it is easy to find them more inclined to dividends, rather than to the capital gains, this could be explained as a reducing risk (gorden, 1962). because of the rapid changing the traditional perception of business motivation, companies are focusing more on wealth creation, as well as increasing share price, dividends and earnings (shukla, 2009). sajid et al. (2012) after examining 75 pakistani companies were listed on karachi stock exchange during 2005–2010 period to check the effects of the dividend policy on the shareholder wealth, assured that company’s share price is an index which reflects the company’s value in the market. they mentioned that a company in general tries to maximise its market value by maximising the shareholder wealth, which is the ultimate goal of the company. fernández (2001) studied 142 companies in the period 1991-1999; he mentioned that companies create value for the shareholder when the actual shareholder return exceeds the expectation return to equity in 1 year, or in other words, when the company outperforms expectations. furthermore, campa and hernando (2004) highlighted nine principles companies should follow in order to create value for shareholders as mentioned below: • make strategic decisions that maximize expected value even at the expense of lowering near-term earnings • make acquisitions that maximize expected value even at the expense of lowering near-term earnings • carry assets only if they maximize value • return cash to shareholders when there are no credible opportunities to invest • reward ceo’s and senior executives for delivering superior long-term returns. fernández (2001) mentioned that companies create shareholder value when the shareholder return exceeds the required return. this process starts with increasing equity market value, moving to sva, then to shareholder return, lastly to required return on equity, and the last step is reaching shareholder value creation. eva and sva were implemented in this study to check the effect of privatization on the shareholder value in the jordanian companies. sva is defined as the changes that happened to the shareholders’ wealth during the given year and the year before (fernández, 2001). eva is one of these methods which was introduced and trademarked by stern stewart (stewart, 1994). it is a management technique developed to compute the economic value created by the firm over a period of time (stern, 1985; stewart, 1994; stern et al., 1995). it is the change in the net operating profit after taxes (nopat), minus the change in the cost of the capital used to generate this nopat (rappaport, 1998). furthermore, stewart (1994) defined eva as the profit generated by the company, minus the cost needed to feed and generate these profits. rappaport (1998) mentioned that eva depends on four elements: a. firm operating profit b. taxes c. debt level d. cost of capital. the aim of the eva is to provide management with a measure of their success in increasing shareholder’s wealth. it is a measure of how much the company made for the shareholders (jog and holst, 1997). the main objective for any kind of business is to create and deliver value for the shareholder in order to make them satisfied. researchers have studied the changes in the shareholder value after implementing the privatization program. dewenter and malatesta (2001) studied the privatisation effects on shareholder value and shareholder return. they used a large sample of 63 from the uk, poland and hungary. the study assured that, companies after privatisation, outperform the public companies. they added that the privatisation program has significant effects on the shareholder return in the long-term. otchere (2005) studied 314 industrial companies, 121 companies of which were privatized. he documented that the share price and performance for privatized companies beat the competitors’ performance without privatization. these results did not resemble the banking sector, according to his study, which tested 46 banks, 18 of which were privatized, because of the nature of the banking sector and its characteristics. furthermore, shukla (2009) tried to provide an easy way to know how to create shareholder value and measure business performance. the study also attempted to present a clear image of how shareholder value is created, in order to provide a background for measuring shareholder value, as well, to establish the relationship between sva and market value added. moreover, furrer et al. (2007) tested the impact of corporate strategy on shareholder value in turnaround and decline situations. the study documented that the beta excess return measures captured the hypothesized relationships between strategy and shareholder value for the sample firms studied. sajid et al. (2012) examined 75 companies listed on the “karachi stock exchange” from 2005 to 2010 to check the influence of darwazeh and dabaghia: privatization effect on shareholder value in the jordanian state owned enterprises international journal of economics and financial issues | vol 8 • issue 2 • 201874 dividend policy on shareholder’s wealth. they found in that the difference in average market value relative to book value of equity is highly significant between dividend paying companies and nonpaying companies. moreover retained earnings have insignificant influence on the market value of equity. lastly, there is a significant influence of dividend policy on the wealth of shareholders as far as the dividend paying companies are concerned. despite there are many studies on privatization and its effects on companies performance, there is still a need for further studies in jordan to reduce the existing gap. research at the international level indicates that privatization does impact the value created for shareholders. in the jordanian context, there is no research to establish the relationship between privatization and shareholder value. hence, the present paper aims at finding out whether privatization impacts shareholder value in the jordanian context. if it affects, the next question is what the underlying relationship is. 3. research methodology 3.1. operational definitions in this research, the following terms will be used: a. full privatization: the transfer from the public to the private sector assets in terms of ownership, management, finance, or control (the international labour office ilo, 2001). this concept contains a wide range of practices such as asset sales, public-private partnerships, public market liberalization, franchises, user fees, internal market arrangements, and contracting out. b. partial privatization: the procedures of selling the shares which do not give the right to control or ownership in the stock market, and keep the management under the government’s hand and do not switch it to the private sector or private owner (gupta, 2005). c. shareholder value creation: the growth in share price, dividends and earnings, which come from strategic decisions, could help the management to deliver this value to the investors, and the company’s ability to raise free cash flow (shukla, 2009). d. jordanian companies: the 23 companies chosen to be the population of this study. all companies have experience with privatization and are registered with the jordanian ministry of industry and trade. 3.2. data giusti et al. (2012) defined the data collection as the research heartbeat. they added that data collection methods consist of a detailed plan of procedures aim to gather data for specific purposes, such as answering a research question or to test a hypothesis. secondary data was collected from databases and annual reports from the companies’ financial statements to test the hypotheses and achieve the study’s objectives. it is necessary to find reliable data sources to avoid misleading results. the nature of this study is quantitative, and the data fit for this study is classified under secondary data, which is a type of financial information and obtained from the companies’ annual appraisal, and companies’ disclosures. annual financial data for the 1996-2013 period of companies available on the amman stock exchange were obtained. the data were obtained from various databases. any additional data required for this study obtained from the executive privatization commission epc and jordan investment corporation jic. data in ase amman stock exchange, which was the primary source, starts from the year 1996, and it was a good year to start because the privatization program in jordan started in 1996. public shareholding companies, limited liability companies, general partnerships, limited partnerships, private shareholding companies, and foreign companies operating in jordan are required to prepare annual audited financial statements within 90 days from fiscal year-end based on the companies law (22/1997). moreover, sound accounting records should be kept, and annual audited financial statements in accordance with international financial reporting standards should be presented. thus, it is safe to be assured that the financial data of sample companies are consistent with the international standards. the total of 2496 firm-year observations covering a period of 18 years (from the year 1996 to 2013) was used for this study. the data was for 5 years prior to privatization i.e., (1998-2002) and 5 years after privatization i.e., (2008–2012) of the former state-owned enterprises (otchere, 2009). this study implemented sva and eva as the proxies’ measure to represent shareholder value. privatization is used as an independent variable, measured by privatization percentage. 3.3. independent variable privatisation (priv) is the independent variable that lies between 0 and 100, measuring the percentage of equity that is private in a firm in a given year, consistent with megginson and netter (2001), gupta (2005). 3.4. dependent variables shareholder value maximization is the main objective firms’ pursuit (wallace, 2003). shareholder value gives an indicator of how much companies’ made for their shareholders (holst, et al., 2010). the calculation of shareholder value takes in consideration the cost needed to generate the profit (stewart, 1994). shareholder value is measured in two ways namely sva and eva; the most popular proxies to measure shareholder value consistent with pompo and ramirez (2003), sun and tong (2002), andreasson (1998). measuring shareholder value gives a clear perception of companies’ performance (chari, 2009; shukla, 2009). sva is calculated by net operating profit after tax nopat, minus the cost of capital consistent with stancic et al. (2012), lambert and burduroglu (2000). also, eva is calculated by the net operating profit after tax nopat, minus invested capital multiplying with wacc consistent with black and wright (2001), jones et al. (2007). following the test of normality, logarithm transformation is applied to both sva and eva. the transformations are consistent with previous studies like sajid et al. (2012). 4. findings a paired-samples t-test was conducted to compare eva in the jordanian companies preand post-privatization as shown darwazeh and dabaghia: privatization effect on shareholder value in the jordanian state owned enterprises international journal of economics and financial issues | vol 8 • issue 2 • 2018 75 in table 2. a significant difference in the scores for preprivatisation (m = 2299257, sd = 4301921) and post-privatization (m = 13269535, sd = 40697756) conditions; t(103)=2.94, p = 0.004. these results suggest that privatization increased eva. in other words, companies in jordan increased their eva after privatization. related to the sva, there was a significant difference in the scores for pre-privatisation (m = 3304335, sd = 8621958) and post-privatization (m = 13404213, sd = 43291022) conditions; t(103)=2.50, p = 0.014. similarly, the results indicate that privatization increased sva. figure 1 shows a comparison between the sva and the economic value added before and after privatization. based on figure 1, it is clear that shareholder value increased after privatization in terms of eva and sva. eva increased as a total of the 23 companies from usd 239.12 million before privatization to usd 1380.03 million after privatization. similarly, svasva increased as a total of the 23 companies from usd 343.65 million before privatization to usd 1394.04 million after privatization. the results suggest an enhancement in the shareholder’s wealth, could be attributed to the aligning between managers’ activities and shareholders’ interests in the privatized companies (jensen and meckling, 1976; bishop and thompson, 1992). privatization in the jordanian companies is proposed to have a significant positive relationship with shareholder value measured by eva, and sva. table 3 shows that there is a significant positive relationship between privatization and shareholder value measured by eva and sva. model 1 shows that coefficient of privatization is (coef = 0.252, p = 0.009) for the eva. also, model 2 shows that the coefficient of privatization for the sva is (coef = 0.024, p = 0.031). thus, h1 and h2 are supported. there is a significant positive relationship between privatization and shareholder value measured by eva and sva. 5. discussion and conclusion this study hypothesized that privatization program affects shareholder value measured by eva and sva. therefore, two hypotheses (h1 and h2) were introduced, depicting the effect of privatization on shareholder value in jordanian companies. the controversy regarding performance appraisal of private and public ownership are still alive in the economic literature. the main reason is the different objectives of ownership structure and lack of consensus on performance measurement criteria. the success privatization stories have created strong waves of privatization transactions worldwide. megginson (2016) documented that governments worldwide raised usd 218.8 billion through privatization sales during 2014, substantially more than the usd 193.7 billion totals for 2013 and the second-largest total on record. companies in jordan have adopted privatization program, and the transactions’ revenues reached at the end of 2002 usd 861 million, while the amount increased and reached usd 2.46 billion as of 31-12-2012 (executive privatization commission, 2014). agency theory illustrates that manager activities in the privatized companies are directed and be more aligned with shareholders’ interests, synchronizing with a reduction of their opportunistic behaviour due to linking of their salaries with the companies’ performance (bishop and thompson, 1992). moreover, laffont and tirole (1993) highlighted the difficulty of monitoring managers in state-owned enterprises due to the absence of both of the manager and incentives to monitor managers. the current research reveals that privatization has no relationship with shareholder value in the jordanian companies. one possible reason for the non relationship between privatization and table 2: paired samples t-test results variable mean pre mean post mean difference t-statistdifference p eva 2299257 13269535 10970278 2.938** 0.004 sva 3304335 13404213 10099878 2.504** 0.014 sva: shareholder value added, eva: economic value added table 3: coefficients for predictors of shareholder value models model 1 (eva) model 2 (sva) variable coefficient t p value variable coefficient t p value constant 5.768 47.729 0.000 constant 5.873 42.684 0.000 priv 0.252 1.370 0.009 priv 0.024 0.117 0.031 r2 87% r2 69% f-value 4.725 f-value 7.331 obs. 208 obs. 208 figure 1: shareholder value before and after privatization darwazeh and dabaghia: privatization effect on shareholder value in the jordanian state owned enterprises international journal of economics and financial issues | vol 8 • issue 2 • 201876 shareholder value is the measurement tool. shareholder value influenced positively by privatization, but the main point that shareholder value calculation took into consideration the cost of capital and based on this the value of a company depends on the yield and cost of capital employed (lovata and costigan, 2002). companies in jordan use the same method and the cost of capital implemented in the calculation equation. based on ramadan (2011) jordanian companies need to expand and increase their size in order to crater value for the shareholder. the results of the study are in line with o’toole et al. (2016) who reveals that there is no relationship between privatization and shareholder value or shareholder value creation. liao (2014) found that privatization did not change the soes operating efficiency or corporate governance. as well, no value delivered for the shareholders. government in jordan still has some control in few privatized companies and this could be one reason for the non-creation of shareholder value. the previous result documented by chen et al. (2009) who argued that companies can record a significant performance improvement after a transfer of ownership control, but only when the new owner is a non-state entity. wickramasinghe (1996) found that privatization did not lead to increased shareholder wealth or companies efficiency after he tested the effects of privatization on a sample of sri lankan companies. uddin and hopper (2003) tested the effects of privatization on shareholder value. the study concluded that shareholder value did not increase after privatization, as well as, a large number of shareholders were affected negatively. pompo and ramirez (2003); sun and tong (2002) provided evidence that the relationship between privatization and shareholder value is positive and significant after they examined the effects of privatization on shareholder value. they argued that the incentives in the private sector play an important role in changing the new manager’s behavior; it reduced the agency conflicts, and push managers to make shareholders more satisfied. therefore, jordanian government should be more aware how to deal with the agency conflicts and increase the shareholders wealth. references alaei, s.f., andersson, a. 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(2012), towards a social theory of agency. journal of management studies, 49(1), 202-222. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(6), 94-99. international journal of economics and financial issues | vol 9 • issue 6 • 201994 estimating the economic returns of education in ksa by using mincerian earnings function benlaria houcine1*, gheraia zouheyr2 1department of business administration, jouf university, ksa, 2department of finance and investment, jouf university, ksa. *email: hbenlaria@yahoo.fr/hbenlarir@ju.edu.sa received: 01 august 2019 accepted: 10 october 2019 doi: https://doi.org/10.32479/ijefi.8659 abstract this study aims to measure the economic rate of returns for investment in ksa. by using both basic and extended mincerian earnings function. in addition to this, the comparison had been established between the results obtained and those of other researches in the same domain. we adopted in the research the model of mincer in evaluating the rate of the economic returns according to previous classifications and the effective experience got by the individual in the work (measured by years). the result of the model application states that the economic return of university education in ksa has been improved by 10.35% based on the benchmark of psacharopoulos international return measured by 9.6%. keywords: the individual return, earnings function, practical experience, theoretical experience jel classifications: i26, j24, j16 1. introduction countries over the world paid particular attention to the education sector in general and higher education in particular, in order to achieve their objectives. these goals consist principally of the community service and upgrading its civilization height, as well as providing the state by the different specialists, technicians and experts in various fields (richard raymond and michael sesnowitz, 1975; walter w. mcmahon, 1975; johnson, 1978; rhoades, 1983). therefore, the university could be considered as the main source of investment as the human wealth is considered as the most important and expensive fortunes of a society (murray, 2007; christian, 2013; benlaria houcine. mostéfaoui sofiane , 2018). due to the growing doubts about the feasibility of investment in higher education especially after an outbreak of some negative unforeseen consequences resulting from this type of investment, as well as the large amount of resources spent; necessary attempts have been made to evaluate the investment in higher education ( albert j. robinson, 1971; walter w. mcmahon, 1974; b. m. carven, b. dick and b. wood, 1983; rajesh kumar sharma, 2006). these endeavors are coupled with the view of some economists that the evaluation of the investment in higher education is difficult and distinguished from the other approaches undertaken to evaluate other kinds of investments (daniel c. rogers, 1972; briggs p. dunn and w. robert sullins , 1982; donald r. winkler, 1984; kathy l. stafford, sven b. lundstedt, arthur d. lynn jr, 1984). the intricacy refers intrinsically to the multiplicity of objectives and the presence of a large scale of non-economic returns. however, this picture might not discourage the ongoing processes to monitor and assess this type of investments (tilak, 1995; westerheijden, 1999; aracil and palomares-montero, 2010; cherednichenko and yangolenko, 2013; hocine and sofiane, 2017). in this context, the measurement of the return on investment in education presents the focus of the economic vision for the sector of education and the way to assess the feasibility of investing in this important arena for both the individual and social levels (renshaw, 1960; byron and manaloto, 1990; mcmillan and western, 2000; wigger, 2004; van den berg and hoffman, 2005; this journal is licensed under a creative commons attribution 4.0 international license houcine and zouheyr: estimating the economic returns of education in ksa by using mincerian earnings function international journal of economics and financial issues | vol 9 • issue 6 • 2019 95 bhandari and bordoloi, 2006; carneiro et al., 2011). the objective of the measurement approach is to rationalize the economic and educational decisions in the community (cunda and miller, 2014; yousapronpaiboon, (2014). in this context, the famous model presented by mincer (1974) called ‘mincerian earnings function,’ made possible the estimation of the rates of return to education within and cross-countries (psacharopoulos, 1995; george psacharopoulos and h.a. patrinos, 2004). 1.2. the sample of the study the models of return-to-education studies in several countries were based on the statistical approvals undertaken by the official authorities in the country, the fact that facilitates the analyses processes undertaken by the researchers. to examine the issue, we adopted in this study a questionnaire including 350 distributed copies and 325 retrieved ones. the results of the (table 1) below show that the average years of study for the total sample is estimated by 16.98% and for males and females by 15.97% and 15.98% respectively: additionally, the following (table 2) presents the means of the ages for the males and females of the study. it indicates clearly the mean ages of females and males are nearly the same. the average of per capita income of the total sample was estimated by 8154 sar (table 3). the classification of the sample by gender and educational level reveals that the average per capita of the males’ income is estimated by 9394 sar higher than of females estimated by 6403 sar (figure 1): years of theoretical experience according to the mincer methodology is defined by the age minus the years of education minus the predefined age for enrollment in the educational system (usually 6 years). this rate is measured in the study by 22% as it is shown by the (table 4): 1.3. model specification mincer (1958) had developed the human capital theory by which the measurement of the rate of return on human capital had been applied. it is important to recall that the incentive to develop the human capital approach was to try to understand the role of individual decisions on the basis of economic behavior in interpreting wage inequality, as opposed to income distribution theories that consider such behavior outside the scope of analysis. human capital models focus on human capital investment decisions by excluding all non-competitive forces with varying incomes. the basic assumptions of the model as developed by mincer are: • that the length of the training period or education is the main source of inequality in the incomes of workers and as well as it increases the worker’s productivity. however, the training process requires a delay in income for a future period • in making a decision on training, individuals are expected to obtain higher incomes in the future to compensate for the cost of training • the cost of training should be limited to the opportunity cost of the income which means the income that would have been figure 1: mean income by educational level (sar) table 1: mean of the study years total sample males females mean of the years 15,97 15,98 15.97 observations 325 254 71 table 2: mean of the study ages total sample males females mean of the years 39 41 38 observations 325 254 71 table 3: mean of the per capita incomes (sar) mean of per capita income total sample males females primary 5738 5980 4166 middle 7493 7645 4248 secondary 8542 8753 5008 higher 11743 13449 10036 mean per capita (sar) 8401 9394 6403 table 4: mean of practical and theoretical years theoretical experience practical experience difference of experience rate of increase % total sample 18.26 14.99 3.27 22 males 19.45 15.58 3.87 25 females 17.07 14.4 2.67 19 earned by the individual if he had not enrolled in the training institutions • it is assumed that individuals do not decide to take future training after the completion of the first training period and the future income flows still remain constant even after the end of the first training period • the interest rate used by individuals in determining future flows is assumed to be constant. the literature is abundant by different studies that measured the rates of return on education based on the theoretical approach as well practical one. the analyses reveal most common applied method in this field that tackle the estimation of the functions based on the dependent variable (logarithm of wages or income), and the independent variable is represented by the years spend in education enrollment as it is shown by the following model: houcine and zouheyr: estimating the economic returns of education in ksa by using mincerian earnings function international journal of economics and financial issues | vol 9 • issue 6 • 201996 not received any education; β is the coefficient of years of schooling and in this case reflects the rate of individual return on education. the previous function assumes that the relationship between years of education and wage logarithms is linear. in other words, each additional year of education has the same return regardless of the level of education, while assuming that this relationship is nonlinear for years of experience. the return on years of experience is expected to be positive but decreases over time (negative sign). 1.4. estimating the individual returns of education by using basic earnings function in order to estimate the rate of return of education in ksa, and in line with the requirements of the study, we adopt the basic earnings function developed by mincer (1974). the software used in the estimation process is eviews 9.0. the results are represented by the following table 5: by estimating the return function presented by equation 01 via the ols method (table 5), it is revealed that the special rate of return for the total sample, male and female are: 11.35%, 12.24% and 10.46%, respectively. in addition to this, the values of student test of (t) indicate the significance of the constant parameter c and the coefficient of the years of study b, as well as the non-significance of the years of experience their squares. these observations are added to those related to the average explanatory capacity in the three cases in which r2 takes the values of 56.45%, 65.56%, 53.45% for the total sample, males and females respectively. on the other hand, the values of the fisher statistic indicate that the model is statistically acceptable, and that the explanatory variables explain the level of the income logarithm (in the case of the total sample, the males and the females) despite the fact that the coefficient of determination is average. the value of the fisher statistic indicates that the model is accepted statistically. based on these results, we cannot rely on years of theoretical experience because: • the reduction in the average age of the sample studied in the three cases: 39, 41 and 38, respectively. • the high level of economic waste represented by the number of years of decline • not taking into account the turnover rate. these and other factors have had a significant impact on the difference between the average theoretical and practical experience. this difference goes beyond practical experience per se. that is why we will rely on years of practical experience in estimating the rate of return rather than the theoretical one (table 6): the rate of return reflects reduced outcomes for the complete sample from 1% to 10.35% by replacing the practical experience with the theoretical one. thus, each extra year spent in higher table 5: estimation of mincer model according to the theoretical experience independent variable total sample males females constant (α) 9.4155* 9.5066* 9.2139* (22.9455) (18.0625) (12.89946) years of study (β) 0.1135* 0.1224* 0.1046* (4.9475) (3.0655) (2.9946) years of theoretical experience () 0.0265 0.0274 0.0282 (1.3452) (0.7654) (1.7865) square of theoretical experience () 0.0028 0.0041 0.0017 (1.4567) (1.5678) (1.6753) r2 56.4563 65.5672 53.456 fisher test f 14.7654 15.6754 12.2976 observations n 325 254 71 *significant at 5% table 6: estimation of mincer model according to the practical experience independent variable constant (α) years of study (β) years of practical experience () square of practical experience () r2 fisher test f observations n total sample 9.7641* 0.1035* 0.0265 0.00274 59.6753 18.879 200 (22.9455) (4.9475) (1.3452) (1.4567) 0.045 0.0243 *significant at 5% the individual rate of return to education is estimated first using the basic earnings function developed by (mincer, 1974): 2 log i i i iy s x ex    = + + − − (1) in order to estimate the individual rate of return to different levels of education, the continuous years of schooling variable (s) would be converted into dummy variables representing the different levels of education: 1 2 3 2 4 i i i i i i i logyi prim moy sec univ exp exp         = + + + + + + + (2) where prim, moy, sec and univ are dummy variables indicating primary, secondary and university education respectively. then the private rates of return to these levels of education could be calculated as follows: 1 prim prim r s  = 2 1 moy moy prim r s s  − = − 3 2 sec sec moy r s s  − = − 4 3 univ univ sec r s s  − = − where s(prim), s(sec) and s(univ) represent the average number of years of schooling for the three levels of education; primary (six years), middle (three years), secondary (3 years), and university (4 years) respectively. where ex indicate the years of theoretical experience; α is a constant indicating the logarithm income of newly hired workers who have houcine and zouheyr: estimating the economic returns of education in ksa by using mincerian earnings function international journal of economics and financial issues | vol 9 • issue 6 • 2019 97 education results in an rise of 10.35% in monthly wages. according to model assumptions, the return on years of experience is positive and declining over time (table 6). the fisher test values and the explanatory power of the r2 model indicate the significance and suitability of the model as a whole to explain the issue (table 6). the above (table 7) and figure 2 indicate that the rate of return on education in males is higher than that of females (11.74% for males versus 9.96 % for females). table 9: mincerian returns to education by level of education independent variable total sample males females constant (α) 9.4155* 9.7791* 09.8967* (17.8641) (19.4537) (16.6754) primary (β1) 0.1562* 0.1665* 0.1446* (4.4012) (4.4693) (3.8432) middle (β2) 0.1346* 0.1486* 0.1211* (4.5423) (4.2276) (3.7635) secondary (β3) 0.1624* 0.1845* 0.1412* (4.3241) (4.1362) (3.5643) higher (β4) 0.0985 0.1025* 0.0945* (3.7451) * (3.9856) (3.2342) years of practical experience (δ) 0.0261 0.0256 0.0291 (1.8624) (1.5674) (1.9672) square of practical experience (γ) 0.00364 0.0049 0.0038 (1.8641) (1,7654) (2,1073) r2 47.6753 46.4532 47.9543 fisher test f 10.4673 10.3451 11.4532 *significant at 5% table 7: mincerian returns to education by gender independent variable males females constant (α) 9.6451* 10.8764* (19.4537) (16.6754) years of study (β) 0.1174* 0.0996* (4.5673) (3.8743) years of practical experience (δ) 0.0276 0.0281 (1.4354) (1.8765) square of practical experience () 0.0047 0.0035 (1.3245) (1.9123) r2 59.6543 67.7654 fisher test f 13.6754 14.6754 observations n 254 71 *significant at 5% table 8: mincerian returns to education by residence independent variable rural urban constant (α) 8.7543* 9.6754* (17.6347) (15.7383) years of study (β) 0.1068* 0.1151* (3.5463) (4.6574) years of practical experience (δ) 0.0176 0.0091 (1.6372) (1.8765) square of practical experience () 0.0048 0.0045 (1.2345) (1.8649) r2 51.9847 62.4534 fisher test f 15.6543 16.4576 observations n 65 260 *significant at 5% figure 2: return rate by gender the (table 8) and (figure 3) indicate the determination of the mincer function by residence shows that the rate of return from education in urban areas is greater than the rate of return in rural areas (11.51% in urban areas and 10.68% in rural areas). this result is in line with international standards. 1.5. estimating the individual returns of education by using extended earnings function in order to estimate the private rate of return to different levels of education in ksa, and in line with the requirements of the study, we adopt the extended earnings function (2). the results are represented by the following table 9; the table 9 and figure 4 above indicate the rate of return for the four levels of education. it is clear that secondary education is the best level of education for individual investment in education, as it yields the highest rate of return 16.65%. it is surprising, then, that primary education is more profitable for individual investment in education than for higher education, a result that is inconsistent with most empirical studies. middle education, on the other hand, is the less profitable investment for individuals in education. 2. discussion of the results the table 10 below and figure 5 demonstrate the distinct outcomes of the individual education return rate for this research. figure 3: rate of return by residence houcine and zouheyr: estimating the economic returns of education in ksa by using mincerian earnings function international journal of economics and financial issues | vol 9 • issue 6 • 201998 table 10: results of the individual return rate estimation indicator total sample gendre place of residence levels of education males females rural urban prim midl sec univ rate of return (%) 10.35 11.74 9.96 9.68 11.51 15.62 13.46 16.24 10.35 observations total 325 254 71 65 260 66 46 90 123 observations n 325 325 325 325 figure 4: individual rates of return by level of education figure 5: results of individual rates of return return from education for males is higher than the rate of return for females. this result corresponds to the results of international studies as the rate of return for males exceeds his peers in the following regions: european countries in transition (17.5%), latin america (13.4%) and sub-saharan africa (12.5%). this is quite the opposite of the rate of return for females in the regions: latin america (12.3%) and subsaharan africa (8.7%). however, these results highlight the important fact that the role of women in the economic growth is low. this is due to a number of factors. the most important one is the low social awareness in these areas. in addition to the negative view of the role of women in economic activity as well as the influence of customs and traditions. • displays the estimated private rates of return for the four levels of education. it is shown clearly that secondary education is the best educational level for individual investment in education since it yields the highest rate of return (16,24%). it was then established that primary education (15.62 %) is more lucrative for individual investment in education than higher education (9.45%), which is consistent with the research of psacharopoulos and global norms. • the individual rate of return to secondary education is greater than the rate of return to other levels of education. this finding implies that the labor market offers better benefits for secondary school graduates. this means that the government should give priority to secondary education from both quantitative and qualitative perspectives. on the contrary, higher education witnesses a decline in yields due to elevated rates of educated unemployment. • the rate of return by place of residence is estimated at 11.51% for urban areas, which is higher than the return rate estimated at 9.68% for rural areas. these results are in line with international standards. this is due to the fact that the division into rural and urban areas adopted by the official authorities seems to be correct. 3. conclusion the study of the feasibility and evaluation of investment projects requires a rigorous scientific approach to ensure that the decisions taken achieve economic development as long as the natural and material resources are limited, as is the case in developed countries. in fact, researches about the evaluation of investment in university education in ksa are still scarce. in light of this, this study comes as an attempt to examine how to evaluate this type of investment in ksa. 4. findings • techniques and models are employed to evaluate education return on investment. maybe the most common is the returnthe findings are linked to the overall sample by gender, place of residence and education levels: the most significant findings of the mincer equation estimation method can be summarized as follows: • after replacing practical experience by theoretical one and recasting the model again, we obtain generally accepted statistical results. • there is a convergence of outcomes between practical experience and theoretical experience. • the explanatory capacity of the estimated models remains acceptable and above from the average. • the rate of return of education for the total sample is 10.35%. it is higher than the rate of return that psacharopoulos got in his study which is 9.6%. the latter is close to 10% as the international standard in this field, and it is higher than the regional rates, which amounted to 9.6% in asia and 6.8% in oecd countries (george psacharopoulos and h.a. patrinos, 2004). • the rate of return from education for males (11.74%), which is higher than the rate of return for females (9.96%), the gap between them is about 2% on average. as well as the same result for all levels of education, we found that the rate of houcine and zouheyr: estimating the economic returns of education in ksa by using mincerian earnings function international journal of economics and financial issues | vol 9 • issue 6 • 2019 99 cost and the earning function methodology of mincer, despite criticism of their right, for precise outcomes and easy use. • the rate of return of education for the total sample is 10.35%. it is higher than the rate of return that psacharopoulos got in his study which is 9.6%. • the findings of this research are correlated with previous research comparable to the values of individual and social higher education returns, which are comparable to separate countries. in general, the results demonstrate the economic feasibility of the individual in ksa since the graduate joins the business life and the rate of individual return exceeds that of the market interest rate. references aracil, a.g., palomares-montero, d. 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(2014), servqual: measuring higher education service quality in thailand. procedia-social and behavioral sciences, 116, 1088-1095. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.40-53 issn: 2146-4138 www.econjournals.com 40 measuring liquidity risk in an emerging market: liquidity adjusted value at risk approach for high frequency data rouetbi emna1 institut supérieur de finance et fiscalité sousse, rue 18 janvier sousse, tunisia. tel. 00 216 73 222 700, fax: 00 216 73 222 701. email: erouetbi@yahoo.fr mamoghli chokri institut des hautes etudes commerciales, 2016 carthage presidence, tunisia. tel. 00 216 71 775 948, fax: 00 216 71 775 944. email: chokri.mamoghli@essect.rnu.tn abstract: the present paper introduces an enhanced liquidity adjusted intraday value at risk measure named the livar applied to a sample of listed securities in an emerging market; namely the tunis stock exchange (bvmt). very specific econometric tools were used to perform models that suit the statistical properties of the data and to obtain a more realistic and efficient measure. this methodology was applied to intraday data. it was found that in the bvmt, the liquidity risk is very high. it represents about 25% of the total cost supported by a day trader for the most active stocks of the considered sample. it can also reach more than 40% for the less liquid ones. these results reveal how thin the tunis stock market is. keywords: liquidity; intraday value at risk; spread; acd; monte carlo simulation. jel classifications: c41; g17 1. introduction in the recent years and with reference to the successive market crises (especially that of the year 2008), the issue of considering liquidity as a risk factor has been frequently revisited. thus, it has become crucial to study the impact of liquidity variations on the market movements. this leads to a growing literature interested mainly in either establishing liquidity adjusted pricing model (pastor and stambaugh (2003), archarya and pedersen (2005), sadka (2006), davivongs and pavabutr (2012)) or incorporating liquidity risk in a well-known risk management tool namely; the value at risk (bangia et al. (1999), le saout (2002), al janabi (2008), aktas et al. (2012). indeed, the latter is a risk indicator of the maximum loss of a financial asset or portfolio at a time horizon and a certain probability. despite the critics addressed to it, the value at risk remains the approach currently used by regulators and market professionals given its ease of calculation and direct interpretation. in this respect, the value at risk framework has been continuously evolving. it began with a jp morgan’s (1996) risk metrics based on the normality assumption corresponding to the asset’s returns. this restrictive assumption has been abandoned in favour of more sophisticated techniques such as the historical and monte carlo simulations having as an objective to state a more realistic framework and obtain a more efficient risk valuation. in this field of research, not only mature markets were explored but also the emerging ones. recently, harvey (2012) advocated the idea that there existed more than one reason to urge the interest in emerging markets. he asserted that it is more advantageous to invest in the emerging markets as they lead to higher expected yields and according to bekaert et al. (2007a) they offer higher opportunities for growth. indeed they are more volatile and then riskier which is not only due to 1we thank luc bauwens from the core belgium, and kouki mokhtar from the high institute of statistics and information analysis, tunis. measuring liquidity risk in an emerging market: liquidity adjusted value at risk approach for high frequency data 41 market environment but also to particular conditions such as political instability and companies governance problems. in this context, studies dealing with risk valuation are of great help especially for regulators since many markets need structural and regulatory changes in order to improve their trading environment (transparency, order rooting, and liquidity) and attract foreign investors given that in many emerging markets, stability depends on foreign order flow. santoso et al. (2010), for instance, declared that from 60% to 70% of the invested funds in indonesia stock market are from foreign sources. thus in this case, foreign portfolio adjustment directly affects market movements. the risk related to international order flow migration makes market regulators more concerned about liquidity and risk valuation. the present paper fits in this framework. we propose a liquidity adjusted value at risk measure performed in an intraday time horizon which requires ultra high frequency data. the challenge is to take into account the intraday particularities of the trading process including liquidity, volatility and trading cost. it is organized as follows: section 1presents a short literature review. section 2 exposes the methodology. results are exposed and discussed in section 3 and the last section concludes the paper. 2. literature review in microstructure literature, stockholders face two types of risk: a market, and a liquidity risk. both types feed uncertainty about the portfolio liquidation value. bangia et al. (1999) divided the latter into two types: uncertainty about future returns (the market risk), and uncertainty about liquidity. the former is related to returns variation. the latter, in turn, is decomposed in two types: endogenous and exogenous liquidity. the first is commonly supported by all the traders interested in stocks. it reflects the market characteristics such as depth, and spread while the second is related to the position taken by the trader. when considering the two types of risk, moulton (2003) asserted that the total supported risk depends on the adequacy between desired quantity and the trading price. bangia et al. (1999), however, defined the trading risk as a result of circumstances which determines the part of each risk on the total uncertainty. as a matter of fact, in a period of a steady market, a trader aiming at buying a large quantity will face a higher level of endogenous liquidity risk, increased with higher market risk. furthermore, in a high volatility period, large trades face high market risk that increases with a weak level of endogenous liquidity risk. the most important question raised by several microstructure studies is how to estimate the two components of liquidity risk, namely; the endogenous and the exogenous ones. in this respect, bangia et al. (1999) provided a pioneering work considered as the starting point of many researches. each time they begin with an associated criticism. the often cited one is related to the exogenous liquidity risk measure. indeed, these authors argued that relative spread represents the cost of an immediate transaction. however, when the order quantity exceeds the depth displayed by the best limits, the execution cost will exceed the half of the quoted spread. it includes both the exogenous and the endogenous liquidity risk. in this case, the latter is the difference between the price impact and half the spread. accordingly, it can be assumed that both endogenous and exogenous liquidity risks are very much linked and the traded quantity determines the importance of each one. nevertheless, shamroukh (2000) suggested to take the spread’s volatility (exogenous liquidity risk) into account unless its effect is insignificant compared to that of price. the second critic addressed to bangia et al. (1999) is relative to the empirical methodology. they based their exogenous liquidity risk measure on a historical simulation which is considered very simplistic since the value at risk corresponds to a percentile of the empirical distribution of the spread. similarly, the endogenous liquidity estimation was the subject of different studies as jarrow and subramanian (1997), almgren and chris (2001) and bertsimas and lo (1998). the first one calculated the optimum portfolio liquidation value during a fixed time horizon. it compared the cost of a block trade and progressive liquidation. bertsimas et al (1998), on the other hand, offered the hypothesis of the fixed liquidation delay. they made dynamic trading strategies aiming at minimizing the execution cost during an exogenous time horizon. this strategy resulted in orders’ sequences drawn up in different quantities that are fixed according to the market conditions. for a risk-averse agent, it is optimal to split the desired volume into fractions and to trade one fraction per period. the authors modelled the price impact as a linear function of the traded volume. unfortunately, these two studies did not take the market risk into consideration. hisata and yamai (2000) generalized the model international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.40-53 42 of almgren and chriss (2001) by considering the impact cost minimization when trading quantities in relation to market liquidity. when using the value at risk approach, they considered a non-linear relation between the traded volume and the market impact variable. first of all, they divided the market impacts into permanent and temporary. the latter refers to the total traded volume. secondly, they formulated an optimum execution strategy which consists in minimizing the liquidation cost. thirdly, they calculated the var (value at risk) adjusted to liquidity. this study pioneered in two major points: it considered the objective of minimizing the trading cost, and implemented a non-linear relation between volume and market impact. however, its major deficiency lies in that it assumed a simple valuation of the impact cost. in another respect, longstaff (2001) defined liquidity as the quantity that could be traded during a period of time. he offered a model of partial equilibrium which consists in choosing a strategy with restricted management’s margins. he concluded that an agent must trade as often as possible to reduce his/her trading cost. pereira and zhang (2007) went further and suggested that it is more advantageous to trade different quantities during different periods. thus, allowing the traded volume to be exogenous. they claimed that the ex-ante liquidity premium which required holding an illiquid stock reflects the ex-post price that will be paid to compensate the loss of its sale. progressive liquidation was also considered by haberle and persson (2000) who proposed a model without a price impact since they asserted that traders exchange quantities lower or equal to the market depth. in this case only exogenous liquidity risk must be measured. according to le saout (2001), periods of extreme variations of both returns and liquidity are rather frequent. he pointed out that large spreads are not observable during the periods of extreme price variations. therefore, var adjusted to liquidity as calculated by bangia et al. (1999) overestimates the risk. on the other hand, they used the relative spread to measure liquidity even though it only represents the tightness of the market and not the price impact. le saout (2001) also proposed to use value weighted spread to take into account the market resiliency. he gave the example of the stock saint gobin quoted on the paris stock exchange to show that for a quantity of 5000, the endogenous liquidity components represent 17.13 % of the total risk. in the same vein, this paper is about measuring liquidity risk in an emerging market: the tunis stock exchange (bvmt). the focus on the latter is attributed to the little microstructure literature that deals with it despite the growing foreign interest in it. in fact, foreign ownership was up to 20% at the end of december 2012. the market capitalization was about 10.5m$ and the daily traded volume reached 4.1m$. its attractiveness is explained by its transparency and the modern automated trading system inspired from euronext named utp (universal trading platform). between 1996 and 2008, tunis stock exchange changed the trading platform twice. this was due to the authority’s pursued objective to offer better trading environment with an acceptable transparency degree and attracting foreign investors especially when extending the trading session duration from one hour and a half to four hours for continuously traded stocks. in this paper we propose an intraday value at risk measure adjusted to liquidity. the objective is to investigate whether liquidity risk is particularly high in bvmt. the ultra high frequency data availability allows us to make this possible in an intraday horizon from a reconstituted limit order book. indeed, this research is conducted in order to validate the following hypotheses: h1: in bvmt, a day trader faces a very high liquidity risk; h2: liquidity risk is higher for less liquid stocks. 3. data and methodology the tunis stock exchange is an emerging market in the mena region. it attracted little attention especially from the microstructure field. the present research fits in this framework as it seems to be the first to focus on the intraday risk valuation. we suggest a very precise methodology that could be used even in the context of mature markets. we tried to take into account every liquidity dimension corresponding not only to trading cost but also to the time opportunity cost. when focusing on liquidity, the choice of the sample is determinant. that is why we applied a parsimonious procedure to the 14 stocks quoted within the continuous session all along the year 2006. in order to choose the most adequate sample: we classified them according to the daily number of trades, daily traded volume, quotation frequency, time duration between successive trades and daily price variation. the first (second) half the total number of stocks represents the most (less) liquid ones. measuring liquidity risk in an emerging market: liquidity adjusted value at risk approach for high frequency data 43 we retained the three most liquid stocks (stb, stpil and sfbt) as well as the first three stocks among the least liquid ones (uib, mg, and biat). during the year 2006, for continuous sessions, trading begins at 10:00 am until 11:30. during this time interval, we reconstituted the order book for the six stocks of the sample. moreover, we have chosen the year 2006 because it represents a favourable context to study liquidity and risk determinants. market professionals confirmed that it is characterized by a great enthusiasm even ''euphoria'' as the market index namely tunindex increased by almost the half. market capitalization has increased by 43% to reach 5.491 million dinars (3.6 m$). 3.1. econometric models the literature review exposed above was based on three among the four liquidity dimensions, namely; tightness, resiliency and depth, when incorporating liquidity cost in the risk measuring. according to kyle (1985), tightness also named market width refers to the spread which defines the cost of an immediate transaction. resiliency represents the speed at which the price will reach a new equilibrium after a trade occurrence. depth, on the other hand, corresponds to the volume that could be traded at the current price. in the same respect, harris (1990) introduced another dimension that is immediacy i.e. the time dimension of the trading process, which refers to the possibility of trading a desired quantity very quickly and at an acceptable cost. unfortunately, this dimension was not explored by the risk valuation framework. therefore, we aim at filling this gap when proposing an empirical model that will make it possible to take into account the fourth liquidity dimensions that could be interpreted as the time opportunity cost. biais et al (1995) argued that a large group of traders stay outside the market waiting for an acceptable opportunity to intervene and satisfy their needs for liquidity. time between successive trades informs us about traders’ interest in trading. it also expresses the time opportunity cost since large durations imply a loss for the traders who have been waiting for long time to have the possibility to find convenient counterparts. however, in microstructure literature, durations have been considered as an indicator of the trading intensity (bauwens and giot (2002)). very recently, rouetbi and mamoghli (2013) used durations between limit order submissions as an indicator of liquidity renewal frequency. the time duration between successive trades has not been approached in the risk valuation literature despite its importance for order driven markets except by dione et al (2006) who pioneered in this context but they omitted the liquidity adjustment of the proposed ivar. we have been inspired by this study which we propose to extend. in this very context, the present work proposes trade durations as a risk amplifying factor introduced in returns’ volatility equation. this specification may make the analysis more complete and thus reliable. moreover, when measuring liquidity risk we suggest an empirical model based on a wellknown one in risk management that is value at risk. by definition, it expresses the maximum loss supported by a trader when liquidating his/her position within a fixed time interval. the employed methodology was inspired by such studies as bangia et al. (1999), le saout (2001) who applied a value at risk approach using an aggregated intraday data. dionne et al. (2006), however, carried out the first research that proposed an intraday measure of the value at risk using high frequency data: the ivar (intraday vale at risk). as a matter of fact, the current work combines the empirical contribution of the three previously cited studies to validate the h1 hypothesis above. moreover, we propose to test whether liquidity risk is higher for less liquid stocks i.e. h2 hypothesis. in this context, we suggest the use of two subsamples: more and less liquid stocks. accordingly and in order to validate the value at risk measure, we have to perform a back testing. in this vein, we propose to divide the sample period into two: the first six months’ data will be dedicated to the model’s estimation and forecasting. the second half of the period will be devoted to back testing and validating the value at risk approach. the challenge, here, is to model market and liquidity risks when taking into account each of the related dimensions of the trading process. to achieve this goal, a set of specific econometric tools is necessary. time dimension requires the use of a duration model i.e. acd (autoregressive conditional duration). price variations (returns) are modelled by an ultra high frequency garch i.e. uhf-garch. the quantity dimension, however, needs to be carefully approached. the traded volume is related to the impact of the trading cost. therefore, it is naturally linked to the endogenous cost of liquidity. we fixed the traded quantity at 100 stocks. we suppose that traders desiring to trade large quantities would use several transitions at minimum 100 stocks per trade. thus returns’ variation will naturally take into account the market price impact and depth. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.40-53 44 to fulfil such a purpose the following steps are necessarily followed: firstly, we propose to model the time durations between mid prices variations. in this respect, we will use the bauwens et al. (2004) procedure to choose the acd model that will efficiently fit the econometric properties of the data. this will be achieved during the estimation period (the first six months of the year 2006). secondly, the conditional duration calculated will be introduced as an explanatory variable into the returns’ volatility equation allotting to the latter an egarch model as in dionne et al. (2006). we will use the in-sample estimation result to predict the value at risk calculations. the back testing period will be used to validate the model. thirdly, we will introduce the exogenous liquidity risk by using the empirical density of the spread. in this respect, we will extend the procedure suggested by bangia et al. (1999). 3.2. estimates of the duration model table 1displays the characteristics of the durations between mid prices variations caused by a minimum traded number of stocks fixed at 100. this choice will enable us to easily calculate the trading and the price impact cost since such quantity is achievable at the best bid or ask price. in the same way, agents wishing to exchange large quantities are supposed to intervene through several orders carrying at most 100 stocks each. thus, our intraday var will account for the strategy of order split aiming at limiting the undergone trading cost. this interpretation supports that of hisata and yamai (2000), almgren and chriss (2001) proposals. moreover, it appears to be in perfect harmony with the temporal horizon considered (intraday). table 1. descriptive statistics of the trade durations: this table reports descriptive statistics associated with the time duration between mid price variations for the most liquid stocks of the bvmt: stb, sfbt, stpil and less liquid ones uib, mg, biat. sample period: january to june 2006. durationsare measured in seconds. stb stpil sfbt uib mg biat observations’ number 6244 4050 2295 1498 1237 991 observations’ number by 30 minutes interval 1st half-anhour 36% 27% 31% 30% 27% 24% 2nd half-anhour 35% 29% 34% 33% 34% 32% 3rd half-anhour 29% 43% 34% 37% 39% 45% raw durations mean 116 161 198 233 225 265 sigma* 209.93 281.76 278.64 363.22 348.89 401.02 id** 1.81 1.75 1.41 1.56 1.55 1.51 min 1 1 1 1 1 1 max 25 44 62 58 67 69 adjusted durations mean 1 1 1 1 1 1 sigma* 1.65 1.59 1.26 1.33 1.33 1.32 id** 1.59 1.57 1.25 1.33 1.33 131 min 0.006 0.005 0.004 0.003 0.003 0.003 max 28.75 22.73 14.61 12.75 12.83 13.09 *sigma is the standard deviation; **the dispersion indice: standard deviation/mean. after adjusting raw durations for intraday seasonality, we carried out the estimated model of gglacd1 (1.1): logarithmic autoregressive conditional duration model which allots to the standardized duration a gamma generalized law. indeed, bauwens et al. (2004) and bauwens and giot (2002) highlighted the flexibility of this type of models and its superiority compared to the simple autoregressive conditional duration model (acd) when studying events related to the trading activity. this model expresses the conditional expected duration as a function of the lagged duration on logarithm: = (1) = +∝ ln( ) + ( ) (2) measuring liquidity risk in an emerging market: liquidity adjusted value at risk approach for high frequency data 45 : the intraday duration at the time i; : the conditional expected duration; : the random variable called standardized duration. table 2 indicates that the durations are over-dispersed; the dispersion index is higher than the unit. the exponential law cannot then describe the behaviour of the standardized durations. in the same way, it is clear that model gglacd1 (1.1) could fit the data. indeed, the stability condition is checked (α+β<1) and the autocorrelations of the residuals are not significant for all the stocks of the sample. the si is lower than the unit. moreover, the three parameters of the model are positive and significant, which confirms the activity clustering over time. periods of short (long) durations are followed by periods of short (long) durations. with reference to the test goodness of fit we notice that specification gglacd1 (1.1) is valid for all the stocks of the sample. thus we can use this model to reproduce the statistical behaviour of the time durations. table 2. estimation results of the model gglacd1(1,1): this table gives the estimation results of gglacd1 (1.1) model : = , = +∝ + where dessaisonnalizedduration observed at the time i. denotes the conditional expected duration. denotes standard duration. stb stpil sfbt uib mg biat coefficients ω p-value 0.171 (0.021) 0.228 (0.032) 0.092 (0.044) 0.192 (0.029) 0.173 (0.041) 0.139 (0.036) α p-value 0.242 (0.022) 0.301 (0.023) 0.252 (0.046) 0.272 (0.025) 0.257 (0.035) 0.216 (0.028) β p-value 0.701 (0.044) 0.640 (0.054) 0.721 (0.133) 0.621 (0.064) 0.712 (0.077) 0.582 (0.110) the gg parameters γ p-value 0.140 (0.049) 0.115 (0.055) 0.426 (0.071) 0.366 (0.062) 0.281 (0.064) 0.389 (0.085) ν p-value 2.567 (0.018) 3.111 (0.029) 2.786 (0.001) 2.985 (0.001) 5.123 (0.002) 2.724 (0.001) residual mean 0.981 0.991 0.990 0.964 0.956 0.975 sigma 1.656 1.768 1.345 1.408 1.484 1.406 1.689 1.867 1.358 1.460 1.553 1.442 min 0.002 0.001 0.002 0.003 0.002 0.003 max 24.126 30.280 15.175 12.656 19.364 16.454 χ2(19)* static pvalue 27.431 (0.095) 39.583 (0.004) 37.189 (0.008) 56.310 (0.000) 52.653 (0.000) 66.834 (0.000) si ** s1 0.980 0.005 0.860 0.031 0.608 0.395 s5 0.766 0.111 0.543 0.153 0.472 0.717 s10 0.625 0.556 0.517 0.623 0.351 0.962 s50 0.841 0.747 0.643 0.722 0.769 0.647 note: the dispersion index (standard deviation/mean) of residuals; ≈n (0,1) test statistic for overdispersion of residuals under exponential null hypothesis; *results of the goodness of fit test; **sii={1,5,10,50} the ljung box ratio of the residual corresponding to the quintile 95% of χ2(i). 3.3. modelling returns returns relative to the mid price variations are modelled by using a garch model adapted to the ultra-high frequency data. the conditional return variance is defined by the following equation: ℎ = (3) ℎ is the conditional variance; is the duration between successive mid price variations caused by trades with 100 stocks minimum volume; is the return variance per unit of time. is a coefficient to be estimated. according to dionne et al (2006), it corresponds to the impact of durations on the conditional volatility. the conditional variance of the durations per unit of time is modelled as follows: average equation: arma (1.1): international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.40-53 46 = + + (4) conditional variance: egarch (1.1): log( ) = + − ( ) + + log ( ) (5) where = ℎ , and = { , ∈ ℤ} is a white noise are i.i.d with a zero mean and a unit variance. for γ = 0 we will find the equation of the uhf-garch introduced by engle (2000). the estimation results of the model are presented in table iii below. table 3 indicates that the egarch (1.1) model is valid for all the stocks of the sample. coefficients of the conditional variance of the returns (β) are lower than the unit. the parameter a is positive and statistically significant for all stocks of the sample: a shock on returns amplifies the stock’s volatility. however the impact of these shocks is asymmetric because the sign of the parameter b is not identical for all securities of the sample. it is positive for stb, mg and biat: negative shocks cause more volatility than positive ones. the opposite is true for stpil, uib and sfbt for which parameter b is significantly negative. table 3. estimation results of the egarch(1,1) for the returns: this table gives the estimation results of egarch (1,1). mean equation: = + + + where the returns at time i and the corresponding residual. the conditional variance equation: log = + − ( ) + + log ( ). the volatility is modeled by the product of the conditional variance and the time duration between mid price variationℎ = . mean equation stpil stb sfbt uib mg biat c p-value 0.0016 (0.042) 0.016 (0.000) 0.011 (0.000) 0.017 (0.001) d p-value 0.598 (0.000) 0.349 (0.000) 0.412 (0.000) -0.878 (0.000) 0.477 (0.000) -0.135 (0.000) f p-value -0.720 (0.000) -0.565 (0.000) -0.604 (0.000) 0.788 (0.000) -0.695 (0.000) -0.214 (0.000) volatility equation  p-value -2.633 (0.000) -1.501 (0.000) -2.618 (0.000) -1.302 (0.000) -1.899 (0.000) -0.658 (0.000) a p-value 0.580 (0.000) 0.376 (0.000) 0.426 (0.000) 0.421 (0.000) 1.125 (0.000) 0.184 (0.000) b p-value -0.059 (0.000) 0.023 (0.000) -0.124 (0.000) -0.161 (0.000) 0.438 (0.000) 0.057 (0.000) β p-value 0.356 (0.000) 0.550 (0.000) 0.422 (0.000) 0.668 (0.000) 0.163 (0.000) 0.795 (0.000) γ p-value 0.056 (0.000) 0.039 (0.000) 0.050 (0.000) 0.028 (0.000) 0.047 (0.000) 0.017 (0.000) p-value of q(20) 0,304 0,426 0,239 0,380 0,560 0,496 p-value of q2(20) 0,486 0,540 0,593 0,871 0,758 0,648 wald test 5488,63 72,720 943,193 453,621 97,543 743,52 the coefficient γ is positive and statistically significant for all the stocks of the sample. an increase in the duration induces an increase in the stock volatility. this result confirms the asymmetric informational theory predictions especially those of admati and pfleiderer (1988) who stated that deceleration of the trading activity signals the presence of information which results in higher volatility. it also confirms the findings of those of rouetbi and mamoghli (2013) who asserted that mid price volatility enhances market activity i.e. liquidity supply and demand. measuring liquidity risk in an emerging market: liquidity adjusted value at risk approach for high frequency data 47 3.4. the monte carlo simulation as it is mentioned in the first section of present paper, the total risk supported is decomposed into market and liquidity risks. empirically speaking, the first could be modelled by the uhfgarch displayed above. according to bangia et al. (1999), liquidity risk is divided into endogenous and exogenous risk. the first is related to the trade size. it is the impact cost of the transaction which is an increasing function in the volume traded. kumar (2003) previously indicated that it can be controlled by reducing the traded quantity. the exogenous liquidity risk, on the other hand, reflects the characteristics of the market such as the spread. it is commonly supported by all the traders. to estimate both market and endogenous liquidity risks, we followed the methodology of dionne et al. (2006) which consists in generating returns series by simulation based on the four preceding equations. exogenous liquidity risk is measured by the relative spread. then, the kornish-fisher approximation is necessary to calculate the corresponding risk component. we justify the choice of this variable by the fact that we fixed at a minimum of 100 stocks the volume per trade which is easily achievable at the best limits. hence, the use of weighted spreads or other price impact measures becomes needless. time durations between mid prices variations will enable us to take into account the market risk and at the same time the endogenous liquidity. the calculation of return during these durations naturally incorporates the impact cost since it is caused by trading a minimum quantity (100). from equation (2) we simulate the durations during the forecasting period. egarch model specified above will be used to generate the returns during these durations. the obtained returns are irregularly spaced in time. however, giot and grammig (2002) insisted that the var estimation requires regular data. thus, we must regroup them into fixed time intervals to make the estimation possible. the monte carlo simulation is made as follows: firstly, we draw random numbers from gamma generalized law that will enable us to build the scenarios for the durations from equation (2); secondly, we draw gaussian random numbers2 which will serve to generate the series of returns and volatility using the egarch equations (4) and (5).then we can generate different scenarios for future durations, returns and volatility. these outputs are irregularly spaced in time. thirdly, we regroup forecasted variables into fixed time intervals; finally, the preceding steps will be repeated until obtaining the desired number of observations. 3.5. ivar calculation and backtesting the ivar corresponds to a percentile of the simulated returns associated with a selected confidence interval. with a confidence level (1-α), the ivar is defined as: p(y < − ( )/ω ) = α (6) / ={1,.....n} where n is the realized length of the process. where is the sum by interval of the tick by tick returns generated by simulation: = ∑ ( ) (7) ( )is the number of observations per time interval t: ∑ ≤ (8) refers to the information set available for durations and returns. the durations generated by simulation are not expressed in seconds since the time of the day effect is removed. they are gathered by interval so that their sum does not exceed t which is fixed at 30 for all the stocks of the sample. for stpil, we generated 2020 observations gathered in 228 intervals from which we determined the percentile of the simulated returns corresponding to the selected confidence level. the ivar series are then confronted with the returns carried out during the testing period. graph 1 displays the realized returns during the back testing period and the forecasted ivar (99.5%) for the stock stpil during the 228 time intervals. 2 returns are not normal but it is the case for the variable . international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.40-53 48 this graph shows that the realized loss is often lower than that calculated by the ivar model except for two observations. however, the graphic analysis is not enough to validate the model. indeed, statistical tests should be made to empirically validate the value at risk measure. it is a question of checking whether the expected loss is lower than that realized for (1-α) % of cases during the backtesting period. graph 1. intraday returns and the ivar: the case of stpil this graph exhibits the returns (r. returns) recorded at the back testing period and the maximum loss calculated at 99.5% confidence level. thus, α represents the maximum level of tolerance. if the real proportion of going beyond is higher than α, the model must be rejected. the first test used is the test of unconditional cover also known as the test of kupiec. it defines a dichotomic variable which is equal to the unit when the realized loss is lower or equal to ivar, and to zero otherwise. ≈ (∝) where α is the theoretical proportion. ∝ refers to the real proportion of going beyond the realized loss; the test of kupiec can then be formulated as follows: h0 :∝=∝ ; h1 : ∝≠∝ the likelihood ratio could be written as follows: = 2[ln(∝ (1 −∝) ) − ln (∝ (1−∝) )] (9) where n is the number of observations and m the number of exceptions (the number of times where ivar is lower than the realized loss). the failure rate of ivar measure is then definite by ∝= . the ratio lr is distributed as a (1). the results of the test are displayed in table 4below: the independence test confirms the validity of ivar measure for our sample. it acts well for all the stocks of the sample for a confidence level of 99.5%. we notice a failure of the model for the 99% level. however, the kupiec test is not enough to validate or not the ivar estimation. accordingly, we suggest a complementary test namely; the exceptions independence test: h0: the exceptions are independent. h1: the exceptions are not independent. the ratio of probability of the test is written as follows: = 2(ln[ ( , ̂ , ̂ )] − ln[ ( ,∝ )] ≈ (1) (10) where: ̂ = (11) -0,03 -0,02 -0,01 0 0,01 0,02 0,03 0,04 0,05 1 11 21 31 41 51 61 71 81 91 10 1 11 1 12 1 13 1 14 1 15 1 16 1 17 1 18 1 19 1 20 1 21 1 22 1 r. returns ivar 99.5% measuring liquidity risk in an emerging market: liquidity adjusted value at risk approach for high frequency data 49 and ̂ = (12) with reference to table (5) for 99.5% confidence level, the estimated var is valid for all the stocks of the sample. these results confirm those of the preceding test. it also confirms the failure of the ivar measure at a 99% confidence level. table 4. back testing results this table displays the tests’ results used in order to confirm the validity of the ivar measure. the likelihood ratio of the kupiec test: = 2[ln(∝ (1−∝) ) − ln (∝ (1−∝) )]. where n is the number of observations, and m the number of exceptions (the number of times where ivar is lower than the realized loss). the ratio lr is distributed as a (1). the likelihood ratio of the second test named independence test: lr = 2(ln[l(i,z ,z )]− ln[l(i,∝ )] ≈ χ (1).where: z = number of interval without exceptions followed by an exception nomber of successive intervals without exceptions and z = h stpil stb sfbt uib mg biat kupiectest 99% p-value 0.036 0.000 0.636 0.005 4.46 0.34 0.014 0.174 7.87 0.212 0.392 0.343 99,5% p-value 0.531 0.000 2.220 0.000 0.17 0.013 0.732 0.032 0.384 0.019 0.015 0.063 independence test 99% p-value 0,329 0.000 24.15 0.290 0.364 0.390 8.24 0.000 99,5% p-value 0,393 0.000 0.288 0.000 1.62 0.000 0.270 0.000 1.79 0.000 2.778 0.000 after calculating the intraday var, measuring the price risk and the endogenous liquidity risk, we propose to include the exogenous liquidity risk component. 3.6. the ivar adjustment to the exogenous liquidity risk: bangia et al. (1999) were the first to introduce the exogenous liquidity risk. they included a component related to the spread to the market risk premium. this component is expressed as follows: = [ ∗ ( ̅ + ̂∝ )] (13) elc: the exogenous liquidity cost; the mid price recorded at the time t. it is the average of best bid and ask prices; ̅the average relative spread (spread/mid); the spread’s volatility; ̂∝the percentile from the spread’s empirical distribution corresponding to the (1-α) confidence level. to obtain as much a realistic measure as possible, it is necessary to take into account the empirical properties of the series. in this vein, bangia et al. (1999) explained that a thick tail of the spread’s distribution reflects a lack of liquidity. the advantage of their method is that it allows the spread to be leptokurtic. however, several authors, such as ernst, stange and kaserer (2008) and herlemont (2009) among others, suggested applying the approximation of cornish fisher instead of using the empirical distribution of the spread. from a quintile of the gaussian distribution, it is possible to calculate , the adjusted one, by introducing the corresponding coefficient of asymmetry as well as the excess kurtosis. = ∝ + ( ∝ − 1) + ( ∝ − 3 ) − (2 ∝ − 5 ) (14) where ∝indicates the α% percentile of the standard normal distribution; is the coefficient of asymmetry (skewness); κ is the excess kurtosis which is equal to 3 in a gaussian distribution. with reference to equation (14), the exogenous liquidity cost (elc) could be expressed as follows: international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.40-53 50 = ∗ ( ̅ + ) (15) table 5 indicates that the spread’s distributions are leptokurtic for all the stocks of the sample. the kurtosis coefficients largely exceed 3. the distributions present thick tails which reflects the lack of liquidity. similarly, all the coefficients of asymmetry are different from 0. they are rather positive. the empirical distributions are all spread out on the right (the skewness coefficients are all >0). thus spread’s series are far from normal. table 5. spread’s descriptive statistics this table presents the descriptive statistics of the average relative spread (bid ask spread/mid price). stpil stb sfbt uib mg biat mean 0.53% 2.89% 0. 77% 8.60% 14.78% 4.26% standard deviation 0.0061 0.085 0.0145 0.172 0.3959 0.0385 skewness 3.414 2.375 9.020 1.956 3.215 1.479 kurtosis 23.389 5.407 51.123 8.870 10.406 11.729 jarque-bera 440928.7 231775.4 963761.7 37847.7 14666.3 124036.8 using the formula of cornish-fisher, we calculated the cost of the exogenous liquidity and adding it to the risk calculated by the monte carlo simulation; we obtained the total cost of intraday liquidation. the ivar adjusted to liquidity named livar could be expressed as follows: = (1 − exp( + ( ) )) + ̅ + ∗ (16) where is the average mid price recorded at the beginning of the estimation period. and are, respectively, the average and the standard deviation of the estimated returns obtained by monte carlo simulation. the estimation results of market and liquidity risks are illustrated in table (6) below: table 6. livar decomposition this table shows the estimation results of the liquidity adjusted value at risk measures expressed by the equation: livar = p (1− exp(μ + ivar(r)σ )) + p (s̅ + z ∗ σ ). where p is the average mid price recorded at the beginning of the estimating period. μ and σ are, respectively, the average and the standard deviation of the estimated returns obtained by monte carlo simulation.elc = [p ∗ (s̅ + z σ )] represents the exogenous liquidity cost. where z is the α% quintile from normal distribution adjusted to skewness and kurtosis of the empirical spread series. stpil stb sfbt uib mg biat initial price (mid in dinar) 37.900 6.575 44.480 15.740 24.730 42.110 market component* (in dinar) p(1 − exp(μ + ivar(r)σ )) 0.450 0.477 0.550 0.538 0.472 0.373 liquidity component (in dinar) 1 2 p(s̅ + z ∗ σ ) 0.146 0.219 0.309 0.356 0.315 0.288 var adjusted to liquidity (in dinar) 0.596 0.696 0.859 0.894 0.787 0.661 elc percentage 24.50% 31.47% 35.97% 39.42% 40% 43.57% *we have calculated the ivar at 99.5% confidence level. **the dinar is the tunisian national currency ernst et al. (2008) attested the superiority of the kornish-fisher approximation compared to the historical simulation used by bangia et al. (1999) in measuring the exogenous liquidity risk. for this reason we adopted this procedure. as a matter of fact, we preferred it to that adopted by lei and lai (2007) which consists in a moving average of the values recorded five days before during the same time interval. the authors were inspired by heuda and wynendaele (2001) who introduced the spread average to the market component of the var. this formulation seems to be very simplistic since it does not account for the spread’s variation in time. the results of estimation displayed in table vi clearly show that the liquidity cost constitutes more than the quarter of the total cost supported by a day trader. it is to be mentioned that for the stock stpil, the cost of the exogenous liquidity represents 24.5% of the total liquidation cost. for measuring liquidity risk in an emerging market: liquidity adjusted value at risk approach for high frequency data 51 the least liquid stocks, this proportion is around 40%. for biat, its share reaches 43.57%. although the quantity per transaction is rather weak, the liquidation cost in a day time horizon is relatively high especially for less liquid stocks. these findings indicate that liquidity risk is found to be very high at the intraday level. it is, also, relatively higher for less liquid stocks. both hypotheses (h1 and h2) are then confirmed. within a value at risk framework, we can say that omitting liquidity risk will lead to underestimate the embedded risk at about 25% for most liquid stocks and more than40% for less liquid ones. liquidity is found to be a preponderant risk component at the intraday level. day trading success which depends on a high volatility level and very liquid securities is not possible in the tunis stock exchange setting. it is the liquidity cost that hampers the profitability of such trading style. further, this study results’ are not surprising as they confirm those found in the emerging markets literature based on averaged intraday data or even monthly ones. indeed, they seem to be in perfect harmony with those of bangia et al. (1999) who asserted that ignoring liquidity risk in emerging markets leads to an underestimated risk measure at about 25%-30%. moreover al janabi (2008) used daily data from emerging gulf cooperation council (gcc) markets to corroborate the already cited results. within a value at risk framework, he claimed that without incorporating liquidity, the risk estimation would fail to reflect the total embedded risk. roy (2004), however, applied bangia et al. (1999) hypothesis in the indian bond market and showed that liquidity risk represents about 16% of the total daily supported risk. his findings, however, contrast with bekaert et al. (2007) who used daily data from 18 emerging markets to shed light on liquidityreturns relation using a var specification (vectorial autoregressive model). they came to the conclusion that liquidity foreshadows returns. but when including liquidity as a risk indicator, results become dependent on the country integration degree. in fact, for the fully integrated models, countries with better liquidity face a higher level of trading cost. they added that liquidity risk decreases when markets are liberalized. however, angelidis and benos (2006) collected data from athens stock exchange and stated that for high capitalization stocks, correcting the var at liquidity is not necessary since liquidity risk represents only 3.4% of the total risk. but for low capitalization ones, this figure is about 11%. hence, it should be integrated in the value at risk measure. finally, and in the light of this literature, our results do confirm the necessity of taking into account the liquidity risk in the risk valuation tools. 4. conclusion this paper contributes to the literature of risk valuation in emerging markets in many ways: firstly, researches on liquidity have often focused on the mature markets. emerging markets were paid less interest. moreover, within this category, only the asian market was always the subject of several studies. mena region has attracted a noticeable lack of attention especially in the microstructure field. this situation urged the present study to be carried out to address liquidity risk estimation in this setting namely; the tunis stock exchange (bvmt). secondly and empirically speaking, we proposed an intraday measure of liquidity risk resulting from a value at risk framework named livar. this one seems to be the most complete in the microstructure literature since it considers every dimension of the liquidity process (tightness, resiliency, time, and depth). in addition, we suggested a rather complex modelling which takes into account empirical specificities of each type of data. in this respect, we used an autoregressive conditional duration model reflecting the dynamics of the durations. the latter is considered as an explanatory variable in the return’s volatility equation as modelled by an egarch (1.1). the estimation of both specific models was done during the estimation period. the resulting parameters were used to calculate and forecast the maximum loss supported by a day trader named the ivar. to perform this measure, the monte carlo simulation was used. indeed, the back testing validated this measure for a confidence level of 99.5%. in fact, the value at risk obtained involves the market risk and the endogenous liquidity one since we considered the time duration between successive trades with a minimum of 100 stocks per trade. as an approximation of the time opportunity cost, duration was also integrated in the returns volatility equation. it was considered as an amplifying factor of the stock’s volatility. the corresponding coefficients were positive for all stocks of the sample. the long waiting time outside the market caused the investors a loss which, in turn, resulted in increased returns’ volatility that will automatically amplify the loss value and then the var level. the last step, international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.40-53 52 in this respect, consisted in integrating the exogenous liquidity cost adjusted to the empirical characteristics of the spread. we used the approximation of cornish fisher which is preferable to the historical simulation used by bangia et al. (1999). we chose the relative spread instead of the weighted one (giot and grammig (2002)), or of xml (gomber et al. (2004)) to measure exogenous liquidity cost. this choice was attributed to the fixed minimum quantity per trade achieved by trades at the best quotes. it seems to be the case that the procedure used is the most complete since it inspired different studies. it can be used to measure liquidity risk in both emerging and mature markets. thirdly and at the theoretical level, we focused on the significant portion of liquidity risk within the total risk supported by an intraday liquidation. this study seems to pioneer in performing this task in emerging markets especially when considering the intraday horizon. in tunis stock exchange, it represents almost the quarter and near the half of the total cost for the most and the least liquid stocks respectively. these findings reveal an interesting feature of the market: that is its thinness which results in important volatility and a lack of liquidity. then liquidity is proved to be very precious in the bvmt. in a word, better insights about the emerging markets will be obtained if further research is carried out. indeed, a plan to extend the livar application performing a comparative study between different emerging markets or between emerging and developed ones seems to be of great relevance. references acharya. v, pedersen, l.h. 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(2000), modelling liquidity risk in var models, working paper, algorithmics uk. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(1), 258-267. international journal of economics and financial issues | vol 8 • issue 1 • 2018258 the impact of financial development on human capital: evidence from emerging market economies cüneyt kiliç1*, burcu özcan2 1canakkale onsekiz mart university, biga faculty of economics and administrative sciences, canakkale, turkey, 2firat university, faculty of economics and administrative sciences, elazig, turkey. *email: c_kilic2006@hotmail.com abstract this study aims to analyze the effect of financial development on human capital in emerging market economies over the years 1990-2015. to this aim, two different panel data models including different proxies for human capital are constructed. results from both models indicate that financial development positively affects the human capital level of emerging market economies. besides, some causality linkages are obtained between financial development and human capital indicators. based on the findings of the study, some important policy implications could be suggested. keyword: financial development, human capital, economic growth, panel data analysis, emerging market economies jel classifications: e44, g20, j24, o16 1. introduction the text a strong and well-developed financial system is essential to economic growth (king and levine, 1993). therefore, since the nineteenth century, a large body of academic literature highlights the relationship between financial development and economic growth (sehrawat and giri, 2014). researchers have identified different channels through which the financial system affects economic growth over time1 (inter alia, ansari, 2002; ang, 2008; beck et al., 2000; de gregorio and guidotti, 1995; gurley and shaw, 1955; goldsmith, 1969; mckinnon, 1973; king and levine, 1993; levine, 1997; levine and zervos, 1998). for instance, levine (1997) argued that financial systems facilitate the trading, hedging, diversifying, and pooling of risk; allocate resources; monitor investments and exert corporate control; mobilize and pool savings; and ease the exchange of goods and services. apart from its growth enriching effects, an efficient and welldeveloped financial system also contributes to economic development. economic development is a broader concept than 1 there is a vast literature on financial development and economic growth nexus. however, we abstain a detailed literature review as the main interest of this paper is not to analyze the nexus of finance-growth. economic growth based purely on gross domestic product (gdp). it is a multi-dimensional concept reflecting social and economic progress including other welfare indicators, such as life expectancy at birth, infant mortality rate and educational attainment rate. investments in human resources and therefore human capital are likely to enrich individual productivity, leading to more economic development (nik et al., 2013). human capital includes both knowledge and skills gained through education, health and nutrition (hakeem and oluitan, 2012). in the literature, education, health, training, migration as well as other investments in human beings are broadly used terms to define human capital. the role of human capital in the economic growth process has been widely studied since the emergence of new growth theory (endogenous growth theory) in the mid-to-late 1980s (chou and chin, 2001). endogenous growth theory inspired largely by romer (1986) and lucas (1988) asserts that output per capita can grow over time because of endogenous forces within the economy such as human capital and knowledge base. in this theory, human capital generates new forms of technology and efficient production that contribute to economic growth. early studies mostly focused on the nexus of financial development and economic growth and overlooked the nexus of financial development and human capital (hatemi-j and shamsuddin, kiliç and özcan: the impact of financial development on human capital: evidence from emerging market economies international journal of economics and financial issues | vol 8 • issue 1 • 2018 259 2016). however, human capital may also have a close relationship with financial development as well as economic growth. a welldeveloped financial market more efficiently mobilizes resources that raise investment in human capital through education expenditure, health expenditure and welfare activities (sehrawat and giri, 2017). access to financial services raises the welfare and productivity levels of both consumers and producers (kumar et al., 2005). more efficient institutions ease borrowing constraints and facilitate individual investments in education and health (pascucci, 2012). in particular, credit constraints have a major role in limited human capital investment choices in developing countries. for instance, the low level of schooling in latin america is ascribed to the presence of binding constraints that prevent the access to credit to finance higher education (attanasio and kaufman, 2009). likewise, human capital may affect financial development as well because skilled and well-educated people (people with high human capital level) have generally better access to information and are less risk averse (outreville, 1999). additionally, education allows people to move from informal sector to formal sector opportunities, resulting in easier access to formal financial services (kargbo et al., 2016). human capital may create financial innovations necessary for financial development which in turns facilitates the acquisition of new human capital (chou and chin, 2001). thus, it can be concluded that there could be a causality running either way. based on the scarcity of the studies analyzing the finance-human capital nexus, we examine this issue for a group of emerging market economies (emes hereafter) using dynamic panel data models. the contributions of this study to the existing literature are manifold. first, the existing studies are insufficient to adequately address this issue. second, we construct and use a financial development index based on four bank-based indicators, whereas other studies have employed individual indicators for financial development. because including all these indicators in a model is likely to create a multi-collinearity problems, we avoid this problem by employing principle component analysis. third, we use panel unit root, co-integration and causality tests allowing for cross-sectional dependence and slope heterogeneity. last, this paper is the first to analyze this issue for emes based on a panel data framework. emes deserve a special research interest due to their rapid economic growth rates and high financial development levels. the report prepared by the world bank (2011) stresses that emes are increasingly becoming a source of growth in the complex global economy. in particular, six major emes brazil, russia, india, indonesia, china and south korea are projected to account for approximately 45 percent of global output by the year 2025. regarding the financial system, most emes still depend largely on the banking sector; however, the stock market development in emes is expected to increase in the future (sadorsky, 2010). additionally, some large emes such as brazil and china have higher levels of financial development than certain advanced economies such as greece and portugal (sahay et al., 2015). concerning the level of human capital, education standards in emes are improving significantly as a result of economic growth and strong public investments (euromonitor, 2016). for instance, 22 out of 25 emes brazil, chile, colombia, mexico, peru, czech republic, egypt, greece, hungary, poland, russia, south africa, turkey, united arab emirates, china, india, indonesia, republic of korea, malaysia, pakistan, philippines and thailand have compulsory education ranging from 6 (malaysia and united arab emirates) to 14 years (mexico, brazil and peru) (world bank, 2017). the present study aims to investigate the effect of financial development on human capital in emes for the years 1990-2015 in the framework of panel data analyses. the rest of the paper is organized as follows. section 2 presents the literature review while section 3 explains the data and the empirical model used. section 4 discusses the empirical findings. section 5 provides conclusion and policy implications. 2. literature review the nexus of finance and human capital has been explored at the empirical level only since the end of 1990s. since then, scholars and researchers have been investigating the issue by using different indicators for human capital, such as school enrollment rates, public expenditure on education or health, life expectancy at birth, and etc. in the existing literature, based on their samples, studies could be classified into two categories: country specific studies and cross-country studies. country specific studies (inter alia, hakeem and oluitan, 2012; nik et al., 2013; sehrawat and giri, 2014; uddin and masih, 2015) analyze the issue applying time series techniques, such as co-integration test, granger causality test, vector autoregressive model and variance decomposition analysis. hakeem and oluitan (2012) found a weak relationship between financial development and human capital in south africa. for iran, nik et al. (2013) studied the influence of financial development on human capital over the period 1977-2010 and found that financial development contributed marginally to human capital. sehrawat and giri (2014) examined the relationship between financial development and human development in india. their findings found evidence of a significant unidirectional causality running from financial development and economic growth to human development index (hdi). for malaysia, uddin and masih (2015) investigated how finance and growth affect human development and found that financial development promotes human development through the channel of economic growth. a recent study by hatemi-j and shamsuddin (2016) obtained a unidirectional causality running from human capital to financial development. worlu and omodero (2016) studied the effect of human capital on financial performance of banks in nigeria without finding any significant effect. last, demirci and ozyakisir (2017) analyzed the relationship between human capital and financial development for turkey over the years 1971-2013 and provided evidence favoring a unidirectional causality from human capital to financial development in both the short-run and the long-run. the second research avenue includes cross-country studies (akhmat et al., 2014; arora, 2012; arora and ratnasiri, 2011; eryigit et al., 2015; hong-ho, 2013; ostojic, 2013; outreville, 1999; pascucci, 2012; sehrawat and giri, 2017). these papers kiliç and özcan: the impact of financial development on human capital: evidence from emerging market economies international journal of economics and financial issues | vol 8 • issue 1 • 2018260 generally employ panel data analyses, such as static panel data models (i.e., fixed effects, random effects, and pooled ols) and dynamic panel data models (i.e., panel co-integration tests). one of the earliest panel studies by outreville (1999), based on a cross-sectional analysis of 57 developing countries over the period 1988-1990, indicated that human capital and socio-political stability are important factors explaining the level of financial development. pascucci (2012), using data on 68 countries, found that improvements of financial market depth are positively and robustly correlated with changes in hdi. in a panel consisting of 21 developing asian countries, arora (2012) found that in countries with low financial development, the quality of education is also very poor between the years 2000-2010. in another study, arora and ratnasiri (2011) showed that human capital positively affects financial development both in the india and the 23 indian states during the period 1999-2008. for european union, ostojic (2013) proved that financial development had a strong positive effect on human development during the period 1990-2000. depending on both a theoretical model and an empirical analysis, hongho (2013) provided evidence that credit market development facilitates human capital accumulation. by making use of a panel including some selected south asian association for regional cooperation (saarc) countries, akhmat et al. (2014) investigated the impact of economic growth and financial development on human development over the period 1988-2008. they found that financial development acts as an important driver of human development. likewise, sehrawat and giri (2017) revealed that both financial development and economic growth lead to increases in human capital for asian countries with a unidirectional causality running from financial development and economic growth to human capital. for 81 provinces in turkey, eryigit et al. (2015) argued that human capital accumulation positively affects financial development and that human capital stock is one of the reasons for financial development gaps over the years 2005-2009. apart from these two main research streams, there are studies exploring the relationship between human capital and financial development in an indirect way through growth models (buiter and kletzer, 1992; de gregorio and guidotti, 1995; de gregorio, 1996; evans et al., 2002; hakeem, 2010; outreville, 1999; pagano, 1993, papagni, 2006). among those, buiter and kletzer (1992) and de gregorio (1996) showed that increasing borrowing constraints reduce human capital accumulation as well as economic growth. the studies in this category create an interaction term between finance and human capital, with the sign of its coefficient indicating whether there is a complementary or substitute relationship between human capital and financial development (evans et al., 2002; kargbo et al., 2016; hakeem, 2010 for the complementary relationship and kendall 2012 for the substitute relationship). additionally, sharma (2016) found no interaction between finance and human capital based on a diverse sample of 66 countries. last, for the panel of economic community of west african states, abubakar et al. (2015) concluded that financial development contributes significantly to economic growth through human capital development without exploring the interaction between human capital and financial development. 3. data and model in this study, we use two popular indicators for human capital2. gross tertiary school enrollment rate (the percentage of the relevant part of the population enrolled in tertiary school) and the government expenditure on education (as a percentage of gdp). as stated by de gregorio (1996), education expenditure may have positive effects on human capital accumulation because it may reflect low private costs or high quality of education (al-yousif, 2008; evans et al., 2002; mekdad et al., 2014; pradhan, 2009; sehrawat and giri, 2017). additionally, primary, secondary and tertiary school enrollment rates are among the most popular indicators of human capital (akhmat et al., 2014; awad et al., 2013; de gregorio, 1996; evans et al., 2002; hakeem and oluitan, 2012; kargbo et al., 2016; nik et al., 2013; sulaiman et al., 2015). however, we represent human capital with tertiary school enrollment rate (awad et al., 2013; hakeem and oluitan, 2012; nik et al., 2013; sulaiman et al., 2015) because people with a higher educational background have a higher level of financial literacy (eryigit et al., 2015). as such, higher educational background would be more determinative on financial development. moreover, primary and secondary education are compulsory in most emes as stated before. as seen in figure 1, in the panel of emes, primary school enrollment rate is stable over time as it is compulsory while secondary school enrollment rate is slowly rising and overlaps primary education. however, tertiary school enrollment rate has an upward trend over the years 1990-2015. due to the fact that banking sector is dominant in emes, we use purely bank-based indicators as our measure of financial development. the variables used to represent financial development are as follows: liquid liabilities as a share of gdp (m3 to gdp), broad money supply as a share of gdp (m2 to gdp), domestic credit provided by banking sector as a percentage of gdp and domestic credit to private sector as a percentage of gdp. in the related literature, liquid liabilities3 and the broad money supply are used to measure financial depth and the overall size of the financial intermediary sector (akhmat et al., 2014; hakeem, 2010; king and levine, 1993; outreville, 1999). they measure the level of monetization of the economy. domestic credit to private sector (priv) is defined by world bank (2017) as financial resources allocated to private sector via loans, purchases of non-equity securities, trade credits and other accounts receivable, which establish a claim for repayment (akhmat et al., 2014; levine and zervos, 1998; levine et al., 2000; nik et al., 2013 used priv as a proxy for financial development). the last indicator-domestic credit provided by banking sector (bank)—equals the ratio of bank credit divided by bank credit plus central bank domestic assets and measures the degree to which the central bank versus commercial banks are allocating credit (levine, 1997). further, we prefer constructing a financial development (fd) index based on these four indicators because there is no single variable that can 2 as a proxy for human capital, we first used the human capital index of barro and lee (2013). however, we couldn’t include it in the model as it was integrated of order two. 3 “liquid liabilities equal currency held outside of the banking system plus demand and interest-bearing liabilities of banks and nonbank financial intermediaries” (king and levine 1993; levine 1997). kiliç and özcan: the impact of financial development on human capital: evidence from emerging market economies international journal of economics and financial issues | vol 8 • issue 1 • 2018 261 capture all aspects of financial development. the simultaneously inclusion of these financial development indicators in the model leads to high correlations among them, indicating some redundancy of information (menyah et al., 2014). therefore, using principal component analysis4, we construct a comprehensive index of financial development to mitigate potential multicollinearity problem (gries et al., 2009; menyah et al., 2014 for a similar methodology). as a control variable, real per capita gdp based on 2010 us dollars is included in the model to measure the real economic performance of emes. the sample of the study includes two separate panels: the first panel consists of 16 emes, namely chile, colombia, mexico, peru, czech republic, hungary, poland, russia, turkey, china, india, indonesia, korea republic, malaysia, philippines and thailand for the years 1990-2015. the second panel includes 17 emerging markets, namely brazil, chile, colombia, czech republic, hungary, india, indonesia, malaysia, mexico, pakistan, peru, philippines, poland, russia, south africa, thailand and turkey for the period 1998-2015. as a proxy for human capital, the first panel uses tertiary school enrollment rate, whereas the second panel utilizes government expenditure on education. the selection of time periods and countries in the panels was dictated by data availability. the morgan stanley capital international (msci) classification is used in the selection of emes. real per capita gdp and tertiary school enrollment data are extracted from the world bank (2017) world development indicators database while government expenditure on education data are obtained from the united nations educational, scientific and cultural organization institute for statistics (unesco uis, 2017). following the related literature (akhmat et al.2014; sehrawat and giri 2014, 2017), we define our model as follows: hcap=f(fd, pgdp) (1) the logarithmic transformation of equation (1) is defined in equation (2). ln hcapit=αi+β1i ln fdit+β2ilnpgdpit+εit (2) 4 principal component analysis was applied based on the natural logarithm values of fd variables. where, ln denotes the natural logarithm; i = 1,2.,…,n indicates the number of countries in each panel while t = 1,….,t refers to the time period. the parameters β1 and β2 represent the long-run elasticity estimates of human capital (lnhcap) with respect to financial development (lnfd) and economic growth (lnpgdp), respectively and εit is the white noise error term. note that two models are estimated as there are two different panels of countries. 4. methodology and empirical results 4.1. results from cross-sectional dependence test and panel unit root tests before proceeding to the empirical analysis, we provide plots of human capital indicators (tertiary enrollment rate and government expenditure on education) versus financial development and real per capita gdp in figure 2. visually, there appear to be positive relationships between human capital and financial development and also between human capital and economic growth. as will be discussed below, our empirical results support these visual inspections as well. text as seen in table 1, the mean values of variables range from −1.31e-09 (lnfd) to 8.6490 (lnpgdp) while their standard deviation values differ between 0.2795 (lnhcap) and 1.000 (lnfd)5. thus, it reveals that data are fairly dispersed around the mean, justifying further estimation of data. at the first stage of analysis, we need to test the cross-sectional dependence to decide on the appropriate unit root test. to this aim, we use the lagrange multiplier (lm) test, which has the null hypothesis of crosssectional independence and follows χ2 distribution, developed by breusch and pagan (bp, 1980). the lm test is preferred to other cross-sectional dependence tests suggested by frees (1995) and pesaran (2014) in case that t is larger than n as in our case. the test results are provided in table 2. text the results provided evidence of cross-sectional dependence in all variables (table 2), indicating that a shock affecting one eme could be easily transmitted to other emes due to globalization, financial integration and international trade (nazlioglu et al., 2011). therefore, we should apply a panel unit root test allowing for cross-sectional dependence. to that aim, smith et al. (2004) developed five panel unit root tests lm , t , min , max and ws tests that handle cross-sectional dependence via a bootstrap procedure. test is the average of individual lm test statistics (lmt) proposed by solo (1984); t tests is a bootstrap version of the ips test of im et al. (2003); the max test was developed by leybourne (1995) and is the mean of individual maxi s t a t i s t i c s ( )max = n max -1 i i n = ∑ 1 ; min t e s t ( )min = n min-1 i i n = ∑ 1 is a more powerful variant of the lm statistics and based on both forward and reverse adf regressions, 5 we didn’t report country level descriptive statistics to conserve space; however, they are available from the corresponding author upon request. source: world bank (2017). world development indicator database figure 1: primary, secondary and tertiary school enrollment rates (gross, %) kiliç and özcan: the impact of financial development on human capital: evidence from emerging market economies international journal of economics and financial issues | vol 8 • issue 1 • 2018262 providing the statistics lm fi and lm ri based on their minima; and finally ws – test is the mean of individual wsi statistics defined by pantula et al. (1994). they have a unit root null hypothesis and allow for heterogeneous autoregressive roots under the alternative hypothesis. in this respect, stationarity holds for at least one panel member if the null hypothesis is rejected. probabilities are reported in parentheses; aindicates the rejection of the unit root null hypothesis at the 1% significance level. 5000 bootstrap replications are used to control for crosssectional dependence, as well as the finite sample bias. a block size that equals 100 is used. the maximum lag order of the individual unit root test regressions is set to 2. model 1 includes gross tertiary school enrollment rate as a proxy for human capital while model 2 includes government expenditure on education. the test results provided in table 3 indicate that all variables are nonstationary in their levels, whereas they are stationary in their first-differences, i.e., they are integrated of order one. 4.2. results for co-integration test and long-run parameter estimates having established that all variables are integrated of order one, we examine the co-integration relationship among the variables. to that source: author’s own calculation figure 2: scatter plots of variables of interest table 1: summary statistics of variables statistics model 1 model 2 lnpgdp lnhcap lnfd lnpgdp lnhcap lnfd mean 8.6271 3.4326 −1.23e-08 8.6490 1.3634 −1.31e-09 median 8.8305 3.4113 −0.1004 8.9285 1.3830 −0.0490 maximum 10.127 4.6017 2.4514 9.9624 2.0362 2.2491 minimum 6.2849 1.0451 −2.2901 6.5602 0.6080 −2.4412 standard deviation 0.8517 0.7426 1.0000 0.8476 0.2795 1.0000 skewness −0.7027 −0.5883 0.3181 −0.8706 −0.3782 0.3080 kurtosis 2.8644 3.1533 2.4299 2.7715 2.6495 2.7895 observations 416 416 416 306 306 306 model 1 includes gross tertiary school enrollment rate as a proxy for human capital while model 2 includes government expenditure on education table 2: breusch and pagan (bp, 1980) lm test results model 1 lm test statistics model 2 lm test statistics lnhcap 346.182a (0.000) lnhcap 226.984a (0.000) lnpgdp 352.894a (0.000) lnpgdp 205.267a (0.000) lnfd 261.158a (0.009) lnfd 222.503a (0.000) model 1 includes gross tertiary school enrollment rate as a proxy for human capital while model 2 includes government expenditure on education. probabilities are reported in parentheses; a indicates the rejection of independence null hypothesis at 1% significance level kiliç and özcan: the impact of financial development on human capital: evidence from emerging market economies international journal of economics and financial issues | vol 8 • issue 1 • 2018 263 purpose, we apply the lm co-integration test proposed by westerlund and edgerton (we, 2007). the we (2007) proved that their test is efficient in small samples and allows for dependence both within and between the cross-sectional units. we (2007) test depends on the lm test suggested by mccoskey and kao (1998) and the sieve-sampling scheme is used in the implementation of the bootstrap procedure. it has an advantage of reducing the distortions of the asymptotic test. its null hypothesis denotes the cointegration for all countries in the panel; however, some countries in the panel are not co-integrated under the alternative hypothesis. its results are provided in table 4. as seen in table 4, we can reject the cross-sectional independence null hypothesis at 1% significance level for both models. therefore, in the we (2007) cointegration test, instead of asymptotic probability values, we should rely on the bootstrap probability values indicating that the null hypothesis of cointegration cannot be rejected in both models. given the presence of cointegration, we proceed to estimate the long-run parameters in the co-integrating vector. however, we should ascertain the slope heterogeneity in order to choose the right estimator. therefore, we employ delta ( )∅ and adjusted delta ( )∅ adj tests suggested by pesaran and yamagata (2008). delta tests reject the null hypothesis of slope homogeneity in both models.6 thereafter, we utilize pedroni’s (2000, 2001) group mean-fully modified ols (gm-fmols) and the group-mean dynamic ols (gm-dols) approaches to estimate the long-run parameters in the co-integrating vector. pedroni’s (2000) gmfmols estimator incorporates a semi-parametric correction to the ols estimator so as to eliminate the endogeneity and serial correlation problems while pedroni’s (2001) gm-dols estimator parametrically corrects the ols estimator (sadorsky, 2009). moreover, pedroni (2000; 2001) asserts that in the presence of heterogeneity in the co-integrated panel data, the group-mean estimators produce more consistent estimates compared to their 6 the values of ∅ test are 20.821 in model 1 and 14.061 in model 2 with zero probability values, while the values of ∅adj test are 22.537 and 15.826 with zero probability values in models 1 and 2, respectively. pooled and weighted counterparts. before estimating the long-run parameters in the co-integrating vector, we demeaned the data with respect to common time effects as gm-fmols and gmdols approaches do not take cross-sectional dependence into account. the results for long-run parameter estimates are tabulated in table 5. as seen in table 5, fmols and dols estimators indicate that financial development and economic growth positively affect human capital in both models. however, economic growth has a higher impact on human capital compared to financial development. for instance, fmols results indicate that 1% increases in fd index and economic growth raise tertiary school enrollment rate about 0.1% and 1.4%, respectively, while public expenditure on education goes up by 0.09% and 0.2%. overall, the empirical findings confirm that financial development encourages human capital in emes. college enrollment rates in emes rise as a result of financial development as people can finance their education expenditures using bank credits. as stated by pascucci (2012), a well-developed financial system solves the borrowing constraints and facilitates individual investments in education. this result is similar to that reached by akhmat et al. (2014), nik et al. (2013), pascucci (2012), uddin and masih (2015), ostojic (2013) and sehrawat and giri (2017). further, economic growth affects human capital positively as well. in this respect, wealthy and fast table 3: smith et al. (2004) panel unit root tests results variables t lm lm min ws model 1-level lnhcap −1.56 (0.97) 3.43 (0.97) 2.57 (0.93) −1.29 (0.92) −1.66 (0.96) lnfd −2.13 (0.39) 5.00 (0.481) 2.60 (0.91) −1.23 (0.91) 0.788 (1.00) lnpgdp −2.28 (0.31) 5.22 (0.32) 2.98 (0.75) −1.42 (0.82) −1.76 (0.87) model 1-first-difference lnhcap −4.17a (0.00) 11.02a (0.00) 9.18a (0.00) −3.49a (0.00) −3.89a (0.00) lnfd −607.41a (0.00) 22.03a (0.00) 21.96a (0.00) −606.14a (0.00) −88.99a (0.00) lnpgdp −4.05a (0.00) 10.48a (0.00) 7.88a (0.00) −3.16a (0.00) 3.45a (0.00) model 2-level lnhcap −2.37 (0.19) 5.46 (0.17) 3.38 (0.60) −1.67 (0.55) −2.19 (0.51 lnfd −2.15 (0.46) 4.69 (0.43) 3.63 (0.41) −1.79 (0.39) −2.24 (0.39) lnpgdp −2.16 (0.45) 4.67 (0.44) 2.56 (0.81) −1.06 (0.93) −1.70 (0.89) model 2-first-difference lnhcap −4.52a (0.00) 10.18a (0.00) 8.48a (0.00) −3.74a (0.00) −4.35a (0.00) lnfd −4.11a (0.00) 9.08a (0.00) 8.29a (0.00) −3.64a (0.00) −4.16a (0.00) lnpgdp −3.50a (0.00) 8.14a (0.00) 7.26a (0.00) −3.13a (0.00) −3.59a (0.00) table 4: results from we (2007) and bp (1980) tests models we (2007) test lm test statistic bootstrap prob. asymptotic prob. model 1 2.629 0.716 0.000 model 2 1.217 0.938 0.112 bp (1980) lm test lm test statistic prob. model 1 431.993a 0.000 model 2 268.772a 0.000 1000 bootstrap replications are used. the lag length selection is based on the approach by campbell and perron (1991). constant is included as a deterministic term. the null hypothesis of we (2007) test is the cointegration between lnhcap and its potential determinants across countries. the bp (1980) test has an independence null hypothesis. a implies the rejection of the null hypotheses in both tests kiliç and özcan: the impact of financial development on human capital: evidence from emerging market economies international journal of economics and financial issues | vol 8 • issue 1 • 2018264 growing emes invest more in their education sectors. as a result of economic growth, more people will get the advantage of higher education and the governments may allocate more money from their budgets for education. this result is in accordance with that of sehrawat and giri (2014, 2017), while it is in sharp contrast with that of akhmat et al. (2014), who found a negative effect of growth on human capital in saarc countries. 4.3. dumitrescu-hurlin (dh 2012) panel causality test results we employ panel causality test proposed by dumitrescu and hurlin (dh 2012) to define the directions of causality linkages between the variables. dh (2012) test is a simple granger (1969) non causality test in heterogeneous panel data models with fixed coefficients and allows for two dimensions of heterogeneity: (i) the heterogeneity of regression models used to test the granger causality and (ii) the heterogeneity of the causal relationships. the dh (2012) test has two test statistics: the first test statistic wnt hnc is based on the individual wald statistics of granger non causality averaged across the cross-section units, while the second test is the standardized statistic z nt hnc based on an approximation of the moments of wald statistics. furthermore, monte carlo analyses demonstrate that the small sample properties of the standardized panel statistics are efficient even in the presence of cross-sectional dependence (dh, 2012). the null hypothesis assumes that there is no causal relationship for any of the cross-sectional units in the panel, whereas the alternative hypothesis proposes a causal relationship for a subgroup of panel.7 dh (2012) test results are provided in table 6. 7 interested readers may refer to dh (2012) for the detailed methodological explanation of the test. as shown in table 6, there are bidirectional causality relationships between all pairs of variables except for the pair financial development and tertiary school enrollment rate. in model 1, the causality is running from human capital (tertiary education) to financial development, but not vice versa. it means that college students use bank credit to finance their college tuition payments and other education expenditures which in turn results in a more developed and efficient financial system (hatemi-j and shamsuddin, 2016; demirci and ozyakisir, 2017 for the similar results). however, in model 2, there exists a bidirectional causality or a feedback relation between government expenditure on education and financial development. in this respect, governments can increase education expenditures with the aid of a well-developed financial system. for instance, governments may provide education loans for students through the banking channel. in this case, more government expenditure on education results in an efficient and a developed financial system as well. for instance, banks can open new branches in the college campuses to provide a better service for students. however, studies in the existing literature generally found a unidirectional causality running from financial development to human capital instead of bidirectional causality (see, inter alia, sehrawat and giri, 2014, 2017). concerning the finance-growth nexus, we obtain a bidirectional relationship, supporting neither the supply-leading hypothesis (a unidirectional causation that runs from financial development to economic growth) nor the demand-following hypothesis (a unidirectional causation running from economic growth to financial development) in the finance literature. financial system and economic growth appear to reinforce each other (abu-bader and abu-qarn, 2008; gries et al., 2011; singh, 2008; woldetable 5: result for long-run parameter estimates independent variables gm-fmols gm-dols model 1 model 2 model 1 model 2 lnfd 0.121a (0.008) 0.099a (0.000) 0.134b (0.044) 0.080b (0.045) lnpgdp 1.491a (0.000) 0.283a (0.000) 1.467a (0.000) 0.363a (0.000) constant is included as a deterministic term; a and b refer to significance at 1% and 5% levels, respectively. model 1 includes gross tertiary school enrollment rate as a proxy for human capital while model 2 includes government expenditure on education table 6: results from the pairwise dumitrescu-hurlin (2012) panel causality test null hypothesis wnt hnc stat. z nt hnc stat. prob. model 1 lnhcap does not homogeneously cause lnfd 5.648a 5.427a 0.000 lnfd does not homogeneously cause lnhcap 2.540 0.484 0.628 lnpgdp does not homogeneously cause lnfd 7.986a 9.143a 0.000 lnfd does not homogeneously cause lnpgdp 4.364a 3.385a 0.000 lnpgdp does not homogeneously cause lnhcap 4.014a 2.828a 0.004 lnhcap does not homogeneously cause lnpgdp 8.186a 9.462a 0.000 model 2 lnhcap does not homogeneously cause lnfd 5.506a 4.120a 0.000 lnfd does not homogeneously cause lnhcap 7.144a 6.323a 0.000 lnpgdp does not homogeneously cause lnfd 23.78a 28.71a 0.000 lnfd does not homogeneously cause lnpgdp 6.287a 5.170a 0.000 lnpgdp does not homogeneously cause lnhcap 7.053a 6.201a 0.000 lnhcap does not homogeneously cause lnpgdp 4.383a 2.609a 0.009 kiliç and özcan: the impact of financial development on human capital: evidence from emerging market economies international journal of economics and financial issues | vol 8 • issue 1 • 2018 265 rufael, 2009 for similar results). with regard to human capital and economic growth nexus, the results provided evidence of a feedback relationship as well (awel, 2013; hassan and kalim, 2012; hussin et al., 2012; rahman, 2011; rehman et al., 2014 for similar results). on one hand, investments in national human capital stock are likely to create wealthier and fast growing economies as emphasized in the endogenous growth theory. in this regard, countries can compete against other countries by investing more in knowledge, technology, innovation and research and development areas. on the other hand, economic growth creates more investments in human capital stock. 5. conclusion and policy implications the objective of the present study is to analyze the effect of financial development on human capital in emes over the period 1990-2015. to represent human capital, tertiary school enrollment rate and government expenditure on education are used as proxy variables while an index of financial development is constructed by using four bank-based indicators. based on the availability of human capital indicators, we have composed two samples of countries, including 16 and 17 emerging economies, respectively. the empirical findings suggest that financial development and economic growth have significant and positive impacts on both human capital indicators. additionally, the results provided evidence of a bidirectional causality linkage between government expenditure on education and financial development and a unidirectional causality linkages running from tertiary school enrollment rate to financial development. in this regard, human capital appears to cause financial development in emes. bank-based financial system creates a channel through which governments of emes may invest more in their education sectors. however, financial development is not a cause of higher education, in contrast, it is the result of higher education. moreover, some feedback relationships between financial development and economic growth and between economic growth and human capital are also supported. in this respect, economic growth is a reason for and a result from both financial development and human capital accumulation. based on the results, we can infer some policy implications. first, the governments of emes should consider financial development level while making projections for the future national human capital demand. otherwise, further developments in financial markets can increase human capital in a way that has not been accounted for, resulting in more difficulties for emes to meet their planned human development targets. second, the policies of economic development, finance and education should be simultaneously considered as there are strong bilateral relations among the corners of the development-finance and human capital triangle. financial policies targeting more investment in education (e.g. lowering interest rates for educational loans) will likely create more educated people with high financial literacy rates. educated people will likely support the development of financial sector as they have sufficient acquaintance with financial instruments and services. moreover, as stated by sehrawat and giri (2017) investments in financial sector and human capital will likely enrich economic prosperity and reduce poverty and income inequality as more investment in human capital will generate higher returns in emes. as a final note, future studies can expand the scope in several ways. first, a financial index can be constructed based on different proxies for financial development, such as capital market based indicators. likewise, different proxies for human capital or human development, such as hdi, could be used. moreover, the existing literature is still in its infancy and needs further studies to analyze the issue for different countries. references abu-bader, s., abu-qarn, a.s. 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(2016), the effect of human capital development on financial performance of banks in nigeria. global journal of human resource management, 4(6), 34-47. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(3), 277-286. international journal of economics and financial issues | vol 9 • issue 3 • 2019 277 the effect of quality financial reporting on good governance otniel safkaur1,2*, nunuy nur afiah3, sugiono poulus3, muhammad dahlan3 1department of accounting, universitas cendrawasih, indonesia, 2students in the doctoral program in accounting science, universitas padjadjaran bandung, indonesia, 3department of accounting, universitas padjadjaran bandung, indonesia. *email: othissafkaur@yahoo.com received: 23 february 2019 accepted: 15 april 2019 doi: https://doi.org/10.32479/ijefi.8047 abstract one of the factors triggering a lack of financial reporting caused by dishonest application of records, it has not been effectively transparent and accountable by various government agencies in indonesia. this study aims to find out how the application of the accrual basis in accounting records in the government and its effect on good governance. this study uses a method of verifying causality to determine the influence between variables. the population in this study were 44 regency and city governments in the provinces of papua and west papua. whereas the observation unit is dppkad in 44 provinces/cities/districts in the regions of papua and west papua. the sampling technique uses a census so that all members of the population become the study sample. the results of this study show empirical evidence that the application of the accrual basis of financial reporting affects good governance resulting from financial reporting of 44 district and city governments in the provinces of papua and west papua. keywords: financial reporting, organizational structure, good governance jel classifications: g2, g3 1. introduction public sector organizations have been considered by the public to be unproductive, inefficient, always losing, low quality, poor in innovation and creativity, and various other criticisms (solikin 2008). therefore, mardiasmo (2002) suggests that the implementation of regional autonomy in indonesia can be seen as a good strategy to respond to the demands of the local community for sharing of power, distribution of income, independence of the management system in the region, strengthening the regional economy, the threat of national disintegration, public panic due to weak security and public order and legal uncertainty ritonga, (2010): changing the centralized system into a decentralized system realized in the form of regional autonomy is one of the fundamental changes felt in the reform era. the implementation of regional autonomy is the realization of a system of good governance and is characterized by increasing regional independence, transparency and public accountability, regional governments that are increasingly responsive to society, increased public participation in regional development, increased efficiency and effectiveness of financial management and public services, and increased democratization in the region (mahmudi, 2010). further confirmed by sulaiman, (2018), darwanis, (2012) argues that public sector good governance is a process of good governance by involving stakeholders in various economic activities, social politics, and the use of various resources such as natural, financial and human resources to the interests of the people carried out by adhering to the principles of justice, equity, equality, efficiency, transparency and accountability. the same thing was stated by hertati (2015), that good governance is closely related to reforms in the fields of bureaucracy, law enforcement, financial management, improving the quality of public services, changing mind-sets and culture-sets, and changing mindset, attitude patterns, and action patterns, become more productive, efficient and effective (van beest, 2009). the implementation of a country that implements good governance according to mardiasmo (2004) means that the administration of the country is based on the principles of good this journal is licensed under a creative commons attribution 4.0 international license safkaur, et al.: the effect of quality financial reporting on good governance international journal of economics and financial issues | vol 9 • issue 3 • 2019278 governance, namely transparency, accountability, participation, law-abiding, responsiveness, consensus-oriented, fairness, effectiveness and efficiency, strategic vision and interrelationships. research related to good governance has indeed been raised as much as solikin (2008), zeyn (2011). arja (2000), cheng (2002), christiaens (1999), christiaens (2001). the results of coal research (2006), prove that the implementation of good governance is a demand for renewal of the financial system with the aim that the management of public money is carried out transparently and accountability to realize community welfare (christiaens 2007). the phenomenon that illustrates the low level of good governance was stated by transparency international (ti) in the 2014 corruption perception index (cpi) survey, which placed indonesia as a country with a high level of corruption and ranked 107 out of 175 countries in the world with a score of 34 0-100 scale. cpi scores are in the range 0-100. number 0 means that the state is perceived as very corrupt, while a score of 100 means that it is perceived as very clean (bpk ri, 2015). furthermore, in 2015 ti in the cpi, also said that indonesia still showed a consistent increase in eradicating corruption, but was hampered by the high level of corruption in the law enforcement and political sector. this condition causes improvements in public service governance to only be able to increase indonesia’s score to 36 and rank 88 of the 168 countries measured. indonesia’s score slowly rose 2 points, and rose quite high by 19 ratings from the previous year (bpk ri, 2015). then in indonesia the cpi score in 2016 increased by one point by 37. the increase in this score indicates that there is still a positive trend to eradicate corruption in indonesia. as of 2012, indonesia’s cpi score has increased by 5 (five) points in a clean 5 year period (bpk ri, 2015). furthermore, the phenomena associated with inadequate government performance have also been stated by minister of administrative reform and bureaucratic reform (pan-rb), that the results of the evaluation of performance accountability of government agencies (akip) in 2016 and districts have increased 2, 95 points. despite the increase, the average performance of pemkab and pemkot across indonesia is still in category c. compared to the previous year, the value of the performance of the regency/city government has increased from 46.92 to 49.87. although the evaluation value has increased, 83 percent of districts and cities (425 regions) are still categorized as c values (bpk ri, 2016). the inadequate system of performance accountability of local governments also occurs in the provinces of papua and west papua, because based on the results of an evaluation of the regional government’s performance accountability system carried out by assistant deputy region iii of menpan-rb naptalina sipayung in 2016, said that the results of six evaluations were jayapura city, jayapura regency, mimika, meruake, mappi, jayawijaya won the title c (somewhat less), while nabire, yalimo, mamberamo raya, yapen islands, waropen and keerom district were given the title d. while 17 districts in papua did not submit reports government institution performance accountability system (sakip) 2016 to the ministry of administrative reform and bureaucratic reform to be evaluated cleanly (bpk ri, 2015). while the results of the evaluation of the performance accountability system of local governments in west papua province in 2015 were given the predicate b for west papua province, sorong city, sorong regency, fak-fak regency and tambraw regency. there are also a number of other districts that are not rated because they have not submitted a clean government agency performance accountability report (bpk ri, 2016). based on the results of the evaluation of the performance accountability system of local governments in the provinces of papua and west papua, it can be said that it has not been a good commitment to realize good governance. the application of good governance in indonesia is accompanied by the birth of the concept of new public management (npm) which is considered as a manifestation of the public sector reform movement, a system used to realize good governance. npm is the beginning of the birth of a bureaucracy marked by changes in public sector accounting in several countries related to organizational accountability practices (stamatiadis, 2009). the npm concept also led to reforms in the public sector accounting, meaning the period in which accounting principles that have been carried out in the private sector, can be adopted by the public sector so that information produced by accounting becomes a tool to measure the extent of efficiency and accountability (van der,2005), van beest, (2009). quality financial reports in the public sector accounting standards board (ipsasb) (2010. p29) include the following characteristics: relevance, faithful representation, understandability, timeliness, comparability, and verifiability. whereas according to government regulation number 71 of 2010 there are four characteristics as normative prerequisites needed so that government financial reports can meet the desired quality which consists of: relevant, reliable, comparable and understandable. the quality of financial statements is not only intended for business entities, but also for public entities. quality financial reports in the public sector, especially in government, are financial reports that are able to present reliable and reliable financial information. to be able to find out whether the financial statements present relevant and reliable financial information, it is necessary to examine the financial statements. examination of financial statements aims to assess the reasonableness of the presentation of financial information including the realization of regional budget reports, cash flow reports, balance sheets, and notes to financial statements prepared and presented by local governments (mardiasmo, 2009). the quality of financial statements can be reflected in opinions (beest et al., 2009). research abdul and abdullah (2006) states that regional financial statements can be said to be of high quality if the financial statements presented each year receive an assessment in the form of an opinion from the financial supervisory agency (bpk). when the bpk provides a fair without exception (wtp) opinion on the lkpd report, it means that it can be said that the financial statements of a local government entity are presented and expressed in a reasonable and quality manner. the phenomenon of the low quality of local government financial reports (lkpd) also occurred in papua and west papua provinces, because based on the results of the bpk-ri examination from 2012 to 2016 that the average opinion was given on the financial statements of the regency and city governments in papua and western provinces is reasonable with exceptions (wdp), unnatural (tw) and not giving opinions (tmp). the following are developments in the results of the bpk-ri audit of the lkpd in the provinces and districts/cities in the province of papua and western provinces in 2012-2016 can be seen in figure 1. safkaur, et al.: the effect of quality financial reporting on good governance international journal of economics and financial issues | vol 9 • issue 3 • 2019 279 based on the picture above, it can be said that the quality of opinion of the lkpd in the provinces of papua and west papua continues to increase. the figure also shows that in 2012 there were no wtp opinions on the financial statements of the district and city governments, but in 2013 it had increased to 4%, in 2014 obtained a 10% wtp opinion and in 2015 and 2016 obtained wtp opinions which increased dramatically namely an average of 18% the high percentage indicates a serious effort by local governments in the provinces of papua and west papua to further optimize efforts for better quality financial reporting. however, we cannot be satisfied with the quality of transparency and accountability in regional financial management with the improved bpk opinion, because it does not describe the actual conditions of regional development. harahap (2006), the quality of government financial reports can be produced through the application of accrual-based accounting systems (harun, 2009). accrual-based accounting is an international based practice in modern financial management in accordance with the principles of the npm that promotes transparency and financial management accountability. according to (harun, 2009) that the accrual basis has become the basis commonly used by companies, both large companies and small companies, both those who have gone public and those who have not gone public because the accrual basis is believed to provide a better picture regarding company performance, so companies can make policies that are more relevant for the future nazier (2009). the same thing can be confirmed by van der hoek (2005), the use of accrual basis is one of the characteristics of the practice of modern financial management in the public sector that aims to provide more transparent information about costs and also can improve the quality of government decision making using expanded information (indra, (2006). furthermore, hertati’s (2015) research on human factors, the inconsistency of the central government in issuing policies related to regional finance is a driving factor in the problematic regional financial accountability into a clean government harahap, (2006). 2. organizational structure hall (2005) states that the organizational structure is the distribution of responsibilities, authority and accountability of each part of an organization robbins, w.a.,(1986). similarly, according to robbins & judge (2014) which states that organizational structure is determining how work is divided, grouped, and formally coordinated. madison (2010) that the organizational structure has two models, namely mechanistic and organic. 2.1. departmentalization departmentalization is the basis used to classify jobs so that the same or similar tasks can be coordinated. the main advantage of the same type of grouping is the achievement of efficiency by collecting the same specialization. functional department seeks to achieve economies of scale by placing people with the same skills and orientation into shared units. 2.2. span of control (range of control) control range is the relationship that occurs between superiors and subordinates in the form of the number of subordinates who can be managed effectively and efficiently. the control range determines the number of managers an organization must have. 2.3. formalization formalization is the level at which work in the organization is standardized. the implementation of the work has a minimum quantity of freedom regarding what must be done. where there is a high formalization, there are job descriptions that are expressed in many organizational rules, and clearly defined procedures that cover work processes in the organization (hall, 2005). 3. good governance governance can be interpreted as a way of managing public affairs (mardiasmo, 2002). hasyim, (2006) suggests governance as a way for the government to manage social and economic resources for the benefit of community development arja (2000). good governance according to perkasa, et al. ( 2012) is a solid and responsible management of development in line with the principles of democracy and an efficient market, avoidance of misallocation of investment funds and prevention of corruption both politically and administratively running budgetary disciplines as well as the creation of legal and politican frameworks for the growth of business activity (zarkasyi.w.2008). yamin and kurniawan, (2011). in line with world bank, good governance according to the van der hoek (2005), is the implementation of authority in the economic, political, and administrative fields to manage various figure 1: development of lkpd opinions for 2012-2016 papua and west papua provinces (in %) source: data in the researcher safkaur, et al.: the effect of quality financial reporting on good governance international journal of economics and financial issues | vol 9 • issue 3 • 2019280 state affairs in all levels and is an instrument of state policy to encourage the creation of conditions of welfare, integrity and social cohesiveness in the community or the establishment of synergic and constructive relationships between the state, the private sector and society. the main key to good governance is an understanding of the principles in it as a benchmark for assessing the merits and performance of a government. there are several good governance principles put forward by undp, namely community participation (participation), upholding the rule of law (rule of law), transparency (transparency), caring for stakeholders/ business world, consensus-oriented, equity, effectiveness and efficiency (effectiveness and efficiency), accountability and strategic vision (strategic vision). good governance according to osborne and geabler (1992) and lundqvist (2001) is the implementation of solid and responsible and efficient and effective governance by maintaining the harmony of constructive interactions between domains (state, private sector and society). furthermore, osborne and geabler (1992) suggested three basic pillars that are interrelated with each other in realizing good governance, namely (1) transparency, namely openness in government, environmental, economic and social management; (2) participation, namely the adoption of democratic decision making and recognition of human rights, freedom of the press and freedom to express people’s opinions or aspirations; (3) accountability, which is the obligation to report and respond from those entrusted with trust to account for successes and failures to trustees until those who give satisfaction are satisfied and if they are not available or dissatisfied, they can be sanctioned. robbins (2014) provides a definition of governance as “the way state power is used in managing economic and social resources for development of society.” governance is defined as the way the government manages social and economic resources for the benefit of community development. the van der hoek (2005), defines good governance as follows: governance is the exercise of economic, political, and administrative authority to manage a country’s affairs and means which promotes social cohesion, integration, and ensuring the well-being of their population which means: governance is the implementation of authority/power in the economic, political and administrative fields to manage various state affairs in all levels and is an instrument of state policy to encourage the creation of conditions of welfare, integrity and social cohesiveness in society. in other words, a synergic and constructive relationship between the state, the private sector and society (state, prevate, society). but in reality, the state is still the most dominant. furthermore tjokroamidjojo (2000), states that: good governance is safeguarded as long as governmental processes are transparent, individuals organize themselves, their expressions are priorities and demands to government offices. in other words, good governance but also with the executive; at the same time, it requires the declaration of decisions and of institutions and budgets. good governance is protection during transparent government processes, individuals organize themselves, express their priorities and demands for government offices. in other words, good governance manifests itself in the success of interactions with constitutional power especially with the legislature, but also with the executive; at the same time, which requires decisions and decentralization of institutions and budgets. according to mardiasmo (2002), that the world bank provides a definition of governance as a way for the government to manage social and economic resources for the benefit of community development, while the undp focuses more on ways of managing the state by considering political aspects that refer to policy making processes; economic aspects that refer to the decision-making process that has implications for the problem of equity, reducing poverty, and improving the quality of life; and finally the administrative aspects that refer to the system of policy implementation. thus the orientation of the public sector development is intended to realize good governance. in indonesia the views on good governance are also expressed by several opinions, among others: the national committee on governance (knkg) (2008) argues that good governance is the embodiment of a country that can be competitively healthy and able to create sustainable added value through responsible management of resources responsible so that the state’s credibility is built, both in the framework of the administration of the country itself, as well as in various aspects of people’s lives, including the application of good corporate governance by the business world. based on the above opinion, what is meant by good governance is a good governance that is capable of managing the resources it has to lead to a just and prosperous society and can be competitively healthy and high by upholding the values of divinity, human rights, openness, accountability and the rule of law. the world bank reveals a number of principles of good governance, namely: strong and participatory civil society; open; predictable policy making; responsible executive; professional bureaucracy; and obey the rule of law. the principles of good governance proposed by the national committee on governance policy (knkg) (2008) are as follows: democracy, transparency, accountability, and legal culture as well as fairness and equality. next according to the national committee on governance (knkg) (zarkasyi, 2008), put forward the principles of good corporate governance (gcg), namely. 3.1. transparency to maintain objectivity in conducting business, companies must provide material and relevant information in a way that is easily accessible and understood by stakeholders. the company must take the initiative to disclose not only problems that are implied by legislation, but also important matters for decision making by shareholders, creditors and other stakeholders. here there are 2 indicators used in assessing company transparency, namely information and policies within the company. 3.2. accountability companies must be able to account for their performance transparently and fairly. for this reason, the company must be managed correctly, measured and in accordance with the interests of the company while taking into account the interests of shareholders and other stakeholders. accountability is a requirement needed to achieve sustainable performance. in assessing the accountability of a company can be seen from two indicators, namely the basis of work and audit. 3.3. responsibility companies must comply with laws and regulations and carry out responsibilities to the community and the environment so safkaur, et al.: the effect of quality financial reporting on good governance international journal of economics and financial issues | vol 9 • issue 3 • 2019 281 that business continuity can be maintained in the long term and get recognition of good corporate citizen corporate social responsibility and compliance (compliance) with laws and regulations. 3.4. independence (independency) to facilitate the implementation of the gcg principles, companies must be managed independently so that each company organ does not dominate each other and cannot be intervened by other parties. there are 2 indicators to assess the company’s independence, namely internal influences and external influences. 3.5. equality and fairness in carrying out its activities, the company must always pay attention to the interests of shareholders, other stakeholders and all people involved in it based on the principle of equality and fairness. to assess equality and fairness that occur within the company there are 2 indicators that can be seen, namely shareholders and stakeholders. by implementing existing gcg principles, it is expected that the company can run effectively and efficiently, so that its performance becomes optimal. similar to the principles of good governance, which was put forward by tjokroamidjojo (2000), especially in the word good (good), the integrity of the implementation of governance if governance both in government, business entities and community organization activities is carried out based on the following principles: a. accountability; b. transparency (transparency) c. openess; d. rule of law (rule of law); e. fairness guarantee. based on the above principles, then in this study to measure good governance is used the principle of transparency and the principle of public accountability, because according to mardiasmo (2009. p18) based on the principles of good governance there are three things that can be played by public sector accounting namely transparency, public accountability, and value for money (economy, efficiency, and effectiveness). therefore, in this study the principle that will be used is transparency and public accountability, because these two principles are most often stated. 4. quality of financial reporting government financial reports are an important component in realizing the accountability of public financial management. the increasing demand for the implementation of public accountability has implications for management in government agencies to provide information to the public, one of which is information about financial statements. the function of information in financial statements will not have benefits if the presentation and delivery of financial information is not reliable and not timely. the dimensions of public accountability include legal accountability and honesty, managerial accountability, program accountability, policy accountability, and financial accountability. regarding the task of enforcing financial accountability, especially in the regions, local governments are responsible for publishing financial reports to stakeholders. accountability is the basis of financial reporting in government based on the right of the community to know and receive explanations for the collection of resources and their use. financial reporting covers all aspects related to the provision and delivery of financial information. financial statements are only one medium in the delivery of financial information. financial statements are basically assertions from the government management that present information that is useful in decision making and to show the accountability of the reporting entity for the resources entrusted to it. local government financial management must be based on good governance, namely financial management carried out in a transparent and accountable manner, which enables users to access the results achieved in the local government. therefore, the information contained in the lkpd must be useful and in accordance with the needs of the users. it must be realized that there are many parties who will rely on information in financial reports published by local governments as a basis for decision making. financial statements are information that is used by an entity to communicate circumstances related to its financial condition to interested parties both from internal entities and external entities (kieso et al., 2012. p5). accounting information is the result of an accounting process that includes the process of recording, grouping, and summarizing financial data of certain entities (kieso et al., 2012). financial statements can also be interpreted as the end result (output) of the accounting cycle, laudon & laudon, (2014). furthermore aren (2014) and homme (2010) say that financial statements can be produced by each entity, both business entities and public entities. mardiasmo (2009) also argues that the financial statements of business entities usually provide a summary of the performance and financial position of the business. whereas financial statements in the public sector, especially government financial reports are a form of transparency as a supporting condition for accountability, namely in the form of openness of the government to public resource management activities (mardiasmo, 2009). quality financial reports according to the international public sector accounting standards board (ipsasb) (2010) are the following characteristics: relevance, faithful representation, understandability, timeliness, comparability, and verifiability. whereas according to government regulation number 71 of 2010 concerning sap states that there are four characteristics as normative prerequisites that are needed so that government financial statements can meet the desired quality consisting of: relevant, reliable, comparable and understandable. the same thing was stated by mardiasmo (2009) that quality financial reports in the public sector, especially in government, are financial statements that are able to present reliable and reliable financial information. van der hoek (2005), define the quality of financial statements as reports that fairly present the state of the entity and activities for the end of the year and provide useful information for users of financial statements. brooks (2006) defines the quality of financial statements as reports in accordance with financial reporting accounting standards that indicate the financial position and results of operations of an entity at the end of the period. 4.1. purpose of financial statements the opinion expressed by o’briens and marakas (2010) that the quality of accounting information can be explained from three dimensions, namely: relevance, timelines, accuracy. besides madison (2010) which states that quality financial reports must safkaur, et al.: the effect of quality financial reporting on good governance international journal of economics and financial issues | vol 9 • issue 3 • 2019282 be understood, relevant, reliable and comparable. in accordance with the opinion of arens et al. (2014) which states that users of financial statements that rely on financial statements to take economic decisions assume that the auditor’s report as an indication of the reliability of the financial statements. in line with the opinion of boynton and johnson (2006) that external users of financial statements rely on audited financial statements to obtain guaranteed reliability of financial statements used to support decisions in lending. furthermore, according to boynton and johnson (2006) that relevance and reliability are the two main qualities that make accounting information useful for decision makers. users of financial statements see the independent auditor’s report for guarantees about the reliability of information and conformity to applicable accounting principles. according to cohen and kaimanakis (2011) that high-quality financial statements must not only be in accordance with accounting standards but at the same time financial statements must be accompanied by an external auditor’s report regarding comments on compliance in the preparation of financial statements. compliance is very important so that financial statements are more informative. the audit report attached to the annual financial report contains useful information and relates to the entity’s compliance with accounting standards. 4.2. effect of quality of financial statements on good governance the financial statements are the government’s main tool of accountability to people’s representatives in parliament or to other state institutions of interest and the general public. in indonesia, the accountability report is presented in the state/regional budget (apbd) budget note. based on these reports the parliament or any party that has an interest in assessing government performance (harun, 2009). according to mardiasmo (2002) that one of the tools to facilitate the creation of public accountability is through the presentation of comprehensive regional government financial reports. in line with the implementation of regional autonomy and fiscal decentralization, the challenge faced by public sector accounting is to provide information that can be used to monitor the accountability of local governments which include financial accountability, managerial accountability, legal accountability, political accountability and accountability of policy. mardiasmo (2002), argues that public accountability is the obligation of the trustee (agent) to provide accountability, present, report, and disclose all activities and activities that are his responsibility to the trustee (principal) who has the right and authority to ask for that responsibility. public accountability consists of two types, namely: 1) vertical accountability, is accountability for managing funds to higher authorities, for example the accountability of work units (dinas) to local governments, accountability of local government to the central government, and the central government to the mpr; and 2) horizontal accountability, namely accountability to the wider community. public accountability in the context of government organizations is the provision of information and disclosure of government financial activities and performance to those interested in the report. the demand for public accountability requires public sector institutions to emphasize horizontal accountability not only vertical accountability (vertical accountability). the demand that later arises is the need to make an external financial report that can describe the performance of public sector institutions. local governments can make financial reports as a means of controlling and evaluating the performance of the government and local government work units (internal), while from the external user side the financial statements of local governments as accountability and decision making. the climate of reform requires more transparent public sector accountability in terms of more informative government financial reports as a necessity. based on these reforms, the indonesian government has adopted an accrual accounting system as an asset reporting tool, operational performance, and cash flow (harun, 2009). government financial reports that are made must meet the qualitative characteristics of adequate financial statements, namely normative measures that need to be realized in accounting information so that they can achieve their objectives. qualitative characteristics of financial statements as normative prerequisites are needed so that quality government financial reports are relevant, reliable, understandable, and comparable (pp no. 71 of 2010). based on pp 71 of 2010 which states that financial statements are prepared to provide relevant information about financial position and all transactions carried out by a reporting entity during a reporting period. information transparency, especially financial and fiscal information, must be carried out in a form that is relevant and easy to understand (van der hoek, 2005). the management of regional governments with accountability cannot be separated from the regional government budget. this is in accordance with the opinion of mardiasmo (2002), who said that the realization of the implementation of regional autonomy is the use of resources carried out economically, efficiently, effectively, fairly and evenly to achieve public accountability. the budget is needed in managing these resources well to achieve the performance expected by the community and to create accountability. good governance requires that governance be carried out by following the principles of good management, namely transparency, accountability, and participation, so that state resources that are in the management of the government truly achieve the maximum goal for the prosperity and progress of the people and the state. one tool to facilitate the creation of public transparency and accountability is through the presentation of comprehensive regional government financial reports. the contents of the report, the accuracy of the numbers listed in the financial statements and produced by an adequate accounting system with good control will greatly determine the accountability of the reporting itself. numbers that do reflect transactions, every economic event that results in changes to an entity. numbers that reflect actual performance, numbers. the results of research conducted by nunuy and peny (2015) state that the quality of financial statements of local governments has a positive and significant effect on the principles of good governance. van der hoek (2005), states that financial and non-financial information has an effect on performance evaluation (financial accountability) and non-financial performance (efficiency and effectiveness). to monitor the results of the operation, the governmental accounting standards boards (gasb) uses an safkaur, et al.: the effect of quality financial reporting on good governance international journal of economics and financial issues | vol 9 • issue 3 • 2019 283 approach known as service efforts and accomplishment (sea), using non-financial indicators to measure the results of operations. from the research, the gasb provides recommendations, namely: 1) the central and regional governments should begin to submit external reports that contain a comprehensive set of sea indicators. 2) more emphasis is placed on measuring outcomes in the reported set of sea data. 3) government entities should provide sea indicators in a comprehensive format. 4) reports should present to the reader, a comparison of the results achieved now with benchmarks good governance as the quality of the relationship between the government and the people served and protected, good governance includes three things, namely: state/ government, private sector/business world, and society. public sector governance is defined as a process of governance, involving stakeholders, various economic activities, socio-politics and utilization of natural resources, finance implemented by adhering to the principles of justice, equity, equality, efficiency, transparency and accountability (nunuy &peny, 2015). three pillars of the basic elements that are interrelated with each other in realizing governace good are accountability, participation and transparency (world bank, 2000). 4.3. influence of organizational atructions to good corporate governance organizational structure is a part that is related to corporate governance (laudon & laudon, 2014). the organizational structure associated with the implementation of tasks, roles and responsibilities is more coordinated and prevents irregularities in work and has become one of the bases that directs the implementation of a quality information system. quality (peny, 2015) can mean success/success is built with good corporate governance. peny (2015) that implementation can lead to an increase in the transparent quality of financial reporting reflected and it can be said that the organizational structure affects the quality of financial reporting. 5. data analysis component structural equation modeling (sem) or variant based on sem was chosen based on the limited number of samples, where only 44 samples were taken and did not qualify using sem based on covariance for the second order factor model type. according to hair et al. (2014), partial least square (pls) is a powerful analytical method because it is not based on many assumptions. data does not have to be multivariate normally (indicators with categories, ordinal scale, intervals to ratios can be used on the same model), samples do not have to be large. hypothesis testing: the hypothesis is formulated into operational equations as follows: based on the framework that has been disclosed, it can be said that the quality of good government financial statements will have a positive effect on good governance (table 1). tests are not carried out using the t-test but by comparing the magnitude of the influence value whether it is >0 or not. if the amount of influence is equal to 0 or smaller then h0 is accepted, but if the opposite path coefficient is greater, then h0 is rejected. 6. results and discussion 6.1. evaluation of outer models in this study there are 2 latent variables namely financial reporting quality (y), and good governance (z). the first stage of evaluation of the measurement model is to evaluate the criteria for convergent validity. based on the estimation results using the help of the smart pls 2.0 program application. the output obtained as shown in figure 2 and table 2. furthermore, the results of the recapitulation of validity and reliability tests for y variables (quality of financial statements) can be seen in the following table. based on table 2, it can be seen that all statements submitted in shaping the quality of financial statements (x3) have validity coefficient values above the critical point of 0.3 which indicates that all statements submitted have been declared valid. and for the results of the reliability coefficient, the cronbach’s alpha value of 0.854 is >0.700 and declared reliable, so it can be concluded that all statements submitted in shaping the quality of financial statements have been able to measure what they want to measure. table 2: test results for instrument validity and reliability variables y variable item no coefficient of validity critical point conclution quality of financial statements (y) 1 0.814 0.300 valid 2 0.842 0.300 valid 3 0.767 0.300 valid 4 0.756 0.300 valid 5 0.649 0.300 valid 6 0.478 0.300 valid 7 0.557 0.300 valid 8 0.767 0.300 valid 9 0.814 0.300 valid 10 0.852 0.300 valid 11 0.462 0.300 valid reliability coefficient 0.854 critical point 0.700 information reliabel source: data processed table 1: hypothesis of indirect effects h0: γ1.1≤0 there is no positive influence on financial reporting on good governance h1: γ1.1>0 there is a positive influence on financial reporting on good governance safkaur, et al.: the effect of quality financial reporting on good governance international journal of economics and financial issues | vol 9 • issue 3 • 2019284 furthermore, the results of the recapitulation of validity and reliability tests for the z variable (good governance) can be seen in the following table. based on table 3, it can be seen that all statements submitted in forming good governance (z) have a validity coefficient value above the critical point of 0.3 which indicates that all submitted statements have been declared valid. and for the results of the reliability coefficient, the cronbach’s alpha value of 0.961 is >0.700 and declared reliable, so it can be concluded that all statements submitted in forming good governance have been able to measure what they want to measure. the variable quality of financial statements is measured by four dimensions, namely relevant, reliable, understandable and comparable. 6.2. respondents’ response 6.2.1. regarding the principles of good governance measuring instruments on the principles of good governance in this study were measured using 5 dimensions which were operationalized into 21 relevant statements. good governance variables are measured in five dimensions, namely transparency, participation, accountability, independence and equality. effect of quality of financial statements on good governance. the hypothesis that will be tested is the effect of the quality of financial statements on the good governance of the provincial/district/city governments in papua and west papua. based on the results of data processing, the path coefficient results for the quality of financial statements on good governance are 0.621 and r2 is 0.386 as shown in table 4. from table 4 above, the total effect of the quality of financial statements (y) on good governance (z) on the provincial/ district/municipal governments in papua and west papua is 0.386 or 38.6%. this means that as much as 38.6% of good governance (z) in the provincial/district/city governments in papua and west papua are influenced by financial report quality factors (y). in the diagram, the effect of financial report quality (y) on good governance (z) can be seen in the following figure 2: from the path diagram depicted in figure 2 above, it can be calculated the effect of variable financial report quality (y) on good governance (z) using the following formula z = 0.621* y. by knowing the magnitude of the path coefficient as seen in the equation and figure above, then further testing of the hypothesis can be done to find out whether the effect of the variable quality of financial statements on the variables of good governance is significant or not. table 3: test results for instrument validity and variable reliability variable item no coefficient of validity critical point conclusion good governance (z) 1 0.885 0.300 valid 2 0.885 0.300 valid 3 0.568 0.300 valid 4 0.783 0.300 valid 5 0.802 0.300 valid 6 0.784 0.300 valid 7 0.681 0.300 valid 8 0.810 0.300 valid 9 0.662 0.300 valid 10 0.876 0.300 valid 11 0.479 0.300 valid 12 0.805 0.300 valid 13 0.720 0.300 valid 14 0.786 0.300 valid 15 0.868 0.300 valid 16 0.865 0.300 valid 17 0.696 0.300 valid 18 0.885 0.300 valid 19 0.820 0.300 valid 20 0.691 0.300 valid 21 0.709 0.300 valid reliability coefficient 0.961 critical point 0.700 information reliable source: data processed table 4: value of path coefficients and value of r‑square quality of financial statements towards good governance sub structure endogenous variable exogenous variable path coefficient t-statistic r-square 2 good governance quality of financial statements 0.621 7.681 0.386 source: data processed good governance financial reporting quality 0,621 figure 2: effect of financial report quality on good governance safkaur, et al.: the effect of quality financial reporting on good governance international journal of economics and financial issues | vol 9 • issue 3 • 2019 285 from the table above, it can be seen that the calculated value obtained by the financial statement quality variable (y) is 7.681. this value is greater than t-table value 1.960. in accordance with the testing criteria of the hypothesis that h0 is rejected and ha is accepted, it means that, the quality of financial statements has a significant effect on good governance in the provincial/ district/city governments in papua and west papua. the results of hypothesis testing shown in table 4.4 show that the value of t count for the financial report quality variable is 7.681. this value is above the t-table value of 1.96. thus, the hypothesis (ho) which states the quality of financial report variables does not have a significant effect on the variables of good governance is rejected, and vice versa accepts the alternative hypothesis (h1) which states the variable quality of financial statements has a significant effect on the good governance variable. thus, the effect of the quality of financial reports on good governance in the provincial/district/ city governments in papua and west papua is significant. 7. conclusion partially, the quality of financial statements has a significant effect on government governance with a contribution of 38.6%. this means that the better the quality of financial reporting, the better the governance system (god governance). the results of testing this 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(2011), effect of good government and government accounting standards on financial accountability. trikonomika journal, 10(1), 52-62. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(4), 259-266. international journal of economics and financial issues | vol 9 • issue 4 • 2019 259 the acceptability of participatory banking products by smes: a conceptual framework amina hachimi*, m. my abdelouhab salahddine the national school of management, abdelmalek essaadi university, tangier, morocco. *email: amina.hachimi@gmail.com received: 08 may 2019 accepted: 22 july 2019 doi: https://doi.org/10.32479/ijefi.8227 abstract designed to contribute to the development of the real economy, the islamic banking sector has grown significantly in the world during the last 40 years due to its ethical, religious and solidarity dimensions. it is set up to boost the banking system, to meet the needs of unmet customers and to give new hope to small and medium enterprises (smes) facing difficulties in accessing conventional bank financing. islamic banks can contribute to the development of these companies and satisfy their financial needs. this article discusses the different factors influencing the decision of sme managers to adopt financing by participatory banks products. in this sense, the conceptual model presented is intended to study the level of acceptability of the participatory banks products by the smes starting from the application of the decomposed theory of planned behavior and the task-technology fit model. keywords: small and medium enterprise, participatory banking products, acceptability jel classifications: d22, g20, o16 1. introduction islamic finance is booming worldwide with more than $1800 billion at the end of 2016 (ifsb) and is concentrated mainly in iran, malaysia and the gulf countries. it has distinguished itself from the conventional system by its resistance to the global financial crisis of 2008 (trabelsi, 2011). the islamic banking sector continues to dominate the islamic financial industry with a percentage of 78.9%. in fact, from its foundations and offered products, the islamic bank appears to be an important financing tool and a credible alternative to meet the needs of small and medium enterprises (smes) in terms of funds (huda, 2012). smes, which contribute to the socio-economic development of a country, are experiencing difficulties in the access to conventional financing. this is due to the information asymmetry and the lack of guarantees leading to credit rationing towards these enterprises. in this sense, participatory banks (islamic banks) can contribute to the deployment of smes by offering them financial products that suit their operating and investment needs. the question arises as to what extent smes are encouraged to adopt participatory banking products in order to satisfy their specific needs and what factors might motivate them to use this method of funding. in this sense, our article highlights the variables impacting the acceptability of participatory banking products by smes. in other words, we will analyze the factors influencing the choice of participatory banks’ products by the leaders of smes using the decomposed theory of the planned behavior and the tasktechnology fit model. our research study on the intention of participatory banking products’ adoption by smes is crucial in the moroccan context. first and foremost, it concerns smes for developing their knowledge of the new so-called participatory banking method this journal is licensed under a creative commons attribution 4.0 international license hachimi and salahddine: the acceptability of participatory banking products by smes: a conceptual framework international journal of economics and financial issues | vol 9 • issue 4 • 2019260 and exploring new ways of financing their activities while benefiting from adapted consulting services and professional follow-up. secondly, it concerns participatory banks with the aim of understanding the real needs and expectations of smes and offering them customized products and services (participatory financial engineering). and finally, it can serve the state as part of the adjustment and arrangement of fiscal and regulatory measures to create a balance between the two financing systems and take into account the actual requirements of smes. 2. factors influencing the decision to adopt participatory banking products by smes first, islamic finance is defined as an independent financial system based on shariah norms and a set of arrangements to conduct a banking activity banning usury (ahmed, 2010). the prohibition of illegal activities and riba, the reduction of uncertainty and the elimination of speculation provide a consistent basis for business growth, regardless of fluctuations in macroeconomic variables (yahya et al., 2012). for the islamic banking sector to continue its development and expansion worldwide, it is essential that potential customers perceive positively and accept the use of the products of the participatory banks which support their financial needs (echchabi and aziz, 2012). it was then that research on perceptions of these banks was a major contribution to improve the islamic banking practice in order to best meet the needs and expectations of clients. the majority of these empirical studies on the intention to adopt islamic banking products and services have been conducted in countries where islamic finance has already been in place for years, for example, malaysia, the gulf countries, pakistan, jordan, indonesia and the united kingdom. these studies have addressed specific aspects of islamic financial activity from choice behavior theories, for example, real estate finance products (abduh and abdul razak, 2012; amin et al., 2014; taib et al., 2008), islamic e-banking (amin, 2007), and the adoption of islamic banking in general (mariadas and murthy, 2017; yahya et al., 2017; reni and ahmad, 2016; echchabi and azzouzi, 2015; echchabi and aziz, 2012; dusuki and abdullah, 2007). in this sense, the research model proposed is based on the decomposed theory of planned behavior (tcpd) which is an improved behavior analysis model based on rogers’ theory of diffusion of innovation (1995), ajzen’s theory of planned behavior (1991), the acceptance model of davis (1989) combined with the task-technology fit model (goodhue and thompson, 1995). it is based on the decomposition of attitudinal, normative, and control beliefs into multidimensional constructs in order to design the factors explaining behavioral intention (taylor and todd, 1995, beiginia et al., 2011). based on this theory, our model identifies the intrinsic and extrinsic factors influencing the choice of participatory banking products and makes it possible to analyze the level of acceptability of this method of financing by the customers (echchabi and azouzi, 2015). 3. adaptation of the tdcp model to the research problem based on studies and research conducted as part of the analysis of the intention to use the products and services of islamic banks in various countries, we detected several variables and factors that allow potential customers to opt for islamic finance. in this sense, we have opted for an adapted model of decomposed theory of planned behavior in order to examine the degree of acceptability of participatory banking products by smes. indeed, it has been observed that the majority of research on the intention to adopt islamic bank financing has been established towards individual potential clients and neglected the businesses niche which is also considered concerned by islamic banking products to meet their funding needs (figure 1). and according to previous studies conducted in this context, the attitude has a positive and significant impact on the intention to use islamic products by individuals (amin et al., 2013, lada et al., 2009, taib et al., 2008). it is measured from several factors namely: 3.1. relative advantage it specifies the benefits and costs of adopting a product. according to gerard and cunningham (2003), this variable can be evaluated on the basis of the degree of economic profitability, social prestige, low initial cost, immediacy of reward, and economy of effort and time. in the field of participatory banking, the majority of authors measured the relative advantage on the basis of islamic finance pricing which refers to the price at which islamic banks sell their products. according to amin (2013), the cost of products is the most influential factor on the attitude of individual customers. this finding has been shared by other authors as well; rahman, 2005; dusuki and abdullah, 2006; ahmad and haron, 2002; hamid and masood, 2011; yahya et al., 2017; echchabi and aziz, 2012; gait and worthington, 2008; amin et al., 2011. elliot et al. (1996) explained that the lower the cost of participatory banking products compared to those of conventional banks, the more favorable and positive the attitude of customers towards participatory banks. in the same vein, product costs are a key element in companies’ decision to opt for islamic banking (jaffar and musa, 2014; rustam et al., 2011). conversely, according to the study conducted in indonesia by reni and ahmad (2016), the cost of the products is not significant and does not impact the attitude of potential customers with regard to the participatory bank. in fact, islamic banks are institutions that are based on the principle of profit and loss sharing, which is a relative advantage over smes. in the moudaraba, the bank shares the profits generally generated by a proportion of 70:30 and assumes all the loss in case of project failure. also, in the mousharaka, the smes are jointly financing with the bank (and its investors-depositors) a project of a strong probable profitability. the islamic financial institution distributes the profits on a 60:40 basis and the losses according to the contributions of each party. these two practices could encourage smes to adopt islamic banking if the rate of profit is high and appropriate. in addition, jalaluddin and metwally (1999) found hachimi and salahddine: the acceptability of participatory banking products by smes: a conceptual framework international journal of economics and financial issues | vol 9 • issue 4 • 2019 261 that the expected rate of return is one of the main factors driving small businesses in australia to use islamic banking. as part of our study, we will measure this variable from the following sub-divisions: the islamic banking pricing (participatory banking products’ cost), the principle of profits and losses sharing, the expected rate of return. 3.2. complexity according to rogers (1995), complexity is the degree to which an innovation is perceived to be relatively difficult to understand and to use. since participatory banking products are still a form of bank innovation, the adoption of this form of financing will only be feasible when the application of islamic banking products and services is readily assimilated and agreed by the clients. yahya et al. (2017) have confirmed that there is a negative relationship between complexity and attitude towards islamic banking products. by cons, echchabi and aziz (2012) reversed these remarks in the moroccan context. in our study, this complexity is measured by the flexibility of terms and conditions of access to participatory bank financing (hamid and masood, 2011) and by the nature of the islamic banking agreements. conventional financing is characterized by rigid conditions and terms limiting access to bank offers to a large number of smes. in this sense, the participatory banking system is obliged to reduce the clauses and formalities (amount of loans granted, guarantees requested, certified summary statements, duration of financing, monthly payments...) in order to encourage smes to use their products. indeed, the complexity of the conditions to access to islamic banking is negatively related to the attitude of potential clients (hamid and masood, 2011). our study postulates that the attitude and perceived behavioral control of the sme’s manager are based on their previous experiences with the conventional financing, and influenced by the degree of the complexity of the contracts and the conditions required by the participatory bank. in fact, islamic financing agreements (cost-plus products or profitand-loss sharing modes) appears to be complicated and difficult to understand as compared to conventional contracts due to the long process and the multitude of operations and parties (iqbal and mirakhor, 2011). however, islamic banking practices seem to be customized in order to meet the requirements of smes specially the partnership modes that are useful to ameliorate the affordability of these enterprises to finance and bank lending (elasrag, 2016). 3.3. uncertainty in the business world, there is a strong uncertainty in the management and direction of enterprises. it can influence their decision-making process (duncan, 1972), their investment choices or their organizational structure (lawrence and lorsch, 1967). in management sciences, the definition of uncertainty is related to the notion of risk (herring, 1983), the lack and the unreliability of information (daft and lengel, 1986; galbraith, 1973; atkinson et al., 2006). uncertainty in islam is linked to speculative activities such as maysir, which is one of the main prohibitions of islamic finance. intention to use participatory bank products by smes demographic variables (leader's profile), company banking experience, age and size of business, financial information on company, business area. attitude towards participatory banking products relative advantage complexity uncertainty image & reputation compatibility subjective norms interpersonal influence external influence perceived behavior control cognitive self -efficacy facilitating conditions figure 1: conceptual framework proposed (made by the authors) hachimi and salahddine: the acceptability of participatory banking products by smes: a conceptual framework international journal of economics and financial issues | vol 9 • issue 4 • 2019262 it refers to gharar and the excessive risk that makes the contract invalid. the uncertainty becomes exaggerated when attached to the good, its price, the term of payment, the delivery clauses, the quantity, etc. (al-suwailem, 2006). according to the study by echchabi and azouzi (2015), uncertainty negatively and significantly influences the attitude of potential customers towards islamic products. it is related to interest rate fluctuations and the degree of perceived risk. cox and rich (1964) defined perceived risk as the nature and the level of uncertainty of a client in using a specific product or service (yahaya et al., 2014). individuals and businesses face different types and levels of risk (mirakhor, 2000). in general, a perceived low risk project is more accepted by banking institutions than a high risk one. in this sense, the degree of perceived risk is a factor influencing the decision to adopt islamic products. the depositors in conventional banks assume less risks due to the pre-agreed return, while in islamic banks, they undertake higher risks because the return is unspecified and depends on the business income. according to the study by yahaya et al. (2016), it has been shown that the perceived risk has a significantly negative impact on the acceptability of the participatory banking products in niger. in fact, the influence of this variable on the consumer decision has been studied by many researchers in several contexts (al-fahim, 2012; zhao et al., 2010; gerrard and cunningham, 2003). in the case of asset transfer-based products such as ijara, the risks associated with the leased asset are borne by the bank until the end of the contract period. this could reduce the level of risk perceived by the sme which requires materials, equipment through leasing contracts. in addition, profit-sharing products give smes the opportunity to share risks with participating financial institutions and their depositors. these risks are generally related to the high variability in the performance of projects financed under a commercial partnership-type contract and the moral risk incentives of sme-borrowers associated with the possibility of sharing losses with banks. however, this type of contract can reduce the credit risk by decreasing the asymmetry of information and the problem of adverse selection. in addition, the concept of trust is frequently used with the term “confidentiality.” to perceive the islamic banking practice as a secure and reliable activity by the potential clients would generate a positive intention to adopt the financing by the participatory bank (yahya et al., 2017). at the level of islamic products (mousharaka and moudaraba), the bank is considered as an associate with the sme in the financed project. so, it must have access to internal documents of the company, however, the sme is generally reluctant to share information with other parties (echchabi and nafiu, 2012). as part of the permanent mousharaka, the different parties (investors, bank, entrepreneurs) remain involved in the investment project in a definitive way. this technique is appropriate for financing projects of a longer term where funds are committed over a long period. in addition, the diminishing mousharaka is the most suitable form for small and medium-sized enterprises that do not have guarantees and wish to hold the entire project after a fixed period. furthermore, the moudaraba financing method is a beneficial option for smes too as it allows the entrepreneur to have the necessary funds for setting up and managing his investment project. in this case, he shares the resulting profits with the participatory bank while the probable losses associated with the project are borne by the bank. in addition, the intermediation of the participatory bank in sme projects is an important and a credible signal on the company’s situation and the reputation of the entrepreneur. since the profitability of the participatory bank in the framework of its contracts is related to the quality of the financed project, the evaluation and the selection of the projects remain unavoidable and essential activities for the bank. in this sense, smes provide a favorable reputational capital, thus enabling them to enter the financial market (al-suwailem, 2008). in the same context, this association of the sme with the participatory bank engenders the participation of the latter in the management of the project and in the decision-making concerning the project. therefore, the notion of power is strongly present in the relationship between the participatory bank and the sme in the context of islamic banking products. moreover, the nature of the islamic banking contracts gives the participatory bank the rights to monitor the activities and transactions carried out by the company, and therefore unlimited access to the company’s private information. this can be summarized in the notion of control which makes it possible to remedy the phenomenon of information asymmetry. since most smes operate as individual or family businesses, our study aims to analyze to what extent the sme could accept the interference of the participatory bank in the management of their projects and activities. thus, it allows to measure the influence of the variables of risk, trust, power and control on the attitude of the managers of smes vis-à-vis the use of participatory banking products. 3.4. image and reputation many studies have confirmed that the reputation of the islamic bank is one of the predominant factors in the intention to adopt islamic bank products and services in several geographical contexts (erol and el-bdour, 1989; naser et al., 1999; haron et al., 1994; dusuki and abdullah, 2007; rustam et al., 2011; hamid and masood, 2011; echchabi and nafiu, 2012; jaffar and musa, 2014; tara et al. 2014). previous studies show that the social responsibility factor is significant in the selection of the bank by customers (al-ajmi et al., 2009; dusuki and abdullah, 2007). this variable allows to analyze whether the choice of the products of the participatory bank by the sme is based on the nature of the bank itself whether it is a window or an independent entity, and hachimi and salahddine: the acceptability of participatory banking products by smes: a conceptual framework international journal of economics and financial issues | vol 9 • issue 4 • 2019 263 to what extent the participatory bank contributes to equity and social responsibility. 3.5. compatibility compatibility is defined as the degree to which an innovation is perceived to be appropriate with the values, needs, beliefs of potential users (rogers, 2003). in the context of the islamic banking system, compatibility involves examining suitability of islamic banking products to the needs of the potential customers, their values, their beliefs and their norms (obeid and kaabachi, 2016). in our case, we will measure the compatibility on the basis of the following subdivisions: diversity of participatory bank products that meet the varied needs and expectations of smes; support of the innovation field of start-ups and smes by the participatory bank; suitability of the products proposed to the principles of sharia. potential customers will tend to choose the islamic banking mode in case it meets their needs and adapts to their values, as an example, the use of the sharing of losses and profits instead of applying riba and the prohibition of illegal activities in the banking system. in this sense, the compatibility variable has a significant impact on the intention of adopting islamic products by potential customers (yahya et al., 2014). this finding is shared by echchabi and aziz (2012), amin et al. (2011, 2013), echchabi and azouzi (2015), rustam et al. (2011), gait and worthington (2008). in fact, religion is an important and significant factor for the adoption of islamic banking products. the higher the adherence and convenience of islamic banks to the principles of sharia, the greater the possibilities of islamic banking adoption (almossawi, 2001). many authors have stipulated that the obligation of religion is the most motivating factor affecting the selection of islamic banks to the detriment of conventional banks (dusuki and abdullah, 2006; ahmad & al., 2010; al-ajmi et al., 2009; metawa and almossawi, 1998; gait and worthington, 2008; metwally, 1996; hegazy, 1995; okumus, 2005; ahmad and haron, 2002; rustam et al., 2011; echchabi and aziz, 2012; jaffar and musa, 2014; el ouafy and chakir, 2015; reni and ahmad, 2016). in addition, rehman (2012) found that the choice of islamic banking products is impacted by people’s age, as older potential clients tend to be more interested in sharia concerns. by contrast, amin et al. (2011) demonstrated that religious motivation is not so significant in the intent to use participatory banking products. in addition, smes are always looking for financing methods that meets their varied needs and in the different phases of maturity in their development cycle. these financial needs may have as an objective the financing of acquisitions, the development of new products, the setting up in new markets, the conquest of new customer segments, the repayment of loans. they differ according to the stage of the life cycle of the company, for example, newly created companies require funds to finance their investment project and support in the early stages of the project. consequently, these companies will benefit from adopting products based on the sharing of losses and profits, contrary to those in the maturity or growth phase that require financing for the expansion of their activities, the acquisition of equipment or local… it is therefore essential to detect the real needs of smes and analyze the degree of suitability of needs in relation to the functionalities and characteristics of the products of the participatory banks. finally, according to hoffman and soyez (2010), clients operating in an area of innovation focus more on distinct product categories and adopt for innovative products, and therefore their choice of bank financing remains influenced by the degree of innovation and adaptation of the banking product in relation to their activity. the second variable family is the subjective norms that refer to social pressures perceived derived from an individual’s references (ajzen, 1991). in the context of islamic finance, previous studies show that subjective norms have a significant influence on the intention of individuals to use islamic products (amin et al., 2013, taib et al., 2008). among the references of an individual, there are members of the sharia council, relatives, friends, etc. (taib et al., 2008). in the case of smes, subjective norms are measured from two variables from the bhattacherjee study (2000), namely: 3.6. interpersonal influence this variable includes the family, the relatives of the manager of the sme. several research have been conducted for individual clients, for example; hegazy (1995) concluded that the most important factor in selecting islamic banks over conventional banks was the advice and recommendations of relatives and friends. the influence of the peer group is significant in the bank decision-making process (tan and chua, 1986). these studies focused on individuals. in our case, we try to analyze the influence of family and friends on the choice of adoption of participatory banking by the leaders of the sme. 3.7. external influence it involves the stakeholders (suppliers, customers, associates...) of the sme, the media report and the opinions of the experts (ulamas, etc.). in the study of ahmad and haron (2002), it was observed that the rate of use of islamic banking products by companies in malaysia is low because of the lack of marketing strategies adopted by the islamic banks. indeed, normative beliefs have a significant impact on the acceptability of islamic banking products, which is demonstrated by the studies of the following authors: erol et al. (1990), metawa and almossawi (1998), osman & al (2009), echchabi and aziz (2012), amin et al. (2013, 2014), reni and ahmad (2016), lajuni et al. (2017). the third construction of the model of decomposed planned behavior theory is perceived behavioral control, which refers to hachimi and salahddine: the acceptability of participatory banking products by smes: a conceptual framework international journal of economics and financial issues | vol 9 • issue 4 • 2019264 perceived ease or difficulty in performing the behavior. it therefore largely concerns the individual’s assessment of his own resources or abilities to control the situation (ajzen, 1991). in other words, it corresponds to the degree of ease or difficulty that represents the realization of a behavior for the individual. this variable reflects the presence of external factors facilitating or constraining the achievement of a given behavior as well as the individual’s perception of his personal effectiveness in order to achieve this behavior (taylor and todd, 1995). in the studies related to islamic banking adoption, jaffar and musa (2014) and amin et al. (2014) showed that control of perceived behavior is the main determinant of adoption intent. from previous empirical studies, this construction is broken down into: 3.8. cognitive self-efficacy in the model of decomposed planned behavior theory, perceived behavioral control is influenced by self-efficacy that refers to individual capacity (bandura, 1977). it is the conviction of the individual to possess the necessary resources to adopt the behavior. in our study, we will analyze this variable in terms of the degree of knowledge of sme managers on the principles and practices of the participatory bank. indeed, haron et al. (1994) and abdullah et al. (2012) have stipulated that potential customers can adopt islamic banking in case they have full cognitive abilities on the practice of islamic banks. from previous studies, it has been observed that the level of knowledge about the differences between the conventional and islamic banking system remains low, which negatively influences their acceptability of islamic banking products (hamid and nordin, 2001). 3.9. facilitating conditions they are defined as the extent to which a person believes that an organizational, technical and regulatory infrastructure exists to support the use of the product (triandis, 1979). in the moroccan context, echchabi and aziz (2012) demonstrated that enabling conditions have a significant influence on perceived behavioral control and consequently on customers’ attitude towards islamic banking products. in the context of our study, this variable is measured from several sub-variables: • government support: it refers to government actions and practices that affect the behavior and decisions of individuals and businesses of any form (amin et al., 2011). indeed, the adoption of islamic products is dependent on the degree of government support (rosly, 2005). in this sense, our study enables to detect whether the choice to opt for islamic banking is influenced by the intermediation of the government from the establishment of guarantee funds dedicated to islamic financing that will facilitate the access of smes and by the fiscal framework on financial transactions operated in the framework of the participatory banking system. • effectiveness of service delivery: several studies on the intention to use islamic bank financing have shown that the advice and expertise of the bank’s staff and the quality of services put in place influence the adoption of participatory banking products (echchabi and nafiu, 2012; rustam et al., 2011; osman et al., 2009; dusuki and abdullah, 2007; metawa and almossawi, 1998). in other words, the expertise and advice of the participatory bank’s staff in specific areas related to the sme’s activity can influence their judgment regarding the use of participatory products. in this sense, our research also analyzes the impact of the quality of the services offered by the participatory bank and the level of staff expertise on the intention of adoption of islamic products by smes. not to mention the variables related to the profile of the manager and to the sme itself (banking experience, size, financial information and sector of activity) which are essential criteria for assessing the behavior of smes toward the participatory banking products. metawa and almossawi (1998), zainuddin et al. (2004), okumus (2005) and amin (2012) studied the influence of sociodemographic variables on the use of islamic banking products. 4. conclusion the purpose of this article is to identify and to highlight the factors that impact the decision of smes to use participatory bank products. to do this, we have based on taylor and todd’s (1995) decomposed theory of planned behavior, which presents a multidimensional belief structure, and the task-technology fit model (goodhue and thompson, 1995). the proposed research model explains the intentions of adoption of participatory banking products by smes taking into account the attitude defined by relative advantage, complexity, uncertainty, compatibility, image and reputation. in addition, the subjective norms determined by interpersonal and external influences that allow to deduce the factors influencing the decision of smes visà-vis the participatory banks. and finally, perceived behavioral control broken down into cognitive self-efficacy and enabling conditions and that impacts the intention of smes to use these products. references abdullah, a.a., sidek, r., adnan, a.a. 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(2010), adoption of internet banking services in china: is it all about trust? international journal of bank marketing, 28(1), 7-26. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(1), 151-159. international journal of economics and financial issues | vol 9 • issue 1 • 2019 151 impact of agricultural sectors and income inequality in rural toward role of public education in decreasing educational inequality in indonesia doddy ismunandar bahari1*, hermanto siregar2, sahara sahara2, handewi purwati saliem rachman3 1doctoral student of agricultural economics, faculty of economics and management, bogor agricultural university, indonesia, 2department of economics, faculty of economics and management, bogor agricultural university, indonesia, 3indonesian centre for agricultural socio economic and policy studies, ministry of agriculture, indonesia. *email: doddyismunandar@yahoo.co.id received: 20 july 2018 accepted: 10 november 2018 doi: https://doi.org/10.32479/ijefi.6924 abstract generally, the aims of this research was to analyze the role and the inputs allocation of public education and the factors which affected educational inequality. using panel data in 33 provinces during 2010–2016 which then analyzed by stochastic frontier method. the results showed excessive allocation of resources in the addition of school buildings at primary and junior secondary school. reducing education inequality could be encouraged through the addition government spending on education, number of teachers in junior secondary education and lecturer in higher education, and number of school buildings in senior secondary school and college education. the role public education performance was only able to affect 83.8 of educational inequality, and its remaining 16.2% due to the high percentage of rural school age labor, percentage of labor in the agricultural sector, farmer’s terms of trade, and gross domestic product per labor on the agricultural sector. keywords: education inequality, public education, agricultural sector, income inequality jel classifications: i24, h41, q19, d63 1. introduction one of unfinished problems dealed by developing countries and emerging markets is poverty, income inequality and educational inequality (jhingan, 2011). meanwhile, education plays a role in poverty alleviation, income inequality, and productivity improvement, therefore it is an important indicator of economic development (worldbank, 2016; 2018). the existence of educational inequality becomes the root of economic development problems because it contributes in generating income inequality. even one-fifth of income inequality in indonesia is due to different levels of education (chongvilaivan and kim, 2015; digdowiseiso, 2009; silva and sumarto, 2013; wicaksono et al., 2017). in addition, developing countries and emerging markets also face constraint which is a limitation of educational finance that results in the provision of public education that is only able to fulfill primary education and junior secondary level, but has not yet been able to provide full education for free to the community (todaro and smith, 2015). in indonesia itself, the low of school enrollment ratio at the senior secondary school level is presumed to be due to improper budget allocations directed towards personnel expenditure rather than funding for the addition of teachers and school buildings for senior secondary levels that are currently minimal compared to ideal requirements (bps, 2016a; chang et al., 2014; oecd, 2010). based on that, the role of government in the allocation of public education input is very important to the educational inequality. the education level achievement is also comodities whose demand is determined by price and income level of society, even the this journal is licensed under a creative commons attribution 4.0 international license bahari, et al.: impact of agricultural sectors and income inequality in rural toward role of public education in decreasing educational inequality in indonesia international journal of economics and financial issues | vol 9 • issue 1 • 2019152 elasticity of demand differs per income level (checchi, 2006). it means that income inequality affects the number of demand for educational services. income inequality itself occurs because the economic structural change has not finished thus the labor surplus of the agricultural sector has not been absorbed by the modern sector and the productivity differences between sectors, where the lowest productivity occurs in the agricultural sector resulting in subsistence wages in the agricultural sector. it is not surprising that household income in the agricultural sector is the lowest compared to other sectors (dethier and effenberger, 2012; yang and greaney, 2016). as a result, poverty is vulnerable to household labor in the agricultural sector in rural areas. even in indonesia alone, the level of income inequality is 0.395 and rural poverty is 17.2 million people (bps, 2016c). the engle curve principle shows that increased incomes will increase educational expenditure along with increased spending on other needs (wongmonta and glewwe, 2016). thus, any propoor growth policy measures that can encourage income raise in low-income communities will lead to decrease in educational inequality (epo and baye, 2016). the main impact of rural poverty on education demand is child labor. working at school age leads to a disruption to school time allocation and even spent all their school time allocation because they help to increase household income (todaro and smith, 2015). increased agricultural sectors performance and labor movement from agriculture to nonagricultural sectors have great response to rural poverty reduction (imai et al., 2017; suryahadi et al., 2009). furthermore, farmer welfare is largely determined by the farmer terms of trade (ftt) (colman, 2010), therefore the success of any agricultural business in every growing season will ensure the fulfillment of farmer household needs including education services consumption. some of these factors can be an impediment to educational inequality decrease even though education cost obtained by poor households is relatively small. this condition shows that income inequality and poverty have an effect on educational inequality. these factors come from the agricultural sector and income inequality in rural areas. based on these descriptions, this paper would like to answer some of the following objectives: (1) to analyze the impact of public education allocation of various levels in reducing educational inequality, (2) to measure the role of public education in reducing educational inequality, and (3) to identify the impact of agricultural sector factors and income inequality in rural to educational inequality. 2. brief literatur review research on the determinant of educational inequality divides in to 2 outlines which are the supply of public education and demand of public education. akyol (2016), cordoba and ripoll (2013), gupta et al., (2002), and shindo (2010) state that government spending and subsidies for education encourage educational investment because it provides incentives to individuals thus makes education consumption becomes higher, leads to the decline of educational inequality. while craigwell et al. (2012) and scippacercola and d’ambra (2014) also assume that besides financial input, increasing supply of public education is driven by increased physical input of public education, the number of teachers and the number of classrooms. as for aggregate yang et al. (2014) suggests that the role of applied education system capable of discriminating educational consumers therefore can be profitable for a particular group of consumers, will ultimately determine the level of educational inequality. supply side of public education studies are able to disclose important factors affecting the educational attainment of each individual to determine educational inequality are the financial input, physical and educational system. on the demand side of public education, various studies indicate factors that can influence educational inequality derived from indicators of economic development. castelló-climent (2010) reveal the causes of differences in educational inequality caused by different levels of economic development namely fertility rate and life expectancy rate. while devkota and upadhyay (2016) and zhang et al. (2015) decompose factors affecting educational inequality into income, social and demographic distribution so they find that income distribution, urbanization and distance to schools determines the level of educational inequality. senadza, 2012, agrawal, 2014, huanfeng, 2016 developed a determinant of inequality in education between regions where rural inequality is much greater than that of urban inequality caused by rural poverty is more vulnerable than urban. in addition, the rural poor are more vulnerable to child labor. poverty happened mostly in rural areas will lead to relatively greater levels of educational inequality in rural areas. epo and baye (2016) state that the decrease in educational inequality comes from pro-poor growth government programs. the findings indicate that the increase in income of the poor people is a major driver of the decline in educational inequality. limitations of previous research are (1) public education study is not comprehensive in answering the role of public education in decreasing educational inequality due to the decomposition of educational input is too minimal because it does not decompose the input at every level in detail, (2) the educational demand side factors that have not been decomposed into more focused factors to accomodate taking policy decision (3) there is no study comparing the effect of educational supply side and education demand side simultaneously to educational inequality, and (4) from epo and baye (2016) findings it can be seen that the direction of educational inequality determinant development incline to derivative factors that are able to determine different levels of economic development. therefore, in this study the development of factors affecting educational inequality comes from education supply factors in entire levels, factors derived from the agricultural sector and income inequality in rural which at the same time determine educational inequality. 3. theoretical framework based on the assertion of the literature review, the theoretical framework is structured as follows. the efficient condition of public goods supply being achieved by government when sum marginal rate of substitution condition of public education services is equal to the marginal rate of transformation of public education services that is in equilibrium between supply of public goods and demand of public goods at the quantity and quantity level of certain public goods prices. the interaction of supply and demand bahari, et al.: impact of agricultural sectors and income inequality in rural toward role of public education in decreasing educational inequality in indonesia international journal of economics and financial issues | vol 9 • issue 1 • 2019 153 of public goods is assumed to occur as perfect competitive market with prices equal to marginal revenue and equal to marginal cost (mc), therefore all factors affecting supply and demand of public goods will affect the achievement of equilibrium (binger and hoffman, 1988; stiglitz, 2000). public education only comes from the government thus the total amount of public education output is generated from all educational inputs used by government namely government expenditures for education function (f) and physical input of education (k), its model assumed as follows. q f kse = 1 2 1 2. (1) the additional cost of each additional input to increase the output of public education (mc) with r is the opportunity cost of using government budget for education and f is the price of the physical input of education. mc = = δ δ tc q rq kse se2 2 (2) the public education supply condition by government occurs when pqe = mr = mc, so the level of efficient public goods supply are: pqe = mc (3) q p k se qe= 2r (4) demand of public goods is the sum of all public goods demand derived from the utility maximization of each individual to consume public education services (qei) and other goods consumption ( qxi ) with budget constraints (mi) at the public education price level ( pqe ) and the price of other goods ( pqx )are certain. maxu q qi ei xi.� = (5) s t m. . i q ei q xp q p qe x i= + (6) the demand of public education services level that maximize the utility and demand of total public education (qei) is the demand of all individuals for public education services therefore public education directly influenced the level of individual income, occurs under the following conditions. q pei i qei = m 2 (7) q pde q i n i e = = ∑1 2 1 m (8) the efficient condition is equilibrium between supply of public goods and demand of public goods (q*) occurs in qde =qse resulting in equilibrium price ( pqe ). 1 2 2 1 p p k q i n i q e e = ∑ =m r (9) p r k mq i n ie =       = ∑. 1 1 2 (10) q q q pse de q i n i e = = = = ∑* 1 2 1 m (11) q k i n i * =       = ∑ 2 1 1 2 r m (12) the existence of income inequality effect so it is assumed that there are three income levels. k n k i n i n i n = = = = ∑ ∑ ∑ ∑= + + 1 1 1 1 2 1 3 m m m m (13) k = 1, 2, 3. (14) the difference in income leads to differences in the amount of demand for public education services. the equilibrium output of education (q*) assumed to be a proxy of the educational attainment of the population. if there is a difference in demand of education (qdek ) then make differences in the number of people who are able to achieve a certain level of education (nk). q q q k nsek dek k i n k k= = =       = = ∑* 2 1 1 2 r m (15) k = 1, 2, 3. (16) to measure the distribution educational attainment of the population or level of educational inequality (gned), the education lorentz curve index is used. the formulation as follows (bellu and liberati, 2006; ozdemir, 2016). gned = 1-([sk+sk-1][yk-yk-1]) (17) s e ek k n k k t = = = ∑ 1 � (18) y n nk k n k k t = = = ∑ 1 � (19) where: yk = cumulative percentage of the amount population at the k education level of the total number of individuals. sk = cumulative percentage of education level k to total education level. ek = achievement of education in k level. et = the total level of education achievement bahari, et al.: impact of agricultural sectors and income inequality in rural toward role of public education in decreasing educational inequality in indonesia international journal of economics and financial issues | vol 9 • issue 1 • 2019154 nk = number of individuals from k education level. nt = total number of individuals. changes in supply of public education (qse) and demand of public education (qde) and the factors affecting it determine the level of educational inequality. gned = 1-([sk+sk-1][yk-yk-1]) (20) gned e e e e k n k k t k n k k t k n k = −       +              = = = = = = ∑ ∑1 1 1 1 � � ∑∑ ∑       +                               = = − n n n n k t k n k k t � � 1 1         (21) gned e e e e k tk n k k tk n k k = −         +                = = = = − ∑ ∑ 1 1 1 1 . kk r m n ki n k tk n k 2 1 1 2 1 = = = ∑ ∑                                     +                                = − = = ∑ ∑ k r m n ki n k tk n k 2 1 1 2 1 1                                                                                              (22) gned=1-(f[k,m,r]) (23) equation (23) shows that the capability supply of public education to reduce educational inequality. to see how vast the affect between the supply and demand of public education, stochastic frontier analysis is used. the use of such analysis is due to its ability to separate the influence of supply and demand of public education on educational inequality. to be used, the equation (24) is transformed as follows. (1-gned)i=(f[ki, mi,ri]) (24) (1-gned)i=β1ki+β2ri+vi-mi (25) in order to separate the supply of public education side effects which are ki and ri, the public demand factor described by the income level of the individual mi is considered to be an aggregate of a set of residual factors besides public education inputs that determine educational inequality, and vi is random error. as coelli et al. (2005) suggests that in the use of stochastic analysis frontier there are 2 interaction functions that are analyzed together that is input production and function of other specific factors. the separation of suppy side of public education from equation (25) is: (1-gned)i=β1ki+β2ri (26) while the side of demand of public education is: mi=δ1z1i+δ2z2i+δnzni (27) 4. research methods the data in this research is in the form of panel data that is combination of time series data and cross-section data in the period 2010–2016 from 33 provinces in indonesia. the data in this study were collected by literature study method that was sourced from several institutions namely the central bureau of statistics (bps), the ministry of finance, and the ministry of education and culture (kemdikbud). the level of educational inequality was measured using gini education index calculated using the education lorenz curve using the education attainment data of 15 years old and over in each province. the calculation of the gini education index as formulated earlier in the equation (20). to answer the first objective of public education input allocation influence in reducing educational inequality, use the function of supply public education in equation (26), educational input (ki) used is the number of teacher/lecturer and the number of school buildings at each level of education, the level of opportunity cost of using budget for education (ri) proxied by the amount of education budget allocated by the government. the function is analyzed using ordinary least square estimated method which is as follows. ln(1-gned)=β0+β1lngeeduit+β2lnntbsit+β3lnntjsit+β4ln ntssit+β5lnnthsit+β6lnnsbsit+β7lnnsjsit+β8nsssit+β9nuhsit +vit–mit (28) where: gned = educational inequality level (percent) gedu = government expenditures for education (million rupiah) ntbe = number of teachers at elementary level (person) ntjs = number of teachers at junior secondary school level (person) ntss = number of teachers at senior secondary school level (person) nthe = number of lecturers at higher education level (person) nsbe = number of elementary school (unit) nsjs = number of junior secondary school (unit) nsss = number of senior secondary school (unit) nuhe = number of universities (units) β0, βi = constants and parameter estimators (i = 1,2,… 7) v = random error m = non-negatif random, described role of demand side of public education signs and expected parameters: β1, β2, β3, β4, β5, β6, β7>0. to answer the second objective, measuring the role of public education on the decrease in educational inequality (rpeit) is bahari, et al.: impact of agricultural sectors and income inequality in rural toward role of public education in decreasing educational inequality in indonesia international journal of economics and financial issues | vol 9 • issue 1 • 2019 155 analyze by using stochastic frontier analysis as in equation (25). this analysis has been widely used in addition to measuring efficiency, as has been done by (baltas, 2005) to analyze differences in demand of food, (menoncin and vigna, 2013) to analyze financial markets, and (aysun et al., 2014) to analyze structural unemployment. frontier estimation on lowest level of educational inequality estimated by using maximum likelihood estimator (mle) method on public education function in equation (27) as conducted by (coelli et al., 2005) in estimating the frontier of a producer’s production level, formulated as follows. rpe gned gned k r m k r it it i i i it i i = − − = + − +( ( ) ( ) exp( ) exp * 1 1 1 2 1 2 β β β β )) = − it itonen mexp ( ). (29) rpeit = the role of public education supply in reducing educational inequality ki,ri = input variable in supply of public education function (1-gned)it = actual level of inequality condition (1-gned)* = the lowest frontier condition of the level of educational inequality. the stochastic frontier analysis in this study uses truncated normal distribution, therefore the frontier is supposed to involve parameters on the production input function and function parameter of the specific factors (coelli et al. 1998). based on that, the lowest frontier of the level of educational inequality is also determined by the factor of public education demand hence the difference between (1-gned)* and (1-gned) is caused role of demand side of public education thus can be seen that the inhibition of the low educational inequality achievement is thought to be influenced by factors from the agricultural sector and several other factors as follows. mit= α0+α1plsait+α2rlyasit+α3plgsit+α4piecit+α5fttit+α6 gnivit+εit (30) mit = role of demand side of public education that obtained the gap between the current level of educational inequality (actual) to the level of minimum educational inequality (frontier). plsa = percentage of school-aged labor (15–19 years) in rural (persons) rlyas = gross domestic product (gdp) per labor of agricultural sector (million rupiah/person) plgs = percentage of labor in agricultural sector of total labor (percent) piec = education consumer price index in rural areas ftt = farmers terms of trade index (ftt) gniv = rural income inequality index α0, αi = constants and parameter estimators (i = 1,2,… 7) 5. results and discussion based on the result of parameter estimation on public education stochastic frontier function result in yield value of r2 showing independent variable explains 64% from total variation of dependent variable. in addition, the fhit value of 27,153 indicates that the input variables of education collectively have a very significant effect on the equity of education. the result tabulation of parameter estimation on the supply of public education function presented in table 1 is generated using the index (1-gned), therefore all the signs of the parameters in the tabulation are counterclockwise to the level of educational inequality (gned). table 1 shows that the increase in government expenditure on education has a significant effect on the decreasing level of educational inequality at a 5% error level. these results indicate that increasing the amount of government expenditure will increase the output of education hence years of school per individual increases, which ultimately decreases educational inequality. these results are supported by the finding of diaz et al., (2016) which shows that the magnitude of education expenditure can increase the output of educational improvement. however, in developing countries and emerging markets this is very constrained given the low government revenues that most of the development funds come from foreign debt. the results tabulation in table 1 shows that not in every level of education the teacher influences significantly to the decrease educational inequality. negative sign of parameter estimation on educational inequality indicate that the increase in the number of elementary, junior secondary and senior secondary school teachers and the number of lecturers capable of reducing educational inequality, despite only the number of junior secondary school teachers and the number of lecturers which are significant. these findings indicate that the number of teachers is one of the important inputs in increasing the output of education and to reduce educational inequality. agasisti et al. (2016) also found similar findings indicating that the number of teachers has a significant effect on the increase of education output. findings of diaz et al. (2016) and (zoghbi et al., 2013) in according with the fact that the number of teachers has a significant effect on educational outcomes caused by the role of teachers who are inputs of human resources in producing educational output that is in the form of table 1: parameter estimation result of supply public education function variable estimated parameter t-ratio constant 4.493 16.168a gedu 0.064 2.502b ntbe 0.023 0.395 ntjs 0.046 2.573b ntss 0.026 0.556 nthe 0.017 2.064c nsbe −0.587 −11.376a njss −0.230 −3.523a nsss 0.561 8.475a nuhe 0.047 2.069b ols goodness of fit r2 0.637 f hit 50.432 a maximum likelihood estimator (mle) goodness of fit σ2 0.013 5.684a γ 0.901 27.561a lr test 124.873a source: processed data (2018) based on frontier 4.1.description: asignificant on α = 1%, bsignificant on α = 5%, csignificant on α = 10%, ols: ordinary least square bahari, et al.: impact of agricultural sectors and income inequality in rural toward role of public education in decreasing educational inequality in indonesia international journal of economics and financial issues | vol 9 • issue 1 • 2019156 academic ability to be able to continue to the next level. the level of significance of the number of teachers/lecturers to educational inequality shows the direction of allocation of human resource placement in public education. the allocation of the number of educational buildings is very significant in determining changes in educational inequality. from table 1, it shows that all educational building inputs have a significant effect on the 5% error level, but the impact of allocation of school building differs between levels. an increase in the number of senior secondary school buildings and the number of university buildings is very significant in reducing educational inequality. meanwhile, the increase in the number of schools at the primary and junior secondary school significantly increased educational inequality, this is meant a negative level of marginality. the excessive addition of school at primary and junior secondary school levels is an improper allocation because the level of educational participation (aps) at primary and junior secondary levels has reached 91% and 95%. meanwhile, education participation rate (aps) at senior secondary school and university level only reached 71.4% and 24.77% (bps, 2018). whereas the budget allocation for the construction of the building is very small compared to the teacher allowance (kemenkeu, 2017) and the percentage of the state senior secondary school level building only reaches 38.17% (bps, 2017). these conditions indicate the addition of excessive school buildings allocations at the primary dan junior secondary school will reduce the budget allocation for the construction of senior secondary school and university level schools, thereby increasing the educational inequality. according to tabel 1, the result using mle method on supply public education funcion shows that the lr-test value of 124.873 is bigger than the value of χ2 kodde-palm of 17.75, it means that the model used is very good in maximizing the probability which produce good parameter estimation. the sigma-squared (σ2) value of 0.013 has a significant effect which means that there is a significant effect of residual variation (vit–mit) which is a factor other than supply side of public education, which determines 1.3% of educational inequality level. while the value of gamma (γ) of 0.901 has a significant effect indicates the role variation from the demand side of public education (mit) that explains 90% of residual variation (vit–mit). the value of gamma (γ) indicates the significant impact of certain factors beyond the allocation of public education inputs that also determine the level of educational inequality. after estimating the minimum level of frontier education with the mle estimation method, it can be estimated the level of public education role in reducing educational inequality. table 2 shows that public education determines 83.8% of changes in educational inequality. this result means that there is a gap between the actual gned conditions and the frontier levels of potential gned educational inequality determined by the frontier function. the occurrence of this gap is caused by demand of public education influence factors that determine the amount of public education consumption that also affect the educational inequality. based on that, it can be seen that supply side of public education role dominates the change in the level of educational inequality of 83.8% and demand side of public education factor takes a role in determining 16.2%. demand side of public education is likely determined by factors such as agricultural sector performance and income inequality in rural areas. according to table 3 that shows the percentage of school-aged labor (plsa) has a positive and significant effect on the increase in educational inequality. school-age labor are caused by the poverty of agricultural households who do not have enough budget to finance their living needs much less to finance their family members’ education. given the capital of the working poor is just the working time, therefore there is a demand for increased household income leads the household to increase the total number of working hours of the household by increasing the number of family members to work. as a result, all family members were included to earn a living. the implications will result in schoolage family members being forced to work and drop out of school. school time is an opportunity cost for the household because the allocation of school time will reduce the allocation of time to work thus reducing household income, this is especially the case for poor households and low-income households. based on this, schoolaged workers caused by rural poverty will reduce educational attainment and increase educational inequality (agrawal, 2014; sim et al., 2016; todaro and smith, 2015). decrease of poverty in rural areas is important in reducing educational inequality. for rural communities, an increase in income will result in increased purchasing power of goods and services, including the purchasing power of education services. increasing the consumption of public education services will result in decreased educational inequality. all the variables that increase the income of the rural community will lead to decreased educational inequality. based on table 3 shows that the gdp per labor of agricultural sector has a negative table 2: level of public education’s role in reducing educational inequality percentage the extent of public education’s role in reducing educational inequality total (%) 0.91-1.00 8 (24.24) 0.81-0.90 14 (42.42) 0.71-0.80 9 (27.27) 0.51-0.70 2 (6.06) total 33 (100) minimum 0.569 maximum 0.983 average 0.838 source: processed data (2018) based on frontier 4.1 table 3: estimation result of factors demand side of public education affecting educational inequality variable estimated parameter t-ratio plsa 0.209 4.476a rylas −0.109 −4.130a plgs 0.121 5.847a piec 0.147 0.985 ftt −0.316 −1.861c gniv 0.134 1.548 source: processed data (2018) based on frontier 4.1. description: asignificant on α = 1%, bsignificant on α = 5%, csignificant on α = 10% bahari, et al.: impact of agricultural sectors and income inequality in rural toward role of public education in decreasing educational inequality in indonesia international journal of economics and financial issues | vol 9 • issue 1 • 2019 157 and significant effect on the level of educational inequality. that indicator is a description of the income level of the agricultural labor. the increase in income per labor in the agricultural sector (rlyas) generates income effects for rural households that will increase the purchasing power of education services. duchesne and nonneman (1998) and liu et al. (2006) found that household income levels will be able to provide great access for an individual to continue his education to a higher level. increased household income in the agricultural sector will reduce the constraints on education finance so that the achievement of the level of household education also increases. table 3 also shows that the percentage of labor in the agricultural sector on total labor or the share of labor in the agricultural sector (plgs) has a positive and significant effect on the level of educational inequality which means that the higher the share of labor in the agricultural sector will lead to an increase in educational inequality. the mobility of labor from the agricultural sector to the non-agricultural sector will encourage the population to be free of poverty and have a decent and higher income, low wages in agricultural due to excess labor in rural areas are subsistence wages (ghatak, 2005; menon and rodgers, 2017). even in indonesia, the ratio of gdp per labor in the agricultural sector, industrial sector and service sector is 1:3:7. the condition shows that the service sector is the sector with the highest income per worker rate in indonesia and is the most responsive growth sector in poverty reduction (bps, 2016c; suryahadi et al., 2009). the rural education customer price index shows (piec) an insignificant effect on the level of educational inequality, although the sign is as expected. the rural education customer price index is a proxy of education cost received by rural communities. an increase in price will decrease demand of education services level thus it will increase inequality. meanwhile, ftt has positive and significant impact on the level of 10% toward the level of educational inequality which shows that the success of farming is one of the determinants of increasing educational equality. ftt is also a proxy that describes the ability of purchasing power of farmers resulting from farming income. therefore, ftt is a form of pro-poor growth that encourages income effect for farmers’ households thus the total consumption of education services will increase, including the poor farmer’s household which depends on their farming income. the effects of pro-poor growth resulted in a decrease educational inequality in rural areas (epo and baye, 2016). these findings suggest a link between the agricultural sector and educational equity. the success of farmers in their farming will determine the level of education services consumption and will ultimately increase educational equity. the rural income inequality index represents the share of poor people in rural areas, increasing inequality showing the increasing number of poor people. the existence of income inequality in rural areas shows an increase in income is not evenly distributed in rural areas. the rural income inequality index (gniv) has a positive effect on the increase education inequality in rural areas even though it has no significant effect but is an important factor in preventing educational equity. due to the improvement of the poor and low-income groups is the community with the least education services consumption level compared with other community groups. the lower the income level will result in lower financing ability to continue education to the higher level (langsten, 2015). in the lower income class the education expenditure budget will be substituted faster than the daily expenditure requirement which indicates the demand for education will be more elastic at lower income class level (checchi, 2006). 6. conclusion based on the purpose and result of discussion in this research, it can be concluded briefly. excessive allocation of resources to the addition of school building inputs at primary and junior secondary school levels have negative impact on educational inequality. the allocation of government expenditures for education functions, improving teachers in junior secondary school education, improving teachers in higher education, and improving school buildings in senior secondary schools and college education have significant effect on reducing educational inequality. public education plays a role of 83.8% in influencing educational inequality and the remaining 16.2% is determined by factors from the demand side of education. although the role of public education is dominant to reduce education inequality but the role of demand side of public education also determines the rate of decline in education inequality. the demand side of public education which influences the level of education inequality is the decrease of the percentage of labor force at school age (15-19 years) in rural areas, the decreasing of labor force percentage of agricultural sector to total indonesian worker, increasing ratio of gdp on labor in the agricultural sector, and increase in the ftt. based on the conclusions of this study, there are some policy implications to accelerate the decrease in education inequality. government spending and public education are still the main instruments for the government in education. increased government spending on education functions and prioritizing increased share of input provision at higher levels of education which are increasing school for senior secondary and college education levels, as well as improving the number of teacher especially at junior secondary school, senior secondary school, and college. public education input allocation is not the only factor that determines the decline in educational inequality. the existence of demand-side factors also influence educational inequality. therefore, the government should take these factors into account in the various education policy decisions that must be done. the policy that can be done to decrease educational inequality is: (1) policy to increase income per worker of agricultural sector through increasing investment and foreign direct investment in agricultural sector, (2) policy to increase ftt (ntp) 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(2013), education production efficiency: evidence from brazilian universities. economic modelling, 31, 94-103. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.8-15 issn: 2146-4138 www.econjournals.com 8 effects of currency unions on foreign direct investment inflows: the european economic and monetary union case cuneyt kilic department of economics, biga faculty of economics and administrative sciences, canakkale onsekiz mart university, turkey. email:c_kilic2006@hotmail.com.tr yılmaz bayar department of business administration, faculty of business administration, karabuk university, turkey. email:yilmazbayar@karabuk.edu.tr feyza arica department of economics, biga faculty of economics and administrative sciences, canakkale onsekiz mart university, turkey. email:feyzarica@gmail.com abstract: reducing exchange rate and inflation, transaction costs and achieving the economic convergence among member countries are major causes of establishing a monetary union. this paper examines the effects of european economic and monetary union on inflows of foreign direct investments to the eurozone by using panel data from 16 group of 20 countries for the period 19992012. we found that real gdp, gdp growth rate and exchange rates of 16 group20 countries affect inflows of real foreign direct investment positively while exchange rate volatility, inflation volatility and distance affects inflows of real foreign direct investment negatively. so european economic and monetary union contribute to the inflows of foreign direct investment by reducing the exchange rate volatility, inflation volatility and distance and supporting economic growth. keywords: european economic and monetary union; group 20 countries; foreign direct investment; panel data analysis. jel classifications: e42; f15; f36 1. introduction european union (eu) has reached the stage of european economic and monetary union (emu) in the european integration process which began in 1950s. the transition to emu has occurred in three stages. removal of all the internal obstacles which prevented free movement of capital, goods, services and people in eu member countries was completed at the first stage between 1990 and 1994. the second stage of emu began with the establishment of european monetary institute in july 1994 and during the second stage technical preparations for the transition to the single currency, strengthening the fiscal discipline, activities aimed at convergence of economic and monetary policies of member countries were conducted, 11 eu member countries (austria, belgium, finland, france, germany, ireland, italy, luxembourg, netherlands, portugal and spain) which met the convergence criteria, formed the emu in may 1998, european central bank (ecb) and the european system of central banks were established in june 1998. the third stage of emu began with the introduction of euro on 1 january 1999 (european commission, 2007:7-9). the last stage of emu has continued nowadays, greece, slovenia, cyprus and malta, estonia and slovakia which met the convergence criteria joined the emu respectively on 1 january 2001, 1 january 2007, 1 january 2008, 1 january 2009, thusly emu has reached 17 member countries. foreign direct investment (fdi) flows increased in parallel with the globalization of financial markets and peaked with about 2 trillion united states (us) dollars in 2007 on the eve of global financial crisis, and then began to decrease with the negative effects of global financial crisis and the effects of currency unions on foreign direct investment inflows: the european economic and monetary union case 9 eurozone sovereign debt crisis. the share of eu-17 in total fdi inflow firstly increased from 25.91% in 1970 to 40.24% in 2012, and then decreased to 10.82% in 2012 with a downward trend (figure 1). figure 1.inward fdi flows in the world and eu (million us dollars at current prices) source: unctad, fdi statistics, http://unctadstat.unctad.org/tableviewer/tableview.aspx? reportid=88 there are lots of motives or determinants which cause enterprises to be a multinational enterprise (mne) in other words own or controls their activities in more than one country (dunning and lundan, 2008:3). many studies have been conducted in order to determine the motives behind fdi. assunção et al. (2011) summarize these studies as follows in table 1: table 1.summary of theories of fdi determinants theory/theoretical approach determinants heckscher-ohlin model / macdougall-kemp model higher return on investment, lower labor costs, exchange risk market imperfections ownership benefits (product differentiation), economies of scale, government incentives product differentiation imperfect competition oligopoly markets following rivals, responding to competition in domestic market product life cycle production function characteristics behavior theory fear of loss of competitive edge, following rivals and increased competition at home internalization market failures/inefficiencies know-how, market failures oli (ownership, location, internalization) paradigm benefits of owning productive processes, patents, technology, management skills advantage of locating in protected markets, favorable tax systems, low production and transport costs, lower risk advantage of internalization cutting transaction costs, lowering risk of copying technology, quality control new trade theory market size transport costs barriers to entry factor endowments institutional approach political variables financial and economic incentives tariffs tax rate source: assunção et al., (2011: 3). international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.8-15 10 in this context emu has potential to affect fdi inflows through reduced exchange rate volatility, increasing market size and trade volume, reduced transaction costs and increased price transparency (dinga and dingová, 2011:2). the effects of exchange rate risk on fdi are mixed. while cushman (1988) and markusen (1995) find a positive relationship between exchange rate volatility and fdi, zis (1989), tavlas (1991), dixit and pindyck (1994), wei and choi (2002), servén (2003), de sousa and lochard (2009), schiavo (2007) and petroulas (2007) found a negative relationship between exchange rate volatility and fdi. so it is uncertain whether the reduced exchange rate volatility will affect fdi inflows to the eurozone positively or not. on the other hand elimination of exchange rate risk and reducing currency conversion costs by emu decreases transaction costs and thusly leads to cost saving and affects returns positively (dinga and dingová, 2011:2). so it is expected that emu affects fdi positively by reducing transaction costs. moreover wei and choi (2002), aristotelous (2005) found that increasing market size and economic growth rate, which mean larger demand, affect fdi inflows positively. this paper investigates the effects of real gdp (size of the host market), change in gdp (growth of the host market), exchange rate volatility, inflation rate volatility (price stability), distance between capital of countries and frankfurt (transaction cost) on fdi inflows to the eurozone and exchange rates of 16 group of 20 (g20) countries by using panel data regression based on a data set of 16 g20 countries (except france, germany, italy using euro and the european commission) for a period of 1999-2012. we will disregard the potential negative effects of 2008 global financial crisis and the ongoing eurozone sovereign debt crisis. the remainder of this paper is organized as follows. section 2 outlines the previous literature, section 3 discusses the data, and section 4 considers the empirical methodology and presents the empirical findings. section 5 concludes the paper. 2. literature review many studies have been conducted to determine the effects of monetary arrangements on international trade such as rose (2000), frankel and rose (2002), micco et al. (2003). on the other hand there have been limited studies on the effects of monetary arrangements on fdi. the gravity model has been used in the most of the studies such as adam (2013), flam and nordström (2007), petroulas (2007), schiavo (2007), brouwer et al. (2008), de sousa and lochard (2009 and 2011), jienwatcharamongkhol (2010), dinga and dingová (2011), folfas (2012), panel regression model was used in some studies such as pantelidis et al. (2012), aristotelous and fountas (2012), aristotelous (2005) and wei and choi (2002). adam (2013), aristotelous and fountas (2012), de sousa and lochard (2009 and 2011), jienwatcharamongkhol (2010), brouwer et al. (2008), petroulas (2007), schiavo (2007), aristotelous (2005) and wei and choi (2002) found that emu affected fdi inflow positively, while kyrikilis et al. (2013), dinga and dingová (2011) and flam and nordström (2007) found that euro had no significant impact on fdi. adam (2013) examined the effect of currency union membership on fdi inflows to economic community of west african states by using gravity model during a period of 1995-2010. he found that the currency union had positive effects on fdi inflows. de sousa and lochard (2011) examined the effect of emu on fdi by using gravity model and they found that emu has increased intra-emu fdi stocks on average about 30%. in another study aristotelous and fountas (2012) also examined the effect of emu on fdi inflows to the eurozone by using panel data from 22 oecd countries for the period 1973-2006 and they found that emu had a statistically significant positive effect on fdi inflows to the eurozone countries and the emu effect on fdi inflows differs substantially across member countries. jienwatcharamongkhol (2010) examined the effect of emu on intra-eurozone fdi flows by using the gravity model with fdi inflows of 24 countries during a period of 1993-2007 and he found that the emu had positive effects on intra-eurozone fdi inflows. brouwer et al. (2008) examined the effects of potential enlargement emu on trade and fdi by using gravity models with a data set of unbalanced panel data including the bilateral trade flows among 29 countries and the distribution of outward fdi stocks among these countries during a period of 1990-2004. they found that there was a complementary relationship between trade and investment and emu had positive effects on fdi. effects of currency unions on foreign direct investment inflows: the european economic and monetary union case 11 petroulas (2007) also examined the effect of emu on fdi inflows from 18 oecd countries by using a gravity based general equilibrium approach during a period of 1992-2001. he found that the launch of euro increased fdi inflows within the emu. on the other hand schiavo (2007) examined the effect of emu on fdi flows by using a gravity model on a sample of 25 developed countries for the period of 1980-2001and he found that currency unions had a positive impact on fdis and increases in exchange rate uncertainty hindered cross-border investment flows. aristotelous (2005) examined the effect of emu on the us fdi flows into the eu by using panel data from 15 eu countries for the period 1966-2003. he found that emu had a positive and statistically significant effect on us fdi flows into the eurozone countries and also there was a positive relationship between host country’s real gdp, real gdp growth rate, relative labor costs, real exchange rate and fdi, and a negative relationship between exchange rate volatility, distance and fdi. in a similar study wei and choi (2002) examined the effects of currency unions including european monetary system and dollar blocs (panama, hong kong and argentina) on international investments by using bilateral fdi from 16 source countries to 57 host countries with panel regression. they found that decreases in exchange rate volatility caused increases in fdi. on the other hand kyrkilis et al. (2013), folfas (2012), dinga and dingová (2011) and flam and nordström (2007) found that euro had no significant impact on fdi. kyrkilis et al. (2013) examined the intra eu-fdi position of various emu countries during a period of 1985-2011 and they found that the emu had no significant impact on fdi inflows across member countries. folfas (2012) also examined the effects of the emu on international flows among the eu member countries by using gravity model during a period of 1995-2010. he found that exchange rate volatility didn’t affect bilateral fdi flows and stocks between eu member countries. dinga and dingová (2011) examined the effects of euro on international fdi flows by using gravity model with data on 35 oecd economies during a period of 1997-2008. they found that the euro had no significant impact on fdi and there was a positive relationship between gdp and fdi, and a negative relationship between distance, unit labor costs, long term exchange rate volatility and fdi. pantelidis et al. (2012) examined the effects of the emu on fdi inflows by using panel regression during a period of 1980-2010. they found that emu had statistically negative effect on fdi inflows to greece, portugal, france, belgium and spain, while germany and ireland had statistically insignificant negative correlation and finland and netherlands had a statistically insignificant positive correlation between launch of euro and inward fdi. 3. data and model we used a sample covering a period of 1999-2012 to examine the possible effects of emu on inward fdi flows to the eurozone. eleven eu countries were a member of emu at the beginning of last stage of emu on 1 january 1999, but the number of eurozone member countries has reached 17 eu countries as of 1 january 2009. we examined the possible effects of emu on fdi flows from 16 g20 countries (argentina, australia, brazil, canada, china, india, indonesia, japan, mexico, russia, saudi arabia, south africa, south korea, turkey, united kingdom and the united states of america) except the eurozone member countries to the eurozone member countries. e views 7.0, gauss 6.0 were used for the analysis. we examined the relationship between real fdi inflows and real gdp, real gdp growth rate, inflation volatility, exchange rate volatility, distance, exchange rates of 16 g20 countries in terms of euro with a panel data analysis. the model is following as: 0 1 2 3 4 5 6. . . . . .it it it it it it it itrfdi gdp gdpgr infvol exvol dist meuro e              (1) a description of the variables used in this study and their data sources follows: the dependent variable, rfdi, is real fdi inflows to the eurozone. the nominal fdi inflows to the eurozone are taken from united nations conference on trade and development (unctad) and converted to real value by dividing gdp deflator. the first independent variable, gdp, is the eurozone’s real gdp measured in euros at constant 2000 prices and it is an indicator of the market size. the data on gdp are taken from international monetary fund (imf). international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.8-15 12 the second independent variable, gdpgr, is the real gdp growth rate of the eurozone and it is an indicator of change in the aggregate demand of the eurozone. the data on gdpgr are taken from international monetary fund (imf). the third independent variable, infvol, the inflation rate volatility of home country, is found byusing an garch(1,1). the fourth independent variable, exvol, the exchange rate volatility of home country, is found by using an garch (1,1). the fifth independent variable, dist, is the distance between the capital of each home country and frankfurt which is generally accepted as the industrial center of the eurozone and is taken as an indicator of market agglomeration effects within the eurozone. the data on dist are taken from http://www.timeanddate.com/worldclock/distance.html. the final independent variable included in the regression (1) is meuroit. meuro is exchange rate of selected g-20 countries in terms of euro. the data are taken from european central bank (ecb). 4. econometric methodology and empirical findings we firstly apply pesaran and yamagata’s (2008) homogeneity test, which modified swamy’s (1970) dispersion test for the panels. an homogenous panel data model (or pooled model) is a model in which all coefficients are common while an heterogeneous panel data model is defined as a model in which all parameters (constant and slope coefficient) vary across individuals (hurlin, 2010). the estimation methods differentiate in accordance with the selection of a homogenous panel or heterogeneous panel data. we follow pesaran and yamagata (2008)’s delta_tilde test statistic in order to determine whether slope coefficients vary across individuals because the cross section dimension is large relatively to the time dimension in the study. results of the homogeneity test of pesaran and yamagata (2008) are presented in table 2. according to pesaran and yamagata (2008), the problem of the small sample can be overcome under the normally distributed errors by considering mean and variance bias adjusted version, delta_tilde_adjusted. thus, we rely on the results regarding delta_tilde_adjusted statistic in table 2. because the p-value of delta_tilde_adjusted is bigger than 0.05 significance level we cannot reject that slope coefficients don’t vary across individuals. that is, it is clear that the null of hypothesis pesaran and yamagata (2008)’s homogeneous test isn’t rejected at 95%. table 2.pesaran and yamagata (2008)’s homogeneity test test statistic p-value delta_tilde -1.721 0.957 delta_tilde_adjusted -2.357 0.991 source: authors’ calculations. according to yule (1926), who introduced spurious regression problem and further analyzed by granger and newbold (1974) using non-stationary time series steadily diverging from long-run mean will produce biased standard errors, which causes to unreliable correlations and unbiased estimations within the regression analysis leading to unbounded variance process (korap, 2007). in order to get unbiased estimations, we investigate the existence of unit root in the series. we have used the approach of levin, lin and chu (llc) (2002) as the unit root test. llc (2002) assume homogeneous autoregressive coefficients between individual. i.e. for all i, and the null hypothesis of the test is against the alternative for all i. the structure of the llc analysis may be specified as follows: i = 1,…, n t= 1,…,t where is trend, is individual effects, is assumed to be independently distributed across individuals. llc estimate to this regression using pooled ols. results for the panel unit root tests are showed in table 3. i  : 0o ih    : 0a ih    , , 1 , 1 . . . jp i t i i i t i ij i t j it j y y y u               i it u effects of currency unions on foreign direct investment inflows: the european economic and monetary union case 13 table 3.panel unit root test variable llc constant constant trend rfdi -2.924 [0.00]* -7.956 [0.00]* gdp 9.957 [1.00] -2.66 [0.00]* dlgdp -9.389 [0.00]* -10.070 [0.00]* gdpgr -10.013 [0.00]* -11.215 [0.00]* infvol -63.460 [0.00]* -85.160 [0.00]* exvol -4.892 [0.00]* -5.986 [0.00]* meuro -16.930 [0.00]* -4.831 [0.00]* numbers in brackets are p-values. * indicates the statistical significance at 1% level. the max lag lengths were set to 2 and schwarz bayesian criterion was used to determine the optimal lag length. d is the first difference operator and l denotes the logarithm of the variable. according to llc, only gdp is not level stationary variable for constant model. but we can clearly reject the null hypothesis of unit root for the other variables at1% significance level. similarly, this result is obtained by taking log-first difference of gdp. we estimate equation (1) using the panel least squares estimation procedure. table 4 reports the results of the panel least squares estimation procedure. the estimates are obtained under the assumption that the intercept and slope coefficients are identical for the different cross-sectional units. the results presented in table 4 are statistically significant. table 4.panel least squares estimates dependent variable: rfdi variable coefficient std. error t-stat prob. c -51234.80 13013.33 -3.937 0.000** dlgdp 6669.052 1154.557 5.776 0.000** gdpgr 2188.138 560.7966 3.901 0.000** infvol -14.17321 1.978746 -7.162 0.000** exvol -0.000281 4.55e-05 -6.172 0.000** dist -0.80050 0.4469 -1.791 0.074* meuro 82542.79 11432.06 7.220 0.000** *,**indicate the statistical significance at 10 and 1% level, respectively. the impact of real gdp, real gdp growth rate and exchange rate of selected g20 countries in terms of euro on fdi inflows is found positive and statistically significant, while the impact of exchange rate volatility, inflation volatility and distance on fdi is found negative and statistically significant. so the demand-related factors, such as market size and market growth, respectively measured by the host country’s real gdp and real gdp growth rate, are statistically significant determinants of real fdi inflows. similarly, supply-related factors, such as distance, inflation and exchange rate volatility and exchange rate of foreign currency against euro are also statistically significant determinants of real fdi inflows. 5. conclusion the introduction of the euro was both an immense political and symbolic step towards an integrated europe. this currency affects economic activity ranging from trade and foreign direct investments to wage-setting behavior and corporate business strategies. the euro exerts influence on many economic activities, one of them being the flow of capital among countries resulting from the removal of restrictions on investment location decisions. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.8-15 14 the 2008 global financial crisis raised a challenge for nations to reconsider the decision to join the monetary union. the investigation of the economic impacts of the economic and monetary union is an important issue for both future euro-zone members and other world countries. thus the impact of the euro on international transactions has become a major concern. on the other hand, the impact of emu on foreign direct investment turns out to be the key issue in macroeconomics. monetary integration may strengthen foreign investments, since it reduces macroeconomic uncertainty, exchange rate and inflation volatility, transaction costs. the creation of the european monetary union, exchange rate stability, inflation stability, inflation stability, distance, gdp growth are important factors behind fdi flows. from this point of view, we examined the possible effects of the emu on fdi inwards from 16 g20 countries by examining the relationship between real fdi inflows and real gdp, real gdp growth rate, exchange rate volatility, inflation volatility, distance, exchange rates of selected g20 countries in terms of euro for a period of 1999-2012. we found that real gdp, gdp growth rate and exchange rate of selected g20 countries affect inflows of real foreign direct investment positively while exchange rate volatility, inflation volatility, distance affects inflows of real foreign direct investment negatively. an exchange rate stability and price stability were achieved in the eurozone countries after establishment of emu and also emu contributed to the reductions in transactions costs and the eurozone member countries achieved significant economic growths until the outburst of global financial crisis. so emu contributed to the fdi inflows via decreases in exchange rate volatility, inflation rate volatility and transaction costs together with increases in gdp and gdp growth rates especially in first years of emu. in order to contribute suggestions to improve future researches, this study could address other policies, which aim at stronger economic integration, such as single euro payment area, target2, which affect the pan-european multinationals. we hope that the analysis presented here offers a convenient framework within which further empirical and theoretical researches on such issues can be conducted. references adam, a.m. (2013), currency union and foreign direct investment inflow: evidence from economic community of west african states (ecowas). far east journal of psychology and business, 11(2), 49-58. aristotelous, k. 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(1991), benefits and costs of entering the eurozone. cato journal, 24, 89–106. time and date (2013), distance calculator-how far is it?. http://www.timeanddate.com/worldclock/ distance.html, (27.08.2013). united nations conference on trade and development (2013), unctadstat. http://unctadstat. unctad.org/reportfolders/reportfolders.aspx, (21.07.2013). wei, s-j., choi, changkyu. (2002), currency blocs and cross border investment. unpublished manuscript. yule, g. (1926), why do we sometimes get nonsense correlations between time series? a study in sampling and the nature of time series. journal of royal statistical society, 89, 1–64. zis, g. (1989), is there still a case for flexible exchange rates? british review of economic issue, 11, 1-20. international journal of economics and financial issues vol. 1, no. 2, 2011, pp.19-32 issn: 2146-4138 www.econjournals.com financial liberalization and banking profitability: a panel data analysis for tunisian banks hakimi abdelaziz e-mail: abdelazizhakimi@yahoo.fr phone number: +216 97 089 263 higher institute of management of sousse address: essanabel post office bp n° 554 jendouba tunisia djelassi mouldi leo – université d’orléans, & higher school of economics and business of tunis –essect e-mail: mouldidjlassi@yahoo.fr hamdi helmi central bank of bahrain/ financial stability directorate. p.o box 27, manama, kingdom of bahrain. e-mail: helmi.hamdi@cbb.gov.bh abstract: the financial liberalization policy was undertaken in several countries like in tunisia in order to have modern and dynamic financial system. however, the consequences of this program are completely divergent from it’s waitings. on the basis of data relating to 9 tunisian banks over the period 1980-2009, and by adopting the panal data analysis, the aim of this paper is to check the effect of financial liberalization on the tunisian banking profitability. the results of our study show a negative and significative relation between financial liberalization and banking profitability. jel classification : e44, g21, l51, n24 key words : financial liberlization, banking profitability,empirical study, panel data, tunisia 1. introduction following the recommendations of the authors of financial repression school, several countries undertook programs of financial liberalization. these actions are in waiting to modernize and instigate financial system. several theoretical and empirical studies were centered on the relation financial liberalization and financial instability, banking crises or bankruptcies. whereas the relation between financial liberalization and banking profitability were timidly studied. the relation between financial liberalization and banking profitability present a paradoxical aspect owing to the fact that there are two antagonistic currents of them. the first one is articulated around the school of financial repression and which admits the founded good of financial liberalization. another finds its roots in work of the authors of neostructuralist school underlining the harmful effect of financial liberalization. the absence of a consensus with regard to the effect of financial liberalization on the banking profitability encourages us to check this relation in a tunisian context. with this intention, our objective is to study the effect of financial liberalization on the profitability of the tunisian banks. in other words, financial liberalization supported the profitability of the tunisian banks or quite to the contrary it is at the origin of its deterioration. the articulation of this paper will be as follows: we will briefly present a review of the literature based on this subject in the first part. the second part will be devoted to study the theoretical base of financial liberalization and its implications. the theoretical international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.19-32 20 framework, followed methodology as well as the results of our study appears in the third part. in the last part we concluded. 2. literature review the study financial liberalization effect on banking profitability was often included in the relation financial liberalization brittleness or banking crisis. this inclusion goes up with the importance of the profitability of the banks like indicator of brittleness. some studies which studied exclusively this relation. fisher and chenard (1997) showed that financial liberalization decreases banking profitability. in this direction, and by the liberalization of the credit rates, it results a financial increase in the financial expenses banking (interests poured with the customers). what involves a reduction in banking profitability as measured by the report of the margin of intermediation on total assets. in the same way the lifting of framing of credit (liberalization of the debtor rates, liberalization of the credit) encouraged the banks to take more risk while seeking to be more profitable. this taking risk is often rewarded by an increase in default risk. barajas, steiner and salazar (1999), in their study relating to the case of colombia showed that financial liberalization affects the banking margin of intermediation. if this margin were not reduced, it knew a deterioration of the quality of the credit distributed. in other words, it results an increase in the banking profitability which is the resultant of the liberalization of the debtor rates. however, this margin will be affected negatively by the bad quality of credit. demerguç-kunt and huizingha (2001) studied the impact of the financial development on the banking profitability. by using banking data relating to developed countries and others in the process of development over the period 1990-1997, it showed that the financial development exerts a significant effect on the banking performance. they also led so that a high level of banking development affects negatively the banking performance. this result is explained by the fact that this development will accentuate the banking competition which decreases the performance of the banks. these authors concluded that the development of the financial market and that of the banking structure are proportional so that it has a complementarity between the two. other authors centered their studies on other determinants which can influence profitability. into this direction, macro-economic variables are introduced with the modeling of the profitability of the banks. among those macroeconomic we can notes the interest rate, the inflation rate and the gross domestic product (gdp) (okpara 2010). with regard to the banking variables most significant we find the liquidity, the size of the bank, the level of risk, the adequacy in capital... afanasieff et al. (2001), by using the technique of the panel data for the case of brazil concluded that the macro-economic variables have a significant effect on banking profitability. guru et al. [2002], while being based on data relating to 17 malaysian trade banks over the period 19861995, stressed the importance of the bank deposits like determinant of the performance of these institutions. demirguç-kunt. a and huizingha (2001), while serving as the banking data relating to 80 countries over the period 1988-1995, examined the determinants of banking profitability. the variables introduced into their modelling concern the banking characters, the macro-economic conditions and the financial structure. other authors showed that financial liberalization exerted harmful effects on the banking structure. they affirm that the financial opening accentuated financial instability, the banking brittleness and bankruptcies as well as the decline of the economic growth. at this level, demirguçkunt and detragiache (1998), fisher and chenard (1997), highlight the existence of a relation between financial liberalization and banking brittleness. after having briefly passed by the literature concerning the relationship between financial liberalization and banking profitability, we will try in the second part to present the theoretical base of financial liberalization and his implications. 3. financial liberalization and its implications by admitting the harmful effect of financial repression on the development and the economic growth, several developed countries and under development adopted policies of liberalization of their financial systems following the recommendations of the authors of the financial repression school. financial liberalization and banking profitability: a panel data analysis for tunisian banks 21 3.1 the financial repression school the financial liberalization literature emanated towards the beginning of the seventies at the time of the construction of financial repression school by works precursors of mc kinnon (1973) and shaw (1973). according to these two authors, financial liberalization is the only effective means to develop banking intermediation, to start again the capital accumulation and to promote the economic growth in the countries. these authors come to present the misdeeds of financial repression and to defend the founded good of financial liberalization. the approach of mc kinnon (1973) and shaw (1973) was well accommodated by other partisans who come to share the same point of view of these authors with regard to the beneficial effect of financial liberalization. among these authors: kapur (1976), which was one of the first to supplement the analysis of these two authors by integrating it in a dynamic model. this reveals that it is preferable to rather increase the nominal rate been useful on the deposits than to reduce the rate of growth of the money supply. indeed, the first sequence makes it possible to achieve two objectives simultaneously: on the one hand, it allows the reduction of inflation thanks to a reduction in the request for currency; in addition, it is at the origin of a direct stimulation of the saving. galbis (1977) is considered one of the partisans of the school of financial repression. it built a model with two sectors: a traditional sector where the output of the capital is constant and weak and a modern sector where the output of the capital is also constant but higher. the first sector proves to be able to finance its investments completely, whereas the second ensures the financing of his investments by his saving and by the bank loans. indeed, financial liberalization impelled by the rise of the real rates of deposits leads to an increase in the average productivity of the investment, insofar as it allows a displacement of the saving of the traditional sector towards the modern sector. lastly, from the recent models come to enrich the initial approach by mc kinnon (1973) and shaw (1973). it is the case, in particular, of work of roubini and martin (1992). their model aims to study the consequences of the exogenic distortions on the financial markets on the long term growth. like the approach of mc kinnon (1973) and shaw (1973) well was answered and accommodated by several authors, others come to criticize it by admitting the direct effect of financial liberalization on financial instability, the deterioration of the banking financial state, brittleness, the crises and the banking bankruptcies. this new current is articulated around the authors of the school neostructuralist. 3. 2 the neostructuralist school the neostructuralist school is articulated around work which comes to dispute the approach of mc kinnon (1973) and shaw (1973). they affirm that the financial liberalization accentuated financial instabilities, banking brittleness and bankruptcies as well as the decline of the economic growth. at this level, demirguç-kunt and detragiache (1998), fisher and chenard (1997), highlight the existence of a relation between financial liberalization and banking brittleness. aljandro. c diaz (1985) in its famous article “goodbye financial repression, hello financial crash” showed that the passage from a situation of financial repression to another of financial liberalization accentuated the financial instability and crises. indeed, although the approach of mc kinnon (1973) and shaw (1973) was accommodated and enriched well by several authors that does not prevent from announcing that it noted a certain number of problem. initially, the theory of financial liberalization supposes an increasing relation between the real interest rate and the saving. this assumption does not take account of the substitution effect and the returned effect. on the contrary, the theory of financial repression supposes a decreasing relation between saving and interest rate. second, the approach of mc kinnon (1973) and shaw (1973) is founded on the implicit assumption that financial market is perfect, whereas stieglitz and weiss (1981) showed that the credit markets suffer from an imperfection of information. this informational imperfection can lead to processes of anti-selection. a third problem is opposed to the mc kinnon and shaw approach which comes to relate to the difference between the expiries from the assets and engagements. lastly, the sequence of mc kinnon and shaw suppose the existence of a relationship between the informal financial sector and financial repression. on the contrary jensen (1989) stresses that the existence of an informal financial market is not forcing the proof necessary of financial repression but rather the demonstration of a particular organization of the production and marketing. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.19-32 22 3.3 implications of financial liberalization the majority of the theoretical studies which covered the subject of financial liberalization announced the harmful effects of this phenomenon more than on these beneficial effects. but we should not be naive by studying the implications of financial liberalization, but rather we will take a nuance of the effects. it is true that financial liberalization was on several parts “culprit” but one should not omit that it was beneficial on other parts with knowing the saving and the investment. 3.3.1 beneficial effects of lf according to venet (1994), financial liberalization was beneficial only on the saving and the investment. with the liberalization of credit rates, it results an increase in the financial saving in waiting in a strong remuneration of deposits. this increase can only stimulate the investment. effects on the saving and the investment according to mc kinnon (1973) and shaw (1973), financial liberalization ensures a better mobilization of capital. in particular, allowing a better adequacy between the investment and the saving, and an acceleration of the process of economic growth. in a study relating to seven asian countries, fry (1978) led so that the real credit interest rate affects positively the national saving. diery and yasim (1993) concluded that the real credit interest rate acts positively in the constitution of the saving in nine countries of africa. in the same way, bandiera and alii (2000), analyzing the impact of financial liberalization on the mobilization of the saving, they found that financial liberalization has a positive and significant direct impact on the saving. by liberalization of the credit rates, and while believing in a strong remuneration, the depositors will resort to save their capital. it results an accumulation of capital what makes it possible the bank to hold a strong financial intensity. once the saving is favoured (financial saving), the bank can meet all the needs for these customers in term of financing. the investment will be thus favoured and each investor finds the optimal financing of his project. if the saving and the investment were the beneficial effect of financial liberalization what it does prevent the economic growth of mc kinnon (1973) and shaw (1973)? according to these two authors, the policy of financial liberalization is work to involve an increase in saving, a stimulation of the investment and thus an economic growth. what escapes from their equation it is the reciprocal behaviour of the two institutions (banks/firms). in other term, by it rationality and prudence the bank will finance the investments of the companies, on the one hand? and in addition how the company it will react with the received initial credit? and how will it maintain the determinants of a good future banking relationships? the relation saves, investment and economic growth is a relation of long term. once one of those components is not respected, this relation will never be checked. 3.3.2 harmful effects of lf the emergence of new banking behaviours the changes which the banking environment following the adoption of financial liberalization policy are at the origin of the birth of new banking behaviours. it is in particular about the taking risk and the speculative behaviour. a great responsibility for propagation of these two behaviours goes up with the phenomenon of hazard moral.  the excessive risk taking several recent analyses sought to study why certain banks remain failing while others prove to be healthy following the process of financial liberalization. the results of these analyses have leaded to the same conclusion so that the failing banks took more risk, which justifies the higher level of profitability recorded with before of the failures and the banking crises (miotti and plihon, 2001). now let us try to clarify the concept of risk taking as well as the explanatory factors. the risk taking consists with an orientation towards the selection and the financing of the risky projects which require high yields. to search more profitability, banks distribute bad credits which require high yields but also to strong probability of defect. the explanation of the risk taking is as follows, by giving to the banks a great liberty of action, financial liberalization increases the opportunity of risk taking. in fear to see their profits lowered and to support possible losses, following the rise of competition, banks are encouraged to finance bad customers. this behaviour would be supported by the public mechanism of protection (pdr). an excess of risk taking, is likely to involve a banking fragility often followed by banking failures and crises. in addition to, the risk taking supported by the financial liberalization and which is likely to involve banking crises, the banks developed a speculative behaviour. financial liberalization and banking profitability: a panel data analysis for tunisian banks 23  the speculative behaviour the concept of speculation consists with a detention of a good (purchase or sale) with an intension of resale on a later date and not the intention of later use. the speculative behaviour was justified by the policy of financial liberalization as by the financial innovations which facilitated the entry of new national or foreign speakers on the financial market. at this level, the banks undergo the competition of direct finance. the access of the borrowers to a direct financing decreases the profitability of the traditional banking operations. confronted with a potential reduction of their operations and their returned, the banks are encouraged to react by raising the mean level of risk of their operations by developing operations of speculative nature. the emergence of new banking behaviours, namely the risk taking and the speculative behaviour goes up with the problem of moral hazard induced by the policy of financial liberalization. the stressing of banking and financial risks the vast program of financial liberalization undertaken within the framework of the emergent countries was followed by an evolution of the banking and financials risks. in this part we will show the transmission channels between financial liberalization and the principal banking and financial risks with knowing the credit risk, liquidity risk, exchange rate and interest rate risk. the easing of banking activity through the lifting of framing of credit gave a great action as regards fixing of interest rates and the distribution of credit. indeed, the banks sought to be more profitable what makes an excess of distributions of credit in spite of the quality of those credit “good or bad”. the “bad” credit distributed will be rewarded by diversions for the fact of the incapacity for the borrowers to honour their engagements what involves a stressing of credit risk. with regard to the liquidity risk, the reform of liberalization of deposit interest rates made involve an increase in banking liquidity which remains less significant to the quantities of credit distributed, on the one hand, and dependent on the depositor’s decisions which can constantly to withdraw their capital in an unforeseen and massive way, on the other hand. what involves an increase in liquidity risk? following the financial liberalization policy, it results an increase in interest rate risk. the explanation is as follows: the easing of the restrictions concerning the mobility of the capital within the framework of the programs of financial liberalization, made the financial institutions and nonfinancial more sensitive to the interest rate risk. indeed, a lender at a variable rate undergoes the risk to see its incomes decreased if the rates drop. also, if the interest rate is fixed, in the event of rise of rate, this lender undergoes an opportunity cost to see his incomes decreased. on the contrary, a borrower at a variable rate court the risk to see its financial expenses increased if the rates go up. if the rate is fixed, this borrower undergoes the risk if the rates decrease. at this level, a definition of the position of the rates is necessary. the position of the rates measures the exposure of the company to the risk of rate; it gathers all engagements and the assets of the company, current, future or conditional, at fixed and fluctuating rate. in connection with the direct effect of the financial liberalization on the risk of rate of exchange, kaminsky and reinhart (1999), find that 56% of the banking crises, which are due to the policy of financial liberalization as being the central cause, were followed by crises of exchange. the exchange rate risk within the framework of a policy of financial liberalization can be summarized simply as follows: the financial opening resulted in the massive entry of the capital like by a level of very high debt on behalf of the poorest countries into those richest. the exchange rate risk is resulted when the national currency (the borrower country) is depreciated compared to the foreign currency (lender country). or an appreciation of the foreign currency compared to the local currency. considering the financial dependence of the poor countries as regards liquidity towards the countries with excess of liquidity (massive debt, placement from abroad), the borrower countries will undergo the difference between the two rates of exchange. banking fragility the policy of financial liberalization was adopted by several emergent countries in order to modernize and instigate the financial system in general and the banking system in particular. this liberalization, according to waiting’s' of the developing countries and developed, should support the growth and the economic development such as is the recommendations of the authors of the financial repression school. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.19-32 24 the observation of the facts suggests that the financial liberalization is beneficial only on the saving and the investment, following the liberalization of the credit rates and the liberalization of the capital account. it results from it indeed, an increase in liquidity what will stimulate the investment. this positive effect is only at a short-term and uncertain; the explanation is as follows: an uncertain positive effect owing to the fact that the investors can constantly and in an unforeseen way to withdraw their capital by seeking other refuges generating a higher output. positive effects in the short term since the banks become increasingly speculative in the absence of a control and sufficient supervision. the banks start the excessive risk taking by financing projects of bad qualities and which require high yields. this will be reflected negatively on the quality of investment of the companies on the one hand, and on the solvency of these last towards the banks on the other hand. from where a deterioration of the financial situation of these institutions it is on this level that several authors centred their research. as an example, demirguç kunt and detragiache (1998), klaus and chenard. (1997), hermosillo and pazarbasioglu (1997). these authors come to underline the harmful effect of financial liberalization like a source of banking fragility. banking crises several theoretical and empirical studies showed the central role of financial liberalization in the occurrence of the banking crises. the literature of the banking crises developed with the courses of second half of the 90 years, following the propagation of the banking bankruptcies and financials difficulties in the world. the successes experiments of financial liberalization are very rare and in the general case, liberalization causes banking and financial crisis accompanied by a brutal fall of the growth and a contraction by the gdp. according to sandretto (1994) “the financial crises are not a new phenomenon, since during twenty last years 125 countries were confronted with this problem whose half of the crises affecting the countries in process of development”. in this direction, several developed and under countries have undergoes the weight of the banking crises after having liberalized their financial systems. the countries of the south are asian (thailand and korea de sud) and of latin america (chilie and argentina) are the more touched. let us take the example of the asian country and more precisely thailand which was the first touched by the banking crises. indeed, the consequences of financial liberalization inform to an inadequacy between the banking system and the measurements of opening, owing to the fact that this last was not well equipped to accommodate profound and radical changes. the competition between the financial institutions induced by the high number of the speakers led to the abolition of the dominant position of the banks. following the policy of financial liberalization, the economic actors find a great action; the banks can freely allocate the capital. banks adopt a new speculative and opportunist behaviour and an excessive risk taking owing to the fact that the risky projects require high yields. these radical modifications are at the origin of the stressing of asymmetry of information what make difficult the role of the supervisors. this imperfection of information combined with the weak monitoring, will support moreover the excessive risk taking. indeed, the most general explanation of the excessive risk taking rests a great part on the responsibility for the financial liberalization. all these failures and banking fragility combined with an unfavourable institutional macroeconomic context are at the origin of an effective banking crisis in 1983. in the case of south korea, the financial crisis was actually started when the government decided in 1997 to not support chæbols in financial difficulty. chæbols is an industrial conglomerate largely turned towards export. to finance their investments, they have recourse to a financing by a debt towards the domestic banking and financial system. consequently, banks would be dependent on the health of chæbols because of their significant credits held on the latter. during the years which preceded the crisis, chæbols tried to increase their shares of market, with this intention they have resorts to a debt from the international markets. because of the surplus capacities of overproduction, chæbols are found in financial difficulty marked by a reduction of their profits and an unbalance between their debts and their assets which are not of the same maturity. this situation will lead the foreign creditors to reduce their exposure to the korean risk and to cut the credit line, from where an effective crisis in 1997. for the case of the countries of latin america, and more precisely the chilie, diaz aljandro (1985) finds that, the results of chileans financial liberalization were catastrophic. as of the first financial liberalization and banking profitability: a panel data analysis for tunisian banks 25 months, the banking bankruptcies are with repetition. following the serious difficulties known by the most significant banks of the country (banco or sono) during the year 1997, the government reconsiders its declarations, and decides to support this in fear of the bankruptcy. in their study, brukett and dot (1991) show that the process of financial liberalization undertaken in chilie did not allow neither the development, nor the economic growth. as for the liberalization of the domestic capital market to the foreign capital, it resulted, according to mc kinnon, in an appreciation of the rate of exchange which it comes to cancel the few rare beneficial effects of the financial liberalization policy. in the case of argentina, miotti and plihon (2001), thus go up the occurrence of banking crises to the unfavourable macroeconomic context of the country and the speculative behaviour of the banks adopted following the financial liberalization. the macroeconomic situation resulted in a brutal deceleration of inflation, a very fast resumption of the credits and a growth economic. in the same way, financial liberalization involved a strong entry of capital of short term which will be placed in speculative activities. this macroeconomic environment characterized by favourable anticipations of growth, an increase in liquidity and a strong banking competition is at the origin of speculative bubbles. the speculative attacks and the massive withdrawals of the capital will be translated quickly into banking bankruptcies. the closed or merged institutions are 20 during first half of the year of 1995, 28 during second half of the year and 8 during first half of the year of 1996 until reaching 86 in 1999. in addition to the macroeconomic context, it is extremely useful to study the banks behaviour. at the beginning of the process of financial liberalization, it results from it an increase competition to increase the shares of market. the argentinean banking system, is thus with a keen competition, high profitability and fragility of the portfolios. this was explained by the development of speculative operations. 4. the impact of financial liberalization on banking profitability 4.1 financial liberalization and banking profitability: theoretical framework on the short term, and after the programs of financial liberalization, it results a higher level of banking profitability. the explanation is as follows: the financial opening was followed by an accumulation of liquidity. this financial intensity goes up with the liberalization of the capital account and the credit rates. while having a strong liquidity, the investment will be favoured; from where an optimal allowance of the resources. in absence of control and sufficient supervision, banks start to finance risky projects which require high yields. indeed, banking profitability is seen increased. the great liberty of action given to the banks, and impelled by financial liberalization, made increase the opportunity of risk taking. the banks continue to be directed moreover towards the financing of the high-risk activities. these financed projects are often with strong probability of defect. the borrowers remain unable to honour their engagements. indeed, it results from it a deterioration of the financial situation of banks which resulted in a weakness and even negative of banking profitability. this low profitability combined with a speculative behaviour, an asymmetry of information and an unfavourable institutional macroeconomic context, constitute a source of banking fragility. it is followed for then by banking bankruptcies and crises. let us take the case of argentina, and according witch studied by miotti and plihon (2001), they prove that financial liberalization affects negatively banking profitability. according to these authors, before falling in bankruptcy, banks obtain higher profitability than the healthy banks. this differential of profitability comes from what the failing banks sought to develop speculative activities. as the strategy of risk taking increases, banking profitability is seen deteriorated and the banks become more fragile. in conclusion, financial liberalization in the emergent countries was accompanied by a high profitability of the banks. this profitability is explained by the insufficiency of supervision and control, which leaded to the stressing of the opportunity of risk taking. an excess of risk taking, a deterioration of the quality of investment and a bad allowance of the resources are at of the origin of a deterioration of the banking profitability which constitutes one of the sources of banking fragility. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.19-32 26 4.2 financial liberalization and banking profitability: empirical application tunisia, as several countries in the process of development engaged in a program of reform of the financial sector during the two last decades. these reforms are generally started after the process of financial liberalization in the south asian and latin america countries. towards the end of the 80 year, the tunisian financial system knew several reforms aiming to more dynamization and modernization. in what follows we will try to check the impact of financial liberalization on the tunisian banking profitability. 4.2.1 methodology several theoretical and empirical studies showed the effect of financial liberalization is ambiguous. on the one hand, most studies come to defend the beneficial effects of financial liberalization; in addition, other work underlines the harmful effects on banking profitability. with this intention, we propose to study in a tunisian context, the impact of financial liberalization on banking profitability. in other term, financial liberalization exerts a negative effect on the profitability of the banks, or, on the contrary, the financial opening in tunisia improves banking profitability. it is taking into account these problems that we will put the following assumptions: basic assumptions h 1 financial liberalization deteriorates banking profitability. h 2 financial liberalization improves banking profitability the sample our sample of test acts of the deposit banks in tunisia (9 banks) over the period 1980 – 2009. it is in particular about: agricultural national bank (bna), tunisian company of bank (stb), tunisian bank (bt), attijari bank (atjb), international arab tunisian bank (biat), amen bank (ab), union of commercial and industry banks (ubci), union international of the banks (uib) and arab tunsian bank (atb). our data base is obtained starting from the financial statistics of the central bank of tunisia (various numbers) or starting from the trade association of the banks in tunisia over the period of study (1980-2009). the model to test the relation between financial liberalization and banking profitability in a tunisian context, we were used the following model. we will use the method of the data of panel and the method of estimate is that of least square ordinary (mco). the econometric model can be written following form: profi, t = α0 + β 1 libi, t+ β 2 riski, t+ β 3 liq i ,t + β 4 contr i,t + profi, t-1 + ε i,t with: prof = measurement of profitability profi, t-1 = profitability lagged1 lib = index of financial liberalization risk = measurement of risk (credit risk). liq = measurement of liquidity contr i = variable of control α = constant i = coefficients to be estimated i = error term definitions and measurements of variables the variable of financial liberalization: several work completed by economists belonging to the world bank and the imf showed the direct effect of financial liberalization on the financial system instability. others confirmed that the phenomenon of financial liberalization constitutes the central cause of the banking crises. the introduction of this variable into the modelling of the performance, fragility or the crises banking 1 the variable of profi, t-1 is introduced in our model to resolve the problem of autocorrelation. financial liberalization and banking profitability: a panel data analysis for tunisian banks 27 proves to be a complex practice. with this intention, several economists regarded as variable dummy by allotting a value of 1 for the period post-liberalization, 0 for the period pre-liberalization. others constituted an index of liberalization. in this context, leaven (2001), to check the effect of financial liberalization on the banking crises used an index made up of six variables. each variable takes value 0 or 1 and the index of liberalization will have a value ranging between 0 and 6. the six variables are as follows: 1 deregulation of the interest rates 2 reduction of the barriers to entry 3 reduction of the obligatory reserves 4 reduction of the credit control 5 privatization 6 prudential regulation maher and willianson (1998) developed a rather significant data base concerning financial liberalization in 34 industrialized countries for the period 1973-1976. the two authors explained the evolution of financial liberalization through six indicators with knowing: 1 the elimination of credit market control 2 the deregulation of the interest rates 3 the elimination of the barriers to entry 4 banking autonomy 5 the role of private banking sector 6 liberalization of the capital account to study the impact of financial liberalization on banking profitability in tunisia we will try to build with a synthetic index of financial liberalization starting from the reforms of financial liberalization. the reforms which we retained are as follows: the creation of the investment companies (csi) 1988 in addition to competition inter-banks like significant determining profitability of the banks, it was creates in 1988 an investment companies. from where the banks become more encouraged to provide a good service and favourable conditions to maintain their share of market and their level of profitability. suppression of the institutional rates of liquidity (sti) 1989: constitute the first reforms of banking system. indeed, this reform aims the generalization of the credits to all sectors contrary to the period of financial repression when the priority and public sectors were privileged. a better prudential regulation (reg) 1992 it makes it possible to reduce the behaviours of the risk takings on behalf of the banks which sometimes prefer to finance projects at the high risk and with weak probability of success. consequently the credit risk will be decreased. the liberalization of the deposit interest rates (ltc) 1994: allows to instigate the saving and to stimulate the investment. however this strong financial intensity available to the banks remains dependent on the decisions of the depositors. lifting of framing of credit (lec) 1996: allows to banks a great margin to operate as regards distribution of credit like to the fixing of the debtor interest rates on the market. the privatization of the public banks (priv) 1997 allows increasing the level of competition between the banks what affects their profitability. banks will seek more share of market, new markets of credit from where the costs of appropriations can be reduced and consequently, banking profitability will be influenced. a justification of choice of these reforms can be presented. the most general forms of financial repression are the framing interest rates of credit into the public sector and the priority activities. to check the impact of the financial liberalization on the banking profitability we choice the most remarkable reforms and which can be regarded as a contradictory situation with that known by a repressed financial system. (for more detail concerning the constitution of the financial liberalization index, see appendix 1). variables of profitability: (prof) the variable of profitability constitutes in our model the explained variable. like profitability measures, we will use the following ratio as used by demirgüç-kunt and huizinga (1999): prof = (received interest –expensive interest) / total assets. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.19-32 28 variable of risk: (risk) to introduce a variable of risk into the model, often we refer to precise measurements. for example, the standard deviation of the benefit, the report of the roa to the standard deviation of the roa as used by goyeau and tarazi (1992). in this present work we will be useful of credit risk owing to the fact that it is the most significant risk in tunisia. the risk of credit is measured by the following ratio risk = total credit / total assets. variable of liquidity: (liq) the variable of liquidity constitutes a significant indicator of banking profitability. it makes it possible to inform about the level of financial intensity for each bank. it also makes it possible to evaluate the function of intermediation banking (collection of deposits and distribution of credit). indeed, this variable allows deciding the level of funds for the banks. in other words, financial liberalization involved a surplus of funds or, on the contrary, it leads to the risk of sufficiency of liquidity which is at the origin of a deterioration of banking profitability. like measures liquidity, we will use the following ratio: liq = total credit / total deposit. control variables: as variables of control we used the banking intermediation. this variable is introduced by klaus and chenard (1997). other macroeconomic indicators were been useful in this modelling. it is about the growth rate of the gdp per capita and the rate of inflation. the introduction of these variables goes up with work of ben naceur and goaied (2001). 4.3 empirical results before carrying out the regression of our model, it is extremely useful to specify the estimations if they are of fixed effects or of random effects. so the test of specification of hausman is essential. the results of our test are given by the table 2. table 1 haussman test result model k )(2 k à 95 % hausman (h) fixed effect (fe) or random effect (r e) model (1) 7 14.06 0.481 (0.786)* r e being given that the model tested comprises 7 explanatory variables (k = 7), these statistics follow chi two to (7) degrees of freedom. the tests of specification of hausman show that our regression is random effect. table 2. result of regression random effect: dependent variable (profitability) variables coefficient std. error t-statistic prob. c 0.042698 0.004917 8.683965 0.0000 lib -0.000831 0.000425 -1.956660 0.0514*** liq 0.013188 0.004508 2.925334 0.0037** risk 0.001066 0.001558 0.684344 0.4944 itr -0.045169 0.004221 -10.70033 0.0000* pib -0.256363 0.049556 -5.173166 0.0000* inf -0.086712 0.043853 -1.977322 0.0491** prof(-1) 0.441389 0.043004 10.26389 0.0000* nbre of observation 270 r2 0.793463 d-w 2.1844 *sig at 1% **sig at 5% ***sig at de10% the test of durbin-watson indicates a coefficient of 2.1844 what indicates the absence of autocorrelation. the variables of financial liberalization (lib), of intermediation (itr), inflation financial liberalization and banking profitability: a panel data analysis for tunisian banks 29 (inf) and gdp (growth rate of gdp per capita) are correlated negatively and significantly with the dependent variable profitability (prof). the variable of liquidity (liq) is correlated positively and significantly with the banking profitability. the profitability lagged (prof (t-1)) affect positively and significantly. starting with interpreting the variables which are correlated positively with the dependent variable. the variable credit risk (risk), proves correlated positively and not significantly with the banking profitability. an excess of credit risk leads to the banking fragility and prepare their bankruptcies. as the banks finance risky projects or distribute bad credits, they require higher interest rates. these projects are with high yield but also with weak probability of success. it is for that which the relation credits risk/ banking profitability is positive only that in the short run. the liquidity variable (liq) constitutes a significant indicator of profitability. in the same way, the liquidity is the principal pillar on which is based the function of intermediation. indeed, a bank having a strong financial intensity can meet the needs for their customers that it is depositor or a borrower. the distribution of “good” credit to “good” borrowers affects positively the banking profitability. on the contrary, the banks having a weak liquidity are obliged to resort to the financial markets financings. this recourse makes increase the financial expenses of the bank what is likely to involve a reduction in its profitability. now let us try to study the variables which act negatively on banking profitability. the variables of financial liberalization, intermediation, concentration, the growth rate of gdp per capita and inflation exert a negative effect on the banking profitability. the variable financial liberalization (lib) presents a negative effect on the dependent variable (prof). to explain this relation we will check the direct effect of the principal reforms of liberalization in tunisia and which were used for to build the index of liberalization. it is in particular the liberalization of interest rates, the lifting of credit control and the prudential regulation. the liberalization of the creditor interest rates results in a strong remuneration of the deposits from where we are waiting for a reduction in banking profitability. in the same way, the banks following the liberalization of the creditor interest rates have a strong financial intensity. however, this intensity remains uncertain and dependent on the decisions of depositors. a massive and unforeseen withdrawal of the capital is likely to support the risk of insufficiency of liquidity which affects negatively the level of profitability of the banks. by the liberalization of the debtor interest rates and the lifting of framing of credit, the banking profitability is seen deteriorating. this liberalization encourages banks to take more risk by requiring rates raised on riskier projects. however, this strong profitability is random and it is associated with a weak probability of success. what decreases the profitability of the banks? in the same way, the lifting of framing of credit deteriorates the banking profitability. indeed, the credits distributed to “bad” borrowers make support banks the costs of adjustments. the latter affect negatively the banking profitability. an insufficient and ineffective prudential regulation tends to support for the banks the speculative behaviour and the risk takings what often involves a reduction in their profitability. in conclusion, and while combining the direct effect of these three principal reforms on the banking profitability, financial liberalization in tunisia comes to exert a harmful effect on banking profitability. the banking intermediation constitutes the traditional raison of the banks. so, it constitutes a significant indicator of profitability. in our modelling this variable is correlated negatively and significantly with the dependent variable. indeed, a reduction in the received interests (risk of credit) or reciprocally an increase in the paid interests (remuneration of the deposits), is likely to decrease the profitability of the banks. it should be noted that an increase in the credit rates must be less proportional to a reduction in the debtor rates. in other term, the credit distributed must exceed the collected deposits in order to more profit for banks. however, banks should not adopt an excessive policy of distribution of credit. the variable growth of gdp per capita affect positively the banking profitability following the literature based on the relation economic growth and the financial performance. however, in our study this relation is negative. former studies assembled a positive association between the inflation and the banking profitability. a high rate of inflation is generally associated by a high interest rate and consequently a significant income of banks. our results show that inflation acts negatively on the profitability of the banks. the explanation is as follows: if inflation is not anticipated and the banks international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.19-32 30 do not adjust their interest rates, it is possible that the banking costs can exceed the products what affects negatively their profitability. 5. conclusion financial liberalization in tunisia is differed from the other experiments on several plans. it takes a gradual and not radical rhythm. thus it is characterized by no occurrence of the crises and the banking bankruptcies as the examples of the south east asian and of latin america. however, and according to the results of our study, the effect of financial liberalization on the banking profitability proves to be similar to results carried out on other countries. financial liberalization decreased the profitability of the tunisian banks. like explanation of these results, the risk taking supported by the liberalization of the debtor rates and the lifting of framing of credit as well as the low financial intensity prove to be responsible. in a tunisian context, we cannot confirm the risk taking on behalf of the banks but we cannot hide the problems of liquidity which suffer the tunisian banking system. the banking intermediation form in tunisia is still more or less traditional in spite of the development of several financial products. the tunisian banks continue to count on the capital of depositors like a financial intensity and do not take the initiative to constitute their own capital. in the same way, the contribution of financial liberalization to the dynamization of banking competition remains little far from waiting’s. let us recall that a high level of competition can reduce the banking profitability. references abiad, a., oomes, n., ueda, k. (2008), the quality effect: does financial liberalization improve the allocation of capital? journal of development economics, 87, 270-282. aljandro. c., diaz. (1985), goodbye financial repression, hello financial crash. journal of development economic v (19) pp 1-24 angkinand. a.p., sawangngoenyuang. w wihlborg, c. (2010), financial liberalization and banking crises: a cross-country analysis. international review of finance, vol 10, issue 2, pp 263– 292, june 2010 bandiera o., capio g., honohan, p., schiantarelli f. (2000), does financial reform raise or reduce savings? review of economics and statistics 82(2), 239-263. barajas, a., r. steiner, n. salazar. (1999), interest spreads in banking in colombia 197496. imf staff papers, vol. 46: 196-224. ben naceur s., m., goaied. (2001), the determinants of the tunisian deposit banks’ performance. applied financial economics, vol.11:317-19. demirgüç-kunt a., huizinga, h. (1999), determinants of commercial bank interest margins and profitability some international evidence. world bank economic review, vol.14, n° 2, pp. 379-408. demirgüç-kunt. a., detragiache, e. (1998), financial liberalization and financial fragility. world bank and research department of imf. diery s., yasim, e.h. (1993), financial liberalization in africa. world development, vol.21, n°11, pp.1867-1881. fisher k., chenard, m. (1997), financial liberalization causes banking system fragility. working paper series n°97 – 1 fray, m. j. (1997), in favour of financial liberalization. economic journal, 107 pp 754 – 770. galbis, v. (1977), financial intermediation and economic growth in less-developed countries: a theorical approach. journal of development studies, vol 13, n°2, pp 58-72 gil, m., kaufman, d. (1999), transparency liberalization and financial crises. world bank, policy research working paper n° 2286. goyeau, d., tarazi, a. (1992), evaluation du risque de défaillance bancaire en europe. revue d’economie politique 102 (2). hermosillo, b., pazarbasioglu, c. (1997), determinant of banking system fragility: a case study of mexico. imf staff paper, vol 44, n°3, september 1997, pp 295-310. kaminsky, g., reinhart, c. (1999), the twin crises: the causes of banking and balance of payments problems. american economic review 89 (3). financial liberalization and banking profitability: a panel data analysis for tunisian banks 31 kapur, b. (1976), alternative stabilization policies for less-developed economies. journal of political economy, vol 84, n°4, août, pp. 777-795. mabrouk. a, mamoghli, c. (2010), is financial innovation influenced by financial liberalization? evidence from the tunisian banking industry. banks and bank systems, volume 5, issue 3, pp 97-111 mc kinnon, ri., (1973), money and capital in economic development. the brooking institution (1973). miotti, l., plihon, d. (2001), libéralisation financière, spéculation et crises bancaires. economie internationale, n° 85, 1er trimestre 2001. okpara, g.c. (2010), the effect of financial liberalization on selected macoeconomic variables : lesson from nigeria. the international journal of applied and finance, 4 (2), pp 53-61 roubini, n., sala-i-martin, x. (1992), financial repression and economic growth. journal of development economics, vol 39, pp. 5-30. sandretto, r. (2000), les risques de la libéralisation financière vue à travers le prisme des crises financières récentes des pays émergents. colloque international, gdr economie et finance internationales, ouverture economique et développement, tunis 23 – 24 juin. shaw, e. s. (1973), financial deepening in economic activity. oxford university press, new york. venet , b. (1994), libéralisation financière et développement économique : une revue critique de la littérature. revue d’économie financière 29. international journal of economics and financial issues, vol. 1, no. 2, 2011, pp.19-32 32 appendix 01 : financial liberalization index2 csi : creation of investment firm sti : suppression of institutional rate of liquidity reg : prudentielle reglementation. ltc : liberalization of creditor rate lec : levée credit encadrement priv : banking privatisation 2 this index summarizes the degree of financial liberalization in tunisia. it takes a maximum value equal to 6 which translates a total liberalization by holding account the selected reforms and a minimal value equal to 0. the principle of constitution of this index is as follows. the year which follows the reform takes the value of 1 that which proceeds takes 0. for the year which follows the second reform we not attribute the value of 1 but rather 2 and so on for the third we attribute 3 until the sixth reform we attribute 6. we did not proceed by method afc or that acp, owing to the fact that the reforms are dispersed in terms of year. année csi sti reg ltc lec priv lib 1980 0 0 0 0 0 0 0 1981 0 0 0 0 0 0 0 1982 0 0 0 0 0 0 0 1983 0 0 0 0 0 0 0 1984 0 0 0 0 0 0 0 1985 0 0 0 0 0 0 0 1986 0 0 0 0 0 0 0 1987 0 0 0 0 0 0 0 1988 0 0 0 0 0 0 0 1989 1 0 0 0 0 0 1 1990 1 1 0 0 0 0 2 1991 1 1 0 0 0 0 2 1992 1 1 0 0 0 0 2 1993 1 1 1 0 0 0 3 1994 1 1 1 0 0 0 3 1995 1 1 1 1 0 0 4 1996 1 1 1 1 0 0 4 1997 1 1 1 1 1 0 5 1998 1 1 1 1 1 1 6 1999 1 1 1 1 1 1 6 2000 1 1 1 1 1 1 6 2001 1 1 1 1 1 1 6 2002 1 1 1 1 1 1 6 2003 1 1 1 1 1 1 6 2004 1 1 1 1 1 1 6 2005 1 1 1 1 1 1 6 2006 1 1 1 1 1 1 6 2007 1 1 1 1 1 1 6 2008 1 1 1 1 1 1 6 2009 1 1 1 1 1 1 6 tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(4), 80-89. international journal of economics and financial issues | vol 9 • issue 4 • 201980 re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration economy projecta case study mohamed buheji* international inspiration economy project, bahrain. *email: buhejim@gmail.com received: 26 march 2019 accepted: 10 june 2019 doi: https://doi.org/10.32479/ijefi.8053 abstract the paper provides a comparative review and analysis between the approaches of poverty and extreme-poverty solutions, emerging in literature and from inspiration economy project poverty labs; carried over 3 years. the paper focuses on the differentiation that current “extreme poverty” elimination requires. notably, the models were evaluated about the changes from different perspectives that influence directly or indirectly the quality of life of the poor, or proactively keep him away from the poverty line. more diagnosis of the challenges on how to deal with poverty mechanisms and constructs were reflected in different proposed approaches, as part of the paper discussion. the implications of the paper emphasis on future structural factors and especially with the emerging work of behavioural economics and inspiration labs. the recommendations are drawn based on the new different approaches shown to be of influence on the “extreme poverty” policies and their ways of empowerment. keywords: extreme-poverty, models for poverty elimination, poverty alleviation jel classification: d6 1. introduction poverty is a very complicated socio-economic problem that has been existing as long as one can remember, in human history. poverty complex nature comes partly from the way solutions are proposed to the problem without realising a practical outcome (buheji, 2018; newell and simon, 1972). more than one-third of the world’s population still lives below the poverty level at an average of $1 a day. poverty has increased with the changes taking place in the world, especially the arab world (under the slogan of economic globalisation). there is an apparent collapse in the standard of living, especially in developing countries (world bank, 2019). world bank (2018) has set a clear plan to end “extreme poverty” by 2030 through targeting to reduce those living on <$1.90 a day. however, to achieve this goal the world needs at least double its speed in eliminating and alleviating extreme-poverty situations. this requires differentiating and disrupting the current contemporary ones. boosting the shared prosperity, i.e., by increasing the incomes of the poorest up to 40% does not happen by coincidence, it needs a holistic approach to the “constructs of quality of life” that engulf the poor. the literature reviewed in this paper starts with a definition of poverty and how its theories evolved. the current capital economy approaches with issues of poverty are reviewed along with causes and factors of the phenomenon of poverty. newly seen factors for the poverty phenomenon were mentioned for reference. we shed light as part of the constructs of this study with more in-depth on the mindset of the poor and how it functions are reviewed. then, capital-based economy approaches to the issues this journal is licensed under a creative commons attribution 4.0 international license buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 2019 81 of poverty are compared in relevance to both the latest new socioeconomic models that the inspiration/behavioural economies approach brings. the literature shows the influence of the different poverty approaches on the decision-making process. synthesis of this literature review would be done later to understand what are the gaps in the current approaches and how the lessons learned from the inspiration economy project – poverty labs (iep-pls). 2. literature review the literature review target to explore the ways poverty is managed. therefore, it starts with poverty and extreme poverty as a definition, a phenomenon, a model, and an approach. studies of the models and the approaches are reviewed in relevance to the principal operations and related interactions. reviewing the existing literature helps to segment the different viewpoints of the latest research, in comparison to the ieppls carried out to handle the issues of poverty from different perspectives and to see how they could contribute to speeding up the elimination of extreme-poverty. 2.1. definition of poverty and extreme-poverty the definition of poverty by the united nations (un) “is a state of deprivation reflected in the low consumption of food and low health conditions and educational level and lack of access to it and low housing conditions.” while extreme-poverty or absolutepoverty was originally defined by the (un, 1995) as “a condition characterised by “severe deprivation” of basic human needs, including food, safe drinking water, sanitation facilities, health, shelter, education and information. what differentiates the poverty versus extreme-poverty conditions is that they depend not only on income but also on access to services. in world bank (2018) extreme poverty is considered to be those who have income below the international poverty line of $2/day. about 96% of those in extreme-poverty reside in south asia, sub-saharan africa, the west indies, east asia, and the pacific. however still, nearly half of those in poverty live in india and china. however, as of 2018, it is estimated that the country with the most people living in extreme poverty in nigeria, at 86 million, then followed by the african sub-saharan. according to the un till 2015 roughly 734 million people remained under the condition of extreme-poverty. poverty is seen as a disability of the individual or the family. it is a condition that leads to deprivation of many things and limitations of many necessities of life. this deficiency leads to deprivation due to insufficient income, or lack of income. extreme-poverty can do even worse. while poverty is a relative concept that changes from time to place, we might be faced with the perpetuation of poverty over time. therefore, sometimes, the poor are considered merely as the one who cannot find the strength of his day and night (schilbach et al., 2016). world bank (2019) describe extreme-poverty as something that creeps up, due to wars, conflict, population growth, migration and fragility. therefore, the world needs many approaches that help to equalise opportunities and improve selective investment in human capital. 2.2. evolution of poverty handling there is a growing interest in understanding the psychology and socio-economic status of the poor and the models that are dealt with them so far. the critical challenge for poverty is that it is rarely approached from a multi-diversity and multi-disciplinary approach (world bank, 2015). today more focus on the psychological influence and on the way the poor see chances in life and even the way they deal with their available assets. much focus also on how to increase the incomes of the poor, in relevance to their capacity to develop their resources (schilbach et al., 2016). hence, we need to find more pragmatic business-models that goes beyond pumping resources to the poor and the services of immediate assistance, or direct cash. it is not enough anymore to have pro-poor productive resources. the models also need to go beyond encouraging savings and investments. part of the new evolution for the models should target to address the needs of discovering opportunities in rural development and in the promotion of poverty elimination clusters that start with the poverty causalities, or in areas where most of the poverty resides. 2.3. types of poverty and extreme poverty many types of poverty situations make the mindset gradually adapt to living such a deprived condition. all the types of poverty and extreme poverty, in reality, participate in creating failure in the capacity of the poor to manage their assets or autonomously develop their condition. first, there is the “financial poverty,” where the poor might have the asset, but not the cash flow. second to this type of poverty is physical poverty, where people would look like poor, or have a health condition that carries the symptoms of poverty as malnutrition. the worst type of poverty is absolute poverty. it is the same as the “extreme poverty” that the poor reach to be in chronic lack of basic food, clean water, health and housing throughout his life cycle. people in absolute (extreme) poverty tend to struggle to experience lots of child deaths from preventable diseases like malaria, cholera and water-contamination related diseases. extreme poverty can be specifically found if generation after generation hand over same poverty status to the next generation. this kind of poverty is usually not common in the developed world. “relative poverty” is another type of poverty where the family can be considered poor if it cannot afford vacations, or send its children to higher education. such people are considered relatively poor since they have no access to government support for food, water, medicine and free housing, they are considered poor because the rest of the community have access to superior services and amenities. buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 201982 then we come to “situational poverty” which is about the adverse conditions that occur when natural disasters or man-made wars occur and people can’t help themselves to be out of the adversity of such situations. the most complicated type of poverty is “chronic poverty” which is a situation occurs when there are no seen escape routes out of poverty and people would feel they are trapped with no access tools to get out of such situation. there is also the “intangible poverty” which is the opposite of the “absolute poverty.” there are also in certain countries and communities what is called the relative poverty where poor is not really poor as per developing countries standard, but they are poor in relevance to the living standards of the country or the community they are living (world bank, 2015, 2018a, 2018b). today, we can also trace what is called “temporary poverty,” which happens due to wars, or natural disasters. then we’ll have the “sustainable poverty” where the family members inherit poverty. finally, there is the human poverty. the “human poverty” is about the inability of meeting the standard of living in the country or the community of the living. the un represented by the undp developed to complement the human development index since (1997). recently, the “human poverty” started to reflect the extent of deprivation in the developed countries as in relevance to the longevity, the knowledge and the decent standard of living (undp, 2010). 2.4. classical and new causes and factors of the phenomenon of extreme poverty almost half of the world till today live on <$2.50 a day while 80% of all humans live on <$10 a day. there are many causes and factors of extreme poverty that have been published in the literature, however, one has to add that these poverty factors are based mainly on the capital-based economy. the repeated factor of poverty that has been with human history is the internal and external human-made conflicts newell and simon (1972). capital-based economy thinkers have been always referring to the family size as a factor of poverty, which not necessarily true. inflation and economical re-structuring programs which led to a different distribution of income or wealth, besides the spread of corruption, crime and bureaucracy are considered other causes. the other type of common poverty factor is the illiteracy and low education (ahmed and buheji, 2018). with the development of neuroscience, now researchers are going deeper in understanding the role of cognitive-load on the poor judgments and decisions. studies show now there are many unexploited opportunities to induce the poor cognitive-load by improving their bandwidth of thinking. the good of this approach is that it brings-in a unified approach to studying the psychology of poverty (mani et al., 2013). researchers are now focusing on factors in the lives of the poor that are affecting their bandwidth; such as malnutrition, alcohol consumption, or sleep deprivation. understanding the bandwidth of the poor thinking makes also now appreciate and realise why they act, or take decisions in specific ways. the functional magnetic resonance imaging now helps to capture the brain’s bandwidth and thus to perform or under-perform certain basic functions that underlie higher-order behaviour and decisionmaking. the main constructs of this bandwidth are the cognitivecapacity which controls the poor capacity to solve problems, or retain information, or get engaged in any logical reasoning. the second construct is the self-control, which underlies the poor ability to manage their cognitive activities, buheji (2017). the availability of this second construct helps the poor to effectively plan, have proper attention to the available resources and thus the maintenance of their capacity to take initiatives, or be even alert to external positive, or negative impulses (mani et al., 2013; d’zurilla and goldfried, 1971). thus, both cognitive-capacity and self-control constructs determine the poor ability to focus, to shift attention, to work with information and memory, and to self-monitor marsh and hicks (1998). the imbalance of both cognitive-capacity and self-control in those with extreme poverty, influence their capacity to capture opportunities or in creating a change in their poverty situations. for example, one could find that their impaired cognitive function influences their performance in competing in the labor market, especially if the work relies heavily on cognitive capacities such as attention, perseverance, or memory. i.e., this malfunction cognition even influences the performance of a waste picker trying to find valuable items among mountains of garbage world bank (2015). the influence of self-control also found to affect their nutritional status and thus affect their physical productivity and mental function. literacy has a great impact on the poor access to the world economy and which helps the poor to deal with loads of information, or instructions more rationally. the absence of self-control leads to many types of addiction, be it alcohol or drugs. these two specifically have long been associated with poverty. lack of cognitive-capacity makes the extremely poor spend much efforts on juggling expenses, and compromise in relevance to what they could poorly consume, thus distracting their efforts in making money. 2.5. how the mindset of the “extremely poor” function? the brain of the extremely poor is usually constrained. hence, it can’t establish a causal relationship between poverty and mental function, mani et al. (2013). the limited functionality of the extremely poor makes him think every day about financial demands. this creates depression such as sleep deprivation and becomes hopeless world bank (2015). the work by mullainathan and shafir (2013) about the psychology of scarcity of those being extremely poor showed that feelings of buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 2019 83 scarcity create more consistent feelings of needs and where the poor would count every small decision as trade-offs. hence, living this scarcity mindset make the poor focus on relatively simple tasks. in the same time, the poor waste their real scarce resources as their cognitive capacities invested in unnecessary functionality world bank (2015). mullainathan and shafir (2013) emphasised that the scarcity mindset makes life less navigable, as people act in a computationally more complex world. the cognitive-overload imposed by scarcity mindset increases the probability of costly errors. errors increase the lack of self-control, thus the poor would fall into repetitive temptations and would enter into “tunnelling.” this tunnelling causes short-sightedness, making it more difficult for the poor to evaluate the alternatives available to them when dealing with difficulties. studies now confirm that the mindset of the poor is not a personal trait, but it is the result of environmental choices produced by scarcity itself. a conservative diagnosis of the mindset of the extremely poor found that it leads them to living with more vulnerable situations. this mindset would make them lack interest in initiatives that could improve their condition. thus, as mentioned by mullainathan and shafir (2013), the poor would keep delaying paying small utility bills till they need to immediate payment is needed for all the overdue bills, then they would seek help for charity or personal loans, and this feeds the continuity of the scarcity mindset. another example was given for how the poor would prevent their children from going to school to seek them bringing in some income for the family, instead of trying to compromise between school and work and thus mitigate the risks of negatively influencing the child’s life forever bull et al. (1988). the communication in the model needs to be engineered in a way that it would raise the choices of the poor in dealing with social programmes. this means we need to create different criteria’s to assist the categories of the potential beneficiaries. again the small adjustments in the communication design and implementation of social programmes can lead to very positive changes in their outcomes. the poor feeding and housing support models should target to give the poor mindset with the minimum of security, so that they would build gradually their temporal horizon, pointing towards possibilities beyond immediate needs. this would improve their decision-making capacity world bank (2015). 2.6. “capital economy” approaches (ca) to the issues of extreme poverty capital economy has brought many solutions to the issues of poverty. many solutions came with improving the continuous services (depending on the nature of the situation). in the last one century, more seasonal services have been developed. however, most of the capitalism efforts gone for emergency services and the enhancement of tools that ensures continuous services for the poor, driven by sympathetic thinking (figure 1). 2.7. “socio-economic” approaches (sa) to the issues of extreme poverty the total use of production capacities of the poor need to be revived. we need to avoid causes of migration and ensure effective human development in this class. currently, the solutions poverty reduction in capital economy focus on developing the labour market for the poor employment and then providing them housing services. other approaches focus on regional development. also, equality in socio-economic fields is leading to more sustainable development to reduce poverty and improve the standard of living. with the development of endowment projects, more small micro-financing projects started. figure 2 illustrate approaches to poverty issues from socioeconomic perspective. 2.8. “inspiration and behavioural economies” approaches (iba) to the issues of extreme poverty instead of discussing the “big issues” around “poverty traps,” banerjee and duflo (2011) recommended that we should approach the concrete situations faced by the poor families and communities in poverty, identifying the main obstacles to the improvement of their lives and the alternatives that could be adopted to remove them. the fight against poverty could be differentiated by the concrete model solutions that change how the poor people, being evaluated, assessed and exploited to great life opportunities. poor people can be a source for real productive economy, if we change their life focus from focusing on invaluable resources as food for the day, to focusing on assets and wealth of their life (ahmed and buheji, 2018). with the development of behavioral economies and lately inspiration economy more projects became focused on creating realized behavioral change in the communities of the poor, d’zurilla and goldfried (1971). as illustrated in figure 3, the poor conditions were more assessed and evaluated towards change. now the projects are more focused on changing the models that deal with poverty. one of the most experienced radical change was carried to the humanitarian ngos, where their role is changed from capturing opportunities of poverty and driven by empathetic thinking. banerjee and duflo (2011). 2.9. understanding how the different approaches of extreme poverty influence the related decisionmaking process? understanding the decision making processes that create poverty is very important for empowering people living in poverty. for example, understanding how governments help productive family programs or the effectiveness of micro-start for small family businesses are essential of the value of these social programs in creating a change to people below middle class. understanding also how these social programs play a role in creating an excessive cognitive and emotional overload help us to see how such decision making influence the community. such understanding of poverty approaches helps the country to manage the weaknesses of the exposed poor, especially those who are under great pressure buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 201984 and with many uncertainties. thus, the more decision making process deal with these uncertainties, the more we can help the poor to reach alternatives that can raise their capacity to deal with challenges datta and mullainathan (2012). sometimes just realising small modifications in communication and design in the social programs would create positive changes in outcomes and would help to see successful models that lead to major transformations. hence, in order to manage to bring people today to come out of poverty, they need services that are more than reducing the cost of basic needs in all possible ways. i.e., they need inflation more than lowering the level of prices, or providing services in health and housing policies, or reducing the cost of education on their children. 3. methodology the research methodology employed in this paper is a qualitative case study. the case study was chosen as a method because it is figure 1: approaches to poverty issues in capital based economy figure 2: approaches to extreme poverty issues from socio-economic perspectives figure 3: approaches to extreme poverty issues in behavioural and inspiration based economy buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 2019 85 suitable for situations that include complex and multiple variables and processes (yin, 2003). the case study is longitudinal as most of the examples in dealing with poverty communities, directly or indirectly, were carried for more than 6 months and operated in different business areas and different countries. the case study is meant to show the differentiated approaches of non-resource based empowerment for the poor and how it can be handled effectively. the cases were divided into three types of approaches: ca, sa, iba. the different poverty communities’ approaches help to visualise differentiated perspectives in dealing with poverty and extremepoverty. all the data in the table were collected based on the field visits and observations and according to the type of the poverty communities’ issues (buheji, 2019). 4. the case study the inspiration economy project target is a problem solving focused socio-economic methodology that targets tackle complex world and communities and solves it through using mostly the intrinsic powers of the community of focus. amongst the most focused upon issues for inspiration labs, the field experiments of the inspiration economy project are the issues of poverty and extreme-poverty. the four tables 1-4 listed in this paper show the types of poverty, or extreme-poverty alleviation and elimination projects that targeted to re-define a new way of tackling poverty from a different angle or different perspective. the result of these projects is called models which try to show the re-defined approaches collectively, from the 29 sectors or perspectives. these cases were carried in a period of 3 years starting from september 2019. the poverty elimination projects the inspiration economy labs focused on sources of poverty and not only resources for supporting poverty. this mindset which discussed in the literature review ensured that the poverty issue was tackled as one complex socio-economic problem that needed different approaches, qin et al. (1995). these approaches, in this longitudinal study, are what differentiates the model of poverty issue diagnosis and way of handling challenges in different situations. all these projects were carried out in the following countries: bahrain, bosnia and herzegovina, slovenia, morocco, mauritania and recently in india; where extreme poverty is found mainly in the african countries buheji (2018). the projects of this case study were divided into four types which reflect the transformation and integration efforts carried out towards poverty and extreme-poverty elimination. the primary type of projects starts with the efforts of transformation from ca to iba (ca and iba). the second type of project work on integrating ca and sa. while the third type of project work on the integration of “socio-economic” approach along with inspiration/iba (sa and iba). the fourth type of projects works on the holistic integration of ca, sa and iba (ca, sa, iba). tables 1-3 represent each of these types consequently. 5. findings in order to understand how the case study projects models table 1 works and came from, the following figure 4 framework table 1: list of poverty elimination models projects that integrate ca and iba type of sector targeted summary of poverty communities related inspiring projects/models education (ca and iba) 1-discovering inspiring students at the right time during their 12 years in education. (early inspiration discovery program) 2-establishing track of the inspired students after graduation (inspiration pathways) 3-establishing early inspiration discovery program 4-establishing boundary-less schools that reach the poor to their door-steps high education (ca and iba) 1-improve the academic counselling for the poor 2-enhance students’ fitness or competence to meet labour market demand. psychiatric services (ca and iba) 1-inspiration of the capacity to manage the anxiety among the poor and avoid reaching the level of chronic anxiety 2-reduce addiction and suicide ratio due to early treatment of main causalities among youth. ca: “capital economy” approaches, iba: inspiration/behavioural economies’ approaches table 2: list of poverty elimination models projects that integrate ca and sa type of sector targeted summary of poverty communities related inspiring projects/models students socio-psychology awareness and counselling programs (ca, sa) 1-sponsoring project on counselling the students’ social workers and councillors 2-simplify tools for measuring poor students’ safety or positive psychology, or stress release, or life challenges against continuity in education, even during child labour conditions 3awareness campaign for schools and universities, rights for the poor students and reduction school bullying, harassment of the poor 4-tackle issues of poor students’ depression and see its influence on society. improve the return of university courses to the socio-economy (ca, sa) 1establish a model for blanket as part of fashion design course; in collaboration between the university and the underprivileged women anemia prevention program (ca, sa) 1-screening girls in villages for anemia and link to socio-economic situation and productivity 2-set preventive measures for future cases in the community with proper family planning. 3-reduce the impact of individuals deficiency by addressing the proper diet plans. iba: inspiration/behavioural economies’ approaches, sa: “socio-economic” approaches buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 201986 table 3: list of poverty elimination models projects that integrate sa and iba type of sector targeted summary of poverty communities related inspiring projects/models social insurance (sa and iba) inspiring the social responsibility plans to ensure that particular type of lower pension jobs is more prepared for entrepreneurship after retirement. labour market (sa and iba) 1-shifting unemployment amongst the low-income families through building models in specific industries and effective counselling 2-raising opportunities for employment through sourcing type for job opportunities, especially in less demanding jobs humanitarian services agency (ngo’s) (sa and iba) 1-reversing the model of poverty support, by making poverty as a temporary condition that we need to prepare the beneficiaries to beyond this stage 2-diverting the type of services to be more for sustained income, instead of non-sustainable support 3-mapping partnership collaboration services (academic, youth, ngo’s, government, etc.) 4-building cost and profit centres based on the type of services needed by the beneficiaries, i.e.,, the low-income families. woman village ngo (sa and iba) 1-enhance the return on capital employed for the villagers during the chain of making to delivery and distribution 2-enhance young girls’ involvement in woman village activities to ensure the sustenance of knowledge transfer. 3-enhancing the corps return on investment and profit margin. 4-setting the type of transformation from distribution to start micro packaging of the high-end product. 5-improving the quality of life of families in the amazigh villages through eco-tourism and small family businesses that support such cluster 6-build youth independence program that counters poverty through raising the capacity of the farmers for competitive packaging and distribution. 7-build youth trust in the village system as a source of income women entrepreneur-ship ngo (sa and iba) 1-analysing the impact of programs on “woman development,” not only “women-empower,” and the “living standards” that comes with the “quality of life” in the ngo area and scope of delivery 2-optimising the inter-disciplinary learning approach 3-enhancing the “learning by doing” practices 4-measure the differentiation of women on the economy. poverty communities transformation program (sa and iba) 1-mitigation of migration amongst youth 2-optimise the youth quality life through students pull thinking targeted programs 3-building a poverty blockage and prevention program 4-addressing the gambling (pitting) behaviour amongst youth and building prevention scheme through schools’ model 5-building youth entrepreneurship and innovation programs 6-enhancing youth contribution in voluntary work 7-bridging the gap between academic social work and social studies schools and the realised community problems. (building life long learning programs that shape the community) 8-improving disserted women shelters returns 9-improving children without known parents’ programs 10-enhancing red-cross programs impact in the positive psychology of the community 11-improving pre-school influence programs on children of homeless and beggars’ families. camel wool carpet factory with a social capital and high community goodwillnouakchott-mauritania (sa and iba) 1reverse-design for wool factoryre-designed the model to be from “production from the factory” to “production to the factory” by the productive families and women cells in the villages 2-re-distribute manual wool carpet machines “from the factory” focused “to villages and production families” focused 3re-establish organic handmade carpet marketing program. bringing low privileged community children to formal-education by focusing on sports (sa and iba) 1-integrating youth with both formal sport and traditional games 2-evaluate possibility for the continuation of formal and informal education 3-use peer to peer education. “education on wheels” and “education at door steps” projects (sa and iba) 1-target to deliver education to rural and isolated communities 2-formal and informal education for children in slums areas. improve the quality of life of “waste pickers” (sa and iba) 1-improve quality of life of “waste pickers” families through differentiating their productivity from municipalities coming to waste management 2-segregating waste bins implantation in universities, schools and hotels, residential societies 3-processing of the collected waste into high-end products (i.e., metals, glass, papers, and organic wastes) processed to high-end products 4-improve the nursery project and ensure the proper distribution channel of nursery plants. ca: “capital economy” approaches, iba: inspiration/behavioural economies’ approaches, sa: “socio-economic” approaches buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 2019 87 of diagnosis versus challenges is proposed to tackle any issue in relevance to poverty, or poverty communities. as shown in figure 1 examples of the early observations from the first field visit shows the assets, or the barriers, or the resources, or the processes that might influence the issue of poverty positively, or negatively, or make it more resource dependent or independent models. the idea of the framework is to motivate the observations of the “hidden opportunities” built in the poverty case or issue tackled, table 4: list of poverty elimination models projects that holistically integrate ca, sa and iba type of sector targeted summary of poverty communities related inspiring projects/models social development (ca, sa and iba) 1-inspiring the capacity of the productive family program to be more self-independent and attractive for more family members to join as full-time employees/owners 2-improving quality of life of families in isolated communities and tribes (enhance the productivity factors for women and families working from home), with a target to reduce the impact of poverty through eco-tourism projects. 3-building stronger family businesses that have higher return on capital employed (roce). 4-enhance the return from elderly homecare production 5-enhance the quality of life of the disabled people and their production 6easing the process of home care 7supporting “working from home” program 8revaluating the capability of social allowance value and entitlement – in relevance to quality of life with priorities. 9enhancing the products quality and competitiveness of the retired and the disabled 10improving the quality of micro start families with a focus on women and people vulnerability. labour fund (ca, sa and iba) divert more mentorship on “necessity entrepreneurship” and improve the solutions they bring to the community. woman empowerment programs (ca, sa and iba) 1-closing the gap and accelerating the transformation towards “women development” instead of “women empowerment” especially among poverty and middle-class women. 2-ensure knowledge sharing between business women, women entrepreneurs and women of productive families programs and especially those of the same or relevant business and link it to gamification rating. (i.e., rating of entrepreneurs who contribute and share knowledge) tender board (ca, sa and iba) diverting more tenders to the benefit of local small smes and families’ businesses housing services (ca, sa and iba) 1-reduce the gap between citizens’ demands and their quality of life needs 2-improving the choices and variety of options in non-villa packages (i.e., flats) 3-reduce the contrary social inequality and improve social coexistence through post-housing services police services (ca, sa and iba) 1-reduction of drugs trafficking through refinement and codification of smuggling through reclassification of information in poverty areas. 2-enhance social harmony between neighbours for small issues among the poor neighbourhood ministry of labour (ca, sa and iba) 1re-engineering counselling services to start from high school and be flexible towards job creators than just job seekers with particular focus on below middle-class families’ students. 3-help start-up companies that collect below middle-class graduate of unique, yet unemployed jobs, that as nursing, social workers, hospitality services. 4-nationalising jobs that represent the country heritage and support tourism with below middle-class families related to these jobs. 5-exploring the possibility of creating human capital bank that would transform 30% of the job seeker towards job creation; over a planned career path. 6-closing the gender gap in unemployment, by re-inventing new productivity jobs for below middle-class graduating women specifically. fisheries (ca, sa and iba) 1-improve return on investment (roi) in fisheries and the resilience in the marines’ food industry 2-bring in the local market of traditional fishers to sustain on the job with their families. 3-establish national fishermen market. agriculture and farming (ca, sa and iba) 1-redesign bahraini farmers’ production by establishing what is called “national farmers’ day.” 2-improve the distribution chain of local salad by attracting consumers to purchase local vegetables and fruits, and arranging deals between hospitality suppliers and local farmers. 3-improve the level of gardening competitions. improve the return of endowments and trusts (ca, sa and iba) 1-they are re-evaluating the current assets returns of endowments and how they are professionally managed to support the people in poverty (directly or indirectly). 2-establishing “sharing economy” innovative practices and solutions to open more “returns on capital employed”. 3-giving an innovative solution for solving problems on disputed family lands 4-innovating on a type of endowments or trust funds to manage the technical and quality of life developments and diversify the resources in supporting the poverty community. ca: “capital economy” approaches, iba: inspiration/behavioural economies’ approaches, sa: “socio-economic” approaches buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 201988 and from different perspectives. the proposed framework targets to help us to collect proper information on the problem and thus to generate potential solutions and outcomes. re-defining small approaches in dealing with the poor would eliminate the need for concrete solutions faced in their real-life contexts. for example, redefining how we evaluate people income and their functionality can have a drastic effect on the type and level of the poor people empowerment. also, this framework would help us to effectively evaluate how the poor could target, or accept certain jobs opportunities. 5.1. proposed framework that guides the approaches and re-define the models of dealing with poverty issues the framework has an approach which targets to re-define any poverty-based model. part of the goals of re-defining the models of poverty approaches is to enhance the cognitive-capacity. these approaches target to excite the capacity of the poor to solve problems. the different boundaries of the framework in figure 4 should also address the weak role of the ngos and the private sectors in dealing with poverty issues. to encourage the new generations of low-income families to become more self-dependent, the framework empowers them to see and exploiting opportunities with minimal resources. the poverty models are shown in figure 4 illustrates mostly how the current models focus only the “well-known” and “clear” reasons, like unemployment, or lack of education. however, the model needs to address other causalities and in different ways. indeed, the model should not be dependent on having the government securing employment opportunities for the poor only. figure 4 also shows that the model should focus on the unknown and with clear causalities, as the absence of work which is the source for generating sufficient incomes. therefore, the models done in the projects address entire livelihood the people in poverty and extreme-poverty usually need to experience or be empowered. this means we need to integrate people competencies and utilise their capacities to support socio-economic development and this is what tables 1-4 focus on. 5.2. importance of poverty model diagnosis one of the primary sources of eliminating poverty is the way we diagnose the current poverty model and its causalities. hence, for example, understanding the decision-making processes in relevance to people living in poverty is only one of the causalities of sustenance of a poverty condition. this diagnosis can lead to the improvement of the poor quality of life outcomes. some of the main points to be diagnosed in poverty conditions studies are the cognitive and emotional setting which people in poverty usually subjected to. the analysis of the information should evaluate the accessibility to the limited alternatives that help the poor to deal with their challenges. recently, significant multi-disciplined research shown that rational agent models which focus on utility-maximising behaviour have significant limitations in dealing with a complex problem like poverty. 5.3. type of approaches to be re-defined studying the examples of the case study, tables 1-4, shows that small adjustments in the way we communicate with the poor can have a positive effect on how they perceive life. the case also shows that dealing with the poor in the early stages of their life can help mitigate their probability to inherit poverty. in general, tables 1-4 illustrate the importance of designing social programmes with clear outcomes. these small transformations which integrate sa and iba, or holistically integrates these two approaches with capital economy based approach illustrate the amount of gap between contemporary approaches and what inspiration labs are suggested to minimise the dependence on waiting for great transformations to happen for the poor from strong external parties as governments, or major fund foundations, or legislative authorities. figure 4: proposed the way we should diagnose and deal with the challenges of the poverty models buheji: re-defining our approaches to extreme poverty: an attempt to disrupting contemporary poverty alleviation approaches through inspiration international journal of economics and financial issues | vol 9 • issue 4 • 2019 89 in order to re-define the models of dealing with poverty, we need to focus on all the relations and strengths that define the known approaches (i.e., the scientifically proven) and the clear approaches (i.e., the clear causalities) parts, as shown in proposed diagnosis versus challenges, in figure 4. 6. discussion and conclusion this paper aims to extend our understanding of the developments needed in current poverty handling business models and to realise which approaches could help re-define the way we tackle poverty. taking into account the literature reviewed, the synthesis was done to both the literature and case study represented by tables 1-4 which represent longitudinal work carried over 3.5 years through inspiration and behavioural economy labs that focused on poverty communities needs specifically. the proposed framework opens up a range of preferences that maximise the probability of behavioural changes amongst the poor community while ensuring the minimum outcome. the case study shows the advantage of the multidisciplinary approaches for a complex issue as extreme poverty. the outcome of the framework proposed help us to focus on the implications of the models that emphasise the independence of the poor from resource-based empowerment models. the proposed framework helps to develop the socio-economic approaches, programs and public policies set for dealing with issues of poverty, depending on the country’s or the community’s situation. the synthesis of both the latest existing models discussed in the literature reviewed and then the models presented as part of the case study realised show that there is a need to re-invent the way we tackle poverty and extreme-poverty. all the current models need to be are re-evaluated on whether they are working to increase the capacity versus demand for the poor and help to develop their self-control. this means we need more projects that would work on the mindset of the poor. the way poverty models are designed has a significant impact on how the future generations of the poor would be transformed out of their community towards the middle-class. as shown in the case study, this can be done as per the capacity of each community, with small changes, where significant influence would accumulate over time. the significance of this research is that it would benefit the decision makers in how to tackle issues of poverty with minimal resources and according to the condition of the country or the community. besides this paper is expected to help those engaged with the management of the mindset of the poor and those who need to tackle different poverty problems in preventive rather than reactive way. the paper is full of examples that open future academic discussions in relevance to the labs, the projects and the policies which trigger the cognitive-capacity of the poor and empower them to solve problems. references ahmed, d., buheji, m. (2018), the distribution of wealth growing inequality? a book review. vol. 4. applied finance and accounting, paper. banerjee, a., duflo, e. (2011), poor economics: a radical rethinking of the way to fight global poverty. new york: public affairs. buheji, m. (2017), understanding problem-solving in inspiration labs. american journal of industrial and business management, 7, 771784. buheji, m. (2018), re-inventing our lives a handbook for socioeconomic problem solving. united kingdom: authorhouse. buheji, m. (2019), re-designing the economic discovery of wealth a framework for dealing with the issue of poverty. international journal of economics, commerce and management united kingdom, 7(2), 387-398. bull, j., cromwell, m., cwikiel, w., di chiro, g., guarina, j., rathje, r., stapp, w., wals, a., youngquist, m. (1988), education in action: a community problem solving program for schools. dexter, michigan: thomson-shore. d’zurilla, t., goldfried, m. 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(2018b), piecing together the poverty puzzle. poverty and shared prosperity. washington, dc: world bank. available from: https://www.openknowledge.worldbank.org/bitstream/ handle/10986/30418/9781464813306.pdf. yin, r.k. (2003), case study research. 3rd ed. thousand oaks, ca: sage publications. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(1), 183-192. international journal of economics and financial issues | vol 9 • issue 1 • 2019 183 labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam nguyen thi hai ninh1*, philippe lebailly2, nguyen mau dung2 1department of economics and rural development, university of liege, belgium, 2faculty of economics and rural development, vietnam national university of agriculture, vietnam. *email: haininh.hua@gmail.com received: 02 october 2018 accepted: 03 january 2019 doi: https://doi.org/10.32479/ijefi.7274 abtract this paper attemps to understand about gender division of labor in pig farming households and to identify factors affecting that division. using primary data collected from 40 pig farming, we find that female laborers play more important role in pig production. more than 60% of women participating in making decision regarding to many stages of pig farming. especially, in small scale households women are observed to take main responsibility for almost all activities as many men do off-farm jobs far from home. compared to wives, husbands are more likely to make decision regarding pig farming. nevertheless, in households with higher-educated and younger couples, we identify a higher probability of husband and wife making decision together. therefore, to improve the role of women in pig farming, it is necessary for local authority to train them knowledge relating to pig farming and to change their husbands’ perception on gender equality. keywords: labor division, pig farming household, gender and economic perspective jel classifications: c01, j01, j16 1. introduction vietnam has achieved a high pace of industrialization, which has led to conversions of a large area of agricultural land and other types of land for non-agricultural purposes, and this has forced thousands of farmer households to change their traditional livelihoods and even their lives (nguyen, 2009). in comparison with other regions in vietnam, the red river delta has the largest number of people affected by the loss of farmland with about 300,000 households and so farmers have to seek various ways to earn their living (hoang, 2009). of these ways, changing from crop cultivation to pig farming is considered as an appropriate decision to improve income for a majority of farm households in the red river region. according to the statistical data in 2011, pig farming percentage distribution by seven ecological areas in the country is highest in the red river delta with approximately 27% (nguyen, 2013). with about 80% of pig raisers identified as smallholders, the development of the pig sector in the red river region is very important for improving income and generating family employment (lapar, 2014). however, the industrialization process has also transformed employment structures and labor supply in many farm households, leading to changes in household’s labor division for agricultural production in general and for pig farming in particular (nguyen et al., 2015). with many husbands and adult sons absent working in industrial and service sectors far away, the trend in labor division of farm households is that women undertake almost all activities relating to cultivation and livestock while men are only confined to some work such as soil preparation and assisting women in tending and harvesting crops and livestock breeding (nguyen, 2011). this journal is licensed under a creative commons attribution 4.0 international license ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019184 the division of labor is defined as the specialization of cooperative labor into specific, circumscribed tasks and roles, intended to increase productivity. historically, the growth of a more and more complex division of labor was closely associated with the growth of total output and trade, and of the complexity of industrialization processes (nguyen, 2010). the concept of labor division has been debated by several famous classic thinkers like adam smith, karl marx and emile durkheim, as well as contemporary scholars such as massey. in their debates, most scholars have paid attention to the division of labor by sector, by region and by gender. in so doing, they have concentrated on the “rationality” of labor divisions within a sector, a region, a family or in an economy as a whole. in vietnam, most research on labor division in agricultural sector has focused on the changing role of women in rice (paris et al., 2009; chi et al., 2010; pham, 2013; gallina, 2016) and aquacultural farming (mekong river commission, 2006; atdhe et al., 2009; arlene et al., 2016; caulier et al., 2016). much less is known about how women fare in pig farming, particularly the division of household labor which is one of the most persistent forms of gender inequality (bussarawan et al., 2008). this paper looks at the division of labor in pig farming households from gender to economic perspectives. in other words, the paper attempts to clarify who does what kinds of work in pig farming households and examine to what extent this labor division affect household’s income under the context of industrialization in the red river delta. in order to address these two questions, in the next section we review theories on gender division of labor. desription of the data and methodology is in section 3. we report results in section 4. conclusion and recommendation are found in section 5. 2. theoretical framework 2.1. gender division of labor the way work is divided between men and women according to their gender roles is usually referred to as the “gender division of labor.” this does not necessarily concern only paid employment, but more generally the work, tasks and responsibilities that are assigned to women and men in their daily lives, and which may, on their turn, also determined certain patterns in the labor market (ilo, 2008). in most countries, houseworks like cleaning, cooking, washing clothes or sustaining the household by small scale agricultural production are considered as women’s tasks, even when they have a paid job outside the home. on the other hand, more technical house tasks such as dealing with electrical or mechanic equipment, is traditionally a man’s job. however, the gender division of labor is not fixed for all time; it changes in response to wider economic, political and social changes (ilo, 2008). under industrialization process of vietnam, men and women follow different migration models, and engage in different occupation when they migrate. migration may also result in men taking on tasks that they would not normally consider within their socially ascribed role, like having to cook for themselves. in contrast, their wivies at home have to deal with technical house tasks and many heavy activities in agricultural production; in some cases, they conduct all of activities alone (gallina, 2016). this paper analyzes gender division of labor in pig farming household by looking at two aspects as time availability and decision making power. 2.1.1. time availability this perspective depicts the division of household labor as a result of husband’s and wife’s competing time commitment. the spouse who is not employed or who works for pay for a smaller number of hours is expected to contribute more to pig farming (bussarawan et al., 2008). 2.1.2. decision making power decision making within households has to do with bargaining, and this bargaining depends on gender role attitudes. that is, husband and wife with more egalitarian attitudes are expected to have more equal decision making power (fondo, 2007). several studies in developing countries have pointed out that men dominate the household decision making power in most places while women have subordinate position (tiransia, 2011). therefore, in our research the role of women in pig farming will be measured by their participation in decision making process with their husbands. 2.2. gender division of labor in economic perspective various theories have been addressed to explain why men and women divide their work in household. such theories can be grouped into several categories like nature, culture, and economy. theories that consider the division of labor by gender to be a pratical response to economic conditions are diverse. some theories suggest that women do the housework and men monopolize paid work because labor specialization maximizes the efficiency of the entire family unit. women are assumed to have “tastes” for doing housework and their commitment to child bearing are seen as limiting their movement into the market place (becker, 1993). resource theories similarly assume that spouses make cost-benefit calculations about housework and paid work using external indicators such as education and income (bussarawan et al., 2008). taking economic perspective into account, our paper sheds the light on affect of gender division of labor on pig farming household’s income. 2.3. factors influencing gender division of labor a numer of factors are responsible for the gender division of labor today: some are gender neutral and others are gender biased. a gender neutral process is one where in a household, comparative advantage and the maximization of household welfare is used to determin which partner does what (fondo, 2007). other variables responsible for the division of labor in pig farming household are age, educational level and perception on gender equality of spouse; number of family laborers who can involve in pig farming and pig production scale (figure 1). 3. research methodology 3.1. reseach site in 2011, the red river delta had the largest pig population in the country with about 7.1 million. accordingly, this region had the highest pig density of 909 pigs per km2 of agricultural land (general statistics office, 2012). however, the number of households engaged in pig farming has decreased over the years since 2016 because of unfavourable movement of relative inputoutput prices, environmental problems, disease outbreaks, and especially industrialization that draws land and labor out of the ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019 185 agricultural sector (lapar, 2014). despite the fact that pig farming has declined in recent years, it is still considered as the major income source of rural households, particularly for those are in shortage of agricultural land and farm laborers. hai duong province is located in the centre of red river delta with many industrial zones have been established which absorb thousands of laborers across the province and other provinces to work. industrialization leads to the largest number of agricultural laborers decrease in hai duong province in comparision with other provinces in the red river region (le thai, 2011). thus, maintenance of pig farming is important livelihood strategy which is decided by many households to cope with the lack of family labor supply. according to statistical data 2015, the value of pig production occupied more than 80% of total value of livestock breeding in the province. 3.2. data collection taking into account all determinants analyzed above, the authors conducted a field survey on pig farming in hai duong province in 2017. in this survey, we interviewed 40 pig farming households which were divided into 2 groups, small scale group includes households with <50 pigs and large scale group consists of those raising more than 50 pigs. this classification is based on the share of pig farming households by scale which is identified by lapar (2014) in his review of pig sector in vietnam (table 1). by dividing pig farming households into these categories, we try to test the hypothesis that there are differences in gender division of labor between 2 groups in terms of working time and making decision of spouse. the household survey was implemented in two first weeks of april 2017. the main purposes of our survey are to gather both quanlitative and quantitative data on pig farming including: number of pigs (sows and fattening) breeding each litter, number of litter per year, pig farming stages (feeding, cleaning, veterinary medicine applying, pig selling). information relating to division of labor in each production stage are also collected like: frequency and time spending of each gender to these activities, decision making power who decides to do what. in addition, demographic characteristics of farm households are saved in order to determine whether it has impact on gender division of labor such as gender, age of household head, perception of husband and wife on gender equality and number of family laborers. a total of 73 respondents including 40 men and 33 women are drawn for the survey. the personal interviews using a standard questionnaire with open and closed questions are implemented separately with husband and wife in a household. they are interviewed in different places to ensure that husband’s answers does not affect his wife responses and vice versa. before doing the main household survey, we did pre-tested in 5 pig production households. the aim of pre-testing was to test the questionnaire to find out if questions were understood and the questions were in a logical order (tiransia, 2011). the questionnaire was then revised and adjusted based on the responses during the pretesting. some questions were reformulated in order to make them easier to understand, especially questions on gender figure 1: analytical frame of labor division in pig farming household table 1: scale of household pig holdings number of pigs share of pig farming households 1–2 51.9 3–5 25.7 6–10 8.9 10–49 12.8 >50 0.8 source: lapar, 2014 ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019186 division of labor as it was found not to catch the actual situation in pig production at the locality. 3.3. data analysis the data are checked and cleaned by going through each and every questionnaire by all authors. missing values are also checked by running frequencies on each variable. for a description of surveyed households, frequency distribution with mean and standard deviation are used. in addition, cross tabulation and chi-square test are also employed to test for differences in proportions and significant difference between two pig farming groups. also, the authors employ mann-whitney two sample and chi square test for non parametric test. in order to examine factors affecting gender division of labor in pig farming household, a logistical regression model is applied. this model helps to quantify the impact of demographic characteristics on the way that households apply to decide who do what. dependent variable is defined by decision making power. it is determined by husband and wife responses about decision for specific activities in pig farming. the answers are either “it is husband,” “it is wife” or “both decide” for the particular tasks. so dependent variable equals to 1 if only wife or both husband and wife involve in decision making, and equals to 0 if only husband decide all the works. 4. results 4.1. demographic characteristics information as in many south east asian countries, men in the red river delta of vietnam are usually householders because of the traditional role of the male breadwinner. it is revealed by some researches that ability of male to make decision is better and more definitive than the one of female and is less affected by outside factors. in accordance with many previous findings, we observe that householders in both groups are mainly male (table 2). there is only one household having female house head among 40 surveyed households. most of householders are over 45 year-old (65%), the rest is in 30-45 year-old range (35%). in households having long period engage in pig farming, householders are observed to be older and more experience. in general, educational level of householders is mostly primary school. so that, their ability to absorb new techniques in pig farming is limited and also, their potential to access pig selling market are narrowed. that affects much their pig farming even though they are willing to learn and to apply new techniques for their works. we identify that the average numbers of family members in a household are 3.9 persons in the large-scale group and 3.7 persons in the small-scale group. this size is also an average size of households in the red river delta in general, it is a medium size and reflects the decrease in mechanical population in rural areas due to migration to cities to seek for non agricultural works. as a result, labor in the households is divided into 2 types, labor for just pig farming and labor for off-farm activities such as working in industrial factories, doing small business, or working in service sector. off-farm laborers who are mainly householders’ sons and daughters with age under 35. almost works in pig farming are not complicated and do not require high skill. therefore, laborers can have time for doing other activities without putting too much effort. households can use all available laborer from grandparents to children for pig farming. they just hire outsource labor only when timing is required or work load is huge. 4.2. gender division of labor in pig farming in pig farming, the division of labor by gender is necessary because each gender has its strong point in knowledge and ability. this division can reduce time consumption and increase productivity that increases the family income. besides, the division also creates stronger connections between the family members. it can be seen that both husband and wife participate in almost works. however, intensities are different. during breeding process, there is no fixed division of labor. when the husband is busy, his wife will do the works and vice versa. when work load is high or need be finished in time, even their children or their grandparents will participate. we find a difference in division of labor between the 2 groups of households. in large-scale households, husband participate in pig farming more than his wife with 75% of the husbands spend over 50% of their time for breeding works (figure 2). conversely, 60% of the wives in small scale households spend more than 50% of their time for breeding works. table 2: household demograpic characteristics description unit large-scale (n=20) small-scale (n=20) average age of householders year-old from 30 to 45 persons 7 7 over 45 persons 13 13 gender of householder male persons 20 19 female persons 0 1 education under secondary school persons 18 20 high school and upper persons 2 0 size of household family members/household persons 3.90 3.70 laborers/household persons 3.20 2.85 labor allocation labor for pig farming persons 41 39 off-farm laborers persons 23 18 source: household survey data ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019 187 in addition to time share in pig farming, we also ask spouse about daily working hours they spend on different breeding stages (table 3). number of working hours the spouses in large-scale group spend each day is more than the one in small-scale group. even though the large-scale households invest more for facilities to reduce time and labor consumption, the quantity of pigs is too high so that working time required is more. further, husbands in large scale households spend more time for pig farming than wives because it is the main family income source. in the smallscale group, wives spend more time because husbands need to do off-farm works for additional income. the division of labor in pig farming is analyzed not only on working time but also on frequency that husband and wife participate in each breeding activities. basically, a full pig farming circle consists of 6 activities including selecting baby pig, preparing foodstuff, feeding, piggery cleaning, veterinary medicine applying and pig selling. in selecting breeds, the husbands are the main decision makers in both groups. only in some households, where the wives are the householders or their husbands are absent, the wives make the decisions. the selecting is very important for quality and productivity of the livestocks and is quite hard because breed suppliers are normally far from home, it needs to travel back and force many times and to be decisive. therefore, the husbands are more suitable for it. foodstuff preparation is simple but requires estimation of food amount enough for livestocks to best grow. in large-scale households this work is done mainly by both wife and husband with 70% in order to keep timing while in the small-scale group, 60% of wives do this stage (figure 3). compare to large-scale group, foodstuff preparation in the small-scale group is quite easy and mainly uses side products of crop cultivation like vegetables, maize, soybean, etc. thus, the wives take responsibility for this task while the husbands do other works to create more income. however, the large-scale households raise large quantity of pig. therefore, this preparation consumes a lot of time and requires both wives and husbands to do. in comparison with other pig farming stages, pig feeding is quite hard and needs be in time, especially in the large-scale households. facilities in the surveyed households are quite primitive. therefore, feeding is done manually by mainly both wives and husbands in this. the proportion of male participating in feeding in the large-scale group is higher than in the small-scale group. in the large-scale households, husbands pay more attention in breeding because it is the main source of income. in general, cleaning piggery and showering pigs are quite important to protect pigs from diseases. in the large-scale group, both wives and husbands of 70% of the households do cleaning job together because of high work load. in both groups, the proportion of female doing it alone is low because this work is hard and health-influent. male with better health does it instead of female. in pig production, applying veterinary medicine for disease protection is very important before diseases break out and are difficult to control. the survey reveals that veterinary service table 3: daily working hours spend on different pig farming stages description large-scale (n=20) p-value small-scale (n=20) p-value husband wife husband wife preparing foodstuff 2.5 2.3 0.000 1.0 2.5 0.009 feeding 4.7 3.0 0.194 1.2 3.8 0.026 piggery cleaning 4.0 2.5 0.043 1.0 2.0 0.081 source: household survey data, mann–whitney test. ***significant p<0.001, **significant p<0.05, *significant p<0.1 figure 2: working time share in pig farming by gender source: household survey data ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019188 at commune level is not very adequate. veterinary shops and veterinarians are mostly in towns that are far from farms. so that, vaccination or disease detection are all done by wives or husbands. injection requires some people doing together in short time. for example, a man catches and keeps a pig, another one prepares drugs and one man is to inject. in both groups, this work is done by mostly wives and husbands together. in some cases, it can be done by only wife or husband due to the other absent but it still needs some help from neighbors or relatives. according to farmers, selling pigs is the final stage of breeding process. it directly brings income to families. normally, traders come directly to households or are called by the householders. householders deal with traders for price. figure 3 shows that in large-scale group, both wife and husband participate in selling. sometimes, the households use outsource labor, which is mainly labor exchange, for pig catching. during selling, catching and driving pigs to trucks are hard works and to be done by male. female is in charge of monitoring weighing scale and recording weight. 4.3. gender division in decision making a part from division in each stage of pig farming, gender division of labor in families is also expressed in terms of decision making power. traditionally, male has usually been breadwinner in a red river delta family. however, with the absence of husbands working off farm far from home, many wivies become breadwinners who are empowered to make decision at home instead of their husbands. with respect to decision making power between husband and wife in pig production, this part focuses on clarify who decide what in terms of financial investment, pig farming activities and pig selling. decisions of financial investment for pig production including how much capital to be invested, how much loan needed and from 10 15 70 0 60 10 25 10 15 75 0 65 5 25 10 20 70 0 15 40 45 10 10 80 0 5 10 80 wife husband both wife husband both la rg e sc al e s m al l s ca le unit: (%) pigs selling medicine applying piggery cleaning pigs feeding food preperation figure 3: division of labor by different pig farming stages source: household survey data ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019 189 where always needs mutual agreement between wife and husband because it requires high capital of about 1000 us dollars for a litter of 10 pigs. an individual rarely make such decisions. loans they need are mostly from their relatives or banks which require both wife and husband to be present. thus, financial investment for pig farming is mostly decided by both wife and husband in 95% of surveyed households (figure 4), and the proportion of wife or husband making decision is equal in both groups. in some cases, when the wife is busy, the husband decides and vice versa but big expenditures will be decided by both. regarding pig farming activities, decision of “who do what” are mostly made by the discussion between wife and husband. in some households in small-scale group where only wife is at home, she has to take this task herself. meanwhile, there is 5% of husbands (figure 4), mostly in the large-scale group, decide all pig farming activites without negotiating with their wivies. among pig farming activities, deciding number of pigs in each litter is very important because that influences subsequent matters such as piggery, labor, foodstuff volume and facilities. it requires decision made by both wife and husband with 95% in the largescale group and 75% in the small-scale group. also, foodstuff type and veterinary medicine mostly are decided by either both wife and husband or husband in both groups. in general, the proportion of sole wife making pig farming activities’ decision is lower than sole husband as wives have to do deal with house tasks and crop production. moreover, wives do not usually attend training classes to enhance their knowledge and experience in pig farming. consequently, their contribution in decision making is normally lower than their husbands. in pig marketing, keeping contact and remaining the longterm relationship with pig traders is very important to have stable market and price. that is the reason why both wife and husband pay attention to this matter in 87.5% of surveyed households (figure 4). in the small-scale households, wives concern more about price and most of them contribute in making price decision with their husbands. husbands normally have longterm views. therefore, most of them take care the relationship with clients. furthermore, all pig traders are men, so that talking man to man is easier and it is faster to achieve final deal. 4.4. economic perspective of labor division in pig farming household theoretically, husband and wife divide their work in house to maximize the efficiency of the entire family unit. in other words, they try to optimize household’s income by using most of family labor resource in terms of educational level, health status, age, etc. accordingly, pig farming households in the red river delta diversify their income sources to obtain as much money as they can by assigning family labor into multiple work including pig farming, crop cultivation and off-farm activities. to achieve an insight into economic aspect of labor division in pig farming households, the authors analyze the correlation between household’s income with the division of working time for pig farming of husband. we attempt to test hypotheses that in households where the main livelihood depends on pig farming, husbands are assigned more time (over 50% of time) working for pig farming activities. on the other hand, in households where husbands working <50% of time for pig farming, it is because they focus on earning income from off-farm activities. in our survey, we also observe that the quantity of pigs in the two groups is quite different. a large-scale household raises average 109 pigs/l. meanwhile, a small-scale household raises only 49 pigs/l. both groups raise 2 litters a year. the weight of figure 4: decision making in pig production at household source: household survey data ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019190 finishing pigs is quite similar and meet standard. in recent years, pork price went down but no one among the surveyed households lost. in households where husbands spend over 50% of working time on pig farming, income from this sector contribtutes to 79% of total household’s income whereas income from off-farm activities is accounted for 18.5% and mostly earned by their adult children (table 4). industrialization process in the red river delta brings a lot of off-farm jobs to farm laborers who achieve requirements on education, health and age. therefore, earning from off-farm activities becomes the main choice of many farm households, especially for those can not afford to invest in large – scale pig farming. households with husbands participate in pig farming <50% of working time are mostly small-scale production. in these households, wivies take more tasks not only in pig farming but also in crop production. that is the reason why income share from crop production of this group is higher than the first group. moreover, income proportion from off-farm activites in this group is also higher than first group with 27.3% (table 4). 4.5. factors influencing division of labor in pig farming households division of labor in pig production depends on many household’s demographic factors including age, health status and educational level of spouse. further, number of family laborers involving in pig farming, pig production scale and especially husband’s perception of gender equality are also considered to have influence on dicision of “who do what” in household. as mentioned in research methodology, the authors apply a binary logistic model to quantify impact of such determinants on decision making in pig farming, whether husband has higher power in assigning who do what or both husband and wife decide together. results of logistic regression model illustrate that production scale, age and educational level of spouse, and husband’s perception of gender equality have statiscally significant effects on decision making process for pig farming. in general, in large scale group the probability of decision making by both husband and wife is 1.768 times higher than in small scale group; the higher educated and younger age of couples, the higher probability that decision in pig farming are made by both of them (table 5). in a traditional family in the red river delta, if a husband has higher education level than his wife, his opinions will be more respected and he will be able to divide works to the others. however in modern household, couples are mostly at younger age and the wife is also high-educated so that couples can discuss to make decision together. furthermore, education is a background to fast and effectively absorb and gain knowledge through training courses. whenever there is a training course, younger women are able to participate. therefore, they can confidently negotiate with their husbands in making decision regarding to pig farming. for what concern on perception of husband about gender equality, the finding is as expected. in household where husband considers that his wife plays an important role in making decision the probability of couples decide all the work is higher. in surveyed households, we recognize a common social perception is that male needs be breadwinner in families. men need be strong and responsible for their families. meanwhile, women with their native gentlenes and sweetness automatically claim to do light, detailed works which are mostly houseworks. women normally do not have much social relationship and definitive decisions like men do. we find that sexism still exists but of course less severely than before. houseworks such as cooking, washing, taking care of children are mostly done by women even though they also have to do agricultural works. while men are mostly in charge of works relating to society, community and having to travel a table 4: household’s income distribution based on husband working time classification income sources husband working time in pig farming over 50% of time (n=21) income share (%) under 50% of time (n=19) income share (%) p-value pig farming (usd) 11.575 79.0 5.637 66.8 0.039 crop production (usd) 370 2.5 500 5.9 0.000 off-farm activities (usd) 2.699 18.5 2.300 27.3 0.067 total income (usd) 14.644 100 8.437 100 0.001 source: household survey data. mann–whitney test. ***significant p<0.001, **significant p<0.05, *significant p<0.1 table 5: results of logistic regression model variation β coefficient significant exp (β) production scale 0.570** 0.014 1.768 age_h −0.552* 0.071 0.575 age_w −0.343* 0.066 0.709 education_h 0.381** 0.032 1.463 education_w 0.394* 0.097 1.482 health_h 1.056 0.349 2.874 health_w 1.769 0.663 5.864 perception_h 0.849** 0.022 2.337 perception_w 1.425 0.201 4.175 family laborer 0.069 0.929 1.071 constant 1.264 0.067 3.539 omnibus tests of model coefficients χ2: 33.898 significant: 0.000 nagelkerke r2: 0.788 **coefficient is significant at the 0.05 level, *coefficient is significant at the 0.1 level ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019 191 lot. when there is a matter concerning breeding or family, both wife and husband will discuss. but eventually, the husband will make the final decision. thus, social perceptions still exist and partly influence the thought about gender in families. in surveyed households, the role of wives in families is appreciated, especially in financial managing. however, there are some men still consider women’s role normal or unimportant. such men’s sexism affects division of labor. reversely, some women self evaluate that they do not have as good decisions as their husband do due to their low level of education and knowledge. they also always consider that their husbands are householders and in charge of making decisions. therefore, when they are assigned a work, they do not refuse even sometimes they feel not right. another reason for that is the conservative of the husbands. they will not change their decisions regardless of their wives’ ideas. thus, women are inhibiting themselves. they need to actively bring out their own opinions to achieve effective division of labor. 5. conclusion despite the fact that pig selling price has reduced in recent years, pig farming still contributes remarkable income to farm households in the red river delta, especially in the context of farmland is transferring to off-farm purposes. however, in pig farming at household level, our paper reveals that there are some limitations about division of labor in the studied area. the householders are not trained for business management, low educational background with 95% of householders obtain only primary and secondary school that inhibits their decision making and dividing works. the education level of laborers, especially women, is also low that obstructs the applying of new techniques and technologies and leads to low productivity. overall, gender division of labor in pig farming is difference in each type of activities and in each group of households. depending on characteristics of each production stage and the contribution of pig farming to total household’s income, the division of labor varies. in the small-scale group where pigs are raised mainly by using their own products of agriculture, wives usually perform more work than husbands because a majority of husbands working in off-farm activities. reversely, in the 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(2009), industrialization and urbanization in vietnam: how appropriation of agricultural land use rights transformed farmers’ livelihoods in a peri-urban hanoi village? working paper ninh, et al.: labor division in pig farming households: an analysis of gender and economic perspectives in the red river delta vietnam international journal of economics and financial issues | vol 9 • issue 1 • 2019192 no.38, east asian development network. paris, t., rola-rubzen, m.f., luis, j.s., chi, t.t.n., wongsamun, c., villanueva, d. (2010), interrelationships between labor outmigration, livelihoods, rice productivity and gender roles. rome, italy: occasional paper, ifad. pham, t.t. (2013), climate change and its gendered impacts on agriculture in vietnam. international journal of development and sustainability, 2(1), 1-11. tiransia, a.s. (2011), gender division of labor in food production and decision making power and impact on household food security and child nutrition in rural rukwa, tanzania. unpublished master thesis. norway: university of oslo. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(3), 333-339. international journal of economics and financial issues | vol 8 • issue 3 • 2018 333 the role of macroeconomic factors on sukuk market development of gulf cooperation council (gcc) countries arafat mansoor al-raeai1*, zairy zainol2, ahmad khilmy bin abdul rahim3 1islamic business school, college of business, university utara malaysia, 06010 sintok, kedah, malaysia, 2head of islamic finance and islamic economic, islamic business school, college of business, universiti utara malaysia, 06010 sintok, kedah, malaysia, 3senior lecturer, islamic business school, college of business, universiti utara malaysia, 06010 sintok, kedah, malaysia. *email: ama.alraei@yahoo.com abstract macroeconomic factors are regional or national economic factors which externally impact the financial strategies of governments and corporations, including debt financing decisions. the literature related to the financial management acknowledges the significant role that macroeconomic factors play to determine the financial market development. the aim of this paper is to propose a conceptual model/framework for investigating the role of macroeconomic factors on sukuk market development (smd) in gulf cooperation council (gcc). gcc economies depend heavily on oil revenues which makes them subject to oil prices fluctuations. therefore, gcc’s governments should diversify their economies by looking for sukuk as an alternative source of financing, to cover their budget deficit, when the price of oil decreases, and reduce their reliance on oil, because sukuk has advantages compared to the conventional bond particularly in terms of less information asymmetry. the prior studies have mostly focused on firms’ characteristics determinants of sukuk issuances but gave a little consideration to the role of country’ characteristics on smd. this paper proposes a framework to explain the main macroeconomic determinants of smd with a focus on the gcc countries that have the largest region in terms of the islamic financial assets. it is anticipated that the outcome will support policymakers to improve the current state of sukuk market. keywords: sukuk, macroeconomic variables, gulf cooperation council countries jel classification: e6 1. introduction several types of research have been carried out on the determinants of the development of capital market including both equity and debt market. hence, the determinants of the stock and bond market development were the subject of major theoretical and empirical studies in both developed and developing countries from the different perspective. on the contrary, the growing importance of sukuk markets around the world has recently opened a new avenue of research into the challenges and factors which the development of sukuk market are facing. nevertheless, there are relatively a very limited amount of literature focusing on sukuk market. though, this paper has not found any study on the role of some macroeconomic variables on sukuk market development (smd) in gcc countries. the financial market is important to contemporary economies. this is because it plays the role of a mediator between lenders and borrowers. thus, sukuk market might play a key role in economic development and support the gross domestic product (gdp) of countries. this can be done through the mobilization of savings and by channelling these savings to useful and islamic law compliant investments. several businesses and policymakers are viewing at the sukuk markets as a long-term financing source. since they are a mechanism of financing for the long-term and thanks to their investment diversification, they can finance potential projects in industry infrastructure, and agriculture (tariq and dar, 2007). kusuma and silva (2014) argued that as many countries tried to establish sources of long-term financing, sukuk appears to be the most relevant way of assisting such countries, expand the pool of capital for investment’s financing and reinforce growth. thomas al-raeai et al.: the role of macroeconomic factors on sukuk market development of gulf cooperation council countries international journal of economics and financial issues | vol 8 • issue 3 • 2018334 (2007) further claimed that there is a huge potential for sukuk whose growth is largely dependent on the gulf cooperation council’s (gcc) and asia’s strong economic base. sukuk as significant players of islamic financial market operate in an external business environment, which is an interdependence of several factors related to a society that form and determine their activities. the external business environment is comprised of political, environmental, social, macroeconomic, legal, and technological factors that impact and form the financial markets and institution’s activities. sukuk issuances are determined by these external business environment determinants which externally impact the financial strategies of corporations, including debt funding decisions. shahida and sapiyi (2013) highlighted that identifying the factors that determine the issuance of sukuk be it based on internal or by external incentives are noteworthy. however, several countries are completely involved in efforts aimed at developing their domestic sukuk markets, but with diverse levels of success recorded to date. accordingly, kusuma and silva (2014) pointed out that the current approaches adopted for the development of the domestic sukuk market vary significantly across countries, due to countryspecific circumstances. moreover, jobst et al. (2008) considered the issue of identifying the factors that may hold back further market development, which is one of the most important issues related to the issuance of sukuk. in particular, it is important to identify the main economic, legal, and regulatory challenges that need to overcome. furthermore, samoui and khowaja (2016) noted that countries trying for the promotion of their sukuk markets should strive to establish their economies and adopt stable macroeconomic policies to create an attraction for investors to hold sukuk securities. gcc states are exporters of oil and any variations in international oil prices can influence growth in gdp, government budgets, development programs, exports, fiscal revenues, and other macroeconomic factors. resultantly, this substantial dependency on oil puts the gcc economies at a high level of exposure to external shocks that could additionally endanger the stability of sukuk markets. recently, the markets have seen the appearance and fast growth of sukuk certificates. these instruments seem to offer governments and corporations not only with an alternative source of financing in compliance with sharia rules but also can be seen as a way to avoid crises. however, the sukuk market has strived in the prior couple of years because of the uncertainty in the global economy which is the main reason behind the dearth of new players. the tendency of recent studies is to focus on the firms’ characteristics and their impact on the choice decisions of bond or sukuk issuance in the firm’s finance structure. however, the influence of macroeconomic factors on smd has remained vague and not fully understood because of lack of the studies. this paper tries to fill the gap by offering a model that can be utilized to explain this research issue and makes an addition to the literature through explaining the relationship between macroeconomic variables and smd in gcc countries. the paper proceeds as follows: section 2 concentrates on the “sukuk.” section 3 discusses various literature related to macroeconomic variables and bond market development. section 4 offers the expected policy implications. section 5 offers some conclusions. 2. what is sukuk? sukuk (plural of sakk) are explained as islamic bonds, literarily denote islamic type of investment certificates that are likened to conventional bonds. issuances of sukuk and islamic banking are two of the most famous and broadly accepted shariah-compliant practices in the industry of islamic finance where islamic banks are considered as conventional bank’s counterparts and sukuk offers the shariah-compliant type of conventional bonds. sukuk, usually recognized as islamic bonds, is an investment certificate which follows islamic law. accounting and auditing organization for islamic financial institutions (2010) describes sukuk as “certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services, or the assets of particular projects or special investment activity.” further, godlewski et al. (2013) opined that sukuk is investment certificates that are characteristic of both bond and stock-like features that are allotted for financing trade activities or in producing tangible assets. contrarily, as compared to conventional bonds, the sukuk do not offer guaranteed returns and cash flows; there is no interest payment, as returns on sukuk are associated with the profit generation that is achieved by real transactions from an underlying real business risk (zakaria et al., 2012). this striking disparity among islamic and conventional financial tools provides a contribution to comparatively positive performance of islamic finance during and post global financial crisis 2008. sukuk (islamic bond) and conventional bonds are similar in purpose and both are used for long-term financing. as noted by ahmad and radzi (2011) and saad et al. (2016), in some respects, the sukuk is like the conventional bonds, it is a security instrument that offers an expected return’s level. though, the fundamental structure and provisions of the sukuk are dissimilar. in that a bond is a representation of the actual debt of the issuer, the sukuk is a representation of certificates of equivalent value with undivided beneficial (proportional to the investor’s participation) ownership in the underlying assets, usufruct, services or investment in certain projects or activities of special investment. contrary to this, conventional bonds can be classified as either pure debt contracts or represent financial claims on opaque projects where the underlying asset may not have a real economic value. 3. review of the related literature despite the emergence of sukuk across different markets worldwide, there are few studies on this subject. consequently, in what follows, it is worth assessing the literature on the macroeconomic determinants of conventional bond markets. 3.1. overview of gccs’ smd the development of sukuk market in gcc countries has undergone through three distinct stages. the first stage from 2001 to 2007 which al-raeai et al.: the role of macroeconomic factors on sukuk market development of gulf cooperation council countries international journal of economics and financial issues | vol 8 • issue 3 • 2018 335 coincided with the oil boom and rapid development of the global market; around 41% of the total sukuk issuances so far were within this period, and only 27% of the total sukuk issuances so far were in the second stage 2008-2010 which was low because of the global financial crisis. the third stage started from 2011 and continues to date. the best time was since 2001 in terms of sukuk issuance in gcc countries, as the number of issuances was 60 in 2012, which was the highest issuances obtained in gcc countries. the issuing value reached a new record, which broke the records of 2007 with a big margin. the beginning of the year 2013 was good for the gcc sukuk market as the number of issuances was 18 within only 3 months. evidently, bahrain was the first issuer of sukuk and the central bank of bahrain issued salam and ijarah sukus are typically oversubscribed. however, the uae issues the highest number of sukuk in terms of volume, making it the leader in gcc region, while bahrain is leading in terms of number of issues in sukuk market. according to thomson reuters report (2016), there has been deterioration in the percentage of gcc’s total sukuk issuance in the recent years. the gcc’s share of global sukuk issuances decreased in the recent years, where the volume of sukuk issuances in the gcc continued to fall since 2013, while the volume of bond financing increased. table 1 presents the descriptive statistics of smd across gcc countries; named saudi arabia, united arab emirates, bahrain, qatar, and kuwait; over the period 2001-2016. table 1 shows that united arab emirates has the lowest level of smd, which is about <1% with standard deviation 0.008 and varies from as low as 0 (no sukuk issuance) to a maximum of 0.89%, while bahrain has the highest level of smd, which is about 9.17% with standard deviation 0.045 and ranges from a minimum of 2.73% to a maximum of 17.6% of gdp. also, the percentage of sukuk market volume relative to gdp for kuwait and saudi arabia seems to be within the same level which is about <1% (0.36% and 0.38% respectively). the level of smd in qatar reported in this study is 78% and ranges from a minimum of 0 to a maximum of 5.4% of gdp. as it can be seen in table 1, the total average of gcc’s smd is very small relative to gdp, which is 2.17% with a maximum value of 17.6% in bahrain. this result is consistent with grassa and gazdar (2014), who found that the sukuk market is new and normally small capital market in the gcc countries, thus gcc’s sukuk market do not approach the level of threshold that enables them to contribute towards economic growth. based on the above discussion, it becomes imperative to conduct this study as an initial attempt to explore the factors affecting the smd in the gcc countries as these factors being overlooked by previous researchers. 3.2. macroeconomic determinants of smd it is apparent that there is a scarcity of literature associated with the sukuk markets at country level, but, in particular, there is also a lack with regard to the gcc’s sukuk market. actually, the empirical literature reviewed in this paper, two studies only include the smd and analyzed the influence of foreign factors on its dynamic behaviour. these two studies conducted by smaoui and khawaja (2016) and said and grassa (2013), are very similar, which only focused on some macroeconomic and financial factors over the same period for 13 countries from different regions. hence, the further empirical investigation becomes necessary. therefore, the current literature reveals research gaps about the factors of smd in gcc countries. there are many macroeconomic factors that can govern the country’s smd level. many authors adopted the following variables (such as, adelegan and radzewicz-bak, 2009; bolgorian, 2011; bhattacharyay, 2013; eichengreen, 2006; felman et al., 2014; le et al., 2015; plummer and click, 2005) for examining the association among macroeconomic variables and bond market development, which are suitable to sukuk market too; hence they can be used in the proposed study (figure 1). 3.2.1. stage of economic development and smd this is a significant macroeconomic factor that has played a role in determining bond market development over the years and the majority of the researchers have determined a significant association among stage of economic development and bond market development. majority of the results tend to be significant and positive (bhattacharyay, 2013; cherif and gazdar, 2010; garcia and liu, 1999a; yartey, 2008; 2010). gdp measures the development stage of the economy through per capita as purchasing power parity of the population. economies falling in the higher stages of economic development tend to have better institutions and less unstable economic conditions, which uplift the development of sound financial markets; consequently, a positive association among the two is noted. concerning sukuk, said and grassa (2013), also concluded that gdp per capita has a significant and positive association with smd among 10 countries from different regions. on the contrary, smaoui and khawaja (2016) found no significant relationship between the gdp per capita and smd. hence, the further empirical investigation becomes necessary. for this paper, we suggest the log gdp per capita in assessing the association between smd and stage of economic development. our expectation is that higher stages of economic development will lead to improving the development of sukuk market. table 1: descriptive statistics of smd by countries over 2001-2016 country n min. max. mean±sd saudi arabia 16 0 0.0137364 0.0038345±0.0039324 united arab emirates 16 0 0.008851 0.0016253±0.0083509 bahrain 16 0.027306 0.1761255 0.0917529±0.0449971 qatar 16 0 0.0540362 0.0078257±0.0134053 kuwait 16 0 0.031756 0.0036019±0.0023473 all countries 80 0 0.1761255 0.0217281±0.0410029 sd: standard deviation, smd: sukuk market development al-raeai et al.: the role of macroeconomic factors on sukuk market development of gulf cooperation council countries international journal of economics and financial issues | vol 8 • issue 3 • 2018336 3.2.2. savings rate and smd sukuk market, like financial intermediaries and banks, represents one way to pooling the savings from surplus units and channelling them into productive investments. on the other hand, if the banking sector is more developed, savings might channel through the banking system rather than sukuk market, reflecting the greater ability of banks to fund themselves and also corporates through deposits in high-saving countries. the rate of savings is assumed to have a significant influence on stock and bond market, where a positive relationship was found (aduda et al., 2012; garcia and liu, 1999; naceur et al., 2007; adelegan and radzewicz-bak, 2009; yartey, 2008). mukherjee (2006) argued that high asian savings rates discourage bond market development by giving banks ample deposits to lend. therefore, the highest savings rates in gcc countries might affect sukuk market positively or negatively. hence, the further empirical investigation becomes necessary. however, there is a consensus among researchers on the measurement of savings rate in relations to stock and bond market development. following prior studies, the savings rate is calculated as the ratio of gross domestic saving as a percentage of gdp. 3.2.3. foreign exchange rate and smd the nature of the exchange rate regime is expected to have implications on the level of bond market development. bases on extant empirical submissions, the link between exchange rate and market size can be both positive and negative, this is due to the fact that exchange rate is critical to balancing how the demand and supply of assets are determined. it is also important for the individuals who hold domestic and foreign assets in their portfolios. bhattacharyay (2013), adelegan and radzewicz-bak (2009), mu et al. (2013) found a negative and significant influence on bond market development. regarding sukuk, sukuk trading has been listed in us dollar rate. therefore, the change in the us dollar rate creates change in sukuk return, which in turn, influence on the volume of sukuk issuances. currency exchange risk occurs when an investor buys sukuk in foreign currencies. high currency volatility creates uncertainty to the real value of the sukuk and thus creates an impediment to smd. ahmad and radzi (2011) found that both sukuk and conventional bond issuance in malaysia consider foreign exchange to be the major cause of bond and sukuk issuance. on the other hand, smaoui and khawaja (2016) found that no significant relationship between the volatility of changes in exchange rates and smd. consequently, our expectation is that the higher the volatility of a country’s exchange rate, the lower is the development of its sukuk market. 3.2.4. inflation rate and smd the rate of inflation is presumed to have a significant impact on the general price level of goods and service in a specific economy which might also include the prices of sukuk. certainly, inflation is capable of increasing interest rates, which makes fixed interest rate instruments to deteriorate in value. also, when the inflation rate increases, the price fixed interest rate instruments tend to decrease. this supposition might be true particularly if the price of a fixed interest rate instrument tends to drop, due to the fixed interest rate may not be adequately defraying interest to stay ahead of inflation. among the contributors to the association between inflation and sukuk issuance (ahmad et al., 2012; naifar and mseddi, 2013). interestingly, shariah-compliant instruments are exposed to inflation but not as much as conventional bonds, because inflation increases the market price of the underlying assets positively. this argument supported by said and grassa (2013) who found that inflation does not seem to have a strong effect on the development of sukuk market. there is no consensus on a single measurement of inflation among researchers. said and grassa (2013) used the rate of inflation to measure its association with smd. however, ahmad et al., 2012 used a proxy of consumer price index to measure annual rate of inflation. though, for the proposed study this paper suggests the figure 1: theoretical framework al-raeai et al.: the role of macroeconomic factors on sukuk market development of gulf cooperation council countries international journal of economics and financial issues | vol 8 • issue 3 • 2018 337 adoption of the inflation rate, because it offers a fair indication of inflation rate in the country. 3.2.5. oil price and smd according to cunado and garcia (2005), oil prices have a different impact on bond prices depending on whether the country is an exporter or importer of oil and the level of economic development of this country. the price of oil determines the level of government budget revenues, and hence, aggregate demand in the whole economy. however, studies about oil price and stock market found that there is a positive relationship between them (basher and sadorsky, 2006; gjerde and sættem, 1999; harrathi and almohaimeed, 2015). on the other hand, the effect of the price of oil on financial markets in net oil importing countries, i.e.,usa and australia, is expected to be a negative (faff and brailsford, 1999; huang et al., 1996; sadorsky, 1999). changes in the price of oil may indirectly affect the prices of sukuk via its effects on the expected inflation rate and the expected real interest rate. gcc economies are characterized by the robustness of their reserves surplus, meagre debt levels and strong credit profiles. yet, these economies suffer from their high dependence on oil revenues. this situation implies a high and significant volatility to variations in international oil prices. indeed, oil exports have a considerable influence on gcc countries’ earnings, government budget revenue, expenditure, and aggregate demand. gcc countries have a broader oil sector, accounting for 45% of global oil reserve. according to thomson reuters reports (2016), there were expectations that oil-exporting countries (particularly those of the gcc) hit by low oil prices would be driven to widen and deepen their sukuk markets to raise finance and solve the major revenue cut in their budgets, but these expectations were not met. there is no agreement on a single measurement of inflation among researchers. basher and sadorsky (2006) and awartani and maghyereh (2013) used the wti crude oil because this measure is the foremost yardstick used for pricing oil imports into the u.s. however, the most of studies preferred the brent oil price because it is used to price two-thirds of the crude oil inter-continentally traded. in line with the previous studies, this paper proposes the adoption of brent oil price as a means of measuring oil price in relation to smd. 3.2.6. trade openness and smd trade openness indicates to the level at which countries or economies allow trade or trade with other countries or economies (zhang et al., 2015). more open economies do less to suppress the securities market because established interests may not be able to insist on policies that suppress competing sources of supply when the economy is exposed to international competition (rajan and zingale, 2001). trade openness variable has been used by a significant number of studies (rajan and zingales, 2001; eichengreen and luengnaruemitchai, 2004; bhattacharyay, 2013). these studies found the significant positive effect of the trade openness on bond market development in developed and asian markets. corporations in open economies need more sources of capital to remain competitive. when there is a higher level of economy openness, it is easier to get access to external funding from the foreign investors. this will improve the development of sukuk market. sukuk markets will be able to do well in a more opened economy, but banks, the dominating finance sources, usually want to protect their influence in the market by limiting the development of securities market towards the foreign market. the expected positive relationship with sukuk market is because of the openness that allows the developing economies in particular easy access to foreign savings or pool of funds. it also boosts international capital flows, enhances the liquidity of the domestic capital market, and reduces the cost of capital for industrial projects. smaoui et al., (2017) found a positive association between trade openness and the development of the sukuk market. in line with the previous studies, this paper proposes the use of the ratio of the total imports plus exports as a proportion of gdp in determining the relationship between smd and trade openness. as much as these macroeconomic variables can have a significant impact on the smd, regulatory authorities and policymakers can do so much in ameliorating such effects thereby strengthening the sukuk market. 4. policy implications the policy implications will be based on the outcome of the proposed research on the role of macroeconomic variables on smd in gcc countries. if the empirical evidence establishes the macroeconomic factors influence the smd then the policy implication will be for the governments, policymakers, investors, creditors and researchers, especially concerning issues relating to sukuk market. it will be possible to make recommendations to support country’s specific factors in the sukuk market that are expected to contribute to the sustainable growth of sukuk market with the findings. this proposed model will be served as a guidance or signal to investors in making a capital investment. this may aid them in making the right decision to invest in sukuk is based on the significant macroeconomic variables. furthermore, it will also be possible to provide recommendations regarding, which factors the management should give more weight in managing risks or minimize the negative effect and avoid unnecessary disappointments. the practice of good factors knowledge will definitely help to promote the growth of the sukuk market. in addition, the study may also offer insights for policy level as to the formulation and implementation of suitable monetary and fiscal policies that could assist in the financial market’s stability by a focus on the macroeconomic variables that effect sukuk issuance. this also will also help to mitigate different factors of macroeconomic involved in the sukuk market. 5. conclusions in view of the ongoing global financial and economic crisis, low oil price and political instability, the development of sukuk markets in gcc region assume high importance for financing the region’s corporate and government sector and large demand for infrastructure. well-developed sukuk markets can provide gcc al-raeai et al.: the role of macroeconomic factors on sukuk market development of gulf cooperation council countries international journal of economics and financial issues | vol 8 • issue 3 • 2018338 countries with alternative sources of financing and at the same time improve the region’s financial resilience by balancing the high dependence on the oil exports and banking sector. further, gcc countries also need to utilize its huge savings and international reserve for meeting large needs of productive investment in the region, particularly in infrastructure through sukuk markets development. local and regional capital can be channelled for long-term infrastructure projects and other productive investment through sukuk markets. therefore, to enhance the sukuk market, there is the need for gcc countries to understand the role of macroeconomic factors on sukuk market. this is essential to promote their sukuk markets through struggle to develop their economies and follow stable macroeconomic policies to make it attractive for investors to hold sukuk securities. references accounting and auditing organization for islamic financial institutions (aaoifi). 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(2015), trade openness, financial openness, and financial development in china. journal of international money and finance, 59, 287-309. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(6), 187-191. international journal of economics and financial issues | vol 8 • issue 6 • 2018 187 1. introduction investors want to get high returns with low risk. for this reason, investors try to reduce the risk by diversifying instead of investing in a single security as it increases the risk. investors should decide which assets will invest in and how much each asset will invest in. however, small investors do not have this knowledge. accordingly, collective investment institutions that provide professional portfolio management services to investors have been established. real estate investment trusts (reits) are also one of the collective investment institutions. they must provide good performance to their managed portfolio. it is important to appraise their performance in order to lose the funds they have and collect new funds. reits were first established in the usa in 1961. reits have been the most important institutional investors in the world real estate markets since their establishment, ın turkey, they began their activities in 1995 after the announcement related to the establishment of reits by capital markets board (hayta, 2009). this journal is licensed under a creative commons attribution 4.0 international license performances appraisal of real estate investment trust in borsa istanbul songul kakilli acaravci 1*†, ali acaravci2, yunus karaomer3 1department of business, faculty of economics and administrative sciences, hatay mustafa kemal university, turkey, 2department of economics, faculty of economics and administrative sciences, hatay mustafa kemal university, turkey, 3department of business, faculty of economics and administrative sciences, hatay mustafa kemal university, turkey. *email: sacaravci@mku.edu.tr received: 08 september 2018 accepted: 28 october 2018 doi: https://doi.org/10.32479/ijefi.7326 abstract the real estate investment trusts (reits) have an important role in the development of the real estate sector. for investors, the reits are financial institution that offer service such as professional portfolio management, risk reduced through diversification, and utilization of scale economies. the reits offer new opportunities for investors by making liquidity high securities the real estate properties in their portfolios. in this paper, the performances of firms traded as the reits in borsa istanbul (bist) during july 2005 june 2016 are investigated by employing 4 different regression models (the capital asset pricing model, fama-french 3 factor model, ff four f model, and ff five f model. in this manner, regression model is estimated in which returns of the reits are used as dependent variable; whereas market premium, size premium, value premium, profitability premium, and investment premium are used as independent variables. the jensen alpha which is a risk-adjusted performance measure is estimated as fixed term (alpha) between related returns and factors in regression equation. positive alpha value refers to the risk-adjusted high performance, while negative alpha value refers the risk-adjusted low performance. it is also tested whether the alpha value is different from zero in performance appraisal. empirical findings suggest that the alpha coefficient is not statistically significant in four different regression models. this result indicate that the reits do not seem to over perform than market premium, size premium, value premium, profitability premium, and investment premium during the analysis period. thus, analysts or investors will be able to estimate expected returns by considering these premiums. keywords: real estate investment trust, jensen alpha, capital asset pricing model, fama-french factor models jel classifications: c19, d53, g14† † this work was financially supported by a grant (mku-bap 18.m.044) from the hatay mustafa kemal university, scientific research project unit. acaravci, et al.: performances appraisal of real estate investment trust in borsa istanbul international journal of economics and financial issues | vol 8 • issue 6 • 2018188 performances appraisal of the reits have been one of the most important and remarkable topics in the field of finance. this paper has two main contributions. first, this paper contributes that the performances of firms traded as the reits in borsa istanbul (bist) during july 2005 june 2016 are investigated by employing four different regression models (the capital asset pricing model (capm), fama-french 3 factor model [ff(3)f], ff four f model (ff(4)f], and ff five f model [ff(5)f]). second, this paper contributes to the literature on performances appraisal of the reits (smith and shulman, 1976; titman and warga, 1986; han and liang, 1995; buttimer et al., 2001; hayta, 2009; erdogan et al., 2016). smith and shulman (1976) investigated performance appraisal of 16 reits from 1963 to 1974 periods for usa using the capm. according to the finding, the reits performed better than other financial indicators for 1963-1973. titman and warga (1986) investigated performance appraisal of the reits from 1973 to 1982 periods using the capm and the arbitrage pricing model. according to the analysis results, it was found that the reits performed similar to the market portfolio. han and liang (1995) investigated performance appraisal of the reits from 1970 to 1993 periods using the capm. according to the finding, it was determined that the reits performed similar to market portfolio and quarterly treasury bills. buttimer et al. (2001) investigated performance appraisal of the reits from 1980 to 1999 periods using the ff(3)f and carhart (1997) model. according to the findings, it was found that the reits indicated significant return performance especially at the beginning of 1990s. hayta (2009) investigated the performance appraisal of 8 reits from july 2002 to june 2007 and july 2003-june 2008 periods for bist using the capm, ff[3]f. according to the analysis results, it was determined that the capm and ff[3]f no explain the variations in stock returns. erdogan et al. (2016) investigated appraisal of the 12 reits from 2011 to 2015 periods for bist the multi criteria decision making methods. according to the analysis results, yesil gyo was the reits which indicated the worst financial performance. the aim of this paper, the performances of firms traded as the reits in bist by employing four different regression models (the capm, ff[3]f, ff[4]f, and ff[5]f) is investigated. this paper is organized as follows: in section 2, we present data, research methods and asset prıcıng models, in section 3, we present our results, and in section 4, concludes. 2. data, research methods and asset pricing models the jensen alpha criterion is an important method used to measure portfolio performance. developed by jensen (1969). the aim of this method is to evaluate portfolio performance considering risk. the jensen criterion is based on the capm. the jensen alpha which is a risk-adjusted performance measure is estimated as fixed term (alpha) between related returns and factors in regression equation. positive alpha value refers to the risk-adjusted high performance, while negative alpha value refers the risk-adjusted low performance. it is also tested whether the alpha value is different from zero in performance appraisal. it is based on the following regression equation (ural, 2010): rpt–rft=αp+bp(rmt–rft)+εpt (1) where rpt, are returns on the analyzed asset p at time t, rmt and rft are market portfolio and risk-free asset at time t; αp and bp are regression parameters. the intercept αp (jensen-alpha) measures the average abnormal return. εpt is a zero-mean residual at time t. in this paper, the jensen alpha value will be estimated using the ff(3)f, ff(4)f, and ff(5)f. these models are used as an alternative way of estimating the alpha. these regression equations are shown as follow: ff[3]f: rpt–rft=αp+bp(rmt–rft)+spt(smbt)+hp(hmlt)+εpt (2) ff[4]f: rpt–rft=αp+bp(rmt–rft)+spt(smbt)+hp(hmlt)+rp(rmwt)+ εpt (3) ff[5]f: rpt–rft=αp+bp(rmt–rft)+spt(smbt)+hp(hmlt)+rp(rmwt)+ cp(cmat)+εpt (4) where rpt is the return on the analyzed asset p at time t; rmt and rft are market portfolio and risk-free asset at time t; smbt is the return on a diversified portfolio of small stocks minus the return on a diversified portfolio of big stocks; hmlt is the difference between the returns on diversified portfolios of high and low market value/book value (me/be) stocks; rmwt is the difference between the returns on diversified portfolios of stocks with robust and weak profitability; cmat is the difference between the returns on diversified portfolios of the stocks of low and high investment firms, which we call conservative and aggressive; εpt is a zeromean residual at time t; the “αp, bp, sp, hp, rp, and cp” are regression parameters, the intercept αp (jensen-alpha) measures the average abnormal return (fama and french, 2015). our sample comprised the 14 reits which traded in bist during the periods between july 2005 and june 2016. we used monthly data from july 2005 to june 2016 as the sample period. data on share returns (rp), it was gathered from data in which finnet (http://www.finnet.com.tr). the bist national-100 indices were used as the market return (rm). it was gathered from data in which finnet (http://www.finnet.com.tr). monthly interest rates derived from the annual interest rates of central government domestic debt stock and used as a risk-free interest rate (rf) in the paper, it was gathered from republic of turkey prime ministry undersecretariat of treasury (http://www.hazine.gov.tr). while the capm performs performance analysis only on the basis of the market risk factor, the ff[3]f, ff[4]f, and ff[5]f perform performance analysis on smb, hml, rmw and cma risk factors. various data of stocks traded in bist are needed to construct these risk factors. when these factors are construct, firms’ me, me/be ratio, profitability, and investment factor ratio are needed. this data was gathered from data in which finnet (http:// www.finnet.com.tr). we construct portfolios following the portfolio construction methodologies of fama and french for construct the factors (fama and french, 1993, 2012, and 2015). firstly, after the firms acaravci, et al.: performances appraisal of real estate investment trust in borsa istanbul international journal of economics and financial issues | vol 8 • issue 6 • 2018 189 in the sample group are divided into 2 groups (based on median value, small and big; s, b) portfolios are determined for the size effect and 3 groups (high, medium, and low; h, m, l) portfolios are determined for the me/be ratio effect. a total of 6 (2 × 3) intersection portfolios are constructed for the size effect and the me/be ratio effect (based on the breakpoint bottom 30%, middle 40%, and top 30%) and (smb and hml) are used for the calculation of (sl, sm, sh, bl, bm, bh) risk factors. later on, the firms in the sample group are divided into 2 groups (based on median value, small and big; s, b) portfolios are determined for the size effect and 3 groups (robust, medium, and weak; r, m, w) portfolios are determined for the net income/book equity ratio effect. a total of 6 (2 × 3) intersection portfolios are constructed for the size effect and the net income/book equity ratio effect (based on the breakpoint bottom 30%, middle 40%, and top 30%) and (smb and rmw) are used for the calculation of (sw, sm, sr, bw, bm, br) risk factors. lastly, the firms in the sample group are divided into 2 groups (based on median value, small and big; s, b) portfolios are determined for the size effect and 3 groups (conservative, medium, and aggressive; c, m, a) portfolios are determined for the investment ratio effect. a total of 6 (2×3) intersection portfolios are constructed for the size effect and the investment ratio effect (based on the breakpoint bottom 30%, middle 40%, and top 30%) and (smb and cma) are used for the calculation of (sc, sm, sa, bc, bm, ba) risk factors. we use the investment variable which is the growth of total assets for the fiscal year ending in “t−1” divided by total assets at the end of “t−2”. portfolio construction periods have calculated between at the end of july of each year t and end in june of each year t+1. thus, in the calendar year t–1 are matched with the returns for july of year t to june of year t+1 for the portfolio construction see table 1. (rm–rf) represents the market premium and it is the return of the market over the risk-free interest ratio. smb represents the size premium. hml represents the value premium, rmw represents the profitability premium, and cma represents investment premium. 3. results the capm is first used in the paper. in the regression model, it is estimated in which returns of the reits are used as dependent variable; whereas return of the market over the risk-free interest ratio (rm–rf) are used as independent variables. table 2 shows the alpha value, t-statistics, adjusted r2, and f statistical values of this regression model. in table 2, it is seen that the alpha coefficients are statistically insignificant in regression models. accordingly, there are no successful performance the reits in the analysis period. in other words, these the reits do not seem to over perform than market premium during analysis period. moreover, the results of the regression equations for the atagy, dzgyo, nugyo, vkgyo are not evaluated due to statistically insignificant f statistics. secondly, the ff[3]f is used in the paper. in the regression model, it is estimated in which returns of the reits are used as dependent variable; whereas return of the market over the risk-free interest ratio (rm−rf), smb and hml factors are used as independent variables. table 3 shows the alpha value, t-statistics, adjusted r2, and f statistical values of this regression model. in table 3, it is seen that the alpha coefficients are statistically insignificant in regression models. accordingly, there are no successful performance the reits in the analysis period. in other words, these the reits do not seem to over perform than market premium, size premium and value premium during analysis period. moreover, the results of the regression equations for the algyo, atagy, dggyo, dzgyo, vkgyo are not evaluated due to statistically insignificant f statistics. third, the ff(4)f is used in the paper. in the regression model, it is estimated in which returns of the reits are used as dependent variable; whereas return of the market over the risk-free interest ratio (rm−rf), smb, hml, and rmw factors are used as independent variables. table 4 shows the alpha value, t-statistics, adjusted r2, and f statistical values of this regression model. in table 4, it is seen that the alpha coefficients are statistically insignificant in regression models. accordingly, there are no successful performance the reits in the analysis period. in other words, these the reits do not seem to over perform than market premium, size premium, value premium and profitability premium during analysis period. moreover, the results of the regression equations for the algyo, atagy, dggyo, dzgyo, vkgyo, ykgyo are not evaluated due to statistically insignificant f statistics. lastly, the ff(5)f is used in the paper. in the regression model, it is estimated in which returns of the reits are used as dependent variable; whereas return of the market over the risk-free interest ratio (rm−rf), smb, hml, rmw, and cma factors are used as independent variables. table 5 shows the alpha value, t-statistics, adjusted r2, and f statistical values of this regression model. in table 5, it is seen that the alpha coefficients are statistically insignificant in regression models. accordingly, there are no table 1: construction of portfolios and factors size me/be ratio net income/book equity ratio (op.) investment ratio (invs.) high (h) medium (m) low (l) robust (r) medium (m) weak (w) conserv (c) medium (m) aggress (a) big (b) bh bm bl br bm bw bc bm ba small (s) sh sm sl sr sm sw sc sm sa factors and their components −smbme/be=(sh+sm+sl)/3−(bh+bm+bl)/3− smbop=(sr+sm+sw)/3–(br+bm+bw)/3− smbinvs=(sc+sm+sa)/3–(bc+bm+ba)/3− smb=(smbme/be+smbop+smbinvs)/3 −hml=(sh−sl)/2+(bh−bl)/2−rmw=(sr−sw)/2+(br−bw)/2− cma=(sc−sa)/2+(bc−ba)/2 source: fama and french, 2015 acaravci, et al.: performances appraisal of real estate investment trust in borsa istanbul international journal of economics and financial issues | vol 8 • issue 6 • 2018190 successful performance the reits in the analysis period. in other words, these the reits do not seem to over perform than market premium, size premium, value premium, profitability premium and investment premium during analysis period. moreover, the results of the regression equations for the algyo, atagy, dggyo, dzgyo, vkgyo are not evaluated due to statistically insignificant f statistics. 4. conclusion the reits have an important role in the development of the real estate sector. the reits are financial institutions that provide investors with services such as professional portfolio management, risk mitigation through diversification, and utilization of scale economies. the reits offer new opportunities for investors by transforming liquidity high securities on the real estate in their portfolios. although there are so studies related to performances appraisal of mutual funds and collective investment funds in turkey, studies investigating the performances appraisal of the reits in turkey is quite limited. the aim of this study is to performances appraisal of firms traded as the reits in bist during the period of 132 months between july 2005 and june 2016 are investigated by employing four different regression models (the capm, ff[3]f, ff[4]f, and ff[5]f). within the scope of the study, the performances of the reits are examined and the jensen alpha which is a riskadjusted performance measure is estimated as fixed term (alpha) between related returns and factors in regression equation. in this manner, regression model is estimated in which returns of the reits are used as dependent variable; whereas market premium, size premium, value premium, profitability premium and investment premium are used as independent variables. empirical findings suggest that the alpha coefficient is not table 2: regressions for 14 reits market portfolio results capm: rpt−rft=αp+bp (rmt−rft)+εpt rp−rf α adj.r 2 f-statistic agyo 0.537 (0.532) 0.087 12.497* [0.000] aksgy 0.586 (0.606) 0.042 5.829** [0.017] algyo 1.023 (0.928) 0.025 3.434** [0.006] atagy 2.131 (1.187) 0.000 0.002 [0.961] avgyo 1.844 (1.037) 0.048 6.690* [0.001] dggyo 2.077 (1.393) 0.032 4.352* [0.001] dzgyo 4.413 (1.302) 0.000 0.005 [0.940] isgyo 0.477 (0.505) 0.069 9.686** [0.002] nugyo 2.018 (1.367) 0.013 1.843 [0.179] ozgyo 1.618 (1.068) 0.041 5.656* [0.001] pegyo −0.194 (−0.151) 0.064 8.946* [0.000] vkgyo 1.241 (0.702) 0.003 0.443 [0.506] ygyo 0.168 (0.124) 0.021 7.321* [0.001] ykgyo 0.207 (0.152) 0.057 7.913* [0.001] observation number 132 values in parentheses are the corrected t statistics according to newey-west method for the heteroscedasticity problem. values in brackets are probability values, ** and * denote significance at the 5% and 1% levels, respectively table 3: regressions for 14 reits size me/be, portfolios results ff[3]f: rpt−rft=αp+bp (rmt−rft)+sp (smbt)+hp (hmlt)+εpt rp−rf α adj.r 2 f-statistic agyo 0.191 (0.198) 0.114 5.524* [0.001] aksgy −0.133 (−0.137) 0.105 5.052* [0.001] algyo 1.067 (0.905) 0.035 1.589 [0.195] atagy 1.689 (0.960) 0.006 0.282 [0.837] avgyo 1.974 (1.174) 0.151 7.626* [0.000] dggyo 2.259 (1.441) 0.037 1.685 [0.173] dzgyo 4.097 (1.227) 0.001 0.067 [0.977] isgyo 0.506 (0.472) 0.116 5.552* [0.001] nugyo 1.727 (1.086) 0.085 3.979** [0.009] ozgyo 1.338 (0.956) 0.074 4.343* [0.001] pegyo −0.286 (−0.234) 0.069 3.205** [0.002] vkgyo 1.570 (0.915) 0.033 1.468 [0.226] ygyo −0.178 (−0.135) 0.106 5.072** [0.002] ykgyo 0.175 (0.123) 0.065 4.014** [0.003] observation number 132 values in parentheses are the corrected t statistics according to newey-west method for the heteroscedasticity problem. values in brackets are probability values, ** and * denote significance at the 5% and 1% levels, respectively table 4: regressions for 14 reits size me/be, size-op., portfolios results ff (4) f: rpt−rft=αp+bp (rmt−rft)+sp (smbt)+hp (hmlt)+rp (rmwt)+εpt rp−rf α adj.r 2 f-statistic agyo 0.275 (0.310) 0.115 4.412** [0.003] aksgy −0.040 (-0.039) 0.107 3.807* [0.001] algyo 0.959 (0.785) 0.037 1.234 [0.299] atagy 2.071 (1.116) 0.011 0.384 [0.819] avgyo 2.357 (1.287) 0.157 5.959* [0.000] dggyo 2.037 (1.284) 0.040 1.357 [0.252] dzgyo 4.780 (1.455) 0.011 0.358 [0.825] isgyo 0.315 (0.289) 0.176 4.619** [0.006] nugyo 1.690 (1.050) 0.085 3.969** [0.003] ozgyo 1.377 (0.970) 0.074 4.343* [0.001] pegyo −0.554 (−0.441) 0.075 3.608** [0.003] vkgyo 1.368 (0.862) 0.036 1.185 [0.320] ygyo 0.103 (0.078) 0.111 3.980** [0.004] ykgyo 0.355 (0.237) 0.068 1.344 [0.154] observation number 132 values in parentheses are the corrected t statistics according to newey-west method for the heteroscedasticity problem. values in brackets are probability values, ** and * denote significance at the 5% and 1% levels, respectively table 5: regressions for 14 reits size-me/be, size-op., and size invs., portfolios results ff (5) f: rpt−rft = αp+bp (rmt−rft)+sp (smbt)+hp (hmlt)+rp (rmwt)+cp (cmat)+εpt rp−rf α adj.r 2 f-statistic agyo 0.244 (0.287) 0.123 3.556** [0.004] aksgy −0.049 (−0.049) 0.108 3.054** [0.005] algyo 0.908 (0.784) 0.066 1.783 [0.120] atagy 2.090 (1.100) 0.013 0.334 [0.891] avgyo 2.384 (1.287) 0.160 4.822* [0.000] dggyo 2.068 (1.271) 0.045 1.207 [0.309] dzgyo 4.682 (1.457) 0.028 0.743 [0.592] isgyo 0.300 (0.276) 0.079 3.168** [0.003] nugyo 1.612 (1.090) 0.118 3.373** [0.002] ozgyo 1.318 (0.967) 0.091 3.178** [0.003] pegyo −0.632 (−0.548) 0.116 3.328* [0.001] vkgyo 1.294 (0.850) 0.065 1.774 [0.122] ygyo 0.104 (0.078) 0.111 3.159* [0.001] ykgyo 0.299 (0.205) 0.090 3.178** [0.002] observation number 132 values in parentheses are the corrected t statistics according to newey-west method for the heteroscedasticity problem. values in brackets are probability values, ** and * denote significance at the 5% and 1% levels, respectively acaravci, et al.: performances appraisal of real estate investment trust in borsa istanbul international journal of economics and financial issues | vol 8 • issue 6 • 2018 191 statistically significant in four different regression models. this result indicate that the reits do not seem to over perform than market premium, size premium, value premium, profitability premium, and investment premium during the analysis period. thus, analysts or investors will be able to estimate expected returns by considering these premiums. moreover, the results of the four different regression equations for the atagy, dzgyo, vkgyo are not evaluated due to statistically insignificant f statistics. performances appraisal of the reits have been one of the most important and remarkable topics for academics, investors and analysts in the field of finance in recent years. in this respect, when studies on turkey and international studies are investigated, it is seen that the capm models are used more performances appraisal of the reits. however, when the studies relating to the ff[4]f and ff[5]f are investigated, it is determined that the study on turkey has not been done yet. thus, this study aims to fulfill this gap and contributes to empirical literature on this subject. it is also expected that this study will make a significant contribution to researchers and analysts. thanks to this work, analysts or investors will be able to investigate the relationship between expected risk and return while investing in the reits. thus, they will be able to carry out their analysis with a more accurate calculation of the expected return and risk. moreover, they will be able to make better speculations with strategies which are presented in the model. furthermore, for further empirical investigations, we propose that researchers will be able to contribute to finance literature by trying different measures and variables at different periods. references available from: http://www.finnet.com.tr. available from: http://www.hazine.gov.tr. buttimer, r., hyland, d., sanders a.b. (2001), the long-run performance of reit ipos. real estate economics, 33, 51-87. carhart, m.m. (1997), on the persistence in mutual fund performance. journal of finance, 52(1), 57-82. erdogan, n.k., altinirmak, s., karamasa, c. (2016), performance assessment of real estate ınvestment trusts (reits) listed in bist via different multi criteria decision making methods. international journal of economics and finance, 8(7), 304-321. fama, e.f., french, k.r. (1993), common risk factors in the returns on stocks and bonds. journal of financial economics, 33, 3-56. fama, e.f., french, k.r. (2012), size, value, and momentum in ınternational stock returns. journal of financial economics, 105, 457-472. fama, e.f., french, k.r. (2015), a five-factor asset pricing model. journal of financial economics, 116, 1-22. han, j., liang, y. (1995), the historical performance of real estate ınvestment trusts. the journal of real estate research, 10(3), 235-262. hayta, o. (2009), gayrimenkul yatirim ortakliklari ve gayrimenkul yatirim ortakliklari performans degerlendirmesi: imkb’de bir uygulama. (yuksek lisans tezi). adana: cukurova universitesi. jensen, m.c. (1969), risk, the pricing of capital assets, and the evaluation of ınvestment portfolios. journal of business, 2, 167-247. smith, k.v., shulman, d. (1976), the performance of equity real estate ınvestment trusts. financial analyst journal, 32, 61-66. titman, s., warga, a. (1986), risk and the performance of the real estate ınvestment trusts: a multiple ındex approach. areuea journal, 14(3), 414-431. ural, m. (2010), yatirim fonlarinin performans ve risk analizi. ankara: detay yayincilik. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.107-121 issn: 2146-4138 www.econjournals.com 107 hedging strategy using copula and nonparametric methods: evidence from china securities index futures1 zhiyuan pan antai college of economics & management, shanghai jiao tong university, pr china. email: panzhiyuan2012@gmail.com xianchao sun school of economics, sichuan university jinjiang college, pengshan, pr china. email: xianchaocd@sina.com abstract: calculating accurately the optimal hedge ratio plays an important role in the futures market for both practitioners and academicians. in this paper, we combine copula and nonparametric technique, where marginal setting is modeled by nonparametric technique and bivariate is linked by dynamic patton (2006)'s sjc copula function, to estimate the parameters of optimal hedge ratio. various types of garch models to fit the marginal distribution are also compared. furthermore, model specification for marginal setting is investigated by hong and li (2005)'s statistics, which test the i.i.d. and u(0,1) simultaneously. the empirical results show that transformed residuals generated by nonparametric technique are i.i.d. u(0,1), while most of one generated by popular garch-type are not. for hedging effectiveness, our methods perform better than traditional copula-garch models. the robust test also supports the results. keywords: hedge strategy; optimal hedge ratio; nonparametric estimation; patton (2006)'s sjc-copula; hong and li (2005)'s statistics; csi 300 index futures. jel classifications: c49; g10; g15 1. introduction the fundamental function of futures market is hedging. the most important issue is to determine the optimal hedge ratio in hedging with related futures products. the optimal hedge ratio consists of the optimized objective function and the ways of parametric estimation. chen, lee, and shrestha (2003) do an excellent review for hedge ratio based on various objective functions. this paper only focuses on the estimation of the optimal hedge ratio rather than the design of optimized objective function. the conventional method to calculate the optimal hedge ratio is the coefficient of regression the spot on the futures, named ordinary least squares (ols) approach (ederington, 1979; malliaris and urrutia, 1991; benet, 1992). however, the optimal hedge ratio is constant over time. grammatikos and aunder (1983) extend to time-varying hedge ratio by random coefficient technique. bivariate garch-type models are also popular to be modeled the dynamic optimal hedge ratio (cecchetti et al., 1988; baillie and myers, 1991; sephton, 1993; park and switzer, 1995; choudhry, 2003). the drawback of these models cannot capture the phenomenon of the symmetry and nonlinear dependence in the returns, which is common style in financial market (cont, 2001; longin and solnik, 2001; ang and chen, 2002; patton, 2006; hong et al., 2007; pan et al., 2014). the issue of dimension curse arises since many parameters are needed to estimate. thanks to the sklar's theorem, these problems have been solved to some extent. for example, copula-garch model is constructed to consider the style of returns, which marginal distribution is modeled by garch-class models with skewed-t distribution and nonlinear dependence is measured by various copula functions (patton, 2006; hsu et al., 2008; lai et al., 2009; wei et al., 2011). as mentioned by patton (2006), before linking the bivariate using copula function, checking the i.i.d.u(0,1) of the transformed residuals is required. most of papers take i.i.d. 1 this work was supported by the chinese national science foundation through grant number 70971087. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.107-121 108 test and u(0,1) test apart. however, according to hong and li (2005), testing hypothesis of i.i.d.u(0,1) jointly is not equal to testing individually. we propose a copula and nonparametric models for the optimal hedge ratio and find some evidence which is not presented in the previous literatures. first, using the nonparametric technique models the marginal distribution. comparing to the garch-class methods, our methods are model-free, which avoids the risk of model misspecification. second, test the null hypothesis of i.i.d.u(0,1) jointly by hong and li (2005)'s statistics. to our knowledge, most of test is apart, i.e., the null hypothesis of i.i.d is checked by ljung-box q-test for first moment correlation and engle test for higher moment correlation, and the standard uniform distribution is tested by traditional kolmogorov-smirnov test. therefore, our joint testing procedure is more accurate than other procedure. third, the empirical results show that the transformed residuals generated by nonparametric technique pass the hong and li (2005)'s statistics but many popular garch-class models do not at 5%significant level. the hedging effectiveness based our approach is superior to one based popular copula-garch approach. the remainder of this paper is as follows. section 2 introduces the optimal hedge ratio based minimum-variance function and hedging effectiveness. section 3 proposes a copula and nonparametric models to calculate the optimal hedge ratio, take traditional copula-garch approach as benchmark and sketch hong and li (2005)'s statistics. application for csi 300 index futures are presented in section 4. summary and conclusion are in section 5. 2. optimal hedge ratio and hedging effectiveness based on various objective functions, the optimal hedge ratios show slightly different. chen, lee and shrestha (2003) do a comprehensive review for these differences. this paper focuses on the most widely used minimum-variance hedge ratio, which minimize the portfolio variance. minimum-variance hedge ratio is first proposed by johnson (1960) and adopted widely in the recent literature. lai et al. (2009), wei et al. (2011) and among others apply this hedge ratio to test their strategies. following the spirit of minimum-variance objective function, we define the optimal hedge ratio as follows, h∗ = cov(r , , r , ) var(r , ) = ρ σ , σ , , (2.1) where h∗ is the optimal hedge ratio at time t, which means per unit value of a long spot position needs to short h∗units in the futures markets. r , and r , denote the logarithmic returns of the spot and futures, respectively. σ , and σ , are the standard deviations of r , and r , at time t, respectively. ρ denotes the time-varying correlation coefficient. to measure the performance of hedge strategy, following ederington (1979), park and switzer (1995), wei, wang and huang (2011) and among others, the hedging effectiveness is given by: e = σ − σ σ = 1 − σ σ (2.2) where subscript r is the returns of hedged portfolio, i.e.,r = r − hr . σ and σ denote the variance of the hedged portfolio and only holding spot, respectively. from equation (2.2), as e reaching to 1, the hedging effectiveness is more sufficient. 3. hedge strategies under the framework describing the optimal hedge ratio in section 2, the crucial task is how to accurately measure the dependence coefficient ρ , standard deviation σ , and σ , , respectively. comparing to widely-used garch-copula approach, our parameters σ , and σ , is model-free based on nonparametric method and the dependence coefficient ρ is estimated by copula function. 3.1 copula and nonparametric model assume both the logarithmic returns of the spot and futures are driven by below equations, r , = μ , + σ , ϵ , (3.1) μ , = ∑ k (r , − r , )r , ∑ k (r , − r , ) (3.2) hedging strategy using copula and nonparametric methods: evidence from china securities index futures 109 σ , = ∑ k (r , − r , )r , ∑ k (r , − r , ) − μ , (3.3) where k ∈ {s,f}. equation (3.2) is well-known nadaraya-watson estimator of μ , which is an consistent estimator and is applied in time series models by chen and gao (2007). equation (3.3) is also kernel estimate of the volatility function appearing in chen and gao (2007) and zheng (2008). unlike parametric models, equation (3.2) (3.3) propose a nonparametric estimate without assuming the function form. in this paper, let the kernel k (u) be gaussian, i.e., k (u) = √ exp (−u / (2b )), where b is a bandwidth. like scott (1992), hong and li (2005) and among others, chooseb = r n / , where r is the sample standard deviation of{r } , and n is sample size. after modeling the marginal distribution, we need to specify the dependence between the logarithmic returns of the spot and futures. the asymmetric dependence in financial market is demonstrated by longin and solnik (2001), ang and chen (2002), patton (2006), hong, tu and zhou (2007) and pan, zheng and chen (2014). therefore, we use the asymmetrized joe-clayton (sjc) copula, which nests symmetric one as a special case, modified by patton (2006) to capture the asymmetric dependence of the spot and futures. the sjc copula is given below: c u ,v τ ,τ = 0.5 c u ,v τ ,τ + c 1 − u ,1 − v τ ,τ + u + v − 1 (3.4) where c u ,v τ ,τ = 1 − (1 − ((1 − (1 − u ) ) ) + (1 − (1 − v ) ) − 1) ) κ = 1 log (2 − ) λ = − 1 log ( ) where τ ∈ (0,1),τ ∈ (0,1). the sjc copula has two parameters τ and τ , which measure the dependence of upper and lower tail dependence, respectively. since the situation of economic change over time, then time-varying dependence should be rational at model specification. thus, let tail dependence term τ and τ be dynamic, which similar to patton (2006), τ = ξ α + α τ + α 1 10 |u − v | (3.5) τ = ξ α + α τ + α 1 10 |u − v | (3.6) where ξ(x) = ( ) is the logistic function. obviously, the values of dependence parameters τ and τ fall in (0, 1) at all times. for the equations (3.5)(3.6), the upper and lower tail dependence are driven by an ar(1) term and a forcing variable which we use formula ∑ |u − v | as. to sum up, the copula and nonparametric models are constructed by nonparametric marginal distribution and dynamic copula function. the joint distribution of returns on the spot and futures is given by: h r , , r , θ,ω = c f r , θ,ω ,g r , θ,ω θ,ω = c f ϵ , θ,ω ,g ϵ , θ,ω θ,ω (3.7) where f (ϵ) = ∑ i(ϵ , ≤ ϵ), and ϵ , = , , , ,k ∈ (s, f) where θ = (τ ,τ ), ω is information set at time t-1. since markov assumption, ω = {r , , r , }. further, we let r , only depend on itself lag term rather than other variable lag term. this assumption is also appearing in patton (2006). c is sjc copula defined in equation (3.4). let f ,g ,f and g be the conditional cumulative distribution function for r , , r , ,ϵ , and ϵ , , respectively. i(a) denote an indicator function, i.e., i(a)=1 if even a holds, otherwise i(a)=0. μ , andσ , are estimated by equation (3.2) and (3.3), respectively. then parameter σ , corresponds to the standard deviation of optimal hedge ratio in equation (2.1), and the dependent coefficient is defined by ρ = max (τ ,τ ). international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.107-121 110 3.2 dynamic copula-garch strategy: benchmark for the purpose of examine the performance of the nonparametric marginal distribution, we take the garch-class as a benchmark and let copula function be similar to section 3.1. in numerous empirical works, the excess kurtosis and skewness styles are found in univariate distribution of many economic variables. and character of volatility cluster becomes common view for financial variables. therefore, garch (p,q)-skewed t model could capture these characters mentioned above (see patton (2004), patton(2006)). r , = μ + ϕ , r , + η , (3.8) η , = h , ϵ , (3.9) ϵ , ~ skewed t(ν,ϱ), k ∈ (s, f) (3.10) where term μ + ∑ ϕ , r , capture the mean value of r , where lag parameter p is generally determined by akaike information criterion (aic). from our empirical analysis, p=1 is superior to others. the residual innovations ϵ , follow a skewed student t distribution to model the skewness and kurtosis. term h is usually adopted to capture the phenomenon of volatility cluster. in this paper, we compare six most cited h processes as follows: model 1. the garch(1,1) model (see bollerslev ,1986) h , = ω + α η , + β h , (3.11) model 2. the nonlinear arch(1,1) model (denoted narch) (see engle and bollerslev, 1986) h , = ω + α |η , | + β h , (3.12) model 3. the gjr(1,1) model (see glosten, jagannathan and runkle, 1993) h , = ω + α η , + γ i(η , < 0)η , + β h , (3.13) model 4. the egarch(1,1) model (see nelsen, 1991) log (h , ) = ω + α ( η , h , − 2 π ) + γ η , h , + β log (h , ) (3.14) model 5. the asymmetric garch(1,1) model (denoted agarch)(see engle, 1990) h , = ω + α (η , + θ ) + β h , (3.15) model 6. the vgarch(1,1) model (see engle and ng, 1993) h , = ω + α ( η , h , + θ ) + β h , (3.16) following hansen (1994), the density of skewed student t distribution is given by: skewed t(ϵ|ν,ϱ) = ⎩ ⎪ ⎨ ⎪ ⎧bc(1 + 1 ν − 2 ( bϵ + a 1 − ϱ ) ) , ϵ < − / bc(1 + 1 ν − 2 ( bϵ + a 1 + ϱ ) ) , ϵ ≥ −a/b where2 < < ∞ and −1 < < 1. and the constant a, b and c are defined as follows: a = 4ϱc ν − 2 ν − 1 ,b = 1 + 3ϱ − a ,c = γ((ν + 1)/2) π(ν − 2)γ(ν/2) the skewed student's t distribution nests the student's t distribution by letting ϱ = 0. parameter ϱ measure the degree of skew to zero, i.e., ϱ > 0 means the right skewness, and vice-versa when ϱ < 0. and parameter ν capture the kurtosis of density. further, we need to check whether model (3.11) is suitable for the logarithmic returnsr , . the intuitive judgement is that if model (3.11) is appropriate, then the probability integral transforms of residual innovation ϵ , will be independent and identical distribution, i.e., uniform (0,1). this results is powerful, is rigid proven by rosenblatt (1952), and is applied to calculate density forecasts (diebold, gunther and tay, 1998; hong, 2002) and construct statistics for model specification (hong and li, 2005; bai, 2003; corradi and swanson, 2006). to our knowledge, most of paper take the test of null hypothesis of i.i.d.u(0,1) apart. i.e., apply ljung-box q-test for first moment and engle test for higher moment to check independent and identical distribution, and the kolmogorov-smirnov (k-s) statistic hedging strategy using copula and nonparametric methods: evidence from china securities index futures 111 for standard uniform distribution, respectively. the existing problem of apart procedure is that it is easy to miss the situation of non-i.i.d.u(0,1). particularly, the critical value of kolmogorov-smirnov statistic cannot be adopted directly since this statistic is not parameter estimation free but the asymptotic distribution of k-s statistic does not take this into account. thus, hong and li (2005) propose a nonparametric omnibus test to check the joint hypothesis of independent and identical distribution and uniform (0,1). as we all known, there has not been paper using nonparametric omnibus test (hong and li, 2005) to check the garch class for building copula model so far. in this paper, we sketch the nonparametric omnibus test proposed by hong and li (2005). for univariate series {r } , let g (r ,r ) be the joint density of {r ,r }. the spirit of nonparametric omnibus test is to comparing the estimator g (r ,r ) ofg (r ,r )with 1, which is the product of two i.i.d. uniform (0,1). the joint density g (r ,r ) is estimated through kernel method given below: g (r ,r ) = 1 n − j k (r ,r )k (r ,r ) where wherek (r ,r_2) is a boundary modified by hong and li (2005). then hong and li (2005) construct a statistics q(j) as follows: q(j) = (n − j)b∫ ∫ g (r ,r ) − 1 dr dr − ba v / , = 1,2,⋯ where a and v are the non-stochastic centering and scaling parameters defined below: a = (b − 2)∫ k (u)du + 2∫ ∫ k (u)dudv − 1 v = 2 ∫ ∫ k(u + v)k(v)dv du where k (x) = k(x)/∫ k(y)dy. under {r } is i.i.d. uniform (0,1), hong and li (2005) show that, q(j) → n(0,1) , as n → ∞. as mentioned in hong and li (2005), it is the most important and information when j=1. thus, we choose j=1 to test the i.i.d. uniform (0,1) jointly2. 4. application empirical analysis is investigated in this section. we calculate the optimal hedge ratio for csi 300 index futures using copula and nonparametric methods we have just described. to check the robustness of these results, robust test is also considered. 4.1 optimal hedge ratio for csi 300 index futures we focus on the daily data from wind database containing the prices of the china securities index 300 (csi 300) spot and index futures, from 19 april, 2010 to 20 april, 2012, yielding 487 observations. in order to check the robustness of our results, we take the csi 100 and csi 200, which consists of the largest 100 stocks in csi 300 and the rest of csi 300, as substitution for csi 300. the main reason for choosing csi 100 and csi 200 is that there exist many funds based on these two indices in china stock exchange market3. figure 1 plots the prices and returns of the csi 300 index futures, csi 300 index, csi 100 index and csi 200 index, respectively. figure 2 depicts the correlations between csi 300 and csi 300 index futures are higher when the market goes down than it goes up, which is consistent with ang and chen (2002)'s findings in the stock market. but our ranging from 0.82 to 0.96 is smaller than theirs. 2 notes: as shown by hong and li (2005) in p46, if model specification is wrong, then statistic q(j) → ∞. unlike traditional two-sided test, q(j) statistic is upper-tailed test since negative values of q(j) statistic appear only under null hypothesis as n → ∞. 3 now, there are only two funds based on csi 300, launched on 7 may, 2012. for more detail see www.csindex.com.cn international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.107-121 112 figure 1. the first column depicts the prices for csi 300 index futures, csi 300 index, csi 100 index and csi 200 in sequence; and the second column shows the returns. figure 2. correlations between returns on csi 300 index and csi 300 index futures. the horizontal axis is the quantile, and the vertical one is the value of correlation under that both exceed that quantile. correlations for csi 100 index and csi 200 index with csi 300 index futures, respectively, not be exhibited, but available upon request. hedging strategy using copula and nonparametric methods: evidence from china securities index futures 113 table 1 provides descriptive statistics for the data. means of the four indices returns exhibit negative, and small relative to counterpart standard deviation. the higher moment shows the four time series are negative skewness and excess kurtosis. the value of jarque-bera test is larger enough to reject the normality hypothesis at significant level 1%. the ljung-box q test indicates there is serial autocorrelation in all time series and autoregression term should be included in mean processes. the augmented dickey-fuller test for unit root shows that the null hypothesis of having a unit root is rejected at the significant level 1%, indicating that these time series are stationary and can be modeled directly. table 1. description of csi 300 index and csi 300 index futures index futures csi300 csi100 csi200 mean(%) -0.054 -0.050 -0.038 -0.040 std dev. (%) 1.522 1.483 1.444 1.656 skewness -0.164 0.306 -0.163 -0.309 kurtosis 4.831 4.368 4.366 3.958 jb test 70.1910*** 45.5580*** 40.0097*** 26.3621*** adf test -23.903** -22.656*** -22.968*** -21.388*** correl -------0.975 0.968 0.926 jb test denotes jarque-bera test of the null hypothesis that the sample comes from a normal distribution. adf test assesses the null hypothesis of a unit root in a univariate time series. correl measures the correlation for csi 300 index, csi 100 index and csi 200 index with csi 300 index futures. *** indicates the rejection at significant level 1%. table 2 and table 3 present the estimation of types of garch models (ar(1)garch (1,1), ar(1)-narch(1,1), ar(1)-gjr(1,1), ar(1)-egarch(1,1), ar(1)-agarch(1,1), ar(1)-vgarch (1,1)) for csi 300 index futures data and csi 300, respectively. there are common features among various garch models. the log-likelihood value is almost the same, implying no garch model is clearly better than others. relative to arch parameter α, most of the garch parameter β is larger up to 0.9, indicating that the volatility is high persistent dependence. figure 3 and figure 4 also depicts the high persistent behavior for various garch models, while nonparamtric volatility performs low persistent. table 2. coefficient of csi 300 index futures under garch-class models garch narch gjr egarch agarch vgarch 0.0438 0.0429 0.0450 0.0552 0.0513 -0.0438 -0.0589 -0.0591 -0.0590 -0.0572 -0.0612 -0.0619 0.0311 0.0604 0.0297 0.0165 0.0100 0.0370 0.0283 0.0078 0.0257 0.0679 0.0258 0.0372 0.9590 0.9520 0.9600 0.9867 0.9667 0.9628 --3.0258 -------- ----0.0043 -0.0234 0.5747 -0.3890 0.0391 0.0441 0.0386 0.0290 0.0346 0.0406 4.5629 4.4791 4.5473 4.4963 4.5473 4.9530 862.4942 861.7935 862.4758 864.2407 862.1388 863.6359 table 4 is model specification using hong and li (2005)'s statistic. the second column is statistics value of hong and li (2005)'s statistic for csi 300 index futures and csi 300 index. they are both negative, and pass the test at the significant level 5% according to the rule of hong and li (2005)s statistics. however, from column 3 to column 7, all of the statistics value is positive, which differ from nonparametric case, and all garch-class models are fall at significant level 10%. in particular, all garch-class models are also fall for csi 300 data at significant level 1%. therefore, modeling the marginal distribution using garch-class models faces the risk of model specification. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.107-121 114 table 3. coefficient of csi 300 index under garch-class models garch narch gjr egarch agarch vgarch 0.0330 0.0370 0.0358 0.0153 0.0417 -0.0355 0.0190 0.0186 0.0175 0.0202 0.0207 -0.0199 0.0355 0.6409 0.0278 1.1521 8.8450e-4 5.5568e-4 0.0157 0.1627 0.0027 -0.1970 0.0147 0.0235 0.9671 0.6317 0.9742 -0.5082 0.9773 0.9765 --0.0501 -------- ----0.0181 0.0435 0.9999 0.0181 -0.0058 4.58e-04 -0.0053 0.013 -0.0116 -0.0048 6.8313 4.4791 6.6696 6.3101 6.7171 6.943 863.8759 865.9224 863.4197 863.7231 862.625 862.875 table 4. hong and li's(2005) test for model specification csi300 nonparam garch narch gjr egarch agarch vgarch futures -2.7983 1.3866* 1.5238* 1.3789* 1.3194* 1.3608* 1.9027&** spot -0.6463 4.5092*** 3.9127*** 4.5398*** 2.5009*** 4.6315**** 4.5616*** notes: hong and li (2005)'s statistic is upper-tail test. ***, **, * denote the rejection at significant level 1%, 5% and 10%, respectively. figure 5 describes the time-varying tail dependence based on sjc-copula and dynamic optimal hedge ratios in figure 6. figure 5 shows the tail dependence for different marginal distribution. the time-varying tail dependence appears steady during the period. the critical reason may be our sample is not enough large and the integrated market trend to fall since 2008 in china security market. from the nonparametric tail dependence figure, the lower tail dependence is larger than the upper one, which is consistent with ang and chen (2002)'s findings. however, ar(1)-narch(1,1) and ar(1)-vgarch(1,1) marginal distribution exhibit upper tail dependence is larger than lower one, which confirms nonparametric marginal distribution is superior to garch-class ones. figure 6 depicts the optimal hedge ratio. it is similar to volatility picture in figure 3 and figure 4. obviously, owing to the tail dependence is steady. thus, the optimal hedge ratio only depends on the counterpart volatility. hedging strategy using copula and nonparametric methods: evidence from china securities index futures 115 figure 3. from top to bottom, the volatility of csi 300 index is estimated by nonparametric model, ar(1)-garch(1,1), ar(1)-narch(1,1), ar(1)-gjr(1,1), ar(1)-egarch(1,1), ar(1)-agarch(1,1), ar(1)-vgarch(1,1). international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.107-121 116 figure 4. from top to bottom, the volatility of csi 300 index futures is estimated by nonparametric model, ar(1)-garch(1,1), ar(1)-narch(1,1), ar(1)-gjr(1,1), ar(1)-egarch(1,1), ar(1)-agarch(1,1), ar(1)-vgarch(1,1). hedging strategy using copula and nonparametric methods: evidence from china securities index futures 117 figure 5. the dynamic tail dependence is estimated by sjc-copula, but marginal distribution is set by nonparametric model, ar(1)-garch(1,1), ar(1)-narch(1,1), ar(1)-gjr(1,1),ar(1)-egarch(1,1), ar(1)-agarch(1,1), ar(1)-vgarch(1,1) from top to bottom. table 5 presents the hedge ratio and hedging effectiveness. mean of hedge ratio of nonparametric marginal distribution is larger than others as well as the standard deviation, ranging from 0.3104 to 1.5501. one may argue that the larger the standard deviation, the more transaction cost. indeed, but transaction cost is less in futures market than one in stock market. anyway, the transaction cost should be considered but left to a future research. the last column shows the hedging effectiveness. the value of nonparametric sjc-copula is larger than other marginal distributions, implying our approach dominates all garch-class models and our nonparametric marginal distribution to capture the behavior of the univariate is more sufficient. and garch-class models may exist the risk of model international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.107-121 118 misspecification which just shown in hong and li (2005)'s statistics and tail dependence behavior in figure 5. figure 6. the dynamic optimal hedge ratios is estimated by equation \ref{he}, and marginal distribution is set by nonparametric model, ar(1)-garch(1,1), ar(1)-narch(1,1), ar(1)-gjr(1,1), ar(1)-egarch(1,1), ar(1)-agarch(1,1), ar(1)-vgarch(1,1) from top to bottom. table 5. hedge ratio and hedging effectiveness marginal setting mean std min max e nonparametric 0.8826 0.1436 0.3104 1.5501 0.9664 garch 0.8482 0.0532 0.7151 0.9548 0.9365 narch 0.8705 0.1224 0.5986 1.0674 0.9307 gjr 0.8584 0.0645 0.6568 0.9956 0.9392 egarch 0.8649 0.1328 0.451 1.2117 0.9296 agarch 0.8533 0.0506 0.7003 0.9453 0.9377 nagarch 0.8719 0.0317 0.7318 0.9328 0.9438 notes: e is calculated by equation 2.2, and the closer the e get to 1, the more sufficient hedging effectiveness is hedging strategy using copula and nonparametric methods: evidence from china securities index futures 119 4.2 robust test to check whether copula and nonparametric models are robust, we substitute csi 100 index and csi 200 index for csi 300 index, which many funds have been exchanged based on them in china security market. we neither present the estimation of various garch-class models for csi 100 index and csi 200 index, nor is figures of volatility, tail dependence and hedge ratios. but all the related results are available on request. from table 6, the nonparametric marginal distribution is not rejected at significant level 5%. however, garch-class models are rejected at significant level 5%, except ar(1)-egarch(1,1) marginal distribution for csi 200 index, which also imply nonparametric technique is more suitable for modeling marginal distribution than garch-class models. table 6. hong and li's(2005) test for model specification csi nonparam garch narch gjr egarch agarch vgarch 100 -0.5812 2.9976*** 2.7958 *** 2.9903** * 2.7939 *** 3.0199 *** 3.0635 *** 200 0.6480 2.6512*** 2.5644*** 2.2403*** 1.1265 *** 2.2626 *** 1.8246 *** notes: see table 4. table 7 presents the hedging effectiveness for csi 100 index and csi 200 index, respectively. the main results are same as csi 300, where the mean of hedge ratio for nonparametric marginal distribution is larger than others, as well as standard deviation. the hedging effectiveness of nonparametric marginal distribution is the closest to 1, indicating the degree of hedge is the best. comparing to the csi 300 index, the value of hedging effectiveness tend to be small. the solution should be found in table 1. the value of correlation with csi 300 index futures is csi 300 index, csi 100 index and csi 200 index in sequence sorted by descending. it also reveals that traded underlying asset pay a critical role in hedging effectiveness. fortunately, two funds based on csi 300 index are launch on 7 may, 2012 that will improves efficiency in china stock market. table 7. hedge ratio and hedging effectiveness marginal setting mean std min max e csi 100 index nonparametric 0.8826 0.16 0.3177 1.7473 0.9493 garch 0.8249 0.0428 0.7265 0.9095 0.9283 narch 0.83 0.117 0.5706 1.0195 0.9143 gjr 0.8218 0.0432 0.7109 0.9165 0.9242 egarch 0.79 0.1376 0.5307 1.3427 0.9079 agarch 0.8256 0.0439 0.7113 0.9241 0.9245 vgarch 0.8316 0.0233 0.7399 0.8693 0.9272 csi 200 index nonparametric 1.0209 0.2951 0.2814 2.4118 0.9098 garch 0.87 0.0566 0.7061 0.9778 0.8395 narch 0.8695 0.0651 0.6842 0.9836 0.8381 gjr 0.8884 0.0894 0.6369 1.0802 0.8467 egarch 0.892 0.1539 0.5243 1.2961 0.8459 agarch 0.889 0.0917 0.7012 1.0878 0.8437 vgarch 0.9167 0.0857 0.7407 1.1825 0.8546 notes: see table 5. 5. conclusions nonparametric technique have rapid developed in many fields of statistics and econometrics. especially, there exists many concerns nonparametric method in financial literature. in this paper, we propose a copula and nonparametric models to estimate the parameters of optimal hedge ratios. i.e., the marginal distribution is modeled by nonparametric technique and bivariate is linked by patton (2006)'s sjc-copula. to highlight this method, we use our approach to do an empirical analysis for csi 300 index futures. meanwhile, comparing with most cited garch-class models, the findings show that our approach obtains the best hedging effectiveness. hong and li (2005)'s statistic shows international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.107-121 120 that contrary to the popular parametric models such as garch model, nonparametric technique can be a robust tool for model specification of financial data. references ang, a., chen, j. 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(2008), “testing models of short-term interest rate”, working paper, shanghai jiao tong university. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2018, 8(3), 250-259. international journal of economics and financial issues | vol 8 • issue 3 • 2018250 linkages of global financial crisis and trade direction in an oil based economy nayef al-shammari1*, shaha al-obaid2 1department of economics, college of business administration, kuwait university, kuwait, 2department of economics, college of business administration, kuwait university, kuwait. *email: alshammari@cba.edu.kw abstract this study examines the influence of the 2008 global financial crisis on trade flows between kuwait and its main trading partners. data sample covers the period from 1990 to 2012. in this study, estimates are tested using, fixed and random effects specifications, as well as hausman test. findings reveal that not all trading flows with kuwait’s trading partners got affected by the financial crises. findings show that is the exports from kuwait to china are affected due to the financial crises. the expected negative influence of the global financial crisis is statistically significant in the case of kuwait trade flows with china. keywords: financial crisis, gravity model, panel approach, kuwait jel classifications: f21, o53, c1 1. introduction the economic growth and prosperity have been experienced by many economies around the world for several years (lardy, 2013); however, the outcome of the global financial crisis changed many objectives (i.e., helpman and krugman, 1985; helpman, melitz, and rubinstein, 2008; hart and tindall, 2009; kose and prasad, 2011). the crisis started mid of 2008 in the us market and grew until it expanded and covered several prominent economies around the world. the spillover effect of this crisis expanded to experience the 2011 european union (eu) crisis or known as (eurozone crisis) affecting the stability of the infrastructure of the financial markets of the member states. greece, spain followed by italy, ireland, and others were some of the member states whom were negatively affected by the crisis at the beginning, which led them later to experience instability and lack of confidence in their financial institutions. this resulted instability mainly due to the poor management of the actual financial infrastructures, and the absence of clarity and honesty of the transfer of financial information, especially in the case of greece. with the position owned by the kuwaiti economy in an international level, its level of integration with other economies is certainly exposed to any global shocks (crystal,1989; al-shammari and al-salman, 2010). the kuwaiti economy is integrated to a number of economies in both phases of exporting and importing. those economies are known as its main trading partners. the kuwaiti economy’s major export commodities take the form of petroleum, petrochemical products, fertilizers and financial services; however, a wide range of products ranging from food products and textiles to machinery as import commodities. accordingly, the relationship between kuwait and its main trading partners is to be influenced by the global financial crisis due to the expansion taking place away from the source. the study attempts to investigate the impact of the global financial crisis of the year 2008 on the trade flows between kuwait and its main trading partners. also, it analyzes the most influenced trade flow by the financial crisis, whether the export flows, import flows, or total trade flows. for the purpose of the study, annual panel data covering the period (1990-2012) of 112 countries is used. the study examines the impact of the financial crisis on kuwait’s trade flows using three different models, each taking the factors of exports, imports, and total trade into consideration separately. the estimations for all the three models involve pooled ols estimation, fixed and random test specifications, after which a hausman test is conducted. al-shammari and al-obaid: linkages of global financial crisis and trade direction in an oil based economy international journal of economics and financial issues | vol 8 • issue 3 • 2018 251 the rest paper is constructed as follows. section ii contains an overview on the kuwaiti economy and its trading partners. in section iii, the literature review is included. section iv contains the methodology and model specification. data description is provided in section v. the empirical findings are explained in section vi. the conclusion and policies implications are provided in section vii. 2. overview of the kuwaiti trading directions the main challenge faced by the kuwaiti economy is the lack of diversification in production away from oil production (elimam, girgis, and kotob, 1997; pfeifer, 2002). this can be seen mainly due to the positive fiscal situation and in part as a result of the poor relationship between the national assembly and the executive branch of the government. this has stymied most movement on economic reforms. this situation finds a path for improvement in the case of diversification as kuwait pledges to spend up to $130 billion over 5 years to diversify the economy away from oil; this in turn leads to attraction of more investments and boosts private sector participation in the economy (figure 1 in appendix a). according to kuwaiti trade, kuwait’s top exported products consists of petroleum oils and gases, crude, and other gaseous hydrocarbons. the majority of exports around 94.8% are composed of mineral fuels, lubricants and related materials. however, the major destinations for such exports are china, saudi arabia, and uae. on the other hand, the cost, insurance, and freight import by origin states that in 2011 the import composition was 37.6% machinery and transport equipment, 18.8% manufactured goods, whereas 16% food, live animals, beverages, and tobacco. however, the top imported products were motor cars and other motor vehicles, transmission apparatus for radio-telephony, radio-broadcasting and medicaments. the major destinations for such imports, which are considered as top three partners for merchandise imports were china, the united states, and japan. a global financial crisis can be simply summarized as a weakness felt in the financial institutions of an economy that is caused by uncontrolled financial activities which have a negative impact on the overall market. this can be in the form of liquidity shortage, businesses failure, and bankruptcy of banks and financial institutions. the growth of such an incident until it cannot be controlled and leads to the collapse of the financial system is what is known as a crisis. accordingly, the study examines the recent global financial crisis that started at 2008 and took place in the us economy then branched out to other economies around the world which are strongly related via transactions with the source. it is seen as the worst experienced financial crisis after the great depression of 1930’s. the crisis resulted in evictions, foreclosures and prolonged unemployment along with the total collapse of large financial institutions leading to the 2008-2012 global recession and contributing to the european sovereign-debt crisis. an incident such as the global financial crisis leaves an impact that can lead to the damage of the corresponding economies. the damage varies according to the relationship between countries understudy and the sources of the crisis lead to financial collapse. the study covers a number of other trade relationships between kuwait and other main trading partners. some of those main partners are the eu and asian bloc made up of china, japan, india, and korea. the study looks at the kuwait and eu relationship. the euro zone has been influenced by the global financial crisis through the experienced weakness of its financial institutions and banking system. those were greatly affected from the crisis that started in the us economy and affected to cover a number of strong economies that are tied in a number of ways to the source. this happened due to the experience of the ‘domino effect’ theory, which is any some change, small in itself, will lead to similar nearby, leading to even more similar change, and so on, in a linear sequence, by analogy to a falling row of dominoes standing on end (eisenhower, 1954). the other trading partner understudy with kuwait is the asian bloc. according to figure 2 in appendix a, the pattern of trade between the two regions evolved with time and was shocked by several trade blockades that came into effect from a number of previous crises in the asian markets (pascha, 2009). for example, the indian-kuwaiti trade trends go far back to the times of the pearl diving era in the gulf. this slowed down and then nourished recently as the indian market started to thrive again. however, the japanese and korean markets thrived with the development of the asian markets and increased in their trade relationships with kuwait. this thrive in the asian markets is related to the us economy through a number of integrations, and so the incident of the global financial crisis had its impact on their markets. this can be seen clearly in the study as a negative influence is present between some of the trade flow relationships of kw-asian. 3. literature review the relationship between the global financial crisis and kuwait’s trade flows with its major trading partners is an aspect that is measured by looking into the impact of one on the other. the literature review summarizes the global financial crisis, its possible reasons, and expected consequences. host of literature that would help to confirm the ability in using the gravity model to measure the impact of the crisis on trade flows is broken down into a number of categories. the first category investigates trade and its determinants with a preview on the main commodity of trade for kuwait, which is oil, followed by the gcc trading impacts as a region (i.e., al-shammari and al-salman, 2010; boughanmi, 2008; insel, and tekce, 2011). later, studies cover the impact of the global financial crisis on both trade and its determinants. finally, an overview of different studies about the gravity model is presented. before undertaking the activity of trade between any two parties in the form of groups, individuals or countries, the terms of trade for any two products between any two parties might be affected by a wide variety of factors that has to be first understood. this is then followed by the recognition that al-shammari and al-obaid: linkages of global financial crisis and trade direction in an oil based economy international journal of economics and financial issues | vol 8 • issue 3 • 2018252 many of the determinants correspond to well-known concerns in business and ethics have to be reached, in order, for the process to be presented and completed successfully. ( egger and larch, 2012). a study by kimura and lee (2006) examines the impact of different factors on bilateral service trade, relative to that of bilateral goods trade. the data covers ten countries of the organization for economic cooperation and development (oecd) and other economies (both member and non-member) for years (1999-2000) and is estimated using standard gravity model. the findings show that service trade is better predicted by the gravity equation than goods trade and that there is a complementary relationship between goods exports and service imports. schumacher and siliverstovs (2006) show how the home-market effects can be estimated using bergstrand generalized gravity equation. the empirical results present significant home-market effects for differentiated goods in many manufacturing industries which are either capital or labor intensive. on the other hand, the paper’s results shows that home-market effects can only be detected for data disaggregated. a study by felbermayr and kohler (2006) finds that wto membership enhances trade. their study investigates the intensive and extensive margin to world trade through the proposition of a “corner-solutions version” of the gravity model to explain movements on both margins. the findings show that a tobit estimation of this model resolves the so-called “distance puzzle”. the paper by huot and kakinaka (2007) studies the bilateral trade flows using the gravity equation with data covering the period (2000-2004) taking into account the establishment of the asean free trade area (afta). the measure of trade structure is constructed by the degree of trade complementarily between cambodia and its trading partners. the findings show that a higher degree of trade complementarily is associated with a higher level of trade flows. a study by ekanayake and mukherjee (2010) analyzes the trade creation and trade diversion effects of the regional trade agreements (rta) in asia and their effects on intra-regional trade flows. the data used is annual for the period (1980-2009) using the gravity model to measure trade creation and diversion effects on trade flows within and across member groups. the findings are similar to other studies on asian trade flows. this is as coefficients of real gross domestic product (gdp), population and distance have expected signs and magnitudes in all estimated models. trading is an activity like any other; it affects outcomes of an economy and gets affected by a number of different factors known as the determinants of trade. those factors come in a variety of forms and are mostly identified as the exchange rate, political circumstances or issues, and trade barriers. according to salim et al. (2011), the establishment of the gcc has a significant impact on trade; however, there is some space for potential activities have begun by the members under the category of trade between the members within the bloc. this shows the importance of kuwait as a country and location for trade and the possibility that arises for improvement of the level of activity with its neighboring countries. the study uses the gravity model for panel data for main trading partners having potential of increased and improved trade between the members themselves. size and distance are considered as main factors playing an important role in the model used in the study, but they also influenced the results achieved. this shows that kuwait has the ability to cover more successful trading within its area and territory. on the other hand, aisen and veiga (2008) reveal that high political instability leads to volatile inflation rates. political instability also has bigger effects on inflation volatility in developing countries with lower degrees of central bank independence and economic freedom. this would lead to an increase in the value of products and items produced and so would cause them to become less attractive and affect the level of trade between economies if exist. sablowski (2012) looks at how the world’s financial crisis has its powers penetrating the european markets. they are mainly poor resistant due to the uneven development and unequal distribution of capital accumulation in the zone itself along with the contradictions of integration. a study by ai et al. (2006) investigates at the co-movement of commodity prices using the excess-co-movement hypothesis. that is when the prices of commodities move together beyond what can be explained by fundamentals. it is found that most of co-movements are among commodities with high price correlation and all co-movements with those with marginal price correlation. common movements in supply factors are found as a factor playing a dominant role in the observed co-movements in commodity prices. this relationship can have its effects on the direction and size of trade along with other factors between the two countries in the relationship. according to the study, it would influence the trade either as export or import between kuwait and any of the countries of the world during the phase of the euro financial crisis. that is because a number of factors combined can play the role and affect the activity of trade. another important factor that has a great impact on trade is the exchange rate and its volatility. mickenzie (1999) finds the impact to have an ambiguous effect. on the other hand, pozo (1992) looks at the effect of the exchange rate volatility on trade in the beginning of the previous century using the rolling standard deviation and generalized autoregressive conditional heteroskedasticity process to measure the exchange rate volatility. the findings show that the volume of british exports to the us decreased with an increase in volatility by any measure. qian and varangis (1994) investigate the influence of exchange rate volatility on trade using arch-inmean model and finds out that the impact is positive in the case of sweden, the uk, and netherlands. however, al-mutairi and hoque (2001) set up a study examining the short and long term behavior of balance of trade and its various determinants for kuwait and its main trading partners through the period (1973-1998). the use johansen’s multivariate co-integration technique for long-run and error correction model for short-run. the findings show that the devaluation, in both nominal and real exchange rates of kuwait, tend to have a positive impact on the trade balance. on the other hand, hondroyiamis al-shammari and al-obaid: linkages of global financial crisis and trade direction in an oil based economy international journal of economics and financial issues | vol 8 • issue 3 • 2018 253 et al. (2008) show that there is little evidence that volatility has a negative and significant impact on trade especially, if commodity is of great importance such as oil and energy resources. eaton and kortum (2002) develop a ricardian trade model incorporating realistic geographic features into general equilibrium and using data on bilateral trade in manufactures, prices and geography from 19 oecd countries in 1990. the equation is set to deliver simple equations of bilateral trade with parameters relating to absolute advantage, comparative advantage (promoting trade) and geographic barriers (resisting it). this helps the model to find gains of trade and effects of tariff reduction along with the role of trade in spreading benefits of new technology. the other extent would be free trade. kowalczyk and riezman (2009) look at free trade areas and their implications of higher world economic welfare equal to the sum of all nations’ volume of trade or efficiency effects through the use of a simple computable general equilibrium model of a world economy where competition is perfect. konishi et al. (2003) show that if custom unions do not affect trade with non-member countries, global free could be achieved immediately if free trade were introduced together with international side payments equal to the terms of trade effects. vicard (2009) studies whether the form or depth of rta would have impact on trade. the study uses the gravity model with panel data for the period (1960-2000). the findings show that creating any kind of rta’s providing trade preferences to their member countries significantly increases bilateral trade. however, their effect on bilateral trade does not significantly differ according to the depth of agreements. 4. methodology and econometric model the estimation commences with the analysis of statistical features of the panel data. the use of panel data entails the application of fixed and random effects test followed by the hausman test. the random effects assumption is that individual specific effects are uncorrelated with the independent variables and vice versa for the fixed effects assumption. to decide between the two, a hausman test is then used. a panel unit root test is conducted to identify whether the variables are stationary at level or after differencing and are carried out directly after the statistical analysis of the data (im, pesaran, and shin, 2003; hadri,2000; and harris,1999). panel unit root tests, described below, will be applied on each variable in the model. the impact of the world financial crisis of 2008 on trade flows between kuwait and its main trade partners is investigated using gravity model which is estimated by panel data with fixed and random effects technique. the regression is used over three times covering the three phases of trade as dependent variables: exports, imports, and total trade. the variables involved take into account two directions of trade: one for exports from kuwait to its main trading partners; the other for imports from its main trading partners to kuwait. below is the basic gravity model with variables used from previous built gravity models ( deardorff, 1998; lewer and berg, 2008; linder,1961; and mccallum,1995, shepotylo, 2010; smarzynska, 2001; and tinbergen,1962): in(x)ij= β0 + β1in(gdpi, gdpj) + β2 in(distance)ij + β3(border)ij + β4 ln(inflation)ij + εij (1) where total exports flows “xij” from country i to country j is measured in current us dollars and then deflated by the us cpi; “gdp” denotes the gdp of country i and j combined in current terms, “distance” is the distance between country i and country j, “border” stands for bordering countries either by land or sea and takes the form of 1 if yes and 0 if no, “inflation” stands for inflation consumer price combined for both country i and j, and εij is an error term. however, since the study is covering the influence of the world financial crisis, this model is expanded to cover a large variety of variables that could capture such an influence. the estimated model is extended by the inclusion of more variables to capture the impact of the global financial crisis on kuwait and its main trading partners. the following is the extended gravity model which follows closely the work of anderson, and van wincoop (2003), anderson and van wincoop (2008), and al-shammari and al-salman (2010): in(x)ij= β0 + β1in(gdpi, gdpj) + β2 in(distance)ij + β3(border)ij + β4 ln(inflation)ij+β5(oil)ij + β6(institutional stability)ij + β7(language)ij + β8(fta)ij + β9(eu)ij + β10(gcc)ij + β11(asian)ij + β12(λi)+β13(πj)+εij (2) where “oil” is the level of oil prices; “institutional stability” is used to measure the level of governance in a country’s with an estimate of −2.5 for weak and 2.5 for strong; “language” stands for a binary variable for language; “fta” stands for free trade agreements between kuwait and other candidates taking the form of 1 if agreement between them and 0 if no agreement exists; “eu” is whether the country is part of the european union, taking the form of 1 if part of the eu and 0 if not part of eu; “gcc” is a dummy variable that takes the form, whether the country i or j is part of the gcc bloc; “asian” stands for a bloc of four asian countries created by the study including china, japan, korea, and india and take the form of 1 if part of bloc and 0 if not part of bloc; and εij is an error term. the variables above are in log forms except for the dummies. those additional variables are chosen based on the study interest. institutional stability looks at the likelihood that the government will be destabilized or overthrown by unconstitutional or violent means through the strength of its rules and regulations and the manner at which they are controlled. this can be related to the crisis by two ways. first, it could lead to the unrest of the financial institutions, and secondly, the financial unrest could lead to the lack of stability so its measure is of importance on the size of influence. on the other hand, oil prices, fta and economic blocs such as eu and gcc are important factors of an economy and interfere in its transactions so would have a direct or indirect impact on the influence of such a crisis. this study is not only looking for any negative influence existing or not, but also it is trying to find out which relationships of trade are influenced and if so do they meet expectations and the size of such an influence. this could be seen through the negative values which mean that influence is present; however, the size of value representing significance is of the most importance, which signals if this negative noise is seen or not. al-shammari and al-obaid: linkages of global financial crisis and trade direction in an oil based economy international journal of economics and financial issues | vol 8 • issue 3 • 2018254 5. data description the data covers kuwait and its main trading partners throughout the period from 1990 to 2012. the data sample covers 112 countries. it includes annual exports and imports data that are in the form of bilateral trade among kuwait and its main trading partners. those values are measured as annual averages in millions of us dollars. trade data extracted from the international monetary fund (imf) database (direction of trade statistics) cd-rom. the data is collected for the variable of gdp in current us dollars in units of billions. this is obtained using the world bank’s world development indicators. the source of data originates from the imf, oecd, and world bank. the oil prices are taken as an average using the brent form of benchmark pricing. the great-circle distance is also known as orthodromic and is considered as the shortest distance between two points on the surface of a sphere, measured along the surface of the sphere. 6. empirical results the model has been estimated using three different tests and techniques known as pooled ols, fixed-effects and randomeffects, and they all follow the same outline of regression, division of tables and variables used. the summary statistics are shown in appendix b table 1. the estimated model is examined using pooled ols in appendix b tables 2-4. findings for most of the traditional gravity estimates are significant, except for border variable. more interestingly, the coefficient of the trading relationship between kuwait and china is greatly affected by the incident of the world financial crisis. results of the pooled ols regression show that the financial crisis affects negatively the trade relationship between china-kuwait across all its three forms of trade; exports, imports, and total trade and show statistically significant results. on the other hand, the trade relationship between kuwait and the gcc is positively affected due to the financial crisis. the estimated coefficient for gcc dummy is statistically significant to affect the exports of kuwait to gcc countries with 5% significance level, whereas estimated coefficient for gcc dummy is statistically significant to affect the total between kuwait and gcc countries with 10% significance level. interestingly, findings show that trade between kuwait and its partners of eu, germany and the asian blocs are statistically not significant. this suggest that the global financial crisis does not have an impact on the trade relationship between these partners and kuwait. appendix b in tables 5-7 show results of the benchmark model using fixed effects procedure. findings of these tables confirm results obtained in the benchmark model using pooled ols in appendix b tables 2-4. according to the results for fixed effects regressions using country specific fixed effects, namely column 1 in appendix b table 5, most of the coefficients of traditional gravity variables are significant and show the expected sign. findings show that the gdp leads to increase overall bilateral trade between two countries. the coefficient of the gdp is statistically significant across all seven columns, suggesting that a one percent increase in the country’s gdp increases their bilateral export by about 105%. according to fixed effects results, a negative impact of the financial crisis is present only for the case of china under the exports at significance level of 10%. the fixed effects results for imports of kuwait from china and total trade between these countries statistically insignificant. on the other hand, the gcc has all positive readings for all three forms of exports, imports, and total trade but all are insignificant. the other readings for the eu, gcc, germany, and asian are all insignificant and showing a positive sign except for the eu in the phase of exports which shows a negative sign. the model is also estimated using the random effect procedure. although results are not shown due to space limit, findings confirm the results obtained in both the pooled ols and fixed effect with some small exceptions. accordingly, the hausman test shows that the p-values are (0.0818) for exports, (0.0000) for imports and (0.0000) for total trade. this shows that the model for exports reveals a result greater than 0.05; therefore, for this case we accept the null hypothesis that there is no substantial difference between estimators of the fixed and random effects models. however, for the other two models of imports and total trade the null hypothesis is rejected leading to the acceptance of the fixed effect model and suggesting that the difference of coefficients from the fixed effect and random effect estimation is systematic. this reveals that the random effect estimation is only consistent and efficient for the exports model (table 8). 7. conclusion this study investigates the influences and effects of the global financial crisis on the trade relationship between kuwait and its main trading partners based on three models of exports, imports, and total trade. the theoretical framework of influencing variables used in this study helps examining the role of the global financial crisis on the direction of trade between kuwait and its main trading partners. kuwait’s main trading partners are characterized in a number of countries like china and germany, and economic blocs such as the eu, gcc and asian. those variables with an influence on the model take the form of combined gdp, combined inflation, oil price, language, border, and political stability. estimates of the model are tested using yearly data over the period (1990-2012). the regression of the models covers the tests of pooled ols, fixed and random effects, and the hausman test. the findings reveal that a negative statistically significant relationship is present between kuwait and china; however, a positive statistically significant relationship exists between kuwait and the gcc bloc. the kuwait-china relationship is influenced in all three forms of trade: exports, imports, and total trade. the kuwait-china relationship is mainly affected due to its strong integration to the us economy, which is the source of the crisis. the chinese-kuwaiti trade relationship is negatively affected by the global financial crisis mainly due to the size and importance al-shammari and al-obaid: linkages of global financial crisis and trade direction in an oil based economy international journal of economics and financial issues | vol 8 • issue 3 • 2018 255 of the interaction of the chinese economy with the us economy which is the source of the global financial crisis. the backfire that landed in the chinese economy from the crisis affected the credibility of its institutions and output levels. on the other hand, the crisis left an effect on oil prices taking the direction of an increase, and so negatively affected the producing economies. kuwait as an economy is influenced by two different perspectives. one as an oil producing economy, and the other is the strong financial interaction with the us economy. this criterion fits with the findings of the study that states the trade relationships between kuwait and china is affected by all its three flows. however, the other affected party from the global financial crisis is the economic bloc of the gcc. the empirical results show a statistically significant positive effect. this is mainly due to the strength of the bloc as a whole and so show an increase in trade between them and the state of kuwait during the global financial crisis. one of the main reasons could be due to the commodity of trade, which is oil. its importance is major to the big and wealthy economies. this shows that distance is not considered an issue during this activity of trade. another factor is also that the commodity of oil is experiencing an inelastic demand, which means that the demand does not go through big changes while changes in price of oil or income levels of importing countries is experienced. this all strengthens the foundation of the bloc and leads to the success of a number of regulations such as the custom union and free trade areas along with the variety of ftas signed. those agreements allow the stability in the flow of trade regardless of the influences from different circumstances such as the global financial crisis. 8. policy implications looking at the case of kuwait and the size of the influence on its economy and trade relationships from the global financial crisis, there are some policy implications that can be extracted. the presence of negative influence means that the kuwaiti economy has to diversify itself and enter other fields of production such as food, clothing, and construction materials. there has to then be trials of gaining at least comparative advantage in the production of a single product as a forward step and which would be considered of importance in the international markets. this is a lesson that the kuwaiti economy has to learn to build a path that leads to self-sufficiency, which later could lead it to be less influenced and vulnerable from different negative external shocks. the impact of the financial crisis can be mitigated by developing fixed trade contracts signed between kuwait and its trading partners. a good example could be the signing of long-term manufacturing or agricultural contracts with fixed trade fares on certain necessary products. this will help to minimize the size of negative influence an incident such as the financial crisis can cause by eliminating the transmission of the impact from any economic shocks in the different economies trading with kuwait. since the state of kuwait have a variety of trading relationships with a number of trading partners, it should take into account renewing those trade relationships by looking into new markets and capturing the potential of building new and more stable trade paths between new partners. those opportunities could mean the addition of new products that would fit the ever-changing needs of the economy and help lessen the risks of the crisis or any financial difficulties that might take place. this diversification can also mean that dependency rates on other economy outputs are shared, which can lead to more stability and strength of the financial infrastructure. this action of diversification can be made possible every 5 years with the renewal of the government’s development plan to exclude any unwanted changes or sudden shocks affecting the overall economic stability. the findings show that blocs such as the gcc, which are small in size but big in wealth and power, have been less affected within themselves. this can be due to different agreements signed between them that can ease trade. this will lead us to seriously thinking of improving the bloc. mainly, due to the results revealed by the study that its ability to overcome the global financial crisis and the very slight impact that has been experienced with no major negative influence. one of the most important steps that have to be taken into consideration is achieving the establishment of the monetary union and custom union as this will help increase the efficiency of the common market within the bloc and so will be a great step towards increasing bilateral trade. this will ease the financial transactions between the bloc and different economies and give the economy strength and support and less damage in cases of collapse that could influence their stability through the “domino effect” theory. this is when a certain economy collapse and the other is influenced and gets affected by the integration between the transactions of both. once the bloc is self-sufficient, the less is the need for integrations and so less collapses through the “domino effect” theory. it will be more of a supporting system than a following one for the other economies and most importantly the economies of the bloc members. finally, the main instruments that maneuver any economy have to be reviewed and adjusted. one of those instruments is the monetary policy, which plays a vital role in the outcomes of any economy. it is usually constructed with two features, the inflation and 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(2009), on trade creation and regional trade agreements: does depth matter. review of world economics, 145(2), 167-187. al-shammari and al-obaid: linkages of global financial crisis and trade direction in an oil based economy international journal of economics and financial issues | vol 8 • issue 3 • 2018 257 appendix (a) figure 1: gross domestic product levels for the kuwaiti economy for 1990-2012 figure 2: trade between kuwait and members of asian bloc (1995-2012) appendix (b) table 1: summary statistics variable observation mean±sd min max year 2513 2001.2±6.568185 1990 2012 fta 2513 0.1002786±0.3004308 0 1 institutional stability 1416 −0.0787359±0.9992027 −3.32 1.67 border 2513 0.0274572±0.163444 0 1 language 2513 0.1368882±0.3437977 0 1 gdp 2512 49.22726±2.29422 42.212 56.26267 exports 1835 1.639227±3.620726 −4.60517 9.719193 imports 1342 2.068575±3.120806 −4.60517 7.759149 total trade 1524 2.274288±3.440525 −4.60517 9.818822 oil price 1791 3.491137±0.7038314 2.282382 4.697202 distance 1768 8.511104±0.7778024 6.035481 9.607841 inflation 1549 1.387419±2.52349 −9.365341 20.35934 gdp: gross domestic product al-shammari and al-obaid: linkages of global financial crisis and trade direction in an oil based economy international journal of economics and financial issues | vol 8 • issue 3 • 2018258 table 2: pooled ols results-exports dependent variable: log exports (1) (2) (3) (4) log gdp 1.030968 (19.71)*** 1.033081 (19.55)*** 1.033444 (19.60)*** 1.032128 (19.52)*** log oil price −0.4229659 (−2.18)* −0.4110891 (−2.04)* −0.5172481 (−2.64)** −0.4498771 (−2.28)** log distance 0.3967381 (2.58)** 0.343064** (2.18)* 0.4132667 (2.65)** 0.3822432 (2.46)** inflation −0.0093311 (−0.16) −0.0147792 (−0.25) −0.0080996 (−0.14) −0.0052432 (−0.09) language 1.832189 (5.24)*** 1.896115 (5.37)*** 1.914853 (5.43)*** 1.89432 (5.36)*** border 0.8860683 (1.26) 0.987621 (1.39) 0.8397408 (1.17) 0.9422483 (1.32) institutional stability 0.3943797 (3.58)*** 0.4654011 (4.11)*** 0.419248 (3.79)*** 0.4138056 (3.70)*** fta 3.486894 (10.10)*** 3.149095 (9.16)*** 3.050268 (8.77)*** 3.362559 (9.12)*** china −6.658466 (−4.88)*** eu −0.8621572 (−1.49) gcc 2.730394 (2.25)** asian −1.063285 (−1.15) adjusted r2 0.458 0.447 0.447 0.44 the table reports t-statistic in parentheses, *significant at 10%, **significant at 5%, ***significant at 1%. robust standard errors (white test). gdp: gross domestic product table 3: pooled ols results-imports dependent variable: log imports (1) (2) (3) (4) (5) log gdp 1.432299 (40.62)*** 1.432152 (40.37)*** 1.432757 (40.38)*** 1.432235 (40.39)*** 1.43279 (40.37)*** log oil price −1.368358 (−11.18)*** −1.386759 (−11.36)*** −1.400091 (−10.96)*** −1.394043 (−11.37)*** −1.396388 (−11.27)*** log distance 0.2324051 (2.40)** 0.2200815 (2.30)** 0.2294785 (2.23)** 0.2233552 (2.34)** 0.2243523 (2.29)** inflation −0.0865635 (−2.53)** −0.0841358 (−2.44)** −0.0847099 (−2.44)** −0.0842599 (−2.45)** −0.0836452 (−2.43)** language 2.12814 (8.93)*** 2.158778 (9.02)*** 2.155817 (9.01)*** 2.160814 (9.02)*** 2.156471 (9.01)*** border 1.542091 (3.45)*** 1.602993 (3.57)*** 1.596744 (3.55)*** 1.566715 (3.46)*** 1.601912 (3.55)*** institutional stability 0.4166194 (6.46)*** 0.4283493 (6.61)*** 0.433196 (6.55)*** 0.4281473 (6.61)*** 0.4299719 (6.60)*** fta 0.686261 (3.19)*** 0.5653236 (2.67)** 0.5583587 (2.62)** 0.5375647 (2.49)** 0.5628604 (2.48)** china −3.124349 (−2.98)** germany 0.4068153 (0.39) eu −0.0820276 (−0.23) gcc 0.4846322 (0.62) asian 0.0032923 (0.01) adjusted r2 0.706 0.703 0.702 0.703 0.702 the table reports t-statistic in parentheses, *significant at 10%, **significant at 5%, *** significant at 1%. robust standard errors (white test). gdp: gross domestic product table 4: pooled ols results-total trade dependent variable: log total trade (1) (2) (3) (4) (5) log gdp 1.341203 (38.31)*** 1.339999 (37.91)*** 1.34087 (37.95)*** 1.342268 (38.07)*** 1.340948 (37.94)*** log oil price −0.9180985 (−7.25)*** −0.9484149 (−7.43)*** −0.9300256 (−7.11)*** −0.9730937 (−7.63)*** −0.9450679 (−7.36)*** log distance 0.3490353 (3.54)*** 0.336853 (3.38)*** 0.3282233 (3.27)*** 0.3580799 (3.59)*** 0.3393915 (3.41)*** inflation −0.0911802 (−2.60)** −0.0865702 (−2.45)** −0.0903275 (−2.54)** −0.0892431 (−2. 53)** −0.0878 63 (−2.48)** language 1.697856 (6.88)*** 1.734199 (6.97)*** 1.73565 (6.98)*** 1.750399 (7.05)*** 1.737544 (6.99)*** border 2.831326 (5.84)*** 2.923728 (5.98)*** 2.911237 (5.95)*** 2.789 207 (5.67)*** 2.903376 (5.90)*** institutional stability 0.5689014 (8.2)*** 0.5904578 (8.44)*** 0.5988836 (8.39)*** 0.5818269 (8.34)*** 0.5845275 (8.32)*** fta 1.892718 (7.99)*** 1.706747 (7.27)*** 1.69314 (7.19)*** 1.614094 (6.77)*** 1.749137 (6.96)*** china −4.669588 (−4.03)*** germany −0.6742229 (−0.59) eu −0.2794086 (−0.74) gcc 1.797083 (2.09)* asian −0.284124 (−0.44) adjusted r2 0.686 0.680 0.680 0.682 0.680 the table reports t-statistic in parentheses, *significant at 10%, **significant at 5%, ***significant at 1%. robust standard errors (white test). gdp: gross domestic product al-shammari and al-obaid: linkages of global financial crisis and trade direction in an oil based economy international journal of economics and financial issues | vol 8 • issue 3 • 2018 259 table 5: fixed effect results-exports dependent variable: log exports (1) (2) (3) (4) log gdp 0.7193826 (6.12)*** 0.7407277 (6.26)*** 0.719604 (6.10)*** 0.7125213 (6.03)*** log oil price 0.0737809 (0.45) 0.1121368 (0.69) 0.0868293 (0.53) 0.0808481 (0.50) inflation −0.0299523 (−0.87) −0.0404345 (−1.16) −0.0302926 (−0.88) −0.0288414 (−0.84) institutional stability 0.0665655 (0.40) 0.0641116 (0.39) 0.0607945 (0.36) 0.0865849 (0.51) china −2.127306 (−2.12)* eu −0.6141545 (1.81) gcc 0.00136 (0.00) asian 0.5006429 (1.01) adjusted r2 0.3108 0.3233 0.3194 0.3240 the table reports t-statistic in parentheses, *significant at 10%, **significant at 5%, ***significant at 1%. robust standard errors (white test). gdp: gross domestic product table 6: fixed effect results-imports dependent variable: log imports (1) (2) (3) (4) (5) log gdp 0.6242383 (9.91)*** 0.6204791 (9.87)*** 0.6207552 (9.86)*** 0.6236719 (9.91)*** 0.6188698 (9.82)*** log oil price −0.3875313 (−4.20)*** −0.3889661 (−4.22)*** −0.4006321 (−4.31)*** −3886816 (−4.21)*** 0.3904959 (−4.23)*** inflation −0.381636 (−2.23)* −0.380305 (−2.23)* −0.0353382 (−2.05)* −0.0382031 (−2.24)* −0.0371157 (−2.17)* institutional stability −0.0390701 (−0.43) −0.0364856 (−0.40) −0.0390923 (−0.43) −0.0371568 (−0.40) −0.0219895 (−0.24) china −0.390701 (−0.06) germany 0.8771742 (1.66) eu 0.1984529 (1.12) gcc 0.1329717 (0.35) asian 0.3342247 (1.19) adjusted r2 0.6246 0.6241 0.6240 0.6253 0.6285 the table reports t-statistic in parentheses, *significant at 10%, **significant at 5%, ***significant at 1%. robust standard errors (white test). gdp: gross domestic product table 7: fixed effect results-total trade dependent variable: log total trade (1) (2) (3) (4) (5) log gdp 0.662476 (9.92)*** 0.660672 (9.90)*** 0.6613094 (9.90)*** 0.6620921 (9.92)*** 0.66196729 (9.89)*** log oil price −0.1691016 (−1.73) −0.1701304 (−1.75) −0.1743073 (−1.78) −0.1710606 (−1.75) −0.1694663 (−1.74) inflation −0.03245 (−1.75) −0.0324366 (−1.75) −0.0314773 (−1.69) −0.0326424 (−1.76) −0.0323593 (−1.75) institutional stability −0.0347862 (−0.35) −0.334859 (−0.34) −0.0346196 (−0.35) −0.031998 (−0.32) −0.0326193 (−0.32) china 0.0477558 (0.08) germany 0.5965928 (0.98) eu 0.0886333 (0.44) gcc 0.254237 (0.59) asian 0.0530291 (0.17) adjusted r2 0.5663 0.5658 0.5663 0.5691 0.5672 the table reports t-statistic in parentheses, *significant at 10%, **significant at 5%, ***significant at 1%. robust standard errors (white test). gdp: gross domestic product table 8: hausman test results dependent variable in natural log exports difference between re and fe imports difference between re and fe total trade difference between re and fe log gdp −0.1427751 −0.2393533 −0.2131442 log oil price 0.1346014 0.2403325 0.2098163 inflation 0.0206733 0.0227583 0.0236935 institutional stability −0.111468 −0.0820057 −0.1166991 fc 0.0483001 0.0865918 0.072615 χ2 (5) 9.78 64.44 48.80 p>χ2 0.0818 0.0000 0.0000 gdp: gross domestic product . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(4), 115-118. international journal of economics and financial issues | vol 9 • issue 4 • 2019 115 analysis of the effect of company micro fundamental factors on company value in companies listed in lq 45 index achmad hilal*, samono samono department of economic and business, universitas persada indonesia yai, jakarta, indonesia. *email: basis.skate@gmail.com received: 06 may 2019 accepted: 08 july 2019 doi: https://doi.org/10.32479/ijefi.8346 abstract this study shows the effect of the company micro fundamental factors on the company value registered in the lq 45 index (2012-2016). company value is paid by prospective investors when a company is sold. the company is projected using the tobin’s q ratio. the company micro fundamental factors in this study are current ratio (cr), debt to equity ratio (der), return on assets (roa), and earning per share (eps). cr is used to measure the ability of a company to fulfill its short-term obligate ions. der is used to assess the debt with equity that reflects the ability of a company to fulfill its obligations. roas is used to measure the ability of company to generate profits with assets used. earnings per share is used to measure the achievement of the management in achieving profits for shareholders. the design of this study is panel data regression using eviews 9 program. the analysis of the data in this study is the f test for simultaneous and correlation tests (adjusted r-square). in this study, der and roas have positive and significant effect on the company’s value (tobin’s q). eps has a negative and significant effect on company value (tobin’s q). cr has no significant negative effect on company value (tobin’s q). simultaneously, cr, der, roas, and eps has significant impact on company value (tobin’s q) with adjusted r-square 0.972082. t means tobin’s q 97.2082% can be explained from the combination of the four independent variables. keywords: company value, current ratio, debt to equity ratio, return on assets, earning per share jel classifications: e10, e32, e60 1. introduction in addition to generating profits, the main goal to be achieved by the company is to impose company value (van binsbergen et al., 2011). company value is the price that the prospective buyer is willing to pay if the company is sold where the development or value trend of a company that shows the development from year to year automatically states that there is an increase in the shareholders’ benefits (pouraghajan et al., 2012). maximizing the value of the company means maximizing the present value of all profits that will be received by investors in the future or long-term oriented (onat et al., 2014). because the value of the company is long-term oriented, every decision making on the policies made by the company must consider the value of the company. analysis fundamental analysis to calculate the intrinsic value of stocks using financial data firm fundamental analysis is an analytical tool to determine the value of a company to process data sourced from internal sources, especially financial statements issued officially by the company, then processed according to the needs analysis to find out the company’s financial ratios, so that the value of the financial ratio will be known about the value of a company (marti, 2004). some of the micro fundamental factor variables used in this study are measures of current ratio (cr), debt to equity ratio (der), return on assets (roa), earning per share (eps). the lq-45 stock index is a leading stock index on the indonesia stock exchange. shares that enter the lq-45 index are selected based on the level of liquidity, market capitalization and performance of the issuing this journal is licensed under a creative commons attribution 4.0 international license hilal and samono: analysis of the effect of company micro fundamental factors on company value in companies listed in lq 45 index international journal of economics and financial issues | vol 9 • issue 4 • 2019116 company. changes in the composition of shares in the lq-45 category are conducted every six months (february and august). of course, stocks that are consistently in the lq-45 index are companies that are stable in terms of lq-45 criteria compared to other companies. in this study the company values be measured with tobin’s q tobin’s q indicators to measure the performance of companies, especially on the value of the company, which shows a proforma management in managing the assets of the company. if the value of tobin’s q of the company is more than one, then the market value of the company is greater than the listed company assets (dietrich, 2007). from table 1, even though the average value of the company has a value of more than 1, in 5 years (2012-2016) the value of the company fluctuates and tends to decrease. decreasing company value will certainly affect market perceptions of companies that will have an impact on the company’s shareholders. 2. literature review 2.1. the value of the company companies use values n is a condition that has been achieved by a company as an overview of public confidence in the company after going through a process of several years, namely since the company was founded until now (dietrich, 2007). tobin’s q is calculated by comparing the ratio of market value of company shares to the book value of the company’s equity (morgan and rego, 2009). (van binsbergen et al., 2011) proposed a simple formula for tobin’s q which is called approximation q, namely: approximate q = (mve + ps + debt)/ta information: mve: market price of company shares the number of shares outstanding, ps: value of preferred stock liquidation. debt: total book value of short-term debt, long-term debt and other debts. ta: the book value of the total assets of the company that is considered equal to the value of the replacement 2.2. cr cr is a measure of liquidity ability, namely the ability to pay debts that must be fulfilled immediately by current assets (graham and harvey, 2002). current asset current ratio= current debt 2.3. der der is a ratio that describes the ratio of debt and equity in corporate funding and shows the ability of the company’s own capital to fulfill all its obligations (pouraghajan et al., 2012). current asset debt to equityrratio= current debt 2.4. roa roa is a ratio that describes the ability of a company’s management in managing assets it controls to generate profits (fama and french, 2004). earning after tax return on asset= total asset 2.5. eps eps is a form of profit given to shareholders from each share held (ovtchinnikov, 2010). net profit earning per share = number of shares 2.6. framework from figure 1, can be formulated of hypothesis: h1:cr has an influence on the value of the company (tobin’s q) simultaneously. h2: der has an influence on firm value (tobin’s q). h3: roa has an influence on the value of the company (tobin’s q). h4: eps has an influence on company value (tobin’s q). h5: cr, der, roa, and eps together have a significant effect on firm value. 3. methodology the population used in this study is a company that is listed on the lq 45 index. where there are 45 companies which every 6 months are updated according to the lq 45 index criteria. while the sampling technique used is purposive sampling, namely sampling techniques with certain considerations. based on the sample criteria there are 18 companies that meet the criteria to be sampled in this study. table 1: average financial performance and value of listed companies in the lq-45 index variable 2012 2013 2014 2015 2016 cr (%) 249,629 206,248 188,7 194,55 194,322 de r (x) 0,74 0,79737 0,84421 0,85947 0,83 roa (%) 15,6384 14,5595 11,9521 9,4779 9,46895 eps (rp) 649,959 580,68 660,498 567,08 535,436 tobin’s q (%) 35.489 38.528 34.022 28.955 29.522 figure 1: theoretical model cr der roa eps thevalue of the company hilal and samono: analysis of the effect of company micro fundamental factors on company value in companies listed in lq 45 index international journal of economics and financial issues | vol 9 • issue 4 • 2019 117 the model used in this study is a panel data regression model. in panel data regression there are three kinds of approaches which consist of the pooled least square approach, fixed effect approach and random effect approach (lu-andrews and yu-thompson, 2015). 4. results and discussion 4.1. effect of liquidity ratio (cr) on corporate value (tobin’s q) partially partial regression test results show there is an influence of liquidity but not significant (cr) on corporate value (tobin’s q) on corporate value (tobin’s q), this is shown from the results of t test obtained t count value of −1.359191 with a probability of 0.1786> 0.05, from the results of regression equation research above it can be seen that the regression coefficient for liquidity variables (cr) is negative at −0.239160, meaning that liquidity (cr) partially has a negative but not significant effect on corporate value (tobin’s q) in lq 45 indexed companies listed on the indonesia stock exchange, this gives an indication that to increase company value (tobin’s q) does not affect the company’s liquidity (dietrich, 2007; gupta et al., 2011). 4.2. effect of leverage ratio (der) on the profitability of corporate values (tobin’s q) partially the regression test results partially show leverage negative and significant influence on corporate value (tobin’s q), this is shown from the results of t test with a value of t count of 3.193988 with a probability of 0.0021 < 0.05, from the results of the regression equation 1 obtained regression coefficient values for leverage variable is negative at 1.728440, meaning that partial leverage has a significant effect on corporate value (tobin’s q) inlq 45 indexed companies listed on the indonesia stock exchange, this has implications for changes in corporate value (tobin’s q) (graham and harvey, 2002; lipson and mortal, 2009). 4.3. effect of the roa ratio on profitability of corporate value (tobin’s q) partially the regression test results partially show there is an effect of roa on corporate value (tobin’s q) positively, this is shown from the results of t test obtained t value of 13.45803 with a probability of 0.0000 < 0.05, from the results of the regression equation research above it can be seen that the regression coefficient for the roa variable is positive at 26.3952, meaning that roa partially has a positive and significant effect on corporate value (tobin’s q) and the variable roa has the greatest influence compared to other variables in the regression model on lq 45 indexed companies listed on the indonesia stock exchange for the period of 2012-2016, implement can support the theory of signaling theory, this gives an indication of a positive signal that profitable companies can increase company value (mulyani, 2017; pouraghajan et al., 2012). 4.4. effect of growth ratio (eps) on profitability of corporate value (tobin’s q) partially the results of the regression test partially show the effect of the earning pershare (eps) ratio on corporate value (tobin’s q) indexed companies lq 45 for the period 2012–2016 shows a negative and significant effect seen from the results of the t test obtained by the value of t −2.364986 with probability is 0.0209 <0.05, from the results of the regression equation research above it can be seen that the regression coefficient for the ratio of eps ratio is negative at -0.000972, meaning that eps partially has a positive and significant effect on corporate value (tobin’s q) lq 45 indexed companies that go public on the indonesian stock exchange for the period 2012-2016, implement it can be said that profitable companies will be able to increase eps (al-najjar & taylor, 2008; docherty et al., 2010; pouraghajan et al., 2012). 4.5. effect of liquidity ratio (cr), leverage ratio (der), roa ratio, and eps ratio, to company values (tobin’s q) together regression test results together showed no effect liquidity ratio (cr), leverage ratio (der), ratios roa, and ratio of earnings per share (eps) jointly to company value (tobin’s q) company lq 45 indexed companies listed on the indonesia stock exchange for the period of 2012-2016, by conducting an f test of 148,565 with α = 5% and degrees of freedom 90 (df = 90-94), having a significant effect on statistical probability 0.0000 <0.05, this shows that the model regression equation can be estimated by panel data using the fixed effect model (fem) method. it can be concluded that the hypothesis says: there is an influence of the liquidity ratio (cr), leverage ratio (der), roa, and the ratio of eps together to corporate value (tobin’s q) in companies lq 45 indexed companies that go public on the indonesia stock exchange for the period 2012-2016 are acceptable (al-najjar and taylor, 2008; farhi and tirole, 2012; hussain et al., 2015). 4.6. individual company influence individually the company is affected by changes in corporate value (tobin’s q) can be seen from the regression equation of each company is very sensitive negatively to changes in the company value ratio (tobin’s q) is a company is a company pt. indonesian telecommunications. tbk (tlkm), meaning the change in the value of the variable liquidity ratio (cr), leverage ratio (der), roa, and the ratio of eps to the corporate value ratio (tobin’s q) responded very quickly negative compared to other companies. the following is the regression equation of the company pt. indonesian telecommunications. tbk (tlkm) individually as follows: t q _ t l k m = − 2 . 0 8 3 0 7 8 − 0 . 3 3 2 9 0 5 − 0 . 2 3 9 1 6 0 * c r _ t l k m + 1 . 7 2 8 4 4 0 * d e r _ t l k m + 2 6 . 3 9 5 2 0 8 * r o a _ tlkm−0.000972*eps_tlkm. whereas the company that has the least sensitivity to changes in the company value ratio (tobin’s q) is the unilever tbk (unvr) company, which includes changes in the value of the variable liquidity ratio (cr), leverage (der), roa) ratio, and the ratio of eps to the corporate value ratio (tobin’s q) is responded very slowly to the corporate value ratio (tobin’s q). the regression equation is the unilever tbk (unvr) company, individually as follows: tq_unvr = 4.72169470459−0.332905161502−0.239160295018*c r_unvr+1.72843971855*der_unvr+26.3952076224*roa_ unvr−0.000972454111345*eps_unvr hilal and samono: analysis of the effect of company micro fundamental factors on company value in companies listed in lq 45 index international journal of economics and financial issues | vol 9 • issue 4 • 2019118 5. conclusions there is a partial negative effect of liquidity (cr) but it is not significant towards corporate value (tobin’s q) in lq 45 indexed companies listed on the indonesia stock exchange. there is a partial effect. positive and significant leverage on company value (tobin’s q) in lq 45 indexed companies is listed on the indonesia stock exchange. there is an influence of roa partially. leverage is positive and significant to company value (tobin’s q) in lq 45 indexed companies listed on the indonesia stock exchange. there is a partial effect of eps leverage positively and significantly on corporate value (tobin’s q) in lq 45 indexed companies listed on the indonesia stock exchange. there is the influence of the liquidity ratio (cr), leverage ratio (der), roa ratio, and the ratio of earnings per share (eps) together with respect to corporate value (tobin’s q). individually the company is affected by changes in corporate value (tobin’s q) where the company with the highest sensitivity to changes in the company value ratio (tobin’s q) is the company pt. telekomunikasi indonesia tbk (tlkm), while the company which has the least sensitivity to changes in the corporate value ratio (tobin’s q) is the unilever tbk (unvr) company. to maintain the stability of the operational activities of the companies indexed lq 45 listed on the stock exchange are advised to keep the balance of short-term liquidity and long term, increase the solvency ratio profitability control, so that the company’s ability to structure financing which is the ratio between debt with manageable asset with investment needs because micro-fundamental factors can affect the value of the company. for the next researcher, if you want to do similar research to add independent variables, such as operating profit margin, net fixed asset turn over, sales growth, dividend policy, and variables relevant to the research objectives, extend research time so that information can be obtained continuous. references al-najjar, b., taylor, p. (2008), the relationship between capital structure and ownership structure: new evidence from jordanian panel data. managerial finance, 34(12), 919-933. dietrich, d. (2007), asset tangibility and capital allocation. journal of corporate finance, 13(5), 995-1007. docherty, p., chan, h., easton, s. (2010), tangibility and investment irreversibility in asset pricing. accounting and finance, 50(4), 809-827. fama, e.f., french, k.r. (2004), the capital asset pricing model: theory and evidence. journal of economic perspectives, 18(3), 25-46. farhi, e., tirole, j. (2011), bubbly liquidity. the review of economic studies, 79(2), 678-706. graham, j., harvey, c. (2002), how do cfos make capital budgeting and capital structure decisions? journal of applied corporate finance, 15(1), 8-23. gupta, p., srivastava, a., sharma, d. (2011), capital structure and financial performance: evidence from india. journal of finance, 39, 857-880. hussain, s.s., hamza, s., miras, h. (2015), the determinants of capital structure for malaysian food producing companies. international journal of accounting, business and management, 1(1), 1-25. lipson, m.l., mortal, s. (2009), liquidity and capital structure. journal of financial markets, 12(4), 611-644. lu-andrews, r., yu-thompson, y. (2015), ceo inside debt, asset tangibility, and investment. international journal of managerial finance, 11(4), 451-479. marti, j.m.v. (2004), social capital benchmarking system: profiting from social capital when building network organizations. journal of intellectual capital, 5(3), 426-442. morgan, n.a., rego, l.l. (2009), brand portfolio strategy and firm performance. journal of marketing, 73(1), 59-74. onat, n.c., egilmez, g., tatari, o. (2014), towards greening the us residential building stock: a system dynamics approach. building and environment, 78, 68-80. ovtchinnikov, a.v. (2010), capital structure decisions: evidence from deregulated industries. journal of financial economics, 95(2), 249-274. pouraghajan, a., malekian, e., emamgholipour, m., lotfollahpour, v., bagheri, m.m. (2012), the relationship between capital structure and firm performance evaluation measures: evidence from the tehran stock exchange. international journal of business and commerce, 1(9), 166-181. van binsbergen, j.h., graham, j.r., yang, j. (2011), optimal capital structure. ssrn electronic journal. available from: https://www. ssrn.com/abstract=1743203. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2020, 10(1), 73-86. international journal of economics and financial issues | vol 10 • issue 1 • 2020 73 an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior soleman alsabban*, omar alarfaj department of economic research, saudi arabian monetary authority, saudi arabia. *email: salsabban@sama.gov.sa received: 30 september 2019 accepted: 10 december 2019 doi: https://doi.org/10.32479/ijefi.8920 abstract theoretically, investors are considered to be rational decision makers in regards to trading in stock markets, however, some empirical studies have statistically discredited this believe. evidence shows that investors seem to act irrationally in the financial markets. this research, therefore, aims to empirically investigate investor’s irrational behavior, specifically, overconfidence behavior in the saudi stock market, tadawul. the data under investigation is from 2007 to 2018, monthly based. according to previous research, positive past market returns influence the level of investors’ overconfidence leading to higher trading turnover in stock markets. to test for overconfidence behavior, a market-wide vector autoregression (var) model is designed to investigate the lead-lag relationship between market returns and market turnover. the results obtained in this research suggest that investors in the saudi stock market are overconfident. keywords: behavioral finance, overconfidence bias, stock market, var jel classifications: d91, g11, g12, g15, e22, g4 1. introduction 1.1. background “people in standard finance are rational. people in behavioral finance are normal.” meir statman many of the theories in both finance and economics such as in sharpe (1964); modigliani and miller (1958); and malkiel and fama (1970) share a common assumption that investors act rationally and analyze all available information before making investment decisions. however, more recent studies such as kahneman (1979); hirshleifer and shumway (2003); and statman et al. (2006), pointed out that investors are far from rational. these studies argue that investors cannot conform to the “rational” assumptions of the standard finance theories. perhaps most notably, it has been pinpointed by statman et al. (2006) that investors are not the “calculative utility maximizing machines” as assumed by the traditional theories in finance. more precisely, people are influenced by their sentiments or emotions and are more likely to make cognitive errors when making investment decisions. for instance, they may be overconfident about their abilities, overreact, or follow the crowd blindly. overconfidence bias is one of many examples of the cognitive errors affecting investor decision making.1 this bias, among others, influences investors’ stock valuation and trading skills. numerous empirical findings in the academic literature show a positive relationship between trading activity and past stock market returns.2 specifically, past stock gains influence investors to trade more. researchers have pointed out that overconfidence bias causes this positive relationship. this cognitive error is a form of heuristics that develop from the brain’s tendency to make mental shortcuts rather than engaging in longer analytical processing. there are various studies in the literature of economics and finance that provide evidence of overconfidence bias in stock 1 other observable biases are herding behavior, disposition bias, anchoring bias, etc effect, self-attribution (thaler, 2005) 2 see the literature review section. this journal is licensed under a creative commons attribution 4.0 international license alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 202074 markets. for example, this is best explained in both daniel et al. (1998) theoretically, and statman et al. (2006), empirically. they have concluded that subsequent to positive stock returns, there will be an increase in trading (volume) in the stock market. that is because gains from past returns have the effect of increasing the confidence of investors, by which it induce them to trade more. the ramification of such behavior could lead to a bubble in stock market, according to shiller (2002); scheinkman and xiong (2003); michailova and schmidt (2016); and gasteren (2016). statman et al. (2006) described overconfidence bias as an exaggerated estimation by an investor of his or her likelihood to experience positive events. this bias has a negative effect on investors’ overall portfolio returns. according to trinugroho and sembel (2011), overconfidence increases the likelihood of making irrational investment decisions. for example, overconfidence can lead investors to buy a stock at a high price, overconfidently thinking its price might go up further, or sell at a low price, overconfidently thinking the stock is worth less now than it was at the purchase date. this is best described by odean (1998b), who has designed a behavioral model to understand overconfident investors. in his model, he assumes that overconfident investors believe they have above average accuracy in their security valuations, and as a result, trade too much and thereby lower their wealth or expected utility. gervais and odean (2001) have developed a theory that overconfident investors tend to exaggerate their trading skills and ignore the fact that they are in a bull market. for instance, during a bull market, stocks tend to perform well, and generate profits, but overconfident investors tend to attribute the realized profit to their own skills. they disregard the fact that the realized gains where most likely due to the current state of the market, which is bullish. several studies that investigate overconfidence bias in stock markets consider trading volumes as a proxy for investor overconfidence such as in shefrin and statman (1985); statman et al. (2006); goetzmann and massa (2003); and ranguelova (2001). these studies take into account the influence of past stock market returns on investors overconfidence. in an empirical study, statman et al. (2006) investigate the impact of overconfidence bias on trading volume in the us stock market. they have used market return to measure the degree of overconfidence, given that the level of overconfidence changes with market returns. their results indicate a significantly positive relationship between market turnover and past (lagged) market returns. this also indicates the presence of overconfidence bias in the us stock market. in another related study about the german stock market, glaser and weber (2007) found that investors tend to trade more when they are overconfident, which is parallel with the statman et al. (2006) findings. 1.2. research objective, justification, and contribution there are certain objectives that will form the basis of this research. the aim is to meet these objectives using empirical models like those of previous studies. earlier studies have confirmed the presence of overconfidence bias in many countries. in this study, we will investigate whether this bias is manifested in the saudi stock market (tadawul). in addition, we will evaluate, from the obtained results, how strong the level of overconfidence is and go further to investigate the reasons behind it. considering data availability, we follow statman et al. (2006) and use turnover of stocks as a proxy for the level of overconfidence. because overconfident investors believe in their abilities and will act based on the information they obtain, trading volume is affected. therefore, if current trading volume can be explained by the past market return, it can be considered as evidence of overconfidence. based on this lead-lag relationship, we will apply a market-wide vector autoregression (var) model and impulse response function (irf) analysis to examine the existence of overconfidence bias in tadawul. several studies have found evidence of a relationship between current trading volume and lagged returns in the stock markets of developed countries (statman et al., 2006; chuang and lee, 2006; glaser and weber, 2007). however, there have been hardly any such empirical studies on the saudi stock market. our aim is to fill that void by investigating the saudi stock market with recent data of tadawul. by testing the lead-lag relationship between returns and turnover, our empirical results confirm the existence of overconfidence bias in the saudi stock market. 1.3. research structure in this study, there will be five sections organized as follows. section 1 introduces and covers a concise background of the study. to give more context to the study, the objectives, justifications and the contribution are also specified in section 1. section 2 delivers a theory review as well as summarizing related research findings. section 3 presents the data and provides a discussion on the empirical model. also, this section delivers details on the dependent and independent variables, for instance, the formulas used in calculating the variables. section 4 is the empirical section of the study. it presents and analyzes the findings. section 5, the last section, summarizes the main findings and discusses if the objectives are met. 2. literature review one of the basic assumptions in classical finance—and perhaps the most controversial—is that of rational agents and efficient markets. the efficient market hypothesis, developed by eugene fama in the 1960s, has become one of the fundamental theories of market behavior (malkiel and fama, 1970). fama defined an efficient market as “a market where there are large numbers of rational profit-maximizers actively competing with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants” malkiel and fama (1970, p. 56). an efficient financial market should have no speculation because all traders would have the same information as one another and could not therefore rationally expect to profit from speculative trading. however, this fundamental concept of market efficiency is highly unlikely to occur in the real world. in the late 1980s, several empirical papers found that investors in financial markets exhibited irrational behavior that could alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 2020 75 not be explained by classic economic theory. therefore, the assumptions of the efficient market hypothesis were questioned, especially its assumption of agents rationality. several prominent studies in psychology showed that people are not always rational when they make decisions. in a nobel prize winning research on prospect theory, kahneman and tversky (1979) argued that people value gains and losses differently and base decisions more on the prospect of gains than on the possibility of losses.3 applying cognitive psychology to evaluate the effect of investors’ behavior in financial markets led to the development of behavioral finance. unlike classical finance, behavioral finance assumes that people exhibit subjective reasoning, which leads to more realistic empirical models. overconfidence bias is one of many cognitive errors or biases discussed in behavioral finance. in the behavioral psychology literature, such as in yates (1990); and campbell et al. (2004), people who presume themselves to have more abilities than they actually retain, and who make decisions based on that presumption, are described as being overconfident. glaser and waber (2007) presented three manifestations of overconfidence: miscalibration, underestimation of volatility, and the “above average” effect. the following is a concise elaboration on these forms of overconfidence. according to glaser and waber (2007), miscalibration is the difference between the accuracy and the probability assigned in any decision making process. for instance, when asked to make a forecast without being precise but estimating within a certain confidence interval, people usually are less accurate. in a similar study by alpert and raiffa (1982), participates were presented with a sequence of ten difficult questions such as “what is the length of the nile river?” they were then asked to provide a low guess and a high guess that they thought would be the correct answer with a probability of 90%. if participants were well calibrated, nine out of ten of them would provide upper and lower guesses that actually contained the correct answer. as expected, participants were, in general, not well calibrated since they have provided guesses that contained fewer correct answers than nine out of ten. in a related study, de bondt (1998) asked 46 stock market investors to predict stock prices and forecast risks in us stock market. the results confirm that there is a miscalibration in the stock market since investors were asked to place 90% confidence intervals on their predictions. in another word, they have found that the majority of investors failed to specify a range of expected future stock prices. glaser et al. (2013) obtained similar findings for student and professional stock traders. some studies focus on the volatility estimates of investors. for example, hilton (2001); and andersen et al. (2004) asked investors to each provide confidence intervals for the return or price of a stock in the future. these studies conclude that investors tend to provide intervals that are too tight and therefore deviate from the possibilities of a correct guesses; they underestimate historical volatilities. graham and harvey (2015) found similar findings. 3 for example, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former even when they achieve the same economic result i.e., the prospect theory. they have asked chief financial officers of us firms to provide quarterly confidence intervals for the market risk premium. they tended to underestimate historical volatilities. a third form of overconfidence is the belief that one is better than the average person is. this is called the “above average” effect. numerous studies have confirmed the existence of this effect. see for example dunning (2005); beer and hughes (2010); sharot (2011); and chamorro‐premuzic and furnham (2014). many researchers have concluded that the above average effect is nearly universal. for instance, when a sample of u.s. students (22 years of age) were asked to evaluate their own driving safety, 93% judged themselves to be in the top 30% of the group (svenson, 1981). glaser and weber (2007) found that more than half of stock market traders think their investment skills are above average, which leads them to trade more. investors who attribute past success to their skill and past failure to bad luck are likely to be overconfident. an investor who is overconfident will want to utilize his perceived superior ability to obtain large returns. in addition, overconfident investors underestimate the risks of their active investing, and so, on average, trade more than other investors do (kyle and wang, 1997; odean, 1998b). 2.1. stock market returns and overconfidence bias the correlation between stock market returns and overconfidence has been under the scope for many years. miller and ross (1975) finds that people attribute their success to their own ability, and attribute their failures to external factors.4 investors in financial markets are no exception according to their argument. gervais and odean (2001) have formulated a model for determining how investors learn about their trading skills and in what way self-attribution bias leads to overconfidence. they begin by assuming that investors do not know the range of their trading skills and they learn about it through experience. they pointed out that each investor’s overconfidence level depends on past successes and failures in stock market trading. they also show that greater overconfidence leads to higher trading volume. the authors also argue that their model could apply to the changing stock market states. for instance, investors during a bull market have more opportunities to make successful investments and gain profits. accordingly, as a result of self-attribution bias, investors will become overconfident and trade more in a bull market, ignoring the fact that their success is more likely to have resulted from the bull market than from their own ability. based on that, it could be expected that overconfidence bias among investors is higher and trading volume is greater, when there is an overall stock market gain. glaser and weber (2007) investigated the effect of stock returns on individual investors in the german stock market from 1997 to 2001. more specifically, they considered which type of stock returns have a stronger effect on investors’ overconfidence level: past market returns, or past portfolio returns. they have found that both past market returns, and past portfolio returns affects investors’ overconfidence, leading them to trade more. they further show that higher past portfolio returns cause investors to trade more, leading to higher risk taking. however, high past market returns are not associated with higher risk taking. according to 4 scientifically, this behavior is called self-attribution bias. see for more details, feather and simon (1971) and hoffmann and post (2014). alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 202076 them, high past portfolio returns make investors overconfident because of self-attribution bias. they feel overconfident in the sense that they think themselves to be better investors than others. on the other hand, high past market returns could potentially make investors overconfident in the sense that they underestimate the volatility of stock returns. as a result, prediction intervals would be too tight that ultimately may result in misevaluation of the stocks. 2.2. overconfidence bias and trading volume when analyzing investor behavior using stock brokerage data, trading frequency is commonly used as a proxy for overconfidence. barber and odean (2000; 2001); and odean (1999) found that u.s. individual investors trade excessively, expose themselves to a high level of risk, and make poor investment decisions. investors with superior information and better trading skills will utilize this ability by trading often to capture high returns. therefore, people with actual high ability and people who believe they have high ability will both trade excessively. it is generally assumed that there are few truly highly investors compared to the number of overconfident ones. therefore, the trading frequency proxy is often believed to represent the behavior of overconfident investors on average. similarly, gervais and odean (2001) examine an overconfidence hypothesis that indicates that if investors are overconfident, they will trade more aggressively after experiencing stock gains. they pointed out that successful past trading experience create overconfidence in investors’ original price trend predictions. such trading gains would then induce investors to buy or sell more in the following periods, and to do so more aggressively. in a related study, chuang and lee (2006) found several comprehensive results such as, past stock market gains lead investors to be overconfident and thus trade more actively.5 furthermore, a positive relationship between investor’s overconfidence and stock market volatility was confirmed in their model. additionally, overconfidence leads investors to underreact to risks associated with investments, causing them to trade more in riskier stocks and as a result, lower their returns. these results are parallel to an experiment conducted by yeoh and wood (2011) in which participants were engaged in an 8 weeks trading competition using london stock exchange share prices. simulating a real-life investment experience, participants were given freedom to trade at any time. using miscalibration as a measure of overconfidence, they have found that overconfident participants tended to trade more and, as a result, underperform in the experiment. in a prominent empirical study, statman et al. (2006) examined the new york stock exchange from 1962 to 2002. the focal point was to test the trading volume predictions of formal overconfidence models. they point out that when examining long-term stock market trading activity, one must account for the fact that the number of shares for a typical stock has increased noticeably over the last four decades. therefore, to offset the secular increase in number of shares, they measured trading activity with turnover (shares traded divided by outstanding shares).6 using vector 5 the reason behind more active trading is that during stock market gains (bull market), investors are more likely to make right forecasts about future stock returns. then, investors become overconfident because of selfattribution bias. 6 see also, lo and wang (2000). autoregression and irfs, they were able to show that there is a statistically significant tendency for market trading activity to increase in the months following positive market returns after accounting for volatility associations. 2.3. overconfidence bias and stock market bubble ultimately, stock market bubbles are infamous for its destructive impact on investments and the economy as a whole. in financial economics, a bubble is referred to as the systematic deviation from the asset’s fundamental value (kindleberger and manias, 1978). even more specifically, a stock market bubble occurs when the asset’s trading price exceeds the discount value of the expected future cash flows (gasteren, 2016). historically, bubbles have been observed in many cases such as the dutch tulip mania in 1634, black monday in the 1920s, the dot com bubble, the recent subprime crisis in 2008, and the saudi stock market crash in 2006. it is fair to say that the main causes of a bubble in stock markets are investors’ irrational behaviors. perhaps this is best explained by the daniel et al. (1998) (dhs) model as it demonstrates the relationship between overconfidence, volatility and bubbles. it starts when investor x receive some private information at time t he/she tends to overreact to this piece of information and value stocks much higher than its actual price. at time t+1 this private information reaches the public, consequently other investors will eventually correct the initial overreaction until the stock reaches its rational expected value at t+k. this is what is considered a short run (harmless) bubble according to daniel et al. (1998). however, in the long run when more investors are involved, the bubble could do a lot of damage in the stock market where instead of stocks prices going back to its rational expected value, it plummets sharply. the role overconfidence in creating bubbles begins when investors overvalue stocks prices, overconfidently thinking that other investors would pay higher in the future and therefore generating profits, for instance similar to investor x. according to michailova and schmidt (2011), they have designed an experiment on 60 subjects (german participants) by which they had to participate in a simulated stock market with virtual money. however, at the end of the experiment, each participant were payed the exact amount earned in the simulation in cash. the purpose of their experiment was to closely test if overconfidence leads to bubbles in stock markets. they have found that the majority of participants were overconfident and that led to the formation of a bubble in the simulated stock market. the ramification of participants’ overconfidence led to overall lower returns. this experiment was on a smaller scale, however, in any given real stock market, that potentially mean that many people could lose substantial amount of money and as a result, the general confidence becomes weak in the stock market and the economy as a whole. 2.4. the saudi stock market crash of 2006 and investors’ behavior the saudi stock exchange (tadawul) is considered to be relatively new since it was established not that long ago in 1985. throughout these 34 years, the saudi stock market have not experienced anything like the 2006 crash. by the end of 2003, the tadawul all share index (tasi), which is the saudi stock market index, recorded a growth in its value by approximately 76%, and 84%, 103.7% in the following 2 years of 2004 and 2005, respectively. alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 2020 77 on february 25 of 2006, tasi had closed at its historical peak of 20,634.86 one day before the market collapse started. by the end of this year, tasi had lost about 65% of its value. unfortunately, the observed pattern was that more than half of the saudi investors, at that time, borrowed money to invest or liquidated their assets to finance their investments. according to annual reports by saudi arabian monetary authority the loans granted for saudi citizens reached a gross balance of us$ 13.4 billion (sar 50.5 billion) at the end of 2002, however the gross loan balance reached us$48 billion (sar180 billion) at the end of 2005. as a result of this irrational behavior, the ramifications hit the saudi average families the hardest at which those families found themselves in bitter situation of not being able to pay the loans back. several studies such as alkhaldi (2015); baamir (2008); and lerner et al. (2017) have investigated the 2006 saudi stock market crash, and found that the crash was caused by different factors, such as the lack of investor’s knowledge and experience, the lack of transparency and market infrastructure, and the lack of regulator’s experience. all of these factors together were the main cause of the crash. the lack of knowledge and experience might lead investors to a cognitive bias when they are making their investment decisions. understanding investors’ behavior in the stock market is very essential since it might help address the kind of problems we have in the market and the way we deal with them. there is an apparent lack of empirical literature on investors’ behavior in the saudi stock market. that said, the overwhelming majority of research has taken a questionnaire-based approach. for instance, alquraan et al. (2016) have randomly distributed 140 questionnaire. the main targeted population of the study was the saudi individual investors in the year of 2015. the results suggested that saudi investors tend to be overconfident when they make their investment decisions, which means saudi investors have a tendency to overestimate their own knowledge, abilities, and judgements. in an attempt to examine investors’ stock portfolios in the saudi stock market, alsedrah and ahmed (2018) have found that investors in the saudi stock market appears to participate in a speculative behavior when making investment decisions. they conclude that overconfidence bias is among other behaviors that persist in the saudi stock market. 3. empirical framework and data collection 3.1. model specification in this study, overconfidence bias is tested in the saudi stock market (tadawul) by closely examining the interactions between market return and market turnover (i.e., trading volume) using empirical model designed specifically to investigate overconfidence bias. this model, the market-wide security model, is based on statman et al. (2006),7 is formulated by estimating vector autoregression (var) and irfs analysis using aggregate stock market data. ultimately, empirical tests based on these estimates are critical in studying the interactions 7 also, chen and zhang (2011), zaiane (2013), metwally and darwish (2015) my et al. (2016), and zia and hashmi (2016). between lagged market returns and trading volume, which are used to test for overconfidence. h0: the current trading volume of transactions is not positively related to lagged market returns. h1: the current trading volume of transactions is positively related to lagged market returns. this hypothesis is justified by the fact that following a bull market, the overconfidence of investors leads them to trade more aggressively due to self-attribution bias. of this fact, this study assumes an increase in transaction volume following gains achieved by the market.8 the vector autoregression (varx) model is applied to examine whether investors will trade more aggressively after market gains, as predicted by the overconfidence hypothesis.9 3.1.1. the model: the estimation of var to test for overconfidence behavior vector autoregressive model (varx) is constructed to investigate whether there are lead-lag relationships among variables. unlike the univariate time-series model, the standard var model estimates several equations simultaneously without specifying which variables are exogenous or endogenous. in this study, a vector autoregression (varx) model is used as it is considered appropriate to test such relationship while introducing exogenous variables based on previous literature. the basic vector autoregression (varx) model is specified as following: 1 0 k l t k t k l t l t k l y a a y b x e− − = = = + + +∑ ∑ where, yt: a (n*1) vector of endogenous variables10 with t observations each. ak: the matrix that measures how trading proxy and returns react to their lags. bl: the matrix that measure how trading proxy and returns react to month (t-1) realizations of exogenous variables. xt: a (n*1) vector of exogenous variables11 with t observations each. k and l: numbers of endogenous and exogenous observations respectively. k and l are chosen based on the akaike information criteria, schwartz criteria (sc), and hannan quinn12. in this paper, the sc leads to k=1 (table 1) and l=1,13 look at table 1. 8 this hypothesis is also mentioned by odean (1998) and gervais and odean (2001). 9 the varx model is different from var in that it allows the use of control variables (exogenous variables in which their values are calculated outside the model). 10 returns and trading proxy (turnover and volume). 11 dispersion and volatility. 12 aic log k t = +∑  2 sc log k t t= +∑  log( ) , hq log k t t= +∑  2 log(log( )) 13 as for the exogenous variables’ lag selection, the appropriate lag is chosen after running varx model in respect to different lag, starting from lag 1 to lag 5. the smallest aic number associated from running varx model is chosen. alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 202078 et: a (n*1) residual vector. it captures the contemporaneous correlation between endogenous variables. fundamentally, the model is constructed to investigate the lead-lag relationship between market return and trading volume, which is specified as following: mturn mret a mturn mret mturn mret t t k k t k t k       =       + = − − ∑ α α 1 1       +         +     = − − ∑ l l t t l t t msig 0 1 1 2 b disp e e mturn mret , ,   the market turnover series is required to be stationary to ensure the model estimation is non-biased and valid. the variables are stationary at their level according to the augmented dickey fuller (adf) and phillips perron (pp) tests that have been applied to the data. 3.1.2. definition of variables • mturn: the monthly market turnover (shares traded) according to earlier literature, trading volume (in shares) and the turnover ratio are both commonly used indicators to measure trading activities. this paper takes into account the historically growing trend of trading volume in the sample period. following statman et al. (2006), the turnover ratio will be used because it is a relative measure which eliminates the influence of growth. the turnover ratio has to be estimated for each stock, using the data of trading volume (in shares) for each individual stock. lo and wang (2000) provide thorough calculation formulas for both share turnover and value-weighted turnover. suppose vi represents the number of shares traded monthly for individual stock i, and si is the outstanding shares of the stock i. hence, the individual turnover is calculated by, ti vi si = . the weight wi for each stock is different with its own market value divided by the total market capitalization. by applying different weights to the turnover ratio for each stock, the market turnover is expressed as follows: t i ivw i n = ∗ =∑ w t1 14 14 where �wi thecapitalizationof thesecurity sumof capitalization foral = ll securitiesinthemarket and capitalization pi si= * (pi, is initial price per share, and si, is shares outstanding for each security). the calculation of each stock during the whole sample period was repeated to obtain a market turnover time series. figure 1 is the plotted graph of monthly market turnover. perhaps it is noticeable that figure 1 indicates that the series may be accompanied with a trend. therefore, the adf unit root test was applied, and the test reject the null hypothesis of existence of a unit root at 1% confidence level. the results suggest market turnover is stationary at its level. a stationary turnover time-series is desired as it eliminates bias in coefficient estimates of the var model. the results of the unit root tests will presented in details in section 4. • mret: the monthly stock market return one way of calculating market returns is directly through raw data on tasi. for monthly market returns, the process involves calculating returns for all stocks within the index for each month. ( ) 151 0 0 p p d total stock returns, mret p − + = the market return series, mret is therefore generated by repeating the process for all months during the sample period. furthermore, market return passes the stationary test (adf unit root test) at 1% significance level. figure 2 shows the fluctuations of market return based on tasi. as can be seen, the recent global financial crises of 2008 affected market returns fluctuations by large margins.15 15 where, p0=initial stock price, p1=ending stock prices, and d=dividends. table 1: lag structure criteria for endogenous variables in market-wide varx model lag ll lr fpe aic sc hq 0 500.7258 na 1.80e-06 −7.553065 −7.421376 −7.499554 1 566.5567 126.6367* 7.00e-07* −8.497049* −8.277568* −8.407864* 2 567.5626 1.904173 7.32e-07 −8.451337 −8.144064 −8.326478 3 571.5948 7.510420 7.32e-07 −8.451829 −8.056763 −8.291296 4 572.4306 1.531179 7.69e-07 −8.403520 −7.920662 −8.207313 5 573.7617 2.398097 8.01e-07 −8.362774 −7.792124 −8.130894 6 577.7007 6.975882 8.02e-07 −8.361842 −7.703400 −8.094288 7 580.9740 5.697061 8.12e-07 −8.350748 −7.604513 −8.047519 8 582.0740 1.881022 8.50e-07 −8.306474 −7.472447 −7.967572 value with star (*) is chosen by specific criterion. aic: akaike information criteria, sc: schwartz criteria, hq: hannan quinn figure 1: monthly market turnover of the saudi stock market (tadawul all share index) alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 2020 79 • msig: the monthly temporal volatility of market return based on daily market returns within the month.16 in addition to mturn and mret, market volatility (msig) is employed as the first control variable. msig r rrt tt t t tt t2 2 1 1 1 2= + = +=∑ ∑ following the statman et al. (2006) specification of the monthly volatility, using the formula provided by french et al. (1987), which is computed by adding squared daily returns with twice the sum of the products of adjacent returns. assuming that rt is day t’s return and t is the number of trading days in month t. figure 3 shows that market return volatility of the saudi stock market (msig2) is somewhat stable, however, 2008 witnessed a high volatility, most likely due to the global financial crisis. this elevated jump in volatility in 2008 can also be attributed to the fact that the saudi stock market have gone through a crash in 2006 that might have temporarily caused investors sentiment in saudi stock market to lean towards conservatism. • disp: cross-sectional standard deviation of returns for all stocks in month t. 16 we have followed french et al. (1987) conditions of volatility calculation. the second control variable dispersion (disp) is introduced, following campbell and lettau (1999). in order to capture the individual risk for individual firms, dispersion variable is employed, which is the cross-sectional volatility of individual firms within tasi on monthly basis. the reason the return dispersion is used as a control variable is to account for any potential trading activity associated with portfolio rebalancing. for instance, large deviations between the individual stock returns within an investment portfolio might lead investors to initiate a trading activity in order to maintain their incepted portfolio weights associated with an investment strategy. disp wi r rt tt n = − =∑ ( ) 2 1 17 first, squared deviation from mean return for each stock is computed and following is the multiplication of marketcapitalization weights to generate disp series. by looking at the cross sectional volatility of firms in tasi shown in figure 4, we can observe that the crisis in 2008 had an impact of the behavior of stock trading that led to high fluctuations and volatility. 3.2. data the data of the saudi stock market in this paper were collected from bloomberg’s database. the tasi is a free float market capitalization-weighted index of more than 190 stocks. for consistency, we have excluded all traded funds such as reits (real estate investment trust) because such funds do not have the same characterization of stocks. in addition, we have also excluded stocks that have been listed in late of 2018 because of the short observations in those stocks. after eliminating those stocks, there are 172 stocks under study. tadawul is continually developing and as a result, each year, a considerable number of companies are listed; therefore, the number of shares traded increases noticeably. however, we took that into account by applying statman et al. (2006) methods of offsetting the inevitable growth of shares traded over time. the data sample period is from 17 where, r n rt t n = =∑ 1 1 figure 2: monthly market return of the saudi stock market (tadawul all share index) figure 3: monthly market volatility of the saudi stock market (tadawul all share index) figure 4: monthly security volatility of the saudi stock market (tadawul all share index) alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 202080 january 2007 to december 2018. the data collected is a monthly based, however, daily data is needed to calculate monthly volatility. the data consists of approximately 400,000 daily observations of price, trading volume, and market capitalization for each stock listed in the tasi. 4. empirical results 4.1. descriptive statistics and unit root tests there is a fairly large number of observations in this study at which n = 143. we believe, in such study, it is important to have an adequate number of observations as it provide estimation that is more precise. by looking at table 2, the results show that the average market return (mret) is 0.3% across all stocks in tasi over the full sample period. the turnover (mturn) averaged about 7% across tasi. however, the descriptive statistics show an unusual outcome for market volatility (msig2) as it averaged about 2.6% which is considered to be low compared to other stock markets such as 16% in the us, 15% in japan, 15% in germany and 7% in hong kong.18 we believe that the reason tasi recorded a low volatility could be due to the fact that investors are being cautious after the devastating 2006 bubble. this may have led investors to implement a safe investment strategy such as buy and hold. the dispersion (disp) records an average of 30% of the collective individual stocks in tasi. 18 see statman et al. (2006), chen and zhang (2011) and zoe (2016). intuitively stationarity implies that the statistical properties of a time series variables do not change over time. in a time series model, it is essential for the variables to be stationary in order to have a valid assumption. as can be seen in table 3, we ran the adf test on all the variables.19 the results show that at 1% confidence level, all variables are stationary at its level. we also ran the pp test to confirm that all variables are stationary in spite of running another unit root test.20 the pp test results show that all variables are stationary at its level. 19 after processing the data, the following adf test (1981) is used: ∆ = + + + +− = −∑y y yt t t j k j t j tα γ β φ ε0 1 1 the theory of unit root test underlies consideration of the serial correlation problem. the null hypothesis of the adf test is γ = 0 versus the alternative hypothesis γ ≠ 0. failing to reject the null hypothesis means that the series under investigation is not stationary, and a unit root exists. 20 the pp unit root (1988) statistics are computed as: ( ) ( )2 2 2 112 1 1 1ˆ1 ( 2 ˆ ) t t t z t x t α α λ δ − − = = − − − ∑ ( ) 2 12 2 2 2ˆ 11 2 1 ˆ1 ˆ ( ) 2ˆ t t t t z t x t α δ λ λ δ λ − −= = = − − ∑ where, 1 ˆ 1 2 1/ 2 1ˆ( 1)( ) t t t t s xα α − − = = − ∑ , and 2 1 2 1 ˆ t t t s t u− = = ∑ and 2λ̂ are estimators of the short and long run variances of ut. the null hypothesis of the pp test is that there is a unit root. failing to reject the null hypothesis means that the series under investigation is not stationary. table 2: descriptive statistics full period 2007-2018 observations: 143 market returns (mret) market volatility (msig2) mean 0.0030 mean 0.0264 standard deviation 0.0667 standard deviation 0.0913 minimun −0.2575 minimum 0.0006 maximum 0.1959 maximum 1.0060 market turnover (mturn) dispersion (disp) mean 0.0695 mean 0.3029 standard deviation 0.0334 standard deviation 0.1037 minimun 0.0198 minimun 0.1340 maximum 0.2124 maximum 0.6923 table 3: unit root tests augmented dickey fuller (adf) phillips perron (pp) level data level data constant trend constant trend mret −10.73 −10.69 −10.73 −10.69 mturn −4.01 −4.40 −3.52 −4.18 msig2 −10.14 −10.31 −10.23 −10.35 disp −6.00 −6.31 −6.07 −6.46 the adf 5% critical values for constant = −2.88, and for trend= −3.44. for the pp constant = −2.88, and for trend = −3.44 table 4: market var estimation results (2007-2018) constant mret (t-1) mturn (t-1) mret (t-2) mturn (t-2) msig2 (t-1) disp (t-1) mret 0.004400 (0.02014) 0.061948 (0.09640) 0.258487 (0.36980) −0.048566 (0.09394) −0.273192 (0.30684) −0.130787 (0.08124) 0.008085 (0.07655) mturn 0.018690*** (0.00563) 0.066930** (0.02696) 0.717416*** (0.10344) −0.003085 (0.02628) −0.002681 (0.08583) 0.041684* (0.02272) −0.004950 (0.02141) standard errors in parentheses, ***p<0.01, **p<0.05, *p<0.1 alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 2020 81 4.2. market-wide var estimation and irf 4.2.1. market var estimation table 4 summarizes the estimation results of the market varx system that contains endogenous variables: market turnover, mturn, and market return, mret. furthermore, the control variables are market volatility, misg2, and dispersion, disp. the following paragraphs discuss the main results obtained from varx model that was designed to test overconfidence behavior in the saudi stock according to statman et al. (2006), the overconfidence hypothesis is verified when lagged market returns are associated with increased market turnover (trading volume). table 4 shows the result of testing our hypothesis using var estimation by incorporating the full sample (2007 to 2018). this study is interested in the second row of table 4 as it shows the results of our hypotheses. looking at market turnover (mturn) with market return (mret) at lag 1, the result shows a statistically significant coefficient, with the estimated parameter of 0.067. however, we have noticed the existence of serial correlation at lag 1, to solve this problem, we proceed to use lag 2 for all endogenous variables as the selection of lag 2 seems to remove serial correlation problem as proposed by foscolo (2012).21 this suggests that current market turnover depends on the first lagged market return. from this observation, the overconfidence hypothesis of our model is verified and confirmed in the saudi stock market, tadawul. in other words, positive past market returns make investors overconfident leading them to trade more. also, the results indicate that market volatility at lag 1 has a positive and statistically significant coefficient of 0.042 in explaining market turnover. in other words, when volatility is high, saudi investors tend to trade more in the subsequent period. we believe the reason behind it is that when there is volatility in tasi, saudi investors might anticipate that the market is reacting to positive news while in reality that is not the case as in many cases, volatility is caused by noisy traders. these results are consistent with statman et al. (2006). the results in table 4 are similar to results on the us stock market (statman et al., 2006; odean, 1998a; gervais and odean, 2001), hong kong stock market (chen and zhang, 2011), and french stock market (siwar, 2011). however, the degree of overconfidence understandably varies between countries.22 for instance, the coefficient of the market return lag 1 with current market turnover in the united states (statman et al., 2006), is 0.816, in hong kong the coefficient is 0.3330, and in france, the coefficient is significant at 0.540, compared with this study’s equivalent results, in which saudi arabia has a significant coefficient of 0.082. in addition, the estimated var is stable (stationary) as all roots lie inside the unit 21 foscolo suggested that serial autocorrelation rapidly declines at higher lags. the serial correlation test results will be displayed in tables 9 and 10 (appendix). 22 it could be a result of different time series or different estimation models. circle as can be seen in figure 6 (appendix). for more diagnostic tests such as heteroscedasticity and normality test, see tables 7 and 8 in appendix. based on estimates of the var model, this study is interested to know whether market return (mret) granger-causes market turnover (mturn). market return is said to granger-cause market turnover if past values of market return are useful for predicting market turnover. for instance, failure to reject the null hypothesis is failure to reject the hypothesis that mret (mturn) does not grangercause mturn (mret). table 5 shows that the granger causality test result confirms the overconfidence hypothesis in the saudi stock market. the null hypothesis “mret does not granger cause mturn” produced a p = 0.0155, therefore, it is rejected at 5% significant interval. this means that past market return (mret) has a positive impact on current market turnover (mturn), i.e., trading volume. however, this relationship does not hold in the opposite way. the p > 10% when the dependent variable is market return. thus, the null hypothesis cannot be rejected. as a result, the influence of past trading volume on the current market return is not realized in the granger causality test. to sum up, this study found a unidirectional granger causality running from lagged market return and current market turnover. 4.2.2. market irf irf uses all the var coefficient estimates to check the impact of one standard deviation shock from the residual. figure 5 shows the four possible irf graphs using the var estimation results in table 4. figure 5a and b plot the response of market turnover (mturn) to a one standard deviation shock in market turnover (mturn) and market return (mret), respectively. for instance, figure 5a shows that a one standard deviation shock to market turnover results in a positive response of 1.8% in the next month’s turnover. this verifies the serial dependence of market turnover, by which the positive effect of a one standard deviation shock to market turnover persists at period one (the effect starts to slowly decline after period one). in figure 5b, the first and second period impulse-responses imply that a one standard deviation shock to market return is followed by 0.4% increases in the 2nd month’s market turnover. the accumulated response over the first 10 months is a 1.0% increase in market turnover compared to average levels. this is a key finding, in that it is an evidence that market return impacts investors’ overconfidence, leading them to trade more. figure 5b accords with var estimation and granger-causality test results. however, it shows a relatively weak response of market turnover to market return starting the following month by 0.4% in the saudi stock market compared to the large and persistent response in the us stock market of approximately 7%, according to statman et al. (2006). the results suggest that investors in the us show a higher level of overconfidence compared to saudi investors. this could be a result of the higher experience level of investors in the us table 5: granger causality test (mret and mturn) null hypothesis observations f-statistics prob. mret does not granger cause mturn 142 6.00551 0.0155 mturn does not granger cause mret 142 0.25745 0.6127 alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 202082 compared to saudi. this phenomena of a positive relationship between higher experience and overconfidence behavior in financial markets is supported by heath and tversky (1991); frascara (1999); kirchler and maciejovsky (2002)23. figure 5c and d plot the response of market return (mret) to a one standard deviation shock in market turnover (mturn) and market return (mret), respectively. for instance, figure 5c shows that market return response to a one standard deviation shock to market turnover is weak, and exists only from 1 month to 3 months. in the 3rd month and afterwards, the impact of the shock starts to move to the negative range. that means that a one-unit shock of market turnover will negatively affect returns by −0.2% in the 3rd month. in other words, positive lagged market returns leads saudi investors to trade more and as a result, this leads to negative overall current market returns. figure 5d indicates that the first period impulseresponse with a one standard deviation shock to market return results in a 6.4% increase in the next month’s return. however, the impact of the shock declines after 2 months and starts to disappear after 3 months. this behavior of market returns can be explained by the momentum theory (rouwenhorst, 1998) – positive returns tend to follow gains in a short time horizon. table 6 (appendix) shows a more detailed results on the impulse response function. 5. conclusion this section summarizes the main empirical findings obtained in section 4. furthermore, there will be a brief discussion whether 23 in addition, glaser et al. (2013) has a similar result because in their experiments professional traders have a higher degree of overconfidence than students in the two tasks examined, namely trend recognition and forecasting of stock price movements. the objectives of this research are achieved as well as addressing the limitations of this research. in addition, suggestions and recommendations for future research will be highlighted in this chapter. 5.1. summary of the study this paper focuses on the most common behavior observed in financial stock markets that is overconfidence bias. this bias is confirmed to have an effect on investor’s decision making in many advanced countries such as the united states, france, japan, and germany. also, it is observed on a stronger level in developing countries such as taiwan, hong kong, hungary, tunisia, and egypt. the method used to obtain the results of this study was by collecting saudi stock market (tadawul) data from 2007 to 2018 using bloomberg database. after processing the data, four variables, in total, were formed (mret, mturn, msig2, disp)24. subsequently, a var model was estimated to test for overconfidence behavior in the saudi stock market. the focal point after running the model is to analyze the relationship between lagged market return and current market turnover, to test for overconfidence bias. the results obtained from the var model, confirm the existence of overconfidence behavior in the saudi stock market. as predicted, the level of overconfidence in saudi is somewhat lower to those of other developed countries. a granger causality test was also conducted as a robustness check for var results. the outcome of the granger causality test matches the var estimation results fairly well. that is, both results show that past market returns and market turnover (volume) are positive related. the results reveal that investors tend to trade more when they get positive returns in the previous month, i.e. they exhibit overconfidence bias. the objectives of the study are met using 24 see chapter 3 (page 18) for further elaboration on the variables. figure 5: impulse response function. response to cholesky on sd (d.f. adjustrd) innovations±2 se. (a) response of mturn to mturn, (b) response of mturn to mret, (c) response of mret to mturn, (d) response of mret to mret a b c d alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 2020 83 appropriate estimation model (var model). at a fundamental level, this study aimed to test for overconfidence bias in the saudi stock market. this objective was achieved using the brilliant example of statman et al. (2006) as the primary foundation to build up the hypothesis and model of this study. 5.2. limitation of the study and recommendations for future research the results confirm that investors in the saudi stock market (tadawul) exhibit overconfidence behavior in their decisionmaking. the most substantial limitation of this study is being unable collect stock market data past 2007. this would have been beneficial in terms of studying the saudi investor’s behavior before and after the global financial crisis of 2008 and the local market crash of 2006. also, a longer sample size would allow for more insight into past stock market behavior and comparison of changes in behavior with recent data. this study investigated the lead-lag relationship between market returns and market turnover by using statman et al. estimation models on a monthly basis. however, there are more ways to test for overconfidence behavior. most obvious and most difficult is by conducting experiments. for example, see hilton (2001); and de bondt (1998). another way, time consuming but effective, is to collect data using a questionnaire such as in zaiane and abaoud (2010); and huisman et al. 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(2016), disposition effect and overconfidence in pakistani stock market. available from: https://www.ssrn.com/ abstract=2745749. alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 2020 85 appendix table 6: impulse response function results response of mturn response of mret period mturn mret period mturn mret 1 0.018343 0.000000 1 0.01144 0.064572 (−0.00109) (0.00000) (−0.00548) (−0.00385) 2 0.013925 0.004322 2 0.00545 0.004 (−0.00204) (−0.00176) (−0.00657) (−0.00623) 3 0.01027 0.003169 3 −0.00163 −0.001771 (−0.00188) (−0.00218) (−0.00344) (−0.00574) 4 0.007205 0.002131 4 −0.001515 −0.000666 (−0.00188) (−0.00172) (−0.00273) (−0.00113) 5 0.005045 0.001481 5 −0.000958 −0.00027 (−0.00183) (−0.00122) (−0.00196) (−0.00078) 6 0.003541 0.001041 6 −0.00065 −0.000184 (−0.00168) (−0.00087) (−0.00135) (−0.00049) 7 0.002486 0.000731 7 -0.000457 −0.000134 (−0.00147) (−0.00063) (−0.00091) (−0.00031) 8 0.001745 0.000514 8 −0.000321 −9.47e-05 (−0.00124) (−0.00047) (−0.00062) (−0.00021) 9 0.001225 0.000361 9 −0.000226 −6.64e-05 (−0.00102) (−0.00035) (−0.00043) (−0.00014) 10 0.00086 0.000253 10 −0.000158 −4.66e-05 (−0.00082) (−0.00026) (−0.00030) −9.80e-05 11 0.000604 0.000178 11 −0.000111 −3.27e-05 (−0.00065) (−0.0002) (−0.00021) −6.80e-05 12 0.000424 0.000125 12 −7.81e-05 −2.30e-05 (−0.00051) (−0.00015) (−0.00014) −4.70e-05 13 0.000298 8.76e-05 13 −5.48e-05 −1.61e-05 (0.000298) (−0.00011) (−0.00010) −3.30e-05 14 0.000209 6.15e-05 14 −3.85e-05 −1.13e-05 (0.00030) (−8.70e-05) −7.00e-05 −2.30e-05 15 0.000147 4.32e-05 15 −2.70e-05 −7.95e-06 (−0.00023) (−6.50e-05) −5.00e-05 −1.60e-05 cholesky ordering: mret mturn, standard errors: analytic table 7: normality test results component skewness chi-square df prob. 1 −0.283495 1.888688 1 0.1693 2 0.704340 11.65822 1 0.0006 joint -13.54690 2 0.0011 component kurtosis chi-square df prob. 1 4.608130 15.19323 1 0.0001 2 3.623673 2.285184 1 0.1306 joint -17.47842 2 0.0002 component jarque-bera df prob. 1 17.08192 2 0.0002 2 13.94340 2 0.0009 joint 31.02532 4 0.0000 alsabban and alarfaj: an empirical analysis of behavioral finance in the saudi stock market: evidence of overconfidence behavior international journal of economics and financial issues | vol 10 • issue 1 • 202086 table 9: serial correlation test (endogenous variables at lag 1) null hypothesis: no serial correlation at lag h lag lre* stat. df prob. rao f-stat df prob. 1 8.384069 4 0.0785 2.121108 (4, 268.0) 0.0785 2 2.085610 4 0.7200 0.521483 (4, 268.0) 0.7200 3 6.190617 4 0.1854 1.559780 (4, 268.0) 0.1854 null hypothesis: no serial correlation at lags 1 to h lag lre* stat df prob. rao f-stat df prob. 1 8.384069 4 0.0785 2.121108 (4, 268.0) 0.0785 2 11.01181 8 0.2010 1.389466 (8, 264.0) 0.2011 3 18.79495 12 0.0936 1.592500 (12, 260.0) 0.0937 *edgeworth expansion corrected likelihood ratio statistic table 10: serial correlation test (endogenous variables at lag 2) null hypothesis: no serial correlation at lag h lag lre* stat. df prob. rao f-stat df prob. 1 1.238463 4 0.8717 0.309166 (4, 262.0) 0.8717 2 4.899923 4 0.2977 1.231762 (4, 262.0) 0.2977 3 10.20009 4 0.0372 2.590230 (4, 262.0) 0.0372 null hypothesis: no serial correlation at lags 1 to h lag lre* stat. df prob. rao f-stat df prob. 1 1.238463 4 0.8717 0.309166 (4, 262.0) 0.8717 2 7.652146 8 0.4682 0.959521 (8, 258.0) 0.4682 3 13.78147 12 0.3149 1.156788 (12, 254.0) 0.3150 *edgeworth expansion corrected likelihood ratio statistic table 8: heteroscedasticity test (includes cross terms) joint test chi-square df prob. 138.2060 81 0.0001 individual components dependent r-squared f(27,113) prob. chi-square (27) prob. res1*res1 0.299650 1.790661 0.0184 42.25061 0.0311 res2*res2 0.418221 3.008583 0.0000 58.96912 0.0004 res2*res1 0.268455 1.535838 0.0626 37.85217 0.0802 figure 6: stability test inverse roots of ar characteristic polynomial . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(3), 205-212. international journal of economics and financial issues | vol 9 • issue 3 • 2019 205 analyzing the enablers for turkish defence industry supply chains: an interpretive structural modelling approach özgür tırpan* gebze technical university, 41400 gebze, kocaeli, turkey. email: otirpan@gtu.edu.tr received: 10 january 2019 accepted: 28 april 2019 doi: https://doi.org/10.32479/ijefi.8085 abstract defense industry is one of the most important contributors to a country’s power in economic and political domain. in this sector, there is always the need for continuous innovation and modernization parallel to the technological developments. in this context, aim is to improve the supply chain management for defense sector with the efforts of providing for it nationally through the life cycle management approach. the purpose of this study is to determine the conceptual enabling factors, the barriers and the targeted dynamics within the supply chain in the context of the turkish defense industry and to create a model that may be useful for it. first, the detailed review of the relevant writings on the concepts affecting the defense industry and supply chain relationship performed. then, the academic and industrial opinions about the bilateral interaction of these concepts have been obtained and analyzed with the help of interpretive structural modeling (ism) method, which chosen as the proper decision making methodology for this work. thus, a general model for the turkish defense industry supply chain is established. in addition, the academic and the industrial views related to these enablers provided to the users separately and comparatively. keywords: defense industry supply chain, defense industry, supply chain management, interpretive structural modelling, decision making jel classifications: h56, l10, m10 1. introduction because of being located in the world’s one of the most instable region, turkey needs a developed defense industry. beside showing a great improvement as a result of effective defense policies, turkish defense industry is still not remain as a one of the top level countries. in this direction it is seen that there is a need for industry depth and supply chain management in order to increase domestic defense procurements and exportation (graham and hardaker, 1998; jackson, 2004). establishing a specialized supply chain which has the ability of sub system design development and creating brand is very important to decrease foreign-source dependence to admissible levels. purpose of this work is to determine conceptual enablers and barriers to supply chain targeted to establish within turkish defense industry dynamics, with literature research and expert opinions in order to give some idea to turkish defense industry firm managers about the concepts that they have to take care of. another purpose is to analyze these determined enablers’ mutual interactions on the basis of academic and sectoral expert opinions with interpretive structural modelling (ism). thus, an ism based model will be revealed related to the turkish defense industry supply chain and by means of this model, interaction levels of determined enablers will be specified. in addition, academic and sectoral opinions will be compared additionally for the interaction of these enablers. 2. literature review high importance of research and development (r&d) ability because of defense industry’s long product life cycles than other sectors and changing customer requirements in this period is indicated by jakson (jackson, 2004). graham and hardaker this journal is licensed under a creative commons attribution 4.0 international license tırpan: analyzing the enablers for turkish defence industry supply chains: an interpretive structural modelling approach international journal of economics and financial issues | vol 9 • issue 3 • 2019206 stated that firms that having technology development strategies rather than chasing economic advantages will cooperate with their customers more closely and be more competitive in terms of problem solving, cost reduction and quality assurance (graham and hardaker, 1998). instead of just buying and selling action, long-term relations based on information sharing have to establish as gates stated (gates, 2004). likewise also dowdall indicated the necessity to increase information sharing levels of technology sub-contractors and close “knowledge gaps” when a base-spread supply chain is considered (dowdall, 2004). ignoring this interaction means having a limited information sharing will reveal many actions that not creating any value inside supply chain and as a natural result decrease in economic sustainability and competitiveness will rise in front of us. according to works of sinkovics et al. (2011), it is seen in literature that information technology usage is mostly effect flexibility and trust concepts in supply chains. however, it should not be forgotten that using a new information technology will only provide a temporary competitiveness as fawcett et al. stated. here the important thing is to maintain this enabler as an approach (fawcett et al., 2011). another important enabler for defense supply chains is economic sustainability. hoffmann et al., indicated that environmental, social and ethical risks may damage financial structure also economic sustainability in supply chains (hofmann et al., 2014). in addition, elrod et al., referred to have a flexible supply understanding for especially duplicate production firms in defense industry supply chains, in order to present quality products while not decreasing profitability means to stay competitive (elrod et al., 2013). as middleton et al. stated, to achieve staying competitive by increasing genuine product development ability, if and only think is to have an adequate design and test infrastructure (middleton et al., 2006). planned infrastructure should be absolutely in international level and accredited and meet also commercial and international demands. in additionally graham and hardaker indicated that developing trust based relationships would avail much more than establishing value based relationships through long term contracts in supply chains (graham and hardaker, 1998). also trust will be the sole concept for clarity and information sharing as dowdall stated (dowdall, 2004). beside all these johnsen et al. indicated the importance of planning, acting and controlling with program management understanding while considering the big picture within huge defense projects (johnsen et al., 2009). additionally defense firms of the future should have innovative approaches following commercial technology developments closely and plan to develop solution range always. in this direction, it is seen in last years that innovative competitiveness culture has been growing on knowledge developing and speed as hult et al. stated (hult et al., 2013). especially mavengere indicated the need of high level qualified human resource through defense supply chains that are using and developing high technology products (mavengere, 2013). at least one remarkable thing is the collaboration of defense industry cluster firms, universities and research centers. also as quetlas and grau indicated, it would be provided to benefit from not only the universities’ and research centers’ fund of knowledge also take advantage of test and experiment opportunity (quetglás, ethics, and 2002 n.d.). thus a safe development environmental will be ensured as spin-off of the commercial products that would be developed previously for defense industry as bellais and guichard (2006) indicated. as the result of literature research main enablers of turkish defense industry supply chain and related example references are given in table 1. 3. analyzing turkish defense industry supply chain enablers mostly used multi criteria consideration methods used in academic researches about turkish deference industry are goal programming (gp), analytic hierarchical process (ahp) and analytic network process (anp) (ersöz and kabak, n.d.). however, except from these methods, in order to collect multi-dimensional academic and sectoral opinions without using any quantitative data for the research model, interpretive structural model (ism) method is preferred. 3.1. interpretive structural modelling interpretive structural model (ism) founded by john n. warfield, is a method that is using to describe and explain the factors and interfacing relations appertaining to a problem by power factors (aykın et al., 2014). first of the five stages of the method is identifying the concepts related to the problem. after initial conceptual enablers are identified by the expert opinions a table 1: enablers of turkish defense industry supply chain and related references defense industry supply chain related elements references e1 r&d ability gates, 2004; graham and hardaker, 1998; jackson, 2004. e2 information sharing datta and christopher, 2011; dowdall, 2004; gates, 2004 e3 information technology usage fawcett et al., 2011; mavengere, 2013; sinkovics et al., 2011 e4 economic sustainability gates, 2004; hofmann et al., 2014; wahl and bull, 2014 e5 flexibility dowdall, 2004; elrod et al., 2004; graham and hardaker, 1998 e6 infrastructure elrod et al., 2014; middleton et al., 2006 e7 trust dowdall, 2004; graham and hardaker, 1998; johnsen et al., 2009 e8 program management understanding dowdall, 2004; gates, 2004; johnsen et al., 2009 e9 competitiveness elrod et al., 2014; hult et al., 2007 e10 qualified human resource gates, 2004; graham and hardaker, 1998; mavengere, 2013 e11 university and research center collaboration bellais and guichard 2006; quetglás and grau, 2002 tırpan: analyzing the enablers for turkish defence industry supply chains: an interpretive structural modelling approach international journal of economics and financial issues | vol 9 • issue 3 • 2019 207 structural self-interaction matrix (ssim) is developed based upon the contextual supporting relations as the second stage. in the third stage, all enablers which relation structures are defined are arrayed in a holistic frame according to the driving and dependence powers to form a reachability matrix. after the necessary transitivity check in reachability matrix, power – dependence graph (micmac) is created related to the driving power and dependence of the enablers as the fourth stage. in this graph, enablers are divided in to 4 group as autonomous, dependent, linkage and in depended. at the final fifth stage interpretive structural model (ism) based model is revealed as arraying enablers related to each other in the same level, ones dependent to others to the lower level and ones driving others to the upper level. therefore, specific relations of the concepts and holistic structure drawn hierarchically. 3.2. data collection method after enablers of turkish defense industry supply chain have identified, dual relationship of these enablers is collected by an online survey based questionnaire. one choose among given options as indicated in next section is requested for every two of enablers by relevant 7 academician and 7 persons having sectoral experience. therefore, total of 57 questions for 11 enablers are answered. 3.3. data collection and structural self-interaction matrix after identifying and enlisting the 11 enablers through literature review and expert opinion, the next step is to analyze these enablers. for this purpose, a contextual relationship of “reaches to” type is chosen. this means that one enabler reaches to another chosen enabler. based on this principle, a contextual relationship is developed. some experts, both from industry and academia, have surveyed in developing the contextual relationship among the enablers. keeping in mind the contextual relationship for each enabler, the existence of a relation between any two enablers (i and j) and the associated direction of this relation has been decided. the following four symbols have been used to denote the direction of the relationship between two enablers (i and j): • v is used for the relation from enabler i to enabler j (i.e. if enabler i influences or reaches to enabler j). • a is used for the relation from enabler j to enabler i (i.e. if enabler j reaches to enabler i). • x is used for both direction relations (i.e. if enablers i and j reach to each other). • 0 is used for no relation between two enablers (i.e. if enablers i and j are unrelated) (table 2). 3.4. reachability matrix the next step is to develop the reachability matrix from structural self-interaction matrix (ssim). this is obtained in two sub-steps. in the first sub-step, the ssim format is converted into the initial reachability matrix format by transforming the information of each cell of ssim into binary digits (i.e. ones or zeros) in the initial reachability matrix. this transformation has done with the following rules: 1. if the cell (i, j) is assigned with symbol v in the ssim, then, this cell (i, j) entry becomes 1 and the cell (j, i) entry becomes 0 in the initial reachability matrix. 2. if the cell (i, j) is assigned with symbol a in the ssim, then, this cell (i, j) entry becomes 0 and the cell (j, i) entry becomes 1 in the initial reachability matrix. 3. if the cell (i, j) is assigned with symbol x in the ssim, then, this cell (i, j) entry becomes 1 and the cell (j, i) entry also becomes 1 in the initial reachability matrix. 4. if the cell (i, j) is assigned with symbol o in the ssim, then, this cell (i, j) entry becomes 0 and the cell (j, i) entry also becomes 0 in the initial reachability matrix. as a result, raw reachability matrix, which indicates the driving and dependence power of each enabler on others, is obtained as table 3 below. in the second sub-step, final reachability matrix is prepared. for this purpose, the concept of transitivity is introduced so that some of the cells of the initial reachability matrix are filled by inference. the final reachability matrix will then consist of some entries from the pairwise comparisons and some inferred entries. the transitivity concept, which states that if a variable “a” is related to “b” and “b” is related to “c”, then “a” is necessarily related to “c,” is used to fill the gap, if any, in the opinions collected during the development of ssim. after incorporating the transitivity concept as described above, the final refined reachability matrix is obtained and is presented in table 4. 3.5. leveling partitions the reachability and antecedent set for each variable are obtained from final reachability matrix. the reachability set for a particular table 2: structural self-interaction matrix e1 e2 e3 e4 e5 e6 e7 e8 e9 e10 e11 e1 r&d ability e2 information sharing a e3 information technology usage a a e4 economic sustainability x x v e5 flexibility a x x a e6 infrastructure a x a x x e7 trust 0 a x x x 0 e8 program management understanding a x x a a 0 x e9 competitiveness v x v a v x x v e10 qualified human resource a x a a x x a a a e11 university and research center collaboration x x x x x 0 v x x x tırpan: analyzing the enablers for turkish defence industry supply chains: an interpretive structural modelling approach international journal of economics and financial issues | vol 9 • issue 3 • 2019208 variable consists of the variable itself and the other variables, which it may help to achieve. the antecedent set consists of the variable itself and the other variables, which may help in achieving them. subsequently, the intersection of these sets is derived for all variables. the variable for which the reachability and the intersection sets are the same, is assigned as the top-level variable in the ism hierarchy as it would not help to achieve any other variable above their own level. after the identification of the top-level element, it is discarded from the list of remaining variables. from table 5, it is seen that the green economic sustainability and university and research center collaboration are found at level i. thus, it would be positioned at the top of the ism hierarchy. this iteration is repeated until the levels of each variable are found out. the identified levels aids in building the digraph and the final model of ism. fallowing six iterations are also given in table 6. 3.6. building the ism based structure for complex problems such as the one under consideration, a number of enablers may be affecting the turkish defense industry supply chain. however, the direct and indirect relationships between the enablers describe the situation far more accurately than any individual factor taken in isolation. ism is an appropriate methodology in such circumstances because on the basis of relationship between the variables, an overall structure can be extracted for the system under consideration. the ism process transforms unclear, poorly articulated mental models of systems into a visible, well-defined overall structure portrayed by a graphical model. from the final reachability matrix (table 4), the structural model is generated by means of vertices or nodes and lines of edges. this can be depicted in a graph called a directed graph or digraph. after accounting for the transitivities as described in the ism table 4: refined reachability matrix e1 e2 e3 e4 e5 e6 e7 e8 e9 e10 e11 dep. p e1 r&d ability 1 1 1 1 1 1 1 1 0 1 1 10 e2 information sharing 0 1 1 1 1 1 1 1 1 1 1 10 e3 information technology usage 0 0 1 0 1 1 1 1 0 1 1 7 e4 economic sustainability 1 1 1 1 1 1 1 1 1 1 1 11 e5 flexibility 0 1 1 0 1 1 1 1 0 1 1 8 e6 infrastructure 0 1 0 1 1 1 1 1 1 1 1 9 e7 trust 1 0 1 1 1 1 1 1 1 1 0 9 e8 program management understanding 0 1 1 0 0 1 1 1 0 1 1 7 e9 competitiveness 1 1 1 0 1 1 1 1 1 1 1 10 e10 qualified human resource 0 1 0 0 1 1 0 0 0 1 1 5 e11 university and research center collaboration 1 1 1 1 1 1 1 1 1 1 1 11 drv. p 5 9 9 6 10 11 10 10 6 11 10 table 5: first iteration for leveling partitions iteration 1 enablers reachability set antecedent set intersection set level e1 r&d ability 1,4,7,9,11 1,2,3,4,5,6,7,8,10,11 1,4,7,11 e2 information sharing 1,2,4,5,6,8,9,10,11 2,3,4,5,6,7,8,9,10,11 2,4,5,6,8,9,10,11 e3 information technology usage 1,2,3,4,5,7,8,9,11 3,5,6,7,8,10,11 3,5,7,8,11 e4 economic sustainability 1,2,4,6,7,11 1,2,3,4,5,6,7,8,9,10,11 1,2,4,6,7,11 1 e5 flexibility 1,2,3,4,5,6,7,9,10,11 2,3,5,6,7,8,10,11 2,3,5,6,7,10,11 e6 infrastructure 1,2,3,4,5,6,7,8,9,10,11 2,4,5,6,7,8,9,10,11 2,4,5,6,7,8,9,10,11 e7 trust 2,3,4,5,7,8,9,11 3,4,5,7,8,9,10 3,4,5,7,8,9 e8 program management understanding 1,2,3,4,5,7,8,9,11 2,3,7,8,10,11 2,3,7,8,11 e9 competitiveness 2,4,6,7,9,11 1,2,3,5,6,7,8,9,10,11 2,6,7,9,11 e10 qualified human resource 1,2,3,4,5,6,7,8,9,10,11 2,5,6,10,11 2,5,6,10,11 e11 university and research center collaboration 1,2,3,4,5,8,9,10,11 1,2,3,4,5,7,8,9,10,11 1,2,3,4,5,8,9,10,11 1 table 3: raw reachability matrix e1 e2 e3 e4 e5 e6 e7 e8 e9 e10 e11 dep. p e1 r&d ability 1 1 1 1 1 1 0 1 0 1 1 9 e2 information sharing 0 1 1 1 1 1 1 1 1 1 1 10 e3 information technology usage 0 0 1 0 1 1 1 1 0 1 1 7 e4 economic sustainability 1 1 1 1 1 1 1 1 1 1 1 11 e5 flexibility 0 1 1 0 1 1 1 1 0 1 1 8 e6 infrastructure 0 1 0 1 1 1 0 0 1 1 0 6 e7 trust 0 0 1 1 1 0 1 1 1 1 0 7 e8 program management understanding 0 1 1 0 0 0 1 1 0 1 1 6 e9 competitiveness 1 1 1 0 1 1 1 1 1 1 1 10 e10 qualified human resource 0 1 0 0 1 1 0 0 0 1 1 5 e11 university and research center collaboration 1 1 1 1 1 0 1 1 1 1 1 10 drv. p 4 9 9 6 10 8 8 9 6 11 9 tırpan: analyzing the enablers for turkish defence industry supply chains: an interpretive structural modelling approach international journal of economics and financial issues | vol 9 • issue 3 • 2019 209 methodology, the digraph is finally converted into the ism model as shown in figure 1. 3.7. mic-mac analysis the objective of mic–mac analysis is to analyze the driver power and the dependence of the variables. the variables are classified into four clusters (figure 2). the first cluster consists of the “autonomous enablers” that have weak driver power and weak dependence. these enablers are relatively disconnected from the system, with which they have only few links, although these may be strong. the second cluster consists of the “dependent enablers” that have weak driver power but strong dependence. the third cluster contains the “linkage enablers” that have strong driving power and also strong dependence. these barriers are unstable in the sense that any action on these barriers will have an effect on others and also a feedback on themselves. the fourth cluster includes the “independent enablers” having strong driving power but weak dependence. it is observed that a variable with a very strong driving power (called a key variable) falls into either the “independent” or “linkage” categories. the driving power and the dependence of each of these enablers are shown in table 4. in this table, an entry of “1” along the columns and rows indicates the dependence and driving power, respectively. when we examine micmac analyze, information technology usage (e3), program management understanding (e8) and qualified human resource (e10) enablers seem the independent variables of the model. in addition, dependent variables appear figure 1: interpretive structural modeling based model for the enablers of turkish defense industry supply chains table 6: next iterations for leveling partitions enablers reachability set antecedent set intersection set level iteration 2 e1 r&d abilit 1,7,9 1,2,3,5,6,7,8,10 1,7 e2 information sharing 1,2,5,6,8,9,10 2,3,5,6,7,8,9,10 2,5,6,8,9,10 e3 information technology usage 1,2,3,5,7,8,9 3,5,6,7,8,10 3,5,7,8 e5 flexibility 1,2,3,5,6,7,9,10 2,3,5,6,7,8,10 2,3,5,6,7,10 e6 infrastructure 1,2,3,5,6,7,8,9,10 2,5,6,7,8,9,10 2,5,6,7,8,9,10 e7 trust 2,3,5,7,8,9 3,5,7,8,9,10 3,5,7,8,9 e8 program management understanding 1,2,3,5,7,8,9 2,3,7,8,10 2,3,7,8 e9 competitiveness 2,6,7,9 1,2,3,5,6,7,8,9,10 2,6,7,9 2 e10 qualified human resource 1,2,3,5,6,7,8,9,10 2,5,6,10 2,5,6,10 iteration 3 e1 r&d ability 1,7 1,2,3,5,6,7,8,10 1,7 3 e2 information sharing 1,2,5,6,8,10 2,3,5,6,7,8,10 2,5,6,8,10 e3 information technology usage 1,2,3,5,7,8 3,5,6,7,8,10 3,5,7,8 e5 flexibility 1,2,3,5,6,7,10 2,3,5,6,7,8,10 2,3,5,6,7,10 e6 infrastructure 1,2,3,5,6,7,8,10 2,5,6,7,8,10 2,5,6,7,8,10 e7 trust 2,3,5,7,8 3 5 7 8 10 3 5 7 8 e8 program management understanding 1,2,3,5,7,8 2,3,7,8,10 2,3,7,8 e10 qualified human resource 1,2,3,5,6,7,8,10 2,5,6,10 2,5,6,10 iteration 4 e2 information sharing 2,5,6,8,10 2,3,5,6,7,8,10 2,5,6,8,10 4 e3 information technology usage 2,3,5,7,8 3,5,6,7,8,10 3,5,7,8 e5 flexibility 2,3,5,6,7,10 2,3,5,6,7,8,10 2,3,5,6,7,10 4 e6 infrastructure 2,3,5,6,7,8,10 2,5,6,7,8,10 2,5,6,7,8,10 e7 trust 2,3,5,7,8 3,5,7,8,10 3,5,7,8 e8 program management understanding 2,3,5,7,8 2,3,7,8,10 2,3,7,8 e10 qualified human resource 2,3,5,6,7,8,10 2,5,6,10 2,5,6,10 iteration 5 e3 information technology usage 3,7,8 3,6,7,8,10 3,7,8 5 e6 infrastructure 3,6,7,8,10 6,7,8,10 6,7,8,10 e7 trust 3,7,8 3,7,8,10 3,7,8 5 e8 program management understanding 3,7,8 3,7,8,10 3,7,8 5 e10 qualified human resource 3,6,7,8,10 6,10 6,10 iteration 6 e6 infrastructure 6,10 6,10 6,10 6 e10 qualified human resource 6,10 6,10 6,10 6 tırpan: analyzing the enablers for turkish defence industry supply chains: an interpretive structural modelling approach international journal of economics and financial issues | vol 9 • issue 3 • 2019210 as r&d ability (e1), economic sustainability (e4) and competitiveness (e9). in micmac analyzes, linkage enablers represent intermediate variables. in this point, we may assume nearby nodes to the path along the dependent variables to the independent variables as mediator variables for their closer driver and dependence powers. also relatively distant nodes to the path along the dependent variables to the independent variables may be assumed as moderator variables because of their relatively high driver and dependence powers. therefore, information sharing (e2), trust (e7) and flexibility (e5) enablers may be accepted as mediator variables while infrastructure (e6) and university and research center collaboration (e11) enablers are moderator variables. 4. discussion 4.1. analysis and literature relation in the micmac analysis in figure 2, first we see that there is no autonomous enabler in our chart. this means that all the selected concepts are acutely related to the turkish defense industry supply chain and all of them should have taken in consideration. in our model, it is show up that r&d ability, economic sustainability and competitiveness concepts are the targeted abilities for turkish defense industry supply chain. although r&d ability is stated as an important primer enabler for especially economic sustainability and competitiveness of defense industry firms (gates, 2004; graham and hardaker, 1998; jackson, 2004); r&d ability (e1) is qualified much more like a goal for our collected perspective. infrastructure and university and research center collaboration are seem to be important effective factors for turkish defense industry supply chain as parallel to the literature (middleton et al., 2006). while infrastructure has the highest driving power and university and research center collaboration seems to have superlative dependence power, both of them are the moderator variables for ism model. especially the dependent character of university and research center collaboration among other turkish defense industry supply chain enablers should be verified and the reason of this should be further searched. also information sharing, trust and flexibility are indicated as intermediate variables for turkish defense industry supply chain confirming related literature (elrod et al., 2013; gates, 2004; hult et al., 2013). one of the most important implication of ism model and the micmac analysis is to determine the basic concepts of the targeted turkish defense industry supply chain. according to our ism work, information technology usage (quetglás, ethics, and 2002 n.d.), program management understanding (gates, 2004) and qualified human resource (graham and hardaker, 1998) are stated as main concepts as parallel to the literature. turkish defense industry must consider gathering more qualified employees aimed at defense technologies with relevant trainings, workshops, etc. in addition, favorable information technologies and program management approach must be used in order to handle comprehensive interrelated defense projects expeditiously. accordingly, turkish government may enhance defense industry regulations and subsidies to have an outstanding defense industry supply chain. 4.2. comparison of academic and industrial views according to academic point of view micmac analysis given in figure 3, infrastructure (e6), trust (e7), program management understanding (e8), qualified human resource (e10), university, and research collaboration (e11) accepted as key concepts to reach r&d ability (e1), information sharing (e2) and economic sustainability (e4) in turkish defense industry supply chain. in addition, information technology usage (e3) and competitiveness (e9) have relatively low interaction among other supply chain concepts while flexibility (e5) accepted as a sole intermediate variable. on the other hand, according to industrial point of view micmac analysis given in figure 4, infrastructure (e6) and program management understanding (e8) accepted as key concepts to reach r&d ability (e1), information technology usage (e3) and economic sustainability (e4) in turkish defense industry supply chain. also flexibility (e5) and qualified human resource (e10) have relatively low interaction among other supply chain concepts while remaining concepts are accepted intermediate variables. figure 2: micmac analysis chart figure 3: academic view mic-mac analysis chart figure 4: industrial view mic-mac analysis chart tırpan: analyzing the enablers for turkish defence industry supply chains: an interpretive structural modelling approach international journal of economics and financial issues | vol 9 • issue 3 • 2019 211 when we evaluate academic and industrial point of views separately for designated 11 concepts related with turkish defense industry supply chain, some different perspectives about some concepts seen. for example while academic point of view states that information sharing and flexibility have strong relation, industrial view sees no relation among these concepts. in addition, academics see no relation between information sharing and qualified human resource while industry indicate a strong link between these concepts. however, the main difference of opinion about turkish defense industry supply chain concepts is on flexibility and competitiveness. from the academic perspective, flexibility stated as a cardinal concept to adapt changing customer requests to stay competitive. besides, industry sees competitiveness as a basis aspect rather than flexibility for a reliable robust supply chain. consequently, main results from this comparison for turkish defense industry are those; • industry is hesitant to trust and university and research collaboration • academics don’t see competitiveness as a superior concept • academics believe that information technology usage is not relatively indispensable • industry don’t think that they can gain much from flexibility • industry do not believe the power of qualified human resource much. 5. conclusion one of the major objectives of this study is to identify and rank the supply chain enablers in turkey defense industry, to establish interrelations among these identified enablers using ism and discuss the managerial implications for improving the turkish defense industry supply chain. after analyzing collected responses of relevant academic and sectoral point of views on 11 enablers determined utilizing the existing researches already carried out, following fundamental implications are obtained; • all of the selected concepts are acutely related to the turkish defense industry supply chain and all of them should have taken in consideration. • dependent variables of the model are as r&d ability, economic sustainability and competitiveness. therefore, these enablers are targeted abilities of turkish defense industry supply chain. • information technology usage, program management understanding and qualified human resource are the independent variables of the model, which industry professionals have to interest primarily. • defense industry, contrary to academics, is still hesitant to trust, university, and research collaboration along supply chain. beyond any doubt, sharing these findings with industry and ensuring inputs for strategic plans will gain important favors to turkish defense industry and in consequence of county economy and security. 6. limitations and scope for future work in this paper, only 11 variables identified for modelling the enablers to turkish defense industry supply chains. further, the model developed from the perspective of academic and industrial experts. in future research, more studies that are extensive needed to explore the variables affecting turkish defense industry supply chains of large scale. the help of experts has sought to analyze the driving power and dependence of the variables, but the framework developed depends upon the opinion of relatively few stakeholders and may have some element of bias. through ism, a relationship model of the variables of turkish defense industry supply chains is developed but this model should validated. path analysis or structural equation modelling approaches have the capability of testing the validity of such a hypothetical model. sem based software could be used to further examine the relationships derived from this model. in the ism model presented in this paper, one of the most important barriers relates to the lack of metrics to quantify the infrastructure and qualified human resource in a supply chain. however, literature has identified several measures but further research is still required to identify and develop a metric to quantify infrastructure and qualified human resource from a perspective of an integrated supply chain. references aykın, s.m., saatçioğlu, o.y., özmen, o.n.t. 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(2011), does it ıntegration really enhance supplier responsiveness in global supply chains? management international review, 51(2), 193-212. international journal of economics and financial issues vol. 2, no. 1, 2012, pp.54-70 issn: 2146-4138 www.econjournals.com productivity growth in some energy intensive manufacturing industries in india: an analytical assessment sarbapriya ray department of commerce, shyampur siddheswari mahavidyalaya, university of calcutta, west bengal, india. email: sarbapriyaray@yahoo.com abstract: this paper estimates productivity performance of india’s energy intensive industries in terms of total factor productivity growth for the entire period, 1979-80 to 2003-04. the productivity performance has been judged in view of translog indices under three input framework-material, labour and capital and a model has been evolved for assessing energy intensity in those industries. the result on the overall productivity shows declining total factor productivity growth during post-reform period as compared to pre-reform period. total output growth in india’s energy intensive an industry is found to be mainly input-driven rather than productivity-driven. the liberalization process is found to have its adverse impact on total factor productivity growth. keywords: energy; intensity; productivity; liberalization jel classification: l65 1. introduction with the introduction of economic reforms in 1991, indian industries have been viewing intense changes in the basic parameters governing its structure and functioning. liberalization implies an increase in market force in the economy. relaxing of licensing rule, reduction in tariff rates, removal of restriction on import of raw materials and technology, price decontrol, rationalization of customs and excise duty, enhancement of the limit of foreign equity participation etc are among those which have been introduced at early 90’s. one major objective of trade liberalization in india has been to enhance industrial productivity and input-use efficiency. this has been made possible with the greater and cheaper access to imported know-how, capital goods, intermediate goods and global capital, relaxing constraints on various input use and technology choices, increased domestic and international competitive pressures by bringing in technological dynamism in industries and permitting more efficient firms to grow and competing out inefficient ones. with the introduction of economic policy reforms, indian industries have been undergoing structural reforms and facing hard competition from external markets. growth of a firm depends on the efficient and rational use of the scarce resources available to the firm. in other words, it is the level of productivity of the factors of production that determines the sustainability of the firm. it was recognized that output growth could not be enhanced by continuous input growth in the long run due to the nature of diminishing returns for input use. for sustained output growth, tfp growth is essential and therefore, tfp growth became synonymous with long-term growth as it reflects the potential for growth (mahadevan, 2004). although there exists voluminous empirical research work regarding nexus between trade liberalization and factor productivity growth, overviews on the link between liberalization and tfpg find inadequate evidence on this issue, it is as yet a controversial issue and debate is still unsettled. the controversy on the impact of liberalization on tfpg and diverse conclusions resulting from empirical investigations are probably due to differing interpretations of liberalization and openness. these varied empirical results initiate us to investigate further into the links between liberalization and productivity growth of indian industry. total factor productivity (tfp) is considered to be the superior indicator than labour productivity and multi-factor productivity in order to characterize industry-level productivity international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.54-70 55 performance. productivity is the key determinant of a nation’s standard of living and an industry’s competitiveness. as such, the ability to predict trends in tfp growth in the industry is very important. estimating productivity level and growth rate to evaluate the efficiency in use of resources in the industry gained a renewed interest both among growth economists and trade economists. theoretically, tfp is a relevant measure for technological change by measuring the real growth in production value, which cannot be explained by changes in the input of labour, capital and intermediate input. however in reality, due to lack of data, most of the works in tfp measurement are limited on the basis of two factor inputs, usually capital and labour. thus, the term “multifactor productivity”(mfp) is prominently used instead of tfp. the increasingly role of materials input on productivity force researchers to reconstruct their productivity measurement model to incorporate all factor inputs, labour, capital and intermediate inputs. therefore, in 1991, the indian economy underwent major economic reforms, after several decades of following an inward looking development strategy. the 1991 reforms were specifically targeted to the manufacturing sector as the sector offered significant prospects for capital accumulation, technical change and linkages and hence job creation, especially for the semi-skilled and poorly educated segment of the labour force, which comprises most of india’s working poor. how much have the economic reforms delivered for the manufacturing sector, compared to their initial expectations? this study tries to explore the answer of the above question in view of certain yardsticks. in this backdrop, this paper develops an analytical framework for measuring total factor productivity growth and tests empirically whether trade reforms improve productivity growth in some manufacturing industries in india-specifically energy intensive industries in india. in view of greater crisis of non renewable energy world wide as well as in india, we have selected some energy intensive manufacturing industries of india into our analytical consideration and evolves modeling framework for measuring energy intensity of those industries. previous findings for the contribution of total factor productivity growth to total output growth yielded contradictory result. many developing countries grew via factor accumulation instead of improved technological change via total factor productivity growth and therefore attempt has also been made to investigate into the fact whether output growth is input driven or productivity driven. an investigation of the issue on analytical front may insert to our knowledge of the issue and throw lights on the distinct set of results produced by the existing studies. the rest of the paper is organized as follows: section 2 presents backdrop behind selecting energy-intensive industries in india under consideration of our productivity study. section 3 depicts methodology for measuring tfpg and energy intensity and their data base. estimates of productivity growth and energy intensity are documented and presented in section 4. section 5 presents and analyses the impact of liberalization on total factor productivity growth and whether output growth is input driven or productivity driven is also presented in this section. section 6 presents concluding remarks. 2. backdrop behind selecting energy-intensive industries in india under consideration of our study india ranks sixth in the total energy consumption and needs to accelerate the development of the sector to meet its growth aspirations. the country, though rich in coal and abundantly endowed with renewable energy in the form of solar, wind, hydro and bio-energy has very small hydro-carbon reserves (0.4 % of the world’s reserve).india, like many other developing countries is a net importer of energy, more than 25percent of primary energy needs being met through imports mainly in form of crude oil and natural gas. the rising oil import bill has been the focus of serious concerns it has placed on scarce foreign exchange resources and also responsible for energy supply shortages. the suboptimal consumption of commercial energy adversely affects the productive sectors, which in turn affects economic growth. the use of energy from commercial sources (fossil fuels and electricity generation) in india has increased ten folds in sixty years since independence in 1947, and the total energy consumption from commercial sources was around 200 million tones of oil equivalent (mtoe) for the year 1998/99. the industrial sector consumes half of the total commercial energy available in india, 70% of which in energy intensive industries in india. an analysis of the share of commercial energy use by different productivity growth in some energy intensive manufacturing industries in india: an analytical assessment 56 sectors indicate that the industry is the most dominant sector, accounting for more than half of the total commercial energy use in the country (teri. 2000c). if the pattern of energy production is noticed, coal and oil accounts for 54 percent and 34 percent respectively with natural gas, hydro and nuclear contributing to the balance. in the power generation front, nearly 62 percent of power generation is from coal fired thermal power plants and 70 percent of coal produced every year in india has been used for thermal generation. on the consumption front, the industrial sector in india is a major energy user accounting for about 52 percent of commercial energy consumption. per capita energy consumption in india is one of the lowest in the world. but, energy intensity, which is energy consumption per unit of gdp, is one of the highest in comparison to other developed and developing countries. the increased energy intensity in indian industry is partly due to investments in basic and energy intensive industries due to emphasis laid in the past development plans on achieving self reliance. it is 3.7 times that of japan, 1.55 times that of united states, 1.47 times that of asia, and 1.5 times that of the world average. thus there is a huge scope for energy conservation in the country. in view of scarce energy resources in india, it is necessary to examine the import dependence of fuel supply. the data of fuel consumption, production within the country and the imports each year in detail is set out in table 1. table 1. consumption, production and imports of commercial fuels sl. item units 1980-81 1990-91 199596 200001 200506 1 coal/lignite consumption mtoe 58.5 108.2 140.7 169.1 181.9 2 coal imports mtoe 0.2 4.0 9.0 11.0 12 3 dependency of coal % 0.3 % 2.8 % 4.4 % 7.0 % 6.7 % 4 oil product consumption mt 31 68.2 77.3 98.6 99.2 5 oil imports as crude products mt 7 26.1 49.8 83.4 85.7 6 oil imports dependency % 23 38 64 85 86 7 consumption of natural gas (all domestic) mtoe 0.2 10 16 25 27 8 electricity consumption (all domestic) mtoe 5.0 6.0 8.0 8.0 9.0 9 total fuel imports as % of total consumption in toe terms. 8 16 24 24 31 source: compiled from several issues of coal bulletin, cmie, petroleum & natural gas statistics, and annual survey of industries. the above table shows that the import dependence has increased in the decade of the 1980s and 1990s and this is due to the increased imports of oil products. the increase in oil import dependency has generated a phenomenal growth from a low 23 per cent in 1980-81 to 86 per cent in 2005-06. from the above analysis, it is quite evident that india still is an importer of energy, particularly of oil. an increase in reliance on oil import, due to increase in demand will put severe pressure on foreign exchange reserves. moreover, energy costs enter into the cost structure of all productive sectors of economy as universal input. the quadrupling of oil prices and subsequent rise of coal and electricity cost during 90s and thereafter accompanied by gradual withdrawal of fuel subsidy by india government had a profound, permanent impact on the indian economy. the initial impact was an explosion in the prices of most of the goods and services. the large increase in the prices of energy during those periods permanently reduced economic capacity or the potential output of indian economy. the productivity of existing capital and labour resources was sharply reduced. in order to clarify the gain which may be expected from the simulative new economic policy introduced in 1991, it is useful to examine the relevance of productivity in those industries in measuring input-use efficiency of the entire industry where demand for energy input as an ingredient of production is much more in production process than any other international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.54-70 57 industries. against this backdrop, while evaluating productivity of individual industry, highest priority has been given on those industries where energy intensity is greater than any other industries. 3. methodology 3.1. description of data and measurement of variables the present study is based on industry-level time series data taken from several issues of annual survey of industries, national accounts statistics, cmie and economic survey, statistical abstracts (several issues), rbi bulletin on currency and finance, handbook of statistics on indian economy, whole sale price in india prepared by the index no of office of economic advisor, ministry of industry etc covering a period of 25 years commencing from 1979-80 to 2003-04. selection of time period is largely guided by availability of data.1 as far as the data relating to energy sectors are concerned , we made use of the data published by the centre for electricity authority (cea) for electricity, petroleum and natural gas statistics (several issues) published by the ministry of oil and natural gas for crude oil ,petroleum product and natural gas. while for the coal, we relied on the coal india dictionary besides different reports of central statistical organization (cso), new delhi, and centre for monitoring indian economy (cmie), annual survey of industries (asi) etc. coal input to different sectors was divided by coal prices to convert rupee value of coal input into physical units (tons). the petroleum demand by production activities in the system consists of furnace oil (fo), lshs (both heavy distillates),hsd and ldo(middle distillates).indian petroleum and natural gas statistics(1983-84,1989-90, 2003-04,2004-05) provided some idea about the usage pattern of refinery products for some production sectors. similarly, volume of electricity consumption was taken into consideration. energy consumed by different sectors in different forms and in different physical units is then converted into mtoe (million ton of oil equivalent) by applying some recent common conversion factors. million ton of oil equivalent (mtoe) is the method of assessing work of calorific value of different sources of energy in terms of one ton oil. the following table shows the conversion procedure of different energy units into mtoe. table 2. conversion factors for transforming different energy inputs into million ton of oil equivalent (mtoe) energy inputs present energy unit conversion factor (into mtoe) coal 1 million ton 0.67 million ton of oil equivalent electricity 12000 million kwh 0.86 million ton of oil equivalent petroleum 1 million ton petroleum 1 million ton of oil equivalent  one million =10 6 =10, 00,000  source: tata energy data dictionary and year book. it is assumed that due to non availability of detailed data about the average calorific content of various grades of coal, the same average calorific value of coal is used in converting coal tonnage into mtoe units. in order to avoid over estimation due to ignoring contribution of material input on tfp, a third variable of intermediate inputs (material including energy input) 2 has been incorporated in the value 1 till 1988 – 89, the classification of industries followed in asi was based on the national industrial classification 1970 (nic 1970). the switch to the nic-1987 from 1989-90 and also switch to nic1998 requires some matching. considering nic1987 as base and further nic 1998 as base, all energy intensive industries have been merged accordingly. for price correction of variable, wholesale price indices taken from official publication of cmie have been used to construct deflators. 2 earlier studies that have not treated material including energy as separate factor of production, has failed to pick-up significant economies that are likely to generate in the use of such input. jorgenson (1988) has observed that in a three input production framework, the contribution of intermediate inputs like material, energy etc. are significant sources of output growth. productivity growth in some energy intensive manufacturing industries in india: an analytical assessment 58 added function as such to obtain gross output. pradhan and barik (1999) argued that the gross output, instead of value added, appears to be the appropriate choice of tfpg estimation in india. generally, tfp growth estimates based on value added terms are over estimated since they ignore the contribution of intermediate inputs on productivity growth (sharma, 1999). therefore, modified gross value of output so calculated has been used as a measure of output suitably deflated by wholesale price index of manufactured. deflated cost of fuel (appendix-a-1) has been taken as measure of energy inputs. deflated gross fixed capital stock at 1981-82 prices is taken as the measure of capital input. the estimates are based on perpetual inventory method. (appendix-a-2) .following the same line as adopted in deflating energy input, the reported series on materials has been deflated to obtain material inputs at constant prices. total number of persons engaged in indian rubber sector is used as a measure of labor inputs as is reported in asi which includes production workers and non-production workers like administrative, technical and clerical staff (goldar and ranganathan, 1991). for recent issues, it is reported in asi under the head ‘persons engaged’, for earlier issues, it is reported as ‘number of employees’. this paper covers a period of 25 years from 1979 -80 to 2003-04. the entire period is subdivided into two phases as pre-reform period (1979 -80 to 1991-92) and post-reform period (1991-92 to 2003-04), sub-division of period being taken logically as such to assess conveniently the impact of liberalization on tfpg. 3.2. econometric specification for tfpg productivity is a marginal contribution of a factor to the output growth of a product. the productivity improvements along with the increase in quantities of factors will also be contributing an additional source of output increase (brahmananda, 1982). productivity increases when the growth in output is greater than the growth in input, or when the rate of growth of output minus the rate of growth of the composite input is positive. economic growth can be obtained either by increasing inputs or by improving productivity factor. productivity growth occurs when a higher output can be attained with a given amount of input, or a certain level of output can be attained with smaller amounts of factor input. this productivity growth is obviously preferable to growth due to increase in factor inputs, since the later might be subject to diminishing marginal return. productivity growth is necessary not only to increase output but also to enhance competitiveness of a country. the estimation of factor productivity will be very useful to evaluate the variations in the performance of an industry over a period of time. the prosperity of a new developed nation has been attributed mainly to the sustained growth of their total factor productivity (prescott, 1997). the partial factor productivity generally is calculated by dividing the total output by the quantity of an input. the main problem of using this measurement of productivity is that it ignores the fact that productivity of an input depends on level of other inputs used. the tfp approach overcomes this problem by taking into account the levels of all the inputs used in the production of output. therefore, in this paper, tfpg is estimated under three input framework applying tran slog3 index of tfp as below: lntfp(t) lnq(t) � � l ls (t) s (t 1) x lnl(t) 2       � k k m ms (t) s (t 1) s (t) s (t 1) x lnk(t) x lnm(t) 2 2               � � q denotes gross value added, l labour, k capital, m material including energy input. ln q(t) = ln q(t) – ln q(t – 1) ln l(t) = ln l(t) – ln l(t – 1) ln k(t) = ln k(t) – ln k(t – 1) 3 the tran slog index of tfp is a discrete approximation to the division index of technical change. it has the advantage that it does not make rigid assumption about elasticity of substitution between factors of production (as done by solow index). it allows for variable elasticity of substitution. another advantage of tran slog index is that it does not require technological progress to be hicksneutral. the tran slog provides an estimate of the shift of the production function if the technological change is non-neutral. international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.54-70 59 ln m(t) = ln m(t) – ln m(t – 1) sk, sl and sm being income share of capital, labor and material respectively and these factors add up to unity. tfp is the rate of technological change. 3.3. model for assessing energy intensity of the industries taken up for the present study the concept of industrial energy intensity denotes the amount of energy required to produce one unit of output. two basic approaches are in use to express industrial energy intensity − per unit of physical product and per unit of economic output. when output is measured in physical units, an estimate of physical energy intensity is obtained (e.g., pj/tonne). economic energy intensity, on the other hand, is calculated using monetary value of output measures (e.g., pj/rs.billion). energy intensity can be measured following various alternative methodologies. a review of literature suggests that there are various alternative measures of energy intensity. 1. energy -output ratio 2. energy-value added ratio 3. energycapital ratio. the practical use of energy-capital ratio as a measure of energy intensity gives rise to certain problems which arises from the problems related to the measurement of capital itself in the production process. misunderstanding around the use of energy-value added ratio comes from the theoretical contradiction between the very concept of value added approach and the definition of energy input. while former is defined as the total value added by the capital and labour excluding the contribution of other intermediate products, the latter ‘energy input’is an intermediate good in itself. from their empirical findings, berndt and wood (1975) call in question the reliability of factor demand studies based on value added specification as they invalidate the conventional value added specification of technology. in this section, an attempt has been made to study the energy intensities of different sectors at an aggregate level which represents a set of measurable coefficients of the energy requirement for the formation of a unit of produced goods or services. energy intensity is a prerequisite numerical exercise for the discussion on structural change in energy demand evaluation of a particular industry or area. our energy intensity analysis covers the period from 1996-97 to 2004-05 which will definitely provide an insight into the both short-term as well as long term responses. iron and steel, cement, aluminum, fertilizers, paper and pulp, chemical, glass are some of the energy intensive industries in india. this section focuses on these seven industries regarding energy consumption vis-à-vis energy intensity. in our study, energy intensity is defined as energy consumption in physical units of ‘j’th industry per crore rupees of value added in that industry. ej k t = energy consumed in physical units in time‘t’ by sector ‘j’ for energy type ‘k’. pjt = ‘j’th industry’s value added. energy intensity (of energy type ‘k’) of ‘j’th industry is given by e j k t = e j k t / p j t [ energy intensity for non-energy sector = ‘000 mtoe /crore rs. where ‘mtoe / rs’ is the mtoe(million ton of oil equivalent) required to produce one unit of output measured in value term , this coefficient is the measure of direct energy intensity]. alternatively, we also make use of energy-output ratio in estimating energy intensity for seven indian manufacturing industries-cement, glass, paper and paper products, fertilizer, aluminium, iron and steel and chemicalunder consideration of our study. therefore, the present study also examines energy-output ratio towards evaluation of energy intensity for individual manufacturing industry. 4. empirical estimation 4.1. results showing energy intensity the following two tables (3 & 4 below) depict the result of coal, electricity and petroleum intensity as well as total intensity of seven indian manufacturing industries under our consideration over a period of 1996-97 to 2004-05. productivity growth in some energy intensive manufacturing industries in india: an analytical assessment 60 table 3. energy intensity in energy intensive industries in india (‘000 mtoe/rs crores) industry/ years energy intensity 1996-‘97 1997-‘98 1998‘99 1999‘00 2000‘01 2001‘02 2002‘03 2003‘04 2004-‘05 average of entire time periods coal intensity (‘000 mtoe/rs crores) 3.5637 2.5509 3.2219 2.6714 2.3289 2.7919 2.9882 3.521 3.8703 3.0565 electricity intensity (‘000 mtoe/rs crores) 0.1803 0.1539 0.1626 0.1362 0.1101 0.1240 0.1356 0.1406 0.1303 0.1415 petroleum intensity (‘000 mtoe/rs crores) 0.1811 0.1865 0.4044 0.6142 0.5416 0.6211 0.7289 0.6562 0.7293 0.5181 cement total intensity(‘000 mtoe/rs crores) 3.9250 2.8914 3.7888 3.4217 2.9806 3.5369 3.8525 4.3178 4.7299 3.7161 coal intensity(‘000 mtoe/rs crores) 0.84041 0.35892 0.8974 0.89047 0.8612 0.62374 0.68935 0.84107 0.85108 0.7615 electricity intensity (‘000 mtoe/rs crores) 0.01400 0.08226 0.1070 0.10574 0.0955 0.11442 0.13950 0.14257 0.17148 0.1081 petroleum intensity (‘000 mtoe/rs crores) 0.00726 0.34373 0.1916 0.18174 0.2446 0.19494 0.17552 0.25826 0.38749 1.0901 iron& steel total intensity (‘000 mtoe/rs crores) 0.8616 0.7849 1.1961 1.1779 1.2013 0.9331 1.0044 1.2419 1.410 1.090 coal intensity (‘000 mtoe/rs crores) 0.1522 0.1377 0.154 0.1706 0.1139 0.1416 0.0529 0.0677 0.1005 0.1212 electricity intensity (‘000 mtoe/rs crores) 0.3915 0.1837 0.2124 0.1434 0.1408 0.167 0.1852 0.1335 0.2355 0.1992 petroleum intensity (‘000 mtoe/rs crores) 0.26413 0.16768 0.0860 0.05539 0.0960 0.12873 0.1298 0.16158 0.16861 0.1398 aluminium total intensity (‘000 mtoe/rs crores) 0.80783 0.48908 0.4525 0.36939 0.3507 0.43733 0.3679 0.36278 0.50461 0.4602 coal intensity (‘000 mtoe/rs crores) 1.20129 0.89006 0.9872 0.99980 1.0720 1.15195 1.22390 1.46147 1.09060 1.1198 electricity intensity (‘000 mtoe/rs crores) 0.09592 0.08575 0.0853 0.07214 0.0687 0.06435 0.07315 0.07251 0.07499 0.0769 petroleum intensity (‘000 mtoe/rs crores) 0.10640 0.26588 0.2504 0.31710 0.3818 0.34705 0.40085 0.4559 0.43943 0.3294 paper total intensity (‘000 mtoe/rs crores) 1.4036 1.24169 1.3230 1.38904 1.5225 1.56335 1.69790 1.98988 1.60502 1.5262 coal intensity(‘000 mtoe/rs crores) 0.48403 0.42044 0.5537 0.55577 0.5114 0.59221 0.49925 0.66869 0.64162 0.5475 electricity intensity (‘000 mtoe/rs crores) 0.09282 0.07430 0.0643 0.05526 0.0472 0.04396 0.02920 0.03759 0.03124 0.0529 petroleum intensity (‘000 mtoe/rs crores) 0.36791 0.26315 0.1927 0.26515 0.4673 0.17157 0.16738 0.37982 0.32025 0.2884 fertilizer total intensity (‘000 mtoe/rs crores) 0.94476 0.75789 0.8108 0.87618 1.0258 0.80774 0.69583 1.0861 0.99311 0.8887 coal intensity (‘000 mtoe/rs crores) 0.33567 0.21179 0.2776 0.25839 0.1825 0.12904 0.11656 0.15728 0.17549 0.20492 electricity intensity (‘000 mtoe/rs crores) 0.07336 0.07269 0.0708 0.06681 0.0586 0.04841 0.06506 0.06467 0.07498 0.06615 petroleum intensity (‘000 mtoe/rs crores) 0.37191 0.59046 0.4623 0.69446 1.1106 0.77407 1.18428 1.26632 1.12479 0.84214 glass total intensity(‘000 mtoe/rs crores) 0.78094 0.87494 0.8108 1.01966 1.3516 0.95152 1.3659 1.48827 1.37526 1.1132 coal intensity(‘000 mtoe/rs crores) 0.13262 0.13606 0.2091 0.07409 0.1047 0.10327 0.25340 0.14201 0.12149 0.1419 electricity intensity (‘000 mtoe/rs crores) 0.06136 0.06373 0.0496 0.03915 0.0329 0.04235 0.06059 0.04083 0.04674 0.04858 petroleum intensity (‘000 mtoe/rs crores) 0.31229 0.24538 0.2330 0.22780 0.4503 0.29220 0.46018 0.32520 0.45714 0.3337 chemical total intensity(‘000 mtoe/rs crores) 0.50627 0.44517 0.4917 0.49168 0.5879 0.43782 0.77417 0.50804 0.62537 0.5242 coal intensity(‘000 mtoe/rs crores) 0.1415 0.1396 0.1475 0.1522 0.174 0.1607 0.1648 0.1553 0.1399 0.1528 electricity intensity (‘000 mtoe/rs crores) 0.03013 0.03006 0.0307 0.03013 0.0302 0.0329 0.0288 0.0258 0.0223 0.0290 petroleum intensity (‘000 mtoe/rs crores) 0.1241 0.2954 0.3617 0.1353 0.1929 0.1878 0.1411 0.1418 0.1305 0.2045 aggregate manufac turing total intensity (‘000 mtoe/rs crores) 0.2957 0.4650 0.5389 0.3176 0.3971 0.3814 0.3347 0.3229 0.2927 0.3863 source: author’s own estimate international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.54-70 61 in table 3, average total energy intensity is computed by taking combined average of coal, electricity and petroleum intensity in each sector taken up for our study. it has been found out that aggregate manufacturing displays an average total intensity of 0.3863 (‘000 mtoe/ rs crore).the industries considered for our study – cement, iron & steel, fertilizer, aluminum, chemical, paper & pulp and glass sectors – are treated as energy intensive because average total intensity in those industries are considerably higher in comparison with that of aggregate manufacturing sectors. alternatively, the step towards identifying energy intensity trends is to calculate overall energy intensity, a general indicator of energy end-use. energy intensity is defined here as the amount of energy (in rs) used to produce a unit of output (in monetary units, rs.). this is simply obtained by dividing deflated energy consumption by deflated output. energy intensity values in indian industries under consideration over the period (1996-97 to 2004-05) are provided in table 3. table 4. measurement of energy intensity by energy-output ratio (%) year cement industry aluminium industry glass industry fertilizer industry paper industry iron&steel industry chemical industry aggregate manufacturing 1979-80 28.37 23.24 21.71 14.40 12.59 16.73 10.13 6.47 80-81 27.68 24.27 20.97 14.29 15.34 16.05 9.45 6.93 81-82 28.64 24.56 24.08 15.01 15.92 13.57 10.44 7.12 82-83 27.42 23.66 24.91 14.75 16.53 13.48 10.54 7.54 83-84 29.19 29.52 22.2 14.89 16.56 15.37 11.78 8.39 84-85 27.26 30.36 21.69 15.19 16.54 13 11.29 8.70 85-86 28.86 27.26 22.99 14.91 14.66 13.39 10.85 9.15 86-87 30.85 28.73 22.5 14.65 15.69 12.37 11.69 9.06 87-88 31.65 30.12 22.27 18.12 15.01 12.32 11.83 9.30 88-89 26.83 28.63 22.33 16.31 15.22 11.47 10.27 7.69 89-90 30.53 29.39 22.58 20.27 14.30 10.43 11.35 7.76 90-91 32.41 25.44 18.53 16.27 13.76 11.35 11.08 7.72 91-92 30.93 29.99 21.69 15.25 14.53 10.88 10.18 8.04 92-93 30.80 25.03 19.57 14.82 14.28 10.44 10.32 8.43 93-94 32.34 20.61 18.84 14.24 13.36 10 9.66 7.92 94-95 31.37 24.35 18.12 14.17 14.45 10.93 10.25 7.80 95-96 32.60 25.87 19.05 13.36 14.29 11.47 10.23 7.23 96-97 27.67 24.21 16.82 14.18 13.12 12.12 10.18 7.87 97-98 26.97 15.83 15.17 12.52 11.8 10.36 9.68 7.12 98-99 26.28 18.4 15.48 10.35 10.98 10.68 7.25 5.90 99-00 24.64 18.9 16.08 10.58 11.22 9.99 7.85 6.15 00-01 19.81 18.87 15.89 11.84 9.28 9.19 8.26 6.36 01-02 25.28 21.17 12 10.93 8.76 8.55 8.14 6.21 02-03 20.67 21.19 16.02 10.42 9.12 9.79 8.89 5.89 03-04 21.57 17.57 15.68 12.46 8.68 10.33 8.31 5.73 average 28.04 24.29 19.49 14.17 13.44 11.77 9 .97 7.46 source: own estimate from asi (several issues) from our analysis of energy-output ratio (table-4), it has been noticed that all the seven industries taken into our consideration have greater energy intensity in comparison with energy intensity of aggregate manufacturing sector. productivity growth in some energy intensive manufacturing industries in india: an analytical assessment 62 diagram 1. cement industry is the most energy intensive showing intensity of around 28 percent and others are ranked accordingly and chemical is the least energy-intensive. therefore, there is no difficulty in considering those industries having comparatively greater intensity as energy intensive industries. 4.2. results showing total factor productivity growth estimation of annual tfp growth rate of india’s energy intensive industries at aggregate level are presented in table 5. table 5. growth rate of tfp at aggregate level (pre-reform period: 1979-80 to 1991-‘92) year cement aluminium iron&steel chemical fertilizer paper&pulp glass tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indice s growth rate in tfp (%) tfp indices growth rate in tfp (%) 79-80 1 1 1 1 1 1 1 80-81 0.9859 -1.41 1.035 3.44 0.9935 -0.65 1.0962 9.62 1.0344 3.44 1.0180 1.80 0.9849 -1.51 81-82 1.0446 5.95 0.9650 -6.96 1.0706 7.76 1.0346 -5.62 0.9648 -6.73 1.0421 2.36 1.0356 5.15 82-83 1.2133 16.15 1.0063 4.15 1.0642 -0.60 0.9898 -4.33 1.0063 4.30 0.9917 -4.84 0.9545 -7.83 83-84 1.1056 -8.88 1.0154 0.909 0.9412 -11.56 0.9657 -2.43 1.0155 0.90 1.0375 4.62 1.1364 19.05 84-85 1.0323 2.66 1.021 0.595 1.0155 7.89 1.0129 4.89 1.0213 0.59 0.9812 -5.43 0.9572 -15.76 85-86 1.0022 -2.92 0.9786 -4.29 0.9858 -2.92 0.9699 -4.25 0.9784 -4.20 1.0963 11.73 0.9393 -1.88 86-87 1.0809 7.85 1.008 2.97 1.0066 2.11 1.0446 7.70 1.0081 3.04 0.9814 -10.48 1.0228 8.89 87-88 1.0364 -4.12 1.015 0.68 1.0793 7.22 0.9977 -4.49 1.0149 0.67 1.02 3.93 0.9521 -6.91 88-89 1.0310 -0.52 0.8799 -13.53 0.9886 -8.40 0.9952 -0.26 0.8796 -13.33 0.9555 -6.32 0.9758 2.49 89-90 1.1647 12.98 1.21 32.04 0.9914 0.28 0.9391 -5.63 1.2 36.43 1.0277 7.55 0.9480 -2.86 90-91 0.9313 -20.04 1.059 -14.08 0.9429 -4.89 1.0071 7.25 1.0592 -11.73 0.8964 -12.77 1.1104 17.13 91-92 1.0336 10.98 0.9739 -8.53 1.0423 10.54 1.0614 5.38 0.9739 -8.05 1.0356 15.53 0.9216 -17.00 average 1.44 -0.2008 0.5650 0.6525 0.44 0.64 -0.09 source: own estimate diagramatic presentation of total energy intensity of industries under consideration of our study 0.00 1.00 2.00 3.00 4.00 5.00 19 96 -‘9 7 19 97 -‘9 8 19 98 -‘9 9 19 99 -‘0 0 20 00 -‘0 1 20 01 -‘0 2 20 02 -‘0 3 20 03 -‘0 4 20 04 -‘0 5 year to ta l e ne rg y in te ns ity cement paper iron&steel aluminium fertilizer glass chemical aggregate international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.54-70 63 table 6. growth rate of tfp at aggregate level (post-reform period: 1991-92 to 2003-04) year cement aluminium iron&steel chemical fertilizer paper&pulp glass tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) tfp indices growth rate in tfp (%) 91-92 1.0336 10.98 0.9740 -8.53 1.0423 10.54 1.0614 5.38 0.9739 -8.05 1.0356 15.53 0.9216 -17.00 92-93 0.9888 -4.33 1.064 9.04 0.9328 -10.51 1.0195 -3.94 1.0643 9.28 0.9959 -3.83 1.0054 9.09 93-94 0.9953 0.66 0.9580 -10.62 1.0054 7.78 1.0049 -1.43 0.9581 -9.98 0.9381 -5.80 0.9390 -6.60 94-95 0.9584 -3.71 0.9390 -1.93 1.181 5.73 0.9434 -6.13 0.9388 -2.01 0.9024 -3.81 0.9547 1.67 95-96 1.0110 5.49 1.035 9.6 0.9107 -14.33 0.9430 -0.04 1.0348 10.23 0.9624 6.65 0.9705 1.66 96-97 0.9943 -1.65 1.039 0.44 1.063 16.72 1.0791 14.43 1.0392 0.43 0.9854 2.38 1.0443 7.60 97-98 1.0835 8.97 0.9360 -10.36 1.0635 0.05 0.9795 -9.23 0.9356 -9.97 1.0124 2.74 0.9515 -8.89 98-99 0.8161 -24.68 1.00 6.34 0.8931 -16.02 1.0582 8.03 0.999 6.78 1.0022 -1.00 1.0876 14.31 99-‘00 1.0573 29.56 1.046 4.67 1.0562 18.26 1.0634 0.49 1.0457 4.67 1.0361 3.38 0.9689 -10.91 00-01 1.0391 -1.73 1.021 -2.49 1.0412 -1.42 1.0998 3.42 1.0208 -2.38 0.9828 -5.14 0.9455 -2.42 01-02 0.9481 -8.75 0.9740 -4.73 1.0178 -2.25 0.9924 -9.77 0.9735 -4.63 0.9648 -1.83 1.0547 11.54 02-03 0.9593 1.18 1.052 7.83 0.9495 -6.71 1.0066 1.44 1.0518 8.04 0.9767 1.23 0.9303 -11.79 03-04 0.9706 1.18 0.8730 -17.89 0.9337 -1.66 0.9377 -6.85 0.8729 -17.01 0.9481 -2.93 0.9578 2.95 average 1.013 -1.43 0.4761 -0.3231 -1.12 0.58 -0.68 source: own estimate therefore, in this section, we present our findings regarding total factor productivity growth (tfpg) obtained by translog approaches. the period covered by our study is from 1979-80 to 200304. for facilitating comparison of the estimates, we have also computed average annual tfpg for the entire period as well as for two subperiods, 1979-80 to 1991-92 and 1991-92 to 2003-04. in cement industry, broad variations in the magnitude of tfpg are found in the estimation. the estimated tfpg of indian cement sector at the aggregate reveals contradictory rates of tfpg growth (both positive and negative) and it varies over years within the same sector. but, our aggregate analysis also depicts sign of declining trend in average tfp growth rate during post-reform period as compared to pre-reform period. it is evident from tables 5 and 6 that the estimated average growth rate of tfp at aggregate level in cement sector for the period 1979-80 to 1991-92 is 1.44 percent p.a whereas post-reform period covering 1991-92 to 2003-04 in our study witnessed a further decreasing growth of 1.013 percent p.a., a noticeable decline from growth rate as in pre-reform period. the trend growth rate of tfp in indian cement sector is assessed to be -0.0043 percent for the entire period 1979-80 to 2003-04(estimated from semi-log trend) implying average overall annual deceleration of 0.0043 percent p.a. on the whole, impact of economic reforms on tfpg at aggregate level was adverse as the average rate of tfpg estimated in the pre-reform period furthermore decreased in postreform period. moreover, difference between mean tfpg of two periods is statistically significant at 0.05 levels thereby indicating that average tfpg between two periods are statistically different. the estimated tfpg rate at the aggregate level of indian aluminium industry for the entire period, 1979-80 to 2003-04 reveals paradoxical pictures with positive as well as negative rates. during pre-reforms period (1979-80 to 2003-’04), aluminium sector has recorded a negative growth rate of -0.2008 %. it could be noticed from the average tfpg estimated during the postreforms period that the reform process yielded negative results on the productivity levels of the aluminium sector because it is visible from the estimated average tfpg that there is a significant drop in the extent of negative tfpg which is -1.43% when compared to that in the pre-reform period. total factor productivity growth in iron and steel industry displays declining growth rate in post-reforms period compared to pre-reform productivity growth in some energy intensive manufacturing industries in india: an analytical assessment 64 period. it is evidenced from table 6 and 7. that the estimated growth rate of tfp at aggregate level for the period 1979-80 to 1991-92 is 0.5650 percent p.a whereas post-reform period covering 1991-92 to 2003-04 in our study witnessed a declining positive growth of 0.4761 percent p.a., a noticeable downfall from growth rate as shown in pre-reform period. on the whole, impact of economic reforms on tfpg of iron industry at aggregate level was adverse as the average rate of tfpg estimated in the pre-reform period furthermore decreased in post-reform period. within the same industry, over the years, there exist severe variations in total factor productivity growth. analysis of the tfpg of indian chemical industry shows declining growth rate in negative fashion during postreforms period. the pre-reform era (1979-80 to 1991-92) witnessed a positive growth rate of 0.6525 percent but during post-reforms period (1991-92 to 2003-04), it is estimated to be -0.3231 percent p.a. moreover, total factor productivity growth shows contradictory positive and negative trends over years within the same industry. inspection of average tfpg of fertilizer industry in india exhibits an overall negative growth rate in tfp. it is obvious from table 6 that the estimated growth rate of tfp for the period 1979-80 to 1991-92 is 0.44 percent p.a which signifies a positive rate of growth in tfp where as postreform period covering 1991-92 to 2003-04 in our study witnessed a sharp negative growth of -1.12 percent p.a., a steeper fall from growth rate as revealed in pre-reform period. this decline is due to reduced capacity utilization caused by downfall in production rather than being a consequence of lack of technical progress. the growth rate of tfp in indian fertilizer sector is assessed to be –0.055 percent p.a. implying average overall annual deceleration for the entire period 1979-80 to 2003-04. on the whole, impact of economic reforms on tfpg at aggregate level was poor as the positive average rate of tfpg estimated in the pre-reform period declined to negative growth in post-reform period. more over, difference between mean tfpg of two periods is statistically significant at 0.05 levels thereby indicating that average tfpg between two periods are statistically different. table 7. trend growth rate of total factor productivity of energy intensive industries in india pre-reform period(1979-80 to1990-91) post reform period(1991-92 to2003-04) industry/year tfpg industry/year tfpg cement -0.00091* (0.14)** 0.20*** cement -0.0032 (-1.61) 0.32 aluminum 0.0022 (0.44) 0.16 aluminium -0.0023 (-1.52) 0.24 iron&steel -0.0034 (-0.92) 0.18 iron&steel -0.0043 (-1.72) 0.44 chemical -0.00097 (-0.6) 0.18 chemical -0.0018 (-1.43) 0.48 fertilizer 0.0053 (0.86) 0.17 fertilizer -0.0023 (-1.52) 0.24 paper & pulp -0.0057 (-1.43) 0.17 paper & pulp -0.006 (-2.07) 0.37 glass 0.00016 (0.30) 0.24 glass -0.001 (-1.29) 0.18 source: estimated from semi log trend *trend growth rate, ** t values, *** adjusted r2 . in paper and pulp sector, the estimated growth rate of tfp for the period 1979-80 to 1991-92 is 0.64 percent per annum whereas during the post-reform period, 1991-92 to2003-04, tfpg shows slight downward trend which is estimated to be 0.58 percent per-annum but average growth rate for the entire period is significantly negative (-0.014 percent). moreover, tfpg varies widely among years within the same paper sector. table 5 and 6 above show that total factor productivity growth of international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.54-70 65 indian glass industry during pre-reform period declined in a negative fashion which is posted as -0.09 and in post-liberalization period, it further declined to -0.68.large variations in the magnitude of tfpg are found in the evaluation. the estimated tfpg of the indian glass industry at the aggregate level reveals differing rates of productivity growth over years. over our study period, negative trend in the tfpg is observed at aggregate level. therefore, overall analysis of average tfpg growth suggests that in all the industries taken up under our study, average tfpg growth depicts declining growth rate during post-reform periods as compared to pre-reform periods. this does not mean, however, that reforms failed to have a favorable effect on industrial productivity. rather, some research undertaken recently (goldar and kumari, 2003; topalova, 2004) has shown that trade liberalization did have a positive effect on industrial productivity. the explanation for the slowdown in tfp growth in indian manufacturing in the post-reform period seems to lie in the adverse influence of certain factors that more than offset the favorable influence of the reforms. two factors that seem to have had an adverse effect on industrial productivity in the postreform period are (a) decline in the growth rate of agriculture and (b) deterioration in capacity utilization in the industrial sector (goldar and kumari, 2003). uchikawa (2001) has pointed out that there was an investment boom in indian industry in the mid-1990s. while the investment boom raised production capacities substantially, demand did not rise which led to capacity under-utilization. goldar and kumari (2003) have presented econometric evidence that indicates that the slowdown in tfp growth in indian manufacturing in the post-reform period is attributable to a large extent to deterioration in capacity utilization. 5. impact of liberalization on total factor productivity growth the process of liberalization can be linked to the manufacturing productivity. with the initiation of a wide range of economic reforms by the india government on various fronts to make domestic industries more efficient and internationally competitive, indian firms were expected to respond positively these measures. the liberalization process was to expose firms to international competition and force them to introduce new methods of production, import quality inputs, capital equipment or technology and compel them to improve their efficiency. trade liberalization is captured by either an explicit measure of liberalization or by a dummy variable capturing a change in the economic policies. the use of dummy variable to demarcate the post-reform period from pre-reform period (as had done earlier by ahluwalia, 1991; harrison, 1994; krishna and mitra, 1998) is subject to criticism. dummy variable technique assumes that trade reform was one time phenomenon and it was complete and at the same time it fails to capture that reform has been gradual over time, rather an ongoing process. in order to understand the impact of liberalization on tfpg more precisely, we use a piecewise linear regression equation (popularly known as spline function) which is depicted as follows. ln y t =  + t + (t – t0) dt , where y t is tfp. in this section, we have tried to judge the effect of economic reforms on total factor productivity growth by using piece wise linear regression equation. if, in the result, the coefficients of difference between two time periods show positivity or negativity and they are statistically significant, then it can be inferred that liberalization may have either favourable or adverse impact of trade reforms on tfpg respectively. the results of piece wise linear regression is depicted and interpreted below. figures in the parentheses are the absolute values of t statistics and r2 is the goodness of fit here b gives the slopes of the regression line in pre-reform period which are negative and insignificant at 5% level in all four industries excepting iron steel, fertilizer and paper industry. this implies that growth in tfpg displays negligible negative trend immediately before liberalization starts, in cement, aluminium, chemical and glass industries. productivity growth in some energy intensive manufacturing industries in india: an analytical assessment 66 table 8. results of piece-wise linear regression of energy intensive industries in india by spline function (tfpg as dependent variable) variables cement aluminium iron & steel chemical fertilizer paper&pulp glass intercept 0.063 -0.008 0.048 0.0234 -0.0089 0.037 0.0055 b -0.00183 (-0.37) -0.003 (-0.58) 0.0018 (0.368) -0.0022 (-0.66) 0.0027 (0.62) 0.0052 (1.30) 0.0014 (-0.37) b′ (t – t0) -0.0028 (-2.28) -0.007 (-2.89) -0.0033 (-2.41) -0.00376 (-2.69) -0.00685 (-1.99) -0.0050 (-2.72) -0.0008 (-2.11) r2 0.14 0.54 0.14 0.24 0.54 0.16 0.60 d-w value 2.21 2.35 2.59 2.62 2.49 254 2.68 source: own estimate from the table 8 above, it is found that in case of cement, aluminum, iron and steel, chemical, fertilizer, paper&pulp and glass industry, liberalization has significant negative impact as because the coefficients of the difference between two time periods are statistically significant at 0.05 level and negative (coefficients being -0.0028, -0.007,-0.0033,-0.00376,-0.00685, -0.005, -0.0008 respectively) . therefore, it has been observed from our analysis that productive performance of most of the energy intensive industries in india has been showing gradual declining trend since the initiation of economic reforms in 1991explicitly reflecting the adverse impact of liberalization on total factor productivity growth. output growthproductivity driven or input accumulation: theoretically, sources of economic growth are composed of factor accumulation and productivity growth. the first source may lead to high growth rates, but only for a limited period of time. thereafter, the law of diminishing returns inevitably occurs. consequently, sustained growth can only be achieved through productivity growth, that is, the ability to produce more and more output with the same amount of input. some researchers argued that the soviet union of the 1950s and the 1960s, and the growth of the asian ‘tigers’ are as examples of growth through factor accumulation (e.g. krugman, 1994). on the other hand, growth in the industrialized countries appears to be as the result of improved productivity (e.g. fare et al, 1994). traditionally (owing to solow), the sources of output growth are decomposed into two components: a component that is accounted for by the increase in factors of production and a component that is not accounted for by the increase in factors of production which is the residual after calculating the first component. the latter component actually represents the contribution of tfp growth. therefore, the pertinent question of whether output growths of these industries are the result of factor accumulation or productivity-driven has been tested for these energy intensive industries. table 9 shows the relative contribution of tfp growth and factor input growth for the growth of output during 1979-80 to 2003-04. observing the growth path, it is apparent that in all the industries under our study, tfp growth contribution is either negative or negligible and insignificant across the entire time frame. therefore, it is true that increase in factor input is responsible for observed output growth and tfp contribution plays negligible role in enhancing output growth. therefore, output growth in energy intensive industries in india was fundamentally dominated by accumulation of factors resulting input-driven growth. international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.54-70 67 table 9. contribution of tfpg to output growth under liberalized trade regime industry contribution of tfpg and inputs to output growth phase 1 (1979-‘80 to ‘85-‘86) phase 2 (1986-‘87 to ‘91-‘92) phase 3 (1992-‘93 to ‘97-‘98) phase 4 (1998-‘99 to 2003-04) pre-reform period (1979-‘80 to 1991-‘92) post-reform period (1991-‘92 to 2003-‘04) entire period (1979-‘80 to03-‘04) output growth 11.05 9.93 6.03 4.75 10.49 5.74 7.94 contribution of input growth 10.05 (95.02%) 8.74 (88.02%) 5.12 (84.91%) 5.29 (111.37%) 9.62 (91.71%) 4.73 (82.35%) 7.944 (100.054%) cement contribution of tfpg 0.55 (4.98%) 1.19 (11.98%) 0.91 (15.09%) -0.54 (-11.37%) 0.87 (8.29%) 1.013 (17.65%) -0.0043 (-0.054%) output growth 5.89 6.65 -3.66 -1.23 6.27 -2.20 5.21 contribution of input growth 3.09 (52.46 %) 10.19 (153.23%) -5.41 (-147.81%) -0.18 (-14.63%) 6.64 (105.9%) -2.23 (-101.36%) 5.32 (102.11%) aluminium contribution of tfpg 2.80 (47.53%) -3.54 (-53.23%) 1.75 (47.81%) -1.05 (-85.37%) -0.37 (-5.90%) 0.03 (1.36%) -0.11 (-2.11%) output growth 4.43 7.33 7.79 6.91 6.29 6.9 6.76 contribution of input growth 3.69 (83.21%) 6.51 (88.81%) 7.09 (90.98%) 6.2 (89.67%) 5.72 (91.02%) 6.42 (93.1%) 6.89 (101.92%) iron&steel contribution of tfpg 0.74 (16.79%) 0.82 (11.19%) 0.70 (9.02%) 0.71 (10.33%) 0.57 (8.98%) 0.48 (6.90%) -0.13 (-1.92%) output growth 7.29 8.06 9.15 5.20 8.04 7.68 7.61 contribution of input growth 7.64 (104.80%) 6.4 (79.40%) 11.04 (111.59%) 5.74 (110.38%) 7.39 (91.92%) 8.0 (104.17%) 7.68 (100.92%) chemical contribution of tfpg -0.35 (-4.80%) 1.66 (20.60%) -1.06 (-11.59%) -0.54 (-10.38%) 0.65 (8.08%) -0.32 (-4.17%) -0.07 (-0.92%) output growth 3.67 26.99 7.09 -2.05 15.33 3.74 8.93 contribution of input growth 3.95 (107.63%) 25.82 (95.66%) 7.43 (100.46%) -1.30 (63.41%) 14.89 (97.13%) 4.86 (127.08%) 8.98 (127.63%) fertilizer contribution of tfpg -0.28 (-7.63%) 1.17 (4.34%) -0.34 (-0.46%) -0.75 (36.59%) 0.44 (2.87%) -1.12 (-27.08%) -0.05 (-27.63%) output growth 6.38 9.40 5.70 2.72 7.79 4.5 6.47 contribution of input growth 4.67 (73.2%) 9.83 (104.58%) 5.55 (97.37%) 3.43 (100.71%) 7.15 (91.78%) 3.56 (79.11%) 6.472 (100.03%) paper&pulp contribution of tfpg 1.71 (26.80%) -0.43 (-4.58%) 0.15 (2.63%) -0.71 (-26.10%) 0.64 (8.22%) 0.94 (20.89%) -0.002 (-0.03%) output growth 7.92 12.77 2.62 2.86 10.34 4.76 6.19 contribution of input growth 8.38 (105.81%) 12.48 (97.73%) 1.86 (70.99%) 2.25 (78.67%) 10.43 (100.87%) 5.44 (114.29%) 6.29 (101.62%) glass contribution of tfpg -0.46 (-5.81%) 0.29 (2.27%) 0.76 (29.01%) 0.61 (21.33%) -0.09 (0.87 %) -0.68 (-14.29%) -0.10 (-1.62%) source: own estimate 6. concluding remarks this study attempts to measure productivity performance of energy intensive industries in india in terms of total factor productivity for the entire period, 1979-80 to 2003-04. the result on the overall productivity displays that tfpg has declined in post-reform period as compared to prereform period. total output growth in those indian industries is found to be mainly input-driven. careful analysis of the relative contribution of tfp growth and factor input growth for the growth of output during 1979-80 to 2003-04 provides us insight that tfp growth contribution to the growth in output is either negative or insignificant across the entire time frame. therefore, it is true that increase in factor input is responsible for observed output growth and tfp contribution plays productivity growth in some energy intensive manufacturing industries in india: an analytical assessment 68 negligible role in enhancing output growth. therefore, growth of output in indian energy intensive industries was fundamentally dominated by factor accumulation resulting input-driven growth rather than productivity-driven. tfp growth in the energy intensive industries under our study shows positive as well as negative growth rates over years within the same individual industry and it varies widely over years. apart from this, the present analysis also reveals that there exists greater heterogeneity in tfp performance across industry groups. total factor productivity growth displays upward and downward trend during post-reform period .in all the industries like cement, aluminum, iron and steel, fertilizer, glass and chemical and paper & pulp industries, post-reform tfp growth rate reflects dismal declining growth rate which reflects negative impact of liberalization thereon. given the fact that there exists high degree of intra industrial disparity of tfpg, it is expected that no single explanation for variations in tfpg in each industry group will hold true. nevertheless, it seems that due to heavy investment in the 1990s, unaccompanied by commensurate expansion of demand, capacity utilization went on worsening in those manufacturing industries. that might have adversely affected the productivity growth. the liberalization process is found to have its adverse impact on total factor productivity growth. all the observations, in turn, place the need for formulating industry specific policies for enhancing total factor productivity growth of energy intensive industries in india. the negative and significant impact of liberalization on productivity suggests that trade policy should focus on productivity enhancing industrial policies that will, in turn, help firm to enter export market after gaining real competitive edge. moreover, the chances of survival in the highly competitive era are high for more productive firms than less productive firms. the economic theory mentions of different possible reasons for keeping idle capacity in a competitive economy. therefore, it can be said that the tendency to attribute all economic outcomes in a period, which coincide with economic reforms may not match with the empirical facts. nevertheless, the industries taken up under our study which keep idle capacity should utilize its capacity to the fullest possible for meeting growing market-demand. india's tariff rates are still among the highest in the world and continue to block india's attractiveness as export platform for energy-intensive manufacturing production. it is also suggested that tariff rates on imported capital goods should be made duty free. it is worth remembering that india has been gradually achieving a high per capita income level so that productivity growth will become more important relative to factor accumulation as a source of economic growth. the unmistakable implication for indian policymakers is the need to open up more to foreign imports, which will help to bring about institutional and technological progress conducive to tfp growth. the seven key industries under consideration of our studynamely cement, iron & steel, chemical, aluminum, paper & pulp, glass and fertilizerconsumes about 65% of the total energy use in india. the energy intensity in some of those industries is reported to be higher than the industries in developed countries. one of the main reasons for higher energy use is the presence of obsolete and energy inefficient processes in some of these sectors. therefore, measures have to be initiated for modernizing the obsolete plants within the industries that will surely be the productivity enhancing mechanism. immediate initiatives have to be taken for drawing up energy consumption norms for various kinds of fuel using equipment. in the absence of energy consumption norms for various energy intensive industries in india, these industries have adopted their own benchmarks. the common practice is to compare their performance with the best specific energy consumption figure in that particular sector/region or their own best figure achieved in the recent past. this attempt may not be adequate. the plants within those industries should also set their long-term goals and year-wise targets may be framed to achieve these goals. few plants in india have achieved specific energy consumption figures which are very close to the best in the world, despite all the constraints. all plants should carefully plan out a roadmap leading to similar objective which will help them to be least cost producer of their product and become competitive globally. the strategies should be to introduced to use alternative fuel like cn.g, natural gas and bio gas fuel instead of oil to cover up the extra strain arising due to severe oil price hike. india needs a sustainable energy policy that will not only meet the future energy demand for rapid economic growth but also protect the environment and conserve scarce resources. by making our thermal power sector more efficient, increasing the use of environmental management systems in energy-intensive industries, imposing stringent emission norms industrial sector, expanding the use of international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.54-70 69 renewable energy technologies and introducing the energy conservation bill, 2000 by government of india, india has already taken major steps in the right direction. industry associations can play an important role to spread the culture of energy efficiency among its plants on a larger scale. in few selected energy intensive industrial sectors, such as, aluminium, cement, chlor-alkali, fertilizer, pulp & paper, petrochemicals, refinery, and textiles, industry association has set up a 'task force' of selected plants and association from that sector with an objective to promote energy efficiency on a sectoral basis. these forums could be utilized by these plants to showcase successful case studies on energy conservation in their premises, share best practices, keep track of international scenario, technological advances occurring in their field and market conditions etc. these forums can also help in framing energy consumption norms and targets for that particular sector. in terms of future applied research directions on indian context, regional level study with plant level data sets would be more informative in decision making process. references ahluwalia, i.j. (1991), productivity and growth in indian manufacturing, oxford university press, delhi. berndt, e.r.and d.o.wood (1975), technology, prices and derived demand for energy, review of economics and statistics, 57, 259-268. brahmananda, p.r (1982), productivity in the indian economy: rising inputs for falling outputs, himalaya publishing house, delhi. färe, r. grosskopf s., norris m. and zhang, z. (1994) productivity growth, technical progress, and efficiency changes in industrialized countries, american economic review, 84, 66-83. goldar, b.n. and anita kumari (2003) import liberalization and productivity growth in indian manufacturing industries in the 1990’s. the developing economies, 41, 436-59. goldar, b. and ranganathan, v.s. (1991), “capacity utilization in indian industries”, the indian economic journal, 39(2), 82-92. harrison, a.e (1994), productivity, imperfect competition and trade reform: theory and evidence, journal of international economics, 36, 53-73. jorgenson, d.w (1988), productivity and post war us economic growth, journal of economic perspectives, 2(4), 23-41. krishna, and mitra, d. (1998), trade liberalization, market discipline and productivity growth: new evidence from india, journal of development economics, 56, 55-83. krugman, p. (1994), “the myth of asia’s miracle”, foreign affairs, 73(6), 62-78. mahadevan, r (2004), new currents in productivity analysis: where to now? productivity series no. 31,asian productivity organization, tokyo, japan. petersson, l (2002), integration and intra-industry trade adjustment in south africa, development south africa,19, 239-259. pradhan,g and barik, k. (1999), total factor productivity growth in developing economiesa study of selected industries in india, economic and political weekly, august 6. prescott, e.c (1997), ‘needed: a theory of total factor productivity’, federal reserve bank of minneapolis, research department staff report no.242, minnesota, us. sharma, kishore (1999),‘productivity growth in developing countries: an international comparison’ in s. b. dahyia (ed.) the current state of economic science, 3, 1234-1252. solow, r.m., (1957) technical change and the aggregate production function, review of economics and statistics, 39, 312-320. topalova, p. (2004), trade liberalization and firm productivity: the case of india, imf working paper wp/04/28, asia pacific department, february. uchikawa, s. (2001), ‘investment boom and underutilization of capacity in the 1990s, economic and political weekly, august 25, 3247–3253. productivity growth in some energy intensive manufacturing industries in india: an analytical assessment 70 appendix appendix: a-1 energy inputs: industry level time series data on cost of fuel of indian energy intensive sectors have been deflated by suitable deflator (base 1981-82 = 100) to get real energy inputs. an input output table provides the purchase made by manufacturing industry from input output sectors. these transactions are used as the basis to construct weight and then weighted average of price index of different sectors is taken. taking into consideration 115 sector input -output table (98-99) prepared by cso, the energy deflator is formed as a weighted average of price indices for various input-output sectors which considers the expenses incurred by manufacturing industries on coal, petroleum products and electricity as given in i-o table for 1998-99. the wip indices (based 198182) of coal, petroleum and electricity have been used for these three categories of energy inputs. the columns in the absorption matrix for 66 sectors belonging to manufacturing (3398) have been added together and the sum so obtained is the price of energy made by the manufacturing industries from various sectors. the column for the relevant sector in the absorption matrix provides the weights used. appendix: a-2 capital stock: the procedure for the arriving at capital stock series is depicted as follows: first, an implicit deflator for capital stock is formed on nfcs at current and constant prices given in nas. the base is shifted to 1981-82 to be consistent with the price of inputs and output. second, an estimate of net fixed capital stock (nfcs) for the registered manufacturing sector for 197071 (benchmark) is taken from national accounts statistics. it is multiplied by a gross-net factor to get an estimate of gross fixed capital stock (gfcs) for the year 1970-71. the rate of gross to net fixed asset available from rbi bulletin was 1.86 in 1970-71 for medium and large public ltd. companies. therefore, the nfcs for the registered manufacturing for the benchmark year (1970-71) as reported in nas is multiplied by 1.86 to get an estimate of gfcs which is deflated by implicit deflator at 1981-82 price to get it in real figure. in order to obtain benchmark estimate of gross real fixed capital stock made for registered manufacturing, it is distributed among various two digit industries (in our study, 7 energy intensive industries) in proportion of its fixed capital stock reported in asi, 1970-71) third, from asi data, gross investments in fixed capital in all seven energy intensive sectors are computed for each year by subtracting the book value of fixed in previous year from that in the current year and adding to that figure the reported depreciation on fixed asset in current year. (symbolically, it = (t t-1 + dt ) / pt) and subsequently it id deflated by the implicit deflator to get real gross investment. fourth, the post benchmark real gross fixed capital stock is arrived at by the following procedure. real gross fixed capital stock (t) = real gross fixed capital stock (t – 1) + real gross investment (t). the annual rate of discarding of capital stock (dst) is assumed to be zero due to difficulty in obtaining data regarding dst. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.196-216 issn: 2146-4138 www.econjournals.com 196 stock prices and implied abnormal earnings growth hafiz imtiaz ahmad nyit, abu dhabi, uae. email: hahmad02@nyit.edu pascal alphonse university of lille north of france, f-59000, lille, france-lsmrc. email: palphonse@univ-lille2.fr michel levasseur university of lille north of france, f-59000, lille, france-lsmrc. email: michel.gabriel.levasseur@gmail.com abstract: in terms of corporate valuation, the frequently used heuristics are price earnings or price earnings to growth ratios. the development of a valuation model of type abnormal earnings growth model including modeling of expected rents evolution, conditions compatible with perfect competition, allows us to propose a testable relationship between market value of share, expected earnings per share in a year, its rate of growth in short term and a set of accounting variables composing a synthetic indicator of growth of company. our results show that (1) expected increase in earnings per share are significantly associated with stock prices for developed countries, (2) but, the persistence of its effects is limited for emerging countries, (3) when the dynamics of growth are more complex, inclusion of synthetic variable of can make a significant correction term (4) and the implied cost of capital is significantly higher for emerging countries than for developed countries. keywords: equity valuation; abnormal earnings; emerging markets jel classifications: g12; g14; m41 1. introduction our study examines the relationship between the market price of a share, expected earnings and its expected growth for the next two years because they are the very value drivers, followed by the financial community through the p/e ratio and peg ratio, for example. consistent with the current accounting literature called, the association. we take the proposal put forward by barth et al. (2001): “an accounting amount is defined as value relevant if it has a predicted association with equity market values” (p.79) and their following remark; “accounting information can be value relevant but not decision relevant if it is superseded by more timely information”. we make no assumption regarding the efficiency of stock markets. our study fits in the course of all those interested to price levels and not their changes. we raise this by a double question: knowing that the form of association between stock price and expected earnings per share depends on the type of growth of the company, (i) that brings short term increase in expected earnings by financial analysts to explain differences in stock market value (ii) can an indicator of growth built on historical accounting data correct the bias introduced by previous measure? the interest in this subject is primarily motivated by practical considerations. investments in the international equity markets have become significant for fund managers worldwide. the use of methods based on comparison of basic observed ratios, for listed companies, between stock prices and expected earnings per share is often considered the most powerful, (liu et al, 2007) reports that “eps forecasts represented substantially better summary measures of value than did ocf forecasts in all five countries examined, and this relative superiority was observed in most industries”. understanding the link between market value and expected earnings is likely to illuminate the investment process in countries where information is more difficult to collect for foreign investors. stock prices and implied abnormal earnings growth 197 the second motivation is of theoretical nature. it focuses on the relationship between book values and market values. the valuation models based on abnormal earnings growth (a.e.g.) provide support to the link between expected future earnings, expected dividends and market values. the pioneering model of ohlson and juettner-nauroth (2005) claim that only the expected earnings for the next two years and expected dividend are sufficient. the empirical evidence is not conducive to this hypothesis (gode and mohanram, 2003), (penman, 2005). the question is whether an extension of the model a.e.g.(abnormal earnings growth) proposing a more fine decomposition of the abnormal earnings growth in volume and intensity provides a better estimate of the link between expected earnings and stock price of a share. we begin our study with a theoretical extension of the model a.e.g. aware of the fact that the models of type aeg are complex in their inner mechanics (brief, 2007), we want to make development of the profitability in the form of a progressive realization of a set of growth opportunities. to do this, we take an idea developed by walker and wang (2003) in a different context, that of r.i.m. (residual income models). as walker and wang, we bring together the microeconomic analysis and modeling of accounting earnings. but we do so as a part of valuation based on taking into account expected earnings and especially their growth. the second part of the study is empirical. three samples are formed over the period 19982008.they include american companies, firms from other developed countries (germany, australia, canada, france, japan, and the united kingdom) and a set from emerging countries (china, korea, hong kong, india, malaysia, singapore, taiwan and thailand). our objective is to provide an international comparison. from historical accounting data, we build a synthetic indicator of growth by company. we, then, proceed to estimate our model by incorporating the variables of expected earnings (in level and in variation), this synthetic variable of growth and other control variables. the objective is to verify (1) that the anticipated effects of abnormal earnings growth are limited in time, (2) that the inclusion of the synthetic variable for growth makes a significant correction when the variable of growth in the short-term alone is insufficient,(3) that the values implicit of cost of capital are acceptable from an economic stand point. our empirical study allows to establish the following results: (i) whatever the geographical zone, expected earnings per share remains the variable most strongly associated with the stock market values. but, the coefficients are higher in developed countries than in emerging countries. the valuation of profits is affected by different levels of their persistence and more generally of risk. the expected change in earning per share is significantly associated with the market value of a share (especially for developed countries) but its persistence is limited (especially in emerging countries). this last result contrary to the intuition which would like the expected growth being greater in emerging countries, the peg is a better tool of valuation in these countries. the per and peg ratio combine in valuation essentially, within developed countries. (ii) these two indicators must be supplemented to avoid either over-valuation or undervaluation. taking into account the intensity of the growth through historical accounting indicators provides a part of the missing information. the corrections are mostly positive (insufficient to take into account the growth potential by the increase of expected earnings, especially in emerging countries) and more rarely negative (low persistence of the intensity of the expected pension, rather in part of developed countries). (iii) at the international level, the expected implied rates of return are significantly higher in emerging countries than in developed countries. the rest of the paper is organized as follows. in section 2, we develop our model; section 3 presents our data and some descriptive statistics. section 4 describes the methods of calculation of the variable of growth. our results are presented in section 5 and section 6 concludes. 2. the model 2.1 the sources of model: we take an idea developed by walker and wang (2003) in a different framework. walker and wang approach to microeconomic analysis and modeling of company’s accounting earnings particularly the r.i.m. (residual income model). they studied several forms of competition and provide, among other, a representation of the dynamic followed by the residual income in a world of perfect competition. we international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.196-216 198 propose a similar extension but applied to the model aeg (abnormal earning growth) proposed by ohlson and juettner-neuroth (2005). we preferred to place our study in the current a.e.g. model because its point of departure is linked to an empirical observation. the accounting variable best associated with market value is expected earnings (ohlson & gao, 2006). unlike the r.i.m. model that bases valuation on the book value of equity, the a.e.g. model anchor valuation in the capitalization of expected earnings (ohlson j.a., 2005). the progress in the modeling requires a description of the dynamics of this earnings. ohlson and juettner neuroth postulate that the annual variation in the expected abnormal earnings (income in excess of the remuneration of reinvested cost of capital) follows an autoregressive process of order 1. not only, no theoretical justification is advanced to support this hypothesis, but this is certainly very restrictive, as it gives only expected incomes very close role in valuation. the purpose of this article is to extend the analysis of walker and wang to the model of ohlson and juettner neuroth in the framework of a pure and perfect competition and unbiased accounting. the originality of this paper is inspired by a measure of growth, already used in accounting literature by hribar and yehuda (hribar & yehuda, 2008). thus indirectly taking into account the expected rents, we, partly, believe to avoid some of the shortcomings highlighted by holthausen and watts (holthausen and watts, 2001). 2.2 the valuation model from abnormal earnings growth and growth opportunities first we assume that the price of a share is equal to the sum of free cash flow received by shareholders discounted at a required rate: p = ∑ ( ) ∞ (1) a second hypothesis, the variation in earnings has two sources: the variation in the value of a rent and reinvestment of undistributed profits. the complementary hypothesis of the reinvestment of the latter at the rate r guarantees the neutrality of the dividend policy. by designating, intensity of expected rent by a and q its extent, we put: eps − eps = a ∙ q − a ∙ q + (eps − fps ) ∙ r (2) this particular set of assumptions used to express the price of share based on the expected income, the required rate of return and expected values of the parameters defining the future rent: = + ∙ ∑ ( [ ∙ ] [ ∙ ]) ( ) (3) to complete the model, we adopt a third hypothesis that the variables a and q follow linear informational dynamics described in (4). the intensity of the rent a is decomposed into a part depending on its past value δ ∙ a and a white noise ε , . its persistence is measured by the parameter δ (with the condition 0 < < 1 to take into account the effects of competition). the extent of the rent q is a function of its trajectory q and a gap which itself decomposes into a corrective movement back toward the track γ ∙ (1 + c) ∙ (q − q ) and a white noise ε , . the coefficient γ measures the intensity of the restoring force to the track q . the trajectory q of the extent of the rent grows at a rate c to take account of the growth. finally, the two white noises embedded in these movements are assumed to be independent: there is no link between variations of intensity and variations of the extent of the rent. = ∙ + , − = ∙ ( + ) ∙ ( − ) + , (4) = ∙ ( + ) , , , = ∀ , this set of assumptions allows to write the following relationship (proof available) = − ( + ) ∙ ∙ ∙ + ∙ [ ] ∙ ∙ (5) with : g = (1 + c) ∙ δ ∙ γ − 1 ℎ = (1 + c) ∙ δ ∙ (1 − γ) ∙ [δ ∙ (1 + c) − 1] ceps = eps + r ∙ fps stock prices and implied abnormal earnings growth 199 the primary interest of this model is to retain the general form of popular valuation models, taking as anchoring the expected earnings per share. for example, if δ = γ = 1, it reduces to the model of ohlson juettner-nauroth which is only a special case. assuming again that e eps = (1 + c) ∙ e eps , we find the standard model of gordon and shapiro. the second interest of this model is mainly to clarify the value of the coefficient included in the autoregressive dynamics of abnormal earnings growth. it is not solely equal to the expected rate of growth in the long run, as in ohlson and juettner-nauroth. it takes into account the value creation potential of the firm, the speed with which the latter will be realized (γ) and its ability to persist (δ). the third interest is to show that under what conditions a valuation based only on expected earnings eps and eps may suffice. it is necessary that the term h is near to zero or that δ ∙ (1 + c) = 1. conversely, when the ability to generate value is not persistent (δ < (1 + c) ), a model of type aeg overestimates the share. when the enterprise is only at the beginning of growth ( q high), its implementation very progressive (γ low) and its ability to create value very persistent (δ > (1 + c) ), then a model of type aeg is very incomplete. its explanatory power is weak and suffers from the absence of key variables. 2.3 the specification of the model tested from an empirical point of view, the measures selected for and are the median forecasts of earnings per share retained by ibes, noted and .the measure chosen for [ ] is the median forecast adopted by ibes for dividend per share, noted .we do not have any direct forecast for ∙ [ ]. the objective of this study is to test the explanatory power of several approximations: ∙ [ ] = ∑ ∙ ∙ (6) where k is one of the n variables potentially correlated with the expected abnormal earnings growth, y knowing that α is a measure of its expected impact on the evolution of the earnings and taps total assets per share. p is the share price in the beginning of the year. the variables p , eps , eps and dps were divided by taps , to be normalized. finally, the model was completed by the inclusion of a control variable for size measured by log of market capitalization in u.s. dollars. the following specification was chosen = + ∙ + ∙ ∙ + ∑ ∙ + ∙ ( ) + (7) one of the main limits of this specification is that it only takes the average values for r and g with in each country. note that according to the theoratical model we should have r = β ∙β + β − β ∙β and g = − . 3. data and descriptive statistics 3.1 constitution of the samples our sample was compiled from the information available in early july 2009 in the data base thomson financial accounting research data and covering 18 countries for which the number of firms represented in this database was the highest, it is possible some information has been modified ex post by data provider. it contains both the developed countries (germany, australia, canada, france, italy, japan, united kingdom, sweden and usa) and emerging countries (brazil, china, korea, hong kong, india, malaysia, singapore, taiwan, and thailand). south africa and india were eliminated from sample due to too few and limited forecast data. in order to study the period 2001-2008 between the two crises, it was necessary to collect the data over the period 1998-2008. in effect some variables appear in the form of annual variations, other as average of past performance. missing information, especially for forecast of earning per share, reduced the sample size. in order to constitute homogenous sample with in each of the country as regards of accounting year, we selected only the companies with year-end corresponding to the date most widely used in the country. generally, it is the 31 december, with the exception of australia (end of june) and japan (end of march). this requirement generally seems not very constraining. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.196-216 issn: 2146-4138 www.econjournals.com 200 table 1. selection of sample this table presents the modalities of selection of companies studied. the period of selection extends from 1998 to 2008.the data comes from worldscope and ibes databases provided by thomson financial. the securities initially selected for all concerned countries are those considered by thomson financial as active or inactive, in order to limit the “survivorship” bias. numbers of these securities correspond to firms effectively disappeared, to not listed companies or yet to particular categories of securities issued. the selection process consisted of a search of market values year after year of these companies and to retain only the firms years for which this information was available. in order to have uniform accounting periods by country, we have selected only those companies that adopted the most usual year end date for each country. by following the sector classification proposed by fama and french (49), we have eliminated all societies of financial sectors and real estate (45-49) and the companies from which the sector was not identified. the following selection consisted of to retain only the firms for which accounting data and earnings per share forecast, necessary for the study was available active and inactive in the database thomson financial number of firms whose fiscal year end date is known the most frequent end of year for the country number of firms having this year end date percentage of firms with this year end date number of firms with a code ff sector less than 45 number of companies with market capitalizations available at least for one year number of firms / year with known market capitalizations b etween 1998 and 2008 number of firms / year with the known book values used between 1998 and 2008 number of firms/ year with equity &capitalizatio n in excess of 1 million $ between 1998 &2008 number of firms / year with positive net income between 1998 and 2008 number of firms / year with positive net income between 2001 and 2008 number of firms/ year with eps forecasts available between 2001 and 2008 usa 28 013 8 574 december 6 086 70.98% 4 531 4 217 32190 30 888 25 127 15 910 12 078 5 940 germany 29 096 7 075 december 6 739 95,3% 6 066 546 4 624 2 457 2 386 1 807 1 424 705 australia 17 369 2 733 june 1 975 72,3% 1 660 1 376 8 163 6 668 5 831 2 613 2 287 851 canada 20 176 5 665 december 5 076 89,6% 4 282 937 6 342 3 962 3 790 2 168 1 778 840 france 27 856 5 750 december 4 781 83,1% 4 131 470 4 099 2 534 2 417 1 924 1 603 812 italy 13 825 1 705 december 1 640 96,2% 1 422 210 1 648 1 287 1 280 967 762 356 japan 36 774 5 604 march 2 969 53,0% 2 652 2 564 24 453 10 979 10 876 9 176 8 167 3 818 united kindom 38 141 7 201 december 3 976 55,2% 3 454 702 4 869 4 771 4 316 2 650 2 107 985 sweden 11 050 1 772 december 1 633 92,2% 1 441 309 2 276 1 054 1 048 776 599 409 other developed countries 194 287 37 505 28 789 25 108 7 114 56 474 33 712 31 944 22 081 18 727 8 776 brazil 21 722 7 335 december 7 318 99,8% 6 615 250 1 957 1 008 974 787 647 252 china 23 521 4 437 december 4 381 98,7% 4 081 1 768 10 682 2 493 2 421 2 047 1 672 381 korea 1 804 1 091 december 998 91,5% 956 948 7 691 5 603 5 482 4 235 3 570 376 hong kong 7 155 1 240 december 805 64,9% 624 469 3 787 3 565 3 390 2 378 2 020 675 indonesia 888 716 december 716 100,0% 570 274 2 228 2 049 1 781 1 362 1 139 232 malaysia 1 938 1 450 december 918 63,3% 794 510 3 859 3 188 3 073 2 338 1 962 519 singapore 6 053 1 610 december 1 146 71,2% 1 014 354 2 564 2 128 2 066 1 581 1 319 340 taiwan 3 754 1 894 december 1 891 99,8% 1 795 1 418 9 725 4 605 4 589 3 630 3 071 628 thailand 1 084 800 december 755 94,4% 641 413 3 191 2 618 2 444 1 944 1 606 424 emerging countries 67 919 20 573 18 928 17 090 6 404 45 684 27 257 26 220 20 302 17 006 3 827 international journal of economics and financial issues vol. 4, no. 1, 2014, pp.196-216 issn: 2146-4138 www.econjournals.com 201 the percentage of companies respecting this practice is most often above 90%.however, there are two major exceptions among the developed countries (japan and united kingdom, where the percentage is around 50%). similarly, hong kong and malaysia have smaller proportions (about 60%). the financial and real estate companies whose accounting standards are often specific and not comparable were eliminated. we could raise within the thomson financial database only the market capitalization for 7 114 companies of the other developed countries and 6 404 companies of emerging countries, for a total firms-year respectively equal to 56 474 and 45 684. companies are not, therefore, present for all years. if we compare these figures to theoretical value of firms-year with a continuous presence over 11 years, we obtain a frequency of occurrence of 72% for other developed countries and 65% for emerging countries. this last sample is, therefore, somewhat less dense. the availability of accounting data required to estimate the variables used in the study further reduced the sample size. the loss of the number of observation is equivalent for the two sub populations (other developed countries and emerging countries), or about 40%. for the rest of the study, we selected only profitable companies. they are more numerous in emerging countries (77%) than among other developed countries (69%). finally, the greatest loss of observation comes from the limited number of forecasts for earning per share available on ibes during this period. the coverage rate is 47% for other developed countries and only 23% for the emerging countries. in total, we have 12 603 firm years distributed for 8 776 to other developed countries and 3 827 for emerging countries. the number of observation is increasing over the period: 802 in 2001 and 1809 in 2008 but relatively stable from 2004 to 2008.the maximum is 2175 in 2007, just before the last financial crisis. 3.2 descriptive statistics the average stock market values normalized by total assets (measured by the item ws.yrendmarketcap divided by the item ws.totalassets of worldscope database from thomson reuters) are substantially similar for emerging countries (1.09) and other developed countries (1.10).the medians are lower because of the asymmetry of the distributions associated with positive sign of this measure. with in groups, the averages are significantly different: the highest for australia (1.47) and indonesia (1.36) and the lowest for italy and japan (0.84) and korea (0.77).the mean and median are higher in the case of usa (1.55 and 1.13 respectively), reflecting a higher capitalization and /or greater indebtedness over this period. the return (measured by the item ibh.epsmedianfyr1 divided by (ws.totalassets/ ws.common shares outstanding) of the databases worldscope and ibes from thomson reuters) appear higher for the emerging countries (0.103) and usa (0.01) than for other developed countries (0.075) if we consider expected earnings per share normalized by total assets per share. brazil emerges as the best performing country (0.14) and japan as the least (0.04).the ratio of the expected change in earnings per share normalized by total assets per share (measured by the difference of ibh.epsmedianfyr2 and ibh.epsmedianfyr1, divided by (ws.totalassets/ ws.commonsharesoutstanding) of the databases worldscope and ibes from thomson reuters) reinforces this impression. it is higher for the usa (0.018) and emerging (0.014) than for other developed countries (0.10), brazil and japan still occupying the same places. the sample firms belonging to other developed countries are sized (measured by the logarithm of market capitalization in usd: ws.yrendmarketcapusd of worldscope database from thomson reuters) a little larger than those of emerging countries, but smaller than the american ones. the companies are significantly smaller for malaysia, thailand and singapore. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.196-216 202 table 2. descriptive statistics this table presents the synthesis of the values taken in the sample by the 3 basic selected variable used in the chosen model, i.e. market capitalization at year end, expected earnings per share for the coming year and expected earnings growth for the following year .all these variables are normalized by total assets for the first, by total assets divided by number of shares for the following two. the table also presents a measure of the size of companies selected through the natural logarithm of the market capitalization. the sample contains for all the countries only the companies whose year end is 31 december (30 june for australia and 31 march for japan). the study period extends from 2001-2008.the data come from worldscope and ibes databases provided by thomson financial panel a : market capitalization / total assets expected eps / total assets per share eaxpected eps variation / total assets per sahre mean median s.d mean median s.d mean median s.d usa 1.55 1.13 1.37 0.10 0.08 0.09 0.018 0.012 0.026 germany 1,11 0,72 1,19 0,07 0,06 0,06 0,012 0,008 0,015 australia 1,47 1,06 1,36 0,11 0,08 0,10 0,017 0,010 0,036 canada 1,11 0,90 0,80 0,08 0,06 0,06 0,009 0,005 0,027 france 0,99 0,70 0,93 0,07 0,05 0,04 0,009 0,007 0,012 italy 0,84 0,67 0,66 0,05 0,05 0,03 0,007 0,006 0,008 japan 0,84 0,64 0,68 0,04 0,04 0,03 0,006 0,004 0,007 united kingdom 1,23 0,96 0,96 0,09 0,07 0,07 0,009 0,007 0,023 sweden 1,22 0,98 1,03 0,09 0,08 0,05 0,012 0,010 0,018 mean 1,10 0,83 0,95 0,075 0,061 0,055 0,010 0,007 0,018 brazil 0,96 0,77 0,72 0,14 0,09 0,37 0,021 0,015 0,031 china 1,11 0,76 1,14 0,08 0,07 0,06 0,012 0,007 0,022 korea 0,77 0,55 0,80 0,08 0,07 0,06 0,012 0,008 0,021 hong-kong 1,24 0,90 1,06 0,09 0,08 0,07 0,014 0,009 0,027 indonesia 1,36 0,82 1,58 0,13 0,11 0,10 0,015 0,013 0,028 malaysia 1,09 0,75 1,11 0,10 0,08 0,07 0,011 0,009 0,016 singapore 1,01 0,81 0,73 0,10 0,09 0,06 0,017 0,013 0,021 taiwan 1,27 0,97 1,02 0,11 0,10 0,08 0,012 0,008 0,031 thaïland 0,98 0,77 0,79 0,10 0,08 0,06 0,011 0,009 0,021 mean 1,09 0,79 0,99 0,103 0,086 0,103 0,014 0,010 0,024 panel b : size variation of sales over 2 years in % variation over 2 year of book value of equity in excess of net income in % ratio of invetsment over 2 years compared to depreciation allowances mean mean median s.d mean median s.d mean median s.d usa 7.72 0.39 0.25 0.51 0.10 -0.02 0.68 1.35 1.10 0.87 germany 6,91 0.22 0.16 0.31 -0.02 -0.08 0.33 1.14 1.02 0.63 australia 6,05 0.69 0.33 1.26 0.28 -0.06 1.27 2.04 1.30 2.70 canada 7,14 0.56 0.29 0.95 0.15 -0.05 0.67 1.88 1.42 1.72 france 7,00 0.25 0.16 0.34 0.02 -0.08 0.41 1.22 1.12 0.69 italy 7,37 0.25 0.17 0.34 -0.08 -0.12 0.25 1.23 1.00 0.81 japan 7,21 0.13 0.10 0.17 0.01 -0.02 0.13 1.20 1.10 0.56 united kingdom 6,96 0.35 0.21 0.62 0.03 -0.11 0.73 1.26 1.02 0.93 sweden 6,77 0.31 0.20 0.47 -0.03 -0.13 0.52 0.99 0.90 0.58 mean 6,93 0.34 0.20 0.56 0.04 -0.08 0.54 1.37 1.11 1.08 brazil 7,65 0.43 0.35 0.35 -0.09 -0.16 0.55 1.71 1.50 0.93 china 6,97 0.61 0.48 0.53 0.03 -0.04 0.23 2.48 2.19 1.58 korea 7,37 0.27 0.23 0.29 -0.02 -0.04 0.24 1.64 1.39 1.00 hong-kong 6,93 0.51 0.34 0.69 0.13 -0.05 0.71 2.40 1.68 2.07 indonesia 6,32 0.51 0.41 0.41 -0.03 -0.09 0.56 1.88 1.63 1.16 malaysia 5,44 0.40 0.28 0.46 -0.01 -0.05 0.23 1.85 1.49 1.30 stock prices and implied abnormal earnings growth 203 singapore 5,83 0.45 0.34 0.50 -0.01 -0.07 0.35 1.90 1.51 1.25 taiwan 6,95 0.48 0.40 0.44 -0.05 -0.07 0.23 1.79 1.57 1.13 thaïland 5,63 0.34 0.25 0.36 -0.09 -0.14 0.32 1.66 1.38 1.25 mean 6,57 0.45 0.34 0.45 -0.02 -0.08 0.38 1.93 1.59 1.30 the accounting measures of past growth were selected based on the methodology inspired by hribar and yehuda (hribar & yehuda, 2008). three basic variables were measured: the variation of sales over 2 years in %, variation of book value of equity in excess of net income in%, and the ratio of investment over 2 years compared to past depreciation during these past years (measured by the items ws.sales, ws.totalcommonequity, ws.netincome, and ws.capitalexpenditurescfstmt ws.depreciationdeplamortexpense of worldscope database from thomson reuters). according to the first and the third indicator, the emerging countries have experienced the sharpest growth. these variables measuring the past growth have been combined into a synthetic indicator which varies from 0 (lowest growth) to 1 (highest growth). the detailed calculation of this indicator is given in annex. 4. the empirical results we comment, in the first paragraph, the different level of association between market values, expected earnings and their expected variation while omitting the supposed impact of dividends. we, then, discuss the possible effects of the bias associated with used forecasts. finally, we propose a series of estimates of the expected implicit rates of return derived from these association relations. 4.1 association between market values and expected earnings without taking into account dividends the estimation of the equation (7) requires a preliminary measurement of the rate r to calculate the abnormal earnings growth. since this rate is not directly observable and that it intervenes in the calculation of expected earnings per share cum dividend, we initially ignore the impact of r ∙ dps . table 3 provides an estimate for 18 countries studied. expected earnings per share for the next year are significantly associated with stock prices in all countries. the primary role of expected earnings in valuation is therefore general, even if the intensity of the association varies considerably (8.77 on average for emerging countries against 6.81 for the usa and 12.10 for other developed countries. the increase in earnings per share is significantly associated with market value in the case of developed countries but this is not always true in case of emerging countries (the coefficients are not significant for brazil and malaysia).the average of these coefficients is 15.63 for usa, 19.79 for other developed countries and 26.7 for emerging countries. the coefficient associated with the composite measure of growth are mostly negative and nonsignificant in developed countries (-0.047 for the usa and on average -0.006 for others),with a notable exception of japan (0.188). this coefficient is positive on average in emerging markets (0.200) but significant only for hong kong, indonesia, malaysia and thailand. note that according to the equation (5), the expected sign for this variable depends on that of the term h. it can be positive and negative according to the degree of persistence and depending on the rate of growth (c), speed (γ)and the ability to persist (δ) which characterize the value creation potential of the firm. when it is negative (positive), only the capitalization of the expected increase in the short-term earnings tends to over value (under value) the share and this factor has made the necessary correction. the empirical results suggest that during this period, growth in short terms earnings was not sustainable over a long period (except japan, which displays very poor performance). in contrast, on average, in the emerging countries, the shortterm variation of earnings does not fully realize long-term growth potential. the coefficients of the variable size are significant in all countries. but it is negative in the usa (-0.022) and in korea and positive in emerging countries (0.124) or other developed countries (0.079). the american sample is large and one that offers the greatest variety of business sizes. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.196-216 204 table 3. association between market values, expected earnings and growth this table presents the estimated values of the coefficients and their t for a regression model whose dependent variable is market capitalization at year end normalized by total assets, and the independent variables are expected earnings per share for the coming year and expected earnings growth for the following year normalized by total assets per share and a synthetic accounting variable measuring the past growth. the size was introduced as a control variable. the regressions were carried out by country with dummies by period. the coefficients t were calculated from “heteroskedasticity consistent standard errors”. the study period extends from 2001 to 2008.the data come from worldscope and ibes databases provided by thomson financial. the observations belonging to extreme percentiles for the dependent variable and the first two independent variables have been eliminated. finally, we have conserved companies appearing at least three times during the period. eps1 eps2-eps1 growth rank size number of observations b1 t b2 t b3 t b4 t r2 f usa 6.810 21.356 15.629 14.187 -0.047 -1.014 -0.022 -3.423 0.423 354.609 5 333 germany 12.922 15.080 32.073 5.353 0.040 0.416 0.092 6.495 0.751 158.052 588 australia 8.916 10.496 12.206 3.717 0.273 2.423 0.114 6.775 0.642 111.390 695 canada 8.085 15.259 8.533 6.033 -0.349 -3.772 0.073 6.599 0.545 71.331 667 france 14.564 17.328 21.376 6.792 0.028 0.341 0.068 7.762 0.704 148.086 698 italy 13.253 17.161 23.849 5.985 0.071 0.931 0.054 4.579 0.760 84.716 307 japan 15.635 50.469 21.149 13.787 0.188 9.095 0.056 12.805 0.745 900.015 3 400 united kingdom 9.975 11.951 17.493 7.509 -0.102 -1.038 0.119 10.035 0.577 104.262 852 sweden 13.479 23.884 21.653 5.786 -0.196 -1.494 0.058 4.253 0.750 96.495 365 other developed countries 12.104 19.792 -0.006 0.079 7 572 brazil 4.729 4.475 1.384 0.695 0.114 0.836 0.162 5.514 0.436 13.862 209 china 6.136 4.962 11.447 2.025 0.160 0.907 0.106 3.719 0.313 11.049 279 korea 9.325 8.367 6.084 2.828 0.147 1.105 -0.036 -1.826 0.601 33.479 256 hong-kong 8.865 14.432 9.473 5.853 0.454 3.972 0.181 10.894 0.568 64.672 552 indonesia 10.333 9.111 9.736 3.336 0.326 2.280 0.158 4.835 0.801 70.107 203 malaysia 11.706 23.695 -0.412 -0.183 0.331 4.116 0.108 4.326 0.772 120.188 402 singapore 9.595 13.413 12.575 4.776 0.003 0.022 0.202 11.016 0.691 47.254 244 taïwan 10.048 27.407 8.152 6.129 0.042 0.649 0.099 7.136 0.821 173.904 430 thaïland 8.204 10.124 6.868 2.858 0.224 2.612 0.134 7.656 0.657 56.446 336 emerging countries 8.771 7.256 0.200 0.124 2 911 4.2 quality of forecasts and association of variables. the coverage of various stocks by financial analysts is certainly uneven in quantity and quality according to the countries concerned. it is not, therefore, clear that the eps forecast reported by ibes constitute a measure of market expectations, endowed with a homogeneous quality. table 4 provides a series of measures of forecast errors characterizing each country at the end of the period. the average absolute error represents 4.76% of average score in usa, 12.01% in other developed countries and 14.42% in emerging countries. the quality of forecasts is significantly higher in the usa. the disparities among countries are strong: italy and brazil have the highest values, while australia and taiwan have the lowest. the average error is positive, suggesting that analysts are pessimistic before publication of earnings, either because they have been conducted by the management (“earning guidance”) or because they are encouraged not to displease the firms: 0.93% of average score in usa, 2.95 % for other developed countries and 0.57% for emerging countries. however, disparities are very large among countries. the averages are thus negative for australia and japan and for more than half of emerging countries. it is possible that analysts’ behaviors are very heterogeneous. if during this period fd regulation has, for example, prompted financial analysts to no longer express an unfounded optimism to usa, the situation had been different in other countries. therefore, it is possible that the market holds expectations for the coming earnings per share, in some cases exceed the forecast reported by ibes, and in other lower. the quality of estimates of association links between expected earnings and market value is affected. stock prices and implied abnormal earnings growth 205 table 4. forecast errors and initial optimism this table presents the forecast errors for earnings per share for the year studied. the errors are estimated from the available year end forecast. the values were normalized by total assets per share. the mean values provide an estimate of bias, that of absolute values a measure of precision. these mean values were divided by the ratio of expected eps divided by total assets per share to obtain a measure of earnings in %. this estimate was preferred to the mean of relative errors, given the presence of low values for certain earnings per share. the initial optimism is measured by the ratio: difference between earnings per share forecast at the beginning of the year and eps realized in the previous year, divided by total assets per share at the beginning of the year. the study period extends from 2001 to 2008.the data come from worldscope and ibes databases provided by thomson financial. the sample is that used previously, except for the measurement of initial optimism which lack certain observations because of the lag of a year. error = (eps realeps expected) / total assets per share eps expected / total assets per share ratios compared to mean expected eps initial optimism value absolute value value mean error / mean value mean s.d value mean s.d mean s.d mean mean s.d usa 0.09% 1.55% 0.46% 1.48% 9.68% 0.93% 4.76% 17.22% 35.23% germany 0.28% 1.50% 0.89% 1.24% 6.97% 4.05% 12.69% 20.05% 83.92% australia -0.04% 1.97% 0.88% 1.77% 10.50% -0.39% 8.37% 20.46% 54.34% canada 0.01% 1.24% 0.67% 1.05% 7.23% 0.18% 9.28% 14.44% 41.55% france 0.35% 1.74% 0.87% 1.55% 6.30% 5.57% 13.79% 10.53% 40.20% italy 0.47% 2.55% 1.00% 2.40% 5.45% 8.63% 18.27% 5.56% 54.94% japan -0.03% 0.77% 0.44% 0.63% 4.36% -0.75% 10.14% 20.47% 47.92% united kingdom 0.21% 1.84% 0.96% 1.59% 7.91% 2.61% 12.09% 12.02% 30.50% sweden 0.31% 1.76% 0.96% 1.50% 8.36% 3.72% 11.47% 16.79% 57.87% other developed countries 0.20% 1.67% 0.83% 1.47% 7.13% 2.95% 12.01% 15.04% 51.40% brazil 0.24% 3.76% 1.88% 3.27% 10.57% 2.24% 17.82% 39.33% 267.16% china -0.11% 1.51% 0.86% 1.25% 7.44% -1.49% 11.60% 14.24% 34.24% korea -0.01% 1.53% 1.00% 1.16% 7.32% -0.13% 13.68% 15.96% 38.80% hong kong 0.00% 2.91% 1.37% 2.57% 8.95% -0.05% 15.31% 14.35% 41.79% indonesia -0.57% 4.23% 2.10% 3.71% 12.25% -4.63% 17.17% 16.97% 42.54% malaysia 0.43% 4.00% 1.50% 3.73% 9.16% 4.68% 16.34% 13.91% 50.46% singapore 0.51% 4.46% 1.48% 4.23% 9.38% 5.47% 15.84% 11.18% 41.84% taiwan -0.15% 1.76% 1.05% 1.42% 10.76% -1.43% 9.75% 15.40% 29.62% thailand 0.04% 1.87% 1.13% 1.50% 9.20% 0.45% 12.26% 16.80% 50.44% emerging countries 0.04% 2.89% 1.38% 2.54% 9.45% 0.57% 14.42% 17.57% 66.32% the analysts’ behavior can vary according to the forecast horizon, with in the same country. more it is distant, more it is difficult to verify the acuteness and more it is easy to be optimistic. bartov et al. (2002) suggest that analysts have an interest in optimism at the beginning of the year and then to revise gradually their forecasts to end the year in pessimistic situation. they accumulate the advantage of revealing flattering long term forecasts without exposing business leaders to announce disappointing realized results. to characterize a possible initial optimism, we have calculated the gap in the beginning of the year between the forecast earnings and last known earning per share, which is to say that of the past year. all these measured have been normalized by total assets per share. the averages shown in table 4 reflect a general optimism: the expected evolution expressed in % of average earnings for concerned countries is of 17.22% in usa, 15.4% in other developed countries and 17.57% in emerging countries. the presence of a bias in the beginning of a period and a possibly different bias at the end of the period doubly affect the measurement of the expected variation of earnings per share. if the forecast for one year is optimistic and the short-term pessimistic, the variation between the two overestimates the progression really expected by the market. if the short-term forecast is infected with a sense of optimism, but that of one year is little concerned the same variation under estimate the actually international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.196-216 206 anticipated growth. finally, if only the forecast in the short term is biased, the impact is identical on both variables: expected earnings and anticipated growth and these variables are found correlated. to isolate the most severe effects of these manipulations of forecasts, we are inspired by the method used by tian (2009). we isolated in each country the forecast likely to be most affected by manipulation. to do this, we have used two criteria. first, the forecast (firm-year) must be initially optimistic (the expected earnings early in the year is higher than the earnings per share published last year). second, the revision of the forecast during the period must be abnormally pessimistic. to determine this second point, we have regressed, for each country, the variation of the forecasts during the period (normalized by total assets per share) on the stock return over the same period in order to eliminate the impact of the information taken into account by the market. we, then, calculated the forecasting residuals and we considered that if these residuals were negative and positive initial optimism, then we were faced with a case which could be suspected of strong manipulation. table 5 resumed the regression carried out in table 3 but by combining a dummy variable taking the value 1 in a suspected case of manipulation and variables related to earnings and variation of earnings. the results obtained in the american market are as per expectations. the suspected cases of manipulation of the forecasts are associated with a coefficient of valuation of expected earnings significantly higher (a difference of 1.634). the market “would correct” the under estimation by the analysts. the coefficients associated to expected variations of earnings is negative but nonsignificant (-0.025). the correction coefficients related to growth is negative (-0.177) but becomes significant. in contrast, the effects are negligible for other developed countries (with the exception of germany). the lack of results may be due to the small size of samples or less elaborated forecasts management by analysts. 4.3 estimation of expected implied rate of return and implied absnormal growth by country taking into account the dividends per share in the estimation of equation (7) requires knowledge of the expected rate of return r. moreover, if the theoretical model is verified; the same rate r should be equal to ∙ + − ∙ . to avoid having to assume zero dividends and thereby introducing a bias in the estimation of the expected implicit rate of return, we proceed iteratively until this implicit rate for the country concerned is equal to that which we used to calculate the abnormal earnings growth. the estimates of the rate r and g were obtained from the coefficients of β1 and β2, only. this allows avoiding taking into account the effects related to the manipulation of forecasts. it is likely that in these cases, the market “corrects” the analysts’ forecasts and the coefficient obtained would be affected by this correction (see (easton & sommers, 2007)). the results obtained in paragraph 4.1 are confirmed in table 6. in all countries expected earnings by the analysts is strongly associated with market value. the coefficients vary across geographic zones (7.27 in usa, 11.39 for other developed countries and 7.90 for emerging countries).the increase in earnings per share is strongly associated with market value in the case of other developed countries but this is not always the case in emerging countries. in the case of developed countries, using a peg1 based heuristics helps to improve the analysis of the market value of securities, beyond the information provided by the forward pe ratio. these two determinants can lead to overvaluation and require correction (case of usa and canada where the coefficients associated with the composite variable of growth is significantly negative) and more rarely to an undervaluation (japan).the results are mixed for emerging countries. the information content of the expected abnormal increase in earnings per share appears more limited. the coefficients associated are much lower (not meaningful for brazil). the links between market value and earnings are more difficult to identify solely from the next two years earnings per share forecast. the reason can come from lower quality financial analysis. but also, the values are certainly dependent on other factors describing the growth opportunities in long term. the historical measurement of the past growth is of little use (coefficients significant in 3 cases out of 9). the traditional valuation heuristics should therefore be handled with much more prudence in these environments. 1 it is not, here, expected earnings per share but a measure of abnormal growth. stock prices and implied abnormal earnings growth 207 table 5. association between market values, expected earnings, growth and manipulation of forecasts this tables table presents the estimated values of the coefficients and their t for a regression model whose dependent variable is market capitalization at year end normalized by total assets, and independent variables are expected earnings per share for the coming year and expected earnings growth for the following year normalized by total assets per share and a synthetic variable measuring the past growth. the size was introduced as a control variable. the dummy variable dm takes the value 1 if a manipulation index has been estimated. the regressions were carried out by country with dummies by period. the coefficients t were calculated from “heteroskedasticity consistent standard errors”. the study period extends from 2001 to 2008.the data come from worldscope and ibes databases provided by thomson financial. the observations belonging to extreme percentiles for the dependent variables and the first two independent variables were eliminated. finally, we have conserved companies appearing at least three times during the period. eps1 eps1*dm eps2-eps1 eps2-eps1*dm growth rank size number of obs. b1 t b1m t b2 t b2m t b3 t b4 t r2 f usa 7.466 21.679 1.634 2.859 17.299 13.712 -0.025 -0.009 -0.117 -2.279 0.028 3.521 0.463 433.489 5 533 germany 12.409 13.778 5.618 1.594 36.372 5.322 -27.435 -2.920 0.062 0.632 0.090 6.564 0.751 158.052 588 australia 9.320 10.590 -1.520 -1.092 12.076 4.345 -0.155 -0.013 0.251 2.234 0.113 6.831 0.642 111.390 695 canada 8.056 14.982 0.573 0.759 7.784 4.824 2.266 0.671 -0.333 -3.559 0.073 6.646 0.545 71.331 667 france 14.431 16.952 -0.340 -0.304 22.804 6.355 -7.080 -1.317 0.034 0.422 0.065 7.556 0.704 148.086 698 italy 12.949 16.314 1.658 1.285 25.930 5.640 -8.797 -1.255 0.062 0.791 0.056 4.563 0.760 84.716 307 japan 15.510 47.160 0.694 1.293 22.000 13.032 -3.115 -0.930 0.187 9.076 0.057 12.252 0.745 900.015 3 400 united kingdom 10.070 11.782 0.072 0.075 16.733 5.910 3.082 0.701 -0.103 -1.059 0.120 10.163 0.577 104.262 852 sweden 13.431 23.827 0.118 0.099 21.988 5.282 -1.788 -0.297 -0.190 -1.511 0.057 4.233 0.750 96.495 365 other developed countries 12.022 0.859 20.711 -5.378 -0.004 0.079 7 572 brazil 4.210 3.481 0.929 0.837 -1.138 -0.235 3.661 0.683 0.121 0.880 0.151 5.332 0.436 13.862 209 china 6.088 4.836 -0.426 -0.233 8.651 2.541 8.448 0.533 0.160 0.904 0.108 3.629 0.313 11.049 279 korea 9.549 8.959 -2.615 -2.061 7.916 2.855 -2.347 -0.754 0.150 1.163 -0.036 -1.839 0.601 33.479 256 hong kong 8.447 14.082 2.908 2.256 9.213 5.516 -2.716 -0.535 0.467 4.172 0.187 11.351 0.568 64.672 552 indonesia 9.474 10.728 2.380 1.376 7.647 4.402 1.798 0.228 0.331 2.286 0.164 4.977 0.801 70.107 203 malaysia 11.734 20.009 -0.114 -0.151 -0.648 -0.255 0.717 0.173 0.330 4.006 0.108 4.292 0.772 120.188 402 singapore 9.590 14.592 2.080 1.165 12.042 5.283 -1.830 -0.230 0.039 0.335 0.209 11.209 0.691 47.254 244 taiwan 9.984 27.565 -0.152 -0.269 6.428 6.004 8.716 2.758 0.056 0.876 0.098 7.447 0.821 173.904 430 thailand 8.207 10.109 0.325 0.276 6.853 2.736 0.706 0.116 0.225 2.607 0.135 7.520 0.657 56.446 336 emerging countries 8.587 0.591 6.329 1.906 0.209 0.125 2 911 the model appears to capture a hierarchy of expected rates of return, although estimates for emerging markets remain very imprecise, country by country. the estimates of expected rates of return are respectively of 10.9% for usa, 8% for other developed countries and 12.3% for the emerging countries. within the last two zones, the estimates vary across countries. for developed countries, the expected returns are lowest in japan (6.0%) and in the eurozone (6.5% for france and 7% for germany) and the highest in canada (11.4%) and australia (10.1%) among emerging countries, brazil (24.7%) and china (14.8%) topped. malaysia (8.8%) , taiwan(9.7%), singapore (9.8%) and korea (9.9%) are in the tail. the implicit values of the parameter g which governs the abnormal earnings growth are strongly negative (-0.406 for usa, on average of -0.595 for developed countries and 1.013 for emerging countries2 (-0.083 if we limit the extreme value to -1). it is interesting to note that no estimates approach the hypothesis advanced by ohlson and juettner –nauroth, namely a positive value close to a long-term rate of growth. 2 this factor cannot be below -1, according to our model. no value appears significantly lower, except the case of malaysia. international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.196-216 208 5. robustness tests the valuation of assets depends in the model used on the discount rate required by the market. initially, we study the effects of two factors associated in the literature to the discount rate, the book to market ratio and the size. then, we take into account the differences in precision in the earnings per share forecast. on the one hand, we can assume that more the forecasts are imprecise, the higher the risk. on the other hand, the more forecasts are precise, the more consensuses of analysts is close to market expectations. in both cases the measures of association should be affected. we, then, assume that the coefficients of persistence (δ) and speed ( γ) that characterize this model may differ if the abnormal growth is positive , or if it is negative. we replicate the test on a sub-sample composed solely of positive expected variations. finally, we conduct a direct estimate of the coefficient g which governs the dynamics of the abnormal growth in earnings per share and compare with the implicit estimates derived from the model. 5.1 implied rate of return and risk factors we classified the companies of each country into two subcategories, those whose studied factor is low and those with high studied factor. the same method was used for the book-to-market ratio and for the size. as these ratios vary country by country and year by year, we chose to classify by companies and not by firm-year to avoid introducing the bias related to the period. the classification is carried out according to the following protocol. for each country, firms in the sample 2008 were divided into two groups around the median of used indicator (bm ratio or size). the same companies were taken in 2007. for those contained therein; the average ratio was performed for each of the sub-groups. if a company appears in 2007 and does not exist in the sample in 2008, it is classified in the sub-population to whom it is the nearest (the smallest distance from its indicator compared to the two averages). the classification is retained for the following. the same approach is repeated in 2006 and beyond. thus, for each of the indicator (bm ratio or size), once a company is classified in her country as big or small. the classification has the advantage of being independent of years and the inconvenience of not taking into account a possible change in the characteristics of the company over the period. from table 7 we can see that companies with the ratio “book to market” high generally have a low coefficient associated with expected earnings (exceptions are italy and united kingdom for developed countries and china for emerging countries): 2.92 against 6.27 to usa, 8.40 against 9.73 for other developed countries and 4.19 against 7.72 for the emerging countries. the observation is consistent with two explanations: (i) the per are lower for these companies, (ii) the weight of per is more reduced in the valuation of shares. the test does not make it possible to decide between these two reasons. the same observation can be made for the coefficient associated with the expected abnormal variation of earnings per share. we have 4.52 against 17.48 for the usa, 8.68 against 20.80 for other developed countries and 2.93 against 7.38 for emerging (with the exception of italy and united kingdom). the contribution of amended peg in the valuation is certainly much reduced for these populations which probably contain many business of extremely poor performance. the expected implied rate of return is high for companies with the high “book to market” ratio in the three geographic zones. this hierarchy is consistent with the presence of a stronger risk factor for these sub-samples, although the rate obtained for us companies in high ratio seems extremely high (24.8%). finally, the synthetic coefficient g, linked to persistence (δ) and the speed (γ) of abnormal growth is lower for firms of “book to market” ratio high. this is consistent with the presence of fewer opportunities for growth, even in the existence of deceleration of expected abnormal earnings. companies of big size as a general rule have a higher coefficient associated with expected earnings (the only exceptions are australia and united kingdom) :7.59 against 6.94 for usa , 12.23 against 10.30 for other developed countries and 8.64 against 6.59 for the emerging countries. the observation is compatible with two explanations: (i) the per are higher for these companies, (ii) the weight of per is greater in the valuation of shares. the same observation cannot be carried out for the coefficient associated with the expected abnormal variation of earnings per share. we have a smaller coefficient for large companies in usa (16.57 against 18.15) and the opposite in the other two zones (27.15 against 15.52 for other developed countries and 12.36 against 5.52 for emerging), with two exceptions canada and korea. it is possible that the u.s. sample contains relatively more small performing businesses, for which the market has more visibility on their future growth. the expected implied rate of return is greater for small businesses within the 3 geographic zones. this hierarchy is consistent with the presence of a risk factor related to the size, but the difference between the obtained rates for us stock prices and implied abnormal earnings growth 209 companies is low (10.7% against 11.2%). finally, the synthetic coefficient g, linked to persistence (δ) and speed (γ) of abnormal growth is lower for small firms in other developed countries and emerging countries and slightly higher in usa. this is consistent with the presence of more numerous growth firms in the american sub-sample of small companies. 5.2 implied return and precision of forecasts the precision with which the analysts forecast the earnings per share can have a double influence on the parameter of the valuation model. on one hand, the more the analysts’ forecasts are accurate, the greater the correlation with market expectations. the measurement errors in dependent variables are reduced. on the other hand, the forecast error may be related to risk of asset/share. the more it is difficult to predict the earnings, the more high is the risk of a share. in this case, one can hypothesize that the rate of return required by shareholders should be higher. the forecast error is measured by the absolute value of the difference between the consensus of analysts at year and the final earnings reported by ibes, so benefiting from homogenous measurement. the difference is normalized, as is always the case, by the value of share in the beginning of year. for each country separately, the companies were ranked according to these normalized differences in two groups: those with high precision (values below the median) and those with a low precision. the table 8 shows that in developed countries, the coefficient associated to expected earnings is higher when the precision is high (8.38 against 6.53 in the usa, 12.26 against 10.59 in other developed countries except the united kingdom and sweden). the differences are not significant in emerging countries. this may be due to a lower rate of return required by shareholders and therefore a higher per or a better measure of expected earnings. the effect is less noticeable for emerging countries where in general the link between the market value and expected earnings by the analysts is less strong. the expected effect on the coefficient associated with the abnormal variation of earnings is more ambiguous. on the one side, if the forecast error is correlated with a risk factor, the lower rate of return increases the value of the coefficient. it is the same if the variation expected by the market is measured with less error. on the other hand, it is possible that the companies whose performances are most difficult to predict are those who benefit from more opportunities of growth. if these last are persistent, then the parameter g of the model is larger and the coefficient associated higher. but it is also possible that the reverse is true. we see in the table 8 that in the usa the coefficient is greater when the precision is high (25.31 against 16.31) and that it is smaller in other developed countries (17.58 against 22.54 with the exception of australia and canada) and in most emerging countries. 5.3 direct estimates of the rates of persistence of the abnormal earnings growth one of the results presented concerns the dynamics of the “abnormal” growth of earnings per share. contrary to the hypothesis advanced by ohlson and juettner-nauroth (2005), the theoretical model developed in section 2 suggest that this abnormal growth does not necessarily follow a constant increase in the long term, but on the contrary guided by various dynamics of which some are compatible with limited persistence. the implicit measures that are derived from the estimates of the associated coefficients of expected earnings and from expected abnormal growth are all consistent with the hypothesis of limited persistence (the negative parameter g). in order to complement this empirical result, we proceeded to the estimation of an autoregressive model with a lag of one year for expected abnormal variation. the need to dispose of consecutive measurement has reduced the size of the sample. the table 9 provides the obtained results. it can be noted that for the most important sample, the usa, the two estimates of g are very close (-0.394 and -0.399). in the case of other developed countries, the direct estimate is higher than implicit (-0.364 and -0.521), while remaining in the order of the magnitude not too far, except for canada. in the case of emerging countries, the differences are more marked (-0.456 and -1.136) and especially the found implicit values are smaller than -1. as the implicit values of the g are obtained from the relationg = − , the errors contained in the implicit values most certainly come from an under valuation of the coefficient β attached to the abnormal growth. the values found in emerging countries and canada are low in comparison to those obtained in other countries, growth in earnings per share are less well anticipated by the consensus of the analysts. it is also noted that these samples are small in size. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.196-216 issn: 2146-4138 www.econjournals.com 210 table 6. expected implicit rates of return as a function of market value, expected earnings and growth this tables presents the estimated values for the coefficients and their t for a regression model whose dependent variable is market capitalization at year-end normalized by total assets, and the independent variables are the earnings per share for the coming year and increase in expected earnings for the following year plus the income generated by the reinvestment of dividends and normalized by total assets per share, the same variable multiplied by a dummy variable indicating the suspected manipulation of forecast and a synthetic accounting variable measuring the past growth. the size was introduced as a control variable, as well as dummy variable for each reporting year. the regression were carried out by country , but taking into account all the years. the coefficients for year dummies are not reported. the coefficients t were calculated from “heteroskedasticity consistent standard errors”. the study period extends from 2001 to 2008.the data come from worldscope and ibes databases provided by thomson financial. eps1 [eps1]*dm eps2-eps1+r.dps1 [eps2-eps1+r.dps1 ]*dm growth rank size implicites measures no. of obs. 1 t 1m t 2 t 2m t 3 t 4 t r 2 r g usa 7.265 21.071 1.697 2.810 17.883 14.174 -0.113 -0.039 -0.140 -2.720 0.022 2.843 0.472 10.9% -0.406 5 533 germany 11.849 12.093 6.057 1.677 34.672 5.255 -25.987 -2.825 0.024 0.250 0.088 6.296 0.747 7.0% -0.342 588 australia 8.564 9.436 -1.473 -1.155 13.690 4.659 1.101 0.103 0.172 1.551 0.117 7.548 0.667 10.1% -0.626 695 canada 7.894 14.504 0.608 0.782 7.478 4.376 2.823 0.823 -0.359 -3.738 0.073 6.585 0.544 11.4% -1.056 667 france 13.862 16.126 -0.079 -0.064 23.977 6.650 -8.138 -1.483 0.016 0.199 0.063 7.482 0.710 6.5% -0.578 698 italy 11.536 13.738 2.882 1.916 29.489 4.583 -13.781 -1.952 0.018 0.236 0.054 4.574 0.772 7.3% -0.390 307 japan 15.252 44.817 0.703 1.241 22.295 12.253 -3.101 -0.944 0.180 8.772 0.057 12.348 0.746 6.0% -0.684 3 400 united kingdom 9.646 11.235 0.123 0.121 17.487 6.180 2.328 0.549 -0.164 -1.659 0.117 10.066 0.585 8.9% -0.549 852 sweden 12.539 22.766 0.211 0.177 23.422 5.558 -2.114 -0.332 -0.226 -1.818 0.054 4.132 0.763 7.0% -0.535 365 other developed countries 11.393 1.129 21.564 -5.859 -0.042 0.078 8.0% -0.595 7 172 brazil 2.959 2.168 1.013 0.870 4.400 1.580 1.843 0.563 0.141 1.030 0.148 5.188 0.488 24.7% -0.673 209 china 5.449 4.258 -2.071 -0.687 8.860 2.883 14.428 0.798 0.160 0.908 0.110 3.747 0.328 14.8% -0.615 279 korea 9.314 8.547 -2.574 -1.967 8.250 3.167 -2.282 -0.731 0.138 1.098 -0.037 -1.857 0.627 9.9% -1.129 256 hong kong 7.652 12.866 2.325 1.574 11.551 6.691 -0.238 -0.044 0.432 4.031 0.188 11.488 0.598 11.2% -0.662 552 indonesia 8.870 11.636 1.684 0.962 8.740 4.383 4.698 0.672 0.284 1.980 0.152 4.844 0.831 10.2% -1.015 203 malaysia 10.925 17.689 0.253 0.281 5.415 2.278 -2.913 -0.707 0.353 4.279 0.113 4.620 0.775 8.8% -2.018 402 singapore 8.850 12.679 3.264 1.910 13.770 6.503 -6.916 -1.141 -0.016 -0.142 0.205 11.005 0.707 9.8% -0.643 244 taiwan 9.644 26.248 -0.438 -0.684 6.491 6.109 7.982 2.433 0.019 0.290 0.096 7.290 0.828 9.7% -1.486 430 thailand 7.428 9.397 0.610 0.501 8.501 3.643 -0.132 -0.022 0.204 2.419 0.136 7.691 0.668 11.9% -0.874 336 emerging countries 7.899 0.452 8.442 1.830 0.191 0.123 12.3% -1.013 2 911 stock prices and implied abnormal earnings growth 211 table 7. expected implicit rates of return by country and risk factors this table presents the estimated values of the first two coefficients and their t for a regression model whose dependent variables is market capitalization at year-end normalized by total assets, and the independent variables are the expected earnings per share for coming year and expected increase in earnings for the following year plus the income generated by the reinvestment of dividends and normalized by total assets per share, the same variables multiplied by a dummy variable indicating the suspected manipulation of forecasts and a synthetic accounting variable measuring the past growth. the size was introduced as a control variable, as well as dummy variables for each reporting year. the regression were carried out by country, but taking into account all the years. the coefficients t were calculated from “heteroskedasticity consistent standard errors”. the study period extends from 2001 to 2008.the data come from worldscope and ibes databases provided by thomson financial. panel a : with partition of the samples according to the book to market ratio low bm ratio high bm ratio eps1 eps2-eps1+r.dps1 implicites measures number of obs. eps1 eps2-eps1+r.dps1 implicites measures number of obs. 1 t 2 t r g 1 t 2 t r g usa 6.272 14.696 17.484 11.081 12.0% -0.359 3 338 2.920 12.139 4.524 6.368 24.8% -0.646 2 195 germany 10.963 9.225 40.292 5.225 7.2% -0.272 349 8.129 12.224 6.211 2.276 11.3% -1.309 239 australia 7.590 6.931 12.799 3.910 11.1% -0.593 405 5.241 6.735 4.502 1.552 16.7% -1.164 290 canada 6.555 9.101 8.079 3.615 13.1% -0.811 361 5.806 11.833 2.272 2.104 16.2% -2.556 306 france 13.714 12.491 27.881 5.593 6.5% -0.492 386 8.201 13.285 7.279 3.650 11.1% -1.127 312 italy 8.745 13.028 6.761 2.575 10.6% -1.294 179 15.468 13.684 18.228 2.507 6.0% -0.849 128 japan 16.081 37.295 24.938 11.310 5.7% -0.645 1 848 9.177 24.815 9.647 6.354 9.9% -0.951 1 552 united kingdom 3.668 11.507 8.578 8.645 18.9% -0.428 440 6.865 6.412 15.764 5.360 11.5% -0.436 412 sweden 10.518 11.997 37.076 6.154 7.5% -0.284 188 8.287 14.176 5.544 3.153 11.2% -1.495 177 other developed countries 9.729 20.801 10.1% -0.602 4 156 8.397 8.681 11.7% -1.236 3 416 brazil 3.789 2.423 3.757 1.058 21.7% -1.008 117 0.067 0.090 3.325 1.432 53.9% -0.020 92 china 2.229 1.212 6.951 1.614 25.2% -0.321 161 4.860 8.535 1.426 0.804 19.5% -3.409 118 korea 10.001 6.925 5.383 1.673 9.5% -1.858 146 4.491 4.880 5.087 3.763 18.4% -0.883 110 hong kong 6.193 8.490 11.296 5.268 13.0% -0.548 313 4.364 10.192 1.597 1.221 21.3% -2.732 239 indonesia 9.884 11.678 10.855 4.274 9.2% -0.911 128 3.819 9.396 2.110 1.744 23.2% -1.810 75 malaysia 10.729 11.770 5.534 1.531 8.9% -1.939 240 4.789 12.720 -0.019 -0.162 nc nc 162 singapore 9.935 8.075 8.209 2.229 9.3% -1.210 137 3.748 6.704 5.624 3.276 20.4% -0.666 107 taiwan 9.949 16.932 6.161 3.874 9.5% -1.615 189 6.330 19.591 3.018 4.323 14.8% -2.097 241 thailand 6.808 6.206 8.278 2.279 12.7% -0.823 194 5.273 14.138 4.168 3.592 16.8% -1.265 142 emerging countries 7.724 7.380 13.2% -1.137 1 625 4.193 2.926 23.5% -1.610 1 286 international journal of economics and financial issues, vol. 4, no. 1, 2014, pp.196-216 212 panel b : with partition of the samples according to size small firms big firms eps1 eps2-eps1+r.dps1 implicites measures number of obs. eps1 eps2-eps1+r.dps1 implicites measures number of obs. 1 t 2 t r g 1 t 2 t r g usa 6.936 13.418 18.152 11.131 11.2% -0.382 2 918 7.593 17.393 16.569 8.706 10.7% -0.458 2 615 germany 10.201 10.032 25.146 3.783 8.2% -0.406 341 12.122 6.710 53.316 4.529 6.4% -0.227 247 australia 10.401 9.885 11.123 3.281 8.8% -0.935 349 6.83 4.980 19.765 3.727 11.1% -0.347 346 canada 7.428 13.037 7.964 3.709 11.9% -0.933 343 8.568 8.473 6.417 2.218 10.8% -1.335 324 france 11.919 17.888 17.179 4.353 7.6% -0.694 413 15.507 9.198 41.920 5.796 5.6% -0.370 285 italy 6.969 11.699 7.934 3.578 12.6% -0.878 156 14.737 16.977 17.979 2.903 6.3% -0.820 151 japan 13.674 33.516 19.878 10.399 6.7% -0.688 1 883 17.126 34.827 29.650 10.543 5.3% -0.578 1 857 united kingdom 10.406 7.473 13.069 3.739 8.7% -0.796 406 9.317 8.426 20.204 4.780 9.0% -0.461 446 sweden 11.389 10.511 21.894 4.138 7.7% -0.520 165 13.657 19.670 27.908 3.822 6.5% -0.489 200 other developed countries 10.298 15.523 9.0% -0.731 4 056 12.233 27.145 7.6% -0.578 3 856 brazil 0.931 0.688 2.895 1.208 44.9% -0.322 93 3.426 2.492 8.343 3.318 19.7% -0.411 116 china 6.119 3.043 2.323 0.478 15.4% -2.635 145 6.956 4.098 8.221 2.200 12.5% -0.846 134 korea 9.063 4.045 11.000 3.411 9.9% -0.824 128 9.595 9.470 4.784 1.696 9.9% -2.006 128 hong kong 6.695 7.945 8.402 5.016 12.9% -0.797 296 8.217 9.708 20.053 5.657 9.8% -0.410 256 indonesia 3.683 10.188 0.103 0.106 27.0% nc 95 10.327 13.454 12.168 5.190 8.8% -0.849 108 malaysia 8.849 13.668 4.298 1.926 10.7% -2.059 202 11.833 14.970 10.075 2.549 7.9% -1.175 200 singapore 8.275 10.099 12.690 5.711 10.4% -0.652 134 10.054 6.982 17.810 2.458 8.6% -0.565 110 taiwan 9.330 23.828 4.709 3.706 10.2% -1.982 245 10.089 16.081 9.468 7.369 9.1% -1.066 185 thailand 6.339 9.621 3.244 1.951 14.7% -1.954 195 7.272 4.758 20.317 4.391 10.6% -0.358 141 emerging countries 6.587 5.518 17.3% -1.403 1 533 8.641 12.360 10.8% -0.854 1 378 international journal of economics and financial issues vol. 4, no. 1, 2014, pp.196-216 issn: 2146-4138 www.econjournals.com 213 table 8. expected implicit rates of return expected by country and forecast accuracy this table presents the estimated values for the first two coefficients and their t for a regression model whose dependent variable is market capitalization at year-end normalized by total assets , and the independent variables are the expected earnings per share for the coming year and expected earnings growth for the for the following year plus the income generated by the reinvestment of dividends and normalized by total assets per share, the same variables multiplied by a dummy variable indicating the suspected manipulation of the forecast and a synthetic accounting variable measuring the past growth. the size was introduced as a control variable, as well as dummy variables for each reporting year. the regressions were carried out by country, but taking into account all the years. the coefficients t were calculated from “heteroskedasticity consistent standard errors”. the study period extends from 2001 to 2008.the data come from worldscope and ibes databases provided by thomson financial. high precision low precision eps1 eps2-eps1+r.dps1 implicites measures no. of obs. eps1 eps2-eps1+r.dps1 implicites measures no. of obs. 1 t 2 t r g 1 t 2 t r g usa 8.378 11.686 25.307 7.988 9.3% -0.331 2 396 6.533 15.954 16.314 12.351 11.8% -0.400 3 137 germany 13.101 11.191 23.294 2.702 6.8% -0.562 321 10.364 8.198 39.355 4.784 7.5% -0.263 267 australia 9.459 11.584 29.451 8.031 8.4% -0.321 405 8.144 7.669 12.304 4.117 10.6% -0.662 309 canada 10.296 11.480 15.613 5.556 8.6% -0.659 392 6.627 9.628 6.200 3.391 13.4% -1.069 275 france 16.182 14.264 22.251 3.704 5.7% -0.727 391 12.510 11.214 23.693 5.046 7.1% -0.528 307 italy 12.670 23.010 3.279 1.558 7.7% -3.864 154 10.775 13.050 33.554 7.035 7.5% -0.321 153 japan 16.325 26.352 16.722 5.282 5.8% -0.976 1 713 13.671 27.589 21.966 10.201 6.6% -0.622 1 687 united kingdom 8.235 9.232 12.775 2.191 10.4% -0.645 440 9.920 7.437 17.683 5.780 8.7% -0.561 412 sweden 11.808 17.732 17.280 6.546 7.6% -0.683 190 12.726 15.213 25.594 4.813 6.9% -0.497 175 other developed countries 12.260 17.583 7.6% -1.055 4 006 10.592 22.544 8.5% -0.565 3 585 brazil 4.172 2.136 2.780 0.521 21.0% -1.506 105 1.971 1.202 6.594 2.142 26.8% -0.299 104 china 0.836 0.224 -1.165 -0.096 nc nc 130 8.890 9.437 8.733 2.859 10.2% -1.018 149 korea 13.323 7.408 3.946 0.802 7.3% -3.377 121 8.994 5.980 6.987 3.205 10.3% -1.287 135 hong kong 7.945 7.099 19.689 4.594 10.1% -0.404 301 7.426 11.607 9.397 5.138 11.7% -0.790 251 indonesia 8.194 9.205 4.133 1.903 11.5% -1.983 115 8.482 7.935 9.436 3.154 10.6% -0.899 88 malaysia 11.351 18.135 6.274 2.196 8.4% -1.809 214 10.947 11.801 5.581 1.537 8.7% -1.961 188 singapore 10.690 8.751 14.396 4.371 8.4% -0.743 137 7.443 8.694 14.479 8.105 11.1% -0.514 107 taiwan 9.167 19.838 9.557 7.870 9.9% -0.959 215 10.023 18.455 5.154 3.615 9.5% -1.945 215 thailand 7.915 7.917 7.184 3.123 11.4% -1.102 181 7.345 6.358 9.696 2.737 11.8% -0.758 155 emerging countries 8.177 7.422 11.0% -1.485 1 519 7.947 8.451 12.3% -1.052 1 392 international journal of economics and financial issues vol. 4, no. 1, 2014, pp.196-216 issn: 2146-4138 www.econjournals.com 214 table 9. direct estimates of the rate of persistence of abnormal earnings growth this table presents the estimated values of the coefficients and their t for a regression model whose dependent variable is expected variation of abnormal earnings eps2-eps1+r.dps1, normalized by total assets per share, and the independent variable is the same variable but shifted by one period. the sample is identical to that of table 11.the estimates of cost of capital have been included. the coefficients t were calculated from “heteroskedasticity consistent standard errors”. the study period extends from 2001 to 2008.the data come from worldscope and ibes databases provided by thomson financial. eps2-eps1+r.dps1 table 11 number of observations 1 t r 2 g g implicite usa 0.606 24.945 0.460 -0.394 -0.399 3 165 germany 0.556 9.056 0.367 -0.444 -0.306 413 australia 0.601 5.504 0.450 -0.399 -0.676 490 canada 0.595 5.635 0.334 -0.405 -0.910 360 france 0.617 11.492 0.410 -0.383 -0.544 477 italy 0.624 11.729 0.461 -0.376 -0.375 209 japan 0.519 19.169 0.310 -0.481 -0.587 2 177 united kingdom 0.806 11.008 0.557 -0.194 -0.394 538 sweden 0.772 9.934 0.585 -0.228 -0.377 243 other developed countries 0.636 -0.364 -0.521 4 907 brazil 0.605 9.289 0.415 -0.395 -0.263 111 china 0.404 4.643 0.231 -0.596 -1.520 137 korea 0.466 4.360 0.255 -0.534 -1.313 130 hong kong 0.688 12.156 0.567 -0.312 -0.458 345 indonesia 0.738 9.349 0.459 -0.272 -0.621 120 malaysia 0.540 5.709 0.355 -0.460 -2.934 253 singapore 0.579 7.804 0.314 -0.421 -0.835 158 taiwan 0.439 8.639 0.352 -0.561 -1.518 193 thailand 0.450 6.979 0.331 -0.550 -0.766 189 emerging countries 0.545 -0.456 -1.136 1 636 6. conclusion the model of the type aeg (for example, (ohlson & juettner-nauroth, 2005), (ohlson & gao, 2006)) provide a parsimonious way of valuing shares by referring to two variables: expected earnings per share and its expected “abnormal” growth. this paper shows that in the context of an international comparison, estimates of these two variables obtained from two years forecasts prepared by financial analysts (source: ibes) are significantly associated with the market values, at least in developed countries. in the latter case, the expected earnings per share in 2 years has an information content that complements a forecasting year. this observation is less evident in the case of the most of emerging countries. the theoretical model that we developed suggest that a valuation based on only these two variables can lead to an under-valuation or to over-valuation according the type of growth experienced by the companies. using a synthetic measure based on past accounting data, we show that in some countries (for example usa, canada), a model of type aeg can lead to an over valuation of companies who have experienced a strong growth in the recent past. the past dynamics cannot be prolonged over a long period and a negative correction term is applied to these companies. in contrast, for others, the growth has not yet led to an increase in earnings per share, enough to account for all the value creation potential of these firms. in most of the emerging countries but also for certainly different reasons in japan, a stock prices and implied abnormal earnings growth 215 positive corrective term is proposed. the study outlines the limitation of aeg models to explain the stock market values. the results suggest that the abnormal growth of earning per share is unlikely to perpetuate by following a constant pace of progress as was initially suggested by ohlson and juettner-naurauth. on a regular basis, the process that seems to best describe the expected evolution of this variable is autoregressive in nature with limited persistence. the estimates for developed countries are coherent on average (around 0.6 to usa and somewhat less for other developed countries). they remain very inaccurate in the case of emerging countries, but still very low. by suggesting using a long term rate of growth, o j-n contributes to propose specification of the models aeg strongly over estimating the values of shares. in addition, by accepting these more complex dynamics for the expected variation of abnormal earnings per share, we can deduce using the models aeg implicit values for the rate of return expected by investors. the results emphasize that these estimates remain consistent with the various commonly recognized factors of risk. finally, we conclude with a practical remark: the combined use of two heuristics that practitioners frequently use in valuation, namely the pe ratio and peg ratio is justified in the context of developed countries and unfortunately less powerful in emerging countries. acknowledgement this research was supported by lille school of finance (faculty of finance, bank and accounting– usdl and skema business school).the authors have received countless advices and comments from eric de bodt. errors and omissions remain their own responsibility. references barth, m.e., beaver, w.h., landsman, w.r. (2001). the relevance of the value relevance literature for financial accounting standard setting: another view. journal of accounting and economics 31, 77-104. bartov, e., givoly, d., hayn, c. (2002). the rewards to meeting or beating earnings expectations. journal of accounting and economics, 33, 173-204. brief, r.p. (2007). accounting valuation models: a short primer. abacus, 43(4), 429-437. easton, p.d., sommers, g.a. (2007). effect of analysts’ optimism on estimates of the expected rate of return implied by earnings forecasts. journal of accounting research, 45(5), 983-1016. gode, d., mohanram, p. (2003). inferring the cost of capital using the ohlson–juettner model. review of accounting studies, 8, 399-431. holthausen, r.w., watts, r.l. (2001). the relevance of the value-relevance literature for financial accounting standard setting. journal of accounting and economics, 31, 3-75. hribar, p., yehuda, n. (2008). reconciling growth and persistence as explanations for accrual mispricing. working paper university of iowa. liu, j., nissim, d., thomas, j. (2007). is cash flow king in valuations ? financial analysts journal, 63(2), 56-68. ohlson, j. a. (2005). on accounting-based valuation formulae. review of accounting studies 10, 323-347. ohlson, j.a., gao, z. (2006). earnings, earnings growth and value. foundations and trends accounting, 1(1), 1-70. ohlson, j., juettner-nauroth, b. (2005). expected eps and eps growth as determinants of value. review of accounting studies, 10(2-3), 349-365. penman, s.h. (2005). discussion of ‘‘on accounting-based valuation formulae’’ and ‘‘expected eps and eps growth as determinants of value". review of accounting studies 10, 367-378. tian, y. (2009). the impact of expectations manipulation on the usefulness of analyst forecasts in firm valuation. working paper university of alberta. walker, m., wang, p. (2003). towards an understanding of profitability analysis within the residual income valuation. accounting and business research, 33(3), 235-246. international journal of economics and financial issues vol. 4, no. 1, 2014, pp.196-216 issn: 2146-4138 www.econjournals.com 216 annex method of calculation of the synthetic variable of growth and company rank according o their stage of growth the synthetic variable y: is defined by: y , = x , , − x , σ , with x = sales sales − 1 x = equities − equities − net income −net income equities x = capital expenditures + capital expenditures depreciation + depreciations we have truncated their values using the fifth percentile as minimum and ninety fifth percentile as a maximum, the reference populations are all profitable firms of the country concerned. i n order to aggregate them; we calculated their values centered and reduced by country. the sum of the variable refers to synthetic growth. companies are then classified each year t as a function of this synthetic variabley.their rank is normalized by the number of observations of the year and noted r , . in order to take into account the persistent phenomenon, we have preferred an aggregate measure over two years.: rc , = (r , + r , )/2. finally, to facilitate interpretation, we calculated : 1 − rc , . international journal of economics and financial issues vol. 2, no. 1, 2012, pp.12-20 issn: 2146-4138 www.econjournals.com central banks’ response to the current financial crisis – between costs and benefits teodora cristina barbu department of money and banking, the bucharest academy of economic studies, romana square, no.6, bucharest, romania. email: teodora_barbu@yahoo.com iustina boitan department of money and banking, the bucharest academy of economic studies, romana square, no.6, bucharest, romania. email: iustinaboitan@yahoo.com abstract: our study is inserted in the thematic area dedicated, during recent years, to the research on central banks’ response to financial crisis. the global financial crisis has outlined a series of weaknesses located at regulatory and supervisory activities’ level, causing major central banks to face a new operating environment, in which traditional monetary policy tools are ineffective (key interest rate close to zero) in restoring the financial markets’ proper functioning. the unconventional monetary policy measures, the dramatic fall of the key interest rate, the balance sheet structure modification and extension of collateral accepted by central banks are the main issues on which we focused our attention, to highlight the costs and benefits recorded by these institutions. all major central banks have implemented highly innovative, flexible facilities and the main beneficiaries have been the banking systems in their entirety. keywords: financial crisis; central banks; unconventional monetary policy jel classifications: e58; g01 1. introduction the global financial crisis, by its severity and huge costs entailed, emphasized the inadequacy of traditional monetary policy instruments and the fact that good macroeconomic fundamentals, such as sustained economic growth, low inflation and unemployment rates, aren’t a guarantee for future financial stability. in response to the financial crisis, which had negative repercussions on macroeconomic environment and the real sector, central banks have resorted, primarily, to an aggressive reduction of monetary policy interest rates, in order to relax monetary policy and increase the banking system’s liquidity. since the key interest rate approached zero in some countries, major central banks such as bank of england, bank of japan, the federal reserve and the european central bank have decided to shift from interest rate targeting to the growth rate of broad money targeting, injecting cash directly into the economy, through non-standard monetary operations. one main feature of unconventional monetary policy measures is the active use of central banks' balance sheet, in order to re-establish the proper functioning of the credit markets, by restoring investors’ confidence and liquidity positions (barbu and boitan, 2012). borio (2009) found that, on the background of recent financial turmoil, it became clear that monetary policy can influence economic activity not only by using interest rate policy, but also through an active and explicit use of the central banks’ balance sheet policy. these measures were justified by two main reasons: first, to maintain price stability, which would not have been possible only by reducing monetary policy interest rates, and secondly, to demonstrate the role of lender of last resort, through which funds were provided to those institutions that recorded short term liquidity deficits. relative to this subject, it is important to mention that the role of lender of last resort has acquired a new dimension, in that liquidity has been provided for the entire financial central banks’ response to the current financial crisis – between costs and benefits 13 market, and not isolatedly, only to few deposit institutions. it can be appreciated, therefore, that through the measures adopted, central banks have restored trust in the financial system. according to buiter and sibert (2007), the flexible innovative nature of central banks arises from supplementing the traditional function of lender-of-last-resort with the market-maker-of-last-resort one, which refers to central banks’ direct intervention on financial instruments markets such as covered bonds, credit default swaps and mortgage-baked securities. this function can be exercised in two ways: either through direct purchases or sales of securities issued by private sector, whose market has become illiquid, or by their inclusion in the collateral accepted for collateralized loans or repurchase agreements. another aspect that emerges from the central banks intervention is the conclusion that the key interest rate close to zero is not the only solution that can be adopted in the crisis. practicing a close to zero monetary policy rate, during long periods of time, creates instability and distortions on financial markets because persistent liquidity can lead to inflationary pressures. these exceptional monetary policy measures significantly changed the risk profile, size and composition of central banks' balance sheets. according to meier (2009), the reputational risk at which central banks are exposed to could be amplified by the possible criticism related to public money waste. loss-making operations, undertaken by the central banks, could weaken the political support for independence and would erode the legitimacy of his mandate. the unconventional monetary policy measures have been classified in three main categories: direct quantitative easing; direct credit easing and indirect (endogenous) credit or quantitative easing. the first two are related to a direct purchase of public or private assets by the central bank, while the latter consists in central bank lending to banks, at different maturities, against extended range of eligible collateral, which is represented by assets whose markets are temporarily impaired or illiquid. when implementing quantitative easing measures, central banks focus mainly on increasing their liability side of the balance sheet, particularly the banks’ reserve accounts at central bank. hence, central banks’ quantitative easing policies are designed to expand the size of the balance sheet. at the core of these policies lies the acquisition of government bonds, which doesn’t change significantly either the central banks’ balance sheet composition or their risk profile. consequently, central banks aren’t exposed to the counterparty risk because the state never defaults, but are exposed to the interest rate risk, as, with the time passing, if their strategy of lowering long term interest rates succeeds, sovereign yields will decrease. meier (2009) adds that, in times of high debt deficits, the outright buying of government bonds exposes the central bank to a possible perception of capture by the fiscal authority. the use of credit easing measures, from a balance sheet standpoint, allows central banks to change the composition of the asset side, by buying different classes of financial assets, the final purpose being the revival of markets for those assets and the private sector’s direct financing. also, the balance sheet composition can be altered by shifting from shorter to longer term securities. however, smaghi (2009) warned that this type of purchases needs to be carefully planned, so as to avoid allocative distortions at industries, firms or regions level. the third type of measures, known as indirect credit easing programs, aimed to support sound financial institutions in having access to short-term liquidity. central banks’ balance sheet size has been rapidly expanded, the increase being determined endogenously by the banking system, based on banks’ individual preference for liquidity. in the following, we have depicted the major central banks’ interventions, representative for the novelty of the measures adopted and the effects generated in the banking system. thus, the analysis has been customized for the european central bank and the federal reserve, showing the ways they have adapted the traditional monetary policy instruments, in terms of eligible collateral, maturity and amount of operations. also, in order to make assessments on how the balance sheet size has evolved, on the composition of the asset and liability side, on the extent to which the risk exposure has increased, but also the effect on their profitability, we analyzed the accounting information taken from annual reports during 2007-2009. international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.12-20 14 2. measures of liquidity supply adopted by fed fed interventions aimed to increase liquidity in the financial system and, at the same time, help banks to borrow in the interbank market. from 2007 until march 2008, the fed has conducted six operations to reduce the key interest rate, from which two in january, at a difference of just eight days. however, the reduction from 1% to 0.25% was one of the most significant operations of this kind conducted in the history of the institution. making a parallel between fed’s actions and the ones of other major central banks in europe, it can be noted that the fed has developed and implemented the most extensive range of unconventional monetary programs, known as credit easing. these consisted in the implementation of four facilities, designed to ease the direct purchase of illiquid assets such as commercial paper, asset-backed commercial paper (abcp), money market instruments and asset-backed securities, in order to provide liquidity to each of these markets (commercial paper market, asset-backed securities market and money market funds), in addition to the interbank market, and improve their functionning. fed’s efforts to revive the main credit markets, heavily threatened by the risk of financial institutions’ insolvency, liquidity risk and credit risk, have resulted in the following strategies:  asset backed commercial paper (abcp) money market mutual fund (mmmf) liquidity facility (amlf) – consists in lending to financial institutions (eligible borrowers were deposit banks and bank holding companies) against asset-backed commercial paper (abcp) collateral. it is noteworthy that only abcps purchased from a money market mutual fund (mmmf) since september 19, 2008 (the program launching date) are accepted as eligible collateral. the program is designed to assist money market mutual funds that hold such securities in order to meet investors’ redemption requests and improve liquidity on the abcp market and money markets in general. the federal reserve bank of boston has been authorized to manage the facility, with any eligible counterparty, in any of the twelve federal reserve districts. last access to this program took place on may 8, 2009. the program expired on february 1, 2010, accumulating a total of 217,349.83758 million dollars.  commercial paper funding facility (cpff) was developed in order to acquire, through a special purpose vehicle funded by the fed, trade securities with a maturity of three months, expressed in dollars, secured and unsecured, issued by u.s. issuers. federal reserve bank of new york was authorized to lend the spv, so that the latter has become a financial institution to facilitate the issuance of securities by eligible issuers. the last purchase of securities took place on january 25, 2010, and the total value of the program amounted to 738,262.5 million dollars.  term asset-backed securities loan facility (talf). traditionally, the u.s. asset-backed securities (abs) market provided substantial funding for loans to households and businesses. as the credit markets’ liquidity impaired and investors' risk aversion rapidly increased, abs market has been blocked. this means that financial institutions could no longer issue abs on loans to existing customers, and therefore cannot finance new loans, because there was no demand for such securities. to facilitate the issuance of abs, the new york fed authorized the talf program, to provide loans with a maturity of three or five years, guaranteed by newly issued abs (the condition was that they have been issued after january 1, 2009) and commercial mortgage-backed securities issued before january 1, 2009. through the talf program it was intended to grant loans of about $ 200 billion. the last access to this facility took place on june 9, 2009. the total value of loans granted was of 71,085.7 million.  large-scale asset purchases were another monetary policy instrument aimed at supporting the functioning of credit markets. in addition, to reduce indebtedness costs and stimulate mortgage loans and housing markets, the fed expanded the range of assets it planned to buy. thus, it has focused on the acquisition of debt instruments issued by government sponsored entities (gses: fannie mae, freddie mac and federal home loan banks), totaling 175 billion dollars. also, to further stimulate the housing markets, the fed proceeded to purchase mortgage-backed securities guaranteed by gses, the total amount sought being of 1,250 billion dollars. currently, this program has already completed acquisition on 31 march 2010, but will continue to settle transactions. following the public launchment of these programs, the targeted markets have promptly reacted and mortgage interest rates have dropped significantly. central banks’ response to the current financial crisis – between costs and benefits 15 also, in order to supplement the financial system liquidity, the fed implemented a series of indirect credit easing programs, to ensure that sound financial institutions have adequate access to liquidity in the short term. these consisted of a series of new credit facilities:  term discount window program was a temporary program that introduced several changes in the credit facility offered by the fed (known as the fed's primary credit discount window facility). it has provided long-term loans to deposit institutions, in return for a wide range of eligible collateral. the maximum maturity of loans has increased from overnight to 30 days on august 17, 2007, and then to 90 days on march 16, 2008.  term auction facility (taf) aimed to stimulate the unsecured interbank market by providing liquidity to deposit institutions, in exchange of a wider range of collateral than the open-market operations allow. all deposit institutions that are considered to be financially sound and are eligible to borrow under the fed's primary credit discount window facility, are also eligible to participate in taf auctions. auctions with a fixed amount extended their maturity from 28 to 84 days. the last auction had been held on march 11, 2010. the total value of loans through the taf is of 3,818,411 million dollars.  term securities lending facility (tslf), through which the fed has lent treasury securities to primary dealers, represented by banks and securities broker-dealers, accepting as collateral investment-grade privately-issued securities. as kuttner (2008) explained, by increasing the supply of good collateral in the financial system, fed has facilitated the credit extension of lenders who do have funds available, but are unwilling to accept risky securities as collateral. because at the core of this transaction lies a simple exchange of securities, it has no impact on the amount of bank reserves, being equivalent with a transaction in which the fed offers a collateralized loan, lending funds against privately-issued collateral, and simultaneously sterilizes the reserves’ increase through a sale of treasury securities. this facility expired on february 1, 2010.  primary dealer credit facility (pdcf) consisted in overnight loans granted to primary dealers, in exchange of investment-grade securities collateral, having as purpose the improvement of their ability to provide financing. this provision of credit was designed to ease liquidity pressures in the broader repo market, a secured funding market where primary dealers obtain the main part of their financing for the securities holdings (tobias, burke, mcandrews 2009, p.1). as primary dealers had no access to the fed’s lender-of-last-resort facility, but were heavily exposed to liquidity risk, because they used to fund long term assets on the short term repo markets, the pdcf program has been designed in order to offer an alternative to the federal reserve’s discount window. the eligible borrowers were only primary dealers of the new york fed, through their clearing banks. at present, this facility has expired since february 1, 2010, accumulating a total of 8,950,991.6 million dolars.  swap lines agreements have been approved by fed in order to ease us dollars funding pressures in offshore markets. these bilateral agreements have been established with 14 central banks, including the bank of england, the european central bank, the bank of japan, the bank of korea, monetary authority of singapore, and the swiss national bank. the swap agreements have allowed foreign central banks to purchase u.s. dollars from the federal reserve and to further lend them to domestic banks in their jurisdictions. since the establishment of the central banks swaps arrangements in december 2007, the fed has acted as a global lender of last resort for dollars. it subcontracted its llr function (along with its monopoly on money creation) to a selected set of foreign central banks (obstfeld 2009, p.45). obstfeld et al (2009, p.7) argued that the implementation of this facility is one of the most notable examples of central bank cooperation in history. also, it was deemed to be a significant driving factor for the major central banks’ balance sheet expansion in the latter half of 2008 (borio and disyatat 2009, p.12). the magnitude of fed’s large-scale intervention in credit markets can be observed from its balance sheet size. at december 31, 2008 compared with december 31, 2007 total assets increased with more than 145%, while at end 2009 it contracted with only 0.48% from previous year. table 1 provides a snapshot of the evolution recorded by some components of the asset and liability side. international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.12-20 16 table 1. fed’s financial statement (selective) 2010 2009 2008 2007 total assets (millions $) 2,427,844 2,235,047 2,245,728 914,776 loans to depository institutions 221 96,618 544,010 48,636 other loans 69,433 100,082 u.s. treasury securities 1,066,952 805,972 481,449 730,329 government-sponsored enterprise debt securities 152,972 167,362 20,740 15,300 federal agency and government-sponsored enterprise mortgagebacked securities 1,004,695 918,927 central bank liquidity swaps 75 10,272 553,728 24,000 total liabilities (millions $) 2,374,796 2,183,767 2,203,576 877,876 securities sold under repurchase agreement 59,703 77,732 88,352 43,985 depository institutions’ deposits 968,052 976,988 860,000 20,767 us treasury, general account 140,773 186,632 106,123 16,120 source: the federal reserve banks combined statements of condition as table 1 show, on the assets side, at end-2008, fed’s actions had been directed towards restoring credit markets’ functioning, by providing plentiful liquidity. hence, loans to depository institutions, us treasury securities and central bank swaps reached a share of over 70% in total assets. during 2009 and 2010, the focus shifted towards purchasing impaired, illiquid private sector assets, so as to clean financial institutions’ portfolios and provide them good collateral. from kuttner’s (2008) viewpoint, the composition of fed’s portfolio changed beyond recognition. if, at end 2006, the us treasury securities/total assets ratio was of 89.72%, one year later, it comprised 79.83 percent of total assets. in 2008, the ratio had fallen sharply to 21.44 percent, so as to accommodate the increase in credit facilities granted through unconventional liquidity programs. at end 2009, following the large-scale asset purchase program announcement, the share of total securities held by fed (us treasury securities, gse securities, mbs) in total assets reached 84.66%, while at december 31, 2010 it raised at 91.63%. related to the federal reserve's liabilities side operations, the amount of currency in circulation has continued to rise at a slow pace, with only 6.89% in 2008 compared with 2007 and with 5.45% et end 2009 compared with 2008. deposits held by depository institutions at fed’s reserve accounts have recorded a sharp increase during 2008, at about 39% of total liabilities, relative to the moment prior to the financial crisis onset, when they counted for only 2.36% in total liabilities. this upward trend continued in 2009 and 2010, at year-end reaching 44.74% of total liabilities, respectively 40.76% (barbu, boitan 2012). the impact of the fed's unconventional strategies can be analyzed in terms of costs and risk taking, on the one hand, and profits, on the other hand. the new size and composition of fed’s balance sheet has determined that the share of capital in total assets, known as the equity ratio, fall from 4.5% to 2%, which means a leverage increase from 22 to 50 (bagus and schiml 2009). consequently, the doubtful quality of fed’s balance sheet raised the problem of insolvency. some solutions have been proposed to overcome the central bank insolvency: -recapitalisation, that could be achieved by two ways: financing from public funds or by monetization of government debt; revaluation of gold reserves (according to the authors mentioned above, a revaluation of gold reserves at market price of $ 810 an ounce, in january 2009, would have increased the capital / assets ratio at 12.35%). central banks’ response to the current financial crisis – between costs and benefits 17 in terms of costs and benefits it can be concluded that fed has fulfilled its role of lender of last resort, by implementing several programs that have required considerable financial resources and have generated significant positive effects on the liquidity level. thus, the cost of intervention has resulted in the risks incurred, as a consequence of acquiring certain impaired assets held by banks, but also in the cost of resources procurement. in terms of profit, we emphasize the reaffirmation of central banks’ authority and role, and the gains obtained due to the difference between interest charged from the banks benefiting from credit facilities and interest paid for deposits from banks in the system. regarding this aspect, more than 7,000 financial institutions keep their deposits at fed. before the onset of the crisis, the value of these deposits represented 12 billion dollars daily. the significant increase of these deposits is explained by the fact that before the crisis, the fed does not pay interest on excess reserves. during the crisis, the fed provided significant liquidity in the banking system, and some of them have become excess reserves (estimated at over one trillion dollars in the year 2009). fed's net profit in 2008 compared to 2007 increased by over 14%, while in 2009 compared to 2008 increased by 21.65%. 3. measures of liquidity supply adopted by ecb the non-standard monetary measures implemented by the ecb can be classified into two broad categories: operations that concern the direct purchase of assets issued by private sector and operations of lending to euro area credit institutions (known as enhanced credit support), characterised by an extended maturity and collateralised with asset-backed securities whose markets are temporarily disrupted or illiquid (barbu, boitan 2012). the firm position of the european central bank of not being involved in the direct purchase of debt instruments issued by the state members makes it the only central bank which intends to buy only securities issued by private sector and not government bonds on the domestic market (euro area). the ecb’s hesitancy to buy government bonds must be seen in the light of its unique position, as a supranational central bank, which has not one but sixteen fiscal authority counterparts (meier, 2009, p. 40). the risk that the ecb becomes a market maker for public debt can be interpreted as being against the treaty that prohibits monetary financing (smaghi 2009), the eurosystem having to decide on the distribution and purchase of government bonds in the euro area countries, so as to avoid providing privileged access to certain countries. hence, the measures adopted by ecb consisted in the direct purchase program for eurodenominated covered bonds (debt securities issued by banks), announced by the governing council on 4 june 2009. the total amount desired was established at eur 60 billion, the acquisitions starting in july 2009 and being expected to be fully implemented until the end of june 2010. it was agreed that the technical modalities imply direct purchases in both primary and secondary markets. the ecb’s engagement in outright purchases of covered bonds had been corelated with the aim of reviving the covered bonds market, from the standpoint of liquidity, spreads, issuance frequency and volume. in addition, the covered bonds purchases involved very low credit risk. ecb’s reluctance in directly purchasing private assets can be justified by its desire to exit quickly and smoothly from the framework imposed on by unconventional methods. heavily reliance on reversible open market operations, such as repos, is a good reason from this standpoint. in the case of buying assets, it may raise the question of whether to keep the security until maturity, or to sell it. for the euro area, trichet (2009) has consecrated the term enhanced credit support to designate the ecb’s policy toolkit through which monetary policymakers aim to fully accommodate banks’ liquidity needs. he defined it as being special measures, focused primarily to banks, which have been taken in order to stronger enhance the flow of credit that it could be achieved through key interest rate reductions alone. ecb’s unconventional measures targeted mainly the euro area banks, representing recognition of their role as the main source of financing in the euro area economy. a) the traditional refinancing operations conducted by ecb have been the subject of a refinement, so as to offer an alternative for the credit institutions, at a time when the cost of borrowing on interbank market became abnormally high. since september 2007, ecb has allowed the provision of liquidity through longer-term refinancing operations, at variable rate tender procedure with full allotment and extended maturities of three or six months. also, ecb publicly announced the temporary expansion of the collateral pool, until the end of 2009. reclassification of collateral was conducted so as to facilitate the supply of international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.12-20 18 liquidity. the list of assets eligible as collateral in ecb’s credit operations has been filled with: marketable debt instruments issued by central government, central banks, local and regional government; euro-denominated syndicated credit claims governed by uk law; debt instruments issued by credit institutions, which are traded on the accepted non-regulated markets; subordinated debt instruments when they are protected by an acceptable guarantee; the credit threshold for marketable and non-marketable assets has been lowered from ato bbb-. also, it has decided to expand the available range of maturities, so as to conduct longer-term refinancing operations at fixed rate tender procedures with full allotment and a maturity of one year. this new change in the characteristics of longer-term refinancing operations was meant to solve the discrepancy between the investment and financing side from banks’ balance sheet, at low indebtedness costs. thus, the liquidity planning horizon becomes broader and less uncertain, encouraging lending (trichet, 2009). the unlimited refinancing offered by ecb in exchange for a wide range of eligible collateral and extended maturities had been maintained until the end of october 2010. b) to avoid foreign currency liquidity shortages in euro area, the governing council of the ecb decided to reactivate, on 11 may 2010, the temporary liquidity swap lines with the federal reserve. the us dollar liquidity provision will take the form of repurchase operations against ecb-eligible collateral and will be carried out as fixed rate tenders with full allotment, at maturities of 7 and 84 days. below we have summarized the impact of unconventional instruments implemented by the ecb on the structure of balance sheet items and their modification. at december 31, 2008 compared with december 31, 2007 ecb’s total assets (expressed in millions euro) sharply increased with over 204%. table 2 provides an overview of the evolution recorded by some components of the asset and liability side. table 2. ecb’s financial statement (selective) 2010 2009 2008 2007 total assets (millions euro) 163,523 137,997 383,903 126,028 claims on non-euro area residents denominated in foreign currency 39,713 35,455 41,610 29,170 claims on euro area residents denominated in foreign currency 4,326 3,293 22,225 3,868 intra-eurosystem claims 67,176 70,873 295,117 71,371 securities of euro area residents denominated in euro 17,925 2,181 0 0 total liabilities (millions euro) 133,201 116,645 363,048 113,039 liabilities to non-euro area residents denominated in euro 1,201 9,515 253,930 14,571 liabilities to non-euro area residents denominated in foreign currency 478 18 1,444 667 liabilities to euro area residents denominated in foreign currency 0 0 272 0 intra-eurosystem liabilities 61,429 40,204 40,149 40,041 source: data collected from ecb annual reports as of 31 december 2008, 31 december 2009 and 31 december 2010 central banks’ response to the current financial crisis – between costs and benefits 19 almost 77% of this substantial increase was due to intra-eurosystem claims, which augmented three times than the value recorded at 2007 year-end. as table 2 depicts, at end 2009 the value of this item returned to approximately the same value as of end 2007. the explanation for this sudden, high increase during 2008 consists in several us dollar bilateral swap transactions with some national central banks in euro area. the item security of euro area residents, which appears only in the financial statements for 2009 and 2010, consists in the euro-denominated covered bonds, issued in the euro area which has been acquired by the ecb, for monetary policy purposes. the claims on non-euro area residents denominated in foreign currency represent the transactions between ecb and the central banks in eu, which are not members of the euro zone. their value increased in 2008, relative to end 2007 with over 42%, mainly due to foreign currency swap transactions between ecb and denmark’s national bank, respective with swiss national bank. the reason for which ecb’s balance sheet size sharply contracted with about 64.05% at 2009 year-end and with 57.4% in 2010 relative to end 2008, lies in the strategy of monetary easing implemented by the central bank. it relied mainly on operations whereby the ecb purchases or sells assets under a repurchase agreement, purchases/sells euro/foreign currency under bilateral swap arrangements or offers credit against temporary extended range of collateral, through full-allotment refinancing operations. as they are reverse transactions, at maturity they simply disappear from ecb’s balance sheet. in addition, the smooth, gradual exit from these non-standard measures, as they simply mature, has been considered by ecb’s officials as a major advantage. on the liabilities side, liabilities to non-euro area residents, denominated in euro, accounted at end 2008 for near 70% of total liabilities. this sharp increase was mainly due to a liability to the federal reserve amounting to €4.5 billion in 2009 and €219.7 billion in 2008, resulted from the temporary swap line that provided us dollar liquidity to ecb, which further directed it to national central banks in eu, in the form of reverse and swap agreements. the 2009 ecb annual report mentions also another liability amounting to €1.8 billion in 2009 and €18.4 billion in 2008. “swiss francs were provided by the swiss national bank by means of a swap arrangement with the aim of offering short-term swiss franc funding to eurosystem counterparties” (ecb annual report, 2009, p.214). the contraction with 96% in the value of the above liabilities at end 2009 illustrates a decline in non-euro area residents’ demand for us dollar and swiss franc liquidity. in 2008, the total net revenues of the ecb have registered a substantial increase of 343.77%, compared with 2007, following the extensive program of liquidity granting in the euro area, through refinancing operations. in 2009, compared to 2008, they increased by 55.23%. the profit for the financial year 2007 was of zero euro, while in 2009 compared to 2008 it saw an increase of 70.4%. 4. concluding remarks several studies have outlined the need that the specific unconventional measures implemented by the major central banks be adapted to the structural characteristics of the economy and, in particular, to the manner companies and individuals obtain financing. smaghi (2009) stated that, given the importance of credit institutions in providing financing to the economy, unconventional measures that would best suit the euro area may differ in purpose and scale of the u.s. and other advanced economies, where the financial system is market-based. in addition, the unique institutional framework of the euro area had been a supplementary challenge in implementing non-standard measures. comparing the scope and nature of unconventional facilities implemented by the fed and the ecb, it can be noted that, in the case of federal reserve, the comprehensive programs designed to unfreeze interbank markets have been just as important as those who have sought to stimulate key credit markets, while ecb adopted a conservative attitude. morgan (2009) justified this prudent attitude by the fact that ecb "made modest steps toward unconventionality" of monetary policy measures. borio and disyatat (2009) argued that the ecb has put a greater emphasis on supporting banks in the euro area because of the region's dependence on bank intermediation, while fed’s intervention, mainly on non-bank credit markets in the u.s. is in full compliance with its market-based financial system. international journal of economics and financial issues, vol. 2, no. 1, 2012, pp.12-20 20 from meier’s (2009) standpoint, the program adopted by the fed is the most ambitious in terms of volume and performance, especially with regard to large scale purchases of private, public and quasi-public securities. on the other hand, purchases of assets made by the ecb are relatively low in volume. non-standard measures taken by both central banks have had an impact on both sides of the balance sheet; therefore it is difficult to assess the monetary policy orientation and summarize it into a single indicator. minegishi and cournède (2010) have a proposal in this regard, namely the use of monetary base as a proxy indicator of unconventional monetary policy actions, as it reflects changes on both sides of the balance sheet. comparing the growth of monetary base in late 2009 and late 2007, the year of the financial crisis onset, it differs significantly between the two monetary authorities. for the fed, it rose during that period more than 137.62%, while the ecb's monetary policy actions have resulted in an increase of over 55%. in the u.s., during 2009, the substantially increase in the monetary base was due largely to substantial asset purchase programs, while in 2008 it was caused by liquidity facilities. for the ecb, the monetary base growth was due, mainly, by the provision of liquidity support to the banking sector rather than by direct intervention in the market through direct purchases of covered bonds. references barbu, t.c., boitan, i. (2012), the effects of the unconventional monetary policy measures adopted during the financial crisis, metalurgia international journal, 1, 167-169. borio, c. (2009), towards a new framework for monetary policy? lessons from the crisis, de nederlandsche bank policy workshop, amsterdam, 21 september 2009. borio, c., disyatat, p. (2009), unconventional monetary policies: an appraisal, bis working papers no. 292. buiter, w., sibert, a. (2007), the central bank as the market maker of last resort: from lender of last resort to market maker of last resort, vox, http://www.voxeu.org. committee on the global financial system (2008), central bank operations in response to the financial turmoil, cgfs publications no 31, july 2008. frbny (2009), commercial paper funding facility: program terms and conditions, effective june 25, 2009 frbny (2009), term asset-backed securities loan facility: terms and conditions, effective november 13, 2009. federal reserve banks, combined financial statements, april 2010, p.7. kuttner, k.n. (2008), the federal reserve as lender of last resort during the panic of 2008, department of economics, williams college. meier, a. (2009), panacea, curse, or nonevent? unconventional monetary policy in the united kingdom, imf working paper wp/09/163. minegishi, m., cournède, b. (2010), monetary policy responses to the crisis and exit strategies, oecd economics department working papers no. 753. morgan, p. (2009), the role and effectiveness of unconventional monetary policy, adbi working paper 163, available at: http://www.adbi.org/workingpaper/2009/11/11/3366.role.unconventional.monetary.policy obstfeld, m. (2009), lenders of last resort and global liquidity, development outreach world bank institute, december 2009. obstfeld, m., shambaugh, j.c., taylor, a.m. (2009), financial instability, reserves, and central bank swap lines in the panic of 2008, nber working paper no. 14826. smaghi, l.b. (2009), conventional and unconventional monetary policy, keynote lecture at the international center for monetary and banking studies, geneva, 28 april 2009. tobias, a., burke, c.r., mcandrews, j.j. (2009), the federal reserve’s primary dealer credit facility, frbny current issues in economics and finance, 15(4), august 2009. trichet, j.c. (2009), credible alertness revisited, presented at the symposium on financial stability and macroeconomic policy, the federal reserve bank of kansas city, 22 august 2009. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(2), 59-72. international journal of economics and financial issues | vol 9 • issue 2 • 2019 59 assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market zainuddin1*, bonar m. sinaga2, sri hartoyo3, erwidodo4 1graduate study program of agricultural economics, faculty of economics and management, bogor agricultural university, bogor, indonesia, 2department of resource and environmental economics, faculty of economics and management, bogor agricultural university, indonesia, 3department of economics, faculty of economics and management, bogor agricultural university, indonesia, 4center for agricultural socio economic and policy studies, agency for agricultural research and development, indonesian ministry of agriculture, indonesia. *email: zainuddin.ubr@gmail.com received: 13 july 2018 accepted: 08 january 2019 doi: https://doi.org/10.32479/ijefi.6893 abstract the purpose of this research is (1) to compare the market power of the rubber product industry (hs code 4011) between australia and similar industries from the exporting country; (2) to analyze the impact of import tariff reduction on rubber product trade especially price, demand, export, import, export value and import value of rubber product for exporting country and importing country; and (3) to analyze the impact of weakening the demand of importing countries on the trade of rubber products (tire) especially price, demand, export, import, export value and import value for exporting country and importing country. the ability of exporters of indonesian rubber products for mark-up prices is lower than similar industry capabilities from thailand, china and japan, but higher than similar industries in australia. the decline in import tariffs has the effect of lowering import prices of rubber products in australia, as well as export prices of rubber products from exporting countries to export markets in australia. the decline in import tariffs for rubber products provides more benefits received by china, thailand and indonesia compared to benefits received by japan and similar industries from australia. the decline in tariffs on rubber products on the condition of weakening demand has an impact on the decline in import prices and consumer prices of these products. export prices of rubber products from exporting countries tend to decrease if market demand weakens, and production of domestic rubber products in australia also decreased. keywords: market power, rubber product, import tariff, weakening demand jel classifications: f12, f17, l13 1. introduction the development of manufacturing industry especially rubber products is quite encouraging when viewed from several aspects of its development. the number of companies reached 46 in 2000–2001 increased to 72 in 2011–2013. the value added of the rubber products industry increased from rp. 5,411 trillion in 2000 to 2001–rp. 42.698 trillion in 2011–2013. the industry is able to absorb labor 144,610,000 people in 2000-2001 increased to 172,620,000 people in 2011–2013 (indonesia’s ministry of industry, 2016). total production of rubber products for export destinations to various countries averaged 84.06% in 2000-2001 declining to 76.81% in 2011-2013. the decline in exported shares is likely to be related to the growing domestic market share, especially the types of tires, inner tubes, footwear and components, apparel and clothing accessories, gloves, and more. besides, there is also the possibility of competition in the export market is getting tighter so that the export share decreases. this journal is licensed under a creative commons attribution 4.0 international license zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 201960 the domestic rubber products industry is being driven by the growth of tire product exports with the code of hs 4011 (new pneumatic tires of rubber) to various countries. tire products such as sedans, truck and bus tires, heavy equipment tires, motorcycle tires and bicycles; saw an increase in exports from 2001 to 2014. competitors came from thailand, china, japan, south korea, india, usa, and european countries. indonesia and the country of rubber products producers take advantage of export opportunities in addition to domestic demand. this is closely related to economic growth that encourages the development of the automotive and transportation sector. malaysia develops rubber manufacturing industry by segmentation of main rubber product is latex product (glove, condom, catheters, rubber thread), followed by tire and inner tubes, footwear and component, industrial rubber goods and general rubber goods. the malaysian rubber board report (2015) shows that the export value of malaysian rubber industry is dominated by rubber products by 54%, rubber wood product by 24%, natural rubber by 14%, and the rest of other products. indonesia and thailand are not as successful as malaysia to build rubber manufacturing industry so far the export value of rubber products is only 10-20% of total rubber and processed rubber exports (un comtrade, 2015). when viewed from the export destination, indonesia’s rubber products and other producing countries are directed to the export markets of the united states, japan, australia, the european union, the middle east, russia, canada and asean as shown in figure 1. although the trend of exports of rubber products in indonesia has increased, in the last 5 years (2011–2015) it has decreased (measured from export value) to most export markets as shown in figure 2. in the same period, imports of rubber products by major importing countries in the world market shows an upward trend as shown in figure 3. this means that there is a decline in the share of indonesian rubber products in export markets of destination figure 1: export of rubber products (tire) to partner countries source: un com trade figure 2: value of export of rubber products indonesia to partner countries source: un com trade zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 2019 61 countries compared to other exporting countries in that period. the decline in export share of processed rubber products can be caused by the inability to compete with similar industries in export destination countries and from other exporting countries. it is possible that a number of indonesian firms exit the export market and temporarily move in the domestic market and other exporting companies remain in export markets but by reducing the export intensity of processed rubber products. various rubber products are exported indonesia such as hs code 4005, 4011, 4013, 4015, and 4016, only hs code 4011 is more prominent in terms of volume, value, export growth, and number of export destination countries. in a relatively long period (more than 20 years) indonesia has exported relatively large volumes of new pneumatic tires of rubber to the united states, japan, germany, australia, malaysia and the philippines. in addition, the development of export destinations in the last 10 years with smaller volumes has been made to potential markets such as asia (india, china, taiwan, south korea, saudi arabia, united arab emirates and iran), eu-africa region (netherlands, france, britain, belgium, italy, turkey, russia, and egypt), and brazil (un comtrade, 2016). indonesia’s rubber processing industry benefited from the availability of domestic natural rubber raw materials at relatively lower prices compared to similar industries in the country of importing natural rubber and rubber products hs 4011 code. however, export markets of these products are subject to tariff escalation with different variations across countries to protect similar industries in the domestic market of importing countries. facts show that over 30 years develop rubber industry especially product with code of hs 4011, natural rubber producer country only ranked 6th-12th biggest exporter country of rubber especially new pneumatic tyres of rubber, while rank 1-5 is occupied by china, japan, united states, germany, and south korea. it is shown that rubber industry products indonesia, malaysia and thailand compete with domestic industry and other supplier countries in export market. since the number of producers is relatively small both in the domestic level of indonesia and in the importing country, the producer’s decision in the industry is identical with the oligopoly market behavior. in relation to the ability to enter export markets in various importing countries, it is necessary to question how market power of indonesian rubber products industry and other exporting countries with similar industries in importing countries. the problem of entering the export market of rubber products in various countries often occur friction tariffs. generally, rubber products importers have tariff escalation practices on imports of rubber products compared to imports of natural rubber commodities. for example, the us rubber export market does not apply import duties for natural rubber commodities (sir and rss), but applies import duties for various rubber products ranging from 0% to 9.3% of product value based on rate of duty (general) in 1996 until 2015. furthermore, australia is an export market of rubber products large enough for indonesia. after the free trade agreement between australia-new zealand and asean (aseanaustralia-new zealand) the import duty of natural rubber.and rubber processing products from 2012 dropped dramatically to 0% to 5%. in the period of 1996-2011, the tariffs are relatively high in the range of 5.0-15.0% for rubber processing products, while for rubber natural rubber, technical specifications and smoked sheets are not subject to import duty (world trade organization, 2016). rubber product trade flows are likely to increase when tariff barriers are reduced to a minimum level that does not incriminate trade flows. the export market as if still isolated by import duties is still considered large enough so that the product becomes uncompetitive. therefore, it is necessary to examine the impact of import tariff reduction on trade of indonesian rubber products and other exporting countries and similar industries in australia. the purpose of this research is (1) to compare market power of rubber product industry (hs code 4011) between australia and similar industry of exporting country origin; (2) to analyze the impact of import tariff reduction on trade of rubber products especially price, demand, export, import, export value and import value of rubber product for exporting country and importing country; and (3) to analyze the impact of the weakening of the demand of the importing country market to the trade of rubber products especially the price, demand, export, import, export value and import value for exporting country and importing country. figure 3: value of imported rubber products by major importing countries of the world source: un com trade zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 201962 2. review literature 2.1. analysis of tariff reduction on trade of rubber products (tire) to australian market models built to analyze the impact of import tariff reductions follow a model of trade strategy that has been widely used in previous research (bresnahan, 1982; brander, 1995; chilimoniuk, 2003; reimer and stiegert, 2006; luckstead et al., 2015). manufacturers of indonesian rubber products (tire) offer products to the domestic market and export markets in j (j = australia). at the same time a number of domestic manufacturers manufacturing rubber products (tires) in country j also produce production for domestic market country j. manufacturers of indonesian rubber products (tire) and similar manufacturers in country j are faced with a downward sloping demand curve that allows to harness market power because the structure of competition is assumed to resemble oligopoly. manufacturers of indonesia’s rubber products (tire) and other producer countries have cost advantages compared to similar producers in j country because the cost of material inputs and labor wages is relatively lower, but it costs shipping and export duty transportation to export markets in j. state j applies import tariff for every type of rubber product (tire) imported from other country. illustrative can be illustrated trade relationship of rubber product (tire) between indonesia with country j (importer) and country k (export competitor). the profit function of domestic manufacturers manufacturing rubber products (tire) in country j is: ( ) ( )π j j jj j j j jdom dom s= p q q c q ; x f (1) pj is the price of the rubber product (tire) in country j, pj (.) is the demand for rubber products (tire) in j, cj and fj respectively variable costs and fixed costs in country j. total rubber product (tire) supplied to country market j is the sum of domestic production ( )jdomq plus import from indonesia ( )jidnq , import from country ( ) j kk q and import from the rest of the world h j ot(q ) . the profit function for indonesian rubber product manufacturers which export rubber products (tire) to export markets j is ( )jidnπ : ( ) ( ) ( ) 1 1 ( ) 1 ; ;  − = = + + τ π  −  −         =         − ∑ ∑ j j j idnj av mj idn j j jj stn j m j j j jidn j sidn idn idn idn p q q p q q c q x tr f (2) where, = + + + j j j jj dom othidn kq q q q q j avτ and j stτ are respectively ad valorem and specific tariff rates for rubber products (tires) to j market. ( )jidnq is the number of indonesian rubber products (tire) for the market j. trj t is the cost of shipping transportation to country j. idnsx is the sliding factor of supply of indonesian rubber products (tire). furthermore, the profit function of rubber product manufacturing (tire) of k (k = japan, china, thailand) exporting rubber product to market j is ( )jidnπ : ( ) ( ) ( ) 1 1 ( ) 1 ; ;  − = = + + τ π  −  −         =         − ∑ ∑ j j j idnj av mj idn j j jj stn j m j j j jidn j sidn idn idn idn p q q p q q c q x tr f (3) where, = + + +j j j jj dom othidn kq q q q q deferential profit functions (1), (2) and (3) to qjdom q j idn, dan q j k are obtained by first order condition which is implicitly a reaction or a trade response function of rubber products. the above reaction or response function has a unique solution when the function is downward sloping and satisfies the second order condition. to analyze the impact of the reduction of import tariff on the amount of rubber product (tire) in market j, it is done by deferential total response function or response above and arranged in the following three matrix equation (ax = b) system:  ∂ ∂∂   ∂ ∂ ∂ ∂∂ ∂       ∂ ∂ ∂  =  ∂ ∂ ∂ ∂ ∂ ∂       ∂ ∂ ∂   ∂ ∂ ∂ ∂ ∂ ∂  ∂ ∂ + ∂ j jj j j j jj j jdom domdom dom idn k domidn idn idn j idnj j j j j j domidn idn idn idn k j kj j j k k k j j j j j j domk k idn k k j j avj j avdom q q q qq q dq dq q q q q q q dq q q q q q q d q                 ∂   ∂ ∂ +  ∂ ∂   ∂ ∂  + ∂ ∂  j j stj j stdom j j j j av stj jj j av stidn idn j j j j av stj jj j av stk k d q d d q q d d q q               (4) the determinant of matrix a is positive as shown |a| > 0. the use of cramer’rule on matrix (4) generates equations for changes in import tariffs in market j as follows: 0, 0, 0, 0 0< < < < > j j j j j idn idn k k dom j j j j j av st av st av dq dq dq dq dq d d d d d     , 0, 0, 0> > > j jj dom idn idn j h h st av st dq dqdq d d d   , 0, 0, 0, 0> > > > j j j j k k dom dom h h h h av st av st dq dq dq dq d d d d    , zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 2019 63 where h ≠ j a decrease in the trade tariff of rubber products will increase the quantity exported to the market j either from indonesia or originating from the country k. conversely, the decline in trade tariffs will reduce the quantity of supply of rubber products (tire) by domestic producers in country j. the effect of trade tariff reduction on the quantity of supply of rubber products (tire) in country j depends on which is more dominant direct effect or indirect effect due to tariff reduction as the following equation. ( ) − − −   = +  +   j h hj ina ina j h h j h h av st av st dq dqdq d d d directeffect                j -h j -hh h l l d d j -h h j -h h av st av st dq dq dq dq + + + + dô dô dô dô indirecteffect (5) 2.2. analysis of weakening demand on the trade of rubber products (tire) to australia market models built to analyze the impact of declining shifting demand for importing countries follow a previous model of trade strategy. manufacturers manufacturing indonesian rubber products sell their products to the domestic market and to export markets j (j = australia). at the same time a number of domestic manufacturers manufacturing rubber products in country j also produce production mainly for sale in domestic market of each country j and they also export the same processed rubber products to other countries. manufacturers indonesian rubber products and country j are faced with a downward sloping demand curve that allows them to harness market power because the structure of competition is assumed to resemble oligopoly. manufacturers manufacturing indonesian rubber products have cost advantages compared to similar companies in j j j state countries utilizing the purchasing power of domestic consumers in country j. the trade relations of rubber products between indonesia and country j (importer) and country k (export competitor). the profit function of domestic manufacturers manufacturing rubber country j products are: ( ) ( ), ;= − −j j jj j j d j jdom dom sp q z q c q x fπ (6) pj is the price of the processed rubber product in country j, pj (.) is the inverse demand of the rubber product (tire) in country j. zd, cj (.) and fj are the demand sliders, variable costs and fixed costs in country j. the profit function of indonesian rubber product manufacturing exporting rubber products (tire) to market j is ( )jidnπ : ( ) ( ) ( ) j j j idnj av m-1j idn j j jj 1 stn j m j j j jidn j sidn idn idn idn d d p (q ) q 1 p q q c q ; x ; tr , z f , z= =         =         + +       ∑ ∑    (7) j avτ and j stτ are respectively ad velorem and specific import tariffs of processed rubber products to market j (australia). ( )jdomq is the number of indonesian rubber products sold in the domestic market. trj is the shipping cost of transportation to country j. idnsx is the sliding factor of supply of indonesian rubber products (tire). furthermore, the profit function for manufacturing rubber products (tire) of countries k exporting these products to market j is ( )jkπ : ( ) ( ) ( ) -1 1 ,, -( ) 1 ; ; -= =      =         + +  ∑ ∑ j j jj j stm nj j k kjk k m j j j jk j av sk k dd k k p qp q q q c zz q x tr f    (8) where, = + + +j j j jj dom othidn kq q q q q the profit functions (6), (7) and (8) are differentiated against a number of factors that weakening demand zd so as to obtain a first order condition. the first derivative has a unique solution when the function is downward sloping and satisfies second order condition. to analyze the impact of weakening demand on rubber products (tire) on export markets of countries j, total deferentials are arranged in the following three matrix equation (bx = z) systems:  ∂ ∂ ∂  ∂   ∂ ∂ ∂ ∂ ∂ ∂ ∂ ∂        ∂ ∂ ∂ ∂   =   ∂ ∂ ∂ ∂ ∂ ∂ ∂ ∂         ∂∂ ∂ ∂     ∂ ∂∂ ∂ ∂ ∂ ∂ ∂  dom dom dom dom d d dom d idn d k d d dom idn idn idn idn idn d d dom d idn d k d d k kk k k d d dd dom d idn d k dz z q z q z q z zdq dq dz z q z q z q z z dq dz z zz q z q z q                     (9) and 0 ∂ ∂ = = ∂ ∂ ∂ ∂ idn k d k d idnz q z q   the determinant of matrix b is positive as shown |b| > 0. the use of cramer’rule on matrix (9) generated an equation of the impact of weakening demand for rubber products (tires) in market j as follows: 0, 0, 0>< > < >< dom idn k d d d dq dq dq dz dz dz the impact of the weakening of demand on the trade of rubber products (tire) cannot be determined can decrease or increase the export of rubber products (tire) to market j whether originating from indonesia or coming from competitor country k. nor can the impact be determined on the quantity of supply of rubber products (tire) by the domestic producers of the country j. 2.3. market power of rubber products (tire) of importing and exporting countries the derivative of profit function (1-3) of the rubber product industry (tire) of the importing and exporting country to the quantity of zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 201964 production and the quantity of exports is obtained perceived or effective marginal revenue equal to the marginal cost as follows:   ( ). ∂ … = + ∂ j j j j j dom j c p p q   (10) ( ) ..1 2    ∂ …+ = + +   + ∂    idnj j j j idn j jav stj idn av j c p p q      (11) ( ) ..1 2    ∂ …+ = + +   + ∂    kj j j j k j jav stj k av j c p p q      (12) θj is the conjectural elasticity of domestic rubber products (tire) in country j. θj.idn is the conjectural elasticity of indonesian rubber products in the country market j. θj.k is the conjectural elasticity of k country rubber products in the country market j. εj is the flexibility of demand for rubber products (tires) in the country market j. τj is the import tariff of rubber products in country j. pj is price of rubber products in importing country j. in order to obtain supply relations, the first is defined as the marginal cost function and demand function by considering the demand and supply coefficients and conjectural elasticities. the marginal cost functions of the domestic industries of importing countries of rubber products (tire) and the marginal cost functions of the rubber products exporting industries are: ( , ) ∂ = ∂ j jdom q j sj dom c c q x q (13) ( , , ) ∂ = ∂ idn idn idn j q j sidn j c c q x tr q (14) ( , , ) ∂ = ∂ k k k j q j sk j c c q x tr q (15) xjs is the factors of supply of rubber products (tire) of exporting countries. trj is transportation or shipping costs to the port of destination. the inverse demand function of rubber products by importing country j represents the demand for products from indonesian exporting origin, country exporter k, domestic production of country j and other countries: ( , )= jj j j dp d q x (16) = + + +j dom idn k othj j j jq q q q q are the factors of demand for rubber products (tires) in importing countries j. qj dom is the quantity of production of rubber products by domestic industry country j. qj idn is the quantity of imported rubber products by country j from indonesia. qkj is the quantity of import of rubber product by country j from country k. qj oth is the quantity of imported rubber product by country j from other country. by using the first order conditions, the marginal cost and demand flexibility function can be derived the supply relations model for rubber products in the importing country (16) and the exporting country (17 and 18) as follows: ( , , )= jj j dom jj sp s q x q (17) ( , , , , )= jj idn idn j j jj sidnp s q x tr q (18) ( , , , , )= jj k k j j jj skp s q x tr q (19) if the plexibility of demand for rubber products (tire) in country market j is εj, the conjectural elasticity of domestic rubber product of importing country j is θj, the conjuctural elasticity of indonesian rubber products in export market of country j is θj.idn, and the conjuctural elasticity of the rubber product of the country k in country market j is θj.k can be formulated the capability of the importing country and the exporting country of the rubber product (tire) to set the price over the marginal cost as follows (motta, 2004 and luckstead et al., 2015): manufacture of rubber products (tires) in importing country j is: − = j j j j j p mc p   similar indonesian industry in importing country j is: ( ) . 1 2  + − + +  = j j j idnav stj av j idn j j p mc p      the same industry of country k in the importing country j is: ( ) j j j kav stj av j. k j j 1 p mc 2 p  + − + +  =      3. methodology 3.1. types and data sources this study uses annual time series data from 1995 to 2015 for data of rubber products especially hs 4011 code. other data associated zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 2019 65 with this study also use the same time range. the sources of data used in this study come from various government institutions, associations, and international institutions such as the central bureau of statistics, the ministry of agriculture, industry and trade, the association of indonesian rubber agents, comtrade statistics, malaysian rubber board, thai rubber association, japan tyres manufactures association (jatma) and others. 3.2. model, estimation, validation and simulation furthermore, the econometric model constructed to analyze the trade of rubber products (hs code 4011) indonesia and other exporting countries on the australian market uses simultaneous equations system because of the interrelated behavioral considerations between price, demand, exports, imports and production in trading of rubber products between exporting countries with the importing country. the developed econometric model is: prices of consumer for rubber products (tire) in australia: rprpaus5=a0+a1*lqdrpaus+a2*rgdpaus+a3*(qautau s-l3qautaus)+a4*rpoilau+e1 supply relations of rubber products (tire) by domestic industry in australia: rprpaus4=b 0+b 1*qrpaus+b 2*(rpmrubau/rpsbr au)+b3*rpcbaus+b4*rpngasau+b5*(rpmrubau/ rwageau)+b6*t+b7*qdrpaus+e2 production of rubber products by domestic industry in australia: q r p a u s = c 0 + c 1 * r p r p a u s 4 + c 2 * ( r p m r u b a u / r p s b r a u ) + c 3 * r p n g a s a u + c 4 * ( r p m r u b a u / rpcbaus)+c5*lmrpaus+e3 supply relations rubber products exporting country of indonesia to australia: rprpiaus=d0+d1*(xrpiaus-l2xrpiaus)+d2*(rpmrubid/ r p s b r i d ) + d 3* r u pa h t r i + d 4* r p c b i d + d 5 * r p n g a s i d + d 6 * r p o i l i d n + d 7 * n t r r p u s d + d 8* ( q d r pa u s / (tfrpaus1+1))+e4 supply relations rubber products exporting country thailand to australia: rprptaus=e0+e1*l2xrptaus+e2*rpsbrth+e3*rpcbt h+e4*hrubgasth+e5*ntrbahtusd+e6*(qdrpaus/ (tfrpaus1+1))+e5 supply relations rubber products exporting country of china to australia: rprpcaus=f0+f1*lxrpcaus+f2*(rpmrubcn/rpsbrcn)+ f3*rwagecn+f4*rpoilcn+f5*ntrynusd+f6*(qdrpaus/ (tfrpaus1+1))+e6 supply relations rubber products exporting countries of japan to australia: rprpjaus=g0+g1*l2xrpjaus+g2*(rpmrubjp/rpsbrjp)+ g3*rpngasjp+g4*rpcbjp+g5*rwagejp+g6*ntryenusd +g7*(qdrpaus/(tfrpaus1+1))+e7 export of indonesian rubber products (tires) to australia: xrpiaus=l0+l1*(rpxrpiaus/(tfrpaus1+1))+l2*(rpmrubid/ rpsbrid)+l3*hrubupahtri + l4*qrpaus+l5*t+e8 export of thailand rubber products (tires) to australia: xrptaus=m0+m1*(rpxrptaus/(tfrpaus1+1))+m2*(rpmrubth/ rpsbrth)+m3*(rpmrubth/rpcbth)+m4*l2qrpaus+m5*rpoil tha+m6*t+e9 export of china’s rubber products (tires) to australia: xrpcaus=n0+n1*(rpxrpcaus/(tfrpaus1+1))+n2*(rpmrubcn/ rpsbrcn)+n3*rpngascn+n4*rwagecn+n5*l2qrpaus+n6*rp oilcn+e10 export of japan’s rubber products (tires) to australia: xrpjaus=o0+o1*rprpjaus*ntryenusd+o2*srpsbrjp+o 3*(rpmrubjp/rpcbjp)+o4*rpoiljp+o5*rwagejp+o6*qrp aus+e11 the demand equation for rubber products (tires) in australia: qdrpaus=qrpaus+mrpaus–xrpaus equation of australian import is the same as the export of world rubber products to australia: mrpaus=xrpwau export of rubber products (tires) of the world to australia: xrpwau=xrpiaus+xrptaus+xrpcaus+xrpjaus+x rpothau the export price of indonesian rubber products (tire) to australia: rpxrpiaus=rprpiaus*(tfrpaus1+1) the export price of thailand rubber products (tire) to australia: rpxrptaus=rprptaus*(tfrpaus1+1) the export price of chinese rubber products (tire) to australia: rpxrpcaus=rprpcaus*(tfrpaus1+1) the export price of japanese rubber products (tire) to australia: zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 201966 rpxrpjaus=rprpjaus*(tfrpaus1+1) the value of imports of rubber products (tires) by australia: nmrpaus=1000*(mrpaus*rprpaus4) the export value of indonesian rubber products (tire) to australia: nxrpidn=1000*(xrpiaus*rpxrpiaus) the export value of thailand rubber products (tire) to australia: nxrptha=1000*(xrptaus*rpxrptaus) the export value of chinese rubber products (tire) to australia: nxrpcn=1000*(xrpcaus*rpxrpcaus) the export value of japanese rubber products (tire) to australia: nxrpjp=1000*(xrpjaus*rpxrpjaus) the demand and supply relationship function is built using simultaneous equations system and estimated using two stages least squares (2sls) in order to estimate consistency and efficiency with consideration of endogeneity problem in equation (sitepu and sinaga, 2018; verbeek, 2012). to find out if a model is valid enough for a simulation then it is necessary to validate the model with the purpose of how far the ability and reliability of the model can represent real-world behavior. the statistical criteria used in validating the model are root mean square percent error (rmspe) and theil’s inequality coefficients (u). a simulation was then conducted to study the effect of exogenous variables on endogenous variables in the model. the purpose of the simulation in this study is to explain the impact of the slowdown in market demand and trade deregulation through the decline of import tariffs in australia using historical simulation (ex-post simulation) as shown in table 1. 4. results and discussion 4.1. the market power of the tire industry in australia and exporting country the lerner index can be used to measure price mark-ups beyond the marginal cost of the exporting and domestic industries in australia. the measurement of how much the price mark-up is calculated by multiplying the price plexibility by the conjectural elasticity. according to luckstead et al. (2015) that the ability of an industry to utilize oligopolistic forces and determine prices exceeds the marginal cost (mark-up) depends on supply conditions (conjunction elasticity) and demand (price flexibility). measurement of price flexibility, conjunctional elasticity and price mark-up exceeds marginal cost by domestic industry in australia and rubber exporting country industries using simultaneous equations system. the price pricing estimation, the conjectural elasticity and the price-up marks are presented in table 2. the plexibility of tire prices in australia toyo tire and rubber company and bridgeston corporation. the conjectural elasticity of domestic rubber products in australia shows magnitude 0.3570. this elasticity is more than the conjectural elasticity of imported tire products ranging from 0.50 to 0.75 or closer to 1. as luckstead et al. (2015) states there are four possible forms of market competition. first, the situation of perfect collusion where the producer acts as a monopoly. conjectural variation is equal to one and the market share is also equal to one so that the conjunction of elasticity equals one. as a result, the mark-up capability of prices is determined by only the plexibility of demand. second, the situation in the competition cournot. conjuctural variation equals one and a small market share of one. the arrival of the price mark-up capability depends on the placement of demand and market share. third, the situation operates in a fully plexible market structure where the ability to mark-up prices is determined by the conjunction of elasticity weighs with demand flexibility. fourth, the situation in the perfect competition where the market share is so small that it is not strong enough to affect the price so that the conjectural elasticity is equal to zero and the price mark-up is also equal to zero or the price equals the marginal cost. the form of competition on the market is not strong enough to affect the price so that the conjectural elasticity is equal to zero and the price mark-up is also equal to zero or the price equals the marginal cost. the form of competition in the export markets of rubber products in australia is closer to the market setuasi pleksibel structure because the choice of origin table 2: capability of mark-up of rubber products of importing and exporting countries 1985-2015 period importing country market (j) exporting country (h) demand flexibility dan conjectural elasticity εj θj θj.k australia 1.462 0.082 indonesia 0.133 thailand 0.255 china 0.269 japan 0.333 mark-up θj εj θj.hεj australia 0.1199 indonesia 0.195 thailand 0.373 china 0.394 japan 0.487 demand flexibility of tire in australia (εj) where j=australia. tire conjectural elasticity in australia (θj) where j=australia. tire conjectural elasticities are exported to australia (θj.h) where, h=indonesia, thailand, cina, dan jepang sources: processed data table 1: scenario model simulation of rubber product trade (tire) indonesia simulation scenario change size (%) a1-a2 decrease in tariff on imported products rubber −35.0−700 b1-b2-b3 weakening demand on rubber products in australia: 1. gdp per capita 2. automotive production 3. price of crude oil 0.5−1.5−3.0 −2.0−4.0−6.0 −10.0−20.0−30.0 zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 2019 67 of products and brands are also available at any time and not so limited. as table 2 shows that the ability of the exporting country (indonesia, thailand, china and japan) determines the price to exceed the higher marginal cost (mark-up) than similar industries in australia. the domestic tire industry in australia only marks up 12%, while indonesia 20% thailand 37%, china 39%, and japan 48%. the australian rubber (tire) product industry is protected by an average import tariff of 12% in the period 1985 to 2015 (world bank, 2016). however, import tariff charges tend to decrease trend. the average tariff on rubber products (tires) in australia was about 15% in the period 1985 to 2004. the import tariffs dropped to an average of about 10% in the period 2005 to 2009, and about 5% in the last 6 years. australia protects the domestic rubber industry by not imposing import tariffs on natural rubber raw materials (zero tariff). australia prefers to strengthen the domestic industry’s competitiveness of rubber products (tires) in response to compete with similar industries from other countries. indonesia’s and thailand’s rubber industries benefit from the abundance of natural rubber raw materials, relatively lower labor costs, and possibly lower shipping costs to australian ports. however, some other input materials (synthetic rubber, carbon black, etc.) must be imported. in contrast, the japanese rubber industry is faced with relatively high labor costs but has the advantage of manufacturing operational efficiency as a source of innovation and technological improvement. china’s rubber products industry benefits from relatively low labor costs but they are faced with higher natural rubber raw material costs due to the imposition of natural rubber tariff rates of around 20%. 4.2. the impact of import tariff reduction on rubber products industry in australia and exporting country australia developed a rubber product processing industry that is mostly aimed at fulfilling domestic demand and the remaining 22.10% in exports to various countries. the needs of natural rubber raw materials are mostly imported from asean countries. production of australian domestic rubber products (tire) at least through major rubber industry companies such as sumitomo rubber industries, toyo tire and rubber company, bridgeston corporation and fukushima rubber corporation, and others. the production of australian rubber products (tire) is an average of 42924 tons from 1985 to 2015 and has tended to decline since 2002 so that the average domestic production of these products amounts to 18430 tons per year in the period 2002 to 2015 (un comtrade, 2016). the decline in domestic production led to an increase in australian imports from a number of countries. in the period 1985 to 2015 the import of these products was an average of 171201 tons per year, doubled in the last 6 years (2010 to 2015) is an average of 342522 tonnes (un comtrade, 2016).the exporting countries of rubber products (tire) to australia such as china, japan, indonesia, thailand, south korea, united states, india, and others. however, the consideration and relevance of continuous export in the last 30 years is the exporting countries of indonesia, thailand, china and japan. the exporting country of rubber products entering the australian export market is faced with the protection of import tariffs. through globalization and trade cooperation both bilaterally and multilaterally always refers to the reduction of trade barriers, both tariff and non-tariff forms. reduction of trade barriers is considered to increase the volume of trade, increased consumption, economic growth and welfare of the community. this is in accordance with erwidodo (2013) on international trade, globalization, and protection. feenstra (2003) concerning the effect of tariff reduction on international trade. through the spirit of globalization and trade cooperation agreement simulated the impact of the reduction of tariff on the import of rubber products (tire) on export markets in australia as listed in table 3. if tariffs on australian imports of rubber products (tire) fell 50% and 75%, import of tire products by −2.61% and −7.22%. the decline in the price of rubber products (tire) reduced the production of rubber products (tire) in the australian domestic industry by 23.56% and 65.29%. conversely, the impact of increased imports of rubber products (tire) by australia by 12.15% and 33.47%. the decline in import prices of rubber products (tire) also impacted the decline in prices of rubber products (tire) consumer level is large enough that demand increased by 9.91% and 27.26%. the result of simulation of tariff reduction of tire product by 50% and 75% has an impact on the decline of export prices of rubber products (tire) from most exporting countries. this simulation also gives an impact of the total increase of world rubber (tire) exports to australia. exports of rubber products (tire) from various countries to australia also experienced a relatively large increase if the decline in import tariffs by australia except japan’s exports decreased. this suggests an indication that the demand behavior of rubber products (tire) in australia is renewal of price changes. the decline in import tariffs lowered the price of imported rubber products (tire) including australian domestic tire products. the possibility of substitution between rubber products (tire) from indonesia, thailand, china with similar products from australia and japan. as a result, the export supply of japanese rubber products to australia has decreased and the production of similar products in australia has also decreased if import tariffs are lowered. meaning that can be lifted from these facts is the reduction of import tariffs rubber products (tire) in australia provide more benefits to the increase in export of these products from china, thailand and indonesia compared to the benefits received by the japanese and australian domestic similar industry. this simulation result gives an impact to the increase of import value of rubber products (tire) by australia. the export value of rubber products (tire) from exporting countries of thailand and china tends to increase if the decrease of import tariff in australia, on the contrary export value of rubber products (tire) from exporting country of indonesia and japan decrease. the decline in export value of japanese rubber products is still related to the decline of japanese product exports to australia due to to lower import tariffs. the high surge from the increase in export value of tire products in australia experienced by the exporting countries of china and thailand, while indonesia decreased. 4.3. the impact of weakening demand for rubber products (tire) in australia the decline in demand for rubber products in australia is affected by slowing growth in gdp per capita, declining automotive production and weakening global crude prices. in the last 3 years zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 201968 australia’s gross national income per capita growth experienced a downward trend of −2.76% in 2013-2015. the decline in national income per capita is related to the global economic downturn with a negative gni per capita growth of −0.77% in 2013 until 2015. a number of countries that become main trading partners of australia also experienced a decrease in gni per capita growth in the period 2013 to 2015 such as the eu −1.01%, japan −6.53% and china’s slowdown from 12.58% in 2010 to 2012–5.53% in 2013 to 2015 and the united states also slows from 2.43% in 2010 to 2012–1.46% in 2013-2015 (world bank, 2016). the interdependence through trade between australia and its major partner spawned a difficult setback to reverse its economic trend in the next few years, except more than expected from domestic consumption with lower gdp growth risks and relatively high unemployment. the weakening demand for rubber products (tire) in australia in the sense that there will be market pessimism due to the possibility of a decline in purchasing power in the australian market. the slower gni growth per capita and the decline in world crude oil prices will push the personal income after tax (disposable income) with the growth slows down. this situation will affect the personal expenditures such as in the purchase of durable goods such as vehicles and equipment (motor vehicle and parts). the impact on the trade of rubber products (tire) was analyzed in the presence of moderate market a1 conditions (average rgdp per capita rose 0.5%, australian automotive production fell −2% and crude oil prices on the world market decreased −10%); pessimists a2 with rgdp per capita down −1.5%, australian automotive production down −4% and world crude oil prices down −20%) and very pessimistic a3 (average rgdp per capita decreased −3.0%, automotive production australia fell −6% and crude oil prices in the world market fell −30%) as listed in table 4. the increasing market pessimism has a sensitive impact on the decline in prices of rubber products (tire) in the australian market. this simulation has had an impact on the decline in prices of consumer rubber products (tire) in australia by −5.87%, −6.44% and −8.08% if market demand further weakens. the weakening of demand also has an impact on the decline in export prices of indonesian, thailand, chinese and japanese rubber products. this simulation resulted in an increase in the production of the domestic industrial rubber products (tire) of australia by 2.01%, 4.03% and 6.05% followed by falling demand for rubber products (tire) in the australian market. an increasingly weakening demand condition is likely to lead to stronger substitution of rubber products (tire) from imported origin to domestic tire products. as a result of weakening demand in the australian market, the impact of decline in imports of rubber products (tire) by australia amounted to −0.99%, −1.99% and −2.98%. the decline in export prices and demand for rubber products (tire) in the australian market has impacted the decline of exports of these products from various countries such as indonesia, thailand and china, while the export of tire products from japan tend to be stable. this simulation has an impact on the decline in the value of imports of rubber products (tire) by australia, as well as the export value of rubber products (tire) from exporting countries also experienced a relatively large decline. in contrast, the export value of rubber products (tire) from japan tend to be stable in case of weakening demand in australia. the excessive decline in export value of chinese and thailand rubber products may be related to the high table 3: the impact of reduced tariffs on imports of rubber products (tire) in australia exporter/variable decrease of import tariff of rubber products basic value 50% 75% changes (%) imported tire prices in australia (us$/kg) 4.521 −2.61 −7.22 consumer tire prices in australia (us$/kg) 4.334 −20.49 −56.77 tire production in australia (ton) 21089 −23.56 −65.29 real prices of indonesian tire exports to australia (us$/kg) 5.138 −28.17 −38.92 real prices of thai tire exports to australia (us $/kg) 4.670 −11.92 −10.51 real prices of chinese tire exports to australia (us $/kg) 1.958 40.98 81.59 real prices of japanese tire exports to australia (us $/kg) 5.610 −2.96 4.88 indonesian tire export price is divided by import tariff+1 0.724 26.83 73.50 thailand tire export price is divided into import tariffs+1 0.687 54.80 150.71 chinese tire export price is divided by import tariffs+1 0.284 151.66 417.09 japan tire export price is divided by import tariff+1 0.837 69.02 189.57 tire demand in australia (ton) 335031 9.91 27.26 australian tire imports (tonnes) 313943 12.15 33.47 indonesian tire exports to australia (tonnes) 18010 17.22 47.22 thailand tire exports to australia (tonnes) 33371 26.88 73.88 china’s tire exports to australia (tonnes) 113374 35.54 97.67 japan’s tire exports to australia (tonnes) 41750 -34.03 -92.95 world tire exports to australia (tonnes) 313943 12.15 33.47 basic value 50 persen 75 persen changes (value) value of australian tire imports (million us $) 1428.90 131.40 338.30 value of indonesia’s tire exports to australia (million us $) 91.00 −14.09 −8.03 value of thai’s tire exports to australia (million us $) 156.04 20.81 94.18 value of china’s tire exports to australia (million us $) 216.85 217.26 616.88 value of japan’s tire exports to australia (million us $) 230.74 −85.07 −221.73 zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 2019 69 substitution of imported tire products with domestic tire products due to lower import tariffs. 4.4. impact of import tariff reduction on rubber products (tire) on conditions of weakening demand in australia the impact of trade deregulation policy through reduced import tariffs on rubber products is analyzed for weakening market demand in australia that is moderate (a1), pessimistic (a2) to very pessimistic (a3) are listed in tables 5 and 6. this combination simulation has an impact on decline in import prices and consumer price levels of rubber products (tires) in australia. although import tariffs are lowered but export prices of rubber products (tire) from exporting countries in australian markets tend to decrease if market demand weakens. the simulation also affects the decline in production of rubber products in australian domestic industries if import tariffs are lowered in conditions of weakening market demand. the impact of the tariff reduction on rubber products (tires) by importing countries despite demand conditions is weakening in accordance with the theoretical framework about the effects of tariff reductions on international trade flows (tweeten, 1992; chacholiades, 1978; houck, 1986). sorenson (1975) in his analysis argument states that the benefits of trade liberalization through the decline of trade barriers is the possibility of diversification of export products from primary commodities to agricultural processed products of the majority of developing countries. under conditions of weakening market demand a relatively large impact on production declines in the australian tire industry if import tariffs are lowered. this is consistent with li and carter (2009) which states that the decline in trqs quotas can improve market access in international trade. hacault (2011) states that the decrease of tariff-rate import quotas in the canadian dairy industry has resulted in an increase in import volume so that domestic prices fall and subsequent impacts are detrimental to producers and benefit domestic consumers. ünüvar and dellal (2017) stated that the reduction in tariffs on sugar affects the decline of production and producer welfare in turkey, but increase in sugar consumption and consumer welfare. mohan et al. (2013) suggest that escalation rates do not become a major barrier to the flow of agricultural processed products exports but the prevalence of non-tariff barriers (including domestic non-tariff barriers) also plays such important roles norms for size, quality, labeling, marketing, traceability (eu), conformity certification, rules of origin, customs, private standards and other. joramo (2016) found an insignificant effect of tariff reductions on imports of agricultural products in norway. this fact is in contrast to other empirical results and possibly due to elasticity of elasticity and so small share of the consumer budget for agricultural product expenditure in norway. it is possible to substitute imported tire products with australian domestic tires because of falling prices due to lower import tariffs. australian domestic tire products are less competitive with similar products of import origin. demand for rubber products (tire) in australia has increased, followed by the increase in global exports of rubber products (tire) to australia. in the condition of weakening table 4: the impact of weakening demand for rubber products (tire) in australia exporter/variable weakening demand for rubber products (tire) basic value a1 a2 a3 changes (%) imported tire prices in australia (us$/kg) 4.521 0.22 0.43 0.65 consumer tire prices in australia (us$/kg) 4.334 5.87 6.44 8.08 tire production in australia (ton) 21089 2.01 4.03 6.05 real prices of indonesian tire exports to australia (us$/kg) 5.138 −3.11 −6.22 −9.34 real prices of thai tire exports to australia (us $/kg) 4.670 −0.97 −1.94 −2.91 real prices of chinese tire exports to australia (us$/kg) 1.958 −7.17 −14.33 −21.50 real prices of japanese tire exports to australia (us$/kg) 5.610 −0.61 −1.21 −1.82 indonesian tire export price is divided by import tariff+1 0.724 −2.86 −5.72 −8.60 thailand tire export price is divided into import tariffs+1 0.687 −1.05 −2.08 −3.11 chinese tire export price is divided by import tariffs+1 0.284 −6.87 −13.74 −20.65 japan tire export price is divided by import tariff+1 0.837 −0.59 −1.18 −1.77 tire demand in australia (ton) 335031 −0.80 −1.61 −2.41 australian tire imports (tonnes) 313943 −0.99 −1.99 −2.98 indonesian tire exports to australia (tonnes) 18010 −1.81 −3.62 −5.42 thailand tire exports to australia (tonnes) 33371 −4.02 −8.04 −12.07 china’s tire exports to australia (tonnes) 113374 −1.38 −2.77 −4.15 japan’s tire exports to australia (tonnes) 41750 0.29 0.57 0.86 world tire exports to australia (tonnes) 313943 −0.99 −1.99 −2.98 basic value a1 a2 a3 changes (value) value of australian tire imports (million us$) 1428.90 −11.40 −22.80 −34.30 value of indonesia’s tire exports to australia (million us$) 91.00 −4.40 −8.68 −12.83 value of thai’s tire exports to australia (million us$) 156.04 −7.79 −15.45 −22.98 value of china’s tire exports to australia (million us$) 216.85 −17.92 −35.38 −52.38 value of japan’s tire exports to australia (million us$) 230.74 −0.73 −1.48 −2.23 a1: australian gdp rose 0.5%; australian automotive production fell 2%; price of crude oil on the world market fell 10% a2: australian gdp down 1.5%; australian automotive production 4%; price of crude oil on the world market fell 20% a3: australian gdp down 3%; australian automotive production 6%; and price of crude oil on the world market fell 30%. sources: processed data zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 201970 demand, exports of rubber products (tire) from various countries to australia increased if the decrease in import tariffs unless japanese exports decreased. this suggests an indication that the demand behavior of rubber products (tire) in australia is renewal of price changes. the decline in import tariffs tends to reduce the price of rubber products of various origin of rubber products including australian domestic tire products. the possibility of substitution between tire products from indonesia, thailand, china with tire table 5: the impact of reduced tariff on imports of rubber products (tire) in the condition of weakening demand is moderate to pessimistic (a1-a2) in australia exporter/variable decrease in tariffs on imports of rubber products basic value a1 a2 50% 75% 50% 75% changes (%) imported tire prices in australia (us$/kg) 4.521 −2.38 −6.94 −0.42 −5.02 consumer tire prices in australia (us$/kg) 4.334 −14.46 −50.43 −23.46 −55.10 tire production in australia (ton) 21089 −21.34 −62.73 56.71 −22.80 prices of indonesian tire exports to australia (us$/kg) 5.138 −30.04 −40.20 −0.76 −14.70 prices of thai tire exports to australia (us $/kg) 4.670 −12.73 −11.29 −10.21 −8.70 prices of chinese tire exports to australia (us$/kg) 1.958 36.21 77.86 −18.85 7.51 prices of japanese tire exports to australia (us$/kg) 5.610 −3.62 4.11 −0.36 7.59 tire demand in australia (ton) 335031 9.02 26.24 9.76 27.09 australian tire imports (tonnes) 313943 11.06 32.21 3.56 23.32 indonesian tire exports to australia (tonnes) 18010 15.28 45.05 3.85 30.91 thailand tire exports to australia (tonnes) 33371 22.65 69.28 18.19 64.35 china’s tire exports to australia (tonnes) 113374 33.87 95.51 15.10 68.34 japan’s tire exports to australia (tonnes) 41750 −33.48 −91.95 −34.32 −91.14 world tire exports to australia (tonnes) 313943 11.06 32.21 3.56 23.32 basic value a1 a2 50% 75% 50% 75% changes (value) value of australian tire imports (million us$) 1428.90 119.80 326.50 108.10 314.70 value of indonesia’s tire exports to australia (million us$) 91.00 −17.31 −10.93 −20.45 −13.77 value of thai’s tire exports to australia (million us$) 156.04 13.37 85.53 6.04 77.01 value of china’s tire exports to australia (million us$) 216.85 198.42 592.13 179.94 567.75 value of japan’s tire exports to australia (million us$) 230.74 −84.85 −219.42 −84.66 −217.15 table 6: the impact of reduced tariff on imports of rubber products (tire) in the condition of weakening demand is very pessimistic (a3) in australia exporter/variable decrease in tariffs on imports of rubber products basic value a3 50% 75% changes (%) imported tire prices in australia (us$/kg) 4.521 −1.90 −6.39 consumer tire prices in australia (us$/kg) 4.334 −11.89 −47.25 tire production in australia (ton) 21089 −16.92 −57.60 prices of indonesian tire exports to australia (us$/kg) 5.138 −33.80 −42.77 prices of thai tire exports to australia (us $/kg) 4.670 −14.35 −12.87 prices of chinese tire exports to australia (us$/kg) 1.958 26.69 70.42 prices of japanese tire exports to australia (us$/kg) 5.610 −4.95 2.58 tire demand in australia (ton) 335031 7.26 24.20 australian tire imports (tonnes) 313943 8.88 29.69 indonesian tire exports to australia (tonnes) 18010 11.40 40.70 thailand tire exports to australia (tonnes) 33371 14.18 60.07 china’s tire exports to australia (tonnes) 113374 30.54 91.19 japan’s tire exports to australia (tonnes) 41750 −32.39 −89.95 world tire exports to australia (tonnes) 313943 8.88 29.69 basic value (million us$) a3 50% 75% changes (value) value of australian tire imports 1428.90 96.30 302.80 value of indonesia’s tire exports to australia 91.00 −23.50 −16.55 value of thai’s tire exports to australia 156.04 −1.19 68.60 value of china’s tire exports to australia 216.85 161.82 543.74 value of japan’s tire exports to australia 230.74 −84.48 −214.91 zainuddin, et al.: assessing market power, impact of import tariff reductions and weakening demand for rubber products (hs code 4011) in the australian market international journal of economics and financial issues | vol 9 • issue 2 • 2019 71 products from japan. as a result, the supply of tire exports from japan to australia has decreased if import tariffs are lowered in conditions of weakening market demand. moreover, the average price of tire products from japan in australia is higher than similar products from other exporting countries. this simulation resulted in an increase in the value of imports of rubber products (tires) by australia with greater value if market demand is weakened. the export value of rubber products (tire) from the exporting country of indonesia decreased, while thailand and china increased export value of rubber products (tire) to the australian market. the value of exports of rubber products (tire) from japan has decreased. the decline in export value of japanese tire products is still related to the decline of japanese product exports to australia due to lower import tariffs on conditions of weakening demand. 5. conclusion the decline in import tariffs has the effect of lowering the prices of imported rubber products (tire) in australia, as well as the export prices of rubber products from exporting countries to export markets in australia. the decline in tariffs on imported rubber products in australia has a negative impact on japanese exports compared to competitors (china, indonesia, thailand). the export of rubber products from japan is more sensitive because of price changes compared to its competitors. the decline in import tariffs for rubber products in australia has benefited more from the increase in exports of these products from china, thailand and indonesia compared to the benefits received by japan and similar industries from australia. the decline in tariffs also had an impact on the decline in the value of imports of australian rubber products. in contrast, the export value of tire products from thailand and china tends to increase relatively large. on the contrary, the export value of similar products from indonesia and japan decreased. demand weakening has had a sensitive impact on the decline in consumer tire prices in australia. similarly, the export prices of rubber products from indonesia, thailand and china. the export price of japanese rubber products to the australian market tends to be stable. the impact of weakening demand on the australian market lowered exports of rubber products from exporting countries. the weakening demand also has an impact on the decline in the value of imported rubber products (tire) by australia. similarly, the export value of rubber products (tire) from indonesia, thailand and china also decreased. on the contrary, the export value of similar products from japan tends to be stable. the decline in tariffs on rubber products (tire) on the condition of weakening demand has an impact on the decline in import prices and prices of consumers of these products. export prices of rubber products (tire) from exporting countries tend to decrease if market demand weakens, as well as production of domestic rubber products (tire) in australia has decreased. demand and imports of rubber (tire) products by australia have increased with smaller increases if demand conditions weaken. exports of rubber products (tire) from exporting countries to the australian market increased unless japanese exports declined. this shows an indication that the demand behavior of rubber products (tire) in australia is responding to price changes. the decline in import tariff tends to reduce the price of rubber products (tire) of various origin of imports of these products including australian domestic tire products. the possibility of substitution between tire products from indonesia, thailand, china and australia with tire products from japan. as a result, the export of rubber products (tire) from japan to australia has decreased if the import tariffs are lowered in the condition of increasingly weakening market demand. references brander, j.a. 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(2016), world bank database statistic. available from: http://www.world bank.org/tariff/. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(3), 244-251. international journal of economics and financial issues | vol 9 • issue 3 • 2019244 foreign inputs and changes in domestic value added exports: empirical evidence from latin american countries guy roland assamoi1*, shaoyuan wang1, yobouet thierry bienvenu gnangoin2, akadje jean roland edjoukou3 1school of international trade and economics, dongbei university of finance and economics, dalian, china, 2school of economics, dongbei university of finance and economics, dalian, china, 3school of accounting, dongbei university of finance and economics, dalian, china. *email: assamoiguyroland@yahoo.fr received: 19 march 2019 accepted: 19 may 2019 doi: https://doi.org/10.32479/ijefi.8059 abstract this paper aims to analyze the factors affecting domestic value added in exports for seven latin american countries (lac) with a focus on the role played by foreign inputs. by using panel data (1995-2016) with fixed effects model, the paper finds that foreign value added (fva) in exports is a strong determinant of positive changes in domestic value added exports in latin america. the paper also finds that institutions, tariffs and labor productivity are important determinants of changes in dva in exports. additionally, a sectoral analysis reveals the positive effect of fva in exports on changes in dva in exports in three sectors: agriculture, manufacture and services. however, fva in exports has no significant effect on dva in exports in the mining sector. overall, our results suggest countries to lower tariffs, to adopt policies that enhance the import of sophisticated intermediates inputs and to promote favorable business environment. keywords: value added exports, global value chains, latin america jel classifications: f13, f14, n16, p33 1. introduction with the emergence of global value chains (gvcs), traditional trade statistics measuring gross exports became unable to objectively capture a country’s real export performance (jara and escaith, 2012; banga, 2014; suder et al., 2014). domestic value added (dva) in exports provides a better measure of a country’s export performance and global competitiveness since only the domestic part of the country’s total exports contributes to its g.d.p. (unctad, 2013). therefore, it is become important for policymakers to understand the main drivers that contribute to greater domestic content of exports. recent studies have investigated the determinants of changes in domestic value added in exports (kowalski et al., 2015, vrh, 2018; gonzales, 2016; yu and luo, 2018). like kowalski et al. (2015), most of the studies subdivided the factors that affecting domestic value added in exports into two broad categories: the structural factors that refer to factor endowments and the policy factors that include trade policies, investment openness, the quality of infrastructure as well as the quality of institutions. few studies have explored the dimension relating to domestic and international linkages. gonzales (2016) has contributed to the literature by investigating the role of foreign factors on enhancing domestic export performance. he found that foreign sourcing (foreign value added [fva]) is a complement to the creation of domestic value added in exports for southeast asian countries. following lopez, this paper aims to investigate the role of foreign factors on changes in domestic value added exports for seven this journal is licensed under a creative commons attribution 4.0 international license assamoi, et al.: foreign inputs and changes in domestic value added exports: empirical evidence from latin american countries international journal of economics and financial issues | vol 9 • issue 3 • 2019 245 selected latin american countries (lac): argentina, brazil, chile, columbia, costa rica, mexico and peru. latin america’s participation in global value chains is low compared to other developing regions like south east asian economies (blyde, 2014; de backer and miroudot, 2013; uneclac, 2014 and oecd/caf/eclac, 2015). thus, most studies were focused on factors that limiting that participation and suggested policies to enhance latin america’s participation in gvcs (cadestin et al., 2016; cruz et al., 2013). however, increasing a country’s participation in gvcs does not necessarily lead to an increase of the domestic content of its exports. therefore, unlike most previous studies on latin america, this study aims to analyze specifically the main drivers that contribute to greater domestic content of latin america exports with a focus on the role played by foreign inputs (fva). figure 1 shows the share of dva and fva in gross exports for the selected countries. it can be noticed that the share of domestic value added in exports1 was relatively important (about 75% of the total exports) over the whole period 1995-2016. on the dva share in exports dynamics, three periods can be identified. first, in the period 1995-2000, dva share in exports considerably decreased from around 83% in 1995 to about 75% in 2000. then, a general upward trend in the share of dva in exports may be observed from 2001 (around 75%) to 2011(over 80%). finally, there was another decrease of dva share over the period 2012-2015 followed by a slight rise just after 2015. additionally, figure 1 shows that an increase of dva share was associated to a decrease of fva share and inversely. over the whole period, an important increase of fva share in exports is observed. this situation may lead to concerns about possible reduction in future domestic share of value added in exports. are the concerns justified? in what extent fva in exports contribute to the domestic export performance of the selected countries? what are the relevant factors that affect domestic value added in exports in those countries? these are precisely the questions this paper seeks to answer. in addition, this paper also provides a sectoral analysis by investigating the role of foreign factors on domestic export performance in the following sectors: agriculture, mining, manufacture and services. overall, the results confirm the positive and strong association between fva in exports and domestic value added in exports. tariffs, institutions as well as labor productivity are also found to be strong determinants of changes in domestic value added exports in latin america. moreover, the results show differences across the determinants of changes in dva across the sectors. 1 the share of dva in exports (gdp in exports) in this paper is calculated relying on the decomposition method of gross exports into value-added exports provided by koopman et al (2010). according to koopman et al (2010), gdp in exports= domestic value in direct final goods exports + domestic value in intermediates exports absorbed by direct importers + domestic value in intermediates exports reexported to third countries + domestic value in intermediates exports that return home. share of dva in exports= (gdp in exports /total gross exports). the rest of the paper is structured as follows. section 2 presents the existing empirical research evidence on the determinants of dva. section 3 gives a description of the empirical strategy. then, the results are presented in section 4, and finally section 5 provides the conclusions. 2. literature review several studies have investigated the determinants of changes in domestic value added in exports. relying on the existing literature, the factors affecting domestic value added in exports can be classified into two broad categories: the structural factors and the policy factors. the structural factors refer to factors endowments while the policy factors include trade policies, investment openness, research and development (r&d), quality of infrastructure as well as quality of institutions (kowalski et al., 2015; jonhson and noguera, 2012). focusing on structural factors, johnson and noguera (2012) found that more manufactured products in a country’s export goods will reduce the value-added in its exports. in other words, the higher the share of the manufacturing sector in a country’s gross domestic product (gdp), the lower the share of domestic value added in its exports. another important structural factor is the market size. countries with larger markets are expected to have higher share of dva in exports since they can rely on a wider array of domestic intermediates both in terms of purchases and sales (oecd, 2015). regarding the policy factors, inward foreign direct investment (ifdi) and trade policy are found to be important determinants of changes in dva in exports. for example, vrh (2018) found that ifdi leads to reduced demand for domestic inputs and has a negative effect on dva in exports for old and new e.u. member states. likewise, kowalski et al. (2015) explained that ifdi is likely to be associated more with importing of foreign inputs for exports processing rather than with exporting the domestic value added for export processing abroad. tariffs also play an important role. gonzales (2016) showed that tariffs have a negative effect on domestic value as tariffs may reduce access to more sophisticated intermediate products which might otherwise help firms become more competitive (bas and strauss-kahn, 2014; bas and strauss-kahn, 2015). by contrast, source: oecd-tiva 2016 and 2018, own calculations figure 1: share (%) of domestic value added and foreign value added in exports for seven latin american countries, 1995-2016 assamoi, et al.: foreign inputs and changes in domestic value added exports: empirical evidence from latin american countries international journal of economics and financial issues | vol 9 • issue 3 • 2019246 caraballo and jiang (2016) found a positive correlation between the tariffs applied to manufactured products and the dva share suggesting that countries with greater protectionism are likely to increase their dva. share in exports. still focusing on policy factors, recent studies emphasized the importance of r&d, labor productivity and institutions on positive changes in dva in exports (beverelli et al., 2017). for example, yu and luo (2018) found that r&d and capital physical positively influences china’s dva in exports. an explanation is that r&d is expected to boost the technological catch-up and innovation while the capital formation will contribute to modern productive system. as for labor productivity, sahu (2016) explained that higher skilled labor tend to positively affect the efficiency of manufacturing and thereby exports and dva in exports. he found a strong and positive relationship between human capital and malaysia’s domestic value added in exports. besides the structural and policy factors, gonzales (2016) shed light on the role of fva in production of exports on positive changes in the domestic value added embodied in exports. he found that fva is a strong complement to the creation of domestic value added in exports for southeast asian countries. this confirms the important link between importing and export competitiveness. by using industry data, kummritz (2014) reached the same conclusion that countries which rely on fva can increase their domestic value added in gdp. focusing on latin america, the existing literature discussed more the determinants of lac’s participation in global value chains rather than specifically discussed the factors that contribute to greater domestic content of their exports. for example, (blyde, 2014; hernández et al., 2014 and oecd/caf/eclac, 2015) found that latin america’s participation in global value chains which is low compared to other developing regions like asia and essentially consists of supplying relatively unprocessed natural resource-based inputs and suggested more diversification of economic activity. likewise, ahmad and primi (2018) also found the extent of gvc’s participation for lac relatively low. thus, they suggested that improving regional integration, reducing barriers to trade as well as building strong domestic supply chains may help to enhance the two regions participation in gvcs. similarly, cadestin et al. (2016) have analyzed, along with other factors, the impact of rules of origin (roo) and non-tariff measures (ntms) on gvc integration in latin america. they found that convergence on roo and regulatory standards as well as a reduction of ntms may help to increase the integration of the region into global value chains (grubler et al., 2015). the key ideas from the existing research findings suggest that in addition to the structural and policy factors (the traditional factors), fva in exports is also an important determinant of the changes in dva in exports. the existing literature also shows that most studies on latin america were focused on suggesting policies to increase lac’s participation in global value chains rather than specifically discussed the factors that may contribute to higher share of dva in their exports. since increasing a country’s participation in gvcs does not necessarily lead to higher share of dva in its exports, this study aims to specifically analyze the factors affecting the changes of dva in exports for latin american with a focus on the role played by fva in the production of exports. 3. empirical strategy 3.1. regression specification this study investigates the determinants of changes in domestic value added in exports with a focus on the role played by fva in exports. as mentioned by kowalski et al.(2015), there is no empirical “gold standard” for analyzing the determinants of gvc trade, so this paper mainly relies on theoretical predictions and existing empirical findings. thus, the regression model for testing the factors affecting domestic value added in exports of the selected lac is as follows: dvait = α+(xit–1)β+µ+εit (1) where dva is an estimated measure of domestic value added content of gross exports in millions us dollar relating to country i and time t. εit is the random error term, while μ represents the country-fixed effects and xit–1 the vector of explanatory variables. x includes the following independent variables: gdp in current us dollar as an indicator of market size, fdi net inflows in current us dollar that indicates the openness to fdi, the simple average of tariff rates applied to all products (tariff), a measure of rule of law (law), labor productivity as an indicator of the output per worker (labor prod) and fva in exports in millions us dollar. all regression specifications are estimated with a fixed effect model. the fixed effect model assumes that each country specific characteristics are correlated with the independent variables. the hausman test statistic confirms the fixed effects as more appropriate than the random-effects model. in all regressions, white’s heteroscedasticity robust standard errors are used for calculating standards errors. to avoid simultaneity bias and to allow for a deferred reaction of dva., all explanatory variables are lagged by 1 year. moreover, all variables, with the exception of rule of law, are in logs to eliminate potential outliers. as a robustness check, a new variable, manufacture value added (manuf) is added to the initial model for regression. additionally, estimations have been reiterated for four broads sectors (agriculture, manufacturing, mining and services) to capture differences across the determinants changes in dva in exports across sectors. 3.2. data and descriptive statistics this study combines several datasets available for the selected countries over the period 1995-2016. the dataset for dva and fva content of gross exports are the oecd value added-trade data (tiva database) of december 2016 and december 20182. as 2 oecd-tiva database (december 2018) covers 64 countries (including all oecd, eu and g20 countries and most east and southeast asian countries and seven latin american countries) and 36 industries. data are provided for the years 2005-2015. for certain indicators, preliminary estimates for 2016 are given. assamoi, et al.: foreign inputs and changes in domestic value added exports: empirical evidence from latin american countries international journal of economics and financial issues | vol 9 • issue 3 • 2019 247 for labor productivity, data have been collected from international labor organization (ilostat) while data on rule of laws were provided by worldwide governance indicators. finally, world development indicators serves as data source for gdp, fdi and tariffs. according to figure 1, and as already mentioned above, there was a general downward in the share of dva in exports (associated with a general upward in the fva share in exports) for the whole sample over the defined period. the two figures below provides detailed information by showing the share of dva and fva in exports by country as well as the share of dva and fva in exports by sector (agriculture, manufacture, mining and services). 3.2.1. share of dva and fva in exports, by country figure 2 shows the share of dva and fva in total exports for each selected country over the period 1995-2016. overall, it can be noticed that the share of dva in exports is much higher than fva’s share in exports for each country. in average, columbia and argentina have the highest share of dva in exports with respectively 90.37% and 90.25%, followed by brazil (88.95%), peru (88.74%), and chile (82.23%) while mexico has the lowest share of dva in exports with (66.84%). regarding the share of fva in exports, in average, mexico has the highest share of fva in exports with 33.16% just followed by costa rica with about 25% and at a lower proportion by chile (17.77%). fva in exports represents less than 12% of the total exports for each of the remaining four countries with columbia and argentina having the lowest shares of fva in their exports. figure 2 also shows that higher share of dva is associated with lower share of fva and vice versa. 3.2.2. share of dva and fva in exports, by sector figure 3 provides the share of dva and fva in exports by sector for all selected countries over the period 1995-2015. a sectoral analysis also shows that fva has a lower share than dva in exports for each sector. the manufacturing sector has the highest share of fva in exports with about 31% in average. far behind, the agriculture sector receives the second largest share of fva in exports with 8.92% while the services sector has the lowest share of fva in exports (6.30%). the share of fva in exports for the mining sector accounts for about 7.26%. focusing on dva in exports, it can be observed that the services and mining sector have the highest share of dva in exports with respectively 93.70% and 92.74%, just followed by the agriculture sector (91.08%) while the manufacturing sector has the lowest share of dva in exports about 68%. similarly, as shown before, slight decreases in the share of dva in exports were associated with slight increases in the share of fva in exports. all sectors have experienced a slight decrease in the share of dva in exports with the manufacturing sector experiencing the most noticeable decrease from around 75.5% in 1995 to about 66% in 2015. 4. results and discussions 4.1. main results table 1 provides the regressions results of the determinants of changes in domestic value added in exports. the column (1) presents the regressions results for all sectors while the following columns (2)-(5) indicate the results for agriculture, manufacturing, mining and services sectors respectively. all regressions include country fixed effects. figure 2: share (%) of domestic value added and foreign value added in exports for seven latin american countries, 1995-2016, by country source: oecd-tiva 2016 and 2018, own calculations assamoi, et al.: foreign inputs and changes in domestic value added exports: empirical evidence from latin american countries international journal of economics and financial issues | vol 9 • issue 3 • 2019248 while considering all sectors, the estimates indicate that rule of laws, tariffs, labor productivity and fva in exports are significant determinants of changes in dva in exports for lac. the results confirm the positive and strong association between fva in exports and domestic value added in exports. fva in exports are found to be strong complement to domestic value added in exports as found by lopez (2016) when focusing on southeast asia. likewise, rule of laws plays a positive role on changes in dva in exports. since rule of laws may give an indication of the quality of institutions, the result suggests that countries with good quality of institutions are expected to have higher share of dva in their exports. as explained by nunn and daniel (2014), poor institutions can hinder the domestic production of intermediate goods leading domestic firms to rely more on foreign intermediates. thus, good institutions can enhance the domestic source: oecd-tiva 2016 and 2018, own calculations figure 3: share (%) of domestic value added and foreign value added in exports for the selected seven latin american countries, 1995-2015, by sector table 1: determinants of the changes in domestic value added in exports dependent variable: ln dva in exports independent variables (1) all (2) agriculture (3) manufacturing (4) mining (5) services gdp (lag 1) 0.0780037 (0.217832) 0.054805 (0.1156474) 0.0113818 (0.2015726) −0.0173691 (0.5143146) −0.0636684 (0.2415249) fdi (lag 1) 0.0833266) (0.1219542) 0.0830824 (0.0698436) 0.0331792 (0.1082664) 0.3846291 (0.2632001) 0.03115 (0.0838503) tariffs (lag 1) −0.5887414*** (0.1577099) −0.3318174 (0.2521703) −0.5800067*** (0.135883) −0.8528735** (0.2327643) −0.2711783 (0.1467295) law (lag 1) 0.6113053* (0.3362863) 0.5718278 (0.4124418) 0.5029466* (0.2863512) 0.8014704 (0.4441006) 0.5498652** (0.2548033) labor prod (lag 1) −2.514297** (1.163242) −2.02963* (1.06998) −2.403765*** (1.018439) −2.556158 (1.464801) −2.687322*** (0.7224764) foreign value added in exports (lag 1) 0.5052265*** (0.0876905) 0.6071612** (0.1734159) 0.491878*** (0.0820556) 0.2689233 (0.1767534) 0.8973187*** (0.1047421) constant 28.17891** (8.717721) 21.82213** (9.329606) 29.45275*** (7.376985) 25.12121*** (6.767117) 31.17262*** (6.418689) observations 121 121 121 121 121 r2 (within) 0.6386 0.6296 0.6060 0.5558 0.6641 country-specific effects yes yes yes yes yes hausman test chi-square (6) 243.05 173.64 1687.77 1164.57 357.10 prob>chi-square 0.000 0.000 0.000 0.000 0.000 robust standards errors in parentheses. all variables are in natural logarithm with the exception of the variable law. explanatory variables are lagged by 1 year. ***p<0.01, **p<0.05, *p<0.1 assamoi, et al.: foreign inputs and changes in domestic value added exports: empirical evidence from latin american countries international journal of economics and financial issues | vol 9 • issue 3 • 2019 249 production of intermediate goods and therefore increase the share of dva in exports. contrary to caraballo and jiang (2016) who found a positive correlation between the tariffs and the dva share, tariffs have a negative effect on changes in dva in exports in selected countries meaning that countries which practice higher tariffs are likely to decrease their share of dva in exports. an explanation is that tariffs tend to reduce the access of more sophisticated intermediates (ahn et al., 2014; cadot and gourdon, 2016, halpern et al., 2015; bas and strauss-khan, 2015). surprisingly, the coefficient of labor productivity is negative which suggests that the higher is the output per worker in a country the lower is its share of dva in exports. this unexpected result may be explained by the fact that the variable labor productivity fails to distinguish between skilled and unskilled labor. thus, labor productivity may not be an appropriate measure for the quality of human capital. regarding the agriculture sector, labor productivity and fva in exports are statistically significant. the coefficient of labor productivity is negative meaning that labor productivity negatively influences the changes in dva in exports while fva in exports positively affects the changes in dva in agriculture exports. focusing on the manufacturing sector, rule of laws, tariffs, labor productivity and fva in exports are found to be significant determinants of changes in dva in exports in the manufacturing sector. tariffs and labor productivity have a negative effect on changes in dva in exports while fva in exports and rule of laws have positive impact on changes in dva in exports. as for the mining sector, only the coefficient of tariffs is statistically significant. the negative coefficient of tariffs indicates that tariffs have a negative impact on changes in dva in exports in the mining sector. finally, for the services sector, rule of law and fva have positive impact on changes in dva in exports while labor productivity has a negative effect on changes in dva in exports. in sum, the results confirm the significant role of fva in exports on positive changes in dva which reinforces the idea that domestic export performance is extremely linked to importing. across the four selected sectors, it can be noticed the effect of fva on positive changes in dva in exports in all sectors with the exception of the mining sector. the services sector is the one with the highest effect of fva on positive changes in dva in exports. 4.2. robustness check to check for the robustness of the results, another variable, namely manufacture, value added (in current us dollars) is added to the initial model. this variable indicates the contribution of the manufacturing sector to gdp and controls for the industrial structure of each country. the higher the share of the manufacturing sector in a country’s gdp, the lower the share of domestic value added in its exports (kowalski et al., 2015). table 2 provides the regressions results with the new added variable. still, the column (1) presents the regressions results for all sectors while columns (2)-(5) indicate the results for agriculture, manufacturing, mining and services sectors respectively. all regressions include country fixed effects. the results in table 2 indicate that the estimations results still hold when a new variable is added to the initial model. when considering all sectors, the coefficients of fva in exports and rule of laws are statistically significant and positive while those table 2: determinants of changes in domestic value added in exports, robustness check results dependent variable: ln dva in exports independent variables (1) all (2) agriculture (3) manufacturing (4) mining (5) services manufacture, value added (lag 1) −0.8208745 (0.5451541) 0.0726811 (0.5695514) −0.6471861 (0.5635193) 0.5590266 (0.9215635) −0.0672973 (0.5716532) gdp (lag 1) 0.7991685 (0.4342855) −0.0128048 (0.5061275) 0.5750025 (0.4651363) −0.5053449 (0.8072007) −0.0018613 (0.4757154) fdi (lag 1) 0.0423037 (0.1262582) 0.0837519 (0,0722417) 0.0061156 (0.1160691) 0.4019914 (0.2702971) 0.0299701 (0.04722) tariffs (lag 1) −0.485667** (0.1793543) −0.3391846*** (0.2435197) −0.4950732** (0.1586926) −0.9261246** (0.2822679) −0.2630832 (0.1537043) law (lag 1) 0.6294352** (0.284479) 0.5784017 (0.4440775) 0.5335054* (0.2364085) 0.8432607 (0.4747855) 0.5456696* (0.2635823) labor prod (lag 1) −2.752106** (0.9611751) −2.038481* (1.085724) −2.596609** (0.8670772) −2.629288 (1.490555) −2.687188*** (0.7132279) foreign value added in exports (lag 1) 0.6280066*** (0.0590537) 0.609187** (0.1651756) 0.5887756*** (0.075761) 0.2433967 (0.2042099) 0.898988*** (0.1152552) constant 31.18229*** (6.898899) 21.90433** (9.37441) 31.90721*** (6.68274) 24.95259** (7.169069) 31.1848*** (6.340516) observations 121 121 121 121 121 r2 (within) 0.6553 0.6298 0.6181 0.5595 0.6643 country-specific effects yes yes yes yes yes hausman test chi-square (7) 261.98 101.34 1244.57 910.99 304.37 prob>chi-square 0.000 0.000 0.000 0.000 0.000 robust standards errors in parentheses. all variables are in natural logarithm with the exception of the variable law. explanatory variables are lagged by 1 year. ***p<0.01, **p<0.05, p<0.1 assamoi, et al.: foreign inputs and changes in domestic value added exports: empirical evidence from latin american countries international journal of economics and financial issues | vol 9 • issue 3 • 2019250 of tariffs and labor productivity are statistically significant and negative. table 2 also shows that the estimations results still hold for each sector. 5. conclusions this paper relies on the decomposition method of gross exports into value-added exports provided by koopman et al. (2010) and recent empirical findings referring to the determinants of changes in dva in exports with a focus on the potential role of foreign inputs (gonzales, 2016; kowalski et al., 2015). fixed effects models are used to investigate the impact of fva in exports and others factors on changes in dva in exports in seven lac. oecd-tiva database (2016 and 2018) served as the main sources of value-added exports data. further, a robustness check is undertaken by adding another variable (the share of manufacturing sector in gdp) to the initial model. the results confirm the strong impact of fva in exports on positive changes in domestic value added in exports reinforcing the idea that domestic export performance is closely linked to importing. likewise, the quality of institutions also plays a positive role on changes in dva in exports. however, tariffs and surprisingly labor productivity have negative effect on changes in dva. the results still hold under the robustness check. additionally, a sectoral analysis is done to capture differences across the determinants of changes in dva in exports across four broad sectors: agriculture, manufacturing, mining and services. fva in exports is found to be a common important factor on positive changes in dva in exports in all sectors with the exception of the mining sector. fva has no significant effect on changes in dva in exports in the mining sector. focusing on differences across sectors, tariffs are strong determinants of changes in dva in exports in the manufacture and mining sectors. the coefficient of labor productivity is statistically significant and negative in all sectors except the mining sector. rule of laws positively influences the changes in dva in exports only in the manufacture and services sectors. overall, the results suggest the countries to lower tariffs in order to enhance the import of sophisticated intermediate inputs. moreover, countries are likely to increase their share of domestic value added in exports by promoting favorable business environment. the paper shows that the seven selected lac have benefited from using fva to boost their domestic export performance. one of the limitations of this paper is the limited coverage of value-added exports data for lac. one could improve the analysis by using different source of input-output table and include more countries. references ahmad, n., primi, a. 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(2018), what are china’s real gains within global value chains? measuring domestic value added in china’s exports of manufactures. china economic review, 47, 263-273. . international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(6), 216-224. international journal of economics and financial issues | vol 9 • issue 6 • 2019216 the impact of managerial overconfidence on capital structure: empirical evidences in vietnam viet quoc pham1*, dinh trung nguyen2 1ufm graduate school, the university of finance marketing, vietnam, 2ho chi minh city tax department, vietnam. *email: vietpq@ufm.edu.vn received: 15 september 2019 accepted: 14 november 2019 doi: https://doi.org/10.32479/ijefi.8862 abstract this paper studies the effects of the managerial overconfidence on the corporate capital structure in the vietnamese stock market for the period 20102016 by estimating generalized least squares (gls) on a sample of 329 non-financial firms listed on the ho chi minh city securities exchange. research results show that managerial overconfidence has an impact on corporate capital structure, in particular firms with overconfident managers have higher overall leverage and short-term liabilities, but tend to reduce long-term debt ratio. in addition, state-owned enterprises having overconfident managers experience higher long-term debt ratios than other enterprises. keywords: capital structure, managerial overconfidence, non-financial listed firms, vietnam jel classifications: g41, g32 1. introduction capital structure is one of the most important concerns that every cfo pays special attention to. therefore, the study of capital structure always attracts the attention of researchers in the world as well as in vietnam. since the publication of modigliani and miller (1958), many authors have studied capital structure studies in developed countries such as bevan and danbolt (2002), akhtar and oliver (2009), frank and goyal (2003) and developing countries such as booth et al. (2001), pandey (2001), chen et al. (2011), etc. the study of determinants of capital structure is necessary and useful for managers to organize and rearrange the business capital of the enterprise through selection and implementation financing decisions aimed to achieve a rational capital structure that is adapted to each stage of development. because optimal capital structure helps businesses minimize the cost of capital, it thereby maximizes business value. according to frank and goyal (2009), capital structure also affects the profitability and risks that businesses may face. therefore, choosing the right capital structure is an art in financial management. in addition to the usual determinants, this paper approached the problem of corporate capital structure in terms of behavioral finance, namely the managerial overconfidence. with this new element, the research paper expects to add a special determinant explaining the change in the debt ratio of the firm. this helps businesses identify the core elements as well as has an accurate view of the influence of management behavior on capital structure and making appropriate decisions in financing. vietnam is a transitional economy, which has changed from centrally planned economy to a market one, with many stateowned enterprises (soes) dominating the economy shown by minor et al. (2018) that soes contributed an estimated 32.2% to vietnam’s gdp at the end of 2013. the study also expects to understand the managerial overconfidence in soes and whether the effect of this overconfidence on the corporate capital structure is different from private owned enterprises. this journal is licensed under a creative commons attribution 4.0 international license pham and nguyen: the impact of managerial overconfidence on capital structure: empirical evidences in vietnam international journal of economics and financial issues | vol 9 • issue 6 • 2019 217 to our knowledge, no research has been done on this subject in vietnam before. the next section of this paper covers literature review, research methods and data collection and analysis, discussions, and conclusion. 2. literature review de bondt and thaler1 (1995) argue that the discovery of overconfidence is one of the most robust findings in decision-making psychology field. psychological studies yielding results that almost every individual are psychologically over-confident. overconfidence is a trend to self-assess the knowledge, ability, and accuracy of information (signals of future possibilities), and at the same time, to underestimate the adverse outcomes and risks can occur. according to nofsinger (2005), psychologists have determined that overconfidence makes overestimate their knowledge, underestimate their risk, and exaggerate their ability to control events. malmendier and tate (2005) noted that executives, especially senior executives, are easily affected by overconfidence and optimism. they face complex and abstract situations, where knowledge is limited, they perceive high levels of control and they demonstrate high levels of engagement; all these things put them in a state of overconfidence. 2.1. the theoretical foundation of the relationship between overconfidence and capital structure the most basic theory of capital structure is that of modigliani and miller (m and m) in 1958 which is considered to be the starting point for studies of modern capital structure. in the two cases studied, the enterprise operates in a non-tax environment and in a tax environment, m and m has made important conclusions about the corporate capital structure. specifically, in the 1958 study, the assumption of no corporate income tax (cit), the m and m theory holds that the structure of capital does not affect the value of the firm (modigliani and miller, 1958). the authors later (modigliani and miller, 1963), by incorporating cit into the research model, concluded: under cit conditions, the value of the levered firm is higher than the value of the unlevered firm because of the benefits from the tax shield (or levered value equal to the value of the unlevered firm plus the present value of the “tax shield”). however, the limit of this theory is in the assumptions of the model (perfect market, no financial distress, no transaction costs) that does not exist in the real capital market. so far, many researchers have tend to adjust the m and m theory by easing the assumptions and taking in account the characteristics of the real market and its participants. the most popular theories are trade-off theory, pecking order theory, market timing theory, among others. 1 richard h. thaler, ph. d., a professor of chicago university, nobel prize in economics 2017 for his “nudge” theory. he is an american economist and the charles r. walgreen distinguished service professor of behavioral science and economics at the university of chicago booth school of business. the trade-off theory inherently developed by kraus and litzenberger (1973) suggests that business executives can identify an optimal capital structure that maximizes firm value based on trade-offs between the benefits and costs of debt (the tradeoff between tax shields and financial distress). according to myers (2001), the greater the corporate debt, the greater the benefit of the tax shield, but the trade-off is the increase in the cost of financial distress. an optimal lever happens when a balance between the benefits and costs of debt is achieved. myers and majluf (1984) published research to show that there is a prioritization of the use of internal and external funding sources, new debt issuance and new equity issuances from asymmetric information between the firm and its counterparties. this leads to a pecking order, whereby the firm’s investment will be financed first by internal capital (mainly retained earnings), followed by new debt issuance and final by new equity issuance. yet, for that reason, the authors argued that it is difficult to determine an optimal capital structure, as theoretically, owner equity is ranked first (retained earnings) and last (issuing new shares) in the classification order. baker and wurgler (2002) argue that market timing is the first factor to consider in determining the corporate capital structure, meaning that the managers of firms generally do not pay attention to the use of debt or equity. they choose the type of funding that brings greater firm value at a specific moment of time. welch’s (2004) study concludes that shocks in stock prices create a prolonged effect on the capital structure and the financing decision of the firm. the trade-off theory, pecking order theory, and market timing theory are different, but they are based on an important assumption that all participants in the market, including managers, are rational. in fact, the market imperfection and human behavioral science also demonstrates that humans are not entirely rational and easily misled. the extensive literature on psychology and behavior suggests that most people, including investors and managers, have significant limitations in their perceptions and tend to develop deceptive behaviors that influence, sometimes heavily on the decision. thus, the theory of behavioral finance has recently emerged, as an important factor in explaining the financial decisions of people. ricciardi and simon (2000) discusses behavioral finance attempts to explain and improve understanding of the theoretical basis of investors, including the associated emotional processes and the extent to which they affect the decision process. basically, behavioral finance tries to explain what, why, and how in finance and investment but from the human behavioral perspective. according to shefrin (2002), three main considerations to consider in order to better understand behavioral finance are bias, experience, and pattern effects. shefrin classifies the bias in behavioral finance as comprising four types: overconfidence; excessive optimism; confirmation bias; illusion of control. according to heaton’s model (2002), optimistic managers influence the firm’s capital and financial structure. a similar forecast is also provided by malmendier and tate (2005; 2008) pham and nguyen: the impact of managerial overconfidence on capital structure: empirical evidences in vietnam international journal of economics and financial issues | vol 9 • issue 6 • 2019218 and fairchild (2005). or, according to march and shapira (1987), after choosing the investment projects, managers become frequent victims of the so-called “hallucinogenic” problem and underestimate the probability of failure of the project. in the above four types of behavioral finance, overconfidence is most closely related to the manager. therefore, within the research limits of the article, the authors focus only on “overconfidence.” 2.2. the effect of overconfidence on the corporate capital structure many research papers around the world have provided empirical evidence to demonstrate the effect of managerial overconfidence on the corporate capital structure. in this way, the papers examine the explanatory ability of traditional capital structure theories and add to human behavioral factors. most of the studies suggest that there is a positive correlation between overconfidence and debt ratio. overconfident managers tend to take more debt than others. hackbarth model (2002) suggests that managers who are overly optimistic and/or overconfident often choose higher debt levels and issue new debt more often. obviously, this is because managers are overconfident that their firms are less financially disturbed than they really are, which in turn means that executives underestimate the overhead costs and will borrow more debt to exploit the tax benefits. oliver (2005) studies the pattern of us firms that have existed for more than 25 years. the author finds that overconfidence of management is significant in explaining the firm’s financial decisions. this affirms the theoretical in behavioral finance that the more confident managers are, the more likely they are to issue debt. barros and da silveira (2007) argues that differences in attitudes, styles, and perceptions of reality pertain to individual characteristics of individual executives that can significantly influence a company’s decisions. in particular, the study has the same effect as hackbarth (2002), providing further evidence that managerial overconfidence is an important determinant of the corporate capital structure. in the same year, ben-david et al. (2007) published a paper showing that overconfident managers often neglect financial distress and therefore use higher leverage than optimal level. in malmendier and tate’s (2005) study, using data from an individual’s portfolio of executives, categorize managers based on overconfident level and examine the relationship between overconfidence and capital structure decision. the results show that managers who are overconfident tend to be less likely to issue equity than the others. however, there are still different results as from tomak (2013), which shows that the relationship between overconfidence and debt ratio is unclear, with no clear and sufficient evidence that overconfident managers tend to use more debt. esghaier (2017) investigated the role of manager’s overcondidence and optimism on financing choice of 160 us industrial companies listed over the period from 2009 to 2015, and found the positive relationship between overcondidence and optimism and firm leverage. based on above empirical and theoretical empirical evidence, the authors expect that there is a positive relationship between managerial overconfidence and debt ratios in vietnamese firms. 2.3. impact of state ownership (so) on capital structure zou and xiao (2006) conducted research of listed firms in china and indicates the so ratio has a positive correlation with the debt ratio for three reasons: first, soes have better access to debt financing in the market because they are guaranteed by the state and this reduces the risk of bankruptcy. second, soes often prefer high debt to avoid stock dilution and to ensure control of this shareholders group. third, the agency problem between the owner and the manager usually exists in soes because of the separation between the voting power and the cash flow. voting rights belong to the state and managers representing the government, their salaries are not directly related to the performance of the businesses they manage. since then, these managers have no pressure or motivation to make the business work. so, to reduce the agency cost, soes tend to use debt as a tool to manage the problem. li et al. (2009) investigated the relationship between ownership structure and capital structure in the chinese market in the period 2000-2004. the empirical results show that the so ratio has a positive relationship with the firm’s debt ratio. the authors also argue that firms with a high proportion of so tend to prefer debt because of soft capital constraints and government guaranteed funding. then, banker et al. (2011) use regression data tables with samples of firms listed on the chinese stock exchanges from 2002 to 2005 also produced a similar result. in contrast to these views, the study by huang (2006) in china argued that the so did not affect the debt ratio. 3. research methodology the study used both qualitative and quantitative methodology in collecting and analyzing data. qualitative research is apt to the types of questions raised to the interviewees about their perception of “managerial overconfidence.” the selection of research method should reflect the research topic and the general research strategy as the methodology decides which methods are used and how each method is used (silverman, 2000). “theoretical perspective” is taken to mean “the philosophical stance lying behind the methodology” (crotty, 1998). the theoretical perspective, according to crotty (1998), provides a context for the process involved a basis for its logic and its criteria. the study adopts the interpretive qualitative paradigm of research which “looks for culturally derived and historically situated interpretations of the social life world” (crotty, 1998). the interpretive qualitative paradigm “exemplifies all the characteristics of qualitative research, … that is the researcher is interested in understanding how participants make meaning of a situation or phenomenon, and this meaning is mediated through the researcher as instrument” (merriam, 2002). the approach taken for this study lies in the acceptance of the importance of understanding and an appreciation of the influence pham and nguyen: the impact of managerial overconfidence on capital structure: empirical evidences in vietnam international journal of economics and financial issues | vol 9 • issue 6 • 2019 219 of subjective interpretations and perceptions in the constructs of a learning organization. this approach focuses on how learning organization is experienced in the everyday world. the phenomenological orientation is “particularly interested in how a learning organization is constructed by those who participate in it” (denscombe, 2003). when the social world is socially constructed, the possibility of seeing things differently increases, thus giving rise to multiple perceptions of reality, supports a predominantly qualitative research orientation, rather than a quantitative one. quantitative method emphasizes objective measurements and the statistical, mathematical, or numerical analysis of data collected through polls, questionnaires, and surveys, or by manipulating pre-existing statistical data using computational techniques. quantitative research focuses on gathering numerical data and generalizing it across groups of people or to explain a particular phenomenon (babbie, 2010; muijs, 2010). quantitative research works on numbers, logic, and an objective perspective. it focuses on numeric and unchanging data and detailed, convergent reasoning rather than divergent reasoning, thus revalidate the research results generated from qualitative method and increase the value and reliability of the research results. 3.1. research hypothesis behavioral finance theory refers to overconfidence that managers who are overconfident tend to have more debt than other financing funds because they always expect great benefits from debt financing and underestimate the cost of debt. a number of empirical evidence around the world supports this theory such as hackbarth (2002), oliver (2005), malmendier and tate (2005) and barros and da silveira (2007). based on empirical evidence and theoretical predictions, the paper expects a positive correlation between overconfidence and corporate capital structure, so the hypothesis is: h1: there is a positive correlation between the managerial overconfidence and the debt ratio of listed firms in vietnam. the study also examines the influence of the so ratio on the relationship between the overconfidence and the capital structure. zou and xiao (2006) showed that soes in china prefer debt financing. according to behavioral finance theory, overconfident managers expect tremendous interest from debt and underestimate the cost of debt. considering the similarity of vietnamese economy and the chinese one (both are transition economies, with strong intervention from the governmant), the hypothesis is: h2: soes in vietnam with managerial over confidence will have higher debt ratios than other enterprises. 3.2. the basis for selecting the research model based on the selection of the model presented above and from the models of the previous studies of frank and goyal (2003; 2009), barros and da silveira (2007), reimoo (2008), while adding the so to investigate the difference of the managerial overconfidence between soes and private enterprise managers. the study will have the following models: levi,t=a0+a1overi,t+a2sizei,t+a3profi,t+a4growi,t+a5tangi,t +a6overi,t×tangi,t+a7uniqi,t+a8liqi,t+a9ndtsi,t+a10soi,t +a11overi,t×soi,t+εi,t in which: dependent variable (lev) is represented by 3 proxies: tlevi,t is the ratio of total debt to total assets of firm i in year t; ltlevi,t is the firm’s long-term debt to total assets ratio in year t; stlevi,t the short-term debt to total assets ratio of firm i in year t. independent variables: overi,t is the managerial overconfidence at the firm i in year t. variable control: sizei,t is the size of firm i in year t; profi,t is the profitability of firm i in year t; growi,t is the growth opportunity of firm i in year t; tangi,t is the tangible fixed asset of firm i in year t; uniqi,t is the uniqueness of firm i in year t; liqi,t is the liquidity of firm i in year t; ndtsi,t is the non-debt tax shield of firm i in year t; soi,t is the so ratio of firm i in year t. variable description: appendix. 3.2.1. research data data is collected from financial statements, annual reports of listed firms. we removed the financial firms from the sample because of their special capital structure. the study used data from 329 non-financial firms listed on vietnam’s stock markets from 2010 to 2016, of which 152 listed on ho chi minh city securities exchange and 177 listed on hnx. sample data includes 2303 observations during the study period. 3.2.2. data processing regression analysis was used to assess the relationship between independent variables and dependent variable. with the characteristics of panel data, the study conducted the estimation of the regression model using pooled ols, fem and rem estimations. we chose the most appropriate model through tests like breusch-pagan lagrange multiplier test, hausman’s test, examine heteroscedasticity and the autocorrelation (modified wald test and wooldridge test) in the model, then used the generalized least squares (gls) method to achieve the meaningful estimation results. 4. research results 4.1. data processing results from table 1, it can be seen that the capital structure of listed firms is generally balanced when the total debt/total assets ratio is 51.94%. short-term debt ratio (average value was 40.82%) is higher than long-term debt ratio (11.12% on average), that indicates a preference for short-term loans from firms, and bank loans are still the main financing source for firms in vietnam. pham and nguyen: the impact of managerial overconfidence on capital structure: empirical evidences in vietnam international journal of economics and financial issues | vol 9 • issue 6 • 2019220 the mean value of over in the sample was 0.3131, indicating that the number of firms with the overconfident manager was low, about one-third of the sample. the mean value of so in the sample is 0.3257, indicating that the number of enterprises under the control of the government is not much (accounting for about one-third of the firms in the sample). in the period of 2011-2015, the equitization and the divestment of soes, that is called “a crucial pillar” of the government’s structural reform in vietnam, has continued (minor et al., 2018). table 2 shows the correlation matrix between variables in the model. the correlation matrix analysis allows us to detect the multicollinearity that can occur in the model. table 2 presents the overall results of the regression. managerial overconfidence is likely positively correlated with total leverage and short-term leverage, and negatively correlated with long-term leverage. interaction of managerial overconfidence with so tends to increase the relationship between managerial overconfidence and levarage. in contrast, the interaction of overconfidence of managers with tangibility lowers the relationship between overconfidence of managers and levarage. further tests on the fit of regression models showed that the fixeffect model is more appropriate than the rem or pooled ols (appendix 3). besides, modified wald test and wooldridge test results gave the evidence of heteroscedasticity and autocorrelation in the fix-effect model (appendix 4), that needed to be adjusted by the gls method. table 3 below presents the results of regression model using gls method with three dependent variables: tlev, ltlev, stlev. 4.2. research result discussion 4.2.1. managerial overconfidence (over) table 3 presented the results of the regression model based on the gls estimation method with three dependent variables (total debt tlev, long-term debt ltlev and short-term debt stlev). the results are supported by previous empirical evidence of hackbarth (2002), oliver (2005), barros and da silveira (2007), esghaier (2017) among others. the empirical result shows that managerial overconfidence is positively related with both total debt ratio and short-term debt ratio, this is consistent with behavioral finance theory and support for hypothesis h1. in contrast, overconfidence has a negative relation with long-term debt this is opposed to behavioral finance theory, although the level of the negative correlation is insignificant. however, the managerial overconfidence is based on the judgment of the manager himself, the result of this study showed that overconfident managers recognize that the benefits of long-term debt cannot compensate the cost. therefore, they reduce the long-term debt ratio of the firms. the other reason is that, executives are confident about the profitability of their investment projects and they do not want to share the benefits to creditors. in the long run, especially for manufacturing firms with high levels of tangible fixed assets and high depreciation costs, they will make trade-off benefits of debt financing with the non-debt tax shield (ndts). the t-test result from appendix 2 shows that private enterprises have more confident managers than the soes. overconfident managers want to demonstrate their ability, so they wish to achieve clear and rapid results, and tend to use more short-term debt (shortermist). at the same time, in the long run, there will be unpredictable challenges and risks, so banks and lenders will also be hesitant to finance businesses. 4.2.2. so the regression results presented in table 3 show that the so is positively associated with tlev and stlev, consistent with the evidence of li et al. (2009) in the chinese market. this result can be explained by the support from the government to state-owned enteprises in accessing bank loan. however, there is insufficient evidence that the so affecting the long-term debt of firms. this result can be explained by fear and uncertainty about the long-term probability of the managers, and soes want to make rapid profits to respond to government budget limit. therefore, the soes prefer short-term debt to long-term debt. besides, given the managerial overconfidence in soes, the results suggest that these managers tend to have more long-term table 1: the descriptive statistics of variables in the model variable number of observation mean median sd max. min. tlev 2303 0.5194 0.5445 0.2189 0.9696 0.0026 ltlev 2303 0.1112 0.0517 0.1388 0.7870 0 stlev 2303 0.4082 0.4082 0.2030 0.9549 0.0026 over 2303 0.3131 0 0.4638 1 0 size 2303 27.1302 27.0812 1.4836 32.8265 23.2820 prof 2303 0.1241 0.1121 0.0894 0.6404 −0.4839 growth 2303 0.1517 0.0807 0.9856 40.7637 −0.9528 tang 2303 0.2601 0.2030 0.2095 0.9366 0 uniq 2303 0.8130 0.8391 0.1596 3.9088 0 liq 2303 2.2255 1.4162 4.1965 145.1005 0.1932 ndts 2303 0.0307 0.0216 0.0310 0.3143 0 so 2303 0.3257 0 0.4687 1 0 source: author’s calculation on stata 14. tlev: total debt/total assets, ltlev: long-term debt/total assets, sltev: short-term debt/total assets, over: managerial overconfidence, size: size of the firm, prof: profit, growth: growth opportunity, tang: tangible fixed asset, uniq: product uniqueness, liq: liquidity, ndts: non-debt tax shield, so: state ownership pham and nguyen: the impact of managerial overconfidence on capital structure: empirical evidences in vietnam international journal of economics and financial issues | vol 9 • issue 6 • 2019 221 ta bl e 2: r es ul ts o f p oo le d o l s, r e m , f e m r eg re ss io n m od el w it h de pe nd en t v ar ia bl es v ar ia bl e t l e v lt l e v st l e v e st im at io n m et ho d p o o l e d r e m f e m p o o l e d r e m f e m p o o l e d r e m f e m o v e r 0. 03 78 ** * 0. 04 27 ** −0 .0 14 8* −0 .0 08 1 0. 05 26 ** * 0. 05 02 ** [2 .8 6] [1 .9 9] [− 1. 77 ] [− 0. 57 ] [4 .1 3] [2 .4 1] si z e 0. 05 08 ** * 0. 07 79 ** * 0. 11 2* ** 0. 03 50 ** * 0. 04 76 ** * 0. 07 37 ** * 0. 01 58 ** * 0. 02 40 ** * 0. 03 88 ** * [2 0. 54 ] [1 8. 86 ] [1 9. 09 ] [2 2. 33 ] [1 6. 76 ] [1 4. 96 ] [6 .6 4] [5 .8 7] [6 .1 3] pr o f −0 .8 64 ** * −0 .4 37 ** * −0 .3 75 ** * −0 .3 75 ** * −0 .1 20 ** * −0 .0 68 9* * −0 .4 89 ** * −0 .3 41 ** * −0 .3 06 ** * [− 16 .5 2] [− 12 .4 9] [− 10 .9 6] [− 11 .3 2] [− 4. 31 ] [− 2. 41 ] [− 9. 70 ] [− 9. 24 ] [− 8. 34 ] g r o w t h 0. 01 10 ** * 0. 00 36 * 0. 00 21 0. 00 49 ** 0. 00 34 ** 0. 00 25 * 0. 00 61 2* 0. 00 06 64 −0 .0 00 42 [2 .9 8] [1 .9 3] [1 .1 5] [2 .0 9] [2 .2 5] [1 .6 6] [1 .7 2] [0 .3 3] [− 0. 22 ] ta n g −0 .0 25 0. 07 89 ** * 0. 09 46 ** * 0. 28 6* ** 0. 27 8* ** 0. 26 4* ** −0 .3 11 ** * −0 .2 01 ** * −0 .1 70 ** * [− 1. 04 ] [3 .6 8] [4 .2 7] [1 8. 82 ] [1 6. 82 ] [1 4. 27 ] [− 13 .4 5] [− 9. 00 ] [− 7. 13 ] o v e r ×t a n g −0 .1 70 ** * −0 .1 12 ** * −0 .0 77 7* −0 .0 07 8 −0 .0 30 6 −0 .0 38 1 −0 .1 62 ** * −0 .0 85 3* −0 .0 39 6 [− 4. 34 ] [− 2. 64 ] [− 1. 70 ] [− 0. 32 ] [− 0. 95 ] [− 1. 00 ] [− 4. 30 ] [− 1. 94 ] [− 0. 81 ] u n iq 0. 16 2* ** 0. 01 9 −0 .0 02 3 −0 .0 88 0* ** 0. 00 35 0. 01 37 0. 25 0* ** 0. 01 77 −0 .0 16 [6 .5 1] [1 .1 9] [− 0. 15 ] [− 5. 57 ] [0 .2 8] [1 .0 6] [1 0. 41 ] [1 .0 5] [− 0. 96 ] l iq −0 .0 16 3* ** −0 .0 06 ** * −0 .0 05 3* ** 0. 00 07 0. 00 12 ** * 0. 00 1* * −0 .0 17 0* ** −0 .0 07 33 ** * −0 .0 06 32 ** * [− 18 .8 3] [− 12 .0 3] [− 11 .0 2] [1 .2 5] [2 .9 7] [2 .5 6] [− 20 .3 6] [− 13 .9 7] [− 12 .2 6] n d t s 1. 14 3* ** 0. 1 0. 09 53 0. 07 94 −0 .3 73 ** * −0 .4 09 ** * 1. 06 3* ** 0. 51 0* ** 0. 50 4* ** [6 .7 9] [0 .7 3] [0 .6 7] [0 .7 4] [− 3. 47 ] [− 3. 43 ] [6 .5 5] [3 .5 2] [3 .2 9] so 0. 01 69 * 0. 00 76 0. 00 76 0. 00 73 −0 .0 02 1 −0 .0 06 1 0. 00 95 8 0. 01 17 0. 01 36 [1 .7 7] [0 .6 3] [0 .5 5] [1 .2 1] [− 0. 24 ] [− 0. 52 ] [1 .0 4] [0 .9 5] [0 .9 1] o v e r ×s o 0. 06 92 ** * 0. 00 05 −0 .0 21 9 0. 02 02 * 0. 01 64 0. 01 64 0. 04 90 ** * −0 .0 11 1 −0 .0 38 4 [4 .0 3] [0 .0 2] [− 0. 96 ] [1 .8 5] [1 .0 7] [0 .8 6] [2 .9 6] [− 0. 53 ] [− 1. 57 ] _c o n s −0 .8 86 ** * −1 .5 72 ** * −2 .4 94 ** * −0 .7 97 ** * −1 .2 28 ** * −1 .9 46 ** * −0 .0 88 9 −0 .1 72 −0 .5 48 ** * [− 12 .2 3] [− 13 .7 9] [− 15 .4 5] [− 17 .3 7] [− 15 .6 3] [− 14 .4 2] [− 1. 27 ] [− 1. 53 ] [− 3. 16 ] n o. o bs er va tio n 23 03 23 03 23 03 23 03 23 03 23 03 23 03 23 03 23 03 r -s qu ar e 0. 39 58 0. 27 9 0. 39 77 0. 21 7 0. 34 1 0. 13 5 fst at is tic 13 6. 46 76 .1 6 13 7. 53 76 .1 6 13 1. 86 38 .3 4 pr ob ab ili ty > f 0. 00 00 0. 00 00 0. 00 00 0. 00 00 0. 00 00 0. 00 00 *, * * an d ** * co rr es po nd to m ea ni ng le ve ls o f 1 % , 5 % , 1 0% n um be r i n sq ua re b ra ck et s is th e st an da rd e rr or . t l e v : t ot al d eb t/t ot al a ss et s, l t l e v : l on gte rm d eb t/t ot al a ss et s, s lt e v : s ho rt -t er m d eb t/t ot al a ss et s, o v e r : m an ag er ia l ov er co nfi de nc e, s iz e : s iz e of th e fir m , p r o f: p ro fit , g r o w t h : g ro w th o pp or tu ni ty , t a n g : t an gi bl e fix ed a ss et , u n iq : p ro du ct u ni qu en es s, l iq : l iq ui di ty , n d t s: n on -d eb t t ax s hi el d, s o : s ta te o w ne rs hi p pham and nguyen: the impact of managerial overconfidence on capital structure: empirical evidences in vietnam international journal of economics and financial issues | vol 9 • issue 6 • 2019222 debt financing. this can also be explained by the t-test result (appendix 2), which shows that soes have more long-term loans than non soes. thus, under the financial support from the government as well as the close relationship with commercial banks, overconfident managers will increase long-term debt to avoid the pressure on returning loans. therefore, the hypothesis h2, that is “overconfidence of managers in enterprises under the control of the state will have higher debt ratios than those of non-state enterprises” is only confirmed for long-term debt. this result also contributes to evidence that managerial overconfidence affects the capital structure of firms. 4.2.3. other determinants firm size affects the capital structure. specifically, firm size has positive correlation with both short-term and long-term debt. this finding is consistent with previous empirical evidence of oliver (2005), barros and da silveira (2007), reimoo (2008) and tomak (2013); supporting tradeoff theory, which suggests that the larger the size of the firm, the more likely it is to use more loans in total assets. profitability has a negative correlation with financial leverage of firms, similar to the findings of deesomsak et al. (2004), huang (2006), reimoo (2008) and tomak (2013). this result can be explained by pecking order theory, which confirms incase firms have higher returns, they will tend to reduce the use of debt, instead of new equity issuance to fund the business. growth opportunities go along with short-term debt and total debt, similar to finding of chen (2004) in the chinese market. this result suggests that firms with high growth rates are believed to be healthy and have easy access to loans. tangibility has positive correlation to long-term debt, but has a negative correlation to short-term debt, consistent with the evidence of reimoo (2008), which shows that with the availability of collateral, firms prefer long-term debt to short-term debt. in case of interaction of this variable with managerial overconfidence, the result shows that firms with high tangible fixed assets and managed by overconfident managers tend to reduce short-term debt and threby total debt; indicating that overconfident managers use less fixed assets as a collateral than other managers. about uniqueness, the empirical result shows that there is a positive relationship between short-term debt and cogs to sales, indicating negative ralationship between financial leverage and uniqueness, supporting the pecking order theory. liquidity is a negatively associated with total debt and short-term debt, consistent with the findings of titman and wessels (1988), deesomsak et al. (2004). this negative correlation indicates that highly liquid firms use less short-term debt. ndts has negative correlation to the long-term debt of the firms, consistent with the results of previous studies such as chen (2004) and huang (2006). 5. conclusion a panel data of 2303 observations is employed from 329 firms listed on vietnam’s stock market for the period from 2010 to 2016 table 3: gls model results with three dependent variables independent variables dependent variable tlev ltlev stlev over 0.0427*** −0.0081* 0.0752*** [3.46] [−1.76] [5.48] size 0.0715*** 0.0292*** 0.0314*** [27.88] [21.91] [11.02] prof −0.488*** −0.0508*** −0.399*** [−17.27] [−4.13] [−12.93] growth 0.0097*** 0.0003 0.0088*** [5.33] [0.47] [3.77] tang 0.0446*** 0.261*** −0.278*** [2.62] [23.35] [−14.93] over×tang −0.113*** −0.0105 −0.142*** [−3.73] [−0.54] [−4.37] uniq 0.0367*** 0.0071 0.0313** [3.62] [0.85] [2.03] liq −0.0108*** 0.0003 −0.0164*** [−11.76] [1.57] [−16.78] ndts −0.14 −0.261*** 0.381*** [−1.34] [−4.98] [3.39] so 0.0134* −0.0023 0.0210** [1.68] [−0.76] [2.34] over×so 0.0213 0.0214*** −0.018 [1.53] [2.80] [−1.17] _cons −1.372*** −0.763*** −0.343*** [−19.16] [−21.05] [−4.32] source: author’s calculation on stata 14. *, ** and *** correspond to meaning levels of 10%, 5% and 1%. the number in square brackets is the standard error. tlev: total debt/total assets, ltlev: long-term debt/total assets, sltev: short-term debt/total assets, over: managerial overconfidence, size: size of the firm, prof: profit, growth: growth opportunity, tang: tangible fixed asset, uniq: product uniqueness, liq: liquidity, ndts: non-debt tax shield, so: state ownership pham and nguyen: the impact of managerial overconfidence on capital structure: empirical evidences in vietnam international journal of economics and financial issues | vol 9 • issue 6 • 2019 223 to investigate the relationship between managerial overconfidence and the capital structure of firms in vietnam. by using the approach of behavioral theory, we try to find the answer to the question: “what is the effect of managerial overconfidence on the capital structure of the firms in vietnam?” the results show that managerial overconfidence does affect the corporate capital structure. firms managed by overconfident managers choose a higher level of leverage (total debt and shortterm debt). in addition, an interesting finding of the article is that overconfident managers tend to reduce long-term debt ratio that can be explained by managerial overconfidence in future investment projects. overconfident managers in vietnam prefer short-term financing. on the contrary, in soes, overconfident managers tend to increase their long-term debt ratio because of the assurance from the government and commercial banks, so that it is easier for the managers to access loans. the study contributes empirical evidence to the study on determinants of corporate capital structure in vietnam. the behavioral finance approach can explain the influence of managerial overconfidence on the financial decisions of a firm. 5.1. limitation and future research the overconfidence can exist in many different forms and expressions. the other proxies of managerial overconfidence are to be further studied to get robust results on the impact of overconfidence on financing decisions. behavioral finance is a new topic and has many aspects to explore. human behavior, in particular, is always influenced by emotional factors, so the financial decisions in the enterprises also correlate with these factors. in this study, overconfidence is just one of the many manifestations of cognitive distortion. having that said, further studies should be explored and empirically tested for other relationships. references akhtar, s., oliver, b. 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(2006), the financing behaviour of listed chinese firms. the british accounting review, 38(3), 239-258. tx_1~at/tx_2~at international journal of economics and financial issues issn: 2146-4138 available at http: www.econjournals.com international journal of economics and financial issues, 2019, 9(4), 37-49. international journal of economics and financial issues | vol 9 • issue 4 • 2019 37 exploring the linkage between corruption and economic development in the case of selected developing and developed nations marc audi1, amjad ali2* 1faculty of business administration, aou university faculty of business administration/university paris 1 pantheon sorbonne, france, 2lahore school of accountancy and finance, university of lahore city campus, pakistan. *email: chanamjadali@yahoo.com received: 17 april 2019 accepted: 19 june 2019 doi: https://doi.org/10.32479/ijefi.8052 abstract corruption is like an epidemic that has the power to destroy a country’s socioeconomic, financial, human and political environment. it has severe consequences in developing countries. this study has examined the impact of existing human, political, financial and economic factors on corruption for a set of panel countries. the data from 1995 to 2004 is used to serve this purpose. for examining the stationarity of the variables, levinlin-chu (2002), fisher-adf and fisher-pp tests are applied. pedroni residual based co-integration and fmols by phillips and hansen (1990) test has been used for examining the co-integration among the variables of the model. the speed of adjustment and short-run relationship has been tested through vecm. the estimated results show that exports, gdp per capita and political stability have a negative impact on corruption, whereas imports, financial development, human development index, bureaucracy, democracy and the rule of law have a positive relationship with corruption. the simplified procedures of import and export will help reduce the practice of bribes and corruption. the governments should take steps not only to increase the income, but also to improve the people’s standard of living. there should be improvements in the political system. democracy is also helpful to get rid of corruption. keywords: corruption, economic development, financial development, human development, political development, ethics jel classifications: d7, o11, o15 1. introduction corruption has developed into a global issue triggered by many structural and institutional factors such as the nature of the political system, the sociocultural background, the low salaries, the low risk of detection and the punishment (lu, 2000; quah 2002). in the simplest form, corruption can be defined as the use of power for personal benefits such as stealing public funds, bribes for procurement of public services and the sale of public assets by government officers without proper procedures. an act of corruption can be characterized by the value of the transaction concerned. although this is a continuous variable, the analytical distinction usually made is between a low value (“petty”) and a large value (“grand”) corruption. typically, the larger the value of the corrupt transaction, the higher the position in the public hierarchy of the public official(s) involved [goel and nelson (1998), fisman and gatti (1999), svensson (2005)]. shleifer and vishny (1993) highlight the different forms and capacities of corruption. corruption exists in all types of societies irrespective of different socioeconomic and cultural history. it occurs everywhere, even though the amount/size varies from a person or a nation to another. mostly, the developing countries that are subject to a low level of transparency and accountability, defective judicial and legislative system, faulty organizational structure and rent seeking movements are trapped in the clutches of corruption. moreover, it exacts many economic and social costs, and distorts this journal is licensed under a creative commons attribution 4.0 international license audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 201938 the composition of government spending at the expense of health and education sectors. it also steers resource allocation towards unproductive direction. further, it discourages the entry of fdi, and thus harms the economic growth (tanzi 2002, de vaal and ebben, 2011). corruption can be considered as the oil that greases the economic growth engine (anoruo and braha, 2005), however, it is broadly perceived that the disadvantages of corruption are far outweighed compared to its advantages. economic growth is a process that influences the economic wellbeing of a community. corruption implements a major threat to economic growth: the public and private sector efficiency is reduced when it enables people to assume positions of power through patronage rather than ability. the current literature lacks of theoretical underpinning that incorporates the potential effects of corruption on aggregate output through its impact on the arguments of the production function (kaufman 1998; shleifer, 1998; ackerman 1999; vittal 1999; chafuen 2000; mo 2001; alesina and angeletos 2002). foreign flows are frequently connected with hefty and lucrative projects or often with denationalization of companies that are good prospects of rent extraction due to a large amount of rent involved and the investor can transfer the cost burden towards customers. hines (1995) proves that us investors differ from others in preferring to locate their fdi in less corrupt countries after 1977. undemocratic countries are more prone to corruption (lapalombara, 1994) as public resources are weakly supervised and officers are interested in using them to appeal to foreign investment. countries enjoying a longer period of democracy along with free media, unrestricted electoral process, voice freedom, and more importantly, political opposition are the key elements to deter corruption. open societies do not only import goods, but they also import their customs, standards and knowledge (treisman, 2000 and sandholtz and mark 2003). corruption is a prevalent irrespective of development, every country has to face a specific level of corruption. this study is going to answer a few questions. what are the main factors that determine corruption in the case of developed and developing countries? how has the development process more or less played a role in spreading malfunctioned activities, whether on systemic or individual basis? despite the increasing economic growth, why is a large segment of the population deprived of the basic facilities of life like education and health, in developing countries, and how are the resources in these countries bound in the hands of a tiny portion of the population? is this a corruption phenomenon? 2. literature review in the existing literature of economics, corruption is globally considered to be growth inhibitor. the existing studies consider it a complex phenomenon because its consequences are more deep-seated problems of distortion, institutional incentives and governance. there is a number of studies that highlight the causes and consequences of corruption and the most reverent are taken here as a literature review. huntington (1968) mentions that corruption aids the economy, particularly in the case of cumbersome regulation, excessive bureaucracy, market restriction or inefficient policies. the resulting waiting costs would be effectively reduced if the payment of speed money could induce bureaucrats to increase their efforts. ironically, however, corrupt officials might, instead of speeding up, actually cause administrative delays in order to attract more bribes. lui (1985) demonstrates the efficiency enhancing the role of corruption via a queuing model and concludes that the size of the economic agents’ bribe reflects their opportunity cost, thereby allowing “better” firms to purchase less red tape. ades and tella (1999) elaborate that strategies for making more competitive markets affect corruption. the low level of rivalry is translated into more rents extracted by a large number of bureaucrats from companies they regulated. there is more corruption in countries enjoying more economic rent, where local companies are protected from external competition or with restrictive trade and where the number of companies is minor. opportunities for corruption can be squeezed if the external rivalry exists. indeed, it creates a negative relation between the size of the trade and the corruption. when the tax and the tariff barriers reduce imports, inward oriented strategies increase corruption. this is the foreign rivalry consequences. limit the trade and financial streams, generate ample chances for the private managers and officers to indulge in corrupt attempts where bribes and payoffs can be offered to get beneficial treatments. this is called “direct policy impact”. bonaglia et al., (2001) argue that openness to trade restrain corruption. the mechanism includes trade policy, foreign rivalry, foreign investors and variations in cost-benefit relationship that is confronted with a country when constructing high-quality organizations to combat corruption. trade relaxation and financial streams can alter the cost-benefit relationship in corruption. goel and korhonen (2011) have discussed the relationship between exports and corruption by using disaggregated statistics of exports covering a large number of countries. it is statistically analyzed that trade of fuel constantly impacts the corruption level, whereas trade in manufacturing material and iron doesn’t. growing countries along economic freedom and political liberalization and larger state scope have a reduced corruption level. haque and kneller (2004) demonstrate that corruption is widespread, particularly in developing countries, especially in the venture relating to the public sector as government officers are given the responsibility of securing public assets being used in the production of creative inputs. because the information is lopsided, between the bureaucracy and government, the bureaucracy may give a misleading report that procure best quality products at high cost, while delivering products with low quality, consuming low cost. this result is the shape of severe impacts on the efficiency of the economy and thus lessening the growth. corruption reduces the worth of public amenities, necessary for production and increases the government expenditures above the efficient level. you and khagram (2005) analyze that people with higher incomes are more inclined toward corrupt activities, whereas individuals bearing lower income levels are incapable to fight with corruption as they don’t have enough resources even they are persuaded to do so. but with the rise in income inequality, people with lower incomes become vulnerable to payoffs in order to have an approach for several state amenities. uslaner (2006) explains that unequal audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 2019 39 income distribution is a reason of increasing corruption and resultantly increased corruption enhances income disparity. apergis et al. (2010) prove that rising gdp per capita has an adverse impact on corruption and income disparity. economic development is the best solution to decrease corruption and income inequality. eicher et al. (2006) have exhibited the bilateral relationship between corruption and education. corruption cut revenues that impede the process of educational accomplishment. subsequently, chances of corruption increase as with less education people or voters are unable to recognize corrupt candidates and vote for such as a politician. blackburn and sarmah (2007) evaluate the connection of economic growth, corruption and life expectancy. improved life expectancy is connected with development as life expectancy, economic sovereignty and higher national incomes can possibly discourage corruption. mocan (2008) argues that corruption is a consequence of impersonal association between bureaucracy and general public in cities. it permits them to use their positions and take more bribes, as more bureaucrats are appointed in cities. due to a larger population and heavy public funds, they can grab resources easily. though, it is feasible that corruption can be higher in areas with lesser population because of lower civil competition and more chances of retaining office in spite of any suspicious matter. gillette (2008) has demonstrated that minor bureaucracy is strongly connected with corruption as compared to major bureaucracy. because where there are more bureaucrats, it can be found, how they exercise their obligations without taking payoffs. so undermanned and incompetent staff can be more suspicion as less is the number of bureaucrats who can demand heavy kickbacks to perform their responsibilities. reduced number of bureaucratic staff can be a cause of increasing corruption due to its relaxed involvement, rarer substitutes for amenities, or lessened productivity of state authorities. therefore, though bureaucrats are penalized for their rent-seeking behavior, the right way is to raise the number of these reviled officers. 3. economic methodology alam (1989) refutes the pro-efficiency argument for corruption by contending that because bribery is illegal, bureaucrats will regulate entry into the bidding process to only those who can trust. since trust is not a proxy for efficiency, there is no reason to believe that the highest bidder will necessarily be most efficient, although the body of theoretical and empirical research that addresses the problem of corruption is still growing (klitgaard 1987; kaufman 1998; shleifer 1998; ades and tella 1999; vittal 1999; chafuen 2000; treisman 2000; wei 2000; alesina and angeletos 2002; johnston 2005; altunbas and thornton 2011). following the previous methodologies, the functional form of this study become as: c = f (ed, fd, hd, pd) where, c = corruption ed = economic development fd = financial development hd = human development pd = political development. the equation can be written as: , , , , , , , , it it it it it it it it it it exp gdp imp dcp hdi bur cpi f demo polstb rlw   =    here cpi = corruption perception index exp = exports of goods and services as % of gdp gdppc = gross domestic product per capita in luc imp = imports of goods and services as % of gdp dcp = domestic credit to private sector as % of gdp hdi = human development index bur = bureaucracy demo = democracy polstb = political stability rlw = rule of law. the econometric model of this study become as: 0 1 2 3 4 5 6 7 8 9 , , , , , , , , it it it it it it it it it it it cpi exp gdp imp dcp hdi bur demo polstb rlw            = + + in the above mentioned equation, i = 1,……, 31 in case of developed panel and i = 1,……., 49 in case of developing panel, whereas t= 1,………., 20 in both cases. abuse of power implicates effecting a legal standard. the sale of public assets by government officers, bribes for procurement of public services and stealing public funds is called corruption and in this study, it is measured by: corruption perception index (cpi) of transparency international (ti) is used in this study, ti is a berlin based non-governmental association that publishes the annual cpi of countries, cpi is a “poll of polls” representing ideas of business people, risk forecasters and indigenous population that has been surveyed cpi is intentionally choosier about the choice of indices used in the aggregation. 80 countries have been selected for analysis, dividing all into 31 developed and 49 developing nations. developed and developing panels have been selected based on income level as per world development indicators database classification. for economic and financial development, data on exports, gaps, imports and domestic credit to private sector has been taken from wdi database. for human development, data on hdi has been extracted from united nations development programmer’s database. for political development, data on bureaucracy, democracy, political stability and rule of law has been obtained from the wgi database as exercised. wgi is produced by daniel kaufmann and aart kraay. 4. econometric methodology this study is going to check the effects of development on corruption. to check stationarity of variables, this study has applied the panel unit root test as it is more powerful than time series unit root tests. three main tests are being employed for this purpose. audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 201940 • levin-lin-chu (2002) • maddala & wu (1999) fisher-adf • choi (2001) fisher-pp. the null and alternative hypothesis as: test name year null hypothesis alternative hypothesis levin-lin-chu 2002 unit root stationary series fisher-adf 1999 unit root stationary series fisher-pp 2001 unit root stationary series if variables are stationary at first difference mean i (1), it is believed to have a long-term relationship between variables, which means that there’s a linear combination in stochastic progression. this particular relationship is also named as long-term equilibrium. in this study, the test for long-term relationship is: first residual based panel co-integration test is familiarized by pedroni (1999). pedroni (1999) uses engle-granger (1987) approach to check co-integration. engle-granger approach is grounded in analysis of residuals that whether they are stationary or not. if variables are i (1) then residuals should i (0) and if variables are i (0) then residual must be (i1). pedroni (1999, 2004) expands the framework of engle-granger to multiple regressions. 5. results and discussion to investigate the impacts of development (economic, financial, human and political) on corruption, this study has applied most relevant econometric techniques. the variables include corruption perception index for corruption, human development index for human development, domestic credit to the private sector as a share of gdp for financial development, gross domestic product per capita in lcu, exports of goods and services as a share of gdp, imports of goods and services as a share of gdp for economic development. moreover, bureaucracy, democracy, political stability and rule of law are taken as a proxy for political development. the 20 years’ time period covered in this study extends from 1995-2014 including 31 developed and 49 developing countries. the developed set of countries includes australia, austria, canada, chile, croatia, czech, republic, denmark, estonia, finland, france, germany, iceland, israel, italy, japan, latvia, lithuania, luxembourg, netherland, poland, portugal, russian, federation, singapore, slovenia, spain, sweden, switzerland, united kingdom, united states, and uruguay. the developing countries comprises of albania, argentina, armenia, azerbaijan, bangladesh, belarus, bolivia, botswana, brazil, bulgaria, cameroon, china, colombia, cost rice, cote d’ivoire, dominican republic, ecuador, egypt, ei-salvador, ghana, guatemala, honduras, hungary, india, indonesia, jordan, kazakhstan, kenya, mauritius, mexico, moldova, morocco, nicaragua, nigeria, pakistan, paraguay, peru, philippines, senegal, south africa, tanzania, thailand tunisia, turkey, uganda, ukraine, venezuela, vietnam and zambia. to find out unit root in the current study, levinlinchu (2000) approach has been replicated. co-integration among variables is tested through pedroni residual based co-integration test (1999, 2004). for the short run association between development and corruption vecm is applied. to review the significance of coefficients fmols is applied. table 1 shows the t-statistics and p-values given by levin-linchu (2002) and fisher type tests by maddala and choi (2001). all the variables are non-stationary at level, as all p-values are insignificant al 1%, 5% and 10%, except in the case of cpi, llc has given significant result at the 10% level of significance. so, we cannot reject the null hypothesis of unit root, but when all variables are converted into 1st difference, they become stationary, as all the p-values are statistically significant at 1% significance level. the order of integration of all variables is same, means all variables are i (1), so we can check the co-integration among them. the table 2 shows the results of residual based panel cointegration test given by pedroni (1999, 2004). the results of four out of seven methods (panel pp-statistic, panel adf-statistics, group pp-statistics, and group adf-statistics) are statistically significant, as p-values of these tests are less than 5% significance level. although some of the results are more than 10%, yet the majority of the result is significant. so, it shows the rejection of the null hypothesis of no co-integration and acceptance of alternative hypothesis of co-integration in both cases. thus, the study found long-run relationship between variables. table 3 shows the results of panel fmols (fully modified ordinary least square). coefficient values indicate long-run coefficients. p-values are significant at 1% significance level. as exp has negative sign so, one-unit increase in exp drop the corruption by 0.0753 units. the other two coefficients have positive values indicating an upsurge independent variable. oneunit increase in gdppc and imf push the corruption by 0.0001 and 0.1691 units respectively. gdppc pores a very slight impact on corruption level. as developed countries, mostly trade in oil and industrial products are available in abundance there, so a rise in exports drops the corruption and they import agricultural products the most which they cannot grow easily so imports grow up the corruption with slight difference in these countries. the table 4 shows the t-statistics, coefficient and p-values of ect (error correction term). as the coefficient is negative and p-value is significant at 1% significance level in case of exp and imp, so the study pledges the presence of a short-run association between cpi-exp and cpi-imp. a negative sign of coefficient also shows convergence towards equilibrium. exp and imp converge towards cpi at the speed of 2.65% and 2.67% annually. coefficient of gdppc has a negative sign indicating convergence towards equilibrium at the speed of 0.02% annually. but its p-value is statistically insignificant showing no short-run connection between cpi and gdppc. 5.1. the results of financial development and corruption table 5 shows the t-statistics and p-values are given by levin-lin-chu (2002) and fisher type tests by maddala and wu (1999) and choi (2001). all the variables are non-stationary at level. llc given significant result at the 10% level of significance for cpi, but the other two have given an insignificant result due audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 2019 41 to which the study considers insignificant at level but when both variables are converted into 1st difference, they become stationary. the order of integration of both variables is same, means both are i (1), so we can check the co-integration between them. the table 6 shows the results of residual based panel cointegration test given by pedroni (1999, 2004). the results of five out of seven methods (panel p-statistic, panel pp-statistics, panel adf-statistics, group pp-statistics, group adf-statistics) are statistically significant. although two results are more than 10%, yet the majority of the results are significance of alternative hypothesis of co-integration in both cases, thus the study detected long-run relationship between variables. table 7 shows the results of panel fmols (full modifies ordinary least square). the coefficient value indicates long-run coefficient. p-value is statistically significant. as dcp has positive sign so, 1 unit increase in dcp reveals a gain in corruption index of 0.0714 units. borrowers of private sector practically use the credit for their own best interest and try to get more credit in any way so that they can earn more and more on it, so more credit often induce more corruption. the table 8 shows the t-statistics, coefficient and the p-values of ect (error correction term). a negative sign of coefficient shows the convergence of dcp towards equilibrium. dcp converges (get back) towards cpi at the speed of 0.725 annually as the data included is on an annual basis. but the p-value is statistically insignificant showing no short-run relationship between both variables. 5.2. results of human development and corruption table 9 shows the t-statistics and p-values given by levin-linchu (2002) and fisher type by maddala and wu (1999) and choi (2001). all the variables are non-stationary at level. llc given significant result at the 10% level of significance for cpi, but the other two given insignificant result due to which study considers insignificant at level. so, we cannot reject the null hypothesis of unit root, but when both the variables are converted into 1st difference, they become stationary. the order of integration of both variables is same, means both are i (1), so we can check the co-integration between them. the table 10 shows the results of residual based panel co-integration test given by pedroni (1999, 2004). results of table 1: panel unit root variables methods at level at 1st difference statistic p-value statistic p-value cpi levin-lin-chu (t*) −1.338* (0.090) −20.582*** (0.0000) fisher-adf (χ2)* 44.229 (0.957) 446.70*** (0.0000) fisher-pp (χ)* 39.592 (0.988) 493.53*** (0.0000) exp levin-lin-chu (t*) 4.686 (1.000) −20.548*** (0.0000) fisher-adf (χ2)* 13.996 (1.000) 453.36*** (0.0000) fisher-pp (χ2)* 11.717 (1.000) 448.76*** (0.0000) gdppc levin-lin-chu (t*) 14.402 (1.000) −8.4583*** (0.0000) fisher-adf (χ2)* 13.571 (1.000) 163.155*** (0.0000) fisher-pp (χ2)* 1.92 (1.000) 353.268** (0.0000) imp levin-lin-chu (t*) 4.0913 (1.000) −24.063*** (0.0000) fisher-adf (χ2)* 13.65 (1.000) 542.063*** (0.0000) fisher-pp (χ2)* 12.03 (1.000) 550.725*** (0.0000) t* shows the t-statistic given by levin-lin-chu (2002) and (χ2)* shows the chi-square statistic given by fisher-adf and fisher-pp. *, ** and *** are to show significance at 10%, 5% and 1% respectively. table 2: panel co-integration alternative hypothesis technique t-statistic common ar coefficients “within-dimension” panel v-statistic 0.609 (0.271) panel p-statistic 0.140 (0.556) panel pp-statistic -3.674*** (0.0001) panel adf-statistic -3.246*** (0.000) individual ar coefficients “between-dimension” group p-statistic 2.534 (0.994) group pp-statistic -3.588*** (0.000) group adf-statistic -3.390*** (0.000) *, ** and *** are to show significance at 10%, 5% and 1% respectively. table 3: the results of fmols variables coefficient t-statistic p-value exp gdp pc −0.075 9.2e-05 [−4.192]*** [7.518]*** (0.000) (0.000) imp 0.169 [8.412]*** (0.000) *, ** and *** are to show significance at 10%, 5% and 1% respectively. table 4: the results of vecm variables coefficient t-statistic p-value exp −0.075 [−4.359]*** (0.000) gdppc 9.26-05 [7.518]*** (0.290) imp 0.169 [8.412]*** (0.000) *, ** and *** are to show significance at 10%, 5% and 1% respectively. audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 201942 the seven methods are statistically significant. so, it shows the rejection of the null hypothesis of no co-integration and acceptance of alternative hypothesis of co-integration in both cases, thus the study found long-run relationship between variables. table 11 shows results of panel fmols (full modified ordinary least square). the coefficient value indicates long-run coefficient. p-values are statistically significant. as hdi has a positive sign, so, table 5: panel unit root variables methods t-statistic p-value t-statistic p-value cpi levin-lin-chu (t*) −1.338* (0.090) −20.582*** (0.0000) fisher-adf (χ2)* 44.229 (0.957) 446.70*** (0.0000) fisher-pp (χ)* 39.592 (0.988) 493.53*** (0.0000) dcp levin-lin-chu (t*) 6.687 (1.000) −13.812*** (0.0000) fisher-adf (χ2)* 13.526 (1.000) 310.48*** (0.0000) fisher-pp (χ2)* 12.519 (1.000) 331.39*** (0.0000) table 6: panel co-integration alternative hypothesis techniques t-statistic common ar coefficients “within-dimension” panel v-statistic 1.147 (−0.125) panel p-statistic −1.527* (−0.063) panel pp-statistic −3.450*** (0.000) panel adf-statistic −3.959*** (0.000) individual ar coefficients “between-dimension” group p-statistic −0.312 (−0.377) group pp-statistic −2.861*** (−0.002) group adf-statistic −4.640*** 0 *, ** and *** are to show significance at 10%, 5% and 1% respectively. table 7: the results of fmols variable coefficient t-statistic p-value dcp 0.071 [43.786]*** (0.000) table 8: the results of vecm variable coefficient t-statistic p-value ect dcp −0.007 [−1.150] (0.250) table 10: panel co-integration alternative hypothesis techniques t-statistic common ar coefficients “within-dimension” panel v-statistic 3.312*** (0.000) – panel p-statistic –4.242* (0.000) – panel pp-statistic –5.163*** (0.000) – panel adf-statistic –6.073*** (0.000) individual ar coefficients “between-dimension” group p-statistic – –3.319** (0.000) group pp-statistic – –7.681*** (0.000) group adf-statistic – –8.264*** (0.000) *, ** and *** are to show significance at 10%, 5% and 1% respectively. table 9: panel unit root variables methods t-statistic p-value t-statistic p-value cpi levin-lin-chu (t*) −1.338* −0.09 −20.582*** (0.0000) fisher-adf (χ2)* 44.229 −0.957 446.70*** (0.0000) fisher-pp (χ)* 39.592 −0.988 493.53*** (0.0000) hdi levin-lin-chu (t*) −0.886 −0.187 -47446*** (0.0000) fisher-adf (χ2)* 33.984 −0.998 668.91*** (0.0000) fisher-pp (χ2)* 34.663 −0.998 623.19*** (0.0000) one-unit increase in hdi shows an increase in corruption index of 7.8162 units. when people are richer and educated, they will be more aware of their fundamental rights, so to get their rights they will indulge in corrupt activities if they are unable to get their works done easily. the table 12 shows the t-statistics, coefficient and the p-values of ect (error correction term). a positive sign of the coefficient audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 2019 43 indicates divergence of hdi towards equilibrium. hdi diverges (depart) from cpi at the speed of 0.4% annually and the p-value is also statistically insignificant presenting no short-run dynamics between both variables. 5.3. result of political development and corruption table 13 shows the t-statistics and p-value given by levin-lin-chu (2002) and fisher type by maddala and wu (1999) and choi (2001). all the variables are non-stationary at level. llc given significant at the 10 % level of significance for the three variables, but the other two given insignificant results due to which study considers them insignificant at level, so we cannot reject the null hypothesis of unit root, but when all variables are converted into 1st difference, they become stationary, as all the p-values are statistically significant at 1% significance level. the order of integration of all variables is same, means all variables are i (1), so we can check the co-integration among them. the table 14 shows the results of residual based panel cointegration test given by pedroni (1999, 2004). the results of five out of seven methods (panel p-statistic, panel pp-statistics, panel adf-statistics, group pp-statistics, group adf-statistics) are statistically significant, as p-values of panel p-statistic is <1% significance level in case of other four tests. although three methods have been given values more than 10%, yet the majority of the results are significant. so, it shows the rejection of the null hypothesis of no co-integration and acceptance of alternative hypothesis of co-integration in both cases. thus, the study found long-run relationship among variables. table 13: panel unit test variables methods at level at 1st difference statistic p-value statistic p-value cpi levin-lin-chu (t*) −1.338* (0.090) −20.582*** (0.0000) fisher-adf (χ2)* 44.229 (0.957) 446.70*** (0.0000) fisher-pp (χ)* 39.592 (0.988) 493.53** (0.0000) bur levin-lin-chu (t*) −2.265 (0.011) −27.868*** (0.0000) fisher-adf (χ2)* 48.715 (0.890) 566.017** (0.0000) fisher-pp (χ2)* 52.367 (0.803) 652.906*** (0.0000) demo levin-lin-chu (t*) −0.2399 (0.405) −30.350*** (0.0000) fisher-adf (χ2)* 40.054 (0.986) 613.52*** (0.0000) fisher-pp (χ2)* 54.664 (0.734) 668.75*** (0.0000) polstb levin-lin-chu (t*) −2.43 (0.007) −33.018*** (0.0000) fisher-adf (χ2)* 64.044 (0.404) 639.70*** (0.0000) fisher-pp (χ2)* 73.313 (0.154) 714.30*** (0.0000) rlw levin-lin-chu (t*) 3.1973 (0.999) −28.339*** (0.0000) fisher-adf (χ2)* 27.354 (1.000) 572.28*** (0.0000) fisher-pp (χ2)* 38.395 (90.992) 629.14*** (0.0000) table 14: panel co-integration alternative hypothesis techniques t-statistic common ar coefficients “within-dimension” panel v-statistic –2.031*** (0.978) – panel p-statistic 0.712* (0.762) – panel pp-statistic –4.158*** (0.000) – panel adf-statistic –3.408*** (0.000) individual ar coefficients “between-dimension” group p-statistic – 2.491** (0.993) group pp-statistic – –5.805*** (0.000) group adf-statistic – –4.857*** (0.000) table 15: the results of fmols variable coefficient t-statistic p-value bur i.613 [7.911]*** 0 demo 2.653 [11.006]*** 0 polstb −0.124 [−0.743] −0.457 rlw 0.687 [2.543]** −0.011 table 16: the results of vecm ect variable coefficient t-statistic p-value bur −0.098 [−5.502]*** 0 demo −0.033 [−4.651]*** 0 polstb −0.039 [−5.407]*** 0 rlw −0.074 [−5.445]*** 0 table 11: the results of fmols variable coefficient t-statistic p-value hdi 7.816 [226.586]*** (0.000) table 12: the results of vecm variable coefficient t-statistic p-value ect hdi 0.004 [1.566] (0.117) audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 201944 table 15 shows results of panel fmols (full modified ordinary least square). the coefficient value indicates long-run coefficient. p-values of bur, demo and rlw are significant at 1% and 5% significance level respectively. these variables affect corruption significantly. one-unit increase in bur, demo, and rlw push the corruption up by 1.6136, 2.6533 and 0.6874 units respectively. but the p-values of polstb is insignificant as it is more than 10%. it affects corruption negatively, but insignificantly, means it has no significant relationship with corruption in developed countries. longer tenure of bureaucracy often results in corrupt activities. in a more democratic nations where media open all secrets and rules are strict to be implemented, some hidden corruption rise to get personal benefits. the table 16 shows the t-statistics, coefficient and the p-values of ect (error correction term). as the coefficients in all cases are negative and p-values are significant at the 1 % significance, the study concludes the presence of a short-run relationship between cpi-bur, cpi-demo, cpi-polstb and cpi-rlw. a negative sign of coefficients shows convergence towards equilibrium. bur converges towards cpi at the speed of 9.88% annually. • demo converges towards cpi at the speed of 3.33% annually. • polstab converges towards cpi at the speed of 3.98%. • rlw converges towards cpi at the speed of 7.46% annually. p-value are statistically insignificant presenting short-run dynamics among different combinations of variables. 5.4. results of economic development and corruption table 17 shows the t-statistics and p-values given by levin-linchu (2002) and fisher type tests by maddala and wu (1999) and choi (2001). all the variables are non-stationary at level, as all p-values are insignificant at 1%, 5% and 10%, so we cannot reject the null hypothesis of unit root, but when all variables are converted into 1st difference, they become stationary as all the p-values are statistically significant at 1% significance level. the order of integration of all variables is same, means all variables are i (1), so we can check the co-integration among them. the table 18 shows the results of residual based panel cointegration test given by pedroni (1999, 2004). the results of four out of seven methods (panel pp-statistic, panel adf-statistic, group pp-statistic, and group adfstatistic) are statistically significant, as p-values of these tests are <1% significance level. table 17: panel unit root variables methods at level at 1st difference statistic p-value statistic p-value cpi levin-lin-chu (t*) 1.7 −0.955 −33.00*** 0 fisher-adf (χ2)* 43.043 −1 907.57*** 0 fisher-pp (χ)* 41.917 −1 967.29*** 0 exp levin-lin-chu (t*) 0.578 −0.718 −29.86*** 0 fisher-adf (χ2)* 55.893 −0.999 838.39** 0 fisher-pp (χ2)* 52 −1 876.56*** 0 gdppc levin-lin-chu (t*) 13.92 −1 −6.88*** 0 fisher-adf (χ2)* 35.115 −1 326.10*** 0 fisher-pp (χ2)* 13.456 −1 523.07*** 0 imp levin-lin-chu (t*) 0.25 −0.598 −29.88*** 0 fisher-adf (χ2)* 53.027 −0.999 841.87*** 0 fisher-pp (χ2)* 48.167 −1 898.08*** 0 table 18: panel co-integration alternative hypothesis techniques t-statistic common ar coefficients “within-dimension” panel v-statistic –2.881 (0.9980) – panel p-statistic 0.690 (0.755) – panel pp-statistic –3.324*** (0.000) – panel adf-statistic –3.973*** (0.000) individual ar coefficients “between-dimension” group p-statistic – 2.835 (0.997) group pp-statistic – –4.283*** (0.000) group adf-statistic – –4.869*** (0.000) table 19: the results of fmols variable coefficient t-statistic p-value exp 0.027 [3.226]*** (0.000) gdppc 0.000 [5.863]*** (0.000) imp 0.054 [6.696]*** (0.000) table 20: the results of vecm ect variable coefficient t-statistic p-value exp −0.044 [−4.541]*** (0.000) gdppc (0.000) [0.033] −0.738 imp −0.046 [−4.653]*** (0.000) table 21: panel unit root variable coefficient t-statistic p-value ect hdi 0.004 [1.566] (0.117) audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 2019 45 although some of the results are more than 10%, yet the majority of the results are significant. so, it shows the rejection of the null hypothesis of no co-integration and acceptance of alternative hypothesis of co-integration in both cases, thus, the study found long-run relationship between variables. table 19 shows the results of panel fmols (full modified ordinary least square), coefficient values indicate long-run coefficients. p-values are significant at 1% significance level. all coefficients have positive values indicating an escalation independent variable. one-unit increase in exp effect corruption by 0.0278 units positively and one-unit upward trend in gdppc and imp push the corruption up by 0.0001 and 0.0549 units respectively. gdppc leaves a very slight impact on corruption level. the nations in this panel are mostly imported industrial products and export agriculture commodities so imports are more prone to corruption as compared to exports. income inequality results in more corruption as compared to gdppc itself. the table 20 shows the t-statistics, coefficient and the p-values of ect (error correction term). as the coefficients are negative and p-values are significant at 1% significance level in case of exp and imp, so the study assures the presence of a short-run association between cpi-exp and cpi-imp. a negative sign of coefficient also shows convergence towards equilibrium. • 4.41% annual convergence of exp towards cpi • 4.6% annual convergence of imp towards cpi. coefficient of gdppc has a negative sign highlighting convergence towards equilibrium at the speed of 0.02% annually, but its p-value is statistically insignificant showing no short-run connection among them. 5.5. results of financial development and corruption table 21 shows the t-statistics and p-values given by levin-linchu (2002) and fisher type test by maddala and wu (1999) and choi (2001). all the variables are non-stationary at level, as all p-values are insignificant at 1%, 5% and 10%, so we cannot reject the null hypothesis of unit root, but all variables are converted into 1st difference, they become stationary, as all the p-values are statistically significant at 1% significance level. the order of integration of all variables is same, all variables are i (1), so we can check the co-integration among them. the table 22 shows the results of residual based panel cointegration test given by pedroni (1999, 2004), the results of four out of seven methods, (panel pp-statistics, panel adf-statistic, group pp-statistic and group adf-statistic) are statistically significant, as p-values of the first two tests are less than 5% and the other two are <1% significance level. although some results are more than 10%, yet the majority of the results are significant. so, it shows the rejection of the null hypothesis of no co-integration and acceptance of alternative hypothesis of co-integration in both cases, thus the study found long-run relationship between variables. table 23 shows the results of panel fmols (full modified ordinary least square), coefficient values indicate long-run coefficients. p-values are significant at 1% significance level. as dcp has positive sign so, one-unit increase in dcp reveals a gain in corruption index of 0.01101 units. people of private sector try to pull maximum credit towards them in order to get extra benefits, so more credit usually results in more doubtful activities. the table 24 shows the t-statistics, coefficient and p-values of ect (error correction term). a negative sign of coefficient shows the convergence of dcp towards equilibrium. dcp convergence (get back) towards cpi at the speed of 4.82% annually as the data include is on an annual basis. the p-values are also statistically significant presenting a shortrun relationship between both variables. 5.6. result of human development and corruption table 25 shows the t-statistics and p-values given by levin-linchu (2002) and fisher type tests by maddala and wu (1999) and choi (2001). all the variables are non-stationary at level, as all p-values are significant at 1%, 5% and 10%, so we cannot reject the null hypothesis of unit root, but when all variables are taken at 1st difference, they become stationary, as all the p-values are statistically significant at 1% significance level. the order of integration of all variables is same, means all variables are i (1), so we can check the co-integration between them. the table 26 shows the results of residual based panel cointegration test given by pedroni (1999, 2004). all the results are statistically significant at the p-values are less than 1% of significance level. so, it shows the rejection of the null hypothesis table 22: panel co-integration alternative hypothesis techniques t-statistic common ar coefficients “within-dimension” panel v-statistic –3.726 (0.999) – panel p-statistic –0.513 (0.001) – panel pp-statistic –3.040*** (0.001) – panel adf-statistic –2.893*** (0.001) individual ar coefficients “between-dimension” group p-statistic 2.424 (0.992) group pp-statistic – –3.943*** (0.000) group adf-statistic – –4.865***(0.000) table 23: the results of fmols variable coefficient t-statistic p-value dcp 0.110 [54.135]*** (0.000) table 24: the results of vecm variable coefficient t-statistic p-value ect dcp −0.048 [-4.675]*** (0.000) audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 201946 of no co-integration and acceptance of alternative hypothesis of co-integration in both cases, thus the study found long-run relationship between variables. table 27 shows results of panel fmols (fully modified ordinary least square). the coefficient value indicates long-run coefficient. p-values are statistically significant at 1% significance level. as hdi has a positive sign, so, one-unit increase in hdi shows an increase in corruption index of 4.9028 units. when people are richer and aware, they spend more to get benefits, if not available easily on a legal basis. the table 28 shows the t-statistics, coefficient and p-values of ect (error correction term). a negative sign of the coefficient indicates a convergence of hdi towards equilibrium. hdi converges (get back) towards cpi at the speed of 2.66% annually. its p-value is also statistically significant at 5% significance level, presenting a short-run connection between both variables. 5.7. results of political development and corruption table 29 shows the t-statistics and p-values given by levin-linchu (2001) and fisher type by maddala and wu (1999) and choi (2001). all the variables are non-stationary at level, as all p-values are insignificant at 1%, 5% and 10%, the null hypothesis of unit root cannot be rejected, but when all variables are taken at 1st difference, they become stationary, as all the p-values are statistically significant at 1% significance level. the order of integration of all variables is same, means all variables are i (1), so we can check the co-integration among them. the table 30 shows the results of residual based panel cointegration test given by pedroni (1999, 2004). the results of four out of seven methods (panel pp-statistic, panel adfstatistic, group pp-statistic, and group adf-statistic) are statistically significant, as p-values are less than 1% significance level in these four tests. although three methods have been given values more than 10%, yet the majority of the results are significant. so, it shows the rejection of the null hypothesis of no co-integration and acceptance of alternative hypothesis of co-integration in both cases, thus the study found long-run relationship among variables. table 31 shows the results of panel fmols (fully modified ordinary least square). coefficient values indicate long-run relationship. p-values of bur, demo and polstb are significant at 1% significance level. these variables have a significant impact on corruption. one-unit increase in bur and polstb drop the corruption level of 0.2875 units and 1.4290 units respectively due to their negative signs. demo affects corruption positively by 1.8782 units as it has positive sign with coefficient. but the p-value of rlw is insignificant as it is more than 10%. it affects corruption negatively by 1.4318 units, but insignificantly. the increased amount of bureaucracy, more stable politicians and a perfect law and order condition often put pressure to overcome malfunctioned activities, but more democracy where everything becomes open, some hidden doubtful activities always run. the table 32 shows the statistics, coefficient and the p-values of ect error correction term). as the coefficients in all cases are negative and p-values are significant at the 1% level of significance, the study settles the presence of a short-run relationship between cpi-bur, cpi-demo, cpi-polstb and cpi-rlw. a negative sign of coefficients shows convergence towards equilibrium. • bur convergence toward cpi at the speed of 11.07% annually. • demo converges toward cpi at the speed of 5.8% annually. • polstb converge toward cpi at the speed of 5.65% annually. • rlw converges towards cpi at the speed of 10.07% annually. table 25: panel unit root variables methods t-statistic p-value t-statistic p-value cpi levin-lin-chu (t*) 1.7 −0.955 −33.086*** (0.000) fisher-adf (χ2)* 43.041 (1.000) 907.57*** (0.000) fisher-pp (χ)* 41.917 (1.000) 967.29*** (0.000) hdi levin-lin-chu (t*) 0.913 (0.819) −28.765*** (0.000) fisher-adf (χ2)* 38.356 (1.000) 763.37*** (0.000) fisher-pp (χ2)* 38.745 (1.000) 1000.67*** (0.000) table 26: panel co-integration alternative hypothesis techniques t-statistic common ar coefficients “within-dimension” panel v-statistic 4.414*** (0.000) – panel p-statistic –7.186*** (0.000) – panel pp-statistic –7.205*** (0.000) – panel adf-statistic –6.709*** (0.000) individual ar coefficients “between-dimension” group p-statistic –3.162*** (0.000) group pp-statistic – –8.293*** (0.000) group adf-statistic – –7.862*** (0.000) table 27: the results of fmols variable coefficient t-statistic p-value hdi 4.902 [155.467]*** (0.000) table 28: the results of vecm variable coefficient t-statistic p-value ect hdi −0.026 [−3.026]*** (0.002) audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 2019 47 p-values are statistically significant presenting short-run dynamic among different combination of variables. 6. conclusions and policy suggestions this study focused on the impacts of development (economic, financial, human, and political) on corruption. it examined this relationship by using 20 years’ data from a sample of two panels of 49 developing and 31 developed countries. the main objective was to discover a long-term connection and short-run dynamics between variables. at first, a thorough literature has been reviewed on the relationship of economic development and corruption, financial development and corruption, human development and corruption respectively. as a result of the discussion, a detailed econometric methodology has been established to be used in this particular study. corruption perception index was used as regress and to measure corruption. regressors were classified into four categories. for economic development gdp per capita, ratio of exports of goods and services to gdp, ratio of imports of goods and services to gdp has been used. for financial development, ratio of domestic credit to private sectors to gdp was employed. human development is measured by human development index and for political development, government effectiveness as a proxy of bureaucracy, voice, and accountability as a proxy of democracy, political stability and rule of law was used. stationarity has been tested to emit spurious results, with the help of three main tests named levin-lin-chu (2002), fisheradf by maddals and wu (1999) and fisher-pp by choi (2001). all variables were stationary at the first difference, therefore, long-term relationship was examined by using pedroni (1999) residual based panel co-integration test. after accomplishing long-run connection among variables, co-integration coefficient has been estimated through panel fmols technique, and the results implied that all development variables have a significant impact on corruption except political stability in case of developed panel and bureaucracy in case of developing panel. lastly, the speed of adjustment and short-term association has been tested by applying panel vecm and the results established that short-run dynamics exist between exp, imp, bur demo, polstb, rlw and cpi in developed countries. whereas in developing countries, all variables have a short-run relationship with corruption expect gdp per capita. table 29: panel unit root variables methods at level at 1st difference statistic p-value statistic p-value cpi levin-lin-chu (t*) 1.7 –0.955 –33.08*** 0 fisher-adf (χ2)* 43.043 –1 907.57*** 0 fisher-pp (χ)* 41.917 –1 967.29*** 0 bur levin-lin-chu (t*) –1.858 –0.315 –35.49*** 0 fisher-adf (χ2)* 131.9 –1 893.47*** 0 fisher-pp (χ2)* 128.59 –0.802 1048.57*** 0 demo levin-lin-chu (t*) –1.761 –0.457 –36.34*** 0 fisher-adf (χ2)* 158.86 –0.994 863.90*** 0 fisher-pp (χ2)* 141.04 –0.298 1121.26*** 0 polstb levin-lin-chu (t*) –2.276 –0.998 –40.97*** 0 fisher-adf (χ2)* 144.54 –1 985.81** 0 fisher-pp (χ2)* 157.14 –0.788 1071.06*** 0 rlw levin-lin-chu (t*) –3.529 –0.459 –37.82*** 0 fisher-adf (χ2)* 135.21 –0.983 965.59*** 0 fisher-pp (χ2)* 134.4 –0.879 1045.11*** 0 table 30: panel co-integration alternative hypothesis techniques t-statistic common ar coefficients “within-dimension” panel v-statistic –1.242 (0.893) – panel p-statistic 1.783 (0.962) – panel pp-statistic –4.860*** (0.000) – panel adf-statistic –6.006*** (0.000) individual ar coefficients “between-dimension” group p-statistic 4.160 (1.000) group pp-statistic – –5.374*** (0.000) group adf-statistic – –6.673*** (0.000) table 31: the results of fmols variable coefficient t-statistic p-value bur −0.28 [−1.349] (0.177) demo 1.87 [12.569]*** (0.000) polstb −1.42 [−3.843]*** (0.000) rlw −1.43 [−7.877]*** (0.000) table 32: the results of vecm variable coefficient t-statistic p-value ect bur −0.11 [−6.808]*** (0.000) demo −0.058 [−5.103]*** (0.000) polstb −0.056 [−4.783]*** (0.000) rlw −0.1 [−6.423]*** (0.000) audi and ali: exploring the linkage between corruption and economic development in the case of selected developing and developed nations international journal of economics and financial issues | vol 9 • issue 4 • 201948 some policy suggestions with the point of view of corruption and development relationship have been inferred from this study, which include: policy makers must simplify the imports and export procedures. it will help reduce the practice of bribes to get their matters resolves quickly. government should take steps to not only increase the income of people, but also to improve their standard of living in other aspects of life especially in developing countries. credit availability to the public sector should also be made available on easy terms similar to that of the private sector. but the policies and check & balance system in both cases should be strict. along with improved standards of living, people should be served without 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